Professional Documents
Culture Documents
+
= 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