Corporate Finance and Portfolio management

1. Net Present Value

n
n
2
2
1
1
0
r) (1
CF
......
r) (1
CF
r) (1
CF
CF NPV
+
+ +
+
+
+
+ =
Invest if : NPV > 0 Do not invest if: NPV< 0
2. Internal Rate of Return 0
IRR) (1
CF
n
0 t
t
t
=
+

=
Invest if: IRR > r Do not invest if: IRR< r
3. Average Accounting Rate of Return (AAR)=
book value Average
income net Average
4. Profitability Index PI=
Invesment Initial
NPV
1
Invesments Initial
flows cash future of PV
+ =
Invest if: PI > 1.0 Do not invest if: PI< 1.0
5. Cost of Capital
e e p p d d
r w r w t) (1 r w (WACC) + + =
where w
d
= target debt proportion in total capital
r
d
= the before-tax marginal tax rate t = the companys marginal tax rate
w
p
= target preferred stock proportion in total capital
r
p
= the marginal cost of preferred stock re = the marginal cost of equity
w
e
= target common stock proportion in total capital
6. Capital Asses Pricing Model Approach ( ) | |
F M i F i
R R E R ) E(R + =
where

I
= the return correlation of stock i to changes in the market return
E(R
M
) = the expected return on the market E(R
M
)-R
F =
the expected market risk premium
7. Dividend Discount Model Approach V0 =
( ) ( )
......
r 1
D
r 1
D
e
2
e
1
+
+
+
+

where
V0 = the intrinsic value of a share Dt = the shares dividend at the end of period t
re = the cost of equity
8.
g r
D
P
e

=
1
0
9. g
P
D
r
e
+ =
0
1
10.
(
(
(
(

|
.
|

\
|
+
=
E
D
t) (1 1
1

equity asset
11. Country equity premium= Sovereign yield spread
(
(
(
(
(
(
(

currency market t developmen the of

terms in market bond soverign the
of devation standard Annualized
index equity of
deviation standard Annualized
12. The cost of preferred stock is the preferred stock dividend divided by the current
preferred stock price :
p
p
p
P
D
r =
13. We can estimate the growth rate in the dividend discount
model by using published forecasts of analysts or by the sustainable growth rate:
14. Current Ratio =
abilities Current li
sests Current as
15. Quick Ratio =
abilities Current li
ceivables nts le invesme m marketab Short-ter Cash Re + +
16. Accounts receivable turnover =
ceivables Average re
es Credit Sal
17. Inventory turnover =
ventory Average in
ods sold Cost of go
18. Number of days of receivables =
on credit y's sales Average da
eceiveable Accounts r
=
365 redit / Sales on c
eceivable Accounts r
19. No. of days of inventory =
sold t of goods y's Average da
Inventory
cos
=
365 ods sold / Cost of go
Inventory
20. Operating cycle = Number of days of inventory + Number of days of receivables
21. Net operating cycle = Number of days of inventory + Number of days of receivables - Number
of days of payables
ROE
EPS
D
1 g
|
.
|

\
|
=
22. Money Market yield =
|
|
.
|

\
|
|
|
.
|

\
|
maturity to days of Number
360
price Purchase
price Purchase - value Face
23. Bond Market yield =
|
|
.
|

\
|
|
|
.
|

\
|
maturity to days of Number
365
price Purchase
price Purchase - value Face
24. Discount- basis yield =
|
|
.
|

\
|
|
.
|

\
|
maturity to days of Number
360
value Face
price Purchase - value Face
25. Cost of trade credit = 1
1
1
period discount beyond
days of Number
365

|
.
|

\
|

+
(
(
(
(

Discount
Discount

26. Return on equity =
equity rs' shareholde Average
assets total Average
assets total Average
Revenues
Revenues
income Net
equity rs' shareholde Average
income Net

=
27. Standard Deviation =

=
n
1 i
i
2
i i
2
P )] E(R [R
28. rij=
j i
ij
Cov
o o
where rij= the correlation coefficient of returns
i
o = the standard deviation of Rit
j
o = the standard deviation of Rjt
29.
2 1 2 , 1 2 1
2
2
2
2
2
1
2
1
2 o o o o o r w w w w
port
+ + =
Derivatives and Alternative Investments
1. FRA payoff formula (from the perspective of the party going )
Notional Principal =
( )
(
(
(
(

|
.
|

\
|
+
|
.
|

\
|

360
rate underlying in Days
xpriation ate rate Underlying 1
360
rate underlying in Days
rate contract Forward expiration at rate g Underliyin

2. Minimum and Maximum Values of Options
Option Minimum value Maximum Value
European call
0
0
> c
0 0
S c s
American call
0
0
> C
0 0
S C s
European put
0
0
> p
T
r X p ) 1 /(
0
+ s
American put
0
0
> P X P s
0
3. Put-call parity = c
0
+ X/ (1+r)
T
=p
0
+s
0
4. Appraisal price =
rate cap Market
NOI
Equity and Fixed income
1. Dividend Discount Model (DDM)
( )
( ) ( ) ( )

+
+ +
+
+
+
+
+
=
k
D
k
D
k
D
k
D
1
......
1 1
1
Vj
3
3
2
2 1
( )

=
+
=
n
t
t
t
k
D
1
1
2. Present value of Free Cash Flows to Equity
( )

=
+
=
n
t
t
j
j
k
FCFE
V
1
1
2. Justified/ Fundamental (P/E)
g k
E D
E
P
i

=
1 1
1
/
4. (Shareholders equity)- (Total value of equity claims that are senior to common stock) = Common
shareholders equity
5. (Common shareholders equity)/ (Number of common stock shares outstanding) = Book value per
share
6. Coupon rate = Yield required by market Price = Par value
Coupon rate < Yield required by market Price < Par value (discount)
Coupon rate > Yield required by market Price > Par value (premium)
7. Price of callable bond = Price of option-free bond Price of embedded call option
8. Price of putable bond = Price of option- free bond + Price of embedded put option
9. Taxable-equivalent yield =
rate tax Marginal - 1
ld exempt yie Tax
10. Present value of an annuity =
( )
(
(
(
(

i
i 1
1
1
payment Annuity
periods of no.

11. Valuing a Zero- Coupon Bond
2
1

+
rs no. of yea
i
alue Maturity v
Where i is the semiannual discount rate
12. Current yield =
Price
interest coupan dollar Annual
13. Yield on an annual-pay basis
(
(

|
.
|

\
|
+ = 1
2
basis equivalent - bond a on Yield
1
2
14. Spread for life =
( )
|
.
|

\
|

Price
100
margin Quoted
Maturity
Price 100 100
15. Z-spread = OAS + Option cost
16.
( )
( )
1
1
1
1

+
+
=
+
+
t
m
m
t m
t m
m t
z
z
f
17. Effective duration =
( )( ) decimal in yield in Change price Initial 2
rise yields if Price - decline yields if Price
18. Macaulay duration =
( )
(

+ + +
+ Price k
PVCF n ..... PVCF 2 PVCF 1
Yield/k 1
1
n 2 1
19. Modified duration=
( ) Yield/k 1
duration Macaulay
+
20. Portfolio Duration =
k k
D w D w D w D w + + + + .....
3 3 2 2 1 1
Financial Reporting and Analysis
1. Assets = Liabilities + Owners equity Revenue Expenses = Net income (loss)
2. Basic EPS
g outstandin shares of number average Weighted
dividends Preferred - income Net
=
3. Diluted EPS =
ersion ed at conv been issu could have
at shares th New common ding outs
res ber of sha verage num Weighted a
vidends eferred di e debt convertibl
rest on After tax Net income
+
|
|
.
|

\
|

+
tan
Pr
int
4. Diluted EPS =
( )
excersice upon received cash with
purchased been have could that Shares
excersice option at issued been have could
that shares New g outstandin
shares of number average Weighted
dividends Preferred Netincome

5. Net profit margin =

Revenue
income Net
6. Gross profit margin=
Revenue
profit Gross
7. FCFF= NI + NCC + Int (1-Tax rate)- FCInv WCInv
8. FCFF = CFO + Int (1-Tax rate) - FCInv
9. FCFF = CFO- FCInv + Net borrowing Net debt repayment
10. Definitions of commonly Used Activity Ratios
Activity Ratios Numerator Denominator
Inventory Turnover Cost of goods sold Average inventory
Days of inventory on hand (DOH) Number of days in period Inventory turnover
Receivables turnover Revenue Average receivables
Days of sales outstanding(DSO) Number of days in period Receivables turnover
Payables turnover Purchases Average trade payables
Number of days payables Number of days in period Payables turnover
Working capital turnover Revenue Average working capital
Fixed asset turnover Revenue Average net fixed assets
Total asset turnover Revenue Average total assets
11. Definitions of commonly Used Liquidity Ratios
Liquidity Ratios Numerator Denominator
Current ratio Current assets Current liabilities
Quick ratio Cash + Short-term marketable investments + Receivables Current liabilities
Cash ratio Cash + Short-term marketable investments Current liabilities
Defensive
interval ratio
Cash + Short-term marketable investments + Receivables Daily cash
expenditures
Additional Liquidity Measures
Cash Conversion cycle (net
operating cycle)
DOH + DSO Number of days of payables
12. Definitions of commonly Used Solvency Ratios
Solvency Ratios Numerator Denominator
Debt Ratios
Debt-to-assets ratio
a
Total debt
b
Total assets
Debt-to-capital ratio Total debt
b
Total debt
b
+ Total shareholders equity
Debt-to-equity ratio Total debt
b
Total shareholders equity
Financial leverage ratio Average total assets Average total equity
Coverage Ratios
Interest coverage EBIT Interest payments
Fixed charge coverage EBIT + Lease payments Interest payments + Lease payments
13. Definitions of commonly Used Profitability Ratios
Profitability Ratios Numerator Denominator
Return on Sales
10

Gross profit margin Gross profit Revenue
Operating profit margin Operating income
11
Revenue
Pretax margin EBT (earnings before tax but after interest) Revenue
Net profit Income Net Income Revenue
Return on Investment
Operating ROA Operating income Average total assets
ROA Net income Average total assets
Return on total capital EBIT Short and long -term debt and equity
ROE Net income Average total equity
Return on common equity Net income-preferred dividends Average common equity
14. ROE = Net profit margin * Asset turnover * leverage
15. ROE = Tax burden * Interest burden * EBIT margin * Asset turnover * Leverage
Quantitative analysis
1. Population Mean: calculated as
Where there are N members in the population and each observation is Xi i =1, 2, N.
Sum of all the deviations is zero.
2. Sample Mean: calculated as
3. Weighted Mean: calculated as
4. Geometric Mean: calculated as
Where there are n observations and each observation is X
i
.
5. Mean Absolute Deviation: is the average of the datas absolute deviations from the mean.
6. Population Variance: is the average of the populations squared deviations from the mean.
The population standard deviation is simply the square root of the population variance.
7. Sample Variance: is the average of the sample datas squared deviations from the sample mean.
The sample standard deviation is

=
=
N
i
i X
X
N
1
1

=
=
n
i
i
X
n
X
1
1

=
=
n
i
i i weighted
X w X
1
n
n
X X X X G ...
3 2 1
=

=
=
n
i
i
X X
n
MAD
1
1
( )

=
=
N
i
i
X
N
1
2 2
1
o
( )
( )

=
n
i
i
X X
n
s
1
2
2
1
1
8. Covariance describes the co-movement between 2 random numbers, given as :
Cov(X
1
, X
2
) =
12

9. Correlation coefficient is a unit-less number, which gives a measure of linear dependence between
two random variables. (X
1
, X
2
) = Cov(X
1
, X
2
) /
1

2
10. Portfolio Expected Return:
E(r
p
) = w
A
r
A
+ (1-w
A
)r
B
Portfolio Variance:
OR
11. Coefficient of variation
12. Sharpe measure
13. Addition Rule
Used to Get Compound Probabilities for Union of Events: P(A OR B) = P(A U B) = P(A) + P(B) - P(A B)
For Mutually Exclusive Events: P(A OR B) = P(A U B) = P(A) + P(B)
14. Sum Rule & Bayes Theorem


Out of a group of 100 patients being treated for chronic back trouble, 25% are chosen at random to
receive a new, experimental treatment as opposed to the more usual muscle relaxant-based therapy
which the remaining patients receive. Preliminary studies suggest that the probability of a cure with the
standard treatment is 0.3, while the probability of a cure from the new treatment is 0.6.
15. Discrete Probability Distributions
Probability distribution for a Binomial random variable is given by:
16. Normal Distribution Random Variable
General Normal random variable X ~ N (,
2
)
X can be standardized to a Standard Normal random variable.
Resulting variable has mean zero and variance equal to 1.
Y X
Y X
XY E Y X Cov
Y X E Y X Cov


=
=
) ( ) , (
)] )( [( ) , (
( ) ( ) ( )
B A A A B A A A r
r r Cov w w w w
p
, 1 2 1
2 2 2 2 2
+ + = o o o
( ) ( )
B A AB A A B A A A r
w w w w
p
o o o o o + + = 1 2 1
2 2 2 2 2
X
s
CV =
p
f p
r r
SM
o
) (
=
) ( ) / ( ) ( ) / ( ) ( ) ( ) (
c c c
A P A B P A P A B P B A P B A P B P + = + =
) ( ) / ( ) ( ) / (
) ( ) / (
) / (
c c
A P A B P A P A B P
A P A B P
B A P
+
=
x n x
x
n
p p C x X P

= = ) 1 ( ) (
o

=
X
Z
17. Confidence Intervals
The standard error of the mean (s
x
) is given by:
18. Errors in Estimation
Type I and Type II Errors
Type I error occurs if the null hypothesis is rejected when it is true
Type II error occurs if the null hypothesis is not rejected when it is false
Significance Level
o-> Significance level
The upper-bound probability of a Type I error
1 - o ->confidence level
The complement of significance level
19. The sample variance for a pooled estimater is given as
20. Hypothesis Tests for Variances
n
s
s
x
=
2
) 1 ( ) 1 (
2 1
2
2 2
2
1 1 2
+
+
=
n n
s n s n
s