29

3. MULTIPLE CHOICE. Which of the following changes would increase the value of a call
option?
A. Lower volatility of the value of the underlying asset.
B. Longer time to maturity.
C. Lower interest rate.
D. Higher strike price.
4. MULTIPLE CHOICE. Which of the following statements regarding forward contracts is true?
A. Forward contracts are traded in organized exchanges.
B. There is marking to market in a forward contract.
C. In a forward contract no money changes hands until delivery date.
D. Each trader in a forward contract must establish a margin account at initial execution of
a trade.
5. MULTIPLE CHOICE. Which of the following statements regarding futures contracts is true?
A. The long-position trader commits to delivering the commodity at contract maturity.
B. A long-position trader may choose not to carry through with the contract if it is
unproftable.
C. The short positions loss may exceed the long positions gain.
D. The long-position trader profts from price increases.
6. MULTIPLE CHOICE. Which of the following statements regarding the value of a call option
is false?
A. If the price of the underlying asset increases, the value of the call increases.
B. If the expiration date of the option is extended, the value of the call increases.
C. If the volatility of the value of the underlying asset decreases, the value of the call
increases.
D. If the exercise price increases, the value of the call decreases.
30
Asset Pricing & Valuation
Models
101 Discounted Cash Flows
Suppose that a project generates a series of expected cash fows from time 1 until time t. To fnd the
present value of this project, we can add the extended stream of cash fows using the discounted cash
fow (or DCF) formula:
The DCF formula for the present value of a stock is just the same as it is for the present value of any
other asset. We just discount the dividend stream (i.e., the cash fows) by the return that can be earned
in the capital market on securities of comparable risk. This required rate of return is typically called
the market capitalization rate.
Example:
What is the present value of a project that generates the following cash fows: $200 at time
1, $150 at time 2, and $300 at time 3 if the interest rate is 5%?
SOLUTION:
102 Market Multiples
Comparative valuation ratios are used to assess the valuation of one frm versus another based on
a fundamental indicator such as earnings. These ratios give insight into how well investors in the
marketplace feel the frm is doing in terms of risk and return. They tend to refect, on a relative
basis, the common stockholders assessment of all aspects of the frms past and expected future
performance.
One of the most commonly used comparative measure is the price-to-earnings multiple commonly
called the P/E ratio is calculated by dividing the market price per share of common stock by the
earnings per share.
The P/E ratio measures the price that investors are prepared to pay for each dollar of earnings. The P/E
ratio is most informative when applied in cross-sectional analysis using an industry average P/E ratio
or the P/E ratio of a benchmark frm.
The P/E ratio is also a useful measure of the markets assessment of the frms growth opportunities.
To see this, denote a stocks current price by P
0
, next periods expected earnings per share by EPS
1
, the
market capitalization rate by r and the net present value of growth opportunities by PVGO. The P/E
ratio formula can be expressed as
(10.1)
10
31
From equation (10.1) we can see that if PVGO = 0, the P/E ratio is just 1/r. However, as PVGO
increases, the P/E ratio can rise considerably. Thus a high P/E multiple indicates that a frm enjoys
ample growth opportunities.
Other comparative ratios commonly used are:
Price-to-book ratio (price per share divided by book value per share). Some analysts view
book value as a useful measure of value, so they use this ratio as an indicator of how the
market values a frm. Firms expected to earn high returns relative to their risk typically
sell at higher price-to-book ratios. Like P/E ratios, price-to-book ratios are typically assed
cross-sectionally to get a feel for the frms return and risk compared to peer frms.
Price-to-cash fow ratio (price per share divided by cash fow per share). Some analysts
prefer to use this ratio rather than the P/E ratio since cash fow fowing into or out of the
frm is less affected by accounting decisions.
Price-to-sales ratio (price per share divided by annual sales per share). This ratio is
particularly useful for start-up frms which have no earnings.
Example:
A frms common stock at the end of 2010 was selling at $32.25, had an earnings per share
of $2.90 and a book value per share of common stock of $23.00. Calculate and interpret the
frms P/E ratio and its price-to-book ratio.
SOLUTION:
The P/E ratio is calculated as follows:

This fgure indicates that investors were paying $11.10 for each $1.00 of earnings.
The price-to-book ratio is calculated as follows:

This fgure indicates that investors are currently paying $1.40 for each $1.00 of book value of the
frms stock. In this case, the frms future prospects are being viewed favorably by investors, who are
willing to pay more than its book value for the frms shares.
103 CAPM
The capital asset pricing model (CAPM) is a model of asset return determination. According to the
CAPM, the only risk that is priced (that is, which requires additional return to compensate the investor
for bearing that risk) is the market risk. Idiosyncratic risk is not priced since investors can diversify it
away.
Recall that a well-diversifed portfolio has virtually no idiosyncratic risk; for such portfolio, the risk
depends on how sensitive it is to market movements. This sensitivity to the market is called beta, . In
general, the beta of stock i,
i
, is defned as:

where
im
is the covariance between stock is return and the market return and
2
m
is the variance of the
market return.
The return of a stock with a beta of 1 will change in exactly the same direction and magnitude as the
markets return. The returns of stocks with betas greater than 1 amplify the overall movements of the
markets return. The returns of stocks with betas between 0 and 1 move in the same direction as the
markets return, but in a smaller magnitude.
32
With this information, we can determine the appropriate rate of return for stock i since, in a
competitive market, this should vary in direct proportion to beta. Two assets with the same beta should
have the same rate of return. This is the fundamental message of the CAPM. The expected rate of
return for any stock i is given by the following equation:
(10.2)
where the r
f
is the market risk-free rate of return, and the r
m
is an estimate of the market rate of return.
The term (r
m
- r
f
) in the right-hand side of equation (10.2) is called the market risk premium. In
practice, the return on a value-weighted portfolio of NYSE stocks is used as a proxy for r
m
. The return
on T-bills is usually used as proxy for the risk-free rate.
As illustrated in Figure 10.1, according to the CAPM model, in equilibrium, every investment should
lie along a positively sloped line know as the security market line. Note, that
i
= 1, then stock i has
the same risk as the market, so the appropriate rate of return of stock i is r
f
= r
m
.

Example:
Table 10.1 provides information about the market portfolio. Using this information
calculate the beta of the frms stock and its expected rate of return.

SOLUTION:
First we calculate the beta plugging the information in the formula

Using this result we can calculate the expected rate of return
33
104 The Black-Scholes Formula
The Black-Scholes model determines the price of an option based on fve factors:
1. Price of underlying asset
2. Exercise price
3. Expiration date
4. Variability of underlying asset
5. Interest rate on risk-free bonds.
All of these factors are directly observable with the exception of the variability of the asset which
needs to be estimated.
The value of the call in the Black-Scholes formula has the same properties that we identifed in chapter
9. It increases with the level of stock price and decreases with the exercise price. It also increases with
the time to maturity and the variability of the underlying asset.
The important assumptions of the Black-Scholes formula are:
(a) The price of the underlying asset follows a lognormal random walk.
(b) Investors can adjust their hedge continuously and costlessly.
(c) The risk-free rate is known.
(d) The underlying asset does not pay dividends.
105 Economic Value Added
Economic value added (EVA) is a method that calculates the net dollar return to shareholders. It is
given by the spread between ROA (return over assets) and the opportunity cost of capital (the market
capitalization rate). It measures the dollar value of the frms return in excess of its opportunity cost.
Another term for EVA is residual income and it can be measured by the following formula:
EVA = residual income = income earned - income required
= income earned - cost of capital x investment
EVA treats the opportunity cost of capital as a real cost that should be deducted from revenues. A
manager can improve a frms EVA by (1) increasing earnings or (2) reducing the cost of capital.
A growing number of frms now calculate EVA and tie management compensation to it. The message
EVA sends to managers is: invest if and only if the increase in earnings is enough to cover the cost of
capital. Thus a focus on EVA can help managers concentrate on increasing shareholders wealth.
PRACTICE QUESTIONS CHAPTER 10
1. MULTIPLE CHOICE. Which of the following statements regarding market multiples is true?
A. The P/E ratio of a frm with no growth opportunities will be equal zero.
B. As growth opportunities become a more important component of the total value of the
frm, the P/E ratio will increase.
C. As growth opportunities become a more important component of the total value of the
frm, the P/E ratio will decrease.
D. The P/E ratio is unrelated to the growth rate opportunities of a frm.
2. MULTIPLE CHOICE. Which of the following statements regarding market multiples is false?
A. A price-to-book ratio greater than one indicates that a frms future prospects are being
viewed favorably by investors.
B. Firms expected to earn high returns relative to risk typically have low price-to-book
ratios.
C. A P/E ratio of 5 indicates that investors are paying $5 for each $1 of earnings.
D. The P/E ratio is commonly used to assess the investors appraisal of share value.
34
3. MULTIPLE CHOICE. Which of the following statements regarding the CAPM is true?
A. Investors should be compensated for bearing idiosyncratic risk.
B. Two assets with the same beta may have different expected rates of return.
C. The appropriate discount rate for a stock with a beta of 1 ( = 1) is the risk-free rate.
D. The appropriate discount rate for a stock with a beta of 1 is the market rate of return.
4. Table 10.2 provides other relevant information about an investment opportunity. What is the
expected rate of return of this project?

5. MULTIPLE CHOICE. Which of the following factors is not required to calculate the price of
an option according to the Black Scholes model?
A. Investors level of risk aversion.
B. Risk-free interest rate.
C. Maturity date.
D. Strike price.
6. MULTIPLE CHOICE. Which of the following statements regarding EVA is true?
A. It measures the spread between ROE and the opportunity cost of capital.
B. It measures the spread between the P/E ratio and the opportunity cost of capital.
C. It measures the spread between ROS and the opportunity cost of capital.
D. It measures the spread between ROA and the opportunity cost of capital.
35
Choosing Investments
Capital budgeting is the process of evaluating and selecting long-term investments that are consistent
with the frms goal of maximizing owner wealth. When frms have determined the relevant cash fows
of a project, the decision-maker must apply appropriate decision techniques to assess whether the
project creates value. The preferred approaches integrate time value procedures and risk and return
considerations.
Capital budgeting decisions should be based on the relevant cash fows associated with a project.
The relevant cash fows are incremental cash fowscash fows that will occur if an investment is
undertaken but that wont occur if it isnt.
111 Net Present Value
The net present value (NPV) of a project is calculated as the present value minus the projects
required investment. Suppose that a project requires an initial investment of C
0
at time 0 (i.e., a cash
outfow) and at time 1 it generates a cash infow of C
1
. The formula for calculating the NPV can be
written as:
(11.1)
The appropriate discount rate, r, is the rate of return offered by equivalent investment alternatives in
the capital market, that is, the opportunity cost of capital.
Now, suppose that a project generates a series of expected cash fows from time 1 until time t as
illustrated in the timeline of Figure 11.1. To fnd the NPV of such project, we can expand the formula
in equation (11.1) by using the discounted cash fow formula as follows:
The net present value rule is to accept only projects that have a positive NPV. This rule entails
accepting only those projects that are worth more than they cost and that therefore, make a net
contribution to the investors wealth. Note that the NPV rule recognizes the time value of money (i.e.,
that a dollar today is worth more than a dollar tomorrow).
11
36
The NPV rule has an adding-up property. Since present values are all measured in todays dollars, we
can add up the NPV of different to calculate the net present value of the combined investment. With
two projects, A and B, the combined NPV is given by
NVP = (A +B) = NVP(A) + NVP(B)
The three important attributes of the NPV as decision-making process are:
1. NPV uses cash fows (as opposed to earnings which are an artifcial construct).
2. NPV uses all the cash fows of the project.
3. NPV discounts the cash fows properly.
NPV depends only on the forecasted cash fows from the project and the opportunity cost of capital
that is why it leads to better investment decisions than other criteria. Any investment rule which does
not recognize the time value of money or that is affected by the managers tastes, the frms choice of
accounting method or the proftability of other independent projects will lead to inferior decisions.
Examples:
1. You are offered a project that requires an initial investment of $400 today and generates a
cash fow of $500 a year from now. Assume that common stocks with the same risk as this
investment offer a 10% expected return. Should you accept the project?
SOLUTION:


Yes, you should accept the project, since it generates a cash infow of $454.55 (in present
value) and requires a cash outfow of only $400. Thus the project increases your wealth by
$54.55.
2. You are offered a project that requires an initial investment of $500 today and generates
the following cash fows: $200 at time 1, $150 at time 2, and $300 at time 3. The interest
rate is 5%. Should you accept the project?
SOLUTION:


Yes, you should accept the project because the NPV is positive.
112 The Internal Rate of Return
The internal rate of return (IRR) is the rate of discount that makes the NPV equal to zero. To fnd
the IIR for an investment lasting t periods, we need to solve for IRR from the expression

(11.2)
Note that even though the IRR appears as the discount rate in equation (11.2) it is not the opportunity
cost of capital. The IRR is a proftability measure that depends solely on the amount and the timing
of the projects cash fows. In contrast, the opportunity cost of capital is the expected rate of return
offered by other assets with the same risk as the project being evaluated and it is determined by the
capital markets.
The IRR rule is to accept a project if the opportunity cost of capital is less than the internal rate of
return. If the opportunity cost of capital is less than the IRR, then the project will have a positive NPV
when discounted at the opportunity cost of capital.
37
The IRR method for selecting capital budgeting projects is popular among fnancial practitioners for
three primary reasons:
1. IRR focuses on all the cash fows associated with the project.
2. IRR adjusts for the time value of money.
3. IRR describes projects in terms of the rate of return they earn, which makes it easier to
compare them with other investments and the frms opportunity cost of capital.
Just like the NPV rule, the IRR rule is a technique based on discounted cash fows and will therefore
give the correct answer if properly used. In fact, as long as the proposed capital budgeting projects
are independent, both NPV and IRR methods will produce the same accept/reject indication. That is,
a project that has a positive NPV will also have an IRR that is greater than the opportunity cost of
capital. There are, however, four cases were caution is required if using the IRR rule:
1. Investing or fnancing? If a project offers positive cash fows followed by negative fows,
then the rule is to accept the project if the IRR is less than the opportunity cost of capital.
2. Multiple IRRs. When a project has nonconventional cash fows (i.e., they have more than
one sign change), more than one IRR might result.
3. Mutually exclusive projects. The IRR rule may give the wrong ranking of mutually
exclusive projects that differ in scale of required investment.
4. Timing problem. The cost of capital for near-term cash fows may be different from the cost
for distant cash fows. In these cases there is no simple yardstick for evaluating the IRR of a
project.
Example:
Consider a project that requires an initial investment of $500 and generates a cash fow of
$650 in a year. Calculate the IRR of this project.
SOLUTION:

Solving for the IIR from the equation, we fnd that IRR = 30%
113 The Payback Period Method
The payback period of a project is found by counting the number of periods it takes before the
cumulative forecasted cash fow equals the initial investment. A frm using the payback period rule
to decide between different investment projects will typically set a cutoff period and accept those
projects with that recover its initial investment within such time frame.
The payback rule has three main drawbacks:
2. It ignores all cash fows after the cutoff date.
3. It gives equal weight to all cash fows before the cutoff date.
4. It requires an arbitrary standard for the cutoff date.
The payback period is an ad hoc rule and is considered an unsophisticated capital budgeting technique
since it does not explicitly consider the time value of money. Aware of the pitfalls of payback, some
decision makers use a variant called the discounted payback period method. Under this approach we
frst discount the cash fows and then we ask how long it takes for the discounted cash fow to equal
the initial investment. This investment criterion, however, still has the major faws of requiring an
arbitrary cutoff date and ignoring all the cash fows after that date.
Example:
Table 11.1 (on the next page) contains information on three possible projects.
a) If a frm uses the payback rule with a cutoff of two years, which projects will be selected?
b) If the opportunity cost of capital is 10%, are the projects selected in part (a) the ones with the
highest NPV?
38
SOLUTION:
a) With a cutoff period of two years, the frm would accept projects A and C only.
b) No, the project with the highest NPV is project B (NPV=3,196.85) which was not selected
according to the payback rule.
PRACTICE QUESTIONS CHAPTER 11
1. MULTIPLE CHOICE. Which of the following statements regarding NPV is true?
A. The NPV rule depends on the managers tastes.
B. The NPV rule does not recognize the time value of money.
C. Because of the adding-up property one might be mislead into accepting a poor project
that is packaged with a good project.
D. NPV depends only on the forecasted cash fows from a project and the opportunity cost
of capital.
2. You are offered a project that costs $1,000 and has an expected cash fow in one year of
$1,150. Calculate the net present value of the project if the interest rate is 5.5%.
3. A manager is contemplating the purchase of a new machine that will cost $150,000 and has a
useful life of three years. The machine would yield (year-end) cost reductions of $45,000 in
year 1, $55,000 in year 2, $65,000 in year 3. If the interest rate is 9%, should the manager
buy the machine?
4. MULTIPLE CHOICE. Which of the following statements regarding the internal rate of return
(IRR) is true?
A. The IRR is the opportunity cost of capital.
B. The IRR is the interest rate that causes the NPV of the project to be equal to 1.
C. The general investment rule is to accept the project if the IRR is less than the discount
rate.
D. The IRR is a proftability measure that depends on the amount and the timing of the
projects cash fows.
5. MULTIPLE CHOICE. Which of the following statements regarding the payback period rule
is true?
A. The payback rule is to accept only those projects that recover their investment within
some specifed period.
B. If the payback period rule is chosen for making investment decisions with a cutoff date
of two years, then a project that recovers its investment in 2.5 years can be selected.
C. The payback rule correctly accounts for the opportunity cost of capital.
D. When deciding between possible investment projects the NPV rule and the payback
period give the same answers.
39
6. MULTIPLE CHOICE. Which of the following statements regarding the capital budgeting
decisions is false?
A. As long as the proposed capital budgeting projects are independent, both NPV and IRR
methods will produce the same accept/reject indication.
B. A defciency of the internal rate of return is that it does not consider the time value of
money.
C. A defciency of the payback method is that it does not consider the time value of
money.
D. If a project has a NPV of zero, it means that the frms overall value will not change if
the project is adopted.

40
Cost of Capital
To properly evaluate potential investments, a frm must know how much its capital costs, that is,
the frm must have a benchmark risk-adjusted discount rate for new investments. The frms cost of
capital is the expected return on a portfolio of all the frms existing securities. It is the opportunity
cost of capital for investing in the frms assets.
The frms cost of capital is the correct discount rate for projects that have the same risk as the frms
existing business.
A frms capital is supplied by its creditors and owners. Firms raise capital by borrowing or by issuing
stock. Thus the overall cost of capital depends on the return demanded by each of these suppliers of
capital.
121 Cost of Debt
The cost of debt when the frm borrows money from an individual or fnancial institution is the
interest rate on the loan. When the frm borrows money by issuing bonds the cost of debt is the interest
rate demanded by the bond investors.
The after-tax cost of debt is the cost to the frm of obtaining debt funds. Because the interest paid on
bonds or bank loans is a tax-deductible expense for a frm, the after-tax cost of debt is less than the
required rate of return of the suppliers of debt capital. Denote the frms (before-tax) cost of capital by
r
D
and the frms marginal tax rate by T, the after-tax cost of debt, ATr
D
, is given by
Example:
Suppose that a frms cost of debt is 15 percent and its marginal tax rate is 40 percent. What
is the frms after-tax cost of debt?
SOLUTION:
, which means that the after-tax cost of debt on a loan at a 15%
rate is 9%.
122 Cost of Equity
If a frm raises capital by issuing preferred or common stock, these investors expect a return on their
investment, this rate of return is the cost of equity. Unlike with bondholders, the claim of preferred
and common stockholders is not contractual, but it is a cost nonetheless since if the return is not
realized, investors could sell their stock, driving the stock price down.
The cost of preferred stock is the rate of return investors require on a frms new preferred stock
plus the cost of issuing the stock. Preferred stock investors generally buy preferred stock to obtain its
associated constant stream of dividends, so, their return on investment can be measured by dividing
the expected preferred stock dividend by the net price of the shares. The foatation costs which are
the costs of issuing new securities must be deducted from the preferred stock price paid by investors
to obtain the net price received by the frm. Denote the expected preferred stock dividend by DIV
p
, the
current price of preferred stock by P
p
and the fotation cost per share by f, the cost of preferred stock,
r
p
, is given by
12
41
The cost of using the companys preferred stock is r
p
because it represents the minimum expected
return that a frms manager must earn when using the money supplied by preferred stockholders.
The cost of preferred stock is higher than the before-tax cost of debt because bondholders and bankers
have a prior claim on frms earning and assets in the event of liquidation. Thus preferred stockholders
take a greater risk than bondholders and bankers and consequently demand a greater rate of return.
The cost of common stock equity is the required rate of return on funds supplied by existing common
stockholders. Two techniques are used to measure the cost of common stock equity: the constant-
growth (Gordon) model and the CAPM model.
As discussed in chapter 8, according to the constant-growth valuation model, the price of a stock is
given by
(12.1)
Solving equation (12.1) for r
E
results in the following expression for the cost of common stock equity:
(12.2)
Equation (12.2) says that the cost of common stock of equity equals the dividend yield (DIV
1
/ P
0
) plus
the expected rate of growth in dividends (g). Because dividends paid are not tax deductible to the frm,
there is no tax adjustment required. Remember that the constant-growth model rests on the assumption
of constant dividend growth in perpetuity.
The CAPM can also be used to determine the expected rate of return of common stock. As we
discussed in chapter 10, the CAPM states that the expected return equals the risk-free rate plus a risk
premium that depends on beta and the market risk premium. The expected stock return is then given
by the expression
(12.3)
The appropriate procedure to estimate the beta of equation (12.3) employs regression analysis on
historical returns. Using the CAPM model indicates that the cost of common stock equity is the return
required by investors as compensation for the frms nondiversifable risk, measured by beta.
The beta of a stock is determined by the characteristics of the frm. There are three main factors to
consider:
1. Cyclicality of revenues: highly cyclical stocks have high betas.
2. Operating leverage: frms with high operating leverage (lower variable costs and higher
fxed costs) are likely to have high betas.
3. Financial leverage: frms with high fnancial leverage (the extent to which a frm relies on
debt) are likely to have high betas.
The cost of equity from new common stock is the cost incurred by a frm when new common stock
is sold. The cost of this capital includes not only stockholders expected returns on their investment
but also the foatation costs incurred to issue new securities. Flotation costs make the cost of using
funds supplied by new stockholders slightly higher than using retained earnings supplied by existing
stockholders.
Example:
Suppose that Style Shoppe is an all-equity frm with a beta of 1.2. The market-risk premium
is 9.5% and the risk-free rate is 5%. What is the expected return of the common stock of
Style Shoppe?
SOLUTION:

Because this is the return that shareholders can expect in the fnancial markets on a stock with a
beta of 1.2, it is the return they can expect on Style Shoppe.
42
123 WACC
We defned the frms cost of capital as the expected return on a portfolio of all the companys existing
securities. Since the value of the frm is the sum of the values of debt and equity we can calculate the
frms cost of capital as a weighted average of the expected return of these two components.
The overall expected return on assets r
A
or weighted-average cost of capital (WACC) is found by
weighting the cost of each specifc type of capital by its proportion in the frms capital structure.
Let D denote the market value of debt and E denote the market value of equity, then the frms asset
value, V, is given by D + V = E. The overall expected return on assets r
A
or WACC can be specifed as
follows:
(12.4)
The formula in equation (12.4) can be expanded to incorporate the cost of preferred stock times its
corresponding weight or proportion. Note that the sum of the weights must equal 1, that is, all capital
structure components must be accounted for.
Now, recall that interest paid on a frms borrowing can be deducted from taxable income. Thus, we
can calculate the after-tax weighted average cost of capital as
Example:
Consider a frm whose debt has a market value of $20 million and whose stock has a market
value of $30 million. The frm pays a 10.5% of interest on its new debt and has a beta of
1.3. The corporate tax is 34%. The market risk premium is 8.5% and the current T-bill rate
is 6.5%. What is the frms after-tax WACC?
SOLUTION:
First, we need to calculate the cost of equity capital:
Now we can calculate the after-tax WACC

PRACTICE QUESTIONS CHAPTER 12
1. MULTIPLE CHOICE. Which of the following statements regarding the cost of internal
common equity is false?
A. It is the rate of return investors require on funds supplied by existing common
stockholders.
B. It is the rate of return investors require on funds supplied by existing common
stockholders, plus fotation costs.
C. It can be calculated using the CAPM model.
D. It is slightly lower than the cost of equity from new common stock.
2. If a frm has a cost of debt of 10% and an after-tax cost of debt of 6%, what is the frms
marginal tax rate?
43
3. MULTIPLE CHOICE. Which of the following statements regarding the cost of equity is true?
A. Just like bondholders, stockholders have a contractual agreement with the frm that
stipulates the required return on their investment.
B. The cost of preferred stock is the cost of issuing new preferred stock.
C. The cost of preferred stock represents the minimum return that a frm must earn when
using the money supplied by preferred stockholders
D. The cost of preferred stock is equal to the expected dividend that a frm must paid
preferred stockholders.
4. What is the overall cost of capital of a frm that has a proportion of debt of 30%, an expected
return on debt of 7.5% and an expected return on equity of 15%?
5. Consider a frm that has a mixture of 40% debt, 10 % preferred stock and 50% common
equity to fnance its assets. The after-tax cost of debt is 5%, the cost of preferred stock is
12% and the cost of common equity is 13.5%. What is the frms weighted average cost of
capital (WACC)?
6. Consider a frm whose debt has a market value of $7 million and whose stock has a market
value of $15 million. The cost of equity is 10% and the cost of debt is 5.5%. If the marginal
tax rate is 35%, what is the frms after-tax WACC?
44
Real Options
As discussed in chapter 11, net present value is the best capital budgeting approach conceptually.
Discounted cash fow analysis, however, commonly assumes that once NPV calculations have been
undertaken when valuing capital budgeting projects, frms will hold the assets passively. This is
rarely the case in practice since frms will make investment and operating decisions on a project over
its entire life. For example, if a projects cash fows are better than anticipated, the project may be
expanded and if they are worse, the project may be contracted, put on hold, or even abandoned. The
opportunity to make such decisions clearly adds value whenever project outcomes are uncertain.
Options to modify projects are known as real options. Net present value calculations typically
ignore the fexibility that real-world frms have; in this respect, NPV underestimates the true value
of a project. Note however that real-option-valuation methods do not replace discounted cash fow
analysis. NPV works well for safe cash fows and it also the starting point in most real-option analysis.
There are four main types of real options:
Expansion Option
This is the option to expand if the immediate investment project succeeds. An expansion option is
equivalent to a call option on follow-on projects in addition to the immediate projects cash fows.
If a manger has the ability to make follow-up investments on a project, she might decide to undertake
(for strategic reasons) a negative-NPV project since todays investments can generate tomorrows
opportunities.
In chapter 10 we showed how the present value of growth opportunities (PVGO) contributes to the
value of a frms common stock. PVGO equals the forecasted total NPV of future investments. We
can think of PVGO as the value of the frms options to invest and expand. The fexibility to adapt
investment to future opportunities is one of the factors that makes PVGO so valuable.
Timing Option
This is the option to wait (and learn) before investing. The timing option is equivalent to owning a call
option on the investment project. The call is exercised when the frm commits to the project. However,
it is often better to defer a positive NPV-value project (as long as the immediate project cash fows are
small) to keep the call alive.
Abandonment Option
This is the option to shrink or abandon a project. It provides partial insurance against failure. The
option to abandon is equivalent to a put option. You exercise that abandonment option if the value of
recovered from the projects assets is greater than the present value of continuing the project for at
least one more period.
A frm that has the option to abandon a project that is no longer proftable will cut its losses and bail
out the projects assets. Tangible assets are usually easier to sell than intangible ones. It helps to have
active secondhand markets, which really only exist for standardized items.
The Flexibility in Production Option
This is the option to vary the mix of output or the frms production methods. In such cases the frm
has the option to acquire one asset in exchange for another.
13
45
131 Decision Trees
Decision trees are commonly used to describe the real options imbedded in capital investment
projects. This type of diagrams help decision-makers to understands project risk and how future
decisions will affect project cash fows.
A decision tree, such as that illustrated in Figure 13.1, has four basic elements:
Decision nodes. A decision node, represented by a small bold square in the tree diagram,
indicates a particular decision faced by the decision maker. Each branch from a decision
node corresponds to a possible decision.
Chance nodes. A chance node, represented by a small bold circle in the tree diagram,
indicates an event faced by the decision maker; an event that has an uncertain outcome.
Each branch from a chance node corresponds to a possible outcome.
Probabilities. Each possible outcome has a corresponding probability. The sum of the
probabilities of all the possible outcomes at a chance node must add up to 1.
Payoffs. The end of each branch is located at the right end of the tree and has a payoff
associated with it.
By displaying the links between todays and tomorrows decisions, decision trees help the decision-
maker identify the strategy with the highest net present value. Once the real options and their cash-
fow consequences have been included in the decision tree, the action that should be undertaken in
each scenario is identifed by working back from the future to the present.
One problem with decision trees is that, in practice, they can get pretty complex very quickly. Thus
often decision trees should be judged not on their comprehensiveness but on whether they show the
most important links between todays and tomorrows decisions.
Example:
A national chain of organic grocery stores is considering introducing a new line of gluten-
free products. The company has the option of introducing this new line in all of its existing
stores nationwide, with a 55% chance of success. However, the frm can conduct a customer
segment research to determine the locations where demand for this type of products is the
highest; this research would take 1 year and cost $1 million. By going through research,
the company will be able to introduce the line only in specifc stores and increase the
probability of success to 70%. If successful, the gluten-free product line will bring a present
value proft (at the time of initial selling) of $30 million. If unsuccessful, the present value
payoff is only $3 million. Should the company conduct customer segment research or
introduce the new products nationwide? The appropriate discount rate is 15%.
46
SOLUTION:
The decision tree with the corresponding payoffs of each strategy is depicted in Figure 13.2.
What is left is to calculate the expected value of each possible strategy as follows:



Now, it is easy to see that the frm should conduct the customer segment research even if
this action implies postponing the initial selling of the products for one year.
PRACTICE QUESTIONS CHAPTER 13
1. MULTIPLE CHOICE. Which of the following statements regarding real options is false?
A. When real options exist, NPV calculations may underestimate the value of a project.
B. An example of a real option is to expand the project.
C. An example of a real option is to abandon the project.
D. An example of a real option is to change the timing of the project.
2. MULTIPLE CHOICE. Which of the following statements regarding real options is false?
A. It is never optimal to defer a positive-NPV project.
B. A frm that has the option to make follow-on investments may decide to undertake
negative-NPV projects.
C. An example of a real option is to vary the frms production methods.
D. An example of a real option is to shrink the scale of a project.
3. MULTIPLE CHOICE. Which of the following statements regarding real options is false?
A. An abandonment option provides partial insurance against failure.
B. Real-option-valuation replaces NPV calculations.
C. An example of a real option is the ability of making follow-up investments.
D. Decision trees can help to identify the possible impact of real options on a projects
cash fows.
4. MULTIPLE CHOICE. Which of the following statements regarding real options is false?
A. An expansion option is like a call option on follow-on projects.
B. A timing option is like a call option on the investment project.
C. An option to abandon is like put option on the projects assets.
D. The option to abandon is only valuable when the projects assets are intangibles.
47
5. MULTIPLE CHOICE. Which of the following is not an element of a decision tree?
A. Decision node.
B. Payoff.
C. Initial node.
D. Equilibrium node.
6. MULTIPLE CHOICE. Which of the following statements regarding real options is false?
A. An expansion option would increase in value if there is a more optimistic forecast
(higher expected value).
B. A way to solve a decision tree is to solve from the present to the future.
C. Projects that can be easily expanded or abandoned are more valuable than those that do
not provide that fexibility.
D. If the discount rate remains constant, an expansion option would increase in value with
increased uncertainty.
48
Effcient Market Hypothesis
141 Effcient Market Hypothesis
An effcient capital market is one in which stock prices fully refect available information. Any
information that could be used to predict stock performance should already be refected in the stock
prices. Prices of stock should increase or decrease only in response to new information. Prices change
at the moment the new information becomes public, they instantaneously adjusts to and fully refects
this new information. After the announcement date there should be no further drift in prices, that is,
there are no delayed responses or overadjustments in prices.
The notion that at any point in time security prices fully refect all publicly available information is
referred to as the effcient market hypothesis (EMH). The EMH has implications for investors and
for frms:
Because information is refected in prices immediately, investors should only expect to
obtain a normal rate of return.
Firms should expect to receive fair value for securities that they sell (fair means that the
price received for the issued securities is equal to the present value)
A return is abnormal if it exceeds the expected or required return appropriate for the risk level of
the investment strategy. Market effciency eliminates many value-enhancing strategies, in particular:
1. Stock prices should not be affected by frms choice of accounting method.
2. Financial managers cannot time issues of bonds and stocks.
3. Firms cannot expect to gain through speculation in currency and bond markets.
4. Prices refect underlying value.
Now that we discussed the consequences of market effciency, we need to cover the foundations of
market effciency, that is, the conditions that will cause market effciency. Markets will be effcient if
any of the following three conditions hold:
1. Rationality. All investors are rational. When new information is released in the market, all
investors will adjust their estimates of stock prices in a rational way.
2. Independent deviations from rationality. Even if some investors are rational, the mistakes
of irrational investors cancel out. That is, market effciency does not require rational
individuals, only countervailing irrationalities.
3. Arbitrage. If rational investors can arbitrage away the mispricings induced by the irrational
investors markets would still be effcient.
There is disagreement among academics and practitioners about whether any of above-mentioned
conditions is likely to hold in the real world. This point of view is based on what is called behavioral
fnance. Adherents to this view argue that investors are not rational, deviations from rationality are
similar across investors, and since arbitrage is costly it will not eliminate ineffciencies.
142 Types of Effciency
There are three versions of the EMH: the weak, semistrong and strong. These versions differ by what
is meant by the term all available information.
Weak form effciency: a market is said to be weakly effcient if it fully incorporates the
information in past stock prices. It does not use any other information such as earnings,
forecasts or merger announcements. Often the weak form effciency is represented
mathematically as

(12.4)
14
49
If stock prices follow equation (14.1) they are said to follow a random walk. The random
component is due to new information on the stock; it can be positive or negative and has
an expected value of zero. The random component in one period is unrelated to the random
component in any past period.
Semistrong form effciency: a market is semistrong form effcient if prices refect in
addition to historical prices, all publicly available information including information such
as published accounting statements.
Strong form effciency: a market is strong form effcient if stock prices refect all (public
and private) information relevant to the frm, even including information available only to
company insiders.
Semistrong form effciency implies weak form effciency and strong form effciency implies
semistrong form effciency. Much evidence from different fnancial markets supports weak form and
semistrong form effciency but not strong form effciency.
PRACTICE QUESTIONS CHAPTER 14
1. MULTIPLE CHOICE. Which of the following statements regarding the Effcient Market
Hypothesis is false?
A. An effcient market is one in which stock prices fully refect available information.
B. On average, no abnormal returns can be obtained by trading on freely available public
information.
C. In an effcient market the price of the shares immediately adjust to new information.
D. If the new information about a company is particularly good, it may take several days
for the price of the stock to adjust.
2. MULTIPLE CHOICE. Which of the following is not a version of the Effcient Market
Hypothesis?
A. Semistrong form.
B. Weak form.
C. Ultrastrong form.
D. Strong form.
3. MULTIPLE CHOICE. Which of the following statement regarding the types of effciency is
true?
A. Semistrong form effciency implies strong form effciency.
B. Weak form effciency implies semistrong form effciency.
C. Weak form effciency implies strong form effciency.
D. Strong form effciency implies semistrong form effciency.
4. MULTIPLE CHOICE. Which of the following statements regarding the Effcient Market
Hypothesis is true?
A. According to the EMH all stock should have the same expected returns.
B. According to the EMH prices are uncaused.
C. According to the EMH prices refect underlying value.
D. According to the EMH managers can boost stock prices through creative accounting.
5. MULTIPLE CHOICE. Which of the following statements regarding the weak form effciency
is false?
A. If markets are weakly effcient, then stock prices follow a random walk.
B. If markets are weakly effcient, then managers can get abnormal returns by analyzing
frm earnings and forecasts.
C. If markets are weakly effcient, the current prices refect past prices.
D. It is the weakest type of effciency that we would expect a fnancial market to display.
50
6. MULTIPLE CHOICE. Which of the following is not a condition that would cause a market to
be effcient?
A. Investors rationality.
B. Independent deviations from rationality.
C. Investors risk aversion.
D. Arbitrage.
51
Institutions and Sources of
Funding
Investment companies are fnancial intermediaries that collect funds from individual investors and
invest them in a wide range of securities. The idea behind these companies is pooling of assets. Each
investor has a claim to the portfolio in proportion to the amount invested.
Investors buy shares in investment companies and ownership is proportional to the number of shares
purchased. The value of each share is called the new asset value (NAV). Net asset value equals
the market value of assets held by a fund minus the liabilities of the fund divided by the shares
outstanding, that is
151 Mutual Funds
Mutual funds are pools of investors money. These funds follow specifc investment policies which are
described in the funds prospectuses and issue shares to investors entitling them to a pro rata portion of
the income generated by the funds. Mutual funds free the individual from many of the administrative
burdens of owning individual securities and offer professional management of the portfolio.
Mutual funds are open-end investment companies which means they can redeem or issue shares for
NAV at the request of the investor. These funds are generally marketed to the public either directly by
the fund underwriter or indirectly through brokers acting on behalf of the underwriter.
Mutual funds are assessed management fees and include other expenses which reduce the investors
rate of return. Costs of investing in mutual funds include:
Front-end loads (commission charge paid when the share is purchased),
Back-end loads (redemption fee incurred when share is sold),
Fund operating expenses (these are usually expressed as a percentage of the total assets
under management)
12b-1 charges (recurring fees used to pay for the expenses of marketing the fund to the
public).
Investment returns of mutual funds are granted pass-through status under the U.S. tax code which
means that taxes are paid only by the investor in the mutual fund, not by the fund itself. As long as all
income is distributed to shareholders, the income is treated as passed through to the investor. Such tax
treatment has the disadvantage for individual investors that the timing of the sale of securities from the
portfolio (and thus the realization of capital gains) is out of the investors control.
2
The rate of return on an investment in a mutual fund is measured as the change in NAV plus any
income distribution (such as dividends or distributions of capital gains) expressed as a fraction of NAV
at the beginning of the investment period. That is, let NAV
0
denote the net asset value at the beginning
of the period and NAV
1
the value of this variable at the end of the period, then the rate of return is
given by
15
2
If the mutual fund is held in a tax-deferred retirement account such as an IRA or 401(K) account, these tax management
issues are irrelevant.
52
Some of the more important fund types, classifed by investment policy are:
Money market funds. These funds invest in money market securities.
Equity funds. These funds invest primarily in stock. It is common to classify stock funds
according to their investment emphasis in two categories: income funds (hold shares of
frms with high dividend yields) and growth funds (hold shares of frms with high prospects
of capital gains). Since growth stocks are typically riskier, growth funds have a higher level
of risk.
Bonds funds. These funds invest primarily in the fxed-income sector.
International funds. These funds with international focus can be classifed in: global
funds (invest in securities worldwide, including the United States), international funds
(only invest in frms located outside of the United States), regional funds (concentrate in a
particular part of the world) and emerging market funds (invest in companies of developing
nations).
Index funds. An index fund tries to match the performance of a broad market index. The
fund buys shares in securities included in a particular index in proportion to each securities
representation of that index. For example, Vangard 500 Index Fund is a mutual fund that
replicates the composition of the Standard & Poors 500 stock price index.
152 Hedge Funds
Hedge funds are vehicles that allow private investors to pool assets to be invested by a fund manager.
Hedge funds are not registered as mutual funds and not subject to SEC regulation. They are typically
only open to wealthy or institutional investors. These funds are only lightly regulated which enables
their managers to pursue sophisticated investment strategies involving heavy use of derivatives, short
sales, and leverage; this in turn implies that returns can be quite volatile.
153 Exchange-Traded Funds
Exchange-traded funds (EFTs) are investment funds that allow investors to trade index portfolios. Two
of the main advantages that ETFs have over conventional mutual funds are:
1. While investors can buy or sell their mutual funds shares only once a day, ETFs trade
continuously.
2. Unlike mutual funds, ETFs can be sold short or purchased on the margin.
ETFs are also cheaper than mutual funds since investors who buy them need to do it through a broker.
This allows the fund to save the cost of marketing itself directly to small investors. This reduction in
expense translates into lower management fees.
154 Pension Funds
A pension plan is a contractual agreement setting out the rights and obligations of all parties involved.
The pension fund of the plan is the cumulation of assets created from contributions and investment
earnings on those contributions, less any payments of benefts from the fund. Contributions to the fund
by either employee or employer are tax-deductible and investment income of the fund is not taxed.
Distributions from the fund, whether to the employer or employee, are taxed as ordinary income.
Pension fund objectives depend on the type of pension plan. There are two basic types:
Defned contribution plans. In such plan, a formula specifes contributions but not beneft
payments. These are in effect tax-deferred retirement savings accounts established by the
frm in trust for its employees, with the employee bearing all the risk and receiving all the
return from the plans assets.
53
Defned beneft plans. In such plan, a formula specifes benefts but not the manner,
including contributions, in which these benefts are funded. In a defned beneft plan, assets
serve as collateral for the liabilities that the frm sponsoring the plan owes to the plan
benefciaries. Thus it is the sponsoring frms shareholders who bear the risk.
The special tax status of pension funds creates the same incentive for both defned contribution and
defned beneft plans to tilt their asset mix toward assets with the largest spread between pretax and
after-tax rates of return.
PRACTICE QUESTIONS CHAPTER 15
1. MULTIPLE CHOICE. Which of the following statements regarding mutual funds is false?
A. For tax purposes, as long as all income is distributed to shareholders, the income is
treated as passed through to the investor.
B. They are close-end investment companies.
C. Some of the costs of investing in mutual funds include front-end loads, back-end loads
and operating expenses.
D. The funds prospectus describes the mutual funds investment policy.
2. MULTIPLE CHOICE. Which of the following statements regarding mutual funds is false?
A. Vangard 500 Index Fund invests primarily in stock of companies outside the United
States.
B. They open-end investment companies.
C. They have a specifed investment policy described in the funds prospectus.
D. They are assessed management fees which reduce the investors rate of return.
3. MULTIPLE CHOICE. Which of the following statements regarding hedge funds is true?
A. Hedge funds are registered as mutual funds.
B. Hedge funds are heavily regulated.
C. Hedge funds allow private investors to pool assets to be invested by a fund manager.
D. Hedge funds are subject to SEC regulation.
4. MULTIPLE CHOICE. Which of the following statements regarding exchange-traded funds
(ETFs) is false?
A. Unlike conventional mutual funds, ETFs trade continuously.
B. ETFs allow investors to trade index portfolios.
C. ETFs are typically cheaper than mutual funds.
D. ETFs cannot be sold short or purchased on the margin.
5. MULTIPLE CHOICE. Which of the following statements regarding pension funds is false?
A. Contributions to the fund by either employee or employer are tax-deductible.
B. Distributions of the fund to the employee are taxed as ordinary income.
C. Investment income of the pension fund is taxed.
D. In a defned contribution pension plan the contributions are specifed but not the
benefts.
6. MULTIPLE CHOICE. Which of the following statements regarding mutual funds is false?
A. Money market funds invest in stock.
B. Bond funds specialize in the fxed-income sector.
C. Index funds try to match the performance of a broad market index.
D. International funds invest in securities located outside the United States.
54
REFERENCES
[1] Bodie Zvi, Alex Kane and Alan J Marcus, Investments, McGraw-Hill Irwin, 6th Ed., 2005
[2] Brealey A Richard, Stewart C. Myers and Franklin Allen, Principles of Corporate Finance,
McGraw-Hill Irwin, 8th Ed., 2006
[3] Gallagher J Timothy, Financial Management: Principles and Practice, 5th Ed
[4] Gitman J. Lawrence, Principles of Managerial Finance, Pearson Prentice Hall, 12th Ed.,
2009
[5] Ross A. Stephen, Randolph W. Westerfeld and Jeffrey Jaffe, Corporate Finance, McGraw-
Hill Irwin, 7th Ed., 2005
[6] Trevino Regina, PreMBA Anlytical Primer: Essential Quantitative Concepts for Business
Math, Palgrave Macmillan, 2008



55
REVIEW QUESTION
ANSWERS
CHAPTER ONE SOLUTIONS:
1.
2.
3.
4.
5.
6. D
CHAPTER TWO SOLUTIONS:
1. B
2. B
3. A
4. C
5. C
6.
CHAPTER THREE SOLUTIONS:
1. D
2. C
3. A
4. D
5. 1/1.50 = .6667
6. A
56
CHAPTER FOUR SOLUTIONS:
1.

2.

3. , so the stock paid a dividend of
4. , so the
three-year holding period return is 7.64%.
5.
6. C
CHAPTER FIVE SOLUTIONS:
1. D
2. A
3. B
4. A
5. D
6. D

CHAPTER SIX SOLUTIONS:
1. 11.8%
2. 1
3. C
4.
so, the portfolios standard deviation is given by
5.
6. B

CHAPTER SEVEN SOLUTIONS:
1. D
2. B
3.

4. D

5.

6. A
.

.
58
CHAPTER THIRTEEN SOLUTIONS:
1. A
2. A
3. C
4. D
5. D
6. B
CHAPTER FOURTEEN SOLUTIONS:
1. D
2. C
3. D
4. C
5. B
6. C

CHAPTER FIFTEEN SOLUTIONS:
1. B
2. A
3. C
4. D
5. C
6. A