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Portfolio Theory
Value Creation
Chienny Hocosol

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Analysis of Projects with

Uneven Lives / Unequal Lives
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Projects withMaster

• When mutually exclusive projects have unequal useful lives, capital budgeting
decision is made based on annual net present value (also called equivalent
annual annuity) and replacement chain methods.
• Mutually exclusive projects are projects out of which only one project has to be
ultimately selected for investment.
• Unlike independent projects, they are competing projects in that selection of
one excludes the other projects from consideration.

• When they have equal lives, decision is simple: accept the project with highest net present
value and/or highest internal rate of return and/or payback period.
• However, when they have unequal lives, more elaborate analysis is required to arrive at the
right decision.

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Replacement Chain title
style Life) Approach

• A method of comparing projects of unequal lives that assumes that

each project can be repeated as many times as necessary to reach
a common life span; the NPVs over this life span are then
compared, and the project with the higher common life NPV is

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Equivalent MasterAnnuity
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(EAA) Method

• A method which calculates the annual payments a project would

provide if it were an annuity. When comparing projects of unequal
lives, the one with the higher equivalent annual annuity should be

Net Present Value

Annual net Present Value =
Annuity Discount Factor for the
Project Life

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Techniques for Measuring

Stand-alone Risk

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Stand-alone Master title style

• reflects the total riskiness of the project (without consideration of any

diversification benefits). It is measured by examining the uncertainty of the
project NPV
Stand-alone Risk = Market Risk + Diversifiable Risk

Market Risk – is part of a security’s stand-alone risk that cannot be eliminated by

Firm-specific or Diversifiable Risk – is part of a security’s stand-alone risk that can eliminated
by diversification

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Methods of Assessing
Master title
style Risk

1. Sensitivity Analysis
This approach focuses on a project’s NPV sensitivity to a single variable. The
approach starts with a base case and calculates the change in NPV in the
event of a change to an input variable in the NPV calculation.

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2. Scenario
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• This is a multi-variable adjustment version of sensitivity analysis. The base,

favorable and unfavorable scenarios will reflect NPVs where multiple inputs
have been adjusted, rather than just one.
• Unlike sensitivity analysis, assumptions are not changed one at a time, but all
assumptions are modified to fit a particular scenario.

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3. Break-even
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• is similar to sensitivity analysis. Variables are adjusted (one-at-a-time) up or

down to determine what value produces a $0 NPV.
• is a method adopted by the firms to determine that how much should be
produced or sold at a minimum to ensure that the project does not lose money.
• Simply, the minimum quantity at which the loss can be avoided.

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4. Monte
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• This capital project risk analysis will use a computer program to simulate likely
events and generate an internal rate of return (IRR) or NPV for the project in
• The computer will pick a random variable and calculate an IRR and NPV; the
process will be repeated many times, generating new IRRs and NPVs.
• Each of the IRRs and NPVs will be analyzed and a statistical report will be
generated for the number of iterations ran, showing data on the mean, standard
deviation, median, etc.

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Capital Market Theory

Risk / Return Analysis

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• is a positive theory in that it hypothesis how investors do behave rather

than, how investors should behave, as, in the case of Modem Portfolio Theory
(MPT) by Markowitz
• It is reasonable "to view capital market" theory, as an extension of portfolio
theory, but it is important to understand that MPT is not based on the validity,
or lack thereof, of capital market theory

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Capital edit Master
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• 1. All investors can borrow or lend money at the risk-free rate of return.
• 2. All investors have identical probability distributions for future rates of return; they
have homogeneous expectations with respect to the three inputs of the portfolio
model i.e. expected returns, the variance of returns, and the correlation matrix.
Therefore, given a set of security prices and a risk-free rate, all investors use the
same information to generate an efficient frontier.
• 3. All investors have the same one-period time horizon.
• 4. There are no transaction costs.
• 5. There are no personal income taxes---investors are indifferent between capital gains
and dividends.
• 6. There is no inflation.
• 7. There are many investors, and no single investor can affect the price of a stock
through his or her buying and selling decisions. Investors are price takers and act as if
prices are unaffected by their own trades.
• 8. Capital markets are in equilibrium.
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Role to Capital
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• Capital market theory attempts to explain the relationship between investment

returns and risks.
• Addresses both individual investments and portfolios of multiple investments
• Uses:
• Portfolio construction: How should a portfolio of assets be constructed given the variety of
different assets available for investment?
• Asset valuation: How much is an asset worth given the characteristics of the other assets in
• Performance measurement: How did an asset perform historically relative to the other
assets in similar markets? How are risk and return attributed?

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Line title style

• The line formed by the action of all investors mixing the market
portfolio with the risk free asset is known as the capital market line.
• All efficient portfolios of all investors would lie along this CML.

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Decision Trees and

Portfolio Risk

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Decision TreeMaster
Basics title style

• Decision trees are organized as follows: An individual makes a big decision,

such as undertaking a capital project, or choosing between two competing
ventures. These decisions—which are often depicted with decision nodes, are
based on the expected outcomes of undertaking particular courses of action.
• Decision Tree analysis can be used to evaluate projects that require decisions
over several time periods or over several stages. However, it is important to
understand that a project with several stages gives managers a valuable real

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Decision TreeMaster
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• A financial option gives the owner the right to buy (or sell) a financial asset at
a certain price for a certain period of time.
• Example: An option to purchase IBM stock at $100 per share at any time for the next three
months. This (call) option has value even if IBM stock is currently selling for less than $100
per share. Why - because IBM stock might have a price of greater than $100 before the
end of the three-month period.

• A real option gives the owner a similar right to do something (or not do
something). Just like a financial option has value, a real option also has value.
• Example: Project X will use of a pilot program that permits the company to evaluate a
scaled down version of the project before funds are spent on a full-scale project.

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Example of Decision
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Portfolio RiskMaster title style

• is a chance that the combination of assets or units, within the investments that
you own, fail to meet financial objectives. Each investment within a portfolio
carries its own risk, with higher potential return typically meaning higher risk.

Portfolio – a collection of investment securities

Portfolio Returns – expected return on a portfolio is the weighted average return

of the stocks held in the portfolio

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Correlation Master title( style

• A measure of the degree of relationship between 2 variables, such as the

expected return of company A and the expected return of company B.
• Positively correlated stocks’ rates of return tend to move in the same direction.
• Negatively correlated stocks’ rates of return tend to move in opposite directions.
• Perfectly correlated stocks’ rates of return move exactly together or exactly

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• Combining stocks that are NOT perfectly correlated will reduce portfolio risk.
• We call this diversification.
• The risk of a portfolio is reduced as the number of stocks in the portfolio
• The lower the positive correlation of each stock we add to the portfolio, the
lower the risk.

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Firm to edit Master
vs Market

• Firm-Specific Risk - That part of a security’s risk associated with factors

generated by events, or behaviors, specific to the firm.

• Market Risk - That part of a security’s risk that cannot be eliminated by

diversification because it is associated with economic or market factors that
systematically affect most firms.

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Portfolio Diversification

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Portfolio Diversification
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• The effect of reducing risks by including a large number of investments in a

portfolio is called diversification.
• The diversification gains achieved will depend on the degree of correlation
among the investments, measured by correlation coefficient.

• Correlation coefficient - can range from -1.0 (perfect negative correlation), meaning that
two variables move in perfectly opposite directions to +1.0 (perfect positive correlation).
Lower the correlation, greater will be the diversification benefits.

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• Combining negatively correlated assets to reduce, or diversify, risk

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Modern Portfolio
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• MPT quantifies the idea of diversified investment portfolios through the use of
• Previously a subjective judgment
• Makes use of the correlations of investment returns for the first time.

• Quantification allows ranking diversification opportunities.

• Given two otherwise identical investments, choose the one that diversifies the portfolio most

• Quantification allows the measurement of total portfolio diversification

• Can now measure the probability of losing a given amount of money
• Can compare the relative diversification of different portfolios.

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MPT to edit
Master title

Investment allocations determine portfolio return and risk

• Multiple portfolios can be constructed with the same expected returns but different levels
of risk
• Multiple portfolios can be constructed with the same risks but different levels of expected
Definition of optimal portfolios:
• For a given level of return, the portfolio with the lowest risk level
• For a given level of risk, the portfolio with the highest return level
MPT identifies optimal portfolios using return, risk, and correlation expectations
• Optimal portfolios maximize diversification.

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Limits Diversification
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• Market risk cannot be diversified away.
• MPT distinguishes between risks inherent in the market and risks that can be
• Systematic Risk (market risk) is inherent in every security and cannot be avoided
• Unsystematic Risk (company specific risk) can be reduced through diversification

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Efficient Market Theory

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Efficient Market

• The Efficient Markets Hypothesis is an investment theory primarily derived from

concepts attributed to Eugene Fama’s research work as detailed in his 1970
book, “Efficient Capital Markets: A Review of Theory and Empirical Work”.
• A market is efficient if prices “fully reflect” available information and adjust
rapidly to new information.
• In an efficient market, public information cannot be used to earn above-market
returns after adjusting for risk.
• In an efficient market, security prices fairly reflect all that is known by investors.
• An efficient market is a “fair game” as long as information is equally available.

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Efficient Market
title style
According to Eugene Fama

• Quoting Eugene Fama “In an efficient market, competition among the many
intelligent participants leads to a situation where, at any point in time, the actual
prices of securities already reflects the effects of information based on events
that have
1. already occurred and on events,
2. as of now, [and events]
3. the market expects to take place in the future”

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EMH to edit
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• Efficient market theory - Stocks are always correctly priced since everything that
is publicly known about a stock is reflected in its market price.
• Random walk theory - All future price changes are independent from previous
price changes, thus, future stock prices cannot be predicted

• If a market is efficient, price levels are not random; price changes are random (cannot be
• Why would price changes be random?
• Prices react to new information
• Information is new only if it is not expected

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Forms EMHMaster title style

1. Weak Form – a market is weak-form efficient if prices fully reflect market data
• Technical Analysis –using patterns in market data to predict price changes.
• If the stock market is weak-form efficient, can technical analysis benefit investors?
2. Semi-strong Form – a market is semi-strong efficient if prices fully reflect all
public information
• Fundamental Analysis –using economic and accounting information to evaluate a security.
• If the stock market is semi strong form efficient, can fundamental analysis benefit investors?
3. Strong Form – A market is strong form efficient if prices fully reflect all
information, public and private. If the stock market is strong form efficient, do
insiders have an advantage over other investors?

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Click to editStrategy
Investment Master title style

In Efficient Market:
• Diversify broadly
• Match portfolio risk to your risk tolerance
• Buy & hold

In Inefficient Market:
• Try to beat the market by identifying undervalued securities or sectors
and overweighting

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Capital Asset Pricing

Model (CAPM)

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• Portfolio theory implied that each investor faced an efficient frontier. But
differences in expectations leads to different frontiers for different investors.
• CAPM provides a framework for assessing whether a security is overpriced,
under priced or correctly priced.

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(CAPM) Assumptions:

• All investors employ Markowitz portfolio theory to find portfolios in the efficient
set and then based on their individual risk preferences invest in one of the
portfolios in the efficient set
• All investors have the same planning horizon and identical beliefs about the
distributions of security returns
• No barriers to flow of capital or information. E.g. no transaction costs, no taxes

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• For well diversified portfolios, non systematic risk tends to go to zero, and the
only relevant risk is systematic risk measured by beta. So a straight line that
shows investors risk and return in terms of expected return and beta is called
the SML. Thus SML provides the relationship between the expected return and
beta of a security or portfolio.

• The straight line relationship between the betas and expected return, and its
slope is often referred to as the reward to risk ratio

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• The relationship between risk and return established by the SML is known as
the CAPITAL ASSET PRICING MODEL. It is basically a simple linear
• The higher the value of beta, higher would be the risk of the security and
therefore larger would be the return expected by the investors. In other words
all securities are expected to yield return commensurate with the riskiness as
measured by beta. This relationship is valid not only for individual securities, but
is also valid for all portfolios whether efficient or inefficient.

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Arbitrage Pricing Model


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Arbitrage Pricing
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• is a theory of asset pricing that holds that an asset’s returns can be forecasted
with the linear relationship of an asset’s expected returns and
the macroeconomic factors that affect the asset’s risk.
• offers analysts and investors a multi-factor pricing model for securities based on
the relationship between a financial asset’s expected return and its risks.
• The theory assumes that market action is less than always perfectly efficient,
and therefore occasionally results in assets being mispriced – either overvalued
or undervalued – for a brief period of time
• The APT asserts that asset prices are determined through an arbitrage
relationship. It is based on the premise that two or more securities or portfolios
that provide the same payoffs to their investors are same and must therefore
sell at the same price. This is the ‘Law of One Price’.

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Assumptions in the Arbitrage
title stylePricing Theory

• APT operates with a pricing model that factors in many sources of risk and
uncertainty, unlike CAPM which only takes into account the single factor of the
risk level of the overall market
• The APT model looks at several macroeconomic factors that determine the risk
and return of the specific asset
• These factors provide risk premiums for investors to consider because the
factors carry systematic risk that cannot be eliminated by diversifying.
• APT suggests that investors will diversify their portfolios, but that they will also
choose their own individual profile of risk and returns based on the premiums
and sensitivity of the macroeconomic risk factors.

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• APT assumes returns generated by a factor model

• Factor Characteristics
• Each risk must have a pervasive influence on stock returns
• Risk factors must influence expected return and have nonzero prices
• Risk factors must be unpredictable to the market

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