You are on page 1of 27

CORPORATE FINANCE

CORPORATE FINANCE

Net Present Value (NPV)

where
CFt = after-tax cash flow at time, t.
r = required rate of return for the investment. This is the firms cost of capital adjusted
for the risk inherent in the project.
Outlay = investment cash outflow at t = 0.

Internal Rate of Return (IRR)

Average Accounting Rate of Return (AAR)

Average net income


AAR =
Average book value

Profitability Index

PV of future cash flows NPV


PI = = 1 +
Initial investment Initial investment

Weighted Average Cost of Capital

Where:
wd = Proportion of debt that the company uses when it raises new funds
rd = Before-tax marginal cost of debt
t = Companys marginal tax rate
wp = Proportion of preferred stock that the company uses when it raises new funds
rp = Marginal cost of preferred stock
we = Proportion of equity that the company uses when it raises new funds
re = Marginal cost of equity

To Transform Debt-to-equity Ratio into a components weight

2011 ELAN GUIDES 47


CORPORATE FINANCE

Valuation of Bonds

where:
P0 = current market price of the bond.
PMTt = interest payment in period t.
rd = yield to maturity on BEY basis.
n = number of periods remaining to maturity.
FV = Par or maturity value of the bond.

Valuation of Preferred Stock

Dp
Vp =
rp
where:
Vp = current value (price) of preferred stock..
Dp = preferred stock dividend per share.
rp = cost of preferred stock.

Required Return on a Stock

Capital Asset Pricing Model

re = RF + i[E(RM) - RF]

where
[E(RM) - RF] = Equity risk premium.
RM = Expected return on the market.
i = Beta of stock . Beta measures the sensitivity of the stocks returns to
changes in market returns.
RF = Risk-free rate.
re = Expected return on stock (cost of equity)

Dividend Discount Model

where:
P0 = current market value of the security.
D1= next years dividend.
re = required rate of return on common equity.
g = the firms expected constant growth rate of dividends.

2011 ELAN GUIDES 48


CORPORATE FINANCE

Rearranging the above equation gives us a formula to calculate the required return on equity:

Sustainable Growth Rate

Where (1 - (D/EPS)) = Earnings retention rate

Bond Yield plus Risk Premium Approach

To Unlever the beta

To Lever the beta

Country Risk Premium

Country risk Sovereign yield Annualized standard deviation of equity index


=
premium spread Annualized standard deviation of sovereign
bond market in terms of the developed market
currency

Amount of capital at which a components cost of capital changes


Break point =
Proportion of new capital raised from the component

Degree of Operating Leverage

Percentage change in operating income


DOL =
Percentage change in units sold

2011 ELAN GUIDES 49


CORPORATE FINANCE

Q (P V)
DOL =
Q (P V) F

where:
Q = Number of units sold
P = Price per unit
V = Variable operating cost per unit
F = Fixed operating cost
Q (P V) = Contribution margin (the amount that units sold contribute to covering fixed
costs)
(P V) = Contribution margin per unit

Degree of Financial Leverage

Percentage change in net income


DFL =
Percentage change in operating income

[Q(P V) F](1 t) [Q(P V) F]


DFL = =
[Q(P V) F C](1 t) [Q(P V) F C]

where:
Q = Number of units sold
P = Price per unit
V = Variable operating cost per unit
F = Fixed operating cost
C = Fixed financial cost
t = Tax rate

Degree of Total Leverage

Percentage change in net income


DTL =
Percentage change in the number of units sold

DTL = DOL DFL

Q (P V)
DTL =
[Q(P V) F C]

where:
Q = Number of units produced and sold
P = Price per unit
V = Variable operating cost per unit
F = Fixed operating cost
C = Fixed financial cost

2011 ELAN GUIDES 50


CORPORATE FINANCE

Break point

PQ = VQ + F + C

where:
P = Price per unit
Q = Number of units produced and sold
V = Variable cost per unit
F = Fixed operating costs
C = Fixed financial cost

The breakeven number of units can be calculated as:

F+C
QBE =
PV

Operating breakeven point

PQOBE = PV + F

F
QOBE =
PV

2011 ELAN GUIDES 51


CORPORATE FINANCE

Purchases = Ending inventory + COGS - Beginning inventory

2011 ELAN GUIDES 52


CORPORATE FINANCE

Face value - Price


% Discount =
Price

365
Inventory turnover

Accounts payable
Number of days of payables =
Average days purchases
Accounts payable 365
=
Purchases / 365 Payables turnover

2011 ELAN GUIDES 53


CORPORATE FINANCE

2011 ELAN GUIDES 54


PORTFOLIO MANAGEMENT

PORTFOLIO MANAGEMENT

Holding Period Return

Pt Pt-1 + Dt P Pt-1 D
R= = t + t = Capital gain + Dividend yield
Pt-1 Pt-1 Pt-1
PT + DT
= -1
P0

where:
Pt = Price at the end of the period
Pt-1 = Price at the beginning of the period
Dt = Dividend for the period

Holding Period Returns for more than One Period

R = [(1 + R1) (1 + R2) .... (1 + Rn)] 1

where:
R1, R2,..., Rn are sub-period returns

Geometric Mean Return


1/n
R = {[(1 + R1) (1 + R2) .... (1 + Rn)] } 1

Annualized Return
n
rannual = (1 + rperiod) - 1

where:
r = Return on investment
n = Number of periods in a year

2011 ELAN GUIDES 55


PORTFOLIO MANAGEMENT

Portfolio Return

Rp = w1R1 + w2R2
where:
Rp = Portfolio return
w1 = Weight of Asset 1
w2 = Weight of Asset 2
R1 = Return of Asset 1
R2 = Return of Asset 2

Variance of a Single Asset


T

2
(R - )
t=1
t
2

=
T

where:
Rt = Return for the period t
T = Total number of periods
= Mean of T returns

Variance of a Representative Sample of the Population

2
(R - R)
t=1
t
2

s =
T-1

where:
R = mean return of the sample observations
2
s = sample variance

Standard Deviation of an Asset

T T

(R - )
t=1
t
2
(R - R)
t=1
t
2

= s=
T T-1

Variance of a Portfolio of Assets

N
2
=
P w w Cov(R ,R )
i,j = 1
i j i j

N N
2
=
P w Var(R ) +
i=1
2
i i
i,j = 1, i j
wiwjCov(Ri,Rj)

2011 ELAN GUIDES 56


PORTFOLIO MANAGEMENT

Standard Deviation of a Portfolio of Two Risky Assets

Utility Function

2
U = E(R) A
2

where:
U = Utility of an investment
E(R) = Expected return
2
= Variance of returns
A = Additional return required by the investor to accept an additional unit of risk.

Capital Allocation Line

The CAL has an intercept of RFR and a constant slope that equals:

Expected Return on portfolios that lie on CML

E(Rp) = w1Rf + (1 - w1) E(Rm)

Variance of portfolios that lie on CML

2 2 2 2 2
= w1 f + (1 - w1) m + 2w1(1 - w1)Cov(Rf,Rm)

Equation of CML

E(Rm) - Rf
E(Rp) = Rf + p
m

where:
y-intercept = Rf = risk-free rate
E(Rm) - Rf
slope = = market price of risk.
m

2011 ELAN GUIDES 57


PORTFOLIO MANAGEMENT

Systematic and Nonsystematic Risk

Total Risk = Systematic risk + Unsystematic risk

Return-Generating Models
k k

E(Ri) - Rf = E(F ) = [E(R ) - R ] + E(F )


j=1
ij j i1 m f
j=2
ij j

The Market Model

Ri = i + iRm + ei

Calculation of Beta

Cov(Ri,Rm) i,mim i,mi


i = 2
= 2
=
m m m

The Capital Asset Pricing Model

E(Ri) = Rf + i[E(Rm) Rf]

Sharpe ratio

Rp Rf
Sharpe ratio =
p

Treynor ratio

Rp Rf
Treynor ratio =
p
2
M-squared (M )

2 m
M = (Rp Rf) Rm Rf
p

Jensens alpha

pRp [RfpRm Rf)]

Security Characteristic Line

Ri RfiiRm Rf)

2011 ELAN GUIDES 58


EQUITY

EQUITY

The price at which an investor who goes long on a stock receives a margin call is calculated
as:
(1 - Initial margin)
P0
(1 Maintenance margin)

The value of a price return index is calculated as follows:


N

nP
i=1
i i

VPRI =
D

where:
VPRI = Value of the price return index
ni = Number of units of constituent security i held in the index portfolio
N = Number of constituent securities in the index
Pi = Unit price of constituent security i
D = Value of the divisor

Price Return

The price return of an index can be calculated as:

VPRI1 VPRI0
PRI =
VPRI0

where:
PRI = Price return of the index portfolio (as a decimal number)
VPRI1 = Value of the price return index at the end of the period
VPRI0 = Value of the price return index at the beginning of the period

The price return of each constituent security is calculated as:

Pi1 Pi0
PRi =
Pi0
where:
PRi = Price return of constituent security i (as a decimal number)
Pi1 = Price of the constituent security i at the end of the period
Pi0 = Price of the constituent security i at the beginning of the period

2011 ELAN GUIDES 59


EQUITY

The price return of the index equals the weighted average price return of the constituent
securities. It is calculated as:

PRI = w1PR1 + w2PR2 + ....+ wNPRN


where:
PRI = Price return of the index portfolio (as a decimal number)
PRi = Price return of constituent security i (as a decimal number)
wi = Weight of security i in the index portfolio
N = Number of securities in the index

Total Return

The total return of an index can be calculated as:

VPRI1 VPRI0 IncI


TRI =
VPRI0

where:
TRI = Total return of the index portfolio (as a decimal number)
VPRI1 = Value of the total return index at the end of the period
VPRI0 = Value of the total return index at the beginning of the period
IncI = Total income from all securities in the index held over the period

The total return of each constituent security is calculated as:

P1i P0i Inci


TRi =
P0i
where:
TRi = Total return of constituent security i (as a decimal number)
P1i = Price of constituent security i at the end of the period
P0i = Price of constituent security i at the beginning of the period
Inci = Total income from security i over the period

The total return of the index equals the weighted average total return of the constituent
securities. It is calculated as:

TRI = w1TR1 + w2TR2 + ....+ wNTRN


where:
TRI = Total return of the index portfolio (as a decimal number)
TRi = Total return of constituent security i (as a decimal number)
wi = Weight of security i in the index portfolio
N = Number of securities in the index

2011 ELAN GUIDES 60


EQUITY

Calculation of Index Returns over Multiple Time Periods

Given a series of price returns for an index, the value of a price return index can be calculated
as:

VPRIT = VPRI0 (1 + PRI1) (1 + PRI2) ... (1 + PRIT)

where:
VPRI0 = Value of the price return index at inception
VPRIT = Value of the price return index at time t
PRIT = Price return (as a decimal number) on the index over the period

Similarly, the value of a total return index may be calculated as:

VTRIT = VTRI0 (1 + TRI1) (1 + TRI2) ... (1 + TRIT)

where:
VTRI0 = Value of the index at inception
VTRIT = Value of the index at time t
TRIT = Total return (as a decimal number) on the index over the period

Price Weighting

Pi
wiP = N

P
i=1
i

Equal Weighting

1
wiE =
N

where:
wi = Fraction of the portfolio that is allocated to security i or weight of security i
N = Number of securities in the index

Market-Capitalization Weighting

QiPi
wiM = N

QP
j=1
j j

where:
wi = Fraction of the portfolio that is allocated to security i or weight of security i
Qi = Number of shares outstanding of security i
Pi = Share price of security i
N = Number of securities in the index

2011 ELAN GUIDES 61


EQUITY

The float-adjusted market-capitalization weight of each constituent security is calculated as:

fiQiPi
wiM = N

fQP
j=1
j j j

where:
fi = Fraction of shares outstanding in the market float
wi = Fraction of the portfolio that is allocated to security i or weight of security i
Qi = Number of shares outstanding of security i
Pi = Share price of security i
N = Number of securities in the index

Fundamental Weighting

Fi
wiF = N

F
j=1
j

where:
Fi = A given fundamental size measure of company i

Return Characteristics of Equity Securities

Total Return, Rt = (Pt Pt-1 + Dt) / Pt-1


where:
Pt-1 = Purchase price at time t 1
Pt = Selling price at time t
Dt = Dividends paid by the company during the period

Accounting Return on Equity

NIt NIt
ROEt = =
Average BVEt (BVEt + BVEt-1)/2

Dividend Discount Model (DDM)

2011 ELAN GUIDES 62


EQUITY

One year holding period:

Multiple-Year Holding Period DDM

where:
Pn = Price at the end of n years.

Infinite Period DDM (Gordon Growth Model)


1 2 3
D0 (1 + gc) D0 (1 + gc) D0 (1 + gc) D0 (1 + gc)
PV0 = 1 + 2 + 3 +...+
(1 + ke) (1 + ke) (1 + ke) (1 + ke)

This equation simplifies to:

1
D0 (1 + gc) D1
PV = 1 =
(ke - gc) ke - g c

The long-term (constant) growth rate is usually calculated as:

gc = RR ROE

Multi-Stage Dividend Discount Model

where:

Dn = Last dividend of the supernormal growth period


Dn+1 = First dividend of the constant growth period

The Free-Cash-Flow-to-Equity (FCFE) Model

FCFE = CFO FC Inv + Net borrowing

2011 ELAN GUIDES 63


EQUITY

Analysts may calculate the intrinsic value of the companys stock by discounting their
projections of future FCFE at the required rate of return on equity.

FCFEt
V0 = (1 + k )
t=1 e
t

Value of a Preferred Stock

When preferred stock is non-callable, non-convertible, has no maturity date and pays dividends
at a fixed rate, the value of the preferred stock can be calculated using the perpetuity formula:
D0
V0 =
r

For a non-callable, non-convertible preferred stock with maturity at time, n, the value of the
stock can be calculated using the following formula:
n Dt F
V0 = (1 + r)
t=1
t
+
(1 + r)
n

where:
V0 = value of preferred stock today (t = 0)
Dt = expected dividend in year t, assumed to be paid at the end of the year
r = required rate of return on the stock
F = par value of preferred stock

Price Multiples

P0 D1/E1
=
E1 r-g

Market price of share


Price to cash flow ratio =
Cash flow per share

Market price per share


Price to sales ratio =
Net sales per share

Market value of equity


Price to sales ratio =
Total net sales

2011 ELAN GUIDES 64


EQUITY

Current market price of share


P/BV =
Book value per share

Market value of common shareholders equity


P/BV =
Book value of common shareholders equity

where:
Book value of common shareholders equity =
(Total assets - Total liabilities) - Preferred stock

Enterprise Value Multiples

EV/EBITDA

where:

EV = Enterprise value and is calculated as the market value of the companys common stock
plus the market value of outstanding preferred stock if any, plus the market value of debt,
less cash and short term investments (cash equivalents).

2011 ELAN GUIDES 65


FIXED INCOME

FIXED INCOME

Bond Coupon
Coupon = Coupon rate Par value

Coupon Rate (Floating)


Coupon Rate = Reference rate + Quoted margin

Coupon Rate (Inverse Floaters)


Coupon rate = K L (Reference rate)

Callable Bond Price


Price of a callable bond = Value of option-free bond Value of embedded call option

Putable Bond Price


Price of a putable bond = Value of option-free bond + Value of embedded put option
Dollar Duration
Dollar duration = Duration Bond value

Inflation-Indexed Treasury Securities

TIPS coupon = Inflation adjusted par value (Stated coupon rate/2)

Nominal spread
Nominal spread (Bond Y as the reference bond) = Yield on Bond X Yield on Bond Y

Relative Yield spread


Yield on Bond X Yield on Bond Y
Relative yield spread =
Yield on Bond Y

Yield Ratio
Yield on Bond X
Yield ratio =
Yield on Bond Y

After-Tax Yield
After-tax yield = Pretax yield (1- marginal tax rate)

Taxable-Equalent Yield
Tax-exempt yield
Taxable-equivalent yield =
(1 marginal tax rate)

2011 ELAN GUIDES 66


FIXED INCOME

Bond Value
Maturity value
Bond Value =
(1+i) years till maturity 2
where i equals the semiannual discount rate

Valuing a Bond Between Coupon Payments.

Days between settlement date and next coupon payment date


w=
Days in coupon period

where:
w = Fractional period between the settlement date and the next coupon payment date.

Expected cash flow


Present value t =
(1 + i) t 1 + w

Current Yield
Annual cash coupon
Current yield =
Bond price

Bond Price

Bond price

where:
Bond price = Full price including accrued interest.
CPNt = The semiannual coupon payment received after t semiannual periods.
N = Number of years to maturity.
YTM = Yield to maturity.

Formula to Convert BEY into Annual-Pay YTM:


2
Annual-pay yield = 1 + ( Yield on bond equivalent basis
2
-1 ]
Formula to Convert Monthly Cash Flow Yield into BEY
BEY = [(1 + monthly CFY)6 1] 2

Discount Basis Yeild


360
d = (1-p)
N

2011 ELAN GUIDES 67


FIXED INCOME

Z-Spread
Z-spread = OAS + Option cost; and OAS = Z-spread - Option cost

Duration
V- - V+
Duration =
2(V0)(y)

where:
y = change in yield in decimal
V0 = initial price
V- = price if yields decline by y
V+ = price if yields increase by y

Portfolio Duration
Portfolio duration = w1D1 + w2D2 + ..+ wNDN

where:
N = Number of bonds in portfolio.
Di = Duration of Bond i.
wi = Market value of Bond i divided by the market value of portfolio.

Percentage Change in Bond Price


Percentage change in bond price = duration effect + convexity adjustment
= {[-duration (y)] + [convexity (y)2]} 100
where:
y = Change in yields in decimals.

Convexity
V+ + V- - 2V0
C= 2
2V0(y)

Price Value of a Basis Point


Price value of a basis point = Duration 0.0001 bond value

2011 ELAN GUIDES 68


DERIVATIVES

DERIVATIVES

FRA Payoff
Floating rate at expiration FRA rate (days in floating rate/ 360)
1 + [Floating rate at expiration (days in floating rate/ 360)

Numerator: Interest savings on the hypothetical loan. This number is positive when the floating rate
is greater than the forward rate. When this is the case, the long benefits and expects to receive a payment
from the short. The numerator is negative when the floating rate is lower than the forward rate. When this
is the case, the short benefits and expects to receive a payment from the long.

Denominator: The discount factor for calculating the present value of the interest savings.

2011 ELAN GUIDES 69


DERIVATIVES

Call Option Payoffs

Intrinsic Value of a Call Option


Intrinsic value of call = Max [0, (St - X)]

Put Option Payoffs

Moneyness and Intrinsic Value of a Put Option

2011 ELAN GUIDES 70


DERIVATIVES

Option Premium
Option premium = Intrinsic value + Time value
Put-Call Parity
C0 + X = P0 + S0
T
(1 + RF)

Synthetic Derivative Securities

Strategy Consisting of Value Equals Strategy Consisting of Value

fiduciary long call + C0 + X = Protective long put + long P0 + S0


call long bond (1 + RF)T put underlying asset

long long C0 = Synthetic long put + long P0 + S0


call call call underlying asset - X/(1+RF)T
+ short bond

long long P0 = Synthetic put long call + short C0 - S0


put put underlying asset +X/(1+RF)T
+ long bond

long long S0 = Synthetic long call C0


underlying underlying underlying + long bond + X/(1+RF)T
asset asset asset + short put - P0

long long X = Synthetic long put + long P0 + S0


bond bond (1 + RF)T bond underlying asset - C0
+ short call

Option Value Limits


Option Minimum Value Maximum Value

European call ECt 0 ECt St


American call ACt 0 ACt St
European put EPt 0 EPt X/ (1 + RFR)T
American put APt 0 APt X

2011 ELAN GUIDES 71


DERIVATIVES

Option Value Bounds

Interest Rate Call Holders Payoff

= Max (0, Underlying rate at expiration - Exercise rate) (Days in underlying Rate) NP
360
where: NP = Notional principal

Interest Rate Put Holders Payoff

= Max (0, Exercise rate Underlying rate at expiration) (Days in underlying rate) NP
360
where:
NP = Notional principal

Net Payment for a Fixed-Rate-Payer

Net fixed-rate paymentt = (Swap fixed rate - LIBORt-1 )(No. of days/360)(NP)


where:
NP equals the notional principal.

2011 ELAN GUIDES 72


DERIVATIVES

Summary of Options Strategies


Call Put
CT = max(0,ST - X) PT = max(0,X - ST)
Value at expiration = CT Value at expiration = PT
Profit: CT - C0 Profit: PT - P0
Holder Maximum profit = Maximum profit = X - P0
Maximum loss = C0 Maximum loss = P0
Breakeven: ST* = X + C0 Breakeven: ST* = X - P0

CT = max(0,ST-X) PT = max(0,X - ST)


Value at expiration = CT Value at expiration = PT
Writer Profit: CT - C0 Profit: PT - P0
Maximum profit = C0 Maximum profit = P0
Maximum loss = Maximum loss = X - P0
Breakeven: ST* = X + C0 Breakeven: ST* = X - P0

Where: C0, CT = price of the call option at time 0 and time T


P0, PT = price of the put option at time 0 and time T
X = exercise price
S0, ST = price of the underlying at time 0 and time T
V0, VT = value of the position at time 0 and time T
profit from the transaction: VT - V0
r = risk-free rate

Covered Call

Value at expiration: VT = ST - max(0,ST - X)


Profit: VT - S0 + C0
Maximum profit = X - S0 + C0
Maximum loss = S0 - C0
Breakeven: ST* = S0 - C0
Protective Put

Value at expiration: VT = ST + max(0,X - ST)


Profit: VT - S0 - P0
Maximum profit =
Maximum loss = S0 + P0 - X
Breakeven: ST* = S0 + P0

2011 ELAN GUIDES 73