Acf

Principles of
Corporate Finance, 8/e

(Special Indian Edition)
Objectives of
The Firm, and
Corporate
Governance
1- 2
Topics Covered
What Is A Corporation?
The Role of The Financial Manager
Who Is The Financial Manager?
Separation of Ownership and Management
Corporate Structure
Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships
Limited Liability
Corporations
Corporate tax on profits +

Personal tax on dividends
(dividend distribution tax as
of now in India)
1- 3
Role of The Financial Manager

(2)
(1)
Financial
manager
Firm's
operations
1- 4
(4a)
(4b)
(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
Financial
markets
Role of The Financial Manager

Common Finance Terminology
Real assets
Financial assets / Securities
Capital markets and financial
markets
Investment / capital budgeting
Financing
1- 5
Who is The Financial Manager?

Chief
ChiefFinancial
FinancialOfficer
Officer
Treasurer
Controller
1- 6
Ownership vs. Management

Difference in Information
Different Objectives
Stock prices and returns

Issues of shares and
other securities
Dividends
Financing
Managers vs.
stockholders
Top mgmt vs.
operating mgmt
Stockholders vs. banks
and lenders
1- 7
Topics Covered
Introduction to Present Value
Foundations of the Net Present Value
Rule
Corporate Goals and Corporate
Governance
1- 8
Present and Future Value

Future Value
Amount to which an
investment will grow
after earning interest
Present Value
Value today of a
future cash
flow.
1- 9
Discount Factors and Rates

Discount Rate
Interest rate used
to compute
present values of
future cash flows.
Discount Factor
Present value of
a Rs.1 future
payment.
1- 10
1- 11
Future Values
Future Value of Rs.100 = FV
FV Rs.100 (1 r )
F
V
R
s.40,(1.05)R
s.420,
Future Values
FV Rs.100 (1 r )
Example - FV
What is the future value of Rs.400,000 if interest is

compounded annually at a rate of 5% for one year?
1- 12
Present Value
Present Value = PV
PV = discount factor C1
1- 13
Present Value
Discount Factor = DF = PV of Rs.1
DF
1
(1 r ) t
Discount Factors can be used to compute the present value of

any cash flow.
1- 14
Valuing an Office Building

Step 1: Forecast cash flows
Cost of building = C0 = 400
Sale price in Year 1 = C1 = 420
Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 5%, then
Cost of capital = r = 5%
1- 15
Valuing an Office Building

Step 3: Discount future cash flows
PV
C1
(1r )
420
(1.05 )
400
Step 4: Go ahead if PV of payoff exceeds investment
NPV 400 370 30
1- 16
Net Present Value

NPV = PV - required investment
C1
NPV = C0
1 r
1- 17
Risk and Present Value

Higher risk projects require a higher rate of
return
Higher required rates of return cause lower
PVs
PV of C1 Rs.420 at 5%
420
PV
400
1 .05
1- 18
Risk and Present Value

420
PV
375
1 .12
420
PV
400
1 .05
1- 19
Risk and Net Present Value

NPV=PV-required investment
NPV=375,000-370,000
Rs.5,000
1- 20
p
r
o
f
i
t
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2
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,
3
7
0
,
R
eturnivesm
.
1
3
5
o
r
1
3
.
5
%
n
Rate of Return Rule
Accept investments that offer rates of return

in excess of their opportunity cost of capital
Example
In the project listed below, the foregone investment

opportunity is 12%. Should we do the project?
1- 21
6
0
N
PV
=-5+1.R
s.45
Net Present Value Rule
Accept investments that have positive net

present value
Example
Suppose we can invest Rs.50 today and receive
Rs.60 in one year. Should we accept the project
given a 10% expected return?
1- 22
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octadnpafm
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a
l
B
o
m
sC.
.18080,,110,30,140,140,Rs10,
Opportunity Cost of Capital
Example
You may invest Rs.100,000 today. Depending on
the state of the economy, you may get one of three
possible cash payoffs:
1- 23
e
x
p
c
t
e
d
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i
t
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0
9
5
.
6
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xpectdreuninvsm
1
5
o
r
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n
Example - continued
The stock is trading for Rs.95.65. Next years
price, given a normal economy, is forecast at
Rs.110
The stocks expected payoff leads to an expected

return.
1- 24
,P
1
0
V
.5R
s.95,60
Example - continued
Discounting the expected payoff at the expected
return leads to the PV of the project
1- 25
e
x
p
c
t
e
d
p
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o
f
i
t
1
0
,
1
0
,
E
xpectdreuninvsm
.
1
0
o
r
%
n
Example - continued
Notice that you come to the same conclusion if you
compare the expected project return with the cost
of capital.
1- 26
Investment vs. Consumption

Some people prefer to consume now. Some
prefer to invest now and consume later.
Borrowing and lending allows us to
reconcile these opposing desires which may
exist within the firms shareholders.
1- 27

income in period 1
100
A
80
Some investors will prefer A

and others B
60
40
20
40
60
income in period 0
80
100
1- 28

The grasshopper (G) wants to
consume now. The ant (A) wants to
wait. But each is happy to invest.
Each invests Rs.185,000 and returns
Rs.210,000 at the end of the year. G
wants to consume now so G borrows
Rs.200,000 and repays Rs.210,000 at
the end of the year. The existence of
capital markets allows G to consume
now and still invest with A in the
project.
1- 29

Rupees
Next Year
210
A invests Rs.185 now

and consumes Rs.210
next year
194
The grasshopper (G) wants to consume

now. The ant (A) wants to wait. But
each is happy to invest. Each invests
Rs.185,000 and returns Rs.210,000 at the
end of the year. G wants to consume now
so G borrows Rs.200,000 and repays
Rs.210,000 at the end of the year. The
existence of capital markets allows G to
consume now and still invest with A in
the project.
G invests Rs.185 now,

borrows Rs.200 and
consumes now.
185
200
1- 30
Rupees
Now
Managers and Shareholder Interests
1- 31
Tools to Ensure Management Pays Attention

to the Value of the Firm
Mangers actions are subject to the scrutiny of the
board of directors.
Shirkers are likely to find they are ousted by more
energetic managers.
Financial incentives such as stock options
Goals of The Corporation

Shareholders desire wealth
maximization
Do managers maximize shareholder
wealth?
Mangers have many constituencies
stakeholders
Agency Problems represent the
conflict of interest between
management and owners
1- 32
Goals of The Corporation

Agency Problem Solutions
1 - Compensation plans
2 - Board of Directors
3 - Takeovers
4 - Specialist Monitoring
5 - Auditors
1- 33
1- 34
Topics Covered
Valuing Long-Lived Assets
PV Shortcuts Perpetuities and Annuities
Compound Interest & Present Values
Nominal and Real Rates of Interest
(inflation)
D
F
1
t(
r)
Present Values
Discount Factor = DF = PV of Rs.1
Discount Factors can be used to compute

the present value of any cash flow.
1- 35
D
F
(1r)t
Present Values
C1
PV DF C1
1 r1
Discount Factors can be used to compute

the present value of any cash flow.
1- 36
Present Values
Ct
PV DF C t
t
(1 r )
Replacing 1 with t allows the formula to be
used for cash flows that exist at any point in
time
1- 37
P
V
R
s.2,5702
3(1.08)2
Present Values
Example
You just bought a new computer for Rs.3,000. The
payment terms are 2 years same as cash. If you can earn
8% on your money, how much money should you set aside
today in order to make the payment when due in two
years?
1- 38
P
V
C
C
1
2
(1
r)(1
r)
Present Values
PVs can be added together to evaluate

multiple cash flows.
1- 39
P
V
(1.07)1(1207)2265.8
Present Values
PVs can be added together to evaluate

multiple cash flows.
1- 40
1- 41
Present Values
Rs.200
Rs.100
Present Value
Year 0
100/1.07
= Rs.93.46
200/1.0772
= Rs.172.42
Total
= Rs.265.88
Year
D
F
.837
.12(027)12
1
Present Values
Given two dollars, one received a year from now

and the other two years from now, the value of
each is commonly called the Discount Factor.
Assume r1 = 20% and r2 = 7%.
1- 42
Present Values
Example
Assume that the cash flows
from the construction and sale
of an office building is as
follows. Given a 5% required
rate of return, create a present
value worksheet and show the
net present value.
Year 0
Year 1
Year 2
170,000 100,000 320,000
1- 43
1- 44
Present Values
Example - continued
Assume that the cash flows from the construction and sale of an office
building is as follows. Given a 5% required rate of return, create a
present value worksheet and show the net present value.
Period
Discount
Factor
Cash
Flow
Present
Value
0
1
1.0
1
1.05 .952
170, 000
100, 000
170, 000
95, 238
320, 000
290, 249
1
1.05 2
.907
NPV Total Rs.25, 011
1- 45
Present Values
Example - continued
Assume that the cash flows from the construction and sale of an office
building is as follows. Given a 5% required rate of return, create a
present value worksheet and show the net present value.
+Rs.320,00
0
-Rs.170,000
Rs.100,000
Present Value
Year
0
Year 0
-170,000
= -Rs.170,000
-100,000/1.05 =
Rs.95,238
320,000/1.052 = Rs.290,249
Total = NPV = Rs.25,011
Short Cuts
Sometimes there are shortcuts that make it
very easy to calculate the present value of
an asset that pays off in different periods.
These tolls allow us to cut through the
calculations quickly.
1- 46
Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.
cash flow
Return
present value
C
r
PV
1- 47
Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.
cash flow
PV of Cash Flow
discount rate
C1
PV0
r
1- 48
1- 49
Short Cuts
Annuity - An asset that pays a fixed sum each year for a

specified number of years.
Asset
Perpetuity (first
payment in year 1)
Year of Payment
1
2..t
t+1
Present Value
C
r
Perpetuity (first payment

in year t + 1)
1
C

t
r (1 r )
Annuity from year

1 to year t
1
C C

t
r r (1 r )
Short Cuts
Annuity - An asset that pays a fixed sum each
year for a specified number of years.
1
1
PV of annuity C
t
r r 1 r
1- 50
Annuity Short Cut

Example
You agree to lease a car for 4 years at Rs.3000 per month.
You are not required to pay any money up front or at the
end of your agreement. If your opportunity cost of capital
is 0.5% per month, what is the cost of the lease?
1- 51
Annuity Short Cut

Example - continued
You agree to lease a car for 4 years at Rs.3000 per
month. You are not required to pay any money up front or
at the end of your agreement. If your opportunity cost of
capital is 0.5% per month, what is the cost of the lease?
1
1
Lease Cost 3000
48
.005 .005 1 .005
Cost Rs.127, 741.0
1- 52
1- 53
Compound Interest
i
ii
Periods Interest
per
per
year
period
iii
APR
(i x ii)
iv
Value
after
one year
v
Annually
compounded
interest rate
6%
6%
1.06
6.000%
1.032
= 1.0609
6.090
1.5
1.0154 = 1.06136
6.136
12
.5
1.00512 = 1.06168
6.168
52
.1154
1.00115452 = 1.06180
6.180
365
.0164
1.000164365 = 1.06183
6.183
Compound Interest
1- 54
Compound Interest
1- 55
Compound Interest
Example
Suppose you are offered an automobile loan at an APR of
6% per year. What does that mean, and what is the true
rate of interest, given monthly payments?
1- 56
Compound Interest
Example - continued
Suppose you are offered an automobile
loan at an APR of 6% per year. What
does that mean, and what is the true rate
of interest, given monthly payments?
Assume Rs.10,000 loan amount.
Loan Pmt 10,000 (1.005)

10,616.78
APR 6.1678%
12
1- 57
Inflation
Inflation - Rate at which prices as a whole are
increasing.
Nominal Interest Rate - Rate at which money
invested grows.
Real Interest Rate - Rate at which the
purchasing power of an investment increases.
1- 58
1
+
n
o
m
i
a
l
n
t
e
r
s
a
t
e
1realintresat=fo
Inflation
1- 59
approximation formula
Real int. rate nominal int. rate - inflation rate
1
+
.
0
5
9
1
rA
lproxim
+
e
a
ian
tto
erns=
ate9-.0
=
3
2
2
r3=
5
o
.0
5%
6or2.6%
1- 60
Inflation
Example
If the interest rate on one year govt. bonds is 5.9%
and the inflation rate is 3.3%, what is the real
interest rate?
Savings
Bond
Topics Covered
Using PV Formulas to Value Bonds
How Common Stocks are Traded
How Common Stocks are Valued
Estimating the Cost of Equity Capital
Stock Prices and EPS
1- 61
1- 62
Valuing a Bond
Example
If today is January 2004, what is the value of the following bond?
A German Government bond (Bund) pays a 5.375 percent annual
coupon, every year for 6 years. The par value of the bond is 100
EURO.
Cash Flows
'05
'06
'07
'08
'09
'10
5.375 5.375 5.375 5.375 5.375 105.375
Valuing a Bond
Example continued
If today is January 2004, what is the value of the following bond?
A German Government bond (Bund) pays a 5.375 percent annual coupon, every
year for 6 years. The par value of the bond is 100 EURO.
The price at a 3.8% YTM is as follows
5.375
5.375
5.375
5.375 105.375
PV
2
3
4
5
1.038 1.038
1.038 1.038 1.038
$108.31
1- 63
Price
Bond Prices and Yields
1- 64
Yield
Stocks & Stock Market

Common Stock - Ownership shares in a
publicly held corporation.
Secondary Market - market in which already
issued securities are traded by investors.
Dividend - Periodic cash distribution from the
firm to the shareholders.
P/E Ratio - Price per share divided by
earnings per share.
1- 65
Stocks & Stock Market

Book Value - Net worth of the firm according
to the balance sheet.
Liquidation Value - Net proceeds that would
be realized by selling the firms assets and
paying off its creditors.
Market Value Balance Sheet - Financial
statement that uses market value of assets
and liabilities.
1- 66
1- 67
Trading of Stocks
Primary Market
Secondary Market
52 weeks
High
Low
Stock (SYM)
Div
Yield
PE
Vol
(100s)
Close
Net
Change
3449
1876.4
Infosys
(INFOSYSTCH)
0.2%
39.52
1539
3177.9
1.4%
Quotations of Infosys in NSE as on 29 April, 2006
D
i
v
1
1
0
E
xpectdR
eturnr0
Valuing Common Stocks
Expected Return - The percentage yield that an

investor forecasts from a specific investment over
a set period of time. Sometimes called the market
capitalization rate.
1- 68
1
0
E
xpectdR
eturn.15
Example: If Fledgling Electronics is selling for

Rs.100 per share today and is expected to sell for
Rs.110 one year from now, what is the expected
return if the dividend one year from now is
forecasted to be Rs.5.00?
1- 69
D
i
v
1
C
apitlzaionR
ate
P
0r
g
1
0
Capitalization Rate can be estimated using the

perpetuity formula, given minor algebraic
manipulation.
1- 70

Return Measurements
Div1
Dividend Yield
P0
Return on Equity ROE
EPS
ROE
Book Equity Per Share
1- 71
iP
D
v
D
i
v
D
i
v
P
1
2
H
H
.
0(
1r)(1r)(1r)
Dividend Discount Model - Computation of todays

stock price which states that share value equals the
present value of all expected future dividends.
H - Time horizon for your investment.
1- 72

Example
Current forecasts are for XYZ Company to pay
dividends of Rs.3, Rs.3.24, and Rs.3.50 over the
next three years, respectively. At the end of three
years you anticipate selling your stock at a market
price of Rs.94.48. What is the price of the stock
given a 12% expected return?
1- 73

Example
Current forecasts are for XYZ Company to pay dividends of Rs.3,
Rs.3.24, and Rs.3.50 over the next three years, respectively. At the end
of three years you anticipate selling your stock at a market price of
Rs.94.48. What is the price of the stock given a 12% expected return?
3.00
3.24
3.50 94.48
PV
1
2
3
(1 .12) (1 .12)
(1 .12)
PV Rs.75.00
1- 74

If we forecast no growth, and plan to hold out
stock indefinitely, we will then value the stock as a
PERPETUITY.
Div1
EPS1
Perpetuity P0
or
r
r
Assumes all earnings are
paid to shareholders.
1- 75

Constant Growth DDM - A version of the dividend
growth model in which dividends grow at a
constant rate (Gordon Growth Model).
1- 76

Example- continued
If the same stock is selling for Rs.100 in the stock
market, what might the market be assuming about
the growth in dividends?
Rs.3.00
Rs.100
.12 g
g .09
Answer
The market is
assuming the dividend
will grow at 9% per
year, indefinitely.
1- 77

If a firm elects to pay a lower dividend, and
reinvest the funds, the stock price may increase
because future dividends may be higher.
Payout Ratio - Fraction of earnings paid out as
dividends
Plowback Ratio - Fraction of earnings retained by
the firm.
1- 78

Growth can be derived from applying the
return on equity to the percentage of
earnings plowed back into operations.
g = return on equity X plowback ratio
1- 79

Example
Our company forecasts to pay a
Rs.8.33 dividend next year, which
represents 100% of its earnings. This
will provide investors with a 15%
expected return. Instead, we decide to
plow back 40% of the earnings at the
firms current return on equity of 25%.
What is the value of the stock before
and after the plowback decision?
1- 80
.P
g
.011R
2
5
4
0
s0.
Example
Our company forecasts to pay a Rs.8.33 dividend next year, which
represents 100% of its earnings. This will provide investors with a
15% expected return. Instead, we decide to plow back 40% of the
earnings at the firms current return on equity of 25%. What is the
value of the stock before and after the plowback decision?
No Growth
8.33
P0
Rs.55.56
.15
With Growth
1- 81

Example - continued
If the company did not plowback some earnings, the stock price
would remain at Rs.55.56. With the plowback, the price rose to
Rs.100.00.
The difference between these two numbers) is called the Present
Value of Growth Opportunities (PVGO).
PVGO 100.00 55.56 Rs.44.44
1- 82

Present Value of Growth Opportunities
(PVGO) - Net present value of a firms
future investments.
Sustainable Growth Rate - Steady rate at
which a firm can grow: plowback ratio X
return on equity.
1- 83
1- 84
Topics Covered
A Review of The Basics
NPV and its Competitors
The Payback Period

The Book Rate of Return
Internal Rate of Return

Capital Rationing
NPV and Cash Transfers

Every possible method for evaluating projects
impacts the flow of cash about the company
as follows.
Cash
Investment
opportunity (real
asset)
Firm
Invest
Shareholder
Alternative:
pay dividend
to shareholders
Investment
opportunities
(financial assets)
Shareholders invest
for themselves
1- 85
Book Rate of Return

Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return.
Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash
flows.
book income
Book rate of return
book assets
1- 86
Payback
The payback period of a project is the number of
years it takes before the cumulative forecasted
cash flow equals the initial outlay.
The payback rule says only accept projects that
payback in the desired time frame.
This method is flawed, primarily because it
ignores later year cash flows and the the present
value of future cash flows.
1- 87
P
a
y
b
c
k
P
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ct-2C
C
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@
1
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%
0
1
2
3
e
r
i
o
d
01580158050
Payback
Example
Examine the three projects and note the mistake
we would make if we insisted on only taking
projects with a payback period of 2 years or less.
1- 88
P
a
y
b
c
k
P
roA
jC
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@
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0
1
2
3
e
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0158015805023
2-5,6804
Payback
Example
Examine the three projects and note the mistake
we would make if we insisted on only taking
projects with a payback period of 2 years or less.
1- 89

Example
You can purchase a turbo powered machine tool
gadget for Rs.4,000. The investment will generate
Rs.2,000 and Rs.4,000 in cash flows for two years,
respectively. What is the IRR on this investment?
1- 90
2
,
0
4
,
0
N
,IR
P
V
4
0
0
1
2
(2
I8
1
R
)
(
1
I
R
)
.%
Example
You can purchase a turbo powered machine tool gadget for Rs.4,000.
The investment will generate Rs.2,000 and Rs.4,000 in cash flows for
two years, respectively. What is the IRR on this investment?
1- 91
IRR=28%
1- 92
1- 93
Pitfall 1 - Lending or Borrowing?

With some cash flows (as noted below) the NPV of the project
increases as the discount rate increases.
This is contrary to the normal relationship between NPV and
discount rates.
Project
A
B
C0
C1
IRR
1,000 1,500 50%
1,000 1,500 50%
NPV @ 10%
364
364

Pitfall 2 - Multiple Rates of Return
Certain cash flows can generate NPV=0 at two different discount
rates.
The following cash flow generates NPV=Rs. 3.3 million at both IRR
% of (-44%) and +11.6%.
Cash Flows (millions of Rupees)
C0 C1...... ......C9
60
12
12
C10
15
1- 94

Pitfall 2 - Multiple Rates of Return
Certain cash flows can generate NPV=0 at two different discount rates.
The following cash flow generates NPV=Rs. 3.3 million at both IRR% of
(-44%) and +11.6%.
NPV
600
IRR=11.6%
300
Discount
Rate
0
-30
-600
IRR=-44%
1- 95
Profitability Index
When resources are limited, the profitability index
(PI) provides a tool for selecting among various
project combinations and alternatives
A set of limited resources and projects can yield
various combinations.
The highest weighted average PI can indicate
which projects to select.
1- 96
Profitability Index
Cash Flows (Rs. millions)
Project
Project CC00
AA
10
10
BB
55
CC
55
CC1
CC2 NPV
@
10
%
NPV
@
10
%
1
2
30
21
30 55
21
55 20
16
20
16
55 15
12
15
12
1- 97
Profitability Index
Cash Flows (Rs. millions)
Project
Project Investment
Investment(Rs.)
(Rs.) NPV
NPV(Rs.)
(Rs.) Profitability
ProfitabilityIndex
Index
AA
10
21
2.1
10
21
2.1
BB
55
16
3.2
16
3.2
CC
55
12
2.4
12
2.4
1- 98
Profitability Index
NPV
Profitability Index
Investment
Example
We only have Rs.300,000 to invest. Which do we select?
Proj NPV
A 230,000
B 141,250
C 194,250
D 162,000
Investment
200,000
125,000
175,000
150,000
PI
1.15
1.13
1.11
1.08
1- 99
Profitability Index
Example - continued
Proj NPV Investment
A 230,000
200,000
B 141,250
125,000
C 194,250
175,000
D 162,000
150,000
PI
1.15
1.13
1.11
1.08
Select projects with highest Weighted Avg PI

WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25)
(300)
(300)
(300)
= 1.01
1- 100
Profitability Index
Example - continued
Proj NPV Investment
A 230,000
200,000
B 141,250
125,000
C 194,250
175,000
D 162,000
150,000
PI
1.15
1.13
1.11
1.08
Select projects with highest Weighted Avg PI

WAPI (BD) = 1.01
WAPI (A) = 0.77
WAPI (BC) = 1.12
1- 101
Inflation
INFLATION RULE
Be consistent in how you handle inflation!!
Use nominal interest rates to discount
nominal cash flows.
Use real interest rates to discount real cash
flows.
You will get the same results, whether you
use nominal or real figures
1- 102
Inflation
Example
You own a lease that will cost you Rs.8,000 next
year, increasing at 3% a year (the forecasted
inflation rate) for 3 additional years (4 years
total). If discount rates are 10% what is the
present value cost of the lease?
1+nominal interest rate
1 real interest rate =
1+inflation rate
1- 103
1- 104
Inflation
Example - nominal figures
Year Cash Flow
PV @ 10%
8000
8000x1.03=8240
8000
1.10
8240
1.102
7272.73
6809.92
8000x1.03 =8240
8487.20
1.103
6376.56
8000x1.033 =8487.20
8741.82
1.104
5970.78
Rs.26, 429.99
1- 105
Inflation
Example - real figures
Year
Cash Flow
PV@6.7961%
1
2
8000
1.03
8240
1.032
=7766.99
=7766.99
7766.99
1.068
7766.99
1.0682
7272.73
6809.92
8487.20
1.033
=7766.99
7766.99
1.0683
6376.56
8741.82
1.034
=7766.99
7766.99
1.0684
5970.78
= Rs.26, 429.99
Timing
Even projects with positive NPV may be
more valuable if deferred.
The actual NPV is then the current value of
some future value of the deferred project.
Net future value as of date t

Current NPV
t
(1 r )
1- 106
1- 107
Timing
Example
You may harvest a set of trees at anytime over the
next 5 years. Given the FV of delaying the
harvest, which harvest date maximizes current
NPV?
Harvest Year
0
Net FV (Rs.1000s) 50 64.4
77.5
89.4
% change in value
20.3
15.4 11.9
28.8
100 109.4
9.4
Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given
the FV of delaying the harvest, which harvest date maximizes current
NPV?
64.4
NPV if harvested in year 1
58.5
1.10
1- 108
6
4
.
N
P
V
ifharvestdinyear1058.
1- 109
Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given
the FV of delaying the harvest, which harvest date maximizes current
NPV?
NPV (Rs.1000s) 50 58.5
Harvest Year
2
3
64.0
67.2 68.3 67.9
Topics Covered
Measuring Portfolio Risk
Calculating Portfolio Risk
Beta and Unique Risk
Diversification & Value Additivity
1- 110
Measuring Risk
Variance - Average value of squared deviations from
mean. A measure of volatility.
Standard Deviation - Average value of squared
deviations from mean. A measure of volatility.
1- 111
1- 112
Measuring Risk
Coin Toss Game-calculating variance and standard deviation
For each head, you get the starting balance plus 30%;
For each tail, you get your starting balance less 10%.
(1)
Percent Rate of
Return ()
+100
+20
-60
(2)
Deviation from
Expected Return
( - r)
+80
0
-80
(3)
Squared Deviation
2
( - r)
(4)
Probability
6400
0.25
0
0.5
6400
0.25
2
Variance = Expected value of ( - r) =
Standard deviation =
variance 800
(5)
Probability
Squared
Deviation
1600
0
1600
3200
56.5685425
Measuring Risk
Diversification - Strategy designed to reduce risk
by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that firm.
Also called diversifiable risk.
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
systematic risk.
1- 113
1- 114
Measuring Risk
(
(
)(
)(
Portfolio rate
fraction of portfolio
=
x
of return
in first asset
+
fraction of portfolio
in second asset
rate of return
on first asset
rate of return
)
)
on second asset
Measuring Risk
1- 115
Measuring Risk
1- 116
1- 117
Portfolio Risk
The variance of a two stock portfolio is the sum of these
four boxes
Stock 1
Stock 1
Stock 2
x 12 12
x 1x 2 12
x 1x 2 12 1 2
Stock 2
x 1x 2 12
x 1x 2 12 1 2
x 22 22
Portfolio Risk
Example
Suppose you invest 47% of your portfolio in
Reliance Energy and 53% in Grasim Industries.
The expected return on your Reliance Energy
stock is 17% and on Grasim is 14%. The expected
return on your portfolio is:
Expected Return (.47 17) (.53 14) 15.41%
1- 118
Portfolio Risk
1- 119
Example
Suppose you invest 47% of your portfolio in Reliance Energy and 53%
in Grasim Industries. The expected return on your Reliance Energy
stock is 17% and on Grasim is 14%. The standard deviation of their
annualized daily returns are 37% and 33%, respectively. Assume a

correlation coefficient of 1.0 and calculate the portfolio variance.
Reliance Energy
Reliance Energy
x12 12 (0.47)2 (37) 2
Grasim
x1 x2 12 1 2
(0.47) (0.53) 1 (37) (33)
Grasim
x1 x2 12 1 2
(0.47) (0.53) 1 (37) (33)
x22 22 (0.53) 2 (33) 2
Portfolio Risk
1- 120
Example
Suppose you invest 47% of your portfolio in Reliance Energy and 53%
in Grasim Industries. The expected return on your Reliance Energy
stock is 17% and on Grasim is 14%. The standard deviation of their
annualized daily returns are 37% and 33%, respectively. Assume a
correlation coefficient of 1.0 and calculate the portfolio variance.
Portfolio variance = [(0.47)2 (37)2] + [(0.53)2 (33)2] +2 (0.47 0.53 1 33 37)
= 1216.61
The standard deviation is
1216.61
34.88 percent
Portfolio Risk
1- 121
Expected Portfolio Return (x 1 r1 ) ( x 2 r2 )
Portfolio Variance x 12 12 x 22 22 2( x 1x 2 12 1 2 )
1- 122

1. Total risk =
diversifiable risk +
market risk
2. Market risk is
measured by beta,
the sensitivity to
market changes
Expected
stock
return
beta
-10%
+10%
- 10%
+10%
-10%
Copyright 1996 by The McGraw-Hill Companies, Inc
Expected
market
return

Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market
index, such as the Nifty or Sensex, is used
to represent the market.
Beta - Sensitivity of a stocks return to the
return on the market portfolio.
1- 123
im
Bi 2
m
1- 124

im
Bi 2
m
Covariance with the

market
Variance of the market
1- 125
1- 126
Topics Covered
Markowitz Portfolio Theory
Risk and Return Relationship
Validity and the Role of the CAPM

Combining stocks into portfolios can reduce
standard deviation, below the level obtained
from a simple weighted average calculation.
Correlation coefficients make this possible.
The various weighted combinations of
stocks that create this standard deviations
constitute the set of efficient portfolios.
portfolios
1- 127

Price changes vs. Normal distribution
Grasim Industries - Daily % change 1994-2006
1- 128

Standard Deviation VS. Expected Return
%
probability
Investment A
% return
1- 129

%
probability
Investment B
% return
1- 130

%
probability
Investment C
% return
1- 131

%
probability
Investment D
% return
1- 132

Expected Returns and Standard Deviations vary given
different weighted combinations of the stocks
1- 133
Efficient Frontier
Each half egg shell represents the possible weighted combinations for two
stocks.
The composite of all stock sets constitutes the efficient frontier
Expected Return (%)
Standard Deviation
1- 134
Efficient Frontier
Lending or Borrowing at the risk free rate ( rf) allows us to exist outside the
efficient frontier.
Expected Return (%)
in
nd
e
L
Bo
wi
o
r
r
ng
rf
S
Standard Deviation
1- 135
Efficient Frontier
Example
Stocks
ABC Corp
Big Corp
28
42
Correlation Coefficient = .4
% of Portfolio
Avg Return
60%
15%
40%
21%
Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%
1- 136
Efficient Frontier
Example
Stocks
ABC Corp
Big Corp
28
42
% of Portfolio
Avg Return
60%
15%
40%
21%
Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%
Lets Add stock New Corp to the portfolio
1- 137
Efficient Frontier
Example
Stocks
Portfolio
New Corp
28.1
30
% of Portfolio
Avg Return
50%
17.4%
50%
19%
NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
1- 138
Efficient Frontier
Example
Stocks
Portfolio
New Corp
28.1
30
% of Portfolio
Avg Return
50%
17.4%
50%
19%
NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
NOTE: Higher return & Lower risk

How did we do that?
DIVERSIFICATION
1- 139
1- 140
Efficient Frontier
Return
B
A
Risk
(measured
as )
1- 141
Efficient Frontier
Return
B
AB
A
Risk
1- 142
Efficient Frontier
Return
AB
A
Risk
1- 143
Efficient Frontier
Return
ABN AB
A
Risk
1- 144
Efficient Frontier
Goal is to move
up and left.
Return
WHY?
ABN AB
A
Risk
1- 145
Efficient Frontier
Return
Low Risk
High Risk
High Return
High Return
Low Risk
High Risk
Low Return
Low Return
Risk
1- 146
Efficient Frontier
Return
Low Risk
High Risk
High Return
High Return
Low Risk
High Risk
Low Return
Low Return
Risk
1- 147
Efficient Frontier
Return
ABN AB
A
Risk
Security Market Line
1- 148
Return
Market Return = rm
Efficient Portfolio
Risk Free
Return
rf
Risk
1- 149

Return
Market Return = rm
.
Efficient Portfolio
Risk Free
Return
rf
1.0
BETA
1- 150

Return
.
Risk Free
Return
rf
Security Market
Line (SML)
BETA

Return
SML
rf
1.0
BETA
SML Equation = rf + B ( rm - rf )
1- 151
Capital Asset Pricing Model
R = rf + B ( r m - rf )
CAPM
1- 152
Testing the CAPM

Beta vs. Average Risk Premium
Avg Risk Premium
1931-2002
30
20
SML
Investors
10
Market
Portfolio
1.0
Portfolio Beta
1- 153
Testing the CAPM

Avg Risk Premium
1931-65
SML
30
20
Investors
Market
Portfolio
10
1.0
Portfolio Beta
1- 154
Testing the CAPM

Avg Risk Premium
1966-2002
30
20
SML
Investors
10
Market
Portfolio
1.0
Portfolio Beta
1- 155
1- 156
Testing the CAPM

Dollars
Return vs. Book-to-Market
(log scale)
High-minus low book-to-market
2003
Small minus big
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
Consumption Betas vs Market Betas

Stocks
(and other risky assets)
1- 157
Stocks
(and other risky assets)
Wealth is uncertain
Market risk
makes wealth
uncertain.
Standard
Wealth
CAPM
Consumption is uncertain
Wealth = market
portfolio
Consumption
Consumption
CAPM
1- 158
Topics Covered
Company and Project Costs of Capital
Measuring the Cost of Equity
Setting Discount Rates w/o Beta
Certainty Equivalents
Discount Rates for International Projects
Company Cost of Capital

A firms value can be stated as the sum of
the value of its various assets
Firm value PV(AB) PV(A) PV(B)
1- 159
Category
Speculative Ventures
Discount Rate
30%
New products
Expansion of existing business
20%
15% (Company COC)
Cost improvement, known technology 10%
1- 160

A companys cost of capital can be compared
to the CAPM required return
SML
Required
return
13
Company Cost
of Capital
5.5
1.26
Project Beta
1- 161
Measuring Betas
The SML shows the relationship between
return and risk
CAPM uses Beta as a proxy for risk
Other methods can be employed to
determine the slope of the SML and thus
Beta
Regression analysis can be used to find
Beta
1- 162
1- 163
Measuring Betas
HLL
HLL return, percent
Price data: Jan 98 Dec 01
20
15
R = 0.42
10
5
0
-20
-15
-10
-5
-5
R2 = .42
-10
B = 0.63
-20
Slope determined from plotting the

line of best fit.
-15
10
15
20
1- 164
Measuring Betas
HLL
Price data: Jan 02- Dec 05
HLL return, percent
= 0.91
20
15
R = 0.49
10
5
R2 = .49
-20
-15
-10
-5
0
-5 0
-10
-15
B = 0.91

line of best fit.
-20
10
15
20
Market return,
percent
Jan 2002-Dec 2005
1- 165
Measuring Betas
Tata Steel
Tata Steel return, percent 40

30
R2 = 0.35
= 1.03
20
10
0
-20
-15
-10
-5
R2 = .35
-10
B = 1.03
-30

line of best fit.
-20
Market
return,15
percent
5
10
20
Jan 1998 - Dec 2001
1- 166
Measuring Betas
Tata Steel
= 1.29
Tata Steel return, percent

40
30
R = 0.52
20
10
-20
R2 = .52
B = 1.29

line of best fit.
-15
-10
-5
0
-10 0
-20
-30
10
15
20
Market return,
percent
Jan 2002-Dec 2005
1- 167
Measuring Betas
HFCL
HFCL return, percent

2
100
= 3.09
80
60
R = 0.38
40
20
0
-20
R = .38
2
B = 3.09

line of best fit.
-15
-10
-5
-20 0
-40
-60
-80
-100
10
15
Market return,
percent
20
Jan 1998 - Dec 2001
1- 168
Measuring Betas
HFCL
HFCL return, percent
R2 = 0.13
= 1.56
20
10
0
-20
R = .13
2
B = 1.56

line of best fit.
-15
-10
-5
0
-10
-20
10
15
20
Market return,
Janpercent
2002-Dec 2005
1- 169
Estimated Betas
equity
Andhra Cements Ltd.
India Cements Ltd.
Madras Cements Ltd.
Shree Digvijay Cement Co. Ltd.
Cement Portfolio
0.99
1.40
0.90
1.74
1.26
Standard Error
0.62
0.32
0.20
0.48
0.29
1- 170
Beta Stability
RISK
CLASS
% IN SAME
CLASS 5
YEARS LATER
% WITHIN ONE
CLASS 5
YEARS LATER
10 (High betas)
35
69
18
54
16
45
13
41
14
39
14
42
13
40
16
45
21
61
1 (Low betas)
40
62
Source: Sharpe and Cooper (1972)

simple approach
Company Cost of Capital (COC) is based

on the average beta of the assets
The average Beta of the assets is based on
the % of funds in each asset
1- 171

simple approach
Company Cost of Capital (COC) is based on the average beta

of the assets
The average Beta of the assets is based on the % of funds in
each asset
Example
1/3 New Ventures B=2.0
1/3 Expand existing business B=1.3
1/3 Plant efficiency B=0.6
AVG B of assets = 1.3
1- 172
Capital Structure
Capital Structure - the mix of debt & equity within a
company
Expand CAPM to include CS
R = r f + B ( rm - r f )
becomes
Requity = rf + B ( rm - rf )
1- 173
Capital Structure & COC

COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V)
(V)
Bassets = Bdebt (D) + Bequity (E)

(V)
requity = rf + Bequity ( rm - rf )
(V)
IMPORTANT
E, D, and V are
all market values
1- 174
Capital Structure & COC

Expected Returns and Betas prior to refinancing
Expected
return (%)
Requity=15
Rassets=12.2
Rrdebt=8
Bdebt
Bassets
Bequity
1- 175
Asset Betas
1- 176
PV(fixed
cost)
PV(fixed
cost)
BBrevenue BBfixed cost
revenue
fixed cost PV(revenue )
PV(revenue)
PV(variabl
eecost)
PV(asset)
PV(variabl
cost)
BBvariable cost
BBasset PV(asset)
variable cost
asset PV(revenue )
PV(revenue
)
PV(revenue)
PV(revenue)
Asset Betas
PV(revenue
))--PV(variabl
eecost)
PV(revenue
PV(variabl
cost)
BBasset BBrevenue
asset
revenue
PV(asset)
PV(asset)
PV(fixed
cost)
PV(fixed
cost)
BBrevenue 11
revenue
PV(asset)
PV(asset)
1- 177
Risk,DCF and CEQ
Ct
CEQt
PV
t
t
(1 r )
(1 rf )
1- 178
Risk,DCF and CEQ

Example
Project A is expected to produce CF = Rs.100
million for each of three years. Given a risk free
rate of 6%, a market premium of 8%, and beta of .
75, what is the PV of the project?
1- 179
Risk,DCF and CEQ

Example
Project A is expected to produce CF = Rs.100 million for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?
r rf B ( rm rf )
6 .75(8)
12%
1- 180
r
(62%
r.758mf)
B
f1
1- 181
Risk,DCF and CEQ
Example
Year
Project A
Cash Flow PV @ 12%
100
89.3
2
3
100
100
79.7
71.2
Total PV
240.2
r
(62%
r.758mf)
B
f1
Risk,DCF and CEQ
Example
Project A
Year
Cash Flow PV @ 12%
1
2
100
100
89.3
79.7
100
Total PV
71.2
240.2
Now assume that the cash

flows change, but are
RISK FREE. What is the
new PV?
1- 182
1- 183
Risk,DCF and CEQ

Example
of .75, what is the PV of the project?.. Now assume that the cash flows
change, but are RISK FREE. What is the new PV?
Year
1
2
3
Project A
Cash Flow PV @ 12%
100
89.3
100
79.7
100
71.2
Total PV
240.2
Year
Project B
Cash Flow PV @ 6%
94.6
89.3
2
3
89.6
84.8
79.7
71.2
Total PV
240.2
Risk,DCF and CEQ

Example
Year
1
2
3
Project A
Cash Flow PV @ 12%
100
89.3
100
79.7
100
71.2
Total PV
240.2
Year
1
2
3
Project B
Cash Flow PV @ 6%
94.6
89.3
89.6
79.7
84.8
71.2
Total PV
240.2
Since the 94.6 is risk free, we call it a Certainty Equivalent

of the 100.
1- 184
Risk,DCF and CEQ

Example
of .75, what is the PV of the project? DEDUCTION FOR RISK
Year
1
2
3
Deduction
Cash Flow CEQ
for risk
100
94.6
5.4
100
89.6
10.4
100
84.8
15.2
1- 185
Risk,DCF and CEQ

Example
The difference between the 100 and the certainty equivalent

(94.6) is 5.4%this % can be considered the annual
premium on a risky cash flow
Risky cash flow

certainty equivalent cash flow
1.054
1- 186
Risk,DCF and CEQ

Example
100
Year 1
94.6
1.054
Year 2
100
89.6
2
1.054
100
Year 3
84.8
3
1.054
1- 187

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Principles of

Corporate Finance, 8/e

Corporate tax on profits +

Role of The Financial Manager

Role of The Financial Manager

Who is The Financial Manager?

Ownership vs. Management

Stock prices and returns

Present and Future Value

Discount Factors and Rates

What is the future value of Rs.400,000 if interest is

Discount Factors can be used to compute the present value of

Valuing an Office Building

Valuing an Office Building

Step 4: Go ahead if PV of payoff exceeds investment

NPV 400 370 30

Net Present Value

Risk and Present Value

Risk and Present Value

Risk and Net Present Value

Accept investments that offer rates of return

In the project listed below, the foregone investment

Accept investments that have positive net

The stocks expected payoff leads to an expected

Opportunity Cost of Capital

Investment vs. Consumption

Investment vs. Consumption

Some investors will prefer A

Investment vs. Consumption

Investment vs. Consumption

A invests Rs.185 now

The grasshopper (G) wants to consume

G invests Rs.185 now,

Managers and Shareholder Interests

Tools to Ensure Management Pays Attention

Goals of The Corporation

Goals of The Corporation

Discount Factor = DF = PV of Rs.1

Discount Factors can be used to compute

Discount Factors can be used to compute

PVs can be added together to evaluate

PVs can be added together to evaluate

Given two dollars, one received a year from now

NPV Total Rs.25, 011

Annuity - An asset that pays a fixed sum each year for a

Perpetuity (first payment

Annuity from year

Annuity Short Cut

Annuity Short Cut

Loan Pmt 10,000 (1.005)

Real int. rate nominal int. rate - inflation rate

5.375 5.375 5.375 5.375 5.375 105.375

Bond Prices and Yields

Stocks & Stock Market

Stocks & Stock Market

Quotations of Infosys in NSE as on 29 April, 2006

Expected Return - The percentage yield that an

Example: If Fledgling Electronics is selling for

Capitalization Rate can be estimated using the

Valuing Common Stocks

Dividend Discount Model - Computation of todays

H - Time horizon for your investment.

Valuing Common Stocks

Valuing Common Stocks