Finance Prep Part2

8/11/2019 Finance Prep Part2

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Asset Pricing & Valuation

Models

101 Discounted Cash Flows

Suppose that a project generates a series of expected cash ows from time 1 until time t. To nd th

present value of this project, we can add the extended stream of cash ows using the discounted c

ow(or DCF) formula:

The DCF formula for the present value of a stock is just the same as it is for the present value of an

other asset. We just discount the dividend stream (i.e., the cash ows) by the return that can be earn

in the capital market on securities of comparable risk. This required rate of return is typically calle

the market capitalization rate.

Example:

What is the present value of a project that generates the following cash ows: $200 at ti1, $150 at time 2, and $300 at time 3 if the interest rate is 5%?

SOLUTION:

102 Market Multiples

Comparative valuation ratios are used to assess the valuation of one rm versus another based on

a fundamental indicator such as earnings. These ratios give insight into how well investors in the

marketplace feel the rm is doing in terms of risk and return. They tend to reect, on a relative

basis, the common stockholders assessment of all aspects of the rms past and expected future

performance.

One of the most commonly used comparative measure is the price-to-earnings multiplecommon

called the P/E ratiois calculated by dividing the market price per share of common stock by the

earnings per share.

The P/E ratio measures the price that investors are prepared to pay for each dollar of earnings. The

ratio is most informative when applied in cross-sectional analysis using an industry average P/E ra

or the P/E ratio of a benchmark rm.

The P/E ratio is also a useful measure of the markets assessment of the rms growth opportunitie

To see this, denote a stocks current price byP0, next periods expected earnings per share byEPS

market capitalization rate by rand the net present value of growth opportunities by PVGO. The P/

ratio formula can be expressed as

(10.1)

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From equation (10.1) we can see that if PVGO = 0, the P/E ratio is just 1/r. However, as PVGO

increases, the P/E ratio can rise considerably. Thus a high P/E multiple indicates that a rm enjoys

ample growth opportunities.

Other comparative ratios commonly used are:

Price-to-book ratio(price per share divided by book value per share). Some analysts vbook value as a useful measure of value, so they use this ratio as an indicator of how themarket values a rm. Firms expected to earn high returns relative to their risk typicallysell at higher price-to-book ratios. Like P/E ratios, price-to-book ratios are typically asscross-sectionally to get a feel for the rms return and risk compared to peer rms.

Price-to-cash ow ratio(price per share divided by cash ow per share). Some analystprefer to use this ratio rather than the P/E ratio since cash ow owing into or out of therm is less affected by accounting decisions.

Price-to-sales ratio(price per share divided by annual sales per share). This ratio isparticularly useful for start-up rms which have no earnings.

Example:

A rms common stock at the end of 2010 was selling at $32.25, had an earnings per shof $2.90 and a book value per share of common stock of $23.00. Calculate and interprerms P/E ratio and its price-to-book ratio.

SOLUTION:

The P/E ratio is calculated as follows:

This gure indicates that investors were paying $11.10 for each $1.00 of earnings.

The price-to-book ratio is calculated as follows:

This gure indicates that investors are currently paying $1.40 for each $1.00 of book value of the

rms stock. In this case, the rms future prospects are being viewed favorably by investors, who

willing to pay more than its book value for the rms shares.

103 CAPM

The capital asset pricing model(CAPM) is a model of asset return determination. According to t

CAPM, the only risk that ispriced(that is, which requires additional return to compensate the inve

for bearing that risk) is the market risk. Idiosyncratic risk is not priced since investors can diversif

away.

Recall that a well-diversied portfolio has virtually no idiosyncratic risk; for such portfolio, the ris

depends on how sensitive it is to market movements. This sensitivity to the market is called beta,

general, the beta of stock i, i, is dened as:

where im

is the covariance between stock is return and the market return and 2mis the variance of

market return.

The return of a stock with a beta of 1 will change in exactly the same direction and magnitude as t

markets return. The returns of stocks with betas greater than 1 amplify the overall movements of t

markets return. The returns of stocks with betas between 0 and 1 move in the same direction as th

markets return, but in a smaller magnitude.


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With this information, we can determine the appropriate rate of return for stock isince, in a

competitive market, this should vary in direct proportion to beta. Two assets with the same beta sh

have the same rate of return. This is the fundamental message of the CAPM. The expected rate of

return for any stock iis given by the following equation:

(10.2)

where the rfis the market risk-free rate of return, and the r

mis an estimate of the market rate of retu

The term (rm- r

f) in the right-hand side of equation (10.2) is called the market risk premium. In

practice, the return on a value-weighted portfolio of NYSE stocks is used as a proxy for rm. The re

on T-bills is usually used as proxy for the risk-free rate.

As illustrated in Figure 10.1, according to the CAPM model, in equilibrium, every investment sho

lie along a positively sloped line know as the security market line. Note, that i= 1, then stock iha

the same risk as the market, so the appropriate rate of return of stock iis rf= r

m.

Example:Table 10.1 provides information about the market portfolio. Using this informationcalculate the beta of the rms stock and its expected rate of return.

SOLUTION:

First we calculate the beta plugging the information in the formula

Using this result we can calculate the expected rate of return


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104 The Black-Scholes Formula

The Black-Scholes model determines the price of an option based on ve factors:

1. Price of underlying asset2. Exercise price3. Expiration date4. Variability of underlying asset5. Interest rate on risk-free bonds.

All of these factors are directly observable with the exception of the variability of the asset which

needs to be estimated.

The value of the call in the Black-Scholes formula has the same properties that we identied in ch

9. It increases with the level of stock price and decreases with the exercise price. It also increases w

the time to maturity and the variability of the underlying asset.

The important assumptions of the Black-Scholes formula are:

(a) The price of the underlying asset follows a lognormal random walk.(b) Investors can adjust their hedge continuously and costlessly.(c) The risk-free rate is known.(d) The underlying asset does not pay dividends.

105 Economic Value Added

Economic value added(EVA) is a method that calculates the net dollar return to shareholders. It

given by the spread between ROA (return over assets) and the opportunity cost of capital (the mar

capitalization rate). It measures the dollar value of the rms return in excess of its opportunity cos

Another term for EVA is residual incomeand it can be measured by the following formula:

EVA = residual income = income earned - income required = income earned - cost of capital x investment

EVA treats the opportunity cost of capital as a real cost that should be deducted from revenues. A

manager can improve a rms EVA by (1) increasing earnings or (2) reducing the cost of capital.

A growing number of rms now calculate EVA and tie management compensation to it. The messa

EVA sends to managers is: invest if and only if the increase in earnings is enough to cover the cost

capital. Thus a focus on EVA can help managers concentrate on increasing shareholders wealth.

PRACTICE QUESTIONS CHAPTER 10

1.MULTIPLE CHOICE. Which of the following statements regarding market multiples is trA. The P/E ratio of a rm with no growth opportunities will be equal zero.B. As growth opportunities become a more important component of the total value of

rm, the P/E ratio will increase.

C. As growth opportunities become a more important component of the total value of rm, the P/E ratio will decrease.

D. The P/E ratio is unrelated to the growth rate opportunities of a rm.

2.MULTIPLE CHOICE. Which of the following statements regarding market multiples is falA. A price-to-book ratio greater than one indicates that a rms future prospects are be

viewed favorably by investors.B. Firms expected to earn high returns relative to risk typically have low price-to-book

ratios.C. A P/E ratio of 5 indicates that investors are paying $5 for each $1 of earnings.D. The P/E ratio is commonly used to assess the investors appraisal of share value.


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3.MULTIPLE CHOICE. Which of the following statements regarding the CAPM is true?A. Investors should be compensated for bearing idiosyncratic risk.B. Two assets with the same beta may have different expected rates of return.C. The appropriate discount rate for a stock with a beta of 1 ( = 1) is the risk-free rateD. The appropriate discount rate for a stock with a beta of 1 is the market rate of return

4. Table 10.2 provides other relevant information about an investment opportunity. What is texpected rate of return of this project?

5.MULTIPLE CHOICE. Which of the following factors is not required to calculate the prican option according to the Black Scholes model?A. Investors level of risk aversion.B. Risk-free interest rate.C. Maturity date.D. Strike price.

6.MULTIPLE CHOICE. Which of the following statements regarding EVA is true?A. It measures the spread between ROE and the opportunity cost of capital.B. It measures the spread between the P/E ratio and the opportunity cost of capital.C. It measures the spread between ROS and the opportunity cost of capital.D. It measures the spread between ROA and the opportunity cost of capital.


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Choosing Investments

Capital budgetingis the process of evaluating and selecting long-term investments that are consi

with the rms goal of maximizing owner wealth. When rms have determined the relevant cash

of a project, the decision-maker must apply appropriate decision techniques to assess whether the

project creates value. The preferred approaches integrate time value procedures and risk and return

considerations.

Capital budgeting decisions should be based on the relevant cash ows associated with a project.

The relevant cash ows are incremental cash owscash ows that will occur if an investment i

undertaken but that wont occur if it isnt.

111 Net Present Value

The net present value(NPV) of a project is calculated as the present value minus the projects

required investment. Suppose that a project requires an initial investment of C0at time 0 (i.e., a cas

outow) and at time 1 it generates a cash inow of C1. The formula for calculating the NPV can bewritten as:

(11.1)

The appropriate discount rate, r, is the rate of return offered by equivalent investment alternatives

the capital market, that is, the opportunity cost of capital.

Now, suppose that a project generates a series of expected cash ows from time 1 until time tas

illustrated in the timeline of Figure 11.1. To nd the NPV of such project, we can expand the form

in equation (11.1) by using the discounted cash ow formula as follows:

The net present valueruleis to accept only projects that have a positive NPV. This rule entails

accepting only those projects that are worth more than they cost and that therefore, make a net

contribution to the investors wealth. Note that the NPV rule recognizes the time value of money (

that a dollar today is worth more than a dollar tomorrow).

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The NPV rule has an adding-up property. Since present values are all measured in todays dollars,

can add up the NPV of different to calculate the net present value of the combined investment. Wi

two projects, A and B, the combined NPV is given by

NVP = (A +B) = NVP(A) + NVP(B)

The three important attributes of the NPV as decision-making process are:

1. NPV uses cash ows (as opposed to earnings which are an articial construct).2. NPV uses all the cash ows of the project.3. NPV discounts the cash ows properly.

NPV depends only on theforecasted cash owsfrom the project and the opportunity cost of capitathat is why it leads to better investment decisions than other criteria. Any investment rule which do

not recognize the time value of money or that is affected by the managers tastes, the rms choice

accounting method or the protability of other independent projects will lead to inferior decisions

Examples:1. You are offered a project that requires an initial investment of $400 today and generacash ow of $500 a year from now. Assume that common stocks with the same risk as tinvestment offer a 10% expected return. Should you accept the project?

SOLUTION:

Yes, you should accept the project, since it generates a cash inow of $454.55 (in presevalue) and requires a cash outow of only $400. Thus the project increases your wealth$54.55.

2. You are offered a project that requires an initial investment of $500 today and generathe following cash ows: $200 at time 1, $150 at time 2, and $300 at time 3. The intererate is 5%. Should you accept the project?

SOLUTION:

Yes, you should accept the project because the NPV is positive.

112 The Internal Rate of Return

The internal rate of return(IRR) is the rate of discount that makes the NPV equal to zero. To n

the IIR for an investment lasting t periods, we need to solve for IRR from the expression

(11.2)

Note that even though the IRR appears as the discount rate in equation (11.2) it is not the opportun

cost of capital. The IRR is a protability measure that depends solely on the amount and the timin

of the projects cash ows. In contrast, the opportunity cost of capital is the expected rate of return

offered by other assets with the same risk as the project being evaluated and it is determined by th

capital markets.

The IRR ruleis to accept a project if the opportunity cost of capital is less than the internal rate o

return. If the opportunity cost of capital is less than the IRR, then the project will have a positive N

when discounted at the opportunity cost of capital.


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The IRR method for selecting capital budgeting projects is popular among nancial practitioners f

three primary reasons:

1. IRR focuses on all the cash ows associated with the project.2. IRR adjusts for the time value of money.3. IRR describes projects in terms of the rate of return they earn, which makes it easier to

compare them with other investments and the rms opportunity cost of capital.

Just like the NPV rule, the IRR rule is a technique based on discounted cash ows and will therefo

give the correct answer if properly used. In fact, as long as the proposed capital budgeting projects

are independent, both NPV and IRR methods will produce the same accept/reject indication. That

a project that has a positive NPV will also have an IRR that is greater than the opportunity cost of

capital. There are, however, four cases were caution is required if using the IRR rule:

1. Investing or nancing?If a project offers positive cash ows followed by negative owthen the rule is to accept the project if the IRR is less than the opportunity cost of capita

2. Multiple IRRs. When a project has nonconventional cash ows (i.e., they have more thaone sign change), more than one IRR might result.

3. Mutually exclusive projects. The IRR rule may give the wrong ranking of mutuallyexclusive projects that differ in scale of required investment.

4. Timing problem. The cost of capital for near-term cash ows may be different from the for distant cash ows. In these cases there is no simple yardstick for evaluating the IRRproject.

Example: Consider a project that requires an initial investment of $500 and generates a cash ow $650 in a year. Calculate the IRR of this project.

SOLUTION:

Solving for the IIR from the equation, we nd that IRR = 30%

113 The Payback Period Method

The payback periodof a project is found by counting the number of periods it takes before the

cumulative forecasted cash ow equals the initial investment. A rm using the payback period ruto decide between different investment projects will typically set a cutoff period and accept those

projects with that recover its initial investment within such time frame.

The payback rule has three main drawbacks:

2. It ignores all cash ows after the cutoff date.3. It gives equal weight to all cash ows before the cutoff date.4. It requires an arbitrary standard for the cutoff date.

The payback period is an ad hoc rule and is considered an unsophisticated capital budgeting techn

since it does not explicitly consider the time value of money. Aware of the pitfalls of payback, som

decision makers use a variant called the discounted payback periodmethod. Under this approac

rst discount the cash ows and then we ask how long it takes for the discounted cash ow to equ

the initial investment. This investment criterion, however, still has the major aws of requiring anarbitrary cutoff date and ignoring all the cash ows after that date.

Example:

Table 11.1 (on the next page) contains information on three possible projects.a) If a rm uses the payback rule with a cutoff of two years, which projects will be selected?b) If the opportunity cost of capital is 10%, are the projects selected in part (a) the ones with

highest NPV?


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SOLUTION:a) With a cutoff period of two years, the rm would accept projects A and C only.b) No, the project with the highest NPV is project B (NPV=3,196.85) which was not selecte

according to the payback rule.


1.MULTIPLE CHOICE. Which of the following statements regarding NPV is true?A. The NPV rule depends on the managers tastes.B. The NPV rule does not recognize the time value of money.C. Because of the adding-up property one might be mislead into accepting a poor proj

that is packaged with a good project.

D. NPV depends only on the forecasted cash ows from a project and the opportunity of capital.

2. You are offered a project that costs $1,000 and has an expected cash ow in one year of$1,150. Calculate the net present value of the project if the interest rate is 5.5%.

3. A manager is contemplating the purchase of a new machine that will cost $150,000 and huseful life of three years. The machine would yield (year-end) cost reductions of $45,00year 1, $55,000 in year 2, $65,000 in year 3. If the interest rate is 9%, should the managbuy the machine?

4.MULTIPLE CHOICE. Which of the following statements regarding the internal rate of re

(IRR) is true?A. The IRR is the opportunity cost of capital.B. The IRR is the interest rate that causes the NPV of the project to be equal to 1.C. The general investment rule is to accept the project if the IRR is less than the disco

rate.D. The IRR is a protability measure that depends on the amount and the timing of the

projects cash ows.

5.MULTIPLE CHOICE. Which of the following statements regarding the payback period ruis true?A. The payback rule is to accept only those projects that recover their investment with

some specied period.

B. If the payback period rule is chosen for making investment decisions with a cutoff of two years, then a project that recovers its investment in 2.5 years can be selected

C. The payback rule correctly accounts for the opportunity cost of capital.D. When deciding between possible investment projects the NPV rule and the payback

period give the same answers.


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6.MULTIPLE CHOICE. Which of the following statements regarding the capital budgetingdecisions is false?A. As long as the proposed capital budgeting projects are independent, both NPV and

methods will produce the same accept/reject indication.B. A deciency of the internal rate of return is that it does not consider the time value

money.C. A deciency of the payback method is that it does not consider the time value of

money.D. If a project has a NPV of zero, it means that the rms overall value will not change

the project is adopted.


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Cost of Capital

To properly evaluate potential investments, a rm must know how much its capital costs, that is,

the rm must have a benchmark risk-adjusted discount rate for new investments. The rms cost o

capitalis the expected return on a portfolio of all the rms existing securities. It is the opportunit

cost of capital for investing in the rms assets.

The rms cost of capital is the correct discount rate for projects that have the same risk as the rm

existing business.

A rms capital is supplied by its creditors and owners. Firms raise capital by borrowing or by issu

stock. Thus the overall cost of capital depends on the return demanded by each of these suppliers o

capital.

121 Cost of Debt

The cost of debtwhen the rm borrows money from an individual or nancial institution is the

interest rate on the loan. When the rm borrows money by issuing bonds the cost of debt is the int

rate demanded by the bond investors.

The after-tax cost of debtis the cost to the rm of obtaining debt funds. Because the interest paid

bonds or bank loans is a tax-deductible expense for a rm, the after-tax cost of debt is less than the

required rate of return of the suppliers of debt capital. Denote the rms (before-tax) cost of capita

rD

and the rms marginal tax rate by T, the after-tax cost of debt,ATrD

, is given by

Example:

Suppose that a rms cost of debt is 15 percent and its marginal tax rate is 40 percent. Wis the rms after-tax cost of debt?

SOLUTION: , which means that the after-tax cost of debt on a loan at a 1

rate is 9%.

122 Cost of Equity

If a rm raises capital by issuing preferred or common stock, these investors expect a return on the

investment, this rate of return is the cost of equity. Unlike with bondholders, the claim of preferre

and common stockholders is not contractual, but it is a cost nonetheless since if the return is not

realized, investors could sell their stock, driving the stock price down.

The cost of preferred stockis the rate of return investors require on a rms new preferred stock

plus the cost of issuing the stock. Preferred stock investors generally buy preferred stock to obtain

associated constant stream of dividends, so, their return on investment can be measured by dividin

the expected preferred stock dividend by the netprice of the shares. The oatation costswhich ar

the costs of issuing new securities must be deducted from the preferred stock price paid by investo

to obtain the net price received by the rm. Denote the expected preferred stock dividend byDIVp

current price of preferred stock byPpand the otation cost per share byf, the cost of preferred sto

rp, is given by

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123 WACC

We dened the rms cost of capital as the expected return on a portfolio of all the companys exis

securities. Since the value of the rm is the sum of the values of debt and equity we can calculate t

rms cost of capital as a weighted average of the expected return of these two components.

The overall expected return on assets rA

or weighted-average cost of capital(WACC) is found by

weighting the cost of each specic type of capital by its proportion in the rms capital structure.

LetDdenote the market value of debt andEdenote the market value of equity, then the rms asse

value, V, is given byD+ V=E. The overall expected return on assets rAor WACC can be specie

follows:(12.4)

The formula in equation (12.4) can be expanded to incorporate the cost of preferred stock times its

corresponding weight or proportion. Note that the sum of the weights must equal 1, that is, all cap

structure components must be accounted for.

Now, recall that interest paid on a rms borrowing can be deducted from taxable income. Thus, w

can calculate the after-tax weighted average cost of capital as

Example:

Consider a rm whose debt has a market value of $20 million and whose stock has a mvalue of $30 million. The rm pays a 10.5% of interest on its new debt and has a beta o1.3. The corporate tax is 34%. The market risk premium is 8.5% and the current T-bill ris 6.5%. What is the rms after-tax WACC?

SOLUTION:

First, we need to calculate the cost of equity capital:

Now we can calculate the after-tax WACC


1.MULTIPLE CHOICE. Which of the following statements regarding the cost of internalcommon equity is false?A. It is the rate of return investors require on funds supplied by existing common

stockholders.B. It is the rate of return investors require on funds supplied by existing common

stockholders, plus otation costs.C. It can be calculated using the CAPM model.D. It is slightly lower than the cost of equity from new common stock.

2. If a rm has a cost of debt of 10% and an after-tax cost of debt of 6%, what is the rmsmarginal tax rate?


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Real Options

As discussed in chapter 11, net present value is the best capital budgeting approach conceptually.

Discounted cash ow analysis, however, commonly assumes that once NPV calculations have bee

undertaken when valuing capital budgeting projects, rms will hold the assets passively. This is

rarely the case in practice since rms will make investment and operating decisions on a project ov

its entire life. For example, if a projects cash ows are better than anticipated, the project may be

expanded and if they are worse, the project may be contracted, put on hold, or even abandoned. Th

opportunity to make such decisions clearly adds value whenever project outcomes are uncertain.

Options to modify projects are known as real options. Net present value calculations typically

ignore the exibility that real-world rms have; in this respect, NPV underestimates the true value

of a project. Note however that real-option-valuation methods do not replace discounted cash ow

analysis. NPV works well for safe cash ows and it also the starting point in most real-option anal

There are four main types of real options:

Expansion Option

This is the option to expand if the immediate investment project succeeds. An expansion option is

equivalent to a call option on follow-on projects in addition to the immediate projects cash ows.

If a manger has the ability to make follow-up investments on a project, she might decide to undert

(for strategic reasons) a negative-NPV project since todays investments can generate tomorrow

opportunities.

In chapter 10 we showed how the present value of growth opportunities (PVGO) contributes to the

value of a rms common stock. PVGO equals the forecasted total NPV of future investments. We

can think of PVGO as the value of the rms options to invest and expand. The exibility to adapt

investment to future opportunities is one of the factors that makes PVGO so valuable.

Timing Option

This is the option to wait (and learn) before investing. The timing option is equivalent to owning a

option on the investment project. The call is exercised when the rm commits to the project. How

it is often better to defer a positive NPV-value project (as long as the immediate project cash ows

small) to keep the call alive.

Abandonment Option

This is the option to shrink or abandon a project. It provides partial insurance against failure. The

option to abandon is equivalent to a put option. You exercise that abandonment option if the value

recovered from the projects assets is greater than the present value of continuing the project for at

least one more period.

A rm that has the option to abandon a project that is no longer protable will cut its losses and ba

out the projects assets. Tangible assets are usually easier to sell than intangible ones. It helps to ha

active secondhand markets, which really only exist for standardized items.

The Flexibility in Production Option

This is the option to vary the mix of output or the rms production methods. In such cases the rm

has the option to acquire one asset in exchange for another.

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131 Decision Trees

Decision treesare commonly used to describe the real options imbedded in capital investment

projects. This type of diagrams help decision-makers to understands project risk and how future

decisions will affect project cash ows.

A decision tree, such as that illustrated in Figure 13.1, has four basic elements:

Decision nodes. A decision node, represented by a small bold square in the tree diagramindicates a particular decision faced by the decision maker. Each branch from a decisionnode corresponds to a possible decision.

Chance nodes. A chance node, represented by a small bold circle in the tree diagram,indicates an event faced by the decision maker; an event that has an uncertain outcome.Each branch from a chance node corresponds to a possible outcome.

Probabilities. Each possible outcome has a corresponding probability. The sum of theprobabilities of all the possible outcomes at a chance node must add up to 1.

Payoffs. The end of each branch is located at the right end of the tree and has a payoffassociated with it.

By displaying the links between todays and tomorrows decisions, decision trees help the decision

maker identify the strategy with the highest net present value. Once the real options and their cash

ow consequences have been included in the decision tree, the action that should be undertaken in

each scenario is identied by working back from the future to the present.

One problem with decision trees is that, in practice, they can get pretty complex very quickly. Thu

often decision trees should be judged not on their comprehensiveness but on whether they show th

most important links between todays and tomorrows decisions.

Example:

A national chain of organic grocery stores is considering introducing a new line of glutefree products. The company has the option of introducing this new line in all of its existstores nationwide, with a 55% chance of success. However, the rm can conduct a custosegment research to determine the locations where demand for this type of products is thighest; this research would take 1 year and cost $1 million. By going through researchthe company will be able to introduce the line only in specic stores and increase theprobability of success to 70%. If successful, the gluten-free product line will bring a prevalue prot (at the time of initial selling) of $30 million. If unsuccessful, the present vapayoff is only $3 million. Should the company conduct customer segment research orintroduce the new products nationwide? The appropriate discount rate is 15%.


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SOLUTION:

The decision tree with the corresponding payoffs of each strategy is depicted in Figure What is left is to calculate the expected value of each possible strategy as follows:

Now, it is easy to see that the rm should conduct the customer segment research even ithis action implies postponing the initial selling of the products for one year.


1.MULTIPLE CHOICE. Which of the following statements regarding real options is false?A. When real options exist, NPV calculations may underestimate the value of a projecB. An example of a real option is to expand the project.C. An example of a real option is to abandon the project.D. An example of a real option is to change the timing of the project.

2.MULTIPLE CHOICE. Which of the following statements regarding real options is false?A. It is never optimal to defer a positive-NPV project.B. A rm that has the option to make follow-on investments may decide to undertake

negative-NPV projects.C. An example of a real option is to vary the rms production methods.D. An example of a real option is to shrink the scale of a project.

3.MULTIPLE CHOICE. Which of the following statements regarding real options is false?

A. An abandonment option provides partial insurance against failure.B. Real-option-valuation replaces NPV calculations.C. An example of a real option is the ability of making follow-up investments.D. Decision trees can help to identify the possible impact of real options on a projects

cash ows.

4.MULTIPLE CHOICE. Which of the following statements regarding real options is false?A. An expansion option is like a call option on follow-on projects.B. A timing option is like a call option on the investment project.C. An option to abandon is like put option on the projects assets.D. The option to abandon is only valuable when the projects assets are intangibles.


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5.MULTIPLE CHOICE. Which of the following is not an element of a decision tree?A. Decision node.B. Payoff.C. Initial node.D. Equilibrium node.

6.MULTIPLE CHOICE. Which of the following statements regarding real options is false?A. An expansion option would increase in value if there is a more optimistic forecast

(higher expected value).B. A way to solve a decision tree is to solve from the present to the future.

C. Projects that can be easily expanded or abandoned are more valuable than those thanot provide that exibility.D. If the discount rate remains constant, an expansion option would increase in value

increased uncertainty.


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Efcient Market Hypothesis

141 Efcient Market Hypothesis

An efcient capital market is one in which stock prices fully reect available information. Anyinformation that could be used to predict stock performance should already be reected in the stoc

prices. Prices of stock should increase or decrease only in response to new information. Prices cha

at the moment the new information becomes public, they instantaneously adjusts to and fully ree

this new information. After the announcement date there should be no further drift in prices, that i

there are no delayed responses or overadjustments in prices.

The notion that at any point in time security prices fully reect all publicly available information i

referred to as the efcient market hypothesis(EMH). The EMH has implications for investors an

for rms:

Because information is reected in prices immediately, investors should only expect toobtain a normal rate of return.

Firms should expect to receive fair value for securities that they sell (fair means that theprice received for the issued securities is equal to the present value)

A return is abnormal if it exceeds the expected or required return appropriate for the risk level

the investment strategy. Market efciency eliminates many value-enhancing strategies, in particula

1. Stock prices should not be affected by rms choice of accounting method.2. Financial managers cannot time issues of bonds and stocks.3. Firms cannot expect to gain through speculation in currency and bond markets.4. Prices reect underlying value.

Now that we discussed the consequences of market efciency, we need to cover the foundations o

market efciency, that is, the conditions that will cause market efciency. Markets will be efcient

any of the following three conditions hold:

1. Rationality. All investors are rational. When new information is released in the market, investors will adjust their estimates of stock prices in a rational way.

2. Independent deviations from rationality. Even if some investors are rational, the mistakof irrational investors cancel out. That is, market efciency does not require rationalindividuals, only countervailing irrationalities.

3. Arbitrage. If rational investors can arbitrage away the mispricings induced by the irratioinvestors markets would still be efcient.

There is disagreement among academics and practitioners about whether any of above-mentioned

conditions is likely to hold in the real world. This point of view is based on what is called behavio

nance. Adherents to this view argue that investors are not rational, deviations from rationality ar

similar across investors, and since arbitrage is costly it will not eliminate inefciencies.

142 Types of Efciency

There are three versions of the EMH: the weak,semistrongandstrong. These versions differ by w

is meant by the term all available information.

Weak form efciency: a market is said to be weakly efcient if it fully incorporates theinformation in past stock prices. It does not use any other information such as earnings,forecasts or merger announcements. Often the weak form efciency is representedmathematically as

(12.4)

14


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If stock prices follow equation (14.1) they are said to follow a random walk. The randocomponent is due to new information on the stock; it can be positive or negative and haan expected value of zero. The random component in one period is unrelated to the randcomponent in any past period.

Semistrong form efciency: a market is semistrong form efcient if prices reect inaddition to historical prices, all publicly available information including information suas published accounting statements.

Strong form efciency: a market is strong form efcient if stock prices reect all (puband private) information relevant to the rm, even including information available onlycompany insiders.

Semistrong form efciency implies weak form efciency and strong form efciency impliessemistrong form efciency. Much evidence from different nancial markets supports weak form a

semistrong form efciency but not strong form efciency.


1.MULTIPLE CHOICE. Which of the following statements regarding the Efcient MarketHypothesis is false?

A. An efcient market is one in which stock prices fully reect available information.B. On average, no abnormal returns can be obtained by trading on freely available pub

information.

C. In an efcient market the price of the shares immediately adjust to new informationD. If the new information about a company is particularly good, it may take several da

for the price of the stock to adjust.

2.MULTIPLE CHOICE. Which of the following is not a version of the Efcient MarketHypothesis?A. Semistrong form.B. Weak form.C. Ultrastrong form.D. Strong form.

3.MULTIPLE CHOICE. Which of the following statement regarding the types of efciency

true?A. Semistrong form efciency implies strong form efciency.B. Weak form efciency implies semistrong form efciency.C. Weak form efciency implies strong form efciency.D. Strong form efciency implies semistrong form efciency.

4.MULTIPLE CHOICE. Which of the following statements regarding the Efcient MarketHypothesis is true?A. According to the EMH all stock should have the same expected returns.B. According to the EMH prices are uncaused.C. According to the EMH prices reect underlying value.D. According to the EMH managers can boost stock prices through creative accountin

5.MULTIPLE CHOICE. Which of the following statements regarding the weak form efcieis false?A. If markets are weakly efcient, then stock prices follow a random walk.B. If markets are weakly efcient, then managers can get abnormal returns by analyzin

rm earnings and forecasts.C. If markets are weakly efcient, the current prices reect past prices.D. It is the weakest type of efciency that we would expect a nancial market to displ


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6.MULTIPLE CHOICE. Which of the following is not a condition that would cause a markbe efcient?A. Investors rationality.B. Independent deviations from rationality.C. Investors risk aversion.D. Arbitrage.


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Institutions and Sources of

Funding

Investment companiesare nancial intermediaries that collect funds from individual investors an

invest them in a wide range of securities. The idea behind these companies is pooling of assets. Eainvestor has a claim to the portfolio in proportion to the amount invested.

Investors buy shares in investment companies and ownership is proportional to the number of shar

purchased. The value of each share is called the new asset value(NAV). Net asset value equals

the market value of assets held by a fund minus the liabilities of the fund divided by the shares

outstanding, that is

151 Mutual Funds

Mutual funds are pools of investors money. These funds follow specic investment policies which

described in the funds prospectuses and issue shares to investors entitling them to a pro rata portio

the income generated by the funds. Mutual funds free the individual from many of the administrat

burdens of owning individual securities and offer professional management of the portfolio.

Mutual funds are open-end investment companieswhich means they can redeem or issue shares

NAV at the request of the investor. These funds are generally marketed to the public either directly

the fund underwriter or indirectly through brokers acting on behalf of the underwriter.

Mutual funds are assessed management fees and include other expenses which reduce the investor

rate of return. Costs of investing in mutual funds include:

Front-end loads(commission charge paid when the share is purchased), Back-end loads(redemption fee incurred when share is sold), Fund operating expenses(these are usually expressed as a percentage of the total assets

under management) 12b-1 charges(recurring fees used to pay for the expenses of marketing the fund to the

public).

Investment returns of mutual funds are granted pass-through status under the U.S. tax code whic

means that taxes are paid only by the investor in the mutual fund, not by the fund itself. As long as

income is distributed to shareholders, the income is treated as passed through to the investor. Such

treatment has the disadvantage for individual investors that the timing of the sale of securities from

portfolio (and thus the realization of capital gains) is out of the investors control.2

The rate of return on an investment in a mutual fund is measured as the change in NAV plus anyincome distribution (such as dividends or distributions of capital gains) expressed as a fraction of N

at the beginning of the investment period. That is, let NAV0denote the net asset value at the begin

of the period and NAV1the value of this variable at the end of the period, then the rate of return is

given by

15

2If the mutual fund is held in a tax-deferred retirement account such as an IRA or 401(K) account, these tax management

issues are irrelevant.


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Some of the more important fund types, classied by investment policy are:

Money market funds. These funds invest in money market securities. Equity funds. These funds invest primarily in stock. It is common to classify stock fun

according to their investment emphasis in two categories: income funds (hold shares ofrms with high dividend yields) and growth funds (hold shares of rms with high prospof capital gains). Since growth stocks are typically riskier, growth funds have a higher lof risk.

Bonds funds. These funds invest primarily in the xed-income sector. International funds. These funds with international focus can be classied in:global

funds(invest in securities worldwide, including the United States), international funds

(only invest in rms located outside of the United States), regional funds(concentrate iparticular part of the world) and emerging market funds(invest in companies of developnations).

Index funds. An index fund tries to match the performance of a broad market index. Thfund buys shares in securities included in a particular index in proportion to each securirepresentation of that index. For example, Vangard 500 Index Fund is a mutual fund thareplicates the composition of the Standard & Poors 500 stock price index.

152 Hedge Funds

Hedge fundsare vehicles that allow private investors to pool assets to be invested by a fund mana

Hedge funds are not registered as mutual funds and not subject to SEC regulation. They are typicaonly open to wealthy or institutional investors. These funds are only lightly regulated which enabl

their managers to pursue sophisticated investment strategies involving heavy use of derivatives, sh

sales, and leverage; this in turn implies that returns can be quite volatile.

153 Exchange-Traded Funds

Exchange-traded funds (EFTs) are investment funds that allow investors to trade index portfolios.

of the main advantages that ETFs have over conventional mutual funds are:

1. While investors can buy or sell their mutual funds shares only once a day, ETFs trade

continuously.2. Unlike mutual funds, ETFs can be sold short or purchased on the margin.

ETFs are also cheaper than mutual funds since investors who buy them need to do it through a bro

This allows the fund to save the cost of marketing itself directly to small investors. This reduction

expense translates into lower management fees.

154 Pension Funds

A pension planis a contractual agreement setting out the rights and obligations of all parties invo

The pension fundof the plan is the cumulation of assets created from contributions and investmen

earnings on those contributions, less any payments of benets from the fund. Contributions to the by either employee or employer are tax-deductible and investment income of the fund is not taxed

Distributions from the fund, whether to the employer or employee, are taxed as ordinary income.

Pension fund objectives depend on the type of pension plan. There are two basic types:

Dened contribution plans. In such plan, a formula species contributions but not benpayments. These are in effect tax-deferred retirement savings accounts established by thrm in trust for its employees, with the employee bearing all the risk and receiving all treturn from the plans assets.


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Dened benet plans. In such plan, a formula species benets but not the manner,including contributions, in which these benets are funded. In a dened benet plan, asserve as collateral for the liabilities that the rm sponsoring the plan owes to the planbeneciaries. Thus it is the sponsoring rms shareholders who bear the risk.

The special tax status of pension funds creates the same incentive for both dened contribution an

dened benet plans to tilt their asset mix toward assets with the largest spread between pretax an

after-tax rates of return.


1.MULTIPLE CHOICE. Which of the following statements regarding mutual funds is falseA. For tax purposes, as long as all income is distributed to shareholders, the income is

treated as passed through to the investor.B. They are close-end investment companies.C. Some of the costs of investing in mutual funds include front-end loads, back-end lo

and operating expenses.D. The funds prospectus describes the mutual funds investment policy.

2.MULTIPLE CHOICE. Which of the following statements regarding mutual funds is falseA. Vangard 500 Index Fund invests primarily in stock of companies outside the United

States.

B. They open-end investment companies.C. They have a specied investment policy described in the funds prospectus.D. They are assessed management fees which reduce the investors rate of return.

3.MULTIPLE CHOICE. Which of the following statements regarding hedge funds is true?A. Hedge funds are registered as mutual funds.B. Hedge funds are heavily regulated.C. Hedge funds allow private investors to pool assets to be invested by a fund manageD. Hedge funds are subject to SEC regulation.

4.MULTIPLE CHOICE. Which of the following statements regarding exchange-traded fun(ETFs) is false?

A. Unlike conventional mutual funds, ETFs trade continuously.B. ETFs allow investors to trade index portfolios.C. ETFs are typically cheaper than mutual funds.D. ETFs cannot be sold short or purchased on the margin.

5.MULTIPLE CHOICE. Which of the following statements regarding pension funds is falseA. Contributions to the fund by either employee or employer are tax-deductible.B. Distributions of the fund to the employee are taxed as ordinary income.C. Investment income of the pension fund is taxed.D. In a dened contribution pension plan the contributions are specied but not the

benets.

6.MULTIPLE CHOICE. Which of the following statements regarding mutual funds is falseA. Money market funds invest in stock.B. Bond funds specialize in the xed-income sector.C. Index funds try to match the performance of a broad market index.D. International funds invest in securities located outside the United States.


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REFERENCES[1] Bodie Zvi, Alex Kane and Alan J Marcus, Investments, McGraw-Hill Irwin, 6th Ed., 20[2] Brealey A Richard, Stewart C. Myers and Franklin Allen, Principles of Corporate Finan

McGraw-Hill Irwin, 8th Ed., 2006[3] Gallagher J Timothy, Financial Management: Principles and Practice, 5th Ed

[4] Gitman J. Lawrence, Principles of Managerial Finance, Pearson Prentice Hall, 12th Ed2009

[5] Ross A. Stephen, Randolph W. Westereld and Jeffrey Jaffe, Corporate Finance, McGraHill Irwin, 7th Ed., 2005

[6] Trevino Regina, PreMBA Anlytical Primer: Essential Quantitative Concepts for BusineMath, Palgrave Macmillan, 2008


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REVIEW QUESTION

ANSWERS

CHAPTER ONE SOLUTIONS:

1.

2.

3.

4.

5.

6. D

CHAPTER TWO SOLUTIONS:1. B2. B

3. A4. C5. C

6.

CHAPTER THREE SOLUTIONS:

1. D2. C3. A4. D5. 1/1.50 = .66676. A


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CHAPTER FOUR SOLUTIONS:

1.

2.

3. , so the stock paid a dividend of

4. , sothree-year holding period return is 7.64%.

5.

6. C

CHAPTER FIVE SOLUTIONS:

1. D2. A3. B4. A5. D6. D

CHAPTER SIX SOLUTIONS:

1. 11.8%2. 13. C

4.

so, the portfolios standard deviation is given by

5.

6. B

CHAPTER SEVEN SOLUTIONS:

1. D2. B

3.

4. D5.

6. A

.

.


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CHAPTER THIRTEEN SOLUTIONS:

1. A2. A3. C4. D5. D6. B

CHAPTER FOURTEEN SOLUTIONS:

1. D2. C3. D4. C5. B6. C

CHAPTER FIFTEEN SOLUTIONS:

1. B2. A3. C4. D5. C6. A

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Finance Prep Part2