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You are on page 1of 91

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

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