the yield to maturity for a zero-coupon bond is the return you will earn as an

investor from holding the bond to maturity and receiving the promised face
value payment.

Law of One Price guarantees that the risk-free interest rate equals the yield to
maturity on such a bond.

D E
WACCL = ´ rd (1- TC ) + ´ rL
When we calculate a bond’s yield to maturity, the yield we compute will be a D+E after-tax cost of debt D + E cost of levered
equity
rate per coupon interval. This yield is typically stated as an annual rate by
multiplying it by the number of coupons per year, thereby converting it to an rL = rf + b L ( E ( rm ) - rf )
APR with the same compounding interval as the coupon rate. é Dù
b L = beta of levered equity, usually b L = bU ê1+
ë E úû
If a bond’s yield to maturity has not changed, then the IRR of an investment in D, E = market value of debt and equity
the bond equals its yield to maturity even if you sell the bond early. These rL = cost of levered equity
results also hold for coupon bonds. T C = corporate tax rate
FCFN + 1  1 + g FCF 
VN = =    FCFN
rwacc − g FCF  (rwacc − g FCF ) 
Pick comparables of similar size. - Market values within 50%-150% are
generally OK, If we don’t know value, we could use sales, assets, or earnings.
Pick comparables in similar industry.
Pick comparables with similar leverage - P/E ratios cannot be compared across
firms with different leverage.
If firms have very different leverage, use enterprise value multiples and
compute enterprise value, then adjust to get equity value.
P0 Div1 / EPS1 Dividend Payout Rate
Forward P/E = = =
EPS1 rE − g rE − g
as interest rates and bond yields rise, bond prices will fall, and vice versa.
Firm with high P/E-Firms with high growth rates, Firm with low cost of equity,
shorter-maturity zero-coupon bonds are less sensitive to changes in interest Firm with high payout rate, Firms which generate cash well in excess of their
rates than are longer-term zero-coupon bonds. investment needs so that they can maintain high payout rates
bonds with higher coupon rates—because they pay higher cash flows
upfront—are less sensitive to interest rate changes than otherwise identical
V0 FCF1 / EBITDA1
bonds with lower coupon rates. =
EBITDA1 rwacc − g FCF
Bond prices converge to the bond’s face value due to the time effect, but Value = Valuation Driver firm × Multipliercomparable
simultaneously move up and down due to unpredictable changes in bond
yields Examples: Earnings, EBITDA, free cash flows; Subscription businesses -Sales or
# subscribers; Real estate-Square feet or acreage; Oil companies -Proven and
probable reserves’ businesses-Patents

Multiples are most useful in case of - firms have limited earnings histories or
cash flows or unpredictable paths to maturity, young firms funded by venture
capitalists, firms going public, For established firms, multiples are used to do a
gut check on free cash flow methods
Caution - Multiple based valuations have limitations - Invisible differences
between firms and their comparables. E.g., differences in accounting policies,
differences in off-balance sheet assets or liabilities. Misvaluation of entire
sectors. Comparable-based valuation only indicates value relative to another
firm, not absolute value. Thus, it is possible that both the firm and its
comparable are misvalued.
A call option gives the owner the right to buy the asset; a put option gives the
owner the right to sell the asset. the long side has the option to exercise, the
short side has an obligation to fulfill the contract. The market price of the
option is also called the option premium. This upfront payment compensates
the seller for the risk of loss in the event that the option holder chooses to
exercise the option.
Long Call: C = max(S - K, 0)
Long Put: P = max(K - S, 0)
call options with lower strike prices have higher market prices—the right to
buy the stock at a lower price is more valuable than the right to buy it for a
higher price. Conversely, because the put option gives the holder the right to
sell the stock at the strike price, for the same expiration date, puts with higher
strikes are more valuable.
If the payoff from exercising an option immediately is positive, the option is
said to be in-the-money. Call options with strike prices below the current stock
price are in-the money, as are put options with strike prices above the current
stock price. Conversely, if the payoff from exercising the option immediately is
negative, the option is out-of-the-money. Call options with strike prices above
the current stock price are out-of-the-money, as are put options with strike
prices below the current stock price.
Portfolio Insurance
Put Call Parity: S + P = PV(K ) + C
you can think of a call as a combination of a levered position in the stock, S -
PV(K ), plus insurance against a drop in the stock price, the put P.
with dividend: C = P + S - PV(K ) - PV(Div)
• Call option
• Higher the strike price (K)
• => lower the profit for the call option buyer.
• => lower the loss for the call option writer.
• => lower the price demanded (or premium) by option writer from buyer.
• Put option
• Higher the strike price (K)
• => higher the profit for the put option buyer.
• => higher the loss for the put option writer.
• => higher the price demanded (or premium) by option writer from buyer.
Because an American option carries all the same rights and privileges as an
otherwise equivalent European option, it cannot be worth less than a
European option. If it were, you could make arbitrage profits by selling a
European call and using part of the proceeds to buy an otherwise equivalent
American call option. Thus, an American option cannot be worth less than its
European counterpart.
a put option cannot be worth more than its strike price.
A call option cannot be worth more than the stock itself.
The intrinsic value of an option is the value it would have if it expired
immediately. Therefore, the intrinsic value is the amount by which the option
is currently in-the-money, or zero if the option is out-of-the-money. If an
American option is worth less than its intrinsic value, you could make arbitrage
profits by purchasing the option and immediately exercising it. Thus, an
American option cannot be worth less than its intrinsic value.
An American option with a later exercise date cannot be worth less than an
otherwise identical American option with an earlier exercise date. Usually the
right to delay exercising the option is worth something, so the option with the
later exercise date will be more valuable.
The same argument will not work for European options, because a one-year
European option cannot be exercised early at six months. As a consequence, a
European option with a later exercise date may potentially trade for less than
an otherwise identical option with an earlier exercise date.
Note on cash flow projection
Sales projections: For existing products: estimated future size of the industry,
likely market share, For new industries: size of the target demographic and
likely penetration, Competition from existing players, threat of new entrants,
new prod
Cost projections-Changing technology, Cost of inputs,Govt policy, How
NREGA impacted labor cost of firms?
Change in NWC: Net working capital is often a percentage of sales revenue,
Differs from industry to industry. :
Capital Exp: Depends on expected growth, High growth: typically capital
expenditure will exceed depreciation, Cannot support growth without
investment; How capital intensive is the business?
Growth Rate: Can you take historical growth rate?-Caution: underlying
fundamentals, business cycle may not persist,
Earnings driver likely to persist?//Growth rate forecasted by analysts: Likely
to be better than historical growth rates. Why? Drawback: Very specialized
business, Analysts don’t cover all companies ,Forecast accuracy quickly fades
farther in future