Economics 173B - Corporate Finance Spring 2016-17

Prof. Garey Ramey

Technical Notes

Notation and denitions.

~ = random variable.
X
X~ = Y~ ) X~ and Y~ are equivalent.
X~ =0 ) X ~ is identically equal to zero.
~ = expectation conditional on information available at year t, t = 0; 1; 2; ::: .
Et [X]
~ = Eu [X]
Law of Iterated Expectations: Eu [Et [X]] ~ for any u < t.

Cash ow stream = sequence of cash ows CA0 ; C~A1 ; C~A2 ; ::: .

CA0 = cash ow at year 0.
C~At = random cash ow at year t, t = 1; 2; ::: .
CA0 ; C~At > 0 ) cash is received.
CA0 ; C~At < 0 ) cash is paid.
C~At = 0 ) no cash ow occurs at year t

Asset = ownership of a particular cash ow stream.

VA0 = current market value of C~A1 ; C~A2 ; ::: (CA0 not included).
V~At = future market value of C~A;t+1 ; C~A;t+2 ; ::: (C~At not included).

r~A1 = return on asset at year 1:

C~A1 + V~A1 VA0

r~A1 = :
VA0
r~At = return on asset at year t > 1:

C~At + V~At V~A;t 1

r~At = :
V~A;t 1

Capital market assumptions.

Assumption 1. Perfectly competitive.

a. All agents are price takers;
b. Traded assets may be arbitrarily scaled, and combined into portfolios;
c. Agents have symmetric information.

1
 Assumption 2. Arbitrage-free. Agent cannot make trades that yield strictly positive
cash ows with certainty.

Assumption 3. Complete. All risks can be traded

Assumption 4. Constant forecasts. For all t > 0 and all u < t, the year u forecast
of r~At does not vary with u:
Eu [~
rAt ] = E0 [~
rAt ] = rAt :

Assumption 5. Flat yield curve. For any given asset, expected returns are constant
over time:
rAt = rA ; t = 1; 2; 3; :::

Valuation Theorem. a. Suppose the capital market is perfectly competitive and arbitrage-
free. Then there exist random variables m ~ SS+t , t = 1; :::; T S, S = 0; 1; :::; T 1, called
stochastic discount factors (SDFs), such that the current market value of an asset is deter-
mined by
XT
VA0 = E0 [m~ 0t C~At ];
t=1
and the future market values are determined by
XT S
V~AS = ~ SS+t C~A;S+t ]; S > 0:
E0 [m
t=1

~ St are unique.1
b. If the market is also complete, then the random variables m

Proposition 2.1. The current market value of C~AS is given by

E0 [C~AS ]
VA0 = :
(1 + rA )S

Proof. Since C~A;S+t = 0 for all t > 0, the Valuation Theorem implies
XT S
V~AS = ~ SS+t 0] = 0:
ES [m
t=1

This means we can write the return r~AS as

C~AS + V~AS V~A;S 1 C~AS V~A;S 1

r~AS = = :
V~A;S 1 V~A;S 1

1
For a proof, see Asset Pricing by John H. Cochrane.

2
Rearrange:
V~A;S 1 (1 + r~AS ) = C~AS :
Now take conditional expectation at year S 1 of both sides of the equation:
h i h i
~ ~
ES 1 VA;S 1 (1 + r~AS ) = ES 1 CAS :

Since V~A;S 1 is known at year S 1, V~A;S 1 may be treated as a constant, and

the left-hand side of the preceding equation may be written as
h i
ES 1 V~A;S 1 (1 + r~AS ) = V~A;S 1 ES 1 [(1 + r~AS )]

= V~A;S 1 (1 + ES 1 [~
rAS ]) = V~A;S 1 (1 + rAS ) ;
where the last equality uses Assumption 4. Thus,
h i
V~A;S 1 (1 + rAS ) = ES 1 C~AS : (1)

Next, since C~A;S 1 = 0, the return r~A;S 1 becomes

C~A;S 1 + V~A;S 1 V~A;S 2 V~A;S 1 V~A;S 2

r~A;S 1 = = :
V~A;S 2 V~A;S 2

Rearrange:
V~A;S 2 (1 + r~A;S 1) = V~A;S 1: (2)
Combining equations (1) and (2) gives
h i
V~A;S 2 (1 + r
~A;S 1 ) (1 + rAS ) = ES 1 C~AS :

Now take conditional expectation at year S 2 of both sides of the equation,

and apply the Law of Iterated Expectations:
h i h i
ES 2 V~A;S 2 (1 + r~A;S 1 ) (1 + rAS ) = ES 2 C~AS :

Since V~A;S 2 and rAS are known at year S 2, they may be treated as constants,
and the left-hand side of the preceding equation may be written as
h i
ES 2 V~A;S 2 (1 + r~A;S 1 ) (1 + rAS )

= V~A;S 2 (1 + rAS ) ES 2 [(1 + r~A;S 1 )]

= V~A;S 2 (1 + rAS ) (1 + ES 2 [~
rA;S 1 ])
= V~A;S 2 (1 + rAS ) (1 + rA;S 1 );

3
 where the the last equality uses Assumption 4. Thus,
h i
V~A;S 2 (1 + rAS ) (1 + rA;S 1 ) = ES 2 C~AS :

Continuing in this way for years S 3; S 4; :::, we eventually reach year 0,

and we arrive at the equation
h i
VA0 (1 + rAS ) (1 + rA;S 1) (1 + rA1 ) = E0 C~AS :

Moreover, Assumption 5 implies

(1 + rAS ) (1 + rA;S 1) (1 + rA1 ) = (1 + rA )S ;

so we may write h i
VA0 (1 + rA )S = E0 C~At ;

which gives the result.

Proposition 2.2. The current market value of the portfolio consisting of Assets 1; :::; J is
given by
XJ j
VA0 = VA0 :
j=1

P j
Proof. Since C~At = Jj=1 C~At , we have, using the Valuation Theorem:

XT h i XT XJ j
VA0 = E0 m~ 0t C~At = ~ 0t
E0 m C~At
t=1 t=1 j=1

XT XJ XT XJ h i
j j
= E0 ~ 0t C~At
m = E0 m~ 0t C~At
t=1 j=1 t=1 j=1
XJ XT h i XJ
j j
= ~ 0t C~At
E0 m = VA0 :
j=1 t=1 j=1

Proposition 2.3. The OCC of the portfolio consisting of Assets 1; :::; J is given by

XJ j
VA0
rA = rj :
j=1 VA0 A

4
 Proof. The Valuation Theorem implies
XT 1 h i
V~A1 = E1 m~ 11+t C~A;t+1 ;
t=1

where the random variables m ~ 1t+1 , t = 1; 2; :::, are the SDFs for valuing assets
at year 1. Thus, for the portfolio consisting of Assets 1; :::; J, we may apply the
argument of Prop. 2.2 to obtain
XJ j
V~A1 = V~A1 :
j=1

It follows that r~A1 may be expressed as

PJ ~j PJ ~j PJ j
C~A1 + V~A1 VA0 j=1 CA1 + j=1 VA1 j=1 VA0
r~A1 = =
VA0 VA0
!
XJ j
C~A1 j
+ V~A1 j
VA0 XJ j
VA0 j
C~A1 j
+ V~A1 j
VA0
= = j
j=1 VA0 j=1 VA0 VA0
!
XJ j
VA0 j
C~A1 j
+ V~A1 j
VA0 XJ j
VA0
= = r~j :
j=1 VA0 j
VA0 j=1 VA0 A1
Take unconditional expectation:
" #
XJ V j j XJ V j h i
A0 A0 j
E0 [~
rA1 ] = E0 r~A1 = E0 r~A1 :
j=1 VA0 j=1 VA0

Finally, Assumption 5 implies

h i
j j
E0 [~
rA1 ] = rA ; E0 r~A1 = rA :

Thus,
XJ j
VA0
rA = rj :
j=1 VA0 A

Proposition 2.4. The current market value of the cash ow stream C~A1 ; C~A2 ; ::: is given
by
X1 CAt
VA0 = :
t=1 (1 + rA )t

5
 Proof. First consider the nite cash ow stream C~A1 ; C~A2 ; :::; C~AT . The future
cash ows may be viewed as a portfolio consisting of T separate assets, with each
asset generating the single cash ow C~At . Prop. 2.1 shows that the value of C~At
considered as a separate asset is given by
CAt
:
(1 + rA )t
Thus, Prop. 2.2 implies
XT CAt
VA0 = :
t=1 (1 + rA )t
For an innite cash ow stream, we have
XT CAt X1 CAt
VA0 = lim = ;
T !1 t=1 (1 + rA )t t=1 (1 + rA )t

provided the limit exists.

Corollary 2.1. The market value of C~A;S+1 ; C~A;S+2 ; ::: at year S > 0 is given by
h i
X1 ES C~A;S+t
V~AS = :
t=1 (1 + rA )t

Proof. First consider a single cash ow C~A;S+t received at year S + t > S. The
arguments from the proof of Prop. 2.1 may be used to obtain, for u < S + t,

V~A;S+t u (1 + ES+t u [rA;S+t ]) (1 + ES+t u [rA;S+t 1 ])

h i
(1 + ES+t u [rA;S+t u+1 ]) = ES+t u C~A;S+t :

Letting u = t and invoking Assumptions 4 and 5 gives

h i
V~AS (1 + rA )t = ES C~A;S+t ;

or h i
ES C~A;S+t
V~AS = :
(1 + rA )t
Next, for T > S, the market value at year S of the cash ow stream
C~A;S+1 ; C~A;S+2 ; :::C~A;T is given by
XT S h i
V~AS = ES m~ SS+t C~A;S+t ;
t=1

6
 ~ SS+t , t = 1; 2; :::, are the SDFs for valuing assets at
where the random variables m
year S. Applying the arguments from the proof of Prop. 2.4 gives
h i
XT S ES C~A;S+t
V~AS = ;
t=1 (1 + rA )t
and the result follows by letting T ! 1, provided the limit exists.

Corollary 2.2. The current market value of V~AS is given by

VAS
:
(1 + rA )S
Moreover, the Valuation Formula converges if and only if
VAS
lim = 0:
S!1 (1 + rA )S

Proof. Consider the cash ow stream in which C~Au = 0 at years u S, and

the ows C~A;S+1 ; C~A;S+2 ; ::: are received at years S + 1; S + 2; ::: . Using the
Valuation Formula (with the index of summation changed to u), we can write
X1 CAu
VA0 =
u=1 (1 + rA )u
XS 0 X1 CAu
= + :
u=1 (1 + rA )u u=S+1 (1 + rA )u

Let t = S u, so that u = S + t and the indices u = S + 1; S + 2; ::: correspond

to t = 1; 2; :::. Thus,
X1 CAu
VA0 = (3)
u=S+1 (1 + rA )u
X1 CA;S+t 1 X1 CA;S+t
= S+t
= S
:
t=1 (1 + rA ) (1 + rA ) t=1 (1 + rA )t

Moreover, from Cor. 2.1 we have

h i
X1 ES C~A;S+t
V~AS = :
t=1 (1 + rA )t
Take unconditional expectation of both sides and apply the Law of Iterated
Expectations:
2 h i3
h i X1 ES C~A;S+t
VAS = E0 V~AS = E0 4 5 (4)
t=1 (1 + rA )t

7
 h h ii
X1 E0 ES C~A;S+t X1 CA;S+t
= := :
t=1 (1 + rA )t t=1 (1 + rA )t
Combining equations (3) and (4) gives the result.
Next, suppose the Valuation Formula converges. This means that, for any
" > 0, there exists S such that S > S implies
X1 CAt
< ":
t=S+1 (1 + rA )t

Let u = t S, so that t = S + u, and also the indices t = S + 1; S + 2; :::

correspond to u = 1; 2; :::. Thus,
X1 CAt X1 CA;S+u 1 X1 CA;S+u
= = :
t=S+1 (1 + rA )t u=1 (1 + rA )S+u (1 + rA )S u=1 (1 + rA )u

Using Cor. 2.1 (with the index of summation changed to u), we have
2 h i3
h i X1 ES C~A;S+u X1 CA;S+u
VAS = E0 V~AS = E0 4 5= :
u=1 (1 + rA )u u=1 (1 + rA )u

Substitute to obtain
X1 CAt VAS
= :
t=S+1 (1 + rA )t (1 + rA )S

It follows that for every " > 0, there exists S such that S > S implies
X1 CAt VAS
t
= < ";
t=S+1 (1 + rA ) (1 + rA )S

which means
VAS
lim = 0:
S!1 (1 + rA )S

The reverse implication follows immediately from these arguments.

Proposition 2.5. If the cash ow stream C~A1 ; C~A2 ; ::: is delayed by S years, then its
current market value is given by
1
V^A0 = VA0 :
(1 + rA )S

8
 Proof. Given the delay, the asset generates zero cash at years t = 1; 2; :::; S 1,
and the cash ows C~A1 ; C~A2 ; ::: are received at years t = S + 1; S + 2; :::. Thus,
the Valuation Formula gives
XS 0 X1 CA;t S
V^A0 = +
t=1 (1 + rA )t t=S+1 (1 + rA )t

X1 CA;t S
= :
t=S+1 (1 + rA )t
Dene u = t S, so that t = S + u, and the years t = S + 1; S + 2; ::: correspond
to years u = 1; 2; :::. Substitute for t and rearrange to obtain:
X1 CAu
V^A0 =
u=1 (1 + rA )S+u

1 X1 CAu 1
= S u
= VA0 :
(1 + rA ) u=1 (1 + rA ) (1 + rA )S

Proposition 2.6. The current market value of a Growing Annuity is given by

8
T
< B 1 1+g
; g= 6 rA
VA0 = r A g 1+r A :
: TB
1+rA ; g = r A

Proof. Suppose g 6= rA . For T = 1 we have, using Prop. 2.4:

B X1 0
VA0 = +
1 + rA t=2 (1 + rA )t

B rA g B rA g 1
= =
1 + rA rA g rA g 1 + r A 1 + rA
B 1 + rA 1 g B 1+g
= = 1 :
rA g 1 + rA rA g 1 + rA
Now x T > 1 and suppose the result holds for 1; 2; :::; T 1. Again using Prop.
2.4, we have
XT B(1 + g)t 1 X1 0
VA0 = t
+
t=1 (1 + rA ) t=T +1 (1 + rA )t

XT 1 B(1 + g)t 1 B(1 + g)T 1

= +
t=1 (1 + rA )t (1 + rA )T

9
 " #
T 1
B 1+g B(1 + g)T 1 rA g
= 1 +
rA g 1 + rA (1 + rA )T rA g

B (1 + g)T 1 1 + rA (1 + g)T 1 (rA g)

= 1 +
rA g (1 + rA )T 1 1 + rA (1 + rA )T
B (1 + g)T 1 (1 + rA ) (1 + g)T 1 (r
A g)
= 1
rA g (1 + rA )T
B (1 + g)T
= 1 :
rA g (1 + rA )T
Thus by induction the result is valid for all T .
For g = rA :
XT B(1 + rA )t 1 X1 0
VA0 = +
t=1 (1 + rA )t t=T +1 (1 + rA )t
XT B TB
= = :
t=1 1 + rA 1 + rA

Proposition 2.7. If g < rA , then the current market value of a Growing Annuity satisties
B
lim VA0 = :
T !1 rA g
Proof. Dene the constant by
1+g
= :
1 + rA
Then 1 < g < rA implies 0 < < 1, so that limT !1 T = 0. Moreover, the
Growing Annuity Formula may be written as
B T
VA0 = 1 :
rA g
Since this is a continuous function of T, we have
B T B
lim VA0 = 1 lim = :
T !1 rA g T !1 rA g

Alternate Proof. Using the Valuation Formula, we have

XT B(1 + g)t 1 B XT (1 + g)t 1
VA0 = =
t=1 (1 + rA )t (1 + rA ) t=1 (1 + rA )t 1

10
 B XT B XT 1
t 1 u
= = ;
(1 + rA ) t=1 (1 + rA ) u=0

where the substitution u = t 1 has been made. Since 0 < < 1, the Geometric
Series Theorem yields
XT 1 1
u
lim = :
T !1 u=0 1
Thus,
B 1
lim VA0 =
T !1 (1 + rA ) 1
B 1 B
= 1+g = :
(1 + rA ) 1 1+rA
rA g

Proposition 2.8. Suppose CB1 ; CB2 ; ::: and I0 satisfy IRR Regularity Conditions 1 and
2. Then the IRR exists uniquely, and the IRR Rule is equivalent to the NPV Rule.

Proof. Dene the function NB (r) by

X1 CBt
NB (r) = I0 ; r > 1:
t=1 (1 + r)t

It follows that rIRR satises the IRR Equation if and only if NB (rIRR ) = 0, i.e.,
NB intersects the r-axis at rIRR .
Using Condition 1, we have
X1
NB (0) = CBt I0 > 0;
t=1

lim NB (r) = I0 < 0:

r!1

Thus NB (r) must cross the r-axis at least once for r > 0. Since NB (r) is a
continuous function, it must intersect the r-axis, which means NB (r) = 0 for
some r > 0. Conclude that an IRR exists. Moreover, Condition 2 implies that
NB (r) is strictly decreasing in r, so it cannot intersect the r-axis more than one
point. Conclude that the IRR is unique.
Next, using Condition 2, we have that rIRR > rB holds if and only if 0 =
NB (rIRR ) < NB (rB ) = NPV, whereas rIRR < rB holds if and only if 0 =
NB (rIRR ) > NB (rB ) = NPV. This proves that the IRR and NPV Rules are
equivalent.

Lemma 4.1. For any l and S, the market value at year S of type l bonds issued at years
S + 1; S + 2; ::: is zero.

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 Proof. Let F~ l (S + u; T ) be the face value of type l bonds of maturity T issued
~ l (S + u; T ) be the market value of these bonds at year
at year S + u, and let D S+u
S +u. Net payments to holders of these bonds at years S +u; S +u+1; S +u+2:::
are as follows:
8
> ~ l (S + u; T );
D t = 0;
>
< S+u
l ~ l
rC F (S + u; T ); t = 1; :::; T 1;
C~D;S+u+t
l
(S +u; T ) = ~ l (S + u; T ) + F~ l (S + u; T );
l F
>
> r t = T;
: C
0; t = T + 1; T + 2; ::: :

Corollary 2.1 implies that the market value of the bonds at year S + u is
h i
X1 ES+u C~D;S+u+t
l (S + u; T )
~ l (S + u; T ) =
D :
S+u l )t
t=1 (1 + rD

Thus, the market value of the bonds at year S is

h i h i
ES D ~ l (S + u; T ) X1 E S
~
C l (S + u; T )
S+u D;S+u+t
~ Sl (S + u; T ) =
D +
l
(1 + rD )u t=1 l )u+t
(1 + rD
2 h i3
h i X E S+u
~
C l (S + u; T )
1 4 ES D ~ l (S + u; T ) +
1 D;S+u+t
5
= l u S+u l )t
(1 + rD ) t=1 (1 + rD

1
= l )u
[ 0 ] = 0:
(1 + rD
It follows that the market value at year S of type l bonds issued in all future
years at all maturities is given by
X1 X1
D~ l (S + u; T ) = 0:
u=1 T =1 S

~ l = F~ l for all S.
l = r l , then D
Proposition 4.1. If type l debt satises rC D S S

Proof. Fix T > 0, and let F~Sl (T ) denote the face value of type l bonds
outstanding at year S that mature at year S + T . Net payments to holders of
these bonds at years S + 1; S + 2; ::: are as follows:
8
< rC ~ l (T );
l F t = 1; :::; T 1;
S
~ l
CD;S+t (T ) = l ~ l ~ l
r F (T ) + FS (T ); t = T;
: C S
0; t = T + 1; T + 2; ::: :

12
 Corollary 2.1 implies that the market value of the bonds at year S is
h i
X1 ES C~D;S+t
l (T ) XT rl F~ l (T ) F~Sl (T )
D~ Sl (T ) = = C S
+
t=1 l )t
(1 + rD t=1 (1 + r l )t (1 + rD l )T
D

~ l (T )
l F
rC 1 F~Sl (T )
S
= l
1 l )T
+ l )T
:
rD (1 + rD (1 + rD
l = r l , we have
Since rC D

~ Sl (T ) = F~Sl (T ) 1 1 F~Sl (T )
D l )T
+ l T
= F~Sl (T ):
(1 + rD (1 + rD )

Moreover, Lemma 4.1 shows that the market value at year S of type l bonds of
all maturities issued at years S + 1; S + 2; ::: is zero. Thus,
X1 X1
D~ Sl = ~ Sl (T ) =
D F~Sl (T ) = F~Sl :
T =1 T =1

Proposition 4.2. If type l debt satises rCl = r l and F l = F l (1 + g l )t for all t > 0, then
D t 0
the value of ITS is given by
l Dl
rD
l 0
V0;IT S = l
:
rD gl

Proof. In view of Prop. 4.1, rC l = r l implies F l = D l . Thus, we have

D 0 0
l l l t
Ft = D0 (1 + g ) , and the Growing Perpetuity Formula yields

X1 rCl Fl
t 1
X1 rl Dl (1 + g l )t 1 l Dl
rD
l D 0 0
VIT S;0 = l )t
= l )t
= l
:
t=1 (1 + rD t=1 (1 + rD rD gl

l = r l and F l = F l for all t > 0. Then the value

Proposition 4.3. Suppose for every l, rC D t 0
and OCC of ITS are given by

VIT S;0 = VD;0 ; rIT S = rD :

Proof. Under the assumptions, Prop. 4.2 implies, for all l,

l Dl
rD
l 0
V0;IT S = l
= D0l :
rD 0

13
 Thus,
XL XL XL
l
VIT S;0 = VIT S;0 = D0l = D0l = D0 ;
l=1 l=1 l=1

XL l
VIT S;0
XL D0l XL D0l l
l l
rIT S = rD = rD = r = rD :
l=1 VIT S;0 l=1 D0 l=1 D0 D

Corollary 4.1. Under the conditions of Proposition 4.3, expected net payouts to debtholders
for all t > 0 are given by
CDt = Intt = rD D0 :

Proof. Let F~M l

t denote the face value of type l debt that matures at year t,
and let F~N t and D
l ~ l denote the face value and market value, respectively, of
Nt
new type l debt issued at year t. The face value of type l debt at year t + 1 is
determined by
F~t+1
l
= F~tl F~M
l ~l
t + FN t :

We have Ft+1 l = Ftl = F0l by hypothesis, so the preceding equation implies

l l
FM t = FN t .
Net payouts to type l debtholders at year t are given by

C~Dt
l glt + F~M
= Int l
t
~N
D l l ~l ~l
t = r C Ft + FM t
~N
D l
t:

l = r l , we have F
Since rC ~l = D ~ l . Substituting for D ~ l and taking expectation
D Nt Nt Nt
gives
l l
CDt = rC Ftl + FM
l
t FNl t = rC
l
Ftl = rC
l
F0l = rC
l
D0l :
Expected net payouts to all debtholders are obtained as follows:
XL XL D0 XL l D0l
l l
CDt = CDt = rD D0l = r D0 = rD D0 :
l=1 l=1 D0 l=1 D D0

Proposition 5.1. The Value of Equity equals the value of the net payout stream:

E0 = E0N P :

14
 Proof. Since each share has a cash value of Divg 1 + P~1 at year 1, the portfolio
g 1 + P~1 )K0 at year 1.
of all currently outstanding shares has a cash value of (Div
Moreover, the denition of C~E1 may be rearranged to obtain
g 1 + P~1 )K0 = C~E1 + P~1 K
(Div ~ 1;

so that the cash value of the portfolio of shares at year 1 equals C~E1 + P~1 K
~ 1.
Thus, the Value of Equity must satisfy
CE1 P1 K 1
E0 = N P
+ 1 ; (5)
1 + rE 1 + rE

where rE N P is the OCC of the net payout stream, and r 1 is the OCC of P ~1 K
~ 1.
E
g 2 + P~2 at year 2, the portfolio
Next, since each share has a cash value of Div
g 2 + P~2 )K
of all shares outstanding at year 1 has a cash value of (Div ~ 1 at year 2.
~
Moreover, the denition of CE2 may be rearranged to obtain
g 2 + P~2 )K
(Div ~ 1 = C~E2 + P~2 K
~ 2:

Since P~1 K
~ 1 is the market value of the portfolio at year 1, it follows that the
current market value of P~1 K
~ 1 must satisfy

P1 K1 CE2 P2 K 2
1 = N P 2
+ 2 )2 ;
1 + rE (1 + rE ) (1 + rE

~2 K
2 is the OCC of P
where rE ~ 2 . Substituting into equation (5) gives

CE1 CE2 P2 K 2
E0 = N P
+ N P 2
+ 2 )2 :
1 + rE (1 + rE ) (1 + rE

Proceding in this way for years t = 2; 3; :::, we obtain

X1 CEt
E0 = N P )t
= E0N P :
t=1 (1 + rE

Proposition 5.2. The Return on Equity equals the OCC of the net payout stream:
NP
rE = rE :

Proof. From the denition of C~E1 we have

g 1 + P~1 )K0 = C~E1 + E
(Div ~1 :

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Thus, using Prop. 5.1, we may write

g 1 + P~1
Div P0 g 1 + P~1 )K0
(Div P0 K0
r~E = =
P0 P0 K 0

C~E1 + E
~1 E0 C~E1 + E
~NP
1 E0N P NP
= = = r~E :
E0 E0AC
Taking expectation at year 0 gives the result.

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