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Module 1

Ebbers Mounts an 'I Never Knew' Defense


By KEN BELSON

Published: March 1, 2005

Bernard J. Ebbers, the former WorldCom chief executive once hailed as one of the most brilliant
telecommunications entrepreneurs ever, told a packed courtroom yesterday, ''I don't know about
technology and I don't know about finance and accounting.''
In taking the stand in his own defense, Mr. Ebbers displayed a folksy innocence that was part of the
defense effort to cast him as someone who relied on others with greater expertise to handle the
details of running WorldCom as it grew from a small regional reseller of phone services to one of
the largest companies in America.
Under questioning by his lawyer, Reid Weingarten, Mr. Ebbers also disputed the prosecution's star
witness, Scott D. Sullivan, WorldCom's former chief financial officer, who testified that Mr. Ebbers
directed the fraud. Mr. Ebbers said over and over that Mr. Sullivan never told him that his
accounting changes ''weren't right'' and that he did not recall conversations that Mr. Sullivan said
they had.
''He has never told me he made an entry that wasn't right,'' Mr. Ebbers said. ''If he had, we wouldn't
be here today.''


He testified that he did poorly in college, where his ''marks weren't too
good,'' and that he bounced from one job to another, working as a
milkman, basketball coach and warehouse manager, before he and a small
group of investors started the predecessor of WorldCom in 1983.
2
Enron case big test of the `idiot
defense'
Ex-chief vows to say he was blind to crimes
January 02, 2006|By Greg Burns, Tribune senior correspondent
The Enron Corp. trial opening Jan. 30 in Houston is shaping up to be
the biggest test yet of the so-called idiot defense.
Former Enron chief Kenneth Lay has vowed to tell jurors from the
witness stand that he knew nothing about crimes committed at the
energy company. And while Wednesday's plea bargain by co-
defendant Richard Causey, a former top Enron accountant, is a blow
to the defense, it is unlikely to change a defense strategy that boils
down to a simple theme: Blame Fastow.


No chief executive "knows everything going on in his company," Lay said
in one of his speeches, so no one should expect him to take responsibility
for the crimes of an executive he portrays as Enron's chief villain. "I did not
know what he was doing."
The key issue is obvious: How could a seasoned
executive paid lavishly over a long period know nothing
about such an audacious rip-off?
3









4
Japanese Prosecutors Arrest Livedoor Chief
By JAMES BROOKE

TOKYO, Jan. 23, 2006 - Takafumi Horie, the brash, T-shirted entrepreneur whose rise captivated Japan and whose fall
spooked the Tokyo Stock Exchange, was arrested tonight on suspicion of spreading false financial information to
deceive investors.

Prosecutors said Mr. Horie and three other executives of Livedoor Co. who were also arrested tried to pump up share
prices by spreading false information, issuing new shares to "acquire" firms already under their control and then selling
the companies to create false "profits."

It was a steep fall for the self-made 33-year-old who only last month was telling workers at a company Christmas party
that his ambition was to make his Internet-based conglomerate the largest company in the world. A University of
Tokyo dropout, Mr. Horie parlayed a 1995 investment of $50,000 into a company that had a $6 billion market
capitalization before last week's crash.

A celebrity member of the "Roppong Hills Tribe," so named for the chic high rise complex where fellow Internet entrepreneurs live, work, and play,
Mr. Horie frequently appeared on television talk shows, becoming the spokesman for an aggressive, self-assured "New Japan.

After he tried to break Japan's baseball cartel and save a hometown team, the public affectionately nicknamed the chubby businessman Horie-mon,
after Doraemon, a cartoon cat. Last August, Prime Minister Junichiro Koizumi tapped this generational icon to run against a ruling party "dinosaur."
The party elder won, but the race further boosted the aura of a business upstart who once said: "All the evils come from aged business managers.

Indeed, while many Japanese debate the rights and wrongs of the financial charges against him, the transgressions by Mr. Horie that caused millions of
Japanese to gasp were societal and sartorial. As part of his general disrespect for older business leaders, he would often wear a T-shirt to negotiations
with men in suits.

In a country where consensus and the common good are held up as ideals, Mr. Horie tooled around Tokyo in a Ferrari with various models as
girlfriends. He wrote books like "How to Make 10 Billion Yen." On quiz shows, when confronted with the unexpected, he was the picture of cool,
saying: "I expected that."

I never studied accounting, Horie testified in November.
A management book I read said to leave that to
specialists, so thats what I did.
Reuters, 16 March 2007
Enacted in the wake of corporate mismanagement
and accounting scandals
Sarbanes-Oxley (SOX) offers guidelines and spells
out regulations that publicly traded companies must
adhere to in the United States.
The Indian Context
Recent Fraud in
India
The Role of
Regulation
Looking Ahead
The Role of
Technology
How large public players get away
with fraud
Uniqueness of fraud in Indian
context. Role of Family ownership
Pressure on management by Stock
based incentive schemes
Impact of Mark-to-Market
Accounting

Regarding Clause 49 of Listing
Agreement and the Sarbanes
Oxley Act
New Laws in the pipeline
Regarding the Setting up of
independent body to oversee
role of auditors
Role of Auditors: Watchdogs or
Bloodhounds?

Impact of
technology in
ease of
committing
/detecting fraud
Ghost Payrolling
and Fraud

Role and potential growth
of Forensic Accounting in
India
Looking ahead - New
regulations, accounting
standards
5
Why do Firms exist?

What are the goals that they are driven by?

Profit Maximization Vs Wealth Maximization

What is the difference between the two?
Goal Objective Advantages Dis advantages
Profit maximi zation Large profits 1. Easy to calculate profits.
2. Easy to determine the link between
financial decisions and profits.
1. Emphasizes the short-term.
2. Ignores risk or uncertainty.
3. Ignores the timing of returns.
4. Requires immediate resources.
Stock holder wealth
maximi zation
Highest share
price of common
stock
1. Emphasizes the long term.
2. Recognizes risk or uncertainty.
3. Recognizes the timing of returns.
4. Considers stockholders` return.
1. Offers no clear relationship between
financial decisions and stock price.
2. Can lead to management anxiety and
frustration.
3. Can promote aggressive
and creative accounting practices.
A costly investment in machinery which would produce
huge saving in the long-run.

Consider two products, A and B, and their projected
earnings over the next five years, as shown below.


Year Product A Product B
1 $20,000 $22,000
2 $20,000 $22,000
3 $20,000 $22,000
4 $20,000 $22,000
5 $20,000 $22,000
$100,000 $110,000
Conflict of interest between a company's management
and the company's stockholders.

The manager, acting as the agent for the shareholders,
or principals, is supposed to make decisions that will
maximize shareholder wealth. However, it is in the
manager's own best interest to maximize his own
wealth.

Carrot or Stick which approach would yield the best
results?
What long-lived assets should
the firm invest in? Capital
Budgeting
How can the firm raise cash for
required capital expenditures? -
Capital Structure
How should short-term
operating cash flows be
managed? Net Working
Capital
Task of the
Financial Manager:
Create Value!!
Companies that solely focus on competition will ultimately die.
Those that focus on value creation will thrive. Mr. Edward De
Bono

The primary purpose of corporate leadership is to create wealth
ethically and legally. This translates to bringing a high level of
satisfaction to five constituencies customers, employees,
investors, vendors, and the society at large. Narayan Murthy

Management doesnt get paid to make its shareholders
comfortable. We get paid to make the shareholders rich. Mr.
Roberto Goizueta

If you dont satisfy shareholders, you dont have the flexibility to
take care of employees and communities. Mr. Jack Welch


Value creation is a corporation's raison d'tre, the ultimate measure
by which it is judged.

Debate has focused on what is the most appropriate type of value
for the corporation to create. Is it:

the value that the stockmarket gives the company (its market value);
the value shown in its balance sheet (the accounting or book value of its
assets minus its liabilities);
something based on its expected future performanceprofits or cash;
or
none of these?


Functions of Financial Managers:
Capital budgeting,
Capital Finance, and
Net working capital activities.

How do financial managers create value?
Try to buy assets that generate more cash than they cost.
Sell bonds and stocks and other financial instruments that
raise more cash than they cost.

A) Firm issues securities to raise cash (the financing decision).
(B) Firm invests in assets (capital budgeting).
(C) Firms operations generate cash flow.
(D) Cash is paid to government as taxes.
(E) Retained cash flows are reinvested in firm.
(F) Cash is paid out to investors in the form of interest and
dividends
Over time, if the cash
paid to shareholders and
bondholders (F) is
greater than the cash
raised in the financial
markets (A), value will be
created.
The Midland Company refines and trades gold. At the end of the year, it sold
2,500 ounces of gold for $1 million to one renowned jeweller. The company
had acquired the gold for $900,000 at the beginning of the year. The company
paid cash for the gold when it was purchased. Unfortunately, it has yet to
collect from the customer to whom the gold was sold. The following is a
standard accounting of Midland's financial circumstances at year-end:
Accounting Profit Perspective Vs Cash Flow Perspective

The Midland Company is considering expanding operations overseas.
It is evaluating Europe and Japan as possible sites. Europe is
considered to be relatively safe, whereas operating in Japan is seen as
very risky. In both cases, the company would close down operations
after one year.
After doing a complete financial analysis, Midland has come up with
the following cash flows of the alternative `plans for expansion under
three equally likely scenariospessimistic, most likely, and optimistic:

The Midland Company is attempting to choose between two proposals for
new products. Both proposals will provide additional cash flows over a four-
year period and will initially cost $10,000. The cash flows from the proposals
are as follows:
Would you prefer to have $1 million now or $1 million
10 years from now?

This illustrates that there is an inherent monetary value
attached to time
Premise: A dollar in hand today is worth more than a
dollar to be received in the future
Why?
A dollar on hand today can be invested to earn interest to
yield more than a dollar in the future.
The amount of interest earned depends on the rate of
return that can be earned on the investment

Assume that you deposit $1,000 at a compound
interest rate of 7% for 2 years.
FV
2
0 1 2
$1,000
7%
FV
1
= P
0
(1+i)
1
= $1,000 (1.07)
= $1,070
Compound Interest
You earned $70 interest on your $1,000 deposit
over the first year.

This is the same amount of interest you would
earn under simple interest.
FV
1
= P
0
(1+i)
1
= $1,000 (1.07)
= $1,070
FV
2
= FV
1
(1+i)
1

= P
0
(1+i)(1+i) = $1,000(1.07)(1.07)
= P
0
(1+i)
2
= $1,000(1.07)
2

= $1,144.90

You earned an EXTRA $144.90 in Year 2 with compound
over simple interest.
FV
1
= P
0
(1+i)
1

FV
2
= P
0
(1+i)
2


General Future Value Formula:
FV
n
= P
0
(1+i)
n

or FV
n
= P
0
(FVIF
i,n
)
Julie Miller wants to know how large her deposit of $10,000
today will become at a compound annual interest rate of 10% for
5 years.
FV
5
0 1 2 3 4 5
$10,000
10%
Calculation based on general formula:
FV
n
= P
0
(1+i)
n

FV
5
= $10,000 (1+ 0.10)
5

= $16,105.10
Assume that you need $1,000 in 2 years. Lets examine the
process to determine how much you need to deposit today at a
discount rate of 7% compounded annually.
0 1 2
$1,000
7%
PV
1
PV
0
PV
0
= FV
2
/ (1+i)
2
= $1,000 / (1.07)
2
= FV
2
/ (1+i)
2

=$873.44
0 1 2
$1,000
7%
PV
0
PV
0
= FV
1
/ (1+i)
1

PV
0
= FV
2
/ (1+i)
2


General Present Value Formula:
PV
0
= FV
n
/ (1+i)
n

or PV
0
= FV
n
(PVIF
i,n
)
Julie Miller wants to know how large of a deposit to make so
that the money will grow to $10,000 in 5 years at a discount rate
of 10%.
0 1 2 3 4 5
$10,000
PV
0
10%
Calculation based on general formula:
PV
0
= FV
n
/ (1+i)
n

PV
0
= $10,000 / (1+ 0.10)
5

= $6,209.21

An annuity is a series of equal dollar payments that
are made at the end of equidistant points in time
such as monthly, quarterly, or annually over a finite
period of time.
If payments are made at the end of each period, the
annuity is referred to as ordinary annuity.
Example 6.1 How much money will you accumulate
by the end of year 10 if you deposit $3,000 each for
the next ten years in a savings account that earns 5%
per year?

The time line: i=5%

Time
Cashflow: 3000 3000 3000
FV [?]
We want to know the future value of the 10 cash flows.
We can compute the future value of each cash flow and
sum them together:

3000(1.05)
9
+ 3000(1.05)
8
+ + 3000 = 37,733.68

0 1 2 10
Since the annuity cash flow has a strong pattern, we
can also compute the future value of the annuity
using a simple formula:



FV
n
=
FV of annuity at the end of nth period.
PMT = annuity payment deposited or received at the end of
each period.
i = interest rate per period
n = number of periods for which annuity will last.


35
$3,000 for 10 years at 5% rate. Use the formula



FV = $3000 {[ (1+.05)
10
- 1] (.05)}
= $3,000 { [0.63] (.05) }
= $3,000 {12.58}
= $37,733.68


36
Instead of figuring out how much money you will
accumulate (i.e. FV), you may like to know how much you
need to save each period (i.e. PMT) in order to accumulate
a certain amount at the end of n years.
In this case, we know the values of n, i, and FV
n
in the
formula FV
n
=PMT [((1+i)
n
-1)/i], and we need to determine
the value of PMT.
PMT=FV
n
/[((1+i)
n
-1)/i].
37
Example 6.2: Suppose you would like to have $25,000 saved 6
years from now to pay towards your down payment on a new
house. If you are going to make equal annual end-of-year
payments to an investment account that pays 7%, how big do
these annual payments need to be?
How much must you deposit in a savings account earning 8%
interest in order to accumulate $5,000 at the end of 10 years?
If you can earn 12% on your investments, and you would like
to accumulate $100,000 for your childs education at the end
of 18 years, how much must you invest annually to reach your
goal?
Verify the answers: 3494.89; 345.15;1793.73
FIN3000, Liuren Wu 38
Suppose you would like to have $25,000 saved 6 years from now to
pay towards your down payment on a new house. If you are going to
make equal annual end-of-year payments to an investment account
that pays 7%, how big do these annual payments need to be?

How much must you deposit in a savings account earning 8%
interest in order to accumulate $5,000 at the end of 10 years?

If you can earn 12% on your investments, and you would like to
accumulate $100,000 for your childs education at the end of 18 years,
how much must you invest annually to reach your goal?

Verify the answers: 3494.89; 345.15;1793.73
FIN3000, Liuren Wu 39
The present value of an ordinary annuity measures the value
today of a stream of cash flows occurring in the future.
Example: What is the value today or lump sum equivalent of
receiving $3,000 every year for the next 30 years if the
interest rate is 5%?
If I know its future value, I can compute its present value.
PV= FV
n
/(1+i)
n
, where

= PMT[ ((1-(1+i)
-n
)/i]

For the example, FV=199,316.54. PV=46,117.35.
FIN3000, Liuren Wu 40
FIN3000, Liuren Wu 41
One can also compute the PV of each cash flow and sum them up.
The Present Value of an Ordinary Annuity
Your grandmother has offered to give you $1,000 per year for the next
10 years. What is the present value of this 10-year, $1,000 annuity
discounted back to the present at 5%?

FIN3000, Liuren Wu 42






Verify the answer:7721.73;
FIN3000, Liuren Wu 43






Verify the answer:7721.73;
An amortized loan is a loan paid off in equal
payments consequently, the loan payments are an
annuity.
Examples: Home mortgage loans, Auto loans
In an amortized loan, the present value can be
thought of as the amount borrowed, n is the
number of periods the loan lasts for, i is the interest
rate per period, and payment is the loan payment
that is made.

FIN3000, Liuren Wu 44
Suppose you plan to get a $9,000 loan from a
furniture dealer at 18% annual interest with annual
payments that you will pay off in over five years.
What will your annual payments be on this loan?
PMT=PV/[(1-(1+i)
n
)/i] =2,878.00.
FIN3000, Liuren Wu 45
Year Amount Owed on
Principal at the
Beginning of the
Year (1)
Annuity
Payment (2)
Interest
Portion
of the
Annuity (3) =
(1) 18%

Repayment of
the Principal
Portion of the
Annuity (4) =
(2) (3)
Outstanding
Loan Balance at
Year end, After
the Annuity
Payment (5)
=(1) (4)
1 $9,000 $2,878 $1,620.00 $1,258.00 $7,742.00
2 $7,742 $2,878 $1,393.56 $1,484.44 $6,257.56
3 $6257.56 $2,878 $1,126.36 $1,751.64 $4,505.92
4 $4,505.92 $2,878 $811.07 $2,066.93 $2,438.98
5 $2,438.98 $2,878 $439.02 $2,438.98 $0.00
FIN3000, Liuren Wu 46
Payments are required at the beginning of each period. Rent is an
example of annuity due. You are usually required to pay rent when you
first move in at the beginning of the month and then on the first of
each month thereafter.
Calculating the Future Value of an Annuity Due
When you are receiving or paying cash flows for an annuity due, your
cash flow schedule would appear as follows:
Let's assume that you are receiving $1,000 every year for the next five
years, and you invested each payment at 5%. The following diagram
shows how much you would have at the end of the five-year period:

Ordinary Annuity : Annuity Due:

( )
( ) i
i
i
n
+
(

+
= 1 *
1 1
* PMT FV
Due Annuity
A perpetuity is a constant stream of identical cash flows with no end.
The formula for determining the present value of a perpetuity is as
follows:


PV is the value of the perpetuity today
C is the recurring payment
r is the required interest rate (not dividend rate)

You want to endow an annual graduation party at your alma mater that is
budgeted to cost $30,000 per year forever. If the university can earn 8%
per year on its investments and the first party is in one years time, how
much will you need to donate to endow the party?


PV(C in perpetuity) =
C
r

PV = C/ r =$30, 000/ 0.08 =$375,000 today
Preferred stock is an example of a perpetuity.
The holder of preferred stock is promised a fixed cash dividend every
period (usually quarter). It is called preferred because the dividend is
paid before common stock dividends but after interest payments.
Suppose GM wants to sell preferred stock at $100 per share. A very
similar issue of preferred stock outstanding has a price of $40 per
share and offers a dividend of $1 every quarter.
What dividend will GM have to offer if the preferred stock is to
sell for $100?
P
2
=C
2
/r $40=1/r r=0.025 P
1
=C
1
/r
$100=C
1
/0.025
C
1
= $2.50
Suppose your firm is trying to evaluate whether to buy an
asset. The asset pays off $2,000 at the end of years 1 and 2,
$4,000 at the end of year 3 and $5,000 at the end of year 4.
Similar assets earn 6% per year. How much should your
firm pay for this investment?

Rule: Discount cash flows to the present, one set of cash
flows at a time and then add them up.



Year


Cash Flow


Present Value
Factor


Present Value


1


2,000






2


2,000






3


4,000






4


5,000






Total Present Value
1 / (1.06) $1886.79
1 / (1.06)
2
$ 1779.99
1 / (1.06)
3
$ 3358.48
1 / (1.06)
4
$ 3960.73
$10,985.73
Investing for More than One Period:
Present Values and Multiple Cash Flows
Cash flows grow g % per time period
C = cash flow in first time period
The formula is:


Example: What is the PV of a $10 payment, growing at 3% per year, for 4
years, with r = 10%?



For a perpetual stream, growing at 3%, we get:
PV = C / (r - g) = 10 / (0.07) = $142.86

Par value: The face value of a bond. It is the dollar amount that is
assigned to a security when representing the value contributed for
each share in cash or goods.

Coupon rate : The yield paid by a fixed income security. A fixed
income security's coupon rate is simply just the annual coupon
payments paid by the issuer relative to the bond's face or par value.

Coupon payment: Payment according to the coupon rate

Maturity date : The date on which the principal amount of a note,
draft, acceptance bond or other debt instrument becomes due and is
repaid to the investor and interest payments stop.

A bond which was issued with a face
value of $1000 that pays a $25 coupon
semi-annually would have a coupon rate
of 5%. All else held equal, bonds with
higher coupon rates are more desirable
for investors than those with lower
coupon rates.
Current Yield : Annual income (interest or dividends) divided by the
current price of the security. This measure looks at the current price of
a bond instead of its face value and represents the return an investor
would expect if he or she purchased the bond and held it for a year.

Yield to Maturity (YTM) : The rate of return anticipated on a bond if it
is held until the maturity date. YTM is considered a long-term bond
yield expressed as an annual rate. The calculation of YTM takes into
account the current market price, par value, coupon interest rate and
time to maturity. It is also assumed that all coupons are reinvested at
the same rate. Sometimes this is simply referred to as "yield" for short.

Current Yield = Annual Cash Flows
Market price
V
B
= Present Value of coupon + present value of par
V
B
= present value of annuity + present value of lumpsum



where: V
B
= bond price
cpn = coupon payment per period
n = number of coupon payments
k = period yield or yield to maturity
par = par value or face value of bond
( ) ( )
n
n
i
par
k 1 k 1
cpn
V
1 i
B
+
+
+
=

=
Suppose you are looking at a bond that has a 10%
annual coupon rate and a face value of $1000. There
are 20 years to maturity. Bonds of similar risk and
maturity are yielding 8%. What should you pay for
the bond?

What is the coupon payment per period?
How many coupon payments are there?
What is the yield per period?
Compute the bond price = 1196.36

What is the price of a 30-year bond that has a 1000
par value and a 9% coupon rate with coupons paid
semiannually, if the market rate is 10%

What is the coupon payment per period?
How many coupon payments are there?
What is the yield per period?
Compute the bond price = 905.35

If YTM > coupon rate, then bond price < par value
Selling at a discount

If YTM < coupon rate, then bond price > par value
Selling at a premium

IF YTM = coupon rate, then bond price = par value
Consider a bond with a $1000 face value, 20 years to
maturity and an annual coupon rate of 10%. What is
the bond price in each of the following cases?

YTM = 11%; price = 920.37
YTM = 10%; price = 1000.00
YTM = 9%; price = 1091.29

Management and investors are both interested in the
yield-to-maturity on a bond
it is the return to the investor in the market and an
indication of the cost of debt to the firm

Solve for YTM given N, PMT, PV and FV where
PMT = periodic coupon payment
PV = current market price of bond
FV = Face or Par Value of Bond
N = Number of periods until the bonds maturity

Requires trial and error if you dont have a financial
calculator
If a bond is selling for $938.55, it has a $1000 par
value and it pays a $90 annual coupon. If there are
10 years until its maturity, what is its YTM?
Without calculations, will the YTM will more or less
than 9%?
Signs matter since we are solving for I/Y
10 n; -938.55 PV; 1000 FV; 90 PMT
compute I/Y = 10%

Current Yield and its relationship to YTM
If a bond with a 10% coupon rate, with coupons paid
semi-annually, has a face value of $1000, 20 years to
maturity and is selling for 1197.93. What is the YTM?
Without doing calculations, is the YTM more or less
than the annual coupon rate?

n = 40; PMT = 50; FV = 1000; PV = -1197.93
compute I/Y = 8%

Interest Rate Risk
change in price due to changes in interest rates
long-term bonds have more interest rate risk than short-
term bonds
Reinvestment Rate Risk
uncertainty concerning rates cash flows can be reinvested
at short-term bonds have more reinvestment rate risk than
long-term bonds
Default Risk
Not as bad as stock, but still there



Why Value Stock

Transactions involving Stock
Secondary Market Trading
IPOs
Share Buybacks

How to Determine Fair Value
Expected Dividend: Price is discounted value of
expected dividends


Where k
S
is the cost of capital

Constant Growth: Used to evaluate growing firms



Firms value is net present value of free cash flows,
discounted at the weighted average cost of capital.
Best overall model.
Can apply to all types of firms.
The principle that potential return rises with an
increase in risk.
Low levels of uncertainty (low-risk) are associated
with low potential returns, whereas high levels of
uncertainty (high-risk) are associated with high
potential returns.
According to the risk-return tradeoff, invested
money can render higher profits only if it is subject
to the possibility of being lost
72
The future is uncertain.
Investors do not know with certainty whether the
economy will be growing rapidly or be in recession.
Investors do not know what rate of return their
investments will yield.
Therefore, they base their decisions on their expectations
concerning the future.
The expected rate of return on a stock represents the
mean of a probability distribution of possible future
returns on the stock.
73
The table below provides a probability distribution for the returns on
stocks A and B
State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
The state represents the state of the economy one period in the future i.e.
state 1 could represent a recession and state 2 a growth economy.
The probability reflects how likely it is that the state will occur. The sum
of the probabilities must equal 100%.
The last two columns present the returns or outcomes for stocks A and B
that will occur in each of the four states.
74
Given a probability distribution of returns, the expected
return can be calculated using the following equation:

N
E[R] = E (p
i
R
i
)
i=1
Where:
E[R] = the expected return on the stock
N = the number of states
p
i
= the probability of state i
R
i
= the return on the stock in state i.
75
In this example, the expected return for stock A
would be calculated as follows:

E[R]
A
= .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%

Now you try calculating the expected return for
stock B!

76
Did you get 20%? If so, you are correct.

If not, here is how to get the correct answer:

E[R]
B
= .2(50%) + .3(30%) + .3(10%) + .2(-10%) = 20%

So we see that Stock B offers a higher expected
return than Stock A.
However, that is only part of the story; we haven't
considered risk.
77
Risk reflects the chance that the actual return on
an investment may be different than the expected
return.
One way to measure risk is to calculate the
variance and standard deviation of the
distribution of returns.
We will once again use a probability distribution
in our calculations.
The distribution used earlier is provided again for
ease of use.
78
Probability Distribution:

State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%

E[R]
A
= 12.5%
E[R]
B
= 20%
79
Given an asset's expected return, its variance can be
calculated using the following equation:
N
Var(R) = o
2
= E p
i
(R
i
E[R])
2
i=1

Where:
N = the number of states
p
i
= the probability of state i
R
i
= the return on the stock in state i
E[R] = the expected return on the stock

80
The standard deviation is calculated as the positive square root of the
variance:
SD(R) = o = o
2
=

(o
2
)
1/2
= (o
2
)
0.5


The variance and standard deviation for stock A is calculated as follows:

o
2
A
= .2(.05 -.125)
2
+ .3(.1 -.125)
2
+ .3(.15 -.125)
2
+ .2(.2 -.125)
2
= .002625

o
A
= (.002625)
0.5
= .0512 = 5.12

Now you try the variance and standard deviation for stock B!
If you got .042 and 20.49% you are correct.
81
If you didnt get the correct answer, here is how to get it:

o
2
B
= .2(.50 -.20)
2
+ .3(.30 -.20)
2
+ .3(.10 -.20)
2
+ .2(-.10 - .20)
2
= .042

o
B
= (.042)
0.5
= .2049 = 20.49

Although Stock B offers a higher expected return than Stock A, it also is
riskier since its variance and standard deviation are greater than Stock A's.

This, however, is still only part of the picture because most investors choose
to hold securities as part of a diversified portfolio.
82
Most investors do not hold stocks in isolation.
Instead, they choose to hold a portfolio of several stocks.
When this is the case, a portion of an individual stock's
risk can be eliminated, i.e., diversified away.
From our previous calculations, we know that:
the expected return on Stock A is 12.5%
the expected return on Stock B is 20%
the variance on Stock A is .00263
the variance on Stock B is .04200
the standard deviation on Stock A is 5.12%
the standard deviation on Stock B is 20.49%

83
The Expected Return on a Portfolio is computed as the weighted
average of the expected returns on the stocks which comprise the
portfolio.
The weights reflect the proportion of the portfolio invested in the
stocks.
This can be expressed as follows:
N
E[R
p
] = E w
i
E[R
i
]
i=1
Where:
E[R
p
] = the expected return on the portfolio
N = the number of stocks in the portfolio
w
i
= the proportion of the portfolio invested in stock i
E[R
i
] = the expected return on stock i
84
For a portfolio consisting of two assets, the above equation
can be expressed as:
E[R
p
] = w
1
E[R
1
] + w
2
E[R
2
]

If we have an equally weighted portfolio of stock A and
stock B (50% in each stock), then the expected return of
the portfolio is:
E[R
p
] = .50(.125) + .50(.20) = 16.25%
85
The variance/standard deviation of a portfolio reflects not only the
variance/standard deviation of the stocks that make up the portfolio
but also how the returns on the stocks which comprise the portfolio
vary together.

Two measures of how the returns on a pair of stocks vary together
are the covariance and the correlation coefficient.
Covariance is a measure that combines the variance of a stocks returns
with the tendency of those returns to move up or down at the same time
other stocks move up or down.
Since it is difficult to interpret the magnitude of the covariance terms, a
related statistic, the correlation coefficient, is often used to measure the
degree of co-movement between two variables. The correlation
coefficient simply standardizes the covariance.

86
The Covariance between the returns on two stocks can be
calculated as follows:
N
Cov(R
A
,R
B
) = o
A,B
= E p
i
(R
Ai
- E[R
A
])(R
Bi
- E[R
B
])

i=1
Where:
o
A,B
= the covariance between the returns on stocks A and B
N = the number of states
p
i
= the probability of state i
R
Ai
= the return on stock A in state i
E[R
A
] = the expected return on stock A
R
Bi
= the return on stock B in state i
E[R
B
] = the expected return on stock B
87
The Correlation Coefficient between the returns on two
stocks can be calculated as follows:
o
A,B
Cov(R
A
,R
B
)
Corr(R
A
,R
B
) =
A,B
= o
A
o
B
= SD(R
A
)SD(R
B
)

Where:

A,B
=the correlation coefficient between the returns on stocks A and B
o
A,B
=the covariance between the returns on stocks A and B,
o
A
=the standard deviation on stock A, and
o
B
=the standard deviation on stock B
88
The covariance between stock A and stock B is as follows:

o
A,B
= .2(.05-.125)(.5-.2) + .3(.1-.125)(.3-.2) +
.3(.15-.125)(.1-.2) +.2(.2-.125)(-.1-.2) = -.0105

The correlation coefficient between stock A and stock B is as
follows:
-.0105

A,B
= (.0512)(.2049) = -1.00
89
Using either the correlation coefficient or the covariance, the
Variance on a Two-Asset Portfolio can be calculated as
follows:

o
2
p
= (w
A
)
2
o
2
A
+ (w
B
)
2
o
2
B
+ 2w
A
w
B

A,B
o
A
o
B

OR
o
2
p
= (w
A
)
2
o
2
A
+ (w
B
)
2
o
2
B
+ 2w
A
w
B
o
A,B


The Standard Deviation of the Portfolio equals the
positive square root of the the variance.
90
Lets calculate the variance and standard deviation of a portfolio
comprised of 75% stock A and 25% stock B:

o
2
p
=(.75)
2
(.0512)
2
+(.25)
2
(.2049)
2
+2(.75)(.25)(-1)(.0512)(.2049)= .00016

o
p
= .00016 = .0128 = 1.28%

Notice that the portfolio formed by investing 75% in Stock A and
25% in Stock B has a lower variance and standard deviation than
either Stocks A or B and the portfolio has a higher expected return
than Stock A.
This is the purpose of diversification; by forming portfolios, some of
the risk inherent in the individual stocks can be eliminated.



End of Module 1