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Corporate Finance Introduction Arguably, the role of a corporation's management is to increase the value of the firm to its shareholders

while observing applicable laws and responsibilities. Corporate finance deals with the strategic financial issues associated with achieving this goal, such as how the corporation should raise and manage its capital, what investments the firm should make, what portion of profits should be returned to shareholders in the form of dividends, and whether it makes sense to merge with or acquire another firm. Balance Sheet Approach to Valuation If the role of management is to increase the shareholder value, then managers can make better decisions if they can predict the impact of those decisions on the firm's value. y observing the difference in the firm's equity value at different points in time, one can better evaluate the effectiveness of financial decisions. A rudimentary way of valuing the equity of a company is simply to take its balance sheet and subtract liabilities from assets to arrive at the equity value. !owever, this book value has little resemblance to the real value of the company. First, the assets are recorded at historical costs, which may be much greater than or much less their present market values. "econd, assets such as patents, trademarks, loyal customers, and talented managers do not appear on the balance sheet but may have a significant impact on the firm's ability to generate future profits. "o while the balance sheet method is simple, it is not accurate# there are better ways of accomplishing the task of valuation. Cash vs. Profits Another way to value the firm is to consider the future flow of cash. "ince cash today is worth more than the same amount of cash tomorrow, a valuation model based on cash flow can discount the value of cash received in future years, thus providing a more accurate picture of the true impact of financial decisions. $ecisions about finances affect operations and vice versa# a company's finances and operations are interrelated. %he firm's working capital flows in a cycle, beginning with cash that may be converted into equipment and raw materials. Additional cash is used to convert the raw materials into inventory, which then is converted into accounts receivable and eventually back to cash, completing the cycle. %he goal is to have more cash at the end of the cycle than at the beginning. %he change in cash is different from accounting profits. A company can report consistent profits but still become insolvent. For e&ample, if the firm e&tends customers increasingly longer periods of time to settle their accounts, even though the reported earnings do not change, the cash flow will decrease. As another e&ample, take the case of a firm that produces more product than it sells, a situation that results in the accumulation of inventory. In such a situation, the inventory will appear as an asset on the balance sheet, but does not result in profit or loss. 'ven though the inventory was not sold, cash nonetheless was consumed in producing it. (ote also the distinction between cash and equity. "hareholders' equity is the sum of common stock at par value, additional paid)in capital, and retained earnings. "ome people have been known to picture retained earnings as money sitting in a shoe bo& or bank account. ut shareholders' equity is on the opposite side of the balance sheet from cash. In fact, retained earnings represent shareholders' claims on the assets of the firm, and do not represent cash that can be used if the cash balance gets too low. In this regard, one can say that retained earnings represent cash that already has been spent. "hareholder equity changes due to three things* net income or losses

payment of dividends share issuance or repurchase. Changes in cash are reported by the cash flow statement, which organi+es the sources and uses of cash into three categories* operating activities, investing activities, and financing activities. Cash Cycle %he duration of the cash cycle is the time between the date the inventory ,or raw materials- is paid for and the date the cash is collected from the sale of the inventory. A company's cash cycle is important because it affects the need for financing. %he cash cycle is calculated as* days in inventory . days in receivables ) days in payables Financing requirements will increase if either of the following occurs* "ales increase while the cash cycle remains fi&ed in duration. Increased sales increase the value of assets in the cycle. "ales remain flat but the cash cycle increases in duration. /hile financially it makes sense to reduce the length of the cash cycle, such a reduction should not be done without considering the impact on operations. For e&ample, one must consider the impact on customer and supplier relations as well as the impact on order fill rates. Revenue, Expenses, and Inventory A firm's income is calculated by subtracting its e&penses from its revenue. !owever, not all costs are considered e&penses# accounting standards and ta& laws prohibit the e&pensing of costs incurred in the production of inventory. 0ather, these costs must be allocated to inventory accounts and appear as assets on the balance sheet. 1nce the finished goods are drawn from inventory and sold, these costs are reported on the income statement as the cost of goods sold ,C12"-. If one wishes to know how much product the firm actually produced, the cost of goods produced in an accounting period is determined by adding the change in inventory to the C12". Assets Assets can be classified as current assets and long)term assets. It is useful to know the number of days of certain assets and liabilities that a firm has on hand. %hese numbers are easily calculated from the financial statements as follows* (umber of days of accounts receivable 3 , accounts receivable 4 annual credit sales - , 567 -. %his also is known as the collection period. (umber of days of inventory 3 , inventory 4 annual C12" - , 567 -. %his also is known as the inventory period. (umber of days of accounts payable 3 , accounts payable 4 C12" - , 567 -, assuming that all accounts payable are for the production of goods. %his also is known as the payables period. Profitability Ratios A firm's profitability can be evaluated using financial ratios. 0eferencing these ratios to those of other firms allows a comparison to be made. %he following is a listing of some useful profitability ratios. 8everage* Assets 4 "hareholder's 'quity 2ross 9argin* defined as 2ross :rofit 4 "ales. 2ross margin measure the profitability considering only variable costs and is a measure of the percentage of revenue that goes to fi&ed costs and

profit. (et :rofit 9argin* defined as (et Income 4 "ales %otal Asset %urnover* defined as "ales 4 %otal Assets 0eturn on Assets ,01A-* defined as (et Income 4 Assets. 01A is a measure of the return on money provided by both owners and creditors, and is a measure of how efficiently all resources are managed. 0eturn on 'quity ,01'-* defined as (et Income 4 'quity, where the equity value is the shareholder's equity at the end of the period in which the income was earned. 01' is a measure of the return on money provided by the firm's owners. 01' can be calculated indirectly as* 01' 3 , (et Income 4 %otal Assets - , %otal Assets 4 'quity 01' also can be calculated using $u:ont analysis* $u:ont Analysis* 01' 3 ,(et Income 4 "ales-,"ales 4 %otal Assets-,%otal Assets 4 'quity%his states that 01' is determined by multiplication of three levers* 01' 3 ,net profit margin-,total asset turnover-,leverage%hese levers are readily viewed on the company's financial statements. /hile 01''s may be similar among firms, the levers may differ significantly. i!uidity %he term working capital is used to describe the current items of the balance sheet. /orking capital includes current assets such as cash, accounts receivable, and inventory, and current liabilities such as accounts payable and other short term liabilities. Net working capital is defined as non)cash current operating assets minus non)debt current operating liabilities. Cash, short) term debt, and current portion of long)term debt are e&cluded from the net working capital calculation because they are related to financing and not to operations. %wo measures of liquidity are the current ratio and the quick ratio. Current 0atio* defined as Current Assets 4 Current 8iabilities. %he current ratio is a measure of the firm's ability to pay off current liabilities as they become due. ;uick 0atio* defined as ;uick Assets 4 Current 8iabilities. Also known as the acid test. ;uick assets are defined as cash, accounts receivable, and notes receivable ) essentially current assets minus inventory. Ban" oans ank loans can be classified according to their durations. %here are short)term loans ,one year or less-, long)term loans ,also known as term loans-, and revolving loans that allow one to borrow up to a specified credit level at any time over the duration of the loan. "ome revolving loans automatically renew at maturity# these loans are said to be <evergreen.< Sources and #ses of Cash It can be worthwhile to know where a firm's cash is originating and how it is being used. %here are two sources of cash* reducing assets or increasing liabilities or equity. "imilarly, a company uses cash either by increasing assets or decreasing liabilities or equity.

Sustainable $ro%th A company's sustainable growth rate is calculated by multiplying the 01' by the earnings retention rate. &ir' Value, E!uity Value, and (ebt Value %he value of the firm is the value of its assets, or rather, the present value of the unlevered free cash flow resulting from the use of those assets. In the case of an all)equity financed firm, the equity value is equal to the firm value. /hen the firm has issued debt, the debt holders have a priority claim on their interest and principal, and the equity holders have a residual claim on what remains after the debt obligations are met. %he sum of the value of the debt and the value of the equity then is equal to the value of the firm, ignoring the ta& benefits from the interest paid on the debt. Considering ta&es, the effective value of the firm will be higher since a levered firm has a ta& benefit from the interest paid on the debt. If there is outstanding preferred stock, the firm value is the sum of the equity value, debt value, and preferred stock value, plus the value of the interest ta& shield. %he debt holders and stock holders each have a claim on the cash flows of the firm. In a given time period, the debt holders have a claim equal to the interest payments during that period plus any principal payments that are due. %he stock holders then have a claim equal to the unlevered free cash flow in that period plus the cash generated by the interest ta& shield, minus the claims of the debt holders. Capital Structure %he proportion of a firm's capital structure supplied by debt and by equity is reported as either the debt to equity ratio ,$4'- or as the debt to value ratio ,$4=-, the latter of which is equal to the debt divided by the sum of the debt and the equity. 1ne can quickly convert between the $4' ratio and the $4= ratio by using the following relationships* $4=3,$4'-4,>.$4'$4'3,$4=-4,>)$4=Ris" Pre'iu's Business risk is the risk associated with a firm's operations. It is the undiversifiable volatility in the operating earnings ,' I%-. usiness risk is affected by the firm's investment decisions. A measure for the business risk is the asset beta, also known the levered beta. In terms of the discount rate, the return on assets of a firm can be e&pressed as a function of the risk)free rate and the business risk premium , 0:-* rA 3 rF . 0: Financial risk is associated with the firm's capital structure. Financial risk magnifies the business risk of a firm. Financial risk is affected by the firm's financing decision. %he total corporate risk is the sum of the business and financial risks and is measured by the equity beta, also known as the levered beta. %he business risk premium , 0:- and financial risk premium ,F0:- are reflected in the levered ,equity- beta, and the return on levered equity can be written as* r' 3 rF . 0: . F0: $ebt beta is a measure of the risk of a firm's defaulting on its debt. %he return on debt can be

written as* r$ 3 rF . default risk premium Cost of Capital %he cost of capital is the rate of return that must be reali+ed in order to satisfy investors. %he cost of debt capital is the return demanded by investors in the firm's debt# this return largely is related to the interest the firm pays on its debt. In the past some managers believed that equity capital had no cost if no dividends were paid# however, equity investors incur an opportunity cost in owning the equity of the firm and they therefore demand a rate of return comparable to what they could earn by investing in securities of comparable risk. %he return required by debt holders is found by applying the CA:9* r$ 3 rF . betadebt , r9 ) rF %he required rate of return on assets ,that is, on unlevered equity- can be found using the CA:9* rA 3 rF . betaunlevered , r9 ) rF ?sing the CA:9, a firm's required return on equity is calculated as* r' 3 rF . betalevered , r9 ) rF ?nder the 9odigliani)9iller assumptions of constant cash flows and constant debt level, the required return on equity is* r' 3 rA . ,>)t- ,rA ) r$-,$ 4 'where t is the corporate ta& rate. %he overall cost of capital is a weighted)average of the cost of its equity capital and the after)ta& cost of its debt capital. %he weighted average cost of capital ,/ACC- then is given by* /ACC 3 r' ,' 4 =8- . r$ ,>)t- ,$ 4 =8Assuming perpetuities for the cash flows, the weighted average cost of capital can be calculated as* /ACC 3 rA @ > ) t,$ 4 =8-A (eglecting ta&es, the /ACC would be equal to the e&pected return on assets because the /ACC is the return on a portfolio of all the firm's equity and all of its debt, and such a portfolio essentially has claim to all of the firm's assets. For arbitrary cash flows, and under the assumption that the debt to value ratio is held constant, the following relationship derived by Bames A. 9iles and Bohn 0. '++ell is applicable* /ACC 3 rA ) t r$ ,$ 4 =8-,>.rA- 4 ,>.r$?nder the same assumptions, the cost of equity capital can be calculated from r A and r$ using the following relationship from 9iles and '++ell* r' 3 rA . @ > ) t r$ 4 ,>.r$-A @ rA ) r$ A $4'

For low values of r$, @ > ) t r$ 4 ,>.r$-A is appro&imately equal to one, and the e&pression can be simplified if high precision is not required. If one cannot assume a constant debt to value ratio, then the A:= method should be used. Esti'atin) Beta In order to use the CA:9 to calculate the return on assets or the return on equity, one needs to estimate the asset ,unlevered- beta or the equity ,levered- beta of the firm. %he beta that often is reported for a stock is the levered beta for the firm. /hen estimating a beta for a particular line of business, it is better to use the beta of an e&isting firm in that e&act line of business ,a pure playrather than an average beta of several firms in similar lines of business that are not e&actly the same. '&pressing the levered beta, unlevered beta, and debt beta in terms of the covariance of their corresponding returns with that of the market, one can derive an e&pression relating the three betas. %his relationship between the betas is* betalevered 3 betaunlevered @ > . ,> ) t- $4' A ) betadebt,>) t - $4' betaunlevered 3 @ betalevered . betadebt,>) t- $4' A 4 @ > . ,> ) t- $4' A %he debt beta can be estimated using CA:9 given the risk)free rate, bond yield, and market risk premium. #nlevered &ree Cash &lo%s /hen valuing the operations of a firm using a discounted cash flow model, the operating cash flow is needed. %his operating cash flow also is called the unlevered free cash flow ,?FCF-. %he term <free cash flow< is used because this cash is free to be paid back to the suppliers of capital. For a particular year, ?FCF is calculated as follows. First, take the annual sales and subtract cash costs and depreciation to calculate the earnings before interest and ta&es ,' I%-. %he ' I% also is referred to as the operating income and represents the pre)ta& earnings without regard to how the business is financed. 1ne then calculates the earnings before interest and after ta& ,' IA%- by multiplying the ' I% by one minus the ta& rate. (ote that the ' IA% represents the after)ta& earnings of the firm as if it were financed entirely with equity capital. %o arrive at the ?FCF, one then adds back to the ' IA% the depreciation e&pense, and subtracts capital e&penditures ,CA:'C- that were not charged against earnings and subtracts any investments in net working capital ,(/C-. In equation form* 1perating Income 3 ' I% ' I% 3 0evenues ) Cash Costs ) $epreciation '&pense ' IA% 3 ' I% ) %a&es, where %a&es 3 ,ta& rate-,' I%?FCF 3 ' IA% . $epreciation '&pense ) CA:'C ) Increase in (/C Capital e&penditures are calculated by using the following equation* = of Assets at Dear 'nd 3 = of assets at eginning of Dear . CA:'C ) $epreciation An additional cash adEustment may be necessary for an increase in deferred ta&es which would

have a positive impact on cash flow. *er'inal Value %he terminal value of a firm is the value at the end of the last year that the unique cash flows are proEected. %his value is the discounted value of all subsequent cash flows. /hile the terminal value associated with a piece of manufacturing equipment typically is less than >FG of the present value, the terminal value associated with a business often is more than 7FG of the total present value. For this reason, the terminal value calculation often is critical in performing a valuation. %he terminal value can be calculated either based on the value if liquidated or based on the value of the firm as an ongoing concern. If the firm is to be liquidated, the liquidation value can be based on book value, salvage value, or break)up value, but liquidation value usually understates the terminal value of a healthy business. 1ne must make assumptions about the salvage value of the assets and net working capital. %he net working capital may have a certain recovery rate since it might not be readily liquidated at balance sheet values. In the pro forma proEections, one often may assume that net working capital will grow at the same rate as cash flow. %he terminal value if the firm is liquidated then is the sum of the discounted value of the cash flow, the recovered net working capital, and the salvage value of the long)term assets, including any ta& benefits. For an on)going firm, the terminal value may be determined by either using discounted cash flow estimates or by using multiples from comparable firms. For the $CF method, if the ?FCF is growing at a rate of g per year for a set number of years, the terminal value can be calculated by modeling the cash flow as a %)year growing perpetuity. At the end of % years, one can assume a different growth rate ,possibly +ero- or liquidation. If multiples from comparable firms are used, the price4earnings ratio, market4book values, or cash flow multiples are commonly used. %he unlevered terminal value is calculated using rA as the discount rate, and the levered terminal value is calculated using the /ACC as the discount rate. %he terminal value of debt or preferred stock is simply the proEected book value of the debt or preferred stock in the year that the terminal value is being calculated. %he terminal value of the common stock is the total levered terminal value less the terminal value of the debt, less the terminal value of the preferred stock ,adding in the amount from any warrants that are e&ercised at their e&ercise price-, plus the cash gained from the e&ercise of any common and preferred warrants. *hree (iscounted Cash &lo% +ethods for Valuin) evered Assets A:= ,AdEusted :resent =alue- 9ethod %he A:= approach first performs the valuation under an unlevered all)equity assumption, then adEusts this value for the effect of the interest ta& shield. ?sing this approach, =8 3 =? . :=I%" where =8 3 value if levered =? 3 value if financed >FFG with equity :=I%" 3 present value of interest ta& shield %he unlevered value is found by discounting the unlevered free cash flow at the required return on assets. %he present value of the interest ta& shield is found by discounting the interest ta& shield savings at the required return on debt, r $.

%he A:= method is useful for valuing firms with a changing capital structure since the return on assets is independent of capital structure. For e&ample, in a leveraged buyout, the debt to equity ratio gradually declines, so the required return on equity and the weighted average cost of capital change as the lenders are repaid. !owever, when calculating the terminal value it may be appropriate to assume a stable capital structure, so in calculating the terminal value in a leveraged buyout situation the /ACC method may be a better approach. Flows to 'quity 9ethod %he flows to equity method sums the (:= of the cash flows to equity and to debt. %hen, =8 3 ' . $ /ACC 9ethod %he /ACC method discounts the unlevered free cash flow at the weighted average cost of capital to arrive at the levered value of the firm. Cash &lo%s to (ebt and E!uity /hen calculating the amount of cash flowing to debt and equity holders, it is not appropriate to use the unlevered free cash flows because these cash flows do not reflect the ta& savings from the interest paid. "tarting with the ?FCF, add back the ta&es saved to obtain the total amount of cash available to suppliers of capital. ,urdle Price At times a firm may wish to know at what price it would have to sell its product for a particular investment to have a positive net present value. A procedure for determining this price is as follows* '&press the operating cash flow in terms of price. %here may be multiple phases such as a short start)up period, a long operating period, and a final year in which the terminal value is calculated. /rite out the e&pression for the (:= using the appropriate discount rate. For the longer operating period, one can calculate an annuity factor to multiply by the operating cash flow e&pression. "olve the e&pression for the cash flow that would result in an (:= of +ero. "ince the operating cash flow was written in terms of price, the price now can be found.

(ebt Valuation /hile debt may be issued at a particular face value and coupon rate, as the debt value changes as market interest rates change. %he debt can be valued by determining the present value of the cash flows by discounting the coupon payments at the market rate of interest for debt of the same duration and rating. %he final period's cash flow will include the final coupon payment and the face value of the bond. Invest'ent (ecision If the unlevered (:= of a proEect is negative, aside from potential strategic benefits, the proEect is destroying value, even if the levered (:= is positive. %he firm always could benefit from the ta& shield of debt by borrowing money and putting it to other uses such as stock buybacks.

-pti'al Capital Structure %he total value of a firm is the sum of the value of its equity and the value of its debt. %he optimal capital structure is the amount of debt and equity that ma&imi+es the value of the firm. Share Buybac" If a firm has e&tra cash on hand it may choose to buy back some of its outstanding shares. 1ne interesting aspect of such transactions is that they can be based on information that the firm has that the market does not have. %herefore, a share buyback could serve as a signal that the share price has potential to rise at above average rates. +er)ers and Ac!uisitions y some definitions, a merger is a type of an acquisition in which one firm acquires all of the assets and liabilities of another to form a combined business entity. In a merger of firms that are appro&imate equals, there often is an e&change of stock in which one firm issues new shares to the shareholders of the other firm at a certain ratio. For the sake of this discussion, the firm's whose shares continue to e&ist ,possibly under a different company name- will be referred to as the acquiring firm and the firm's whose shares are being replaced by the acquiring firm will be referred to as the target firm. '&cluding any synergies resulting from the merger, the total post) merger value of the two firms is equal to the pre)merger value. !owever, the individual post) merger values of the firms likely will be different from their pre)merger values because the e&change ratio of the shares probably will not e&actly reflect the firms' values with respect to one another. %he e&change ratio is skewed because the target's shareholders are paid a premium for their shares. "ynergies take the form of revenue enhancements and cost savings. /hen two companies in the same industry merge, such as two banks, the revenue For the merger to make sense for the acquiring firm's shareholders, the synergies resulting from the merger must be more than the initial lost value. %he minimum required synergies are found solving for the synergies in the following equation* ,pre)merger value of both firms . synergies)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))) 3 pre)merger stock price post)merger number of shares where the pre)merger stock price refers to the price of the acquiring firm. Appendi& Co'poundin) and (iscountin) Continuous compounding* F=t 3 C e r t :erpetuity* := 3 C 4 r 2rowing perpetuity* := 3 C 4 , r )g %)year annuity ,% equally spaced payments-* := 3 , C 4 r - @ > ) >4,>.r-% A

%)year growing := 3 @C 4 ,r)g-A H>) @,>.g- 4 ,>.r-A% I

Investment 9anagement
Investment management is about attaining investment obEectives under specified constraints# for e&ample, achieving the best possible return for a given level of risk. %o meet these obEectives, the investor may buy equity in an asset such a stock, a fund, or real estate, or buy debt issued by governments and corporations. y effectively managing such investments the investment manager can achieve a higher return for a specified acceptable level of risk. %here are many tools for reaching this goal.

Expected Return and Portfolio Variance


%he two basic metrics for an investment portfolio are the return and the variance. In the case of an individual dividend)paying stock, the return is given by* 0i 3 @,:> . $>- 4 :FA ) >, where $> is the dividend paid at time t

>.

%he future return of a stock or a portfolio is not known with certainty# there are different probabilites for different return scenarios, one of which actually will unfold. 2iven n possible return scenarios, each with its own probability pi, the e&pected return is*

',0- 3 i3>,n pi 0i
%he variance of such a stock or portfolio is given by*

J = i3>,n pi @0i ) ',0-AJ


Portfolios A portfolio has certain advantages over a single security. %he return of one security may tend to move in the same direction as the return of another security, but in the opposite direction of the return of a third security. ecause of these tendencies, when securities are grouped into a portfolio, for a given e&pected return the variance of that return can be reduced. %he Eoint tendencies between the returns can be measured by covariances. %he covariance in two securities' returns is given by*

Cov,0>, 0J) = >J 3 >J >J


%he correlation coefficient between security i and the market is given by*

im = im / i m
For two securities,

Jp = i3>,n E3>,n &i&E iE Jp 3 &J> J> . &JJ JJ . J &> &J >J 3 &J> J> . &JJ JJ . J &> &J >J >J where &J 3 > ) &>
(ote that if %)bills that earn the risk)free rate are included, for RF 3 F. 2iven two securities, many different portfolios can be constructed by varying the weighting of each security in the portfolio. %o find the minimum variance portfolio,

set d> 4 d&> 3 F 3K &> = (JJ - >J >J) / (J> + JJ - 2 >J >JFor an equally weighted portfolio with all standard deviations equal and all covariances equal to +ero*

=ar,0p- 3 ,>4(J) i3>,n =ar,0i3 ,>4(- =ar,0i= (1/N) Ji and p 3

,>4(>4J)

Ris" Ad.usted Return


$ifferent investors have different aversions to risk. /hen managing a portfolio for a particular investor, the goal is to ma&imi+e the portfolio return for the level of risk that the investor is willing to take. %he following model can be used* 9a&imi+e L 3 ',0p- ) A =ar,0pwhere A 3 investor's aversion to risk as measured by the variance of the portfolio return. %o ma&imi+e the function assuming the investor's assets are only in the market portfolio and the riskfree asset, first let wm 3 the fraction of assets in the market portfolio. %hen

',0p- 3 rF . wm ,0m ) rFand

=ar,0p- 3 wJm Jm. %hen L 3 rF . wm @',0m- ) rFA ) F.7 A wJm Jm


and

dL4dwm 3 ',0m- ) rF ) A wm Jm 3 F
"olving for A,

A 3 @',0m- ) rFA 4 , wm JmBeta


%he risk of an individual security in a well diversified portfolio can be measured by its beta. "uch risk is nondiversifiable. eta of an individual security with respect to the market is*

im = im / Jm 3 Cov,0i, 0":7FF- 4 =ar,0":7FFeta of a risk)free asset with respect to the market 3 F. etas determined using historical data are subEect to estimation error. 9errill 8ynch and some other firms adEust this value back towards the mean beta of the market ,3>- or industry using

adEusted 3 w historical . ,>)w) <true<


%he lower the confidence in Mhistorical, the lower should be the value chosen for w. eta of a portfolio* pm = xi im , where &i is the weight. 1ne is willing to accept a lower return on a security or a portfolio having a negative beta since it can reduce the portfolio risk as part of a larger portfolio. 'fficient portfolios lie on the capital market line ,C98-. %his C98 is not a part of the CA:9. For this line to be used, there must be perfect correlation between the portfolio in question and the market portfolio. %his implies that the line is only for those portfolios that are a combination of the tangential portfolio ,usually the market portfolio- and the risk)free rate. C98* ',0p- 3 0F . @ ',0m- ) 0F ] p / m If borrowing is not permitted, the rational risk)averse investor will choose a portfolio along the capital market line up to the efficient frontier, and then follow the efficient frontier for levels of higher risk and return. %he variance and e&pected return of the market portfolio can be obtained by combining any two portfolios that lie on the efficient frontier and solving for the weights in the following e&pression* ',0m- 3 w> ',0>- . ,>)w>- ',0J%he covariance between any two portfolios on the efficient frontier can be found by finding the weights needed to emulate the market portfolio and then solving for N >J in the following equation*

Jp 3 wJ> J> . wJJ JJ . J w> wJ >J CAP+


%he "harpe)8intner version of the capital asset pricing model implies that as a result of all investors holding the market portfolio, there is a linear relation between the e&pected return on a security and its M. %he following is the security market line ) any security's e&pected return will lie on this line. %his line applies to all securities, not Eust efficient portfolios.

',0i- 3 0F . @ ',0m- ) 0F ] im "harpe)8intner ',0i- 3 0+ . @ ',0m- ) 0+ ] im lack '&pected return of a portfolio using CA:9* ',0p- 3 0F . @ ',0m- ) 0F ] pm
If the assumption of equal borrowing and lending rates is rela&ed, investors no longer are required to hold the market portfolio# instead, they can hold a range of portfolios along the efficient frontier between the point of tangency of the lending line and the point of tangency of the borrowing line. CA:9 requires the measure of two unknown quantities ) market risk premium and beta. !owever, attempts to estimate e&pected returns by using historical stock return data have resulted in std errors about double those of CA:9, because for CA:9 the better precision in the estimate of the market risk premium more than offsets the additional estimation error in beta. %here have been many difficulties in testing CA:9. 0oll argued that the CA:9 must always hold for ex post data if the pro&y chosen for the market is efficient. !e also argued that it is impossible to measure the true market, so the CA:9 cannot be tested. !owever, in >OPJ "tambaugh found that adding other risky assets such as corporate bonds, real estate, and consumer durables to the market portfolio did not materially affect the tests.

Sin)le &actor +odel /+ar"et +odel0 0it 3 ai + i0mt . eit t = 1, ...,


where eit is the distance from the regression line at time t. %he mean value of e it 3 F and the covariance between 0m and ei 3 F. %his is a regression model that characteri+es the risk of a security over time by measuring its beta over a time interval. M iis different from the M im used in the CA:9 in that Mim is more of a present)day beta rather than one taken over time. In the traditional approach of testing the CA:9, in the first step one uses this model to measure the beta of all securities ,or portfolios-. In the second step one estimates the CA:9 itself by regressing the security returns on the estimated betas. /hen testing CA:9 in this manner, one must question the validity of tests using ex post data to test the ex ante CA:9. Also, there is measurement error in individual security betas. ?sing portfolios instead in the first)pass regression helps. =ariance using the single)factor model* =ar,0i) = Ji =ar,0m- . =ar,eiwhere 0i, 0m, and ei are random variables. %he variance of the mean return a i is +ero by definition, so this term falls out. In a well)diversified portfolio, =ar,e i- 3 F. In this equation, M Ji =ar,0m- is the variance e&plained by the market. %he percent of variance e&plained by the market then is given by Ji =ar,0m) / Ji 3 0J (ote that ,>)0J- is the idiosyncratic variance. %hese e&pressions apply to portfolios as well by replacing i with p. For two portfolios or securities in which their e i's are uncorrelated, the covariance between them is given by* iE = i E Jm . %his is derived by finding the covariance between*

0it 3 ai + i0mt . eit and 0Et 3 ai + E0mt . eEt


Cross Section of Co''on Stoc" Returns Fama and French used a multi)factor model using additional risk factors related to si+e, price4book, etc. %hey concluded that three <risk< factors were sufficient. 2abriel !awawini and $onald Qeim's paper reports that stock returns depended si+e, '4:, CF4:, :4 , and prior returns. !owever, these factors were not due to risk. %he premia related to si+e and :4 are mainly due to the Banuary effect. It is unlikely that the risk is higher in Banuary. %he si+e R :4 premia are uncorrelated across international markets. %his is inconsistent with the notion of well)integrated international markets, in which similar risks should result in similar returns.

+ar"et12eutral Strate)ies 9arket)neutral strategies balance the market risk by going long on some securities and short on others. "ome people propose using the %)bill rate as a benchmark against which to compare the market return of a such a strategy. 1ne can argue that even though the market)neutral strategy is risky, since it has +ero beta it does not contribute to the risk of the market portfolio and therefore should not command a premium over the risk)free rate. 1n the other hand, if the e&pected returns on the long side are higher than those on the short, the benchmark return should e&ceed the risk) free rate. *radin) Costs An important factor in the performance of high)turnover portfolios is the amount of the trading costs, including e&plicit costs such as commissions, fees, and ta&es, the market maker spread, the impact of trading on market price, and the opportunity cost incurred during the delay between the time the decision is made and the time the trade is e&ecuted. %rading costs can be reduced through passive fund management and electronic trading. on)1*er' Investin) %he conventional wisdom is that over the long run, stock will generate returns superior to those of bonds. ut while the variance of the geometric means of the returns declines as the time hori+on increases, the variance of the terminal wealth increases. If a put option were purchased to insure a certain terminal wealth, the cost of that option would increase as the time hori+on increases. %o the e&tent that option prices are a measure of risk, the risk of stock investments then increases as the time hori+on lengthens. %he optimal asset allocation is a function of the present wealth, target future wealth, risk tolerance, and time hori+on. 8ong)term returns are difficult to analy+e statistically because as the historical time hori+on increases, the number of possible independent samples of returns decreases. In >OO>, utler and $omian illustrated a procedure that attempts to overcome this difficulty by first listing the monthly returns for the "R: 7FF and the long)term bonds over a long historical time hori+on. y randomly selecting data, returns over various long)term holding periods can be emulated by multiplying the appropriate number of random samples. An almost limitless number of samples for each holding period can be generated using this method. :erforming such an analysis with data taken from the SOJ months from >OJ6)>OO> indicates that over a >F)year time period, there is an >>G chance that stocks will underperform bonds# over a JF)year time period this probability reduces to 7G. (efined1Benefit Pension Plans In a defined)benefit plan, the plan sponsor ,usually an employer- guarantees a level of future benefits to the plan participants, taking responsibility for any shortfall in the investment performance of the plan. FA" PS requires that any unfunded liability in the present value of the benefits appear on the balance sheet of the employer. 1ne alternative for the plan sponsor is to place the present value of the plan liability into government bonds of the same duration as the liability, in which case there is no chance of shortfall and the liability is fully immuni+ed. Furthermore, because pension plans are not ta&ed, the incentive to hold equity in order to take advantage of lower ta&es on capital gains is diminished. For a given level of risk, ta& implications increase the return most for investments such as bonds, which have a large spread between pre) ta& and after)ta& return. An alternative to bonds is for the pension fund to place its money into riskier assets such as common stocks. ?nder this latter alternative, there e&ists both the chance of a shortfall and the chance of a surplus. !owever, FA" PS does not permit a surplus to be reported as an asset on the sponsor's balance sheet, and the surplus often gets allocated to the plan participants. (onetheless, for many reasons it is common for firms to hold equity in their pension funds. %he :ension enefit 2uarantee Corporation ,a federal agency- guarantees the

benefits, and the sponsor's premiums are independent of the risk level of the pension fund's investments. For employers in financial distress, the pension guarantee from : 2C effectively is a put option. 2iven that put options increase in value as risk increases, there is an incentive for some firms to invest the pension fund in risky assets. In defined)benefit plans there e&ists the opportunity for ta& arbitrage. %he plan sponsor can issue debt in order to buy equity in the pension plan. %he pension plan then can invest the funds in bonds. ecause of the ta& status of the pension fund, the ta&es on the pension plan's bond interest will be deferred, and the sponsor will enEoy the interest ta& shield from its debt issuance. %he sponsor then reali+es an arbitrage profit equal to the interest rate multiplied by the corporate ta& rate, with no increase in the firm's overall risk. Arbitra)e Pricin) *heory In >OS6, "teve 0oss presented the arbitrage pricing theory ,A:%- as an alternative to the CA:9 that requires fewer assumptions. %he A:% is an equilibrium theory, which differs from a factor model in that it specifies relationships between e&pected returns across securities and attributes that influence those securities. A factor model allows the first term in the model, the e&pected return, to differ across securities and therefore can represent either and efficient or an inefficient market. 0oss assumed that returns have the first term in common, and the other terms depend on several different systematic factors, as opposed to the single market risk premium factor of the CA:9. %he model takes the form* Rpt = !"Rp# $ %p1&1t $ %p'&'t $ ... $ %p(&(t $ ept where &i 3 value of the it) factor, %pi 3 sensitivity of the return to the it) factor, k 3 number of factors, and ept equals the idiosyncratic variation in the return. Assuming an efficient market in equilibrium, the first term to the right of the equal sign is the same for all securities and is appro&imately equal to the risk)free rate. '&amples of factors that could be included in the model are monthly industrial production, changes in e&pected inflation, une&pected inflation, une&pected changes in the risk premium, and une&pected shifts in the term structure of interest rates. "uch variables likely affect most or all stocks. +ar"et12eutral Strate)ies Revisited 2iven that <alpha< is the return above the market return, by constructing a portfolio long on positive alpha stocks and short on negative alpha stocks, one can cancel the effect of the market. %his market)neutral strategy sometimes is referred to as a <double alpha, no beta< strategy. ecause such a strategy is uncorrelated with the market, the volatility depends on non)market factors. If the market)neutral portfolio is well)diversified across many types of industries, the volatility can be low. If the portfolio is concentrated in a smaller number of stocks and industries, the volatility can be high. Furthermore, if the portfolio is not balanced among stocks of different si+e or value4growth measures, there could be higher volatility as a result of these non)market risk factors. +utual &unds 9utual funds charge fees to their investors. %ransaction fees called loads sometimes are charged for fund purchases or redemptions. "uch fees are deducted directly from the investor's account and represent a charge for the broker's service of providing information and fund selection advice. 1perating e&penses are fees that are deducted from the fund earnings before distribution to investors, and typically average slightly more than >G per year. %wo components of operating e&penses are management fees and >Jb)> fees. %he >Jb)> fees represent a reimbursement for the fund's marketing e&penses. Style Analysis 9utual funds can be characteri+ed according to investment style, such as value or growth. !owever, the actual fund composition may not correspond closely to its stated investment style,

and reports of portfolio holdings may not be very representative since they are only snapshots taken at one point in time. %his limitation makes the public's view of the holdings subEect to distortions such as <window)dressing,< in which the portfolio manager buys stocks that have performed well so that investors will see those stocks in the portfolio holdings ,cost basis is not reported- and perceive the manager to be capable of selecting the top performers. "tyle analysis is a method of characteri+ing the true style of a fund based on its behavior, not on its stated obEectives and holdings. "tyle analysis is performed by first selecting a set of indices that correspond to particular styles, such as small)cap value, small)cap growth, large)cap value, large)cap growth, and cash. ?sing a weighted combination of these indices, one can construct a passive benchmark portfolio that tracks the return of the portfolio being analy+ed as closely as possible. Assume that there are five indices available with which to compose the benchmark. %he following steps are used to analy+e the style* >. $efine the benchmark return for period t to be* RBenc)*ark,t = w1R1,t $ w'R',t $ w+R+,t $ w,R,,t $ w-R-,t J. $efine the tracking error to be* et = RFund,t . RBenc)*ark,t 5. "olve for the weights by minimi+ing the standard deviation of the mean tracking error over the entire time period being analy+ed under the constraint that the weights sum to one and are each greater than or equal to +ero ,unless net short positions are permitted in the fund-. %he standard deviation of the tracking error is given by*

(e) = [ ( 1 / T-1 ) t=1, "et . e*ean#' A>4J


Evaluatin) &und Perfor'ance /hen the popular press publishes mutual fund performance rankings, it usually does not consider the risk that the portfolio manager took to achieve that return. "uch rankings do not necessarily reflect the skill of the manager. %o adEust for risk, one should consider the ratio of e&cess returns to risk, or consider risk)adEusted differential returns. For the risk, one can use standard deviations or betas. %he <"harpe 9easure<* / !"Rp# . !"RF# 0 1 2p %he <%reynor 9easure<* / !"Rp# . !"RF# 0 1 %p "td dev. differential measure* / !"Rp# . !"RF# 0 . / !"RB# . !"RF# 0 2p 1 2B <Bensen 9easure<* / !"Rp# . !"RF# 0 . / !"RB# . !"RF# 0 %p %he Bensen measure is perhaps the most widely used measure of fund performance. In the above measures, Rp is the return of the portfolio under test, RB is the return of a passive benchmark portfolio, RF is the risk)free rate, and !"R# represents the mean historical returns. In determining which measure to use, one should consider the purpose of the measurement. For portfolios that represent a large portion of its investors' assets, a method that uses standard deviation should be used# the "harpe 9easure and the other "td. deviation differential measure are more appropriate. For ranking fund performance, the ratio of e&cess return to risk should be measured# the "harpe 9easure or the %reynor 9easure are more appropriate. +ar"et Efficiency %here is some evidence of some autocorrelation in stock prices. "mall amounts of both positive autocorrelation, in which stock returns tend to move in the direction of the previous period, and negative autocorrelation, in which returns tend to move in a direction opposite to that of the previous period, have been observed. In situations of positive autocorrelation, momentum investing strategies should be employed, and in situations of negative autocorrelation, contrarian strategies should be used. !owever, for shorter term trading, any advantage from these techniques is neutrali+ed by trading costs, and for longer terms there is not yet enough data to confirm or deny any net advantage. Bonds

Coupon bearing notes and bonds typically make fi&ed interest payments two times per year. Lero coupon bonds are sold at a discount and pay off their face values at maturity. Lero coupon treasury securities are issued by commercial institutions who separate the interest and principal payments. %hese +ero coupon bonds are known as CA%'s, %I20's, and "%0I:'s. ond prices often are quoted in the format &*y, where & is the integer dollar amount and y is the fractional amount in 5Jnd's of a dollar. %he spot rate is the rate that would correspond to a single cash flow at maturity for a bond purchased today, as is the case with a +ero coupon bond. A notation used for spot rates is rn, where n is the number of periods ,e.g. years- into the future when a loan made today is to mature. %he forward rate is the rate at which a future loan is made today. A notation used for forward rates is 3*,n, where * is the number of periods from the present when the loan is to commence, and n is the number of periods into the future when the loan is to end. Forward rates can be e&pressed in terms of spot rates* > . 3*,n = " > . rn # 1 " > . r* # %he ask price of a ?.". %reasury bill is calculated from the <asked< rate ,not asked yield- as follows* Ask :rice 3 >F,FFF @ > ) asked rate , ( 4 56F - A where ( 3 the number of days until maturity. %he implied rate ,spot rate- is , >F,FFF 4 Ask :rice ) > -. %his implied rate does not represent an annuali+ed basis. %he annuali+ed rate is found by raising the implied rate to the 5674( power* Annuali+ed 0ate 3 , Implied 0ate -567 4 ( %he bond equivalent yield is the yield to maturity y that satisfies the following equation* : 3 Tn3>,( Cn 4 , > . y4J -n where : 3 price, Cn 3 cash flow at the end of each period, ( 3 number of periods. For a +ero coupon bond there is only one cash flow at maturity. %he value of a coupon bond can be modeled as a portfolio of +ero)coupon bonds having face values and maturity dates that correspond to the coupon payments and dates. "umming the prices of the +ero)coupon bonds then would give the value of the coupon bond, and any difference would represent an arbitrage opportunity. Forward rates can be calculated using the prices and returns of bills, notes, or bonds provided they cover the proper time periods. For e&ample, given the si& month spot rate r4.-, one can calculate the one year spot rate r1.4 by using the data for a one year note the following equation* 5rice = coupon1 1 "1$r4.-# $ "coupon' $ 3ace value# 1 "1$r1.4# 1nce the spot rates are known, the forward rate can be calculated as already illustrated. %he spot rate is not quoted on an annuali+ed basis. %o annuali+e it* Annuali6ed 7ield = "8pot Rate#x1y where x is the number of periods in one year, and y is the number of periods included in the spot rate. %he duration of a bond often is thought of in terms of time until maturity. !owever, in addition to the payoff of the face value at maturity, there are the coupon payment cash flows that influence effective duration. %wo bond with equal yield)to)maturities and maturity dates will have different effective durations if their coupon rates are different. Frederick 9acaulay suggested the following method of determining duration* 'ffective $uration 3 Tt3>,% t H @ Ct 4 , >.y4J -t A 4 @Tt3>,% Ct 4 , >.y4J -tA I where % 3 life of the bond in semiannual periods, Ct 3 cash flow at end of tth semiannual period, y 3 yield to maturity, e&pressed as a bond)equivalent yield. A +ero)coupon bond has no coupon payments and therefore its effective duration always is equal to the time until maturity and does not change as yield)to)maturity changes. $uration essentially measures the sensitivity of a bond's price to movements in interest rates. y this definition, duration is defined as 9:"9515#1/9"1$r#1"1$r#0 If one plots the price of a non)callable bond as a function of its yield, the plot will be concave up ,conve& down- rather than linear. %his curvature is called conve&ity, and in this case, positive conve&ity. Conve&ity is due to the fact that effective duration increases as interest rates decrease.

ecause of the effectively shorter duration, the coupon bond yield curve will be below that of the +ero coupon bond when forward rates are rising with time, and above it when they are dropping. Lero coupon rates often are more useful for capital budgeting purposes. 0esearch has found that diversified portfolios of Eunk bonds have lower variance than those of high)grade bonds. %here are several contributing factors to this initially surprising result. First, while individual Eunk bonds are risky, much of this risk can be diversified in a portfolio. "econd, because of the higher coupon rate, Eunk bonds effectively have a shorter duration than do higher grade bonds and therefore a lower sensitivity to interest rate movements. %hird, Eunk bonds are more likely to be called than are higher)grade bonds, since there is a strong incentive to refinance at lower rates if the issuer's credit improves. %his characteristic reduces the effective duration resulting in less volatility.

"tock Inde& :rimer "tock indices are useful for benchmarking portfolios, for generali+ing the e&perience of all investors, and for determining the market return used in the Capital Asset :ricing 9odel ,CA:9-. A hypothetical portfolio encompassing all possible securities would be too broad to measure, so pro&ies such as stock indices have been developed to serve as indicators of the overall market's performance. In addition, speciali+ed indices have been developed to measure the performance of more specific parts of the market, such as small companies. It is important to reali+e that a stock price inde& by itself does not represent an average return to shareholders. y definition, a stock price inde& considers only the prices of the underlying stocks and not the dividends paid. $ividends can account for a large percentage of the total investment return. /eighting 1ne characteristic that varies among stock indices is how the stocks comprising the inde& are weighted in the average. 'ven if no e&plicit weighting is applied when calculating an average, there may be an implicit one. /hile a one dollar price change in one stock in a simple stock price inde& will have the same effect as a one dollar change in any other stock, a given percentage increase of a higher price stock influences the inde& more than a corresponding percentage increase of a lower price stock. For e&ample, a >G change in a U>FF stock will change the inde& more than a >G change in a U>F stock. For this reason, indices that are based on the simple summation of stock prices are referred to as price)weighted. In a price)weighted inde&, a change in the stock price of the largest company in the inde& would influence the average no more than an equal change in the stock price of the smallest company in the inde&. !owever, the larger company's performance will have a greater impact on the economy. %o consider the si+e of a company, a market capitali+ation weighted inde& ,or value) weighted inde&- can be used, in which a company's impact on the inde& is proportional to the si+e of the company. In value)weighting, in effect the market capitali+ation of the stocks influence the inde&, not the prices. For this reason, there is no need to adEust for stock splits. "ome indices do not weight for market capitali+ation, but do adEust for price differences to remove the implicit price weighting. %his unweighted method tracks the performance of an inde& in which equal dollar amounts are invested in the underlying stocks. "ome consider an unweighted inde& to be a good indicator of the market's performance from the perspective of the investor who places an equal amount of money in each stock in his or her portfolio, regardless of its market capitali+ation. !owever, if every investor placed an equal amount of money in each investment, relatively few investors would own small)cap stocks, so an unweighted inde& would not reflect the portfolio performance of the average investor when all investors are considered. "ome ?.". "tock :rice Inde&es %here are hundreds of indices that are designed to measure the broad market or specific parts of it. !ere are some of the more commonly)used indices, listed in alphabetical order. $ow Bones Industrial Average %he $ow Bones Industrial Average is a price)weighted inde& of industrial stocks and is the most widely quoted stock inde&. In the early >PPF's, there was no broad market measure ) investors focused on the prices of individual stocks. 1n Buly 5rd, >PPV $ow Bones R Co. first published an inde& of >> companies in

the Customer's Afternoon 8etter, which later became the /all "treet Bournal. At that time, there were O railroad stocks and J industrial stocks in the inde&. In >PPV, the railroads were the largest and most stable companies. %he stocks of industrial companies were considered speculative investments. In >PO6, Charles $ow introduced an inde& for industrial stocks and the original $ow average became a railroad stock inde&. 9ore companies were added to the industrial inde& until >OJP, when the number was increased to 5F. %he $ow Bones Industrial Average uses a divisor to adEust for events that result in no change in a company's value but that would otherwise influence the inde&. 1ne such event is a stock split# another is the replacement of one company in the inde& by another. /hile this adustment does not result in a change in the inde& value when a stock splits, because the inde& is price)weighted the newly split stock will have a lower price and therefore less influence on the inde&. $ow Bones %ransportation Average %he $ow Bones %ransportation Average is a price)weighted inde&. It originated from the inde& of O railroad stocks and J industrial stocks that $ow Bones R Co. introduced in >PPV. In >PO6 when the original inde& became the $ow Bones 0ailroad Average the industrial stocks were removed from it. 8ater, the 0ailroad Average was renamed to the %ransportation Average. In addition to railroads, today the average includes other transportation stocks such as airlines and trucking companies. $ow Bones ?tility Average %he $ow Bones ?tility Average is a price)weighted inde& of >7 utility stocks, especially electric utilities and gas utilities. It was created in >OJO with >P stocks, was increased to JF stocks si& months later, then reduced to >7 stocks in >O5P. (asdaq Composite Inde& %he (asdaq Composite Inde& is a market capitali+ation weighted inde& of more than 7FFF stocks. Comprising all (asdaq)listed common stocks, it is the most commonly used inde& for tracking the (asdaq. 0ussell JFFF %he 0ussell JFFF is a market capitali+ation weighted inde&. It was created in >OPV by the Frank 0ussell Company. %he 0ussell universe of stocks covers 5FFF companies, and the 0ussell JFFF represents the smallest two)thirds of those companies. As such, it is a small)cap inde&. "R: >FF %he "R: >FF is a market capitali+ation weighted inde& of large)cap companies. %his inde& also is known by its ticker symbol, 1'C. It comprises >FF large blue)chip companies across a wide range of industries. "R: 7FF

%he "R: 7FF is a market cap weighted inde& of large)cap companies from a variety of industries. It includes industrial, utility, transportation, and financial stocks. %he "R: 7FF is widely used as a benchmark by institutional investors. =alue 8ine Composite Inde& %he =alue 8ine Composite Inde& is a broad, unweighted inde& of appro&imately >SFF companies covered in the =alue 8ine Investment "urvey. /ilshire 7FFF %he /ilshire 7FFF is a market capitali+ation weighted inde&. It was created by /ilshire Associates in >OSV. It is the broadest inde&, including virtually every actively traded ?.". stock.

%rading Costs

%he cost associated with trading securities can have a non)negligible impact on portfolio return. %rading costs include the following* '&plicit costs ) commissions, fees, and ta&es. 9arket maker spread ) difference between the bid and ask prices that the specialist sets for a stock# the specialist keeps the difference as compensation for providing immediacy. For less liquid stocks, the specialist has greater e&posure to adverse price movements and likely will make the spread larger. 9arket impact ) results when high volume trades influence the market price. 9arket impact can be broken into two components ) a temporary one and a permanent one. %he temporary component is due to the need for liquidity to fill the order. %he permanent impact is due to the change in the market's perception of the security as a result of the block trade. 1pportunity cost ) the effective cost of price movements that occur before the trade e&ecutes. (D"' specialists sometimes may appear to have a monopoly on trading their respective securities, creating a larger than necessary spread between bid and ask. !owever, there is more competition than is initially obvious. First, there is competition for the specialist positions, providing the specialist incentive to price fairly. Furthermore, there are other specialists on the floor who may be willing to trade within the spread if it is too wide. %he total trading cost of a buy transaction is calculated by taking the percentage increase of the average purchase price as compared to the price when the buy decision was made, and adding the commissions, fees, and ta&es as a percentage of the price when the buy decision was made. Active portfolio managers attempt to outperform passive benchmarks, but trading costs reduce any reali+ed advantages. %ypical trading commissions run F.JFG of the transaction amount, and the typical cost due to bid)ask spread and market impact is F.77G. %he total cost of a trade then is F.S7G of the trade amount. If a fund has a portfolio turnover rate of PFG, and for every sell transaction the stock is replaced via a buy transaction, a total of >6FG of the portfolio value will be transacted each year. For trading costs of F.S7G per transaction, the annual trading costs amount to ,>.6-,F.S7G- 3 >.JFG of the portfolio value. If one adds a F.5G management fee to this amount, the total becomes >.7FG. 0educing %rading Costs* :assively %raded Funds :assive portfolios have lower transaction costs and overall trading costs. %he transaction cost is typically F.J7G of the transaction value, since a passive portfolio does not have to trade as quickly and can be more patient with each transaction. A typical turnover rate for a passive portfolio is about VG per year, and assuming replacement PG of the portfolio value will be transacted each year for annual trading costs of only ,F.FP-,F.J7G- 3 F.FJG of the portfolio value. :assive portfolios have lower management fees, for e&ample, F.>FG, so the total of trading costs and management fees is only F.>JG, compared to >.7FG for a typical actively managed fund. :assively managed funds that track an inde& often have returns less than that of the inde& because of trading costs, especially for small)cap indices in which the securities are less liquid. %hese trading costs can be reduced if the weights of the securities in the fund are allowed to deviate somewhat from the inde&, since both trading volume and the need for immediacy are reduced. %he correlation with the inde& still can remain quite high under the rela&ed weights.

In >OPJ $imensional Fund Advisors ,$FA- introduced a passive small)cap <O)>F< fund composed of the lower two deciles of (D"' market capitali+ation. %he fund sacrificed tracking accuracy by allowing the weights to deviate in order to minimi+e trading costs. %he result was higher performance than other small)cap funds. %he O)>F fund even outperformed the stocks in the lower two market capitali+ation deciles of the (D"', partly due to the following strategies* %he Pth decile is treated as a hold range, not a sell range, %he $FA waits a minimum of one year before buying I:1's, %he fund does not buy stocks selling for less than UJ or having less than U>F million in market capitali+ation, %he fund does not buy (A"$A; stocks having fewer than four market makers, %he fund does not buy bankrupt stocks, and %he fund is passive, not rigidly inde&ed. (ote that using the Pth decile as a hold range effectively increases the average market cap of the portfolio and increases returns in periods in which large caps outperform small caps, such as in the >OPF's. 0educing %rading Costs* 'lectronic %rading 'lectronic crossing networks have lower trading costs than do e&changes because of lower commissions, no bid)ask spread, and elimination of market impact. y matching the natural buyers and sellers of a security at some predetermined price, for e&ample, the (D"' closing price, electronic crossing networks eliminate the need for a market maker to provide liquidity. !owever, crossing networks require buyers and sellers to participate in order for there to be liquidity. Furthermore, there are the disadvantages of potentially limited liquidity and no inherent price discovery mechanism. 'lectronic communications networks are computeri+ed bulletin boards for matching trades. ecause the traders can remain anonymous, price impact is diminished. Another electronic trading mechanism is the single)price call auction in which buyers and sellers simply place limit orders. %he market clearing price is set at the intersection of the supply and demand curves.

"ecurity Analysis

Introduction "ecurity analysis is about valuing the assets, debt, warrants, and equity of companies from the perspective of outside investors using publicly available information. %he security analyst must have a thorough understanding of financial statements, which are an important source of this information. As such, the ability to value equity securities requires cross)disciplinary knowledge in both finance and financial accounting. /hile there is much overlap between the analytical tools used in security analysis and those used in corporate finance, security analysis tends to take the perspective of potential investors, whereas corporate finance tends to take an inside perspective such as that of a corporate financial manager. E!uity Value and Enterprise Value %he equity value of a firm is simply its market capitali+ation# that is, the market price per share multiplied by the number of outstanding shares. %he enterprise value, also referred to as the firm value, is the equity value plus the net liabilities. %he enterprise value is the value of the productive assets of the firm, not Eust its equity value, based on the accounting identity* Assets 3 (et 8iabilities . 'quity (ote that net values of the assets and liabilities are used. Any cash and cash)equivalents would be used to offset the liabilities and therefore are not included in the enterprise value. As an analogy, imagine purchasing a house with a market value of U>FF,FFF, for which the owner has U7F,FFF in equity and a U7F,FFF assumable mortgage. %o purchase the house, the new owner would pay U7F,FFF in cash and assume the U7F,FFF mortgage, for a total capital structure of U>FF,FFF. If UJF,FFF of that market value were due to UJF,FFF in cash locked in a safe in the basement, and the owner pledged to leave the money in the house, the cash could be used to pay down the U7F,FFF mortgage and the net assets would become UPF,FFF and the net liabilities would become U5F,FFF. %he <enterprise value< of the house therefore would be UPF,FFF. Valuation +ethods %wo types of approaches to valuation are discounted cash flow methods and financial ratio methods. %wo discounted cash flow approaches to valuation are* J. value the cash flow to equity, and 5. value the cash flow to the enterprise. %he cash flow to equity approach to valuation directly discounts the firm's cash flow to the equity owners. %his cash flow takes the form of dividends or share buybacks. /hile intuitively straightforward, this technique suffers from numerous drawbacks. First, it is not very useful in identifying areas of value creation. "econd, changes in the dividend payout ratio result in a change in the calculated value of the company even though the operating performance might not change. %his effect must be compensated by adEusting the discount rate to be consistent with the new payout ratio. $espite its drawbacks, the equity approach often is more appropriate when valuing financial institutions because it treats the firm's liabilities as a part of operations. "ince banks have significant liabilities that are owed to the retail depositors, they indeed have

significant liabilities that are part of operations. %he cash flow to the enterprise approach values the equity of the firm as the value of the operations less the value of the debt. %he value of the operations is the present value of the future free cash flows e&pected to be generated. %he free cash flow is calculated by taking the operating earnings ,earnings e&cluding interest e&penses-, subtracting items that required cash but that did not reduce reported earnings, and adding non)cash items that did reduce reported earnings but that did not result in cash e&penditures. Interest and dividend payments are not subtracted since we are calculating the free cash flow available to all capital providers, both equity and debt, before financing. %he result is the cash generated by operations. %he free cash flow basically is the cash that would be available to shareholders if the firm had no debt ) the cash produced by the business regardless of the way it is financed. %he e&pected future cash flow then is discounted by the weighted average cost of capital to determine the enterprise value. %he value of the equity then is the enterprise value less the value of the debt. /hen valuing cash flows, pro forma proEections are made a certain number of years into the future, then a terminal value is calculated for years thereafter and discounted back to the present. &ree Cash &lo% Calculation %he free cash flow ,FCF- is calculated by starting with the profits after ta&es, then adding back depreciation that reduced earnings even though it was not a cash outflow, then adding back after) ta& interest ,since we are interested in the cash flow from operations-, and adding back any non) cash decrease in net working capital ,(/C-. For e&ample, if accounts receivable decreased, this decrease had a positive effect on cash flow. If the accounting earnings are negative and the free cash flow is positive, the carry)forward ta& benefit will is in effect reali+ed in the current year and must be added to the FCF calculation. evera)e In >O7P, economists and now (obel laureates Franco 9odigliani and 9erton !. 9iller proposed that the capital structure of a firm did not affect its value, assuming no ta&es, no bankruptcy costs, no transaction costs, that the firm's investment decisions are independent of capital structure, and that managers, shareholders, and bondholders have the same information. %he mi& of debt and equity simply reallocates the cash flow between stockholders and bondholders, but the total amount of the cash flow is independent of the capital structure. According to 9odigliani and 9iller's first proposition, the value of the firm if levered equals the value if unlevered* =8 3 =? !owever, the assumptions behind :roposition I do not all hold. 1ne of the more unrealistic assumptions is that of no ta&es. "ince the firm benefits from the ta& deduction associated with interest paid on the debt, the value of the levered firm becomes* =8 3 =? . tc $ where tc 3 marginal corporate ta& rate. /hen considering the effect of ta&es on firm value, it is worthwhile to consider ta&es from a potential investors point of view. For equity investors, the firm first must pay ta&es at the corporate ta& rate, tc, then the investor must pay ta&es at the individual equity holder ta& rate, t e. %hen for debt holders,

After)ta& income 3 , debt income -, > ) td For equity holders, After)ta& income 3 , equity income -, > ) tc -, > ) te %he relative advantage ,if any- of equity to debt can be e&pressed as* 0elative Advantage ,0A- 3 , > ) tc -, > ) te - 4 , > ) td 0A K > signifies a relative advantage for equity financing. 0A W > signifies a relative advantage for debt financing. 1ne can define % as the net advantage of debt* % 3 > ) 0A For % positive, there is a net advantage from using debt# for % negative there is a net disadvantage. 'mpirical evidence suggests that % is small# in equilibrium % 3 F. %his is known as 9iller's equilibrium and implies that the capital structure does not affect enterprise value ,though it can affect equity value, even if %3F-. Calculatin) the Cost of Capital (ote that the return on assets, ra, is sometimes referred to as the ru, the unlevered return. 2ordon $ividend 9odel* :F 3 $iv> 4 , re ) g where :F 3 current stock price, $iv> 3 dividend paid out one year from now, re 3 return of equity g 3 dividend growth rate %hen* re 3 , $iv> 4 :F - . g Capital Asset :ricing 9odel* %he security market line is used to calculate the e&pected return on equity* re 3 rf . be , rm ) rf where rf 3 risk)free rate, rm 3 market return be 3 equity beta !owever, this model ignores the effect of corporate income ta&es. Considering corporate income ta&es*

re 3 rf , > ) tc - . be @ rm ) rf , > ) tc - A where tc 3 corporate ta& rate. 1nce the e&pected return on equity and on debt are known, the weighted average cost of capital can be calculated using 9odigliani and 9iller's second proposition* /ACC 3 re ' 4 , ' . $ - . rd $ 4 , ' . $ %aking into account the ta& shield* /ACC 3 re ' 4 , ' . $ - . rd , > ) tc - $ 4 , ' . $ For % 3 F ,no ta& advantage for debt- the /ACC is equivalent to the return on assets, r a. rd is calculated using the CA:9* rd 3 rf . bd @ rm ) rf , > ) tc - A For a levered firm in an environment in which there are both corporate and personal income ta&es and in which there is no ta& advantage to debt ,%3F-, /ACC is equal to r a, and the above /ACC equation can be rearranged to solve for re* re 3 ra . ,$4'-@ra ) rd,>)tc-A From this equation it is evident that if a firm with a constant future free cash flow increases its debt)to)equity ratio, for e&ample by issuing debt and repurchasing some of its shares, its cost of equity will increase. ra also can be calculated directly by first obtaining a value for the asset beta, ba, and then applying the CA:9. %he asset beta is* ba 3 be , ' 4 = - . bd , $ 4 = -, > ) tc %hen return on assets is calculated as ra 3 rf , > ) tc - . ba @ rm ) rf , > ) tc - A In summary, for the case in which there is personal ta&ation and in which 9iller's 'quilibrium holds , % 3 F -, the following equations describe the e&pected returns on equity, debt, and assets* re 3 rf , > ) tc - . be @ rm ) rf , > ) tc - A ra 3 rf , > ) tc - . ba @ rm ) rf , > ) tc - A rd 3 rf . bd @ rm ) rf , > ) tc - A %he cost of capital also can be calculated using historical averages. %he arithmetic mean generally is used for this calculation, though some argue that the geometric mean should be used. Finally, the cost of equity can be determined from financial ratios. For e&ample, the cost of unleveraged equity is* re,? 3 @ re,8 . rf,debt , > ) tc - $4' A 4 , > . $4' -

re,8 3 b,>.g- 4 ,:4'- . g where b 3 dividend payout ratio g 3 , > ) b - ,01'where ,>)b- 3 plowback ratio. %he payout ratio can be calculated using dividend and earnings ratios* b 3 , $ividend 4 :rice - , :rice 4 'arningsShare Buy1Bac" %ake a firm that is >FFG equity financed in an environment in which % is not equal to +ero# i.e., there is a net ta& advantage to debt. If the firm decides to issue debt and buyback shares, the levered value of the firm then is* =8 3 =? . % ,debt%he number of shares that could be repurchased then is* n 3 ,debt- 4 , price per share after releveringwhere the price per share after relevering is* =8 4 ,original number of outstanding shares%he buyback will lower the firm's /ACC. Pro.ect Valuation %he (:= of a capital investment made by a firm, assuming that the investment results in an annual free cash flow : received at the end of each year beginning with the first year, and assuming that the asset is financed using current debt4equity ratios, is equal to* (:= 3 ):F . : 4 /ACC 3arrants and -ptions /arrants are call options issued by a corporation. %hey tend to have longer durations than do e&change)traded call options. In >OS5, Fischer lack and 9yron "choles published an option valuation model that today is known as the lack)"choles model. %he formula calculates the price of a call option to be* C 3 " (,d>- ) Ce)r% (,dJwhere C 3 price of the call option " 3 price of the underlying stock C 3 option e&ercise price r 3 interest rate % 3 current time until e&piration

( 3 area under the normal curve d> 3 @ ln,"4C- . ,r . sJ4J- % A 4 s %>4J dJ 3 d> ) s %>4J :ut)call parity requires that* : 3 C ) " . Ce)r% %hen the price of a put option is* : 3 Ce)r% (,)dJ- ) " (,)d>/arrants require some modifications to the lack)"choles parameters. /hen warrants are e&ercised, the company typically issues new shares at the e&ercise price to fill the order. %he resulting increase in shares outstanding dilutes the share value. If there were n shares outstanding, and * warrants are e&ercised, a represents the percentage of the value of the firm that is represented by the warrants, where a3*4,*.n/hen using the lack)"choles model to value the warrants, it is worthwhile to use total amounts instead of per share amounts in order to better account for the dilution. %he current share price 8 becomes the enterprise value ,less debt- to be acquired by the warrant holders. %he e&ercise price is the total warrant e&ercise amount, adEusted for the fact that in paying cash to the firm to e&ercise the warrants, the warrant holders in effect are paying a portion of the cash, a, to themselves. %he inputs to the model are outlined in the following table. Blac"1Scholes Para'eters for Pricin) -ptions and 3arrants Input Para'eter " C % r s -ption Pricin) current share price e&ercise price per share current time to e&piration interest rate standard deviation of stock return 3arrant Pricin) a =, where = is enterprise value minus debt. total warrant e&ercise amount multiplied by > ) a. average % for warrants interest rate standard deviation for returns on enterprise value, including warrants

Valuation Calculation 1nce the free cash flow and /ACC are known, the valuation calculation can be made. If the free cash flow is equally distributed across the year, an adEustment is necessary to shift the year)end cash flows to mid)year. %his adEustment is performed by shifting the cash flow by one)half of a year by multiplying the valuation by , > . /ACC - >4J. %he enterprise value includes the value of any outstanding warrants. %he value of the warrants must be subtracted from the enterprise value to calculate the equity value. %his result is divided by the current number of outstanding shares to yield the per share equity value. PE$ Ratio

As a rule of thumb, the :4' ratio of a stock should be equal to the earnings growth rate. 9athematically, this can be shown as follows* : 3 $ 4 re . :=21 where : 3 price, $ 3 annual dividend, re 3 return on equity, and :=21 3 present value of growth opportunities. For high growth firms, :=21 usually dominates $ 4 r e. :=21 is equal to the earnings divided by the earnings growth rate (ebt Valuation %o valuing bonds, one calculates the e&pected payoffs considering the probability of default and the amount that is recovered in case of default. It is assumed that the cash flow from the recovered amount is reali+ed at the end of the year of default. %wo approaches to valuing bonds are* >. $iscount the e&pected cash flow at the e&pected bond return# or J. $iscount the scheduled bond payments at the rating)adEusted yield)to)maturity. 9ethod >* $iscount the e&pected cash flow at the e&pected bond return :rice 3 the sum for each year t of ',CF-t 4 , > . rdebt -t where ',CF-t 3 e&pected cash flow in year t. For a one year bond* : 3 ',CF- 4 @> . ',rd-A %he e&pected bond return is the risk)adEusted discount rate, r debt. %he e&pected cash flow is the cash flow considering the probability of default* ',CFdebt- 3 p , > . C- F . , > ) p- l F where p 3 probability of no default l 3 recovery rate in case of default, ,percentage of face valueC 3 annual coupon rate of the bond F 3 face value of the bond rdebt can be calculated using the CA:9* rdebt 3 rf . bdebt X"R:7FF where X"R:7FF 3 risk premium for the market portfolio bdebt 3 covariance between rdebt and the market return# rf 3 D%9 on a risk)free bond having the same maturity. If bdebt is not known, it can be found using ordinary least squares regression. If p3 > ,no default risk-, then rdebt 3 D%9. %he difference in rdebt and D%9 is the default risk. 9ethod J* $iscount the scheduled bond payments at the rating)adEusted yield)to)maturity For this method, estimate the 0AD%9 by averaging the market D%9's of bonds in the same group. %he promised cash flows then are discounted at this rate.

9arkov Chain 0epresentation ond valuation can be modeled as a 9arkov Chain problem in which a transition matri& is constructed for the probabilities of moving from one rating to another. For e&ample, if there are five possible ratings* A, ,C,$,', and F# and p&y represents the probability of moving from state x to state y, then the transition matri& would look like the following* pAA pA pCA p$A p'A pA p pC p$ p' pAC pC pCC p$C p'C pA$ p$ pC$ p$$ p'$ pA' p' pC' p$' p''

For multiple periods, the transition matrices for each period must be multiplied in order to calculate the multi)period probabilities. %his multiplication easily can be performed by spreadsheet software. Accountin) Issues $epreciation of goodwill is an e&pense on the income statement, but unlike depreciation of fi&ed assets, depreciation of goodwill is not ta& deductible. $lossary A:=* AdEusted :resent =alue CA:9* Capital Asset :ricing 9odel 'nterprise =alue* 9arket value of a firm's equity plus the net market value of its debt. 'nterprise value 3 market cap . 8%$ ) net cash R investments FCF* Free Cash Flow 8%$* 8ong)%erm $ebt 90:* 9arket risk premium, defined as rm ) rf , unless it specifically is referred to as ta&)adEusted market risk premium, in which case there would be a factor to adEust r f for ta&es. (1:8A%* (et 1perating :rofits 8ess AdEusted %a&es 18"* 1rdinary 8east "quares ,method of regression:'2* %he ratio of :4' to growth rate in earnings. 0A$0* 0isk AdEusted $iscount 0ate 0AD%9* 0ating)AdEusted Dield)%o)9aturity 01'* 0eturn 1n 'quity# equivalent to the e&pected return on retained earnings

D%9* Dield %o 9aturity