SAINT JEROME MANAGEMENT AND BUSINESS SCHOOL

COURSE TITLE: FINANCIAL MATHEMATICS

LEVEL: ONE

LECTURER: FORBENEH JUDE

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COURSE OUTLINE

CHAPTER 1 – TIME PREFERENCE OF MONEY: COMPOUNDING AND DISCOUNTING METHODS

CHAPTER 2 - LOANS

CHAPTER 3 – CAPITAL BUDGETING

CHAPTER 4 – THE CONCEPT OF RISK AND RETURN

CHAPTER 5 – EVALUATION OF BONDS AND SHARES

CHAPTER 6 – COST OF CAPITAL

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CHAPTER 1 – TIME PREFERENCE OF MONEY: COMPOUNDING AND DISCOUNTING METHODS

Money has time value. A franc today is more valuable than a year next. The recognition of the time value of
money and risk is extremely vital in financial decision making. Thus, we conclude that time value of money
is central to the concept of finance. It recognizes that the value of money is different at different points of
time. Since money can be put to productive use, its value is different depending upon when it is received or
paid. In simpler terms, the value of a certain amount of money today is more valuable than its value
tomorrow. It is not because of the uncertainty involved with time but purely on account of timing. The
difference in the value of money today and tomorrow is referred as time value of money.

There are two techniques for adjusting time value of money. They are:

1. Compounding Techniques/Future Value Techniques

2. Discounting/Present Value Techniques

The value of money at a future date with a given interest rate is called future value. Similarly, the worth of
money today that is receivable or payable at a future date is called Present Value.

1.1- Concepts of simple and compound interest

Interest is the compensation one gets for lending a certain assets. In other words, it is the reward for
lending the capital to somebody for a period of time. For instance, suppose that you put some money on a
bank account for a year. Then, the bank can do whatever it wants with that for a year. To reward you for
that, it pays you some interest. The asset being lent is called the capital. Usually, both the capital and the
interest is expressed in money. However, that is not necessary. For instance, a farmer may lend his tractor
to a neighbour, and get 10% of the gain harvested in return. In this course, the capital is always expressed
in money, and in that case it is also called the principal.

There are various methods for computing the interest. As the name implies, simple interest is easy to
understand, and that is the main reasons why we talk about it here. The idea behind simple interest is that
the amount of interest is the product of three quantities: the rate of interest, the principal, and the period of
time. However, simple interest suffers from a major problem. For this reason, its use in practice is limited.

The interest earned (I) on a capital C lent over a period n at a rate i is C x n x i (i.e., I = Cni)

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Example – How much interest do you get if you put 1000 for two years in a savings account that pays
simple interest at a rate of 9% per annum? And if you leave it in the account for only half a year?

Solution. If you leave it for two years, you get

2 x 0.09 x 1000 = 180 in interest.

If you leave it for only half a year, then you get ½ x 0.09 x 1000 = 45

Most bank accounts use compound interest. Compounding interest rate is commonly used in computing
monthly loan repayment such as housing loan, in evaluating investment, and in valuing securities. The idea
behind compound interest is that in the second year, you should get interest on the interest you earned in
the first year. In other words, the interest you earn in the first year is combined with the principal, and in the
second year you earn interest on the combined sum.

A capital C lent over a period n at a rate i grows to C (1 + i) n.

Example – How much do you have after you put 1000 pounds for two years in a savings account that pays
compound interest at a rate of 9% per annum?

Answer. If you leave it in the account for two years, then at the end you have:

(1 + 0.09)2 x 1000 = 1188.10

1.2 - Future and Present Value (single principal sum)

In generally, the concepts of future and present value are apprehended with the use of line diagram as
shown below:

0 n

P = F (1 + i)−n F = P(1 + i)n

1.2.1 – Future value

The future of an investment is acquired by compounding future value of cash flows. Generally, to calculate
the future value (capitalisation) of a capital invested today, we need to designate the compounding rate of

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interest and the period in which the capital is invested. Indeed, the general formula of compound interest
facilitates the calculation of future value of a lump sum.

Let’s denote by:

P = Present value

i = The interest rate

n = The number of periods

F = The future value obtained after n periods

The general formula of future value is F = P(1 + i)n

The term (1+i) n is the compound value factor (CVFn,i) of a lump sum of money of 1 frs, and it always has a
value greater than 1 for positive i, indicating that CVF increases as i and n increase. To compute the future
value of a lump sum amount, we should simple multiply the amount by compound value factor (CVF) for the
given interest rate, i and the time period, n. The value of CVF is obtained from financial tables.

Example – Consider a sum of 8, 200 pounds is deposited into a savings account that pays 5% per annum.
How much will be in the next 5 years if compounding is done annually.

Answer. F = 8,200 x (1+0.05)2 = 8,200 x (1.05)2 = 10,466 pounds

Example – Suppose that a capital of 500 dollars earns 150 dollars of interest in 6 years. What was the
interest rate if compound interest is used?

Answer. The capital accumulated to 650 dollars, so in the case of compound interest we have to solve the
rate i from the equation

(1 + i) 6. 500 = 650 (1+i) 6 = 1.3

1 + i = 1.31/6 = 1.044698 . . . .

i = 1 - 1.044698 = 0.044698 . . . .

Example : How long does it take to double your capital if you put it in an account paying compound interest
at a rate of 7 ½ %

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Answer. The question is for what value of n does a capital C accumulate to 2C if i = 0.075. So we have to
solve the equation C (1+0.075)n = 2C . The first step is to divide by C to get (1.075)n = 2. . Then take
logarithms:

log 2
log (1.075)n = log 2 n log (1.075) = log 2 n = log(1.075) = 9.58 . . . . . .

1.2.2 – Present value

To determine the present value, is to find out how much should be deposited at present in other to yield a
desire amount in the future. Discounting is the process of determining present values of a lump sum of
money. The compound interest rate used for discounting cash flows is called the discount rate. The present
value is the inverse of future value which can be simplified as follows:

1
P=F (1+i)n
or P = F (1 + i)−n

Example. Suppose a total sum of 10,500 euro is needed in 5 years from now. What will be the single sum
of money need to be deposited today in an account that pays 5% per annum?

Answer. P = 10,500 x (1+0.05)-5 = 10,500 x (1.05)-5 = 8,227

1.2.3-Using natural logarithms to calculate future and present values of a single sum

When using “Logs” the following properties must be respected:

 Log (a * b) = log a + log b

 Log (a/b) = log a + log b
 Log an = n log a

If a capital is P is deposited in an account that yields compound interest for n years at the rate i, it will
yield an amount of F:

F = P(1 + i)n (take logs of both sides)

Log F = Log P(1 + i)n

Log F = Log P + n Log(1 + i)

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 F = 10Log P+n Log(1+i)

It implies as well that: P = 10Log F−n Log(1+i)

N.B : Using Naperian’s logarithm , we have F = 𝑒 ln P+n ln(1+i) and P = 𝑒 ln F−n ln(1+i)

Example. A capital of 100 000 f is deposited in an account at 6% interest rate compounded annually. What
will be the future amount after 10 years?

Answer. F = 𝑒 ln100000+10 ln(1.06) = 179084.7697 or F = 10Log 100000+n Log(1.06) = 179084.7697

1.24-Using financial tables to calculate future and present value of a single sum

Example. A capital of 100 000 f is deposited in an account at 6% interest rate compounded annually. What
will be the future amount after 10 years?

Answer. F = 100 000 x FVIF10, 6

From the table, future value interest factor (FVIF6, 10) = 1,79084. 7697

F = 100000 x 1.7908 = 179080

1.25-Stated interest rate (j)

Stated interest rate (j) can be determined if a present value, a future value and a period (n) are known,
which is given by: -

j = (FV/PV) 1/n – 1

Example. Consider a balance sum of 10,500 dollars will be realised in an investment at the end of a 5-year
if a single sum of 8,200 dollars is invested today. What is the stated interest rate per annum given a
compounding frequency semi-annually?

Answer. j = (10.500/ 8,200)1/10 – 1

= (1.2805)0.1 – 1

= 0.025 0r 2.5% per quarter (10% p.a.)

1.2.6- Stated period (n)

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For a given sum of money today, we can also determine its time period (n) if the interest rate and terminal
future sum are known, which is given by : -

n = log (FV/PV) ÷ log (1+i)

Example. Consider placing a lump sum deposit of 8.500 today in a savings account that earns interest at
5% p.a. How long does it take to realise a savings balance of 15,000 if the compounding period is
annually?

Answer. n = log (15,000/8,500) ÷ log (1.05)

= log (1.7647) ÷ 0.0212

= 0.24667 ÷ 0.0212

= 11 years 7 months

1.2.7 – Multiple compounding periods

Up to now, we assumed that cash-flow occurs or interest is paid once a year. In practice interest is often
paid more frequently, for instance quarterly (four times a year). For example, banks may pay interest on
savings account quarterly. On bonds or debentures and public deposits, companies may pay interest semi-
annually. Similarly financial institutions may require corporate borrowers to pay interest quarterly or half-
yearly. The interest rate is usually specified on an annual basis in a loan agreement or security (such as
bonds), and is known as nominal interest rate.

If compounding is done more than once a year, the actual annualized rate of interest would be higher than
nominal interest rate and is called the effective interest rate. Effective interest rate (EIR) brings all the
different bases of compounding such as yearly, half-yearly, quarterly, and monthly on a single platform for
comparison to select the beneficial base.

An effective interest rate is the nominal/stated interest rate adjusted by the frequency of compounding. It is
the rate of interest, which is compounded annually, generates the same amount of interest payment as the
nominal rate does when compounded m times per year.

i
EIR (r) = (1 + )m −1
m

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Where:

i = annual nominal rate of interest

m = number of compounding per year

Example. Suppose that an account offers a nominal interest rate of 8% p.a. payable quarterly. What is the
effective interest rate? What if the nominal rate is the same, but interest is payable monthly? Weekly?
Daily?

Answer. For interest payable quarterly, we put m = 4 and i = 0.08 and n = 1. We have:

0.08 4
r = (1 + ) − 1 = 0.08243 = 8.243%
4

0.08 12
Monthly (p =12): r = (1 + ) − 1 = 0.08300 = 8.300%
12

0.08 52
Weekly (p=52): r = (1 + ) − 1 = 0.08322 = 8.322%
52

0.08 365
Daily (p =365): r = (1 + ) − 1 = 0.08328 = 8.328%
365

The concept of multi-compounding can be used to accomplish the multi-period compounding or

discounting. The equation below is to compute the compounded and/or discounting value of a sum in case
of the multi-period compounding:

i nxm
Fn = P [1 + ]
m

1 i −nxm
P=F [ i nxm
] = F (1 + m)
(1+ )
m

Fn is the future value, P the cash flow today, i the annual rate of interest, n is the number of years and m is
the number of compounding per year.

Example. If a company pays 15 per cent interest, compounded quarterly, on a 3- year public deposit of
1,000, then the total amount compounded after 3 years will be:

Solution.

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 i nxm
Fn = P [1 + ]
m

0.15 3x4
Fn = 100 [1 + ]
4

= 1,555

o Continuous compounding

Sometimes compounding may be done continuously. For example, banks may pay interest continuously;
they call it daily compounding. The continuous compounding function takes the form of the following
formula:

𝐹𝑛 = 𝑃 𝑥 𝑒 𝑖𝑥𝑛

𝐹
P = 𝑒 𝑖𝑛𝑛 = 𝐹𝑛 𝑥 𝑒 −(𝑖𝑥𝑛)

In the equation above, interest rate i is multiplied by the number of years n and e is equal to 2.7183.

Example. Let us find out the compound value of 1,000 interest rate being 12 per cent per annum if
compounded annually, semi-annually, quarterly and monthly for 2 years.

Answer. If the compounding is done continuously, then the compound value will be: -

F2 = 1,000 x e(0.12)(2) = 1,000 x e0.24 = 1,000 x 1.2713 = 1,271.30 frs

2 – ANNUITIES

Annuity is a fixed payment (or receipt) each year for a specified number of years. If you rent a flat and
promise to make a series of payments over an agreed period, you have created an annuity. The equal
instalments loans from the house financing companies or employers are common examples of annuities. A
stream of cash flows that is made in an equal size and at regular interval is known as annuity. However, a
stream of cash flows may also occur irregularly and in different sizes, and therefore the computations of PV
or FV will involve more than a single formula.

A series of equal cash payments that comes in at the same point in time when the compounding period
occurs is known as simple annuity. In contrast, in a general annuity the annual payments occur more
frequent than interest is compounded or the interest compounding occurs more frequent than annuity

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payments are made. In short, there is mismatch of occurrence frequency between annuity made and
interest compounded.

Simple annuities comes in four different forms as follows: -

o Ordinary annuity – an annuity payment made at the end of each compounding period;
o Annuity due – a series of equal cash payments made at the beginning of each compounding
period;
o Deferred annuity – a series of equal cash payments may also occur after a lapse of compounding
periods;

and

o Perpetuity – a series of equal payments occurs forever

2.1 – Simple annuities

2.1.1– Ordinary Annuity

o Future value

Ordinary annuities are regular payments made at the end of each compounding period. The FV of an
ordinary annuity is the sum of all the regular equal payments and the compounded interest accumulated at
the end of last period. The FV is determined as follows: -

(1+i)n − 1
FV = A [ ]
i

The compound value of an annuity in case of the multi-period compounding is given as follows:

𝑖 𝑛𝑥𝑚
(1+ ) −1
𝑚
𝐹𝑛 = 𝐴 [ 𝑖 ]
𝑚

where:

A = annuity payment at end of each period

Example. Consider an equal yearly sum of 1,200 dollars deposited regularly for 5 years in a savings
account that pays 5% p.a. compounded annually. What is the future value?

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Answer. Illustration

Annuities 1200 1200 1200 1200 1200

Year 0 1 2 3 4 5

Note : The annuity is paid at the end of each year in which there is total of 5 annuities paid.

(1.05)5 −1
FV = 1,200 x = 6,631 dollars
0.05

o Present value

The PV of an ordinary annuity is the sum of all regular equal payments discounted at a certain rate in at the
end of each period. It is determined as: -

1− (1+i)−n
PV = A [ ] (8)
i

1− (0.05)−5
Considering the example above, PV = 1,200 x = 5,195 dollars
0.05

2.1.2 - Annuity due

The concepts of compound value and present value of an annuity are based on the assumption that series
of cash flows occur at the end of the period. In practice, cash flows could take place at the beginning of
the period. It is common in lease or hire purchase contracts that lease or hire purchase payments are
required to be made in the beginning of each period. Annuity due is a series of fixed receipts or payment
starting at the beginning of each period for a specified number of periods.

Annuity due is the same as ordinary annuity with a slight different in the timing of the payments made. The
annuity payments are made at the beginning of each compounding period. The computations of present
value and future value therefore have to take into consideration the earlier occurrence of annuity, i.e. at the
front of compounding periods. For instance, an annuity payment of 1,200 is made annually for 5 years with
an interest rate of 5% p.a.

o Present value

In determining the present value, we consider one(1) annuity payment is made in the present and n-1 made
in the future periods as indicated in the timeline below: -

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Annuities 1200 1200 1200 1200 1200

Year 0 1 2 3 4 5

1− (1+i)− (n−1) 1− (1+i)−n

PV = A [ + 1 ] or PV = A [ ] (1 + i) (Present value of an annuity x (1+i) (9)
i i

1− (1.05)− (4)
PV = 1,200 [ + 1 ] = 1,200 x 4.546 = 5,454.75 dollars
0.05

o Future value

In determining the future value (FV) of an annuity due, we consider n+1 as the annuities occur at the
beginning of each compounding period. For instance, considering the above example, we take n = 6 and
from equation 7, minus a factor 1 since there is no annuity payment made at the beginning of period 6.
Thus,

(1+i)n+1 − 1 (1+i)n − 1
FV = A [ − 1] or FV = A [ ] (1 + i) (future value of annuity x (1+i) (10)
i i

(1.05)6 − 1
Answer. FV = 1,200 [ − 1] = 1,200 x 5.8019 = 6962.28 dollars
0.05

2.1.3– Deferred Annuity

There are instances when the annuity payments made after a number of compounding periods have
elapsed. Assuming annuity payments made only after 2 years have passed as indicated in a timeline
below:

Annuities 1200 1200 1200

Year 0 1 2 3 4 5

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The annuity is the same as the ordinary annuity except that the even stream of cash flows occurs later in a
given compounding periods.

For example, we consider the above timeline in which an annuity of 1,200 dollars only occurs at the end of
the period 3, 4 and 5. What is the present value if the interest rate is 5% p.a. compounded annually?

Answer. To determine the present value, we should consider the following approach:

1− (1+𝑖)−𝑛 1− (1+𝑖)−𝑛
PV= A [ − ]
𝑖 𝑖

PV = 1200 x (PVFA5%,3 − PVFA5%,2 )

PV = 1,200 x (4.329 − 1.859) (using financial tables)

PV = 1,200 x 2.47

PV = 2.964 dollars

2.1.4– Perpetuity

When annuity payments occur continuously, only the present value of annuities should be considered.
Supposed a non-redeemable share provide dividends in perpetuity of 120 dollars per year while the market
rate of return is 10% p.a. To determine the PV the even stream of cash flows is simply discounted by 10%,
which gives 1,200 dollars, i.e. 120/0.1 = 1,200 dollars. Thus, the present value of perpetuity is:

𝐴
P=
𝑖

Where,

A = present value of annuity

i = interest rate or rate of return

2.2 – General annuities

In a general annuity, the compounding of interest does not occur at the same time as an annuity payment is
made. Suppose we place a sum of money for a 12-month period in a fixed deposit account and rollover

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upon maturity in each subsequent year. If the account pays interest semi-annually, effectively the rate of
interest is greater than the stated or nominal rate.

To determine its future value or present value, we have to convert the stated interest rate (nominal interest
rate) that matches the payments period, which gives the effective interest rate. This depends on the
frequency of compounding period whether it is yearly, semi-annually, quarterly, monthly or daily. When the
nominal rate of interest is adjusted according to the frequency of compounding, the effective rate of interest
is used to calculate both the future and present value of annuity.

𝑖
(1+ ) 𝑛𝑥𝑚 −1
Future value of an annuity is = A[ 𝑚
𝑖/𝑚
] ; and

1− (1+i/m)−nxm
Present value of annuity is = A [ ]
i/m

Example. Let us find out the compound value of 1,000 interest being 12 per cent per annum if compounded
annually, semi-annually, quarterly and monthly for 2 years.

2.2.2– Uneven stream of cash flows

A stream of cash flows may not necessarily occur in equal sizes over the life term of an investment. For
instance, Investment made by a firm does not frequently yield constant periodic cash flows (annuity). In
most instances the firm receives a stream of uneven cash flows. The procedure is to calculate the presence
value of each cash flow and aggregate all present values. Thus:

𝐴
P = ∑𝑛𝑡=1 (1+𝑖)
𝑡
𝑡
(12)

Year 1 – 2, 000 dollars

Year 2 – 1, 500 dollars

Year 3 – 3, 000 dollars

Year 4 – 3 000 dollars

What is the PV if the discount rate is 5% p.a. compounded annually?

2,000 1,500 3,000 3,000

Answer. PV = (1.05) + + + = 1904.762 + 1,360.50 + 2591.517 + 2468.107 = 8324. 886
1.052 1.053 1.054

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2.2.2 - Present value of growing annuity: In financial decision-making there are number of situations
where cash flows may grow at a constant rate. For example, in the case of companies, dividends are
expected to grow at a constant rate. In such a situations, the present value is given by: -

1 (1+𝑔)1 (1+𝑔)2 (1+𝑔)𝑛−1

P = A[(1+𝑖) + (1+𝑖)2
+ (1+𝑖)3
+ …+ (1+𝑖)𝑛
]

where,

Vn = Vo (1 + r) n, is the constant rate of growth of cash flows in percentage;

Vo= variable for which the growth rate is needed;

Vn = variable value (amount) at the end of year ‘n’; and

(1 + r) n= growth rate.

In the equation above, n – the symbol for the number of year is not finite and that it extends to infinity (∞).
Then the calculation of the present value of a constantly growing perpetuity is given by the simple formula
as follows:

A
P = i−g

Example. Suppose dividends of 66 after one are expected to grow at 10 per cent indefinitely. The discount
rate is 21 per cent. What is the present value of the dividend?

Solution.

A
P = i−g

66
P = 0.21−0.1 = 600

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CHAPTER 2 – LOANS

2.1 – Annuity payment (A)

The amount of annuity payment can also be determined given that its present value or future value is
known. Suppose a present value of 5,195 is discounted at a rate of 5% p.a. compounded annually over a 5-
year period. What is the annual regular payment made?

1− (1+i)−n
From the equation PV = A [ ]
i

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 PV i x PV
Annuities (A) = 1− (1+i)−n = 1− (1+i)−n
i

A = 5, 195 ÷ 4.3295

A ≅ 1, 200

o Annuities can also be viewed from a borrowing perspective. Assume that a loan sum of 50, 000
dollars compounded monthly at 12% p.a. for 10 years, what is the monthly payment then?

Answer. n = 120 months, i = 12/12 = 1%, PV = 50, 000.

1− (1.01)−120
50, 000 = A [ 0.01
]

50, 000 = A (69.7005)

A = 50 000 / 69.7005 = 717.35 dollars (monthly payment)

2.2- Loan Balance

Consider a loan with a fixed term of maturity, to be redeemed by a series of repayments. If the repayments
prior to maturity are only to offset the interests, the loan is called an interest-only loan. If the repayments
include both payment of interest and partial redemption of the principal, the loan is called a repayment loan.
We consider two approaches to compute the balance of the loan: the prospective method and the
retrospective method.
a) The prospective method is forward looking. It calculates the loan balance as the present value of all
future payments to be made. With the prospective method, the outstanding loan balance at any point in
time is equal to the present value at that date of the remaining payments.
b) The retrospective method is backward looking. With the retrospective method, the outstanding loan
balance at any point in time is equal to the original amount of the loan accumulated to that date less the
accumulated value at that date of all payments previously made. In other words, it calculates the loan
balance as the accumulated value of the loan at the time of evaluation minus the accumulated value of all
instalments paid up to the time of evaluation.
Let the loan amount be L, and the rate of interest per payment period be i. If the loan is to be paid back in
1
n instalments of an annuity-immediate, the instalment amount A is given by A = L [ 1−(1+i)−n ]
i

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We also denote L =B0 , which is the loan balance at time 0. Immediately after the mth payment has been
made the loan is redeemable by a n-m annuity-immediate.
To use the retrospective method, we first calculate the accumulated loan amount at time m, which is
L(1 + i)m
(1+i)m −1
The accumulated value of the instalments isA [ ].
i
(1+i)m −1
Thus, the loan balance can also be written as L(1 + i)m - A [ ]
i

Example. A housing loan of $400,000 was to be repaid over 20years by monthly instalments of an annuity-
immediate at the nominal rate of 5% per year. After the 24th payment was made, the bank increased the
interest rate to 5.5%. If the lender was required to repay the loan within the same period, how much would
be the increase in the monthly instalment. If the instalment remained unchanged, how much longer would it
take to pay back the loan?

Solution: We first demonstrate the use of the prospective and retrospective methods for the calculation of
the loan balance after the 24th payment. The amount of the monthly instalment is

400,000 400,000
A= 0.05 −240
= 151.525 = 2,639.82,
1−(1+ )
12
0.05
[ 12 ]
where, 0.05/12 is the monthly effective rate
By the prospective method, after the 24th payment the loan would be redeemed with a 216-payment
annuity-immediate so that the balance is

2,63982
B216 = 0.05 216
= 375,490
1−(1+ )
12
0.05
[ 12 ]

By the retrospective method:

0.05 24
(1+ ) −1
o The accumulated value of the instalments is 2,639 [ 12
0.05 ].
12

19
 0.05 24
o The accumulated loan amount is L(1 + i)m = 400,000 (1 + )
12
0.05 24
0.05 24 (1+ ) −1
o The balance is 400,000 (1 + ) − 2,639 [ 12
0.05 ]. = 375,490
12
12

After the increase in the rate of interest, if the loan is to be repaid within the same period, the revised
0.055 24
(1+ ) −1
monthly instalment is 375,490 [ 12
0.055 ] = 2,742.26, so that the increase in instalment is 2,742.26 -
12

2,639.82 = 102.44.
Example. Suppose that a loan of 2500 pounds at 6 ½ % interests can be repaid by ten instalments of
347.76 pounds, each being paid at the end of the year. Now, what is the remaining balance of the loan after
six years?

o The accumulated value of these payments is

A [(1+i) n -1)/ i] = 347.76[(1.065)6 -1)/ 0.065] (future value of annuity)

FV = 347.76 (7.063728) = 2456.48

o The value of the loan after six year is

2500 (1+0.065) 6 = 2500 x 1.459142 = 3647.86 (future value of lump sum)

o So the remaining balance of the loan is 3647.86 – 2456.48 = 1191.36

The prospective method uses that the remaining balance equals the present value of the remaining
payments. The borrower still has to make four payments of 347.76 pounds. We need the present value of
these payments six years after the start of the loan. This is one year before the first of the four remaining
payment is due, so the present value of the four remaining payments is

1− (1.065)−4
347.76 [ ] = 347.76 x 3.425799 = 1191.36 pounds
0.065

Example. Assume that a loan sum of 50, 000 dollars compounded monthly at 12% p.a. for 10 years, what is
the monthly payment then? What is the principal balance of 49 th month of the balance after 48 month (i.e.
72 months remaining)?

20
Answer. n = 120 months, i = 12/12 = 1%, PV = 50, 000.

1− (1.01)−120
50, 000 = A [ ]
0.01

50, 000 = A (69.7005)

A = 50 000 / 69.7005 = 717.35 dollars (monthly payment)

Answer. The principal balance at the beginning of 49th month is 36,393 which is computed as follows:

a) Prospective method

P = 717.35 x [1- (1.01)-72 / 0.01]

= 717.35 x 51.15039

= 36692.73

b) Retrospective method

(1.01)48 −1
o Accumulated value of payment is 717.35 x = 43918.03768
0.01

o Value of loan after 48 months is 50000 (1.01)48 = 80611.30388

o Remaining balance of the loan is 80611.30388 − 43918.03768 = 36692.73

2.3- Loan Repayment Methods

Loan is an arrangement in which a lender gives money or property to a borrower and the borrower agrees
to return the property or repay the money, usually along with interest, at some future point(s) in time.
Various methods of repaying a loan are possible. We will consider two of them: The amortization method
and the sinking fund method.
The amortization method: In this method the borrower makes instalment payments to the lender. Usually
these payments are at a regularly spaced periodic intervals; the progressive reduction of the amount owed
is described as the amortization of the loan. Examples include car loan, home mortgage repayment.
The sinking fund method: In this method the loan will be repaid by a single lump sum payment at the end
of the term of the loan. The borrower pays interest on the loan in instalments over this period. However, the
borrower may prepare himself for the repayment by making deposits to a fund called a sinking fund to
accumulate the repayment amount.

21
2.3.1- Amortization
When a loan is being repaid with the amortization method, each payment is partially a repayment of
principal and partially a payment of interest. Determining the amount of each for a payment can be
important. An amortization schedule is a table which shows the division of each payment into principal and
interest, together with the outstanding loan balance after each payment is made.

Example. A loan of 2,500 pounds at a rate of 6 ½ % is paid off in ten years, by paying ten equal instalments
at the end of every year. How much each instalment? Establish a loan schedule or amortisation table of the
loan.

1− (1+i)−n
Answer. From the equation, PV = A [ ]
i

We have, 2,500 = A [1- (1.065)-10 / 0.065]

2,500 = A (7.18883)

A = 2,500/7.18883

A = 347.7617 pounds

Year Payment (a) Interest paid (b) Principal repaid (c) Outstanding balance (d)

a = annuity b = d x i (i=0.065) c=a–b d = d (n) – c (n+1)

O - - - 2500

1 347.76 162.50 185.26 2314.74

2 347.76 150.46 197.30 2117.44

22
3 347.76 137.63 210.13 1907.31

4 347.76 123.93 223.78 1683.53

5 347.76 109.43 238.33 1445.20

6 347.76 93.94 253.82 1191.38

7 347.76 77.44 270.32 921.06

8 347.76 59.87 287.89 633.17

9 347.76 41.16 306.60 326.57

10 347.76 21.23 326.53 0.04

2.3.2- Sinking Fund

A loan may also be served by payment of interest on a periodic basis, with a lump sum equal to the original
principal paid at the end of the loan period. Indeed, an alternative for repaying a loan in instalments by the
amortization method, a borrower can accumulate a fund which will exactly repay the loan in one lump sum
at the end of a specified period of time. The borrower deposits an amount periodically into a sinking fund so
as to accumulate to the principal. This fund is called a sinking fund. It is generally required that the
borrower periodically pay interest on the loan, sometimes referred to as a service. In some cases payments
into a sinking fund may vary irregularly at the discretion of the borrower. However, we will be dealing with
sinking funds with regular contributions.
Because the balance in the sinking fund could be applied against the loan at any point, the net amount of
the loan is equal to the original amount of the loan minus the sinking fund balance.
However, if the rate of interest paid on the loan equals the rate of interest earned on the sinking fund, then
the amortization method and the sinking fund method are equivalent.

Companies generally create sinking funds to retire bonds (debentures) on maturity. The factor used to
calculate the annuity for a given future sum is called the sinking fund factor.

o Consider a loan of amount P and rate of interest i.

o By the sinking fund method, the borrower pays an amount P x i each period to serve the interest.

23
 o He deposits instalments into a sinking fund. Suppose the sinking fund accumulates interest at the
rate of interest i.
𝑖
o To accumulate to P at time n , each sinking fund instalment is P[(1+𝑖)𝑛 −1]
𝑖
o The total amount the borrower has to pay each period is P x i + P[(1+𝑖)𝑛−1]

Example. Construct a sinking fund schedule of a loan of $5,000 to be repaid over 6 years with a 6-payment
annuity-immediate at effective rate of interest of 6% per year.
Solution. The interest payment is 5,000 x 0.06 = 300, and the sinking fund deposit is
0.06
5,000[(1+0.06)6 −1] = 716.81

Hence the total annual instalment is 300 + 716.81 = 1,016.81. The sinking fund schedule is presented
below.
Year Instalment Interest payment Sinking fund deposit sinking fund interest sinking fund balance
1 1,016.81 300 716.81 0.00 716.81

2 1,016.81 300 716.81 43.01 1,476.63

3 1,016.81 300 716.81 88.60 2,282.04

4 1,016.81 300 716.81 136.92 3,135.77

5 1,016.81 300 716.81 188.15 4,040.73

6 1,016.81 300 716.81 242.44 5,000.00

Total 6,100.86 1,800 4,300.86 699.14

Throughout the 6 years the sinking fund accumulates interest of 699.14, which is the difference between
the interest paid under the sinking fund method and the interest paid using amortisation namely, 1,800 –
1,100.86.

a) We now consider the case where the sinking fund earns a rate of interest different from that charged to
the loan. Suppose the sinking fund earns interest at the rate of j per payment period. For a loan of amount
𝑗
P, to accumulate to the principal in the sinking fund over n periods the periodic instalment is P[(1+𝑗)𝑛−1].
j 𝑗
Hence, the total instalment is P x i + P[(1+j)n −1] = P(𝑖 + (1+𝑗)𝑛 −1
).

24
 o When i = j, the sinking fund method and the amortisation method are the same.

Example. A 5-year loan of $500 is to be repaid by a 5-payment annuity-immediate using the sinking fund
method. The loan charges 6% interest and the sinking fund credits 4% interest. What is the annual
instalment? If this instalment is used to pay back a loan of the same amount by amortization, what is the
rate of interest?

0.04
Solution. The instalment is 500 x 0.06 + 500[(1+0.04)5 −1] = 122.31

CHAPTER 3 – CAPITAL BUDGETING DECISIONS

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure
decisions. A capital budgeting decision may be defined as the firm’s decisions to invest its current funds
most efficiently in the long-terms assets in anticipation of an expected flow of benefits over a series of
years. The long-term assets are those that affect the firm’s operations beyond the one-year period. The
firm’s investment decisions would generally include expansion, acquisition, modernisation and replacement
of the long-term assets.

3.1 – Investment evaluation criteria and investment decision rule

25
Three steps are involved in the evaluation of an investment:

o Estimation of cash flows

o Estimation of the required rate of return (the opportunity cost of capital)
o Application of a decision rule for making choice

However, our discussion in this chapter is confined to the third step. Generally, the first two steps are
assumed as given.

The investment decision rules may be referred to as capital budgeting techniques, or investment criteria. A
sound appraisal technique should be used to measure the economic worth of an investment project. The
essential property of a sound technique is that it should maximise the stakeholders’ wealth. The following
other characteristics should also be possessed by a sound investment evaluation criterion:

o It should consider all cash flows to determine the true profitability of the project.
o It should provide for an objective and unambiguous way of separating good projects from bad
projects.
o It should help ranking of projects according to their true profitability.
o It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash
flows are preferable to later ones.
o It should help to choose among mutually exclusive projects that project which maximises the
shareholders’’ wealth.
o It should be a criterion which is applicable to any conceivable investment project independent of
others.

3. 2 – Evaluation criteria

A number of investment criteria (or capital budgeting techniques) are in use in practice. They may be
grouped in the following two categories:

o Discounted Cash Flow (DCF) Criteria

 Net present value (NPV)
 Internal rate of return (IRR)
 Profitability index (PI)
o Non-discounted Cash Flow Criteria

26
  Payback period (PB)
 Discounted payback period
 Accounting rate of return (ARR)

3.2.1 – Discounted Cash Flow Criteria

3.2.1.1 – Net Present Value Method

The net present value (NPV) method is the classic economic method of evaluating the investment
proposals. The net present value criterion is the most valid technique of evaluating an investment project. It
is consistent with the objective of maximising the wealth of shareholders. The formula for the net present
value can be written as follows:

𝐶 𝐶2 𝐶 𝐶𝑛
NPV = [(1+𝑘)
1
+ (1+𝑘)2
3
+ (1+𝐾) 3+ ....+ (1+𝑘)𝑛
] − 𝐶0

𝐶
NPV = ∑𝑛𝑡=1 (1−𝑘)
𝑡
𝑡 − 𝐶0

where 𝐶1 , 𝐶2 . .. represent the net cash inflows in the year 1, 2 . . . , k is the opportunity cost of capital, 𝐶0
is the initial cost of the investment and n is the expected life of the investment. It should be noted that the
cost of capital, k, is assumed to be known and is constant.

Example. Assume that a project costs 2,500 dollars now and is expected to generate year-end cash inflows
of 900, 800, 700, 600, and 500 in years 1 through 5. The opportunity cost of the capital may be assumed to
be 10 per cent. Calculate the present value.

𝐶 𝐶2 𝐶 𝐶𝑛
Answer. NPV = [(1+𝑘)
1
+ (1+𝑘)2
3
+ (1+𝑘)3 + ....+ (1+𝑘)𝑛
] − 𝐶0

900 800 700 600 500

NPV = [(1+0.1) + (1+0.1)2
+ (1+0.1)3 + (1+0.1)4
+ (1+0.1)5
] − 2500

NPV = 225 dollars

o Acceptance rule

It should be clear that the acceptance rule using the NPV method is to accept the investment project if the
net present value is positive (NPV > 0) and to reject it if the net present value is negative (NPV < 0). The
positive net present value will result only if the project generates cash inflows at a rate higher than the

27
opportunity cost of capital. A project with zero NPV (NPV = 0) may be accepted. A zero NPV implies that
project generates cash flows at a rate just equal to the opportunity cost of capital. The NPV acceptance
rules are:

 Accept the project when NPV is positive NPV > 0

 Reject the project when NPV is negative NPV < 0
 May accept the project when NPV is zero NPV = 0

3.2.1.2– Internal Rate of Return Method (required rate of return, cut-off or hurdle rate)

The internal rate of return (IRR) method is another discounted cash flow technique, which takes account of
the magnitude and timing of cash-flows. It is referred to as the internal rate of return. It is the rate that
equates the investment outlay with present value of cash inflows received after one period. This also
implies that the rate of return is the discount rate which makes NPV =0. IRR can be determined by solving
the following equation for r.

𝐶 1 𝐶2 𝐶 3 𝐶𝑛
[(1+𝑟) + (1+𝑟)2
+ (1+𝑟)3+ ....+ (1+𝑟)𝑛
] = 𝐶0

C
C0 = ∑nt=1 (1−r)
t
t

C
= ∑nt=1 (1−r)
t
t − C0 = 0

It can be noticed that the IRR equation is the same as the one used for the NPV method. In the NPV
method, the required rate of return, k, is known and the present value is found, while in the IRR method the
value of r has to be determined at which the net present value becomes zero.

a) Uneven cash flows: Calculating IRR by Trial and Error

The value of r can be found by trial and error. The approach is to select any discount rate to compute the
present value of cash inflows. If the calculated present value of the expected cash inflow is lower than the
present value of cash outflows, a lower rate should be tried. On the other hand, a higher value should be
tried if the present value of inflows is higher than the present values of outflows. This process will be
repeated unless the net present value becomes zero.

28
Example. A project costs 16000 and is expected to generate cash inflows of 8000, 7000 and 6000 at the
end of each year for next 3 years.

Answer. We know that for an estimating internal rate of return, NPV = 0. That is,

8000 7000 6000

[(1+𝑟) + (1+𝑟)2
+ (1+𝑟)3 ] − 16, 000 = 0

When r = 20, NPV = - 1004

A negative NPV of 1,004 at 20 per cent indicates that the project’s true rate of return is lower than 20 per
cent.

Let us try 16 per cent as the discount rate.

When r =16 per cent, NPV = - 16

Since the project’s NPV is still negative at 16 per cent, a rate lower than 16 per cent should be tried.

When r = 15%, NPV = 200.

It implies that, the true rate of return lie between 15-16 per cent. We can find out a close approximation of
the rate of return by the method of linear interpolation as follows:

Knowing that r is between 15 and 16, and 0 is between -16 and 200.

𝑟−15 0+16
=
16−15 200−16

r = 15 +0.08 = 15.8%

3.2.1- Level cash Flows

An easy procedure can be followed to calculate the IRR for a project that produces level or equal cash
flows each period. To illustrate, let us assume that an investment would cost 20,000 and provide annual
cash flow of 5,430 for 6 years.

Solution. The NPV can be found as follows:

NPV = - 20,000 + 5,430 (PVFA6,r) = 0

29
 20, 000 = 5,430 (PVFA6,r)

PVFA6, r = 20, 000 / 5,430

PVFA6,r = 3.683

The rate, which gives a PVFA of 3.683 for 6 years, is the project’s internal rate of return. Looking up PVFA
in financial table across the 6-year row, we find it approximately under the 16 per cent column. Thus, 16 per
cent is the project’s IRR that equates the present value of the initial outlay (20,000) with the constant
annual cash inflows (5,430) for 6 years.

o Acceptance rule

The accept-or-reject rule, using the IRR method, is to accept the project if its internal rate of return is higher
than the opportunity cost of capital (r>k). The project shall be rejected if its internal rate of return is lower
than the opportunity cost of capital (r<k). The decision maker may remain indifferent if the internal rate of
return is equal to the opportunity cost of capital. Thus the IRR acceptance rules are:

 Accept the project when r>k

 Reject the project when r<k
 May accept the project when r=k

3.2.1.3- Profitability index

Yet another time-adjusted method of evaluating the investment proposals is the benefit-cost (B/C) ratio or
profitability index. Profitability index is the ratio of the present value of cash-inflows, at the required rate of
return, to the initial cash outflow of the investment. The formula for calculating benefit-cost ratio or
profitability index is as follows:

Ct
PV of cash inflows PVCt ∑n
t=1 (1+k)t
PI = = =
Initial cash outlay C0 C0

Example. The initial cash outlay of a project is 100,000 and it can generate cash inflows of 40,000, 30,000,
50,000, and 20,000 in year I through 4. Assume a 10 per cent rate of discount. Calculate the profitability
index of the project.

30
 40,000 30,000 50,000 20,000
Answer. The PV of cash inflows at 10 per cent discount is (1+0.1) + (1+0.1)2
+ (1+0.1)3 + (1+0.1)4
=
𝑃𝑉 112.350
112.350. This implies that profitability index (PI) = = = 1.1235
𝐶0 100,000

o Acceptance rule

The following are the PI acceptance rules:

 Accept the project when PI is greater than one PI > 1

 Reject the project when PI is less than one PI < 1
 May accept the project when PI is equal to one PI = 1

3.2.1.4- Payback

The payback (PB) is one of the most popular and widely recognised traditional methods of evaluating
investment proposals. Payback is the number of years required to recover the original cash outlay invested
in a project. If the project generates constant annual cash inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow. That is:

Initial Investment C0
Payback = Annual Cash Inflow = C

Example. Assume that a project requires an outlay of 50,000 and yields annual cash inflow of 12,500 for 7
years. What is the payback period for the project?

50,000
Answer. The payback period for the project is: PB = 12,000 = 4 years

o Unequal cash flows. In the case of unequal cash flows, the payback period can be found out by
adding up the cash inflows until the total is equal to the initial cash outlay.

Example. Suppose that a project requires a cash outlay of 20,000, and generates cash inflows of
8,000, 7,000, 4,000 and 3,000 during the next 4 years. What is the project payback?

Answer. When we add up the cash inflows, we find that in the first three years 19,000 of the original
outlay is recovered. In the fourth year cash inflow generated is 3,000 and only 1,000 of the original
outlay remains to be recovered. Assuming that the cash inflows occur evenly during the year, the time

31
 required to recover 1,000 will be (1000/3000) x 12 months = 4 months. Thus, the payback period is 3
years and 4 months.

o Acceptance rule

Many firms use the payback period as an investment evaluation criterion and a method of ranking projects.
They compare the project’s payback with a predetermined, standard payback. The project would be
accepted if its payback period is less than the maximum or standard payback period set by management.
As a ranking method, it gives highest ranking to the project, which has the shortest payback period. Thus, if
the firm has to choose between two mutually exclusive projects, the project with shorter payback period will
be selected.

3.2.1.5 - Discounted payback period

One of the serious objections to the payback method is that it does not discount the cash flows for
calculating the payback period. We can discount the cash flows and then calculate the payback. The
discounted payback period is the number of periods taken in recovering the investment outlay on the
present value basis. Discounted payback period for a project will be always higher than simple payback
period because its calculation is based on the discounted cash flows. Discounted payback rule is better as
it discounts the cash flows until the outlay is recovered. But it does not help much. It does not take into
consideration the entire series of cash flows.

Example. Project P and Q involve the same outlay of 4,000 each. The opportunity cost of capital may be
assumed as 10%. The cash flows of the projects are shown in table below:

Cash flows C1 C2 C3 C4
P 3,000 1,000 1,000 1,000
Q 0 4,000 1.000 2,000
Calculate the discounted and simple payback period of both projects.

Answer.

Cash flows C0 C1 C2 C3 C4 Simple PB Discounted PB NPV at 10%

P 4,000 3,000 1,000 1,000 1,000 2 years
PV= [Cn x (1+i)-n ] 4,000 2,727 826 751 683 2.6 year 987

32
 Q 4,000 0 4,000 1.000 2,000 2 years
PV= [Cn x (1+i)-n ] 4,000 0 3,304 751 1,366 2.9 year 1,421
The projects are indicated of the same desirability by the simple payback period. When cash flows are
discounted to calculate the discounted payback period, project P recovers the investment outlay faster than
project Q, and therefore, it would be preferred over project Q.

3.2.1.6- Accounting rate of return method

The accounting rate of return (ARR), is also known as the rate return on investment (ROI), uses
accounting information, as revealed by financial statements, to measure the profitability of an investment.
The accounting rate of return is the ratio of the average after tax profit divided by the average investment.
The average investment would be equal to half of the original investment if it were depreciated constantly.
Alternatively, it can be found out by dividing the total of the investment’s book values after depreciation by
the life of the project. The accounting rate of return, this, is an average rate and can be determined by the
following equation:

Average income
ARR = Average investment x 100

However, average income should be defined in terms of earnings after taxes without an adjustment for
interest . EBIT (1-t) or net operating profit after tax. Thus,

[∑n
t=1 EBITt (1−t)]
n
ARR = I0 +In
2

where EBIT is earnings before interest and taxes, t tax rate, I0 book value of investment in the beginning, In
book value of investment at the end of n number of years.

Example. A project will cost 40,000. Its stream of earnings before depreciation, interest and tax (EBDIT)
during first year through five years is expected to be 10,000, 12,000, 14,000, 16,000 and 20,000. Assume a
50 per cent tax rate and depreciation on straight-lines basis.

Solution.

Period 1 2 3 4 5 Average

EBDIT 10, 000 12,000 14,000 16,000 20,000 14,400

33
Depreciation (Cost / 5) 8,000 8,000 8,000 8,000 8,000 8,000

EBIT 2000 4,000 6,000 8,000 12, 000 6,400

Taxes at 50% 1,000 2,000 3,000 4,000 6,000 3,200

EBIT (1-t) 1,000 2,000 3,000 4,000 6,000 3,200

Book value of investment

Beginning 40,000 32,000 24,000 16,000 8,000

Ending 32,000 24,000 16,000 8,000 -

Average 36,000 28,000 20,000 12,000 4,000 20,000

EBDIT= Earnings before depreciation, interest and taxes; EBIT = Earnings before interest and taxes and
EBIT (1 – t) = Earnings before interest and after taxes

3,200
IRR = 20,000 𝑥 100 = 16 per cent

o Acceptance rule: As an accept-or-reject criterion, this method will accept all those projects whose
ARR is higher than the minimum rate established by the management and reject those projects
which have ARR less than the minimum rate. This method would rank a project as number one if it
has highest ARR and lowest rank would be assigned to the project with lowest ARR.

.CHAPTER 4- THE CONCEPT OF RISK AND RETURN

Risk and return are most important concepts in finance. In fact, they are the foundation of the modern
finance theory. Risk and return are basic to the understanding of assets or securities. Generally, return
refers to an investor’s expectation in acquiring financial securities. Most often, rate of return are expressed
in the form of a percentage. However, the risk of a security depends on the volatility of its return. In any
investments decisions, investors are interested in the return and risk of a security.

The information about the expected return and risk helps an investor to make decision about investments.
However, this depends on the investor’s risk preference. Generally, investors would prefer investments with
higher rates of return and lower risk. For instance, a risk-averse investor will choose from investments with
equal rates of return, the investment with low risk. Similarly, if investments have equal risk, the investor

34
would prefer the one with higher return. A risk-neutral investor does not consider risk, and he would
always prefer investments with higher returns. A risk-seeking investor likes investments with higher risk
irrespective of the rates of return.

4.1 – Average rate of return

A return is simply a change in cash flow from an initial period to another and the rate is expressed by dividing the
change in the cash flow by initial cash out flow. The change may be positive which indicates a gain or negative that
indicates a loss. The rate of return (R) is given by:

FV−PV
R= PV

where:

FV = future value of investment;

PV = present value of investment; and

R = rate of return

On the other hand, the return on a security (for example share) consists of two parts: the dividend and the
capital gain. The rate of return for one period is given by the following equation:

Return = Dividend yield + Capital gain

D1 (P1 − P0 )
R= +
P0 P0

Given the yearly returns, we can calculate average or mean return. The average rate of return is the sum of
the various one-period rates of return divided by the number of periods. The simple arithmetic average or
mean annual returns is as follows:

𝑛
1
𝑅̅ = ∑ 𝑅𝑡
𝑛
𝑡=1

4.2 – Rates of return and holding periods

35
Investors may hold their investment in shares for longer periods than for one year. Suppose you invest 1 frs
today in a company’s share for five years. The holding period of return is calculated using the geometric
mean. Thus, the compound annual rate of interest is the geometric mean. Thus,

n
√(1 + x1 ) x (1 + x2 ) x (1 + x3 ) x . . . x (1 + xn ) − 1

where:

x1 , x2 , x3 , . . . . . xn are respective rates of return for each period.

n = number of rates

Example. The rates of return are 18%, 9%, 0%, -10% and 14%. What is the worth of your shares?
Calculate the compound rate of return.

Solution. You hold the share for five years; hence, you can calculate the worth of your investment assuming
that each year dividends from the previous year are reinvested in shares.

The worth of your investment after five years is = (1 + 0.18) x (1 + 0.09) x (1 + 0.0) + (1 – 0.10) + (1 + 0.14)
= 1.32

Your one year frs investment has grown to 1.32 frs at the end of five years. Thus your total return is 1.32 –
1 = 32 per cent.

Compound rate of return =

5
√(1.18) x (1.09) x (1.00) x (0.09)x(1.14) − 1 = 1.057 – 1 = 0.057 or 5.7%

It implies that, 1 frs invested today at 5.7% compound rate would grow to approximately 1.32 frs after five
years.

4.3 – Risk of rates of return: Variance and standard deviation

36
We can think of risk of return as the variability in rates of returns. The variability of rates of returns may be
defined as the extent of the deviations (for dispersion) of individual rate of return from the average rate of
return. There are two measures of this dispersion: variance or standard deviation. Standard deviation is the
square root of variance. Standard deviation summarises variability and it is a measure of total risk. The
formulae calculating variance and standard deviation of historical rates of return of a security as follows:

1
σ2 = ̅ )2
∑nt=1(R t − R
n−1

1
̅ )2
σ = √n−1 ∑nt=1(R t − R

N.B: In the case of sample of observations, we divide the sum of squares of the deviations by n-1 to
account for the degree of freedom. If you were using population data, then the divider will be n.

4.4 – Expected return and risk: Incorporating probabilities in estimates

Instead of using historical data for calculating return and risk, we may use forecasted data. Suppose you
are considering buying a financial security. You do not know the outcomes. The outcomes may depend on
the economic conditions, the performance of the company and other factors. You will have to think of the
outcomes under possible economic scenarios to arrive at the judgment about the expected return. The
expected rate of return [E(R)] is the sum of the product of each outcome (return) and its associated
probability:

[E(R)] = ∑ni=1 R i Pi

where:

E(R) = expected rate of return

Ri = the outcome i

Pi = probability of the occurrence of i

n = total number of outcomes

On the other hand, the variance of return σ2 = ∑𝑛𝑖=1[𝑅𝑖 − 𝐸(𝑅)]2 𝑃𝑖 , and

𝜎 = √∑𝑛𝑖=1[𝑅𝑖 − 𝐸(𝑅)]2 𝑃𝑖

37
Example. The table below summarises the range of returns under the possible states of economic
conditions along with probabilities. Calculate the expected rate and the variance of return.

Economic conditions Rate of return (%) Probability

Growth 18.5 0.25
Expansion 10.5 0.25
Stagnation 1.0 0.25
Decline -6.0 0.25

Solution. E(R) = (18.5 x 0.25) + (10.5 x 0.25) + (1.00 x 0.25) + (-6.0 x 0.25) = 0.06 0r 6%

σ2 = [18.5 − 6]2 0.25 + [10.5 − 6]2 0.25 + [1.0 − 6]2 0.25 + [−6.0 − 6]2 0.25 =
86.375

𝜎 = √86.375 = 9.29%

The expected rate of return is low (6%) and the standard deviation is high (9.29%). You may like to search
for an investment with higher expected return and lower standard deviation.

4.5 – Portfolio theory and assets pricing models

A portfolio is a bundle or a combination of individual assets or securities. The portfolio theory provides a
normative approach to investors to make decisions to invest their wealth in assets or securities under risk.
It is based on the assumption that investors are risk-averse. This implies that investors hold well-diversified
portfolios instead of investing their entire wealth in a single or a few assets. One important conclusion of the
portfolio theory is that if the investors hold a well-diversified portfolio of assets, then their concern should be
the expected rate of return and risk of the portfolio rather than individual risk. The second assumption of the
portfolio theory is that the returns of assets are normally distributed. This means that the mean (the
expected value) and variance (or standard deviation) analysis is the foundation of the portfolio decisions.

4.5.1 – Portfolio Returns: Two-asset case

The return of the portfolio is equal to the weighted average of the returns of individual assets (or securities)
in the portfolio with weights being equal to the proportion of investment value in each asset. However, there
is a direct and simple method of calculating the expected rate of return on a portfolio if we know the

38
expected rates of return on individual assets and their weights. The expected rate of return on a portfolio is
the weighted average of the expected rates of return on assets in portfolio.

E(R p ) = w x E(R x ) + (1 − w) x E(R y )

where:

E(R p ) = expected rate of return on portfolio

w = proportion of investments in asset x and (1-w) is the remaining investment in asset y.

E(R x ) = expected rate of return of the asset x

E(R y ) = expected rate of return of asset y

Example. The possible outcomes of two assets in different states of economy are given in the table below.

Return (%)
State of Economy Probability X Y
A 0.10 -8 14
B 0.20 10 -4
C 0.40 8 6
D 0.20 5 15
E 0.10 -4 20

Suppose that the investor decides to invest 50 per cent of his wealth in x and 50 per cent in y. What is the
expected rate of return on the portfolio consisting of both x and y.

Solution. E(Rx) = -8 x 0.10 + 10 x 0.20 + 8 x 0.40 + 5 x 0.20 + -4 x 0.10 = 5%

E (Ry) = 14 x 0.10 + -4 x 0.20 + 6 x 0.40 + 15 x 0.20 + 20 x 0.10 = 8%

E(R p ) = (0.5 x 5) + (0.5 x 8) = 6.5%

4.5.2 – Portfolio Risk: Two-asset case

39
We have seen in the previous section that returns on individual assets fluctuate more than the portfolio
return. Thus, individual assets are more risky than the portfolio. We can use variance or standard deviation
to measure the risk of the portfolio of assets as well. The portfolio variance or standard deviation depends
on the co-movement of returns on two assets. When we consider two assets, we are concerned with the
co-movement of the assets. Covariance of returns on two assets measures their co-movement. The
covariance of two-assets x and y is given as:

Covxy = ∑ni−1[R x − E(R x )] [R y − E(R y )] x Pi

where :

Covxy = covariance of returns on securities x and y

Rx = returns on security x

Ry = returns on security y

E (Rx) = expected returns of x

E (Ry) = expected returns on y

Pi = probability of occurrence of the state of economy

We can, however, compute the correlation to measure the relationship between two returns. Correlation is
Covxy
a measure of the linear relationship between two variables. Correlation coefficient of x, y (r) = σx σy

The value of correlation, called the correlation coefficient, could be positive, negative or zero. The
correlation coefficient always ranges between -1.0 and +1.0. A correlation coefficient of +1.0 implies a
perfectly positive correlation while a correlation coefficient of -1.0 indicates a perfectly negative correlation.
The correlation between the two variables will be zero if they are not all related to each other.

Example. Using the information in the table above, calculate the portfolio risk of the two assets.

Covxy = ∑ni−1[R x − E(R x )] [R y − E(R y )] x Pi = 0.1 (-8-5) (-14-8) + 0.2(10-5) (-4-8) + 0.4 (8-5) (6-8)
+ 0.2 (5-5) (15-8) + 0.1(-4-5) (20-8) = -33.0

40
 Covxy
Correlation (r) = σx σy

σx = 5.8%

σy = 7.63%

r = -33.0 / 5.8 x 7.63 = -0.746

Securities X and Y are negatively correlated. The correlation coefficient of -0.746 indicates a high negative
relationships. If an investor invests her wealth in both instead any one of them, she can reduce the risk.

4.5.3- Variance and Standard Deviation of a two-asset portfolio

The variance of two-security portfolio is given by the following equation:

σ2p = σ2x wx2 + σ2y wy2 + 2wx wy Covxy =σ2x wx2 + σ2y wy2 + 2wx wy σx σy Corxy

It may be noted from the above equation that the variance of a portfolio includes the proportionate
variances of the individual securities and the covariance of the securities. The covariance depends on the
correlation between the securities in the portfolio. The risk of the portfolio would be less than the weighted
average risk of the securities for low or negative correlation.

The standard deviation of two-asset portfolio is the square root of the variance:

𝜎𝑝 = √σ2x wx2 + σ2y wy2 + 2wx wy Covxy = σ2x wx2 + σ2y wy2 + 2wx wy σx σy Corxy

4.5.4- Minimum variance portfolio

What is the best combination of two securities so that the portfolio variance is minimum? The minimum
variance portfolio is also called the optimum portfolio. However, investors do not necessarily strive for the
minimum variance portfolio. We can use the following general formula for estimating optimum weights of
two securities X and Y so that the portfolio variance is minimum:

σ2y − Covxy
ω∗ = σ2x + σ2y − 2Covxy

41
where ω∗ is the optimum proportion of investment in security X. Investment in Y will be 1 - ω∗ .

4.6- Risk diversification: Systematic and unsystematic risk

When more and more securities are included in a portfolio, the risk of individual securities in the portfolio is
reduced. The risk totally vanishes when the number of securities is very large. But the risk represented by
covariance remains. Thus, risk has two parts: diversifiable (unsystematic) and non-diversifiable
(systematic).

4.61- Systematic risk

Systematic risk arises on account of the economy-wide uncertainties and the tendency of individual
securities to move together with changes in the market. This part of risk cannot be reduced through
diversification. It is also known as market risk. Investors are exposed to market risk even when they hold
well-diversified portfolios of securities. Examples of systematic risk include: the government changes the
interest rate policy, the corporate tax is increased, the government resorts to massive deficit financing, the
inflation rates increases, the government withdraws tax on dividend payments by companies, etc.

4.6.2 - Unsystematic risk

Unsystematic risk arises from the unique uncertainties of individual securities. It is also called unique risk.
These uncertainties are diversifiable if a large numbers of securities are combined to form well-diversified
portfolios. Uncertainties of individual securities in a portfolio cancel out each other. Thus unsystematic risk
can be totally reduced through diversification. Examples of unsystematic risk include: the company declare
strike, the R and D expert leaves the company, a formidable competitors enters the market, the company
losses a big contract in a bid, the company makes a breakthrough in process innovation, the government
increases custom duty on the material used by the company, the company is unable to obtain adequate
quantity of raw material, etc.

4.6.3- Total risk

Total risk of an individual security is the variance (or standard deviation) of its return. It consists of two
parts: Total risk of a security = Systematic + Unsystematic risk

4.7- Combining a risk-free asset and a risky asset

42
A risk-free asset or security has a zero variance or standard deviation. The risk-free security has no risk of
default. The government treasury bills or bonds are appropriate examples of the risk-free security as they
have no risk of default. Since the risk-free security has zero standard deviations, the covariance between
the risk-free security and risky security is also zero (Cov =0). The portfolio risk is simply given as the
product of the standard deviation of the risky security and its weight. Thus,

σp = ωσj

where :

σp = risk of the portfolio

σj = standard deviation of risky security

𝜔 = proportion of holding the risky asset

4.7.1- Capital asset pricing model

The capital asset pricing model (CAPM) is a model that provides a framework to determine the required
rate of return on an asset and indicates the relationship between return and risk of the asset. The required
rate of return specified by CAPM helps in valuing an asset. Under CAPM, risk of an individual risky security
is defined as the volatility of the security’s return vis-à-vis the return of the market portfolio. The risk of an
individual risky security is its systematic risk. Systematic risk is measured as the covariance of an individual
risky security with the market portfolio. Therefore, the risk-return relationship equation is as follows:

E(Rm )−Rf
E(R j ) = R f + (covarj,m )
σ2m

The term, covarj,m / σ2m is called the security beta, βj . Beta is a standard measure of a security’s
systematic risk. The beta of a market portfolio is 1. The market portfolio is the reference for measuring the
volatility of individual risky securities. Since a risk-free security has no volatility, it has zero beta. We can
rewrite the equation as follows:E(R j ) = R f + [𝐸(R m ) − R f ] βj .

where :

E(R j ) = expected return on security j;

43
R f = risk-free rate of interest;

R m = expected return on the market portfolio; and

βj = undiversifiable risk of security j.

Example. The risk free rate of return is 8% and the market rate of return is 17%. Betas for four shares, P,
Q, R and S are respectively 0.60, 1.00, 1.20 and -0.20. What are the required rates of return on these four
shares?

Solution. From the equation E(R j ) = R f + [𝐸(R m ) − R f ] βj

E(R P ) = 0.08 + (0.17 -0.08) x 0.60 = 0.134 or 13.4%

E(R Q ) = 0.08 + (0.17 -0.08) x 1.00 = 0.170 or 17.0%

E(R R ) = 0.08 + (0.17 -0.08) x 1.20 = 0.188 or 18.8%

E(R S ) = 0.08 + (0.17 -0.08) x -0.20 = 0.062 or 6.2%

4.7.2-The Arbitrage Pricing Theory (APT)

The CAPM is not always able to account for the difference in assets’ return using their betas. This paved
way for the development of an alternative approach, called the arbitrage pricing theory (APT), for estimating
the asset’ expected returns. APT, unlike CAPM, does not assume that investors employ mean-variance
analysis for their investment decisions. However, like CAPM, APT is founded on the notion that investors
are rewarded for assuming non-diversifiable (systematic) risk; diversifiable (unsystematic) risk is not
compensated. Beta is considered as the most important single factor in CAPM that captures the systematic
risk of an asset. In APT, there are a number of industry-specific and macro-economic factors that affect the
security returns. Thus a number of factors may measure the systematic (non-diversifiable) risk of an asset
under APT. The fundamental logic of APT is that investors always indulge in arbitrage whenever they find
differences in the return of assets with similar risk characteristics.

In APT, the return of an asset is assumed to have two components: predictable (expected) and
unpredictable (uncertain) return. Thus, return on asset j will be:

E(R j ) = R f + UR s + UR m

44
where:

UR s = unexpected component of return arising from the specific factors related to the firm.

UR m = unexpected return that arises from the economy-wide, market-related factors

4.7.3- Concept of risk under APT

APT assumes that market risk can be caused by economic by economic factors such as changes in gross
domestic product, inflation, and the structure of interest rate and these factors could affect firms differently.
For example, different firms may feel the impact of inflation differently. Therefore, under APT, multiple
factors may be responsible for the expected return on the share of a firm. Therefore, under APT the
sensitivity of the asset’s return to each factor is estimated. For each firm, there will be as many betas as the
number of factors. Therefore,

E(R j ) = R f + (β1 F1 + β2 F2 + β3 F3 + ⋯ + βn Fn ) + UR s

where β1 is firm j’s factor one beta, β2 is factor two beta and so on. F represents a surprise in factors.

Example. Suppose that GNP, inflation, interest rate, stock market index and industrial production affect the
share return of the firm. – Divine Home Company. Further, we have information about the forecasts and
actual values of these factors, and the firm’s GNP beta, inflation beta, interest rate beta and the stock
market beta.

An investor is considering making an investment in the share of Divine Home Company. The following are
the attributes of five economic forces that influence the return of Divine’s share:

Factor Beta Expected Value (%) Actual value

GNP 1.95 6.00 6.50

Inflation 0.85 5.00 5.75

Interest rate 1.20 7.00 8.00

Stock market index 2.50 9.50 11.50

Industrial production 2.20 9.00 10.00

45
The risk-free (anticipated) rate of return on the Divine’s share is 9 per cent. How much is the total return on
the share?

Solution. The total return will consists of anticipated (risk-free) return and unanticipated return as follows:

E(R j ) = R f + β1 (R F1 − R f1 ) + β2 ( R F2 − R f2 ) + β3 ( R F3 − R f3 ) + ⋯ + βn ( R Fn − R fn )

= 9 + 1.95 (6.5 - 6) + 0.85 (5.75 – 5) + 1.20 (8 – 7) + 2.5 (11.5 – 9.5) + 2.20 (10 - 9) = 19%

CHAPTER 5 – EVALUATION OF SECURITIES: BONDS AND SHARES

Assets can be real or financial; securities like shares and bonds are called financial assets while physical
assets like plants and machinery are called real assets. Companies raise long-term funds in the forms of
equity and debt from the capital market. Capital market facilitates the buying and selling of securities such
as shares bonds or debentures. They perform two functions: liquidity and pricing securities. Liquidity means
the convenience and speed of transforming assets into cash, or transferring assets from one person to
another. In the capital markets hundreds of investors make several deals a day. The screen-based trading
makes these deals known to all in the capital markets. Thus, a large number of buyers and sellers interact
in the markets.

46
5.1 – A Bond

A bond is a long-term debt instrument or security. Bonds issued by the government do not have any risk of
default. The government will always honour obligations on its bonds. The private sector companies also
issue bonds, which are also called debentures. In the case of bonds or debentures, the rate of interest is
always fixed and known to investors. The principal of a redeemable bond or bond with maturity is payable
after a specified period, called maturity period. The appropriate capitalisation, or discount, rate would
depend upon the risk of the bond. The risk in holding a government bond is less than the risk associated
with a debenture issued by a company. Consequently, a lower discount rate would be applied to the cash
flows of the government bond and a higher rate to the cash flows of the company debenture. The yield on
government securities serve as a benchmark for the market and private debt securities are issued above
the government yields.

Some of the important features of bonds include:

o Face value: Face value is called par value.

o Interest rate: The interest rate on the debenture is fixed and known. It is called contractual rate of
interest or coupon rate.
o Maturity: Debentures are issued for a specified period of time.
o Redemption value: The value that a bond holder will get on maturity is called redemption, or
maturity value. Debentures are mostly redeemed on maturity. Redemption of debentures can be
accomplished either through a sinking fund or buy-back (call) provision. The cash set aside
periodically to redeem debenture is called Sinking fund.
o Market value: The price at which a bond is currently sold or bought is called the market value of the
bond (debenture). Market value may be different from par value or redemption value.
o Bonds may be classified into three categories: bonds with maturity, pure discount bonds and
perpetual bonds.
o Bonds with maturity are bonds with a specified rate of interest and a maturity period.
o Pure discount bonds do not carry and explicit rate of interest. It provides for the payment of a lump
sum amount at a future date in exchange for the current price of the bond. They are also called
zero-coupon or interest bonds.
o Perpetual bonds have an indefinite life and therefore, it has no maturity value. These bonds are
hardly found in practice.

47
5.1.1 - Bonds value and Yields

It is relatively easy to determine the present value of a bond since its cash flows and the discount rate can
be determined without any difficulty. The expected cash flows consist of annual interest payments plus
repayment of principal.

5.1.1.1 – Bonds with maturity

The government and companies mostly issue bonds that specify the interest rate (coupon) and the maturity
period. The present value of a bond (debenture) is the discounted value of its cash flows; that is, the annual
interest payments (coupon payment) plus bond’s terminal, or maturity, value.

Bond value = Present value of interest + Present value of maturity value. That is,

C F
B0 = ∑nt=1 (1+r)
t
t + (1+ r)n
, or

1−(1+r)−n
B0 = C ( ) + F(1 + r)−n
r

where :

B0 = market price or current value of a bond;

C = coupon payment at the end of each period;

r = required rate of return;

F = face value or par value of a bond; and

n = number of periods

Example. Suppose an investor is considering the purchase of a five-year, 1000 par value bonds, bearing a
nominal rate of interest of 7 per cent per annum. The investor’s required rate of return is 8 per cent. What
should he be willing to pay now to purchase the bond if it matures par?

Solution. The investors will receive cash 70 as interest each for 5 years and 1000 on maturity. Therefore,
the present value of the bond is:

70 70 70 70 70 1000
B0 = (1.08)1
+ (1.08)2
+ (1.08)3
+ (1.08)4
+ (1.08)5
+ (1.08)5
= 960.51

48
 1−(1+0.08)−5
B0 = 70 ( ) + 1000(1 + 0.08)−5 = 960.51
0.08

o Yield to maturity

The yield-to- maturity is the measure of a bond’s rate of return that considers both the interest income and
any capital gain or loss. The interest rate (or expected rate of return) used in discounting a bond is known
as the yield to maturity (YTM) because bondholders assume holding the bonds until their maturity dates.

The bond value has an inverse relationship with the interest rate. In other words, the higher the rate used to
discount the cash flows the lower is the bond present value (price). So rising interest rates lowers the bond
prices. A bond is traded at a discount if the expected rate or required rate of return is greater than the
coupon rate, i.e., a bond’s price is less than its face value. Conversely, a bond is traded at premium if the
expected or required rate is less than the coupon rate, i.e. the bond’s price is greater than its face value.

The yield to maturity of a perpetual bond is equal to interest income divided by the bond’s price. Thus,

INT
kd =
B0

Example. If the rate of interest on 1,000 par value perpetual bond is 18 per cent and its price is 800. What
is it yield to maturity.

Solution.
INT
kd = B0

80
kd = = 0.10 or 10%
800

5.1.1.2 – Pure discount bonds

Pure discount bonds do not carry an explicit rate of interest. It provides for the payment of a lump sum
amount at a future date in exchange for the current price of the bond. The difference between the face
value of the bond and its purchase gives the return or YTM to the investor. Pure discounts bonds are also
called deep-discount bonds or zero-interest bonds or zero-coupon bonds. It is quite simple to find the value
of a pure discount bond as it involves one single payment (face value) at maturity. The market interest rate,

49
also called the market yield, is used as the discount rate. The present value a zero-coupon bond is given
by:

B0 = F(1 + r)−n

where:

B0 = market price or current value of a zero-coupon bond;

F = face value or par value of a zero-coupon bond

r = required rate of return; and

n = no. of periods

Example. Consider a bond with a face value of 500,000 with a maturity of 30 years. Suppose the current
market yield on similar bonds is 9 per cent. What is the value of the pure-discount bond today?

Solution. B0 = 500,000(1 + 0.09)−30 = 37,685.57

5.1.1.3 – Perpetual bonds

Perpetual bonds, is also called ‘consols’, has an indefinite life and therefore, it has no maturity. Perpetual
bonds or debentures are rarely found in practice. In case of the perpetual bonds, as there is no maturity, or
terminal value, the value of the bonds would simply be the discounted value of the infinite stream of interest
flows. The value of the bond is determined by:

C
B0 = r

Example. Suppose that a 10 per cent 1000 bond will pay 100 annual interests into perpetuity. What would
be its value if the market yield or interest rate is 15 per cent.

100
Solution. B0 = = 667
0.15

5.2 – Valuation of shares

Ordinary shares represent the ownership position in a company. The holders of ordinary shares, called
shareholders (or stockholders in USA), are the legal owners of the company. Shareholders are entitled to

50
dividend payment for the capital contribution. The amount or rate of dividend is not fixed; the company’s
board of director decides it. Authorised share capital represents the maximum amount of capital, which a
company can raise from shareholders. The portion of the authorised capital which has been offered to
shareholders is called issued share capital. Subscribed share capital represents that part of the issued
share capital, which has been accepted by shareholders. The amount of subscribed share capital actually
paid up by the shareholders is called paid-up capital. The total paid-up share capital is equal to the issue
price of an ordinary share multiplied by the number of ordinary shares. The issue price may include two
components: the par value and the share premium. The par value is the price per ordinary share stated in
the memorandum of association. Ordinary shareholders have: a claim on the income, claim on the assets,
and right to control, voting rights, and limited liability.

Preference is often considered to be a hybrid security since it has many features of both ordinary shares
and debenture. Unlike ordinary shareholders, preference shareholders have a fixed rate of dividend, and a
priority claim on the income and asset of the company. They usually do not have voting rights. A preference
share can either be redeemable, irredeemable, cumulative, participative, or convertible. Redeemable
preference share are share with maturity, irredeemable preference are shares without any maturity. In the
case of cumulative preference share, unpaid dividends accumulate and are payable in the future. Dividends
in arrears do not accumulate in the case of non-cumulative preference share. Convertible preference
shares have the ability to be converted into ordinary shares after a stated period. Participative preference
share gives a contingent participative right to its holders.

5.2.1 – Ordinary shares

The valuation of ordinary or equity shares is relatively more difficult. The difficulty arises because of two
factors: - first the rate of dividend on equity shares is not known; also, the payment of equity is
discretionary. Thus, the estimates of the amount and timing of the cash flows expected by equity holders
are more uncertain. However, the value of a share today depends on cash inflows expected by investors
and risk associated from an equity share consist of dividends that the owner expects to receive while
holding the share and the price, which the owner is expected to receive when he sells the share, will
include the original investment plus a capital gain (or minus a capital loss).

Normally, a shareholder does not hold shares in perpetuity. He holds shares for some time, receives the
dividends and finally, sells them to a buyer to obtain capital gain. For shareholders in general, the expected

51
cash inflows consist only of future dividends and, therefore, the value of an ordinary share is determined by
capitalising the future dividend stream at the opportunity cost of capital. The opportunity cost of capital is
the return that the shareholder could earn from an investment of equivalent risk in the market. The value of
a share is the present value of its future stream of dividends.

5.2.1.1 – Single period valuation

For single period valuation, the present value of the share today, P0, will be determined as the present
value of the expected dividend per share at the end of the first year, DIV 1, plus the present value of the
expected price of the share after a period, P1. That is:

D1 + P1
P= 1+r

where:

P = current market price or value of an ordinary share;

D1 = expected dividend at the end of period 1;

P1 = anticipated market at the end of year 1; and

r = the required rate of return

Example. Let us assume that an investor intends to buy a share and will hold it for one year. Suppose he
expects the share to pay a dividend of 2 next year, and would sell the share at an expected price of 21 at
the end of the year. If the investor’s opportunity cost of capital or the required rate of return is 15 per cent,
how much should he pay for the share today?

2+ 21
Solution. P = = 20
1.15

o If the share price is expected to grow at a constant annual compound growth rate of g per cent,
D1
then we can write P as follows: P = r−g

o By rearranging the above equation, the investor’s expected rate of return could be determined as
D1
follows: r = +g
P

5.2.1.2 – Multi-period valuation

52
In the preceding section, we discussed a single-period share valuation model, where the investor was
expected to hold share for one year and then sell it at the end of the year. We can further extend the time
horizon. Investors who hold ordinary shares for a long period rather than just for short-term capital gains
will benefit from annual dividends that depend on the growth of the company’s earnings. So in the case of
multiple holding periods, the expected future cash flows are assumed constant and the valuation of an
ordinary share using the constant growth rate model is defined by If the period is n, we can write the
general formula for share value as follows:

D Pn
P = ∑nt=1 (1+r)
t
t
+ (1+r)n

where:

Dt = stream of expected dividends per periods

r = required rate of return

Pn = expected price at year n

n = number of periods

Example. Suppose that the price of a share today is 20 and it is expected to increase at an annual rate of 5
per cent. Suppose the opportunity cost of capital is 15 per cent, what would be the share price if it were
held for 5 years?

Solution. P0 = 20, P1 = 20 (1.05) = 21 , P2 = 20(1.05)2 = 22.05, P3 = 20(1.05)3 = 2.21 and so on.

2.00 2.10 2.21 2.32 2.43 25.53

𝑃0 = [ + + + + ] + = 7.31 + 12.69 = 20
(1.15)1 (1.15)2 (1.15)3 (1.15)4 (1.15)5 (1.15)5

5.2.1.3 - Growth in dividends

Dividends do not remain constant. Earnings and dividends of most companies grow overtime, at least,
because of their retention policies.

o Normal growth: If a totally equity financed firm retains a constant proportion of its annual earnings
(say, b) and reinvests it at its internal rate of return, which is return on equity (say ROE), then it can

53
 be shown that the dividends will grow at a constant rate equal to the product of retention ratio and
return on equity; that is g = b x ROE.
o Let us assume that dividends grow at a constant rate to infinity (g). When dividends grow
𝐷1
constantly the formula for share valuation can be written as follows:𝑃0 = . The capitalisation
𝑟−𝑔

rate or opportunity cost of capital must be greater than the growth rate; otherwise, absurd result will
be attained. If r = g, the equation will yield an infinite price, and if r < g, the result will be a negative
price. The initial dividend per share, must, be greater than zero; otherwise equation will obtain a
zero price. The relationship between r and g is assumed to remain constant and perpetual.
o Super-normal growth. The dividends of a company may grow at the same constant rate
indefinitely. It may face a two-stage growth situation. In the first stage, dividends may grow at a
super-normal growth rate when the company is experiencing very high demand for its products and
is able to extract premium from customers. Afterwards, the company’s product may normalise and
therefore, earnings and dividends may grow at a normal rate. The share value in a two-stage
growth situation can be determined in two parts. First, we can find the present value of constantly
growing dividend annuity for a definite super-normal growth period. Second, we can calculate the
present value of constantly growing dividend indefinitely (in perpetuity) after the super-normal
growth period. Therefore, if the dividends of a firm are expected to grow at a super normal growth
rate, gs, for n years and then grow at a normal growth rate, g n, till infinity, the value of the share is
given as follows : Share value = PV of dividends during infinite super-normal growth period + PV of
𝐃𝟎 + (𝟏+𝐠 𝐬 )𝐭 𝐃𝐧+𝟏
dividends during indefinite normal growth period. Thus, 𝐏𝟎 = ∑𝐧𝐭=𝟏 (𝟏+𝐫)𝐭
+ , where r =
𝐫−𝐠 𝐧

capitalisation rate; gn = infinite normal growth rate; and gc = super-normal growth rate.

Example. A company earned 6 per share and paid 3.48 per share as dividend in the previous. Its earnings
and dividends are expected to grow at 15 per cent for six years and then at a rate of 8 per cent indefinitely.
The capitalisation rate is 18 per cent. What is the price of the share today?

5.2.2 – Preference share valuation

Like bonds, it is relatively easy to estimate cash flows associated with preference shares. The cash flows
may include annual preference dividend and redemption value on maturity in case of redeemable
preference shares. The value of the preference share would be the sum of the present values of dividends
and the redemption value. The valuation of preference shares depends on two broad characteristics, i.e.

54
whether the shares are redeemable or non-redeemable. The redeemable preference shares behave like a
bond. The shareholders receive fixed payment (dividends) each year and redeem the shares later. The
valuation of redeemable preference shares is done the same way as bonds in which there are a stream of
future cash flows and a redemption sum to be taken into considerations.

5.2.2.1 – Non-redeemable preference share

In the case of non-redeemable preference shares, the fixed annual dividends are the only future cash
flows. Since there is no share’s terminal life the dividends received are in perpetuity as long as the issuing
company is not liquidated. The value of such share is given by :

D
P= r

where:

P = market price or current value of non-redeemable preference share;

D = amount of fixed annual dividend; and

r = required rate of return

By re-arranging the equation and given the market price of shares and dividend sum, the market expected
rate of return could be determined by: r = D / p

Example (a). A company’s non-redeemable preference shares have a dividend rate of 6% on a par value of
2 dollars. What would be the current value if an investor’s required rate of return were 4.8%?

Example (b). Assume that in the above scenario the market price for the preference share is 3 dollars.
What is the shareholders’ expected rate of return?

0.06 x 2
Solution.(a) P = = 2.50
0.048

(b) r = 0.12 / 3 = 0.04 (4%)

5.2.2.2 – Redeemable preference share

55
In the case of a redeemable preference share, a formula similar to the valuation of bond can be used to
value them with a maturity period: value of preference share = present value of dividends + present value
D Pn
of maturity value. P0 = ∑nt=1 (1+r)
t
t
+ (1+r)n

where,

𝑃0 = current value of preference share

Dt = preference dividend per share in period t

r = required rate of return

Pn = value of the preference share on maturity

Example. An investor is considering the purchase of a 12-year, 10% 100 par value preference share. The
redemption value of the preference share on maturity is 120. The investor’s required rate of return is
10.5%. What should she be willing to pay for the share now?

Solution. The investor would expect to receive 10 as preference dividend each year for 12 years and 110
on maturity (i.e. at the end of 12 years). We can use the present value annuity factor to value the constant
stream of preference dividends and the present value factor to value the redemption payment. Thus:

D Pn 1− (1+𝑟)−𝑛 1− (1+0.105)−12
P0 = ∑nt=1 (1+r)
t
t + (1+r)n
= D [ ] + 𝑃𝑛 (1 + 𝑟)−𝑛 = 10 [ ] + 120(1 +
𝑟 0.105

0.105)−12 = 102.71

CHAPTER 6 – COST OF CAPITAL

Firms generally financing their asset expansion or working capital using internally generated funds, and or
securing bank borrowings, and/or issuing debt securities (money market and capital market), and/or issuing
shares. Whatever the capital mix, there are always costs directly associated with employing these funding
sources. The costs are significantly in the form dividends and interest payments.

56
A firm may issue money market securities such as short-term notes or issue private debt securities such as
bonds. The firm may also issue shares or take up bank loans. The interest payments on bank loans,
coupons on bonds and discount rates on notes contribute to the total cost of capital. Dividend payments on
ordinary shares and preference shares also contribute to the total cost, which ultimately is expressed as the
weighted average cost of capital (WACC).

The cost of capital is one of the most difficult and disputed topics in the finance theory. Capital is defined as
the various securities mix or resources used by a firm to finance its activities. A firm is viewed as a place
where resources are coordinated to create value. The aim of stockholders to invest in capital is to maximise
their wealth. When shareholders acquire the share of a company, they expect a return on the capital
invested. For simplification, it is considered that firms rely on debt and equity as major sources of finance.
Investing in the security of firm, necessitate the forgoing of present consumption to create excess future
value of present resources. Since the future is uncertain, investors are compensated for the risk
undertaken.

The securities used by a company are associated to different risk level. For instance, ordinary share is
riskier than preference share, and preference is riskier than debt. Debt holders have a priority claim on the
assets and cash flows of the business than preference and ordinary shareholders. On the other hand,
preference shareholders have a priority claim on the assets and cash flow of the firm. Unlike ordinary
shareholders, preference shareholders’ dividend rate is fixed. The distribution of dividend to ordinary
shareholders is done when other financial obligations have been met. Ordinary shareholders might not
receive dividend when there is insufficient profit or loss. However, ordinary shareholders have claim on the
residual assets and cash flows. The rate of return required by investors depends on the intensity of risk
perceived. Creditors or lenders expect a constant interest rate and the principal amount when debt is
matured. They are, however, exposed to the risk of a default. Since the firm cash flows are uncertain, there
is probability that it may default on its obligation to pay interest on profit. Shareholders expect the payment
of dividend. However, the payment of interest is a legal obligation, where the payment of dividends is not a
legal obligation, and is determined by the financial policy if the company.

6.1 – THE SIGNIFICANCE OF THE COST OF CAPITAL

It is a concept of vital importance in the financial decision-making. It is used as a standard for:

 Evaluating investment decisions,

57
  Designing a firm’s debt policy, and
 Appraising the financial performance of top management.

a) Investment decisions: The primary purpose of measuring the cost of capital is its use as a financial
standard for evaluating the investment project. In the Net Present Value (NPV) method, an investment
project is accepted if it has a positive NPV. The project NPV is calculated by discounting its cash flows by
the cost of capital. In the Internal Rate of Return (IRR) method, the investment project is accepted if it has
an IRR greater than the cost of capital.

b) Designing debt policy: The debt policy of a firm is significantly influenced by the cost consideration. In
designing the financing policy, that is, the proportion of debt and equity in the capital structure of firm is
aimed at maximising the firm value by minimising the overall cost of capital. The cost of capital can also be
useful in deciding about the methods of financing at a point of time. For example, cost may be compared in
choosing between leasing and borrowing.

c) Performance appraisal: The cost of capital framework can be used to evaluate the financial
performance of top management. Such an evaluation will involve a comparison of actual profitability of the
investment projects undertaken by the firm with the projected overall cost of capital, and the appraisal of
the actual costs incurred by management in raising the required funds.

6.2 – THE CONCEPT OF THE OPPORTUNITY COST OF CAPITAL

Decision-making is the process of choosing among alternatives. In the investment decision, an individual or
a manager encounters innumerable computing investment opportunities to choose from. The opportunity
cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk.
Thus, the required rate of return on an investment project is an opportunity cost.

a) Shareholders opportunity and values: Shareholders supply the funds to a firm, therefore, they are
considered to be the owners of the firm, and retained it control. Part of the capital provided by shareholders
is called equity. Since the firm’s objective is to maximise the wealth of shareholders, any investment
project should be analysed in terms of their values to shareholders. In all equity financed firm, the equity
capital of ordinary shareholders is the only source to finance investment projects, the firm’s cost of capital is
equal to the opportunity cost of equity capital, which will depend only on the business risk of the firm. Thus,
the opportunity or the cost of capital is the required rate of return expected by shareholders on the capital

58
invested. The expected rate of return concerns a constant stream of dividends that will be distributed to
shareholders. Based on the fact that economic agents are rational, a shareholder acquires the share(s) of a
firm, because he/she envisages to acquire a satisfactory return as compared to other investment
opportunities at the market. Thus, the price of the shares of a company is highly affected by its dividend
policy and the force of demand and supply at the market. A risk neutral investor will acquire risky but highly
profitable securities.

b) Creditors’ claims and opportunities: In practice, both shareholders and creditors (debt-holders)
supply funds to finance a firm’s investment project. However, creditors supply funds to the firm in the form
of loan, and receive regular payments of interest and the principle at the end of a specified period of time.
Interest payment is a legal obligation, and gives to lenders the right to claim the asset or cash flows of the
firm when it is bankrupt. Bankruptcy occurs when the firm is incapable to meet its financial obligations.
However, the opportunity cost of capital of creditors is the expected rate of interest on the capital invested.

The required rate of return depends on investment opportunities of equivalent risk available in the financial
market (or the opportunity cost of capital). Thus the required rate of return is market determined. Investors
will require different rates of return on various securities since they have risk differences. Higher the risk of
a security, the higher the rate of return demanded by investors. The required rate of return of any security is
composed of a risk- free rate and a risk- premium. A risk-free will require compensation for time value.

6.3 - GENERAL FORMULA FOR THE OPPORTUNITY COST OF CAPITAL

It is obvious to recall that, the required rates of return are market-determined. They are established in the
capital market by the actions of competing investors. The influence of the market is direct in the case of
new issue of ordinary and preference shares and debt. The market price of securities is a function of the
return expected by investors.

6.3.1 - Cost of debt: A company may raise debt in a variety of ways. It may borrow funds from financial
institutions or public either in the form of public deposits or debentures (bonds) for a specified period of time
at a certain rate of interest. A debenture or bond may be issued at par or at a discount or premium as
compared to its face value. The cost of debt is actually the rate of interest charged on borrowing by a
lender to a firm. The contractual rate of interest or the coupon rate forms the basis for calculating the cost
of debt.

59
6.3.1.1 -Debt issued at Par: The before-tax cost of debt is the rate of return required by lenders. It is easy
to compute before-tax cost of debt issued and to be redeemed at par.

I
Kd = i = B
o

where,

Kd = before tax cost of debt;

i = the coupon rate of debt;

Bo = issue price of the bond (it is equal to be the face value F); and

I = amount of interest.

The amount of interest payable to the lender is always equal to : Interest = Face value of debt x interest
rate .

Example. A company decides to sell a new issue of 7 year 15 per cent bonds of 100 each at par. If the
company realises the full face value of 100 bond and will pay 100 principal to bondholders at maturity, the
before-tax cost of debt will be:

I 15
Solution. Kd = i = B = 100 = 0.15 𝑜𝑟 15%
o

6.3.1.2- Debt issued at Discount or Premium:

I Bn
Bo = ∑nt=1 (1+kt t
+ (1+kd )n
d)

where:

Bn = repayment of debt on maturity

. Kd = cost of debt

It = amount of interest at period t; and

n = number of periods

60
Example. Assume that in the preceding example of 7-year 15 per cent bonds, each bond is sold below par
for 94. Calculate the cost of debt.

I Bn
Solution. Bo = ∑nt=1 (1+kt t
+ (1+kd )n
d)

15 100
94 = ∑7t=1 (1+k t + (1+kd )7
d)

94 = 15 (PVFA7,kd) + 100 (PVFA7,kd)

By trial and error, kd = 16.5%

If the discount or premium is adjusted for computing taxes, the following short-cut method can also be used
1
I+ (F− B0 )
to calculate the before-tax cost of debt: k d = 1
n
, where, F represents the face value of the debt
(F+ B0 )
2

Thus using data of the above example, we obtain

1
I+ (F− B0 )
n
kd = 1
(F+ B0 )
2

1
15+ (100− 94) 15.86
kd = 1
7
= = 0.164 0𝑟 16.4%
(100+ 94) 97
2

iii) Tax adjustment: The interest paid on debt is tax deductible. Interest charges are allowable for tax
deduction because interest payments are considered operating expenditures in a corporate entity. Thus,
effectively a firm’ cost of debt is reduced by its corporate tax rate. The higher the interest charges, the lower
will be the amount of tax payable by the firm. Therefore, it is necessary to adjust the before-tax cost of debt.
The after-tax corporate cost of debt is as follows:

k̅ d = 𝐤 𝐝 (1 – t)

where,

k̅ d = after-tax cost of debt

k d = before-tax cost of debt; and

61
t is the corporate tax rate;

Example. If the before-tax cost of bond on our example is 16.5%, and the corporate tax rate is 35%, the
after-tax cost of bond will be:

Solution. k̅ d = k d (1 – t)

= 0.1650 (1 – 0.35)

= 0.1073

= 10.73%

6.3.2 - Cost of preference Capital: The measurement of the cost of equity capital poses some conceptual
difficulty. Unlike, in the case of debt where the payment of interest is a legal obligation, in preference
capital, dividends is not a legal binding on the firm and even if the dividends are paid, it is not a charge on
earnings; rather it is a distribution of appropriation of earnings to preference shareholders. The cost of
preference capital is a function of the dividend expected by investors.

a) Cost of irredeemable preference share

D
kp = Po

Where:

kp is the cost of preference share;

D is the expected dividend; and

Po is the issue price of preference share.

Example : A company issues 10 per cent irredeemable preference shares. The face value per share is
100frs, but the issue price is 95frs. What is the cost of preference share? What is the cost if the issue price
is 105frs?

D
Solution. k p = Po

10
kp = 95

62
 = 0.1053 or 10.53%

Issue price 105:

10
kp = 105

= 0.0952 or 9.52%

b) Cost of redeemable preference share

Dt Pn
Po = ∑nt=1 t + n
(1+kp ) (1+kp )

N.B: The cost of preference share is not adjusted for taxes because preference dividend is paid after the
corporate taxes have been paid.

6.3.3 - Cost of equity capital: Firms may be raise equity capital internally by retained earnings.
Alternatively, they could distribute the entire earnings to equity shareholders and raise equity capital
externally by issuing new shares. In both cases, shareholders are providing funds to the firms to finance
their capital expenditures. Therefore, the equity shareholders’ required rate of return would be the same
whether they supply funds by purchasing new shares or by foregoing dividends, which could have been
distributed to them.

6.3.3.1 -Cost of internal equity: The Dividend-Growth Model

A firm’s internal equity consists of its retained earnings. The opportunity cost of the retained earnings is the
rate of return foregone by equity shareholders. The shareholders generally expect dividend and capital gain
from their investment. The required rate of return of shareholders can be determined from the dividend
growth model.

a) Normal growth: The dividend valuation model for a firm whose dividends are expected to grow at a
constant rate of g is as follows:

D1
Po = k
e −g

By rearranging the variables in the dividend growth model, the required return can be expressed as follows:
D
ke = P 1 + g and D1 = Do (1+g),
o

63
where:

ke = required rate of return for ordinary shareholders;

D1 = expected dividend in the period 1;

P0 = current price of the shares; and

g = anticipated rate of dividend growth.

Example. Suppose that the current market price of a company’s share is 90 and the expected dividend per
share next year is 4.50. If the dividends are expected to grow at a constant rate of 8%, the shareholders
required rate of return is:

D
Solution. ke = P 1 + g
o

4.50
ke = + 0.08
90

= 0.05 + 0.08 = 0.13 or 13%

b) Supernormal growth: A firm may pass through different phases of growth. Hence, dividend may grow
at different rates in the future. The growth rate may be very high for a few years, and afterwards, it may
become neutral indefinitely in the future. The dividend-valuation model can also be used to calculate the
cost of equity under different growth assumptions. If the dividends are expected to grow at a super-normal
growth rate, g s , for n years and thereafter, at a normal, perpetual growth rate of , g n , beginning in year
n+1, then the cost of equity can be determined by the following formula:

Do(1+ g )t Pn
Po = ∑nt=1 s
(1+ke )t
+ (1+ ke )n

Pn is the discounted value of the dividend stream, beginning in year n+1 and growing at a constant,
perpetual rate 𝑔𝑛 , at the end of year n, and therefore it is equal to:

Dn+1
Pn = k
e −gn

1
Multiplying Pn by (1+ k 2
we obtain the present value of Pn in year o. Thus,
e)

64
 Do (1+ gs )t Dn+1 1
Po = ∑nt=1 (1+ke )t
+ x (1+ke )n
,
ke −gn

where, g s , is the supernormal growth, n is the number of years, g n is the perpetual growth rate.

Example. Assume that a company’s share is currently selling for 134. Current dividend, D 0 are 3.50 per
share and expected to grow at 15% over the next 6 years and then at a rate of 8 percent forever. What is
the company’s cost of equity capital.

Solution. The company’s cost of equity can be found out as follows:

Do (1+ gs )t Dn+1 1
Po = ∑nt=1 (1+ke )t
+ x (1+ke )n
,
ke −gn

3.50(1+ 0.15)t D7 1
134 = ∑nt=1 (1+ke )t
+ x (1+ke )6
(ke −0.08)

4.03 4.63 5.33 6.13 7.05 8.11 8.11(1.08) 1

134 = (1+𝑘 + (1+ 𝑘𝑒 )2
+ (1+ 𝑘𝑒 )3
+ (1+ 𝑘𝑒 )4
+ (1+ 𝑘𝑒 )5
+ (1+ 𝑘𝑒 )6
+ 𝑥 (1+ 𝑘𝑒 )6
𝑒) (1+ 𝑘𝑒 )

By trial and error, we found that 𝑘𝑒 = 0.12 𝑜𝑟 12 𝑝𝑒𝑟 𝑐𝑒𝑛𝑡

c) Zero growth: The cost of equity of a share on which a constant amount of dividend is expected
perpetually is given as follows:

D
Ke = P 1 , the growth rate g will be zero if the firm does not retain any of its earnings; that is, the firm follows
o

𝐷
a policy of 100 percent payout. Under such case, dividends will be equal to earnings. Thus, K e = 𝑃 1 =
𝑜

EPS1
(since g =0). This implies that in a no-growth situation, the expected earnings-per (E/P) share may
Po

be used as the measure of the firm’s cost of capital.

6.3.3.2 - Cost of external equity: The Dividend Growth Model

The firm’s external equity consists of funds raised externally through public or rights issues. The minimum
rate of return, which the equity shareholders require on funds supplied by them by purchasing new shares
to prevent a decline in the existing market price of the equity share, is the cost of external equity. The firm

65
can induce the existing or potential shareholders to purchase new shares when it promises to earn a rate of
return equal to :

D1
ke = + g
P0

Thus, the shareholders’ required rate of return from retained earnings and external equity is the same. The
cost of external equity is, however, greater than the cost of internal equity for one reason. The selling price
of the new shares issues may be less than the market price. Thus, the formula for the cost of new issues of
equity capital may be written as follows:

D
Ke = P 1 + g ,
1

where P1 is the issue price of the new equity. The cost of retained earnings will be less than the cost of new
issue of equity if 𝑃0 > 𝑃1 .

Example. The share of a company is currently selling for 100. It wants to finance its capital expenditures of
100 million either by retaining earnings or selling new shares. If the company sells new shares, the issue
price will be 95. The dividend per share next year is 4.75 and it is expected to grow at 6%. Calculate (i) the
cost of internal equity (retained earnings) and (ii) the cost of external equity (new issue of share).

D
Solution. Using the equation, ke = P 1 + g can be used to calculate the cost of internal equity
o

D
ke = P 1 + g
o

4.75
ke = 100 + 0.06= 0.1075 = 10.75%

The cost of external equity can be calculated as follows:

D
Ke = P 1 + g
1

4.75
Ke = + 0.06 = 0.11 or 11%
95

It is obvious that the cost of external equity is greater than the cost of internal equity because of the under-
pricing.

66
6.3.3.3- The cost of equity: Earnings-Price ratio model

As a general rule, it is not theoretically correct to use the ratio of earnings to price as a measure of the cost
of equity. The earnings-price (E/P) ratio does not reflect the true expectations of the ordinary shareholders.

There are exceptions, however. One exception that we have already pointed out is the no-growth firms.
The cost of equity in the case of the no-growth firms is equal to the expected E/P ratio:

DIV1
ke = + g
P0

EPS1 (1−b)
ke = + br (g = br)
P0

EPS1
ke = (b = 0)
P0

where b is the earnings retention rate, EPS1 is the expected earnings per share and r is the return
investment (equity).

Another situation where the expected earnings-price ratio may be used as a measure of the cost of equity
is expansion, rather than growth faced by the firm. A firm is said to be expanding, not growing, if the
investment opportunities available to it are expected to earn a rate of return equal to the cost of equity.
Thus, for expansion,

EPS1 (1−b)
Po = (ke −rb)
,

EPS1
if r = ke , then ke = Po

Example. A firm is currently earning 100, 000 and its share is selling at market price of 80. The firm has 10,
000 shares outstanding and has no debt. The earnings of the firm are expected to remain stable, and it has
a payout ratio of 100 percent. What is the cost of equity? If the firm’s payout ratio is assumed to be 60
percent and then it earns 15 per cent rate of interest on its investment opportunities, then, what would be
the firm’s cost of equity?

Solution. In the first case since expected growth rate is zero, we can use expected earnings-price to
compute the cost of equity. Thus,

67
 EPS1
ke = P0

E/P
ke = P0

100,000
10,000
ke = 80

10
ke = = 0.125 or 12.5%
80

The earnings per share are 100, 000 ÷ 10, 000 = 10. If the firm pays out 60 per cent of its earnings, the
dividend per share will be: 10 x 0.6 = 6, and the retention ratio will be 40 per cent. If the expected return on
interval investment opportunities is 15 per cent, then the firm’s expected growth is : 0.40 x 0.15 = 0.06 or
6%. The firm’s cost of equity will be:

10
𝑘𝑒 = + 0.06 = 0.075 + 0.06 = 0.135 or 13.5%
80

6.3.3.4 - Cost of equity and the capital asset pricing model (CAPM)

As per CAPM, the required rate of return on equity is given by the following relationship:

k e = R f + (R m − R f )βj

where ,

R f is the risk-free rate;

R m − R f is the market risk premium; and

βj is the beta of the firm’s share. Beta is the systematic risk of an ordinary share in relation to the
market.

Example. Suppose the risk-free rate is 6 per cent, the market risk premium is 9 per cent and beta of L&T’s
share is 1.54. The cost of equity for L&T is:

Solution. k e = R f + (R m − R f )βj = 0.06 + 0.09 x 1.54 = 0.1986 ≈ 20%

6.4- Weighted average cost of capital (WACC)

68
The weighted average cost of capital of a firm may be used as a hurdle rate in discounting future cash
flows in capital budgeting or investment analysis. In this regards, the WACC assumes that a firm’s new
project employs the same debt/equity mix of the firm, and the project risk is equivalent to the firm risk.

The WACC can also be viewed as the required rate of return for the firm in which the firm employs the
average cost as the rate at which the project or investment must earned to compensate its investors for the
use of funds. Once the component costs have been calculated, they are multiplied by the proportion of the
respective sources of capital to obtain the weighted average cost of capital (WACC). If we assume that a
firm has only debt and equity in its capital structure, then the WACC (r) will be:

E D
r = re (V) + rd (V)

where:

r = WACC;

rd = cost of debt;

re = cost of equity;

D = market value of the firm’s debt;

E = market value of the firm’s equity; and

V = (D+E), market value of the firm.

The use of market value, as opposed to book value, is important in deriving the average cost to reflect the
current cost in raising funds, which has more economic significance for a project’s evaluation. There is also
a corporate tax implication such as interest payments on debt that are charged against earnings. Thus, the
equation above can be re-expressed as follows:

E D
r = re (V) + rd (1 − t c ) (V)

where:

t c = the firm’s corporate tax rate.

. In a general form, the formula of calculating WACC can be written as follows:

69
Ko = k1w1 + k2w2 + k3w3 + . . .

Where k1, k2, . . . are component costs and w1, w2 weights of various types of capital employed by the
company.

Example. A firm has E = 100 and D = 100, and the total market value of the firm is 200. So its capital
structure is 50% equity and 50% debt. If the rate of return on equity is 11.6% and on debt is 12%, then the
WACC:

Solution. r = (0.116 x 0.5) + (0.12 x 0.5)

= 0.058 + 0.06

= 11.8%

Assume that a corporate tax rate of 28%, then the after-tax WACC is :

r = (0.116 x 0.5) + (0.12) (1 – 0.28) (0.5)

= 0.058 + 0.043

= 10.1%

Normally a firm employs various sources of capital funds in financing its operations and investments.
Hence, its cost of debt depends on the firm’s debt structure. A preferred share is considered debt security
because of its debt-like characteristics. The firm may also employ short-term borrowings such as bank
overdraft or short-term notes, or the firm may also use long-term borrowings such as term loans or bonds.

Reading list

1.Samuel A. Broverman, Mathematics of Investment and Credit, 4th ed., ACTEX Publications, 2008. ISBN
978-1-56698-657-1.

2.Stephen G. Kellison, The Theory of Interest, 3rd ed., McGraw-Hill, 2009. ISBN 978-007-127627-6.

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3.John McCutcheon and William F. Scott, An Introduction to the Mathematics of Finance, Elsevier
Butterworth-Heinemann, 1986. ISBN 0-75060092-6.

4.Petr Zima and Robert L. Brown, Mathematics of Finance, 2nd ed., Schaum's Outline Series, McGraw-Hill,
1996. ISBN 0-07-008203.

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