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Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

Finance and the Financial Manager

Chapter 1

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2

Topics Covered
w What Is A Corporation?
w The Role of The Financial Manager
w Who Is The Financial Manager?
w Separatio...
3

Corporate Structure
Sole Proprietorships

Unlimited Liability
Personal tax on profits

Partnerships

Limited Liability
...
4

Role of The Financial Manager
(2)

(1)

Financial
manager

Firm's
operations

(4a)

(4b)

(3)
(1) Cash raised from inve...
5

Who is The Financial Manager?
Chief Financial Officer

Treasurer

Comptroller

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6

Ownership vs. Management
Difference in Information
w Stock prices and
returns
w Issues of shares and
other securities
w...
7

Financial Markets
Money

Primary

OTC

Markets

Markets
Secondary
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8

Financial Institutions
Company

Obligations

Funds

Intermediaries
Banks
Insurance Cos.
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9

Financial Institutions
Intermediaries

Obligations

Funds

Investors
Depositors
Policyholders
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Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

Present Value and The Opportunity
Cost of Capital

Ch...
11

Topics Covered
w Present Value
w Net Present Value
w NPV Rule
w ROR Rule
w Opportunity Cost of Capital
w Managers and ...
12

Present Value
Present Value

Discount Factor

Value today of
a future cash
flow.

Present value of
a $1 future
payment...
13

Present Value

Present Value = PV
PV = discount factor × C1
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14

Present Value
Discount Factor = DF = PV of $1

DF =

1
t
(1+ r )

Discount Factors can be used to compute the present ...
15

Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C0 = 350
Sale price in Year 1 = C1 = 400
Ste...
16

Valuing an Office Building
Step 3: Discount future cash flows

PV =

C1
(1+r)

=

400
(1+.07)

= 374

Step 4: Go ahead...
17

Net Present Value
NPV = PV - required investment
C1
NPV = C0 +
1+ r
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Risk and Present Value
w Higher risk projects require a higher rate of
return.
w Higher required rates of return cause...
19

Risk and Present Value
PV of C1 = $400 at 12%
400
PV =
= 357
1 + .12
PV of C1 = $400 at 7%
400
PV =
= 374
1o+e.07.com
...
20

Rate of Return Rule
w Accept investments that offer rates of return
in excess of their opportunity cost of capital.
Ex...
21

Net Present Value Rule
w Accept investments that have positive net
present value.
Example
Suppose we can invest $50 to...
22

Opportunity Cost of Capital
Example
You may invest $100,000 today. Depending on the
state of the economy, you may get ...
23

Opportunity Cost of Capital
Example - continued
The stock is trading for $95.65. Depending on the
state of the economy...
24

Opportunity Cost of Capital
Example - continued
The stocks expected payoff leads to an expected
return.
80 + 100 + 140...
25

Opportunity Cost of Capital
Example - continued
Discounting the expected payoff at the expected
return leads to the PV...
26

Investment vs. Consumption
w Some people prefer to consume now. Some
prefer to invest now and consume later.
Borrowing...
27

Investment vs. Consumption
income in period 1
100
An

80

Some investors will prefer A

60

and others B

40

Bn

20

...
28

Investment vs. Consumption
The grasshopper (G) wants to
consume now. The ant (A) wants to
wait. But each is happy to i...
29

Investment vs. Consumption
w

Dollars
Later

A invests $100 now
and consumes $114
next year

114
107

The grasshopper ...
30

Managers and Shareholder Interests
w Tools to Ensure Management Responsiveness
Subject managers to oversight and revie...
Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

How to Calculate Present Values

Chapter 3

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32

Topics Covered
w Valuing Long-Lived Assets
w PV Calculation Short Cuts
w Compound Interest
w Interest Rates and Inflat...
33

Present Values
Discount Factor = DF = PV of $1

DF =

1
t
(1+ r )

w Discount Factors can be used to compute
the prese...
34

Present Values
C1
PV = DF × C1 =
1 + r1
DF =

1
( 1+ r ) t

w Discount Factors can be used to compute
the present valu...
35

Present Values

Ct
PV = DF × Ct =
1 + rt
w Replacing “1” with “t” allows the formula
to be used for cash flows that ex...
36

Present Values
Example
You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you c...
37

Present Values
w PVs can be added together to evaluate
multiple cash flows.

PV =

C1
(1+ r )

C2

1

+ (1+ r ) 2 +......
38

Present Values
w Given two dollars, one received a year from
now and the other two years from now, the
value of each i...
39

Present Values
Example
Assume that the cash flows
from the construction and sale
of an office building is as
follows. ...
40

Present Values
Example - continued
Assume that the cash flows from the construction and sale of an office
building is ...
41

Short Cuts
w Sometimes there are shortcuts that make it
very easy to calculate the present value of an
asset that pays...
42

Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.

cash flow
Return =
...
43

Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.

cash flow
PV of Cas...
44

Short Cuts
Annuity - An asset that pays a fixed sum each
year for a specified number of years.

1
1 
PV of annuity =...
45

Annuity Short Cut
Example
You agree to lease a car for 4 years at $300 per month.
You are not required to pay any mone...
46

Annuity Short Cut
Example - continued
You agree to lease a car for 4 years at $300 per
month. You are not required to ...
47

Compound Interest
i
ii
Periods Interest
per
per
year
period

iii
APR
(i x ii)

iv
Value
after
one year

v
Annually
com...
48

18
16
14
12
10
8
6
4
2
0

10% Simple

om

llecti
Number e-cYears on.c
softwar of o
ding-

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, Skype: iii
...
49

Inflation
Inflation - Rate at which prices as a whole are
increasing.
Nominal Interest Rate - Rate at which money
inve...
50

Inflation
1+ nominal interest rate
1 + real interest rate =
1+inflation rate

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51

Inflation
1+ nominal interest rate
1 + real interest rate =
1+inflation rate

approximation formula

Real int. rate ≈ ...
52

Inflation
Example
If the interest rate on one year govt. bonds is 5.9%
and the inflation rate is 3.3%, what is the rea...
53

Inflation
Example
If the interest rate on one year govt. bonds is 5.9%
and the inflation rate is 3.3%, what is the rea...
54

Inflation
Example
If the interest rate on one year govt. bonds is 5.9%
and the inflation rate is 3.3%, what is the rea...
55

Valuing a Bond
Example
If today is October 2000, what is the value of the following
bond?
w An IBM Bond pays $115 ever...
56

Valuing a Bond
Example continued
If today is October 2000, what is the value of the following bond?
w An IBM Bond pays...
57

Bond Prices and Yields
1600
1400

Price

1200
1000
800
600
400
200
0
0

2

4

6
8
10
12
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Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

The Value of Common Stocks

Chapter 4

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59

Topics Covered
w How To Value Common Stock
w Capitalization Rates
w Stock Prices and EPS
w Cash Flows and the Value of...
60

Stocks & Stock Market
Common Stock - Ownership shares in a
publicly held corporation.
Secondary Market - market in whi...
61

Stocks & Stock Market
Book Value - Net worth of the firm according to
the balance sheet.
Liquidation Value - Net proce...
62

Valuing Common Stocks
Expected Return - The percentage yield that an
investor forecasts from a specific investment ove...
63

Valuing Common Stocks
Expected Return - The percentage yield that an
investor forecasts from a specific investment ove...
64

Valuing Common Stocks
The formula can be broken into two parts.
Dividend Yield + Capital Appreciation

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65

Valuing Common Stocks
The formula can be broken into two parts.
Dividend Yield + Capital Appreciation

Div1 P1 − P0
Ex...
66

Valuing Common Stocks
Capitalization Rate can be estimated using the
perpetuity formula, given minor algebraic
manipul...
67

Valuing Common Stocks
Capitalization Rate can be estimated using the
perpetuity formula, given minor algebraic
manipul...
68

Valuing Common Stocks
Return Measurements

Div1
Dividend Yield =
P0
Return on Equity = ROE
EPS
ROE =
Book Equity Per S...
69

Valuing Common Stocks
Dividend Discount Model - Computation of today’s
stock price which states that share value equal...
70

Valuing Common Stocks
Dividend Discount Model - Computation of today’s
stock price which states that share value equal...
71

Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay
dividends of $3, $3.24, and $3.50 over the ...
72

Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24,
and $3.50 over the ...
73

Valuing Common Stocks
If we forecast no growth, and plan to hold out stock
indefinitely, we will then value the stock ...
74

Valuing Common Stocks
If we forecast no growth, and plan to hold out stock
indefinitely, we will then value the stock ...
75

Valuing Common Stocks
Constant Growth DDM - A version of the dividend
growth model in which dividends grow at a consta...
76

Valuing Common Stocks
Example- continued
If the same stock is selling for $100 in the stock
market, what might the mar...
77

Valuing Common Stocks
w If a firm elects to pay a lower dividend, and reinvest
the funds, the stock price may increase...
78

Valuing Common Stocks
Growth can be derived from applying the
return on equity to the percentage of earnings
plowed ba...
79

Valuing Common Stocks
Example
Our company forecasts to pay a $5.00
dividend next year, which represents
100% of its ea...
80

Valuing Common Stocks
Example
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its ea...
81

Valuing Common Stocks
Example
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its ea...
82

Valuing Common Stocks
Example - continued
If the company did not plowback some earnings, the
stock price would remain ...
83

Valuing Common Stocks
Present Value of Growth Opportunities (PVGO)
- Net present value of a firm’s future
investments....
84

FCF and PV
w Free Cash Flows (FCF) should be the
theoretical basis for all PV calculations.
w FCF is a more accurate m...
85

FCF and PV
Valuing a Business
The value of a business is usually computed as the
discounted value of FCF out to a valu...
86

FCF and PV
Valuing a Business
FCF1
FCF2
FCFH
PV H
PV =
+
+ ... +
+
1
2
H
(1 + r ) (1 + r )
(1 + r )
(1 + r ) H

PV (fr...
87

FCF and PV
Example
Given the cash flows for Concatenator Manufacturing
Division, calculate the PV of near term cash fl...
88

FCF and PV
Example - continued
Given the cash flows for Concatenator Manufacturing Division, calculate
the PV of near ...
89

FCF and PV
Example - continued
Given the cash flows for Concatenator Manufacturing Division, calculate
the PV of near ...
Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

Why Net Present Value Leads to
Better Investment Deci...
91

Topics Covered
w NPV and its Competitors
w The Payback Period
w The Book Rate of Return
w Internal Rate of Return
w Ca...
92

NPV and Cash Transfers
w Every possible method for evaluating projects
impacts the flow of cash about the company
as f...
93

Payback
w The payback period of a project is the number
of years it takes before the cumulative
forecasted cash flow e...
94

Payback
Example
Examine the three projects and note the mistake we
would make if we insisted on only taking projects
w...
95

Payback
Example
Examine the three projects and note the mistake we
would make if we insisted on only taking projects
w...
96

Book Rate of Return
Book Rate of Return - Average income divided by
average book value over project life. Also called
...
97

Internal Rate of Return
Example
You can purchase a turbo powered machine tool
gadget for $4,000. The investment will g...
98

Internal Rate of Return
Example
You can purchase a turbo powered machine tool gadget for $4,000. The
investment will g...
99

Internal Rate of Return
Example
You can purchase a turbo powered machine tool gadget for $4,000. The
investment will g...
100

Internal Rate of Return
2500
2000

IRR=28%

1000
500

-1000
-1500
-2000
Discount rate (%)
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101

Internal Rate of Return
Pitfall 1 - Lending or Borrowing?
w With some cash flows (as noted below) the NPV of
the proj...
102

Internal Rate of Return
Pitfall 1 - Lending or Borrowing?
w With some cash flows (as noted below) the NPV of the proj...
103

Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
w Certain cash flows can generate NPV=0 at two
different...
104

Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
w Certain cash flows can generate NPV=0 at two different...
105

Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projects
w IRR sometimes ignores the magnitude of the
project....
106

Internal Rate of Return
Pitfall 4 - Term Structure Assumption
w We assume that discount rates are stable
during the t...
107

Internal Rate of Return
Calculating the IRR can be a laborious task. Fortunately,
financial calculators can perform t...
108

Internal Rate of Return
Calculating the IRR can be a laborious task. Fortunately,
financial calculators can perform t...
109

Profitability Index
w When resources are limited, the profitability
index (PI) provides a tool for selecting among
va...
110

Profitability Index
NPV
Profitability Index =
Investment
Example
We only have $300,000 to invest. Which do we select?...
111

Profitability Index
Example - continued
Proj NPV
A
230,000
B
141,250
C
194,250
D
162,000

Investment
200,000
125,000
...
112

Profitability Index
Example - continued
Proj NPV
A
230,000
B
141,250
C
194,250
D
162,000

Investment
200,000
125,000
...
113

Linear Programming
w Maximize Cash flows or NPV
w Minimize costs
Example

Max NPV = 21Xn + 16 Xb + 12 Xc + 13 Xd
subj...
Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

Making Investment Decisions with
the Net Present Valu...
115

Topics Covered
w What To Discount
w IM&C Project
w Project Interaction
Timing
è Equivalent Annual Cost
è Replacement
...
116

What To Discount
Only Cash Flow is Relevant

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117

What To Discount
Only Cash Flow is Relevant

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118

What To Discount
Points to “Watch Out For”
ÜDo not confuse average with incremental
payoff.
ÜInclude all incidental e...
119

Inflation
INFLATION RULE
w Be consistent in how you handle inflation!!
w Use nominal interest rates to discount
nomin...
120

Inflation
Example
You own a lease that will cost you $8,000 next year,
increasing at 3% a year (the forecasted inflat...
121

Inflation
Example
You own a lease that will cost you $8,000 next year,
increasing at 3% a year (the forecasted inflat...
122

Inflation
Example - nominal figures

Year
1
2
3
4

Cash Flow
PV @ 10%
8000
8000
1.10 = 7272.73
8240
8000x1.03 = 8240
...
123

Inflation
Example - real figures

Year
1
2
3
4

Cash Flow
8000
1.03
8240
1.032
8487.20
1.033
8741.82
1.034

= 7766.99...
124

IM&C’s Guano Project
Revised projections ($1000s) reflecting inflation

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125

IM&C’s Guano Project
w NPV using nominal cash flows

1,630 2,381 6,205 10,685 10,136
NPV = −12,000 −
+
2 +
3 +
4 +
1....
126

IM&C’s Guano Project
Cash flow analysis ($1000s)

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IM&C’s Guano Project
Details of cash flow forecast in year 3 ($1000s)

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128

IM&C’s Guano Project
Tax depreciation allowed under the modified accelerated cost
recovery system (MACRS) - (Figures ...
129

IM&C’s Guano Project
Tax Payments ($1000s)

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130

IM&C’s Guano Project
Revised cash flow analysis ($1000s)

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131

Timing
w Even projects with positive NPV may be
more valuable if deferred.
w The actual NPV is then the current value...
132

Timing
Example
You may harvest a set of trees at anytime over the
next 5 years. Given the FV of delaying the harvest,...
133

Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given
the FV of delaying ...
134

Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given
the FV of delaying ...
135

Equivalent Annual Cost
Equivalent Annual Cost - The cost per period
with the same present value as the cost of
buying...
136

Equivalent Annual Cost
Equivalent Annual Cost - The cost per period
with the same present value as the cost of
buying...
137

Equivalent Annual Cost
Example
Given the following costs of operating two machines
and a 6% cost of capital, select t...
138

Equivalent Annual Cost
Example
Given the following costs of operating two machines
and a 6% cost of capital, select t...
139

Equivalent Annual Cost
Example
Given the following costs of operating two machines
and a 6% cost of capital, select t...
140

Machinery Replacement
Annual operating cost of old machine = 8
Cost of new machine
Year:

0
15

1
5

2
5

3
5

NPV @ ...
141

Cost of Excess Capacity

A project uses existing warehouse and requires a new one to be built in
Year 5 rather than Y...
142

Fluctuating Load Factors

Two Old Machines
Annual output per machine

750 units

Operating cost per machine

2 × 750 ...
143

Fluctuating Load Factors

Annual output per machine

Two New Machin es
750 units

Capital cost pe machine
Operating c...
144

Fluctuating Load Factors

One Old Machine
Annual output per machine
500 units
Capital cost pe machine
0
Operating cos...
Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

Introduction to Risk, Return, and the
Opportunity Cos...
146

Topics Covered
w 72 Years of Capital Market History
w Measuring Risk
w Portfolio Risk
w Beta and Unique Risk
w Divers...
147

The Value of an Investment of $1 in 1926
5520

Index

1000

S&P
Small Cap
Corp Bonds
Long Bond
T Bill

1828

55.38
39...
148

The Value of an Investment of $1 in 1926

Index

1000

S&P
Small Cap
Corp Bonds
Long Bond
T Bill

Real returns
613
20...
149

Rates of Return 1926-1997
Percentage Return

60
40
20
0
-20
Common Stocks
Long T-Bonds
T-Bills

-40
-60 26

30

35

4...
150

Measuring Risk
Variance - Average value of squared deviations from
mean. A measure of volatility.
Standard Deviation ...
151

Measuring Risk
Coin Toss Game-calculating variance and standard deviation
(1)
(2)
(3)
Percent Rate of Return Deviatio...
152

Measuring Risk
Histogram of Annual Stock Market Returns
# of Years

13
10

4

40 to 50

30 to 40

20 to 30

10 to 20
...
153

Measuring Risk
Diversification - Strategy designed to reduce risk by
spreading the portfolio across many investments....
154

Measuring Risk

(
(

)(
)(

Portfolio rate
fraction of portfolio
=
x
of return
in first asset

rate of return
on firs...
155

Portfolio standard deviation

Measuring Risk

0
5

10

15

Number of Securities
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156

Portfolio standard deviation

Measuring Risk

Unique
risk
Market risk

0
5

10

15

Number of Securities
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157

Portfolio Risk
The variance of a two stock portfolio is the sum of these
four boxes:

Stock 1
Stock 1
Stock 2

2 2
x ...
158

Portfolio Risk
Example
Suppose you invest $55 in Bristol-Myers and $45
in McDonald’s. The expected dollar return on
y...
159

Portfolio Risk
Example
Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. The
expected dollar return on y...
160

Portfolio Risk
Example
Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. The
expected dollar return on y...
161

Portfolio Risk

Expected Portfolio Return = (x 1 r1 ) + ( x 2 r2 )

Portfolio Variance = x ó + x ó + 2( x 1x 2ñ 12ó 1...
162

Portfolio Risk
The shaded boxes contain variance terms; the remainder
contain covariance terms.
1
2
3
STOCK

To calcu...
163

Beta and Unique Risk
1. Total risk =
diversifiable risk +
market risk
2. Market risk is
measured by beta,
the sensiti...
164

Beta and Unique Risk
Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market
inde...
165

Beta and Unique Risk

σ im
Bi = 2
σm
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166

Beta and Unique Risk
σ im
Bi = 2
σm

Covariance with the
market

Variance of the market
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Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

Risk and Return

Chapter 8

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168

Topics Covered
w Markowitz Portfolio Theory
w Risk and Return Relationship
w Testing the CAPM
w CAPM Alternatives

io...
169

Markowitz Portfolio Theory
w Combining stocks into portfolios can reduce
standard deviation below the level obtained
...
Markowitz Portfolio Theory
Price changes vs. Normal distribution
Microsoft - Daily % change 1986-1997
600
500

# of Days
(...
Markowitz Portfolio Theory
Price changes vs. Normal distribution
Microsoft - Daily % change 1986-1997
600
500

# of Days
(...
172

Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment C
20
18

% probability

16
14
12
10
8
6
...
173

Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment D
20
18

% probability

16
14
12
10
8
6
...
174

Markowitz Portfolio Theory
u Expected Returns and Standard Deviations vary given
different weighted combinations of t...
175

Efficient Frontier
•Each half egg shell represents the possible weighted combinations for two
stocks.
•The composite ...
176

Efficient Frontier
•Lending or Borrowing at the risk free rate (rf) allows us to exist outside the
efficient frontier...
177

Efficient Frontier
Example
Stocks
ABC Corp
Big Corp

σ
28
42

Correlation Coefficient = .4
% of Portfolio
Avg Return
...
178

Efficient Frontier
Example
Stocks
ABC Corp
Big Corp

σ
28
42

Correlation Coefficient = .4
% of Portfolio
Avg Return
...
179

Efficient Frontier
Example
Stocks
Portfolio
New Corp

σ
28.1
30

Correlation Coefficient = .3
% of Portfolio
Avg Retu...
180

Efficient Frontier
Example
Stocks
Portfolio
New Corp

σ
28.1
30

Correlation Coefficient = .3
% of Portfolio
Avg Retu...
181

Efficient Frontier
Example
Stocks
Portfolio
New Corp

σ
28.1
30

Correlation Coefficient = .3
% of Portfolio
Avg Retu...
182

Efficient Frontier
Example
Stocks
Portfolio
New Corp

σ
28.1
30

Correlation Coefficient = .3
% of Portfolio
Avg Retu...
183

Efficient Frontier
Return

B
A
Risk
(measured
ion.com as σ)
are-collect
tw

g-sof
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.gonch
, Skype: iii
mail...
184

Efficient Frontier
Return

B
AB
A
Risk
ion.com
are-collect
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iii.gonch@...
185

Efficient Frontier
Return

AB
A

N

B

Risk
ion.com
are-collect
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.gonch
, Skype: iii
mail.com
iii.g...
186

Efficient Frontier
Return

ABN AB
A

N

B

Risk
ion.com
are-collect
g-softw
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.gonch
, Skype: iii
mail.com
i...
187

Efficient Frontier
Goal is to move
up and left.

Return

WHY?

ABN AB
A

N

B

Risk
ion.com
are-collect
g-softw
www.t...
188

Efficient Frontier
Return
Low Risk
High Return

Risk
ion.com
are-collect
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.gonch
, Skype: iii
mail....
189

Efficient Frontier
Return
Low Risk

High Risk

High Return

High Return

Risk
ion.com
are-collect
g-softw
www.tradin
...
190

Efficient Frontier
Return
Low Risk

High Risk

High Return

High Return

Low Risk
Low Return
Risk
ion.com
are-collect...
191

Efficient Frontier
Return
Low Risk

High Risk

High Return

High Return

Low Risk

High Risk

Low Return

Low Return
...
192

Efficient Frontier
Return
Low Risk

High Risk

High Return

High Return

Low Risk

High Risk

Low Return

Low Return
...
193

Efficient Frontier
Return

ABN AB
A

N

B

Risk
ion.com
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i...
194

Security Market Line
Return

.
Efficient Portfolio

Risk Free
Return

= rf
Risk
ion.com
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195

Security Market Line
Return

Market Return = rm

Efficient Portfolio

Risk Free
Return

.

= rf
Risk
ion.com
are-coll...
196

Security Market Line
Return

Market Return = rm

Efficient Portfolio

Risk Free
Return

.

= rf
Risk
ion.com
are-coll...
197

Security Market Line
Return

Market Return = rm

.
Efficient Portfolio

Risk Free
Return

= rf
1.0

ion.com
are-colle...
198

Security Market Line
Return

Market Return = rm
Security Market
Line (SML)

Risk Free
Return

= rf
1.0

ion.com
are-c...
199

Security Market Line
Return
SML

rf
1.0

BETA

n.c SML Equationof= are-+olBct(ormom rf )
r f c le i
ng-s tw
www.tradi...
200

Capital Asset Pricing Model

R = rf + B ( rm - rf )

CAPM
ion.com
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...
201

Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium
1931-65

SML

30

20

Investors

10

Market
Portfolio...
202

Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium
1966-91

30

SML

20

Investors
10

Market
Portfolio
...
203

Testing the CAPM
Company Size vs. Average Return
Average Return (%)
25
20
15
10
5

Company size

0

Largeston.com
i
a...
204

Testing the CAPM
Book-Market vs. Average Return
Average Return (%)
25
20
15
10
5

Book-Market Ratio

0

Loweston.com
...
205

Consumption Betas vs Market Betas
Stocks
(and other risky assets)

Wealth = market
portfolio

ion.com
are-collect
g-s...
206

Consumption Betas vs Market Betas
Stocks
(and other risky assets)

Market risk
makes wealth
uncertain.

Wealth = mark...
207

Consumption Betas vs Market Betas
Stocks
(and other risky assets)

Market risk
makes wealth
uncertain.

Wealth = mark...
208

Consumption Betas vs Market Betas
Stocks
(and other risky assets)

Market risk
makes wealth
uncertain.

Wealth = mark...
209

Consumption Betas vs Market Betas
Stocks
(and other risky assets)

Stocks
(and other risky assets)
Wealth is uncertai...
210

Consumption Betas vs Market Betas
Stocks
(and other risky assets)

Stocks
(and other risky assets)
Wealth is uncertai...
211

Arbitrage Pricing Theory
Alternative to CAPM
Expected Risk
Premium = r

- rf

= Bfactor1(rfactor1 - rf)

+ Bf2(rf2 - ...
212

Arbitrage Pricing Theory
Alternative to CAPM
Expected Risk
Premium = r

- rf

= Bfactor1(rfactor1 - rf)

Return

= a ...
213

Arbitrage Pricing Theory
Estimated risk premiums for taking on risk factors
(1978-1990)
Estimated Risk Premium
Factor...
Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

Capital Budgeting and Risk

Chapter 9

ion.com
are-co...
215

Topics Covered
w Measuring Betas
w Capital Structure and COC
w Discount Rates for Intl. Projects
w Estimating Discoun...
216

Company Cost of Capital
w A firm’s value can be stated as the sum of the
value of its various assets.

Firm value = P...
217

Company Cost of Capital
w A company’s cost of capital can be compared
to the CAPM required return.
SML

Required
retu...
218

Measuring Betas
w The SML shows the relationship between
return and risk.
w CAPM uses Beta as a proxy for risk.
w Bet...
219

Measuring Betas
Hewlett Packard Beta

R2 = .53
B = 1.35

Slope determined from 60 months of
prices and plotting the l...
220

Measuring Betas
Hewlett Packard Beta

R2 = .49
B = 1.33

Slope determined from 60 months of
prices and plotting the l...
221

Measuring Betas
Hewlett Packard Beta

R2 = .45
B = 1.70

Slope determined from 60 months of
prices and plotting the l...
222

Measuring Betas
Hewlett Packard Beta

R2 = .35
B = 1.69

Slope determined from 60 months of
prices and plotting the l...
223

Measuring Betas
A T & T Beta
Price data - Jan 78 - Dec 82

B = 0.21

Slope determined from 60 months of
prices and pl...
224

Measuring Betas
A T & T Beta
Price data - Jan 83 - Dec 87

B = 0.64

Slope determined from 60 months of
prices and pl...
225

Measuring Betas
A T & T Beta
Price data - Jan 88 - Dec 92

B = 0.90

Slope determined from 60 months of
prices and pl...
226

Measuring Betas
AT&T

Beta

Price data - Jan 93 - Dec 97

B = .90

Slope determined from 60 months of
prices and plot...
227

Beta Stability
RISK
CLASS

% IN SAME
CLASS 5
YEARS LATER

% WITHIN ONE
CLASS 5
YEARS LATER

10 (High betas)

35

69

...
228

Capital Budgeting & Risk
Modify CAPM
(account for proper risk)
• Use COC unique to project,
rather than Company COC
•...
229

Company Cost of Capital
simple approach
w Company Cost of Capital (COC) is based on
the average beta of the assets.
w...
230

Company Cost of Capital
simple approach
Company Cost of Capital (COC) is based on the average beta of
the assets.
The...
231

Capital Structure
Capital Structure - the mix of debt & equity within a company
Expand CAPM to include CS

R = rf + B...
232

Capital Structure & COC
COC = rportfolio = rassets

ion.com
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233

Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V)
(V)

ion.com
are-coll...
234

Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V)
(V)
Bassets = Bdebt (...
235

Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V)
(V)
Bassets = Bdebt (...
236

Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V)
(V)
Bassets = Bdebt (...
237

Capital Structure & COC
Expected Returns and Betas prior to refinancing

Expected
return (%)

20
Requity=15
Rassets =...
238

Pinnacle West Corp.
Requity = rf + B ( rm - rf )
= .045 + .51(.08) = .0858 or 8.6%

Rdebt = YTM on bonds
= 6.9 %
ion....
239

Pinnacle West Corp.
Boston Electric
Central HUdson
Consolidated Edison

Beta Standard. Error
.60
.19
.30
.18
.65
.20
...
240

Pinnacle West Corp.
COC = rassets

D
E
= rdebt + requity
V
V
= .35(.08) + .65(.10)
= .093 or 9.3%

ion.com
are-collec...
241

International Risk
Correlation
σ Ratio
Beta
coefficient
Argentina
3.52
.416
1.46
Brazil
3.80
.160
.62
Kazakhstan
2.36...
242

Unbiased Forecast
w Given three outcomes and their related
probabilities and cash flows we can determine
an unbiased ...
243

Asset Betas
Cash flow = revenue - fixed cost - variable cost

PV(asset) = PV(revenue) - PV(fixed cost) - PV(variable ...
244

B revenue

Asset Betas

PV(fixed cost)
= Bfixed cost
+
PV(revenue )
PV(variabl e cost)
PV(asset)
+ B variable cost
+ ...
245

Asset Betas
B asset = B revenue

PV(revenue ) - PV(variabl e cost)
PV(asset)

 PV(fixed cost) 
= Brevenue 1 −
PV(a...
246

Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for
each of three years. Given a risk free ra...
247

Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free ra...
248

Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free ra...
249

Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free ra...
250

Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free ra...
251

Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free ra...
252

Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free ra...
253

Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free ra...
254

Risk,DCF and CEQ
w The prior example leads to a generic certainty
equivalent formula.

Ct
CEQt
PV =
=
t
t
(1 + r )
(1...
Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

A Project Is Not a Black Box

Chapter 10

ion.com
are...
256

Topics Covered
w Sensitivity Analysis
w Break Even Analysis
w Monte Carlo Simulation
w Decision Trees

ion.com
are-co...
257

How To Handle Uncertainty
Sensitivity Analysis - Analysis of the effects of
changes in sales, costs, etc. on a projec...
258

Sensitivity Analysis
Example
Given the expected cash flow
forecasts for Otoban Company’s
Motor Scooter project, liste...
259

Sensitivity Analysis
Example - continued
Investment
Sales
Variable Costs
Fixed Costs
Depreciation
Pretax profit
.Taxe...
260

Sensitivity Analysis
Example - continued
Possible Outcomes
Range
Variable
Market Size

Pessimisti c Expected Optimist...
261

Sensitivity Analysis
Example - continued
NPV Calculations for Pessimistic Market Size Scenario
Year 0
Investment
Sale...
262

Sensitivity Analysis
Example - continued
NPV Possibilities (Billions Yen)
Range
Variable
Market Size

Pessimisti c Ex...
263

Break Even Analysis
w Point at which the NPV=0 is the break even point.
w Otoban Motors has a breakeven point of 8,00...
264

Monte Carlo Simulation
Modeling Process
w Step 1: Modeling the Project
w Step 2: Specifying Probabilities
w Step 3: S...
265

Decision Trees
960 (.8)

Turboprop
-550
NPV= ?

+150(.6)

220(.2)
930(.4)

+30(.4)

140(.6)
800(.8)
-150

+100(.6) or...
266

Decision Trees
960 (.8)

Turboprop
-550
NPV= ?

+150(.6)

220(.2)
930(.4)

+30(.4)

-150

+100(.6) or

NPV= ?

100(.2...
267

Decision Trees
960 (.8)

Turboprop
-550
NPV= ?

+150(.6)

220(.2)
930(.4)

+30(.4)

-150

+100(.6) or

NPV= ?

100(.2...
268

Decision Trees

Turboprop
-550
NPV= ?

960 (.8)

660 +150(.6)
− 150 = 450
1.10

220(.2)
930(.4)

+30(.4)
-150

+100(....
269

Decision Trees
NPV=888.18

Turboprop
-550
NPV= ?

NPV=444.55

960 (.8)

+150(.6)

220(.2)
930(.4)

+30(.4)

812 NPV=5...
270

Decision Trees
960 (.8)

NPV=888.18

+150(.6)

Turboprop
-550
NPV= ?

220(.2)

710.73
NPV=444.55

930(.4)

+30(.4)

N...
271

Decision Trees
960 (.8)

NPV=888.18

+150(.6)

Turboprop
-550
NPV=96.12

220(.2)

710.73

930(.4)

+30(.4)

NPV=550.0...
272

Decision Trees
960 (.8)

NPV=888.18

+150(.6)

Turboprop
-550
NPV=96.12

220(.2)

710.73

930(.4)

+30(.4)
*450
NPV=5...
Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

Where Net Present Values
Come From

Chapter 11

ion.c...
274

Topics Covered
w Look First To Market Values
w Forecasting Economic Rents
w Marvin Enterprises

ion.com
are-collect
g...
275

Market Values
w Smart investment decisions make
MORE money than smart
financing decisions

ion.com
are-collect
g-soft...
276

Market Values
w Smart investments are worth more than
they cost: they have positive NPVs
w Firms calculate project NP...
277

Market Values
w Projects may appear to have positive NPVs
because of forecasting errors.
e.g. some acquisitions resul...
278

Market Values
w Positive NPVs stem from a comparative
advantage.
w Strategic decision-making identifies this
comparat...
279

Market Values
w Don’t make investment decisions on the
basis of errors in your DCF analysis.
w Start with the market ...
280

Market Values
w Don’t assume that other firms will watch
passively.
Ask -How long a lead do I have over my rivals? Wh...
281

Department Store Rents

NPV = -100 + 8
1.10

+ ... +

8 + 134

= $ 1 million

1.1010

[assumes price of property appr...
282

Using Market Values
EXAMPLE: KING SOLOMON’S MINE
Investment

= $200 million

Life

= 10 years

Production

= .1 milli...
283

Using Market Values

EXAMPLE: KING SOLOMON’S MINE - continued
If the gold price is forecasted to rise by 5% p.a.:
NPV...
284

Do Projects Have Positive NPVs?
w Rents = profits that more than cover the
cost of capital.
w NPV = PV (rents)
w Rent...
285

Competitive Advantage
Proposal to manufacture specialty chemicals
w Raw materials were commodity chemicals
imported f...
286

Marvin Enterprises
Capacity

Technology Industry

Unit cost

1. 2011

120

Marvin Capital Prodn. Salvage
value
17.5
5...
287

Marvin Enterprises
Prices

Technology Production Interest Interest Invest Scrap
cost
on
on
above below
capital salvag...
288

Marvin Enterprises
Demand for Garbage Blasters

Demand
800
Demand = 80 (10 - Price)

400
320
240

Price = 10 x quanti...
289

Marvin Enterprises
Value of Garbage Blaster Investment
NPV new plant = 100 x [-10 + Σ ((6 - 3)/1.2t ) + 10/1.25
= $29...
290

Marvin Enterprises
VALUE

•VALUE OF CURRENT BUSINESS:
At price of $7 PV = 24 x 3.5/.20

420

•WINDFALL LOSS:
Since pr...
291

Marvin Enterprises
Alternative Expansion Plans
NPV $m.
600
NPV new plant

400
Total NPV of
investment

200
100
-200

...
Principles of Corporate Finance
Brealey and Myers

u

Sixth Edition

Making Sure Managers Maximize NPV

Chapter 12

ion.co...
293

Topics Covered
w The capital investment process
w Decision Makers and Information
w Incentives
w Residual Income and ...
294

The Principal Agent Problem

Shareholders = Owners

Question: Who has
the power?

Answer: Managers
Managers = Employe...
295

Capital Investment Decision
Strategic Planning
“Top Down”

Capital Investments

Project Creation
“BottomaUp”ollection...
296

Off Budget Expenditures
ÜInformation Technology
ÜResearch and Development
ÜMarketing
ÜTraining and Development

ion.c...
297

Information Problems

The correct
information
is …

1. Consistent Forecasts
2. Reducing Forecast Bias
3. Getting Seni...
298

Growth and Returns
Rate of return, %
12
11
Economic rate of return

10
9
8

Book rate of return

7

5

10

15

20

25...
299

Brealey & Myers Second Law
The proportion of proposed
projects having a positive NPV
at the official corporate hurdle...
300

Incentives
Agency Problems in Capital Budgeting
w Reduced effort
w Perks
w Empire building
w Entrenching investment
w...
301

Incentive Issues
w Monitoring - Reviewing the actions of
managers and providing incentives to
maximize shareholder va...
302

Residual Income & EVA
w Techniques for overcoming errors in
accounting measurements of performance.
w Emphasizes NPV ...
303

Residual Income & EVA
Quayle City Subduction Plant ($mil)
Income

Assets

Sales

550

Net W.C.

COGS

275

Property, ...
304

Residual Income & EVA
Quayle City Subduction Plant ($mil)

130
ROI =
= .13
1,000
Given COC = 10%

NetROI = 13% − 10% ...
305

Residual Income & EVA
Residual Income or EVA = Net Dollar return
after deducting the cost of capital.

EVA = Residual...
306

Residual Income & EVA
Quayle City Subduction Plant ($mil)

Given COC = 12%

EVA = Residual Income
= 130 − (. 12 × 1,0...
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
Brealey & myers   principles of corporate finance, 6th edition slides
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