FM212 (2012-13 syllabus), ivantwk@gmail.

com 1
FM212 HIGHLIGHTS

(1, 2) Calculating present value

Discount rates, discount factors, PV and NPV

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Perpetuity: An asset that pays CF in perpetuity

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Annuity: An asset that pays CF each year for a fixed
number of years

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Compound and simple interest

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Nominal and real interest rates: Be consistent when
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(3) Value of bonds and stock

Bonds

YTM: Implicit constant interest rate based on future
CF and current bond price

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Stocks

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Valuing stocks: Dividend discount model

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Gordon growth multiple (g): Assume that ROE, PBR
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Present value of growth opportunities (PVGO)

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FM212 (2012-13 syllabus), ivantwk@gmail.com 2

Price change with and without growth

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(4) Risk and return

Variance: Measure of total risk of a security and is a
measure of stand-alone risk. Total risk has both
unique and market risk characteristics. Government
and risk-free bonds have standard deviation of 0

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Portfolio risk

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Portfolio variance increases with higher financing
margins (e.g. financing through borrowing). Portfolio
standard deviation doubles when 50% of total amount
can be borrowed

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Beta: Measure of the volatility of the securitys returns
to changes in market returns (measure of market risk).
Diversification lowers idiosyncratic risks but does not
affect market risk (ie. nondiversifiable risk)

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(5) Portfolio theory

Markowitz portfolio theory: Combining stocks into
portfolios can reduce SD below the level obtained
from a simple weighted average calculation



Lending and borrowing: Lending and borrowing at the
risk free rate enables one to attain all possible
expected returns located on the line joining !
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to the
efficient portfolio

Mean Variance Efficient portfolio: Combination of
stocks that has the lowest risk for a given return
expectation the best possible portfolio

Security market line: Linear relationship between risk
(beta) and expected return that makes one indifferent
to taking a long/short position on that asset. Assets
above the SML are undervalued (long), whereas
assets below the SML are overvalued (short)

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True SML vs CAPM: The true SML has a higher
vertical intercept and is flatter than the SML modelled
in the CAPM. This may be due to (1) risk-seeking
investors who are leverage-constrained would
demand high beta stocks, driving up their prices and
driving down expected returns, (2) true beta
measurements underestimate the market risk
Lend
Borrow
Long
Short
1
r_m
FM212 (2012-13 syllabus), ivantwk@gmail.com 3
premium (ie. slope of the SML), (3) low beta stocks are
often overlooked by investors and tend to be
undervalued

Sharpe ratio: The Sharpe ratio characterizes how well
the return of an asset compensates the investor for
the additional risk taken. Holding all else equal, an
asset with a higher Sharpe ratio provides better
returns for the same risk. The market portfolio has the
highest Sharpe ratio

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Arbitrage Pricing Theory: An alternative to CAPM,
relying on multiple betas (e.g. macroeconomic
indicators) to measure sensitivity to multiple risk
factors not just the market factor

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Comparing CAPM and APT

Model Advantages Disadvantages
CAPM Considers only
systematic risk,
reflecting a reality in
which most investors
hold diversified
portfolios

Generates a
theoretically-derived
relationship between
return and
systematic risk

Difficult to estimate
market return and
beta

World capital
markets are not
perfect, assets may
be priced incorrectly
and individual
investors may not be
able to borrow at the
risk-free rate
APT Excludes the
measurement of
market efficient
portfolios

Allows for multiple
sources of risk that
affect stock returns

Demands that
investors perceive
and reasonably
estimate factor
sensitivities

(6) Market efficiency

Random Walk Theory: Movement of stock prices from
day to day do not reflect any pattern. Statistically, the
movement of stock prices is random with a positive
drift over the long term

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Forms of market efficiency

Form of efficiency Description
Weak (ie. markets have
no memory)
It is impossible to make
consistently superior
profits by studying past
returns. Prices follow a
random walk

Semistrong (ie. there are
no financial illusions)
Prices reflect all past
information and current
public information. Prices
will adjust immediately to
information as it becomes
publically available

Strong (ie. trust market
prices)
Prices reflect all
information that can be
acquired by the analysis
of the company the
economy both public
and private


(7) Put and call options

Call option: The right to buy a security at a specified
price within a specified time exercise when P >
Strike (call option is in the money)

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Put option: The right to sell a security at a specified
price within a specified time exercise when P <
Strike (put option is in the money)

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Long (Buy) Short (Sell)
Call option Right to buy Oligation to sell
Put option Right to sell Obligation to buy

Black-Scholes variables: Any change in expected
return has no effect on call option prices. Since the
underlying prices are constant, a higher expected
option payoff is discounted at an exactly offsetting
higher rate

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FM212 (2012-13 syllabus), ivantwk@gmail.com 4
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Volatility,
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Option payoff (Option price = 0, kink at EX)

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Option profit (Option price = p, kink at EX)

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Put-call parity: If two security packages have identical
payoffs in all states in the next period, they must have
identical prices this period (assuming no arbitrage).
Holding stock price and risk-free rate constant,
anything that increases the call price must increase
the put price by the same amount

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Exploiting arbitrage opportunities

Put + Stock < Call + EX Put + Stock > Call + EX
Buy put and stock

Borrow PV(EX)

Sell call
Buy call

Lend PV(EX)

Sell put and stock

(8) Options pricing theory

(1) Replicating strategy: Value options by constructing
option equivalents. We calculate at each terminal
stock price the portfolio of delta shares plus
borrowing that has the same payoff as the option. We
then set the price of the option to equal the replicating
portfolio, working backwards until the starting date (d
= option delta/hedge ratio, x = risk-free rate)



Option delta/hedge ratio: A measure of the sensitivity
of changes in option price in relation to small changes
in stock price. Delta tells us the fractional shares of
EX
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EX
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50
60
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30
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30d + 1.01x = 0
FM212 (2012-13 syllabus), ivantwk@gmail.com 5
stock needed to hedge the risk of 1 option. A call will
be exercised when delta is 1 (equivalent to buying the
stock with a deferred payment so a one-dollar
change in the stock price matches a one-dollar
change in the option price), not exercised when delta
is 0 (option is essentially valueless, regardless of
change in stock price)

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(2) Binomial risk-neutral probability: Value options by
calculating risk-neutral probabilities the hypothetical
probabilities that upward and downward stock price
movements will give an expected return that is equal
to the risk-free return. We price the option by taking
next-period prices and calculating expected values
using risk-neutral probabilities, discounting
backwards until the starting date

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Multi-period risk-neutral probability

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Binomial model

Call options without dividends: In the absence of
dividends, the value of a call option increases with
time to maturity (ie. exercising early would reduce its
value). Hence American and European calls have the
same value



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Put options without dividends: American and
European put options differ in price with or without
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[1] (A)
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(udA - EX) or 0
[6] (ddA)
(ddA - EX) or 0
European Put
100
(17.71)
125
(5.28)
156.25
(0)
80
(28.91)
100
(10)
64
(46)
American Put
100
(18.46)
125
EX: -15
No EX: 5.28
156.25
(0)
80
EX: 30
No EX: 28.91
100
(10)
64
(46)
FM212 (2012-13 syllabus), ivantwk@gmail.com 6
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Call options with dividends (same for put options)

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(9) Valuing government bonds

Valuing a bond: The price of a bond is negatively
related to yield/YTM. Coupon is negatively related to
the length of the maturity period

YTM: Implicit constant interest rate based on future
CF and current bond price

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Bond duration: A weighted average time to maturity of
all cash flow payments of the bond. It measures the
true time length of the bond adjusted for the size of
the cash flow and when it is received. A higher
duration implies higher volatility

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Purpose of bond duration: Duration can be used to
measure a portfolios interest rate risk exposure.
Liabilities can also be matched with portfolios of
similar durations so as to hedge risk from interest rate
changes

Modified duration/volatility: A measure of the
sensitivity of changes in bond price in relation to a 1%
change in interest rate (absolute, not % change)

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Forward rate: The expected interest rate, fixed today,
on a loan made in the future at a fixed time

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Spot rate: The actual interest rate today for relevant
maturity. The future rate refers to the spot rate in the
future

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Zero coupon/strip bonds: A method for solving for n-
year spot rates (!
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European Call
100
(13.60)
No EX: 118
(28.78)
147.25
(57.25)
94.4
(4.4)
No EX: 73
(0.58)
91.25
(1.25)
58.4
(0)
100
(16.48)
EX: 125
(35)
No EX: 118
(28.78)
147.25
(57.25)
94.4
(4.4)
EX: 80
(0)
No EX: 73
(0.58)
91.25
(1.25)
58.4
(0)
FM212 (2012-13 syllabus), ivantwk@gmail.com 7
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Expectations theory and term structure: In equilibrium,
investment in a series of short-maturity bonds must
offer the same expected return as an investment in a
single long-maturity bond (only then will investors be
indifferent between holding both short and long-
maturity bonds). The future spot rate is the forward
rate. An upward sloping yield curve indicates that
investors anticipate short term interest rates to rise in
the future vice versa

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Liquidity preference and term structure: Short-term
rates tend to be lower than long rates due to the
preferences of borrowers for shorter-term liabilities
and lenders for longer-term assets. Short-term
investors must be offered a positive risk premium to
hold longer-term bonds (the future spot rate might be
lower than predicted by expectations). Positive slope
of the term structure does not necessarily mean that
short-term rates are expected to increase

Risk and term structure: In exchange for price and
interest rate volatility, investors without long-term
investment horizons will only hold long-term bonds if
they offer higher returns upward sloping yield curve

Inflation and term structure: If rising inflation is an
important risk for long-term investors (ie. future cash
flows will be less valuable), borrowers must offer
some extra incentives if they want investors to lend
long upward sloping yield curve

Coupon is negatively related to yield: A bond with a
higher (lower) coupon has a greater (smaller)
proportion of its total payments coming earlier when
interest rates are low. This explains a lower (higher)
yield. This means that zero coupon bonds have the
highest yields, whereas annuities (ie. fixed equal
payments annually) have the lowest yields

(10) Forwards and futures

Spot contract: A contract for immediate sale and
delivery of an asset. Spot prices are denoted as !
!


Forward contract: A contract for the delivery of an
asset at a set price on a set date in the future

Futures contract: Similar to a forward contract, but
with a standardizing intermediary (e.g. clearing house)

Futures vs forwards: Futures and forwards differ in the
following aspects that may account for differences in
prices

Difference Explanation
Futures are exchange-
traded whereas forwards
are not
Reduces counterparty
(credit) risk, making
futures more desirable
and hence more
expensive

Futures are marked to
market, whereas forwards
are not

Reduces counterparty
(credit) risk, making
futures more desirable
and hence more
expensive

If interest rates are
correlated with futures
price, futures buyers can
receive payments when
interest rates are high and
reinvest at a high rate.
Futures are hence more
expensive

Futures are written on
standard underlying
deliverables

Basis risk renders futures
less perfect hedge than
forwards. Futures may
hence be less expensive


Marking to market: Resetting the contract at the end
of each day to reflect changes in asset price so as to
lower counterparty risk (ie. contract default)



Pricing financial futures: Assume that short-term
dividend yield is risk-free, and dividends are paid just
before the futures contracts maturity date

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Pricing commodity futures: Commodity futures differ
from financial futures in the sense that yields are not
observable and depend on storage costs and
Buyer
(Long)
Seller
(Short)
Asset price falls (-Y)
Give seller Y
New contract price: F+X-Y
Asset price rises (+X)
Give buyer X
New contract price: F+X
FM212 (2012-13 syllabus), ivantwk@gmail.com 8
convenience. Net convenience yield is determined by
commodity users desire to hold the commodity for
production or consumption. NCY can vary over time
due to inventory and seasonal factors. Excessive
inventories can reduce convenience yield to zero,
whereas commodity shortages can drive up
convenience yields

!"#! !"# %&'("')"'%" *)"+, -.&/ 0&+,)'1 )'("'#&.*

!
!!!
! !
!"# %"&"'() *(++ ,**(&
! !
!!!
! !
!
! ! !
!
! !"# %&'("')"'%"
!"#$% '($)*+),"-".,/ ."'' $..",/ '(." 0()1")+")0"


! ! !
!
! ! !
!
! !"#$%&' )#*"* ! !"#$%#&%#'% )&%*+
! !"# %&'("')"'%" *)"+,
!


!! ! !
!
! ! !
!
! !"#
!


Replicating a commodity future

!!"##"$ !
!
!" !
!
!"# %&' ()* +,--,#.(' (,#!'

!!"#"$$"%& ()** +"##",-./& 01/ (."$12)& $)01/ *"13
!
!!!
! !
!
! ! !
!
! !"#$%#&%#'% ! !"#$%&'

!!"#$%&'() %+ %,# -+./(." .(%#0 +%,#./&1# (.2&%.(3#

Pricing foreign exchange futures: Let F denote the
price of forex futures in home currency (e.g. $X/). Let
P denote the price of forex in home currency (e.g.
$Y/). Let r* denote the foreign risk-free interest rate
and !
!
denote the domestic risk-free interest rate



!
!!!
! !
!"# %"&"'(
! !
!!!
! !
!
! ! !
!
! ! !
!


!! ! !
!
! ! !
!
! ! !
!


!"#$%&'#() %&$#$+,! ! ! !
!
! ! !
!
! ! !
!


Replicating a forex future: Suppose that X is
scheduled to be converted into $ in the next period,
with exchange rates fixed today

!!"##"$ !
!
! ! !
!
!"# %&"'()* *&#!+ !
!
!
!
! ! !
!


!!"#$%& (& !
!
!" $%! ! !
!
!
! ! !
!
! ! !
!
!" ! ! !

!!"#$%&'() %+ %,# -+./(." .(%#0 +%,#./&1# (.2&%.(3#

(11) Capital budgeting and the NPV rule

NPV rule: Converting future FCFs into comparable
risk-adjusted PVs that can be summed

!"!
!
! !"!
!
!
! !"!
!
! ! !
!
!
!
!!!
!!""#$% '( !"!
!
! !

Book rate of return (BRR): Average income divided by
average book value over project life

!"" !
!""# %&'"()
!""# %&&'(&


Payback period: Number of years required for
cumulative cash outflows to equal initial outlay

!"##$% '(#)%*+ +",+ !"#
!
!"!
!
! !"!
!
!
!!!


Internal rate of return (IRR): Discount rate that makes
NPV equal to zero (higher IRR is preferred)

!"# ! !"!
!
!
!"!
!
! ! !""
!
!
!!!
! ! !!""#$% '( !"" ! !
!


IRR using incremental CFs

!"!
!
! !"!
!!!!
! !"!
!!!!
!
!"!
!!!!
! !"!
!!!!
! ! !"!
!
!
!
!!!
! !

!" !"!
!
! !
!
! !"##$% '(#)%!* +

!"# ! ! !"!
!
!"#$ &'( )$*+,-. #$ /!0-1 2!+!-.* *02,-#2

Comparing investment appraisal methods

Method Advantages Disadvantages
NPV Recognizes the cost
of lending capital
(e.g. time value and
risk of money)

Depends on
forecasted CFs

PVs are additive

Ignores flexibility of
investment
decisions (see Real
options), potentially
underestimating
true value
BRR Market values and
CFs not considered

Average historic
profitability is not
the right hurdle for
evaluating future
investments

Payback FCFs after cutoff
date are ignored
Interest rate differential Expected ination rate difference
Forward and spot difference Expected change in spot rates
Interest rate parity
Expectations theory
PPP
Equal real interest
FM212 (2012-13 syllabus), ivantwk@gmail.com 9

FCFs before cutoff
date are assigned
equal weights

IRR Lending vs
borrowing: Not all
CFs decline with
increasing DR (high
returns for lenders
and low returns for
borrowers)

Multiple rates of
return: Certain CFs
can generate
NPV=0 at multiple
DRs

Mutually exclusive
projects: Magnitude
of project (in terms
of NPV) may be
ignored use
incremental CFs

Term structure: DRs
may not be stable
over the project
duration


Applying NPV: Profitability index

!" !
!"#
!"#$%&'$"&
!!"#"$% '()*"$%+ ,-%. .-/."+% 0123

Free cash flows (FCF)

!"! ! ! ! ! !"#$ ! !"# ! !!"# ! !"#$%

!"! ! ! ! ! !"#$%& ! !"#$ ! !!"# ! !"#$%

!"! ! !"#$%&'() +, ! !!"# ! !"#$%

Equivalent annual cost: An unbiased comparison of
projects with different economic lives and NPVs

!"# !
!"#
!""#$%& ()*%+,


Timing: Delay project if deferred NPV is larger

!"##$%& ()* !
!!
!
! ! !
!


(12) Real options

Decision trees example: Call option to expand

!
!
! !!!



!" !"!
!"#$%&
!
!!! !!!!!"" ! !!!!!""
! ! !!!
!
! !!"#

!" !"!
!"# %&'()*
!
!!! !!!!!"# ! !!!!!"#
! ! !!!
!
! !!"#

!" !"!
!"#$%&
! !" !"!
!"# %&'()*
!!"#$%&

!" !"!
!"#$
!
!!! !!!!!!" ! !!!!!""
! ! !!!
!
! !!"

!" !"!
!
!
!!!! !"" ! !"#
!"#$%&
! !!!!!"
! ! !!!
! !!

!"!
!
! !!"#
!!
!
! !!
!"!
!
! !"
!"!
!"#$
! !"#
!"!
!"#$%&
! !!!"

Decision trees example: No option to expand



!" !"!
!"
!
!!! !!!!!"# ! !!!!!"#
! ! !!!
!
! !!"#

!" !"!
!"#$
!
!!! !!!!!!" ! !!!!!""
! ! !!!
!
! !!"

!" !"!
!
!
!!!!!"" ! !!!!!"
! ! !!!
! !!"

!"!
!
! !!"#
!!
!
! !"
!"!
!
! !"
!"!
!"#$
! !"#
!"!
!"
! !!"

Value of option to expand

!"#$ &'()&* +#$," ! !!"
!"!
!
! !"
!"!
!
! !!"
CF_0 = -250
NPV = 117
CF_1a(0.6) =
100
Expand
CF_1a = -150
CF_2a(0.8) =
800
CF_2b(0.2) =
100
Not expand
CF_2a(0.8) =
410
CF_2b(0.2) =
180
CF_1b(0.4) =
50
CF_2a(0.4) =
220
CF_2b(0.6) =
100
CF_0 = -250
NPV = 52
CF_1a(0.6) = 100
CF_2a(0.8) = 410
CF_2b(0.2) = 180
CF_1b(0.4) = 50
CF_2a(0.4) = 220
CF_2b(0.6) = 100
FM212 (2012-13 syllabus), ivantwk@gmail.com 10

Decision tree example: Put option to abandon

!
!
! !!!"



!"!
!
!
!!!"#$!!" ! !!!"#$!!"
! ! !!!"
! !!"!!"

Decision tree example: No option to abandon



!"!
!
!
!!!"#$!!" ! !!!"#$!!
! ! !!!"
! !!!!!"

Value of option to abandon

!"#$%&$'($) &+),&$ -#./( ! !"!!"
!"!
!
! !!!!"
!"!
!
! !!!!"

(13) Payout policy

Dividend policy relevance vs irrelevance

Modigliani-Miller (M&M)
Dividend policy
irrelevance: Firm value
and shareholders wealth
do not change with
dividend policy. There is
merely a transfer of
wealth between new and
original shareholders.
Original owners capital
change exactly offsets
change in cash dividends
received

Lintner: Managers act as
if dividend policy is
relevant
Constant investment
but investments can be
made when dividends are
retained

No transactions costs
Firms have long-term
target dividend payout
ratios

Dividend changes follow
shifts in long-run
but investment banking
costs are incurred

Efficient capital markets
but information
asymmetry and market
mis-pricing exist

Managers maximize
shareholders wealth
but Principal-Agent
problems may exist

Homogeneous taxes
but tax rates on capital
gains and dividends differ

sustainable earnings

Managers are reluctant to
make dividend changes
that might have to be
reversed

Firms repurchase stock
with excess cash/replace
equity with debt


!"#$%$&' ! !"#$% '()*' ! !"#$ &'()&
!"#$ &'()*+
! ! ! !"# ! !
!"#$ &'()*&+


Dividend decision

!"!
!
! !"!
!
! !"#$ &'() ! !"#$%& #"&()!!"!
!
! !"!
!
!"#$%& ()"*$%


M&M payout policy irrelevance: Issuing higher
dividends via stock issue

!
!
!
!
!
!"#!
!
! !"#$
!
!
!
!
! !!"#
!"#!
!
! !"#$
!
!!!!

!"#$
!
!
!!"#
!
!
! !

!"# ! !"#$ ! !"# %&'() *&+ !
!
!"# !"#$
!


!"# %&'()* +)( (',-,"(# ,%
!"#$
!
!"#$
!
! !"#$
!
!"#"$% !"#

!
!
!"#$
!
!"# %&"'(
!
!"!
!
! !!"#
! ! !
!
!"#$
!
!"#$
!
! !"#$
!
!"!
!
! ! !
!
!
!!!
!"# %&'("


M&M payout policy irrelevance: Stock repurchases
using excess cash (assuming all FCF are paid out as
dividends)

!
!
! !"#$%% #'%( !
!"!
!
!!
!
!
!"#$%% #'%( !
!"!
!
!"#$
!


!"#$
!"#$%&'()"*
!
!"#$%% #'%(
!
!


!"!
!
!
!"!
!"#$
!
! !"#$
!"#$%&'()"*
!!
!
!
!"!
!
!
! !
!


Tax consequences: Examing the effects of dividend
payout on share price

!
!"# %&'
! !
!" $%&
!"#
!
! ! !
!"#
! ! !
!"#$%"& ("$)*

NPV(0) = 11.03
Good state (p =
0.3805)
Do not abandon
NPV_1a = 18
Abandon
NPV_1b = 10
Bad state (1 - p =
0.6195)
Do not abandon
NPV_1a = 8
Abandon
NPV_1b = 10
NPV(0) = 11.03
Good state (p =
0.3805)
Do not abandon
NPV_1a = 18
Bad state (1 - p =
0.6195)
Do not abandon
NPV_1a = 8
FM212 (2012-13 syllabus), ivantwk@gmail.com 11

Views on payout policy

View Explanation
Right: High dividend
payout ratios are better
than low ones. Dividend
increases are followed by
stock price increases of
0.36%, whereas dividend
decreases are followed
by stock price decline of -
1.1% (Aharony and
Swary)
Dividends are regarded
as spendable income,
whereas capital gains are
merely additions to
principal

Regular dividends may
relieve shareholders of
transaction costs and
inconvenience

Shareholder discipline in
spending only dividend
income instead of
dipping into capital

Signaling mechanism.
Paying out funds to
shareholders prevents
managers from misusing
or wasting funds on
negative NPV projects

Left: Firms should pay the
lowest possible cash
dividend excess cash
should be retained or
used to repurchase
shares when dividend
taxes are higher than
capital gain taxes

Financing high dividends
via equity issue result in
shareholders bearing tax
and transaction costs

Taxes on dividends need
to be paid immediately
whereas capital gains
taxes can be deferred
hence lowering PV of tax
obligation

Middle: Firm value is not
affected by dividend
policy
Clientele effects result in
firms having no incentive
to change their payout
policies, as there are
already sufficient low and
high payout firms

Tax-exempt institutions
are indifferent between
holding low and high-
payout stocks

Dividend policy changes
over the firms life cycle


(14) Capital structure

M&M proposition I Capital structure irrelevance: If
capital markets are efficient, firms cannot increase
their value by adjusting capital structure firm value is
independent of risk and amount of leverage
undertaken, assuming that the standard M&M
assumptions apply AND there are no bankruptcy
costs

!!
!"#$%$&$'
! !!
!"#$%$&$'
! !"

!!
!"#"$"%
! ! !
!"#"$"%
! !
!"#"$"%
! !" ! ! ! ! ! ! !"

Leverage boosts EPS

!"#$%&'() '(+,-# ! !"#$%$&#
!"#$
!"#"!"#
!
!"#$%&'() '(+,-#
!"#$
!"#$%$&$'


!"#$# !"#$
!"#"$"%
! !"#$
!"#$%$&$'


!
!
!"##$ &'( )* +,-+(. .,$/ 0(.1(,2(&

M&M capital structure irrelevance in the absence of
bankruptcy costs (1 period example)

!!
!"#$%
!
!"#$"% !" !"#$"% ! !"
!" !" !" ! !"#$"%


!!
!"#$%&
! !" ! !!
!"#$%


!" !"#$% !
! !!
!"#$%
! ! !


!" !"#$% !
! !!
!"#$%&
! ! !


!" !
!
!
!"#
! ! !
!
! !!
!"#$%&
! ! !
!
! !!
!"#$%
! ! !
! !" !
!


Exploiting arbitrage opportunities: Cost of owning a
levered firm must equal that of an unlevered firm with
equal and perfectly correlated cash flows. Otherwise
one can short the overvalued stock while going long
on the undervalued stock, earning positive income at
zero risk

! !
!
!
!
! ! !
!
!
!
! !

Constructing zero-risk, zero-investment portfolios with
constant positive income (when L is overvalued)

!"#$% '()% !
!
! !
!
!
!
!
!
! !
!!"#$

!"#$% '()($(* (+,-%. !
!
! !
!
!
!
!
!
!
!
!
! !
!!"#$

!"#$ &#'()(*(+ (,&-./ !
!
! !!"#$

!"# !
!
!
!
!
!
!
!!"!
!
!"!
!
! !
!
!!
!
!"#$%$&# (" )
!
!
!
!
!
!
!
! !"!
!
! !!!
!
!"#$%&'( !"!
!


Exchanging equal equity holdings with similar income
stream and a one-off positive payoff (when L is
overvalued)

!"#$% '($$)*% + ),(-%. "#/0-*12 !
!
! !!!!
!
!
!


FM212 (2012-13 syllabus), ivantwk@gmail.com 12
!"#$%" '()('$*'+ !
!
! !! !"!
!
! !!!
!


!"#$ ! # $%&'() *+,-'./0 !
!
! !!!
!
!
!
! !!!
!
!
!


!"# %&'&%"(%) !
!
! !!!"!
!


!"##"$ ! !
!!!
!
!
!
! !! !"!
!
! !!!
!
!


!"#$ &$'!!"" $!%&'&() $*+!"" ! !
!
! ! ! !
!
! !

!"#"$%&$ "&()*% +&(,-&.%$ ! !
!
! !" ! !
!


M&M proposition II: The expected return on equity of
a levered firm increases in proportion to the D/E ratio.
Any increase in expected return is offset by an
increase in risk (hence leverage does not affect firm
value) WACC does not change

!
!"#$%$&$' $)*+,-
! !
!
!
!"#$%$&$' $)*+,-
! !
!


!"## !" !
!
! !
!
!
!
! ! !
! !
!
!
!
! ! !


!!
!
! !
!
! !!
!
! !
!
!
!
!


!
!
! !
!
!
!
! ! !
! !
!
!
!
! ! !


!!
!
! !
!
!
!
!
!
!
! !
!


After-tax WACC

!"## !" !
!
! !
!
!
!
! ! !
! ! ! !
!"# %&'()*
! !
!
!
!
! ! !


Adjusted present value

!"# ! !"#
!"# %&#!!"# %&''
!
!!!!!
!
!"#!!"# !"##
!" !"# %&'()*
!
!"#$
!
!
! !
!" !"#


!"# ! !"#
!"# %&"'!!"# %&''
!""#$%&' )*+) ,-. / 0

Traditional view on debt policy: Borrowing increases
!
!
more slowly than M&M predicts but shoots up
when excessive. WACC can be minimized at an
optimum D/E ratio. This may be due to (1) investors
fail to recognize the financial risk created by moderate
borrowing and accept a lower rate of return than they
should, (2) market imperfections result in firms being
able to borrow more cheaply than individual investors,
saving transaction costs and inconvenience

(15, 16) Borrowing limits

Refuting M&M (Taxes): Tax shield increases total
distributed income, as equity capitalizes all future tax
savings. Share price increases, and shareholders
wealth increases accordingly

!" !"# %&'()* !
!!!!!
!
!
!
! !!!

!" !"# %&'()* + "%%(,% !
!!!!!
!
!
!


!
!"# %&'()*
! !
!


Book values
Assets Equities and liabilities
No change Debt ! !""#!!
Equity ! !""#!!

Market values
Assets Equities and liabilities
Tax shield ! !!! Debt ! !""#!!
Equity ! ! ! ! !!

Relative advantage of debt (RAD)

!"# !
! ! !
!
! ! !
!
! ! !
!

!""#$ &$'( )* !"# ! !
!""#$ $&#'() '* !"# ! !




Refuting M&M (Costs of financial distress): Capital
structure is based on a tradeoff between tax savings
and costs of financial distress (empirically 2.5%) that
increase with higher D/E ratios. This tradeoff
determines optimal capital structure. Equity holders
bear bankruptcy costs, as bondholders must be paid
the risk-free rate to hold bonds

! ! !
!"" $%&'()
! !" !"# %&'()* ! !" !"#

!!
!"# %&'( )"*+,-.'/0
! ! ! !
!"#$%&'()*
!!
!"# %& '"%()*+,-.


!"# !! ! !! ! !! !
!
!

Risk shifting: Holding business risk constant, any
increase in firm value is shared between shareholders
and bondholders. Shareholders of levered firms gain
when business risk increases

!" !"#$%
!"#$%
!
!"!
!"#$%&'
! ! !
!
!"!
!"!#!"
! ! !
! !" !"#$%
!"#$


FM212 (2012-13 syllabus), ivantwk@gmail.com 13
!" !"#$
!"#$%
!
!"!
!"#$%&'
! ! !
!
!"!
!"#$%&
! ! !
! !" !"#$
!"#$


!"#$% '()*+,-# ."-/ 0+12-"3+ 456 72% 8+ '(+9+((+:; 2#
!"#$%"&'(%$!) +$%,%$%-.%! #$% +/$!/%( &0%$ 1&-("&'(%$!)

Action Debtors Owners
Liquidation
Win Lose
Take on more debt for zero
NPV project

Lose Win
Issue stock for positive NPV
project

Win Win
Extend debt maturity

Lose Win

Refuting M&M (Constant investment): Due to
asymmetric information, managers actions and
capital structure serve as signals about expectations
and future profitability

!
!"#$%&' )**#+*&%,%*'
!
!
!
!!"#$
!
! !"#
!"#$
!


!"#$
!
! !"#$
!
!
!"#$ "& '()*#$+*($
!
!"#$%&' )**#+*&%,%*'
!"# %&'("% )%%*"+, -!./0


!"# %&'()&*"#)(% +,-) ./
!!"#$
!"#$
!
!" $%& "'()

Equity issue with asymmetric information if perceived
NPV is lower than true NPV results in new
shareholders gaining at the old shareholders expense

!
!
!!"#$
!
! !"!
!"#$"%&"'
!"#$
!
!
!"#$"%&"'
!
!
!
!!"#$
!
! !"!
!"#$
!"#$
!
!
!"#$


!"#$
!"#$"%&"'
! !"#$
!"#$


!
!
!!"#$
!
! !"!
!"#$
! !
!"#$"%&"'
!!!"#$
!"#$
!
!
!"#$%&"'
! !
!"#$


!
!"#$%&"'
! !
!"#$"%&"'
!!"#$
!"# %&'("&)*+"(%, -'./
! !
!"#$
! !
!"#$%&"'
!"#$
!
!"# %&'()&*"#)(%+ "*%%


Debt issue increases share price due to gains from
interest tax shield

!
!
!!"#$
!
! !"# ! ! ! !"#$ "& '()*#$+*($
!"#$%&' )*+!!
! !" !"
!"#$
!
!
!"#$% '$()


!
!"#$% '$()
! !
!"#$% $'#()*
! !
!"#$%&"'
! !
!"#$"%&"'


Asymmetric information problem: If managers strive to
maximize original shareholders wealth, they will only
issue additional equity (hence losing ! ! ! share of the
firm to new shareholders) and undertake the positive
NPV project in the state that delivers a higher payoff
to original shareholders. This is inefficient, because a
project with positive NPV is forgone in some state of
the world

Good state Bad state
Assets in place ! !
Investment ! !
NPV ! !
Total ! ! ! ! ! ! ! ! ! !

! !" ! ! !""# ! ! ! ! ! ! ! ! !"# ! ! ! ! ! !

Good state Bad state
Invest ! ! ! ! ! ! ! ! ! ! ! !
Do not invest ! !

! !"#$ &'()*+ &' ,-+. *+/+)* ! ! !"#$ &'()*+ &' , -'".

Overcoming information asymmetry

Method Description
Financing using retained
earnings
Managers can consider
investment projects on
their own merit, rather
than rely on expensive
external financing. In
doing so, managers are
not forced to forgo
positive NPV projects

Announcing the realized
state
Managers can announce
the realized state to the
market. However, talk is
cheap, and all managers
will have an incentive to
say that their equity is
undervalued

From a legal and
competitive perspective,
announcements of such a
confidential nature may
not be feasible

Bank debt Managers can reveal the
confidential realized state
to banks to lower the
information asymmetry
between lenders and
borrowers

Rights issue Managers can issue new
equity to existing
shareholders. This
eliminates the conflict
between original and new
shareholders, as they are
the same people


FM212 (2012-13 syllabus), ivantwk@gmail.com 14
Pecking order theory: Managers prefer retained
earnings to external financing, because it allows them
to consider projects on their own merit (rather than
rely on market pricing). Financial slack is valuable, as
retained earnings are cheaper than external financing.
Equity financing may be perceived as existing equity
being overvalued, and is hence used as a last resort.
There is no well-defined target D/E ratio

Tradeoff theory: Most companies have target debt
ratios, and debt ratios are positively related to the
percentage of tangible assets to total assets. D/E
ratios are higher when firms have more taxable
income to shield and are unlikely to incur the costs of
financial distress. This could be due to (1) high
profitability, (2) increasing marginal tax rates, (3) lower
cost of financial distress, (4) less risky cash flows

Pecking order vs tradeoff theory: (1) Profitable firms
often rely on internally-generated funds and have low
debt ratios, (2) large and mature firms that have
access to bond markets seldom carry out equity
financing, (3) new growth firms without tangible assets
are likely to rely on equity issues

Refuting M&M (Principal-agent problem/dark side to
financial slack): Managers interests may not be
aligned with that of the shareholders. In aligning
incentives and ensuring that excess cash is directed
to positive NPV projects, debt can serve as a bonding
mechanism to discipline managers into staying
efficient and generating sufficient CFs to meet debts

(17) Types of debt

Repayment provisions

Provision Description
Sinking fund A fund established to
retire debt before maturity

Callable bond Bond with an option for
issuer to buy back before
maturity at a specified
call price

Puttable bond Bond with an option for
investor to demand
repayment before
maturity at a discount

Payment in kind Issuer can choose to pay
interest in the form of
cash or more bonds


Callable bonds: Call when market price equals call
price. When market price exceeds call price, low
yields mean that the firm should buy back existing
debt and issue new debt in the market with lower
coupon and same price

Convertible bonds: Financial instrument that starts life
as a bond but may subsequently be converted into
stock. The higher the conversion ratio, the more
valuable the convertible vice versa. The higher the
conversion price, the less valuable the convertible vice
versa

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Convertible value vs conversion value: Convertible
values are higher due to a coversion premium.
Convertibles are more secure and offer a higher
interest payment than stock dividends. The value of
the call option to convert as well as the difference
between interest and dividend income reflects this

Converting convertibles: As long as interest payments
exceed dividends, conversion should be postponed.
Exercise the option to convert early if the net dividend
exceeds the difference between the option value and
its intrinsic value

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Issuing convertibles: Convertibles are issued due to
(1) differences in risk perceived by managers and the
market (e.g. markets will demand higher coupon rates
for straight debt), (2) preventing the asset substitution
problem (shareholders have lesser incentives to take
on risky projects if debtholders are given the right to
become shareholders too)

(18) Mergers, corporate governance and control

Valid sources of synergy/value

Source Description
Restructuring and
realigning managers
Eliminating management
inefficiencies (e.g.
FM212 (2012-13 syllabus), ivantwk@gmail.com 15
incentives undertaking negative NPV
projects) and obsolete
products

Market power Consolidating market
power by buying out the
competition

Economies of scale
(mostly through horizontal
mergers)
Reduce costs through
combined production,
sharing central services
(e.g. office management,
accounting and financial
control) and transferring
technology or distribution
platforms

Economies of vertical
integration (vertical
mergers)
Reduce costs through
gaining control of vertical
processes (e.g. owning
the supply chain) or
complementary resources

Reduction in taxes Firms may enjoy tax
benefits (tax shield)
through combined debt

Surplus funds Holding on to excess
cash may cause the firm
to become an acquisition
target. Instead of paying
out dividends, firms may
choose to buy other firms
instead


Dubious sources of value

Source Description
Increasing financial slack Managers may want to
buy a company for its
cash reserves so as to
avoid raising capital to
finance positive NPV
projects but it costs a
dollar to buy a dollar

Diversification/combined
stock has lower volatility
than individual stocks
Diversification only lowers
idiosyncratic risks, and
there is little evidence to
show that investors place
a premium for diversified
firms. Shareholders can
diversify away
idiosyncratic risks
themselves and are
hence no better off

If diversification can
reduce the probability of
costly financial distress,
firm value may increase
and shareholders may be
better off

Empirically, diversified
firms have lower market-
to-book asset ratios than
its synthetic comparables
(Lang and Stulz, 1994).
Excess values are
negatively related to
future excess returns
(Lamont and Polk, 2001)

Increasing EPS Overall EPS increases,
but there is no real gain
to the combined entitys
value (bootstrap effect).
EPS cannot increase
indefinitely, and EPS
growth in the long run will
be lower due to share
dilution

Lower financing costs While interest rates on
debt may be lower, the
acquirer will now be
responsible for the
targets debt as well
overall risk has increased


Equity-financed merger with premium (x%)

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Increasing EPS through merger: EPS is not a good
indicator of shareholder well being. A higher EPS may
be the consequence of riskier cash flows, whereas a
lower, safer EPS may precede a higher rate of
growth in future earnings

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Price-earning ratio: In the absence of synergies, P/E of
the combined entity will be between the P/E ratios of
the acquirer and target. Like EPS, P/E is not a good
indicator of shareholder well being

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Cash-financed merger gains: Due to asymmetric
information, optimistic managers would prefer to
finance the merger with cash. Pessimistic managers
would prefer to finance the merger with equity, as they
think that their shares are overvalued

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FM212 (2012-13 syllabus), ivantwk@gmail.com 16
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Terminal values

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Cash vs equity financing: In a MM world, there is no
difference between financing a merger with cash or
equity

Factor Explanation
Equity valuation If shares are overvalued,
equity financing will be
cheaper than cash
financing, vice versa

Control If the bidding company
has a large shareholder, it
may want to finance the
merger with cash instead
to avoid diluting the key
shareholders controlling
and voting rights

Taxes A cash bid would result in
target shareholders being
subject to taxes


Takeover defense: Takeover defenses give managers
greater bargaining power in extracting value from
bidders. Protected from takeovers, managers can
focus on long-term objectives instead of short-term
positions. Long-term contracts can also be preserved.
Stock prices generally fall following an amendment of
a firms anti-takeover defenses

Method Description
Greenmail Repurchasing the
company (indireclty
bribing the acquirer to go
away), with (empirically) a
16% premium

Poison pill Rights issue (ie. for
existing shareholders) at
steeply discounted prices
to reduce acquirers
ownership. Share price
falls 2% on average when
poison pill is announced

Employee stock
ownership plan (ESOP)
Employees are given the
right to vote (in stock) for
or against the merger

Supermajority provision Merger must be approved
by a supermajority
instead of the
conventional 50%,
making it more difficult
for acquirer to pass its
proposition

White knight Approaching friendly
potential acquirers to
compete in the bidding
contest


Merger gains: (1) Acquirers stock price, on average,
falls post merger. This may be due to excess
management confidence which is downplayed by
investors or a signaling mechanism indicating that the
market is stagnant, (2) Target earn high percentage
returns due to often large differences in market cap,
(3) On average, combined entities are worth more than
the sum of their individual entities

(19) Initial public offerings (IPO)

IPOs

Benefits Costs
Provides market access
and funds for investment

Diversify investors: With
market access, initial
investors can diversify
their holdings and reduce
idiosyncratic risks

Exit strategy for VCs and
angel investors

Monetary costs:
Investment banking fees,
regulatory compliance,
IPO underpricing,
accounting for up to 20%
of total costs

Disclosure, loss of control
and freedom: Managers
are now accountable to
public shareholders, with
full disclosure and
regulatory requirements


Role of investment banks: (1) Assist the firm in
registering and meeting SEC requirements, (2) Provide
credibility in backing the IPO, (3) Value and price the
issue, (4) Absorb risk by underwritting the issue
(buying the issue and selling them to the public) with
appropriate price stabilizing mechanisms

Uncertainty in issuance

Negative Positive
Insufficient demand Excess demand: The
FM212 (2012-13 syllabus), ivantwk@gmail.com 17

Price risk

Criminal and civil liability
(negligence and
misrepresentation)

Reputational risk

investment bank can (1)
choose to exercise an
over allotment option by
issuing more shares at
the offer price, (2) select
investors through lottery,
(3) fixing the percentage
of investor types

Rights issue: Owning every A number of existing
shares gives you the right to purchase B number of
new shares at the issue price (often lower than the
current price)

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Buying into a rights issue (as above, owning every A
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New shares issue: Issuing new shares to raise a target
level of capital, assuming no issuance costs. As a
result, a fraction of old equity owners holdings
(assume previously 100%) are given up

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IPO returns: In the short run, IPO returns are risky and
procyclical (during booms, IPO returns are high due to
greater incidence of underpricing). IPO returns are
lower with certainty (e.g. larger firms are underpriced
less). Short term returns average 16%. In the long run,
IPO returns are low empirically lower than a portfolio
of comparable stocks (34% vs 62%)

Underpriced IPOs

Factor Description
Underwriter price
supports
Underwritters take on risk
by buying the issue
before selling them in
capital markets. As such,
they would buy at a price
lower than the offer price

Benefits underwritters
clients
Underwritters clients can
earn higher profits by
buying the stock at issue
and selling it soonafter for
a quick profit

Increase firms ability to
raise further capital
Low offering price raises
the price when the stock
is traded, enhancing the
firms ability to raise
further capital

But old shareholders
lose, because they have
sold shares at a lower
price than what they are
worth

Winners curse Investors will only buy the
stock if they believe that
they will not be paying
more than what it is worth

Asymmetric information Future profitability is not
made known to investors.
The IPO is underpriced to
attract investors to buy
into the issue


(20) Risk management and hedging

Rationale for hedging: In a MM world, there is no
place for hedging. This is because investors can
hedge these risks themselves

Factor Explanation
Cost of financial distress Hedging lowers the
expected cost of financial
distress by lowering the
probability of financial
distress

Financial constraints Hedging lowers the risk
of being financially
constrained especially if
investment opportunities
and cash flows are
countercyclical

Managerial incentives Hedging can improve
managerial incentives in
the presence of moral
hazard


FM212 (2012-13 syllabus), ivantwk@gmail.com 18
The case for insurance firms: Insurance companies
mainly provide insurance against idiosyncratic risks.
The remaining risk is passed on to shareholders
through the securities market

For Against
Expertise in estimating
and pricing probabilities
(assuming competitive
insurance industry)

Ability to pool and
diversify risks by selling a
spectrum of different
policies

Administrative costs are
incurred

Moral hazard and adverse
selection

Risk pool may have
correlated risks

Insurance companies
may not be able to
adequately deal with
large-scale, rare losses.
Companies (e.g. BP) may
resort to the stock market
to insure against such
losses (e.g. stock
devaluation)