Formulas

Data
Capital $ 100,000.00 1
Interest Rate 9% PV 91743.11927
n Years 6 PV Annuity
Growth 2.5% PV Perpetuity
PV Annuity Growing
PV Perpetuity Growing
Er 10%
Risk Aversion 2.4 Free Cash Flow
Variance 9% Dividend Growth Model
Dividend Payments Stock Price
Total Payouts Equity Value
Free Cash Flows Enterprise Value
Holding Period Return
Effective Annual Rate
Annualized Percentage Rate
Sharpe Ratio Reward to Volatility Ratio
Utility
Expected Return
 1. Solve NEW exercises beside the existing tutorials for every Chapter
2. Write all Formulas in a Word + beside every exercise

2 3 4 5 6 Other
84167.99933 77218.34801 70842.52111 64993.13863 59626.73269
448591.8590231
$ 1,111,111.11
474634.9315735
1538461.538462

(revenues - costs + depreciation) * (1-Tc) + de

P = Dividend1 / (discount rate - growth rate)

erprise Value
(ending price - beginning price + divident or i

ward to Volatility Ratio risk premium / SD

-0.008
ErR*wR + ErF*wF
 preciation) * (1-Tc) + depreciation - CapEx - △NWC
ount rate - growth rate)

ning price + divident or interest) / beginning price

C ($) 4200
r 12%

a)
FV 9284.86191111

b)
FV 863965.411242

c)
PV 546.17

r (1) 12%
r(2) 2%

0 1 2 3
CF -20000 1000 3000
PV -20000 892.86 2391.58 0.00

a)
NPV -10276.096493 No, we should not take the opportunity

b)

0 1 2 3
CF -20000 1000 3000
PV -20000 980.39215686 2883.506344 0
NPV 270.86449808 Yes, we should take the opportunity

IRR - is when NPV equals 0

Bond 200
r 12%

a)
Value of P (after) 1666.66666667

b)
Value of P (before) 1866.67 Perpetuity V + Perpetuity V*r

Growth (1) 40% (1-5) 1. Calculate CF for year 1 ( 7000000)

Growth (2) 3% (6>) 2. Calculate Growing Annuity Year 1-5 (60128108)
interest r 7% 3. Calculate Growing perpetuity FOR YEAR 6 (but fi
Years 5 4. Calculate Value of Perpetuity
Earnings 5000000 5. Discount the Value Perpetuity
6. Calculate PV
The Annuity
CF year 1 7000000 earnings*(1+growth)
Years 5
discount rate 7%
Growth 40%
Value 60128107.6655

The Perpetuity
CF year 6 27697936
Discount rate 7%
Growth 3%
Value year 5 692448400
Value year 0 493706139

Total value 553834247

A)
r 13%
1 2 3
Time 0 -2500 -2000 -1000
Cash flow 5000 -2193.2 -1539.3 -675.2

select an interest rate by yourself to begin with, then calculate the PV based on it. Afterward we can use "goal se

PV 5000
NPV 5000 2. Use Goal Seek to find out IRR - 1) Set cell: curren

IRR 13.99% IRR - invest only when IRR is higher than 14% becau

B)
r 10%
0 1 2 3
Cash flow 5000 -2500 -2000 -1000

PV 5000 -2272.727273 -1652.89256 -751.314801

NPV 0.0

C)

r 20%
Time 0 1 2 3
Cash flow 5000 -2500 -2000 -1000
PV 5000 -2083.333333 -1388.88889 -578.703704

NPV 0 technically we can accept this offer

NPV rule and IRR rule are consistent, under IRR rule, we rejected projects with IRR under 14% which showed tha

DeepW fishing CF 0 1 2 3
CF -600000 270000 350000 300000
PV -600000 217224.78493 226547.4968 156227.7183
NPV 0
IRR 24%

NewMarine CF 0 1 2 3
CF -1800000 1000000 700000 900000
PV -1800000 823294.36321 474469.5259 502236.1109
NPV 0
IRR 21%

--------------------------------------------------------------------------------------
Annual Return 15%
DeepW fishing CF 0 1 2 3
CF -600000 270000 350000 300000
PV -600000 234782.6087 264650.2836 197254.8697

NPV 0

NewMarine CF 0 1 2 3
CF -1800000 1000000 700000 900000
PV -1800000 869565.21739 529300.5671 591764.6092

NPV 0

We will go for the NSM as the NPV is much higher than for the DWF. The IRR is not consistent with NPV

If all IRR are positive - we have only 1 irr, but here we have changes 4 times so we have 4 IRRs

0 1 2 3
Cash Flow -504 2862 -6070 5700
PV -504.0 2290.4 -3887.5 2921.5
NPV 0.0
Average of these 4 years, but it changes 4 times
IRR 25% IRR, NPV, r - are connected

IRR NPV
5.0% -5.485
10% -2.243
15.0% -0.760 Chart IRR
20% -0.173 1.000
25.0% 0.000
0.000
30% 0.014 0.0% 20.0% 40.0% 60.0% 80.0%
35.0% -0.006 -1.000
40% -0.010
-2.000
45.0% 0.012
50% 0.049 -3.000

-4.000

-5.000
 -1.000

-2.000

-3.000
55.0% 0.080
-4.000
60% 0.082
65.0% 0.032 -5.000
70% -0.090
-6.000
75.0% -0.300
80% -0.610
85.0% -1.031 X axis - IRR
90% -1.567 Y axis - NPV
95.0% -2.223
100% -3.000
 4 5 6 7 8 9 10
20000
0 0 0 0 0 0 6439.4647

t take the opportunity

4 5 6 7 8 9 10
20000
0 0 0 0 0 0 16406.966
 ke the opportunity

r year 1 ( 7000000)
wing Annuity Year 1-5 (60128108)
wing perpetuity FOR YEAR 6 (but first calculate Value for year 5)
e of Perpetuity
alue Perpetuity
 4
-1000
-592.3

it. Afterward we can use "goal seeker" in excel function

to find out IRR - 1) Set cell: current NPV (so find it first) 2) Value: 0, 3) By changing cell: IRR

when IRR is higher than 14% because NPV should not be lower than 0

4
-1000

-683.013455

4
-1000
 -482.253086

n accept this offer

IRR under 14% which showed that NPV is negative. When IRR is above 14%, the NPV is positive

CF/(1+irr)^t
not consistent with NPV

1. Determine how many IRR are

we have 4 IRRs

4
-2000
-820.3

hanges 4 times

Chart IRR

40.0% 60.0% 80.0% 100.0% 120.0%

Incrimental Earnings: the amount by which the firm’s earnings are expected to change as a result of the investment d
Free Cash Flow: the incremental effect of a project on the firm’s available cash, separate from any financing decision
Earnings does not inclued the cost of capital!!!
Average Annual Growth Rate: [(final growth rate) / (first growth rate)]^n - 1 = percent.
Growth = Retention Rate * Return on new Investment
Growth = Change in Earnings / Earnings
Share Repurchase: firm uses excess cash to buy back its own stock. This decreases share count, increasing earnings a
Weighted Average Cost of Capital: is the average cost of capital the firm must pay to all of its investors, both debt an
Enterprise Value: assesses the value of the underlying business assets, unencumbered by debt and separate from an
P/E Price to Earnings Ratio: the share price divided by its earnings per share
Net Working Capital: current assets minus current liabilities.
Chapter 8
Ch. 8, problem

Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the Mini Mochi M
for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9.14 million this year and b
Mini Mochi Munch will be more likely to try Kokomochi’s other products. As a result, sales of other products are
Mochi Munch is 36%, and its gross profit margin averages 24% for all other products. The company’s marginal
Find the Unleavered Income

Question 1: What are the incremental earnings associated with the advertising campaign?
0 1 2 3
Cost $ (3.76)
MMM $ 9.14 $ 7.14
Other $ 3.55 $ 3.55
Marg Tax 38% 38%

Earnings $ (3.76) $ 7.87 6.6278 0

Total 10.7356 14.4956 6.6278
Unleavered income is EBIT after tax.

Ch. 8, problem

Castle View Games would like to invest in a division to develop software for video games. To evaluate this decis
financial officer has developed the following estimates (in millions of dollars):
Question 1: Assuming that Castle View currently does not have any working capital invested in this divisi
years of this investment.

0 1 2 3
Cash 7 12 16
Recievable 19 25 26
Inventory 6 7 11
Payable 16 21 23

Cash Flows 16 23 30
Page 280
DELTA NET WORKING CAPITAL??
Ch. 8, problem

Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are d
years (in millions of dollars):

Information Year 1 Year 2

Revenues 106.50 159.90
COSG and operating expenses 47.70 59.50
Depreciation 25.90 35.50
Increase in net working capital 3.10 7.60
Capital expenditures 29.10 43.80
Marginal corporate tax rate 40% 40%

Question 1: What are the incremental earnings for this project for years 1 and 2?
Year 1 Year 2
Revenue 106.5 159.9
Cost of sold
goods,
expenses 47.7 59.5
Depreciation 25.9 35.5
Net Capital
Increase 3.1 7.6
Capital
Expenditure 29.1 43.8
Marginal Tax 40% 40%

Earnings -38.8 -42.86

Cash Flow -35.7 16
VERY IMPORTANT TO CALCULATE FREE CASH FLOW
Question 2: What are the free cash flows for this project for the first two years?

Ch. 8, problem 1

Bay Properties is considering starting a commercial real estate division. It has prepared the following four-yea
division:

Year 1 2 3
Free Cash flow -159,000 14,000 98,000

Question 1: Assume cash flows after year 4 will grow at 3% per year, forever. If the cost of capital for this
What is the value today of this division?

Growth after year 4 3%

Cost of capital 14%

v 0 1 2 3
Free Cash
Flow -159000 14000 98000
Discout!! -139473.684211 10772.5454 66147.20859
Chapter 9
Ch. 9, problem 1

DFB, Inc., expects earnings at the end of this year of $4.01 per share, and it plans to pay a $2.09 dividend at tha
expected return of 15.1% per year. Suppose DFB will maintain the same dividend payout rate, retention rate, an
shares.

Question 1: What growth rate of earnings would you forecast for DFB?

Earnings per share $4.01

Dividend per share $2.09
Retained earnings per share $1.92
Expected return 15.1%

Retention Rate 48%

g 7.23%
Question 2: If DFB’s equity cost of capital is 12.8%, what price would you estimate for DFB stock today?

Cost of capital = 12.8% P

Question 3: Suppose DFB instead paid a dividend of $3.09 per share at the end of this year and retained o
what stock price would you estimate now? Should DFB raise its dividend?

Dividend per share = $3.09 P

New Retention 23%
New Growth 3.464339152119700%

Even if you think it's silly, just write that increasing the dividend will cause a decrease in share price!
Ch. 9, problem 1

Proctor and Gamble paid an annual dividend of $1.72 in 2009. You expect P&G to increase its dividends by 8%
appropriate equity cost of capital for Proctor and Gamble is 8% per year.

Question 1: Use the dividend-discount model to estimate its value per share at the end of 2009
2009 1
Dividend per share $1.72 $1.86
Dividend growth (1-5) 8.00%
Dividend growth (6-∞) 3.00% $1.86
Cost of capital 8.00% 1.72
Share price (PV) $ 44.03

Ch. 9, problem 1

Suppose Amazon.com Inc. pays no dividends but spent $1.88 billion on share repurchases last year. If Amazon’s
6.4% per year, estimate Amazon’s market capitalization.

Question 1: If Amazon has 432 million shares outstanding, what stock price does this correspond to?

Information:

Share repurchases $1.88 bn

Share repurchase growth 6.40%
Shares outstanding 0.432 bn
Cost of capital 8.10%
Dividends 0 Or, 1.88 billion. As if all the money is pa
Share Repurchases 2.00032 Share Prices =
Market Capitalization 117.6658823529
Ch. 9, problem 1

Heavy Metal Corporation is expected to generate the following free cash flows over the next five years:

Year 1 2
Free Cash flow ($ millions) 51.30 69.70
PV 44.842657343 53.257494254
After then, the free cash flows are expected to grow at the industry average of 4.3% per year. Using the discount

Question 1: Estimate the enterprise value of Heavy Metal.

Growth after year 5 4.30%

WACC 14.40%

PV 6 years on 854.020792079
Discounted 435.851276146
EV = 443.76 This is the present value of all of the future cash flows

PV 672.636392744

Question 2: If Heavy Metal has no excess cash, debt of $280 million, and 35 million shares outstanding, es

Debt $ 280.00
Shares outstanding 35.00
Mkt Cap $ 392.64
Share Price $ 11.22 = 672.64 - 280.00

Ch. 9, problem 2

You notice that PepsiCo (PEP) has a stock price of $72.62 and EPS of $3.93. Its competitor, the Coca-Cola Com

Question 1: Estimate the value of a share of Coca-Cola stock using only this data.
 PepsiCo Coca-Cola
Stock price $72.62 $39.36
EPS $3.93 $2.13

P/E 18.4783715013
$39.36

Question 2: Discuss the choice of multiple

Price to Earnings Ratio 72.62/3.93 ~ x/2.13

Better to use earnings before interest and tax. If you just use earnings before tax, interest can skew the
P/E is adequate if valuing banks or financial institutions because the interest rate is similar.

Ch. 9, problem 2

Suppose that in January 2006, Kenneth Cole Productions had sales of $531 million, EBITDA of $51.3 million, e

Sales $531.00 million

Excess Cash $107.00 million
Debt $3.30 million
EBITDA $51.30 million
Shares outstanding 23 million
Avg. EV/Sales 1.06

Question 1: Using the average enterprise value to sales multiple in Table 9.1, estimate KCP’s share price.

Share Price: $ 28.98

something $562.86 million .=. mkt value + debt - cash/investments.
mkt value - 103.7
Enterprise V $562.86 666.56 $ 28.98
Mkt Cap $666.56
Share Price: $28.98
Question 2: What range of share prices do you estimate based on the highest and lowest enterprise value t
Sales*EV/Sales #-debt #/shares
High: 2.19 $1,162.89 $1,159.59 $50.42
Low: 0.47 $249.57 $246.27 $10.71
Share Price
Question 3: Using the average enterprise value to EBITDA multiple in Table 9.1, estimate KCP’s share pr
 multiply EBITDA subtract debt divide shares
EV/EBITDA 8.49 435.54 $539.24 $23.45

HIGHEST 10.75 551.48 $548.18 $23.83

LOWEST 6.66 341.66 $338.36 $14.71

Question 4: What range of share prices do you estimate from the highest and lowest enterprise value to E
see above

Ch. 9, problem 2

Consider the following data for the airline industry for December 2015 (EV = enterprise value, Book = tangible

Accounting is different in different countries, so the P/Book ratio might look different for the same company in
Operating in the same industry does not mean you operate in the same sub industry. Some companies
hange as a result of the investment decision
eparate from any financing decisions

cent.

s share count, increasing earnings and dividends on a per-share basis.

y to all of its investors, both debt and equity holders. If the firm has no debt, rWACC = rE (cost of capital)
bered by debt and separate from any cash and marketable securities. Mkt Value of equity + debt - cash

Chapter 8
Ch. 8, problem 2

atest dessert product, the Mini Mochi Munch. Kokomochi plans to spend $3.76 million on TV, radio, and print advertising this year
Munch by $9.14 million this year and by $7.14 million next year. In addition, the company expects that new consumers who try the
. As a result, sales of other products are expected to rise by $3.55 million each year. Kokomochi’s gross profit margin for the Mini
ther products. The company’s marginal corporate tax rate is 38% both this year and next year.

dvertising campaign?
4 5.555555555

5.5555555556

237

Ch. 8, problem 7

for video games. To evaluate this decision, the firm first attempts to project the working capital needs for this operation. Its chief
lars):
working capital invested in this division, calculate the cash flows associated with changes in working capital for the first five

4 5
15 14
21 23
14 15
25 31

25 21

Ch. 8, problem 9

es. Although long-term cash flows are difficult to estimate, management has projected the following cash flows for the first two

ars 1 and 2?

Revenues minus
expenses and
FIND EBIT depreciation.

Subtract tax from EBIT to get unleavered net income

FCF add depreciation minus capital expenditures minus increase in net working capital.
two years?

Ch. 8, problem 19

It has prepared the following four-year forecast of free cash flows for this

4
221,000

forever. If the cost of capital for this division is 14%, what is the continuation value in year 4 for cash flows after year 4?

Use Formula for the perpetuity

4 5 6

221000 227630 2069363.63636364 1129293.93513671

130849.7413 118223.8890682 942774.234993818
Chapter 9
Ch. 9, problem 10

d it plans to pay a $2.09 dividend at that time. DFB will retain $1.92 per share of its earnings to reinvest in new projects with an
dividend payout rate, retention rate, and return on new investments in the future and will not change its number of outstanding

B?

3.464339152119700%
d you estimate for DFB stock today?

$ 37.52

at the end of this year and retained only $0.92 per share in earnings. If DFB maintains this higher payout rate in the future,
dend?

$ 33.10 No??

ll cause a decrease in share price!

Ch. 9, problem 12

ect P&G to increase its dividends by 8% per year for the next five years (through 2014), and thereafter by 3% per year. The
r.

r share at the end of 2009

2 3 4 5 …
$2.01 $2.17 $2.34 $2.53 $2.60

$2.01 $2.17 $2.34 $2.53 52.0612324172

1.72 1.72 1.72 1.72 35.432

Ch. 9, problem 16

hare repurchases last year. If Amazon’s equity cost of capital is 8.1%, and if the amount spent on repurchases is expected to grow by

k price does this correspond to?

PV = $ 110.59 bn

P0 = $ 255.99

1.88 billion. As if all the money is paid as a dividend.

 272.3747276688 Market Cap (amount of all shares) divided by number of outstanding shares.

Ch. 9, problem 19

flows over the next five years:

3 4 5 6
79.50 74.30 82.70 86.2561
53.099331716 43.3795173783 42.2061159068
ge of 4.3% per year. Using the discounted free cash flow model and a weighted average cost of capital of 14.4%.

100.00

90.00

80.00

70.00

60.00

50.00 FCF
ure cash flows
PV
40.00

30.00

20.00

10.00

0.00
1 2 3 4 5 6

and 35 million shares outstanding, estimate its share price.

Ch. 9, problem 24

3.93. Its competitor, the Coca-Cola Company (KO), has EPS of $2.13.

nly this data.

ngs before tax, interest can skew the way the earnings is calculated. KO might owe more money on interest than Pepsi.
e interest rate is similar.

Ch. 9, problem 26

31 million, EBITDA of $51.3 million, excess cash of $107 million, $3.3 million of debt, and 23 million shares outstanding

able 9.1, estimate KCP’s share price.

EV = mkt value + debt - cash/investments

value + debt - cash/investments.
value - 103.7 103.7

highest and lowest enterprise value to sales multiples in Table 9.1?

n Table 9.1, estimate KCP’s share price.

ghest and lowest enterprise value to EBITDA multiples in Table 9.1?

Ch. 9, problem 28

EV = enterprise value, Book = tangible book value). Discuss the challenges of using multiples to value an airline.

AAL has high P/book, low in other

SKYW is high EV/EBIT & P/E but low in sales and

If one is consistently higher then maybe it's a good c

Otherwise you can't trust only one measure!

ook different for the same company in different countries.

same sub industry. Some companies buy, produce, or lease airplanes. Working abroad? Internal only??
 print advertising this year
ew consumers who try the
rofit margin for the Mini

this operation. Its chief

g capital for the first five

flows for the first two

ash flows after year 4?

the perpetuity

in new projects with an

umber of outstanding

g = retention rate * return on investment

 Constant Dividend Growth Model:

payout rate in the future, Cost of Capital - Growth

3% per year. The

Total Payout Model

ases is expected to grow by

Constant Growth perpetuity = total dividends / rE-g

r of outstanding shares.

Free Cash Flow Model

14.4%.

Enterprise Value

Enterprise Value to EBITDA multiple

FCF
PV

EPS = price per share / shares

on interest than Pepsi.

ares outstanding

debt - cash/investments
n airline.

ook, low in other

/EBIT & P/E but low in sales and book

ly higher then maybe it's a good choice.

't trust only one measure!
 Chapter 8
Ch. 8, problem 2

Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the Mini Mochi
print advertising this year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $
company expects that new consumers who try the Mini Mochi Munch will be more likely to try Kokomochi’s oth
$3.55 million each year. Kokomochi’s gross profit margin for the Mini Mochi Munch is 36%, and its gross prof
corporate tax rate is 38% both this year and next year.
Find the Unleavered Income

Question 1: What are the incremental earnings associated with the advertising campaign?

0 1 2
Incremental Earnings ($000)
Sales MMM $ 9.140 $ 7.140
Gross Profit Margin(1) 36% 36%
Sales Other $ 3.550 $ 3.550
Gross Profit Margin(2) 24% 24%
Gross Profit $ 4.142 $ 3.422

Sell, Gen, Admin Exp (Ads) 3.76

EBIT $ 0.382 $ 3.422
Corporate Tax 38% $ 0.145 $ 1.301
Unlevered Income $ 0.237 $ 2.122

Ch. 8, problem 7

Castle View Games would like to invest in a division to develop software for video games. To evaluate this deci
operation. Its chief financial officer has developed the following estimates (in millions of dollars):

Question 1: Assuming that Castle View currently does not have any working capital invested in this divis
capital for the first five years of this investment.

Year 1 Year 2 Year 3

Cash 7 12 16
Accounts Receivable 19 25 26
Inventory 6 7 11
Accounts Payable 16 21 23
CF 16 23 30
Delta 16 7 7

Ch. 8, problem 9

Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are
flows for the first two years (in millions of dollars):

Information Year 1
Revenues 106.50
COSG and operating expenses 47.70
Depreciation 25.90
Increase in net working capital 3.10
Capital expenditures 29.10
Marginal corporate tax rate 40%

Question 1: What are the incremental earnings for this project for years 1 and 2?
* Incremental earnings > inc. all incremental revenues and costs associated with the project, incl. project extern

Information Year 1 Year 2

Revenues 106.50 159.90
COSG and operating expenses 47.70 59.50
Depreciation 25.90 35.50
EBIT 32.90 64.90
Marginal corporate tax rate 13.16 25.96 40%
Unlevered Income 19.74 38.9

Question 2: What are the free cash flows for this project for the first two years?

Unlevered Income 19.74 38.9

+ Depreciation 25.90 35.50
- Increase in net working capital 3.10 7.60
- Capital expenditures 29.10 43.80
FCF 13.44 23.04

Ch. 8, problem 19
Bay Properties is considering starting a commercial real estate division. It has prepared the following four-ye
division:

Year 1 2
Free Cash flow -159,000 14,000

Question 1: Assume cash flows after year 4 will grow at 3% per year, forever. If the cost of capital for thi
flows after year 4? What is the value today of this division?

Growth after Year 4 3%

Cost of Capital 14%

Year 1 2
Free Cash flow -159,000 14,000
Continuation Value

Year 1 2
Free Cash flow -159,000 14,000
Continuation Value
Total CF to be discounted -159,000 14,000
Present Value -139474 10773

(NPV) Value division = 1293525 , =SUM(PV)

Ch. 9, problem 10
DFB, Inc., expects earnings at the end of this year of $4.01 per share, and it plans to pay a $2.09 dividend at th
new projects with an expected return of 15.1% per year. Suppose DFB will maintain the same dividend payout
will not change its number of outstanding shares.

Expected Earning per share $ 4.01

Pay dividend per share $ 2.09
retain to reinvest per share $ 1.92
E(return) 15.1%

Question 1: What growth rate of earnings would you forecast for DFB?

Retention rate 47.9% 1. find the retention rate first

2. find the Growth rate
Growth Rate 7.23%

Question 2: If DFB’s equity cost of capital is 12.8%, what price would you estimate for DFB stock today?

Equity Cost of Capital 13%

Stock Price 37.52

Question 3: Suppose DFB instead paid a dividend of $3.09 per share at the end of this year and retained
payout rate in the future, what stock price would you estimate now? Should DFB raise its dividend?

Expected Earning per share $ 4.01

Pay dividend per share $ 3.09 (change)
retain to reinvest per share $ 0.92 (change)

Retention rate 22.9% (new)

Growth rate 3.46% (new)
Equity Cost of Capital 13%

New Stock Price 33.10

No, the DFB should not raise it’s dividend because the Stock price goes down as dividend raises up

Ch. 9, problem 12

Proctor and Gamble paid an annual dividend of $1.72 in 2009. You expect P&G to increase its dividends by 8
per year. The appropriate equity cost of capital for Proctor and Gamble is 8% per year.

Question 1: Use the dividend-discount model to estimate its value per share at the end of 2009

Dividend per share $1.72

Value of Annuity (1-5) 8.00%
Value of Perpetuity (6-∞) 3.00%
Cost of capital 8.00%
Share price (PV)
2009 2010 2011
0 1 2
Value of Annuity (1-5) 1.8576 2.006208
Value of Perpetuity (6-∞)
PV (discount) 0 1.72 1.72
NPV 44.032
 Ch. 9, problem 16

Suppose Amazon.com Inc. pays no dividends but spent $1.88 billion on share repurchases last year. If Amazon’
is expected to grow by 6.4% per year, estimate Amazon’s market capitalization.

Question 1: If Amazon has 432 million shares outstanding, what stock price does this correspond to?

Total share repurchase 1.88

Equity cost of capital 8.10%
Expected growth 6.40%
Shares 432 4.32

0 1
CF (last year) 1.88 2.00 =C203*(1+C199)^D202
Growing Perpetuity 117.67 =D203/(C198-C199)

Stock price/share $ 22.12

Ch. 9, problem 19

Heavy Metal Corporation is expected to generate the following free cash flows over the next five years:

Year 1
Free Cash flow ($ millions) 51.30

After then, the free cash flows are expected to grow at the industry average of 4.3% per year. Using the discoun
14.4%.

Question 1: Estimate the enterprise value of Heavy Metal.

Expected growth 4.30%

WACC 14.40%

Year 1
Free Cash flow ($ millions) 51.30
Growing perpetuity
PV (discount ) 44.8426573

NPV => (enterprise value) 672.6

Question 2: If Heavy Metal has no excess cash, debt of $280 million, and 35 million shares outstanding, e

Shares 35
CF 672.6
Debt 280

Share price 11.22 =(C238-C239)/C237

Ch. 9, problem 24

You notice that PepsiCo (PEP) has a stock price of $72.62 and EPS (earnings per share) of $3.93. Its competit

Question 1: Estimate the value of a share of Coca-Cola stock using only this data.
PepsiCO (PEP) Coca-Cola (KO)
Stock price $ 72.62 $ 39.36
EPS (earnings per share) $ 3.93 $ 2.13

P/E Ratio 18.4783715013

Question 2: Discuss the choice of multiple

Ch. 9, problem 26

Suppose that in January 2006, Kenneth Cole Productions had sales of $531 million, EBITDA of $51.3 million,
outstanding

Sales $ 531.00
EBITDA 51.3
Excess cash $ 107.00
Debt $ 3.3
Shares outs 23

Question 1: Using the average enterprise value to sales multiple in Table 9.1, estimate KCP’s share price

Avg. Entreprise value to sales 1.06

Entreprise value / firm $ 562.86 * we can't get share price from EV

Market capitalization $ 666.56 MVE = EV + C -D <= With EV reversed formula w

Price per share $ 28.98

Question 2: What range of share prices do you estimate based on the highest and lowest enterprise value

Entreprise value to sales (low) 0.47

Entreprise value to sales (high) 2.19

Entreprise value/firm (low) $ 249.57

Entreprise value/firm (high) $ 1,162.89

Market capitaliza (low) $ 353.27 MVE = EV + C -D

Market capitaliza (high) $ 1,266.59

Share price (low) $ 15.36

Share price (high) $ 55.07

Question 3: Using the average enterprise value to EBITDA multiple in Table 9.1, estimate KCP’s share p

Avg. Entreprise Value EBITDA 8.49 1. copy the avg. EV EBITDA

Entreprise value $ 435.54 2. EBITDA * AVG. Entreprise V

Market Capitalization $ 539.24 3. ENTRPRISE VALUE + CASH(e

Share price $ 23.45 4. Market capital / Nr shares

* I can calculate the Share pric

Question 4: What range of share prices do you estimate from the highest and lowest enterprise value to

Entreprise value to sales (low) 6.66

Entreprise value to sales (high) 10.75

Entreprise value/firm (low) $ 341.66

Entreprise value/firm (high) $ 551.48

Market capitaliza (low) $ 445.36

Market capitaliza (high) $ 655.18

Share price (low) $ 19.36

Share price (high) $ 28.49

Ch. 9, problem 28

Consider the following data for the airline industry for December 2015 (EV = enterprise value, Book = tangib
airline.

Accounting is different in different countries, so the P/Book ratio might look different for the same co
Operating in the same industry does not mean you operate in the same sub industry. Some companie
 Chapter 8
Ch. 8, problem 2

ssert product, the Mini Mochi Munch. Kokomochi plans to spend $3.76 million on TV, radio, and
of the Mini Mochi Munch by $9.14 million this year and by $7.14 million next year. In addition, the
re likely to try Kokomochi’s other products. As a result, sales of other products are expected to rise by
nch is 36%, and its gross profit margin averages 24% for all other products. The company’s marginal

ng campaign?

3 4

Revenue*Gross Margin

Gross Profit - Operating Expenses (Ads campaign) > (get EBIT this way)
EBIT*Tax rate
Unlevered income = EBIT-Tax rate

Ch. 8, problem 7

o games. To evaluate this decision, the firm first attempts to project the working capital needs for this
llions of dollars):

money owed to a company by its debtors.

money owed to a company by its creditors

capital invested in this division, calculate the cash flows associated with changes in working

* Working capital investment is the amount of money you require to expand y

Year 4 Year 5
 15 14
21 23
14 15
25 31
25 21
-5 -4 Delta = change ( + -)

delta calculation is extra, better to have it than not

Ch. 8, problem 9

ough long-term cash flows are difficult to estimate, management has projected the following cash

Year 2 Unlevered income - means, cash available to capital investors without taking i
159.90 - the money we get (as a firm) before paying any outsta
59.50 Earning = PROFIT - EXPENSES
35.50
7.60
43.80
40%

nd 2?
the project, incl. project externalities and opportunity costs but excluding sunk costs and interest expenses |

,= Revenue - Costs
,=EBIT * Tax rate
,= EBIT - Tax rate

ars?

Corporate tax

= 38.9+35.5 - 7.6 -43.8

Ch. 8, problem 19
prepared the following four-year forecast of free cash flows for this

3 4 5 6>
98,000 221,000 227630 0

r. If the cost of capital for this division is 14%, what is the continuation value in year 4 for cash

3 4 5
98,000 221,000 227630 = 221.000*(1+3%)
2069364 =227630/(14%-3%)

3 4
98,000 221,000
2069364
98,000 2,290,364
66147 1356079

PV is to be discounted from FCF, but I used 'Total CF to be discounted' because Year 4 the nr. is differen

ns to pay a $2.09 dividend at that time. DFB will retain $1.92 per share of its earnings to reinvest in
ain the same dividend payout rate, retention rate, and return on new investments in the future and

find the retention rate first = retain/earnings

find the Growth rate
stimate for DFB stock today?

3. equity cost of capital is given

4. find the stock price based on 'Div1/rE-g'
Equity Return

nd of this year and retained only $0.92 per share in earnings. If DFB maintains this higher
DFB raise its dividend?

Div1 = (rE - g) * P0

wn as dividend raises up

Ch. 9, problem 12

to increase its dividends by 8% per year for the next five years (through 2014), and thereafter by 3%
er year.

at the end of 2009

rE = Rate return on Equity/Interest rate/C

2012 2013 2014 5 because we start calculatin Perpetuity from year 5

3 4 5 5
2.1667046 2.340041 2.5272443 2.60306162
52.0612324
1.72 1.72 1.72 35.432

1. Calculate Value Annuity

 2. Calculate Perpetuity
3. Calculate the PV
4. Sum up the NPV
*when discounting Perpetuity, use year 5 not 6

Ch. 9, problem 16

urchases last year. If Amazon’s equity cost of capital is 8.1%, and if the amount spent on repurchases

does this correspond to?

203*(1+C199)^D202 1. to clauclate Perpetuity, I need to Calculate next year's CF

D203/(C198-C199) 2. Calculate value of Growring Perpetuity
3. Calculate the stock price/share = value of the company/nr of shares

* we use the Growing perpetuity because the growth is fixed at 6.4% (it just continues to grow)
** convert millions to bill = 432/100 = 4.32
Growing Perpetuity

Ch. 9, problem 19

ver the next five years:

2 3 4 5
69.70 79.50 74.30 82.70

3% per year. Using the discounted free cash flow model and a weighted average cost of capital of

* WACC - takes into accoun the debt

2 3 4 5 6
69.70 79.50 74.30 82.70 86.2561 1. Calculate the CF for year 6
 854.020792 2. Calculate the growing Perpetuity
53.257494 53.099332 43.379517 42.2061159 435.851276 2. Discount PV = CF/(1+WACC)^time
4. calculate the entreprise value (NPV)

500.00

450.00
million shares outstanding, estimate its share price.
400.00

1. CASH is the same

350.00

2. THERE'S DEBT300.00
280, = (CF - DEBT)
3. (CF-DEBT)/ NR250.00
SHARES
200.00
(CF-DEBT)/ NR SHARES
150.00

100.00

50.00
Ch. 9, problem 24 0.00
0 1 2

r share) of $3.93. Its competitor, the Coca-Cola Company (KO), has EPS of $2.13.

data.

1. Calculate Ratio = P/E (PRICE/EARNINGS)

2. Multiply P/E Ratio * Coca-Cola (KO) EPS

Ch. 9, problem 26

on, EBITDA of $51.3 million, excess cash of $107 million, $3.3 million of debt, and 23 million shares

* all nrs are in mio, no need to convert anything

EBITDA - earnings before interest tax depreciation and amortization

 estimate KCP’s share price.

e price from EV

With EV reversed formula we can get PRICE PER SHARE

t and lowest enterprise value to sales multiples in Table 9.1?

9.1, estimate KCP’s share price.

copy the avg. EV EBITDA

EBITDA * AVG. Entreprise Value EBITDA

ENTRPRISE VALUE + CASH(excess) - Debt

Market capital / Nr shares

can calculate the Share price by having the nr. of shares

d lowest enterprise value to EBITDA multiples in Table 9.1?

Ch. 9, problem 28

nterprise value, Book = tangible book value). Discuss the challenges of using multiples to value an

ok different for the same company in different countries.

ub industry. Some companies buy, produce, or lease airplanes. Working abroad? Internal only??
IT this way)

s debtors.

money you require to expand your business, meet short-term business responsibilities and cover business expenses.
Delta = change ( + -)

pital investors without taking into account any interest payments due on outstanding capital debt
firm) before paying any outstanding debt

1. Solve NEW exercises beside the existing tutorials for every Chapter
Corporate tax 2. Write all Formulas in a Word + beside every exercise
 'Cost capital' and 'r' is the same
C of Cap-cost of keeping the money without using them

ecause Year 4 the nr. is different due to Continuation Value

turn on Equity/Interest rate/Cost of Capital
Cost of keeping the capital =
year 5 not 6

just continues to grow)

the CF for year 6 YEARS -> X VALUES

the growing Perpetuity PRICE -> Y Values
PV = CF/(1+WACC)^time
the entreprise value (NPV)

500.00

450.00

400.00

350.00

DEBT300.00
280, = (CF - DEBT)
)/ NR SHARES
250.00

200.00

150.00

100.00

50.00

0.00
0 1 2 3 4 5 6 7
ness expenses.
Holding Period Return
Standard Deviation is RISK
Certainty Equivalent Rate
Indifference curve plotting the Expected Return against an investor's utility
Expected Value of the Return on the Portfolio
Standard Deviation of the value of the portfolio
Equation for the proportion of the amount to invest in risky asset, thus also the risk free asset.

Ch. 5, problem

You’ve just stumbled on a new dataset that enables you to compute historical rates of return on U.S. stocks all the way back to 1

Question 1: What are the advantages and disadvantages in using these data to help estimate the expected rate of return
Advantages: we have many data points to create a statistical average and predict the actions of the future. We can measure certa
correspond best with the present year. The larger the sample size the better

Disadvantages: The data that we have proves that some market conditions are only 20/20 in hindsight. Trying to predict the futu
to failure. The future is not DEPENDANT on the past, but follows the past. Er is a calculation of future values, not past values,
doesn't have any bearing on the equation.

Ch. 5, problem

Answers:
A large role, but not the only role. The money market fund I would have good liquidity and not worry about losing access to mo
Bond where I am lilkely to only put 'extra' cash into it. The one year deposit is a good compromise of liquidity and security. If y
year bond, you might be stuck with a great interest rate or with a low interest compared to the market!
A large role, but not the only role. The money market fund I would have good liquidity and not worry about losing access to mo
Bond where I am lilkely to only put 'extra' cash into it. The one year deposit is a good compromise of liquidity and security. If y
year bond, you might be stuck with a great interest rate or with a low interest compared to the market!

Ch. 5, problem

Answers:
Information:
Probability HPR End $ Beg $ Validate
Boom 0.35 44.5% $ 140.00 $ (252.25) $ (1.56)
Normal growth 0.3 14.0% $ 110.00 $ (127.91) $ (1.86)
Recession 0.35 -16.5% $ 80.00 $ (68.67) $ (2.17)
Solutions

HPR = end/beg - beg/beg + div/beg

Beg $ = (end + div) / HPR - 1

Ch. 5, problem
Information:
Nominal HPR 80%
Inflation rate 70%
Probability 100%
a. What is the real HPR on the bond over the year?

Real HPR 5.882%

b. Compare this real HPR to the approximation

Real HPR 10% =C92-C93

Ch. 6, problem
 Good state Bad state
End of the year cash flow 200,000 70,000
Probabilities 0.5 0.5

Risk-free investment in T bills 6%

4.a answers

Risk premium 8%

sum probabilities 135000 [(135000-p)/p]-.06 = .08 We will only invest if the Er m

Equation 135000-p = .14p So, if Er-rF > rP, then invest!
135000 = 1.14p
Maximum willing to pay $ 118,421.05

4.b answers

If you purchased the portfolio at that price, the rate of return would be 14%, which is the risk free rate plus your risk premium.

135000

4.c answers

Risk premium 12%

P= $ 114,406.78 In order to get the 12% risk premium, you have to buy the portfolio for less.

4.d answers
higher risk premium = lower price

Ch. 6, problem

Answers:
Information SD Er Er
Utility level U 0.05 0 0.05 0.05
Risk aversion A 3 0.05 0.05375 0.055 2.5
New Risk AversA* 4 0.1 0.065 0.07
0.15 0.08375 0.095 2

0.2 0.11 0.13

Expected Return
1.5
0.25 0.14375 0.175
0.3 0.185 0.23 1
0.35 0.23375 0.295
0.4 0.29 0.37 0.5
0.45 0.35375 0.455
0
0.5 0.425 0.55 0 0.2
0.7 0.785 1.03
1 1.55 2.05
Ch. 6, problem

Answers:
Information
Utility level U 0.05
Risk aversion A 4

Ch. 6, problem

Answers:

Information
rf 8%
σf 0%
(1-y): safe 30%
E(rp) 18%
σp 28%
y: risky 70%
S (expected return) 15.00%
SD 19.60000%

Ch. 6, problem

Answers:
Revelant information from problem 13:
rf = 8%
σf = 0%
E(rp) = 18%
σp = 28%
S= #DIV/0! 5/ 14

Why are the sharpe ratio's the same?? Because both investors invest ON THE CAL. Thus, they both have the same Sharpe ratio
Draw the graph in the exam!!
Always give more information than too little!

Ch. 6, problem

17.a answers:

Revelant information from problem 13 and this question: ErC = ErP*y + rF - rF*y
rf = 8% y = [E(rC) - rF] / [ErP - rF]
E(rp) = 18%
E(rC) = 16%
y= 80.00%

17.b answers:

Revelant information from problem 14

The risky portfolio includes: pC proportions
Stock A: 25% 20.0%
Stock B: 32% 25.6%
Stock C: 43% 34.4%
 T-Bill 20% 20.0%
Good

17.c answers:

Information
σp = 28% How do you get total SD without the rF asset deviation?? Ass
σC = 22.40%

Ch. 6, problem

19.a answers:
Information
Risk aversion A = 3.5
rf 8% y = (Erp - rF) / (A*∂^2p)
σf 0%
(1-y): safe 30%
E(rp) 18%
σp 28%
y: risky 70%
y 0.3644314869

19.b answers:
 Ch. 6, problem

CAL: Capital Allocation Line: for a single portfolio vs for the whole market below
CML: Capital Market Line: the tangent line drawn from the point of the risk-free asset to the fea
27.a answers:

Information
Passive portfolio Active porfolio y = Active y-1 = Active ErC
Expected rate of return 13% 18% 0% 100% 8.0%
Standard deviation 25% 28% 10% 90% 9.0%
20% 80% 10.0%
Risk free rate 8% 30% 70% 11.0%
Sharpe 5/ 28 40% 60% 12.0%
50% 50% 13.0%
60% 40% 14.0%
Sharpe CAL 0.3571428571 70% 30% 15.0%
Sharpe CML 0.2 80% 20% 16.0%
90% 10% 17.0%
100% 0% 18.0%

y = Passive y-1 = Passive ErC

We LIKE a steeper CAL!! 0% 100% 8.0%
Risk Premium is the lowest Er of the most secure portfolio. 10% 90% 8.5%
How do we plot CAL without a risk free rate?! 20% 80% 9.0%
ARE THEY THE SAME>!>!>!>!>!>!! 30% 70% 9.5%
40% 60% 10.0%
50% 50% 10.5%
60% 40% 11.0%
 70% 30% 11.5%
80% 20% 12.0%
90% 10% 12.5%
100% 0% 13.0%

27.b answers:

My Active fund has better returns for each given SD. So, if you only want a SD of 10%, you are more likely to have hig
Of course, you will pay for this in terms of active management fees lol.
et.

Ch. 5, problem 2

stocks all the way back to 1880.

expected rate of return on U.S. stocks over the coming year?

ure. We can measure certain years or periods that

t. Trying to predict the future solely on the past will lead

re values, not past values, so although old data helps, it

Ch. 5, problem 4

y about losing access to money, unlike T-

liquidity and security. If you take the 20
!
 Ch. 5, problem 7

HPR = dividend yield + rate of capital gains

E(r) 𝜎^2
0.15575 0.029282947
0.042 0.0028812
-0.05775 0.004025897
0.14 0.036190044
MEAN Variance SD

Ch. 5, problem 13

Nominal is not accounting for inflation

Ch. 6, problem 4
 Er = (probability of returns) - (portfolio) / portfo

will only invest if the Er minus risk free rate is GREATER than the risk premium.
if Er-rF > rP, then invest!

Portfolio / (rF + rP + 1)

e plus your risk premium. You want more than the risk premium, so you would pay less for the portfolio, NOT MORE.

uy the portfolio for less.

 Ch. 6, problem 6

Chart Title
2.5

2
Expected Return

1.5

0.5

0
0 0.2 0.4 0.6 0.8 1 1.2
SD

Ch. 6, problem 7
Ch. 6, problem 13

Ch. 6, problem 15
have the same Sharpe ratio.

Ch. 6, problem 17
he rF asset deviation?? Assume that risk free has 0 deviation? Well…it is supposed to.

Ch. 6, problem 19

(Erp - rF) / (A*∂^2p)

 Ch. 6, problem 27

market below
he risk-free asset to the feasible region for risky assets Slope of the Capital Market Line is the Sharpe Ratio

SDc CAL Er $D$362*E362+$C$365*F362

0.0% 0.08 Ex re (active) * y(active) + risk free *y-1 active
2.8% 0.09
5.6% 0.1 CAL - A
8.4% 0.11 20.0%
11.2% 0.12
14.0% 0.13 18.0%
16.8% 0.14
19.6% 0.15 16.0%
22.4% 0.16
25.2% 0.17 14.0%

28.0% 0.18
12.0%
Expected Return

10.0%

SDc CML Er 8.0%

0.0% 0.08
2.5% 0.085 6.0%
5.0% 0.09
7.5% 0.095 4.0%
10.0% 0.1
2.0%
12.5% 0.105
15.0% 0.11
0.0%
0.0% 5.0% 10.0%

Stan
 2.0%

0.0%
17.5% 0.115 0.0% 5.0% 10.0%
20.0% 0.12 Stan
22.5% 0.125
25.0% 0.13

e more likely to have higher returns with me.

counting for inflation
Where A = index of investor's risk aversion.
returns) - (portfolio) / portfolio.
 Where M is the portfolio of no rF assets.

s the Sharpe Ratio

CAL - Active Fund

10.0% 15.0% 20.0% 25.0% 30.0%

Standard Deviation
10.0% 15.0% 20.0% 25.0% 30.0%

Standard Deviation
sk aversion.
Holding Period Return
Standard Deviation is RISK
Certainty Equivalent Rate
Indifference curve plotting the Expected Return against an investor's utility
Expected Value of the Return on the Portfolio
Standard Deviation of the value of the portfolio
Equation for the proportion of the amount to invest in risky asset, thus also the risk free asset.

Ch. 5, problem 2

You’ve just stumbled on a new dataset that enables you to compute historical rates of return on U.S. stocks all the way back

Question 1: What are the advantages and disadvantages in using these data to help estimate the expected rate of retu

Advantages: we have many data points to create a statistical average and predict the actions of the future. We ca
best with the present year. The larger the sample size the better

Disadvantages: The data that we have proves that some market conditions are only 20/20 in hindsight. Trying to
failure. The future is not DEPENDANT on the past, but follows the past. Er is a calculation of future values, no
have any bearing on the equation.

Ch. 5, problem 4

Answers:
 Ch. 5, problem 7

Answers:

State of the market Probability Ending Price

Boom 0.35 $ 140.0
Normal Growth 0.3 $ 110.0
Recession 0.35 $ 80.0

Mean [Avg. E(r)] 14% =SUMPRODUCT(D68:D70,F68:F70)

Variance 6.5% =D68*(F68-C72)^2+D69*(F69-C72)^2+D70*(F
std dev 25.5%

Ch. 5, problem 1

a. What is the real HPR on the bond over the year?

HPR 80%
inflation rate (r) 70%

Real HPR/bond 5.9%

b. Compare this real HPR to the approximation

Real HPR 10% [rnom - i ]

Ch. 6,

Probability p(s) 0.5

Cash flow [CF] 70000 200000
T-bills 6%
risk premium 8% 14%

Required return= 14%

4.a answers

E(r) [next year] 135000

PV (discount) 118421

4.b answers

If you purchased the portfolio at that price, the rate of return would be 14%, which is the risk free rate

14% =t-bills +risk premium

4.c answers

E(r) [next year] 135000 =135000

risk premium 12%
Required return 18% =t-bill + 12%

PV 114407
4.d answers

If risk premium is higher (12%) we are willing to pay less (114.407), because we take more risk. And vi

Ch. 6,

* U (utility level) => hapinness; the higher E(r) , the higher U

Answers:

U: utility level 0.05

A: risk aversion 3 4

Std dev E(r) E(r)

0 0.050 0.050
0.05 0.054 0.055
0.1 0.065 0.070
0.15 0.084 0.095
0.2 0.110 0.130
0.25 0.144 0.175

Ch. 6,

Information
Utility level U 0.05
Risk aversion A 4

see previous

Ch. 6, p

Std dev 28%

E(r) p 18%
T-bill rate 8%

Y = proportion of the risky portf

(y) Risky Fund 70% y = risky p =
(1-y) Risk-free 30% 1-y

Expected value 15.0%

Std dev 19.6% = (risky fund*std dev) + (risk-free*0)

Ch. 6, p

Sharpe Ratio (S) 35.7%

Ch. 6, p
17.a answers: What is the proportion y?

T-bill rate(risk-free) 8%
E(r) p-portfolio 18%
E(r) c-complete 16%

Proportion (y) 80.0% proportion of the risky (y) portfolio

17.b answers: What are you client's investment proportions in your 3 stocks and T-bill fund?

The risky portfolio includes:

Stock A 25% 20.0%
Stock B 32% 25.6%
Stock C 43% 34.4%

T-bill 20% 20.0%

100.0%
17.c answers: What is the standard deviation on the rate of return on your client's portfolio?

Std dev | portfolio 28%

Std dev | client portf 22.40%

Ch. 6, p

A: 3.5

19.a answers:

Std dev 28%

E(r) p 18%
T-bill rate 8%

y 36.4%
1-y 63.6%
19.b answers:What is the expected value and standard deviation of the rate of return on your client's opt

Expected value 11.64%

Std dev 10.2% =(y*std dev) + (1-y)*0

Ch. 6, p

CAL: Capital Allocation Line: for a single portfolio vs for the whole market below
CML: Capital Market Line: the tangent line drawn from the point of the risk-free

27.a answers:
Passive portfolio (CML)
E(r) 13%
std dev 25%

Active Portfolio (CAL)

E(r) 18%
Std dev 28%

Risk-free r 8%

Slope CML (Sharpe ratio) 20%

Slope CAL (Sharpe ratio) 36%

STD DEV CML CAL

0% 8.00% 8.00%
25% 13.00%
28% 18.00%
30% 14.00% 18.71%
ree asset.

Ch. 5, problem 2

on U.S. stocks all the way back to 1880.

mate the expected rate of return on U.S. stocks over the coming year?

the actions of the future. We can measure certain years or periods that correspond

ly 20/20 in hindsight. Trying to predict the future solely on the past will lead to
calculation of future values, not past values, so although old data helps, it doesn't

Ch. 5, problem 4
 Ch. 5, problem 7

HPR = dividend yield + rate of capital g

HPR (inc div) *HPR - is still considered a return

44.5% *std dev - is risk
14.0% * std dev = SQRT(var)
-16.5% 1. Calculate Mean, in order to calculate Std dev: =sumproduct(…)
2. Calculate std dev.
68:D70,F68:F70)
2+D69*(F69-C72)^2+D70*(F70-C72)^2

Ch. 5, problem 13
 Ch. 6, problem 4

* t-bills is the foundation, wherefrom I start off and pile up with 8% on top

4%, which is the risk free rate plus your risk premium.
se we take more risk. And vice-verso, when we take a lower risk premium, we're paying more ,because less risk is implied

Ch. 6, problem 6

the higher U

E(r) = U + 0.5 * A * Var

0.200

0.180

0.160

0.140

0.120

0.100

0.080

0.060

0.040

0.020

0.000
0 0.05 0.1 0.15 0.2 0.25 0.3

Ch. 6, problem 7
 Ch. 6, problem 13

E(R) - prediction for the future

Expected rate of return - regular rate of return
r - rate of return

proportion of the risky portfolio, 70% of entire port is risky

70%
30%

=> std dev C(complete) = y(riskyportfolio) std dev portfolio (28%)

dev) + (risk-free*0) Why multimply by 0? - because the risk-free does not have any deviation

Ch. 6, problem 15

Ch. 6, problem 17
 ErC = ErP*y + rF - rF*y
y = [E(rC) - rF] / [ErP - rF]

risky (y) portfolio

and T-bill fund?

lient's portfolio?

Ch. 6, problem 19

Risk averse - avoiding crazy things, old people

of return on your client's optimized portfolio?

*std dev) + (1-y)*0

Ch. 6, problem 27

vs for the whole market below

from the point of the risk-free asset to the feasible region for risky assets

CAL: The CAL is derived with the risk-free and 'the' risky portfolio, P
CML: We call the capital allocation line provided by 1-month T-bills and a broad index of co

20.00%

18.00%

16.00%

14.00%

12.00%

10.00%
x - horizontal, std dev ------->
y - vertical, cml cal | 8.00%

6.00%

4.00%

2.00%
12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
0% 5% 10% 15% 20% 25%
p(s) = probability 'of a scenario'
r(s) = HPR 'in each scenario'
yield + rate of capital gains
se less risk is implied
ate of return
crazy things, old people specifically
and a broad index of common stocks the Capital market line (CML)
5% 20% 25% 30% 35%
 Ch. 7

Answers:
stock, bonds, cash, no debt
The Expected Return on a Portfolio is computed as the weighted average of the expected returns o

SD of the returns will increase or decrease risk based on how high the SD is.
Expected Return multiplied by SD to get the risk, right?
If Correlation with other assets is high, ie you have at REIT, then risk will be higher.

the minimum-variance portfolio has a standard deviation smaller than that of either of the individual component assets.

Answers:

E(r_S) 20% 17.39% This is the weight of the stock S

 E(r_B) 12% 82.61% weight of stock B
σS 30
σB 15 bonds 22.5
ρ 0.1 Stocks 45
Er 13%
SD 1761%
MATRIX 3% 0%
0% 9%

Ch. 7

Answers:

Optimal allocation??
Formula on slide in lecture notes. Slide 30.
wS 0.4516
wB 0.5484
ErP 16%
SD P 17%

Ch. 7

Answers:

Risk free interest rate 8%

Sharpe Formula 0.460

Ch. 7

For this question we add an intercept to the slope from above

Answers 9.a:

E(r_C) 14%
Risk free rate 8%
Sharpe 0.460
SD.P

Answers 9.b:

ErC = y (what we put in risky) * ErP + (1-y)*rF

How do we find weights?? Isolate for y! y = Erc - rf / ErP - rf

-0.75 missing ErP

Multiply weight by the proportions to get numbers for stocks, bonds,

Ch. 7,
Answers:

Stock E( r) σ
A 10% 5
B 15% 10

Correlation -1

w 40
1-w -39
Erp 4

Ch. 7,

Answers:
D, because the lower correlation you have, the more reduction in risk you receive per reduction in E(r).

Ch. 8

Answers:

alpha is a factor that affects the returns of a stock and does not affect the market.
Managers like it because they can take these stocks and get better returns (or worse losses) than the
market.
As alpha increases, the sharpe ratio decreases and the CAL line becomes flatter.

"The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk."

Ch. 8
Answers 6a:

β_A 0.8 E(r_A) 13%

β_B 1.2 E(r_B) 18%
σ(e_A) 0.3 r_f 8%
σ(e_B) 0.4
σ_M 22%
Incorrect Correct
ErP σ(A) 0.3478160433
SDP σ(B) 0.4792661056
∫BP
nonsystematic SD???

Answers 6b:

Weight A 30%
Weight B 45% NonSys SD A 0.09
Weight C 25% NonSys SD B 0.18
0.2700
β 0.78 Correct Formula 0.00729
SD 0.00000
Er 14.00% 14%
Nonsystem SD -0.27
 Ch. 8

Answers 7a.

A because the stocks are farthest from the line

Answers 7b.

B because the R-square is steep

Answers 7c.

In stock A, there are things that cannont be explained by the R-squared.

Answers 7d.

alpha is the intercept, so it's stock A

positive alpha is better than negative alpha'

Stock B because the R-squared is higher.

Higher R-squared means it follows the market better.

Ch. 8

Answers:

σ_M 20%
R-square A 0.2
R-square B 0.12
Beta A 0.7
Beta B 1.2
SDEV Var_A 0.098
SD_A 31%
Var_B
SD_B
 Ch. 8,

Answers:

σ_M 20% Beta is systematic risk. It measures volatility.

R-square A 0.2 SD is the firm specific??
R-square B 0.12 Use corr coefficient to get the covariance between mk
Beta A 0.7
Beta B 1.2

system risk 1.960%

A's firm-spec risk Difference 7.8400%

system risk 5.76%

B's firm-spec risk Difference 42.2%
 Ch. 7, problem 2

e of the expected returns on the stocks which comprise the portfolio.

a and c Portfolio Risk is a measure of each of the assets' variace and SD, thus the new asset will affect n

Ch. 7, problem 4

Xa = (σ
THIS IS THE MINIMUM VARIAN

individual component assets.

s is the weight of the stock S

ght of stock B

WminS = SDb^2 - Cov(rS,rB) / SD

Cov = 45
Er 13.391304347826100%
Var 13.9174585386 SQRT!!!!

Ch. 7, problem 7

lecture notes. Slide 30.

Ch. 7, problem 8
 Ch. 7, problem 9

Formula from book, Er = rF + (ErP)-rF / SDP * SDC

y = mx + b, sharpe is m
b=y-c/m

y-b / x = m 13% Rearrage Slope formula to get VarianceC

Erc - rf / ErP - rf

to get numbers for stocks, bonds, and risk free.

Ch. 7, problem 12
covariance of two stocks, then use the formula?
Then calculate weight for each stock
A: 66.67
B: 33.33
Value: 11.67

Ch. 7, problem 17
 Ch. 8, problem 4

ty or total risk." 4/9 2/9

Ch. 8, problem 6
 Var(A) = BA^@ * VarM + VarFirm-spec e?

SD is just sigma, also called variance.

Risk is sigma^2, also called covariance.

?????
Ch. 8, problem 7

R square, R^2, is the correlation coefficient

the percentage of a portfolio's perform

he performance of a benchmark
index. TheR square is measured on a s
measurement of 100 indicating that the
e isentirely determined by the benchma
Ch. 8, problem 9

R-squared measures how well the regression line fit

Higher R-squared means there is a LOWER SD

Beta = Correlation A_Mkt * SD A / SD Mkt

SD_A = BA^2*varM^2 / R^2
Corr A 0.4472135955
Corr B 0.3464101615
Variance
SD A 31.3% 0.098
SD B 69.3% 0.48
 Ch. 8, problem 10

sk. It measures volatility. CapM calculates the expected return of an asset based on its beta (volatil

to get the covariance between mkt and stck, then get SD of stock?

B^2 * varM^2
D, thus the new asset will affect new risk

a = (σb²-ρabσaσb) / (σa² + σb² – 2ρabσaσb)

IS IS THE MINIMUM VARIANCE PORTFOLIO. To get the weight of S, do this.
minS = SDb^2 - Cov(rS,rB) / SDS^2 + SDB^2 - 2*Cov(rS,rB)
he correlation coefficient

e of a portfolio's performance explainable by t

e of a benchmark
quare is measured on a scale of 0 to 100, with a
of 100 indicating that the portfolio's performanc
ermined by the benchmark index,
s how well the regression line fits the data.
means there is a LOWER SD

_A = BA^2*varM^2 / R^2
asset based on its beta (volatility) and expected returns.
 Ch. 7, problem 2

Answers:
a) Standard deviation Portofolio variance now includes a variance term for rea
b) Correlation

Ch. 7, problem

Answers:
Minimum-variance/least risky portfolio (diff f
E(r_S) (D) 20%
E(r_B) (E) 12%
σS (D) 30%
σB(E) 15%
ρ (correla) 0.1
T-bill 8%

Covariance 0.0045 1,
Wmin (D) 17% 2,
Wmin (E) 83%

Er 13.4% 3, E(r) - (Er D*Wmin D) + (Er E*Wmin E)

Variance 2% 4,
SD 13.7% 5, sqrt = in order to find out the std dev, we need to fi

Ch. 7, problem 7

Asset = stock, bond and t-bill

Answers:
Optimal risky portfolio (different from minim
E(r_S) (D) 20%
E(r_B) (E) 12%
σS (D) 30%
σB(E) 15%
ρ (correla) 0.1
T-bill 8%

W (S) 45% 1,
Wweight (E) 55% 2,

E(r) 15.6% 3,
variance 2.7% 4,
Std dev 16.5% 5,

Ch. 7, problem 8
Answers:

S 46.0%

Ch. 7, problem 9

E(rC) 14%
E(rP) 15.6% (above) (E(r) -risky portfolio
std dev P 16.5% (above)
t-bill 8% (above)

Answers 9.a:

σc (std dev complete portfolio)

13.0%

Answers 9.b:

y (proportion) 78.8%
1-y (t-bill) 21.2%

Stock 35.6% =C81*C127

Bond 43.2% =C82*C127
T-bill 21.2%
100%
Ch. 7, problem 2

a variance term for real estate returns and a covariance term for real estate returns with return for each of the other three a

Ch. 7, problem 4

ast risky portfolio (diff from optimal risky portfolio, which is next Q)
-1 correlation means they are completely opposite
 +1 correlation means they are closely related

w= weight, D= stock/bond, E= stock/bond

e std dev, we need to find out the variance, thus, find the VARIANCE formula

Ch. 7, problem 7

(different from minimum-variance/least risky portfolio)

Ch. 7, problem 8
Ch. 7, problem 9

===> the reversed formula is what we need σc = ErC-rf/((ErP-rf)/σp)

==> reversed formula because we need to find 'y', which is the ''prop
y = (ErC-rf)/(ErP-rf)
ach of the other three asset classes
nd 'y', which is the ''proportion''
 Ch. 9, Problem 1

Answer

E(rp) 18%
rf 6%
E(rM) 14%

Beta 1.5

Ch. 9, Problem 2

Answer

E(ri) 14%
rf 6% new Er
Price 50 $
Mkt rPremium 8.0% Doubled = 16%
Beta 1 Market Risk Premium is the market return minus risk free rate
Beta x 2 2 Rearrange formula, calculate for Beta, then double.
rPremium 22.0% Use formula to determine Expected Risk Premium
Dividend 7 Dividend equals Expected return times the price
MktP 31.818181818 Mkt price is the dividends divided by the risk premium. Divide dividend per share by
DIVIDEND DISCOUNT MODE
Ch. 9, Problem 8
Answer 8a

rf 8% Years 1 2 3 4
E(rM) 16% -40 15 15 15 15
βproject 1.8 Discounted 12.254901961 10.012174805 8.1798813763 6.6829096211
Sum 58.092131897
NPV 18.0921318966 subtract debt 18.092131897
Highest Beta

ErP = 0.224 @ Beta of 1.8

ErP @ 0 -1

IRR 35.7%
Calculate Beta 3.4667 This is the beta when you calculate IRR and the NPV is 0. IRR number is the rate of return a

Answer 8b

Ch. 9, Problem 17
Answer

rf 6%
E(rM) 16%
Stock price 50 $
Dividend 6$
βi 1.2
Erp 18%
New Price 33.3333333333 Price equals dividends divided by Risk Premium. We calculated expected future rP.
Actual new price $ 52.000

Ch. 9, Problem 20

Answer 20a

r1 19% Beta of 1.5 means the stock moves 50% more than the marke
r2 16%
β1 1.5 rM1 16.0000%
β2 1 rM2 16.0000%
Risk Free 10%
#1 0.1266666667 rM should be equal for both investors, set them equal and det
#2 0.16
Individual 1, because individual 2's return is the exact same as the market. In

We can't answer this because we need information about the market rate to determine abnormal returns, or a.
Answer 20b

rf 6%
rM 14%
rP 8%

r1 18% 1%
r2 14% 2% This investor's actual return is greater than his expected portfolio return, ther

Answer 20c

rf 3%
rM 15%
rP 12%

r1 21% -2%
r2 15% 1% Likewise, investor 2 is greater in this condition

Ch. 11, Problem 3

Answer
Yes. The efficient market hypothesis states that the price reflects all known information. Know information displays the price.
The Law of One Price says that similarly valued alternatives should have the same ERR.

Risk premiums and investor risk aversion

 Ch. 11, Problem 6

Answer
Not necessarily; New information causes changes in the price. Also, there is a lag in the amount of time from the information to
Rational markets say high volatility reflects crazy amount of new information.
Irrational theory says that it is true, the market doesn't really know what the price should be because it is full of irrational invest

High volatile prices reflects highly volatile expected returns. Seasonal stocks?

Ch. 11, Problem 9

Answer

c, because this should be known by all people and thus the price would. This contradicts the weak-form hypothesis.

Ch. 11, Problem 17

Answer

a. agree; managers have different information and make money on this.

no, because there is randomness in the market.
c. consistent, because increased volatility does not garuntee higher returns.

Ch. 11, Problem 19

Answer 19a

rf 1%
rM 1.50%
β 2 MINUS RISK-FREE??? Or NOT?
Lawsuit gain 1
Equity 100
rr 3.00% rate of the market times the beta, plus the percent of gain divided by current equity. Minus ri
rr2 4.00% rate of return is one percent higher from the gain in lawsuit.
Er 2%
Lawsuit Gain changes because it was expected to be 2, and comes out as 1, there is a -1 lawsuit gain!

Answer 19b

Ch. 11, Problem 20

Answer

rM 3%

rA 4%
rB 1.7%
Bpex would have won the lawsuit. Apex expected MORE than what they got, and Bpex received more than what the expected!!
Ch. 11, Problem 21

Answer 21a

E(rM) 12%
rf 4%
β 0.5
Equity 100 $

Er 8%
Er$$ 8 million
Answer 21b

Erm 10%
Er 7%

Answer 21c

Settlement 5 million
return 10%
Er 7%
Extra 3% Extra attribution, the amount the market did over the return
3 What is the surprise amount the firm earns from the settlement???
Prior expectation 2 Settlement minus the surprise amount
Ch. 11, Problem 23

Answer

If we predict the recession, it would already be reflected in the prices, thus you won't know if the price will change afterwards.

Ch. 11, Problem 26

Answer

If the market expects EVEN HIGHER earnings than what was reported, then market will be pessimistic and price will fall.
Ch. 9, Problem 1

B = (Erp - rf) / (Erm - rf)

Ch. 9, Problem 2

22% P = CF / r
cash flow divided by risk

de dividend per share by required rate of return and you get the price of the stock.
IDEND DISCOUNT MODEL
Problem 8
 5 6 7 8 9 10
15 15 15 15 15 15 -40
5.4598934813 4.4606972887 3.64436053 2.9774187336 2.4325316451 1.9873624552

mber is the rate of return at NPV of 0.

h. 9, Problem 17
 E(r) = (D +P1 - P0) / P0

xpected future rP. Can't use this equation because it was the formula for a perpetuity. This is not a perpetuity.

h. 9, Problem 20

50% more than the market.

ors, set them equal and determine what is the risk free rate.

xact same as the market. Individual 1 made 3% more than the other.
ected portfolio return, therefore this is the better investor.

h. 11, Problem 3

mation displays the price.

h. 11, Problem 6

me from the information to the correct price reflection. Also there are anomolies.

it is full of irrational investors.

h. 11, Problem 9

rm hypothesis.

h. 11, Problem 17
Problem 19

wer 19a

by current equity. Minus risk-free.

awsuit gain!

h. 11, Problem 20
re than what the expected!!
Problem 21
 As we get new info expected retrun will change and price will ch

h. 11, Problem 23

ce will change afterwards.

h. 11, Problem 26

tic and price will fall.

Announcement: job offer for finance CV? divna94@hotmail.it
n will change and price will change as well as a consequence.
 Ch. 12, Problem 1

Answer
Behavioral Biases
Framing If you tell a kid about compound interest, show him that a few dollars a month adds up to millions in you
Mental Accounting Good if you spread your risk even more…one portfolio may be retirement fund, another might be vacatio
Regret Avoidance Young people who start investing will be discouraged if they lose money and begin investing in an ETF
Technical Trading Rules: look at a price and it goes up and down and up and down, we assume it will follow a pattern because

Ch. 12, Problem 2

Why would an advocate of the efficient market hypothesis believe that even if many investors exhibit the behavioral
Answer

Not sure why…is it because everyone has the

same motivation and the same information?
Therefore, on average, as many people are
swayed positively by behavioral biases, that
many people will be swayed negatively thus
cancelling out the effect.

This is because some investors are irrational, but as long as there are SOME rational investors, they will exploit and a

Ch. 12, Problem 3

Answer
Arbitrage
Costs of trading might exceed the minimal arbitrage benefit.
Faulty models might give you a benefit that doesn't exist in reality

Fundamental Risk: "markets are inefficient longer than you can stay solvent??"
Implementation Costs: cost of trading and implementing the arbitrages
Model Risk: your model might be wrong!!
 Ch. 12, Problem 11

Answer
Because, if you mine enough data, you are garunteed to find a small percentage of random statistically significant co

We believe we have found a pattern which in fact does not exist. The so called 'pattern' might actually just be random

You have a utility function U = E ( r%) - 0.5 Aσ ( r%) with A = 3. You have three assets to invest in: asset A with expec
2

and a return standard deviation of 0.3, and a risk-free asset with a return of 0.02. The correlation coefficient between re
correlation is -0.2.

a)
Illustrate graphically the difference in portfolio opportunity sets (feasible combinations in expected return-standard dev
if the beliefs were both true, and explain why they are different.

Answer
A 3
E(rA) 7% U.A 6.90625%
E(rB) 15% U.B 14.86500%
σA 0.25 Portfolios A B
σB 0.3 1 1 0
rf 2% 2 0.9 0.1
ρABreal 0.4 3 0.8 0.2
ρABbias -0.2 4 0.7 0.3
5 0.6 0.4
6 0.5 0.5
7 0.4 0.6
wA real 8% 8 0.3 0.7
wB real 92% 9 0.2 0.8
wA bias 42% 10 0.1 0.9
wB bias 57.9% 11 0 1

The Bias case gives us an estimate that we can have the SAME RETURN for a lower SD!!
If there was no correlation, the line would be completely vertical, with all portfolios having the same SD.
But since there is a correlation, the line is non linear

Calculate the optimal risky portfolios with the true correlation coefficient and your subjective belief, as if the respective

Answer

E(rA) D 7
E(rB) E 15 SD P Er P real Er P bias
σA D 25 0% 2.00% 2.00%
σB E 30 3% 3.09% 3.22%
rf 2% 5% 4.18% 4.43%
ρABreal 40 8% 5.27% 5.65%
ρABbias -20 10% 6.36% 6.86%
13% 7.45% 8.08%
Real Bias 15% 8.54% 9.29%
18% 9.63% 10.51%
20% 10.72% 11.72%
ErP 14% 11.6% 23% 11.81% 12.94%
SD P 28.3% 19.8% 25% 12.90% 14.15%
Sharpe 0.44 0.49 28% 13.99% 15.37%
30% 15.08% 16.59%
33% 16.17% 17.80%
35% 17.25% 19.02%
38% 18.34% 20.23%
Find the allocations between the optimal risky portfolio and the risk-free asset under the different beliefs. Why do you choose t

Answer

Real Bias
A 3 y 0.51 0.82
rf 0.02 y-1 0.49 0.18

e)
What is your utility loss from having incorrect beliefs? How would you evaluate the magnitude of this loss in terms fundamenta

Answer

U = E ( r%
) - 0.5 Aσ 2 ( r%)
 U = E ( r%
) - 0.5 Aσ 2 ( r%) U real U bias
14.2% 11.6%

Real Bias
Er C 8.33% 9.88% What must the return on the regular portf
SD C 14.53% 16.21%
f)
How much of the expected return of the optimal risky portfolio constructed with correct beliefs about return characteristics wou
about the correlation between the assets?

Answer

I would be willing to lose up to 2.5% which would put me at equal return as the incorrect belief portfolio??

g)

Now, assume that your utility function is characterized by A = 8. How do your answers to questions 1d) through 1f) change? Gi
of risk aversion and the impact of a bias in the belief about the correlation between asset returns?

Answer

U real U bias difference SD real

A=.3 14.3% 11.6% 2.7%
A=3 14.2% 11.6% 2.6%
A=8 14.0% 11.5% 2.5%

My answers do not change???

Incorrect Beliefs has a FAR GREATER impact on portfolio return than your risk aversion does (to a degree)

When Standard Utility rises the Utility decreases because the formula subtracts from SD.
 Ch. 12, Problem 1

lars a month adds up to millions in your later life.

tirement fund, another might be vacation fund. You have a variety of risk and return.
money and begin investing in an ETF or Vanguard fund, thus doing better in the long run.
assume it will follow a pattern because of what it did in the past. If the market was compeltely efficient, we couldn't make these assumption

Ch. 12, Problem 2

any investors exhibit the behavioral biases discussed in the chapter, securty prices might still be set efficiently?

nal investors, they will exploit and arbitrage the misprices out of the market.

Ch. 12, Problem 3

 Ch. 12, Problem 11

of random statistically significant correlations that in fact have no bearing on the stock value.

attern' might actually just be random occurrence of the lifetime of the stock.

assets to invest in: asset A with expected return 0.07 and a return standard deviation of 0.25, asset B with expected return 0.15
he correlation coefficient between returns of assets A and B is 0.4. However, due to a behavioural bias you believe that the

ions in expected return-standard deviation space) stemming from combinations of the risky assets under the different beliefs, as

16.0%

14.0%
Er SD real SD bias
7.0% 0.250 0.250
12.0%
7.8% 0.239 0.221
8.6% 0.231 0.197
10.0%
9.4% 0.227 0.180
10.2% 0.226 0.172
8.0%
11.0% 0.230 0.175
11.8% 0.238 0.188
12.6% 0.250 0.208 6.0%

13.4% 0.264 0.235

14.2% 0.281 0.266 4.0%

15.0% 0.300 0.300

2.0%

0.0%
0.160 0.180 0.200 0.220 0.240 0.260 0.280 0.3
 2.0%

ng the same SD. 0.0%

0.160 0.180 0.200 0.220 0.240 0.260 0.280 0.3

subjective belief, as if the respective beliefs were correct, and draw the different capital allocation lines.

35.00%

30.00%

25.00%

20.00% Er P rea l
Er P bi as
Compl ete Portfol i o
15.00% Effici ecy rea l
Effici ecy bi as

10.00%

5.00%

0.00%
0% 5% 10% 15% 20% 25% 30% 35% 40%

different beliefs. Why do you choose to hold a larger fraction of the optimal risky security in one scenario compared to the other?

If the correlation is negative, you allocate more money in risky portfolio because it equals the sa

gnitude of this loss in terms fundamental economic quantities?

 This is 2.5% of your total portfolio. If 1 million, you have lost 25,000 dollars!!

at must the return on the regular portfolio be so that the Utility of the actual portfolio = the biased portfolio??

beliefs about return characteristics would you be willing to give up in order to be equipped with correct instead of incorrect beliefs

ncorrect belief portfolio??

o questions 1d) through 1f) change? Give an intuitive interpretation of the differences in results. What do you conclude about the degree
returns?

SD bias Er C real Er C bias

oes (to a degree)

 Behavioral Finance
Information Processing Behavioral Biases
Extrapolation and Conservatism Framing

ouldn't make these assumptions.

efficiently?
th expected return 0.15
ou believe that the

r the different beliefs, as

Real
Bi as

240 0.260 0.280 0.300 0.320

240 0.260 0.280 0.300 0.320

Er real Er Bias
0.02 0.02
14% 12%

SD real SD bias
0 0
0.28 0.20

mpared to the other?

rtfolio because it equals the same amount of SD for a higher expected return.
 SD Er
0% 14.22%
d of incorrect beliefs 3% 14.31%
5% 14.59%
8% 15.06%
10% 15.72%
13% 16.56%
15% 17.59%
18% 18.81%
20% 20.22%
23% 21.81%
25% 23.59%
28% 25.56%
30% 27.72%
33% 30.06%
35% 32.59%
conclude about the degree

The two indifference curves will not be the same, the biased utility is slightly lower thus
d utility is slightly lower thus making a less efficient use of the portfolio. It is NOT tangent to the CAL.
Maturity Settlement Coupon Bid Asked Asked Yield
4/30/2019 4/30/2018 1.25% 99.0859 99.1016 0.212%
4/30/2024 4/30/2018 2.00% 96.1797 96.1953 0.269%

4/3/2018 5/15/2046 0.025 0.03024

Consider a 3.5% coupon bond with a maturity of four years. The bond pays annual coupon payments and has a face
curve over the one to five year maturity spectrum is given by:

Maturity 1 2 3 4 5
YTM 2.50% 3.00% 3.50% 4.00% 4.25%

Purchase 1/1/2018
maturity yrs 1/1/2022 Maturity 1 2
Coupon rate 3.50% $35.00 CF $35.00 $35.00
Maturity yrs 4 PV 34.14634146 32.99085682
Face value $1,000 bond price
Bond Value
YTM 0.03956 =YIELD() YTM PV 33.66806376 32.38681478
Use goal seek to set YTM PV bond value equal to bond bond price
face value, then change YTM
Year 1 35 0.975609756 34.14634146
Year 2 35 0.942595909 65.98171364
Year 3 35 0.901942706 94.7039841
Year 4 1035 0.854804191 3538.889351
SUM 3733.72139
Macauly's # 3.73 (Less than the time to maturity)

forward rate actual rate

f1 2.50% 2.50%
f2 3.50% 3.00%
f3 4.51% 3.50%
f4 5.51% 4.00%

Inverted Yield Curve

Maturity yrs 1 2 3 4 5
YTM 2.00% 2.00% 1.75% 1.75% 1.50%
CF $35.00 $35.00 $1,035.00
PV 34.31372549 33.64090734 982.5102642
Bond Price $1,050.46
Old Bond Price 983.4275487
HPR 0.0409857599 10.38% equals new bond price plus 35 divided by
Price $ 983.42 USE GOAL SEEK
YTM 0.084
Duration 0.000
Settlement 1/1/2018
Maturity 1/1/2021
Weight 0.0326652757 0.03202478 0.935309944
Duration

Problem 16, chapter 16

A 30-year maturity bond making annual coupon payments with a coupon rate of 12% has duration of 11.54 years
and convexity of 192.4. The bond currently sells at a yield to maturity of 8%. Use a financial calculator or
spreadsheet to find the price of the bond if its yield to maturity falls to 7% or rises to 9%. What prices for the bond
at these new yields would be predicted by the duration rule and the duration-with-convexity rule? What is the
percentage error for each rule? What do you conclude about the accuracy of the two rules?

Periods 30 FV 1000
Settlement 1/1/2018
Maturity 1/1/2048
coupon 12% 120
duration 11.54
convexity 192.4
Price $1,450.31 $1,620.45 $1,308.21

YTM 7% 8% 9%
=DURATION() 12.309353556 11.5471407 10.83720245
=MDURATION() 11.504068744 10.69179694 9.94238757

Yield change -1% equals 7% minus 8%

Mduration 10.691796943
Price Change 10.69% equals negative M Duration times yield change
New Price 1,605.28
Error -0.945%

Price change 11.654%

new price $1,619.33 Old price plus (old price * Price change)

Repeat Process for price change from 8% to 9%

coupon 12% 120

duration 8% 11.54
duration 9% 10.84
convexity 192.40
Periods 30
FV 1000
Price 8% $1,450.31
Price 9% $1,308.21

Yield change 1.00% equals 9% minus 8%

Mduration 8% 10.685185185
price change -10.69%
New Price $1,295.34
Error -0.99%

price change w/ convexity -9.72%

New Price w/ convexity $1,309.29
Error 0.08%
 Coupons per yredemption Price
2 100.00 101.036854999
2 100.00 110.2989081078

2 100 90.122 The difference in value here and on the website is slight and

ayments and has a face value of $1,000. The zero-coupon yield

3 4
$35.00 $1,035.00
31.5679947 884.7223377158
983.4275306972

31.15432415 886.218346038
983.4275487325

0.00001804

me to maturity)
 Forward Rate = -1 + [ (1+YTM)^n / (1+YTM1-n)^1-n ]
If the forward rate is greater than the previous forward rate,

THIS IS A GOOD TEMPLATE! USE IT! Forward Rate!!

1/1/2000
1/1/2003

maturity 1 2 3
Weight 3.47% 3.35% 3.21%
Individual Duration 0.034721767 0.067093621 0.096299911
price plus 35 divided by old price -1 Bond Duration

Modified Duration 3.652158712

Change in Price -0.36521587
The Line is straight if we only take the duration into account. But, as it is, we can u
Duration is good for small changes, but for big changes in YTM we need to accoun
Convexity is the rate that the duration changes alon

ration of 11.54 years

calculator or
hat prices for the bond
y rule? What is the

USE duration formula and Mduration formula!!

The yield change is quite small, so the error rate is SMALL.

BUT! The new price based on convexity is still slightly more accurate than the pric
d on the website is slight and probably due to rounding of numbers.

Time Period
Coupon Payment
y = periodic yield maturity 1
n = periods YTM 2.50%
M = maturity value Forward 2.500%
n / (1+YTM1-n)^1-n ]
n the previous forward rate, then forward rate is greater than YTM

E IT! Forward Rate!!

4
89.96% Weight = PV / Bond Price
3.598525809 D = weight * Time
3.796641108 SUM()

ccount. But, as it is, we can use the modified duration to create a more accurate curve.
es in YTM we need to account for maturity.
ration changes along the price-yield curv

y more accurate than the price without convexity.

 2 3 4 5
3.00% 3.50% 4.00% 4.25%
3.502% 4.507% 5.515% 5.256%
 Ch. 12, problem 15
In mid-2009, Rite Aid had CCC-rated, 11-year bonds outstanding with a yield to maturity of 17.3%. At the time, sim
yield of 2%. Suppose the market risk premium is 4% and you believe Rite Aid’s bonds have a beta of 0.39. The expect
event of default is 52%.

Question 1: What annual probability of default would be consistent with the yield to maturity of these bonds in

Rite Aid YTM: 17.30%

Treasury Yield: 2%
Market risk premium: 4%
Rite Aid beta: 0.39
Expected loss of default: 52%
Average default rate: 12.20%
rd = 10.96%

CAPM 3.56%
Annual probability 26.42%

Question 2: In mid-2015, Rite-Aid's bonds had a yield of 8,8%, whilse similar maturity Trea

Rite Aid Yield: 8.80% SAME AS ABOVE

Treasury Yield: 0.8%

Ch. 12, problem 18

Your firm is planning to invest in an automated packaging plant. Harburtin Industries is an all-equity firm that sp
business. Suppose Harburtin’s equity beta is 0.88, the risk-free rate is 3.9%, and the market risk premium is 4.9%. If
is all equity financed, estimate its cost of capital.

Question 1: Estimate its cost of capital

ALL-EQUITY, NO DEBT
Project beta: 0.88
Risk-free rate: 3.90%
Market risk premium: 4.90%

CAPM 4.78% SAME AS ABOVE

Ch. 12, problem 22

Consider the following airline industry data from mid-2009:

Company name Market cap ($ mn) Total EV ($ mn)

Delta Airlines 4908.4 16956.8
Southwest Airlines 4866.5 6304.2
Jetblue Airways 1297.6 3850.9
Continental Airlines 1139.4 4408.3

Question 1: Use the estimates in Table 12.3 to estimate the debt beta for each firm (Use an average if multiple r

Debt Beta
Delta Airlines 0.17 From Chart
Southwest Airlines 0.075
Jetblue Airways 0.285
Continental Airlines 0.26

Question 2: Estimate the asset beta for each firm.

Debt E/V D/V

Delta Airlines 12048.4 0.2894649934 0.71
Southwest Airlines 1437.7 0.771945687 0.23
Jetblue Airways 2553.3 0.3369601911 0.66
Continental Airlines 3268.9 0.2584669827 0.74
Question 3: What is the average asset beta for the industry, based on these firms?

Average 0.749712741

Ch. 12, problem 23

Weston Enterprises is an all-equity firm with two divisions.
The soft drink division has an asset beta of 0,53, expects to generate free cash flow of $76 million this year, and antic
The industrial chemicals division has an asset beta of 1,14, expects to generate free cash flow of $44 million this year
Suppose the ris-free rate is 2% and the market risk premium is 4%.

Question 1: Estimate the value of each division.

Risk-free rate: 2%
Market risk premium: 4%
if they mention perpetual growth, USE IT!
Soft drink:
Cash flow this year: 76 million
Asset beta: 0.53
Anticipated growth rate: 4%

Required Return CAPM 4.12%

Value 63333.33 million

The industrial chemicals division:

Cash flow this year: 44 million
Asset beta: 1.14
Anticipated growth rate: 2%

CAPM 6.56%
Value 964.91 million

SUM 64,298.25

Question 2: Estimate Weston's current equity beta and cost of capital. Is the cost of capital useful for valuing W
How is Weston's equity beta likely to change over time?

Equity Beta 0.54

Cost of capital (CAPM) 4.16%

Ch. 14, problem 4

Wolfrum Technology (WT) has no debt. Its assets will be worth $444 million in one year if the economy is strong, but
equally likely. The market value today of its assets is $257 million.

Question 1: What is the expected return of WT stock without leverage?

State of economy: Strong Weak

Assets: 444 226 THIS WAY Better 335
Probability: 0.5 0.5
Return 72.76% -12.06%
Market value of assets today: 257 million

expected return 30.35%

Question 2: Suppose the risk-free interest rate is 5%. If WT borrows $52 million today at this rate and uses the
value of its equity just after the dividend is paid, according to MM?

Risk-free rate: 5%
New debt: 52 million
New Equity 205
MM1 says that value of firm doesn't depend on capital structure

Question 3: What is the expected return of WT stock after the dividend is paid in part 2?

Equity: 205 million

Dividend: 52 million
Risk-free rate: 5%

Expected Return 36.78% LONG FORMULA

Ch. 14, problem 6

Suppose Alpha Industries and Omega Technology have identical assets that generate identical cash flows. Alpha Indu
for a price of $24 per share. Omega Technology has 22 million shares outstanding as well as debt of $100 million.

Question 1: According to the MM proposition I, what is the stock price for Omega Technology?

Alpha:
Shares outstanding: 14 million
Price per share: 24 $
Market Value 336 million

Omega Tech:
Shares outstanding: 22 million
Debt 100 million
Stock Price 15.27 $

Question 2: Suppose Omega Technology stock currently trades for $15 per share. What arbitrage opportunity
opportunity?
Question 2: Suppose Omega Technology stock currently trades for $15 per share. What arbitrage opportunity
opportunity?

Current Price 15.00

MM says value should be 15.27
Arbitrage opportunity 0.27 Per share

Imperfect market where information is not symmetrical

Ch. 14, problem 8

Schwartz Industry is an industrial company with 103.5 million shares outstanding and a market capitalization (equity
It has $1.21 billion of debt outstanding. Management have decided to delever the firm by issuing new equity to repay

Question 1: How many new shares must the firm issue?

Shares outstanding: 0.1035 billion

Market cap (MVE): 4.41 billion
Debt outstanding: 1.21 billion
price per share 42.61 $
Needed shares 0.028397959 billion 28.398 million

Question 2: Suppose you are a shareholder holding 100 shares, and you disagree with this decision.
Assuming a perfect capital market, describe what you can do to undo the effect of this decision.

Take on more debt, in a perfect market the debt does not change total value.
Company has 100 million outstanding shares, they want to remove shares, so they romove debt, then they take out
For us to have leverage with debt, we need to borrow debt to buy 27.xx shares. Now your portfolio will have 127.xx s

0.274376417
27.43764172 x100
1169.082126 x share price

Ch. 14, problem 11

Consider the entrepreneur described in Section 14.1 (and referenced in Tables 14.1–14.3). Suppose she funds the proj

Question 1: According to MM Proposition I, what is the value of the equity? What are its cash flows if the econ
economy is weak?
Value of project: 1000
Value of debt 750
Required return on debt: 5% risk-free rate

VALUE OF equity 250

238.10

State of economy: Strong Weak

Project CF: 1400 900
Debt 787.5 787.5
Equity 612.5 112.5

Question 2: What is the return of the equity in each case? What is its expected return?

Strong Weak
Return 145% -55%
Prob 0.5 0.5 We just assume that there is a 50/50 c

Expected Return (average) 45%

Question 3: What is the risk premium of equity in each case? What is the sensitivity of the levered equity retur
How does its sensitivity compare to that of unlevered equity?

Risk premium of levered equity 40% Expected return minus required return

sensitivity 200% Strong economy return minus weak economy return

Returns to unlevered equity

Cash Flows 1400 900
Return 40% -10%
Expected Return 15%
return minus risk free rate 10%
SENSITIVITY 50%

Sensitivity Comparison!!! 4 difference of Unlevered to Levered

Levered equity is and risk premium are 4x larger than the

WAAC =250/1000*C279+750/1000*x
 Ch. 14, problem 13
Suppose Visa Inc. (V) has no debt and an equity cost of capital of 9.2%. The average debt-to-value ratio for the credi
average amount of debt for its industry at a cost of debt of 6%?

Question 1: Estimate the cost of equity

Equity cost of capital: 9.20%

Industry Debt-to-value ratio: 13% Equity to debt
Industry cost of debt: 6%
debt 0
Cost of equity 9.67816% Debt to value ratio VS debt to equity value. To get value y

Ch. 14, problem 14

Global Pistons (GP) has common stock with a market value of $470 million and debt with a value of $299 million.
Investors expect a 13% return on the stock and a 5% return on the debt. Assume perfect capital markets.

Question 1: Suppose GP issues $299 million of new stock to buy back the debt. What is the expected return of t

Market cap (MVE): 470

Debt value: 299
Expected return on equity: 13%
Expected return on debt: 5%
Company Value 769

Pretax WCC 9.89%

Question 2: Suppose instead GP issues $71 million of new debt to repurchase stock.

i. If the risk of the debt does not change, what is the expected return of the stock after this transac

Issued debt: 71 million

Return on unlevered Equity (WACC) 9.89%
New Mkt Cap 399
New Debt 370
Company Value 769

New Return 14.42%

ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than

Expected return will decrease when risk of the stock increases

Just look at formula

Ch. 15, problem 1

Problem 1
Pelamed Pharmaceuticals has EBIT of $133 million in 2006. In addition, Pelamed has interest expenses of $49 millio

Question 1: What is Pelamed’s 2006 net income?

EBIT 133
Interest 49 84 54.6
Tax rate: 35%
Income 54.6

EBT 84
Tax 29.4
Net Income 54.6

Question 2: What is the total of Pelamed’s 2006 net income and interest payments?

Total 103.6 Net income and interest payments

Question 3: If Pelamed had no interest expenses, what would its 2006 net income be? How does it compare to y

Income 86.45 Don't pay interest, just taxes

Lower 'income' than if debt was issued.

Difference 17.15 The difference is known as the tax shield

Question 4: What is the amount of Pelamed’s interest tax shield in 2006?

Tax Shield 17.15

Ch. 15, Problem 5

Your firm currently has $116 million in debt outstanding with a 8% interest rate. The terms of the loan require it to re
Suppose that the marginal corporate tax rate is 30%, and that the interest tax shields have the same risk as the loan
What is the present value of the interest tax shields from this debt?

Debt: 116 million

Tax rate: 30%
Interest rate: 8%
Payments every year: 29
Years 0 1
Payments 34.8
PV 32.22222222
Interest 9.28
Debtt 116 87
Tax Shield 2.784
PV of tax shield

Ch. 15, problem 12

Summit Builders has a market debt-equity ratio of 1.30, a corporate tax rate of 38%, and pays 9% interest on its debt
amount?

Question 1

Debt-equity ratio: 1.3

Corporate tax rate: 38%
Interest on debt: 9%
Reduction due to ITS 1.933% Debt / Debt Plus Equity!!!

WACC = pretax WACC - xxx

Ch. 15, problem 20

Suppose the corporate tax rate is 35%, and investors pay a tax rate of 25% on income from dividends or capital gain
Your firm decides to add debt so it will pay an additional $30 million in interest each year. It will pay this interest exp

Question 1: How much will debt holders receive after paying taxes on the interest they earn?

Corporate tax rate: 35%

Dividend income tax: 25%
Interest income tax: 32.40%
Yearly interest payments: 30 million

Debt holders get… 20.28 Interest payment * (1-tax)

Question 2: By how much will the firm need to cut its dividend each year to pay this interest expense?

Cut how much? 19.5 yearly pymt * (1-corp tax)

Question 3: By how much will this cut in the dividend reduce equity holders’ annual after-tax income?

Reduction of after-tax income 14.625

Question 4: How much less will the government receive in total tax revenues each year?

Debt revenue to gov 9.72

Loss of debt revenue

 4.875
10.5

Loss of tax revenue to gov -5.655

Question 5: What is the effective tax advantage of debt τ*?

Effective tax T* 27.885% yes, it is below Tc

 Ch. 12, problem 15
o maturity of 17.3%. At the time, similar maturity Treasuries had a
nds have a beta of 0.39. The expected loss rate of these bonds in the
52%.

yield to maturity of these bonds in mid-2009?

p is probability of default
L is expected loss of 1$
expected return of the bond is….

cost of capital = YTM - probability * expected

Prob = (YTM - cost of capital) / expected loss

Equations on page 450 12.7

8%, whilse similar maturity Treasuries had a yield of 0,8%. What probability of default would you estimate now?

ME AS ABOVE

Ch. 12, problem 18

dustries is an all-equity firm that specializes in this
he market risk premium is 4.9%. If your firm’s project
of capital.

cost of capital of an all equity firm is the CAPM

ME AS ABOVE

Ch. 12, problem 22

Equity beta Debt ratings Debt Beta

2.097 BB 0.17
0.976 A/BBB 0.075
1.806 B/CCC 0.285
1.974 B 0.26

firm (Use an average if multiple ratings are listed)

Debt Beta = Bu*(E+D)-E*Be / D

Beta (asset) = Beta (equity) / [1+ [(1-t)*D/E]]
Beta (equity) = Beta (asset)*[1+ [(1-t)*D/E]]

What is t???

Asset Beta
0.727799042
0.770523064
0.797516451
0.703012408
 Ch. 12, problem 23

w of $76 million this year, and anticipates a 4% perpetuity growth rate.

ee cash flow of $44 million this year, and anticipates a 2% perpetual growth rate.

hey mention perpetual growth, USE IT!

r(e) is the required return on equity

Value = CF / r - g
cost of capital useful for valuing Weston's projects?

Beta (equity) = Beta (asset)*[1+ [(1-t)*D/E

E is one division, D is the other division.

Ch. 14, problem 4

e year if the economy is strong, but only $226 million in one year if the economy is weak. Both events are

30.35%

ion today at this rate and uses the proceeds to pay an immediate cash dividend, what will be the market
d in part 2?

Ch. 14, problem 6

ate identical cash flows. Alpha Industries is an all-equity firm, with 14 million shares outstanding that trade
g as well as debt of $100 million.

mega Technology?

SEE THE PROBLEM BELOW, APPARENTLY SIMILAR

are. What arbitrage opportunity is available? What assumptions are necessary to exploit this
 THIS IS ALWAYS AT THE EXAMS!!!!

Ch. 14, problem 8

and a market capitalization (equity value) of $4.41 billion.
firm by issuing new equity to repay all outstanding debt.

398 million

ree with this decision.

ct of this decision.
THIS IS ALWAYS AT THE EXAMS!!!!

y romove debt, then they take out equity and have NO DEBT anymore
ow your portfolio will have 127.xx shares instead of 100!

Ch. 14, problem 11

1–14.3). Suppose she funds the project by borrowing $750 rather than $500.

What are its cash flows if the economy is strong? What are its cash flows if the
 U is market value of equity
A is market value of assets

just assume that there is a 50/50 chance of one condition vs the other.

sitivity of the levered equity return to systematic risk?

s required return risk premium equals exp return minus risk free rate

n minus weak economy return

erence of Unlevered to Levered

risk premium are 4x larger than the unlevered equity and premium
 Ch. 14, problem 13
ge debt-to-value ratio for the credit services industry is 13%. What would its cost of equity be if it took on the

83%

debt to equity value. To get value you just take 100% minus debt

Ch. 14, problem 14

ebt with a value of $299 million.
erfect capital markets.

t. What is the expected return of the stock after this transaction?

of the stock after this transaction?

stock be higher or lower than in part (i)?

Ch. 15, problem 1

has interest expenses of $49 million and a corporate tax rate of 35%.

est payments

ome be? How does it compare to your answer in part b?

wn as the tax shield

Ch. 15, Problem 5

he terms of the loan require it to repay $29 million of the balance each year.
lds have the same risk as the loan.

Facebook and Apple pay only 1-2% of taxes!!

In america it was 40% taxes last year LOL
2 3 4
34.8 34.8 34.8
29.83539095 27.62536199 25.57903888
6.96 4.64 2.32
58 29 0
2.088 1.392 0.696
6.96

Ch. 15, problem 12

%, and pays 9% interest on its debt. The interest tax shield from its debt lowers Summit’s WACC by what
 Ch. 15, problem 20
ome from dividends or capital gains and a tax rate of 32.4% on interest income.
ach year. It will pay this interest expense by cutting its dividend.

erest they earn?

ay this interest expense?

annual after-tax income?

each year?
Tc = corporate tax rate
Ti = interest tax
Te = equity tax, or dividends tax which are payed as income to shareholders
of the bond is….

TM - probability * expected loss rate

t of capital) / expected loss rate

you estimate now?

/ [1+ [(1-t)*D/E]]
[(1-t)*D/E]]
asset)*[1+ [(1-t)*D/E]]
2% of taxes!!
 Problem 1
The below table shows the distribution of the value for a new project one year into the future.
Suppose that all risk is diversifiable and that the risk-free interest rate is 5%.

State Probability Value Face Value 100

1 0.3 155
2 0.2 130
3 0.2 90
4 0.3 80

a) What is the value of the equity in the project if there is no leverage.

Risk free rate 5%

Equity 109.05 SUMPRODUCT()

b) What is the payoff to debt and equity for each state?

Debt Payoff Equity Payoff

100 55
100 30
90 0
80 0

c) What is the initial value of the debt?

87.619047619

d) What is the expected return and yield-to-maturity on the debt?

face value 100 face value - value of debt / 1

YTM 14%

return
14.13%
 14.13%
2.72%
-8.70%

Expected return 5% return * probabilities

e) What is the initial value of equity?

21.428571429 Probabilities * equity payoff / discount rate

21.43 Equity value - debt!

f) What is the total value of the project when financed in part with leverage?

109.04761905 Equity plus debt

g) How do your above answers to problem 1 a) – 1 f) change if there is a 25% loss in value in the event of a defa

State Probability Value Debt Payoff Equity Payoff

1 0.3 155 100 55
2 0.2 135 100 35
3 0.2 67.5 67.5 0
4 0.3 60 60 0

Face Value 100

Value of the debt 81.5

YTM 0.226993865
Return 9955%
9955%
6705%
5955%

expected return 81.04601227

Value of the equity 22.38

Problem 2
You are given the following table showing the market value of equity,
the market value of debt and equity beta estimated following the CAPM for five firms.

Firm Equity Debt Beta (equity)

A 100 150 2.25
B 100 50 2.25
C 100 90 2.85
D 100 80 2.7
E 100 200 2.7

a) Given the knowledge that the level of debt has been randomly assigned to these firms akin to an experiment
belong to the same industry, which firms do you think belong to the same industry?

Firms A and B belong to the same industry, as well as firms D and E because their Beta's are similar.
Firm Equity Debt Beta (equity) E/V Beta Unlevered
A 100 150 2.25 0.4 0.9
B 100 50 2.25 0.666666667 1.5
C 100 90 2.85 0.526315789 1.5
D 100 80 2.7 0.555555556 1.5
E 100 200 2.7 0.333333333 0.9
b) How would you answer to part a) change if the level of debt were not randomly assigned to firms?

If debt were actual, and not assigned, then I woul definitely change; within an industry, many firms have similar debt-
Services and capital goods industries usually have larger cash reserves to account for seasons and financial difficulty.

We assume firms in the same industry have approximately the same capital structure.
 Problem 3
The following table contains estimates of the present value of
tax shields and probabilities of financial distress for different levels of debt.

0 40 50 60 70
PV of tax shield 0 0.76 0.95 1.14 1.33
Prob of distress 0% 0% 1% 3% 7%
Distress Cost 1 1 1 1 1
PV Distress 0 0 0.0095238095 0.028571429 0.066666667
Net benefit 0 0.76 0.9404761905 1.111428571 1.263333333
Find the optimal level of debt for financial distress costs between 1 and 25 with increments of 1. Hint: The MA
problem.
MAX() returns the highest value in an array
INDEX() returns a cell value (x,y) based on an array
MATCH() finds a value, or the closest substitute and returns the position based on an a
Risk free rate 5%
Distress Cost 1 Use the Data Table What If function, and only input in the row cell…refer to d

Distress cost
0.00 0.00 0.76 0.94 1.11 1.26
1.00 0.94 1.11 1.26
2.00 0.93 1.08 1.20
3.00 0.92 1.05 1.13
4.00 0.91 1.03 1.06
5.00 0.90 1.00 1.00
6.00 0.89 0.97 0.93
7.00 0.88 0.94 0.86
8.00 0.87 0.91 0.80
9.00 0.86 0.88 0.73
10.00 0.85 0.85 0.66
11.00 0.85 0.83 0.60
12.00 0.84 0.80 0.53
13.00 0.83 0.77 0.46
14.00 0.82 0.74 0.40
15.00 0.81 0.71 0.33
16.00 0.80 0.68 0.26
17.00 0.79 0.65 0.20
18.00 0.78 0.63 0.13
 19.00 0.77 0.60 0.06
20.00 0.76 0.57 0.00
21.00 0.75 0.54 -0.07
22.00 0.74 0.51 -0.14
23.00 0.73 0.48 -0.20
24.00 0.72 0.45 -0.27
25.00 0.71 0.43 -0.34

Ch. 16, problem 7

Which type of firm is more likely to experience a loss of customers in the event of financial distress:You have received
B offers to pay you $83,000 for two years. Both jobs are equivalent. Suppose that firm A’s contract is certain, but that
event, it will cancel your contract and pay you the lowest amount possible for you not to quit. If you did quit, you exp
unemployed for three months while you search for it.

a) Say you took the job at firm B. What is the least Firm B can pay you next year in order to match what you w

Months unemployed year 2 3

Months in a year 12
Salary for new job $ 79,000
Salary per month $ 6,583
Salary lost in year 2 $ 19,750
Salary in Year 2 $ 59,250 75% of salary you could make in that year, 7

Value
Discounted Value

b) Given your answer to part (a), and assuming your cost of capital is 5%, which offer pays you a higher prese
Year 1 Year 2
Salary A 79000.00 79000.00
Salary B 83000.00 59250.00

Cost of capital 5%

Discounted Discounted Sum

Salary A 75,238.10 71,655.33 146,893.42
Salary B 79,047.62 53,741.50 132,789.12
c) Based on this example, discuss one reason why firms with a higher risk of bankruptcy may need to offer hig

Increasing the risk of bankruptcy increases the chance of lost income from finding a new job, which decreases the ov
Thus, increasing wage proportional to the risk of bankrupcy accounts for the chance that you will lose your job and n

Ch. 16, problem 20

Zymase is a biotechnology startup firm. Researchers at Zymase must choose one of three different research strategies
The risk of each project is diversifiable.

Strategy Probability Payoff ($m)

A 100% 90
B 50% 160
50% 0
C 10% 370
90% 20

a) Which project has the highest expected payoff?

A 90
B 80
C 55

b) Suppose Zymase has debt of $35 million due at the time of the project’s payoff. Which project has the highe
Debt 35 m

Strategy Probability Payoff ($m) Payoff Equity

A 100% 90 55
B 50% 160 125
50% 0 0 MAX() function
C 10% 370 335
90% 20 0

Prj Epected Payoff

A 55
B 62.5
C 33.5

c) Suppose Zymase has debt of $130 million due at the time of the project’s payoff. Which project has the high

Debt 130 $m

Strategy Probability Payoff ($m) Payoff Equity

A 100% 90 0
B 50% 160 30
50% 0 0 MAX() function
C 10% 370 240
90% 20 0

Prj Epected Payoff

A 0
B 15
C 24

d) If management chooses the strategy that maximizes the payoff to equity holders, what is the expected agenc
expected agency cost to the firm from having $130 million in debt due?

Agency Cost is 90million minus B strategy which is 80million 10

Agency Cost is 90 million minus strategy C which is 24million 66

Ch. 16, problem 21

Petron Corporation’s management team is meeting to decide on a new corporate strategy. There are four options, eac
success, as shown below:

Strategy
A B C D
Probablity of succes 93% 77% 61% 45%
Firm value 55 63 71 79

Assume that for each strategy, firm value is zero in the event of failure.

a. Which strategy has the highest expected payoff?

A B C B
Value 51.15 48.51 43.31 35.55

b) Suppose Petron’s management team will choose the strategy that leads to the highest expected value of Petr
has:
(i) No debt?
(ii) Debt with a face value of $16 million?
(iii) Debt with a face value of $32 million?

Equity payoff 51.15 48.51 43.31

Debt A B C
(i) 0 51.15 48.51 43.31

(ii) 16 36.27 36.19 33.55

(iii) 32 21.39 23.87 23.79

Probability of success 93% 77% 61%
Probability of failure 7% 23% 39%

Strategy B with 16 million in debt?

c) What agency cost of debt is illustrated in your answer to part (b)?

Any problems between shareholders has a chance to cause agency costs.

If there is strife between debt and equity holders, there will be agency costs

Ch. 16, problem 22

Consider the setting of Problem 21, and suppose Petron Corp. has debt with a face value of $32 million outstanding.
and there are no taxes.

a) What is the expected value of equity, assuming Petron will choose the strategy that maximizes the value of it

Tax 0
Risk free rate 0%
Face value of debt 32

Equity value (from above) 23.87

Probability (from above) 77%

Debt Value 24.64 face value of debt times probability

Total Value 48.51

b) Suppose Petron issues equity and buys back its debt, reducing the debt’s face value to $4 million. If it does s
the firm increase?

Debt 4 $m

A B C D Max Equity Value

Expected Equity Value 47.43 45.43 40.87 33.75 A

c) Suppose you are a debt holder, deciding whether to sell your debt back to the firm. If you expect the firm to
debt?
c) Suppose you are a debt holder, deciding whether to sell your debt back to the firm. If you expect the firm to
debt?
There is a RISK FREE RATE
So, the face value is equal to the debt value
We want 32-4 = 28million. There is no discounting or interest rate to speak of, so we just ask for the face value of the

d) Based on your answer to (c), how much will Petron need to raise from equity holders in order to buy back th

Just the face value of the debt.

e) How much will equity holders gain or lose by recapitalizing to reduce leverage? How much will debt holders
its leverage?

Equity holders
Equity value after 47.43 debt of 4
Equity holders buy back 28
Net Payoff to equity holders 19.43
If no buyback, value to equity holder 23.87 debt of 32
Loss from buyback 4.44

Debt Holders
receive from equity holders 28
still hold in risk-free debt 4
Total payoff 32 Increase in value
Worth if no buyback 24.64
Gain 7.36
Ch. 16, problem 24

You own your own firm, and you want to raise $30 million to fund an expansion. Currently, you own 100% of the firm
equity, you will need to sell two-thirds of the firm. However, you would prefer to maintain at least a 50% equity stake

a) If you borrow $20 million, what fraction of the equity will you need to sell to raise the remaining $10 million

Current ownership 100%

Sell 67%
Capital needed 30 million
Borrow (debt) 20 million
capital 10 million

30m / .67 45
New Proportion 22% sell this amount of the firm
b) What is the smallest amount you can borrow to raise the $30 million without giving up control? (Assume pe

50% stake * 30 million 15

Ch. 16, problem 26

Ralston Enterprises has assets that will have a market value in one year as follows:
Suppose the CEO is contemplating a decision that will benefit her personally but will reduce the value of the firm’s a
Probability 3% 7% 26% 28% 26%
Value ($million) 65 75 85 95 105
minus debt 0 5 15 25 35

a) If Ralston has debt due of $70 million in one year, the CEO’s decision will increase the probability of bankru

If there are no personal benefits, then just 3%

If there are personal interests, then 3% + 7%

b) What level of debt provides the CEO with the biggest incentive not to proceed with the decision?

Probability is the highest at a debt of 85-105, so there is a greater chance of paying back the debt. Probability is with
 Ch. 16, problem 30

According to the managerial entrenchment theory, managers choose capital structures so as to preserve their cont
losing control in the event of default. On the other hand, if they do not take advantage of the tax shield p

Suppose a firm expects to generate free cash flows of $90 million per year, and the discount rate for these cash flo
firm and finance it with $750 million in permanent debt. The raider will generate the same free cash flows, and the
over the current value of the firm. According to the managerial entrenchment hypothesis

FCF per year 90 $m

Discount rate 10%
Tax rate 40%

Raider debt 750 $m

Premium required 20%

tax shield w/ raider 300 $m

Unlevered Value 900

Levered Value 1200

Premium 20%

Levered value discounted 1000

min tax shield required 100

Debt required 250 tax shield divided by tax rate
Problem 1
alue in the event of a default?

ONLY THE LAST TWO CHANGE, because there is a default

 Problem 2

ms akin to an experiment, the market is otherwise perfect, all debt is risk free, and not all firms

Need to find Beta of the unlevered firm!!

a Unlevered

We can assume A and E are same, and BCD are the same, but HARD TO SAY!

igned to firms?

ny firms have similar debt-equity ratios. In medical field they are comprised of mostly debt due to high cost of research until me
ns and financial difficulty.
 Problem 3

80 90
1.52 1.71
16% 31%
1 1 Distress is 1 EVERY TIME. Simulate for 1
0.152380952 0.2952380952
1.367619048 1.41
ments of 1. Hint: The MAX(), INDEX() and MATCH() functions in excel are useful in solving the

the position based on an array

t in the row cell…refer to distress cost cell

Max Column(max) Optimal Debt

1.37 1.41
1.37 1.41 1.4 7 90
1.22 1.12 1.215238095 6 80
1.06 0.82 1.13 5 70
0.91 0.53 1.063333333 5 70
0.76 0.23 0.997142857 4 60
0.61 -0.06 0.968571429 4 60
0.45 -0.36 0.94 4 60
0.30 -0.65 0.911428571 4 60
0.15 -0.95 0.882857143 4 60
0.00 -1.24 0.854761905 3 50
-0.16 -1.54 0.845238095 3 50
-0.31 -1.83 0.835714286 3 50
-0.46 -2.13 0.826190476 3 50
-0.61 -2.42 0.816666667 3 50
-0.77 -2.72 0.807142857 3 50
-0.92 -3.01 0.797619048 3 50
-1.07 -3.31 0.788095238 3 50
-1.22 -3.60 0.778571429 3 50
 -1.38 -3.90 0.769047619 3 50
-1.53 -4.19 0.75952381 3 50
-1.68 -4.49 0.75 3 50
-1.83 -4.79 0.74047619 3 50
-1.98 -5.08 0.730952381 3 50
-2.14 -5.38 0.721428571 3 50
-2.29 -5.67 0.711904762 3 50

h. 16, problem 7

distress:You have received two job offers. Firm A offers to pay you $79,000 per year for two years. Firm
ontract is certain, but that firm B has a 50% chance of going bankrupt at the end of the year. In that
it. If you did quit, you expect you could find a new job paying $79,000 per year, but you would be

rder to match what you would earn if you quit?

u could make in that year, 79k * .75

r pays you a higher present value of your expected wage?

tcy may need to offer higher wages to attract employees.

ob, which decreases the overall value of the job.

ou will lose your job and not have money for a few months.

h. 16, problem 20
ifferent research strategies. The payoffs (after-tax) and their likelihood for each strategy are shown below.

ich project has the highest expected payoff for equity holders?
 Choose B

hich project has the highest expected payoff for equity holders?

Choose C

hat is the expected agency cost to the firm from having $35 million in debt due? What is the
 WRONGGGGGGGGG

h. 16, problem 21
There are four options, each with a different probability of success and total firm value in the event of

st expected value of Petron’s equity. Which strategy will management choose if Petron currently

35.55
D Max Equity Value Expected equity value = Probability * (firm value - debt)
35.55 A

28.35 A

21.15 B
 45%
55%

h. 16, problem 22
f $32 million outstanding. For simplicity, assume all risk is idiosyncratic, the risk-free interest rate is zero,

maximizes the value of its equity? What is the total expected value of the firm?

to $4 million. If it does so, what strategy will it choose after the transaction? Will the total value of

x Equity Value

If you expect the firm to reduce its debt to $4 million, what price would you demand to sell your
sk for the face value of the debt

rs in order to buy back the debt?

w much will debt holders gain or lose? Would you expect Petron’s management to choose to reduce

By buying back debt, the firm increases in value by 2.92

But, equity holders may not like this and would rather not lose value of 4.44

rease in value 2.92 debt holders gain 7, equity holders lose 4

h. 16, problem 24

you own 100% of the firm’s equity, and the firm has no debt. To raise the $30 million solely through
t least a 50% equity stake in the firm to retain control.

he remaining $10 million? (Assume perfect capital markets.)

Firm Value 15

New Equity Total 25 firm value plus 10 million raised

Fraction to Sell 40% 10 million raised by new equity

g up control? (Assume perfect capital markets.)

h. 16, problem 26

ce the value of the firm’s assets by $10 million. The CEO is likely to proceed with this decision unless it substantially increases th
7% 3%
115 125
45 55

the probability of bankruptcy by what percentage?

the decision?

he debt. Probability is within 3% change (26-28)

h. 16, problem 30

o as to preserve their control of the firm. On the one hand, debt is costly for managers because they risk
vantage of the tax shield provided by debt, they risk losing control through a hostile takeover.

ount rate for these cash flows is 10%. The firm pays a tax rate of 40%. A raider is poised to take over the
me free cash flows, and the takeover attempt will be successful if the raider can offer a premium of 20%
entrenchment hypothesis, what level of permanent debt will the firm choose?

Tax Shield = Corp Tax * Debts

to high cost of research until medicine passes trials.
nless it substantially increases the firm’s risk of bankruptcy.
 Problem 1

Consider the example of Avco, Inc., evaluating a new investment project. The investment project has identical risk to a publicly
covariance with the market portfolio than Avco, but has the same D/E ratio and cost of debt as Avco. The project will have sales
a rate of 5% for 4 years, and then remain constant at the same level for an additional 3 years, for a total project life span of 8 y
million and $9 million the first year, and will remain a constant fraction of sales throughout the life of the project. Upfront R&D
necessary investment in equipment of $30 million is depreciated via the straight-line method over the life of the project. The pr
identical to Avco’s capital structure excluding the project. The tax rate is 40%, and there is no net working capital. The risk free
portfolio is 9%.Without the project, Avco has a cost of capital of 6% for debt and 10% for equity.

Question a: What are the sales, gross profit, EBIT, unlevered net income and free cash flow throughout the life of the pr

Million $ Year 0 1 2 3
Sales $ 60.00 $ 63.00 $ 66.15
Costs of goods sold $ (25.00) $ (26.25) $ (27.56)
Costs / Sales Ratio $ 0.42 $ 0.42 $ 0.42
Gross Profit $ 35.00 $ 36.75 $ 38.59
Operating Expenses $ (10.00) $ (9.00) $ (9.45) $ (9.92)
OE / Sales Ratio $ 0.15 $ 0.15 $ 0.15
Depreciation $ (3.75) $ (3.75) $ (3.75)
EBIT $ (10.00) $ 22.25 $ 23.55 $ 24.92
Income Tax at 40% $ 4.00 $ (8.90) $ (9.42) $ (9.97)
Unlevered Net Income $ (6.00) $ 13.35 $ 14.13 $ 14.95

Free Cash Flows

Plus: Depreciation $ 3.75 $ 3.75 $ 3.75
Less: Capital Expenditures $ (30.00)
Less: Increases in NWC
Free Cash Flow(FCF) $ (36.00) $ 17.10 $ 17.88 $ 18.70

Question b: What is the WACC for the project?

0 1 2 3
Free Cash Flow(FCF) $ -36.00 $ 17.10 $ 17.88 $ 18.70

Equity Beta Initial 1.20 1. find beta

Equity Beta Prject 1.44 2. find beta project
r(E) Project 11.20% 3. find return on project
WACC 7.40% 4. find return on WACC
Question c: What is the PV of the free cash flows of the project starting from year 1 and onwards? What is the NPV of th
0 1 2 3
Free Cash Flow(FCF) $ (36.00) $ 17.10 $ 17.88 $ 18.70
Discounted @ 9% $ (36.00) $ 15.92 $ 15.50 $ 15.09

NPV $ 76.84

Question d: What is the project's levered continuation value throughout the life of the project? Calculate the levered con
continuation value and free cash flow
0 1 2 3
Free Cash Flow(FCF) $ (36.00) $ 17.10 $ 17.88 $ 18.70
Levered Value $ 112.84 $ 104.09 $ 93.92 $ 82.17
r(waac) 7.4%

Project Levered Value $ 570.86

Question e: Find the debt capacity throughout the life of the project.
0 1 2 3
Free Cash Flow(FCF) $ (36.00) $ 17.10 $ 17.88 $ 18.70
d = 50%
D(t) $ 56.42 $ 52.05 $ 46.96 $ 41.08

Levered Value
Debt must increase $ 285.43
Question f: What is the net borrowing throughout the life of the project?

Net Borrowing $ (4.37) $ (5.09) $ (5.87)

Question g: What fraction of the value of the project stems from tax shields?

Tax Shield / V(L) 6.65%

Adjusted Present Value Method

Unlevered Cost of Capital 8.0%
Value w/o leverage $ 74.20 value is lower bc we need to add in tax benefits

Debts $ 3.39 $ 3.12 $ 2.82

Tax Shield $ 1.35 $ 1.25 $ 1.13
Discounted $ 1.25 $ 1.07 $ 0.89
PV tax shield $ 5.29
Leveraged Value $ 79.49

Question h: Calculate the free cash flow to equity and its present value.

Free Cash Flow(FCF) $ (36.00) $ 17.10 $ 17.88 $ 18.70 $ 19.56

After Tax Expense $ - $ (2.03) $ (1.87) $ (1.69) $ (1.48)
Net Borrowing $ - $ (4.37) $ (5.09) $ (5.87) $ (6.74)
FCFE $ (36.00) $ 10.69 $ 10.92 $ 11.13 $ 11.34
PV FCFE $ (36.00) $ 9.62 $ 8.83 $ 8.10 $ 7.42
NPV $ 20.42

Chapter 18, Problem 2

Suppose Caterpillar, Inc., has 666 million shares outstanding with a share price of $73.09 and $24.41 billion in debt. If in
$86.62 per share, how much debt will Caterpillar have if it maintains a constant debt-equity ratio?

# Initial Shares 666 Million Equity $ 48,677.94

Initial Price / Share $ 73.09
Initial Debt $ 2,441.00 Million D/E 0.0501459183

After three years

# Shares 709 Million Equity $ 61,413.58
Price per share $ 86.62
Debt $ 3,079.64
 Chapter 18, Prob

In 2015, Intel Corporation had a market capitalization of $134 billion, debt of $13.2 billion, cash of $13.8 billion, and EB
repurchase, which market imperfections would be most relevant for understanding the consequence for Intel's value? W

2015 This might be a negative signa

Market Cap 134 Billion Cash is best, then debt, then ra
Debt 13.2 Billion
Cash 13.8 Billion Risk increases when you add d
EBIT 16 Billion Tax Shield increases when you
Shares are undervalued, so the
Investors say that taking on de
Taking on more debt than cash
Interest rate 6%
Interest on debt 0.792
debt/EBIT 0.0495 TESTS
new interest on debt 7.92
New debt/EBIT 0.495
Chapter 18, Problem 4

Backcountry Adventures is a Colorado-based outdoor travel agent that operates a series of winter backcountry huts.
million. But profits will depend on the amount of snowfall: If it is a good year, the firm will be worth $5 million, and i
managers always keep the debt to equity ratio of the firm at 25%, and the debt is riskless.

Question a: What is the initial amount of debt?

Initial Firm Value $ 3.50 Million Good Bad

D/E Ratio 25% 5 2.5

D/E 1:4 Debt $ 0.70 million

D/(D+E) 1:5 Equity $ 2.80

Question b: Calculate the percentage change in the value of the firm, its equity and debt once the level of snowfall is rev
its target debt to equity ratio.
NEW VALUES Firm Value Value % Debt % Equity %
Good State 5 42.86% 0.00% 53.57%
Bad State 2.5 -28.57% 0.00% -35.71%

Question c: Calculate the percentage change in the value of outstanding debt once the firm adjusts to its target debt to e

Firm Value Equity Value Debt Value D/V Ratio D/E Ratio
Good State $ 5.00 $ 4.00 $ 1.00 20.00% 25.00%
Bad State $ 2.50 $ 2.00 $ 0.50 20.00% 25.00%

Δ Firm Value (%)Δ Equity Value (%)Δ Debt Value (%)

Good State 42.86% 42.86% 42.86%
Bad State -28.57% -28.57% -28.57%

Question d: What does this imply about the riskiness of the firm's tax shields? Explain.

Because the debt is riskless, the only risk to the tax shields is the amount of outstanding debt. This risk is identical to
shields are identical to the riskiness of the firm as a whole.

Debt is riskless, so the firm's tax shields change with the firm's level of debt. Risk of Tax Shield is equal to risk of firm

Chapter 18, Problem 12

In year 1, AMC will earn $2100 before interest and taxes. The market expects these earnings to grow at a rate of 2.7% per year
depreciation) or changes to net working capital. Assume that the corporate tax rate equals 42%. Right now, the firm has $5250
so that on average the debt will grow by 2.7% per year. Suppose the risk-free rate equals 4.5%, and the expected return on the
In year 1, AMC will earn $2100 before interest and taxes. The market expects these earnings to grow at a rate of 2.7% per year
depreciation) or changes to net working capital. Assume that the corporate tax rate equals 42%. Right now, the firm has $5250
so that on average the debt will grow by 2.7% per year. Suppose the risk-free rate equals 4.5%, and the expected return on the

Question a: If AMC were an all-equity (unlevered) firm, what would its market value be?

EBIT $ 2,100.00
Corporate Tax Rate 42.00% UNLEVERED FCF = EBIT * (1-T(c))
Risk-free rate 4.50%
Industry Asset Beta 1.27
Growth Rate of Unlevered 2.70%
Market Rate 9.90%

CAPM 11.36% CAPM is unlevered cost of cap

Question b: Assuming the debt is fairly priced, what is the amount of interest AMC will pay next year? If AMC's debt is
expected to grow?

Debt Currently $ 5,250.00

Interest $ 236.25
New Debt $ 5,391.75
New Interest $ 242.63
Interest grows @ 2.7% The same rate?
Question c: Even though AMC's debt is riskless (the firm will not default), the future growth of AMC's debt is uncertain
future interest payments have the same beta as AMC's assets, what is the present value of AMC's interest tax shield?

Debt Currently $ 5,250.00

Interest $ 236.25

Interest Tax Shield $ 99.23

PV of growing perpetuity $ 1,146.05

Question d: Using the APV method, what is AMC's total market value, V(L)? What is the market value of AMC's equity
V(U) + ITS $ 1,146.05 How to get total market value???
Total Mkt Value $ 15,213.96
Total Equity Value (-debt) $ 9,963.96

Question e: What is AMC's WACC? (Hint: Work backward from the FCF and V(L))

g 2.70% P0 = FCF / (WACC + g)

r(WACC) = (FCF/P0) + g
r(WACC) = 10.71%

Question f: Using the WACC, what is the expected return for AMC equity?

Redo the formula

Re = (WACC - (D/V)*r(D)*(1-tC)) / (E/V)

return on equity 14.97%

Question g: Show that the stated relation holds for AMC.

Equity Beta 1.94 Debt Beta is ignored, rearrange formula for Beta Equity

Asset Beta 1.27 Beat Debt is ignored, calculate

Question h: Assuming that the proceeds from any increases in debt are paid out to equity holders, what cash flows do th
flows expected to grow? Use that information plus your answer to part (f) to derive the market value of equity using the

The will receive growth rate of debt * current year's debt * return on debt
2.7%!

Debt year 0 $ 5,250.00

Debt year 1 $ 5,391.75
Increase in Interest $ 141.75

FCFE $ 1,222.73 EBIT - Interest - taxes + debt proceeds

Growing Perpetuity formula $ 9,963.96

Chapter 18, Problem 14

Amarindo, Inc. (AMR), is a newly public firm with 10.5 million shares outstanding. You are doing valuation analysis of AMR. You
expect the firm's free cash flow to grow by 4.4% per year is subsequent years. Because the firm has only been listed on the stoc
equity beta. However, you do have beta data for UAL, another firm in the same industry:

Equity Beta Debt Beta D/E Ratio

UAL 1.80 0.36 1.20

AMR has a much lower debt-equity ratio of 0.36, which is expected to remain stable, and its debt is risk-free. AMR's corporate t
market portfolio is 11.3%.

Question a: Estimate AMR's equity cost of capital

Equity CoC Debt CoC
D/E Ratio UAL 1.20 15.94% 7.59%
D/E Ratio AMR 0.36
Risk-Free Rate 5.50%
Expected Market Return 11.30%

B(U) UAL 1.0145

r(U) UAL, CAPM 11.38%

r(E) AMR 13.50%

r(D) AMR 5.50%

r(WACC) 11.02% Calculate using levered WACC formula

Question b: Estimate AMR's share price

Corporate Tax Rate 25.00%

Growth Rate of FCF 4.40%
Shares Outstanding 10.5 Million
Free Cash Flow y 1 15.37

Value $ 232.18

Equity Value AMR $ 171.81 Must calculate E/V ratio * Value$

Value / shares $ 16.36

m1

as identical risk to a publicly traded firm whose return on equity has a 20% higher
o. The project will have sales of $60 million the first year, after which the sales will grow by
a total project life span of 8 years. Manufacturing costs and operating expenses are $25
of the project. Upfront R&D expenses of $10 million is immediately tax deductible, while
the life of the project. The project will be financed with equal amounts of debt and equity,
orking capital. The risk free interest rate is 4% and the expected return on the market

Beta
Manufacturing Fraction
Operating Exp Fraction
D/E
Tax Rate
hroughout the life of the project? Risk-free Rate
Market Premium
4 5 6 7 8 Debt CoC
$ 69.46 $ 72.93 $ 72.93 $ 72.93 $ 72.93 Equity CoC
$ (28.94) $ (30.39) $ (30.39) $ (30.39) $ (30.39)
$ 0.42 $ 0.42 $ 0.42 $ 0.42 $ 0.42
$ 40.52 $ 42.54 $ 42.54 $ 42.54 $ 42.54
$ (10.42) $ (10.94) $ (10.94) $ (10.94) $ (10.94)
$ 0.15 $ 0.15 $ 0.15 $ 0.15 $ 0.15
$ (3.75) $ (3.75) $ (3.75) $ (3.75) $ (3.75)
$ 26.35 $ 27.85 $ 27.85 $ 27.85 $ 27.85
$ (10.54) $ (11.14) $ (11.14) $ (11.14) $ (11.14)
$ 15.81 $ 16.71 $ 16.71 $ 16.71 $ 16.71

$ 3.75 $ 3.75 $ 3.75 $ 3.75 $ 3.75

is this right?
$ 19.56 $ 20.46 $ 20.46 $ 20.46 $ 20.46

4 5 6 7 8
$ 19.56 $ 20.46 $ 20.46 $ 20.46 $ 20.46

Beta initial (r(E) -r(f)) / (E(r) - r(f))

Beta Project
r(E) Project
r(WACC)
 CAPM

ards? What is the NPV of the project?

4 5 6 7 8
$ 19.56 $ 20.46 $ 20.46 $ 20.46 $ 20.46
$ 14.70 $ 14.32 $ 13.33 $ 12.41 $ 11.56

? Calculate the levered continuation value as the discounted sum of the next period's

4 5 6 7 8
$ 19.56 $ 20.46 $ 20.46 $ 20.46 $ 20.46 Levered Value = (FCF + V(L))
$ 68.69 $ 53.31 $ 36.79 $ 19.05 $ - USE EQUATION 18.4

4 5 6 7 8
$ 19.56 $ 20.46 $ 20.46 $ 20.46 $ 20.46

$ 34.34 $ 26.65 $ 18.40 $ 9.53 $ -

$ (6.74) $ (7.69) $ (8.26) $ (8.87) $ (9.53)

 in tax benefits
Unlevered CoC is lower than equity CoC (risk from leverage) and higher than WACC (a
$ 2.46 $ 2.06 $ 1.60 $ 1.10 $ 0.57
$ 0.99 $ 0.82 $ 0.64 $ 0.44 $ 0.23
$ 0.72 $ 0.56 $ 0.40 $ 0.26 $ 0.12

$ 20.46 $ 20.46 $ 20.46 $ 20.46

$ (1.24) $ (0.96) $ (0.66) $ (0.34)
$ (7.69) $ (8.26) $ (8.87) $ (9.53)
$ 11.54 $ 11.24 $ 10.93 $ 10.59
$ 6.78 $ 5.95 $ 5.20 $ 4.53

r 18, Problem 2

$24.41 billion in debt. If in three years, Caterpillar has 709 million shares outstanding trading for
ratio?

Million
 Chapter 18, Problem 3

ash of $13.8 billion, and EBIT of nearly $16 billion. If intel were to increase debt by $1 billion and use the cash for a share
quence for Intel's value? Why?

might be a negative signal to investors that they need cash or need control of their company. Increasing debt is usually a good s
h is best, then debt, then raising equity.

increases when you add debt

Shield increases when you add debt.
es are undervalued, so the company wants to purchase shares while it is a 'good deal'
stors say that taking on debt is good because bank would not give money if you couldn't repay.
ng on more debt than cash you have to repay is a very good signal (signalling)

roblem 4

winter backcountry huts. Currently, the value of the firm(debt+equity) is $3.5

be worth $5 million, and if it is a bad year it will be worth $2.5 million. Suppose

the level of snowfall is revealed, but before the firm adjusts the debt level to achieve
djusts to its target debt to equity ratio.

𝚫�=(�_𝟏−�_𝟎)/�_𝟎
𝚫�=(�_𝟏−�_𝟎)/�_𝟎
𝚫�=(�_𝟏−�_𝟎)/�_𝟎

ebt. This risk is identical to the risk of the firm as a whole, so the riskiness of the tax

ield is equal to risk of firm.

18, Problem 12

w at a rate of 2.7% per year. The firm will make no net investments (i.e. capital expenditures will equal
ight now, the firm has $5250 in risk-free debt. It plans to keep a constant ratio of debt to equity every year,
d the expected return on the market equals 9.9%. The asset beta for this industry is 1.27.
 Unlevered FCF $ 1,218.00

PV Perpetuity $ 14,067.91 Total Mkt Value

M is unlevered cost of capital

Use APV when capital structure changes.

Use WACC when capital structure is constant
next year? If AMC's debt is expected to grow by 2.7% per year, at what rate are its interest payments

of AMC's debt is uncertain, so the exact amount of the future interest payment is risky. Assuming the
MC's interest tax shield?

rket value of AMC's equity?

ormula for Beta Equity
ders, what cash flows do the equity holders expect to receive in one year? At what rate are those cash
et value of equity using the FTE method. How does that compare to your answer in (d)?

FCFE Method

18, Problem 14

luation analysis of AMR. You estimate its free cash flow in the coming year to be $15.37 million, and you
s only been listed on the stock exchange for a short time, you do not have an accurate assessment of AMR's

AMR equity beta?

s risk-free. AMR's corporate tax rate is 25%, the risk-free rate is 5.5%, and the expected return on the

CAPM, equity CoC risk-free + Beta * mkt premium

Debt CoC Yield to maturity * (1 - marginal tax)
1. CoC of peers
2. De-leverage CoC by calculating CoC if they had no debt
3. Calculate weighted average
4. Re-lever CoC with debt-ratio d = D:V ratio

D/V = (D/E) / 1+(D/E)

 1.2
nufacturing Fraction -42%
erating Exp Fraction -15%
1
40%
4%
rket Premium 9%
6%
10%
ered Value = (FCF + V(L))t+1 / (1+wacc)
E EQUATION 18.4
and higher than WACC (adds tax benefits)
cash for a share

g debt is usually a good signal that they can deal with the issue.
CAPM
 Ch. 20, probl

The common stock of the P.U.T.T Corporation has been trading in a narrow range for the past month, and you are convinced it
however. The current price of the stock is $100 per share, and the price of a 3-month call option at an exercise price of $100 is

Question 1: What is the price of a 3-month put option with exercise price $100 (risk freee rate is 10%)

C 10
S 100
X 100
risk free 0.1
T 0.25

Formula 21.2 $ 7.53 per share, or $753 for 100 shares

7.6454089676

The difference between the two is due to rounding error from the exponential formula within excel

Question 2: What would be a simple options strategy to exploit your belief about the future stock price movement, and w

A good strategy is to purchase a put option AND a call option to create a short term hedge or protection against losses.
Because it is a out option, the price should decrease for the value of the option to increase.

*strattle*

Ch. 20, proble

An investor purchases a stock for $38 and a put for $0.50 with a strike price of $35. The investor sells a call for $0.50 with a st

Question 1: What is the maximum profit and loss for this position?

Stock $ $ 38.00 Buy Stock

Put Option $ 0.50 Buy Stock Price 38
Strike Price $ 35.00 30 -8
Call Option $ 0.50 Sell 31 -7
Strike Price $ 40.00 32 -6
 33 -5
34 -4
MAX PROFIT $ 2.00 35 -3
MAX LOSS $ 3.00 36 -2
37 -1
38 0
39 1
40 2
41 3
42 4
43 5
44 6
45 7

Question 2: Draw the profit and loss diagram for this strategy as a function of the stock price at expiration.

Chart Title
3

0
28 30 32 34 36 38
-1

-2

-3

-4

Ch. 20, proble

In this problem, we derive the put-call parity relationship for European options on stocks that pay dividends before option expir
the option.

Question 1: What is the value of a stock-plus-put position on the expiration date of the option?

(Change in Stock $) + MAX(X - Stock $, 0) - ($ of Put)

 Profit is infinite, but losses are cut-off at the put premium.
This is called 'Hedgeding'

Question 2: Now consider a portfolio comprising a call option and a zero-coupon bond with the same maturity date as th
should find that its value equals that of the stock-plus-put portfolio regardsless of the stock price.

Question 3: What is the cost of establishing the two portfolios in Q1 and Q2? Derive the put-call parity relation by equa

Stock + Put Cost S+P

Bond + call Cost C + PV(X+D)

Put Call Parity S + P = C + PV(X + D)

Ch. 20, proble

Question 1: A butterfly spread is the purchase of one call at exercise price X1, the sale of two calls at exercise price X2, a
amount, and the calls have the same expiration date. Graph the payoff diagram to this strategy.

Price Buy Call X1 Sell 2 Calls X2 Buy Call X3

100 110 120 SUM

0 0 30 0 30
10 0 30 0 30
20 0 30 0 30
30 0 30 0 30
40 0 30 0 30
50 0 30 0 30
60 0 30 0 30
70 0 30 0 30
80 0 30 0 30
90 0 30 0 30
100 0 30 0 30
110 10 30 0 40
120 20 10 0 30
130 30 -10 10 30
140 40 -30 20 30
150 50 -50 30 30
160 60 -70 40 30
170 70 -90 50 30

Question 2: A vertical combination is the purchase of a call with exercise price X2 and a put with exercise price X1, with

Price Buy Put X1 Buy Call X2

100 110 SUM

0 100 0 100
10 90 0 90
20 80 0 80
30 70 0 70
40 60 0 60
50 50 0 50
60 40 0 40
70 30 0 30
 80 20 0 20
90 10 0 10
100 0 0 0
110 0 0 0
120 0 10 10
130 0 20 20
140 0 30 30
150 0 40 40
160 0 50 50
170 0 60 60

Ch. 20, proble

A bearish spread is the purchase of a call with exercise X2 and the sale of a call with exercise price X1, with X2 greater than X1

Price Sell Call X1 Buy Call X2

100 110 SUM

0 15 0 15
10 15 0 15
20 15 0 15
30 15 0 15
40 15 0 15
50 15 0 15
60 15 0 15
70 15 0 15
80 15 0 15
90 15 0 15
100 15 0 15
110 5 0 5
120 -5 10 5
130 -15 20 5
140 -25 30 5
150 -35 40 5
160 -45 50 5
170 -55 60 5

Ch. 20, proble

An executive compensation scheme might provide a manager a bonus of $1,000 for every dollar by which the company's stock p
the firms stock?
 A call option is not excercised until the stock price exceeds a certain price (exercise price). After it pa
The manager also recieves a bonus proportional to the degree of her success.

Ch. 20, proble

Assume a stock has a value of $100. The stock is expected to pay a dividend of $2 per share at year-end. An at-the-money Europ
a 1-year at-the-money European call option on the stock?

S 100
X 100
D 2
P 7
r 0.05

Call Value Rearrange Formula $ 9.86 P + S - PVx - PVd

Ch. 21, probl

All else equal, is a call option on a stock with a lot of firm-specific risk worth more than one on a stock with little firm-specific
The Value equation for a call equation does not directly relate to the firm specific risk

I would say it is easier to predict the movement of the market because you have more data and less volatility.

If a firm has more risk, then it has a greater probability for reward.
A call option cannot lose more than the amount you spent to purchase it.
So, the upside is GREATER if there is more risk.

YES, it should be worth more.

Ch. 21, probl

We will derive a two-state put option value in this problem. S0 = 100; X = 110; 1+r = 1.10. S can be either 130 or 80.

Question 1: Show that the range of S is 50, whereas that of P is 30 across the two states. What is the hedge ratio of the pu

1+r 1.1 130

S0 100 100
uS0 130 80
dS0 80
X 110 0
??? X
S range 50 30
P is a Put 30

H - 3/5

Question 2: Form a portfolio of three shares of stock and five puts. What is the (nonrandom) payoff to this portfolio?
 S = 80 S = 130
3 shares 240 390
5 Puts 150 0

Total 390 390

Question 3: What is the PV of the portfolio?

Discounted 354.54545455

Question 4: Given that the stock is currently selling at 100, solve for the value of the put.

3S + 5P = 300 + 5P
300 + 5P = 354.55
5P = 54.55
P = 10.91

Ch. 21, proble

Use the Black-Scholes formula to find the value of a call option on the following stock

Time to expiration 0.5 years

Standard deviation 0.5 per year
variance 0.25 =.5^2
Exercise price 50 $
Stock price 50 $
Interest rate 0.03 per year
Dividend 0

d1 0.2192031022
d2 -0.1343502884
C 7.3419869851

N(d1) 0.5867540805
N(d2) 0.4465627946

Ch. 21, proble

Find the value of a put option on the stock in Problem 11 with the same exercise price and expiration as the call option.

Time to expiration 0.5

Standard deviation 0.5
Exercise price 50
Stock price 50
Interest rate 0.03
Dividend 0

d1 0.2192031022
d2 -0.1343502884
C 7.3419869851

Formula 21.3 6.5975839653

OR! Use the Put-Call Parity

Value based on the Put-Call theorem

Formula 21.2 6.5975839653
 Ch. 21, proble

Recalculate the value of the call option in Problem 11, successively substituting one of the changes below while keeping the oth

Time to expiration 3 months

Standard deviation 0.25 per year
Exercise price 55 $
Stock price 55 $
Interest rate 0.05 per year

Initial Calculation
Time to expiration 6
Standard deviation 0.5
Exercise price 50
Stock price 50
Interest rate 0.03
Dividend 0

Time to expiration
Time to expiration 3
Standard deviation 0.5
Exercise price 50
Stock price 50
Interest rate 0.03
Dividend 0

Standard deviation
Time to expiration 6
Standard deviation 0.25
Exercise price 50
Stock price 50
Interest rate 0.03
Dividend 0

Exercise price
Time to expiration 6
Standard deviation 0.5
Exercise price 55
Stock price 50
Interest rate 0.03
Dividend 0

Stock price
Time to expiration 6
Standard deviation 0.5
Exercise price 50
Stock price 55
Interest rate 0.03
Dividend 0

Interest rate
Time to expiration 6
Standard deviation 0.5
Exercise price 50
Stock price 50
Interest rate 0.05

Ch. 21, proble

You would like to be holding a protective put position on the stock XYZ Co. to lock in a guaranteed minimum value of $100 at y
The T-bill rate is 5%. Unfortunately, no put options are traded on XYZ Co.
You would like to be holding a protective put position on the stock XYZ Co. to lock in a guaranteed minimum value of $100 at y
The T-bill rate is 5%. Unfortunately, no put options are traded on XYZ Co.

Question 1: Supposed the desired put option were traded. How much would it cost to purchase?

1+r 1.05
S0 100 Put
uS0 110
dS0 90
X 100

P=

H -0.5

Shares purchased 1
Puts purchased 2

S=90 S=110
1 SHARE 90 110
2 PUTS 20 0

Total 110 110 PV 104.7619047619

1S + 2P = 100 + 2P
2.380952381

Question 2: What would have been the cost of the protective put portfolio?

Protective Put Portfolio is 1 put + 1 share

1 Share 100
1 Put 2.380952381
SUM 102.38095238

Question 3: What portfolio position in stock and T-bills will ensure you a payoff equal to the payoff that would be provid
Show that the payoff to this portfolio and the cost of establishing the portfolio match those of the desired protective put.
Payoff of Protective Put with X = 100

S = 90 S = 110 2 stocks
PP 100 110 x tbills

110*N + FV = 110
90 * N + FV = 100 Multiply by -1

110*N + FV = 110
N*-90 - FV = -100
Cut out FV
20*N = 10
N = .5

.5 * 90 + FV = 100
45+FV = 100
FV = 55
52.380952381

Ch. 21, proble

XYZ Corp. will pay a $2 per share dividend in two months. Its stock price currently is $60 per share. A call option on XYZ has a
stock's volatility (standard deviation) = 7% per month. Find the Black-Scholes value of the option. (Hint: Try defining one "per

Time to expiration 2
Standard deviation 0.07
Exercise price 55
Stock price 60
Interest rate 0.005
Dividend 0
 Ch. 20, problem 7

ast month, and you are convinced it is going to break far out of that range in the next three months. You do not know whether it will go up o
ption at an exercise price of $100 is $10.

eee rate is 10%)

Use 'EXP()' for 'e' where the exponent goes inside the parentheses.

tial formula within excel

uture stock price movement, and what price movemenvt is necessary for it to become profitable?

r protection against losses.

Ch. 20, problem 10

estor sells a call for $0.50 with a strike price of $40.

Put Option Call Option Put Cost Call Cost SUM

35 40 -0.5 0.5
5 0 -3
4 0 -3
3 0 -3
 2 0 -3
1 0 -3
0 0 -3
0 0 -2
0 0 -1
0 0 0
0 0 1
0 0 2
0 -1 2
0 -2 2
0 -3 2
0 -4 2
0 -5 2

ck price at expiration.

Chart Title
I lose more money if the stock pri

36 38 40 42 44 46

Ch. 20, problem 12

at pay dividends before option expiration. For simplicity, assume that the stock makes one dividendp payment of $D per share at the expira

option?

Stock Price 1 100

Put X 100
Put cost 20
 Price @ expiration 1 150
Price @ expiration 2 70

Value 1 30
Value 2 -20

with the same maturity date as the option and with face value (X+D). What is the value of this portfolio on the option expiration da
stock price.

he put-call parity relation by equating these costs.

Buying a Call = S - X

Writing a Call = -1 * (S - X)

Ch. 20, problem 13

of two calls at exercise price X2, and the purchase of one call at exercise price X3. X1 is less than X2, and X2 is less than X3 by the s
strategy.

80

60

40

20

0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 17

-20

-40

-60

-80

-100

a put with exercise price X1, with X2 greater than X1. Graph the payoff to this strategy.

Chart Title
120

100

80

x1
Axis Title

60 x2
s um

40
 80

x1

Axis Title
60 x2
s um

40

20

0
0 20 40 60 80 100 120 140 160 180

Axis Title

Ch. 20, problem 14

se price X1, with X2 greater than X1. Graph the payoff to thsis trategy and compare it to Figure 20.10.

Chart Title
80

60

40

20
X1
Axis Title

0 X2
0 20 40 60 80 100 120 140 160 180 SUM

-20

-40

-60

-80

Axis Title

This is a bearish spread, a bullish spread would be reveresed in value such that the payoff is 5 until unti

Ch. 20, problem 19

ollar by which the company's stock price exceeds some cutoff level. In what way is this arrangement equivalent to issuing the manager a cal
 price (exercise price). After it passes the cutoff, the holder of the call recieves profit that is proportional to the change in price.

Ch. 20, problem 23

at year-end. An at-the-money European-style put option with one-year maturity sells for $7. If the annual interest rate is 5%, what must be

S - PVx - PVd

Ch. 21, problem 4

e on a stock with little firm-specific risk? The betas of the stocks are equal.
nd less volatility.

Ch. 21, problem 9

. S can be either 130 or 80.

. What is the hedge ratio of the put?

ndom) payoff to this portfolio?

ut.

Ch. 21, problem 11

 Ch. 21, problem 12

xpiration as the call option.

Value of a European Put Option

 Ch. 21, problem 13

hanges below while keeping the other parameters as in Problem 11.

 Ch. 21, problem 32

ranteed minimum value of $100 at year-end. XYZ currently sells for $100. Over the next year the stock price will increase by 10% or decrea
purchase?

10

to the payoff that would be provided by a protective put with X=100?

hose of the desired protective put.
 Ch. 21, problem 39

er share. A call option on XYZ has an exercise price of $55 and 3-month time to expiration. The risk-free interest rate is 0.5% per month, an
option. (Hint: Try defining one "period"as a month, rather than as a year, andthink about the net-of-dividend value of each share.)
 KEY EQUATIONS
t know whether it will go up or down,
se more money if the stock price decreases than if the stock price increases

of $D per share at the expiration date of

o on the option expiration date? You
nd X2 is less than X3 by the same

X1
130 140 150 160 170 X2
X3
SUM

x1
x2
s um
 x1
x2
s um

160 180

X1
X2
160 180 SUM

that the payoff is 5 until until the strick price and then it becomes 15

nt to issuing the manager a call option on

onal to the change in price.

erest rate is 5%, what must be the price of

will increase by 10% or decrease by 10%.
rest rate is 0.5% per month, and the
value of each share.)
Y EQUATIONS