Pamela Peterson Drake Investments and Financial Managment Resources PDF

Pamela Peterson Drake Page 1 of 1
Sites - http://educ.jmu.edu/~drakepp/sites.htm
Learning Resources - http://educ.jmu.edu/~drakepp/general/index.html
Instructional: Investments - http://educ.jmu.edu/~drakepp/investments/index.html
Instructional: Principles of Financial Management - http://educ.jmu.edu/~drakepp/principles/index.html
Regression - http://educ.jmu.edu/~drakepp/statistics/index.html
Value Added Measures - http://educ.jmu.edu/~drakepp/value/index.html
http://educ.jmu.edu/~drakepp/ 2/28/2011
Pamela Peterson Drake Page 1 of 1
Department Head and J. Gray Ferguson Professor of

Finance
Department of Finance and Business Law
James Madison University
ADDRESS ZSH335 / MSC PHONE 540.568.6530

0203 EMAIL drakepp@jmu.edu
James Madison FAX 540.568.3017
University
College of
Business
Harrisonburg,
Virginia 22802
BIOGRAPHY
Professor Pamela Peterson Drake, Ph.D. CFA, is the J. Gray Ferguson

Professor of Finance and Department Head, Department of Finance and
Business Law in the College of Business at James Madison University. She
received her Ph.D. in finance from the University of North Carolina at Chapel
Hill and her B.S. in Accountancy from Miami University. Professor Drake
previously taught at Florida State University and Florida Atlantic University.
drakepp mailto: drakepp@jmu.edu
Resume: http://educ.jmu.edu/~drakepp/resume.pdf
http://educ.jmu.edu/~drakepp/content.htm 2/27/2011
Pamela Peterson Drake
Contact information
Office ZSH335 / MSC 0203
address Department of Finance and Business Law
College of Business
Harrisonburg, Virginia 22802
Internet e-mail: drakepp@jmu.edu
Home page: peregrin.jmu.edu/~drakepp/
Phone Office 540.568.6530
FAX 540.568.3017
Education
1992 Chartered Financial Analyst® Institute of Chartered Financial Analysts
1981 Ph.D. Business Administration University of North Carolina

Chapel Hill, North Carolina
Area of Concentration: Finance
1975 B.S. Business Administration Miami University, Oxford, Ohio

Major: Accountancy
Experience
July 2007 to the present
J. Gray Ferguson Professor and Department of Finance and Business Law
Department Head College of Business, James Madison University
December 2004 to June 2007

Associate Dean and Professor College of Business, Florida Atlantic University
August 1991 to December 2004

Professor Department of Finance
College of Business, Florida State University
August 1986 to July 1991
Associate Professor Department of Finance
August 1981 to July 1986
Assistant Professor Department of Finance
January 1976 to June 1977
Tax Accountant Arthur Andersen & Co., Chicago, Illinois
Research and creative activity
Publications in journals
Academic and practitioner journals
“The Dynamics of Medical Malpractice Insurance: Evidence from 1993 to 2003,” with
Faith Neale and Kevin Eastman. Forthcoming, March 2009, Journal of Risk and
Insurance.
“The Effect of the Gramm-Leach-Bliley Act on the Insurance Industry,” with Faith Neale,
Journal of Economics and Business, Vol. 57, Issue 4, July/August 2005, pp. 317-338.
“Speculative Bubbles and U.S. Markets: An Empirical Analysis,” with Yvette S. Harman,
Corporate Finance Review, Vol. 7, No. 6 (May/June 2003) pp. 25-38.
"The New Science of Finance," with Don Chance. American Scientist, (May-June 1999),
pp. 256-263.
"Using the Web in the Classroom," Journal of Financial and Strategic Decisions (Winter
1999).
"Measuring the Performance of Performance Measures," Investor Relations Quarterly,
Vol. 1, No. 4 (Spring 1998) pp. 15-23.
"The Choice of Capital Instruments," with Larry Wall, Economic Review, Vol. 83, No. 2
(Second quarter 1998), pp. 4-17.
"The Role of Alternative Methodology on the Relation between Portfolio Size and
Diversification," with Kristine Beck and Steven Perfect, Financial Review, Vol. 31, No.
2 (May 1996), pp. 381-406.
"Banks Responses to Binding Regulatory Capital Requirements," with Larry Wall,
Economic Review, Federal Reserve Bank of Atlanta (March/April 1996) pp. 1-17.
"Abnormal Returns and Analysts Earnings Forecast Revisions Associated with the
Publication of Stock Highlights by the Value Line Investment Survey," with David R.
Peterson, Journal of Financial Research, Vol. 18, No. 4 (Winter 1995) pp. 465-478.
"Self-Tender Offers: The Effects of Free Cash Flow, Cash Flow Signalling, and
Measurement of Tobin's q," with Steven B. Perfect and David R. Peterson, Journal of
Banking and Finance, Vol. 19, No. 6 (September 1995) pp. 1005-1023.
"Variance Increases Following Large Stock Distributions: The Role of Changing Bid-Ask
Spreads," with David R. Peterson, Journal of Banking and Finance, Vol. 18, No. 1
(January 1994) pp. 199-206.
"Dutch Auction versus Fixed-Price Self-Tender Offers: Do Firms Overpay in Fixed-Price
Offers," with David R. Peterson, Journal of Financial Research, Vol. 16, No. 1 (Spring
1993), pp. 39-48.
"An Investigation of Market Reaction to the Choice of Accounting Method," with Michael
Sullivan and Stephen Huffman, WIU Journal of Business, Vol. 3 (1992), pp. 89-104.
"A Further Understanding of Stock Distributions: The Case of Reverse Stock Splits," with
David R. Peterson, Journal of Financial Research, Vol. 15, No. 3 (Fall 1992) pp. 189-
205.
Pamela Peterson Drake 2 of 13

Research and creative activity, continued
"The Medium of Exchange in Mergers and Acquisitions," with David R. Peterson, Journal
of Banking and Finance, Vol. 15 (1991), pp. 383-405.
"Valuation Effects of New Capital Issues by Large Bank Holding Companies," with Larry
Wall, Journal of Financial Services Research, Vol. 5 (December 1990), pp. 77-87.
"Two-Stage Acquisitions, Free-Riding, and Corporate Control," with Michael J. Sullivan
and David R. Peterson, Financial Review, Vol. 25 (August 1990), pp. 405-420.
"Profitability of a Trading Strategy Based on Unexpected Earnings," with John Alexander
and Delbert Goff, Financial Analysts Journal, Vol. 45 (July/August 1989) pp. 65-71.
"Event Studies: A Review of Issues and Methodology," Quarterly Journal of Business and
Economics, Vol. 28 (Summer 1989), pp. 36-66.
"Reincorporation: Motives and Shareholder Wealth." Financial Review, (May 1988)
pp.151-160.
"The Adoption of New-Issue Dividend Reinvestment Plans and Shareholder Wealth," with
David R. Peterson and Norman H. Moore, Financial Review, Vol. 22 (May 1987), pp.
221-232.
"On the Relation Between Earnings Changes, Analysts' Forecasts, and Stock Price
Fluctuations," with Gary Benesh, Financial Analysts Journal, (November/December
1986) pp. 29-39.
"Shelf Registrations and Shareholder Wealth: A Comparison of Shelf and Traditional
Equity Offerings," with Norman H. Moore and David R. Peterson, Journal of Finance,
Vol. 41 (June 1986), pp. 451-464.
"The Neglected Stock Anomaly: Further Evidence," with James S. Ang and David R.
Peterson, Review of Business and Economic Research, Vol. 21, No. 2 (Spring 1986)
pp. 44-52.
"Investigations into the Determinants of Risk: A New Look," with James S. Ang and
David R. Peterson, Quarterly Journal of Business and Economics, Vol. 24 (Winter
1985), pp. 3-20.
"Direct Evidence on the Marginal Rate of Taxation on Dividend Income," with David R.
Peterson and James S. Ang, Journal of Financial Economics, Vol. 14 (June 1985), pp.
267-282.
"The Extinguishment of Debt through In-Substance Defeasance," with David R. Peterson
and James S. Ang, Financial Management, Vol. 14 (Spring 1985), pp. 59-67.
"Marginal Tax Rates: Evidence From Nontaxable Corporate Bonds: A Note," with David R.
Peterson and James S. Ang, Journal of Finance, Vol. 40 (March 1985), pp. 327-332.
"The Leasing Puzzle," with James S. Ang, Journal of Finance, Vol. 39 (September 1984),
pp. 1055-1065.
"A Reexamination of the Empirical Relationship between Investment and Financing
Decisions," with Gary A. Benesh, Journal of Financial and Quantitative Analysis, Vol.
18 (December 1983), pp. 439-453.
"The Effect of Changing Expectations upon Stock Returns," with David R. Peterson,
Journal of Financial and Quantitative Analysis, Vol. 17 (December 1982), pp. 799-
813.
"Divergence of Opinion and Return," with David R. Peterson, Journal of Financial
Research, Vol. 5 (Summer 1982), pp. 125-134.
"A Re-Examination of Seemingly Unrelated Regressions Methodology Applied to
Estimation of Financial Relationships," Journal of Financial Research, Vol. 3
(Fall 1980), pp. 297-308.

Published proceedings (refereed)
"An Assessment of the Relation between Stock Distribution Size and the Magnitude of
Stock Price Reaction," with Lin Klein and John Hassell, in Proceedings of the 1994
Southwest Meetings of the American Accounting Association.
"Lingering Questions About Tax Reform," The CATO Journal (Fall 1985), pp. 651-656.
"Financial and Tax Accounting Treatment for Hedging with Financial Futures Contracts,"
with Michael L. Rice, published in proceedings, International Futures Trading
Seminar, Chicago Board of Trade, 1979.
Books, monographs, and related material

Books
Capital Markets, Financial Management, and Investment Management. Frank J. Fabozzi
and Pamela Peterson Drake. John Wiley & Sons, May 2009 [ISBN: 978-0-470-40735-
6].
The Complete CFO Handbook: From Accounting to Accountability, Frank J. Fabozzi,
Pamela Peterson Drake and Ralph S. Polimeni, John Wiley & Sons, November 2007
[ISBN-10: 978-0-470-09926-1].
Analysis of Financial Statements, Pamela Peterson and Frank J. Fabozzi, published by
John Wiley & Sons, February 2006 [ISBN: 0-471-71964-1].
Financial Management and Analysis, Pamela P. Peterson and Frank J. Fabozzi, published
by John Wiley & Sons, July 2003, 1,024 pages [ISBN: 0-471-23484-2]. E-book:
August 2003.
Capital Budgeting, Pamela P. Peterson and Frank J. Fabozzi, published by John Wiley &
Sons, January 2002, 243 pages [ISBN: 0-471-21833-2]. E-book: February 2004.
Analysis of Financial Statements, Frank J. Fabozzi and Pamela Peterson, published by
Frank J. Fabozzi and Associates, March 1999, 286 pages [ISBN: 1-883249-59-7].
Financial Management and Analysis, published by McGraw-Hill Publishing Company,
1994, 931 pages [ISBN: 0-07-049667-6].
Instructor's Manual to Accompany Financial Management and Analysis, published by
McGraw-Hill Publishing Company, 1994.
Solutions Manual to Accompany Financial Management and Analysis, published by
McGraw-Hill Publishing Company, 1994.
Study Guide to Accompany Financial Management and Analysis, with Marianne
Westerman, published by McGraw-Hill Publishing Company, 1994.
Lotus and Excel worksheets to accompany Financial Management and Analysis,
distributed by McGraw-Hill Publishing Company, 1994.
Study Guide to accompany Corporate Finance by Julian R. Franks, John E. Broyles, and
Willard T. Carleton, with David R. Peterson. Kent Publishing Company, Boston
(1985).

Monographs
Real Options and Investment Valuation, with Don M. Chance, a monograph published by
the Association for Investment Management and Research Educational Foundation,
2002 [ISBN: 0-943205-57-3].
Company Performance and Measures of Value Added, with David R. Peterson, a
monograph published by the Association for Investment Management and Research
Educational Foundation, 1996 [ISBN: 0-943205-36-0].
Chapters in books
In Handbook of Finance, (John Wiley & Sons, 2008), Frank J. Fabozzi, editor. Co-
authored with Frank J. Fabozzi:
Chapter II.55, “Introduction to Financial Management and Analysis”
Chapter II.56, “Introduction to International Corporate Financial Management”
Chapter II.57, “Corporate Strategy and Financial Planning”
Chapter II.65, “The Investment Problem and Capital Budgeting”
Chapter II.66, “Estimating Cash Flows of Capital Budgeting”
Chapter II.68, “Capital Budgeting and Risk”
Chapter II.84, “Management of Accounts Receivable”
Chapter II.85, “Inventory Management”
Chapter III.31, “Dividend Discount Models”
Chapter III.53, “Cash-Flow Analysis”
Chapter III.54, “Financial Ratio Analysis”
Chapter III.55, “Mathematics of Finance”
“Cost of Capital,” with Yves Courtois and Gene C. Lai. in Corporate Finance: A Practical
Approach, Michelle R. Clayman, Martin S. Fridson, and George Troughton, editors,
(John Wiley & Sons, CFA Institute) 2008, pp. 127-169.
“Capital Structure and Leverage,” with Raj Aggarawal, Cynthia Harrington, Adam Kobor.
in Corporate Finance: A Practical Approach, Michelle R. Clayman, Martin S. Fridson,
and George Troughton, editors, (John Wiley & Sons, CFA Institute) 2008, pp. 171-
217.
“Working Capital Management,” with Edgar A. Norton and Kenneth L. Parkinson, in
Corporate Finance: A Practical Approach, Michelle R. Clayman, Martin S. Fridson, and
George Troughton, editors, (John Wiley & Sons, CFA Institute) 2008, pp. 263-309.
“Financial Statement Analysis” in Corporate Finance: A Practical Approach, Michelle R.
Clayman, Martin S. Fridson, and George Troughton, editors, (John Wiley & Sons, CFA
Institute) 2008, pp. 311-366.
“Sources of Information for Investing in Common Stock,” with Frank J. Fabozzi, in The
Handbook of Financial Instruments, Frank J. Fabozzi, editor, Wiley Finance, 2002.
“Traditional Fundamental Analysis I: Sources of Information,” with Frank J. Fabozzi, in
The Theory & Practice of Investment Management, Frank J. Fabozzi and Harry M.
Markowitz, editors, John Wiley & Sons, 2002.
“Traditional Fundamental Analysis II: Financial Ratio Analysis,” with Frank J. Fabozzi, in
The Theory & Practice of Investment Management, Frank J. Fabozzi and Harry M.
Markowitz, editors, John Wiley & Sons, 2002.

“Traditional Fundamental Analysis III: Earnings Analysis, Cash Analysis, Dividends, and
Dividend Discount Models,” with Frank J. Fabozzi, in The Theory & Practice of
Investment Management, Frank J. Fabozzi and Harry M. Markowitz, editors, John
Wiley & Sons, 2002.
“Basics of Fundamental Equity Analysis for High-Yield Credit Analysis,” with Frank J.
Fabozzi, in Bond Credit Analysis, Framework and Case Studies, Frank J. Fabozzi,
editor, Frank J. Fabozzi Associates, 2001.
“Value-Based Measures of Performance,” in Value-Based Metrics: Foundations and
Practice, Frank J. Fabozzi and James L. Grant, editors, published by Frank J. Fabozzi
Associates, 2000.
"Event Studies" essay, in The New Palgrave Dictionary of Money and Finance, Peter
Newman, editor, New York: Stockton Press, 1992.
Consulting activity
Consultant, Department of Environmental Regulation, State of Florida, 2001-present;
Project: Financial Assurance Standards for the Phosphate Industry.
Expert witness, Securities and Exchange Commission, SEC vs. Seahawk Deep Ocean
Technology, John C. Morris, Gregory H. Stemm and Daniel S. Bagley (November
1997)
Awards, grants, and fellowships

Research Grant, Research Foundation of the Association for Investment Management and
Research (AIMR), 2000-01. Project entitled "Real Options and Investment Valuation,"
with Don Chance.
College of Business Summer Instructional Grant, Florida State University, 1996
Teaching Award, Teaching Incentive Program, Florida State University, 1995-6
Research Grant, Research Foundation of the Association for Investment Management and
Research (AIMR), 1995-96. Project entitled "Company Performance and Measures of
Value Added," with David R. Peterson
Department of Finance, Florida State University, Faculty Research Grant, Summer 1994.
College of Business Faculty Research Grant, Florida State University: 1984, 1985, 1987,
1989, 1990, and 1993
Advisor of the Year, 1991-92, Florida State University Student Government Leadership
Awards
Developing Scholar Award, Florida State University, 1989-90
Committee on Faculty Research Support (COFRS), Florida State University: 1982 and
1988
McKnight Faculty Development Program Fellowship, McKnight Foundation, 1985-86

Teaching activity
Courses taught at James Madison University

Number Title Level
FIN 360 Money and Capital Markets Undergraduate
FIN 490/362 Financial Analysis Undergraduate
FIN250 Introduction to Quantitative Finance Undergraduate
Courses taught at Florida Atlantic University

Number Title Level Format
FIN 3403 Principles of Finance Undergraduate Online
FIN 4422 Cases in Financial Management Undergraduate Video-conferenced
FIN 4504 Investments Undergraduate Online and traditional
Courses taught at Florida State University

Number Title Level
FIN 3403 Financial Management of the Firm Undergraduate
FIN 4424 Problems in Financial Management Undergraduate
FIN 5515 Investments Masters
FIN 5804 Valuation Theory Masters
FIN 5907 Empirical Research in Finance Doctoral
FIN 5935 Valuation Theory II Doctoral
FIN 6842 Empirical Research Methods Doctoral
QMB 3200 Quantitative Methods in Business Undergraduate
Service on doctoral dissertation committees

Florida Atlantic University
Student Department Date Completed
Surendranath Jory Finance July 2007
Florida State University

Wendy Habegger* Finance March 2005
Faith Neale Insurance August 2004
Karl Lawrence Finance August 2001
Yvette Harman* Finance August 2000
Tommy Carnes Accounting August 1997
Shelly Howton Finance April 1997
Dominic Peltier-Rivest Accounting October 1996
Eric Higgins Finance August 1996
William Ortega Accounting September 1995
Kristine Beck* Finance July 1995
Mitch Conover Finance March 1995

Service on doctoral dissertation committees, Florida State University, continued

Mark Dawkins Accounting October 1994
Eileen Foley Finance September 1993
Tim Louwres Accounting June 1993
Terry Grant Accounting December 1991
John Alexander* Finance August 1991
Delbert Goff Finance March 1991
Stephen Huffman Finance July 1990
Anne Gleason Finance June 1990
Michael Sullivan* Finance December 1988
Linda Klein Finance November 1987
Donald Fehrs Finance August 1987
William Megginson Finance November 1986
Alan Tucker Finance June 1986
Kenneth Jessel Finance April 1985
* Chairperson
Other teaching activity

Faculty training in video-conferencing, Faculty development, Florida Atlantic University.
2006 and 2007.
Course developer and content provider for an online course, MBA593 Investment and
Portfolio Management, Jones University, Summer 2003.
Instructor, Schweser Study Program, 2001-2003. Instruct at Level II in preparing
candidates for the Chartered Financial Analyst (CFA) examination (U.S. and European
locations).
Instructor, The Financial Analyst Review, CFA Examination Review program (Raleigh,
Salt Lake City and Zurich, Switzerland), 1993-2000. Instruct in the areas of financial
statement analysis, quantitative applications, valuation, and equity analysis for the
preparation of candidates for the Chartered Financial Analyst (CFA) examination,
Levels I, II, and III.
Instructor, Introduction to Financial Planning online course (distance learning), Center
for Professional Development, Florida State University, Fall 1997.

Service activity
Service activity: Professional

Professional associations
Member, Council of Examiners, CFA Institute, 2008
Member, Board of Directors, Southern Finance Association, 2004-07
Track Chair for Awards, Financial Management Association meeting, 2006
President, Southern Finance Association, 2004-05
Vice-President of Program, Southern Finance Association, 2004
Member, Professional Development Committee, Association for Investment Management
and Research, 2002-04
Member, Association for Investment Management and Research Continuing Education
Task Force, 1999-02
Education track chair, Eastern Finance Association meeting, 2002
Education track chair, Financial Management Association meetings, 2001 and 2002
Vice-President of Education, Financial Management Association, 2000-02
Chair, Committee on Mentoring, Financial Management Association, 1999
Organizer, Women's Issues Breakfast, Financial Management Association annual
meeting, 1999
Member of the Board of Directors, Southern Finance Association, 1997-9
Vice-President of Membership, Financial Management Association, 1996-97
Vice-President of Awards, Financial Management Association, 1994-95
Member, Doctoral Dissertation Awards Committee, Financial Management Association,
1994
Member, Corporate Finance Paper Award Committee, Financial Management Association
meeting, 1994
Chairperson, Corporate Finance Paper Award Committee, Financial Management
Association meeting, 1993
Member, Board of Directors, Financial Management Association Student Chapters, 1991-
93
Southeast Director, Financial Management Association, 1989-91
Member, Nominating Committee, Financial Management Association Vice-President for
Education, 1990
Member, Nominating Committee, Financial Management Association, 1990-92
Chairperson, Committee on the Quality of Presentations at the Annual Meeting, Financial
Management Association, 1988-89
Member, Long-Range Planning Committee, Financial Management Association, 1987-88
Member, Board of Directors, Eastern Finance Association, 1986-89

Service activity, continued
Program committees
Financial Management Association, 1989-91, 1993-94, 1996-97, 2000-02, 2005-06,
2008
Southern Finance Association, 1990, 1992
Allied Institute for Decision Sciences, 1986
Eastern Finance Association, 1984-89, 2003
Editorships
Associate editor, FMA Online, 2001-present.
Associate editor, Quarterly Journal of Business and Economics, 1991-present
Co-editor, with Dennis Logue and Mike Edleson, Contemporary Finance Digest 1996-
2001
Associate editor, Financial Practice and Education, 1994-2000
Associate editor, Financial Management Collections, 1992-1996
Associate editor, Financial Management, 1993-1996
Associate editor, Financial Review, 1987-1991
Other
Panelist, KPMG PhD Project, Doctoral Student Association conference, 1998, 2002
Presentation to the Jacksonville Financial Analysts Society, “Real Options,” October 2002
Presentation at the University of South Florida, "Value-Based Measures and Stock
Returns," Finance faculty workshop, November 10, 1999
Presentation at the Tampa Bay Financial Analyst Society, "Value-Based Measures," based
on the AIMR prepared presentation, November 9, 1999
Panelist, Interviewing Panel Session, Financial Management Association annual meeting,
1999
Grader, CFA examination, Level II, 1999
Presentation at the Equity Research and Valuation Techniques conference, Association
for Investment Management and Research, December 1998, entitled "Do the New
Measures of Company Performance Measure Up?"
Supervisor, CFA Exam, Tallahassee site, 1997 and 1998
Presentation to the faculty at the University of North Florida, "Using the Web in the
Classroom" February 1998
Presentation to the Financial Analysts Seminar, Association for Investment Management
and Research, July 1997 "Value-Added Investing"
Ad hoc reviewer for a number of academic journals
Speaker, College of Business, University of Central Oklahoma, Salute to Teaching,
October 1996
Speech to the faculty and students of the University of Central Oklahoma, "Keeping Up
with Technology: Tools for Teaching," October, 1996, in conjunction with the Salute
to Teaching program.

Presentation to the Corporate Finance Financial Planning Roundtable, Financial
Management Association, 1992; participant in the roundtable, 1991-95
Moderator for Corporate Roundtable, Financial Management Association, 1995
Service activity: James Madison University

College
Presenter, Sub-Prime in Prime Time, October 28, 2008 (with Barkley Rosser and Luis
Betancourt)
Diversity Committee, 2008-present
Instructor for web page segment, CyberCity, 2008
Community
Numerous appearances on WCTV, Harrisonburg ABC affiliate.
Service activity: Florida Atlantic University

University
Member, Instructional Technology/Distance Learning Advisory Committee, 2006-2007.
Presentation in the ITSS IT Showcase, April 2007.
Presentation on distance learning to the Higher Education Press of China, February 2006
Member, Committee on Synchronous Distance Learning, 2005
Member, Ad Hoc Committee on Scripps/MacArthur campus facilities planning, 2005
College
Scheduling Coordinator, College of Business, 2007-2007.
Presentation of faculty development workshops: Blackboard, Teaching online, and
Teaching through video-conferencing, 2005-2007.
Department
Course coordinator, Principles of Financial Management (FIN3403), 2006-2007.
Community
Speaker, St. Lucie Centennial High School, January 2006, November 2006, May 2007.
Speaker, Economic Forecast luncheon, MF Securities, Vero Beach, April 2007.
Guest editorials:
“Retirees, be wary when offered ‘free lunch’”, Scripps newspapers, February 28,
2007.
“The Truth about Coverage: Affordable and Otherwise,” Scripps newspapers,
August 8, 2006.
“Bubble or No Bubble Open the Case …” Scripps newspapers, May 23, 2006.
Guest on radio, WPSL, May 12, 2006.

Life Long Learning Program (Treasure Coast), four-lecture series, Scandals and
Scoundrels, October 17-November 7, 2006.
Speaker, IRCC, classes in economics, 2006-2007.
Organizer, the Financial Awareness Workshop, Florida Atlantic University’s Port Saint
Lucie Campus, January 2006.
Hosted, American Association of University Women meeting at Florida Atlantic
University’s Port Saint Lucie Campus, January 2006.
Service activity: Florida State University

University
Member, University Admissions Committee, 2003-2004
Member, Council for Instruction, 2000-01
Panelist, Diversity and Civility Panel, WFSU-TV (Channel 43), November 4, 1999
Member, Search Committee for the Assistant Director, Academic Programs, Center for
Academic Support and Distance Learning, 1998
Member, Search Committee for the Assistant Vice-President - Technology, 1998
Web Development Committee, 1997-present
Presentation to the Legislator and Legislative Staff campus visit, September, 1997
Presentation at the grand opening ceremony of the "Open University/Florida State
University Resource and Production Center," September 1997
Presentation at the "New Faculty Orientation," August 1997
Member, Student Government Leadership Awards Committee, 1993 and 1994
Member, Southern Association of Colleges and Schools Review Committee, Education
Resources Subcommittee, 1992-93
Member, Computer Users' Committee, 1992-93
Member, Graduate Policy Committee, Review of the Doctoral Program in Economics,
1991
Member, Graduate Policy Committee, Review of the Doctoral Program in Oceanography,
1989
Chairperson, University Stores Committee, 1986-91
Advisor, Black Transfer Student Retention, 1988-89
Member, Refund Committee, 1986-89
Member, Committee on the Review of Teaching Assistants, 1988
Advisor, Basic Studies, 1981-84
Member, Merit / Achievement Scholars Program Committee, 1982-83

College
Member and Department representative, Promotion and Tenure Committee, 2002-03;
2003-04
Member, Summer Instructional Grant Committee, 1997
Member, Scholarship Committee, 1994-1996
Member, Minority Affairs Committee, 1981-83; 1992
Member, Library Advisory Committee, 1987-92
Member, Computer Research Specialist Search Committee, 1983-84
Member, Computer Advisory Committee, 1982-84
Department
Member, Promotion and Tenure Committee, 2002-03; 2003-04
Advisor, Financial Management Association Student Chapter, 1990-02
Finance Workshop Coordinator, 1989-96
Member, Doctoral Examining Committee, 1986-04
Advisor, Undergraduate Finance Majors, 1984-85; 1987-91
Member, Promotion and Tenure Committee, 1987-88
Member, Promotion and Tenure Criteria Committee, 1985
Member, Merit Criteria Committee, 1984
Member, Committee for the Review of Doctoral Quantitative Course Sequence, 1981-82

Pamela Peterson Drake PhD., CFA
Finance, Investments, Financial Management Resources
http://educ.jmu.edu/~drakepp/
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Table Of Contents
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00.00.00.00 - Homepage - http://educ.jmu.edu/~drakepp/
00.01.00.00 - Pamela Peterson Drake - mailto:drakepp@jmu.edu

00.02.00.00 - Department of Finance and Business Law - http://www.jmu.edu/finance/
00.03.00.00 - James Madison University - http://www.jmu.edu/
00.04.00.00 - JMU Web Privacy Statement - http://www.jmu.edu/jmuweb/privacy.shtml
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Table Of Contents
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01.00.00.00 - Learning Resources - http://educ.jmu.edu/~drakepp/general/index.html
02.00.00.00 - Instructional: Investments - http://educ.jmu.edu/~drakepp/investments/index.html
03.00.00.00 - Instructional: Principles of Financial Management - http://educ.jmu.edu/~drakepp/principles/index.html
04.00.00.00 - Regression - http://educ.jmu.edu/~drakepp/statistics/index.html
05.00.00.00 - Value Added Measures - http://educ.jmu.edu/~drakepp/value/index.html
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01.00.00.00 - Learning Resources - http://educ.jmu.edu/~drakepp/general/index.html
01.01.00.00 - Readings - http://educ.jmu.edu/~drakepp/general/readings.htm

01.01.01.00 - Calculating interest rates - http://educ.jmu.edu/~drakepp/principles/module3/interestrates.pdf
01.01.02.00 - Careers in Finance - http://educ.jmu.edu/~drakepp/principles/module1/careers.pdf
01.01.03.00 - Free cash flow - http://educ.jmu.edu/~drakepp/general/FCF.pdf
01.01.04.00 - Time value of money: Part I - http://educ.jmu.edu/~drakepp/principles/module3/tvm.pdf
01.01.05.00 - Time value of money: Part II - http://educ.jmu.edu/~drakepp/principles/module3/tvm2.pdf
01.01.06.00 - Understanding financial statements - http://educ.jmu.edu/~drakepp/principles/module2/pg.pdf
01.02.00.00 - Research Resources - http://educ.jmu.edu/~drakepp/general/research.htm
01.02.01.00 - Gathering information - http://educ.jmu.edu/~drakepp/general/research.htm#gather
01.02.01.01 - Sources of Industry Information - http://educ.jmu.edu/~drakepp/general/Industry_information_sources.pdf
01.02.01.02 - Instructions on locating SEC filings - http://educ.jmu.edu/~drakepp/general/edgar.pdf
01.02.01.03 - Library resources - http://educ.jmu.edu/~drakepp/general/library_resources.pdf
01.02.01.04 - Gathering data from Mergent Online - http://educ.jmu.edu/~drakepp/general/mergent.pdf
01.02.01.05 - Gathering data from Mergent Online Example worksheet - http://educ.jmu.edu/~drakepp/investments/examples/Kellogg.xls
01.02.02.00 - Analyzing information - http://educ.jmu.edu/~drakepp/general/research.htm#analyze
01.02.02.01 - Estimating the market model: Step by step - http://educ.jmu.edu/~drakepp/general/market_model.pdf
01.02.02.02 - Estimating the market model example workbook - http://educ.jmu.edu/~drakepp/general/examples/msft.xls
01.02.02.03 - Comparing share price performance of a stock - http://educ.jmu.edu/~drakepp/general/Relative_performance.pdf
2 / 8
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01.02.03.00 - Writing reports - http://educ.jmu.edu/~drakepp/general/research.htm#write
01.02.03.01 - Writing Suggestions - http://educ.jmu.edu/~drakepp/general/writing.pdf
01.02.03.02 - How To Avoid Plagiarism - http://educ.jmu.edu/~drakepp/general/avoidplagiarism.pdf
01.02.03.03 - RefWorks Importing instructions - http://educ.jmu.edu/~drakepp/general/Refworks.pdf
01.03.00.00 - Tools - http://educ.jmu.edu/~drakepp/general/tools.htm

01.03.01.00 - Accounting Review - http://educ.jmu.edu/~drakepp/acc/index.html
01.03.02.00 - Bond value and duration calculations using Microsoft Excel - http://educ.jmu.edu/~drakepp/investments/examples/bond_example.xls
01.03.03.00 - Charting in Microsoft Excel - http://educ.jmu.edu/~drakepp/general/excel_charting.pdf
01.03.04.00 - Creating a Microsoft PowerPoint Presentation - http://educ.jmu.edu/~drakepp/general/pp.pdf
01.03.05.00 - Creating a Microsoft PowerPoint Presentation example - http://educ.jmu.edu/~drakepp/general/pp_ex.ppt
01.03.06.00 - Financial Calculators - http://educ.jmu.edu/~drakepp/principles/calculator/index.html
01.03.07.00 - What is a geometric mean? - http://educ.jmu.edu/~drakepp/general/geometricmean.pdf
01.03.08.00 - Option pricing calculator - http://educ.jmu.edu/~drakepp/investments/scripts/opt.htm
01.04.00.00 - Statistics - http://educ.jmu.edu/~drakepp/statistics/index.html

01.04.01.00 - Notes on regression - http://educ.jmu.edu/~drakepp/statistics/regression.pdf
01.04.02.00 - StudyMate Regression Activities - http://educ.jmu.edu/~drakepp/statistics/regress.htm
01.04.03.00 - Regression using Microsoft Excel - http://educ.jmu.edu/~drakepp/statistics/regression_using_Excel.pdf
01.04.04.00 - Regression example - http://educ.jmu.edu/~drakepp/statistics/regressionexample.pdf
01.04.05.00 - Regression example Solutions - http://educ.jmu.edu/~drakepp/statistics/regressionexample.xls
01.04.06.00 - Home pricing example - http://educ.jmu.edu/~drakepp/statistics/homepricing_class.xls
01.05.00.00 - Examples - http://educ.jmu.edu/~drakepp/general/example.htm

01.05.01.00 - Duration example in Microsoft Excel - http://educ.jmu.edu/~drakepp/general/duration.xls
01.05.02.00 - Du Pont Analysis applied to Sears - http://educ.jmu.edu/~drakepp/principles/module2/dupont_sears.pdf
01.05.03.00 - Equity Valuation - http://educ.jmu.edu/~drakepp/principles/module4/Equity_Valuation.pdf
01.05.04.00 - Portfolio Risk and Return - http://educ.jmu.edu/~drakepp/principles/module5/portfolio_risk.pdf
01.05.05.00 - Two-stage Dividend Growth - http://educ.jmu.edu/~drakepp/principles/module4/twostagedvm.pdf
01.06.00.00 - Distance learning - http://educ.jmu.edu/~drakepp/general/distance.htm

01.06.01.00 - Blackboard:
01.06.01.01 - A Guide to the Student Using Blackboard - http://educ.jmu.edu/~drakepp/general/blackboard.pdf
01.06.01.02 - Creating equations in Blackboard - http://educ.jmu.edu/~drakepp/general/blackboard_equations.pdf
01.06.02.00 - E-mail:
01.06.02.01 - How do I read my jmu.edu mail without using WebMail? - http://educ.jmu.edu/~drakepp/general/email.pdf
01.07.00.00 - Other - http://educ.jmu.edu/~drakepp/general/other.htm

01.07.01.00 - Formulas:
01.07.01.01 - Bonds - http://educ.jmu.edu/~drakepp/investments/formulas/formulas_investing_in_bonds.pdf
01.07.01.02 - Cost of capital - http://educ.jmu.edu/~drakepp/fin3403/module7/coc_formulas.pdf
01.07.01.03 - Derivatives - http://educ.jmu.edu/~drakepp/investments/formulas/formulas_options.pdf
01.07.01.04 - Market indices - http://educ.jmu.edu/~drakepp/investments/formulas/formulas_market_indices.pdf
01.07.01.05 - Financial ratios - http://educ.jmu.edu/~drakepp/principles/module2/fin_formulas.pdf
01.07.01.06 - Risk - http://educ.jmu.edu/~drakepp/principles/module5/rrformulas.pdf
01.07.01.07 - Stock and bond valuation - http://educ.jmu.edu/~drakepp/principles/module4/val_formulas.pdf
3 / 8
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01.07.01.08 - Time value of money - http://educ.jmu.edu/~drakepp/principles/module3/tvm_formulas.pdf
01.07.02.00 - Time value of money tables:
01.07.02.01 - Table of Compound Factors - http://educ.jmu.edu/~drakepp/principles/module3/fvtable.html
01.07.02.02 - Table of Discount Factors - http://educ.jmu.edu/~drakepp/principles/module3/pvtable.html
01.07.02.03 - Future Value Annuity Factors - http://educ.jmu.edu/~drakepp/principles/module3/fvantable.html
01.07.02.04 - Present Value Annuity Factors - http://educ.jmu.edu/~drakepp/principles/module3/pvantable.html
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
02.00.00.00 - Instructional: Investments - http://educ.jmu.edu/~drakepp/investments/index.html
02.01.00.00 - Modules - http://educ.jmu.edu/~drakepp/investments/modules/index.html

02.01.01.00 - Module 1 - Introduction & SOX Act of 2002 - http://educ.jmu.edu/~drakepp/investments/modules/module1.pdf
02.01.02.00 - Module 2 - Types of investments - http://educ.jmu.edu/~drakepp/investments/modules/module2.pdf
02.01.03.00 - Module 3 - Markets and trading mechanisms - http://educ.jmu.edu/~drakepp/investments/modules/module3.pdf
02.01.04.00 - Module 4 - Market indices - http://educ.jmu.edu/~drakepp/investments/modules/module4.pdf
02.01.05.00 - Module 5 - Fundamental analysis - http://educ.jmu.edu/~drakepp/investments/modules/module5.pdf
02.01.06.00 - Module 6 - Portfolio theory - http://educ.jmu.edu/~drakepp/investments/modules/module6.pdf
02.01.07.00 - Module 7 - Asset pricing models - http://educ.jmu.edu/~drakepp/investments/modules/module7.pdf
02.01.08.00 - Module 8 - Stock analysis and valuation - http://educ.jmu.edu/~drakepp/investments/modules/module8.pdf
02.01.09.00 - Module 9 - Bond analysis and investment - http://educ.jmu.edu/~drakepp/investments/modules/module9.pdf
02.01.10.00 - Module 10 - Derivatives - http://educ.jmu.edu/~drakepp/investments/modules/module10.pdf
02.02.00.00 - Problem Sets - Studymate problem sets, and Problem sets - http://educ.jmu.edu/~drakepp/investments/problems.htm
02.02.01.00 - Studymate problem sets:
02.02.01.01 - Module 1 - http://educ.jmu.edu/~drakepp/investments/problems/mod1.htm
02.02.02.00 - Problem sets:

02.02.02.01 - Tax equivalent yield calculations - http://educ.jmu.edu/~drakepp/investments/problems/tax_equivalent_yield.pdf
02.02.02.02 - U. S. Treasury bill yield calculations - http://educ.jmu.edu/~drakepp/investments/problems/yields_on_tbills.pdf
02.02.02.03 - Trading on margin - http://educ.jmu.edu/~drakepp/investments/problems/trading_on_margin.pdf
02.02.02.04 - Short selling - http://educ.jmu.edu/~drakepp/investments/problems/short_selling.pdf
02.02.02.04 - Market indices - http://educ.jmu.edu/~drakepp/investments/problems/market_indices.pdf
02.02.02.06 - Portfolio risk - http://educ.jmu.edu/~drakepp/investments/problems/portfolio_risk.pdf
02.02.02.07 - Duration - http://educ.jmu.edu/~drakepp/investments/problems/duration.pdf
02.02.02.08 - Option pricing - http://educ.jmu.edu/~drakepp/investments/problems/option_pricing.pdf
02.02.02.09 - Option pricing worksheet - http://educ.jmu.edu/~drakepp/investments/problems/OPM.xls
4 / 8
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02.03.00.00 - Optional Readings - http://educ.jmu.edu/~drakepp/investments/optread.html
02.03.01.00 - Careers in finance - http://educ.jmu.edu/~drakepp/fin3403/module1/careers.pdf
02.03.02.00 - Sarbanes-Oxley Act of 2002 - http://news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley072302.pdf
02.03.03.00 - Financial accounting information - http://educ.jmu.edu/~drakepp/fin3403/module2/fin_acc.pdf
02.03.04.00 - Financial ratios - http://educ.jmu.edu/~drakepp/fin3403/module2/fin_rat.pdf
02.03.05.00 - Financial analysis - http://educ.jmu.edu/~drakepp/fin3403/module2/fin_analysis.pdf
02.03.06.00 - Time value of money: Part I - http://educ.jmu.edu/~drakepp/fin3403/module3/tvm.pdf
02.03.07.00 - Time value of money: Part II - http://educ.jmu.edu/~drakepp/fin3403/module3/tvm2.pdf
02.03.08.00 - Calculating interest rates - http://educ.jmu.edu/~drakepp/fin3403/module3/interestrates.pdf
02.03.09.00 - Asset valuation - http://educ.jmu.edu/~drakepp/fin3403/module4/asset.pdf
02.03.10.00 - Bond valuation - http://educ.jmu.edu/~drakepp/fin3403/module4/bondval.pdf
02.03.11.00 - Stock valuation - http://educ.jmu.edu/~drakepp/fin3403/module4/stock.pdf
02.03.12.00 - Measuring risk - http://educ.jmu.edu/~drakepp/fin3403/module5/riskreturn_measure.pdf
02.03.13.00 - Risk, return, and diversification - http://educ.jmu.edu/~drakepp/fin3403/module5/riskreturn2.pdf
02.04.00.00 - Financial Calculators - http://educ.jmu.edu/~drakepp/general/calculator/index.html

02.04.01.00 - The basics - http://educ.jmu.edu/~drakepp/general/calculator/general.html
02.04.02.00 - Hewlett-Packard models - http://educ.jmu.edu/~drakepp/general/calculator/hp.html
02.04.03.00 - Texas Instruments models - http://educ.jmu.edu/~drakepp/general/calculator/ti.html
02.05.00.00 - Formulas - http://educ.jmu.edu/~drakepp/investments/formulas/index.html
02.06.00.00 - Miscellaneous - http://educ.jmu.edu/~drakepp/investments/misc.html

02.06.01.00 - Background for the course:
02.06.01.01 - Accounting Review - http://educ.jmu.edu/~drakepp/acc/index.html
02.06.01.02 - Need a little bit of help with Algebra? - http://educ.jmu.edu/~drakepp/fin3403/tools/algebra.html
02.06.01.03 - Time value of money - http://educ.jmu.edu/~drakepp/fin3403/module3/tvm.pdf
02.06.01.04 - Understanding financial statements - http://educ.jmu.edu/~drakepp/fin3403/module2/pg.pdf
02.06.02.00 - Tools:
02.06.02.01 - Financial Calculators - http://educ.jmu.edu/~drakepp/fin3403/calculator/index.html
02.06.02.02 - Charting in Microsoft Excel - http://educ.jmu.edu/~drakepp/fin3403/tools/excel_charting.pdf
02.06.02.03.01 - Creating a Microsoft PowerPoint Presentation - http://educ.jmu.edu/~drakepp/fin3403/tools/pp.pdf
02.06.02.03.02 - Creating a Microsoft PowerPoint Presentation, An Example - http://educ.jmu.edu/~drakepp/investments/tools/pp_ex.ppt
02.06.02.04 - Option pricing calculator - http://educ.jmu.edu/~drakepp/investments/scripts/opt.htm
02.06.02.05 - Microsoft Excel worksheet for bond value and duration calculations -
http://educ.jmu.edu/~drakepp/investments/examples/bond_example.xls
02.06.03.01 - Table of Compound Factors - http://educ.jmu.edu/~drakepp/fin3403/module3/fvtable.html
02.06.03.02 - Table of Discount Factors - http://educ.jmu.edu/~drakepp/fin3403/module3/pvtable.html
02.06.03.03 - Future Value Annuity Factors - http://educ.jmu.edu/~drakepp/fin3403/module3/fvantable.html
02.06.03.04 - Present Value Annuity Factors - http://educ.jmu.edu/~drakepp/fin3403/module3/pvantable.html
02.06.04.00 - Careers in Finance:
02.06.04.01 - Careers in Finance a general overview - http://www.fau.edu/~ppeter/fin3403/module1/careers.pdf
02.06.04.02 - CFA Institute - http://www.cfainstitute.org/
02.06.04.03 - Certified Financial Planner Board of Standards - http://www.cfp.net/
5 / 8
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02.06.04.04 - NASD exams - http://www.nasd.com/web/idcplg?IdcService=SS_GET_PAGE&nodeId=759&ssSourceNodeId=10
02.07.00.00 - Glossary - http://educ.jmu.edu/~drakepp/investments/glossary.html
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
03.00.00.00 - Instructional: Principles of Financial Management - http://educ.jmu.edu/~drakepp/principles/index.html
03.01.00.00 - Course modules - http://educ.jmu.edu/~drakepp/principles/modules.htm
03.01.01.00 - Module 1: Introduction - http://educ.jmu.edu/~drakepp/principles/module1/index.html

03.01.01.01 - Learning Outcomes - http://educ.jmu.edu/~drakepp/principles/module1/learning_outcomes.pdf
03.01.01.02 - Introduction to Financial Management - http://educ.jmu.edu/~drakepp/principles/module1/introduction.pdf
03.01.01.03 - Careers in Finance - http://educ.jmu.edu/~drakepp/principles/module1/careers.pdf
03.01.01.04 - Forms of Business - http://educ.jmu.edu/~drakepp/principles/module1/forms.pdf
03.01.01.05 - Objective of Financial Management - http://educ.jmu.edu/~drakepp/principles/module1/objective.pdf
03.01.01.06 - Foundation Questions and Problems - http://educ.jmu.edu/~drakepp/principles/module1/foundation1.htm
03.01.01.07 - StudyMate Activities - http://educ.jmu.edu/~drakepp/principles/module1/mod1.htm
03.01.02.00 - Module 2: Financial Analysis - http://educ.jmu.edu/~drakepp/principles/module2/index.html

03.01.02.02 - Financial Accounting Information - http://educ.jmu.edu/~drakepp/principles/module2/fin_acc.pdf
03.01.02.03 - Financial Ratio Analysis - http://educ.jmu.edu/~drakepp/principles/module2/fin_rat.pdf
03.01.02.04 - Financial Analysis - http://educ.jmu.edu/~drakepp/principles/module2/fin_analysis.pdf
03.01.02.05 - Du Pont applied to Sears Roebuck - http://educ.jmu.edu/~drakepp/principles/module2/dupont_sears.pdf
03.01.02.06 - Financial Analysis Links - http://educ.jmu.edu/~drakepp/principles/module2/fin_links.pdf
03.01.02.07 - Understanding Financial Statements - http://educ.jmu.edu/~drakepp/principles/module2/pg.pdf
03.01.02.08 - Financial Ratio Formulas - http://educ.jmu.edu/~drakepp/principles/module2/fin_formulas.pdf
03.01.02.09 - Using Financial Accounting Information - http://educ.jmu.edu/~drakepp/principles/module2/acc.html
03.01.02.10 - Accounting Review Crossword Puzzle - http://educ.jmu.edu/~drakepp/principles/module2/accpuzzle.htm
03.01.02.11 - Financial Ratios - http://educ.jmu.edu/~drakepp/principles/module2/finrat.html
03.01.02.12 - Financial Ratios (Quiz) - http://educ.jmu.edu/~drakepp/principles/module2/ratioquiz.htm
03.01.03.00 - Module 3: Time Value of Money - http://educ.jmu.edu/~drakepp/principles/module3/index.html

03.01.03.02 - Time value of money: Part I - http://educ.jmu.edu/~drakepp/principles/module3/tvm.pdf
03.01.03.03 - Calculating a future value - http://educ.jmu.edu/~drakepp/principles/module3/fv.pdf
03.01.03.04 - Time value of money: Part II - http://educ.jmu.edu/~drakepp/principles/module3/tvm2.pdf
03.01.03.05 - Calculating interest rates - http://educ.jmu.edu/~drakepp/principles/module3/interestrates.pdf
03.01.03.06.01 - Time value of money practice problems - http://educ.jmu.edu/~drakepp/principles/module3/tvm_problems.pdf
03.01.03.06.01 - Time value of money practice problems Solutions - http://educ.jmu.edu/~drakepp/principles/module3/tvm_problems_solutions.pdf
03.01.03.08 - Additional problem sets - http://educ.jmu.edu/~drakepp/principles/problems.html
03.01.04.00 - Module 4: Valuation - http://educ.jmu.edu/~drakepp/principles/module4/index.html

6 / 8
--- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- ---

03.01.04.02 - Asset valuation - http://educ.jmu.edu/~drakepp/principles/module4/asset.pdf
03.01.04.03 - Bond valuation - http://educ.jmu.edu/~drakepp/principles/module4/bondval.pdf
03.01.04.04 - Stock valuation - http://educ.jmu.edu/~drakepp/principles/module4/stock.pdf
03.01.04.05 - Two stage growth - http://educ.jmu.edu/~drakepp/principles/module4/twostagedvm.pdf
03.01.04.06 - Equity valuation - http://educ.jmu.edu/~drakepp/principles/module4/Equity_Valuation.pdf
03.01.04.07.01 - Valuation practice problems - http://educ.jmu.edu/~drakepp/principles/module4/valuation_problems.pdf
03.01.04.07.02 - Valuation practice problems solutions - http://educ.jmu.edu/~drakepp/principles/module4/valuation_problems_solutions.pdf
03.01.05.00 - Module 5: Risk and Return - http://educ.jmu.edu/~drakepp/principles/module5/index.html

03.01.05.02 - Types of risk - http://educ.jmu.edu/~drakepp/principles/module5/riskreturn.pdf
03.01.05.03 - Measuring risk - http://educ.jmu.edu/~drakepp/principles/module5/riskreturn_measure.pdf
03.01.05.04 - Risk, return, and diversification - http://educ.jmu.edu/~drakepp/principles/module5/riskreturn2.pdf
03.01.05.05 - Risk formulas - http://educ.jmu.edu/~drakepp/principles/module5/rrformulas.pdf
03.01.05.06 - Portfolio risk - http://educ.jmu.edu/~drakepp/principles/module5/portfolio_risk.pdf
03.01.05.07.01 - Risk and return practice problems - http://educ.jmu.edu/~drakepp/principles/module5/rr_problems.pdf
03.01.05.07.02 - Risk and return practice problems Solutions - http://educ.jmu.edu/~drakepp/principles/module5/rr_problems_solutions.pdf
03.01.05.09 - StudyMate Activities - http://www.fau.edu/~ppeter/fin3403/module5/mod5.htm
03.01.06.00 - Module 6: Capital Budgeting - http://educ.jmu.edu/~drakepp/principles/module6/index.html

03.01.06.02 - Capital budgeting and cash flows - http://educ.jmu.edu/~drakepp/principles/module6/capbudcf.pdf
03.01.06.03 - Capital budgeting techniques - http://educ.jmu.edu/~drakepp/principles/module6/capbudtech.pdf
03.01.06.04 - Capital budgeting and risk - http://educ.jmu.edu/~drakepp/principles/module6/cbrisk.pdf
03.01.06.05 - Capital budgeting formulas - http://educ.jmu.edu/~drakepp/principles/module6/cbformulas.pdf
03.01.06.06 - Explanation: Williams 5 and 10 - http://educ.jmu.edu/~drakepp/principles/module6/williams.pdf
03.01.06.08 - Capital budgeting practice problems - http://educ.jmu.edu/~drakepp/principles/module6/cbproblems.pdf
03.01.06.09 - Capital budgeting practice problems Solutions - http://educ.jmu.edu/~drakepp/principles/module6/cbproblems_solutions.pdf
03.01.07.00 - Module 7: Capital Structure and the Cost of Capital - http://educ.jmu.edu/~drakepp/principles/module7/index.html

03.01.07.01 - Learning Outcomes http://educ.jmu.edu/~drakepp/principles/module7/learning_outcomes.pdf
03.01.07.02 - Capital structure http://educ.jmu.edu/~drakepp/principles/module7/capital_structure.pdf
03.01.07.03 - Cost of capital http://educ.jmu.edu/~drakepp/principles/module7/coc.pdf
03.01.07.04 - Cost of capital formulas http://educ.jmu.edu/~drakepp/principles/module7/coc_formulas.pdf
03.01.07.05.01 - Capital structure practice problems http://educ.jmu.edu/~drakepp/principles/module7/cs_practice_problems.pdf
03.01.07.05.02 - Capital structure practice problems Solutions
http://educ.jmu.edu/~drakepp/principles/module7/cs_practice_problems_solutions.pdf
03.01.07.06.01 - Cost of capital practice problems http://educ.jmu.edu/~drakepp/principles/module7/coc_problems.pdf
03.01.07.06.02 - Cost of capital practice problems Solutions http://educ.jmu.edu/~drakepp/principles/module7/coc_problems_solutions.pdf
03.01.07.07 - StudyMate Activities http://educ.jmu.edu/~drakepp/principles/module7/mod7.htm
03.01.07.08 - Additional problem sets http://educ.jmu.edu/~drakepp/principles/problems.html
7 / 8
--- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- --- ---

03.02.00.00 - Problem sets - http://educ.jmu.edu/~drakepp/principles/problems.html
03.02.01.00 - StudyMate Activities - http://educ.jmu.edu/~drakepp/principles/studymate.html
03.02.02.00 - Problem sets - http://educ.jmu.edu/~drakepp/principles/probsets.html
03.03.00.00 - Calculators - http://educ.jmu.edu/~drakepp/general/calculator/index.html

03.03.01.00 - The basics - http://educ.jmu.edu/~drakepp/general/calculator/general.html
03.03.02.00 - Hewlett-Packard models - http://educ.jmu.edu/~drakepp/general/calculator/hp.html
03.03.03.00 - Texas Instruments models - http://educ.jmu.edu/~drakepp/general/calculator/ti.html
03.04.00.00 - Miscellaneous - http://educ.jmu.edu/~drakepp/principles/misc.html

03.04.01.00 - Background for the course:
03.04.01.01 - Need a little bit of help with Algebra? - http://educ.jmu.edu/~drakepp/principles/tools/algebra.html
03.04.01.02 - Accouting Review - http://wise.fau.edu/~ppeter/acc/
03.04.02.00 - Formulas:
03.04.02.01 - Financial ratio formulas - http://educ.jmu.edu/~drakepp/principles/module2/fin_formulas.pdf
03.04.02.02 - Time value of money formulas - http://educ.jmu.edu/~drakepp/principles/module3/tvm_formulas.pdf
03.04.02.03 - Valuation formulas - http://educ.jmu.edu/~drakepp/principles/module4/val_formulas.pdf
03.04.02.04 - Risk formulas - http://educ.jmu.edu/~drakepp/principles/module5/rrformulas.pdf
03.04.02.05 - Capital budgeting formulas - http://educ.jmu.edu/~drakepp/principles/module6/cbformulas.pdf
03.04.02.06 - Cost of capital formulas - http://educ.jmu.edu/~drakepp/principles/module7/coc_formulas.pdf
03.04.03.00 - Foundation Tools:
03.04.03.01 - Understanding financial statements - http://educ.jmu.edu/~drakepp/principles/module2/pg.pdf
03.04.03.02 - MACRS tables - http://educ.jmu.edu/~drakepp/principles/tax/macrs.htm
03.04.03.03 - Kmart Financial Statements - http://educ.jmu.edu/~drakepp/principles/module2/kmart.xls
03.04.04.01 - Table of Compound Factors - http://educ.jmu.edu/~drakepp/principles/module3/fvtable.html
03.04.04.02 - Table of Discount Factors - http://educ.jmu.edu/~drakepp/principles/module3/pvtable.html
03.04.04.03 - Future Value Annuity Factors - http://educ.jmu.edu/~drakepp/principles/module3/fvantable.html
03.04.04.04 - Present Value Annuity Factors - http://educ.jmu.edu/~drakepp/principles/module3/pvantable.html
03.04.05.00 - Research
03.04.05.01 - Instructions on locating SEC filings - http://wise.fau.edu/~ppeter/fin3403/assignments/Instructions_EDGAR.pdf
03.04.05.02 - A guide to gathering financial data for financial analysis from Mergent Online -
http://wise.fau.edu/~ppeter/fin4504/examples/mergent.pdf
03.04.05.03 - Charting in Microsoft Excel - http://educ.jmu.edu/~drakepp/principles/tools/excel_charting.pdf
03.04.05.04.01 - Creating a Microsoft PowerPoint Presentation - http://educ.jmu.edu/~drakepp/principles/tools/pp.pdf
03.04.05.04.02 - Creating a Microsoft PowerPoint Presentation example - http://educ.jmu.edu/~drakepp/principles/tools/pp_ex.ppt
03.04.05.05 - Writing suggestions - http://wise.fau.edu/~ppeter/fin4504/examples/writing.pdf
03.04.05.06 - How do you avoid plagiarism? - http://wise.fau.edu/~ppeter/fin3403/assignments/avoidplagiarism.pdf
03.05.00.00 - Glossary - http://educ.jmu.edu/~drakepp/principles/tools/glossary.html
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
04.00.00.00 - Regression - http://educ.jmu.edu/~drakepp/statistics/index.html

04.01.00.00 - Notes on regression - http://educ.jmu.edu/~drakepp/statistics/regression.pdf
8 / 8
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04.02.00.00 - StudyMate Regression Activities - http://educ.jmu.edu/~drakepp/statistics/regress.htm
04.03.00.00 - Regression using Microsoft Excel - http://educ.jmu.edu/~drakepp/statistics/regression_using_Excel.pdf
04.04.01.00 - Regression example (Data) - http://educ.jmu.edu/~drakepp/statistics/regressionexample.pdf
04.04.02.00 - Regression example (Solution) - http://educ.jmu.edu/~drakepp/statistics/regressionexample.xls
04.05.00.00 - Home pricing example - http://educ.jmu.edu/~drakepp/statistics/homepricing_class.xls
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
05.00.00.00 - Value Added Measures - http://educ.jmu.edu/~drakepp/value/index.html
05.01.00.00 - Overview - http://educ.jmu.edu/~drakepp/value/intro.htm

05.02.00.00 - Notes - http://educ.jmu.edu/~drakepp/value/notes.htm
05.02.01.00 - Notes Exhibits - http://educ.jmu.edu/~drakepp/value/exhibits.htm#exh1
05.03.00.00 - Glossary - http://educ.jmu.edu/~drakepp/value/glossary.html
05.04.00.00 - Research - http://educ.jmu.edu/~drakepp/value/research.htm
05.05.00.00 - Links - http://educ.jmu.edu/~drakepp/value/links.htm

05.05.01.00 - General explanations:
05.05.01.01 - CalPERS use of EVA in their Focus List - http://www.calpers-governance.org/alert/selection/eva.asp
05.05.01.02 - Aswath Damodaran' EVA page - http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/eva.html
05.05.01.03 - Economics Value Added: The Invisible Hand at Work, by Michael Durant - http://www.crfonline.org/orc/pdf/ref8.pdf
05.05.01.04 - ROI Guide: Economic Value Added, by John Berry, February 17, 2003, Computerworld -
http://www.computerworld.com/managementtopics/roi/story/0,10801,78514,00.html
05.05.01.05 - The Bonus Barrier on CFO Europe.com - http://www.cfoeurope.com/displaystory.cfm/1737457/l_print
05.05.02.00 - Consulting firms' sites:

05.05.02.01 - Stern Stewart & Co. - http://www.sternstewart.com/
05.05.02.02 - Value Based Management .net - http://www.valuebasedmanagement.net/methods_eva.html
05.05.02.03 - Valuation Resources - http://www.valuationresources.com/Publications/EVA.htm
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James Madison University, Harrisonburg, Virginia 22802
01.00.00.00
Learning Resources
Resources page for Pamela Peterson Drake, James Madison University Page 1 of 1
Learning Resources in Finance

A COLLECTION OF WRITINGS, EXAMPLE, AND TOOLS TO ASSIST THE FINANCE STUDENT, PREPARED BY
PAMELA PETERSON DRAKE

J. GRAY FERGUSON PROFESSOR &
DEPARTMENT HEAD, DEPARTMENT OF FINANCE AND BUSINESS LAW
JAMES MADISON UNIVERSITY
http://educ.jmu.edu/~drakepp/general/index.html 3/2/2011
Readings prepared by Pamela Peterson Drake Page 1 of 2
Readings in Finance
PREPARED BY PAMELA PETERSON DRAKE, JAMES MADISON UNIVERSITY
z Calculating interest rates

z Careers in Finance
z Free cash flow
z Time value of money: Part I
z Time value of money: Part II
z Understanding financial statements
http://educ.jmu.edu/~drakepp/general/readings.htm 3/2/2011
Readings prepared by Pamela Peterson Drake Page 2 of 2
Shortcut Text Internet Address

Calculating interest rates http://educ.jmu.edu/~drakepp/principles/module3/interestrates.pdf
Careers in Finance http://educ.jmu.edu/~drakepp/principles/module1/careers.pdf
Free cash flow http://educ.jmu.edu/~drakepp/general/FCF.pdf
Time value of money: Part I http://educ.jmu.edu/~drakepp/principles/module3/tvm.pdf
Time value of money: Part II http://educ.jmu.edu/~drakepp/principles/module3/tvm2.pdf
Understanding financial
http://educ.jmu.edu/~drakepp/principles/module2/pg.pdf
statements
http://educ.jmu.edu/~drakepp/general/readings.htm 3/2/2011
Calculating interest rates
A reading prepared by Pamela Peterson Drake
OUTLINE
1. Introduction
2. Annual percentage rate
3. Effective annual rate
1. Introduction
The basis of the time value of money is that an investor is compensated for the time value of money
and risk. Situations arise often in which we wish to determine the interest rate that is implied from
an advertised, or stated rate. There are also cases in which we wish to determine the rate of interest
implied from a set of payments in a loan arrangement.
2. The annual percentage rate

A common problem in finance is comparing alternative financing or investment opportunities when
the interest rates are specified in a way that makes it difficult to compare terms. One lending source
may offer terms that specify 91/4 percent annual interest with interest compounded annually,
whereas another lending source may offer terms of 9 percent interest with interest compounded
continuously. How do you begin to compare these rates to determine which is a lower cost of
borrowing? Ideally, we would like to translate these interest rates into some comparable form.
One obvious way to represent rates stated in various time intervals on a common basis is to express
them in the same unit of time -- so we annualize them. The annualized rate is the product of the
stated rate of interest per compounding period and the number of compounding periods in a year.
Let i be the rate of interest per period and let n be the number of compounding periods in a year.
The annualized rate, also referred to as the nominal interest rate or the annual percentage
rate (APR), is
APR = i x n
where i is the rate per compounding period and n is the number of compound periods in a year.
The Truth in Lending Act requires lenders to disclose the annual percentage rate on consumer loans. 1
As you will see, however, the annual percentage rate ignores compounding and therefore
1
15 U.S.C. §§1601-1666j; Federal Reserve System Regulation Z, 1968.
Calculating interest rates, a reading prepared by Pamela Peterson Drake 1

understates the true cost of borrowing. Also, as pointed out in the Report to Congress by the Board
of Governors of the Federal Reserve System, Finance Charges for Consumer Credit under the Truth in
Lending Act, the APR does not consider some other costs associated with lending transactions.
The Truth in Savings Act (Federal Reserve System Regulation DD, 1991) requires institutions to
provide the annual percentage yield (APY) for savings accounts, which is a rate that considers
the effects of compound interest. As a result of this law, consumers can compare the yields on
different savings arrangements. But this law does not apply beyond savings accounts.
To see how the APR works, let's consider the Lucky Break Loan Company. Lucky's loan terms are
simple: pay back the amount borrowed, plus 50 percent, in six months. Suppose you borrow $10,000
from Lucky. After six months, you must pay back the $10,000, plus $5,000. The annual percentage
rate on financing with Lucky is the interest rate per period (50 percent for six months) multiplied by
the number of compound periods in a year (two six-month periods in a year). For the Lucky Break
financing arrangement,
APR = 0.50 x 2 = 1.00 or 100 percent per year
But what if you cannot pay Lucky back after six months? Lucky will let you off this time, but you must
pay back the following at the end of the next six months:
x the $10,000 borrowed,
x the $5,000 interest from the first six months, and
x 50 percent interest on both the unpaid $10,000 and the unpaid $5,000 interest ($15,000 x
.50 = $7,500).
So, at the end of the year, knowing what is good for you, you pay off Lucky:
Amount of original loan $10,000
Interest from first six months 5,000
Interest on second six months 7,500
Total payment at end of year $22,500
It is unreasonable to assume that, after six months, Lucky would let you forget about paying interest
on the $5,000 interest from the first six months. If Lucky would forget about the interest on interest,
you would pay $20,000 at the end of the year -- $10,000 repayment of principal and $10,000 interest
-- which is a 100 percent interest rate.
Using the Lucky Break method of financing, you have to pay $12,500 interest to borrow $10,000 for
one year's time -- or else. Because you have to pay $12,500 interest to borrow $10,000 over one
year's time, you pay not 100 percent interest, but rather 125 percent interest per year:
Annual interest rate on a Lucky Break loan = $12,500 / $10,000 = 125 percent
What's going on here? It looks like the APR in the Lucky Break example ignores the compounding
(interest on interest) that takes place after the first six months.
And that's the way it is with all APR's: the APR ignores the effect of compounding. And therefore this
rate understates the true annual rate of interest if interest is compounded at any time prior to the
end of the year. Nevertheless, APR is an acceptable method of disclosing interest on many lending
arrangements since it is easy to understand and simple to compute. However, because it ignores
compounding, it is not the best way to convert interest rates to a common basis.

Another way of converting stated interest rates to a common basis is the effective rate of interest.
The effective annual rate (EAR) is the true economic return for a given time period -- it takes into
account the compounding of interest -- and is also referred to as the effective rate of interest.
Using our Lucky Break example, we see that we must pay $12,500 interest on the loan of $10,000
for one year. Effectively, we are paying 125 percent annual interest. Thus, 125 percent is the
effective annual rate of interest.
In this example, we can easily work through the calculation of interest and interest on interest. But
for situations where interest is compounded more frequently we need a direct way to calculate the
effective annual rate. We can calculate it by resorting once again to our basic valuation equation:
FV = PV (1 + i)n
Next, we consider that a return is the change in the value of an investment over a period and an
annual return is the change in value over a year.
Suppose you invest $100 today in an investment that pays 6 percent annual interest, but interest is
compounded every four months. This means that 2 percent is paid every four months. After four
months, you have $100 (1.2) = $102, after eight months you have $102 (1.02) = $104.04, and after
one year you have $104.04 (1.02) = 106.1208, or, $100 (1.02)3 = $106.1208
The effective annual rate of interest (EAR) is $6.1208 paid on $100, or 6.1208 percent. We can
arrive at that interest by rearranging the basic valuation formula based on a one year period:
$106.1208 = $100 (1 + 0.02)3
$106.1208/$100 = (1 + 0.02)3
1.061208 = (1 + 0.02)3
EAR = (1 + 0.02)3 – 1 = 0.061208 or 6.1208 percent
In more general terms, the effective interest rate, EAR, is:
EAR = (1 + i)n 1
The effective rate of interest (a.k.a. effective annual rate or EAR) is therefore an annual rate that
takes into consideration any compounding that occurs during the year.
Let's look how the EAR is affected by the compounding. Suppose that the Safe Savings and Loan
promises to pay 6 percent interest on accounts, compounded annually. Because interest is paid once,
at the end of the year, the effective annual return, EAR, is 6 percent. If the 6 percent interest is paid
on a semi-annual basis -- 3 percent every six months -- the effective annual return is larger than 6
percent because interest is earned on the 3 percent interest earned at the end of the first six months.
In this case, to calculate the EAR, the interest rate per compounding period -- six months -- is 0.03
(that is, 0.06 / 2) and the number of compounding periods in an annual period is 2:
EAR = (1 + i)n - 1
EAR = (1 + 0.03)2 - 1 = 1.0609 - 1 = 0.0609 or 6.09%.
Extending this example to the case of quarterly compounding with a nominal interest rate of 6
percent we first calculate the interest rate per period, r, and the number of compounding periods in a
year, n:
i = 0.06 / 4 = 0.015 per quarter, and
n = 12 months / 3 months = 4 quarters in a year.
The EAR is:

EAR = (1 + 0.015)4 - 1 = 1.0614 - 1 = 0.0614 or 6.14%
Suppose there are two banks: Bank A, paying 12 percent interest compounded semi-annually, and
Bank B: paying 11.9 percent interest compounded monthly. Which bank offers you the best return on
your money? Comparing APR's, Bank A provides the higher return. But what about compound
interest? The EAR's for each account are calculated as:
Bank A:
EAR = (1 + 0.12/2)2 - 1 = (1 + 0.06)2 = 1.1236 - 1 = 0.1236 or 12.36%
Bank B:
EAR = (1 + 0.119/12)12 - 1 = (1 + 0.0099)12 - 1 = 1.1257 - 1 = 0.1257 or 12.57%
Bank B offers the better return on your money, even though it advertises a lower APR. If you deposit
$1,000 in Bank A for one year, you will have $1,123.60 at the end of the year. If you deposit $1,000
in Bank B for one year, you will have $1,125.70 at the end of the year, providing the better return on
your savings.
PayDay Loans – The fast and expensive way to borrow

A payday loan is a short-term loan with very high interest rates. In a typical payday loan, if you want to borrow
$100 you write a check for $125. The lender holds on to your check during the loan period. At the end of the
loan period, usually 10-14 days, the lender deposits your check. If you want to extend your loan, you pay the
minimum of $25 cash and then enter into a new contract to pay. If you do not pay off the loan or pay the fee to
roll over the loan, the lender will deposit your check and you risk being charged with writing bad checks.
What is the APR for this payday loan?
APR = 0.25 (365/14) = 651.79%
What is the EAR for this payday loan?
EAR = (1 + 0.25)365/14 -1 = 3,351.86%
The regulations pertaining to payday loans varies among states, but most states allow very generous lending
terms – generous, that is, to the lenders. [For a list of state limits on payday loans, see the Bankrate Monitor.]

A. Continuous compounding
The extreme frequency of compounding is continuous compounding. Continuous compounding is
when interest is compounded at the smallest
possible increment of time. In continuous Example 1: Comparing effective rates
compounding, the rate per period becomes
extremely small: Problem
Which of the following terms represent the lowest cost of
i = nominal interest rate / credit on an effective annual interest rate basis?
And the number of compounding periods in a 1. 10% APR, interest compounded semi-annually.
year, n, is infinite. As the rate of interest, i, 2. 9.75% APR, interest compounded continuously.
gets smaller and the number of compounding 3. 10.5% APR, interest compounded annually.
periods approaches infinity, the EAR is: 4. 9.8% APR, interest compounded quarterly.
APR
EAR = (1 + /n)n - 1 Solution
where APR is the annual percentage rate. d

What does all this mean? It means that the 1. EAR = (1 + 0.05)2 - 1 = 10.25%
interest rate per period approaches 0 and the 2. EAR = e0.0975 - 1 = 10.241%
number of compounding periods approaches 3. EAR = 10.5%
infinity -- at the same time! For a given 4. EAR = (1 + 0.0245)4 - 1 = 10.166%
nominal interest rate under continuous
compounding, it can be shown that: Exhibit 1: Effective Annual Rates of
EAR = eAPR - 1 Interest Equivalent to an Annual
Percentage Rate of 6 percent
For the stated 6 percent annual interest rate Frequency of
compounded continuously, the EAR is: compounding per
year Calculation EAR
EAR = e0.06 - 1 = 1.0618 - 1 EAR = 0.0618 or
6.18 percent . Annual (1 + 0.060)1 - 1 6.00%
Semi-annual (1 + 0.030)2 - 1 6.09
The relation between the frequency of Quarterly (1 + 0.015)4 - 1 6.14
0.06
compounding, for a given stated rate, and the Continuous e -1 6.18
effective annual rate of interest for this example
indicates that the greater the frequency of
compounding, the greater the EAR.
B. Calculator and spreadsheet applications

Financial calculators typically have a built-in program to help you go from APRs to EARs and vice
versa. For example, using the financial calculator, we can TI 83/84 HP10B
calculate the EAR that corresponds to a 10 percent APR with Using TVM Solver
2
quarterly compounding: The result is an EAR of 10.3813 EFF(10,4) 10 NOM%
percent. ENTER 4 P/Y
EFF%
2
Because these calculations require changing the payments per period settings (i.e., P/YR) in some
calculator models, be sure to change these back to one payment per period following the calculations
-- otherwise all subsequent financial calculations may be incorrect.

In a similar manner, we can calculate the nominal (i.e., APR) rate that corresponds to a given EAR.
TI 83/84 HP10B Suppose we want to find the nominal rate with quarterly
Using TVM Solver compounding that is equivalent to an effective rate of 10
NOM(10,4) 10 EFF% percent. The equivalent APR is 9.6455 percent. In other
ENTER 4 P/Y words, if a lender charges 9.6455 percent APR, it will earn,
NOM% effectively, 10 percent on the loan.
Continuous compounding calculations cannot be done using the built in finance programs. However,
most calculators -- whether financial or not -- have a program that allows you to perform calculations
using e, the base of natural logarithms. The EAR corresponding to an APR with continuous
compounding is 10.52 percent, which you can calculate as e0.1-1.
TI 83/84 HP10B Spreadsheet functions can also be used to calculate either the
x nominal rate or the effective rate. In Microsoft Excel®, for
e (.1)-1 ENTER .1
example, you can calculate the effective rate that equivalent to
ex – 1 =
an APR of 10 percent with monthly compounding as:
=EFFECT(.10,12),
which produces an answer of 10.471 percent.
Similarly, finding the nominal rate with monthly compounding that is equivalent to an EAR of 10
percent,
=NOMINAL(.10,12),

What is free cash flow
and how do I calculate it?
A summary provided by
Pamela Peterson Drake, Florida Atlantic University
CONTENTS:
Estimates of cash flows .................................................................................................................... 1

Free cash flow ................................................................................................................................. 2
Free cash flow and agency theory .................................................................................................. 3
Free cash flow to equity ................................................................................................................ 3
Free cash flow to the firm.............................................................................................................. 3
Valuation using free cash flow........................................................................................................... 4
Example.......................................................................................................................................... 5
Issues............................................................................................................................................. 6
Online resources for additional information on free cash flow............................................................... 6
The value of a company requires estimating future cash flows to providers of capital and capitalizing
these to determine a value of the company today. But what are these cash flows and how do we
estimate them?
Estimates of cash flows

Cash flows have been estimated a number of ways, which adds to the confusion about how we should
value a company. Consider the simplest form of cash flow, which is the earnings before depreciation
and amortization, EBDA. This cash flow is sometimes referred to as the accounting cash flow
because before we had the statements of cash flow or the older, funds flow statement, EBDA was often
used as a quick estimate of cash flow. The calculation is simple and only requires information from the
income statement:
(EQ 1) EBDA = Net income + depreciation + amortization
In the EBDA, we are adding the primary non-cash expense that had been deducted to arrive at net
income.
If we are valuing a company, however, we must consider that the cash flow should be that available to
the suppliers of capital – i.e., creditors and owners. Because interest is deducted to arrive at net income,
what we need is a cash flow before any interest. This then provides an estimate of cash flow that could
be paid to both creditors and owners. This cash flow is referred to as earnings before interest,
depreciation, and amortization, or EBITDA:
(EQ 2) EBITDA = Net income + interest + depreciation + amortization

Also known as …
Analysts look at a company’s EBITDA because this enables comparison
of the results from operations among companies in the same line of EBITDA is also known as
business that should have similar operating cost structures. And operating income before
because it is an earnings number before depreciation and amortization, depreciation and
it is not affected by the method the company chooses to spread the amortization, or OIBDA.
capital costs over the assets’ useful life. However, EBITDA, though
1
useful in some applications, is does not fully reflect the cash flows of a company.
The requirement that companies report cash flow information in the statement of cash flows provides
information that is useful in financial analysis and valuation. This statement requires the segregation of
cash flows by operations, financing, and investment activities. A key cash flow in both analysis and
valuation is the cash flow for/from operating activities. This cash flow is calculated by adjusting net
income for non-cash expenses and income, as well as for changes in working capital accounts. This
latter adjustment is used to convert the accrual-based accounting into cash-based accounting.
The calculation uses information from both the company’s income statement and its balance sheet:
Net other non-cash increase in

(EQ 3) CFO = + depreciation + amortization + -
income charges (income) net working capital
Net working capital is defined as:
(EQ 4) Net working capital = Current assets – current liabilities
Therefore, if net working capital increases, this is an offset to cash flow from operations, whereas if net
working capital decreases, this is an enhancement of the cash flow from operations.
Cash flow from operations is a key indicator of a company’s financial health, because without the ability
to generate cash flows from its operations, a company may not be able to survive in the future: cash
flows are the lifeblood of a company.
Free cash flow

It has always been recognized that cash flow, no matter how we calculated it, does not necessarily reflect
what was available for the suppliers of capital (that is, creditors and owners). An alternative cash flow,
known as free cash flow (FCF), is useful in gauging a company’s cash flow beyond that necessary to
grow at the current rate. This is because a company must make capital expenditures to continue to exist
and to grow and FCF considers these expenditures.
In analysis and valuation, the essence of free cash flow is expressed as cash flow from operations, less
any capital expenditures necessary to maintain its current growth:
(EQ 5) Free cash flow = CFO - capital expenditures necessary

to maintain current growth
Unfortunately, the amount that a company spends on capital expenditures necessary to maintain current
growth is not something that can be determined from the financial statements. Therefore, many analysts
revert to using the earlier calculation of free cash flow, using the entire capital expenditure for the
period:
(EQ 6) Free cash flow = CFO - capital expenditures
This represents the financial flexibility of the company; that is, these funds represent the ability to take
advantage of investment opportunities beyond the planned investments. However, because capital
expenditures for many companies tend to be “lumpy” (that is, vary significantly from year to year),
caution should be applied in interpreting the year-to-year variations in FCF that are due solely to the
“lumpiness” of cash flows.
2
Free cash flow and agency theory
Michael Jensen developed a theory of free cash flow in an agency context. 1 The theory focused on the
availability of free cash flow and the agency costs associated with this availability. His theory associated
agency costs with free cash flow: if a company has free cash flow, this cash flow may be wasted and,
hence, is underutilized – resulting in an agency cost. There has been research and debate as to whether
there are truly costs to free cash flow, yet his theory did shift focus away from earnings and towards to
the concept of free cash flow.
Free cash flow to equity

In the valuation of the equity of a company, we need to consider that owners, as the residual claimants,
are affected by the debt financing of a company. Therefore, the free cash flow to equity (FCFE) is
the FCF adjusted for the debt cash flows. 2 The debt cash flow adjustment, or net borrowings, is:
(EQ 7) Net borrowing = new debt debt

financing repayment
The free cash flow to equity, starting with the cash flow from operations, is:
(EQ 8) FCFE = cash flow - capital net

from operations expenditures borrowing
Another form of the calculation is to start with net income and then add non-cash charges (or subtract
non-cash income), such as depreciation, amortization, charges for the write-down of assets, and deferred
income taxes:
(EQ 9) FCFE = Net + non-cash - capital + net

income charges (income) expenditures borrowing
Free cash flow to the firm

We can calculate the FCFF by starting with cash flows from operations:
(EQ 10) FCFF = Cash flow

from operations
ª
¬

º
+ «Interest 1- tax » - capital
rate ¼ expenditures
Another approach is to begin with earnings before interest and taxes:
(EQ 11)
FCFF = EBIT 1 - tax +
rate non-cash - capital increase in
charges (income) expenditures working capital
Recognizing that:
(EQ 12)
EBIT 1 - tax = Net
rate income
ª º

+ «Interest 1- tax » ,
¬ rate ¼
we can re-write equation 11 in terms of net income:
1
Michael Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” American
Economic Review, 76, no. 2 (May 1986), pp. 323–329.
2
If the company has preferred stock and the company pays preferred dividends, the free cash flow to
common equity (FCFCE) is the FCFE, less any preferred dividends.
3
(EQ 13) FCFF = Net
income
ª
¬
º

+ «Interest 1- tax » + non-cash - capital increase in
rate ¼ charges (income) expenditures working capital
The FCFF is often referred to as the unlevered free cash flow because it is the cash flow before
interest on debt is considered.
We can reconcile the free cash flow to the firm with the free cash flow to equity by noting that the
difference between the two are:
Interest paid on debt, and

Net new debt financing.
In other words,
(EQ 14) Free cash flow to the firm = FCFE + ª interest 1-tax rate º - net
«¬expense »¼ borrowings
Valuation using free cash flow

The valuation of a company requires discounting the future cash flow to the present. The cash flows that
we use in this valuation are forecasted free cash flows. The model that we use to determine a value
today depends on the assumptions regarding the growth of the free cash flows.
Let r indicate the appropriate cost of capital, let g represent the estimated growth rate and let t indicate
the period. The value of a firm is calculated by choosing the appropriate model:
Growth assumption Model General formula

FCF
No growth Perpetuity Value =
r
FCF1
Constant growth Gordon growth model Value =
r-g
f FCF
Non-constant growth Discounted cash flow Value= ¦ t
t=1 r
The appropriate cost of capital and free cash flow depend on what you are valuing:
In the valuation of equity, the cost of capital is the cost of equity and the free cash flow is the free
cash flow to equity.
In the value of the firm, the cost of capital is the weighted average cost of capital for the firm and the
free cash flow is the free cash flow to the firm.
For example, if you are valuing the equity of a company and are assuming that the free cash flows will
grow at a constant rate indefinitely, then the appropriate formulation is:
FCFE1
(EQ 15) Value of equity =
re - g
with re the cost of equity. If, on the other hand, you are valuing the entire firm and are assuming that the
cash flows will grow at the rate of g1 for t1 periods and then g2 thereafter, the appropriate formulation is:
4
§ FCFF0 (1+g1 ) t1 (1+g2 ) ·
¨
(EQ 16) Value of the firm= ¦
FCFF0 (1+g)
t1
+
t
¨ rc -g2 ¸¸
t=1 (1+rc ) t ¨ (1+rc ) t1 ¸
¨ ¸
© ¹
where rc indicates the weighted average cost of capital.
Example
Consider Lowe’s Companies’ 2005 fiscal year annual report. The following information is available from
the company’s financial statements, with dollar amounts in millions:
Source
Statement
Amount Income Balance of cash
Item in millions statement sheet flows
Cash flow from operations $3,842
Net income $2,771
EBIT [calculated as: $4,506 +158] $4,664
Depreciation and amortization $1,051
Other non-cash adjustments $133
Change in working capital $113
Capital expenditures [calculated as: $3,379 - 61] $3,318
Net debt financing [calculated as: $1,031 – 633] $380
Interest expense $158
Tax rate (estimated as $1,735 / $4,506) 38.5%
Therefore, assuming that all capital expenditures are necessary for maintaining the current growth, the
free cash flows for 2005, in millions, are:
Free cash flow Equation Calculation

Free cash flow to equity EQ 8 $3,842 – 3,318 + 380 = $904
EQ 9 $2,771 + 1,051 + 133 - 3,318 – 113 + 380 = $904
Free cash flow to the firm EQ 10 $3,842 + 158 (1 - 0.385) - 3,318 = $621
EQ 11 $2,868 + 1,051 + 133 – 3,318 - 113 = $621
EQ 13 $2,771 + 1,051 + 133 + 158 (1-0.385) – 3,318 - 113 = $621
EQ 14 $904 + 158 (1 – 0.385) - 380 = $621
Suppose Lowe’s cash flows are expected to grow at rate of 21 percent for the next five years and then
4.5 percent thereafter. If the cost of equity is 8.5 percent and the weighted average cost of capital is 7.5
percent, the valuation of the company and of the equity is calculated as $55 billion and $44 billion
respectively:
Horizon Value
in millions FCF1 FCF2 FCF3 FCF4 FCF5 value today
Value of the firm $751 $909 $1,100 $1,331 $1,611 $67,328 $49,422
Value of equity $1,094 $1,324 $1,601 $1,938 $2,345 $61,256 $43,891
5
Issues
There are a number of issues that arise in calculating and using free cash flows in valuation. These issues
include:
The different definitions of free cash flow. We look at definitions of free cash flow, free cash flow to
equity, and free cash flow to the firm. But there are actually many different calculations to represent
these cash flows and, to add to the confusion, many are simply referred to as free cash flow.
Estimating free cash flow for future periods using current financial information presumes that the
current performance is representative of the company and its ability to generate cash flows. Variation
in capital expenditures from year to year, combined with the typical variability in net income, suggest
that a better benchmark may use some type of averaging of cash flows from several periods, not just
one fiscal period.
The benefit of free cash flow is still debated. While free cash flow provides financial flexibility, it also
provides temptation to invest in non-value adding projects.
The value estimated using free cash flows should be evaluated with respect to the sensitivity of the
estimate to the specific calculation of free cash flow, the assumptions regarding growth rates, and the
assumptions imbedded in the calculation of the appropriate cost of capital.
Online resources for additional information on free cash

flow
1. Damadoran, Aswath, “Firm Valuation: Cost of Capital and APV Approaches,” Chapter 15.
2. Damadoran, Aswath, “Free Cash Flow to Equity Discount Models, Chapter 14.
3. Mills, John, Lynn Bible, and Richard Mason. “Defining Free Cash Flow,” The CPA Journal, 2002.
4. Motley Fool, Foolish Fundamentals: Free Cash Flow.
5. Tarter, John, Federal Reserve Bank of Cleveland, Supervision & Regulation Department, “EBITA a
Useful Cash-Flow Tool, But No Substitute for Good Judgment.”
6. Value-Based Management.net, “Earnings Before Interest, Taxes, Depreciation and Amortization.”
6
Understanding Financial Statements
Prepared by Pamela Peterson Drake
The financial statements included in this explanation of financial statements are the 2004 financial
statements of Procter & Gamble. Comments are inserted along with many of the account titles; click
on the comment icon and the comment window will appear.
Full understanding of financial statements requires reading all the footnotes that accompany the
statements. To access the footnotes to these statements, go to Procter & Gamble’s Investor
Relations web site.
Procter & Gamble
Consolidated Statements of Earnings

See accompanying Notes to Consolidated Financial Statements
Years Ended June 30
Amounts in millions except per share amounts 2004 2003 2002
Net Sales $51,407 $43,377 $40,238

Cost of products sold 25,076 22,141 20,989
Selling, general and administrative expense 16,504 13,383 12,571
Operating Income 9,827 7,853 6,678
Interest expense 629 561 603
Other non-operating income, net 152 238 308
Earnings Before Income Taxes 9,350 7,530 6,383
Income taxes 2,869 2,344 2,031
Net Earnings $6,481 $5,186 $4,352
Basic Net Earnings Per Common Share $2.46 $1.95 $1.63

Diluted Net Earnings Per Common Share $2.32 $1.85 $1.54
Dividends Per Common Share $0.93 $0.82 $0.76
Source: www.proctergamble.com Modifications have been made to the original statements to provide comments and
explanations.
Procter & Gamble
Consolidated Balance Sheets
Assets
June 30
Amounts in millions 2004 2003

Current Assets
Cash and cash equivalents $5,469 $5,912
Investment securities 423 300
Accounts receivable 4,062 3,038
Inventories
Materials and supplies 1,191 1,095
Work in process 340 291
Finished goods 2,869 2,254
Total Inventories 4,400 3,640
Deferred income taxes 958 843
Prepaid expenses and other receivables 1,803 1,487
Total Current Assets 17,115 15,220
Property, Plant and Equipment
Buildings 5,206 4,729
Machinery and equipment 19,456 18,222
Land 42 591
23,542 25,304
Accumulated depreciation (11,196) (10,438)
Net Property, Plant and Equipment 14,108 13,104
Goodwill and Other Intangible Assets
Goodwill 19,610 11,132
Trademarks and other intangible assets, net 4,290 2,375
Net Goodwill and Other Intangible Assets 23,900 13,507
Other Non-Current Assets 1,925 1,875
Total Assets $57,048 $43,706
Procter & Gamble
Consolidated Balance Sheets, continued
Liabilities and equity
2004 2003
Current Liabilities
Accounts payable $3,617 $2,795
Accrued and other liabilities 7,689 5,512
Taxes payable 2,554 1,879
Debt due within one year 8,287 2,172
Total Current Liabilities 22,147 12,358
Long-Term Debt 12,554 11,475
Deferred Income Taxes 2,261 1,396
Other Non-Current Liabilities 2,808 2,291
Total Liabilities 39,770 27,520
Shareholders’ Equity
Convertible Class A preferred stock, stated value $1 per share 1,526 1,580
(600 shares authorized)
Non-Voting Class B preferred stock, stated value $1 per 0 0
share(200 shares authorized)
Common stock, stated value $1 per share (5,000 shares 2,544 2,594
authorized; shares outstanding:2004 – 2,543.8, 2003 -
2,594.4)
Additional paid-in capital 2,425 1,634
Reserve for ESOP debt retirement (1,283) (1,308)
Accumulated other comprehensive income (1,545) (2,006)
Retained earnings 13,611 13,692
Total Shareholders’ Equity 17,278 16,186
Total Liabilities and Shareholders’ Equity $57,048 $43,706
explanations.
Procter & Gamble
Consolidated Statements of Cash Flows
Years ended June 30
Amounts in millions 2004 2003 2002

Cash and Cash Equivalents, Beginning of Year $5,912 $3,427 $2,306
Operating Activities
Net earnings 6,481 5,186 4,352
Depreciation and amortization 1,733 1,703 1,693
Deferred income taxes 415 63 389
Change in accounts receivable (159) 163 96

Change in inventories 56 (56) 159
Change in accounts payable, accrued and other liabilities 625 936 684
Change in other operating assets and liabilities (88) 178 (98)
Other 299 527 467
Total Operating Activities 9,362 8,700 7,742
Investing Activities
Capital expenditures (2,024) (1,482) (1,679)
Proceeds from asset sales 230 143 227
Acquisitions (7,476) (61) (5,471)
Change in investment securities (121) (107) 88
Total Investing Activities (9,391) (1,507) (6,835)
Financing Activities
Dividends to shareholders (2,539) (2,246) (2,095)
Change in short-term debt 4,911 (2,052) 1,394
Additions to long-term debt 1,963 1,230 1,690
Reductions of long-term debt (1,188) (1,060) (461)
Proceeds from the exercise of stock options 555 269 237
Treasury purchases (4,070) (1,236) (568)
Total Financing Activities (368) (5,095) 197
Effect of Exchange Rate Changes on Cash and Cash Equivalents (46) 387 17
Change in Cash and Cash Equivalents (443) 2,485 1,121
Cash and Cash Equivalents, End of Year $5,469 $5,912 $3,427
Supplemental Disclosure
Cash payments for:
Interest $630 $538 $629
Income taxes 1,634 1,703 941
Non-cash spin-off of Jif and Crisco businesses 150
Acquisition of Businesses
Fair value of assets acquired, excluding cash $11,954 $61 $6,042
Fair value of liabilities assumed (4,478) - (571)
Acquisitions 7,476 61 5,471
explanations.
Research tools in Finance instruction Page 1 of 2
Research Resources for the Finance student

CREATED BY PAMELA PETERSON DRAKE, JAMES MADISON UNIVERSITY
Gathering information | Analyzing information | Writing reports
Gathering information
z Sources of Industry Information

z Instructions on locating SEC filings
z Library resources
z Gathering data from Mergent Online and the accompanying example worksheet
Analyzing information
z Estimating the market model: Step by step and the accompanying example workbook
z Comparing share price performance of a stock
Writing research papers
z Writing Suggestions
z How To Avoid Plagiarism
z RefWorks Importing instructions
http://educ.jmu.edu/~drakepp/general/research.htm 3/2/2011
Research tools in Finance instruction Page 2 of 2

Gathering information http://educ.jmu.edu/~drakepp/general/research.htm#gather
Analyzing information http://educ.jmu.edu/~drakepp/general/research.htm#analyze
Writing reports http://educ.jmu.edu/~drakepp/general/research.htm#write
Sources of Industry
http://educ.jmu.edu/~drakepp/general/Industry_information_sources.pdf
Information
Instructions on locating
http://educ.jmu.edu/~drakepp/general/edgar.pdf
SEC filings
Library resources http://educ.jmu.edu/~drakepp/general/library_resources.pdf
Gathering data from
http://educ.jmu.edu/~drakepp/general/mergent.pdf
Mergent Online
example worksheet http://educ.jmu.edu/~drakepp/investments/examples/Kellogg.xls
Estimating the market
http://educ.jmu.edu/~drakepp/general/market_model.pdf
model: Step by step
example workbook http://educ.jmu.edu/~drakepp/general/examples/msft.xls
Comparing share price
http://educ.jmu.edu/~drakepp/general/Relative_performance.pdf
performance of a stock
Writing Suggestions http://educ.jmu.edu/~drakepp/general/writing.pdf
How To Avoid Plagiarism http://educ.jmu.edu/~drakepp/general/avoidplagiarism.pdf
RefWorks Importing
http://educ.jmu.edu/~drakepp/general/Refworks.pdf
instructions
http://educ.jmu.edu/~drakepp/general/research.htm 3/2/2011
Sources of Industry Data
for Financial Analysis
Prepared by Pamela Peterson Drake, Florida Atlantic University
There are many sources of industry data available on the Internet. These sources include free and fee-
based information. All U.S. Government information is available at no charge to the public. In addition,
industry associations make a great deal of data available at no charge, though many associations retain
some information for members only. Further, there are many industry-specific analyses created by financial
analysts, but this information is generally fee-based. However, most of these analyses are based on
publicly-available economic and financial data.
The URLs of the various sources do change over time, so you may have to perform an Internet search to
locate the information.
The purpose of this listing of sources of industry data is to provide a starting point for an analysis of an
industry. This listing is not intended to be comprehensive. From these links, you will find links to many other
sources of industry economic and financial information.
CONTENTS
General overview of industries.................................................................................................................1
General economic information on industries and sectors ...........................................................................2
Industry-specific data .............................................................................................................................3
General overview of industries

Source Availability
Google http://finance.google.com
Yahoo! finance http://finance.yahoo.com
Value Line Investment Survey Available through FAU Libraries using EZProxy
Mergent Online Available through FAU Libraries using EZProxy
Standard & Poor’s NetAdvantage Available through FAU Libraries using EZProxy
1 of 4
General economic information on industries and sectors
Information URL Source
Annual survey of manufacturers http://www.census.gov/mcd/asmhome.html U.S. Census Bureau
Consumer Price Indexes http://stats.bls.gov/cpi/ U.S. Department of Labor
Current Industrial Reports http://www.census.gov/cir/www/ U.S. Census Bureau
General statistics on industries http://www.census.gov/csd/susb/susb.htm U.S. Census Bureau
Government agencies linked by industry http://www.fedstats.gov/ FedStats
Industry benchmarks and ratios http://www.bizstats.com/ BizMiner
Industry classifications and descriptions http://www.naics.com/ NAICS Association
International trade http://www.usitc.gov/ U.S. International Trade Commission
Producer Price Indexes http://stats.bls.gov/ppi/ U.S. Department of Labor
Trends in trade http://www.ita.doc.gov/td/industry/otea/outlooknews.htm U.S. Industry & Trade Outlook
2 of 4
Industry-specific data
Industry URL Source
Air Transportation http://www.bls.gov/oco/cg/cgs016.htm U.S. Department of Labor
http://www.airlines.org/ Air Transport Association
Broadcasting http://www.bls.gov/oco/cg/cgs017.htm U.S. Department of Labor
http://www.nab.org/ National Association of Broadcasters
Confections and candy http://www.candyindustry.com/ Candy Industry
Construction http://www.bls.gov/oco/cg/cgs003.htm U.S. Department of Labor
http://www.census.gov/mcd/ U.S. Census Bureau
Electric Industry http://www.eia.doe.gov/cneaf/electricity/page/at_a_glance/fi_tabs.html U.S. Department of Energy
http://www.eei.org/ Edison Electric Industry
Food Services http://www.bls.gov/oco/cg/cgs023.htm U.S. Department of Labor
http://www.ifdaonline.org/ International Foodservice Distributors Association
Furniture http://www.furnituretoday.com/ Furniture Today
Gambling http://www.americangaming.org/industry/index.cfm American Gaming Association
http://www.casinoworldnews.com/ Casino World News
Homebuilding http://www.ofheo.gov/ Office of Federal Housing Enterprise Oversight
http://www.nahb.org/ National Association of Home Builders
http://www.realtor.org/ National Association of Realtors
Hotels and Other Accommodations http://www.bls.gov/oco/cg/cgs036.htm U.S. Department of Labor
http://www.hotel-online.com/ Hotel Online
Insurance http://www.ambest.com/ A. M. Best Company
http://www.naic.org/ National Association of Insurance Commissioners
http://www.iii.org/ Insurance Information Institute
Mining http://www.bls.gov/oco/cg/cgs004.htm U.S. Department of Labor
http://minerals.er.usgs.gov/minerals/ U.S. Geological Survey
http://www.bizminer.com/drilldown/industries/1000-Metal-Mining.asp BizMiner
Motor Vehicles and Parts http://www.bls.gov/oco/cg/cgs012.htm U.S. Department of Labor
Manufacturing http://www.census.gov/svsd/www/vius/products.html U.S. census Bureau
Oil and Gas Extraction http://www.bls.gov/oco/cg/cgs005.htm U.S. Department of Labor
http://www.bizminer.com/drilldown/industries/1300-Oil-Gas-Extraction.asp BizMiner
3 of 4
Industry-specific data, continued
Petroleum industry http://www.eia.doe.gov/emeu/mecs/iab/petroleum/index.html U.S. Department of Energy

http://api-ec.api.org/industry/index.cfm?bitmask=001004000000000000 American Petroleum Institute
Pharmaceuticals http://www.bls.gov/oco/cg/cgs009.htm U.S. Department of Labor
http://www.pharmaceutical-business-review.com/ Pharmaceutical Business
Retail Drug Stores http://www.nacds.org/wmspage.cfm?parm1=507 National Association of Chain Drug Stores
Retail Trade http://www.census.gov/econ/www/retmenu.html U.S. Census Bureau
Securities http://www.sia.com/research/html/quarterly_securities_results.html Securities Industry Association
Telecommunications http://www.bls.gov/oco/cg/cgs020.htm U.S. Department of Labor
Truck Transportation and http://www.bls.gov/oco/cg/cgs021.htm U.S. Department of Labor
Warehousing http://www.census.gov/svsd/www/cfsmain.html U.S. Census Bureau
4 of 4
How to locate a filing with the
Securities and Exchange Commission
An introduction to the EDGAR system
Step 1: Go the Securities and Exchange Commission’s

EDGAR site
The Securities and Exchange Commission, SEC, site is at http://www.sec.gov:
Use the link on this page to “Search Company Filings” using the SEC’s EDGAR system. Select
Companies & Other Filers within this site
1
Step 2: Enter the search data
Using the company’s name, CIK (Central Index Key, a unique identifier within the system), or
Ticker Symbol, input the information on the company that you are searching for, followed by the
clicking on the Find Companies link. 1 For example, if I want to find information on Microsoft, I
would type in MSFT for its Ticker Symbol.
If you search by name, but the name is associated with one or more companies, you will be
required to select among the list of companies with similar names.
Step 3: Search for the specific filing

Once you reach the information on the company of interest, you will now discover that there are
many filings for a given company.
1
Company names and ticker symbols may not be unique over time, but the CIK is unique.
2
You can simply scroll down to find what you need, or you can list the specific form that you wish.
For example,
If you wish a 10-K filing you would enter 10-K in the Form Type box.
If you wish a Proxy Statement, you would enter DEF 14A in the Form Type box.
If you wish an 8-K filing, you would enter 8-K in the Form Type box.
The Proxy Statements for Microsoft are listed as:
3
Given a choice between the [html] and [text] versions of the file, you are likely to find the HTML
version easier to read. For filings in more recent years, you will also find that in the HTML files,
you can see the entire file in HTML form or specific jpg files:
4
Clicking on the document link for the DEF14A, produces:
5
A B C D E F G H I J K L M N O P
1 Kellogg Company
2 Liquidity ratios
3 Prepared by Pamela Peterson Drake
4
5 12/31/1990 12/31/1991 12/31/1992 12/31/1993 12/31/1994 12/31/1995 12/31/1996 12/31/1997 12/31/1998 12/31/1999 12/31/2000 12/31/2001 12/28/2002 12/27/2003 1/1/2005
6 Current ratio 0.93854 0.88568 1.15462 1.02511 1.20950 1.12913 0.69513 0.88560 0.87082 0.98829 0.64463 0.86157 0.58490 0.64975 0.74554
7 Quick ratio 0.61437 0.58283 0.76583 0.69323 0.87513 0.83144 0.50191 0.62354 0.60815 0.67099 0.46658 0.60133 0.38482 0.41482 0.50625
8
9
10 1.4
11 Current ratio Quick ratio
12 1.2
13
14 1.0
15
16 0.8
17 Coverage
18 0.6
19
20 0.4
21
22 0.2
23
24 0.0
25 1990 1992 1994 1996 1998 2000 2002 2005
26
Fiscal year
27
28
KellogCompany_Liquidity
1/1
Kellogg Company
1
Liquidity ratios
2
Prepared by Pamela Peterson
Drake
3
4
5 33238 33603 33969 34334 34699 35064 35430 35795 36160 36525 36891 37256 37618 37982 38353
6 Current ratio =KellogCompany_Data!B24/KellogCompany_Data!B55 =KellogCom=KellogCom=KellogCom=KellogCom=KellogCom=KellogCom=KellogCom=KellogCom=KellogCom=KellogCom=KellogCom=KellogCom=KellogCom=KellogCom
7 Quick ratio =(KellogCompany_Data!B24-KellogCompany_Data!B16)/KellogCompany_Data!B55 =(KellogCo =(KellogCo =(KellogCo =(KellogCo =(KellogCo =(KellogCo =(KellogCo =(KellogCo =(KellogCo =(KellogCo =(KellogCo =(KellogCo =(KellogCo =(KellogCo
8
9
10 1.4
11 Current ratio Quick ratio
12 1.2
13
14 1.0
15
16 0.8
17 Coverage
18 0.6
19
20 0.4
21
22 0.2
23
24 0.0
25 1990 1992 1994 1996 1998 2000 2002 2005
26
Fiscal year
27
28
KellogCompany_Liquidity
1/1
1 Kellogg Co
2
3 As Reported Annual Balance Sheet 33238 33603 33969 34334 34699 35064 35430 35795 36160 36525 36891 37256 37618 37982 38353
4 Currency USD USD USD USD USD USD USD USD USD USD USD USD USD USD USD
5 Auditor Status Not Available Not Available Not Qualified Not Qualified Not Qualified Not Qualified Not Qualified Not Qualified Not Qualified Not Qualified Not Qualified Not Qualified Not Qualified Not Qualified Not Qualified
6 Consolidated Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
7 Scale Thousands Thousands Thousands Thousands Thousands Thousands Thousands Thousands Thousands Thousands Thousands Thousands Thousands Thousands Thousands
8
9 Cash & cash equivalents 100500 178000 126300 98100 266300 221900 243800 173200 136400 150600 204400 231800 100600 141200 417400
10 Trade receivables - - - - - - - 595000 705900 561500 607200 692000 681000 716800 700900
11 Allowance for doubtful accounts - - - - - - - 7500 12900 8600 8600 15500 16000 15100 13000
12 Other receivables - - - - - - - - - 125600 86700 85800 76000 53100 88500
13 Accounts receivable, net 430200 420000 519100 536800 564500 590100 592300 587500 693000 678500 685300 762300 741000 754800 776400
14 Raw materials & supplies 174800 173200 167700 148500 141700 129700 135200 135000 133300 141200 138200 170700 172200 185300 188000
15 Finished goods & materials in process 184900 227900 248700 254600 254600 247000 289700 299300 318100 362600 305600 403800 431000 464500 493000
16 Inventories 359700 401100 416400 403100 396300 376700 424900 434300 451400 503800 443800 574500 603200 649800 681000
17 Prepaid expenses 80600 110400 108600 - - - - - - - - - - - -
18 Other current assets - - - 121600 127000 240100 267600 - - - - - - - -
19 Prepaid advertising & promotion - - - - - - - 95200 69900 - - - - - -
20 Deferred income taxes 70400 63500 66200 85500 79400 - - 113400 89900 108500 136500 151500 207800 150000 101900
21 Other prepaid assets - - - - - - - - - 127800 136800 181900 110800 101400 145100
22 Other current assets - - - - - - - 64100 55900 - - - - - -
23 Total other current assets - - - - 206400 - - 272700 215700 236300 273300 333400 318600 251400 247000
24 Total current assets 1041400 1173000 1236600 1245100 1433500 1428800 1528600 1467700 1496500 1569200 1606800 1902000 1763400 1797200 2121800
25 Land 41000 40400 40500 40600 47300 50000 52400 49000 49300 44100 40500 65700 62600 75100 78300
26 Buildings 1026900 1045500 1021200 1065700 1122600 1202800 1226100 1213800 1247900 1255300 1197100 1279100 1345600 1417500 1504700
27 Machinery & equipment 2462800 2635500 2629400 2857600 3141000 3283000 3464100 3434700 3608200 3595500 3683100 4074500 4284800 4555300 4751300
28 Construction in progress 141300 168300 302600 308600 289600 202000 277500 283100 341400 261800 114500 192700 159600 171600 159600
29 Accumulated depreciation 1076600 1243200 1331000 1504100 1707700 1953000 2087200 2207300 2358000 2515800 2508300 2659200 3012400 3439300 3778800
30 Property, net 2595400 2646500 2662700 2768400 2892800 2784800 2932900 2773300 2888800 2640900 2526900 2952800 2840200 2780200 2715100
31 Other assets 49700 56500 62400 164500 141000 201000 588500 - - - - - - - -
32 Goodwill, gross - - - - - - - - - 205100 218700 3138500 - - -
33 Less: Accumulated amortization - - - - - - - - - 4400 10500 69000 - - -
34 Goodwill, net - - - - - - - 194300 185500 200700 208200 3069500 3106600 3098400 3095100
35 Other intangibles, gross 62900 49800 53300 59100 - - - - - 144500 217800 2118800 2046600 2069500 2067200
36 Less: Accumulated amortization - - - - - - - - - 9600 18600 67700 20600 35100 46100
37 Other intangibles, net - - - - - - - 191200 194000 134900 199200 2051100 - - -
38 Other assets - - - - - - - 251100 286700 263000 355200 393200 483100 520600 837300
39 Total other assets - - - - - - - 636600 666200 598600 762600 5513800 5615700 5653400 5953500
40 Total assets 3749400 3925800 4015000 4237100 4467300 4414600 5050000 4877600 5051500 4808700 4896300 10368600 10219300 10230800 10790400
41 Current maturities of long-term debt 102300 260700 1900 1500 900 1900 501200 211200 1100 2900 901100 82300 776400 578100 278600
42 U.S. commercial paper - - - - - - - - - - - 320800 409800 296000 690200
43 Canadian commercial paper - - - - - - - - - - - 171100 - 15300 12100
44 Other notes payable - - - - - - - - - - - 21400 11100 9500 7400
45 Notes payable 280300 188400 210000 386700 274800 188000 652600 368600 620400 518600 485200 513300 420900 320800 709700
46 Accounts payable 247100 289800 313800 308800 334500 370800 335200 328000 386900 305300 388200 577500 619000 703800 767200
47 Other current liabilities 479900 585500 545300 517600 575000 704700 710000 - - - - - - - -
48 Accrued income taxes - - - - - - - 30500 69400 83500 130800 77300 151700 143000 96200
49 Accrued salaries & wages - - - - - - - 99700 100700 126000 96600 233500 228000 261100 270200
50 Accrued advertising & promotion - - - - - - - 308800 243400 211800 178200 233200 309000 323100 322000
51 Accrued interest - - - - - - - - - - - 112400 123200 108300 69900
52 Other accrued liabilities - - - - - - - - - - - 378100 386700 327800 332200
53 Other current liabilities - - - - - - - 310500 296600 339700 312500 - - - -
54 Total other current liabilities - - - - - - - 749500 710100 761000 718100 1034500 1198600 1163300 1090500
55 Total current liabilities 1109600 1324400 1071000 1214600 1185200 1265400 2199000 1657300 1718500 1587800 2492600 2207600 3014900 2766000 2846000
56 U.S. Dollar notes - - - - - - - - 600000 600000 600000 4059700 3687600 3242700 3066400
57 Euro Dollar notes - - - - - - - 1200000 1000000 1000000 1000000 500000 500000 500000 -
58 U.S. Dollar debentures - - - - - - - - - - - 1085300 1085800 1086300 1086800
59 Commercial paper - - - - - - - 400000 - - - - - - -
60 Other debt - - - - - - - 26600 15600 15700 10300 56300 22400 14500 18000
61 Total long-term debt - - - - - - - 1626600 1615600 1615700 1610300 5701300 5295800 4843500 4171200
62 Less current maturities - - - - - - - 211200 1100 2900 901100 82300 776400 578100 278600
63 Long-term debt 295600 15200 314900 521600 719200 717800 726700 1415400 1614500 1612800 709200 5619000 4519400 4265400 3892600
64 Other liabilities 95400 426400 683900 787500 755400 840500 841900 - - - - - - - -
65 Nonpension postretirement benefits - - - - - - - 444100 435200 424900 408500 475100 329600 291000 269700
66 Deferred income taxes 347000 - - - - - - 237700 259200 251300 266700 949800 986400 1062800 1187600
67 Other liabilities - - - - - - - 125600 134300 118700 121800 245600 473800 402400 337300
68 Total other liabilities - - - - - - - 807400 828700 794900 797000 1670500 1789900 1756200 1794600
69 Common stock 38600 77400 77500 77600 77600 77800 77900 103700 103800 103800 103800 103800 103800 103800 103800
70 Capital in excess of par value 81200 60200 69200 72000 68600 105200 123900 92600 105000 104500 102000 91500 49900 24500 -
71 Retained earnings (accumulated deficit) 2542400 2889100 3033900 3409400 3801200 3963000 4150300 1240400 1367700 1317200 1501000 1564700 1873000 2247700 2701300
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72 Treasury stock at cost 797300 880900 1105000 1653100 1980600 2361200 2903400 157300 394300 380900 374000 337100 278200 203600 108000
73 Currency translation adjustment -36900 -14000 130400 167200 159300 193900 166300 281900 - - - - - - -
74 Foreign currency translation adjustments - - - - - - - - - - - -489200 -487600 -406000 -334300
75 Cash flow hedges-unrealized net loss - - - - - - - - - - - -48900 -46300 -51900 -46600
76 Minimum pension liability adjustments - - - -25300 - - - - - - - -13300 -319500 -271300 -59000
77 Accumulated other comprehensive income (loss) - - - - - - - - -292400 -331400 -435300 -551400 -853400 -729200 -439900
78 Total shareholders' equity (deficit) 1901800 2159800 1945200 1713400 1807500 1590900 1282400 997500 889800 813200 897500 871500 895100 1443200 2257200
79
80 Kellogg Co
81
82 As Reported Annual Income Statement 33238 33603 33969 34334 34699 35064 35430 35795 36160 36525 36891 37256 37618 37982 38353
87
88 Net sales 5181400 5786600 6190600 6295400 6562000 7003700 6676600 6830100 6762100 6984200 6954700 8853300 8304100 8811500 9613900
89 Other revenue (deductions), net -5100 14600 - - - - - - - - - - - - -
90 Gross operating revenues 5176300 5801200 - - - - - - - - - - - - -
91 Cost of goods sold 2676600 2828700 2987700 2989000 2950700 3177700 3122900 3270100 3282600 3325100 3327000 4128500 4569000 4898900 5298700
92 Selling & administrative expenses - - - - - - - 2366800 2513900 - - - - - -
93 Selling, general, & administrative expense 1618800 1930000 2140100 2237500 2448700 2566700 2458700 - - 2585700 2551400 3523600 2227000 2368500 2634100
94 Restructuring charges - - - - - - - 184100 70500 244600 86500 33300 0 - -
95 Non-recurring charges - - - - - 421800 136100 - - - - - - - -
96 Operating profit (loss) - - 1062800 1068900 1162600 837500 958900 1009100 895100 828800 989800 1167900 1508100 1544100 1681100
97 Interest expense 66200 58300 29200 33300 45400 62600 65600 108300 119500 118800 137500 351500 391200 371400 308600
98 Disposition-related charges - - - - - - - - - -168500 - - - - -
99 Other income (expense), net - - 36800 -1500 12800 21100 -33400 3700 6900 -4800 15400 -12300 27400 -3200 -6600
100 Total costs & expenses 4361600 4817000 - - - - - - - - - - - - -
101 Earnings before income tax-United States - - - - - - - 576400 564000 235100 561900 464200 791300 799900 952000
102 Earnings before income taxes-Foreign - - - - - - - 328100 218500 301600 305800 339900 353000 369600 413900
103 Earnings before income taxes 814700 984200 1070400 1034100 1130000 796000 859900 904500 782500 536700 867700 804100 1144300 1169500 1365900
104 Current federal income tax provision - - - - - - - 129400 128700 135900 134000 120900 157100 141900 249800
105 Current state income tax provision - - - - - - - 29600 17800 20600 20300 30100 46200 40500 30000
106 Current foreign income tax provision - - - - - - - 143000 87200 102400 127100 99600 108900 125200 137800
107 Total current income tax provision - - - - - - - 302000 233700 258900 281400 250600 312200 307600 417600
108 Deferred federal income tax provision (benef) - - - - - - - 50200 30600 -60700 -1200 53100 82800 91700 51500
109 Deferred state income tax provision (benefit) - - - - - - - 4000 1700 -4500 4100 1200 8400 -8600 5300
110 Deferred foreign income tax provision (benef) - - - - - - - -15700 13900 4700 -4300 17200 20000 -8300 900
111 Total deferred income tax provision - - - - - - - 38500 46200 -60500 -1400 71500 111200 74800 57700
112 Income taxes 311900 378200 387600 353400 424600 305700 328900 340500 279900 198400 280000 322100 423400 382400 475300
113 Earnings before extraordinary loss 502800 606000 682800 680700 705400 - - - 502600 338300 - 482000 720900 - -
114 Extraordinary loss, net of tax - - - - - - - - - - - 7400 0 - -
115 Earnings before cumul eff of acctg change - - - - - - - - - - - - - 787100 -
116 Cumulative effect of accounting change, net - - -251600 - - - - -18000 - - - -1000 0 - -
117 Net earnings 502800 606000 431200 680700 705400 490300 531000 546000 502600 338300 587700 473600 720900 787100 890600
118 Weighted average shares outstanding-basic 483200 482400 477800 463000 448400 438300 424900 414100 407800 405200 405600 406100 408400 407900 412000
119 Weighted average shares outstanding-diluted - - - - - 438300 424900 414100 408600 405700 405600 407200 411500 410500 416400
120 Year end shares outstanding 482634 480926 474638 455840 443402 433410 419296 410800 405000 405500 405638.655 406611 407852.275 409699.62 413022.374
121 Earnings per share from cont opers-basic 1.04 1.255 - - 1.575 1.12 1.25 1.36 1.23 0.83 - 1.19 1.77 1.93 -
122 Earnings (loss) per share-acctg change-basic - - - - - - - -0.04 - - - - - - -
123 Net earnings per share-basic 1.04 1.255 0.905 1.47 1.575 1.12 1.25 1.32 1.23 0.83 1.45 1.17 1.77 1.93 2.16
124 Earnings per share from cont opers-diluted - - - - - 1.12 1.25 1.36 1.23 - - 1.18 1.75 1.92 -
125 Earnings (loss) per share-acctg change-dil - - - - - - - -0.04 - - - - - - -
126 Net earnings per share-diluted - - - - - 1.12 1.25 1.32 1.23 0.83 1.45 1.16 1.75 1.92 2.14
127 Total number of employees - - - - - 14487 14511 14339 14498 15051 15196 26424 25676 25250 25000
128 Number of common stockholders - - - - - 28073 26751 25305 24634 47511 46711 46126 41965 44635 43584
129 Depreciation & amortization 200200 222800 231500 265200 256100 258800 251500 287300 278100 288000 290600 438600 348400 - -
130
131 Kellogg Co
132
133 As Reported Annual Retained Earnings 33238 33603 33969 34334 34699 35064 35430 35795 36160 36525 36891 37256 37618 37982 38353
138
139 Previous retained earnings 2271400 2542400 2889100 3033900 3409400 3801200 3963000 4150300 1240400 1367700 1317200 1501000 1564700 1873000 2247700
140 Retirement of treasury stock - - - - - - - 3095800 - - - - - - -
141 Dividends 231800 259300 286400 305200 313600 328500 343700 360100 375300 388700 403900 409800 412600 412400 417600
142 Stock options exercised & other ret earnings - - - - - - - - - 100 - -100 - - -19400
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143 Retained earnings 2542400 2889100 3033900 3409400 3801200 3963000 4150300 1240400 1367700 1317200 1501000 1564700 1873000 2247700 2701300
144
145 Kellogg Co
146
147 As Reported Annual Cash Flow 33238 33603 33969 34334 34699 35064 35430 35795 36160 36525 36891 37256 37618 37982 38353
152
153 Net earnings 502800 606000 431200 680700 705400 490300 531000 546000 502600 338300 587700 473600 720900 787100 890600
154 Cumulative effect of accounting change - - 251600 - - - - - - - - - - - -
155 Depreciation & amortization 200200 222800 231500 265200 256100 258800 251500 287300 278100 288000 290600 438600 348400 372800 410000
156 Pre-tax (gain) loss on sale of subsidiaries - - -58500 -65900 -26700 - - - - - - - - - -
157 Deferred income taxes 45600 -5400 100 -22300 24500 -78700 58000 38500 46200 -60500 -1400 71500 111200 74800 57700
158 Restructuring charges, net of cash paid - - - - - 385300 90600 133800 62200 220100 62500 31200 0 - -
159 Disposition-related charges - - - - - - - - - 168500 - - - - -
160 Other adjustments 17700 16800 34700 11900 -49300 9100 14500 9500 21700 65700 -1200 -66000 700 76100 104500
161 Pension & oth postretirement benefit contribs - - - - - -74500 -156800 -114500 -88800 -78100 -84300 -76300 -446600 -184200 -204000
162 Trade receivables -75000 10200 -99100 -17700 -27700 -25600 10900 5100 -102600 21000 1100 100900 28100 -17900 13800
163 Other receivables - - - - - - - - - - - - - - -39500
164 Inventories 34300 -41400 -15300 13300 6800 19600 -35400 -8100 -15000 -39100 54500 15800 -26400 -48200 -31200
165 Prepaid expenses -74400 -22900 -900 -32300 -5400 - - - - - - - - - -
166 Other current assets - - - - - -33700 -500 -11000 33200 14700 -20200 -17800 71100 400 -17800
167 Accounts payable -3800 42700 24000 -5000 25700 36300 -41000 -8700 58900 -84800 75100 47600 41300 84800 63400
168 Accrued liabilities 171800 105600 -57400 -27700 57400 - - - - - - - - - -
169 Other current liabilities - - - - - 54100 -11300 1900 -76800 -58600 -83500 112900 151200 25300 -18500
170 Operating assets & liabilities - - - - - 50700 -77300 -20800 -102300 -146800 27000 259400 265300 44400 -29800
171 Net cash flows from operating activities 819200 934400 741900 800200 966800 1041000 711500 879800 719700 795200 880900 1132000 999900 1171000 1229000
172 Additions to properties -320500 -333500 -473600 -449700 -354300 -315700 -307300 -312400 -373900 -266200 -230900 -276500 -253500 -247200 -278600
173 Acquisitions of businesses - - - - - - -505200 -25400 -27800 -298200 -137200 -3858000 -2200 - -
174 Dispositions of businesses - - 115000 95600 95500 - - - - 291200 - - 60900 14000 -
175 Property disposals 18000 25200 18800 19000 15600 6300 11600 5900 6800 36600 4800 10100 6000 13800 7900
176 Other investing activities -7900 -11600 -10600 -25100 7800 500 14100 2600 -3100 -7600 -16000 -19400 0 400 300
177 Net cash flows from investing activities -310400 -319900 -350400 -360200 -235400 -308900 -786800 -329300 -398000 -244200 -379300 -4143800 -188800 -219000 -270400
178 Chng in notes pay w/maturs of 90 days or less 367800 182100 21600 176700 -111900 -86800 906600 -374700 -152900 -410800 290500 -154000 -226200 208500 388300
179 Iss of notes pay w/matur greater than 90 days - - - - - - 137000 4800 5500 292100 3500 549600 354900 67000 142300
180 Reduct of notes pay w/matur more than 90 days - - - - - - -79000 -14100 -800 -19000 -331600 -365600 -221100 -375600 -141700
181 Reduction of notes payable -463700 -274000 - - - - - - - - - - - - -
182 Issuances of long term debt 24200 4300 311700 208300 200000 - - 1000000 600000 - - 5001400 0 498100 7000
183 Reductions of long-term debt -102400 -126000 -270200 -1700 -2900 -400 -3400 -507900 -210300 -14100 -4800 -1608400 -439300 -956000 -682200
184 Net issuances of common stock 8400 17700 13400 2900 2300 36800 18800 70700 15200 12900 4500 26400 100900 121600 291800
185 Purchase of treasury stock -86900 -83600 -224100 -548100 -327300 - - - - - - - - - -
186 Common stock repurchases - - - - - -374700 -535700 -426000 -239700 - - - -101000 -90000 -297500
187 Cash dividends -231800 -259300 -286400 -305200 -313600 -328500 -343700 -360100 -375300 -388700 -403900 -409800 -412600 -412400 -417600
188 Other financing activities -6500 1100 11400 2900 -6100 -5600 -6600 - - - - 600 0 -600 -6700
189 Net cash flows from financing activities -490900 -537700 -422600 -464200 -559500 -759200 94000 -607300 -358300 -527600 -441800 3040200 -944400 -939400 -716300
190 Effect of exchange rate changes on cash 2300 700 -20600 -4000 -3700 -17300 3200 -13800 -200 -9200 -6000 -1000 2100 28000 33900
191 Incr (decr) in cash & cash equivalents 20200 77500 -51700 -28200 168200 -44400 21900 -70600 -36800 14200 53800 27400 -131200 40600 276200
192 Cash & cash equivalents at beginning of year 80300 100500 178000 126300 98100 266300 221900 243800 173200 136400 150600 204400 231800 100600 141200
193 Cash & cash equivalents at end of year 100500 178000 126300 98100 266300 221900 243800 173200 136400 150600 204400 231800 100600 141200 417400
194 Interest expense paid - - - - - - - 85000 113000 124000 141000 303000 386000 372000 333000
195 Income taxes paid - - - - - - - 332000 211000 242000 246000 195700 250000 289000 421000
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Estimating a market model:
Step-by-step
The purpose of this document is to guide you through the process of estimating a market model for the
purpose of estimating the beta of a stock. The beta of a stock is the slope coefficient in the following
equation:
rit= D +E rmt t = 1,2, …, T
where rit is the return on stock i in period t and rmt is the return on the market in period t. Some of the
more challenging elements of this process is gathering the necessary data and then putting it in a form
that allows us to use Microsoft Excel® to estimate the regression.
In this example, I will demonstrate how to estimate the beta of Microsoft stock using sixty months of
returns.
Contents:
1. Obtaining stock prices and dividends ......................................................................................... 1
2. Calculating returns on the stock ................................................................................................ 5
3. Obtaining returns on a market index.......................................................................................... 6
4. Estimating the market model..................................................................................................... 7
5. Determining the growth in value.............................................................................................. 10
1. Obtaining stock prices and dividends

There are many sources of downloadable stock prices on the Internet. One such source is Yahoo!
Finance. There are several paths to the stock prices and I will demonstrate one of these paths for you.
Using the main page of Yahoo! Finance, type in the ticker symbol of the stock of interest into the Enter
Symbol(s) box and click on GO:
1
This will produce the current day’s information on the stock’s trading, along with links to company and
industry specific information. In the left-most menu, click on Historical Prices.
Now we specify the information that we need, which is monthly prices. Ideally, we want to estimate the
market model using at least sixty monthly returns. This means that we need sixty-one months of prices.
Specifying the start and end date,
We then Get Prices.
We see the prices and dividends, starting with the most recent period. Because we don’t want to retype
all this ourselves, we click on the link in the lower portion of this page to Download To Spreadsheet:
We then are given a choice to Open or Save:
2
Choosing Save, I then specified the name as msft. I now have a common-separated-value (.csv) file
named msft.csv. When I open this file in Microsoft Excel®, I now see the data as follows:
For purposes of calculations and graphing, it is easier to have the data sorted in chronological order
(instead of reverse chronological order), so I highlight the rows 2 through 61 and then use Excel
commands of Data -- Sort:
3
and sort by date:
I can use the same Yahoo! Finance page to get the dividends as well by selecting the Dividends Only
choice. This produces a list of cash dividends over the same period:
This produces the list of dividends as follows:
4
which I can then download to a spreadsheet or simply type into the stock price worksheet. Because
there are so few of these, I simply insert them into the work sheet by hand. You will notice that
Microsoft had a 2:1 stock split on February 18, 2003.
We need to be alert for stock dividends and stock splits because it affects the data we are using.
Fortunately, Yahoo! Finance adjusts the stock prices for stock dividends and stock splits, Please note,
however, that not all online sources do so. Further, Yahoo! Finance does not adjust cash dividends for
stock splits and dividends, so if there are any cash dividends prior to the split, we need to adjust these
appropriately; failure to do so will result in an error in the returns. 1
Be sure to save the file as a Microsoft Excel workbook because we will be adding elements to this
worksheet that may be lost if we keep it as a .csv file. Just use the File –
Save As command and then specify the file type as a workbook.
2. Calculating returns on the stock

Once we’ve entered the cash dividends into our worksheet, we are now ready to calculate returns.
Remember that a monthly return is calculated as:
Price at the end of the month - Price at the beginning of the month + cash dividend
Monthly return =
Price at the beginning of the month
In the worksheet, this translates into referring to the cells for the prices and the dividend. For the return
for September 2000, we calculate this as =(G3-G2+H3)/G2:
1
For example, if Microsoft had paid a dividend of, say, $0.10 prior to the 2:1 split, I would have to adjust
it to $0.05 so that it is consistent with the split-adjusted share prices.
5
Copying this cell’s formula to the remaining cells in column I, we then have the returns on MSFT for each
month for sixty months.
3. Obtaining returns on a market index

This is actually a tough part of the calculation. It is easy to retrieve the level of an index, say the S&P
500, but it is difficult to find the corresponding dividends on the index. Because dividends can be a
significant part of the return, we don’t want to leave them out. One of the few places on the Internet
where we can find the return on the S&P 500 index that includes dividends is at Standard & Poor’s site.
This is a downloadable spreadsheet – simply Save the file when prompted: 2
2
I have found that Internet Explorer will often freeze when I try to open an Excel file from such an
option. It seems to work well to save the file first and then open it in Excel.
6
Using the same method to sort the data as we used previously, I sort the data:
4. Estimating the market model

We now have data in two workbooks: msft.xls and MONTHLY.xls. But we need the data in one
worksheet. Do accomplish this, I’ll go into my msft.xls worksheet, Insert – Worksheet, and then copy
what I need from MONTHLY.xls (the 1-month total return for each month) to msft.xls, which will be the
returns from September 2000 through August 2005 (sixty months): 3
3
If you are copying a value from a worksheet that was computed in that worksheet (as opposed to a
value simply typed in), when you copy and then paste the value into the new worksheet, you need to
specify Edit -- Paste-special and check the Values option.
7
The market model is the regression of the returns on the stock against the return on the market.
Therefore, I use the Microsoft Excel Tools – Data Analysis and select Regression:
I then need to specify the Y and X variables, which I do by clicking on the worksheet icon in the selection
boxes and then highlighting the cells in the worksheet:
When I select OK, I end up with a regression output as a new worksheet:
8
The slope coefficient, beta, is 1.348860788. Rounding to three decimal places, the equation is
rit= 0.008 +1.349 rmt
We can see this relationship by graphing the returns. To prepare for the charting, I created a new
worksheet by copying the market model data worksheet [Edit – Move or Copy Sheet – Create a
copy] and then reordered the return columns so the returns on the market (the X axis) are listed first
and then the returns on MSFT (Y-Axis). Then
Highlight the data (the cells B5:c64)

Insert – Chart -- XY (Scatter)
I placed the chart on the same worksheet as the plotting data (sheet named plotting). With only
specifying the X and Y titles and removing the legend (which is meaningless in this type of chart), I have
the following:
9
which is not very easy to interpret. Fixing up the graph (by double-clicking what I want to fix the
formatting on and then specifying it to my preferences, I end up with the following graph, including the
trendline:
50%
40%
30%
20%
Return on
10%
MSFT
0%
-10%
-20%
-30%
-20% -10% 0% 10% 20%
Return on the S&P 500
5. Determining the growth in value

We have captured the relation between Microsoft’s stock returns and those of the S&P 500 using
regression, arriving at a security beta of 1.35. Another way of comparing the two investments is by
10
looking at wealth changes from each investment. To do this, we use the returns that we have already
calculated and then use compounding to look at the growth in value over this same period.
First, we need to create another worksheet, so we will again Edit – Move or copy worksheet –
Create a copy from our market model data worksheet to create the new worksheet we’ll call
wealth. We will calculate the value of $1 invested at the beginning of September 2000 in each
investment, MSFT and the S&P 500. Starting with the basic worksheet and entering the compounded
value calculation. For the month of September, 2000, the ending wealth is $1 multiplied by the return for
the month; for the MSFT investment, the entry into cell E5 is: 1*(1+B5) and for the S&P 500 the entry
into cell F5 is 1*(1+C5). For the next month, value of $1 invested is the value in E5 multiplied by 1
plus the return in B6, and so on:
Once we have these values computed, we can graph these values using a simple line graph over time.
Using the default settings for this graphing, we end up with:
But after working with this graph a bit, we can produce:
11
Value of $1 invested in MSFT in September 2000
Value of $1 invested in the S&P 500 in September 2000
$1.2
$1.0
$0.8
Value of $1
invested $0.6
9/2000
$0.4
$0.2
$0.0
09/2000
02/2001
07/2001
12/2001
05/2002
10/2002
03/2003
08/2003
01/2004
06/2004
11/2004
04/2005
Month
From looking at the worksheet, we conclude that if we invested $1 in Microsoft in September 2000, we
will now have $1.02 of value. If we had invested $1 in the S&P 500, we would have $0.87 at the end of
August 2005.
You can find the worksheet that resulted from this effort here.
12
Comparing share-price
performance of a stock
A “How-to” write-up by Pamela Peterson Drake
Analysis of relative stock performance is challenging because stocks trade at different prices,
indices are calculated using an index system, and some stocks pay dividends. A simple way to
compare the performance of stocks or compare the performance of a stock with that of an index
is to determine the value of $1 invested in both over a period of time. This requires calculating
the returns, including dividends, for all stocks or indices used in the comparison, and then
calculating the compounded value of $1 invested at a point in time.
CONTENTS:
Step 1: Download stock prices and dividends .................................................................. 1

Step 2: Calculate returns for the stock and the comparative firm or index ........................... 4
Step 3: Compound the value of $1 invested in the stock .................................................. 8
Step 4: Represent performance graphically .................................................................... 8
References...................................................................................................................... 9
Step 1: Download stock prices and dividends

The easiest method of calculating returns from publicly-available information is to use a source
such as Yahoo! Finance. You will need to specify the stock’s ticker symbol, the range of time, and
the interval. For example, suppose I want to calculate the relative stock performance for Walt
Disney common stock. I would specify its symbol, DIS:
1
Then, under the chart, I click on the “Max” link. This produces the chart for all available data:
2
At the bottom of that page is the link to “Historical Prices”. Specify the range of dates and select
“Monthly”, and then ”Get Prices”:
Then click on the link for downloading, which is at the bottom of the page, producing the
following:
It is best to click on “Save” and then open the file in Microsoft Excel. 1
Repeat the “Get Prices” with the “Dividends Only” option selected. This will produce a
downloadable list of dividends for the same period.
1
Some users experience difficulty when they choose the “Open” option in the File Download dialog.
3
Download this file as well.
Step 2: Calculate returns for the stock and the comparative

firm or index
Open the file of stock prices in Microsoft Excel. 2 The data is provided in reverse-chronological
order. The calculation of returns will make more sense if you reorder the data chronologically.
Highlight the rows with the dates and prices, and then use Data > Sort and sort by Date.
2
This is a .csv file, so you may have to specify “All Files” in the file type. You can then “Save As” an Excel
Workbook.
4
Add the dividends into the file appropriately:
Calculate the returns using the “Adj Close” prices and the dividends:
5
The cell formula for the returns is:
Return = Price at end of the month - price at end of the previous month dividend during the month
price at end of previous month
Once the returns are computed for the stock of interest, we also need to add the returns for the
comparable into the worksheet. For another stock, you would repeat the procedure that we just
completed. For a market return, you need the monthly return (including dividends) for the index.
The total monthly return on the S&P 500 is available. 3
3
Please note that this data is sometimes not available on weekends from this website.
6
We now have a spreadsheet that has the returns on DIS and returns on the S&P 500:
7
Note that since we collected prices started at the month end of January 2, 2003, we can only
calculate returns starting in month-end February 3, 2003. 4
Step 3: Compound the value of $1 invested in the stock

The value of $1 is used as a measure of the relative performance because it is one way to
standardize the returns from two investments that may have different trading prices. The
calculation is simple:
Value at Value at
1 Return for month
end of month end of previous month
Step 4: Represent performance graphically

Highlight the Value of $1 columns for the stock and the comparative and then Insert > Chart and
create the chart. For the case of the DIS stock relative to the S&P 500, we see that the
performance of both is very similar by the end of the period of study, but there were deviations,
especially during the late-2004 and early-2005 months.
4
This is a draw back of using Yahoo! Finance data: the month end is defined relative to when you draw the
data. Drawing the data near the beginning of a month will elicit month ends that are the first trading day of
the month. Take care in lining up the S&P500 returns with those of the stock because the month end for the
S&P500 data is the last trading day of the month. Hence, there will be a small amount of out-of-“synchness”
in the comparison that is unavoidable.
8
Relative Performance of Walt Disney stock (DIS) and the Standard & Poor's
500 (S&P 500) Index
$1.8
$1.6
$1.4
$1.2
Value $1.0
of $1 $0.8 Value in DIS Value in S&P500
$0.6
$0.4
$0.2
$0.0
1-May-03
3-May-04
2-May-05
3-Nov-03
1-Nov-04
1-Nov-05
1-Mar-05
3-Mar-03
1-Mar-04
1-Oct-03
1-Oct-04
3-Oct-05
1-Jun-04
1-Jul-04
2-Aug-04
1-Sep-04
1-Dec-04
3-Jan-05
1-Feb-05
1-Jun-05
1-Jul-05
1-Aug-05
1-Sep-05
1-Dec-05
2-Jan-03
3-Feb-03
2-Jun-03
1-Jul-03
1-Aug-03
2-Sep-03
1-Dec-03
2-Jan-04
2-Feb-04
1-Apr-03
1-Apr-04
1-Apr-05
Month
Source: Yahoo! Finance and Standard and Poor’s 500.
References
1. Standard and Poor’s, www2.standardandpoors.com/spf/xls/index/MONTHLY.xls
2. Yahoo! Finance, http://finance.yahoo.com/
9
Instructional tools Page 1 of 2
Learning Resources: Tools

CREATED BY PAMELA PETERSON-DRAKE, JAMES MADISON UNIVERSITY
z Accounting Review
z Bond value and duration calculations using Microsoft Excel
z Charting in Microsoft Excel
z Creating a Microsoft PowerPoint Presentation, with an example
z Financial Calculators. Instructions on financial calculations for various models of calculators.
z What is a geometric mean? Instructions on how to calculate a geometric mean return
z Option pricing calculator
http://educ.jmu.edu/~drakepp/general/tools.htm 3/2/2011
Instructional tools Page 2 of 2

Accounting Review http://educ.jmu.edu/~drakepp/acc/index.html
Bond value and duration
calculations using http://educ.jmu.edu/~drakepp/investments/examples/bond_example.xls
Microsoft Excel
Charting in Microsoft
http://educ.jmu.edu/~drakepp/general/excel_charting.pdf
Excel
Creating a Microsoft
http://educ.jmu.edu/~drakepp/general/pp.pdf
PowerPoint Presentation
example http://educ.jmu.edu/~drakepp/general/pp_ex.ppt
Financial Calculators http://educ.jmu.edu/~drakepp/principles/calculator/index.html
What is a geometric mean? http://educ.jmu.edu/~drakepp/general/geometricmean.pdf
Option pricing calculator http://educ.jmu.edu/~drakepp/investments/scripts/opt.htm
http://educ.jmu.edu/~drakepp/general/tools.htm 3/2/2011
Page 1 of 2
Regression
Prepared by Pamela Peterson Drake, James Madison University
z Notes on regression
z StudyMate Regression Activities
z Regression using Microsoft Excel
z Regression example with Solutions
z Home pricing example using data submitted by members of the class
http://educ.jmu.edu/~drakepp/statistics/index.html 3/2/2011
Page 2 of 2

Notes on regression http://educ.jmu.edu/~drakepp/statistics/regression.pdf
StudyMate Regression
http://educ.jmu.edu/~drakepp/statistics/regress.htm
Activities
Regression using Microsoft
http://educ.jmu.edu/~drakepp/statistics/regression_using_Excel.pdf
Excel
Regression example http://educ.jmu.edu/~drakepp/statistics/regressionexample.pdf
Solutions http://educ.jmu.edu/~drakepp/statistics/regressionexample.xls
Home pricing example http://educ.jmu.edu/~drakepp/statistics/homepricing_class.xls
Examples for Finance instruction Page 1 of 2
Examples of calculations for financial decision-making

CREATED BY PAMELA PETERSON DRAKE,JAMES MADISON UNIVERSITY
z Duration example in Microsoft Excel

z Du Pont Analysis applied to Sears
z Equity Valuation
z Portfolio Risk and Return
z Two-stage Dividend Growth
http://educ.jmu.edu/~drakepp/general/example.htm 3/2/2011
Examples for Finance instruction Page 2 of 2

Duration example in
http://educ.jmu.edu/~drakepp/general/duration.xls
Microsoft Excel
Du Pont Analysis applied
http://educ.jmu.edu/~drakepp/principles/module2/dupont_sears.pdf
to Sears
Equity Valuation http://educ.jmu.edu/~drakepp/principles/module4/Equity_Valuation.pdf
Portfolio Risk and Return http://educ.jmu.edu/~drakepp/principles/module5/portfolio_risk.pdf
Two-stage Dividend
http://educ.jmu.edu/~drakepp/principles/module4/twostagedvm.pdf
Growth
http://educ.jmu.edu/~drakepp/general/example.htm 3/2/2011
The Du Pont System of the Analysis of Return Ratios
Applied to Sears, Roebuck & Co.
Return on Assets (ROA)1 Return on Equity (ROE) 2
Calculation for fiscal year 2003 Calculation for fiscal year 2003
Return on assets = total asset turnover net profit margin Return on equity = total asset turnover net profit margin equity multiplier
net profit § sales · § net profit · net profit § sales · § net profit · § total assets ·
=¨ =¨ ¸¨ ¸¨ ¸
total assets © total assets ¸¹ ¨© sales ¸¹ equity © total assets ¹ © sales ¹ © equity ¹
$3,397 § $41,124 · § $3, 397 · $3,397 § $41,124 · § $3, 397 · § $27, 723 ·
¨ ¸¨ ¸ ¨ ¸¨ ¸¨ ¸
$27,723 © $27, 723 ¹ © $41,124 ¹ $6,401 © $27, 723 ¹ © $41,124 ¹ © $6, 401 ¹
0.1225 = 1.4834 times 0.08260 0.5307 = 1.4834 times 0.0826 4.3310
Check on your work: Check on your work:
12.25% = 12.25% 53.07% = 53.07%
Try it for 2002: Return on assets = 2.73% Try it for 2002: Return on equity = 20.38%
1 net profit § sales · § net profit · 2 net profit § sales · § net profit · § total assets ·
= ¨¨ ¸¨ ¸ = ¨¨ ¸¸ ¨ ¸ ¨¨ ¸¸
total assets © total assets ¸¹ © sales ¹ equity © total assets ¹ © sales ¹ © equity ¹
Du Pont Analysis example (P. Peterson) 1 of 5

Using the DuPont Breakdown
Comparing 2002 and 2003:
Year 2003 2002

Return on equity 53.07% 20.38%
Return on assets 12.25% 2.73%
Total asset turnover 1.4834 times 0.8206 times

Net profit margin 8.26% 3.326%
Equity multiplier 4.3110 times 7.4647 times
Why the change in return on assets from 2002 to 2003?

o Increase in its profit margin.
o Increase in its asset turnover (due primarily to a reduction in assets through the sale of credit card receivables in 2003 to Citigroup at a
$6 billion profit).
Why the change in return on equity from 2002 to 2003?

o Increase in its asset turnover (due primarily to a reduction in assets through the reduction in credit card receivables by selling them to
Citigroup at a $6 billion profit).
o Reduction in long-term debt (from some of the proceeds from the sale of its credit card receivables) and in increase in equity from the
profit on the sale of the receivables.

SEARS, ROEBUCK AND CO.
Consolidated Statements of Income
millions, except per common share data 2003 2002 2001

REVENUES
Merchandise sales and services $ 36,372 $ 35,698 $ 35,755
Credit and financial products revenues 4,752 5,668 5,235
Total revenues 41,124 41,366 40,990
COSTS AND EXPENSES

Cost of sales, buying and occupancy 26,231 25,646 26,234
Selling and administrative 9,111 9,249 8,892
Provision for uncollectible accounts 1,747 2,261 1,866
Depreciation and amortization 909 875 863
Interest, net 1,025 1,143 1,415
Loss on early retirement of debt, net 791 -- --
Special charges and impairments 112 111 542
Total costs and expenses 39,926 39,285 39,812
Operating income 1,198 2,081 1,178
Gain on sale of businesses 4,224 -- --
Other income, net 27 372 45
Income before income taxes, minority interest and cumulative effect
of change in accounting principle 5,449 2,453 1,223
Income taxes 2,007 858 467
Minority interest 45 11 21
Income before cumulative effect of change in accounting principle 3,397 1,584 735
Cumulative effect of change in accounting for goodwill -- (208) --
NET INCOME $ 3,397 $ 1,376 $ 735
Source: Sears, Roebuck & Co. www.sears.com

millions, except per share data 2003 2002

ASSETS
Current assets
Cash and cash equivalents $ 9,057 $ 1,962
Credit card receivables 1,998 32,563
Less allowance for uncollectible accounts 42 1,832
Net credit card receivables 1,956 30,731
Other receivables 733 891
Merchandise inventories, net 5,335 5,115
Prepaid expenses and deferred charges 407 535
Total current assets 18,196 39,983
Property and equipment

Land 392 442
Buildings and improvements 7,151 6,930
Furniture, fixtures and equipment 4,972 5,050
Capitalized leases 609 557
Gross property and equipment 13,124 12,979
Less accumulated depreciation 6,336 6,069
Total property and equipment, net 6,788 6,910

Goodwill 943 944
Tradenames and other intangible assets 710 704
Other assets 708 1,134
TOTAL ASSETS $ 27,723 $ 50,409

LIABILITIES
Current liabilities
Short-term borrowings $ 1,033 $ 4,525
Current portion of long-term debt and capitalized lease obligations 2,950 4,808
Merchandise payables 3,106 2,945
Income taxes payable 1,867 787
Other liabilities 2,950 3,753
Unearned revenues 1,244 1,199
Other taxes 609 580
Total current liabilities 13,759 18,597
Long-term debt and capitalized lease obligations 4,218 21,304

Pension and postretirement benefits 1,956 2,491
Minority interest and other liabilities 1,389 1,264
COMMITMENTS AND CONTINGENT LIABILITIES
SHAREHOLDERS' EQUITY
Common shares issued ($. 75 par value per share, 1,000 shares authorized,
230.4 and 316.7 shares outstanding, respectively) 323 323
Capital in excess of par value 3,519 3,505
Treasury stock - at cost (7,945) (4,474)
Deferred ESOP expense (26) (42)
Accumulated other comprehensive loss (1,106) (1,056)
Total Shareholders' Equity 6,401 6,753
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 27,723 $ 50,409

Equity Valuation
Prepared by Pamela P. Peterson, Florida State University
The valuation models

A share of common stock is a perpetual security that derives its value from the future cash flows
that the investor will receive. The future cash flows of a stock are the future dividends:
D1 D2 Df
P0 ...
(1 r) (1 r)2
(1 r)f
where
P0 =today's price
D t =dividends in period t
r =required rate of return (a.k.a. discount rate)
Because the dividends on common stock are uncertain in amount and timing, this presents a
problem in valuation.
Constant dividend amount
If the dividends are expected to be the same amount each period (D), forever, the value of a
share of stock is the present value of a perpetuity, or:
D
P0
r
The value of a stock today is the present value of all future dividends:
Constant growth in dividends
If dividend grow at a constant rate g, the present value of dividends,

D1 D2 Df
P0 ...
(1 r) (1 r)2
(1 r)f
is equivalent to the simpler form (a.k.a. dividend valuation mode, DVM, Gordon model):
D1
P0 .
rg
Two-stage growth model
If dividends do not grow at a constant rate forever, but instead are expected to grow at one rate for the
immediate future and another rate from that point on, we must modify the constant growth model to
accommodate the changing growth.
Consider that there are two growth rates,
g1 for n1 periods
g2 thereafter
Therefore, the present value of dividends can be stated as comprised of two parts:
Part 1: Present value of dividends in the first n1 periods
D1 D2 Dn
P0 of dividends from period 1 through period n1 ... 1
(1 r) (1 r)2
(1 r)n1
Part 2: Present value of the dividends beyond n1
D n 1 Dn 2 Df
1
1
...
(1 r)1 (1 r)2 (1 r)f
P0 of dividends beyond period n1 .
(1 r)n1
Because the dividends beyond n1 grow at a constant rate, we can rephrase the latter
equation as:
Dn 1
1
rg
(1 r)n1
Putting the two parts of the present value together, therefore, we have:
Dn 1
1
D1 D2 Dn rg
P0 ... 1
.
(1 r) (1 r)2
(1 r)n1 (1 r)n1
In other words, the present value of a stock with two-stage growth in dividends is equal to the
present value of the individual dividends in the first stage, plus the present value of the price
expected at the end of the first stage. Because:
D n 1
Pn 1 ,
1 r-g 2
where Dn 1 = Dn (1 g 2 ) , then
1 1
D1 D2 Dn Pn
P0 ... 1
1
.
(1 r) (1 r)2
(1 r) n 1 (1 r)n1
We can restate the dividends in terms of dividends today, D0, and the two growth rates as:
D0 (1 g1 )n1 (1 g 2 )
D0 (1 g1 ) D0 (1 g1 )2 r g2
P0 ...
(1 r) (1 r)2 (1 r)n1
Examples
Constant dividend
D0=$2
r=5%
D $2
P0 $40
r 0.05
Constant growth
D0=$2
r=5%
g=4%
D1 $2(1.04) $2.08
P0
rg 0.05 0.04 0.01
Two-stage growth
D0=$2
r=5%
g1=10%
g2=2%
n1=3
First, calculate the dividends per share for each period in the first stage and for the first
dividend in the second stage:1
D1=$2(1.10) =$2.20
D2=$2(1.10)2=$2.20(1.10)=$2.42
D3=$2(1.10)3=$2.42(1.10)=$2.662
D4=$2(1.10)3(1.02)=$2.662(1.02)=$2.71524
1Note that the dividend in the fourth period is affected by the dividend growth in the first stage as well as
the dividend growth in the second stage, or D4 = D0 (1 + g1)n1 (1+g2).
Then calculate the present value:2
$2.71524
$2.20 $2.42 $2.662 0.05 0.02
P0
(1 0.05) (1 0.05)2 (1 0.05)3 (1 0.05)3
$2.20 $2.42 $2.662 $90.508

P0
(1 0.05) (1 0.05)2 (1 0.05)3 (1 0.05)3
P0 $2.09524 $2.19501 $2.29954 $78.18421
P0 $84.774
The project dividends corresponding to each of the three models in the example are shown
below:
$5.0 Constant dividend

$4.5 Constant dividend growth of 4%
Two-stage growth (first stage = 10%, second stage = 2%)
$4.0
$3.5
$3.0
Dividend
per $2.5
share
$2.0
$1.5
$1.0
$0.5
$0.0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Years from today
2 You will notice that once we have calculated the future dividends and future price, we are solving for the
present value of uneven cash flows. If you are using a financial calculator to solve for the present value
(i.e., the NPV, the three relevant cash flows are: $2.20. $2.42, $93.17, because the two cash flows of
$2.662 (i.e., D3) and $90.508 (i.e., P0) occur at the same time (i.e., the end of the third period).
Portfolio Risk and Return
Prepared by Pamela Parrish Peterson, PhD., CFA
The return on a portfolio of assets is calculated as:

N
rp = ¦ w i ri
i=1
where ri is the expected return on asset i, and
wi is the weight of asset i in the portfolio.
Portfolio risk is calculated using the risk of the individual assets (measured by the standard
deviation), the weights of the assets in the portfolio, and either the correlation between or
among the assets or the covariance of the assets’ returns.
For a two-asset portfolio, the risk of the portfolio, Vp, is:
ıp = w12ı12 +w 22ı 22 +2w1ı1w 2ı 2ȡ12
or
ıp = w12ı12 +w 22ı 22 +2w1w 2cov12
cov12
since ȡ12 =
ı1ı 2
where Vi is the standard deviation of asset i’s returns,
U12 is the correlation between the returns of asset 1 and 2, and
cov12 is the covariance between the returns of asset 1 and 2.
Problem What is the portfolio standard deviation for a two-asset portfolio comprised
of the following two assets if the correlation of their returns is 0.5?
Asset A Asset B
Expected return 10% 20%
Standard deviation of expected 5% 20%
returns
Amount invested $40,000 $60,000
Solution Vp = 13.115%
Calculation ıp = 0.420.052 +0.62 0.22 +2(0.4)(0.05)(0.6)(0.2)(0.5)
ıp (0.16)(0.0025) (0.36)(0.04) (2)(0.0012)

ıp 0.0004 0.0144 0.0024
ıp 0.0172 0.131149 or 13.1149%
Portfolio risk and return 1 of 2

Portfolio risk and return practice problems
Problem 1 What is the portfolio return and standard deviation for a two-asset
portfolio comprised of the following two assets if the correlation of their
returns is 0.5?
Asset C Asset D
Standard deviation of expected returns 5% 30%
Correlation 0.40
returns is 0.5?
Asset E Asset F
Correlation 0.20
returns is 0.5?
Asset G Asset H
Correlation -0.30
Solutions to portfolio risk and return practice problems
Problem Expected portfolio return Portfolio risk

1 16% 16.1632%
2 23% 16.8582%
3 19% 23.2413%

Problem: Two-stage dividend growth
A stock currently pays a dividend of $2 for the year. Expected
dividend growth is 20% for the next three years and then growth
is expected to revert to 7% thereafter for an indefinite amount of
time. The appropriate required rate of return is 15%. What is this
stock’s intrinsic value?
Solution:
D1 D2 D3 P3 D4
P0 where P3
(1 r)1 (1 r)2 (1 r)3 (1 r)3 (r g2 )
D0 (1 g1)3 (1 g2 )
D0 (1 g0 ) D0 (1 g1)2 D0 (1 g1)3 (r g2 )
P0 2
3

(1 r)1
(1 r) (1 r) (1 r)3
$3.69792
$2.40 $2.88 $3.456 (0.15 0.07 )
P0 1
2
3

(1 0.15) (1 0.15) (1 0.15) (1 0.15)3
$46.224
P0 $2.086957 2.177694 $2.272376
1.520875
P0 $2.086957 2.177694 $2.272376 $30.39303
P0 $36.930057
Distance learning resources Page 1 of 2
Online learning resources for students

Blackboard | E-mail
Blackboard
z A Guide to the Student Using Blackboard

z Creating equations in Blackboard
E-mail issues
z How do I read my jmu.edu mail without using WebMail?
http://educ.jmu.edu/~drakepp/general/distance.htm 3/2/2011
Distance learning resources Page 2 of 2

Blackboard http://educ.jmu.edu/~drakepp/general/distance.htm#blackboard
E-mail http://educ.jmu.edu/~drakepp/general/distance.htm#email
A Guide to the Student Using
http://educ.jmu.edu/~drakepp/general/blackboard.pdf
Blackboard
Creating equations in Blackboard http://educ.jmu.edu/~drakepp/general/blackboard_equations.pdf
How do I read my jmu.edu mail
http://educ.jmu.edu/~drakepp/general/email.pdf
without using WebMail?
http://educ.jmu.edu/~drakepp/general/distance.htm 3/2/2011
Other learning resources for the Finance student Page 1 of 2
Other Learning Resources for the Finance Student

Formulas Time value of money tables
z Bonds z Table of Compound Factors

z Cost of capital z Table of Discount Factors
z Derivatives z Future Value Annuity Factors
z Market indices z Present Value Annuity Factors
z Financial ratios
z Risk
z Stock and bond valuation
z Time value of money
http://educ.jmu.edu/~drakepp/general/other.htm 3/2/2011
Other learning resources for the Finance student Page 2 of 2
Shortcut
Internet Address
Text
Bonds http://educ.jmu.edu/~drakepp/investments/formulas/formulas_investing_in_bonds.pdf
Cost of
http://educ.jmu.edu/~drakepp/fin3403/module7/coc_formulas.pdf
capital
Derivatives http://educ.jmu.edu/~drakepp/investments/formulas/formulas_options.pdf
Market
http://educ.jmu.edu/~drakepp/investments/formulas/formulas_market_indices.pdf
indices
Financial
http://educ.jmu.edu/~drakepp/principles/module2/fin_formulas.pdf
ratios
Risk http://educ.jmu.edu/~drakepp/principles/module5/rrformulas.pdf
Stock and
bond http://educ.jmu.edu/~drakepp/principles/module4/val_formulas.pdf
valuation
Time value
http://educ.jmu.edu/~drakepp/principles/module3/tvm_formulas.pdf
of money
Table of
Compound http://educ.jmu.edu/~drakepp/principles/module3/fvtable.html
Factors
Table of
Discount http://educ.jmu.edu/~drakepp/principles/module3/pvtable.html
Factors
Future Value
Annuity http://educ.jmu.edu/~drakepp/principles/module3/fvantable.html
Factors
Present
Value
http://educ.jmu.edu/~drakepp/principles/module3/pvantable.html
Annuity
Factors
http://educ.jmu.edu/~drakepp/general/other.htm 3/2/2011
Risk formulas
1. Types of risk
Q(P-V)
Degree of operating leverage = DOL= ,
Q(P-V)-F
[Q(P-V)-F]
Degree of financial leverage = DFL
[Q(P-V)-F-I]
Q(P-V)
Degree of total leverage = DTL= = DOL x DFL.
Q(P-V)-F-I
Nominal return = Inflation rate + real return
2. Risk measurement
N
Expected value = E (x) = ¦ pn xn
n=1
Standard deviation N
of possible outcomes
= V(x) ¦ pn (xn H(x))2
n 1
3. Risk, return, and diversification

S
Return on a portfolio = rp ¦ wiri
i 1
N
Covariance One,Two ¦ p r
i=1
i One,i - One rTwo,i - Two
Portfolio standard deviation, 2-security portfolio = w12 V12 + w 22 V22 + 2w1 w2 cov1,2
.
N N N
2 2
Portfolio standard deviation = ¦ wi Vi + ¦ ¦ wi w jcovij .
i=1 i 1 j 1 jzi
Correlation covariance of the two assets' returns cov1,2

U1,2
coefficient
standard deviation of

returns on first asset returns on second asset V1V2
S
Portfolio beta = Ep ¦ wiEi
i 1
Return on a security, CAPM = ri = rf + (rm - rf) Ei
Prepared by Pamela Peterson-Drake, Florida Atlantic University 1

02.00.00.00
Investments
Welcome to the Investment Resource site Page 1 of 1
Welcome to the Resource Site for Investments
This material is based on a self-directed online course in Investments, though anyone is welcome to travel through
the modules to learn about securities and securities markets. The module lectures have active links to additional
content, so it is recommended that you view these online so that you can take advantage of all of the resources.
http://educ.jmu.edu/~drakepp/investments/welcome.htm 2/28/2011
Modules, Investments, Pamela Peterson Drake Page 1 of 2
Modules
Note: Each Module consists of an introduction/lecture and a set of tasks. You
should read the introduction and then begin working on the tasks. The text
readings are from Charles P. Jones, Investments: Analysis and Management, 9th
Edition.
Module
Click on the link below to begin Topic
Module 1 Introduction & SOX Act of 2002
Module 2 Types of investments
Module 3 Markets and trading mechanisms
Module 4 Market indices
Module 5 Fundamental analysis
Module 6 Portfolio theory
Module 7 Asset pricing models
Module 8 Stock analysis and valuation
Module 9 Bond analysis and investment
Module 10 Derivatives
http://educ.jmu.edu/~drakepp/investments/modules/index.html 2/28/2011
Modules, Investments, Pamela Peterson Drake Page 2 of 2

Module 1 http://educ.jmu.edu/~drakepp/investments/modules/module1.pdf
http://educ.jmu.edu/~drakepp/investments/modules/index.html 2/28/2011
Module 1
Introduction to investments
Prepared by Pamela Peterson Drake, Ph.D., CFA
1. Overview
A. Preparation for the course
In this course, you will be introduced to securities and securities markets. We cover a lot of
ground in this course, so be sure that you are ready for FIN4504. You should have already
successfully completes the pre-requisites for this course:
Accounting: ACG2021 and ACG2071 (or the equivalent three-course sequence at a
community college)
Economics: ECO2013 and ECO2023
Finance: FIN3403, C or better
If you have not completed the pre-requisites, you must wait to take this course until you have
done so.
This is a dynamic environment, with laws and regulations changing constantly and the market
continuously bombarded with company, industry, and world events. Some of what you will learn
is not yet in text books; you will notice that some of the required reading is from the Internet. I
recommend that you subscribe to the Wall Street Journal because you will need ready access to
articles that I cite.
The basic structure of the course is that we cover securities, markets, and fundamental analysis
before the mid-term exam, and portfolio theory, asset pricing, and valuation after the mid-term
exam. We take the chapters out of the order that they are presented in the text for a simple
reason: I want to make sure that you have what you need in a timely manner for your project.
About the project: You are required to complete the project according to the project
requirements that are provided to you. You will be assigned to a group and you will also be
assigned a company within that group’s industry. There is no possibility for changing companies
– it is your job to analyze and report on your assigned company. You will work with your group
for the industry portion of the project, but you will work individually on the company portion of
the project.
You will need the text book (which you can order online), a student subscription to the Wall
Street Journal (online is fine), a financial calculator, and access to the web. You will also need
access to the following software:
Microsoft Word®
Microsoft Excel®
Microsoft PowerPoint®
If you do not have this software, you will find it available on computers available at all FAU
campuses.
You will find that distance learning courses are more challenging than the traditional, in-person
course. This is primarily because distance learning courses require more reading, more student
responsibility with respect to timely completion of tasks, and more communication with the
FIN4504: Investments, Module 1 1

instructor, as compared to the same course in-person. You should expect to devote at least 12
hours per week to this course; if you cannot devote this amount of time, please consider taking
the course in a different format.
Contacting the professor is easy:

by email: ppeter@fau.edu
by phone: 772.873.3314
in person: 309 JU, FAU’s Port St. Lucie campus.
Please be aware that there will be times during the semester in which I am unavailable by either
email or phone. If I will not be checking my email every 24 hours, I will notify you of that
situation (e.g., traveling with limited access). If you email me and I do not reply within 24 hours,
simple re-send the email. 1
B. The investment setting

We will be studying investments this semester. An investment is simply any expenditure at a
point in time that is expected to generate future cash flows. It is expected that the investment
will produce future cash flows sufficient to compensate the investor for the opportunity cost of
the funds and risk. The opportunity cost of funds is what investors could have earned in a
similar-risk investment. We often refer to this opportunity cost of funds as the required rate of
return. As you will see throughout this course, risk and return are both important in evaluating
an investment.
EXHIBIT 1 INVESTMENTS AND THE RISK-RETURN TRADE-OFF
We will be looking at Financial
different investments Expected futures
and how the returns return Warrants
on these investments
are related to risk. Corporate
bonds
Consider the
investments detailed
Options on
in Exhibit 1. A U.S. Risk-free
stocks
Treasury Bill (T-Bill) is, rate of Common
essentially, a default interest stocks
risk-free security. The
return you earn on a
T-Bill is the risk free
Risk
rate of interest. Other
investments, such as
corporate bonds and common stocks, have additional risk, but also a higher expected return.
Derivatives, which include warrants, options, and futures, all have much higher potential
returns – but also higher risk.
1
Please be aware that repeated emails within one day may be interpreted by an email filter as
spam.

If we look back on returns historically, we see that the level and volatility of returns is consistent
with the expectations
regarding risk and return. EXHIBIT 2 HISTORICAL RETURNS, 1999-2005
Money Market Long-term AA Bond Index S&P 500 Gold

Consider the returns in
Exhibit 2 for money market 30%
funds, corporate AA bonds,
stocks (represented by the 20%
S&P 500 index), and gold. 10%
The money market returns Annual
are low, but have very little 0%
return
variation from year to year. -10%
Stocks and gold produced
the higher returns, but -20%
these investments also had
-30%
the greater volatility.
1999 2000 2001 2002 2003 2004 2005
Year
C. Calculating
returns Source: Wall Street Journal, “Year in Review,” various years.
We often describe a return
on an investment in terms of an annual holding period. The return for one year on an
investment is calculated as:
Ending value of Beginning value of Cash flow from

the investment the investment the investment
Holding period return =
Beginning value of the investment
When we refer to returns over a multiple of years, we state returns on an average annual basis.
By average, we mean geometric average, not arithmetic average. For example, consider an
investment that produces the following annual returns:
Year Return
2006 20%
2007 15%
2008 25%
The geometric average annual return is:
geometric average annual return = 3 (1+0.2)(1+0.15)(1+0.25) 1 19.928%

The arithmetic average annual return, EXAMPLE: ANNUAL RETURNS
which in this example is 20%, is not
an accurate measure of the three- Problem
year return performance because it
ignores compounding from period to Consider the following returns on an investment.
period.
Year Return
2006 10%
You should be prepared to calculate
2007 -5%
returns, given end-of-period values. 2008 20%
You should also be prepared to
calculate returns on investments if What is the average annual return on this investment?
there are intermediate cash flows,
such as dividends or interest. You Solution
should review your time value of
money skills. Be sure to take the Return = 3 (1.1)(0.95)(1.2) 1
Time Value of Money Quiz at the
course Blackboard site. If you score at Return = (1.1)(0.95)(1.2) 1 / 3 1 7.837%

least a 70%, we know you’re ready
for this course. How do you take a value to the 1/3 power?
Using an HP10B calculator, use the yx key. Using
D. Sarbanes-Oxley Act of a TI-83/84 calculator, use the ^ key.
2002
The Sarbanes-Oxley Act of 2002
(SOX Act) is the most wide-sweeping legislation to affect the securities industry since the
Securities Act of 1933 and the Securities Exchange Act of 1934. The SOX Act affects many
participants in our financial markets: investors, security analysts, corporate management, and
accountants. The provisions of this Act include:
Establishes the Public Company Accounting Oversight Board (PCAOB), with Securities and
Exchange Commission (SEC) oversight.
Prohibits an accounting firm from performing non-audit services for an audit client.
Reduces potential conflicts of interest for CEO, Controller, CFO or Chief Accounting Officer.
Specifies rules for “independent” audit committees.
Requires certifications of audit reports by CEO and CFO.
Requires reimbursement of bonuses or other incentive based compensation in the event of a
restatement.
Prohibits insider trading during pension fund black-outs.
Prohibits personal loans to executives.
Requires disclosure of management assessment of internal controls.
Requires disclosure of whether at least one member of the audit committee is a financial
expert.
Requires real time disclosures of changes in operations or financial condition.
Specifies that destroying documents to impede an investigation is a felony.
Specifies that securities fraud is a crime punishable by fines and up to 10 years of prison.
Grants additional powers to the SEC (e.g., freeze payments to officer).
The SOX Act came about following numerous financial scandals that involved publicly-traded
corporation, accountants, investment bankers, and brokers. As you can see in Exhibit 3, most of
the provisions of the SOX Act are a response to specific misdeeds.

EXHIBIT 3 SOME OF THE IMPETUS FOR SOX
AUDIT AND NON-AUDIT FEES

o In 2000, Adelphia paid Deloitte & Touche LLP audit fees of $1,319,000 and non-audit fees
of $2,182,000.
o Founding family members (Rigas) were found guilty of bank fraud and conspiracy; Adelphia
filed for bankruptcy in 2002.
CONFLICTS OF INTEREST
o HIH Insurance ltd (Australia) included two retired members of the external auditor’s firm as
board members.
o Results? “undesirable corporate governance practices” [The company collapsed]
INDEPENDENCE OF AUDIT COMMITTEE MEMBERS

o Adelphia 2000 audit committee: Pete J. Metros and Timothy Rigas
REIMBURSEMENT OF BONUSES
o Gateway fraud, 2000 [earnings manipulation by extending credit to those denied
credit, manipulating revenue, etc.], with exiting executives receiving bonuses.
o John J. Todd (CEO), 2000: salary of $412,500 + $224,500 bonus; $1,567,500 cash
severance payment
o Jeffrey Weitzen (CFO), 2000: salary of $1 million + $4.95 million in exercised
options gain; $5.64 million cash severance payment.
PROHIBITS INSIDER TRADING DURING PENSION FUND BLACK-OUTS

o Kenneth Lay, CEO of Enron, ''went so far as to tout the [Enron] stock as a good
investment for his own employees -- even after he had been warned that a wave
of accounting scandals was about to engulf the corporation.''
o Enron stock fell from $85/share to under $1/share once the scandal was revealed.
Insiders sold before the price fell, but employees (who had invested on average
60% of their pension in Enron) could not trade because of the pension black-out
period.
Learn more about the recent scandals (links):

CNN’s Money Scandal site
Corporate Scandal Primer by the Washington Post
Adelphia, presented by the AICPA
Enron, summarized by Business Week

How does SOX change things? There are many implications, including increased disclosures and
increased disclosures. In addition, any OPTION BACK-DATING
misstatements by the company are now a
greater cause for concern for corporate Many companies were swept up in back-dating of
management and auditors. option include companies Affiliated Computer
Services, CNET, KB Home, and Home Depot. At
The recent problems related to the option back- this time cases are still being investigated, though
dating of options, however, further frustrates there have been some plea deals and executives
resigning.
the efforts to restore confidence in corporate
management and financial statement reporting. The Perfect Payday, Wall Street Journal
A back-dated option is an executive option special section.
grant in which the date of the grant has been “Untainted Firms Alter How they Offer
manipulated to provide greater benefits to the Options”, by Joann S. Lublin, Wall Street
executive and to minimize taxes. Such Journal.
manipulation, however, violates financial
disclosure laws, as well as tax laws.
2. Learning outcomes
LO1.1 Rank investments on the basis of both expected returns and risk.
LO1.2 Calculate the return on an investment.
LO1.3 List and briefly describe the key provisions of the Sarbanes-Oxley Act of 2002.
LO1.4 Describe the implications of Sarbanes-Oxley Act of 2002 for auditors, corporate
management, and investors.
3. Module Tasks
A. Review the course material
Syllabus
Course Schedule
Blackboard site
Mirror site
B. Required readings
Chapter 1, “Understanding Investments,” Investments: Analysis and Management, by
Charles P. Jones, 9th edition.
C. Other material
Time Value of Money Review Quiz, available at the course Blackboard site. Retake
this exam until you score above a 70%.
Current events, a course journal available through Blackboard®.
D. Optional readings
The time value of money: Part I, a reading prepared by Pamela Peterson Drake
The time value of money: Part II, a reading prepared by Pamela Peterson Drake
E. Practice problems sets

Textbook author’s practice questions, with solutions.

F. Module quiz
Available at the course Blackboard site. See the Course Schedule for the dates of the
quiz availability.
G. Project progress
You will be assigned a company by the end of the first week. You should do the
following:
1. Locate your company’s investors/shareholders web site.
2. Research your company’s line(s) of business, basic history, and industry.
3. Begin the write-up of the company’s operations.
4. Post a message on your group’s discussion board, letting your group members
know how best to reach you for information sharing purposes.
4. What’s next?
In Module 2, we will look at the different types of direct and indirect investments. Direct
investments include stocks, bonds, and derivatives. Indirect investments include mutual fund
shares, closed-end fund shares, and exchange traded fund shares.

Module 2
Different types of investments
1. Overview
An investor can invest directly in securities or indirectly. Direct investing involves the purchase
of a security. In this case, the investor controls the purchase and sale of each security in their
portfolio. Indirect investing involves investing in mutual funds, closed-end funds, or exchange-
traded funds. In this case, the investor does not control the composition of the fund’s
investment; the investor only controls whether to buy or sell the shares of the fund.
A. Direct investing
We’ll introduce you to alternative investment vehicles in this module, but we will go into much
greater detail in later modules. We can classify most direct securities into the following types:
1. Money market securities e.g., Treasury bills, commercial paper

2. Capital market securities e.g., Municipal bonds, corporate bonds, stocks
3. Derivatives e.g., Options, futures
i) Money market securities

Money market securities are short-term, highly liquid, low-risk debt of governments, banks, or
corporations. These include:
U.S. Treasury bills (T-Bills)

Negotiable certificates of deposit (CDs)
Commercial paper
Eurodollars
Repurchase agreements
Bankers’ acceptances
The rate on U.S. Treasury bills is often used as a reference rate -- benchmark for quoting and
analyzing rates. 1 For example, if the rate on the U.S. T-Bill is 3.5% and the rate on a specific
certificate of deposit is 4.2%, we say that there is a spread of 70 basis points (bp). The spread
is simply the difference between the rate on the CD and the rate on the T-Bill, quoted in terms of
basis points, where one basis point (bp) is 1% of 1% (or in other words, there are 100 bp in a
1% yield).
There are two different methods that are commonly used in quoting T-Bill rates, the discount
yield basis and the investment yield basis. T-Bills are sold at a discount and do not pay
interest, so what you earn on the T-Bill is the difference between what you paid and what you
get at maturity. The discount yield basis is the conventional method for quoting T-Bill rates, but
this method tends to understate the true yield:
1
Another common reference rate is the London InterBank Offer Rate (LIBOR).
1

Face - Purchase
Discount = value price
x

360

yield Face value Maturity of bill in days
The investment yield basis is useful in comparing T-bill yields with those of other short-term
securities:
Investment = value
Face - Purchase
price
x

365

yield Purchase price Maturity of bill in days
The two primary differences

between these yields are that Example: Yields on Treasuries
1. the denominator in the first
Problem
term is different (face value Consider a 182-day Treasury bill that has a price of $9,835 per
for are discount basis, $10,000 face value.
purchase price for the 1. What is the discount yield?
investment yield), and 2. What is the investment yield?
2. the number of days used for
annualization (360 for the Answer
discount yield, 365 for the Discount = $10,000-$9,835
x 360
investment yield). yield 182
1. $10,000
Discount =0.0165 x 1.97802 = 0.032637 or 3.2637%
Does it make a difference? It is yield
important to be precise in all
communications regarding pricing Investment = $10,000-$9,835
x 365
yield 182
and yields, so it is important to 2. $9,835
understand the difference Investment =0.01678 x 2.0055 = 0.033646 or 3.3646%
between these two methods of yield
stating yields. If you would like to
compare the discount basis and
investment yields, check out the recent rates for U.S. T-Bills at the Bureau of Public Debt web
site, http://wwws.publicdebt.treas.gov/AI/OFBills .
ii) Long-term debt

Long-term debt securities consist of notes and bonds, which are legal obligations for the issuer to
repay the borrowed funds. Notes and bonds are long-term debt securities issued by
governments, governmental agencies, municipalities, or corporations. Debt securities are
characterized by a face value (the amount due at maturity) and an interest rate (unless they are
specifically a zero coupon bond). Debt instruments may have additional features; they may be
convertible (that is, exchangeable into another security) or callable (that is, they may be
bought back by the issuer).
U.S. Treasury bonds are debt of the federal government. These are interest-bearing securities
that have maturities ranging from ten to thirty years. They are generally sold at face value and
pay interest; some Treasury bonds are inflation-indexed (TIPS).
There are also government and government-sponsored agency securities. These agencies
include:
Government National Mortgage Association (GNMA, Ginnie Mae)

Federal National Mortgage Association (FNMA, Fannie Mae) – home mortgages
Federal Home Loan Mortgage Corporation (FHLMC, Freddie Mac) – home mortgages
2
Federal Home Loan Bank (FHLB) -- home mortgages
Farm Credit System (FCS) – farm credit
SLMA (Sallie Mae) – student loans
Municipal securities are bonds and notes sold by state, county, or city governments, or any
other governmental body (e.g., airport authority). These securities are either general
obligation bonds, which are backed by “full faith and credit” of the government, or revenue
bonds, which are repaid with revenues generated by the financed project (e.g., municipal
airport). Because municipal securities are often tax free with respect to federal taxation, we
must convert a municipal yield into an equivalent taxable yield in order to compare investments.
To find the tax-equivalent yield (TEY),
Tax-exempt municipal yield

Taxable equivalent yield =
(1 - marginal tax rate)
where the marginal tax rate is the investor’s tax rate on his/her next dollar of income.
Another form of debt security is the asset

Examples of tax equivalent yields
backed security. Asset backed
securities are securities that are created Assuming a marginal tax rate of 35% ...
by pooling debts and selling the interests Tax-exempt Taxable equivalent
in these debts. The process of pooling municipal yield yield
10% 15.385%
these debts into a trust and selling
5% 7.692%
interests in this trust is referred to as 3% 4.615%
securitization and is diagrammed in 4% 6.154%
Exhibit 1 for home mortgages.
Examples of assets that are securitized include credit card receivables, accounts receivable,
student loans, leases, and
auto loans. Mortgage
Exhibit 1 Securitization of mortgages backed securities are
asset-backed securities that
are pools of mortgages.
Mortgage backed securities These mortgages may be
Mortgage becomes Buys an interest fixed rate, floating rate,
Create part of a pool in the interest and
mortgage of mortgages principal repayment residential, or commercial
of the mortgage mortgages.
$ $ $
Another debt investment is
Homeowner Lender Pooling Investor the corporate note or bond.
Entity Corporate notes and bonds
typically pay interest and
Payments on the mortgage Payments to the investors
may have conversion or call
features. A convertible
bond is a bond that allows
the investor to exchange it
for another security, such as
shares of stock of the
company, at a
predetermined rate. In
other words, a convertible
bond is a bond with an embedded option: the investor has a put option, allowing the exchange of
the bond for another security (typically stock). A callable bond is a bond in which the issuer
3
has the option to buy the bond back from the investor at a predetermined price (the call price).
The callable bond therefore has an embedded option: the issuer has the option to “call” (that is,
buy) the bond back from the investor.
The credit quality of corporate bonds is indicated by a bond rating. There are three major rating
services:
1. Moodys,
2. Standard & Poor’s, and
3. Fitch Ratings
Bonds in the top two classes are referred to as high quality bonds. Bonds in the top four
classes are referred to as investment grade debt. Bonds rated lower than in the top four
classes are referred to as speculative debt, high yield debt, or junk bonds. The Standard &
Poor’s bond ratings are listed in Exhibit 2.
The bond rating Exhibit 2 Standard & Poor’s bond ratings

agencies had been
criticized for the Investment grade
slowness in revising AAA Highest quality. Ability to pay interest and principal very strong.
bond ratings for AA High quality. Ability to pay interest and principal strong.
deteriorating corporate A Medium to high quality. Ability to pay interest and principal, but
more susceptible to changes in circumstances and the economy.
situations (e.g., Enron BBB Medium quality. Adequate ability to pay, but highly susceptible to
and Kmart). The SEC adverse circumstances.
has been looking at the
role of bond rating Speculative grade
BB Speculative. Less near-term likelihood of default relative to other
agencies and whether speculative issues.
there should be a closer B Current capacity to pay interest and principal, but highly susceptible
scrutiny of rating to changes in circumstances.
CCC Likely to default, where payment of interest and principal is
agencies. (See dependent on favorable circumstances.
Spotlight on Credit CC Debt subordinate to senior debt rated
Rating Agencies, for CCCC Debt subordinate to senior debt rated
example). CCCD Currently in default, where interest or principal has not been made
as promised.
In response to the lag Source: Standard & Poor's CREDITWEEK, "Long-term Rating Definitions," February 11, 1991, p. 128.
between company
events and the ratings
revision, rating services
now have implied ratings, also known as market implied ratings. The rating service uses
the yield spread of a company’s bonds relative to that of the similar-maturity government bond to
back into the perceived
risk of the company by What’s a yield spread?
investors, and then
A yield spread is the difference between the yield on a debt instrument and
associates this the yield on a similar-maturity default-free bond (that is, a government bond).
perceived risk with a For example, if 10-year corporate bond has a yield of 5.41% and the yield on
rating. The rating a 10-year U.S. government bond is 4.74%, the yield spread is the difference:
services disclose both 5.41% - 4.74% or 0.67%. However, yield spreads are always quoted using
the assigned bond basis points (bp). A basis point is 1/100 of 1%. In other words 1% is 100
rating and the implied bp. This means that the yield spread in this example is 67 bp.
bond rating for
securities that it rates. Because the difference between a 10-year corporate bond and a 10-year U.S.
government bond is the possibility of default, the yield spread is used as a
measure of risk: the greater the yield spread, the greater the risk.
4
iii) Equity securities
An equity security is an ownership interest in a corporation, represented by a share of stock.
There are two types of stock that corporations issue: preferred stock and common stock.
Preferred stock has preference over common stock with respect to income and claims on
assets. Common stock is the residual ownership of the company.
When a company first goes Exhibit 3 Google’s IPO

public (that is, it is selling
Volume Close
shares to the public, becoming $350 25,000,000
a publicly-traded corporation), $300
20,000,000
this transaction is referred to $250
as an initial public offering. Price $200 15,000,000 Volume
There is usually a lot of per of shares
fanfare when a large, share $150 10,000,000 traded
privately-held corporation has $100
5,000,000
an initial public offering. $50
Consider Google, which went $0 0
public August 13, 2004 by
8/19/04
9/20/04
10/25/04
11/29/04
1/3/05
2/7/05
3/14/05
4/18/05
5/23/05
6/27/05
8/1/05
offering 19.6 million of its
Class A shares at $85 per
share. In the first day of
trading, the stock rose to $100 Source of data: Yahoo! Finance
per share. Since the offering,
Google stock has risen to over three times its offering price, as we show in Exhibit 3.
Cash flows to shareholders are referred to as dividends, whereas additional shares given to
shareholders are referred to as stock dividends. If the board of directors of a company feels
the price of the stock is too high, it will split the stock in a forward stock split, or more
commonly referred to as simply a stock split. A forward stock split is a proportionate increase in
the number of shares outstanding, e.g., 2:1 or 3:1. If a company feels its stock is too low, it may
perform a reverse stock split. A reverse stock split is a proportionate decrease in the number
of shares outstanding (e.g., 1:2 or 1:3).
Cash dividends are not an obligation of a corporation, Exhibit 4 Dividend payment time
but rather are determined at the discretion of the board line
of directors. The board will declare on the declaration
date that a specified dividend be paid on the payment Two business
days
date to shareholders as of the record date. The
exchanges then specify the ex-dividend date based on | . . . ----|-- . . . -- |
declaration record payment
the record date as two business days prior to the record date date date
date. These dates are show in the time line in Exhibit 4.

If an investor buys the stock on the ex-dividend date, ex-dividend date
they do not receive the forthcoming dividend; if he/she
buys the stock the day before the ex-dividend date, he/she will receive the forthcoming dividend.
iv) Derivatives
Derivatives are not themselves equity interests or debt securities, but rather represent a right
or obligation related to equity or debt securities. Forwards, futures, and options are types of
derivative securities. These securities are considered derivatives because they “derive” their value
from another asset – the underlying asset (or simply “the underlying”). For example, an option
on a stock is a right to buy a stock, so its value depends on the price of the underlying – the
stock.
5
An option is a contract that gives its owner the right, but not the obligation, to conduct a
transaction involving an underlying asset at a predetermined future date and at a predetermined
price (exercise or strike price):
A call option is the right to buy the underlying

A put option is the right to sell the underlying
“Writing” an option is taking the opposite position.
A forward contract is a contract that gives the contract holder the right and the legal obligation
to conduct a transaction for a specified quantity of an asset at a specific time in the future. A
futures contract is a standardized forward contract. Though futures contracts originated in
agricultural commodities and metals, there is now an active market in futures related to financial
instruments, such as the S&P500 futures contracts.
B. Indirect investing
Exhibit 5 Share of the market for indirect investing, 2005
Investment companies are
organizations that hold portfolios Closed end Exchange
of securities, such as Fidelity, funds traded funds
2.9% 3.1%
Janus, or T. Rowe Price. These
investment companies provide an Unit trusts
opportunity for investors to own a 0.4%
part of a fund’s portfolio. There
are several different types of
funds:
Unit investment trust
(UIT), which is an Mutual funds
unmanaged, fixed income 93.6%
portfolio.
Closed-end investment Source of data: Investment Company Institute, www.cic.org
company, which is an
offering like stock; the funds shares trades like stock in secondary market.
Open-end investment company (a.k.a. mutual fund), which is open-ended (that is, the
fund accepts additional investors’ funds). This type is managed, marketed aggressively.
Exchange traded fund (ETF), which is a passively managed fund that is designed to mimic
an index.
As you can see in Exhibit 5, the mutual funds are the largest form of indirect investing in terms of
amount invested in funds.
6
i) Unit investment trusts
A unit investment trust is created from a one-time offering of a fixed number of units. The
offering is in the form of an initial public offering. The portfolio is a fixed, passively-managed
portfolio – that is, a buy and hold strategy. UITs have a fixed termination date, which may be
one year, thirty years, or more.
The UIT portfolios may consist of equity investments, fixed income investments, or some
combination. There are thousands of UITs, with many specializing in sector investments. UITs
distribute any dividend
or interest income to
Exhibit 6 Unit investment trusts investors, but there are
no capital gain
$120,000 Tax-free debt trusts consequences until the
Taxable debt trusts investor buys or sells
$100,000
Equity trusts their shares.
$80,000
A unit is typically
$60,000
$1,000 initially and is
sold by brokers. Units
$40,000
of a UIT are valued at
$20,000
the net asset value and
redeemable at the NAV,
$0
though the sponsor
may create a limited
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
secondary market for
the units.
Source of data: Investment Company Institute
As you can see in
Exhibit 6, the popularity of unit
investment trusts has been Example: Net asset value (NAV)
declining over the past 15 years
and the type of UIT investors The value of a share in a mutual fund or UIT is determined by the
prefer has changed from tax-free funds’ net asset value. Mutual funds and UIT calculate NAV each
debt trusts to equity trusts. day and report the NAV based on a single share.
Example: suppose the fund owns three investments:
Stock Market value

A $12,000
B $10,000
C $8,000
Total value of fund $30,000
Number of shares of fund 1,000
NAV $30 per share
7
Unit investment trusts
Advantages Disadvantages
Diversified portfolio Portfolio does not change with market
Buy-and-hold strategy (minimize fees) conditions.
Can sell units at any time at NAV.
Low administrative costs
C. Closed end funds

Closed end funds are
created with a fixed Exhibit 7 Closed-end funds
number of shares are sold
at one time, using an Domestic equity Global equity Domestic taxable
initial public offering Domestic municipal Global bond
(IPO). The shares of the
$300,000
fund then trade in
$250,000
secondary market (e.g.,
$200,000
Nasdaq, NYSE). The price Assets
$150,000
of the fund share is in millions
$100,000
determined by the
$50,000
market, and this price
$0
may be greater or less 1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
than the shares’ NAV.
Shares of closed end Year
funds are not
redeemable; that is, an Source: Investment Company Institute
investor cannot “cash
out” of the fund shares, but rather must sell he shares to another investor in the secondary
market.
Registered investment advisers manage these funds. Because investors are not able to redeem
shares, the fund is able to invest in illiquid securities. Closed-end funds have increased in
popularity in the past few years, as you can see in Exhibit 7.
Closed-end funds
Investors can sometimes buy shares at a Investors pay taxes on income and capital
discount from the NAV and sell shares at a gains annually.
premium. Fixed number of shares, hence less
Do not have to sell shares to meet redemption liquidity
demands.
Distributions according to prescribed schedule.
Lower fees than most mutual funds.
D. Mutual funds
Mutual funds (a.k.a. open-end funds) purchase investments using the pooled funds of the
investors. The fund may invest in stocks, bonds, and many other investments. there are large
fund “families,” such as Fidelity, Vanguard, Janus, and T. Rowe Price, that will maintain many
different types of funds, with different purposes and different portfolio managers. The
investment adviser of the fund (the fund manager) directs the investments according to the
fund’s objectives.
8
Exhibit 8 Mutual fund growth, 1984-2004
Purchases of mutual
fund shares can be Equity funds Hybrid funds Bond funds Money market funds
made at prices at
$10,000
the close of the
day, but not during $8,000
the day. Any
dividends and/or Assets $6,000
interest are passed in billions $4,000
through to investors
in the form of an $2,000
income distribution. $0
If there are any
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
capital gains (net of
losses), these are Year
also are passed
through to investors Source of data: Investment Company Institute, www.ici.org
in the form of a
capital gains
distribution.
There are many different types of mutual funds, which may be classified as follows:
Money market funds
Bond funds (domestic taxable; domestic non-taxable)
Global
Equity funds (domestic; global)
Hybrid funds
As you can see in Exhibit 8, investors’ interest in mutual funds has grown over the past twenty
years.
Mutual funds
Diversification No guarantees
Professional management Fees
Liquidity Tax effect
Convenience
9
E. Exchange-traded funds (ETFs)
An exchange-traded fund (ETF) is an indexed fund; its composition matches the specified
index. The first
exchange traded Exhibit 9 Exchange-Traded Funds by type of fund, 1993-2005
fund (ETF) was in
1993, which is a
Standard & Poor’s Bond
$350,000
Depositary Receipts Global equity
$300,000 Domestic equity
(SPDRs) ETF,
created by the $250,000
AMEX. Examples of Assets $200,000
ETFs include QQQs, in millions
$150,000
IShares, SPDRs and
$100,000
Diamonds.
$50,000
The management $0
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1994
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1999
2000
2001
2002
2003
2004
2005
fee of an ETF is
low, approximately
Year
12bp, and an ETF’s
price is generally
close to its NAV. 2
Exchange traded funds, while a currently a small portion of the indirect investment market, have
been growing in popularity.
Exchange-traded funds
Tax advantage vis-à-vis mutual funds [i.e., Transactions fees for buying and selling
tax efficient]
Low turnover within the fund (and hence
lower fees).
Investors can buy or sell ETFs any time
during market hours.
F. Mutual fund fees and performance

One of the current issues regarding funds is the fee structure and disclosure of these funds.
Many funds are not forthcoming in disclosing their fees to investors, which has caused concerns.
Funds may be load or no-load funds. The distinction between load and no-load is with respect
to whether the fund has a sales load, which is a charge either up front or when the investor
redeems the shares (that is, a deferred sales charge). Loads (that is, sales charges) range
from 1% to 9% of the investment’s value.
Whether a fund is a no-load or load fund, there are still many other types of fees that the
investor may incur, including:
Redemption fee, paid to fund to defray costs associated with sale of shares (SEC limits to
2%);
Purchase fee, paid to the fund (not broker) to defray fund’s cost associated with purchase;
2
100 basis points (BP) is equivalent to 1%. Therefore, 12 bp is 0.12%.
10
Exchange fee, paid when an investor transfers his/her funds to another fund in the same
group.
Account fee, which is a separate fee associated with the maintenance of the fund;
Management fees, which are paid out of fund assets to adviser for services; and
12b-1 fee, which is a distribution fees for marketing and selling shares [NASD limits to
0.75% per year].
There is no evidence that load funds do better than no-load funds. Performance of a fund is
dependent on the management of the
portfolio and the fees other than the loads Current issues regarding mutual funds
that the fund may charge.
1. Mutual fund governance. The Securities and
Funds that invest in stocks tend to outperform Exchange Commission is proposing that mutual
the market by 1.3% per year, before funds adopt governance such that the Board of
considering expenses and returns on non- Directors is comprised of 75% independent
stock investments. The net returns on funds directors and chaired by an independent director.
under-perform the market by 1%. Of this
2. Redemption fee rule. The Securities and
difference, 0.7% is due to underperformance
Exchange Commission is proposing amendments
of non-stock holdings and 1.6% is due to to the redemption fee rule that would provide
expenses and transactions costs. more transparency for mutual funds regarding
the investments made by accounts held by
For more information, check out the SEC’s broker-dealers for clients. This is in response to
guide to mutual funds and mutual fund fees. market timing problems revealed in 2005.
For news or data on mutual funds, check out:
CNN Money Mutual Funds site
Mutual Funds: Investing in America’s Future, Investment Company Institute
Morningstar.com
Yahoo! Finance Mutual Funds Center
LO1 Distinguish between indirect and direct investing
LO2 Calculate the discount and investment yields.
LO3 Calculate the tax equivalent yield on an investment given the tax-exempt yield.
LO4 Distinguish between an investment grade and speculative bond on the basis of bond
ratings.
LO5 Describe the process by which asset-back securities are created.
LO6 List the cash flows expected from stocks and bonds
LO7 Define and give an example of a derivative security.
LO8 List the advantages and disadvantages of unit investment trusts, closed-end funds, open-
ended funds, and exchange traded funds.
LO9 List the types of fees investors pay for no-load and load funds.
LO10 Calculate the net asset value of a fund.
3. Module tasks
A. Required readings
Chapter 2, “Investment Alternatives,” Investments: Analysis and Management, by
Chapter 3, “Indirect Investing,” Investments: Analysis and Management, by Charles
P. Jones, 9th edition.
11
Invest Wisely: An Introduction to Mutual Funds, Securities and Exchange
Commission.
B. Optional readings
Appendix 3-A
Investment Choices, a compilation by the Securities and Exchange Commission of
basic information on the different types of direct and indirect investments.
C. Practice problems sets

Textbook author’s practice questions, with solutions, for Chapter 2
Textbook author’s practice questions, with solutions, for Chapter 3
Studymate® activity
D. Module quiz
See the course schedule for the quiz window.
E. Project progress
Meet with your group members online an assign duties.
Learn about your company’s industry.
Follow current events pertaining to your own company.
4. What’s next?
In Module 3, we’ll take a look at the how securities are traded. Specifically, we will examine the
different markets that exist in the U.S. and elsewhere, the mechanics of trading, and market
barometers (a.k.a. market indices).
12
Module 3
Markets and trading mechanics
1. Overview
A market is simply a means of bringing buyers and sellers together for the transfer and trade of
goods and services. A market facilitates the flow of funds from one party to another. Well-
functioning markets are essential in a capitalistic society. The characteristics of a good market
include:
1. The availability of information at no or low costs.

2. Liquidity – the existence of ready buyers and sellers.
3. Price continuity – minimal changes in prices as a result of transactions taking place.
4. Low transactions costs.
5. Informational efficiency – prices of assets in the market reflect all available public
information.
Our focus in this course is on the capital markets the markets in which debt and equity
securities are traded. There are two types of capital markets: primary and secondary. Primary
capital markets involve new securities, generating new capital to the issuer, whereas
secondary capital markets involve securities traded among investors.
A. Primary capital markets

Investment bankers are important in the primary market because they are often used to help
bring the security issue to investors. The process of bringing securities to the markets is referred
to as underwriting. There are different types of underwriting arrangements:
Negotiated bid, in which the

issuer and the underwriter
negotiate the public offering
price.
Primary offering of securities
Competitive bid, in which
underwriters submit proposals Issuer
for the purchase of the
securities and the underwriter
submitting the best bid is Investment
banker
awarded the securities.
Best-efforts offering, in
which the investment banks Syndicate Syndicate Syndicate
member 1 member 2 member 3
do not commit to a specific
number of securities that it
will sell, but rather uses their Broker Broker Broker Broker Broker Broker
best efforts to sell the security
to investors. Investors
In the negotiated and competitive
Module 3 1 of 9
offerings, the underwriter, or underwriters if several are used in the form of an underwriting
syndicate, buy the securities from the issuer and then sell these securities to investors. In the
case of a best efforts offering, the investment banker does not buy the shares from the issuer.
In addition, a company may file a shelf registration for securities, which stays “on the shelf”
until the issuer is prepared to offer any number of securities within the registered amount.
These registrations provide the issuer with more flexibility in the timing of any issues included in
the registration. And in addition to offering securities for sale to the public, an issuer may also
sell securities directly to a small number of investors in a private placement.
B. Secondary capital markets

i) Types of markets by form of trading
In a pure auction market, buyers and sellers submit bids to a central location. These buy and
sell orders are matched by broker. In a dealer
market, the dealers – who are individuals – own
securities. They stand ready to buy or sell securities Bid quote: What a buyer is willing to pay
and will quote a bid and an ask price. Brokers, who for a specified amount of stock
represent investors who wish to buy or sell, then shop
Ask quote: What a seller is willing to take
around for dealer with best bid or ask
for a specified amount of stock
In a call market, the trading of individual stocks

takes place at specified times. One party determines
the single price that satisfies the most orders and then all transactions at this price. In a
continuous market, trades occur whenever the market is open and the prices are determined by
auction or by dealers. In the New York Stock Exchange, for example, the opening price is
determined by a call market, but then trading during the trading hours is determined by the
continuous market.
ii) Examples of markets

In the U. S., there are nine national exchanges:
American Stock Exchange (AMEX)

Boston Stock Exchange
Chicago Board Options Exchange (CBOE)
Chicago Stock Exchange
International Securities Exchange
National Stock Exchange
New York Stock Exchange (NYSE)
Pacific Exchange
Philadelphia Stock Exchange
The NYSE is the largest stock exchange in the U.S. in terms of the market value of shares traded,
whereas the CBOE is the largest options exchange. National exchanges outside the U. S. include
the London Stock Exchange (LSE) and the Tokyo Stock Exchange (TSE).
The Nasdaq is a large U.S. over-the-counter market. An over-the-counter market has no

physical presence, but rather trading is carried out over computers. The Nasdaq was created in
Module 3 2 of 9
1971 by the National Association of Securities Dealers (NASD) to become the first electronic
market in the U. S. 1 However, the
Nasdaq is currently exploring a The Pink Sheets
conversion to an exchange.
You have likely heard of the pink sheets, which is an
The Nasdaq has two markets: the electronic system that provides quotes of over-the-counter
National Market System, which are securities. Dealers provide their bid and ask quotes to this
the larger, more actively traded system (operated by Pink Sheets LLC) and brokers can then
securities, and SmallCap, which are the view these quotes.
smaller, newer companies.
There are no listing requirements for companies on Pink
Sheets. The companies whose stocks are on the Pink Sheets
One of the distinguishing differences are very small, and the market for their stock is generally
between the NYSE and Nasdaq markets quite thin.
is the listing standards. For example,
the NYSE requires that the company be Investors trading Pink Sheet companies should be aware
much larger in terms of market value of that the companies whose stocks are traded in this market
equity, net income, and share trading are not required to file financial statements – or any other
volume that is required by the Nasdaq type of disclosure – with the Securities and Exchange
market. Commission.
Many of the current email scams involve pumping up the

NYSE listing requirements price of companies with stocks on pink sheets and then
Nasdaq listing requirements dumping the stocks. These pump-and-dump schemes try
to take advantage of uninformed investors. The companies
whose stock is hyped are most often unaware of these
schemes.
iii) Trading mechanics
Another difference between the Number of securities listed

markets is the procedure for
trading. The NYSE is an auction
1975-2004
market, whereas the Nasdaq is a Nasdaq NYSE
dealer market. In the Nasdaq,
6,000
investors buy from and sell to a
5,000
dealer. In the NYSE, on the other
4,000
hand, investors are buying and
selling between each other, with 3,000
bidding among investors. In the 2,000

Nasdaq market, market makers, 1,000
who are the dealers, manage the 0
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process by working with investors.

In the NYSE market, the specialist Year
manages the process by matching
buyers and sellers.
Source: www.nyse.com and www.nasdaq.com
1
Note that the Nasdaq is not an exchange. Though it has applied to become an exchange, it is
not one yet.
Module 3 3 of 9
Up until the NYSE going public in early 2006, members of the NYSE bought seats on the
exchange. The last seat on the
NYSE sold for $3.55 million on
December 30, 2005. When the The price of membership on the NYSE
NYSE merged with Archipelago
Holdings in 2006, seat holders $3,000,000
converted their ownership in the $2,500,000
exchange to cash and public
shares in the new company, $2,000,000
with each seat worth $6.3 Membership

$1,500,000
price
million in terms of cash and
$1,000,000
shares.
$500,000
Now that the NYSE is a publicly
$0
traded company, NYSE LLC, the
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1999
2002
ability to trade on the floor of
the exchange is no longer seat
based, but SEAT based: trading Source: www.nyse.com
licenses, referred to as licenses
in the Stock Exchange Auction
Trading Systems (SEAT). In other words, a SEAT is required to trade. Only 1,366 SEATS are
issued.
There are different types of exchange members:

1. Specialists, who are members who match buy and sell orders, and also act as dealers,
maintaining an orderly market.
2. Floor brokers, who are independent members who act as brokers for other members,
executing buy and sell orders.
3. Commission brokers, who are employees of member firms who buy and sell for customers
of firm; also referred to as house brokers.
4. Registered traders, who are members who buy and sell for their own accounts; also
referred to as independent brokers.
In the case of trading on the NYSE, the investor contacts a broker to specify the trade and then
the broker contacts floor broker, who places order with specialist. The specialist is a member
of the exchange who is responsible for maintaining an orderly market, providing capital and
stabilizing prices. The specialist brokers the deal, finding the other side of the transaction. There
is only one specialist for a given stock and a specialist may perform this function for any number
of stocks.
Module 3 4 of 9
The Nasdaq, on the
other hand, operates as
a dealer market. In a
dealer market, there are
any number of
competing dealers, or
market makers, for a
stock. These market
makers facilitate trading
of shares by
maintaining an
inventory in a stock and
posting bid and ask
prices for that stock
that they will honor.
In the Nasdaq system,

Individual investors,
through their brokers,
therefore can “shop
around” electronically
for the best price for a
given transaction.
Though the market

mechanisms differ
between the NYSE and
the Nasdaq, there is not
much difference, in effect, between a market maker on Nasdaq and a specialist on the NYSE.
iv) Types of orders

Investors may submit orders that specify buying or selling at whatever is the current price, or
they can specify a price. The different types of orders are as follows:
Market order: buy or sell at current price
Limit order: buy or sell at specified price
Stop loss order: sell if price below a specified price.
Stop buy order: buy if price above a specified price.
Investors may also buy on margin. Buying “on margin” is the purchase of stock by borrowing
portion of purchase price. The investor pays interest to the brokerage at the call money rate.
The initial margin requirements are set by the Federal Reserve (currently 50%). After the initial
purchase, an investor must have equity in the account that meets the maintenance margin. The
equity in the account is:
Investor’s equity = Market value of stock – amount borrowed
The maintenance margin is a specified minimum equity as a percentage of the value of the
account. The maintenance margin set by the Federal Reserve is currently 25%, but brokerages
may require more (say, 30%). If the maintenance margin is not met, the broker will make a
margin call, which requires the investor to put more equity into the account. In the event that
more equity is not placed in the account, the broker will sell the stock to satisfy the call.
Module 3 5 of 9
Example: Buying on margin
Suppose you buy 100 shares of ABC stock at $50 per share: total cost = $5,000, borrowing 50%, or
$2,500. And suppose that the maintenance margin is 30%.
If the stock’s price goes to $60/sh, your equity is $6,000-2,500 = $3,500

o In terms of the equity percentage, $3,500 / $6,000 = 58.333%
If the stock’s price goes to $40/sh, your equity is $4,000-2,500 = $1,500

o In terms of the equity percentage, $1,500 / $4,000 = 37.5%
What would the stock’s price have to be before there is a margin call?
Equity Value of shares - $2,500

0.3
Value of shares Value of shares
The stock’s price would have to decline to $35.71 per share before there is a call.
The profit or loss on buying stocks on margin must factor in the commissions on the purchase
and sale, as well as any interest on the loan.
Profit or loss from = proceeds commission cost of commission interest

buying on margin from sale on sale shares on purchase on loan
The return on the margin transaction is therefore:
profit or loss
Return on margin account =
initial equity
Compared to the return from buying and selling stocks without margin loans, any profits or losses
are exaggerated from using margin loans.
Example: Effect of margin loans on returns
Problem
Suppose you buy 100 shares of stock at $50 per share and you borrow $2,000 at the call money rate of 8%.
This means that your initial equity investment is $3,000. If transactions costs are 1% for buying and for
selling, what is the return on this one-year transaction if the stock price in one year is:
1. $40?
2. $70?
Solution
1. At $40 per share, your loss is $4,000 – 40 - 2,000 – 3,000 – 50 – 160= -$1,250, or a return of -
$1,250 / $3,000 = 41.67%. [If there was no borrowing, the loss would have been -$1,090 or
$1,090 / $5,000 = -21.8%]
2. At $60 per share, your profit is $7,000 – 70 - 2,000 – 3,000 – 50 – 160= $1,720, or a return of
$1,720 / $3,000 = 57.33%. [If there was no borrowing, the profit would have been $1,880 /
$5,000 = 37.6%.]
Module 3 6 of 9
v) Short sales
A short sale (or “shorting”) is the sale of stock you don’t own. There are restrictions to short
sales, which affect the profitability of these transactions. The primary restriction is the uptick
rule. This rule requires that the price of short sale must be higher than last trade price and is
intended to prevent downward manipulation of stock prices through shorting. Another restriction
is that short sellers must pay any cash dividends to the party who lent the stock. Because the
shorting investor is selling stock he/she does not own, the “lending” shareowner must be
compensated for any dividends not received from the stock.
A trader earns a profit from short selling when the price goes down by more than the commission
and any cash dividends:
Profit or loss = proceeds from - commission on dividends cost of buying commission on

sale of shares sale of shares on shares shares purchase of shares
When you buy a stock, the

most you can lose is the value
of the stock. However, when
you sell stock short, you face, Short sales: Prevalence
potentially, an unlimited
downside risk. And this is Short-interest S&P 500
what makes short selling so 8000 2000
risky. 2 Combining this risk
Short 6000 1500
with the fact that there are Level of
interest
other short sellers out there 4000 1000
shares S&P 500
of the same security, if the in millions 2000 500
market price of the stock
0 0
rises, there may be a short
1977
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1983
1986
1989
1992
1995
1998
2001
2004
squeeze in which many
traders are clamoring for the Year
stock, resulting in upward
pressure on the stock’s price Source: NYSE Fact Book and Yahoo! Finance
– not what short sellers would
like to see.
In general, the short interest (that is, the number of shares sold short) increases as the level of
the market increases, but this pattern has changed in recent years.
C. Recent innovations and changes in markets

Technology and global competition are changing the way markets operate and are affecting the
spirit of cooperation among markets. In addition, the trading scandals in recent history have
resulted in tightened regulator scrutiny of these self-regulated markets:
In the 1990s, the SEC fined Nasdaq companies and required the NASD to increase self-
policing when it was found that dealers fixed spreads (that difference between the bid and
the ask, which is the profit the dealer makes on the transactions). [Check out the SEC’s
report on these issues]
2
On June 23, 2004, the SEC adopted Regulation SHO (Securities Exchange Act Release No. 50103, 69 FR
48008) which is a pilot program in which the SEC is examining the effects of short selling on prices and
trading.
Module 3 7 of 9
In 2003, the NYSE was embroiled in a scandal involving the compensation for its chairman,
Richard A. Grasso. These scandals and other events have led to changes in the markets and
governing of the markets.
In 2004, five of the specialist firms on the NYSE reached a settlement with the SEC regarding
charges of trading ahead of public limit orders.
In 2004, the SEC focused attention on abuses in mutual fund shares trading, such as late-
trading trading, in which trading for some investors was allowed after 4 p.m. at the 4 p.m.
pricing, and market timing, and late-trading that violated the funds’ prospectuses.
In 2005, the SEC focused attention on trading abuses by specialists on the NYSE. The SEC
found that specialists were “trading ahead” of customers, hence benefiting personally from
the inside information that they possess regarding customer buy and sell orders.
Innovations that affect the trading of securities include:

Super-Dot. Electronic order routing system used by the NYSE for trades of less than 2,100
shares for market orders and less than 30,100 shares for limit orders.
Intermarket Trading System (ITS). Connects NYSE, AMEX, Nasdaq, and other markets.
Electronic communications networks (ECNs), including Instinet, Archipelago, and Brut,
were introduced in 1997 to assist with order handling, acting as electronic brokers to match
buying and selling orders. ECNs provide competition for market makers in bringing orders to
the market.
SuperMontage. Nasdaq’s order-display and execution network, which is an extremely fast
computerized trading system.
Increasing off-hours trading, e.g., NYSE’s Crossing Sessions I and II
In addition, changes in laws and regulations have had a significant impact on markets and
trading, including:
Financial Services Modernization Act of 1999, which allows banks, brokerages, and insurance
companies to offer investment services.
New rules under Regulation NMS, adopted by the Securities and Exchange Commission,
June 2005
Ö Requires trading centers to have procedures to prevent execution of trades at inferior
prices.
Ö Fair and non-discriminatory access to quotations.
Ö Prohibits sub-penny quotations.
Ö Requirements for consolidating, distributing and displaying market information.
We also see a movement toward mergers of markets across borders, creating more global
trading markets. Much of this is ongoing in 2006. 3
LO3-1 Define a market and list and describe the characteristics of a well-functioning market.
LO3-2 Distinguish between primary and secondary markets.
LO3-3 Compare auction and dealer markets.
LO3-4 Compare call and continuous markets.
LO3-5 List and briefly describe the different stock and bond markets in the U.S.
LO3-6 Distinguish U.S. markets in terms of listing requirements, trading, and membership.
LO3-7 Calculate the returns available on buying stocks on margin.
3
The Nasdaq made an offer for the London Stock Exchange (LSE) in early 2006 that was
rejected. However, the Nasdaq continues to increase its ownership stake in the exchange such
that in May 2006 this interest was 23% of outstanding shares in LSE. The NYSE made an offer in
May 2006 for Euronext, which is still under consideration.
Module 3 8 of 9
LO3-8 Diagram and calculate the profit or loss on a short sale transaction.
3. Module Tasks
Chapter 4, “Securities Markets,” Investments: Analysis and Management, by Charles
Chapter 5, “How Securities are Traded,” Investments: Analysis and Management, by
Margin: Borrowing Money to Pay for Stocks, provided by the SEC
Short Sale Restrictions, provided by the SEC
Investor Alert: Stock Market Fraud “Survivor” Checklist, provided by the SEC

Trading on margin, prepared by Pamela Peterson Drake
Short selling, prepared by Pamela Peterson Drake
StudyMate activity
D. Project Progress
At this point, you should have gathered the general descriptive information about
your company and the industry in which it operates.
You should have contacted your group members and developed a plan for acquiring
and communicating the necessary information for the project’s industry tasks.
You should be following event pertaining to your company and its industry.
E. Module quiz
See the schedule for the Module quiz dates.
4. What’s next?
In this module, we focus on trading mechanics and the rules and regulations that affect trading
strategies. In Module 4, we will take a look at market indices, focusing on the differences among
the indices: the calculations behind these indices, and the securities that make up these indices.
Module 3 9 of 9
Module 4
Market indices
1. Overview
Individual security prices are reported each day on the Internet, in local newspapers, and in the
financial press. But individual stocks’ prices may not be indicative of how a security market as a
whole may be performing.
Why would you care how the market is faring? There are at least two reasons. First, the prices
of securities tend to move together - not in perfect tandem, but most tend to move in the same
general direction. Second, general movements of the market tend to precede economic
developments. For example, an upward movement in the market during a recession usually tells
us that the end of the recession is nearing. Both of these factors have consequences for
investors and for corporations contemplating new equity issues.
In general, a market indicator is a summary measure of how a group of stocks and/or bonds
performing. Indicators provide a means for us to gauge the movement of market prices over
time. There are many uses of market indices. These include:
As benchmarks to evaluate performance, such as comparisons for performance of mutual
fund managers or as indicators of the performance of asset classes (e.g., stocks, bonds).
To create and monitor an index fund. Indicators are often used as a basis for the
construction of an indexed fund. Some exchange traded funds (ETFs) have been created
to mimic indexes (for example, SPDRs).
To forecast future market movements.
To measure market rates of return. Understanding past returns help us predict future
market movements (e.g., using technical analysis).
As a proxy for the market portfolio in the calculating systematic risk of a stock.
An indicator may be calculated as an average of the prices of representative stocks, perhaps

weighted in some way, or as an index -- a sum or average of representative prices reported as a
ratio.
Factors important in constructing a market index include:
1. the sample of securities included,

2. the weights applied to the sample securities (that is, price-weighted, value-weighted, or
un-weighted), and
3. the computational procedure (type of averaging; method of adjusting for splits)
As an example, the oldest and most watched stock market indicator is the Dow Jones
Industrial Average (DJIA), comprised of the stocks of thirty large, well-established and
profitable firms (sometimes called "blue chip" firms) and weighted to reflect various events that
have occurred during the histories of those firms. The DJIA is constructed as a price-weighted
average of the thirty stocks.
Module4: Market Indices 1 of 13

A more representative indicator is the Standard & Poor’s 500 Stock Index (S&P 500), which
includes 500 common stocks. The S&P 500 is a value-weighted index; that is, each stock’s return
is weighted by the market value of the company’s outstanding stock. The S&P 500 is reported
relative to the base years 1941-1943, which are arbitrarily given the index value 10. So, for
example, when that index reached 900 in January 2003, we knew that stock prices were
generally about ninety times as high as in 1943.
In addition to general stock market indicators such as the DJIA and the S&P 500, a number of
industry-specific stock indicators are computed and published by financial services. These
include the Dow-Jones Transportation Average and the S&P 400 Utilities Stock Index.
Global equity indexes include:
the FT/S&P Actuaries World Indexes (thirty countries),

the Morgan Stanley Capital International Indexes (MSCI), a set of market-weighted
indexes, and
the Dow Jones World Stock Index (thirty-three countries), calculated using own-country
currency as well as U. S. dollar.
In addition to stock indicators, there are a number of indicators that serve as barometers of the
bond market. However, a bond market indicator series is more difficult to create than a stock
market indicator because of a number of reasons:
there is a larger number of bonds than stocks,

there is more variety in features,
the universe of bonds is constantly changing (bonds matures, stocks don’t),
a bond’s value changes constantly as duration and interest rates change over the life of
the bond, and
there are difficulties in pricing some types of bonds (e.g., convertible, callable bonds).

The changes in the bond
indexes over time are Exhibit 1 Levels of the Dow Jones Industries Average
(DJIA), Standard and Poor’s 500 Index, and the
determined, in large part,
Nasdaq Index, October 1984 through June 200
by changes in interest
rates. There are few well- Panel A Levels of the indices
developed corporate bond
markets world-wide, Dow Jones Industrial
including the Lehman 15000 S&P 500 5000 Level
Brothers Aggregate Bond Level 4000 of the
10000 Nasdaq
Index, JP Morgan of the 3000 S&P 500
DJIA 2000 or
Government Bond Index, 5000
1000 Nasdaq
S&P/TSX Canadian Bond 0 0 index
Index and the FTSE Global
Oct-84
Jun-86
Feb-88
Oct-89
Jun-91
Feb-93
Oct-94
Jun-96
Feb-98
Oct-99
Jun-01
Feb-03
Oct-04
Jun-06
Bond Index Series.
Month
We can see the similarities
in the stock indexes over
time comparing three Panel B Logarithmic value of the barometers
different market Dow Jones Industrial
barometers, as shown in S&P 500
100000
Exhibit 1. As we see in 10000 Nasdaq
Log of 1000
Panel A of this exhibit, the
index 100
trends among the three 10
indices are similar. The 1
Oct-84
Jun-86
Feb-88
Oct-89
Jun-91
Feb-93
Oct-94
Jun-96
Feb-98
Oct-99
Jun-01
Feb-03
Oct-04
Jun-06
stock market bubble in the
1999-2000 period is
evident in all three Month
barometers, though more
pronounced in the Nasdaq Source of data: Yahoo! Finance
indicator.
Because the barometers are different starting points and compositions, it’s not easy to compare
them without some type of adjustment. Remember from your basic math classes, by taking logs
we are able to capture the percentage change in the index, hence we can better compare the
barometers once we have transformed them using logs.
The different market barometers basically move together, but with minor exceptions – such as
the Internet bubble years.
The three indicators track very closely until late 1998. The returns on these three indicators are
highly correlated in the period from October 1984 through May, 2006 as indicated by the
calculated correlation coefficients (for which 1 is perfect, positive correlation and 0 indicates no
correlation):
DJIA S&P 500 Nasdaq

DJIA 1.0000
S&P 500 0.9895 1.0000
Nasdaq Composite 0.9082 0.9490 1.0000
If we isolate the Internet Bubble years, 1998 through 2002, however, we see a different picture
of correlation among the markets, with less correlation between the blue-chips and the Nasdaq:

DJIA S&P 500 Nasdaq
DJIA 1.0000
S&P 500 0.8628 1.0000
Nasdaq Composite 0.7101 0.9065 1.0000
A bond market indicator may represent government bonds, such as Shearson Lehman Brothers'
Long-term Treasury Index, or corporate bonds. Bond indexes for corporate bonds are generally
created separately for investment grade bonds and high-yield bonds. Investment grade
bonds are those rated BBB
A note about correlation (Baa) or higher. The four
purveyors of investment grade
The correlation between any two samples is a measure of association.
bond indexes
When we refer to “correlation”, we are referring to the correlation
coefficient, which is the ratio of the covariance to the product of the
are Merrill Lynch, Lehman
standard deviations of the two samples. A correlation coefficient ranges Brothers, Salomon Brothers,
from -1 (perfect negative correlation) to +1 (perfect positive and Ryan Treasury. High-yield
correlation). bonds
(a.k.a. junk bonds) are those
In the case of the correlation of an index, we are interested in the that are not investment grade
association between the time series of the two indices: Do these series (that is, they are rated as BB
move together? How closely do they move together? You tell both or lower). There is less
visually (in Exhibit 1) and statistically, that the major indices are
correlation among high-yield
closely, positively correlated.
bond indexes (compared to
the investment grade
indexes).
We can make some general statements about how market indicators are related to one another
over time:

Broad U.S. stock market An aside about logs
indicators, such as the
DJIA, the S&P 500, and the Consider $1,000 invested for 30 years at 5% and then at 10%. The
growth of the value of $1,000 follows the following paths:
Wilshire 5000, are
correlated with one
$20,000
another. FV of $1,000 at 5%
Correlations among $15,000 FV of $1,000 at 10%
countries’ stock market FV in
indexes are significant, but $10,000
dollars
not as high as within- $5,000
country comparisons.
There is a high degree of $0
correlation among high- 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
grade bond indexes. Period in the future
There is little correlation
within high-yield bond If we take logs of the future values, we see that the constant growth
indexes, and there is little in the above graph is transformed into straight lines:
correlation between high-
yield bond indexes and 12
10
high-grade indexes.
8
Natural
6 Log of FV of $1,000 at 5%
A. The price-weighted log of FV
4
Log of FV of $1,000 at 10%
average 2
A price-weighted average is 0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
a simple, arithmetic average of
the values of the stocks in the Period in the future
average. If there is a stock
split or other adjustment (e.g.,
reverse stock split, stock dividend), the divisor is no longer the number of stocks in the average,
but rather is adjusted appropriately.
An example of a price-weighted average is the Dow Jones Industrial Average (DJIA).
Consider an example of a price-weighted average comprised of three stocks, A, B and C, with the
following share price and number of shares outstanding:
Number of
Price per Number of shares
share at time Price per share shares outstanding at
Stock t at time t+1 outstanding at t t+1
A $10 $15 100 100
B $20 $15 150 150
C $30 $18 200 400 Í 2:1 split between t and
t+1 1
The price-weighted average at time t is:

price-weighted average at t = (10 + 20 + 30) / 3 = 20
1
A stock split is a change in the number of shares outstanding. If you own 100 shares of stock and the stock has a
2:1 stock split, you have 200 shares after the split; if the stock had split 3.5:1, you own 350 shares after the split.

The price-weighted average at time t+1 is more challenging. First, the Note: The split changes
the divisor. The divisor is revised so that the average (if prices change for no other reason than
the split) is the same; that is:
[10 + 20 + (30/2) ] / X = 20
Solve for X: 45 / X = 20 Æ X = 2.25
The price-weighted average at time t+1 is:
Price-weighted averaget+1 = (15 + 15 + 18) / 2.25 = 48 / 2.25 = 21.333
In a price-weighted series, the divisor is constantly changing to keep up with the stock dividends
and stock splits of the components of the series.
The Dow Jones Industrial Average, a price-weighted series, is comprised of thirty stocks. In
1928, it was decided that the divisor be altered to reflect stock dividends and splits, in the
method we have just demonstrated. This means that the divisor today is quite small because of
all that has happened in the component stocks (and their replacements) over the years. The
divisor for the DJIA in September 2005 was 0.12560864.
B. Value-weighted series
A value-weighted series uses the market value of the series at a point in time as its base (usually
scaled to 100).
N
Pit Q it
Index t i 1
N
Pib Q ib
i 1
where
P is the price of the stock;
Q is the number of shares outstanding;
t is the day for the index computation;
b is the base day for the index; and
N is the number of stocks in the index;
The index is automatically adjusted for stock splits and other capital changes by its construction.
Consider the same example as before, but calculate the value-weighted index comprised of three
stocks, A, B and C, with the following share price and number of shares outstanding:
Number of Number of
Price per Price per shares shares Market Market value
share at share at outstanding outstanding at value of of shares at
Stock time t time t+1 at t t+1 shares at t t+1
A $10 $15 100 100 $1,000 $1,500
B $20 $15 150 150 $3,000 $2,250
C $30 $18 200 400 $6,000 $7,200
$10,000 $10,950
Suppose the beginning value of the index is 100 and the base value is $5,000.

The index value as of time t:
($10×100)+($20×150)+($30×200)
Index t = ×100
$5,000
$1,000+$3,000+$6,000
Index t = ×100
$5,000
Index t =200
The index value as of time t+1:
($15×100)+($15×150)+($18×400)
Index t+1 = ×100
$5,000
$1,500+$2,250+$7,200
Index t+1 = ×100
$5,000
Index t+1 =219

Another way of looking at this calculation is to compare market values:
$10,000
Index t =100x =200
$5,000
$10,950
Index t =100x =219
$5,000
C. Un-weighted value series

In an un-weighted series (a.k.a. equal-weighted series), each security has an equal weight. The
return on each stock, therefore, gets equal weight. Examples of an un-weighted value series
include the Value Line averages and the Financial Times (FTSE) series. Instead of calculating the
arithmetic average of the stocks’ returns, most un-weighted series use the geometric average.
Consider the same example as before, but calculate the un-weighted index comprised of three
stocks, A, B and C, with the following share price and number of shares outstanding:
Number of Number of
Price per Price per shares shares
share at share at outstanding outstanding at
Stock time t time t+1 at t t+1
A $10 $15 100 100
B $20 $15 150 150
C $30 $18 200 400 Í2:1 split between t and t+1
The holding period yield (HPY) is calculated as:

Price t+1 -Price t
HPY=
Price t
So, for Stock A,

($15-10)
HPYA = =50%
$10
Therefore
Stock Holding period yield
A 0.50 or 50%
B -0.25 or –25%
C 0.20 or 20%
Note that the use of the geometric average instead of an arithmetic average makes a difference:
arithmetic average = (0.50 – 0.25 + 0.20) / 3 = 0.15 or 15%
geometric average = [(1 + 0.50)(1 – 0.25)(1 + 0.20) ]1/3 – 1

= [1.35]1/3 – 1 =0.1052 or 10.52%
Suppose the Index value at time t is 1000. The index value using an arithmetic average is 1,000
(1 + 0.15) = 1150 and using a geometric average is 1,000 (1 + 0.1052) = 1105.2.
D. Summary and comparisons

By understanding how an index is constructed, we get a better idea why these market
barometers move as they do. Consider the three indices that we calculated earlier. Each is
represented with different levels because of the way they are constructed. The levels of the three
indices for periods t, t+1, and t+2 are as follows:
Level
Average or index t t+1 t+2
Price-weighted average 20 21.333 22.667
Value-weighted index 200 219.000 212.000
Un-weighted index 1000 1105.20 1306.68
We also see that the calculated returns based on the levels are different – again, because of the
way in which the indices are constructed and calculated.
Return
Average or index t to t+1 t+1 to t+2
Price-weighted average 6.665% 6.253%
Value-weighted index 9.500% -3.196%
Un-weighted index 10.520% 18.230%
In the case of a value-weighted index, a small change in a large capitalization stock will result in
a large change in the level of the index. In the case of a price-weighted series, a large
movement in the price of a single component of the series can result in a major movement in the
series. When we watch the day-to-day fluctuations in the DJIA and the S&P500, we should keep
in mind the different stocks that these indicators represent and the different computational
methods behind these indicators.
Consider the characteristics and differences among the leading market indicators:
The DJIA is a price-weighted indicator that includes large capitalization, “blue chip”
companies. But because it is limited to only thirty stocks, it is not often representative of
the market’s movements as a whole. Further, because it is comprised of only U.S.

companies, it does not tell use much about how stocks markets in general are
performing.
The S&P 500 index is a value-weighted series that is comprised of stocks of 500 different
large capitalization stocks that are widely-held. The stocks are drawn in a way to
represent the different sectors in the economy and do include stocks of non-U.S.
companies that are widely held in the U.S.
The Nasdaq 100 is a value-weighted series, but the precise calculation is not public
information. As the name implies, the Nasdaq 100 is comprised of 100 different Nasdaq-
listed companies. Because of the predominance of technology stocks listed on the
Nasdaq, the index is heavily influenced by the price movements of technology stocks.
The Wilshire 5000 index is a value-weighted index comprised of the stocks of over 6,000
companies, representing a broad spectrum of companies whose stocks are traded on the
MYSE, AMSE, and Nasdaq markets. Like the S&P500, the Wilshire 5000 index is
influenced by the movements of the larger capitalized stocks.
The Russell 2000 is a small-capitalization index, designed to represent the movements of
the smaller stocks.
Market indicators: Facts
In addition to these U.S.
market barometers, there Name Date Number of Method of weighting
are a number of non-U.S. begun stocks
and global indices. For DJIA 1884 30 Price weighted
example, the DAX is S&P 500 1957 500 Value weighted
Wilshire 5000 1970 6,400+ Value weighted**
comprised of German
Nasdaq 100 1985 100 Value weighted*
companies’ stocks, whereas Russell 2000 1984 2000 Value weighted
the Hang Seng is comprised Nasdaq Composite 1971 4000+ Value weighted
of stocks traded on the Hong FTSE 100 1984 100 Equal weighted
Kong stock market. FTSE All World 1987 2,200+ Value weighted**
DAX 1987 30 Value weighted
Hang Seng 1969 33 Value weighted
* proprietary calculation method based on the value weighted method

** float-adjusted market capitalization
Check out:
List of stock market indices, by Wikipedia
Market Indices, quotes and descriptions from the Nasdaq

Example Calculating the value of an index
Problem
Consider the following:
Stock Pt Pt+1 Sharest Sharest+1

M $10 $12 1,000 1,000
N $20 $22 2,000 2,000
O $60 $20 1,000 3,000
O had a 3:1 split between t and t+1
Calculate, for t+1:

the price-weighted average,
the value-weighted index value (assuming a base of the index of 1000 and a base
value of $80,000), and
the un-weighted index value using a geometric average (assuming index
value at time t is 1000).
Which of the following indicates the price-weighted average, value-weighted index, and un-
weighted (geometric) index, respectively for t+1?
A. 32.4; 1450; 1097
B. 27.33; 142.5; 1010
C. 32.4; 1450; 1010
D. 27.33; 145; 1097
Solution: A
At time t,
Price-weighted average is 30
Value weighted series is 1375
Un-weighted series (geometric) is 1097
E. Returns on indexes
A return on an index is calculated using the same method as you would use in calculation the
return on a stock:
Pt -Pt-1 +D t
rt =
Pt-1
where rt is the return I period t, Pt is the closing stock price for period t, Pt-1 is the closing stock
price at the previous period, and Dt is the cash dividend on during period t.
What makes this a bit more challenging is including the cash dividends because these are not
readily available. Simply calculating the percentage change in the index from day to day or from
month to month ignores a substantial portion of the return on an index.
Consider the S&P 500 in 2006,

Quarter end Level Dividends
03/31/2006 1294.83 $5.91
06/30/2006 1270.20 $6.02
09/30/2006 1335.85 $6.09
12/31/2006 1418.30 $6.86
The level of the S&P 500 at the beginning of 2006 was 1248.83. Calculating the returns for each
quarter in 2006 with and without dividends produces different returns:
Return without Return with

Quarter end dividends dividends
03/31/2006 3.728% 4.215%
06/30/2006 -1.902% -1.446%
09/30/2006 5.168% 5.642%
12/31/2006 6.172% 6.628%
Does this make a difference? Yes. In much of the benchmarking that we do in analyzing returns
on investments, we compare the returns on a stock with those of a benchmark, such as a stock
index. A correct comparison requires that we calculate the returns with accuracy, which requires
including dividends. For some stocks, dividends may be small or not at all, but for other stocks
the dividends may be a large part of the return. This is also true with stock indexes: ignoring
dividends is ignoring a portion of the return.
You can see the significance of ignoring dividends when you look at wealth relatives over time, as
shown in Exhibit 2. The wealth relative used here is to consider an equal investment (in this
case, $1) in the index without and with returns. As you can see, ignoring dividends results in a
significant difference in the performance of the index. In other words, if you calculate a return on
an index without considering the dividends paid on the stocks comprising this index, you are
ignoring a portion of the returns and are therefore incorrect.

Exhibit 2 The value of $1 invested in the S&P 500 index, calculated with and without cash
dividends considered, 1998-2006
$9
Value without dividends
$8 Value with dividends
$7
$6
Value of $1
invested $5
3/31/1998 $4
$3
$2
$1
$0
03/31/1988
03/31/1989
03/31/1990
03/31/1991
03/31/1992
03/31/1993
03/31/1994
03/31/1995
03/31/1996
03/31/1997
03/31/1998
03/31/1999
03/31/2000
03/31/2001
03/31/2002
03/31/2003
03/31/2004
03/31/2005
03/31/2006
Quarter
Source of data: Standard & Poor’s, www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS
LO4-1 Describe the uses of stock and bond market indices.
LO4-2 List and briefly describe the major U.S. stock indicators.
LO4-3 Calculate different indices, including a price-weighted average, a value-weighted index,
and an equal-weighted index.
LO4-4 List the reasons why a bond index is difficult to construct.
LO4-5 Explain why the major market indicators of the DJIA and the S&P 500 may not move in
perfect tandem with each other.
3. Module Tasks
“Indexes: The Good, The Bad and The Ugly,” by Rick Wayman, Investopedia.
Market Indices, provided by the SEC
Chapter 9 of the Irwin Guide to Using the Wall Street Journal, by Michael B. Lehman,
available through the FAU Libraries’ to netLibrary [Note: if you are accessing this
from off-campus, you must use EZProxy to access this material. Process: FAU
Libraries – EZProxy – Indexes and Databases -- netLibrary]

Market indices, prepared by Pamela Peterson Drake
StudyMate activity

D. Project progress
At this point in time, you should have completed the company description write-up
and gathered the financial data that you’ll need to analyze your company.
Check out Gathering Financial Information from Mergent Online to learn how to get
downloadable financial data on your company.
E. Module quiz
quiz availability.
4. What’s next?
Up to this point, we have been focusing on the instruments and mechanics of the stock and bond
markets. In Module 1 you were introduced to the concept of investments and investing. In
Module 2, you were introduced to the different types of investments – direct and indirect – that
are available to investors. You learned about the mechanics of trading in Module 3, where you
learned how short selling and margin trading affect investors’ returns. In this module, you
learned about how the different indices are constructed and why they may not move quite in
tandem.
In the next module, our focus is on fundamental analysis. The valuation of a stock requires
understanding the financial condition and performance of company. Not just what has happened,
but where the company is heading. You’ll have to use your accounting background and financial
ratio analysis tools to get an idea of the current situation and future of a company. You will be
applying what you learn in this module to your course project.

Module 5
Fundamental analysis
1. Overview
The purpose of this module is to explore financial analysis and introduce you to the concepts and
tools of cash flow analysis, financial
ratio analysis, and common size
analysis. I have assumed that you Want a review of financial statements and financial
have covered the basics of financial ratios? Check out the following:
ratio analysis in your principles of Financial accounting information
finance course. If you have not
Financial ratio analysis
covered this material – or do not
remember much about it – you may Financial analysis
want to go back and read about
financial analysis.
Financial analysis is the selection, evaluation,

Analysis of the economy
and interpretation of financial and other pertinent
data. In other words, financial analysis is figuring
out what information to use and how to use it. Analysis of the industry
Aside from the company’s financial disclosures,
the analyst must also perform an analysis of the
economy and the industry in which the company Analysis of the company
operates.
Financial ratios analysis
The tools that we use to analyze the company’s
financial information include:
o Financial ratio analysis; Cash flow analysis
o Cash flow analysis; and
o Common size analysis.
Common size analysis
A. Economic analysis
With respect to the information on the economy, the analyst must evaluate how the company
performs in different economic environments. Armed with this information and economic
forecasts, the analyst will be able to develop better forecasts of how the particular company will
perform in the future.
Economic data that is needed includes:
Production and income;

Employment;
Consumption;
Investment activity;
Interest rates;
Stock prices; and
Inflation.
Module 5: Fundamental Analysis 1 of 20

The analyst takes this Exhibit 1 Growth in GDP over time
information and compares it
with the company over the Panel A Real GDP, 1929 through 2004 in 2000 chained
past few years – preferably dollars
over at least one or two
economic cycles – and gets $12,000
an idea of whether the $10,000
company’s fortunes are $8,000
Real GDP
cyclical. A primary indicator
in billions of $6,000
of an economy’s health is 2000 dollars $4,000
the growth in real gross
domestic product (GDP). $2,000
$0
1929
1937
1945
1953
1961
1969
1977
1985
1993
2001
The National Bureau of
Economic Research
identifies periods of Year
economic contraction (that
is, recession) and Panel B Annual percentage change in real GDP, 1929
expansion. You can see the through 2004
real GDP and percentage
20%
changes in annual real GDP
15%
in Exhibit 1. In Panel A you
10%
see the read GDP plotted Percentage
5%
over time, which reflects change in real
0%
the general trend of growth GDP
-5%
in the economy. In Panel B -10%
you can see the year-to -15%
year growth in GDP,
1929
1937
1945
1953
1961
1969
1977
1985
1993
2001
whereas in Panel C you can
see percentage change in Year
real GDP each quarter over
the past fifteen years. In Panel C Quarterly percentage change in real GDP, 1990
these graphs, you can see through mid-2005
the most recent
recessionary periods that 2.0%
1.5%
extended from July 1990 Percentage 1.0%
through March 1991 and change 0.5%
from March 2001 to in real GDP 0.0%
November 2001. -0.5%
-1.0%
1990-01-01
1991-04-01
1992-07-01
1993-10-01
1995-01-01
1996-04-01
1997-07-01
1998-10-01
2000-01-01
2001-04-01
2002-07-01
2003-10-01
2005-01-01
How does an analyst use

this information? One way
to use this information is to
compare the inflation- Quarter
adjusted changes in a
company’s revenues with Source of data: Board of Governors of the Federal Reserve System
those of GDP and
determine whether the company’s revenues tend to follow along with the economy. If a
company’s revenues change along with the economy, we refer to the company as a cyclical
company. A company whose revenues change in the opposite direction of the economy is a
counter-cyclical company. Aside from examining the performance of the company relative to

the economy in general, the analyst must also determine the company’s sensitivity to changes in
interest rates and other economic indicators.
Though it is important to examine a company in the context of its domestic economy, the analyst
must also consider a company’s vulnerability to changes in the economies of all of the countries
in which it operates.
B. Industry analysis
In addition to an analysis of the economy, the analyst must take a close look at the industry or
industries in which the company operates. Aspects of the industry analysis that are important
include:
Nature of competition. Who are the company’s primary competitors? Is the industry
competitive?
Market share for each company in the industry. Is the company a leader in the industry?
Labor conditions. Is the company able to find a sufficiently skilled workforce? Does the
company outsource some or all of its production or service? Is the company’s workforce
unionized? If so, what is the current contract period and what is the likelihood of a
strike?
Regulatory conditions. Is the company regulated? If so, does this affect the company’s
profitability in a positive or negative manner? Are there barriers to entry into the industry
because of regulations?
Price elasticity of demand and supply. What determines the demand for the company’s
products? How price-competitive is the market for the company’s product?
Sensitivity of demand to economic conditions. How does the industry perform relative to
the economy? Are all members of the industry affected in the same way by changes in
the economy?
These are just some of the factors that an analyst must consider. There are many, additional
factors to consider that will vary according to the particular industry.
A classification system that is used by many financial services is the North American Industry
Classification System (NAICS), which replaced the Standard Industrial Classification
(SIC) system in 1997. 1 The NAICS is used to classify businesses according to the goods or
services produced. The NAICS is a six-digit coding system that is used by many financial services
to classify companies for the purposes of industry data and statistics.
In the analysis of an industry and a company, it is important to understand the sources of value
added. In basic economics, you learned that a firm creates value when it has a comparative or
competitive advantage. When analyzing an industry and a company, the financial analyst must
identify the comparative or competitive advantage that provides economic profit and sustainable
growth in the future. You will recall that economic profit (a.k.a. economic value added) is
the income of the company in excess of the firm’s cost of capital. 2 A company’s sustainable
growth is the growth rate that it can keep up with without having to resort to additional
financial leverage.
1
The SIC system had been used since the 1930s.
2
Economic profit is not the same as accounting profit. The primary difference between the two
profits is the cost of capital, or the opportunity cost of capital. The cost of capital is deducted to
arrive at economic profit; accounting profit does not consider the cost of capital.

One way to analyze these advantages is to use the five factors that are outlined by Michael
Porter: 3
1. Threat of new entrants. The industry/company may have an advantage if there are
barriers to new entrants.
2. Bargaining power of buyers. The stronger the bargaining power of buyers, the less
advantage that a/an industry/company has.
3. Bargaining power of suppliers. The greater the bargaining power of suppliers, the lower
the economic profit.
4. Rivalry among competitors. The more competitive the industry, the lower the economic
profits for any member of the industry.
5. Threat of substitutes. The greater the ability of competitors to imitate the products or
services of a company, the lower the potential economic profit. Patents, trademarks, and
copyrights will lower the threat of substitutes.
These are often referred to as Porter’s Five Forces. As the analyst examines the industry and
the company – past, present, and future -- these questions must be addressed:
What are the sources of the industry’s and company’s economic profit?
What are the sources of the company’s sustainable growth?
C. Company analysis
The analysis of a company requires looking closely at the company’s financial history and recent
events, with a goal of assessing the future prospects of the company. The types of information
that an analyst must gather include:
Financial statement data and related disclosures;

Major news items in recent years;
Position and market share in industry;
International investment;
Where the company is in its life cycle (i.e. high growth/developmental, maturing,
declining);
Contributions of major product, divisions, or subsidiaries to the company’s performance;
Research and development efforts;
Sensitivity of company to commodity prices (e.g., oil); and
Major litigation.
One of the key ingredients in a company analysis is the analysis of the financial disclosures.
i) Financial statement disclosures

Financial statements in the U.S. are based on Generally Accepted Accounting Standards
(GAAP). GAAP are a set of principles that are promulgated from a number of sources, including
the Financial Accounting Standards Board (FASB), the Accounting Principles Board (APB), and the
American Institute of Certified Public Accountants Research Bulletins (among others).
The Securities and Exchange Commission (SEC) requires the reports to be filed by all publicly-
traded corporations, including:
10-K, an annual filing in which the company provides the financial statements, footnotes,
and other required disclosures.
3
Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New
York: Free Press: 1985).

10-Q, a quarterly filing in which the company provides the required, yet unaudited quarterly
financial statements, which contain much less detail than the annual statements.
8-K report, which is a report of significant company events.
The Sarbanes-Oxley Act of 2002 (SOX) has expanded the required disclosures that companies
must make in these filings. You can find all of the filings of publicly-traded companies online at
the SEC’s EDGAR archives.
The SEC, by law, has the authority to specify accounting principles for corporations under its
jurisdiction. The SEC has largely delegated this responsibility to the Financial Accounting
Standards Board (FASB). While recognizing FASB Statements of Financial Accounting Standards
(SFAS) as authoritative, the SEC also issues accounting rules, often dealing with supplementary
disclosures. SOX has expanded the ability of the SEC to provide oversight to the auditing of
companies by public-accounting firms.
There is an effort to harmonize accounting standards around the world. The International
Accounting Standards Committee (IASC), along with the International Organization of Securities
Commissions (IOSCO) and the European Economic Community (EEC), promulgate International
Financial Reporting Standards (IFRS), which are required for financial disclosures of
companies in the European Economic Community. While many recent principles by the FASB and
IAS have been similar and some even coordinated to be the same, there remain some differences
in accounting principles between IFRS and U.S. GAAP. However, it is expected that the two sets
of principles will converge to one set of international accounting principles within a few years.
Publicly-traded companies in the U. S. issue annual reports and quarterly reports to their
shareholders and file 10-K, 10-Q, and other reports with the SEC. The following financial
statements and disclosures are generally required in these reports:
The balance sheet, which is a report of a company’s assets, liabilities, and equity at a point
in time.
The income statement, which is a report of a revenues, expenses, and profit over a period
of time.
The statement of cash flows, which summarizes cash flows from operating activities,
investing activities, and financing activities
The statement of stockholders' equity, which details changes in stockholders’ equity
Footnotes and supplemental schedules, which offer more detailed information about
accounting procedures, assumptions, and contingent liabilities.
The auditor's report that accompanies financial statements gives the auditor's opinion on whether
the statements present fairly what they purport to present and whether the accounting principles
used are generally accepted. The reports to the SEC are generally more detailed than the annual
reports sent to shareholder.
What the financial statements don’t tell us

The financial statements provide a great deal of information about a company, but there is still
more that we may want to know. The scandals in recent years involving Enron, Worldcom,
Xerox, and Sunbeam, among others, have brought more attention to what the statements don’t
tell us. In particular, the focus has shifted to a company’s off-balance sheet liabilities. Off-
balance sheet financing are methods used to finance a company without showing debt on the
balance sheet. Fortunately, there has been a significant improvement in accounting principles in
recent years that brings many of the formerly off-balance sheet liabilities on to the balance sheet.

These formerly off-balance sheet liabilities include pension and other post-retirement benefit
liabilities, capital lease obligations, and asset retirement obligations. Examples of off-balance
sheet financing that remain off-balance sheet include sales of receivables with recourse or
guarantee, the use of finance subsidiaries, joint ventures to borrow funds and acquire assets,
and take-or-pay agreements. 4
What’s an analyst to do? Basically, an analyst must consider these off-balance sheet liabilities
and incorporate them in the analysis by estimating the extent of the firm’s obligation and include
this obligation along with the other liabilities of the firm in analyzing a firm’s financial leverage.
What to watch for in a financial disclosure

The recent years have taught us to be more circumspect of financial disclosures. Here are a few
things to watch for in analyzing financial statements:
In the financial statements, look for:

Auditor’s report: qualified? A lack of a going-concern qualification is the death knell of
companies.
Write-off or write-down of assets. What does this imply for future earnings)
Write-down of inventory. If they write-it down, what does it mean about their decision
to build it up? What will this do to future earnings when they sell these goods?
In the footnotes, look for:

Adoption of a new accounting standard before the company is required to adopt it.
Because new standards are usually a change to a more conservative than current
practice, why did they adopt it before they had to?)
Related-parties transactions footnote. Are there any major transactions involving officers
or management of the company?
Shifting of receivables to or from subsidiary. Playing this game can be very misleading.
Reduction in a line of credit.
Change in assumptions for pension accounting. The assumptions regarding the discount
rate, return on plan assets, and future growth in compensation affect the pension
expense and liability.
Change in depreciation lives or salvage values. These changes may or may not be
disclosed, but they affect reported earnings.
Contingent liabilities. How extensive? Should any of these really be on the balance sheet?
Comparing year-to-year changes and overall trends look for:

Change in accounting method, other than due to a new accounting principle (e.g.,
change from FIFO to LIFO or vice-versa).
Substantial increase in deferred revenue. Deferred revenue is money collected from
customers before delivering goods or services.
Increase in the valuation allowance. The valuation allowance (reported in the tax
footnote) is the amount of the deferred tax benefits they do not expect to be able to use
in the reasonable future. Why do they not expect to use these?
Cash flow from operations that is increasing or decreasing at a rate different from that of
net income. The basic trend of CFO and net income should be the similar.
Falling reserves for bad debts and accounts receivable. A company may boost sales
growth by reporting less than appropriate allowance for bad debts.
4
Take-or-pay agreements are contracts that commit a firm to buy a minimum quantity of a good
over a specified period of time, paying even if they do not take delivery of the goods.

ii) Financial ratio analysis
Financial statements and the accompanying footnotes provide a wealth of data to analyze.
Because this data can easily become overwhelming, analysts typically examine relationships
among these items to provide a more meaningful analysis.
There many ratios available – in fact, there are hundreds of ratios that can be formed based on
the income statement, balance sheet, and statement of cash flow items. The formulas for the
most common financial ratios are provided here.
There are many uses of ratios. These include:

Stock valuation models (e.g., estimating return on investment and growth),
Estimating systematic risk,
Assessing credit-worthiness (e.g., bond ratings), and
Predicting bankruptcy.
Importance of financial ratios

A single value of a financial ratio is not meaningful by itself, but must be examined in context of
the firm’s history (past performance), the industry, the major competitors, and the economy. A
time-series analysis of ratios involves examining the pattern of ratios over time, say 5 or 10
years. We can spot trends and also get a sense of the variability of the ratio over time. A cross-
sectional analysis of ratios involves examining the differences in ratios across firms at a point
in time. We generally compare a company’s financial ratios with those of the industry leaders,
the major competitors, or the average of the industry.
Commonly used ratios

There are too many ratios to present here, but here is a sampling of the ratios and how they are
used. As you will recall from your study of the principles of finance, there are many financial
ratios that the analyst can use to evaluate a company. We can classify these ratios into several
categories:
1. Liquidity ratios provide information on a firm's ability to meet its short-term

obligations.
2. Profitability ratios provide information on the amount of income from each dollar of
sales. We look at these ratios to see how well the company is managing its expenses.
3. Activity ratios relate information on a firm's ability to manage its resources (that is, its
assets) efficiently.
4. Return on investment ratios provide information on the amount of profit, relative to
the assets employed to produce that profit.
5. Financial leverage ratios provide information on the degree of a firm's fixed financing
obligations and its ability to satisfy these financing obligations.
6. Shareholder ratios describe the firm's financial condition in terms of amounts per
share of stock.
Liquidity ratios
A company’s need for liquidity depends, in large part, upon the company’s line(s) of business and
customs of credit. For example, a retail establishment must have a certain amount of cash on
hand at each retail location for day-to-day transactions, whereas a service business does not
have such requirements. In some industries it is customary to extend credit to customers,
whereas in other industries it is not.

We use information about a company’s operating cycle in our investigation of a company’s need
for liquidity. The operating cycle is the length of time it takes to turn the investment of cash in
inventory back into cash. Basically, the longer a company’s operating cycle, the greater the need
for liquidity.
The operating cycle

The operating cycle is measured in length of time and is the sum of:
1. The number of days of inventory

2. The number of days of receivables
The number of days of inventory is the number of

Exhibit 2 The operating cycle of
days a company could go without adding inventory until General Electric 2002
they deplete inventory. The number of days of Number of days …
receivables is the number of days it takes to collect on Inventory 41.4 days
credit accounts. Therefore, the net operating cycle is the Receivables 148.9 days
number of days it takes to turn the investment in Payables 93.7 days
inventory into cash, considering that purchases are Net operating cycle 96.6 days
acquired with credit.
We can also calculate the net operating cycle, which is the operating cycle, less the number of
days of payables. The number of days of payables is the length of time the company takes in
paying off its suppliers.
Number of days of inventory

+ Number of days of receivable
Number of days of payables
Net operating cycle
Liquidity ratios
The longer the company’s operating cycle, the more liquidity that a company typically needs.
We use liquidity ratios, along with the company’s operating cycle information, to assess the
company’s ability to meets its short-term obligations.
The current ratio is the ratio of current assets Current ratios:

to current liabilities; indicates a firm's ability to Consumer products, 2004
satisfy its current liabilities with its current
assets. Clorox 0.8
Colgate-Palmolive 1.0
The quick ratio is the ratio of quick assets
Kimberly-Clark 1.1
(generally current assets less inventory) to Procter & Gamble 0.8
current liabilities; indicates a firm's ability to
satisfy current liabilities with its most liquid Source: S&P NetAdvantage
assets.
Profitability ratios
We use profitability ratios to assess a company’s performance over a given period of time. We
use these ratios to assess the ability of a company to manage its expenses.

Gross profit margin is the ratio of gross profit Net profit margins:
to sales. Indicates how much of every dollar of Consumer products, 2004
sales is left after costs of goods sold.
Operating profit margin is the ratio of Clorox 12.6%
operating profit (EBIT) to sales. Indicates how Colgate-Palmolive 12.5%
much of each dollar of sales is left over after Kimberly-Clark 11.7%
operating expenses. Procter & Gamble 12.6%
Net profit margin is the ratio of net income to
Source: S&P NetAdvantage
sales. Indicates how much of each dollar of
sales is left over after all expenses are paid.
Activity ratios
The analyst uses activity ratios to asses the company’s use of its assets.
Inventory turnover is the ratio of cost of goods sold to inventory. Indicates how many
times inventory is created and sold during the period.
Accounts receivable turnover is the ratio of net credit sales to accounts receivable.
Indicates how many times in the period credit sales have been created and collected.
Total asset turnover is the ratio of sales to total assets; indicates the extent that the
investment in total assets results in sales.
Fixed asset turnover is the ratio of sales to fixed assets; indicates the ability of the
firm's management to put the fixed assets to work to generate sales.
Financial leverage ratios

We are often concerned about a company’s ability to meet its financial obligations and the risk
associated with its financing obligations. We can use financial leverage ratios, in combination
The debt to assets ratio indicates the proportion of assets that are financed with debt
(both short-term and long-term debt).
The debt to equity ratio indicates the relative uses of debt and equity as sources of
capital to finance the firm's assets, evaluated using book values of the capital sources.
The equity multiplier is the ratio of total assets to shareholders’ equity, which also
provides information on the relative use of debt and equity; the greater this ratio, the
more reliant the company is on debt financing.
The interest coverage ratio indicates the firm's As an example of a financial analysis,
ability to satisfy interest obligations on its debt. take a look at the brief analysis of Delta
Also known as the times-interest-earned ratio. Air Lines.
Note: this file contains audio

Return on investment ratios
Return on investment ratios provide the analyst with information regarding the net benefit of
employing a specific investment. There are three commonly used return ratios:
Operating return on investment ratio is a measure of the operating income resulting

from the firm's investment in total assets. This
ratio is also known as the basic earning power Return on assets:
ratio. Consumer products, 2004
Return on assets indicates the firm's net profit
Clorox 14.6%
generated per dollar invested in total assets.
Colgate-Palmolive 16.1%
Return on equity is the profit generated per Kimberly-Clark 10.5%
dollar of shareholders' investment (i.e., Procter & Gamble 12.6%
shareholders' equity).
Source: S&P NetAdvantage
We can breakdown any return ratio into components,

enabling the analyst to attribute changes in returns to the management’s utilization of assets, the
ability to manage expenses, and even tax effects.
Analyzing return ratios Exhibit 3 Applying the DuPont System to the Return on Equity
in terms of profit
margin, turnover ratios, Net income
and other components, Shareholders' equity
referred to as the
DuPont System, is Sales Net income Total assets
credited to the E. I. du
Total assets Sales Shareholders' equity
Pont Corporation,

whose management
developed a system of Sales EBIT EBT Total assets
(1 - tax rate)
breaking down return Total assets Sales EBIT Shareholders' equity
ratios into their
components. EBIT = Earnings before interest and taxes
EBT = Earnings before taxes
Return on equity can be
broken down into the return on assets and the equity multiplier, as you can see in Exhibit 3.

We can use the Du Pont
system to help detect trends Exhibit 4 Return, total asset turnover, and net profit
margin
in assets utilization and
efficiency that may explain Panel A Kmart, 1990-2000
trends in a return over time.
Total asset turnover
For example, Consider
Return on assets
Kmart’s return on assets 3.5 Net profit margin 12%
1990 through 2000, as 10%
3.0
shown in Panel A of Exhibit 8%
5 2.5 6%
2. We see that the return on
2.0 4%
assets deteriorated after Turnover 2% Return or
1992 and Kmart recovered 1.5 0% margin
somewhat in 1998, falling 1.0 -2%
once again prior to the 0.5
-4%
bankruptcy filing in 2001. -6%
0.0 -8%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
So what was Kmart’s
problem? The asset turnover Fiscal year
did not change much over
this period; in fact, there is a
slight improvement in the Panel B Wal-Mart, 1990-2004
turnover over time. What
appears to be driving the Total asset turnover
Return on assets
return on assets is the profit
3.5 Net profit margin 12%
margin, which reflects the
3.0 10%
company’s ability to manage
2.5 8%
its expenses. In the case of
2.0 Return or
Kmart, the focus in Turnover
1.5
6%
margin
diagnosing any problems – 1.0 4%
and suggesting any 0.5 2%
remedies, lies in the 0.0 0%
management of its expenses.
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Comparing Kmart’s
experience with that of Wal- Fiscal year
Mart, shown in Panel B of
Exhibit 2, we see that Wal-
mart’s return on assets is driven by its total asset turnover.
Shareholder ratios
We can restate financial data into measures that are on a per share basis, including:
Earnings per share (EPS) is the amount of income earned during a period per share of
common stock.
Book value equity per share is the amount of the book value of common equity per
share of stock.
Dividends per share (DPS) is the dollar amount of cash dividends paid during a
period, per share of common stock.
In addition, we often look at other ratios that provide useful information. For example, the
dividend payout ratio, which is the ratio of cash dividends paid to earnings for a period, tells
5
Kmart filed for bankruptcy in January of 2001. In 2004, Sears Roebuck & Co. merged with
Kmart.

us how much of a company’s earnings are paid out to owners. Its complement, the plowback
ratio (that is, the ratio of retained earnings to earnings) tells us how much the company is
reinvesting in itself.
The price-earnings ratio (P/E or PE ratio) is the

ratio of the price per share of stock to the earnings per Price-earnings ratios: Annual range
Consumer products, 2004
share of stock. It is often used as a barometer of what
investors believe is the future growth of the company; Clorox 18-23
the larger the ratio, the greater the anticipated growth. Colgate-Palmolive 18-24
However, we have seen price-earnings that are Kimberly-Clark 16-19
unreasonable – that is, much higher than the typical 12- Procter & Gamble 20-23
15 times we usually see for stocks – which may indicate
unreasonable pricing by investors. We saw a great deal Source: S&P NetAdvantage
of this mis-pricing during the Internet run-up in prices leading up to the burst of the Internet
stock “bubble”.
Use of financial ratios

Once you have identified the financial data necessary for the ratios, the actual calculation of
these ratios is quite straightforward. The more important task of the financial analyst is to make
sense of all this information. We typically look at financial ratios along three dimensions:
1. Other financial dimensions of the company

2. Trends over time for the company itself
3. Comparisons with companies in the same industry.
Other financial characteristics

One of the important lessons of financial ratio analysis is that there is no value of a particular
ratio that is good or bad. It all depends on how that ratio fits into the whole scheme of the
company’s financial condition and performance. For example, a company that has 70% of its
assets financed with debt may be worrisome to its owners if it has a high degree of business risk,
but not so worrisome if it has a lower degree of business risk. As another example, consider a
company that has a high inventory turnover. A high turnover may be good, indicating that the
company is managing its inventory very efficiently. On the other hand, a high turnover may be
bad, indicating the company has a high risk of stock-outs. How do we resolve whether this is
good or bad? We look at other dimensions of the company, such as its profitability, to see
whether the turnover is a problem.
The Du Pont system is a useful tool to employ to look at the interaction of the different
characteristics of a company. We can use this system to break down return ratios into the
components – the drivers – that may explain the returns.
Trends over time

With respect to trends over time for the company, we generally look at the company’s ratios over
a period of time of at least five years, but preferably enough years to see how the company
performs over different points in an economic cycle (i.e., peaks and troughs). Along with these
trends, however, the analyst must consider the major company events that may explain changes
over time. For example, if the company has a major acquisition or divestiture over the range of
years examined this will affect any trends.
Also, consider whether there were significant changes in accounting principles that may affect
the observed trend. For example, since 2001 goodwill is not amortized, but instead is reviewed
annually to see whether its value is impaired. If you are looking at a company’s ratios over a

range of years that includes years before and after 2001, you will have a slight bias (upward) in
the earnings of the company due to the elimination of goodwill amortization – companies are no
longer hurting earnings from amortization. For companies that choose to write-off a portion of
these goodwill (e.g., AOL Time Warner wrote off $54 billion of goodwill in 2002), the financial
picture is distorted because of:
1. the “big bath” taken when the goodwill is written off, and
2. returns on assets are enhanced from a lower asset base following the write off.
Therefore, it is important to consider the impact of accounting changes in the comparability of

financial results over time.
Comparables
In assessing the financial health of a company, we often compare the financial ratios of a
company with those of its major competitors or the industry as a whole. The challenge is often
identifying the competitors or the industry. With respect to competitors, we want to compare the
company with those competitors that have similar lines of business in similar proportions.
Consider Procter & Gamble. Its major competitors are Johnson and Johnson and Kimberly Clark,
with Johnson and Johnson being the closest in size to Procter & Gamble. When we look at these
three companies, however, we can see that the companies’ business segments are different.
Consider the comparison of Procter & Gamble (PG) with Johnson and Johnson (JNJ). Though
both companies are in the consumer products industry, their participation in the industry differs,
as we can see from the business segment data from their respective 10-K filings for 2004:
Revenues Assets
Procter & Gamble in billions in billions
P&G Beauty $19.483 $11.340
Health Care 7.786 3.256
Baby Care and Family Care 11.890 7.426
Fabric Care and Home Care 15.262 6.706
Snacks and Coffee 3.140 1.749
Revenues Assets
Johnson and Johnson in billions in billions
Consumer $8.333 $5.056
Pharmaceutical 22.128 11.112
Medical Devices and Diagnostics 16.887 15.052
Though it is ideal to compare the company that is the focus of the analysis with companies in the
same industry, it is quite difficult to find competitors that are truly comparable. If we use
industry averages instead of selecting particular companies, this does give us a broader picture of
the condition and performance of the industry, but we are including results for companies that
are leaders and laggards in the industry.
Limitations of financial ratios

Financial ratios are easy to calculate, but there are some limitations of using financial ratios to
assess a company’s financial health:
1. The use of accounting information that permits some choice of accounting principles.
Therefore, comparisons over time or across companies may not be appropriate because of
differing accounting principles.
2. Companies restate their financial results due to errors or misapplications of accounting
principles, making comparability over time difficult.

3. It is often difficult to determine the appropriate industry to use in comparing firms. Many
firms operate in several different lines of business, making it challenging to identify the
industry.
4. The necessity to consider more than one type of ratio. There are interactions among the
different ratios that require considering different ratios simultaneously (e.g., liquidity and
profitability).
5. Determining the approach target or comparison value for a ratio is difficult, requiring some
range of acceptable values.
Financial ratios are not the only information that an analyst uses to analyze a company. The
financial ratio analysis must be put in context of the larger picture of the company that includes
the industry in which it operates and the economy.
iii) Cash flow analysis

A financial analyst analyzes a company’s cash flows using a number of tools:
1. Patterns in the three cash flows from the statement of cash flows: CFO, CFI, CFF
2. Financial ratios that compare cash flows with investments.
3. Analysis of the trends in free cash flow
Statement of cash flow information

The statement of cash flows provides information on the cash flows of a company from
operations, for or from investments, and for or from financing. Analysts use these cash flows to
evaluate a company’s financial health and to predict the future cash flows.
Looking at trends in cash flows, in conjunction with balance sheet and income statement
information, an analyst can learn about a company’s future cash-generating abilities. For
companies experiencing financial difficulty, the cash flow information is more useful than the
other financial statements in assessing the firm’s current and future financial condition.
The statement of cash flows is useful in financial analysis because:
The entries in the statement are less affected by the choice of accounting principles than the
income statement, which makes it attractive to use in assessing a company’s performance.
The statement highlights liquidity problems and a company’s ability to internally generate
funds.
Trends in the different components of the statement of cash flows can aid the analyst in
assessing current and future condition of the company.
Comparisons between net income and the cash flow from operations can reveal management
or manipulation of earnings; the two series should follow the same trend and significant
deviations should be a warning flag to take a closer look at the method the company used to
determine net income.
Classification Issues
Relying on cash flows from the statement of cash flows presents a dilemma for the analyst
because the ideal manner of classifying cash flows may not coincide with GAAP used to prepare
the statement.
Consider the effect of the classification of leases. Companies that lease will have lower cash flow
from operations relative to a non-leasing firm because the lease expense reduces the cash flow
from operations (whereas the depreciation expense on purchased assets does not). While an

operating lease and a capital lease may be very similar in nature (that is, both provide the use of
an asset in exchange for periodic payments), the classification of a lease as operating versus
capital for accounting purposes affects the classification of cash flows.
Further muddying the cash flows is the method used in U.S. GAAP to classify interest and
dividends income and expense. 6 Because interest and dividend received are included in operating
cash flows, a return on capital using cash flow from operations will differ from the true return on
capital. Additionally, interest expense is deducted to arrive at net income and hence cash flow
from operations, even though it is a financing flow. This makes it difficult to compare firms with
different capital structures.
So what is an analyst to do? An analyst must look at each company and the methods of
accounting that each chooses and then restate the company’s statement of cash flows to suit his
judgment regarding the appropriate classification of cash flows.
We can trace the patterns of cash flows over time to get an idea of the company’s future,
sustainable performance. A healthy company is able to generate cash flows from its operations.
Though there may be an occasional year in which the company does not generate cash flows
from operations, it is important for any company to generate cash flows from operations in most
fiscal years. Cash flows from operations will vary along with the company’s earnings, though
there may be less variability when compared to that of net earnings. The primary difference
between net income and cash flows from operations is that attributed to depreciation, depletion,
and amortization. Another difference may be
Another sign of a healthy company is a continual investment in its plant and equipment. As
companies replace equipment to continue operations, they spend ever increasing amounts for
the replacement equipment. Companies that are at least maintaining their current growth will,
on net, have negative cash flows for investment purposes. On the other hand, companies that
are divesting themselves of portions of their business may have, on net, positive cash flows from
investments.
6
The International Financial Reporting Standards (IFRS), on the other hand, provide the
flexibility for companies to classify interest income and expense, as well as dividend income, in
the appropriate investing or financing classification.

Companies that are Exhibit 5 Cash flows for Eastman Kodak Company
growing quickly – more
quickly than the cash flow Panel A Net earnings and cash flows from operating activities
from operations permit,
will borrow and/or issue Net earnings Cash flows from operating activities
$4,000
stock and, therefore,
$3,000
have positive cash flows
from financing. $2,000
Companies that are in
maturing and are able to $1,000
millions
support its operations on $0
its cash flows from
operations may pay off -$1,000
the financing, and hence -$2,000
have negative cash flows 1990 1992 1994 1996 1998 2000 2002 2004
from financing. Fiscal year
We can see the differing

patterns of income and Panel B Cash flows from operating, financing, and investing
activities
cash flows from
operations in Exhibit 5 for Cash flow s from operating activities
Eastman Kodak over the $8,000 Cash flow s from investing activities
period 1990 through $6,000 Cash flow s from financing activities
2004. Cash flows from $4,000
operating activities are $2,000
Cash $0
less variable than net
flow -$2,000
earnings, as you can see
in this example. -$4,000
-$6,000
Focusing on the cash -$8,000
flows from the different -$10,000
sources, we see that 1990 1992 1994 1996 1998 2000 2002 2004
Kodak generates cash Fiscal year
flows from operations
each year, but that the Source of data: Mergent Online
level of these cash flows
has declined in general.
Kodak continues to invest, which is consistent with a healthy company. However, the level of
investment has declined for the most recent year, 2004. Kodak was paying off its debts over
time, but just recently, in 2003, had to borrow because of insufficient cash flow from operating
activities.
Financial ratios with cash flows

Many analysts focus on a company’s cash flows instead of earnings. This is primarily because it
is generally believed that cash flows give a better indication of a company’s performance and are
not as easily managed or manipulated as earnings. A case that illustrates this is that of retailer
W. T. Grant, which filed for bankruptcy in 1975. W. T. Grant’s financial problems were not
evident in its current ratio or profitability ratios, but were evident in its cash flows.
An informative ratio is the ratio of cash flow from operations (CFO) to current liabilities, which
provides information regarding the company’s ability to satisfy its immediate, short-term
commitments:

Cash flow from operations
CFO to current liabilities =
current liabilities
Another commonly used cash flow ratio is the ratio of the stock’s price to cash flow per share.
This ratio is similar to the price-earnings ratio that is often used to assess investor’ belief
regarding the future growth of the company. The price-to-cash flow ratios indicates the multiple
that investors give the stock, which is indicative of sentiment regarding the future growth of the
company’s stock price.
We can also use operating cash flow in the place of net income to evaluate a company’s financial
performance. For example, we can construct a type of profitability ratio by comparing cash flow
to sales. Or, we can compare sales to cash flow, forming the sales-to-cash flow ratios
Sales per share
Sales to cash flow =
Cash flow per share
Free cash flow

Free cash flow (FCF) is the cash generated during a period in excess of the capital
expenditures needed to maintain the firm’s present productive capacity. The larger a company’s
free cash flow, the better able the firm is to meet financial obligations and to grow in the future.
There several formulas used in determining FCF, with the differences due to the purpose of the
calculation: is the analyst calculating the cash flow available to shareholders? to all suppliers of
capital (bondholders and shareholders? The former is referred to as the free cash flow to
equity and the latter is referred to as the free cash flow to the firm.
In its purest form, and to be consistent with theory, the capital expenditures are only those
needed to maintain the company’s current growth. However, as a practical matter, it is not
possible to look at a company’s financial statements and determine how much of the reported
capital expenditures are needed for the current growth and how much are not. Therefore, most
analysts simply use the total capital expenditures amount (taken from the statement of cash
flows) in their calculation:
Free cash flow = Cash flow from operations – capital expenditures
The amount of the capital expenditures for the year is provided in the statement of cash flows.
A financial healthy company will have positive free cash flow, which gives it the financial flexibility
to explore additional investment opportunities as they become available. Consider Peregrine
Systems, a software company that went bankrupt in 2003 and was then bought by Hewlett
Packard in 2005. The company had declining free cash flows, as shown in Exhibit 6, with
negative flows in the 2001, 2002, and 2003 fiscal years.

There are variations in the Exhibit 6 Free cash flows for Peregrine Systems
definition of free cash flow in
application: whether this is $80,000
cash flow available to the firm $60,000
$40,000
(use cash flow from $20,000
operations before interest $0
expense) or to shareholders Free cash
-$20,000
flow
(use cash flow from in thousands
-$40,000
operations). There are also -$60,000
variations due to the amount -$80,000
-$100,000
of capital expenditure and
-$120,000
other necessary uses of cash -$140,000
flow; for example, some
03-95
03-97
03-99
03-01
03-03
03-04
analysts remove dividends
from the cash flow, arguing Fiscal year end
that the dividends are
outflows that are not Source: Mergent Online
reinvested in the company.
Some companies now report free cash flow in their financial statements, along with the required
financial disclosures. However, most often they don’t tell us how they computed it.
iv) Common size analysis

Common size analysis is the analysis of financial statement items through comparisons among
financial statement or market data. Common size analysis compares each item in a financial
statement with a benchmark item. Common size analysis is useful in analyzing trends in
profitability and trends in investments and financing activity.
We construct a common size statement by restating each account in a statement as a percentage

of some benchmark:
For the income statement, the benchmark is sales; each item in the income statement is
restated as a percentage of sales.
For the balance sheet, the benchmark is total assets; each item in the balance sheet is
restated as a percentage of total assets.
Common size analysis is useful because it allows us to spot trends that would not be obvious
using other means. Consider the picture of Harley-Davidson, the manufacturer of motorcycles,
as we look at its asset composition over time in Exhibit 7. In Panel A, you can see the growth in
the company’s plant, property, and equipment, inventory, and accounts receivable. In Panel B,
in which each account is restated as a percentage of total assets, you can see how Harley
Davidson is changing its business, relying less on the manufacturer of motorcycles and relying
more on the financing of the motorcycles.

Exhibit 7 Harley Davidson, 1990 – 2004
Panel A Growth in accounts over time
$6,000,000
Goodw ill
$5,000,000
Prepaid expenses
$4,000,000 Other assets

Amount Marketable securiites
invested $3,000,000
Cash
in thousands
$2,000,000 Accounts receivable
Inventory
$1,000,000
Plant, property, and equipment
$0
1990
1992
1994
1996
1998
2000
2002
2004
Fiscal year
Panel B Common size balance sheet
100%
Goodw ill
80% Prepaid expenses
Portion Other assets
of 60%
Marketable securiites
total Cash
40%
assets Accounts receivable
20% Inventory
Plant, property, and equipment
0%
1990
1992
1994
1996
1998
2000
2002
2004
Fiscal year
Source of data: Mergent Online
D. Recap
In this module, we’ve covered the basic tools used to analyze a company’s financial condition and
performance. A useful approach in the analysis of a company is to begin with the economy and
then analyze the company’s industry. Once you have an idea of how the company fits into the
economy and the industry, you can then analyze the company’s financial condition and
performance using the tools of financial ratio analysis, cash flow analysis, and common size
analysis.
2. Module Tasks
Chapter 13, “Economy/Market Analysis,” Investments: Analysis and Management, by

Chapter 14, “Sector/Industry Analysis,” Investments: Analysis and Management, by
Chapter 15, “Company Analysis,” Investments: Analysis and Management, by Charles
Sustainable growth, a reading by Pamela Peterson Drake
A financial analysis of Delta Airlines, a PowerPoint presentation
Financial ratio analysis, by biz ed. A thorough review of financial ratios.
Take Your Fiscal Temperature with Financial Ratios, by American Express

Jones, Chapter 13 questions and problems
Module 5 StudyMate Activity
D. Progress on the project

By the completion of this module, you should gathered the financial data on your
company – preferably at least the past ten fiscal years of data – and calculated
financial ratios for the different aspects of the company’s financial condition and
performance.
The best source of the actual data for the ratios is Mergent Online, which is available
through the Florida Atlantic University library. This is a database that permits
downloading data into worksheets that can be transformed into Microsoft Excel®
worksheets for analysis.
You should begin charting the financial ratios over time and identifying trends,
changes in trends, and major corporate events that affect the company’s financial
condition and performance.
Using Porter’s Five Forces, identify the sources of competitive advantage for your
company.
E. Module quiz
quiz availability.
3. What’s next?
In this module, you have learned about some of the tools that analysts use to evaluate the
financial condition and performance of a company. While you have seen financial ratio analysis in
your principles of finance and accounting courses, we are taking these tools a step further in this
module to get you to see the bigger picture of how this applies to an actual company, how you
need to look at many aspects of a company’s condition and performance, and how you can
incorporate common size and cash flow analysis into your evaluation.
When you complete this module, you have completed one half of the course. So far we have
looked at securities, securities markets, and securities trading. We have also see how to analyze
a company in the context of its industry and the economy. Following the mid-term exam, we will
be focusing on portfolio theory, asset pricing theory, valuation of securities, and derivatives.

Module 6
Portfolio risk and return
1. Overview
Security analysts and portfolio managers are concerned about an investment’s return, its risk,
and whether it is priced correctly by the market. If markets are efficient, the price reflects
available information quickly.
A basic tenet of valuation is that the greater the investment’s risk, the greater the return needed
to compensate investors for that risk. But the question that arises is: What risk is rewarded by
the market? Portfolio theory addresses how risk is affected when a portfolio consists of more
than one investment.
A. Efficient Markets
An efficient capital market is a market in which asset prices adjust rapidly to new information.
Though sometimes the price may under-adjust or over-adjust, the degree of bias is not
predictable. An efficient capital market is also defined by some as a market in which all relevant
information is impounded in an asset’s price. This latter definition describes an informationally
efficient market, which has the following characteristics:
a large number of profit-maximizing market,

these participants analyze and value securities, and
news that may affect an asset’s value is random.
i) The random walk

In an efficient market, stock prices are not predictable – they don’t follow any particular pattern
and hence there is no way to gauge the future path of prices by looking at past prices. This is
because stock prices follow a random walk. A random walk is a time series in which the value
of the series in one period is equal to the value of the series in another period, plus some
random error:
xt = xt-1 + et
where … which means…

E(et) = 0 The expected error is zero
E(et2) = 2 The variance of the error is constant
E(ei,j)=0 if ij The correlation between the error terms of two different time periods
is zero.
The implication of a random walk is that the best forecast of the xt is xt-1. If asset prices follow a
random walk, then the best forecast of the value of an asset in a given period is the value of the
asset in the previous period. Extending this to market trading strategies, this implies that the
best forecast for tomorrow’s price is today’s price. In other words, it is not possible to design a
trading system based on current information and consistently earn abnormal returns. An

abnormal return is a return on an investment in excess of that associated with the level of risk
of the investment. It is the difference between the predicted return and the actual return.
In calculating abnormal returns, we must consider the amount of risk associated with the asset’s
value and, of course, any transactions costs. The predicted return is often estimated using the
market model, which adjusts the expected return for the market’s return in that period and
considers the stock’s market risk
ii) Forms of the efficient market

When we refer to efficient markets, we are really referring to a set of definitions of market
efficiency. We classify efficient markets according to the type of information that we believe is
compounded in the price of assets: weak form, semi-strong form, and strong form.
EFFICIENT MARKETS AND THE IMPLICATIONS
Type What it means What it implies
Weak form Prices reflect all security market An investor cannot trade on the basis of past stock
information. prices and volume information and earn abnormal
returns.
Semi-strong form Prices reflect all publicly An investor cannot trade on the basis of publicly-
available information. available information and earn abnormal returns.
Strong form Prices reflect both private and An investor cannot trade on basis of both publicly-
public information. available and private information and earn abnormal
returns.
Researchers have examined stock prices for various markets to test whether or not the market is
efficient.
iii) Evidence on market efficiency

The forms of an efficient market differ according to what information we assume is already
impounded in the current stock price. Testing the different forms, therefore, requires evaluating
what information is contained in stock prices and what information is not.
Tests of the weak form of market efficiency involve looking at the predictability of prices based
on past prices. If a trading rule could be devised to consistently earn abnormal returns, this
would be evidence contrary to the weak form of efficiency. The tests of the weak form require
using statistical tests of autocorrelation or runs tests. For example, if we want to test whether
the prices of stocks are influenced by the phases of the moon, we would compare the returns on
stocks in the different phases over time and test whether there is a difference in these prices
according to the moon phase. If there is such a difference, this suggests a market efficiency and,
hence, an opportunity to profit from the observed pattern of prices.
Generally, researchers have found that securities markets in the U.S. are weak-form efficient.
Therefore, there is no benefit to be gained from using technical analysis, which relies on the
use of patterns in prices. However, there are some studies that show that there exist some
calendar-based anomalies that researcher are still puzzling over. An anomaly is a pricing
situation in which an investor can earn an abnormal profit by trading in a certain manner. These
possible anomalies include the:
January effect

Weekend effect
Turn-of-the-year effect
Holiday effect
Intra-day effect
Month-of-the-year
Day-of-the-week
Though researchers have attempted to explain the existence of these calendar-based anomalies,
they may simply be artifacts of the specific time period that was studied and not truly evidence
against a weak-form efficient market.
The evidence regarding the semi-strong form is mixed, though most of the evidence suggests
that prices of securities react quickly and efficiently to new information. Still, there is some
evidence that raises doubts about whether prices fully reflect all available public information.
Tests of semi-strong form require examining whether or not abnormal returns can be earned if
an investor trades using publicly-available information after the information is released. 1 A test
of the semi-strong form of market efficiency requires great care in adjusting for the effects of the
market and for risk.
Researchers use a set of procedures commonly referred to as an event study to analyze prices.
An event study requires estimating abnormal returns associated with an informational event. The
event study generally follows the following steps:
STEP 1: For a sample of securities, the researcher identifies the trading day on which
an announcement is made. The announcement of interest may be an
announcement such as a stock split, a merger, or a change in a law.
STEP 2: The researcher collects stock returns for the days preceding, including and
following the event.
STEP 3: The researcher analyzes the stock’s typical relation with that of the market in
general. Usually, an extensive period such as sixty-months is used to
estimate a stock’s typical relation to the market.
STEP 4: The researcher focuses on the announcement day and the succeeding
trading days and measures abnormal returns.
STEP 5: The researcher performs statistical tests on the abnormal returns to assess
whether these returns are different from zero.
There are a number of studies that examine whether an earnings surprise is reflected quickly
into stock prices. An earnings surprise is an announcement of earnings in which these earnings
differ from what investors were expecting. While we expect the stock’s price to increase for
positive surprises and decrease for negative surprises, we expect this effect to be sudden and
prices reflect the extent of the surprise very quickly. However, some studies find that there may
still be opportunities to profit by trading in surprise securities after the announcement is made.
Some evidence suggests that company-specific factors can be used to predict stock market
performance. For example, in a series of studies, Eugene Fama and Kenneth French document
that the book-to-market value of equity ratio is related to security prices such that there is
possible profitable trading opportunities from trading using this ratio to form your buy-sell
1
We would expect the stock prices to react to the information. So, for example, if a company’s
earnings were better than expected, we would expect the company’s stock price to increase at
this news.

strategy. 2 There is also evidence that suggests that the size of the firm is related to security
prices. 3 However, the debate regarding whether these are truly pricing anomalies or whether
they are statistical artifacts continues.
Tests of the strong form address the question: Does trading on private information lead to
abnormal profits? Researchers have examined this form by focusing on the trading, for example,
of:
Corporate insider trading (the legal variety)

Stock exchange specialists
Security analysts
Professional money managers
The evidence is mixed, but we can draw some general conclusions:
If an investor has monopolistic access to information, that investor may be able to earn
abnormal profits.
Superior fundamental analysis cannot be used to generate consistent abnormal profits.
iv) Implications of efficient capital markets

We can draw the following conclusions from the wealth of evidence on efficient markets:
It is not possible to earn abnormal profits from technical analysis.

Making profits from fundamental analysis requires estimating values of assets that are better
gauges of value than actual market prices, which is difficult to do.
It may be possible to earn abnormal returns using private information, though it is not
possible for the typical investor to do so and, in some cases, it is not legal for an investor to
trade on inside information.
B. Portfolio Theory
The theories related to risk and return deal with portfolios of assets. A portfolio is simply a
collection of investments. An important concept is that combining assets in a portfolio can
actually result in lower risk than the assets considered separately because of diversification.
i) Diversification
Diversification is the reduction of risk from investing in assets whose returns are not in synch.
Diversification is based on correlations: if assets' returns are not perfectly positively correlated,
combining these assets in the same portfolio reduces the portfolio’s risk.
The return on a portfolio is the weighted average of the individual assets’ expected returns,
where the weights are the proportion of the portfolio’s value in the particular asset. The
portfolio’s risk is calculated considering:
2
See, for example, Eugene Fama and Kenneth French,” The Cross-Section of Expected Stock
Returns,” Journal of Finance, Vol. 46, (June 1992) pp. 427-466.
3
For a review of a number of these studies, see G. William Schwert, “Size, Stock Returns, and
Other Empirical Regularities,” Journal of Financial Economics, Vol. 17 (June 1983) pp. 3-12.

The weight of the asset WHAT TO CHOOSE?
in the portfolio.
The standard deviation Risk averse investors prefer more return to less, and prefer
of each asset in the less risk to more.
portfolio.
The correlations among Consider the following investments and the associated
the assets in the expected return and risk (measured by standard deviation):
portfolio.
In portfolio theory, we assume Expected Standard

that investors are risk averse. Investment return deviation
In other words, we assume that A 10% 12%
investors do not like risk and B 10% 11%
therefore demand more expected C 11% 12%
return if they take on more risk. D 11% 11%
E 9% 10%
F 12% 13%
If you are a risk-averse investor, which investment would
ii) Measuring risk
you prefer of each of the following pairs:
So how do we measure risk?
One way to quantify risk is to A or B? C or D? D or E? E or F?
calculate the standard
deviation of the probability Some choices are clear, and some are not. Some, like the
distribution of future outcomes. choice between D and E, depend on the investor’s individual
In the case of an investment, we preferences for risk and return tradeoff, which we refer to
are trying to gauge the risk as their utility function.
associated with future returns on
the investment.
The standard deviation of the probability distribution is a measure of risk. The standard
deviation is measured relative to the expected value, which is a measure of central tendency for
a probability distribution. For a given expected value, the greater the standard deviation of the
probability distribution, the greater the dispersion and, hence, risk.
Calculating the standard deviation requires calculating the expected value of the probability
distribution. The expected value is calculated as:
N
E(x) = pi xi
i=1
The standard deviation, , is calculated as:
N
= pi (xi -E(xi ))2
i=1
where
pi is the probability of outcome i,
xi is the value of outcome i, and
N is the number of possible outcomes.

EXAMPLE: CALCULATING THE EXPECTED VALUE
Problem
Calculate the expected return and standard deviation associated with the following distribution:
Outcome Probability Return

1 20% -10%
2 50% 20%
3 30% 40%
Solution
Outcome pi xi pi xi
1 20% -10% -0.02
2 50% 20% 0.10
3 30% 40% 0.12
E(x) = 0.20
Expected return = 20%
Outcome pi xi xi-E(x) (xi-E(x))2 pi(xi-E(x))2

1 0.20 -0.10 -0.30 0.09 0.018
2 0.50 0.20 0.00 0.00 0.000
3 0.30 0.40 0.20 0.04 0.012
2 = 0.030
= 0.03 = 0.17321 = 17.321%
iii) Correlations and covariance

Covariance and correlation are statistical measures of the extent that two sets of data – two
variables -- are related to one another. The covariance between two random variables is a
statistical measure of the degree to which the two variables move together. The covariance
captures how one variable is different from its mean as the other variable is different from its
mean. A positive covariance indicates that the variables tend to move together; a negative
covariance indicates that the variables tend to move in opposite directions.
The covariance is calculated as the ratio of the covariation to the sample size less one:
N
(x -x)(y -y)
i=1
i i
Covariance =
N-1
where N is the sample size
xi is the ith observation on variable X,
x is the mean of the variable x observations,
yi is the ith observation on variable Y, and
y is the mean of the variable Y observations.
The actual value of the covariance is not meaningful because it is affected by the scale of the two
variables. That is why we calculate the correlation coefficient – to make something interpretable
from the covariance information.

The correlation coefficient, , is a measure of the strength of the relationship between or
among variables. For two variables, X and Y, we calculate it as:
covariance betwen x and y

standard deviation standard deviation
of x of y
Note: Correlation does not
imply causation. We may say
that two variables X and Y are
correlated, but that does not
N

(x i -x) (y i -y)

mean that X causes Y or that Y
causes X – they simply are
i=1
=
N-1
related or associated with one
N N another.
(x -x) (y -y)
i=1,n
i
2
i
2
i=1
N-1 N-1
or, using shorthand notation,
cov XY
XY =
XY
whereXY is the correlation between the returns on X and Y, covXY is the covariance of the
returns on asset X and Y, and X and Y are the standard deviations of the returns on X and Y,
respectively.
In the context of asset returns, a correlation coefficient is a measure of the extent to which
the time series of two assets' returns tend to move together. Correlation coefficients range from
-1 (perfect negative correlation) to +1 (perfect positive correlation). Correlations may be positive,
negative, or zero.

CORRELATION AND STOCK RETURNS
Consider the daily stock returns for three stocks, Dell Computer, General Motors, and Kellogg, from June 21,
2004 through June 22, 2006. These companies are in different industries, but are affected by the same
general economics movements. Hence, there should be some positive correlation among the returns on
these stocks.
We can calculate the returns on the stocks by downloading the daily prices and the dividends paid per
share. From Yahoo! Finance, we download the prices and dividends, using this information to calculate the
daily return on a stock.
The daily return for a stock is calculated as:
Price on day t - Price on day t-1 + Dividend on day t

Daily return =
Price on day t-1
Using a sample of days to demonstrate, we’ll use GM stock prices and dividends:
Day Closing Dividends Return

price per share
9-Aug-04 $37.18
10-Aug-04 $37.83 0.73%
11-Aug-04 $37.90 $ 0.50 -2.19%
12-Aug-04 $37.06 -1.34%
13-Aug-04 $36.94 4.20%
If we repeat this computation for all of the trading days and for all three stocks, we can then get an idea of
the relationship between the returns on these stocks.
Using Microsoft Excel®, we calculate the correlation coefficients, , using function CORREL:
Dell GM Kellogg
Dell 1.00000000 0.14824737 0.13284603
GM 0.14824737 1.00000000 0.15568776
Kellogg 0.13284603 0.15568776 1.00000000
The stock returns of Dell, GM and Kellogg are positively correlated with one another. If you would like to
see the worksheet that generated these correlations, accompanied by the return calculations and
scatterplots, click here.
iv) Measuring portfolio risk

A portfolio’s return is a weighted average of the individual asset’s expected returns. That’s
simple. But the risk of a portfolio is much more complicated. A portfolio’s risk is calculated
considering the relationships among the returns of the assets that make up the portfolio. The
portfolio’s risk, p, is less than the weighted average of individual asset returns’ standard
deviations if the returns’ correlation is less than 1.0.
The portfolio standard deviation for an N-asset portfolio is:

N N N
p = wi2 i2 + wi w ji jrij
i=1
i=1 j=1j=i
or, using the covariance of i's and j's returns instead of i jrij ,
N N N
p = wi2 i2 + wi w jcovij
i=1
i=1 j=1j=i
where
wi is the weight of the ith asset in the portfolio,

i is the standard deviation of the ith asset’s returns
rij is the correlation coefficient for returns of assets i and j
covij is the covariance for the returns of assets i and j.
For a two-assest portfolio, the portfolio risk calculation is much simpler. Consider the portfolio
comprised of securities X and Y: 4
p = w X 2 X 2 + w Y 2 Y 2 + 2w X w Y X Y rXY
or, using the covariance of X's and Y's returns instead of X Y rXY ,
p = w X 2 X 2 + w Y 2 Y 2 + 2w X w Y cov XY
You’ll notice that the third term in each equation is what distinguishes the portfolio standard
deviation from being a simple weighted average of the standard deviations of the individual
asset’s returns.
This is diversification at work. A portfolio’s risk is reduced as you combine assets whose returns
are not perfectly positively correlated. You’ll notice when you work problems, the key driver in
this calculation is the correlation. It is actually possible to add an asset to a portfolio that will
increase the portfolio’s return, yet reduces the portfolio’s risk.
4
Where does the “2” come from? Consider the first formula. Because we are summing the third
term from 1 to N (in this case 2) to consider the correlation of return of X with those of Y and the
returns of Y with those of X, we have wXwYXYrXY + wYwXYXrYX that we simplify as
2wXwYXYrXY.

Example: Portfolio risk
Problem
Consider the following investments A, B, and C that can be placed in a portfolio:
Stock Expected return Standard deviation

A 10% 20%
B 8% 15%
C 5% 10%
The correlations among these investments are as follows:
A B C
A 1.00 0.40 0.80
B 0.40 1.00 -0.20
C 0.80 -0.20 1.00
What is the expected return and standard deviation for a portfolio comprised of:
1. 50% of Stock A and 50% of Stock B

2. 40% of Stock A, 40% of Stock B, and 20% of Stock C?
Solution
1. 50% of Stock A and 50% of Stock B
Expected return = 9%
Portfolio variance = 0.01 + .00563 + 2 (0.003) = 0.02163
Portfolio standard deviation = 14.71%
2. 40% of Stock A, 40% of Stock B, and 20% of Stock C?
Expected return = 8.2%

Portfolio variance = 0.0064 + .00360 + 0.0004 + 2 (0.00192 0.00024 + 0.00128) = 0.0163
Portfolio standard deviation = 12.77%
C. Modern Portfolio Theory

Diversification is the foundation of modern portfolio theory (MPT). MPT is the theory of
selecting the optimal combination of assets that are expected to provide the highest possible
return for a given level of return (or least risk for a given level of return).]
Harry Markowitz developed a model that describes investors’ choices. He makes several
assumptions in his model: 5
Investors consider the probability distribution of expected returns.

Investors seek to maximize their utility.
Investors estimate risk on the basis of variability of expected returns.
Investors base decisions solely on risk and return.
Investors are risk averse. That is, for a given level of risk, investors prefer greater return;
for a given level of return, investors prefer less risk.
5
Harry Markowitz, “Portfolio Selection,” Journal of Finance, (March 1952) pp. 77-91.

From his model, he develops the idea that there is an optimal set of portfolios in terms of risk
and return. This optimal set is referred to as the efficient frontier. The efficient frontier is the
set of portfolios that have the greatest return for a level of risk or, equivalently, the lowest risk
for a level of return. Portfolios on the efficient frontier are preferred to the “interior” portfolios.
Let’s construct the efficient frontier. We will look at possible portfolios and their expected risk
and expected return in the two dimensions: return (vertical axis) and risk (horizontal axis):
Return
Risk
Now we calculate the expected return and risk of all possible portfolios that can be constructed
using available investable assets. If we begin to plot the return-risk for each portfolio, we see
the following (with representing the expected return and standard deviation for a given
portfolio):
Return
B
C D
Risk
We can see in this graph that there are some portfolios that appear better than others in terms
of risk and return. For example, a risk averse investor would prefer A to B (more return, same
risk) and would prefer C to D (same return, lower risk).
If we keep this up, considering every possible portfolio, including all possible weights for each
asset, we eventually end up with the following:

Efficient
frontier
Return
Risk
Every portfolio that lies on the efficient frontier (in this diagram, this means a portfolio that lies
on the red line) is superior to the portfolios that lie interior to the frontier (in this diagram, in the
blue area).
Once we have derived the efficient frontier, we can choose the portfolio on that frontier that is
best for an investor. If we consider that investors have a personal tradeoff between risk and
return, referred to as a utility curve, we can determine where the optimal portfolio lies on the
efficient frontier. More risk-averse investors have steeper utility curves. The optimal portfolio is
the portfolio on the efficient frontier that has the highest utility.
Return
Investor X’s
optimal
portfolio
Investor Y’s
optimal
portfolio
Risk
The optimal for portfolio for each investor is the point of tangency between their utility curves
and the efficient frontier. The optimal portfolio represents the group of assets that maximizes
the investor’s utility. In other words, this selection of assets offers the greatest level of
satisfaction, among all possible portfolios, for the investor considering how he or she feels about
risk and return. In the diagram above, the optimal portfolios of Investors X and Y are different
because of different utility functions, but they lie on the efficient frontier.

The implications of modern portfolio theory are that:
Some portfolios are preferred to others.

There exists an optimal portfolio for each investor.
D. Implications
The fact that markets are efficient is often viewed as sad news among students of finance
because many wish to be able to learn about securities and markets so that they could make
their fortunes trading. If markets are efficient, does this mean that investment management is
fruitless? No. Investment managers select investments that are appropriate for the investor’s
return objectives and risk objectives. Efficient markets just tell us that it is not possible to earn
abnormal returns. Earning returns commensurate with the risk that is taken on is consistent with
an efficient market.
If markets are efficient, does this mean that financial analysts do not perform a useful function?
Quite the contrary. Financial analysts help investors understand the possible returns and risks
associated with investments, which helps the investor choose what is appropriate for her
portfolios.
LO6-1 Describe, in terms of the direction and speed of response, how stock prices react to
announcements that may affect the stock’s valuation.
LO6-2 Demonstrate mathematically how they interact to affect the risk of portfolios.
LO6-3 Illustrate how portfolios’ risk changes as the composition of the portfolio changes.
3. Module Tasks
Chapter 6, “The Returns and Risks from Investing,” Investments: Analysis and
Management, by Charles P. Jones, 9th edition.
Chapter 7, “Portfolio Theory,” Investments: Analysis and Management, by Charles P.
Jones, 9th edition.
Chapter 8, “Selecting the Optimal Portfolio,” Investments: Analysis and Management,
by Charles P. Jones, 9th edition.
Chapter 6, “Technical Analysis and the Random-Walk Theory,” in A Random Walk
Down Wall Street, by Burton G. Malkiel, 1999. Available free through NetLibrary as
an e-book through the Florida Atlantic University libraries.
Chapter 8, “A New Walking Shoe: Modern Portfolio Theory,” in A Random Walk Down
Wall Street, by Burton G. Malkiel, 1999. Available free through NetLibrary as an e-
book through the Florida Atlantic University libraries. In this chapter, Malkiel
discusses modern portfolio theory, risk and returns.
Measuring risk, a detailed presentation of how to calculate the expected return and
standard deviation for a probability distribution, prepared by Pamela Peterson Drake

Textbook author’s practice questions, with solutions, Chapter 6

Portfolio risk and return calculations
D. Project progress
You should be gathering information on your company’s stock price, including
monthly closing prices and dividends over the past five years. You should look over
the posting entitled Estimating the market model: Step by step and begin working
through this process.
E. Module quiz
quiz availability.
4. What’s next?
In this module, we have look at the portfolio theory and the related mathematics. This is the
necessary foundation for understanding asset pricing models, which is our next topic. Following
the theories of asset pricing, we look at the valuation of stocks, bonds, and derivatives.

Module 7
Asset pricing models
1. Overview
Asset pricing models are different ways of interpreting how investors value investments. Most
models are based on the idea that investors hold well-diversified portfolios and that investors are
rational.
The most widely known asset-pricing model is the capital asset pricing model (CAPM). This
model results in a simple view of how assets are valued: investors are rewarded, in terms of
greater expected return, if they bear greater market risk.
An alternative to the CAPM is the arbitrage pricing theory (APT), which is based on different
assumptions regarding how markets and investors behave. The APT results in a more general
view that returns are explained by unexpected changes in fundamental economic factors, such as
changes industrial production.
A. The Capital Asset Pricing Model

Portfolio theory is the foundation of asset pricing and concerns how investors make investment
decisions. Portfolio theory tells us that investors consider expected return and risk important in
pricing assets.
There are two prominent theories that describe the trade-off between risk and return. The first
is the capital asset pricing model (CAPM), which we cover first. The second is the arbitrage
pricing theory (APT), which we also cover in this module.
The basic idea of the capital asset pricing theory is that there is a positive relation between risk
and expected return and that the only risk that is relevant in an investor’s decision is market
risk, which cannot be removed by diversification (hence, it is often referred to as non-
diversifiable risk). If investors can hold diversified portfolios, then the only risk that is
“priced” (or in other words, rewarded in terms of higher return), is the risk that cannot be
diversified away.
The CAPM, developed by William Sharpe, extends the work of Harry Markowitz that we looked at
in a previous module, by introducing the possibility that investors can borrow or lend at the risk-
free rate of interest. 1 Lending at the risk-free rate means that the investor buys a risk-free
investment, such as a U.S. Treasury Bill. Borrowing at the risk-free rate means that the investor
can borrow at the same rate as the U.S. Treasury Bill. Of course this is not realistic, but it helps
us determine what is important in the pricing of assets – and we can add the realism after we
understand the basic framework. The risk-free investment and borrowing possibilities expand
investors’ opportunities.
1
William F. Sharpe, “A Simplified Model of Portfolio Analysis” Management Science, Vol. 9 (January 1963)
pp. 277-293.

A risk-free asset is one in which there is no correlation of its returns with those of a risky
asset. 2 The expected return on the risk-free asset is rf and the standard deviation of its returns is
zero.
The ability to invest in the risk-free asset or borrow at the risk-free rate enhances opportunities:
More risk-averse investors can lend at the risk-free rate and hold some portion of the market
portfolio in their portfolio.
Less risk-averse investors can borrow at the risk-free rate and leverage the market portfolio.
Think about what a risk-free asset does to a portfolio’s risk. The formula for the portfolio risk for
a two-security portfolio is:
p =2 w 2A 2A + wB2 B2 + 2w A wB A B AB
where
p, A and B B indicate the standard deviations of the portfolio, Security A and Security B,
respectively;
wA and wB indicate the weight in the portfolio of A and B; 3 and
AB indicates the correlation between A and B.
If Security A is risk-free, this means that the A is zero and that AB is zero. This also means that
the portfolio risk is: 4
p =2 wB2 B2 = wB B
From this equation, you can see that the risk of the portfolio then depends on how much is
invested in the risky asset and the risk of that risky asset.
Consider the following example. Suppose you have two securities, K and L, that have a
correlation of 0.30 and the following characteristics:
Expected Standard
Security return deviation
K 6% 42%
L 4% 30%
The expected return and standard deviation of the two-security portfolio in different proportions
of K and L (with K’s weight along the horizontal axis), is:
2
The risk that it is free of is default risk. Such a security may still have other types of risk, such as interest
rate risk and reinvestment rate risk.
3
Note that the weights must sum to 1.0.
4
This is because both of the terms w 2A 2A and 2w A wB A B AB become zero when A is zero.

45%
7%
40%
6%
35%
5% 30%
Expected 4% Standard 25%
return 3% deviation 20%
15%
2%
10%
1%
5%
0% 0%
0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100%
Proportion of K Proportion of K
But if we were to combine security K with a risk-free security, M: 5
Security Expected return Standard

deviation
K 6% 42%
M 4% 0%
We can see that the return and risk of the portfolio is quite different:
45%
7% 40%
6% 35%
5% 30%
Standard 25%
Expected 4%
deviation 20%
return 3%
15%
2%
10%
1% 5%
0% 0%
0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100%
Proportion of K Proportion of K
The separation theorem states that the investment and financing decisions of an investor are
separate:
The investment decision is the decision to invest in the market portfolio and/or the risk-free
asset.
5
Remember: if the security is risk-free, it’s returns do not have any variation and hence there is no
standard deviation. Also, if the returns on the risk-free security do not vary, then there would be no
correlation with the returns of the other security, K.

The financing decision is whether to lend of borrow along the capital market line (CML).
The capital market line is the set of possible optimal portfolios that exit once we introduce the
risk-free asset. The capital market line is the line that is tangent to the efficient frontier (that we
developed in Module 6):
Capital market line (CML)

Expected
g
return wi n
rr o
Bo Efficient
frontier
i ng
nd Market
Le port folio
Standard deviation
of returns
The market portfolio is the point of tangency of the CML and the efficient frontier and is
comprised of all investable risky assets. The market portfolio is a completely diversified portfolio.
A completely diversifiable portfolio has no unsystematic risk. The only risk in a diversified
portfolio is systematic risk.
In the often-used diagram of possible portfolios of different sizes, as shown below, we see that
the unsystematic, diversifiable risk disappears for portfolios of a sufficiently large number of
securities; however, the non-diversifiable, systematic risk remains: 6
RISK SEMANTICS
Portfolio
standard
Risk that goes away when a portfolio
deviation
As the number of securities in the
is diversified:
portfolio becomes larger, the Unsystematic risk
unsystematic risk declines Unique risk
Diversifiable risk
Firm-specific risk
Risk that cannot be diversified away:

Systematic risk
unsystematic risk Non-diversifiable risk
systematic risk Market risk
Number of securities in the portfolio
6
This graph is constructed by calculating the average portfolio standard deviation for each size portfolio.
Therefore, for the average portfolio standard deviation of portfolios of the size of one security is plotted,
followed by the average portfolio standard deviation of portfolios of the size of two securities, etc. Because
of diversification, the risk of a portfolio declines for ever-larger portfolios – to a point.

B. The capital asset pricing model
The capital asset pricing model (CAPM) is a theory in which the expected return on an asset
is the sum of the return on a risk-free asset and the return commensurate with the asset's
market risk: risk premium for the market
E(ri) = E(rf) + E(rm - rf)

where asset’s risk premium for
bearing market risk
E(ri) = the expected return on asset i,
E(rf) = the expected return on the risk-free asset,
E(rm - rf) = the expected risk premium on the market portfolio, and
= beta, the measure of market risk.
Whereas the term E(rm-rf) is the risk premium for RISK PREMIUMS
the market as a whole (i.e., on average for the
entire market), the term E(rm - rf) is, therefore, The risk premium for the market is often
the compensation for the ith asset’s market risk. confused with the market risk premium for an
asset. The difference is the factor of .
The model makes a many assumptions about the
market and how investors view investments: The risk premium of the market – that is,
for the average stock in the market – is:
Investors base their investment decision on
E(rm - rf)
expected return and the variance of returns.
Investors prefer more wealth to less wealth. The market risk premium for an
Any amount can be borrowed or lent at the individual asset is the risk premium for the
risk free rate of interest. market, adjusted by the factor of :
Investors have homogeneous expectations.
All investors have the same investment E(rm - rf)
horizon.
All investments are infinitely divisible.
There are no taxes or transactions costs.
There is no inflation.
The capital market is in equilibrium.
The market portfolio is an efficient portfolio that contains all investable risky assets.
A number of these assumptions are basically common sense, such as the assumption that
investors prefer more wealth to less. And there are some that are not very realistic, such as no
taxes (which we may all wish for, but it is not likely to come true). For now, let’s make these
assumptions and then we’ll see what happens if we relax a few of these.
Market risk is the sensitivity of the asset's returns to changes in the return on the market.
Because investors are only compensated (in terms of a higher expected return) for bearing
market risk, the greater an asset’s market risk, the greater the expected return on the asset.
The security market line (SML) captures the relation between expected return and market risk
().

Expected
retu rn
SML
rm
rf
1.0
The security market line depicts the following:
There is a positive relation between market risk and expected return.

The of the market is 1.0
The expected return of an asset with a = 1 is rm.
Beta, is a measure of market risk: the greater the beta, the more sensitive are the returns on
the stock to changes in the returns on the market. A beta of 1.2 for Company X means that:
If the market return goes up 1 percent, the return of Company X stock is expected to go up
1.2 times 1 percent, or 1.2 percent.
if the market in general goes down 1 percent, the return of Company X stock is expected to
go down 1.2 percent.
We estimate a stock’s beta using the market model regression:
Rit = a + b Rmt
where
Rit = the return on stock i on day t,
Rmt = the return on the market proxy for day t,
a = the estimated intercept, and
b = the estimated slope, the estimate for b.
We usually estimate this model using sixty monthly returns or at least 250 daily returns. And we
often use a comprehensive market index, such as the S&P 500 index, as the proxy for the market
portfolio. For a detailed explanation of how to estimate a beta, check out Estimating a market
model: Step-by-step.
Suppose that a company’s stock has a beta of 1.2. And suppose that the expected risk-free rate
of interest is 4 percent and the expected premium for the market as a whole is 5 percent. What
is the expected return on this stock?
RABC = 0.04 + 1.2 (0.05)

= 0.04 + 0.06
= 10 percent

If a security has an expected return that deviates from what is expected based on the SML, we
consider the stock to be mispriced. For example, if the expected return is greater than that
expected with the SML, the stock is considered underpriced; as the price is adjusted upward to
reflect its true value, the return will be greater than that predicted by the SML. Consider the
three stocks, labeled 1, 2 and 3 whose expected return and market risk are plotted below:
Expected
retu rn
n SML
o
p
rf

From this, we conclude that:
n is underpriced: the expected return is greater than that sufficient for its market risk.
o is overpriced: the expected return is less than that sufficient for its market risk.
p is correctly priced: the expected return is sufficient for its market risk.
The beta of a portfolio is the weighted average of the Beta examples

betas of the securities in the portfolio, where the weights
Company Stock’s beta,
are the proportion of the portfolio invested in the asset. Allstate Corp. 0.274
General Electric 1.101
A portfolio comprised of 75 percent Toys-R-Us stock and 25 General Motors 1.173
percent Yahoo! stock has a beta of 1.914: Microsoft 1.723
Southtrust Corp. 0.419
p = (0.75) (1.367) + (0.25) (3.555) Yahoo! 3.555
= 1.02525 + 0.88875
Source: Yahoo! Finance
= 1.914
What happens when the assumptions are not true? What most researchers have found is that
even if the assumptions are violated, the general conclusions of the CAPM hold: a stock’s return
is best explained by the return on the market, with some adjustment for the beta of the stock.
There is debate whether the CAPM adequately describes security returns. However, there is no
other generally accepted model that better describes security returns. Recent evidence questions
the validity of CAPM, though there is no alternative model that is more widely accepted than the
CAPM.
C. The Arbitrage Pricing Theory

The arbitrage pricing theory (APT) was developed by Roll and Ross as an alternative to the
CAPM. CAPM has been criticized for making assumptions that are unrealistic and for not
adequately explaining observed pricing anomalies.
APT has fewer assumptions than the CAPM. These assumptions are the following:

Investors prefer more wealth to less wealth.
Assumes capital markets are perfect.
Investors have homogeneous expectations.
Assumes that investors can arbitrage any pricing discrepancies.
Like the CAPM, the APT assumes that investors diversify, so the only risk that is “priced” (that is,
compensated for in terms of higher returns) is non-diversifiable risk. A difference between CAPM
and APT, is that in the APT the systematic risk can be measured by more than just one factor.
The APT provides that returns are generated from one of more factors, where these factors are
surprises, or unanticipated changes in economic conditions. The theory does not specify how
many factors drive returns, nor does it address what these factors are.
Expected returns are represented as k factors:
E(Ri
!"# #"$ $%%%"& &'"
where
j is the jth factor
ij is the sensitivity of asset i’s return to the jth factor.
The j relate the sensitivity of asset’ return to the risk factor. The j is the risk premium
associated with the jth risk factor.
Suppose that an analyst uses the necessary statistical techniques to estimate the j and ij. And
suppose that 1 = 0.3 and 1 = 1.5. This means that the portfolio has an exposure to the first
factor of 0.3 and that the price of risk of the factor is 1.5%. This means that the first factor
contributes 0.3 x 1.5 percent = 0.45 percent to the expected return of the portfolio. If portfolio
manager alters the portfolio to increase the exposure from the first risk factor, the portfolio’s
expected return increases (as indicated by the positive value of 1); the portfolio manager
accomplishes this by shifting investments such that the exposure to the first factor is more than
0.3.
If there is one factor – which is permissible within the APT – the CAPM may be viewed as a
special case of APT (i.e., one-factor APT). The evidence regarding support for the theory is
mixed. Some find that there are economic factors that drive returns, whereas others argue that
the theory cannot be tested.
The macroeconomic factors found most often in research are the following: 7
1. Unanticipated inflation
2. Unanticipated changes in industrial production
3. Unanticipated changes in the yield spread
4. Unanticipated changes in the term structure of interest rates
The reason that these factors are all unanticipated is that’s the surprises that drive returns. Prices
of assets already reflect the known information about the economy. It is when there is something
unanticipated that causes investors to revalue assets, producing a return.
7
These factors are observed by many researchers, including Nai-Fu Chen, Richard Roll and Stephen Ross,
“Economic Forces and the Stock Market: Testing the APT and Alternative Asset Pricing Theories,” Journal of
Business, Vol. 59, No. 3 (July 1986) pp. 383-403.

Now that we know what it is, what can we do with it? The theory uses economic reasoning to
describe how investors value securities. Broader than the CAPM and less restrictive in
assumptions than the CAPM, the APT relates stock returns to economic factors in a very general
sense.
So what good is it? Well, once we have an idea the risk exposures of a portfolio and the
securities in the portfolio, we can then manage the portfolios to better manage these risks.
In this module, we’ve looked at the two prominent theories of asset pricing. We know that there
is a risk-return tradeoff and that investors will seek out the best investment opportunities,
holding well-diversified portfolios. But how do investors manage risk? What risk are they trying
to manage?
In the CAPM, there is one risk that is important in asset pricing: market risk. In this model, the
market factor is the one and only one factor that drives returns. This makes things very simple.
If we know how a stock’s returns vary according to the market’s return, we can gauge its risk.
And if we have an estimate of the market’s return and we understand a stock’s market risk, we
can estimate a stock’s return or assess whether a stock is under, over, or correctly priced.
But the CAPM has lots of unrealistic assumptions and the simplification of the investing world into
one factor may not be appropriate. The APT is an alternative theory to the CAPM, relying less on
assumptions and allowing more factors to influence returns.
Both models are depictions of how investors view risk and return. Both models rely to some
extent on assumptions. And both models are supported and contradicted by empirical evidence.
So what’s a portfolio manager to do? Understand the risk-return tradeoff, understand that non-
diversifiable risk is what is important in determining asset prices, and understand than one or
more economic factors influence the returns on assets.
LO7-1 Describe the capital asset pricing model;
LO7-2 Discuss the role of and relevant risk in the capital asset pricing model;
LO7-3 List and briefly discuss the assumptions of the capital asset pricing model;
LO7-4 Calculate the expected return on a security, given the risk-free rate of interest, the
market risk premium, and beta.
LO7-5 Explain how arbitrage is used to explain security returns in the arbitrage pricing theory;
LO7-6 List and briefly discuss the assumptions of the arbitrage pricing theory; and
LO7-7 Distinguish between the CAPM and APT.
3. Module Tasks
Chapter 9, “Capital Market Theory,” Investments: Analysis and Management, by
“Hedge funds”, by Pamela Peterson Drake.
B. Other material
Risk, return, and diversification, background reading from FIN3403, prepared by

C. Optional readings
Diversification and the CAPM, a PowerPoint lecture from the University of Iowa.
The CAPM and APT, a lecture from MIT.
D. Practice problems sets

E. Module quiz
quiz availability.
F. Project progress
At this point in the semester, you should have completed the data gathering for Part C of
the project.
4. What’s next?
In Module 6 and Module 7, we establish the foundation for the valuation of assets. In particular,
we focus on the calculation of returns and the determination and calculation of portfolio risk. In
Module 8, we look at the valuation of stocks, focusing primarily on the valuation of common
stocks. In Module 8, we will apply the most commonly used models in stock valuation, including
the dividend valuation model and the two-stage dividend discount model. In Module 9, we will
look at how we value bonds, including the role of interest rate risk and duration in valuation. In
our final module, Module 10, we will focus on the use and valuation of derivatives, most notably
options and futures.

Module 8
Investing in stocks
1. Overview
When an investor buys a WARREN BUFFETT ON INTRINSIC VALUE
share of common stock, it
is reasonable to expect From the 1994 annual report to shareholders of Berkshire Hathaway 1
that what an investor is
willing to pay for the “We define intrinsic value as the discounted value of the cash that can
be taken out of a business during its remaining life. Anyone calculating
share reflects what he
intrinsic value necessarily comes up with a highly subjective figure that
expects to receive from it. will change both as estimates of future cash flows are revised and as
What he expects to interest rates move. Despite its fuzziness, however, intrinsic value is
receive are future cash all-important and is the only logical way to evaluate the relative
flows in the form of attractiveness of investments and businesses.
dividends and the value …
To see how historical input (book value) and future output (intrinsic
of the stock when it is
value) can diverge, let's look at another form of investment, a college
sold. education. Think of the education's cost as its "book value." If it is to
be accurate, the cost should include the earnings that were foregone by
The value of a share of the student because he chose college rather than a job.
stock should be equal to
the present value of all For this exercise, we will ignore the important non-economic benefits
of an education and focus strictly on its economic value. First, we must
the future cash flows you
estimate the earnings that the graduate will receive over his lifetime and
expect to receive from subtract from that figure an estimate of what he would have earned had
that share. Since he lacked his education. That gives us an excess earnings figure, which
common stock never must then be discounted, at an appropriate interest rate, back to
matures, today's value is graduation day. The dollar result equals the intrinsic economic value of
the present value of an the education.
infinite stream of cash
Some graduates will find that the book value of their education exceeds
flows. And also, common its intrinsic value, which means that whoever paid for the education
stock dividends are not didn't get his money's worth. In other cases, the intrinsic value of an
fixed, as in the case of education will far exceed its book value, a result that proves capital was
preferred stock. Not wisely deployed. In all cases, what is clear is that book value is
knowing the amount of meaningless as an indicator of intrinsic value.”
the dividends -- or even if
there will be future dividends -- makes it difficult to determine the value of common stock.
A. The dividend valuation model

The basic premise of stock valuation is that in a market with rational markets, the value of the
stock today is the present value of all future cash flows that will accrue to that investor in the
stock. In other words, you get (in a present value sense) what you pay for. Using time value of
money principles, we can determine the price of a stock today based on the discounted value of
future cash flows. We refer to this price as the intrinsic value of the stock because it is the
1
Available at the Berkshire Hathaway web site, http://www.berkshirehathaway.com/letters/1994.html .

value of the stock that is perceived based on all available information. Is it always right on
target? No, but it’s close.
If dividends are constant forever, the value of a share of stock is the present value of the
dividends per share per period, in perpetuity. Let D1 represent the constant dividend per share
of common stock expected next period and each period thereafter, forever, P0 represent the price
of a share of stock today, and r the required rate of return on common stock. 2 The current price
of a share of common stock, P0, is:
P0 = D1 / r.
The required rate of return is the compensation for the time value of money tied up in their
investment and the uncertainty of the future cash flows from these investments. The greater the
uncertainty, the greater the required rate of return. If the current dividend is $2 per share and
the required rate of return is 10 percent, the value of a share of stock is $20. Therefore, if you
pay $20 per share and dividends remain constant at $2 per share, you will earn a 10 percent
return per year on your investment every year.
If dividends grow at a constant rate, the value of a share of stock is the present value of a
growing cash flow. Let D0 indicate this period's dividend. If dividends grow at a constant rate, g,
forever, the present value of the common stock is the present value of all future dividends, which
– in the unique case of dividends growing at the constant rate g – becomes what is commonly
referred to as the dividend valuation model (DVM):
D0 (1 g) D1
P0
rg rg
This model is also referred to as the Gordon model. 3 This model is a one of a general class of
models referred to as the dividend discount model (DDM).
2
The required rate of return is the return demanded by the shareholders to compensate them
for the time value of money and risk associated with the stock’s future cash flows.
3
The model was first proposed by Myron J. Gordon, The Investment Financing, and Valuation of
the Corporation, [Homewood: Irwin], 1962.

If dividends are expected EXAMPLES OF DIFFERENT PATTERNS OF DIVIDEND GROWTH
to be $2 in the next period
and grow at a rate of 6 Today’s dividend = $1.00
percent per year, forever, $11.00
the value of a share of Constant
stock is: $10.00 Constant dollar increase of 5¢
$9.00 Constant growth at 5%
$2 / (0.10-0.06) = $50. Constant growth at 10%
$8.00
Constant decline at 5%
Because we expect $7.00
dividends to grow each Dividend $6.00
period, we also are per
share $5.00
expecting the price of the
stock to grow through time $4.00
as well. In fact, the price $3.00
is expected to grow at the
$2.00
same rate as the
dividends: 6 percent per $1.00
period. $0.00
Today 2 4 6 8 10 12 14 16 18 20 22 24
The DVM can be used to Year into the future
calculate the current price
of a stock whether
dividend grow at a constant rate, dividends do not grow (that is, g = 0 percent), or dividends
actually decline at a constant rate (that is, g is negative). For a sample worksheet on this model,
click here.
EXAMPLES
Example 1
Suppose dividends on a stock today are $5 per share and dividends are expected to grow at a rate of 5% per
year, ad infinitum. If the required rate of return is 8%, what is the value of a share of stock?
Solution
D0 (1 g) $5(1 0.05)
P0 $175
rg 0.08 0.05
Example 2
Suppose dividends on a stock today are $1.20 per share and dividends are expected to decrease each year
at a rate of 2% per year, forever. If the required rate of return is 10%, what is the value of a share of
stock?
Solution
D0 (1 g) $1.20(1 0.02) $1.176
P0 $9.80
rg 0.10 0.02 0.12
Example 3
Suppose dividends on a stock today are $1 per shares and dividends are expected to remain the same,
forever. If the required rate of return is 8%, what is the value of a share of stock?
Solution
D0 (1 g) $1
P0 $12.50
rg 0.08

B. Non-constant growth in dividends
Let's look at another situation, one in which growth is expected to change as time goes on. This
is a common scenario because companies experience a life-cycle phenomena with rapid growth
in the developing stage, slowing growth in the maturing stage, and possibly declining growth in
the final stage of its existence. Further, companies may experience changes in their growth due
to acquisitions and divestitures.
Consider a share of common stock whose dividend is currently $2.00 per share and is expected
to grow at a rate of 10 percent per year for two years and afterward at a rate of 4 percent per
year. Assume a required rate of return of 6 percent. To tackle this problem, identify the cash
flows for the first stage, calculate the price at the end of the first stage, and then assemble the
pieces:

$2(1+0.10) $2(1+0.10)2 P2
P0 = + +
(1+0.06)1 (1+0.06)2 (1+0.06)2

Present value of price
Present value of dividends
at end of two years
$2.20 $2.42 P2
P0 = + +
1.06 1.1236 (1+0.06)2
$2.42(1.04)
where P2 = =$125.84
0.06-0.04
$2.20 $2.42 $125.84

P0 = + +
1.06 1.1236 1.1236
P0 =$2.0755+2.1538+112.00=$116.23
This is a two-stage growth model. You can see that it is similar to the dividend valuation
model, but with a twist: the DVM is used to determine the price beyond which there is constant
growth, but the dividends during the first growth period are discounted using basic cash flow
discounting. You can see by the math that we could alter the calculations slightly to allow for,
say, a three-stage growth model.

Example: Three-stage dividend growth model
Problem
Consider the valuation of a stock that has a current dividend of $1.00 per share. Dividends are
expected to grow at a rate of 15 percent for the next five years. Following that, the dividends are
expected to grow at a rate of 10% for five years. After ten years, the dividends are expected to grow
at a rate of 5% per year, forever. If the required rate of return is 10%, what is the value of a share
of this stock?
Solution
n Calculate the dividends for years 1 through 11: 4
Dividend
growth
Year rate Dividend
1 15% $ 1.150
2 15% $ 1.323
3 15% $ 1.521
4 15% $ 1.749
5 15% $ 2.011
6 10% $ 2.212
7 10% $ 2.434
8 10% $ 2.677
9 10% $ 2.945
10 10% $ 3.239
11 5% $ 3.401
o Calculate the present value of each of these dividends for years 1 through 10:
Year Dividend Present value

1 $ 1.150 $1.045455
2 $ 1.323 $1.092975
3 $ 1.521 $1.142656
4 $ 1.749 $1.194595
5 $ 2.011 $1.248895
6 $ 2.212 $1.248895
7 $ 2.434 $1.248895
8 $ 2.677 $1.248895
9 $ 2.945 $1.248895
10 $ 3.239 $1.248895
p Calculate the present value of the dividends beyond year 10:

$3.401
P10 $68.0225
(0.10 0.05)
q Calculate the present value of the price at year 10:
$68.0225
PVP $26.22562
(1 0.10)10
10
4
We need year 11’s dividend because when we calculate the price of the stock at the end of the
first two growth periods, we need to have the next year’s dividend.

r Calculate the sum of the present value of the dividends:
10 Dt
PVdividends in year 1-10 $11.96905
t
t 1 (1 0.10)
s Calculate the price today as the sum of the present value of dividends in years 1-10 and the
price at the end of year 10:
P0 = $26.22562 + 11.9690 = $38.19582
Graphical representation
$120 $6
$100 $5
Dividend Price
$80 $4
Price Dividend
per $60 $3 per
share share
$40 $2
$20 $1
$1.00
$1.15
$1.32
$1.52
$1.75
$2.01
$2.21
$2.43
$2.68
$2.94
$3.24
$3.40
$3.57
$3.75
$3.94
$4.13
$4.34
$4.56
$4.79
$5.03
$5.28
$0 $0
0
10
12
14
16
18
20
Period into the future
C. The uses of the DVM

The dividend valuation model provides a device in which we can relate the value of a stock to
fundamental characteristics of the company. One use is to associate the company’s stock’s price-
to-earnings ratio to fundamental factor. The price-to-earnings ratio, also known as the price-
earnings ratio or PE ratio, is the ratio of the price per share to the earnings per share of a
stock. We can relate this ratio to the company’s dividend payout, expected growth, and the
required rate of return. Let:
P0 = today’s price,
E0 = current earnings per share,
D0 = current dividend per share,
g = expected growth rate
r = required rate of return.
If we take the DVM and divide both sides by earnings per share, we arrive at an equation for the
price-earnings ratio in terms of dividend payout, required rate of return, and growth:
D0
(1 g)
P0

E0

Dividend payout ratio
1+g
E0 rg r-g
This tells us that the PE ratio is

directly related to the dividend payout [× dividend payout Æ ×PE];
inversely related to the required rate of return [× r Æ ØPE]; and
directly related to the rate of growth [×growth Æ ×PE].
We can also rearrange the DVM to solve for the required rate of return:
D1 D
P0 (r 1 g
rg P0
This tells us that the required rate of return is comprised of the dividend yield (that is, D1/P0)
and the rate of growth (also referred to as the capital yield).
We can also use the dividend valuation model to relate the price-to-book value ratio (i.e., the
ratio of the price per share to the book value per share) to factors such as the dividend payout
ratio and the return on equity. First, we start with the DVM and make a substitution for the
dividend payout ratio:
D0
E (1 g)
D (1 g) E0 0 D
P0 0 because 0 E0 D0
rg rg E 0
Let B0 indicate the current book value per share and let ROE0 indicate the current return on book
equity, calculated as the ratio of earnings to the book value of equity.
E
We know that E0 = B0
ROE0
because ROE0 = 0 . Therefore,
B0
B0
ROE0
D0 E 1 g
P0 0
rg
We can then relate the price of a stock to book value, the return on equity, the dividend payout,
the required rate of return, and the growth rate:
Increase B0 Æ Increase P0
Increase ROE0 Æ Increase P0
Increase D0/E0 Æ Increase P0
Increase g Æ Increase P0
Increase r Æ Decrease P0
We can also relate the price-to-book ratio to the return on equity, the dividend payout, the
required rate of return, and the growth rate:
P0
ROE0
D0 E 1 g
0
B0 rg
Increase ROE0 Æ Increase P0/B0

Increase D0/E0 Æ Increase P0/B0
Increase g Æ Increase P0/B0
Increase r Æ Decrease P0/B0
In other words, we can use the dividend valuation model, along with our knowledge of financial
relations (i.e., financial statements and financial ratios), to relate the stock’s price and price
multiples to fundamental factors.

D. Stock valuation and market efficiency
The theories of stock valuation are an expression of the belief that what rational investors will
pay for a stock is related to what they expect to get from the stock in the future, in terms of cash
flows, and the uncertainty related to these cash flows. Does this really work? Is the stock price
really related to what we view to be a stock’s intrinsic value?
Basically, yes. But in reality, stock valuation is not as simple as it looks from the models we’ve
discussed:
How do you deal with dividends that do not grow at a constant rate?
What if the firm does not pay dividends now?
The DVM doesn’t apply in the case when dividends do not grow at a constant rate (or at least in
stages) or in the case when the company does not pay dividends. In those cases, we need to
resort to other models, such as the valuing free cash flows or valuing residual income.
Valuation is the process of determining what something is worth at a point in time. When we
value investments, we want to estimate the future cash flows from these investments and then
discount these to the present. This process is based on the reasoning that no one will pay more
today for an investment than what they could expect to get from that investment on a time and
risk adjusted basis.
If a market is efficient, this means that the price today reflects all available information. This
information concerns future cash flows and their risk. The price that is determined at any point
in time is affected by the marginal investor – the one willing to pay the most for that stock. As
information reaches the market that affects future cash flows or the discount rate that applies to
these cash flows, the price of a stock will change. Will it change immediately to the “correct”
valuation? For the most part. The more complex the information and valuation of the
information, the more time it takes for the market to digest the information and the stock to be
properly valued. For well-known companies, a given piece of material information will be
reflected in the stock’s price within fifteen minutes – too late for the individual investor to react
to it.
The implication of efficient markets is that technical analysis will not be profitable. It also means
that fundamental analysis, while valuable in terms of evaluating future cash flows, assessing risk,
and assisting in the proper selection of investments for a portfolio, will not produce abnormal
returns – it will simply produce returns commensurate with the risk assumed. We can see this
with mutual funds. We assume that the fund managers have adequate access to all publicly
available fundamental information. However, these fund managers cannot outperform random
stock picks. Even the most sophisticated fundamental analysis cannot generate abnormal
returns.
E. Efficient markets and investment strategies

Investing may be passive or active. Passive investing (a.k.a. buy-and-hold strategy)
involves investing for the long-term. The passive investor does not adjust the portfolio because
of short-term movements in any given security, sector, or the market in general. Rather, the
investor is looking for the long-term appreciation of the portfolio.
Active investing, on the other hand, involves a number of strategies that seek to profit from
short-term changes in the market. These strategies include:

Momentum investing. This involves adjusting the portfolio to take advantage of trends
in individual stocks or groups of stocks.
Sector rotation. This involves adjusting the stocks to emphasize the sectors that are
expected to perform better according to the economic cycle.
Market timing. This involves varying the proportion invested in equities according to
recent movements in the stock market.
The reality of efficient markets and stock valuation for both technical analysis and fundamental
analysis is that active investment strategies are not consistently profitable. In other words, by
following an active strategy an investor will not consistently generate abnormal returns for the
investor. In fact, if there is a great deal of turnover in the portfolio in an active strategy, the
transactions costs will exaggerate any losses and will reduce potential gains. This is not to say
that an investor may not get lucky and win big for a given strategy for a given period. However,
applying that active strategy over an extended period of time (i.e., different market and
economic cycles) will not consistently generate returns beyond those expected for the risk and
transactions costs involved.
The key, therefore, is for an investment manager to determine the appropriate risk for the
portfolio and required cash flows (based on the clients’ or investors’ preferences) and then use
fundamental analysis to select the securities that are appropriate for the risk-cash flow
requirements. The overwhelming evidence pertaining to investment strategies is that the most
profitable strategy is to buy and hold for the long-term.
LO8-1 Identify and estimate the future cash flows associated with stocks.
LO8-2 Classify actual companies’ dividend patterns as constant, constant-growth, or non-
constant growth.
LO8-3 Value the future cash flows associated with stocks using the no-dividend growth model,
the constant dividend model, the constant growth model, the two-stage growth model.
LO8-4 Explain the implications of efficient markets and valuation principles for investment
strategies.
3. Module Tasks
Chapter 10, “Common Stocks: Analysis, Valuation, and Management,” Investments:
Analysis and Management, by Charles P. Jones, 9th edition.
Chapter 11, “Common Stocks: Analysis and Strategy,” Investments: Analysis and
Management, by Charles P. Jones, 9th edition.
B. Other material
PowerPoint lecture for Chapter 10, provided by the text’s author
PowerPoint lecture for Chapter 11, provided by the text’s author
Chapter 12, “Market Efficiency,” Investments: Analysis and Management, by Charles
Dividend Discount Model, by John Del Vecchio for the Motley Fool
Dividend Discount Models, by Aswath Damodoran, New York University

Two-Stage Dividend Growth Models
E. Module quiz
quiz availability.
F. Project progress
At this point, you should have completed gathering all data, written the stock
analysis portion of Part C of the project.
You should be working on the risk and beta analysis portions of the project.
4. What’s next?
In this module, we looked at alternative valuation models for stocks. The primary model is the
dividend valuation model, which we use to value a stock based on expected future cash flows
and the uncertainty of these cash flows. You’ve seen the dividend valuation model in your
principles of finance course, but we take it a few steps further to make it a bit more realistic. We
will also use the dividend valuation model to relate stock prices to fundamental factors of the
company.
In Module 9, we focus our attention on bonds. We look at bond valuation and examine how the
sensitivity of a bond’s value to changes in interest rates using duration measures. In Module 10,
we look at derivatives, specifically options on stocks, futures, and forwards.

Module 9
Investing in bonds
1. Overview
Long-term debt securities, such as notes and bonds, are
legally binding commitments by the borrower/issuer to THE YIELD CURVE
repay the principal amount when promised. Notes and
bonds may also require the borrower to pay interest The yield-curve is the relation
between maturity and yield. The
periodically, typically semi-annually or annually, and
normal yield curve is one in which the
generally stated as a percentage of the face value of the securities with longer maturities are
bond or note. A bond’s term to maturity is the number of associated with higher yields.
years over which the issuer has promised the obligation’s
cash flows. The term to maturity is important in bond Yield
analysis because it determines the bond’s cash flows.
Further, the yield is related to the bond’s maturity because
of the yield-curve effect and, hence, a bond’s price volatility
is affected by the term to maturity.
Maturity
The principal value is the amount that the issuer (i.e.,

borrower) agrees to repay at the maturity date. The However, inverted yield curves do
principal amount of the loan is referred to as the par value, occur, such that shorter-term
the principal, the maturity value, the redemption securities have higher yields.
value, or the face value.
Yield
Bonds may be coupon bonds or zero-coupon bonds. In the

case of a coupon bond, the issuer pays interest
periodically, as a percentage of the bond’s face value. We
refer to the interest payments as coupon payments or Maturity
coupons and the percentage rate as the coupon rate. If The inverted yield curve is often a
these coupons are a constant amount, paid at regular pre-cursor of a recessionary economic
intervals, we refer to the security paying them as having a period.
straight coupon. A debt security that does not have a
promise to pay interest we refer to as a zero-coupon note or bond.
Though most corporate bonds are straight coupon bonds, the issuer may design an interest
payment scheme for a bond that deviates from the semi-annual coupon payments. Variations in
interest payments include:
Deferred interest: interest payments begin at some specified time in the future.
Step-up interest: the coupon rate is low at the beginning of the life of the bond, but
increases at a specified later point in time to a specified rate.
Payment-in-kind interest (PIK): the investor has a choice of receiving cash or a
similar bond in lieu of interest.
Reset interest: the coupon rate is revised periodically as market interest rates change
to force the price of the bond to a predetermined level.

The value of a debt security today is the present value of the promised future cash flows, which
are the interest and the maturity value. Therefore, the present value of a debt is the sum of the
present value of the interest
payments and the present value
of the maturity value. To
calculate the value of a debt YIELD TERMINOLOGY
security, we discount these future
Yield-to-maturity (YTM): the average annual return
cash flows at some rate that assuming the bond is held to maturity.
reflects both the time value of Yield-to-call: annual return if the bond is called at a
money and the uncertainty of specified point in time (and price).
receiving these future cash flows. Effective annual return: the return over a year
We refer to this discount rate as considering the interest and the change in price over the
the yield. The more uncertain year.
the future cash flows, the greater Horizon yield: the return calculated for a specified
the yield. It follows that the horizon, future yield, and reinvestment rate.
Current yield: annual interest divided by the current
greater the yield, the lower the
price.
value of the debt security.
T
he uncertainty of the bond’s future cash
flows is affected, in part, by whether
EXAMPLE: HORIZON YIELD the bond is secured or unsecured. A
secured bond is back by the legal
Consider bonds that have a 10 percent coupon rate, claim to specific property, whereas the
matures in 10 years, and is currently priced at 95. What
unsecured bond is backed only by the
is the realized yield in two years if the reinvestment rate
is 7.5 percent and the yield in two years is 7 percent?
general credit of the borrower.
Unsecured bonds are also referred to as
The current price of the bond is $950 or 95. This is debentures. A subordinated
the present value, PV. debenture is an unsecured bond that
The future value of the interest is $211.53 or 21.153 is junior to senior unsecured bonds, and
[PMT=$50,n=4,i=3.75 percent] hence there is more uncertainty
The future value of the bond is $1,181.41 or 118.141 pertaining to these securities.
[PMT=$50,n=16,FV=$1,000,i=3.5]
The future value with reinvested cash flows is
In Wall Street terminology, the term
$211.53 + 1,181.41 = $1,392.94 or 139.294
The number of periods is 4. yield-to-maturity is used to describe
an annualized yield on a security if the
Solving for the yield: security is held to maturity. This is the
PV = 950 standard for quoting a market yield on a
FV = 1392.94 security. For example, if a bond has a
N=4 return of 5 percent over a six-month
Solve for i period, the annualized yield-to-maturity
for a year is 2 times 5 percent or 10
i = Six-month yield = 10.04 percent
percent. In the valuation of a bond that
Horizon yield is 10.04 percent x 2 = 20.08 percent
pays interest semi-annually – which
includes most U.S. corporate bonds –
the discount rate is the six-month yield (that is, the yield-to-maturity divided by 2).

The present value of the maturity value is the present value of a future amount. In the case of a
straight coupon security, the present value of the interest payments is the present value of an
annuity. In the case of a zero-coupon security, the present value of the interest payments is
zero, so the present value of the debt is the present value of the maturity value.
We can rewrite the formula for the present value of a debt security using some new notation and
some familiar notation. Because there are two different cash flows -- interest and maturity value
-- let PMT represent the
EXAMPLE: VALUATION OF A STRAIGHT BOND
coupon payment
promised each period and
Problem
FV represent the maturity
Suppose a bond has a $1,000 face value, a 10 percent coupon
value. Also, let N indicate
(paid semi-annually), five years remaining to maturity, and is
the number of periods
priced to yield 8 percent. What is its value?
until maturity, t indicate a
specific period, and i
Solution
indicate the yield. The
Given information:
present value of a debt
Maturity value = FV = $1,000
security, PV, is:
N
Periodic cash flow = PMT = $100/2 = $50
PMTt FV
PV= t=1 (1+i) t
+
(1+i)N
Number
Discount
of periods=
rate =
N
i =
=5x2
8 percent / 2
= 10
= 4 percent
10
$50 $1,000
If the bond pays interest
semi-annually, then N is
PV= (1 + 0.04)
t=1
t
+
(1 + 0.04)10
the number of six-month
= $405.55 + $675.56 = $1,081.11
periods until maturity and
i is the six-month yield, or
yield-to-maturity ) 2.
Consider the following example. Suppose that the bond of the Wilma Company has four years
remaining to maturity, a coupon rte of 5 percent, and is priced to yield 6 percent. What is the
value of a Wilma bond? The value is $964.90:
TI-83/84 HP10B Microsoft Excel®

Using TVM Solver
N=8 1000 FV =PV(.03,8,25,1000)*-1
i=3 3 i/YR
PMT = 25 8n
FV = 1000 25 PMT
Solve for PV PV

EXAMPLE: ANNUAL V. SEMI-ANNUAL INTEREST
Consider a $1,000 face value bond with a coupon rate of 6 percent, matures in 5 years, and is
priced to yield 7 percent.
If the bond pays interest annually, then:
FV = $1,000
PMT = 6 percent of $1,000, or $60 per year)
N = 5 years
i = 7 percent
5
$60 $1,000
PV = (1+0.07) + (1+0.07)
t=1
t 5
=$959
You can use your financial calculator to solve for this by inputting the four known values (FV=1000;
PMT=60, N=5, i = 7) and solving for the unknown PV.
If the bond pays interest semi-annually, then:
FV = $1,000
PMT = 6 percent of $1,000, divided by 2, or $30 per year
N = 10 six-month periods
i = 7 percent/2, or 3.5 percent
10
$30 $1,000
PV = (1+0.035) + (1+0.035)
t=1
t 10
=$958
You can use your financial calculator to solve for this by inputting the four known values (FV=1000;
PMT=30, N=10, i = 3.5) and solving for the unknown PV.
The small difference between the two present values is due to the extra compounding available for
reinvestment in the case of a semi-annual bond. Most U.S. bonds pay semi-annual interest and
therefore you should assume that all bonds have semi-annually compounding unless told otherwise.
This bond is a discount bond because the yield-to-maturity, the 7 percent, is greater than the
coupon of 6 percent.
Note: You should assume all bonds are semi-annual pay bonds unless told otherwise.
Try it: Bond values
1. Suppose a bond is priced to yield 6 percent, with a maturity in five years and a coupon rate of
5 percent. What is this bond’s quoted value?
2. Suppose a bond matures in six years, has a coupon rate of 6 percent, and is priced to yield 7
percent. What is this bond’s quote?
3. Suppose a zero coupon bond matures in ten years. If this bond is priced to yield 10 percent,
what is its quoted value?
A. Calculating the yield on a bond

We calculate the yield on a bond using the information about the bond’s:
1. Maturity, which indicates the number of periods remaining, N;

2. Coupon, which indicates the cash flow, PMT;
3. Current price, which indicates the value of the bond today, PV; and
4. Face value, which indicates the cash flow at the end of the bon’s life, FV.
In other words, we have five elements in a bond valuation, and in the case of solving for the
yield to maturity we are given four of the five elements. We cannot solve directly for the yield - -
the solution is determined using iteration. Fortunately, our financial calculators and spreadsheets
can do this for us.
Suppose a bond with a 5 percent coupon (paid semi-annually), five years remaining to maturity,
and a face value of $1,000 has a price of $800. What is the yield to maturity on this bond?
Given: 1
Periodic cash flow = PMT = $25
Number of periods = N = 10
Maturity value, M = FV = $1,000
Present value = PV = $800
The yield per six months

is 5.1 percent. Therefore, TI-83/84 HP10B Microsoft Excel®
the yield to maturity is Using TVM Solver
5.1 percent x 2 =10.2 N = 10 1000 FV =RATE(10,25,-800,1000,0) * 2
PV = 800 800 +/- PV
percent.
PMT = 25 10 n
FV = 1000 25 PMT
Another way of describing Solve for i I
a bond is to use the Then multiply by 2 X2
bond quote method. In
this case, the interest payment and
BOND QUOTES the value of the bond are stated as
a percentage of the bond’s face
A bond may be stated in terms of a percentage of the bond’s value. This is the method that you
face value or as a dollar value. Consider a bond with a face will see most often used in practice.
value of $1,000 and a coupon rate of 6 percent. We can For example, if a bond is quoted at
value this bond using the percentages or the dollar values:
115, this means that it is trading at
As a percentage As a dollar value 115 percent of its face value. If it
Face value 100 $1,000 has a face value of $500, it is
Coupon 3 every six $30 every six therefore priced at $1150. if it has a
payments months months face value of $500, it is valued at
$575. A bond quote of 85 indicates
The advantage of using the percentage method (a.k.a. bond that the bond is trading for 85
quote method) is that you don’t have to know the bond’s percent of its face value. The bond
face value to calculate the yield or value – you state every quote method provides a more
parameter as a percentage of the face value.
generic method of communicating a
bond’s value – you don’t have to
know the bond’s face value to
determine its price.
Continuing this same problem, restating the elements in terms of the bond quote,
Periodic cash flow = PMT = 2.5
1
Hint: The bond is selling at a discount, so the YTM must be greater than the coupon rate of 5
percent

Number of periods =N = 10
Maturity value, M = FV = 100
Present value = PV = 80

Using TVM Solver
N = 10 100 FV =RATE(10,2.5,-80,100,0) * 2
PV = 80 80 +/- PV
PMT = 2.5 10 n
FV = 100 2.5 PMT
Solve for i I
Then multiply by 2 X2
When we solve for the yield to maturity, we simply use 100 for the face value or FV. We solve
the problem in the same manner as before.
Try it: Bond yields
1. Suppose a bond is priced at 98, with a maturity in five years and a coupon rate of 5 percent.
What is this bond’s quoted value?
2. Suppose a bond matures in six years, has a coupon rate of 6 percent, and is quoted at 101.
What is this bond’s yield to maturity?
3. Suppose a zero coupon bond matures in ten years. If this bond is priced at 65, what is its yield
to maturity?
B. The yield curve

The yield curve is the set of spot rates for different maturities of similar bonds. The normal
yield curve is upward-sloping, which means that longer maturity securities have higher rates.
Term structure theories are explanations for the shape of the yield curve:
Expectations hypothesis
Liquidity preference hypothesis
Segmented market hypothesis
The expectations hypothesis states that current interest rates are predictors of future interest
rates (that is, “forward” rates). In other words, a spot rate on a two-year security (R2) should be
related to the spot rate on a one-year security (R1) and the one-year forward rate one year from
now (1r1): 2
(1 + R2)2 = (1 + R1) (1 + 1r1)
If the one-year rate is 5 percent and the two year rate is 6 percent, the expectations hypothesis
implies that the one-year rate one year from today is the rate that solves the following:
(1 + 0.06)2 = (1 + 0.05)(1 + 2r1)
Using Algebra, we see that the one year rate for next year that is inferred from the current rates
is 7.01 percent:
2
You’ll notice in this section that we are using an upper-case “R” to indicate the spot rate and a
lower case “R” to indicate the forward (i.e., future) rate.

1.1236 = 1.05 (1 + 2r1)
2r1= 7.01 percent
YIELD CURVES: COMPARISON OF OCTOBER 2006 WITH OCTOBER 2004 AND OCTOBER 2005
6%
5%
4%
Yield 3%
10/27/2004
2% 10/27/2005
10/27/2006
1%
0%
1 1 2 3 5 7 10 20 30
mo Maturity in years
Source of data: Yahoo! Finance and the U.S. Treasury

The yield curve in October 2004 was a “normal” curve.
The yield curve in October 2005 was a flattening curve.
The yield curve in October 2006 was an inverted curve.
The liquidity preference hypothesis states that investors prefer liquidity and therefore require
a premium in terms of higher rates if they purchase long-term securities. The segmented market
hypothesis states that there are different preferences for different segment of the market and
that the yield for a given maturity is dependent on the supply and demand of securities with that
maturity.
No matter the explanation for the shape of the yield curve, the most accurate valuation of a bond
considers the yield curve. We can consider the yield curve when we use spot rates for different
maturities in the bond valuation:
N
CFt
P0 = (1+i )
t=1 t
t
where
it = discount rate for the period t
Consider annual-pay bond with a coupon of 5 percent, a face value of $1,000, and four years to
maturity. Suppose the yield curve indicates the following spot rates:3
Maturity Spot rate

1 year 4.0 percent
2 year 4.5 percent
3 year 5.0 percent
4 year 5.5 percent
3
A spot rate is a current rate.

What is this bond’s value? To determine this value, we discount the individual cash flows at the
appropriate spot rate and then sum these present values.
Bond cash Present value of

Maturity Spot rate flow cash flow 4
1 year 4.0 percent $50 $48.077
2 years 4.5 percent $50 45.786
3 years 5.0 percent $50 43.192
4 years 5.5 percent $1,050 847.578
$984.633
Using the yield curve, the value of the bond is $984.633. If, on the other hand, we had simply
used the four-year spot rate, we the value of the bond is $982.474. The extent of the difference
depends on the slope of the yield curve
C. Option-like features
The issuer may add an option-like feature to a bond that will either provide the issuer or the
investor more flexibility and/or protection. For example, a callable bond is a bond that the
issuer can buy back at a specified price. This option is a call option (i.e., an option to buy) of the
issuer and the investor bears the risk of the bond being called away, especially when interest
rates have fallen. The callable bond agreement specifies the price at which the issuer will buy
back the bond and there may be a schedule of prices and dates, with declining call prices as the
bond approaches maturity. A putable bond, on the other hand, is a bond that gives the
investor the right to sell the bond back to the issuer at a pre-determined price, usually triggered
by an event, such as a change in control of the issuer. A putable bond, therefore, gives the
investor a put option (i.e., an option to sell) on the bond.
The yield to call is the yield on a callable bond, considering that the bond is called at the
earliest date. Consider the following example. The Bagga Company issued bonds that have five
years remaining to maturity, and a coupon rate of 10 percent. These bonds have a current price
of 115. These bonds are callable starting after two years at 110. What is the yield-to-maturity
on these bonds? What is the yield-to-call on these bonds? The first step is to identify the given
information:
Given
parameter Yield to maturity Yield to call
FV 100 110
PV 115 115
PMT 5 5
N 10 4
For the yield to maturity,

Using TVM Solver
N = 10 100 FV =RATE(10,5,-115,100,0) * 2
PV = 115 115 +/- PV
PMT = 5 10 n
FV = 100 5 PMT
Solve for i I
4
This is calculated simply as the present value of the lump-sum future vaule. For example, for
the cash flow of $50 three years from now, the present value is $50 / (1 + 0.05)3 = $43.192

The yield to maturity is 6.4432 percent. For the yield to call,

Using TVM Solver
N=4 110 FV =RATE(4,5,-115,110,0) * 2
PV = 115 115 +/- PV
PMT = 5 4n
FV = 110 5 PMT
Solve for i I
The yield to call is 3.3134 x 2 = 6.6268 percent. We can see the relation between these yields on
the bond’s current value (that is, the PV) in bond quote terms:
30%
25%
20% Yield to maturity

Yield to call
Yield 15%
10%
5%
0%
80 84 88 92 96 100 104 108 112 116 120
Bond quote
Both the yield to call and the yield to maturity are lower for higher current bond values.
Another option-like feature is a conversion feature. A convertible bond has such a feature,
which gives the investor the right to exchange the debt for a specified other security of the
issuer, such as common stock. The exchange rate is specified in the convertible bond
agreement.
The valuation of a bond with option-like features is quite complex because it involves valuing the
option as well. This is beyond the scope of this module.
D. Bond ratings
A bond rating is an evaluation of the default risk of a given debt issue by a third party, a ratings
service. There are three major ratings services: Moody’s, Standard & Poor’s, and Fitch. Ratings
range from AAA to D, with some further ratings within a class indicated as + and – or with
numbers, 1, 2 and 3. The top four ratings classes (without counting breakdowns for +,- or 1,2,3)
indicate investment-grade securities. Speculative grade bonds (a.k.a. junk bonds) have
ratings in the next two classes. C-rated bonds are income or revenue bonds, trading flat (in
arrears), whereas D-rated bonds are in default.
Ratings are the result of a fundamental analysis of a bond issue, assessing the default risk of the
issue. Ratings are affected by many factors, including:
profitability (+)
size (+)
cash flow coverage (+)

financial leverage (-)
earnings instability (-)
Ratings most often are the same across the rating agencies, but split ratings do occur. Ratings
are reviewed periodically and may be revised upward or downward as the financial circumstances
of the issuer change. For a given issuer, ratings are performed on the most senior unsecured
issue and then junior issues are rated (generally at a lower rating) according to their indentures.
Because bond ratings are of specific issues of an issuer, it is possible for a given issuer to have
bonds that are rated differently. The primary differences relate to maturity and security on the
particular issue.
E. The coupon-yield relationship

When we look at the value of a bond, we see that its present value is dependent on the relation
between the coupon rate and the yield.
If the coupon is less than the yield to maturity, the bond sells at a discount from its face or
maturity value.
If the coupon is greater than the yield to maturity, the bond sells at a premium to its face
value.
If the coupon is equal to the yield to maturity, the bond sells at par value (its face value).
Consider a bond that pays 5 percent coupon interest semi-annually, has five years remaining to
maturity, and a face value of $1,000. The value of the bond depends on the yield to maturity:
the greater that yield to maturity, the lower the value of the bond. For example, if the yield to
maturity is 10 percent, the value of the bond is $806.96. If, on the other hand, the yield to
maturity is 4 percent, the value of the bond is $1,044.91.
$1,400
$1,200
$1,000
Value
of the $800
bond
$600
$400
$200
$0
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
Yield-to-maturity
You can see that there is convexity in the Coupon rate > Yield to maturity Ö Premium
relation between the value and the yield. In Coupon rate < Yield to maturity Ö Discount
other words, the relation is not linear, but Coupon rate = Yield to maturity Ö Face value
rather curvilinear.

F. Duration
The pattern of cash flows and the time remaining to maturity all relate to the sensitivity of a
bond’s price to changes in yields. Also, as we saw in the earlier section, the sensitivity of a
bond’s price depends on the size of the yield because of the curvilear relation between yield and
value. In general,
The greater the coupon rate, the lower the sensitivity to changing interest rates, ceteris
paribus.
The greater the time remaining to maturity, the greater the sensitivity to changing
interest rates, ceteris paribus.
The greater the yield to maturity, the lower the sensitivity to changing interest rates.
The convex relation between value and yield therefore means that we need to consider what the
starting yield is as we consider the effect of changes in yields on the bond’s value.
An implication of this convex relationship is
that the change in a bond’s value depends on Low Low
× ×
what the starting yield is, how much it
changes, and whether it is an up or down Medium High
Yield to maturity
volatility volatility
change in yield. That’s where duration
Coupon rate
comes in – it’s a measure of the average
length of time for the bond’s cash flows and is
used to estimate the change in price of the
bond for a change in yield.
Low Medium
volatility volatility
Basically, duration is a time-weighted measure
of the length of a bond’s life. The longer the Ø Ø
duration, the greater the bond’s volatility with High High
LowÕ Periods remaining to ÖHigh
respect to changes in the yield to maturity.
maturity
There are different measures of duration for

different purposes: Macauley duration, modified duration, and effective duration.
Macauley’s duration is the percentage change in the value of the bond from a small
percentage change in its yield-to-maturity. We calculate this measure of duration using a time-
weighting of cash flows.
Present value of time weighted cash flow

Macauley's duration =
Present value of the bond
The weight is the period. For example, if interest is paid annually, the weight for the first interest
payment is 1.0, the weight for the second interest payment is 2.0, and so on.
Modified duration is a measure of the average length of time of the bond’s investment,
considering that some cash flows are received every six months and the largest cash flow (the
face value) is received at maturity. Modified duration requires an adjustment to Macauley’s
duration:
Maclauley's duration
Modified duration =
(1 + yield-to-maturity)

If interest is paid semi-annually, the time weighting in the Macauley duration measures uses the
whole and half years (0.5, 1.0, 1.5, 2.0, etc.) and the yield to maturity in the modified duration’s
denominator is the semi-annual rate (i.e., yield to maturity ) 2).
Effective duration is a measure of the impact on a bond’s price of a change in yield-to-

maturity. Though similar to Macauley’s duration in interpretation, its calculation is flexible to
allow it to be used in cases when the bond has an embedded option (e.g., a callable bond).
PV- -PV+
Effective duration =
2 PV0 i
where
i = change in yield
PV+ =Value of the bond if the yield went up by i
PV- = Value of the bond if the yield went down by i
PV0 =Value of the bond at the yield-to-maturity
The approximate percentage change in price for both the modified and effective duration
measures is:
% change = -1 x duration x change in yield
We say that this is an approximate change because we still haven’t accounted for the convexity,
or the curvature in the relationship. There is a measure of convexity that can be used to fine-
tune this approximate price change to get a closer estimate of the change, but this calculation is
outside of the scope of this module.
Consider a bond with a 10 percent coupon, five years to maturity, and a current price of $1,000.
What is the duration of this bond? The modified duration is 3.8609 years.
Present Time-weighted
Period Cash flow value cash flow
0.5 $50 $47.62 $23.81
1.0 $50 $45.35 45.35
1.5 $50 $43.19 64.79
2.0 $50 $41.14 82.27
2.5 $50 $39.18 97.94
3.0 $50 $37.31 111.93
3.5 $50 $35.53 124.37
4.0 $50 $33.84 135.37
4.5 $50 $32.23 145.04
5.0 $1,050 $644.61 3,223.04
Sum $4,053.91
$4, 053.91
Macauley duration = 4.0539
$1, 000
4.0539
Modified duration = 3.8609
1.05
The value of the bond if the yield is 9 percent is $1,039.56, whereas the value of the bond if the
yield is 11 percent is $962.31. If the current yield is 10 percent, resulting in a current value is
$1,000, the effective duration is 3.8626 years:

$1,039.56-962.31 77.25
Effective duration= 3.8625 years
2($1000)(0.01) 20
This means that if we expect yields to increase 2 percent, the expected change in this bond’s
price is
% change = -1 x duration x change in yield
% change = -1 (3.8625) (-0.02) = -7.725 percent
Let’s see how accurate this is. If the yield goes from 10 percent to 8 percent, the bond’s value
goes from $1,000 to $1,081.11, a change of 8.111%. Why didn’t we hit the price on the mark?
Two reasons: (1) the estimate using duration is good for very small changes in yields and less
accurate for large changes, and (2) we haven’t considered the convexity.
Why worry about duration? Because we are interested in measuring and managing risk. For
example, if we put together a portfolio of bonds we are interested in the risk of that portfolio,
which is affected in part by the interest-sensitivity of the individual bonds that comprise the
portfolio.

EXAMPLE: DURATION
Consider an annual-pay bond with a face value of $1,000, four years remaining to maturity, a
coupon rate of 8 percent, and a yield of 6 percent.
Macauley and Modified Duration
Present value Time- Present value

of cash flows weighted cash of time-
(discounted at flow (period x weighted
Period Cash flow 6 percent) cash flow) cash flow
1 $ 80.00 $ 75.47 $ 80.00 $ 75.47
2 80.00 71.20 160.00 142.40
3 80.00 67.17 240.00 201.51
4 1,080.00 $ 855.46 4,320.00 3,421.84
$1,069.30 $ 3,841.22
Macauley's duration = $3,841.22 / $1,069.30 = 3.5923
Modified duration = 3.5923 / 1.06 = 3.3889
Approximate percentage price change for an increase in yield of 1 percent:

% change= - (3.3889)(0.01) = -3.3889 percent
Effective Duration
Present
Yield-to- value of the
maturity bond
5 percent $1,106.38
6 percent $1,069.30
7 percent $1,033.87
Effective duration = ($1,106.38 - $1,033.87)/[2 ($1,069.30)(0.01) = 3.3904
Approximate percentage price change for an increase in yield of 1 percent:
% change = = - (3.3904)(0.01) = -3.3904 percent
Convexity is the degree of curvature of a bond’s value-YTM relationship. We use convexity to

refine our estimate of the bond’s sensitivity to changes in the YTM. Though the mathematics of
convexity is out of the scope of this course, you should understand the concept of convexity and
the fact that different bonds may have different convexity. Consider three bonds, labeled 1, 2
and 3.
Bond Coupon Maturity

1 5 percent 30 years
These three bonds have different convexity by virtue of their different coupons and maturities:

400
350
300 Bond 1
250 Bond 2
Bond quote
200 Bond 3
150
100
50
0
0% 4% 8% 12% 16% 20% 24% 28%
Yield to maturity
Try it: Duration

1. Consider a bond that has a coupon rate of 5 percent, five years remaining to maturity, and is
priced to yield 4%. Assume semi-annual interest.
a. What is the effective duration for this bond?
b. What is the approximate change in price if the yield increases from 4% to 5%?
2. Consider a bond that has a coupon rate of 5 percent, ten years remaining to maturity, and is
G. Summary
In this module, we look at bond valuation and the sensitivity of the bond’s valuation to changes
in interest rates. We explore valuation issues beyond the simple value of a straight coupon bond,
extending the valuation to a non-flat yield curve. We also take a brief look at bond ratings and
the determinants of these ratings, as well as the option-like features of bonds. Further, we look
at the measures of interest rate sensitivity: Macauley, modified, and effective duration measures.
These measures help us gauge the sensitivity of a bond’s value to changes in yields.
LO9.1 List the features of bonds that result in different interst rate patterns and how
these features affect a bond’s valuation.
LO9.2 Calculate the yield to maturity, horizon yield, and yield to call for a bond.
LO9.3 Distinguish between the value of a bond with annual interest v. semi-annual
interest.
LO9.4 List and explain briefly the different explanations for the shape of the yield curve.
LO9.5 Calculate the value of a bond using the yield curve.
LO9.6 Explain how option-like features affect a bond’s value.
LO9.7 Distinguish between an investment grade debt security and a junk bond in terms
of ratings.
LO9.8 Demonstrate through calculations the relation between a bond’s value and its
yield to maturity.
LO9.9 Calculate the Macauley, modified, and effective duration of a bond and the
expected change in a bond’s value for a given change in yield.
LO9.10 Explain and demonstrate how the estimated change in a bond’s value using
duration measures is does not predict the change in value precisely.

3. Module Tasks
Chapter 17, “Bond Yields and Prices,” Investments: Analysis and Management, by
Chapter 18, “Bond Analysis and Strategy,” Investments: Analysis and Management, by
B. Other material
Bond Center Education, Yahoo! Finance
Valuation of Corporate Securities, by StudyFinance.com
Duration, by Financial Pipeline

StudyMate Activity
Investment Mini-Quiz: Bonds, by Learning for Life
Quiz: Bonds, by Smart Money
E. Module quiz
Available at the course Blackboard site. See the Course Schedule for the dates of the quiz
availability.
F. Project progress
At this point, you should have completed all the data gathering and analysis for your
project and a great deal of the write-up.
Focus on your writing, Make sure that all statements are supported with citations, that all
of your graphs are derived from your Excel worksheet, and that you have completed all
required tasks.
4. What’s next?
In this module, we looked at the valuation and risk associated with bonds. In Module 10, we
introduce you to derivatives: options, futures, and forwards. Though derivative instrument have
been around for a long time, the actual traded options and futures contracts and the way in
which investors use these contracts are only a few decades old. Investors use derivatives for
both speculation and hedging. Because derivatives derive their value from some other asset, the
pricing of derivatives is rather complex.

Solutions to Try it problems
Try it: Bond values
1. Suppose a bond is priced to yield 6 percent, with a maturity in five years and a coupon rate of
5 percent. What is this bond’s quoted value?
I = 3%; N = 10; PMT = 2.5; FV = 100
Solve for PV: PV = 95.734899
2. Suppose a bond matures in six years, has a coupon rate of 6 percent, and is priced to yield 7
percent. What is this bond’s quote?
I = 3.5%; N = 12; PMT = 3; FV = 100
3. Suppose a zero coupon bond matures in ten years. If this bond is priced to yield 10 percent,
what is its quoted value?
I = 5%; N = 20; PMT = 0; FV = 100
Try it: Bond yields
1. Suppose a bond is priced at 98, with a maturity in five years and a coupon rate of 5 percent.
What is this bond’s quoted value?
PV = 98; N = 10; PMT = 2.5; FV = 100
Solve for i: I = 2.73126;
YTM = 5.46251%
2. Suppose a bond matures in six years, has a coupon rate of 6 percent, and is quoted at 101.
What is this bond’s yield to maturity?
N = 12; PMT = 3; PV = 101; FV = 100
Solve for i: I = 2.90013;
YTM = 5.80027%
3. Suppose a zero coupon bond matures in ten years. If this bond is priced at 65, what is its yield
to maturity?
N = 20; PV = 65; FV = 100; PMT = 0
Solve for i: I = 2.177279%;
YTM = 4.35456%

Try it: Duration
1. Consider a bond that has a coupon rate of 5 percent, five years remaining to maturity, and is
Yield Value
3% 109.22218
4% 104.49129
5% 100.00000
Effective duration = (109.22218 - 100)/(2 (104.49129) (0.01)) = 4.41289
4.41289 x 0.01 x -1 = -4.41289%
2. Consider a bond that has a coupon rate of 5 percent, ten years remaining to maturity, and is
Yield Value
3% 117.16864
4% 108.17572
5% 100.00000
Effective duration = (117.16864 - 100)/(2 (108.17572) (0.01)) = 7.935533
7.935533 x 0.01 x -1 = -7.935533%
Note: You should get the identical effective duration and price change if you use the dollar value of
the bonds, assuming a $1,000 face value.

Module 10
Derivatives
1. Overview
Derivative securities are investments that draw, or derive, their value from some other
investment. For example, an equity option is a derivative security whose value depends on the
value of the underlying stock for which there is a choice (that is, an option) to buy or sell that
stock. Derivative securities have become important in both protecting the value of an investment
and in speculation. These securities take on many different forms, including forwards (which
are obligations to transact in the future), futures (which are standardized forward contracts),
and options (rights to transact in the future).
The value of a derivative security is complex because it not only depends on the value of the
underlying investment, but also on the characteristics of the particular derivative contract. If the
value of the derivative security in the market is not in line with the value of the underlying asset,
there exists an arbitrage opportunity. Investors taking advantage of these arbitrage
opportunities will keep the values of the derivative in line with that appropriate for the value of
the underlying asset.
A. Options and option-pricing

An option is a contract that gives its owner the right, but not the obligation to conduct a
transaction involving an underlying asset at a predetermined future date and at a predetermined
price (exercise price or strike price). This differs from a futures contract, which is a
commitment to transact in the
future.
A call option is the right to

buy the underlying asset. A
put option is the right to sell
the underlying asset. The buyer
of an option is referred to as
the holder, whereas the seller
of the option is referred to as
the writer. The buyer of the call
option is referred to as having a
long position on the stock,
whereas the writer of a call
option has a short position.
The buyer of a put option has a
position that is similar to a short
position on a stock; the buyer is
hoping that the price of the
underlying asset will fall.

Owners of options pay for the right to buy or sell by paying a premium. Investors take a
position in an option depending on their expectations regarding the change in the price of the
underlying asset:
The buyer of a call option expects the price of the underlying asset to increase.
The buyer of a put option expects the price of the underlying asset to decrease.
The writer of a call option expects the price of the underlying asset to either decrease or
stay the same.
The writer of a put option expects the price of the underlying asset to either increase or
stay the same.
Prior to or at maturity – a.k.a. expiration or expiry – the investor in the option may:
1. Let the option expire worthless;

2. Exercise the option (that is, buy the
asset in the case of a call option or EXAMPLE: CALL OPTION
sell the asset in the case of a put
option); or Consider options on Microsoft stock. On October 28,
3. Sell the option to another investor. 2005, Microsoft common stock had a price of $25.42. at
that time, there were many different call and put options
available with different exercise prices and expirations.
We often refer to options’ moneyness,
which is the relation between the The call option with a January, 2008 expiration and a
exercise price and the price of the strike price of $35.00 was selling for $0.65. This means
underlying. For a call option, that:
Out-of-the-money is when the The intrinsic value of the call option is $0.
asset’s price is less than the The time value of the call option is $0.65 per share.
exercise price. If an investor wants to buy this call option, the
At-the-money is when the asset’s investor must pay $0.65 x 100 = $65 for the right to buy
100 shares of Microsoft common stock at $35 per share
price is equal to the exercise price.
before the option’s expiration in January 2008.
In-the-money is when the asset’s If you want to write a call option, you would receive
price is greater than the exercise the $65 and be committed to sell 100 shares of the stock
price. at $35 per share if the option buyer chooses to exercise
this option.
For a put option,
Let’s say that the price of Microsoft stock rises to $37 per
Out-of-the-money is when the share and the investor exercises the option. The
asset’s price is greater than the investor’s profit is:
exercise price.
Value of stock $3,700
At-the-money is when the asset’s Purchase price 3,500
price is equal to the exercise price. Call premium 65
In-the-money is when the asset’s Profit $ 135
price is less than the exercise price.
From the call writer’s viewpoint,
The value of an option has two
components: Proceeds $3,500
Purchase price 3,700
Call premium 65
1. the intrinsic value, what it is
Profit -$135
worth if exercised immediately,
and If the price of Microsoft stock rises to only $30 per share,
2. the time value, which is the the investor does not exercise the option. The investor’s
present value of the expected loss is $65 and the writer’s gain is $65.

increase in the value of the option prior to expiry.
The option’s intrinsic value is the value realized from immediate exercise. Let S0 be the current
stock price and let E be the exercise price. The intrinsic value for a call option is the maximum of
S0-E or 0, whereas the intrinsic value of a put option is the maximum of E-S0 or 0. In other
words, an option will have intrinsic value different from zero if it is in-the-money.
An option’s time value is the amount by which the option premium exceeds the option’s intrinsic
value:
Time value = options price – intrinsic value
The time value depends on the amount of time remaining to expiry and the volatility of the
underlying asset’s value.
Options can be written on just about any asset. Consider the following options:
TYPES OF OPTIONS
Equity options Options on the stock of individual companies.
Stock index options Options are traded on many different indexes (e.g. S&P 100 (OEX)).
One difference between options on stocks and those on stock indexes:
options on stock indexes are settled in cash.
Foreign currency Contracts are for the sale or purchase of a specified amount of foreign
options currency at a fixed exchange rate. A currency call option gives the
holder the right to buy the currency at a later date at a specified
exchange rate.
Options on futures An option on a futures contract gives the holder the right to enter into
a futures contract at a later date and at a predetermined price.
Trading in options takes place in over-the-counter markets and on exchanges. Organized

exchanges may specialize in options on stocks and stock indexes (e.g., Chicago Board Options
Exchange). The Options Clearing Corporation (OCC) acts as a clearinghouse for CBOE
contracts, guaranteeing the writer’s performance.
Example of options exchanges include:
Chicago Board Options Exchange (CBOE)

Philadelphia Stock Exchange
American Stock Exchange
Pacific Exchange
London International Financial Futures and Options Exchange
Tokyo Stock Exchange
Exchanges are self-regulated, but there are a number of protections built into our financial
system to protect investors provided by:
Options Clearing Corporation

Securities and Exchange Commission
Federal Reserve System
Securities Investor Protection Corporation
National Association of Securities Dealers

i) Models used to value an option
Option valuation is not as straight-forward as, say, bond valuation. The value of an option
depends on several elements:
The exercise price of the option.

The time value of money.
The current price of the underlying asset.
The probability that the underlying asset’s price will change in the future.
The time remaining to expiration of the option.
There are many models that may be used to value an option. The two most widely used models
are:
a) The binomial option pricing model a.k.a. binomial lattice or binomial tree
b) The Black-Scholes option pricing model.
These models differ in complexity and the assumptions. The models use the characteristics of the
option contract, the value of the underlying asset, and assumptions about how prices of the
underlying change through time to estimate the option’s price.
To explore these two methods of valuing an option, please click on the buttons below.
(a) Binomial option pricing model

A binomial option pricing model is a method of determining the value of an option given that
there are two – and only two -- possible outcomes or scenarios in any given period. We use the
binomial option pricing model as an introduction to the basics of options: How an option takes on
a value, given the price of the underlying asset. To use binomial option pricing, we must draw a
tree diagram that details the paths of the underlying asset’s price and the call option’s value.
We construct the tree by first laying out the tree given the possible paths that the stock price
may follow and then use backward induction to determine the value of a call option on that
stock. 1,2
Consider an option that has an exercise price, E, of $25 and a current price, S, of $20. Also
consider the following:
The risk-free rate is 5%.

The percentage change in the stock’s price in an up movement is 60%.
The percentage change in the stock’s price in a down movement is 40%.
The probability of an “up” movement, p.
1 See, for example, Richard J. Rendleman, Jr., and Brit J. Baxter, “Two State Option Pricing,” Journal of
Finance, Vol. 34, No. 5 (December 1979) pp. 1093-1110 and John C. Cox and Mark Rubinstein, “ Option
Pricing: A Simplified Approach,” Journal of Financial Economics, Vol. 7, No. 3 (September 1979) pp. 229-
264.
2
In the end, you’ll be able to see that backward induction is simply common sense: Once we know what
the underlying asset’s prices may be, we will know what the possible values of the call option may be also.

USING THE BINOMINAL OPTION PRICING MODEL
The probability of an up movement is
derived from the idea that prices move Step 1
according to a random walk. This Calculate the stock prices at each node in the
probability is determined using tree, using the u and d
information about the risk free rate, the
upward and downward movements and
following formula: Step 2
Value the call option at the end of the second
p=(r-d)/(u-d) period stock prices
where
r = 1 + risk-free rate of interest,
u = 1 + percentage change in the price
Step 3
in the up movement, and
Value the call option at the end of the first
d = 1 + percentage change in the price period, discounting the call option values and
in the down movement. weighting by the probabilities associated with
each branch
Using the provided information on r, d,
and u, the probability of an upward
movement in the example is 45%:
Step 4
Value the call option today by discounting the
p = (1.05-0.6)/(1.6-0.6) =0.45 value of the call option at the end of period
one and weighting by the probabilities
and the probability of a downward
movement is the complement, or 55%:
(1-p) = 0.55
We can map out the stock price paths using the following steps:
Step 1: Calculate the stock prices at each node in the tree, using the u and d
Therefore, the stock price in the up possibility, Su, is $20 (1 + 0.60) = $32. Similarly, the stock
price in the down movement is Sd = $20 (1 – 0.40) = $12. The stock price in the possibility of
two periods in a row of up markets, Suu, is $20 (1 + 0.60)2 = $51.2; whereas the worst case
situation, in which the price goes down two periods in a row, is $20 (0.6)2 = $7.2.
Stock price tree

.2
=$51 $51.2
(1.6)
$32
$32
=$ 32
(1.6) $32 (0.6)=
$19.2
$2 0
$19.2
$20 $ 20
(0.6
)=$1
2
$12 (1.6)=$ 19.2 $19.2
$ 12
(0.6)
$12 =$ 7 .
2
$7.2

Step 2:Value the call option at the end of the second period stock prices
Given the stock price tree, we can value the call option on the stock, starting at the end of the
second period and working backward to the present:
Call option value tree
$26.2
$0
$0
$0
If the stock’s price is $51.2 at the end of the second period, the value of the option is $51.2 – 25
= $26.2. If the stock’s price is anything less than or equal to $25 at the end of the second
period, the value of the call option is $0.
The value of the call at the end of the second period is the maximum of $0 and S – E. For
example, in the Suu position, the value of the call is $51.2 – 25 = $26.2, whereas in the Sdd
position, the value of the call is $0 because the stock price is not above the exercise price.
Step 3: Value the call option at the end of the first period, discounting the call option values and
weighting by the probabilities associated with each branch:

[(0.45) $26.2 + (0. 55)$0 ] / 1.05
$26.2
$11.2286
$0
C
$0
$0
$0
We discount the value of the call options, weighing the each call option’s value by the probability
of the movement (up or down). Because there is only one case in which the call option has an
intrinsic value in this example, the calculation is rather straight-forward.
Step 4: Value the call option today by discounting the value of the call option at the end of
period one and weighting by the probabilities

$26.2
$11.2286
$0
$4.81
$0
$0
[(0.45) $11.2286 + (0. 55)$0 ] / 1.05 $0
Therefore, the value of the call option is $4.81.
As you can see, the value of the call option depends on the value of the underlying asset at the
end of the period. In many scenarios the call option expires worthless. It is the possibility that
the call option has value at expiration – in this case in the event of two up-movements (the path
Suu) – that gives the call option value today.
(b) Black-Scholes option pricing model

The binomial model can assist us in determining the value of an option if we assume a simple
world with few, discrete time periods. But when we make things more realistic, we need a more
powerful model to value an option. The Black-Scholes model, developed by Fischer Black and
Myron Scholes, provides us with a tool to value a call option. 3
The Black-Scholes model requires five inputs
1. Exercise price of the option, E

2. Price of the underlying asset, S
3. Risk-free rate of interest, r
4. Volatility of underlying asset’s price,
5. Time to expiration,T
According to the Black-Scholes model, the value of a call option, C, is:

-rT
C = S N(d1 ) -E e N(d2 )
where
2
ln(S/E)+ r+ T
2
d1 =

T
d2 = d1 - T
Suppose you have the following information regarding an option:
3 Fischer Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of Political
Economy, Vol. 81, No. 2 (May-June 1973) pp. 637-654.

Parameter Value
Value of the underlying asset S $40
Exercise price of the option E $35
Time remaining to maturity T 3
Risk free rate r 5%
Volatility 40%
What is the value of the option using the Black- USING THE BLACK-SCHOLES OPTION
Scholes model? PRICING MODEL
Step 1: Calculate the values of d1 and d2 Step 1

3 Calculate the value of the d1

ln($40/$35)+ 0.05+
0.16 and d2 parameters.

d1 =
2
0.4 3
Step 2
0.1335+0.39 Calculate the cumulative
d1 = =0.7557 normal probability values for d1
0.6928 and d2.
d2 = 0.7557 - 0.4 3=0.0629

Step 3
Step 2: Calculate the values of N(d1) and Calculate the value of the
N(d2), using a normal density function option using the formula for
table the value of a call option
N(d1) = 0.7751 N(d2) = 0.5250
We can use either a cumulative normal density function table or the Microsoft Excel® function
NORMDIST:
NORMDIST(x,mean,standard_dev,cumulative)
For example,
=NORMDIST(.7751,0,1,TRUE)
Step 3: Calculate the value of the option using the formula for the value of a call
option.
The value of the option, C, is $15.1885:
C = $40 (0.7751) -$35 e-0.05(3) (0.5250)
C = $31.0040 - $15.8155
C = $15.1885
If we look at the value of the option for different values of the underlying asset’s value, we see
the following:

$35
Value of the option
$30
$25
Value of the $20

call option
(C) $15
$10
$5
$0
$13
$17
$21
$25
$29
$33
$37
$41
$45
$49
$53
$57
$1
$5
$9
Asset price (S)
The option has value at all asset prices (albeit a small option value) because of the potential for
the underlying asset’s price to increase in value in the future. The change in the value of the
option for a given change in the asset’s price depends
on the value of the asset’s price: the change in the
value of the option per $1 change in the asset’s price
is greater for lower prices of the asset than for larger Try it
values of the asset.
Check out the option valuation program.
The most challenging input to the Black-Scholes model All you need to do is input the option’s:
is volatility. 4 We estimate volatility by using either
Exercise price
historical volatility or an implied volatility. The Underlying price
estimate of historical volatility requires examining Time to maturity (in years; e.g., 6
historical prices of the underlying asset and calculating months is .5)
the annualized standard deviation of these historical Risk-free rate of interest (in decimal
prices. Implied volatility requires looking at call form; e.g., 4% is entered in as 0.04)
prices of calls on the same underlying (but for Volatility (in decimal form; e.g., 40%
different expiration and exercise prices) and working per year is 0.40)
backward to see what standard deviation is implied
The option’s value is calculated for you.
given the market value of those calls. 5
Though the Black-Scholes

Relation to the value of a …
model is quite useful in
call option put option
estimating the value of an
Value of the underlying
asset
S + option, it cannot handle
dividend-paying stocks very
Exercise price of the option E + well. However, there are
Time remaining to maturity T + + models, such as that
developed by Robert Merton,
Risk free rate r + that incorporate cash flows,
Volatility + + such as dividends. 6 A
further difficulty of the Black-Scholes model is that it does not incorporate transactions costs or
taxes.
4
For a review of the issues involved when estimating volatility, see Stewart Mayhew, “Implied Volatility,”
Financial Analysts Journal, Vol. 51, No. 4 (July-August 1995) pp. 8-20.
5
The calculation of implied volatility is beyond the scope of this module.
6
Robert C. Merton, “The Theory of Rational Option Pricing,” Bell Journal of Economics and Management
Science (Spring 1973) pp. 141-183.

In some applications, it is difficult to estimate the inputs. In the case of an option on a traded
stock, there is generally no problem in estimating the five inputs. However, in other applications,
such as when the underlying is not traded in an active market, it may be difficult to estimate the
inputs.
ii) Option strategies

Options may be used for many purposes, including reducing risk of a particular investment or
betting on future movements in the price of the underlying asset.
Key to developing an option strategy, for whatever purpose, is understanding the sensitivities of
options to the characteristics of the option (e.g., time to expiration). And before we consider
different strategies, we also need to understand the relation that exists between puts and calls,
and how to calculate the payoffs from strategies.
The value of an option, whether we are using a binomial model or a Black-Scholes model, is
affected by changes in one of the five inputs. For example, if the price of the underlying
increases, the value of the option changes also. The sensitivity of an option’s value to changes in
the parameters is casually referred to as the “Greeks” because we represent the sensitivities with
Greek letters.
The “Greeks” of Options

Delta, * Change in the price of an option for a one unit change in the
price of the underlying asset
Kappa, + a.k.a. Vega Change in an option’s price to changes in the volatility of the
underlying asset
Rho, Change in an option’s price to a change in the risk-free rate of
interest
Gamma, , Rate of change of * as the underlying stock price changes
Theta, - Change in an option’s price to the passage of time
The sensitivity of the change in the price of the option to a change in the value of the underlying,
delta, is also referred to as the hedge ratio. We refer to it by that name because we use the
delta in designing a hedge to eliminate a risk associated with the change in the value of the
underlying asset.
Consider the option that we valued earlier that has a current value of $15.1885 when the stock’s
price is $40. If the stock’s price were to move to $41, the value of the option, using calculation
like we did before, would be $15.9662. The delta on this option is:
$15.9662-15.1885
= =0.7777
$41-40
As you can see by looking at the graph of the option’s value relative to the stock’s price, delta is
different for different stock prices. For example, for this same option, if the price of the stock
changes from $20 to $21,
$3.2349-2.8178
= =0.4170
$21-20
We can graph the delta to see how the value changes depending on the price of the underlying
asset:

1.0
0.9 Delta
0.8
0.7
0.6
Delta 0.5
0.4
0.3
0.2
0.1
0.0
3
7
1
5
3
7
1
5
9
7
$1
$5
$9
$1
$1
$2
$2
$2
$3
$3
$4
$4
$4
$5
$5
Stock price (S)
Delta is close to zero when the underlying asset’s price is low, but approaches 1.0 as the
underlying asset’s price increases.
(a) Put-call parity

There is a relation between the value of a call option and the value of a put option. We refer to
this relation as the put-call parity relationship.
This means that buying a call option (that is, “long call”), plus writing a put (that is, “short put”)
must be equivalent in value to investing in the stock in the cash market and borrowing to buy
this investment. 7 If this relation does not hold, there would be arbitrage opportunities between
the cash (i.e., spot) market and the options market. 8
Let P indicate the value of the put option, C the value of the call option, S the current (spot) price
of the underlying asset, r the risk-free rate of interest, and T the time to maturity. The put-call-
parity relation is that:
Buying a call option Buying the stock
& &
Writing a put option Borrowing the funds
or
C – P = S - E e-rT
which is Algebraically equivalent to
P + S = C + E e-rT
and
P = C - S + E e-rT
7
Borrowing the present value of the underlying asset is E/erT = E e-rT. This calculation uses continuous
compounding (hence, Euler’s “e”).
8
An arbitrage opportunity exists when an investor can buy an asset in one market and sell the asset in
another market simultaneously and make a profit.

This is a very convenient relationship because we can use it to solve for the value of a put option
once we have calculated the value of a call option. In our example in which the stock is trading
for $40 and the exercise price is $35, the option has a value of $15.1885. This implies that the
value of the put is:
P = $15.1885 - $40 + $35 (e-0.05(3))
P = $15.1885 - $40 + $30.1248
P = $5.3133
The put-call parity relation is useful in creating a synthetic security, which is the creation of
the equivalent of one security out of combinations (buying/selling) of the others. For example,
you can create a synthetic put by buying a call, selling the stock, and lend the proceeds of the
stock sale.
(b) Option strategies

There are many option strategies that are available to investors; too many to discuss in this
module. However, we’ll look at some of the more common strategies in this section.
We evaluate strategies by evaluating the conditions in which they are profitable. A convenient
device to evaluate strategies is to use payoff diagrams, which are charts that indicate the profit
or loss for different values of the underlying asset.
For example, the payoff diagram for a strategy of buying a call option for $2 that has an exercise
price of $20 is:
$20
$15 Payoff for call buyer

Payoff for call writer
$10
$5
Profit
or $0
loss
-$5
-$10
-$15
-$20
$1 $4 $7 $10 $13 $16 $19 $22 $25 $28 $31 $34 $37 $40
Price of the underlying
The maximum loss for the call buyer is $2 and the maximum gain for the call writer is $2. If the
price of the underlying stock is $30, the profit for the call buyer is $30-20-2 = $8 and the loss for
call writer is $30-20+2 = $8.
The payoff for a put option follows a similar symmetry with respect to the writer and the buyer of
the option. Consider a put option that has a premium of $2 and an exercise price of $20.

$20
$15 Payoff for put buyer

Payoff for put writer
$10
$5
Profit
or $0
loss
-$5
-$10
-$15
-$20
$1 $4 $7 $10 $13 $16 $19 $22 $25 $28 $31 $34 $37 $40
Price of the underlying
In the case of the put option, the buyer of the option makes a profit when the price of the
underlying is less than the exercise price minus the premium. The writer of the put option, on
the other hand, makes a profit of the put premium when the price of the underlying is at or
above the exercise price of $20.
Consider the following sampling of option strategies:
Long straddle. A long straddle is one in which the investor purchases both a put and a call
option for the same underlying, for which the exercise price is the same. The investor uses
this strategy if he/she expects the price to change in either direction.
Consider a straddle in which the investor buys one call option with an exercise price of $20
for $2, and buys one put option with an exercise price of $20 for $2. The payoff is:
$18
$14
Break-even
$10 prices
Profit
or $6
loss
$2
-$2
-$6
$1
$3
$5
$7
$9
$11
$13
$15
$17
$19
$21
$23
$25
$27
$29
$31
$33
$35
$37
$39
Price of the underlying stock
The maximum loss is $3.50 if the price is at $20 – the investor has paid for both options, but
would not exercise them at $20. There is profit once the price of the underlying either falls
below $20-2-2 = $16 or above $20+2+2 = $24.
To see how the payoff is determined for a strategy, we calculate the payoff for each part of
the strategy and then sum the payoffs. In the straddle strategy, we can calculate the payoff
for the call and the put separately, and then sum these:

Profit or loss on
call with an Profit or loss on put
Price of the exercise price of with an exercise Profit or
underlying $20 and a cost of price of $20 and a loss on the
asset $2 cost of $2 strategy
$11 -$2 $7 $5.00
$12 -$2 $6 $4.00
$13 -$2 $5 $3.00
$14 -$2 $4 $2.00
$15 -$2 $3 $1.00
$16 -$2 $2 $0.00
$17 -$2 $1 -$1.00
$18 -$2 $0 -$2.00
$19 -$2 -$1 -$3.00
$20 -$2 -$2 -$4.00
$21 -$1 -$2 -$3.00
$22 $0 -$2 -$2.00
$23 $1 -$2 -$1.00
$24 $2 -$2 $0.00
$25 $3 -$2 $1.00
$26 $4 -$2 $2.00
$27 $5 -$2 $3.00
$28 $6 -$2 $4.00
$29 $7 -$2 $5.00
Short straddle. A short straddle is one in which the investor sells both a put and a call
option for the same underlying, for which the exercise price is the same. The investor uses
this strategy if he/she does not expect the price to change much if at all. Consider a short
straddle that involves writing a put and call, both with an exercise price of $20 and a
premium of $2:
$18
$14
$10
$6
Profit
$2
or
-$2
loss
-$6
-$10
Break-even
-$14
prices
-$18
$1
$3
$5
$7
$9
$11
$13
$15
$17
$19
$21
$23
$25
$27
$29
$31
$33
$35
$37
$39
The investor only makes a profit if the underlying stock’s price falls between $16 and $24.
Long strangle. A long strangle is one in which the investor purchases both a put and a call
option for the same underlying, for which the exercise price of the call is greater than the
exercise of the put. The investor uses this strategy if he/she expects the price of the
underlying to change in either direction. The investor would use a strangle instead of a
straddle the greater the movement expected in the underlying asset’s price.

Consider a strategy of buying a call option with an exercise price of $22 for $2 and a put
option with an exercise price of $20 for $2. This strategy is profitable if the underlying
asset’s price is less than $16 or greater than $26.
$18
$14
Break-even
$10 prices
Profit
or $6
loss
$2
-$2
-$6
$1
$3
$5
$7
$9
$11
$13
$15
$17
$19
$21
$23
$25
$27
$29
$31
$33
$35
$37
$39
Long butterfly. A long butterfly is a strategy that requires buying a call option with one
exercise price, E1, buying a call option with some other exercise price, E3, and selling two
calls with an exercise price between that of the two purchased calls, E2; hence, E1 < E2 < E3.
The investor creates a butterfly spread if he/she expects the underlying asset’s price not to
deviate substantially from E2.
Consider the strategy of buying a call option with an exercise price of $50 for $8 and a call
option with an exercise price of $70 for $2, as well as writing two calls with an exercise price
of $60 for $4. This strategy produces a profit as long as the underlying asset’s price is
between $52 and $68: 9
9
How do you determine the profit on the strategy? You calculate the profit of each individual
strategy for each price of the underlying asset and then sum. If the underlying asset’s price is
$60, the profit or loss from this strategy is $2 – 2 + 4 + 4 = $8. If the underlying asset’s price is
$60, the profit or loss is -$8 – 2 + 4 + 4 = -$2

$10 Maximum profit of $8
$8
$6
Profit $4 Break-even @ $52 Break-even at $68

or
loss $2
$0
-$2
-$4
$20 $26 $32 $38 $44 $50 $56 $62 $68 $74 $80 $86 $92 $98
Price of the underlying asset
Covered call. If an investor writes a call on an asset but does not own the asset, this is
referred to as a naked call. A covered call is the situation in which the investor owns the
underlying and writes a call (that is, is short the call). The investor uses this strategy if
he/she does not expect the price to move, yet wants to collect the option premium. The
payoff for a covered call is similar to writing a put option.
There are other strategies that investors use beyond those that we have mentioned. When
developing a strategy, it is important to understand the motivation for the strategy (e.g.,
reducing risk, expect that the asset’s value will increase, or expecting the asset’s value not to
change) and the possible payoffs for different possible values of the underlying asset.
B. Forwards and Futures

Forwards and futures are types of derivative securities. A forward contract is a contract that
gives the contract holder the right and the legal obligation to conduct a transaction for a
specified quantity of an asset at a specific time in the future. A futures contract is a
standardized forward contract.
Futures are traded on exchanges (e.g., Comparison: Forwards v. Futures

Chicago Mercantile Exchange). Trading is Forwards Futures
done using the open outcry method, Private contracts Trade on organized
referred to as pit trading, or Contracts have exchanges
electronically (e.g., on GLOBEX). Traders default risk Standardized terms
of forwards and futures are either Do not require Performance
cash at inception guaranteed by
hedgers, who are reducing their risk
Not regulated clearinghouse
exposure, or speculators, who are
Require traders to post
betting on the future price of the margin money
underlying asset. Regulated by the
government
The underlying asset in the case of
futures and forwards may be commodities (such as metals, energy, or agricultural products) or
financial (such as foreign currencies, debt, and equities).
A futures contract identifies:

the underlying asset and the quality of the underlying asset, and
the quantity of the underlying.

The exchange on which a futures contract is traded
specifies:
the minimum price fluctuation (i.e., the tick size), FUTURES IN THE MOVIES
and
the maximum prices limits are set by the exchange. In the 1983 movie “Trading Places”,
starring Eddie Murphy, the Duke
brothers attempted a scheme to use
Consider frozen orange juice futures traded on the New the USDA crop report information that
York Board of Trade. The contract for 15 thousand they obtained illegally to make profits
pounds of frozen orange juice for delivery in January in orange juice futures contracts.
2006 was trading for $12,050, or 80.333¢ per pound on
October 28, 2005. Just two weeks earlier, prior to
Hurricane Wilma, the same contract was selling for $10,465, or 69.767¢ per pound. The futures
prices are a good predictor (on a discounted basis) of the spot prices in the future. The futures
prices change as expectations about the supply and demand for the underlying asset change.
i) Hedging
Hedging is the reduction or elimination of risk associated with an asset position. A hedger has
some type of risk exposure in the spot market for the asset. For example, the grapefruit grower
is exposed to risk of price fluctuations during the growing season through the harvest.
The different types of positions that a hedger may take include:
A short hedge is performed by selling futures.

A long hedge is performed by buying futures.
A cross-hedge is the use of a futures contract on an asset that is similar, but not identical
from the risky asset to be hedged.
The grower of orange juice would want to sell futures contracts, delivering the orange juice at
the expiration of the contract. 10 The producer and marketer of orange juice would want to buy
the future contract, locking in the price it pays to buy the orange juice at the expiration of the
contract.
The hedge ratio is the number of futures contracts to hold for a given underlying cash market
position:
Futures position
Hedge ratio =
Cash market position
An investor who wishes to hedge a position will use the hedge ratio to determine how many
futures contracts are needed to properly hedge the spot position.
ii) Arbitrage
The spot price is the price of the good today. The futures price is the price agreed upon for
the delivery of the good at a future point in time. The basis is the difference between the spot
or cash price of the asset and the futures price:
Basis = spot price – futures price
10
In the case of agricultural commodities, the farmer or grower will want to focus on expiration dates that
are close to the harvest or slaughter dates.

The basis is a function of the time to maturity, costs of financing, and physical storage costs.
The normal situation is that the basis is negative. That is,
Oil Futures: What they tell us
spot price < futures price
If you bought a futures contract on Brent crude Oil,
for deliver June 2007 on July 10, 2006, the cost of
and that the basis converges to zero at the contract is $75.21 per barrel [per Yahoo!
maturity. Finance].
There is no arbitrage opportunity if: On the same day, the spot price for Brent crude oil
was $73.99 [per WTRG Economics]. This means
F = S (1 + c) that the basis is -$1.22. It is expected that the spot
price of oil will converge upon $75.21 by June
where
2007. In other words, investors expect the price to
increase in the next year.
F is the price of the futures,
S is the price of the spot, and
c is the carrying cost.
Suppose the spot price of silver is $3.00 per ounce. And

Example: Cash-and-Carry
suppose that the price of a futures contract on silver Arbitrage
delivered in one year is $3.50. If the cost-of-carry is
10%, is there an arbitrage opportunity? Yes. Spot price of crude oil = $70
Futures price of crude oil =
$3.50 $3.00 (1+0.10) $80
Cost of carry = 10%
We exploit the arbitrage opportunity by buying what is
relatively underpriced and selling what is relatively Now
overpriced. How do we know which is under and over Borrow $70.00 at 10%
priced? Compare the two ways to invest: buy the Buy crude oil at $70.00 today
futures contract or borrow to buy the spot for cash. Sell the futures contract (for
Which is relatively cheaper? To see this, examine the sale of crude oil @ $80 in the
pricing in the silver contract. The futures price is $3.50 future)
and borrowing to buy the silver in the cash market is
$3.30. In other words, the futures contract is over Cash flow: $70.00 – 70.00 = $0
priced relative to the cash market:
Later
$3.50 > $3.30 Pay back the loan: $70 + (10%
x $70)
Cost in the future market > Cost in the cash market Sell the crude oil at $80
So, we would want to sell the futures contract and buy Cash flow (profit): $80 – 70 -
the silver in the spot market. This is referred to as a (10% x $70) = $3
cash-and-carry arbitrage because we get the cash
and “carry” the underlying. A reverse-cash-and-carry arbitrage (sell short the underlying
asset and buy the futures contract) would be used if the futures contract were underpriced
relative to the cash market.
LO10-1 Distinguish between a call option and a put option on a stock and between writing an
option and buying and option and identify which options would be appropriate to use
depending on an investor’s expectations and objectives.
LO10-2 Explain the role of arbitrage in markets.
LO10-3 Relate the price of an option to the payoff from the option strategy.

LO10-4 List the determinants of an option’s value, relating each to an option’s value, and identify
these determinants for traded options.
LO10-5 Draw and label a binomial tree for a two-period binomial option and value the option.
LO10-6 Analyze the role of each variable in the Black-Scholes option pricing model and calculate
the value of an option using this model.
LO10-7 Draw and label a payoff diagram for strategies involving options.
LO10-8 Analyze the role of a covered position in options and determine payoffs from uncovered
and covered positions.
LO10-9 For a given forward or futures contract, identify whether an arbitrage opportunity exists
and, if so, design a strategy to exploit that opportunity and compute the arbitrage
profits.
3. Module Tasks
Chapter 19, “Options,” Investments: Analysis and Management, by Charles P. Jones,
9th edition.
Chapter 20, “Futures,” Investments: Analysis and Management, by Charles P. Jones,
9th edition.
B. Other material
Options basics, from the CBOE.
Class: Options Pricing, Chapters 1 through 3, by the Options Industry Council
Flash quiz on option payoff diagrams.

Option pricing problems, prepared by Pamela Peterson Drake
StudyMate Activity
E. Module quiz
quiz availability.
F. Project progress
Project is due by Midnight, August 4thth.
4. What’s next?
The final exam.

FIN4504 Problem sets Page 1 of 2
Studymate problem Problem sets

sets
z Tax equivalent yield calculations
z Module 1 z U. S. Treasury bill yield calculations
z Module 2 z Trading on margin
z Module 3 z Short selling
z Module 4 z Market indices
z Module 5 z Portfolio risk
z Module 6 z Duration
z Module 7 z Option pricing and the accompanying option pricing
z Module 8 worksheet
z Module 9
z Module 10
http://educ.jmu.edu/~drakepp/investments/problems.htm 2/28/2011
FIN4504 Problem sets Page 2 of 2

Module 1 http://educ.jmu.edu/~drakepp/investments/problems/mod1.htm
Tax equivalent yield
http://educ.jmu.edu/~drakepp/investments/problems/tax_equivalent_yield.pdf
calculations
U. S. Treasury bill
http://educ.jmu.edu/~drakepp/investments/problems/yields_on_tbills.pdf
yield calculations
Trading on margin http://educ.jmu.edu/~drakepp/investments/problems/trading_on_margin.pdf
Short selling http://educ.jmu.edu/~drakepp/investments/problems/short_selling.pdf
Market indices http://educ.jmu.edu/~drakepp/investments/problems/market_indices.pdf
Portfolio risk http://educ.jmu.edu/~drakepp/investments/problems/portfolio_risk.pdf
Duration http://educ.jmu.edu/~drakepp/investments/problems/duration.pdf
Option pricing http://educ.jmu.edu/~drakepp/investments/problems/option_pricing.pdf
option pricing
http://educ.jmu.edu/~drakepp/investments/problems/OPM.xls
worksheet
http://educ.jmu.edu/~drakepp/investments/problems.htm 2/28/2011
Tax-equivalent yield calculations
A problem set prepared by Pamela Peterson Drake, Florida Atlantic University
Tax-exempt yield
Taxable equivalent yield =
(1 - marginal tax rate)
1. Suppose the yield on a taxable fund is 1.50 percent, whereas the yield on a tax-free fund
is 1 percent. The investor’s marginal tax rate is 28 percent.
a. What is the tax-equivalent yield?
b. Which would the investor prefer: the tax-free fund or the taxable fund?
2. How much you would need to earn on a taxable bond to equal your 6 percent after-tax
rate that you can earn on municipal bonds if your marginal tax rate is 27 percent?
3. What is the yield on a tax-exempt municipal bond that is equivalent to a 6% yield on a
taxable bond if your marginal tax rate is
a. 25%?
b. 35%?
4. Suppose you are subject to both a federal income tax rate of 35% and a state income
tax rate of 5%. If you can earn 5% on a tax-exempt security, what is the equivalent
taxable equivalent yield?
5. Complete the following table with taxable equivalent yields:
Marginal tax rate

Tax-exempt yield
25% 30% 35%
3%
4%
5%
6%
Tax-equivalent yield calculations 1 of 2

Solutions
1.
a. 1 / 0.72 = 1.38%
b. Tax-equivalent yield is 1.38 percent; the taxable fund, at 1.50 percent, would be
the better deal.
2. 6% / (1-0.27) = 8.225%
3. Taxable equivalent yield (1 - marginal tax rate) = Tax-exempt municipal yield
a. 6% (1-0.25) = 6% (0.75) = 4.5%

b. 6% (1-0.35) = 6% (0.65) = 3.9%
4. 5% / (1 – 0.35 - 0.05) = 5% / 0.60 = 8.333%
5.
Marginal tax rate
Tax-exempt yield
25% 30% 35%
3% 4.000% 4.286% 4.615%
4% 5.333% 5.714% 6.154%
5% 6.667% 7.143% 7.692%
6% 8.000% 8.571% 9.231%
Tax-equivalent yield calculations 2 of 2

U. S. Treasury bill yield calculations
A problem set prepared by Pamela Peterson Drake, Florida Atlantic University
Formulas
⎛ face value - purchase price ⎞ ⎛ 360 ⎞

Discount-basis yield = ⎜ ⎟ ⎜ number of days to maturity ⎟
⎝ face value ⎠⎝ ⎠
⎛ face value - purchase price ⎞ ⎛ 365 ⎞

Investment yield = ⎜ ⎟ ⎜ number of days to maturity ⎟
⎝ purchase price ⎠⎝ ⎠
1. For each of the following Treasury Bills, calculate the discount basis yield and the investment
yield:
Discount Investment
T-Bill Maturity Price per $100 basis yield yield
A 28-day 99.7667
B 91-day 99.2480
C 182-day 98.3190
D 14-day 99.8769
E 91-day 99.2214
F 182-day 98.4631
2. Suppose the investment yield on a 182-day T-bill is 4%. What is its discount-basis yield?
U. S. Treasury bill yield calculations 1 of 2

Solutions
1.
Discount Investment
T-Bill Maturity Price per $100 basis yield yield
A 28-day 99.7667 3.000% 3.048%
B 91-day 99.2480 2.975% 3.039%
C 182-day 98.3190 3.325% 3.429%
D 14-day 99.8769 3.165% 3.213%
E 91-day 99.2214 3.080% 3.147%
F 182-day 98.4631 3.040% 3.130%
Example: T-Bill A
⎛ $100 - 99.7667 ⎞ ⎛ 360 ⎞

Discount-basis yield = ⎜ ⎟⎜ ⎟ = ( 0.002333 ) (12.85714 ) = 2.99957%
⎝ $100 ⎠ ⎝ 28 ⎠
⎛ $100 - 99.7667 ⎞ ⎛ 365 ⎞

Investment yield = ⎜ ⎟⎜ ⎟ = (0.00233846 ) (13.035714 ) = 3.04835%
⎝ $99.7667 ⎠ ⎝ 28 ⎠
2. First, solve for the purchase price of the T-bill, given the investment rate and the days to
maturity:
⎛ $100 - P ⎞ ⎛ 365 ⎞ ⎛ $100 - P ⎞

⎜ ⎟ ⎜ 182 ⎟ = ⎜ ⎟ (2.005495 ) = 4%
⎝ P ⎠⎝ ⎠ ⎝ P ⎠
Solve for P in
⎛ $100 - P ⎞ 0.04
⎜ ⎟ = 2.005495
⎝ P ⎠
using Algebra:
⎛ 0.04 ⎞
$100 − P = ⎜ ⎟ P
⎝ 2.005495 ⎠
⎡ ⎛ 0.04 ⎞ ⎤ ⎛ 0.04 ⎞
$100 = ⎢ ⎜ ⎟ P ⎥ + P = ⎜ 1+ ⎟ P
⎣ ⎝ 2.005495 ⎠ ⎦ ⎝ 2.005495 ⎠
$100 = 1.019945 P
P = $98.044483
Second, solve for the discount-basis yield:
⎛ $100 - 98.044483 ⎞ ⎛ 360 ⎞

Discount-basis yield = ⎜ ⎟⎜ ⎟ = (0.019555 )(1.978022 ) = 3.86802%
⎝ $100 ⎠ ⎝ 182 ⎠
U. S. Treasury bill yield calculations 2 of 2

Trading on margin
A problem set prepared by Pamela Peterson Drake
Formulas
Equity = Value of shares in account - loan
Profit or loss from = proceeds commission cost of commission interest

buying on margin from sale on sale shares on purchase on loan
profit or loss
Return on margin account =
initial equity
Problems
1. Suppose you buy 1000 shares of General Motors (GM) stock at $36 per share, for a total
purchase price of $36,000. And suppose you deposit $18,000 to meet the 50% margin
requirement, borrowing the remainder. Suppose that the maintenance requirement is
30%.
a. What is your initial equity?
b. What is your equity in the account if the stock’s price rises to $40 per share?
c. What is your equity in the account if the stock’s price falls to $30 per share?
d. What is the minimum value of the securities before there is a margin call on your
account?
2. Suppose you buy 200 shares of stock that is currently trading for $100 per share. And
suppose you buy this stock using a 50% margin, borrowing $10,000 of the purchase
price of $20,000. If the stock pays no dividend, you incur a 1% commission when
buying and selling the stock, and the margin loan is at a rate of 8% per year, what is the
return on your investment if you sell the shares after one year at:
a. $125 per share?
b. $100 per share?
c. $90 per share?
Trading on margin problem set 1 of 2

Solutions
Hints:
You make a profit on margin trading when the price of the stock rises by more than the
amount of any commissions and interest on the margin loan.
The return on trading on margin is always relative to the investment, which is the price
of shares less any margin loan amount.
1.
a. $36,000 – 18,000 = $18,000
equity in account = $18,000 / $36,000 = 50%
b. $40,000 – 18,000 = $22,000

c. $30,000 – 18,000 = $12,000

Value of shares-equity Value of shares-$18,000

d. = = 30%
Value of shares Value of shares
Value of shares = $25,714.29, or $25.714 per share
2.
a. $25,000 – 250 – 20,000 – 200 – 800 = $3,750
return = $3,750 / $10,000 = 37.50%
b. $20,000 – 200 – 20,000 – 200 – 800 = -$1,200

return = -$1,200 / $10,000 = -12%
c. $18,000 – 180 – 20,000 – 200 – 800 = -$3,180

return = -$3,180 / $10,000 = -31.8%
Trading on margin problem set 2 of 2

Market indices
Problems
1. Consider indices created using the following stocks:
Stock Price on Price on day 2 Price on day 3

day 1
1 $40 $41 $42
2 $25 $20 $25
3 $10 $12 $5
The shares outstanding for these stocks are as follows:
Stock Shares Shares Shares

outstanding outstanding outstanding
on day 1 on day 2 on day 3
1 100 100 100
2 100 100 100
3 200 200 400
Note: Stock 3 had a 2:1 stock split prior to the opening on day 3.
Calculate the following:

a. The price-weighted average on days 1, 2, and 3, assuming a divisor of 3 on day 1.
b. The value weighted average on days 1, 2, and 3, assuming a base of $8,000 and
indexing value of 100.
c. The arithmetic average equal-weighted index for days 2 and 3, assuming a base
index value of 100 on day 1.
d. The return on the price-weighted average, value-weighted average, and an
arithmetic average for days 2 and 3, using the assumptions appropriate from
questions a through c.
Market indices problem set 1 of 3

2. Consider indices created using the following stocks:
Stock Price on Price on day 2 Price on day 3

day 1
1 $40 $41 $40
2 $60 $61 $62
3 $10 $12 $13
The shares outstanding for these stocks are as follows:
Stock Shares Shares Shares

outstanding outstanding outstanding
on day 1 on day 2 on day 3
1 100 100 100
2 100 100 100
3 1,000 1,000 1,000

a. The price-weighted average on days 1, 2, and 3, assuming a divisor of 3 on day 1.
b. The value weighted average on days 1, 2, and 3, assuming a base of $20,000 and
indexing value of 1000.
c. The geometric average equal-weighted index, assuming a base index value of 1000
on day 1.
d. The return on the price-weighted average, value-weighted average, and a geometric
average for days 2 and 3, using the assumptions appropriate from questions 1
through 3.

Solutions
1.
a. Day 1: ($40+25+10) / 3 = 25
Day 2: ($41+20+12) / 3 = 24.333
Adjust divisor for day 3 by solving for X:
($41+20+6)/ X = 24.333
X = 2.75346
Day 3: ($42+25+5)/2.75346 = 26.1489
b. Day 1: [($40*100)+($25*100)+($10*200)] / $8,000 x 100 = 106.25
Day 2: [($41*100)+($20*100)+($12*200)] / $8,000 x 100 = 106.25
Day 3: {$42*100)+($25*100)+($5*400)] / $8,000 x 100 = 108.75
c. Day 2: 100 x [$41/$40 + $20/$25 + $12/$10)] / 3 = 100.833
Day 3: 100.8333 x [($42/$41)+($25/$20)+($5/$6)] / 3 = 104.454
d.
Day 2 Day 3
Price-weighted (24.333-25)/25 = -2.668% (26.1489-24.333)/24.333) = 7.4627%
Value- (106.25-106.25)/106.25 = 0% (108.75-106.25)/106.25 = 2.3529%
weighted
Equal- (100.833-100)/100 = 0.833% (104.454-100.833)/100.833 = 3.591%
weighted
2.
a. Day 1: ($40+60+10) / 3 = 36.667
Day 2: ($41+61+12) / 3 = 38.00
Day 3: ($40+62+13)/ 3 = 38.33
b. Day 1: [($40 x 100)+($60 x 100)+($10 x 1000)] / $20,000 x 1000 = 1000
Day 2: [($41 x 100)+($61 x100)+($12 x 1000)] / $20,000 x 1000 = 1110
Day 3: {$40 x 100)+($62 x 100)+($13 x 1000)] / $20,000 x 1000 = 1160
c. Day 2: 1000 x [$41/$40 x $61/$60 x $12/$10)]1/3
1000 x [(1.025)(1.01667)(1.2)] 1/3 = 1077.361
Day 3: 1077.361 x [($40/$41)+($62/$61)+($13/$12)]1/3 = 1103.387
d.
Day 2 Day 3
Price-weighted (38-36.667)/36.667 = 3.636% (38.33-38)/38) = 0.877%
Value- (1110-1000)/1000 = 11% (1160-1110)/1110 = 4.505%
weighted
Equal- (1077.361-1000)/1000 = (1103.387-1077.361)/1077.361 = 2.4157%
weighted 7.7361%

Short selling
Calculation
Profit or loss = proceeds from - commission on dividends cost of buying commission on

sale of shares sale of shares on shares shares purchase of shares
Problems
1. Suppose you decide that the Bear Company stock is selling at too high a price at its
current $50 per share price. You are convinced that the price of Bear stock will fall in the
next couple of months, so you decide to sell 100 shares of Bear stock short. Ignoring
transactions costs, if the Bear Company does not pay dividends and if you do not have to
use a margin account, what is your profit or loss if the stock’s price goes to
a. $40 and you buy at that price to cover your short?
b. $55 and you buy at that price to cover your short?
2. You are very sure that the stock of the Dippy Company will drop from its present price of
$40. You decide to sell 100 shares of Dippy Company stock short. Now suppose that
you must pay your broker 1% in transactions costs for all purchases and sales. If Dippy
Company pays a dividend of $1 per share, what is your profit or loss if you buy the stock
back at:
a. $35?
b. $40?
c. $45?
3. You are very sure that the stock of the Goofy Company will drop from its present price of
$100. You decide to sell 100 shares of Goofy Company stock short. Now suppose that
you must pay your broker 0.5% in transactions costs for all purchases and sales. If
Goofy Company pays no dividends, what is your profit or loss if you buy the stock back
at:
a. $50?
b. $150?
c. $100?
Short selling problem set 1 of 2

Solutions
Hint: You make a profit in a short sale transaction only when the price of the stock declines by
more than the amount of any commissions and any dividends.
1.
a. A profit: $5,000 – 4,000 = $1,000
b. A loss: $5,000 – 5,500 = -$500
2.
a. $4,000 – 40 – 100 – 3,500 – 35 = $325
b. $4,000 – 40 – 100 – 4,000 – 40 = -$180
c. $4,000 – 40 – 100 – 4,500 – 45 = -$685
3.
a. $10,000 – 50 – 5,000 – 25 = $4,925
b. $10,000 – 50 – 15,000 – 75 = -$5,125
c. $10,000 – 50 – 10,000 – 50 = -$100
Short selling problem set 2 of 2

Portfolio risk and return calculations
Formulas
N N N
p = i1
w i2 i2 ww p
i1 j 1j i
i j i j ij
or
N N N
p = i1
w i2 i2 w w cov
i1 j 1j i
i j ij
For a two-security portfolio,
p = w12 12 w 22 22 2w1 w 2 1 2p1,2
or
p = w12 12 w 22 22 2w1 w 2 cov1,2
Problems
For each of the following two-security portfolios, calculate the portfolio’s expected return, variance of
returns, and the standard deviation of returns.
First security Second security Correlation

between the
Expected Standard Weight in Expected Standard Weight in two securities’
Portfolio return deviation portfolio return deviation portfolio returns
A 4% 2% 30% 10% 4% 70% 0.50

B 3% 5% 50% 10% 20% 50% -0.10
C 10% 12% 40% 4% 2% 60% 0.10
D 6% 7% 60% 5% 5% 40% 0.00
E 6% 3% 40% 10% 10% 60% -0.50
F 15% 20% 60% 15% 10% 40% 0.30
G 10% 6% 20% 20% 5% 80% 0.80
Solutions
Portfolio Portfolio standard
Portfolio expected return Portfolio variance deviation
A 8.20% 0.000988 3.14%
B 6.50% 0.010125 10.06%
C 6.40% 0.002563 5.06%
D 5.60% 0.002164 4.65%
E 8.40% 0.003024 5.50%
F 15.00% 0.01888 13.74%
G 18.00% 0.002512 5.01%
Duration Problem Set
Formulas
2N
t CFt
Macauley duration
t 1 YTM
t
1
2
Macauley duration
Modified duration =

1 YTM
2

P1% decrease in yield P1% increase in yield

Effective duration =
2 (initialpriceofsecur ity) 0.01
Problems
Calculate modified duration and effective duration for each of the following bonds:
Bond Description
A A coupon rate of 6%, maturity of ten years, and currently priced to yield 5%
B A coupon rate of 6.5%, a maturity of five years, and currently priced to yield
4.3%
C A coupon rate of 4.5%, a maturity of 10 years, and priced to yield 6.5%
Solutions
Bond Macauley Modified Effective

duration duration duration
A 7.7618 7.5725 7.5845
B 4.3833 4.2911 4.2932
C 4.5071 4.3653 4.3674
Example, Bond A
Present Present
value of value Time-
Cash cash scaled by Time weighted
Period flow flow price weight cash flow
1 30 29.26829 0.0272 0.5 0.0136
2 30 28.55443 0.0265 1.0 0.0265
3 30 27.85798 0.0258 1.5 0.0388
4 30 27.17852 0.0252 2.0 0.0504
5 30 26.51563 0.0246 2.5 0.0615
6 30 25.86891 0.0240 3.0 0.0720
7 30 25.23796 0.0234 3.5 0.0819
8 30 24.6224 0.0228 4.0 0.0914
9 30 24.02185 0.0223 4.5 0.1003
10 30 23.43595 0.0217 5.0 0.1087
11 30 22.86434 0.0212 5.5 0.1167
12 30 22.30668 0.0207 6.0 0.1242
13 30 21.76261 0.0202 6.5 0.1312
14 30 21.23182 0.0197 7.0 0.1379
15 30 20.71397 0.0192 7.5 0.1441
16 30 20.20875 0.0187 8.0 0.1500
17 30 19.71585 0.0183 8.5 0.1555
18 30 19.23498 0.0178 9.0 0.1606
19 30 18.76583 0.0174 9.5 0.1654
20 1030 628.5791 0.5831 10.0 5.8313
Macauley= 7.7618
Modified = 7.7618 / 1.025 = 7.5725
Effective duration:
Value of bond at current YTM $1,077.95

Value of bond if YTM+1% $1,000.00
Value of bond if YTM-1% $1,163.51
Effective duration = ($1,163.51 – 1,000) / (2 * 1,077.95 * 0.01) = 7.5845

Option pricing problems
Formulas
Value of S N(d ) X N(d ) S N(d ) Xe rT N(d )

the option 1
rT 2
1
2
e
S 2
S
2
ln r 0.5 T
d1 X =

ln r
X

T
2

1 T
T 2

and
1
d2 d1 T 2 d1 T

where
S is the value of the underlying asset,
X is the exercise price,
r is the continuously compounded risk-free rate of interest,
T is the number of years to expiration of the option,
2 is the annualized variance of the continuously compounded return on the stock, and
N(d1) and N(d2) are cumulative normal probabilities..
Intrinsic value = Max (Current market value of underlying stock price – Exercise price, $0)
Time value = Value of the option – Intrinsic value
Option pricing problems, Peterson Drake 1 of 2

Problems
Using the accompanying option pricing worksheet, complete the following table:
Value of the option

Standard deviation
Time to expiration
Risk free rate of
of stock’s price
In the money?
Intrinsic value
Exercise price
Stock price
Time value
Yes or No
Call interest
option
A $40 $45 5% 0.40 1 year
B $10 $9 3% 0.30 6 months
C $20 $22 4% 0.35 1 year
D $25 $20 3% 0.45 2 years
E $30 $10 5% 0.50 3 years
Solutions Value of the option

Standard deviation
Time to expiration
Risk free rate of
of stock’s price
In the money?
Intrinsic value
Exercise price
Stock price
Time value
Yes or No
interest
Option
A $40 $45 5% 0.40 1 year $10.62 Yes $5 $5.62
B $10 $9 3% 0.30 6 months $0.44 No $0 $0.44
C $20 $22 4% 0.35 1 year $4.46 Yes $2 $2.46
D $25 $20 3% 0.45 2 years $3.83 No $0 $3.83
E $30 $10 5% 0.50 3 years $0.91 No $0 $0.91
Option pricing problems, Peterson Drake 2 of 2

Value of a call option for different prices of the underlying stock
Worksheet prepared by Pamela Peterson Drake
$40
Instructions: Insert values for the exercise
price, time to expiry, risk-free rate of interest, $35
and the standard deviation
Underlying $30
Characteristics of the option stock price Value of the option
Parameter Value $ 1.00 $ 0.0000000000000002 $25
Exercise price of the option $25 $ 2.00 $ 0.0000000001076040
Value of the
Time to expiry, in years 1 $ 3.00 $ 0.0000000596067271 $20
call option
Risk-free rate of interest 4% $ 4.00 $ 0.0000029254356656
Standard deviation of the underlying stock's price 0.40 $ 5.00 $ 0.0000430412717138 $15
$ 6.00 $ 0.0003134365787480
$ 7.00 $ 0.0014515882730265 $10
$ 8.00 $ 0.0049249876916291
$ 9.00 $ 0.0133516707977320 $5
$ 10.00 $ 0.0306080025254752
$0
$ 11.00 $ 0.0616779009524843
$1
$5
$9
$13
$17
$21
$25
$29
$33
$37
$41
$45
$49
$53
$57
$ 12.00 $ 0.1122965141085860
$ 13.00 $ 0.1884901183951680 Stock price
$ 14.00 $ 0.2961136024141190
$ 15.00 $ 0.4404587946472350
$ 16.00 $ 0.6259718136442620
$ 17.00 $ 0.8560879196916660
$ 18.00 $ 1.1331725330901300
$ 19.00 $ 1.4585468561456900
$ 20.00 $ 1.8325735442624900
$ 21.00 $ 2.2547794265862100
$ 22.00 $ 2.7239961430909000
$ 23.00 $ 3.2385041849127500
$ 24.00 $ 3.7961702614075700
$ 25.00 $ 4.3945717013209400
$ 26.00 $ 5.0311045647354300
$ 27.00 $ 5.7030743142779700
$ 28.00 $ 6.4077693743254100
$ 29.00 $ 7.1425188331677900
$ 30.00 $ 7.9047360520168500
$ 31.00 $ 8.6919501564134600
$ 32.00 $ 9.5018273975109500
$ 33.00 $ 10.3321842577336000
$ 34.00 $ 11.1809939921749000
$ 35.00 $ 12.0463880820654000
$ 36.00 $ 12.9266538551315000
$ 37.00 $ 13.8202293155767000
$ 38.00 $ 14.7256960327849000
$ 39.00 $ 15.6417707670223000
$ 40.00 $ 16.5672963636217000
$ 41.00 $ 17.5012323236781000
$ 42.00 $ 18.4426453573352000
$ 43.00 $ 19.3907001429364000
$ 44.00 $ 20.3446504490797000
$ 45.00 $ 21.3038307244431000
$ 46.00 $ 22.2676482197913000
$ 47.00 $ 23.2355756757389000
$ 48.00 $ 24.2071445867996000
$ 49.00 $ 25.1819390354370000
$ 50.00 $ 26.1595900779405000
$ 51.00 $ 27.1397706558952000
$ 52.00 $ 28.1221910019147000
$ 53.00 $ 29.1065945054459000
$ 54.00 $ 30.0927540032628000
$ 55.00 $ 31.0804684592903000
$ 56.00 $ 32.0695599992924000
$ 57.00 $ 33.0598712674323000
$ 58.00 $ 34.0512630735768000
$ 59.00 $ 35.0436123022959000
$ 60.00 $ 36.0368100566946000
Black-Scholes OPM
Option Pricing Worksheet
A B C D I J
1 Value of a call option for different prices of the
2 Worksheet prepared by Pamela Peterson Drake
3
Instructions: Insert values for the exercise price, time to Underlying Value of the option
expiry, risk-free rate of interest, and the standard deviation stock price
Characteristics of the option
4
5 Parameter Value 1 =(I5*G5)-(C$6*EXP((C$8*-1)*C$7)*H5)
6 Exercise price of the option 25 =I5+1 =(I6*G6)-(C$6*EXP((C$8*-1)*C$7)*H6)
7 Time to expiry, in years 1 =I6+1 =(I7*G7)-(C$6*EXP((C$8*-1)*C$7)*H7)
8 Risk-free rate of interest 0.04 =I7+1 =(I8*G8)-(C$6*EXP((C$8*-1)*C$7)*H8)
9 Standard deviation of the underlying stock's price 0.4 =I8+1 =(I9*G9)-(C$6*EXP((C$8*-1)*C$7)*H9)
10 =I9+1 =(I10*G10)-(C$6*EXP((C$8*-1)*C$7)*H10)
11 =I10+1 =(I11*G11)-(C$6*EXP((C$8*-1)*C$7)*H11)
12 =I11+1 =(I12*G12)-(C$6*EXP((C$8*-1)*C$7)*H12)
13 =I12+1 =(I13*G13)-(C$6*EXP((C$8*-1)*C$7)*H13)
14 =I13+1 =(I14*G14)-(C$6*EXP((C$8*-1)*C$7)*H14)
15 =I14+1 =(I15*G15)-(C$6*EXP((C$8*-1)*C$7)*H15)
16 =I15+1 =(I16*G16)-(C$6*EXP((C$8*-1)*C$7)*H16)
17 =I16+1 =(I17*G17)-(C$6*EXP((C$8*-1)*C$7)*H17)
18 $40 =I17+1 =(I18*G18)-(C$6*EXP((C$8*-1)*C$7)*H18)
19 =I18+1 =(I19*G19)-(C$6*EXP((C$8*-1)*C$7)*H19)
20 $35 =I19+1 =(I20*G20)-(C$6*EXP((C$8*-1)*C$7)*H20)
21 =I20+1 =(I21*G21)-(C$6*EXP((C$8*-1)*C$7)*H21)
22 $30 =I21+1 =(I22*G22)-(C$6*EXP((C$8*-1)*C$7)*H22)
23 =I22+1 =(I23*G23)-(C$6*EXP((C$8*-1)*C$7)*H23)
24 $25 =I23+1 =(I24*G24)-(C$6*EXP((C$8*-1)*C$7)*H24)
25 =I24+1 =(I25*G25)-(C$6*EXP((C$8*-1)*C$7)*H25)
Value of the
26 $20 =I25+1 =(I26*G26)-(C$6*EXP((C$8*-1)*C$7)*H26)
call option
27 =I26+1 =(I27*G27)-(C$6*EXP((C$8*-1)*C$7)*H27)
28 $15 =I27+1 =(I28*G28)-(C$6*EXP((C$8*-1)*C$7)*H28)
29 =I28+1 =(I29*G29)-(C$6*EXP((C$8*-1)*C$7)*H29)
$10
30 =I29+1 =(I30*G30)-(C$6*EXP((C$8*-1)*C$7)*H30)
31 =I30+1 =(I31*G31)-(C$6*EXP((C$8*-1)*C$7)*H31)
$5
32 =I31+1 =(I32*G32)-(C$6*EXP((C$8*-1)*C$7)*H32)
33 =I32+1 =(I33*G33)-(C$6*EXP((C$8*-1)*C$7)*H33)
$0
34 =I33+1 =(I34*G34)-(C$6*EXP((C$8*-1)*C$7)*H34)
$1
$5
$9
$13
$17
$21
$25
$29
$33
$37
$41
$45
$49
$53
$57
35 =I34+1 =(I35*G35)-(C$6*EXP((C$8*-1)*C$7)*H35)
36 Stock price =I35+1 =(I36*G36)-(C$6*EXP((C$8*-1)*C$7)*H36)
37 =I36+1 =(I37*G37)-(C$6*EXP((C$8*-1)*C$7)*H37)
38 =I37+1 =(I38*G38)-(C$6*EXP((C$8*-1)*C$7)*H38)
39 =I38+1 =(I39*G39)-(C$6*EXP((C$8*-1)*C$7)*H39)
40 =I39+1 =(I40*G40)-(C$6*EXP((C$8*-1)*C$7)*H40)
41 =I40+1 =(I41*G41)-(C$6*EXP((C$8*-1)*C$7)*H41)
42 =I41+1 =(I42*G42)-(C$6*EXP((C$8*-1)*C$7)*H42)
43 =I42+1 =(I43*G43)-(C$6*EXP((C$8*-1)*C$7)*H43)
44 =I43+1 =(I44*G44)-(C$6*EXP((C$8*-1)*C$7)*H44)
45 =I44+1 =(I45*G45)-(C$6*EXP((C$8*-1)*C$7)*H45)
46 =I45+1 =(I46*G46)-(C$6*EXP((C$8*-1)*C$7)*H46)
47 =I46+1 =(I47*G47)-(C$6*EXP((C$8*-1)*C$7)*H47)
48 =I47+1 =(I48*G48)-(C$6*EXP((C$8*-1)*C$7)*H48)
49 =I48+1 =(I49*G49)-(C$6*EXP((C$8*-1)*C$7)*H49)
50 =I49+1 =(I50*G50)-(C$6*EXP((C$8*-1)*C$7)*H50)
51 =I50+1 =(I51*G51)-(C$6*EXP((C$8*-1)*C$7)*H51)
52 =I51+1 =(I52*G52)-(C$6*EXP((C$8*-1)*C$7)*H52)
53 =I52+1 =(I53*G53)-(C$6*EXP((C$8*-1)*C$7)*H53)
54 =I53+1 =(I54*G54)-(C$6*EXP((C$8*-1)*C$7)*H54)
55 =I54+1 =(I55*G55)-(C$6*EXP((C$8*-1)*C$7)*H55)
56 =I55+1 =(I56*G56)-(C$6*EXP((C$8*-1)*C$7)*H56)
57 =I56+1 =(I57*G57)-(C$6*EXP((C$8*-1)*C$7)*H57)
58 =I57+1 =(I58*G58)-(C$6*EXP((C$8*-1)*C$7)*H58)
59 =I58+1 =(I59*G59)-(C$6*EXP((C$8*-1)*C$7)*H59)
60 =I59+1 =(I60*G60)-(C$6*EXP((C$8*-1)*C$7)*H60)
61 =I60+1 =(I61*G61)-(C$6*EXP((C$8*-1)*C$7)*H61)
62 =I61+1 =(I62*G62)-(C$6*EXP((C$8*-1)*C$7)*H62)
63 =I62+1 =(I63*G63)-(C$6*EXP((C$8*-1)*C$7)*H63)
64 =I63+1 =(I64*G64)-(C$6*EXP((C$8*-1)*C$7)*H64)
65
66
67
68
69
70
71
72
Optional Readings, FIN4504 (P. Peterson) Page 1 of 2
Optional readings
z Careers in finance
z Sarbanes-Oxley Act of 2002
z Financial accounting information
z Financial ratios
z Financial analysis
z Time value of money: Part I
z Time value of money: Part II
z Calculating interest rates
z Asset valuation
z Bond valuation
z Stock valuation
z Measuring risk
z Risk, return, and diversification
http://educ.jmu.edu/~drakepp/investments/optread.html 2/28/2011
Optional Readings, FIN4504 (P. Peterson) Page 2 of 2

Careers in finance http://educ.jmu.edu/~drakepp/fin3403/module1/careers.pdf
Sarbanes-Oxley Act of
http://news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley072302.pdf
2002
Financial accounting
http://educ.jmu.edu/~drakepp/fin3403/module2/fin_acc.pdf
information
Financial ratios http://educ.jmu.edu/~drakepp/fin3403/module2/fin_rat.pdf
Financial analysis http://educ.jmu.edu/~drakepp/fin3403/module2/fin_analysis.pdf
Time value of money: Part
http://educ.jmu.edu/~drakepp/fin3403/module3/tvm.pdf
I
Time value of money: Part
http://educ.jmu.edu/~drakepp/fin3403/module3/tvm2.pdf
II
Calculating interest rates http://educ.jmu.edu/~drakepp/fin3403/module3/interestrates.pdf
Asset valuation http://educ.jmu.edu/~drakepp/fin3403/module4/asset.pdf
Bond valuation http://educ.jmu.edu/~drakepp/fin3403/module4/bondval.pdf
Stock valuation http://educ.jmu.edu/~drakepp/fin3403/module4/stock.pdf
Measuring risk http://educ.jmu.edu/~drakepp/fin3403/module5/riskreturn_measure.pdf
Risk, return, and
http://educ.jmu.edu/~drakepp/fin3403/module5/riskreturn2.pdf
diversification
http://educ.jmu.edu/~drakepp/investments/optread.html 2/28/2011
Financial Calculators, Pamela Peterson Drake, James Madison University) Page 1 of 2
Financial calculators
Prepared by Pamela Peterson, James Madison University
1. The basics
2. Hewlett-Packard models
3. Texas Instruments models
http://educ.jmu.edu/~drakepp/general/calculator/index.html 2/28/2011

The basics http://educ.jmu.edu/~drakepp/general/calculator/general.html
Hewlett-Packard models http://educ.jmu.edu/~drakepp/general/calculator/hp.html
Texas Instruments models http://educ.jmu.edu/~drakepp/general/calculator/ti.html
Using a Financial Calculator, Pamela Peterson Drake Page 1 of 5
Using a Financial Calculator

OUTLINE
A. The basics
B. Tips
C. Examples
A. The basics
Most calculator are designed so that many keys serve double-duty or triple-duty to
keep hand-held calculators small, but useful, for many different types of
calculations. For example, in the HP10B calculator the key labeled yx is used for
both multiplication ("x") and raising a value to a power ("yx"). How do you raise
some value to a power? You first strike the orange-colored key, , and then yx ).
The orange-colored key tells the computer to use the second function (yx) of this
key.
Examples (using the HP10B):
Multiplying one value by another (for example, 3 x 4):
3 x 4 = with the answer, 12, displayed.
Raising a value to a power (for example, 34),
3 yx 4 y x
with an answer of 81. You'll notice that you had to strike the and yx keys
twice in this calculation, but we did not have to use the = key.
Access to the double or triple level functions differs among calculators. For the
HP10B, the alternate function of a key is accessed by using the orange-colored key,
. In other models the alternative function may be accessed through, for example,
a 2nd key or a g key. You need to refer to the manual that came with your financial
calculator to see how to access these second or third level functions.
In addition to access to different levels through a single key, some calculators,

such as the HP17B and HP19B, have a set of unidentified keys (just below the
display) that perform a function assigned to them based on the "screen" shown in
the display. For example, if you select the time value of money screen (by striking
the key below the "FIN" in the display and then the below the "TVM" in the
display), these keys are assigned to represent "PV" , "N", "FV", and so on.
In the examples that follow, the keys are described by the label corresponding to
http://educ.jmu.edu/~drakepp/general/calculator/general.html 2/28/2011
the function you are using. For example, to calculate 34 on the HP10B, the key
strokes are indicated as:
3 yx 4 yx
putting the key's label in the box representing the key to indicate which key to hit.
In the case of keys identified by a display screen, such as for the HP19B, we
indicate the keystroke in a like manner.
The basic math calculations (such as addition, subtraction, multiplication, and

division) are similar among the different brands and models. With the exception of
the HP12C, the math is performed much like you would if you were doing it without
the calculator. Consider the problem of multiplying 3 by 4:
All models except HP12C: 3 x 4 =
Division, addition, and subtraction are performed in a like manner.
The HP12C uses reverse-Polish notation, which is tough to get used to but becomes
a time-saver in complex calculations.
HP12C: 3 ENTER 4 x
Let's look closely at an example using the HP10B calculator to solve a future value
problem: If an investor deposits $1,000 today in an account that pays 5% interest
each year, how much will be in the account at the end of 10 years? The following
are given in the problem description:
Present value (PV) = $1,000

Interest rate per period (r) = 5% per year
Number of periods (t) = 10 years
and we want to solve for FV. The first thing we need to do is tell the computer the
present value. However, in the HP10B (like most financial calculators), we have to
change the sign on the present value in order for the calculator's program to work.
We input $1,000 as the present value and change its sign,
1 0 0 0 +/- PV
We then need to tell the computer the interest rate, in whole numbers (that is, 5%
is "5"):
5 I/YR
The number of compounding periods is next,
10N
And we solve for the future value by striking the FV key, FV. The future value,
$1,628.90, will then be displayed.
B. Tips
1. Get your calculator ready to use. Your calculator may come from the
factory with certain display and calculation settings. For example, the HP10B
comes ready to perform calculations using 2 decimal places (a display
setting) and twelve payments per year (a calculation setting). If you need
more precision, you need to adjust the display. Also, if you require one
payment per period, as in most of our calculations, you need to adjust the
payments per year.
2. Adjust the number of digits displayed. Use at least four places to the
right of the decimal place for all calculations. When working with interest
rates, it is very important to use more than two decimal places. You can set
your calculator's display program to display a specified number of decimal
places. To change the setting to display four decimal places, for example:
HP10B DISP 4
HP12C f 4
HP17B DSP FIX 4 INPUT
3. Check the frequency of payments. Most calculations require one interest

compounding per period. Since this is the case, we need to make sure that
the calculator program we are using considers only one compounding per
period.
HP10B 1 P/YR
HP12C frequency of payments within a period is not programmed
HP17B FIN TVM OTHER P/YR 1 INPUT
4. Use short-cuts whenever possible. Many calculators allow you to key in a

value and then key in how many times that value is repeated. For example, if
you have to input six consecutive cash flows of $1 each in your HP12C,
1 g CFj 6 g Nj
where the sequence " 6 g Nj" tells the calculator's program that the one
dollar cash flow is repeated six times. In the case of the HP17B and the
HP19B, the shortcut for cash flows is the prompt "#TIMES" that corresponds
to a period's cash flow.
5. Clear the calculator's registers after each problem. The information you
input and the results of the calculations you perform are stored in the
computer's registers (its memory for the bits and pieces of information).
Clear your registers before starting a new calculation. If you fail to clear the
registers in your calculator, you will find that the next problem you do will
use data left over from the last problem -- even if you had turned off your
calculator since the last problem. To clear your calculator:
HP10B Clear All

HP12C f REG
HP17B CLEAR DATA
In the case of the HP17B, which allows storage of individual cash flow data,
you need to clear the cash flow information separately: CLEAR DATA YES
6. Check the timing of the cash flows. Check to see whether your calculator
is programmed to assume cash flows at the end of the period or the
beginning of the period. Many calculator brands allow you to specify when
cash flows occur (beginning or end of the period), which is useful for annuity
due calculations. However, like most registers in the calculator, the calculator
remembers the last way you specified the cash flows, so you must change
this register if you, say, switch from an annuity due to an ordinary annuity
calculation.
To change the setting from end-of-period to beginning-of-period,
HP10B BEG/END
HP12C g BEG
HP17B FIN TVM OTHER BEG EXIT
7. Check your work. Always check for the reasonableness of your calculations;
it's very easy to hit the wrong key -- especially when taking tests. Learn to
do your problem with your calculator and then either check your answers
using another method, such as algebra or with the tables of factors, or simply
use common sense checks for reasonableness.
C. Examples
1. Hewlett Packard 10B

2. Hewlett Packard 12C
3. Texas Instruments BAII+

The basics http://educ.jmu.edu/~drakepp/general/calculator/general.html#basics
Tips http://educ.jmu.edu/~drakepp/general/calculator/general.html#tips
Examples http://educ.jmu.edu/~drakepp/general/calculator/general.html#examples
Hewlett Packard 10B http://educ.jmu.edu/~drakepp/general/calculator/hp10b.html
Hewlett Packard 12C http://educ.jmu.edu/~drakepp/general/calculator/hp12c.html
Texas Instruments BAII+ http://educ.jmu.edu/~drakepp/general/calculator/ba2.html
Instructions on Financial Calculator Use, HP10B (P. Peterson, FSU) Page 1 of 3
Hewlett Packard 10B

Calculator examples
prepared by Pamela Peterson
Examples
1. Calculating a future value

2. Calculating the present value of an annuity
3. Calculating the value of a bond
4. Valuing a series of uneven cash flows
5. Calculating the yield to maturity on a bond
Problem:
Suppose you invest $10,000 today in an account that pays 5% interest,

compounded annually, how much will you have in the account at the end of 6
years?
Solution: $13,401
10000 +/- PV
5 I/Y
6 N
FV
Problem:
Suppose you are promised annual payments of $1,500 each year for the next five
years, with the first cash flow occurring in one year. If the interest rate is 4%, what
is this stream of cash flows worth today?
Solution: $6,678
1500 PMT
5 N
4 I/Y
PV
Problem:
http://educ.jmu.edu/~drakepp/general/calculator/hp10b.html 2/28/2011
Calculate the value of a bond with a maturity value of $1,000, a 5% coupon (paid
semi-annually), five years remaining to maturity, and is priced to yield 8%.
Solution: $878.34
Note:
FV = 1,000 (lump-sum at maturity)
CF = $25 (one half of 5% of $1,000)
N = 10 (10 six-month periods remaining)
i = 4% (six-month basis, 8%/2)
1000 FV
10 N
4 I/Y
25 PMT
PV
Problem:
Consider the following cash flows,
CF0 = -$10,000
CF1 = +$5,000
CF2 = $0
CF3 = +$2,000
CF4 = +$5,000
a. What is the internal rate of return for this set of cash flows?
b. If the discount rate is 5%, what is the net present value corresponding to
these cash flows?
Solution:
a. IRR = 7.5224%
b. NPV = +$603.09
10000 +/- CF
5000 CF
0 CF
2000 CF
5000 CF
IRR
5 I/Y
NPV
where indicates the orange-colored key to reach the 2nd level functions.
Problem:
Calculate the yield to maturity of a bond with a maturity value of $1,000, a 5%

coupon (paid semi-annually), ten years remaining to maturity, and is priced $857.
Solution: 7.01%
Note:
FV = $1,000 (lump-sum at maturity)

CF = $25 (one half of 5% of $1,000)
PV = $857
1000 FV
20 N
857 +/- PV
25 PMT
i
x 2
Instructions on Financial Calculator Use, HP12C Pamela Peterson Drake Page 1 of 3
Hewlett Packard 12C

Calculator examples prepared by Pamela Peterson Drake
Examples

Problem:

years?
Solution: $13,401
10000 CHS PV
5 i
6 n
FV
Problem:
Solution: $6,678
1500 PMT
5 n
4 i
PV
Problem:
http://educ.jmu.edu/~drakepp/general/calculator/hp12c.html 2/28/2011
Solution: $878.34
Note:
CF = $25 (one half of 5% of $1,000)
1000 FV
10 n
4 i
25 PMT
PV
Problem:
CF0 = -$10,000
CF1 = +$5,000
CF2 = $0
CF3 = +$2,000
CF4 = +$5,000
these cash flows?
Solution:
a. IRR = 7.5224%
b. NPV = +$603.09
10000 CHS g CF0

5000 g CFj
0 g CFj
2000 g CFg
5000 g CFg
f IRR
5 i
f NPV
Problem:

Solution: 7.01%
Note:

CF = $25 (one half of 5% of $1,000)
PV = $857
1000 FV
20 n
857 CHS PV
25 PMT
i
2 x
Instructions on Financial Calculator Use, BA2Plus, Pamela Peterson Drake Page 1 of 3
Texas Instruments BAII+
Calculator examples prepared by Pamela Peterson Drake
Examples

Problem:

years?
Solution: $13,401
10000 +/- PV
5 I/Y
6 N
CPT FV
Problem:
Solution: $6,678
1500 PMT
5 N
4 I/Y
CPT PV
http://educ.jmu.edu/~drakepp/general/calculator/ba2.html 2/28/2011
Problem:
Solution: $878.34
Note:
CF = $25 (one half of 5% of $1,000)
1000 FV
10 N
4 I/Y
25 PMT
CPT PV
Problem:
CF0 = -$10,000
CF1 = +$5,000
CF2 = $0
CF3 = +$2,000
CF4 = +$5,000
these cash flows?
Solution:
a. IRR = 7.5224%
b. NPV = +$603.09
CF 10000 +/- ENTER

1 ENTER 5000 ENTER
1 ENTER 0 ENTER
1 ENTER 2000 ENTER
1 ENTER 5000 ENTER
CPT IRR
CPT NPV
5 I/Y
CPT
Problem:

Solution: 7.01%
Note:

CF = $25 (one half of 5% of $1,000)
PV = $857
1000 FV
20 N
857 +/- PV
25 PMT
CPT i
x 2 =
For more information on this calculator, visit Texas Instrument's site, which includes a
guidebook (instructions manual)
Hewlett Packard Financial Calculators (Pamela Peterson Drake) Page 1 of 2
Hewlett-Packard
Hewlett-Packard's HP10B
Hewlett-Packard 10B Calculator Examples, Prepared by Pamela Peterson Drake

Hewlett Packard's 10B site
Calculator Tutorial Prepared by Dr. Mayes, Clemson University
Hewlett-Packard's HP12C
Hewlett-Packard 12C Calculator Examples, Prepared by Pamela Peterson Drake

Hewlett Packard's 12C site
Calculator Tutorial, Prepared by Dr. Mayes, Clemson University
http://educ.jmu.edu/~drakepp/general/calculator/hp.html 2/28/2011
Hewlett Packard Financial Calculators (Pamela Peterson Drake) Page 2 of 2

Hewlett-Packard 10B Calculator
http://educ.jmu.edu/~drakepp/general/calculator/hp10b.html
Examples
Hewlett Packard's 10B site http://www.hp.com/calculators/business/10b_info.html
Calculator Tutorial http://clem.mscd.edu/~mayest/calculators/hp10b.htm
Hewlett-Packard 12C Calculator
http://educ.jmu.edu/~drakepp/general/calculator/hp12c.html
Examples
Hewlett Packard's 12C site http://www.hp.com/calculators/business/12c_info.html
Calculator Tutorial http://clem.mscd.edu/~mayest/calculators/hp12c.htm
http://educ.jmu.edu/~drakepp/general/calculator/hp.html 2/28/2011
Texas Instruments' Financial Calculators (Pamela Peterson Drake) Page 1 of 2
Texas Instruments
Texas Instruments' TI83
1. Using the TI83/TI84 Calculator Financial Functions, Prepared by Pamela Peterson

Drake
Net Present Value Profiles and the TI-83 Prepared by Pamela Peterson. A
"how to" guide to plotting net present value profiles and calculating cross-
over rates using the TI-83.
Calculation of the standard deviation using the TI-83/84, Prepared by Pamela
Peterson. A "how to" guide to using Lists to calculate the standard deviation
of a probability distribution.
2. Texas Instrument's Guides
TI-83
TI-84
3. Other resources
Calculator Tutorial Prepared by Dr. Mayes, Clemson University
Texas Instruments' BAII+
1. Texas Instruments BAII+ Calculator examples Prepared by Pamela Peterson, FSU

2. Texas Instrument's BAII+ site
3. Calculator Tutorial Prepared by Dr. Mayes, Clemson University
Wondering how your TI graphing calculator can perform financial functions? Click here
http://educ.jmu.edu/~drakepp/general/calculator/ti.html 2/28/2011
Texas Instruments' Financial Calculators (Pamela Peterson Drake) Page 2 of 2

Using the TI83/TI84
Calculator Financial http://educ.jmu.edu/~drakepp/general/calculator/ti83.html
Functions
Net Present Value Profiles
http://educ.jmu.edu/~drakepp/general/calculator/ti83_npv.pdf
and the TI-83
Calculation of the standard
deviation using the TI- http://educ.jmu.edu/~drakepp/general/calculator/ti83_stddev.pdf
83/84
TI-83 http://education.ti.com/us/product/tech/83pse/guide/83pseguideus.html
TI-84 http://education.ti.com/us/product/tech/84pse/guide/guidesgs.html
Calculator Tutorial http://clem.mscd.edu/~mayest/calculators/ti83.htm
Texas Instruments BAII+
http://educ.jmu.edu/~drakepp/general/calculator/ba2.html
Calculator examples
Texas Instrument's BAII+
http://education.ti.com/us/product/tech/baii/guide/baiiguideus.html
site
Calculator Tutorial http://clem.mscd.edu/~mayest/calculators/baiiplus.htm
Click here javascript:openpopup()
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Miscellaneous, FIN4504 (P. Peterson) Page 1 of 2
Miscellaneous
Background for the course Time value of money tables
z Accounting Review z Table of Compound Factors

z Need a little bit of help with Algebra? z Table of Discount Factors
z Time value of money z Future Value Annuity Factors
z Understanding financial statements z Present Value Annuity Factors
Tools Careers in Finance
z Financial Calculators. Instructions on financial calculations for z Careers in Finance a general

various models of calculators. overview.
z Charting in Microsoft Excel z CFA Institute
z Creating a Microsoft PowerPoint Presentation, with an z Certified Financial Planner
example Board of Standards
z Option pricing calculator z NASD exams
z Microsoft Excel worksheet for bond value and duration
calculations
http://educ.jmu.edu/~drakepp/investments/misc.html 2/28/2011

Accounting Review http://educ.jmu.edu/~drakepp/acc/index.html
Need a little bit of help
http://educ.jmu.edu/~drakepp/fin3403/tools/algebra.html
with Algebra?
Time value of money http://educ.jmu.edu/~drakepp/fin3403/module3/tvm.pdf
Understanding
http://educ.jmu.edu/~drakepp/fin3403/module2/pg.pdf
financial statements
Financial Calculators http://educ.jmu.edu/~drakepp/fin3403/calculator/index.html
Charting in Microsoft
http://educ.jmu.edu/~drakepp/fin3403/tools/excel_charting.pdf
Excel
Creating a Microsoft
PowerPoint http://educ.jmu.edu/~drakepp/fin3403/tools/pp.pdf
Presentation
example http://educ.jmu.edu/~drakepp/investments/tools/pp_ex.ppt
Option pricing
http://educ.jmu.edu/~drakepp/investments/scripts/opt.htm
calculator
Microsoft Excel
worksheet for bond
http://educ.jmu.edu/~drakepp/investments/examples/bond_example.xls
value and duration
calculations
Table of Compound
http://educ.jmu.edu/~drakepp/fin3403/module3/fvtable.html
Factors
Table of Discount
http://educ.jmu.edu/~drakepp/fin3403/module3/pvtable.html
Factors
Future Value Annuity
http://educ.jmu.edu/~drakepp/fin3403/module3/fvantable.html
Factors
Present Value Annuity
http://educ.jmu.edu/~drakepp/fin3403/module3/pvantable.html
Factors
Careers in Finance http://www.fau.edu/~ppeter/fin3403/module1/careers.pdf
CFA Institute http://www.cfainstitute.org/
Certified Financial
Planner Board of http://www.cfp.net/
Standards
http://www.nasd.com/web/idcplg?
NASD exams
IdcService=SS_GET_PAGE&nodeId=759&ssSourceNodeId=10
http://educ.jmu.edu/~drakepp/investments/misc.html 2/28/2011
Black-Scholes Option Pricing Calculator, P. Peterson Drake, Florida Atlantic University Page 1 of 1
Option pricing calculator

Using the Black-Scholes Option Pricing Model
Instructions:
1. Input the five parameters of the option in the appropriate boxes below.
2. Click on the "Calculate the value of the options" button.*
INPUTS
VOLATILITY OF THE VALUE
OF THE UNDERLYING ASSET RISK-FREE RATE OF
PRICE OF THE UNDERLYING [i.e., standard INTEREST TERM IN YEARS
ASSET EXERCISE PRICE deviation] [e.g., .04 for 4%] [e.g., .5 for 6 months]
S X r T
Intermediate calculations**
d1 = d2 = N(d1) = N(d2) =
Estimated values of the call and put options
VALUE OF THE CALL OPTION INTRINSIC VALUE OF THE CALL OPTION VALUE OF THE PUT OPTION INTRINSIC VALUE OF THE PUT OPTION
C IC P IP
References
1. Black, Fischer, and Myron Scholes, "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, (May-
June 1973) pp. 637-54.
2. Carr, Peter. "A Calculator Program for Option Values and Implied Standard Deviations," Journal of Financial Education,
Vol. 17, No. 1 (Fall 1988) pp. 89-93.
*
This calculator uses the model proposed by Black and Scholes (1973) and does not incorporate dividends.
**
These calculations uses the approximation to the cumulative normal probability suggested by Peter Carr (1988).
DISCLAIMER: This calculator is for educational purposes. This calculator is not intended from investment purposes.
http://educ.jmu.edu/~drakepp/investments/scripts/opt.htm 2/28/2011
A B C D E F G H I
1 Example: Sensitivity of bond values to changes in yield to maturity
2 created by Pamela Peterson Drake
3
4 Bond characteristics
5 Coupon 10%
6 Maturity 20
YTM Value of
7 the bond
8 0% 300.00
9 1% 262.78
10 2% 231.34
11 3% 204.71
12 4% 182.07
13 5% 162.76
14 6% 146.23
15 7% 132.03
16 8% 119.79
17 9% 109.20
18 10% 100.00
19 11% 91.98
20 12% 84.95
21 13% 78.78
22 14% 73.34
23 15% 68.51
24 16% 64.23
25 17% 60.40
26 18% 56.97
27 19% 53.89
28 20% 51.10
29 21% 48.58
30 22% 46.29
31 23% 44.20
32 24% 42.29
33 25% 40.54
34
35 500
36
450
37
38 400
39 350 Value of the bond
40
300
41 Bond
42 250
quote
43 200
44 150
45
100
46
47 50
48 0
49 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
50 Yield to maturity
51
52
BondValueAnDurationWorksheet
Value & YTM
A B C D E F G H I
1 Example: Sensitivity of bond values to changes in yield to maturity
2 created by Pamela Pe
3
5 Coupon 0.1
6 Maturity 20
YTM Value of the bond
7
8 0 =PV(B8/2,B$6*2,B$5*100/2,100)*-1
9 =B8+1% =PV(B9/2,B$6*2,B$5*100/2,100)*-1
10 =B9+1% =PV(B10/2,B$6*2,B$5*100/2,100)*-1
11 =B10+1% =PV(B11/2,B$6*2,B$5*100/2,100)*-1
12 =B11+1% =PV(B12/2,B$6*2,B$5*100/2,100)*-1
13 =B12+1% =PV(B13/2,B$6*2,B$5*100/2,100)*-1
14 =B13+1% =PV(B14/2,B$6*2,B$5*100/2,100)*-1
15 =B14+1% =PV(B15/2,B$6*2,B$5*100/2,100)*-1
16 =B15+1% =PV(B16/2,B$6*2,B$5*100/2,100)*-1
17 =B16+1% =PV(B17/2,B$6*2,B$5*100/2,100)*-1
18 =B17+1% =PV(B18/2,B$6*2,B$5*100/2,100)*-1
19 =B18+1% =PV(B19/2,B$6*2,B$5*100/2,100)*-1
20 =B19+1% =PV(B20/2,B$6*2,B$5*100/2,100)*-1
21 =B20+1% =PV(B21/2,B$6*2,B$5*100/2,100)*-1
22 =B21+1% =PV(B22/2,B$6*2,B$5*100/2,100)*-1
23 =B22+1% =PV(B23/2,B$6*2,B$5*100/2,100)*-1
24 =B23+1% =PV(B24/2,B$6*2,B$5*100/2,100)*-1
25 =B24+1% =PV(B25/2,B$6*2,B$5*100/2,100)*-1
26 =B25+1% =PV(B26/2,B$6*2,B$5*100/2,100)*-1
27 =B26+1% =PV(B27/2,B$6*2,B$5*100/2,100)*-1
28 =B27+1% =PV(B28/2,B$6*2,B$5*100/2,100)*-1
29 =B28+1% =PV(B29/2,B$6*2,B$5*100/2,100)*-1
30 =B29+1% =PV(B30/2,B$6*2,B$5*100/2,100)*-1
31 =B30+1% =PV(B31/2,B$6*2,B$5*100/2,100)*-1
32 =B31+1% =PV(B32/2,B$6*2,B$5*100/2,100)*-1
33 =B32+1% =PV(B33/2,B$6*2,B$5*100/2,100)*-1
34
35
500
36
37 450
38 400
39 350 Value of the bond
40 300
41 Bond
250
42 quote
43 200
44 150
45 100
46 50
47
0
48
49 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
51
52
Value & YTM
A B C D E F G H I
1 Price and duration relation
2 created by Pamela Peterson Drake
3
5 Coupon 5%
6 Maturity 25
YTM Price Price if Price if Effective
YTM+1% YTM-1% duration
7
8 0% 225.00
9 1% 188.29 158.79 225.00 17.58
10 2% 158.79 135.00 188.29 16.78
11 3% 135.00 115.71 158.79 15.96
12 4% 115.71 100.00 135.00 15.12
13 5% 100.00 87.14 115.71 14.29
14 6% 87.14 76.54 100.00 13.46
15 7% 76.54 67.78 87.14 12.65
16 8% 67.78 60.48 76.54 11.85
17 9% 60.48 54.36 67.78 11.09
18 10% 54.36 49.21 60.48 10.37
19 11% 49.21 44.83 54.36 9.68
20 12% 44.83 41.10 49.21 9.04
21 13% 41.10 37.90 44.83 8.44
22 14% 37.90 35.13 41.10 7.88
23 15% 35.13 32.72 37.90 7.37
24 16% 32.72 30.61 35.13 6.91
25 17% 30.61 28.75 32.72 6.48
26 18% 28.75 27.10 30.61 6.09
27 19% 27.10 25.64 28.75 5.74
28 20% 25.64 24.33 27.10 5.42
29 21% 24.33 23.15 25.64 5.12
30 22% 23.15 22.08 24.33 4.86
31 23% 22.08 21.11 23.15 4.62
32 24% 21.11 20.22 22.08 4.40
33 25% 20.22 19.41 21.11 4.20
34 26% 19.41 18.66 20.22 4.01
35 27% 18.66 17.97 19.41 3.85
36 28% 17.97 17.34 18.66 3.69
37 29% 17.34 16.74 17.97 3.55
38 30% 16.74 16.19 17.34 3.42
39 31%
40
41
42
Price
43
44 500 Effective duration 20
45 450 18
46 400 16
47 350 14
48
300 12
49 Bond
50 250 10 Duration
quote
51 200 8
52 150 6
53 100 4
54
50 2
55
0 0
56
1% 4% 7% 10% 13% 16% 19% 22% 25% 28%
57
59
60
Price and duration
A B C D E F G H I
Price and duration relation
1
created by Pamela Peterson Drake
2
3
5 Coupon 0.05
6 Maturity 25
YTM Price Price if YTM+1% Price if YTM-1% Effective duration
7
8 0 =PV(B8/2,B$6*2,B$5*100/2,100)*-1
9 =B8+1% =PV(B9/2,B$6*2,B$5*100/2,100)*-1 =PV(B10/2,B$6*2,B$5*100/2,100)*-1 =PV(B8/2,B$6*2,B$5*100/2,100)*-1 =(E9-D9)/(2*C9*0.01)
39 =B38+1%
40
41
42
Price
43
44 500 Effective duration 20
45 450 18
46 400 16
47 350 14
48
300 12
49 Bond
50 250 10 Duration
quote
51 200 8
52 150 6
53 100 4
54 50 2
55
0 0
56
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
57
59
60
Price and duration
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03.00.00.00
Financial Management
Communications Page 1 of 1
Welcome
These materials are provided to support the principles of financial management course. Feel free to browse and
learn.
http://educ.jmu.edu/~drakepp/principles/commun.htm 2/28/2011
Course modules
Note: Each module includes readings, problems sets, and tasks. All graded quizzes and exams are only available
through the course Blackboard site.
z Module 1: Introduction
z Module 2: Financial Analysis
z Module 3: Time Value of Money
z Module 4: Valuation
z Module 5: Risk and Return
z Module 6: Capital Budgeting
z Module 7: Capital Structure and the Cost of Capital
http://educ.jmu.edu/~drakepp/principles/modules.htm 2/28/2011

Module 1: Introduction http://educ.jmu.edu/~drakepp/principles/module1/index.html
Module 2: Financial Analysis http://educ.jmu.edu/~drakepp/principles/module2/index.html
Module 3: Time Value of Money http://educ.jmu.edu/~drakepp/principles/module3/index.html
Module 4: Valuation http://educ.jmu.edu/~drakepp/principles/module4/index.html
Module 5: Risk and Return http://educ.jmu.edu/~drakepp/principles/module5/index.html
Module 6: Capital Budgeting http://educ.jmu.edu/~drakepp/principles/module6/index.html
Module 7: Capital Structure and the Cost of
http://educ.jmu.edu/~drakepp/principles/module7/index.html
Capital
http://educ.jmu.edu/~drakepp/principles/modules.htm 2/28/2011
Module 1, Introduction to Financial Management, Pamela Peterson Drake Page 1 of 2
Module 1: Introduction to Financial Management

Elements
1. Module1: Introduction to Financial Management IMPORTANT: READ FIRST
2. Reading: Introduction to Financial Management
3. Reading: Careers in Finance
4. Reading: Forms of Business
5. Reading: Objective of Financial Management
6. Problem set: Foundation Questions and Problems
7. StudyMate Activity
http://educ.jmu.edu/~drakepp/principles/module1/index.html 2/28/2011
Module 1, Introduction to Financial Management, Pamela Peterson Drake Page 2 of 2

Module1: Introduction to Financial
http://educ.jmu.edu/~drakepp/principles/module1/learning_outcomes.pdf
Management
Introduction to Financial
http://educ.jmu.edu/~drakepp/principles/module1/introduction.pdf
Management
Careers in Finance http://educ.jmu.edu/~drakepp/principles/module1/careers.pdf
Forms of Business http://educ.jmu.edu/~drakepp/principles/module1/forms.pdf
Objective of Financial Management http://educ.jmu.edu/~drakepp/principles/module1/objective.pdf
Foundation Questions and Problems http://educ.jmu.edu/~drakepp/principles/module1/foundation1.htm
StudyMate Activity http://educ.jmu.edu/~drakepp/principles/module1/mod1.htm
MODULE 1:
INTRODUCTION TO FINANCIAL MANAGEMENT
OUTLINE
1. Introduction
3. Module 1 tasks
4. Module 1 overview and discussion
1. Introduction
The purpose of this module is to introduce you to finance, financial management of a business
enterprise, and the objective of financial decision-making. You are introduced to the basics of the
forms of business enterprise, which provides you with the foundation to understand the agency
relationship that exists between the management of a business and owners.
Throughout this module, as in all modules, you are made aware of current events and issues that
affect the financial manager. Through current events you will see the principles of financial
management demonstrated – both in a good light, but sometimes in a light that is not so
complimentary.
Each module in this course is structured in a similar manner:
1. Introduction
3. Tasks, which include readings, problem sets, and quizzes
4. Overview and discussion
It is recommended that you read the module introduction for each module prior to working on any of
the module’s tasks.
2. Learning Outcomes
LO1.1 Define the objective of the firm.
LO2.2 Relate the characteristics of the different forms of business to the objective of the firm.
LO1.3 Identify the agency relationships that exist within a business enterprise.
LO1.4 Explain how the efficiency of the market relates to the objective of the firm.
LO1.5 Describe and compare different forms of management compensation.
LO1.6 Describe the recent changes in laws and corporate governance and relate these changes
to the agency relationships within a firm.
3. Module 1 tasks
A. Readings
i) Required reading
a. Introduction to financial management
b. Careers in finance
c. Forms of business
d. The objective of financial management
e. Testimony Concerning Implementation of the Sarbanes-Oxley Act of 2002, by William
H. Donaldson, Chairman, U.S. Securities and Exchange Commission
ii) Optional reading

Summary of Sarbanes-Oxley
B. Problem set
Problems sets are provided in each module to assist you in learning the material. These
problems sets are non-graded tasks. It is recommended that you complete these problem
sets prior to attempting the graded online quiz. Solutions to all problem sets are available
through links in the problem set.
Foundations: Questions and problems
Module 1 StudyMate Activities

A. Introduction
In this module, we introduce you to the area of finance. There are three primary areas:
corporate finance, investments, and financial institution. These areas are connected through
finance theory and principles, which are grounded in economic theory and principles. Recent
changes in laws, including the Financial Services Modernization Act of 1999, have blurred the
distinction among these functional areas somewhat.
B. Careers
The career opportunities in Finance include those available in corporate finance, Investments,
and financial institutions. The skills needed for success in the finance field include an
aptitude for math, a solid foundation in finance and economic theory, and an understanding
of accounting.
Take a look at the salary ranges for these different careers and you’ll see that the up-side in
financial careers is substantial.
C. Forms of business
To truly understand financial decision-making, you need to understand the different forms of
business enterprise. These different forms differ in terms of the relation between owners
and managers, as well as in terms of taxation and financial disclosures.
There are three primary forms of business – the sole proprietorship, the partnership, and the
corporation. In addition, there are several hybrids, which include the limited liability
company form that has gained in popularity in the last few years.
D. The objective of financial management

Finance is about making the best use of a business’s resources. The objective of financial
management is to put these resources to the best uses to increase the value of the
enterprise.
The challenge is that the larger business enterprises sometimes have a “disconnect” between
the owners and managers, creating what we refer to as “agency problems”. You can see the
result of these problems in the recent financial scandals that include Enron, Worldcom,
Sunbeam, and, unfortunately, many others.
In theory, if a business invests its resources in the best uses, then society is better off. This
works in practice – to a point. As long as a business is held accountable for its impact on its
stakeholders and the environment, the maximization of owners’ wealth will also result in the
maximization of societal benefits.
E. Sarbanes-Oxley
The recent scandals have resulted in distrust in financial accounting reporting and the
financial markets. In response to this situation, Congress passed a far-reaching and
significant law, commonly referred to as Sarbanes-Oxley or SOX, that is changing the way we
do business in the U.S. – especially the financial aspect of business.
This law affects many aspects of a publicly-traded corporation and has altered the
responsibilities of accountants, CEOs, CFOs, and financial analysts. The law is so new that
the impact of this law, with regard to restoring faith in financial markets and disclosures, is
unknown.
F. What’s next?
In this module we laid the foundation for financial decision-making. In the next module, we
will focus on one of the most important tools that financial decision-makers have at hand –
financial analysis.
You’ll notice that financial analysis requires knowledge of accounting and financial
statements. If you’re rusty in accounting, you may want to take advantage of the links
suggested in this next module that focus on the review of accounting.
© 2007 Pamela Peterson Drake

INTRODUCTION TO FINANCE
OUTLINE
1. Introduction
2. Overview of financial management and analysis
3. Financial management and financial analysis
4. Current issues
1. Introduction
Finance is the application of economic principles and concepts to business decision making and
problem solving. In other words, finance is simply applied economics. We will be applying much of
what you learned in microeconomics and macroeconomics in the study of the principles of finance.
The topic of finance can generally be broken into three general, yet related areas:
1. Financial management deals with the management of finances of a business enterprise,

2. Investments deals with financial markets and security pricing, and
3. Financial institutions deals with financial firms (such as banks).
No matter what area of finance you Finance …

work in, you will use the same basic
knowledge of finance. The purpose is analytical.
is based on economic principles.
of this course is to introduce you to
uses accounting information as input to decision-making.
this common body of knowledge, and is global in perspective.
then show you how it is used in is constantly changing.
financial decision-making. is the study of how to invest and raise money productively.
Financial management requires using knowledge of

Don’t remember much of the accounting?
economics, accounting, law, and other business Walk through the Accounting Review
disciplines. In addition, financial management Check out the StudyMate Activity
requires proficiency in financial mathematics and
statistics.
2. Overview of financial management and analysis
There are a number of different types of financial decisions made within the firm. Investment
decisions concern the use of funds for future benefit, such as extending credit to customers or
purchasing a processing plant.
Suppose you have an idea for a new service: the exam wake-up service. If you want to start up this
business and sell your new service, you must address questions like these:
How much will it cost to purchase the equipment needed to provide this service?
Once you start up this business, how much money will be tied up in working capital such as
cash on hand, accounts receivable, and inventory of parts to service the equipment?
What cash flows do you expect from this service? That is, how much cash is expected to
come in to the firm due to sales of the service, and how much cash is expected to flow out
due to expenses, such as wages?
By how much are actual future cash flows likely to vary from expected cash flows?
Will you extend credit to purchasers of your service? If so, for how long? How will you collect
on any late accounts?
If you don't use your money to produce and market this service, what else can you do with
it?
Or, as another example, suppose we are considering how much of a firm's assets to keep available as
cash. This is an investment decision because we will be investing in cash -- tying up funds in cash
balances that could be used elsewhere. It requires addressing at least the following questions:
How large a cash balance is needed? Can a cash balance be too large?
How certain are we about the amount of cash we will need in the future?
Where should our cash balance be held? In the bank? Under a mattress? Invested in United
States Treasury Bills?
Should the cash balance be kept constant throughout the year or should it change as needs
change?
What else could we do with the money if we don't have it tied up in cash?
Financing decisions concern the acquisition of funds to finance investments and operations, such as
issuing bonds to fund an expansion of a company's plant.
A company's operations and investments can be financed from outside the business by incurring
debts, as through bank loans and the sale of bonds, or by selling ownership interests. Since each
method of financing obligates the business in different ways, financing decisions can be very
important. The major differences are:
Debts must be repaid, with interest, within a specified amount of time. However,
creditors (those lending the money) generally do not share in the control or profits of the
borrowing firm.
Proceeds from the sale of ownership interests do not need to be repaid. However, such
sale dilutes the control of (and profits accruing to) the current owners.
The choice of financing method then involves considering, at the least,
the length of time the funds will be needed;

the ability of the firm to make payments to a creditor on a fixed schedule; and
the willingness of current owners to have their ownership interest (and hence control) of
the firm diluted.
Some decisions, such as leasing, require both investment nd financing decisions simultaneously. No
matter the type of decision, however, the financial manager must focus on expected return and risk.
3. Financial management and financial analysis

In general, financial management is the management of cash flows to make a profit for the firm's
owners. Financial management requires the coordination of all areas of a business to effectively
benefit the owners. Within a company, financial decision-making is usually managed by the
controller, treasurer, or vice-president of finance.
The organization may be a business enterprise, such as a manufacturing company, an accounting
firm, an oil producer, or a credit union, or it may be a charitable organization. The day-to-day
purpose of financial management is to meet current and future operating needs. Its tasks include the
development, application, and monitoring of policies and decisions regarding such business activities
as:
collection of customer receipts;

investment in marketable securities;
investment in long-term assets, such as a factory building;
payment of obligations; and
raising long-term funds.
Departments that typically perform financial management tasks include Accounts Payable (payments
to suppliers), Capital Budgeting (investment in long-term assets), Accounts Receivable (collection of
customer credit accounts), and Financial Planning (planning for cash inflows and outflows). In many
organizations, some of the functions of
financial management are integrated with For more detailed descriptions of the financial
accounting and economics functions. These management functions within a business
finance-oriented departments usually work in enterprise, check out the Association for Financial
concert with other departments within the Professionals web site.
firm. For example, the development of a new
product takes the joint efforts of Production Management, Marketing, and Finance personnel to
identify the new product, plan its production and distribution, and assess the future benefits of the
new product for the business enterprise.
Financial analysis is a tool that involves evaluating the financial condition and operating
performance of a business enterprise. Financial analysis requires an evaluation of the firm, the firm's
industry, and the economy.
Firms and investors can obtain data useful for analysis Within the firm, financial analysis may
from various financial service sources (such as Standardbe used not only to evaluate the
& Poor's, Moody's, and Dun & Bradstreet). performance of the firm, but also of its
divisions or departments and its product
lines. Analyses may be performed both periodically and as-needed, not only to ensure informed
investment and financing decisions, but also as an aid in implementing personnel policies and
rewards systems.
Outside the firm, financial analysis may be used to determine the credit-worthiness of a new
customer, to evaluate the ability of a supplier to hold to the conditions of a long-term contract, and
to evaluate the market performance of competitors.
4. Current issues
Current issues that are the focus of financial managers, investors, and regulators include:
Earnings management and financial disclosures. The recent scandals involving Enron,
Worldcom, Sunbeam and many other companies, has raised concerns over the financial
information that companies have disclosed.
Executive compensation and company performance. Many of the cases of earnings
management have arisen in an effort of either boost earnings performance to meet or beat
analysts’ expectations, or to boost compensation based on earnings or share price.
Corporate governance. The failures of the monitoring function of boards of directors are
apparent in the recent scandals.
The Sarbanes-Oxley Act, passed in 2002, addresses these and other issues pertaining to disclosures
and governance in public corporations. 1 This Act addresses audits by independent public
accountants, financial reporting and disclosures, conflicts of interest, and corporate governance at
public companies. Each of the provisions of this Act can be traced to one or more scandals that
occurred in the few years leading up to the passage of the Act. In addition, this Act establishes the
Public Company Accounting Oversight Board (PCAOB).
© 2007 Pamela Parrish Peterson-Drake
1
Public Law 107-204.
CAREERS IN FINANCE
OUTLINE
1. Introduction
2. Careers in financial management
3. Careers in investments
4. Careers in financial institutions
5. Professional designations in finance
6. Salaries of finance professionals
7. Career sites
1. Introduction
Regardless of the particular area of finance, the financial manager needs to understand
decision making in all areas of finance. The banker needs to understand the financing
decision of the small business. The security analyst needs to understand the effect of
interest rates on corporations' investment decisions. The corporate treasurer needs to
understand the role of the Federal Reserve in determining the money supply and interest
rates. In addition, while the foundations are the same, the three areas of finance offer
different career paths. We will discuss each of the three primary career paths in finance,
followed by a discussion of professional designations and salaries associated with financial
careers.
2. Careers in financial management

Financial management is the investment and financing decision-making that goes on within
all types of firms. The firm may be a business enterprise, such as a manufacturing
company, an accounting firm, an oil producer, a credit union, or a charitable organization.
The small retail firm requires decisions such as the source of funds for its seasonal cash
needs, selecting the appropriate level of inventory and cash on-hand, and deciding when
best to expand. The large corporation needs to set its credit terms, decide where to get
funds needed for expansion, and determine how much to pay in dividends to owners.
The day-to-day purpose of a firm's financial management is to meet current and future
operating needs. The financial managers' tasks include the development, application, and
monitoring of policies and decisions regarding such business activities as:
Creating and evaluating credit policies for customers.

Investing excess cash balances.
Acquiring another company.
Issuing additional equity securities.
Careers in Finance 1 of 6
Spinning-off a subsidiary.
Higher-level positions that focus primarily on financial management typically include

controller, treasurer, vice president of finance, and chief financial officer. The controller has
responsibilities for accounting and auditing functions and financial planning. The treasurer
has responsibilities for obtaining capital for investments and investing cash in other assets
of the business. The vice-president of finance has policy-making duties and acts as a liaison
between financial managers and other management personnel. Often the vice-president for
finance oversees the activities of the controller and the treasurer. The chief financial officer
(CFO) is generally part of the top layer of management that reports to the board of
directors. The CFO has authority over all of the company's financial decisions, authorizing
appropriations and expenditures.
Careers in financial management include cash management, credit analysis, capital
budgeting (decisions relating to investments), budget analysis, and corporate treasury
management. Take a look at a sampling of career descriptions:
Chief Financial Officer of a Public Manufacturing Company: Shape the future strategy
of the company by capitalizing on future growth opportunities. Compensation is
performance-oriented incentive.
Vice President of Finance: Plan the company's long-term financing, considering the
company's target capital structure, market conditions, and the costs of capital.
Project Finance Manager: Obtain financing for investment projects that is consistent
with the firm's target capital structure and considers market conditions and the costs
of capital.
Capital Budgeting Analyst: Analyze project appropriation requests, examining project
information for compliance with company capital budgeting procedures and providing
a recommendation report for capital projects. Analyze projects placed in service for
deviations from budget.
Revenue Analyst: Analyze past periods' revenues and forecast future revenues for
budgeting and planning purposes.
Credit Manager: Establish and manage credit and collections policies of the company.
Income Tax Compliance Manager: Manage tax compliance activities so that the
company complies with all domestic and foreign tax jurisdictions. Participate in the
financial planning of the company to control tax costs.
Financial Analyst: Financial analysis of competitors' financial statements, with
periodic reporting to senior management on competitors' financial condition and
performance.
3. Careers in investments
Careers in the investments fields comprise two types: the "buy side" and the "sell side". On
the "buy side," the careers include managing pension funds, insurance companies, and
mutual funds, as well as providing advice and management of individuals' retirement funds
and other savings. A manager of a pension fund, for example, may participate in
determining how much of the fund is invested in stocks and bonds, which stocks and bonds
to purchase, and when specific stocks and bonds are sold.
On the "sell side," the careers include security analysis, which requires analyzing economic,
market, and financial information, and brokerage-related careers, which involve selling
securities and executing trades for customers. A security analyst, for example, may
specialize in a particular industry, with particular focus on the major firms in that industry.
Using economic, market, and company-specific information, the analyst may evaluate the
performance of a particular company's stock and make forecasts with respect to the
company's future earnings.
Examples of careers in the investments field include:
Securities Analyst: Analyze and report on companies and industries, considering

economic and market conditions, making recommendations that assist investors with
their investment decisions.
Portfolio Review Associate: Review the performance of mutual fund portfolios and
present the reviews to clients.
Municipal Analyst: Analyze and prepare commentaries of municipal debt securities.
Financial Planner: Analyze and advise clients on asset allocation and investment
selections to help them achieve their investment goals.
Hedging and Arbitrage Manager for Fixed Income Securities: Create a profit center
through arbitrage trading and hedging in fixed income securities and derivatives.
Options Specialist: Identify and analyze option hedging strategies that include listed
options, commodities options, commodities and stock options.
Pension Fund Portfolio Manager: Manage assets held by the pension fund for the
future benefit if employees, determining the asset allocation and selection of
securities appropriate for the investment objectives and policies of the pension fund.
Stockbroker: Advise clients regarding potential investments and execute clients'
trade orders to buy or sell investments.
4. Careers in financial institutions

Financial institutions include banks, savings and loans, credit unions, mutual funds, and
investment banks. In recent years, the functions of traditional banking institutions include
the services of financial planning, brokerage, and insurance, what are discussed under
investment careers.
In the field of banking, we see employment opportunities such as the following:
Senior Vice President -- Consumer Lending: Develop credit and lending policies.
Devise a method of evaluating the effectiveness of these policies.
Senior Vice President, Manager of Corporate Banking: Develop new banking
relationships that include commercial lending and credit management.
Corporate Banking Officer: Maintain and expand banking service relationships with
existing clients and develop new client relationships.
Vice President -- Credit Policy: Establish credit and collection policies on loans;
analyze and evaluate the credit-worthiness of unique projects submitted by
customers for financing.
Director of Management Reporting: Develop, plan and direct aspects of budgeting,
cost accounting, and reporting for a large, multinational credit card company.
Careers in financial institutions include both the private sector (i.e., with banks and other
financial service firms) and the public sector (e.g., with the Federal Reserve banks).
5. Professional designations in finance

You will find that when you graduate, you are not done learning. You must continue to learn
about your chosen field, most likely focusing on a specialization such as security analysis or
treasury management. There are a number of professional designations associated the
different finance career paths, most of which require formal or self-study course work,
examinations, continuing education, and compliance with ethical standards. Table 1 is a
summary of several of these professional designations.
6. Salaries for finance professionals

The amount you can earn in a career in finance depends on a number of factors, including
the number of years of experience, specialized skills, professional designations, educational
background, and the size of the employer. Consider the field of investment banking. The
salaries range widely, depending on experience level, location, and required degrees and
experience. For current salaries in finance fields, check out CareerJournal.com, published by
the Wall Street Journal, and Robert Half Finance & Accounting, a placement service for
finance and accounting professionals.
Incentives that tied to goals, such as meeting or beating the performance of the firm's
competitors, supplement the salaries of many finance professionals. The Chief Financial
Officer (CFO) or Vice-President of Finance may be a company's highest or one of its highest
paid officers. The median CFO salary at large U.S. companies is over $450 thousand, but
some are over $2 million once you figure in the bonus and other forms of compensation,
such as stock options. 1
Salaries change each year not only to adjust for the effects of inflation, but to reflect the
supply and demand for finance professionals in different specializations, geographical area,
and experience levels.
7. Career sites
Careers in Business, a comprehensive site with links to recommended books and
career sites.
The Wall Street Journal Careers web site provides a wealth of information on finance
careers.
For listings of finance-related jobs, see the Financial Job Network.
© Pamela Peterson Drake
1
Per CareerJournal.com, CareerJournal’s Salaries Tables for Chief Financial Officers.
Table 1 Professional designations in finance
Designation Examination Experience requirement Education requirement Contact for further information
Certified Treasury 4-hour exam 2 years of cash/treasury no mention Association for Financial Professionals
Professional (CTP) management experience 7315 Wisconsin Ave, Suite 600 West
(or 1 year and an advanced Bethesda, MD 20814-3211
Formerly: Certified Cash
business degree)
Manager (CCM) www.afponline.org
Certified Financial Manager 4 4-hour exams 2 years of financial Bachelor degree, hold a Institute of Management Accountants
(CFM) management or CMA or CPA designation, 10 Paragon Drive
management accounting or score above the 50th
Montvale, New Jersey 07645-1759
percentile on the GMAT
www.imanet.org
Certified Financial Planner Comprehensive 2- 3 years in financial Bachelor or master Certified Financial Planners Board of
(CFP) day 10-hour planning degrees and approved Standards
exam financial planning program 1670 Broadway, Suite 600
Denver Colorado 802202-4809
www.cfp.net
Certified Management 4 parts, 2 years in management Bachelor degree, hold a Institute Management Accountants
Accountant (CMA) completed within accounting CMA or CPA designation, 10 Paragon Drive
3 years or score above the 50th Montvale, NJ 07645-1759
percentile on the GMAT
www.imanet.org
Table 1, cont. Professional designations in finance
Designation Examination Experience requirement Education requirement Contact for further information
Certified Public Accountant Comprehensive 4- Varies by state Bachelor degree with a American Institute of Certified Public
(CPA) part 2 1/2 day major in accounting (150 Accountants
examination (14 total semester hours 1211 Avenue of the Americas
hours) recommended) New York, NY 10036
www.aicpa.org
www.cpa-exam.org
Chartered Financial 3 comprehensive 6- 4 years as in an investment Bachelor degree or CFA Institute

Analyst (CFA) hour exams; must decision-making capacity equivalent in experience; 560 Ray C. Hunt Drive
be passed CFA study and Charlottesville, VA 22903-2981
sequentially examination program.
www.cfainstitute.org
Personal Financial Comprehensive 6- 250 hours per year for Bachelor degree with a American Institute of CPAs
Specialist (PFS) hour exam preceding 3 years in major in accounting; CPA Personal Financial Planning Division
financial planning Harborside Financial Center,201 Plaza
III
Jersey City, NJ 07311-3881
www.aicpa.org/pfs/
FORMS OF BUSINESS
OUTLINE
1. Introduction
2. The sole proprietorship
3. Partnerships
4. The corporate form of business
5. Hybrids
1. Introduction
The financial decisions of a business enterprise must be made with some objective in mind --
otherwise it's like shooting an arrow without a target. This applies whether the decision is an
investment decision (e.g., buying equipment), or a financing decision (e.g., issuing bonds). In this
reading, we first look at the different forms of business enterprise; we look at these forms in order to
better understand the context in which decisions are made. Following the discussion of the forms of
business, we focus on the objective of financial management: the maximization of owners' wealth.
We then take a look at the agency relationship -- when managers represent owners' interests -- and
some of the problems this agency relationship may create.
There are three basic forms of business:
1. Sole proprietorship
2. Partnership
3. Corporation
In the U.S., the most common form of business is the sole proprietorship. However, in terms of the
business revenue, the corporate form is dominant in the U.S. We will look at each of these three
forms of business and then take a look at hybrid forms that borrow features from one or more of
these basic forms of business.
2. The sole proprietorship

A sole proprietorship is a business enterprise owned by one person. It is the simplest and most
common form of business enterprise because it is a business owned and controlled by one person --
the proprietor. The proprietor receives all income from the business and alone decides whether to
reinvest the profits back into the business or use them for personal expenses.
Forms of business, a reading prepared by Pamela Peterson Drake 1 of 7

If more funds are needed to operate or expand the business than are generated by business
operations, the owner either contributes his or her personal assets to the business or borrows. For
most sole proprietorships, local banks represent the primary source of borrowed funds. However,
there is a limit to how much banks will lend proprietorships, most of which are relatively small
businesses.
A proprietor is liable for all the debts of the business; in fact, it is the proprietor who incurs the debts
of the business. If there are insufficient business assets to pay a business debt, the proprietor must
pay the debt out of personal assets.
For tax purposes, the sole proprietor reports income from the business on his or her personal income
tax return. Business income is treated as the proprietor's personal income. Therefore, business
income is taxed once -- as the proprietor's individual taxable income.
Because the proprietorship is dependent on the single owner, the life of a sole proprietorship ends
with the life of the proprietor, though the assets of the business may pass to the proprietor's heirs.
The assets may also be sold to some other firm, at which time the sole proprietorship ceases to exist.
The basic distinguishing features of a sole proprietorship are:
a. Financing of the business enterprise is from proprietor's own funds and from bank
borrowings.
b. The proprietor is liable for debts of the business.
c. Income of business is taxed as income of the proprietor.
d. Life of the business ends with the life of the proprietor.
There are a number of advantages and disadvantages of a sole proprietorship as a form of doing
business. Advantages include the following:
1. Decision-making is simple (because the proprietor controls decisions).

2. The owner receives all income from business.
3. Income is taxed at only one level (that of the owner).
But the sole proprietorship form of business is not without is its disadvantages. Disadvantages
include:
1. Unlimited liability -- the owner is liable for all debts of the business.
2. Limited life of the proprietorship -- the life is limited by the life of the owner.
3. The business has limited access to additional funds. Most of the fund are from the
proprietor's own assets or from lending arrangement with local banks.
3. Partnership
A partnership is a business enterprise owned by two or more persons who share the income and
liability of the business. There are different types of partnerships, including:
General partnership
Limited partnership
Master limited partnership

These different types of partnerships differ in terms of the liability and control of the partners.
A general partnership is a partnership in which each partner is liable for the debts of the business;
each partner referred to as a general partner. The owners (i.e., the partners) share in the
management of the business and share in the profits and losses of the business according to the
terms of the partnership agreement. In a general partnership, each partner is liable for the debts of
the partnership under the legal concept of joint and several liabilities. Joint and several liability
means that a creditor can sue one or more of the partners separately or all of them together.
The life of the partnership may be limited by agreement or by life of partners, requiring a
reformulation of the partnership as partners exit and enter the partnership. Further, ownership of a
partnership interest cannot be freely transferred; this causes some problems in cases of a partner
wanting to leave or in the event of the death of a partner (because the partnership share cannot be
inherited).
The partnership can raise funds from either partner contributions or from borrowing from local banks,
though these sources may be quite limiting for a growing partnership. Because the partners own 100
percent of the ownership, additional ownership interests cannot be sold. The importance of this
limitation is that a large, growing partnership may be constrained by its limited sources of financing.
The income of partnership is taxed as income of partner (in portions agreed upon in partnership
agreement), flowing directly to the taxable income of the partner. Like the sole proprietorship, the
business income of a partnership is taxed only once -- as the individual owners' income.
There are a number of advantages of the partnership form of business. Advantages include:
1. The general partners are decision-makers.

2. The owners (the partners) divide income according to partnership agreement.
3. Income is taxed once.
Disadvantages include:
1. Unlimited liability for each partner.

2. A limited life of partnership.
3. Limited access to additional funds.
A limited partnership is a partnership in which there are both general partners -- who typically are
also the managers of the partnership -- and limited partners -- who have limited liability but also
limited say in the decision-making of the partnership (which is why limited partners are often referred
to as "silent partners").
A master limited partnership is a limited partnership in Examples of master limited

which limited liability ownership units are publicly traded. The partnerships
ownership interests, which represent a specified ownership
percentage, are traded in much the same way as the shares of Alliance Resource Partners, LP
a corporation. One difference, however, is that a corporation AmeriGas Partners, LP
can raise new capital by issuing new ownership interests, Inergy, LP
increasing the number of shares of stock (but diluting existing Magellan Midstream Partners, LP
shares), whereas a master limited partnership cannot. It is not Pacific Energy Partners, LP
possible to sell more than a 100 percent interest in the Sonoco Logistics, LP
partnership, yet it is possible to sell additional shares of stock TEPPCO, LP

in a corporation. Master limited partnerships are a popular form of business in for natural resource
business ventures.
4. The corporate form of business

A corporation is a business entity created by law that is capable of entering into contracts, incurring
liabilities and carry out business. The corporation comes into being when the state grants a charter. A
charter is granted when the firm files the articles of incorporation (a description of the business
and the rights and responsibilities of its owners), which includes the bylaws (rules of governance),
and forms the board of directors (the representatives of the owners). The board of directors may
consist of both inside directors (employees of the corporation) and outside directors (non-
employees). Within the board of directors of a company are several committees, including the audit
committee and the compensation committee. The Sarbanes-Oxley Act of 2002 imposes a requirement
that the audit committee, which is responsible for the appointment, oversight, and compensation of
the independent public accounting firm that audits the company’s financial statements, be comprised
solely of independent members of the board of directors. 1
In effect, the state corporate laws serve as the boundary for the articles of incorporation. However,
being incorporated in a certain state does not mean that the firm must do business there -- or even
relocate its headquarters. The majority of large U.S. corporations are incorporated in the state of
Delaware, primarily because of its "corporate-friendly" and court-tested laws.
Unlike the sole proprietorship and partnership, the corporation is a taxable entity. It files its own
income tax return and pays taxes on its income. That income is determined according to special
provisions of the federal and state tax codes and is subject to a separate schedule of corporate tax
rates.
If the board of directors decides to distribute cash to the owners, that money is paid out of income
left over after the corporate income tax has been paid. The amount of the cash payment, or
dividend, must then also be included in the taxable income of the owners. Therefore, a portion of
the corporation's income (i.e., the portion paid out to owners) is subject to double taxation: once as
corporate income and once as individual owner's income. The dividend declared by the directors of a
corporation is distributed to owners in proportion to the numbers of shares of ownership they hold. If
owner A has twice as many shares as owner B, he or she will receive twice as much money.
The ownership interest of a corporation (also referred to as equity), can be owned by a very few
investors (i.e., a closely-held corporation) or publicly traded (i.e., a public corporation or publicly-held
corporation). In other words, a corporation may be a privately-held corporation or a publicly-traded
corporation. Examples of large, well-known private corporations include Mars, Publix, and Cargill. A
corporation can raise funds by borrowing or by issuing additional ownership interests.
Public corporations must register with the Securities and Exchange Commission (SEC), describing
their business, filing financial statements, and describing any security issuance. The Securities and
Exchange Act of 1934 requires corporations in interstate commerce (1) whose stock is listed on
national exchanges, or (2) who have over 500 shareholders and over $1,000,000 in assets, to file an
initial registration statement with the Securities and Exchange Commission (SEC), a federal agency
created to oversee the enforcement of United States (U.S.) securities laws. This statement provides
information regarding the nature of the business, the debt and stock of the corporation, the officers
1
Section 301, Sarbanes-Oxley Act of 2002.

and directors, any owners of more than 10 percent of the stock, financial statements, articles of
incorporation, by-laws, and other items.
Each corporation required to file this registration statement must also make periodic reports to the
SEC, updating the information in the registration statement, and provide annual and quarterly
financial statements. For example, the annual filing, referred to as a 10-K statement, provides
financial statements (e.g., income statement, balance sheet) as well as management's discussion and
analysis. Both the registration statement and the updating information are made available to the
public -- and particularly the shareholders (and potential shareholders) -- following review by the
SEC.
There are a number of advantages and disadvantages of the corporate form of business. Advantages
include:
1. Limited liability - the most an owner can lose is the original investment in the company.
2. The business enterprise has a life in perpetuity -- out living its owners.
3. The corporation has access to additional funds through the sale of new share of stock.
4. Income is distributed according to proportionate ownership.
Disadvantages include:
1. The separation of ownership and decision-making.

2. Double taxation on income -- income is taxed at both the corporate level and the individual
owner level when dividends are paid out.
Example: Double Taxation
Suppose a corporation has taxable income of $100,000 and is taxed at a flat rate of 40 percent of taxable
income. Suppose further that the corporation pays all of its after-tax income to its shareholders whose income is
taxed at an average rate of 30 percent.
The corporation pays $100,000 x 0.40 = $40,000 in taxes and pays the remainder, $100,000 - 40,000 =
$60,000, to shareholders.
The shareholders then must pay taxes of $60,000 x 0.30 = $18,000.
Out of the $100,000 of income, shareholders are left with only $60,000 - 18,000 = $42,000.
In effect, the shareholders' income has been taxed at the rate of 58 percent. In other words, for each dollar
of income, 58¢ is paid in taxes.
Shareholder
Tax paid by
income after
corporation
taxes
40%
42%
Tax paid by
shareholders
18%
Figure 1. Breakdown of $100,000 of corporate income if the corporate tax is 40 percent and the tax on shareholders' income
is 30 percent

5. Hybrids
There are a number of other forms of business enterprise that are hybrids of the three basic forms.
The hybrid forms that we will discuss are the professional corporation, the joint venture, and the
limited liability company.
A professional corporation is a corporation (for tax purposes) in which owners have unlimited
liability. The businesses that are likely to form such corporations are those that provide services and
require state licensing. These businesses include public accountants, physicians, surgeons, architects,
and attorneys, since it is generally felt that it is in the public interest to hold such professionals
responsible for the liabilities of their business.
A joint venture is a partnership or a corporation formed for a specific business operation. For tax
and other legal purposes, a joint venture partnership is treated as a partnership and a joint venture
corporation is treated as a corporation.
U. S. corporations have entered into joint ventures with foreign corporations, enhancing participation
and competition in the global marketplace. Joint ventures are an easy way of entering a foreign
market and of gaining an advantage in a domestic market. For example, General Electric’s energy
subsidiary, GE Energy, formed a joint venture partnership with Shanghai Xin Hua Control Technology
in 2005, giving General Electric a solid footing in the power generation business in China.
Joint ventures are becoming increasingly popular as a way of doing business. Participants -- whether
individuals, partnerships, or corporations -- get together to exploit a specific business opportunity.
Afterward, the venture can be dissolved. Recent alliances among communication and entertainment
firms have sparked thought about what the future form of doing business will be. Some believe that
what lies ahead is a virtual enterprise -- a temporary alliance without all the bureaucracy of the
typical corporation -- that can move quickly and decisively to take advantage of profitable business
opportunities.
More recently, companies are using a hybrid form the limited liability company (LLC), which
combines the best features of a partnership and a corporation. In 1977, Wyoming became the first
state to permit LLCs. In 1988 the Internal Revenue Service ruled that the LLC be treated as a
partnership for tax purposes, while its owners are not liable for its debts.2 Since this ruling, all fifty
states have passed legislation permitting limited liability companies.
Though state laws vary slightly, in general, The limited liability company form of business is
the owners of the LLC have limited liability. not new
The IRS considers the LLC to be taxed as a
partnership if the company has no more than The limited liability company originated in Germany in
two of the following characteristics: 1892 as the Gesellschaft mit beschränkter Haftung
(GmbH), and has since become an accepted form of
business in most nations. For example, in France this
1. Limited liability. form of business is referred to as a sociétés à
2. Centralized management. responsabilité limitée. See LLC History for more
3. Free transferability of ownership information.
interests.
4. Continuity of life.
2
Internal Revenue Service Ruling 88-76.

If the company has more than two of these, it will be treated as a corporation for tax purposes,
subjecting the income to taxation at both the company level and the owners'.

THE OBJECTIVE OF FINANCIAL
MANAGEMENT
A Reading prepared by Pamela Peterson Drake
OUTLINE
1. The objective of financial management
2. Managers representing owners: the agency relationship
1. The objective of financial management

Simply put, the objective of financial management is to maximize the value of the firm. And while
we can state this objective simply, it is much more complex that that. The management of the firm
involves many stakeholders, including owners, creditors, and participants in the financial markets,
as shown in Figure 1.
Figure 1: The nexus of the firm
Financial markets
determine
provide
value
information
protect social
investment costs Other
Creditors Management stakeholders
lend of the firm economic
money benefits
maximize
hire and fire
owners’
managers
wealth
Owners
The objective of financial management 1 of 7

For a corporation, this goal translates to maximizing shareholders' wealth, as represented by the
market value of equity. The market value of equity, also referred to as the market
capitalization (or known informally as the market cap) is the present value of all expected
future cash flows to owners (as represented as dividends).
The price of a share of stock at any time -- what buyers and sellers in a free market are willing to
pay for it -- is called its market value. The market value of shareholders' equity is the value of all
owners' interest in the corporation and is calculated as the product of the market value of a share
of stock and the number of shares of stock outstanding:
Market value of Number of shares Market price per

shareholders' equity outstanding share of stock
The number of shares of stock outstanding is the total number of shares that are owned by
shareholders. For example, on December 2,
2005, there were 1,923,609,276 shares Try it.
Walt Disney Company shares outstanding.
The price of Disney stock on that date was Calculate the current market value of equity for your
$24.88 per share. Therefore, the market favorite company. To find the current market value,
value of Disney's equity on December 2, multiply the current price by the current number of
2005 was $47.844 billion. shares outstanding. You can locate the shares
outstanding and current price from many services,
Investors buy shares of stock in anticipation including Yahoo! Finance and MSN Money. You will
of future dividends and increases in the need the company’ ticker symbol, which is from one
market value of the stock. How much are to five letters in length.
they willing to pay today for this future --
and hence uncertain -- stream of dividends? They are willing to pay exactly what they believe it is
worth today, an amount that is called its present value and that reflects:
the uncertainty associated with receiving the future payments,

the timing of these future payments, and
compensation for tying-up funds in this investment.
In other words, the market price of a share of stock at any time already includes investors'
evaluation of both future dividends and the future market value of the stock. Consider a five-year
investment horizon, where an investor has expectations regarding dividends in the next five years,
as well as the price of the stock in five years. Then,
Present value today Present value today of

Share price today = of dividends expected during + the share price at the
the next five years end of five years
But since the share price after five years is itself a present value of future dividends (those after
five years, ad infinitum),
Share price today = Present value today of dividends expected each period forever
So to maximize the economic well being of the corporation's owners, managers must maximize the
market price of the stock. Market price is a measure of owners' economic well being.

Economic profit vs. accounting profit
The objective of financial management is to maximize owners' wealth. The way to do this is to
maximize economic profit -- yet this is not the same thing as maximizing accounting profit.
Economic profit is the difference between revenues and costs, where costs include the
opportunity cost of invested funds. An opportunity cost is the cost of not investing in the next best
alternative use of funds; therefore, it is what one gives up. The normal profit is the minimum
return investors demand for their funds; in other words, it is the profit when economic profit is
zero. Accounting profits and economic profits differ because accounting profits ignore the
opportunity cost of funds and are subject to accounting procedures that may not reflect actual cash
flows or economic reality.
Economic profit is the difference between revenues and costs, where costs include both the actual
business costs (i.e., the explicit costs) and the implicit costs. The implicit costs are the payments
that are necessary to secure the needed resources, the cost of capital. With any business
enterprise, someone supplies funds, or capital, that the business then invests. The supplier of these
funds may be the business owner, an entrepreneur, or banks, bondholders, and shareholders. The
cost of capital depends on both the time value of money -- what could have been earned on a risk-
free investment -- and the uncertainty associated with the investment. The greater the uncertainty
associated with an investment, the greater the cost of capital.
Consider the case of the typical corporation. Shareholders invest in the shares of a corporation with
the expectation that they will receive future dividends. But shareholders could have invested their
funds in any other investment, as well. So what keeps them interested in keeping their money in
the particular corporate? Getting a return on their investment that is better than they could get
elsewhere, considering the amount of uncertainty of receiving the future dividends. If the
corporation cannot generate economic profits, the shareholders will move their funds elsewhere.
Many U.S. corporations, including Coca-Cola, Briggs & Stratton, and AT&T, embraced a method of
evaluating and rewarding management performance that is based on the idea of compensating
management for economic profit, rather than for accounting profit. The most prominent of recently
developed techniques to evaluate a firm's performance are economic value-added and market
value-added, developed by Stern Stewart. Economic value-added (EVA®) is another name for the
firm's economic profit. Key elements of estimating economic profit are:
1. calculating the firm's operating profit from financial statement data, making adjustments to
accounting profit to better reflect a firm's results for a period;
2. calculating the cost of capital; and
3. comparing operating profit with the cost of capital.
The difference between the operating profit and the cost of capital is the estimate of the firm's
economic profit, or economic value-added.
A related measure, market value-added (MVA), focuses on the market value of capital, as
compared to the cost of capital. The key elements of market value-added are:
1. calculating the market value of capital;

2. calculating the amount of capital invested (i.e., debt and equity); and
3. comparing the market value of capital with the capital invested.

The difference between the market value of capital and the amount of capital invested is the
market value-added. In theory, the market value added of a firm is the present value of the firm's
future economic profits.
The application of economic profit is relatively new in the “Capital is that part of wealth which is
measurement of performance, yet the concept of devoted to obtaining further wealth.”
economic profit is not new -- it was first noted by Alfred
Marshall in the nineteenth century. 1 What this recent -- Alfred Marshall (1824-1924)
emphasis on economic profit has accomplished is focus
attention away from accounting profit and towards clearing the cost of capital hurdle.
Share prices and efficient markets

An efficient market is a market in which the price of assets rapidly reflects all publicly available
information. An implication of efficient markets, for example is that it is not possible to "time" the
issuance of a security since investors will pay “The essence of the efficient market thing is,
only what it is worth. It is generally believed after all, as we in economics have always
that the U.S. securities markets are efficient held: There's no free lunch.”
markets; the valuation effects of any new
information are reflected quickly into a security's -- Merton Miller (1923-2000)
price. How quickly? It depends on the stock and
the type of information, but generally it takes less than fifteen minutes for a stock's price to move
in response to news. Therefore, at any point in time the market value of a company's share of
stock reflects all publicly-available information regarding that company.
2. Managers representing owners: the agency relationship

An agency relationship is the relationship between the principal and the agent, in which the
agency acts for the principal. In a corporation, the principals are the shareholders and the agents
are the managers. There are a number of problems with the agency relationship that results from
differing interests of the principals and the agents. For example,
Agents may consume excessive perquisites ("perks"),

Agents may shirk (not expend their best efforts), and
Agents may act in their own self interest (instead of that of the principal).
Actual corporate events provide a host of examples of some of the problems with the agency
relationship. For example, managers of a corporation may fight a takeover that would be in the
best interests of shareholders. As another example, managers adopt golden parachutes, which
are lucrative compensation packages that take effect if a manager loses his or her job in a
takeover.
These agency problems result in direct and indirect costs: monitoring costs, bonding costs, and
residual losses.
1
Alfred Marshall. 1890. Principles of Economics. New York: Macmillan & Co., vol. 1, page 142.

1. Monitoring costs are costs incurred by the principal to monitor the actions of the agents
(e.g., annual report to shareholders).
2. Bonding costs are costs incurred by the agent to ensure they will act in the best interests
of the principals (e.g., binding employment contract).
3. The residual loss is the implicit cost when management and shareholders' interests
cannot be aligned, even when bonding and monitoring costs are incurred.
Motivating managers: Executive compensation

The goal is to provide incentives for management to work in the owners' best interests. There are
many different ways of compensating managers. The methods include:
a. Salary: a fixed cash payment per period.

b. Bonus: a cash payment, based on some measure of operating performance, such as
earnings.
c. Stock appreciation rights: compensation corresponding to changes in the firm's share price.
d. Performance shares: shares of stock given as rewards based on operating performance.
e. Stock options: options to buy shares of stock at a specified price (exercise price) within a
specified period of time.
f. Restricted stock grant: options to buy stock, where the stock must be owned for a period
of time.
The salary portion of the compensation -- the minimum cash payment an executive receives --
must be enough to attract talented executives. But a bonus should be based on some measure of
performance that is in the best interests of shareholders -- not just on the past year's accounting
earnings. For example, a bonus could be based on gains in market share. The basic idea behind
stock options and grants is to make managers owners since the incentive to consume excessive
perks and to shirk are reduced if managers are also owners. As owners, a manager not only share
the costs of perks and shirks, but they also benefit financially when their decisions maximize the
wealth of owners.
So, the key to motivation through stock is not really the value of the stock, but rather ownership of
the stock. For this reason, stock appreciation rights and performance shares, which do not involve
an investment on the part of recipients, are not effective motivators. Stock options do work to
motivate performance if they require owning the shares over a long time period, are exercisable at
a price above the current market price of the shares (to encourage managers to get the share price
up), and require managers to tie up their own wealth in the shares.
Currently, there is a great deal of concern because executive compensation is not linked to
performance. Often, executives receive compensation packages that bear no relation to the
company's performance in terms of creating value to shareholders. One problem is that
compensation packages for top management are designed by the board of directors’ Compensation
Committee and this committee has not always been independent of the company’s management.
Moreover, reports disclosing these compensation packages to shareholders (the proxy statements)
are often confusing, which makes shareholders' monitoring task more challenging. Both problems
can be avoided by adequate and understandable disclosure of executive compensation to
shareholders, and with compensation packages determined by members of the board of directors
who are not executives of the firm. The SEC disclosure requirements were enhanced in 1993,
which offer shareholders a clearer picture of executive salaries and stock options than what was
available in the past.

Owners have one more tool with which to motivate management -- the threat of firing. As long as
owners can fire managers, managers will be encouraged to act in owners' interest. However, if the
owners are apathetic -- as they often are in large corporations -- or if they fail to monitor
management's performance and the reaction of directors to that performance, the threat may not
be credible. The removal of a few poor managers can, however, make this threat very believable.
Example: Executive Compensation at General Electric
General Electric provides its executives with compensation from several different sources:
Salary
Bonus, based on individual performance and contingent long-term performance awards,
Stock options, with exercise prices fixed at the date of the option grant,
Stock appreciation rights, that provide shares based on the difference between the market price at the
date of the rights grant and the market price when the rights are exercised,
Restricted stock units, giving the executives income equal to the quarterly dividend on common stock and
giving the executives shares of company stock when the units “lapse” or mature, and
Long-term incentive awards, based on performance targets of earnings per share growth, revenue growth,
return on total capital, and cash generated.
Also, General Electric requires stock ownership based on a multiple of the executive’s base salary. The
compensation for the Chief Executive Officer and Chairman of the Board, Jeffrey R. Immelt, for 2002 and 2003
is as follows:*
2004 2003 2002

Salary $3,000,000 $3,000,000 $3,000,000
Bonus 5,300,000 4,250,000 3,900,000
Other (e.g., financial consulting, use of corporate aircraft) 234,829 257,515 179,694
Restricted stock grant 0 0 525,000
Long term incentive plan payouts 0 0 6,693,000
All other 279,316 255,164 270,964
Total 8,814,145 $7,762679 $14,568,658
*Source: The Securities and Exchange Commission’s EDGAR database, General Electric, Schedule 14A, filed
March 2, 2004, http://www.sec.gov/Archives/edgar/data/40545/000119312504033072/ddef14a.txt and March
4, 2005, http://www.sec.gov/Archives/edgar/data/40545/000119312505042227/ddef14a.htm#page57580_7
3. Shareholder wealth maximization and social

responsibility
Beyond the shareholders, managers have a responsibility to the firm's stakeholders (its
employees, community, customers). It may be possible to maximize owners' wealth and be socially
responsible.
When financial manager assess a potential investment in a new product, they examine the risks
and the potential benefits and costs. If the risk-adjusted benefits do not outweigh the costs, they
will not invest. Similarly, managers assess current investments for the same purpose; if benefits do
not continue to outweigh costs, they will not continue to invest in the product but will shift their
investment elsewhere. This is consistent with shareholder wealth maximization and with the
allocative efficiency of the market economy.

However, discontinuing investment in an unprofitable business may mean closing down plants,
laying off workers, and, perhaps, destroying an entire town that depends on the business for
income. So decisions to invest or disinvest may affect great numbers of people.
All but the smallest business firms are linked in some way to groups of persons who are dependent
to a degree on the business. These groups may include suppliers, customers, the community itself,
and nearby businesses, as well as employees and shareholders. The various groups of persons that
depend on a firm are referred to as its stakeholders because they all have some stake in the
outcomes of the firm.
Can a firm maximize the wealth of shareholders and stakeholders at the same time? If a firm
invests in the production of goods and services that meet the demand of consumers in such a way
that benefits exceed costs the firm will be allocating the resources of the community efficiently,
employing assets in their most productive use. But maximizing the wealth of stakeholders succeeds
only if these costs include costs to stakeholders. In the case of stakeholders who are employees or
members of the community, the firm has a responsibility to assist employees and other
stakeholders who are affected. Failure to do so could tarnish its reputation, erode its ability to
attract new stakeholder groups to new investments, and ultimately act to the detriment of
shareholders.
The effects of a firm's actions on others are referred to as externalities; pollution is a very
current example that keeps increasing in importance. Suppose the manufacture of a product
creates a toxic by-product. If the firm takes action to reduce or treat this by-product, it incurs a
cost that either increases the price of its product or decreases profit and the market value of its
stock. If competitors do not likewise incur costs to reduce their hazardous waste, the firm is at a
disadvantage and may be driven out of business through competitive pressure. 2 The firm may try
to use its efforts at reducing the hazardous waste to enhance its reputation, in the hope that this
will lead to a sales increase large enough to make up for the cost of reducing the waste. This is
what is called a market solution: the market places a value on the hazardous waste control and
rewards the firm (or an industry) for it. If society really believes that harming the environment is
bad and that reducing hazardous waste is good, the interests of owners and society can be aligned.
It is more likely, however, that costs of reducing or treating hazardous waste will be viewed as
reducing owners' wealth. Then firms must be forced to reduce such waste through government
laws or regulations. But such laws and regulations also come with a cost -- the cost of
enforcement. Again, if the benefits of mandatory pollution control outweigh the cost of government
action, society is better off. And if the government requires all firms to reduce pollution or
hazardous waste, then pollution control costs simply become one of the conditions under which
owner wealth-maximizing decisions are to be made.
2
This is a very real threat of U.S. companies competing against companies that have little cost associated with
the environmental impact of their processing.

Foundation Questions and Problems Page 1 of 2
Solutions to questions and problems

Foundations of Finance
1. List the advantages and disadvantages of the following forms of business:
a. Sole proprietorship
ADVANTAGES
1. Easy to form. DISADVANTAGES

2. Low cost to form.
3. Owner is typically the manager of the 1. Unlimited liability for the owner.
business. 2. Limited access to additional capital.
4. Income is taxed only once (at proprietor 3. Life of proprietorship ends with
level). proprietor.
b. Partnership
DISADVANTAGES
ADVANTAGES
1. Unlimited liability for the
1. Easier to form than a corporation. owners.
2. Low cost to form. 2. Limited acces to additonal
3. Income and assets are shared according to the capital.
partnership agreement. 3. Life of partnership ends with
4. Income is taxed only once (at partner level). partners.
c. Corporation
DISADVANTAGES
ADVANTAGES
1. Double taxation.
1. Limited liability for the 2. Must be granted corporate charter by a state.
owners. 3. Agency problems arise as owners become separated from
2. Ready access to capital. management.
2. List and briefly describe the advantages of a limited liability company form of business relative to the
corporate form of business.
1. Easier to form.
2. If designed to satify tax laws, not subject to double taxation.
3. Explain the difference, if any, between accounting profit and economic profit.
1. Accounting profit is based on accounting principles that use, in part, historical values.
2. Economic profit considers the opportunity cost of capital, whereas accounting profit does not.
3. Accounting profit can be manipulated by the judicious choice of accounting methods; economic profit,
theoretically, can only be determined using one method.
4. Maximizing economic profit is consistent with maximizing the value of the firm; maximizing accoutnig
profit may not be.
4. What is the goal of the firm and how does it relate to a company's profit?
http://educ.jmu.edu/~drakepp/principles/module1/foundation1s.htm 2/28/2011
Foundation Questions and Problems Page 2 of 2
1. The goal of the firm is to maximize value,

2. Maximizing a firm's economic profit is consistent with maximizing the firm's value.
3. The maximization of accounting profit is not necessarily consistent with the goal of maximizing a firm's
value.
5. List and briefly describe three compensation devices that may be used to provide incentives for managers to
maximize owners' wealth.
1. Bonus: a cash amount that is rewarded based on meeting specified performance targets.
2. Options: options that give the employeed the right to buy stock at a specified price within a specified
period of time.
3. Stock appreciation rights: compensation corresponding to changes in the firm's share price.
4. Performance shares: shares of stock given as rewards based on operating performance.
5. Restricted stock grant: options to buy stock, where the stock must be owned for a period of time.
6. What is the role of Sarbanes-Oxley in corporate governance?
Sarbanes-Oxley affects corporate governance with the several provisions that affect corporate governance,
including:
a. Creates the Public Company Accounting Oversight Board, which monitors the accounting profession
and auditing of public companies.
b. Requires the Board's Audit Committee members to be independent and increases the responsibilities
of the members of the committee.
c. Requires disclosure regarding whether the company's Audit Committee has a financial expert as one of
its members.
d. Addresses potential conflicts of interest with regard to the auditing accounting firm.
http://educ.jmu.edu/~drakepp/principles/module1/foundation1s.htm 2/28/2011
Module 1 StudyMate Activity, Pamela Peterson Drake Page 1 of 2
Introduction to Financial Management StudyMate Activity
Flash Cards
Pick a Letter
Fill In The Blank
Matching
Crosswords
Quiz
Challenge
Glossary
http://educ.jmu.edu/~drakepp/principles/module1/mod1.htm 2/28/2011
Module 1 StudyMate Activity, Pamela Peterson Drake Page 2 of 2

Flash Cards javascript:launchSWFmod1('?gm=FlashCards&ds=ALL&sk=wct&arg=t')
Pick a Letter javascript:launchSWFmod1('?gm=PickALetter&ds=ALL&sk=wct&arg=t')
Fill In The Blank javascript:launchSWFmod1('?gm=FillInTheBlank&ds=ALL&sk=wct&arg=t')
Matching javascript:launchSWFmod1('?gm=Matching&ds=ALL&sk=wct&arg=t')
Crosswords javascript:launchSWFmod1('?gm=Crosswords&ds=ALL&sk=wct')
Quiz javascript:launchSWFmod1('?gm=PracticeQuiz&ds=ALL&sk=wct&arg=ttttf')
Challenge javascript:launchSWFmod1('?gm=Challenge&ds=ALL&sk=wct')
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Principles of Financial Management, Module 2, Pamela Peterson Drake Page 1 of 2
Module 2: Financial Analysis

Elements
1. Module 2: Financial Analysis IMPORTANT: READ FIRST
2. Reading: Financial Accounting Information
3. Reading: Financial Ratio Analysis
4. Reading: Financial Analysis
5. Example: Du Pont applied to Sears Roebuck
6. Financial Analysis Links
7. Example: Understanding Financial Statements, an explanation using Procter and Gamble
8. Financial Ratio Formulas
9. Problem set: Using Financial Accounting Information
10. Accounting Review Crossword Puzzle
11. Problem set: Financial Ratios with solutions
12. Practice set: Financial Ratios, (non-credit) with solutions
13. Financial Ratio Analysis StudyMate Activity
Principles of Financial Management, Module 2, Pamela Peterson Drake Page 2 of 2

Module 2: Financial Analysis http://educ.jmu.edu/~drakepp/principles/module2/learning_outcomes.pdf
Financial Accounting Information http://educ.jmu.edu/~drakepp/principles/module2/fin_acc.pdf
Financial Ratio Analysis http://educ.jmu.edu/~drakepp/principles/module2/fin_rat.pdf
Financial Analysis http://educ.jmu.edu/~drakepp/principles/module2/fin_analysis.pdf
Du Pont applied to Sears Roebuck http://educ.jmu.edu/~drakepp/principles/module2/dupont_sears.pdf
Financial Analysis Links http://educ.jmu.edu/~drakepp/principles/module2/fin_links.pdf
Understanding Financial Statements http://educ.jmu.edu/~drakepp/principles/module2/pg.pdf
Financial Ratio Formulas http://educ.jmu.edu/~drakepp/principles/module2/fin_formulas.pdf
Using Financial Accounting
http://educ.jmu.edu/~drakepp/principles/module2/acc.html
Information
Accounting Review Crossword
http://educ.jmu.edu/~drakepp/principles/module2/accpuzzle.htm
Puzzle
Financial Ratios http://educ.jmu.edu/~drakepp/principles/module2/finrat.html
Financial Ratios http://educ.jmu.edu/~drakepp/principles/module2/ratioquiz.htm
Financial Ratio Analysis StudyMate
http://educ.jmu.edu/~drakepp/principles/module2/mod2.htm
Activity
MODULE 2:
FINANCIAL ANALYSIS
OUTLINE
1. Introduction
3. Module 2 tasks
1. Introduction
The purpose of this module is to introduce you to financial analysis. Financial analysis is a tool
that is used by financial managers and analysts to assess a company’s financial condition and
performance. Financial analysis is also used to forecast or predict the future course of a
company’s condition and performance.
Financial analysis has become increasingly important as investors, regulators, and corporate
management grapple with the recent corporate scandals. Many of these scandals involve
manipulating accounting numbers, outright corporate fraud, and shifting information off the
financial statements and into the footnotes.
The Securities and Exchange Commission and the Attorney General of New York, among other
regulators, have been pursuing investigations involving a wide range of corporate misdeeds, but
most of these misdeeds relate to the accounting information that is provided to investors and
shareholders. Examples include:
Shifting debt off the balance sheet and into special purpose entities [Enron];
Inflating revenues [Krispy Kreme; Worldcom; Sunbeam; AOL Time Warner; Global
Crossing; Peregrine Systems]
Hiding debt off-balance sheet [Adelphia]
Many companies have restated their financial results after having the “errors in their ways”
pointed out to them by the SEC. The passage of the Sarbanes Oxley Act of 2002 and related
rules and regulations are a direct result of these scandals.
These scandals make it even more important that investors understand how to interpret financial
data and to understand how much “wiggle room” companies have within generally accepted
accounting practices.
In this module we introduce you to financial analysis. We begin with a review of financial
accounting, and then learn the tools of analysis, which include financial ratio analysis.
Module 2 Overview 1
2. Learning Outcomes
LO2.1 Analyze a company’s financial statements
LO2.2 Infer a company’s financial health from the information provided in the statement of
cash flows.
LO2.3 Explain how companies may be able to manage financial information
LO2.4 Identify the role of accounting principles in the quality of financial statements
LO2.5 Explain the purpose of performing financial analysis
LO2.6 Relate the a firm’s operating cycle to its liquidity
LO2.7 Differentiate the profit margins and identify how each is used to interpret a firm’s
financial health
LO2.8 Calculate measure of a firm’s effectiveness in using assets and relate these to
components of a firm’s operating cycle
LO2.9 Apply the Du Pont system to interpret trends in return ratios
LO2.10 Calculate ratios that express financial information on a per share basis
LO2.11 Explain the tools used to use financial ratios effectively
LO2.12 Recognize and list problems and dilemmas of financial analysis
3. Module 2 tasks
A. Readings
i) Required reading
(a) Financial accounting information
(b) Financial ratios
(c) Financial analysis
ii) Other resources
(a) Understanding financial statements. A detailed explanation of many of the accounts
typically found on the financial statements of a publicly traded corporation. Procter &
Gamble is used as an example.
(b) Financial ratio formulas, for reference purposes.
(c) The Du Pont system applied to Sears Roebuck & Co.; an example of how to use the Du
Pont system applied to actual financial data.
(d) Other links.
iii) Optional reading
Fabozzi and Peterson text, Chapter 5 (Financial Statements) and Chapter 22 (Financial
Analysis)
B. Problem sets
Module 2 Overview 2
These problems sets are non-graded tasks. It is recommended that you complete these problem
sets prior to attempting the graded online quiz.
Using financial accounting information
Accounting review crossword puzzle
Financial ratio problems
Financial ratio practice quiz (non-credit)
StudyMate activity

A. Financial accounting information
Financial analysis requires a good understanding of financial accounting information. Without this
understanding, the financial information that we use in analysis is meaningless. In this review of
accounting, we cover the basics of the balance sheet, the income statement, and the statement
of cash flows. In addition, we discuss other sources of company information, such as the notes
to the financial statements.
B. Financial ratios
Financial ratios are tools that we use to help us to use accounting information to describe a
company’s financial condition and performance. There are hundreds of ratios that could be
calculated and we look at a small subset of these ratios.
We cover ratios that capture a company’s liquidity, profitability, and financial leverage. In
addition, we introduce to shareholder ratios that are, basically, restatements of financial data on
a per share basis.
C. Financial analysis
The calculation of ratios is straightforward. The tough part is making sense out of all the
information, both the raw data and the ratios. Financial analysis is the process of taking all the
data and interpreting that data to tell us something about the company’s financial condition (Is it
healthy? Can it satisfy its financial obligations in the future?) and performance (Is it profitable?
Will it continue to be profitable?).
In financial analysis, we use financial data in many different ways: Du Pont analysis, common
size analysis, and trend analysis.
In performing financial analysis, we must be aware of problems that go along with using
accounting information. We also have to be aware of what a ratio can tell us … and what it
doesn’t tell us; we can’t read much into a single ratio, but rather must put it in perspective in
three dimensions: other ratios of the same firm, the same ratio for benchmark (i.e., comparable)
firms, and trends over time.
D. What’s next?
The next two modules involve the mathematics of finance. Once you master the mathematics of
finance in the context of valuation, we’ll put those tools together with the information from the
first two modules in the modules on capital budgeting and capital structure.
Module 2 Overview 3
Module 2 Overview 4
Financial Accounting Information
A reading prepared by Pamela Peterson-Drake
OUTLINE
1. The balance sheet

2. The income statement
3. The statement of cash flows
4. Other information
5. Summary
1. The balance sheet

The balance sheet is a report of the assets, liabilities, and equity of a firm at a point in time,
generally at the end of a fiscal quarter or fiscal year.
Assets
Assets are resources of the business enterprise, which are comprised of current or long-lived assets.
Current assets
Current assets are assets that can be turned into cash in one operating cycle or one year,
whichever is longer. Non-current assets are all other assets; that is, assets that cannot be liquidated
quickly. A company's need for current assets is dictated, in part, by its operating cycle. The
operating cycle is the length of time it takes to turn the investment of cash into goods and services
for sale back into cash in the form of collections from customers. The longer the operating cycle, the
greater a company’s need for liquidity. Most firms' operating cycle is less than or equal to one year.
There are different types of current assets:
Cash, bills, and currency are assets that are equivalent to cash (e.g., bank account).
Marketable securities are securities that can be readily sold.
Accounts receivable are amounts due from customers arising from trade credit.
Inventories are investments in raw materials, work-in-process, and finished goods for sale.
Non-current assets comprise both physical and non-physical assets. Plant assets are physical assets,
such as buildings and equipment and are reflected in the balance sheet as gross plant and equipment
and net plant and equipment. Gross plant and equipment is the total cost of investment in
physical assets. Net plant and equipment is the difference between gross plant and equipment
and accumulated depreciation, and represents the book value of the plant and equipment assets.
Accumulated depreciation is the sum of depreciation taken for physical assets in the firm's
possession.
Financial Accounting Information, prepared by Pamela Peterson-Drake 1

Exhibit 1: The Gorebush Company Balance Sheet
as of December 31, 2004
in millions
2003 2004 2003 2004
Cash $50 $60 Accounts payable $100 $150
Accounts receivable 100 110 Long-term debt 400 300
Inventory 200 180 Common stock 50 50
Property, plant, and equipment $800 $900 Retained earnings 400 500
Accumulated depreciation 200 250
Net property, plant, and equipment 600 650
Total assets $950 $1,000 Total liabilities and equity $950 $1,000
Interpreting financial statements requires knowing a bit about how assets are depreciated for
financial reporting purposes. Depreciation is the allocation of the cost of an asset over its useful life
(or economic life). In the case of the fictitious Gorebush Company, whose balance sheet is shown in
Exhibit 1, the original cost of the fixed assets (i.e., plant, property, and equipment) -- less any write-
downs for impairment -- for the year 2004 is $900 million. The accumulated depreciation for
Gorebush in 2004 is $250 million; this means that the total of depreciation taken on existing fixed
assets over time is $250 million. The net property, plant, and equipment account balance is $650
million. This is also referred to as the book value or carrying value of these assets.
Intangible assets are assets having no physical existence, such as patents and trademarks.
Intangible assets may be amortized over some period, which is akin to depreciation.
Liabilities
Liabilities are obligations of the business enterprise. Liabilities are generally broken into two major
groups: current liabilities and long-term liabilities. We generally use the terms “liability” and “debt”
as synonymous terms, though liabilities is actually a broader term, encompassing not only the explicit
contracts that a company has, in terms of short-term and long-term debt obligations, but also
includes obligations that are not specified in a contract, such as environmental obligations or asset
retirement obligations.
Short-term liabilities
Current liabilities are obligations due within one year or one operating cycle (whichever is longer).
Current liabilities consist of:
Accounts payable are amounts due to suppliers for purchases on credit.
Wages and salaries payable are amounts due employees.
Current portion of long-term indebtedness.
Short term bank loans.
Long-term liabilities
Long-term liabilities are obligations that are due beyond one year. There are different types of
long-term liabilities, including:
Notes payables and bonds, which are indebtedness (loans) in the form of securities.
Capital leases are rental obligations that are long-term, fixed commitments.

Deferred taxes are taxes that may have to be paid in the future that are currently not due,
though they are expensed for financial reporting purposes. Deferred taxes arise from
differences between accounting and tax methods (e.g., depreciation methods). 1
Equity
Equity is the ownership interest of the business enterprise. Book value of equity is the total value
of the ownership of a firm, according to accounting principles. Book value is comprised of:
Par value, which is a nominal amount per share of stock (sometimes prescribed by law), or
the stated value, which is a nominal amount per share of stock assigned for accounting
purposes if the stock has no par value.
Additional paid-in-capital, which is the amount paid for shares of stock by investors in
excess of par or stated value.
Treasury stock, which is the accounting value of shares of the firm's own stock bought by
the firm.
Retained earnings, which is the accumulation of prior periods' earnings, less any prior
periods' dividends.
As an example, consider Microsoft's stockholders' equity reported in its 1 st quarter 2001 balance
sheet, in millions:
June 30, Sept. 30,
2001 2001
Common stock and paid-in capital s(hares authorized 12,000; outstanding 5,283
$23,195 $26,661
and 5,316)
Retained earnings, including accumulated other comprehensive income of $1,527
18,173 18,682
and $1,459
Total stockholders' equity $41,368 $45,343
The book value of equity for Microsoft at the end of its first quarter of 2001 is $45.343 billion, or
$43,343/5,316 = $8.53 per share.
More on depreciation
There are different methods that can be used to allocate an asset's cost over its life. Generally, if the
asset is expected to have value at the end of its economic life, the expected value, referred to as a
salvage value (or residual value), is not depreciated; rather, the asset is depreciated down to its
salvage value. There are different methods of depreciation that we classify as either straight-line or
accelerated. Straight-line depreciation allocates the cost (less salvage value) in a uniform manner
(equal amount per period) throughout the asset's life. Accelerated depreciation allocates the
asset's cost (less salvage value) such that more depreciation is taken in the earlier years of the
asset's life. There are alternative accelerated methods available, including:
Declining balance method, in which a constant rate applied to a declining amount (the
undepreciated cost), or
Sum-of-the-years' digits method, in which a declining rate applied to the asset's
depreciable basis.
1
Though deferred income taxes are often referred to as liabilities, some analysts will classify them as equity if the deferral is
perceived to be perpetual. For example, a company that buys new depreciable assets each year will always have some level of
deferred taxes; in that case, an analyst will classify deferred taxes as equity.

In the declining balance (DB) method, the rate is determined as:
DB rate = 1 - (salvage value/original cost)1/useful life
Therefore, if the original cost of $1 million, the salvage value is $100,000, and the useful life is 10
years, the declining balance rate is:
DB rate = 1 - ($100,000/$1,000,000)0.10 = 20.567,
which is then applied each year against the undepreciated balance (that is, the cost less he
accumulated depreciation). For this same asset, the sum-of-the-years' digits (SYD) depreciation for
the first year is:
SYD first year = $900,000 ( 10/55) = $163,636
where the denominator is 10+9+8+7+6+5+4+3+2+1 = 55.
Accelerated methods result in higher depreciation expenses in earlier years, relative to straight-line,
as you can see in Exhibit 2. In addition, accelerated methods result in lower reported earnings in
earlier years, relative to straight-line.
A major source of deferred income taxes and deferred tax assets is the accounting methods used for
financial reporting purposes and tax purposes. In the case of financial accounting purposes, the
company chooses the method that best reflects how its assets lose value over time, though most
companies use the straight-line method. However, for tax purposes the company has no choice but
to use the prescribed rates of depreciation, using the Modified Accelerated Cost Recovery System
(MACRS). For tax purposes, a company does not have discretion over the asset’s depreciable life or
the rate of depreciation – they must use the MACRS system.

Exhibit 2: Comparison of depreciation expense and book value
Depreciation expense each year for an asset with an original cost of $100,000, a salvage value of $10,000, and a
10 year useful life. The Excel worksheet that produced this graph is available here.
Panel A: Depreciation expense
Straight-line depreciation
$25,000
Sum-of-years'-digits depreciation
$20,000
Double declining-balance depreciation with optimal switch
$15,000
Depreciation
expense
$10,000
$5,000
$0
1 2 3 4 5 6 7 8 9 10
Year in asset's life
Panel B: Book value of the asset
$100,000
$90,000 Sum-of-years'-digits depreciation
$80,000 Double declining-balance depreciation with optimal switch
$70,000
Net book $60,000
value of $50,000
the asset $40,000
$30,000
$20,000
$10,000
$0
1 2 3 4 5 6 7 8 9 10
Year in asset's life
The MACRS system does not incorporate salvage value and is based on a declining balance system.
The depreciable life for tax purposes may be longer than or shorter than that used for financial
reporting purposes. For example, the MACRS rate for a 3- and 5-year assets are as follows:
Year 3-year 5-year
1 33.33% 20.00%
2 44.45% 32.00%
3 14.81% 19.20%
4 7.41% 11.52%
5 11.52%
6 5.76%
You’ll notice the fact that a 3-year asset is depreciated over 4 years and a 5-year asset is depreciated
over six years. That’s the result of using what is referred to as a half-year convention – using only
half a year’s worth of depreciation in the first year of an asset’s life. This system results in a leftover
amount that must still be depreciated in the last year (i.e., the fourth year in the case of a 3-year

asset and the sixth year in the case of a 5-year asset). A comparison of straight-line and MACRS
depreciation is provided in Exhibit 3.
Exhibit 3: Depreciation for financial accounting purposes v. tax purposes

Consider an asset that costs $200,000 and has a salvage value of $20,000. If the asset has a useful life of 8
years, but is classified as a 5-year asset for tax purposes, the depreciation and book value of the asset will be
different between the financial accounting records and the tax records.
Panel A: Depreciation expense
$70,000
$60,000 Straight-line depreciation
$50,000 MACRS depreciation
Depreciation $40,000
expense $30,000
$20,000
$10,000
$0
1 2 3 4 5 6 7 8
Panel B: Book value
$200,000
$150,000 MACRS deprecaition
Book
$100,000
value
$50,000
$0
1 2 3 4 5 6 7 8
A note on minority interest

On many companies’ consolidated financial statements, you will notice a balance sheet account
entitled “Minority Interest”. When a company owns a substantial portion of another company, the
accounting principles require that the company consolidate that company’s financial statements into
its own. Basically what happens in consolidating the financial statements is that the parent company
will add the accounts of the subsidiary to its accounts (i.e., subsidiary inventory + parent inventory =
consolidated inventory).2 If the parent does not own 100% of the subsidiary’s ownership interest, an
account is created, referred to as minority interest, which reflects the amount of the subsidiary’s
assets not owned by the parent. This account will be presented between liabilities and equity on the
consolidated balance sheet. Is it a liability or an equity account? It’s neither.
2
There are some other adjustments that are made for inter-corporate transactions, but we won’t go into those at this time.

A similar addition and adjustment takes place on the income statement. The minority interest account
on the income statement reflects the income (or loss) in proportion to the equity in the subsidiary not
owned by the parent.
2. The income statement

The income statement is a summary of operating performance over a period of time (e.g., a fiscal
quarter or a fiscal year). The bottom line of the income statement consists of the owners' earnings
for the period. To arrive at this "bottom line", we need to compare revenues and expenses. The basic
structure of the income statement includes:
Sales or revenues Represent the amount of goods or services sold, in terms of
price paid by customers.
Less: Cost of goods sold (or cost of sales) The amount of goods or services sold, in terms of cost to the
firm.
Gross profit The difference between sales and cost of goods sold
Less: Selling and general expenditures Salaries, administrative, marketing expenditures, etc.
Operating profit Income from operations (ignores effects of financing decisions
and taxes); earnings before interest and taxes (EBIT),
operating income, and operating earnings.
Less: Interest expense Interest paid on debt
Net income before taxes Earnings before taxes
Less: Taxes Taxes expense for the current period
Net income Operating profit less financing expenses (e.g., interest) and
taxes.
Less: Preferred stock dividends Dividends paid to preferred shareholders
Earnings available to common shareholders Net income less preferred stock dividends; residual income
Though the structure of the income statement varies by company, the basic idea is to present the
operating results first, followed by non-operating results. In the case of the Gorebush Company,
whose income statement is presented in Exhibit 4, the income from operations is $190 million,
whereas the net income (i.e., the "bottom line") is $100 million.
Exhibit 4: The Gorebush Company Income
Statement
For the period ending December 31, 2004
in millions
Sales $1,000
Cost of goods sold 600
Gross profit $400
Depreciation 50
Selling, general, and administrative expenses 160
Operating profit $190
Interest expense 23
Income before taxes $167
Taxes 67
Net income $100
3. The statement of cash flows

The statement of cash flows is the summary of a firm's cash flows, summarized by operations,
investment activities, and financing activities. A simplified cash flow statement is provided in Exhibit
5 for the fictitious Gorebush Company. Cash flow from operations is cash flow from day-to-day
operations. Cash flow from operating activities is basically net income adjusted for (1) non-cash

expenditures, and (2) changes in working capital accounts. The adjustment for changes in working
capital accounts is necessary to adjust net income that is determined using the accrual method to a
cash flow amount. Increases in current assets and decreases in current liabilities are positive
adjustments to arrive at the cash flow; decreases in current assets and increases in current liabilities
are negative adjustments to arrive at the cash flow.
Exhibit 5: The Gorebush Company Statement of
Cash Flows Cash flow for/from investing is the cash
For the period ending December 31, 2004 flows related to the acquisition (purchase) of
in millions plant, equipment, and other assets, as well as
Net income $100 the proceeds from the sale of assets. Cash flow
for/from financing activities is the cash flow
Add depreciation 50
from activities related to the sources of capital
Subtract increase in accounts receivable -10 funds (e.g., buyback common stock, pay
Add decrease in inventory 20 dividends, issue bonds).
Add increase in accounts payable 50 Not all of the classifications required by
Cash flow from operations $210 accounting principles are consistent with the
true flow for the three types of activities. For
example, interest expense is a financing cash
Retire debt -$100 flow, yet it affects the cash flow from operating
Cash flow for financing -100 activities because it is a deduction to arrive at
net income. This inconsistency is also the case
for interest income and dividend income, both of
Purchase of equipment -$100 which result from investing activities, but show
Cash flow for investment -100 up in the cash flow from operating activities
through their contribution to net income.
The sources of a company’s cash flows can
Change in cash flow $10
reveal a great deal about the company and its
prospects. For example, a financially healthy company will have cash flows from operations (that is,
positive operating cash flows) and cash flows for investing (that is, negative investing cash flows).
To remain viable, a company must be able to generate funds from its operations; to grow, a
company must be continually make capital investments.

The change in cash flow –
Exhibit 6 Cash flow patterns
a.k.a. the net cash flow –
Panel A: Microsoft is the bottom line in the
statement of cash flows
and is equal to the
$20,000 CFO change in the cash
$15,000 CFI account as reported on
CFF the balance sheet. For the
$10,000
Gorebush Company,
$5,000 shown in Exhibit 5, the
net change in cash flow is
$0
a positive $10 million; this
($5,000) is equal to the change in
($10,000) the cash account from
$50 to $60 million.
($15,000)
1995 1996 1997 1998 1999 2000 2001 2002 2003 By studying the cash
flows of a company over
time, we can gauge a
company's financial
Panel B: Toys-R-Us health. For example, if a
company relies on
$1,000
CFO external financing to
CFI support its operations
$800
CFF (that is, cash flows from
$600
financing and not from
$400
operations) for an
$200 extended period of time,
$0 this is a warning sign of
($200) financial trouble up
($400) ahead.
($600) Two examples of patterns
($800) are provided in Exhibit 6;
1995 1996 1997 1998 1999 2000 2001 2002 2003 both companies have
healthy cash flows, yet as
you can see, Toys R Us
experienced some
difficulties 2000, prior to
its extensive store
remodeling/remerchandising.
4. Other information
In addition to the three basic financial statements, additional information is provided by companies in
their annual and quarterly reports to shareholders. This additional information includes the statement
of stockholders' equity, notes and earnings per share information.
Statement of stockholders' equity

The statement of stockholders' equity is a summary of the changes in the equity accounts, including
information on stock options exercised, repurchases or shares, and treasury shares.

Notes
Notes contain additional information, supplementing or explaining financial statement data. Notes
provide information about the firm's accounting policies, income taxes, and pension liabilities, among
other matters. Notes are presented in both the annual report and the 10-K filing (with the SEC),
though the latter usually provides a greater depth of information.
Earnings per share (EPS)

Companies provide information on earnings per share (EPS) in their annual and quarterly financial
statement information, as well as in their periodic press releases. Generally, EPS is calculated as net
income, divided by the number of shares outstanding. Beginning with fiscal years ending after
December 15, 1997, companies must report both basic and diluted earnings per share. This replaces
the previous requirement
of simple, primary, and
Exhibit 7: Adobe Systems, Inc., Earnings per share,
fully diluted EPS.
1998-2003
Basic earnings per
share is netincome $1.40
Basic EPS Diluted EPS
(minus preferred
$1.20
dividends), divided by the
$1.00
average number of shares
outstanding. Diluted Earnings $0.80
per share $0.60
earnings per share is
net income (minus $0.40
preferred dividends), $0.20
divided by the number of $0.00
shares outstanding 1998 1999 2000 2001 2002 2003
considering all dilutive
securities (e.g.,
convertible debt, options).
Diluted earnings per
share, therefore, gives the shareholder information about the potential dilution of earnings. For
companies with a large number of dilutive securities (e.g., stock options, convertible preferred stock
or convertible bonds), there can be a significant difference between basic and diluted EPS. You can
see the effect of dilution by comparing the basic and diluted EPS.
Consider Adobe Systems. Its basic and diluted earnings per share differed slightly, primarily due to
restricted stock options, as shown in Exhibit 7.3
Pro forma financial data

Pro forma financial information is really a misnomer – the information is neither pro forma (that is,
forward looking), nor reliable financial data. What is it? Creative accounting. It started during the
Internet/Tech boom in the 1990s and persists today: companies release financial information that is
prepared according to their own liking, using accounting methods that they create. Why did
companies start doing this? What’s wrong with generally accepted accounting principles (GAAP)?
During the Internet/Tech stock boom, many start-up companies quickly went public and then felt the
pressures to generate profits. However, profits in that industry were hard to come by during that
period of time. What some companies did is generate financial data that they included in company
releases that reported earnings that were not determined by GAAP – but rather by methods of their
3
Source: Adobe Systems, Inc., 10-K filings, 2003 and 2000.*

own. In some cases, these alternative methods hid a lot of the ills of these companies. A couple of
examples are shown in Exhibit 8.
Exhibit 8: Examples of Pro forma v. GAAP earnings
The use of pro forma financial
data may be misleading to
Net income for 2001, Pro forma IAS or GAAP
investors. For example, if a
in millions …
press release refers to last
Nokia (EUR) €3,789 €2,220 quarter’s earnings, are these
Cisco (USD) $3,086 -$1,014 pro forma or GAAP?
In response, the Securities and
IAS = International accounting standards Exchange Commission now
GAAP = Generally accepted accounting standards requires that if companies
EUR = Euro release pro forma financial data,
USD = U.S. Dollar they must also reconcile this
Source: Yahoo! Finance data with GAAP.
5. Summary
The much of the financial data that is used in financial analysis is drawn from the company’s financial
statements. It is important to understand this data so that we can interpret this information and use
it in analysis of a company’s financial condition and performance in the past and what we expect of
the financial condition and performance in the future.

Financial ratio analysis
OUTLINE
1. Introduction
2. Liquidity ratios
3. Profitability ratios and activity ratios
4. Financial leverage ratios
5. Shareholder ratios
1. Introduction
As a manager, you may want to reward employees based on their performance. How do you know
how well they have done? How can you determine what departments or divisions have performed
well? As a lender, how do decide the borrower will be able to pay back as promised? As a manager of
a corporation how do you know when existing capacity will be exceeded and enlarged capacity will be
needed? As an investor, how do you predict how well the securities of one company will perform
relative to that of another? How can you tell whether one security is riskier than another? We can
address all of these questions through financial analysis.
Financial analysis is the selection, evaluation, and interpretation of financial data, along with other
pertinent information, to assist in investment and financial decision-making. Financial analysis may be
used internally to evaluate issues such as employee performance, the efficiency of operations, and
credit policies, and externally to evaluate potential investments and the credit-worthiness of
borrowers, among other things.
The analyst draws the financial data needed in financial analysis from many sources. The primary
source is the data provided by the company itself in its annual report and required disclosures. The
annual report comprises the income statement, the balance sheet, and the statement of cash flows,
as well as footnotes to these statements. Certain businesses are required by securities laws to
disclose additional information.
Besides information that companies are required to disclose through financial statements, other
information is readily available for financial analysis. For example, information such as the market
prices of securities of publicly-traded corporations can be found in the financial press and the
electronic media daily. Similarly, information on stock price indices for industries and for the market
as a whole is available in the financial press.
Another source of information is economic data, such as the Gross Domestic Product and Consumer
Price Index, which may be useful in assessing the recent performance or future prospects of a
company or industry. Suppose you are evaluating a company that owns a chain of retail outlets.
What information do you need to judge the company's performance and financial condition? You
need financial data, but it doesn't tell the whole story. You also need information on consumer
Financial ratios, a reading prepared by Pamela Peterson Drake 1

spending, producer prices, consumer prices, and the competition. This is economic data that is
readily available from government and private sources.
Besides financial statement data, market data, and economic data, in financial analysis you also need
to examine events that may help explain the company's present condition and may have a bearing on
its future prospects. For example, did the company recently incur some extraordinary losses? Is the
company developing a new product? Or acquiring another company? Is the company regulated?
Current events can provide information that may be incorporated in financial analysis.
The financial analyst must select the pertinent information, analyze it, and interpret the analysis,
enabling judgments on the current and future financial condition and operating performance of the
company. In this reading, we introduce you to financial ratios -- the tool of financial analysis. In
financial ratio analysis we select the relevant information -- primarily the financial statement data --
and evaluate it. We show how to incorporate market data and economic data in the analysis and
interpretation of financial ratios. And we show how to interpret financial ratio analysis, warning you
of the pitfalls that occur when it's not used properly.
We use Microsoft Corporation's 2004 financial statements for illustration purposes throughout this
reading. You can obtain the 2004 and any other year's statements directly from Microsoft. Be sure to
save these statements for future reference.
Classification of ratios
A ratio is a mathematical relation between one quantity and another. Suppose you have 200 apples
and 100 oranges. The ratio of apples to oranges is 200 / 100, which we can more conveniently
express as 2:1 or 2. A financial ratio is a comparison between one bit of financial information and
another. Consider the ratio of current assets to current liabilities, which we refer to as the current
ratio. This ratio is a comparison between assets that can be readily turned into cash -- current assets
-- and the obligations that are due in the near future -- current liabilities. A current ratio of 2:1 or 2
means that we have twice as much in current assets as we need to satisfy obligations due in the near
future.
Ratios can be classified according to the way they are constructed and their general characteristics.
By construction, ratios can be classified as a coverage ratio, a return ratio, a turnover ratio, or a
component percentage:
1. A coverage ratio is a measure of a company's ability to satisfy (meet) particular obligations.

2. A return ratio is a measure of the net benefit, relative to the resources expended.
3. A turnover ratio is a measure of the gross benefit, relative to the resources expended.
4. A component percentage is the ratio of a component of an item to the item.
When we assess a company's operating performance, we want to know if it is applying its assets in
an efficient and profitable manner. When we assess a company's financial condition, we want to
know if it is able to meet its financial obligations.
There are six aspects of operating performance and financial condition we can evaluate from financial
ratios:
1. A liquidity ratio provides information on a company's ability to meet its shortterm,
immediate obligations.
2. A profitability ratio provides information on the amount of income from each dollar of
sales.

3. An activity ratio relates information on a company's ability to manage its resources (that is,
its assets) efficiently.
4. A financial leverage ratio provides information on the degree of a company's fixed
financing obligations and its ability to satisfy these financing obligations.
5. A shareholder ratio describes the company's financial condition in terms of amounts per
share of stock.
6. A return on investment ratio provides information on the amount of profit, relative to the
assets employed to produce that profit.
We cover each type of ratio, providing examples of ratios that fall into each of these classifications.
2. Liquidity Ratios
Liquidity reflects the ability of a company to meet its short-term obligations using assets that are
most readily converted into cash. Assets that may be converted into cash in a short period of time
are referred to as liquid assets; they are listed in financial statements as current assets. Current
assets are often referred to as working capital because these assets represent the resources needed
for the day-to-day operations of the company's long-term, capital investments. Current assets are
used to satisfy short-term obligations, or current liabilities. The amount by which current assets
exceed current liabilities is referred to as the net working capital. 1
The role of the operating cycle

How much liquidity a company needs depends on its operating cycle. The operating cycle is the
duration between the time cash is invested in goods and services to the time that investment
produces cash. For example, a company that produces and sells goods has an operating cycle
comprising four phases:
(1) purchase raw material and produce goods, investing in inventory;
(2) sell goods, generating sales, which may or may not be for cash;
(3) extend credit, creating accounts receivables, and
(4) collect accounts receivables, generating cash.
The operating cycle is the length of time it takes to convert an investment of cash in inventory
back into cash (through collections of sales). The net operating cycle is the length of time it takes to
convert an investment of cash in inventory and back into cash considering that some purchases are
made on credit.
The number of days a company ties up funds in inventory is determine by:
(1) the total amount of money represented in inventory, and
(2) the average day's cost of goods sold.
The current investment in inventory -- that is, the money "tied up" in inventory -- is the ending
balance of inventory on the balance sheet. The average day's cost of goods sold is the cost of goods
1
You will see reference to the net working capital (i.e., current assets – current liabilities) as simply working
capital, which may be confusing. Always check the definition for the particular usage because both are common
uses of the term working capital.

sold on an average day in the year, which can be estimated by dividing the cost of goods sold found
on the income statement by the number of days in the year.
We compute the number of days of inventory by calculating the ratio of the amount of inventory on
hand (in dollars) to the average day's Cost of Goods Sold (in dollars per day):
Inventory Inventory
Number of days inventory
Average day' s cost of goods sold Cost of goods sold / 365
If the ending inventory is representative of the inventory throughout the year, the number of days
inventory tells us the time it takes to convert the investment in inventory into sold goods. Why worry
about whether the year-end inventory is representative of inventory at any day throughout the year?
Well, if inventory at the end of the fiscal year-end is lower than on any other day of the year, we
have understated the
number of days of Try it!
inventory. Wal-Mart Stores, Inc., had cost of revenue of $219,793 million for the fiscal
year ended January 31, 2005. It had an inventory balance of $29,447 million
Indeed, in practice most
at the end of this fiscal year. Using the quarterly information, Wal-Mart’s
companies try to choose average inventory balance during the fiscal year is $29,769.25:
fiscal year-ends that
coincide with the slow Inventory balance, in millions
period of their business.
That means the ending $33,347
$34,000
balance of inventory would
be lower than the typical $32,000
daily inventory of the year. $30,000
$29,447
We could, for example, $28,320 $27,963
$28,000
look at quarterly financial
statements and take $26,000
averages of quarterly
$24,000
inventory balances to get
April July October January
a better idea of the typical
inventory. However, here
for simplicity in this and Source: Wal-Mart Stores 10-K and 10-Q filings
other ratios, we will make Based on this information, what is Wal-Mart’s inventory turnover for fiscal year
a note of this problem and 2004 (ending January 31, 2005)?
deal with it later in the
discussion of financial Solution:
ratios. Using the fiscal year end balance of inventory:
We can extend the same $29,447 $29, 447
Number of days inventory = 48.9 days
logic for calculating the $219,793/365 $602.173
number of days between a
sale -- when an account Using the average of the quarterly balances:
receivable is created -- to $29,769.25 $29, 769.25
the time it is collected in Number of days inventory = 49.436 days
$219,793/365 $602.173
cash. If the ending
balance of receivables at In other words, it takes Wal-Mart approximately 50 days to sell its
the end of the year is merchandise from the time it acquires it.
representative of the
receivables on any day throughout the year, then it takes, on average, approximately the "number of
days credit" to collect the accounts receivable, or the number of days receivables:
Accounts receivable Accounts receivable
Number of days receivables
Average day's sales on credit Sales on credit / 365

What does the operating cycle have to do with liquidity? The longer the operating cycle, the more
current assets needed (relative to current liabilities) because it takes longer to convert inventories
and receivables into cash. In other words, the longer the operating cycle, the more net working
capital required.
We also need to look at the liabilities on the balance sheet to see how long it takes a company to pay
its short-term obligations. We can apply the same logic to accounts payable as we did to accounts
receivable and inventories. How long does it take a company, on average, to go from creating a
payable (buying on credit) to paying for it in cash?
Accounts payable Accounts payable
Number of days payables
Average day's purchases Purchases / 365
First, we need to determine the amount of an average day's purchases on credit. If we assume all
purchases are made on credit, then the total purchases for the year would be the Cost of Goods Sold,
less any amounts included in this Cost of Goods Sold that are not purchases. 2
The operating cycle tells us how long it takes to convert an investment in cash back into cash (by
way of inventory and accounts receivable):
Number of days Number of days
Operating cycle
of inventory of receivables
The number of days of purchases tells us how long it takes use to pay on purchases made to create
the inventory. If we put these two pieces of information together, we can see how long, on net, we
tie up cash. The difference between the operating cycle and the number of days of payables is the
net operating cycle:
Net operating cycle = Operating Cycle - Number of days of purchases
or, substituting for the operating cycle,
Number of days Number of days Number of days
Net operating cycle
of inventory of receivables of purchases
The net
operating cycle Microsoft's Number of Days Receivables
therefore tells
us how long it 2004:
takes for the Average day's receivables = $36,835 million / 365 = $100.9178 million
company to get
cash back from Number of days receivables = $5,890 million / $100.9178 million = 58.3643 days
its investment Now try it for 2005 using the 2005 data from Microsoft’s financial statements.
in inventory
and accounts Answer: 65.9400 days
receivable, Source of data: Income Statement and Balance Sheet, Microsoft Corporation Annual Report 2005
considering that
purchases may be made on credit. By not paying for purchases immediately (that is, using trade
credit), the company reduces its liquidity needs. Therefore, the longer the net operating cycle, the
greater the company’s need for liquidity.
2
For example, depreciation is included in the Cost of Goods Sold, yet it not a purchase. However, as a quite
proxy for purchases, we can use the accounting relationship: beginning inventory + purchases = COGS + ending
inventory.

Measures of liquidity
Liquidity ratios provide a measure of a company’s ability to generate cash to meet its immediate
needs. There are three commonly used liquidity ratios:
1. The current ratio is the ratio of current assets to current liabilities; Indicates a company's
ability to satisfy its current liabilities with its current assets:
Current assets
Current ratio
Current liabilitie s
2. The quick ratio is the ratio of quick assets (generally current assets less inventory) to
current liabilities; Indicates a company's ability to satisfy current liabilities with its most
liquid assets
Current assets - Inventory
Quick ratio
3. The net working capital to sales ratio is the ratio of net working capital (current assets
minus current liabilities) to sales; Indicates a company's liquid assets (after meeting
shortterm obligations) relative to its need for liquidity (represented by sales)
Current assets - Current liabilitie s
Net working capital to sales ratio
Sales
Generally, the larger these liquidity ratios, the better the ability of the company to satisfy its
immediate obligations. Is there a magic number that defines good or bad? Not really.
Consider the current ratio. A large amount of current assets relative to current liabilities provides
assurance that the company will be able to satisfy its immediate obligations. However, if there are
more current assets than the company needs to provide this assurance, the company may be
investing too heavily in these non- or low-earning assets and therefore not putting the assets to the
most productive use.
Microsoft Liquidity Ratios -- 2004 Another consideration is the

operating cycle. A company
Current ratio = $70,566 million / $14,696 million = 4.8017 with a long operating cycle
Quick ratio = ($70,566-421) / $14,696 = 4.7731 may have more need to
liquid assets than a
Net working capital-to-sales = ($70,566-14,969) / $36,835 = 1.5515 company with a short
Source of data: Balance Sheet and Income Statement, Microsoft Corporation Annual operating cycle. That’s
Report 2005 because a long operating
cycle indicate that money is
tied up in inventory (and then receivables) for a longer length of time.

3. Profitability ratios
Profitability ratios (also referred to as profit margin ratios) compare components of income with sales.
They give us an idea of what makes up a company's income and are usually expressed as a portion
of each dollar of sales. The profit margin ratios we discuss here differ only by the numerator. It's in
the numerator that we reflect and thus evaluate performance for different aspects of the business:
The gross profit margin is the ratio of gross income or profit to sales. This ratio indicates how
much of every dollar of sales is left after costs of goods sold:
Gross income
Gross profit margin
Sales
Microsoft's 1998 Profit Margins The operating profit margin is the

ratio of operating profit (a.k.a. EBIT,
Gross profit margin = ($14,484 - 1,197)/$14,484 = 91.736%
operating income, income before
Operating profit margin = $6,414 / $14,484 = 44.283% interest and taxes) to sales. This is a
Net profit margin = $4,490 / $14,484 = 31%
ratio that indicates how much of each
dollar of sales is left over after operating
Source of data: Microsoft Corporation Annual Report 1998 expenses:
___ Operating income
Operating profit margin =
Microsoft's 2004 Profit Margins Sales
Gross profit margin = ($36,835 – 6,716)/$36,835 = 81.767% The net profit margin is the ratio of
net income (a.k.a. net profit) to sales,
Operating profit margin = $9,034 / $36,835 = 24.526% and indicates how much of each dollar
Net profit margin = $8,168 / $36,835 = 22.175% of sales is left over after all expenses:
Source of data: Income Statement, Microsoft Corporation Annual Report Net income
2005 Net profit margin .
Sales
4. Activity ratios
Activity ratios are measures of how well assets are used. Activity ratios -- which are, for the most
part, turnover ratios -- can be used to evaluate the benefits produced by specific assets, such as
inventory or accounts receivable. Or they can be use to evaluate the benefits produced by all a
company's assets collectively.
These measures help us gauge how effectively the company is at putting its investment to work. A
company will invest in assets – e.g., inventory or plant and equipment – and then use these assets to
generate revenues. The greater the turnover, the more effectively the company is at producing a
benefit from its investment in assets.
The most common turnover ratios are the following:
1. Inventory turnover is the ratio of cost of goods sold to inventory. This ratio indicates how
many times inventory is created and sold during the period:
Cost of goods sold
Inventory turnover
Inventory
2. Accounts receivable turnover is the ratio of net credit sales to accounts receivable. This
ratio indicates how many times in the period credit sales have been created and collected on:

Sales on credit
Accounts receivable turnover
Accounts receivable
3. Total asset turnover is the ratio of sales to total assets. This ratio indicates the extent that
the investment in total assets results in sales.
Sales
Total assets
4. Fixed asset turnover is the ratio of sales to fixed assets. This ratio indicates the ability of
the company’s management to put the fixed assets to work to generate sales:
Sales
Fixed asset turnover
Fixed assets
Microsoft’s Activity Ratios – 2004

Accounts receivable turnover = $36,835 / $5,890 = 6.2538 times
Total asset turnover = $36,835 / $92,389 = 0.3987 times
Source of data: Income Statement and Balance Sheet, Microsoft Corporation Annual
Report 2005
Turnovers and numbers of days

You may have noticed that there is a relation between the measures of the operating cycle and
activity ratios. This is because they use the same information and look at this information from
different angles. Consider the number of days inventory and the inventory turnover:
Inventory
Number of days inventory
Average day's cost of goods sold
Cost of goods sold

Inventory turnover
Inventory
The number of days inventory is how long the inventory stays with the company, whereas the
inventory turnover is the number of times that the inventory comes and leaves – the complete cycle
– within a period. So if the number of days inventory is 30 days, this means that the turnover within
the year is 365 / 30 = 12.167 times. In other words,
365 365 Cost of goods sold
Inventory turnover =
Number of days inventory Inventory Inventory
Cost of goods sold / 365

Try it!
Wal-Mart Stores, Inc., had cost of revenue of $219,793 million for the fiscal year ended January 31, 2005. It
had an inventory balance of $29,447 million at the end of this fiscal year.
Source: Wal-Mart Stores 10-K
Wal-Mart’s number of days inventory for fiscal year 2004 (ending January 31, 2005) is
$29,447 $29, 447

Number of days inventory = 48.9 days
$219,793/365 $602.173
Wal-Mart’s inventory turnover is:

$219,793
Inventory turnover = 7.464 times
$29,447
And the number of days and turnover are related as follows:

Inventory turnover = 365 / 48.9 = 7.464 times
Number of days inventory = 365 / 7.464 = 48.9 days
5. Financial leverage ratios

A company can finance its assets either with equity or debt. Financing through debt involves risk
because debt legally obligates the company to pay interest and to repay the principal as promised.
Equity financing does not obligate the company to pay anything -- dividends are paid at the
discretion of the board of directors. There is always some risk, which we refer to as business risk,
inherent in any operating segment of a business. But how a company chooses to finance its
operations -- the particular mix of debt and equity -- may add financial risk on top of business risk
Financial risk is the extent that debt financing is used relative to equity.
Financial leverage ratios are used to assess how much financial risk the company has taken on. There
are two types of financial leverage ratios: component percentages and coverage ratios. Component
percentages compare a company's debt with either its total capital (debt plus equity) or its equity
capital. Coverage ratios reflect a company's ability to satisfy fixed obligations, such as interest,
principal repayment, or lease payments.
Component-percentage financial leverage ratios

The component-percentage financial leverage ratios convey how reliant a company is on debt
financing. These ratios compare the amount of debt to either the total capital of the company or to
the equity capital.
1. The total debt to assets ratio indicates the proportion of assets that are financed with
debt (both shortterm and longterm debt):
Total debt
Total debt to assets ratio
Total assets
Remember from your study of accounting that total assets are equal to the sum of total debt
and equity. This is the familiar accounting identity: assets = liabilities + equity.
2. The longterm debt to assets ratio indicates the proportion of the company's assets that
are financed with longterm debt.
Long - term debt
Long - term debt to assets ratio
Total assets

3. The debt to equity ratio (a.k.a. debt-equity ratio) indicates the relative uses of debt and
equity as sources of capital to finance the company's assets, evaluated using book values of
the capital sources:
Total debt
Total debt to equity ratio
Total shareholders' equity
One problem (as we shall see) Note that the debt-equity ratio is related to the debt-to-total assets
with looking at risk through a ratio because they are both measures of the company’s capital
financial ratio that uses the book structure. The capital structure is the mix of debt and equity that
the company uses to finance its assets.
value of equity (the stock) is that
most often there is little relation Let’s use short-hand notation to demonstrate this relationship. Let D
between the book value and its represent total debt and E represent equity. Therefore, total assets
market value. The book value of are equal to D+E.
equity consists of: If a company has a debt-equity ratio of 0.25, this means that is debt-
to-asset ratio is 0.2. We calculate it by using the ratio relationships
the proceeds to the
and Algebra:
company of all the stock
issued since it was first D/E = 0.25
incorporated, less any D = 0.25 E
treasury stock (stock
repurchased by the Substituting 0.25 E for D in the debt-to-assets ratio D/(D+E):
company); and D/(D+E) = 0.25 E / (0.25 E + E) = 0.25 E / 1.25 E = 0.2
the accumulation of all In other words, a debt-equity ratio of 0.25 is equivalent to a debt-to-
the earnings of the assets ratio of 0.2
company, less any This is a handy device: if you are given a debt-equity ratio and need
dividends, since it was the debt-assets ratio, simply:
first incorporated.
D/(D+E) = (D/E) / (1 + D/E)
Let's look at an example of the
Why do we bother to show this? Because many financial analysts
book value vs. market value of discuss or report a company’s debt-equity ratio and you are left on
equity. IBM was incorporated in your own to determine what this means in terms of the proportion of
1911. So its book value of equity debt in the company’s capital structure.
represents the sum of all its stock
issued and all its earnings, less all dividends paid since 1911. As of the end of 2003, IBM's book value
of equity was approximately $28 billion and its market value of equity was approximately $162 billion.
The book value understates its market value by over $130 billion. The book value generally does not
give a true picture of the investment of shareholders in the company because:
earnings are recorded according to accounting principles, which may not reflect the true
economics of transactions, and
due to inflation, the dollars from earnings and proceeds from stock issued in the past do not
reflect today's values.
The market value, on the other hand, is the value of equity as perceived by investors. It is what
investors are willing to pay, its worth. So why bother with the book value of equity? For two reasons:
first, it is easier to obtain the book value than the market value of a company's securities, and
second, many financial services report ratios using the book value, rather than the market value.
We may use the market value of equity in the denominator, replacing the book value of equity. To do
this, we need to know the current number of shares outstanding and the current market price per
share of stock and multiply to get the market value of equity.

Coverage financial leverage ratios
In addition to the leverage ratios that use information about how debt is related to either assets or
equity, there are a number of financial leverage ratios that capture the ability of the company to
satisfy its debt obligations. There are many ratios that accomplish this, but the two most common
ratios are the times interest coverage ratio and the fixed charge coverage ratio.
The times-interest-coverage ratio, also referred to as the interest coverage ratio, compares the
earnings available to meet the interest obligation with the interest obligation:
Earnings before interest and taxes
Times - interest - coverage ratio
Interest
The fixed charge coverage ratio expands on the obligations covered and can be specified to include
any fixed charges, such as lease payments and preferred dividends. For example, to gauge a
company’s ability to cover its interest and lease payments, you could use the following ratio:
Earnings before interest and taxes Lease payment
Fixed - charge coverage ratio
Interest Lease payment
Coverage ratios are often used in debt covenants to help protect the creditors.
Microsoft’s Financial Leverage Ratios – 2004

Total debt to total assets = ($94,368 - 74,825) / $94,368 = 0.20709 or 20.709%
Debt to equity ratio = ($94,368 - 74,825) / $74,825 = 0.26118 or 26.118%
Source of data: Balance sheet, Microsoft Corporation Annual Report 2005
The ratios we have explained to this point deal with the performance and financial condition of the
company. These ratios provide information for managers (who are interested in evaluating the
performance of the company) and for creditors (who are interested in the company's ability to pay its
obligations). We will now take a look at ratios that focus on the interests of the owners -- shareholder
ratios. These ratios translate the overall results of operations so that they can be compared in terms
of a share of stock:
Earnings per share (EPS) is the amount of income earned during a period per share of common
stock.
Net income available to shareholders
Earnings per share
Number of shares outstanding
As we learned earlier in the study of Financial Statement Information, two numbers of earnings per
share are currently disclosed in financial reports: basic and diluted. These numbers differ with respect
to the definition of available net income and the number of shares outstanding. Basic earnings per
share are computed using reported earnings and the average number of shares outstanding.
Diluted earnings per share are computed assuming that all potentially dilutive securities are
issued. That means we look at a “worst case” scenario in terms of the dilution of earnings from
factors such as executive stock options, convertible bonds, convertible preferred stock, and warrants.
Suppose a company has convertible securities outstanding, such as convertible bonds. In calculating
diluted earnings per share, we consider what would happen to both earnings and the number of

shares outstanding if these bonds were converted into common shares. This is a “What if?” scenario:
what if all the bonds are converted into stock this period. To carry out this “What if?” we calculate
earnings considering that the company does not have to pay the interest on the bonds that period
(which increases the numerator of earnings per share), but we also add to the denominator the
number of shares that would be issued if
these bonds were converted into shares. 3
What’s a convertible security?
Another source of dilution is executive A convertible security is a security – debt or equity – that
stock options. Suppose a company has 1 gives the investor the option to convert—that is, exchange –
million shares of stock outstanding, but the security into another security (typically, common stock).
has also given its executives stock options Convertible bonds and convertible preferred stocks are
that would result in 0.5 million new shares common.
issued if they chose to exercise these Suppose you buy a convertible bond with a face value of
options. This would not affect the $1,000 that is convertible into 100 shares of stock. This
numerator of the earnings per share, but means that you own the bond and receive interest, but you
would change the denominator to 1.5 have the option to exchange it for 100 shares of stock. You
million shares. If the company had can hold the bond until it matures, collecting interest
meanwhile and then receiving the face value at maturity, or
earnings of $5 million, its basic earnings
you can exchange it for the 100 shares of stock at any time.
per share would be $5 million / 1 million Your choice. Once you convert your bond into stock,
shares = $5.00 per share and its diluted however, you no longer receive any interest on the bond.
earnings per share would be $5 million /
1.5 million shares = $3.33 per share. Some issuers will limit conversion such that the bond cannot
be converted for a fixed number of years from issuance.
As an example, consider Yahoo!'s earnings per share reported in their 2004 annual report:
Item 2003 2004

Basic EPS $0.19 $0.62
Diluted EPS $0.18 $0.58
The difference between the basic and diluted earnings per share in Yahoo!'s case is attributable to its
extensive use of stock options in compensation programs.
Book value equity per share is the amount of the book value (a.k.a. carrying value) of common
equity per share of common stock, calculated by dividing the book value of shareholders’ equity by
the number of shares of stock outstanding. As we discussed earlier, the book value of equity may
differ from the market value of equity. The market value per share, if available, is a much better
indicator of the investment of shareholders in the company.
The priceearnings ratio (P/E or PE ratio) is the ratio of the price per share of common stock to
the earnings per share of common stock:
Market price per share
Price-earnings ratio =
Earnings per share
Though earnings per share are reported in the income statement, the market price per share of stock
is not reported in the financial statements and must be obtained from financial news sources. The
3
A “catch” is that diluted earnings per share can never be reported to be greater than basic earnings per share.
In some cases (when a company has many convertible securities outstanding), we may calculate a diluted
earnings per share greater than basic earnings per share, but in this case we cannot report diluted earnings per
share because it would be anti-dilutive.

P/E ratio is sometimes used as a proxy for investors' assessment of the company's ability to generate
cash flows in the future. Historically, P/E ratios for U.S. companies tend to fall in the 10-25 range, but
in recent periods (e.g., 2000-2001) P/E ratios have reached much higher. Examples of P/E ratios (P/E
ratios at the end of 2004): 4
Ticker
Company P/E ratio
symbol
Amazon.com AMZN 57
Time Warner Inc. TWX 29
IBM IBM 21
Coca-Cola KO 22
Microsoft MSFT 36
Yahoo! YHOO 98
3M Co. MMM 23
General Electric GE 24
We are often interested in the returns to shareholders in the form of cash dividends. Cash
dividends are payments made by the company directly to its owners. There is no requirement that
a company pay dividends to its shareholders, but many companies pay regular quarterly or annual
dividends to the owners. The decision to pay a dividend is made by the company’s board of
directors. Note that not all companies pay dividends.
Dividends per share (DPS) is the dollar amount of cash dividends paid during a period, per share
of common stock:
Dividends paid to shareholders

Dividends per share
The dividend payout ratio is the ratio of cash dividends paid to earnings for a period:
Dividends
Dividend payout ratio =
Earnings
The complement to the dividend payout ratio is the retention ratio or the plowback ratio:
Earnings - Dividends
Retention ratio =
Earnings
We can also convey information about dividends in the form of a yield, in which we compare the
dividends per share with the market price per share:
Dividends per share
Dividend yield =
The dividend yield is the return to shareholders measured in terms of the dividends paid during the
period.
We often describe a company's dividend policy in terms of its dividend per share, its dividend payout
ratio, or its dividend yield. Some companies' dividends appear to follow a pattern of constant or
4
Source: Yahoo! Finance

constantly growing dividends per share. And some companies' dividends appear to be a constant
percentage of earnings.
Summary
You’ve been introduced to a few of the financial ratios that a financial analyst has in his or her toolkit.
There are hundreds of ratios that can be formed using available financial statement data. The ratios
selected for analysis depend on the type of analysis (e.g., credit worthiness) and the type of
company. You’ll see in the next reading how to use these ratios to get an understanding of a
company’s condition and performance.

Financial analysis
OUTLINE
1. Return ratios and the DuPont system
2. Other tools
3. Effective use of financial analysis
4. Problems and dilemmas in financial analysis
5. Summary
1. Return ratios and the Du Pont system

Return-on-investment ratios
Return-on-investment ratios, more commonly called return-on-asset ratios, compare measures of benefits
we have not yet considered with measures of investment. What we want to evaluate will determine the
benefit that is represented in the numerator and the resources affecting that benefit, represented in the
denominator. What distinguishes return-on-investment ratios from the activity ratios (such as an
inventory turnover or receivable turnover) is that the numerator is the net benefit, rather than the gross
benefit from an activity.
The return on operating assets ratio (a.k.a basic earning power ratio) is the ratio of operating
earnings to assets:
Operating income
Basic earning power ratio = Operating return on assets =
Total assets
It is a measure of the operating income resulting from the firm's investment in total assets.
The return on assets is the ratio of net income to assets and indicates the firm's net profit generated
per dollar invested in total assets:
Net income
Return on assets =
Total assets
The return on equity is the ratio of net income to shareholders' equity and represents the profit
generated per dollar of shareholders' investment (that is, shareholders' equity):
Net income
Return on equity =
Shareholders' equity
The return on common equity is the ratio of
net income available to common shareholders Exhibit 1 Microsoft's 2005 Return Ratios
to common shareholders' equity. This return Basic earning power = $14,561 / $94,368 = 15.430%
is the profit generated per dollar of common
shareholders' investment (that is, common Return on assets = $12,254 / $94,368 = 12.985%
shareholders' equity). Return on equity = $12,254 / $74,825 = 16.377%
We provide the return ratios for Microsoft for Source of data: Microsoft Corporation 2005 Annual Report, fiscal year
2005 in Exhibit 1. Microsoft has only one type ended June 30, 2005
of stock, so therefore the return on common
equity is equivalent to the return on equity.
The DuPont System

The Du Pont system was developed by E.I. du Pont Nemours, the system is a method of decomposing
the return ratios into their profit margin and turnover components. Suppose the return on assets changes
from 20% to 10%. We do not know whether this decreased return is due to a less efficient use of the
firm's assets -- that is, due to lower activity or to lower profit margins. A lower return on assets could be
due to lower activity, lower margins, or both. Since we are interested in evaluating past operating
performance to evaluate different aspects of the management of the firm or to predict future
performance, knowing the source of these returns is valuable information. The DuPont system allows us
to breakdown the return ratios into components, identifying the sources of the changes in returns.
For example, we can breakdown the operating return on assets and the return on assets to two
components, operating margin and total asset turnover:
Operating income Operating income Sales
Operating return on assets =
Total assets Sales Total assets
Net income Net income Sales
Return on assets =
Total assets Sales Total assets
By looking at the components, turnover and profit margin, and their changes from year to year, we get a
better idea of what is behind changes in returns from year to year. Similarly, the return on shareholders'
equity can be broken down into three components:
Net income Net income Sales Total assets
Return on equity =
Total assets Sales Total assets Shareholders' equity
You can see how Microsoft’s

Exhibit 2: Applying the Du Pont System to Microsoft
return on operating assets
Increase is both the more effective use of assets and improved operating margins: is broken down into the
turnover and profit margin
Ratio 2004 2005
in Exhibit 2. As you see in
Total asset turnover 0.39033 times 0.56186times this exhibit, the change in
multiplied by … Operating profit margin 24.526% 36.596% the operating return is
…equals Return on operating assets 9.573% 15.530% attributable to both an
increase in the turnover and
Source of data: Microsoft Corporation 2005 Annual Report, fiscal year ended June 30, 2005
the profit margin.
The task of breaking down
ratios into components can be performed on any return ratio and can reduce the ratios to their smallest
components. For example, the return on equity can be broken down into five components: net profit
margin, asset turnover, equity multiplier, equity's share of income, and tax burden. A breakdown of the
return on assets into four components (i.e., asset turnover, operating profit margin, interest burden, and
Financial Analysis, prepared by Pamela Peterson Drake 2

tax burden) is diagrammed in Exhibit 3. In a similar manner, the return on equity can be broken down
into five components: asset turnover, operating profit margin, interest burden, tax burden, and the equity
multiplier.
Why is it useful to do such a Exhibit 3: Du Pont breakdown of the return on assets

breakdown? The system of looking at
the components of the returns of a
company help in:
1. Comparing the performance
and condition of a company
against its competitors;
2. Analyzing trends in the returns
of a company in the context of
trends of the components; and
3. Forecasting the returns of a
company based on forecasts of
the components.
Regarding comparisons with
competitors, consider that companies
in the same line of business should
have similar operating profit margins and asset turnovers. Focusing on these ratios may help explain
why companies in the same industry have different returns. Further, the interest burden is influenced by
the company’s financial decisions. By comparing these dimensions across companies in the same
industry, we get a better sense of how these decisions affect a company’s fortunes.
Regarding the source of changes in returns, consider Kmart prior to its bankruptcy filing in 2002. 1 Its
total asset turnover, profit margin, and return on assets are graphed in Exhibit 4.
1
Kmart filed for bankruptcy in January of 2002. Kmart and Sears agreed to merge in 2004.
We can see in Exhibit 4, Panel A, that Kmart’s return
Exhibit 4: Kmart’s woes
on assets changed over time: dramatic decreases in
1993 and 1995, some recovery in 1997-1998, and
then a decline as it approached bankruptcy. 2 Panel A: Return on assets
What was the source of Kmart’s woes? There is 8%

usually not just one source of a company’s financial 6%
4%
difficulties, but the use of the du Pont system allows
2%
us to get some idea of what led to Kmart’s challenges. 0%
We can see in Panel B that the total asset turnover did -2%
-4%
not change much during the 1990-2000. If we were to
-6%
compare this turnover with that of its competitors, we -8%
would see that Kmart’s turnover was quite similar.
90
91
92
93
94
95
96
97
98
99
00
19
19
19
19
19
19
19
19
19
19
20
Looking at Kmart’s net profit margin, as shown in
Panel C, we see that the changes in the net profit
margin appear to have been a strong influence on
Panel B: Total asset turnover
Kmart’s returns.
What does this mean? What we surmise from this 3.0
analysis is that Kmart’s difficulties are related to the 2.5
management of expenses, rather than the deployment
2.0
and us of its assets. If we wanted to get a more
detailed look, we could break the net profit margin 1.5
into components of the operation profit margin, the 1.0
interest burden, and the tax burden to see what why 0.5
the net profit margin changed over time. 0.0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2. Other tools
Panel C: Net profit margin
Common size analysis
4%
Common size analysis is the analysis of financial 3%
statement items through comparisons among these 2%
items. In common size analysis, we compare each 1%
item in a financial statement with a benchmark item: 0%
-1%
For the income statement, the benchmark is sales. For
-2%
a given period, each item in the income statement is -3%
restated as a percentage of sales. -4%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
For the balance sheet, the benchmark is total assets.

For a given point in time, each item in the balance
sheet is restated as a percentage of total assets.
Source: Kmart’s 10-K reports
To see how this works, consider The Acme Company’s
financial statements below. The reported financial data in the right-most columns has been converted
into percentages of sales revenues (i.e., common size statements), shown in the left-most columns:
2
Kmart filed for bankruptcy in January of 2002. Kmart and Sears agreed to merge in 2004.

Common-size
statement stated as
Acme Company Income Statements a % of Sales Amount in millions
2005 2004 2005 2004
Sales 100.0% 100.0% $178,174 $164,013
Cost of sales 73.0% 75.1% 130,028 123,195
Gross profit 27.0% 24.9% $48,146 $40,818
Selling, general, and administrative expenses 9.1% 8.9% 0 0
Net income 3.8% 3.0% $6,698 $4,963
We can restate also Acme’s reported balance sheet items in terms a percentage of total assets:
Common-sized
statement stated as
Acme Company Balance Sheets a % of total assets Amount in millions
2005 2004 2005 2004
Cash, cash equiv., and marketable securities 10.0% 10.0% $22,984 $22,262
Finance receivables 25.7% 25.9% 58,870 57,550
Accounts receivable 3.3% 3.0% 7,493 6,557
Inventories 5.3% 5.4% 12,102 11,898
Deferred income taxes 9.8% 8.8% 22,478 19,510
Equipment on operating leases 14.5% 13.6% 33,302 30,112
Property 15.1% 16.9% 34,567 37,504
Intangible assets 5.0% 5.7% 11,469 12,691
Other assets 11.2% 10.8% 25,623 24,058
Total assets 100% 100% $228,888 $222,142
In a similar manner, the liabilities and equity can be restated in terms of total assets:
Common-sized
statement stated
as a % of total
Acme Company’s Balance Sheets, continued assets Amount in millions
2005 2004 2005 2004
Accounts payable 6.9% 6.4% $15,782 $14,221
Notes and loans payable 40.6% 38.4% 93,027 85,300
Deferred income taxes 1.3% 1.4% 2,923 3,196
Postretirement benefits other than pensions 18.0% 19.4% 41,168 43,190
Pensions 3.1% 3.4% 7,043 7,581
Accrued expenses and other liabilities 22.1% 20.3% 50,490 45,144
Minority interests 0.3% 0.0% 727 92
Debentures 0.1% 0.0% 222 0
Stockholders' equity 7.6% 10.5% 17,506 23,418
Total liabilities and equity 100% 100% $228,888 $222,142
We can also represent this information in graphical form, which allows us to see trends in these
components over time. Using
Harley-Davidson as an Exhibit 5 Graphical representation of the common-size
example, consider the income statements for Harley Davidson, 1991-2004
statements for this company Panel A Income statement
of the period 1991-2004, as
shown in Exhibit 5, Panel A.
100%
Here we can see that the 90%
increasing profitability while 80% Net income
the cost of goods sold has 70%
declined relative to total 60% Non-operating items
revenues. Looking at the 50% Income taxes
company’s product line and 40% Operating expenses
30%
business operations, we see Cost of goods sold
20%
that this increase in 10%
profitability corresponds to 0%
the shift in generating profits 1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
not just from the sale of
motorcycles, but from the
financing of these sales and Panel B Assets
licensing.
We can see this shift in 100%
business purpose in the asset Other assets
composition over time, as 80%
shown in Panel B. Finance
Property, plant &
receivables have become 60% equipment, net
increasingly more important
40% Finance receivables, net
as a use of funds. This is
understandable because the
20% Total current assets
financing of its cycles has
increased the profitability of
0%
the company.
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
In Panel C, which is the

representation of the
company’s liabilities and Panel C Liabilities
equity, we see that the capital
structure – that is, how the
100%
business chooses to finance
its business, is rather stable 80%
over time. Total stockholders' equity
60% Other liabilities
Common size analysis is 40% Finance debt

useful in analyzing trends in Total current liabilities
profitability (using the 20%
common size income
statements) and trends in 0%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
investments and financing

(using the common size
balance sheet).

3. Effective use of financial analysis
As we learned in the discussion of financial ratios, we can use financial ratios along with other pertinent
data to evaluate the financial condition and operating performance of a company. Though a single ratio
for a given company at a point in time tells us very little, if we examine the trends in the ratios over time
and compare these trends with those of firms in similar lines of business, we can get a good idea of
where this company has been -- financially speaking -- and where it may be heading. Therefore, the
analysis of financial ratios and other information involves examining:
trends over time for the company,
trends over time for companies in similar lines of business, and
economic and market conditions.
Choosing a benchmark
To make comparisons, the analyst most likely will want to compare the firm with other firms. But
identifying the other firms in the same or similar lines of business presents a challenge. A system that has
been used for many years for classifying firms by lines of business is the Standard Industrial Classification
(SIC) system, which was developed by the Office of Management and Budget. However, starting in 1997,
another classification system, North American Industry Classification System (NAICS) replaces SIC codes
with a system that better represents the current lines of business. Using the NAISC, we can classify a
firm and then compare this firm with other of that class.
Classifying firms into industry groups is difficult because most firms have more than one line of business.
Most large corporations operate in several lines of business. Do we classify a firm into an industry by the
line of business that represents:
the most sales revenue generated?
the greatest investment in assets?
the greatest share of the firm's profits?
It is not clear which is the most appropriate method and a firm may be classified into different industries
by different financial services and analysts.
Exhibit 6 Breakdown of the Beverage Industry’s Sales In making comparisons, there is

an issue of whether the
benchmark should be all other
firms in the industry (say, an
Cadbury average), or the leading firms in
Schweppes the industry. Consider the case
Coca-Cola of Pepsico, Inc.. Pepsico, Inc. is
Enterprises a producer of beverages and
Cott Corporation snacks. The primary competitors
to Pepsico in this industry are
PepsiCo., Inc Coca-Cola, Cadbury Schweppes,
and Cott Corporation.. The
breakdown of sales in this
industry for 2005 is shown in
Exhibit 6.
Source of data: Value Line Investment Survey
When comparing PepsiCo to the
industry,
Should we use just the two major competitors as the industry benchmark? If so, so we simply
average Cadbury’s, Cott’s and Coca Cola’s ratios or do we weight them in some manner (e.g., by
market share)?
Should we consider the smaller competitors at all?
Should we compare PepsiCo with the other large firm in the industry, Coca-Cola?
The benchmark that we choose may affect the conclusions that we draw with respect to a firm's
operating performance.
Let's see how we would use information over time for PepsiCo (PEP) and Coca-Cola (KO). Consider the
net profit margins for both companies, as shown in Exhibit 7.
Exhibit 7 Net profit margin, 1995-2004 Looking at the net profit

margin, we see that the
PEP KO profit margin of PepsiCo has
25% improved over time and that
of Coca-Cola has improved
20% slightly.
15% The net profit margin
measures the company’s
10%
ability to manage its
5% expenses. Both companies
are subject to similar
0% operating risk, but PepsiCo
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 relies more on debt financing
than does Coca-Cola, as
indicated by the higher debt
to equity ratio; PepsiCo has a
debt to equity ratio of 18
percent in 2004, compared to Coca-Cola’s 7 percent. However, both companies have debt-to-equity
ratios much lower than the next two largest competitors: Cott Corporation has a debt-equity ratio of 60
percent, whereas Cadbury Schweppes has a debt-equity ratio of 95 percent.
Exhibit 8 Return on equity, 1995-2004 Comparing the return on

equity for the two
PEP KO companies, as shown in
60% Exhibit 8, we get a slightly
different picture: PepsiCo’s
50%
return on equity has
40% remained about the same
30% over the 1995-2004 period,
yet the return on equity for
20%
Coco-Cola has declined over
10% this same period.
0%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Evaluating creditworthiness
One use of financial analysis is to evaluate the credit-worthiness or debt quality of a business. Credit-
rating services (e.g., Dun & Bradstreet, Standard & Poor's, and Moody's Investor Service) provide an
evaluation of a firm's ability to meet its obligations. Rating services use both financial analysis and the
characteristics of the obligations to evaluate credit-worthiness.
Bond ratings reflect the credit quality of a particular debt issue. These ratings reflect not only the credit-
worthiness of the issuer, but also the features of the debt issue, such as security or a sinking fund. Bonds
are often classified according to credit quality. Bond ratings for both Moody's and Standard & Poor's are
summarized in Table 1.
We can classify bonds into broader groups based on these ratings: investment grade debt and non-
investment grade debt. Investment grade debt is debt with little credit risk -- the borrowers are expected
to be able to pay the promised interest and principal. In terms of the bond ratings in Table 1, investment
grade debt encompasses the top four rating classes (AAA through BBB for Standard and Poor's and Aaa
through Baa for Moody's). Non-investment grade debt, also referred to as junk bonds or speculative
grade debt, on the other hand, are debt securities with a great deal of credit risk -- that is, there is a
good chance the borrowers will not be able to pay the promised interest and principal.
Predicting bankruptcy
Financial analysis is often used to evaluate the likelihood that a firm will be unable to pay its obligations.
We can see that there are often indications of a firm's financial distress prior to the actual declaration of
bankruptcy.
Because financial distress is generally signaled through financial characteristics well before a formal
bankruptcy, statistical models are often used to discriminate between financially healthy and financially
unhealthy firms based on financial ratios or other characteristics over several years.
The general
characteristics of a firm Exhibit 9 Delta Airlines and the Altman Z-score
used in these models
A healthy company generally has a Z-score above 2.6
include liquidity, An unhealthy company generally has a Z-score below 1.11.2006
profitability, financial A company with a Z-score between 1.11-2.6 bears watching.
leverage, and asset
turnover. Statistical 3.0
models employ
2.0
techniques, such as
discriminant analysis 1.0
and regression analysis, Z-score 0.0
to identify the
characteristics of firms -1.0
most likely to -2.0
experience difficulty
meeting financial -3.0
6/30/91
6/30/92
6/30/93
6/30/94
6/30/95
6/30/96
6/30/97
6/30/98
6/30/99
6/30/00
12/31/00
12/31/01
12/31/02
12/31/03
12/31/04
obligations.
In the case of
discriminant analysis, Fiscal year end
for example, scores are
calculated based on
financial ratios and Source of data: Mergent Online and Delta Air Lines’ 10-K filings
these scores are then
associated with the likelihood of financial distress. Ed Altman developed a series of models of bankruptcy
prediction using discriminant analysis. 3 For example, applying his model for publicly-traded non-
manufacturing companies to Delta Airlines, as we show in Exhibit 9, we see that Delta Airlines’ financial
health improved during the 1993 through 1998, but its health deteriorated up until its bankruptcy filing in
2005.
4. Problems and dilemmas in financial analysis

Using accounting data
There are a number of issues that arise simply from the fact that much of the financial data we use in
analysis is accounting information. The problems associated with using reported accounting data include:
Use of historical costs and inflation. Accounting data are not adjusted for inflation and
represent historical cost instead of current or replacement costs for most assets. It is likely that
the reported book value of assets do not reflect the market value or replacement value of a firm's
assets.
The different methods of accounting. Firms can select from alternative accounting
procedures (e.g., LIFO vs. FIFO), which makes comparisons among firms difficult. The analyst
must often look beyond the basic financial statement information to remove distortions that may
arise from specific accounting practices.
The occurrence of extraordinary and special items. The analyst must determine whether
the effects of extraordinary and special items should be included in the analysis. In recent years,
3
For a summary of these models, see Bankruptcy, Credit Risk, and High Yield Junk Bonds, by Edward I. Altman,
Blackwell Publishing, 2002.

extraordinary items have become quite "ordinary", with some firms reported extraordinary items
each year.
The difficulty in classify "fuzzy" items. Some accounting items are difficult to classify,
especially when distinguishing between liabilities and equity accounts. Therefore, the analyst
must understand not only the accounting principles behind the numbers, but also understand
business practices. For example, in the case of the deferred taxes, the analyst must understand
not only what gives rise to the deferred taxes, but whether this accounting item represents an
on-going difference between tax and accounting income (and, hence, is more suitably classified
as equity) or whether this item represents a temporary timing difference (and, hence, is more
suitably classified as a liability).
Selecting and interpreting ratios

Interpretation of ratios one at a time is difficult since there is no "good" or "bad" value when viewed in
isolation. Ratios should be selected that have meaning for that firm. For example, inventory turnover for
a hospital doesn't make much sense. What is inventory for a hospital? Bed pans? But inventory turnover
is very important for, say, a retailer such as Wal-Mart.
Further, some ratios do not make sense under certain circumstances. For example, if a firm has negative
earnings, the price-earnings ratio is meaningless. As another example, consider a firm that has negative
book value of equity (and, yes, this can happen). In this case, any ratio that uses book value of equity,
such as the debt-equity ratio, is meaningless.
Forecasting
We often examine trends in ratios and other financial data to predict the future, forecasting the future
based on historical trends. For example, we may extrapolate a trend in sales or a trend in operating
profit. And though this may result in a reasonable forecast for the immediate future, the business
environment is very complex and many factors can affect the future performance or conditions of a
company. Therefore, we generally develop forecasts using information in addition to the basic trend, such
as forecasts of economic and market conditions.
But we need to be careful in predicting the future revenues or income of a company based solely on the
past. As companies mature, growth slows and this needs to be considered in making any forecasts. How
much does growth slow? It depends on many factors, including industry structure (e.g., degree of
competition), changing demographics, and government regulation.
We can also look to analysts' forecasts. We could look to individual analysts' forecasts or look at
consensus forecasts collected by financial service firms including IBES, Zack's, and First Call. These
forecasts are typically in the form of forecasts of earnings per share. This information is reported by
many web-based services, including Yahoo! Finance. For example, we can see the consensus forecasts
for USX-U.S. Steel, as reported by Yahoo!, which tells us not only whether there was an earnings
surprise (that is, actual earnings deviated from consensus or expected earnings) for the latest quarter,
but the consensus forecast for the next quarter, the next reported fiscal year, and one-year ahead. 4
4
The desire to meet and beat analysts’ forecasts of earnings put a great deal of pressure on the management of
some companies, resulting in unethical management of reported earnings.
5. Summary
Financial analysis of a company requires a wealth of information. There is so much information available
and so much of the analysis can be computerized, that the task of the analyst is to select the appropriate
tools, gather the pertinent information, and interpret the information.
Analysis is becoming more important following the recent scandals as investors and financial managers
are learning to become more skeptical of accounting information and look more closely at trends in data,
comparisons with other firms, the relation between management compensation and earnings, and
footnote disclosures. It is not necessarily the case that all of the scandals could have been detected with
closer scrutiny, but there were warning signs in the trends and hints in footnotes that should have at
least raised the caution flags among analysts.

Table 1: Bond Rating Classifications: Standard & Poor’s, Moody's
Standard & Poor's
Investment grade
AAA Highest quality. Ability to pay interest and principal very strong.
AA High quality. Ability to pay interest and principal strong.
A Medium to high quality. Ability to pay interest and principal, but more susceptible to changes in
circumstances and the economy.
BBB Medium quality. Adequate ability to pay, but highly susceptible to adverse circumstances.
Speculative grade
BB Speculative. Less near-term likelihood of default relative to other speculative issues.

B Current capacity to pay interest and principal, but highly susceptible
to changes in circumstances.
CCC Likely to default, where payment of interest and principal is dependent on favorable
circumstances.
CC Debt subordinate to senior debt rated CCC
C Debt subordinate to senior debt rated CCC-
D Currently in default, where interest or principal has not been made as promised.
Source: Standard & Poor's CREDITWEEK, "Long-term Rating Definitions," February 11, 1991, p. 128.
Moody's
Investment Grade
Aaa Best quality. Smallest investment risk.

Aa High quality.
A Upper to medium grade. Favorable investment attributes.
Baa Medium grade. Adequate ability to pay interest and principal.
Speculative grade
Ba Speculative. Ability to pay interest and principal uncertain in the future

B Lack of desirable investment characteristics. Likelihood of paying interest and principal in the future
is small.
Caa Poor standing. May be in default or other problems with respect to payment of interest and
principal.
Ca Very speculative. May be in default
C Poor prospects of becoming investment standing
Source: Moody's Industrial Manual, "Key to Moody's Corporate Bond Ratings," 1991, pp. vi-vii.
The Du Pont System of the Analysis of Return Ratios
Applied to Sears, Roebuck & Co.
Return on Assets (ROA)1 Return on Equity (ROE) 2
Calculation for fiscal year 2003 Calculation for fiscal year 2003
Return on assets = total asset turnover net profit margin Return on equity = total asset turnover net profit margin equity multiplier
net profit sales
net profit
net profit sales
net profit
total assets
= =
total assets total assets sales equity total assets sales equity
$3,397 $41,124
$3, 397
$3,397 $41,124
$3, 397
$27, 723

$27,723 $27, 723 $41,124 $6,401 $27, 723 $41,124 $6, 401
0.1225 = 1.4834 times 0.08260 0.5307 = 1.4834 times 0.0826 4.3310

Check on your work: Check on your work:
12.25% = 12.25% 53.07% = 53.07%
Try it for 2002: Return on assets = 2.73% Try it for 2002: Return on equity = 20.38%
1 net profit sales

net profit
2 net profit sales
net profit
total assets
= =
total assets total assets sales equity total assets sales equity

Using the DuPont Breakdown
Comparing 2002 and 2003:
Year 2003 2002

Return on equity 53.07% 20.38%
Return on assets 12.25% 2.73%
Total asset turnover 1.4834 times 0.8206 times

Net profit margin 8.26% 3.326%
Equity multiplier 4.3110 times 7.4647 times
Why the change in return on assets from 2002 to 2003?

o Increase in its asset turnover (due primarily to a reduction in assets through the sale of credit card receivables in 2003 to Citigroup at a
$6 billion profit).
Why the change in return on equity from 2002 to 2003?

o Increase in its asset turnover (due primarily to a reduction in assets through the reduction in credit card receivables by selling them to
Citigroup at a $6 billion profit).
o Reduction in long-term debt (from some of the proceeds from the sale of its credit card receivables) and in increase in equity from the
profit on the sale of the receivables.

Consolidated Statements of Income
millions, except per common share data 2003 2002 2001

REVENUES
Merchandise sales and services $ 36,372 $ 35,698 $ 35,755
Credit and financial products revenues 4,752 5,668 5,235
Total revenues 41,124 41,366 40,990
COSTS AND EXPENSES

Selling and administrative 9,111 9,249 8,892
Provision for uncollectible accounts 1,747 2,261 1,866
Interest, net 1,025 1,143 1,415
Loss on early retirement of debt, net 791 -- --
Special charges and impairments 112 111 542
Total costs and expenses 39,926 39,285 39,812
Operating income 1,198 2,081 1,178
Gain on sale of businesses 4,224 -- --
Other income, net 27 372 45
Income before income taxes, minority interest and cumulative effect
of change in accounting principle 5,449 2,453 1,223
Income taxes 2,007 858 467
Minority interest 45 11 21
Income before cumulative effect of change in accounting principle 3,397 1,584 735
Cumulative effect of change in accounting for goodwill -- (208) --
NET INCOME $ 3,397 $ 1,376 $ 735

millions, except per share data 2003 2002

ASSETS
Current assets
Cash and cash equivalents $ 9,057 $ 1,962
Credit card receivables 1,998 32,563
Less allowance for uncollectible accounts 42 1,832
Net credit card receivables 1,956 30,731
Other receivables 733 891
Merchandise inventories, net 5,335 5,115
Prepaid expenses and deferred charges 407 535
Property and equipment

Land 392 442
Buildings and improvements 7,151 6,930
Furniture, fixtures and equipment 4,972 5,050
Capitalized leases 609 557
Gross property and equipment 13,124 12,979
Less accumulated depreciation 6,336 6,069
Total property and equipment, net 6,788 6,910

Goodwill 943 944
Tradenames and other intangible assets 710 704
Other assets 708 1,134
TOTAL ASSETS $ 27,723 $ 50,409

LIABILITIES
Current liabilities
Short-term borrowings $ 1,033 $ 4,525
Current portion of long-term debt and capitalized lease obligations 2,950 4,808
Merchandise payables 3,106 2,945
Income taxes payable 1,867 787
Other liabilities 2,950 3,753
Unearned revenues 1,244 1,199
Other taxes 609 580
Long-term debt and capitalized lease obligations 4,218 21,304

Pension and postretirement benefits 1,956 2,491
Minority interest and other liabilities 1,389 1,264
COMMITMENTS AND CONTINGENT LIABILITIES
SHAREHOLDERS' EQUITY
Common shares issued ($. 75 par value per share, 1,000 shares authorized,
230.4 and 316.7 shares outstanding, respectively) 323 323
Treasury stock - at cost (7,945) (4,474)
Deferred ESOP expense (26) (42)
Accumulated other comprehensive loss (1,106) (1,056)
Total Shareholders' Equity 6,401 6,753
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 27,723 $ 50,409

Useful financial analysis links
More information about financial analysis
A lecture on financial ratios by Larry Lynch, Roanoke University, providing great coverage of
the Du Pont system.
An informative guide provided by IBM as part of their investors' relations site, Analyzing the
Financials, is a well-done overview of using financial data.
Sources of financial data

Securities and Exchange Commission’s EDGAR archives. Complete (and free) corporate
filings, including all 10-K, 10_Q, and 8-K statements for all publicly-traded corporations.
Yahoo! Finance. A great source of stock price data, recent financial statements, and basic
company statistics.
Federal Reserve Bank of St. Louis FRED. Economic and financial data, much of
downloadable.
Information about recent corporate scandals

CBS Marketwatch Scandal Sheet
The Corporate Scandal Sheet (Forbes)
Corporate Scandal Jokes from About
Financial Analysis Links, prepared by Pamela Peterson-Drake

Relations web site.
Procter & Gamble

Years Ended June 30
Net Sales $51,407 $43,377 $40,238

Income taxes 2,869 2,344 2,031
Net Earnings $6,481 $5,186 $4,352

explanations.
Procter & Gamble
Assets
June 30

Current Assets
Inventories
Land 42 591
23,542 25,304
Goodwill 19,610 11,132
Total Assets $57,048 $43,706
Procter & Gamble
2004 2003
Current Liabilities
2,594.4)
explanations.
Procter & Gamble
Years ended June 30

Net earnings 6,481 5,186 4,352

Other 299 527 467
Acquisitions (7,476) (61) (5,471)
Cash payments for:
Interest $630 $538 $629
Income taxes 1,634 1,703 941
explanations.
Financial ratio formulas
1. Operating cycle
Inventory Inventory
Average day's cost of goods sold Cost of goods sold / 365

Number of days of receivables

Cost of Ending Beginning

Note: Purchases =
goods sold inventory inventory

Operating cycle

Net operating cycle
2. Liquidity
Current assets
Current ratio

Quick ratio

Sales
3. Profitability
Gross income
Gross profit margin
Sales
Operating income
Sales
Financial ratio formula sheet, prepared by Pamela Peterson-Drake 1

Net income
Net profit margin
Sales
4. Activity
Cost of goods sold
Inventory turnover
Inventory
Sales on credit
Accounts receivable
Sales
Total assets
Sales
Fixed assets
5. Financial leverage
Total debt
Total assets
Long - term debt

Total assets
Total debt
Total assets
Equity multiplier =

Interest


Earnings per share

Dividends per share
Dividends
Earnings

Earnings per share
7. Return ratios
Operating income
Total assets
Net income
Return on assets =
Total assets
Net income
Return on equity =

Accounting problems Page 1 of 1
Solutions to Questions and Problems: Using Financial Information

1. The DoeDoe Company purchased an asset for $2 million. This asset has a salvage value of $50,000 and is to
depreciated over a 15 year life.
a. What is the depreciation expense for the first year of the asset's life using straight-line depreciation?
using sum-of-the-years' digits depreciation?
Straight-line depreciation = ($2,000,000 - 50,000) / 15 = $130,000
Sum-of-years'-digits depreciation = (15/120) ($2,000,000 - 50,000) = $243,750
b. What is the depreciation expense for the last year of the asset's life using straightline depreciation?
using sum-of-the-years' digits depreciation?
Straight-line depreciation = ($2,000,000 - 50,000) / 15 = $130,000
Sum-of-years'-digits depreciation = (1/120) ($2,000,000 - 50,000) = $16,250
2. Which depreciation method provides the greatest net income early in the life of an asset: straight-line or
declining balance?
Straight-line depreciation provides the greatest net income in the early years because it yields the lower
depreciation (relative to the accelerated methods).
3. Suppose a company has assets of $5 million and liabilities of $3 million. What is this company's book value of
equity?
Book value of equity = $5 million - 3 million = $2 million
4. The Jackson Company has the following amounts recorded:

{ common stock of $2 million
{ additional paid-in capital of $12 million
{ retained earnings of $23 million
{ treasury stock of $3 million
What is the book value of equity for Jackson Company?
Book value of equity (in millions) = $2 + 12 + 23 - 3 = $34
http://educ.jmu.edu/~drakepp/principles/module2/accs.html 3/1/2011
Crossword Puzzle Page 1 of 1
Solution to the Accounting Review Puzzle
Created by Pamela Peterson Drake
http://educ.jmu.edu/~drakepp/principles/module2/accpuzzles.htm 3/1/2011
Solutions to Financial Ratio Analysis Problems Page 1 of 2
Solutions to Financial Ratio Analysis Problems

A. Du Pont
1. Calculate the following ratios for DuPont for 1997 and 1996:
a. current ratio
1997: current ratio = $11,874/$14,070 = 0.8439 times
1996: current ratio = $11,103/$10,987 = 1.0106 times
b. inventory turnover
1997: inventory turnover = $26,377/$4,070 = 6.4808 times
1996: inventory turnover = $25,144/$3,706 = 6.7847 times
c. total asset turnover
1997: total asset turnover = $46,653/$42,942 = 1.0864 times
1996: total asset turnover = $45,150/$37,870 = 1.1922 times
d. operating profit margin
Note: operating profit is not provided directly on the income statement,

but must be calculated.
1997: operating profit margin = $13,607/$46,653 = 0.2917 or 29.17%
1996: operating profit margin = $13,093/$45,150 = 0.2900 or 29%
e. net profit margin
1997: net profit margin = $2,405/$46,653 = 0.0516 or 5.16%
1996: net profit margin = $3,636/$45,150 = 0.0805 or 8.05%
f. debt to equity
1997: debt to equity = $31,002 / $11,270 = 2.7508
1996: debt to equity = $26,657 / $10,593 = 2.5165
2. Evaluate the change in the return on assets from 1996 to 1997 for DuPont using the DuPont system.
1997: return on assets = $2,405 / $42,942 = 0.0560 or 5.60%
1996: return on assets = $3,636 / $37,870 = 0.0960 or 9.60%
The return on assets declined from 1996 to 1997. This decline is attributed to
both a decline in profitability (as evidenced by the decrease in the net profit
margin from 8.05% to 5.16%) and the decline in efficiency (as evidenced by
the decrease in the total asset turnover from 1.1922 to 1.0864 times)
http://educ.jmu.edu/~drakepp/principles/module2/finratios.html 3/1/2011
Solutions to Financial Ratio Analysis Problems Page 2 of 2
B. Intel, 1998
1. Calculate the following ratios for Intel for 1998:
a. Fixed asset turnover
fixed asset turnover = $26,273 / $11,609 = 2.2632
b. Operating profit margin
operating profit margin = $8,379 / $26,273 = 31.892%
c. Basic earning power
basic earning power = $8,379 / $31,471 = 26.625%
2. Has Intel's interest coverage ratio improved from 1996? Explain.
interest coverage, 1996 = $7,553 / $25 = 302.12 times
The actual coverage ratio decreased slightly from 1996 to 1998, but this ratio is not very
meaningful in the context of evaluating Intel because Intel uses so little debt in its capital
structure (e.g., the ratio of debt to equity is less than 7% in 1998).
http://educ.jmu.edu/~drakepp/principles/module2/finratios.html 3/1/2011
Financial Ratios Quiz, Pamela Peterson Drake Page 1 of 2
Financial ratio quiz
(1) A high inventory turnover may indicate

a) an efficient use of the investment in inventory.

b) a high risk of stock-outs.

c) a low profit margin.

d) Both selections (a) and (b) are correct.

(2) Inventory is removed from liquid assets in the calculation of the quick ratio
because
a) inventory is meaningless.

b) it is usually the least liquid of the current assets.

c) because it is a large part of current assets.

d) because it cannot be sold for cash.

(3) Total asset turnover is

a) the ratio of credit sales to total assets.

b) the ratio of sales to total assets.

c) the ratio of the cost of goods sold to total assets.

d) high.

(4) The net profit margin

a) is less than or equal to the operating profit margin.

b) is less than or equal to the gross profit margin.

c) is greater than the operating profit margin.

d) Both selections (a) and (b) are correct sentence competions.

(5) The DuPont system invoves analyzing return ratios by breaking them down
into
a) profit margin and turnover components.

b) turnover and liquidity components.

c) leverage components.

d) their individual parts.

(6) The debt-to-equity ratio is a measure of a firm's

a) financial leverage

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Financial Ratios Quiz, Pamela Peterson Drake Page 2 of 2
b) operating leverage

c) liquidity

d) profitability

(7) The CBA Company has a net profit margin of 5% and a total asset turnover
of 5 times. What is CBA's return on assets?
a) 1%

b) 5%

c) 10%

d) 25%

(8) A company with a debt-to-equity ratio of 2.5 and $10 million of assets has
debt of
a) $2.9 million

b) $5 million

c) $7.14 million

d) $8.23 million

(9) The interest coverage ratio is the ratio of

a) operating income to the interest expense.

b) net income to the interest expense.

c) gross profit to operating profit.

d) net income to interest income.

(10) A current ratio of 2.0

a) tells us that current assets are twice current liabilities.

b) is good.

c) indicates a problem with liquidity.

d) is greater than the quick ratio for a firm.

Grade Me!
http://educ.jmu.edu/~drakepp/principles/module2/ratioquiz.htm 3/1/2011
Solution Page 1 of 1
Solution to Quiz
Question 1=d
Question 2=b
Question 3=b
Question 4=d
Question 5=a
Question 6=a
Question 7=d
Question 8=c
Question 9=a
Question 10=a
Note: The solutions in red are the ones to the questions you had incorrectly answered.
http://educ.jmu.edu/~drakepp/principles/module2/ratioresults.htm 3/1/2011
Financial Ratio Analysis StudyMate Activity Page 1 of 2
Financial Ratio Analysis StudyMate Activity
Flash Cards
Pick a Letter
Fill In The Blank
Matching
Crosswords
Quiz
Challenge
Glossary
Financial Ratio Analysis StudyMate Activity Page 2 of 2

Time Value of Money Module, Pamela Peterson Drake Page 1 of 2
Module 3: Time Value of Money

Elements
1. Module 3: Time value of money IMPORTANT: READ FIRST
2. Reading: Time value of money: Part I
3. Supplemental reading: Calculating a future value
4. Reading: Time value of money: Part II
5. Reading: Calculating interest rates
6. Problem set: Time value of money practice problems and Solutions
7. Time value of money StudyMate activity
8. Check out here for additional problem sets.
Time Value of Money Module, Pamela Peterson Drake Page 2 of 2

Module 3: Time value of
http://educ.jmu.edu/~drakepp/principles/module3/learning_outcomes.pdf
money
Time value of money: Part I http://educ.jmu.edu/~drakepp/principles/module3/tvm.pdf
Calculating a future value http://educ.jmu.edu/~drakepp/principles/module3/fv.pdf
Time value of money: Part II http://educ.jmu.edu/~drakepp/principles/module3/tvm2.pdf
Calculating interest rates http://educ.jmu.edu/~drakepp/principles/module3/interestrates.pdf
Time value of money practice
http://educ.jmu.edu/~drakepp/principles/module3/tvm_problems.pdf
problems
Solutions http://educ.jmu.edu/~drakepp/principles/module3/tvm_problems_solutions.pdf
Time value of money
StudyMate activity
here http://educ.jmu.edu/~drakepp/principles/problems.html
MODULE 3:
TIME VALUE OF MONEY
OUTLINE
1. Introduction
3. Module 3 tasks
1. Introduction
The purpose of this module is to introduce you to the math of finance. The focus of this
module is on the time value of money – the valuation of cash flows at different points in
time. This is an essential tool in financial decision-making because decisions are made
considering benefits and costs that occur at different points in time.
Your financial calculator is a wonderful tool that can be used to do the hard work in the
calculations. However, mastery of financial math requires understanding the mathematics
behind the calculations that your calculator performs. Why bother knowing what’s behind it
all? Because not every financial transaction fits neatly into the financial calculator’s
programs.
The tools that you will learn in this module are necessary to understanding securities’
valuation and capital budgeting, which are key topics in financial decision-making. An added
benefit to learning financial math is that you will be better prepared for consumer-finance
decisions. For example, with the math that you learn in this module you will be able to
calculate the true, effective rate of interest on a car loan and the true, effective rate on credit
card borrowing.
You may have some experience with financial math from other coursework, but we will be
covering the financial math with more depth than most other courses. This is necessary in
order to set the stage for the more intense requirements of capital budgeting.
Module 3 Overview 1
LO3.1 Apply valuation principles to calculate the future value of lump-sum amount.
LO3.2 Apply valuation principles to calculate the present value of a lump-sum amount.
LO3.3 Distinguish between discrete and continuous compounding of interest.
LO3.4 Calculate the FV and PV of a lump sum for different compounding frequencies, including
continuous compounding.
LO3.5 Apply valuation principles to calculate the future value and the present value of a series of
cash flows.
LO3.7 Distinguish between an ordinary annuity and an annuity due.
LO3.8 Calculate the present value lump-sum amount for a deferred annuity.
LO3.9 Solve for the deposits or withdrawals in a deferred annuity.
LO3.10 Amortize a loan, breaking out both interest and principal payments, for loans with and
without a balloon payment.
LO3.11 Solve for the interest rate for both lump-sum and annuity situations.
LO3.12 Solve for the number of periods for both lump-sum and annuity situations.
LO3.13 Convert an APR into an EAR, and vice-versa.
3. Module 3 tasks
A. Readings
i) Required reading
(a) Time value of money: Part 1
(b) Time value of money: Part II
(c) Calculating interest rates
ii) Other resources
(a) Calculator help. A guide to calculating the problems using a HP, TI or similar
calculator.
(b) Study Finance: Time Value of Money. An overview of the time value of money
provided by the University of Arizona.
iii) Optional reading
(a) Calculating a future value, a step-by-step approach.
(b) Fabozzi and Peterson text, Chapter 7 (Mathematics of Finance)
B. Problem sets
These problems sets are non-graded tasks.
Time value of money practice problems and solutions
5-minutes workouts:
o Future and Present Values
o Annuities
o Uneven Cash Flows
o EAR vs. APR
o Interpreting Problems
Time Value of Money Practice Problems
More Time Value of Money Practice Problems
Module 3 Overview 2
Time Value of Money Practice Test
Annuity Practice Problems
Loan Amortization: Example and Explanation
Deferred Annuity Problem: Example and Explanation
Time Value of Money StudyMate Activities

A. Introduction
Financial decisions involve dealing with cash flows that occur at different points in time. For
example, if a company is considering a new product, the decision depends on the comparison
of the cost of the project today with the expected benefits from the new product in the form
of future cash flows.
Therefore, the financial manager must be able to translate values through time, either
forward or backward, depending on the application. Translating a value or set of values
through time requires consideration of both the rate of interest and the number of compound
or discount periods.
B. Time value of money: Part I

In this reading, we establish the basic concepts and math of valuation. You are introduced
to the basic valuation equation and how it is used to translate a lump-sum monetary amount
forward in time – calculating the future value – and backward in time – calculating the
present value.
This reading is designed assuming that the reader has never become acquainted with the
time value of money principles. You may have seen the time value of money before in
another course, but you are encouraged to work through the examples to make sure that
you are familiar with the notation and the methods of calculation offered in this reading so
that you are prepared for further readings.
Throughout this and other readings, calculator and spreadsheet assistance is provided. The
two calculators that are demonstrated are the Texas Instruments (TI) Model 83 (and TI-84,
since they have the same programs) and the Hewlett Packard (HP) 10B. The spreadsheet
assistance is for Microsoft Excel®.
C. Time value of money: Part II

In this reading, we take a look at valuing a series of cash flows, whether even or uneven. If
the series consists of even cash flows (that is, cash flows of the same amount at periodic
intervals of time), we can use short-cuts to value these cash flows. We address three
annuities: ordinary, annuity due, and deferred annuity. We also take a look at the algebraic
manipulations necessary for solving for the unknown number of periods and for solving for
the unknown interest rate.
The mathematics of finance can become quite complex, but no matter the complexity, it all
harks back to the basic valuation equation.
D. Calculating interest rates

In financial decision-making, we are concerned about how interest rates affect value. The
focus of this reading is on making sense of two common methods of stating interest rates:
the annual percentage rate (APR) and the effective annual rate (EAR).
Module 3 Overview 3
Consumer laws require that lenders state the loan arrangement’s APR. However, the APR
does not consider compounding, which affects the true cost of the loan. Therefore, we need
to understand how to translate a stated rate into a true, effective rate of interest. This is
especially important when comparing borrowing opportunities in which the terms of the loans
differ.
E. Is a financial calculator necessary?

Do you really need a financial calculator or one with financial programs? Absolutely. Though
you may be able to complete all of the financial math problems in this module without a
financial calculator (by spending a bit more time on each problem), you will not be able to
perform the financial math in the next module without the financial programs. If you have
just acquired a financial calculator or have never used the financial programs in your
calculator, now is a good time to get used to the programs.
What’s the best calculator? Well, there are actually several good calculators you could
acquire. The readings refer to two calculators: The Texas Instruments (TI) TI-83 and the
Hewlett-Packard (HP) 10B.
The TI-83 (and the new model TI-84) is a scientific calculator with excellent financial
programs. If you already have one of these from other courses, you will find that
this is all you need for this course.
The Hewlett-Packard 10B is a “best buy” in terms of a good price on a calculator that
does everything you need.
There are other good calculators that you can use: some of the other TI scientific calculators
have financial applications that can be downloaded from TI’s website and there are imitators
of the HP10B that work just as well. 1,2 When in doubt, as the instructor.
F. What’s next?
The next module focuses on valuation. You’ll notice when you get there that it’s an
application of the financial mathematics from Module 3. We use this math to value stocks,
bonds, and other investments in Module 4. In Module 5, you’ll see how risk enters the
picture and affects valuation.
1
Check out the calculator help at the course web site to see if your calculator is supported by the course.
2
You will notice that I did not mention TI’s BAII+ calculator. This calculator has shown to be a problem for
students in the past because it has a very cumbersome cash flow/NPV/IRR programs, as well as confusing
registry clearing routines. Use this calculator at your own risk.
Module 3 Overview 4
The time value of money: Part I
OUTLINE
1. Introduction
2. Compounding
3. Discounting
1. Introduction
A. The basics
Evaluating financial transactions requires valuing uncertain future cash flows; that is, determining
what uncertain cash flows are worth at different points in time. We are often concerned about what
a future cash flow or a set of future cash flows are worth today, though there are applications in
which we are concerned about the value of a cash flow at a future point in time. One complication
is that there is a time value of money: a dollar today is not worth a dollar tomorrow or next year.
Another complication is that any amount of money promised in the future is uncertain, some riskier
than others.
The purpose of this reading is to develop the concepts and mathematical tools that will enable you to
move money though time, both backwards and forwards. Once we master these tools, we’ll apply
them to more realistic transactions.
Moving money through time – that is, finding the equivalent value to money at different points in
time – involves translating values from one period to another. Translating a value to the present is
referred to as discounting. Translating a value to the future is referred to as compounding.
Translating money from one period involves interest, which is how the time value of money and risk
enter into process.
The principal is the amount borrowed. Interest is the compensation for the opportunity cost of
funds and the uncertainty of repayment of the amount borrowed; that is, it represents both the price
of time and the price of risk. The price of time is compensation for the opportunity cost of funds
and the price of risk is compensation for bearing risk.
Interest is compound interest if interest is paid on both the principal and any accumulated interest.
Most financial transactions involve compound interest, though there are a few consumer transactions
that use simple interest (that is, interest paid only on the principal or amount borrowed).
The future value is the sum of the present value and interest:
Future value = Present value + interest
The basic valuation equation that is the foundation of all the financial mathematics is:
The time value of money: Part I , A reading prepared by Pamela Peterson Drake 1
FV = PV (1 + i)n
Where FV is the future value, PV is the present value, i is the rate of interest, and n is the number of
compounding periods. The term [(1 + i)n] is the compound factor.
We can rearrange the basic valuation equation to solve for the present value, PV:
1
FV
PV = FV
(1 + i)n (1 + i)n ,

where 1 (1+i)t is the discount factor.
2. Compounding
We begin with compounding because this is the most straightforward way of demonstrating the
effects of interest. Consider the following example: Suppose you invest $1,000 in an account that
pays 6 percent interest, compounded annually. How much will you have in the account at the end of
1 year if you make no withdrawals? After 2 years? After 5 years? After 10 years? Using the subscript
to indicate the year,
FV1 = $1,000 (1 + 0.06) = $1,060
FV2 = $1,000 (1 + 0.06) (1 + 0.06) = $1,000 (1 + 0.06)2 = $1,000 (1.1236) = $1,123.60
FV5 = $1,000 (1 + 0.06)5 = $1,000 (1.3382) = $1,338.23
FV10 = $1,000 (1 + 0.06)10 = $1,000 (1.7908) = $1,790.85
What if interest was not compounded interest (that is, if interest is simple interest)? Then we would
have a lower balance in the account:
FV1 = $1,000 + [$1,000 (0.06)] = $1,060
FV2 = $1,000 + [$1,000 (0.06)] + [$1,000 (0.06)] = $1,000 + [$1,000 (0.06)(2)] = $1,120
FV5 = $1,000 + [$1,000 (0.06) (5)] = $1,300
FV10 = $1,000 + [$1,000 (0.06) (10)] = $1,600
You can see the difference between compounded and simple interest in Exhibit 1, which shows the
growth of $1,000 at 6 percent using both types of interest.
The difference between the Exhibit 1: Future value of $1,000 at a 6 percent interest
future value with compounded rate
interest and that with simple
interest is the interest-on-
$3,500
interest. For example, at the Compound interest Simple interest
$3,000
end of 10 years the interest $2,500
on interest is $1,790.85 - $2,000
Future
1,600.00 = $190.85. $1,500
value
Most financial transactions $1,000
involve compound interest. If $500
the method of calculating $0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
interest is not stated, you
should assume that the Number of periods
interest is compound interest.
Example 1: Compound Interest Example 2: Compound Interest vs. Simple Interest
Problem Problem
Suppose that the Fosters invest Suppose you are faced with a choice between two accounts,
$100,000 today in an investment Account A and Account B. Account A provides 5 percent
that produces a return of 5 percent interest, compounded annually and Account B provides 5.25
per year. What will their investment percent simple interest. Consider a deposit of $10,000 today.
be worth in two years? Which account provides the highest balance at the end of 4
years?
Solution
Solution
FV2 = $100,000 (1 + 0.05)2
FV2 = $100,000 (1.1025) Account A
FV2 = $110,250
Account A:
FV4 = $10,000 (1 + 0.05)4 = $12,155.06
Account B:
FV4 = $10,000 + ($10,000 (0.0525)(4)] = $12,100.00
A. Calculator and spreadsheet solutions

The calculations can be made easier with the help of either a financial calculator or a spreadsheet
program. The calculator financial functions assume compound interest; if you wish to perform a
calculation with simple interest, you must rely on the mathematical programs of your calculator.
Using a calculator, for example, we calculate the future value of $1,000 invested 10 years at 6
percent with the following key strokes:
TI 83/84 HP10B
Using TVM Solver
N = 10 1000 +/- PV
I% = 6 10 N
PV = -1000 6 I/YR
PMT = 0 FV
FV = Solve 1
PV is the present value, N is the number of compound periods, I percent or I/YR is the interest rate
per period, and FV is the future value.
You will notice that we changed the sign on the PV. This is because of the way the financial function
is programmed, assuming that the present value is the outflow. The changing of the sign for the
present value is required in most (but not all) financial calculators.
If we want to use the math functions, instead of the financial program of a calculator, you would
need to use a power key, such as yx or ^ and input the interest in decimal form:
1
In the TI83/84, The TVM Solver is found in APPS or FINANCE, depending on the model. “Solve” is executed on
the TI83/84 using the ALPHA and then SOLVE keys.
In Microsoft Excel®, the calculation uses the worksheet function TI 83/84 HP10B
FV:
(1+.06)^10 1+.06=
=FV(rate,nper,pmt,pv,type) ENTER N yx
Where “type” is 0 (indicating cash flows and values occur at the X1000 10 yx
end of the period). Using notation similar to that found on ENTER X 1000
calculators, this command becomes: ENTER
=FV(i,N,PMT,PV,0)
Because there are no other cash flows in this problem, PMT (which represents periodic cash flows,
such as a mortgage payment) is zero. To calculate the FV, the function requires the following inputs:
=FV(.06,10,0,-1000,0)
Note that in the financial functions of your calculator, the interest rate is represented as a whole
number (that is, 6 for 6 percent), whereas in the math functions of your calculator and in
spreadsheet functions, the interest rate is input in decimal form (that is, .06 for 6 percent).
Why can’t I calculate the future value with simple interest using my calculator
functions?
Calculators’ time value of money programs are set up to perform calculations involving compound
interest. If you want to calculate the future value using simple interest, you must resort to old
fashion mathematics:
Simple interest = Principal amount x interest rate per period x number of periods
Or
Simple interest = PV i N
The future value of a lump-sum if interest is computed using simple interest is therefore:
FVsimple = PV + PV i N = PV (1 + iN)
If the present value is $1,000 and interest is simple interest at 5 percent per year, the future
value after four periods is:
FVsimple = $1,000 + $1,000 ( 0.05) (4) = $1,000 (1 + 0.2) = $1,200
The interest paid on interest in compounding is the difference between the future values with
compound and simple interest.
B. Frequency of compounding
If interest is compounded more frequently than once per year, you need to consider this in any
valuation problem involving compounded interest. Consider the following scenario:
$1,000 is deposited in account at the beginning of the period and 12% interest paid on the account,
with interest compounded quarterly. This means that at the end of the first quarter, the account has
a balance of:
0.12
FV1st quarter = $1,000 (1 + /4) = $1,000 (1 + 0.03) = $1,030
The following quarters' balances are calculated in a like manner, with interest paid on the balance in
the account:
FV2nd quarter = $1,030.00 (1 + 0.03) = $1,060.90
FV3rd quarter = $1,060.90 (1 + 0.03) = $1,092.73
FV4th quarter = $1,092.73 (1 + 0.03) = $1,125.51
Therefore, at the end of
Example 3: Frequency of compounding
one year, there is a
balance of $1,000 (1 + Problem
0.03)4 = $1,125.51. Suppose you invest $20,000 in an account that pays 12 percent interest,
compounded monthly. How much do you have in the account at the end of 5
When you face a situation years?
in which interest is
Solution
compounded more
frequently than on an N = Number of periods = 5 years x 12 months per year = 60 months
annual balance, you need I = Rate per period = 12% / 12 = 1%
to adjust both the number FV = $20,000 (1 + 0.01)60 = $20,000 (1.8167) = $36,333.93
of periods and the interest
Using an HP10B calculator,
rate accordingly. 2
20000 +/- PV
If interest is compounded 1 I/YR
continuously (that is, 60 N FV
instantaneously), the ®
compound factor uses the Using Microsoft Excel ,
exponential function, e, the =FV(.01,60,0,-20000,0)
inverse of the natural
logarithm. The compound factor is:
e(annual interest rate)(number of years) = eAPR x
If annual interest is 10 percent, continuously compounded, the compound factor for one year is:
e 0.10 = 1.1052
For two years, the factor is:
e(0.10)(2) = e0.20 = 1.2214
For 10 years, the factor is:
e(0.10)(10) = e1 = 2.7183
Using a calculator, you need to use the math function ex. For example, suppose you want to calculate
the future value of $1,000 invested five years at 4 percent, with interest compounded continuously.
The future value is:
FV5 = $1,000 e(0.04)(5) = $1,000 e0.2 = $1,000 (1.2214) = $1,221.40
TI 83/84 HP10B
Using Microsoft Excel®, you use the exponential 1000 x 2nd ex (.04 x 5) .04 x 5
worksheet function, EXP: ENTER N ex
X 100 ENTER
=1000*EXP(0.04*5)
where the value in parentheses is the exponent.
2
The number of periods is therefore the number of compounding periods, not the number of years.
Example 4: Continuous compounding
Example 5: Continuous versus discrete
Problem compounding
Suppose you invest $1,000 today in an account
Problem
that pays 9 percent interest, compounded
Suppose you invest $5,000 in an account that earns
continuously. What will be the value in this
10 percent interest. How much more would you
account at the end of ten years?
have after 20 years if interest is compounded
Solution: continuously instead of compounded semi-annually?
FV = $1,000 e(0.09)(10) Solution:
0.9 FVcontinuously = $5,000 e(0.1)(20)
= $1,000 e
=$5,000 (7.3891) = $36,945.28
= $1,000 (2.4596) = $2,459.60
FVsemi-annually = $5,000 (1 + 0.05)40
= $5,000 (7.0400) = $35,199.94
Difference = $36,945.28 - 35,199.94
= $1,745.34
3. Discounting
Translating a value back in time -- referred to as discounting -- requires determining what a future
amount or cash flow is worth today. Discounting is used in valuation because we often want to
determine the value today of some future value or cash flow (e.g., what a bond is worth today if it
promised interest and principal repayment in the future).
The equation for the present value is a rearrangement of the basic valuation equation that we saw
earlier:
FV
PV = ,
(1 + i)n
where:
PV is the present value (today's value),
FV the future value (a value or cash flow sometime in the future),
i the interest rate per period, and
n the number of compounding periods.
As you can see, there are many
ways to represent solving for the Example 6: Discounting
present value.
Problem
From the formula for the present Suppose that you wish to have $20,000 saved by the end of
value we know that five years. And suppose you deposit funds today in account
as the number of discount that pays 4 percent interest, compounded annually. How much
periods, n, becomes must you deposit today to meet your goal?
larger, the discount factor
becomes smaller and the Solution
present value becomes Given: FV = $20,000; n = 5; i = 4%
less, and PV = $20,000/(1 + 0.04)5 = $20,000/1.21665
PV = $16,438.54
as the interest rate per
period, i, becomes larger, the discount factor becomes smaller and the present value
becomes less.
Therefore, the present value is influenced by both the interest rate (i.e., the discount rate) and the
number of discount periods.
A. Calculator and spreadsheet solutions

If you want to take a value to power (e.g., (1 + 0.05)8), you generally key in the base (e.g., 1.05)
and then use the key marked as ^ or yx: (1 + 0.05)8 = 1.4775. To invert a value (e.g., 1/1.4775),
use the key marked 1/x: 1/1.4775 = 0.6768.
Calculate the present value of $6,000 to be received in eight years if the interest rate is 5 percent per
year:
$6,000
PV = $4, 061.04
(1.05)8
TI 83/84 HP10B
The present value is $4,061.04. You will notice that the Using TVM Solver
calculator displays the present value as a negative number. This N=8 8N
has to do with the way the program is written for the I% = 5 5 I/YR
calculator; it is written such that 0 = FV - PV(1+i)n. FV = 6000 6000 FV
The present value can also be calculated using Microsoft Excel®. PMT = 0 PV
The present value function is: PV = Solve
=PV(rate,nper,pmt,fv,type)
where
rate is the interest rate, stated in decimal form;
nper is the number of periods;
pmt is 0 in this case because we are assuming no other cash flows;
fv is the future value; and
type reflects the timing (0 or end of period, the usual assumption, and 1 for the beginning
of the period).
Suppose we want to calculate the present value of $500,000 to be received in ten years, with an
interest rate of 7 percent. The entry in the Excel® spreadsheet is:
=PV(.07,10,0,500000,0)
and because the default assumption is that an amount is received at the end of the period, we can
also write this entry as:
=PV(.07,10,0,500000)
®
The answer is $254.174.65. An Excel spreadsheet demonstrating the use of the PV function for this
problem (using several different interest rates), along with a chart of the present values, is available
here.
B. Frequency of compounding
Suppose that interest is compounded more frequently than annually. We must therefore adjust both i
and n to reflect this more frequent compounding. Consider an example: calculate the present value
of $10,000 to be received at the end of five years if the annual interest rate is 6 percent,
compounded semi-annually. If the annual rate is 6 percent, the semi-annual rate is 6 percent / 2 = 3
percent. The number of semi-annual periods is 5 years x 2 times per years = 10. Therefore, the
present value of this $10,000 is calculated as:
PV = $10,000 [1 / (1 + 0.03)10] = $10,000 (0.7441) = $7,440.94
If interest is compounded continuously, the present value is calculated as:
PV = 1 / eAPR x
where APR is the annual percentage rate, x is the number of years, and e is the base of the natural
logarithm. For example, what is the present value of $10,000to be received at the end of five years if
the interest rate is 6 percent, compounded continuously?
PV = $10,000 (1 / e(0.06)(5)) = $10,000 (1 / e0.30)
PV = $10,000 (1 / 1.3499) = $10,000 (0.7408) = $7,408.18
Exhibit 2: Discounting with different frequencies of We can see the difference

compound interest the frequency of
compounding makes in
Exhibit 2, in which this last
Annual compounding example has been
$500,000 Quarterly compounding expanded to include
$450,000 Continuous compounding quarterly and continuous
compounding. For a given
$400,000
Present annual percentage rate, the
value $350,000
greater the frequency of
with $300,000
compounding, the greater is
10 years of $250,000 the effective interest rate
discounting $200,000 and the smaller is the
$150,000 present value. But as you
$100,000 can also see in the Exhibit,
$50,000 the difference may be quite
$0 small.
%
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10
Annual interest rate
Example 7: Present value with quarterly Example 8: Present value with continuous
compounding compounding
Problem Problem
How much would you have to deposit today in an How much would you have to deposit today in an
account that pays 4 percent annual interest, account that pays 4 percent annual interest,
compounded quarterly, if you wish to have a compounded continuously, if you wish to have a
balance of $100,000 at the end of ten years? balance of $100,000 at the end of ten years?
Solution Solution
Given information: Given information:
FV = $100,000, FV = $100,000
i = 4%/1 = 1%; i = 4%
n = 10 x 4 = 40 quarters n = 10 years
PV = $100,000 (1 / (1+0.01)40) PV = $100,000 (1 / e(0.04)(10))
PV = $100,000 (0.6717) = $67,165.31 PV = $100,000 (0.67032) = $67,032
Example 9: Solving for a present value

Problem
Which of the following requires the least amount of a deposit today?
a. A balance of $10,000 four years from today that has grown from a sum deposited in an account that
pays 8 percent interest, compounded quarterly.
b. A balance of $10,000 five years from today that has grown from a sum deposited in an account that
pays 7 percent interest, compounded annually.
c. A balance of $10,000 ten years from today that has grown from a sum deposited in an account that
pays 4 percent interest, compounded continuously.
d. A balance of $10,000 eight years from today that has grown from a sum deposited in an account that
pays 4 percent interest, compounded semi-annually.
Solution
c
PVa = $10,000 / (1 + 0.02)16= $7,284.46
PVb = $10,000 / (1 + 0.07)5 = $7,129.86
PVc = $10,000 / e(0.04)(10) = $6,703.20
PVd = $10,000 / (1 + 0.02)16 = $7,284.46
©2007, Pamela Peterson Drake
Calculating a future value
Step by Step
Consider a deposit of $1,000. Suppose the deposit earns interest at the rate of 5 percent, compounded
annually. What we need to do is calculate the future value of the deposit, with interest earned on both
the deposit (that is, the principal amount) and the interest that has accumulated to date.
The basic formula is:
FV = PV (1 + i)N – 1
where
FV = future value;
PV = present value;
I = interest rate per period; and
N = number of periods.
Using calculators and spreadsheets, we specify the given information and then solve. In calculating the
future value, the given information is PV, I, and N.
In the TI83/84 calculators, use the Applications: Finance: TVM Solver. Specify the N, I, and PV, and
then solve for FV. Be sure to input the present value as a negative number. Note that the PMT = 0,
P/Y = 1; C/Y = 1, and the PMT are at the END.
In the HP10B calculator, specify the N, I, and PV, and then solve for the FV. Be sure to input the PV
value as a negative number. Note that the number of payments per period, P/YR, should be set to 1.
In Microsoft Excel®, use the FV function:

=FV(rate, number of periods, number of payments, present value)
Examples:
How much will be in the account at the end of one year? .................................................................... 2
How much will be in the account at the end of two years?................................................................... 2
How much will be in the account at the end of three years? ................................................................ 4
How much will be in the account at the end of four years? .................................................................. 5
How much will be in the account at the end of five years?................................................................... 6
How much will be in the account at the end of ten years? ................................................................... 7
Calculating a future value: Step by step 1 of 7

How much will be in the account at the end of one year?
Solve for the future value, FV. Interest is earned at the end of the period and is paid only on the
principal amount because this is the first time interest is paid.
Given information
Value of
Parameter Notation parameter
Present value PV $1,000
Interest rate per period I 0.05
Number of periods N 1
Formula
FV = PV (1+i)N $1,000 (1 + 0.05)1 $1, 000 (1.05) $1, 050
Calculator & Spreadsheet

TI 83/84 HP10B Microsoft Excel®
Using TVM Solver
N=1 1000 +/- PV =FV(.05,1,0,-1000)
I% = 5 1N
PV = -1000 5 I/YR
PMT = 0 FV
FV = Solve 1
Dissecting the future value

Deposit $1,000
Interest earned during the period on the deposit 50
Future value $1,050
Future value if simple interest $1,000 + 50 = $1,050.000

Interest on interest 0
Future value if compounded interest $1,050.00
1
In the TI83/84, The TVM Solver is found in APPS or FINANCE, depending on the model. “Solve” is
executed on the TI83/84 using the ALPHA and then SOLVE keys.

How much will be in the account at the end of two years?
Solve for the future value, FV. Interest is earned at the end of the period and is paid on both the amount
and the interest earned in the first period.
Given information
Value of
Formula
FV = PV (1+i)N $1,000 (1 + 0.05)2 $1, 000 (1.1025) $1,102.50

Using TVM Solver
N=2 1000 +/- PV =FV(.05,2,0,-1000)
I% = 5 2N
PV = 1000 5 I/YR
PMT = 0 FV
FV = Solve

Deposit $1,000.00
Interest on the deposit accumulated from prior periods $50 = 50.00
Interest earned during the period on the deposit $1,000 x 0.05 = 50.00
Interest on interest earned during the period $50 x 0.05 = 2.50
Future value $1,102.50
Future value if simple interest $1,000 + 50 + 50 = $1,100.000

Interest on interest $2.50 = 2.50

How much will be in the account at the end of three
years?
Given information
Value of
Formula
FV = PV (1+i)N $1,000 (1 + 0.05)3 $1, 000 (1.157625) $1,157.625

Using TVM Solver
N=3 1000 +/- PV =FV(.05,3,0,-1000)
I% = 5 3N
PV = 1000 5 I/YR
PMT = 0 FV
FV = Solve

Deposit $1,000.000
Interest on the deposit accumulated from prior periods $50 + 50 = 100.000
Interest on interest earned in prior periods $2.50 = 2.500
Interest on interest earned during the period ($100.00+2.50) x 0.05 = 5.125

Interest on interest $2.500 + 5.125 = 7.625

How much will be in the account at the end of four years?
Given information
Value of
Formula
FV = PV (1+i)N $1,000 (1 + 0.05)4 $1, 000 (1.21550626) $1, 215.506

Using TVM Solver
N=4 1000 +/- PV =FV(.05,4,0,-1000)
I% = 5 4N
PV = 1000 5 I/YR
PMT = 0 FV
FV = Solve

Deposit $1,000.000
Interest on the deposit accumulated from prior periods $50 + 50 +50 = 150.000


How much will be in the account at the end of five years?
Given information
Value of
Formula
FV = PV (1+i)N $1,000 (1 + 0.05)5 $1, 000 (1.276281563) $1, 276.28

Using TVM Solver
N=5 1000 +/- PV =FV(.05,5,0,-1000)
I% = 5 5N
PV = 1000 5 I/YR
PMT = 0 FV
FV = Solve

Deposit $1,000.000
Interest on the deposit accumulated from prior periods $50 + 50 +50 + 50 = 200.000


How much will be in the account at the end of ten years?
Answer: Future value = $1,628.895
$1,800
Interest on interest in current period
$1,600 Interest on interest in prior periods
Interest on the deposit in current period
$1,400 Interest on the deposit in prior periods
Deposit
$1,200
$1,000
Value
$800
$600
$400
$200
$0
0 1 2 3 4 5 6 7 8 9 10
End of period

The time value of money: Part II
OUTLINE
1. Introduction
2. Annuities
3. Determining the unknown interest rate
4. Determining the number of compounding periods
5. Valuing a perpetual stream of cash flows
1. Introduction
The basics of determining the equivalence of an amount of money at a different point in time is
essential in valuing securities, capital projects, and other transactions. Many financial decisions
involve not one, but more than one cash flow that occurs at different points in time. Valuing these
multiple cash flows is simply an extension of translating single values through time.
A. Valuing a series of cash flows

Consider the following: You plan to deposit $10,000 in one year, $20,000 in two years, and $30,000
in three years. If the interest earned on your deposits is 10 percent,
1. What will be the balance in the account at the end of the third year?
2. What is the value today of these deposits?
The balance in the account at the end of the third year is calculated as the sum of the future values,
or $64,100:
Today
0 1 2 3
| | |
$10,000 $20,000 $30,000
ª 22,000
ª 12,100
FV = $64,100
What is the value of the deposits today? The value of these deposits today is calculated as the sum
of the present values, or $48,160.28:
The time value of money: Part II, A reading prepared by Pamela Peterson Drake 1
Today
0 1 2 3
| | |
$10,000 $20,000 $30,000
$9,090.91 ©
16,529.93 ©
22,539.44 ©
PV = $48,160.28
Why would we want to know the future value of a series? Suppose you are setting aside funds for
your retirement. What you may want to know is how much you will have available at the time you
retire. You’ll have to assume a specific return on your funds – that is, how much interest you can
earn on your savings – but you can calculate how much you’ll have at some future point in time.
Why would we want to know the present value of a series? Suppose you are considering investing in
a project that will produce cash flows in the future. If you know what you can earn on similar
projects, what is this project worth to you today? How much would you be willing to pay for this
investment? We can calculate the present value of the future cash flows to determine the value
today of these future cash flows.
Example 1: Value of a series of cash flows

Problem
Suppose you deposit $100 today, $200 one year from today, and $300 two years from today, in an account that
pays 4 percent interest, compounded annually.
1. What is the balance in the account at the end of two years?
2. What is the balance in the account at the end of three years?
3. What is the present value of these deposits?
Solution
1. What is the balance in the account at the end of two years?
FV = $100 (1.04)2 + $200 (1.04) + $300 = $616.16
2. What is the balance in the account at the end of three years?
FV = $100 (1.04)3 + $200 (1.04)2 + $300 (1.04) = $616.16 (1.04) or $640.81
3. What is the present value of these deposits?
PV = $100 + $200/(1.04) + $300/(1.04)2= $100 + 192.31 + 277.37 = $569.68
B. A calculator short-cut
In cases in which you require a present value of uneven cash flows, you can use a program in your
financial calculator, the NPV program. 1 The NPV program requires you to input all cash flow,
beginning with the cash flow in the next period, in order, and specifying the interest rate. 2 Using the
earlier problem, you can calculate the present value of the uneven series of cash flows as:
1
NPV represents net present value – the present value of all future cash flows.
2
If there is no cash flow you must input a “0” to hold the time period’s place in the program – otherwise, the
cash flow will receive an incorrect time value of money.
TI 83/84 HP10B Note that there is no short-cut
Create the list and store it in a list 0 CF in most calculators for the
{CF1,CF2,CF3} STO listname 10000 CF future value of an uneven series
{10000,20000,30000} STO L1 20000 CF of cash flows. To calculate the
30000 CF future value of an uneven series
Use the NPV program in the TVM Solver, 10 I/YR of cash flows, you need to
NPV(interest rate, CF0, listname) NPV calculate the future value of
NPV(10,0,L1) ENTER each of the individual cash flows
and then sum these future
values to arrive at the future value of the series.
C. Annuities
An annuity is a series of even cash flows. Because the cash flows are the same amount, the math is
simpler. Suppose you have a series of three cash flows, each of $1,000. The first cash flow occurs
one year from today, the second occurs two years from today, and the third occurs three years from
today. The present value of this series is:
3 3
$1,000 $1,000 $1,000 $1, 000 1
PV =
(1 + i)1

(1 + i) 2

(1 + i) 3
(1 i)
t 1
t
$1, 000 (1 i)
t 1
t
Using the notation CF to represent the periodic cash flow, we can represent this a
N N
CF 1
PV = (1+i)
t 1
t
CF (1 i)
t 1
t
(1 i)
1
The term t
is the annuity discount factor.
t 1
There are different types of annuities in financial transactions, which differ in terms of the timing of
the first cash flow:
An ordinary annuity is an annuity in which the first cash flow is one period in the future.
An annuity due is an annuity in which the first cash flow occurs today.
A deferred annuity is an annuity in which the first cash flow occurs beyond one period
from today.
The example that we just completed is an example of an ordinary annuity. You can see the timing
issue when comparing the time lines associated with each. Consider the following 3-cash flow
annuities: the ordinary annuity, an annuity due, and a deferred annuity with a deferral of three
periods.
End of period
Today 1 2 3 4 5
| | |
Ordinary
annuity
CF CF CF
PV FV
| | |
Annuity
due
CF CF CF
PV FV
| | |
annuity
Deferred
CF CF CF
PV FV
CF represents the periodic cash flow amount. In the case of an annuity, this amount is the same
each period. Because of the time value of money, the valuation of these annuities, whether we are
referring to the present value or the future value, will be different.
i) Valuing an ordinary annuity
The ordinary annuity is the most common annuity that we’ll encounter, though deferred annuities
and annuities due do occur with some frequency as well. The future value of an ordinary annuity is
simply the sum of the future values of the individual cash flows. Consider a three-payment ordinary
annuity that has payments of $1,000 each and a 5 percent interest rate.
The future value of this annuity is:
Today 1 2 3
| | | |
$1,000 $1,000 $1,000.0
ª 1,102.5
ª 1,050.0
FV= $3,152.5
The present value of this annuity is:
Today 1 2 3
| | | |
$1,000 $1,000 $1,000
$952.381 ©
907.029 ©
863.838 ©
PV = $2,723.248
We can represent the value of the annuity in more general terms. Let t indicate a time period, CF
represent the individual cash flow, and let N indicate the number of cash flows. The future value is
the sum of the future values of the cash flows:
N-1
FV=CF(1 + i)N-1 CF(1 + i)N-2 ... CF(1 + i)0 = CF

(1+i)t

t=0
The present value of an ordinary annuity can be represented as:
N
CF
N
1
1+i)N

PV = (1+i)
t 1
t
CF
t 1 (1 i)t
CF 1-
i

We used the notation “CF” to indicate a cash flow. In the case of an annuity, this cash flow is the
same each period. The term
N-1
t
(1+i)
t=0
is referred to as the future value annuity factor and the term
N
1
(1 i) t
t 1
is referred to as the present value annuity factor.

In financial calculator applications, the cash flow associated with an annuity is referred to as a
payment, or PMT.
TI 83/84 HP10B Consider another example. Suppose you wish to calculate the
Using TVM Solver
present value of a four-payment ordinary annuity that has
N=4 4N annual payments of $5,000 each. If the interest rate is 5
I% = 5 5 I/YR percent, the present value is $17,729.75. Using a calculator, we
FV = 0 5000 PMT input the known values (i.e., N, I, PMT) and solve for PV. 3
PMT = 5000 PV Referring to the timeline above, you can see that the value you
PV = Solve calculated occurs one period before the first cash flow (i.e.,
today).
TI 83/84 HP10B
Using TVM Solver
Now suppose you wish to calculate the future value. You use
N=4 4N the same inputs, but simply solve for the future value instead of
I% = 5 5 I/YR the present value, resulting in a value of $21,550.63. Referring
PV = 0 5000 PMT to the timeline above, you can see that the value you calculated
PMT = 5000 FV occurs at the same time as the last cash flow, which in this
FV = Solve example is at the end of the fourth year.
3
Be sure that your calculator is set for one payment per period and in the END mode.
Example 2: Valuing an annuity
Problem
Consider a four-payment annuity in which the payment is $2,500 and the interest rate is 6
percent.
1. What is the present value of this annuity?
2. What is the future value of this annuity?
Solution
1. PV = $8,662.76
2. FV = $10,936.54
Note:
FV of ordinary annuity
(1 i)N
PV of ordinary annuity
$10, 936.54
(1 0.06)4
$8, 662.76
ii) Valuing an annuity due
An annuity due is like an ordinary annuity, yet the first cash flow occurs immediately, instead of one
period from today. This means that each cash flow is discounted one period less than each cash flow
in a similar payment ordinary annuity.
N
FV=CF(1 + i)1 CF(1 + i)2 ... CF(1 + i)N+1 = CF

(1+i)t+1

t=0
N N
CF 1
PV = (1+i)
t 1
t-1
CF (1 i)
t 1
t-1
Consider the example of a three-payment annuity due in which the payments are $1,000 each and
the interest rate is 5 percent. The future value of this annuity due is $3,310.125:
Today 1 2 3
| | | |
$1,000 $1,000 $1,000
ª $1,157.625
ª 1,102.500
ª 1,050.000
FV= $3,310.125
The present value of this three-payment annuity due is:
Today 1 2 3
| | | |
$1,000.000 $1,000 $1,000
$952.381 ©
907.029 ©
PV = $2,859.410
Comparing the values of the ordinary annuity with those of the annuity due, you’ll see that the values
differ by a factor of (1+i):
Value of Value of value of annuity due
ordinary annuity
value of ordinary annuity
annuity due
Present value $2,723.248 $2,859.410 1.05

Future value $3,152.500 $3,310.125 1.05
This factor represents the difference in the timing of the cash flows: the cash flows of the annuity
due occur one period prior to the cash flows for a similar-payment ordinary annuity.
Using a financial calculator to value an annuity due requires changing the mode from END to BEG or
BEGIN. Once in the BEG or BEGIN mode, you can input the values as you did with the ordinary
annuity. 4
Consider a five-payment annuity due with an annual payment of $3,000 and an interest rate of 6
percent. The present value of this annuity due is $13,395.317.
TI 83/84 HP10B The future value of this TI 83/84 HP10B

Using TVM Solver Using TVM Solver
annuity due is
Set BEGIN Set BEG Set BEGIN Set BEG
$17,925.956.
N=5 5N N=5 5N
I% = 6 6 I/YR I% = 6 6 I/YR
FV = 0 3000 PMT PV = 0 3000 PMT
PMT = 3000 PV PMT = 3000 FV
PV = Solve FV = Solve
Congrats! You’ve just won the lottery!

Suppose you have just won a $1 million lottery. When you win the lottery, you generally receive payments of
the lottery jackpot over twenty years, with the first payment immediately. Therefore, your $1 million lottery
winnings consist of twenty annual payments of $50,000 each, beginning when you claim your prize. 5 But wait!
Don’t forget about taxes. The IRS will take 28 percent of each check, so you are left with $36,000 each year.
So what is the $1 million lottery jackpot worth to you today? If you can invest your funds to produce a return of
3 percent, that $1 million jackpot is worth $551,656.77 today:
PVannuity due:
PMT = $36,000
N = 20
I = 3 percent
N 1
N 1
PV =CF
(1 i)t-1
$36, 000
(1 i) t-1
$551, 656.77

t 1 t 1
So, if someone offered you a lump-sum of $500,000 for your lottery winnings, would you take it? No. If
someone offered you $600,000 for your lottery winnings, would you take it? Yes.
4
Caution: A common mistake is to leave the calculator in the annuity due mode when calculating other, non-due
problems.
5
Therefore, this is an annuity due pattern of cash flows. It would be lousy public relations for a lottery
commission to say, “Congratulations, you’ll get your first check in one year.”, so most lotteries begin payments
immediately.
iii) Valuing a deferred annuity
A deferred annuity is an annuity in which the first cash flow occurs beyond the end of the first
period. The key to solving for the present value is to break down the analysis into manageable steps.
For example, if you are solving for a present value of a deferred annuity, the two steps are:
Step 1: Solve for present value of ordinary annuity

Step 2: Discount this present value to today
Consider a deferred annuity that consists of three payments of $1,000 and an interest rate of 5
percent. If the annuity is deferred three periods, the first cash flow occurs at the end of the third
period, the second cash flow occurs at the end of the fourth period, and so on. A simple way of
solving this problem is to first calculate the present value at the end of the second period, treating
this as an ordinary annuity, and then discounting this present value (PV2) two periods to the today
(PV0), producing a present value of the deferred annuity of $2,470.066:
Step 1: Calculate the present of a three-payment ordinary annuity
Today 1 2 3 4 5
| | | | | |
$1,000 $1,000 $1,000
$952.381 ©
907.029 ©
863.838 ©
PV2 = $2,723.248
TI 83/84 HP10B
Using TVM Solver
N=3 3N
I% = 5 5 I/YR
FV = 0 1000 PMT
PMT =1000 PV
PV = Solve
Step 2: Calculate the present value of a lump sum amount
Today 1 2 3 4 5
| | | | | |
$1,000 $1,000 $1,000
$952.381 ©
907.029 ©
863.838 ©
PV2 = $2,723.248
PV0 = $2,470.066 ©
TI 83/84 HP10B
Using TVM Solver
N=2 2N
I% = 5 5 I/YR
FV = 2723.248 2723.248 FV
PMT = 0 PV
PV = Solve
There is no built-in function for deferred annuities on your financial calculator, so when faced with a
deferred annuity you need to break it down into steps and execute each step using your calculator’s
functions.
There are many types of deferred annuities that you may encounter in financial management.
Solving these depends on what information is given. Like all time value of money problems, there is
one unknown element that we want to solve for. In an deferred annuity, this unknown may be the
amount of savings that lead up to withdrawals, the amount of withdrawals given a savings program,
the number of savings deposits to make to satisfy planned withdrawals, and the number of
withdrawals possible given a savings program. No matter the problem, it can usually be broken into
two or three manageable pieces.
Example 3: Present value of a deferred annuity

Problem
Suppose that you wish to have a balance in your savings account when you retire at 65 years of age such that
you can make withdrawals of $10,000 each year for 20 years, starting with your 66th birthday. How much must
you deposit on your 35th birthday in an account paying 5 percent interest, compounded annually, so that you
can meet your goal?
Solution
Step 1: Solve for the present value of the withdrawals.
Given information: CF = $10,000; i = 5%; N = 20
PV = $10,000 (PV ann. factor, i = 5%, N = 20)
PV = $10,000 (12.4622) = $124,622
This is the balance required at the time of your 65th birthday (that is, at the end of 30 periods). Why
65th and not 66th? Because we used an ordinary annuity approach to solving this, which means that
the PV of the series occurs one period prior to the first cash flow -- in other words, by using the
ordinary annuity "short-cut" the PV is on your 65th birthday, not on your 66th birthday.
Note: from 35 to 36 is one period, 35 to 37 is two periods, ... , 35 to 65 is 30 periods).
Step 2: Solve for the present value of your 65th birthday balance
Given: FV = $124,622; N = 30; i = 5%
PV = $124,622/(1 + 0.05)30
PV = $124,622 (0.23138) = $28,834.72
Check it out:
PV = $28,834.72 (1 + 0.05)30 = $28,834.72 (4.32194)= $124,622
Example 4: Solving for the amount of the deferred annuity
Problem
Suppose you deposit $1,000 in an account at the end of each year, starting next year, for thirty years (thirty
deposits). Your goal is to live off of the savings for twenty years, starting the year after your last deposit.
If you can earn 6 percent on your deposits and your withdrawals in retirement are an even, annual amount,
what is the amount you can withdraw once you retire?
Solution
Step 1: Determine the future value of the deposits
Given:
PMT = $1,000
N = 30
I = 6%
0 1 2 3 4 … 30 31 32 … 50
-|----|----|----|----|--… --|----|----|-- … --|--
D D D D D W W W
×
FV30 of deposits: $79,058.129
Step 2: Determine the withdrawal
Given:
PV of withdrawals = $79,058.129
N = 20
I = 6%
0 1 2 3 4 … 30 31 32 … 50
-|----|----|----|----|--… --|----|----|-- … --|--
D D D D D W W W
×
PV30 of withdrawals
Solve for PMT
PMT = $6,892.65
D. Loan amortization
Earlier, you learned how to value an annuity. If an amount is loaned and then repaid in installments,
we say that the loan is amortized. Therefore, loan amortization is the process of calculating the
loan payments that amortize the loaned amount. We can determine the amount of the loan
payments once we know the frequency of payments, the interest rate, and the number of payments.
Consider a loan of $100,000. If the loan is repaid in twenty-four installments and if the interest rate
is 5 percent per year, we calculate the amount of the payments by applying the relationship:
PV = CF (present value annuity factor for N=24 and i=0.05/12=0.0042)
We are given the following:
PV = $100,000
I = 5%/12 = 0.4167%
N = 24
And we want to solve for the payment. The payment, PMT, is $4,378.19.
Therefore, the monthly payments are $4,378.19 each. In other words, if payments of $4,378.19 are
made each month for twenty-four months, the $100,000 loan will be repaid and the lender earns a
return that is equivalent to a 5 percent APR on this loan.
Using a financial calculator,
TI 83/84 HP10B
Using TVM Solver
N = 24 2N
I% = .05/12 .05/12 I/YR
PV = -100000 -100000 PV
PMT = Solve PMT
We can also use a spreadsheet to perform this calculation. In Microsoft's Excel, we can solve for the
monthly payment using the PMT function:
=PMT(rate, number of payments, amount of loan, future value, timing indicator)
where the timing indicator is 1 for beginning of the period flows (i.e., annuity due) and 0 for end of
period flows (i.e., ordinary annuity).
=PMT(.05/12,24,-100000,0,0)
We can calculate the amount of interest and principle repayment associated with each loan payment
using a loan amortization chart, as shown in Exhibit 1.
The principle amount of the
Exhibit 1: Loan amortization on a $100,000 loan for loan declines as payments are
twenty-four months and an interest rate of 5 made. The proportion of each
percent per year loan payment devoted to the
repayment of the principle
Interest on the Principal paid increases throughout the loan
loan off period from $3,970.47 for the
= 0.05/12 x = loan first payment to $4,368.94 for
Loan (remaining repayment - Remaining the last payment. The decline
Payment payment principle) interest principle in the loan's principle is
Today $0.00 $0.00 $0.00 $ 100,000.00 shown graphically in Exhibit 2.
1 $ 4,387.14 $416.67 $ 3,970.47 $ 96,029.53 You’ll notice that the decline
2 $ 4,387.14 $400.12 $ 3,987.02 $ 92,042.51 in the remaining principle is
3 $ 4,387.14 $383.51 $ 4,003.63 $ 88,038.88 not a linear, but is curvilinear
4 $ 4,387.14 $366.83 $ 4,020.31 $ 84,018.57 due to the compounding of
5 $ 4,387.14 $350.08 $ 4,037.06 $ 79,981.51 interest.
6 $ 4,387.14 $333.26 $ 4,053.88 $ 75,927.63 You can download the Excel
7 $ 4,387.14 $316.37 $ 4,070.77 $ 71,856.85 spreadsheet that created this
8 $ 4,387.14 $299.40 $ 4,087.74 $ 67,769.12 table and the corresponding
9 $ 4,387.14 $282.37 $ 4,104.77 $ 63,664.35 graph here.
10 $ 4,387.14 $265.27 $ 4,121.87 $ 59,542.48
11 $ 4,387.14 $248.09 $ 4,139.05 $ 55,403.44
12 $ 4,387.14 $230.85 $ 4,156.29 $ 51,247.14
13 $ 4,387.14 $213.53 $ 4,173.61 $ 47,073.54
14 $ 4,387.14 $196.14 $ 4,191.00 $ 42,882.54
15 $ 4,387.14 $178.68 $ 4,208.46 $ 38,674.07
16 $ 4,387.14 $161.14 $ 4,226.00 $ 34,448.08
17 $ 4,387.14 $143.53 $ 4,243.61 $ 30,204.47
18 $ 4,387.14 $125.85 $ 4,261.29 $ 25,943.18
19 $ 4,387.14 $108.10 $ 4,279.04 $ 21,664.14
20 $ 4,387.14 $ 90.27 $ 4,296.87 $ 17,367.27
21 $ 4,387.14 $ 72.36 $ 4,314.78 $ 13,052.50
22 $ 4,387.14 $ 54.39 $ 4,332.75 $ 8,719.74
23 $ 4,387.14 $ 36.33 $ 4,350.81 $ 4,368.94
24 $ 4,387.14 $ 18.20 $ 4,368.94 $ 0.00
Exhibit 2: Loan amortization
Loan principle for a $100,000 loan with interest of 5% per year over the
life of the loan
$100,000
$96,030
$92,043
$88,039
$84,019
$79,982
$75,928
$71,857
$100,000
$67,769
$63,664
$59,542
$55,403
$51,247
$80,000
$47,074
$42,883
$38,674
Loan principle
$34,448
$60,000
$30,204
remaining
$25,943
$21,664
$17,367
$13,052
$40,000
$8,720
$4,369
$20,000
$0
$0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Month
2. Determining the unknown interest rate

Let's say that you have $1,000 to invest today and in five years you would like the investment to be
worth $2,000. What interest rate would satisfy your investment objective? We know the present
value (PV = $1,000), the future value (FV = $2,000) and the number of compounding periods (n=5).
Using the basic valuation equation:
FV = PV (1 + i)n ,
and substituting the known values of FV, PV, and n,
$2,000 = $1,000 (1 + i)5
Rearranging, we see that the ratio of the future value to the present value is equal to the compound
factor for five periods at some unknown rate:
$2,000 / $1,000 = (1 + i)5 or 2.000 = (1 + i)5,
where 2.000 is the compound factor.
We therefore have one equation with one unknown, i. We can determine the unknown interest rate
either mathematically or by using the table of compound factors. Using the table of factors, we see
that for five compounding periods, the interest rate that produces a compound factor closest to
2.0000 is 15 percent per year.
We can determine the interest rate more precisely, however, by solving for i mathematically:
2 = (1 + i)5.
Taking the fifth root of both sides, and representing this operation is several equivalent ways,
1+ i = 21/5 = 200.20
You'll need a calculator to figure out the fifth root:
20.20 = 1.1487 = (1 + i)
i = 1.1487 - 1 = 0.1487 or 14.87 percent.
Therefore, if you invested $1,000 in an investment that pays 14.87 percent compounded interest per
year, for five years, you would have $2,000 at the end of the fifth year. We can formalize an
equation for finding the interest rate when we know PV, FV, and n from the valuation equation and
notation: FV = PV (1 + i)n ,
Using Algebra,
i= FV
1
PV
As an example, suppose that the value of an investment today is $100 and the expected value of the
investment in five years is expected to be $150. What is the annual rate of appreciation in value of
this investment over the five year period?
We can use the math or financial programs in a calculator to solve for i, which is 8.447 percent.
TI 83/84 HP10B Or, we can use a spreadsheet. Using the Excel function RATE,
Using TVM Solver
N=5 100 +/- PV =RATE(number of periods, periodic payment, PV, FV, 0,-.10)
I% = Solve 5N
PV = -100 150 FV =RATE(5,0,-100,150,0,.10)
PMT = 0 i/YR
FV = 150
Example 5: Calculating the interest rate
Problem
Suppose you borrow $1,000, with terms that you will repay
in a lump-sum of $1,750 at the end of three years. What is
the effective interest rate on this loan?
Solution
PV = $1,000
FV = $1,750
n=3
i = ($1,750/$1,000)1/3 – 1 = 20.51%
A. Application: Determining growth rates

There are many applications in which we need to determine the rate of change in values over a
period of time. If values are increasing over time, we refer to the rate of change as the growth rate.
To make comparisons easier, we usually specify the growth rate as a rate per year. We can use the
information about the starting value (the PV), the ending value (the FV), and the number of periods
to determine the rate of growth of values over this time period. To make comparisons among
investments, we typically need to determine the average annual growth rate.
For example, consider an investment that has a value of $100 in year 0, a value of $150 at the end
of the first year and a value of $200 at the end of two periods. What is this investment's annual
growth rate?
PV = $100
FV = $200
n=2
i = ($200/$100)1/2 - 1 = 20.5 - 1 = 1.4142 - 1 = 41.42%
Checking our work,
$100 (1 + 0.4142)(1 + 0.4142) = $200
Therefore, $100 grows to $200 at the rate of 41.42% per year.
This rate is the geometric average of the annual growth rates. To see this, consider the two annual
growth rates for this example. The growth rate in the first year is ($150-100)/$100, or 50 percent.
the growth rate for the second year is ($200-150)/$150 = 33.3333 percent. The geometric
average is calculated as:
geometric average rate = [(1 + i1)(1 + i2) ... (1 + in)]1/n - 1
which for this example is:
geometric average rate over the two years = [(1 + 0.50)(1 + 0.3333)]1/2 - 1 = 41.42%
This is different from the arithmetic average rate of (0.50+0.3333)/2 = 41.67 percent. The arithmetic
average is not appropriate because it does not consider the effects of compounding.
Example 6: Determining growth rates Example 7: Beanie Babies

Consider the growth rate of dividends for Bell Atlantic. Bell Problem
Atlantic paid dividends of $2.36 per share in 1990 and
$2.76 in 1994. We have dividends for two different points Susie Sweetie bought Iggy the Iguana two
in time: 1990 and 1994. With 1990 dividends as the years ago for $5. Today, Iggy is worth $7.
present value, 1994 dividends as the future value, and What is the average annual return that
n=4: Susie has earned on her Iggy investment?
($2.76/$2.36)1/4= - 1 = 3.99% Solution
Therefore, Bell Atlantic's dividends grew at a rate of almost
PV = $5
4% per year over this four year period.
FV = $7
Looking at an earlier period, in 1986 Bell Atlantic paid n=2
$2.04 in dividends. The rate of growth over the period
1986-1990 is: i = (7 / 5)1/2 - 1
i = 18.32%
growth rate = ($2.36/$2.04)1/4 = - 1 = 3.71%
The growth rate from 1986 through 1994 falls between
3.71% and 3.99%:
growth rate = ($2.76/$2.04)1/8= - 1 = 3.85%
B. Application: Determining the effective rate on loans

We can calculate the effective annual rate for an installment loan in much the same manner that we
can calculate the EAR for a savings account. Consider a loan of $10,000 that is paid back in twenty-
four monthly installments of $470.74 each, with the first installment due at the end of the first
month. Calculating the EAR corresponding to this loan requires us to first calculate the monthly rate
and then translate this rate into the EAR.
We are given the following information:
PV = $10,000
CF = $470.74
N = 24
Using the ordinary annuity relation,
PV = CF (present value annuity factor, N=24, i = ?)
and substituting the known values,
$10,000 = $470.74 (present value annuity factor, N=24, i = ?)
we find that the present value annuity factor is 21.2431. Using a financial calculator, we find that the
monthly rate, i, is 1 percent. Therefore, the effective annual rate on this loan is:
EAR = (1 + 0.01)12 - 1 = 12.68%
TI 83/84 HP10B
Using TVM Solver
Example 8: Effective rate on a loan
N = 24 10000 +/- PV
PV = -10000 24 N Problem
PMT = 470.74 470.74 PMT Suppose you receive a loan of $10,000 that requires you to repay
FV = 0 i/YR the loan in 60 monthly installments of $200 each. What is the
effective annual rate of interest on this loan?
I% = Solve
Solution
PV = $10,000
The key to solving for the effective CF = $200
annual rate is to find the rate per N = 60
compounding period. If the
$10,000 = $200 (PV annuity factor for N=60 and i=?)
compounding period is less than one $10,000 / $200= 50 = (PV annuity factor for N=60 and i=?)
year, we can then use the relation
above, inserting the rate per Using a calculator or spreadsheet function, i = 0.61834%
compounding period and the number EAR = (1 + 0.0061834)12 - 1 = 7.6778%
of compounding periods in a year to
determine the effective annual rate.
3. Determining the number of compounding periods

Let's say that you place $1,000 in a savings account that pays 10 percent compounded interest per
year. How long would it take for that savings account balance to reach $5,000? In this case, we know
the present value (PV=$1,000), the future value (FV=$5,000), and the interest rate (i=10% per
year). What we need to determine is the number of compounding periods.
Let's start with the basic valuation equation and insert the known values of PV, FV, and i:
FV = PV (1 + i)n
$5,000 = $1,000 (1 + 0.10)n
Rearranging,
(1 + 0.10)n = 5.000
Therefore, the compound factor is 5.0000.
Like the determination of the unknown interest rate, we can determine the number of periods either
mathematically or by using the table of compound factors. If we use the table of compound factors,
we look down the column for the 10 percent interest rate to find the factor closest to 5.000 Then we
look across the row containing this factor to find n. From the table of factors, we see that the n that
corresponds to a factor of 5.000 for a 10 percent interest rate is between 16 and 17, though closer to
17. Therefore, we approximate the number of periods as 17.
Solving the equation mathematically is a bit more complex. We know that:
5 = (1 + 0.10)n
We must somehow rearrange this equation so that the unknown value, n, is on one side of the
equation and all the known values are on the other. To do this, we must use logarithms and a bit of
algebra. Taking the natural log of both sides:
ln 5 = n ln(1 + 0.10)
or
ln 5 = n ln 1.10,
where "ln" indicates the natural log. Substitute the values of the natural logs of 5 and 1.10,
1.6094 = n (0.0953) .
Rearranging and solving for n,
n = 16.8877 which means 17 whole compound periods.
Since the last interest payment is at the end of the last year, the number of periods years is 17 -- it
would take 17 years for your $1,000 investment to grow to $5,000 if interest is compounded at 10
percent per year.
As you can see, given the present and future values, calculating the number of periods when we
know the interest rate is a bit more complex than calculating the interest rate when we know the
number of periods. Nevertheless, we can develop an equation for determining the number of periods,
beginning with the valuation formula:
FV = PV (1 + i)n,
Using algebra and principles of logarithms,
ln FV - ln PV
n=
ln (1+i)
Suppose that the present value of an investment is $100 and you wish to determine how long it will
take for the investment to double in value if the investment earns 6 percent per year, compounded
annually:
ln 200 - ln 100
n= 11.8885 12 years
ln (1+0.06)
You'll notice that we round off to the next whole period. To see why, consider this last example. After
11.8885 years, we have doubled our money if interest were paid 88.85 percent the way through the
twelfth year. But, we stated earlier that interest is paid at the end of each period -- not part of the
way through. At the end of the eleventh year, our investment is worth $189.93, and at the end of the
twelfth year, our investment is worth $201.22. So, our investment's value doubles by the twelfth
period -- with a little extra, $1.22.
The tables of factors can be used to approximate the number of periods. The approach is similar to
the way we approximated the interest rate. The compounding factor in this example is 2.0000. and
the discounting factor is 0.5000 (that is, FV/PV= 2.0000 and PV/FV = 0.5000). Using the table of
compound factors, following down the column corresponding to the interest rate of 6 percent, the
compound factor closest to 2.0000 is for 12 periods. Likewise, using the table of discount factors,
following down the column corresponding to the interest rate of 6 percent, the discount factor closest
to 0.5000 is for 12 periods. We can use the table of annuity factors in a like manner to solve for the
number of payments in the case of an annuity.
TI 83/84 HP10B We could also perform this calculation using a spreadsheet.

Using TVM Solver Using Excel's NPER function
PV = -100 100 +/- PV
PMT = 0 200 FV =NPER(i,pmt,pv,fv,type)
FV = 200 6 i/YR =NPER(.06,0,-100,200,0)
I% = 6% N
N = Solve
Example 9: Determining the number of periods
Problem
How long does it take to double your money if the interest rate is 5% per year, compounded annually?
Solution
PV = $1
FV = $2
i = 5%
n = (ln 2 - ln 1)/ln 1.05 = (0.6931 - 0)/0.0488 = 14.2029 Ö 15 years
Problem
How long does it take to triple your money if the interest rate is 5% per year, compounded annually?
Solution
PV = $1
FV = $3
i = 5%
n = (ln3 - ln1)/1.05 = (1.0986 - 0) / 0.0488 = 22.5123 years Ö 23 years
Problem
How long does it take to double your money if the interest rate is 12% per year, compounded quarterly?
Solution
PV = $1
FV = $2
i = 12%/4 = 3%
n = (0.6931-0) / 0.0296 = 23.4155 quarters Ö 24 quarters = 6 years
4. Valuing a perpetual stream of cash flows

Some cash flows are expected to continue forever. For example, a corporation may promise to pay
dividends on preferred stock forever. Or, a company may issue a bond that pays interest every six
months, forever. How do you value these cash flow streams? When we calculated the present value
of an annuity, we took the amount of one cash flow and multiplied it by the sum of the discount
factors that corresponded to the interest rate and number of payments. But what if the number of
payments extends forever -- into infinity?
A series of cash flows that occur at regular intervals, forever, is a perpetuity. Valuing a perpetual
cash flow stream is just like valuing an ordinary annuity. It looks like this:

CF 1
PV = (1+i)
t 1
t
CF (1+i)
t 1
t
As the number of discounting periods approaches infinity, the summation approaches 1/i. To see
why, consider the present value annuity factor for an interest rate of 10 percent, as the number of
payments goes from 1 to 200:
Number of Present value
payments in the annuity discount
annuity factor
1 0.0909
10 6.1446
50 9.9148
100 9.9993
1000 10.000
As the number of payments increases, the factor approaches 10, or 1/0.10. Therefore, the present
value of a perpetual annuity is very close to 1/i.
Suppose you are considering an investment that promises to pay $100 each period forever, and the
interest rate you can earn on alternative investments of similar risk is 5 percent per period. What are
you willing to pay today for this investment?
PV = $100 / 0.05 = $2,000.
Therefore, you would be willing to pay $2,000 today for this investment to receive, in return, the
promise of $100 each period forever.
Let's look at the value of a perpetuity from a different angle. Suppose that you are given the
opportunity to purchase an investment for $5,000 that promises to pay $50 at the end of every
period forever. What is the periodic interest per period -- the return -- associated with this
investment?
We know that the present value is PV = $5,000 and the periodic, perpetual payment is CF = $50.
Inserting these values into the formula for the present value of a perpetuity:
PV = $5,000 = $50/i.
Solving for i,
i = $50/$5,000 = 0.01 or 1% per period.
Therefore, an investment of $5,000 that generates $50 per period provides 1 percent compounded
interest per period.
Calculating interest rates
OUTLINE
1. Introduction
2. Annual percentage rate
1. Introduction
The basis of the time value of money is that an investor is compensated for the time value of money
and risk. Situations arise often in which we wish to determine the interest rate that is implied from
an advertised, or stated rate. There are also cases in which we wish to determine the rate of interest
implied from a set of payments in a loan arrangement.
2. The annual percentage rate

A common problem in finance is comparing alternative financing or investment opportunities when
the interest rates are specified in a way that makes it difficult to compare terms. One lending source
may offer terms that specify 91/4 percent annual interest with interest compounded annually,
whereas another lending source may offer terms of 9 percent interest with interest compounded
continuously. How do you begin to compare these rates to determine which is a lower cost of
borrowing? Ideally, we would like to translate these interest rates into some comparable form.
One obvious way to represent rates stated in various time intervals on a common basis is to express
them in the same unit of time -- so we annualize them. The annualized rate is the product of the
stated rate of interest per compounding period and the number of compounding periods in a year.
Let i be the rate of interest per period and let n be the number of compounding periods in a year.
The annualized rate, also referred to as the nominal interest rate or the annual percentage
rate (APR), is
APR = i x n
where i is the rate per compounding period and n is the number of compound periods in a year.
The Truth in Lending Act requires lenders to disclose the annual percentage rate on consumer loans. 1
As you will see, however, the annual percentage rate ignores compounding and therefore
1
15 U.S.C. §§1601-1666j; Federal Reserve System Regulation Z, 1968.

understates the true cost of borrowing. Also, as pointed out in the Report to Congress by the Board
of Governors of the Federal Reserve System, Finance Charges for Consumer Credit under the Truth in
Lending Act, the APR does not consider some other costs associated with lending transactions.
The Truth in Savings Act (Federal Reserve System Regulation DD, 1991) requires institutions to
provide the annual percentage yield (APY) for savings accounts, which is a rate that considers
the effects of compound interest. As a result of this law, consumers can compare the yields on
different savings arrangements. But this law does not apply beyond savings accounts.
To see how the APR works, let's consider the Lucky Break Loan Company. Lucky's loan terms are
simple: pay back the amount borrowed, plus 50 percent, in six months. Suppose you borrow $10,000
from Lucky. After six months, you must pay back the $10,000, plus $5,000. The annual percentage
rate on financing with Lucky is the interest rate per period (50 percent for six months) multiplied by
the number of compound periods in a year (two six-month periods in a year). For the Lucky Break
financing arrangement,
APR = 0.50 x 2 = 1.00 or 100 percent per year
But what if you cannot pay Lucky back after six months? Lucky will let you off this time, but you must
pay back the following at the end of the next six months:
the $10,000 borrowed,
the $5,000 interest from the first six months, and
50 percent interest on both the unpaid $10,000 and the unpaid $5,000 interest ($15,000 x
.50 = $7,500).
So, at the end of the year, knowing what is good for you, you pay off Lucky:
Amount of original loan $10,000
Interest from first six months 5,000
Interest on second six months 7,500
Total payment at end of year $22,500
It is unreasonable to assume that, after six months, Lucky would let you forget about paying interest
on the $5,000 interest from the first six months. If Lucky would forget about the interest on interest,
you would pay $20,000 at the end of the year -- $10,000 repayment of principal and $10,000 interest
-- which is a 100 percent interest rate.
Using the Lucky Break method of financing, you have to pay $12,500 interest to borrow $10,000 for
one year's time -- or else. Because you have to pay $12,500 interest to borrow $10,000 over one
year's time, you pay not 100 percent interest, but rather 125 percent interest per year:
Annual interest rate on a Lucky Break loan = $12,500 / $10,000 = 125 percent
What's going on here? It looks like the APR in the Lucky Break example ignores the compounding
(interest on interest) that takes place after the first six months.
And that's the way it is with all APR's: the APR ignores the effect of compounding. And therefore this
rate understates the true annual rate of interest if interest is compounded at any time prior to the
end of the year. Nevertheless, APR is an acceptable method of disclosing interest on many lending
arrangements since it is easy to understand and simple to compute. However, because it ignores
compounding, it is not the best way to convert interest rates to a common basis.

Another way of converting stated interest rates to a common basis is the effective rate of interest.
The effective annual rate (EAR) is the true economic return for a given time period -- it takes into
account the compounding of interest -- and is also referred to as the effective rate of interest.
Using our Lucky Break example, we see that we must pay $12,500 interest on the loan of $10,000
for one year. Effectively, we are paying 125 percent annual interest. Thus, 125 percent is the
effective annual rate of interest.
In this example, we can easily work through the calculation of interest and interest on interest. But
for situations where interest is compounded more frequently we need a direct way to calculate the
effective annual rate. We can calculate it by resorting once again to our basic valuation equation:
FV = PV (1 + i)n
Next, we consider that a return is the change in the value of an investment over a period and an
annual return is the change in value over a year.
Suppose you invest $100 today in an investment that pays 6 percent annual interest, but interest is
compounded every four months. This means that 2 percent is paid every four months. After four
months, you have $100 (1.2) = $102, after eight months you have $102 (1.02) = $104.04, and after
one year you have $104.04 (1.02) = 106.1208, or, $100 (1.02)3 = $106.1208
The effective annual rate of interest (EAR) is $6.1208 paid on $100, or 6.1208 percent. We can
arrive at that interest by rearranging the basic valuation formula based on a one year period:
$106.1208 = $100 (1 + 0.02)3
$106.1208/$100 = (1 + 0.02)3
1.061208 = (1 + 0.02)3
EAR = (1 + 0.02)3 – 1 = 0.061208 or 6.1208 percent
In more general terms, the effective interest rate, EAR, is:
EAR = (1 + i)n 1
The effective rate of interest (a.k.a. effective annual rate or EAR) is therefore an annual rate that
takes into consideration any compounding that occurs during the year.
Let's look how the EAR is affected by the compounding. Suppose that the Safe Savings and Loan
promises to pay 6 percent interest on accounts, compounded annually. Because interest is paid once,
at the end of the year, the effective annual return, EAR, is 6 percent. If the 6 percent interest is paid
on a semi-annual basis -- 3 percent every six months -- the effective annual return is larger than 6
percent because interest is earned on the 3 percent interest earned at the end of the first six months.
In this case, to calculate the EAR, the interest rate per compounding period -- six months -- is 0.03
(that is, 0.06 / 2) and the number of compounding periods in an annual period is 2:
EAR = (1 + i)n - 1
EAR = (1 + 0.03)2 - 1 = 1.0609 - 1 = 0.0609 or 6.09%.
Extending this example to the case of quarterly compounding with a nominal interest rate of 6
percent we first calculate the interest rate per period, r, and the number of compounding periods in a
year, n:
i = 0.06 / 4 = 0.015 per quarter, and
n = 12 months / 3 months = 4 quarters in a year.
The EAR is:

EAR = (1 + 0.015)4 - 1 = 1.0614 - 1 = 0.0614 or 6.14%
Suppose there are two banks: Bank A, paying 12 percent interest compounded semi-annually, and
Bank B: paying 11.9 percent interest compounded monthly. Which bank offers you the best return on
your money? Comparing APR's, Bank A provides the higher return. But what about compound
interest? The EAR's for each account are calculated as:
Bank A:
EAR = (1 + 0.12/2)2 - 1 = (1 + 0.06)2 = 1.1236 - 1 = 0.1236 or 12.36%
Bank B:
EAR = (1 + 0.119/12)12 - 1 = (1 + 0.0099)12 - 1 = 1.1257 - 1 = 0.1257 or 12.57%
Bank B offers the better return on your money, even though it advertises a lower APR. If you deposit
$1,000 in Bank A for one year, you will have $1,123.60 at the end of the year. If you deposit $1,000
in Bank B for one year, you will have $1,125.70 at the end of the year, providing the better return on
your savings.
PayDay Loans – The fast and expensive way to borrow

A payday loan is a short-term loan with very high interest rates. In a typical payday loan, if you want to borrow
$100 you write a check for $125. The lender holds on to your check during the loan period. At the end of the
loan period, usually 10-14 days, the lender deposits your check. If you want to extend your loan, you pay the
minimum of $25 cash and then enter into a new contract to pay. If you do not pay off the loan or pay the fee to
roll over the loan, the lender will deposit your check and you risk being charged with writing bad checks.
What is the APR for this payday loan?
APR = 0.25 (365/14) = 651.79%
What is the EAR for this payday loan?
EAR = (1 + 0.25)365/14 -1 = 3,351.86%
The regulations pertaining to payday loans varies among states, but most states allow very generous lending
terms – generous, that is, to the lenders. [For a list of state limits on payday loans, see the Bankrate Monitor.]

A. Continuous compounding
The extreme frequency of compounding is continuous compounding. Continuous compounding is
when interest is compounded at the smallest
possible increment of time. In continuous Example 1: Comparing effective rates
compounding, the rate per period becomes
extremely small: Problem
Which of the following terms represent the lowest cost of
i = nominal interest rate / credit on an effective annual interest rate basis?
And the number of compounding periods in a 1. 10% APR, interest compounded semi-annually.
year, n, is infinite. As the rate of interest, i, 2. 9.75% APR, interest compounded continuously.
gets smaller and the number of compounding 3. 10.5% APR, interest compounded annually.
periods approaches infinity, the EAR is: 4. 9.8% APR, interest compounded quarterly.
APR
EAR = (1 + /n)n - 1 Solution
where APR is the annual percentage rate. d

What does all this mean? It means that the 1. EAR = (1 + 0.05)2 - 1 = 10.25%
interest rate per period approaches 0 and the 2. EAR = e0.0975 - 1 = 10.241%
number of compounding periods approaches 3. EAR = 10.5%
infinity -- at the same time! For a given 4. EAR = (1 + 0.0245)4 - 1 = 10.166%
nominal interest rate under continuous
compounding, it can be shown that: Exhibit 1: Effective Annual Rates of
EAR = eAPR - 1 Interest Equivalent to an Annual
Percentage Rate of 6 percent
For the stated 6 percent annual interest rate Frequency of
compounded continuously, the EAR is: compounding per
year Calculation EAR
EAR = e0.06 - 1 = 1.0618 - 1 EAR = 0.0618 or
6.18 percent . Annual (1 + 0.060)1 - 1 6.00%
Semi-annual (1 + 0.030)2 - 1 6.09
The relation between the frequency of Quarterly (1 + 0.015)4 - 1 6.14
0.06
compounding, for a given stated rate, and the Continuous e -1 6.18
effective annual rate of interest for this example
indicates that the greater the frequency of
compounding, the greater the EAR.
B. Calculator and spreadsheet applications

Financial calculators typically have a built-in program to help you go from APRs to EARs and vice
versa. For example, using the financial calculator, we can TI 83/84 HP10B
calculate the EAR that corresponds to a 10 percent APR with Using TVM Solver
2
quarterly compounding: The result is an EAR of 10.3813 EFF(10,4) 10 NOM%
percent. ENTER 4 P/Y
EFF%
2
Because these calculations require changing the payments per period settings (i.e., P/YR) in some
calculator models, be sure to change these back to one payment per period following the calculations
-- otherwise all subsequent financial calculations may be incorrect.

In a similar manner, we can calculate the nominal (i.e., APR) rate that corresponds to a given EAR.
TI 83/84 HP10B Suppose we want to find the nominal rate with quarterly
Using TVM Solver compounding that is equivalent to an effective rate of 10
NOM(10,4) 10 EFF% percent. The equivalent APR is 9.6455 percent. In other
ENTER 4 P/Y words, if a lender charges 9.6455 percent APR, it will earn,
NOM% effectively, 10 percent on the loan.
Continuous compounding calculations cannot be done using the built in finance programs. However,
most calculators -- whether financial or not -- have a program that allows you to perform calculations
using e, the base of natural logarithms. The EAR corresponding to an APR with continuous
compounding is 10.52 percent, which you can calculate as e0.1-1.
TI 83/84 HP10B Spreadsheet functions can also be used to calculate either the
x nominal rate or the effective rate. In Microsoft Excel®, for
e (.1)-1 ENTER .1
example, you can calculate the effective rate that equivalent to
ex – 1 =
an APR of 10 percent with monthly compounding as:
=EFFECT(.10,12),
Similarly, finding the nominal rate with monthly compounding that is equivalent to an EAR of 10
percent,
=NOMINAL(.10,12),

Solutions to
Time value of money
practice problems
1. What is the balance in an account at the end of 10 years if $2,500 is deposited today and
the account earns 4% interest, compounded annually? quarterly?
Annual compounding:
FV = $2,500 (1 + 0.04)10 = $2,500 (1.4802) = $3,700.61
Quarterly compounding:
FV = $2,500 (1 + 0.01)40 = $2,500 (1.4889) = $3,722.16
2. If you deposit $10 in an account that pays 5% interest, compounded annually, how
much will you have at the end of 10 years? 50 years? 100 years?
10 years: FV = $10 (1+0.05)10 = $10 (1.6289) = $16.29
50 years: FV = $10 (1 + 0.05)50 = $10 (11.4674) = $114.67
100 years: FV = $10 (1 + 0.05)100 = $10 (131.50) = $1,315.01
3. How much interest on interest is earned in an account by the end of 5 years if $100,000
is deposited and interest is 4% per year, compounded continuously?
Note: Interest on interest is the difference between the future value calculated using
compounded interest and the future value calculated using simple interest, because
simple interest includes only interest on the principal amount, not the interest-on-
interest.
Continuously compounded:
FV = $100,000 e0.04(5) = $100,000 (1.2214) = $122,140.28
Simple interest:
FV = $100,000 + [$100,000(0.04)(5)] = $100,000 + 20,000 = $120,000
Interest on interest = $122,140.28 = $120,000 = $2,140.28

4. How much will be in an account at the end of five years the amount deposited today is
$10,000 and interest is 8% per year, compounded semi-annually?
FV = $10,000 (1+0.04)10 = $10,000 (1.4802) = $14,802.44
5. Complete the following, solving for the present value, PV:
Future Interest Number of Present

Case
value rate periods value
A $10,000 5% 5 $7,835.26
B $563,000 4% 20 $256,945.85
C $5,000 5.5% 3 $4,258.07
6. Suppose you want to have $0.5 million saved by the time you reach age 30 and suppose
that you are 20 years old today. If you can earn 5% on your funds, how much would you
have to invest today to reach your goal?
Solutions to Time Value of Money Practice Problems 1

Given: FV = $500,000; i = 5%; n = 10
PV = $500,000 (1 / (1 + 0.05)10) = $500,000 (0.6139) = $306,959.63
7. How much would I have to deposit in an account today that pays 12% interest,
compounded quarterly, so that I have a balance of $20,000 in the account at the end of
10 years?
Given: FV = $20,000; i = 12%/4 = 3%; n = 10 x 4 = 40 quarters
PV = $6,131.14
8. Suppose I want to be able to withdraw $5,000 at the end of five years and withdraw
$6,000 at the end of six years, leaving a zero balance in the account after the last
withdrawal. If I can earn 5% on my balances, how much must I deposit today to satisfy
my withdrawals needs?
Given: Hint -- There are two different future values. Treat as two separate present
values, then combine.
FV = $5,000; n = 5, i = 5%
PV = $3,917.63
FV = $6,000; n = 6, i = 5%
PV = $4,477.29
PV of the two future values = $3,917.63 + 4,477.29 = $8,394.92
Or, can use the NPV function in a financial calculator:

In the TI-83/84, the cash flows are {0,0,0,0,5000,5000}
In the HP10B, the cash flows are 0,0,0,0,0,5000,5000
9. Consider a loan of $1 million that is paid off quarterly over a period of nine years.
Calculate the dollar amount of interest and loan principle repaid corresponding to each
payment if the interest rate is 6% per year, compounded quarterly.
Beginning Principal Remaining

Year Quarter balance Payment Interest repayment principal
0 $ 1,000,000.00
1 $ 1,000,000.00 $ 36,152.40 $ 15,000.00 $ 21,152.40 $ 978,847.60
2 $ 978,847.60 $ 36,152.40 $ 14,682.71 $ 21,469.68 $ 957,377.92
3 $ 957,377.92 $ 36,152.40 $ 14,360.67 $ 21,791.73 $ 935,586.20
1 4 $ 935,586.20 $ 36,152.40 $ 14,033.79 $ 22,118.60 $ 913,467.59
5 $ 913,467.59 $ 36,152.40 $ 13,702.01 $ 22,450.38 $ 891,017.21
6 $ 891,017.21 $ 36,152.40 $ 13,365.26 $ 22,787.14 $ 868,230.07
7 $ 868,230.07 $ 36,152.40 $ 13,023.45 $ 23,128.94 $ 845,101.13
2 8 $ 845,101.13 $ 36,152.40 $ 12,676.52 $ 23,475.88 $ 821,625.25
9 $ 821,625.25 $ 36,152.40 $ 12,324.38 $ 23,828.02 $ 797,797.23
10 $ 797,797.23 $ 36,152.40 $ 11,966.96 $ 24,185.44 $ 773,611.80
11 $ 773,611.80 $ 36,152.40 $ 11,604.18 $ 24,548.22 $ 749,063.58
3 12 $ 749,063.58 $ 36,152.40 $ 11,235.95 $ 24,916.44 $ 724,147.14
13 $ 724,147.14 $ 36,152.40 $ 10,862.21 $ 25,290.19 $ 698,856.95
14 $ 698,856.95 $ 36,152.40 $ 10,482.85 $ 25,669.54 $ 673,187.41
15 $ 673,187.41 $ 36,152.40 $ 10,097.81 $ 26,054.58 $ 647,132.82
4 16 $ 647,132.82 $ 36,152.40 $ 9,706.99 $ 26,445.40 $ 620,687.42
17 $ 620,687.42 $ 36,152.40 $ 9,310.31 $ 26,842.08 $ 593,845.34
18 $ 593,845.34 $ 36,152.40 $ 8,907.68 $ 27,244.72 $ 566,600.62

19 $ 566,600.62 $ 36,152.40 $ 8,499.01 $ 27,653.39 $ 538,947.23
5 20 $ 538,947.23 $ 36,152.40 $ 8,084.21 $ 28,068.19 $ 510,879.05
21 $ 510,879.05 $ 36,152.40 $ 7,663.19 $ 28,489.21 $ 482,389.84
22 $ 482,389.84 $ 36,152.40 $ 7,235.85 $ 28,916.55 $ 453,473.29
23 $ 453,473.29 $ 36,152.40 $ 6,802.10 $ 29,350.30 $ 424,122.99
6 24 $ 424,122.99 $ 36,152.40 $ 6,361.84 $ 29,790.55 $ 394,332.44
25 $ 394,332.44 $ 36,152.40 $ 5,914.99 $ 30,237.41 $ 364,095.03
26 $ 364,095.03 $ 36,152.40 $ 5,461.43 $ 30,690.97 $ 333,404.06
27 $ 333,404.06 $ 36,152.40 $ 5,001.06 $ 31,151.33 $ 302,252.73
7 28 $ 302,252.73 $ 36,152.40 $ 4,533.79 $ 31,618.60 $ 270,634.12
29 $ 270,634.12 $ 36,152.40 $ 4,059.51 $ 32,092.88 $ 238,541.24
30 $ 238,541.24 $ 36,152.40 $ 3,578.12 $ 32,574.28 $ 205,966.96
31 $ 205,966.96 $ 36,152.40 $ 3,089.50 $ 33,062.89 $ 172,904.07
8 32 $ 172,904.07 $ 36,152.40 $ 2,593.56 $ 33,558.83 $ 139,345.24
33 $ 139,345.24 $ 36,152.40 $ 2,090.18 $ 34,062.22 $ 105,283.02
34 $ 105,283.02 $ 36,152.40 $ 1,579.25 $ 34,573.15 $ 70,709.87
35 $ 70,709.87 $ 36,152.40 $ 1,060.65 $ 35,091.75 $ 35,618.12
9 36 $ 35,618.12 $ 36,152.40 $ 534.27 $ 35,618.12 $ (0.00)
10. Suppose you deposit $100,000 in an account today that pays 6% interest, compounded
annually. How long does it take before the balance in your account is $500,000?
Given: I = 6%; PV = $100,000; FV = $500,000
Solution: N = 28
11. The Lucky Loan Company will lend you $10,000 today with terms that require you to pay
off the loan in thirty-six monthly installments of $500 each. What is the effective annual
rate of interest that the Lucky Loan Company is charging you?
Given: PV = $10,000; N = 36; PMT = 500
Solve for i: i = 3.6007%
EAR = (1 + 0.036007)12 – 1 = 52.8806%
12. How long does it take for your money to grow to ten times its original value if the
interest rate of 5% per year?
Given: PV = 1; FV = 10; I = 5%
Solution: 48 years
13. Under what conditions does the effective annual rate of interest (EAR) differ from the
annual percentage rate (APR)?
If interest is compounded more frequently than once a year, the EAR will be different
than the APR; the EAR will be greater than the APR except in the case in which there is
annual compounding (in which case the EAR will be equal to the APR)
14. As the frequency of compounding increases within the annual period, what happens to
the relation between the EAR and the APR?
The EAR will become larger than the APR as the frequency of compounding increases.
The largest difference between the two is in the case in which interest is compounded
continuously.
15. If interest is paid at a rate of 5% per year, compounded quarterly, what is the:
a) annual percentage rate?

APR = 5%
b) effective annual rate?
EAR = (1 + 0.0125)4 - 1 = 5.0945%
16. L. Shark is willing to lend you $10,000 for three months. At the end of six months, L.
Shark requires you to repay the $10,000, plus 50%.
a) What is the length of the compounding period?
Six months
b) What is the rate of interest per compounding period?
50%
c) What is the annual percentage rate associated with L. Shark's lending activities?
APR = 50% x 2 = 100%
d) What is the effective annual rate of interest associated with L. Shark's lending
activities?
EAR = (1 + 0.50)2 - 1 = 125%
17. The Consistent Savings and Loan is designing a new account that pays interest quarterly.
They wish to pay, effectively, 16% per year on this account. Consistent desires to
advertise the annual percentage rate on this new account, instead of the effective rate,
since its competitors state their interest on an annualized basis. What is the APR that
corresponds to an effective rate of 16% for this new account?
EAR = 16%
APR = 1.160.25 this takes the fourth root of 1 + EAR
i = 3.78%
APR = 3.78% x 4 = 15.121%
18. Consider an annuity consisting of three cash flows of $2,000 each. Assume a 4% interest
rate. What is the present value of the annuity if the first cash flow occurs:
a) today.
PV of annuity due = $5,772.19
b) one year from today.
PV of ordinary annuity = $5,550.18
c) two years from today.
PV of a deferred annuity = $5,550.18 / 1.04 = $5,336.71
d) three years from today.
e) four years from today.

f) five years from today.
19. Suppose you wish to retire forty years from today. You determine that you need $50,000
per year once you retire, with the first retirement funds withdrawn one year from the day
you retire. You estimate that you will earn 6% per year on your retirement funds and
that you will need funds up to and including your 25th birthday after retirement.
a) How much must you deposit in an account today so that you have enough funds
for retirement?
PVretire = $50,000 (PV annuity factor, N=25 and i=6%)
Given: PMT = $50,000; N = 25; I = 6%; Solve for PV
PVretire = $639.167.81
Given: FV = $639,167.81; N = 40; I = 6%; Solve for PV

PVtoday = $639,167.81 / (1 + 0.06)40 = $62,141.29
b) How much must you deposit each year in an account, starting one year from
today, so that you have enough funds for retirement?
PVretire = $639.167.81
Given: FV = $639,167.81; N = 40; I = 6%; Solve for PMT

PMT = $4,130.01
20. Using an interest rate of 5% per year, what is the value today of the following cash
flows:
Years from today Cash flow
1 £0
2 £0
3 £ 10,000
4 £ 10,000
FV = $8,638.38 + 8,227.02 = $16,865.40
Note: Cash flow list: {0,0,10000,10000}

Solutions to
Time value of money
practice problems
1. What is the balance in an account at the end of 10 years if $2,500 is deposited today and
the account earns 4% interest, compounded annually? quarterly?
Annual compounding:
FV = $2,500 (1 + 0.04)10 = $2,500 (1.4802) = $3,700.61
Quarterly compounding:
FV = $2,500 (1 + 0.01)40 = $2,500 (1.4889) = $3,722.16
2. If you deposit $10 in an account that pays 5% interest, compounded annually, how
much will you have at the end of 10 years? 50 years? 100 years?
10 years: FV = $10 (1+0.05)10 = $10 (1.6289) = $16.29
50 years: FV = $10 (1 + 0.05)50 = $10 (11.4674) = $114.67
100 years: FV = $10 (1 + 0.05)100 = $10 (131.50) = $1,315.01
3. How much interest on interest is earned in an account by the end of 5 years if $100,000
is deposited and interest is 4% per year, compounded continuously?
Note: Interest on interest is the difference between the future value calculated using
compounded interest and the future value calculated using simple interest, because
simple interest includes only interest on the principal amount, not the interest-on-
interest.
Continuously compounded:
FV = $100,000 e0.04(5) = $100,000 (1.2214) = $122,140.28
Simple interest:
FV = $100,000 + [$100,000(0.04)(5)] = $100,000 + 20,000 = $120,000
Interest on interest = $122,140.28 = $120,000 = $2,140.28

4. How much will be in an account at the end of five years the amount deposited today is
$10,000 and interest is 8% per year, compounded semi-annually?
FV = $10,000 (1+0.04)10 = $10,000 (1.4802) = $14,802.44
5. Complete the following, solving for the present value, PV:
Future Interest Number of Present

Case
value rate periods value
A $10,000 5% 5 $7,835.26
B $563,000 4% 20 $256,945.85
C $5,000 5.5% 3 $4,258.07
6. Suppose you want to have $0.5 million saved by the time you reach age 30 and suppose
that you are 20 years old today. If you can earn 5% on your funds, how much would you
have to invest today to reach your goal?

Given: FV = $500,000; i = 5%; n = 10
PV = $500,000 (1 / (1 + 0.05)10) = $500,000 (0.6139) = $306,959.63
7. How much would I have to deposit in an account today that pays 12% interest,
compounded quarterly, so that I have a balance of $20,000 in the account at the end of
10 years?
Given: FV = $20,000; i = 12%/4 = 3%; n = 10 x 4 = 40 quarters
PV = $6,131.14
8. Suppose I want to be able to withdraw $5,000 at the end of five years and withdraw
$6,000 at the end of six years, leaving a zero balance in the account after the last
withdrawal. If I can earn 5% on my balances, how much must I deposit today to satisfy
my withdrawals needs?
Given: Hint -- There are two different future values. Treat as two separate present
values, then combine.
FV = $5,000; n = 5, i = 5%
PV = $3,917.63
FV = $6,000; n = 6, i = 5%
PV = $4,477.29
PV of the two future values = $3,917.63 + 4,477.29 = $8,394.92
Or, can use the NPV function in a financial calculator:

In the TI-83/84, the cash flows are {0,0,0,0,5000,5000}
In the HP10B, the cash flows are 0,0,0,0,0,5000,5000
9. Consider a loan of $1 million that is paid off quarterly over a period of nine years.
Calculate the dollar amount of interest and loan principle repaid corresponding to each
payment if the interest rate is 6% per year, compounded quarterly.
Beginning Principal Remaining

Year Quarter balance Payment Interest repayment principal
0 $ 1,000,000.00
1 $ 1,000,000.00 $ 36,152.40 $ 15,000.00 $ 21,152.40 $ 978,847.60
2 $ 978,847.60 $ 36,152.40 $ 14,682.71 $ 21,469.68 $ 957,377.92
3 $ 957,377.92 $ 36,152.40 $ 14,360.67 $ 21,791.73 $ 935,586.20
1 4 $ 935,586.20 $ 36,152.40 $ 14,033.79 $ 22,118.60 $ 913,467.59
5 $ 913,467.59 $ 36,152.40 $ 13,702.01 $ 22,450.38 $ 891,017.21
6 $ 891,017.21 $ 36,152.40 $ 13,365.26 $ 22,787.14 $ 868,230.07
7 $ 868,230.07 $ 36,152.40 $ 13,023.45 $ 23,128.94 $ 845,101.13
2 8 $ 845,101.13 $ 36,152.40 $ 12,676.52 $ 23,475.88 $ 821,625.25
9 $ 821,625.25 $ 36,152.40 $ 12,324.38 $ 23,828.02 $ 797,797.23
10 $ 797,797.23 $ 36,152.40 $ 11,966.96 $ 24,185.44 $ 773,611.80
11 $ 773,611.80 $ 36,152.40 $ 11,604.18 $ 24,548.22 $ 749,063.58
3 12 $ 749,063.58 $ 36,152.40 $ 11,235.95 $ 24,916.44 $ 724,147.14
13 $ 724,147.14 $ 36,152.40 $ 10,862.21 $ 25,290.19 $ 698,856.95
14 $ 698,856.95 $ 36,152.40 $ 10,482.85 $ 25,669.54 $ 673,187.41
15 $ 673,187.41 $ 36,152.40 $ 10,097.81 $ 26,054.58 $ 647,132.82
4 16 $ 647,132.82 $ 36,152.40 $ 9,706.99 $ 26,445.40 $ 620,687.42
17 $ 620,687.42 $ 36,152.40 $ 9,310.31 $ 26,842.08 $ 593,845.34
18 $ 593,845.34 $ 36,152.40 $ 8,907.68 $ 27,244.72 $ 566,600.62

19 $ 566,600.62 $ 36,152.40 $ 8,499.01 $ 27,653.39 $ 538,947.23
5 20 $ 538,947.23 $ 36,152.40 $ 8,084.21 $ 28,068.19 $ 510,879.05
21 $ 510,879.05 $ 36,152.40 $ 7,663.19 $ 28,489.21 $ 482,389.84
22 $ 482,389.84 $ 36,152.40 $ 7,235.85 $ 28,916.55 $ 453,473.29
23 $ 453,473.29 $ 36,152.40 $ 6,802.10 $ 29,350.30 $ 424,122.99
6 24 $ 424,122.99 $ 36,152.40 $ 6,361.84 $ 29,790.55 $ 394,332.44
25 $ 394,332.44 $ 36,152.40 $ 5,914.99 $ 30,237.41 $ 364,095.03
26 $ 364,095.03 $ 36,152.40 $ 5,461.43 $ 30,690.97 $ 333,404.06
27 $ 333,404.06 $ 36,152.40 $ 5,001.06 $ 31,151.33 $ 302,252.73
7 28 $ 302,252.73 $ 36,152.40 $ 4,533.79 $ 31,618.60 $ 270,634.12
29 $ 270,634.12 $ 36,152.40 $ 4,059.51 $ 32,092.88 $ 238,541.24
30 $ 238,541.24 $ 36,152.40 $ 3,578.12 $ 32,574.28 $ 205,966.96
31 $ 205,966.96 $ 36,152.40 $ 3,089.50 $ 33,062.89 $ 172,904.07
8 32 $ 172,904.07 $ 36,152.40 $ 2,593.56 $ 33,558.83 $ 139,345.24
33 $ 139,345.24 $ 36,152.40 $ 2,090.18 $ 34,062.22 $ 105,283.02
34 $ 105,283.02 $ 36,152.40 $ 1,579.25 $ 34,573.15 $ 70,709.87
35 $ 70,709.87 $ 36,152.40 $ 1,060.65 $ 35,091.75 $ 35,618.12
9 36 $ 35,618.12 $ 36,152.40 $ 534.27 $ 35,618.12 $ (0.00)
10. Suppose you deposit $100,000 in an account today that pays 6% interest, compounded
annually. How long does it take before the balance in your account is $500,000?
Given: I = 6%; PV = $100,000; FV = $500,000
Solution: N = 28
11. The Lucky Loan Company will lend you $10,000 today with terms that require you to pay
off the loan in thirty-six monthly installments of $500 each. What is the effective annual
rate of interest that the Lucky Loan Company is charging you?
Given: PV = $10,000; N = 36; PMT = 500
Solve for i: i = 3.6007%
EAR = (1 + 0.036007)12 – 1 = 52.8806%
12. How long does it take for your money to grow to ten times its original value if the
interest rate of 5% per year?
Given: PV = 1; FV = 10; I = 5%
Solution: 48 years
13. Under what conditions does the effective annual rate of interest (EAR) differ from the
annual percentage rate (APR)?
If interest is compounded more frequently than once a year, the EAR will be different
than the APR; the EAR will be greater than the APR except in the case in which there is
annual compounding (in which case the EAR will be equal to the APR)
14. As the frequency of compounding increases within the annual period, what happens to
the relation between the EAR and the APR?
The EAR will become larger than the APR as the frequency of compounding increases.
The largest difference between the two is in the case in which interest is compounded
continuously.
15. If interest is paid at a rate of 5% per year, compounded quarterly, what is the:
a) annual percentage rate?

APR = 5%
b) effective annual rate?
EAR = (1 + 0.0125)4 - 1 = 5.0945%
16. L. Shark is willing to lend you $10,000 for three months. At the end of six months, L.
Shark requires you to repay the $10,000, plus 50%.
a) What is the length of the compounding period?
Six months
b) What is the rate of interest per compounding period?
50%
c) What is the annual percentage rate associated with L. Shark's lending activities?
APR = 50% x 2 = 100%
d) What is the effective annual rate of interest associated with L. Shark's lending
activities?
EAR = (1 + 0.50)2 - 1 = 125%
17. The Consistent Savings and Loan is designing a new account that pays interest quarterly.
They wish to pay, effectively, 16% per year on this account. Consistent desires to
advertise the annual percentage rate on this new account, instead of the effective rate,
since its competitors state their interest on an annualized basis. What is the APR that
corresponds to an effective rate of 16% for this new account?
EAR = 16%
APR = 1.160.25 this takes the fourth root of 1 + EAR
i = 3.78%
APR = 3.78% x 4 = 15.121%
18. Consider an annuity consisting of three cash flows of $2,000 each. Assume a 4% interest
rate. What is the present value of the annuity if the first cash flow occurs:
a) today.
PV of annuity due = $5,772.19
b) one year from today.
PV of ordinary annuity = $5,550.18
c) two years from today.
d) three years from today.
e) four years from today.

f) five years from today.
19. Suppose you wish to retire forty years from today. You determine that you need $50,000
per year once you retire, with the first retirement funds withdrawn one year from the day
you retire. You estimate that you will earn 6% per year on your retirement funds and
that you will need funds up to and including your 25th birthday after retirement.
a) How much must you deposit in an account today so that you have enough funds
for retirement?
PVretire = $639.167.81
Given: FV = $639,167.81; N = 40; I = 6%; Solve for PV

PVtoday = $639,167.81 / (1 + 0.06)40 = $62,141.29
b) How much must you deposit each year in an account, starting one year from
today, so that you have enough funds for retirement?
PVretire = $639.167.81
Given: FV = $639,167.81; N = 40; I = 6%; Solve for PMT

PMT = $4,130.01
20. Using an interest rate of 5% per year, what is the value today of the following cash
flows:
Years from today Cash flow
1 £0
2 £0
3 £ 10,000
4 £ 10,000
FV = $8,638.38 + 8,227.02 = $16,865.40
Note: Cash flow list: {0,0,10000,10000}

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Valuation module, Pamela Peterson Drake Page 1 of 2
Module 4: Valuation
Elements
1. Module 4: Valuation IMPORTANT: READ FIRST
2. Reading: Asset valuation
3. Reading: Bond valuation
4. Reading: Stock valuation
5. Explanation: Two stage growth
6. Explanation: Equity valuation A detailed comparison of models
7. Problem set: Valuation practice problems and Solutions
9. Check here for additional problem sets.
Valuation module, Pamela Peterson Drake Page 2 of 2

Module 4: Valuation http://educ.jmu.edu/~drakepp/principles/module4/learning_outcomes.pdf
Asset valuation http://educ.jmu.edu/~drakepp/principles/module4/asset.pdf
Bond valuation http://educ.jmu.edu/~drakepp/principles/module4/bondval.pdf
Stock valuation http://educ.jmu.edu/~drakepp/principles/module4/stock.pdf
Two stage growth http://educ.jmu.edu/~drakepp/principles/module4/twostagedvm.pdf
Equity valuation http://educ.jmu.edu/~drakepp/principles/module4/Equity_Valuation.pdf
Valuation practice
problems
MODULE 4:
VALUATION
OUTLINE
1. Introduction
3. Module 4 tasks
1. Introduction
Financial managers must often make decisions regarding the benefits and costs associated
with an investment. We capture the benefits and costs in valuation: determining what an
investment is worth today and comparing this to the cost of the investment.
The key to valuation is determining the expected future cash flows – both the amount and
timing – and the discount rate. The discount rate is the rate the investors require or demand
form the investment; hence, the discount rate is often referred to as the required rate of
return. The more uncertain the future cash flows, the higher the required rate of return.
The purpose of this module is to introduce you to the valuation of assets. We will apply the
financial mathematics that you learned in the time value of money module to assets in
general and then specifically to the valuation of bonds and stocks.
LO4.1 Apply financial math to value assets with different patterns of cash flows.
LO4.2 Calculate growth rates associated with cash flows and values of assets.
LO4.3 Relate growth in cash flows to values.
LO4.4 Calculate returns and yields on investments with different patterns of cash flows.
LO4.5 Apply valuation principles to calculate the value of a bond, considering the bond’s
coupon rate, maturity, and time to maturity.
LO4.6 Analyze the effect of a change in yield-to-maturity on the value of a bond.
LO4.7 Calculate the yield-to-maturity on a bond.
LO4.8 Apply valuation principles to calculate the value of a stock.
LO4.9 Relate the different patterns of cash flows on stocks to the valuation of a stock.
LO4.10 Infer the return on stocks from for different patterns of future cash flows and the
stock’s current value.
Module 4 Overview 1
3. Module 4 tasks
A. Readings
i Required reading
(a) Asset valuation
(b) Bond valuation
(c) Stock valuation
(1) Problem: Two-stage dividend growth
(2) Equity valuation: A comparison of models
ii Other resources
(a) Study Finance: Valuation of corporate securities. An overview of the
valuation provided by the University of Arizona.
(b) Bond Valuation at Corporate Finance Live by Rock Mathis, Prentice-Hall
(c) Stock Valuation at Corporate Finance Live by Rock Mathis, Prentice-Hall
iii Optional reading
Fabozzi and Peterson text, Chapter 8 (Principles of Asset Valuation and
Investment Returns) and Chapter 9, pp. 211-245 (Valuation of Securities and
Options)
B. Problem sets
These problems sets are non-graded tasks. It is recommended that you complete these
problem sets prior to attempting the graded online quiz.
Valuation practice problems and solutions
5-minutes workouts: Bond valuation and Bond yields
Bond valuation practice problems
Two-stage dividend problems
Valuation review
Valuation quiz (non-credit)
StudyMate Activity

A. Asset valuation
Financial managers must evaluate the valuation of the company’s investments, whether
these are investments in assets in place – that is, the existing property, plant, equipment,
and land, among other assets – or assets that the company may wish to acquire. Financial
managers make decisions that require evaluating the acquisition or disposition of equipment,
subsidiaries, patents, etc. In making these decisions, the financial manager must compare
the cost of the investment with the future cash flows that are associated with the
investment. To accomplish this, the financial manager must value the investments, assessing
whether the benefits outweigh the costs associated with the investment.
In this reading, you are introduced to the principles and mathematics of the valuation of
assets. We examine the valuation mathematics for different cash flow: uneven, even and
infinite, and even and finite. In addition to the valuation of assets, you are introduced to the
calculation of returns on assets.
Module 4 Overview 2
B. Bond valuation
Interest rates in the economy change every moment and this means that any security whose
value is affected by the interest rates changes every moment. Debt securities are securities
that involve a promise by the borrower to repay the amount of the loan (the maturity value),
as a promise to pay periodic interest. The value of a debt security is the present value of this
interest and the maturity value, discounted at some rate, which we refer to as a yield. Yields
change constantly, hence bond values change constantly: as interest rates increase, bond
values decrease, and vice-versa.
In this reading, you learn how to value both coupon and zero-coupon bonds. In addition,
you learn how to calculate the yield on a bond given a current price. Through examples,
you’ll see how bonds’ values change as yields change. In addition, you will see how a bond’s
price will change simply from the passage of time.
C. Stock valuation
The valuation of preferred and common stocks is very challenging because the cash flows for
these securities, the cash dividends, are not contractual as they are for bonds. Cash
dividends on stocks are paid at the discretion of the board of directors. A company can start
or stop paying dividends at any time and a company can change the amount of dividends at
any time. Dividends can be paid quarterly, annually, semi-annually, or at irregular intervals,
though most companies that pay dividends do so on a quarterly basis.
Dividends on preferred stock are generally stated as a fixed amount per quarter, though
there is no guarantee that the company will pay them. The board of directors could decide
not to pay them or, if they are cumulative, pay them later. The only catch is that a company
must pay any preferred dividends before they pay any dividends to common shareholders.
The dividends on common stocks can take on many different patterns – or no pattern at all.
These dividends may be constant, may grow at a constant rate forever, or grow at one rate
and then grow at a different rate some time in the future. The many variations make the
valuation of common stock quite challenging.
Investors constantly revalue stocks as information is received; this information may include
information concerning the economy, markets, the company, regulation, and world events, to
name a few. This means that expectations concerning the future cash flows and the
uncertainty related to these cash flows is constantly changing – resulting in changing stock
prices. Take a look at a stock’s price within a given trading day and you’ll see just how much
things change.
D. What’s next?
In this module, we’ve focused on the cash flow component of valuation. The discount rate
that we have been using in valuation is the rate that reflects the time value of money and the
compensation for bearing risk. In the next module, we focus on risk, taking a look at the
different definitions of risk, methods of quantifying risk, and the relevant risk for valuation
purposes. This will prepare you for capital budgeting, covered in Module 6
Module 4 Overview 3
Asset Valuation
A reading prepared by
___________________________________________________________
OUTLINE
1. Introduction
2. The role of the marketplace in the valuation of assets
3. Valuation of securities
4. Summary
___________________________________________________________
1. Introduction
Valuation compares the benefits of a future “Price is what you pay. Value is what you get.”
investment decision with its cost. The process of -- Warren Buffett
valuation involves estimating future cash flows --
both inflows and outflows -- and discounting these future cash flows to the present at a discount rate
that reflects the uncertainty of these cash flows. Another way of evaluating investments is to answer
the question: given its cost and its expected future benefits, what return will a particular investment
provide? We will look at how to calculate the value and the return on investments, focusing stocks in
this reading.
Suppose I offer you the following investment opportunity: give me $900 today, and I will pay you
$1,00 one year from today. Whether or not this is a good investment depends on:
What you could have done with your $900 instead of investing it with me, and
How uncertain are you that I will pay the $1,000 in one year.
If your other opportunities with the same amount of uncertainty provide a return of 10 percent, is
this loan a good investment? There are two ways to evaluate this. First, you can figure out what you
could have wound up with after one year, investing your $900 at 10 percent:
Value at end of one year = $900 + (10% of $900)
Value at end of one year = $900 (1 + 0.10)
Value at end of one year = $990.
Since the $1,000 promised is more than $990, you are better off with the investment I am offering
you.
Another way of looking at this is to figure out what the $1,000 promised in the future is worth today.
To calculate its present value, we must discount the $1,000 at some rate. The rate we'll use is out
opportunity cost of funds, which in this case is 10 percent:
$1, 000
Value today of $1,000 in one year = = $909.09
(1 0.10)1
This means that you consider $909.09 today to be worth the same as $1,000 in one year. In other
words, if you invested $909.09 today in an investment that yields 10 percent, you end up with
$1,000 in one year. Since today's value of the receipt of $1,000 in the future is $909.09 and it only
Asset valuation, A reading prepared by Pamela Peterson Drake 1

costs $900 to get into this deal, the investment is attractive: it costs less than what you have
determined it is worth.
Because there are two ways to look at this -- through its future value or through its present value --
which way should you go? While both approaches get you to the same decision, it is usually easier in
terms of the present value of the investment.
Let's look at another example. Suppose you have an opportunity to buy an asset expected to give
you $500 in one year and $600 in two years. If your other investment opportunities with the same
amount of risk give you a return of 5 percent a year, how much are you willing to pay today to get
these two future receipts?
We can figure this out by discounting the $500 one period at 5 percent and the second $600 two
periods at 5 percent:
$500 $600
Present value of investment = 1

(1 0.05) (1 0.05)2
Present value of investment = $476.19 + $544.22

Present value of investment = $1,020.41
Using a financial calculator’s NPV function, we can arrive at the same present value.
TI-83/84 HP10B
This investment is worth $1,020.41 today, so you will
{500,600} STO listname 1000 +/- CFj
be willing to pay $1,020.41 or less for this
NPV(5,-1000,listname) 500 CFj
investment:
600 CFj
If you pay more than $1,020.41, you get a 5 i/YR
return less than 5 percent; NPV
If you pay less than $1,020.41 you get a return more than 5 percent; and
If you pay $1,020.41 you get a return of 5 percent.
We can look at this problem from a different perspective, solving for the return on the investment.
Suppose you pay $1,000 for the investment that produces $500 at the end of one period and $600 at
the end of two periods. What is the return on this investment? Solving for the return involves trial
and error -- that is, trying different interest rates to find the one in which the cost of the investment
(the $1,000) is equal to the present value of the two cash flows.
Try 4 percent
$500 $600
$1,000 =? 1

(1 0.04) (1 0.04)2
$1,000 =? $480.77 + $554.73

$1,000 $1,035.50
This tells us that we have not discounted enough (that is, 4 percent is too low a rate). We know that
the present value of these cash flows using a 5 percent discount rate is $1,020.41 (from our work
above), so we should try an even higher rate of 6 percent:
Try 6 percent
$500 $600
$1,000 =? 1

(1 0.06) (1 0.06)2
$1,000 =? $471.70 + $534.00

$1,000 $1,005.70

Repeating this same procedure using 7 percent gives us a value of the right-hand side of this
equation of $991.35. Because $991.35 is less than the $1,000, this means that the rate that equates
the cost of the investment (the $1,000) with the future cash flows is between 6 percent and 7
percent. Using a financial calculator’s IRR function, we can determine this precisely – and without
having to do all the iterations ourselves.
TI-83/84 HP10B
The interest rate that equates the $1,000 investment
{500,600} STO listname -1000 CFj
with the present value of the two cash flows is 6.39
IRR(-1000,listname) 500 CFj
percent. This means that if you buy this investment
600 CFj
for $1,000 and hold it for two years and receive the
IRR
$500 and $600 as promised, you will have a return of
6.39 percent on your investment. This interest rate is often referred to as the investment's internal
rate of return (IRR).
Let's look at still another example. Suppose you are evaluating an investment that promises $10
every year forever. This type of cash flow stream is referred to as a perpetuity. The value of this
investment is the present value of the stream of $10's to be received each year to infinity where each
$10 is discounted the appropriate number of periods at some annual rate i:
$10 $10 $10 $10
Present value of investment = + + +...+
(1+i) 1
(1+i) 2
(1+i) 3
(1+i)
which we can write in short-hand notation using summation notation as:

$10 1
Present value of investment = (1+i)
t=1
t
$10 (1+i)
t=1
t
Or, because as t approaches , 1/(1 + i)t is equal to 1/i, we can rewrite the present value of this
perpetual stream as:
1
$10
Present value of investment = $10
i i
If the discount rate to translate this future stream into a present value is 10 percent, the value of the
investment is $100:
$10
Present value of investment = $100.
0.10
The 10 percent is the discount rate, also referred to as the capitalization rate, for the future cash
flows comprising this stream. Looking at this investment from another angle, if you consider the
investment to be worth $100 today, you are capitalizing -- translating future flows into a present
value -- the future cash flows at 10 percent per year. As you see from these examples, the value of
an investment depends on:
the amount and timing of the future cash flows, and
the discount rate used to translate these future cash flows into a value today.
This discount rate represents how much an investor is willing to pay today for the right to receive a
future cash flow. Or, to put it another way, the discount rate is the rate of return the investor
requires on an investment, given the price he or she is willing to pay for its expected future cash
flow.
We can generalize this relationship a bit more. Let CFt represent the cash flow from the investment in
period t, so that CF1 is the cash flow at the end of period 1, CF2 is the cash flow at the end of period
2, and so on, until the last cash flow at the end of period N, CFN. If the investment produces cash

flows for a finite number of periods, N, and the discount rate is i, the value of the investment -- the
present value -- is:
CF1 CF2 CF3 CFN
Present value of investment = + + +...+ ,
(1+i)1 (1+i)2 (1+i)3 (1+i)N
which we can write more compactly as:

N CFt
Present value of the investment =
t
t=1 (1+i)
Example 1: Example 2:
Value of an investment Value of an investment with uneven cash flows
Problem Problem
What is the value of an investment that Consider the following cash inflows from an investment
provides cash flows of $2,000 at the end of today:
each year for the next four years if you have
End of
determined that the appropriate discount rate
Years from period
on this investment is 6 percent?
today cash flow
Solution 1 $3,000
2 $0
Because these cash flows are the same amount
3 $2,500
and occur at regular intervals of time, we can
solve this using an ordinary annuity approach: If your opportunity cost of funds is 5 percent, what is this
investment worth today?
PMT = $2,000
N=4 Solution
i = 6% Given:
CF1 = $3,000
PV = $6,930.21
CF2 = $0
CF3 = $2,500
i = 5%
PV = $5,016.7369
2. The Role of the Marketplace in the Valuation of

Assets
"Both wise mean and foolish will trade in the market, but no one group by itself will set the
price. Nor will it matter what the majority, however overwhelming, may think; for the last
owner, and he alone, will set the price. Thus marginal opinion will determine market price."
John Burr Williams, The Theory of Investment Value,

[Amsterdam: North-Holland Publishing Company, 1938] p. 12.
If you are faced with a decision whether to make a particular investment, you figure out what it is
worth to you -- its value -- and compare it with what it will cost you. If the investment costs less than
you think it is worth, you will buy it; if it costs more than you think it is worth, you will not buy it.
Now suppose several different people are considering buying the same, one of a kind asset. Each
potential investor evaluates whether the asset is priced at more or less than what he or she thinks it

is worth by making this comparison and either buying or selling the asset based on whether they
think it is over- or under-priced, the buyers and sellers determine its price.
A. Price determination in a market

Let's see how this works. Three investors, A, B, and C, have an opportunity to buy an asset expected
to generate $100 each period forever. This is a perpetuity whose value is the ratio of the $100 to the
discount rate.
If each investor thinks that this asset represents an investment that has a different amount of risk,
they each will use a different discount rate to value it. If investors are risk averse -- they do not like
risk -- they will value an asset using a higher discount rate the more uncertain they are about the
future cash flows. Suppose:
Investor uses the discount rate ... and values the asset as ...
A 8.0% $1,250
B 10.0% $1,000
C 12.5% $ 800
And suppose the asset is owned by Investor C who has been looking at alternative investment
opportunities with similar risk that yield 12.5 percent and as a result figures that the asset is worth
only $800. Both Investors A and B would be interested in buying it from C for more than $800 and C
would be willing to sell it for more than $800. Since both A and B want this asset, they would bid for
it.
So what is the market price of the asset? If its price is $1,000, Investor B would be indifferent
between this asset and his other investments of similar risk. At $1,000, Investor A would still think it
is under-priced and want to buy it. So the price is bid up to reflect the highest value investors are
willing to pay: $1,250. If Investor A buys the asset for $1,250, he gets a return of 8 percent, which is
what he thinks is appropriate given his assessment of the asset's risk.
What makes this process work is investors' desire to exploit profitable opportunities: C to sell it for
more than she thinks it is worth, and A and B to buy it for less than they think it is worth.
If we assume that investors are interested in maximizing their wealth, those investors thinking an
asset is over-priced will want to sell it and those thinking it is under-priced will want to buy it. Buyers
and sellers will continue to buy and sell until they have exhausted what they believe are all the
profitable opportunities. When that happens, the assets are neither over- or under-priced. This point
where buying and selling is in balance is referred to as a market equilibrium. As John Burr William
states, the price of an asset is determined by the investor with the highest valuation of the asset. If
the price of an asset is above or below its market equilibrium price, investors will buy and sell it until
its price is the market equilibrium price. As long as an asset can be traded without any restrictions in
a market, buying and selling it will determine its price. However, if there is a barrier to trading -- such
as a limit on the quantity that can be sold -- this trading is inhibited and the asset's price will not
reflect the valuation of the highest valuer.
In addition, if there are costs to trading -- such as a fee each time a trade is made -- investors will
figure the cost into their bidding. For example, if there is a $100 fee to buy the asset, the most
Investor A would be willing to pay is $1,150 and the most Investor B would be willing to pay is $900,
considering there is a $100 fee to buy it.
B. Markets
A market may be structured as a pure auction market, as a dealer market, as a call market, or some
combination of these markets. In a pure auction market buyers and sellers submit bids to a central

location. These buy and sell orders are matched by a broker. In a dealer market, the dealers –
who are individuals – own securities. They stand ready to buy or sell securities and will quote a bid
and an ask price. Brokers, who represent investors who wish to buy or sell, then shop around for
dealer with best price.
In a call market the trading of individual stocks takes place at specified times. One party
determines the single price that satisfies the most orders and then all transactions at this price. In a
continuous market, trades occur whenever the market is open and the prices are determined by
auction or by dealers. In the New York Stock Exchange (NYSE), for example, the opening price is
determined by a call market, but then trading during the trading hours is determined by the
continuous market.
Markets in the United States
The NYSE is the largest stock exchange in the U.S. in
terms of the market value of shares traded, whereas the American Stock Exchange (AMEX)
Chicago Board Options Exchange (CBOE) is the largest Boston Stock Exchange
options exchange. National exchanges outside the U. S. Chicago Board Options Exchange (CBOE)
include the London Stock Exchange (LSE) and the Tokyo Chicago Stock Exchange
Stock Exchange (TSE). International Securities Exchange
National Stock Exchange
The Nasdaq is a large U.S. over-the-counter market. An New York Stock Exchange (NYSE)
over-the-counter market has no physical presence, but Pacific Exchange
rather trading is carried out over computers. The Nasdaq Philadelphia Stock Exchange
was created in 1971 by the National Association of Securities Dealers (NASD) to become the first
electronic market in the U. S. 1 However, the Nasdaq is currently exploring a conversion to an
exchange. The Nasdaq has two markets: the National Market System, which are the larger, more
actively traded securities, and SmallCap, which are the smaller, newer companies.
One of the distinguishing differences between the NYSE Listing requirements

and Nasdaq markets is the listing standards. For example, NYSE listing requirements
the NYSE requires that the company be much larger in Nasdaq listing requirements
terms of market value of equity, net income, and share trading volume that is required by the
Nasdaq market.
Another difference between the markets is the procedure for trading. The NYSE is an auction
market, whereas the Nasdaq is a dealer market. In the Nasdaq, investors buy from and sell to a
dealer; in the NYSE, on the other hand, investors are buying and selling between each other, with
bidding among investors. In the Nasdaq market, market makers, who are the dealers, manage the
process by working with investors; in the NYSE market, the specialist manages the process by
matching buyers and sellers.
The markets in the U.S. for stocks, bonds, and options are well-organized, self-regulated, and
efficient. Therefore we can have confidence that the prices we observe for these assets reflect their
true value to investors.
3. Valuation of securities
When we value an investment, we need to know its expected future cash flows and the uncertainty
of receiving them. To value securities you must understand the nature of the cash flows, their timing,
and the uncertainty associated with these future cash flows. Let's look at three types of securities:
common stock, preferred stock, and debt. These securities have different types of cash flows and the
uncertainty of each is different also.
1
Note that the Nasdaq is not an exchange. Though it has applied to become an exchange, it is not
one yet.

Notes and bonds are both debt securities. Both are legal contracts to pay interest and principal. The
primary difference between a note and a bond is that a bond has an indenture agreement, which is a
document stating the certain conditions and restrictions that the borrower must satisfy, such as
maintaining a specified current ratio.
Most debt securities represent obligations of the borrower to pay interest at regular intervals (usually
every six months) and to repay the principal amount of the loan -- referred to as the maturity value
or the face value -- at the end of the loan period; that is, at maturity. If you issue a debt security,
you are entering into a contract with the purchaser of that debt security -- the creditor -- to repay
the loan. Any interest and principal that you promise to pay are legal obligations -- failure to pay as
promised results in dire consequences.
Debt securities are senior to equity securities: the borrower must satisfy their obligations to the
creditors before making payments to owners. Therefore, the cash flows from debt securities are more
certain than the cash flows of either preferred stock or common stock.
If you invest in common stock, you buy shares that represent an ownership interest in the firm.
Shares of common stock are a perpetual security -- there is no maturity. If you own shares of
common stock, you have the right to receive a certain portion of any dividends -- but dividends are
not a sure thing. Whether a firm will pay dividends is up to its board of directors -- the
representatives of the common shareholders. Typically we see some pattern in the dividends
companies pay: dividends are either constant or grow at a constant rate. But there is no guarantee
that dividends will be paid in the future and, if paid, what the monetary amount will be.
A preferred stock is also an equity investment in the company. However, preferred shareholders
have preference (i.e., seniority) over common shareholders with respect to both income and assets in
the event of a liquidation of the company. In other words, a company must pay its preferred
shareholders its dividends before it pays any dividends to common shareholders.
Preferred shareholders are in a similar situation as the common shareholders with respect to whether
dividends will be paid. They expect to receive cash dividends in the future, but the payment of these
dividends is up to the board of directors. But there are three major differences between the dividends
of preferred and common shares. First, the dividends on preferred stock usually are specified at a
fixed rate or dollar amount, whereas the amount of dividends is not specified for common shares.
Second, preferred shareholders are given preference: their dividends must be paid before any
dividends are paid on common stock. Third, if the preferred stock has a cumulative feature, dividends
not paid in one period accumulate and are carried over to the next period. Therefore, the dividends
on preferred stock are more certain than those on common shares.
4. Summary
The valuation of securities therefore requires first identifying the type, amount, and timing of the
cash flows associated with the security. The valuation of debt securities is a bit more straightforward
than the valuation of equity securities because the amount and timing of the cash flows are
contractual. The valuation of stock requires estimating what dividends, if any, the company will pay
in the future.
Once the amount and timing of the security’s cash flows are estimated, the valuation of these assets
requires the application of the time value of money mathematics to determine the present value of
these future cash flows.
© 2007 Pamela P. Peterson Drake

Bond valuation
___________________________________________________________
OUTLINE
1. Valuation of long-term debt securities
2. Issues
3. Summary
___________________________________________________________
1. Valuation of long-term debt securities

Debt securities are obligations to repay an amount borrowed, along with some compensation for the time
value of money and risk. The borrowers may be corporations, the government, or governmental
agencies. The lenders may be corporations, governments, pension funds, mutual funds, or individual
investors.
Long-term debt securities, such as notes and bonds, are promises by the borrower to repay the principal
amount. Notes and bonds may also require the borrower to pay interest periodically, typically semi-
annually or annually, and generally stated as a percentage of the face value of the bond or note. We
refer to the interest payments as coupon payments or coupons and the percentage rate as the coupon
rate. If these coupons are a constant amount, paid at regular intervals, we refer to the security paying
them as having a straight coupon. A debt security that does not have a promise to pay interest we
refer to as a zero-coupon note or bond.
The value of a debt security today is the present value of the promised future cash flows -- the interest
and the maturity value. 1 Therefore, the present value of a debt is the sum of the present value of the
interest payments and the present value of the maturity value:
Present value of a bond = present value of interest payments + present value of maturity value
To calculate the value of a debt security, we discount the future cash flows -- the interest and maturity
value -- at some rate that reflects both the time value of money and the uncertainty of receiving these
future cash flows. We refer to this discount rate as the yield. The more uncertain the future cash flows,
the greater the yield. It follows that the greater the yield, the lower the present value of the future cash
flows -- hence, the lower the value of the debt security.
Most U.S. bonds pay interest semi-annually. 2 In Wall Street parlance, the term yield-to-maturity
(YTM) is used to describe an annualized yield on a security if the security is held to maturity. For
example, if a bond has a return of 5 per cent over a six-month period, the annualized yield-to-maturity
for a year is 2 times 5 per cent or 10 per cent. 3 The yield-to-maturity, as commonly used on Wall Street,
is the annualized yield-to-maturity:
Annualized yield-to-maturity = six-month yield x 2
1
The maturity value is also referred to as the face value of the bond.
2
You should assume all bonds pay interest semi-annually unless specified otherwise.
3
But is this the effective yield-to-maturity? Not quite. This annualized yield does not take into consideration the
compounding within the year if the bond pays interest more than once per year.
Bond Valuation, a reading prepared by Pamela Peterson Drake 1

When the term “yield” is used in the context of bond valuation without any qualification, the intent is that
this is the yield to maturity.
A note about rates The present value of the maturity value is the present value of a
The interest cash flows associated lump-sum, a future amount. In the case of a straight coupon
with a bond are determined by the security, the present value of the interest payments is the present
coupon rate. value of an annuity. In the case of a zero-coupon security, the
present value of the interest payments is zero, so the present
The discount rate is associated
value of the debt is the present value of the maturity value.
with the yield to maturity.
We can rewrite the formula for the present value of a debt security
using some new notation and some familiar notation. Since there are two different cash flows -- interest
and maturity value -- let C represent the coupon payment promised each period and M represent the
maturity value. Also, let N indicate the number of periods until maturity, t indicate a specific period, and
rd indicate the six-month yield. The present value of a debt security, V, is:
N
Ct M
V
t=1 1+r t (1+r )N
d d
To see how the valuation of future cash flows from debt securities works, let's look at the valuation of a
straight coupon bond and a zero-coupon bond.
A. Valuing a straight-coupon bond

Suppose you are considering investing in a straight coupon bond that:
promises interest 10 percent each year;
promises to pay the principal amount of $1,000 at the end of twelve years; and
has a yield of 5 percent per year.
What is this bond worth today? We are given the following:
Interest = $100 every year
Number of years to maturity = 12
Maturity value = $1,000
Yield to maturity = 5% per year
Most U.S. bonds pay interest twice a year. Therefore, we adjust the given information for the fact that
interest is paid semi-annually, producing the following:
C = $100 / 2 = $50
N = 12 x 2 = 24
M = $1,000
rd = 5% / 2 = 2.5%
24
$50 $1,000
V $1, 447.1246
t=1 1+0.025 t (1+0.025)24

This value is the sum of the value of the interest payments (an ordinary annuity consisting of 24 $50
payments, discounted at 2.5 percent) and the value of the maturity value (a lump-sum of $1,000,
discounted 24 periods at 2.5 percent).

Another way of representing the bond valuation is to state all
the monetary inputs in terms of a percentage of the face TI-83/84 HP10B
value. Continuing this example, this would require the Using TVM Solver
following: N = 24 1000 FV
I = 2.5 24 n
C = 10 / 2 = 5 PMT = 50 2.5 i/YR
N = 12 x 2 = 24 FV = 1000 50 PMT
M = 100 Solve for PV PV
rd = 5% / 2 = 2.5%
24
5 100
V 144.71246
t=1 1+0.025 t (1+0.025)24

This produces a value that is in terms Try it. Bond quotes

of a bond quote, which is a
percentage of face values. For a Bond Quote Face value Value of bond
$1,000 face value bond, this means A 103.45 $1,000
that the present value is 144.71246 B 98.00 $1,000
percent of the face value, or C 89.50 $500
$1,447.1246. D 110.00 $100,000
Why bother with bond quotes? For E 90.00 €1000
two reasons: First, this is how you F 120.25 ¥10000
will see a bond’s value quoted on any G 65.45 $10,000
financial publication or site; second,
this is a more general approach to Solutions are provided at the end of the reading.
communicating a bond’s value and
can be used irregardless of the bond’s face value. For example, if the bond has a face value of $500
(i.e., it’s a baby bond), a bond quote of 101 translates into a bond value of $500 x 101% = $505.
This bond has a present value greater than its maturity value, TI-83/84 HP10B
so we say that the bond is selling at a premium from its Using TVM Solver
maturity value. Does this make sense? Yes: The bond pays N = 24 100 FV
interest of 10 percent of its face value every year. But what I = 2.5 24 n
investors require on their investment -- the capitalization rate PMT = 5 2.5 i/YR
considering the time value of money and the uncertainty of FV = 100 PV
the future cash flows -- is 5 percent. So what happens? The Solve for PV
bond paying 10 percent is attractive -- so attractive that its
price is bid upward to a price that gives investors the going rate, the 5 percent. In other words, an
investor who buys the bond for $1,447.1246 will get a 5 percent return on it if it is held until maturity.
We say that at $1,447.1246, the bond is priced to yield 5 percent per year.
Suppose that instead of being priced to yield 5 percent, this bond is priced to yield 10 percent. What is
the value of this bond?
C = $100 / 2 = $50
TI-83/84 HP10B
N = 12 x 2 = 24
Using TVM Solver
M = $1,000
N = 24 1000 FV
rd = 10% / 2 = 5%
I=5 24 n
24 PMT = 50 5 i/YR
$50 $1,000 $1, 000
V FV = 1000 PV
t=1 1+0.05 (1+0.05)24
t
Solve for PV

The bond's present value is equal to its face value and we say that the bond is selling "at par". Investors
will pay face value for a bond that pays the going rate for bonds of similar risk. In other words, if you buy
the 10 percent bond for $1,000.00, you will earn a 10 percent annual return on your investment if you
hold it until maturity.
Suppose, instead, the interest on the bond is $20 Example: Bond valuation
every year -- a 2 percent coupon rate. Then,
Problem
C = $20 / 2 = $10
N = 12 x 2 = 24 Suppose a bond has a $1,000 face value, a 10
M = $1,000 percent coupon (paid semiannually), five years
rd = 10% / 2 = 5% remaining to maturity, and is priced to yield 8
percent. What is its value?
24
$10 $1,000 $448.0543 Solution
V
t=1 1+0.05 t (1+0.05)24
PV of interest = $405.54
PV of face value = $1,000 (0.6756) = $675.60
The bond sells at a discount from its face value. Value = $405.54 + 675.60 = $1,081.14
Why? Because investors are not going to pay face
value for a bond that pays less than the going rate Using a calculator,
for bonds of similar risk. If an investor can buy 4 I/YR
other bonds that yield 5 percent, why pay the face 10 N
value -- $1,000 in this case -- for a bond that pays 50 PMT
only 2 percent? They wouldn't. Instead, the price 1000 FV
of this bond would fall to a price that provides an PV
investor earn a yield-to-maturity of 5 percent. In
other words, if you buy the 2 percent bond for Using Microsoft's Excel® spreadsheet function,
$448.0543, you will earn a 5 percent annual return =PV(rate,nper,pmt,fv,type)*-1
on your investment if you hold it until maturity.
=PV(.04,10,50,1000,0)*-1
So when we look at the value of a bond, we see
that its present value is dependent on the relation between the coupon rate and the yield. We can see
this relation in our example: if the yield exceeds the bond's coupon rate, the bond sells at a discount
from its maturity value and if the yield is less than the bond's coupon rate, the bond sells at a premium.
As another example, consider a bond with five years remaining to maturity and is priced to yield 10
percent. If the coupon on this bond is 6 percent per year, the bond is priced at $845.57 (bond quote:
84.557). If the coupon on this bond is 14 percent per year, the bond is a premium bond, priced at
$1,154.43 (bond quote: 115.443). The relation between this bond’s value and its coupon is illustrated in
Exhibit 1.

Exhibit 1: Value of a $1,000 face-value bond that has five years remaining to maturity and
is priced to yield 10 percent for different coupon rates
$1,193.04
$1,154.43
$1,115.83
$1,077.22
$1,038.61
$1,000.00
$1,400
$961.39
$922.78
$884.17
$845.57
$1,200
$806.96
$768.35
$729.74
$691.13
$652.52
$613.91
$1,000
$800
Value
$600
$400
$200
$0
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
Annual coupon rate
Different value, different coupon rate, but same yield?
The yield to maturity on a bond is the market’s assessment of the time value and risk of the bond’s cash
flows. This yield will change constantly to reflect changes in interest rates in general, and it will also
change as the market’s perception of the debt issuer’s risk changes.
At any point in time, a company may have several different bonds outstanding, each with a different
coupon rate and bond quote. However, the yield on these bonds – at least those with similar other
characteristics (e.g., seniority, security, indentures) – is usually the same or very close. This occurs
because the bonds are likely issued at different times and with different coupons and maturity, but the
yield on the bonds reflects the market’s perception of the risk of the bond and its time value.
Consider two bonds:
Bond A: A maturity value of $1,000, a coupon rate of 6 percent, ten years remaining to maturity, and
priced to yield 8 percent. Value = $864.0967
Bond B: A maturity value of $1,000, a coupon rate of 12 percent, ten years remaining to maturity,
and priced to yield 8 percent. Value = $1,271.8065.
How can one bond costing $864.0967 and another costing $1,271.8065 both give an investor a return of
8 percent per year if held to maturity? Bond B has a higher coupon rate than Bond A (12 percent versus
6 percent), yet it is possible for the bonds to provide the same return. Bond B you pay more now, but
also get more each year ($120 versus $60). The extra $60 a year for 10 years makes up for the extra you
pay now to buy the bond, considering the time value of money.
Same bond, different yields, hence different values
As interest rates change, the value of bonds change in the opposite direction; that is, there is an inverse
relation between bond prices and bond yields.
Let's look at another example, this time keeping the coupon rate the same, but varying the yield.
Suppose we have a $1,000 face value bond with a 10 percent coupon rate that pays interest at the end
of each year and matures in five years. If the yield is 5 percent, the value of the bond is:

V = $432.95 + $783.53 = $1,216.48
If the yield is 10 percent, the same as the coupon rate, 10 percent, the bond sells at face value:
V = $379.08 + $620.92 = $1,000.00 Try it! Bond values and yields

If the yield is 15 percent, the bond's value is Consider a bond that pays interest at the rate of 6 percent
less than its face value: per year and has ten years remaining to maturity. Calculate
the value of the bond if its face value is $1,000 and the bond
V = $335.21 + $497.18 = $832.39 quote for the specific yields to maturity:
When we hold the coupon rate constant and
Yield to maturity Value of bond Bond quote
vary the yield, we see that there is a negative
5%
relation between a bond's yield and its value.
6%
We see a relation developing between the 7%
coupon rate, the yield, and the value of a debt 8%
security:
Solutions are provided at the end of the reading.
if the coupon rate is more than the
yield, the security is worth more than
its face value -- it sells at a premium;
if the coupon rate is less than the yield, the security is less that its face value -- it sells at a
discount.
if the coupon rate is equal to the yield, the security is valued at its face value.
Example: Bond valuation We can see the relation between the

Problem annualized yield-to-maturity and the
value of the 8 percent coupon bond in
Suppose we are interested in valuing a $1,000 face value bond that Exhibit 2. The greater the yield, the
matures in five years and promises a coupon of 4 percent per year, lower the present value of the bond.
with interest paid semi-annually. This 4 percent coupon rate tells us
This makes sense since an increasing
that 2 percent, or $20, is paid every six months. What is the bond's
value today if the annualized yield-to-maturity is 6 percent? 8 yield means that we are discounting the
percent future cash flows at higher rates.
Solution For a given bond, if interest rates go up,
its price goes down; if interest rates go
If the yield-to-maturity is 6 percent:
down, its price goes up.
Interest, C = $20 every six months
Number of periods, N = 5 times 2 = 10 six-month periods
Maturity value, M = $1,000
Yield, rd = 6%/2 = 3% for six-month period
The value of the bond is $914.69797
If the yield-to-maturity is 8 percent, then:
Interest, C = $20 every six months

Number of periods, N = 5 times 2 = 10 six-month periods
Maturity value, M = $1,000
Yield, rd = 8% / 2= 4% for six-month period
The value of the bond is $837.7821

Exhibit 2: Value of a five-year, $1,000 face value bond with an 8 percent coupon for
different yields to maturity
$1,400.00
$1,340.56
$1,284.14
$1,230.55
$1,179.65
$1,131.28
$1,085.30
$1,041.58
$1,500
$1,000.00
$960.44
$922.78
$886.94
$1,250
$852.80
$820.28
$789.29
$759.76
$1,000
Value $750
$500
$250
$0
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
YTM
B. Valuing a zero-coupon bond

A zero-coupon bond is a debt security that is issued without a coupon. The value of a zero-coupon
bond is easier to figure out than the value of a coupon bond. Let's see why. Suppose we are considering
investing in a zero-coupon bond that matures in five years and has a face value of $1,000. If this bond
does not pay interest -- explicitly at least -- no one will buy it at its face value. Instead, investors pay
some amount less than the face value, with its return based on the difference between what they pay for
it and -- assuming they hold it to maturity -- its maturity value.
If these bonds are priced to yield 10 percent, their present value is the present value of $1,000,
discounted five years at 10 percent. We are given: 4
M = $1,000
TI-83/84 HP10B
N = 10
Using TVM Solver
rd = 5%
N = 10 1000 FV
The value of the debt security is: I=5 10 n
PMT = 0 5 i/YR
$1,000
V $613.91325 FV = 1000 PV
(1+0.05)10 Solve for PV
The price of the zero-coupon bond is sensitive to the yield: if the yield changes from 10 percent to 5
percent, the value of the bond increases from $613.91325 to $781.19840. We can see the sensitivity of
the value of the bond's price over yields ranging from 1 percent to 15 percent in Exhibit 3.
4
You will notice that we still convert the number of years into the number of six-month periods and we convert the
yield to maturity to a six-month yield. This is because the convention for reporting yields on bonds, whether coupon
or zero-coupon, is to assume an annualized yield that is the six-month yield multiplied by two.

Exhibit 3: Value of a five-year maturity zero coupon bond for different yields to maturity
$1,000.00
$951.35
$905.29
$861.67
$820.35
$781.20
$744.09
$708.92
$1,000
$675.56
$643.93
$613.91
$900
$585.43
$558.39
$532.73
$508.35
$800
$485.19
$700
$600
Value $500
$400
$300
$200
$100
$0
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
YTM
2. Calculating the yield to maturity

In the previous section, we valued a bond, given a specific yield-to-maturity. But we are often concerned
the yield that is implied in a given bond’s price. For example, what is the yield-to-maturity on a bond
that has a current price of $900, has five years remaining to maturity, an 8 percent coupon rate, and a
face value of $1,000? We are given the following:
N = 10
C = $40
M = $1,000
V = $900
The six-month yield, rd, is the discount rate that solves the following:
10
$40 $1,000
$900
t=1 1+r t (1+r )10
d d
TI-83/84 HP10B There is no direct solution, so we must use iteration. 5 In

Using TVM Solver other words, without the help of a financial calculator or a
N = 10 1000 FV spreadsheet, we would have to try different values of rd until
PV = -900 900 +/- PV we cause the left and right hand sides of this equation to be
PMT = 40 10 n equal. Fortunately, calculators and spreadsheets make
FV = 1000 40 PMT calculations much easier. Once we arrive at rd, we multiply
Solve for i i this by two to arrive at the yield-to-maturity. We can use
5
That is, we cannot algebraically manipulate this equation to produce rd on the left-hand side and the
remainder on the right-hand side of the equation and solve.

either the dollar amounts (that is, $40, $1000, and $900 for PMT, FV, PV, respectively) or in bond quote
terms (that is, 4, 100, and 90 for PMT, FV, and PV,
respectively).
TI-83/84 HP10B
Using TVM Solver
Using a calculator, the six-month yield is 5.315% and,
N = 10 100 FV
therefore, the yield to maturity is 10.63%. Using Microsoft
PV = -90 90 +/- PV
Excel®, we use the RATE function and multiply this rate by
PMT = 4 10 n
two, as follows:
FV = 100 4 PMT
Solve for i I =RATE(10,40,-900,1000,0) * 2
The yield-to-maturity calculation is similar for a zero-coupon
bond, with the exception that there is no interest: there is simply a present value, a future value, and a
number of six-month periods. Again, the rate from this calculation must then be multiplied by two to
produce the yield-to maturity.
Example: Yield-to-maturity Example: YTM for a zero-coupon bond
Problem Problem
Suppose a zero-coupon with five years remaining
B, Inc. has a bond outstanding with 8 years
to maturity and a face value of $1,000 has a price
remaining to maturity, a $1,000 face value, and a
of $800. What is the yield to maturity on this
coupon rate of 8% paid semi-annually. If the
bond?
current market price is $880, what is the yield to
maturity (YTM) on the BD bonds?
Solution
Solution
Given:
Given: FV = $1,000
FV = $1,000 N = 10
N = 16 PV = $800
PV = $880 PMT = $0
PMT = $40 Solve for i
Solve for i
i = 2.2565%
i = 5.116434% YTM = 2.2565% x 2 = 4.5130%
YTM = 5.116434 x 2 = 10.232868%
Try it! Yields to maturity

Consider a bond that pays interest at the rate of 6 percent
per year, a face value of $1,000, and has ten years
remaining to maturity. Calculate the yield to maturity of
the bond for the various bond values:
Bond value Yield to maturity

$1,100 4.733%
$1,000 6.000%
$900 7.435%
$800 9.087%
Solutions are provided at the end of the reading.

3. Issues
A. Changes in interest rates
We have already seen that value of a bond changes as the yield changes: if the yield increases, the
bond’s price decreases; if the yield decreases, the bond’s price increases. Just how much a bond’s value
changes for a given yield change depends on the cash flows of the bond and the starting point, in terms
of yield.
Consider the 8 percent coupon bond with five years to maturity that we saw earlier. If the yield changes
from 5 percent to 6 percent, the price of the bond goes from $1,131.28 to $1,085.30; in percentage
terms, the price declines 4.064 percent. But if the yield changes from 10 percent to 11 percent, the price
changes from $922.78 to $886.94, a decline of 3.884 percent. In other words, this bond’s price is more
sensitive to yield changes for lower yields.
We can also compare bonds and their price sensitivities. Consider two bonds with the following
characteristics:
Bond C: A 5 percent coupon bond with six years remaining to maturity and a face value
of $1,000.
Bond D: Zero-coupon bond with six years remaining to maturity and a face value of
$1,000.
Bond C is more valuable because it has the additional cash flows from interest, relative to Bond D. But
which bond’s value is more sensitive to changes in yields? The value of each bond is graphed in Exhibit 4
for yields from 0 percent to 15 percent. The change in price for a given yield change is more for the
zero-coupon bond, Bond D, than the coupon bond; for example:
Percentage change in the
bond’s value
Change in yield Bond C Bond D
From 5 percent to 6 percent -4.98% -5.67%
This is because the entire cash flow for the zero-coupon bond is twelve periods into the future, whereas
the coupon bond has cash flows in the near periods as well, which are not as affected by the yield
change as the maturity value.

Exhibit 4: Value of bonds with six years to maturity:
Bond C has a 5 percent coupon and Bond D is a zero-coupon bond
$1,300
$1,200
Bond C Bond D
$1,100
$1,000
$900
$800
$700
Value
$600
$500
$400
$300
$200
$100
$0
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
YTM
B. Time passage
We have seen examples of bonds that trade at either a premium or a discount from their face values.
This is usually the case: bonds are often issued at or near their face value, but as time passes, yields
change and hence the value of the bond changes. But eventually, the value of the bond must be equal
to the maturity value. 6 If the yield is held constant, the value of a bond approaches the maturity value
as time passes. If the yield changes during the life of the bond, the value still approaches the maturity
value as time passes, but perhaps not in a smooth path.
Consider a bond that has a 10 percent coupon, a maturity value of $1,000, ten years (i.e., 20 periods)
remaining to maturity, and is priced to yield 6 percent. If the yield does not change until the bond
matures, the price of the bond will decline until it reaches $1,000, the maturity value, as shown in Exhibit
5. If this bond’s yield changes, say to 4 percent with 10 periods remaining, the value adjusts
appropriately (i.e., increasing) and the bond’s value will decline towards $1,000 at maturity, as shown in
Exhibit 6.
6
Otherwise there would be a windfall gain or a large loss to someone owning the bond just prior to maturity.

Exhibit 5: Value of a 10 percent coupon, Exhibit 6: Value of a 10 percent coupon, $1,000
$1,000 maturity value bond, with maturity value bond, with ten years to
ten years to maturity, and priced maturity, and priced to yield 6 percent
to yield 6 percent for the first five years and 4 percent for
the last five years
$1,400
$1,400
$1,200
$1,200
$1,000
$1,000
$800
$800 Value
Value
$600
$600 $400
$400 $200
$200 $0
20
18
16
14
12
10
8
6
4
2
0
$0
Periods remaining
20
18
16
14
12
10
8
6
4
2
0
Periods remaining
In a similar manner, a discount bond’s value will increase over time, approaching the maturity value, as
shown in Exhibit 7.
Exhibit 7: Value of a 4 percent coupon,

$1,000 maturity value bond, with
ten years to maturity, and priced
to yield 6 percent
$1,000
$800
$600
Value
$400
$200
$0
20
18
16
14
12
10
8
6
4
2
0
Periods remaining
C. Other valuation issues

A borrower could design a debt security with any features that are necessary for the issuer’s financial
situation or creditors’ demand. There are endless variations in debt securities’ characteristics that may
affect how we value the security. Consider a few of these characteristics:

Feature Description Valuation challenge
Convertible debt At the discretion of the creditor, the debt The value of the security is the
security may be exchanged for another value of the straight bond, plus
security, such as a specified number of the value of the option to convert.
common shares.
Deferred interest Interest is scheduled such that it is not paid The value of the security is the
in the first few years, but begins some time present value of the interest (a
in the future. deferred annuity) and the face
value.
Variable interest The coupon amount depends on the interest The valuation requires a forecast
rate of some other security (i.e, of the coupon, based on forecasts
benchmarked); for example, it may be of the benchmark’s interest rate.
stated as prime rate + 5%.
Other features include security (i.e., collateral), a put option (the investor’s option to sell the security
back to the issuer), a sinking fund (i.e., putting aside funds or periodically retiring the debt). These,
and many more, can be combined in a given debt security, making the valuation of the security quite
challenging. Most of these features will affect the risk associated with the bond’s future cash flows; for
example, if the bond is secured, this reduces the risk of the
bond’s future cash flows because this collateral can be used to The yield curve
pay off the debt obligation. The yield-curve is the relation
between maturity and yield. The
normal yield curve is one in which the
D. Risk and yields securities with longer maturities are
associated with higher yields.
The risk associated with the debt obligation’s future cash flows
However, inverted yield curves do
affects the discount rate that investors use to value the debt: the
occur, such that shorter-term securities
greater the risk, the greater the discount rate applied. Consider have higher yields. The inverted yield
the following two bonds as of February 2006: 7 curve is often a pre-cursor of a
Verizon Communications, 5.55% coupon, maturing February recessionary economic period.
2016 Check out Yahoo! Finance for the
current U.S. Treasury yield curve.
Boise Cascade Corporation, 7.35% coupon, maturing February
2016
Both bonds mature at the same time. However, the bond rating on the Verizon bond is A, which
indicates that it is investment grade debt, whereas the bond rating on the Boise Cascade bond is BB,
which indicate that it is speculative grade debt. The former has a yield to maturity of 5.492 percent,
whereas the latter has a yield to maturity of 7.284 percent. The greater yield for the Boise Cascade bond
reflects the greater relative risk of this bond. These yields are higher than those of a similar-maturity
U.S. Treasury Bond, which has a yield to maturity of 4.653 percent. The U.S. Treasury bond has no
default risk and hence it is priced to yield less than the similar-maturity corporate bonds.
Why do we mention maturity in the comparison of bonds’ yields? Because one of the influences of a debt
security’s yield is the yield curve. The yield curve is the relation between the time remaining to maturity
and the yield. A bond’s yield is influenced by the time value of money, the riskiness of the future cash
7
Source: Yahoo! Finance, February 13, 2006.

flows, and the yield curve. The yield curve is affected by a number of factors, with the largest influence
being the general economy.
4. Summary
The valuation of debt securities is an application of the time value of money mathematics. The key is to
take the bond’s characteristics (i.e., coupon, maturity value) and translate them into inputs for the
financial mathematics.
Bond valuation can get more complicated that what we’ve discussed in this reading because issuers have
a great deal of flexibility in designing these securities, but any feature that an issuer includes in the debt
security is usually just a simple an extension of asset valuation principles and mathematics.

Solutions to Try it!
Bond quotes
Bond Quote Face value Value of bond 8
A 103.45 $1,000 $1,034.50
B 98.00 $1,000 $980.00
C 89.50 $500 $447.50
D 110.00 $100,000 $110,000
E 90.00 €1000 €900,000
F 120.25 ¥10000 ¥12025
G 65.45 $10,000 $6,545
Bond values and yields

Yield to maturity Value of bond Bond quote
5% $1,077.95 107.795
6% $1,000.00 100.00
7% $928.94 92.894
8% $864.10 86.410
Yields to maturity
Bond value Yield to maturity
$1,100 4.733%
$1,000 6.000%
$900 7.435%
$800 9.087%
8
Note that a comma is used in European math conventions, which is different than the U.S. convention of a decimal
place.

Stock valuation
___________________________________________________________
OUTLINE
1. Valuation of common stock

2. Returns on stock
3. Summary
___________________________________________________________
1. Valuation of common stock

"[A] stock is worth the present value of all the dividends ever
to be paid upon it, no more, no less. The purchase of a
stock represents the exchange of present goods for future
goods..."
John Burr Williams, The Theory of Investment Value, p. 80.
When you buy a share of common stock, it is reasonable to figure that what you pay for it should reflect
what you expect to receive from it -- return on your investment. What you receive are cash dividends in
the future. How can we relate that return to what a share of common stock is worth?
The value of a share of stock should be equal to the present value of all the future cash flows you expect
to receive from that share of stock: 1
Price of a First period's dividends Second period's dividends Third period's dividends
...
share of stock 1 2 3
(1 + discount rate) (1 + discount rate) (1 + discount rate)
Because common stock never matures, today's value is the present value of an infinite stream of cash
flows. Another complication is that common stock dividends are not fixed, as in the case of preferred
stock. 2 Not knowing the amount of the dividends -- or even if there will be future dividends -- makes it
difficult to determine the value of common stock.
1
The cash flows that are valued are the cash dividends.
2
Preferred stock’s dividends are generally fixed in amount, yet there remains uncertainty as to whether the dividends
will be paid in the future because they are paid at the discretion of the company’s board of directors.
Stock valuation, a reading prepared by Pamela Peterson Drake 1

Let Dt represent the dividend per share of common stock
expected next period, P0 represent the price of a share of stock Cash dividend v. Stock dividends
today, and re the required rate of return on common stock. The Cash dividends are distributions of cash
required rate of return is the return shareholders demand to to shareholders in proportion to the
compensate them for the time value of money tied up in their ownership interest. We generally
investment and the uncertainty of the future cash flows from report cash dividends on the basis of
these investments. The required rate of return is the opportunity the dividend per share (DPS) (i.e.,
cost of the owners’ capital. dividends divided by earnings available
to shareholders).
The current price of a share of common stock, P0, is:
Stock dividends, which are the
D1 D2 D3 D issuance of additional shares of stock in
P0 ...
(1 re )
proportion to existing holdings, does
(1 re )1 (1 re )2 (1 re )3 not involve cash and does not affect the
value of a share of stock directly. There
which we can write using summation notation,
is some evidence that stock dividends
Dt may provide a signal about the future
P0 . prospects of the company, but in
t
t 1 (1 re ) general stock dividends should not
affect the current value of the stock
So what are we to do? Well, we can grapple with the valuation of other than reducing the stock’s value to
common stock by looking at its current dividend and making reflect the additional shares outstanding
assumptions about any future dividends it may pay. (that is, the shareholder “pie” is now
cut into more pieces after the stock
dividend, though no cash has changed
A. The dividend valuation model hands).
If dividends are constant forever, the value of a share of stock is the present value of the dividends per
share per period, in perpetuity. The summation of a constant amount (that is, if D1 = D2 = … = D= D)
discounted from perpetuity simplifies to:
D
P0 .
re
This is generally the case for a preferred stock and is the case for some common stocks. If the current
dividend is $2 per share and the required rate of return is 10 percent, the value of a share of stock is:
$2
P0 $20 .
0.10
Stated another way, if you pay $20 per share and dividends remain constant at $2 per share, you will
earn a 10 percent return per year on your investment every year. A problem in valuing common stock,
however, is that the amount of cash dividends often changes through time.
If dividends grow at a constant rate, the value of a share of stock is the present value of a growing cash
flow. Let D0 indicate this period's dividend. If dividends grow at a constant rate, g, forever, the present
value of the common stock is the present value of all future dividends is:
D (1 g) D0 (1 g)2 D0 (1 g)3 D (1 g)

P0 0 ... 0
(1 re )1 (1 re )2 (1 re )3 (1 re )
Pulling today's dividend, D0, from each term,

(1 g) (1 g)2 (1 g)3 (1 g)
P0 D0 ...
(1 re )1 (1 re )2 (1 re )3 (1 re )
Using summation notation:

(1 g)t (1 g)
P0 D0 which approaches D0 .
t 1 (1 re )t (re g)
If we represent the next period's dividend, D1, in terms of this period's dividend, D0, compounded one
period at the rate g,
D (1 g) D1
P0 0
(re g) (re g)
3
This equation is referred to as the dividend valuation model (DVM) or the Gordon model.
Consider a firm expected to pay a constant dividend of $2 per share, forever. If this dividend is
capitalized at 10 percent, the value of a share is $20:
$2
P0 $20
0.10
If, on the other hand, the dividends are expected to be $2 in the next period and grow at a rate of 6
percent per year, forever, the value of a share of stock is $50:
$2
P0 $50
(0.10 0.06)
Does this make sense? Yes: if dividends are expected to grow in the future, the stock is worth more than
if the dividends are expected to remain the same. The stock’s price will actually grow at the same rate as
the dividend.
If today's value of a share is $50, what are we saying about the value of the stock next year? If we move
everything up one period, D1 is no longer $2, but $2 grown one period at 6 percent, or $2.12. Therefore,
we expect the price of the stock at the end of one year, P1, to be $53:
$2.12
P1 $53
(0.10 0.06)
At the end of two years, the price will be even larger:
$2.25
P2 $56.18
(0.10 0.06)
3
The model was first presented by Myron J. Gordon in “Dividends, Earnings and Stock Prices,” Review of Economics
and Statistics, May 1959, pp. 99-105.

What is the growth in the price of this stock? From today to the end of one period, the price grew
$53/$50 – 1 = 6 percent. 4 From
the end of the first period to the Exhibit 1: Price per share over time using three different growth
end of the second period, the price rates
grew $56.18/$53 – 1 = 6 percent. D1 = $2
Because we expect dividends to re = 10%
g = 0%, 3%, and 6%
grow each period, we also are
expecting the price of the stock to
grow through time as well. In fact,
the price is expected to grow at the $90 Price with g=6% Price with g=3%
same rate as the dividends: 6 $80
percent per period. For a given Price with g=0%
$70
required rate of return and
dividend -- in this case re = 10 $60
percent and D1 = $2 -- we see that
Value of a $50
the price of a share of stock is share of stock $40
expected to grow each period at
the rate g. $30
We can see this in Exhibit 1, where $20

the price of a stock with a dividend $10
next period of $2 is plotted over
$0
time for three different growth
0 1 2 3 4 5 6 7 8 9 10
rates: 0 percent, 3 percent, and 6
Period into the future
percent.
Example: Dividend valuation model Example: Valuing a preferred share

Problem Problem
The Pear Company has a current dividend If a preferred share has a $25 par value, a
of $3.00 per share. The dividends are dividend rate of 10.25 percent, and a required
expected to grow at a rate of 3% per year rate of return of 8 percent, what is its value?
for the foreseeable future. If the current
Solution
required rate of return on Pear Company
stock is 10 percent, what is the price of a Dividend = D = $25 (0.1025) = $2.5625
share of Pear common stock?
P0 = $2.5625 / 0.08 = $32.03
Solution
Given: D0=$3.00; g = 3%; re=10%
D1 = $3.00 (1 + 0.03) = $3.09
P0 = $3.09 / 0.07 = $44.143
What if the dividends are expected to decline each year? That is, what if g is negative? We can still use
the dividend valuation model, but each dividend in the future is expected to be less than the one before
it. For example, suppose a stock has a current dividend of $5 per share and the required rate of return is
4
Where did this formula come from? Consider FV = PV (1 + i)n. If n = 1, then FV = PV (1+i) and therefore i =
(FV/PV) – 1.

10 percent. If dividends are expected to decline 3 percent each year, what is the value of a share of
stock today? We know that D0 = $5, re = 10%, and g = -3%. Therefore,
$5(1 0.03) $4.85
P0 $37.31
(0.10 0.03) 0.13
Next period's dividend, D1, is expected to be $4.85. We capitalize this at 13 percent: 10% - (-3%) or
10% + 3%. What do we expect the price of the stock to be next period?
$5(1 0.03)2 $4.70

P0 $36.19
(0.10 0.03) 0.13
The expected price goes the same way as the dividend: down 3 percent each year.
B. Valuation of common stock with non-constant dividends

The dividend valuation model captures the valuation of stock whose dividends grow at a constant rate, as
well as the valuation of stock whose dividends do not grow at all (that is, the perpetuity model, with g =
0%). However, dividends may not be either a constant amount or have a constant growth. Dividends are
declared by the company’s board of directors. There is no obligation on the part of the board to pay
dividends of any amount or periodicity. Dividends for a stock may simply not follow any discernable
pattern or may not be paid at all.
We do observe that companies go through a life cycle, with fairly well-defined stages: high growth at the
outset, then maturity, and, perhaps, decline. Accompanying these growth stages, the dividends of some
companies grow not at a constant rate forever, but
rather in stages. Any number of different future growth growth
rate
rates may be appropriate, depending on the company’s
circumstances. g1
To see how to value a stock whose dividends are neither g2
constant or of constant growth, consider a stock whose
dividends grow at two distinct rates: high growth initially
and then maturing. We can use a modification of the
dividend valuation model to capture two stages. In this n time
case, we need to value the dividends that are expected
in the first stage that grow at one rate, g1, and then the
value of the dividends that are expected in the second
stage, that grow at rate g2. If we assume that the second stage is the steady state forever, then the
second stage is analogous to the dividend valuation model; that is, constant growth at g2.
Consider a share of common stock whose dividend is currently $3 per share (that is, D0 = $3) and is
expected to grow at a rate of 4 percent per year for three years (that is, g1 = 4%) and afterward at a
rate of 2 percent per year after five years (that is, g2 = 2%). If the required rate of return is 10 percent,
this becomes:
$3 (1+0.04) $3 (1+0.04)2 $3 (1+0.04)3 $3 (1+0.02)4 $3 (1+0.02)5

P0 ...
(1+0.10)1 (1+0.10)2 (1+0.10)3 (1+0.10)4 (1+0.10)5
which is
$3.12 $3.2448 $3.37459 $3.44208 $3.51093
P0 ...
(1+0.10)1 (1+0.10)2 (1+0.10)3 (1+0.10)4 (1+0.10)5

The present value of dividends received after the third year -- evaluated three years from today -- is the
expected price of the stock in three years, P3, discounted to the present. The expected dividend in the
fourth period, D4, is $3.44208, so the price at the end of the third year is $43.026:
$3.44208
P3 $43.026
(0.10 0.02)
$3.44208
$3.12 $3.2448 $3.37459 (0.10 0.02)
P0
(1+0.10)1 (1+0.10)2 (1+0.10)3 (1 0.10)3
$3.12 $3.2448 $3.37459 $43.026

P0
(1+0.10)1 (1+0.10)2 (1+0.10)3 (1 0.10)3
P0 $2.83636 2.68165 $2.53538 $32.32607 $40.37946
The value of a share of this stock today is $40.37946, which is comprised of the present value of the
dividends in the first three years ($2.83636 +2.68165+2.53538 = $8.05339) and the present value of the
dividends beyond three years, worth $32.32607 today.
The price per share and dividends per share for the first ten years is as follows:
Dividend
per Price per $50 $5
Period share share Price Dividend
$45 $4
0 $3.00 $40.38
1 $3.12 $41.30 $40 $4
2 $3.24 $42.96 $35
3 $3.37 $43.03 $3
4 $3.44 $43.89 Price $30
$3
5 $3.51 $44.76 per $25 DPS
6 $3.58 $45.66 share $2
$20
7 $3.65 $46.57 $2
8 $3.73 $47.50 $15
9 $3.80 $48.45 $10 $1
10 $3.88 $49.42 $1
$5
$0 $0
0 1 2 3 4 5 6 7 8 9 10

Two-stage dividend example: Procter & Gamble, 1991-2005
Dividends per share (DPS) grew at an annual rate around 12-13% in the years 1993 through 2000, and slowed
to 8-9% in the years 2001-04. The growth in dividends increased in 2005, which coincides with substantial
restructuring of the company and the acquisition of Gillette.
$1.03
$1.20
$0.93
$0.82
$0.76
$1.00
$0.70
$0.64
$0.57
$0.80
$0.51
$0.45
$0.40
$0.35
DPS $0.60
$0.31
$0.28
$0.26
$0.24
$0.40
$0.20
$0.00
1991 1993 1995 1997 1999 2001 2003 2005
Fiscal year end
As you can see, the valuation problem for a two-stage growth model is simply an extension of the
financial mathematics that we used to value a stock for with a single growth rate. We can extend this
approach further to cases in which there are three, four, or more different growth stages expected in a
company’s future. 5
5
If there is no discernable pattern in terms of future growth rates, we are left with simply discounted an uneven
series of expected dividends.

Example: Two-stage growth in dividends
Problem
A stock currently pays a dividend of $2 for the year. Expected dividend growth is 20 percent for the
next three years and then growth is expected to revert to 7 percent thereafter for an indefinite amount
of time. The appropriate required rate of return is 15 percent. What is the value of this stock?
Solution
Cash flows:
Period Cash flow
1 CF1 = D1= $2 (1.20) = $2.40
2 CF2 = D2 = $2 (1.20)2 = $2.88
3 CF3 = D3 + P3
D3 = $2 (1.20)3 = $3.456
P3 = $3.69792/(0.15-0.07) = $46.224
CF3 = #3.456 + 46.224 = $49.68

Or, using equations:
$3.69792
$2.40 $2.88 $3.456 (0.15-0.07)
P0 = + + +
(1+0.15)1 (1+0.15)2 (1+0.15)3 (1+0.15)3
P0 =$2.086957 + 2.177694 + 2.272376 + 30.39303
P0 =$36.930057
C. Stock valuation and financial management decisions

We can relate the company’s dividend policy to its stock value using the price-earning ratio in conjunction
with the dividend valuation model.
Let's start with the dividend valuation model with constant growth in dividends:
D1
P0
re g
If we divide both sides of this equation by earnings per share, we can represent the dividend valuation
model in terms of the price-earnings (P/E) ratio:
D1
P0 EPS1 dividend payout ratio

EPS1 re g re g
This tells us the P/E ratio is influenced by the dividend payout ratio, the required rate of return on equity,
and the expected growth rate of dividends. For example, an increase in the growth rate of dividends is
expected to increase the price-earnings ratio. As another example, an increase in the required rate of
return is expected to decrease the price-earning ratio.
Another way of using this information is to estimate the required rate of return that is implied in a stock’s
current price. If we rearrange the last equation to solve for re,

D1
EPS1 D1
re = +g = + g,
P0 P0
EPS1
we see that the required rate of return is the sum of the dividend yield and the expected growth rate.
Proctor & Gamble’s Required Rate of Return

Using the equation:
D1
re = +g
P0
and using current information on the dividend payout or 36 percent, a current dividend of $1.03, a current stock
price of $59.56, and the expected growth rate of dividends of 11 percent, the required rate of return as of February
2006 is estimated as:
re = [$1.03 (1.11)/ $59.56] + 0.11 = ($1.1433 / $59.56) + 0.11 = 0.0192 + 0.11 = 12.92%
Source of data: Yahoo! Finance (stock price) and Mergent Online (dividend per share and earnings per share). The growth rate of
dividends was estimated using the calculated 2004 to 2005 dividend growth rate.
2. Return on stocks
The return on stock is comprised of two components: (1) the appreciation (or depreciation) in the market
price of the stock -- the capital yield -- and (2) the return in the form of dividends, -- the dividend
yield:
Return on stock = Capital yield + Dividend yield.
If the stock does not pay dividends, then the entire return is the capital yield. If, on the other hand, the
return is derived from both the change in the value of the stock and the cash flows from dividends, the
return is more complicated.
A. Return with no dividends

Let's first ignore dividends. The return on common stock over a single period of time (e.g., one year)
where there are no dividends is the change in the stock's price divided by the beginning share price:
End of
period price P1 P0 FV PV
Return on a share of stock =
Beginning of P0 PV
period price
If the period of time in which this spans is more than one year, we can determine the annual return using
time value of money math,
where:
FV = Ending price
PV = Beginning price
n = number of years in the period
The annual return is calculated as:
FV
Annual return on a share of stock = i n
PV

Solving for i gives us the average annual return, which is the geometric average return.
Let's see how this works. At the end of 1990, Multiclops stock TI-83/84 HP10B
was $20 per share, and at the end of 2005 Multiclops stock Using TVM Solver
was $60 a share. The average annual return on Cyclops was: N = 15 20 +/- PV
Return on Multiclops stock, 1990-2005 = PV = -20 40 FV
$60 1 PMT = 0 15 n
15 1 15 3 1 3 15 1 7.599% FV = 40 i/YR
$20
Solve for i
Multiclops stock has an average (that is, geometric average) return of 7.599 percent per year.
B. Return with dividends at the end of the period

If there are no dividends, we simply compare the change in the price of the shares with the original
investment to arrive at the return. However, if there are dividends, we need to consider them as cash
inflows, as well as the change in the share's price, in determining the return. The simplest way to
calculate the return is to assume that dividends are received at the end of the period:
Example: To simplify our analysis, let's ignore our stock broker's commission. Suppose we bought 100
shares of Purple Computer common stock at the end of 2003 at $35.25 per share. We have invested 100
x $35.25 = $3,525 in Purple stock. During 2003, Purple Computer paid $0.45 per share in dividends, so
we earned $45.00 in dividends. If we sold the Purple shares at the end of 2003 for 43 ($43.00 per share,
or $4,300.00 for all 100 shares), what was the return on our investment? It depends on when the
dividends were received. If we assume that the dividends were all received at the end of 2003, our return
is calculated comparing the stock's appreciation and dividends to the amount of the investment:
Return on Purple Computer stock = ($4,300.00 - 3,525.00 + 43.00) / $3,525.00
Return on Purple Computer stock = 0.2321 or 23.21 percent in 1990.
We can break this return into its capital yield (that is, appreciation in the value of the stock) and dividend
yield components:
$4,300-3,525 $43
Return on Purple Computer stock = 21.99% 1.22% 23.21%
$3,525 $3,525
Most of the return on Purple stock was from the capital yield, 21.99 percent -- the appreciation in the
stock's price.
But like most dividend-paying companies, Purple does not pay dividends in a lump-sum at the end of the
year, but rather pays dividends at the end of each quarter. If we want to be painfully accurate, we could
calculate the return on a quarterly basis and then annualize.
Consider the case of the Green Computer company stock. Suppose you buy Green Computer stock at the
end of 2002 for $40 per share. And suppose that Green paid dividends of $2 at the end of 2003, $3 at
the end of 2004, no dividend in 2005, and $2.5 at the end of 2006. And suppose you sell the stock at
the end of 2006 for $50. What is your return on Green Computer stock? To determine this, we first
translate this information into cash flows and then determine the return, the internal rate of return. Be
sure to combine the two cash flows that occur at the end of 2006: $2.50 + $50 = $52.50.
End of period Cash flow
The return is the internal rate of return on this set of cash flows, which is
2002 -$40.00
2003 +$2.00
10.11433 percent.
2004 +$3.00
2005 +$0.00
2006 +$52.50

TI-83/84 HP10B
{2,3,0,52.50} STO listname 40 +/- CFj
You will notice in many cases that the dividend yield is 3 CFj
calculated by simply taking the ratio of the annual 0 CFj
dividend to the beginning period price. The dividend 52.5 CFj
yield quoted in the Wall Street Journal, for example, is IRR
the ratio of next year's expected dividend to today's
share price. Whereas these short-cuts are convenient, remember that the true return should take into
account the time value of money. This is especially important when you are considering large dividends
relative to the stock price or when reinvestment rates are high.
In the preceding example, we assumed that you sold the investment at a specific point in time, realizing
the capital appreciation or depreciation in the investment -- that is, actually getting cash. But we can also
think about a return without actually selling the investment. What if you didn't sell the Purple stock at the
end of 2003? You would receive the dividends for 2003 whether or not you sold the stock at the end of
the year, so you would have the dividend yield of 1.2 percent. Your investment would still have increased
in value during the year, even if you didn't sell it. If you don't sell the Purple stock, you still have a capital
yield for the year, it's just not realized. A capital gain on a stock you haven't sold is what many refer to as
a "paper gain".
You can see that we can compute returns on investments whether or not we have sold them. In the
cases where we do not sell the asset represented in the investment, we compute the capital yield (gain
or loss) based on the market value of the asset at the point of time we are evaluating the investment.
It becomes important to consider whether or not we actually realize the capital yield only when we are
dealing with taxes. We must pay taxes on the capital gain only when we realize it. As long we you don't
sell the asset, we are not taxed on its capital appreciation.
3. Summary
The valuation of common stocks is difficult because you must value a future cash flow stream that is
uncertain with respect to both the amount and the timing. However, understanding that stocks’
dividends exhibit patterns helps us manage the valuation of these securities.
Investors are constantly valuing and revaluing common stocks as expectations about future cash flows
change, whether this is the timing and amount or the uncertainty associated with these expected future
cash flows. Though they may not each have the dividend valuation model, or some variation, in their
head, we assume that they are rational and will value a stock according to the best estimates regarding
the risks and rewards from investing in the stock.

Problem: Two-stage dividend growth
A stock currently pays a dividend of $2 for the year. Expected
dividend growth is 20% for the next three years and then growth
is expected to revert to 7% thereafter for an indefinite amount of
time. The appropriate required rate of return is 15%. What is this
stock’s intrinsic value?
Solution:
D1 D2 D3 P3 D4
P0 where P3
(1 r)1 (1 r)2 (1 r)3 (1 r)3 (r g2 )
D0 (1 g1)3 (1 g2 )
D0 (1 g0 ) D0 (1 g1)2 D0 (1 g1)3 (r g2 )
P0 2
3

(1 r)1
(1 r) (1 r) (1 r)3
$3.69792
$2.40 $2.88 $3.456 (0.15 0.07 )
P0 1
2
3

(1 0.15) (1 0.15) (1 0.15) (1 0.15)3
$46.224
P0 $2.086957 2.177694 $2.272376
1.520875
P0 $2.086957 2.177694 $2.272376 $30.39303
P0 $36.930057
Equity Valuation
Prepared by Pamela P. Peterson, Florida State University
The valuation models

A share of common stock is a perpetual security that derives its value from the future cash flows
that the investor will receive. The future cash flows of a stock are the future dividends:
D1 D2 D
P0 ...
(1 r) (1 r)2
(1 r)
where
P0 =today's price
D t =dividends in period t
r =required rate of return (a.k.a. discount rate)
Because the dividends on common stock are uncertain in amount and timing, this presents a
problem in valuation.
Constant dividend amount
If the dividends are expected to be the same amount each period (D), forever, the value of a
share of stock is the present value of a perpetuity, or:
D
P0
r
The value of a stock today is the present value of all future dividends:
Constant growth in dividends
If dividend grow at a constant rate g, the present value of dividends,

D1 D2 D
P0 ...
(1 r) (1 r)2
(1 r)
is equivalent to the simpler form (a.k.a. dividend valuation mode, DVM, Gordon model):
D1
P0 .
rg
Two-stage growth model
If dividends do not grow at a constant rate forever, but instead are expected to grow at one rate for the
immediate future and another rate from that point on, we must modify the constant growth model to
accommodate the changing growth.
Consider that there are two growth rates,
g1 for n1 periods
g2 thereafter
Therefore, the present value of dividends can be stated as comprised of two parts:
Part 1: Present value of dividends in the first n1 periods
D1 D2 Dn
P0 of dividends from period 1 through period n1 ... 1
(1 r) (1 r)2
(1 r)n1
Part 2: Present value of the dividends beyond n1
D n 1 Dn 2 D
1
1
...
(1 r)1 (1 r)2 (1 r)
(1 r)n1
Because the dividends beyond n1 grow at a constant rate, we can rephrase the latter
equation as:
Dn 1
1
rg
(1 r)n1
Putting the two parts of the present value together, therefore, we have:
Dn 1
1
D1 D2 Dn rg
P0 ... 1
.
(1 r) (1 r)2
(1 r)n1 (1 r)n1
In other words, the present value of a stock with two-stage growth in dividends is equal to the
present value of the individual dividends in the first stage, plus the present value of the price
expected at the end of the first stage. Because:
D
Pn n1 1 ,
1 r-g 2
where Dn 1 = Dn (1 g 2 ) , then
1 1
D1 D2 Dn Pn
P0 ... 1
1
.
(1 r) (1 r)2
(1 r) n 1 (1 r)n1
We can restate the dividends in terms of dividends today, D0, and the two growth rates as:
D0 (1 g1 )n1 (1 g 2 )
D0 (1 g1 ) D0 (1 g1 )2 r g2
P0 ...
(1 r) (1 r)2 (1 r)n1
Examples
Constant dividend
D0=$2
r=5%
D $2
P0 $40
r 0.05
Constant growth
D0=$2
r=5%
g=4%
D1 $2(1.04) $2.08
P0
r g 0.05 0.04 0.01
Two-stage growth
D0=$2
r=5%
g1=10%
g2=2%
n1=3
First, calculate the dividends per share for each period in the first stage and for the first
dividend in the second stage:1
D1=$2(1.10) =$2.20
D2=$2(1.10)2=$2.20(1.10)=$2.42
D3=$2(1.10)3=$2.42(1.10)=$2.662
D4=$2(1.10)3(1.02)=$2.662(1.02)=$2.71524
1Note that the dividend in the fourth period is affected by the dividend growth in the first stage as well as
the dividend growth in the second stage, or D4 = D0 (1 + g1)n1 (1+g2).
Then calculate the present value:2
$2.71524
$2.20 $2.42 $2.662 0.05 0.02
P0
(1 0.05) (1 0.05)2 (1 0.05)3 (1 0.05)3
$2.20 $2.42 $2.662 $90.508

P0
(1 0.05) (1 0.05)2 (1 0.05)3 (1 0.05)3
P0 $2.09524 $2.19501 $2.29954 $78.18421
P0 $84.774
The project dividends corresponding to each of the three models in the example are shown
below:
$5.0 Constant dividend

$4.5 Constant dividend growth of 4%
Two-stage growth (first stage = 10%, second stage = 2%)
$4.0
$3.5
$3.0
Dividend
per $2.5
share
$2.0
$1.5
$1.0
$0.5
$0.0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Years from today
2 You will notice that once we have calculated the future dividends and future price, we are solving for the
present value of uneven cash flows. If you are using a financial calculator to solve for the present value
(i.e., the NPV, the three relevant cash flows are: $2.20. $2.42, $93.17, because the two cash flows of
$2.662 (i.e., D3) and $90.508 (i.e., P0) occur at the same time (i.e., the end of the third period).
Valuation practice problems
Asset valuation
1. Consider an investment that promises cash flows of $4,000 at the end of two years and
$5,000 at the end of three years. If your required rate of return on this investment is 10%,
what is the value of this investment?
2. Consider an investment that promises cash flows of $3,000 at the end of the first year and
$2,000 at the end of the second year. If you pay $4,500 for this investment, what is your
return on your investment?
3. What is the value at the end of 2005 of the following set of cash flows if the discount rate is
6%?
End of year Cash flow

2006 $10,000
2007 $0
2008 $4,000
2009 $5,000
Stock valuation
1. If the required rate of return on a common stock were to increase, what would you expect to
happen to the price of a share of the stock (assuming no other changes)?
2. Calculate the price of a share of stock for each company, given the information regarding
dividends, the growth rate of dividends, and the required rate of return:
Current dividend Expected growth Required rate

Company
per share rate of dividends of return
Company 1 $2.00 5% 10%
Company 2 $3.00 3% 7%
Company 3 $5.00 2% 6%
Company 4 $2.25 0% 8%
Company 5 $2.00 -5% 6%
3. Interview, Inc. paid dividends of $0.055 per share in 2004. In 2008, Interview paid dividends
of $0.09 per share. What was the average annual growth rate of Interview's dividends from
2004 to 2008?
Bond valuation
1. Consider a bond that has ten years remaining to maturity, a 10% coupon (interest paid semi-
annually), and a maturity value of $1,000.
a. If the yield on the bond is 10%, what is the value of the bond today?
b. If the yield on the bond is 8%, what is the value of the bond today?
c. If the yield on the bond is 12%, what is the value of the bond today?
2. The XYZ bond has a maturity value of $1,000 and a 10% coupon, with interest paid semi-
annually.
a. If there are five years remaining to maturity and the bonds are priced to yield 8%,
what is the bond's value today?
b. If there are five years remaining to maturity and the bonds are priced to yield 10%,
c. If there are five years remaining to maturity and the bonds are priced to yield 12%,
3. What is the value of a zero-coupon bond that has five years remaining to maturity and has a
yield-to-maturity of:
a. 6%?
b. 8%?
c. 10%?
Solutions to Valuation practice problems
Prepared by Pamela Peterson-Drake
Asset valuation
1. Value = $4,000 / (1 + 0.10)2 + $5,000 / (1 + 0.10)3

Value = $3,305.79 + 3,756.57
Value = $7,062.36
TI-83/84 HP10B
{0,4000,5000} STO listname 0 CFj
NPV(10,0,listname) 0 CFj
4000 CFj
5000 CFj
10 i/YR
NPV
2. Return = 7.869%
TI-83/84 HP10B
{3000,2000} STO listname 4500+/- CFj
2000 CFj
IRR
3. Value = $16,752.91
TI-83/84 HP10B
{10000,0,4000,5000} STO listname 0 CFj
NPV(6,0,listname) 10000 CFj
0 CFj
4000 CFj
5000 CFj
6 i/YR
NPV
Stock valuation
1. If re increases, the value of a share of stock would decrease. Note the relation between
the price and re: P = D1 / re - g
2.
Company D0 g re D1 P0
Company 1 $2.00 5% 10% $2.10 $2.10/0.05 = $42
Company 2 $3.00 3% 7% $3.09 $3.09 / 0.04 = $77.25
Company 3 $5.00 2% 6% $5.10 $5.10 / 0.04 = $127.50
Company 4 $2.25 0% 8% $2.25 $2.25 / 0.08 = $28.125
Company 5 $2.00 -5% 6% $1.90 $1.90 / 0.11 = $17.27
3. Given:
PV = $0.055
FV = $0.090
n=4
Solve for i
i = g = 13.10%
Bond valuation
1. Given:
M = $1,000
C = 10% x $1,000 x 0.5 = $50
N = 10 x 2 = 20
a. rd = 5%; V = $1,000.00 [bond quote = 100]

b. rd = 4%; V = $1,135.90 [bond quote = 113.59]
c. rd = 6%; V = $885.30 [bond quote = 88.53]
2. Given:
M = $1,000
N = 10
C = $50
a. rd = 4%; V = $1,081.11 [bond quote = 108.11]

b. rd = 5%; V = $1,000.00 [bond quote = 100]
c. rd = 6%; V = $926.40 [bond quote = 92.64]
3. Given:
M = $1,000
N = 10
a. rd = 3%; V = $744.09 [bond quote = 74.409]

b. rd = 4%; V = $675.56 [bond quote = 67.556]
c. rd = 5%; V = $613.91 [bond quote = 61.391]
Valuation StudyMate Activity, Pamela Peterson Drake Page 1 of 2
Valuation StudyMate Activity
Fact Cards
Fact Cards Plus
Flash Cards
Pick a Letter
Fill In The Blank
Matching
Crosswords
Quiz
Challenge
Glossary
Valuation StudyMate Activity, Pamela Peterson Drake Page 2 of 2

Fact Cards javascript:launchSWFmod4('?gm=FactCards&ds=ALL&sk=wct&arg=t')
Fact Cards Plus javascript:launchSWFmod4('?gm=FactCardsPlus&ds=ALL&sk=wct&arg=t')
Practice problems

Interactive, online activities that provide a review of the Traditional problem sets, with solutions, along
material for specified topics. Activities include crossword with other types of material (e.g., printable
puzzles, fill-in the blanks, flashcards, and quizzes. crossword puzzles, practice tests).

Practice problems
| Capital structure

Risk and return
Problems
Solutions

Solutions
Solutions
crossword puzzle
Shortcut
Internet Address
Text
Financial
ratios
Time value of
money
Risk and
return
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budgeting
Capital
structure
Using
Financial
Accounting
Information
Accounting
Review
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Puzzle
Tax-rate
schedules
Taxes: Sale
of assets
Practice
Taxation
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loss problems
Financial
Problems
Financial
Formulas
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of Money
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Problems
More Time
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Text
Value of
Money
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values
Uneven cash
flows
Interpreting
problems
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Problems
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Loan
Amortization:
Example and
Explanation
Deferred
Annuity
Example and
Explanation
Calculator
assistance
Time Value
tables
Valuation
problems
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quiz
Two-stage
growth
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Text
practice
Problems
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valuation
Bond
valuation
practice
problems
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problems
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return
practice
problems
More risk and
return
practice
problems
Risk
problems
Risk-return
problem
Risk and
return
crossword
puzzle
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budgeting
practice
problems
Goofy
Gadget
Gooferizer
Project
B. B. Dome
Project
Shortcut
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Text
Rockafellar
Company
5-minute
Work-out --
budgeting
techniques
Capital
budgeting
practice
Problems
Capital
Practice Test
Capital
budgeting
practice
problems
Capital
structure
practice
problems
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capital
practice
problems
Capital
structure and
crossword
puzzle
Module 5, Peterson Drake, Page 1 of 2
Module 5: Risk and Return

Elements
1. Module 5: Risk and return IMPORTANT: READ FIRST
2. Reading: Types of risk
3. Reading: Measuring risk
4. Reading: Risk, return, and diversification
5. Risk formulas
6. Explanation: Portfolio risk A detailed demonstration of the estimation of portfolio risk
7. Problem set: Risk and return practice problems and Solutions
8. Risk and Return StudyMate Activity
Module 5, Peterson Drake, Page 2 of 2

Module 5: Risk and return http://educ.jmu.edu/~drakepp/principles/module5/learning_outcomes.pdf
Types of risk http://educ.jmu.edu/~drakepp/principles/module5/riskreturn.pdf
Measuring risk http://educ.jmu.edu/~drakepp/principles/module5/riskreturn_measure.pdf
Risk, return, and diversification http://educ.jmu.edu/~drakepp/principles/module5/riskreturn2.pdf
Risk formulas http://educ.jmu.edu/~drakepp/principles/module5/rrformulas.pdf
Portfolio risk http://educ.jmu.edu/~drakepp/principles/module5/portfolio_risk.pdf
Risk and return practice
problems
Risk and Return StudyMate
http://www.fau.edu/~ppeter/fin3403/module5/mod5.htm
Activity
MODULE 5:
RISK AND RETURN
OUTLINE
1. Introduction
3. Module tasks
4. Module overview and discussion
1. Introduction
Financial managers must often make decisions regarding the benefits and costs associated
with an investment. We capture the benefits and costs in valuation: determining what an
investment is worth today and comparing this to the cost of the investment. An important
component in the valuation process is the discount rate, which reflects the risk associated
with the investment: the greater the risk, the greater the discount rate.
One of the tasks of a financial manager is identifying the different sources of risk. There are
many types of risk; we discuss and demonstrate several types of risk in this module. Another
task is to quantify risk. A financial manager must compare different investment projects to
determine which, if any, provide the appropriate return for the associated risk. To accomplish
this, the financial manager must measure this risk. In this module, we detail several
different measures of risk.
An important dimension to risk is diversification. Diversification is the reduction in risk from
investing in assets whose cash flows are not perfectly correlated. Every business invests in
many different assets: buildings, machinery, current assets, intangibles, etc. There is risk
associated with the cash flow uncertainty of each asset. If we consider these assets as a
whole – that is, as a portfolio – the risk of the business is the pooled risk of these
investments, considering the effects of diversification.
The purpose of this reading is to introduce you to the different types of risk that a financial
manager faces. In addition, you are introduced to the measurement of risk and the
diversification and portfolio effects of risk.
LO5.1 List and explain different types of risk that a financial manager faces, including cash
flow risk, interest rate risk, reinvestment rate risk, and purchasing power risk.
LO5.2 Explain how leverage affects the volatility of operating income and net income, using
the concepts of the degrees of operating, financial, and total leverage.
LO5.3 Explain how risk aversion affects financial decision-making.
Module 5 Overview 1
LO5.4 Construct a measure of risk using a probability distribution.
LO5.5 Identify the role of correlation in the evaluation of risk.
LO5.6 Explain how the concept of a portfolio and diversification affects financial decision-
making.
LO5.7 Calculate a portfolio’s risk for a 2-asset portfolio.
LO5.8 Identify the role of the CAPM in identifying the relevant risk of an asset
LO5.9 Use the CAPM model to estimate the return on an asset.
3. Module tasks
A. Readings
i Required reading
(a) Types of risk
(b) Measuring risk
(c) Risk, return, and diversification
ii Other resources
(a) Defining risk, by Glyn Holton, Financial Analysts Journal, Vol. 60, No. 6,
2004. Historical background on risk and its definitions.
(b) Portfolio theory, presented by Riskglossary.com.
(c) Risk formulas
Fabozzi and Peterson text, Chapter 10 (Risk and Expected Returns) and Chapter
9, pp. 211-245 (Valuation of Securities and Options), available through
NetLibrary at Florida Atlantic University’s Libraries.
B. Problem sets
Risk and return practice problems and solutions
Risk and return practice problems
Risk-Return problem
Risk and return crossword puzzle (non-interactive)
C. Achievements
1. Module quiz. Complete the online quiz by March 28th. This quiz consists of ten
questions. The guidelines of this quiz are the same as all other graded quizzes in this
course:
a. The Honor Code applies. You are permitted to use all materials at hand, but you
are not permitted the assistance of any person.
Module 5 Overview 2
b. There is no backtracking allowed. Once you answer a question, you are not
permitted to go back to check your work or change your answer.
c. You must complete the quiz within the time permitted. The time limit for this
quiz is 75 minutes. Failure to complete the quiz within the time frame may result
in the loss of credit for the quiz.
2. Assignment 2. Begin the analysis needed for Assignment 2. Assignment 2 is due April
26th.

A. Types of risk
Every financing and investment decision has some uncertainty about its outcome. This
uncertainty affects the valuation because the more uncertain a future cash flow, the less
valuable it is today. There is many forces that affect the uncertainty associated with
investment and financing, including unanticipated changes in laws, consumer demand, the
economy, and interest rates. Risk is the degree of uncertainty. In financing and investment
decisions there are many types of risk we must consider. In this reading, we address cash
flow risk, reinvestment rate risk, interest rate risk and purchasing power risk. We also
address the tendency for individuals to be risk averse, which affects how risk is incorporated
into financial decision-making.
B. Risk measurement
When we make financial decisions, we must evaluate the benefits and the costs associated
with the decision. When we assess the benefits and costs, however, we must also
understand the uncertainty associated with the possible outcomes of the investments. The
purpose of this reading is to develop a method of measuring risk in order to make it easier to
incorporate risk into the decision-making process.
C. Risk, return, and diversification

All businesses can be viewed as a collection of different investments, made at different points
in time. We refer to a collection of investments as a portfolio. While we usually think of a
portfolio as a collection of securities (stocks and bonds), we can also think of a business in
much the same way -- a portfolios of assets such as buildings, machinery, inventories,
patents, et cetera. As managers, we are concerned about the overall risk of the firm's
portfolio of assets.
In this reading, we develop the concepts of diversification and how this affects a portfolio’s
risk. We also discuss asset pricing models, specifically the capital asset pricing model and
the arbitrage pricing model, which help us focus on the risk that is most relevant for financial
decision-making.
D. What’s next?
In this module, we’ve focused on risk: what it is, how we measure it, and how it relates to
diversification. In our next module, we bring together the time value of money, financial
statement information, and our understanding of risk to develop the tools to evaluate capital
projects.
Module 5 Overview 3
Types of risk
OUTLINE
1. Risk
2. Cash Flow Risk
3. Reinvestment Rate Risk
4. Interest rate risk
5. Purchasing Power Risk
6. Returns and the tolerance for bearing risk
7. Summary
1. Risk
"Risk is a most slippery and elusive concept. It's hard for investors
-- let alone economists -- to agree on a precise definition,"
Burton G. Malkiel, A Random Walk Down Wall Street, 1985, p. 187.
With any financing or investment decision, there is some uncertainty about its outcome. Uncertainty is
not knowing exactly what will happen in the future. There is uncertainty in most everything we do as
financial managers because no one knows precisely what changes will occur in such things as tax laws,
consumer demand, the economy, or interest rates. Though the terms "risk" and "uncertainty" are many
times used to mean the same, there is a distinction between them. Uncertainty is not knowing what's
going to happen.
Risk is how we characterize how much uncertainty exists: the greater the uncertainty, the greater the
risk. Risk is the degree of uncertainty. In financing and investment decisions there are many types of risk
we must consider.
"October: This is one of the particularly
The types of risk a financial manager faces include: dangerous months to invest in stocks.
cash flow risk; Other dangerous months are July,
January, September, April, November,
reinvestment risk;
May, March, June, December, August
interest rate risk; and
and February."
purchasing power risk.
- Mark Twain
Let's take a look at each of these types of risk.
2. Cash flow risk

Cash flow risk is the risk that the cash flows of an investment will not materialize as expected. For any
investment, the risk that cash flows may not be as expected -- in timing, amount, or both -- is related to
the investment's business risk.
Types of risk, a reading prepared by Pamela Peterson Drake 1

A. Business risk
Business risk is the risk associated with operating cash flows. Operating cash flows are not certain
because neither are the revenues nor expenditures comprising the cash flows. Regarding revenues:
depending on economic conditions and the actions of competitors, prices or quantity of sales (or both)
may be different from what is expected. This is sales risk.
Regarding expenditures: operating costs are comprised of fixed costs and variable costs. The greater the
fixed component of operating costs, the less easily a company can adjust its operating costs to changes
in sales.
Business Risk
The mixture of fixed and variable
costs depends largely on the type
of business. For example, fixed Sales Risk Operating Risk
operating costs make up a large portion of an airline's operating costs: no matter how many passengers
are flying, the airline still needs to pay gate fees, pay a pilot, and buy fuel. The variable costs for an
airline -- the costs that change depending on the number of passengers -- amount to a little bit of fuel
and the cost of the meal (which can't be much!).
Even within the same line of business, companies can vary their fixed and variable costs. For example, an
airline could develop a system that allows it to vary the number of cabin stewards and baggage handlers
according to passenger traffic, varying more of its operating costs as demand changes. We refer to the
risk that comes about from the mix of fixed and variable costs as operating risk. The greater the fixed
operating costs, relative to variable operating costs, the greater the operating risk.
Let's take a look at how operating risk affects cash flow risk. Remember back in economics when you
learned about elasticity? That's a measure of the sensitivity of changes in one item to changes in another.
We can look at how sensitive a firm's operating income are to changes in demand, as measured by unit
sales. We'll calculate the operating income elasticity, which we call the degree of operating leverage
(DOL).
The degree of operating leverage is the ratio of the percentage change in operating cash flows to the
percentage change in units sold. Let's simplify things and assume that we sell all that we produce in the
same period. Then,
Degree of percentage change in operating income
= DOL =
operating leverage percentage change in units sold
Suppose the price per unit is $30, the variable cost per unit is $20, and the total fixed costs are $5,000. If
we go from selling 1,000 units to selling 1,500 units, an increase of 50 percent of the units sold,
operating cash flows change from:
Item Selling 1,000 Selling 1,500
units units
Revenues $30,000 $45,000
less variable costs 20,000 30,000
less fixed costs 5,000 5,000
Operating income $ 5,000 $10,000
Operating income doubled when units sold increased by 50 percent. What if the number of units
decreases by 25 percent, from 1,000 to 750? Operating income declines by 50 percent. What is
happening is that for a 1 percent change in units sold, the operating income changes by two

times that percentage, in the same direction. If units sold increased by 10 percent, operating cash flows
would increase by 20 percent; if units sold decreased by 10 percent, operating income would decrease by
20 percent.
We can represent the degree of operating leverage in terms of the basic elements of the price per unit,
variable cost per unit, number of units sold, and fixed operating costs. Operating income is:
Operating price
number of
variable cost
number of
fixed operating

income per unit units sold per unit units sold costs
How much does operating income change
when the number of units sold changes? Exhibit 1: The degree of operating leverage for different
It changes by the difference between the number of units produced and sold
price per unit and the variable cost per P = $30; V = $20; F = $5,000
unit -- called the contribution margin --
times the change in units sold. The
8
percentage change in operating cash
6
flows for a given change in units sold
4
simplifies to:
2
DOL
Q(P-V) 0
DOL= , -2
Q(P-V)-F
-4
where Q is the number of units, P is the -6
100
400
700
1,000
1,300
1,600
1,900
2,200
2,500
2,800
price per unit, V is the variable operating
cost per unit, and F is the fixed operating
cost. Therefore, P-V is the contribution Number of units produced and sold
margin per unit.
Applying the formula for DOL using the
data in the example, we can figure out the sensitivity to change in units sold from 1,000 units:
1,000 ($30-20) $10, 000
DOL @ 1,000 units = 2
1,000 ($30-20)-5,000 $5, 000
The DOL of 2.0 means that a 1 percent change in units sold results in a 1 percent x 2.0 = 2 percent
change in operating income.
Why do we specify that the DOL is at a particular quantity sold (in this case 1,000 units)? Because the
DOL will be different at different numbers of units sold. For example, at 2,000 units,
2,000 ($30-20)
DOL @ 2,000 units = 1.333
2,000 ($30-20)-5,000
We can see the sensitivity of the DOL for different number of units produced and sold in Exhibit 1. When
operating profit is negative, the DOL is negative. At the break-even number of units produced and sold
of 500, the DOL is undefined because 500 ($30-20) – $5,000 = $0. The DOL gradually declines when
there is a profit as more units are produced and sold.
Let's look at similar situation, but where the firm has shifted some of the operating costs away from fixed
costs and into variable costs. Suppose the firm has a unit sales price of $100, a variable cost of $70 a
unit, and $10,000 in fixed costs. A change in units sold from 1,000 to 1,500 -- a 50 percent change --
changes operating profit from $20,000 to $35,000, or 75 percent.
The DOL in this case is 1.5:
1,000 ($100-70)
DOL @ 1,000 units = 1.5
1,000 ($100-70)-10,000

and the change in operating income is 75 percent:
Percentage change percentage change
DOL 1.5 (50%) 75%

in operating income in units sold
But what if, instead, the company is able to reduce fixed costs, shifting some to variable costs? Suppose
the fixed costs are now $5,000 and the variable costs are $80 per unit. The DOL at 1,000 units is now
1.33 and the percentage change in operating income is 1.33 (50 percent) = 66.5 percent. We can see
the difference in the leverage in these two cases, labeled Case 1 and Case 2, respectively, in Exhibit 2.
Exhibit 2: Profitability and the degree of operating leverage

Case 1: P = $100; V = $70; F = $10,000
Case 2: P = $100; V = $80; F = $5,000
Panel A: Operating income Panel B: DOL
$60,000 8
Case 1 Case 1
6
$50,000 Case 2
4
$40,000 Case 2 2
Operating $30,000 0
DOL
income $20,000 -2
-4
$10,000 -6
$0 -8
-$10,000 -10
100
300
500
700
900
1,100
1,300
1,500
1,700
1,900
100
300
500
700
900
1,100
1,300
1,500
1,700
1,900
Number of units produced and sold Number of units produced and sold
What we see in this latter example is what we saw a bit earlier in our reasoning of fixed and variable
costs: the greater use of fixed, relative to variable operating costs, the more sensitive operating income is
to changes in units sold and, therefore, more operating risk.
Both sales risk and operating risk influence a firm's operating cash flow risk. And both sales risk and
operating risk are determined in large part by the type of business the firm is in. But management has
more opportunity to manage and control operating risk than they do sales risk.
Suppose a firm is deciding on which equipment to buy to produce a particular product. The sales risk is
the same no matter what equipment is chosen to produce the product. But the available equipment may
differ in terms of fixed and variable operating costs of producing the product. Financial managers need to
consider the operating risk associated with their investment decisions.
B. Financial risk
When we refer to the cash flow risk of a security, we expand our concept of cash flow risk. A security
represents a claim on the income and assets of a business, therefore the risk of the security is not just
the risk of the cash flows of the business, but also the risk related to how these cash flows are distributed
among the claimants -- the creditors and owners of the business. Therefore, cash flow risk of a security
includes both its business risk and its financial risk.
Financial risk is the risk associated with how a company finances its operations. If a company finances
with debt, it is a legally obligated to pay the amounts comprising its debts when due. By taking on fixed
obligations, such as debt and long-term leases, the firm increases its financial risk. If a company finances
its business with equity, either generated from operations (retained earnings) or from issuing new equity,

it does not incur fixed obligations. The more fixed-cost obligations (debt) incurred by the firm, the
greater its financial risk.
We can quantify this risk somewhat in the same way we did for operating risk, looking at the sensitivity
of the cash flows available to owners when operating cash flows change. This sensitivity, which we refer
to as the degree of financial leverage (DFL), is:
Percentage change in net income
DFL= ,
Percentage change in operating income
Net income is equal to operating income, less interest and taxes. If operating income changes, how does
net income change? Suppose operating cash flows change from $5,000 to $6,000 and suppose the
interest payments are $1,000 and, for simplicity and wishful thinking, the tax rate is 0 percent:
Operating Operating
income of income of
$5,000 $10,000
Operating income $ 5,000 $ 6,000
Less interest 1,000 1,000
Income before taxes $ 4,000 $ 5,000
Less tax (40 percent) 1,600 2,000
Net income $2,400 $3,000
A change in operating income from $5,000 to $6,000, which is a 20 percent increase, increases income
before taxes by $1,000 and net income by $600 – each a 25 percent increase.
What if, instead, our fixed financial costs are $3,000? A 20 percent change in operating income results in
a 50 percent change in the net income from $1,200 to $1,800. Using more debt financing, which results
in more interest expense, increases the sensitivity of owners' income.
Operating Operating
income of income of
$5,000 $10,000
Operating income $ 5,000 $ 6,000
less interest 3,000 3,000
Income before taxes $ 2,000 $ 3,000
Less tax (40 percent) 800 1,200
Net income $1,200 $1,800
We can write the sensitivity of owners' cash flows to a change in operating income, continuing the
notation from before and including the fixed financial cost, I, as:
[Q(P-V)-F](1-t) [Q(P-V)-F]
DFL=
[Q(P-V)-F-I](1-t) [Q(P-V)-F-I]
In the case where:

Number of units sold = Q = 1,000
Price per unit = P = $30
Variable cost per unit = V = $20
Fixed operating costs = F = $5,000
Fixed financing costs = I = $1,000
1,000($30-20) - $5,000 $5, 000
DFL@1,000 units= 1.25
1,000($30-20) - 5,000 $1, 000 $4, 000
If fixed financial costs are $3,000, the DFL is equal to 2.5:

1,000 ($30-20) - 5,000 $5, 000
DFL@1,000 units= 2.5
1,000 ($30-20) - 5,000 3, 000] $2, 000
Again, we need to qualify our degree of leverage by the level of production since DFL is different at
different levels operating income.
The greater the use of financing sources that require fixed obligations, such as interest, the greater the
sensitivity of cash flows to owners to changes in operating cash flows.
C. Operating and financial risk

The degree of operating leverage gives us an idea of the sensitivity of operating cash flows to changes in
sales. And the degree of financial leverage gives us an idea of the sensitivity of owners' cash flows to
changes in operating cash flows. But often we are concerned about the combined effect of both
operating leverage and financial leverage. Owners are concerned about the combined effect because
both contribute to the risk associated with their future cash flows. And financial managers, making
decisions to maximize owners' wealth, need to be concerned with how investment decisions (which affect
the operating cost structure) and financing decisions (which affect the capital structure) affect owners'
risk.
Let's look back on the example using fixed operating costs of $5,000 and fixed financial costs of $1,000.
The sensitivity of owners' cash flow to a given change in units sold is affected by both operating and
financial leverage. Consider increasing the units sold up 50 percent. If there was no interest (and
therefore no financial leverage), the owners' cash flow would equal operating cash flow. Then a 50
percent increase in units sold would result in a 100 percent increase in cash flows to owners. Now
consider decreasing units sold by 50 percent. This would result in a 100 percent decrease in cash flows to
owners. But if there is financial leverage, this leverage exaggerates the effect of operating leverage.
Consider again the case where there is $1,000 of interest:
Units produced and sold
1,000 1,500 500
Revenues $30,000 $45,000 $15,000
less variable costs 20,000 30,000 10,000
less fixed costs 5,000 5,000 5,000
Operating income $5,000 $ 10,000 $0
less interest 1,000 1,000 1,000
Income before tax $4,000 $9,000 -$1,000
less tax 1,600 3,600 -400
Net income $2,400 $5,400 -$600
If units sold increases by 50 percent, from 1,000 to 1,500 units,
operating income increases from $5,000 to $10,000, or 100 percent, and
net income increases from $2,400 to $5,400, or 125 percent.
If units sold decrease by 50 percent, from 1,000 to 500 units,
operating income decreases from $5,000 to $0, or 100 percent, and
net income decreases from $2,400 to -$600, or 125 percent.
Combining a firm's degree of operating leverage with its degree of financial leverage results in the
degree of total leverage (DTL), a measure of the sensitivity of the cash flows to owners to changes in
unit sales:
% change in net income
DTL=
% change in the number of units sold and produced

and which is also equal to:
Q(P-V) [Q(P-V)-F](1-t) Q(P-V)
DTL= = DOL x DFL.
Q(P-V)-F [Q(P-V)-F-I](1-t) Q(P-V)-F-I
Suppose:
Number of unit sold = Q = 1,000
Price per unit = P = $30
Variable cost per unit = V = $20
Fixed operating cost = F = $5,000
Fixed financing cost = I = $1,000
Then,
1,000($30-$20)
DTL= 2.5
1,000($30-$20)-$5,000-$1,000
which we could also have gotten from multiplying the DOL, 2, by the DFL, 1.25. This means that a 1
percent increase in units sold will result in a 2.5 percent increase in net income; a 50 percent increase in
units sold results in a 125 percent increase in net income; a 5 percent decline in units sold results in a
12.5 percent decline in income to owners; and so on. We can see the DOL, DFL and DTL for different
number of units produced and sold for this example in Exhibit 3.
Exhibit 3: Degrees of operating, financial and total leverage
for different number of units produced and sold In the case of operating leverage, the
fixed operating costs act as a fulcrum:
the greater the proportion of operating
P = $30
V = $20 costs that are fixed, the more sensitive
F = $5,000 are operating cash flows to changes in
I = $1,000 sales. In the case of financial leverage,
the fixed financial costs, such as
interest, act as a fulcrum: the greater
8
the proportion of financing with fixed
6 DOL DFL DTL cost sources, such as debt, the more
Degree 4 sensitive cash flows available to
owners are to changes in operating
2 cash flows.
0
Combining the effects of both types of
100
300
500
700
900
1100
1300
1500
1700
1900
leverage, we see that fixed operating

Number of units produced and sold and financial costs together act as a
fulcrum that increases the sensitivity of
cash flows available to owners.

Try it! DOL, DFL and DTL
Consider a company that manufacturers and sells a single product, the X product. It costs the company €1 per unit
of X in variable costs. Fixed operating costs are €30,000. The company also has fixed financial costs of €10,000.
The company expects to sell each unit of X for €5. Complete the following chart:
Production DOL DFL DTL Operating profit Net profit
15,000
20,000
30,000
40,000
Solutions are available at the end of this reading.
D. Default risk
When you invest in a bond, you expect interest to be paid (usually semi-annually) and the principal to be
paid at the maturity date. But not all interest and principal payments may be made in the amount or on
the date expected: interest or principal may be late or the principal may not be paid at all! The more
burdened a firm is with debt -- required interest and principal payments -- the more likely it may be
unable to make payments promised to bondholders and the more likely there may be nothing left for the
owners. We refer to the cash flow risk of a debt security as default risk or credit risk.
Technically, default risk on a debt security depends on the specific obligations comprising the debt.
Default may result from:
failure to make an interest payment when promised (or within a specified period),
failure to make the principal payment as promised,
failure to make sinking fund payments (that is, amounts set aside to pay off the obligation), if
these payments are required,
failure to meet any other condition of the loan, or
bankruptcy.
Why do financial managers need to worry about default risk?
Because they invest their firm's funds in the debt securities of other firms and they want to know
what default risk lurks in those investments;
Because they are concerned how investors perceive the risk of the debt securities their own firm
issues; and
Because the greater the risk of a firm's securities, the greater the firm's cost of financing. We can see this
in Exhibit 4, where we show the yields on Aaa and Baa-rated bonds over the period 1919-2005. 1 Aaa-
rated bonds have less default risk than Baa-rated bonds, and hence have lower yields. You may notice a
wider spread between the Aaa and Baa-rated bond yields during the depression and in recessionary
periods.
1
These yields are for bond ratings by Moody’s Investor Service. The equivalent Standard & Poor’s
ratings are AAA and BBB.

Exhibit 4: Yields on bonds with different levels of default risk, 1919-2005
20%
18%
16%
Aaa Baa
14%
12%
Percent 10%
8%
6%
4%
2%
0%
1919-01-01
1921-01-01
1923-01-01
1925-01-01
1927-01-01
1929-01-01
1931-01-01
1933-01-01
1935-01-01
1937-01-01
1939-01-01
1941-01-01
1943-01-01
1945-01-01
1947-01-01
1949-01-01
1951-01-01
1953-01-01
1955-01-01
1957-01-01
1959-01-01
1961-01-01
1963-01-01
1965-01-01
1967-01-01
1969-01-01
1971-01-01
1973-01-01
1975-01-01
1977-01-01
1979-01-01
1981-01-01
1983-01-01
1985-01-01
1987-01-01
1989-01-01
1991-01-01
1993-01-01
1995-01-01
1997-01-01
1999-01-01
2001-01-01
2003-01-01
2005-01-01
Month
Source: Board of Governors of the Federal Reserve System, Series H.15 Selected Interest Rates
Default risk is affected by both business risk - which includes sales risk and operating risk -- and financial
risk. We need to consider the effects operating and financing decisions have on the default risk of the
securities a firm issues, since the risk accepted through the financing decisions affects the firm's cost of
financing.
3. Reinvestment rate risk

Another type of risk is the uncertainty associated with reinvesting cash flows, not surprisingly called
reinvestment rate risk.
Suppose you buy a U.S. Treasury Bond that matures in five years. There is no default risk, since the U.S.
government could simply print more money to pay the interest and principal. Does this mean there is no
risk when you own a Treasury bond? No. You need to do something with the interest payments as you
receive them and the principal amount when it matures. You could stuff them under your mattress,
reinvest in another Treasury bond, or invest them otherwise. If yields have been falling, however, you
cannot reinvest the interest payments from the bond and get the same return you are getting on the
bond.
From the time that you bought the Treasury bond until its maturity five years later, yields on investments
may have changed. While the yield on the mattress option hasn't changed (it's still 0 percent), the yields
on other investments may have changed. When your Treasury bond matures, you face reinvestment risk.
If we look at an investment that produces cash flows before maturity or sale, such as a stock (with
dividends) or a bond (with interest), we face a more complicated reinvestment problem. In this case
we're concerned with the reinvestment of the final proceeds (at maturity or sale), but also with the
reinvestment of the intermediate dividend or interest cash flows (between purchase and maturity or
sale).
Let's look at the case of a five-year bond issued by Company Y, that pays 10 percent interest (at the end
of each year, to keep things simple), and has a par value of $1,000. This bond is a coupon bond; that is,

interest is paid at the coupon rate of 10 percent per year, or $100 per bond. If you buy the bond when it
is issued at the beginning of 2005 and hold it to maturity, you will have the following cash flows:
Company One Bond
Date Cash flow
January 1, 2005 -$1,000.00
December 31, 2005 100.00
December 31, 2006 100.00
December 31, 2007 100.00
December 31, 2008 100.00
December 31, 2009 1,100.00
You face five reinvestment decisions along the life of this bond: the four intermediate flows at the end of
each year, and the last and largest cash flow that consists of the last interest payment and the par value.
Suppose we wish to compare the investment in the Company One bond with another five-year bond,
issued by Company Two, that has a different cash flow stream, but a yield that is nearly the same.
Company Two's bond is a zero-coupon bond; that is, it has no interest payments, so the only cash flow to
the investor is the face value at maturity:
Company Two bond
Date Cash Flow
January 1, 2005 - $1,000.00
December 31, 2009 +$1,610.51
Both bonds have the same annual yield-to-maturity of 10 percent. If the yield is the same for both bonds,
does this mean that they have the same reinvestment rate risk? No. Just from looking at the cash flows
from these bonds we see there are intermediate cash flows to reinvest from Company One's bond, but
not from Company Two's bond.
Let's see just how sensitive the yield on the investment is to changes in the assumptions on the
reinvestment of intermediate cash flows. Suppose we are not able to reinvest the interest payments at 10
percent, but rather at 5 percent per year. We calculate the yield on the bonds assuming reinvestment at
5 percent -- a modified internal rate of return -- by calculating the future value of the reinvested
cash flows and determining the discount rate that equates the original investment of $1,000 to this future
value: 2
Company One bond Company Two bond
Date Cash flow Value as of Cash flow Value as of
Dec. 2009 Dec. 2009
December 31, 2005 $ 100.00 $ 121.55
December 31, 2006 100.00 115.76
December 31, 2007 100.00 110.25
December 31, 2008 100.00 105.00
December 31, 2009 1,100.00 1,100.00 $1,610.50 $1,610.50
Future value with cash flows $1,552.00 $1,610.50
reinvested 5 percent
Using the value of the cash flow as of December 31, 2009 as the future value and the $1,000 investment
as the present value, the modified internal rates of return are 9.19 percent for Company One's bond and
10 percent for Company Two's bond. You'll notice that the modified internal rate of return for Company
2
Is there a short cut in a financial calculator? Not really. Most financial calculators do not have the necessary
program for a net future value, so you are left with calculating this type of problem using the time value of money
programs to calculate the individual future values and then summing these.

Two's bond is the same as its yield-to-maturity -- because there are no intermediate cash flows. This is
shown in Exhibit 5.
Exhibit 5 The modified internal rate of return for Company One What we learn is that if we
and Company Two bonds for different reinvestment compare two bonds with the
rates same yield-to-maturity and the
same time to maturity, the
bond with the greater coupon
12% rate has more reinvestment
10% rate risk. That's because it has
8% more of its value coming sooner
Modified
in the form of cash flows.
internal rate 6% Company One bond
of return 4% Company Two bond Two types of risk closely related
to reinvestment risk of debt
2% securities are prepayment risk
0% and call risk. Consider the case
0%
2%
4%
6%
8%
10%
12%
14%
of mortgage-backed securities.
These are securities that
Reinvestment rate represent a collection of home
mortgages. An intermediary,
such as a large finance company, will pool the mortgages together and then sell interests in these
mortgages; as the home owner pays interest, this interest is passed on to the investor in this pool of
mortgages. In most cases, a home owner is
permitted to prepay the mortgage, either in whole
or in part; that is, a home owner may pay off the Modifying the internal rate
mortgage early. If paid off early, investors in A bond's yield is the bond's internal rate of return.
mortgage-backed securities get paid off early, The internal rate of return assumes that any cash
requiring them to reinvest cash flows from this flows from the asset (interest, in the case of a
investment earlier than expected. The problem? bond) are reinvested at a rate equal to the bond's
Home owners tend to refinance when interest yield.
rates are low, hence prepaying on the higher rate
mortgages. When investors receive these earlier A modified internal rate of return is the return on
cash flows, they reinvest them at a time of lower an asset, assuming that intermediate cash flows
interest rates; therefore their investment are reinvested at a specific rate. The modified
opportunities are much lower-yielding than the internal rate of return can provide a more realistic
mortgage-backed securities they had invested in. return on an investment since it accounts for
reinvestment at some rate other than the asset's
Investors in securities that can be paid off earlier internal rate.
than maturity face prepayment risk -- the risk Assuming that we can invest intermediate cash
that the borrower may choose to prepay the loan - flows (e.g., interest) at the current yield until the
- which causes the investor to have to reinvest the maturity of the investment is often not realistic.
funds.
Call risk is the risk that a callable security will be called by the issuer. If you invest in a callable security,
there is a possibility that the issuer may call it in (buy it back). While you may receive a call premium (a
specified amount above the par value), you have to reinvest the funds you receive.
There is reinvestment risk for assets other than stocks and bonds, as well. if you are investing in a new
product -- investing in assets to manufacture and distribute it -- you expect to generate cash flows in
future periods. You face a reinvestment problem with these cash flows: What can you earn by investing
these cash flows? What are your future investment opportunities?

If we assume that investors do not like risk -- a safe assumption -- then they will want to be
compensated if they take on more reinvestment rate risk. The greater the reinvestment rate risk, the
greater the expected return demanded by investors.
Reinvestment rate risk is relevant in our investment decisions no matter the asset and we must consider
this risk in assessing the attractiveness of investments. The greater the cash flows during the life of an
investment, the greater the reinvestment rate risk of the investment. And if an investment has a greater
reinvestment rate risk, this must be factored into our decision.
4. Interest rate risk

Interest rate risk is the sensitivity of the change in an asset's value to changes in market interest rates.
And, you should remember that market interest rates determine the rate we must use to discount a
future value to a present value. The value of any investment depends on the rate used to discount its
cash flows to the present. If the discount rate changes, the investment's value changes.
Suppose we make an investment in a project that we expect to have in operation for ten years. Two
years into the project, we look at our investment opportunities and see that the returns on alternative
investments have increased. Does this affect our value of this two-year-old project? Sure: we now have a
higher opportunity cost - the return on our best investment opportunity -- and therefore the value of the
two-year-old project is now less and we need to assess whether to continue or terminate the project.
And this works if the opportunity cost declines as well. If the return on our next best investment
opportunity declines, the existing project will look even better. Interest rate risk also is present in debt
securities. If you buy a bond and intend to hold it until its maturity, you don't need to worry about its
value changing as interest rates change: your return is the bond's yield-to-maturity. But if you do not
intend to hold the bond to maturity, you need to worry about how changes in interest rates affect the
value of your investment. As interest rates go up, the value of your bond goes down. As interest rates go
down, the value of your bond goes up.
Let's compare the change in the value of the Company One bond to the change in the value of the
Company Two bond as the market interest rate changes. Suppose that it is now January 1, 2006; that is,
one year after the bonds were issued.
If yields remain at 10 percent, the value of the bonds are $1,000 and $1,099.99 for the Company
One and Company Two bonds, respectively.
If market interest rates change causing the bonds to yield 12 percent, the value of the Company
One and Company Two bonds, respectively, are $939.98 and $1.060.89.
But how sensitive are the values of the bond to changes in market interest rates? If the bonds' yield
changed on January 1, 2001 from 10 percent to 12 percent, the value of Company One bond would drop
from $1,000.00 to $938.26 -- a drop of $61.74, or 6.17 percent of the bond's value. The drop would be
greater for Company Two's bond -- a drop of $76.50 or 6.95 percent of its value. Looking at changes in
the value of the bonds for different yield changes, we see that the Company Two bond's value is more
sensitive to changes in yields than is Company One's:
Yield change Yield change Yield change
Bond from 10% to 12% from 10% to 14% from 10% to 8%
Company One -$61.74 or -6.17% -$116.54 or -11.65% +$66.23 or +6.62%
Company Two -$76.50 or -6.95% -$146.45 or -13.31% +$83.77 or +7.62%
We can see this graphically in Exhibit 5.

We can make some generalizations Exhibit 6 Sensitivity of Company One and Company Two
about the sensitivity of a bond's bonds with four years remaining to maturity for
value to changes in yields. different yields
For a given coupon rate, the $1,800

longer the maturity of the bond, $1,600 Company One bond
the more sensitive the bond's Company Two bond
$1,400
value to changes in market
interest rates. Why? Because $1,200
Value
more or the bond's value is $1,000
of the
farther out into the future (the bond $800
principal payments) and the $600
more the present value is
$400
affected by a change in the
discount rate. $200
$0
For a given maturity, the lower
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
the coupon rate, the more
sensitive the bond's value to a Yield to maturity
change in the yield. Why? The
greater the coupon rate, the
more of the bond's present value is derived from cash flows that are affected less by discounting.
Example: Maturity and interest rate risk Example: Coupon rate and interest rate risk
Compare the change in the value of two bonds that Compare two bonds that have the same time remaining to
have the same coupon rate, 10 percent and the maturity, five years, the same face value, $1,000, and
same face value, $1,000, with interest paid both are priced to yield 10 percent. If Bond HC has a 10
annually. If Bond SM has five years remaining to percent coupon and Bond LC has a 5 percent coupon, a
maturity and Bond LM has ten years remaining to change in the yield has a greater effect of the value of
maturity, a change in the yield on the bonds from Bond LC than on Bond HC.
10 percent to 12 percent results in a greater
When yields change from 10 percent to 12 percent,
change in Bond LM's value.
Bond HC's value changes from $1,000 to $928, down
When interest changes from 10 percent to 12
7.20 percent
percent,
Bond LC's value changes from $810 to $748, down
Bond SM's value changes from $1,000 to $928,
7.65 percent
down 7.2 percent
Bond LM's value changes from $1,000 to $887,
down 11.3 percent

Try it! Interest rate sensitivity
Consider two bonds: Bond ABC and Bond XYZ. Bond ABC has a coupon rate of 5 percent and matures in six years.
Bond XYZ has a coupon rate of 8 percent and matures in two years. Calculate the value of both of these bonds for
the different yields to maturity, completing this table:
Yield to maturity Bond ABC Bond XYZ
4 percent
5 percent
6 percent
7 percent
8 percent
9 percent
Which bond’s value is more sensitive to changes in the yield to maturity?
5. Purchasing power risk

Purchasing power risk is the risk that the price-level may increase unexpectedly. If a firm locks in a
price on your supply of raw materials through a long-term contract and the price-level increases, it
benefits from the change in the price level and your supplier loses -- the firm pays the supplier in cheaper
currency. If a firm borrows funds by issuing a long-term bond with a fixed coupon rate and the price-level
increases, the firm benefits from an increase in the price level and its creditor is harmed since interest
and the principal are repaid in a cheaper currency.
Consider the 4 percent and 6 percent inflation rates for the years 20X1 and 20X2, respectively. If you
borrowed $1,000 at the beginning of 20X1 and paid it back two years later, you are paying back $1,000
in end-of-20X2 dollars. But how much is a 20X2 dollar worth relative to beginning-of-20X1 dollars? We
can use the compounding relation to work this out. We know that the future value is $1,000. We also
know that the rate of inflation over the two year period is determined from compounding the two
inflation rates:

r 1 inf lation rate 1 inf lation rate 1
for 20X1 for 20X2
r = (1 + 0.04) (1 + 0.06) - 1.0000 = 1.1024 - 1.0000 = 10.24 percent over 20X1 and 20X2
We can solve the basic valuation relation for today's value, PV, considering r to be a two-year rate (that
is, a period is defined as the two-year stretch from the beginning of 20X1 through the end of 20X2):
FV = PV (1 + r)
$1,000 = PV (1 + 0.1024),
and rearranging to solve for PV,
$1, 000
PV $907.11
1.1024
Therefore, the $1,000 you paid back at the end of 20X2 was really only worth $907.11 at the beginning
of 20X1. As a borrower, you have benefited from inflation and your lender has lost.
How much should your lender have demanded just to keep up with inflation? That is, how much should
your lender have demanded without any compensation for the time-value-of-money or for the
uncertainty that you will pay it back?
FV = $1,000 (1 + 0.1024) = $1,102.40.
Demanding $1,102.40 in return at the end of 20X2 would have just compensated your lender for the
purchasing power loss since the beginning of 20X1.

The extent to which inflation is anticipated is reflected in interest rates. Let's refer to the return after
considering inflation as the real return and refer to the return before removing inflation as the nominal
return. Therefore,
Nominal return + 1 = 1 +
Inflation
Real
1+ .
rate return
This relation between the nominal return, the inflation rate, and the real return is referred to as the
Fisher effect.
If we solve for the nominal return, we can state this return in terms of the inflation rate, the real rate,
and the cross-product:
return rate return

Nominal 1 inflation 1 real 1

Nominal inf lation real real inf lation
return rate return return rate
As you can see, the nominal return is comprised of three parts: the inflation rate, the real return, and the
cross-product of the inflation rate and the real return. Because this cross-product term is usually quite
small -- 0.24 percent or 0.0024 in the last example -- we often leave it out and consider the nominal
return to be the sum of the inflation rate and the real return.
The difference between the nominal return and the real return is often referred to as the inflation
premium, because it is the additional return necessary to compensate for inflation.
Anticipated inflation is incorporated into interest rates and valuations. The risk associated with
purchasing power is the risk that there will be unanticipated changes in inflation that will affect the
purchasing power. Any unanticipated changes in inflation will affect the parties on both sides of the
transaction, with one party gaining as the other losing.
You can see the impact of inflation on interest rates in Exhibit 7, where the real and nominal rates of
interest are graphed from January 2003 through January 2006. The widening of the span between these
two rates in 2004 and 2005 raised concerns for inflation, prompting the Federal Reserve to raise the
Federal Funds rate.

Exhibit 7: The real and nominal long-term interest rate
Based on rates on Long-term U.S. Treasury securities
6%
Real Long Rate Long Rate
5%
4%
Rate 3%
2%
1%
0%
1/2/2003
2/6/2003
3/13/2003
4/16/2003
5/21/2003
6/25/2003
7/30/2003
9/3/2003
10/7/2003
11/12/2003
12/17/2003
1/23/2004
2/27/2004
4/1/2004
5/6/2004
6/10/2004
7/16/2004
8/19/2004
9/23/2004
10/28/2004
12/3/2004
1/7/2005
2/11/2005
3/18/2005
4/22/2005
5/26/2005
6/30/2005
8/4/2005
9/8/2005
10/13/2005
11/17/2005
12/22/2005
1/30/2006
Day
Source: U.S. Treasury, Interest Rate Statistics, http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/
6. Returns and the tolerance for bearing risk

Which product investment do you prefer, A or B? Most people would choose A since it provides the same
expected return, with less risk. Most
people do not like risk -- they are risk Example: Risk aversion and investor choices
averse. Risk aversion is the dislike for Risk averse investors prefer more return to less, and prefer less risk
risk. Does this mean a risk averse to more.
person will not take on risk? No -- they
Consider the following investments and the associated expected
will take on risk if they feel they are return and risk (measured by standard deviation):
compensated for it.
Expected Standard
A risk neutral person is indifferent Investment return deviation
towards risk. Risk neutral persons do A 10% 12%
not need compensation for bearing risk. B 10% 11%
A risk preferent person likes risk -- C 11% 12%
someone even willing to pay to take on D 11% 11%
risk. Are there such people? Yes. E 9% 10%
F 12% 13%
Consider people who play the state
lotteries, where the expected value is If you are a risk-averse investor, which investment would you prefer
always negative: the expected value of of each of the following pairs:
the winnings is less than the cost of the A or B? A or C?
lottery ticket.
C or D? A or D?
When we consider financing and
D or E? D or F?
investment decisions, we assume that
most people are risk averse. Managers, E or F? C or F?
as agents for the owners, make Some choices are clear, and some are not. Some, like the choice
decisions that consider risk "bad" and between D and E, depend on the investor’s individual preferences
that if risk must be borne, they make for risk and return tradeoff, which we refer to as their utility
sure there is sufficient compensation for function.

bearing it. As agents for the owners, managers cannot have the "fun" of taking on risk for the pleasure
of doing so.
Risk aversion is the link between return and risk. To evaluate a return you must consider its risk: Is
there sufficient compensation (in the form of an expected return) for the investment's risk?
7. Summary
There are many different types of risks that a financial manager faces. We’ve illustrated a few in this
reading, but there are many more risks, some of which are quantifiable, some of which are not. Any
investment involves risks and the challenge is to understand what these risks are and how large they are.
Because investment decision-making requires a trade-off between benefits and costs, understanding the
risk of an investment is essential to understanding the benefits and costs.
8. Solutions to Try it!

DOL, DFL and DTL
Production DOL DFL DTL Operating profit Net profit
15,000 2.000 1.500 3.000 €30,000 €20,000
20,000 1.600 1.250 2.000 €50,000 €40,000
30,000 1.333 1.125 1.500 €90,000 €80,000
40,000 1.231 1.083 1.333 €130,000 €120,000
Interest rate sensitivity

Yield to maturity Bond ABC Bond XYZ
4 percent $1,052.88 $1,076.15
5 percent $1,000.00 $1,056.43
6 percent $950.23 $1,037.17
7 percent $903.37 $1,018.37
8 percent $859.22 $1,000.00
9 percent $817.63 $982.06
In terms of interest rate sensitivity, the bond with the longer maturity and lower coupon has
more interest rate sensitivity. We can confirm this by comparing the price changes in the bonds
as yields change:
Change in % change in % change in
yield to value of Bond value f Bond
maturity ABC XYZ
4 Æ 5 percent -5.02% -1.83%
5 Æ 6 percent -4.98% -1.82%
6 Æ 7 percent -4.93% -1.81%
7 Æ 8 percent -4.89% -1.80%
8 Æ 9 percent -4.84% -1.79%

Measuring risk
OUTLINE
1. Return and risk
2. Expected return
3. Standard deviation of the possible outcomes
4. Summary
1. Return and risk

When we make financial decisions, we must evaluate the benefits and the costs associated with the
decision. When we assess the benefits and costs, however, we must also understand the uncertainty
associated with the possible outcomes of the investments. For example, in evaluating a new product, the
company will use its knowledge of marketing to estimate the expected annual sales for each of the next
few years.
While we typically think of forecasts as point estimates, there really is a distribution about those
estimates. If next year’s sales are estimated to be $100 million, there is a chance that sales will be more
or less than this point estimate. Therefore, forecasts really entail looking at the entire probability
distribution; that is, all the possible sales and their associated probabilities. The purpose of this reading
is to develop a method of quantifying this probability distribution to make it easier to incorporate risk into
the decision-making process.
2. Expected return
We refer to both future benefits and future costs as expected returns. Expected returns are a measure
of the tendency of returns on an investment. This doesn't mean that these are the only returns possible,
just our best measure of what we expect.
Suppose we are evaluating the investment in a new product. We do not know and cannot know precisely
what the future cash flows will be. But from past experience, we can at least get an idea of possible
flows and the likelihood -- the probability -- they will occur. After consulting with colleagues in marketing
and production management, we figure out that there are two possible cash flow outcomes, success or
failure, and the probability of each outcome. Next, consulting with colleagues in production and
marketing for sales prices, sales volume, and production costs, we develop the following possible cash
flows in the first year:
Scenario Cash flow Probability
Product success $4,000,000 40%
Product flop - 2,000,000 60%
But what is the expected cash flow in the first year? The expected cash flow is the average of the
possible cash flows, weighted by their probabilities of occurring:
Expected cash flow = 0.40 ($4,000,000) + 0.60 (-$2,000,000)
Measuring risk, a reading prepared by Pamela Peterson Drake 1

= $1,600,000 + 1,200,000
= $400,000.
The expected cash flow is $400,000.
The expected value is a guess about the future outcome. It is not necessarily the most likely outcome.
The most likely outcome is the one with the highest probability. In the case of our example, the most
likely outcome is $2,000,000.
A general formula for any expected value is:
Expected value = (x) = p1x1 + p2x2 + p3x3 +...+pnxn..+...+ pNxN.
where (x) is the expected value;

n indicates a possible outcome;
N is the number of possible outcomes;
pn is the probability of the nth outcome; and
xn is the value of the nth outcome.
We can abbreviate this formula by using summation notation:

N
Expected value = (x) = pn xn.
n=1
Applying the general formula to our example,
N = 2 (there are two possible outcomes)
p1 = 0.40 Must sum to 1.0 or 100 percent
p2 = 0.60
x1 = $4,000,000
x2 = -$2,000,000
2
(cash flow) = pn xn= p1 x1 + p2 x2
n=1
(cash flow) = 0.40 ($4,000,000) + 0.60 (-$2,000,000) = $400,000.

Considering the possible outcomes and their likelihoods (i.e., probabilities), we expect a $400,000 cash
flow.
The calculation of the expected value requires that all possible outcomes be included. Therefore, the
probabilities (the pi's) must sum to 1.00 or 100 percent -- if not, you have left out a possible outcome:
N
pn = 1.000 or 100 percent.
n=1
3. Standard deviation of the possible outcomes

The expected return gives us an idea of the tendency of the future outcomes -- what we expect to
happen, considering all the possibilities. But the expected return is a single value and does not tell us
anything about the diversity of the possible outcomes. Are the possible outcomes close to the expected
value? Are the possible outcomes much different than the expected value? Just how much uncertainty is

there about the future? Because we are concerned about the degree of uncertainty (risk), as well as the
expected return, we need some way of quantifying the risk associated with decisions.
Suppose we are considering two products, Product A and Product B, with estimated returns under
different scenarios and their associated probabilities:
Product A Product B
Probability of Probability of
Scenario possible outcome Outcome Scenario possible outcome Outcome
Success 25 percent 24 percent Success 10 percent 40 percent
Moderate success 50 percent 10 percent Moderate success 30 percent 30 percent
Failure 25 percent -4 percent Failure 60 percent -5 percent
We refer to a product's set of the possible outcomes and their respective probabilities as the probability
distribution for those outcomes.
We can calculate the expected cash flow for each product as follows:
Product A
Return Probability
xn pn pnxn
Failure -4% 25% -1%
Moderate success 10% 50% 5%
Success 24% 25% 6%
(x) = 10%
Product B
Return Probability
xn pn pnxn
Failure -5% 60% -3%
Moderate success 30% 30% 9%
Success 40% 10% 4%
(x) = 10%
Both Product A and Product B have the same expected return. Let's now see if there is any difference in
the possible outcomes for the two products.
The possible returns for Product A range from -4 percent to 24 percent, whereas the possible returns for
Product B range from -5 percent to 40 percent. The range is the span of possible outcomes. For
Product A the span is -4 – 24 percent = 28 percent; for Product B the span is 45 percent. A wider span
indicates more risk, so Product B has more risk than Product A.
If we represent graphically the possible cash flow outcomes for Products A and B, with their
corresponding probabilities, as in Exhibit 1, we see there is more dispersion of possible outcomes with
Product B -- they are more spread out -- than those of Product A.

But the range by itself doesn't tell
Exhibit 1 Probability distributions of the returns to
Product A and Product B
us much about the possible cash
flows at these extremes, nor within
the extremes. And the range does
100%
not tell us anything about the
90% probabilities at or within the
80% extremes.
Product A Product B
70% A measure of risk that does tell us
60% something about how much to
Probability 50% expect and the probability that it
will happen is the standard
40%
deviation. The standard
30% deviation is a measure of
20% dispersion that considers the values
10% and probabilities for each possible
0%
outcome. The larger the standard
deviation, the greater the deviation
-5%
-1%
3%
7%
11%
15%
19%
23%
27%
31%
35%
39%
of possible outcomes from the
Return expected value. The standard
deviation considers the deviation, or
distance, of each possible outcome
from the expected value and the probability associated with it.
The standard deviation of possible returns, represented by (x), is calculated in six steps:
Step 1: Calculate the expected value.
Step 2: Calculate the deviation of each possible outcome from the expected value
Step 3: Square each deviation.
Step 4: Weight each squared deviation, multiplying it by the probability of the outcome
Step 5: Sum these weighted squared deviations.
Step 6: Take the square root of the sum of the squared deviations.
Let's calculate the standard deviation of the expected cash flows for Product A:
Step 1 Step 2 Step 3 Step 4
Return Probability pnxn xn- (x) (xn- (x))2 pn(xn- (x))2
Failure -4% 25% -1% -0.14 0.0196 0.00490
Moderate 10% 50% 5% 0.00 0 0.00000
Success 24% 25% 6% 0.14 0.0196 0.00490
(x) = 10% 2 = 0.000980 Step 5
= 0.098995 or 9.8995% Step 6
We can represent these six steps in a single formula:
= (x) pn (xn E(x))2
n 1
For Product B,

Return Probability pnxn xn- (x) (xn- (x))2 pn(xn- (x))2
Failure -5% 60% -3% -0.15 0.0225 0.01350
Moderate 30% 30% 9% 0.20 0.0400 0.01200
Success 40% 10% 4% 0.30 0.0900 0.00900
(x) = 10% 2 = 0.03450
= 0.185742 or 18.5742%
In summary,
Expected Standard deviation
Product return of possible outcomes
Product A 10% 9.90%
Product B 10% 18.57%
Whereas the expected value of both products is the same, there is a different distribution of possible
outcomes for the two products. When we calculate the standard deviation around the expected value,
we see that Product B has a larger standard deviation. The larger standard deviation for Product B tells
us that Product B has more risk than Product A since its possible outcomes are more distant more from
its expected value.
The variance and the standard deviation

The variance and the standard deviation are both measures of dispersion. In fact, they are related: the
standard deviation is the square root of the variance. So why do we go beyond the calculation of the variance
to get the standard deviation? For two reasons.
First, the variance is in terms of squared units of measure (say, squared dollars or squared returns), whereas
the standard deviation is in terms of the original unit of measure. It gets tough trying to interpret squared
dollars or squared returns.
Second, if the probability distribution is approximately normally distributed (that is, bell-shaped, with certain
other characteristics), we can use the standard deviation to compactly describe the probability distribution;
not so with the variance. There are uses for the variance in statistical analysis, but for purposes of describing
and comparing probability distributions, we focus on the expected value and the standard deviation.
If we are comparing investments with different expected values, we can restate the risk as the coefficient of
variation, which is the ratio of the standard deviation to the expected value, and make comparisons. The
coefficient of variation is not useful in a comparison, however, in cases in which the expected return is zero or
negative.
Try it! Standard deviation of a probability distribution

Consider the following probability distribution
Scenario Probability Net income
A 20 percent $1 million
B 30 percent $2 million
C 40 percent $3 million
D 10 percent $4 million
What is the expected net income and standard deviation of the net income given this information?

4. Summary
Evaluating risk and its effect on financial decisions is challenging. The purpose of demonstrating one
method of evaluating risk in investment decision-making is to illustrate the relation between risk and
return. The expected return on an investment is a point estimate. The risk is related to the possible
deviation of the possible returns from what is expected. If we can quantify the possible outcomes from
and investment and their associated probabilities, we can estimate a measure of risk, the standard
deviation. We can then use the expected return and standard deviation in our decision-making.

Standard deviation of a probability distribution
Scenario Probability Net income Px (x- x )2 p(x- x )2
in millions
A 20 percent $1 million $0.2 1.96 0.392
B 30 percent $2 million 0.6 0.16 0.048
C 40 percent $3 million 1.2 0.36 0.144
D 10 percent $4 million 0.4 2.56 0.256
$2.4 0.840
Expected value = $2.4 million
Standard deviation = 0.84 = $0.9165 million

Risk, return, and diversification
OUTLINE
1. Introduction
2. Diversification and risk
3. Modern portfolio theory
4. Asset pricing models
5. Summary
1. Introduction
As managers, we rarely consider investing in only one project at one time. Small businesses and large
corporations alike can be viewed as a collection of different investments, made at different points in time.
We refer to a collection of investments as a portfolio.
While we usually think of a portfolio as a collection of securities (stocks and bonds), we can also think of
a business in much the same way -- a portfolios of assets such as buildings, inventories, trademarks,
patents, et cetera. As managers, we are concerned about the overall risk of the company's portfolio of
assets.
Suppose you invested in two assets, Thing One and Thing Two, having the following returns over the
next year:
Asset Return
Thing One 20%
Thing Two 8%
Suppose we invest equal amounts, say $10,000, in each asset for one year. At the end of the year we will
have $10,000 (1 + 0.20) = $12,000 from Thing One and $10,000 (1 + 0.08) = $10,800 from Thing Two,
or a total value of $22,800 from our original $20,000 investment. The return on our portfolio is therefore:
$22,800-20,000
Return = 14%
$20,000
If instead, we invested $5,000 in Thing One and $15,000 in Thing Two, the value of our investment at
the end of the year would be:
Value of investment =$5,000 (1 + 0.20) + 15,000 (1 + 0.08) = $6,000 + 16,200 = $22,200
and the return on our portfolio would be:
$22,200-20,000
Return = 11%
$20,000
which we can also write as:
Risk, return, and diversification, a reading prepared by Pamela Peterson Drake 1

$5,000
$15,000

Return = (0.2) (0.08) 11%
$20,000 $20,000
As you can see more immediately by the second calculation, the return on our portfolio is the weighted
average of the returns on the assets in the portfolio, where the weights are the proportion invested in
each asset.
We can generalize the formula for a portfolio return, rp, as the weighted average of the returns of all
assets in the portfolio, letting:
i indicate the particular asset in the portfolio,

wi indicate the proportion invested in asset i,
ri indicate the return on asset i, and
S indicate the number of assets in the portfolio
The return on the portfolio is:

rp = w1r1 + w2r2 + ... + wSrS ,
which we can write more compactly as:
S
rp wiri
i 1
Example: The return on a portfolio
Problem
Consider a portfolio comprised of three assets, with expected returns and investments of:
Asset Expected return Investment

A 10% $20,000
B 5% 10,000
C 15% 20,000
What is the expected return on the portfolio?
Solution
rp = 40% (10%) + 20% (5%) + 40% (15%)
rp = 0.04 + 0.01 + 0.06
rp = 0.11 or 11%
2. Diversification and risk

"My ventures are not in one bottom trusted Nor to one place; nor is my whole
estate Upon the fortune of this present year. Therefore my merchandise makes
me not sad"
- William Shakespeare, Merchant of Venice.
In any portfolio, one investment may do well while another does poorly. The projects' cash flows may be
"out of synch" with one another. Let's see how this might happen.
Let's look at the idea of "out-of-synchness" in terms of expected returns, since this is what we face when
we make financial decisions. Consider Investment One and Investment Two and their probability
distributions:

Scenario Probability of Return on Return on
Scenario Investment One Investment Two
Boom 30% 20% -10%
Normal 50% 0% 0%
Recession 20% -20% 45%
We see that when Investment One does well, in the boom scenario, Investment Two does poorly. Also,
when Investment One does poorly, as in the recession scenario, Investment Two does well. In other
words, these investments are out of synch with one another.
Now let's look at how their "out-of-synchness" affects the risk of the portfolio of One and Two. If we
invest an equal amount in One and Two, the portfolio's return under each scenario is the weighted
average of One and Two's returns, where the weights are 50 percent:
Scenario Probability Weighted average return
Boom 0.30 [0.5 ( 0.20)] + [0.5 (-0.10)] = 0.0500 or 5%
Normal 0.50 [0.5 ( 0.00)] + [0.5 ( 0.00)] = 0.0000 or 10%
Recession 0.20 [0.5 (-0.20)] + [0.5 ( 0.45)] = 0.1250 or 12.5%
The calculation of the expected return and standard deviation for Investment One, Investment Two, and
the portfolio consisting of One and Two results in the following the statistics,
Return on Return on Return on a
Probability of Investment Investment portfolio comprised
Scenario scenario One Two of One and Two
Boom 30% 20% -10% 5%
Normal 50% 0% 0% 0%
Recession 20% -20% 45% 12.5%
Expected return 2% 6% 4%
Standard deviation 14.00% 19.97% 4.77%
The expected return on Investment One is 2 percent and the expected return on Investment Two is 6
percent. The return on a portfolio comprised of equal investments of One and Two is expected to be 4
percent. The standard deviation of Investment One 's return is 14 percent and of Investment Two 's
return is 19.97 percent, but the portfolio's standard deviation, calculated using the weighted average of
the returns on investments One and Two in each scenario, is 4.77 percent. This is less than the standard
deviations of each of the individual investments because the returns of the two investments do not move
in the same direction at the same time, but rather tend to move in opposite directions.
A. The role of covariance and correlation

The portfolio comprised of Investments One and Two has less risk than the individual investments
because each moves in different directions with respect to the other. A statistical measure of how two
variables -- in this case, the returns on two different investments -- move together is the covariance.
Covariance is a statistical measure of how one variable changes in relation to changes in another
variable. Covariance in this example is calculated in four steps: 1
Step 1: For each scenario and investment, subtract the investment's expected value from
its possible outcome;
1
You should notice a similarity between the calculation of the covariance and the variance (that you
learned in the Measuring Risk reading). In the case of the variance, we took the deviation from the
expected value and squared it before weighting it by the probability. In the case of the covariance, we
take the deviations for each asset, multiply them, and then weight by the probability.

Step 2: For each scenario, multiply the deviations for the two investments;
Step 3: Weight this product by the scenario's probability; and
Step 4: Sum these weighted products to arrive at the covariance.
Deviation of Deviation of
Investment One's Investment Two's Product
return from its return from its of the Weight the product by
Scenario Probability expected return expected return deviations the probability
Boom 0.30 0.1800 -0.1600 -0.0288 -0.00864
Normal 0.50 -0.0200 -0.0600 0.0012 0.00060
Recession 0.20 -0.2200 0.3900 -0.0858 -0.01716
covariance =-0.02520
As you can see in these calculations, in a boom economic environment, when Investment One is above
its expected return (deviation is positive), Investment Two is below its expected return (deviation is
negative). In a recession, Investment One's return is below its expected value and Investment Two's
return is above its expected value. The tendency is for the returns on these portfolios to co-vary in
opposite directions -- producing a negative covariance of -0.0252.
We can represent this calculation in a formula, using pi to represent the probability, r to represent the
possible return, the to represent the expected return:
N
Covariance One,Two p r
i=1
i One,i -E One rTwo,i -E Two
Let's see the effect of this negative covariance on the risk of the portfolio. The portfolio's variance
depends on:
1. the weight of each asset in the portfolio;

2. the standard deviation of each asset in the portfolio; and
3. the covariance of the assets' returns.
Let cov1,2 represent the covariance of two assets' returns. We can write the portfolio variance for a two-
security portfolio as:
Portfolio variance, 2-security portfolio = w1212 + w22 22 + 2 w1 w2 cov1,2.
The portfolio standard deviation is the square root of the variance, or:
Portfolio standard deviation, 2-security portfolio = w12 12 + w 22 22 + 2w1w 2 cov1,2 .
More generally, the formula is:

N N N
2 2
Portfolio standard deviation = wi i + wiw ji jrij
i=1 i 1 j 1 j i
Recognizing that the covariance is the product of the correlation and the respective standard deviations,
we can also write the formula as:
N N N
2 2
Portfolio standard deviation = wi i + wi w jcov ij .
i=1 i 1 j 1 j i
We can apply this general formula to our example, with Investment One's characteristics indicated with a
1 and Investment Two's with a 2,

w1 = 0.50 or 50 percent
w2 = 0.50 or 50 percent
s1 = 0.1400 or 14.00 percent
s2 = 0.1997 or 19.97 percent
cov1,2 = -0.0252.
The portfolio variance, p2, is:
p2 = 0.502(0.14002) + 0.502(0.19972) + 2 (0.50)(0.50)(-0.0252) = 0.002275,
and the portfolio standard deviation,p, is 0.0477 or 4.77 percent, which, not coincidentally, is what we
got when we calculated the standard deviation directly from the portfolio returns under the three
scenarios.
The standard deviation of the portfolio is lower than the standard deviations of each of the investments
because the returns on Investments One and Two are negatively related: when one is doing well the
other may be doing poorly, and vice-versa. That is, the covariance is negative.
Example: The portfolio variance and standard deviation The investment in assets whose returns
are out of step with one another is the
Problem
whole idea behind diversification.
Consider a portfolio comprised of two securities, F and G: Diversification is the combination of
assets whose returns do not vary with
Statistic Security F Security G one another in the same direction at the
Expected return 10% 20% same time. If all returns on assets moved
Standard deviation 5% 8% together precisely, there is no benefit (in
terms of risk reduction) from investing in
Percentage of portfolio invested 40% 60%
different assets. However, as long as the
The covariance between the two securities' returns is 0.002. What assets’ returns do not move precisely
is the portfolio's standard deviation? along with each other, there will be some
potential for a risk reduction.
Solution
If the returns on investments move
p2 =0.16 (0.0025) + 0.36 (0.0064) + [(2) (0.002) (0.40) (0.60)] together, we say that they are correlated
p2 = 0.0004 + 0.0023 + 0.00096 = 0.00366 with one another. Correlation is the
tendency for two or more sets of data --
p = 0.06050 or 6.05 percent in our case returns -- to vary together. 2
The returns on two investments are:
Positively correlated if one’s returns tend to vary in the same direction at the same time as
the other’s returns.
Negatively correlated if one’s returns tend to vary in the opposite direction with respect to the
other’s returns.
Uncorrelated if there is no relation between the changes in one’s returns with changes in the
other’s returns.
Statistically, we can measure correlation with a correlation coefficient, . The correlation coefficient
reflects how the returns of two securities vary together and is measured by the covariance of the two
securities' returns, divided by the product of their standard deviations:
2
Correlation is a statistical measure of association.

Correlation covariance of the two assets' returns
coefficient


returns on first asset returns on second asset
cov1,2
1,2
12
By construction, the correlation coefficient is bound between -1 and +1. We can interpret the correlation
coefficient as follows:
If the correlation coefficient is … this indicates that there is …
+1 a perfect, positive correlation between the two assets' returns.
-1 a perfect, negative correlation between the two assets returns.
0 no correlation between the two assets returns.
between 0 and +1 positive, but not perfect positive correlation between the two assets
returns, as illustrated in Exhibit 1.
between -1 and 0 negative, but not perfect negative correlation between the two
assets returns, as illustrated in Exhibit 2.
In the case of Investments One and Two, the covariance of their returns is between -1 and 0. Therefore,
we say that the returns on Investment One and Investment Two are negatively correlated with one
another.
Exhibit 1 Positive correlation between the Exhibit 2 Negative correlation between the
returns on Security V and Security W return on Security X and Security Y
2.5
2.5
2
2 1.5
1.5 1
1 0.5
Return on Return on
0.5 0
V X
-0.5
0
-1
-0.5 -1.5
-1 -2
-1.5 -2.5
-1.5 -1 -0.5 0 0.5 1 1.5 -2 -1 0 1 2
Return on W Return on Y
By investing in assets with less than perfectly correlated cash flows, you are getting rid of -- diversifying
away -- some risk. The less correlated the cash flows, the more risk you can diversify away -- to a point.
Let's see how the correlation and portfolio standard deviation interact. Consider two investments, E and
F, whose standard deviations are 5 percent and 3 percent, respectively. Suppose our portfolio consists of
an equal investment in each; that is, w1=w2=50 percent.
If the correlation between ... this means that and the portfolio's
the assets' returns is ... the covariance is ... standard deviation is ...
+1.0 +0.00150 4.00%
+0.5 +0.00075 3.50%
0.0 0.00000 2.92%
- 0.5 -0.00075 2.18%
- 1.0 -0.00150 0.00%
The less perfectly positively correlated are two assets' returns, the lower the risk of the portfolio
comprised of these assets.

Let's think about what this means for a company. Consider
Example: Correlation and covariance Proctor & Gamble whose products include Tide detergent,
Prell shampoo, Pampers diapers, Jif peanut butter, and Old
Problem
Spice cologne. Are the cash flows from these products
Consider Securities F and G: positively correlated? To a degree, yes. The cash flows
Standard deviation of F's returns = 5% from these products depend on consumer spending for
consumption goods. But are they perfectly correlated? No.
Standard deviation of G's returns = 8% For example, diaper sales depend on the diaper wearing
Covariance of F & G's returns = 0.002 population, whereas cologne products depend on the male
What is the correlation between F & G's returns? Try it! Portfolio risk
Solution
Suppose you are given the following information on two
Correlation = 0.002 / ((0.05)(0.08)) = 0.50 stocks, Tweedle Dee and Tweedle Dum:
cologne-wearing population. The cash flows of Tweedle Tweedle

these different products also depend on the Dee Dum
actions of competitors -- the degree of Expected return 6% 10%
competition may be different for the diaper Standard deviation of returns 8% 12%
market than the peanut butter market. Further,
the cash flows of the products are affected by The correlation of the returns for Tweedle Dee and Tweedle
different input pricing – the costs of the raw Dum is 0.35
inputs to make these products. If there is a bad
year for the peanut crop, the price of peanuts If you invest 40 percent of your portfolio in Tweedle Dee and
the remainder in Tweedle Dum, what is the expected return
may increase substantially, reducing cash flows
and standard deviation for your portfolio?
from Jif -- but this increase in peanut prices is
not likely to affect the costs of, say, producing
laundry detergent.
The effects of diversification on portfolio risk
Returns on individual stocks, A and B Returns on a portfolio of stocks comprised of equal

parts of A and B
Correlation between the returns on A and B = -0.71
4%
4% Portfolio of A and B
A B
3%
3%
2%
2%
Return
Return
1%
1%
0%
0%
-1%
-1%
-2%
-2%
1 5 9 13 17 21 25 29
1 5 9 13 17 21 25 29
Period
Period

B. Portfolio size and risk
What we have seen for a portfolio with two assets can be extended to include any number of assets.
Alas, the calculations get more complicated because we have to consider the covariance between every
possible pair of assets. But the basic idea is the same. The risk of a portfolio declines as it is expanded
with assets whose returns are not perfectly correlated with the returns of the assets already in the
portfolio.
The idea of diversification is based on beliefs about what will happen in the future: expected returns,
standard deviation of all possible returns, and expected covariance between returns. How valid are our
beliefs about anything in the future? We can get an idea by looking at the past. So we look at historical
returns on assets -- returns over time -- to get an idea of how some asset's returns increase while at the
same time others do not or decline.
Let's look at the effects of diversification with common stocks. As we add common stocks to a portfolio,
the standard deviation of returns on the portfolio declines -- to a point. This is illustrated in Exhibit 3,
where the ratio of the amount of risk is shown on the vertical axis as a ratio of the portfolio’s standard
deviation to the typical individual security’s standard deviation. After around twenty different stocks, the
portfolio's standard deviation is about as low as it is going to get. Why does the risk seem to reach some
point and not decline any farther? Because common stocks' returns are generally positively correlated
with one another. There just aren't enough negatively correlated stocks' returns to reduce portfolio risk
beyond a certain point.
Exhibit 3 Diversification illustration We refer the risk that goes

away as we add assets as
1.2
diversifiable risk. We
Ratio of the refer to the risk that
portfolio standard 1
cannot be reduced by
deviation to that adding more assets as
of the typical non-diversifiable risk.
individual asset 0.8
As more assets are added to the portfolio, the
portfolio's risk declines, eventually leveling off Risk is not diversified only
0.6 with common stocks.
Consider a business that
0.4 has many different product
lines. While the returns on
0.2 these product lines may
not be perfectly correlated,
0 the returns are influenced
1 6 11 16 21 26 31 36 by similar forces -- for
Number of assets in the portfolio example, the economy and
industry competition -- so
that the returns are most
likely positively correlated.
3. Modern portfolio theory

The idea that we can reduce the risk of a portfolio by introducing assets whose returns are not highly
correlated with one another is the basis of Modern portfolio theory (MPT). MPT tells us that by

combining assets whose returns are not correlated with one another, we can determine combinations of
assets that provide the least risk for each possible expected portfolio return.
Though the mathematics involved in determining the optimal combinations of assets are beyond this text,
the basic idea is provided in Exhibit 4.
Exhibit 4 Development of the efficient frontier Each blue colored point in Panel A
Panel A
in Exhibit 4 represents a possible
portfolio that can be put together
The return and risk of different portfolios that can be formed with available comprising different assets and
securities … different weights. The points in
this graph represent every
16% possible portfolio. As you can see
in this diagram:
12%
some portfolios have a higher
Return 8% expected return than other
portfolios with the same level
4% of risk;
some portfolios have a lower
0% standard deviation than other
0% 5% 10% 15% 20% 25% portfolios with the same
Standard deviation expected return.
Investors are risk averse: they

Panel B
more return to less return and
When all possible portfolios are considered, there are a set of portfolios prefer less risk to more risk.
that are better than all others in terms of risk and return. These portfolios Therefore, some portfolios are
fall on the efficient frontier: better than others. The best
portfolios -- those that can't be
beat in terms of either the level
16% of return for the amount of risk or
the amount of risk for the level of
12% return -- make up what is called
the efficient frontier. If
Return 8% investors are rational, they will go
for the portfolios that fall on this
4% efficient frontier. All the possible
portfolios and the efficient
0% frontier (shown in green) are
0% 5% 10% 15% 20% 25% diagrammed in Panel B of Exhibit
Standard deviation 4.
So what portfolio would an
investor choose? A rational
investor would choose a portfolio that has a better risk-return combination than others; therefore, a
rational investor would choose a portfolio that falls along the efficient frontier. But which of these many
portfolios along the frontier would an investor select? An investor would have to address the issue of
their tolerance for risk and would selection the portfolio along this frontier that is the level of risk that is
preferred. 3
3
In economics, we referred to this tradeoff between risk and return is the investor’s utility function.

What is the relevance of MPT to financial managers? MPT tells us that
we can manage risk by judicious combinations of assets in our portfolios; and
there are some combinations of assets that are preferred over others.
The relation between portfolio returns and portfolio risk was recognized by two Nobel Laureates in
Economics, Harry Markowitz and William Sharpe. Harry Markowitz tuned us into the idea that investors
hold portfolios of assets and therefore our focus is upon the portfolio return and the portfolio risk, not on
the return and risk of individual assets. 4 Is this reasonable? Probably. Not many businesses consists of a
single asset. Nor do investors invest in only one asset.
The relevant risk to an investor is the portfolio's risk, not the risk of an individual asset. If an investor
holds assets in a portfolio and is considering buying an additional asset or selling an asset from the
portfolio, what must be considered is how this change will affect the risk of the portfolio. This concept
applies whether we are talking about an investor holding 30 different stocks or a business that has
invested in 30 different projects. The important thing in valuing an asset is its contribution to the
portfolio's return and risk.
4. Asset pricing models

A. The capital asset pricing model
William Sharpe took the idea that portfolio return and risk are the only elements to consider and
developed a model that deals with how assets are priced. This model is referred to as the capital asset
pricing model (CAPM).
We just saw that there is a set of portfolios that make up the efficient frontier -- the best combinations of
expected return and standard deviation. All the assets in each portfolio, even on the frontier, have some
risk. Now let's see what happens when we add an asset with no risk -- referred to as the risk-free asset.
Suppose we have a portfolio along the efficient frontier that has a return of 4 percent and a standard
deviation of 3 percent. Suppose we introduce into this portfolio the risk-free asset, which has an expected
return of 2 percent and, by definition, a standard deviation of zero. If the risk-free asset's expected
return is certain, there is no covariance between the risky portfolio's returns and the returns of the risk-
free asset.
A portfolio comprised of 50 percent of the risky portfolio and 50 percent of the risk-free asset has an
expected return of (0.50) 4% + (0.50) 2% = 3% and a portfolio standard deviation calculated as follows:
Portfolio variance = p2 = 0.502(0.03) + 0.502(0.00) + 2 (0.00) 0.50 (0.50) = 0.0075.
Portfolio standard deviation = p = 0.0866.
If we look at all possible combinations of portfolios along the efficient frontier and the risk-free asset, we
see that the best portfolios are no longer along the entire length of the efficient frontier, but rather are
the combinations of the risk-free asset and one -- and only one -- portfolio of risky assets on the frontier.
The combinations of the risk-free asset and this one portfolio is shown in Exhibit 4. These combinations
differ from one another by the proportion invested in the risk-free asset; as less is invested the risk-free
asset, both the portfolio's expected return and standard deviation increase.
William Sharpe demonstrates that this one and only one portfolio of risky assets is the market portfolio
-- a portfolio that consists of all assets, with the weights of these assets being the ratio of their market
value to the total market value of all assets.
4
Harry Markowitz, “Portfolio Selection,” Journal of Finance, (March 1952) pp. 77-91.

If investors are all risk averse -- they only take on risk if there is adequate compensation -- and if they
are free to invest in the risky assets as well as the risk-free asset, the best deals lie along the line that is
tangent to the efficient frontier. This line is referred to as the capital market line (CML), shown in
Exhibit 5.
If the portfolios along the capital Exhibit 5: The capital market line
market line are the best deals and are
available to all investors, it follows
that the returns of these risky assets
16%
will be priced to compensate investors
for the risk they bear relative to that 12%
of the market portfolio. Since the
portfolios along the capital market Return 8%
line are the best deals, they are as
diversified as they can get -- no other 4%
combination of risky assets or risk-
free asset provides a better expected 0%
return for the level of risk or provides 0% 5% 10% 15% 20% 25%
a lower risk for the level of expected Standard deviation
return.
The capital market line tells us about
the returns an investor can expect for a given level of risk. The CAPM uses this relationship between
expected return and risk to describe how assets are priced. The CAPM specifies that the return on any
asset is a function of the return on a risk-free asset plus a risk premium. The return on the risk-free asset
is compensation for the time value of money. The risk premium is the compensation for bearing risk.
Putting these components of return together, the CAPM says:
Expected return on an asset = expected return on a risk free asset + risk premium
In other words, the expected return on an asset is the sum of the compensation for the time value of
money and compensation for bearing risk.
The market portfolio therefore represents the most well-diversified portfolio -- the only risk in a portfolio
comprising all assets is the non-diversifiable risk. 5 As far as diversification goes, the market portfolio is
the best you can do, since you have included everything in it.
By the same token, if we assume that investors hold well-diversified portfolios (approximating the market
portfolio), the only risk they have is non-diversifiable risk. If assets are priced to compensate for the risk
of assets and if the only risk in your portfolio is non-diversifiable risk, then it follows that the
compensation for risk is only for non-diversifiable risk. Let's refer to this non-diversifiable risk as market
risk.
Since the market portfolio is made up of all assets, each asset possesses some degree of market risk.
Since market risk is systematic across assets, it is often referred to as systematic risk and diversifiable
risk is referred to as unsystematic risk. Further, the risk that is not associated with the market as a
whole is often referred to as company-specific risk when referring to stocks, since it is risk that is specific
to the company's own situation -- such as the risk of lawsuits and labor strikes -- and is not part of the
risk that pervades all securities.
5
We often use major indices, such as the S&P 500, as proxies for the market portfolio.

The measure of an asset's return sensitivity to The risk that reflects an The risk that reflects an
the market's return, its market risk, is referred asset's return' movement asset's returns' not moving
to as that asset's beta. with asset returns in general along with asset returns in
is referred to as ... general is referred to as ...
The expected return on an individual asset is non-diversifiable risk diversifiable risk
the sum of the expected return on the risk- market risk company-specific risk
free asset and the premium for bearing systematic risk unsystematic
market risk. Let ri represent the expected
return on asset i, rf represented the expected return on the risk-free asset, and b i represent the degree
of market risk for asset i. Then:
ri = rf + (rm - rf) i
The term (rm - rf), is the market risk premium -- if

you owned all the assets in the market portfolio, you
expect to be compensated (rm - rf) for bearing the risk
of these assets. b is measure of market risk, which In the CAPM, the term rm-rf is referred to as the
serves to fine-tune the risk premium for the individual market risk premium. It is the premium for bearing
average market risk. We multiply this by the asset’s
asset. For example, if the market risk premium were 2
beta, i, to adjust this market risk premium to arrive
percent and the for an individual asset were 1.5, at the asset’s risk premium.
you would expect to receive a risk premium of 3
percent since you are taking on 50 percent more risk If you are provided the market return, rm, you must
than the market. first subtract the risk-free rate of interest, rf, from this
to determine the market risk premium, rm-rf.
For each asset there is a beta. If we represent the
expected return on each asset and its beta as a point on a graph, and we do the same for every asset in
the market, and connect all the points, the result is the security market line, SML, as shown in Exhibit
6.
Exhibit 6 The security market line As you can see in this

graph, the greater the
Expected (that is, increasing
Return values of along the
horizontal axis), the
greater is the expected
return on the asset.
Exoected
return on If there were no market
the market risk (that is, = 0), the
asset’s expected return
is equal to the expected
Expected Compensation for risk
return on return on the risk-free
risk-free asset. If the asset's risk
Compensation for the time value of money
asset is similar to the risk of
0.1 0.4 0.7 1 1.3 1.6 1.9 2.2 2.5 the market as a whole
( = 1.0), that asset's
Security Beta
expected return is the
return on the market
portfolio.
For an individual asset, is a measure of sensitivity of its returns to changes in return on the market
portfolio. 6
6
In economics class, you referred to this sensitivity as elasticity.

If is one, we expect that for a given change of 1 percent in the market portfolio return, the
asset's return is expected to change by 1 percent.
If is less than one, then for a 1 percent change in the expected market return, the asset's
return is expected to change by less than 1 percent.
If is greater than one, then for a 1 percent change in the expected market return, the asset's
return is expected to change by more than 1 percent.
We typically estimate the for a common stock by looking at the historical relation between its return
and the return on the market as a whole. The s of some firms' stocks are close to one, indicating that
the returns on these stocks tend to move along with the market. There are some betas around 0.3
(Homestake Mining and Southern Company, for example), indicating that the returns on these securities
do not move along with the market: if the market were to go up 10 percent, we would expect these
securities' returns to go up only around 3 percent. Then there are some stocks whose beta is much
higher than 1.0. For example, if J-Mart has a of 1.5. This means that if the market is expected to go up
1 percent, we expect J-Mart's return to go up 1.5 percent; if the
Exhibit 7: Estimated betas for a
market is expected to go down 1 percent, we expect J-Mart's sample of common
return to go down 1.5 percent. stocks
When we introduced the idea of risk, we discussed many different Common stock
types of risk, many of which affect cash flows. For example, every Advance Auto Parts 0.90
firm has some type of business risk. And some of that business Big Lots 1.10
risk is common among all firms -- all firm's sales are affected by BJ’s Wholesale 1.05
the economy to some extent. But some of that business risk an Claire’s Stores 1.10
investor can diversify away by buying stocks whose sensitivity to PetSmart 1.00
the economy are out of synch with one another. However, part of Williams-Sonoma 1.25
business risk cannot be diversified away -- we are stuck with it. Archer-Daniels Midland 0.70
This is the risk that concerns investors and they want to be Reynolds American 0.95
compensated for it. W.M. Wrigley 0.55
If we know part of the risk of a particular asset is common to all Stillwater Mining 1.30
assets, and we have a large enough representation of all in the 3Com 1.15
assets in our portfolio, then we don't need to be concerned with Seagate Technologies 1.20
the diversifiable risk. We are concerned about the market risk of
each asset in the portfolio and how it contributes to the market Source: Value Line Investment Survey,
various reports, 2006.
risk of the entire portfolio.
We can get a good idea of the portfolio's market risk by using a
that represents the composition of the assets in the portfolio. To determine the portfolio's beta, p we
need to know the weighted average of the betas of the assets that make up the portfolio, where each
weight is the proportion invested in each asset. Let p indicate the beta of the portfolio, wi indicate the
proportion invested in each the asset i, and bi. the beta for asset i. If there are S assets in the portfolio,
then:
p = w1 1 + w2 2 + w3 3 + ... + wS S,
or more compactly,
S
p wii
i 1
Suppose we have three securities in our portfolio, with the amount invested in each and their security
beta as follows:

Security Security beta Amount invested
AAA 1.00 $10,000
BBB 1.50 $20,000
CCC 0.75 $20,000
The portfolio's beta is:

$10, 000
$20, 000
$20, 000
p 1 $50, 000 1.5 $50, 000 0.75

$50, 000
p (0.2)(1) (0.4)(1.5) (0.4)(0.75)
p 0.2 0.6 0.3 1.1
If the expected risk-free rate of interest is 4 percent and the expected return on the market is 7 percent,
the p = 1.1 means that the expected return on portfolio is 4 percent + 1.10 (7 percent - 4 percent) =
7.3 percent.
Example: The Portfolio Beta
The CAPM, with its description of the
relation between expected return and risk Problem
and the importance of market risk in asset Consider a portfolio comprised of three securities with the
pricing, has some drawbacks. following security betas and proportions invested in each:
Security Security beta Proportion invested

First, the estimate of is just that: an
1 1.00 50%
estimate. For stocks, the is typically
estimated using historical returns. But the 2 2.00 25%
proxy for market risk depends on the 3 0.50 25%
method and period in which is it is
Solution:
measured. For assets other than stocks,
estimation is more difficult. Portfolio beta = 50% (1.00) + 25% (2.00) + 25% (0.50)
Portfolio beta = 0.50 + 0.50 + 0.125 = 1.125
Second, the CAPM includes some
unrealistic assumptions. For example, it assumes that all investors can borrow and lend at the same rate.
Though the conclusions of the CAPM are logical, in terms of the role of diversification and the market
portfolio, the theoretical model is based on a large number of assumptions, some of which are unrealistic
(e.g., all investors have the same expectations regarding risk and return for all assets).
Third, the CAPM is a theory that cannot be tested. The market portfolio is a theoretical construct (that is,
all investable assets) and not really observable, so we cannot test the relation between the expected
return on an asset and the expected return of the market to see if the relation specified in the CAPM
holds.
Try it! Expected return using the CAPM
Lastly, in studies of the CAPM applied to For the stocks in Exhibit 7, calculate the expected return on
common stocks, the CAPM does not explain each stock if the expected risk free rate of return is 3 percent
the differences in returns for securities that and the expected risk premium on the market is 4 percent.
differ over time, differ on the basis of dividend
yield, and differ on the basis of the market value of equity (the so called "size effect"). 7
7
See, for example, Eugene Fama and Kenneth French, ”The Cross-Section of Expected Stock Returns,”
Journal of Finance, Vol. 46, (June 1992) pp. 427-466.

Though it lacks realism and is difficult to apply, the CAPM makes some sense regarding the role of
diversification and the type of risk we need to consider in investment decisions.
B. The arbitrage pricing model

An alternative to CAPM in relating risk and return is the Arbitrage Pricing Model. The arbitrage pricing
model developed by Stephen Ross, is an asset pricing model that is based on the idea that identical
assets in different markets should be priced identically.
While the CAPM is based on a market portfolio of assets, the arbitrage pricing model doesn't mention a
market portfolio at all. Instead, the arbitrage pricing model states that an asset's returns should
compensate the investor for the risk of the asset, where the risk is due to a number of economic
influences, or economic factors. Therefore, the expected return on the asset i, ri, is:
ri = rf + 1f1 + 2f2 + 3 f3+ ...
where each of the 's reflect the asset's return's sensitivity to the corresponding economic factor, f. The
arbitrage pricing model looks much like the CAPM, but the CAPM has one factor -- the market portfolio.
There are many factors in the Arbitrage Pricing Model.
What if an asset's price is such that it is out of line with what is expected? That's where arbitrage comes
in. Any time an asset's price is out of line with how market participants feel it should be priced -- based
on the basic economic influences -- investors will enter the market and buy or sell the asset until its price
is in line with what investors think it should be.
What are these economic factors? They are not specified in the original Arbitrage Pricing Model, though
evidence suggests that these factors include:
Unanticipated changes in inflation;

Unanticipated changes in industrial production;
Unanticipated changes in risk premiums; and
Unanticipated changes in the difference between interest rates for short and long term securities.
Anticipated factors are already reflected in an asset's price. It is the unanticipated factors that cause an
asset's price to change. For example, consider a bond with a fixed coupon interest. The bond's current
price is the present value of expected interest and principal payments, discounted at some rate that
reflects the time value of money, the uncertainty of these future cash flows, and the expected rate of
inflation. If there is an unanticipated increase in inflation, what will happen to the price of the bond? It
will go down since the discount rate increases as inflation increases. And if the price of the bond goes
down, so too does the return on the bond. Therefore, the sensitivity of a bond's price to changes in
unanticipated inflation is negative.
The Arbitrage Pricing Model is not without drawbacks. First, the factor sensitivities must be estimated.
The model is based on the sensitivities of expected returns to unanticipated changes in the factors. Alas,
the best we can do, much like the CAPM, is look at historical relationships. Second, some financial
observers argue that a single factor, namely the market portfolio, does just as good a job in explaining
security returns as the more complex multiple factor approach of the Arbitrage Pricing Model.
C. Financial decision-making and asset pricing

Portfolio theory and asset pricing models lay the groundwork for financial decisions. While portfolio
theory and asset pricing theory are complex and rely on many assumptions, they do get us thinking
about what is important:

Return and risk must both be considered.
Since investors must be compensated for risk, a greater return is expected for bearing
greater risk.
Investors hold portfolios of assets; therefore the relevant risk in the valuation of assets is the
portfolio's risk.
If a corporation is considering investing in a new product, there are two levels of thinking to work
through in evaluating its risk and returns:
If a firm takes on the product, it is adding it to its portfolio of assets and needs to consider
the affect of this product on the firm's overall risk.
Since a firm is owned by investors, who themselves may own portfolios of assets, the
relevant risk to consider is how the change in the firm's risk affects the owners' portfolio risk.
Therefore, when we evaluate the new product's future cash flows, the discount rate that we apply to
value these future cash flows must reflect how that product affects the owners' portfolio risk.
5. Summary
Portfolio theory and the related mathematics help us understand the relation between risk and return.
Though portfolio theory is often demonstrated in terms of investing in stocks, the concepts are much
more comprehensive. Consider that every business is a portfolio of assets, some tangible and some
intangible. By understanding how diversification works, a financial manager gains a better understanding
of the relevant risks in decision-making and, hence, a better understanding of valuation of investments.

Portfolio risk
Standard deviation = 0.00102 0.00518 2(0.000806) = 8.843%
Expected return using the CAPM

Common stock ri
3Com 1.15 7.6%
Advance Auto Parts 0.90 6.6%
Archer-Daniels Midland 0.70 5.8%
Big Lots 1.10 7.4%
BJ’s Wholesale 1.05 7.2%
Claire’s Stores 1.10 7.4%
PetSmart 1.00 7.0%
Reynolds American 0.95 6.8%
Seagate Technologies 1.20 7.8%
Stillwater Mining 1.30 8.2%
W.M. Wrigley 0.55 5.2%
Williams-Sonoma 1.25 8.0%

Risk formulas
1. Types of risk
Q(P-V)
Q(P-V)-F
[Q(P-V)-F]
[Q(P-V)-F-I]
Q(P-V)
Q(P-V)-F-I
2. Risk measurement
N
Expected value = E (x) = pn xn
n=1
= (x) pn (xn (x))2
n 1

S
Return on a portfolio = rp wiri
i 1
N
i=1
Portfolio standard deviation, 2-security portfolio = w12 12 + w 22 22 + 2w1 w2 cov1,2
.
N N N
2 2
Portfolio standard deviation = wi i + wi w jcovij .
i=1 i 1 j 1 j i

1,2
coefficient


12

S
Portfolio beta = p wii
i 1
Return on a security, CAPM = ri = rf + (rm - rf) i

Portfolio Risk and Return
Prepared by Pamela Parrish Peterson, PhD., CFA
The return on a portfolio of assets is calculated as:

N
rp = w i ri
i=1
where ri is the expected return on asset i, and
wi is the weight of asset i in the portfolio.
Portfolio risk is calculated using the risk of the individual assets (measured by the standard
deviation), the weights of the assets in the portfolio, and either the correlation between or
among the assets or the covariance of the assets’ returns.
For a two-asset portfolio, the risk of the portfolio, p, is:
ıp = w12ı12 +w 22ı 22 +2w1ı1w 2ı 2ȡ12
or
ıp = w12ı12 +w 22ı 22 +2w1w 2cov12
cov12
since ȡ12 =
ı1ı 2
where i is the standard deviation of asset i’s returns,
12 is the correlation between the returns of asset 1 and 2, and
cov12 is the covariance between the returns of asset 1 and 2.
Problem What is the portfolio standard deviation for a two-asset portfolio comprised
of the following two assets if the correlation of their returns is 0.5?
Asset A Asset B
Standard deviation of expected 5% 20%
returns
Solution p = 13.115%
Calculation ıp = 0.420.052 +0.62 0.22 +2(0.4)(0.05)(0.6)(0.2)(0.5)
ıp (0.16)(0.0025) (0.36)(0.04) (2)(0.0012)

ıp 0.0004 0.0144 0.0024
ıp 0.0172 0.131149 or 13.1149%

Portfolio risk and return practice problems
returns is 0.5?
Asset C Asset D
Correlation 0.40
returns is 0.5?
Asset E Asset F
Correlation 0.20
returns is 0.5?
Asset G Asset H
Correlation -0.30
Solutions to portfolio risk and return practice problems
Problem Expected portfolio return Portfolio risk

1 16% 16.1632%
2 23% 16.8582%
3 19% 23.2413%

Types of risk
1. Distinguish between sales risk and operating risk. Can firm have a high degree of sales risk and a
low degree of operating risk? Explain.
2. Consider two bonds. Bond A has a face value of $1,000 and a coupon rate of 10%. Bond B has a
face value of $1,000 and a coupon rate of 5%. Both bonds have the same maturity. Which bond
has the greater interest rate risk?
3. Consider two bonds. Bond C has a face value of $1,000 and five years remaining to maturity.
Bond D has a face value of $1,000 and ten years remaining to maturity. Both bonds have the
same coupon rate of 10%. Which bond has the greater interest rate risk?
4. Consider the Gum Company. Gum sells packs of gum for $0.50 each. It costs $0.20 per pack to
manufacture and distribute the gum. Gum has fixed operating costs of $5,000 and fixed financing
costs of $3,000.
a. What is Gum's degree of operating leverage at 50,000 packs produced and sold?
b. What is Gum's degree of financial leverage at 50,000 packs produced and sold?
c. What is Gum's degree of total leverage at 50,000 packs produced and sold?
Risk measurement
1. For each of the following probability distributions, calculate the expected value and standard
deviation:
a.
Outcome Probability Outcome value

Good 30% $40
Normal 50% $20
Bad 20% $10
b.
Pessimistic 10% $1,000,000
Moderate 40% $4,000,000
Optimistic 50% $6,000,000
c.
One 10% 60%
Two 50% 40%
Three 30% 20%
Four 10% -40%
d.
Risk and return practice problems 1

A 10% $1,000
B 20% $2,000
C 40% $3,000
D 20% $4,000
E 10% $5,000
2. There is a 50% probability that the Plum Company's sales will be $10 million next year, a 20%
probability that they will be $5 million, and a 30% probability that they will be $3 million.
a. What are the expected sales of Plum Company next year?
b. What is the standard deviation of Plum's next year's sales?
3. You want to win the Lottery? Good Luck! The odds of winning a $6 million lottery jackpot in
Florida are 1 in 14,000,000. What is the expected value of a $1 lottery ticket investment?
4. Consider the following investments:
Investment Expected return Standard deviation

A 5% 10%
B 7% 11%
C 6% 12%
D 6% 10%
Which investment would you prefer between the following pairs?
a. A and D?
b. B and C?
c. C and D?
Risk, return and diversification

1. The covariance of the returns on the two securities, A and B, is -0.0005. The standard deviation
of A's returns is 4% and the standard deviation of B's returns is 6%. What is the correlation
between the returns of A and B?
2. Company X has a beta of 1.45. The expected risk-free rate of interest is 2.5% and the expected
premium for the market as a whole is 10%. Using the CAPM, what is ABC’s expected return?
3. Consider a portfolio comprised of four securities in the following proportions and with the
indicated security beta.
Security Amount invested Beta Expected return
A $1.5 million 1.0 12.0%
B $1.0 million 1.5 13.5%
C $2 million 0.8 9.0%
a. What is the portfolio's beta?
b. What is the portfolio's expected return?
4. ABC Company has a beta of 1.2. The expected risk-free rate of interest is 4% and the expected
premium for the market as a whole is 5%. What is the expected return for ABC Company stock?
5. Consider Securities D and E with the following estimates:

E(R ) = 8% = 12% E(R ) = 13% = 20%
D D E E
Now consider the portfolios that can be formed with D and E, assuming that the investment is
equal between D and E (that is, each has a weight of 50%). What is the portfolio’s standard
deviation if the correlation between D and E for each of the following?
a. 1.0
b. 0.3
c. 0.0
d. -1.0
6. Consider Securities X and Y with the following estimates:
E(R ) = 5% = 10% E(R ) = 15% = 25%
X X Y Y
If the portfolio is comprise of 40% X and 60% Y and if the correlation between the returns on X
and Y is -0.25, what is the portfolio’s expected return and risk?

Types of risk
1. Distinguish between sales risk and operating risk. Can firm have a high degree of sales risk and a
low degree of operating risk? Explain.
Sales risk is the uncertainty regarding the number of units sold and the price per unit. This risk is
affected by economic and market conditions. Operating risk is the uncertainty in operating
earnings arising from the mix of variable and fixed operating costs. A firm can have a great deal
of sales risk (e.g., a very competitive industry) and yet have low operating risk because of their
operating cost structure.
2. Consider two bonds. Bond A has a face value of $1,000 and a coupon rate of 10%. Bond B has a
face value of $1,000 and a coupon rate of 5%. Both bonds have the same maturity. Which bond
has the greater interest rate risk?
Bond B because it has the lower coupon rate.
3. Consider two bonds. Bond C has a face value of $1,000 and five years remaining to maturity.
Bond D has a face value of $1,000 and ten years remaining to maturity. Both bonds have the
same coupon rate of 10%. Which bond has the greater interest rate risk?
Bond D because it has the longer maturity.
4. Consider the Gum Company. Gum sells packs of gum for $0.50 each. It costs $0.20 per pack to
manufacture and distribute the gum. Gum has fixed operating costs of $5,000 and fixed financing
costs of $3,000.
a. What is Gum's degree of operating leverage at 50,000 packs produced and sold?
DOL = (50,000 ($0.50-0.20))/(50,000 ($0.50-0.20) - 5,000) = 1.5
b. What is Gum's degree of financial leverage at 50,000 packs produced and sold?
DFL = ((50,000 ($0.50-0.20) - 5,000)/(50,000 ($0.50-0.20) - 5,000 - 3,000) = 1.42857
c. What is Gum's degree of total leverage at 50,000 packs produced and sold?
DTL = 1.5 x 1.42857 = 2.142857
Solutions to risk and return practice problems 1

Risk measurement
1. For each of the following probability distributions, calculate the expected value and standard
deviation:
a.
Outcome Probability Outcome value px x-E(x) (x-E(x))2 p(x-E(x))2
Good 30% $40 $12 $16 $256 77
Normal 50% $20 $10 -$4 $16 8
Bad 20% $10 $2 -$14 $196 39
100% E(x) = $24 variance = 124
standard deviation = $11
b.
Pessimistic 10% $1,000,000 $100,000 -$3,700,000 $13,690,000,000,000 1,369,000,000,000
Moderate 40% $4,000,000 $1,600,000 -$700,000 $490,000,000,000 196,000,000,000
Optimistic 50% $6,000,000 $3,000,000 $1,300,000 $1,690,000,000,000 845,000,000,000
100% E(x) = $4,700,000 variance = 2,410,000,000,000
standard deviation = $1,552,417
c.
2 2
Outcome Probability Outcome value px x-E(x) (x-E(x)) p(x-E(x))
One 10% 60% 0.060000 0.320000 0.102400 0.010240
Two 50% 40% 0.200000 0.120000 0.014400 0.007200
Three 30% 20% 0.060000 -0.080000 0.006400 0.001920
Four 10% -40% -0.040000 -0.680000 0.462400 0.046240
E(x) = 0.280000 variance = 0.065600
standard deviation = 25.61%
d.
A 10% $1,000 $100 -$2,000 4,000,000 400,000
B 20% $2,000 $400 -$1,000 1,000,000 200,000
C 40% $3,000 $1,200 $0 0 0
D 20% $4,000 $800 $1,000 1,000,000 200,000
E 10% $5,000 $500 $2,000 4,000,000 400,000
E(x) = $3,000 variance = 1,200,000
standard deviation = $1,095
2. There is a 50% probability that the Plum Company's sales will be $10 million next year, a 20%
probability that they will be $5 million, and a 30% probability that they will be $3 million.
a. What are the expected sales of Plum Company next year?
Expected value = $6.9 million
b. What is the standard deviation of Plum's next year's sales?

Variance = 4.8050 + 0.7220 + 4.5630 = 10.09
Standard deviation = square root of 10.09 = $3.1765 million
3. You want to win the Lottery? Good Luck! The odds of winning a $6 million lottery jackpot in
Florida are 1 in 14,000,000. What is the expected value of a $1 lottery ticket investment?
E
Lottery ticket
= [0.0000000714 ($6,000,000)] + [0.9999999286 ($0)]

cash flow
Ã Ã
winning losing
= $0.43 + $0
= $0.43.
Spending $1 for a ticket with an expected value of 43c/ means that you expect to lose 57c/
4. Consider the following investments:
Investment Expected return Standard deviation

A 5% 10%
B 7% 11%
C 6% 12%
D 6% 10%
Which investment would you prefer between the following pairs?
a. A and D? D
b. B and C? B
c. C and D? D
Risk, return and diversification

1. The covariance of the returns on the two securities, A and B, is -0.0005. The standard deviation
of A's returns is 4% and the standard deviation of B's returns is 6%. What is the correlation
between the returns of A and B?
Correlation = -0.0005 / ((0.04)(0.06)) = -0.2083
2. Company X has a beta of 1.45. The expected risk-free rate of interest is 2.5% and the expected
return on the market as a whole is 10%. Using the CAPM, what is ABC’s expected return?
r = 2.5% + 1.45(10% - 2.5%) = 13.375%

3. Consider a portfolio comprised of four securities in the following proportions and with the
indicated security beta.
Security Amount invested Beta Expected return
A $1.5 million 1.0 12.0%
B $1.0 million 1.5 13.5%
C $2 million 0.8 9.0%
a. What is the portfolio's beta?
p = (1.5/4.5) 1.0 + (1/4.5) 1.5 + (2/4.5) 0.8

p = 0.3333 + 0.3333 + 0.3556 = 1.0222
b. What is the portfolio's expected return?
E(p) = (1.5/4.5)0.12 + (1/4.5) 0.135 + (2/4.5) 0.09
E(p) = 0.04 + 0.03 + 0.04 = 0.11 or 11%
4. ABC Company has a beta of 1.2. The expected risk-free rate of interest is 4% and the expected
premium for the market as a whole is 5%. What is the expected return for ABC Company stock?
r = 4% + 1.2(5%) = 10%
5. Consider Securities D and E with the following estimates:
E(R ) = 8% = 12% E(R ) = 13% = 20%
D D E E
Now consider the portfolios that can be formed with D and E, assuming that the investment is
equal between D and E (that is, each has a weight of 50%). What is the portfolio’s standard
deviation if the correlation between D and E for each of the following?
(a) rij =1.0
N N N
2 2
p = Xi i + Xi X ji jrij
i=1 "
i=1 j=1j=i
p = (0.52 0.122 )+(0.52 0.22 ) +2 (0.5)(0.5)(0.12)(0.2) 1.0!

p = 0.0036+0.0100+0.012= 0.0256=0.16
(b) rij 0.3
p (0.52 0.122 ) (0.52 0.22 ) 2 (0.5)(0.5)(0.12)(0.2) 0.3!

p 0.0036 0.0100 0.0036 0.0172 0.131149
(c) rij 0.0
p (0.52 0.122 ) (0.52 0.22 ) 2 (0.5)(0.5)(0.12)(0.2) 0.0

p 0.0036 0.0100 0.0 0.0136 0.116619
(d) r ij = -1.0
p = (0.52 0.122 )+(0.52 0.22 ) +2 (0.5)(0.5)(0.12)(0.2)( -1.0)

p = 0.0036+0.0100-0.012= 0.0016=0.04
6. Consider Securities X and Y with the following estimates:

E(R ) = 5% = 10% E(R ) = 15% = 25%
X X Y Y

If the portfolio is comprise of 40% X and 60% Y and if the correlation between the returns on X
and Y is -0.25, what is the portfolio’s expected return and risk?
Expected return = 0.4(0.05) + 0.6(0.15) = 0.02 + 0.09 = 0.11 or 11%
Variance = (0.4)(0.4)(0.10)(0.10) + (0.6)(0.6)(.25)(.25)+(2)(0.4)(0.6)(0.1)(0.25)(-0.25)

Variance = 0.0016 + 0.0225+-0.0030 = 0.0211
Standard deviation = 14.5268%

Practice problems

Interactive, online activities that provide a review of the material for Traditional problem sets, with solutions, along with
specified topics. Activities include crossword puzzles, fill-in the blanks, other types of material (e.g., printable crossword
flashcards, and quizzes. puzzles, practice tests).

Practice problems
Foundation | Taxes | Financial ratios | Time value of money | Valuation | Risk and return | Capital budgeting |
Capital structure

Taxes 5-minute workouts: Bond valuation | Bond yields
5-minute work outs: Tax-rate schedules | Taxes: Sale of assets Bond valuation practice problems
Risk and return
Future and present values | Annuities | Uneven cash flows Capital budgeting cash flow practice problems
EAR vs. APR | Interpreting problems Goofy Gadget Gooferizer Project, with solutions
Annuity Practice Problems B. B. Dome Project
Time Value of Money Practice Test Rockafellar Music Company
Loan Amortization: Example and Explanation 5-minute Work-out -- Capital budgeting
Deferred Annuity Problem: Example and Explanation techniques
NOTE:Calculator assistance and Time Value of Money tables are Capital budgeting techniques practice Problems
available. Capital Budgeting Practice Test
Solutions

Solutions
Cost of capital practice problems and Solutions
Capital structure and cost of capital crossword
puzzle

Financial ratios http://educ.jmu.edu/~drakepp/principles/probsets.html#ratios
Time value of money http://educ.jmu.edu/~drakepp/principles/probsets.html#tvm
Risk and return http://educ.jmu.edu/~drakepp/principles/probsets.html#rr
Capital budgeting http://educ.jmu.edu/~drakepp/principles/probsets.html#cb
Capital structure http://educ.jmu.edu/~drakepp/principles/probsets.html#cs
Using Financial
Accounting http://educ.jmu.edu/~drakepp/principles/module2/acc.html
Information
Accounting Review
Crossword Puzzle
Tax-rate schedules http://educ.jmu.edu/~drakepp/principles/tax/Taxratework.htm
Taxes: Sale of assets http://educ.jmu.edu/~drakepp/principles/tax/worktax.html
Practice Problems in
http://educ.jmu.edu/~drakepp/principles/tax/taxprob.html
Taxation
Net operating loss
problems
Financial Ratio
http://educ.jmu.edu/~drakepp/principles/module2/finrat.html
Problems
Financial Ratio
Formulas
Time Value of Money
Practice Problems
More Time Value of
Money Practice http://educ.jmu.edu/~drakepp/principles/module3/dann.html
Problems
Future and present
values
Uneven cash flows http://educ.jmu.edu/~drakepp/principles/module3/work3.html
Interpreting problems http://educ.jmu.edu/~drakepp/principles/module3/work4.html
Annuity Practice
http://educ.jmu.edu/~drakepp/principles/module3/defprob.htm
Problems
Time Value of Money
http://educ.jmu.edu/~drakepp/principles/module3/tvmtest.html
Practice Test
Loan Amortization:
Example and http://educ.jmu.edu/~drakepp/principles/module3/loan_amortization.htm
Explanation
Deferred Annuity http://educ.jmu.edu/~drakepp/principles/module3/Deferred_Annuity_Problem.htm

Problem: Example and

Explanation
Calculator assistance http://educ.jmu.edu/~drakepp/principles/calculators/index.html
Time Value of Money
http://educ.jmu.edu/~drakepp/principles/misc.html#tvmtables
tables
Valuation problems http://educ.jmu.edu/~drakepp/principles/module4/valuation_problems.pdf
Valuation quiz http://educ.jmu.edu/~drakepp/principles/module4/valuequiz.htm
Two-stage dividend
growth practice http://educ.jmu.edu/~drakepp/principles/module4/twostage.htm
Problems
Bond valuation http://educ.jmu.edu/~drakepp/principles/module4/workbd.html
Bond valuation
practice problems
Bond yield practice
http://educ.jmu.edu/~drakepp/principles/module4/yield.html
problems
Risk and return
practice problems
More risk and return
practice problems
Risk measurement
http://educ.jmu.edu/~drakepp/principles/module5/riskexamples.htm
problems
Risk-return problem http://educ.jmu.edu/~drakepp/principles/module5/riskret.html
Risk and return
crossword puzzle
Capital budgeting cash
http://educ.jmu.edu/~drakepp/principles/module6/cf.html
flow practice problems
Goofy Gadget
Gooferizer Project
B. B. Dome Project http://educ.jmu.edu/~drakepp/principles/module6/bbdome.html
Rockafellar Music
http://educ.jmu.edu/~drakepp/principles/module6/cbrock.html
Company
5-minute Work-out --
Capital budgeting http://educ.jmu.edu/~drakepp/principles/module6/cbwork.html
techniques
Capital budgeting
techniques practice http://educ.jmu.edu/~drakepp/principles/module6/cb.html
Problems
Capital Budgeting
http://educ.jmu.edu/~drakepp/principles/module6/cbtest.html
Practice Test
Capital budgeting http://educ.jmu.edu/~drakepp/principles/module6/cbproblems.pdf

practice problems
Capital structure
practice problems
Cost of capital practice
problems
Capital structure and
crossword puzzle
FIN3403: Module 6, Peterson-Drake, FAU Page 1 of 2
Module 6: Capital Budgeting

Elements
1. Module 6: Capital budgeting IMPORTANT: READ FIRST
2. Reading: Capital budgeting and cash flows
3. Reading: Capital budgeting techniques
4. Reading: Capital budgeting and risk
5. Capital budgeting formulas
6. Explanation: Williams 5 and 10 A detailed demonstration of the estimation of cash flows
7. Capital Budgeting StudyMate Activity
8. Practice problems: Capital budgeting practice problems and Solutions
FIN3403: Module 6, Peterson-Drake, FAU Page 2 of 2

Module 6: Capital budgeting http://educ.jmu.edu/~drakepp/principles/module6/learning_outcomes.pdf
Capital budgeting and cash flows http://educ.jmu.edu/~drakepp/principles/module6/capbudcf.pdf
Capital budgeting techniques http://educ.jmu.edu/~drakepp/principles/module6/capbudtech.pdf
Capital budgeting and risk http://educ.jmu.edu/~drakepp/principles/module6/cbrisk.pdf
Capital budgeting formulas http://educ.jmu.edu/~drakepp/principles/module6/cbformulas.pdf
Williams 5 and 10 http://educ.jmu.edu/~drakepp/principles/module6/williams.pdf
Capital Budgeting StudyMate
Activity
Capital budgeting practice
problems
MODULE 6:
CAPITAL BUDGETING
OUTLINE
1. Introduction
3. Module tasks
1. Introduction
As you are seeing throughout your study of finance, financial managers make decisions regarding
the benefits and costs associated with an investment. An important part of decision making
within a business enterprise is that which involves long-lived projects. The purpose of this
module is to introduce you to the decision-making process for long-lived projects, which we refer
to as capital projects. Without capital projects, which include replacement projects, new
products, expansions, and acquisitions, a business enterprise will not continue to grow.
The capital budgeting process requires estimating cash flows and then applying techniques that
help the financial manager evaluate the benefits and costs of the investment project. In general,
a company should invest in projects that enhance owners’ wealth. Therefore, the financial
manager must use those techniques that will help in identifying the projects that will add value.
The challenges that we face in capital budgeting are many: estimating incremental cash flows
from a project, incorporating risk, and selecting among the many projects that are available. In
this module, we focus on the method of estimating cash flows, techniques that we can apply to
these cash flows, and how risk may be incorporated into the decision process.
LO6.1 Explain the objective of capital budgeting and relate this to the objective of the firm.
LO6.2 Differentiate between mutually exclusive projects and independent projects.
LO6.3 Explain the basic process of capital budgeting decision-making.
LO6.4 Calculate investment cash flows relevant for a capital project.
LO6.5 Calculate operating cash flows for each year of a capital project.
LO6.6 List the different capital budgeting techniques that are used to evaluate projects.
LO6.7 Calculate the payback period and discounted payback period for a project.
LO6.8 Calculate the net present value of a capital project.
Module 6 Overview 1
LO6.9 Calculate the profitability index of a capital project.
LO6.10 Draw an investment profile for a capital project.
LO6.11 Calculate the IRR for a project.
LO6.12 Calculate the MIRR for a project.
LO6.13 Identify the problems associated with the IRR and the MIRR.
LO6.14 List the advantages and disadvantages of the different capital budgeting techniques.
LO6.15 Identify the capital budgeting techniques that are appropriate for a capital budgeting
situation.
LO5.16 Identify how risk affects the capital budgeting decision and may be incorporated in
decision-making.
LO5.17 Recognize the relevant risk for capital budgeting.
LO5.18 Understand how sensitivity analysis and simulation may be used to assess risk of a
capital budgeting project.
LO5.19 Estimate an asset’s beta.
3. Module tasks
A. Readings
i Required reading
(a) Capital budgeting & cash flows
(b) Capital budgeting techniques
(c) Capital budgeting and risk
ii Other resources
(a) William 5 & 10 Capital budgeting example
(b) Capital budgeting formulas
(c) Advantages and disadvantages of the different capital budgeting techniques
(d) Capital Budgeting, Study Finance.com, The University of Arizona
(a) Fabozzi and Peterson text, Chapters 12, 13 and 14 (Long-term Investment
Decisions). Available through the Florida Atlantic University Libraries’ NetLibrary®
access.
(b) Investment Decisions -- Capital budgeting, prepared by the United Nations.
B. Problem sets
These problems sets are non-graded tasks. It is recommended that you complete these problem
sets prior to attempting the graded online quiz.
Capital budgeting practice problems and solutions
Capital Budgeting Cash Flow Practice Problems
Goofy Gadget Gooferizer Project, with solutions
Module 6 Overview 2
B. B. Dome Project
Rockafellar Music Company
5-minute Work-out -- Capital Budgeting Techniques
Capital Budgeting Techniques Practice Problems

A. Capital budgeting and cash flows
Determining whether an investment project produces benefits that out weigh the costs requires
first estimating the cash flows that a project will produce. This requires estimating how a
business’s cash flows change when an investment is made; in other words, what are the
incremental cash flows?
Estimating these incremental cash flows requires estimating the cash flows from the investment
itself – acquiring and disposing of the investment’s assets – and the cash flows from operating
the investment – those affected by the revenues, expenditures, depreciation, and taxes. The
bottom line is a set of net cash flows for each period associated with the investment decision.
B. Capital budgeting techniques

Once we estimate the net cash flows that arise from an investment opportunity, we apply
techniques to these cash flows to assess the attractiveness of the opportunity. These techniques
produce a result in terms of the length of time to pay back the investment (the payback period
and the discounted payback period), the value added (the net present value), the benefit-cost
ratio (the profitability index) or the return (the internal rate of return and the modified internal
rate of return).
In most general circumstances, the internal rate of return, net present value, and profitability
index will produce similar recommendations regarding accepting an investment project. However,
if there is a limit on the capital budget or if projects are mutually exclusive, we must be careful in
selecting the technique to use in our investment selection process.
C. Capital budgeting and risk

The cash flows that we evaluate using the capital budgeting techniques are merely estimates.
The future is not know with certainty and neither are future cash flows. Therefore, we must
factor the degree of uncertainty into our decision making. We generally do this by adjusting the
discount rate associated with the project by the amount of risk. Specifically, we should adjust
the discount rate for the amount of systematic risk associated with the project. And while that
sounds appropriate in theory, it is difficult to do in practice.
D. What’s next?
In the next module, we focus on the capital structure of the business. The capital structure that
a company selects affects the financial risk of the business and, hence, the company’s cost of
capital.
Module 6 Overview 3
Capital budgeting &
cash flow analysis
OUTLINE
1. Introduction
2. Cash flows from investments
3. Investment cash flows
4. Operating cash flows
5. Putting it all together
6. Summary
1. Introduction
As long as a company exists, it invests in assets. In fact, a company invests in assets to continue to exist,
and moreover, to grow. By investing to grow, a company is at the same time investing to maximize the
owners' wealth. Maximizing wealth of a company's owners requires that its managers continually evaluate
investment opportunities and determine which ones provide a return commensurate with their risk. Let's
look at Company A, B, and C, each having identical assets and investment opportunities, but that:
Company A's management does not take advantage of its investment opportunities and simply pays
all of its earnings to its owners;
Company B's management only makes those investments necessary to replace any deteriorating
plant and equipment, paying out any left-over earnings to its owners; and
Company C's management invests in all those opportunities that provide a return better than what
the owners could have earned had they had the same amount of invested funds to invest
themselves.
In the case of Company A, the owners' investment in the company is not what it could be as long as the
company has investment opportunities that are better than those available to owners. By not even
making investments to replace deteriorating plant and equipment, Company A will eventually shrink until
it has no more assets.
In the case of Company B, its management is not taking advantage of all profitable investments --
investments that provide a higher return than the return required by its owners. This means that there
are foregone opportunities and owners' wealth is not maximized.
But in the case of Company C, management is making all profitable investments, maximizing owners'
wealth. Company C will continue to grow as long as there are profitable investment opportunities and its
management takes advantage of them. And Company C represents most large corporations: continually
making investments and growing over time.
Capital budgeting & cash flows, a reading prepared by Pamela Peterson Drake 1
A. The investment problem
Capital investments
Companies continually invest funds in assets and these assets produce income and cash flows that the
company may either reinvest in more assets or pay to its owners. These assets represent the company's
capital. Capital is the company's total assets and is comprised of all tangible and intangible assets.
These assets include physical assets (such as land, buildings, equipment, and machinery), as well as
assets that represent property rights (such as accounts receivable, notes, stocks, and bonds). When we
refer to capital investment, we are referring to the company's investment in its assets. 1
The company's capital investment decision may be comprised of a number of distinct decisions, each
referred to as a project. A capital project is a set of asset investments that are contingent on one
another and are considered together. Suppose a company is considering the production of a new
product. It must make a decision of whether or not to produce this new product. This capital project
requires acquiring land, building facilities, and purchasing production equipment. And this project may
also require the company to increase its investment in its working capital -- inventory, cash, or accounts
receivable. Working capital is the collection of assets needed for day-to-day operations that support a
company's long-term investments.
The investment decisions of the company are decisions concerning a company's capital investment. When
we refer to a particular decision that financial managers must make, we are referring to a decision
pertaining to a capital project.
Investment decisions and owners' wealth maximization

Let's see what we must evaluate in our investment decisions to maximize the wealth of owners of the
company we manage. We already know the value of the company today is the present value of all its
future cash flows. But we need to understand better where these future cash flows come from. They
come from:
1. assets that are already in place, which are the assets accumulated as a result of all past
investment decisions, and
2. future investment opportunities.
Future cash flows are discounted at a rate that represents investors' assessments of the uncertainty that
these cash flows will flow in the amounts and when expected. To evaluate the value of the company, we
need to evaluate the risk of these future cash flows; that is, the project’s business risk.
A project's business risk is reflected in the discount rate, which is the rate of return required to
compensate the suppliers of capital (bondholders and owners) for the amount of risk they bear. From
investors' perspective, the discount rate is the required rate of return (RRR). From the company's
perspective, the discount rate is the cost of capital -- what it costs the company to raise a dollar of new
capital.
1
The term capital also has come to mean the funds used to finance the company's assets. In this sense,
capital consists of notes, bonds, stock, and short-term financing. We use the term "capital structure" to
refer to the mix of these different sources of capital used to finance a company's assets. The term capital in
financial management, a company's resources and the funds committed to these resources, does not mean the same
thing in other fields. In accounting, the term "capital" means the owners' equity, the difference between the amount
of a company's assets and its liabilities. In economics, the term capital means the physical (real) of the company, and
therefore excludes the assets that represent property rights. In law the term capital refers to the amount of owners'
equity required by statute for the protection of creditors. This amounts to the stated capital, which often is the par
value of the company's stock.
Suppose a company invests in a new project.
If the project generates cash flows that just compensate the suppliers of capital for the risk
they bear on this project (that is, it earns the cost of capital), the value of the company does
not change.
If the project generates cash flows greater than needed to compensate them for the risk
they take on, it earns more than the cost of capital, increasing the value of the company.
If the project generates cash flows less than needed, it earns less than the cost of capital,
decreasing the value of the company.
How do we know whether the cash flows are more than or less than needed to compensate for the risk
that they will indeed flow? If we discount all the cash flows at the cost of capital, we can assess how this
project affects the present value of the company. If the expected change in the value of the company
from an investment is:
positive, the project returns more than the cost of capital;
negative, the project returns less than the cost of capital;
zero, the project returns the cost of capital.
Capital budgeting is the process of identifying and selecting investments in long-lived assets, where
long-lived means assets expected to produce benefits over more than one year. In this reading, we first
look at the capital budgeting process in general. After looking at the broad picture of how investment
decisions are made, we look at how projects may be classified. This classification helps us identify of the
cash flows we need to consider in our decisions. We then look at the mechanics of estimating future cash
flows using estimates of future revenues, expenses, and depreciation. We summarize our analysis of cash
flows with examples analyzing two different investment projects.
B. Capital budgeting
A company must continually evaluate possible investments. Investment decisions regarding long-lived
assets are a part of the on-going capital budgeting process. Ideas about what projects to invest in are
generated through facts gathered at lower management levels, where they are evaluated and screened.
The suggested investments that pass this first level filter up through successive management levels
toward top management or the board of directors, who make the decisions about which one will get how
much capital.
Before a company begins thinking about capital budgeting, it must first determine its corporate strategy -
- its broad set of objectives for future investment. How does a company achieve its corporate strategy?
By making investments in long-lived assets that will maximize owners' wealth. Selecting these projects is
what capital budgeting is all about.
C. Classifying investment projects

An investment generally provides benefits over a limited period of time, referred to as its economic life.
The economic life or useful life of an asset is determined by factors including physical deterioration,
obsolescence, and the degree of competition in the market for a product.
Economic life
The economic life or useful life of a project is an estimate of the length of time that the asset will
provide benefits to the company. After its useful life, the revenues generated by the asset tend to decline
rapidly and its expenses tend to increase.
Typically, an investment requires expenditure up-front -- immediately -- and provides benefits in the form
of cash flows received in the future. If benefits are received only within the current period -- within one
year of making the investment -- we refer to the investment as a short-term investment. If these benefits
are received beyond the current period, we refer to the investment as a long-term investment and refer
to the expenditure as a capital expenditure.
Any project representing an investment may comprise one or more assets. For example, a new product
may require investment in production equipment, a building, and transportation equipment -- all making
up the bundle of assets comprising the project we are evaluating. Short-term investment decisions
involve, primarily, investments in current assets: cash, marketable securities, accounts receivable, and
inventory. The objective of investing in short-term assets is the same as long-term assets: maximizing
owners' wealth. Nevertheless, we consider them separately for two practical reasons:
1. Decisions about long-term assets are based on projections of cash flows far into the future and
require us to consider the time value of money.
2. Long-term assets do not figure into the daily operating needs of the company.
Decisions regarding short-term investments, or current assets, are concerned with day-to-day operations.
And a company needs some level of current assets to act as a cushion in case of unusually poor
operating periods, when cash flows from operations are less than expected.
Risk
Suppose you are faced with two investments, A and B, each promising a $100 cash inflow ten years from
today. If A is riskier than B, what are they worth to you today? If you do not like risk, you would consider
A less valuable than B because the chance of getting the $100 in ten years is less for A than for B.
Therefore, valuing a project requires considering the risk associated with its future cash flows.
The project's risk of return can be classified according to the nature of the project represented by the
investment:
A replacement project is an investment that involves the replacement of existing equipment or
facilities.
Replacement projects include the maintenance of existing assets to continue the current
level of operating activity. Projects that reduce costs, such as replacing older technology
with newer technology or improving the efficiency of equipment or personnel, are also
considered replacement projects.
To evaluate replacement projects we need to compare the value of the company with the
replacement asset to the value of the company without that same replacement asset.
What we're really doing in this comparison is looking at opportunity costs: what cash
flows would have been if the company had stayed with the old asset.
There's little risk in the cash flows from replacement projects. The company is simply
replacing equipment or buildings already operating and producing cash flows. And the
company typically has experience in managing similar new equipment.
An expansion project is an investment in a project that broadens existing product lines and
existing markets.
Expansion projects are intended to enlarge a company's established product or market.
There is little risk associated with expansion projects. The reason: A company with a
history of experience in a product or market can estimate future cash flows with more
certainty when considering expansion than when introducing a new product outside its
existing product line.
A new product or market investment involves introducing a new product or entering into a new
market.
Investment projects that involve introducing new products or entering into new markets
are riskier than the replacement and expansion projects. That's because the company
has little or no management experience in the new product or market. Hence, there is
more uncertainty about the future cash flows from investments in new product or new
market projects.
A mandated project is a project required by government laws or agency rules.
A company is forced or coerced into its mandated projects. These are government
mandated projects typically found in "heavy" industries, such as utilities, transportation,
and chemicals, all industries requiring a large portion of their assets in production
activities. Government agencies, such as the Occupational Health and Safety Agency
(OSHA) or the Environmental Protection Agency (EPA), may impose requirements that
companies install specific equipment or alter their activities (such as how they dispose of
waste).
Dependence among projects

In addition to considering the future cash flows generated by project, a company must consider how it
affects the assets already in place -- the results of previous project decisions -- as well as other projects
that may be undertaken. Projects can be classified as follows according to the degree of dependence with
other projects: independent projects, mutually exclusive projects, contingent projects, and
complementary projects.
An independent project is one whose cash flows are not related to the cash flows of any other project.
In other words, accepting or rejecting an independent project does not affect the acceptance or rejection
of other projects. An independent project can be evaluated strictly on the effect it will have on the value
of a company without having to consider how it affects the company's other investment opportunities,
and vice versa.
Projects are mutually exclusive if the acceptance of one precludes the acceptance of other projects.
There are some situations where it is technically impossible to take on more than one project. For
example, suppose a manufacturer is considering whether to replace its production facilities with more
modern equipment. The company may solicit bids among the different manufacturers of this equipment.
The decision consists of comparing two choices:
1. Keeping its existing production facilities, or
2. Replacing the facilities with the modern equipment of one manufacturer.
Because the company cannot use more than one production facility, it must evaluate each bid and
determine the most attractive one. The alternative production facilities are mutually exclusive projects:
the company can accept only one bid. The alternatives of keeping existing facilities or replacing them are
also mutually exclusive projects. The company cannot keep the existing facilities and replace them!
Contingent projects are dependent on the acceptance of another project. Suppose a greeting card
company develops a new character, Joe Cool, and is considering starting a line of Joe Cool cards. If Joe
catches on, the company will consider producing a line of Joe Cool office supplies -- but only if the Joe
Cool character becomes popular. The office supply project is a contingent project. It is contingent on the
company (1) taking on the Joe project and (2) Joe Cool 's success.
Another form of dependence is found in complementary projects. Projects are complementary
projects if the investment in one enhances the cash flows of one or more other projects. Consider a
manufacturer of personal computer equipment and software. If it develops new software that enhances
the abilities of a computer mouse, the introduction of this new software may enhance its mouse sales as
well.
2. Cash flow from investments
A. Incremental cash flows
A company invests only to make its owners "better off", meaning increasing the value of their ownership
interest. A company will have cash flows in the future from its past investment decisions. When it invests
in new assets, it expects the future cash flows to be greater than without this new investment. Otherwise
it doesn't make sense to make this investment. The difference between the cash flows of the company
with the investment project and the cash flows of the company without the investment project -- both
over the same period of time -- is referred to as the project's incremental cash flows.
We have to look at how it will change the future cash flows of the company to evaluate an investment.
How much the value of the company changes as a result of the investment? The change in a company's
value as a result of a new investment is the difference between its benefits and its costs:
Project's change in the value of the company = Project's benefits - Project's costs.
A more useful way of evaluating the change in the value is the breakdown the project's cash flows into
two components
1. The present value of the cash flows from the project's operating activities (revenues and
operating expenses), referred to as the project's operating cash flows (OCF) ; and
2. The present value of the investment cash flows, which are the expenditures needed to acquire
the project's assets and any cash flows from disposing the project's assets.
or,
Change in the value Present value of the change in operating Present value of
= +
of the company cash flows provided by the project investment cash flows
The present value of a project's operating cash flows is typically positive (indicating predominantly cash
inflows) and the present value of the investment cash flows is typically negative (indicating
predominantly cash outflows).
3. Investment cash flows

When we consider the cash flows of an investment we must also consider all the cash flows associated
with acquiring and disposing of assets in the investment. An investment may comprise:
one asset or many assets;
an asset purchased and another sold; and
cash outlays that occur at the beginning of the project or spread over several years.
Let's first become familiar with cash flows related to acquiring assets; then we'll look at cash flows related
to disposing assets.
A. Asset acquisition
In acquiring any asset, there are three cash flows to consider:
1. Cost of the asset,
2. Set-up expenditures, including shipping and installation; and
3. Any tax credit.
The tax credit may be an investment tax credit or a special credit -- such as a credit for a pollution
control device -- depending on the tax law. Cash flow associated with acquiring an asset is:
Cash flow from acquiring assets = Cost + Set-up expenditures - Tax credit.
Suppose the company buys equipment that costs $100,000 and it costs $10,000 to install it. If the
company is eligible for a 10% tax-credit on this equipment (that is, 10% of the total cost of buying and
installing the equipment), the change in the company's cash flow from acquiring the asset is $99,000:
Cash flow from acquiring assets = $100,000 + $10,000 - 0.10 ($100,000+10,000)
= $100,000 + $10,000 - $11,000
= $99,000.
The cash outflow is $99,000 when this asset is acquired: $110,000 out to buy and install the equipment
and $11,000 in from the reduction in taxes. What about expenditures made in the past for assets or
research that would be used in the project we're evaluating? Suppose the company spent $1,000,000
over the past three years developing a new type of toothpaste. Should the company consider this
$1,000,000 spent on research and development when deciding whether to produce this new project we
are considering? No! These expenses have already been made and do not affect how the new product
changes the future cash flows of the company. We refer to this $1,000,000 as a sunk cost and do not
consider it in the analysis of our new project. Whether or not the company goes ahead with this new
product, this $1,000,000 has been spent. A sunk cost is any cost that has already been incurred that
does not affect future cash flows of the company.
Let's consider another example. Suppose the company owns a building that is currently empty. Let's say
the company suddenly has an opportunity to use it for the production of a new product. Is the cost of the
building relevant to the new product decision? The cost of the building itself is a sunk cost because it was
an expenditure made as part of some previous investment decision. The cost of the building does not
affect the decision to go ahead with the new product.
Suppose the company was using the building in some way producing cash (say, renting it) and the new
project is going to take over the entire building. The cash flows given up represent opportunity costs that
must be included in the analysis of the new project. However, these forgone cash flows are not asset
acquisition cash flows. Because they represent operating cash flows that could have occurred but will not
because of the new project, they must be considered part of the project's future operating cash flows.
Further, if we incur costs in renovating the building to manufacture the new product, the renovation costs
are relevant and should be included in our asset acquisition cash flows.
B. Asset disposition
Many new investments require getting rid of old assets. At the end of the useful life of an asset, the
company may be able to sell it or may have to pay someone to haul it away. If the company is making a
decision that involves replacing an existing asset, the cash flow from disposing of the old asset must be
figured in since it is a cash flow relevant to the acquisition of the new asset.
Disposition of new investment

If the company disposes of an asset, whether at the end of its useful life or when it is replaced, two types
of cash flows must be considered:
1. what you receive or pay in disposing of the asset; and
2. any tax consequences resulting from the disposal.
Cash flow from Proceeds or payment from disposing Taxes from disposing
= -
disposing assets assets assets
The proceeds are what you expect to sell the asset for if you can get someone to buy it. If the company
must pay for the disposal of the asset, this cost is a cash outflow.
Consider the investment in a gas station. The current owner may want to leave the business (retire,
whatever), selling the station to another gas station proprietor. But if a buyer cannot be found because of
lack of gas buyers in the area, the current owner may be required to remove the underground gasoline
storage tanks to prevent environmental damage. Thus, a cost is incurred at the end of the asset's life.
The tax consequences are a bit more complicated. Taxes depend on:
(1) the expected sales price, and
(2) the book value of the asset for tax purposes at the time
of disposition.
A common mistake in these

Sales price more than book value but less than original cost
calculations is to calculate
If a company sells the asset for more than its book value but less than its the tax consequences of
original cost, the difference between the sales price and the book value is the sale, but forget to add
a gain, taxable at ordinary tax rates. the cash flow from the
actual sale. This is an
Sales price more than original cost important cash flow that
should not be left out.
If a company sells the asset for more that its original cost, then the gain
is broken into two parts:
1. Capital gain: the difference between the sales price and the original cost; and
4. Recapture of
depreciation: the
Book value and gains
difference between
the original cost and The book value, or carrying value, of an asset is the value at which the asset is
the book value. reported on the company books (hence the use of the term “book”). It is the
difference between the original cost of the asset and any accumulated
The capital gain is the depreciation.
benefit from the
Consider an asset that is purchased at the beginning of 20X1 for $1 million. If
appreciation in the value of this is a 3-year MACRS asset, its depreciation, accumulated depreciation, and
the asset and may be taxed book value each year is the following: 2
at special rates, depending
Book value
on the tax law at the time of
MACRS Accumulated at end of
sale. The recapture of
Year rate Depreciation depreciation year
depreciation represents the 20X1 33.33% $333,300 $333,300 $666,700
amount by which the 20X2 44.51% $444,500 $777,800 $222,200
company has over- 20X3 14.81% $148,100 $925,900 $74,100
depreciated the asset during 20X4 7.41% $74,100 $1,000,000 $0
its life. This means that
Whether there is a gain or a loss on the sale of this asset depends on whether
more depreciation has been the sales prices is above the book value (hence, a gain), or below the book value
deducted from income (hence, a loss).
(reducing taxes) than
necessary to reflect the If the sales price is above the original cost of $1 million, then the total gain is
broken into two parts – that which is above the original cost (sales price –
usage of the asset. The
original cost), which is taxed at capital gains rates, and that which is below
recapture portion is taxed at (original cost – book value), which is taxed at ordinary rates.
the ordinary tax rates, since
this excess depreciation Try it! Gains and losses
taken all these years has
reduced taxable income. Calculate the gain or loss if the asset described above is sold:
1. At the end of 20X2 for $250,000
Sales price less than
book value 2. At the end of 20X3 for $50,000
3. At the end of 20X1 for $1,100,000
If a company sells an asset
for less than its book value, Solutions are provided at the end of the reading
the result is a capital loss. In
this case, the asset's value has decreased by more than the amount taken for depreciation for tax
purposes. A capital loss is given special tax treatment:
If there are capital gains in the same tax year as the capital loss, they are combined, so that the
capital loss reduces the taxes paid on capital gains, and
If there are no capital gains to offset against the capital loss, the capital loss is used to reduce
ordinary taxable income.
The benefit from a loss on the sale of an asset is the amount by which taxes are reduced. The reduction
in taxable income is referred to as a tax-shield, since the loss shields some income from taxation. If the
company has a loss of $1,000 on the sale of an asset and has a tax rate of 40%, this means that its
taxable income is $1,000 less and its taxes are $400 less than they would have been without the sale of
the asset.
2
MACRS depreciation rates are the rates prescribed by the U.S. Internal Revenue Code for depreciation for tax
purposes. These rates are provided in the Appendix to this reading.
Example1: Gains and losses from selling an asset
Suppose you are evaluating an asset that costs $10,000 that you expect to sell in five years. Suppose further that the
book value of the asset for tax purposes will be $3,000 after five years and that the company's tax rate is 40%. What
are the expected cash flows from disposing this asset?
Case 1: Sell the asset for $8,000

If you expect the company to sell the asset for $8,000 in five years, $10,000 - 3,000 = $7,000 of the asset's cost will
be depreciated, yet the asset lost only $10,000 - 8,000 = $2,000 in value. Therefore, the company has over-
depreciated the asset by $5,000. Since this over-depreciation represents deductions to be taken on the company's
tax returns over the five years that don't reflect the actual depreciation in value (the asset doesn't lose $7,000 in
value, only $2,000), this $5,000 is taxed at ordinary tax rates. If the company's tax rate is 40%, the tax = 40% x
$5,000 = $2,000.
The cash flow from disposition is the sum of the direct cash flow (someone pays us for the asset or the company
pays someone to dispose of it) and the tax consequences. In this example, the cash flow is the $8,000 we expect
someone to pay the company for the asset, less the $2,000 in taxes we expect the company to pay, or $6,000 cash
inflow.
Case 2: Sell the asset for $12,000

Suppose instead that you expect the company to sell this asset in five years for $12,000. Again, the asset is over-
depreciated by $7,000. In fact, the asset is not expected to depreciate, but rather appreciate over the five years. The
$7,000 in depreciation is recaptured after five years and taxed at ordinary rates: 40% of $7,000, or $2,800. The
$2,000 capital gain is the appreciation in the value of the asset and may be taxed at special rates. If the tax rate on
capital gain income is 30%, you expect the company to pay 30% of $2,000, or $600 in taxes on this gain. Selling the
asset in five years for $12,000 therefore results in an expected cash inflow of $12,000 - 2,800 - 600 = $8,600.
Cash 3: Sell the asset for $1,000

Suppose you expect the company to sell the asset in five years for $1,000. If the company can reduce its ordinary
taxable income by the amount of the capital loss, $3,000 - 1,000 = $2,000, our tax bill be 40% of $2,000, or $800
because of this loss. We refer to this reduction in the taxes as a tax-shield, since the loss "shields" $2,000 of income
from taxes. Combining the $800 tax reduction with the cash flow from selling the asset, the $1,000, gives the
company a cash inflow of $1,800.
Disposition of existing asset(s)

Let's also not forget about disposing of any existing assets. Suppose the company bought equipment ten
years ago and at that time expected to be able to sell fifteen years later for $10,000. If the company
decides today to replace this equipment, it must consider what it is giving up by not disposing of an asset
as planned.
If the company does not replace the equipment today, it would continue to depreciate it for five
more years and then sell it for $10,000.
If the company replaces the equipment today, it would not have five more years' depreciation on
the replaced equipment and it would not have $10,000 in five years (but perhaps some other
amount today).
This $10,000 in five years, less any taxes, is a forgone cash flow that we must figure into the investment
cash flows. Also, the depreciation the company would have had on the replaced asset must be
considered in analyzing the replacement asset's operating cash flows. So, any time that you are making
a decision pertaining to replacing an asset, don’t forget about the forgone.
Example 2: Initial cash flow Example 3: Cash flow from disposition
Problem Problem
Suppose a company spends $1 million on research and Equipment is bought for $500,000. It is depreciated
development of a new drug. The cost to buy the as a three-year asset using MACRS. At the end of two
necessary equipment to produce and distribute the years, the equipment is sold for $100,000. What is the
drug is $2.5 million. Working capital is expected to cash flow effect of this sale? Assume a 35% tax rate.
increase by $250,000 when the company embarks on MACRS rates for a 3-year asset are 33.33%, 44.45%,
the new product. What is the initial cash flow for this 14.81%, and 7.41%, respectively.
project?
Solution
Solution
Book value (BV) at the time of sale:
Initial cash flow: BV= $500,000 (0.0741 + 0.1481) = $111,100
Cash flow or
Cost of equipment -$2,500,000 BV= $500,000(1 - 0.3333 - 0.4445) = $111,100
Increase in working capital - 250,000 Loss = $100,000 - 111,100 = $11,100
Initial cash flow -$2,750,000 Tax benefit = (0.35)($11,100) = $3,885
CF = $100,000 + 3,885 = $103,885
4. Operating cash flows

In the simplest form of investment, there will be a cash outflow when the asset is acquired and there
may be either a cash inflow or an outflow at the end of its economic life. In most cases these are not the
only cash flows -- the investment may result in changes in revenues, expenditures, taxes, and working
capital. These are operating cash flows since they result directly from the operating activities -- the day-
to-day activities of the company.
What we are after here are estimates of operating cash flows. We cannot know for certain what these
cash flows will be in the future, but we must attempt to estimate them. What is the basis for these
estimates? We base them on marketing research, engineering analyses, operations research, analysis of
our competitors -- and our managerial experience.
A. Change in revenues
Suppose we are a food processor considering a new investment in a line of frozen dinner products. If we
introduce a new ready-to-eat dinner product that is not frozen, our marketing research will indicate how
much we should expect to sell. But where do these new product sales come from? Some may come from
consumers who do not already buy frozen dinner products. But some of the not-frozen dinner product
sales may come from consumers who choose to buy the not-frozen dinners product instead of frozen
dinners. It would be nice if these consumers are giving up buying our competitors' frozen dinners. Yet
some of them may be giving up buying our frozen dinners. So, when we introduce a new product, we are
really interested in how it changes the revenues of the entire company (that is, the incremental
revenues), rather than the sales of the new product alone.
We also need to consider any foregone revenues -- opportunity costs -- related to our investment.
Suppose out company owns a building currently being rented to another company. If we are considering
terminating that rental agreement so we can use the building for a new project, we need to consider the
foregone rent -- what we would have earned from the building. Therefore, the revenues from the new
project are really only the additional revenues -- the revenues from the new project minus the revenue
we could have earned from renting the building.
Bottom line: When a company undertakes a new project, the financial managers want to know how it
changes the company's total revenues, not merely the new product's revenues.
B. Change in expenses
When a company takes on a new project, all the costs associated with it will change the company's
expenses. If the investment involves changing the sales of an existing product, we need an estimate the
change in unit sales. Once we have an estimate in how sales may change, we can develop an estimate of
the additional costs of producing the additional number of units by consulting with production
management. And, we will want an estimate of how the product's inventory may change when
production and sales of the product change.
If the investment involves changes in the costs of production, we compare the costs without this
investment with the costs with this investment. For example, if the investment is the replacement of an
assembly line machine with a more efficient machine, we need to estimate the change in the company's
overall production costs such as electricity, labor, materials, and management costs.
A new investment may change not only production costs but also operating costs, such as rental
payments and administration costs. Changes in operating costs as a result of a new investment must be
considered as part of the changes in the company's expenses. Increasing cash expenses are cash
outflows, and decreasing cash expense are cash inflows.
C. Change in taxes
Taxes figure into the operating cash flows in two ways. First, if revenues and expenses change, taxable
income and, therefore, taxes change. That means we need to estimate the change in taxable income
resulting from the changes in revenues and expenses resulting from a new project to determine the
effect of taxes on the company. Second, the deduction for depreciation reduces taxes. Depreciation itself
is not a cash flow. But depreciation reduces the taxes that must be paid, shielding income from taxation.
The tax-shield from depreciation is like a cash inflow.
Suppose a company is considering a new product that is expected to generate additional sales of
$200,000 and increase expenses by $150,000. If the company's tax rate is 40%, considering only the
change in sales and expenses, taxes go up by $50,000 x 40% or $20,000. This means that the company
is expected to pay $20,000 more in taxes because of the increase in revenues and expenses.
Let's change this around and consider that the product will generate $200,000 in revenues and $250,000
in expenses. Considering only the change in revenues and expenses, if the tax rate is 40%, taxes go
down by $50,000 x 40%, or $20,000. This means that we reduce our taxes by $20,000, which is like
having a cash inflow of $20,000 from taxes. Now, consider depreciation. When a company buys an asset
that produces income, the tax laws allow it to depreciate the asset, reducing taxable income by a
specified percentage of the asset's cost each year. By reducing taxable income, the company is reducing
its taxes. The reduction in taxes is like a cash inflow since it reduces the company's cash outflow to the
government.
Suppose a company has taxable income of $50,000 before depreciation and a flat tax rate of 40%. If the
company is allowed to deduct depreciation of $10,000, how has this changed the taxes it pays?
Without depreciation With depreciation
Taxable income $50,000 $40,000
Tax rate 0.40 0.40
Taxes $20,000 $16,000
Depreciation reduces the company's tax-related cash outflow by $20,000 - 16,000 = $4,000 or,
equivalently, by $10,000 x 40% = $4,000. A reduction is an outflow (taxes in this case) is an inflow. We
refer to the effect depreciation has on taxes as the depreciation tax-shield.
Let's look at another depreciation example,
this time considering the effects of replacing A Note on Depreciation
an asset has on the depreciation tax-shield
cash flow. Suppose you are replacing a Depreciation itself is not a cash flow. But in
machine that you bought five years ago for determining cash flows, we are concerned with the
$75,000. You were depreciating this old effect depreciation has on our taxes -- and we all
machine using straight-line depreciation know that taxes are a cash outflow. Since
over ten years, or $7,500 depreciation per depreciation reduces taxable income, depreciation
year. If you replace it with a new machine reduces the tax outflow, which amounts to a cash
that costs $50,000 and is depreciated over inflow.
five years, or $10,000 each year, how does For tax purposes, companies are permitted to use
the change in depreciation affect the cash accelerated depreciation (specifically the rates
flows if the company's tax rate is 30%? We specified under the Modified Accelerated Cost
can calculate the effect two ways: Recovery System (MACRS)) or straight-line. An
1. We can compare the depreciation and accelerated method is preferred in most situations
related tax-shield from the old and the since it results in larger deductions sooner in the
new machines. The depreciation tax- asset's life than using straight-line depreciation.
shield on the old machine is 30% of Therefore, accelerated depreciation, if available, is
$7,500, or $2,250. The depreciation preferable to straight-line due to the time value of
tax-shield on the new machine is 30% money.
of $10,000, or $3,000. Therefore, the Under the present tax code, assets are depreciated
change in the cash flow from to a zero book value. Salvage value -- what we
depreciation is $3,000 - 2,250 = $750. expect the asset to be worth at the end of its life -- is
2. We can calculate the change in not considered in calculating depreciation. So is
depreciation and calculate the tax- salvage value totally irrelevant to the analysis? No.
shield related to the change in Salvage value is our best guess today of what the
depreciation. The change in asset will be worth at the end of its useful life some
depreciation is $10,000 - 7,500 = time in the future. Salvage value is our estimate of
$2,500. The change in the depreciation how much we can get when we dispose of the asset.
tax-shield is 30% of $2,500, or $750. Just remember you can't use it to figure depreciation
for tax purposes.
D. Change in working capital
Working capital consists of short-term assets, also referred to as current assets, which support the day-
to-day operating activity of the business. Net working capital is the difference between current assets and
current liabilities. Net working capital is what would be left over if the company had to pay off its current
obligations using its current assets. The adjustment we make for changes in net working capital is
attributable to two sources:
1. a change in current asset accounts for transactions or precautionary needs; and
2. the use of the accrual method of accounting.
An investment may increase the company's level of operations, resulting in an increase in the net working
capital needed (also considered transactions needs). If the investment is to produce a new product, the
company may have to invest more in inventory (raw materials, work-in-process, and finished goods). If
to increase sales means extending more credit, then the company's accounts receivable will increase. If
the investment requires maintaining a higher cash balance to handle the increased level of transactions,
the company will need more cash. If the investment makes the company's production facilities more
efficient, it may be able to reduce the level of inventory.
Because of an increase in the level of transactions, the company may want to keep more cash and
inventory on hand for precautionary purposes. That is because as the level of operations increase, the
effect of any fluctuations in demand for goods and services may increase, requiring the company to keep
additional cash and inventory "just in case". The company may increase working capital as a precaution
because if there is greater variability of cash and inventory, a greater safety cushion will be needed. On
the other hand, if a project enables the company to be more efficient or lowers costs, it may lower its
investment in cash, marketable securities, or inventory, releasing funds for investment elsewhere in the
company.
We also use the change in working capital to adjust accounting income (revenues less expenses) to a
cash basis because cash flow is ultimately what we are valuing, not accounting numbers. But since we
generally have only the accounting numbers to work from, we use this information, making adjustments
to arrive at cash.
To see how this works, let's look at the cash flow from sales. Not every dollar of sales is collected in the
year of sale. Customers may pay some time after the sale. Using information from the accounts
receivable department about how payments are collected, we can determine the change in the cash flows
from revenues. Suppose we expect sales in the first year to increase by $20,000 per month and it
typically takes customers thirty days to pay. The change in cash flows from sales in the first year is
$20,000 x 11 = $220,000 -- not $20,000 x 12 = $240,000. The way we adjust for this difference between
what is sold and what is collected in cash is to keep track of the change in working capital, which is the
change in accounts receivable in this case. An increase in working capital is used to adjust revenues
downward to calculate cash flow:
Change in revenues $240,000
Less: Increase in accounts receivable 20,000
Change in cash inflow from sales $220,000
On the other side of the balance sheet, if the company is increasing its purchases of raw materials and
incurring more production costs, such as labor, the company may increase its level of short-term
liabilities, such as accounts payable and salary and wages payable.
Suppose expenses for materials and supplies are forecasted at $10,000 per month for the first year and it
takes the company thirty days to pay. Expenses for the first year are $10,000 x 12 = $120,000, yet cash
outflow for these expenses is only $10,000 x 11 = $110,000 since the company does not pay the last
month's expenses until the following year. Accounts payable increases by $10,000, representing one
month's of expenses. The increase in net working capital (increase in accounts payable Ö increases
current liabilities Ö increases net working capital) reduces the cost of goods sold to give us the cash
outflow from expenses:
Cost of goods sold $120,000
Less: increase in accounts payable 10,000
Change in cash flow from expenses $110,000
A new project may result in either:
an increase in net working capital;
a decrease in net working capital; or
no change in net working capital.
Further, working capital may change at the beginning of the project and at any point during the life of
the project. For example, as a new product is introduced, sales may be terrific in the first few years,
requiring an increase in cash, accounts receivable, and inventory to support these increased sales. But all
of this requires an increase in working capital -- a cash outflow.
But later sales may fall off as competitors enter the market. As sales and production fall off, the need for
the increased cash, accounts receivable and inventory falls off also. As cash, accounts receivable, and
inventory are reduced, there is a cash inflow in the form of the reduction in the funds that become
available for other uses within the company.
A change in net working capital can be thought of
Classifying working capital changes
specifically as part of the initial investment -- the
amount necessary to get the project going. Or it can In many applications, we can arbitrarily classify
be considered generally as part of operating activity -- the change in working capital as either
the day-to-day business of the company. So where do investment cash flows or operating cash flows.
we classify the cash flow associated with net working And the classification doesn't really matter
capital? With the asset acquisition and disposition since it's the bottom line, the net cash flows,
represented in the new project or with the operating that matter. How we classify the change in
cash flows? working capital doesn't affect a project's
attractiveness.
Bottom line: If a project requires a change in the
company's net working capital accounts that persists However, we will take care in the examples in
for the duration of the project -- say, an increase in this text to classify the change in working
inventory levels starting at the time of the investment capital according to whether it is related to
-- we tend to classify the change as part of the operating or investment cash flows so you can
acquisition costs at the beginning of the project and see how to make the appropriate adjustments.
as part of disposition proceeds at the end of project.
If, on the other hand, the change in net working
capital is due to the fact that accrual accounting does not coincide with cash flows, we tend to classify
the change is part of the operating cash flows.
5. Putting it all together

Here's what we need to put together to calculate the change in the company's operating cash flows
related to a new investment we are considering:
Changes in revenues and expenses;
Cash flow from changes in taxes from changes in revenues and expenses;
Cash flow from changes in cash flows from depreciation tax-shields; and
Changes in net working capital.
There are many ways of compiling the component cash flow changes to arrive at the change in operating
cash flow. We will start by first calculating taxable income, making adjustments for changes in taxes,
non-cash expenses, and net working capital to arrive at operating cash flow.
Suppose you are evaluating a project that is expected to increase sales by $200,000 and expenses by
$150,000. Accounts receivable are expected to increase by $20,000 and accounts payable are expected
to increase by $5,000, but no changes in cash or inventory are expected. Further, suppose the project's
assets will have a $10,000 depreciation expense for tax purposes. If the tax rate is 40%, what is the
operating cash flow from this project?
Change in sales $200,000
Less change in expenses 150,000
Less change in depreciation 10,000
Change in taxable income $ 40,000
Less taxes 16,000
Change in income after taxes $ 24,000
Add depreciation 10,000
Less increase in working capital 15,000
Change in operating cash flow $ 19,000
So that we can mathematically represent how to calculate the change in operating cash flows for a
project, let's use the symbol "#" to indicate "change in":
#OCF = change in operating cash flow;
#R = change in revenues;
#E = change in expenses;
#D = change in depreciation;
t = tax rate; and
#NWC = change in working capital
The change in the operating cash flow is:
#OCF = (#R - #E - #D) (1 - t) + #D - #NWC
We can also write this as:
#OCF = (#R - #E) (1 - t) + #Dt - #NWC
Applying these equations to the previous example,
#OCF = (#R - #E - #D) (1 - t) + #D - #NWC
#OCF = ($200,000 - 150,000 - 10,000)(1 - 0.40) + $10,000 - $15,000
#OCF = $19,000
or, using the rearrangement of the equation,
#OCF = (#R - #E) (1 - t) + #Dt - #NWC
#OCF = ($200,000 - 150,000) (1 - 0.40) + $10,000 (0.40) - $15,000
#OCF = $19,000.
Let's look at one more example for the calculation of operating cash flows. Suppose you are evaluating
modern equipment which you expect will reduce expenses by $100,000 during the first year. And, since
the new equipment is more efficient, you can reduce the level of inventory by $20,000 during the first
year. The old machine cost $200,000 and was depreciated using straight-line over ten years, with five
years remaining. The new machine cost $300,000 and will be depreciated using straight-line over ten
years. If the company's tax rate is 30%, what is the expected operating cash flow in the first year? Let's
identify the components:
#R = $0 The new machine does not affect revenues
The new machine reduces expenses that will reduce taxes and increase
#E = -$100,000
cash flows
The new machine increases the depreciation expense from $20,000 to
#D = +$10,000
$30,000
The company can reduce its investment in inventory releasing funds to
#NWC = -$20,000
be invested elsewhere
t = 30%
The operating cash flow from the first year is therefore:
#OCF = (#R - #E - #D) (1 - t) + #D - #NWC
#OCF = (+$100,000 - 10,000) (1 - 0.30) + $10,000 - -$20,000
#OCF = $63,000 + $10,000 + $20,000
#OCF = $93,000.
Example 4: Change in expenses Example 5: Change in depreciation

Problem Problem
If a project is expected to increase Suppose the Inter.Com Company is evaluating its
costs by $50,000 per year and the depreciation methods on a new piece of equipment that
tax rate of the company is 40%, costs $100,000. And suppose the equipment can be
what is the net cash flow from the depreciated using straight-line over five years or treating it
change in costs? as a 3-year MACRS asset. What is the difference in the cash
flows associated with depreciation under these two methods
Solution
in the second year if its marginal tax rate is 40%?
-$50,000 + 20,000 = -$30,000
Solution
Difference in depreciation = $20,000 – 44,450 = $24,450
Tax shield of difference = (0.40) $24,450 = $9,780
A. Net cash flows

By now we should know that an investment's cash flows consist of: (1) cash flows related to acquiring
and disposing the assets represented in the investment, and (2) how it affects cash flows related to
operations. To evaluate of any investment project, we must consider both to determine whether or not
the company is better off with or without it.
The sum of the cash flows from asset acquisition and disposition and from operations is referred to as net
cash flows (NCF). And this sum is calculated for each period. In each period, we add the cash flow from
asset acquisition and disposition and the cash flow from operations. For a given period,
Net cash flow = Investment cash flow + Change in operating cash flow (i.e., #OCF).
The analysis of the cash flows of investment projects can become quite complex. But by working through
any problem systematically, line-by-line, you will be able to sort out the information and focus on those
items that determine cash flows.
Example 6: Determining net cash flows
Problem
The Acme.Com Company is evaluating replacing its production equipment that produces anvils. The current
equipment was purchased ten years ago at a cost of $1.5 million.
Acme depreciated its current equipment using MACRS, considering the equipment to be a 5-year MACRS asset. If
they sell the current equipment, they estimate that they can get $100,000 for it.
The new equipment would cost $2.5 million and would be depreciated as a 5-year MACRS asset. The new
equipment would not affect sales, but would result in a costs savings of $400,000 each year of the asset's 10-year
useful life.
At the end of its 10-year life, Acme estimates that it can sell the equipment for $30,000. Also, because the new
equipment would be more efficient, Acme would have less work-in-process anvils, reducing inventory needs initially
by $20,000. Acme's marginal tax rate is 40%. Assume that the equipment purchase (and sale of the old
equipment) occurs at the end of the year 2000 and that the first year of operating this equipment is 2001 and the
last year of operating the equipment is 2010.
Solution
Pieces of information to use:
Book value of current equipment = $0
Sale of current equipment = $100,000
Tax on sale of current equipment = $40,000
Initial outlay for new= -$2,500,000
#E = $400,000
#WC = -$20,000 (initially)
#WC = $20,000 (at end of project)
Depreciation:
Year 1: 0.2000 ($2,500,000) = $500,000
Year 2: 0.3200 ($2,500,000) = $800,000
Year 3: 0.1920 ($2,500,000) = $480,000
Year 4: 0.1152 ($2,500,000) = $288,000
Year 5: 0.1152 ($2,500,000) = $288,000
Year 6: 0.0576 ($2,500,000) = $144,000
Worksheet:
2000 2001 2002 2003 2004 2005
Initial payment -$2,500,000
Sale of new $100,000
Tax on sale of new -$40,000
Change in working capital, #WC $20,000
Investment cash flows -$2,420,000
Change in revenues, #R $0 $0 $0 $0 $0
Change in expenses, #E -$400,000 -$400,000 -$400,000 ($400,000) ($400,000)
Change in depreciation, #D $500,000 $800,000 $480,000 $288,000 $288,000
Change in taxable income, (#R-#E-#E) -$100,000 -$400,000 -$80,000 $112,000 $112,000
Change in taxes, t(#R-#E-#E) -$40,000 -$160,000 -$32,000 $44,800 $44,800
Change in after-tax income, (1-t)(#R-#E-#E) -$60,000 -$240,000 -$48,000 $67,200 $67,200
Change in depreciation, #D $500,000 $800,000 $480,000 $288,000 $288,000
Change in operating cash flows $440,000 $560,000 $432,000 $355,200 $355,200
Net cash flow -$2,420,000 $440,000 $560,000 $432,000 $355,200 $355,200
Continued …
2006 2007 2008 2009 2010
Sale of new $30,000

Tax on sale of new -$12,000
Change in working capital, #WC -$20,000
Investment cash flows -$2,000
Change in revenues, #R $0 $0 $0 $0 $0
Change in expenses, #E ($400,000) -$400,000 -$400,000 -$400,000 -$400,000
Change in depreciation, #D $144,000 $0 $0 $0 $0
Change in taxable income (#R-#E-#E) $256,000 $400,000 $400,000 $400,000 $400,000
Change in taxes, t(#R-#E-#E) $102,400 $160,000 $160,000 $160,000 $160,000
Change in after-tax income, (1-t)(#R-#E-#E) $153,600 $240,000 $240,000 $240,000 $240,000
Change in depreciation, #D $144,000 $0 $0 $0 $0
Net cash flow $297,600 $240,000 $240,000 $240,000 $238,000
B. Simplifications
To actually analyze a project's cash flows, we need to make several simplifications:
We assume that cash flows into or out of the company at certain points in time, typically at the end
of the year, although we realize a project's cash flows into and out of the company at irregular
intervals.
We assume that the assets are purchased and put to work immediately.
By combining inflows and outflows in each period, we are assuming that all inflows and outflows in a
given period have the same risk.
Because there are so many flows to consider, we focus on flows within a period (say a year), assuming
they all occur at the end of the period. We assume this to reduce the number of things we have to keep
track of. Whether or not this assumption matters depends: (1) the difference between the actual time of
cash flow and when we assume it flows at the end of the period (that is, a flow on January 2 is 364 days
from December 31, but a flow on December 30 is only one day from December 31), and (2) the
opportunity cost of funds. Also, assuming that cash flows occur at specific points in time simplifies the
financial mathematics we use in valuing these cash flows.
Keeping track of the different cash flows of an investment project can be taxing. Developing a checklist of
things to consider can help you wade through the analysis of a project's cash flows.
Try it! Determining cash flows

The president of the Cha-Cha Company (CCC) has asked you to evaluate the proposed acquisition of a dance floor,
converting its floor space from “mingling” to “dancing”. The new floor costs $1,000,000 and it is classified in the 7-
year MACRS class. The purchase of the dance floor would not require any change in working capital. The dance floor
would increase the company’s attendance, increasing before-tax revenues by $400,000 per year, but would also
increase operating costs by $100,000 per year because it increases maintenance costs. The floor is expected to be
used for ten years. At the end of the ten years, CCC is likely to convert it back to “mingling” at a cost of $200,000.
The firm's marginal tax rate is 30%. What are the net cash flows for each year of the project’s life?
6. Summary
Determining whether an investment’s benefits outweigh its costs requires that the financial manager first
estimate the future cash flows associated with the investment. For a capital project, this often entails
estimating future periods’ revenues and costs. In addition, the manager must incorporate taxes into
these cash flows because this is a significant part of these future cash flows.
The task of estimating the cash flows appears, at first, to be quite daunting. But this is an exercise that
all companies must go through for every capital project. The amount of material that must be sorted
through to determine the relevant information for this estimation is often substantial and it is the
responsibility of the financial managers of the company to sort through this material, determine the
relevant information, and organize it in such a way to enable the estimation of the cash flows in every
period of the project’s life. One of the key tools that financial managers use is a spreadsheet program,
such as Microsoft Excel®.
The goal is to estimate the net cash flow associated with each year of a project’s life. Once these are
determined, we apply financial theory and mathematics to assess whether the project’s benefits outweigh
its costs.

Gains and losses
Book value
at end of
Year year
20X1 $666,700
20X2 $222,200
20X3 $74,100
20X4 $0
Calculate the gain or loss if the asset described above is sold:
Gain = $250,000 – 222,200 = $27,800
This gain is taxed at ordinary rates because $250,000 is less than $1 million.
Loss = $50,000 – 74,100 = -$24,100
This is a capital loss.
3. At the end of 20X1 for $1,100,000
Gain = $1,100,000 – 666,700 = $433,300
Because the sales price exceeds the original cost, the gain is taxed in two parts:
Taxed at capital gains rates $100,000
Taxed at ordinary rates 333,300
Total gain $433,300
Determining cash flows
Check out the Microsoft Excel® worksheet
Year
0 1 2 3 4 5 6 7 8 9 10
Investment cash flow
Asset cost -$1,000,000 -$200,000
Investment cash flow -$1,000,000 $0 $0 $0 $0 $0 $0 $0 $0 $0 -$200,000
Operating cash flows

Change in revenues $400,000 $400,000 $400,000 $400,000 $400,000 $400,000 $400,000 $400,000 $400,000 $400,000
Change in expenses $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000
Change in depreciation $142,900 $244,900 $174,900 $124,900 $89,300 $89,200 $89,300 $44,600 $0 $0
Change in taxable income $157,100 $55,100 $125,100 $175,100 $210,700 $210,800 $210,700 $255,400 $300,000 $300,000
Change in tax $47,130 $16,530 $37,530 $52,530 $63,210 $63,240 $63,210 $76,620 $90,000 $90,000
Change in income after tax $109,970 $38,570 $87,570 $122,570 $147,490 $147,560 $147,490 $178,780 $210,000 $210,000
Add: depreciation $142,900 $244,900 $174,900 $124,900 $89,300 $89,200 $89,300 $44,600 $0 $0
Change in operating cash flow $252,870 $283,470 $262,470 $247,470 $236,790 $236,760 $236,790 $223,380 $210,000 $210,000
Change in net cash flows -$1,000,000 $252,870 $283,470 $262,470 $247,470 $236,790 $236,760 $236,790 $223,380 $210,000 $10,000
8. Appendix: MACRS depreciation rates
MACRS depreciable life

Year 3-year 5-year 7-year 10-year 15-year 20-year
1 33.33% 20.00% 14.29% 10.00% 5.00% 3.750%
2 44.45 32.00 24.49 18.00 9.50 7.219
3 14.81 19.20 17.49 14.40 8.55 6.677
4 7.41 11.52 12.49 11.52 7.70 6.177
5 11.52 8.93 9.22 6.93 5.713
6 5.76 8.92 7.37 6.23 5.285
7 8.93 6.55 5.90 4.888
8 4.46 6.55 5.90 4.522
9 6.56 5.91 4.462
10 6.55 5.90 4.461
11 3.28 5.91 4.462
12 5.90 4.461
13 5.91 4.462
14 5.90 4.461
15 5.91 4.462
16 2.95 4.461
17 4.462
18 4.461
19 4.462
20 4.461
21 2.231
For more detail on MACRS, check out the information provided by the Internal Revenue Service.
Capital budgeting techniques
OUTLINE
1. Introduction
2. Evaluation techniques
3. Comparing techniques
4. Capital budgeting in practice
5. Summary
1. Introduction
The value of a firm today is the present value of all its future cash flows. These future cash flows
come from assets are already in place and from future investment opportunities. These future cash
flows are discounted at a rate that represents investors' assessments of the uncertainty that they will
flow in the amounts and when expected:
CFt
Value of the firm =
t
t=1 (1+r)
where CFt is the cash flow in period t and r is the required rate of return. The objective of the
financial manager is to maximize the value of the firm. In a corporation, the shareholders are the
residual owners of the firm, so decisions that maximize the value of the firm also maximize
shareholders' wealth.
The financial manager makes decisions regarding long-lived assets; this process is referred to as
capital budgeting. The capital budgeting decisions for a project requires analysis of:
its future cash flows,
the degree of uncertainty associated with these future cash flows, and
the value of these future cash flows considering their uncertainty.
We looked at how to estimate cash flows in a previous reading where we were concerned with a
project's incremental cash flows, comprising changes in operating cash flows (change in revenues,
expenses, and taxes), and changes in investment cash flows (the firm's incremental cash flows from
the acquisition and disposition of the project's assets).
And we know the concept behind uncertainty: the more uncertain a future cash flow, the less it is
worth today. The degree of uncertainty, or risk, is reflected in a project's cost of capital. The cost of
capital is what the firm must pay for the funds to finance its investment. The cost of capital may be
an explicit cost (for example, the interest paid on debt) or an implicit cost (for example, the expected
price appreciation of its shares of common stock).
Capital budgeting techniques, a reading prepared by Pamela Peterson Drake 1

In this reading, we focus on evaluating the future cash flows. Given estimates of incremental cash
flows for a project and given a cost of capital that reflects the project's risk, we look at alternative
techniques that are used to select projects.
For now all we need to understand about a project's risk is that we can incorporate risk in either of
two ways: (1) we can discount future cash flows using a higher discount rate, the greater the cash
flow's risk, or (2) we can require a higher annual return on a project, the greater the risk of its cash
flows.
2. Evaluation techniques
Look at the incremental cash flows for Project X and Project Y shown in Exhibit 1. Can you tell by
looking at the cash flows for Investment A whether or not it enhances wealth? Or, can you tell by
just looking at Investments A and B which one is better? Perhaps with some projects you may think
you can pick out which one is better simply by gut feeling or eyeballing the cash flows. But why do it
that way when there are precise methods to evaluate investments by their cash flows?
We must first determine the cash flows from each Exhibit 1: Estimated cash flows for
investment and then assess the uncertainty of all the Investments X and Y
cash flows in order to evaluate investment projects
and select the investments that maximize wealth. End of period cash flows
Year Project X Project Y
We look at six techniques that are commonly used by 2006 -$1,000,000 -$1,000,000
firms to evaluating investments in long-term assets: 2007 $0 $325,000
2008 $200,000 $325,000
1. Payback period, 2009 $300,000 $325,000
2. Discounted payback period, 2010 $900,000 $325,000
3. Net present value,

4. Profitability index,
5. Internal rate of return, and
6. Modified internal rate of return.
We are interested in how well each technique discriminates among the different projects, steering us
toward the projects that maximize owners' wealth.
An evaluation technique should:
Consider all the future incremental cash flows from the project;
Consider the time value of money;
Consider the uncertainty associated with future cash flows, and
Have an objective criterion by which to select a project.
Projects selected using a technique that satisfies all four criteria will, under most general conditions,
maximize owners' wealth.
In addition to judging whether each technique satisfies these criteria, we will also look at which ones
can be used in special situations, such as when a dollar limit is placed on the capital budget.
A. Payback period
The payback period for a project is the time from the initial cash outflow to invest in it until the time
when its cash inflows add up to the initial cash outflow. In other words, how long it takes to get your

money back. The payback period is also referred to as the payoff period or the capital recovery
period. If you invest $10,000 today and are promised $5,000 one year from today and $5,000 two
years from today, the payback period is two years -- it takes two years to get your $10,000
investment back.
Suppose you are considering Investments X and Y, each requiring an investment of $1,000,000 today
(we're considering today to be the last day of the year 2006) and promising cash flows at the end of
each of the following years through 2010. How long does it take to get your $1,000,000 investment
back? The payback period for Project X is four years:
Accumulated
Year Project X cash flows
2006 -$1,000,000
2007 $0 -$1,000,000
2008 200,000 -800,000
2009 300,000 -500,000
2010 900,000 +400,000
By the end of 2009, the full $1,000,000 is not paid back, but by 2010 the accumulated cash flow hits
(and exceeds) $1,000,000. Therefore, the payback period for Project X is four years.
The payback period for Project Y is four years. It is not until the end of 2010 that the $1,000,000
original investment (and more) is paid back.
We have assumed that the cash flows are received at the end of the year. So we always arrive at a
payback period in terms of a whole number of years. If we assume that the cash flows are received,
say, uniformly, such as monthly or weekly, throughout the year, we arrive at a payback period in
terms of years and fractions of years. 1
For example, assuming we receive cash flows uniformly throughout the year, the payback period for
Project X is 3 years and 6.6 months (assuming $75,000 cash flow per month). Our assumption of
end-of-period cash flows may be unrealistic, but it is convenient to use this assumption to
demonstrate how to use the various evaluation techniques. We will continue to use this end-of-period
assumption throughout the coverage of capital budgeting techniques.
Is Project X or Y more attractive? A shorter payback period is better than a longer payback period.
Yet there is no clear-cut rule for how short is better. If we assume that all cash flows occur at the
end of the year, Project X provides the same payback as Project Y. Therefore, we do not know in this
particular case whether quicker is better.
In addition to having no well-defined decision criteria, payback period analysis favors investments
with "front-loaded" cash flows: an investment looks better in terms of the payback period the sooner
its cash flows are received no matter what its later cash flows look like. Payback period analysis is a
type of "break-even" measure. It tends to provide a measure of the economic life of the investment
in terms of its payback period. The more likely the life exceeds the payback period, the more
attractive the investment. The economic life beyond the payback period is referred to as the post-
payback duration. If post-payback duration is zero, the investment is worthless, no matter how short
the payback. This is because the sum of the future cash flows is no greater than the initial
investment outlay. And since these future cash flows are really worth less today than in the future, a
zero post-payback duration means that the present value of the future cash flows is less than the
project's initial investment.
1
But then we would have a challenge applying the methods that apply the time value of money, so
for simplicity sake we assume end-of-period cash flows in illustrating the capital budgeting
techniques.

The payback method should only be used as a coarse initial screen of investment projects. But it can
be a useful indicator of some things. Because a dollar of cash flow in the early years is worth more
than a dollar of cash flow in later years, the payback period method provides a simple, yet crude
measure of the liquidity of the investment.
The payback period also offers some indication on the risk of the investment. In industries where
equipment becomes obsolete rapidly or where there are very competitive conditions, investments
with earlier payback are more valuable. That's because cash flows farther into the future are more
uncertain and therefore have lower present value. In the personal computer industry, for example,
the fierce competition and rapidly changing technology requires investment in projects that have a
payback of less than one year since there is no expectation of project benefits beyond one year.
Because the payback method doesn't tell us the particular payback period that maximizes wealth, we
cannot use it as the primary screening device for investment in long-lived assets.
B. Discounted payback period

The discounted payback period is the time needed to pay back the original investment in terms of
discounted future cash flows.
Each cash flow is discounted back to the beginning of the investment at a rate that reflects both the
time value of money and the uncertainty of the future cash flows. This rate is the cost of capital --
the return required by the suppliers of capital (creditors and owners) to compensate them for time
value of money and the risk associated with the investment. The more uncertain the future cash
flows, the greater the cost of capital.
The cost of capital, the required rate of return, and the discount rate
We discount an uncertain future cash flow to the present at some rate that reflects the degree of
uncertainty associated with this future cash flow. The more uncertain, the less the cash flow is worth
today -- this means that a higher discount rate is used to translate it into a value today.
This discount rate is a rate that reflects the opportunity cost of funds. In the case of a corporation,
we consider the opportunity cost of funds for the suppliers of capital (the creditors and owners). We
refer to this opportunity cost as the cost of capital.
The cost of capital comprises the required rate of return (RRR) (that is, the return suppliers of capital
demand on their investment) and the cost of raising new capital if the firm cannot generate the
needed capital internally (that is, from retaining earnings). The cost of capital and the required rate
of return are the same concept, but from different perspective. Therefore, we will use the terms
interchangeably in our study of capital budgeting.
Calculating the discounted payback period

Returning to Projects X and Y, suppose that each has a cost of capital of 10 percent. The first step in
determining the discounted payback period is to discount each year's cash flow to the beginning of
the investment (the end of the year 2006) at the cost of capital:

Project X Project Y
Accumulated Accumulated
discounted discounted
Year Cash flows cash flows Cash flows cash flows
2006 -$1,000,000.00 -$1,000,000.00 -$1,000,000.00 -$1,000,000.00
2007 $0.00 -$1,000,000.00 $295,454.55 -$704,545.45
2008 $165,289.26 -$834,710.74 $268,595.04 -$435,950.41
2009 $225,394.44 -$609,316.30 $244,177.31 -$191,773.10
2010 $614,712.11 $5,395.81 $221,979.37 $30,206.27
How long does it take for each investment's discounted cash flows to pay back its $1,000,000
investment? The discounted payback period for both X and Y is four years.
Discounted payback decision rule

It appears that the shorter the payback period, the better, whether using discounted or non-
discounted cash flows. But how short is better? We don't know. All we know is that an investment
"breaks-even" in terms of discounted cash flows at the discounted payback period -- the point in time
when the accumulated discounted cash flows equal the amount of the investment.
Using the length of the payback as a basis for selecting investments, Projects X and Y cannot be
distinguished. But we've ignored some valuable cash flows for both investments, those beyond what
is necessary for recovering the initial cash outflow.
C. Net present value

If offered an investment that costs $5,000 today and promises to pay you $7,000 two years from
today and if your opportunity cost for projects of similar risk is 10 percent, would you make this
investment? To determine whether or not this is a good investment you need to compare your
$5,000 investment with the $7,000 cash flow you expect in two years. Because you determine that a
discount rate of 10 percent reflects the degree of uncertainty associated with the $7,000 expected in
two years, today it is worth:
$7, 000
Present value of $7,000 to be received in 2 years = = $5,785.12.
(1 0.10)2
By investing $5,000, today you are getting in return, a promise of a cash flow in the future that is
worth $5,785.12 today. You increase your wealth by $785.12 when you make this investment.
Another way of stating this is that the present value of the $7,000 cash inflow is $5,785.12, which is
more than the $5,000, today's cash outflow to make the investment. When we subtract today's cash
outflow to make an investment from the present value of the cash inflow from the investment, the
difference is the increase or decrease in our wealth referred to as the net present value.
The net present value (NPV) is the present value of all expected cash flows.
Net present value = Present value of all expected cash flows.
The word "net" in this term indicates that all cash flows -- both positive and negative -- are
considered. Often the changes in operating cash flows are inflows and the investment cash flows are
outflows. Therefore we tend to refer to the net present value as the difference between the present
value of the cash inflows and the present value of the cash outflows.

We can represent the net present value using summation notation, where t indicates any particular
period, CFt represents the cash flow at the end of period t, i represents the cost of capital, and N the
number of periods comprising the economic life of the investment:
N CFt
NPV present value present value
of cash inflows of cash outflows t
t 1 (1 r)
Cash inflows are positive values of CFt and cash outflows are negative values of CFt. For any given
period t, we collect all the cash flows (positive and negative) and net them together. To make things
a bit easier to track, let’s just refer to cash flows as inflows or outflows, and not specifically identify
them as operating or investment cash flows.
Take another look at Projects X. Using a 10 percent cost of capital, the present values of inflows are:
Project X
Discounted cash
Year Cash flow flow
2006 -$1,000,000 -$1,000,000.00
2007 $0 $0.00
2008 200,000 165,289.26
2009 300,000 225,394.44
2010 900,000 614,712.11
L NPV = +$5,395.81
This NPV tell us that if we invest in X, we

TI-83/84 HP10B
expect to increase the value of the firm by
{0,200000,300000,900000} STO listname 1000000 +/- CFj
$5,395.81. Calculated in a similar manner,
NPV(10,-1000000,listname) 0 CFj
the net present value of Project Y is 200000 CFj
$30,206.27. We can use a financial 300000 CFj
calculator to solve for the NPV as well, 900000 CFj
inputting the cash flows in order, making 10 i/YR
sure that the $0 cash flow for year 2007 is NPV
included in the list of cash flows.
We can also use Microsoft Excel to solve for the net present value. The Excel spreadsheet entries for
the data would be:
A B and the net present value requires the use of the NPV
1 Year Project X unction:
2 2006 -$1,000,000
3 2007 $0 =NPV(.1,B3:B6)+B2
4 2008 $200,000
5 2009 $300,000
6 2010 $900,000
Net Present Value Decision Rule

A positive net present value means that the investment increases the value of the firm -- the return is
more that sufficient to compensate for the required return of the investment. A negative net present
value means that the investment decreases the value of the firm -- the return is less than the cost of
capital. A zero net present value means that the return just equals the return required by owners to

compensate them for the degree of uncertainty of the investment's future cash flows and the time
value of money. Therefore,
if... this means that... and you...
NPV > $0 the investment is expected to should accept the project.

increase shareholder wealth
NPV < $0 the investment is expected to should reject the project.

decrease shareholder wealth
NPV = $0 the investment is expected not to should be indifferent between

change shareholder wealth accepting or rejecting the project
Project X is expected to increase the value of the firm by $5,395.81, whereas Project Y is expected to
increases add $30,206.27 in value. If these are independent investments, both should be taken on
because both increase the value of the firm. If X and Y are mutually exclusive, such that the only
choice is either X or Y, then Y is preferred since it has the greater NPV. Projects are said to be
mutually exclusive if accepting one precludes the acceptance of the other.
D. Profitability index
The profitability index uses some of the same information we used for the net present value, but it is
stated in terms of an index. Whereas the net present value is:
N CFt
NPV present value present value
of cash inflows of cash outflows t
t 1 (1 r)
The profitability index, PI is:

N CIF
t
present value t
of cash inflows t 1 (1 r)
PI
present value N COF
t
of cash outflows t
t 1 (1 r)
where CIF and COF are cash inflows and cash outflows, respectively.
Project X
Year Cash flow Discounted cash flow
2007 $0 $0.00
2008 200,000 165,289.26
2009 300,000 225,394.44
2010 900,000 614,712.11
N CIFt
t
= +$1,005,395.81
L t 1 (1 r)
Therefore, the profitability index is:

$1, 005, 395.81
PIX 1.0054
$1, 000, 000
The index value is greater than one, which means that the investment produces more in terms of
benefits than costs.

The decision rule for the profitability index is therefore depends on the PI relative to 1.0:
PI > 1.0 the investment is expected to increase should accept the project.
shareholder wealth
PI < 1.0 the investment is expected to decrease should reject the project.
shareholder wealth
PI = 1.0 the investment is expected not to should be indifferent between

change shareholder wealth accepting or rejecting the project
There is no direct solution for PI on your TI-83/84 HP10B

calculator; what you need to do is {0,200000,300000,900000} STO listname 0 +/- CFj
calculate the present value of all the cash NPV(10,0,listname) ENTER 0 CFj
inflows and then divide this value by the $ 1000000 ENTER 200000 CFj
300000 CFj
present value of the cash outflows. In the
900000 CFj
case of Project X, there is only one cash 10 i/YR
out flow and it is already in present value NPV
terms (i.e., it occurs at the end of 2006). $ 1000000
E. Internal rate of return

Suppose you are offered an investment opportunity that requires you to put up $50,000 and has
expected cash inflows of $28,809.52 after one year and $28,809.52 after two years. We can evaluate
this opportunity using a time line, as shown in Exhibit 1.
Exhibit 4 Time line of investment opportunity The return on this investment is the discount
rate that causes the present values of the
0 1 2 $28,809.52 cash inflows to equal the present
---|----------------|-----------------|------------ value of the $50,000 cash outflow, calculated
as:
-$50,000 $28,809.52 $28,909.52
$28, 809.52 $28, 809.52
$50, 000
(1 IRR)1 (1 IRR)2
Another way to look at this is to consider the investment's cash flows discounted at the IRR of 10
percent. The NPV of this project if the discount rate is 10 percent (the IRR in this example), is zero:
$28, 809.52 $28, 809.52
$50, 000
(1 0.10)1 (1 0.10)2
An investment's internal rate of return (IRR) is the discount rate that makes the present value of all
expected future cash flows equal to zero. We can represent the IRR as the rate that solves:
N CFt
$0
t
t 1 (1 IRR)
The IRR for X is the discount rate that solves:

$0 $200, 000 $300, 000 $900, 000
$1, 000, 000
(1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR)4
Using a calculator or a computer, we

TI-83/84 HP10B
get the more precise answer of {0,200000,300000,900000} STO listname -1000000 +/- CFj
10.172 percent per year. IRR(-1000000,listname) 0 CFj
200000 +/- CFj
Looking back at the investment 300000 +/- CFj
profiles of Projects X and Y, you'll 900000 +/- CFj
notice that each profile crosses the IRR
horizontal axis (where NPV = $0) at the discount rate that corresponds to the investment's internal
rate of return. This is no coincidence: by definition, the IRR is the discount rate that causes the
project's NPV to equal zero.
Internal rate of return decision rule

The internal rate of return is a yield -- what we earn, on average, per year. How do we use it to
decide which investment, if any, to choose? Let's revisit Investments A and B and the IRRs we just
calculated for each. If, for similar risk investments, owners earn 10 percent per year, then both A and
B are attractive. They both yield more than the rate owners require for the level of risk of these two
investments:
Investment IRR Cost of capital
X 10.172% 10%
Y 11.388% 10%
The decision rule for the internal rate of return is to invest in a project if it provides a return greater
than the cost of capital. The cost of capital, in the context of the IRR, is a hurdle rate -- the minimum
acceptable rate of return. For independent projects and situations in which there is no capital
rationing, then
IRR > cost of capital the investment is expected to should accept the project.
increase shareholder wealth
IRR < cost of capital the investment is expected to should reject the project.
decrease shareholder wealth
IRR = cost of capital the investment is expected not should be indifferent

to change shareholder wealth between accepting or
rejecting the project
The IRR and mutually exclusive projects

What if we were forced to choose between projects X and Y because they are mutually exclusive?
Project Y has a higher IRR than Project X -- so at first glance we might want to accept Project Y.
What about the NPV of X and Y? What does the NPV tell us to do? If we use the higher IRR, it tells
us to go with Y. If we use the higher NPV if the cost of capital is 5 percent, we go with X. Which is
correct? Choosing the project with the higher net present value is consistent with maximizing
owners’ wealth. Why? Because if the cost of capital is 10 percent, we would calculate different NPVs
and come to a different conclusion, as you can see from the investment profiles in Exhibit 3.

When evaluating mutually exclusive projects, the one with the highest IRR may not be the one with
the best NPV. The IRR may give a different decision than NPV when evaluating mutually exclusive
projects because of the reinvestment assumption:
NPV assumes cash flows reinvested at the cost of capital.
IRR assumes cash flows reinvested at the internal rate of return.
This reinvestment assumption may cause different decisions in choosing among mutually exclusive
projects when:
the timing of the cash flows is different among the projects,
there are scale differences (that is, very different cash flow amounts), or
the projects have different useful lives.
With respect to the role of the timing of cash flows in choosing between two projects: Project Y's
cash flows are received sooner than X's. Part of the return on either is from the reinvestment of its
cash inflows. And in the case of Y, there is more return from the reinvestment of cash inflows. The
question is "What do you do with the cash inflows when you get them?" We generally assume that if
you receive cash inflows, you'll reinvest those cash flows in other assets.
With respect to the reinvestment rate assumption in choosing between these projects: Suppose we
can reasonably expect to earn only the cost of capital on our investments. Then for projects with an
IRR above the cost of capital we would be overstating the return on the investment using the IRR.
Bottom line: If we evaluate projects on the basis of their IRR, it is possible that we may select one
that does not maximize value.
With respect to the NPV method: if the best we can do is reinvest cash flows at the cost of capital,
the NPV assumes reinvestment at the more reasonable rate (the cost of capital). If the reinvestment
rate is assumed to be the project's cost of capital, we would evaluate projects on the basis of the
NPV and select the one that maximizes owners' wealth.
The IRR and capital rationing

What if there is capital rationing? Suppose Investments A and B are independent projects.
Projects are independent if that the acceptance of one does not prevent the acceptance of the other.
And suppose the capital budget is limited to $1,000,000. We are therefore forced to choose between
A or B. If we select the one with the highest IRR, we choose A. But A is expected to increase wealth
less than B. Ranking investments on the basis of their IRRs may not maximize wealth.
We saw this dilemma in the previous reading pertaining to projects X and Y when we looked at their
investment profiles. The discount rate at which X's NPV is $0.00 is X's IRR = 10.172 percent, where
X's profile crosses the horizontal axis. Likewise, the discount rate at which Y's NPV is $0.00 is B's IRR
= 11.388 percent. The discount rate at which X's and Y's profiles cross is the cross-over rate, 7.495
percent. For discount rates less than 7.495 percent, X has the higher NPV. For discount rates greater
than 7.495 percent, Y has the higher NPV. If Y is chosen because it has a higher IRR and if Y's cost
of capital is less than 7.495 percent, we have not chosen the project that produces the greatest
value.
The source of the problem in the case of capital rationing is that the IRR is a percentage, not a dollar
amount. Because of this, we cannot determine how to distribute the capital budget to maximize
wealth because the investment or group of investments producing the highest yield does not mean
they are the ones that produce the greatest wealth.

Multiple internal rates of return
The typical project usually involves only one large negative cash flow initially, followed by a series of
future positive flows. But that's not always the case. Suppose you are involved in a project that uses
environmentally sensitive chemicals. It may cost you a great deal to dispose of them. And that will
mean a negative cash flow at the end of the project.
Suppose we are considering a project that has cash flows as follows:
End of period
Period
cash flow
0 -$100
1 +260
2 +260
3 -490
What is this project's IRR? One possible solution is IRR = 14.835 percent, yet another possible
solution is IRR = 191.5 percent.
Exhibit 4: The case of multiple IRRs We can see this

graphically in
Exhibit 4, where
$60 the NPV of these
cash flows are
$40
shown for
$20 discount rates
Net from 0 percent to
$0
present 250 percent.
value -$20 Remember that
-$40 14.835% 191.5% the IRR is the
discount rate that
-$60
causes the NPV
-$80 to be zero. In
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
220%
240%
terms of this
graph, this
Discount rate means that the
IRR is the
discount rate
where the NPV is
$0, the point at which the present value changes sign -- from positive to negative or from negative to
positive. In the case of this project, the present value changes from negative to positive at 14.835
percent and from positive to negative at 250 percent.
Bottom line: We can’t use the internal rate of return method if the sign of the cash flows change
more than once during the project’s life.
F. Modified internal rate of return

The internal rate of return method assumes that cash flows are reinvested at the investment’s
internal rate of return. Consider Project X. The IRR is 10.17188 percent. If we take each of the
cash inflows from Project X and reinvest them at 10.17188 percent, we will have $1,472,272.53 at
the end of 2010:

Number of
periods earning Future value of cash flow
a return reinvested at 10.17188%
3 $0.00
2 242,756.88
1 330,515.65
0 900,000.00
$1,473,272.53
The $1,473,272.53 is referred to as the project’s terminal value. 2 The terminal value is how much
the company has from this investment if all proceeds are reinvested at the IRR. So what is the
return on this project? Using the terminal value as the future value and the investment as the
present value,
FV = $1,473,272.53
PV = $1,000,000.00
N = 4 years
$1, 473, 272.53

i4 10.17188%
$1, 000, 000.00
In other words, by investing $1,000,000 at the end of 2006 and receiving $1,473,272.53 produces an
average annual return of 10.1718 percent, which is the project’s internal rate of return.
The modified internal rate of return is the return on the project assuming reinvestment of the cash
flows at a specified rate. Consider Project X if the reinvestment rate is 5 percent:
Number of periods Future value of cash flow
earning a return reinvested at 5%
3 $0.00
2 220,500.00
1 315,000.00
0 900,000.00
$1,435,500.00
The modified internal rate of return is 9.4588 percent:
FV = $1,435,500
PV = $1,000,000
N = 4 years
$1, 435,500
i4 9.4588%
$1, 000, 000.00
2
For example, the 2008 cash flow of $200,000 is reinvested at 10.17188 percent for two periods
(that is, for 2009 and 2010), or $200,000 (1 + 0.1017188)2 = $242,756.88.

The MIRR is therefore a
Exhibit 5 MIRRs for Project X and Project Y function of both the
reinvestment rate and the
pattern of cash flows, with
higher the reinvestment rates
12%
leading to greater MIRRs. You
10%
can see this in Exhibit 5, where
8% the MIRR of both Project X and
Project X Project Y
MIRR
6% Project Y is plotted for different

4% reinvestment rates. Project Y’s
2% MIRR is more sensitive to the
0% reinvestment rate because more
of its cash flows are received
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
%
sooner, relative to Project X’s
10
11
Reinvestment rate cash flows.
If we wish to represent this
technique in a formula,
CIF (1+i)
t=1
t
N-t
MIRR= N N
COFt
(1+i)
t=1
t
where the CIFt are the cash inflows and the COFt are the cash outflows. In the previous example,
the present value of the cash outflows is equal to the $1,000,000 initial cash outlay, whereas the
future value of the cash inflows is $1,435,500.
If... this means that... and you...
MIRR > cost of capital the investment is expected to should accept the project.
return more than required
MIRR < cost of capital the investment is expected to should reject the project.
return less than required
MIRR = cost of capital the investment is expected to are indifferent between

return what is required accepting or rejecting the
project
G. Scale differences
Scale differences -- differences in the amount of the cash flows -- between projects can lead to
conflicting investment decisions among the discounted cash flow techniques. Consider two projects,
Project Big and Project Little, that each have a cost of capital of 5 percent per year with the following
cash flows:

End of period Project Big Project Little
0 -$1,000,000 -$1.00
1 + 400,000 + 0.40
2 + 400,000 + 0.40
3 + 400,000 + 0.50
Applying the discounted cash flow techniques to each project,
Technique Project Big Project Little
NPV $89,299 $0.1757
PI 1.0893 1.1757
IRR 9.7010% 13.7789%
MIRR 8.0368% 10.8203%
Mutually exclusive projects
If Big and Little are mutually exclusive projects, which project should a firm prefer? If the firm goes
strictly by the PI, IRR, or MIRR criteria, it would choose Project Little. But is this the better project?
Project Big provides more value -- $89,299 versus $0.18. The techniques that ignore the scale of the
investment -- PI, IRR, and MIRR -- may lead to an incorrect decision.
Capital rationing
If the firm is subject to capital rationing -- say a limit of $1,000,000 -- and Big and Little are
independent projects, which project should the firm choose? The firm can only choose one -- spend
$1 or $1,000,000, but not $1,000,001. If you go strictly by the PI, IRR, or MIRR criteria, the firm
would choose Project Little. But is this the better project? Again, the techniques that ignore the scale
of the investment -- PI, IRR, and MIRR -- leading to an incorrect decision.
H. The investment profile

We may want to see how sensitive is our decision to accept a project to changes in our cost of
capital. We can see this sensitivity in how a project's net present value changes as the discount rate
changes by looking at a project's investment profile, also referred to as the net present value profile.
The investment profile is a graphical depiction of the relation between the net present value of a
project and the discount rate: the profile shows the net present value of a project for each discount
rate, within some range.

The net present value profile for the two projects is shown in Exhibit 2 for discount rates from 0
percent to 20 percent. To help
you get the idea behind this Exhibit 2: The investment profiles of Projects X and Y
graph, we've identified the
$500,000
NPV's of this project for
discount rates of 5 percent and $400,000
10 percent. You should be able
$300,000
to see that the NPV is positive
10.172%
for discount rates from 0 $200,000
Net
percent to 10.172 percent, and present $100,000
negative for discount rates value
higher than 10.172 percent. $0
The 10.172 percent is the -$100,000
internal rate of return; that is,
the discount rate at which the -$200,000
net present value is equal to -$300,000
$0. Therefore, Project X
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
increases owners' wealth if the
cost of capital on this project is Required rate of return
less than 10.172 percent and
decreases owners' wealth if the
cost of capital on this project is greater than 10.172 percent.
Let's impose X's NPV profile on the NPV profile of Project Y, as shown in the graph in Exhibit 3. If X
and Y are mutually exclusive projects -- we invest in only one or neither project -- this graph clearly
shows that the project we invest in depends on the discount rate. For higher discount rates, B's NPV
falls faster than A's. This is because most of B's present value is attributed to the large cash flows
four and five years into the future. The present value of the more distant cash flows is more sensitive
to changes in the discount rate than is the present value of cash flows nearer the present.
If the discount rate is less

Exhibit 3: Investment profiles of Investments X and Y than 7.495 percent, X adds
more values than Y. If the
$500,000
discount rate is more than
$400,000 Project X 7.495 percent but less than
Project Y 11.338 percent, Y increases
$300,000
wealth more than X. If the
$200,000 7.495% discount rate is greater
Net
present $100,000 than 11.338 percent, we
value should invest in neither
$0
project because both would
-$100,000 decrease wealth.
-$200,000 The 7.495 percent is the
-$300,000 cross-over discount rate
which produces identical
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
NPV's for the two projects.

Required rate of return If the discount rate is 7.495
percent, the net present
value of both investments
is $88,660. 3
3
The precise cross-over rate is 7.49475 percent, at which the NPV for both projects is $88,659.

Example 1: The investment profile
Problem
Consider a project that has the following expected cash flows:
End of year Cash flow
2005 -$1,000,000
2006 800,000
2007 400,000
2008 70,000
2009 30,000
Draw this project’s investment profile for discount rates from 0 percent to 20 percent.
Solution
Step 1: Calculate the NPV if the discount rate = 0%. You calculate this by simply adding up all cash
flows (both positive and negative. In this example, this is $300,000.
Step 2: Calculate the IRR. In this case, this is 19.95%
Step 3: Calculate the NPV for some discount rate between 0% and the IRR.
Step 4: Mark the result from Steps 1, 2 and 3 on the graph and connect the points.
$350,000
$300,000
$250,000
$200,000
NPV $150,000
$100,000
$50,000
$0
-$50,000
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
Discount rate
Solving for the cross-over rate

For Projects X and Y, the cross-over rate is the rate that causes the net present value of the two
investments to be equal. Basically, this boils down to a simple approach: calculate the differences in
the cash flows and then solve for the internal rate of return of these differences.
Year Project X Project Y Difference
2006 -$1,000,000 -$1,000,000 $0
2007 $0 $325,000 -$325,000
2008 $200,000 $325,000 -$125,000
2009 $300,000 $325,000 -$25,000
2010 $900,000 $325,000 $575,000

The internal rate of return of these differences is the cross-over rate. Does it matter which project’s
cash flows you deduct from the TI-83/84 HP10B
other? Not at all – just be {-325000,-125000,-25000,575000} STO listname 0 +/- CFj
consistent each period. IRR(0,listname) 325000 +/- CFj
125000 +/- CFj
Bottom line: The cross-over rate
25000 +/- CFj
is the decision point between two 575000 CFj
mutually exclusive projects. IRR
Example Cross-over rates

Problem
Consider two projects, P & Q, with the following sets of cash flows:
End of P Q
period
0 -$10 -$20
1 4.2 0
2 4.2 0
3 4.2 26
What is the cross-over rate for these two projects’ investment profiles?
Solution
End of P Q Difference
period
0 -$10 -$20 +$10
1 4.2 0 +4.2
2 4.2 0 +4.2
3 4.2 26 -21.8
Cross-over rate is the IRR of the differences, or 7.52 percent
3. Comparing techniques
If we are dealing with mutually exclusive projects, the NPV method leads us to invest in projects that
maximize wealth, that is, capital budgeting decisions consistent with owners' wealth maximization. If
we are dealing with a limit on the capital budget, the NPV and PI methods lead us to invest in the set
of projects that maximize wealth.
The advantages and disadvantages of each of the techniques for evaluating investments are
summarized in Table 1. We see in this table that the discounted cash flow techniques are preferred
to the non-discounted cash flow techniques. The discounted cash flow techniques -- NPV, PI, IRR,
MIRR -- are preferable since they consider (1) all cash flows, (2) the time value of money, and (3)
the risk of future cash flows. The discounted cash flow techniques are also useful because we can
apply objective decision criteria -- criteria we can actually use that tells us when a project increases
wealth and when it does not.
We also see in this table that not all of the discounted cash flow techniques are right for every
situation. There are questions we need to ask when evaluating an investment and the answers will
determine which technique is the one to use for that investment:
Are the projects mutually exclusive or independent?
Are the projects subject to capital rationing?
Are the projects of the same risk?
Are the projects of the same scale of investment?

Here are some simple rules:
1. If projects are independent and not subject to capital rationing, we can evaluate them and
determine the ones that maximize wealth based on any of the discounted cash flow
techniques.
2. If the projects are mutually exclusive, have the same investment outlay, and have the same
risk, we must use only the NPV or the MIRR techniques to determine the projects that
maximize wealth.
3. If projects are mutually exclusive and are of different risks or are of different scales, NPV is
preferred over MIRR.
If the capital budget is limited, we can use either the NPV or the PI. We must be careful, however,
not to select projects simply on the basis of their NPV or PI (that is, ranking on NPV and selecting the
highest NPV projects), but rather how we can maximize the NPV of the total capital budget. In other
words, which set of capital projects will maximize owners’ wealth?
Try it! Capital budgeting techniques
Suppose an investment requires an initial outlay of $5 million and has expected cash flows of $1
million, $3.5 million and $2 million for the first three years, respectively. What is this project’s:
1. Payback period?
2. Discounted payback period using a 10 percent required rate of return?
3. Net present value using a 10 percent required rate of return?
4. Internal rate of return?
5. Modified internal rate of return using 5 percent reinvestment rate?
4. Capital budgeting techniques in practice

Among the evaluation techniques in this chapter, the one we can be sure about is the net present
value method. NPV will steer us toward the project that maximizes wealth in the most general
circumstances. But what evaluation technique do financial decision makers really use?
We learn about what goes on in practice by anecdotal evidence and through surveys. We see that:
there is an increased use of more sophisticated capital budgeting techniques;
most financial managers use more than one technique to evaluate the same projects, with a
discounted cash flow technique (NPV, IRR, PI) used as a primary method and payback period
used as a secondary method; and
the most commonly used is the internal rate of return method, though the net present value
method is gaining acceptance.
IRR is popular most likely because it is a measure of yield and therefore easy to understand.
Moreover, since NPV is expressed in dollars -- the expected increment in the value of the firm
and financial managers are accustomed to dealing with yields, they may be more comfortable
dealing with the IRR than the NPV.
The popularity of the IRR method is troublesome since it may lead to decisions about projects that
are not in the best interest of owners in certain circumstances. However, the NPV method is
becoming more widely accepted and, in time, may replace the IRR as the more popular method.
And is the use of payback period troublesome? Not necessarily. The payback period is generally used
as a screening device, eliminating those projects that cannot even break-even.

Further, the payback period can be viewed as a measure of a yield. If the future cash flows are the
same amount each period and if these future cash flows can be assumed to be received each period
forever -- essentially, a perpetuity -- then 1/payback period is a rough guide to a yield on the
investment. Suppose you invest $100 today and expect $20 each period, forever. The payback period
is 5 years. The inverse, 1/5= 20 percent per year, is the yield on the investment.
Now let's turn this relation around and create a payback period rule. Suppose we want a 10 percent
per year return on our investment. This means that the payback period should be less than or equal
to 10 years. So while the payback period may seem to be a rough guide, there is some rationale
behind it.
Use of the simpler techniques, such as payback period, does not mean that a firm has
unsophisticated capital budgeting. Remember that evaluating the cash flows is only one aspect of the
process:
cash flows must first be estimated,
cash flows are evaluated using NPV, PI, IRR, MIRR or a payback method; and
project risk must be assessed to determine the cost of capital.
5. Summary
The payback period and the discounted payback period methods give us an idea of the time it takes
to recover the initial investment in a project. Both of these methods are disappointing because they
do not necessarily consider all cash flows from a project. Further, there is no objective criteria that
we can use to judge a project, except for the simple criterion that the project must pay back.
The net present value method and the profitability index consider all of the cash flows from a project
and involve discounting, which incorporates the time value of money and risk. The net present value
method produces an amount that is the expected added value from investing in a project. The
profitability index, on the other hand, produces an indexed value that is useful in ranking projects.
The internal rate of return is the yield on the investment. It is the discount rate that causes the net
present value to be equal to zero. IRR is hazardous to use when selecting among mutually exclusive
projects or when there is a limit on capital spending.
The modified internal rate of return is a yield on the investment, assuming that cash inflows are
reinvested at some rate other than the internal rate of return. This method overcomes the problems
associated with unrealistic reinvestment rate assumptions inherent with the internal rate of return
method. However, MIRR is hazardous to use when selecting among mutually exclusive projects or
when there is a limit on capital spending.
Each technique we look at offers some advantages and disadvantages. The discounted flow
techniques -- NPV, PI, IRR, and MIRR -- are superior to the non-discounted cash flow techniques --
the payback period and the discounted payback period.
To evaluate mutually exclusive projects or projects subject to capital rationing, we have to be careful
about the technique we use. The net present value method is consistent with owners' wealth
maximization whether we have mutually exclusive projects or capital rationing.
Looking at capital budgeting in practice, we see that firms do use the discounted cash flow
techniques, with IRR the most widely used. Over time, however, we see a growing use of the net
present value technique.

6. Try it! Solutions
1. Payback period?
The sum of the cash flows at the end of two years is $4.5 million
The sum at the end of three years is $6.5 million
Payback = Three years
2. Discounted payback period using a 10 percent required rate of return?
The sum of the discounted cash flows at the end of three years is: 4
$0.9091 + 2.8926 + 1.5026 = $5.3043
Discounted payback period = Three years.
3. Net present value using a 10 percent required rate of return?
Present value of inflows = $5.3043 million (we know this from the discounted
payback period calculation).
Present value of outflows = $5 million
NPV = $5.3043 – 5 = $0.3043 million
4. Internal rate of return?
We know that the IRR must be greater than 10 percent because the NPV is positive
when the discount rate is 10 percent.
IRR = 13.13 percent
5. Modified internal rate of return using a 5 percent reinvestment rate?
Terminal value = $1 (1.05)2 + $3.5 (1.05) + $2 = $1.1025 + 3.675 + 2 = $6.7775
million
TV = FV = $6.7775; N = 3; PV = $5; Solve for i
MIRR = 10.6708 percent
4
Why not check for discounted payback after two years? Because if it does not payback in two years
using undiscounted cash flows, it does not payback in terms of discounted cash flows.

Capital budgeting & risk
OUTLINE
1. Introduction
2. Measurement of project risk
3. Incorporating risk in the capital budgeting decision
4. Assessment of project risk in practice
5. Summary
1. Introduction
"To understand uncertainty and risk is to understand the key business problem -- and the
key business opportunity." -- David B. Hertz, 1972.
The capital budgeting decisions that a financial manager makes require analyzing each project's:
1. Future cash flows

2. Uncertainty of future cash flows
3. Value of these future cash flows
When we look at the available investment opportunities, we want to determine which projects will
maximize the value of the company and, hence, maximize owners' wealth. That is, we analyze each
project, evaluating how much its benefits exceed its costs. The projects that are expected to increase
owners' wealth the most are the best ones. In deciding whether a project increases shareholder wealth,
we have to weigh its benefits and its costs. The costs are:
the cash flow necessary to make the investment (the investment outlay) and
the opportunity costs of using the cash we tie up in this investment.
The benefits are the future cash flows generated by the investment. But we know that anything in the
future is uncertain, so we know those future cash flows are not certain. Therefore, for an evaluation of
any investment to be meaningful, we must represent how much risk there is that its cash flows will differ
from what is expected, in terms of the amount and the timing of the cash flows. Risk is the degree of
uncertainty. We can incorporate risk in one of two ways:
we can discount future cash flows using a higher discount rate, the greater the cash flow's risk,
or
we can require a higher annual return on a project, the greater the cash flow's risk.
And, of course, we must incorporate risk into our decisions regarding projects that maximize owners'
wealth. In this reading, we look at the sources of cash flow uncertainty and how to incorporate risk in the
capital budgeting decision. We begin by describing what we mean by risk in the context of long-lived
Capital budgeting & risk, a reading prepared by Pamela Peterson Drake 1

projects. We then propose several commonly used statistical measures of capital project risk. Then we
look at the relation between risk and return, specifically for capital projects. And we follow with how risk
can be incorporated in the capital budgeting decision and how it is applied in practice.
A. Risk
Risk is the degree of uncertainty. When we estimate (which is the best we can do) what it costs to invest
in a given project and what its benefits will be in the future, we are coping with uncertainty. The
uncertainty arises from different sources, depending on the type of investment being considered, as well
as the circumstances and the industry in which it is operating. Uncertainty may due to:
Economic conditions -- Will consumers be spending or saving? Will the economy be in a

recession? Will the government stimulate spending? Will there be inflation?
Market conditions -- Is the market competitive? How long does it take competitors to enter into
the market? Are there any barriers, such as patents or trademarks that will keep competitors
away? Is there sufficient supply of raw materials and labor? How much will raw materials and
labor cost in the future?
Taxes -- What will tax rates be? Will Congress alter the tax system?
Interest rates -- What will be the cost of raising capital in future years?
International conditions -- Will the exchange rate between different countries' currencies change?
Are the governments of the countries in which the company does business stable?
These sources of uncertainty influence future cash flows. To evaluate and select among projects that will
maximize owners' wealth, we need to assess the uncertainty associated with a project's cash flows. In
evaluating a capital project, we are concerned with measuring its risk.
Relevant cash flow risk

Financial managers worry about risk because the suppliers of capital -- the creditors and owners ---
demand compensation for taking on risk. They can either provide their funds to your company to make
investments or they could invest their funds elsewhere. Therefore, there is an opportunity cost to
consider: what the suppliers of capital could earn elsewhere for the same level of risk. We refer to the
return required by the suppliers of capital as the cost of capital, which comprises the compensation to
suppliers of capital for their opportunity cost of not having the funds available (the time value of money)
and compensation for risk.
Cost of capital = Compensation for the time value of money + Compensation for risk
Using the net present value criterion, if the present value of the future cash flows is greater than the
present value of the cost of the project, it is expected to increase the value of the company, and
therefore is acceptable. If the present value of the future cash flows is less than the present value of the
costs of the project, it should be rejected. And under certain circumstances, using the internal rate of
return criterion, if the project's return exceeds the project's cost of capital, the project increases owners'
wealth. From the perspective of the company, this required rate of return is what it costs to raise capital,
so we also refer to this rate as the cost of capital.
We refer to the compensation for risk as a risk premium -- the additional return necessary to compensate
investors for the risk they bear. How much compensation for risk is enough? 2 percent? 4 percent? 10
percent?
How do we assess the risk of a project? We begin by recognizing that the assets of a company are the
result of its prior investment decisions. What this means is that the company is really a collection or
portfolio of projects. So when the company adds another project to its portfolio, should we be concerned
only about the risk of that additional project? Or should we be concerned about the risk of the entire

portfolio when the new project is included in it? To see which, let's look at the different dimensions of risk
of a project.
B. Different types of project risk

If we have some idea of the uncertainty associated with a project's future cash flows -- its possible
outcomes -- and the probabilities associated with these outcomes, we will have a measure of the risk of
the project. But this is the project's risk in isolation from the company's other projects. This is the risk of
the project ignoring the effects of diversification and is referred to as the project's total risk, or stand-
alone risk.
Since most companies have other assets, the stand-alone risk of the project under consideration may not
be the relevant risk for analyzing the project. A company is a portfolio of assets and the returns of these
different assets do not necessarily move together; that is, they are not perfectly positively correlated with
one another. We are therefore not concerned about the stand-alone risk of a project, but rather how the
addition of the project to the company's portfolio of assets changes the risk of the company's portfolio.
Now let's take it a step further. The shares of many companies may be owned by investors who
themselves hold diversified portfolios. These investors are concerned about how the company's
investments affect the risk of their own personal portfolios. When owners demand compensation for risk,
they are requiring compensation for market risk, the risk they can't get rid of by diversifying. Recognizing
this, a company considering taking on a new project should be concerned with how it changes the
market risk of a company. Therefore, if the company's owners hold diversified investments, it is the
project's market risk that is relevant to the company's decision making.
Even though we generally believe that it's the project's market risk that is important to analyze, stand-
along risk should not be ignored. If we are making decisions for a small, closely-held company, whose
owners do not hold well-diversified portfolios, the stand-alone risk gives us a good idea of the project's
risk. And many small businesses fit into this category.
And even if we are making investment decisions for large corporations that have many products and
whose owners are well-diversified, the analysis of stand-alone risk is useful. Stand-alone risk is often
closely related to market risk: in many cases, projects with higher stand-alone risk may also have higher
market risk. And a project's stand-alone risk is easier to measure than market risk. We can get an idea of
a project's stand-alone risk by evaluating the project's future cash flows using statistical measures,
sensitivity analysis, and simulation analysis.
2. Measurement of project risk

"Take calculated risks. That is quite different from being rash."
–- George S. Patton, 1944.
A. Statistical measures of cash flow risk

We will look at three statistical measures used to evaluate the risk associated with a project's possible
outcomes: the range, the standard deviation, and the coefficient of variation. Let's demonstrate each
using new products as examples. Based on experience with our company's current product lines and the
market research for new Product A, we can estimate that it may generate one of three different cash
flows in its first year, depending on economic conditions:

Economic
Cash flow Probability
condition
Boom $10,000 20% or 0.20

Normal 5,000 50% or 0.50
Recession -1,000 30% or 0.30
Looking at this table we can see there is more than one possible outcome. There are three possible
outcomes, each representing a possible cash flow, and its probability of occurring.
Looking at this probability distribution, we see that there is some chance of getting a -$1,000 cash flow
and some chance of getting a +$10,000 cash flow, though the most likely possibility (the one with the
greatest probability) is a +$5,000 cash flow.
But to get an idea of Product A's risk, we need to know a bit more. The more spread out the possible
outcomes, the greater the degree of uncertainty (the risk) of what is expected in the future. We refer to
the degree to which future outcomes are "spread out" as dispersion. In general, the greater the
dispersion, the greater the risk. There are several measures we could use to describe the dispersion of
future outcomes. We will focus on the range, the standard deviation, and the coefficient of variation.
The range
The range is a statistical measure representing how far apart the two extreme outcomes of the
probability distribution are. The range is calculated as the difference between the best and the worst
possible outcomes:
Range = Best possible outcome - Worst possible outcome
For Product A, the range of possible outcomes is $10,000 - (-$1,000) = $11,000. The larger the range,
the farther apart are the two extreme possible outcomes and therefore more risk.
The standard deviation

Though easy to calculate, the range doesn't tell us anything about the likelihood of the possible cash
flows at or between the extremes. In financial decision-making, we are interested in not just the extreme
outcomes, but all the possible outcomes.
One way to characterize the dispersion of all possible future outcomes is to look at how the outcomes
differ from one another. This would require looking at the differences between all possible outcomes and
trying to summarize these differences in a usable measure.
An alternative to this is to look at how each possible future outcome differs from a single value,
comparing each possible outcome with this one value. A common approach is to use a measure of central
location of a probability distribution, the expected value.
Let's use N to designate the number of possible future outcomes, xn to indicate the nth possible outcome,
pn to indicate the probability of the nth outcome occurring, and E (x) to indicate the expected outcome.
The expected cash flow is the weighted average of the cash flows, where the weights are the
probabilities:
E(x) = x1p1 + x2p2 + x3p3 +...+ xnpn + ... + xNpN
N
n=1

The standard deviation is a measure of how each possible outcome deviates -- that is, differs -- from
the expected value. The standard deviation provides information about the dispersion of possible
outcomes because it provides information on the distance each outcome is from the expected value and
the likelihood the outcome will occur. The standard deviation is:
= (x) pn (xn (x))2
n 1
We begin our calculation of standard deviation by first calculating the expected outcome, E(x). In our
example, there are three possible outcomes, so N = 3. Adding the probability-weighted outcome of each
of these three outcomes results in the expected cash flow:
E(Cash flow for Product A) = (0.20) $10,000 + (0.50) $5,000 + (0.30)-$1,000
E (Cash flow for Product A) = $2,000 + $2,500 - $300
E (Cash flow for Product A) = $4,200
The calculations for the standard deviation are provided in Exhibit 1. The standard deviation is a
statistical measure of dispersion of the possible outcomes about the expected outcome. The larger the
standard deviation, the greater the dispersion and, hence, the greater the risk.
Exhibit 1: Calculation of expected return and standard deviation for Product A
Economic Cash flow times Squared Weighted squared

conditions Cash Flow Probability probability Deviation deviation deviation
Boom $10,000 20% $ 2,000 5,800 33,640,000 6,728,000
Normal 5,000 50% 2,500 800 640,000 320,000
Recession -1,000 30% (300) -5,200 27,040,000 9,112,000
E(x) = $4,200 % = 15,160,000
= $3,893.58
The coefficient of variation

The standard deviation provides a useful measure of dispersion. It is a measure of how widely dispersed
the possible outcomes are from the expected value. However, we cannot compare standard deviations of
different projects' cash flows if they have different expected values.
We can do that with the coefficient of variation, which translates the standard deviation of different
probability distributions (because their scales differ) so that they can be compared.
The coefficient of variation for a probability distribution is the ratio of its standard deviation to its
expected value:
Coefficient of variation = Standard deviation / Expected value
or
x
Coefficient of variation =
x

Example: Expected return and standard deviation Risk can be expressed statistically in terms
of measures such as the range, the
Consider investing in a project whose possible returns standard deviation, and the coefficient of
next period and associated probabilities are: variation. Now that we know how to
calculate and apply these statistical
Possible outcome Probability measures, all we need are the probability
distributions of the project's future cash
-10% 20% flows so we can apply these statistical
0% 50% tools to evaluate a project's risk.
+20% 30% Where do we get these probability
What is this project's expected return and standard distributions? From research, judgment,
deviation? and experience. We can use sensitivity
analysis or simulation analysis to get an
First, calculate the expected return: idea of a project's possible future cash
flows and their risk.
Possible outcome, xi Probability, pi xi pi
Estimates of cash flows are based on
-0.10 0.20 -0.02 assumptions about the economy,
0.00 0.50 0.00 competitors, consumer tastes and
0.20 0.30 0.16 preferences, construction costs, and taxes,
among a host of other possible
E(x)=0.04 assumptions. One of the first things we
have to consider about our estimates is
Then, calculate the variance how sensitive they are to these
assumptions. For example, if we only sell
xi- E (x) (xi- E (x))2 pi (xi- E (x))2 two million units instead of three million
-0.14 0.0196 0.00392 units in the first year, is the project still
profitable? Or, if Congress increases the
-0.04 0.0016 0.00080 tax rates, will the project still be
0.16 0.0256 0.00768 attractive?
2(x) = 0.01240 We can analyze the sensitivity of cash
flows to change in the assumptions by
Variance = 0.01240 using re-estimating the cash flows for
Standard deviation = 0.11136 or 11.136% different scenarios. Sensitivity analysis,
also called scenario analysis, is a method
of looking at the possible outcomes, given a change in one of the factors in the analysis. Sometimes we
refer to this as "what if" analysis -- "what if this changes", "what if that changes", ..., and so on.
Tools that can be used to evaluate total risk
Sensitivity analysis (also called scenario analysis) is the examination of possible cash flows and
returns on an investment when one uncertain element is altered ("what if?" analysis).
Sensitivity analysis illustrates the effects of changes in assumptions. But because sensitivity analysis
focuses only on one change at a time or different sets of variations at a time, it is not very realistic. We
know that not one, but many factors can change throughout the life of the project. In the case of the
Williams project, there are a number of assumptions built into the analysis that are based on uncertainty,
including the sales prices of the building and equipment in five years and the entrance of competitors no
sooner than five years. And you can use your imagination and envision any new product and the
attendant uncertainties regarding many factors including the economy, the company's competitors, and
the price and supply of raw material and labor.

Sensitivity analysis becomes unmanageable if we start changing two factors at the same time (change
more than two and it's even worse). A manageable approach to changing two or more factors at the
same time is computer simulation. Simulation analysis is the analysis of cash flows and returns on
investments when more than one uncertain element is considered (allowing more than one probability
distribution to enter the picture). Simulation analysis allows the financial manager to develop a probability
distribution of possible outcomes, given a probability distribution for each variable that may change.
Simulation analysis is more realistic than sensitivity analysis because it introduces uncertainty for many
variables in the analysis. But if you use your imagination, this analysis may become complex since there
are interdependencies among many variables in a given year and interdependencies among the variables
in different time periods.
However, simulation analysis looks at a project in isolation, ignoring the diversification effects of projects,
focusing instead on a single project's total risk. And simulation analysis also ignores the effects of
diversification for the owners' personal portfolio. If owners hold diversified portfolios, then their concern
is how a project affects their portfolio's risk, not the project's total risk.

Demonstration of simulation analysis
Suppose that we are making an investment of $80 million in the equipment for a new product. Through research
with our marketing and production management, we have determined the expected price and cost per unit, as
well as the number of units to produce and sell. Along with these estimates, we have a standard deviation that
gives us an idea of the uncertainty associated with these estimates.
For simplicity, we have assumed that these three variables – price, cost, and number of units – are distributed
normally with the mean and standard deviations provided by the company’s management. From the accounting
department, we have an estimate of the range of possible tax rates during the product’s life; we’ve assumed a
uniform distribution for these rates.
This analysis has produced the following:
Variable Number of units Price per unit Expense per unit Tax rate
Mean 10,000,000 $14 $0.75 Minimum 35%
Standard deviation 1,000,000 $2 $0.05 Maximum 45%
We assume that the product will be produced and sold for the foreseeable future.
Using Microsoft Excel®1 , we simulated 1,000 draws (that is, 1,000 random selections from each of the four
variables’ distributions) using the above information and calculated the product’s internal rate of return for each
of these draws. The spreadsheet consists of distribution specifications and the results of the random draws: 2
The result is a distribution of possible internal rates of return for the product, as depicted in the histogram.
120
100
80
Frequency 60
40
20
0
9%
12%
15%
18%
21%
24%
27%
29%
32%
35%
38%
41%
44%
47%
50%
53%
IRR
The height of this distribution is the number of draws (out of the possible 1,000 replications) for which the IRR
fell into the range of IRRs depicted in the horizontal axis. In terms of risk, the wider the dispersion of possible
IRRs relative to the expected IRR, the greater the product’s risk.
3. Measuring a project's market risk

If we are looking at an investment in a share of stock, we could look at that stock's returns and the
returns of the entire market over the same period of time as a way of measuring its market risk. While
this is not a perfect measurement, it at least provides an estimate of the sensitivity of that particular
stock's returns as compared to the returns of the market as a whole. But what if we are evaluating the
market risk of a new product? We can't look at how that new product has affected the company's stock
return! So what do we do?
1
To perform this analysis, we use Microsoft Excel’s Random Number Generator in the Data Analysis
program to perform the simulation given our specified distributions of all the variable factors.
2
For an explanation of how to use Microsoft Excel® in simulation, go to http://office.microsoft.com/en-
us/assistance/HA011118931033.aspx

Though we can't look at a project's returns and see how they relate to the returns on the market as a
whole, we can do the next best thing: estimate the market risk of the stock of another company whose
only line of business is the same as the project's risk. If we could find such a company, we could look at
its stock's market risk and use that as a first step in estimating the project's market risk.
Let's use a measure of market risk, referred to as beta and represented by . is a measure of the
sensitivity of an asset's returns to change in the returns of the market. is an elasticity measure: if the
return on the market increases by 1 percent, we expect the return on an asset with a of 2.0 to increase
by 2 percent, if the return on the market decreases by 1 percent, we expect the returns on an asset with
a of 1.5 to decrease by 1.5 percent, and so on. The asset beta, therefore, is a measure of the asset's
market risk. To distinguish the beta of an asset from the beta we used for a company's stock, we refer to
an asset's beta as asset and the beta of a company's stock as equity.
A. Market risk and financial leverage

If a company has no debt, the market risk of its common stock is the same as the market risk of its
assets. This is to say the beta of its equity, equity, is the same as its asset's beta, asset.
Financial leverage is the use of fixed payment obligations, such as notes or bonds, to finance a
company's assets. The greater the use of debt obligations, the more financial leverage and the more risk
associated with cash flows to owners. So, the effect of using debt is to increase the risk of the company's
equity. If the company has debt obligations, the market risk of its common stock is greater than its
assets' risk (that is, equity greater than asset), due to financial leverage. Let's see why.
Consider an asset's beta, asset. This beta depends on the asset's risk, not on how the company chose to
finance it. The company can choose to finance it with equity only, in which case equity greater than
asset. But what if, instead, the company chooses to finance it partly with debt and partly with equity?
When it does this, the creditors and the owners share the risk of the asset, so the asset's risk is split
between them, but not equally because of the nature of the claims. Creditors have seniority and receive a
fixed amount (interest and principal), so there is less risk associated with a dollar of debt financing than a
dollar of equity financing of the same asset. So the market risk borne by the creditors is different than
the market risk borne by owners.
Let's represent the market risk of creditors as debt and the market risk of owners as equity. Since the
asset's risk is shared between creditors and owners, we can represent the asset's market risk as the
weighted average of the company's debt beta, debt, and equity beta, equity:

asset debt proportion of assets equity proportion of assets
financed with debt financed with equity
asset debt &debt equity &equity
But interest on debt is deducted to arrive at taxable income, so the claim that creditors have on the
company's assets does not cost the company the full amount, but rather the after-tax claim, so the
burden of debt financing is actually less due to interest deductibility. Further, the beta of debt is generally
assumed to be zero (that is, there is no market risk associated with debt). It can then be shown that the
relation between the asset beta and the equity beta is:

1
asset equity
debt

1 (1 ')
equity
This means that an asset's beta is related to the company's equity beta, with adjustments for financial
leverage. You'll notice that if the company does not use debt, equity = asset and if the company does use
debt, equity < asset.
Therefore, we can translate a equity into a asset by removing the company's financial risk from its
equity. As you can see in equation above, to do this we need to know:
the company's marginal tax rate;

the amount of the company's debt financing; and
the amount of the company's equity financing.
The process of translating an equity beta into an asset beta is referred to as "unlevering" since we a
removing the effects of financial leverage from the equity beta, equity, to get a beta for the company's
assets, asset.
Using a pure-play
A company with a single line of business is referred to as a pure-play. Selecting the company or
companies that have a single line of business,
where this line of business is similar to the Examples of pure plays
project's, helps in estimating the market risk of a
Company Industry equity
project. We estimate a project's asset beta by
7-Eleven Convenience 0.75
starting with the pure-play's equity beta. We can stores
estimate the pure-play's equity beta by looking at Universal Corporation Tobacco 0.60
the relation between the returns on the pure- POSCO Steel producer 1.00
play's stock and the returns on the market. Once American Water Works Water utility 0.45
we have the pure-play's equity beta, we can then
"unlever" it by adjusting it for the financial Source: Value Line Investment Survey
leverage of the pure-play company.
Suppose a pure-play company has the following financial data:
equity = 1.1
Debt = $3,914 million
Equity = $4,468 Example: Levering and unlevering betas
Its asset beta, asset, is 0.6970: Calculate the asset beta for each of the following
companies:

1 Equity equity
asset 1.1 0.6970 Company Marginal tax rate Debt
$3, 914

Company A 40% $100 $200 1.5
1 (1 0.34)
$4, 468 Company B 30% $100 $400 1.5
Company C 40% $100 $200 1.0
Because many U.S. corporations whose stock's
Solution:
returns are readily available have more than one line asset for Company A = 1.1538
asset for Company B = 1.2766
asset for Company C = 0.7692
of business, finding an appropriate pure-play company may be difficult. Care must be taken to identify
those that have lines of business similar to the project's.
Try it! Asset betas
Calculate the asset beta for each of these companies:
Company Tax rate Debt Equity equity

3M 35% $10.33 billion $55.51 billion 0.90
Amazon.com 35% $3.45 billion $16.18 billion 1.70
Sprint Nextel 35% $49.54 billion $70.88 billion 1.15
Walt Disney Company 35% $29.95 billion $52.90 billion 1.35
Yahoo! 35% $2.08 billion $47.13 billion 1.90
Note: Tax rate is assumed.

Source of data: Yahoo! Finance and Value Line Investment Survey
Bottom line: We can’t estimate the relevant, market risk of a project because this is not measurable
directly. What we can do is use the market risk of a company in a similar, single line of business and then
uses that company’s stock beta – with some adjustments for differing financial leverage – to estimate the
beta for the project. With this beta, we can then estimate the cost of capital for the project.
4. Incorporating risk in the capital budgeting decision

In using the net present value method to value future cash flows, we know that the discount rate should
reflect the project's risk. In using the internal rate of return method, we know that the hurdle rate -- the
minimum rate of return on the project -- should reflect the project's risk. Both the net present value and
the internal rate of return methods, therefore, depend on using a cost of capital that reflects the project's
risk.
A. Risk-adjusted rate
The cost of capital is the cost of funds (from creditors and owners). This cost is the return required by
these suppliers of capital. The greater the risk of a project, the greater the return required, and hence,
the greater the cost of capital.
The cost of capital can be viewed as the sum what suppliers of capital demand for providing funds if the
project were risk-free plus compensation for the risk they take on.
The compensation for the time value of money includes compensation for any anticipated inflation. We
typically use a risk-free rate of interest, such as the yield on a long-term U.S. Treasury bond, to represent
the time value of money.
The compensation for risk is the extra return required because the project's future cash flows are
uncertain. If we assume that the relevant risk is the stand-alone risk (say, for a small, closely-held
business), investors would require a greater return, the greater the project's stand-alone risk. If we
assume that the relevant risk is the project's market risk, investors would require a greater return, the
greater the project's market risk.
B. Return required for the project's market risk

Now let's explain how to determine the premium for bearing market risk. We do this by first specifying
the premium for bearing the average amount of risk for the market as a whole and then, using our
measure of market risk, fine tune this to reflect the market risk of the asset. The market risk premium
for the market as a whole is the difference between the average expected market return, rm, and the
risk-free rate of interest, rf. If you bought an asset whose market risk was the same as that as the
market as a whole, you would expect a return of rm - rf to compensate you for market risk.
Next, let's adjust this market risk premium for the market risk of the particular project by multiplying it by
that project's asset beta, asset:
Compensation for market risk = asset (rm - rf).

This is the extra return necessary to compensate for the project's market risk. The asset beta fine-tunes
the risk premium for the market as a whole to reflect the market risk of the particular project. If we then
add the risk-free interest rate, we arrive at the cost of capital:
Cost of capital = rf + asset (rm - rf)

Suppose the expected risk-free rate of interest is 4 percent and the expected return on the market as a
whole is 10 percent. If the basset is 2.00, this means that if there is a 1 percent change in the market
risk premium, we expect a 2 percent change in the return on the project. In this case, the cost of capital
is 16 percent:
Cost of capital = 0.04 + 2.00 (0.10 - 0.04) = 0.16 or 16%
If asset beta is 0.75, instead, the cost of capital is 8.5 percent:
Cost of capital = 0.04 + 0.75 (0.06) = 0.085 or 8.5%
If we are able to gauge the market risk of a project, we estimate the risk-free rate and the premium for
market risk and put them together. But often we are not able to measure the market risk, nor even the
risk-free rate. So we need another way to approach the estimation of the project's cost of capital.
C. Adjusting the company's cost of capital

Another way to estimate the cost of capital for a project without estimating the risk premium directly is to
use the company's average cost of capital as a starting point. The average cost of capital is the
company's marginal cost of raising one more dollar of capital -- the cost of raising one more dollar in the
context of all the company's projects considered altogether, not just the project being evaluated. We can
adjust the average cost of capital of the company to suit the perceived risk of the project:
If a new project being considered is riskier than the average project of the company, the cost of
capital of the new project is greater than the average cost of capital.
If the new project is less risky, its cost of capital is less than the average cost of capital.
If the project is as risky as the average project of the company, the new project's cost of capital
is equal to the average cost of capital.
As you can tell, altering the company's cost of capital to reflect a project's cost of capital requires
judgment. How much do we adjust it. If the project is riskier than the typical project do we add 2
percent? 4 percent? 10 percent? There is no prescription here. It depends on the judgment and
experience of the decision maker. But this is where we can use the measures of a project's stand-alone
risk to help form that judgment.

5. Assessment of project risk in practice
Most U.S. companies consider risk in some manner in evaluating investment projects. But considering risk
is usually a subjective analysis as opposed to the more objective results obtainable with simulation or
sensitivity analysis.
Companies that use discounted cash flow techniques, such as internal rate of return and net present
value methods, tend to use a single cost of capital. But using a single cost of capital for all projects can
be hazardous.
Suppose you use the same cost of capital for all your projects. If all of them have the same risk and the
cost of capital you are using is appropriate for this level of risk, no problem. But what if you use the same
cost of capital but your projects each have different levels of risk?
Suppose you use a cost of capital that is the cost of capital for the company's average risk project. What
happens when you apply discounted cash flow techniques, such as the net present value or the internal
rate of return, and use this one rate? You will end up:
rejecting profitable projects (which would have increased owners' wealth) that have risk below
the risk of the average risk project because you discounted their future cash flows too much, and
accepting unprofitable projects whose risk is above the risk of the average project, because you
did not discount their future cash flows enough.
Companies that use a risk-adjusted discount rate usually do so by classifying projects into risk classes by
the type of project. For example, a company with a cost of capital of 10 percent may use a 14 percent
cost of capital for new products and a much lower rate of 8 percent for replacement projects. Given a set
of costs of capital, the financial manager need only figure out what class a project belongs to and then
apply the rate assigned to that class.
Companies may also make adjustments in the cost of capital for factors other than the type of project.
For example, companies investing in projects in foreign countries will sometimes make an adjustment for
the additional risk of the foreign project, such as exchange rate risk, inflation risk, and political risk.
The cost of capital is generally based on an assessment of the company's overall cost of capital. First, the
company evaluates the cost of each source of capital -- debt, preferred stock, and common equity. Then
each cost is weighted by the proportion of each source to be raised. This average is referred to as the
weighted average cost of capital (WACC).
There are tools available to assist the decision-maker in measuring and evaluating project risk. But much
of what is actually done in practice is subjective. Judgment, with a large dose of experience is used more
often than scientific means of incorporating risk. Is this bad? Well, the scientific approaches to
measurement and evaluation of risk depend, in part, on subjective assessments of risk, the probability
distributions of future cash flows and judgments about market risk. So it is possible that by-passing the
more technical analyses in favor of completely subjective assessment of risk may result in cost of capital
estimates that better reflect the project's risk. But then again it may not. The proof may be in the
pudding, but it is difficult to assess the "proof" since we cannot tell how well companies could have done
had they used more technical techniques!
6. Summary
To screen and select among investment projects, the financial manager must estimate future cash flows
for each project, evaluate the riskiness of those cash flows, and evaluate each project's contribution to
the company's value and, hence, to owners' wealth. The financial manager has to evaluate future cash
flows -- cash flows that are estimates, which mean they are uncertain. The financial manager must also
to incorporate of risk into the analysis of projects to identify which ones maximize owners' wealth.

Statistical measures that can be used to evaluate the risk of a project's cash flows are: the range, the
standard deviation, and the coefficient of variation. Sensitivity analysis and simulation analysis are tools
that can be used in conjunction with the statistical measures, to evaluate a project's risk. Both techniques
give us an idea of the relation between a project's return and its risk. However, since the company is
itself a portfolio of projects and it is typically assumed that owners hold diversified portfolios, the relevant
risk of a project is not its stand-along risk, but rather how it affects the risk of owners' portfolios, its
market risk.
Risk is typically figured into our decision-making by using a cost of capital that reflects the project's risk.
The relevant risk for the evaluation of a project is the project's market risk, which is also referred to as
the asset beta. This risk can be estimated by looking at the market risk of companies in a single line of
business similar to that of the project, a pure-play. An alternative to finding a pure-play is to classify
projects according to the type of project (e.g. expansion) and assign costs of capital to each project type
according to subjective judgment of risk.
Most companies adjust for risk in their assessment of the attractiveness of projects. However, this
adjustment is typically done by evaluating risk subjectively and ad hoc adjustments to the company's cost
of capital to arrive at a cost of capital for a particular project.

Asset betas

1

Company equity Debt/equity

1 (1 ')
debt
equity

asset
3M 0.90 0.18609 0.89209 0.80288
Amazon.com 1.70 0.21323 0.87827 1.49306
Sprint Nextel 1.15 0.69893 0.68761 0.79076
Walt Disney Company 1.35 0.56616 0.73099 0.98684
Yahoo! 1.90 0.04413 0.97212 1.84702

Capital budgeting formulas
Cash flows
#OCF = (#R - #E - #D) (1 - t) + #D - #NWC or #OCF = (#R - #E) (1 - t) + #Dt - #NWC
where
t = tax rate; and
Techniques
N CIFt
t
N CFt t 1 (1 r)
Net present value = NPV Profitability index = PI
t N COF
t 1 (1 r) t
t
t 1 (1 r)
N CFt
IRR is the rate that solves the following: $0
t
t 1 (1 IRR)
CIF (1+i)
t=1
t
N-t
Modified internal rate of return = MIRR= N N

COFt
(1+i)
t=1
t
where CFt is the cash flow at the end of period t, and CIFt and COFt are cash inflows and cash outflows, respectively,
at the end of period t.
Risk
N N x
E (x) = pn xn (x) pn (xn (x))2 Coefficient of variation =
n 1 x
n=1

1
asset equity
debt

1 (1 ')
equity
Compensation for market risk = asset (rm - rf)


Prepared by Pamela Peterson-Drake 1

The Expansion of the Williams 5 & 10
A capital budgeting problem prepared by Pamela Peterson Drake
The Problem
The Williams 5 & 10 Company is a discount retail chain, selling a variety of goods at low prices.
Business has been very good lately and the Williams 5 & 10 Company is considering opening one
more retail outlet in a neighboring town at the end of 1999. They figure that it would be about
five years before a large national chain of discount stores moves into that town to compete with
its store. So it is looking at this expansion as a five-year prospect. After five years, it would most
likely retreat from this town.
Williams' managers have researched the expansion and determined that the building needed
could be built for $400,000 and it would cost $100,000 to buy the cash registers, shelves, and
other equipment necessary to start up this outlet. Under MACRS, the building would be classified
as 31.5-year property and depreciated using the straight-line method, with no salvage value. This
means that 1/31.5 of the $400,000 is depreciated each year. Also under MACRS, the equipment
would be classified as 5-year property. The Williams 5 & 10 expects to be able to sell the building
for $350,000 and the equipment for $50,000 after five years.
The Williams 5 & 10 extends no credit on its sales and pays for all its purchases immediately. The
projections for sales and expenses for the new store for the next five years are:
Year Sales Expenses

2000 $200,000 $100,000
2001 300,000 100,000
2002 300,000 100,000
2003 300,000 100,000
2004 50,000 20,000
The new store requires $50,000 of additional inventory. Since all sales are in cash, there is no
expected increase in accounts receivable. However, the firm anticipates no other changes in
working capital. The tax rate is a flat 30% and there are no investment tax credits associated
with this expansion. Also, capital gains are taxed at the ordinary tax rate.
The Analysis
To determine the relevant cash flows to evaluate this expansion, let's look at this problem bit-by-
bit.
"The Williams 5 & 10 Company is a discount retail chain, selling a variety of goods at low prices.
Business has been very good lately and the Williams 5 & 10 Company is considering opening one
more retail outlet in a neighboring town at the end of 1999."
Williams 5 & 10 Capital budgeting example, prepared by Pamela Peterson-Drake 1

This is an expansion of the business into a new market. Since Williams has other similar outlets,
this is most likely a low risk type of investment.
"They figure that it would be about five years before a large national chain of discount stores
moves into that town to compete with its store. So it is looking at this expansion as a five-year
prospect. After five years it would most likely retreat from this town."
The economic life of this project is five years. They expect to expand into this market for only
five years, leaving when a competitor enters.
"Williams' managers have researched the expansion and determined they the building needed
could be built for $400,000 and it would cost $100,000 to buy the cash registers, shelves, and
other equipment necessary to start up this outlet."
The initial outlay for the building and equipment is $500,000. There are no set-up charges, so we
can assume that all other initial investment costs are included in these figures.
"Under MACRS, the building would be classified as 31.5-year property and depreciated using the
straight-line method with no salvage value. This means that 1/31.5 of the $400,000 is
depreciated each year. Also under MACRS, the equipment would be classified as 5-year
property."
The depreciation expense for each year is:
Depreciation Expense
Year Building Equipment Total
1 $12,698 $20,000 $ 32,698
2 12,698 32,000 44,698
3 12,698 19,200 31,898
4 12,698 11,520 24,218
5 12,698 11,520 24,218
Total $63,490 $ 94,240
The book values of the building and equipment at the end of the fifth year are:
Book value of building = $400,000 - 63,490 = $336,510,

and
Book value of equipment = $100,000 - 94,240 = $5,760.
"The Williams 5 & 10 expects to sell the building for $350,000 and the equipment for $50,000
after five years."
The sale of the building is a cash inflow of $350,000 at the end of the fifth year. The building is
expected to be sold for more than its book value, creating a taxable gain of $350,000 - 336,510
= $13,490. The tax on this gain is $4,047.
The sale of the equipment is a cash inflow of $50,000. The gain on the sale of the equipment is
$50,000 - 5,760 = $44,240. The tax on this gain is 30% of 44,240, or $13,272.

"Williams extends no credit on its sales and pays for all its purchases immediately. The
projections for sales and expenses for the new store for the next five years are:
Year Sales Expenses

2000 $200,000 $100,000
2001 250,000 100,000
2002 300,000 100,000
2003 300,000 100,000
2004 50,000 20,000
The change in revenues, #R, and the change in cash expenses, #E, correspond to the sales and
costs figures.
"The new store would require $50,000 of additional inventory. Since all sales are in cash, there is
no expected increase in accounts receivable. However, the firm anticipates no other changes in
working capital."
The increase in inventory is an investment of cash when the store is opened, a $50,000 cash
outflow. That's the amount Williams has to invest to maintain inventory while the store is in
operation. When the store is closed in five years, there is no need to keep this increased level of
inventory. If we assume that the inventory at the end of the fifth year can be sold for $50,000,
that amount will be a cash inflow at that time. Since this is a change in working capital for the
duration of the project, we include this cash flow as part of the asset acquisition (initially) and its
disposition (at the end of the fifth year).
"The tax rate is a flat 30% and there are no investment tax credits associated with this
expansion. Also, capital gains are taxed at the ordinary tax rate of 30%."
Once we know the tax rate we can calculate the cash flows related to acquiring and disposing of
assets and the cash flow from operations.
We can calculate the cash flows from operations in the following manner:
Year #R #E #D (#R - #E - #D)(1-') (#R - #E - #D)(1-') + #D

2001 $200,000 $100,000 $32,698 $ 47,111 $ 79,809
2002 300,000 100,000 44,698 108,711 153,409
2003 300,000 100,000 31,898 117,671 149,569
2004 300,000 100,000 24,218 123,047 147,265
2005 50,000 20,000 24,218 4,047 28,265
Or, we can calculate the incremental operating cash flows from the new store using the other
operating cash flow equation:

Year #R #E (#R - #E)(1-') #D' (#R - #E)(1-') + #D'
2001 $200,000 $100,000 $ 70,000 $ 9,809 $ 79,809
2002 300,000 100,000 140,000 13,409 153,409
2003 300,000 100,000 140,000 9,569 149,569
2004 300,000 100,000 140,000 7,265 147,265
2005 50,000 20,000 21,000 7,265 28,265
The pieces of this cash flow puzzle are put together in Exhibit 1, which identifies the cash inflows
and outflows for each year, with acquisition and disposition cash flows at the top and operating
cash flows below.
Exhibit 1: Worksheet for the William 5 and 10 Expansion Project

End of year
Initial 2001 2002 2003 2004 2005
Investment cash flows
Purchase and sale of building -$400,000 $350,000
Tax on sale of building -4,047
Purchase and sale of equipment -100,000 50,000
Tax on sale of equipment -13,272
Change in working capital -50,000 50,000
Investment cash flows -$550,000 $432,681
Change in operating cash flows

Change in revenues $200,000 $300,000 $300,000 $300,000 $50,000
Less: Change in expenses -100,000 -100,000 -100,000 -100,000 -20,000
Less: Change in depreciation -32,698 -44,698 -31,898 -24,218 -24,218
Change in taxable income $67,302 $155,302 $168,102 $175,782 $5,782
Less: taxes -20,191 -46,591 -50,531 -52,735 -1,735
Change in income after tax $47,111 $108,711 $117,671 $123,047 $4,047
Add: Change in depreciation, 32,698 44,698 31,898 24,218 24,218
Net cash flows -$550,000 $79,809 $153,409 $149,569 $147,265 $460,946
Investing $550,000 initially is expected to result in cash inflows during the following five years, as
shown in Exhibit 1.

Capital Budgeting StudyMate Activity, Pamela Peterson Drake Page 1 of 2
Capital Budgeting StudyMate Activity
Flash Cards
Pick a Letter
Fill In The Blank
Matching
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Quiz
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Glossary
Capital Budgeting StudyMate Activity, Pamela Peterson Drake Page 2 of 2

Capital budgeting practice problems
Capital budgeting and cash flows

1. If a firm invests $5 million in research and development of a new product, is this $5 million
considered in the decision to of whether or not to go ahead and produce and market this
new product?
2. Suppose Congress increases the rate of depreciation from the 200 declining balance (under
the MACRS) to a 300 declining balance system. What affect will this change have on the cash
flows associated with a capital project?
3. If a firm sells a depreciable asset for more than its book value, what are the tax
consequences of this sale? What are the cash flow consequences?
4. AAA Company is considering the purchase of new equipment to replace their existing
equipment. The old equipment was purchased five years ago for $200,000 and has a $0 book
value. AAA can sell the old equipment for $100,000. The new equipment costs $200,000 and
they expect to sell it in five years for $50,000, when it has a book value of $40,000. AAA has
a tax rate of 40%. What are the cash flows related to AAA's acquisition and disposition of
equipment in this replacement decision?
5. BBB Company is considering the purchase of new equipment to replace their existing
equipment. The old equipment was purchased five years ago for $200,000 and has a
$100,000 book value. BBB can sell the old equipment for $50,000. The new equipment costs
$200,000 and they expect to sell it in five years for $50,000, when it has a book value of
$60,000. If it had kept the old equipment, it would have a book value of $0 in five years and
would have no resale value or cost of dismantling. EWE has a tax rate of 40%. What are the
cash flows related to BBB 's acquisition and disposition of equipment in this replacement
decision?
6. Consider the investment in a new machine that is expected to have the following:
Change in Change in Change in Change in
Year
revenues expenses depreciation working capital
1 +$100,000 +$ 75,000 +$20,000 +$20,000
2 + 200,000 + 90,000 + 40,000 + 10,000
3 + 300,000 + 100,000 + 30,000 - 10,000
4 + 200,000 + 50,000 + 10,000 - 10,000
5 + 100,000 + 25,000 0 - 10,000
If the firm's tax rate is 30%, what is the expected incremental cash flow each year for this
new machine?
Capital budgeting practice problems, prepared by Pamela Peterson-Drake 1

1. The internal rate of return is often referred to as the yield on an investment. Explain the
analogy between the internal rate of return on an investment and the yield to maturity on a
bond.
2. The net present value method and the internal rate of return method may produce different
decisions when selecting among mutually exclusive projects. What is the source of this
conflict?
3. The net present value method and the internal rate of return method may produce different
decisions when selecting projects under capital rationing. What is the source of this conflict?
4. The modified internal rate of return is designed to overcome a deficiency in the internal rate
of return method. Specifically, what problem is the MIRR designed to overcome?
5. You are evaluating an investment project, Project CCC, with the following cash flows:
Period End of
period cash
flow
0 -$100,000
1 35,027
2 35,027
3 35,027
4 35,027
a. Internal Rate of Return

b. Modified Internal Rate of Return, assuming reinvestment at 0%
c. Modified Internal Rate of Return, assuming reinvestment at 10%
6. You are evaluating an investment project, Project DDD, with the following cash flows:
Period End of period

cash flow
0 -$100,000
1 43,798
2 43,798
3 43,798
a. Internal rate of return

7. You are evaluating an investment project, Project EEE, with the following cash flows:

cash flow
0 -$200,000
1 65,000

2 65,000
3 65,000
4 65,000
5 65,000
a. Calculate the following:

b. Internal Rate of Return
d. Modified Internal Rate of Return, assuming reinvestment at 15%
8. You are evaluating an investment project, Project FFF, with the following cash flows:

cash flow
0 -$100,000
1 0
2 0
3 0
4 174,901
a. Internal Rate of Return


Capital budgeting and risk
1. What distinguishes sensitivity analysis from simulation analysis?
2. Suppose you are responsible for determining the cost of capital of a project. How should your
approach differ if the firm is a small, one-owner firm, as compared to a large publicly-held
corporation?
3. Suppose the GGG Company evaluates most projects using the net present value method and
a single discount rate that reflects its marginal cost of raising new capital. Can you see any
problem with their method?
4. Suppose the HHH's management evaluates investment opportunities by grouping projects
into three risk classes: low, average, and high risk. They assign a cost of capital to each
group and use this cost of capital to discount a project's future cash flows: 5% for low risk,
10% for average risk, and 15% for high risk projects. Critique their method of adjusting for
risk.
5. Product A has an expected first year cash flow of $10 million and a standard deviation of its
probability distribution of its first year cash flows of $2 million. Product B has an expected
first year cash flow of $15 million and a standard deviation of its probability distribution of
first year cash flows of $3 million. Which product has the greater total risk?
6. Consider the probability distribution of cash flows for Product X:
Probability Cash Flow

20% $1 million
40% $3 million
40% $5 million
a. Expected cash flow.

b. Standard deviation of the cash flows.
c. Coefficient of variation of the cash flows.
7. Calculate the asset beta for each firm, III, JJJ and KKK:
Firm Marginal tax rate Debt Equity Equity beta

Firm III 50% $300 $200 1.5
Firm JJJ 30% $300 $400 1.5
Firm KKK 40% $200 $200 1.0

Solutions to capital budgeting practice problems
Capital budgeting and cash flows
1. No. The $5 million is a sunk cost: whether or not the firm goes ahead with the new product,
the $5 million has been spent.
2. An increase in the rate of depreciation will cause the cash flows from depreciation (the
depreciation tax-shield) to become larger in the earlier years of a project's life and smaller in
the latter years of its depreciable life.
3. If the asset is sold for less than its original cost, the difference between its sale price and its
book value is taxed as ordinary income. If the asset is sold for more than its original cost, the
difference between its sales price and the original cost is taxed as a capital gain (usually at
rates lower than for ordinary income) and the difference between its original cost and its
book value is taxed as ordinary income. The cash flow from the sale include the cash inflow
from the sale itself and the cash outflow for taxes.
4. Year 0:
Purchase new equipment: Cash flow (acquire new equipment) -$200,000
Sell old equipment:
+$100,000
Cash flow from sale
Tax of sale (40% of $100,000) - 40,000
Net cash flow from sale of old + 60,000
Cash flow, Year 0 -$140,000

Year 5:
Sale of new equipment:
+$50,000
Cash flow from sale
Tax on sale 40% of $10,000 - 4,000
Net cash flow from sale of new +$46,000
5. Cash flow in Year 0: -$130,000
Cost of the new equipment = -$200,000
Sale of the old equipment = +$50,000
Tax benefit from $50,000 loss on sale = 0.4 ($50,000) = +$20,000
Note: loss on sale of old equipment = $50,000 - $100,000 = -$50,000

Cash flow in Year 5: +$54,000
Cash flow from sale of new equipment = +$50,000
Tax benefit from $10,000 loss on sale = 0.4 ($10,000) = +$4,000
6.
Change in Change in Change in Change in working Incremental cash
Year
revenues expenses depreciation capital flow
1 +$100,000 +$ 75,000 +$20,000 +$20,000 +$3,500
2 + 200,000 + 90,000 + 40,000 + 10,000 +79,000
3 + 300,000 + 100,000 + 30,000 - 10,000 +159,000
4 + 200,000 + 50,000 + 10,000 - 10,000 +118,000
5 + 100,000 + 25,000 0 - 10,000 +62,500
Solutions to capital budgeting practice problems 1

1. The internal rate of return on an investment is the return considering the cash inflows and
the reinvestment of the cash inflows (at this IRR). The yield to maturity of a bond is the
return on the bond from interest, the reinvestment of the interest (at this yield), and the
principal repayment.
2. The source of this conflict is the reinvestment rate assumption. The NPV method assumes
reinvestment at the required rate of return, whereas the IRR assumes reinvestment at the
IRR. For certain required rates of return, the project with the higher IRR may not have the
greatest present value.
3. The source of this conflict is the manner in which the method assesses the investment. The
NPV produces a dollar value of wealth enhancement, whereas the IRR is in terms of a yield.
4. The MIRR is designed to overcome the reinvestment rate assumption inherent in the IRR
method. Since the IRR method's reinvestment assumption may be unrealistic, the MIRR
provides an alternative method that permits a more realistic reinvestment assumption to be
built-in.
5.
a. IRR = 15%
b. MIRR = 8.8%
Note: FV = Terminal value = $35,027 x 4 = $140,108
c. MIRR = 12.92%
Because the cash flows are the same, we can use the future value o an annuity to
solve for the terminal value:
FV = Terminal value = $35,027 (FV annuity factor for n=4 i = 10%)
FV = $162,560
6.
a. IRR = 15%
Use the annuity relation to determine the i (the IRR).
b. MIRR = 13.178%
Terminal value = $144,971.38
c. MIRR = 14.6359%
7.
a. IRR = 18.7189%
b. MIRR = 14.6873%
c. MIRR = 16.9875%
8.
a. IRR = 15%
b. MIRR = 15%
Note: Because there is only one cash inflow, you can use the following to solve for
the MIRR: FV = $174,901; PV = $100,000;n = 4; Solve for i (the MIRR)

Capital budgeting and risk
1. The standard deviation of the expected value is a measure of dispersion about the expected
value; that is, how the possible outcomes deviate from the central tendency of the probability
distribution. The standard deviation is in the same unit of measure as the expected value
(e.g. dollars, return, units sold). The coefficient of variation is a measure of dispersion that is
standardized to reflect dispersion relative to the expected value (e.g. a coefficient of variation
of 2.0 indicates that the standard deviation is two times the expected value). The coefficient
of variation is useful in comparing the dispersion of distributions that are centered on
different expected values.
2. A standard deviation of $500 and an expected value of $1,200 indicates that it is 64% likely
that the possible outcome will be within 1.64 ($500) or $820 either side of the expected
value of $1,200, or in the range $380 to $2,020. [Note: The 64% and the 1.64 are based on
the properties of the normal distribution.]
3. Procedure:
Step 1: Classify the project in terms of its line of business
Step 2: Identify firms with single lines of business that are the same as the project's, and
whose stock is traded in the financial markets
Step 3: Calculate the beta of the firm's or firms' stock
Step 4: Unlever the betas
Step 5: If there is more than one firm in the same line of business, average their betas
This will produce an estimate of the project's beta.
4. Sensitivity analysis involves modifying one parameter at a time in the examination possible
future outcomes to a decision, whereas simulation analysis allows modifying more than one
parameter and explicitly incorporates the probability distributions of the parameters of the
decision.
5. The approach to determine the cost of capital for a small, single owner business would be
different than that of a large publicly-held corporation since stand-alone, or project specific
risk is more important for the small, single owner firm than for the large corporation. In the
case of large corporation, the focus should be on the project's market risk, not on a project's
total risk.
6. Using a single rate to evaluate all projects is not a problem as long as all projects have the
same risk and this risk is the same as that of the rest of the firm's projects.
If the projects differ in terms of riskiness, a single rate will result in the rejection of
profitable, yet less risky projects and the acceptance of unprofitable projects with risk greater
than the average project's risk.
7. Using risk classes is a step towards using risk-adjusted discount rates. However, there are
two potential problems:
(1) Determining the discount rates for the risk classes
(2) The possibility that projects within a given class will have different risks.
8. Neither. The total risk of the two products is the same (that is, they have identical coefficient
of variations):
Coefficient of variation, Product A = $2/$10 = 0.20
Coefficient of variation, Product B = $3/$15 = 0.20
9.
a. Expected cash flow = $0.2 + $1.2 + 2.0 = $3.40
b. Standard deviation = $1.4967
c. Coefficient of variation = $1.4976/ $3.4000 = 0.4405
10. Calculate the asset beta for each firm, III, JJJ and KKK:
Firm III: 1.5 (0.5714) = 0.8571
Firm JJJ: 1.5 (0.6557) = 0.9836
Firm KKK: 1.0 (0.6250) = 0.6250

Module 7, Peterson Drake Page 1 of 2
Module 7: Capital Structure and the Cost of Capital

Elements
1. Module 7: Capital structure and the cost of capital IMPORTANT: READ FIRST
2. Reading: Capital structure
3. Reading: Cost of capital
4. Cost of capital formulas of the estimation of cash flows
5. Problem set: Capital structure practice problems and questions and Solutions
6. Problem set: Cost of capital practice problems and Solutions
Module 7, Peterson Drake Page 2 of 2

Module 7: Capital
structure and the cost http://educ.jmu.edu/~drakepp/principles/module7/learning_outcomes.pdf
of capital
Capital structure http://educ.jmu.edu/~drakepp/principles/module7/capital_structure.pdf
Cost of capital http://educ.jmu.edu/~drakepp/principles/module7/coc.pdf
Cost of capital
http://educ.jmu.edu/~drakepp/principles/module7/coc_formulas.pdf
formulas
Capital structure
practice problems and http://educ.jmu.edu/~drakepp/principles/module7/cs_practice_problems.pdf
questions
http://educ.jmu.edu/~drakepp/principles/module7/coc_problems.pdf
problems
MODULE 7:
CAPITAL STRUCTURE & THE COST OF CAPITAL
OUTLINE
1. Introduction
3. Module tasks
1. Introduction
Financial managers weight the benefits and costs associated with the investment and
financing decisions that they make. An important financing decision that the financial
management of a company makes is the capital structure decision; that is, how does the
company finance its business? The capital structure decision affects the financial risk that a
company assumes and affects the cost of capital.
The greater a company’s reliance on debt financing, the greater the benefit that a company
receives in terms of the tax deductibility of interest; as you will see, the government shares
some of the cost of the debt. But along with that benefit from taxes, the greater the
company’s reliance on debt, the greater is the increased chance of bankruptcy, which is
accompanied by an increase in the company’s cost of capital.
What a financial manager must do is strike a balance between the benefit from interest
deductibility and the potential cost of bankruptcy. The challenge is that a company doesn’t
know it has too much debt until it reaches that point at which it can no longer handle this
debt. By then, it’s too late.
In this module, you will be introduced to the theory of capital structure. This theory is based
on a reasoning of the factors to consider in choosing a company’s capital structure. You will
also be introduced to the methods of estimating the cost of capital. These methods use
valuation principles and tools.
LO7.1 Explain the sensitivity of earnings to owners to financial leverage.
LO7.2 Quantify the risk associated with financial leverage.
LO7.3 Explain the role of interest deductibility for tax purposes in the capital
structure decision.
LO7.4 Explain the role of bankruptcy and bankruptcy costs in the capital structure
decision.
Module 7 Overview 1
LO7.5 Demonstrate through example and graphically the interaction between
interest deductibility and bankruptcy costs in the capital structure decision.
LO7.6 List reasons why capital structures may differ among industries and among
companies within an industry.
LO7.7 Estimate the cost of capital for a company.
LO7.8 Compare and contrast the cost of equity capital determined by the DVM and
the CAPM
LO7.9 Identify the problem and issues related to the estimation of the cost of
capital
3. Module tasks
A. Readings
i Required reading
Capital structure
Cost of capital
ii Other resources
Cost of capital formulas
Online Tutorial #8: How Do You Calculate A Company's Cost of Capital?, by
Expectations Investing.
Kevin Bracker’s brief explanation of capital structure theory
Fabozzi and Peterson text, Chapters 18 and 11, available free through FAU
Libraries and NetLibrary.
B. Problem sets
Capital structure practice problems and solutions
Cost of capital practice problems and solutions.
StudyMate Activity
C. Achievements
1. Module quiz. Complete the online quiz by April 25th. The guidelines of this quiz are
the same as all other graded quizzes in this course:
a. The Honor Code applies. You are permitted to use all materials at hand, but you
are not permitted the assistance of any person.
b. There is no backtracking allowed. Once you answer a question, you are not
permitted to go back to check your work or change your answer.
Module 7 Overview 2
c. You must complete the quiz within the time permitted. The time limit for this
quiz is 75 minutes. Failure to complete the quiz within the time frame may result
in the loss of credit for the quiz.
2. Assignment 2. Continue the analysis needed for Assignment 2. Assignment 2 is due
April 26th.

A. Capital structure
The combination of debt and equity used to finance a company's projects is referred to as
capital structure. The capital structure of a firm is some mix of debt, internally generated
equity, and new equity. But what is the right mixture? It depends on a number of factors.
The best capital structure depends on several factors. The two primary factors are interest
and financial risk. A difference in the cost of debt and equity to a company arises because
dividends paid are not deductible for tax purposes, whereas interest paid on debt is tax
deductible. Therefore, debt is a cheaper source of capital.
But unlike equity, debt is a legal commitment, with attendant legal consequences for failure
to pay what is due. If a firm finances its activities with debt, the creditors expect the amount
of the interest and principal -- fixed, legal commitments -- to be paid back as promised.
Failure to pay may result in legal actions by the creditors. Therefore, a company does not
want to take on more debt that it can handle.
Determining the best balance between the benefits of debt and the costs of debt is a
challenge for financial managers.
B. The cost of capital

The cost of capital is the firm's cost of using funds provided by creditors and shareholders. A
firm's cost of capital is the cost of its long-term sources of funds: debt, preferred equity, and
common equity. The cost of each source reflects (1) the risk of the assets the firm invests in.
(2) the hierarchy of the risk associated with its seniority over the other sources, and (3)
whether what is paid to suppliers of capital is tax deductible.
The cost of capital is what it costs for additional capital, though we often look to the past to
gauge this cost. What we want, ideally, is to estimate the cost of raising another dollar of
capital – in other words, the marginal cost of capital.
We estimate the cost of capital using what we know about taxes and returns on the different
sources of capital. For example, we estimate the cost of debt by first calculating the yield to
maturity on existing bonds and then adjusting this cost for the tax deductibility of interest.
The cost of capital is in important input in financial decision making because investment
decisions involve comparing the benefit of an investment – the return – with the cost, where
this cost reflects the cost of capital.
Module 7 Overview 3
Capital structure
OUTLINE
1. Introduction
2. Capital structure and financial leverage
3. Capital structure and taxes
4. Capital structure and financial distress
5. Assembling the pieces of theory
6. Reconciling theory with practice
7. Summary
1. Introduction
A business invests in new plant and equipment to generate additional revenues and income, which is
the basis for its future growth. The funds raised from sources, such as long-term debt and equity,
are referred to as capital, which invested in long-lived assets to generate future cash flows.
One way to pay for investments is to generate Invest in

capital from the firm's operations. Earnings capital
projects
belong to the owners and can either be paid
to them -- in the form of cash dividends -- or Reinvest in
plowed back into the firm. The owners' the company
investment in the firm is referred to as
owners' equity or, simply, equity. If Earnings
management plows earnings back into the
firm, the owners expect it to be invested in
projects that will enhance the value of the firm Interest
and, hence, enhance the value of their equity. to
Therefore, funds from reinvested earnings creditors
represent capital from equity. Dividends
to owners
But earnings may not be sufficient to support

all profitable investment opportunities. In that Exhibit 1 Flow of funds between the suppliers
case the firm is faced with a decision: forgo of capital and the company
profitable investment opportunities or raise
additional capital. A firm can raise new capital either by borrowing (i.e., incurring debt) or by selling
additional ownership interests (i.e., equity) or both.
The combination of debt and equity used to finance a company's projects is referred to as capital
structure. The capital structure of a firm is some mix of debt, internally generated equity, and new
equity. But what is the right mixture?
Capital structure, a reading prepared by Pamela Peterson Drake 1

What is the best capital structure depends on several factors. If a firm finances its activities with
debt, the creditors expect the amount of the interest and principal -- fixed, legal commitments -- to
be paid back as promised. Failure to pay may result in legal actions by the creditors.
Suppose you borrow $100 and promise to repay the $100 plus $5 in one year. Consider what may
happen when you invest the $100:
If you invest the $100 in a project that produces $120, you pay the lender the $105 you owe
and keep the $15 profit.
If your project produces $105 back, you pay the lender $105 and keep nothing.
If your project produces $100, you pay the lender $105, with $5 coming out of your personal
funds.
If you reinvest the funds and get a return more than the $5 (the cost of the funds), you keep all the
profits. But if you get a return of $5 or less, the lender still gets her or his $5 back. This is the basic
idea behind financial leverage -- the use of financing that has a fixed, but limited payments.
If the firm has abundant earnings, the creditors are paid a fixed amount and the owners reap
all what remains of the earnings after the creditors have been paid.
If earnings are too low, the creditors must be paid what they are due, leaving the owners
nothing out of earnings.
Failure to pay interest or principal as promised may result in financial distress. Financial distress is
the condition where a firm makes decisions under pressure to satisfy its legal obligations to its
creditors. These decisions may not be in the
best interests of the owners of the firm. A distressed company may enter bankruptcy,
With equity financing there is no obligation. which is a legal status that permits the restructuring
Though the firm may choose to distribute of its obligations in the expectation that the
funds to the owners in the form of cash company may be able to survive this status and
dividends there is no legal requirement to do emerge from bankruptcy as a healthy, going
so. Furthermore, interest paid on debt is concern. If a company is deemed by the bankruptcy
deductible for tax purposes, whereas courts as not able to survive as a going concern, the
dividend payments are not tax deductible. company may be liquidated.
One measure of the extent debt is used to

finance a firm is the debt ratio, the ratio of debt to equity:
Debt
Debt ratio = .
Equity
The greater the debt ratio, the greater the use of debt for financing operations vis-à-vis equity
financing. Another measure is the debt-to-assets ratio, which is the extent to which the assets of
the firm are financed with debt:
Debt
Debt-to-assets =
Assets
There is a tendency for companies in some industries to use more debt than others. We see this
looking at the capital structure for different industries in Exhibit 2, where the proportion of assets
financed with debt and equity are shown graphically for several industries.

We can make some generalizations Exhibit 2 Different capital structures for different
about differences in capital industries, 2003
structures across industries from
this figure: Debt Equity
Industry 100
Industries that are more reliant
upon research and development 0% 20% 40% 60% 80% %
for new products and Air transport
Percentage
technology -- for example, of long-term
chemical companies -- tend to Apparel
capital
have lower debt-to-asset ratios Auto & truck
than companies without such
Building materials
research and development
needs -- for example, grocery Grocery store
stores. Newspaper
Railroad
Industries that require a
relatively heavy investment in Shoe
fixed assets, such as iron and
steel foundries, tend to have
lower debt-to-asset ratios. Source: Value Line Investment Survey
Industries with more volatile

operating earnings (such as electronic computer companies) tend to finance assets more with
equity than with debt.
Exhibit 3 Capital structure within industries, using the book value Yet within each industry
of shareholders’ equity there is variation of debt
ratios. The amount of the
Debt Book value of equity book value of long-term
0% 20% 40% 60% 80% 100% debt and the book value of
equity for 2003 for
AMR Corporation individual companies in the
air transport industry are
Continental Air
graphed in Exhibit 3.
Delta Air Lines
In the case of Delta Air
JetBlue Airways Lines and Northwest
Airlines, the book value of
Midwest Air Group
shareholders’ equity is
Northwest Airlines negative. 1 We get a
different picture of the debt
Southwest Airlines burden of companies if we
use the market value of
Source: Value Line Investment Survey equity, as shown in Exhibit
4. For example, using the
book value of equity, Jet Blue has a long-term debt to equity ratio of 1.5, whereas using the market
value of equity, we see that Jet Blue has a long-term debt to equity ratio of 0.3. It is preferable to
use the market value of equity in describing a company’s financial leverage because it is a better
representation of a company’s reliance on debt.
1 Negative book equity is possible and usually results from a series of severe net losses.

Why do some industries
tend to have companies Exhibit 4 Capital structure within industries, using the market
value of shareholders’ equity, 2003
with higher debt ratios than
other industries? Why do
Debt Market value of equity
some companies choose to
have different capital 0% 20% 40% 60% 80% 100%
structures than other
companies in the same AMR Corporation
industry? By examining the
role of business risk, Continental Air
financial leveraging,
Delta Air Lines
financial distress, and
taxes, we can explain some
JetBlue Airways
of the variation in debt
ratios between industries. Midwest Air Group
And by analyzing these
factors we can explain how Northwest Airlines
the firm's value may be
affected by its capital Southwest Airlines
structure.
Source: Value Line Investment Survey
2. Capital structure and financial leverage

Debt and equity financing create different types of obligations for the firm. Debt financing obligates
the firm to pay creditors interest and principal -- usually a fixed amount -- when promised. If the
firm earns more than necessary to meet its debt payments, it can either distribute the surplus to the
owners or reinvest. Equity financing does not obligate the firm to distribute earnings. The firm may
pay dividends or repurchase stock from the owners, but there is no obligation to do so.
The fixed and limited nature of the debt obligation affects the risk of the earnings to the owners.
Consider the Sample Corporation that has $20,000 of assets, all financed with equity. There are
1,000 shares of Sample stock outstanding, valued at $20 per share. The firm's current Balance Sheet
is simple:
Sample Corporation balance sheet

Assets $20,000 Liabilities $ 0
Equity (1,000 shares) 20,000
Suppose Sample Corporation has investment opportunities requiring $10,000 of new capital. Further
suppose Sample can raise the new capital either of three ways:

Alternative A: Issue $10,000 equity (500 shares of stock at $20 per share)
Alternative B: Issue $5,000 of equity (250 shares of stock at $20 per share) and
borrow $5,000 with an annual interest of 5 percent and
Alternative C: Borrow $10,000 with an annual interest of 5 percent 2
The balance sheet representing each financing method is shown in Exhibit 5. The only difference
between the three alternative means of financing is with respect to how the assets are financed:
Exhibit 5 Financial leverage resulting from three different financing alternatives

Debt to assets
Alternative Assets Liabilities Equity Debt ratio ratio
A $30,000 $0 $30,000 0% 0%
B $30,000 $5,000 $25,000 20% 16.7%
C $30,000 $10,000 $20,000 50% 33.3%
How do we interpret these ratios? Let's look at Alternative B. The debt ratio of 20 percent tells us
that the firm finances its assets using $1 of debt for every $5 of equity. The debt-to-assets ratio tells
us that 16.7 percent of the assets are financed using debt or, putting it more clearly, almost 17c/ of
every $1 of assets is financed with debt.
Suppose Sample has $4,500 of

Exhibit 6 Income to owners for different returns on operating earnings. This means it
assets and different financing alternatives has a $4.500/$30,000 = 15 percent
return on assets (ROA = 15%).
Panel A: ROA = 15%
And suppose there are no taxes.
A B C The earnings per share (EPS) differs
Operating earnings $4,500 $4,500 $4,500 under the different alternatives, as
Less: interest expense 0 500 1,000 shown in Panel A of Exhibit 6, with
Net income $3,500 $4,000 $3,500 the higher financial leverage
$ Number of shares 1,500 1,250 1,000 alternative, Alternative C, producing
Earnings per share $3.00 $3.20 $3.50
the greatest earnings per share.
Panel B: ROA = 10%
A B C
If we are earning a return that is
Operating earnings $3,000 $3,000 $3,000 the same as the cost of debt, 10
Less: interest expense 0 500 1,000 percent, the earnings per share are
Net income $3,000 $2,500 $2,000 not affected by the choice of
$ Number of shares 1,500 1,250 1,000 financing, as shown in Panel B.
Earnings per share $2.00 $2.00 $2.00 Now suppose that the return on
Panel C: ROA = 5% assets is 5 percent. In this case,
shown in Panel C, earnings per
A B C share are the lowest for Alternative
Operating earnings $1,500 $1,500 $1,500 C.
Less: interest expense 0 500 1,000
Net income $1,500 $1,000 $500
$ Number of shares 1,500 1,250
Comparing the results of each of
1,000
Earnings per share $1.00 $0.80 the alternative financing methods
$0.50
provides information on the effects
of using debt financing. As more debt is used in the capital structure, the greater the "swing" in EPS.
2 It may be unrealistic to assume that the interest rate on the debt in Alternative C will be the same as the
interest rate for Alternative B since in Alternative C there is more credit risk. For purposes of illustrating the
point of leverage, however, let's keep the interest rate the same.

In our example, if the return on assets is 15 percent, Alternative C has the highest earnings per
share, but if the return on assets is 5 percent, Alternative C has the lowest earnings per share.
We cannot say ahead of time what next period's earnings will be. So what can we do? Well, we can
make projections of earnings under different economic climates, and make judgments regarding the
likelihood that these economic climates will occur.
When debt financing is used instead of equity (Alternative C in our example), the owners don't share
the earnings -- all they must do is pay their creditors the interest on debt. But when equity financing
is used instead of debt (Alternative A), the owners must share the increased earnings with the
additional owners, diluting their return on equity and earnings per share.
A. The leverage effect

Equity owners can reap most of the rewards through financial leverage when their firm does well.
But there is a down side they may suffer when the firm does very poorly. What happens if earnings
are down so low they are not enough to pay interest? Interest must be paid no matter how low the
earnings. Where does the money come from to pay interest when earnings are insufficient? It
comes from:
reducing the assets in some way, such as using working capital needed for operations or
selling buildings or equipment;
taking on more debt obligations; or
issuing more shares of stock.
Whichever the firm chooses, the burden ultimately falls upon the owners.
This leveraging effect is illustrated in Exhibit 7 for Sample Corporation where we have broadened the
number of possible return on asset outcomes ranging from 0 percent to a 30 percent. Alternative C
provides for the most upside potential for the equity holders, it also provides for the most downside
potential as well. Hence, Alternative A -- all equity -- offers the more conservative method of
financing operations.

The three alternatives
Exhibit 7 Sample Corporation’s earnings per share for different
have identical
levels of operating earnings and for different financing
earnings per share
alternatives
when there is a 10
percent return on
assets. Sample Alternative A: $10,000 new equity
Corporation's 10 Alternative B: $5,000 new equity and $5,000 new debt
$6
percent return on Alternative C: $10,000 new debt
assets is referred to $5
as the EPS $4
indifference point:
the return where the $3
EPS are the same Earnings
$2
under the financing per share
alternatives. $1
$0
Above a 10 percent
return on assets (that -$1
is, above operating -$2
earnings of $3,000),
-$400
$200
$800
$1,400
$2,000
$2,600
$3,200
$3,800
$4,400
$5,000
$5,600
$6,200
Alternative C offers
the most to owners.
Operating earnings
But Alternative C also
has the most
downside potential,
producing the worst
earnings to owners below this 10 percent return on assets.
B. Quantifying the leverage effect

We can see the effects of financial leverage by putting numbers to this uncertainty of possible
outcomes. Consider once again the three return-on-assets outcomes -- 5 percent, 10 percent and 15
percent -- but this time we are attaching probabilities we're guessing (somehow) that each of these
will happen. Suppose that the probability associated with each outcome is:
Economic climate Return on assets Probability
Slow 5% 20%
Normal 10% 60%
Boom 15% 20%
We can measure the risk associated with each alternative by calculating the standard deviation of the
possible earnings per share. The larger the standard deviation, the greater the uncertainty
associated with the alternative.
The calculations of the expected EPS, the standard deviation of EPS, and the coefficient of variation
are shown in Exhibit 8 for each of the three alternative financing arrangements. Though each
alternative has the same expected earnings per share, they differ in terms of the risk associated with
these expected earnings per share.

Exhibit 8 Earnings per share distribution for different alternatives
ALTERNATIVE A: $10,000 EQUITY, $0 DEBT

Deviation Deviation Probability x squared
EPS Probability EPS x probability from E(EPS) squared deviation
$1.00 20% $0.20 -$1.00 1.0000 0.2000
2.00 60% 1.20 0.00 0.0000 0.0000
3.00 20% 0.60 1.00 1.0000 0.2000
E(EPS) = $2.00 2(EPS) =0.4000

(EPS) = 0.4000 = $0.6325
ALTERNATIVE B: $5,000 EQUITY $5,000 DEBT

$0.80 20% $0.16 -$1.60 2.5600 0.5120
2.00 60% 1.20 0.00 0.0000 0.0000
3.20 20% 0.64 1.20 1.4400 0.2880
E(EPS) = $2.00 2(EPS) =0.8000
(EPS) = $0.80 = $0.8944
ALTERNATIVE C: $0 EQUITY, $10,000 DEBT

$0.50 20% $0.10 -$1.50 2.2500 0.4500
2.00 60% 1.20 0.00 0.0000 0.0000
3.50 20% 0.70 1.50 2.2500 0.4500
E(EPS) = $2.00 2(EPS) =0.9000
(EPS) = 0.9000 = $0.9487
C. Comparing risk among alternatives

In the Sample Corporation example, the expected values for alternatives are the same. However, if
we are trying to compare risk among different probability distributions that have different expected
values, we need to scale the standard deviation to make each comparable. We do this dividing the
standard deviation by the expected value, giving us a scaled down value of dispersion, referred to as
the coefficient of variation, CV: (EPS) / (EPS). The larger the coefficient of variation, the
greater the risk. See Appendix D for details on the calculation and interpretation of CV.
It happens that each alternative has the same expected EPS, but the standard deviations differ. The
all-debt financing (Alternative C) results in the highest standard deviation of EPS. This result
supports the notion that financial leverage increases the returns to owners, but also increases the
risk associated with the returns to owners.

3. Capital structure and taxes
A. What we learn from Modigliani and Miller
The value of a firm -- meaning the value of all its assets -- is equal to the sum of its liabilities and its
equity (the ownership interest). Does the way we finance the firm's assets affect the value of the
firm and hence the value of its owners' equity? It depends.
The basic framework for the analysis of capital structure and how taxes affect it was developed by
two Noble Prize winning economists, Franco Modigliani and Merton Miller. 3 Modigliani and Miller
reasoned that if the following conditions hold, the value of the firm is not affected by its capital
structure:
Condition #1: Individuals and corporations are able to borrow and lend at the same terms (referred
to as "equal access");
Condition #2: There is no tax advantage associated with debt financing (relative to equity
financing); and
Condition #3: Debt and equity trade in a market where assets that are substitutes for one another,
they trade at the same price. This is referred to as a perfect market. If assets are
traded in a perfect market, the value of assets with the same risk and return
characteristics trade for the same price.
Under the first condition, individuals can borrow and lend on the same terms as the business entities.
Therefore, if individuals are seeking a given level of risk, they can either (1) to borrow or lend on
their own or (2) invest in a business that borrows or lends. In other words, if an individual wants to
increase the risk of her investment, she could choose to invest in a company that uses debt to
finance its assets. Or, the individual could invest in a firm with no financial leverage and take out a
personal loan -- increasing her own financial leverage.
The second condition isolates the effect of financial leverage. If deducting interest from earnings is
allowed in the analysis, it would be difficult to figure out what effect financial leverage itself has on
the value of the firm. The third condition insures that assets are priced according to their risk and
return characteristics.
Under these conditions, the value of Sample Corporation is the same, no matter which of the three
financing alternatives it chooses. The total income to owners and creditors is the same. For
example, if the return on assets is expected to be 15 percent, the total income to owners and
creditors is $4,500 under each alternative:
Total income to
Income to Income of owners and
Financing owners creditors creditors
Alternative A: $10,000 equity $4,500 $ 0 $4,500
Alternative B: $5,000 equity, $5,000 debt $4,000 $ 500 $4,500
Alternative C: $10,000 debt $3,500 $1,000 $4,500
3 Franco Modigliani and Merton H. Miller. "The Cost of Capital, Corporation Finance, and the Theory of
Investment," American Economic Review, Vol. 48, No. 3 (June 1958).

Assume that the expected return on assets is 15 percent, for each period, forever. It follows that the
value of Sample can be determined using the formula for the valuation of a perpetuity, PV =CF/r.
Expressing this in terms of the value of the firm:
expected earnings per period

Value of the company = .
capitalization rate
The discount rate is referred to as the capitalization rate, which is the discount rate that translates
future earnings into a current value. The capitalization rate reflects the uncertainty associated with
the expected earnings in the future. The more uncertain the future earnings, the less a dollar of
future income is worth today and the greater the capitalization rate. But the uncertainty regarding
the earnings on the assets is not affected by how the assets are financed. How the assets are
financed affects who gets what.
Assume the appropriate discount rate for Sample Corporation's future income is 15 percent. Then:
$4,500
Value of Sample Corporation = = $30,000.
0.15
Because there are no creditors to share with in the case of all-equity financing (Alternative A), the
value of equity for Sample is the present value of earnings stream of $4,500 per period discounted at
15 percent, or $30,000. However, the value of Sample Corporation with debt financing (Alternatives
B and C), is a bit more difficult.
In the case of Alternatives B and C, Sample Corporation's owners view their future earnings streams
as more risky than in the case of no debt. Hence, the discount rate should be higher, reflecting the
debt used.
Modigliani and Miller show that the discount rate for the earnings to equity owners is higher when
there is the use of debt and the greater the debt the higher the discount rate. Specifically, they
show that the discount rate of the earnings to owners is equal to the discount rate of a firm with no
financial leverage plus the compensation for bearing risk appropriate to the amount of debt in the
capital structure.
The compensation for bearing risk, as reasoned by Modigliani and Miller, should be the risk premium
weighted by the relative use of debt in the capital structure. The risk premium is the difference
between the discount rate for the net income to owners and the discount rate on earnings to
creditors (the interest), which is assumed to be risk-free. Interest is paid to creditors no matter how
well or how poorly the firm is doing; hence, it is considered risk-free to creditors. And the greater
the use of debt, the greater the risk premium.
Let rs be the discount rate for risky earnings to owners and let rd be the discount rate for risk-free
debt earnings. The risk premium is equal to re - rd. The discount rate that should be applied to the
earnings to owners is:
debt

Capitalization rate=rs (rs rd )
equity
In the case of the Sample Corporation, the equity discount rate for the financing alternatives is
calculated by adjusting the discount rate of the earnings stream, rs = 15 percent, for risk associated
with financial leveraging. If the interest rate on debt, rd, is 10 percent,

$0

Alternative A: Capitalization rate=0.15 (0.15 0.10) 15%
$30, 000
$5, 000

Alternative B: Capitalization rate=0.15 (0.15 0.10) 16%
$25, 000
$10, 000

Alternative C: Capitalization rate=0.15 (0.15 0.10) 17.5%
$20, 000
We calculate the value of Sample Corporation equity under each alternative valuing the earnings to
owners’ stream, using the appropriate capitalization rate.
$4,500
Alternative A: Value of equity = = $30,000.
0.15
$4, 000
Alternative B: Value of equity = = $25,000.
0.16
$3,500
Alternative C: Value of equity = = $20,000.
0.175
Modigliani and Miller show that the value of the firm depends on the earnings of the firm, not on how
the firm's earnings are divided between creditors and shareholders.
Summarizing,
Alternative A Alternative B Alternative C
Value of debt $0 $5,000 $10,000
Value of equity 30,000 25,000 20,000
Value of the firm $30,000 $30,000 $30,000
An implication of the Modigliani and Miller analysis is that the use of debt financing increases the
expected future earnings to owners. But it also increases the risk of these earnings and, hence,
increases the discount rate investors use to value these future earnings. Modigliani and Miller reason
that the effect that the increased expected earnings has on the value of equity is just offset by the
increased discount rate applied to these riskier earnings.
Bottom Line: In the absence of taxes, the value of the firm - the "pie" -- is not affected by how you
slice it.
B. Interest deductibility and capital structure

The use of debt has a distinct advantage over financing with stock, thanks to Congress. The Internal
Revenue Code, written by Congress, allows deducting interest paid on debt to determine taxable
income. This deduction represents a form of a government subsidy of financing activities. By
allowing interest to be deducted from taxable income, the government is sharing the firm's cost of
debt.
To see how this subsidy works, compare three companies: Firm U (unlevered), Firm L (levered) and
Firm LL (lots of leverage). Suppose all have the same $5,000 taxable income before interest and
taxes. Firm U is financed entirely with equity, whereas Firm L is financed with $10,000 debt that

requires an annual payment of 10 percent interest. If Firm LL (Lots of Leverage) has the same
operating earnings and tax rate as Companies U and L, but uses $20,000 of debt (at the 10 percent
interest rate). If the tax rate for all companies is 30 percent, the tax payable and net-income-to-
owners are calculated as follows:
Firm U Firm L Firm LL
no debt $10,000 debt $20,000 debt
Taxable income before taxes & interest $5,000 $5,000 $5,000
Less: interest expense 0 -1,000 - 2,000
Taxable income before taxes $5,000 $4,000 $3,000
Less: taxes @ 30% -1,500 -1,200 -900
Net income to owners $3,500 $2,800 $2,100
Income to creditors $0 $1,000 $2,000

Income to owners 3,500 2,800 2,100
Income to creditors and owners $3,500 $3,800 $4,100
By financing its activities with debt, paying interest of $1,000, Firm L reduces its tax bill by $300 --
the difference between Firm U's $1,500 tax bill and Firm L's $1,200 tax bill. In the case of Firm L,
the creditors have $1,000 of income, the government receives $1,200 of income, and the owners
receive $2,800. The $300 represents money Firm L does not pay because they are allowed to deduct
the $1,000 interest. This reduction in the tax bill is a type of subsidy.
Comparing Firm LL to Firm L, we see that creditors' income (the interest expense) is $2,000 ($1,000
more than Firm L), taxes are $900 ($300 lower than Firm L's $1,200 taxes) and the net income to
owners $2,100 ($700 lower than Firm L's net income). If Firm L were to increase its debt financing
from $10,000 to $20,000, like Firm LL's, the total net income to the suppliers of capital -- the
creditors and owners -- is
increased $300, from
Exhibit 9 Distribution of income among owners, creditors, $3,800 to $4,100.
and the government for different levels of debt
financing The distribution of
incomes differs among
Firms U, L, and LL. 4 In
Owner's Income Creditors' Income Governments' Income the case of Firm U, 70
percent of the income
100%
90%
goes to owners and 30
80% percent goes to the
70% government in the form
Percentage 60%
50% of taxes. In the case of
of income 40% Firm LL, 42 percent of the
30% income goes to owners
20%
10% and 18 percent goes to
0% taxes, with the remaining
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
$16,000
$18,000
$20,000
40 percent going to
creditors.
Level of debt Extending this example to

different levels of debt
4 We are assuming, for simplicity, that the cost of debt (10 percent) remains the same for all levels of debt
financing. And this would be the case in a perfect market.

financing, as shown in Exhibit 9, a pattern emerges. The government subsidy for debt financing
grows as the level of debt financing grows. With increases in the use of debt financing, the creditors'
share of earnings increases and the owners' and the government's share decrease.
An interesting element introduced into the capital structure decision is the reduction of taxes due to
the payment of interest on debt. We refer to the benefit from interest deductibility as the interest
tax shield, since the interest expense shields income from taxation. The tax shield from interest
deductibility is:
Tax-shield =
Tax
Interest
.
rate expense
If Firm L has $10,000 of 10 percent debt and is subject to a tax of 30 percent on net income, the tax
shield is:
Tax-shield = 0.30 [$10,000 (0.10)] = 0.30 ($1,000) =$300.
A $1,000 interest expense means that $1,000 of income is not taxed at 30 percent.
Recognizing that the interest expense is the interest rate on the debt, rd, multiplied by the face value
of debt, D, the tax shield for a firm with a tax rate of 'is:
Tax-shield =
Tax
Interest rate
Face value
' r D.
rate on debt of debt . = d
How does this tax-shield affect the value of the firm? The tax shield is valuable since it reduces the
net income of the firm that goes to the government in the form of taxes.
We should specify that the tax rate is the marginal tax rate -- the tax rate on the next dollar of
income. Suppose you have a salary of $20,000 a year. And suppose the first $20,000 of income is
taxed at 20 percent and any income over that is taxed at 30 percent. If you are considering making
an investment that will generate taxable income above $20,000, what tax rate do you use in making
your decision? You use 30 percent, because any income you earn above the $20,000 will be taxed at
30 percent, not 20 percent. And since we are concerned with how interest protects income from
taxation, we need to focus on how it shields taxable income beyond the income that is shielded by all
other tax deductible expenses. Suppose you have income of $20,000 and deductible expenses other
than interest of $20,000. If you are considering borrowing, does the interest expense shield
anything? No, so the marginal tax rate is 0 percent.
If we used the average tax rate (that is, the ratio of taxes to taxable income) instead of the marginal
tax rate, we would understate the benefit from the interest deduction.

If the level of debt
Average v. marginal tax rates
financing, D, is
considered permanent
Suppose the first $10,000 of income is taxed at 20 percent, the next
(that is, when the current
$10,000 of income at 30 percent, and any income above $20,000 taxed
debt matures, new debt
at 40 percent. If you have $40,000 of taxable income, your taxes are
in the same amount is
$13,000:
issued to replace it), and
if the interest rate on the Tax on first $10,000 $ 2,000 Á 20% of $10,000
debt, rd, is considered Tax on second $10,000 3,000 Á 30% of $10,000
fixed, and if the tax rate Tax on income over $20,000 8,000 Á 40% of $20,000
on the net income is Total tax $13,000
considered to remain
and your average tax rate is $13,000/$40,000 = 32.5 percent. But
constant at ', then the
your marginal rate -- the rate on any income over $40,000 -- is 40
tax shield is expected to
percent.
be generated in each
period, forever.
Therefore, the tax shield represents a perpetual stream whose value is:
Periodic stream
Present value of a perpetual stream = .
Discount rate
The discount rate is the interest rate on the debt and the periodic stream is the tax shield each
period. The present value of the interest tax shield (PVITS is:
Tax
Interest rate
Face value
' r D
rate on debt of debt d
PVITS = = .
Interest rate
rd
on debt
Simplifying,
PVITS =
Tax
Face value
'D.
rate of debt =
This means Firm L with $10,000 of debt at an interest rate of 10 percent and a tax rate on income of
30 percent, has a $3,000 tax-shield:
PVITS = (0.30) $10,000 = $3,000.
The fact that the Internal Revenue Code allows interest on debt to reduce taxable income increases
the value of Firm L by $3,000.
Tax shields from interest deductibility are valuable: if a firm finances its assets with $50,000 of debt
and has a tax rate of 30 percent, the tax shield from debt financing (and hence the increase in the
value of the firm) is $15,000!
If the firm is expected to maintain the same amount of debt in its capital structure,
Value of Value of the firm

'D
the firm = if all equity financed +
Therefore, the value of the firm is supplemented by the tax subsidy resulting from the interest
deducted from income.

Bottom Line: Companies that use debt benefit because of the tax-deductibility of interest on debt
because, essentially, the government is subsidizing this form of financing.
C. Personal taxes and capital structure

A firm's corporate taxes and debt affects its value: the more debt it uses, the more interest is
deductible, the more income is shielded from taxes.
But personal taxes also enter into the picture. Who is going to buy this debt? Investors. But
investors face personal taxes and have to make decisions about what investments they want to buy.
And if their income from debt securities -- their interest income -- is taxed differently from their
income on equity securities -- their dividends and capital appreciation -- this may affect how much
they are willing to pay for the securities. This affects the return the firm must offer investors on debt
and equity to entice them to buy the securities.
We won't go through the mathematics of how personal taxes affect the interest rates a firm must
offer, but we can look at the major conclusions regarding personal taxes and capital structure:
If debt income (interest) and equity income (dividends and capital appreciation) are taxed at
the same rate, the interest tax shield is still 'D and increasing leverage increases the value of
the firm.
If debt income is taxed at rates higher than equity income, some of the tax advantage to
debt is offset by a tax disadvantage to debt income. Whether the tax advantage from the
deductibility of interest expenses is more than or less than the tax disadvantage of debt
income depends on: the firm's tax rate; the tax rate on debt income; and the tax rate on
equity income. But since different investors are subject to different tax rates (for example,
pension funds are not taxed), determining this is a problem.
If investors can use the tax laws effectively to reduce to zero their tax on equity income,
companies will take on debt up to the point where the tax advantage to debt is just offset by
the tax disadvantage to debt income. 5
Bottom Line: There is a benefit from using debt, though it may not be as large as 'D because of
personal taxes.
D. Unused tax shields

The value of a tax shield depends on whether or not the firm can use an interest expense deduction.
In general, if a firm has deductions that exceed income the result is a net operating loss. The firm
does not have to pay taxes in the year of the loss and may "carry" this loss to another tax year.
This loss may be applied against previous years' taxable income (with some limits). The previous
years' taxes are recalculated and a refund of taxes previously paid is requested. If there is
insufficient previous years' taxable income to apply the loss against, any unused loss is carried over
into future years (with some limits), reducing future years' taxable income. 6
5 This reasoning was developed by Merton Miller in "Debt and Taxes," [Journal of Finance, May 1977) pp. 261-
276].
6 The tax code provisions, with respect to the number of years available for net operating loss carry backs and
carryovers have changed frequently. In 2004, for example the code permits a carry back for two previous tax

Therefore, when interest expense is larger than income before interest, the tax shield is realized
immediately -- if there is sufficient prior years' taxable income. If prior years' taxable income is
insufficient (that is, less than the operating loss created by the interest deduction), the tax shield is
less valuable because the financial benefit is not received until some later tax year (if at all). In this
case, we discount the tax shield to reflect both the uncertainty of benefiting from the shield and the
time value of money.
To see how the value of an interest tax shield may become less valuable, let's suppose The Dismal
Firm has the following financial results:
The Dismal Firm

Year 1 Year 2 Year 3
Taxable income before interest $ 7,000 $ 8,000 $6,000
Interest expense 5,000 5,000 5,000
Taxable income $ 2,000 $ 3,000 $ 1,000
Tax rate 0.40 0.40 0.40
Tax paid $ 800 $ 1,200 $ 400
Suppose further that the Dismal Firm has the following result for Year 4:
Year 4
Taxable income before interest $ 1,000
Interest expense 8,000
Taxable income -$7,000
Suppose the tax code permits a carry back of two years and a carryover of fifteen years.
Unfortunate Firm can take the net operating loss of $7,000 and apply it against the taxable income of
previous years, beginning with Year 1:
The Dismal Firm
Calculation of Tax Refunds Based on Year 4 Net Operating Loss
Year 1 Year 2 Year 3
Taxable income before interest $7,000 $8,000 $6,000
Interest expense 5,000 5,000 5,000
Taxable income - original $2,000 $3,000 $1,000
Application of Year 4 loss 0 - 3,000 - 1,000
Taxable income - recalculated $ 0 $ 0 $ 0
Tax due - recalculated $ 0 $ 0 $ 0
Refund of taxes paid $ 0 $ 1,200 $ 400
By carrying back the part of the loss, the Dismal Firm has applied $4,000 of its Year 4 loss against
the previous years' taxable income: 3,000 (Year 2) + 1,000 (Year 3) and receives a tax refund of
$2,400 (=$1,200 + 400 = $1,600). There remains an unused loss of $3,000 ($7,000 - $4,000).
This loss can be applied toward future tax years' taxable income, reducing taxes in future years. But
since we don't get the benefit from the $3,000 unused loss -- the $3,000 reduction in taxes -- until
sometime in the future, the benefit is worth less than if we could use it today.
years and a carry forward for fifteen future tax years, though there are exceptions to these rules [IRC Section
172 (b)].

The Dismal Firm, with an interest deduction of $8,000, benefits from $5,000 of the deduction; $1,000
against current income and $4,000 against previous income. Therefore, the tax shield from the
$8,000 is not $3,200 (40 percent of $8,000), but rather $1,600 (40 percent of $4,000), plus the
present value of the taxes saved in future years. The present value of the taxes saved in future
years depends on:
1. the uncertainty that the Dismal Firm will Are there any Dismal companies out
generate taxable income and there?
2. the time value of money.
A number of companies had deferred tax
The Dismal Firm's tax shield from the $8,000 interest assets arising from unused tax loss
expense is less than what it could have been because carryovers as of 2005. Examples include:
we couldn't use all of it now. The bottom line of the Delta Airlines
analysis of unused tax shields is that the benefit from Priceline.com
the interest deductibility of debt depends on whether Salton
or not the firm can use the interest deductions. Titan International
Bottom Line: If a company does not generate
sufficient taxable income to use the benefit from interest deductibility, the value from using debt
financing is less than 'D and may not in fact have any benefit.
4. Capital structure and financial distress

A firm that has difficulty making payments to its creditors is in financial distress. Not all companies in
financial distress ultimately enter into the legal status of bankruptcy. However, extreme financial
distress may very well lead to bankruptcy. 7
A. Costs of financial distress

The costs related to financial distress without legal bankruptcy can take different forms. For
example, to meet creditors' demands, a firm takes on projects expected to provide a quick payback.
In doing so, the financial manager may choose a project that decreases owners' wealth or may forgo
a profitable project.
Another example of a cost of financial distress is the cost associated with lost sales. If a firm is
having financial difficulty, potential customers may shy away from its products because they may
perceive the firm unable to provide maintenance, replacement parts, and warranties. If you are
arranging your travel plans for your next vacation, do you want to buy a ticket to fly on an airline
that is in financial difficulty and may not be around much longer? Lost sales due to customer
concern represent a cost of financial distress -- an opportunity cost, something of value (sales) that
the firm would have had if it were not in financial difficulty.
Still another example of costs of financial distress is costs associated with suppliers. If there is
concern over the ability of the firm to meet its obligations to creditors, many suppliers may be
unwilling to extend trade credit or, if willing, may extend trade credit at less favorable terms. Also,
suppliers may be unwilling to enter into long-term contracts to supply goods or materials. As a firm
loses its long-term guarantees to certain goods or materials, the greater the uncertainty it will be
7 Whereas bankruptcy is often a result of financial difficulties arising from problems in paying creditors, some
bankruptcy filings are made prior to distress, when a large claim is made on assets (for example, class action
liability suit).

able to obtain these items in the future and the higher will be the costs associated with renegotiating
contracts.
B. The role of limited liability

Limited liability limits owners' liability for obligations to the amount of their original investment in
the shares of stock. Limited liability for owners of some forms of business creates a valuable right
and an interesting incentive for shareholders. This valuable right is the right to default on obligations
to creditors -- that is, the right not to pay creditors. Because the most shareholders can lose is their
investment, there is an incentive for the firm to take on very risky projects: if the projects turn out
well, they pay creditors only what is owed and keep the rest, and if the projects turn out poorly, they
pay creditors what is owed -- if there is anything left.
We can see the benefit to owners from limited liability by comparing the Unlim Company, whose
owners have unlimited liability, and the Lim Company, whose owners have limited liability. Suppose
that the two companies have the following, identical capital structure in Year 1:
Year 1
Unlim Company Lim Company
Debt $1,000 $1,000
Equity 3,000 3,000
Total value of firm’s assets $4,000 $4,000
Owners' equity is $3,000 in both cases.
If the value of the assets of both companies in Year 2 is increased to $5,000, the value of both debt
and equity is the same for both companies:
Year 2
Debt $1,000 $1,000
Equity 4,000 4,000
Total value of firm’s assets $5,000 $5,000
Now suppose the total value of both firm's assets in Year 2 drops to $500. If there are insufficient
assets to pay creditors the $1,000 owed them, the owners with unlimited liability must pay the
difference (the $500); if there are insufficient assets to pay creditors the $1,000 owed them, the
owners with limited liability do not make up the difference and the most the creditors can recover is
the $500.
Year 2
Debt $1,000 $500
Equity -500 0
Total value of firm’s assets $500 $500
In this case, the Unlim Company's owners must pay $500 to its creditors because the claim of the
creditors is greater than the assets available to satisfy their claims. The Lim Company's creditors do
not receive their full claim and since the owners are shielded by limited liability -- the creditors
cannot approach the owners to make up the difference.
We can see the role of limited liability for a wider range of asset values by comparing the creditors'
and owners' claims in Figure 13-6 for the Unlim Company (Panel a) and the Lim Company (Panel b).
The creditors make their claims at the expense of owners in the case of the Unlim Company for asset
values of less than $1,000. If the value of assets of the Unlim Company is $500, the creditors
recover the remaining $500 of their claim from the owners' personal assets (if there are any such

assets). In the case of Lim Company, however, if the assets' value is less than $1,000, the creditors
cannot recover the full $1,000 owed them -- they can't touch the personal assets of the owners! 8
The fact that owners with limited liability can lose only their initial investment -- the amount they pay
for their shares -- creates an incentive for owners to take on riskier projects than if they had
unlimited liability: they have little to lose and much to gain. Owners of the Lim Company have an
incentive to take on risky projects because they can only lose their investment in the firm. But they
can benefit substantially if the payoff on the investment is high.
For companies whose owners have limited liability, the more the assets are financed with debt, the
greater the incentive to take on risky projects, leaving creditors "holding the bag" if the projects turn
out to be unprofitable. This is a problem: there is a conflict of interest between shareholders'
interests and creditors' interests. The investment decisions are made by managers (who represent
the shareholders) and, because of limited liability, there is an incentive for managers to select riskier
projects that may harm creditors who have entrusted their funds (by lending them) to the firm.
However, creditors are aware of this and demand a higher return on debt (and hence a higher cost
to the firm). The result is that shareholders ultimately bear a higher cost of debt.
C. Bankruptcy and bankruptcy costs

When a firm is having difficulty paying its debts, there is a possibility that creditors will foreclose
(that is, demand payment) on loans, causing the firm to sell assets which could impair or cease
operations. But if some creditors force payment, this may disadvantage other creditors. So what
has developed is a way of orderly dealing with the process of the firm paying its creditors -- the
process is called bankruptcy.
Bankruptcy in the U.S. is governed by the Bankruptcy Code, created by the Bankruptcy Reform Act of
1978. A firm may be reorganized under Chapter 11 of this Code, resulting in a restructuring of its
claims, or liquidated under Chapter 7. 9
U.S. Code, Title 11 – Bankruptcy
Chapter 11
bankruptcy
Chapter 1 General provisions
provides the
Chapter 3 Case Administration
troubled firm
Chapter 5 Creditors, the debtor, and the estate
with
Chapter 7 Liquidation
protection
Chapter 9 Adjustment of debts of a municipality
from its
Chapter 11 Reorganization
creditors
Chapter 12 Adjustment of debts of a family farmer with regular annual income
while it tries
Chapter 13 Adjustment of debts of an individual with regular income
to overcome
its financial difficulties. A firm that files bankruptcy under Chapter 11 continues as a going concern
during the process of sorting out which of its creditors get paid and how much. On the other hand, a
firm that files under bankruptcy Chapter 7, under the management of a trustee, terminates its
operations, sells its assets, and distributes the proceeds to creditors and owners.
8 Lenders are aware of this dilemma and, for small businesses, often require managers (who are also
shareholders) to be personally liable for the corporation's debts. This allows lenders to avoid the problem of
limited owners' liability.
9 Public law 95-598, TITLE I, SEC 101, November 6, 1978, 92 STAT. 2549.

We can classify bankruptcy costs into direct and indirect costs. Direct costs include the legal,
administrative, and accounting costs associated with the filing for bankruptcy and the administration
of bankruptcy. These costs are estimated to be 6.2 percent of the value of the firm prior to
bankruptcy. 10 For example, the fees and expenses for attorneys representing shareholders and
creditors' committees in the Texaco bankruptcy were approximately $21 million. 11
The indirect costs of bankruptcy are more difficult to evaluate. Operating a firm while in bankruptcy
is difficult since there are often Large U.S. Bankruptcies
delays in making decisions,
creditors may not agree on the Assets
operations of the firm, and the Year of pre-
objectives of creditors may bankruptcy bankruptcy
differ from the efficient Company filing in billions
Worldcom 2002 $104
operation of the firm to
Enron 2001 $63
maximize the wealth of the Conseco 2002 $61
owners. One estimate of the Texaco, Inc. 1987 $36
indirect costs of bankruptcy, Financial Corporation of America 1998 $34
calculated by comparing actual Global Crossing Ltd. 2002 $30
and expected profits prior to UAL Corporation 2002 $25
bankruptcy, is 10.5 percent of Adelphia Communications 2002 $21
the value of the firm prior to Pacific Gas & Electric 2001 $21
12 MCorp 1989 $20
bankruptcy.
Source: Bankruptcylawfirms.com
Another indirect cost of
bankruptcy is the loss in the value of certain assets. Because many intangible assets derive their
value from the continuing operations of the firm, the disruption of operations in bankruptcy may
change the value of some companies in a manner different than other companies. For example, if
part of a firm's value is attributed to its expertise in research and development, disrupting these
activities due to reorganizing (for example, reducing investment in new products) may reduce the
value of the firm.
The extent the value of a business enterprise depends on intangibles varies among industries and
among companies, so the potential loss in value from financial distress varies as well. For example,
a drug company may experience a greater disruption in its business activities than, say, a steel
manufacturer, since much of the value of the drug company may be derived from research and
development, leading to new products.
D. Financial distress and capital structure

The relationship between financial distress and capital structure is simple: as more debt financing is
used, fixed, legal obligations increase (interest and principal payments), and the ability of the firm to
satisfy these increasing, fixed payments decreases. Therefore, as more debt financing is used, the
probability of financial distress and then bankruptcy increases.
10 The direct cost is taken from the study by Edward I. Altman ["A Further Empirical Investigation of the
Bankruptcy Cost Question," Journal of Finance, Vol. 39, No. 4 (September 1984) pp. 1067-1089], based on his
study of industrial companies.
11 Wall Street Journal, June 2, 1988, page 25.
12 The indirect cost estimate is taken from Altman, ibid. (page 1077).

For a given decrease in operating earnings, a firm that uses debt to a greater extent in its capital
structure (that is, a firm that uses more financial leverage), has a greater risk of not being able to
satisfy the debt obligations and increases the risk of earnings to owners.
Another factor to consider in assessing the probability of distress is the business risk of the firm.
Business risk is the uncertainty associated with the earnings from operations and is the uncertainty
inherent in the type of business.
Business risk is comprised of sales risk and operating risk. Sales risk is the risk associated with
sales, as a result of economic and market forces that affect the volume and prices of goods or
services sold. Operating risk is the risk associated with the operating cost structure of the business.
A cost structure is comprised of both fixed and variable costs; the greater the use of fixed costs,
relative to variable costs, the greater the operating risk. If sales were to decline, the greater use of
fixed costs in the operating cost structure results in an exaggerated affect on operating earnings.
When an airline flies between any two cities, most of its costs are the same whether there is one
passenger or one hundred passengers. Its costs are mostly fixed (fuel, pilot, gate fees, et cetera),
with very little in the way of variable costs (the cost of the meal). Therefore, an airline's operating
earnings are very sensitive to the number of tickets sold.
The effect of the mixture of fixed and variable costs on operating earnings is akin to the effect of
debt financing (financial leverage) on earnings to owners. Here it is referred to as operating
leverage; the greater the fixed costs in the operating cost structure, the greater the leveraging
affect on operating earnings for a given change in sales. The greater the business risk of the firm,
the greater the probability of financial distress.
The concern in assessing the effect of distress on the value of the firm is the present value of the
expected costs of distress. And the present value depends on the probability of financial distress:
the greater the probability of distress, the greater the expected costs of distress.
The present value of the costs of financial distress increase with the increasing relative use of debt
financing because the probability of distress increases with increased financial leverage. In other
words, as the debt ratio increases, the present value of the costs of distress increases, lessening
some of the value gained from the use of tax deductibility of interest expense.
Summarizing the factors that influence the present value of the cost of financial distress:
1. The probability of financial distress increases with increases in business risk.
2. The probability of financial distress increases with increases in financial risk.
3. Limited liability increases the incentives for owners to take on greater business risk.
4. The costs of bankruptcy increase the more the value of the firm depends on intangible
assets.
We do not know the precise manner in which the probability of distress increases as we increase the
debt-to-equity ratio. Yet, it is reasonable to think the probability of distress increases as a greater
proportion of the firm's assets are financed with debt.
5. Assembling the pieces of theory

As we increase the relative use of debt in the capital structure, we see that the value of the firm
increases as a result of the tax-shield of interest deductibility but this benefit is eventually offset by
the expected costs of financial distress. Putting together the tax shield from interest together with
the costs of financial distress we can see that there is some ratio of debt to equity that maximizes
the value of the firm. Since we do not know the precise relationship between the tax-shield and

distress costs, we cannot specify, for a given firm, what the optimal debt to equity ratio should be.
And although we have not yet considered other factors that may play a role in the determining the
value of the firm, we can say:
The benefit from the tax deductibility of interest increases as the debt to equity ratio
increases.
The present value of the cost of financial distress increases as the debt to equity ratio
increases.
This "trade-off" between the tax deductibility of interest and the cost of distress can be summarized
in terms of the value of the firm in the context of the Modigliani and Miller model:
Value of the firm Present value Present value

Value of the firm = if all equity + of the - of financial
financed interest tax-shield distress
The value of the firm is affected by taxes and the costs of financial distress. As a firm becomes more
financially levered (using more debt financing relative to equity financing), its value is increased. And
the costs associated with financial distress (both direct and indirect costs) reduce the value of the
firm as financial leverage is increased. Hence, the trade-off between the tax deductibility of interest
and the costs of financial distress.
These considerations help to explain the choice between debt and equity in a firm's capital structure.
As more debt is used in the capital structure, the benefit from taxes increases the firm's value, while
the detriment from financial distress decreases its value. This trade-off is illustrated in the three
graphs in Exhibit 8.
Case 1: The value of the firm versus the debt ratio, with no interest tax deductibility and no costs to
financial distress.
Case 2: The value of the firm versus the debt ratio, with the tax deductibility of interest, but with no
costs to financial distress.
Case 3: The value of the firm versus the debt ratio, with the tax deductibility of interest and with
costs to financial distress.

Case 3 is the most
Exhibit 9 Demonstration of the role of taxes and distress in the value of
the firm comprehensive and
realistic case. At
moderate levels of
Case 1: no interest tax deductibility and no costs to financial distress financial leverage
Case 2: with the tax deductibility of interest, but with no costs to financial distress (low debt ratios),
Case3:with the tax deductibility of interest and with costs to financial distress
the value
contributed by tax
shields more than
offsets the costs
associated with
financial distress.
Value of the firm However, at some
debt ratio the
detriment from
financial distress
may outweigh the
Proportion of debt in the capital structure benefit from
corporate taxes,
reducing the value
of the firm as more debt is used. Hence, the value of the firm increases as more debt is taken on, up
to some point, and then decreases.
At that point, the value of the firm begins to diminish as the probability of financial distress increases,
such that the present value of the costs of distress outweigh the benefit from interest deductibility.
The mix of debt and equity that maximizes the value of the firm is referred to as the optimal
capital structure. This is the point where the benefit from taxes exactly offsets the detriment from
financial distress. The optimal capital structure is that mix of debt and equity that produces the
highest value of the firm.
At first glance, the value enhancement from tax shields appears simple to calculate: multiply the
corporate tax rate times the face value of debt. However, it is not that simple, for many reasons.
The use of the 'D for valuation assumes:
1. A constant marginal corporate tax rate;
2. Refinancing debt at current interest rates; and
3. The firm will earn sufficient taxable income (before interest payments) to be able to use the
interest deduction.
Marginal corporate tax rates change frequently, at the discretion of Congress. Interest rates change
through time and it is very unlikely that refinancing in, say, twenty years will be at current interest
rates. Further, you cannot always predict that a company will generate future income that will be
sufficient to cover the interest expenses.
And the expected costs of financial distress are difficult to calculate. You cannot simply look at a firm
and figure out the probability of distress for different levels of financial leverage. The probability of
distress at different levels of debt financing may differ among companies, dependent upon their
business risk. The costs of distress are also difficult to measure. These costs will differ from firm to
firm, depending on the type of asset (that is, intangibles versus tangibles) and the nature of the
firm's supplier and customer relationships.

6. Reconciling theory with practice
So what good is this analysis of the trade-off between the value of the interest tax-shields and the
costs of distress if we cannot apply it to a specific firm? Whereas we cannot specify a firm's optimal
capital structure, we do know the factors that affect the optimum. The bottom line? There is a
benefit from taxes but, eventually, this benefit may be reduced by costs of financial distress.
A. Capital structures among different industries

The analysis of the capital structure trade-off leaves us with several financial characteristics of
companies that affect the choice of capital structure:
The greater the marginal tax rate, the greater the benefit from the interest deductibility and,
hence, the more likely a firm is to use debt in its capital structure.
The greater the business risk of a firm, the greater the present value of financial distress
and, therefore, the less likely the firm is to use debt in its capital structure.
The greater extent that the value of the firm depends on intangible assets, the less likely it is
to use debt in its capital structure.
It is reasonable to expect these financial characteristics to differ among industries, but be similar
within an industry. The marginal tax rate should be consistent within an industry because:
the marginal tax rates are the same for all profitable companies;
the tax law provides specific tax deductions and credits (for example, depreciation
allowances and research and development credits) creates some differences across
industries, but generally apply to all companies within an industry since the asset structure
and the nature of investment is consistent within an industry; and
the companies in an industry are subject to the same economic and market forces that may
cause tax shields to be unusable. Therefore, it is reasonable to assume that capital
structures be similar within industry groups.
B. Capital structures within industries

The capital structures among companies within industries differ for several possible reasons. First,
within an industry there may not be a homogeneous group of companies. For example, Walt Disney
Company, Caesars World, and Bowl America are all considered members of the amusement industry,
but they have quite different types of business risk. The problem of industry groupings is
exasperated by the fact that many companies operated in many different lines of business.
Adding to the difficulty in comparing Companies is the recent Financial Standards Accounting Board
(FASB) requirement that Companies consolidate the accounting data of majority-owned subsidiaries.
The capital structure of the automobile manufacturers (for example, General Motors and Ford Motor
Company) look quite different when the financing subsidiaries and included in the calculation of their
debt ratios.
Another reason an industry may appear to comprise Companies having different capital structures is
the way the debt ratio is calculated. It makes a difference if we are using the book value of equity or
the market value of equity in our comparison with the amount of debt that a firm carries. The book

value of equity, also referred to as stockholders' equity, is the amount of stockholders' equity
reported in the balance sheet. The book value of equity is the sum of the capital stock, paid-in
capital, and retained earnings accounts -- which all reflect historical values, not current values. The
market value of equity is the value of owners' equity in the financial marketplace. We calculate it
by multiplying the market price per share of stock times the number of shares outstanding.
C. Trade-off theory and observed capital structures

The trade-off theories can explain some of the capital structure variations that we observe.
Companies whose value depends to a greater extent on intangibles, such as in the semiconductor
and drug industries, tend to have lower debt ratios. Companies in more volatile product markets,
such as the electronics and telecommunications industries, tend to have lower debt ratios.
However, the trade-off theories cannot explain all observed capital structure behavior. We observe
several profitable companies in the drug manufacturing industry that have no long-term debt
(American Home products, Forest Laboratories, and Marion Laboratories). Though these companies
do have a large investment in intangibles, they choose not to take on any debt at all. By taking on
some debt, they can enhance the value of their companies. Yet they choose not to do so.
We also see companies that have high business risk and high debt ratios. Companies in the air
transportation industry experience a volatile product market, with a high degree of operating
leverage. Companies in this industry must invest heavily in jets, airport gates, and reservations
systems, and have a history of difficulty with labor. However, these companies also have high debt
ratios. One possible explanation for airlines taking on a great deal of financial leverage on top of their
already high operating leverage is that their assets, such as jets and gates, can be sold quickly,
offsetting the effects of their greater volatility in operating earnings. Whereas the high business risk
increases the probability of financial distress, the liquidity of their assets reduces the probability of
distress. But hindsight tells us more about the airline industry. The overcapacity of the industry just
prior to the recession of 1989-91 meant that there wasn't much of a market for used jets and planes.
The airlines suffered during this economic recession: of the fourteen companies in existence just
prior to 1989, four companies entered bankruptcy (Continental, Pan Am, Midway, and America
West), and two were liquidated (Eastern Airlines and Braniff).
D. Factors important in selecting a capital structure

The analysis of the trade-off and pecking order explanations of capital structure suggests that there
is no satisfactory explanation of capital structure. What we learn from examining these possible
explanations is that there are several factors to consider in making the capital structure decision:
Taxes The tax deductibility of taxes makes debt financing attractive. However, the
benefit from debt financing is reduced if the firm cannot use the tax shields.
Risk Since financial distress is costly, even without legal bankruptcy, the likelihood
of financial distress depends on the business risk of the firm, in addition to any
risk from financial leverage.
Type of assets The cost of financial distress is likely to be more for companies whose value
depends on intangible assets and growth opportunities.
The financial manager's task is to assess the business risk of the firm, predicting the usability of tax
deductions in the future, evaluating how asset values are affected in the event of distress, and
estimating the relative issuance costs of the alternative sources of capital. In the context of all these

considerations, the financial manager can observe other companies in similar situations, using their
decisions and consequences as a guide.
7. Summary
Financial leverage is the use of fixed cost sources of funds. The effect of using financial leverage is
to increase both the expected returns and the risk to owners. Taxes provide an incentive to take on
debt, since interest paid on debt is a deductible expense for tax purposes, shielding income from
taxation. But the possibility of incurring direct and indirect costs of financial distress discourages
taking on high levels of debt.
Taxes and financial distress costs result in a trade-off. For low debt ratios, the benefit of taxes more
than overcomes the present value of costs of distress, resulting in increases in the value of the firm
for increasing debt ratios. But beyond some debt ratio, the benefit of taxes is overcome by the costs
of financial distress; the value of the firm decreases as debt is increased beyond this point.
An explanation for the capital structures that we observe is that companies prefer to raise capital
internally, but will raise capital externally according to a pecking order from safe to riskier securities.
Though we cannot figure out the best capital structure for a firm, we know what factors to consider
in the capital structure decision: taxes, business risk, asset type, issuance costs, and investor
interpretations of security issuance announcements.

The cost of capital
OUTLINE
1. Introduction......................................................................................................................... 1
2. Determining the proportions of each source of capital that will be raised................................... 3
3. Estimating the marginal cost of each source of capital ............................................................. 3
A. The cost of debt ................................................................................................................... 3
B. The cost of preferred equity .................................................................................................. 4
C. The cost of common equity ................................................................................................... 5
4. Calculating the weighted average cost of capital ..................................................................... 8
5. Reality check ....................................................................................................................... 9
6. Summary........................................................................................................................... 10
1. Introduction
The cost of capital is the company's cost of using funds provided by creditors and shareholders. A
company's cost of capital is the cost of its long-term sources of funds: debt, preferred equity, and
common equity. And the cost of each source reflects the risk of the assets the company invests in. A
company that invests in assets having little risk in producing income will be able to bear lower costs of
capital than a company that invests in assets having a higher risk of producing income. For example, a
discount retail store has much less risk than an oil drilling company. Moreover, the cost of each source of
funds reflects the hierarchy of the risk associated with its seniority over the other sources. For a given
company, the cost of funds raised through debt is less than the cost of funds from preferred stock that,
in turn, is less than the cost of funds from common stock. Why? Because creditors have a senior claim
over assets and income relative to preferred shareholders, who have seniority over common
shareholders.
The Cost of Capital, a reading prepared by Pamela Peterson Drake 1

If there are difficulties in meeting
obligations, the creditors receive their Exhibit 1 Case in point: The satisfaction of claims in the
promised interest and principal before Eastern Airlines’ bankruptcy and liquidation
the preferred shareholders who, in
In millions
turn, receive their promised dividends Claim
before the common shareholders. If Claim type amount Payout
the company is liquidated, the funds Secured debt with sufficient collateral $747.1 $747.1
from the sale of its assets are Secured debt with insufficient $453.7 $234.2
distributed first to debt-holders, then collateral
to preferred shareholders, and then to Accrued interest on secured debt $308.2 $174.4
common shareholders (if any funds Unsecured debt $1,575.0 $175.8
are left). An example of the Preferred stock 350.8 $0.0
Common stock $820.0 $0.0
possibility of insufficient funds to pay
claimants is the case of Eastern Source: Lawrence A. Weiss and Karen H. Wruck, “Information problems,
airlines, which declared bankruptcy in conflicts of interest, and asset stripping: Chapter 11’s failure in the case of
Eastern Airlines,” Journal of Financial Economics, Vol. 48, 1998, p 86.
1991, is shown in Exhibit 1. Eastern
Airlines’ secured creditors had
collateral (i.e., security) sufficient to pay their claims; all other claimants did not receive their full claim
on the assets of the company because there simply were insufficient funds available at the time the
company liquidated.
For a given company, debt is less risky than preferred stock, which is less risky than common stock.
Therefore, preferred shareholders require a greater return than the creditors and common shareholders
require a greater return than preferred shareholders.
Estiamting the cost of capital requires us to first determine the cost of each source of capital we expect
the company to use, along with the relative amounts of each source of capital we expect the company to
raise. Then we can determine the marginal cost of raising additional capital. We can do this in three
steps, as shown in Exhibit 1.
We look at each step in this reading. We first discuss how Exhibit 1: The cost of capital
to determine the proportion of each source of capital to estimation process
be used in our calculations. Then we calculate the cost of
Step 1
each source. The proportions of each source must be Determine the proportions of each source
determined before calculating the cost of each source of capital that will be raised
since the proportions may affect the costs of the sources
of capital. We then put together the cost and
proportions of each source to calculate the company's Step 2
Estimate the marginal cost of
marginal cost of capital. We also demonstrate the
each source of capital
calculations of the marginal cost of capital for an actual
company, showing just how much judgment and how
many assumptions go into calculating the cost of capital. Step 3
That is, we show that it's an estimate. Calculate the
weighted average cost of capital
The cost of capital for a company is the cost of raising an
additional dollar of capital; therefore this cost is the company’s marginal cost capital. Suppose that a
company raises capital in the following proportions: debt 40 percent, preferred stock 10 percent, and
common stock 50 percent. This means an additional dollar of capital is comprised of 40¢ of debt, 10¢ of
preferred stock, and 50¢ of common stock.

2. Determining the proportions of each source of capital
that will be raised
Our goal as financial managers is to estimate the optimum proportions for our company to issue new
capital -- not just in the next period, but well beyond. If we assume that the company maintains the
same capital structure -- the mix of debt, preferred stock, and common stock -- throughout time, our task
is simple. We just figure out the proportions of capital the company has at present. If we look at the
company's balance sheet, we can calculate the book value of its debt, its preferred stock, and its
common stock. With these three book values, we can calculate the proportion of debt, preferred stock,
and common stock that the company has presently. We could even look at these proportions over time to
get a better idea of the typical mix of debt, preferred stock and common stock.
But are book values going to tell us what we want to know? Probably not. What we are trying to
determine is the mix of capital that the company considers appropriate. It is reasonable to assume that
the financial manager recognizes that the book values of capital are historical measures and looks instead
at the market values of capital. Therefore, we must obtain the market value of debt, preferred stock, and
common stock.
If the securities represented in a company's capital are publicly-traded -- that is, listed on exchanges or
traded in the over-the-counter market -- we can obtain market values. If some capital is privately placed,
such as an entire debt issue that was bought by an insurance company or not actively traded, our job is
tougher but not impossible. For example, if we know the interest, maturity value, and maturity of a bond
that is not traded and the yield on similar risk bonds, we can get a rough estimate of the market value of
that bond even though it is not traded.
Once we determine the market value of debt, preferred stock, and common stock, we calculate the sum
of the market values of each, and then figure out what proportion of this sum each source of capital
represents. But the mix of debt, preferred stock, and common stock that a company has now may not be
the mix it intends to use in the future. So while we may use the present capital structure as an
approximation of the future, we really are interested in the company's analysis and resulting decision
regarding its capital structure in the future.
3. Estimating the marginal cost of each source of capital

A. The cost of debt
The cost of debt is the cost associated with raising one more dollar by issuing debt. Suppose you
borrow one dollar and promise to repay it in one year, plus pay $0.10 to compensate the lender for the
use of her money. Since Congress allows you to deduct from you income the interest you paid, how
much does this dollar of debt really cost you? It depends on your marginal tax rate -- the tax rate on
your next dollar of taxable income. Why the marginal tax rate? Because we are interested in seeing how
the interest deduction changes your tax bill. We compare taxes with and without the interest deduction
to demonstrate this.

Suppose that before considering interest expense you have $2 of taxable income subject to a tax rate of
40 percent. Your taxes are $0.80. Now suppose your interest expense reduces your taxable income by
$0.10, reducing your taxes from $2.00 x 40 percent = $0.80 to $1.90 x 40 percent = $0.76. By deducting
the $0.10 interest expense, you have reduced your tax bill by $0.04. You pay out the $0.10 and get a
benefit of $0.04. In effect, the cost of your debt is not $0.10, but $0.06 -- $0.04 is the government's
subsidy of your debt financing. We can generalize this benefit from the tax deductibility of interest. Let rd
represent the cost of debt per year before considering the
tax deductibility of interest, r*d represent the cost of debt Example 1: The cost of debt
after considering tax deductibility of interest, and t be the Problem
marginal tax rate. The effective cost of debt for a year is:
Suppose the Plum Computer Company can issue
debt with a yield of 6 percent. If Plum's marginal
rd* = rd (1 - t) tax rate is 40 percent, what is its cost of debt?
Solution
$0.10
Using our example, rd = = 10 percent and t = 40 rd = 0.06 (1 0.40) = 0.0360 or 3.6 percent
$1.00
percent and the effective cost of debt is:
rd* = 0.10 (1 - 0.40) = 0.06 or 6 percent per year.
Creditors receive 10 percent, but it

only costs the company 6 percent. Example 2: Cost of debt
In our example, the required rate of Problem

return is easy to figure out: we Suppose the ABC Company can issue bonds with a face value of
borrow $1, repay $1.10, so your $1,000, a coupon rate of 5 percent (paid semi-annually), and 10 years
lender's required rate of return of 10 to maturity at $980 per bond. If the ABC Company’s marginal tax rate
percent per year. But your cost of is 30 percent, what is its cost of debt?
debt capital is 6 percent per year, less Solution
than the required rate of return,
Given: FV = $1,000; PV = $980; N = 20; PMT = $25
thanks to Congress. Most debt
financing is not as straight-forward, rd = 2.6299% x 2 = 5.2598%
requiring us to figure out the yield on r *
= 5.2598% (1 - 0.30) = 3.6819%
the debt -- the lender's required rate d
of return -- given information about

interest payments and maturity value.
B. The cost of preferred equity

The cost of preferred equity is the cost associated
with raising one more dollar of capital by issuing shares Example 3: The cost of preferred equity
of preferred stock. Preferred stock is a perpetual security
-- it never matures. Consider the typical preferred stock Problem
with a fixed dividend rate, where the dividend is Suppose the XYZ Company is advised that if it
expressed as a percentage of the par value of a share. issues preferred stock with a fixed dividend of
The value of preferred equity is the present value of all $4 a share, it will be able to sell these shares
future dividends to be received by the investor. If a at $50 per share. What is the cost of
share of preferred stock has a 5 percent dividend (based preferred stock to XYZ?
on a $100 par value) paid at the end of each year, the Solution
value of the stock today is the present value of the
stream of $5's forever: rp = $4/$50 = 8%
Value of preferred equity = P = $5 / cost of preferred stock

If the cost of preferred equity is 10 percent, the price a share of stock is worth $5/0.10 = $50. Therefore,
Dividend D
Cost of preferred equity = rp = =
Price per share P0
Because dividends paid on preferred stock are not deductible as an expense for the issuer's tax purposes,
the cost of preferred stock is not adjusted for taxes -- dividends paid on this stock are paid out of after-
tax dollars.
C. The cost of common equity

The cost of common equity is the cost of raising one more dollar of common equity capital, either
internally -- from earnings retained in the company -- or externally -- by issuing new shares of common
stock. There are costs associated with both internally and externally generated capital.
How does internally generated capital have a cost? As a company generates funds, some portion is used
to pay off creditors and preferred shareholders. The remaining funds are owned by the common
shareholders. The company may either retain these funds (investing in assets) or pay them out to the
shareholders in the form of cash dividends. Shareholders will require their company to use retained
earnings to generate a return that is at least as large as the return they could have generated for
themselves if they had received as dividends the amount of funds represented in the retained earnings.
Retained funds are not a free source of capital. There is a cost. The cost of internal equity funds (i.e.,
retained earnings) is the opportunity cost of funds of the company's shareholders. This opportunity cost
is what shareholders could earn on these funds for the same level of risk. The only difference between
the costs of internally and externally generated funds is the cost of issuing new common stock. The cost
of internally generated funds is the opportunity cost of those funds -- what shareholders could have
earned on these funds. But the cost of externally generated funds (that is, funds from selling new shares
of stock) includes both the sum of the opportunity cost and cost of issuing the new stock.
The cost of issuing common stock is difficult to estimate because of the nature of the cash flow streams
to common shareholders. Common shareholders receive their return (on their investment in the stock) in
the form of dividends and the change in the price of the shares they own. The dividend stream is not
fixed, as in the case of preferred stock. How often and how much is paid as dividends is at the discretion
of the board of directors. Therefore, this stream is unknown so it is difficult to determine its value.
The change in the price of shares is also difficult to estimate; the price of the stock at any future point in
time is influenced by investors' expectations of cash flows farther into the future beyond that point.
Nevertheless, there are two methods commonly used to estimate the cost of common stock: the
dividend valuation model and the capital asset pricing model. Each method relies on different
assumptions regarding the cost of equity; each produces different estimates of the cost of common
equity.
Cost of common equity using the dividend valuation model

The dividend valuation model (DVM) states that the price of a share of stock is the present value of
all its future cash dividends, where the future dividends are discounted at the required rate of return on
equity, r. If these dividends are constant forever (similar to the dividends of preferred stock, we just
covered), the cost of common stock is derived from the value of a perpetuity. However, common stock
dividends do not usually remain constant. It's typical for dividends to grow at a constant rate. Using the
dividend valuation model,
P0 = D1 (re - g)

where D1 is next period's dividends, g is the growth rate of dividends per year, and P is the current stock
price per share. Rearranging this equation to solve instead for re,
D1
re = +g
P0
we see that the cost of common equity is the sum of next period's dividend yield, D1/P, plus the growth
rate of dividends:
Cost of common equity = Dividend yield + Growth rate of dividends
Consider a company expected to pay a constant dividend of $2 per share per year, forever. If the
company issues stock at $20 a share, the company's cost of common stock is:
re = $2/$20 = 0.10 or 10 percent per year.
But, if dividends are expected to be $2 in the next period and grow at a rate of 3 percent per year, and
the required rate of return is 10 percent per year, the expected price per share (with D1 = $2 and g = 3
percent) is:
P = $20 / (0.10 - 0.03) = $28.57.
The DVM makes some sense regarding the relation between the cost of equity and the dividend
payments: The greater the current dividend yield, the greater the cost of equity and the greater the
growth in dividends, the greater the cost of equity. However, the DVM has some drawbacks:
How do you deal with dividends that
Example 4: The cost of equity using the DVM
do not grow at a constant rate? This
model does not accommodate non- Problem
constant growth easily.
Consider the Plum Computer Company that currently
What if the company does not pay
pays an annual dividend of $2.00 per share. Plum's
dividends now? In that case, D1
common stock has a current market value of $25 per
would be zero and the expected price
share. If Plum's annual dividends are expected to grow
would be zero. But a zero price for
at 5 percent per year, what is its cost of common stock?
stock does not make any sense! And
if dividends are expected in the
Solution
future, but there are no current
dividends, what do you do?
Given: P = $25; D0 = $2.00; g = 5%
What if the growth rate of dividends
is greater than the required rate of D1 = D0 (1 + g) = $2.00 (1 + 0.05) = $2.10
return? This implies a negative stock
re = ( D1/P ) + g = 0.084 + 0.05 = 0.134 or 13.4%
price, which isn't possible.
What if the stock price is not readily
available, say in the case of a privately-held company? This would require an estimate of the
share price.
Therefore, the DVM may be appropriate to use to determine the cost of equity for companies with stable
dividend policies, but it may not applicable for all companies.
Cost of common equity using the capital asset pricing model

The investor's required rate of return is compensation for both the time value of money and risk. To
figure out how much compensation there should be for risk, we first have to understand what risk we are
talking about. The capital asset pricing model (CAPM) assumes an investor holds a diversified
portfolio -- a collection of investments whose returns are not in synch with one another. The returns on
the assets in a diversified portfolio do not move in the same direction at the same time by the same
amount. The result is that the only risk left in the portfolio is the risk related to movements in the market
as a whole (i.e., market risk).
If investors hold diversified portfolios, the only risk they have is market risk. Investors are risk averse,
meaning they don't like risk, so if they are going to take on risk they want to be compensated for it.
Investors who only bear market risk need only be compensated for market risk. If we assume all
shareholders' hold diversified portfolios, the risk that is relevant in the valuing a particular investment is
the market risk of that investment. It is this market risk that determines the investment's price. The
greater the market risk, the greater the compensation -- meaning a higher yield -- for bearing this risk.
And the greater the yield, the lower the present value of the asset because expected future cash flows
are discounted at a higher rate that reflects the higher risk.
The cost of common equity, estimated using the CAPM, is the sum of the investor's compensation for the
time value of money and the investor's compensation for the market risk of the stock:
Compensation for the Compensation for

Cost of common equity =
time value of money market risk
Let's represent the compensation for the time value of money as the expected risk-free rate of interest,
rf. If a particular common stock has market risk that is the same as the risk of the market as a whole,
then the compensation for that stock's market risk is the market risk premium. The market's risk
premium is the difference between the expected return on the market, rm, and the expected risk-free
rate, rf:
re = rf + (rm - rf)
where rf is the expected risk free rate of interest, Example 5: The cost of equity using the CAPM
is a measure of the company's stock return to
changes in the market's return (beta), and rm is the Problem
expected return on the market. The Plum Computer Company's common stock has an
estimated beta of 1.5. If the expected riskfree rate of
The CAPM is based on two ideas that make sense: interest is 3 percent and the expected return on the
investors are risk averse and they hold diversified market is 9 percent, what is the cost of common stock
portfolios. But the CAPM is not without its for Plum Computer Company?
drawbacks. First, the estimates rely heavily on
Solution
historical values -- returns on the stock and returns
on the market. These historical values may not be Given: rf = 3%; rm = 9%; = 1.5
representative of the future, which is what we are re = rf + (rm rf)
trying to gauge. Also, the sensitivity of a company's
stock returns may change over time; for example, re = 3% + 1.5 (9% 3%) = 12%
when the company changes its capital structure.
Second, if the company's stock is not publicly-traded, there is no source for even historical values.

4. Calculating the weighted average cost of capital
The cost of capital is the average of the cost of each source, weighted by its proportion of the total
capital it represents. Hence, it is also referred to as the weighted average cost of capital (WACC) or
the weighted cost of capital (WCC). The weighted average cost of capital is:
WACC = wdr d* + wprp + were
where
wd is the proportion of debt in the capital structure;

wp is the proportion of preferred stock in the capital structure; and
we is the proportion of common stock in the capital structure.
As you raise more and more money, the cost of each additional dollar of new capital may increase. This
may be due to a couple of factors: the flotation costs and the demand for the security representing the
capital to be raised.
As you raise more and more money, the cost of

each additional dollar of new capital may increase. Example 6: Calculating the WACC
This may be due to a couple of factors: the Problem
flotation costs and the demand for the security
Consider the Plum Computer Company once again.
representing the capital to be raised. For example, Suppose Plum will raise capital in the following
the cost of internal funds from retained earnings proportions: Debt: 40 percent; Preferred stock: 10
will differ from the cost of funds from issuing percent; Common stock: 50 percent. What is Plum's
common stock due to flotation costs. If a weighted average cost of capital if its cost of debt is 3.6
company expects to generate $1,000,000 entirely percent, its cost of preferred stock is 8 percent, and its
from what's available in internal funds -- retained cost of common stock is 12 percent?
earnings -- there are no flotation costs. But if the Solution
company needs $1,000,001, that $1 above
$1,000,000 will have to be raised externally, WACC = 0.40 (0.036) + 0.10 (0.08) + 0.50 (0.12)
requiring flotation costs. WACC = 0.0144 + 0.008 + 0.06
Additional capital may be more costly since the WACC = 0.0824 or 8.24%
company must offer higher yields to entice
investors to purchase ever larger issues of securities. Considering the effects of flotation costs and the
additional yield necessary to entice investors, we most likely face a schedule of marginal costs of debt
capital and a schedule of marginal costs of equity capital. Hence, we need to determine at what level of
raising funds the marginal cost of capital for the company changes.

Exhibit 2 Return on capital v. cost of capital
Let's see what maximizing shareholder
wealth means in terms of making
25% investment and financing decisions. To
IRR MCC maximize owners’ wealth we must invest
20% in a project until the marginal cost of
capital is equal to its marginal benefit.
Return or15% What is the benefit from an investment? It
cost of is the internal rate of return -- also known
capital 10% as the marginal efficiency of capital. If we
begin by investing in the best projects
5% (those with highest returns), and then
proceed by investing in the next best
projects, and so on, the marginal benefit
0%
from investing in more and more projects
$10 $20 $30 $40 $50 $60
declines.
Additional capital
Also, as we keep on raising funds and
investing them, the marginal cost of funds
increases. To maximize shareholders' wealth, we should invest in projects to the point where the
increasing marginal cost of funds is equal to the marginal benefit from our investment. Relation between
the marginal cost of capital (MCC) and the marginal return on investment (IRR) is shown in
Exhibit 2. The point at which the marginal cost and marginal benefit intersect is the optimal capital
budget. This is the point at which the value of the company is maximized.
5. Reality check
Determining the cost of capital appears straight-forward: find the cost of each source of capital and
weight it by the proportion it will represent in the company's new capital. But it is not so simple. There
are many problems in determining the cost of capital for an individual company.
Consider, for example,
How do you know what it will cost to raise an additional dollar of new debt? You may seek the
advice of an investment banker. You may look at recent offerings of debt with similar risk as
yours. But until you issue your debt, you will not know for sure.
The cost of preferred equity looks easy. But how do you know, for a given dividend rate, what
the price of the preferred stock will be? Again, you can seek advice or look at similar risk issues.
But until you issue your preferred stock, you will not know for sure.
The cost of common equity is more perplexing. There are problems associated with both the
DVM and the CAPM.
In the case of the DVM: what if dividends are not constant? What if there are no current
dividends? And the expected growth rate of dividends is merely an estimate of the future.
In the case of the CAPM, what is the expected risk-free rate of interest into the future? What is
the expected return on the market into the future? What is the expected sensitivity of a
particular's asset's returns to that of the market's return? To answer many of these questions, we
may derive estimates from looking at historical data. But this can be hazardous.
Estimating the cost of capital requires a good deal of judgment. It requires an understanding of the
current risk and return associated with the company and its securities, as well as of the company's and
securities' risk and return in the future.
If you are able to derive estimates of the costs of each of the sources of capital, you then need to
determine the proportions in which the company will raise capital. If your company is content with its

current capital structure and you expect to raise capital according to the proportions already in place,
your job is simpler. In this case, the proportions can be determined by estimating the market value of
existing capital and calculating the weights.
On the other hand, if your company raises capital in proportions other than its current capital structure,
there is a problem of estimating how this change in capital structure affects the costs of the components.
Consider a company that has a current capital structure, in
market value terms, of 50 percent debt and 50 percent Exhibit 3: Costs of capital for different
industries, 2005
common stock. What happens to the market value of each
component if the company undergoes a large expansion and Industry Cost of
raises new funds solely from debt? This increase in debt may capital
increase the cost of debt and the cost of common stock. Advertising 9.03%
This will occur if this additional debt is viewed as Air Transport 8.40%
significantly increasing the financial risk of the company -- Beverage 5.83%
Biotechnology 10.28%
the chance that the company may encounter financial
E-commerce 18.14%
problems -- thereby increasing the cost of capital. But this Internet 16.65%
increase in the use of debt may also decrease the cost of Petroleum 6.64%
capital. This could result because the company will be using Retail store 8.16%
more of the lower cost capital -- debt. Trucking 6.84%
Wireless networking 13.58%
Whether the cost of financial risk outweighs the benefit from
the tax deductibility of interest is not clear -- and cannot be Source: Aswath Damadoran,
http://pages.stern.nyu.edu/~adamodar/
reasonably forecasted.
Estimates of the cost of capital require a great deal of information on individual companies, as well as
forecasts of the return on a risk-free asset and on the market. Estimates of costs of capital for several
different industries for 2005 are shown in Exhibit 3. As you can see, these costs of capital reflect the
business and financial risk of companies; for example, the wireless networking industry has a great deal
of business risk and companies in this industry experience higher costs of capital.
6. Summary
The cost of capital is the marginal cost of raising additional funds. This cost is important in our
investment decision making because we ultimately want to compare the cost of funds with the benefits
from investing these funds. The cost of capital is determined in three steps: (1) determine what
proportions of each source of capital we intend to use; (2) calculate the cost of each source of capital,
and (3) put the cost and the proportions together to determine the weighted average cost of capital.
The required rate of return on debt is the yield demanded by investors to compensate them for the time
value of money and the risk they bear in lending their money. The cost of debt to the company differs
from this required rate of return due to flotation costs and the tax benefit from the deductibility of
interest expense. The required rate of return on preferred stock is the yield demanded by investors and
differs from the company's cost of preferred equity because of the costs of issuing additional shares (the
flotation costs).
The cost pf common equity is more difficult to estimate than the cost of debt or preferred stock because
of the nature of the return on stock: Dividends are not guaranteed nor fixed in amount, and part of the
return is from the change in the value of the stock. The dividend valuation model and the capital asset
pricing model are two methods commonly used to estimate the required rate of return on common
equity. The DVM deals with the expected dividend yield and is based on an assumption that dividends
grow at some constant rate into the future. The CAPM assumes that investors hold diversified portfolios,
so they require compensation for the time value of money and the market risk they bear by owning the
stock.

The proportion of each source of capital that we use in calculating the cost of capital is based on what
proportions we expect the company to raise new capital. If the company already has a capital structure --
a mix of debt and equity it feels appropriate -- then that same proportion of each source of capital, in
market value terms, is a good estimate of the proportions of new capital.
The cost of capital is the cost of raising new capital. The weighted average cost of capital is the cost of all
new capital for a given level of financing. The cost of capital is a marginal cost -- the cost of an additional
dollar of new capital at a given level of financing.
In determining the optimal amount to spend on investments, the relevant cost is the marginal cost, since
we are interested in investing until the marginal cost of the funds is equal to the marginal benefit from
our investment. The point where marginal cost = marginal benefit results in the optimal capital budget.
The actual estimation of the cost of capital for a company requires a bit of educated guesswork, and lots
of reasonable assumptions. Using readily available financial data, we can, at least, arrive at a good
enough estimate of the cost of capital.

Cost of debt = rd* = rd (1 - t)

t = marginal tax rate
rd = yield on debt
Dp
Cost of preferred equity = rp =
P0
Dp = periodic dividend
P0 = current price
Cost of equity (DVM) = re = ( D1 / P ) + g
g = expected growth rate of dividends
D1 = next period’s dividend
P0 = current price
Cost of equity (CAPM) = re = rf + (rm - rf)
rf = expected risk free rate of interest
B = beta
rm = expected return on the market
wd is the proportion of debt in the capital structure
wp is the proportion of preferred stock in the capital structure

Capital structure practice questions/problems
1. Consider the Albatross Company that has $1 million of assets, which are currently financed
using 40 percent debt and 60 percent equity. Suppose Albatross were to acquire $0.5 million
of additional assets, but can select between two financing alternatives: all debt, borrowing
at 5%, or all equity, issuing 1 million new shares. What is the debt-equity ratio for each
alternative financing arrangement?
2. Consider two firms, A and B:
Firm A Firm B
Discount rate for earnings stream 10% 12%
Discount rate for risk-free debt earnings 5% 8%
Earnings before additional interest $100 $200
Alternative 1
Debt $0 $0
Alternative 2
Debt $500 $1,000
Assume that the tax rate is 0%. Calculate the capitalization rate for earnings for each firm
and for each alternative financing arrangement. In addition, calculate the value of equity
and debt in each case.
3. Explain why interest deductibility would encourage companies to use debt financing.
4. Explain how each of the following affects the capital structure decision:
a. Interest deductibility
b. Likelihood of bankruptcy
c. Limited liability
d. Net operating loss carryovers
5. The ABC Company has a current capital structure consisting of $100,000 of 10% coupon
debt and $300,000 of equity. ABC wants to raise $100,000 of capital by either selling
additional shares of stock or issuing debt. There is currently 30,000 shares of stock
outstanding and ABC expects to pay 10% interest per year. ABC expects operating earnings
of $30,000 in the following year.
a. What is ABC’s debt ratio under each of the two financing alternatives?
b. If interest on debt is not deductible by ABC, what is the distribution of next year’s
$30,000 among claimants?
c. If interest on debt is deductible by ABC, and ABC has a tax rate of 30%, what is the
distribution of next year’s $30,000 among claimants (including the government)?
d. Suppose ABC’s probability distribution of next year’s earnings is as follows:
Operating
Scenario Probability earnings
Good 25% $50,000
Normal 50% $30,000
Bad 25% $0
What is ABC’s expected earnings to owners and standard deviation of earnings to

owners under the two alternatives? Assume that there are no taxes.
Capital structure practice questions/problems 1

Solutions to capital structure practice questions/problems
1. Debt-equity for all debt = ($0.4+0.5) / $0.6 = 1.5

Debt-equity for all equity = $0.4 / ($0.6+0.5) = 0.3636
2.
Firm A Firm B
Discount rate for earnings stream 10% 12%
Discount rate for risk-free debt earnings 5% 8%
Earnings before additional interest $100 $200
Alternative 1
Debt/equity 0.0 0.0
Earnings after interest $100 $100
Capitalization rate 0.10 0.12
Value of debt $0 $0
Value of equity (EBT/discount rate) 1,000 1,667
Value of the firm (debt + equity) $1,000 $1,667
Alternative 2
Debt/equity 1.0 1.5
Earnings after interest $75 $120
Capitalization rate 0.10+[(0.10-0.05)(1)] = 0.15 0.12+[(0.12-0.08)0.04(1.5)] =0.18
Value of debt $500 $1,000.00

Value of equity (EBT/discount rate) $500 666.67
Value of the firm $1,000 $1,666.67
3. Interest deductibility lowers the cost of using debt vis-à-vis equity financing. Therefore,
companies have an incentive to use debt because its cost is much lower than that of
equity.
4.
a. Interest deductibility: makes the use of debt more attractive by lowering the cost
of debt to the company.
b. Likelihood of bankruptcy: the greater the probability of bankruptcy, the less debt
that a company would want to take on.
c. Limited liability: The fact the owners bear only a fixed amount of the risk on the
downside of investments creates an incentive to take on riskier projects. This
limit on the owners’ liability encourages creditors to require a premium for
bearing this risk.
d. Net operating loss carryovers: If a company cannot use all of its tax benefits
from interest, then the cost of debt is not as low as it could be if they could use
these benefits; hence, the lack of profitability negates the benefits from interest
deductibility. Therefore, companies that are not generating profits for tax
purposes do not benefit from the tax deductibility of interest.
Solutions to capital structure practice questions/problems, prepared by Pamela Peterson-Drake 1

5.
a. Alternative 1 debt ratio = 0.25 Alternative 2 debt ratio = 0.67
b.
Alternative 1 Alternative 2
Income to claimants $30,000 $30,000
Debt owners $10,000 $20,000

Equity owners $20,000 $10,000
c.
Alternative 1 Alternative 2
Income to claimants $14,000 $7,000
Debt owners $10,000 $20,000

Equity owners $14,000 $7,000
Government $6,000 $3,000

d.
ABC Company: Evaluating financing alternatives
Without taxes
Alternative 1
Operating Interest Net

2 2
Scenario earnings on debt income Probability pn xn x n -E(x) (x n -E(x)) pn (x n -E(x))
Good $50,000 $10,000 $40,000 25% $10,000 $22,500 506,250,000 $126,562,500
Normal $30,000 $10,000 $20,000 50% $10,000 $2,500 6,250,000 $3,125,000
Bad $0 $10,000 ($10,000) 25% -$2,500 -$27,500 756,250,000 $189,062,500
E(x) = $17,500 σ2 = $318,750,000
σ= $17,854
Coefficient of variation = 1.020
Alternative 2
Good $50,000 $20,000 $30,000 25% $7,500 $22,500 506,250,000 $126,562,500
Normal $30,000 $20,000 $10,000 50% $5,000 $2,500 6,250,000 $3,125,000
Bad $0 $20,000 ($20,000) 25% -$5,000 -$27,500 756,250,000 $189,062,500
E(x) = $7,500 σ2 = $318,750,000
σ= $17,854

With taxes
Alternative 1
Net
income
Operating Interest after
2 2
Scenario earnings on debt taxes Probability pn xn x n -E(x) (x n -E(x)) pn (x n -E(x))
Good $50,000 $10,000 $28,000 25% $7,000 $15,750 248,062,500 $62,015,625
Normal $30,000 $10,000 $14,000 50% $7,000 $1,750 3,062,500 $1,531,250
Bad $0 $10,000 ($7,000) 25% -$1,750 -$19,250 370,562,500 $92,640,625
E(x) = $12,250 σ2 = $156,187,500
σ= $12,497
Alternative 2
Good $50,000 $20,000 $21,000 25% $5,250 $15,750 248,062,500 $62,015,625
Normal $30,000 $20,000 $7,000 50% $3,500 $1,750 3,062,500 $1,531,250
Bad $0 $20,000 ($14,000) 25% -$3,500 -$19,250 370,562,500 $92,640,625
E(x) = $5,250 σ2 = $156,187,500
σ= $12,497

Cost of Capital Practice Problems
1. Why is it that, for a given firm, that the required rate of return on equity is always
greater than the required rate of return on its debt?
2. The Mountaineer Airline Company has consulted with its investment bankers and
determined that they could issue new debt with a yield of 8%. If Mountaineer '
marginal tax rate is 39%, what is the after-tax cost of debt to Mountaineer?
3. The Blue Dog Company has common stock outstanding that has a current price of
$20 per share and a $0.5 dividend. Blue Dog’s dividends are expected to grow at a
rate of 3% per year, forever. The expected risk-free rate of interest is 2.5%,
whereas the expected market premium is 5%. The beta on Blue Dog’s stock is 1.2.
a. What is the cost of equity for Blue Dog using the dividend valuation model?
b. What is the cost of equity for Blue Dog using the capital asset pricing model?
4. Gaggle Internet, Inc. is evaluating its cost of capital under alternative financing
arrangements. In consultation with investment bankers, Gaggle expects to be able to
issue new debt at par with a coupon rate of 8% and to issue new preferred stock
with a $2.50 per share dividend at $25 a share. The common stock of Gaggle is
currently selling for $20.00 a share. Gaggle expects to pay a dividend of $1.50 per
share next year. Market analysts foresee a growth in dividends in Invest stock at a
rate of 5% per year. Gaggle' marginal tax rate is 35%.
a. If Gaggle raises capital using 45% debt, 5% preferred stock, and 50% common
stock, what is Gaggle's cost of capital?
b. If Gaggle raises capital using 30% debt, 5% preferred stock, and 65% common
stock, what is Gaggle’s cost of capital?
Prepared by Pamela Parrish Peterson

Cost of Capital Practice Problems
1. Why is it that, for a given firm, that the required rate of return on equity is always greater
than the required rate of return on its debt?
The required rate of return on equity is higher for two reasons:
• The common stock of a company is riskier than the debt of the same company.
• The interest paid on debt is deductible for tax purposes, whereas dividends paid
on common stock are not deductible.
2. The Mountaineer Airline Company has consulted with its investment bankers and determined
that they could issue new debt with a yield of 8%. If Mountaineer ' marginal tax rate is 39%,
what is the after-tax cost of debt to Mountaineer?
rd* = 0.08 (1 – 0.39) = 0.0488 or 4.88%
3. The Blue Dog Company has common stock outstanding that has a current price of $20 per
share and a $0.5 dividend. Blue Dog’s dividends are expected to grow at a rate of 3% per
year, forever. The expected risk-free rate of interest is 2.5%, whereas the expected market
premium is 5%. The beta on Blue Dog’s stock is 1.2.
a. What is the cost of equity for Blue Dog using the dividend valuation model?
re = {[$0.50(1 + 0.03)] /$20} + 0.03 = 0.05575 or 5.575%
b. What is the cost of equity for Blue Dog using the capital asset pricing model?
re = 0.025 + (0.05) 1.2 = 0.025 + 0.06 = 8.5%
4. Gaggle Internet, Inc. is evaluating its cost of capital under alternative financing
arrangements. In consultation with investment bankers, Gaggle expects to be able to issue
new debt at par with a coupon rate of 8% and to issue new preferred stock with a $2.50 per
share dividend at $25 a share. The common stock of Gaggle is currently selling for $20.00 a
share. Gaggle expects to pay a dividend of $1.50 per share next year. Market analysts
foresee a growth in dividends in Invest stock at a rate of 5% per year. Gaggle' marginal tax
rate is 35%.
rd* = 0.08 (1 – 0.35) = 0.52 or 5.2%
rp = $2.50 / $25 = 10%
re = $1.50 / $20 + 5% = 7.5% + 5% = 12.5%
a. If Gaggle raises capital using 45% debt, 5% preferred stock, and 50% common stock,
what is Gaggle's cost of capital?
WACC = [0.45 (0.052)] + [0.05 ( 0.10)] + [0.50 (0.125)]
WACC = 0.0234 + 0.005 + 0.0625 = 0.0909 = 9.09%
b. If Gaggle raises capital using 30% debt, 5% preferred stock, and 65% common stock,
what is Gaggle’s cost of capital?
WACC = [0.30 (0.052)] + [0.05 ( 0.10)] + [0.65 (0.125)]
WACC = 0.0156 + 0.005 + 0.08125 = 0.10185 = 10.185%
Prepared by Pamela Parrish Peterson

Capital structure and the cost of capital Page 1 of 2
Capital structure and the cost of capital
Flash Cards
Pick a Letter
Fill In The Blank
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Crosswords
Quiz
Challenge
Glossary
Capital structure and the cost of capital Page 2 of 2

Practice problems


Practice problems
Foundation | Taxes | Financial ratios | Time value of money | Valuation | Risk and return | Capital budgeting |
Capital structure

Taxes 5-minute workouts: Bond valuation | Bond yields
5-minute work outs: Tax-rate schedules | Taxes: Sale of assets Bond valuation practice problems
Risk and return
Future and present values | Annuities | Uneven cash flows Capital budgeting cash flow practice problems
EAR vs. APR | Interpreting problems Goofy Gadget Gooferizer Project, with solutions
Annuity Practice Problems B. B. Dome Project
Time Value of Money Practice Test Rockafellar Music Company
Loan Amortization: Example and Explanation 5-minute Work-out -- Capital budgeting
Deferred Annuity Problem: Example and Explanation techniques
NOTE:Calculator assistance and Time Value of Money tables are Capital budgeting techniques practice Problems
available. Capital Budgeting Practice Test
Solutions

Solutions
Cost of capital practice problems and Solutions
Capital structure and cost of capital crossword
puzzle

Financial ratios http://educ.jmu.edu/~drakepp/principles/probsets.html#ratios
Time value of money http://educ.jmu.edu/~drakepp/principles/probsets.html#tvm
Risk and return http://educ.jmu.edu/~drakepp/principles/probsets.html#rr
Capital budgeting http://educ.jmu.edu/~drakepp/principles/probsets.html#cb
Capital structure http://educ.jmu.edu/~drakepp/principles/probsets.html#cs
Using Financial
Accounting http://educ.jmu.edu/~drakepp/principles/module2/acc.html
Information
Accounting Review
Crossword Puzzle
Tax-rate schedules http://educ.jmu.edu/~drakepp/principles/tax/Taxratework.htm
Taxes: Sale of assets http://educ.jmu.edu/~drakepp/principles/tax/worktax.html
Practice Problems in
http://educ.jmu.edu/~drakepp/principles/tax/taxprob.html
Taxation
Net operating loss
problems
Financial Ratio
http://educ.jmu.edu/~drakepp/principles/module2/finrat.html
Problems
Financial Ratio
Formulas
Time Value of Money
Practice Problems
More Time Value of
Money Practice http://educ.jmu.edu/~drakepp/principles/module3/dann.html
Problems
Future and present
values
Uneven cash flows http://educ.jmu.edu/~drakepp/principles/module3/work3.html
Interpreting problems http://educ.jmu.edu/~drakepp/principles/module3/work4.html
Annuity Practice
http://educ.jmu.edu/~drakepp/principles/module3/defprob.htm
Problems
Time Value of Money
http://educ.jmu.edu/~drakepp/principles/module3/tvmtest.html
Practice Test
Loan Amortization:
Example and http://educ.jmu.edu/~drakepp/principles/module3/loan_amortization.htm
Explanation
Deferred Annuity http://educ.jmu.edu/~drakepp/principles/module3/Deferred_Annuity_Problem.htm

Problem: Example and

Explanation
Calculator assistance http://educ.jmu.edu/~drakepp/principles/calculators/index.html
Time Value of Money
http://educ.jmu.edu/~drakepp/principles/misc.html#tvmtables
tables
Valuation problems http://educ.jmu.edu/~drakepp/principles/module4/valuation_problems.pdf
Valuation quiz http://educ.jmu.edu/~drakepp/principles/module4/valuequiz.htm
Two-stage dividend
growth practice http://educ.jmu.edu/~drakepp/principles/module4/twostage.htm
Problems
Bond valuation http://educ.jmu.edu/~drakepp/principles/module4/workbd.html
Bond valuation
practice problems
Bond yield practice
http://educ.jmu.edu/~drakepp/principles/module4/yield.html
problems
Risk and return
practice problems
More risk and return
practice problems
Risk measurement
http://educ.jmu.edu/~drakepp/principles/module5/riskexamples.htm
problems
Risk-return problem http://educ.jmu.edu/~drakepp/principles/module5/riskret.html
Risk and return
crossword puzzle
Capital budgeting cash
http://educ.jmu.edu/~drakepp/principles/module6/cf.html
flow practice problems
Goofy Gadget
Gooferizer Project
B. B. Dome Project http://educ.jmu.edu/~drakepp/principles/module6/bbdome.html
Rockafellar Music
http://educ.jmu.edu/~drakepp/principles/module6/cbrock.html
Company
5-minute Work-out --
Capital budgeting http://educ.jmu.edu/~drakepp/principles/module6/cbwork.html
techniques
Capital budgeting
techniques practice http://educ.jmu.edu/~drakepp/principles/module6/cb.html
Problems
Capital Budgeting
http://educ.jmu.edu/~drakepp/principles/module6/cbtest.html
Practice Test
Capital budgeting http://educ.jmu.edu/~drakepp/principles/module6/cbproblems.pdf

practice problems
Capital structure
practice problems
problems
Capital structure and
crossword puzzle
Practice problems


Practice problems
| Capital structure

Risk and return
Problems
Solutions

Solutions
Solutions
crossword puzzle
Shortcut
Internet Address
Text
Financial
ratios
Time value of
money
Risk and
return
Capital
budgeting
Capital
structure
Using
Financial
Accounting
Information
Accounting
Review
Crossword
Puzzle
Tax-rate
schedules
Taxes: Sale
of assets
Practice
Taxation
Net operating
loss problems
Financial
Problems
Financial
Formulas
Time Value
of Money
Practice
Problems
More Time
Shortcut
Internet Address
Text
Value of
Money
Practice
Problems
Future and
values
Uneven cash
flows
Interpreting
problems
Annuity
Problems
Time Value
Practice Test
Loan
Amortization:
Example and
Explanation
Deferred
Annuity
Example and
Explanation
Calculator
assistance
Time Value
tables
Valuation
problems
Valuation
quiz
Two-stage
growth
Shortcut
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Text
practice
Problems
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valuation
Bond
valuation
practice
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problems
Risk and
return
practice
problems
More risk and
return
practice
problems
Risk
problems
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problem
Risk and
return
crossword
puzzle
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budgeting
practice
problems
Goofy
Gadget
Gooferizer
Project
B. B. Dome
Project
Shortcut
Internet Address
Text
Rockafellar
Company
5-minute
Work-out --
budgeting
techniques
Capital
budgeting
practice
Problems
Capital
Practice Test
Capital
budgeting
practice
problems
Capital
structure
practice
problems
Cost of
capital
practice
problems
Capital
structure and
crossword
puzzle
Financial calculators
Prepared by Pamela Peterson, James Madison University
1. The basics
2. Hewlett-Packard models
3. Texas Instruments models

The basics http://educ.jmu.edu/~drakepp/general/calculator/general.html
Hewlett-Packard models http://educ.jmu.edu/~drakepp/general/calculator/hp.html
Texas Instruments models http://educ.jmu.edu/~drakepp/general/calculator/ti.html
Miscellaneous
z Background for the course
{ Need a little bit of help with Algebra?
{ Accouting Review
z Formulas
{ Financial ratio formulas
{ Time value of money formulas
{ Valuation formulas
{ Risk formulas
{ Capital budgeting formulas
{ Cost of capital formulas
z Foundation tools
{ Understanding financial statements
{ MACRS tables
{ Kmart Financial Statements
z Time value of money tables
{ Table of Compound Factors
{ Table of Discount Factors
{ Future Value Annuity Factors
{ Present Value Annuity Factors
z Research
{ Instructions on locating SEC filings
{ A guide to gathering financial data for financial analysis from Mergent Online
{ Charting in Microsoft Excel
{ Creating a Microsoft PowerPoint Presentation, with an example
{ Writing suggestions
{ How do you avoid plagiarism?
http://educ.jmu.edu/~drakepp/principles/misc.html 2/28/2011

Need a little bit of help with
http://educ.jmu.edu/~drakepp/principles/tools/algebra.html
Algebra?
Accouting Review http://wise.fau.edu/~ppeter/acc/
Financial ratio formulas http://educ.jmu.edu/~drakepp/principles/module2/fin_formulas.pdf
Time value of money formulas http://educ.jmu.edu/~drakepp/principles/module3/tvm_formulas.pdf
Valuation formulas http://educ.jmu.edu/~drakepp/principles/module4/val_formulas.pdf
Risk formulas http://educ.jmu.edu/~drakepp/principles/module5/rrformulas.pdf
Capital budgeting formulas http://educ.jmu.edu/~drakepp/principles/module6/cbformulas.pdf
Cost of capital formulas http://educ.jmu.edu/~drakepp/principles/module7/coc_formulas.pdf
Understanding financial statements http://educ.jmu.edu/~drakepp/principles/module2/pg.pdf
MACRS tables http://educ.jmu.edu/~drakepp/principles/tax/macrs.htm
Kmart Financial Statements http://educ.jmu.edu/~drakepp/principles/module2/kmart.xls
Table of Compound Factors http://educ.jmu.edu/~drakepp/principles/module3/fvtable.html
Table of Discount Factors http://educ.jmu.edu/~drakepp/principles/module3/pvtable.html
Future Value Annuity Factors http://educ.jmu.edu/~drakepp/principles/module3/fvantable.html
Present Value Annuity Factors http://educ.jmu.edu/~drakepp/principles/module3/pvantable.html
Instructions on locating SEC
http://wise.fau.edu/~ppeter/fin3403/assignments/Instructions_EDGAR.pdf
filings
A guide to gathering financial data
for financial analysis from http://wise.fau.edu/~ppeter/fin4504/examples/mergent.pdf
Mergent Online
Charting in Microsoft Excel http://educ.jmu.edu/~drakepp/principles/tools/excel_charting.pdf
Creating a Microsoft PowerPoint
http://educ.jmu.edu/~drakepp/principles/tools/pp.pdf
Presentation
example http://educ.jmu.edu/~drakepp/principles/tools/pp_ex.ppt
Writing suggestions http://wise.fau.edu/~ppeter/fin4504/examples/writing.pdf
How do you avoid plagiarism? http://wise.fau.edu/~ppeter/fin3403/assignments/avoidplagiarism.pdf
http://educ.jmu.edu/~drakepp/principles/misc.html 2/28/2011
Algebra Help Page, P. Peterson Page 1 of 1
Need a little help with Algebra?

Check out these sites:
z Introduction to Algebra
z Algebra Solutions
z Algebra Help
http://educ.jmu.edu/~drakepp/principles/tools/algebra.html 2/28/2011
Introduction to Algebra Page 1 of 10
Introduction to Algebra
Variables
Expressions
Equations
Solution of an equation
Simplifying equations
Combining like terms
Simplifying with addition and subtraction
Simplifying by multiplication
Simplifying by division
Word problems as equations
Sequences
Math Contests Contest Problem Books Educational Software

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Variables
A variable is a symbol that represents a number. Usually we use letters such as n, t, or x for variables. For
example, we might say that s stands for the side-length of a square. We now treat s as if it were a number we
could use. The perimeter of the square is given by 4 × s. The area of the square is given by s × s. When working
with variables, it can be helpful to use a letter that will remind you of what the variable stands for: let n be the
number of people in a movie theater; let t be the time it takes to travel somewhere; let d be the distance from my
house to the park.
Expressions
An expression is a mathematical term or a sum or difference of mathematical terms that may use numbers,
variables, or both.
Example:
The following are examples of expressions:
3+7
2×y+5
2 + 6 × (4 - 2)
z + 3 × (8 - z)
http://www.mathleague.com/help/algebra/algebra.htm 2/28/2011
Example:
Roland weighs 70 kilograms, and Mark weighs k kilograms. Write an expression for their combined weight.
The combined weight in kilograms of these two people is the sum of their weights, which is 70 + k.
Example:
A car travels down the freeway at 55 kilometers per hour. Write an expression for the distance the car will have
traveled after h hours. Distance equals rate times time, so the distance traveled is equal to 55 × h..
Example:
There are 2000 liters of water in a swimming pool. Water is filling the pool at the rate of 100 liters per minute.
Write an expression for the amount of water, in liters, in the swimming pool after m minutes. The amount of
water added to the pool after m minutes will be 100 liters per minute times m, or 100 × m. Since we started with
2000 liters of water in the pool, we add this to the amount of water added to the pool to get the expression 100 ×
m + 2000.
To evaluate an expression at some number means we replace a variable in an expression with the number, and
simplify the expression.
Example:
Evaluate the expression 4 × z + 12 when z = 15.
We replace each occurrence of z with the number 15, and simplify using the usual rules: parentheses first, then
exponents, multiplication and division, then addition and subtraction.
4 × z + 12 becomes
4 × 15 + 12 =
60 + 12 =
72
Example:
Evaluate the expression (1 + z) × 2 + 12 ÷ 3 - z when z = 4.
We replace each occurrence of z with the number 4, and simplify using the usual rules: parentheses first, then
exponents, multiplication and division, then addition and subtraction.
(1 + z) × 2 + 12 ÷ 3 - z becomes
(1 + 4) × 2 + 12 ÷ 3 - 4 =
5 × 2 + 12 ÷ 3 - 4 =
10 + 4 - 4 =
10.
Equations
An equation is a statement that two numbers or expressions are equal. Equations are useful for relating variables
and numbers. Many word problems can easily be written down as equations with a little practice. Many simple
rules exist for simplifying equations.
Example:
The following are examples of equations:
2=2
17 = 2 + 15
x=7
7=x
t+3=8
3 × n +12 = 100
w + 4 = 12 - w
y - 1 - 2 - 9.3 = 34
3 × (d + 4) - 11 = 321 - 23
Example:
Translate the following word problem into an equation:
My age in years y plus 20 is equal to four times my age, minus 10.
The first expression stands for "my age in years plus 20", which is y + 20.
This is equal to the second expression for "four times my age, minus 10", which is 4 × y - 10.
Setting these two expressions equal to one another gives us the equation:
y + 20 = 4 × y - 10
Solution of an Equation
When an equation has a variable, the solution to the equation is the number that makes the equation true when
we replace the variable with its value.
Example:
We say y = 3 is a solution to the equation 4 × y + 7 = 19, for replacing each occurrence of y with 3 gives us
4 × 3 + 7 = 19 ==>
12 + 7 = 19 ==>
19 = 19 which is true.
Examples:
x = 100 is a solution to the equation x ÷ 2 - 40 = 10
z = 12 is a solution to the equation 5 × (z - 6) = 30
Counterexample:
y = 10 is NOT a solution to the equation 4 × y + 7 = 19. When we replace each y with 10, we get
4 × 10 + 7 = 19 ==>
40 + 7 = 19 ==>
47 = 19 not true!
Counterexamples:
x = 200 is NOT a solution to the equation x ÷ 2 - 40 = 10
z = 20 is NOT a solution to the equation 5 × (z - 6) = 30
Simplifying Equations
To find a solution for an equation, we can use the basic rules of simplifying equations. These are as follows:
1) You may evaluate any parentheses, exponents, multiplications, divisions, additions, and subtractions in the
usual order of operations. When evaluating expressions, be careful to use the associative and distributive
properties properly.
2) You may combine like terms. This means adding or subtracting variables of the same kind. The expression
2x + 4x simplifies to 6x. The expression 13 - 7 + 3 simplifies to 9.
3) You may add any value to both sides of the equation.
4) You may subtract any value from both sides of the equation. This is best done by adding a negative value to
each side of the equation.
5) You may multiply both sides of the equation by any number except 0.
6) You may divide both sides of the equation by any number except 0.
Hint: Since subtracting any number is the same as adding its negative, it can be helpful to replace subtractions
with additions of a negative number.
Example:
This problem illustrates grouping like terms and dealing with subtraction in an equation.
Solve x - 12 + 20 = 37.
Replacing the -12 with a +(-12), we get
x + (-12) + 20 = 37.
Since addition is associative, the two like terms (the integers) may be combined.
(12) + 20 = 8
The left side of the equation becomes
x + 8 = 37.
Now we may subtract 8 from each side of the equation, (we will actually add a -8 to each side).
x + 8 + (-8) = 37 + (-8)
x + 0 = 29
x = 29
We can check this solution in the original equation:
29 - 12 + 20 = 37x + 0 = 29
17 + 20 = 37
37 = 37 so our solution is correct.
Example:
This problem illustrates the proper use of the distributive property.
Solve 2 × (x + 1 + 4) = 20.
Grouping like terms in the parentheses, the left side of the equation becomes
2 × (x + 1 + 4) ==> 2 × (x + 5).
Using the distributive property,
2 × (x + 5) ==> 2 × x + 2 × 5.
Carrying out multiplications,
2 × x + 2 × 5 ==> to 2x + 10.
The equation now becomes
2x + 10 = 20.
Subtracting a 10 (adding a -10) to each side gives us
2x + 10 + (-10) = 20 + (-10) ==>
2x + (10 + (-10)) = 20 - 10 ==>
2x + 0 = 10 ==>
2x = 10.
Since the x is multiplied by 2, we divide both sides by 2 to solve for x:
2x = 10 ==>
2x ÷ 2 = 10 ÷ 2 ==>
(2x)/2 = 5 ==>
x = 5.
We can check this solution in the original equation:
2 × (5 + 1 + 4) = 20 ==>
2 × 10 = 20 ==>
20 = 20 so our solution is correct.
Combining like terms
One of the most common ways to simplify an expression is to combine like terms. Numeric terms may be
combined, and any terms with the same variable part may be combined.
Example:
Consider the expression 2 + 7x + 12 - 3x - 5. The numeric like terms are the numbers 2, 12, and 5. The variable
like terms are 7x and 3x. Combining the numeric like terms, we have 2 + 12 - 5 = 14 - 5 = 9. Combining the
variable like terms, we have 7x - 3x = 4x, so the expression 2 + 7x + 12 - 3x - 5 simplifies to 9 + 4x.
Simplifying with addition and subtraction
We can use addition and subtraction to get all the terms with variables on one side of an equation, and all the
numeric terms on the other.
The equations 3x = 17, 21 = y, and z/12 = 24 each have a variable term on one side of the = sign, and a number
on the other.
The equations x + 3 = 12, 21 = 30 - y, and (z + 2) × 4 = 10 do not.
We usually do this after simplifying each side using the distributive rules, eliminating parentheses, and
combining like terms. Since addition is associative, it can be helpful to add a negative number to each side
instead of subtracting to avoid mistakes.
Examples:
For the equation 3x + 4 = 12, we can isolate the variable term on the left by subtracting a 4 from both sides:
3x + 4 - 4 = 12 - 4 ==>
3x = 8.
For the equation 7y - 200 = 10, subtracting the 200 on the left side is the same as adding a -200:
7y + (-200) = 10.
If we add 200 to both sides of the equation, the 200 and -200 will cancel each other:
7y + (-200) + 200 = 10 + 200 ==>
7y = 210.
For the equation 8 = 20 - z, we can add z to both sides to get 8 + z = 20 - z + z ==> 8 + z = 20. Now subtracting
8 from both sides,
8 + z - 8 = 20 - 8 ==>
z = 12, so we get a solution for z.
Simplfying by multiplication
When solving for a variable, we want to get a solution like x = 3 or z = 2001. When a variable is divided by
some number, we can use multiplication on both sides to solve for the variable.
Example:
Solve for x in the equation x ÷ 12 = 5.
Since the x on the left side is being divided by 12, the equation is the same as x × 1/12 = 5. Multiplying both
sides by 12 will cancel the 1/12 on the left side:
x × 1/12 × 12 = 5 × 12 ==>
x × 1 = 60 ==>
x = 60.
Simplifying by division
When solving for a variable, we want to get a solution like x = 3 or z = 2001. When a variable is multiplied by
some number, we can use division on both sides to solve for the variable.
Example:
Solve for x in the equation 7x = 133. Since the x on the left side is being multiplied by 7, we can divide both
sides by 7 to solve for x:
7x ÷ 7 = 133 ÷ 7 ==>
(7x)/7 = 133 ÷ 7 ==>
x/1 = 19 ==>
x = 19.
Note that dividing by 7 is the same as multiplying both sides by 1/7.
Word problems as equations
When converting word problems to equations, certain "key" words tell you what kind of operations to use:
addition, multiplication, subtraction, and division. The table below shows some common phrases and the
operation to use.
Word Operation Example As an equation
sum addition The sum of my age and 10 equals 27. y + 10 = 27
The difference between my age and my
difference subtraction younger sister's age, who is 11 years old, is 5 y - 11 = 5
years.
product multiplication The product of my age and 14 is 168. y × 14 = 168
times multiplication Three times my age is 60. 3 × y = 60
less than subtraction Seven less than my age equals 32. y - 7 = 32
The total of my pocket change and 20 dollars
total addition y + 20 = 22.43
is $22.43.
more than addition Eleven more than my age equals 43. 11 + y = 43
Sequences
A sequence is a list of items. We can specify any item in the list by its place in the list: first, second, third,
fourth, and so on. Many useful lists have patterns so we know what items occur in each place in the list. There
are 2 kinds of sequences. A finite sequence is a list made up of a finite number of items. An infinite sequence is
a list that continues without end.
Examples:
The following are examples of finite sequences.
The sequence 1, 3, 5, 7, 9, 11, 13, 15, 17, 19 is the sequence of the first 10 odd numbers.
The sequence a, e, i, o, u, is the sequence of vowels in the alphabet.
The sequence m, m, m, m, m, m is the sequence of 6 m's.
The sequence 1, 0, 1, 0, 1, 0, 1, 0, 1, 0, 1, 0 is the sequence of 12 alternating 1's and 0's.
The sequence 1, 2, 3, 4, ..., 9998, 9999, 10000 is the sequence of the first ten thousand integers.
The sequence 0, 1, 4, 9, 16, 25, 36, 49 is the sequence of the squares of the first 8 whole numbers.
Examples:
The following are examples of infinite sequences.
The sequence 2, 4, 6, 8, 10, 12, 14, 16, ... is the sequence of even whole numbers. The 100th place in this
sequence is the number 200.
The sequence a, b, c, a, b, c, a, b, c, a, b, ... is the sequence of the letters a, b, c, repeating in this pattern forever.
The 100th place in this sequence is the letter a. The 300th place in this sequence is the letter c.
The sequence -1, 2, -3, 4, -5, 6, -7, 8, -9, ... is the sequence of integers with alternating signs. The 10th place in
this sequence is 10. The 100th place in this sequence is 100. The 101st place in this sequence is -101.
The sequence 1, 0, 1, 0, 0, 1, 0, 0, 0, 1, 0, 0, 0, 0, 1, ... is a sequence of 1's separated by 1 zero, then 2 zeros, then
3 zeros, and so on. The 100th place in this sequence is a 0. The 105th place in this sequence is a 1.
The sequence 1, 3, 6, 10, 15, 21, 28, 36, 45, ... is the sequence of places the 1 occurs in the sequence of 1's and
0's above! If this sequence seems strange, note the difference between pairs of numbers next to one another:
3-1=2
6-3=3
10 - 6 = 4
15 - 10 = 5
21 - 15 = 6
28 - 21 = 7
Checking these differences makes the pattern clearer.
1, 1, 1, 1, 1, 1, ... is the sequence where every item in the list is the number 1.
1, 2, 3, 4, 5, 6, 7, ... is the sequence of counting numbers. Each item in the list is its place number in the list.
a, b, a, b, a, b, a, b, ... is the sequence of alternating letters a and b. The a's occur in odd-numbered places, and
the b's occur in the even-numbered places.
1/1, 1/2, 1/3, 1/4, 1/5, 1/6, 1/7, ... is the sequence of reciprocals of the whole numbers.
1, 4, 9, 16, 25, 36, 49, 64, 81, ... is the sequence of squares of the whole numbers.
a, e, i, o, u, a, e, i, o, u, a, e, ... is the repeating sequence of vowels in the alphabet.
4, 7, 10, 13, 16, 19, 22, 25, ... is the sequence of numbers beginning with the number 4, and each number in the
list is 3 more than the number before it.
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This page may not be mirrored or reproduced on any other internet site.
Last updated August 2006 by Steve Conrad and Dan Flegler.
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Time value of money formulas
1. Time value of a lump-sum

A. Discrete compounding
FV = PV (1 + i)n
where FV is the future value,

PV is the present value
i is the rate of interest, and
n is the number of compounding periods
1
PV =
(1 + i)n
ln FV - ln PV
i= FV
1
PV
n=
ln (1+i)
B. Continuous compounding
FV = PV eAPR x
where x is the number of years

APR is the annual percentage rate
e Euler’s e
FV
PV = APR x
e
2. Time value of annuities

A. Ordinary annuity
N N
FV =
t=1
CF(1+i)N-t CF (1+i)
t=1
N-t
N
CF
N
1
1+i)N

PV = (1+i)
t 1
t
CF
t 1 (1 i)t
CF 1-
i

N
(1 i)
1
where t
is the annuity discount factor; and
t 1
N
(1+i)
t=1
N-t
is the annuity compound factor.
B. Annuity due
N
FV=CF(1 + i)1 CF(1 + i)2 ... CF(1 + i)N+1 = CF

(1+i)t+1

t=0
N N
CF 1
PV = (1+i)
t 1
t-1
CF (1 i)
t 1
t-1
C. Perpetuity
CF
PV =
i
3. Determining annual interest rates

A. Discrete compounding
APR = i x n
EAR = (1 + i)n 1 =(1 + APR

/n)n – 1
B. Continuous compounding
EAR = eAPR - 1
Financial ratio formulas
1. Operating cycle
Inventory Inventory
Average day's cost of goods sold Cost of goods sold / 365


Cost of Ending Beginning

Note: Purchases =
goods sold inventory inventory

Operating cycle

Net operating cycle
2. Liquidity
Current assets
Current ratio

Quick ratio

Sales
3. Profitability
Gross income
Gross profit margin
Sales
Operating income
Sales

Net income
Net profit margin
Sales
4. Activity
Cost of goods sold
Inventory turnover
Inventory
Sales on credit
Accounts receivable
Sales
Total assets
Sales
Fixed assets
5. Financial leverage
Total debt
Total assets
Long - term debt

Total assets
Total debt
Total assets
Equity multiplier =

Interest


Earnings per share

Dividends per share
Dividends
Earnings

Earnings per share
7. Return ratios
Operating income
Total assets
Net income
Return on assets =
Total assets
Net income
Return on equity =

Valuation formulas
Prepared by Pamela Peterson-Drake, Florida Atlantic University
1. Asset valuation
N CFt
Present value of the investment =
t
t=1 (1+i)
where CFt is the cash flow at the end of period t;
i is the discount rate; and
N is the number of periods;
2. Stock valuation
A. General formulation
Dt
P0
t
t 1 (1 re )
where P0 is price of a share of stock today;
Dt is the dividend at the end of period t;
re is the required rate of return; and
t indicates the period.
B. Perpetuity
D
P0
re
C. Dividend valuation model

D (1 g) D1
P0 0
(re g) (re g)
D. Two-stage dividends
DN 1 DN (1 g2 )
1 1
N1 Dt (re g2 ) N1 D (1 g )t
P0
Dt
0 1 (re g2 )
t 1 (1 re )
t t 1 (1 re )t (1 re )N1 t 1 (1 re )t (1 re )N1
PV of all dividends = PV of 1st + PV of 2nd

stage dividends stage dividends
where N1 is the length of first stage

g1 is the growth of dividends in the first stage
g2 is the growth of dividends in the second stage
3. Bond valuation
N
Ct M
V
t=1 1+r t (1+r )N
d d
where V is the value of the bond;
Ct is the coupon payment at the end of period t;
M is the maturity value; and
rd is the yield [Note: for semi-annual coupons, rd is the six-month yield].
Risk formulas
1. Types of risk
Q(P-V)
Q(P-V)-F
[Q(P-V)-F]
[Q(P-V)-F-I]
Q(P-V)
Q(P-V)-F-I
2. Risk measurement
N
n=1
= (x) pn (xn (x))2
n 1

S
Return on a portfolio = rp wiri
i 1
N
i=1
Portfolio standard deviation, 2-security portfolio = w12 12 + w 22 22 + 2w1 w2 cov1,2
.
N N N
2 2
Portfolio standard deviation = wi i + wi w jcovij .
i=1 i 1 j 1 j i

1,2
coefficient


12

S
Portfolio beta = p wii
i 1
Return on a security, CAPM = ri = rf + (rm - rf) i

Capital budgeting formulas
Cash flows
#OCF = (#R - #E - #D) (1 - t) + #D - #NWC or #OCF = (#R - #E) (1 - t) + #Dt - #NWC
where
t = tax rate; and
Techniques
N CIFt
t
N CFt t 1 (1 r)
Net present value = NPV Profitability index = PI
t N COF
t 1 (1 r) t
t
t 1 (1 r)
N CFt
IRR is the rate that solves the following: $0
t
t 1 (1 IRR)
CIF (1+i)
t=1
t
N-t
Modified internal rate of return = MIRR= N N

COFt
(1+i)
t=1
t
where CFt is the cash flow at the end of period t, and CIFt and COFt are cash inflows and cash outflows, respectively,
at the end of period t.
Risk
N N x
E (x) = pn xn (x) pn (xn (x))2 Coefficient of variation =
n 1 x
n=1

1
asset equity
debt

1 (1 ')
equity
Compensation for market risk = asset (rm - rf)


Prepared by Pamela Peterson-Drake 1

Cost of debt = rd* = rd (1 - t)

t = marginal tax rate
rd = yield on debt
Dp
Cost of preferred equity = rp =
P0
Dp = periodic dividend
P0 = current price
Cost of equity (DVM) = re = ( D1 / P ) + g
g = expected growth rate of dividends
D1 = next period’s dividend
P0 = current price
Cost of equity (CAPM) = re = rf + (rm - rf)
rf = expected risk free rate of interest
B = beta
rm = expected return on the market
wd is the proportion of debt in the capital structure
wp is the proportion of preferred stock in the capital structure

Relations web site.
Procter & Gamble

Years Ended June 30
Net Sales $51,407 $43,377 $40,238

Income taxes 2,869 2,344 2,031
Net Earnings $6,481 $5,186 $4,352

explanations.
Procter & Gamble
Assets
June 30

Current Assets
Inventories
Land 42 591
23,542 25,304
Goodwill 19,610 11,132
Total Assets $57,048 $43,706
Procter & Gamble
2004 2003
Current Liabilities
2,594.4)
explanations.
Procter & Gamble
Years ended June 30

Net earnings 6,481 5,186 4,352

Other 299 527 467
Acquisitions (7,476) (61) (5,471)
Cash payments for:
Interest $630 $538 $629
Income taxes 1,634 1,703 941
explanations.
KMart Balance Sheet
31-Jan-01 31-Jan-00
Assets
Cash and cash equivalents $ 401 $ 344
Merchandise inventories 6,412 7,101
Other current assets 811 715
Property and equipment, net 6,557 6,410

Other assets and deferred charges 449 534
Total Assets $ 14,630 $ 15,104
Liabilities and Equity

Long-term debt due within one year $ 68 $ 66
Trade accounts payable 2,288 2,204
Accrued payroll and other liabilities 1,256 1,574
Taxes other than income taxes 187 232
Long-term debt and notes payable 2,084 1,759

Capital lease obligations 943 1,014
Other long-term liabilities 834 965
Company obligated mandatorily redeemable convertible preferred securities of
a subsidiary trust holding solely 7-3/4% convertible junior subordinated
debentures of Kmart (redemption value of $898 and $1,000, respectively)
887 986
Common stock, $1 par value, 1,500,000,000 shares authorized; 486,509,736
and 481,383,569 shares issued, respectively 487 481
Total Liabilities and Shareholders' Equity $ 14,630 $ 15,104
Source: http://www.kmart.com
KMart_BalanceSheet
Kmart Statement of Cash Flows
Cash Flows From Operating Activities 31-Jan-01 31-Jan-00 31-Jan-99

Net income (loss) from continuing operations $ (244) $ 633 $ 518
Adjustments to reconcile net income (loss) from
continuing
operations to net cash provided by operating
activities:
One-time charge for strategic actions 728 -- --
Equity loss in BlueLight.com 64 -- --
Decrease (increase) in inventories 324 -565 -169
Increase in trade accounts payable 84 157 124
Increase in accounts receivable -103 -62 -76
Deferred income taxes and taxes payable -204 258 308
Decrease in other long-term liabilities -113 -116 -64
Changes in other assets and liabilities -57 92 60
Cash used for store closings and other charges -102 -80 -94
Voluntary early retirement programs -- -- 19

Net cash provided by continuing operations $ 1,154 $ 1,087 $ 1,297
Net cash used for discontinued operations $ (115) $ (83) $ (60)
Net cash provided by operating activities $ 1039 $ 1,004 $ 1,237
Cash Flows From Investing Activities

Capital expenditures (1,087) (1,277) (981)
Investment in BlueLight.com -55 -- --
Acquisition of Caldor leases -- (86) --
Proceeds from divestitures -- -- 87
Decrease in property held for sale or financing and -- -- 99
other
Net cash used for investing activities (1,142) (1,363) (795)
Cash Flows From Financing Activities

Proceeds from issuance of debt 397 297 --
Issuance of common shares 53 63 76
Purchase of convertible preferred securities -84 -- --
Purchase of common shares -55 -200 -30
Payments on debt -73 90 -188
Payments on capital lease obligations (78) (77) (88)
Net cash provided by (used for) financing 160 (7) (230)
activities
Net change in cash and cash equivalents 57 -366 212

Cash and cash equivalents, beginning of year 344 710 498
Cash and cash equivalents, end of year $ 401 $ 344 $ 710
KMart_SOCF
Kmart's Income Statement
31-Jan-01 31-Jan-00 31-Jan-99

Sales $ 37,028 $ 35,925 $ 33,674
Gross margin 7,370 7,814 7,355
Selling, general and administrative expenses 7,415 6,514 6,245
Voluntary early retirement programs -- -- 19
Continuing income (loss) before interest, income taxes
and dividends on convertible preferred securities of
subsidiary trust -45 1,300 1,091
Interest expense, net 287 280 293
Income tax provision (benefit) -134 337 230
Dividends on convertible preferred securities of
subsidiary trust, net of income taxes of $25, $27 and
$27, respectively 46 50 50
Net income (loss) from continuing operations -244 633 518
Discontinued operations, net of income taxes of $(124) -- (230) --
Net income (loss) $ (244) $ 403 $ 518
Basic earnings (loss) per common share

Net income (loss) from continuing operations $ (0.48) $ 1.29 $ 1.05
Discontinued operations -- (0.47) --
Net income (loss) $ (0.48) $ 0.82 $ 1.05
Diluted earnings (loss) per common share

Net income (loss) from continuing operations $ (0.48) $ 1.22 $ 1.01
Discontinued operations -- (0.41) --
Net income (loss) $ (0.48) $ 0.81 $ 1.01
Basic weighted average shares (millions) 482.8 491.7 492.1

Diluted weighted average shares (millions) 482.8 561.7 564.9
KMart_IncomeStatement
Definitions, Principles of Financial Management Page 1 of 29
Glossary
A B C D E F G H I J K L M
N O P Q R S T U V W X Y Z
A
Accelerated depreciation
A method of depreciation that results in greater depreciation expenses in the earlier years
of an asset's life.
Accounting profit
The difference between revenues and expenses of a business enterprise, determined

according to a set of accounting principles (e.g., in the U.S., accounting profit is
determined according to generally accepted accounting principles, GAAP).
Accounts payable
Amounts due to suppliers for goods or services purchased on credit.
Accounts receivable
Amounts due from customers arising from the extension of trade credit.
The ratio of net credit sales to accounts receivables; a measure of the number of times in
a period that credit sales have been created and collected.
Accumulated depreciation
The sum of depreciation taken for physical assets in the firm's possession.
Activity ratio
A ratio that relates information on a firm's ability to manage its resources efficiently.
Addition paid-in capital
An amount paid for shares of stock in excess of the par or stated value of the shares.
Add-on interest
An interest arrangement in which interest is added to the loaned amount, and the
principal (amount borrowed) and interest are repaid in equal, periodic payments.
Adjustable rate mortgage
A loan, secured by real estate, with an interest rate that varies according to some other,
specified rate.
http://educ.jmu.edu/~drakepp/principles/tools/glossary.html 2/28/2011
Agency relationship
A relation between two parties in which one party (the agent) is authorized by the other
party (the principal) to make decisions or take actions for the benefit of the authorizing
party.
Agent
A person authorized by another person (the principal) to act for him.
Amortized
A present value that has been transformed into an equivalent series of cash flows
considering the time value of money.
Annualized rate
A rate of interest stated on an annual basis (i.e., as a rate per year).
Annual percentage rate, APR
A standard for reporting interest rates, in accordance to the Truth in Lending Act, that
results in a simplified manner of annualizing and comparing rates. The interest rate per
compound period is multiplied by the number of compound periods in a year, producing
an annualized rate of interest.
Annual percentage yield, APY
An annualized rate that considers the effects of compounding with the year. See also EAR.
Annuity
A series of even cash flows that occur at even intervals of time.
Annuity due
A series of periodic, even cash flows in which the first cash flow occurs today.
APR
See annual percentage rate.
Arbitrage
The process of buying and selling identical assets in different markets at different prices
until the asset have the same price everywhere.
Arbitrage Pricing Model
A model of asset prices that states that the expected return on an asset is the sum of the
risk free rate and the expected return associated with unanticipated factors.
Arbitrage Pricing Theory
An asset pricing theory developed by Stephen Ross that is based on the idea that identical
assets in different markets should be priced identically.
Articles of incorporation
A document that is filed with the state by a business entity that seeks incorporation; the
document describes the business and the rights and responsibilities of its owners.
Asset
Property, either real, personal, tangible, or intangible.
Asset-backed security
A security created by pooling together assets (e.g., home mortgages, credit card accounts
receivable) and selling interests in these assets.
Assumable mortgage
A mortgage that allows the borrower to sell the property to another party and this party
assumes the debt obligation.
Average tax rate
The average rate of tax on a dollar of taxable income, calculated as the ratio of taxes to
taxable income. The tax rate paid, on average, per dollar of taxable income.
B
Balance sheet
A statement of assets, liabilities, and net worth at a point in time. Also referred to as the
statement of financial position.
Basic earnings per share (Basic EPS)
Net income, less preferred dividends, divided by the number of shares of stock
outstanding.
Basic earning power ratio
The ratio of a firm's operating income to its total assets; a measure of the return on a
firm's investment in assets.
Beta
A measure of the sensitivity of an asset's returns to the changes in the returns on the
market portfolio.
Blind trust
A trust in which the grantor has no influence or information regarding the decisions of the
trustee.
Board of directors
The governing body of a corporation that is elected by and makes decisions in the interest
of the corporation's owners.
Bond
An agreement between a lender (the issuer) and a borrower(the investor).
Book value of equity
The value of the ownership interest in a company according to the accounting conventions
applied; the sum of the par value of equity, additional paid in capital, retained earnings,
less treasury stock.
Book value of equity per share
The ratio of the book value of shareholders' equity to the number of shares of stock
outstanding.
Bond
A debt obligation in which the borrower promises to repay the amount of the borrowed
loan at a specified point of time in the future, plus (if agreed upon) pay interest on the
borrowed funds.
Bonding costs
Costs incurred by an agent in an agency relationship to ensure that he/she will act in the
best intersts of the principals.
Bonds and notes
Promises to repay borrowed funds and to make periodic interest payments.
Budget
A written plan that organizes actual and projected cash inflows and outflows over a period
of time.
Budgeting
The process of organizing, projecting, monitoring and controlling future cash inflows and
outflows.
Business cycle
Economic activity that spans temporary phases of activity of expansion, recession and
recovery, producing a wave-like pattern of economic activity.
Business risk
The uncertainty associated with the operating cash flows of business enterprise.
Bylaws
The rules of governance of an organization; for a corporation, the bylaws (along with the
articles of incorporation) become part of its corporate charter.
C
Call risk
The uncertainty regarding whether a callable security (e.g., callable bond) will be called
(i.e., purchased) from the investor by the issuer.
Capital
A firm's resources; funds raised from long-term sources, such as bonds and stocks.
Capital asset pricing model, CAPM
A theory of how assets are priced, where the expected return on an asset is the sum of
the risk free rate of interest and a premium for bearing market risk.
Capital budgeting
The process of identifying and selecting investments in long-lived assets.
Capital gain
A gain (profit) on the sale of an asset used in business, which may receive preferential tax
treatment through an exclusion of a portion of the gain from taxation or simply from a
lower tax rate.
Capitalization rate
The discount rate that translates a future series of cash flows into a present value.
Capital lease
A rental obligation that is considered a long-term debt.
Capital market line
The preferred set of portfolios for risk averse investors that are a combination of the
optimal portfolio (i.e., market portfolio) and either borrowing or lending opportunities.
Capital rationing
A situation in which there is a limit on the amount of spending on long-term investment

projects.
Capital recovery period
See payback period
Cash flow from financing activities
Cash flows arising from the issuance, retirement, or repurchase of debt and equity
securities.
Cash flow from investing activities
Cash flows related to the purchase or sale of physical assets.
Cash flow from operating activities
Cash flows of the firm arising from day-to-day operations.
Cash flow interest coverage ratio
The ratio of a firm's cash flow available to pay interest to its interest expense; a measure
of a firm's use of financial leverage.
Cash flow risk
The uncertainty associated with the amount and timing of future cash flows from an
investment.
Cash flow statement
A summary of cash inflows and outflows. For an individual using the cash basis of
accounting, this statement is a summary of income (i.e., cash inflows) and expenses (i.e.,
cash outflows) during a period of time (e.g., a year). Also referred to as the income and
expenditures statement and the income statement.
Certified Financial Planner Board
A non-profit professional regulatory organization that regulates financial planners by

means of the trademark law, licensing individuals who meet its certification requirements
to use the registered CFP marks.
Commercial bank
A corporation that is chartered under federal and state regulations to provide financial
services to both individual and business customers.
Common stock
The residual (last-in-line) ownership of a corporation, represented by shares of stock.
Common-size analysis
The study of financial statements that have been restated such that each item is reported
as a percentage of a base, where the base for the balance sheet is total assets and the
base for the income statement is sales revenues.
Community property
Property owned by both parties to a marriage. In states with community property laws,
any property acquired after marriage becomes community property.
Compounding
Translating a value today into a future value, considering that interest is earned on
interest.
Compound interest
The payment of interest both on the principal amount and accumulated, earned interest.
Consensus forecast
A measure of the forecasts about a particular item, such as gross domestic product or a
company's earnings; in the case of analysts' earnings forecasts, the average of the
available forecasts is often used as the consensus forecast.
Consumer credit
Debt that is created when consumers are given an extenstion in the time to pay for goods
or services.
Consumer price index (CPI)
A measure of prices or the cost of living published by the Bureau of Labor Statistics of the
U.S. Department of Labor. The index is constructed to track the price level of a group of
goods and services.
Consumer Credit Protection Act
See Truth in Lending Act
Continuous compounding
An arrangement in which interest paid on interest such that the compounding period is the
smallest unit of time possible; compounding in which there are an infinite number of
compounding peiods.
Conventional mortgage
A loan, secured by a home, that has a fixed interest rate and is typically not insured or
guarenteed by a governmental agency.
Convertible security
A bond or stock that can be exchanged for another security of the issuer.
Corporation
A business entity created by law that is capable of entering into contracts, incurring
liabilities and carrying out business.
Correlation
Association of two variables.
Correlation coefficient
A statistical measure of the association between two variables that is bounded by -1

(perfect negative correlation) and +1 (perfect positive correlation); the ratio of the
covariance between two variables to the product of the standard deviations of the two
variables.
Cost of capital
The cost of funds to a business enterprise, usually stated in percentage terms; the
weighted average of the cost of debt and equity of a firm.
Coupon
The interest on a debt.
Coupon rate
The annual interest on an interest-bearing debt obligation, expressed as a percentage of

the security's face value.
Covariance
A statistical measure of the association between two variables.
Coverage ratio
A measure of a firm's ability to satisfy particular obligations (e.g., current ratio is a

measure of a firm's ability to satisfy its current liabilities).
Credit risk
The uncertainty regarding the timely payment of amounts owed.
Credit union
A non-profit cooperative that pools depositors' (members') funds and make loans to
members. Members have a common bond (e.g., same employer).
Cross-over rate
The discount rate at which the net present values of two projects are equal; the internal
rate of return of the differences in the cash flows of two projects.
Currency risk
The uncertainty associated with changes in the relative value of currencies.
Current asset
An asset that can reasonbly be expected to be liquidated (i.e., turned into cash) within
one operating cycle (which is usually one year).
Current liability
A debt obligation that is due within one year.
Current ratio
The ratio of a firm's current assets to its current liabilities; a coverage ratio.
D
Debentures
Debt backed only by the general credit of the issuer.
Declining balance method
A method of depreciation that applies a constant rate to a declining, undepreciated

balance of an asset's book value.
Default risk
The uncertainty associated with the payment of required cash flows of a security (that is,
the interest or principal of a bond) when promised.
Deferred annuity
A series of level cash flows that occur at regular intervals, though the first cash flow
occurs after the end of the first interval.
Deferred taxes
A tax obligation that is expected in the future, but for which the expense has been
deducted from income for financial reporting purposes.
Degree of financial leverage, DFL
The sensitivity of net income to owners to changes in operating income.
Degree of operating leverage, DOL
The sensitivity of operating earnings to change in unit sales.
Degree of total leverage, DTL
The sensitivity of net income to owners to changes in unit sales; the product of the degree
of operating leverage and the degree of financial leverage.
Depreciation
The allocation of the cost of an asset over its useful life.
Depreciation tax shield
the amount of tax that is eliminated because of the tax-deductibility of the depreciation
expense for the determination of taxes.
Depression
A severe recession, marked by high unemployment, low prices, and severally decreased
economic activity.
Derivative securities
Securities in which the value is determined (derived) from another security or asset.
Diluted earnings per share (Diluted EPS)
Net income, divided by the number of shares outstanding considering all dilutive
securities.
Discount bond
A bond that is selling for less than its face or par value; a bond whose coupon rate is less
than the bond's yield-to-maturity.
Discounted payback period
The time it takes for the initial investment to be paid back in terms of discounted future
cash flows, where future cash flows are discounted at the project's cost of capital.
Discounting
The process of translating a future value (i.e., a value at some future point in time) into a
current, present value (i.e., a value at the current point in time, today).
Discount interest
An interest rate on a loan arrangement in which the interest is "paid up front"; that is, the
funds available to the borrower are equal to the amount of the loan, less the discount
(specified as percentage of the loaned amount).
Diversifiable risk
Risk that can be eliminated by combining assets whose returns are not perfectly,
positively correlated with one another.
Diversification
The reduction of risk through the inclusion of different securities whose returns are not
perfectly positively correlated with one another.
Dividends received deduction
The deduction of a portion (specified in tax law) of dividends received by a corporation

from another corporation.
Dividend payout ratio
The ratio of dividends to earnings; the percentage of earnings that are paid out to owners
in the form of dividends.
Dividends per share
The ratio of dividends paid to the number of shares of stock outstanding.
Dividend valuation model (DVM)
A model that relates the price of a share of stock to expected next period dividends, the
expected growth rate of future dividends, and the required rate of return.
Du Pont system
A method of decomposing return ratios into components, the mosts common use of which
is to break return ratios in the profit margin and turnover components.
E
Earnings per share (EPS)
The net income of a company, divided by the number of shares outstanding.
Earnings surprise
The deviation of actual earnings from expected earnings; actual earnings per share less
expected or forecasted earnings per share.
Economic life
The estimate of the length of time that an asset will provide benefits to a firm. Also
referred to as the useful life.
Economic profit
The difference between revenues and costs, where costs include the opportunity cost of
invested funds and normal profits.
Economic value added, EVA
Another name for economic profit; EVA is a trademarked designation of Stern Stewart for
the concept of economic profit.
Effective annual rate, EAR
An annualized rate that considers compound interest; also known as the effective
annual rate of interest and the effective rate of interest.
Efficient frontier
The set of possible portfolios that dominate other portfolios in terms of risk and return.
Efficient market
A market in which information is reflected rapidly into asset prices.
Estate planning
The process by which clients ensure that the maximum portion of their estate will be left
to their heirs and beneficiaries.
Expected return
The anticipated return; regarding a probability distribution, the weighted average of the
possible outcomes, with the weights being the probabilities.
Externalties
Effects of an action by one party on another party not directly involved in the action.
F
Fiduciary duty
The responsibility to act in another's best interest.
Fiduciary relation
A relation that is founded on the trust or confidence of one party in the fidelity or integrity
of another party.
Financial analysis
The evaluation of the financial condition and operating performance of a business

enterprise.
Financial distress
The situation in which a business enterprise is having difficulty satisfying immediate and
near-term obligations, which may result in non-optimal financing and investment decisions
in an attempt to meet these obligations.
Financial leverage
The use of debt to finance a business which, because of the fixed financing expenses
associated with debt, results in a "leveraging" or accentuating effect on the returns to
owners; also referred to as gearing.
Financial leverage ratio
A ratio that reflects the extent to which a firm has financed its assets with debt.
Financial management
The management of the cash flows of a business to make a profit for the firm's owners.
Financial plan
A set of strategies and products that are available to meet the client's objectives.
Financial planning
Planning that includes the key aspects of a client's financial affairs and is targeted to
achieve the client's financial goals.
Fisher effect
The decomposition of the nominal interest rate into the inflation rate, the real return, and
the cross-product of the inflation rate and the real return.
The ratio of sales to fixed assets; a measure of the firm's ability to put fixed assets to
work to generate sales.
Fixed charge coverage ratio
The ratio of a firm's income available to cover fixed financing obligations to its fixed
financing obligation; a measure of a firm's use of financial leverage.
Futures contract
A security that represents an arrangement to buy or sell an asset at a fixed price at a

fixed time in the future.
Future value
The value at some time in the future of a current value or a series of cash flows.
Future value annuity factor
The sum of compound factors that is used to translate an annuity (i.e., a series of even,
periodic cash flows) into a value in the future.
G
General partnership
A partnership in which each partner is liable for the debts of the business (partner referred
to as a general partner). Each partner is liable for the debts of the partnership: "joint and
several" liability.
Geometric average
The nth root of the product of a series of n values; with respect to returns or interest
rates, geometric average rate = [(1 + i1)(1 + i2) ... (1 + in)]1/n - 1
, where ii is the interest rate or return for the ith item or time period.
Golden parachute
A compensation package that provides a significant benefit to an employee that loses his
or her job in the event of a change in control of a business.
Gross domestic product, GDP
A measure of the value of all goods and services produced by workers and capital in the
U.S.
Gross plant and equipment
The total cost of physical assets in the possession of the business.
Gross profit margin
The ratio of gross profit (i.e., sales less cost of goods sold) to sales; a measure of a firm's
profitability.
Growth rate
The rate of change in the value of an asset, generally stated on an annual basis.
H
Half-year convention
In tax law, one half year's depreciation is taken in the first year of an asset's life no
matter when in the year the asset is placed in service.
Home equity loan
A loan that uses the home as security (i.e., collateral), usually based on the difference
between the market value of the home and the amount due on the existing mortgage.
I
Illegal insider trading
Trading on material, non-public information.
Income and expenditures statement
See cash flow statement.
Income statement
A financial statement that conveys the revenues and expenses of a business enterprise.
Independent projects
In the context of capital budgeting, projects in which the acceptance of one does not
preclude the acceptance of another.
Inflation
The increase in the general level of prices for goods and services.
Installment credit
Credit that is repaid in two or more payments.
Insurable interest
What an insured person must stand to lose something if there is a loss associated with the
property. In the case of an insurable interest, the insured cannot lose more than his/her
financial interest in the property.
Intangible asset
An asset that has no physical existence, such as a patent or a trademark.
Interest
The compensation for the opportunity cost of funds and the uncertainty of repayment of
the amount borrowed.
Interest coverage ratio
The ratio of a firm's operating income (i.e., earnings before interest and taxes) to its
interest obligation; a measure of a firm's use of financial leverage.
Interest rate risk
The sensitivity of a security's price to a change in market yields.
Internal rate of return (IRR)
The return that equates the present value of an investment's inflows with the present
value of the investment's outflows; the return or interest rate that equates the cost of the
investment with the present value of the investment's future cash flows.
Inter vivos trust
See living trust.
Inventory
Raw materials and work-in-process used in the production of goods, as well as finished
goods held for sale.
Inventory turnover
The ratio of the cost of goods sold to inventory; a measure of how many times the
investment in inventory "turns over" or completely cycles through the firm from raw
materials to sold finished goods.
Investing
The process of purchasing securities for the long-term in the expectation of receiving
future benefits in terms of price appreciation and/or cash dividends.
Investment grade debt
Debt that has a credit quality rating of BBB (using Standard and Poor's system) or Baa
(using Moody's system) or better.
Investment policy
A statement that specifies, in general terms, the goals or objectives of the financial plan
considering the client's return objectives, risk tolerance, liquidity needs, time horizon, tax
situation, and estate goals.
Investment tax credit
A credit against taxes payable as a specific percentage of an asset's cost.
Investment profile
See net present value profile.
J
Joint and several liability
A liability in which a creditor may sue one or more parties to a liability separately or all
together.
Joint tenants with rights to survivorship
A form of ownership where the person shares the asset equally with one or more joint
owners and at an owner's death the assets automatically trnsfer to the other joint owner
(s). In this form of title, if one of the parties dies, the other joint owners have title to the
property and the property does not get tied up in probate and an owner cannot generaly
sell property without the consent of the other joint owners.
Joint venture
A partnership or a corporation that is formed by two or more entities for a specific

business purpose.
Junk bond
See speculative grade debt.
L
Liability
Debt obligation.
Liability insurance
Insurance that protects the insured against losses from legal actions.
Limited liability company (LLC)
A form of business permitted in some (but not all) states that is a hybrid of the
partnership and corporate forms. The LLC is taxed as a partnership (that is, the business'
taxable income flows through to the owners' income), yet has limited liability similar to a
corporation.
Limited partnership
A partnership in which one or more of the partners has limited liability.
Liquidity ratio
A ratio that conveys the ability of a business to satisfy its immediate obligations.
Living trust
A trust created during the lifetime of the grantor, with assets being transferred to the
trust during the grantor's lifetime.
Loan amortization
The process of determining the payments necessary to pay off a loan, considering the
compounding of interest.
Loan credit
Credit (borrowing) created by a financial institution.
Long term debt to assets ratio
The ratio of a firm's long-term debt (i.e., debt due beyond one year) to its total assets; a
measure of a firm's financial leverage.
Long term debt to equity ratio
The ratio of a firm's long-term debt (i.e., debt obligations due beyond one year) to its
shareholders' equity.
Long-term liabilities
Debt obligations that are due beyond one year into the future.
M
MACRS
See modified accelerated cost recovery system.
Marginal tax rate
The rate of tax on next dollar of taxable income.
Marketable securities
Securities that may be readily sold.
Market capitalization
The value of the equity interest; the product of the market price per share of stock and
the number of shares of stock outstanding.
Market equilibrium
A situation in a market where assets are bought and sold such that buying and selling are
in balance.
Market portfolio
The portfolio of assets that includes all investable assets; often proxied by the Standard
and Poor's 500 stock index.
Market risk
Non-diversifiable risk; the risk that is systematic across assets.
Market risk premium
The additional compensation required by investors for bearing market risk.
Market value
The current price of an asset, as determined in a market.
Market value added
the difference between the market value of a firm's capital and
Market value of equity
The current value of the ownership interest. In the case of a corporation, the product of
the market price of a share of stock and the number of shares outstanding.
Master limited partnership
A limited partnership in which the ownership units are traded in the public security
market.
Modern portfolio theory
The collection of theories that address the reduction of risk that results from the
combination of investments in a portfolio whose returns are not perfectly, positively
correlated with one another.
Modified accelerated cost recovery system (MACRS)
A depreciation system used in U.S. tax law that is based on a double declining balance
system with a half-year convention and no salvage value.
Modified internal rate of return, MIRR
The return or yields on an investment that considers the reinvestment of any cash flows
generated from the investment at a specified rate.
Monitoring costs
Costs incurred by an principal in an agency relationship for monitoring the actions of an

agent.
Mortgage
A loan secured by real estate.
Municipal bond
A debt security issued by a state or local government.
Mutual fund
An investment company that raises funds by selling stock to the public and then investing
the proceeds in other securities. The value of the stock of the mutual fund fluctuates with
the value of the individual securities that make up its investment portfolio.
Mutual savings bank
A financial institution that is owned by its members (its depositors) and that provides
consumer loans and accepts interest earning savings accounts.
Mutually exclusive projects
In the context of capital budgeting, projects in which the acceptance of one precludes the
acceptance of the other(s).
N
Net cash flow (NCF)
In the context of capital budgeting, the sum of the investment cash flow and operating
cash flow for a given period.
Net operating cycle
The length of time that it takes for a business to turn its investment of cash in goods and
services back into cash considering that both sales and purchases are made on credit.
Net operating loss
An excess of deductions over gross income from business operations.
Net plant and equipment
The difference between the gross plant and equipment and the accumulated depreciation;
the book value of physical assets.
Net present value
The difference between the present value of the future cash inflows and the present value
of the cash outflows of a project, where all cash flows are discounted at the cost of capital
for the project.
Net present value profile
A graphical representation of the net present value of a project for different discount
rates. Also referred to as the investment profile.
Net profit margin
The ratio of net income to sales; a measure of a firm's profitability.
The ratio of net working capital (i.e., current assets minus current liabilities) to sales; a
measure of liquidity.
Nominal interest rate
A rate of interest that is quoted without regard to compounding of interest within the
specified period of time (e.g., within a year); also known as the stated rate.
Nominal return
See nominal interest rate.
Non-investment grade debt
See speculative grade debt.
Normal profit
The minimum return suppliers of capital demand for the use of their funds.
Notes payable
Debt obligations of a business evidenced by promissory notes.
The number of days worth of inventory on hand, on average, throughout the period; the
ratio of the balance in inventory to the average day's cost of goods sold.
The number of days of payables due, on average, throughout the period; the ratio of the
balance in accounts payable to the average day's purchases.
The number of days of receivables, on average, throughout the period; the ratio of the
balance in accounts receivable to the average day's credit sales.
O
Operating cycle The length of time it takes to turn the investment of cash in goods and services back into cash in
terms of collections from customers.
Operating profit margin
The ratio of operating income (i.e., earnings before interest and taxes) to sales; a
measure of a firm's profitability.
Option
The right to buy (call option) or sell (put option) a specified asset at a specified price
within a specified period of time.
Ordinary annuity
A set of periodic, even cash flows in which the first cash flow occurs one period in the
future.
P
Partnership
A business enterprise owned by two or more persons who share the income and liability of
the business.
Par value
Face value of a security; for a share of stock, a nominal amount assigned per share
according to the company's charter; for a debt obligation, the amount owed.
Payback period
The number of periods in which it takes the original investment to be paid off in terms of
expected future cash flows. Also referred to as the capital recovery period and the payoff
period.
Payoff period
See payback period.
Perpetuity
A series of even cash flows that continue ad infinitum (i.e., forever).
Plant assets
Assets that have a physical existence, such as a building or a piece of equipment.
Portfolio
A collection of investments.
Pour-over trust
A trust that combines aspects of the living and testamentary trust; the trust is created
during the life of the grantor, yet the trust receives assets at the time of the granotr's
death (e.g., life insurance proceeds).
Prepayment risk
The uncertainty regarding whether a loan will be paid off early, resulting in an immediate
need to reinvest the loan proceeds in another investment vehicle.
Premium bond
A bond that has a price below the par or face value; bonds whose coupon rate is greater
than the yield-to-maturity on the bond.
Present value
The current value of a cash flow or a series of cash flows.
Present value annuity factor
The sum of discount factors that is used to translate an annuity (i.e., a series of even,
periodic cash flows) into a value today.
Price-earnings ratio (P/E)
The ratio of the market price per share of stock to the earnings per share of a corporation.
Primary market
A market in which a security is first sold, raising funds for the issuer.
Principal
In a loan situation, the amount borrowed. In an agency relationship, the party that gives
another party (the agent) authority to act in the principal's interest.
Probability distribution
The possible outcomes to an uncertain event and their respective likelihoods of occurence.
Principle of indemnity
The concept that an insured party cannot be compensated for more than the economic
loss suffered.
Professional corporation
A corporation in which the owners have unlimited liability.
Profitability ratio
A ratio of income to sales; example: the net profit margin is the ratio of net profit to
sales.
Profitability index
The ratio of the present value of a project's cash inflows to the present value of a project's
cash outflows.
Property insurance
Insurance that protects against losses of real or personal property from event such as fire,
wind, and theft.
Purchasing power risk
The uncertainty associated with unanticipated changes in inflation (and, hence, purchasing
power).
Q
Quick ratio
The ratio of current assets less inventory to current liabilities; a measure of the firm's
ability to meet its most immediate obligations.
R
Range
A statistical measure of dispersion that is the difference between the highest and lowest
valued observations or outcomes.
Real return
The return or yield on an investment after taking out the effects of inflation.
Recapture of depreciation
The difference between the lesser of an asset's original cost or sales price and its book
value for tax purposes, which is taxed as ordinary income for tax purposes.
Recession
A decline in business activity (output, employment, income and trade), that typically lasts
from six months to a year and is usually accompanied by contractions in the economy.
Recovery
In the context of economic conditions, a period of time in which levels of production,

employment, and sales begin to improve.
Registered Investment Adviser
An individual who provides investment advice and is required by the Investment Adviser
Act to register with the Securities and Exchange Commission.
Reinvestment rate risk
The uncertainty associated with the yield on the reinvestment of intermediate cash flows
(e.g., the interest earned on a bond).
Required rate of return
The return that shareholders demand to compensate themm for the time value of money
tied up in their investment and the uncertainty of the future cash flows from this
investment.
Residual loss
The implicit cost in an agency relationship that remains after monitoring and bonding
efforts, resulting from the misalignment of managers and owners' interests.
Residual value
The expected value of an asset at the end of its useful life. Also referred to as the salvage
value.
Retained earnings
In a balance sheet, the accumulation of prior periods' earnings, less any paid dividends; in
an income statement, the amount of earnings for the period not paid out in dividends.
Return
The income on an investment, generally stated as a percentage of the original investment

or beginning of year value.
Return on assets
The ratio of net income to total assets; a measure of a firm's return on its investment in
total assets.
Return on common equity
The ratio of earnings available to common shareholders to common shareholders' equity;

a measure of common shareholdes' return on their investment.
Return on equity
The ratio of net income to shareholders' equity; a measure of shareholders' return on their
investment.
Return ratio
A measure of the net benefit from the employment of resources, expressed as a ratio of
the net benefit to the amount of resources expended.
Reverse mortgage
A loan, secured by real estate, that provides periodic payments to the homeowner from
the financial institution, increasing the amount loan over time.
Right of subrogation
The right of the insurer to seek reimbursement from the party that caused the loss (or
from the person's insurance company).
Risk
In insurance, a danger or a hazard of a loss of the insured property. The chance of

deviating from the average or expected value.
Risk aversion
An individual's dislike for risk such that the individual must be compensated for bearing
risk.
Risk neutral
Indifferent towards risk.
Risk preferent
A desire to take on risk; a willingness to pay to take on risk.
Risk tolerance
An individual's ability to emotionally and financially deal with the exposure to a financial
loss.
Rule of 72
A rule of thumb that can be used to determine the length of time it takes for an amount to
double. The product of the number of periods and the interest rate (as a whole number) is
equal to 72 for the doubling of an amount.
Rule of 78
A method of determining the proportions of paid installments that are interest and
repayments of principal, and is, effectively, a penalty for early repayment of the loan.
S
Sales credit
Credit created by the seller of the goods or services.
Sales risk
The uncertainty associated with the number of units to be sold and the price at which
these units will be sold.
Salvage value
The expected value of an assetat the end of its useful life. Also referred to as the residual
value.
Savings and loan association
A financial institution that accepts savings deposits and provides home loans.
Secondary market
A market in which assets are sold among investors (e.g., NYSE).
Secured debt or secured loan
Debt backed by collateral; in the event of non-payment of interest and/or principal, the
specified asset can be sold and the proceeds used to pay the creditor.
Security market line
The relationship between the expected return on a security and the security's beta.
Shareholder ratio
A ratio that restates financial data in terms of a share of stock.
Simple interest
An interest arrangement on a loan such that interest is calculated based on the loaned
amount only.
Sole proprietorship
A business enterprise owned by one person.
Speculative grade debt
Debt that is rated BB -- using Standard and Poor's system (or Ba using Moody's system) -
- or less; non-investment grade debt; also referred to as junk bond.
Standard deviation
A statistical measure of dispersion; the square root of the variance.
Stakeholders
Persons who have an interest in the well-being of a company; the shareholders,

employees, community, and customers of a company.
Statement of cash flows
A financial statement that summarizes the cash flows from operating activities, the cash
flows from (or for) financing activities, and the cash flows from (or for) investing
activities.
Stated value
A nominal amount assigned to a share of stock for accounting purposes.
Statement of financial position
See Balance sheet.
Straight coupon
Interest specified as a fixed percentage of the security's face value.
Straight line depreciation
A method of depreciation that expenses the same amount of an asset's cost each year of
the asset's life.
Subchapter S corporation ("Sub S")
A corporation that qualifies for a special tax status that allows the corporation to be
treated as a partnership for tax purposes, bringing any losses directly to the owners'
individual tax returns.
Sum of years' digits
A method of depreciation that expenses an amount equal to ratio of the years remaining
in the asset's life to the sum of the years' of an assets's life.
Systematic risk
See market risk.
T
Testamentary trust
A trust established at the time of the death of the grantor.
Tax credit
A credit against taxes payable, which reduces taxes paid dollar-for-dollar.
Tenants in common
A form of ownership in which each owner's share can be sold, deeded, or given away
without the other owners' consent.
Tenants by the entirety
A form of ownership reserved for married persons in which the property is owned jointly
but the consent of the other spouse is required to divide or sell the property.
Terminal value
In the context of capital budgeting, the future value of an investment that includes both
the cash flows generated from the investment and the returns from reinvesting any
intermediate cash flows.
Term life insurance
An insurance policy in which the insurer agrees to pay a specified amount of money in he
event of the death of the insured during the policy period. There is no savings aspect to
term insurance and the specified amount may be fixed throughout the policy period
(straight term insurance) or decreasing throughout the policy period (decreasing term
insurance).
The ratio of a firm's total debt (i.e., current and long term debt) to its total assets; a
measure of a firm's financial leverage.
Treasury stock
The value of the shares of a corporation's own stock that is bought and held by the
corporation.
Trusts
A legal document that transfer the property and/or income of one party to another
party/parties.
Truth in Lending Act
A law that is intended to assure that every consumer who has the need for consumer
credit is given meaningful information with respect to the cost of credit. Also referred to as
the Consumer Credit Protection Act.
Turnover ratio
A measure of the gross benefit from the employment of resources, expressed as a ratio of
this gross benefit (e.g., sales revenue) to resources (e.g. total assets).
U
Unsystematic risk
The risk of an asset's returns that is unrelated to changes in the returns of the market in
general; also referred to as company-specific risk.
W
Whole life insurance
An insurance policy in which the insurer agrees to pay a specified amount of money in the
event of the death of the insured. Whole life policies also have a saving feature such that
there is a cash value of a policy, based on earnings on paid-in premiums, which increases
throughout the life of the policy.
Y
Yield
The amount earned on a security over a period of time, generally stated as a percentage
of the value of the security at the beginning of the period.
Yield curve
A representation of interest rates for different time remaining to maturity.
Yield to call
The return on a callable security calculated assuming that the security will be called (that
is, bought back by the security issuer) at a specific point in time at a specified call price;
usually calculated using the first available call.
Yield to maturity
The yield or return calculated assuming that the investor buys the security and holds it to
maturity.
Z
Zero-coupon bond
A debt obligation that does not pay explicit interest.
04.00.00.00
Regression
Page 1 of 2
Regression
z Notes on regression
z StudyMate Regression Activities
z Regression using Microsoft Excel
z Regression example with Solutions
z Home pricing example using data submitted by members of the class
Page 2 of 2

Notes on regression http://educ.jmu.edu/~drakepp/statistics/regression.pdf
StudyMate Regression Activities http://educ.jmu.edu/~drakepp/statistics/regress.htm
Regression using Microsoft Excel http://educ.jmu.edu/~drakepp/statistics/regression_using_Excel.pdf
Regression example http://educ.jmu.edu/~drakepp/statistics/regressionexample.pdf
Solutions http://educ.jmu.edu/~drakepp/statistics/regressionexample.xls
Home pricing example http://educ.jmu.edu/~drakepp/statistics/homepricing_class.xls
Correlation and Regression
Notes prepared by Pamela Peterson Drake
Index
Basic terms and concepts ...................................................................................................................1
Simple regression ...............................................................................................................................5
Multiple Regression ..........................................................................................................................13
Regression terminology .....................................................................................................................20
Regression formulas .........................................................................................................................21
Basic terms and concepts

1. A scatter plot is a graphical representation of the relation between two or more variables. In
the scatter plot of two variables x and y, each point on the plot is an x-y pair.
2. We use regression and correlation to describe the variation in one or more variables.
A. The variation is the sum
of the squared deviations
of a variable. Example1: Home sale prices and square footage
N Home sales prices (vertical axis) v. square footage for a sample
∑ ( x-x )
2
Variation= of 34 home sales in September 2005 in St. Lucie County.
i=1 $800,000
B. The variation is the $700,000
numerator of the $600,000
variance of a sample: $500,000
N Sales
$400,000
∑ (x-x )
2 price
$300,000
Variance= i=1 $200,000
N-1
$100,000
C. Both the variation and the
$0
variance are m easures
0 500 1,000 1,500 2,000 2,500 3,000
of the dispersion of a
sample. Square footage
3. The covariance between two

random variables is a statistical measure of the degree to which the two variables move together.
A. The covariance captures how one variable is different from its mean as the other variable
is different from its mean.
B. A positive covariance indicates that the variables tend to move together; a negative
covariance indicates that the variables tend to move in opposite directions.
C. The covariance is calculated as the ratio of the covariation to the sample size less one:
N
∑ (x -x)(y-y)
i=1
i i
Covariance =
N-1
where N is the sample size
xi is the ith observation on variable x,
x is the mean of the variable x observations,
yi is the ith observation on variable y, and
Regression Notes, Prepared by Pamela Peterson Drake 1 of 22

y is the mean of the variable y observations.
D. The actual value of the covariance is not meaningful because it is affected by the scale of
the two variables. That is why we calculate the correlation coefficient – to make
something interpretable from the covariance information.
E. The correlation coefficient , r, is a measure of the strength of the relationship between
or among variables.
Calculation:
Note: Correlation does not
covariance betwen x and y
r= imply causation. We may say
⎛ standard deviation ⎞⎛ standard deviation ⎞ that two variables X and Y are
⎜⎜ ⎟⎟⎜⎜ ⎟⎟
⎝ of x ⎠⎝ of y ⎠ correlated, but that does not
mean that X causes Y or that Y
⎛ N ⎞
⎜
⎜∑ (x-x)
i (yi -y) ⎟
⎟
causes X – they simply are
related or associated with one
⎝ i=1 ⎠
r=
( N-1) another.
N N
∑ (x-x) ∑ (y -y)
i=1,n
i
2
i
2
i=1
N-1 N-1
Example 2: Calculating the correlation coefficient

Squared Squared
Deviation deviation of Deviation deviation of Product of
of x x of y y deviations
Observation x y x- x (x- x ) 2 y- y (y- y )2 (x- x )(y- y )
1 12 50 -1.50 2.25 8.40 70.56 -12.60
2 13 54 -0.50 0.25 12.40 153.76 -6.20
3 10 48 -3.50 12.25 6.40 40.96 -22.40
4 9 47 -4.50 20.25 5.40 29.16 -24.30
5 20 70 6.50 42.25 28.40 806.56 184.60
6 7 20 -6.50 42.25 -21.60 466.56 140.40
7 4 15 -9.50 90.25 -26.60 707.56 252.70
8 22 40 8.50 72.25 -1.60 2.56 -13.60
9 15 35 1.50 2.25 -6.60 43.56 -9.90
10 23 37 9.50 90.25 -4.60 21.16 -43.70
Sum 135 416 0.00 374.50 0.00 2,342.40 445.00
Calculations:
x = 135/10 = 13.5
y = 416 / 10 = 41.6
s 2x = 374.5 / 9 = 41.611
s 2y = 2,342.4 / 9 = 260.267
445/9 49.444
r= = =0.475
41.611 260.267 (6.451)(16.133)
i. The type of relationship is represented by the correlation coefficient:

r =+1 perfect positive correlation
+1 >r > 0 positive relationship

r=0 no relationship
0 > r > −1 negative relationship
r = −1 perfect negative correlation
ii. You can determine the degree of correlation by looking at the scatter graphs.
• If the relation is upward there is positive correlation.
• If the relation downward there is negative correlation.
Y 0 < r < 1.0 Y -1.0 < r < 0

X X
iii. The correlation coefficient is bound by –1 and +1. The closer the coefficient to –1 or +1,
the stronger is the correlation.
iv. With the exception of the extremes (that is, r = 1.0 or r = -1), we cannot really
talk about the strength of a relationship indicated by the correlation coefficient
without a statistical test of significance.
v. The hypotheses of interest regarding the population correlation, ρ, are:
Null hypothesis H0: ρ =0
In other words, there is no correlation between the two variables
Alternative hypothesis Ha: ρ=
/ 0
In other words, there is a Example 2, continued

correlation between the In the previous example,
two variables
r = 0.475
vi. The test statistic is t-distributed with n- N = 10
2 degrees of freedom:
0.475 8 1.3435
r N- 2 t= = = 1.5267
t= 1 − 0.475 2 0.88
1 - r2
vii. To make a decision, compare the calculated t-statistic with the critical t-statistic
for the appropriate degrees of freedom and level of significance.

P roblem
Suppose the correlation coefficient is 0.2 and the number of observations is 32. What is the calculated test
statistic? Is this significant correlation using a 5% level of significance?
Solution
Hypotheses:
H0: ρ=0
Ha: ρ≠0
0.2 32 - 2 0.2 30
Calculated t -statistic: t= = = 1.11803
1 - 0.04 0.96
Degrees of freedom = 32-1 = 31
The critical t-value for a 5% level of significance and 31 degrees of freedom is 2.042. Therefore, there is no
significant correlation (1.11803 falls between the two critical values of –2.042 and +2.042).
P roblem
Suppose the correlation coefficient is 0.80 and the number of observations is 62. What is the calculated test
statistic? Is this significant correlation using a 1% level of significance?
Solution
Hypotheses: H0: ρ=0 v. Ha: ρ≠0
0.80 62 − 2 0.80 50 5.65685
Calculated t -statistic: t= = = = 9.42809
1 − 0.64 0.36 0.6
The critical t-value for a 1% level of significance and 11 observations is 3.169. Therefore, the null hypothesis
is rejected and we conclude that there is significant correlation.
F. An outlier is an extreme value of a variable. The outlier may be quite large or small
(where large and small are defined relative to the rest of the sample).
i. An outlier may affect the sample statistics, such as a correlation coefficient. It is
possible for an outlier to affect the result, for example, such that we conclude
that there is a significant relation when in fact there is none or to conclude that
there is no relation when in fact there is a relation.
ii. The researcher must exercise judgment (and caution) when deciding whether to
include or exclude an observation.
G. Spurious correlation is the appearance of a relationship when in fact there is no
relation. Outliers may result in spurious correlation.
i. The correlation coefficient does not indicate a causal relationship. Certain data
items may be highly correlated, but not necessarily a result of a causal
relationship.
ii. A good example of a spurious correlation is snowfall and stock prices in January.
If we regress historical stock prices on snowfall totals in Minnesota, we would get
a statistically significant relationship – especially for the month of January. Since
there is not an economic reason for this relationship, this would be an example
of spurious correlation.

Simple regression
1. R egression is the analysis of the relation between one variable and some other variable(s),
assuming a linear relation. Also referred to as least squares regression and ordinary least
squares ( OLS ).
A. The purpose is to explain the variation in a variable (that is, how a variable differs from
it's mean value) using the variation in one or more other variables.
B. Suppose we want to describe, explain, or predict why a variable differs from its mean.
Let the ith observation on this variable be represented as Yi, and let n indicate the
number of observations.
The variation in Yi's (what we want to explain) is:
N
Variation
∑ (y-y )
2
= i = SSTotal
of Y
i=1
C. The least squares principle is that the regression line is determined by minimizing the
sum of the squares of the vertical distances between the actual Y values and the
predicted values of Y.
Y
A line is fit through the XY points such that the sum of the squared residuals (that is, the
sum of the squared the vertical distance between the observations and the line) is
minimized.
2. The variables in a regression relation consist of dependent and independent variables.
A. The dependent variable is the variable whose variation is being explained by the other
variable(s). Also referred to as the ex plain ed variable , the endogenous variable , or
the predicted variable .
B. The independent variable is the variable whose variation is used to explain that of the
dependent variable. Also referred to as the ex planatory variable , the ex ogenous
variable , or the p r e d icting variable.
C. The parameters in a simple regression equation are the slope (b1) and the intercept (b0):
yi = b0 + b1 xi + εi
where yi is the ith observation on the dependent variable,

xi is the ith observation on the independent variable,
b0 is the intercept.
b1 is the slope coefficient,
εi is the residual for the ith observation.

Y
b1

b0
0 X
D. The slope , b1, is the change in Y for a given one- Hint: Think of the regression line
unit change in X. The slope can be positive, as the average of the relationship
negative, or zero, calculated as: between the independent
N variable(s) and the dependent
∑ (y
i=1
i − y)(x i − x) variable. The residual represents
the distance an observed value of
cov(X, Y) N −1 the dependent variables (i.e., Y) is
b1 = = N
var(X) away from the average relationship
∑ (x
i =1
i − x) 2
as depicted by the regression line.
N−1
Suppose that: A short -cut formula for the slope coefficient:

N
⎛N N ⎞
∑ (y − y)(x i − x ) = 1,000 N
∑ (yi − y)(xi − x) N
⎜
⎜ ∑ xi ∑ yi ⎟
⎟
∑ xi yi − ⎝ i=1 i= 1 ⎠N
i=1
i=1
N
b1 = N − 1 = i =1
∑ (x i − x ) 2 = 450 N
∑ (xi − x )2
⎛ N
⎜⎛ x ⎞
2 ⎞
⎟
i=1
i=1 N ⎜⎜⎜ ∑ ⎟
i⎟ ⎟
N= 30 N −1 ∑ xi2 − ⎜ ⎝ i=1 ⎠ N ⎟
i =1 ⎜ ⎟
Then ⎜ ⎟
⎜ ⎟
⎝ ⎠
1,000 Whether this is truly a short-cut or not depends on the method of
b̂1= 29 = 34.48276 =2.2222
performing the calculations: by hand, using Microsoft Excel, or
450 15.51724
29 using a calculator.
E. The intercept , b0, is the line’s intersection with the Y-axis at X=0. The intercept can be
positive, negative, or zero. The intercept is calculated as:
b̂0 =y-b1 x

3. Linear regression assumes the
following: Example 1, continued:
A. A linear relationship exists Home sales prices (vertical axis) v. square footage for a sample
between dependent and of 34 home sales in September 2005 in St. Lucie County.
independent variable. $800,000
Note: if the relation is not
$600,000
linear, it may be possible
to transform one or both $400,000
variables so that there is a Sales
$200,000
price
linear relation.
$0
B. The independent variable
-$200,000
is uncorrelated with the
residuals; that is, the -$400,000
independent variable is -1,000 0 1,000 2,000 3,000 4,000
not random. Square footage
C. The expected value of the
disturbance term is zero;
that is, E(εi)=0
D. There is a constant variance of the disturbance term; that is, the disturbance or residual
terms are all drawn from a distribution with an identical variance. In other words, the
disturbance terms are hom osk edastistic . [A violation of this is referred to as
heterosk edasticity .]
E. The residuals are independently distributed; that is, the residual or disturbance for one
observation is not correlated with that of another observation. [A violation of this is
referred to as autocorrelation.]
F. The disturbance term (a.k.a. r e s i d u a l, a.k.a. error t erm ) is normally distributed.
4. The standard error of the estim ate , SEE, (also referred to as the standard error of the
resid u al or standard error of the regression , and often indicated as se) is the standard
deviation of predicted dependent variable values about the estimated regression line.
SSResidual
5. Standard error of the estimate (SEE) = se2 =
N− 2
2
∑( )
N N N
∑ ∑ eˆ
2
y i − bˆ 0 − bˆ i x i
2
(y i − yˆ i ) i
i=1 i =1 i=1
SEE = = =
N−2 N−2 N−2
where SSResidualis the sum of squared errors;
^ indicates the predicted or estimated value of the variable or parameter;
and
ŷ I = bˆ 0 + bˆ i xi, is a point on the regression line corresponding to a value of the
independent variable, the xi; the expected value of y, given the estimated mean
relation between x and y.

A. The standard error of the estimate Example 2, continued
helps us gauge the "fit" of the
regression line; that is, how well we Consider the following observations on X and Y:
have described the variation in the Observation X Y
dependent variable. 1 12 50
i. The smaller the standard 2 13 54
error, the better the fit. 3 10 48
4 9 47
ii. The standard error of the 5 20 70
estimate is a measure of 6 7 20
close the estimated values 7 4 15
(using the estimated 8 22 40
regression), the ŷ 's, are to 9 15 35
the actual values, the Y's. 10 23 37
Sum 135 416
iii. The εi’s (a.k.a. the
disturbance terms; a.k.a. The estimated regression line is:
the residuals) are the
vertical distance between yi = 25.559 + 1.188 xi
the observed value of Y and
and the residuals are calculated as:
that predicted by the
y y- y
equation, the ŷ 's. Observation x y ε2
1 12 50 39.82 10.18 103.68
iv. The εi’s are in the same
2 13 54 41.01 12.99 168.85
terms (unit of measure) as
3 10 48 37.44 10.56 111.49
the Y’s (e.g., dollars,
4 9 47 36.25 10.75 115.50
pounds, billions)
5 20 70 49.32 20.68 427.51
6. The coefficient of determ ination , R2, is 6 7 20 33.88 -13.88 192.55
the percentage of variation in the 7 4 15 30.31 -15.31 234.45
dependent variable (variation of Yi's or the 8 22 40 51.70 -11.70 136.89
sum of squares total, SST) explained by the 9 15 35 43.38 -8.38 70.26
independent variable(s). 10 23 37 52.89 -15.89 252.44
Total 0 1,813.63
A. The coefficient of determination is
calculated as: Therefore,
Explained variation SSResidaul = 1813.63 / 8 = 226.70
R2= SEE = √226.70 = 15.06
Total variation
Total variation − Unexplained variation SS Total − SS Residual SS Regression
= = =
Total variation SS Total SS Total
B. An R2 of 0.49 indicates that the independent variables explain 49% of the variation in
the dependent variable.

Example 2, continued
Continuing the previous regression example, we can calculate t he R2:
Observation x y (y- y ) 2 ŷ Y- ŷ ( ŷ - y ) 2 ε2
1 12 50 70.56 39.82 10.18 3.18 103.68
2 13 54 153.76 41.01 12.99 0.35 168.85
3 10 48 40.96 37.44 10.56 17.30 111.49
4 9 47 29.16 36.25 10.75 28.59 115.50
5 20 70 806.56 49.32 20.68 59.65 427.51
6 7 20 466.56 33.88 -13.88 59.65 192.55
7 4 15 707.56 30.31 -15.31 127.43 234.45
8 22 40 2.56 51.70 -11.70 102.01 136.89
9 15 35 43.56 43.38 -8.38 3.18 70.26
10 23 37 21.16 52.89 -15.89 127.43 252.44
Total 416 2,342.40 416.00 0.00 528.77 1,813.63
R2 = 528.77 / 2,342.40 = 22.57%

or
R2 = 1 – (1,813.63 / 2,342.40) = 1 – 0.7743 = 22.57%
7. A confidence interval is the range of regression coefficient values for a given value estimate of
the coefficient and a given level of probability.
A. The confidence interval for a regression coefficient b̂1 is calculated as:
b̂1 ± t cs b̂
1
or
b̂1 − t c s b̂ < b1 < b̂1 + t c s b̂

1 1
where tc is the critical t-value for the selected confidence level. If there are 30 degrees
of freedom and a 95% confidence level, tc is 2.042 [taken from a t-table].
B. The interpretation of the confidence interval is that this is an interval that we believe will
include the true parameter ( s b̂ in the case above) with the specified level of confidence.
1
8. As the standard error of the estim ate (the variability of the data about the regression line)
rises, the confidence widens. In other words, the more variable the data, the less confident you
will be when you’re using the regression model to estimate the coefficient.
9. The standard error of the coefficient is the square root of the ratio of the variance of the
regression to the variation in the independent variable:
s 2e
s bˆ =
1 n
∑ (x
i=1
i − x) 2
A. Hypothesis testing: an individual explanatory variable

i. To test the hypothesis of the slope coefficient (that is, to see whether the
estimated slope is equal to a hypothesized value, b0 , Ho: b = b1, we calculate
a t-distributed statistic:
b̂1 -b1
tb =
sb̂
1
ii. The test statistic is t−distributed with N−k−1 degrees of freedom (number of
observations (N), less the number of independent variables (k), less one).
B. If the t−statistic is greater than the critical t−value for the appropriate degrees of
freedom, (or less than the critical t−value for
a negative slope) we can say that the slope Note: The formula for the standard
coefficient is different from the hypothesized error of the coefficient has the variation
value, b1. of the independent variable in the
C. If there is no relation between the denominator, not the variance. The
dependent and an independent variable, the variance = variation / n-1.
slope coefficient, b1, would be zero.
Y

b0 b1 = 0

0 X
• A zero slope indicates that there is no change in Y for a given change in X

• A zero slope indicates that there is no relationship between Y and X.
D. To test whether an independent variable explains the variation in the dependent variable,
the hypothesis that is tested is whether the slope is zero:
Ho: b1= 0
versus the alternative (what you conclude if you reject the null, Ho):
Ha: b1 =
/ 0
This alternative hypothesis is referred to as a two-sided hypothesis. This means that we
reject the null if the observed slope is different from zero in either direction (positive or
negative).
E. There are hypotheses in economics that refer to the sign of the relation between the
dependent and the independent variables. In this case, the alternative is directional (>
or <) and the t-test is one-sided (uses only one tail of the t-distribution). In the case of a
one-sided alternative, there is only one critical t-value.

Example 3: Testing the significance of a slope coefficient
Suppose the estimated slope coefficient is 0.78, the sample size is 26,
the standard error of the coefficient is 0.32, and the level of
significance is 5%. Is the slope difference than zero?
bˆ 1 − b1 0.78 − 0
The calculated test statistic is: tb = = = 2.4375
s b̂ 0.32
1
The critical t-values are ± 2.060:
-2.060
2.060
___________|__________________|__________
Reject H0 Fail to reject H0 Reject H0
Therefore, we reject the null hypothesis, concluding that the slope is

different from zero.
10. Interpretation of coefficients.

A. The estimated intercept is interpreted as the value of the dependent variable (the Y) if
the independent variable (the X) takes on a value of zero.
B. The estimated slope coefficient is interpreted as the change in the dependent variable for
a given one-unit change in the independent variable.
C. Any conclusions regarding the importance of an independent variable in explaining a
dependent variable requires determining the statistical significance if the slope
coefficient. Simply looking at the magnitude of the slope coefficient does not address
this issue of the importance of the variable.
11. Forecasting is using regression involves making predictions about the dependent variable based
on average relationships observed in the estimated regression.
A. P redicted values are

values of the Example 4
dependent variable Suppose you estimate a regression model with the following
based on the estimated estimates:
regression coefficients ŷ = 1.50 + 2.5 X 1
and a prediction about In addition, you have forecasted value for the independent variable,
the values of the X1 =20. The forecasted value for y is 51.5:
independent variables. ŷ = 1.50 + 2.50 (20) = 1.50 + 50 = 51.5
B. For a simple regression,
the value of Y is predicted as:

ŷ = bˆ 0 + bˆ i xp
where ŷ is the predicted value of the dependent variable, and
xp is the predicted value of the independent variable (input).
12. An analysis of variance table (AN OVA table) table is a summary of the explanation of the
variation in the dependent variable. The basic form of the ANOVA table is as follows:
Degrees of
Source of variation freedom Sum of squares Mean square
Regression (explained) 1 Sum of squares regression Mean square regression =
(SSRegression) SSRegression
1
Error (unexplained) N-2 Sum of squares residual SSResidual
Mean square error =
(SSResidual) N-2
Total N-1 Sum of squares total
(SSTotal)
Example 5
Source of Degrees of Sum of Mean
variation freedom squares square
Regression (explained) 1 5050 5050
Error (unexplained) 28 600 21.429
Total 29 5650
5,050
R2 = =0.8938 or 89.38%
5,650
600
SEE = = 21.429 =4.629
28

Multiple Regression
1. M ultiple regression is regression analysis with more than one independent variable.
A. The concept of multiple regression is identical to that of simple regression analysis
except that two or more independent variables are used simultaneously to explain
variations in the dependent variable.
y = b0 + b1 x1 + b2x2 + b3x3 + b4 x4
B. In a multiple regression, the goal is to We do not represent the multiple
minimize the sum of the squared errors. regression graphically because it would
Each slope coefficient is estimated while require graphs that are in more than two
holding the other variables constant. dimensions.
2. The intercept in the regression equation has the
same interpretation as it did under the simple linear case – the intercept is the value of the
dependent variable when all independent variables are equal zero.
3. The slope coefficient is the parameter that reflects the change in the dependent variable for a
one unit change in the independent variable.
A. The slope coefficients (the betas) are A slope by any other name …
described as the movement in the • The slope coefficient is the elasticity
dependent variable for a one unit of the dependent variable with
change in the independent variable – respect to the independent variable.
holding all other independent variables
• In other words, it’s the first
constant.
derivative of the dependent variable
B. For this reason, beta coefficients in a with respect to the independent
multiple linear regression are sometimes variable.
called partial betas or partial regression
coefficients .
4. Regression model:
Yi = b0 + b1 x1i + b2 x2i + εi
where:
bj is the slope coefficient on the jth independent variable; and
xji is the ith observation on the jth variable.
A. The degrees of freedom for the test of a slope coefficient are N-k-1, where n is the
number of observations in the sample and k is the number of independent variables.
B. In multiple regression, the independent variables may be correlated with one another,
resulting in less reliable estimates. This problem is referred to as m ulticollinearity .
5. A confidence interval for a population regression slope in a multiple regression is an interval
centered on the estimated slope:
b̂ i ± t cs b̂
i
or
{b̂ i − t c s bˆ < b i < b̂ i + t c s bˆ

i i
}
A. This is the same interval using in simple regression for the interval of a slope coefficient.
B. If this interval contains zero, we conclude that the slope is not statistically different from
zero.

6. The assumptions of the multiple regression model are as follows:
A. A linear relationship exists between dependent and independent variables.
B. The independent variables are uncorrelated with the residuals; that is, the independent
variable is not random. In addition, there is no exact linear relation between two or
more independent variables. [Note: this is modified slightly from the assumptions of the
simple regression model.]
C. The expected value of the disturbance term is zero; that is, E(εi)=0
D. There is a constant variance of the disturbance term; that is, the disturbance or residual
terms are all drawn from a distribution with an identical variance. In other words, the
disturbance terms are hom osk edastistic . [A violation of this is referred to as
heterosk edasticity .]
E. The residuals are independently distributed; that is, the residual or disturbance for one
observation is not correlated with that of another observation. [A violation of this is
referred to as autocorrelation.]
F. The disturbance term (a.k.a. residual, a.k.a. error term) is normally distributed.
G. The residual (a.k.a. disturbance term, a.k.a. error term) is what is not explained by the
independent variables.
7. In a regression with two independent variables, the resid u al for the ith observation is:
εi =Y i – ( b̂ 0 + b̂1 x1i + b̂ 2 x2i)

8. The standard error of the estim ate (SEE) is the standard error of the residual:
N
∑ eˆ 2
t
SSE
t =1
se = SEE = =
N − k −1 N − k −1
9. The degrees of freedom , df, are calculated as:
number of number of
df = − − 1 = N − k − 1 = N − (k + 1)
observatio ns independen t variable s
A. The degrees of freedom are the number of independent pieces of information that are
used to estimate the regression parameters. In calculating the regression parameters,
we use the following pieces of information:
• The mean of the dependent variable.
• The mean of each of the independent variables.
B. Therefore,
• if the regression is a simple regression, we use the two degrees of freedom in
estimating the regression line.
• if the regression is a multiple regression with four independent variables, we use five
degrees of freedom in the estimation of the regression line.

10. Forecasting is using regression involves
making predictions about the dependent Example 6: Using analysis of variance
variable based on average relationships information
observed in the estimated regression. Suppose we estimate a multiple regression model
A. P redicted values are values of that has five independent variables using a sample
the dependent variable based on of 65 observations. If the sum of squared residuals
the estimated regression is 789, what is the standard error of the estimate?
coefficients and a prediction Solution
about the values of the
independent variables. Given:
B. For a simple regression, the value SSResidual = 789

of y is predicted as: N = 65
k=5
yˆ = bˆ 0 + bˆ 1 xˆ 1 + bˆ 2 xˆ 2
789 789
where SEE = = =13.373
65-5-1 59
ŷ is the predicted value of
the dependent variable,
b̂ i is the estimated parameter, and
x̂ i is the predicted value of the independent variable
C. The better the fit of the regression Caution: The estimated intercept and
(that is, the smaller is SEE), the more all the estimated slopes are used in the
confident we are in our predictions. prediction of the dependent variable
value, even if a slope is not statistically
significantly different from zero.
Example 7: Calculating a forecasted value
Suppose you estimate a regression model with the following estimates:

^
Y = 1.50 + 2.5 X 1 − 0.2 X 2 + 1.25 X 3
In addition, you have forecasted values for the independent variables:
X 1=20 X 2=120 X 3=50
What is the forecasted value of y?
Solution
The forecasted value for Y is 90:
^
Y = 1.50 + 2.50 (20) − 0.20 (120) + 1.25 (50)
= 1.50 + 50 − 24 + 62.50 = 90
11. The F-statistic is a measure of how well a set of independent variables, as a group, explain the
variation in the dependent variable.
A. The F-statistic is calculated as:

N
(yî − y)2
Mean squared regression MSR
SSRegression
∑ k
F= = = k = i=1
Mean squared error MSE SSResidual N
(yi − ˆy)2
N-k-1 ∑ N− k −1
i=1
B. The F−statistic can be formulated to test all independent variables as a group (the most
common application). For example, if there are four independent variables in the model,
the hypotheses are:
H0: b1 = b 2 = b3 = b 4 = 0
Ha: at least one bi ≠ 0
C. The F-statistic can be formulated to test subsets of independent variables (to see
whether they have incremental explanatory power). For example if there are four
independent variables in the model, a subset could be examined:
H0: b1=b 4 =0
Ha: b1 or b4 ≠ 0
12. The coefficient of determ in a t io n , R2, is the percentage of variation in the dependent variable
explained by the independent variables.
Total Unexplained
-
Explained variation variation variation
R2 = =
Total variation Total variation
∑ (yˆ − y) 2
R2 = i=1
N
∑ (y − y) 2 0 < R2 < 1
i=1
A. By construction, R2 ranges from 0 to 1.0

B. The adjusted-R 2 is an alternative to R2:
⎛ N −1 ⎞
R 2 =1−⎜ ⎟(1 − R 2 )
⎝N−k⎠
i. The adjusted R2 is less than or equal to R2 (‘equal to’ only when k=1).
ii. Adding independent variables to the model will increase R2. Adding independent
variables to the model may increase or decrease the adjusted-R2 (Note:
adjusted-R2 can even be negative).
iii. The adjusted R2 does not have the “clean” explanation of explanatory power that
the R2 has.
13. The purpose of the Analysis of Variance (ANOVA) table is to attribute the total variation of the
dependent variable to the regression model (the regression source in column 1) and the residuals
(the error source from column 1).
A. SSTotal is the total variation of Y about its mean or average value (a.k.a. total sum of
squares) and is computed as:

n
SS Total = ∑ (y -y)
i=1
i
2
where y is the mean of Y.
B. SSResidual (a.k.a. SSE) is the variability that is unexplained by the regression and is
computed as:
n
SSResidual =SSE= ∑ ( y -ˆy ) =∑ ê
i=1
i i
2
i
where is Ŷ the value of the dependent variable using the regression equation.
C. SSRegression (a.k.a. SSExplained) is the variability that is explained by the regression equation
and is computed as SSTotal – SS Residual.
N
SSRegression = ∑ (y-y)
i=1
ˆ i
2
D. MSE is the mean square error, or MSE = SSResidual / (N – k - 1) where k is the number of
independent variables in the regression.
E. MSR is the mean square regression, MSR =SSRegression / k
Analysis of Variance Table (ANOVA)
df SS Mean
(Degrees of (Sum of Square
Source Freedom) Squares) (SS/df)
Regression k SSRegression MSR
Error N-k-1 SSResidual MSE
Total N-1 SSTotal
SS Regression SSResidual
R2= =1-
SS Total SS Total
MSR
F=
MSE
14. Dum m y variables are qualitative variables that take on a value of zero or one.
A. Most independent variables represent a continuous flow of values. However, sometimes
the independent variable is of a binary nature (it’s either ON or OFF).
B. These types of variables are called dummy variables and the data is assigned a value of
"0" or "1". In many cases, you apply the dummy variable concept to quantify the impact
of a qualitative variable . A dummy variable is a dichotomous variable; that is, it
takes on a value of one or zero.

C. Use one dummy variable less than the number of classes (e.g., if have three classes, use
two dummy variables), otherwise you fall into the dummy variable "trap" (perfect
multicollinearity – violating assumption [2]).
D. An interactive dummy variable is a dummy variable (0,1) multiplied by a variable to
create a new variable. The slope on this new variable tells us the incremental slope.
15. Heterosk edasticity is the situation in which the variance of the residuals is not constant across
all observations.
A. An assumption of the regression methodology is that the sample is drawn from the same
population, and that the variance of residuals is constant across observations; in other
words, the residuals are homoskedastic.
B. Heteroskedasticity is a problem because the estimators do not have the smallest possible
variance, and therefore the standard errors of the coefficients would not be correct.
16. Autocorrelation is the situation in which the residual terms are correlated with one another.
This occurs frequently in time-series analysis.
A. Autocorrelation usually appears in time series data. If last year’s earnings were high, this
means that this year’s earnings may have a greater probability of being high than being
low. This is an example of positive autocorrelation . When a good year is always
followed by a bad year, this is negative autocorrelation.
B. Autocorrelation is a problem because the estimators do not have the smallest possible
variance and therefore the standard errors of the coefficients would not be correct.
17. M ulticollinearity is the problem of high correlation between or among two or more
independent variables.
A. Multicollinearity is a problem because
i. The presence of multicollinearity can cause distortions in the standard error and
may lead to problems with significance testing of individual coefficients, and
ii. Estimates are sensitive to changes in the sample observations or the model
specification.
B. If there is multicollinearity, we are more likely to conclude a variable is not important.
C. Multicollinearity is likely present to some degree in most economic models. P erfect
m ulticollinearity would prohibit us from estimating the regression parameters. The
issue then is really a one of degree.
18. The economic meaning of the results of a regression estimation focuses primarily on the slope
coefficients.
A. The slope coefficients indicate the change in the dependent variable for a one-unit
change in the independent variable. This slope can than be interpreted as an elasticity
measure; that is, the change in one variable corresponding to a change in another
variable.
B. It is possible to have statistical significance, yet not have economic significance (e.g.,
significant abnormal returns associated with an announcement, but these returns are not
sufficient to cover transactions costs).

To… use…
test the role of a single variable in explaining the variation the t -statistic.
in the dependent variable
test the role of all variables in explaining the variation in the the F-statistic.
dependent variable
estimate the change in the dependent variable for a one- the slope coefficient.
unit change in the independent variable
estimate the dependent variable if all of the independent the intercept.
variables take on a value of zero
estimate the percentage of the dependent variable’s the R2.
variation explained by the independent variables
forecast the value of the dependent variable given the the regression equation,
estimated values of the independent variable(s) substituting the estimated values
of the independent variable(s) in
the equation.

Regression terminology
Analysis of variance Perfect negative correlation

ANOVA Perfect positive correlation
Autocorrelation Positive correlation
Coefficient of determination Predicted value
Confidence interval R2
Correlation coefficient Regression
Covariance Residual
Covariation Scatterplot
Cross-sectional se
Degrees of freedom SEE
Dependent variable Simple regression
Explained variable Slope
Explanatory variable Slope coefficient
Forecast Spurious correlation
F-statistic SSResidual
Heteroskedasticity SSRegression
Homoskedasticity SSTotal
Independent variable Standard error of the estimate
Intercept Sum of squares error
Least squares regression Sum of squares regression
Mean square error Sum of squares total
Mean square regression Time-series
Multicollinearity t-statistic
Multiple regression Variance
Negative correlation Variation
Ordinary least squares

Regression formulas
Variances
N N
N ∑ (x − x)2 ∑ (x-x)(y-y)
i i
Variation = ∑ (x − x )
2 i =1 i =1
Variance = Covariance =
i=1
N−1 N-1
Correlation
⎛ N ⎞
∑
⎜ (x − x) 2 (y − y) 2 ⎟
⎜ i i ⎟
⎝ i=1 ⎠
r=
(N − 1) t=
r N- 2
N N
1 - r2
∑ (x
i =1,n
i − x) ∑ (y i − y) 2
i =1
N −1 N −1
Regression
yi = b0 + b1 xi + εi y = b0 + b1 x1 + b2x2 + b3x3 + b4 x4 + εi
N
∑ (y
i=1
i − y)(x i − x)
cov(X, Y) N −1
b1 = = N
b̂0 =y-b1 x
var(X)
∑ (x
i =1
i − x) 2
N−1
Tests and confidence intervals

2
∑( )
N N N
∑ ∑ eˆ
2
y i − bˆ 0 − bˆ i x i
2
(y i − yˆ i ) i
i=1 i =1 i=1
se = = =
N−2 N−2 N−2
s 2e
s bˆ =
1 n
∑ (x
i=1
i − x) 2
N
(yî − y)2
b̂1 -b1 Mean squared regression MSR
SSRegression
∑ k
tb = F= = = k = i=1
sb̂ Mean squared error MSE SSResidual N
(yi − ˆy)2
1
N-k-1 ∑
i=1
N− k −1
b̂1 − t c s b̂ < b1 < b̂1 + t c s b̂

1 1
Simple Regression, prepared by Pamela Peterson Drake 21

Forecasting
ˆ +ˆb x + ˆb x +ˆb x +...+bx
ŷ=b ˆ
0 i 1p i 2p i 3p i Kp
Analysis of Variance
n n N
SS Total = ∑
i=1
(y i -y) 2 SSResidual =SSE= ∑
i=1
∑
( yi -ˆyi 2) = ˆ
ei ∑ (y-y)
SSRegression = ˆ
i=1
i
2
SS Regression ⎛ SS ⎞
∑ (yˆ − y) 2
i=1
R2= =1- ⎜ Residual ⎟ = N
SS Total ⎝ SS Total ⎠
∑ (y − y)
i=1
2
N
(yî − y)2
Mean squared regression MSR
SSRegression
∑ k
F= = = k = i=1
Mean squared error MSE SSResidual N
(yi − ˆy)2
N-k-1 ∑ N− k −1
i=1
Simple Regression, prepared by Pamela Peterson Drake 22

Regression StudyMate Page 1 of 2
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Flash Cards
Pick a Letter
Fill In The Blank
Matching
Crosswords
Quiz
Challenge
Glossary
http://educ.jmu.edu/~drakepp/statistics/regress.htm 3/1/2011
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Regression step-by-step
using Microsoft Excel®
Notes prepared by Pamela Peterson Drake, Florida Atlantic University
Step 1: Type the data into the spreadsheet
The data should be arranged in columns, with one column containing the observations on the dependent
variable and then other, adjoining columns containing the observations on the independent variables. It is
easier to interpret your results if you provide headings on each of your variable columns.
Step 2: Use Excel®’s Data Analysis program, Regression
In the Tools menu, you will find a Data Analysis option.1 Within Data Analysis, you should then choose
Regression:
1
If you do not find this option, you will want to click on Add-ins and then specify Data Analysis as an option.
Step 3: Specify the regression data and output
You will then be presented with the Regression specifications. Using this screen, you can then specify the
dependent variable [Input Y Range] and the columns of the independent variables [Input X Range]. If you
include the variable names in the column headings and these column headings are part of the range of
observations that you specified, be sure to check the Labels box.
You can then specify where you would like the results to be placed. If you leave the default checked as New
Worksheet Ply, a new worksheet will be created that provides the results:
Regression example
For the data below,

Calculate the slope and the intercept for a regression of y on x.
Calculate the correlation coefficient and the related t-statistic.
Observation y x
1 100 70
2 90 80
3 70 60
4 85 55
5 90 70
6 85 60
7 95 50
8 98 60
9 90 65
10 100 70
A B C D E F G H I J
1 SUMMARY OUTPUT
2
3 Regression Statistics
4 Multiple R 0.2284049
5 R Square 0.0521688
6 Adjusted R Square -0.0663101
7 Standard Error 9.3514317
8 Observations 10
9
10 ANOVA
11 df SS MS F Significance F
12 Regression 1 38.5057971 38.505797 0.4403215 0.525623891
13 Residual 8 699.5942029 87.449275
14 Total 9 738.1
15
16 Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 90.0%Upper 90.0%
17 Intercept 75.181159 22.97529334 3.2722611 0.0113179 22.20003801 128.16228 32.457498 117.90482
18 x 0.2362319 0.356002922 0.6635673 0.5256239 -0.58471232 1.0571761 -0.4257726 0.8982364
Regression_UsingDataAnalysis
A B C D E F G H I J K L M N
1 Regression Problem
2 Solutions to estimation of the regression line
3 Prepared by Pamela Peterson Drake
4
5 Given information Calculations Calculated using estimated
(y-ymean) x residual
6 Observation y x y-ymean x-xmean (x-xmean) (y-ymean)2 (x-xmean)2 y-predicted residual squared
7 1 100 70 9.7 6.0 58.2 94.09 36.0 91.717391 8.2826087 68.601607
8 2 90 80 -0.3 16.0 -4.8 0.09 256.0 94.07971 -4.0797101 16.644035
9 3 70 60 -20.3 -4.0 81.2 412.09 16.0 89.355072 -19.355072 374.61883
10 4 85 55 -5.3 -9.0 47.7 28.09 81.0 88.173913 -3.173913 10.073724
11 5 90 70 -0.3 6.0 -1.8 0.09 36.0 91.717391 -1.7173913 2.9494329
12 6 85 60 -5.3 -4.0 21.2 28.09 16.0 89.355072 -4.3550725 18.966656
13 7 95 50 4.7 -14.0 -65.8 22.09 196.0 86.992754 8.0072464 64.115995
14 8 98 60 7.7 -4.0 -30.8 59.29 16.0 89.355072 8.6449275 74.734772
15 9 90 65 -0.3 1.0 -0.3 0.09 1.0 90.536232 -0.5362319 0.2875446
16 10 100 70 9.7 6.0 58.2 94.09 36.0 91.717391 8.2826087 68.601607
17
18 Sum 903 640 0.0 0.0 163 738.10 690.0 903.0 0.0 699.6
19 Average 90.3 64 0.0 0.0 16.3 73.81 69.0 90.3 0.0 70.0
20 Standard deviation 9.056 8.756
21
22 Results
23 Correlation 0.22840
24 Beta 0.23623
25 Intercept 75.18116
26 Variation of y (SSTotal) 738.10
Residual variation
27 (SSresidual) 699.59
28 R-squared 5.217%
29 Line: y = 75.18116 + 0.23623 x
Regression_ProblemDemo
A B C D E F G H I J K L M N
Regression Problem
1
Solutions to estimation of the
regression line
2
Prepared by Pamela Peterson
Drake
3
4
5 Given information Calculations Calculated using estimated regression
Observation y x y-ymean x-xmean (y-ymean) x (y-ymean)2 (x-xmean)2 y-predicted residual residual squared
(x-xmean)
6
7 1 100 70 =C7-C$19 =D7-D$19 =F7*G7 =F7^2 =G7^2 =(B$25+(B$24*D7)) =C7-L7 =M7^2
8 2 90 80 =C8-C$19 =D8-D$19 =F8*G8 =F8^2 =G8^2 =B$25+(B$24*D8) =C8-L8 =M8^2
9 3 70 60 =C9-C$19 =D9-D$19 =F9*G9 =F9^2 =G9^2 =B$25+(B$24*D9) =C9-L9 =M9^2
10 4 85 55 =C10-C$19 =D10-D$19 =F10*G10 =F10^2 =G10^2 =B$25+(B$24*D10) =C10-L10 =M10^2
11 5 90 70 =C11-C$19 =D11-D$19 =F11*G11 =F11^2 =G11^2 =B$25+(B$24*D11) =C11-L11 =M11^2
12 6 85 60 =C12-C$19 =D12-D$19 =F12*G12 =F12^2 =G12^2 =B$25+(B$24*D12) =C12-L12 =M12^2
13 7 95 50 =C13-C$19 =D13-D$19 =F13*G13 =F13^2 =G13^2 =B$25+(B$24*D13) =C13-L13 =M13^2
14 8 98 60 =C14-C$19 =D14-D$19 =F14*G14 =F14^2 =G14^2 =B$25+(B$24*D14) =C14-L14 =M14^2
15 9 90 65 =C15-C$19 =D15-D$19 =F15*G15 =F15^2 =G15^2 =B$25+(B$24*D15) =C15-L15 =M15^2
16 10 100 70 =C16-C$19 =D16-D$19 =F16*G16 =F16^2 =G16^2 =B$25+(B$24*D16) =C16-L16 =M16^2
17
18 Sum =SUM(C7:C16) =SUM(D7:D16) =SUM(F7:F16) =SUM(G7:G16) =SUM(H7:H16) =SUM(I7:I16) =SUM(J7:J16) =SUM(L7:L16) =SUM(M7:M16) =SUM(N7:N16)
19 Average =AVERAGE(C6:C16) =AVERAGE(D6:D16) =AVERAGE(F6:F16) =AVERAGE(G6:G16) =AVERAGE(H6:H16) =AVERAGE(I6:I16) =AVERAGE(J6:J16) =AVERAGE(L6:L16) =AVERAGE(M6:M16) =AVERAGE(N6:N16)
Standard deviation
20 =STDEV(C6:C16) =STDEV(D6:D16)
21
22 Results
23 Correlation =(H18/9)/(C20*D20)
24 Beta =(H18/9)/(D20*D20)
25 Intercept =C19-(B24*D19)
Variation of y (SSTotal)
26 =I18
Residual variation (SSresidual)
27 =N18
28 R-squared =(B26-B27)/B26
29 Line: y = 75.18116 + 0.23623 x
Regression_ProblemDemo
A B C D E F G H I
1 SUMMARY OUTPUT
2
3 Regression Statistics
4 Multiple R 0.921874166
5 R Square 0.849851978
6 Adjusted R Square 0.827955392
7 Standard Error 419334.6147
8 Observations 56
9
10 ANOVA
11 df SS MS F Significance F
12 Regression 7 4.77734E+13 6.82477E+12 38.81207601 1.18174E-17
13 Residual 48 8.44039E+12 1.75842E+11
14 Total 55 5.62138E+13
15
16 Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 90.0% Upper 90.0%
17 Intercept -495,276.27 277,400.80 -1.79 0.08 -1,053,027.95 62,475.41 -960,539.60 -30,012.93
18 Square footage 310.07 95.08 3.26 0.00 118.89 501.25 150.59 469.55
19 Number of bedrooms -389,493.22 100,278.44 -3.88 0.00 -591,116.53 -187,869.92 -557,682.65 -221,303.80
20 Number of bathrooms 639,211.40 88,219.04 7.25 0.00 461,835.13 816,587.67 491,248.29 787,174.51
21 Number of car-garage 14,791.71 98,527.49 0.15 0.88 -183,311.09 212,894.51 -150,460.98 180,044.40
22 Whether it has a pool -39,908.23 134,058.91 -0.30 0.77 -309,451.73 229,635.28 -264,755.08 184,938.63
23 Whether on a lake 203,167.15 183,822.28 1.11 0.27 -166,432.30 572,766.61 -105,144.02 511,478.33
24 Whether on a golf course 289,503.63 315,691.77 0.92 0.36 -345,237.20 924,244.46 -239,982.24 818,989.50
HomePricing_FullRegressionModel
A B C D E F G H I
1 Correlation among all variables
2
Correlation coefficients
Home listing Square Number of Number of Number of Whether it Whether on a Whether on a
3 price footage bedrooms bathrooms car-garage has a pool lake golf course
4 Home listing price 1.000
5 Square footage 0.765 1.000
6 Number of bedrooms 0.282 0.642 1.000
7 Number of bathrooms 0.873 0.795 0.499 1.000
8 Number of car-garage 0.445 0.554 0.371 0.465 1.000
9 Whether it has a pool 0.345 0.430 0.311 0.381 0.463 1.000
10 Whether on a lake 0.598 0.527 0.130 0.534 0.349 0.280 1.000
11 Whether on a golf course 0.067 0.004 -0.083 -0.003 0.038 0.179 -0.095 1.000
12
13 t-statistics for test of significance
14 Square footage 8.722
15 Number of bedrooms 2.161 6.156
16 Number of bathrooms 13.138 9.625 4.235
17 Number of car-garage 3.656 4.890 2.936 3.861
18 Whether it has a pool 2.702 3.495 2.404 3.029 3.840
19 Whether on a lake 5.490 4.555 0.962 4.644 2.735 2.144
20 Whether on a golf course 0.496 0.027 -0.613 -0.023 0.282 1.338 -0.702
HomePricing_Correlation
A B C D E F G H I
1 Correlation among all variables
2
Correlation coefficients
3 Home listing price Square footage Number of bedrooms Number of bathrooms Number of car-garage Whether it has a pool Whether on a lake Whether on a golf course
4 Home listing price 1
5 Square footage 0.764756863649098 1
6 Number of bedrooms 0.282104941557548 0.642141888643393 1
7 Number of bathrooms 0.872760685061135 0.794823735926187 0.499326213118154 1
8 Number of car-garage 0.445482306875712 0.553980765314891 0.37097331976958 0.465154678725025 1
9 Whether it has a pool 0.345061809100023 0.429544322704799 0.310939271621838 0.38106292692596 0.463164605885655 1
10 Whether on a lake 0.598493332357613 0.526866574156347 0.129765916030458 0.534226624558688 0.3488440471284 0.280026638759455 1
11 Whether on a golf course 0.0673800437580461 0.00369645037919283 -0.0831249188233611 -0.0031902674301123 0.0382989993080951 0.179161283295523 -0.095149870953075 1
12
13 t-statistics for test of significance
14 Square footage =(B5*(54^0.5)) / ((1-(B5^2))^0.5)
15 Number of bedrooms =(B6*(54^0.5)) / ((1-(B6^2))^0.5) =(C6*(54^0.5)) / ((1-(C6^2))^0.5)
16 Number of bathrooms =(B7*(54^0.5)) / ((1-(B7^2))^0.5) =(C7*(54^0.5)) / ((1-(C7^2))^0.5) =(D7*(54^0.5)) / ((1-(D7^2))^0.5)
17 Number of car-garage =(B8*(54^0.5)) / ((1-(B8^2))^0.5) =(C8*(54^0.5)) / ((1-(C8^2))^0.5) =(D8*(54^0.5)) / ((1-(D8^2))^0.5) =(E8*(54^0.5)) / ((1-(E8^2))^0.5)
18 Whether it has a pool =(B9*(54^0.5)) / ((1-(B9^2))^0.5) =(C9*(54^0.5)) / ((1-(C9^2))^0.5) =(D9*(54^0.5)) / ((1-(D9^2))^0.5) =(E9*(54^0.5)) / ((1-(E9^2))^0.5) =(F9*(54^0.5)) / ((1-(F9^2))^0.5)
19 Whether on a lake =(B10*(54^0.5)) / ((1-(B10^2))^0.5) =(C10*(54^0.5)) / ((1-(C10^2))^0.5) =(D10*(54^0.5)) / ((1-(D10^2))^0.5) =(E10*(54^0.5)) / ((1-(E10^2))^0.5) =(F10*(54^0.5)) / ((1-(F10^2))^0.5) =(G10*(54^0.5)) / ((1-(G10^2))^0.5)
20 Whether on a golf course =(B11*(54^0.5)) / ((1-(B11^2))^0.5) =(C11*(54^0.5)) / ((1-(C11^2))^0.5) =(D11*(54^0.5)) / ((1-(D11^2))^0.5) =(E11*(54^0.5)) / ((1-(E11^2))^0.5) =(F11*(54^0.5)) / ((1-(F11^2))^0.5) =(G11*(54^0.5)) / ((1-(G11^2))^0.5) =(H11*(54^0.5)) / ((1-(H11^2))^0.5)
HomePricing_Correlation
Home pricing analysis
Dummy variables: 1 if yes, 0 if no
Whether on
Home listing Square Number of Number of Number of Whether it Whether on a golf
Submitted by price footage bedrooms bathrooms car-garage has a pool a lake course
Lida Ty $ 274,900 2,550 3 2 2 1 0 0
Lida Ty $ 98,000 1,560 2 2 0 0 0 0
Lida Ty $ 379,900 3,035 3 2 2 1 0 0
Lida Ty $ 575,000 3,750 4 3 3 1 0 0
Lida Ty $ 253,990 3,030 3 2 2 0 0 0
V. Lucas $ 347,000 3,100 4 2 2 1 0 0
V. Lucas $ 529,900 2,500 4 3.5 2 0 1 0
V. Lucas $ 226,900 1,532 3 2 2 0 0 0
V. Lucas $ 225,000 1,440 3 2 1 0 0 0
V. Lucas $ 248,900 1,200 3 2 2 1 0 0
James Archer $ 789,000 4,110 4 3 2 1 1 0
James Archer $ 599,000 3,300 3 3 1/2 3 0 0 0
James Archer $ 499,000 2,500 4 3 2 1 0 0
James Archer $ 277,977 1,860 3 2 2 0 0 0
James Archer $ 299,000 1,762 3 2 2 0 0 0
James Archer $ 329,900 1,800 3 2 2 0 0 0
Matthew Milne $ 399,999 2383 4 2 2 0 0 0
Matthew Milne $ 185,900 1654 3 2 2 0 0 0
Matthew Milne $ 294,900 2790 4 2 2 0 0 0
Matthew Milne $ 449,900 3252 4 3.5 2 1 0 0
Matthew Milne $ 384,990 3484 6 4 2 1 0 0
Beth Ann $ 210,000 1356 2 2 2 1 1 0
Beth Ann $ 75,000 950 2 2 1 0 0 0
Beth Ann $ 179,000 957 2 2 2 1 0 0
Beth Ann $ 1,400,000 4360 4 4 2 1 1 0
Beth Ann $ 218,000 1549 3 1 2 1 0 0
Jennifer Delellis $ 176,000 1200 2 2 1 0 0 0
Barbara Pearce $ 1,295,000 2,400 3 2.5 2 1 0 0
Barbara Pearce $ 248,900 1,200 3 2 2 1 0 0
Barbara Pearce $ 269,000 2,100 4 2 2 0 0 0
Barbara Pearce $ 347,000 3,100 4 2 2 1 0 0
Barbara Pearce $ 315,000 2,156 4 3 2 1 0 0
Tara McFarlane $ 505,000 3818 4 3 2 1 0 0
Tara McFarlane $ 525,000 3057 4 2 2 0 0 0
Tara McFarlane $ 298,900 1764 3 2 0 0 0 0
Tara McFarlane $ 169,900 1866 3 2 0 0 0 0
Tara McFarlane $ 159,900 1316 3 2 0 0 0 0
Dino Bruner $ 366,000 2006 3 2 2 1 0 1
Dino Bruner $ 459,000 2793 3 2 2 0 1 0
Dino Bruner $ 389,000 3000 4 3 2 1 0 0
Dino Bruner $ 269,000 2159 3 2 2 0 0 0
Dino Bruner $ 268,900 1630 3 2 2 1 0 0
Renee Rice $ 798,500 2600 4 2 2 1 1 0
Renee Rice $ 550,000 3500 5 3 2 1 0 0
Renee Rice $ 299,999 1808 3 2 2 0 0 0
Renee Rice $ 200,000 1176 3 2 0 0 0 0
Renee Rice $ 159,000 912 2 1 1 0 0 0
Angela Stetzer $ 5,200,000 7,551 5 6.5 3 1 1 0
Angela Stetzer $ 4,300,000 5,000 4 6.5 3 1 1 0
Angela Stetzer $ 4,000,000 3,950 3 5.5 3 1 1 0
Angela Stetzer $ 2,385,000 4,943 3 3.5 2 1 1 0
Angela Stetzer $ 1,650,000 3,119 3 3 2 1 0 1
HomePricing_FullData
05.00.00.00
Value Added Measures

Value Added page for Pamela Peterson Drake, James Madison University Page 1 of 2
An overview of value-added measures of performance

Investors and companies have sought measures of company performance that would identify whether the management
of a company, or a company as a whole, is using the company resources in their best use. The information that we have
to work with is prepared according to generally accepted accounting standards or international accounting standards.
And though these standards are designed to provide information to shareholders, they are also designed to be used by
many different types of companies, often in a one-size-fits-all approach. The downside of this flexibility is that there is a
great deal of "wiggle room" in describing company performance using accounting values.
The challenge is that any measured performance that uses values from accounting statements are subject to the same
criticism as are the accounting statements: the values can be easily manipulated. Combine this is incentives to enhance
performance and poor corporate governance, and you've got a formula for trouble.
The economic profit based measures of performance, including economic value added, are designed to overcome some of
the problems of using financial statement performance metrics, such as net income and return on investment. Economic
profit, as you'll recall from introductory economics, is the profit that remains after considering the cost of capital. Stern
Stewart, Inc., introduced many companies to their formulation of economic profit and started companies thinking in the
right direction: adjust accounting income for the cost of capital. It sounds simple, but it's much more complicated than
that.
The purpose of this site is to provide resources to assist you in learning a bit more about value-added metrics, including
economic value added.
http://educ.jmu.edu/~drakepp/value/index.html 3/2/2011
Value Added page for Pamela Peterson Drake, James Madison University Page 2 of 2

Pamela Peterson Drake http://educ.jmu.edu/~drakepp/index.html
Overview http://educ.jmu.edu/~drakepp/value/intro.htm
Notes http://educ.jmu.edu/~drakepp/value/notes.htm
Glossary http://educ.jmu.edu/~drakepp/value/glossary.html
Research http://educ.jmu.edu/~drakepp/value/research.htm
Links http://educ.jmu.edu/~drakepp/value/links.htm
Pamela Peterson Drake mailto:drakepp@jmu.edu
Department of Finance and Business Law http://www.jmu.edu/finance/
James Madison University http://www.jmu.edu/
JMU Web Privacy Statement http://www.jmu.edu/jmuweb/privacy.shtml
http://educ.jmu.edu/~drakepp/value/index.html 3/2/2011
Notes on Value-Added Measures of Performance Page 1 of 10
Value-added measures of performance

Notes prepared by Pamela Peterson Drake, James Madison University
OUTLINE
I. Introduction
II. What is value-added?
III. How does a firm add value?
IV. Dimensions of value-added methods
V. Determining value-added
VI. Empirical evidence on value-added measures vs. traditional measures
VII. Recommendation
VIII. Future research
I. Introduction
A. Many companies have embraced -- and others have felt obligated to look at -- performance
measures that depart from the traditional accounting based measures such as earnings per
share and return on investment.
B. These new "value-based" measures include economic-value-added (which is Stern Stewart's

registered EVA method), shareholder value increase, economic value creation, and market-
value-added.
C. Related measures include Holt Value Associates' and Boston Consulting's CFROI and Alcar's
Discounted Cash Flow Analysis.
D. Many variants of value-added measures have been spawned and many consulting firms are
selling value-based products.
E. These measures have been used in compensation arrangements, capital decision-making, and
in financial disclosures.
II. What is value-added?
A. Terminology
1. We say that a firm has added value over a period of time when it has generated a profit
in excess of a firm's cost of capital.
2. This profit is typically referred to as the economic profit, a concept developed by

economists in the 19th century. [Exhibit 1 -- top]. This is also referred to as economic
value added (EVA, a registered trademark of Stern Stewart ).
3. A related concept is market value added (MVA) , which is the difference between the
market value and the book value of a firm's capital. [Exhibit 1]
http://educ.jmu.edu/~drakepp/value/notes.htm 3/2/2011
B. Basic principles
1. Calculating economic profit requires first the calculation of net operating profit after
taxes.
1. To calculate NOPAT, accounting numbers are adjusted to reflect operating

earnings without accounting distortions [Exhibit 2]
2. Note: These adjustments may differ among firms (and among consultants'
metrics).
2. Second, we determine the amount of capital, starting with the book value of common
equity and adding different debt components and adjustments. [Exhibit 3]
One of the keys is to make sure that you are consistent between the adjustments
to arrive at NOPAT [Exhibit 2] and capital [Exhibit 3].
3. Third, we determine the cost of capital
As I will discuss later, this is not as straightforward as purported.
4. Finally, we subtract the dollar cost of capital from Net Operating Profit After Tax
But, as you can see, we could do all this in a return form as well.
C. Historical basis
1. Economic profit was established long ago. As an example, consider the writing of Alfred
Marshall over 100 years ago.
"When a man is engaged in business, his profits for the year are the excess of his
receipts from his business during the year over his outlay for his business. The
difference between the value of the stock of plant, material, etc. at the end and at the
beginning of the year is taken as part of his receipts or as part of his outlay, according
as there has been an increase or decrease of value. What remains of his profits after
deducting interest on his capital at the current rate ... is generally called his earnings
of undertaking or management."
[Alfred Marshall, Chapter 4, Income, Capital, Book II Some Fundamental Notions, The
Principles of Economics, 1890].
2. Today we see this concept developed in every principles of economic text. The idea of
economic profit is the basis of the capital budgeting techniques of net present value and
the internal rate of return, which can be found in finance texts over the past thirty years.
3. Economists have been preaching the concept of economic profit for over 100 years and
finance professors have been putting students through the rigor of net present value
and internal rate of return for thirty years.
4. In the texts of the late-1960s and early 1970s, the cost of capital is referred to as the
"minimum acceptable return," or the "minimum revenue required". Profit is defined as
earnings in excess of the cost of capital.
5. Along with promotion of the concept of economic profit, economics and finance
professor have been discouraging the use of accounting-based performance measures
for many years.
6. So why the change in heart? Most of this change can be credited to Stern Stewart's
efforts to develop a product that has its foundation in economic and financial theory.
D. Examples
1. Value-added and cost of capital:
a. Let's look at the basics of determining value added. Suppose a firm has an
accounting profit of $100 million. If the firm has a cost of capital (in dollar terms )
of $75 million, the firm has added $25 million of value during the period. If, on
the other hand, the firm has a cost of capital of $125 million, the firm has
destroyed $25 million in value.
b. The cost of capital is the return required by the suppliers of capital. This cost
reflects both the time value of money and compensation for risk -- the more risk
associated with a firm, the greater the firm's cost of capital. Factoring in the cost
of capital tells us whether the accounting profit of $100 million is sufficient to
keep the suppliers of capital (the creditors and the owners) from moving their
funds elsewhere.
2. Let's look at another example of calculating economic profit [Exhibit 4]
a. If the firm generates $900 million and its cost of capital is 10%, we say that the
firm has added value ($10 million) during the period.
b. Looking at the calculation of market value added [Exhibit 5], we see that it
requires book and market values of the different elements of capital (debt and
equity).
c. In practical applications, however, what is really done is include only the market
value of equity -- the preferred stock and debt are taken at book value (and
included in the market value of capital as such).
3. Looking at actual figures of EVA and MVA (as reported in Forbes) we get a more
realistic picture. [Exhibit 6]. Here we see that:
It is possible to have a positive MVA and a negative EVA (TRW in 1996 & 1995)
If is possible to have a negative MVA and a positive EVA (Ford in 1996 & 1995)
The MVA figure corresponds very closely to the difference between the market
value of equity and the book value of equity (therefore, MVA is due mostly to the
market-book difference).
Coca-Cola, 1995 (determines 1996 ranking):

market value of equity $92,961 mm
book value of equity $ 5,392 mm
difference $87,569 mm
III. How does a firm add value?
A. The secret to creating value.
1. Let step back a moment and look at where this value-added comes from. Value is not
created out of thin air. In fact, if product and factor markets are perfectly competitive,
there should be no excess profits. (this is basic economic theory)
2. It is only through market imperfections that firms can earn excess profits -- that is,
invest in positive net present value projects.
Keys to a perfectly competitive market:
z Costless entry and exit

z Undifferentiated products
z Increasing marginal costs of production
B. The odds of creating value.
1. Creating value requires an advantage that prevents investments from being priced fairly
and economic profits driven to zero. We should not expect value creation from every
business for every period of time.
2. If we observe "value-creation", we should inquire:
Is this measurement error?

If not, what is the source?
C. Sources of value-added
1. The sources of value-added are from basic economics:
a. Economies of scale : a given increase in production, marketing or distribution

results in less than proportional increase in cost (i.e., there are cost advantages to
being large and there are high capital requirements); [e.g., IBM with mainframes
in 1960's].
b. Economies of scope : efficiencies are gained when an investment can support

many activities [e.g., 3M and its adhesives technology]
c. Cost advantages : companies enjoy cost advantages that are not available to new
entrants [e.g., McDonald's and its locations; Microsoft and its Windows operating
system]
d. Product differentiation : invest in capacity to differentiate products, through

patents, reputation (brand name), technologically innovative, service [e.g., Coca-
Cola (advertising), Disney, McDonald's]
e. Access to distribution channels : well-developed distribution channels provide a

competitive advantage.
f. Government policy : government regulations can limit entry of potential

competitors.
2. Note: These advantages are often referred to as "drivers"
IV. Dimensions of value-added methods
A. Using EVA-like methods for compensation
1. The basic idea
a. One of the most widely touted uses of economic profit metrics is to determine
compensation.
b. There is some dissatisfaction with current compensation practices, whether tied to

accounting metrics or using options.
c. The basic idea is to tie compensation to a measure of economic profit.
d. Examples
Eli Lilly (stock price has done quite well since adopting in 1994)
Coca-Cola (still uses some non-EVA Â option awards)
SPX (uses a bonus bank system)
Georgia Pacific (no bonuses for 1996)
R. Donnelly (no bonuses for 1996)
Quaker Oats (stock is essentially flat-lined since adoption)
AT&T (did poorly after adopting it, done well after "re-evaluating its use")
e. Problems in measuring success of adopting EVA for compensation:
1. There has not been sufficient time to measure success. Further, there has
been a relatively low cost of capital and an "up" stock market, so we have
not seen what happens when the cost of capital increases.
2. There is anecdotal evidence on both successes and failures.
a. It is difficult to distinguish firms on the basis of the "extent" to

which the program is applied
b. Issues: Does EVA-based compensation apply to all managers? Are

different metrics used for different management groups? Are other
compensation methods (e.g., options) also in place?
B. Using EVA principles throughout financial decision-making
A. The basic idea
1. Economic value-added-principles include not only tying compensation to economic

profit, but changing financial policy -- especially capital structure policy.
2. A greater use of debt financing is advocated (i.e., repurchase of common stock

financed with debt). This is consistent with financial theory that touts the benefits
from debt financing.
B. The issues
1. First, I should note that this aspect of economic profit does not appear to have
been widely adopted.
2. We should be cautious in applying financial theory directly to practice.
a. For example, financial theory cannot prescribe how much debt is too much.
b. Further, these EVA-based policies have not been tested in high-interest

environments.
C. Using value-added measures for investment strategies
1. There are several concerns about using value-added measures as a metric for
determining investment strategies.
2. Economic profit is measured with error (see below).
3. The empirical evidence suggests that value-added measures are really not much better
than traditional measures (e.g., return on investment) (see below)
V. Determining value-added
A. Conceptual Issues
1. Time horizon
a. Over what period is added value measured?
b. Decisions are made today that, hopefully, generate future cash flows of a firm.
c. How do we measure performance over a recent period of time whose benefit may
not be realized until some time in the future? One approach is to look at current
periods' economic profit.
If we calculate economic profit for a period of time, we are measuring

income from an historical period.
d. Have we captured the benefit from this period's decisions on future period's
income? Probably not. Only under specialized circumstances have we captured
future benefits.
2. Short sighted versus far-sightedness
1. Using economic profit, have we encouraged management to become far-sighted

instead of short-sighted? Probably not.
2. Have we improved upon accounting profit as a measure of performance?

Probably.
3. What we have done by using economic profit in place of accounting profit is make
the firm's management more accountable to the suppliers of equity capital.
3. Momentum
1. How defined?
a. Instead of looking at single-period measures, we could look at multiple

periods, focusing on year-to-year changes and "momentum".
b. Issues: However, "momentum" is a vague concept (2 years' improvement?

3 years'?)
c. As more time is considered, there is more chance that management has

changed.
2. What does it tell us?
a. Momentum tells us that the firm has generated economic profit in the past.
This does not tell us that the firm will generate economic profit in the
future.
b. Using economic theory, one may argue that firms that have generated
economic profit in the past are less likely to generate them in the future
(since barriers to competition tend to fall over time).
B. Computational Issues
1. Adjustments to accounting income
a. Calculating NOPAT [Exhibit 2]
i. One of the primary concerns that we have with accounting principles is

that there is one set of principles (with few choices) that is applied to many
different types of firms.
ii. Are the adjustments required for economic value-added subject to the
same criticism?
iii. The adjustments require many assumptions and estimations.
Some of these adjustments are not palatable.

Many of these adjustments differ among consultants.
b. Calculating amount of capital [Exhibit 3]
1. Adjustments are made (e.g., add back LIFO reserve) to book values.
2. Some estimations are required (e.g., present value of non-capitalized

leases)
3. Many book values are used in the calculation of capital. But just how good
a number is a book value of an asset?
c. Cost of capital calculations
1. Issues
a. There is no general agreement on the "correct" method of

calculating the cost of capital.
b. The cost of capital is sensitive to the method of calculation. Issues

that arise:
a. Dividend valuation method vs. CAPM?
b. If CAPM, which beta to use? We know that individual security

betas are unstable over time.
c. Risk-free rate of return? Which rate to use? 5%? 6%?
c. And economic profit is, in turn, sensitive to the calculation of the

cost of capital.
d. Using the figures in Exhibit 6, if the cost of capital differed from

what was presented by 3% (e.g., for Coca Cola in 1996, if the cost
of capital was 9%-15%, the resulting economic profit is quite
different:
Economic profit Economic profit

if cost of capital if cost of capital
Company NOPAT ($mm) +3% -3%

Coca-Cola +$3,253 +$1,862 +$2,418
TRW $743 -$97 +$237
Ford $7,078 -$89 +$3,271
2. Ambiguities
a. Do we use an imbedded rate or an expected cost of capital?
b. That is, do we measure performance on how the firm covers its cost
of capital that it has incurred (imbedded) or do we measure
performance on how the firm covers its future cost of capital? Are
suppliers of capital forward-looking?
c. What if decisions are made today for future investments that will
increase the cost of capital. Do we use today's cost of capital or do
we use a higher cost of capital.
Note: An article on EVA; discussed Coca-Cola's decision to invest in

China and said that it was an easy decision to make since the expected
returns were greater than (1) what it could get otherwise, and (1) Coca-
Cola's cost of capital. But should this cost of capital been Coca-Cola's
imbedded cost or should a higher hurdle been used (since it was
investing in a riskier market)
3. Fama and French (Journal of Financial Economics,1997) document the

imprecise nature of the cost of equity for industries and speculate on the
greater imprecision for individual firms' cost of equity.
VI. Empirical evidence on value-added measures vs. traditional measures
A. The key to understanding a performance metric is to see how well it performs in rigorous
testing. Are the firms that add value (per the value-added metric) also the firms that benefit
shareholders the most? The answer is empirical.
B. The difficulty is that there is a great deal of anecdotal evidence that touts the success of
metrics, but much of this is provided by consulting firms.
C. Peterson and Peterson show that value-added metrics do not outperform traditional measures
(i.e., what ever edge the value-added metrics have it is slight).
D. Others
1. Bacidore, Boquist, Milbourn and Thakor (Financial Analysts Journal, May/June 1997)
show that EVA explains 1% of variation in abnormal returns (i.e., R-squared of 1%).
(Their proposed measure, REVA explains 3%)
2. Kramer and Pushner (Financial Practice and Education, Spring/Summer 1997) regress
MVA on EVA and find an R-square of 10% (Note: removing "outliers" increases this to
30%). Conclude that the market focuses more on earnings than EVA.
VII. Recommendation
A. Use both traditional metrics and value-added metrics.
B. Reliance on a single measure is not warranted.
VIII. Future research
A. Rigorous and independent testing of value metrics
Need to apply thorough testing to see whether value metrics help investment
performance. Need to control for market movements and risk.
B. Rigorous and independent testing of value-added approach to financial management
C. Challenges:
A. How are value-added principles applied? How do you quantify the difference between a
firm that uses, say EVA, for compensation for top management only with a firm that
uses EVA for all management levels?
B. How do you account for the different adjustments that individual companies make? How
do account for the degree of discretion regarding making adjustments?

Introduction http://educ.jmu.edu/~drakepp/value/notes.htm#num1
What is value-added? http://educ.jmu.edu/~drakepp/value/notes.htm#num2
How does a firm add value? http://educ.jmu.edu/~drakepp/value/notes.htm#num3
Dimensions of value-added methods http://educ.jmu.edu/~drakepp/value/notes.htm#num4
Determining value-added http://educ.jmu.edu/~drakepp/value/notes.htm#num5
Empirical evidence on value-added
http://educ.jmu.edu/~drakepp/value/notes.htm#num6
measures vs. traditional measures
Recommendation http://educ.jmu.edu/~drakepp/value/notes.htm#num7
Future research http://educ.jmu.edu/~drakepp/value/notes.htm#num8
Exhibit 1 http://educ.jmu.edu/~drakepp/value/exhibits.htm#exh1
Exhibit 5 http://educ.jmu.edu/~drakepp/value/exhibts.htm#exh5
Value Added Measures Exhibits (P. Peterson) Page 1 of 2
Value Added Measures: Exhibits

Exhibit 1: Basic Definitions
Economic profit = Net operating profit after taxes - Cost of capital
Exhibit 2: Calculation of Net Operating Profit after Taxes (NOPAT)
Operating profit after depreciation and amortization

+ Implied interest expense on operating leases
+ Increase in LIFO reserve
+ Goodwill amortization
+ Increase in bad debt reserve + Increase in net capitalized research and development
- Cash operating taxes
_________________________________________
NOPAT
Note: See Peterson and Peterson [(Research Foundation, AIMR 1996) Table 3.1, p. 14] for more detail and an example of this calculation.
Exhibit 3: Calculation of the Amount of Capital
Book value of common equity

+ Preferred stock
+ Minority interest
+ Deferred income tax reserve
+ LIFO reserve
+ Accumulated goodwill amortization
+ Interest-bearing short-term debt
+ Long-term debt
+ Capitalized lease obligations
+ Present value of non capitalized leases
_______________________________
Capital
See Peterson and Peterson [(1996), Table 3.3, p. 19] for more detail and an example of this calculation.
Exhibit 4: Example of the Calculation of Economic Profit
NOPAT = $900 million Cost of capital = 10% Capital = $8,900 million
http://educ.jmu.edu/~drakepp/value/exhibits.htm 3/2/2011
Value Added Measures Exhibits (P. Peterson) Page 2 of 2
Economic profit = $900 million - 890 = $10 million
Exhibit 5: Example of the Calculation of Market Value Added
Item 20Y2 20Y1 Change

Book value of common equity $ 4,000 $ 3,700 + $300
Book value of preferred equity 300 300 0
Book value of debt 5,200 5,000 + $200
Book value of capital $ 9,500 $ 9,000 + $500
Mkt value of common equity $15,000 $12,000 +$3,000

Est. mkt value of capital $20,500 $17,300 +$3,200
Market value added +$11,000 +$8,300 +$2,700
Exhibit 6: EVA and MVA
1996 1995
MVA EVA Capital MVA EVA Capital
Cost of Cost of
Company (mm) (mm) (mm) capital (mm) (mm) (mm) capital
Coca-Cola $87,820 $2,140 $9,276 12.0% $60,846 $1,884 $8,468 10.0%
TRW $710 -$70 $5,563 12.1% $324 -$151 $5,433 12.0%
Ford Motor -$12,915 $1,591 $55,995 9.8% -$13,757 $985 $54,160 12.9%
Source: Ronald B. Lieber, "Who are the Real Wealth Creators?" [Fortune, December 9, 1996, pp. 107-116] and Anne B. Fisher "Creating
Stockholder Wealth," [Fortune, December 11, 1995, pp. 105-116].
Back to Notes on Value Added Measures
http://educ.jmu.edu/~drakepp/value/exhibits.htm 3/2/2011
Value-Added Glossary (P. Peterson-Drake, FAU) Page 1 of 2
Glossary for value-added metrics

Basic earning power ratio
The ratio of the earnings from operations (earnings before interest and taxes) to total assets.
This ratio is often used as a measure of the effectiveness of operations.
Capital
The net investment in a firm by the suppliers of capital; the net assets of the firm, calculated as
the difference between the total assets of the firm and the current, non interest bearing
liabilities.
Cash flow return on investment (CFROI)
A financial ratio promoted by Holt/Boston Consulting, calculated as the return on a firm's

investment using estimated inflation adjusted gross investment, inflationadjusted gross cash
flow, and inflation adjusted non depreciable assets.
Comparative advantage
An advantage that one firm has over its competitors in the cost of producing or distributing
goods or services.
Competitive advantage
An advantage that one firm has over its competitors due to the structure of the markets in
which they operate.
Cost of capital
The marginal cost of an additional dollar of capital; the weighted average of the costs of the
capital expected to be raised by the firm to support future investment opportunities.
Driver
A comparative or competitive advantage that generates economic profit.
Economic profit
The difference between revenues and costs over a period of time, where costs comprise
expenditures, opportunity costs, and normal profits.
Economic value-added (EVA)
The dollar amount of value added over a specified period of time. Also known as economic
profit.
Free cash flow
http://educ.jmu.edu/~drakepp/value/glossary.html 3/2/2011
Value-Added Glossary (P. Peterson-Drake, FAU) Page 2 of 2
The cash flow of a firm, less any capital expenditures.
Internal Rate of Return (IRR)
The discount rate that equates the present value of an investment's future cash flows to the
investment's cost; the rate of return on an investment, assuming that all intermediate cash
flows are invested projects with an identical rate of return.
Market value-added (MVA)
The increase in the firm's value over a period, controlling for the capital employed to generate
the change in value; the difference between the market value of the firm and the value of the
firm's capital.
Net present value
The present value of future cash flows of an investment project, less the present value of the
investment's cash flows, where discounted at the cost of capital; a measure of the
enhancement of shareholders' wealth arising from investment decisions.
Normal profit
The minimum return of a firm necessary for the suppliers of capital to retain their investment in
the firm.
Operating capital
Capital, less goodwill and any excess cash and marketable securities.
Return on assets
The ratio of net income to total assets. This ratio provides a measure of how profitably and
efficiently a firm is employing its assets.
Return on equity
The ratio of net income to the book value of equity. This ratio provides a measure of the return
to shareholders' investment in the firm.
Return on investment ratio
A financial ratio in that consists of a numerator that reflects the benefit derived from an
investment and a denominator that reflects to the resources employed. Return on investment
ratios include the basic earning power ratio, the return on assets, and the return on equity.
Weighted average cost of capital (WACC)
The arithmetic average of the costs of the firm's capital from different sources (i.e., debt,
preferred stock, and common stock), where the cost of each source is weighted by the
proportion the source represents in the firm's target capital structure.
http://educ.jmu.edu/~drakepp/value/glossary.html 3/2/2011
Research on value-added measures of performance

Compiled by Pamela Peterson Drake, James Madison University
Articles in the popular press
z Anonymous. "The Acronym A-list," CFO: The Magazine for Senior Financial Executives, Vol. 12, No. 10
p. 46.
z Armitrage, Howard M. 1996. ""Economic Value Creation: What Every Management Accountant Should
Know," CMA: The Management Accounting Magazine," Vol. 70 Issue 8 (October ) pp. 21-
z Birchard, B. 1994. "Mastering the New Metrics." CFO (October).
z Blair, Alistair. 1997 "EVA Fever," Management Today (January) pp. 42-
z Brossy, R., and J. E. Balkcom. 1994. "Getting Executives to Create Value." Journal of Business
Strategy, (January-February) Vol. 15, pp.18-21.
z Byrne, John A., and L. Bongiorno. 1995. "CEO Pay: Ready for Takeoff." Business Week (April 24):88-
119.
z Harris, Roy. 1996. "A Study in Sniping," CFO: The Magazine for Senior Financial Executives," October,
Vol. 12, No. 10, page 44.
z Katzeff, Paul. 2002. "Economic Value is a Valuable Economic Measure for Some Companies",
Investors' Business Daily, (September 9).
z Klinkerman, Steve. 1997. "Case Study: EVA at Centura Banks," Banking Strategies, Vol. 73, No. 1
(January/February) pp. 58-
z Madden, Bart J. 1995. "The Case for Cash Flow ROI in Linking Company Performance with Market
Valuation." Valuation Issues (November),4-7.
z Myers, Randy. 1996. "Metric Wars," CFO: The Magazine for Senior Fnancial Executives, Vol. 12, No.
10, (October) pp. 41-50.
z Oliver, Judith. 1996. "Which Numbers Count," Management Today, (November).
z Padgett, Tania. 1996. "Cold Water on Idea of Banks as Hot Performers," The American Banker, (July
24).
z Padgett, Tania. 1997. "Hot New Evaluative Tool Winning Wall St. Adherents," The American Banker
(March 14) p. 20.
z Rutledge, J. 1993. "De-jargoning EVA." Forbes, Vol. 152 (October 25) p. 148.
z Saint, D. K. 1995. "Why Economic Value is a Yardstick for Numbers, Not People." Financial Executive
(March/April):9-11.
z Shiely, John S. 1996. "Is Value Management the Answer?" Chief Executive, No. 119 (December) p. 54-
.
z Stern, Joel. 1993. "Value and People Management." (July 1993) No. 104 pp. 35-37.
z Stewart, G. Bennett 1994. "EVA: Fact and Fantasy." Journal of Applied Corporate Finance (Summer)
vol. 7 no. 2:71-84.
z Thomas, R., and L. Edwards. 1993. "For Good Decisions, Determine Business Values More Accurately."
Corporate CashFlow (September):37-40.
z Topkis, Maggie. 1996. "A New Way to Find Bargains," Fortune (December 9) p. 265.
z Tully, Shawn. 1993. "The Real Key to Creating Wealth." Fortune (September 29), pp. 38-49.
z Tully, Shawn. 1994. "America's Best Wealth Creators." Fortune (November 28, pp.143-162.
z Walbert, L. 1993. "America's Best Wealth Creators." Fortune (December 27), pp. 64-76.
Research papers
z Anderson, Anne, Roger Bey and Samuel Weaver. 2004. "Economic Value Added Adjustments: Much
Ado About Nothing," working paper (Lehigh University).
z Bacidore, Jeffrey M., John A. Boquist, Todd T. Milbourn, and Anjan V. Thakor. 1997. "The Search for
the Best Financial Performance Measure," Financial Analysts Journal, (May/June) pp. 11-20.
http://educ.jmu.edu/~drakepp/value/research.htm 3/2/2011
z Beneda, Nancy. Valuing Operating Assets in Place and Computing Economic Value Added,CPA Journal
z Biddle, G. C., R.M. Bowen en J.S. Wallace. 1997. "Does EVA beat earnings? Evidence on associations
with stock returns and firm values," Journal of Accounting and Economics, Vol. 24, pp. 301-336.
z Damodaran, Aswath, 1998. "Value Creation and Enhancement: Back to the Future," Contemporary
Finance Digest, Vol. 2 (Winter), pp. 5-51.
z Dillon, Ray D., and James E. Owers. 1997. "EVA as a Financial Metric: Attributes, Utilization, and
Relationship to NPV," Financial Practice and Education, (Spring/Summer), pp. 32-40.
z Grant, James L. 1996. "Foundations of EVA for Investment Managers" Journal of Portfolio
Management, (Fall), p. 41-
z Jones, T. P. 1995. "The Economic Value-added Approach to Corporate Investment." in Corporate
Financial Decision Making and Equity Analysis, ICFA Continuing Education, Association for Investment
Management and Research, pp. 12-20.
z Kramer, Jonathan K., and George Pushner. 1997. "An Empirical Analysis of Economic Value-Added as
a Proxy for Market Value Added," Financial Practice and Education (Spring/Summer) pp. 41-49.
z Reimann, B. C. 1988. "Decision Support Software for Value Based Planning." Planning Review
(March/April), pp. 26-32.
z Shrieves, Ronald E., and John M. Wachowitz, 2000. Free Cash Flow (FCF), Economic VAlue Added
(EVA) and Net Present VAlue (NPV): A Reconciliation of Variations of Discoutned-Cash-Flow (DCF)
Valuation," (University of Tennessee), (June).
z "EVA: A new panacea?", Business and Economic Review, Vol 42; Jul-Sep 1996, p.26-28.
z Sheehan, T. J. 1994. "To EVA or Not to EVA: Is That the Question?" Journal of Applied Corporate
Finance (Summer) vol. 7, no. 2, pp. 84-87.
z Uyemura, Dennis G. 1997. "EVA: a Top-Down Approach to risk Management," The Journal of Lending
& Credit Risk Management, (February) Vol. 79, No. 6, page 40.
z Stern, Joel 1993. "EVA: Share Options that Maximize Value." Corporate Finance, no. 105 (August), pp.
31-32.
z Stern, Joel 1994. "No Incentive for Bad Management." Corporate Finance (March), pp. 43-44.
z Stern Stewart EVA Roundtable. 1994. Journal of Applied Corporate Finance, vol. 7 no. 2 (Summer),
pp. 46-70.
z Stewart, Bennett G., 1993. "EVATM: Fact and fantasy," Journal of Applied Corporate Finance, pp. 6-
19.
Books
z Copeland, Thomas, T. Koller, and J. Murrin. 1994. Valuation: Measuring and Managing the Value of
Companies, second edition, New York: John Wiley & Sons.
z Ehrbar, Al. EVA: The Real Key to Creating Wealth, Harvard Business School Press.
z Peterson, Pamela P., and David R. Peterson. 1996. Company Performance and Measures of Value
Added, Charlottesville: The Research Foundation of the Institute of Chartered Financial Analysts.
z Stewart, G. Bennett III. 1991. The Quest for Value. Harper Collins Publishers, Inc..

Economic Value is a Valuable
Economic Measure for Some http://www.kellogg.northwestern.edu/news/hits/020909ibd.htm
Companies
Valuing Operating Assets in
Place and Computing Economic http://www.nysscpa.org/cpajournal/2004/1104/essentials/p56.htm
Value Added
Free Cash Flow (FCF),
Economic VAlue Added (EVA)
and Net Present VAlue (NPV): A
http://bus.utk.edu/finance/WP/eva.pdf
Reconciliation of Variations of
Discoutned-Cash-Flow (DCF)
Valuation,"
Links for Value-Added Measures of Performance Page 1 of 2
Links to resources on value-added measures of performance
General explanations
z CalPERS use of EVA in their Focus List

z Aswath Damodaran' EVA page
z Economics Value Added: The Invisible Hand at Work, by Michael Durant
z ROI Guide: Economic Value Added, by John Berry, February 17, 2003, Computerworld
z The Bonus Barrier, CFO Europe.com.
Consulting firms' sites
z Stern Stewart & Co.

z Value Based Management .net
z Valuation Resources
http://educ.jmu.edu/~drakepp/value/links.htm 3/2/2011
Links for Value-Added Measures of Performance Page 2 of 2

CalPERS use of EVA in their Focus List http://www.calpers-governance.org/alert/selection/eva.asp
Aswath Damodaran' EVA page http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/eva.html
Economics Value Added: The Invisible Hand at
http://www.crfonline.org/orc/pdf/ref8.pdf
Work
ROI Guide: Economic Value Added http://www.computerworld.com/managementtopics/roi/story/0,10801,78514,00.html
The Bonus Barrier http://www.cfoeurope.com/displaystory.cfm/1737457/l_print
Stern Stewart & Co. http://www.sternstewart.com/
Value Based Management .net http://www.valuebasedmanagement.net/methods_eva.html
Valuation Resources http://www.valuationresources.com/Publications/EVA.htm
http://educ.jmu.edu/~drakepp/value/links.htm 3/2/2011
Valuation Page 1 of 6
Economic Value Added (EVA)

z The Economic Value Added (EVA) is a measure of surplus value created on an investment.
z Define the return on capital (ROC) to be the ìtrueî cash flow return on capital earned on an investment.
z Define the cost of capital as the weighted average of the costs of the different financing instruments used to finance the
investment.
EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project)
Things to Note about EVA
z EVA is a measure of dollar surplus value, not the percentage difference in returns.
z It is closest in both theory and construct to the net present value of a project in capital budgeting, as opposed to the IRR.
z The value of a firm, in DCF terms, can be written in terms of the EVA of projects in place and the present value of the
EVA of future projects.
DCF Value and NPV
Value of Firm = Value of Assets in Place + Value of Future Growth
= ( Investment in Existing Assets + NPVAssets in Place) + NPV of all future projects
= ( I + NPVAssets in Place) +
where there are expected to be N projects yielding surplus value (or excess returns) in the future and I is the capital invested in
assets in place (which might or might not be equal to the book value of these assets).
The Basics of NPV
NPVj = : Life of the project is n years
Initial Investment = : Alternative Investment
NPVj =
NPV to EVA (Continued)
z Define ROC = EBIT (1-t) / Initial Investment: The earnings before interest and taxes are assumed to measure true earnings
on the project and should not be contaminated by capital charges (such as leases) or expenditures whose benefits accrue to
future projects (such as R & D).
z Assume that : The present value of depreciation covers the present value of capital
invested, i.e, it is a return of capital.
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/eva.html 3/2/2011
DCF Valuation, NPV and EVA
Value of Firm = ( I + NPVAssets in Place) +
In other words,
Firm Value = Capital Invested in Assets in Place + PV of EVA from Assets in Place + Sum of PV of EVA from new projects
A Simple Illustration
Assume that you have a firm with
IA = 100 In each year 1-5, assume that
ROCA = 15% I = 10 (Investments are at beginning of each year)
WACCA = 10% ROCNew Projects = 15%
WACC = 10%
z Assume that all of these projects will have infinite lives.
After year 5, assume that
z Investments will grow at 5% a year forever

z ROC on projects will be equal to the cost of capital (10%)
Firm Value using EVA Approach
Capital Invested in Assets in Place = $ 100
EVA from Assets in Place = (.15 - .10) (100)/.10 = $ 50
+ PV of EVA from New Investments in Year 1 = [(.15 - .10)(10)/.10] = $ 5
+ PV of EVA from New Investments in Year 2 = [(.15 - .10)(10)/.10]/1.12 = $ 4.55
Value of Firm = $ 170.86
Firm Value using DCF Valuation
Terminal
Base Year 1 2 3 4 5
Year
EBIT(1-t) from
15 15 15 15 15 15
Assets in Place
EBIT(1-t): yr 1 1.50 1.50 1.50 1.50 1.50
EBIT(1-t) in yr
1.50 1.50 1.50 1.50
2
EBIT(1-t) in yr
1.50 1.50 1.50
3
EBIT(1-t) in yr
1.50 1.50
4
EBIT(1-t) in yr
1.50
5
EBIT(1-t) 16.50 18.00 19.50 21.00 22.50 23.63
- Net Capital
10.00 10.00 10.00 10.00 10.00 11.25 11.81
Expenditures
FCFF -10.00 6.50 8.00 9.50 11.00 11.25 11.81
PV of FCFF -10.00 $ 5.91 $6.61 $7.14 $7.51 $6.99
Terminal
$236.25
Value
PV of
$146.69
Terminal Value
Value of Firm $170.85
In Summary
z Both EVA and Discounted Cash Flow Valuation should provide us with the same estimate for the value of a firm.
z In their full forms, the information that is required for both approaches is exactly the same - expected cash flows over time
and costs of capital over time.
z A policy of maximizing the present value of economic value added over time should be the equivalent of a policy of
maximizing firm value.
In Practice: Some Measurement Issues
z How do you measure the capital invested in assets in place?

{ Many firms use the book value of capital invested as their measure of capital invested. To the degree that book value
reflects accounting choices made over time, this may not be true.
{ In cases where firms alter their capital invested through their operating decisions (for example, by using operating
leases), the capital and the after-tax operating income have to be adjusted to reflect true capital invested.
z How do you measure return on capital?
{ Again, the accounting definition of return on capital may not reflect the economic return on capital.
{ In particular, the operating income has to be cleansed of any expenses which are really capital expenses (in the sense
that they create future value). One example would be R& D.
{ The operating income also has to be cleansed of any cosmetic or temporary effects.
z How do you estimate cost of capital?
{ DCF valuation assumes that cost of capital is calculated using market values of debt and equity.
{ If it assumed that both assets in place and future growth are financed using the market value mix, the EVA should
also be calculated using the market value.
{ If instead, the entire debt is assumed to be carried by assets in place, the book value debt ratio will be used to
calculate cost of capital. Implicit then is the assumption that as the firm grows, its debt ratio will approach its book
value debt ratio.
Year-by-year EVA Changes
z Firms are often evaluated based upon year-to-year changes in EVA rather than the present value of EVA over time.
z The advantage of this comparison is that it is simple and does not require the making of forecasts about future earnings
potential.
z Another advantage is that it can be broken down by any unit - person, division etc., as long as one is willing to assign
capital and allocate earnings across these same units.
z While it is simpler than DCF valuation, using year-by-year EVA changes comes at a cost. In particular, it is entirely
possible that a firm which focuses on increasing EVA on a year-to-year basis may end up being less valuable.
Year-to-Year EVA Changes
0 1 2 3 4 5 Term. Yr.
EBIT(1-t) $ 15.00 $ 16.50 $ 18.00 $ 19.50 $ 21.00 $ 22.50 $ 23.63
WACC(Capital) $ 10.00 $ 11.00 $ 12.00 $ 13.00 $ 14.00 $ 15.00 $ 16.13
EVA $ 5.00 $ 5.50 $ 6.00 $ 6.50 $ 7.00 $ 7.50 $ 7.50
PV of EVA $ 5.00 $ 4.96 $ 4.88 $ 4.78 $ 4.66
Terminal Value of
$ 75.00
EVA
Value: Assets in
$ 100.00
Place =
PV of EVA = $ 70.85
When Increasing EVA on year-to-year basis may result in lower Firm Value
1. If the increase in EVA on a year-to-year basis has been accomplished at the expense of the EVA of future projects. In this case,
the gain from the EVA in the current year may be more than offset by the present value of the loss of EVA from the future
periods.
z For example, in the example above assume that the return on capital on year 1 projects increases to 17%, while the cost of
capital on these projects stays at 10%. If this increase in value does not affect the EVA on future projects, the value of the
firm will increase.
z If, however, this increase in EVA in year 1 is accomplished by reducing the return on capital on future projects to 14%, the
firm value will actually decrease.
Firm Value and EVA Tradeoffs over Time
0 1 2 3 4 5 Term. Yr.
Return on Capital 15% 17% 14% 14% 14% 14% 10%
Cost of Capital 10% 10% 10% 10% 10% 10% 10%
EBIT(1-t) $ 15.00 $ 16.70 $ 18.10 $ 19.50 $ 20.90 $ 22.30 $ 23.42
WACC(Capital) $ 10.00 $ 11.00 $ 12.00 $ 13.00 $ 14.00 $ 15.00 $ 16.12
EVA $ 5.00 $ 5.70 $ 6.10 $ 6.50 $ 6.90 $ 7.30 $ 7.30
PV of EVA $ 5.18 $ 5.04 $ 4.88 $ 4.71 $ 4.53
Terminal Value of
$ 73.00
EVA
Value: Assets in
$ 100.00
Place =
PV of EVA = $ 69.68
EVA and Risk
2. When the increase in EVA is accompanied by an increase in the cost of capital, either because of higher operational risk or
changes in financial leverage, the firm value may decrease even as EVA increases.
z For instance, in the example above, assume that the spread stays at 5% on all future projects but the cost of capital increases
to 11% for these projects. The value of the firm will drop.
EVA with Changing Cost of Capital
0 1 2 3 4 5 Term. Yr.
Return on Capital 15% 16% 16% 16% 16% 16% 11%
Cost of Capital 10% 11% 11% 11% 11% 11% 11%
EBIT(1-t) $15.00 $16.60 $18.20 $19.80 $21.40 $23.00 $24.15
WACC(Capital) $10.00 $11.10 $12.20 $13.30 $14.40 $15.50 $16.65
EVA $5.00 $5.50 $6.00 $6.50 $7.00 $7.50 $7.50
PV of EVA $4.95 $4.87 $4.75 $4.61 $4.45
Terminal Value $68.18
Value of Assets in Place = $100.00
PV of EVA = $64.10
Value of Firm = $164.10
Advantages of EVA
1. EVA is closely related to NPV. It is closest in spirit to corporate finance theory that argues that the value of the firm will
increase if you take positive NPV projects.
2. It avoids the problems associates with approaches that focus on percentage spreads - between ROE and Cost of Equity and
ROC and Cost of Capital. These approaches may lead firms with high ROE and ROC to turn away good projects to avoid
lowering their percentage spreads.
3. It makes top managers responsible for a measure that they have more control over - the return on capital and the cost of capital
are affected by their decisions - rather than one that they feel they cannot control as well - the market price per share.
4. It is influenced by all of the decisions that managers have to make within a firm - the investment decisions and dividend
decisions affect the return on capital (the dividend decisions affect it indirectly through the cash balance) and the financing
decision affects the cost of capital.
EVA and Market Value Added
z The relationship between EVA and Market Value Added is more complicated than the one between EVA and Firm Value.
z The market value of a firm reflects not only the Expected EVA of Assets in Place but also the Expected EVA from Future
Projects
z To the extent that the actual economic value added is smaller than the expected EVA the market value can decrease even
though the EVA is higher.
Implications of Findings
z This does not imply that increasing EVA is bad from a corporate finance standpoint. In fact, given a choice between
delivering a "below-expectation" EVA and no EVA at all, the firm should deliver the "below-expectation" EVA.
z It does suggest that the correlation between increasing year-to-year EVA and market value will be weaker for firms with
high anticipated growth (and excess returns) than for firms with low or no anticipated growth.
z It does suggest also that "investment strategies"based upon EVA have to be carefully constructed, especially for firms
where there is an expectation built into prices of "high" surplus returns.
When focusing on year-to-year EVA changes has least side effects
1. Most or all of the assets of the firm are already in place; i.e, very little or none of the value of the firm is expected to come from
future growth.
[This minimizes the risk that increases in current EVA come at the expense of future EVA]
2. The leverage is stable and the cost of capital cannot be altered easily by the investment decisions made by the firm.
[This minimizes the risk that the higher EVA is accompanied by an increase in the cost of capital]
3. The firm is in a sector where investors anticipate little or not surplus returns; i.e., firms in this sector are expected to earn their
cost of capital.
[This minimizes the risk that the increase in EVA is less than what the market expected it to be, leading to a drop in the market
price.]
When focusing on year-to-year EVA changes can be dangerous
z 1. High growth firms, where the bulk of the value can be attributed to future growth.
z 2. Firms where neither the leverage not the risk profile of the firm is stable, and can be changed by actions taken by the
firm.
z 3. Firms where the current market value has imputed in it expectations of significant surplus value or excess return projects
in the future.
z Note that all of these problems can be avoided if we restate the objective as maximizing the present value of EVA over
time. If we do so, however, some of the perceived advantages of EVA - its simplicity and observability - disappear.
Economic Value Added: The Invisible Hand at Work
By: Michael Durant, CPA, CCE
Abstract
Adam Smith, one of the fathers of classical economic thought, observed that firms and resource
suppliers, seeking to further their own self-interest and operating within the framework of a
highly competitive market system, will promote the interest of the public, as though guided by an
“invisible hand. “ (Smith, 1776)
The market mechanism of supply and demand communicates the wants of consumers to
businesses and through businesses to resource suppliers. Competition forces business and
resource suppliers to make appropriate responses. The impact of an increase in consumer
demand for some product will raise that goods price. The resulting economic profits signal other
producers that society wants more of the product. Competition simultaneously brings an
expansion of output and a lower price.
Profits cause resources to move from lower valued to higher valued uses. Prices and sales are
dictated by the consumer. In the quest for higher profits, businesses will take resources out of
areas with lower than normal returns and put them into areas in which there is an expectation of
high profits. Profits allocate resources.
The primary objective of any business is to create wealth for its owners. If nothing else the
organization must provide a growth dividend to those who have invested expecting a value
reward for their investment. As companies generate value and grow, society also benefits. The
quest for value directs scarce resources to their most promising uses and most productive
users. The more effectively resources are employed and managed, the more active economic
growth and the rate of improvement in our standard of living as a society. Although there are
exceptions to the rule relating to the value of economic wealth, most of the time there is a
distinct harmony between creating increased share value of an organization and enhancing the
quality of life of people in society.
In most companies today the search for value is being challenged by a seriously out of date
financial management system. Often, the wrong financial focus, cash strategies, operating
goals, and valuation processes are emphasized. Managers are often rewarded for the wrong
achievements and in many cases they are not rewarded for the efforts that lead to real value.
Balance sheets are often just the result of accounting rules rather than the focus of value
enhancement. These problems beg for approaches to financial focus that are completely
different from current approaches. New approaches must start nothing less than a revolution in
thinking in the process of economic evaluation.
One of the focuses that have proved to be incorrect in the valuation of economic worth is
earnings per share (EPS). Earnings per share has long been the hallmark of executives that
appear in meetings of the shareholders, as the measure of their accomplishments. This, along
with return on equity has long been thought of as the way to attract Wall Street investment.
There is nothing that points to EPS as anything more than a ratio that accounting has developed
for management reporting. Many executives believe that the stock market wants earnings and
that the future of the organization’s stock depends on the current EPS, despite the fact that not
one shred of convincing evidence to substantiate this claim has ever been produced. To satisfy
Wall Street’s desire for reported profits, executives feel compelled to create earnings through
creative accounting.
Accounting tactics that could be employed to save taxes and increase value are avoided in favor
of tactics that increase profit. Capital acquisitions are often not undertaken because they do not
meet a hypothetical profit return. R&D and market expanding investments get only lip service.
Often increased earnings growth is sustained by overzealous monetary support of businesses
that are long past their value peak.
We must ask then, what truly determines increased value in stock prices. Over and over again
the evidence points to the cash flow of the organization, adjusted for time and risk, that investors
can expect to get back over the life of the business.
Economic Value Added (EVA) is a measurement tool that provides a clear picture of whether a
business is creating or destroying shareholder wealth. EVA measures the firm’s ability to earn
more than the true cost of capital. EVA combines the concept of residual income with the idea
that all capital has a cost, which means that it is a measure of the profit that remains after
earning a required rate of return on capital. If a firm’s earnings exceed the true cost of capital it
is creating wealth for its shareholders.
Definition of Economic Value Added

A discussion on Economic Value Added has to begin with the origin of the concept. EVA is
based on the work of Professors Franco Modigliani and Merton H. Miller. In October, 1961,
these two finance professors published “Dividend Policy, Growth and the Valuation of Shares”,
in the Journal of Business. The ideas of free cash flow and the evaluation of business on a cash
basis were developed in this article. These ideas were extended into the concept of EVA by
Bennett Stewart and Joel Stern of Stern, Stewart & Company.
Economic Value Added is defined as net operating profit after taxes and after the cost of capital.
(Tully, 1993) Capital includes cash, inventory, and receivables (working capital), plus
equipment, computers and real estate. The cost of capital is the rate of return required by the
shareholders and lenders to finance the operations of the business. When revenue exceeds the
cost of doing business and the cost of capital, the firm creates wealth for the shareholders.
EVA = Net Operating Profit – Taxes – Cost of Capital
Calculating Net Operating Profit After Taxes (NOPAT)

NOPAT is easy to calculate. From the income statement we take the operating income and
subtract taxes. Operating income is sales less cost of sales and less selling, general and
administrative expenses. The following example from XYZ Company illustrates the NOPAT
calculation.
XYZ Company
Sales $2,436,000
Cost of Goods Sold 1,700,000
Gross Profit 736,000
Selling, General & Admin Expenses 400,000

Operating Profit 336,000
Taxes 134,000
NOPAT 202,000
Calculating Cost of Capital

Many business don’t know their true cost of capital, which means that they probably don’t know
if their company is increasing in value each year. There are two types of capital, borrowed and
equity. The cost of borrowed capital is the interest rate charged by the bondholders and the
banks.
Equity capital is provided by the shareholders. An investor’s expected rate of return on an

investment is equal to the risk free rate plus the market price for the risk that is assumed with
the investment. The relationship between expected return and risk is measured by comparing a
company to the market.
The risk of a company can be decomposed into two parts. An investor can eliminate the first
component of risk by combining the investment with a diversified portfolio. The diversifiable
component of risk is referred to as non-systematic risk.
The second component of risk is non-diversifiable and is called the systematic risk. It stems
from general market fluctuations which reflects the relationship of the company to other
companies in the market. The non-diversifiable risk creates the risk premium required by the
investor. In the security markets the non-diversifiable risk is measured by a firm’s beta. The
higher a company’s non-diversifiable risk, the larger their beta. As the beta increases the
investor’s expected rate of return also increases. (Levy, 1982)
Current estimates of beta for a wide variety of companies are available from Value Line and
Bloomberg.
Shareholders usually expect to earn about six percent more on stocks than government bonds.
With long term government bonds earning 7.5%, a good estimate for the cost of equity capital
would be about 13.5 %. The true cost of capital would be the weighted average cost of debt and
equity.
Measuring Capital Employed
The next step is to calculate the capital that is being used by the business, from the economist
point of view. Accounting profits differ from economic profits. Under generally accepted
accounting principles, most companies appear to be profitable. However, many actually destroy
shareholder wealth because they earn less than the full cost of capital. EVA overcomes this
problem by explicitly recognizing that when capital is employed it must be paid for.
In financial statements, created using generally accepted accounting principles, companies pay
nothing for equity capital. As discussed earlier, equity capital is very expensive.
Economic profits are defined as total revenues less total costs, where costs includes the full
opportunity cost of the factors of production. The opportunity cost of capital invested in a
business is not included when calculating accounting profits.
Capital would include all short and long term assets. In addition, other investments that have
been expensed using accrual accounting methods are now included as capital. For example,
research and development, leases, and training, which are investments in the future, that GAAP
requires to be expensed in the year they occur, would be treated as a capital investment and
assigned a useful life. (Stern, 1996)
If the business invest in developing new products this year, that amount would be added back to
operating profits and to the capital base. If the product has a five-year life, deduct 1/5 of the
investment would be deducted each year from operating profits and from the capital base in
each of the next five years. For XYZ Company we determine that the adjusted capital balance
is $1,500,000.
Weighted Average Cost of Capital

Weighted average cost of capital examines the various components of the capital structure and
applies the weighting factor of after-tax cost to determine the cost of capital. (O’Byrne, 1996)
The following example will show the formation of the weighted average cost of capital.
XYZ Company
Long Term Debt $500,000

Preferred Stockholders’ Equity $200,000
Common Stockholders’ Equity
Common Stock $300,000
Paid in Surplus $100,000
Retained Earnings $300,000
Total Common Equity $700,000
Total Capital $1,400,000
Long Term Debt
Long Term Debt includes bonds, mortgages and long term secured financing.
Bond Cost Let’s say we can issue bonds with a face value of $100 per bond and it is
estimated that the bond will generate $96.00 net proceeds to the company after discounting and
financing costs. The normal interest is $14.00 or approximately $9.00 after taxes (assuming a
35% tax rate). To obtain the cost, we divide the after tax interest by the proceeds.
$9.00/ $96.00 = 9.475% which is the after tax cost of bond financing
Mortgage and Long Term Financing Costs Our banker has informed us that our long term
rate is two points above prime, which is currently 10%, putting our lending rate at 12%. With a
35% tax rate it comes to a 7.8% cost. Our banker has informed us that our mortgage rates are
presently 11%, which would give us an after tax cost on mortgage money of 7.15%.
We weight the cost of long term debt, by taking the average of the cost of long term debt, which
would give us:
(7.8% +7.15%)/2 = 7.48%
and multiplying the long term debt of $500,000 by 7.48% will give us a weighted average cost of
LTD of $34,400.
Preferred Stock Costs

We take the present market value of the preferred stock less discounts or finance costs and
divide dividends per share by this value. For example, Preferred stock of $100 per share less
$2.00 finance costs or $98.00 proceeds. Dividends on Preferred are $11.00 per share.
$11.00/ $98.00 = 11.2% after tax cost of preferred
To calculate the weighted preferred stock, we multiply the after tax cost of 11.2% by the
preferred stock of $200,000 which gives us $22, 400.
Common Equity Costs

Common equity has three components – common stock, paid in surplus and retained earnings.
From the shareholder’s viewpoint, all three are costs. If retained earnings are used in the
business, the stockholders cannot use them elsewhere to earn money and therefore they carry
an opportunity cost.
Stockholders invest because they expect to receive benefits, which will be equivalent to what
they would receive on the next best investment when risk is considered. Stockholders expect
two benefits from common stock, dividends present and future and capital appreciation from
growth. The valuation of common equity must take into consideration both the present and
future earnings of the stock.
To calculate the weighted cost of common equity we consider the present market price of the
stock less issuing costs. For example we issue common stock for $100 a share less $15.00
issuing cost or proceeds of $85.00 per share. This is divided into the future earnings per share
estimate by investors or reliable analysts. If we use $12.00 per share, then the weighted cost
will look like this:
$12.00/$85.00 = 14.1% after tax cost of common stock
Using the 14.1% and the total common equity of $700,000 our cost of common equity is
$98,700.
Total Weighted Average Cost of Capital

A summary of the three components gives us the weighted average cost of capital.
XYZ Company
Long Term Debt $500,000 * 7.48% $37,400
Preferred Stockholders’ Equity $200,000 * 11.2% $22,400
Common Equity $700,000 * 14.1% $98,700
Total Capital $1,400,000 $158,500

The Weighted Average Cost of Capital is $158,500/$1,400,000 = 11.3%. Cost of capital is
calculated by multiplying total capital by the weighted average cost of capital.
Calculating EVA
After tax operating earnings less the cost of capital is equal to EVA. From the above example
we can calculate XYZ Company’s EVA and determine if this business is creating wealth for its
owners.
XYZ Company
NOPAT $202,000
Charge for Capital
Capital Employed $1,500,000
Cost of Capital 11.3%
Capital Charge $169,500
ECONOMIC VALUE ADDED $32,500
Methods Used to Increase EVA

The only way to increase EVA is through the actions and decisions of managers. People make
the decisions and changes that create value. Companies that use EVA as their financial
performance measure focus on operating efficiency. It forces assets to be closely managed.
There are three tactics that can be used to increase EVA: earn more profit without using more
capital, use less capital, and invest capital in high return projects. (Tully, 1998)
Conclusion
EVA is both a measure of value and also a measure of performance. The value of a business
depends on investor’s expectations about the future profits of the enterprise. Stock prices track
EVA far more closely than they track earnings per share or return on equity. A sustained
increase in EVA will bring an increase in the market value of the company.
As a performance measure, Economic Value Added forces the organization to make the
creation of shareholder value the number one priority. Under the EVA approach stiff charges are
incurred for the use of capital. EVA focused companies concentrate on improving the net cash
return on invested capital.
EVA is changing the way managers run their businesses and the way Wall Street prices them.
When business decisions are aligned with the interest of the shareholders, it is only a matter of
time before these efforts are reflected in a higher stock price.
Levy, Haim and Marshall Sarnat, Capital Investment and Financial Decisions, Englewood Cliffs, New Jersey;
Prentice Hall International, 1982.
O’Byrne Stephen F., EVA and Market Value, Journal of Applied Corporate Finance, Spring 1996, 116 – 126.
Smith, Adam, The Wealth of Nations (New York: Modern Library, Inc., originally published in 1776), p.28.
Stern, Joel M., EVA and Strategic Performance Measurement, Global Finance 2000, The Conference Board, Inc.,
1996.
Tully, Shawn, America’s Greatest Wealth Creators, Fortune, November 9, 1998, 193 – 196.
Tully, Shawn, The Real Key to Creating Wealth, Fortune, September 20, 1993, 123 – 132.
Michael W. Durant, CCE, CPA is the Director of Credit, VF Jeanswear, Greensboro NC.
He is the former Director of Research for Credit Research Foundation.
© Copyright 1999 by the Credit Research Foundation.

All rights in this book are reserved.
No part of the book may be reproduced in any manner whatsoever without written permission.
Printed in the United States of America
Credit Research Foundation

8840 Columbia 100 Parkway
Columbia MD 21045
410-740-5499
ROI Guide: Economic Value Added Page 1 of 3
ROI Guide: Economic Value Added

John Berry
February 17, 2003 (Computerworld)

Definition: Economic Value Added (EVA) -- a name trademarked by Stern Stewart & Co. -
subtracts the capital charge (the capital investment times the cost of capital) from the net
financial benefits of the investment.
What it means: Economic profit is wealth created above the capital cost of the investment.
EVA prevents managers from thinking that the cost of capital is free.
Strengths: EVA focuses managers on the question, "For any given investment, will the
company generate returns above the cost of capital?" Companies that embrace EVA have
bonus compensation schemes that reward or punish managers for adding value to or
subtracting value from the company.
Weaknesses: As with any metric, it's hard to link precise EVA returns to a specific
technology investment. EVA is ideally suited to publicly traded companies, not private
companies, because it deals with the cost of equity for shareholders, as opposed to debt
capital.
If a company invests in manufacturing equipment or a warehouse, how much additional profit
will be required to pay for it? Managers are intuitively aware of the importance of value
creation to their businesses. EVA is a management philosophy and performance metric that
elevates those goals from intuition to rigorous analysis and ensures that no investment
escapes scrutiny.
Yes, that includes IT. The fundamental proposition of EVA is that capital isn't free and its cost
must be factored into every benefit analysis or return-on-investment model when an
investment in a plant, equipment or a new customer relationship management system is
contemplated. Putting a finer point on this concept, EVA targets equity capital as opposed to
debt capital. Managers often treat equity capital as free when it's not -- shareholders could
have invested elsewhere.
Since IT represents a big percentage of a company's annual capital budget, whether a
company factors in the cost of capital when deciding on some technology investment is
hardly academic. The pure EVA calculation for the company as a whole is:
Net operating profit after taxes - capital charge (capital investment x cost of capital)
But, purely speaking, there is no net operating profit after taxes (NOPAT) arising out of an IT
investment, so the net financial benefits of the IT investment are used as a replacement for
NOPAT.
Consider, for instance, a case where the cost-benefit analysis reveals that a $50,000 IT
investment will return $8,000 in net quantifiable benefits. The ROI is 16% ($8,000 divided by
$50,000). The cost of capital in the company is 12%. Using the formula above, the EVA in
this case is $2,000:
$8,000 net benefits - ($50,000 capital investment x 12% cost of capital) = $2,000 EVA
Another way to calculate EVA in this example is to simply deduct the 12% cost of capital from
the 16% ROI, then multiply by the investment:
4% x $50,000 = $2,000 EVA
EVA is always expressed as a dollar amount.
"EVA doesn't make it easy to quantify IT benefits but creates clarity so that all the pluses and
minuses of these IT decisions can be considered in ways that companies [that don't use
EVA] find difficult to do," says Bennett Stewart, co-founder of Stern Stewart & Co., a New
York-based consultancy that coined the term Economic Value Added, but not the concept.
Consider a recent EVA analysis that Robert Egan, vice president of IT at Boise Cascade
Corp., and his colleagues conducted for a storage investment. The decision was whether to
keep storage assets or replace them with new technology that has lower maintenance
charges. (The example is illustrative. Egan declined to provide real cost figures.)
The new storage technology costs $1 million, with maintenance costs of $100,000 per year.
The maintenance expense on the old storage technology is $350,000. (For simplicity, we'll
assume that the new storage equipment offers no benefits other than the lower maintenance
costs.)
Boise's cost of capital is about 16%. Therefore, the capital charge for investing in the new
http://www.computerworld.com/s/article/print/78514/ROI_Guide_Economic_Value_Added... 3/2/2011
storage is 16% x $1 million, or $160,000, which EVA says must be added to the $100,000
maintenance costs to get the true cost.
The result: The total cost of the new storage is $260,000, vs. $350,000 for the old storage.
"In this case, have you lowered the operating cost enough to make up for spending the
capital?" asks Egan. Yes -- $90,000 worth.
Boise is constantly reminded of the obvious point that technology isn't free. The company is
also aware of the less obvious fact: neither is the capital to finance it.
Berry is an IT management consultant and analyst in Bend, Ore. Contact him at
vision@according2jb.com.
Do the Math! An ROI Guide

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Do the Math! An ROI Guide

ROI Diligence Yields Rewards
ROI Guide: Payback Period
ROI Guide: Net Present Value
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ROI Guide: Balanced Scorecard
ROI Guide: Economic Value Added
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Where ROI Models Fail
Forget ROI
The Almanac: ROI
The Next Chapter: ROI
The New ROI
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Department Head and J. Gray Ferguson Professor of

ADDRESS ZSH335 / MSC PHONE 540.568.6530

Professor Pamela Peterson Drake, Ph.D. CFA, is the J. Gray Ferguson

drakepp mailto: drakepp@jmu.edu

1981 Ph.D. Business Administration University of North Carolina

1975 B.S. Business Administration Miami University, Oxford, Ohio

December 2004 to June 2007

August 1991 to December 2004

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02.05.00.00 - Formulas - http://educ.jmu.edu/~drakepp/investments/formulas/index.html

02.06.00.00 - Miscellaneous - http://educ.jmu.edu/~drakepp/investments/misc.html

02.07.00.00 - Glossary - http://educ.jmu.edu/~drakepp/investments/glossary.html

03.00.00.00 - Instructional: Principles of Financial Management - http://educ.jmu.edu/~drakepp/principles/index.html

03.01.00.00 - Course modules - http://educ.jmu.edu/~drakepp/principles/modules.htm

03.01.01.00 - Module 1: Introduction - http://educ.jmu.edu/~drakepp/principles/module1/index.html

03.01.02.00 - Module 2: Financial Analysis - http://educ.jmu.edu/~drakepp/principles/module2/index.html

(EQ 7) Net borrowing = new debt debt

(EQ 8) FCFE = cash flow - capital net