FINANCE LECTURE NOTES

Lecture 1: Introduction to investment policy

➔ A lot of evaluations that are based on book value are undervalued! (Especially with a
firm with some unique technology)
Book, market and fair value

➔ WE ARE FOCUSING ON INTRINSIC VALUE - in finance

Return on the invested capital (ROIC) – left side
Average cost of capital – right side
Backing the topic…

Time value of money: FV and PV

In order to solve the problem: if I take 100 euros today or in a one year, we can use two
methods to reach the conclusion that it is more profitable to take 100 today:

FV: How much is your money worth in the future?...

Simple interest vs Compounding interest

COMPOUND INTEREST
Sensitivity analysis:

➔ Point 1: +10% extra level of monthly payment:

➔ 1 to 1 relationship between modifying the amount of savings an d the final outcome

(money)

➔ Point 2: interest rate +10%, etc:

Everything is the most sensitive to the rate → the rate is the most important because the
compounding effect!!! → Compounding effect makes all sensitive to the rate!!!

Lecture 2: Applications of Future Value

➔ We are using future value mostly for the estate planning!
o Saving on a savings account
o Investing in stocks/bonds/trackers
o Contributing to a pension fund savings plan

➔ Except from a principal and interest we should also pay some administrative costs)
hidden costs in a loan)

Effective Annual Rate

 ➔ The rate that you pay on a loan depend on riskiness!!!
Collateral: The term collateral refers to an asset that a lender accepts as security for a
loan. Collateral may take the form of real estate or other kinds of assets, depending on the
purpose of the loan. The collateral acts as a form of protection for the lender (bank for
example). That is, if the borrower defaults on their loan payments, the lender can seize the
collateral and sell it to recoup some or all of its losses.
Nominal interest rate (r) – bank state this rate but says that it is on a monthly basis
But the EAR tells us our real rate (real cost - higher):

Morale: The higher the frequency of compounding, the bigger the difference between the
“stated annual rate” and the effective annual rate!
➔ Nominal interest rate ignores compounding! → Always look at the compounding and
EAR!

Applying EAR:
Most of mortgagees are annuity loans! – fixed the same amount every month but different
proportion of interest and principal

➔ But here we are taking the interest only loan

Important: look at fees! – additional “administrative payments” to the loan! → hidden costs
➔ If there are no additional fees the APR = annual rate!!!

ANOTHER EXAMPLE – WITH HANDLING FEE:

APR totally ignores time value of money!

Conclusion:
EAR tries to look at the impact of compounding!

- There is a difference between stated rate and effective rate that we pay
- The higher the compounding frequency the more we pay
APR try to look at the impact of additional costs!

- In 5 years

Some important fact to remember:

Formula from CANVAS:
In order to calculate the APR use the following equation:
Lecture 3: Present Value (PV)
General Present Value formula:

Some Special cases: Perpetuity & Annuity

 - Monthly income
- PV of money income - We are summing up all the present values (area after blue
line)
- New job lasts 10 years – we are going to miss the green part – right now the area
under blue line is ANNUITY (finite time horizon)

PVa – Annuity
PV∞ – Perpetuity = infinite Annuity

ANNUITY
Where did that discount rate come from?!
 ➔ You subtract right sit from the left site…?

ROIC from Investopedia.com:

• Return on invested capital (ROIC) is the amount of money a company makes

that is above the average cost it pays for its debt and equity capital.
• The return on invested capital can be used as a benchmark to calculate the
value of other companies
• A company is thought to be creating value if its ROIC exceeds its weighted
average cost of capital (WACC)

NOPAT = (operating profit) x (1 – effective tax rate)

Written another way, ROIC = (net income – dividends) / (debt + equity).
WACC – Weighted Average Cost of Capital
WACC is the discount rate that a company uses to estimate its net present
value.
In most cases, a lower WACC indicates a healthy business that’s able to attract
investors at a lower cost. By contrast, a higher WACC usually coincides with
businesses that are seen as riskier and need to compensate investors with
higher returns.
WACC is calculated by multiplying
the cost of each capital source
(debt and equity) by its relevant
weight and then adding the
products together. In the above
formula, E/V represents the
proportion of equity-based
financing, while D/V represents
the proportion of debt-based
financing.
 In corporate finance we should use WACC instead of interest rate and
operating cash flows (NOCF) instead of just cash flows

CONNECT exercises:
Lecture 4: Present Value – Applications

WCR - Working capital requirement – the amount of financial resources needed to cover
the cost of production cycle, upcoming operational expenses and the repayments of debts =
The amount of money needed to cover your operating cost

WCR = Current assets – Current Liabilities

How to solve the above exercise:
Calculate the annuity for 7 years + Whole discounted cash flow from year 8 (8 year
back because it is WCR in year 8 = 13000) – initial investment (65000) – initial WCR
(13000)
Different method:
REPLACEMENT DECISIONS
Equivalent Annuity Cash Flow (EACF Method)
Workshop 2: PV
Key formulas:
Lecture 5: Stocks and Bonds
Cash flow of a bond

Issuers
Governments and corporations issue bonds to raise money from investors today in exchange
for promised future payments.
Formula for any security:

Valuation of a bond (example):

 ➔ Here we have risk-free interest rate*

➔ Less maturity = higher PV

Growing discount rate is not good for a bond holders!

Spot rate – stopa procentowa przez konkretny okres czasu

The term structure of interest rate (example):

At Pa we have spot rate for the first period of a coupon = 0,1

At Pb we have spot rate for cashflow (coupon) from the first year as well as from the
second year – there we have a spot rate for year 2 + Face Value at the end of year 2 –
also 2nd year spot rate
At Pc we do not have any cashflows of coupons but only face value after 3 years → So
here we should use 3rd year spot rate

If interest rates go up ➔ the value of bonds goes down

Trading at par, at a premium and at a discount

- if coupon rate = required rate (r), then Price of the bond = Face value; ‘trades at par’
- if coupon rate > required rate (r), then Price of the bond > Face value; trades at a premium
- if coupon rate < required rate (r), then P bond < Face value; the bond trades at a discount

If Price of a bond > face value, then YTM < coupon rate
If Price of a bond < face value, then YTM > coupon rate
If Price of a bond = face value, then YTM = coupon rate
Yield to maturity (YTM of a bond)

The price and coupon payments of a bond determine the yield

to maturity of that bond!
y – YTM of a Bond
“YTM is a Weighted average of a spot rate”
The lower the price of a bond the higher the YTM

How to find the YTM of a bond – based on the spot rate (example):

Step 1 – what is the price of a bond – Sum of the Present value of cashflows (with spot rates)
Step 2 – What is the yield of this bond – the percentage that should give us the same price
so it is the aggregated spot rates!!! → You have to put y in the formula in the place of every
spot rate and equate it to the price
Step 3 – solve the equation for y
The yield to maturity (YTM) of a zero coupon bond with a maturity of t-years
equals the t-year spot rate! (rn = YTMn)!
➔ The lower the price the higher the yield
➔ YTM – your average return on the bond

From Investopedia:

Because YTM is the interest rate an investor would earn by reinvesting every
coupon payment from the bond at a constant interest rate until the bond's maturity
date, the present value of all the future cash flows equals the bond's market price.

“If YTM goes up the price of the bonds goes down – you are on the loss”
Spot rate VS forward rate
f – forward rate (in strategy 2) – we invest 100 for 1 year first and then this 105,3 is again
invested for one year with the forward rate! = initial investment for two year (strategy 1)

➔ Forward rate is determined by the spot rates that we observe on the market
CORPORATE BONDS

Default risk – ryzyko żeby nie uiścić zależności

The Yield is high here as we used the promised cash flow instead of expected cashflow

Scenario 3:
5,1% = discount rate + Risk premium (4 +1,1)

If you would have some coupon there (assume 4%) then you will
have to: 0,5*900 + 0,5*(1000 + 40)

To summarize:

The credit quality is estimated by rating-agencies

- Issuer ratings
- Issue ratings
Issue Ratings:

Ratings can be used to compute the probability of default and thus compute expected cash
flows and thus compute the price of a bond

Lecture 6: Application of valuation of stocks and bonds

Note: Div1 – is a dividend at date t=1 and Po is the price at date t=0

1. Spot rate vs forward rate (strategy)

 2. The evaluation of equity shares (common stocks) – Philips
example

Po = 0.85/(0,05-0,04) = 23,61
Price 3 Jan 2022 = 33,15

➔ g was wrong!

3. For the exam: Dividend vs Gordon Model

Let’s reduce the payout ratio and invest it → dividend goes down

Return on retained earnings = RONI

Assume RONI = 12%

→ By reduce the payout ratio and investing in new stores we created value!!!
Another situation:
Value creation is called NPVGO:

EPS1 – value of assets in place = 60

NPVGO = 4.29

*Idea for research paper: “Is 6.95 a huge NPVGO in relation to EPS1=26.20?”
 4. MULTIPLES:

𝑃 𝑃𝑜 𝑃𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜
𝑟𝑎𝑡𝑖𝑜 = =
𝐸 𝐸𝑃𝑆1 𝑟−𝑔

MV E – Market value of Equity

MV D – Market value of Debt

Some useful formulas:

𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑔𝑛𝑠 𝑡ℎ𝑖𝑠 𝑦𝑒𝑎𝑟 𝐸𝑃𝑆 − 𝐷𝑖𝑣 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑡ℎ𝑖𝑠 𝑦𝑒𝑎𝑟 𝐸𝑃𝑆
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒(1 − 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒)
𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = 𝑅𝑂𝐸(𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠) × 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜
𝐷𝑖𝑣0 = 𝐸𝑃𝑆 × 𝑑𝑖𝑣. 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜
𝑃𝑜 𝑃𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜
=
𝐸𝑃𝑆1 𝑟−𝑔
𝐷𝑃𝑆
𝑇𝑟𝑢𝑒 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒(𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒) =
𝑟−𝑔
 𝑟 𝑚
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 = (1 + ) −1
𝑚
Here r can be the interest (amount of money you receive every period) divided by the
amount you did invest (28/1000 eg)
m – periods of compounding (eg semiannual m=2)

Lecture 7: Portfolio Theory

TOTAL RETURN FORMULA:

R – final(total) return
 𝑺𝑫 = √𝒗𝒂𝒓
➔ Expected return of your portfolio is always = weighted average
of each security (like below)
Correlations:
Below prices of shares is affected by weather:

E(R) of A and B = 8%

Buying both of shares:

Return of 8% - risk free return as weather is always good or bad

We created a “hedge for a weather” → And this is what hedge funds do:
create portfolio of securities with low risk
“Price goes up → expected return goes down”
1st – correlation between A and B
2nd – covariance between A and B
3rd – variance of A → deviation to the power of 2
IMPORTANT EXAMPLE:
Step 1: Calculating variance, return and deviation:
Wrong method: fuck

RAi – actual return of A in a current state of market (recession for example)

RA – expected return of A
0,04686 – the variance! – last column
Sigma = final standard deviation
Step 2: Calculate correlation coefficient

So far (formulas):

PORTFOLIO ANALYSIS:
Henry Markowitz formula:

➔ Xa and Xb are the proportions of both securities

Example:
Situation 1:

➔ If correlation coefficient I equal to 1 the risk is weighted average of

security 1 and 2
Quick Digression: 7 portfolios of A and B
All possible combinations:

Situation 2:

Again, create different comibanation of portfoluo A and B with thi corelation coeficient:
Here, expected return is the same (as always due to weighted average
construction of it) but RISK IS DIFFERENT AS THE correlation coefficient
changed (=0)!

Situation 3:
To summarize:

To summarize:
This is MRP in general
*If the correlation coefficient = -1 then we get:

➔ No risk of security => SD of security = 0

➔ When sth is RISKY IN THE SAME LEVEL as sth it means that they have
THE SAME BETA!

FORMULA FOR HOLDING PERIOD RETURN:

Rt = (1+R1)*(1+R2)*…*(1+Rt)-1
R1, R2, Rt = returns from subsequent periods

LECTURE 9: Portfolio model applications

Long versus short positions

Going short – you borrow shares and sell it in the market and use proceeds to buy other
shares (always starts with negative sign)

Going long – you buying shares and hold it in portfolio

Going short = <0

Going long = >1
Corr coef between -1 and 1:

Corr coef = 1

Corr coef = -1

Efficient portfolios are on the higher line!

When we have more than 2 risky securities:
How do we determine the level of risk of such a portfolio?

Variance of a portfolio = sum of all cells (cells including securities in the

portfolio)
Formula for the variance (risk) of the portfolio consisting of 3 shares:

MRP – minimum risk portfolio

We should consider portfolios only above MRP on the frontier!
P – most efficient portfolio (tangent portfolio)
F – risk free asset
Sharp ratio = (E(Rp) – Rf)/risk (Rp)
“Going short in F” → you borrow money for security F
When you would borrow to invest in P you will appear in the line above P

CML reflects all efficient portfolios – efficient set

P here→ Market Portfolio consists of all individual securities!
CML equation:

- The risk of P2 I twice as high as risk of P

- The risk of P1 is half lower of P
LECTURE 10: Capital Asset Pricing Model (CAPM)
Recapping portfolio Theory:

Yet... to identify the efficient portfolio, we must a priori already know the expected
returns, the volatilities, and the correlations between all stocks.
Since this is impossible to forecast, how do we put portfolio theory into practice?
We use the CAPM to price the riskiness of an individual stock, by calculating the
return investors demand on a risky asset (=stock)

Decomposing risk:

The riskiness of any stock has two components:

1. Idiosyncratic part of risk: Firm-specific; can be diversified away.
2. Systematic part of risk (market risk): Sensitivity to market movements; cannot be
diversified away.
This means that for every 1 stock you add to your portfolio, you add both a piece of market
risk and some firm-specific risk to your portfolio.

Individual stock in portfolio theory (risk)

The Capital Asset Pricing Model (CAPM) assumes, a.o.:

• Investors are risk-averse, and will thus always diversify their investments.
• Capital markets are efficient, and any investor can buy and sell at the current market
prices;
• Companies and households can borrow and lend at the risk-free rate;
• Investors only hold efficient portfolios (so max. return on your risk-taking);
• On average, all investors have the same expectations about volatilities, correlations
and expected returns (efficient portfolio and market portfolio will now overlap).
Under these assumptions, any investor is assumed to solely go for a well-diversified
portfolio.

• Risk and return in finance → building WACC (discount rate for firms in NPV)
• We will create our discount rate such that it properly reflects the riskiness of the
funding
INTRODUCING CAPM:

Re – required return on equity

Beta(e) – beta of equity

Special cases
CASE 1:
CASE 2:

E(rm) is the ‘expected return on the market portfolio’. This is no more than the expected
(annualised) return on the index.

WHAT IS BETA?
Beta focuses on market movements, no for idiosyncratic risk
Low betas are typically found in stable product markets with lower than average exposure
to the business cycle.

➔ The lower beta, the lower risk, the lower expected return
To summarize:

Interest + government rates going up → the line move up!:

How can we calculate expected return of the market: An expected return is calculated
by multiplying potential outcomes by the odds of them occurring and then totaling
these results

Getting back to our fictitious firm:

In terms of debt part: we do not use CAPM to determine required return on debt!

But how can we calculate Rd (required return on debt)?

*Beta of equity is the risk for shareholders. It goes up when company gets debt (this is why D
is in numerator) → when company gets debt the risk goes up as in situation when company
bankrupt the first people that company paying back from remaining assets are government
(taxes), financial institutions (debts) etc. Shareholders are in the end.
Putting everything together:

NOCF - Net operating cash flows

D and E are amount of debt and equity of a firm (from balance sheet)?
LECTURE 11: Applications of CAPM
Measuring betas and returns
➔ The riskiness of every firm/security is reflected in WACC!

Transforming prices into returns

We can also do this for stock indices!

➔ Excess return – excess of Rf = Rm - Rf

In times of negative interest rates (quite often – LIBOR), the excess

returns become weird (‘-rf ’ then becomes ‘+|rf |’) which means the more
negative the rf , the bigger the excess return.
Interesting things to note:
➔ Return you have on government bond is approx. rate of
inflation!!!
➔ Rf is often LIBOR or EURIBOR, etc. rates!

DETERMINANTS OF THE CAPM BETA

Determinant 1: Cyclicality of revenues (business risk)
- mainly for asset beta
- typically impact the riskiness of our operating assets

Highly cyclical stocks have high betas.

E.g., retailers and automotive firms fluctuate with the business cycle. Food firms,
transportation firms, and utilities are less dependent upon the business cycle.
Note that cyclicality is not the same as variability - stocks with high standard
deviations need not have high betas.

Determinant 2: Degree of operating leverage (business risk)

- mainly for asset beta
- typically impact the riskiness of our operating assets

The degree of operating leverage (DOL) measures how sensitive a firm (or
project) is to its fixed costs.
➔ Operating leverage increases as fixed costs rise and variable costs fall.
➔ Operating leverage magnifies the effect of cyclicality on beta.
The degree of operating leverage is given by:
 ➔ EBIT – often refers as the operating profit

Determinant 3: Degree of financial leverage

Stockholders only have a so-called ‘residual claim’; that is, in case a firm is
liquidated, the stockholders are the last ones to be paid back.
Since stockholders only have a residual claim, any increase in the degree of financial
leverage has a direct on stockholder risk exposure.
After all, more debt implies a lower chance the stockholders get anything at all in
case of liquidation.
 ➔ The Asset beta measures the riskiness of the firm’s assets (it depicts
cyclicality of revenue and degree of operating leverage – full depiction of firm
performing!!!)
The mixture of D and E for which WACC that is minimized is called the ‘optimal’
capital structure.
The WACC reflects the riskiness of the assets you invest in.
➔ If you operate multiple business units (that have different risk-return
characteristics) then you must calculate a WACC per division.

➔ Accept projects with a WACC garter than a firm’s WACC! And above SML line
(lower risk) (undervalued)

WORKSHOP – summary:
 ➔ WACC reflect the weighted average rate of return the
company’s financiers could have earned, given their respective
risk-taking

Negative beta = gold!

Final lecture 12: Making investment decisions
1. Profitability index – for different NPVs (different sizes
of two projects)

Not wise decision!

 2. Equivalent Annual Cash Flows (EACF) – for different
periods of investments’ lifespans
Consider the valuation of two projects, each having a different lifespan. Typical applications
of these ‘unequal lives’ comparisons include

EXAMPLE:
 3. REPLACEMENT DECISIONS in EACF:

ALTERNATIVES TO NPV THAT PROF MULDER IS NOT HAPPY WITH:

1. Internal Rate of Return
 ➔ The idea is now that if you have a number of projects, you should pick the one
with the highest IRR.
IRR is bad because it tells nothing about risk of the cash flows so we cannot compare
different projects
You can only use IRR only if two projects has the same risk level!

2. Hurdle Rate

A hurdle rate analysis (a.k.a. minimum acceptable rate of return, MARR) focuses on the
minimum acceptable rate of return on an investment project, and is defined as:

Hurdle Rate = Cost of Capital (WACC) + Risk Premium

Problem here: double counting of risk (in WACC and in Risk Premium)
The idea is that the risk premium should compensate for uncertain CFs... but this is illogical.

If your CFs are (idiosyncratically) uncertain, then run better scenario analysis on your CF
forecasts.
If the assets exhibit more systematic riskiness than the average of your assets, you should
adjust the WACC for the project (via the project’s beta).

➔ Here we are incorrectly rejecting positive NPV project

3. Payback period – only when your company is near to

bankruptcy (only!)
EAC example:

1. Machine A has the following:

• An initial capital outlay of $105,000

• An expected lifespan of three years
• An annual maintenance expense of $11,000

2. Machine B has the following:

• An initial capital outlay of $175,000

• An expected lifespan of five years
• An annual maintenance expense of $8,500

Using the formula above, the annuity factor or A(t,r) of each project must
be calculated. These calculations would be as follows:

Another helpful formulas:

𝐸𝐴𝐶 + 𝐹𝐶 × (1 − 𝑡𝑐 ) − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 × 𝑡𝑐
𝑃𝑉 𝐵𝐸𝑃 (𝑏𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 𝑖𝑛 # 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠) =
(𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 − 𝑉𝐶) × (1 − 𝑡𝑐 )

𝐹𝐶 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝐴𝑐𝑐𝑜𝑢𝑗𝑛𝑡𝑖𝑛𝑔 𝐵𝐸𝑃 (𝑖𝑛 # 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠) =
𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 − 𝑉𝐶