FIN 508 Textbook August 2016 PDF

ANALYTICAL TECHNIQUES IN
FINANCIAL MANAGEMENT
Riaz Hussain
Kania School of Management

University of Scranton
Scranton, Pennsylvania
August 2016
..
This copy of
Analytical Techniques in
Financial Management
by
Riaz Hussain
is for your personal use only.
You cannot give it, or sell it,
to anyone else in any form,
printed or electronic.
ii
PREFACE
Intended for MBA students taking the required course in managerial finance, this book
presents the fundamental principles of finance in a cohesive form. It emphasizes the need
for an analytical solution to a financial decision-making problem. It covers the main
topics for the long-term financial management of a firm. However, we can use the basic
ideas developed here to manage the current assets of a firm successfully.
Analytical Techniques is a workbook designed to help students understand the basic ideas
in finance, and to apply them in solving practical problems. The book develops and
applies different analytical techniques, such as discounting, net present value, and
probability models, in the financial decision-making. Students are encouraged to learn
Excel or Maple as an analytical tool and apply it in solving financial problems. They
should go through all the examples, and work out the problems.
Throughout the book, the emphasis is on the usefulness of the fundamental concept of net
present value. The capital asset pricing model analyzes the risk and return for a project.
The option pricing theory is now a part of many valuation models.
If you find a mistake in the book, whether it is a typographical misprint, a mathematical
error, or a factual misrepresentation, please communicate it to me by email at
hussain@scranton.edu. I gratefully acknowledge the helpful suggestions of many
students who worked their way through the earlier versions of this text. Their critical
feedback was essential in completing this book.
Riaz Hussain
iii
contents
Chapter
Topic
Page
1.
2.
3.
4.
5.
Finance and Analytical Tools

Time Value of Money
Valuation of Bonds and Stock
Capital Budgeting under Certainty
Capital Budgeting under Uncertainty
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
Portfolio Theory
Capital Asset Pricing Model
Option Pricing Theory
Cost of Capital
Capital Structure Theory: Value Maximization
Capital Structure Theory: Minimizing WACC
Dividend Policy
Leasing
Investment Analysis
Review Problems
117
128
146
166
184
208
218
229
242
259
16.
Formulas and Tables
271
iv
1
18
43
67
89
1. Finance and Analytical Tools

Objectives: After reading this chapter, you will be able to
1. Get an overview of finance and basic algebra.
2. Use geometric series in financial calculations.
3. Understand the basic concepts of statistics.
4. Use Excel, Maple, or WolframAlpha to solve mathematical problems.
1.1
Field of Finance
When you look at the balance sheet of a company, you will see the assets and liabilities
are categorized as long-term, or short-term. In this course, we are dealing with the
management of long-term assets (machinery, equipment, buildings, land, etc.) and longterm liabilities (bonds) and other long-term financing (stocks, preferred stock). Another
course, FIN 363, Intermediate Finance, deals with the management of current assets
(cash, marketable securities, accounts receivable, and inventories) and current liabilities
(accounts payable, short-term financing, and accruals).
The following diagram outlines the relationship between the short-term and the long-term
assets and liabilities.
Assets
FIN 363
FIN 508
Liabilities and Equity
Current Assets
Current Liabilities
Accounts Payable
Accruals
Notes Payable
Short
term
Long-term Assets
Plant and Equipment
Less Accumulated Depreciation
= Net Plant and Equipment
Long-term Liabilities
Long-term bonds
Owners' Equity
Common Stock
Preferred Stock
Retained Earnings
Long
term
Total Assets are equal to
Total Liabilities and Equity
Cash
Marketable Securities
Accounts Receivable
Inventories
The above diagram represents the balance sheet of a company. It is the snapshot of the
financial condition of a corporation on a certain date. The last line in the above table
shows a very important concept in finance,
Total Assets are equal to Total Liabilities and Equity
Analytical Techniques
_____________________________________________________________________________
In symbols, one can write it as

In this equation,
V=B+S
(1.1)
V = total market value of the company

B = total market value of the liabilities of the company. This includes bonds and shortterm notes.
S = total market value of the stock of the company. This includes common and preferred
stock.
We will discuss this equation in more detail in chapter 9.
First, one should learn the basic financial principles, such as time value of money, risk,
options, cash flows, and the measurable quantities such as the stock price, earnings per
share, debt ratio, etc. FIN 508, explains these basic ideas, and their application to longterm financial management of a company.
You may say, If I were a CFO of a company, I would monitor the spending daily. You
will be focusing on the tan part of the diagram, which is a valid activity. You will
monitor cash, accounts receivables, inventory, and the daily cash flows. However, you
have to know the whole picture. The most important decisions are made in the blue part
of the diagram. Here you are raising and investing millions, perhaps billions, of dollars.
The recent IPO of Twitter (November 7, 2013) is a good example of this activity. If you
make an error, it may turn out to be a big mistake.
When you are making a financial decision at a company, you cannot rely entirely on gut
feeling, just because you know your business. You have to do some homework first and
find the right course of action. If you are presenting your case to a board of directors, or
in a court of law, you have to convince the audience with facts. We are learning to do that
here in this course.
The relationship between different finance courses is as follows.
MBA 503C FIN 508
1.2
FIN 581 Financial Institutions

FIN 582 Advanced Financial Management
FIN 583 Investment Analysis
FIN 584 International Finance
FIN 585 Derivative Securities
FIN 586 Portfolio Theory
FIN 587 Treasury Management
Problem Solving
One can learn finance efficiently by learning to solve financial problems analytically.
This textbook has plenty of problems, many of them are solved examples, and the others
_____________________________________________________________________________
are the end-of-the-chapter exercises. There are two ways to look at any homework
problem. The first one is the quick one:
Homework Problem Formula Answer
Some students have the temptation to solve the problem quickly without understanding
the concept that the problem is supposed to develop. They miss the real purpose of the
exercise, which is to consolidate an idea and observe its application.
There is another way to look at the same problem.
Study the material in

the text to learn new
concepts
Concepts, such as
risk, time value of
money, required rate
of return, options,
CAPM
Study the worked out

examples to see how the
concepts can be applied
to practical problems
Can I write these

concepts in the form of
mathematical equations?
Is there a similar problem,

worked out in the text,
which can be applied here?
Homework
Problem
Solution
Is it possible to break this

problem into a set of
simpler problems, solve
them separately, and
recombine them?
The second method is obviously more cumbersome, but it helps the student understand
the material.
Our approach toward learning finance is to translate a word problem into a mathematical
equation involving some unknown quantity, solve the equation, and get the answer. This
will help us determine an exact answer, rather than just an approximation. This will lead
to a better decision.
Before we actually start studying finance and the financial management as a discipline, it
is worthwhile to review some of the fundamental concepts in mathematics first. This will
help us appreciate the usefulness of analytical techniques as powerful tools in financial
decision-making. We shall briefly review elementary algebra, basic concepts in statistics,
and finally learn Excel, Maple, or WolframAlpha as a handy way to cut through the
mathematical details.
1.3
Video 01A, Linear Equations
To review the basic concepts of algebra, we look at the simplest equations first, the linear
equations. These equations do not have any squares, square roots, or trigonometric or
other complicated mathematical functions.
_____________________________________________________________________________
Example
1.0. Suppose John buys 300 shares of AT&T stock at $26 a share and pays a commission
of $10. When he sells the stock, he will have to pay $10 in commission again. Find the
selling price of the stock, so that after paying all transaction costs, Johns profit is $200.
Let us define profit as the difference between the final payoff F, after commissions, and
the initial investment I0, including commissions. We can write it as a linear equation as
follows
= F I0
We require a profit of $200, thus, = 200. Suppose the final selling price of the stock per
share is x, the number we want to calculate. The initial investment in the stock, including
commission, is I0 = 300(26) + 10 = $7810. Selling 300 shares at x dollars each, and
paying a commission of $10, gives the final payoff as, F = 300x 10. Make these
substitutions in the above equation to obtain
200 = 300x 10 7810
Moving things around, we get
200 + 10 + 7810 = 300x
Or,
8020 = 300x
Or,
x = 8020/300 = 26.73333333 $26.73
This means that the stock price should rise to $26.73 to get the desired profit. Note that
the answer has a dollar sign and it is truncated to a reasonable degree of accuracy,
namely, to the nearest penny.
Next, consider a somewhat more complicated problem involving dollars, doughnuts, and
coffee.
1.1. Jane works in a coffee shop. During the first half-hour, she sold 12 cups of coffee
and 6 doughnuts, and collected $33 in sales. In the next hour, she served 17 cups of
coffee and sold 8 doughnuts, for which she received $46. Find the price of a cup of coffee
and that of a doughnut.
This is an example where we have to find the value of two unknown quantities. The
general rule is that you need two equations to find two unknowns. We have to develop
two equations by looking at the sales in the first half-hour and in the second hour.
Suppose the price of a cup of coffee is x dollars, and that of a doughnut y dollars.
First half-hour, 12 cups and 6 doughnuts for $33, gives
Second hour, 17 cups and 8 doughnuts for $46, gives
Now we have to solve the above equations for x and y.
12 x + 6 y = 33
17 x + 8 y = 46
_____________________________________________________________________________
First, try to eliminate one of the variables, say y. You can do this by multiplying the first
equation by 8 and the second one by 6, and then subtracting the second equation from the
first. This gives
8*12 x + 8*6 y = 8*33
6*17 x + 6*8 y = 6*46
Subtracting second from first, (8*12 6*17) x = 8*33 6*46
Simplifying it,
6 x = 12,
or
x=2
Substituting this value of x in the first equation, we have 12*2 + 6 y = 33

Or,
6y = 33 24 = 9
y = 9/6 = 3/2
The answer is that a cup of coffee sells for $2 and a doughnut for $1.50.
1.4
WolframAlpha
Mathematica is a useful analytical software, which has capabilities similar to Maple. It

can perform all the mathematical problems equally well. Mathematica has a website at
WolframAlpha, which is free to use. The instructions at WolframAlpha are almost
identical to those in Maple. You should explore this website and use it when you do not
have access to Maple. In this text, you can access WolframAlpha by clicking on this
button WRA.
For instance, to solve the equations in example 1.1
12 x + 6 y = 33
17 x + 8 y = 46
for x and y, enter the instructions as follows:
WRA solve(12*x+6*y=33,17*x+8*y=46)
It provides the solution as x = 2, y = 3/2.
To see the sine wave of Figure 1.1, write
WRA plot(sin(x), x=0..2*Pi)
_____________________________________________________________________________
1.5
Non-linear Equations
Non-linear equations contain higher powers of the unknown variable, or the variable
itself may show up in the power of a number. For instance, a quadratic equation is a nonlinear equation. The general form of a quadratic equation is
The roots of this equation are
ax2 + bx + c = 0
(1.2)
b b2 4ac
x=
2a
(1.3)
Consider the following examples of non-linear equations.

Examples
1.2. Solve for x:
1.113x = 2.678
First, we recall the basic property of logarithm functions, namely,

ln(ax) = x ln a
Taking the logarithm on both sides of the given equation, we obtain
x ln(1.113) = ln(2.678)
Or,
ln(2.678) 0.9850702
x = ln(1.113) = 0.1070591 = 9.201
You can save some time by doing the calculation at WolframAlpha as follows:
WRA 1.113^x = 2.678
1.3. Solve for x,
(2 + x)2.11 = 16.55
_____________________________________________________________________________
2 + x = (16.55)1/2.11
This gives
x = (16.55)1/2.11 2 = 1.781
Or,
You can verify the answer at WolframAlpha as follows:

WRA (2+x)^2.11=16.55
5x2 + 6x 11 = 0
1.4. Find the roots of
This is a typical quadratic equation. Use equation (1.2) and put a = 5, b = 6, and c = 11.
This gives
6 36 4(5)(11) 6 256 6 16
11
x=
=
=
= 5 or 1
10
10
10
You can verify the answer at WolframAlpha as follows:
WRA 5*x^2+6*x-11=0
1.6
Geometric Series
In many financial management problems, we have to deal with a series of cash flows.
When we look at the present value, or the future value, of these cash flows, the resulting
series is a geometric series. Thus, geometric series will play an important role in
managing money. Let us consider a series of numbers represented by the following
sequence
a , ax , ax2 , ax3 , ... , axn1
The sequence has the property that each number is multiplied by x to generate the next
number in the list. There are altogether n terms in this series, the first one has no x, the
second one has an x, and the third one has x2. By this reasoning, we know that the nth
term must have xn1 in it. This type of series is called a geometric series. Our concern is
to find the sum of such a series having n terms with the general form
S = a + ax + ax2 + ax3 + ... + axn1
(1.4)
To evaluate the sum, proceed as follows. Multiply each term by x and write the terms on
the right side of the equation one-step to the right of their original position. We can set up
the original and the new series as follows:
S = a + ax + ax2 + ax3 + ... + axn1
xS =
ax + ax2 + ax3 + ... + axn1 + axn
If we subtract the second equation from the first one, most of the terms will cancel out,
and we get
7
_____________________________________________________________________________
S xS = a axn
Or,
S(1 x) = a(1 xn)
or,
Sn =
a (1 xn)
1x
(1.5)
This is the general expression for the summation of a geometric series with n terms, the
first term being a, and the ratio between the terms being x. This is a useful formula,
which we can use for the summation of an annuity.
If the number of terms in an annuity is infinite, it becomes a perpetuity. To find the sum
of an infinite series, we note that when n approaches infinity, xn = 0 for x < 1. Thus, the
sum for an infinite geometric series becomes
a
S = 1 x
To obtain equations (1.4) and (1.5) at WolframAlpha, use the following instructions:
WRA sum(a*xî,i=0..n-1)
WRA sum(a*xî,i=0..infinity)
Examples
1.5. Find the sum of
3 + 6 + 12 + 24 ..., 13 terms
We identify a = 3, x = 2, and n = 13. Putting these in (1.4), we get

a (1 xn) 3 (1 213)
S = 1 x = 1 2 = 3(213 1) = 24,573
To verify the answer at WolframAlpha, use the following instruction:
WRA sum(3*2î,i=0..12)
1.6. Find the sum of 1.7 + 2.21 + 2.873 ..., 11 terms
Here a = 1.7, and x = 2.21/1.7 = 1.3. Also, n = 11. This gives
S=
a (1 xn) 1.7 (1 1.311) 1.7(1.311 1)

= 1.3 1
= 95.89
1x =
1 1.3
At WolframAlpha, use the following instruction.

WRA sum(1.7*1.3î,i=0..10)
8
(1.6)
_____________________________________________________________________________
25
1.7. Find the value of 1.12i
i=1
100
The mathematical expression possibly means a sum of one hundred annual payments of
$25 each, discounted at the rate of 12% per annum. Write it as
100
25
25
25
25
25
25
1.12i = 1.12 + 1.122 + 1.123 + 1.124 + ... + 1.12100
i=1
25
This is a geometric series, with the initial term a = 1.12 , the multiplicative factor x =
1
1.12 , and the number of terms, n = 100. Use the equation
a (1 xn)
Sn = 1 x
to get
Sn =
(1.5)
(25/1.12) (1 1/1.12100)
= 208.33
1 1/1.12
The keystrokes needed to perform the calculation on a TI-30X calculator are as follows:
25 1.12 1 1 1.12 100 1 1 1.12
To verify at WolframAlpha, use the following instruction,
WRA sum(25/1.12î,i=1..100)
1.7
Video 01B Elements of Statistics
Probability theory plays an important role in financial planning, forecasting, and control.
At this point, we shall briefly review some of the basic concepts of probability and
statistics. In many instances, we have to deal with quantities that are not known with
certainty. For example, what is the price of IBM stock next year or the temperature in
Scranton tomorrow? The future is unpredictable. The market may go up tomorrow, or
down. One way to get a handle on the unknown is to describe it in terms of probabilities.
For instance, there is a 30% chance that it may rain tomorrow. On the other hand, there is
an even chance that the market may go up or down on a given day. The sum of the
probabilities for all possible outcomes is, of course, one.
We may base the probabilities of different outcomes on the past observations of a certain
event. For instance, we look at the stock market for the last 300 trading days and we
notice that on 156 days it went up. Then it is fair to say that it has a 156/300 = 0.52 =
52% chance that it may go up tomorrow as well. A complete set of all probabilities is a
_____________________________________________________________________________
probability distribution. The probability distribution for the stock market may look like
this:
Outcome
Probability
Market moves up
52%
Market moves down
48%
In the above case, we are assuming that the market does not end up exactly at the closing
level of the previous day.
The distribution in the previous example is a discrete probability distribution. Another
example of such a distribution is the set of probabilities for the outcomes of a roll of dice.
With a single die, the probability is 1/6 each of getting a 1, or 2, or 3, and so on.
A probability distribution may be continuous, such as the normal probability distribution.
The probability distribution describing the life expectancy of human beings, or machines,
is a continuous distribution. At present, we shall try to describe the uncertainty in terms
of discrete probability. We are going to use a subjective probability distribution to
describe the uncertain future.
We can find the expected value of a certain quantity by multiplying the probability of
each outcome by the value of that outcome.
Example
1.8. A project has the following expected cash flows
State of the Economy
Good
Fair
Poor
Probability
60%
30%
10%
Cash Flow X
$10,000
$6,000
$2,000
To find the expected cash flow, we compute

E(X) = .6($10,000) + .3($6,000) + .1($2,000) = $8,000
Consider a random variable X. Its outcome is X1 with a probability P1, X2 with a
probability P2, and so on. In general, the outcome is Xi with a probability Pi. Then the
expected value of X is
E(X) = P1X1 + P2X2 + ... + PiXi
Write this as
n
(1.7)
Expected value of X,
E(X) = PiXi = X
i=1
Next, we would like to know how much scatter, or dispersion, is present in this expected
value of X. We may estimate this by the variance of X, or the standard deviation of X,
defining them as follows.
10
_____________________________________________________________________________
Variance of X,
var(X) = Pi(Xi X )2
n
(1.8)
i=1
Standard deviation of X,
(X) = var(X)
(1.9)
In the above example the standard deviation of the cash flow is

(X) = .6(10,000 8000)2 + .3(6000 8000)2 + .1(2000 8000)2 = $2683
This figure represents the uncertainty, or the margin of error, in the cash flow.
At times, it is necessary to find the mutual dependence of two different events. For
example, we start two separate projects X and Y. The following table shows their
expected cash flows. The first project X, is the same as the one discussed above on the
previous page.
Good
Fair
Poor
Probability
60%
30%
10%
Cash Flow X
$10,000
$6,000
$2,000
Cash Flow Y
$12,000
$8,000
$6,000
The two projects seem to be in step, both making more money in good economy and less
in poor economy. They seem to be closely related. Is there a way to measure it
quantitatively? The answer is yes, by using a measure called the correlation coefficient.
First we define the covariance between two random variables X and Y as the
n
Covariance between X and Y, cov(X,Y) = Pi(Xi X )(Yi Y )

(1.10)
i=1
To find the covariance between the two projects, find the expected value of Y. Do it as
Y = .6($12,000) + .3($8,000) + .1($6,000) = $10,200

Next, find
cov(X,Y) = .6(10,000 8000)(12,000 10,200)
+ .3(6,000 8,000)(8,000 10,200) + .1(2,000 8,000)(6,000 10,200)
= 6,000,000
The six-million figure found above is not particularly meaningful. We next introduce a
more practical measure of interdependence of two projects, the correlation coefficient,
defined as
cov(X,Y)
r(X,Y) = (X)(Y)
(1.11)
Write the above equation as
cov(X,Y) = r(X,Y)(X)(Y)
(1.12)
11
_____________________________________________________________________________
We already know (X) to be $2683. We also evaluate (Y) to be

(Y) = .6(12,000 10,200)2 + .3(8000 10,200)2 + .1(6000 10,200)2 = $2272
The smaller value of (Y) indicates that the cash flows are more tightly bunched. Finally,
we find the correlation coefficient as
cov(X,Y) 6000000
r(X,Y) = (X)(Y) = 2683*2272 = .9843
Note that r(X,Y) is a pure number and its value always lies between +1 and 1. That is
1 < r(X,Y) < 1
(1.13)
If the two projects are completely (meaning 100%), positively (meaning, moving in the
same direction) correlated, the correlation coefficient between them is +1. This will be
the case if one project is a carbon copy of the other one. If they are totally unrelated, the
coefficient should be 0. This will be the case if one project is completely independent of
the other one. If the two projects are such that whatever happens in one, the exact
opposite happens with the other, then their correlation coefficient is 1.
The high value of r(X,Y), .9843, in the above example is not particularly surprising
because the two projects go hand in hand, performing well in good times and poorly in
bad times. Some of these ideas are particularly helpful in understanding the risk and
return of different portfolios.
1.8
Excel
It is important that the students are able to set up finance problems using Excel, which is
now a standard of business and industry. A good working knowledge of this software
should be an integral part of every business students education. Almost all business
programs offer courses in the use of this software. If you want to brush up your skill in
the use of Excel, you may go the following Microsoft website for a variety of tutorials.
http://office.microsoft.com/en-us/training/CR100479681033.aspx
To get started on Excel, consider one of the previous problems that we solved by using
the logarithm function.
1.2. Solve for x:
1.113x = 2.678
Set up the table shown below. Adjust the number in the green cell B2 until the numbers
in cells B3 and B4 come very close together. B2 gives the answer.
12
_____________________________________________________________________________
1
2
3
4
A
Base =
Unknown power =
Result (given) =
Result(calculated) =
B
1.113
9.201184226
2.678
=B1^B2
It is possible to embed an Excel table within a Word document. To do that, go the Insert
tab in a Word document. When it opens, click on Table. In the Table menu, click on
Excel Spreadsheet near the bottom. An Excel sheet opens up, where you can do your
work. When you finish your Excel work, click anywhere on the Word document, and you
can leave Excel. To go back into the Excel spreadsheet, double-click on the table, which
will reveal all the calculations and formulas.
Next, consider example 1.8 on page 8 again. Set it up on Excel as follows.
1
2
3
4
5
6
7
8
9
10
A
Good
Fair
Poor
E(X)
E(Y)
Cov(X,Y)
sigma(X)
sigma(Y)
r(X,Y)
B
Probability
60%
30%
10%
=B2*C2+B3*C3+B4*C4
=B2*D2+B3*D3+B4*D4
=B2*(C2-B5)*(D2-B6)+B3*(C3-B5)*(D3-B6)+B4*(C4-B5)*(D4-B6)
=SQRT(B2*(C2-B5)^2+B3*(C3-B5)^2+B4*(C4-B5)^2)
=SQRT(B2*(D2-B6)^2+B3*(D3-B6)^2+B4*(D4-B6)^2)
=B7/B8/B9
C
Cash Flow X
10000
6000
2000
8000
10200
6000000
2683.28157
2271.56334
0.98437404
D
Cash Flow Y
12000
8000
6000
The numerical results of the formulas in cells B5:B10 are given in green cells C5:C10.
The principal advantage of Excel is that it can handle large tables of numbers.
1.9
Video 01C Maple
Maple is an extremely powerful analytical software. Working with Maple is quite easy.
The help facility in Maple is very valuable and it can guide the user through various
steps, using plenty of examples. Maple has extensive application in science, mathematics,
engineering, and finance. Time spent in learning this program can pay rich dividends in
terms of greater accuracy and higher productivity. The following instructions will get you
started with Maple.
Since Maple interprets capital and lower case letters distinctly, we should use the
symbols carefully. Maple has many built in mathematical functions and constants, such
as
ln, exp, Pi, sin, sqrt
Maple can do exact arithmetic calculations and displays the answer in its totality. For
example, we need the exact value of 264, or the factorial of 50, or the value of to 50
significant figures. We do this as follows: enter the commands at the > prompt, end each
line with a semicolon, and strike the return key.
13
_____________________________________________________________________________
2^64;
18446744073709551616
50!;
30414093201713378043612608166064768844377641568960512000000000000
evalf(Pi,50);
Here
3.1415926535897932384626433832795028841971693993751
evalf
calculates the result in floating point with 50 significant figures. Maple can also do
algebraic calculations. For instance, to solve the equations
5x + 6y = 7
6x + 7y = 8
for x and y, enter the instructions as follows:
eq1:=5*x+6*y=7;
eq2:=6*x+7*y=8;
solve({eq1,eq2},{x,y});
eq1 := 5 x + 6 y = 7
eq2 := 6 x + 7 y = 8
{y = 2, x = -1}
The symbol := is used specifically to define objects in Maple. In other words, if we type
eq1;
then the computer will recall the equation defined as eq1 and display it as
5x+6y=7
Maple can also do differentiation and integration. Consider the function
ln x
x3 + x
To differentiate this function with respect to x, we type in
diff(x^3+ln(x)/x,x);
1 ln(x)
3 x2 + x2 x2
14
_____________________________________________________________________________
To integrate the result with respect to x, recreating the original function, we enter
int(%,x);
ln x
x3 + x
Here we use % as a symbol to designate the previous expression.

We can also use Maple to plot functions. For instance, if we want to see the visual
representation of the well-known sine wave, as in Figure 1.1, we write.
plot(sin(x),x=0..2*Pi);
Fig. 1.1: Plot of sin x for 0 < x < 2
It is possible to add text in the plots, draw three-dimensional or animated plots, and draw
plots in color. All plots in this book are drawn with the help of Maple.
Problems
Solve the following equations:
1.9.
16x 54 = 15x 32
x = 22
1.10. (x +1) (x 2) = (x 1) (x + 2)
x=0
1.11. (10 x + 3) (3 x + 4) = (5 x + 6) (6 x + 7)
x = 15/11
x2 x7
1.12. x 3 = x 9
x = 3
x+4 x+6
1.13. x + 5 = x + 8
x = 2
Solve the following equations for x and y:
15
_____________________________________________________________________________
1.14.
2x + 6y = 32
5x + 8y = 45
x = 1, y = 5
1.15.
3x + 4y = 15
5x + 8y = 45
x = 15, y = 15
1.16. At Wal-Mart, in the hardware department, a customer buys five gallons of paint
and six brushes and pays $97.52 for them, including 6% sales tax. Another person buys
eight gallons of paint and five brushes and pays $146.28, including the sales tax. Find the
price of a gallon of paint and that of a brush.
Paint, $16 per gallon; brushes, $2 each
Solve for x,
1.17.
(1 + x)3.2 = 8.4
x = 0.9446
1.18.
1.767x = 3.876
x = 2.38
1.19.
3.909x = 15.99
x = 2.033
1.20.
2x2 + 7x 9 = 0
x = 1, 9/2
1.21.
3x2 + 4x 7 = 0
x = 1, 7/3
1.22. 2.5 + (2.5)(.3) + (2.5)(.3)(.3) ..., infinite terms
3.571
1
1
1
1.23. 1.1 + 1.12 + 1.13 + ... 9 terms
5.759
Find the roots of
Find the sum of the following series:
30 30(1.05) 30(1.05)2
1.24. 1.12 + 1.122 + 1.123 + ... 36 terms
386.60
10 500
1.25.
1.12i
i=1
2825.11
100 25
1.26. 1.12i
i=1
208.33
24 300
1.27. Write WolframAlpha instruction to find the sum, 1.01i
i=1
sum(300/1.01î,i=1..24), 6373.02
16
_____________________________________________________________________________
1.28. The cash flows from two projects under different states of the economy are as
follows:
State of the economy Probability Project A Project B
Poor
20%
$3000
$5000
Average
30%
$4000
$7000
Good
50%
$6000
$15,000
Find the coefficient of correlation between the two projects.
.9922
1.29. The expected return from two stocks, Microsoft and Boeing, under different states
of the economy are as follows:
State of the economy Probability Microsoft Boeing
Poor
10%
5%
40%
Average
40%
10%
10%
Good
50%
20%
50%
(A) Find the expected return of Microsoft and of Boeing.
(B) Find the of Microsoft and of Boeing.
(C) Find the coefficient of correlation between the two stocks.
13.5%, 17%
7.762%, 34.07%
.9471
Key Terms
Accounts payable, 1
Accounts receivable, 1
Accruals, 1
Annuity, 7
Cash, 1
Common stock, 1
Correlation coefficient, 10,
11
Covariance, 10
Excel, 1, 3, 11, 12
Expected value, 9, 10
Geometric series, 1, 6, 7
Inventories, 1
Linear equation, 1
Linear equations, 3, 5
Long-term bonds, 1
Maple, 1, 3, 12, 13, 14
Marketable securities, 1
Normal probability
distribution, 9
17
Notes payable, 1
Perpetuity, 7
Preferred stock, 1
Probability distribution, 9
Quadratic equation, 1, 5
Retained earnings, 1
Standard deviation, 10
Statistics, 1, 3, 8
2. TIME VALUE OF MONEY

Objectives: After reading this chapter, you should be able to
1. Understand the concept of compounding and discounting.
2. Calculate the present value, or the future value of a single payment, or a series of
payments.
3. See the effect of monthly, daily, or continuous compounding, or discounting.
2.1
Video 02A, Single Payment Problems
Suppose someone offers you to have $1000 today, or to receive it a year from now. You
would certainly opt to receive the money right away. A dollar in hand today is worth
more than a dollar you expect to receive a year from now. There are several reasons why
this is so.
First, you can invest the money and make it grow. For example, in July 2009, the rate of
interest paid by leading banks for a one-year certificate of deposit was 2%. This means
you can get the $1000 today, invest it, and earn $20 on it by next year. There is very little
risk in this investment.
Second, there is the risk of inflation that eats away the purchasing power of the dollar.
The rate of inflation in USA has been rather low recently, less than 1%, but in some other
countries, it has been much higher. Still you will need more than $1 next year to buy
what one dollar can buy today.
Third, there is an element of risk in this deal. If you receive the money today, you are
sure to have it in your pocket. On the other hand, the person who is promising you the
money may not be around next year, or he may change his mind.
Finally, you may take the money now and use it to buy some necessary things, such as
food and clothing. If you already have all the necessities, you may want to spend the
money on pleasurable pastimes, such as a vacation or a flat-screen television set. Human
beings prefer having pleasant things as soon as possible and postpone unpleasant
experiences.
The banks and thrift institutions realize this and in order to attract investors' savings they
offer to pay interest on deposits. Suppose you deposit $100 in a bank that offers 6%
annual interest. This amount will become $106 by next year, that is, it increases by a
factor of 1.06. After two years it will grow by a factor of 1.06 again and it becomes
100(1.06)(1.06) = $112.36. The additional $0.36 is the interest earned in the second year
on the $6 first year interest. In this way, compounding the interest annually, $100 will
grow to 100(1.06)3 = $119.10, after three years.
To get a general result, let assume that the interest rate is r; then the amount will increase
by a factor of (1 + r) every year. We define
18
2. Time Value of Money
_____________________________________________________________________________
PV = present value, or the initial deposit

FV = future value of this initial deposit
After n years,
FV = PV (1 + r)n
(2.1)
This is one of the basic formulas in finance. It relates four quantities: FV the future value
of a sum of money, PV the present value of that money, r the rate of growth, or interest
rate per period, and n the number of periods. For instance, n could be 8 years, and r could
be 7% per year.
If the compounding is quarterly, then the rate of interest will be r/4 per quarter, but there
will be 4n periods for compounding. Thus (2.1) becomes
FV = PV (1 + r/4)4n
For monthly compounding, the rate of interest is r/12 and the number of periods 12n. In
general, if we carry out the compounding k times a year, then we may write (2.1) as
FV = PV (1 + r/k) kn
(2.2)
If k becomes very large, then the procedure will compound the money "continuously.
Recall the definition of the exponential function
rk
limit
er = k 1 + k
which gives
(2.3)
rkn
limit
ern = k 1 + k
When k approaches infinity, we see that

FV = PV ern
(2.4)
How is it possible to compare two cash payments that we will receive at different points
in time? For example, which is more desirable: $200 that we will get after 2 years, or
$250 available after 3 years? We find the answer, of course, by comparing their present
values. The present value of different future payments brings them to a common level,
namely, the present instant, and thus it is easy to compare them. To find the present value
we rewrite (2.1) as
FV
PV = (1 + r)n
(2.5)
The above equation represents a very useful concept in finance, namely, discounting. If
we know the future value of a sum of money, we discount it to get its present value.
19
_____________________________________________________________________________
Examples
2.1. Wilkins Micawber has just received $20,000 and he is thinking of saving it for his
retirement that is 15 years away. First National Bank offers 7% interest on a 15-year
deposit, compounded annually. Second National Bank gives 6.9% annually, but
compounds it monthly. Third National Bank pays 6.5%, but compounds the interest
continuously. What should Micawber do?
Use (2.1) to find the final value of the deposit for the first bank as
FV(First) = 20,000(1.07)15 = $55,180.63
For the Second Bank, one has to use the monthly rate of interest, which is 6.9%/12 =
.069/12. The money grows at this rate for 12*15 = 180 months. The future value is
FV(Second) = 20,000(1 + .069/12)180 = $56,135.48
Many processes in nature show a continuous rate of growth. For example, the population
of a city grows continuously, but not uniformly. If the interest is added every instant in
time and added back to the principal, then the sum of money will grow continuously. In
mathematics, one can model continuous growth with the exponential function, hence the
term exponential growth. The exponential function y, has the form y = ex, where x is the
exponent and e has the approximate value 2.718281828. Use equation (2.4).
FV(Third) = 20,000e.065*15 = $53,023.34
To solve the problem in Excel, set up the following table
1
2
3
4
5
A
Initial amount, $ =
First Nat Bank
Second Nat Bank
Third Nat Bank
B
20000
Rate
.07
.069
.065
C
Time, years =
Compounding
Annually
Monthly
Continuously
D
15
Final value
=B1*(1+B3)^D1
=B1*(1+B4/12)^(D1*12)
=B1*exp(B5*D1)
To verify the results at WolframAlpha, try these expressions.

WRA 20000*1.07^15
WRA 20000*(1+.069/12^180
WRA 20000*exp(.065*15)
He should put his money in Second National Bank, which gives the highest final value.
2.2. Find the future value of the following investments:
20
_____________________________________________________________________________
(A) A deposit of $10,000 left in the bank for 10 years and accumulating interest at the
rate of 9% annually, compounded quarterly.
If the compounding is quarterly, then the rate of interest will be r/4 per quarter, but there
will be 4n periods for compounding. Thus (2.1) becomes
FV = PV (1 + r/4)4n
Or,
FV = 10,000(1 + .09/4)40 = $24,351.89
(B) A $10,000 certificate of deposit maturing in 10 year, with 9% interest rate,

compounded continuously.
For continuous compounding, use
FV = PV ern
(2.4)
Put PV = $10,000, r = .09, and n = 10,

FV = 10,000 e(.09)(10) = $24,596.03
To verify the results at WolframAlpha, try these expressions.
WRA 10000*(1+.09/4)^40
WRA 10000*exp(.09*10)
2.3. You have a choice of receiving $10,000 now, or $11,100 a year from now, or
$12,500 two years from now. What is the best option? Assume that the discount rate is
10%.
By far the best way to compare the value of one payment and another one is to compare
their present values. This is a very important principle in finance and we will use it
frequently in the remaining chapters of the textbook. With a discount rate, r = 10%, and
using (2.5), the present values are:
PV(Option I) = $10,000
PV(Option II) = 11,100/1.1 = $10,090.91
PV(Option III) = 12,500/1.12 = $10,330.58
Comparing them, the third option is the best option.
2.2
Video 02B, Multiple Payment Problems
There are many examples in finance where we have to deal with a series of payments.
For example, the paychecks that we receive over the course of a year, or the rent
payments from a rental property, or the payments we have to make to pay off an
21
_____________________________________________________________________________
installment loan. In a typical problem, we have to find the present value of a set of future
payments, or the final value of an account where we have made periodic deposits.
A series of payments constitute an annuity, even if the payments are not made annually.
Similarly, a perpetuity is a stream of payments that goes on forever. For a series of
payments, either we sum them one by one, or apply the result for the summation of a
geometric series. We define a geometric series as
S = a + ax + ax2 + ax3 + ... + axn1
(1.3)
where a is the initial term and x is the ratio between successive terms. The summation of
the series, Sn is
a (1 xn)
Sn =
(1.5)
1x
A very important problem in finance is that of finding the present value of a set of future
payments. Suppose we represent each payment, or cash flow, by C, and the discount rate
by r. Then the discounted value of n such cash flows is
n
C
PV = (1 +
i=1
r)i
C
C
C
C
= 1 + r + (1 + r)2 + (1 + r)3 + ... + (1 + r)n
C
To find the sum of this series, we notice that the first term is a = 1 + r and the ratio
1
between the terms is x =
. By using equation (1.5) we get
1+r
1
C
1 (1 + r)n
1 + r
PV =
1
11+r
After some simplification, it gives the result
n
(1 + r)i =
i=1
C[1 (1 + r)n]
r
(2.6)
To check equation (2.6), send the following instruction to WolframAlpha,

WRA sum(C/(1+r)î,i=1..n)
To find the value of an infinite geometric series, we need the relation
a
S = 1 x
22
(1.5)
_____________________________________________________________________________
The above equation is valid only if the ratio x < 1, then xn approaches zero when n
approaches infinity.
For instance, we want to find the PV of a perpetuity that pays C per year forever. With a
discount rate r, the result is
C
C
(2.7)
(1 + r)i = r
i=1
In equations (2.6) and (2.7), we assume that the first cash flow occurs after one period.
Now consider the case when the first cash flow is after k periods, and continues for the
next n periods. The present value of the cash flows is thus
C
C
C
C
k+
k+1 +
k+2 + ... +
(1 + r) (1 + r)
(1 + r)
(1 + r)k+n1
Write it as
n
1
C
C
C
C
1
C
+
+
+
...
+
=
(1 + r)k1 1 + r (1 + r)2 (1 + r)3

(1 + r)n
(1 + r)k1 i=1 (1 + r)i
Thus the present value of n cash flows each one C, the first one available after k periods
is
n
1
C
PV = (1 + r)k1 (1 + r)i
(2.8)
i=1
In many instances, we have to find the future value of a series of payments. An example
is the future value of a retirement account in which a person makes periodic payments
and the money is growing at a compound rate. Suppose, we make an initial deposit of C
right now, and then another similar one after one month, and so on for a total of n
deposits. Assume that the interest rate, or the rate of growth of money, is uniformly r per
month. The future value of the first deposit after n months will be C(1 + r)n. The future
value of the second deposit will be C(1 + r)n1 because it has only n 1 months to grow.
By extending the argument, we can find the future value of all n deposits as
C(1 + r)n + C(1 + r)n1 + C(1 + r)n2 + C(1 + r)n3 + ... + C(1 + r)
This is a geometric series with a = C(1 + r)n, x = 1/(1 + r), and n = n. Substituting these
values in the general summation formula (1.5), we get
FV =
C(1 + r)n[1 1/(1 + r)n]

1 1/(1 + r)
With some simplification, it becomes

FV =
C(1 + r)[(1 + r)n 1]

r
23
(2.9)
_____________________________________________________________________________
Equation (2.9) gives the future value of n payments made at the beginning of every
period, each one C, which are accumulating interest at the periodic rate r. To verify (2.9),
use the following instruction at WolframAlpha.
WRA sum(C*(1+r)î,i=1..n)
Examples
2.4. An investor deposits $100 at the beginning of each month in a savings account. The
bank pays 6% annual interest, but compounds it monthly. Find the total amount in this
account after 100 months.
The compounding rate is 0.5% monthly, or 0.005 per month. The first $100 are
compounded for 100 months, the second $100 for 99 months, and the last $100 for only
one month, the total amount is
FV = 100(1.005)100 + 100(1.005)99 + 100(1.005)98 + ... + 100(1.005)
This is a geometric series, with first term a = 100(1.005)100, ratio between the terms
x = 1/1.005, and n = 100 terms altogether. Using equation (1.5) we get
FV =
100 (1.005)100 [1 1.005100]

= $12,998.04
1 1/1.005
Another way to look at the problem is to use (2.9)

FV =
Which gives the result as FV =
C(1 + r)[(1 + r)n 1]

r
100(1.005)[1.005100 1]
= $12,998.04
.005
Look at the summation as
100
FV = 100(1.005)i
i=1
To verify the result, use the Maple command as

sum(100*1.005î,i=1..100);
The result comes out to be $12,998.04.
You can get the same result on WolframAlpha by sending the following instruction.
WRA sum(100*1.005î,i=1..100)
24
(2.9)
_____________________________________________________________________________
Video 02C 2.5. Vinson Massif is 24 years old. He has just started a savings program.
He would like to accumulate $2 million for his retirement at the age of 65. The savings
account pays interest at the annual rate of 9%, compounding it monthly. How much
money should Vinson put at the beginning of each month so that at the end of 41 years he
would attain his goal?
He will retire after 41 years and thus there are 12(41) = 492 monthly payments. Suppose
each payment is X. The first payment will accumulate interest for 492 months, the second
for 491 months, and the last one for one month. The monthly interest rate is 0.75% =
0.0075. Thus
2,000,000 = X(1.0075)492 + X(1.0075)491 + X(1.0075)490 + ... + X(1.0075)
This is a geometric series with a = X(1.0075)492, x = 1/1.0075, and n = 492. Thus by
equation (1.5),
X (1.0075)492 [1 1/1.0075492]
2,000,000 =
1 1/1.0075
This gives us X = $386.74
To solve the problem in Maple, proceed as follows.
2000000=sum(X*1.0075î,i=1..492);
solve(%);
To solve the problem on WolframAlpha, copy and paste the following line:
WRA 2000000=sum(X*1.0075î,i=1..492)
One can do the problem on Excel by the following steps. Adjust the value in the green
cell B7 to get the final amount in cell B8 to be equal to the target amount in cell B4.
1
2
3
4
5
6
7
8
A
Current age, years
Retirement age, years
Interest rate, per year
Target amount, $
Total months
Monthly rate
Monthly deposit, $
Final amount, $
B
24
65
9%
2,000,000
=12*(B2-B1)
=B3/12
386.74
=B7*((1+B6)^B5-1)/(1-1/(1+B6))
2.6. Axel Heiberg has just accepted a job with an annual salary of $24,000. He has
decided to put 10% of his gross monthly income into a retirement account at the
beginning of every month. The retirement account pays interest at the rate of 0.75% every
month. Axel also expects to receive an annual raise of 10% each year for the next several
25
_____________________________________________________________________________
years. How much money will he accumulate in his retirement fund at the end of two
years?
His pay is $2000 per month and 10% of that is $200. For the first year, the saving is $200
per month, but second year it goes up by 10% to $220 per month. The future value is thus
FV = 200(1.0075)24 + 200(1.0075)23 + ... 12 terms + 220(1.0075)12 + 220(1.0075)11 + ... 12 terms
The above expression is a sum of two geometric series. For the first series, a =
200(1.0075)24, n = 12, x = 1/1.0075, and for the second series, a = 220(1.0075)12, n = 12,
and x = 1/1.0075. Using (1.5), we get the answer as
200 (1.0075)24 [1 1/1.007512] 220 (1.0075)12 [1 1/1.007512]
FV =
+
1 1/1.0075
1 1/1.0075
=
[200 (1.0075)24 + 220 (1.0075)12] [1 1/1.007512]

= $5,529.
1 1/1.0075
To solve the problem on WolframAlpha, copy and paste the following line:
WRA sum(200*1.0075î,i=13..24)+sum(220*1.0075î,i=1..12)
2.7. Suppose you deposit $200 at the beginning of every month in an account that pays
interest at the rate of 9% per year, compounding it monthly. How long will it take you to
accumulate $10,000 in this account?
The monthly interest rate is 0.75% or 0.0075, and the monthly growth factor is 1.0075.
Suppose it takes n months to accumulate the desired amount. The future value in the
account is the sum of the future value of each deposit. Then
FV = 10,000 = 200(1.0075)n + 200(1.0075)n1 + ... + 200(1.0075)
We may sum up the series by using equation (1.5). In our case a = 200(1.0075)n, x =
1/1.0075, and n = n. This gives
10,000 =
Or,
200 (1.0075)n (1 1/1.0075n)

1 1/1.0075
10,000 =
200 (1.0075n 1)
1 1/1.0075
Or,
10 000(1 1/1.0075)
+ 1 = 1.0075n
200
Or,
1.0075n = 1.372208435
26
_____________________________________________________________________________
Taking the natural logarithm of both sides, we get

n ln(1.0075) = ln(1.372208435)
which gives
n = 42.347539.
At the end of 42 months, the amount in the account is

200 (1.0075) (1 1.007542)
= $9904.39
1 1.0075
Another $95.61 on the first day of the 43rd month will do it.
To do the problem on Excel, use (2.9) to put the accumulated amount in cell B5 and set
the spreadsheet as follows. Since 10,000/200 = 50, the answer is 50 months if the bank
pays no interest. If the bank is paying interest, the answer should be somewhat less than
50 months, perhaps between 40 and 50 months. Start by putting 40 in cell B3.
1
2
3
4
5
6
7
A
Monthly payment, C
Monthly interest rate, r
Number of months, n
Target amount
Accumulated amount
Shortage
Answer:
200
=.09/12
42
10000
=B1*(1+B2)*((1+B2)^B3-1)/B2
=B4-B5
=B3+1
last months payment

months
Adjust the value in cell B4 until the shortage in cell B6 is less than 200. The answer is 43
months, with the last monthly payment being $95.61.
To solve the problem on WolframAlpha, copy and paste the following:
WRA 10000=sum(200*1.0075î,i=1..n)
2.8. Suppose you deposit $125 at the beginning of each month in an account that
compounds interest continuously at the annual rate of 8%. Find the total amount in this
account after 30 months.
By using equation (2.4), the FV of the first $125 after 30 months will be 125e.08(30/12).
Similarly, the FV of the second $125 after 29 months will be 125e.08(29/12), and so on. The
total amount will be
FV = 125e.08(30/12) + 125e.08(29/12) + 125e.08(28/12) ... 30 terms
This series can be summed by using (1.5), where n = 30, a = 125e.08(30/12) = 152.6753448,
x = e.08/12 = .9933555063 and n = 30. Thus
27
_____________________________________________________________________________
FV =
125e.08(30/12) (1 e.08(30/12)) 125(e.08(30/12) 1)

=
= 4165.15
1 e.08/12
1 e.08/12
The account should have $4,165.15 at the end of 30 months.

To solve the problem on Excel, set up a table like this one.
1
2
3
4
A
Amount of deposit =
Number of periods =
Continuously compounded interest rate =
Final amount =
B
125
30
=.08/12
=B1*(exp(B3*B2)-1)/(1-exp(-B3))
C
dollars
months
per month
To verify the answer at WolframAlpha, use the following instruction.

WRA sum(125*exp(.08*i/12),i=1..30)
If you want to develop a general formula with continuous compounding, you may do it as
follows. Suppose you deposit A dollars per period, at the beginning of every period, for n
periods. The continuously compound rate of interest is r. Then the first deposit becomes
Aern after n periods. The second deposit will become Aer(n1) after n1 periods, the third
one Aer(n2) after n2 periods, and so on. The total amount will be
S = Aern + Aer(n1) + Aer(n2) + n terms
This is a geometric series with first term a = Aern, the ratio between the terms x = er, and
the number of terms n = n. Use (1.5) to find the sum as
Aern(1 ern) A(ern 1)
Sn =
= 1 er
1 er
2.9. Clifford Montdale is going to put $100 at the beginning of each month in a savings
account that pays interest at the rate of 7% per year, compounding it monthly. This rate is
fixed for one year, and it will go down to 6% in the second year. Find the balance in this
account after two years.
Consider the future value of each deposit, and then sum them up. The first deposit will
remain in the bank earning interest at the rate of 7/12% per month for the first 12 months,
and then at a rate of 6/12 = 1/2% per month for the next 12 months. Its future value is
100(1 + .07/12)12(1 + .06/12)12.
The next deposit's future value will be 100(1 + .07/12)11(1 + .005)12, because it will earn
interest at the rate of 7/12% for the first 11 months, then at the rate of 6/12% = .5% =
.005 for the next 12 months. Continuing the procedure further, the future value of the first
12 payments will be
100(1 + .07/12)12(1.005)12 + 100(1 + .07/12)11(1.005)12 + ... + 100(1 + .07/12)1(1.005)12
28
_____________________________________________________________________________
During the second year, the interest rate is down to .5% per month. We can write the sum
of future values of the payments for second year as
100(1.005)12 + 100(1.005)11 + 100(1.005)10 + ... + 100(1.005)1
This results in two geometric series. For the first series, the initial term
a = 100(1 + .07/12)12(1.005)12, The ratio between the terms x = 1/(1 + .07/12), and the
number of terms n = 12. For the second series, a = 100(1.005)12, x = 1/(1.005), and the
number of terms n = 12. Applying (1.5), we get the total amount to be
S=
100(1 + .07/12)12(1.005)12[1 1/(1 + .07/12)12] 100(1.005)12[1 1/1.00512]

+
1 1/(1 + 0.07/12)
1 1/1.005
= $2563.09
The answer is quite reasonable because it consists of $2400 of actual deposits and $163
in interest for two years. To solve the problem on WolframAlpha, copy and paste the
following line:
sum(100*1.005^12*(1+.07/12)î,i=1..12)+sum(100*1.005î,i=1..12)
Video 02.10 2.10. Harold Brown is planning to put some money on the first of every
month in a savings account that pays 12% annual interest, compounded monthly. He will
start by putting $500 on February 1, 2008, but keep on increasing his deposits by 1%
every month. On what date will this account have more than $1 million for the first time?
This is a problem of future value and compounding. We find the final value as the sum of
all the deposits with proper compounding. Suppose Harold Brown reaches the milliondollar mark after n months. The first $500 will earn interest at the rate of 1% per month,
compounding monthly, and after n months, its value will become 500(1.01)n.
Next month, the deposit will increase by 1% and it will be 500(1.01). This deposit will
grow for only n 1 months, because one month has already elapsed. Its final value will
be 500(1.01)(1.01)n1. We can write it as 500(1.01)n. The final value of both deposits will
be identical because the second deposit starts out with a bigger amount, but has less time
to grow. The two factors cancel out precisely.
The deposit for the following month is 1% greater than the previous months deposit and
it equals 500(1.01)2. However, it can grow only for n 2 months and it finally becomes
500(1.01)2(1.01)n2. Merging the powers, the result is 500(1.01)n. This gives exactly the
same final value. We discover that the final value of each deposit is the same, namely,
500(1.01)n. Since there are n such deposits, their total final value should be n[500(1.01)n].
We can summarize the previous discussion in the following equation.
1,000,000 = 500(1.01)n + 500(1.01)(1.01)n1 + 500(1.01)2(1.01)n2 + ...
29
_____________________________________________________________________________
Or,
1,000,000 = 500n (1.01)n
We can solve the above equation for n by using Maple. We enter the instruction
fsolve(1000000=500*n*1.01^n,n);
and we get n = 221.2568054. Thus after 222 months, or, 18 years and 6 months, he
should have more than a million dollars. The exact amount is 500*222*1.01222 =
$1,010,806.30.
To get the answer on WolframAlpha, enter the following
WRA 1000000 = 500*n*1.01^n
If Harold Brown decides to increase his monthly deposit by 2% every month, while the
bank keeps on paying 1% monthly interest, then the first equation will become
1,000,000 = 500(1.01)n + 500(1.02)(1.01)n1 + 500(1.02)2(1.01)n2 + ...
In this case, the numbers do not cancel out neatly. Notice that the sum of the powers is n.
The factor (1.01) starts with power n and ends with power 1. The factor (1.02) starts with
power 0 and it ends with power n 1. We can represent the above equation as follows
n
1,000,000 = 500(1.02)i1(1.01)n+1i
i=1
Note that the sum of the powers is i 1 + n + 1 i = n as required. The starting values for
the two powers are 0 and n, and the first term in the summation is 500(1.02)0(1.01)n,
when i = 1. To solve the equation using Maple, enter
1000000=sum(500*1.02^(i-1)*1.01^(n+1-i),i=1..n);
solve(%);
The result is 162.1914189. This means Harold Brown can achieve his goal sooner, in 163
months. This is quite reasonable because he is increasing his initial deposit at a faster
rate.
For WolframAlpha, enter the following
1000000=sum(500*1.02^(i-1)*1.01^(n+1-i),i=1..n)
It does not give an accurate answer. However, the two diagrams suggest a value of
around 162.
To do the problem on Excel, set up a table as follows.
30
_____________________________________________________________________________
1
2
3
A
500
=A1*1.02
=A2*1.02
B
=A1*1.01
=(A2+B1)*1.01
=(A3+B2)*1.01
Column A will show the deposit for each month and column B the total accumulated in
the account up to that point. Next, highlight the cells (A2,B2,A3,B3) and drag down the
handle. When you reach row 163, the total accumulated in cell B163 will be
1,018,185.809, which is just over a million dollars.
2.11. The winner of the recent lottery received notice that he would get his money in 20
annual installments of $281,347 each. He will get the first installment right now. If the
discount rate is 12%, find the present value of his winnings.
281347
1.12i
i=1
19
PV = 281,347 +
= 281,347 +
281347 (1 1.1219)
= $2,353,686
0.12
To get the answer on WolframAlpha, enter the following,

WRA sum(281347/1.12î,i=0..19)
2.12. A person has the following options in settlement of a life insurance policy:
(1) A cash settlement of $100,000, or
(2) A monthly payment of $1,000 available at the end of each month for the next 20 years
If the proper discount rate in this case is 12%, which method is better for the recipient?
The present value of the monthly payments is the sum of discounted cash flows. For
monthly cash flows, the discount rate is 1% per month. There are 240 payments. For
summation of terms, use (2.6).
240 1000
1.01i =
i=1
1000(1 1.01240)
= $90,819.42
.01
Clearly, the cash settlement is better.

2.13. You have just bought a car from your friend. He gives you two options: pay for the
car in 48 monthly installments of $109 each, or 60 monthly installments of $89 each. The
time value of money is 12% annually. Which is the cheaper method of payment?
Compare the present value of the two payment options by discounting them at the rate of
12% per year, or 1% per month.
31
_____________________________________________________________________________
48 109
109(1 1.0148)
PV of 48 monthly payments = 1.01i =
= $4,139.16
.01
i=1
89
89(1 1.0160)
PV of 60 monthly payments = 1.01i =
= $4,001.00
.01
i=1
60
It is better to take the 60-month option.

2.14. You are interested in buying a new sports car costing $21,000. You can afford only
$5,000 as the down payment and the bank will finance the rest at 11.8%. What are the
level monthly payments that will pay off the loan in 48 months?
The basic financial principle in this problem is as follows:
The present value
of the loan
The present value

of future payments
We can express it as
n
P
L = (1 + r)i
(2.10)
i=1
The amount of loan is $16,000, the number of payments is 48, and the monthly interest
rate is 0.118/12. Thus if P is the monthly payment, then
48
(1 + .118/12)i =
i=1
Or,
P[1 (1 + .118/12)48]
= 16,000
.118/12
16000 (0.118/12)
P = 1 (1 + 0.118/12)48 = $419.77
To get the answer on WolframAlpha, enter the following expression

WRA sum(P/(1+.118/12)î,i=1..48)=16000
2.15. You have bought a piece of land in Wayne County for $12,000. You agreed to pay
the owner the price in five equal annual installments of $3,000 each, the first one right
now. What is the implicit rate of interest that the owner is charging?
Equating the cash price of the land to the discounted value of all the payments, we get
4 3000
12,000 = 3000 + (1 + r)i
i=1
32
_____________________________________________________________________________
4 3000
9,000 = (1 + r)i
Or,
i=1
To solve this equation using Maple, type the main instruction as

fsolve(9000=sum(3000/(1+r)î,i=1..4),r,0..1);
The instruction "fsolve" requires the program to solve the following equation in
floating point and find the value of r within the range 0 to 1. The instruction "sum" takes
the summation of the following terms. After some computation the result .1258983250
shows up on the screen. This is the interest rate of 12.59%.
1
2
3
4
A
Number of periods =
Each payment =
Present value of loan =
Implied interest rate =
B
4
-3000
9000
=RATE(B1,B2,B3)
C
dollars
dollars
13%
One can do the problem in Excel by using the RATE function. The inputs for the function
are =RATE(nper,pmt,pv,[fv],[type],[guess]), but the result is inaccurate.
At WolframAlpha, enter the following to get a positive real solution
WRA 12000=3000+sum(3000/(1+r)î,i=1..4)
2.16. You have borrowed $56,000 as a mortgage loan to buy a house. The bank will
charge interest at the rate of 9% annually and requires a minimum monthly payment of
$500. At the end of five years, you must pay off the entire mortgage by a balloon
payment. You plan to pay only the minimum amount each month and then pay off the
loan with the final payment. Find this balloon payment.
During uncertain economic times, when the interest rates are liable to fluctuate widely,
the lending institutions give out short-term loans that require a balloon payment to pay
off the loan. At the time of the balloon payment, the borrower can renegotiate the loan at
the current interest rates and it may include another balloon payment. Suppose the
balloon payment is B, then the equality of loan value to the present value of all payments
implies that
n
P
B
(2.11)
L=
i+
(1
+
r)
(1
+
r)n
i=1
Put numerical values,
60
500
B
56,000 = 1.0075i + 1.007560
i=1
Or,
56,000 =
500(1 1.007560)
B
+
.0075
1.007560
33
_____________________________________________________________________________
Which gives B = 56,000
500(1 1.007560)
(1.007560) = $49,966.07
.0075
You can check the answer with Maple by using the following steps.
L=sum(P/(1+r)î,i=1..n)+B/(1+r)^n;
subs(L=56000,P=500,r=.09/12,n=5*12,%);
solve(%);
The following Excel table will solve the problem.
1
2
3
4
5
A
Interest rate =
Number of payments =
Payment per month =
Initial loan =
Balloon payment =
B
.0075
60
500
-56000
=FV(B1,B2,B3,B4)
C
per month
dollars
dollars
$49,966.07
To get an approximate answer on WolframAlpha, enter the following,

WRA 56000=sum(500/1.0075î,i=1..60)+B/1.0075^60
2.17. You have borrowed $500 from a friend with the understanding that you will pay
him back in three installments: $100 after one month, $200 after two months, and $220 at
the end of the third month. Find the implied interest rate in this arrangement.
Set the loan value to the PV of the three payments as
100
200
220
500 = 1 + r + (1 + r)2 + (1 + r)3
You cannot solve this problem by the Present Value tables but you can go to
WolframAlpha and paste the following instruction.
WRA 500=100/(1+r)+200/(1+r)^2+220/(1+r)^3
the answer comes out to be .017777 = 1.7777% monthly.
The nominal annual rate is 12 times the monthly rate, that is, 12(.017777) = .2133 =
21.33%. The effective annual rate is due to the monthly compounding and it comes out to
be 1.017777121 = 23.55% annually. The effective interest rate is higher than the
nominal rate.
2.18. Sebastian Cabot has received $135,000 in compensatory damages. He has placed
the money in a trust account that pays 6% annual interest, compounded monthly. Cabot
will withdraw $1000 a month out of this account, starting one month after the initial
deposit. Calculate the money in the account after 25 withdrawals.
34
_____________________________________________________________________________
The monthly interest rate is .5% = .005. With the withdrawal rate of $1000 a month, the
25 1000
present value of 25 withdrawals is 1.005i. This means the present value of amount of
i=1
25 1000
money in the account after 25 months will be 135000 1.005i. This amount is
i=1
growing at the rate of .005 per month for 25 months. Thus, its future value is
25 1000
FV = 135000 1.005i(1.00525) = $126,368.29
i=1
In general, it becomes
n
w
FV = A (1 + r)i(1 + r)n
i=1
(2.12)
Here FV is the future value of the account, which had an initial amount A. The account
pays interest at rate r. The owner of the account has made n withdrawals, each one equal
to w. This leads us to the question that if a person has a nest egg A from which he
regularly withdraws w per month, how long will it take him to exhaust his savings. To
answer that, we use Maple and type in the instructions:
0=(A-sum(w/(1+r)î,i=1..n))*(1+r)^n;
solve(%,n);
After some simplification, we get the answer as
w
lnw Ar
n = ln(1 + r)
(2.13)
Consider a person with a total savings of $400,000, which is earning interest at the rate of
% per month. He withdraws $3000 from it every month. He will exhaust his savings in
3000
ln3000 400000*.005
n=
= 220.3 months = 18.36 years
ln(1.005)
2.19. Alabama Corporation has taken a loan of $60,000 with the understanding that it
will make the monthly payments of $600. The bank will charge the interest at the rate of
9% per year on the unpaid balance. After how many months will the balance become
$48,686.38?
The present value of the loan L in terms of the discounted future values is
35
_____________________________________________________________________________
n
P
B
L = (1 + r)i + (1 + r)n
(2.11)
i=1
where P is the regular monthly payment and B is the balloon payment, or balance after n
periods. We may solve it for n by using Maple as follows:
L=sum(P/(1+r)î,i=1..n)+B/(1+r)^n;
solve(%,n);
The result is
rB P
lnrL
P
n = ln(1 + r)
(2.14)
Substituting r = 0.0075, B = $48,686.38, L = $60,000, P = $600, we get the value of n as

.0075*48686.38 600
ln .0075*60000 600
n=
= 60
ln(1.0075)
Thus after 60 months the balance will be $48,686.38.
To do the problem on Excel, you can set up a table like this one. Adjust the number of
payments in cell B2, until the value in cell B5 becomes equal to required balance of
$48,686.38.
1
2
3
4
5
A
Interest rate =
Number of payments =
Payment per month =
Initial loan =
Balance =
B
.0075
60
600
-60000
=FV(B1,B2,B3,B4)
C
per month
dollars
dollars
$48,686.38
To check the answer at WolframAlpha, copy and paste the following instruction.
WRA 60000=sum(600/1.0075î,i=1..n)+48686.38/1.0075^n
2.20. A bank offers the following program to its customers. If you deposit $100 at the
beginning of every month for the next 7 years, then in return the bank will give you $100
a month forever, starting a month after your last monthly payment. If the time value of
money is 13.2% annually, would you join in this program?
First, find the present value of your payments. Suppose you make your first payment
today, the second payment at the end of the first month, and the 84th payment at the end
of the 83rd month. The monthly discount rate is 13.2/12 = 1.1% = .011. Because you
make the first payment now, the present value of 84 payments is
36
_____________________________________________________________________________
83 100
100(1 1.01183)
PV1 = 100 + 1.011i = 100 +
= $5524.33
.011
i=1
Next, find the present value of banks payments. You made your last payment at the end
of the 83rd month and the bank will make its first payment at the end of the 84th month.
The present value of the bank's payments is
100
100
100
PV2 = 1.01184 + 1.01185 + 1.01186 + ...
This is an infinite geometric series with a = 100/1.01184 and x = 1/1.011. Using (1.6),
100/1.01184
PV2 = 1 1/1.011 = $3666.58
You are paying the bank an excess amount of 5,524.33 3,666.58 = $1,857.75,
calculated in present value dollars. The net present value of this transaction is
$1,857.75. Because the net present value is negative, you should not join.
You can find the net present value at WolframAlpha with the following instruction.
WRA -100-sum(100/1.011î,i=1..83)+sum(100/1.011î,i=84,infinity)
2.21. In the last problem, at what minimum rate of interest would the customers consider
making their deposits in this program?
The bank's payments have a smaller present value due to a higher discount rate. One has
to find a smaller discount rate that will equate these two values. At some equilibrium
point, the equation PV1 = PV2 will hold. This gives us
83
1
1
1
1
1 + (1 + r)i = (1 + r)i = (1 + r)83 (1 + r)i
i=1
i=84
i=1
Or,
1+
1 (1 + r)83
1
1
=
83
r
(1 + r)
r
Multiplying by r throughout, we get

Multiply by (1 + r)83 to get
Or,
1
r + 1 (1 + r)83 = (1 + r)83
(1 + r)84 = 2
r = 21/84 1 = .008285892 monthly
37
_____________________________________________________________________________
The annual rate is 12(.008285892) = 0.099430704 = 9.943% annually. If the interest rates
in the market are less than 9.943%, then the depositors will come out ahead. In the time
of high inflation, when the interest rate is more than 10%, the bank will win this game.
To perform the calculation on WolframAlpha, copy and paste the following:
WRA sum(1/(1+r)î,i=0..83)=sum(1/(1+r)î,i=84,infinity)
The result is .00828589.
2.3
Evaluation of Financial Tools
Finance is an analytical subject. For instance, you want to know if a firm should acquire
$20 million in new capital by selling bonds or by selling stock. You have to work with
certain numbers (its existing debt, equity, interest rates, expected earnings, etc.) to make
an informed decision. After you decide, say bonds are the better choice, you should also
find out the degree of confidence in your decision.
Suppose you want to know if a firm should buy a car or lease it for the next five years. To
make the decision correctly, you should use several variables as inputs, such as the initial
value of the car, its resale value after five years, the depreciation schedule, the cost of
capital, the lease payments, and the income rate tax of the company.
To do these problems, you need mathematical equations and calculations. What is the
best way to handle finance calculations? Let us consider three tools used to do such
calculations, a calculator, Excel, and WolframAlpha.
You can do every problem in this course using a calculator. I consider this as a good way
to understand the basic ideas in finance and to use them in solving simple calculations.
The hands-on approach gives you a feel for the solution.
Excel is best suited for solving problems that involve a large number of data. For
instance, if I know the price of Microsoft stock for the last thirty weeks, I would use
Excel to find the volatility of the stock, , which is an input in the Black-Scholes model.
You can also do every problem in this course in Excel.
Excel has the drawback that it does not show the details of the calculations, unless you
look for them. Even then, the details are coded as = B5*(1-1/(1+B6)^B7)/B6. You have to
search for values of these symbols in different cells. It takes the instructor a long time to
find the mistake in an Excel sheet submitted by a student, because the mistake is possibly
hidden somewhere in a score of cells.
Excel can find the answer very quickly if you use functions such as =PV(), =FV(),
=NPER(), etc. It is almost magic. However, some students fail to understand what lies
behind these calculations. For them, it is a black box. They are unable to explain why it
gives the correct answer. For instance, you can find the present value of 12 annual
38
_____________________________________________________________________________
payments of $100 each that you expect to receive, the first one available after one year,
using a discount rate of 5%. You can use =PV() function. The input is
EXCEL =PV(0.05,12,-100,0,0)
and the answer is $886.33. That is fine for undergraduate calculations. It leaves two
questions unanswered. What is the mathematical relationship between various factors?
Why do we use 100, instead of +100, to find the value of positive cash flows?
Can you do the calculation if the payments are not starting after one year, but after 5
years? What do you do if the payments are increasing by 3% every year? What if the
payments start at year 10 and increase by 7% every year thereafter? It is quite difficult to
handle these calculations using the Excel function =PV().
Consider the following questions and their answers by using WolframAlpha.
1. Find the present value of 12 annual payments of $100 each, the first one available after
one year, using a discount rate of 5%.
First, write the cash flows as a series of numbers, whose sum gives the desired result.
PV = 100/1.05 + 100/1.05^2 + 100/1.05^3 + 12 terms
Next, insert the following expression at WolframAlpha.
WRA sum(100/1.05î,i=1..12)
The answer is $886.32.
5 years, using a discount rate of 5%.
Write the cash flows and their summation as follws.
PV = 100/1.05^5 + 100/1.05^6 + 100/1.05^7 + 12 terms
WRA sum(100/1.05î,i=5..16)
The answer is $729.18 and it is less than the previous answer, $886.32, due to a delay in
the payments.
5 years, using a discount rate of 5%. The payments are increasing 3% annually.
In this case, you introduce the growth factor 1.03 and increase its power every year.
39
_____________________________________________________________________________
PV = 100/1.05^5 + 100*1.03/1.05^6 + 100*1.03^2/1.05^7 + 12 terms

WRA sum(100*1.03^(i-5)/1.05î,i=5..16)
If you take i = 5 in the above expression, it gives the first term as 100/1.05^5. For i = 6, it
gives the second term and so on. The result is $847.72, which is more than the previous
answer, $729.18, because the payments are increasing every year.
Which tool is best for you, you can decide it on your own. I prefer WolframAlpha. It is
freely available on the internet, at least for now. It is simple to use. It shows the details of
the calculations. It shows a graphical solution. It is easy to debug.
Problems
2.22. You have decided to deposit $100 in O'Neill National Bank at the beginning of
every month. The bank compounds interest on a monthly basis but at a variable rate
adjusting it annually. You know that during the first year, the interest will be 8%
annually, but during the second year, it may go up to 9%. Find the expected amount in
your account after two years.
$2631.00
2.23. Conrad Aiken has a retirement account in which he has been adding a certain sum
of money on the first of every month. He started by depositing $250 in the first month but
kept on increasing his deposits by 1% every month. The bank was adding interest to his
account monthly at the rate of 0.8% per month during the first year and then 0.9% per
month during the second year. Find the total amount in this account at the end of two
years.
$7,500.87
2.24. Homer Zeno has borrowed $50,000 from the bank with the understanding that he
will make a minimum payment of $500 per month. The bank will charge interest at the
rate of 1% per month on the unpaid balance. Homer plans to make $500 monthly
payments for the first 12 months, then $600 monthly payments for the next 48 months,
and then pay off the entire loan by making a balloon payment at the end of the 61st
month. Find this balloon payment.
$44,316.52
2.25. You have taken a $100,000 mortgage loan at Albert Savings Association at the rate
of 9% annually. You are required to pay $1,000 monthly payment. Approximately, how
long will it take you to pay off the loan?
15 years 6 months
2.26. Cooper Corporation has borrowed $120,000 from the bank at 8% annual interest
rate, compounded monthly. The company plans to pay $2,000 per month for the first 12
months, and then pay $2500 per month for the next 12 months. Find the remaining
balance of the loan after 24 months.
$82,655.21
2.27. Atbara Corporation has taken a five-year loan from the local bank at the annual
interest rate of 9%. Atbara will pay back the $250,000 loan in monthly installments. Find
(a) the monthly payment, and (b) the balance of the loan after 24 payments.
40
_____________________________________________________________________________
(a) $5189.59, (b) $ 163195.99

2.28. Akron Corporation has borrowed $1.2 million from a bank with the understanding
that it will pay $50,000 a month, until the loan is paid off. The bank will charge 9% per
year interest on the unpaid balance, calculated monthly. Akron will make the payments at
the end of each month. Find the following:
(A) How long will it take Akron to pay off the loan?
(B) What is the balance of the loan after 24 months?
27 months
$126,272.71
2.29. You would like to accumulate a million dollars for your retirement. You have
another 35 years before you retire. The local bank, where you intend to keep the money,
will compound interest monthly at the annual rate of 6%. How much money should you
deposit at the beginning of each month to reach your goal?
$698.41
2.30. Rutherford B. Hayes has borrowed $80,000 as a mortgage loan at 7.5% interest rate
and 30-year term. He has to pay the loan in monthly installments. After how many
payments will the unpaid balance become $40,000?
265 months
Multiple Choice Questions
1. The future value of $1100, compounding at the rate of 6% annually, after 10 years is
(a) $1600.00
(c) $1819.40
(b) $1790.85
(d) $1969.93
2. The present value of $5000 that you will get after 10 years, discounting at the rate of
5% per year, is
(a) $2508.91
(c) $2965.34
(b) $2899.77
(d) $3069.57
3. Suppose Republic of Scandia has a steady 30% inflation rate and a loaf of bread costs
100 liras today. Its price, in liras, last year was
(a) 66.67
(c) 76.92
(b) 70
(d) 130
4. The monthly interest rate on a savings account is 1%, compounded monthly. The
effective annual rate is
(a) 11.25%
(c) 12.68%
(b) 12.00%
(d) 13.13%
5. If the discount rate is 7%, then the present value of $40,000 that you expect to get after
15 years is
41
_____________________________________________________________________________
(a) $14,497.84
(c) $106,400.80
(b) $15,037.48
(d) $110,361.26
6. The future value of $10,000 after 11 years, growing at the rate of 12% per year is
(a) $34,237.40
(c) $34,785.50
(b) $34,522.71
(d) $34,984.51
7. The future value of $1000 after 5 years, with interest rate 6% and using monthly
compounding, will be
A. $1348.85
B. $1338.23
C. $1374.49
D. $1349.86
8. The present value of $10,000, available after 6 years, with continuous discounting at
the rate 7% per year, is
A. $9958.09
B. $6663.42
C. $6570.47
D. $6650.57
Key Terms
annuity, 21
compounding, 17, 18, 20, 23,
24, 25, 27, 28, 33
discount rate, 20, 21, 22, 30,
36
discounting, 17, 18, 31
effective annual rate, 33

exponential function, 18
future value, 17, 18, 20, 22,
23, 25, 27, 28, 34
inflation, 17, 37
nominal annual rate, 33
42
perpetuity, 21, 22
present value, 17, 18, 20, 21,
22, 30, 31, 32, 34, 35, 36
risk, 17
3. VALUATION OF Bonds AND Stock

Objectives: After reading this chapter, you will
1. Understand the role of bonds in financial markets.
2. Distinguish between different types of bonds, such as zero-coupon, perpetual, discount,
convertible, and junk bonds and apply the bond pricing formulas to evaluate these
bonds.
3. Understand the concepts of equity capital, stock, and dividends.
4. Apply Gordon's growth model to evaluate the equity of a firm.
5. Find the value of a stock with supernormal growth for a few periods followed by
normal growth.
3.1
Video 03A Capital formation
Corporations need capital, meaning money, to run their business. They need the money to
make capital investments, which are investments in land, buildings, equipment, and
machinery. In order to acquire capital the firms turn to investors. Figure 3.1 represents the
relationship between the corporations and investors.
Investors
Capital
Return on investment
Corporation
Fig. 3.1: The relationship between the investors and a corporation.
Examining the long-term capital structure of a company, we find that the capital comes in
two forms: debt and equity. When a company acquires debt capital, it simply borrows
money on a long-term basis from the investors. A company can also borrow money from
a financial institution for the short-term. The firms issue financial instruments called bonds
and sell them to the investors for cash. Bonds are merely promissory notes that promise to
pay the investors the interest on the bonds regularly, and then pay the principal when the
bonds mature.
When a corporation wants to raise equity capital, it sells stock to the investors. The
stockholders then become part owners of the company. The ownership of stock gives them
an equity interest in the company. There are important differences between debt and equity
capital. For instance, the bonds mature after several years and the company must redeem
the bonds by paying the principal back to the investors. There is no maturity date for the
stock. The bondholders receive regular interest payments from the company. The
stockholders may or may not receive dividends from the company. The stockholders vote
for the election of board of directors, but the bondholders do not have any voting rights.
The board of directors has the ability to make important decisions at the company, such as
hiring or firing of its president.
43
3. Valuation of Bonds and Stock
_____________________________________________________________________________
3.2
Valuation of Bonds
The face amount of a typical bond is $1,000. The market value of the bond could be more
than $1,000, and then it is selling at a premium. A bond with a market value less than
$1,000 is selling at a discount, and a bond, which is priced at its face value, is selling at
par. The market price of a bond is usually quoted as a percentage of its face value. For
instance, a bond selling at 95 is really selling at 95% of its face value, or $950.
Figure 3.2 shows an advertisement that appeared in the Wall Street Journal of July 23,
1997. Dynex Capital, Inc. issued bonds with a total face value of $100 million in July 1997.
The bonds carried a coupon of 77/8%. This means that each bond pays $78.75 in interest
every year. Actually, half of this interest is paid every six months. The bonds will mature
after 5 years, which is relatively short time for bonds. They are senior notes in the sense
that the interest on these bonds will be paid ahead of some other junior notes. This makes
the bonds relatively safer.
$100,000,000
DYNEX
Dynex Capital, Inc.
Senior Notes Due July 15, 2002
Interest Payable January 15 and July 15
Price 99.900%
plus accrued interest from July 15, 1997
Paine Webber Incorporated Smith Barney Incorporated

77/8%
Fig. 3.2: A bond advertisement in Wall Street Journal.
The price of these bonds is $999 for each $1,000 bond. Occasionally, the corporations may
reduce the price of a bond and sell them at a discount from their face value. This is true if
the coupon is less than the prevailing interest rates, or if the financial condition of the
company is not too strong. The buyer must also pay the accrued interest on the bond. If an
investor buys the bond on July 25, 1997, he must pay accrued interest for 10 days. When
the bonds are publicly traded, they will be listed as Dynex 77/8s02. The information about
the bonds is frequently displayed as: Madison Company 4.75s33. We learn to interpret it
as follows:
Madison Company: This is the name of the entity that issues the bonds
4.75: This is the coupon rate, or the annual rate of interest paid on the bonds, that is 4.75%
per annum
s: This is just a separator between the two numbers
33: This is the year when the bond will mature, namely, 2033
44
_____________________________________________________________________________
The two companies listed at the bottom of the advertisement, Paine Webber Incorporated
and Smith Barney Incorporated, are the underwriters for this issue. Underwriters, or
investment banking firms, such as Merrill Lynch, will take a certain commission for selling
the entire issue to the public.
Since the appearance of this advertisement, several changes have occurred. On November
3, 2000, Paine Webber merged with UBS AG, a Swiss banking conglomerate. Smith
Barney is now part of Morgan Stanley Smith Barney. Corporations no longer use fractions
in identifying the coupon rates; instead, decimals are used universally.
An important feature of every bond issue is the indenture. The indenture is a detailed legal
contract between the bondholders and the corporation that spells out the rights and
obligations of both parties. In particular, it gives the bondholders the right to sue the
company and force it into bankruptcy, if the company fails to pay the interest payments on
time. This provides safety to the bondholders, and puts serious responsibility on the
corporation.
The two factors that determine the interest rate of a bond are the creditworthiness of the
corporation and the prevailing interest rates in the market. A company that is doing well
financially, and has good prospects in the future, will have to pay a lower rate of interest
to sell bonds. A company that is close to bankruptcy will have a hard time selling its bonds,
and must attach a high coupon rate to attract the investors.
The term sinking fund describes the amount of money that a company puts aside to retire
its bonds. For example, a company issues bonds with face value $50 million, which will
mature in 20 years. During the last five years of their existence, the company may set aside
$10 million per year to buy back, or retire their bonds. This $10 million is the sinking fund
payment. This procedure spreads the loan repayment over a five-year period and is easier
for the company to manage.
To retire the bonds, the corporation may buy the bonds in open market if they are selling
below par. The corporation may also call the bonds, depending on the provisions of the
indenture, by paying more than the face value of the bonds to the bondholders. Such bonds
are called callable bonds.
We can evaluate a bond by finding the present value of the interest payments and that of
the principal. The proper discount rate that calculates the present value depends on the risk
of the bonds. The risky bonds have a relatively higher discount rate. Further, the discount
rate is also the rate of return required by an investor buying that bond. The basic financial
principle is:
The present value of a bond is simply the present value
of all future cash flows from the bond, properly discounted.
We may express the above statement as follows
45
_____________________________________________________________________________
n
C
F
B = (1 + r)i + (1 + r)n
(3.1)
i=1
The first term on the right side is the present value of the coupon payments, or the interest
payments in dollars. The second term is the present value of the face amount of the bond
in dollars. This resembles equation (2.9).
Recently, CalTech issued very long maturity bonds, 100 years to be exact. In 1997, a
company in Luxembourg issued bonds that would mature after 1,000 years. British
Government has issued perpetual bonds, called consols, which are still available today and
carry a coupon rate of 2%. In principle, an American company can issue perpetual bonds
that will never mature but the Federal Government prohibits that.
Perpetual bonds have an infinite life span. In essence, they are perpetuities. The
bondholders continue to receive interest payments and if they want to, they can always sell
the bonds to other investors. Since the bond is never going to mature, the implicit
assumption is that the investors will never receive the face amount of such a bond. From
(2.7), when n approaches infinity, the summation becomes C/r. The second term for the
present value of the face amount also approaches zero. From (3.1) we get the simple
formula for perpetual bonds.
C
B= r
(3.2)
Some companies try to conserve cash and they may sell zero-coupon bonds. These bonds
make no periodic interest payments and they pay the entire accumulated interest and the
principal at the maturity of the bond. Because of this feature, these bonds sell at a
substantial discount from their face value. For instance, General Motors issued zero coupon
bonds in 1996 due to mature in 2036. In January 2007, these bonds were selling at 38.11,
or $381.10 per $1000 bond. For zero-coupon bonds, the first term in (3.1) is zero because
C is zero. This leaves only the second term for the valuation of zero-coupon bonds as
follows:
F
B = (1 + r)n
(3.3)
Occasionally, a company may issue convertible bonds. A bondholder, at his discretion, can
exchange a convertible bond for a fixed number of shares of stock of the corporation. For
example, the bondholder may get 50 shares of stock by giving up the bond. If the price of
the stock is $10 a share, then the conversion value of the bond will be $500, that is, the
bond can be converted into $500 worth of stock. The market value of the bond will always
be more than the conversion value. If the price per share rises to $25, then the price of the
bond will be at least 50(25) = $1250. Thus, the convertible bonds are occasionally trading
above their face value.
At times, the financial health of a company deteriorates quite a bit. The company may even
stop paying interest on the bonds, and there is little hope of recovery of principal of these
46
_____________________________________________________________________________
bonds. Such bonds, with extremely high investment risk, are frequently labeled as "junk"
bonds.
An investor buys a bond for its rate of return, or its yield. We define the current yield, y, of
a bond as follows.
Annual interest payment of the bond
y = Current market value of the bond
The annual interest payment of the bond equals cF, where c is the coupon rate, and F is the
face value of the bond. With B being the market value of the bond, we may write
y = cF/B
(3.4)
This represents the return on the investment provided the bond is held for a short period.
While holding a bond to maturity, one receives money in the form of interest payments,
and there is a change in the value of the bond. The annual interest payment of the bond is
cF, as seen before. If you have bought the bond at a discount, it will rise in value reaching
its face value at maturity. On the other hand, the bond may drop in price if it has been
bought at a premium. In any case, it should be selling for its face value at maturity. The
total price change for the bond is FB, where F is the face value of a bond and B is its
purchase price. This change may be positive or negative depending upon whether F is
more, or less, than B. On the average, the price change per year is (FB)/n, where n is the
number of years until maturity. On the average, the price of the bond for the holding period
is (F + B)/2. Thus the yield to maturity Y, of a bond is given, approximately, by dividing
the annual return by the average price. This is given by:
annual interest payment + annual price change
Y average price of the bond for the entire holding period
Or,
cF + (F B)/n
(F + B)/2
(3.5)
Let us define b as the market value of the bond expressed as a fraction of its face value.
For instance, if a bond is selling at 90% of its face, or $900 per $1000 bond, then b = .9.
With this definition, it is possible to write (3.5) as
Y
2(cn + 1 b)
n(1 + b)
(3.5a)
For a bond selling at par, b = 1, meaning the bond is selling at its face value. In that case,
(3.5a) gives Y = c.
In equation (3.1), the discount rate r is also equal to the yield to maturity, Y. The reason for
the approximation in the equation (3.5) is that the value of a bond does not reach the face
amount linearly with time, as seen in Figure 3.3.
47
_____________________________________________________________________________
Consider a bond that has 8% coupon, pays interest semiannually, and will mature after 10
years. Assume that the investors require 10% return on these bonds. Then the current value
of the bond is
20 40
1000
B=
i+
20 = $875.38
1.05
1.05
i=1
As the bond approaches maturity, its value reaches $1,000. This is shown in Fig. 3.3. Notice
that the curve is not a straight line. The bond value rises slowly at first and then more
rapidly when it is close to maturity.
Equation (3.5) calculates the yield to maturity of a bond only approximately. To find it
more accurately, we depend on the alternate definition of yield to maturity: The yield to
maturity of a bond is that particular discount rate, which makes the present value of the
cash flows to be equal to the market value of the bond. Thus, we go back to (3.1), put
known values of B, n, C, and F, and evaluate the unknown r. That is the yield to maturity
of the bond. We need a set of Maple or WolframAlpha instructions to get the final answer.
Fig. 3.3: The value of a bond with respect to time to maturity. Face value $1000, coupon 8%, 10 years to
maturity, semiannual payments, yield to maturity 10%.
The US Government borrows heavily in the financial markets by issuing Treasury bonds.
They are issued with maturity date ranging from six months to thirty years. The yield of
these bonds fluctuates. The following table gives the yield of Treasury securities on
January 5, 2007.
48
_____________________________________________________________________________
US Treasury Bond Rates, January 5, 2007
Maturity Yield Yesterday Last Week Last Month
3 Month
4.88
4.87
4.84
4.83
6 Month
4.87
4.85
4.82
4.83
2 Year
4.72
4.67
4.78
4.56
3 Year
4.65
4.60
4.71
4.47
5 Year
4.62
4.57
4.65
4.43
10 Year
4.63
4.58
4.68
4.47
30 Year
4.72
4.69
4.79
4.58
Table 3.1: Source: http://finance.yahoo.com/bonds
One can plot the yield against the time to maturity to get the Treasury yield curve, shown
in Figure 3.4. The curve is plotted on a semi-log scale to accommodate long maturity dates.
Normally, one expects that the longer maturity bonds have a higher yield, but this is not
the case in January 2007. Hence, we see an inverted yield curve in the diagram.
Figure 3.4. The inverted Treasury yield curve on January 5, 2007. On the x-axis, .1e2 means 10 years, and
.2e2 is 20 years.
Maturity
2yr AA
2yr A
5yr AAA
5yr AA
5yr A
10yr AAA
10yr AA
10yr A
20yr AAA
20yr AA
20yr A
Corporate Bonds, January 5, 2007

Yield Yesterday Last Week Last Month
5.04
4.98
5.11
4.86
5.13
5.08
5.20
4.92
5.06
5.03
5.11
5.19
5.13
5.09
5.17
4.93
5.20
5.16
5.23
4.99
5.18
5.07
5.30
5.08
5.32
5.33
5.42
5.19
5.43
5.37
5.47
5.26
5.68
5.71
5.76
5.06
5.76
5.79
5.84
5.68
5.82
5.85
5.90
5.71
Table 3.2: The yield of bonds as a function of quality and time to maturity. Source:
http://finance.yahoo.com/bonds January 5, 2007
49
_____________________________________________________________________________
Table 3.2 shows the yields of corporate bonds on January 5, 2007. The letters AAA, AA,
and A represent the quality of bonds, or bond rating, by Fitch. The least risky bonds are
designated by AAA, and so on. We notice two things. First, the longer maturity bonds of
the same quality rating have a higher yield. For instance, for bonds with A rating, the yield
for 2- year maturity is 5.13%; and for 20 years, it is 5.82%. Second, the yield is higher for
riskier bonds. Consider 5-year bonds. The yield rises from 5.06% to 5.20% when the rating
drops from AAA to A.
Issue
Price
Federal Home Ln Mtg

Goldman Sachs
Emerson Electric
Clear Channel Comm.
Scotia Pacific
Brookstone
Fedders No Am
Wise Metals
99.00
104.40
100.53
90.90
81.50
99.88
72.50
90.74
Coupon
%
5.000
5.750
5.125
7.250
7.710
12.000
9.875
10.250
Maturity
date
27-Jan-2017
1-Oct-2016
1-Dec-2016
15-Oct-2027
20-Jan-2014
15-Oct-2012
1-Mar-2014
15-May-2012
YTM
%
5.128
5.168
5.056
8.165
11.634
12.020
16.575
12.678
Current
Yield
5.051
5.508
5.098
7.976
9.460
12.015
13.621
11.296
Fitch
Ratings
AAA
AA
A
BBB
BB
B
CCC
CC
Callable
Yes
No
No
No
No
Yes
Yes
Yes
Table 3.4: The yield of bonds as a function of quality and time to maturity. Source: Source:
http://finance.yahoo.com/bonds January 5, 2007
Table 3.4 shows a sampling of bonds available in the market in January 2007. They are
arranged in terms of their quality rating, the least risky bonds are the top and the riskiest
ones at the bottom.
Normally, when a buyer buys a bond he has to pay the accrued interest on the bond. This
is the interest earned by the bond since the last interest payment date. Occasionally some
bonds trade without the accrued interest and they are thus dealt in flat. Some corporations
gradually get deeper in financial trouble. As they come closer to bankruptcy, their bonds
lose their value drastically. Finally, they become junk bonds.
Video 03B Examples
3.1. An investor wants to buy a bond with face value $1,000 and coupon rate 12%. It pays
interest semiannually and it will mature after 5 years. If her required rate of return is 18%,
how much should she pay for the bond?
The present value of a bond is the sum of the present value of its interest payments plus the
present value of its face value. The annual interest on the bonds is .12(1000) = $120, and
thus the semiannual interest payment is $60. The annual required rate is 18%, or 9%
semiannually. This is the discount rate. There are 10 semiannual periods in 5 years. Put n
= 10, r = .09, F = 1000 in (3.1), which gives
10 60
1000
60(1 1.0910) 1000
B = 1.09i + 1.0910 =
+ 1.0910 = $807.47
0.09
i=1
She should pay $807.47 for the bond.

50
_____________________________________________________________________________

WRA sum(60/1.09î,i=1..10)+1000/1.09^10
3.2. American Airlines bonds pay interest on January 15 and July 15, and they will mature
on July 15, 2017. Their coupon rate is 11%. Because of the risk characteristics of American
Airlines, you require a return of 15% annually on these bonds. How much should you pay
for a $1,000 bond on January 16, 2011?
With 11% coupon, the annual interest payment is $110, which is $55 semiannually. If you
buy the bonds on January 16, 2011, you will miss the payment made on January 15.
Therefore you will get only one payment in 2011, on July 15. You will get two payments
each in 2012, 2013, 2014, 2015, 2016, and 2017. Altogether, you will get 13 interest
payments of $55 each.
The annual discount rate is 15%, which is 7.5% semiannually. Substitute n = 13, r = .075,
F = 1000 in (3.1), which gives the PV of these interest payments, plus the discounted face
value as
13
55
1000
55[1 1.07513]
1000
B = 1.075i + 1.07513 =
+
0.075
1.07513 = $837.48
i=1
WRA sum(55/1.075î,i=1..13)+1000/1.075^13
3.3. A zero coupon bond with face value $1,000 and 6.25 years until maturity is available
in the market. Because of its risk characteristics, you require 11.5% return, compounded
annually, on this bond. How much should you pay for it?
For a zero-coupon bond, use
Put F = 1000, r = .115, n = 6.25,
to get
F
B = (1 + r)n
(3.3)
1000
B = 1.1156.25 = $506.44
3.4. Canopus Corporation's 9% coupon bonds pay interest semiannually, and they will
mature in 10 years. You pay 30% tax on interest income, but only 15% on capital gains.
Your after-tax required rate of return is 12%. Assume that you pay taxes once a year. What
is the maximum price you are willing to pay for a $1,000 Canopus bond?
Suppose you pay x dollars for a $1,000 bond. The annual interest is $90; or $45 every six
months. For semiannual cash flows, the discount rate is 6%, which is one-half of the annual
required rate of return. In ten years, you will get 20 semiannual payments.
The annual tax on $90 interest income is .3(90) = $27.
51
_____________________________________________________________________________
After 10 years, you receive the face value of bond, $1,000, and you have a capital gain of
(1000x). However, you have to pay tax on the capital gain, which comes to (.15)(1000
x) = 150 .15x. The after-tax amount is thus 1000(150 .15x) = 850 + .15x.
Apply the financial principle:
PV of
the
bond
PV of 20 semiannual
interest payments,
discounted at 6%
Write it in symbols,
PV of 30% of $90,
paid in taxes
annually for 10 years
PV of the after-tax final payment,

which is $1000 minus 15% of the
difference between 1000 and x
20 45
10 27
850 + .15x
x = 1.06i 1.12i + 1.1210 (A)
i=1
i=1
Move the terms with x on the left side of the equation and rewrite it as
10 27
.15 20 45
850
x 1 1.1210 = 1.06i 1.12i + 1.1210

i=1
i=1
Use (3.1) to complete the summation as

.15 45(1 1.0620) 27(1 1.1210)
850
x 1 1.1210 =
+
.06
.12
1.1210
Or,
.9517040145 x = 516.1464548 152.5560218 + 273.6772511
Or,
x = 669.6070148 = $669.61
To verify the answer at WolframAlpha, use the following instruction to solve (A).
WRA x=sum(45/1.06î,i=1..20)-sum(.3*90/1.12î,i=1..10)+(1000-(1000-x)*.15)/1.12^10
3.5. You have bought a $1,000 bond for $450, with a coupon of 5%, which has 10 years
until maturity. The interest is paid semiannually. Find the yield to maturity for this bond.
Here we use
cF + (F B)/n
(F + B)/2
Put c = .05, F = 1000, B = 450, n = 10, in (3.5), which gives

Y
.05*1000 + (1000 450)/10

= .1448
(1000 + 450)/2
Or, about 14.5% per year.
52
(3.5)
_____________________________________________________________________________
To find the yield accurately, we set the current price equal to the sum of discounted future
interest payments and the face value. Suppose the unknown yield to maturity is r, which is
also the proper discount rate to use in the bond valuation equation (3.1). Assume the bond
pays interest semiannually. Therefore, we should use r/2 as the discount rate for $25
semiannual interest payments.
20
25
1000
450 = (1 + r/2)i + (1 + r/2)20
i=1
Or,
25[1 (1 + r/2)20]
1000
+
r/2
(1 + r/2)20
i=1
20
450 =
We may solve this equation by using Maple. If we enter the command

fsolve(450=sum(25/(1+r/2)î,i=1..20)+1000/(1+r/2)^20,r=0..1);
the answer shows up as .1635007175 or about 16.35%.

To solve the problem using WolframAlpha, write the above equation as
WRA 450=25*(1-1/(1+r/2)^20)/r*2+1000/(1+r/2)^20
You can do it on Excel by setting up the spreadsheet as follows. Adjust the value in cell
B5 until the value in cell C5 becomes close to zero. The exact yield to maturity is in cell
B5, with the quantity in cell C5 equal to .002, which is less than a penny.
1
2
3
4
5
A
Face amount of bond =
Market value of bond =
Coupon rate =
Time to maturity =
Yield to maturity =
B
1000
450
5%
10
16.35%
dollars
dollars
years
=B2-B3*B1/2*(1-1/(1+B5/2)^(2*B4))/B5*2-B1/(1+B5/2)^(2*B4)
This is the annual return, or 16.35%. This is the exact answer with four-digit accuracy.
Video 03C 3.6. Bareilly Corporation bonds will mature after 3 years, and carry a coupon
rate of 12%. They pay interest semiannually. However, due to poor financial condition of
the company, you believe that there is a 30% probability Bareilly will go bankrupt in any
given year, provided it has survived the previous years. In case of bankruptcy, you expect
that the company will make the interest payments for that year. It will pay only 20% of the
principal at the end of that year. If your required rate of return is 12%, find the value of this
bond.
You may organize the calculation as follows. The probability of going bankrupt in the first
year is 30%, or .3. The probability of surviving the first year is thus .7. The company must
survive the first year to get into the second year. The probability of survival in the first
53
_____________________________________________________________________________
year, and bankruptcy in the second year is thus (.7)(.3) = .21. Similarly, the probability of
bankruptcy in the third year is (.7)(.7)(.3) = .147. Lastly, the probability of surviving three
years is (.7)(.7)(.7) = .343. The sum of all these probabilities is, of course, 1.
Event
Probability
Bankrupt in second year
.7(.3) = .21
Bankrupt in third year
.7(.7)(.3) = .147
Survive all 3 years
.7(.7)(.7) = .343
Sum of the above
Bankrupt in first year
.3
PV of cash flows
60
200
1.06i + 1.062 = 288.00
i=1
2
60
200
.21(366.33)
60
200
.147(436.03)
1.06i + 1.064 = 366.33
i=1
6
Prob*PV
.3(288.00)
1.06i + 1.066 = 436.03
i=1
6
60
1000
1.06i + 1.066 = 1000
i=1
.343(1000)
$570.43
Next consider the PV of cash flows in each case. The value of the bond is expected PV of
all cash flows, which is $570.43
3.7. Jackson Corporation has issued callable bonds with the call feature that the company
can call the bonds after 3 or 4 years, by paying the face value of the bonds plus the accrued
interest. There is 50% probability that Jackson will call the bonds after 3 years. If it does
not call the bonds after 3 years, there is 50% probability that it will call them after 4 years.
The bonds will mature after 5 years anyway. The bonds have a coupon rate of 6% and they
pay interest semiannually. Your required rate of return is 10%. Find the value of the bonds
according to your requirements.
There are only three possibilities, namely, that the bonds will mature after 3 years, or 4
years, or 5 years. Because of the conditional probability, the probability of each outcome
is as follows. The table shows the present value of the cash flows.
Life of Bond Probability
3 years
4 years
5 years
.5
.5*.5 = .25
PV of Cash Flows
6
30
1000
30
1000
30
1000
1.05i + 1.056 = 898.49
i=1
8
1.05i + 1.058 = 870.74
i=1
10
.5*.5 = .25 1.05i + 1.0510 = 845.57

Total = 1
i=1
Probability*(PV of Cash Flows)

.5*898.49 = 449.24
.25*870.74 = 217.68
.25*845.57 = 211.40
Total = $878.32
To verify the answer at WolframAlpha, use the following instruction

.5*(sum(30/1.05î,i=1..6)+1000/1.05^6)+.25*(sum(30/1.05î,i=1.
.8)+1000/1.05^8)+.25*(sum(30/1.05î,i=1..10)+1000/1.05^10)
54
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3.7. Compton Company bonds pay interest semiannually, and they will mature after 10
years. Their current yield is 8%, whereas their yield to maturity is 10%. Find the coupon
rate and the market value of these bonds. Hint: use (3.1) and (3.4).
Since we have to find the value of two unknown quantities, the coupon rate, c, and the
market value of the bond, B, we need to develop two equations. Recall that the yield to
maturity of a bond is the same as the required rate of return r. Assume semiannual interest
payments.
Semiannual required rate of return or the discount factor, r = .05,
The number of interest payments of the bond, n = 20,
The face value of the bond, F = 1000,
The dollar value of each interest payment, C = cF/2 = 500c, in (3.1)
20 500c
1000 500c(1 1.0520) 1000
B = 1.05i +
+ 1.0520
1.0520 =
.05
i=1
Or, with some simplification B = 6231c + 376.9
(1)
This is the first equation. To get the second equation, put y = .08 in (3.4). This gives
.08 = c(1000)/B
Solving (2) for c, we find
(2)
c = (.08/1000)B
Substituting the above value of c in (1), we get

B = 6231(.08/1000)B + 376.9
Or,
B = .4985B + 376.9
Or,
B(1 .4985) = 376.9
Or,
Going back to (2),
B = 376.9/(1 .4985) $751.51

c = (.08/1000) 751.5 6.012%
This gives the coupon rate as 6.012%, and the market value of the bond to be $751.51.
To solve the problem using WolframAlpha, write the two basic equations as
WRA B=sum(500*c/1.05î,i=1..20)+1000/1.05^20,.08=c*1000/B
55
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3.3
Valuation of Stock
The two principal components of the capital structure of a company are its equity and debt.
A corporation sells its stock to the investors to raise equity capital. The financial markets
ultimately determine the value of a share of stock. If the company is in strong financial
condition and it has good earnings prospects, then the investors will aggressively buy its
stock and raise the price per share. The market value of a stock could be quite different
from its book value or its accounting value. The value of the stock depends upon the
expectations of the investors regarding the future earnings and growth possibilities of the
firm.
Table 3.5 gives the information about the stocks of some well-known companies. The
information is for close of business on January 5, 2007. The first column shows the range
of the stock price, in dollars, for the past 52 weeks. The next two columns give the name
of the company and its stock symbol. The fourth and fifth columns show the closing price
of the stock and its net change. General Electric, for instance, closed at $37.56 per share,
down 19. The next two columns show the annual dividend per share and the dividend
yield. For Boeing, the annual dividend is $1.40 per share and its dividend yield is
1.40/89.15 = .0157 = 1.57%.
52 Week
Range
65.90-92.05
44.81-57.00
32.06-38.49
32.85-43.95
21.46-30.26
27.83-37.34
Stock
Symbol
Boeing
BA
Citigroup
C
Gen Electric
GE
Home Depot HD
Microsoft MSFT
PP&L
PPL
Close Net
Chg
89.15 -0.38
54.77 -0.29
37.56 -0.19
37.79 -0.78
29.64 -0.17
35.55 -0.63
Div Yld % PE
1.40
1.96
1.12
0.90
0.40
1.10
1.57
3.60
3.00
2.30
1.30
3.10
41.50
11.79
22.83
13.60
23.69
15.74
Volume
1000s
3,168
13,130
26,729
21,676
44,680
1,048
Market
Cap
70.4B 0.62
269.1B 0.44
387.2B 0.51
81.21B 1.28
291.4B 0.71
13.56B 0.24
Table 3.5: Stock prices. Source: Finance.Yahoo.com, January 7, 2007
The next column shows the P-E ratio, which is the ratio between the price of the stock per
share and the earnings per share. For Citigroup, it is 11.79. This gives the earnings per
share as 54.77/11.79 = $4.65 per share. Citigroup pays $1.96 as dividends out of this
money. Thus its dividend payout ratio is 1.96/4.65 = 42.15%. The next column shows the
trading volume. More than 44 million shares of Microsoft changed hands that day. The
next column shows the total market value of the company, in billions of dollars. The last
column shows the of the stock. Beta is a measure of the risk of the stock. We shall look
at it more closely in chapter 5. It is interesting to note that all stocks went down on this
trading day, but it is not surprising because all the major market indicators shown in Table
3.6 also went down.
Symbol
Last
Change
Dow
12,398.01 82.68 (0.66%)
NASDAQ 2,434.25 19.18 (0.78%)
S&P 500 1,409.71 8.63 (0.61%)
Table 3.6. The stock market indices on January 5, 2007, source, Finance.Yahoo.com
56
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An investor buying the common stock of a corporation is looking at two possible returns:
the receipt of cash dividends and the growth of the company. Let us make a couple of
simplifying assumptions to develop a formula for stock valuation.
1. Assume that the firm is growing steadily, that is, its growth rate remains constant. This
also means that the dividends of the firm are also growing at a constant rate. In reality, the
firms grow in an uncertain way.
2. The growth is supposed to continue forever. This is also quite unrealistic because the
companies tend to grow rapidly at first, then the growth rate slows down, and some mature
firms actually decline in value.
Even though the assumptions are not very good, its gives a fairly accurate result. Let us
define:
P0 = price of the stock now
D1, D2, D3, ... = the stream of cash dividends received in year 1, 2, 3, ...
g = growth rate of the dividends
R = the required rate of return by the stockholders
Assuming that the company is going to grow forever, then the price of the stock now is just
the discounted value of all future dividends.
D1
D2
D3
P0 = 1 + R + (1 + R)2 + (1 + R)3 + ...
But D2 = D1(1 + g), D3 = D1(1 + g)2, D4 = D1(1 + g)3, and so on. Thus
D1
D1(1 + g) D1(1 + g)2
P0 = 1 + R + (1 + R)2 + (1 + R)3 + ...
D1
This becomes an infinite geometric series, with the first term a = 1 + R and the ratio of
1+g
terms x = 1 + R . Using equation (1.5),
a
S = 1 x
(1.5)
we get
D1
P0 =
1 + g
(1 + R) 1 1 + R
Simplifying it,
D1
P0 = R g
(3.6)
57
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Money Market Rates

Tuesday, July 31, 2007, Wall Street Journal
PRIME RATE: 8.25% (effective 6/29/06). This is a benchmark rate used by banks in
making loans to their commercial customers. The best customers pay close to the prime
rate, while less creditworthy customers pay more.
DISCOUNT RATE: 6.25% (Primary) (effective 6/29/06). This is the rate charged by the
Federal Reserve for the loans made to the member banks.
FEDERAL FUNDS: 5.4375%, high, 4.500% low, 4.250% near closing bid, 5.00%
offered. Effective rate 5.32%. Reserves traded by the member banks for overnight use
in amounts of $1 million or more.
CALL MONEY: 7.00% (effective 6/29/06). This is the rate of interest used by
stockbrokers for making loans to their customers for the purchase of common stocks.
COMMERCIAL PAPER: placed directly by General Electric Capital Corporation,
5.24% 30 to 44 days, 5.25% 45 to 61 days, 5.28% 62 to 89 days, 5.29% 90 to 119 days,
5.30% 120 to 190 days, 5.29% 191 to 219 days, 5.28% 220 to 249 days, 5.27% 250 to
270 days.
CERTIFICATES OF DEPOSIT: 5.28% one month, 5.36% three months, 5.46% six
months.
LONDON INTERBANK OFFERED RATE (LIBOR): 5.3300% one month, 5.42625%
three months, 5.5150% six months, 5.5675% one year. The rate is set by the British
Banker's Association, and is used by one bank making loan to another bank. This is a
key rate used in international transactions, especially interest rate swaps.
FOREIGN PRIME RATES: Canada 6.25%, European Central Bank 4.00%, Japan
1.875%, Switzerland 4.42%, Britain 5.75%, Australia 6.25%, Hong Kong 8.00%.
TREASURY BILLS: Results of the Monday, August 31, 2007, auction of the short-term
T-bills sold at a discount in units of $1,000 to $1 million. 5.055% 4 weeks, 4.825% 13
weeks, 4.800% 26 weeks.
MERRILL LYNCH READY ASSETS TRUST: 4.70%, average rate of return, after
expenses, for the past 30 days; not a forecast of future returns.
CONSUMER PRICE INDEX: June 208.4, up 2.7% from a year ago. Bureau of Labor
Statistics.
Table 3.3: Money rates
58
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Myron J. Gordon (1920-2010)
Equation (3.6) gives us the valuation of a common stock. It is a

well-known result called Gordon's growth model, named after
Myron Gordon. This result is valid only if R > g. Although it is
based on some unrealistic assumptions, the formula does provide
fairly accurate stock valuation. The following problems will
illustrate the general method of evaluation of equity when the
growth rate is not constant.
3.4. Preferred Stock

Preferred stock is similar to the common stock. It is part of the equity-portion of the capital
structure of the firm. However, the preferred stock has several important differences.
First, the dividends of the preferred stock remain constant. That is, the rate of growth of
dividends is zero. If a preferred stock pays $3 annually, it will continue to do so, even if
the issuing company experiences very strong growth. In this respect, the preferred stock is
similar to a bond, which pays constant interest payments.
Second, the dividends of the preferred stock are paid ahead of the common stock, hence
the name preferred stock. This makes the preferred stock a safer investment relative to the
common stock, but it is not quite as safe as the bonds of the same corporation.
Third, the preferred stock usually has a limited life. This means that a company may issue
a preferred stock and then take it out of circulation after five years. The preferred
stockholders must give up their stock and receive cash. In this respect, preferred stock is
similar to a bond, which will also mature after five or ten years.
Fourth, a preferred stock has no voting rights. The common stockholders have the right to
elect the board of directors of a firm, which makes important decisions at the firm. The
bondholders of a firm do not have voting rights either.
To summarize, the preferred stock has some features of a bond and some other features of
a stock. It is a hybrid security.
Examples
Video 03E 3.8. The common stock of Steerforth Inc has just paid a dividend of $2.00.
The dividends are expected to grow at the rate of 10% for the next three years, and then at
the rate of 5% forever. Find the price of this stock, assuming the required rate of return is
20%.
The price of a stock is equal to the sum of discounted future dividends received by an
investor. The current dividend is $2, but it will grow at the rate of 10% for the next three
years. The dividend after one year is 2(1.1); after two years, it becomes 2(1.1)2; and after
three years, it is 2(1.1)3. After that, the growth slows down to 5%. Thereafter the dividends
59
_____________________________________________________________________________
are: 2(1.1)3(1.05) after 4 years, and 2(1.1)3(1.05)2 after 5 years, and so on. All these
numbers are discounted at the rate of 20%. If P0 is the current price of the stock, then
2 (1.1) 2 (1.1)2
2 (1.1)3 2 (1.1)3 (1.05) 2 (1.1)3 (1.05)2
P0 = 1.2 + 1.22 +
+
+ ...
1.23 +
1.24
1.25
2 (1.1)3
Starting with the third term, 1.23 , it becomes an infinite series with a = 2(1.1/1.2)3, and
x = 1.05/1.2. The sum of all terms is thus
2 (1.1) 2 (1.1)2 2 (1.1/1.2)3
P0 = 1.2 + 1.22 + 1 1.05/1.2 = $15.84
To solve the problem using WolframAlpha, write the above equations as
WRA 2*1.1/1.2+2*(1.1/1.2)^2+sum(2*(1.1/1.2)^3*(1.05/1.2)î,i=0..infinity)
3.9. Sirius Inc. common stock just paid a quarterly dividend of $1.00. Investors expect this
dividend to grow at annual rate of 4%, compounded quarterly, for the next 10 quarters.
Then it will remain constant in future. The stockholders require a return of 12% on their
investment in Sirius. What is the current market price of Sirius common stock?
The growth rate of dividends is 4% per year, or 1% per quarter. The required rate of return
per year is 12%, or 3% per quarter. Adding together the discounted value of the return from
the first 10 quarters and the infinite many quarters thereafter will give the value of the
stock.
For the first 10 quarters, the dividends are growing at 1% per quarter and they are D1 =1.01,
D2 = 1.012, D3 = 1.013, and so on. For the remaining quarters, starting with the 11th quarter,
the dividend will remain constant at 1.0110. The discount rate is 3%. Thus
1.01 1.012 1.013
1.019 1.0110
1.0110 1.0110 1.0110
P0 = 1.03 + 1.032 + 1.033 + ... + 1.039 + 1.0310 + 1.0311 + 1.0312 + 1.0313 + ...
Write the first ten terms as the summation of one geometric series and the remaining terms
as another infinite geometric series. For the first series, we let a = 1.01/1.03, x = 1.01/1.03,
and n = 10 in equation (1.4). For the remaining terms, put a = 1.0110/1.0311, and x = 1/1.03
in (1.5). This gives
P0 =
(1.01/1.03)[1 (1.01/1.03)10] 1.0110/1.0311

+ 1 1/1.03
1 1.01/1.03
After simplification, the stock price comes out to be $36.39.

60
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WRA sum((1.01/1.03)î,i=1..10)+sum(1.01^10/1.03î,i=11..infinity)
3.10. Gabon Corporation is expected to have the following growth rates: 10% during the
first three years, 5% during the next three years, and then zero forever thereafter. Gabon
just paid its annual dividend of $5. What is the price of a share of Gabon stock if the
stockholders require a return of 10% on their investment?
We can find the stock price by the following summation. The PV of cash flows for the first
three years, next three years, and the remaining years, are shaded in different colors.
P0 =
5(1.1) 5(1.1)2 5(1.1)3

5(1.1)3(1.05) 5(1.1)3(1.05)2 5(1.1)3(1.05)3
+
+
+
+
2 +
3
1.1
1.1
1.1
1.14
1.15
1.16
+
Canceling terms,
P0 = 5 + 5 + 5 +
5(1.1)3(1.05)3 5(1.1)3(1.05)3 5(1.1)3(1.05)3

+
+
+ ...
1.17
1.18
1.19
5(1.05) 5(1.05)2
5(1.05)3 5(1.05)3 5(1.05)3
+
+
2
1.1
1.1
1.13 + 1.14 + 1.15 + ...
The shaded series is an infinite series. Add all items to get

5(1.05/1.1)3
P0 = 15 + 5(1.05/1.1) + 5(1.05/1.1)2 + 1 1/1.1 = $72.16
3.11. Troy Company has issued $5 cumulative preferred stock. The cumulative feature
means that if the company is unable to pay the dividends in any year, it must pay them
cumulatively next year. The probability that the company will actually pay the dividends
in any year is 70%. At the end of three years, Troy must pay all the dividends and buy back
the stock for $50 per share. If your required rate of return is 12%, how much should you
pay for a share of this stock?
The company will certainly make the final payment in year 3. Consider the three-year
period and the cash payments. There are four possible outcomes.
Year 1
$0
$0
$5
$5
Year 2
$0
$10
$0
$5
Year 3
$65
$55
$60
$55
Probability
.3(.3) = 0.09
.3(.7) = 0.21
.7(.3) = 0.21
.7(.7) = 0.49
The total probability of all outcomes is 1. The PV of the cash flows is thus
55
60
5
55
65
10
5
5
PV = 0.091.123 + 0.211.122 + 1.123 + 0.211.12 + 1.123 + 0.491.12 + 1.122 + 1.123
61
_____________________________________________________________________________
= $47.29
You should pay at most $47.29 for one share of stock.
3.12. Mayfield Corporation stock is expected to pay a dividend of $2.00 one year from
now, $2.50 two years from now, $3.00 three years from now, and then $4.00 a year at the
end of the fourth and subsequent years. The stockholders of Mayfield require 15% return
on their investment. Find the price of a share of Mayfield stock now, and just after the
payment of the first dividend.
The value of the stock is the present value of all future dividends, discounted at the rate of
15%. Display the cash flows and their present values in the following table.
Year
1
2
3
4
5
6
...
Dividend $2.00 $2.50 $3.00 $4.00 $4.00 $4.00 ... $4.00

2
2.5
3
4
4
4
4
Discounted
...
2
3
4
5
6
value
1.15 1.15 1.15 1.15 1.15 1.15
1.15
Discounting at the rate of 15%, write the present value of the cash flows as
2
2.5
3
4
4
4
P0 = 1.15 + 1.152 + 1.153 + 1.154 + 1.155 + 1.156 +
Look at the shaded terms. Note that starting with the fourth term, with $4 dividend, it
4
, and the ratio
becomes an infinite geometric series. The first term in the series, a =
1.154
between the terms, x = 1/1.15. Use equation (1.5) to find the sum.
a
S = 1 x
(1.5)
It gives,
2
2.5
3
4/1.154
P0 = 1.15 + 1.152 + 1.153 + 1 1/1.15 = $23.14
After the payment of the first $2 dividend, the next dividend will be $2.50 available one
year later, $3.00 two years later and so on. To visualize the cash flows, draw another table
as follows.
Year
1
2
3
4
5
6
...
Dividend $2.50 $3.00 $4.00 $4.00 $4.00 $4.00 ... $4.00

Proceeding on the same lines as before, we get the present value of the cash flows
2.5
3
4
4
4
4
P1 = 1.15 + 1.152 + 1.153 + 1.154 + 1.155 + 1.156 +
62
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Starting with the third term, it becomes an infinite geometric series, with a = 4/1.153, and
x = 1/1.15. Use again to get
2.5
3
4/1.153
P1 = 1.15 + 1.152 + 1 1/1.15 + = $24.61
Why does the value of the stock increase after a year? This is because the investors are
expecting to receive a higher set of dividends. This becomes clear when we compare the
two timelines and the cash flows.
Problems
3.13. Philadelphia Electric Co. (now Exelon) bonds were once selling at 120.25, with 27
years to maturity and semiannual interest payments. The coupon rate was 18%. If your
required rate of return were 16% at the time, would you have bought these bonds?
B = $1,123.04, no
3.14. The Somerset Company bonds have a coupon of 9%, paying interest semiannually.
They will mature in 10 years. However, because of poor financial health of the company
you do not expect to receive more than 5 interest payments. Also, you do not expect to
receive more than 50% of the principal, after 4 years. Your required rate of return is 12%.
What is the maximum price you are willing to pay for these bonds?
$503.26
3.15. Gambia Express bonds have a coupon of 8%, pay interest semiannually, have a face
value of $1,000 and will mature after 10 years. Your income tax rate for interest income is
40%, but only 16% on capital gains. You pay the taxes once a year. How much should you
pay for a Gambia bond if your after-tax required rate of return is 10%?
$666.85
3.16. Leo Corporation bonds have a coupon of 9%; they pay interest semiannually; and
they will mature in 6 years. You pay 30% tax on ordinary income and 20% on capital gains.
What price should you pay for a Leo bond so that it gives you an after-tax return of 15%?
$647.78
3.17. In 2008, Rumsfeld Co 13s2027 bonds paid interest annually, and their price was
quoted as 98. You had to pay 28% tax on interest income and capital gains, and your
required after-tax rate of return was 10%. Do you think you would have bought these bonds
as a long-term investment?
No, B = $943.90
3.18. Caruso Corporation 9% bonds will mature on January 15, 2019. They pay interest
semiannually. On July 16, 2007, these bonds are quoted as 87.375. If your required rate of
return is 11.5%, should you buy these bonds?
No, B = $842.70, they sell at $873.75
3.19. Cincinnati Corporation 9% bonds pay interest semiannually, on April 15 and October
15, and they will mature on April 15, 2019. They are selling at 89 on October 16, 2008.
Considering its risk characteristics, your required rate of return for this bond is 10%.
(A) Do you think you should buy this bond?
63
Yes, B = $935.89
_____________________________________________________________________________
(B) Suppose you buy the bond at the market price, what is its approximate yield to
maturity?
10.63%
(C) Use Excel, Maple, or WolframAlpha to find its exact yield to maturity.
10.77%
3.20. Jefferson Corporation has issued callable bonds. The call feature states that the
company can call the bonds after 5 or 6 years, by paying $1050 for each bond plus the
accrued interest. There is 50% probability that Jefferson will call the bonds after 5 years.
If it does not call the bonds after 5 years, there is 50% probability that it will call them after
6 years. The bonds will mature after 7 years anyway and the bondholders will receive the
face value of the bonds. The bonds have 7% coupon rate and they pay interest
semiannually. Your required rate of return is 9%. Find the value of the bonds. $942.23
3.21. HAL Inc. stock is selling for $121 per share and it just paid an annual dividend of
$4.40. According to your careful analysis, you feel that HAL will continue to grow at the
rate of 25% per year for the next three years and then it will maintain a growth rate of 10%
per year forever. Its dividend payout ratio is expected to remain constant. Would you invest
your money in HAL, if your required rate of return is 16%?
S = $116.29, don't buy
3.22. White Rock Company stock just paid an annual dividend of $2.00. The dividends
are expected to grow at the rate of 3% annually for the next 10 years. After 10 years, White
Rock will stop growing altogether, but will continue to pay dividends at a constant rate.
What is the price of this stock, assuming 12% discount rate.
$20.20
3.23. Baffin Corporation stock has just paid the annual dividend of $4.00. The company
is expected to grow at the rate of 10% (along with its dividends) for the next three years,
then it is expected to grow at the rate of 3% forever. The investors require a return of 12%
for their investment in the Baffin stock. What is the fair market price of a share of the
stock?
$54.95
3.24. Timon Corporation stock has just paid the annual dividend of $2. This dividend is
expected to grow at the rate of 5% per year for the next ten years, and then it will remain
constant. If your required rate of return is 12%, how much should you pay for a share of
Timon stock?
$23.01
3.25. McCormack Corporation just paid the annual dividend of $4.00. The dividends are
expected to have a growth rate as follows: g1 = 7%, g2 = 5%, g3 = 3%, g4 = g5 = ... = 0,
where the g's represent the growth in the first year, second year, etc. Your required rate of
return is 10%. How much should you pay for a share of McCormack stock?
$45.86
3.26. Carpenter Corporation is expected to pay $2.00 dividend after one year, $3.00 after
2 years, $4.00 after 3 years, and then $5.00 a year uniformly after fourth and subsequent
years. If the stockholders of Carpenter require 12% return on their investment, find the
price of the stock now. What is its price just after the payment of the first $2.00 dividend?
$36.68, $39.08
64
_____________________________________________________________________________
3.27. Clifford Corporation stock is expected to pay a dividend on every January 25. In
2008, the dividend is $3.00, in 2009 $3.25, in 2010 $3.50, and in 2011 and all the
subsequent years it is expected to be $4.00. The shareholders of Clifford require a return
of 13% on their investment. Find the price of this stock on January 14, 2008, just before it
pays its dividend. What is its price on January 28, 2010, just after it has paid its dividend?
$32.71, $30.77
1. For a bond selling at its face value, 5 years before maturity,
A. the yield to maturity equals its current
yield
B. the bond should have zero coupon
C. the coupon rate is more than its current

yield
D. the coupon rate is equal to the prime rate
2. For the yield-to-maturity of a bond to be equal to its current yield,

A. the bond must be selling at a discount C. the bond must sell at its face value
B. the bond should have zero coupon
D. coupon rate must be equal to the prime rate
3. A bond is listed in WSJ as Ford 8.5s17 and priced as 85. This means
A. Its semiannual interest payment is $85 C. Its price is $85
B. Its maturity date is unknown
D. Its current yield is 10%
4. For a perpetual bond,
A. It is not possible to calculate its
current yield
B. The face amount is unknown
C. The market price is inversely proportional to

the interest rates
D. The coupon rate is not known
5. Gordon's growth model does not assume that

A. the rate of growth of dividends is constant
B. the required rate of return by the stockholders is
greater than the rate of growth of the company
C. the company must pay all

its earnings in dividends
D. the growth will continue
forever
6. For a zero-coupon bond,

A. The coupon rate is not known
B. The face amount is not known
C. The market price is directly proportional to the

interest rates
D. It is possible to calculate its current yield
65
_____________________________________________________________________________
7. For a bond that is selling at par

A. The face value is not equal to its
market value
B. The current yield is less than its yield
to maturity
C. The coupon rate is equal to its current

yield
D. The coupon rate is more than its yield
to maturity
8. For a zero-coupon bond

A. The market price is more than its face value C. The yield to maturity is zero
B. The current yield is zero
D. The risk of the bond is zero
9. The prime rate is the rate used by
A. Stock brokers for loans to their
customers
B. Federal Reserve for loans to
member banks
C. Banks as a benchmark rate for commercial

lending
D. Treasury Department for short-term
borrowing
Key Terms
accrued interest, 40, 47
beta, 52
board of directors, 39
bond rating, 45
bondholders, 39, 41, 42
bonds, 39, 40, 41, 42, 43, 44,
45, 47, 48, 50, 51, 57, 58
book value, 52
call money, 46
callable bonds, 41
capital, 39, 48, 52, 58
capital investments, 39
commercial paper, 46
Consumer Price Index, 46
convertible bond, 39, 42
coupon, 40, 41, 42, 43, 44, 47,
48, 49, 50, 51, 52, 57, 58
current yield, 43
debt capital, 39
discount rate, 41, 43, 48, 55,
58
Discount Rate, 46
dividends, 39, 52, 53, 54, 55,
56, 58, 59
equity, 39, 52, 54
equity capital, 39, 52
Federal Funds, 46
Gordon's growth model, 39,
54
indenture, 41
interest, 39, 40, 41, 42, 43, 46,
47, 48, 49, 50, 51, 57, 58
junior notes, 40
junk bonds, 42, 47
66
LIBOR, 46
P-E ratio, 52
perpetual bond, 39, 42
prime rate, 46
risk, 41, 42, 47, 48, 52, 58
senior notes, 40
sinking fund, 41
stock, 39, 42, 52, 53, 54, 55,
56, 58, 59
stockholders, 39, 53, 55, 56,
59
Treasury Bills, 46
underwriters, 40
yield, 43, 44, 45, 47, 49, 51,
52, 58
yield-to-maturity, 43
zero-coupon bond, 39, 42
4. CAPITAL BUDGETING UNDER CERTAINTY

1. Understand the concept of net present value.
2. Use NPV approach in decision-making.
3. Understand the meaning of internal rate of return. Appreciate the difficulty in applying
this concept, and its inability to give a unique, or optimal solution.
4. See the effect of depreciation and taxes on the investment decisions.
4.1
Video 04A Capital Budgeting
In the course of their business, firms have to make capital investment decisions. This
involves critical evaluation of long-term investments and their impact on the value of the
company. The corporations make large investments in buildings and land, and in plant
and equipment. There is a constant need for modernization of equipment due to changes
in technology. As the firm grows, they need larger facilities. A firm may embark on new
projects, which may entail large investment of time and capital. The firm considers all
these decisions in light of the long-term benefit of the corporation. From the financial
point of view, only those projects will be acceptable that add to the value of the firm, and
increase the wealth of the owners of the firm.
A company has to evaluate many projects. Some of these projects may be mutually
exclusive in the sense that you have to pick only one and exclude others. A company may
want to install gas heat, or oil heat, in a factory, but not both. The company may have to
evaluate several alternative projects and rank them according to their profitability.
Finally, they may have to pick only one or two projects that they can finance with the
available capital. Thus, capital budgeting becomes an important issue.
We will consider one of the most important concepts in finance, the net present value,
which is the optimal decision making model to screen out the profitable projects from the
unprofitable ones. The net present value, NPV, of a project is the discounted sum of all
cash flows of a project, negative and positive, present and future. We may treat the initial
investment as a negative cash flow at present. Discount the future cash flows at a rate that
depends on the cost of capital of the firm and the risk of the project. By definition,
n
C
NPV = I0 + (1 + r)i
i=1
In the above expression, we define the symbols as follows:

I0 = initial investment in the project,
C = after-tax annual earnings of the project,
n = life of the project in years, and
r = risk-adjusted discount rate for the cash flows.
67
(4.1)
4. Capital Budgeting Under Certainty
_____________________________________________________________________________
The decision rule in using NPV is that if the NPV is positive the project is acceptable,
otherwise not. This is also in concert with the fundamental aim of the corporation to
maximize its value. Alternative decision rules such as the internal rate of return, IRR or
payback period are inadequate in many situations and may give misleading results.
The payback period method is really quite easy to apply. For example if a firm spends
$5000 to start a project that generates an income of $1000 annually, then the payback
period is 5 years. On the other hand, a project that costs $8,000 and generates $2000
annually will have the payback period 4 years. Based on the criterion of payback period,
the second project with the shorter time is better.
There are three serious defects in the payback period method. The main problem with this
methodology is that this procedure ignores the time value of money. It does not discount
the future cash flows and treats them at par with the present investment. This violates a
very fundamental concept in finance.
The second problem is that we are not looking at the risk of the project. The riskier cash
flows should have less value than more secure cash flows. We should adjust the discount
rate according the risk involved.
The third drawback is that we are not looking at the entire set of cash flows, meaning, we
ignore the cash flows that occur after the time when we have recovered the initial
investment. Perhaps there are large negative cash flows that appear after the recovery of
the initial investment. This could change the calculation completely. We shall ignore this
method of project evaluation completely.
Closely related to the NPV method is the internal rate of return method. The internal rate
of return method has some merit. Actually, it is merely an extension of the NPV method
and we shall look at it in the next section.
We shall first consider simple problems in capital budgeting where the cash flows and
other outcomes are known with certainty. Later we shall include the complications due to
non-uniform cash flows, taxes and depreciation, and resale value. In the next chapter, we
shall continue the discussion of capital budgeting under uncertainty.
Examples
4.1. An investment requires the following cash outlays: $10,000 now and $5,000 a year
from now. The investment will give a cash return of $5,000 annually for 6 years, the first
payment coming in after 3 years. The risk-free rate is 6%. If the proper discount rate is
12%, would you accept this investment?
The firm should look at first two cash flows, $10,000 now, and $5000 a year from now,
as definite commitment to finance the project. The firm can certainly pay $5000 next year
by investing in a risk-free bond now, whose present value is 5000/1.06. Considering all
the cash flows,
68
_____________________________________________________________________________
5000 5000 5000 5000 5000 5000 5000

NPV = 10,000 1.06 + 1.123 + 1.124 + 1.125 + 1.126 + 1.127 + 1.128 (A)
We can either add them up separately, or combine them with the help of a formula. We
may write the above cash flows as
5000
1
5000 5000 5000 5000 5000 5000
NPV = 10,000 1.06 + 1.122 1.12 + 1.122 + 1.123 + 1.124 + 1.125 + 1.126
5000
1 6 5000
NPV = 10,000 1.06 + 1.122 1.12i
i=1
C[1 (1 + r)n]
C
=
(1 + r)i
r
i=1
n
Use,
(2.6)
5000
1
5000(1 1.126)
NPV = 10,000 1.06 + 1.122
= $1671
.12
Because of the positive NPV, we should accept the investment.

To solve the problem using WolframAlpha, write equation (A) as
WRA
-10000-5000/1.06+sum(5000/1.12î,i=3..8)
4.2. A young woman buys a life insurance policy on her 21st birthday. She has to pay an
annual premium of $147 through her 64th birthday. On her 65th birthday, she will receive
$10,000 as the surrender value of the policy. If she lives long enough to collect herself,
and assuming a discount rate of 12% in this case, find the NPV of this policy to the owner
of the policy.
Of course, the life insurance policy will also provide a $10,000 benefit to her heirs in case
she dies before reaching her 65th birthday. Here we are concerned only with the NPV of
her investment in case she lives to collect the benefits herself. She makes 44 payments of
$147 each, the first one right now. She also receives one payment of $10,000 after 44
years. Considering the present value of all the payments, we have
43 147
10000
NPV = 147 1.12i + 1.1244 (A)
i=1
= 147
147(1 1.1243) 10000

+ 1.1244 = $1294.33
.12
The negative NPV in this case does not mean that she should not buy the insurance. In
fact, it may be quite reasonable to provide $10,000 benefits to her children in case she
dies before she reaches the age of 65 by paying $1294 in current dollars.
69
_____________________________________________________________________________
To solve the problem at WolframAlpha, write equation as (A)

WRA
sum(147/1.12î,i=0..43)+10000/1.12^44
4.3. Devon Inc. wishes to invest $50,000 in a new project, which will give a return of
$10,000 annually for the first 5 years, and then an uncertain amount every year for the
next 5 years. The proper discount rate is 11% annually. Calculate the minimum value of
the uncertain return, which will make the project worthwhile for Devon.
Suppose the uncertain cash flow is x. To break even, the NPV of the project is zero. Thus,
we may write the problem as follows:
5 10000
10
x
NPV = 0 = 50,000 +
+
i
1.11
1.11i
i=1
i=6
1 5 x
The second summation on the right side is equivalent to 1.115 1.11i .
i=1
Using (2.6), we get

50,000
Solving for x, we get
10000(1 1.115)
1 x(1 1.115)
=
.11
.11
1.115
10 000(1 1.115)
.11
1.1151 1.115 50,000
=x
.11
This gives
x = $5945.75
To solve the problem at WolframAlpha, use the following expression

WRA
4.2
0=-50000+sum(10000/1.11î,i=1..5)+sum(x/1.11î,i=6..10)
Video 04B Internal Rate of Return
The internal rate of return, or IRR, of a project is that particular discount rate r, which
will make the net present value of the project equal to zero. If we let
n
C
NPV = 0 = I0 + (1 + r)i
(4.2)
i=1
and solve the equation for r, then this particular discount rate is the internal rate of return.
Once we find the IRR, it is compared with the risk-adjusted discount rate for the given
project. If IRR is greater, the project is accepted.
This equation is difficult to solve in general. However, certain calculators, such as HP12C, have the capability of getting the answer. If the cash flows are uniform, using tables
and interpolating the value of the discount rate may solve the problem. The best way to
handle (4.2) is to use WolframAlpha.
70
_____________________________________________________________________________
Although many managers use the IRR as a decision-making tool to accept or reject a
project, it has some serious flaws.
First, a project may not have a unique IRR. This is because a quadratic or a higher degree
equation has multiple roots. Some of these values do not have any economic significance
whatsoever, and it is not always possible to identify the correct value. Second, one cannot
use the IRR method reliably to rank projects. This is again due to multiplicity of roots of
the equation.
All these problems are absent in the NPV method, which is the optimal method for
decision-making. The only advantage of using IRR is that one can compare it directly to a
hurdle rate, or a minimum acceptable rate of return set by the managers of a corporation.
Examples
4.4. Betsey Trotwood is planning to open a restaurant. Her initial investment will be
$50,000. She expects to receive $20,000 at the end of first, second, and third year. Find
the internal rate of return of her project.
In general, we can solve the internal rate of return problems using Maple. We equate the
present value of all cash flows to zero, and find the proper discount rate. In this case,
20000
(1 + r)i = 0
i=1
3
50,000 +

WRA
-50000+sum(20000/(1+r)î,i=1..3)=0
The real solution is r .0970103, which is about 9.7%.

To get the result using Excel, set up the spreadsheet as follows. Adjust the value of the
number in B1 until the result in cell B2 becomes very close to 0.
1
2
A
IRR =
NPV = 0
B
.09701
-50000+20000*(1-1/(1+B1)^3)/B1
4.5. An investment of $10,000 will return $3,000 at the end of each of the next five
years. Find the IRR of this investment.
To solve for IRR we set the NPV equal to zero. Thus
3000
NPV = 10,000 + (1 + r)i = 0
5
i=1
71
_____________________________________________________________________________

WRA -10000+sum(3000/(1+r)î,i=1..5)=0
This gives the real solution as r .152382, which is 15.24%.
4.6. An investment has an initial outlay of $1200; an income of $5,000 at the end of one
year; and an expense of $3,000 at the end of second year. Find the internal rate of return
of this investment.
By definition, the internal rate of return of an investment is the discount rate that will
make its net present value to be zero. Suppose the required discount rate is r. Then
Let 1 + r = x. Then
5000
3000
NPV = 1200 + 1 + r (1 + r)2 = 0
1200 +
or, multiplying by x2,
(A)
5000 3000
x x2 = 0
1200 x2 + 5000x 3000 = 0
Dividing throughout by200, we get

6x2 25x + 15 = 0
This is a quadratic equation and we may solve it by using the standard formula. The
solution of
ax2 + bx + c = 0
is
b b2 4ac
x=
2a
In our case the solution is
x=
25 625 4(6)(15) 25 265

=
= 3.44 or 0.727
12
12
Since x = 1 + r, r = 2.44, 0.273. This is a case of multiple internal rates of return. There
is not much economic sense in the two values of IRR calculated above. Therefore, we are
unable to decide the case on the basis of IRR.
At WolframAlpha, write equation (A) as follows and click on Approximate forms.
WRA -1200+5000/(1+r)-3000/(1+r)^2=0
72
_____________________________________________________________________________
Fig. 4.1 shows the calculated value of NPV at different discount rates. When the discount
rate is zero, NPV = $800. Note that the NPV = 0 for r = .273 and 2.44. By differentiating
the function
5000
3000
1200 + 1 + r (1 + r)2
with respect to r and setting the derivative equal to zero, we get the maximum value of
NPV as $883 when r = 20%. We can observe that in Fig. 4.1.
Fig. 4.1: The diagram shows the IRR for a project. The curve crosses the x-axis at r = .273 and r = 2.44.
4.7. (A) Jefferson Corporation is considering a project that requires a cash outlay of
$4,000 now, and another $3,000 expense one year from now. The risk-free rate is 6%.
The project will terminate after two years, at which time it will generate a single positive
cash flow of $10,000. Calculate the internal rate of return of this project.
(B) If the cost of capital for Jefferson is 20%, should it undertake the above project?
(C) Verify your answer to (B) by calculating the NPV of the project.
(A) There is no uncertainty in the second payment of $3000 because the company has
already made the commitment to fund the project. This cash flow must be discounted at
the risk-free discount rate. Setting the NPV equal to zero, we have
4000
3000 10000
+
=0
1.06 (1 + r)2
Or,
10000
3000
(1 + r)2 = 4000 + 1.06 = 6830
Or,
(1 + r)2 = 10,000/6830 = 1.464
Or,
1 + r = 1.209995206
73
_____________________________________________________________________________
Which gives
r = .21 = 21%
(B) With the cost of capital at 20%, which is less than the IRR, the project is acceptable.
3000 10000
(C) NPV = 4,000 1.06 + 1.22 = $114.26
Since the NPV is positive, the project is indeed acceptable.
4.3
Video 04D Taxes and Depreciation
At this point in our calculation of the net present value of a project, we must also include
two important considerations: depreciation and taxes. They have a strong impact on our
decision making process. We also have to contend with them in real life situations.
We know of the physical depreciation; that machinery and equipment wears down with
age. The value of old equipment decreases with time. The old equipment is subject to
frequent breakdowns and is not quite that productive as new equipment. Modern
technology tends to get obsolete rather quickly, that is, depreciates more rapidly. This
loss of value is the basis for depreciation as an accounting term.
Depreciation is a non-cash expense and companies use it to offset taxable income. One
can calculate the depreciation on a straight-line basis. A machine with a 5-year life will
have depreciation equal to 20% of its value in each year.
A faster method of depreciation is the sum-of-years-digits method. Since 1 + 2 + 3 + 4 +
5 = 15, the depreciation in the five years will be 5/15, 4/15, 3/15, 2/15 and 1/15,
respectively. A third method is the modified accelerated cost recovery system, or
MACRS. The following table gives a simplified version of MACRS for assets with a 3year, 5-year, and 7-year life.
MACRS Percentage
Year 3 Year 5 Year 7 Year
Year 3 year 5 year 7 year
1
33.33% 20.00% 14.29%
2
44.45% 32.00% 24.49%
3
14.81% 19.20% 17.49%
4
7.41% 11.52% 12.49%
5
11.52% 8.93%
6
5.76% 8.92%
7
8.93%
8
4.46%
Table 4.1: Source: Internal Revenue Service
74
_____________________________________________________________________________
What is the optimal depreciation policy of a corporation? A company should use the
depreciation method, subject to IRS regulations, which gives it the maximum present
value of the tax benefits of depreciation.
Let us find the after-tax cash flows for a project as follows:
Pre-tax income per year = E
Depreciation per year = D
Taxable income per year = E D
Income tax rate = t
Income tax due = t(E D)
Earnings after taxes = E t(E D) = E tE + tD = E(1 t) + tD
This gives us the after-tax cash flow as
C = E(1 t) + tD
(4.3)
In the above equation, tD is called the tax benefit of depreciation. For a tax-exempt
entity, such as a university, t = 0. In that case (4.3) reduces to C = E, meaning after-tax
cash flow is the same s the pre-tax income. We should combine (4.1) and (4.3) to do the
NPV calculations involving taxes and depreciation.
As an example, consider an asset with initial value $50,000. The firm depreciates it with
MACRS, with three-year life, as shown in the previous table. Assume that the firm uses
11% as the discount rate and its tax rate is 32%. Then the present value of tax benefits of
depreciation is
=
50000(.3333)(.32) 50000(.4444)(.32) 50000(.1482)(.32) 50000(.0741)(.32)

+
+
+
1.113
1.114
1.11
1.112
= $13,090.08
In some cases, we have to include maintenance cost, or running cost, of a piece of
equipment. Maintenance expense is a tax-deductible item and its net cost is (1 t)M. The
after tax cash flow in this situation is
C = E(1 t) + tD (1 t)M
Or,
4.4
C = (1 t)(E M) + tD
(4.4)
Resale Value
A corporation may buy an asset, such as a car, or a machine, or a building, use it for a
number of years, and then sell it. We should also consider the additional factor, the resale
value of the machine. While using the asset, the corporation may depreciate the asset and
get the corresponding tax benefit, tD. When a company sells a piece of equipment, it
75
_____________________________________________________________________________
may, or may not, pay taxes on the sales price. It all depends upon the book value of the
equipment. The book value, B, of a capital asset is the original value of the asset minus
the depreciation already taken. For instance, if the initial value of a car is $20,000 and it
is depreciated at the rate of $5000 per year, then its book value after one year is $15,000,
after two years $10,000, after three years $5,000, and after four years, when the car is
fully depreciated, the book value is zero. By definition,
B = I0 nD
(4.5)
where I0 is the price of the new equipment, n is the number of years it has been in service,
and D is the (uniform) annual depreciation. For non-uniform depreciation, nD represents
the total amount of depreciation. The book value of a brand new asset is I0, whereas the
book value of a fully depreciated asset is zero. Of course, the book value of an asset can
never be negative.
The tax, T due at the time of selling a piece of equipment is the income tax rate, t
multiplied by the difference between the sales price and the book value. Thus
T = t(S B)
(4.6)
where T = tax due, t = income tax rate, S = sale price of the equipment, and B = book
value of the equipment. If T is negative, the company gets a tax credit. This will happen
when the sale price is less than the book value of the asset. The after-tax value of S
becomes W, where
W = S T = S t(S B)
Put B = I0 nD from (4.5)
W = S t[S (I0 nD)]

W = S t(S I0 + nD)
(4.7)
Use equation (4.7) to find the after-tax resale value of an asset. For a fully-depreciated
assets, the book value is zero. Or, nD = I0. This will simplify equation (4.7) to
W = S(1 t)
The following table gives the corporate income tax rate in USA in 2015.
Taxable Income Over But Not Over
Of the Amount Over
$0
50,000
15%
0
50,000
75,000
$7,500
+ 25%
$50,000
75,000
100,000
13,750
+ 34%
75,000
100,000
335,000
22,250
+ 39%
100,000
335,000
10,000,000
113,900
+ 34%
335,000
10,000,000
15,000,000
3,400,000 + 35%
10,000,000
15,000,000
18,333,333
5,150,000 + 38%
15,000,000
18,333,333
35%
0
Source: Internal Revenue Service, 2014 Instructions for Form 1120
76
(4.8)
_____________________________________________________________________________
Examples
4.8. Dora Corporation is planning to buy a machine for $10,000, which will result in
$3,000 annual saving for the next five years. Dora will depreciate the machine in 5 years
using the straight-line method and then sell it for $1500. The tax rate of Dora is 30%, and
the proper discount rate is 15%. Should Dora make the investment?
A savings of $3,000 is equivalent to a pre-tax additional income of $3,000. The
depreciation is 10,000/5 = $2,000 annually. The machine is fully depreciated after five
years and the company pays taxes on resale value. After taxes, it is 1500(1 .3) = $1050.
Using (4.3), we get the net cash flow as
C = 3000(1 .3) + .3(2000) = $2700
2700 1050
2700(1 1.155) 1050
+ 1.155 = $427.15
i +
5 = 10,000 +
1.15 1.15
.15
i=1
5
NPV = 10,000 +
Based on the above considerations, Dora should reject the proposal.

WRA
-10000+sum((3000*(1-.3)+.3*10000/5)/1.15î,i=1..5)+1500*(1-.3)/1.15^5
4.9. Tyree Corporation is considering the purchase of a machine, which will cost
$80,000. Tyree will depreciate it uniformly over 4 years although it will run for 5 years.
It will then sell the machine for $10,000. The tax rate of Tyree is 25%, and the proper
discount rate is 11%. Find the minimum earnings before taxes generated by this machine
that will make it profitable.
Suppose the minimum earnings before taxes is x. After taxes, it becomes
C = x(1 t) + tD = x(1 .25) + .25(80,000/4) = .75x + 5000
The tax benefit of depreciation, tD = $5000, will continue for 4 years, while the other
factor, .75x, will go on for 5 years. The company pays taxes on the resale value. After
taxes, it becomes 10,000(1 .25) = $7500. Discounting all the cash flows and setting
NPV = 0, we get
5 .75x
4 5000
7500
NPV = 80,000 + 1.11i + 1.11i + 1.115 = 0
i=1
i=1
Or,
.75x
i=1
Or,
Or,
5000
7500
1.11i = 80,000 1.11i 1.115

i=1
2.771922763x = 60,036.88659
x = $21,658.93
77
_____________________________________________________________________________
The machine must generate at least $21,658.93, before taxes, annually to be profitable.
WRA -80000+sum(.75*x/1.11î,i=1..5)+sum(5000/1.11î,i=1..4)+7500/1.11^5=0
4.10. Tompkins Farms needs a harvesting machine that will need $4,000 in annual
maintenance costs. Tompkins will depreciate the machine fully over 10 years and then
sell it for 15% of its purchase price. It will save $18,000 in labor costs annually. The tax
rate of Tompkins is 30%, and the proper discount rate is 12%. How much should
Tompkins pay for the machine just to break even?
Suppose the initial investment in the machine is I0, which will result in the NPV to
become zero. The tax benefit of depreciation per year, tD = .3(I0/10) = .03 I0.
The annual cash flow C, including savings, maintenance expenses, depreciation and
taxes, is given by (4.4) as
C = (1 .3)(18,000 4,000) + .03 I0 = 9800 + .03 I0
The resale value is .15I0. After taxes, it becomes .15(1 .3) I0 = .105 I0. Using a discount
rate of 12%, (4.1) gives the NPV as
9800 + .03 I0 .105 I0
+ 1.1210 = 0
1.12i
i=1
10
NPV = I0 +
10 9800
.03
.105
+
=
1.12i
1.12i 1.1210
i=1
i=1
10
Isolating I0,
I0 1 +
Or,
.7966861193 I0 = 55,372.18568
Or,
I0 = $69,503.14
Tompkins should not buy the machine for more than $69,503.14.
WRA -x+sum((9800+.03*x)/1.12î,i=1..10)+.105*x/1.12^10=0
4.5
Hurdle Rate
As the course progresses, you will develop a better understanding of the concepts. Take
for instance, the discount rate that a company uses in evaluating its projects. This depends
on two factors. The first factor is the cost of capital of a firm, which we will discuss in
Chapter 9. If the cost of capital for a firm is 12%, then the minimum acceptable rate of
return, and the discount rate, for a given project must be 12%.
The second factor is risk. The measurement of risk is more difficult. We will talk about it
in Chapter 6 and 7. Suppose a firm, with cost of capital 12%, is undertaking a rather risky
project. The risk-adjusted discount rate will be, perhaps, 14 or 15%. Additional source of
78
_____________________________________________________________________________
risk is due to leveraging, which will further increase the cost of capital. We will discuss
leveraged beta of a firm in chapter 11. Calculating the discount rate is a little complicated
but after completing this course, I hope you will have a better feel for this number.
In real life, firms use a hurdle rate, an arbitrarily chosen discount rate, which tends to
be too high, perhaps 25% or 30%. Otherwise, they will calculate the internal rate of
return of a project. If it is more than say 25%, they will accept the project. By using a
high discount rate, they are just playing it safe, but they are also rejecting many
reasonable projects with positive NPV.
In Chapter 15, we will look at the analysis of investment opportunities. We have to look
at the proper discount rate again.
The US government occasionally provides investment tax credit to corporations to
encourage investment in plant and equipment. This gives a boost to the economic
development. For example, if 10% tax credit is available, the initial investment is 90% of
the price of the equipment and the remaining cost is deductible from the income tax of
the company. The total depreciation depends on the actual cost of the equipment, which
is, in this case 90% of the price of the equipment. Currently, however, this tax credit is
not available.
4.11. Grissom Corporation is planning to buy a new computer and is considering three
alternatives. The price of each computer, along with its annual revenues and maintenance
expenses, assumed to be at the end of each year, are shown below.
Brand
Price Revenue Maintenance
IBM
$80,000 $20,000
$4,000
Dell
70,000
18,000
3,000
Gateway 100,000 25,000
5,000
An investment tax credit of 10% is available and the company will depreciate the
computers over a 10-year period with no residual value. Grissom is in the 40% marginal
tax bracket and its hurdle rate is 15%. Which computer, if any, should Grissom acquire?
Consider IBM computer first. Its list price is $80,000, so Grissom is able to acquire it for
.9(80,000) = $72,000. Grissom will depreciate it over 10 years, thus the annual
depreciation is $7200.
Maintenance expense is a tax-deductible item and its after-tax cost is (1 t)M. The aftertax cash flow in this problem is
C = (1 t)(E M) + tD
For IBM, C = (1 .4)(20,000 4,000) + .4(72,000/10) = $12,480
10 12480
12480(1 1.1510)
NPV = 72,000 + 1.15i = 72,000 +
= $9366
.15
i=1
79
(4.4)
_____________________________________________________________________________
For Dell, C = (1 .4)(18,000 3,000) + .4(63,000/10) = $11,520

10 11520
11520(1 1.1510)
NPV = .9(70,000) + 1.15i = .9(70,000) +
= $5184
.15
i=1
For Gateway, C = (1 .4)(25,000 5,000) + .4(90,000/10) = $15,600

10 15600
15600(1 1.1510)
NPV = .9(100,000) + 1.15i = .9(100,000) +
=$11,707
.15
i=1
Because all computers have a negative NPV, the firm should reject them all. However,
relative to one another, Dell computer is the best investment.
4.12. The Cameron Company has these three options to buy a new machine:
Machine
Cost
Maintenance Cost of capital
Alpha
$40,000
$5000
10%
Beta
$45,000
$4500
9%
Gamma $50,000
$4000
8%
All the machines are identical in nature and each one will generate pre-tax revenue of
$18,000 annually. The company will depreciate any of the machines on a straight-line
basis over next 5 years with no residual value. The company is in 35% tax bracket.
Which machine should Cameron buy?
It is possible to have different discount rates. For instance, the manufacturer of the
machine may offer to loan the money to the firm to buy the machine at a lower rate to
compensate for the higher price of the equipment. The annual cash flow for each machine
and its NPV are as follows:
Alpha, C = (1 .35)(18,000 5,000) + .35(8,000) = $11,250
11250
11250(1 1.15)
=
40,000
+
= $2646
.1
1.1i
i=1
5
NPV = 40,000 +
Beta, C = (1 .35)(18,000 4,500) + .35(9,000) = $11,925

5 11925
11925(1 1.095)
NPV = 45,000 + 1.09i = 45,000 +
= $1384
.09
i=1
Gamma, C = (1 .35)(18,000 4,000) + .35(10,000) = $12,600

5 12600
12600(1 1.085)
NPV = 50,000 + 1.08i = 50,000 +
= $308
.08
i=1
Machine Alpha is the best buy on this basis.

80
_____________________________________________________________________________
4.13. The Adams Company is planning to buy a new machine for $80,000 that will
increase the pre-tax earnings of the company by $30,000 annually. The company will
depreciate the machine fully on a straight-line basis over a 5-year period, and then sell it
for $10,000. The company has a tax rate of 40%. If the after-tax cost of capital of Adams
is 11%, should it purchase the machine?
This is a problem involving the resale value of the equipment. When the company sells
the fully depreciated machine, its book value is zero. The tax applicable on the sale is
thus tS, by equation (4.4). The after-tax value of the sale is (1 t)S = (1 .4)(10,000) =
$6,000. This money is available after 5 years, and we must find its present value.
The cash flow is C = (1 .4)(30,000) + .4(16,000) = $24,400
Including the sale of the equipment,
5 24400
6000
NPV = 80,000 + 1.11i + 1.115
i=1
(A)
This gives NPV = $13,741. It is a very good investment. Buy it.

To solve the problem at WolframAlpha, write equation (A) as
WRA -80000+sum(24400/1.11î,i=1..5)+6000/1.11^5
4.14. Carver Corporation is planning to buy a machine costing $50,000, and it will
depreciate it fully along a straight line over 5 years. The machine will generate unknown
earnings before interest and taxes (EBIT), which will remain constant for the first 5 years
and then drop to half that value during the next five years. The tax rate of Carver is 30%,
and its discount rate is 10%. Calculate the EBIT for the machine to just break even, that
is, have zero NPV.
Suppose the unknown EBIT is E. The tax benefits of depreciation are available only
during the first five years. Then the cash flows are:
First five years, C = E(1 .3) + .3(10,000) = .7 E + 3000
Next five years, C = (E/2)(1 .3) = .35 E
To break even, set NPV = 0,
.7 E + 3000 10 .35 E
+ 1.1i = 0
1.1i
i=1
i=6
5
NPV = 50,000 +
(A)
Isolating the terms containing E, we get
5 3000
5 .7 E
10 .35 E
50,000 + 1.1i + 1.1i + 1.1i = 0
i=1
i=1
i=6
Put
10
.35 E
.35 E
1.1i = 1.15 1.1i

i=6
i=1
81
in the above equation,
_____________________________________________________________________________
50,000 +
5
3000(11.15)
1 0.35(1 1.15)
0.7(1 1.1 )
=
E
+
0.1
0.1
1.15
0.1
Or,
38,627.64 = 3.4773739 E
Or,
E = $11,108
The machine must generate $11,108 per year for the first five years, and then half that
amount for the next five years just to break even.
WRA -50000+sum((.7*x+3000)/1.1î,i=1..5)+sum(.35*x/1.1î,i=6..10)=0
4.15. Gray Metals Company needs a new machine, which would save the company
$3,000 annually for the first five years and then $2,000 annually for another five years.
Gray will depreciate the machine on a straight-line basis for 10 years. Gray is in the 40%
tax bracket and its after-tax cost of capital is 8%. What is the break-even price of the
machine for Gray?
Suppose the break-even price is x, which should equal the discounted future cash flows,
including the tax benefits of depreciation. If the price of the machine is x, then
depreciation per year is x/10 or 0.1x and the corresponding tax advantage is 0.1(x)(0.4) =
0.04x. The quantity E(1 t) for the first five years is 3000(1 .4) = $1800, and for the
next five years, it is 2000(1 .4) = $1200.
Consider the present value of three sets of cash flows:
(1) PV of E(1 t) = $1800 annually for years 1-5
(2) PV of E(1 t) = $1200 annually for years 6-10
(3) PV of tax benefits of depreciation, tD = 0.04x for years 1-10
The sum of these is the price of the machine x. Thus
5 1800
10 1200
10 .04x
x = 1.08i + 1.08i + 1.08i
i=1
Or,
Or
Or,
Or,
i=6
i=1
10 .04
1 5 1200
5 1800
x 1 1.08i = 1.08i + 1.085 1.08i
i=1
i=1
i=1
0.04(1 1.08
x 1
0.08
10
) 1800 (1 1.085)
1 1200 (1 1.085)
+ 1.085
=
0.08
0.08
x(.7315967) = 10,447.72
x = 14,280.71
82
(A)
_____________________________________________________________________________
The break-even price of the machine is $14,280.71.

WRA x=sum(1800/1.08î,i=1..5)+sum(1200/1.08î,i=6..10)+sum(.04*x/1.08î,i=1..10)
4.16. Monroe Corporation needs a machine, which will cost $100,000. Monroe will
depreciate it on a straight-line basis over 5 years with no resale value. The tax rate of
Monroe is 28%, and its after-tax cost of capital is 11%. The machine will have an EBIT
of $18,000 a year for the first five years, and then an uncertain amount for the next five
years, years 6 through 10. Find the minimum amount of this uncertain EBIT, which will
make the purchase of this machine acceptable.
Suppose the unknown EBIT for the years 6 through 10 is E. The cash flows are:
For first five years, C = 18,000(1 .28) + .28(20,000) = $18,560
For next five years, C = E(1 .28) = .72 E
Setting NPV equal to zero, we have
5 18560
10 .72 E
NPV = 100,000 + 1.11i + 1.11i = 0
i=1
i=6
18560(1 1.115)
1 5 .72 E
1 0.72E(1 1.115)
=
=
1.11i 1.115
0.11
1.115 i=1
0.11
Or,
100,000
Or,
E = 100,000
which gives
(A)
.11
18560(1 1.115)
5
(1.11
)
0.11
0.72(1 1.115)
E = $19,886

WRA -100000+sum(18560/1.11î,i=1..5)+sum(.72*x/1.11î,i=6..10)=0
4.6
Projects with Unequal Lives
All the problems that we have discussed so far involve either a single project, or two
projects with equal lives. In real life, we may have to compare the performance of two
machines with different lives. One machine may be cheaper, but it will not last as long as
a more expensive one. How can we possibly compare two machines with different lives?
One way to handle a problem like this one is to assume that you will continue to replace a
machine by a similar one forever. This means that the life of the project is infinity in each
case, but this life is spanned by one kind of machine or the other. Consider the following
problem.
83
_____________________________________________________________________________
4.17. You want to install a new heat pump in your house. Two different models are
available, Shinn and Gardner. They are both satisfactory in performance. Their
characteristics are as follows:
Heat Pump
Shinn
Gardner
Cost
$3000
$4000
Life
4 years
5 years
Annual expenses
$700
$600
The proper discount rate is 12%. Which unit should you buy?
Assume that you cannot depreciate the equipment in your personal home. The problem
requires careful analysis since the machines have different lives. Assume that you will
replace the machines every 4 or 5 years forever. For the first unit, the NPV is
700 700
700
700 3000 700
700
NPV = 3000 1.12 1.122 1.123 1.124 1.124 1.125 1.126 ...
(A)
The terms in the blue color represent the cost of new equipment and its replacement after
four years. The remaining terms are due to the annual expense of the heat pump. The
negative signs mean cash outflows. The entire series is consisting of two infinite series.
1
The ratio of the blue terms with numerator 3,000 is 1.124, and the ratio for the other terms
with numerator 700 is 1/1.12. Using (1.5), we get
NPV =
3000
700
= $14,064.19
1
1
1 1.124 1.12 1 1.12
This figure, $14,064.19, represents the total cost (measured in present dollars) of using
the Shinn heat pump for an infinitely long period. The calculations for the Gardner unit
are done similarly. Change the cost of the equipment from $3000 to $4000; life of the
machine from 4 to 5 years, and annual cost from $700 to $600. Making these changes, for
the Gardner unit, we get
NPV =
4000
600
1
1.12 (1 1/1.12) = $14,246.99
1 1.125
Comparing the total costs, it is better to buy the Shinn Heat unit.
To do the calculation using WolframAlpha, write equation (A) as
WRA sum(3000/1.12^(4*i),i=0..infinity)-sum(700/1.12î,i=1..infinity)
WRA sum(4000/1.12^(5*i),i=0..infinity)-sum(600/1.12î,i=1..infinity)
84
_____________________________________________________________________________
A second approach to do these problems is to find the equivalent annual cost. This cost is
the sum of the payments that will amortize the purchase price of the equipment, plus the
cost of running it. First, we find the amount needed to amortize the purchase cost of the
heat-pump. For Shinn, the amortization amount A is given by
4
A
3000 = 1.12i
i=1
Solving it, we get A = $987.70. This means that either we can pay $3000 to buy the unit
now, or we may pay $987.70 every year for the next four years. Next, we add the annual
running cost, $700, to it. Then we get the total equivalent annual cost to be 987.70 + 700
= $1687.70.
Following the same procedure for the other unit, we get
5
A
4000 = 1.12i
i=1
This gives A = $1109.64. The total equivalent annual cost is thus 1109.64 + 600 =
$1709.64. Comparing the two costs, we find that Shinn unit is cheaper.
If we find the PV of these costs in perpetuity, it comes out to be 1687.70/.12 =
$14,064.17 for Shinn, and 1709.64/.12 = $14,247.00 for Gardner. These numbers are the
same as found by the previous method. Thus, the two methods are equivalent.
4.18. Djibouti Corporation is considering the purchase of an air conditioning unit and it
has these two choices.
Unit
A
B
Initial cost
$80,000
$70,000
Annual cost
$10,000
$8,000
Expected life
5 years
4 years
Djibouti is in the 40% tax bracket. Which unit should it buy? Assume that it will
depreciate each piece of equipment on a straight-line basis with no residual value during
its working life. The proper discount rate is 10%.
In this problem, we are concerned with three items: (1) The replacement cost of the unit
every four or five years (2) the annual after-tax cost of electricity and (3) the annual tax
benefits of depreciation of the unit.
For Unit A, the replacement cost is $80,000 every five years, the after-tax cost of
electricity is (1 .4)(10,000) = $6,000 annually, and the tax benefit from depreciation is
.4(80,000/5) = $6400. Combining the after-tax cost of electricity and the tax benefit of
depreciation, we have a net benefit of 6400 6000 = $400 annually. The NPV for an
infinite period is thus
85
_____________________________________________________________________________
80000 80000
400 400 400
NPV(A) = 80,000 1.15 1.110 ... + 1.1 + 1.12 + 1.13 + ...
80000
400
= 1 1/1.15 + 0.1 = $207,038
For the second unit, the replacement cost is $70,000 every four years, the annual after-tax
cost of electricity is .6(8000) = $4800, and the tax benefit of depreciation is .4(70,000/4)
= $7000. Combining the last two we have a benefit of 7000 4800 = $2200. Using the
previous calculation as a guide, we have
70 000
2200
NPV(B) = 1 1/1.14 + 0.1 = $198,830
Based on these calculations, unit B is somewhat cheaper.
Let us solve this problem using equivalent annual cost. The equivalent annual cost for
replacing the first unit is found from
5 A
80,000 = 1.1i
i=1
This gives us
Or,
80,000 =
A(1 1.15)
.1
80 000*.1
A = 1 1.15 = $21,103.80
The tax benefit due to depreciation per year is .4*80,000/5 = $6400. The after-tax cost of
electricity is (1 .4)10,000 = $6000. Thus the total cost for Unit A is 21,103.80 6400 +
6000 = $20,703.80.
70000*.1
The replacement cost for Unit B is found as B = 1 1.14 = $22,082.96. The tax benefit
due to depreciation per year is .4*70,000/4 = $7000. The after-tax cost of electricity is
(1 .4)8,000 = $4800. Thus the total cost for Unit B is 22,082.96 7000 + 4800 =
$19,882.96.
Comparing their costs, $20,703.80 and $19,882.96, Unit B is cheaper,
To reconcile the answer, we also calculate the total cost for an infinite time horizon, we
get 20,703.80/.1 = $207,038 and 19,882.96/.1 = $198,830, as before.
86
_____________________________________________________________________________
Problems
4.19. The Scranton Times is planning to buy a new press for $120,000 that will save the
company $30,000 annually. The press has a useful life of 10 years. The Times has a tax
rate of 40%, and it will depreciate the machine on a straight-line basis. The after-tax cost
of capital of the Times is 9.6%. Should it buy the new press?
NPV = $22,536.20, yes
4.20. Ellsmere Corporation plans to buy a new machine for $50,000, which will save the
company $12,000 annually. Ellsmere will depreciate the machine on the ACRS with
three-year life, the annual depreciation being 29%, 47%, and 24%. The company expects
that the machine will run for 5 years, and then it will sell it for $5,000. The after-tax cost
of capital to the company is 8%, and its tax rate is 40%. Should Ellsmere buy the
machine?
NPV =$1,970.99, no
4.21. Cline Incorporated wants to buy a machine for $24,000, and depreciate it on
straight-line basis over 6 years. Cline has marginal tax rate of 35% and its after-tax cost
of capital is 7%. Calculate the minimum pre-tax annual earnings generated by this
machine to justify its purchase.
$5592.46
4.22. Allen Corporation has to decide between the following two air conditioning units
for an office building. Both units are adequate in their performance.
Carrier Worthington
Initial cost
$120,000
$80,000
Annual maintenance cost $10,000
$12,000
Annual electricity cost
$20,000
$25,000
Expected life
6 years
5 years
The company will use straight-line depreciation, with no resale value. The tax rate of
Allen is 28%, and the proper discount rate is 10%. Which one of these units will prove to
be less costly in the long run?
NPV(Carrier) = $435,529, NPV(Worthington) = $432,638 (cheaper)
4.23. Alcott Corp is interested in buying a machine for $40,000. It will depreciate the
machine uniformly to zero value over a 5-year period. During this period, the machine
will add $8,000 annually to the EBDIT of the company. Finally, Alcott will sell the
machine for $5,000. The tax rate of Alcott is 40% and the proper discount rate is 9%.
Should Alcott buy the machine?
NPV = $6,933, no
4.24. Darwin Corporation is going to buy a machine for $152,000 that will save the
company $20,000 annually. Darwin will depreciate the machine completely in five years
using straight-line method. The tax rate of company is 30%, and it uses a discount rate of
12%. Show that this machine will never be profitable.
87
_____________________________________________________________________________

1. The discount rate of a project does not depend upon the
A. risk of project
C. prevailing interest rates
B. cost of capital of firm D. life of project
2. The after-tax cash flow of a project does not depend upon the
A. income tax rate of company C. riskless interest rate
B. pre-tax earnings from project D. annual depreciation of assets
3. The tax due at the time of the sale of an asset does not depend upon the
A. income tax rate of firm C. sale value of asset
B. book value of asset
D. discount rate for project
4. Define: T = tax due at the time of sale of an asset, t = income tax rate, B = book value
of the asset, S = its sale price. The relationship between these quantities is
A. T = (B S)(1 t)
B. T = (S B)(1 t)
C. T = (B S)t
D. T = (S B)t
Key Terms
capital budgeting, 60, 61
capital investment, 60
cost of capital, 60, 66, 67, 70,
73, 74, 75, 79
depreciation, 60, 61, 67, 68,
69, 71, 73, 74, 78, 79
internal rate of return, 60, 61,

63, 64, 65, 66
mutually exclusive, 60
net present value, 60, 63, 65,
67
non-uniform cash flows, 61
88
payback period, 61
risk, 60, 61, 63, 66
taxes, 60, 61, 67, 68, 69, 73
5. CAPITAL BUDGETING UNDER UNCERTAINTY

Objectives: After reading this chapter, you should
1. Understand the basic ideas of discrete and continuous probability distributions.
2. Apply the concepts of probability to the problems of financial decision-making.
3. Be able to analyze problems involving inflation.
4. Understand the role of options in the capital budgeting decisions.
5.1
Probability and Capital Budgeting
We do not know the outcome of many future events with certainty. One way to handle
the problem is to use a probabilistic model that would describe the situation. This is
especially true of financial decisions where we do not know the future cash flows exactly.
One way to overcome this uncertainty is to develop a subjective probability distribution
about different possible outcomes. To find the expected value of the uncertain outcome,
we first multiply the probability of various possible outcomes with the value of each
outcome, and then sum them all. We express this in the form of an equation:
n
E(V) = PiVi
(1.6)
i=1
Here E(V) is the expected value of an uncertain outcome, Pi is the probability that the
outcome Vi will occur, and n is the total number of possible outcomes.
If there are a large number of independent observations of a random event, then we may
approximate the result by the normal probability distribution. The two parameters
describing the distribution are the mean, or the expected value of a variable, and its
standard deviation . A smooth bell-shaped curve will represent the probabilities. The
area under the curve represents the cumulative probability of a certain outcome. These
values are available in a table set up so that the total area under the curve is unity, and the
area under half the curve is 0.5. The table provides the values for the area under the
curve, measured from the center, up to a point that is a certain number z of standard
deviations away from the mean value.
Examples
Video 05A 5.1. Mr. Barkis is considering an investment in Murdstone Inc stock. He
believes that the continuously compounded returns of the stock will have a normal
distribution, with mean of 15%, and standard deviation 30%. What is the probability that
the continuously compounded return is more than 20%? What is the probability that his
loss is greater than 10%?
Using the concept of continuous compounding, we may relate the final stock price P1 and
the initial price P0 by the expression P1 = P0erT. The function erT is the exponential
89
5. Capital Budgeting Under Uncertainty
_____________________________________________________________________________
function. It represents the exponential growth of money with time. Here T is a certain
time period, say one year. We may write P1 = P0erT as
erT = P1/P0
Taking logs on both sides, we get
rT = ln(P1/P0)
which gives
r=
ln(P1/P0)
T
(5.1)
We define z as the number of standard deviations that a given value is away from the
mean value. Here the mean value of returns is = 0.15, the required return is x = 0.2, and
the standard deviation is = 0.3. Since the required return is more than the expected
return, it is unlikely that the stock will accomplish that. The resulting probability is less
than 50%. Find z as
x 0.2 0.15 0.05
z= =
= 0.3 = 0.1667
0.3
Now draw the normal probability distribution curve with z = 0 in the center and z =
0.1667 a little right of the center. The area to right of z = 0.1667, shaded yellow, under
the tail of the curve will represent the answer.
The probability table, in Chapter 16, shows the area under the curve from the mid point to
a given point z. This is the green area in the above diagram. In our case, we have to find
the probability of making more than 20% on our investment. This is equivalent to the
yellow area on the right side of z = .1667. In the table, the area corresponding to z = .16 is
.0636, and for z = .17, it is .0675. We have to find the area for z = .1667, which is 67% of
the way between z = .16 and z = .17. We have to interpolate the numbers between .0636
and .0675. The total area under the curve is 1, half of it is .5, and so we have
P(r > 0.2) = .5 [.0636 + .67(.0675 .0636)] = 0.4338, or 43.38%.
You can check the naswer at Excel by copying the following instruction.
90
_____________________________________________________________________________
EXCEL =1-NORMDIST(.2,.15,.3,TRUE)
The answer is quite plausible. We expect to make 15%, and there is a good possibility
that we may make more than 20% in view the standard deviation of 30%.
For a loss of 10%, the return is 0.1. For the loss to be greater than 10%, the return must
be less than 10%. We calculate z to be
z=
x 0.1 0.15
= .8333
=
0.3
For a negative value of z, you just take the absolute value, because the probability table
gives the area under the curve on either side of the mean value. This time we have to look
for area on the left side of z = .8333, under the tail of the curve, which corresponds to a
return of less than 10%.
From the table, we first get the area between z = .8333 and the center of the curve. The
table gives the area for z = .83 as .2967 and that for z = .84, it is .2995. Since we have to
go 33% of the way from .83 to .84 to reach .8333, we intertoplate the table as follows.
P(r < 0.1) = .5 [.2967 + .33(.2995 .2967)] = .2024 or 20.24%.
This result seems reasonable because there is a fair chance that the stock can indeed go
down by 10%.
1
2
3
4
5
6
7
8
A
Expected return,
Standard deviation,
First required return, x
z = (x )/
Prob(R > .2)
Second required return, x
z = (x )/
Prob(R < -.1)
B
.15
.3
.2
=(B3-B1)/B2
=1-NORMDIST(B4,0,1,true)
-.1
=(B6-B1)/B2
=NORMDIST(B7,0,1,true)
In Excel, the function NORMDIST(x,mean,standard_dev,cumulative) serves the purpose of

the probability table in Chapter 16. For instance, NORMDIST(x,.15,.3,true) will calculate
the cumulative area from the left end of the curve up to point x. If you need the area to the
91
_____________________________________________________________________________
right of point x, you enter 1 NORMDIST(x,.15,.3,true). To do this problem, you can enter
the following instructions.
EXCEL =NORMDIST(-.1,.15,.3,TRUE)
5.2. Black Ink is in financial distress. Its bonds have a 12% coupon rate and they pay the
interest semiannually. There is a 70% chance that it will go bankrupt after 1 year, and it
faces certain bankruptcy after 2 years. In case of bankruptcy, the company will pay
interest due on the bonds, but will pay only 30% of the principal, at the end of that year.
If your required rate of return is 12%, how much should you pay for a $1,000 Black Ink
bond?
In this problem, we look at the probability of an outcome and multiply it with the dollar
amount of that outcome, and then add all the products. There is a 70% chance that the
company will go bankrupt after one year, and 30% that it will be bankrupt after two
years. These are the only two possible outcomes because the company will not survive
after two years.
If the company goes bankrupt after one year, the bond should pay two interest payments
plus $300 at the end of one year. If it survives another year, it should pay four interest
payments, plus $300 at the end of the second year. The semiannual discount rate is 6%.
Multiplying the probability of an outcome with the present value of that outcome, and
adding the results, we have
300
300
2 60
4 60
P0 = 0.7 1.06i + 1.062 + 0.3 1.06i + 1.064
i=1
i=1
(A)
2
4
60(1 1.06 ) 300
60(1 1.06 ) 300
= 0.7
+
+
0.3
+ 1.064 = $397.56
0.06
0.06
1.062
You may check the answer at WolframAlpha, by writing equation (A) as

WRA .7*(sum(60/1.06î,i=1..2)+300/1.06^2)+.3*(sum(60/1.06î,i=1..4)+300/1.06^4)
5.3. Mrs. Guinea lost her husband at the age of 65. She is eligible to receive $100,000 in
cash for the life insurance policy of her husband. She also has the alternate choice of
receiving $15,000 in annual installments for as long as she lives, with the first payment
available now. Mrs. Guinea can invest money with a return of 12%, and she has chosen
the second option. Find the minimum number of installments that she should receive to
come out ahead. Actuarial tables indicate that the expected life of a 65-year old female is
16 years, with a standard deviation of 6 years. What is the probability that Mrs. Guinea
has made the right decision?
Suppose Mrs. Guinea lives for the next n years. The first payment is available
immediately. To break even, the present value of the two options should be equal. Thus
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15000
100,000 = 15,000 + 1.12i
i=1
n
Simplifying terms,
85,000 =
(A)
15000 (1 1.12n)
0.12
85000(.12)
n
15000 = 1 1.12
Or,
1.12n = 1
Or,
85000(.12)
15000 = .32
Taking natural logs on both sides, we get

n ln(1.12) = ln(.32)
Or,
ln(0.32)
n = ln(1.12) = 10.05

WRA 100000=15000+sum(15000/1.12î,i=1..n)
Thus, Mrs. Guinea must live another 11 years and collect 12 installments in all to come
out ahead. Since she expects to live another 16 years, there is more than 50% chance that
she will live another 11 years. We may find the probability that she may indeed live an
additional 11 years as follows. Find
z=
x 11 16
= .8333
6
=
Draw a normal probability distribution curve, with z = 0 in the center and z = .8333 to
the left of center. We need to find the area to the right of z = .8333 to find the
93
_____________________________________________________________________________
probability that she will live more than 11 years. This area is well over 50%. Using the
table, we get the probability as
P(life > 11) = 0.5 + 0.2967 + .33(.2995 .2967) = 0.7976 80%
To verify the probability on an Excel spreadsheet, enter the information as follows.
EXCEL =1-NORMDIST(11,16,6,TRUE)
Video 05B, 5.4. Quincy Corporation is planning to buy a machine for $80,000. The
company will depreciate it over a 5-year period with no resale value. However, the
machine has an uncertain life as given in the following probability distribution table:
Probability
40%
30%
30%
Life (years)
4
5
6
While the machine is running, it will produce an EBIT of $20,000 a year. The tax rate of
Quincy is 30%, and the proper discount rate is 12%. Should Quincy buy the machine?
The annual depreciation of the machine is $16,000 and its tax benefit is .3(16,000) =
$4800. The after-tax cash flow, C = 20,000(1 .3) + .3(16,000) = $18,800.
If the machine breaks down at the end of the fourth year, the company can take the taxbenefit of depreciation of the fifth year at that time. The cash flows are $18,800 for the
years 14, plus another $4800 for year 4.
If the machine runs for five years, the cash flow for each year is $18,800.
If the machine runs for six years, the cash flows for the first five years are $18,800 each.
For the sixth year, the tax benefit of depreciation is not available, and the cash flow is
only 20,000(1 .3) = $14,000.
Including the probability of each outcome, we get
4 18800
5 18800
5 18800
4800
14000
NPV = 80,000 + .4 1.12i + 1.124 + .3 1.12i + .3 1.12i + 1.126
i=1
i=1
i=1
(A)
= 80,000 + 24,061.06 + 20,330.94 + 22,458.79 = $13,149, reject

.4*(sum(18800/1.12î,i=1..4)+4800/1.12^4)+.3*sum(18800/1.12î,i
=1..5)+.3*(sum(18800/1.12î,i=1..5)+14000/1.12^6)-80000
94
_____________________________________________________________________________
5.5. Jupiter Company needs a new computer costing $100,000. Jupiter will depreciate the
computer over 5 years with no resale value. There is, however, a 30% chance that it may
break down completely after 4 years. While the computer is running, it will add $40,000
annually to the pretax income of Jupiter, which has a tax rate of 40%. For a discount rate
of 8%, should Jupiter buy this computer?
Here
C = 40,000(1 .4) + .4(20,000) = $32,000
If the machine breaks down after 4 years, we have to take the fifth-year depreciation at
that time. The probability of breakdown after four years is 30% and there is a 70%
probability that it would run smoothly for 5 years. Thus
4 32000
5 32000
.4(20000)
NPV = 100,000 + .3
+ .7
i +
4
1.08
1.08
1.08i
i=1
i=1
= 100,000 + .3
] [
[32000(1.08 1.08
(A)
.4(20000)
32000(1 1.085)
+
.7
4
1.08
.08
] [
= $22,997, buy it.

.3*(sum(32000/1.08î,i=1..4)+.4*20000/1.08^4)+.7*sum(32000/
1.08î,i=1..5)-100000
5.6. Cavendish Company wants to acquire a new computer that will cost $150,000 and it
will save the company $33,000 annually. The following probability distribution table
represents the best estimate of its expected useful life and the corresponding salvage
value:
Probability Life Resale Value
20%
4 years
$30,000
30%
5 years
$20,000
50%
6 years
$10,000
The company will depreciate the computer fully in 4 years. The tax rate of Cavendish is
30%, and the proper discount rate is 8%. Should Cavendish buy the computer?
The tax benefit of the computer for each year is tD = .3(150,000/4) = $11,250. The
present value of the tax benefits for all four years is thus
4
11250
1.08i = $37,261.43
i=1
Next, look at the probability of different lives, savings generated by the computer, and
the salvage value in each case. Since the company will depreciate the computer
95
_____________________________________________________________________________
completely when it sells it, the proceeds of the sale are fully taxable. After taxes, the
resale value after four years is 30,000( 1 .3) = $21,000, after five years it is 20,000( 1
.3) = $14,000, and after six years it is 10,000( 1 .3) = $7000.
The annual earnings after taxes, excluding the tax benefit of depreciation, are 33,000( 1
.3) = $23,100. Combining all the above numbers, we find the NPV as follows:
4 23100 21000
5 23100 14000
NPV = 150,000 + 37,261.43 + 0.2
+
0.3
i +
1.08i + 1.085
1.084
i=1 1.08
i=1
6 23100
7000
+ 0.5 1.08i + 1.086

(A)
i=1
= $8,221.64, reject
sum(.3*150000/4/1.08î,i=1..4)+.2*(sum(23100/1.08î,i=1..4)
+21000/1.08^4)+.3*(sum(23100/1.08î,i=1..5)+14000/1.08^5)+.
5*(sum(23100/1.08î,i=1..6)+7000/1.08^6)-150000
Video 05.07, 5.7. Fisher Corporation does not expect to pay taxes in the near future. It
is planning to acquire a new machine, which will have a useful life of two years.
However, there is a 10% probability that the machine will break down after only one
year. There are two states of economy, good and bad, with the probability of occurrence
60% and 40% in any given year. If the economy is good, the after-tax cash flow from the
machine is $20,000 annually, and if the economy is bad, the cash flow is only $15,000.
The proper discount rate is 12%. What is the maximum amount that Fisher should pay for
this machine?
The company is not paying taxes, thus t = 0. Using (4.3),
C = E(1 t) + tD
(4.3)
we get C = E, meaning that the cash flows before and after taxes are identical. We find
the expected cash flow under two different states of the economy by multiplying the
probability by the corresponding cash flow and adding the results. This gives us
E(C) = .6(20,000) + .4(15,000) = $18,000
Next, consider two possible outcomes of the life of the project. To get the total NPV,
multiply each probability of life with the dollar outcome of that life, whether it is one
year or two years. To break even, we get
18000
18000 18000
NPV = I0 + .1 1.12 + .9 1.12 + 1.122 = 0
96
(A)
_____________________________________________________________________________
18000
18000 18000
I0 = .1 1.12 + .9 1.12 + 1.122 = $28,986
Or,

WRA
-x+.1*18000/1.12+.9*(18000/1.12+18000/1.12^2)=0
5.8. Quincy Corporation wants to buy a machine for $50,000, with a maximum life of 4
years. However, there is a 20% probability that the machine will break down after only 3
years. There is an investment tax credit of 6%. The company will depreciate the machine
on ACRS basis, with a life of 3 years. Assume that the depreciation in the first year is
25%, second year 38%, and 37% in the third year. The tax rate of the company is 34%
and its discount rate is 12%. What is the minimum pretax income of this machine to
make it profitable for Quincy?
Because of the 6% investment tax credit, the net cost of the equipment is 94% of its price,
namely, 0.94(50,000) = $47,000. The company can depreciate only this amount. The tax
benefit of depreciation is tD per year.
.38
.37
.25
The PV of tax benefits of depreciation = .34(47,000)1.12 + 1.122 + 1.123 = $12,616.32
Suppose the minimum pre-tax earning is E, which is just enough to break even. Its aftertax value is E(1 .34) = .66E. There are two possible outcomes: the life of the machine is
either three years (probability 20%) or four years (probability 80%). Including the
probability of breakdown, we get
3 .66E
4 .66E
.2(.66)(1 1.123) .8(.66)(1 1.124)
PV of earnings = .2 1.12i + .8 1.12 i =
+
E
.12
.12
i=1
i=1
= 1.920762 E
To break even, the NPV is equal to zero. Thus
47,000 + 12,616.32 + 1.920762 E = 0
This gives
E = $17,901
You may check the answer at WolframAlpha, by using the following instruction.
47000=.34*47000*(.25/1.12+.38/1.12^2+.37/1.12^3)+.2*sum(.66
*x/1.12î,i=1..3)+.8*sum(.66*x/1.12î,i=1..4)
Video 05.09, 5.9. Galen Mining requires a digging machine that costs $50,000. It will
depreciate the machine uniformly over its life of 5 years. The tax rate of Galen is 35%
and the proper discount rate is 11%. Because of the uncertain price of the ore, the
97
_____________________________________________________________________________
expected pre-tax revenue from the machine is $15,000 annually, with a standard
deviation of $3,000. What is the probability that the machine will prove to be profitable?
First, find the income generated by the machine that is just enough to break even, or
make NPV = 0. If the after-tax cash flow is C, then to break even
5
C
i
1.11
i=1
NPV = 0 = 50,000 +
Or,
50,000 =
This gives
C(1 1.115)
.11
50000(.11)
C = 1 1.115 = $13,528.52
To verify the result, use the following at WolframAlpha,

WRA 0=-50000+sum(x/1.11î,i=1..5)
The annual depreciation is $10,000. If E is the corresponding pre-tax earnings, then
13528.52 = E (1 .35) + .35(10,000)
This gives
E = $15,428.49.
The machine must generate $15,428.49 to break even. Since it is expected to make only
$15,000 annually, chances are less than 50% that it will be profitable. Further,
z = (15,428.49 15,000)/3000 = .1428
Draw a normal probability distribution curve, with z = 0 in the center and z = .1428
somewhat right of the center. The area further to the right of z = .1428, under the tail of
the curve, gives the answer. Checking the tables, we get
P(being profitable) = 0.5 [.0557 + .28(.0596 .0557)] = .4432 = 44.32%
98
_____________________________________________________________________________
You may verify the answer by using the following instruction at Excel.
EXCEL =1-NORMDIST(15428.56,15000,3000,TRUE)
5.10. Adams Corporation is planning to buy a machine that will cost $40,000 and
depreciate it on a straight-line basis over a 5-year period with no residual value. The tax
rate of Adams is 30%, and the proper discount rate is 15%. The earnings before taxes
from the machine are uncertain, but their expected value is $15,000 a year, with a
standard deviation of $3,000. Calculate the probability that the machine will be a
profitable investment. Adams requires the probability of being profitable to be more than
60% to buy the machine. Based on your calculation, should Adams buy the machine?
First, find the break-even point, where the earnings before taxes E are just enough to
make the NPV of the investment equal to zero.
After-tax cash flow,
At break even point,
C = E(1 .3) + .3(8000) = .7E + 2400

.7E + 2400
1.15i
i=1
5
NPV = 0 = 40,000 +
WRA 0=-40000+sum((.7*x+2400)/1.15î,i=1..5)
This gives
E = $13,618.
Since the breakeven point is $13,618 and the machine is expected to make $15,000,
chances are more than 50% that the machine will be profitable.
Further
z = (13,618 15000)/3000 = 0.4607
Draw a normal probability curve with z = 0 at the center and z = 0.4607 to the left of
center. The area under the hump of the curve, on the right of z = 0.4607 gives the result.
From the tables, P(profitable) = 0.5 + .1772 + 0.07(0.1808 0.1772) = 67.75%
You can get the same answer at Excel by using the following instruction.
EXCEL =1-NORMDIST(13618,15000,3000,TRUE)
Since Adams requires the probability of profitability to be at least 60%, it should buy the
machine.
Video 05.11, 5.11. Benton Corporation is planning to buy a machine that may add
$4000 to the pre-tax earnings of the company if the economy is good (probability 60%),
or only $3500 if the economy is bad (probability 40%). Benton will depreciate the
machine on the straight-line basis for four years, even though it has a 20% chance that it
may last for five years. The tax rate of Benton is 30%, and the proper discount rate is
99
_____________________________________________________________________________
11%. Find the maximum price that Benton should pay for this machine to make it a
profitable investment.
Suppose the break-even price of the machine is P and thus the depreciation per year is
P/4. The expected pretax earnings are 0.6(4000) + 0.4(3500) = $3800. The after-tax
earnings are
C = 3800(1 .3) + .3(P/4) = 2660 + .075P, for the years 1-4
C = 3800(1 .3) = $2660 for the fifth year.
To break even, the present value of the machine should be equal to the present value of
all cash flows. Including the 20% probability for the fifth-year cash flow, we get
2660 + .075P .2(2660)
+ 1.115 (A)
1.11i
i=1
4
P=
4 .075
4 2660 .2(2660)
P 1 1.11i = 1.11i + 1.115
i=1
i=1
Or,
Or,
.7673165733 P = 8252.505534 + 315.7161065
Solving for P, we get P =
8252.505534 + 315.716106
= $11,166.
.7673165733
If Benton buys the machine for less than $11,166, it should be a profitable investment.
To verify the answer at WolframAlpha, write equation (A) as,
WRA P=sum((2660+.075*P)/1.11î,i=1..4)+.2*2660/1.11^5
Video 05.12, 5.12. Hawley Corporation needs a new computer that will produce annual
savings estimated at $5000 with a standard deviation of $2000. The company will buy the
computer for $20,000, depreciate if fully on a straight line over four years, and then sell it
for $3,000. The tax rate of Hawley is 25%, and it uses a discount rate of 11%. Find the
probability that the computer will have a positive NPV. Should Hawley buy the
computer?
In this problem, the additional factor to consider is the resale value of the machine. To
calculate the after-tax value of the resale price, we use
W = S(1 t) + tB
(4.7)
Since the machine is fully depreciated, its book value B is zero, Hawley has to pay taxes
on the sales price of the machine. After taxes, it becomes (1 .25)(3000) = $2250.
100
_____________________________________________________________________________
To break even, suppose the earnings before taxes are E. With $5000 annual depreciation
and 25% tax rate, the after-tax cash flow is, by (4.3),
This gives
C = E( 1 .25) + .25(5000) = .75E + 1250

.75E + 1250 2250
+ 1.114 (A)
1.11i
i=1
4
NPV = 0 = 20,000 +
4 1250
4 0.75
2250
20,000 1.11i 1.114 = E 1.11i
i=1
Or,
i=1
E = $6291.72
To verify the result at WolframAlpha, use the following instruction,

WRA 0=-20000+sum((.75*x+1250)/1.11î,i=1..4)+2250/1.11^4
The computer is expected to generate only $5000 annually. Thus is it unlikely that it will
be profitable. Calculate the z-value as
z=
6291.72 5000
= 0.6459
2000
To visualize that, draw a normal probability distribution curve, with z = 0 at the center
and z = 0.6459 to the right of center. The area further to the right of z = 0.6459 gives the
answer. From the tables,
P(NPV > 0) = 0.5 [0.2389 + 0.59(0.2422 0.2389)] = 25.92%
You may check the answer at Excel by using the following expression,
The probability that the computer is going to be profitable is only about 26%. Hawley
should not buy it.
5.13. Columbus Corporation plans to acquire a computer that will last for 5 years, and
costs $100,000. The company will use straight-line method to fully depreciate the
computer in 4 years, and then sell it for $10,000 after 5 years. Columbus will use 9%
discount rate for this investment, and its income tax rate is 35%. The pretax saving from
this computer is uncertain, with expected value $24,000 per year, and standard deviation
$6,000. What is the probability that the computer will have a positive NPV? Should
Columbus buy this machine?
First we find the pretax earnings E that will make NPV = 0. The annual depreciation is
$25,000. The after-tax cash-flow is given by (4.3)
101
_____________________________________________________________________________
C = E(1 .35) + .35(25,000) = .65E + 8750

Consider this as two cash flows: .65E, which will go on for five years and $8750 only for
the first four years. Finally, the after-tax value of the sales price is (1 .35)10,000 =
$6500. Setting the NPV equal to zero, we get
8750 5 .65E 6500
1.09i + 1.095 (A)
1.09i + i=1
i=1
4
0 = 100,000 +
Or,
This gives
0 = 100,000 + 28,347.54 + 2.52827E + 4224.55

E = $26,669.54
Verify the answer by solving (A) at WolframAlpha as follows,

WRA 100000=sum(8750/1.09î,i=1..4)+sum(.65*x/1.09î,i=1..5)+6500/1.09^5
Since the machine is expected to generate $24,000 annually in earnings, it is unlikely that
it will become profitable. Calculate the z-value as
z = (26,669.54 24,000)/6,000 = .4449
Draw a normal probability distribution curve, with z = 0 at the center and z = .4449 to the
right of center. The area further to the right of z = .4449, under the tail of the curve, gives
the answer. From the tables,
P(profitable) = .5 [.1700 + .49(.1736 .1700)] = 32.82%
You can also get the same result by using Excel as,
Considering the low probability of profitability, Columbus should not buy it.
5.14. Lucas Corporation plans to buy a machine for $100,000, and depreciate it
uniformly over its useful life of 5 years. The machine will produce annual pretax revenue
of $27,000. The tax rate of Lucas is 35% and it will use 11% as the discount rate for this
investment. The resale value of the machine after five years has a mean of $20,000 with a
standard deviation of $5000. Calculate the probability that this machine will be
profitable. Should Lucas buy it?
Suppose the resale value of the machine is S to break even. Since the machine is fully
depreciated at the time of sale, the sale amount is taxable. Its after-tax value is (1 .35)S
= .65S. The annual depreciation is $20,000, and thus the annual after-tax cash flow from
this machine is
C = (1 .35)27,000 + .35(20,000) = $24,550
102
_____________________________________________________________________________
This gives
24550 .65S
1.11i + 1.115 (A)
i=1
5
NPV = 0 = 100,000 +
Solve (A) at WolframAlpha as follows,
WRA 100000=sum(24550/1.11î,i=1..5)+.65*S/1.11^5
to get S,
S = $24,020.45
Since the resale value is only $20,000, the probability is less than 50% that it will be
profitable. Draw a normal probability distribution curve, with = $20,000 at the center
and = $5000. The required x = $24,020.45 is somewhat to the right of center. The area
further to the right of x gives the answer. Calculate the z-value as
Using the tables,
z = (24020 20000)/5000 = .8041
P(profitable) = .50 [.2881 + .41(.2910 .2881)] = .2107

There is only a 21% probability that the machine will be profitable. The company should
not buy it.
5.15. Delta Corporation is planning to buy a new machine at a cost of $30,000, which
will increase the pretax earning of the company by $10,000 annually. The maximum life
of the machine is 5 years, but there is also a 10% probability that it will break down after
3 years and a 20% probability that it will last only 4 years. Delta will depreciate the
machine on a straight-line basis for 5 years. In the case of a breakdown, Delta will
discard the machine, and lease a replacement machine for $8,000 annually, paying it in
advance every year. The after-tax cost of capital is 12%, and the company is in 30% tax
bracket. Should Delta proceed with the purchase? It cannot lease the machine for full five
years.
First, look at the earnings of the machine. The pretax earning from the machine, whether
it is the first one or the leased one, is $10,000 a year and its after-tax value is 10,000(1
.3) = $7,000. Take the PV for the full five years. This amounts to
5 7000
PV of E(1 t) = 1.12i = $25,233.43
i=1
You may solve (A) at WolframAlpha as follows,

WRA sum(7000/1.12î,i=1..5)
103
(A)
_____________________________________________________________________________
Next, consider the possibility that the machine breaks down after 3 years. The company
will write it off and lease a second one. At that time, the company does the following:
1. Takes the tax benefits of depreciation for the fourth and the fifth year. The depreciation
per year is $6,000 and its tax benefit, tD, is .3(6000) = $1800 per year. The total tax
benefit for the fourth and the fifth years is $3600.
2. Pays the lease payments for the two years in advance each year. The lease payments
are tax deductible, and so their after-tax value is 8000(1 .3) = $5600 annually.
3. Considers the 10% probability that the machine breaks down after three years and
finds the PV of the cash flows.
3 1800 3600 5600 5600
PV of 3-year life = .1
(B)
i +
3
3
4 = $65.92
i=1 1.12 1.12 1.12 1.12
You may solve (B) at WolframAlpha as follows,
WRA .1*(sum(1800/1.12î,i=1..3)+3600/1.12^3-5600/1.12^3-5600/1.12^4)
In the above expression, the summation is the PV of tax benefit of depreciation for the
first three years; $3600 is the tax benefit for years 4 and 5; $5600 is the after-tax value of
lease payment; and 0.1 is the probability factor.
Now consider the possibility that the machine runs for four years. At the end of the fourth
year, the company does the following:
1. Finds the PV of four years of tax benefits of depreciation, $1800 per year.
2. Takes the fifth year depreciation at the end of the fourth year. Its tax benefit is $1800.
3. Pays the lease payment for the fifth year, $5600 after taxes.
4. Incorporates the 20% probability of this event and calculates the PV of the cash flows.
4 1800 1800 5600
PV of 4-year life = .2 1.12i + 1.124 1.124 = $610.45
i=1
(C)
You may solve (C) at WolframAlpha as follows,

WRA .2*(sum(1800/1.12î,i=1..4)+1800/1.12^4-5600/1.12^4)
The PV of a 5-year life for the first machine does not involve the second machine. The
probability of this event is 70%. Thus
5 1800
PV of 5-year life = .7 1.12i = $4542.02
(D)
i=1
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You may solve (D) at WolframAlpha as follows,

WRA .7*sum(1800/1.12î,i=1..5)
Combine (A), (B), (C), and (D) to get the NPV of all possibilities
NPV = 30,000 + 25,233.43 65.92 + 610.45 + 4,542.02 = $319.98.
The machine is barely acceptable.
5.2
Inflation
In financial modeling, one can also include the effects of inflation, which will influence
the future earnings or expenses of a corporation. Although inflation rates are difficult to
predict accurately, one can use the past as a proxy for the future and arrive at a reasonable
estimate of the rate of inflation. We should adjust the future cash flows accordingly.
Examples
5.16. A corporation has the following pension benefit for its retired employees. It pays
annual payments equal to 35% of an employees last salary at the time of retirement,
adjusting them upward according to the rate of inflation. Find the cost of these benefits to
the company for an employee who has just retired with an annual salary of $32,000. The
company expects to make 16 annual payments and expects the inflation rate to be 3.5%
during this period. The cost of capital to the company is 12%. The company will make
the first payment now.
First payment = 0.35(32,000) = $11,200
11200(1.035)i
1.12i
i=1
15
NPV = 11,200 +
= 11200 +
In this summation, a =
(A)
11200 (1.035) 11200 (1.035)2

11200 (1.035)15
+
+
...
+
2
1.12
1.12
1.1215
11200 (1.035)
1.035
,x=
, and n = 15. Using (1.4), we get
1.12
1.12
NPV = 11,200 +
11200 (1.035) 1 (1.035/1.12)15

1.12
1 1.035/1.12 = $105,834
The company may also offer to make a single payment of $105,834 as the settlement for
the pension benefits.
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WRA 11200+sum(11200*1.035î/1.12î,i=1..15)
5.17. Benin Corporation has the following pension plan. It will give 35% of a person's
last annual salary as pension in annual installments, with the first payment at the time of
retirement. The pension has a cost of living adjustment, which is expected to be +3%
annually in the future. Benin uses a discount rate of 9%. Find the present value of the
pension cost for an employee who has just retired with an annual salary of $42,000. She
expects to receive 17 payments.
PV = 0.35(42,000) +
=
0.35(42,000)(1.03) 0.35(42,000)(1.03)2
+
+ 17 terms (A)
1.09
1.092
0.35(42,000)[1 (1.03/1.09)17]
= $165,056
1 1.03/1.09

WRA sum(.35*42000*(1.03/1.09)î,i=0..16)
5.18. California Gold Mining Company plans to buy a dredging machine, which costs
$40,000. The machine will produce an EBIT of $4,000 in the first year, but this will
increase at the rate of 10% annually due to the rising price of gold. The machine will last
for 10 years and the company will depreciate it on a straight-line basis. The tax rate of the
company is 30% and the proper discount rate is 12%. Should California buy the
machine?
Suppose the initial investment in the machine is I0. The depreciation per year is thus I0/n,
and the tax benefit of depreciation per year is t(I0/n). Suppose the EBIT from the machine
in the first year is E. Due to the inflation rate of f per year, it will become E(1 + f) in the
second year, E(1 + f)2 in the third year, and so on. To generalize, the earnings in the ith
year are E(1 + f)i1. Thus
n E(1 + f)i1(1 t) + tI /n
0
NPV = I0 +
i
(1
+
r)
i=1
Substituting the numerical values, I0 = $40,000, E = $4,000, f = 0.1, n = 10, t = 0.3, r =
0.12, we get
10 4000(1.1)i1(1 .3) + .3(40,000)/10
NPV = 40,000 +
1.12i
i=1
Use the Maple expression (red) or WolframAlpha (blue) to get the result.
-40000+sum((4000*.7*1.1^(i-1)+.3*40000/10)/1.12î,i=1..10);
-40000+sum((4000*.7*1.1^(i-1)+.3*40000/10)/1.12î,i=1..10)
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The result is NPV = $10,135.92, which is not acceptable.

5.19. Carpenter Corporation is considering a project with an initial cost of $100,000. The
pre-tax cash inflows in current dollars, without adjustment for inflation, are as follows.
Year:
1
2
3
4
5
Amount: $40,000 $30,000 $30,000 $30,000 $40,000
The estimate for inflation during this period is that it will be either 4%, with probability
30%; or 5%, with probability 70%. Accordingly, the company should adjust the cash
flow projections upwards. The company is in 35% tax bracket and it uses a discount rate
of 12%. Should it accept the project?
Assuming that the inflation is 4% annually, the pretax cash flows will become
40,000(1.04), 30,000(1.04)2, 30,000(1.04)3, etc. We multiply the cash flows by (1 .35)
to get their after-tax amount. Multiplying with the respective probabilities, and
discounting, we get the NPV as
NPV = 100,000 + (1 .35)
40000(1.04) 30000(1.04)2 30000(1.04)3 30000(1.04)4 40000(1.04)5
0.3
+
+
+
+
1.12
1.122
1.123
1.124
1.125
{ [
40000(1.05) 30000(1.05)2 30000(1.05)3 30000(1.05)4 40000(1.05)5

+ 0.7
+
+
+
+
1.12
1.122
1.123
1.124
1.125
]}
= $9264, reject the project.

You may verify the result at WolframAlpha as follows,
WRA -100000+(1-.35)*(.3*sum(.35*42000*(1.03/1.09)î,i=0..16)
5.3
The Option to Postpone a Project
In many situations, the investment decision of a corporation also has options embedded in
it. For example, a corporation can start a project now, or wait for a year and then start the
project. Therefore, the company has the option to delay the project. Later on, when the
project is becoming profitable, the company has the option to expand the project. If the
sales are not what they were originally anticipated, the firm may have the option to
contract the project. Finally, if the project is creating a big loss, then the firm should have
the option to abandon the project outright.
Each option listed above has a certain value, because it provides the company with
flexibility in its planning. For example, the company can build a factory now, or build it
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next year. By building the factory now, the company exercises its option and thereby
loses the value of that option. It is also possible to find the value of this option.
Suppose a corporation can start a project right away, or wait for a while and then decide
whether to get on with the project. Consider the following simplified example.
Example
5.20. An oil company can invest $16,000 to drill a well and start producing oil. The
revenue from the well is uncertain, depending on the price of oil. At present, the price of
oil is $20 a barrel, but after a year, it could go up to $30 a barrel, or drop to $10 a barrel,
with equal probability. Let us assume that the new price of oil will stay constant forever.
The well will produce 100 barrels of oil a year forever with no cost. The oil revenues are
available at the end of each year. The cost of capital is 10%. Should the company drill the
well now, or wait for a year and then drill?
Suppose the company drills the well right now and starts producing the oil. The annual
revenue from the well is $3000, or $1000, depending on the price of oil. Both of these
outcomes are equally probable. The cash flows start a year from now and continue
forever. The following expression gives the NPV,
1000
3000
i + .5
1.1i = 16,000 + .5[3000/.1 + 1000/.1] = $4,000
1.1
i=1
i=1
NPV = 16,000 + .5
Based on this incomplete analysis, the company should go ahead and drill the well. The
answer is, however, wrong because we have ignored the value of the option to delay the
decision for a year. The probability that the oil price will rise or drop is 50% each.
Suppose the risk-free rate is 6%, then
16000 3000
NPV(oil = $30) = .5 1.06 + 1.1i = $6089
i=2
16000 1000
NPV(oil = $10) = .5 1.06 + 1.1i = $3002
i=2
If the company waits for a year and then drills the well, then its choice is clear it will
drill only if the price of oil is $30 a barrel. For a price of $10, the NPV is negative and the
company will not get into oil production. The company must wait for a year and then
decide to drill.
Suppose the company did not have the option to wait. It is now or never. In that case, the
company should go ahead and drill now with an NPV of $4000. Since the second NPV is
$2089 more than the first NPV, this is the value of the option to wait.
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5.4
The Option to Abandon a Project
There may be several reasons for a company to stop a project: the market conditions have
changed, the plans have changed, or the project simply is not profitable any more. The
flexibility afforded by this option to continue or discontinue a project also adds value to
the company. It is possible to evaluate the optimal time to replace a car, or a machine, or
a whole factory. You may have to compare the NPV of abandoning versus the NPV of
continuing the project. The following example will illustrate the point.
Examples
5.21. A company has decided to buy a machine for $50,000. It will depreciate the
machine on a straight-line basis over its useful life of five years. The tax rate of the
company is 40% and the proper discount rate 10%. The following tables gives the resale
value, S of the machine and its pretax revenue, E.
Time, years Pretax revenue, E Resale value, S
0
$0
$50,000
1
$22,000
$38,000
2
$18,000
$27,000
3
$14,000
$17,000
4
$12,000
$8,000
5
$10,000
$0
The company has the option to keep or sell the machine at any time. What is the optimal
time to replace the machine?
Recall (4.3) and (4.7) to calculate the after-tax cash flows and the after-tax value of the
resale price of the machine. We augment the information in the above table as follows:
Time
0
1
2
3
4
5
E
$0
$22,000
$18,000
$14,000
$12,000
$10,000
S
E(1 t) + tD
$50,000
$0
$38,000
$17,200
$27,000
$14,800
$17,000
$12,400
$8,000
$11,200
$0
$10,000
B
S(1 t) + tB
$50,000
$50,000
$40,000
$38,800
$30,000
$28,200
$20,000
$18,200
$10,000
$8800
$0
$0
To find the optimal replacement time, we find the NPV of the machine if it is used only
for one year, or two years, and so on. The NPV for all possibilities will be
NPV(1 year) = 50,000 +
17200 38800
1.1 + 1.1 = $909
NPV(2 years) = 50,000 +
17200 14800 28200

1.1 + 1.12 + 1.12 = $1174 (highest)
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NPV(3 years) = 50,000 +
17200 14800 12400 18200

1.1 + 1.12 + 1.13 + 1.13 = $858
NPV(4 years) = 50,000 +
17200 14800 12400 11200 8800

1.1 + 1.12 + 1.13 + 1.14 + 1.14 = $844
NPV(5 years) = 50,000 +
17200 14800 12400 11200 10000

1.1 + 1.12 + 1.13 + 1.14 + 1.15 = $1043
It is interesting to note that the NPV reaches a maximum after two years, equaling $1174.
Considering all these results, it is best to replace the machine after two years.
The value of the option to stop at any time after the project has commenced is the
difference between the maximum NPV and the NPV for full 5 years. It comes out to be
1174 1043 = $131
5.22. A company can build a factory now at a cost of $900, or wait for a year and build it
at a cost of $1200, or $800. The probability of increased cost is 60%. The future cost
depends on the pending legislation. The output from the factory will have a net cash flow
of $100 per year forever. The proper discount rate for the cash flows is 10%, while the
risk free rate is 6%. Should the company build now or next year?
100
NPV(build now) = 900 + 1.1i = $100
i=1
1200 100
800 100
NPV(build next year) = .6 1.06 +
+
.4
1.06 + 1.1i = $72.04
1.1i
i=2
i=2
The company should build the factory now.
5.23. A company can automate its payroll department by purchasing a computer. The
computer costs $25,000 now, but it may cost only $20,000 next year. The company
expects to save $6500 a year during its useful life of 5 years. The discount rate is 12%,
and the risk-free rate is 6%. The company uses straight-line depreciation and its tax rate
is 30%. Should the company install the computer this year, or next year?
The depreciation in the first case is $5000 annually, and in the second case $4000
annually.
5 6500(1 .3) + .3(5000)
NPV(install now) = 25,000 +
= $3191.10
1.12i
i=1
20000 6 6500(1 .3) + .3(4000)
NPV(install next year) = 1.06 +
= $361.26
1.12i
i=2
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The company should not install the computer at present. It should re-evaluate the
situation after a year or two. Perhaps the price of the computer will drop futher, or the
savings will increase.
5.24. A company has the option of buying a machine now, or waiting for a year. If the
company buys the machine now it will cost $12,000 while the current discount rate is
10%. If the company buys the machine next year, the machine will cost $13,000, but the
discount rate will be 9%. In any case, the machine has a useful life of 5 years with no
resale value. The machine will generate $4000 in annual pretax revenues. The tax rate of
the company is 30%. The risk-free rate is 6%. What is the better strategy?
Considering the after-tax cash flows in each case, find the NPV as
4000(1 .3) + .3(2400)
= $1343.57
1.1i
i=1
5
NPV(buy now) = 12,000 +
13000 6 4000(1 .3) + .3(2600)

NPV(wait for a year) = 1.06 +
= $511.034
1.09i
i=2
The company should buy the machine now. The value of the option to wait is zero,
because the company will not wait. An option cannot have a negative value.
Videos at YouTube that discuss real options are:
https://www.youtube.com/watch?v=yegyVwgCE0M
https://www.youtube.com/watch?v=AOZu_DZVCuA
Problems
5.26. Webster Company stock does not pay any dividends and it sells for $55 a share.
The continuously compounded expected return of the stock is .12, with standard
deviation of 0.22. Find the probability that the stock will be selling for more than $60
after one year.
P(S > 60) = 55.96%
5.27. Green Acres common stock pays no dividend, but its expected return is 13% with a
standard deviation of 30%. Currently the stock is selling for $65 a share. If you buy the
stock now, what is the probability that its price next year will be between $60 and $70?
P(60 < S < 70) = 18.46%
5.28. You are looking for an investment opportunity that will provide a yield of at least
10%. You estimate that the returns from the Ford Motor Company stock have normal
distribution with mean 12.5% and standard deviation 8.5%. What is the probability of
achieving your objective if you buy Ford stock? What is the probability that your loss
will be limited to 5% of your investment?
P(r > .1) = 61.57%, P(r > .05) = 98.02%
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5.29. Marshall Company is in financial distress. Its bonds will mature on December 31,
2010, and they pay 8% interest annually on December 31. There is a 30% chance that the
company may become bankrupt in a given year. In case of bankruptcy, the company will
not pay interest on the bonds for that year and will settle the claims by paying 30% of the
principal at the end of the year. Suppose your required rate of return on these bonds is
14%, how much would you pay for a bond on January 1, 2008?
$486.51
5.30. Benin Company 7.5s14 bonds are selling at 27. Your careful analysis reveals that
the company will survive the first year. It may go bankrupt during the second year
(probability 50%) or during the third year (probability 50%). Before bankruptcy, it will
continue to pay the semiannual interest payments. In case of bankruptcy, the company
will not pay any interest for that year, and you expect to get only 20% of the face amount
of the bond, which will be available one year after the bankruptcy. For instance, if Benin
goes bankrupt during the second year, you will receive the final payment at the end of the
third year. Your required rate of return is 12%. Use the semiannual discount rate for all
cash flows. Do you think you should buy Benin bonds?
No, B = $232.58
5.31. Macmillan Corporation's cumulative preferred stock pays $5 annual dividend, the
first one will be received a year from now. The cumulative feature means that if the
company does not pay the dividends in a given year, it must pay the total dividends due
the following year. The payment of dividends is contingent upon the earnings after taxes,
and you feel that there is 90% chance that the dividends will indeed be paid in a given
year. In any case, at the end of 3 years, the company will buy back the stock by paying
$50 per share to the stockholders, plus any dividends due. The discount rate for this
investment is 14%. What price would you pay for a share of Macmillan stock? $45.25
5.32. The York Company wants to buy a new stamping machine that costs $100,000.
The machine has an expected life of 10 years with a standard deviation of 2 years. York
will depreciate the machine over a 10-year period. The cost of running the machine is
$10,000 annually, and it generates $30,000 annual revenue. The company has income tax
rate of 30%, and it uses 10% as the discount rate. What is the probability that the machine
will break down within 8 years? If it runs for only 8 years, what is its NPV?
P(life < 8) = 15.87%, NPV = $6507.21
5.33. Burundi Airlines is planning to acquire a Boeing 757 at a cost of $24 million. The
plane has an uncertain life span: it may last for 6 years (probability 50%), 7 years
(probability 30%), or 8 years (probability 20%). The airline will depreciate the plane on a
straight-line basis with a life of 6 years, with no residual value. While the plane is flying,
it will generate a pretax income of $6 million annually. The tax rate of Burundi is 40%
and its after-tax cost of capital is 9%. Should Burundi buy the new plane?
NPV = $672,782, buy it
5.34. Usfan Company is interested in buying a computer with uncertain life. The
following table shows its expected life and resale value:
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Expected life Probability Resale value

3 years
20%
$20,000
4 years
30%
$10,000
5 years
50%
$5,000
The computer will save the company $40,000 annually while it is running. Usfan will
depreciate it fully on a straight-line basis in 3 years. The tax rate of Usfan is 30%, and the
proper discount rate in this case is 12%. The cost of the computer is $90,000. Should
Usfan buy it?
Yes, NPV = $25,368
5.35. Pisces Corporation is planning to buy a machine for $20,000 that may run for 4
years (probability 60%), 5 years (probability 30%), or for 6 years (probability 10%).
Pisces will depreciate the machine on straight-line basis for 4 years, without any resale
value. The tax rate of Pisces is 30% and the proper discount rate is 8%. Calculate the
minimum annual earnings generated by this machine to be acceptable to Pisces.
$5887.52
5.36. Thales Corporation wants to buy a machine for $60,000. It will depreciate the
machine over a six-year period with no salvage value. The machine will generate pre-tax
revenue of $20,000 annually, the tax rate of Thales is 32%, and the proper discount rate is
11%. The machine has uncertain life: it may run for 5 years (probability 50%), 6 years
(probability 30%), or 7 years (probability 20%). Should Thales buy the machine?
NPV = $8841.69, yes.
5.37. Cobb Company is planning to invest in a machine that will run for 5 years. Cobb
uses straight-line depreciation. The annual pretax revenue from the machine has normal
distribution, with mean $12,000 and standard deviation $4000. The tax rate of the
company is 30% and its after-tax cost of capital is 8%. How much should Cobb invest in
this machine so that there is greater than 80% probability that it will turn out to be
profitable.
$31,731.46
5.38. Rayburn Corporation is considering the purchase of a new machine that has an
expected life of 5 years with a standard deviation of 2 years. The machine will cost
$40,000 and will generate a pre-tax income of $10,000 annually. The tax rate of Rayburn
is 40% and its cost of capital is 7%. Rayburn will depreciate the machine on a straightline basis over 5 years with no residual value. Calculate the probability that the machine
will have a life of between 4 and 7 years. Is the machine acceptable if it runs for only 4
years?
53.28%, NPV = $6396.48, no
5.39. Acheson Corporation is planning to buy a machine that will cost $30,000. Its life is
uncertain: it may become obsolete after two years (probability 25%) and definitely after
three years. The economy in any given year may be good (probability 60%) or bad
(probability 40%). If the economy is good, the machine will generate pre-tax annual
revenue of $15,000 and if the economy is bad, the expected revenue will only be
$10,000. The tax rate of Acheson is 40% and it will depreciate the machine for 3 years on
a straight-line basis. The proper discount rate is 7%. Should Acheson buy the machine?
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NPV = $567.71, no
5.40. Martin Company is looking into a machine with a cost of $20,000 that will run for
5 years. Martin will depreciate the machine completely over this period. The tax rate of
the company is 30%, and its cost of capital is 8%. The expected pretax income from the
machine is $5,000 annually, with a standard deviation of $2,000. Calculate the
probability that the machine will turn out to be profitable.
41.26%
5.41. Cooper Inc. plans to buy a new machine for $25,000 for a project that will last 5
years. The machine will generate $8,000 annually in pretax revenue. The tax rate of
Cooper is 30% and its after-tax cost of capital 8%. Assume straight-line depreciation for
five years. There is a 10% chance that the machine may break down after 3 years and a
20% probability of breakdown after 4 years. If the machine breaks down, Cooper will get
a used machine as a replacement for $12,000. The used machine has a two-year useful
life. At the end of the project, neither machine will have a resale value. Should Cooper
buy this machine?
NPV = $1418.54, buy
5.42. Salam Corporation would like to buy a new electric furnace for $42,000 that will
increase the EBIT of the company by $8,000 annually. The actual life of the furnace is
unpredictable, but for depreciation purposes, it is 7 years. The proper discount rate is 9%
and the tax rate is 30%. Find the minimum number of years that the furnace must run
before it would become a profitable investment.
NPV(9 years) = $632.70 > 0
5.43. Richardson Company is considering the purchase of a machine that it expects will
run for 5 years, even though there is a 20% chance that it may break down completely
after 4 years. While the machine is running, it will generate $20,000 annually in pre-tax
income. Richardson will depreciate the machine on a straight-line basis over a five-year
period with no salvage value. The income tax rate of Richardson is 30% and its after-tax
cost of capital is 11%. The cost of the machine is $80,000. Should Richardson install the
NPV = $12,116, no
machine?
5.44. Laird Company is planning to invest in a project with expected after-tax cash flow
of $12,000 annually with a standard deviation $4000. The project requires an initial
investment of $75,000 and another expense of $25,000 at the end of the first year. The
first income will occur at the end of the second year. Calculate the probability that the
project will be profitable (that is, its NPV > 0) after 10 years. The cost of capital to Laird
is 9%.
7.33%
5.45. Bush Inc. is planning to acquire a machine with expected life 5 years. Bush will
depreciate the machine on a straight-line basis without any salvage value. The following
table shows the pre-tax income generated by the machine depending on the state of the
economy.
State of the economy Probability Expected income
Good
30%
$23,000
Fair
50%
$18,000
Poor
20%
$12,000
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The economic conditions in any given year are independent of the conditions in the
previous year. Bush will not buy the machine unless it has NPV of at least $30,000. The
proper discount rate in this case is 12%, and the income tax rate for Bush is 35%.
Calculate the maximum price that Bush should pay for this machine.
$17,225.36
5.46. Benue Company is interested in buying a machine that costs $80,000. Benue will
depreciate the machine over a 5-year period with no resale value. The actual life of the
machine is uncertain, but while it is operating, it will generate pretax revenue of $25,000
annually. The tax rate of Benue is 30%, and it uses 10% discount rate for such an
investment. Find the NPV of this investment if the machine lasts (a) 4 years, and (b) 7
years.
(a) $6033.54, (b) $23,393.11
5.47. Bomu Corporation is planning to buy a $70,000 machine with a 5-year life. Bomu
will depreciate the machine fully over that period and then sell it for $10,000. The annual
pretax revenue from the machine is uncertain, with a mean of $25,000, and standard
deviation $10,000. The income tax rate of Bomu is 30% and the cost of capital 12%. Find
the probability that the machine will be profitable.
68.56%
5.48. Syracuse Company is planning to buy a machine for $50,000 that will be
depreciated fully in five years on a straight-line basis. The machine is estimated to last 7
years, and then it will be sold for $5000. The before-tax earnings from the machine are
estimated to be $10,000 annually, with a standard deviation of $2000. The tax rate of
Syracuse is 30%, and its after-tax cost of capital 12%. Find the probability that this
machine will be profitable.
18.8%
5.49. Cleveland Corporation needs a machine that will cost $120,000 and it will generate
$25,000 annual pretax earnings. The company will depreciate the machine over 5 years,
with no resale value. The discount rate for this investment is 8%, and the income tax rate
of Cleveland is 32%. The machine may actually run for 5 years (probability 30%), or 6
years (probability 70%). Should Cleveland buy this machine?
No, NPV = $13,961
5.50. Chadwick Company has a pension plan that provides lifetime benefits to its retiring
employees, including cost of living adjustments. The first payment, paid a year after the
retirement, is equal to 60% of the last annual salary. However, the benefits are expected
to rise by 4% annually in the future. The expected number of annual payments to a 65year old person is 18. The cost of capital to Chadwick is 11%. Find the present value of
the benefits payable to a person whose last salary is $50,000 per year.
$295,890.13
5.51. Lakeland Clinic, a tax-exempt entity, is interested in buying a MRI device now, or
postponing it for a year. The current price of the equipment is $3 million, but it is
expected to go up to $3.2 million next year. The hospital plans to use the machine for a
period of 6 years, and during this period the value of the machine is expected to drop at a
compound annual rate of 10%. The equipment will produce revenue of $500,000
annually. The cost of capital for hospital is 8%. What is the best course of action? What
is the value of the option to wait?
NPV(now) = $316,134, NPV(later) = $169,549, option value = 0
115
_____________________________________________________________________________
5.52. Western Airlines is planning to acquire a plane for $50 million. They will
depreciate it completely on a straight-line basis over 5 years. The tax rate of Western is
30% and its cost of capital 10%. The plane should generate $20 million annually in
pretax income, not including maintenance costs. The resale value and the annual
maintenance cost (in millions) of the plane are variable as shown in the following table:
Time Maintenance Resale value
0 year
$0
$50 million
1 year
$5 million
$45 million
2 year
$8 million
$40 million
3 year $10 million
$35 million
4 year $12 million
$30 million
5 year $15 million
$25 million
What is the optimal time to keep the airplane flying? What is the value of the option to
sell the plane ahead of time, rather than to keep it for full five years?
Optimal 2 years, NPV(2) = $2.273 million, value of the option = $2.289 million
Key Terms
continuous, 81
discrete, 81
expected value, 81, 90, 92
inflation, 81, 95, 96, 97
mean, 81, 82, 83, 93, 102,
103, 105
normal probability
distribution, 81, 85
options, 81, 98
probability distributions, 81
random, 81
116
standard deviation, 81, 82,

84, 89, 90, 91, 92, 93, 102,
103, 104, 105
subjective probability
distribution, 81
6. PORTFOLIO THEORY
1. Understand the basic reason for portfolio formation.
2. Calculate the risk and return characteristics of a portfolio.
6.1
Video 06A Portfolio Formation
A portfolio is a collection of projects, or securities, or investments, held together as a

bundle. For example, you may buy 100 shares of Boeing, 200 shares of Microsoft, and 5
PP&L bonds in an account. This is your portfolio of investments. If you own a home, then
you may include the value of the house in your portfolio. A portfolio may also include less
tangible items as your professional education, or even a license to practice law. The total
value of your portfolio may fluctuate with time.
Corporations also have a portfolio of different projects. They carefully select profitable
projects and invest in them. The banks loan money to individuals and corporations. They
have a loan portfolio, and they try to monitor the quality of their portfolios. The quality of
a loan portfolio can deteriorate if too many loans are non-performing.
Why do people, or corporations, form a portfolio? The simple answer is diversification.
You do not want to put all your eggs in one basket. It is a good idea to diversify your risk,
and if some of the investments do not pan out, the others will keep the value of the portfolio
intact.
6.2
Portfolio Theory
We can form a portfolio by carefully selecting a set of securities.
The two main features of a portfolio are its risk and expected
return. In 1952, Harry Markowitz first developed the ideas of
portfolio theory based on statistical reasoning. He showed that
one could reduce the risk for a given return by putting together
unrelated or negatively correlated securities.
Harry Markowitz (1927- )
We may define the realized return of a single security as the sum

of price appreciation and the dividends, divided by the
acquisition cost of the security. For example, if we buy a stock at
$50 a share, get a $2 dividend on it, and then sell it for $52, then
the return, in dollars, is $4. The return, as a percentage, is 4/50 =
8%. In general, we may define the return as
R=
P1 P0 + D1
P0
117
(6.1)
6. Portfolio Theory
_____________________________________________________________________________
where the purchase price of the stock is P0, its selling price is P1, and D1 is the dividend
paid, if any, at the end. The quantity P1 P0 is the price appreciation of the stock, and
along with the dividend, is the total change in the value of the investment.
Modifying (6.1), we can represent the expected return of a security as
E(R) =
E(P1) P0 + E(D1)
P0
(6.2)
where E() is the expectations operator. Suppose we have a probability distribution pi, with
i = 1 ... n, describing n states of the economy and we also have the returns Ri under each
state, then
n
E(R) = piRi = R
(6.3)
i=1
The second component of any investment is the amount of risk inherent in that investment.
We may use the standard deviation of return, (R), as a measure of risk. This is because
the standard deviation of a random outcome represents the uncertainty, or spread, in that
random variable. For a stock, it may represent the risk of that stock investment. Using the
notation of (1.6 1.8), we write
(R) = pi(Ri R)2

i=1
1/2
(6.4)
To quantify the dependence of one stock on the other, recall equation (1.10) which defines
the correlation coefficient, rij. Mathemathically,
cov(Ri,Rj)
rij = (R )(R )
i
(6.5)
For any two securities that are completely unrelated, the correlation coefficient between
them is zero, rij = 0. For perfectly positively correlated securities, rij = 1, and for those that
are perfectly negatively correlated, rij = 1. In real life, most of the securities are partially
positively correlated with one another.
6.3
Two-Security Portfolio
Let us first consider the simplest portfolio, the one that has only two securities in it, say the
stock of two major corporations, GM and IBM. If we add up all the weights of securities
in a given portfolio, the sum should be equal to one. For instance, if a portfolio has 75%
assets invested in GM and 25% in IBM, then 0.75 + 0.25 = 1. In general,
w1 + w2 = 1
118
(6.6)
6. Portfolio Theory
_____________________________________________________________________________
The return defined by (6.1) is the realized return. This is in the past. What is the future
return of the stock? That is more difficult to predict. However, we can represent the
expected return by the symbol E(R). Similarly, we can represent the expected return of a
portfolio by E(Rp). For any two-security portfolio, the expected return of the portfolio,
E(Rp), will depend upon the return of the two securities, and their weights. Indeed, the
return is the weighted average of the returns of the individual securities. That is,
E(Rp) = w1 E(R1) + w2 E(R2)
(6.7)
What is the risk of a two-security portfolio? The total risk will depend upon the weights of
the two securities. If more money is invested in GM, then the portfolio risk will tend to be
closer to the risk of GM.
Let us look at equation (6.4). This equation represents the risk of a portfolio. One way to
measure risk is to use the standard deviation of returns. (R). For more risky securities, the
standard deviation, or the spread of returns is higher. For less risky securities, the spread is
less, meaning we are more confident what the return will be. For risk-free securities, the
is zero.
For a two-security portfolio, the risk comes from both the securities. However, you cannot
add risk linearly. In general, two units of risk of one security plus two units of risk from
another security does not add up to four units of risk. In fact, the risk of one security may
partially cancel the risk of another security when you hold them together as a portfolio.
The greater is the diversification of the portfolio, the lesser is the risk of the portfolio.
One could measure diversification in terms of correlation coefficient, r12 between two
stocks. You get greater diversification if you have stocks, which are unrelated to one
another. In other words, their correlation coefficient is smaller.
To begin with, is a non-linear quantity. As seen in (6.4), you have to find it by taking the
square root of a sum of squares. When you add the sigmas of two securities, you cannot
say that the sigma of the portfolio is the sum of their individual sigmas. You have to add
them by squaring them first, then adding them, and then you have to take the square root.
It also depends on the weights of the securities. Finally, risk of the portfolio, (Rp) depends
on their correlation coefficient, r12. It does become complicated. Using statistical theory,
one can prove that (6.8) represents the risk of a portfolio correctly. Including the weights
and risks of the two securities, and the correlation coefficient between them, we can write
the total risk of a portfolio as follows:
(Rp) = w12 12 + w22 22 + 2w1w2 12r12
Or,
(Rp) = w12 12 + w22 22 + 2w1w2 cov(1,2)
(6.8)
(6.8a)
Going from a two- to a three-security portfolio complicates the problem further. In this
case, we have to consider the correlation coefficient between the first and the second stock,
between the first and the third stock, and between the second and the third stock. That is,
119
6. Portfolio Theory
_____________________________________________________________________________
the formula should have r12, r13, and r23. This is what we find in equation (6.11). It is better
to use a computer program that can handle such equations to optimize the formation or a
real portfolio with perhaps thirty stocks.
6.4
Portfolios with Three or More Securities
We can readily extend the results for the two-security portfolio to the portfolios with three
or more securities. For a three-security portfolio, equations (6.6-8) become
w1 + w2 + w3 = 1
E(Rp) = w1 E(R1) + w2 E(R2) + w3 E(R3)
(Rp) =
w1212
w2 22
w3232
(6.9)
(6.10)
+ 2w1w212r12 + 2w1w313r13 + 2w2w323r23

(6.11)
We can extend our analysis for a portfolio with n securities. To summarize, let us define:
E(Rp) = expected return of the portfolio
E(Ri) = expected return of the security i
wi = weight of the security i, as a percentage of the total value of the portfolio
(Rp) = standard deviation of the returns of the portfolio
i = standard deviation of the returns of the security i
cov(i,j) = covariance between the returns of securities i and j
rij = correlation coefficient between the securities i and j.
For a portfolio with n securities, (6.8) will become
We may write it as
w1 + w2 + w3 + ... + wn = 1
n
wi = 1
(6.12)
i=1
For an n-security portfolio, the expected return is

or,
E(Rp) = w1 E(R1) + w2 E(R2) + w3 E(R3) + ... + wn E(Rn)

n
E(Rp) = wi E(Ri)
(6.13)
i=1
By definition, the covariance between the returns of the securities i and j is equal to the
product of the correlation coefficient between these securities and the standard deviations
of the returns of these two securities. Mathematically, we can write it as
cov(i,j) = ijrij
120
(6.14)
6. Portfolio Theory
_____________________________________________________________________________
For instance, we may write

12r11 = var(1) = cov(1,1)
and
12r12 = cov(1,2)
Let us write (6.11) as follows:

2 2
+ w1w212r12 + w1w313r131/2
w1 1
w2222
+ w2w323r23
(Rp) = w2w121r21 +
w3w131r31 + w3w232r32 + w3232
The terms along the principal diagonal are the variance terms, and those off the diagonal
are the covariance ones. We can sum the terms in each row by using sigma notation with j
as an index, and then sum the rows using i as the index. Finally, we get for n securities,
1/2
(Rp) = wiwjcov(i,j)
i=1 j=1
(6.15)
If a portfolio is composed of projects whose expected returns Ri and their standard

deviations i are all expressed in dollar amounts then we do not look at the weights of the
projects. That is, we drop the w's from the previous equations. We may write (6.6) and (6.7)
as
E(Rp) = E(R1) + E(R2)
(6.16)
(Rp) = 12 + 22 + 2 12r12
(6.17)
For an n-security portfolio, with dollar amounts of investments and returns, we rewrite
(6.12) and (6.14) as
n
E(Rp) = E(Ri)
(6.18)
i=1
(Rp) = cov(i,j)
Examples
i=1 j=1
1/2
(6.19)
Video 06.01 6.1. Cooper Corporation has the opportunity to invest in two of the following
three proposals. Which two projects should the company select, if the company wants to
maximize the ratio between expected NPV and the standard deviation?
Expected NPV
Standard deviation
Corr. coeff. between
Project A
$10,000
$2,000
(A,B) = .4
121
Project B
$11,000
$1,900
(A,C) = .5
Project C
$9,000
$1,500
(B,C) = .8
6. Portfolio Theory
_____________________________________________________________________________
In this problem, we regard the expected NPV as the expected return. The project costs and
returns are in dollars. For a two-security portfolio, with investments in projects 1 and 2, the
sigma of the portfolio is given by
(Rp) = 12 + 22 + 2 12r12
(6.17)
For the projects A + B, NPV = $21,000

= 20002 + 19002 + 2(0.4)(2000)(1900) = $3263
NPV/ = 21,000/3263 = 6.4349
For A + C, NPV = $19,000
= 20002 + 15002 + 2(0.5)(2000)(1500) = $3041
NPV/= 19,000/3041 = 6.2472
For B + C, NPV = $20,000
= 19002 + 15002 + 2(0.8)(1900)(1500) = $3228
NPV/= 20,000/3228 = 6.1958
Cooper corporation should invest in projects A and B.
6.2. Suppose you want to invest $40,000 in ExxonMobil, whose expected return is 15%
with standard deviation 20%, and $10,000 in Boeing whose expected return is 18% with
standard deviation 21%. The correlation coefficient between the securities is 0.75. Find the
expected total value of your portfolio after one year, and its standard deviation in dollars.
The total value of the portfolio is 40,000 + 10,000 = $50,000. The weight of the first
security is 40,000/50,000 = .8. The weight of the second security is thus .2. Therefore,
w1 = 0.8, w2 = 0.2.
The expected return of the portfolio comes out to be
E(Rp) = 0.8(0.15) + 0.2(0.18) = 0.156
The standard deviation of the return of portfolio is
(Rp) = (.8)2(.2)2 + (.2)2(.21)2 + 2(.8)(.2)(.21)(.2)(.75) = .1935 = 19.35%
Note that the standard deviation of the portfolio, 19.35%, is less than the standard deviation
of either of its two components, Exxon Mobil, 20%, and Boeing, 21%.
122
6. Portfolio Theory
_____________________________________________________________________________
To find the expected value of the portfolio after one year, and its sigma, in dollars, we
calculate
E(V) = $50,000 (1.156) = $57,800
and
(V) = $50,000 (0.1935) = $9,675
6.3. Suppose you have $40,000 that you would like to invest equally in four securities A,
B, C, and D. The expected returns from these securities are 10%, 11%, 12%, and 13%,
respectively. The standard deviations of these returns are 12%, 14%, 16%, and 18%,
respectively. The correlation coefficient between any two securities is 0.8. If the returns
are normally distributed, what is the probability that the portfolio will be worth more than
$50,000 after one year?
Since you want to invest your money equally among four securities, the weight of each
security is 25%. This means w1 = w2 = w3 = w4 = .25. Because the correlation coefficient
between any two securities is the same, 0.8, we have r12 = r13 = r14 = r23 = r24 = r34 = 0.8.
Find E(Rp) by multiplying the weight of each security by its expected return, and then
adding everything.
E(Rp) = 0.25(0.1) + 0.25(0.11) + 0.25(0.12) + 0.25(0.13) = 0.115 = 11.5%
Similarly, find the of the portfolio as follows,
2
2 1/2
+ (.25) (.14) + (.25) (.16) + (.25) (.18)

(.25)+(.12)
2(.25)2(.12)(.14)(.8) + 2(.25)2(.12)(.16)(.8)
(Rp) =
+ 2(.25)2(.12)(.18)(.8) + 2(.25)2(.14)(.16)(.8)
2
2
+ 2(.25) (.14)(.18)(.8) + 2(.25) (.16)(.18)(.8)
= 0.1384
If we require the portfolio to be worth more than $50,000, then the required return is
(50,000 40,000)/40,000 = 0.25, or 25%. The expected return of the portfolio is 11.5%, it
quite unlikely that the return will exceed 25%. To calculate the probability, find
z = (0.25 0.115)/0.1384 = 0.9755
Draw a normal probability distribution curve, with z = 0 in the center and z = .9755 to the
right of center. Since the expected portfolio return is 11.5%, and we require it to have a
return of more than 25%, it is unlikely that it will actually happen. The probability of it is
the area under the tail of the curve, on the right side of z = .9755. Using the tables, calculate
the probability as
P(R > 0.25) = .5 [.3340 + .55(.3365 .3340)] = 0.1643 = 16.43%
There is a 16.43% chance that the portfolio is worth more than $50,000 after one year.
123
6. Portfolio Theory
_____________________________________________________________________________
Figure 6.1. The shaded area to the right of z = .9755 represents the probability that the return of the
portfolio will be more than 25%.
The following instructions will solve the problem in Excel.

1
2
3
4
5
6
7
8
9
A
E(R)
(R)
Corr Coeff
Weights
E(Rp)
(Rp)
Req retn
z
Probability
B
0.1
0.12
0.8
0.25
=B4*(B1+C1+D1+E1)
C
.11
.14
D
.12
.16
E
.13
.18
=B4*SQRT(B2^2+C2^2+D2^2+E2^2+2*B3*(B2*C2+B2*D2+B2*E2+C2*D2+C2*E2+D2*E2))
=(50000-40000)/40000
=(B7-B5)/B6
=1-NORMDIST(B8,0,1,true)
6.4. Capella Corporation has an expected return of 12% and sigma .25, the expected return
of Rigel Corporation is 15% and its sigma 0.30. The coefficient of correlation between the
two companies is 0.25. Make a portfolio of these stocks so that the expected return of the
portfolio is 13%. What is the sigma of the portfolio?
We have to make a portfolio such that its expected return is 13%, but we do not know the
weights of the two securities. To find the weights, w1 and w2, you will need two equations.
The two equations are
w1 + w2 = 1
(6.6)
and
E(Rp) = w1 E(R1) + w2 E(R2)
(6.7)
Substituting numbers in (6.6), we get
.13 = w1 (.12) + w2 (.15)
(A)
To facilitate the calculation at WolframAlpha, subsitute w1 = x and w2 = y, then use this

expression,
WRA x+y=1,.13=.12*x+.15*y
124
6. Portfolio Theory
_____________________________________________________________________________
The solution is x = .666667 and y = .333333, or w1 = 2/3, then w2 = 1/3. Using (6.8), we
get
(Rp) = w1212 + w2222 + 2w1w212r12
Or,
(Rp) = (2/3)2(.25)2 + (1/3)2(.3)2 + 2(2/3)(1/3)(.25)(.3)(.25) = 0.2147
WRA sqrt((2/3*.25)^2+(1/3*.3)^2+2*2/3*1/3*.25*.3*.25)
We notice that the (Rp) = 0.2147 is less than 1 = .25 and 2 = .3. In other words, it is
quite possible to form a portfolio out of two securities so that the sigma of the portfolio is
less than the sigma of either of the two securities. This is because the risk of one security
can possibly offset the risk of the other one.
Video 06.06 6.6. Elizabeth Corporation is starting two new projects. Project A requires
an investment of $5,000, has expected return of 16% with standard deviation 14%. Project
B has initial investment of $15,000, expected return of 15% with standard deviation 10%.
The correlation coefficient between the projects is 0.75. Find the expected return, in dollars,
of the portfolio of these two projects. What is the probability that this return is less than
$4,000?
The total value of the portfolio is $20,000 and the weights are 0.25 and 0.75. We calculate
the expected return of the portfolio as
E(Rp) = 0.25(0.16) + 0.75(0.15) = 0.1525 = 15.25%
and in dollars,
E(Rp) = 0.1525(20,000) = $3,050
(Rp) = (.25)2(.14)2 + (.75)2(.1)2 + 2(.25)(.75)(.14)(.1)(.75) = 0.1038629

If the return is less than $4,000, it is less than 4,000/20,000 = 0.2 = 20%.
The expected return of the portfolio is 20%, but the required return is 15.25%, or less. The
portfolio can have a return of 15.25% quite easily and thus the required probability is more
than 50%. To find it, first calculate
z = (0.2 0.1525)/0.1038629 = 0.4573.
Draw a normal probability distribution curve, with z = 0 in the center. z = .4573 will be
somewhat to the right of center. The area under the hump of the curve, to the left of z =
.4573, will give the required probability. From the tables,
P(R < $4,000) = 0.5 + 0.1736 + .73(.1772 .1736) = 67.62%
EXCEL =NORMDIST(.2,.1525,.1038629,TRUE)
125
6. Portfolio Theory
_____________________________________________________________________________
Problems
6.7. Bankhead Corporation is considering the following projects, which are all acceptable.
Project A Project B Project C
Expected return
$4000
$5000
$6000
Standard deviation
$2100
$2500
$2800
Correlation coefficients (A,B) = .8 (A,C) = .7 (B,C) = .6
Bankhead can take any one, any two, or all three projects. If the company wants to
maximize the ratio E(R)/(R), what is the best course of action?
Invest in B and C. Ratio = 2.3195 for B + C
6.8. Costello Corporation is undertaking these three projects:
Cost
$235,000 $455,000 $310,000
Expected return
12%
11%
13%
Standard deviation
8%
9%
10%
Find the probability that the return on the portfolio is more than 15%.
33.87%
6.9. The Lambda Corporation has the opportunity to invest in any of the following three
proposals:
Expected return
$10,000
$11,000
$12,000
Standard deviation
$2,000
$2,500
$2,800
If the company can invest in one, two, or three projects, what should it do to maximize the
ratio between expected return and standard deviation?
E(R)/ ratios: A = 5, B = 4.4, C = 4.28, (A + B) = 5.5630, (A + C) = 5.2680,
(B + C) = 4.5735, (A + B + C) = 5.2916. Take (A + B)
6.10. Kagera Company has made a portfolio of these three securities:

Cost
E(R) (R)
Treasury bond
$100,000 6%
0
Kasai Corporation $80,000 15% 25%
Limpopo Company $70,000 16% 30%
The correlation coefficient between Kasai and Limpopo is 0.6. If the returns are normally
distributed, find the probability that the return of the portfolio is more than 15%.
41.04%
126
6. Portfolio Theory
_____________________________________________________________________________
6.11. Suppose you have $50,000 that you would like to invest in two companies,
Bethlehem Books and Allentown Audio. Bethlehem has a return of 10% and standard
deviation 15%, while Allentown has return of 15% with a standard deviation of 20%. The
correlation coefficient between them is .5. Your portfolio should have a return of 12%.
Find the standard deviation of this portfolio's returns.
(Rp) = 14.73%
6.12. The expected return from two stocks, Apple and Google, under different states of the
economy are as follows:
State of the economy Probability Apple Google
Poor
10%
0%
50%
Average
30%
20%
20%
Good
60%
20%
30%
You have invested $40,000 in Apple and $60,000 in Google to form a portfolio. Find the
following.
(A) Expected return of Apple and of Google.
(B) The of Apple and of Google.
(C) Coefficient of correlation between the two stocks.
(D) Expected return and of the portfolio.
(E) Probability that the return of the portfolio will be more than 15%.
1. The risk of a two-security portfolio depends upon
I. The risks of individual securities,
II. The weights of the securities,
III. The correlation coefficient between them.
A. I and II only
C. I and III only
B. II and III only

D. I, II, and III
2. The basic reason for making a portfolio is to

A. Enhance the return of the portfolio
B. Minimize the risk of the portfolio
C. Maximize the market exposure
D. Attain a return equal to the riskless rate of return
127
18%, 19%
6%, 23.43%
.9816
18.6%, 16.42%
58.68%
7. CAPITAL ASSET PRICING MODEL

1. Understand the concept of beta as a measure of systematic risk of a security.
2. Calculate the beta of a stock from its historical data.
3. Understand the Capital Asset Pricing Model.
4. Apply it to determine the risk, return, or the price of an investment opportunity.
7.1
Beta
In the section on capital budgeting, we saw the need for a risk-adjusted discount rate for
risky projects. The risk of an investment or a project is difficult to measure and to quantify.
This difficulty arises from the fact that different persons have different perceptions of risk.
What may be quite a risky project to one investor may appear to be fairly safe to another
person. After all, how can you quantify courage, or patience, or risk, or beauty?
In the section on portfolio theory, we used as a measure of risk, which is really the
standard deviation of returns. Another useful measure of risk is the of an investment.
Like , is also a statistical measure of risk. We infer it from the observations of the past
performance of a stock. For example, we may want to find the risk of buying and holding
the stock of a particular corporation, such as IBM, and we are interested in finding the of
IBM. We can start by looking at the historical value of three variables:
1. The returns of IBM stock, Rj. We define the return on a stock by the relation
Rj =
P1 P0 + D1
P0
(7.1)
In the above equation, P0 is the purchase price of the stock, P1 its price at the end of the
holding period, and D1 is the dividend paid, if any, at the end. The quantity P1 P0 is the
price appreciation of the stock, and along with the dividend, is the total change in the value
of the investment. The return is equal to be the change in the value of the investment
divided by the original investment. For example to find the monthly rate of return on the
IBM stock, we may want to know the price of the stock at the beginning of each month,
the price at the end of the month, and the dividends paid during that particular month. We
have to develop a series of numbers representing the return for each month for the last 24
months, say.
2. The returns of the market, Rm. A market index provides an overall measure of the
performance of the market. The oldest and the most popular market index is the Dow Jones
Industrial Average. The problem with this index is that it uses only 30 stocks in its
valuation. For a broader market index, we may have to look at S&P100, or S&P500 index.
There is even an index for over-the-counter stocks called the NASDAQ Composite Index.
The value of these indexes is available daily.
128
7. Capital Asset Pricing Model
_____________________________________________________________________________
Let us track the market for the last 24 months. If we know the value of the index at the start
and finish of each month, we can find the return of the market for that month. The dividend
yield for the market is around 1.71% annually at present. Therefore, we define the overall
return on the market as
Rm =
M1 M0
M0 + d1
(7.2)
where M0 is the beginning value and M1 the ending value of the market index, and d1 is the
dividend yield as a percent for that period. With some effort, we may be able to develop a
set of market returns for each of the last 24 months.
3. The riskless rate of interest, r. The securities issued by the Federal government, such as
the Treasury bills, bonds, and notes, are, by definition, riskless. They are the safest
investments available, backed by the full faith and taxing power of the government. Their
rate of return depends on their time to maturity, and for longer maturity, the return is
generally higher. The Treasury yield curve is available on the Internet.
After some research, we may also get a series of riskless rates for each of the past 24
months.
Then we define two variables x and y as:
y = Rj r
x = Rm r
where Rj = return on the stock j each month for the last 24 months,
Rm = corresponding monthly returns on the market for the same period,
and
r = riskless rate of interest per month, for the last 24 months.
By subtracting the riskless rate of interest, we are able to see the return due to the risk
inherent in the given stock, and the return from the risk in the market. Thus, we are
comparing the returns exclusively due to the risk in the investments.
A regression line drawn between the various observed values of x and y will show a certain
linear relationship between x and y. The slope of the line will give the rate of change of y
with respect to x. In other words, the slope will signify how much the return on the stock
will change corresponding to a given change in the return on the market. In this diagram
let us say that the slope of the line is , and the y-intercept is . The quantity is practically
zero, and it is statistically insignificant. The quantity , on the other hand, represents an
important concept.
This responsiveness of the stock return to the changing market conditions is called the
"beta" of the stock. Stocks with low betas will show very little movement due to the
fluctuations in the stock market. High beta stocks will tend to be jumpy showing a large
variation in response to small changes in the market.
129
_____________________________________________________________________________
Fig. 7.1: A regression line between y and x.
High stocks, due to their large volatility, will be more unpredictable, and therefore, more
risky. Low beta stocks show relatively small volatility, and they are more predictable and
safe.
Beta is a statistical quantity, and it is a measure of the systematic risk, or the market related
risk of a stock. These results can also be expressed as a statistical formula,
j =
cov(Rj,Rm) rjmmj rjmj

=
=
var(Rm)
m2
m
(7.3)
where cov(Rj,Rm) is the covariance between the returns on the stock j and the market, and
var(Rm) is the variance of the returns on the market. If we have collected sufficient
statistical data, we may find by using
=
n(xy) (x)(y)
nx2 (x)2
=
where n is the number of x and y values.
(7.4)
y x
(7.5)
One can apply the concept of beta to a portfolio. The beta of a portfolio is simply the
weighted average of the betas of the securities in the portfolio,
Beta of a portfolio,
p = w11 + w22 + w33 + ... = wii

i=1
130
(7.6)
_____________________________________________________________________________
The advantage of using as a measure of risk is that it can combine linearly for different
securities in a portfolio, but the disadvantage is that it can measure only the market related
risk of a security. On the other hand, can measure the risk independent of the market
conditions, but its disadvantage is that it is non-linear in character and difficult to apply in
practice. Both and are incomplete measures of risk; they change with time, and are
difficult to measure accurately.
By definition, the beta of a riskless investment is zero. Further, the beta of the market is 1.
This is seen by setting j = m in (7.3) and noting that the covariance of a random variable
with itself is just its variance.
A security that has a high beta should show a large rise in price when there is an upward
movement in the market, and has a large drop in price in case of a downward movement.
These large price fluctuations can cause a considerable amount of uncertainty about the
return of this security, and greater risk associated with it. Therefore, a high beta security is
also a high-risk security. Thus, beta is frequently used as a measure of the risk of a security.
A low beta security is a defensive security and a high beta of a stock means a more
aggressive management stance.
The numerical value of for different stocks is available from sources on the Internet, such
as www.etrade.com, and www.yahoo.com.
Examples
Video 07.01 7.1. Calculate the of Hauck Corporation from the following data. The
prices are at the beginning and end of each year:
Year
2005
2006
2007
2008
Price of
S&P 500
S&P 500 Riskless
Hauk stock
Dividend
index
dividend
rate
per
share
yield
beginning end
beginning end
$25
$27
$1.00
1000
1050 3.05%
6.00%
$27
$29
$1.00
1050
1100 3.00%
6.00%
$29
$32
$1.50
1100
1200 2.95%
5.95%
$32
$33
$1.50
1200
1250 2.80%
5.90%
The return from the security in 2005 is capital gains ($2) plus dividends ($1) divided by
the initial price ($25), that is, 3/25 = 0.12. The riskless rate during 2005 was 0.06, thus the
excess return was 0.12 0.06 = 0.06. The return on the market for the same year was 5/100
+ 0.0305 = 0.0805. The excess return was 0.0805 0.06 = 0.0205. Designating the excess
return for security as y and that for the market as x, we can tabulate the calculations as:
Year
2005
2006
2007
2008
Rj
3.00/25
3.00/27
4.50/29
2.50/32
r
.06
.06
.0595
.059
= y
= .06
= .051111
= .095672
= .019125
Rm
5/100 + .0305
5/105 + .03
10/110 + .0295
5/120 + .028
131
r
.06
.06
.0595
.059
= x
= 0.0205
= 0.017619
= 0.060909
= 0.010667
_____________________________________________________________________________
Here n = 4, the number of periods, or x, y pairs

xy = (.0205)(.06) + (.017619)(.051111) + (.060909)(.095672) + (.010667)(.019125)
= 0.0081618
x = 0.0205 + 0.017619 + 0.060909 + 0.010667 = 0.109695
y = .06 + .051111 + .095672 + .019125 = 0.225908
x2 = (0.0205)2 + (0.017619)2 + (0.060909)2 + (0.010667)2 = 0.00455437
Using equation (7.4)
=
4(0.0081618) (0.109695)(0.225908)
= 1.271927967 1.27
4(0.00455437) (0.109695)2
One can do the above problem with the help of Maple as follows:
#n is the number of periods, or returns
#n+1 is the number of price data points
n:=4;
#Price is an array to store price of stock
Price:=array(1..n+1,[25,27,29,32,33]);
#Div is an array to store dividends
Div:=array(1..n,[1,1,1.5,1.5]);
#Market is the array to store market index data
Market:=array(1..n+1,[100,105,110,120,125]);
#Markdiv is the array to store market dividends as percent
Markdiv:=array(1..n,[.0305,.03,.0295,.028]);
#RF is the array to store riskfree rate
RF:=array(1..n,[.06,.06,.0595,.059]);
#x, y are the arrays to store x, y values
x:=array(1..n); y:=array(1..n);
for i to n do
x[i]:=(Market[i+1]-Market[i])/Market[i]+Markdiv[i]-RF[i];
y[i]:=(Price[i+1]-Price[i]+Div[i])/Price[i]-RF[i] od;
unassign('i');
n*sum(x[i]*y[i],i=1..n)-sum(x[i],i=1..n)*sum(y[i],i=1..n);
n*sum(x[i]^2,i=1..n)-sum(x[i],i=1..n)^2;
beta=%%/%;
7.2. Calculate the of Maine Corporation from the following data. The prices are at the
beginning and at the end of each year:
132
_____________________________________________________________________________
Year
2000
2001
2002
2003
7.2
Price of
Maine
25-27
27-29
29-32
32-33
Dividend of
Maine
$2.00
$2.00
$2.50
$2.50
S&P 500
index
100-105
105-110
110-120
120-125
S&P 500
dividend
3.05%
3.20%
3.50%
4.00%
Riskless
rate
8.0%
8.5%
7.5%
7.0%
= 0.89
Capital Asset Pricing Model
Beta is a measure of the market risk, or the systematic risk, of a security. A security with a
large beta will have large swings in its price in relation to the changes in the market index.
This will lead to a higher standard deviation in the returns of the security, which will
indicate a greater uncertainty about the future performance of the security.
Draw a diagram with the of various securities along the X-axis and their expected return
along the Y-axis. We have already noticed that is a linear measure of risk. If we assume
that a linear relationship exists between the risk and return, then only two points are
sufficient to draw a straight line in this diagram. The line, representing the relationship
between risk and expected return, is called the security market line. Under equilibrium
conditions, all other securities will also lie along this line. Higher securities will have a
correspondingly higher expected return. Figure 7.2 shows this graphically.
Fig. 7.2: Security market line.
By definition, beta of the market is equal to 1. The securities with more than average risk
will have beta greater than 1, and less risky securities have beta less than 1. On this scale,
the beta of a riskless security is zero. Such securities will provide riskless rate of return, r,
to the investors. An example of such a security is the Treasury bill.
133
_____________________________________________________________________________
The security market line represents the risk-return characteristics of various securities,
assuming that there is linear relationship between risk and return. Point A represents a
riskless security with beta equal to zero and return r. Point B shows a market-indexed
security which could be a very large mutual fund portfolio, which is invested in a large
number of securities all weighted according to assets of the corporations whose securities
make up the portfolio. Point C shows an individual security whose beta is i and whose
expected return is E(Ri). Since A, B, C all lie along the same straight line, then
Slope of segment AC = slope of segment AB
This gives,
E(Ri) r E(Rm) r
=
i
1
E(Ri) = r + i [E(Rm) r]
Or,
(7.7)
Equation (7.7) gives the expected return of a security i in terms of its

risk, expected return on the market, and the riskless rate. It is a
forward-looking model, and thus gives the expected values of the
returns. This equation represents what is known as the "Capital Asset
Pricing Model", CAPM for short, and was developed in the 1960s by
William Sharpe, Jan Mossin, and John Lintner. The use of this model
is illustrated by the following examples.
William Sharpe (1934- )
Positive Alpha: Too Good to be True?
New research from Robert Jarrow suggests that positive alpha is improbable.
During the past 25 years, an entire segment of the investment industry was constructed on the belief that
positive alphas exist and can be exploited by portfolio managers to yield greater profit at less risk. New
research by the Johnson School's Robert Jarrow strongly suggests that positive alphas are rare to nonexistent.
"Every hedge fund in the world claims to have positive alpha, but I say it can't be," says Jarrow, Ronald P.
and Susan E. Lynch Professor of Investment Management at the Johnson School. "The claims for positive
alpha are too strongprofessional investment managers are taking risks that are hidden."
Alpha, an estimate of an asset's future performance, after adjusting for risk, is a measure routinely calculated
by portfolio managers. Positive alpha suggests that an investor can realize higher returns at lower risk than
by holding an index. In other words, by investing in assets with positive alpha, one can "beat the market,"
without exposure to the risk otherwise associated with the promised rate of return.
Jarrow used mathematical modeling to prove that positive alphas are equivalent to arbitrage opportunities.
And arbitrage opportunitiesrisk-free trading of an asset between two markets to take advantage of a price
differentialare rare in financial markets. According to Jarrow's research, positive alpha can exist only in
the presence of a true arbitrage opportunity. For this to occur, two stringent conditions must be met. First,
there must exist a market imperfection that enables the arbitrage opportunity to persist, even as arbitrageurs
capitalize upon it; second, there must be a source of financial wealth, on which the arbitrageurs draw, either
knowingly or unknowingly.
134
_____________________________________________________________________________
"Academics have looked for arbitrage opportunities in financial markets, and haven't found many. So it seems
implausible to have so many positive alphas out there." Jarrow says. "To have positive alpha for any length
of time means that someone is consistently losing money to someone else, and that's hard to believe."
In his paper "Active Portfolio Management and Positive Alphas: Fact or Fantasy?" forthcoming in the Journal
of Portfolio Management, Jarrow outlines his model and offers examples of both true and false positive
alphas, drawn from the pivotal events of the credit market crisis. His conclusions include a word of caution
to investors.
"The moral of this paper is simple," Jarrow writes. "Before one invests in an investment fund that claims to
have positive alphas, one should first understand the market imperfection that is causing the arbitrage
opportunity and the source of the lost wealth. If the investment fund cannot answer those two questions, then
the positive alpha is probably fantasy and not fact."
The Journal of Portfolio Management, Summer 2010, Vol. 36, No. 4: pp. 17-22
Examples
Video 07.03 7.3. Chicago Corp stock will pay a dividend of $1.32 next year. Its current
price is $24.625 per share. The beta for the stock is 1.35 and the expected return on the
market is 13.5%. If the riskless rate is 8.2%, what is the expected growth rate of Chicago?
Using the capital asset pricing model (CAPM),
E(Ri) = r + i [E(Rm) r]
(7.7)
We first find the expected rate of return as

E(Ri) = 0.082 + 1.35 [0.135 0.082] = 0.15355 = R
The expected rate of return E(Ri), for a security is also its required rate of return R by the
investors. Using the growth model for a stock, equation (3.6),
D1
P0 = R g
we get,
R g = D1/P0,
or
g = R D1/P0,
which gives g = 0.15355 1.32/24.625 = 0.1. Thus the growth rate is 10%.
Video 07.04 7.4. Peggotty Services common stock has a = 1.15 and it expects to pay a
dividend of $1.00 after one year. Its expected dividend growth rate is 6%. The riskless rate
is currently 12%, and the expected return on the market is 18%. What should be a fair price
of this stock?
E(Ri) = r + i [E(Rm) r]
we get
E(Ri) = 0.12 + 1.15 [0.18 0.12] = 0.189

135
(7.7)
_____________________________________________________________________________
Thus, the expected return on the stock is 0.189, and the expected growth rate is 0.06. Using
(3.1) once again,
1
P0 = 0.189 0.06 = $7.75
Video 07.05 7.5. The beta of Vega Inc is 1.15, its rate of growth is 10%, it will give a
dividend of $3.00 next year, and its common stock sells for $50 a share. The riskless rate
is 8%. By careful planning and by selecting more secure projects, Vega has reduced its
risk. Its new beta is estimated to be 1, while everything else (income, dividends, growth
rate, capital structure, market return, etc.) is the same. What is its new share value?
The total return on a stock is the sum of its dividend return and the growth rate. If r is the
required rate of return, E(Ri) is the expected rate of return, g is the growth rate, D1 is the
dividend to be paid next year, and P0 is its price now, then
D1
3
R = P + g = 50 + 0.1 = 0.16 = E(Ri)
0
Use
E(Ri) = r + i [E(Rm) r]
(7.7)
Drop the subscript i, and solve for E(Rm), to get

Or,
Or,
E(Rm) = r +
E(R) r
E(Rm) = 0.08 + (0.16 0.08)/1.15 = 0.1496
The new is 1, and since the of the market is also 1, this implies that
E(R) = E(Rm) = 0.1496
Thus
P0 = 3/(0.1496 0.1) = $60.53
7.6. Eastern Oil stock currently sells at $120 a share. The stockholders expect to get a
dividend of $6 next year, and they expect that the dividend will grow at the rate of 5% per
annum. The expected return on the market is 12% and the riskless rate is 6%. This morning
Eastern announced that it has won the multimillion dollar navy contract, and in response
to the news, the stock jumped to $125 a share. Find the beta of the stock before and after
the announcement.
D1
Using Gordon's growth model, P0 = R g, we get R = D1/P0 + g, which is also the expected
return on the stock, E(R). But by CAPM,
E(Ri) = r + i [E(Rm) r]
136
_____________________________________________________________________________
E(Ri) r
= E(R ) r
we get
Thus
And
D1/P0 + g r 6/120 + 0.05 0.06

=
= 0.667, before.
0.12 0.06
E(Rm) r
=
6/125 + 0.05 0.06

= 0.633, after.
0.12 0.06
7.7. Jupiter Gas Company is planning to acquire Saturn Water Company. The additional
pre-tax income from the acquisition will be $100,000 in the first year, but it will increase
by 2% in future years. Because of diversification, the beta of Jupiter will decrease from
1.00 to 0.9. Currently the return on the market is 12% and the riskless rate is 6%. What is
the maximum price that Jupiter should pay for Saturn? The tax rate of Jupiter is 35%.
The new beta for Jupiter is 0.9. Using CAPM, its expected return, and hence the cost of
capital will be
E(R) = 0.06 + 0.9(0.12 0.06) = 0.114
After tax income = 100,000 (1 0.35) = $65,000.
The total value of a firm is the present value of its future earnings, properly discounted.
Thus, the value added to Jupiter due to the acquisition of Saturn is the present value of
future after-tax earnings of Saturn, discounted at a rate equal to the cost of capital of Jupiter,
and summed up to infinity. Thus
65000 65000 (1.02) 65000 (1.02)2
PV = 1.114 +
+
... = $691,489
1.1142
1.1143
WRA sum(65000*1.02^(i-1)/1.114î,i=1..infinity)
Jupiter should pay at most $691,489 for Saturn.
7.8. Hamlin Dairies stock has a beta of 1.33. It has just paid its annual dividend of $1.20,
and it sells for $30 a share. Shareholders believe that Hamlin is growing at the rate of 7%
annually and will maintain a constant dividend payout ratio. Due to the unexpected death
of the chairperson, Hannibal Hamlin, the company is facing an uncertain future, and the
price per share dropped to $25. There is no other change in the company (dividends,
growth, sales, etc.) or in the market. The riskless rate is 6%. In light of the greater risk of
the company, find its new beta.
If the current dividend is $1.20, next year it will be 1.20(1.07) = $1.284. Apply Gordons
growth model, (3.6), to find the required rate of return for the stockholders. Before
Hamlins death, it is
R = D1/P0 + g = 1.20(1.07)/30 + 0.07 = 0.1128 (before)
137
_____________________________________________________________________________
After Hamlins death, the stock price drops suddenly, but the growth potential and the
current dividend remains intact. Thus the required rate of return after the death is
R = 1.20(1.07)/25 + 0.07 = 0.12136 (after)
The expected and the required rate of return for the stock are the same, meaning R = E(R).
We can use these numbers in CAPM, (7.7), to get two equations:
Before,
After,
0.1128 = 0.06 + 1.33 [E(Rm) 0.06]

0.12136 = 0.06 + [E(Rm) 0.06]
Put = x and E(Rm) = y temporarily. Copy and paste the following instruction at
WolframAlpha to solve the two equations simultaneously.
WRA .1128=.06+1.33*(y-.06),.12136=.06+x*(y-.06)
The approximate solution is x 1.54562 and y 0.0996992. Solving for beta, we get,
= 1.55
The new , 1.55, is higher than the previous , 1.33, because of the uncertainty created by
the death of the chairperson. Greater uncertainty also means greater risk.
7.9. Epperly Fund invests in S&P500 companies and thereby simulates a market portfolio.
The expected return of Epperly is 13.5%, with a standard deviation of 10%. Suppose you
are able to borrow $10,000 at the riskless rate of 9%, and you already have $10,000 of your
own money. If you invest this $20,000 in Epperly Fund, what is the probability that you
will have a return greater than 25% on your own money?
The of the market is 1, by definition. Epperly Fund mimics the market and therefore, its
is also 1. When you borrow money to buy securities, the amount of borrowing is
equivalent to a negative cash position in your account. The of cash is zero, because the
value of cash does not change due to fluctuations in the stock market. The total value of
the portfolio you own is $10,000, which equals your investment. Its composition is as
follows:
Value Weight
Epperly Fund $20,000 1
2
Cash
10,000 0
1
Portfolio
10,000 2
1
To find the of the portfolio, use
p = w11 + w22 = 2(1) + (1)(0) = 2
This is highlighted in the previous table. With the help of CAPM, find
138
_____________________________________________________________________________
E(Rp) = .09 + 2(.135 .09) = .18

The portfolio is consisting of two items with weights 2 and 1. The of the components
is, 10% for Epperly Fund and zero for cash. Using equation (6.4) for the of a two-security
portfolio, we have
p = (2)2(.1)2 + (1)2(0) + 2(2)(1)(.1)(0)r12
Solving the above equation, we get p = .2. We note that the expected return of the portfolio
is 18% with a standard deviation of 20%. The required return is more than 25%. The
probability of getting that return is less than 50%. To calculate it, first find
z = (25 18)/20 = 0.35
Draw a normal probability distribution curve, with z = 0 at the center and z = .35 to the
right of center. The probability of getting a return of greater than 25% is equal to the shaded
area to the right of z = .35. From the table, we get its value as,
P(R > 0.25) = 0.5 .1368 = .3632 = 36.32%.
EXCEL =1-NORMDIST(.25,.18,.2,TRUE)
7.10. Markham Co paid a dividend of $3.00 yesterday, but these dividends are expected
to grow at the rate of 5% in the long run. The beta of Markham is 0.95, the expected return
on the market is 15%, and the riskless rate is 10% at present. Find the price of one share of
Markham stock.
Using the CAPM, we have, E(R) = 0.10 + 0.95(0.15 0.1) = 0.1475
Using Gordon's growth model, we get the price of a share as
3(1.05)
P0 = 0.1475 0.05 = $32.31
7.11. You have developed the following information about two mutual funds:
139
_____________________________________________________________________________
Name of fund
Beta Expected return
Dione Market Fund 1.00
14%
Rhea Energy Fund 0.80
13%
You have $5,000 to invest and you put $3,000 in Dione and $1,000 each in Rhea and
riskless bonds. Find the beta and expected return of your portfolio.
Let us first find the riskless rate. Dione has of 1, the same as that of the market. Thus the
expected return of the market is also 0.14. Using CAPM, and using the information about
Rhea,
0.13 = r + 0.8(0.14 r)
which gives the riskless rate, r = .09. The weights of securities are
w1 = 0.6,
w2 = 0.2,
and
w3 = 0.2.
The beta of the portfolio is just the weighted average of the betas of the individual
securities. That is,
p = 0.6(1.00) + 0.2(0.8) + 0.2(0) = 0.76
Similarly, the expected return on the portfolio is given by
E(Rp) = 0.6(0.14) + 0.2(0.13) + 0.2(0.09) = 0.128
You can also calculate the expected return of the portfolio by substituting = .76, r = .09
and E(Rm) = .14 in CAPM. This gives
E(Rp) = .09 + .76[.14 .09] = .128
7.12. Pindar Corporation stock is selling for $80 a share and its dividend next year is
expected to be $2. S&P500 index is 1437 at present, and it is expected to go up to 1550
after one year. The average dividend yield for the S&P500 is 1.52%, and the riskless rate
is 5.14%. If the beta of Pindar is 1.14, find the expected price of one share of Pindar after
one year.
Using the information about the market, find the expected percentage return on the market
as the sum of the dividend yield of the market (.0152) and its price appreciation (1550
1437)/1437. This gives
E(Rm) = 0.0152 + (1550 1437)/1437 = .09384
Next, find the expected return of Pindar using CAPM. Put r = .0514, = 1.14, and E(Rm)
= .09384.
E(Rj) = 0.0514 + 1.14(.09384 0.0514) = .09978
If x is the expected price of the stock next year, then the return of the stock is,
140
_____________________________________________________________________________
.09978 = (x 80 + 2)/80
This gives
x = 80(.09978) + 80 2 = $85.98
7.13. A portfolio is formed as follows:

Stock
Amount invested
(R)
Childs Corporation
$12,000
1.25 25%
Jermyn Company
$13,000
1.20 22%
The riskless rate is 7%, and the expected return on the market is 14%. The covariance
between the two stocks is 0.0385. Find the expected return, and the standard deviation of
returns of the portfolio, in dollars, and as a percentage.
With the total value of the portfolio = 12,000 + 13,000 = $25,000, it is easy to see that the
weights are w1 = 12/25 = 0.48, and w2 = 0.52
Using CAPM, the expected returns are
E(R1) = 0.07 + 1.25(0.14 0.07) = 0.1575
and
E(R2) = 0.07 + 1.2(0.14 0.07) = 0.1540
The portfolio return is E(Rp) = 0.48(0.1575) + 0.52(0.154) = 15.568%

= 0.15568(25,000) = $3892
The correlation coefficient, r12 =
cov(1,2)
0.0385
=
12
(0.25)(0.22) = 0.7
The portfolio sigma, (Rp) = 0.482 0.252 + 0.522 0.222 + 2(0.48)(0.52)(0.25)(0.22)(0.7)

= 21.61%
And in dollars, (Rp) = 0.2161(25,000) = $5403
7.14. The of Blakely Company is 1.2. Blakely is planning to acquire Waymart
Corporation which will result in the combined company to have a of 1.3. The riskless
rate is 6%, and the expected return on the market is 12%. Waymart Corporation is expected
to have first year earnings after taxes of $40,000, and these earnings are expected to
increase by 3% per annum in future. How much should Blakely pay for Waymart?
The value of the acquisition is the present value of future earnings, discounted at the riskadjusted discount rate. We should find the discount rate and the future earnings. With =
1.3, use CAPM to find the risk adjusted discount rate = 0.06 + 1.3(0.12 0.06) = 0.138.
Assume that the earnings will continue forever. Thus,
141
_____________________________________________________________________________
40000 40000(1.03) 40000(1.03)2

PV of earnings = 1.138 +
+
+ ...
1.1382
1.1383
This is a geometric series, with a =
PV of earnings=
40000
1.138
1.03
1 1.138
40000
and x = 1.03/1.138. Use equation (1.6),
1.138
= $370,370
The value of Waymart is thus $370,370

7.15. McNamara Fund has expected return of 10.5%, standard deviation of 17.5%, and
beta of 0.8. Schlesinger Fund has expected return of 12.5%, standard deviation of 21% and
beta of 1.1. The two mutual funds have correlation coefficient of 0.7. Find the expected
return and standard deviation of the market. What is the riskless rate of return?
First we use the CAPM, and put the numbers for the two funds, which gives us
McNamara:
Schlesinger:
0.105 = r + 0.8 [E(Rm) r]

0.125 = r + 1.1 [E(Rm) r]
To solve the equations, put r = x and E(Rm) = y temporarily. Then copy and paste the
following instruction at WolframAlpha.
WRA .105=x+.8*(y-x), .125=x+1.1*(y-x)
Solving the two equations, we get E(Rm) = 0.1183, and r = 0.05167
Next we construct the market portfolio out of these two funds. The of the market, by
definition, is 1. The weights are w1 and w2, and they are combined to get = 1 for the
market portfolio. Thus, we have
w1 + w2 = 1
0.8 w1 + 1.1 w2 = 1
To solve the equations, put w1 = x and w2 = y temporarily. Then copy and paste the
following instruction at WolframAlpha.
WRA x+y=1,8/10*x+11/10*y=1
Solving these two equations we get, w1 = 1/3 and w2 = 2/3. The same result can be obtained
by combining the expected returns of the two funds to get the expected return of the market.
Now we can find the sigma of the market as follows:
(Rm) = (1/3)2 0.1752 + (2/3)2 0.22 + 2(1/3)(2/3)(0.175)(0.21)(0.7) = 0.1856
142
_____________________________________________________________________________
7.16. Armstrong Corporation $6 preferred stock sells for $50 a share. The beta of this stock
is 1.25. The current riskless rate is 8%. Just yesterday, Louis Armstrong, the founder and
CEO, died and the stock dropped to $47 a share in response to the news. Find the new beta
of Armstrong preferred.
A preferred stock has fixed dividends, that is, there is no expectation of growth. This means
g = 0 in Gordons growth model, P0 = D1/(R g), which becomes P0 = D1/R. Rewrite it as
R = D1/P0. This implies that the current return of the stock is 6/50 = .12.
This is quite reasonable. If you buy a stock for $50 a share and it pays a dividend of $6
annually, without any growth opportunity, the return is indeed 12%.
Using CAPM,
.12 = .08 + 1.25[E(Rm) .08]
Solve this equation to get E(Rm) = (.12 .08)/1.25 + .08 = .112

This is quite reasonable, because the stock, with its 1 = 1.25, has a return of .12; and the
market with its = 1, should have a lower expected return, perhaps around 11%.
Let 1 = 1.25, beta of the stock before Armstrongs death and 2 = beta of the stock after
his death. Now assume that Armstrong is just an insignificant player in the stock market,
and the market will ignore his demise. The expected return on the market will remain at
.112 and the risk-free rate at .08. The new return on the stock is 6/47. The CAPM gives us
6/47 = .08 + 2[.112 .08]
This gives
2 = (6/47 .08)/(.112 .08) = 1.49
The answer is quite reasonable, because Louis Armstrong was a very important individual
at Armstrong Company. His departure has introduced a substantial measure of uncertainty,
or risk, in the company, thereby increasing its from 1.25 to 1.49.
Problems
7.17. The Washington Corp stock has a of 1.15 and it will pay a dividend of $2.50 next
year. The expected rate of return of the market is 17% and the current riskless rate is 9%.
The expected rate of growth of Washington is 4%. Find the value of its common stock.
$17.61 per share
7.18. Molopo Company has = 1.2, whereas the return on the market is expected to be
12%, with a standard deviation of 8%. The riskless rate is 6% at present. The stock of
Molopo is selling at $100 a share, but it does not pay any dividends. Find the probability
that it will be selling for more than $120 by next year. Assume that the entire change in the
stock price is due to the change in the market.
23.94%
7.19. Cheever Corp stock is selling at $40 a share. Its dividend next year will be $2 a share
and its beta is 1.25. Crane Company has the same growth rate as Cheever. The current
143
_____________________________________________________________________________
stock price of Crane is $55 a share, and its dividend this year is $3. The riskless rate is 8%
and the expected return on the market is 16%. Find the beta of Crane stock.
1.3955
7.20. Kingston Corporation has = 1.2. It is interested in buying Plains Corporation which
also has = 1.2. Kingston believes that after the acquisition, its will be 1.1. The expected
after-tax earnings from Plains will be $50,000 for the first year, but this figure is expected
to increase by 3% per year in future. The expected return on the market is 12%, and the
riskless rate is 6%. Find the amount that Kingston should spend on this acquisition.
$520,833
7.21. Toledo Corporation estimates its as 1.3, whereas the risk-free rate is 5% at present.
The expected return on the market is 11%, with a standard deviation of 7%. Assume that
the variation in the Toledo stock price is entirely due to the fluctuations of the market. If
you invest $10,000 in Toledo stock now, what is the probability that the value of your
investment will be more than $12,000 by next year?
21.45%
7.22. Palmer Company stock has paid a dividend of $1.25 this year, which is in line with
its long-term growth rate of 5%. Its current is 1.2 and the expected return of the market
is 12%. Today, after the company won the multimillion-dollar contract from the navy, the
stock jumped 3%, to $15.45 a share, in response to the good news. Find the risk-free rate
r = 3.25%, new = 1.171
and the new of the stock.
7.23. Johnson Corporation preferred stock sells for $37 a share and pays an annual
dividend of $4. The of this stock is 1.3. The current riskless rate is 3%. The common
stock of Johnson was upgraded by the analysts from hold to buy today. In response to
the news, the preferred stock jumped in price by $1. Find the new of Johnson preferred.
1.253
7.24. Karaj Company stock sells at $50 a share. It has = 1.64 and = .5. The risk-free
rate is 4%, and the expected return on the market is 11%. You have formed a portfolio with
these two items in it:
(1) 800 shares of Karaj stock
(2) A zero-coupon risk-free bond with face value $40,000, maturing after 1 year
Calculate the following:
(A) Initial value of the portfolio
(B) Expected value of the portfolio after one year
(C) Initial of the portfolio
144
$78,461.54
$86,192.00
25.49%
_____________________________________________________________________________
Multiple-choice Questions
1. The of stock is not
A. A statistical quantity
B. A measure of its market related risk
C. Equal to 1 for an average-risk stock

D. Related to the price of the stock
2. According to CAPM,
A. is a nonlinear measure of risk
B. All securities must lie below the security market line
C. Higher risk stocks should provide lower returns in the long run
D. The expected return of the market is more than the riskless rate of return
Key Terms
beta, 116, 117, 118, 119, 120,
121, 123, 124, 125, 126,
127, 128, 129, 130, 131
Capital Asset Pricing Model,
116, 121, 122
capital budgeting, 116
CAPM, 122, 123, 124, 125,
127, 128, 129, 130
discount rate, 116, 129
dividend, 116, 117, 119, 121,

123, 124, 125, 127, 128,
130, 131
Dow
Jones
Industrial
Average, 116
linear relationship, 117, 121,
122
market index, 116, 117, 120,
121
regression line, 117, 118
145
return, 116, 117, 119, 121,

122, 123, 124, 125, 126,
127, 128, 129, 130, 131
risk, 116, 117, 118, 119, 121,
122, 124, 125, 130, 131
S&P500, 116, 126, 128
security market line, 121
standard deviation of returns,
116, 128
systematic risk, 116, 121
8. OPTION PRICING THEORY

1. Understand the role of options in financial markets and the terminology used.
2. Calculate the value of an option using the Black-Scholes model.
3. Apply the put-call parity theorem.
4. Use options in portfolio management and the valuation of risky securities.
8.1
Options
Suppose you believe that the price of gold is going to increase in the near future and you
want to buy some gold in anticipation of its price rise. However, you do not have enough
capital to finance your purchase and you do not want to take the risk of a major loss in the
event of a sharp drop in the price of gold. You can overcome both these problems by buying
a "call option" on gold. If the gold rises in price you can exercise your option to buy gold
at a preset price and resell it in the market for an immediate profit. If the price drops, you
have to do nothing, and your loss will be limited to the premium paid for the call option.
The call option gives you the right but not the obligation to buy an asset at a previously
agreed upon price.
There are several elements in a call option:
1. A call option is a contract between a buyer of the call option and a seller of the option.
The buyer and seller enter into the contract by mutual agreement.
2. The buyer of the call pays a certain amount of money to the seller of the call to initiate
this contract. This amount is non-refundable, and is called the call price or call premium.
3. This contract gives the buyer of the call the right but not the obligation to buy a certain
asset. The asset may be a piece of land, an ounce of gold, or 100 shares of Home Depot
stock. The buyer of the call exercises the call option if he buys the assets. Of course, he
may not exercise the option at all. If the option is exercised, the seller of the call is obligated
to sell the asset. It is an asymmetric contract. The buyer of the call must compensate the
seller of the call for this disadvantage by paying a premium for the call, C.
4. There is a strict time limit for this contract, T. When this time has elapsed, the call expires
and the contract becomes void.
5. There is a certain exercise price, X, which is the purchase price of the asset. This is the
price that buyer of the call option must pay to the seller of the call if he (the buyer of the
call) decides to buy the asset by exercising the call during the life of the option.
The buyer of a call will exercise the call only if it gives him some financial advantage. For
instance, if the exercise price of a call is $40 and the stock is trading at $43 per share just
146
8. Option Pricing Theory
_____________________________________________________________________________
before the expiration of the call, then the owner of a call will exercise it and buy the stock
by paying only $40 per share for the stock. This gives him an advantage of $3 per share.
The buyer of a call believes that the price of the asset will rise above the exercise price
during the life of the contract and that he will be able to buy the asset at less than its market
value. In case of a large drop in the value of the asset, his loss is limited to the premium
paid for the call.
The seller of the call believes that the price of the asset will remain the same, perhaps drop
a little. He expects that the call will not be exercised against him and that he will keep the
asset and pocket the premium. When the call expires at time T, which was not exercised,
he may want to sell another call.
If you own a call option, you may take any one of these actions:
1. Exercise your call and buy the asset, by paying the exercise price;
2. Sell the call to another investor before expiration, who may be interested in its profit
potential; or,
3. Do nothing, and let the option expire. After expiration, the value of a call is zero.
Another example of an option is the ticket to a sports event. If you buy a basketball ticket
for $5 from University of Scranton, you can do any of the three things: You can exercise
the option by watching the game, or, you can sell the ticket to a friend, or, you may let the
option expire by not attending the game. The University keeps the $5 in any case.
When you buy a put option, it gives you the right but not the obligation to sell an asset at
a certain exercise price within a given time. The buyer of a put believes that the value of
the underlying asset will fall in the near future and that he will be able to sell it at a fixed
price by exercising his put and thus make a profit. The seller of a put believes that the value
of the asset will actually rise and that he will keep the put premium.
The most important form of puts and calls are those on common stocks. For example you
can buy a call option on Boeing stock that will expire after 3 months. These options are
traded on well organized options exchanges. One can see real-time option prices on the
Internet. A good website for financial information is www.yahoo.com and its financial
section.
We make the following observations from the table.
(1) The call price decreases as the exercise price rises, for the same expiration time.
(2) For the same exercise price, the call price rises as the time to expiration increases.
(3) For the same time to maturity, the put price rises as the exercise price increases.
(4) For the same exercise price, the put price increases as the time to maturity increases.
147
_____________________________________________________________________________
Microsoft Corp. (MSFT) 30.45 0.64 (2.06%)

January 25, 2007, at 4:00 PM ET
CALL OPTIONS
Strike
25.00
27.50
30.00
32.50
35.00
Last
5.80
3.30
1.40
0.40
0.15
Chg
0.44
0.56
0.30
0.04
0.05
PUT OPTIONS
Strike
27.50
30.00
32.50
35.00
37.50
Last
0.20
0.80
2.27
4.18
6.64
Last
0.15
0.23
0.45
0.90
1.65
2.70
4.70
9.08
Ask Vol Open Int

5.70
85
290
3.40 1,428
601
1.40 6,127
1,414
0.45 7,046
5,515
0.15 761
53
Expire at close Fri, Mar 16, 2007
Chg
Bid
0.15
0.30 0.75
0.45 2.25
0.12 4.50
0.00 6.90
Ask Vol Open Int

0.20 1,069
642
0.80 7,987
3,294
2.35 722
127
4.60
5
780
7.10
10
10
Expire at close Fri, Jan 18, 2008
Chg
Bid
Ask
Vol Open Int
0.51 11.10 11.30
732
68,052
0.60
8.80 9.10
97
56,618
0.40
6.70 6.90
369 186,080
0.40
4.80 5.00
127 113,036
0.20
3.20 3.30 1,420 365,211
0.11
1.95 2.00 1,358
483
0.10
1.00 1.10 2,726 105,582
0.05
0.25 0.30
450
59,188
PUT OPTIONS
Strike
20.00
22.50
25.00
27.50
30.00
32.50
35.00
40.00
Bid
5.50
3.20
1.35
0.40
0.10
0.10
CALL OPTIONS
Strike Last
20.00 11.30
22.50 8.90
25.00 6.90
27.50 4.80
30.00 3.30
32.50 2.00
35.00 1.05
40.00 0.25
Expire at close Fri, Mar 16, 2007
Expire at close Fri, Jan 18, 2008
Chg
0.00
0.03
0.05
0.20
0.25
0.16
0.50
0.00
Bid
0.10
0.20
0.45
0.85
1.65
2.85
4.60
9.40
Ask
0.15
0.30
0.50
1.00
1.70
3.00
4.80
9.60
Vol Open Int

4
227,277
478 86,706
467 145,824
743 112,323
774 84,062
93
1,768
261
8,781
2
155
Table 8.1: Option data for January 25, 2007
148
_____________________________________________________________________________
When the call options expire, they are in the money if the stock price is higher than the
exercise price. They are at the money if the strike price is just equal to the stock price. They
are out of the money, hence worthless, if the stock price is less than the exercise price. An
option that is in the money has some value. You can unlock this value by exercising it, and
buying the stock at the exercise price, which is less than the current stock price. For
instance, at expiration, when the stock is selling at $50 and the exercise price is $45, then
the value of a call is just $5. We may generalize this result by the equations
CT = ST X, if ST > X
= 0,
(8.1a)
if ST X
(8.1b)
where CT = call price at time T, that is, at expiration. Also, ST is the stock price at time T,
and X is the exercise price. The may write (8.1a) and (8.1b) as
CT = max(ST X, 0)
(8.2)
Here "max" means the greater of the two quantities in the parenthesis.
Before expiration, the value of a call option is the sum of its intrinsic value and its time
value.
Total value of an option
Intrinsic value
Time value
The intrinsic value is the value of the option if it is exercised immediately. If the stock price
is less than or equal to the exercise price then you do not want to exercise the option. In
that case the intrinsic value is zero.
Consider the Microsoft options of the Table 8.1. The stock is priced at $30.45. The
March30 is selling for $1.40. If we buy one of these calls and exercise it immediately, it
will give us a benefit of 45 per share, because we are able to buy the $30.45 stock for only
$30. The intrinsic value of this option is thus 45. Subtracting it from the total value of the
option, we find the time value of the call to be 1.40 .45 = $0.95.
Next we consider the January35 call option that is selling for $1.05. Its entire value is its
time value, and it has no intrinsic value at all. The time value of an option is always positive
and it gradually becomes zero as the time to expiration dissipates.
8.2
Black-Scholes Option Pricing Model
We have already seen that the value of a call depends upon the stock price, the exercise
price, and the time to maturity. Its value at maturity is given by (8.2). Calculating its value
prior to maturity is a much more difficult problem. Further analysis reveals that it depends
upon two more factors, the riskless interest rate r and the volatility of the stock measured
by its .
149
_____________________________________________________________________________
Define the following:

S = Market or current price of the underlying asset. This asset could be an ounce of gold, a
share of IBM stock, a piece of land, or any other suitable asset. The price of this asset is a
stochastic variable: it may go up or down in price in a random manner.
X = Exercise price of the option. This is a fixed price, agreed upon by the buyer and the
seller, at which the option holder has a right to buy the asset. The exercise price of the
option can be above or below the market value of the asset.
T = The time period during which the option is viable. An "American" option can be
exercised at any time during this period whereas a "European" option can be exercised only
at the end of this period. The life of an option can be anywhere from one day to several
years.
= The standard deviation of the continuously compounded rate of return due to price
changes of the underlying asset. This is the volatility of the asset. As noted earlier, the price
S of the asset is a variable. If it is changing rapidly and by large amounts then is large. If
the price of an asset is not changing at all then its sigma is obviously zero.
r = Riskless rate of interest. One can determine this quantity by using the yield of Treasury
securities.
C = Price of a call option prior to maturity.
Fischer Black
1938-1995
Myron Scholes
1941-
Robert Merton
1944-
The relationship between the call price of an option and the other five parameters was first
discovered by Fischer Black and Myron Scholes in 1973, and independently by Robert
Merton. This remarkable result can be expressed as
C = S N(d1) X erT N(d2)
150
(8.3)
_____________________________________________________________________________
where
and
ln(S/X) + (r + 2/2) T
T
(8.4)
ln(S/X) + (r 2/2) T
= d1 T
T
(8.5)
d1 =
d2 =
and N(d) is the cumulative normal density function, which is equal to the area under the
normal probability distribution curve from minus infinity to the point d. The table at the
end of this book give the numerical values to find out N(d). We may also express N(d) as
a definite integral as
1 d x2/2
N(d) =
dx
(8.6)
e
2
Example (8.1) gives the Maple code to find the price of a call option using equations (8.3)
- (8.6).
It is possible to show that the call price is positively correlated with the asset price, time to
maturity, riskless rate, and variability of price returns, but it is negatively correlated to the
exercise price. We can express it as
C = f(S +, X , T +, r +, +)
Black-Scholes formula gives the price of a European call option of a non-dividend paying
stock or some other asset. It also assumes that people are rational investors, that r and
remain constant, that there are no taxes or transaction costs, and that the capital markets
are efficient. Despite all these restrictions it is a remarkably accurate and practical formula
for options valuation.
Fig. 8.1: The value of a call, X = 100, T = .25, r = .05, = .3, for varying stock price.
151
_____________________________________________________________________________
Fig. 8.1 shows the value of a call with time to maturity T = 3 months, exercise price X =
$100, riskless rate r = 5%, volatility = .3 as the stock price S changes from $80 to $120.
Hans Stoll (1969) discovered a very important relationship between the value of a call and
the value of a put. We can write the relationship, known as the put-call parity theorem, as
P + S = C + X erT
(8.7)
Substituting the value of C from (8.3), we get

P + S = S N(d1) X erT N(d2) + X erT
Or,
P = S N(d1) S X erT N(d2) + X erT
Or,
P = S [N(d1) 1] X erT [N(d2) 1]
(8.8)
With the help of (8.8), we can find the value of a European put on a stock. You can watch
a Youtube video on put-call parity theorem by clicking here.
By judicious use of put or call options, it is possible to manage the risk inherent in the
investment process. For example if you own the stock of a corporation, you may wish to
sell call options on your stock. In case of a drop in the price of the stock the options will
expire worthless. The premium you have already collected on the options will be yours to
keep and it will offset some of your loss in the value of the stock. What you have done is
to "hedge" your exposure to risk. In fact, it is possible to eliminate risk altogether by setting
up a riskless hedge. This can be done as follows.
Suppose you buy h shares of a stock and sell one call option. Here h is unknown but it is
the proper number of shares to set up the riskless hedge. The total money invested in the
hedge, or the value V of the hedge is
V=hSC
where S is the price of the stock and C the price of the call option. The value of the hedge
should not vary as a result of variation in the price of the stock, and therefore the partial
derivative of V with respect to S should be zero.
V
S = 0
Or,
Or,
Since
C
h S = 0,
S (h S C) = 0
or
C
h = S
152
(8.9)
(8.3)
_____________________________________________________________________________
Differentiating the above expression with respect to S gives us, after considerable algebra,
C
S = N(d1)
(8.10)
Comparing (8.9) and (8.10) we note that

h = N(d1)
(8.11)
The number of shares of stock, h, that one should buy for each option sold is called the
"hedge ratio" and it is just equal to N(d1). Hedging is also used to take advantage of any
temporary mispricing of the options. If the call options happen to be selling at a price which
is more than their theoretical value, one can sell them and buy an appropriate number of
shares. Likewise, if the options are relatively underpriced one can buy them and sell the
stock, using the same hedge ratio.
8.3
Options, Stockholders, and Bondholders
Consider a company that is financed partly by stockholders and partly by bondholders.

They are all stakeholders in the company. Because of the provisions of the indenture, the
bondholders have a stronger claim on the company. If the company is liquidated, the
bondholders will get their money first and then the stockholders. In other words, the
stockholders will get the leftover amount, after the bondholders are satisfied. This is also
the case if the bonds reach maturity and the bondholders are ready to receive the face value
of the bonds.
Consider a company with zero-coupon bonds with face value $25 million, which will
mature after 10 years. The bondholders are not getting any interest and they will have to
wait for 10 years before they receive their share. Suppose the value of the company is V
after 10 years, consider the following three possibilities for V and the division of that
amount. The amount received by each stakeholder will depend on the final value of the
firm.
Firm
value
V > 25
V = 25
Share of
Share of
Explanation
Bondholders Stockholders
25
V 25
Suppose the total value of the firm is $35 million.
Bondholders will receive their share first, which is
$25 million, and the stockholders will get the
remaining value of the firm, which is $10 million
25
If the value of the firm is $25 million, the

bondholders will liquidate the firm and get the face
value of the bonds, which is also $25 million. The
stockholders will get nothing.
153
_____________________________________________________________________________
V < 25
Suppose the value of the firm after 10 years is only

$20 million. The bondholders will not be able to
get the face value of their bonds. They will just
have to settle for $20 million. Each bond will be
worth only 20/25*1000 = $800. The bondholders
will get 80 on the dollar. The stockholders will
get nothing.
Now consider a call option and its payoff at maturity. Recall equation (8.2)
CT = max(ST X, 0)
(8.2)
This equation implies that the value of the call, at maturity, is the difference between the
stock price and the exercise price provided the stock price is higher than the exercise price,
otherwise it is zero.
Comparing the payoff of a call option and the relationship between bondholders and
stockholders, we reach a very important conclusion.
The stockholders of a corporation hold a call option on the assets of the firm,
with an exercise price equal to the face value of the zero-coupon bonds,
and time to maturity equal to the maturity of the bonds.
Examples 8.8-8.10 illustrate this relationship.
Examples
8.1. Anglia Corporation stock price is $40 a share. The risk-free rate is 6%, and the
volatility of the stock, is .4. Find the price of a call option that will expire after 6 months,
with the exercise price $35. What is the price of the corresponding put option?
First, we write the information in symbolic form as follows: S = 40, X = 35, r = .06, T = .5,
and = .4. Substitute these numbers in (8.4)
d1 =
which gives
d1 =
Similarly,
d2 =
(8.4)
ln(40/35) + [0.06 + (0.4)2/2] (0.5)

= .7196
0.4 0.5
d2 =
gives
ln(S/X) + (r + 2/2) T
T
ln(S/X) + (r 2/2) T
= d1 T
T
ln(40/35) + [0.06 (0.4)2/2] (0.5)

= .4367
0.4 0.5
154
(8.5)
_____________________________________________________________________________
Draw a normal probability distribution curve, with 0 at the center and stretching up to
on both sides. First take d1 = .7196, which lies to the right of center. N(d1) is defined as the
area under the curve from to d1, which will be somewhat more than .5. To find its value,
check the tables for d1 = .7196. This comes out as
Similarly,
Put this in (8.3),
which gives
N(d1) = .5 + .2611 + .96(.2642 .2611)] = 0.7641

N(d2) = .5 + .1664 + .67(.1700 .1664)] = 0.6689
(8.3)
C = (40)(.7641) (35)(e.06(.5))(.6689) = $7.85
To find the value of the put option, use (8.8),

P = S [N(d1) 1] X erT [N(d2) 1]
This gives
(8.8)
P = 40[.7641 1] 35 e.06(.5) [.6689 1] = $1.81
For WolframAlpha, the procedure is as follows.

For
d1
d2
N(d1)
N(d2)
C
P
Enter
(LN(40/35)+(.06+.4^2/2)*.5)/(.4*SQRT(.5))
(LN(40/35)+(.06-.4^2/2)*.5)/(.4*SQRT(.5))
1/SQRT(2*Pi)*INTEGRATE[EXP[-x^2/2],{x,-infinity,.719592}]
1/SQRT(2*Pi)*INTEGRATE[EXP[-x^2/2],{x,-infinity,.436749}]
40*.764112-35*EXP(-.06*.5)*.668853
40*(.764112-1)-35*EXP(-.06*.5)*(.668853-1)
Result
0.719592
0.436749
0.764112
0.668853
7.84649
1.81208
To do it as a shortcut on WolframAlpha, enter Black Scholes in the input space, then the
following information about the option itself.
option name:
option type:
strike price:
European
call
$35
time to expiration:
6 mo
underlying price:
$40
volatility:
40 %
dividend yield:
0%
riskfree interest rate:
6%
To get the value of the put option, change call into put.
155
_____________________________________________________________________________
The Maple code for the problem is as follows:

restart;assign(S=40,X=35,T=.5,r=.06,sigma=.4);
Nd:=1/sqrt(2*Pi)*int(exp(-x^2/2),x=-infinity..d):
d1:=evalf((ln(S/X)+(r+sigma^2/2)*T)/sigma/sqrt(T));
d2:=evalf(d1-sigma*sqrt(T));
Nd1:=evalf(subs(d=d1,Nd));
Nd2:=evalf(subs(d=d2,Nd));
C:=evalf(S*Nd1-X*exp(-r*T)*Nd2);
P:=evalf(S*(Nd1-1)-X*exp(-r*T)*(Nd2-1));
The result comes out to be call = $7.85 and put = $1.81.
To do the problem in Excel, proceed as follows.
1
2
3
4
5
6
7
8
9
10
11
A
Stock price, S =
Exercise price, X =
Riskfree rate, r =
Time to maturity, T =
Volatility, =
d1 =
d2 =
N(d1) =
N(d2) =
Call =
Put =
B
40
35
0.06
0.5
0.4
=(LN(B1/B2)+(B3+B5^2/2)*B4)/B5/SQRT(B4)
=B6-B5*SQRT(B4)
=B1*B8-B2*EXP(-B3*B4)*B9
=B1*(B8-1)-B2*EXP(-B3*B4)*(B9-1)
C
dollars
dollars
per year
year
per (year)
dollars
dollars
One can write Black-Scholes model and its components using WolframAlpha as follows.
For
d1
d2
N(d1)
N(d2)
C
P
Enter
(LN(S/X)+(r+^2/2)*T)/(r*SQRT(T))
(LN(S/X)+(r-^2/2)*T)/(r*SQRT(T))
1/SQRT(2*Pi)*INTEGRATE[EXP[-x^2/2],{x,-infinity,AAA}]
1/SQRT(2*Pi)*INTEGRATE[EXP[-x^2/2],{x,-infinity,BBB}]
S*FFF-X*EXP(-r*T)*GGG
S*(FFF-1)-X*EXP(-r*T)*(GGG-1)
Result
AAA
BBB
FFF
GGG
Call
Put
8.2. (A) Uriah Heep has just bought 100 oz of gold at $350 per ounce. He has calculated
that the standard deviation of returns in gold investment is 0.243, and that the riskless rate
is 11%. He would like to sell call options on gold at an exercise price of $375 per ounce,
with a maturity of three months. What is the correct value of these options?
(B) Suppose Uriah was able to sell options on 10 oz of gold. The price of gold at the end
of 3 months is $400 per ounce. Now he liquidates all his gold and settles the options, what
is his total profit?
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_____________________________________________________________________________
(C) Using a discount rate of 15%, find the NPV of this investment.
(A) Here we are given that:
S = current price of the underlying asset = $350
X = exercise or the striking price of the option = $375
r = riskless rate of interest = 0.11 per year
T = time to maturity of the option = 0.25 years
= standard deviation of the continuously compounded rate of return from the
price fluctuations of the underlying asset = 0.243
The price of the option is calculated by using the Black-Scholes model as shown below:
d1 =
ln(350/375) + [0.11 + 0.5 (0.243)2] (0.25)

= 0.2808
0.243 0.25
d2 = 0.280755 0.243 0.25 = 0.4023

Draw normal probability distribution curve, with 0 at the center and stretching up to on
both sides. First take d1 = 0.2808, which will lie slightly left of center. N(d1) is defined
as the area under the curve from to d1, which will be somewhat less than .5. To find its
value, check the tables for .2808. This comes out as
N(d1) = .5 [.1103 + .08(.1141 .1103)] = 0.3894
Figure 8.2. N(d1) is defined as the area under the normal probability distribution fumction
curve from to d1. This is the shaded area in the diagram.
Similarly,
N(d2) = .5 [.1554 + .2256(.1591 .1554)] = 0.3438

C = 350 (0.3894) 375e0.11(0.25) (0.3438) = $10.86
(B) Since Heep sold options on only 10 oz of gold, he was able to sell 90 oz of gold at a
profit of $50 per oz. The options ended up in the money, that is, the final price of gold was
higher than the exercise price. As a result the buyers of the options exercised their options
157
_____________________________________________________________________________
by forcing Heep to sell the gold to them at the rate of $375 per oz. On these ten ounces of
gold he made $25 per ounce besides collecting the $10.86 option premium calculated in
part (A). Let us define profit as the difference between the final payoff and the initial
investment, without regard to the risk involved, and without the time value of money. The
total profit works out as follows:
Initial investment = cost of buying gold cash received by selling the options
= 100(350) 10(10.86) = $34,891.40
Final payoff = money received by selling 90 oz of gold in the open market at $400 an oz
+ money received by selling 10 oz of gold to the option holders at $375 an oz
= 90(400) + 10(375) = $39,750
Profit = 39750 34891.40 = $4858.60
(C) To calculate the NPV, we have to subtract the initial investment from the present value
of the future payoff, using a discount rate that includes the risk of the investment. Using
the continuously compounded discount rate, as we used it in the calculation of the option
price, NPV comes out as
NPV = 34,891.40 + 39,750e(.15)(.25) = $3395.58
Note that NPV is less than the profit and it is a more conservative measure of the
profitability of an investment.
8.3. William Horner bought 100 oz of gold at $1663 an oz. Then he sold call options on
25 oz of gold, exercise price $1680, for $100 each; and options on 35 oz of gold, exercise
price $1700, for $80 each. The cost of capital for Horner is 9%. All the options will expire
after 6 months and then Horner will liquidate his position. Use continuous discounting, to
calculate the NPV of this hedge if the price of gold after 6 months is expected to be $1700
an oz.
Initial investment = (value of 100 oz of gold at $1663 per oz)
(value of 25 options sold, at $100 each, with X = 1680)
(value of 35 options sold, at $80 each, with X = 1700)
= 100*1663 25*100 35*80 = $161,000
If the expected final price of gold is $1700, options with X = 1680 will be exercised, and
he will deliver 25 oz of gold and receive $1680 per oz. The options with X = 1700 will
expire worthless because when the stock price is exactly equal to the exercise price, at
expiration, then the value of the option is zero. Therefore, he will sell the remaining 75 oz
of gold in the market at $1700 per oz. Thus
Final payoff = money received because some of the options have been exercised + money
received by selling the rest of gold in open market = 25*1680 + 75*1700 = $169,500.
158
_____________________________________________________________________________
To summarize, his initial invest was $161,000 and the final payoff was $169,500. With
these two numbers, we can find the following on this investment.
Profit = 169,500 161,000 = $8,500
The above value of the profit is misleading because we did not consider the time value of
money and we did not take into account the risk involved. To compensate for these factors,
we should find the NPV of the investment. We can do it in two ways, in discrete time and
in continuous time. The results are as follows.
Discrete time, NPV = 161,000 + 169,500(1.09).5 = $1351.56
With continuous discounting, NPV = 161,000 + 169,500e.09*.5 = $1041.57
8.4. Adam Diller bought 100 shares of Apple stock at $580.32 per share. He also sold 1
call option on the stock, at 41.66, with exercise price 590, and with 132 days till expiration.
Using a discount rate of 12%, continuously compounded, find the stock price where Adam
will just break even in this investment. Neglect transaction costs.
At the break-even point, the NPV of the investment will be zero. By selling the call, the
net cost of stock is reduced by $41.66 per share. The break-even price of the stock should
be around 580.32 41.66 = $538.66. The buyer of the option will not exercise the option
because the final stock price, $538.66 is much less than the exercise price of the call option.
Let us find the answer more accurately including the time value of money.
The initial cost of stock = 100(580.22) = $58,022
Cash received by selling the call option = 100(41.66) = $4166
Net cost of this hedge = 58,022 4166 = $53,856
Suppose the final stock price is x. This is around $540, as seen by the approximate
calculation. The final payoff from selling the stock at x per share will be 100x. Its present
value, using 12% continuously compounded discount rate and 132 days to maturity, will
be 100xe.12(132/365). Setting NPV = 0, we get
53,856 + 100xe.12(132/365) = 0
You may solve it at WolframAlpha by using the instruction
-53856+100*x*exp(-.12*132/365)=0
The result is x = $562.45.
8.5. You own 1,000 shares of GM stock which is currently selling for $75 a share, and
your estimate of its sigma is 0.225. The riskless rate is 11.2%. What is the price of three
month call options at an exercise price of $80? How many call options should you sell in
order to set up a perfect hedge?
159
_____________________________________________________________________________
In this problem, S = 75, X = 80, T = .25, r = .112, = .225

d1 =
ln(75/80) + (.112 + .2252/2)(.25)

= .2685368546
.225 .25
d2 =
ln(75/80) + (.112 .2252/2)(.25)

= .3810368545
.225 .25
N(d1) = =NORMDIST(-.2685368546,0,1,TRUE) = .3941430552

N(d2) = =NORMDIST(-.3810368545,0,1,TRUE) = .3515879509
C = 75*.3941430552 80*exp(.112*.25)*(.3515879509) = 2.21032647
The call price is $2.21.
One can set up a hedge by buying the shares of GM and selling call options on them. In
order to set up a riskless hedge, one has to buy N(d1) shares of stock and sell one option.
With the proper hedge ratio as N(d1) = 0.3941, one should buy 0.3941 shares per call, or
1/0.3941 calls per share. But we already have 1,000 shares, therefore, we have to sell
1,000/0.3941 calls altogether. This works out to be 2537 calls.
As the time to maturity changes and the stock price fluctuates, the hedge ratio N(d1) also
changes. To keep the hedge riskless, we have to recalculate N(d1) periodically and adjust
the hedge accordingly.
8.6. (A) Stanley Corporation stock is currently selling for $76 a share, riskless rate is 12%,
and the sigma for Stanley is 0.25. Find the price of a nine-month Stanley call option with
an exercise price of $70.
(B) Suppose the options in part (A) are selling for $10 each. Explain how you would set
up a hedge to take advantage of the mispricing.
(A) From the option pricing formula we get: d1 = 0.9038, d2 = 0.6873, N(d1) = 0.8169,
N(d2) = 0.7540, and call price = $13.85.
(B) Since options are selling for $10 apiece, which is substantially less than their theoretical
value of $13.85, you must buy them. To set up the hedge you buy the calls and sell the
stock short in the proper hedge ratio of 0.8169. The overall size of this hedging operation
depends upon the amount of available funds. For example, you may buy 1,000 options and
sell 817 shares short, maintaining the hedge ratio of 0.817. When the price of the options
reach an equilibrium, you can take your guaranteed profits. The cost of buying calls is
1,000(10) = $10,000. The proceeds from the short sale of stock is 817(76) = $62,092. The
net proceeds are 62,092 10,000 = $52,092. You should invest this amount in riskless
government bonds while waiting for the profits to occur.
160
_____________________________________________________________________________
Here we are assuming that our estimate of the of Stanley is absolutely correct and the
rest of the market does not know it yet. We also assume that there are no transaction costs,
that is, no brokerage commissions. We also assume that there are no restrictions against
short selling, and that we are continuously adjusting the hedge ratio while the stock and
option prices are changing. In practice this is very difficult to do.
8.7. (A) Denver Corporation stock is currently selling for $100, riskless rate is 12%, and
the sigma for Denver is .25. Find the price of a nine month Denver call option with an
exercise price of $100.
(B) Suppose the options in the last problem are selling for $15 each. Explain how you
would set up a hedge to take advantage of the mispricing.
In part (A) we get: d1 = 0.5239, d2 = 0.3074, N(d1) = 0.6998, N(d2) = 0.6207, and call price
= $13.25.
In part (B) we notice that the calls are overpriced at $15 each compared to their theoretical
value of $13.25, and we should sell them. Because the hedge ratio N(d1) is roughly 0.7, we
should buy 0.7 shares of stock for each option sold. For example we can sell 1,000 options
but buy only 700 share of Denver. This will require a cash outlay of
700(100)
1000(15) = $55,000. If we could borrow that money at a rate equal to the riskless interest
rate, and if we wait until the prices regain equilibrium then we should make a profit of
1,000 (15 13.25) = $1,750.
8.8. Glenn Corporation has an overall market value of $40 million. The firm has zerocoupon bonds outstanding, maturing in 5 years, with the face value $25 million. The for
this company is 0.25, and the riskless rate is 8%. Glenn has one million shares of common
stock. What is the market value per share of its common stock?
The stockholders of a company hold a call option on the assets of the company after the
bondholders are satisfied. The bondholders have a senior claim on the assets of the firm in
the case of liquidation of the firm. The stockholders share whatever is left over, after all
the other claims are satisfied.
The value of the underlying asset is the current market value of the firm, namely, $40
million. The exercise price is the face value, not the market value, of the zero coupon bonds,
$25 million. The value of the option is the total market value of the common stock of the
firm. Substituting S = 40, X = 25, T = 5, r = .08, and = .25, in the Black-Scholes formula,
we find: d1 = 1.8358, d2 = 1.2768, N(d1) = 0.9668, N(d2) = 0.8992, and call price = 23.60.
This means that the value of 1 million shares of common stock is $23,600,000. The price
of the stock per share comes to $23.60.
8.9. Fischer Black is the sole stockholder of Black Belt Co., which has an overall value of
$50,000. The company has borrowed some money from an investor, Myron Scholes, and
has promised to pay him back the entire amount as a lump sum of $30,000 after 5 years.
161
_____________________________________________________________________________
The of Black Belt is 0.25, and the riskless rate is 6%. Find the market value of the
holdings of Black and Scholes individually.
Being a stockholder, Black holds an option on the assets of the firm after Scholes has been
satisfied. The value of the option can be found by the option pricing formula with S =
50,000 X = 30,000 which gives C = $28,369. This represents Black's portion of the assets.
The total market value of a firm is equal to the market value of its common stock plus the
market value of its debt. The value of the debt in this case is thus 50,000 28,369 =
$21,631. This is the value of Scholes' claims on the company.
If we evaluate his claim as if it were riskless, its value is 30,000 e0.06(5) = $22,225. Because
the debt is not riskless, its value is somewhat less. The difference between $22,225 and
$21,631 is $594, which is about 2.67% of $22,225. The debt is quite safe because there is
a good possibility that the $50,000 firm will have a terminal value of $30,000 after 5 years.
8.10. Carolina Inc has a total value of $5 million. It has zero coupon bonds maturing in 10
years with a face value of $4 million. The riskless rate is 10%, and of Carolina is .25.
Using Black-Scholes model, find the market value of a single $1,000 bond.
Use the following in the Black-Scholes formula: S = 5, X = 4, T = 10, r = .1, and = .25.
This gives us d1 = 1.9425, d2 = 1.1519, N(d1) = .9740, N(d2) = .8753, C = 3.582.
This means that the market value of the stock of Carolina is $3,582,000, and that of the
bonds 5,000,000 3,582,000 = $1,418,000. Since the face value of the bonds is
$4,000,000, each $1,000-bond is selling for 1,000*(1,418,000/4,000,000) = $354.50
If the bonds were riskless they would be selling for 1,000 e0.1(10) = $367.88 each. This
agrees with the price of the risky bonds found above, because the riskless bonds are
somewhat more valuable.
8.11. Enceladus Corporation has a total value of $5 million. It has $2 million of zerocoupon bonds maturing in 12 years. The sigma of Enceladus is .4 and riskless bonds with
12-year maturity have a yield of 9%. Find the market value of a $1,000 Enceladus bond.
Using Black-Scholes formula with S = 5, X = 2, r = 0.09, = 0.4, and T = 12, we get d1 =
2.1335, d2 = 0.74788, N(d1) = 0.98356, N(d2) = 0.77273, and C = 4.393. This means that
the value of equity is $4.393 million, and the value of debt is 5 4.393 = $0.607 million.
A thousand dollar bond sells for (1000)(0.607/2) = $303.50.
8.12. Calhoun's Saloon is run jointly by Calhoun and his brother-in-law Breckinridge.
Calhoun is the sole stockholder of the company, but the company owes Breckinridge
$10,000 which will be paid as a lump sum after 5 years. Considering the income generated
by the business, it is estimated that the value of the business is $20,000. The risk of the
business is measured by its which is estimated to be 0.5. The riskless rate is 10%. Calhoun
162
_____________________________________________________________________________
wants to pay a fair price to Breckinridge for his loan and thus become the sole proprietor
of the business. How much should Calhoun pay Breckinridge now?
Here we have to use the Black-Scholes formula with the following values: S = 20,000, X =
10,000, T = 5, = 0.5, r = 0.1. This gives: d1 = 1.626, d2 = 0.5082, N(d1) = 0.9481, N(d2)
= 0.6943, C = 14,750. In general, the stockholders of a firm hold a call option on the assets
of a firm, with an exercise price equal to the face value of the bonds of the firm. Calhoun
is the stockholder and he holds a call option on the assets of the firm after the bondholder,
Breckenridge, is satisfied. Thus the value of Calhoun's investment is $14,750. The total
value of a firm equals the value of stock plus the value of the debt. The present value of
Breckinridge's loan, the value of debt, is thus 20,000 14,750 = $5,250. Therefore Calhoun
should pay Breckinridge $5,250 to buy him out.
Problems
8.13. The common stock of Zeta Corporation is currently selling for $56.375 per share and
the standard deviation of its continuously compounded rate of return is .256. The riskless
rate is 9.55%. Find the price of a call option at the exercise price of $60 with maturity time
of 9 months?
d1 = 0.1528, d2 = 0.0689, N(d1) = 0.5607, N(d2) = 0.4725, C = $5.22
8.14. Find the price of a call option on one share of Mackellar Corporation stock with
exercise price of $100 and a time to maturity of 9 months. The market price of Mackellar
stock is $106 per share and has a sigma of 0.45. The riskless rate is 7.5%.
d1 = 0.4887, d2 = 0.0990, N(d1) = 0.6875, N(d2) = 0.5394, C = $21.88
8.15. Dole Co stock is currently selling for $122 per share and its sigma is estimated to be
.234. The riskless rate is 6.55% at present. Find the price of call option on Dole with an
exercise price of $130 and expiring in 63 days.
$2.27
8.16. Arcturus Co common stock has market price $95 per share and its sigma is 0.2. Find
the value of a European call option with an exercise price of $90 and a term of 9 months
on the Arcturus stock. The riskless rate is 12%.
C = $14.48
8.17. The current price of gold is $457 an oz. The standard deviation of investment returns
in gold has been estimated to be 0.15, and the riskless rate is 6%. Calculate the price of a
six-month call option on gold with the exercise price of $475.
C = $17.50
8.18. Red Buttons has the option to buy a piece of land for $50,000 after one year. The
market value of the land is $40,000 at present, and the of returns for real estate
investments of this type is around 0.3. The riskless rate is 12%. What is the value of this
option?
$3,149
8.19. Charles Heston bought 100 shares of Priceline at $644.36 per share. He then sold 1
call at 27.36, with expiration time 41 days and exercise price 650. The risk-adjusted
discount rate for this hedge is 10%, continuously compounded. Suppose at expiration of
the option, the stock is selling at $660 per share. Find the NPV of this investment.
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_____________________________________________________________________________
$2573.95
8.20. Miles Davis has bought 100 oz of gold at $460 an oz. He has sold call options on 30
oz of gold, with exercise price $480, for $10 each; and options on 40 oz of gold, exercise
price $470, for $20 each. All options will expire after 6 months and then Davis will
liquidate his position. Davis expects the price of gold after six months to be $475 an oz.
He uses 12%, continuously compounded, as the discount rate. Calculate the NPV of this
hedge.
NPV = $354.54
8.21. Rutherford Corporation has total assets of $40 million. The company has $20 million
(face value) of zero-coupon bonds which will mature in 12 years. The riskless rate is 9%
and the of Rutherford Corporation is .45. Find the market value of Rutherford bonds.
What would be the value of these bonds if they were riskless?
Market value of bonds = $5,451,000. Their value, if riskless = $6,792,000.
8.22. Capricornus Company has a total value of $40 million. Its debt is in the form of zero
coupon bonds which will mature in 10 years. The riskless rate is 6.5% at present. The sigma
of Capricornus is 0.45. Find the debt/assets ratio of Capricornus. The face value of bonds
is also $40 million.
32.99%
8.23. Dulles Corporation has a total value of $80 million and it has $40 million (face
amount) of zero coupon bonds outstanding. The bonds will mature in 10 years. The riskless
rate is 8% and the sigma of Dulles is 0.25. Find the market value of the stock of Dulles.
$62.348 million
8.24. Pluto Inc has $20 million face value zero-coupon bonds due in 5 years, and its is
0.45. The total market value of Pluto is $30 million and the riskless rate is 11%. The
company has 2 million shares outstanding. Find its price per share.
$10.02
8.25. Turabah Company has total value $50 million. It has zero-coupon bonds with face
value $40 million, maturing after 20 years. The riskfree rate is 6%. The volatility of
Turabah Company is .4. Using Black-Scholes model, find the value of its $1000 bond.
B = $195.63
8.26. Schnectedy Company has total value $200 million, and it has $100 million (face
value) of zero-coupon bonds maturing after 15 years. The of Schnectedy is estimated to
be .4 and the riskfree interest rate is 6%. Using Black-Scholes model estimate the
debt/assets ratio for the company.
15.77%
8.27. Rolls and Royce started a car company by investing 100,000 each. Rolls was a
stockholder, and thus the owner of the company. The corporation agreed to pay Royce
300,000 after ten years for his share of the business. However, by mutual agreement the
company was sold after 5 years for 800,000 and the money was divided according to the
option pricing theory. The riskless rate at the time was 3%, and the sigma of Rolls-Royce
Company was estimated to be 0.4. Find the amount of money that went to Rolls and to
Royce.
164
_____________________________________________________________________________
S = 800, X = 300, = 0.4, T = 5 years, r = 0.03, d1 = 1.712, d2 = 0.8171, N(d1) = 0.9565,

N(d2) = 0.7931, Call price = 560.427, Rolls' share = 560,427, Royce's share = 239,573
8.28. Beaver Corporation is owned jointly by sisters Allison and Barbara, Allison's share
being 60%. The value of the corporation is $50,000 and its risk in terms of sigma is
estimated to be 0.5. Allison would like to buy Barbara out and offers her $20,000 cash, or
a note for $30,000 payable by Beaver Corporation after 5 years. The riskless rate is 9%.
Should Barbara take the cash or the note?
PV of note = $15,724, take cash.
8.29. Ryles is the only stockholder of Ryles & Hewish, but Hewish has lent a certain sum
of money to the business with the understanding that the company will pay him back
$100,000 after 6 years. The current value of the business is $150,000 and its is estimated
to be about 0.4. The riskless rate is 8%. If the company were to be liquidated today, what
would be a fair distribution of cash to Hewish and Ryles?
Ryles = $96,872, Hewish = $53,128.
Multiple Choice Question
1. Suppose the value of a call for a certain stock, with certain time to maturity, and a
certain exercise price, is C. Also, the value of a put, for the same stock, same time to
maturity, and same exercise price, is P. Then
A. P is greater in value than C
B. P is lesser in value than C
C. P is equal in value to C
D. P is unrelated in value to C
Key Terms
American option, 139
at the money, 138
Black-Scholes model, 135,
144, 148, 151
call option, 135, 149
call premium, 135
call price, 135, 136, 138, 139,
140, 146, 147
European option, 139
exercise, 135, 136, 138, 139,
140, 141, 143, 144, 145,
146, 147, 148, 149, 150
exercise price, 138, 150

expiration time, 136
hedge, 141, 142, 146, 147,
150
hedge ratio, 142, 146
in the money, 138, 145
intrinsic value, 138
option, 135, 136, 138, 139,
140, 141, 142, 143, 144,
145, 146, 147, 148, 149,
150, 151
out of the money, 138
165
put option, 136

put-call parity theorem, 135
riskless rate, 139
time value, 138, 145
transaction costs, 140, 147
volatility, 138, 139, 141, 143,
151
9. COST OF CAPITAL
Objectives: After studying this chapter, you will be able to
1. Calculate the cost of various forms of capital: stock, bonds, and preferred stock.
2. Apply the concept of original issue discount.
3. Find the weighted average cost of capital.
9.1
Cost of Capital
Capital is the lifeblood of any corporation. A company cannot invest in new machinery
and equipment without capital; it cannot embark on new projects without adequate
capitalization; it cannot even pay its current bills without sufficient working capital. Just
like any scarce resource, there is a cost associated with capital.
What is capital, and how do the corporations get it? Capital is the money, or cash, needed
by the firms to do their business. The corporations obtain capital from investors who have
saved some money and want to invest it. Of course, the investors require a certain return
on their investment depending on the amount of risk they are willing to take. The
following diagram illustrates the relationship between investors and corporations.
Corporations
Capital
Return on investment
Investors
Fig. 9.1. The relationship between investors and corporations.
Investors will not invest their money unless there is a reasonable return on their
investments. For instance, if the company offers bonds with coupon 8%, but the investors
require 10% return on such an investment, then the investors will not buy these bonds. If
the investors do not buy the bonds, their price will drop in the financial markets. The
price will drop to a point where the return on these bonds becomes 10%, and they reach
an equilibrium point. Thus we reach a very import conclusion:
The cost of capital
to a corporation
The required rate of

return for the investors
This cost of capital depends upon the supply and demand of capital in the capital markets.
During a recession, investors do not have enough savings to invest in the capital of
corporations. The Federal Reserve can lower the interest rates, or increase the money
supply, in an effort to facilitate the availability of capital.
The main components of the capital of a corporation are equity and debt. The firms
acquire equity capital by selling common stock. Similarly, they sell bonds to obtain debt
166
9. Cost of Capital
_____________________________________________________________________________
capital. Besides these two, the corporations may also sell preferred stock, convertible
bonds, and warrants as additional forms of capital.
The preferred stockholders get their dividends ahead of the common stockholders. This
gives them a more secure investment, relative to common stock, and thus the return is
lower. The cost of preferred stock to the firm is, therefore, less than the cost of common
equity.
Convertible bonds are hybrid securities that act like straight bonds in that they provide
regular coupon payments. They also act like stock because they can be converted into
common stock at the option of the bondholder. If the price of the stock rises, then the
price of the bond also rises. The cost of issuing convertible debt is difficult to ascertain
because of the complicated relationship between the stock value and the convertible bond
value. The cost of convertible bonds lies between the cost of debt and the cost of equity.
The bondholders of a company are in a secure financial position. This is due to the fact
that bond interest is paid before taxes or dividends. In case of liquidation of a
corporation, again the bondholders are the first ones to receive money from the sale of
assets. As a result of their greater security, the bondholders have a lower required rate of
return. The stockholders bear greater risk and expect to be compensated for it. Thus we
reach another important conclusion:
For a given company, kd is always less than ke.
Let us look at the cost of different components of capital.
9.2
Cost of Debt
We recall the principle that the cost of debt is equal to required rate of return by the
bondholders. Thus the cost of debt capital for a firm is equal to the yield to maturity for
its bonds for the bondholders. For most corporations, it is possible to find on the Internet
the bond prices, coupon rates, and the year of maturity. Using this information, we can
find the yield to maturity, and thus the cost of debt capital for that company.
The interest paid by a corporation is tax deductible, thereby lowering its cost of debt. For
example, a company has a debt of $1000, with an interest rate of 10%. It pays $100 in
interest annually. It can use the $100 as a tax deduction. Suppose the company has tax
rate of 30%, then its tax savings will be $30 because of this deduction. The net cost of
interest expense is $70, which means the after-tax cost of debt is 70/1000 = 7%. This 7%
is really (1 .3)(.1) = 0.07. We may write it as (1 t)kd, where kd is the cost of debt
before taxes, and t is the tax rate. Let us write this result as
If the cost of debt
before taxes is kd
then
167
the cost of debt after

taxes is (1 t)kd.
9. Cost of Capital
_____________________________________________________________________________
When a company issues new bonds to raise additional capital, the company gets deeper
into debt. This reduces the security of bondholders. The company has to pay a higher
interest rate to sell the new bonds. The bonds of the companies that are in severe financial
distress are aptly called "junk bonds."
It is possible to get a more precise value of the after-tax cost of debt by including two
additional features of a bond. First, the corporation pays the interest semiannually; and
second, it gets the tax benfits of interest payments annually.
When a bond is selling at par, it is selling at its face value, namely $1000. Suppose a
company issues bonds at par with face value F. The coupon rate on these bonds is r and
they will mature after n years. The interest on the bonds is paid semiannually. Let us
assume that the company pays taxes once a year at a rate t. If the after-tax cost of debt is
k, then k is given by the following equation that says NPV = 0,
F
Face value
of the bond
2n
rF/2
(1 + k/2)i
i=1
PV of interest
payments
rFt
(1 + k)i
i=1
PV of tax benefits
of interest payments
F
(1 + k)n
=0
PV of the
final payment
The above equation represents the common adage, You get what you pay for. In this
case, the corporation gets (1) the face value of the bonds when they are sold and (2) the
tax benefit of interest payments, in PV terms. The company pays for it (1) by paying
interest on the bonds, semiannually, and (2) paying the face value of the bonds at
maturity, measured in PV terms. Note that everything is reduced to its present value.
It is common to use Excel or WolframAlpha, to get a numerical solution to the problems.
For instance, if r = 10%, t = 30%, n = 10 years, then k 7.1188%. The result is somewhat
different from the simple answer of 7% from the expression (1 .3)(.1). To verify the
result, use the following expression at WolframAlpha,
1000-sum(.1*1000/2/(1+x/2)î,i=1..2*10)+sum(.1*1000*.3/(1+x)î,i=1..10)-1000/(1+x)^10=0
WolframAlpha does not give you the desired answer immediately. The reason is that this
is an equation of degree 20 and theoretically, it has 20 roots. Many of the roots are
complex and we are not interested in them. It provides some of the real roots. If you do
not see what you are looking for, you should ask for more roots, until the desired result
shows up. In this case it offers the result x = 0.071188, or about 7.119%. If the problem
is more complicated, the free version of WolframAlpha will not give you any result. You
can still solve the problem on Excel, Maple, or Mathematica.
Occasionally, a firm may issue bonds that sell at less than their face value. The difference
between the face value F and issue price G is called the original issue discount. For
instance, a corporation may issue a $1000 bond for only $900 and thus the original issue
discount is $100. Eventually, the firm must redeem the bond for its face value F. The
Internal Revenue Service allows the companies to treat the original issue discount as a
168
9. Cost of Capital
_____________________________________________________________________________
virtual form of interest, although they do not pay it to the bondholders. For the investors,
the IRS gives the instructions in Publication 550. This is spread over the life of the bond
and its annual value is (F G)/n. The annual tax benefit to the corporation due to this
item is t(F G)/n.
Including the original issue discount, the after-tax cost of debt, k, for a bond issued at a
discount, G, where G < F, is given by the following expression. The NPV = 0 equation
includes the present value all cash flows, after taxes, as seen by the corporation.
G
Original price of
the bond
2n
rF/2
(1 + k/2)i
i=1
PV of interest
payments
[rF + (F G)/n]t
(1 + k)i
i=1
n
PV of tax benefits of interest

and original issue discount
F
(1 + k)n
=0
PV of the final
payment
To understand the previous equation, consider a numerical example. A firm issues a bond
by selling it to the public at G = $700 with face value F = $1000. This is a discount bond
and the firm uses the original issue discount to find its after-tax cost of debt. Suppose the
income-tax rate of the company is 32%. The difference between the selling price and the
face value is $300, which is the original issue discount. The firm has to pay this amount
to the bondholders when the bonds mature. For tax purposes, the firm spreads it out over
ten years, claims a virtual interest payment of $30 per year, and gets a tax benefit .32(30)
= $9.60 every year. Suppose the coupon rate of the bond is r = 5%, and it will mature
after n = 10 years. The bond pays interest semiannually. Using the concept of NPV = 0
for all cash flows to the firm, one can write
20 .05*1000/2
10 [.05*1000 + (1000 700)/10](.32)
1000
700 (1 + k/2)i +
i
(1 + k)
(1 + k)10 = 0
i=1
i=1
Simplifying it, we get
10 25.6
25
1000
700 (1 + k/2)i + (1 + k)i (1 + k)10 = 0
i=1
i=1
20
To solve it with Maple, enter the following instructions

700-sum(25/(1+k/2)î,i=1..20)+sum(25.6/(1+k)î,i=1..10)-1000/(1+k)^10=0;
solve(%);
The result is .06711987555, or about 6.712%. To do it with WolframAlpha, copy and
paste the following instruction
solve(700-sum(25/(1+x/2)î,i=1..20)+sum(25.6/(1+x)î,i=1..10)-1000/(1+x)^10=0, x>0)
It asks for real, positive roots only. WolframAlph comes out with the right answer, r
.0671199 or 6.712%. To verify if this is a valid answer, we find the approximate yield to
maturity for the bond by using equation (3.5) on page 36. This gives
169
9. Cost of Capital
_____________________________________________________________________________
Y [50 + (1000 700)/10]/850 = .09411764704

With tax rate 32%, the after-tax cost of debt is (1 .32)(.09411764704) = .064 = 6.4%.
This is close to the previous value.
To do it on Excel, use the following table. Adjust the value of the unknown after-tax cost
of debt in cell B1, until the NPV of the bond in cell B9 becomes very close to zero. With
the after-tax cost of debt as 9.412%, the NPV in cell B9 is about $0.0007.
1
2
3
4
5
6
7
8
9
9.3
A
After-tax cost of debt =
Sale price of the bond = $
Time to maturity = years
Coupon rate = %
Income tax rate = %
PV of interest payments =
PV of tax benefits =
PV of final payment =
NPV of bond = 0
B
6.712%
700
10
5%
32%
=-B4*1000*(1-1/(1+B1/2)^(2*B3))/B1
=(B4*1000+(1000-B2)/B3)*B5*(1-1/(1+B1)^B3)/B1
=-1000/(1+B1)^B3
=B2+B6+B7+B8
Cost of Equity
The cost of equity for a firm is more difficult to estimate primarily because of the greater
uncertainty in the cash flows per share of stock. We may use one of the following four
methods.
1. The first method is to find the cost of debt and then add a risk premium to it because
the stockholders bear greater risk than the bondholders do. This risk premium may vary
roughly from 3% to 8%, depending upon the financial health of the firm. If ke is the cost
of equity, and kd is the cost of debt, then an approximate relationship is:
ke = kd + risk premium
(9.1)
2. The second method is to apply Gordon's growth model (3.6)

D1
P0 = R g
(3.6)
Here R is the required rate of return by the stockholders. But this is also the cost of equity
for the firm ke. This leads us to write the above equation as
D1
ke = P + g
(9.2)
The right side of this equation has two terms. The first one, P01 represents the dividend
yield of a stock, and the second one, g, the rate of growth of the company. The return of a
stock is indeed the sum of these two factors. High dividend stocks usually have a low
170
9. Cost of Capital
_____________________________________________________________________________
growth rate. For the stocks that pay no dividends at all, the investors are pinning their
hopes on the future growth potential of the company.
3. Another method of estimating the cost of equity is to apply the Capital Asset Pricing
Model (7.7)
E(Ri) = r + i [E(Rm) r]
(7.7)
Here E(R) is the expected return of the stock, which is also the required rate of return for
an investor, and thus it is also the cost of equity capital for a firm. If we know the of a
stock, the riskless rate of return r, and the expected return of the market, we can find the
cost of equity for that company as
ke = r + i [E(Rm) r]
(9.3)
4. An approximate method for estimating the cost of equity is simply to look at the
previous performance of a stock. Using past as a proxy for the future, we assume that the
expected return on the stock is just equal to the previous return of that stock. This is then
the cost of equity for the firm,
ke = historical return of the stock
9.4.
Cost of Preferred Stock
Note the following differences between a preferred stock and a common stock.
1. Preferred stock pays regular dividends, while common stock may, or may not, pay
dividends.
2. Preferred stock is safer than the common, because the preferred dividends are paid out
before the common dividends.
3. Preferred stock has no growth potential and the dividends remain constant, whereas the
dividends of the common stock have the possibility of growing over time.
4. Preferred shares have a limited life in most cases and the company buys them back at
the issuing price after a few years.
5. A company that issues preferred stock does not get any tax benefit because the
dividends of preferred stock are not tax deductible. Thus, the pretax and after-tax cost of
capital for preferred stock is the same.
6. The preferred stockholders do not have voting rights and they cannot elect the board of
directors of a company.
Considering all that, one should use Gordons growth model, with g = 0, to find the cost
of capital for preferred stock.
171
9. Cost of Capital
_____________________________________________________________________________
9.5.
Weighted Average Cost of Capital
Consider a corporation that uses only common stock and bonds in its capital structure.
Assume that both the stock and the bonds are publicly traded and they have a certain
market value. Then the total market value of the corporation is just equal to the market
value of the common stock plus the market value of the bonds. The real value of any
asset is determined by the market and it is not necessarily equal to its book value. The
market value of an asset can fluctuate for many reasons. For example when the interest
rates rise, the market price of bonds of a company will drop. If the company has poor
earnings projections, the price of its common stock will fall. The management, of course,
tries to maximize the value of the company, not just for the stockholders, but for the
bondholders as well.
The two major components of the capital of a company are the equity and the debt, or to
put it other words, common stock and bonds. We have already seen they have different
costs to the company, the debt being considerably cheaper. That is why almost all the
companies include debt in their capital structure. Let us define
S = market value of the entire common stock of the company
B = market value of the bonds of the company
V = market value of the company
then the total market value of the company is just equal to the sum of the market values
of its debt and equity. That is,
V=B+S
(9.4)
The weight of debt, or the percentage of debt, in the capital structure is B/V. Similarly,
the weight of equity is S/V. The correct cost of debt is after taxes, namely, (1 t)kd.
Combining these ideas, we find the weighted average cost of capital, WACC, to be
B
S
WACC = (1 t) kd V + ke V
(9.5)
where t = income tax rate of the company

ke = cost of equity capital
kd = pre-tax cost of debt capital.
(1 t)kd = after-tax cost of debt.
We may easily modify (9.5) to include preferred stock, or more than one bond issue. For
example, if the company has preferred stock, whose market value is P, then the total
value of the company V is given by
V=B+S+P
Suppose the cost of preferred stock is kp, then (9.5) can be stretched out as
172
(9.4a)
9. Cost of Capital
_____________________________________________________________________________
B
S
P
WACC = (1 t) kd V + ke V + kp V
(9.5a)
Along with the preferred stock, suppose a corporation has two separate bond issues, with
market value B1 and B2, with pretax cost of debt kd1 and kd2, respectively. In this case,
(9.4 and (9.5) become
V = B1 + B2 + S + P
(9.4b)
S
P
kd1 B1 + kd2 B2
WACC = (1 t)
+
k
+
k
e
p
V
V
V
(9.5b)
The reason for calculating the WACC of a corporation is that it is the proper discount rate
that should be used in computing the NPV of the projects under consideration, provided
the projects are of average risk and the company is using the existing capital to finance
the new projects.
The capital cost of riskier projects is, of course, higher and the company should evaluate
it separately. If the corporation is raising new capital to finance a new project, it may
change the WACC and the company should make the acceptance decision under the new
WACC.
Examples
9.1. Schirra Lumber Company is in 40% tax bracket. It wants to calculate the after-tax
cost of the following:
(A) A bond sold at par with a 13% coupon.
(B) A 10-year bond with 6% coupon and face value $1,000 sold for $600.
(C) A preferred stock sold for $25, with quarterly dividends of $0.50 each, if the
company plans to call the issue after 5 years at a price of $30 per share.
(D) A common stock at $15 a share, if the dividends are expected to grow at the rate of
3% annually, and the dividend next year is $2.00.
(A) If the bond has a coupon of 13% and it is sold at par, the pre-tax cost of capital is
13%. The interest is a tax deductible item, and so the cost of interest is reduced by the tax
rate. The after tax cost of capital is .13(1 .4) = .078 = 7.8%.
(B) Let us look at the problem from the point of view of an investor who buys this bond.
For him the approximate yield to maturity is, using (3.5),
Y
60 + (1000 600)/10
= .125
800
which is also the cost of debt to the company. After taxes, it should be (1 .4)(.125) =
.075 = 7.5%. This is only an approximate answer.
173
9. Cost of Capital
_____________________________________________________________________________
Let us examine this problem a little more closely. First, the company receives $600 when
it sells a bond. Second, the company makes 20 semiannual interest payments of $30 each
which are discounted at the semiannual after-tax rate as r/2. The company makes a final
payment of $1000 for the bond. The difference between the initial and the final price of
the bond is thus $400. According to IRS regulations, the company is able to spread out
the difference, $400, over ten years as $40 per year. This is called the original issue
discount and it is a deductible expense. The total deduction per year is thus $100,
consisting of $40 in original issue discount and $60 in interest payments. This gives an
annual tax benefit of .4(100) = $40. Finally, the company has to pay $1000 to retire the
bond. Considering the PV of all the cash flows, the NPV of this operation is zero,
20
10 100(.4)
30
1000
NPV = 600 (1 +
+
i
i
r/2) i=1 (1 + r) (1 + r)10 = 0
i=1
PV of
sale
PV of interest
payments
PV of tax
benefits
PV of final
payment
Solve the above equation at WolframAlpha with this instruction:

600-sum(30/(1+r/2)î,i=1..20)+sum(40/(1+r)î,i=1..10)-1000/(1+r)^10=0
The result is r .0805132, or 8.051%.

To do the problem on Excel, first simplify the above equation as follows.
NPV = 600
30[1 (1 + r/2)20] 40[1 (1 + r)10]

1000
+
(1 + r)10 = 0
r/2
r
Since we already know that the answer is near 7.5%, we put .075 in cell B6 as an
approximate answer. Then fill the other cells with the above equation as follows. Adjust
the value in cell B6 until the result in cell B8 comes close to 0. Finally, when the number
in cell B6 is .08051, the value in cell B8 is -0.015649569. The difference is less than 2
cents. The after-tax cost of debt for the company is 8.051%.
1
2
3
4
5
6
7
8
A
Face value of bond =
Selling price of bond =
Coupon rate =
Number of years =
Income tax rate =
After-tax cost of debt =
NPV = 0
B
1000
600
.06
10
.4
.08051
=B2-B3*B1*(1-1/(1+B6/2)^(2*B4))/B6
=B7+B5*((B1-B2)/B4+B3*B1)*(1-1/(1+B6)^B4)/B6-B1/(1+B6)^B4
(C) The stock pays $2 annually, and is redeemed five years later at $30. Using (3.5),
Y
2 + (30 25)/5
= .1091
27.50
174
9. Cost of Capital
_____________________________________________________________________________
which gives the nominal annual cost of capital to be approximately 10.91%.

There is no tax benefit of paying dividends. The following equation gives the exact result
20
.5
30
0 = 25 (1 + r/4)i (1 + r)5
i=1
For WolframAlpha, use the following instruction

0=25-sum(.5/(1+r/4)î,i=1..20)-30/(1+r)^5
The answer is approximately r = 11.43%.

(D) The cost of capital, k, to the company is the required rate of return, R, to an investor.
D1
Thus R = k in Gordon's growth model for stock evaluation, namely, P0 = R g , where P0
is the price of the stock, D1 the dividend to be paid next year, k is the cost of equity, and g
is the growth rate. This gives
k = g + D1/P0 = 0.03 + 2/15 = .1633 = 16.33%
Based on the above considerations it is cheapest to raise new capital by floating new
bonds at 13% coupon with an after-tax cost of capital of 7.8%.
9.2. Verizon Corporation has decided to issue zero-coupon bonds to raise new capital.
The company will sell these bonds at 50% of their face value and their maturity date is
set at ten years. The tax rate of Verizon is 32%, and it gets tax benefits of the original
issue discount over the life of the bond. Find the after-tax cost of this bond.
To find the after-tax cost of capital for a zero-coupon bond, we equate the present value
of cash inflows to the present value of the cash outflows, discounted at the after-tax cost
of debt.
The first cash inflow is the money that the company receives by selling the bond, namely
$500. The second set of cash inflows are the tax benefits to the company during the life
of the bond. The final cash outflow is when the company pays $1000 at the maturity of
the bonds.
The original issue discount, 1000 500 = $500, is spread uniformly over ten years. The
discount per year is thus 500/10 = $50. Let us assume that the government allows this
$50 as the cost of borrowing the money for Verizon, and that it is tax deductible. The tax
benefit arising out of it is .32(50) = $16 per year. We also have to find the present value
of these benefits for the next ten years, and add them to selling price of the bond, $500.
This is then equated to the present value of the face amount of the bond, $1000. You can
write it as the following equation,
175
9. Cost of Capital
_____________________________________________________________________________
t(F B)
F
B + n(1 + r)i = (1 + r)n
n
i=1
In this equation, we define:
B = the value of the bond when it first issued = $500,

F = the face amount of the bond = $1000,
t = income tax rate of the corporation = 32%,
n = the life of the bond = 10 years,
r = after-tax cost of debt capital, unknown.
This gives us
.32(1000 500)
1000
= (1 + r)10
i
+
r)
10(1
i=1
10
500 +
To do it on WolframAlpha, copy and paste the following instruction.

500+sum(.32*(1000-500)/10/(1+r)î,i=1..10)=1000/(1+r)^10
It gives r .0481818 = 4.818% as the after-tax cost of debt.

9.3. Colfax Markets has $200,000 in equity and $100,000 in long-term debt with interest
rate of 9%. The company needs $100,000 in additional capital, with $50,000 in equity
and $50,000 with bonds with a coupon of 9.5%. After the new financing, the company is
expected to have EBIT of $40,000, with a standard deviation of $10,000. Find the interest
coverage ratio of Colfax. Find the probability that this ratio is less than 1.
The current capital structure of the company consists of $200,000 in stock and $100,000
in bonds. The interest rate on the existing bonds is 9%. The company needs to raise
another $100,000. It will do that by selling $50,000 in stock and $50,000 in bonds, but
the new bonds will carry a coupon of 9.5%. We can find the total interest due by
multiplying the coupon rate on the bonds by their face value.
Total annual interest payment, after the new financing = 0.09(100,000) + 0.095(50,000)
= $13,750.
By definition, the interest coverage ratio is
EBIT
40000
Interest Coverage Ratio = Total interest due = 13750 = 2.909
The interest coverage ratio gives us the sense how comfortably can the company pay its
interest obligations. The interest coverage ratio can become less than 1, if the EBIT falls
below $13,750. This is quite unlikely to happen. To find the probability, we first calculate
the z-value as
z = (x )/ = (13,750 40,000))/10,000 = 2.625.
176
9. Cost of Capital
_____________________________________________________________________________
Draw the normal probability table with z = 0 in the center and z = 2.625 far to the left.
The probability that EBIT < $13,750 is represented by the area to the left of z = 2.625.
This area is quite small. Next, we check the probability tables. The result is
P(EBIT < $13,750) = .5 [.4956 + .5(.4957 .4956)] = 0.435%

EXCEL =NORMDIST(13750,40000,10000,true)
With the interest coverage ratio nearly 3, it is highly unlikely that the company will
default on its interest obligation. In reality, the companies keep some cash reserves too. If
the interest coverage ratio falls below 1, then they can still pay the interest due by dipping
into their cash reserves.
9.4. Western College, a tax exempt institution, plans to raise new capital by selling
bonds. The bonds will provide tax-free income to the investors. It may be able to sell 5year bonds with 8% coupon at 90. Or, it may issue zero coupon bonds, with 10 year term
to maturity, which will give the same return to the bondholders as the first issue.
Calculate the selling price of the zero coupon bonds.
The yield to maturity for the 5-year bonds is given approximately by
Y
C + (F P)/n 80 + (1000 900)/5

(F + P)/2 = (1000 + 900)/2 = 0.1053
The yield for the zero coupon bonds is also 0.1053. Using FV = PV(1 + r)n we get
1000 = PV(1.1053)10 which gives PV = $367.45
To find a more precise answer, we use the equation
10
40
1000
900 (1 + r/2)i (1 + r)5 = 0
i=1
For WolframAlpha, the instruction is
177
9. Cost of Capital
_____________________________________________________________________________
900-sum(40/(1+r/2)î,i=1..10)-1000/(1+r)^5=0
the answer comes out to be r = 10.85%. The value of the zero-coupon bonds is thus
PV = 1000(1.1085)10 = $356.91
9.5. Walker Corporation has currently $80 million face value bonds with a coupon of
11%, and selling at par. It has 10 million shares of common stock outstanding, which is
expected to give a dividend of $4.00 next year. The stockholders require 18% return on
their investment, and they expect the dividends to grow at an annual rate of 5%. The
company also has 100,000 shares of preferred stock which has a dividend of $6.00. The
preferred shareholders require a return of 15%. The tax rate of the company is 40%. What
is its WACC?
The cost of debt, kd = 0.11, cost of equity, ke = .18, and the cost of preferred stock, kp =
0.15. Calculate the market values of the three components of the total capital of the
company.
Market value of bonds = B = $80 million
D1
4
Using the equation P0 = R g , we get P0 = 0.18 0.05 = $30.769231 per share
Total value of common stock for 10 million shares = S = $307.69231 million
Price of preferred stock = 6/0.15 = $40 per share.
Total value of preferred stock for 100,000 shares = P = $4 million
Total value of the firm = S + B + P = V = 80 + 307.69231 + 4 = $391.69231 million
Modify equation (9.5) to include the cost of preferred stock as,
B
S
P
WACC = (1 t)kd V + ke V + kp V
WACC =
(9.6)
0.6 (0.11) (80) + 0.18 (307.69231) + 0.15 (4)

= .1564 = 15.64%
391.69231
9.6. The beta of Kenner Corporation stock is 1.25, the market return is 12%, and the
riskless rate is 6%. The dividend on Kenner next year will be $2.50, and it is expected to
grow at 3.5% annually in the future. The company has 1 million shares of common
stock, 50,000 shares of $3 preferred stock whose holders require a return of 10% on their
investment, and $10 million face value of bonds with a coupon of 5%, and maturity of 20
years. The yield to maturity for the bonds is 8%. The income tax rate of the company is
35%. Find its WACC.
Here = 1.25, E(Rm) = 0.12, r = 0.06. Using CAPM, find the cost of equity as
178
9. Cost of Capital
_____________________________________________________________________________
ke = r + i [E(Rm) r]
we get
(9.3)
ke = 0.06 + 1.25(.12 0.06) = 0.135
D1
2.5
The stock price per share is P0 = R g = 0.135 0.035 = $25
The total value of the stock for 1 million shares, S = $25 million.
The price of preferred stock = 3/0.1 = $30 per share
Total value of 50,000 preferred shares = 50,000 (30) = $1,500,000.
The yield to maturity of the bonds is not only the pre-tax cost of debt capital to the
company, but it is also the proper discount rate to evaluate the bonds. The annual interest
on the bonds is .05(10,000,000) = $500,000. The semiannual interest is half of that,
$250,000, with 40 payments. The market value of the bonds is thus
250000 10000000
1.04i + 1.0440 = $7,031,084
i=1
40
B=
Total value of the firm = 25,000,000 + 1,500,000 + 7,031,084 = $33,531,084

WACC =
(1 .35) (0.08) (7,031,084) + 0.1 (1500,000) + 0.135 (25000000)

33531084
= 11.60%
9.7. Shrike Company has 2 million shares of its common stock outstanding and they are
priced at $40 each. The current dividend is $3 per share, which is expected to grow at the
rate of 5% annually in the future. Shrike also has $40 million in long term bonds selling
at par with a coupon rate of 8%. It has 1 million shares of preferred stock with dividend
of $2 per share, and these shares yield 9% to the shareholders. The income tax rate of
Shrike is 36%. Find its WACC.
Using (9.2), find the cost of equity as
ke =
D0(1 + g)
+ g = 3(1.05)/40 + 0.05 = 0.12875
P0
Further, kd = 0.08 and kp = 0.09 are given.

The value of the stock and bonds are: S = $80 million, B = $40 million.
The total value of the preferred stock is P, where
179
9. Cost of Capital
_____________________________________________________________________________
P=
2000000
= $22.222 million
.09
The total value of firm, V = 80 + 40 + 22.222 = $142.222 million

Combining all these factors,
WACC =
(1 .36)(.08)(40) + .12875(80) + .09(22.222)

= 10.09%
142.222
9.8. Southern Inns has 12% cost of debt and 18% cost of equity. At present it has $100
million (face amount), 8% coupon, 10-year bonds that pay interest semiannually. It also
has 5 million shares of common stock selling at $25 each. The tax rate of Southern Inns is
30%. Find its WACC.
First, find total the market value of the bonds. The discount rate is r = 12% per annum =
.06 semiannually. With 8% coupon, the annual interest is $8 million, and semiannual
interest $4 million. There are 10 years to maturity, or 20 semiannual payments. Thus,
n
20
C
F
4
100
B = (1 + r)i + (1 + r)n = 1.06i + 1.0620 = $77.060 million.
i=1
i=1
The total market value of the stock, S and the market value of the company, V are:
S = 5(25) = $125 million, and V = 125 + 77.060 = $202.060 million.
With kd = .12, ke = .18, and t = .3, the WACC of the company is thus
WACC = (1 0.3)(0.12)(77.06/202.06) + 0.18(125/202.06) = 14.34%
9.9. Vermont Corporation common stock sells for $40 a share. It will pay a dividend of
$4 next year, which is expected to grow at the rate of 5% annually. Vermont $5 preferred
stock is selling for $39 a share. The company also has perpetual bonds with coupon 3%,
but they sell at 35% of their face value. Vermont has a tax rate of 35%; it has 5 million
shares of common stock; 1 million shares of preferred stock; and $300 million (face
amount) of bonds. Using the existing capital, should Vermont undertake a project with a
return of 17%?
Find the cost for different components of the capital.
Using Gordon's growth model (9.2), ke = D1/P0 + g = 4/40 + .05 = 0.15.
From (3.2), for a perpetual bond, its market value B is the ratio between the annual
interest payment, C, and the required rate of return by the bond holders, r. That is, B =
C/r. In this case, B = $350 and C = $30 per year. The required rate of return for a
180
9. Cost of Capital
_____________________________________________________________________________
bondholder is thus $30/$350 = 0.08571. Now r is also the pretax cost of debt. Thus r = kd
= 30/350 = 0.08571.
The preferred stock has no growth in dividends. Using (9.2), the cost of capital for
preferred stock is thus kp = 5/39 = 0.1282.
The market value of the stock, S = 5*40 = $200 million.
The market value of the bonds, B = .35*300 = $105 million.
The market value of the preferred stock, P = 39*1 = $39 million.
The total value of the company, V = 200 + 105 + 39 = $344 million.
WACC = (1 .35)*.08571*105/344 + .15*200/344 + .1282*39/344 = 11.88%
With the cost of capital around 12%, a project with a return of 17% is quite attractive,
provided the risk of the new project is the same as the risk of the existing projects of the
company.
9.10. Crookes Corporation has the following capital structure: $25 million (face amount)
of bonds with coupon 5%, which will mature in 10 years and sell at 70% of the face
value; and 5 million shares of stock priced at $10 each. It is estimated that the difference
between the cost of debt and equity is around 5%. The tax rate of Crookes is 30%. Find
its WACC.
Find the cost of debt, kd as the yield to maturity of the bonds, given by equation (3.5). Put
F = $1000, B = $700, n = 10 years, and cF = .05(1000) = $50
kd = Y =
cF + (F B)/n 50 + (1000 700)/10

= 9.41%
(F + B)/2 =
(1000 + 700)/2
Cost of equity is 5% higher than the cost of debt, ke = 14.41%,

Market value of the bonds, B = 0.7(25) = $17.5 million,
Market value of the stock, S = 5*10 = $50 million,
Total market value of the company, V = $67.5 million,
Income tax rate, t = 0.3
Thus
WACC = 0.7(0.0941)(17.5/67.5) + 0.1441(50/67.5) = 12.38%
Problems
9.11. Ellington Corporation has tax rate of 35%. It may raise new capital in one of the
following three ways. Find the after-tax cost of new capital.
(A) By selling common stock at $45 a share which will pay a dividend of $4 next year
which is expected to further grow at the rate of 5% per annum forever.
13.89%
181
9. Cost of Capital
_____________________________________________________________________________
(B) By selling 8% bonds at 90 that will mature in 10 years.
~6.158%, 6.318% exactly
(C) By selling $8 preferred stock at $75 a share, redeemable at par after 5 years.10.67%
9.12. Aliquippa Company wants to issue discount bonds with a market value equal to
30% of their face value. The bonds will carry 6% coupon, paying interest semiannually,
and they will mature after 10 years. The income tax rate of Aliquippa is 40%.
(A) Calculate the approximate yield-to-maturity of the bonds and the after-tax cost of
debt for Aliquippa.
YTM 20%, after-tax cost of debt 12%
(B) Using the concept of original issue discount, write an equation that gives the after-tax
cost of debt for Aliquippa. Solve this equation by using Excel or Maple.
14.66%
9.13. Taf Company has the following capital structure: 5 million shares of stock, selling
at $25 each, with = .9; zero-coupon bonds with face amount $50 million, maturing in
10 years, with yield to maturity 8%; and 1 million shares of preferred stock selling at $12
per share, paying a dividend of 30 per quarter. The income tax rate of Taf is 40%. The
riskfree rate is 6%, and the expected return on the market 16%. Find the weighted
average cost of capital for Taf.
13.15%
9.14. Procyon Corporation has 55% debt and 45% equity (market values) in its capital
structure. The pretax cost of debt is 10%, and that of equity 15%. The total value of the
company is $15 million and its income tax rate is 35%. Procyon has to raise $2 million in
new capital, which will make the EBIT of the company to be $4 million, with a standard
deviation of $2 million. The company has decided to raise the new capital half with debt
and half with equity at the existing rates. Calculate Procyon's new WACC, and the
probability that its interest coverage ratio (ICR) will be less than one.
WACC = 10.38%, P(ICR < 1) = 6.21%
9.15. Mercury Corporation stockholders expect a growth rate of 4% in the company, and
a dividend of $1.00 next year. The Mercury stock is currently selling for $10 a share.
There are 3 million shares of the common stock. The company also has $50 million face
value zero-coupon bonds which will be due after 10 years. The bondholders have a
required rate of return of 8%. Mercury has a tax rate of 35%. Find its WACC. 10.17%
9.16. Blue Grass Co has the following capital structure. It has 2 million shares of
common stock selling for $20 each. The stock will pay a dividend of $2 next year and
this dividend is expected to grow at the rate of 5% annually. Blue Grass has just raised
$20 million by selling 10% coupon bonds at par. Blue Grass also has 1 million shares of
preferred stock which pays a dividend of $1.50 annually, and the preferred shareholders
have a required rate of return of 12%. Blue has a 35% income tax rate. Find the WACC of
12.14%
Blue Grass.
9.17. Heisenberg Corporation has the following capital structure: $60 million (face
value) of 11% bonds selling at 95, maturing after 10 years; 10 million shares of common
182
9. Cost of Capital
_____________________________________________________________________________
stock selling at $10 each, with current dividend of $1.00 annually; and one million shares
of preferred stock selling at $40 each and paying an annual dividend of $5. The common
dividends are expected to grow at the rate of 3% annually, and the company's tax rate is
30%. Find the WACC of Heisenberg.
11.68%
9.18. Libra Corporation has debt/assets ratio of .4, its cost of debt is 9% and that of
equity 13%. The tax rate of Libra is 30%. The company is not growing and its dividend
payout ratio is 100%. Libra has 2 million shares of common stock, with a dividend of $2
per share. Find the price per share of Libra, its total value, and its WACC.
$15.38, $51.28 million, 10.32%
9.19. Haig Co has 4 million shares of common stock selling at $45 each. It has $70
million (face value) of bonds, with 6% coupon, maturing in 5 years, and selling at 90.
The difference between the cost of debt and the cost of equity for Haig is estimated to be
6%. The tax rate of Haig is 30%. The firm also has 2 million shares of preferred stock
that pay annual dividends of $5 each. The preferred shareholders get a return which is 2%
less than the return of the common shareholders. Find the WACC of Haig.
WACC = 12.26%
9.20. Hall Corporation has 40 million shares of common stock, priced at $7.25 per share,
with = 1.5. The company has $200 million in bonds, selling at 80% of their face value
and maturing after 10 years. The CFO at Hall has calculated the WACC of the company
as ~12.491%. The company has income-tax rate 35%, the risk-free rate is 6%, and the
expected return on the market is 12%. Find the coupon rate on the bonds.
9%
Key Terms
bonds, 152, 153, 154, 157,
160, 161, 162, 163, 164,
165, 166, 167, 168
capital, 152, 156, 157
convertible bonds, 153
cost of capital, 152, 158, 160,
165, 166
cost of debt, 153, 156, 158,
167
cost of equity, 156
debt, 152, 153, 154, 156, 157,
158, 159, 160, 161, 163,
165, 166, 167, 168
dividends, 153, 156, 158,

160, 163, 167, 168
equity, 152, 153, 156, 157,
158, 160, 161, 163, 164,
165, 166, 167, 168
Gordon's growth model, 156,
160, 165
junk bonds, 154
original issue discount, 152,
154, 159, 160, 167
preferred stock, 152, 153,
163, 164, 165, 167, 168
risk premium, 156
183
stock, 152, 153, 156, 157,

158, 160, 162, 163, 164,
165, 166, 167, 168
WACC, 158, 163, 164, 165,
166, 167, 168
warrants, 153
weighted average cost of
capital, 152, 158, 167
10. CAPITAL STRUCTURE THEORY: VALUE MAXIMIZATION

1. Maximize the EPS for a firm using either debt or equity.
2. Use the critical, or indifference EBIT, to decide the use of debt or equity.
3. Understand the concept of tax shield and bankruptcy costs.
4. Find the value of a leveraged firm.
10.1
Capital Structure of a Firm
Investors provide the capital to a corporation. They do so by buying the stock or the bonds
of that company. The company merges the money acquired from stockholders and
bondholders in a pool and does its business with that capital.
Consider a firm financed entirely by the capital provided by the stockholders. It is an allequity firm with no debt. The company is in a strong financial position because it does not
have to worry about interest payments. Is it a good idea to run a company that way? No,
because we have already seen that the cost of debt is less than the cost of equity. That is
why in real life the corporations carry fairly large amounts of debt. Fig. 10.1 shows the
capital structure of two companies with different percentages of debt and equity.
(A)
(B)
Fig. 10.1: Capital structure of a firm (A) with 75% equity and 25% debt, (B) with 25% equity and 75% debt.
We know that debt is less costly than equity, why not finance a company entirely with
debt? Perhaps we should have 75% debt and 25% equity. The problem with this setup is
that in case of a lean year, or perhaps even a bad quarter, the company may not have enough
money to pay the interest due on the bonds. We also know that the bondholders have the
right to force the company into liquidation in case of default. To avoid this unpleasant
outcome, companies should avoid having too much debt.
184
10. Capital Structure Theory: Value Maximization
_____________________________________________________________________________
Is there an optimal mix of debt and equity for a company? Yes. Ideally, the optimal mix of
debt and equity will maximize the value of a firm. It will possibly maximize its earnings
per share. Perhaps the optimal capital structure will minimize the weighted average cost of
capital for the corporation. We shall explore all these possibilities.
The debt capacity of a company depends upon its line of business, the level, and
consistency of its earnings, and the need for new capital. The managers of a firm are
supposed to maximize the value of the firm. One quick and easy way to measure their
performance is to look at the value of the stock as it is published daily.
10.2
EBIT-EPS Analysis
One way to improve the value of a stock is to increase its earnings per share, as defined by
(10.1). It is easy to look up the price-earnings ratio of stocks, which gives the investors a
snapshot of the financial health of the company. The P-E ratio is the ratio between price
per share and earnings per share of a stock. A stock with a lower P-E ratio, among similar
stocks in the same industry, is more attractive to the investors because its price is relatively
less. As more and more investors buy that stock, they will bid up its price and increase the
P-E ratio.
Is it possible to enhance the expected earnings per share of a company by judicious use of
financing for new projects? The answer is yes.
The following diagram represents roughly the flow of funds in a corporation
Revenues
fixed costs variable costs

depreciation
Earnings before interest

and taxes, EBIT
Earnings before taxes,

EBT
Earnings after taxes, EAT
interest, to bondholders (1)
income tax, to government (2)

sinking fund, to retire some debt (3)
dividends, to preferred stockholders (4)
dividends, to common stockholders (5)
Retained earnings, RE
added back to the equity of the firm
Fig. 10.2: The diagram shows the flow of funds in a corporation.
185
_____________________________________________________________________________
The earnings-per-share is defined as

Total earnings after taxes
EAT
EPS = Number of shares of stock outstanding = N
(10.1)
Suppose a company is need of additional financing worth F dollars, which it can raise by
either selling new bonds or new stock. To find the method of raising new capital that will
maximize its EPS, let us define:
EBIT = expected earnings before interest and taxes after the new financing
EPS = earnings per share, after the new financing
I = interest that has to be paid on existing debt, if any
SF = sinking fund payments on existing debt, if any
PD = dividends on preferred stock, if any
t = corporate income tax rate
N = number of shares of stock outstanding
F = amount of new financing required
r = rate of interest on debt, if bonds are used for new financing
P = price per share of stock, if equity is used for new financing
The interest paid on the bonds is tax deductible. Thus the taxable income is (EBIT I), and
the amount of tax paid is (EBIT I)t. The amount left after paying taxes, or, earnings after
taxes, EAT is
EAT = (EBIT I)(1 t)
(10.2)
After paying the sinking fund payments and the dividends to preferred stockholders, we
have (EBIT I)(1 t) SF PD. This amount is available to common stockholders
because we have satisfied all other claims. This the earnings after taxes, EAT. Thus, the
EPS comes out to be
(EBIT I) (1 t) SF PD
EPS =
(10.3)
N
Suppose the company goes ahead and sells bonds with face value F and coupon rate r. The
interest payable on the bonds is rF, which adds to the interest due. After this new financing,
the new EPS is given by
EPS(bonds) =
(EBIT I r F) (1 t) SF PD
N
(10.4)
If the firm decides to use equity for new financing, it will sell new stock to raise capital.
The number of shares of new stock is F/P, where F is the total amount of new financing
and P is the price per share. This increases the total number of shares, making it N + F/P.
There is no change in the interest due; it is still I. The EPS in this case is
EPS(stock) =
N + F/P
186
(10.5)
_____________________________________________________________________________
The financing that gives the greater EPS is clearly the better choice. It is also possible to
find the new EPS when a combination of debt and equity is used for the new capital.
Rewrite (10.3) as
EPS(bonds) =
EBIT (1 t) (I + r F) (1 t) + SF + PD
N
N
Recall the equation of a straight line in the intercept form, namely,

y=mx+b
where m is the slope, and b the y-intercept. Note that the relationship between EPS and
1t
, and a
EBIT is linear, and that the line representing them will have a positive slope
N
(I + r F) (1 t) + SF + PD
negative y-intercept,
N
Similarly, write (10.4) as
EPS(stock) =
EBIT (1 t) I (1 t) + SF + PD
N + F/P
N + F/P
I (1 t) + SF + PD
, but it is smaller in
N + F/P
1t
magnitude compared to the previous case. The slope is
, which is also less than
N + F/P
the previous slope. Let us represent it on a diagram as shown below. The critical EBIT is
at the intersection of the two lines. If the expected EBIT is higher than the critical point
then bond financing is the better alternative.
The intercept for this line is also negative,
In Fig. 10.3, the critical EBIT is at the intersection of the two lines. This is also the point
where the EPS for the bonds equals the EPS for the stock.
An alternate way to do the EBIT-EPS analysis is to find the critical EBIT where the EPS
for the two types of financing is equal. Use the right hand sides of equations (10.4) and
(10.5), and set them equal to one another. We designate the critical EBIT by E*.
(E* I r F) (1 t) SF PD (E* I) (1 t) SF PD
=
N
N + F/P
We can solve the above equation by using Maple as follows
((e-i-r*F)*(1-t)-SF-PD)/N=((e-i)*(1-t)-SF-PD)/(N+F/P);
solve(%,e);
simplify(%);
187
_____________________________________________________________________________
Fig. 10.3. EPS for various EBIT, the intersection of lines is the critical EBIT.
The result comes out to be

E* = I + r(NP + F) +
SF + PD
1t
(10.6)
If the sinking fund term and the preferred dividends are missing, then the equation becomes
much simpler,
E* = I + r(NP + F)
(10.7)
In (10.7), I = interest due on the current debt of the corporation

r = coupon rate on the new bonds, if the company uses debt for new financing
N = number of current shares of the company
P = price per share for new shares, if the company uses equity financing
F = amount of new capital required by the company
Once E* is found by using the above expression, then we use the following decision rule,
If E(EBIT) > E*, use bonds
If E(EBIT) < E*, use stock
Fig. 10.4. Decision rule for using stock or bonds for new financing.
If the expected EBIT after the financing is known along with its standard deviation, then it
is possible to calculate the probability of getting the interest coverage ratio to be less than
one, or the probability of having made the right decision. In Fig. 10.3, the two lines intersect
188
_____________________________________________________________________________
at the point where EBIT is $4.929 million. Since the actual EBIT is $6 million, the bonds
should give a higher EPS.
The previous discussion of EBIT-EPS analysis is myopic in nature. It looks at the EBIT
for the next year only. For example, a firm may opt for debt financing because its expected
EBIT is high, well over the critical E*. If the EBIT for subsequent years is much lower, the
company will not benefit from debt financing. In the next section, we consider the longterm effects of debt financing, or leveraging.
10.3
Tax Shield, Bankruptcy Costs, and Optimal Capital Structure
As we have already seen, the cost of debt is lower than the cost of equity, it is desirable to
include debt financing in the capital structure. It is tempting to have a lot of debt and very
little equity. The drawback of this arrangement is that the company is overly exposed to
default risk. If the bondholders do not receive their interest payments on time, they can
force the company into bankruptcy. If the earnings of a company before payment of interest
or taxes are 5 or 6 times the amount of interest due, then the company is in a rather safe
position. If this interest coverage ratio is down to about 1.25, then there is substantial
probability of default.
Although debt is less expensive form of capital, too much of it can cause serious financial
problems for the firm. The lenders and stockholders foresee this and both expect higher
returns on their investment. Higher required rate of return will force the price of a security
downward. This will result in lower bond and stock prices and hence a lower overall value
of the firm. How can the management increase the value of a firm? It is possible by having
an optimal mix of debt and equity.
One cannot find the optimal blend of capital by an established formula. The company has
to base its decision on several variables, primarily on expected earnings and the stability
of earnings. If the earnings are high and quite stable, the company can afford to have more
debt. For a corporation with erratic earnings it is safer to finance the projects mostly with
equity.
If an all-equity firm wants to replace some equity with debt, it can do so by issuing bonds
and using the proceeds from the sale of bonds to repurchase its common stock. This
procedure will lower its WACC, which will increase its value. This increased value is really
due to the "tax shield" provided by the deductibility of interest from the income before
paying taxes. The present value of all future tax savings equals the tax shield, that is, the
increase in the value of the company.
Suppose a company is initially unleveraged, that is, it has no debt. Next, it issues a certain
amount of bonds, B, and uses the proceeds to buy back its own stock. The company is just
replacing one form of capital with another form of capital, without changing its physical
characteristics. If the bonds carry a coupon r, then the annual interest paid on these bonds
is rB. This interest is tax deductible. This means, the company is not paying interest on the
amount rB. The resulting tax savings is trB, where t is the tax rate of the company.
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Once the company issues this debt, it will save an amount trB in taxes every year until the
debt is paid off. At that time, the company will issue new debt and thereby continue this
tax benefit forever. The company is thus increasing its value by an amount equal to the
present value of all future tax savings. This comes out to be
trB
PV = (1 + i
r)
i=1
We may solve this by using the formula for the present value of perpetuity,
(1 + r)i = r
i=1
(2.7)
With C = trB in the above equation, we find

Tax shield = tB
(10.8)
The above equation assumes that the discount rate of the tax savings equals the coupon rate
of the bonds. This assumption is not exactly right because the bonds introduce more risk
in the company. In other words, the tax shield is somewhat less than tB and (10.8) is only
an approximation.
This increase in value is linearly proportional to the amount of debt issued. However, the
increase cannot go on unchecked. After a while, the firm takes on too much debt and it
becomes too risky. This increases the probability of bankruptcy, and hence the concomitant
bankruptcy costs increase too. Higher bankruptcy costs then reduce the value of the firm
at an ever-increasing rate. The net result is that the firm falls in value rapidly. There is a
certain point where the firm reaches its maximum value due to the right amount of equity
and debt in its capital structure. This point represents the optimal capital structure of the
company.
Figure 10.5 illustrates the impact of debt on the value of a firm. Starting with the
unleveraged value VU, the value rises steadily with the increasing debt. However, the
bankruptcy costs become more and more important with growing debt and the value
reaches a peak when the amount of debt is at its optimal level. This represents the optimal
capital structure of the firm. We may represent these concepts by the equation
VL = VU + tB b
where VL = value of the leveraged firm
VU = value of the unleveraged firm
tB = tax shield provided by the debt B
b = bankruptcy costs
190
(10.9)
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The above equation provides a simple way of expressing the value of a leveraged firm
including the bankruptcy costs. The main difficulty is that no analytical formula exists,
which can calculate the bankruptcy costs.
To find the change in the value of a leveraged firm when it undergoes a change in its capital
structure, we may write equation (10.9) in its differential form as follows,
VL = tB b
(10.10)
This equation says that the change in the total value of the corporation, VL is the result of
two changes. First, a positive change due to tax shield provided by additional debt, tB,
and second, a negative change due to higher bankruptcy costs, b. Equation (10.10) is
useful in calculating the change in the value of a company when it undergoes a change in
its capital structure.
Consider the example of a corporation, which issues $10 million in new debt and buys back
its own stock from the proceeds. If its tax rate is 30%, it will increase its value by tB =
.3(10) = $3 million. If its bankruptcy costs increase by $1 million, then its value will
decrease by that amount. The net change in value will be $2 million, as predicted by
(10.10).
In a similar manner, an overleveraged company may reduce its debt by issuing additional
equity and buying back its own bonds. Since the company has reduced its debt, it is less
likely to go bankrupt and its bankruptcy costs will decrease. Reduction in bankruptcy costs
mean higher value of the company. At the same time, the lowering of debt reduces its tax
shield, and its total value. The net change in the value of the company is again given by
(10.10).
When a company finds itself in a financial crisis, it tries to seek refuge in a bankruptcy
court. It presents its case in a federal court, asking for some time to find a solution to its
financial troubles, while the creditors do not demand any payments. If the federal judge
approves their financial plan, he appoints a trustee that oversees the financial dealings of
the corporation. The company must sell many of its assets to pay off the creditors. If it is
successful in raising enough money, it can get back on its feet. If the assets of the firm are
too small, then the judge has to decide how to distribute the money to various claimants.
The bankruptcy costs are either explicit or implicit. Some of the explicit costs are as
follows: legal bills, filing fees, trustee's fees, the losses incurred when the assets are sold
piecemeal. The value of the various components of the firm is much less than the value of
the viable, moneymaking enterprise that it once was.
When the company is in financial difficulty, the suppliers become wary and they demand
the payment up front, in cash, which is already in short supply. The company is unable to
get trade credit. The banks also try to collect their loans from the firm. The customers tend
to desert a company that they expect will go out of business soon. All these factors add to
the implicit cost of bankruptcy.
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Fig. 10.5 shows a firm with unleveraged value $10 million and tax rate 30%. The straight
line represents the value of the firm if it could increase its value by tax shield alone. The
value will reach $12.4 million when the debt is $8 million. The curve represents the more
realistic situation including bankruptcy costs. In this case the firm reaches a peak value of
$11.017 million when it takes on the optimal debt B* = $4.613 million. When the debt is
$8 million, the value of the firm is reduced to $7.54 million.
Figure 10.5. The diagram shows the leveraged value of a firm. The upward sloping straight line represents
the value added to the firm due to tax shield tB. The increased bankruptcy costs force the value downward,
resulting in the curved line as the actual value of the firm. The peak of the curved line represents the optimal
capital structure of the firm.
Consider a simple example. A company has the following capital structure: $60 million in
equity and $40 million in debt. The total value of the company is $100 million. Its
debt/assets ratio is 40%.
The company keeps $10 million in a checking account and invests the remaining $90 in
other assets. One day the company decides to use all its cash to buy its own stock. Now the
company has no cash, $50 million in outstanding stock, and $40 million in debt. The total
value of the company is now 40 + 50 = $90 million. The debt/assets ratio is 40/90 44%.
Since the company has no cash, it is unable to pay its bills on time. It struggles to pay its
workers and suppliers with the new income that it generates. If the word gets around that
the company will not be able to pay the interest on its debt obligation, the threat of
bankruptcy rises. Suppose the bankruptcy costs, which are directly related to the
probability of going bankrupt, increase by $5 million. As a result, the value of the company
falls to $85 million. The debt is still $40 million and the debt/assets ratio of the company
will now be 40/85 47%.
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Altogether, the debt ratio has increased from 40% to 47%. This is an extreme case and it
illustrates the relationship between available cash, debt, equity, bankruptcy costs, and
debt/assets ratio of a company.
What should a company do when it is facing a cash crunch? It must raise new capital by
selling stock or bonds, whichever is more advantageous, and keep enough cash on hand.
Note that not all stock buybacks are bad news. If a company is underleveraged, it can
increase its debt ratio by buying back its own stock. If the stock price is depressed in the
market, the managers of the company may buy their own stock at bargain prices.
The real world companies have to make decisions to reduce their debt (Ford), or buy their
own shares (Dollar General). Are they making the right decision? Companies have to
choose between debt or equity in raising new capital. They can decide by looking at the
resulting expected EPS. As the following problems illustrate, they can find the probability
of being right.
Examples
10.1. Florida Company, which is an all-equity firm, wants to raise $5 million in new
capital. After the new financing, its EBIT is expected to be $5 million, with a standard
deviation of $2 million. The company currently has 2 million common shares selling at
$10 each. The company can either sell stock at $9.75 a share, or sell bonds at par with a
coupon of 12%. What is the better method of financing, debt or equity? What is the
probability that you are right in your decision?
Use
EBIT* = I + r(NP + F)
(10.7)
Since the company is an all-equity firm, it has no existing debt and no interest to pay. Thus
I = 0. The interest rate on the new debt is 12%, which makes r = .12. The new financing is
F = $5,000,000. The existing number of shares, N = 2,000,000. The price per share, P =
$9.75. Substituting these values, we get
EBIT* = 0.12 [2,000,000 (9.75) + 5,000,000] = $2,940,000
Since the expected EBIT = $5 million, is greater than EBIT* = $2.94 million, it is preferable
to use bonds.
The probability of making the right decision is equal to the probability that E(EBIT) is
more than E*.To find the probability that the chosen method is the correct one, first find
the z-value,
z = (x )/ = (2.94 5)/2 = 1.03
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Draw a normal probability distribution curve with z = 0 in the center and z = 1.03 to the
left of center. The shaded area, to the right of z = 1.03 represents the probability of EBIT
to be more than $2.94 million. Since the probability is more than 50%, we find from the
tables
P(EBIT > 2.94) = .5 + .3485 = .8485
The probability that using bond financing is the right decision is about 85%.
EXCEL =1-NORMDIST(2.94,5,2,true)
10.2. Fisher Corporation is an all-equity firm with 1 million shares outstanding, each
selling for $50. The company needs $10 million for expansion. It can raise the new capital
entirely by bonds with 8% coupon. Alternatively, it can raise $5 million in bonds with
coupon 7.5%, and $5 million in stock, at $47.50 a share. The EBIT for next year has a
normal distribution, with a mean of $4 million and standard deviation of $2 million.
Fishers marginal tax rate is 40%. Based on EBIT-EPS analysis, which method is better?
For the preferred method, what is the probability that the interest coverage ratio is less than
one?
First, calculate the earnings per share in each case using (10.4) and (10.5).
For $10 million in debt, we get
EPS(bonds) =
(EBIT I r F) (1 t) (4 .08*10)(1 .4)

=
= $1.92
N
1
For $5 million in debt and $5 million in equity, we find the interest as .075*5 ($ million)
and the number of additional shares as 5/47.5 (million).
EPS(bonds and stock) =
(EBIT r D) (1 t) [4 .075*5] (1 0.4)

=
= $1.97
N+n
1 + 5/47.5
Since the second method gives a higher EPS, it is better to use half debt and half equity to
acquire new capital.
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For the preferred method, the interest payments for the year will be 7.5% of $5 million, or
.075*5 = $0.375 million. The probability that EBIT is less than $0.375 million is quite
small, much less than 50%. Find it by calculating z,
z = (.375 4)/2 = 1.8125
Draw a normal probability distribution curve with z = 0 in the center and z = 1.8125 well
to the left of center. The shaded area, under the tail of the curve, represents the probability
of EBIT to be less than $0.375 million. From the table, we get it as
P(EBIT < .375) = .5 [.4649 + .25(.4656 .4649)] = .0349 = 3.49%
EXCEL =1-NORMDIST(.375,4,2,true)
10.3. Hamburg Company has the following capital structure: 10 million shares of common
stock selling at $25 a share; 7% bonds with face value $100 million, selling at 90; 1 million
shares of $5 preferred stock, selling at $30 a share. Hamburgs tax rate is 35%. The
company has to raise $10 million in additional capital, either by selling bonds with coupon
8%, or by selling common stock at $25 a share. The EBIT of the company, after new
financing, is expected to be $50 million, with a standard deviation of $20 million. The
company must also pay $4 million of principal payments to the previous bondholders.
What is the better method of financing? For the method selected, what is the probability
that the company will be able to pay interest, sinking fund payments, and preferred-stock
dividends out of its current EBIT?
Use (10.4) and (10.5) to find the EPS for each type of financing.
For bonds, EPS =
=
For stock, EPS =
(EBIT r1D r2F) (1 t) SF PD

N
[50 .07*100 .08*10] (1 .35) 4 5
= $1.843
10
(EBIT r1D) (1 t) SF PD
N + F/P
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[50 .07*100] (1 .35) 4 5

= $1.822
10 + 10/25
Based on the EBIT-EPS analysis, bond financing is slightly better.

The company has to pay the following current obligations: (a) interest, 7% on $100 million
on old debt plus 8% on $10 million in new debt, (b) taxes at the rate of 35%, (c) sinking
fund payments, $4 million, and (d) dividends for preferred stock, $5 million. The minimum
EBIT to cover all that is given by
(EBIT .07*100 .08*10) (1 .35) 4 5 = 0
EBIT = $21.646 million
Since the company expects to have $50 million in EBIT, the probability is well over 50%
that it will have $21.646 million. To find the probability, find z-value as
z = (21.646 50)/20 = 1.4177
Draw a normal probability curve, with z = 0 in the center and z = 1.4177 left of center.
The area to the right of z = 1.4177, which is more than 50%, gives the answer. From the
table, we get the result.
Prob(EBIT > 21.646) = .5 + .4207 + .77(.4222 .4207) = .9219 = 92.19%
10.4. Neptune Corporation has a dividend payout ratio of 40% and its tax rate is 40% as
well. Not expected to grow in the next several years, the annual dividend of Neptune is
$3.00. The stockholders have a required rate of return of 14%. The company has $100
million face value of bonds with a coupon of 9% selling at 93.75, and it has 20 million
shares of common stock. Find the EBIT and the total value of the company.
Since 40% of EPS is paid out as a $3.00 dividend,
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0.4(EPS) = 3, or EPS = $7.50

Use
EPS =
N
(10.3)
Put EPS = $7.50, I = .09*100 = $9 million, t = .4, SF = PD = 0, and N = 20 million.

7.50 =
which gives
EBIT = 20*7.50/.6 + 9 = $259 million
From Gordon's growth model,

one gets
(EBIT 9) (1 .4)
20
P0 =
D1
Rg
(3.6)
3
P0 = .14 0 = $21.43 per share
Total value of stock = 21.43*20,000,000 = $ 428.571 million

Value of debt = $93,750,000
Total value of the firm = 428.571 + 93.75 = $ 522.321 million
10.5. Janus Corporation has the following capital structure: 40 million common shares
each selling at $12; 7% bonds with face value $300 million priced at 65; and 1 million
shares of $6 preferred stock selling for $50 each. The tax rate of the company is 35%. Janus
needs $50 million in new capital, either debt or equity, whichever one gives higher earnings
per share. Janus can sell the new bonds at par with a coupon of 11%, and the new stock at
$11 a share, net. After the new financing, Janus expects its EBIT to be $70 million with a
standard deviation of $20 million.
(A) Find the EBIT, which will make Janus indifferent toward debt or equity financing.
(B) Which form of financing is better?
(C) For the recommended financing, find the probability that Janus is unable to meet its
preferred dividends from the current EBIT.
Use
E* = I + r(NP + F) +
SF + PD
1t
(10.6)
to find the critical EBIT, where Janus is indifferent between debt and equity. In (10.6),
I = the interest on the existing debt, is .07*300 = $21 million
r = the coupon rate on new debt is 11%
N = the number of existing shares, is 40 million
P = the price per share of the new stock is $11
F = the amount of new capital, is $50 million
SF = the sinking fund payment, is zero
PD = the amount of preferred dividends, is $6 million
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t = the tax rate is 35%. This gives

0+6
E* = 21 + .11(40*11 + 50) + 1 .35 = $84.131 million
Since the expected EBIT, $70 million, is less than the critical value, it is better to use equity
financing.
The minimum EBIT to cover interest, taxes, and $6 million in preferred dividends, in that
order, is given by
(EBIT 0.07*300) (1 .35) 6 = 0
Solving for EBIT, we get the minimum EBIT as $30.23 million. Since the company expects
to have $70 million EBIT, the probability that EBIT will be less than $30.23 million is quite
small. To find it, calculate z.
z = (30.23 70)/20 = 1.9885
Draw a normal probability curve, with z = 0 in the center and z = 1.9885 left of center.
The small area, to the left of z = 1.9885, under the tail of the curve gives the answer. From
tables,
P(EBIT < 30.23) = .5 [.4761 + .85(.4767 .4761)] = .0234 = 2.34%
EXCEL =NORMDIST(30.23,70,20,true)
10.6. Robin Corporation has the following capital structure: $30 million in long-term
bonds selling at par with interest rate 9% and requiring a sinking fund payment of $3
million annually; 1 million shares of common stock selling at $50 each; and 1 million
shares of preferred stock selling at $10 each and paying a dividend of $1. The common
stockholders have a required rate of return of 15% on their investment. The income tax rate
for Robin is 35%. Robin needs $5 million in additional capital, which it can raise by selling
either common stock or bonds at the existing capital costs. The expected EBIT after the
new financing will be $18 million with the standard deviation $6 million. Based on the
EBIT-EPS analysis, find the preferred method of raising the new capital. Calculate the
probability that you have made the right choice.
First, find the critical EBIT from
E* = I + r(NP + F) +
Which gives
SF + PD
1t
(10.6)
3+1
E* = .09*30 + .09(1*50 + 5) + 1 .35
This gives E* as $13.804 million. Since the expected EBIT is $18 million, it is better to use
bond financing.
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In order to be right in this decision, the company should make at least $13.804 million in
EBIT. To find the probability of that happening, we first calculate the z-value as
z = (13.804 18)/6 = 0.6994
Draw a normal probability curve with z = 0 in the center and z = 0.6994 to the left of
center. The area to the right of z = 0.6994, under the hump of the curve, which is more
than 50%, gives the result. From the tables,
P(EBIT > 13.804) = .5 + .2549 + .94(.2580 .2549) = .7578
The probability of being right is close to 76%.
10.7. Defoe Company has $75 million in long-term bonds with 8% coupon; and 10 million
shares of common stock priced at $25 each. Defoe needs another $10 million in new
capital, which it may raise by selling bonds with 8.5% coupon, or by selling stock at $23
per share, net. The company has to pay $3 million in preferred dividends. Find the EBIT of
the company after the new financing which will make the EPS for bond and stock financing
to be equal. If the company expects to have EBIT of $17 million, what type of financing
will maximize the EPS. The income-tax rate of the company is 30%.
First, find the critical EBIT using
E* = I + r(NP + F) +
SF + PD
1t
(10.6)
0+3
E* = .08*75 + .085(10*23 + 10) + 1 .3 = 30.686
For $30.686 million in EBIT, the company will be indifferent towards stock or bond
financing. Since the expected EBIT is $17 million, it is better to use stock financing.
10.8. Cockcroft Corporation at present has $30 million in debt, and $60 million in equity.
It has decided to raise $10 million in additional debt at its current cost of debt of 10%. The
price per share of Cockcroft is $45. The expected EBIT after the new financing is $20
million, with a standard deviation of $10 million. Calculate the probability that the interest
coverage ratio is less than one. Find the probability that it made the right choice of
financing with debt instead of equity.
Minimum EBIT to pay the interest = .1(30 + 10) = $4 million.
Since the company expects to have $20 million in EBIT, it should have no difficulty in
paying the $4 million interest payments. To find the probability of not being able to pay it,
find z as
z = (4 20)/10 = 1.6
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Draw a normal probability curve with z = 0 in the center and z = 1.6 to the left of center.
The area under the tail of the curve, on the left of z = 1.6, gives the desired probability.
From the table,
P(default) = 0.5 0.4452 = 0.0548 = 5.48%
EXCEL =NORMDIST(4,20,10,true)
Since the probability of default is quite small, it is better to finance with debt. Next, find
the critical EBIT from
E* = I + r(NP + F)
(10.7)
Which gives
E* = .1*30 + .1*(60 + 10) = $10 million
In order to be right, the E(EBIT) must be more than $10 million. The z-value is
z = (10 20)/10 = 1
Draw a normal probability curve with z = 0 in the center and z = 1 to the left of center.
The larger area on the right of z = 1, gives the desired probability. From the table,
P(being right) = 0.5 + 0.3413 = 84.13%
This also makes sense because the expected EBIT, $20 million, is quite large compared to
the critical EBIT, $10 million.
EXCEL =1-NORMDIST(10,20,10,true)
Video 10.9 10.9. Delaware Corporation is an all equity firm with 30% tax rate. It has 1.5
million shares, each selling for $25, with a dividend of $3. The company plans to issue $10
million (face amount) of bonds at 85 with a coupon of 8%. It will use the proceeds of the
bonds to repurchase the stock. Find the total value of the company before and after the
issuance of bonds.
Initially the company is an all equity firm and its total value is just the value of its stock, S
= 25 (1.5) = $37.5 million.
After the bond issue the firm gets a "tax shield" whose value = tB, where t is the corporate
income tax rate and B is the market value of the bonds. The amount of equity replaced by
debt equals the market value of the debt. The cost of capital cancels out. Assume that there
are no bankruptcy costs. Tax shield = 0.3 (0.85) (10) = $2.55 million
A more detailed look at the problem is as follows.
The discount factor r is the cost of debt = 80/850
tI
tI .3*.08*10
Tax shield = PV = (1 + r)i = r = 80/850 = $2.55 million
i=1
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The total value of the firm increases by an amount equal to the tax shield. Thus the new
value is 37.5 + 2.55 = $40.05 million.
10.10. Bohr Corporation, an all-equity firm, has a total value of $30 million. The company
needs $5 million in new capital, which it can raise by selling common stock or by selling
zero-coupon bonds maturing after 10 years. The bonds will sell at 40. The company is not
paying any taxes at present. For equity financing, the company will sell the common stock
at $25 a share. The beta of stock is 0.78, the expected market return is 12%, and the riskless rate is 6%. Find the preferred method of financing for Bohr.
Find the marginal cost of capital in both cases. For zero-coupon bonds, use
FV = PV (1 + r)n
(2.1)
which gives
100 = 40(1 + r)10
1001/10
r = 40 1 = 0.09596 = 9.596%

Or,
Use CAPM to get ke,
ke = E(R) = r + [E(Rm) r]
(7.7)
= 0.06 + 0.78[0.12 0.06] = 0.1068 = 10.68%

Since the company is not paying taxes, the after-tax cost of bonds is still 9.596%, and that
of stock 10.68%. Thus, it is better to use debt financing. To further check the result,
evaluate the WACC in both cases.
WACC(bonds) = (1 0)(0.09596)(5/35) + 0.1068(30/35) = .1053 = 10.53%
And
WACC(stock) = 0.1068 = 10.68
This means that bond financing is slightly better.

In this problem, the advantage of tax shield is zero, because the corporate tax rate is zero.
We cannot use the EBIT-EPS analysis here because the earning figures or number of shares
is unknown.
10.11. The Clinton Press has $45 million in long-term debt with interest rate of 12.5%,
and its income tax rate is 40%. Clinton has the optimal capital structure with debt/assets
ratio of 0.45; and it has to maintain this ratio. Clinton's dividend payout ratio is 0.35. The
company has EBIT of $15.625 million. Considering retained earnings to be part of equity,
how much new debt should the company acquire in order to maintain its present capital
structure?
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The earnings after taxes EAT, earnings before interest and taxes EBIT, the interest due I,
and the income tax rate t are related by the equation
EAT = (EBIT I)(1 t)
This gives
EAT = [15.625 0.125 (45)] (1 0.4) = $6 million.
Since the dividend payout ratio is 35%, the company retains 65% of the EAT. Retained
earnings = 6 (0.65) = $3.9 million.
The retained earnings become part of the capital in the form of equity. In other words, the
equity has increased by $3.9 million. To maintain the optimal capital structure, the increase
in capital should be 55% equity and 45% debt. Thus $3.9 million should be matched by
3.9*45/ 55 = $3,190,909 of new debt.
Video 10.12 10.12. Columbia Corporation has debt-to-assets ratio 50%, cost of equity
12%, and cost of debt 8%. Its tax rate is 40%. The total bankruptcy cost for Columbia is
estimated to be $10 million, but the probability of going bankrupt is 20%. If Columbia
reduces its leverage ratio to 40%, it will also reduce the probability of bankruptcy to 10%.
The total value of Columbia is $40 million at present. If Columbia wants to maximize its
value, should it use the lower leverage ratio?
Because its debt/assets ratio is 50%, the current debt at Columbia is .5*40 = $20 million.
The probability of bankruptcy is 20%, and the total costs in case of actual bankruptcy are
$10 million. Thus the current bankruptcy costs are estimated to be 0.2*10 = $2 million.
The tax rate is 0.4, and the total value of Columbia is $40 million. Using
VL = VU + tB b
we get
Or,
(10.9)
40 = VU + 0.4(20) 2
VU = 40 0.4(20) + 2 = $34 million
This means that the value of the company will drop from $40 million to $34 million if it
eliminates its debt altogether. In other words, leveraging has added $6 million to the value
of Columbia.
Suppose the new value of the company is VL with bankruptcy costs down to $1 million and
debt/assets ratio 0.4. This gives us
VL = VU + 0.4(0.4)VL 1
Substitute VU = $34 million in the above equation to get
WRA x=34+.4*.4*x-1
VL = 34 + 0.4(0.4)VL 1
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Solve it to get
VL = $39.286 million
Since the new VL, $39.286 million, is less than the initial value of the company, $40 million,
it is better to stay with the existing capital structure.
Video 10.13 10.13. Merle Company has debt/assets ratio of 0.4 at present. You believe
that it should increase debt ratio to its optimal value 0.45. You believe that the bankruptcy
costs will not change appreciably due to this restructuring and the company will benefit
from the additional tax shield. The present value of Merle is $20 million and its tax rate is
30%. What will be the value of its debt and its equity after you implement your plan?
Present value, V1 = $20 million.
Since the debt/assets ratio is 40%, B1 = 0.4(20) = $8 million.
Suppose the debt increases from $8 million to B2.
Since there is no change in the bankruptcy costs,
The value added = additional tax shield = t B = 0.3 (B2 8).
The total value of Merle becomes V2 = 20 + 0.3 (B2 8).
But the new debt/assets ratio is 45%, thus
B2
20 + 0.3 (B2 8) = 0.45 (A)
Or,
B2 = .45[20 + .3(B2 8)]
Or,
B2 .45(.3)B2 = .45(20) .45(.3)(8)
Or,
B2 = $9.156 million
WRA x/(20+.3*(x-8))=.45
Comparing B1 = $8 million and B2 = $9.156 million, Merle should issue $1.156 million in
bonds and buy back stock with that money.
The additional debt will add tB in tax shield, without any reduction in value due to
bankruptcy costs. The new value of Merle = 20 + 0.3(1.156) = $20.347 million.
Therefore, the new value of the stock is the difference between the new total value of the
company and its new total debt. The total new value of stock = 20.347 9.156 = $11.191
million.
(B) If the initial stock price per share is $24, what is its stock price after the financial
restructuring?
Before: Total value of stock = $12 million
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Number of shares = 12/24 = .5 million = 500,000

Face value of new bonds = $1,156,000
Number of shares repurchased = 1,156,000/24 = 48,167
After: Remaining shares = 500,000 48,167 = 451,833
Value of these shares, from part (A), $11,191,000
Price/share = 11,191,000/451,833 = $24.77
Comparing the initial price of the stock, $24, with its final price, $24.77, the company has
made the right move.
Video 10.14 10.14. Northern Electric has debt/assets ratio of 30% and tax rate 25%. The
total market value of the corporation is $100 million. The management has proposed that
the company increase its leverage ratio to 35% even though it would add $3 million to the
bankruptcy costs. If the firm wants to maximize its total value, should it move to the higher
debt level?
Use the equation
For existing setup,
VL = VU + tB b
(10.9)
100 = VU + 0.25(0.30)(100) b,
For proposed debt level,
VL = VU + 0.25(0.35) VL b 3,
Subtracting,
100 VL = 7.5 0.0875 VL + 3,
WRA 100-x=7.5-.0875*x+3
which gives, VL = $98.082 million. Since the restructuring results in a lower overall value
of the firm, the firm should keep its present debt level.
Problems
10.15. Aquarius Company has the following capital structure: 10 million shares of
common stock selling at $25 each, $150 million of long-term debt with coupon of 8%, and
1 million shares of preferred stock with a dividend of $2.50. Aquarius would like to raise
$50 million in additional capital. It can do that by either selling bonds or equity at the
existing rates. The expected EBIT of Aquarius after the new financing is $30 million with
a standard deviation of $10 million. The tax rate of Aquarius is 32%. Which method of
financing will maximize its EPS? Using the preferred method, what is the probability that
Aquarius will be unable to pay its interest and preferred dividends out of its current
earnings?
EPS(bonds) = $0.7020, EPS(stock) = $0.8117, P(default) = 7.60%
10.16. Rusk Inc needs $50 million in new capital, which it may acquire by selling bonds
at par with coupon of 12% or by selling stock at $40 (net) per share. The current capital
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structure of Rusk consists of $300 million (face value) of 10% coupon bonds selling at 90,
and 10 million shares of stock selling at $43 apiece. After the new financing, the EBIT of
Rusk is expected to be $70 million with a standard deviation of $30 million. Which method
of financing do you recommend? What is the probability that you are right?
Sell stock, 67.96%
10.17. Berks Corporation is expecting to have EBIT next year of $12 million, with a
standard deviation of $6 million. Berks has $30 million in bonds with coupon of 10%,
selling at par, which are being retired at the rate of $2 million annually. Further, Berks has
100,000 shares of preferred stock, which pays annual dividend of $5 per share. The tax rate
of Berks is 40%. Calculate the probability that Berks will not be able to pay interest, sinking
fund, and preferred dividends, out of its current income, next year.
21.03%
10.18. For Cambria Corporation debt-to-equity ratio, marginal tax rate, and dividend
payout ratio are all 40%. The cost of debt is 10%. Cambria has 1 million shares of common
stock, and $25 million in long-term bonds. Its dividend is $1 per share. Find the EBIT and
the price per share for Cambria.
$6.667 million, $62.50
10.19. Holiday Inc has $50 million in long-term debt at 8% and one million shares of
common at $70 a share. It needs $10 million in new financing which it can raise by selling
new bonds with 8.5% coupon, or stock at $70 a share. The tax rate of Holiday is 35%. After
the new financing, the expected EBIT is $10 million, with a standard deviation of $2
million. If the objective is to maximize the EPS, what is the preferred method of financing?
What is the probability that you have made the right choice?
Sell stock, 65.54%
10.20. Nunn Company has 3 million shares of common stock selling at $19 each. It also
has $25 million in bonds with coupon rate of 8%, selling at par. Nunn needs $10 million in
new capital, which it can raise by selling stock at $18, or bonds at 9% interest. The expected
EBIT after the new capitalization is $6 million, with a standard deviation of $3 million.
What is the preferred method of raising new capital? What is the probability that you are
Sell stock, 72.13%
right?
10.21. Delta Corporation is an all equity firm with a total value of $20 million. It requires
an additional capital of $5 million, which may be either equity, or debt at the interest rate
of 10%. After the new capitalization, the expected EBIT is $5 million, with standard
deviation of $1.5 million. The company pays income tax at 30% rate, and it has 1 million
shares outstanding. What is the preferred method of raising new capital, if the objective is
to maximize the EPS? What is the probability that you are right in your decision?
Debt financing is better, P(being right) = 95.2%
10.22. Uranus Corporation currently has equity of $40 million and debt of $20 million, in
terms of market values. Its EBIT for next year is projected to be $12 million with a standard
deviation of $3 million. Uranus is in the 40% tax bracket. The bonds have a face value of
$25 million and they carry a coupon of 10%. Uranus has 1 million shares of common stock
outstanding. The company plans to raise an additional $6 million in capital, half with
equity, and half with debt. The new debt will have interest rate of 12%. What will be EPS
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for next year? What is the probability that Uranus will not be able to pay its interest next
year?
EPS = $5.10, P(EBIT < $2.86 m) 0.1%
10.23. Pauli Incorporated has 12 million shares of common stock selling at $12 each, and
$45 million in long-term debt at a pre-tax cost of 12%. The tax rate of Pauli is 40%. The
company has to pay $1 million in preferred dividends and $4 million in sinking fund at the
end of this year. Pauli needs an additional capital of $25 million, which will then give an
expected EBIT next year of $35 million, with a standard deviation of $10 million. The new
financing can be with bonds at a coupon of 12.5%, or with common stock at $11.50 a share.
Which type of financing will give the higher EPS for next year? In the method selected,
what is the probability that the company will be able to pay the interest, sinking fund, and
preferred dividends, out of its current income?
EPS(bonds) = $.9070, EPS(stock) = $.9002, bonds are slightly better. Prob = 96.52%
10.24. Handy, Inc. has debt-to-assets ratio of 40%, tax rate of 35%, and total value of $100
million. W. C. Handy, the CFO, would like to increase the leverage ratio to 42%, and he
believes that there will be no change in the bankruptcy cost of the company. Find the face
value of the 12% coupon bonds that the company should sell, and buy back its own stock
from the proceeds, to accomplish the financial restructuring.
$2,344,666
10.25. Rochester Company plans to buy back 1 million shares of its own stock from its
cash reserves at $50 a share. This will increase the bankruptcy costs by $10 million, and
the debt/assets ratio from 35% to 40%. The income tax rate of the company is 30%. Find
the value of the stock per share after this buyback. Is the company making the right move?
$48.09, no
10.26. Altoona Company has debt/assets ratio 50%, which is too high and it should be at
45% to be optimal. This debt reduction should also reduce the bankruptcy costs by $30
million. At present, Altoona has 5 million shares of common stock selling at $50 each. The
tax rate of Altoona is 30%.
(A) How many shares of stock should the company sell, and buy back bonds from the
proceeds, to attain its optimal capital structure?
265,896 shares
(B) What is the total value of the company before and after the capital restructuring?
$500 million, $526.012 million
10.27. Cypress Semiconductor Corp. has authorized a $600 million share buyback.
Cypress has 161 million shares outstanding and $424 million in cash. Cypress plans to buy
the stock at $15 a share. The company has no debt at present. To finance the stock
repurchase, Cypress will use up all its cash and borrow enough money to buy the stock,
which will increase its bankruptcy costs by $10 million. The tax rate of the company is
30%. Calculate the price per share after the stock buyback.
$15.35
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Key Terms
bankruptcy costs, 169, 175,
176, 177, 185, 187, 189,
191
critical, 172, 173, 182, 183,
184, 185
critical EBIT, 169

earnings per share, 170, 171,
179, 182
indifference EBIT, 169
leveraged firm, 169, 175
207
tax shield, 169, 174, 175,

176, 177, 185, 186, 187,
188
unleveraged firm, 174, 175,
176
11. CAPITAL STRUCTURE THEORY: MINIMIZING WACC

Objectives: After reading this chapter, you should be able to
1. Calculate the leveraged and the unleveraged of a corporation.
2. Find the cost of capital for a risky venture.
3. Understand how firms are able to minimize their WACC.
11.1
Leveraged Beta
Consider an all-equity firm, a company with no debt. By borrowing money, the firm can
leverage its own assets and it can generate a higher return on its equity capital. Thus, we
may think of a company that has no debt as unleveraged. Most of the companies in real life
are leveraged corporations, although some companies prefer to remain debt-free. Some of
the well-known examples of unleveraged firms are Microsoft, Apple, and Google. We
define the leverage ratio as the ratio between the total debt and the total assets of a
corporation.
By adding debt to its capital structure, a company becomes more risky. This is because of
the additional burden of paying interest when it is due. If the amount of debt is small, a
firm can pay the interest without much difficulty. As the debt increases, a firm gets more
risky due to higher probability of default. Highly leveraged companies are very risky
companies because they may not be able to pay their interest. This greater risk causes an
increase in their beta. The increased risk also leads to higher cost of capital for the firm.
We can develop a relationship between the beta of the stock of a firm when it is
unleveraged, U, to the beta of the stock of the same firm when it is leveraged, L. We
already know that the value of a leveraged firm increases due to the tax shield. Let us
assume that the value of a leveraged firm is VL, where VL = B + S, the sum of its debt and
equity. The beta of the entire firm LF is the weighted average of the beta of its equity L,
and the beta of its debt, B. We may write it as
S L B B
LF = V + V
L
L
(11.1)
Assume that the bankruptcy costs are zero. Using (10.8), we get the value of the leveraged
firm to be
VL = VU + tB
Thus the beta of a leveraged firm VL, equals the weighted average of the beta of the
unleveraged firm VU, and the beta of the tax shield tB. Thus
VU U tB B
LF = V + V
L
L
Comparing (11.1) and (11.2), we get
208
(11.2)
11. Capital Structure Theory: Minimizing WACC
_____________________________________________________________________________
S L B B VU U tB B
VL + VL = VL + VL
Or,
S L + B B = VU U + tB B
Substituting VU = VL tB = B + S tB = S + (1 t)B in the above equation, we get

S L + B B = [S + (1 t)B]U + tB B
Or,
S L = [S + (1 t)B] U B B + tB B
Or,
B
B
L = 1 + (1 t) S U (1 t) S B

If the risk of the bonds is negligible, then B = 0, and the above equation becomes
B
L = U 1 + (1 t) S
(11.3)
We define the symbols in this equation as

L = beta of the stock of a leveraged firm
U = beta of the stock of the same firm, if it were unleveraged
t = corporate income tax rate
B/S = debt-to-equity ratio in terms of market values
Equation (11.3) is a well-known relationship first established by
Robert S. Hamada in 1969. This result is only an approximate one
and it is valid under these assumptions:
(1) The firm has only moderate leveraging.
(2) Its bonds are practically risk free.
(3) The bankruptcy costs are almost zero.
Robert S. Hamada (1937- )
This is a very useful result. It enables us to separate the inherent business risk of firm from
its financial risk due to leveraging. We shall see several examples where we can use this
relationship.
11.2
Minimizing WACC
We have already seen that increasing the leverage of a company increases its value at first.
Then the value falls off with the greater possibility of bankruptcy. In a similar way we can
reason that the weighted average cost of capital will fall initially when a company takes on
debt, but then with increasing leverage, the WACC will actually rise.
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In Figure 11.1, we examine the cost of capital of a firm. The firm has a value of $10 million
when it is not leveraged. Then it gradually acquires debt from 0 to $8 million. The
increasing debt will increase the of the firm, which will increase its cost of equity capital.
Assume that the cost of equity is 14% when there is no debt. With increasing debt, the cost
of equity rises to over 50%. The steep rise in the cost of equity is due to the greater threat
of bankruptcy.
It is possible to minimize the WACC of a firm by a suitable mix of debt and equity. In the
above example, assume that the firm is initially unleveraged. Further, assume that the
income tax rate of the company is 30%. The cost of capital, that is, the cost of equity is
14% initially. As the company acquires debt, the stock of the company becomes more and
more risky, and so the cost of equity rises. As the company gets deeper in debt, there is a
steep increase in the probability of bankruptcy.
Assume that the cost of debt is 6% initially, which is close to the riskless rate. The cost of
debt rises as the debt level increases, but at a slower rate compared to the increase in the
cost of equity. This is because, in case of bankruptcy, the bondholders have better
protection than the stockholders do.
The weighted average cost of capital starts out as the cost of equity because there is no debt
at that point. It tends to decrease as the company replaces equity with debt, the less
expensive form of capital. After reaching a minimum value when debt equals $2.46
million, in this example, the weighted average cost of capital rises again. At this minimum
value of WACC the company has an optimal mix of debt and equity.
Fig. 11.1. The cost of equity, cost of debt, and the weighted average cost of capital for a corporation as the
amount of debt increases in the capital structure of the firm.
Unfortunately, no analytical formula exists, which can calculate the optimal debt level that
will minimize WACC. The companies try to find the optimal debt level by experimentation.
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Examples
Video 11.1 11.1. Planck Company is an all equity firm with total value of its assets equal
to $20 million. Its is 0.88 and the tax rate 30%. The company plans to issue $1 million
of debt and simultaneously repurchase its stock worth $500,000. The company will use the
additional capital for expanding its own business. Assuming that the bankruptcy costs are
zero, what is the total value of the company after recapitalization? Find the new of Planck.
The total value of the firm increases due to (1) infusion of new capital of $500,000 and (2)
tax shield, tB. Note that the tax shield is due only to the equity that is replaced with debt.
This adds up to 500,000 + 0.3(500,000) = $650,000. The total value of the company after
recapitalization = 20 + 0.65 = $20.65 million.
The new financing will change the company from an all-equity to a leveraged firm. Its debt
is $1 million, and equity $19.65 million. Assuming that the bankruptcy costs remain
negligible, this gives the new beta as
B
L = U 1 + (1 t) S = 0.88[1 + (1 0.3)(1/19.65)] = .9113
Video 11.2 11.2. Slayton Company has debt-to-assets ratio of 25%. Its cost of debt is 8%
and the income tax rate is 30%. Using Shepard Video Games as a proxy, Slayton Co wants
to enter the video games business. Shepard has a debt-to-assets ratio of 20%, of 1.10, and
tax rate of 35%.
(A) Find the beta of this project for Slayton, using its current capital structure.
(B) If the riskless rate is 5%, expected return on the market is 12%, what return should
Slayton require on the new venture?
The of a company measures its market-related risk. The risk is due to two factors: (1) the
nature of the business and (2) the financial leverage of the company. However, we can
separate the risk due to leveraging by calculating the unleveraged of the firm. First, look
at Shepard Video Games. Find its debt/equity ratio, or B/S ratio, as follows:
For Shepard, B/V = .2, S/V = .8, B/S = (B/V)/(S/V) = .2/.8 = .25
Its unleveraged beta, using (11.3), is
L
1.1
U(Shepard) = 1 + (1 t) B/S = 1 + (1 0.35)(.25) = .9462
Thus, the risk inherent in the video games business is represented by the unleveraged of
0.9462. Slayton has to take this risk for the new project, thus, for this project only,
U(Shepard) = U(Slayton). Using this as the unleveraged for Slayton Company, find its
leveraged as follows:
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For Slayton, B/V = .25, S/V = .75, which gives B/S = .25/.75 = 1/3
B
L(Slayton) = U 1 + (1 t) S = .9462 [1 + (1 0.3)(1/3)] = 1.167
The for this project for Slayton is 1.167.
Find the cost of equity by using CAPM, (7.7),
ke = r + [E(Rm) r] = 0.05 + 1.167 [0.12 0.05] = 0.1317
The cost of debt for Slayton, kd = .08. Using (9.5), find the WACC as
WACC = (1 0.3)(0.08)(0.25) + (0. 1317)(.75) = 0.1128
The WACC for this project is 11.28% if Slayton uses its current capital to finance the
project. Thus, this is the required rate of return on the new project.
11.3. Mimas Corporation has $175 million in equity and $30 million in long-term debt, in
terms of market values. Mimas has tax rate of 30% and its is 1. Mimas plans to issue $5
million of new bonds and buy back its own stock with the proceeds of the bond sale. The
bankruptcy costs are negligible. Find the new value, and the new of the company.
The total value of the company is 175 + 30 = $205 million. The new debt will have a tax
shield of 0.3(5) = $1.5 million. Thus, the total value of the firm will rise to $206.5 million.
This includes $35 million in debt. The new value of the equity will be 206.5 35 = $171.5
million. Initially B/S = 30/175. Using (11.3),
L
1
U = 1 + (1 t) B/S = 1 + (1 .3)(30/175) = .8929
The new B/S = 35/171.5. Thus the new leveraged beta from (11.3) is
B
L = U 1 + (1 t) S = .8929 [1 + (1 .3)(35/171.5)] = 1.02
11.4. Carter Corporation has debt/assets ratio 15%, tax rate 35% and (leveraged) beta 1.25.
Carter is in the meat packing business. Sylvan Bus Lines has debt/assets ratio 25%, tax rate
30%, and beta 1.6. The riskless rate is 5% and the expected rate of return from the market
is 11%. The cost of debt for Sylvan is 8%. Sylvan plans to start a meat packing division
with its existing capital. Calculate the minimum return on the new venture acceptable to
Sylvan.
First, find the unleveraged of Carter, which represents the risk inherent in the meat
packing business. For Carter, B/V = .15, S/V = .85, thus B/S = .15/.85 = 15/85. Using (11.3)
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L
1.25
U = 1 + (1 t) B/S = 1 + (1 .35) (15/85) = 1.25/(1+.65*15/85) = 1.121
Use this beta as a measure of the inherent risk in meat packing business to find the
leveraged beta for Sylvan as follows.
B/V = .25, S/V = .75, thus B/S = .25/.75 = 1/3
For Sylvan,
L = 1.121 [1 + (1 0.3)(1/3)] = 1.383

Using CAPM, (7.7), find the cost of equity as
ke = r + [E(Rm) r] = .05 + 1.383 (.11 .05) = .1330
and finally the WACC,
WACC = (1 0.3)(0.08)(0.25) + .1330 (0.75) = .1137
which gives the minimum acceptable return on the new venture as 11.37%.
The following table illustrates the way one can use Excel to solve the problem. The result
will show up in cell E7.
1
2
3
4
5
6
7
8
9
A
Carter
Sylvan
Market
B
B/V =
t=
betaL =
B/V =
t=
betaL =
kd =
r=
E(Rm) =
C
0.15
0.35
1.25
0.25
0.3
1.6
0.08
0.05
0.11
D
B/S = (B/V)/(1-B/V)
=C1/(1-C1)
betaU =
B/S = (B/V)/(1-B/V)
=C3/(1+(1-C2)*E1)
=C4/(1-C4)
betaL =
WACC =
=E3*(1+(1-C5)*E4)
=(1-C5)*C7*C4+G6*(1-C4)
ke =
=C8+E6*(C9-C8)
Video 11.5 11.5. Curie Corporations capital consists of $10 million in long-term debt,
and common stock with a market value of $70 million. Its is 1.35 and the income tax rate
30%. The cost of equity for Curie is 14% and the cost of debt 9%. The riskless rate is 6%.
The company has just sold $10 million of new equity to finance new projects. Find its (a)
old WACC and (b) its new WACC.
(a) First, find the WACC of the company before the addition of new capital. Its debt is $10
million and equity $70 million. Its total capital is $80 million. Thus B/V = 10/80 = 1/8, and
therefore, S/V = 7/8. Using (9.5),
old WACC = (1 .3)(.09)(1/8) + (.14)(7/8) = .130375
(b) The ratio B/S = 1/7 for Curie. Find the unleveraged beta of the company,
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L
1.35
U = 1 + (1 t) B/S = 1 + (1 .3) (1/7) = 1.22727
With the new financing, the total equity becomes $80 million while the total debt remains
at $10 million. Thus the ratio B/S becomes 1/8. The new leveraged beta is
L = 1.22727 [1 + (1 0.3)(1/8)] = 1.33466
The new beta, 1.335, is somewhat lower the old beta, 1.35. This is due to reduced debt-toequity ratio, from 1/7 to 1/8. Using CAPM, we have the old cost of equity, ke of the
company as
Old ke = r + [E(Rm) r]
.14 = .06 + 1.35 [E(Rm) .06]
Solving for E(Rm), we get E(Rm) = (.14 .06)/1.35 + .06 = .119259
Now find the new values, after refinancing,
New ke = 0.06 + 1.33466 (.119259 0.06) = .139091
With the addition of $10 million in new equity, the total stock of the company is now $80
million and its total value $90 million. This makes new B/V = 1/9 and new B/S = 8/9. Thus
New WACC = (1 0.3) (0.09)(1/9) + .139091 (8/9) = .130636
As a result of additional equity capital, WACC increases from 13.0375% to 13.0636%, an
increase of three basis points. This is a very small increase, implying that the WACC
remains fairly constant due to a change in the capital structure. This small change is also
apparent in the flatness of the WACC curve in Figure 11.1.
11.6. ABC Corporation has $10 million in long-term bonds with 9% coupon selling at par.
It also has 3 million shares of stock selling at $30 each. Its is 1.6. The income tax rate of
ABC is 32%, the riskless rate is 6%, and the expected return on the market 12%. ABC is
planning to borrow another $10 million at 9% interest to expand its business. Find the
WACC of the company before and after the new financing.
At present, = 1.6, r = .06, E(Rm) = .12. Using CAPM, get the current cost of equity as
ke = r + [E(Rm) r] = .06 + 1.6(.12 .06) = .156
Since B = $10 million and S = 3*30 = $90 million, V = $100 million. Further, t = .32, kd =
.09, B/V = 10/100 = .1 and S/V = .9. Next, calculate the present WACC as
WACC = (1 .32)(.09)(.1) + (.156)(.9) = .14652
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The company is adding debt, thereby increasing its leverage ratio, its risk, and its beta.
However, it is not replacing any equity by debt and so its tax shield remains constant. To
find the new , we have to un-leverage the old and then re-leverage it.
Using (11.3),
L
1.6
U = 1 + (1 t) B/S = 1 + (1 .32) (1/9) = 1.4876
After adding debt, total debt becomes $20 million and the total value of the company
becomes 100 + 10 = $110 million. The value of the stock is still $90 million. Therefore,
B/S becomes 2/9. Thus
L = U 1 + (1 t)
B
= 1.4876[1 + (1 .32)(2/9)] = 1.7124
S
The new cost of equity is

ke = r + [E(Rm) r] = .06 + 1.7124 (.12 .06) = .16274
Combining all factors, we get the new WACC as
WACC = (1 .32)(.09)(2/11) + .16274(9/11) = .14428
Comparing the initial value, 14.652% and the final value, 14.428%, note that the WACC
has gone down slightly due to addition of cheaper form of capital.
Key Terms
leverage ratio, 192, 199, 201
leveraged , 192, 196
unleveraged , 192, 195
WACC, 192, 193, 194, 196,

197, 198, 199, 200, 201
Problems
11.7. Allen Corporation is planning to expand into the fast developing business of ondemand movies. Allen has debt-to-equity ratio of 1, its pretax cost of debt is 15%, and its
marginal tax rate is 40%. The Gardner Corporation is already in the video business, has a
of 1.5, debt-to-equity ratio of 0.75, and marginal tax rate of 25%. The riskless rate is 10%
and the expected return on the market is 20%. What beta should Allen use in evaluating
this project? What is its required return on the project?
1.536, 17.18%
11.8. Omega Corporation has debt-to-equity ratio of 0.7. Its cost of debt is 16%, and its
marginal tax rate is 40%. Omega is considering a project to go into fish-and-chips business.
Kappa Fish-and-Chips, which is already in the same business has a debt-to-equity ratio of
0.3, beta of 1.25, and a tax rate of 50%. If the riskless rate is 10% and the return on the
market is 18%, what is the required return for this project for Omega?
17.1%
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11.9. Venus Cosmetics Company is an all-equity firm producing only cosmetics. Its beta
is estimated to be 1.35. Mars Chemical Corporation is interested in starting a cosmetics
division. The total market value of Mars' stock is $25 million, and the bonds are worth $20
million. The beta of Mars is 1.25 and its tax rate is 40%. Assuming that the new division
is financed by the existing capital of Mars, what is the required rate of return of the new
venture? The riskless rate is 10% and the market return is 15%. The cost of debt for Mars
is 12%.
14.31%
11.10. Southampton Publishing Corporation has tax rate of 40%, debt-to-equity ratio of
40%, and has (leveraged) beta of 1.25. The riskless rate is 9% and the market return is 16%.
Victoria Publishing Company is an all equity company and is in the same business. What
is the required rate of return by the Victoria stockholders?
16.06%
11.11. Herter Company has debt/assets ratio of 0.3, but Mr. Herter feels that it should
increase to 0.4. The current tax rate of Herter Co is 35% and its beta is 1.25. The increased
leverage will add $10 million to the bankruptcy costs, and $35 million to the tax shield of
the company. By calculating the change in the total value of the firm, do you think that the
company should adopt the new plan? Calculate the new total value of the company and its
new beta.
Yes, current value = $900 million, new value = $925 million, new L = 1.401
11.12. Dauphin Corporation has cost of equity 15%, tax rate 40%, and debt-to-equity ratio
of 30%. Fayette Corporation has tax rate 35% and debt-to-equity ratio of 50%. Both
Dauphin and Fayette are in the same business of selling automotive parts. If the riskless
rate is 8% and the expected return on the market is 13%, find the cost of equity for Fayette.
15.86%
11.13. Yukawa Corporation is an all-equity firm with 10% cost of capital. Its competitor
in the same line of business, Tomonaga, Inc. has WACC of 9.5%, but has debt-to-assets
ratio 30%. Both companies are in the 20% tax bracket. Find the cost of debt for Tomonaga.
The riskless rate is 6% and the expected return on the market is 10%.
kd = 6.42%
11.14. The following table provides financial information of two soft-drink companies.
Firm
Total equity Total debt Cost of debt Tax rate
Troy Company
$75 million $25 million
8%
30%
1.5
Utica Corporation $55 million $25 million
9%
35%
-The riskless interest rate is 6% and the expected return on the market 14%. Which company
has lower WACC?
WACC(Troy) = 14.90%, WACC(Utica) = 14.62% (lower)
11.15. Ambler Company has $40 million in equity and $25 million in debt. Its tax rate is
35%; its cost of equity 15%; and its is 1.5. Arnold Corporation, its principal competitor
in the same line of business, has $60 million in equity and $30 million in debt. The tax rate
of Arnold is 35%, and its cost of debt is 10%. The riskless rate of interest is 6%. Find the
WACC of Arnold.
11.82%
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11.16. The following table provides the financial information of two companies, with the
dollar amounts in millions:
Company Debt Cost of debt Equity Cost of equity Tax rate Business
Lansing Co. $43
10%
$77
18.6%
30%
Publishing
Phoenix Co. $15
9%
$66
17.0%
25%
TV stations
At present, the risk-free rate is 6% and the expected return on the market 14%. If Lansing
Company wants to start a TV station as a side business, using its existing capital, what is
the minimum acceptable rate of return on the new venture? From your analysis, can you
deduce which is the riskier business, publishing or TV stations?
14.75%, TV
11.17. Kemp Company has beta 1.5, debt/assets ratio 45%, and tax rate 30%. The cost of
debt for Kemp is 9%, and of equity 14%. The riskless rate is 8%. Find the WACC of Kemp.
If its debt/assets ratio is increased to 48% while its cost of debt remains unchanged, what
is the new WACC? Which leverage ratio is better?
WACC(1) = .10535, WACC(2) = .1045, second is better.
11.18. Jeddah Restaurants has debt/equity ratio .5, and its leveraged beta is 1.6. Its tax rate
is 30%, and its cost of equity is 16%. The risk-free rate is 6%. Masturah Restaurants has
debt/equity ratio .4, and tax rate 35%. Find the cost of equity for Masturah.
15.33%
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12. DIVIDEND POLICY

1. Understand the factors that lead to the dividend policy of a company.
2. See the effect of paying a cash dividend, giving a stock dividend, or declaring a stock
split, on the value of a firm.
3. Know the residual theory of dividends, and realize the possibility of dividend policy
being a residual decision, or an irrelevant issue.
12.1
Dividends and Stock Valuation
From the discussion on the flow of funds in a firm, we may recall that the corporations pay
out dividends to the stockholders after the bondholders have received interest payments
and the government has received its share of taxes. In other words, the stockholders are the
last ones in the line to receive the financial benefits from a company.
The dividend payments are made at the discretion of the board of directors. The directors
may choose to give little or no dividends to the stockholders if the company cannot afford
to pay them. This may happen if the company is suffering a temporary cash shortage, or it
has several profitable opportunities available that need to be funded first.
When a company gives out a dividend, say $2 per share, then the price of the stock, in
response to the payout, also drops by roughly $2 a share. This means that if a stockholder
owns 100 shares of a stock selling at $70 a share will receive a $200 dividend check, but
his stock will now be worth $6800. The income from the dividends is offset by the loss in
the value of the stock. It would be the same if an investor with a bank balance of $7,000
withdraws $200 from the bank.
The reason for the above phenomenon is quite simple. The $2 value of the dividend is
embedded in the total initial value of the stock, $70. The investors who buy the stock are
expecting this payment. If an investor buys the stock right after the payment of dividend,
he knows that he will not get the dividend and he will pay only $68 per share. We may
look at the financial structure of the entire company. Suppose the company has 1 million
shares. Then the company must have $2 million in cash in a checking account to pay the
dividends. Once the dividends are paid out, the cash is gone. The value of the company, in
particular, the value of its stock, decreases by $2 million. This amounts to $2 per share.
Occasionally a company may give a stock dividend, say 10%. This means that a
stockholder who already has 100 shares will now receive a stock certificate for 10
additional shares. He now owns 110 shares, but the market value of these shares is just
equal to the market value of the 100 shares before the declaration of the stock dividend. It
is the same pie but it is cut up in a larger number of relatively smaller pieces. The value of
the stock per share will also drop correspondingly. There is no change in the value of your
stock holdings when you receive a 10% stock dividend.
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A stock split occurs when one share of stock is split into, say, three shares. The number of
shares is tripled, but the price of each share drops to one-third of its previous value. Again,
we notice that there is no change in the value of your stock investments whether you own
100 shares at $30 apiece, or 300 shares at $10 each. The total value remains constant at
$3000.
In view of the above arguments, it seems that receiving dividends is quite immaterial for
the investors and the companies should not worry about their dividend policy. The
stockholders do not get richer by receiving the dividends; after all, it is their money
anyway. Yet, corporations pay a lot of attention to their dividend policy, as we shall see.
12.2
Mechanics of Dividend Payment
Most of the companies pay their dividends quarterly. A few weeks before the dividend
payment date, the board of directors would meet and declare a dividend. This is a formal
announcement by the company that it will indeed pay the dividend on time. The
announcement also fixes a record date: only those investors who are the owners of stock
at the end of business on the record date will be entitled to receive the dividends. If you
become the owner of a stock after the record date, then you will not get the dividend.
If you buy the stock, after the record date, it will be too late to receive the dividend. You
will end up buying the stock without the dividend, that is, ex dividend. The stocks that will
go ex dividend tomorrow are listed in today's newspaper. So today, you have the
opportunity to buy these stocks if you want to receive their dividends. The dividend checks
are mailed out a few weeks after the record date.
12.3
Dividend Policy
The payment of dividends is an important decision for any company. If the dividends are
too low, the stockholders who buy the stock for the dividend income would not be happy.
If the company has a generous dividend policy, it will not have money left for growth.
Besides, paying or not paying a dividend should not affect the shareholders wealth anyway.
This complicates the dividend puzzle further.
Let us consider three possible dividend policies for a corporation.
Dividend Policy #1: Suppose a company adopts the following dividend policy: it will pay
out a fixed ratio, say 50%, of its earnings after taxes, and keep the other 50% as retained
earnings. For instance, if earnings are $4 per share, the company will pay out $2 in dividend
per share, and if the earnings are $5 a share, the dividend will be $2.50. Another way of
saying this is that the company maintains a constant dividend-payout-ratio policy. The
following diagram shows the EPS and DPS for the last several years. This dividend policy
is shown in Fig. 12.1.
Dividend Policy #2: This dividend policy says that the firm should maintain a constant
dollar dividend per share, and increase it whenever possible. For example, a company
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12. Dividend Policy
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should pay out $2 per share annually, no matter what the annual EPS is. Further, it should
raise it to say $3, and then maintain it at that level. This is shown in Fig. 12.2.
Dividend Policy #3: This dividend policy follows these steps:
First, the firm should identify and finance the projects with positive NPV,
Second, it should maintain the optimal capital structure, before and after new financing,
Third, pay out any leftover earnings as dividends.
This is the essence of the residual theory of dividends.
Fig. 12.1: Constant dividend-payout-ratio policy.
Fig. 12.2: Constant dollar-amount dividend policy.
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The residual theory of dividends makes a lot of economic sense. When the investors buy
the stock of a corporation, it is with the understanding that the managers of the company
can make superior investment decisions; otherwise, the investors should invest the money
elsewhere. Now the managers have the money, they should search out and finance
profitable projects, those with positive NPV. The financing decision should be based on
the optimality of the capital structure. For instance, if the company already has too much
debt, it should finance the new projects with equity. The source of new equity capital is the
retained earnings. The residual amount of money, if there is any, should be paid out to the
stockholders. If the company keeps this money, they will end up investing it in negative
NPV projects.
According to the residual theory of dividends, the company should not follow Policy #1,
or Policy #2, because the dividend decision is merely a residual decision. They must make
the investment and financing decisions first.
The surprising fact is that most of the corporations follow Policy #2, where they try to
maintain a regular dollar amount of dividend per share, and increase it periodically. The
reasons for this anomaly are not known. However, several theories have been proposed to
explain this phenomenon.
Examples
12.1. Georgia Corporation has EBIT of $35 million this year. Next year the EBIT will
depend upon two factors: weather and labor problems. If the weather is good (probability
30%), the earnings will rise by 20%. If the weather is normal (probability 50%), the earning
will remain the same, but for poor weather (probability 20%), the earnings will decline by
20%. In the case of a strike (probability 10%), the earnings will decline by 40%. The
probability of the strike does not depend upon the weather. The company has to pay $5
million interest next year and has a tax rate of 35%. If it intends to pay $10 million in
dividends next year out of its earnings after taxes, what is its expected dividend payout
ratio?
Considering probabilities of different outcomes, find the expected EBIT:
Weather Labor Probability*outcome Expected EBIT
Good
Strike
.3 (.1) (1.2) (.6) (35) = 0.756
Good
No strike + .3 (.9) (1.2) (1) (35)
+ 11.34
Normal
Strike
+ .5 (.1) (1) (.6) (35)
+ 1.05
Normal No strike + .5 (.9) (1) (1) (35)
+ 15.75
Bad
Strike
+ .2 (.1) (.8) (.6) (35)
+ 0.336
Bad
No strike + .2 (.9) (.8) (1) (35)
+ 5.04
Adding all the numbers in the last column, gives the expected EBIT as $34.272 million.
An alternative method to find the expected EBIT is as follows:
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Labor effect = .1(.6) + .9(1) = .96 (EBIT will decrease by 4% due to labor problems)
Weather effect = .3(1.2) + .5(1) + .2(.8) = 1.02 (EBIT will increase 2% due to weather)
Combined effect = .96(1.02) = .9792 (EBIT will become 97.92% of this year)
Thus the expected EBIT is, E(EBIT) = .9792(35,000,000) = $34,272,000
Next, calculate EAT, which comes out to be
EAT = (EBIT I)(1 t) = (34.272 5)(1 .35) = $19.03 million
The company wants to pay $10 million in dividends. Thus the expected dividend payout
ratio = 10/19.03 = .5256 = 52.56%
12.2. Gamma Corporation common stock is selling for $50 per share. It has $10 million in
long-term bonds with coupon 8%. The income tax rate of Gamma is 30%. It has 1 million
shares outstanding, and its current EBIT is $4 million. The company maintains 50%
dividend payout ratio. The company has decided to repurchase its shares at $50 per share,
instead of giving a cash dividend. How many shares should the company buy, and what
would be the price of the shares after this acquisition?
The earnings after taxes for Gamma are
EAT = (EBIT I)(1 t) = (4 .08*10)(1 .3) = $2.24 million
From EAT, the company pays 50% in dividends, which is $1.12 million. If the company
pays the dividends in cash, the dividend per share will be $1.12. On the other hand, the
company can use this money to buy back the shares at $50 apiece. The number of shares
that the company should buy back = 1,120,000/50 = 22,400.
Let us calculate the value of the stock per share after the payment of dividends. The total
present value of the company is $60 million, which includes $1.12 million that the
company will pay out as dividends. After the payment of dividends, the value of the
company becomes 60 1.12 = $58.88 million. The value of the debt remains $10 million
and thus the value of the equity becomes $48.88 million. For 1 million shares, the price per
share becomes $48.88 per share. Every stockholder will get $1.12 per share in cash, and
the price of the stock will also go down by $1.12.
If the company buys 22,400 shares of its own stock, it must spend $1.12 million. This
reduces the value of total equity to $48.88 million as before. Some of the stockholders will
sell their stock (22,400 shares in all) and they will get $50 per share. This is the market
price of the stock. The company now has 1,000,000 22, 400 = 977,600 shares outstanding.
The total value of these shares is $48.88 million. The price per share is
48,880,000/977,6000 = $50. Thus, the stockholders who chose not to sell their shares retain
their stock value at $50 per share.
12.3. Virginia Corporation has 5 million shares of common stock, each selling for $14.69.
The company has $10 million in long-term bonds with 7% coupon, selling at par. This year
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the company had EBIT of $12 million, which is expected to grow 5% next year. The tax
rate of the company is 35%. The P/E ratio of Virginia is expected to remain constant. Next
year the company wants to distribute 30% of its after-tax earnings to its shareholders by
the stock repurchase method. How many shares of stock should it buy back?
For this year, the earnings after taxes, EAT are
EAT = (EBIT I) (1 t) = (12 .07*10)(1 .35) = $7.345 million
With 5 million shares, the earnings per share = 7.345/5 = $1.469
The P/E ratio of the company for this year is
Price per share
P/E ratio = Earnings per share = 14.69/1.469 = 10
Because the P/E ratio remains constant, the earnings after taxes and the stock price are
growing at the same rate.
For next year, the EBIT will grow by 5% and it will become 12*1.05 = $12.6 million. The
earnings after taxes, EAT next year will be
EAT = (EBIT I) (1 t) = (12.6 .07*10)(1 .35) = $7.735 million
With 5 million shares, the earnings per share = 7.735/5 = $1.547
Because P/E ratio remains constant at 10, the price per share will be ten times the earnings,
or 10(1.547) = $15.47. We need this share price to calculate the number of shares to buy.
The company plans to distribute 30% of earnings after taxes as dividends next year. This
comes out to be .3(7.735) = $2.3205 million.
With the price per share at $15.47, the company should buy back x shares, where
Number of shares repurchased, x = 2,320,500/15.47 = 150,000
12.4. Burr Machine Co stock has price/earnings ratio of 12, annual dividend of $1.20 and
a dividend payout ratio of 30%. The company has 1 million shares outstanding. Burr has
$30 million in long-term debt carrying an interest rate of 11%, and it has a tax rate of 30%.
Find (a) the EBIT and (b) the total value of Burr.
From (10.3), we get the dividend per share, DPS, as
DPS = DPR
Substituting numbers,
[(EBIT I) (1 N t) SF PD]
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1.20 = .3
Solving for EBIT,
[(EBIT .11*30)1 (1 .3) 0 0] (A)
EBIT = 1.20/.3/.7 + .11*30 = $9.01429 million

WRA 1.2=.3*(x-.11*30)*(1-.3)
Since P/E = 12, and EPS = $4.00, the price of stock is $48 per share. The value of equity
is $48 million, the value of debt is $30 million, and the value of the company is $78 million.
12.5. Trenton Corporation expects to have EBIT next year of $120 million with a standard
deviation of $30 million. Trenton has tax rate of 35%. It also has $200 million (face value)
of 8.5% bonds and $300 million (face value) of 9% bonds. The company has a dividend
payout ratio of 45%. Trenton has 20 million shares outstanding. Find the probability that
the dividend next year will be more than $1.00 per share.
First, find the EBIT, which will give rise to a dividend of $1.00, by using (10.3),
[EBIT 0.085(200) 0.09(300)] (1 0.35)(0.45)
= 1 (A)
20
20
EBIT = .45(1 .35) + .085*200 + .09*300
This gives
EBIT = $112.376 million
WRA (x-.085*200-.09*300)*(1-.35)*.45/20=1
Since the company expects to have $120 million in EBIT, and it needs $112.376 million,
the probability is more than 50% that it will be able to pay $1 dividend. Draw a normal
probability distribution curve, with = 120 in the center and x = 112.376 somewhat to the
left of center. The area to the right of 112.376 represents the probability of making more
than $112.376 million in EBIT. To calculate it, find
From the tables,
z = (120 112.376)/30 = .2541
P(DPS > $1) = 0.5 + .0987 + .41(.1026 .0987) = .6003 = 60.03%

12.6. Phoebe Corporation stock has P/E ratio of 12, and it just paid a quarterly dividend of
$1.00. Phoebe has debt/equity ratio of 0.8, and has 2 million shares of common stock.
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Phoebe is not growing and it pays all of its after-tax income as dividends. Find the total
value of Phoebe.
The annual dividend is $4. Since the company pays out all of its after-tax income as
dividends, the after-tax income per share must also be $4 annually. Since the P/E ratio is
12, price per share must be 12 times after-tax income. Thus, the price per share is 12*4 =
$48. Since there are 2 million shares outstanding, the total value of equity should be
2*48 = $96 million. Since the debt/equity ratio is 0.8, it means B/S = 0.8, or B = 0.8 (96)
= $76.8 million. Thus, the value of the debt is $76.8 million. Hence the total value of
Phoebe is 96 + 76.8 = $172.8 million.
Video 12.7 12.7. The Zeta Co has EBIT of $10 million, $30 million of long-term debt at
11%, and tax rate of 30%. It has $5 million of profitable projects available. Zeta has 1
million shares outstanding, selling at $70 each. At present, the company has an optimal
mix of debt and equity. Using the residual theory of dividends, calculate its dividend per
share.
To follow the residual theory, the company must do two things: (a) finance its profitable
projects, and (b) maintain an optimal capital structure. The company has $30 million in
debt and $70 million in equity. Thus, its debt/assets ratio is 30%. The company should
finance the new projects in that ratio, namely, 0.3(5) = $1.5 million with debt, and 0.7(5)
= $3.5 million with equity.
The earnings after taxes = [10 0.11(30)](1 .3) = $4.69 million. This represents new
equity. But the company needs only $3.5 million in new equity to finance new projects,
thus it should give out 4.69 3.5 = $1.19 million in dividends. This comes out to be $1.19
per share.
In order to maintain its optimal capital structure, Zeta should also borrow another $1.5
million in new debt. The retained earnings are $3.5 million, and along with the new $1.5
million in new debt, the company will be able to finance the new projects while maintaining
its optimal capital structure.
12.8. Gill Corporation follows the residual theory of dividends. Its expected EBIT for next
year is $30 million with a standard deviation of $10 million. Gill has $60 million in bonds
with average coupon of 9%. It also pays $4 million in a sinking fund annually. Gill will
need $15 million to finance new projects while maintaining its current debt/assets ratio at
30%. The tax rate of Gill is 35%, and it has 7 million shares of common stock. Find the
probability that it will be able to pay $1 dividend per share from its current earnings next
year.
The company needs $15 million to finance new projects, using .3(15) = $4.5 million in new
debt and .7(15) = $10.5 million in retained earnings. Since the company puts $4 million in
the sinking fund to retire old debt, it must borrow an additional $4 million to maintain its
debt to assets ratio. Thus, the total new debt is $8.5 million.
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The retained earnings, RE, and total common dividends, CD, are related by the equation
RE = (EBIT I) (1 t) SF PD CD
Substituting numerical values, we get the required EBIT as
10.5 = (EBIT .09*60) (1 .35) 4 0 1*7 (A)
EBIT = (10.5 + 4 + 7)/.65 + .09*60 = $38.477 million
WRA 10.5=(x-.09*60)*(1-.35)-4-0-1*7
Since the company expects to have only $30 million in EBIT, the probability is less than
50% that it will be able to pay $1 dividend per share. To find the probability, find z as
z = (38.477 30)/10 = .8477
Draw a normal probability curve with z = 0 in the center and z = .8477 to the right of center.
The area to the right of z = .8477, under the tail of the curve, represents the probability that
EBIT is more than $38.477 million. Checking the tables, we find the probability as
P(dividend < $1) = .5 [.2995 + .77(.3023 .2995)] = .1983 = 19.83%
Key Terms
dividend policy, 202, 203,
204, 211
ex dividend, 203
residual theory of dividends,

202, 204, 205, 209, 211,
212
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stock dividend, 202

stock split, 202, 203
12. Dividend Policy
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Problems
12.9. Taurus Corporation has the following dividend policy: if the earnings after taxes are
less than $1 million, the dividend payout ratio will be 35%, but if these earnings are over
$1 million, the dividend payout ratio will be 45%. Taurus expects that its EBIT for next
year will be $6 million with a standard deviation of $4 million. Taurus has $20 million in
long-term bonds with coupon of 9%, and 1.5 million shares of common stock. Calculate
the probability that Taurus will give a dividend of more than $1 per share. The tax rate of
Taurus is 30%.
44.41%
12.10. Rogers Corporation stock sells at $27 per share and its dividend per share is $1.20.
Rogers has price-earnings ratio 16. The company has $40 million worth of bonds, selling
at par, with 8.5% coupon. The EBIT of Rogers is $12 million and its tax rate is 30%.
Calculate: (a) the dividend payout ratio, (b) the total number of shares, (c) the total value
of Rogers.
(a) 71.11%, (b) 3.567 million, (c) $136.32 million
12.11. The expected EBIT of Krupa Co next year is $20 million with standard deviation
of $4 million. The tax rate of Krupa is 30% and it has 10 million shares of common, stock.
Krupa has to pay $8 million in interest and $5 million in a sinking fund. What is the
probability that Krupa will be able to pay a dividend of $1 per share next year and have no
0.92%
money left over as retained earnings?
12.12. Bethe Company stock sells at $45 a share and pays $2 dividends annually. The tax
rate of the company is 30%. Bethe has 2 million shares outstanding. The expected EBIT
next year is $30 million with a standard deviation of $5 million. The interest payable next
year is $5 million. Calculate the probability that the company will be able to maintain its
current dividend.
Almost 100%
12.13. Jefferson Company has $120 million of bonds outstanding, with coupon of 12.5%,
selling at 95. It has 2 million shares of $4 preferred stock and 10 million shares of common
stock. Jefferson has EBIT of $76,958,042 this year, and it has income tax rate of 35%.
Jefferson must also pay a principal payment of $5 million to the bondholders. The company
has decided to have a dividend payout ratio of 55%. What dividend should Jefferson
declare on the common stock per share?
$1.50
12.14. Hofuf Company follows the residual theory of dividends. It has 4 million shares of
common stock, and it maintains its optimal debt/assets ratio at 30%. Its EBIT next year is
expected to be $12 million, with a standard deviation of $3 million. The income tax rate of
Hofuf is 35% and it has to pay $1 million in interest. It would like to finance $5 million in
new projects from retained earnings and new borrowings. Find the probability that it will
be able to give a dividend of at least $1 next year.
42.88%
12.15. Ithaca Company has 5 million shares of common stock selling at $50 each. It also
has $100 million in long-term bonds with coupon 8%, selling at 90. The tax rate of Ithaca
is 32%. Next year its EBIT is expected to be $20 million with a standard deviation of $8
million. The company plans to continue its $2 dividend per share. Ithaca also wants to add
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$5 million to its total retained earnings next year. Find the probability that it will be able
to maintain its dividend.
10.43%
12.16. Wilson Corporation follows the residual theory of dividends. It has 100 million
shares of common stock, and has EBIT of $120 million. Wilson has $200 million in longterm bonds with coupon 10%. The tax rate of Wilson is 35%. The company has $40 million
in new projects that are to be financed using current earnings and new bonds. Wilson must
also maintain its debt/assets ratio of 40%. Find (a) the amount of new bonds that Wilson
should sell, and (b) its dividend per share.
$16 million, $0.41
228
13. LEASING
1. Make the optimal choice between leasing and buying an asset.
2. Calculate the lease payments, or the purchase price, which will make leasing equivalent
to buying.
3. Discern some of the advantages and disadvantages of leasing.
13.1
Leasing
A company may be in need of a piece of equipment. It can either lease the equipment or
buy it outright. In recent years, leasing has become a common source of financing for
corporations.
There are several reasons why companies want to lease an asset whether it is a computer,
an airplane, or a warehouse. First, it gives them some flexibility. If it is a startup company,
they may want to lease some office space and start their operations. They do not want to
invest in a building, for instance, where they have to tie up a large amount of capital for a
long of time. Second, a company may not have the cash needed to buy an asset. They may
be trying to conserve cash and invest in some profitable projects. Third, they may simply
need the asset for a short time and there is no point in buying it. Fourth, it is perhaps cheaper
for them to lease the equipment, as indicated by the NPV analysis of the lease.
The companies may still want to buy certain assets, especially the ones that actually
increase in value, such as buildings and land. In many instances, they have to buy an asset
because it is not possible for them to lease it. A company may want to build a factory to
their own specifications and needs.
In some cases, a company may sell an asset and lease it back. For example, a bank may
sell the building that it owns, generate a substantial amount of cash, and make a large profit
because it bought the building a long time ago. Then it simply leases the building for its
own use. It does not have to move out of its quarters. This is a sale-and-leaseback
arrangement.
IBM
Corporation
(Lessor)
Computer (asset)
Lease payments
Mercy
Hospital
(Lessee)
Figure 13.1. In a direct lease, only two parties are involved

A lease may be direct lease, or a leveraged lease. In a direct lease, only two parties are
involved, the owner of the asset and the end user of the asset. The owner of the asset is
known as the lessor, and the end user, the lessee. An example may be IBM Corporation
leasing a computer to Mercy Hospital. The two parties negotiate various terms of the lease,
229
13. Leasing
_____________________________________________________________________________
such as the amount of lease payments, when are they due, who will take care of the
maintenance costs, and so on. The lease arrangement is shown in Figure 13.1.
A leveraged lease involves three parties. The owner of the asset buys the asset by borrowing
the money from a bank, and then rents the asset out to the end user. The owner of the asset
is leveraging the lease and he does not want to tie up his personal capital in the asset. For
example, a property owner may buy an apartment building by borrowing the money from
the bank and then lease the apartments to individuals or families. The arrangement for a
leveraged lease is as shown below.
Bank
Mortgage loan
Loan payments
Landlord
Apartment house
Rent payments
Tenants
Fig. 13.2. In a leveraged lease, three or more parties may be involved.

In the above situation, it is possible to carry out the financial analysis from the point of
view of the bank, or the proprietor, or the tenant. The loan officer at the bank may want to
make sure that the loan is properly secured by examining the physical condition of the
building, the financial strength of the property owner, and assessing his managerial ability.
He should also look at the actual lease contracts, if available.
The property owner is an entrepreneur. He wants to analyze the lease and see if it is
profitable for him. He has to look at all the cash flows: mortgage loan payments, rents, the
maintenance expenses, the real estate taxes, his income tax rate, and the tax benefits of
depreciation of the building. The tenant wants to examine the advantages of renting the
apartment: convenience, predictable rent payments, and his personal preference. He may
also consider the advantages of borrowing the money and buying a house: the deductibility
of interest on the mortgage loan, the freedom to remodel the house, the needs of his family,
and so on. We are interested in the financial analysis only.
13.2
Capital Leases
Frequently corporations sign up long-term leases to make sure that they have access to a
particular asset without interruption. Wal-Mart may lease a store for several years, or a
corporation may lease a computer until it becomes obsolete. A long-term lease is called a
capital lease, or a financial lease, if it satisfies at least one of the following four conditions:
1. The lessee will become the owner of the asset when the lease expires.
2. The lessee will have the right to purchase the asset at below its then market value at the
expiration of the lease.
3. The term of the lease exceeds 75% of the economic life of the asset.
4. The present value of the lease payments is more than 90% of the initial value of the asset.
230
13. Leasing
_____________________________________________________________________________
If the lease does not satisfy any of the above terms, it is then an operating lease. A capital
lease is essentially similar to buying the asset. From the accounting point of view, capital
leases are shown as capital assets on the balance sheet of a corporation.
Occasionally, a company may sell an asset and lease it back. This type of transaction is
called a sale-and-leaseback arrangement, or simply a leaseback. A company may own a
valuable asset, such as a large office building, but it is not utilizing it fully. It can sell the
asset to generate much needed cash and then, instead of vacating that property, it can lease
some of that space for its own use. The best example of this arrangement is the sale-andleaseback of Pan Am Building by Pan American World Airways in 1981.
Another example of sale and leaseback transaction took place in Scranton recently.
Scranton Times-Tribune
Bank building sells for $7.6 million
JAMES HAGGERTY, STAFF WRITER
Published: August 9, 2014
SCRANTON PNC Financial Services Group sold its regional headquarters building in Scranton for
$7.6 million, according to documents filed with the Lackawanna County recorder of deeds.
The Times-Tribune reported the transaction July 31, but the bank did not disclose the sale price.
The 113,000-square-foot building at Penn Avenue and Spruce Street was purchased by an affiliate of
American Realty Capital Properties Inc., a New York-based real estate investment trust.
PNC agreed to lease part of the structure until July 31, 2029.
13.3
Lease Analysis
After calculating the NPV of all cash flows of buying or leasing, one can determine which
method is less expensive. The answer may very well depend upon the corporate tax rate,
the cost of capital, the depreciation schedule, whether or not outside financing is involved.
The lease payments are generally due at the beginning of each period and the taxes are paid
at the end of each period. The lease payments, the depreciation, and the interest payments
are all deductible business expenses for tax purposes.
It is generally accepted that the discount rate used to find the NPV is the after-tax cost of
debt, (1 t)kd. There are several reasons for it. When a corporation is leasing an asset, it
has to sign a lease contract that requires regular cash payments, and if the corporation is
not making the lease payments on time, the owner has the right to repossess the asset. It is
quite similar to borrowing the money to buy the asset. If the borrower does not pay the
regular installment payments on time, the lender has a right to repossess the asset.
231
13. Leasing
_____________________________________________________________________________
When a company is leasing an asset, it is simply borrowing it. The company has no
ownership right, or an equity interest in the asset. It has to return the asset to the owner at
the end of the lease in good condition. This is similar to borrowing money by selling a bond
where you have to pay the interest on the principal, and pay back the full amount when the
bond matures. The after-tax of cost of debt, the cost associated with a bond, should also
apply to a lease.
The corporations tend to use lease financing an alternative to debt financing. Although they
are not exact substitutes of one another, they play essentially similar roles. Therefore, for
lease analysis, we shall use the after-tax cost of debt, (1 t)kd as the proper discount rate.
Examples
Video 13.1 13.1. Alpha Power Corporation needs 25 new vans for their maintenance
crews. The vans cost $25,000 each, and an investment tax credit of 10% is available. Alpha
will depreciate the vans over a 4-year period on a straight-line basis and then sell them for
$5,000 each on the average. The company can borrow money at 9% interest by making the
loan payments at the end of each year for four years. The company expects to pay income
tax at 30% rate for the next 4 years. Beta Leasing Co leases the same vans at $5,000 each
annually for a 4-year period, with the payments made in advance for each year. Alpha can
take the tax benefits of lease payments at the end of each year. Using NPV method, find
the cheaper way to acquire the vehicles.
The best way to do the problem is to calculate the NPV of leasing and the NPV of buying
a single van, compare the two, and select the cheaper one. The cheaper method is applicable
to one van or 25.
In all leasing problems, we will use the after-tax cost of debt, (1 t)kd as the proper discount
rate. In this case, it is (1 .3)(.09) = .063.
Because of the 10% investment credit, the vans will effectively cost 90% of their purchase
price, or, .9(25,000) = $22,500 each. Thus,
Initial investment = $22,500
Since the company spends only $22,500 on a van, it is able to depreciate that amount over
4 years. Thus, the depreciation per year is 22,500/4 = $5625. With the tax rate at 30%, the
annual tax benefit of depreciation is .3(5625) = $1687.50. The present value of the tax
benefit of depreciation for four years is
4 1687.50
1687.50(1 1.0634)
PV(tax benefit of depreciation) = 1.063i =
= $5807.42
.063
i=1
WRA sum(.9*25000/4*.3/1.063î,i=1..4)
232
13. Leasing
_____________________________________________________________________________
The company will sell the van for $5000 after 4 years. Since the asset is depreciated fully,
the company will pay taxes on the whole amount. The after-tax value is (1 .3)(5000) =
$3500. Its present value of this amount is
3500
PV(resale value of equipment) = 1.0634 = $2741.16
WRA (1-.3)*5000/1.063^4
To find the NPV of buying a van, add the initial investment, the present value of the tax
benefits of depreciation, and the present value of after-tax final sales value. This gives
NPV(buying) = 22,500 + 5807.42 + 2741.16 = $13,951.42
WRA -.9*25000+sum(.9*25000/4*.3/1.063î,i=1..4)+(1-.3)*5000/1.063^4
Now consider the cash flows due to leasing a van. The company has to make four payments
at the beginning of each of the four years. The present value of this is
3 5000
5000(1 1.0633)
= $18,291.22
PV(lease payments) = 5000 1.063i = 5000
.063
i=1
WRA sum(5000/1.063î,i=0..3)
The tax benefit of a lease payment, tL, is .3(5000) = $1500 per year, at the end of each of
the next four years. Their present value is
1500 1500(1 1.0634)
PV(tax benefit of lease payments) = 1.063i =
= $5162.15
.063
i=1
4
WRA sum(.3*5000/1.063î,i=1..4)
Combining the present value of lease payments and their tax benefits, we get
NPV(leasing) = 18,291.22 + 5162.15 = $13,129.07
WRA sum(5000/1.063î,i=0..3)+sum(.3*5000/1.063î,i=1..4)
Comparing the NPV(buying) = $13,951.42 with NPV(leasing) = $13,129.07, we notice
that leasing is cheaper.
To set it up in Excel, create the following spreadsheet.
233
13. Leasing
_____________________________________________________________________________
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
A
Purchase price =
Investment tax credit =
Net cost =
Cost of debt =
Income tax rate =
Discount rate =
Sale price =
Number of years =
PV of tax benefit of depreciation =
PV of after-tax sales price =
NPV(buy) =
Lease payment, in advance =
PV of lease payments =
Tax benefit of lease payments =
NPV(lease) =
25000
.1
=B1*(1-B2)
.09
.3
=(1-B5)*B4
5000
4
=B5*B3/B8*(1-1/(1+B6)^B8)/B6
=B7*(1-B5)/(1+B6)^B8
=-B3+B9+B10
5000
=-B12-B12*(1-1/(1+B6)^(B8-1))/B6
=B5*B12*(1-1/(1+B6)^B8)/B6
=B13+B14
Video 13.2 13.2. Campbell Company has to decide between leasing a warehouse for four
years at the fixed annual rent of $24,098.04, payable in advance; and buying it outright for
$100,000. If Campbell buys the warehouse, it can borrow the money at 12% interest for
four years. The company will depreciate the warehouse on the straight-line basis for 10
years, but actually sell it for $30,000 after 4 years. The marginal tax rate of the company
is 35%. Assume that the tax benefits of leasing are not available until the end of that year.
Should Campbell buy or lease the warehouse?
The after-tax cost of debt, the discount rate, is 0.12(1 0.35) = 0.078.
The depreciation of the warehouse is $10,000 annually, and therefore its tax benefit is
.35(10,000) = $3500. The book value of the warehouse after 4 years is $60,000. The
company plans to sell it for $30,000, which will create a loss of $30,000. However, this
loss also has a tax benefit of 30,000(0.35) = $10,500. The final sale brings in $30,000 in
cash and $10,500 in tax benefits for a total of $40,500.
The NPV of the purchase decision is thus
4 3500
40500
NPV(buy) = 100,000 + 1.078i + 1.0784 = $58,365.52 (A)
i=1
Assume that the company makes the lease payments at the beginning of each year, but their
tax benefits are not available until the end of that year, the NPV of leasing is,
24098.04 4 24098.04(.35)
1.078i + i=1
1.078i
i=1
3
NPV(lease) = 24,098.04
= 24,098.04 62,327.79 + 28,060.33 = $58,365.50

234
(B)
13. Leasing
_____________________________________________________________________________
Since the two costs are exactly alike, the company is indifferent between leasing and
buying the warehouse.
You can use WolframAlpha to solve (A) as follows:
-100000+sum(3500/1.078î,i=1..4)+40500/1.078^4
and (B), by using the following expression.
-sum(24098.04/1.078î,i=0..3)+sum(.35*24098.04/1.078î,i=1..4)
To do the problem in Excel, type in the following instructions:
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
Buying
Initial cost
Depreciation period
Holding period
Tax rate
Cost of debt
Discount rate
PV of tax benefit of depreciation
Book value
Sales price
PV of sales price
NPV of buying
Leasing
Lease payments, given
PV of lease payments
PV of their tax benefits
NPV of leasing
B
100000
10
4
.35
.12
=(1-B5)*B6
=B2/B3*B5*(1-1/(1+B7)^B4)/B7
=B2-B4*B2/B3
30000
=(B10-(B10-B9)*B5)/(1+B7)^B4
=-B2+B8+B11
24098.04
=-B14-B14*(1-1/(1+B7)^(B4-1))/B7
=B14*B5*(1-1/(1+B7)^B4)/B7
=B15+B16
13.3. Altair Corporation is considering the alternatives of buying or leasing a new

machine. It may buy the machine for $1 million, use it for five years, and then sell it for
$100,000. Altair will depreciate the machine completely over this period. Altair's after-tax
cost of debt is 12% and its tax rate 30%. The lease will be for five years, with equal
payments made in advance each year, with the tax benefits available after one year. What
lease payment will make the cost of leasing equal to the cost of buying?
The after-tax cost of debt for the company is 12%, which is the proper discount rate. Next,
consider the net cost of buying the machine. The cost of the machine is $1 million and the
annual depreciation is $200,000. The annual tax benefit from the depreciation will be
.3(200,000) = $60,000. The final sale price is $100,000, but after taxes it becomes
100,000(1 .3) = $70,000. Combining these numbers, we get
235
13. Leasing
_____________________________________________________________________________
60000 70000
NPV(buy) = 1,000,000 + 1.12i + 1.125 = $743,993.55
i=1
5
Suppose the lease payments are x dollars annually, payable in advance, and their tax
benefits, .3x, are available at the end of each year. Thus
4
5 .3x
x
NPV(lease) = x 1.12i + 1.12i
i=1
i=1
1 1.124 .3(1 1.125)

=x 1
+
= 2.955916486x
.12
.12
Equate the two costs, as

This gives
743,993.55 = 2.955916486x
x = $251,696.40
Thus, the annual lease payments are $251,696, in advance, which will equate the cost of
leasing to the cost of buying this machine.
You can use WolframAlpha to verify the answer as follows:
-1000000+sum(.3*1000000/5/1.12î,i=1..5)+100000*(1.3)/1.12^5=-sum(x/1.12î,i=0..4)+sum(.3*x/1.12î,i=1..5)
13.4. Dallas Corporation has to decide between buying and leasing a computer. If Dallas
buys the computer, it will cost $200,000, but an investment tax credit of 10% is also
available. Dallas will depreciate the computer using a 5 year ACRS, with depreciation of
18%, 33%, 25%, 16% and 8% for the five years respectively. After 5 years, Dallas expects
to sell the computer for $20,000. The tax rate of the company is 40% and its after-tax cost
of debt is 11%. King Leasing Co will lease the same computer to Dallas for 5 years, but
will charge the annual lease payments in advance every year. Dallas will get the tax benefits
immediately. Find the lease payment, which will make Dallas indifferent towards leasing
or buying.
Let us first find the net cost of buying the computer. The purchase price is $200,000, the
investment tax credit is $20,000, and so the net initial investment is $180,000.
The PV of tax benefits due to depreciation
0.18 0.33 0.25 0.16 0.08
= 0.4 (180,000) 1.11 + 1.112 + 1.113 + 1.114 + 1.115 = + $55,128.13
The PV of after-tax proceeds of the sale =
20000 (1 0.4)
= + $7,121.42
1.115
236
13. Leasing
_____________________________________________________________________________
Adding these, we get the NPV(buy) = 180,000 + 55,128.13 + 7,121.42 = $117,750.45

Suppose the lease payments are X dollars, payable in advance, and the tax benefits are also
available at the same time. This gives
(1 .4)X
.6X(1 1.114)
=
.6X
= 2.4614674 X
i
1.11
.11
i=1
4
NPV(lease) = (1 .4)X
Equating the two costs, we get
2.4614674 X = 117,750.45
X = the annual lease payment = $47,838
.4*180000*(.18/1.11+.33/1.11^2+.25/1.11^3+.16/1.11^4+.08/1.11^5)+
20000*(1-.4)/1.11^5-200000*(1-.1)=-sum((1-.4)*x/1.11î,i=0..4)
13.5. Titan Trucking Company needs 10 new trucks. Each truck costs $45,000, lasts on
the average 6 years, with no residual value. Titan depreciates the trucks on a straight-line
basis. A 10% investment tax credit is also available. If it buys the trucks, Titan has to pay
$1,000 annually per truck for maintenance. Titan has tax rate of 40%. Hyperion Leasing
Company will lease these trucks to Titan at an annual cost of $10,000 per truck, payable in
advance. Titan can buy the trucks by borrowing money at the rate of 15% per annum. What
is your recommendation to Titan whether to buy or to lease the trucks?
Let us calculate the result for one truck. Because of the 10% investment tax credit, the net
cost of each truck is .9(45,000) = $40,500. The proper discount rate in this case is the aftertax cost of debt = (1 0.4)(0.15) = 0.09. We find the NPV as follows:
NPV(buy) = 40,500
Investment
in the truck
1000(1 0.4)
1.09i
i=1
6
PV of after-tax cost of
maintenance
(40,500/6)(.4)
= $31,079.57 (A)
1.09i
i=1
6
PV of tax benefits of
depreciation
Assuming that the lease payments are payable in advance each year and the tax benefits
are available at the end of the year, we get
NPV(lease) = 10,000
First lease
payment
10000
1.09i
i=1
PV of remaining
five payments
.4(10,000)
1.09i
i=1
6
= $30.952.80 (B)
PV of tax benefits
of lease payments
Comparing the net cost of leasing and buying, we see that it is better to lease the trucks.
237
13. Leasing
_____________________________________________________________________________

A=-40500-sum(1000*.6/1.09î,i=1..6)+sum(40500/6*.4/1.09î,i=1..6)
B=-sum(10000/1.09î,i=0..5)+sum(.4*10000/1.09î,i=1..6)
13.6. Dalton Company needs a new computer, which it may buy for $140,000. It will
depreciate it on a straight-line basis over 7 years to zero value, and then sell for $10,000.
Alternately, Dalton may lease the same computer for 7 years with annual lease payments
of $25,000 payable in advance. Dalton can take the tax credit of lease payments
immediately. The tax rate of Dalton is 35%, and its pre-tax cost of debt 10%. Should it buy
or lease?
The discount rate in this case is (1 t)kd = (1 .35)(.10) = .065.
20000(.35)
10000 (1 0.35)
+
= $97,425.57 (A)
i
1.065
1.0657
i=1
7
NPV(buy) = 140,000 +
Initial
investment
PV of tax benefit of
depreciation
PV of after-tax
resale value
25000(1 .35)
= $94,916.47 (B)
1.065i
i=1
6
NPV(lease) = 25,000(1 .35)

PV of first lease
payment, after tax
PV of remaining six
payments, after taxes
Comparing the cost of buying and leasing, we see that leasing is the better alternative.
A = -140000+sum(20000*.35/1.065î,i=1..7)+10000*(1-.35)/1.065^7
B = -sum(25000*(1-.35)/1.065î,i=0..6)
13.7. James Corporation needs a corporate jet for the next four years. It can buy the jet for
$15 million. The company will depreciate the jet on a straight-line basis over the next 15
years, but sell it for $11 million after four years. The cost of debt for the company is 12%
and its income tax rate 25%. Calculate the annual lease payment, payable in advance each
year, which will make the cost of leasing equal to the cost of buying. Assume that the tax
benefits of the lease payments are available immediately.
The proper discount rate in this problem is (1 t)kd = (1 .25)(.12) = .09. The annual
depreciation is $1 million and its tax benefit tD is $.25 million. Finally, the jet is sold for
its book value, $11 million, and there is no payment of taxes. With amounts in $million,
238
13. Leasing
_____________________________________________________________________________
.25
11
NPV(buy) = 15 + 1.09i + 1.094 = $6.397392709 million
4
i=1
Suppose the lease payment is L and its tax benefit is available immediately, then after taxes,
it becomes (1 .25)L = .75L. Thus
3 .75L
NPV(lease) = .75L 1.09i = $2.648470999L million
i=1
Equating the two costs,

which gives
$2.648470999L = $6.397392709
L = 2.415504157 = $2.4155 million

-15+sum(.25/1.09î,i=1..4)+11/1.09^4=-sum(.75*L/1.09î,i=0..3)
To simplify the leasing problems, we use the words immediately or right away to indicate
that if the annual lease payment L is made at time t = 0, its tax benefit tL is also calculated
at t = 0. This is the case in Examples 13.4, 13.6, and 13.7.
Similarly, the terms a year later, or at the end of the year signify that if the annual lease
payment L is made at time t = 0, its tax benefit tL is available at t = 1. This happens
frequently, as in Examples 13.1, 13.2, 13.3, and 13.5.
It is also possible to do the calculation twice, once with immediate benefits and once with
delayed benefits. The average of these values will give a more realistic result.
We do this to simply the calculations. In real life, the lease payments are on a monthly
basis and their cumulative tax benefit is available after several months. For example, a
company may lease a machine in November 2011, pay $2000 fee in November 2011, and
$1000 monthly lease payments in November and December 2011. The total lease-related
payments are $4000 in 2011. Suppose the income tax rate of the company is 30%. The
company can claim the tax benefit = .3(4000) = $1200 in April 2012 when it files its income
tax return.
Problems
13.8. Aries Corporation needs a computer, which it can buy for $100,000. Aries will
depreciate the computer uniformly over its useful life of 4 years. An investment tax credit
of 10% is also available, and the computer will have no residual value. Aries plans to
borrow the money at an interest rate of 10% specifically to finance the purchase. The tax
rate of Aries is 40%. Gemini Leasing Corporation can also lease the same computer to
239
13. Leasing
_____________________________________________________________________________
Aries for the same period. Calculate the annual lease payments, made in advance each year,
and their tax benefit taken right away, that will make Aries indifferent to leasing or buying.
$26,687
13.9. Muskie Corporation needs a new computer, which costs $120,000 depreciating it on
a straight-line basis over its economic life of 5 years. Muskie may be able to sell the
computer at that time for $20,000. The tax rate of Muskie is 35% and it is able to borrow
funds to acquire the computer at annual interest rate of 10%. Vance Corporation can lease
the same computer to Muskie at the annual fee of $25,000, payable in advance for the next
five years. Should Muskie buy or lease the computer, if the tax benefits of leasing are
delayed?
NPV(buy) = $75,604, NPV(lease) = $74,283, lease.
13.10. Bedford Corporation is planning to lease a machine for the next five years for an
annual lease payment of $2,000 paid in advance, plus a non-refundable initial fee of $3,000.
There is a one-year delay for the tax benefits of leasing. Bedford may buy the machine,
depreciate it fully over the next five years, and then sell it for 10% of the purchase price.
Bedford can borrow the money at 9% interest rate to finance the purchase, and its tax rate
is 40%. Calculate the price of the machine, which will make purchasing or leasing to be
$12,207
equally costly.
13.11. Chandrasekhar Corporation plans to acquire a corporate jet, by either leasing it or
buying it. The five annual lease payments are $245,000 each, payable in advance. The
company can buy the jet by borrowing money at 9% interest. The tax rate of the company
is 30%. If it buys the jet, the company will depreciate it over 10 years, using straight-line
method. However, it will sell it after five years at 80% of its original cost. Calculate the
price of the jet, which will equate the cost of buying to the cost of leasing. Assume that the
tax benefits of lease payments are available immediately.
$2,166,738
13.12. Gore Inc is planning to lease a computer for $6,216 per annum, payable in advance,
for a period of 4 years. The lease will cover maintenance expenses. The president of Gore
feels that if he buys the same computer he should be able to sell it at 20% of the purchase
price after 4 years. However, in case of purchase, the company must pay annual
maintenance expenses of $800 at the end of each year. The pretax cost of debt of Gore is
10% and its income tax rate is 35%. If Gore buys the computer, it will depreciate it fully
in four years. What is the maximum price that Gore should pay for this computer? Assume
that Gore can take the tax credit for lease payments (a) immediately, and (b) a year later.
(a) Immediate: $21,629, (b) Delayed: $22,438
13.13. Violet Ray Inc needs a new computer. They may buy it for $50,000, depreciate it
completely on a straight-line basis for five years, and then sell it for a residual value of
$5,000. There will be an investment tax-credit of 10%. The cost of debt of the company is
10%, and its marginal tax rate is 40%. Orange Computer will also lease the computer to
Violet for 5 years, charging the lease payments in advance each year. For what lease
payments will Violet be indifferent towards buying or leasing?
$9925
240
13. Leasing
_____________________________________________________________________________
13.14. Dammam Overnight Delivery Service would like to acquire 300 vans for its
business. It can buy each van for $30,000, depreciate it completely over 5 years, and then
sell it for $10,000. The tax rate of Dammam is 30%, and its cost of debt is 10%. Dhahran
Rental Company will lease these vans to Dammam for a period of 5 years at the annual
rate of $6,000, paid in advance. Dammam will get the tax benefits of the lease at the end
of each year. Should Dammam buy or lease these vans?
NPV(buy) = $17,628.74, NPV(lease) = $18,942.91, buy
13.15. Albany Company needs a new computer that costs $50,000 with expected life of 5
years. Albany will depreciate it completely during this period on a straight-line basis and
then sell it for $10,000. Albany is also considering leasing the same computer for five
years, by paying an annual lease payment in advance, and taking the tax benefits
immediately. Find the amount of the lease payment, which will make the buying or leasing
to be equally costly for the company. The tax rate of Albany is 30%, and its cost of debt
10%.
L = $10,651 annually
13.16. Liberia Company needs a car, which it may lease by paying an initial fee of $2000,
and lease payments for $400 a month in advance for 36 months. The cost of debt for the
company is 12% and its tax rate 25%. The company pays its income tax annually. Liberia
may also buy the car for $15,000, depreciate it fully over five years, but sell it at some
unknown price after three years. Find the selling price of the car that will make buying and
leasing to be equivalent. Should the company buy or lease the car?
$1323.45, buy the car
Key Terms
capital lease, 214, 215
discount rate, 215, 216, 217,
219, 220
financial lease, 214
leasing, 213, 215, 216, 217,

218, 219, 221, 222, 223
lessee, 213, 214
lessor, 213
241
leveraged lease, 213, 214

operating lease, 215
14. INVESTMENT ANALYSIS

Objective: After reading this chapter, you will be able to analyze investment opportunities,
particularly the real-estate investments.
14.1
Real Estate Investments
In this chapter, we shall look at some of the investment opportunities that present
themselves to the corporations and individuals alike. We analyze the situations with the
help of a powerful tool, the NPV analysis. The desirability of an investment depends on
whether its NPV is positive or not. These examples provide an overview of the investment
process.
Investing in real estate is quite popular. Many people buy a house, live in it comfortably,
and then sell it at an appreciated price. We will look at real estate as an investment
opportunity. First, consider a simple example where an investor buys a house, rents it out
for a while, and then sells it at a profit.
To examine this situation analytically, assume that the purchase price of the house is H. Its
selling price after n years is Hn. The profit, Hn H, is taxable income, and the tax due at
the time of sale is (Hn H)t, where t is the income tax rate. The cash flow at the time of
sale is thus Hn (Hn H)t. = Hn(1 t) + Ht. Suppose the risk-adjusted discount rate for
such an investment is r. Then the NPV of the investment is
NPV = H +
Hn(1 t) + Ht
(1 + r)n
(14.1)
Equation (14.1) is incomplete because it does not consider depreciation, rental income, or
maintenance expenses. We can make the problem more realistic by renting the house at the
annual rent R, and include the annual maintenance costs M. Assume that R and M are
calculated at the end of the year. The maintenance expenses may also cover the real estate
taxes. The net rental income R M is taxable income, and its annual after-tax value is (R
M)(1 t). At the same time, the homeowner can use the depreciation of the house as a
tax deduction and create an annual benefit of tD, where D is the annual depreciation. The
annual cash flow, C is thus
C = (R M)(1 t) + tD.
When the investor sells the house, the capital gain on the sale is the selling price minus the
book value of the house. The book value of the house is given by H nD. The after-tax
cash flow from the sale of the house is thus
Hn (Hn H + nD)t
242
14. Investment Analysis
_____________________________________________________________________________
Including rental income, maintenance, and depreciation, (14.1) becomes

(R M)(1 t) + tD Hn (Hn H + nD)t
+
(1 + r)i
(1 + r)n
i=1
n
NPV = H +
(14.2)
We have assumed that the depreciation is on a straight-line basis and the income tax rate
for the ordinary income and the capital-gains income is the same. We can make the model
more complete by assuming a different tax rate t for ordinary income and tg for capital
gains. This will make (14.2) to be
(R M)(1 t) + tD Hn (Hn H + nD)tg
+
(1 + r)i
(1 + r)n
i=1
n
NPV = H +
(14.3)
We should modify equation (14.2) if the annual rents are available in advance every year.
It will then become
n1
n (M + D R)t M
R
Hn (Hn H + nD)t
NPV = H +
+
(14.4)
i+
i
(1
+
r)
(1
+
r)
(1 + r)n
i=0
i=1
Next, we consider two other important costs: the closing costs when we buy the house and
the selling costs when we sell it. The closing costs include the transfer taxes, attorney's
fees, title insurance, loan origination fees, "points," document preparation fees, and deed
recording fees. The bank may charge a fee, called points, when it approves a loan. It is
usually between 0% and 3% of the amount of loan. In many places, the buyer and the seller
pay the transfer taxes to the state and local governments. At present, the transfer tax rate in
Scranton, PA, is 2.15%, both for the buyer and the seller.
Let us consider a comprehensive problem about real estate investments. It is instructive to
follow the details of the problem and to modify it to solve simpler problems.
Purchase price of the house = $150,000 (land = $30,000, building = $120,000)
Depreciation schedule = 25 years, on a straight line
Initial rent = $1200 at the end of each month, expected to increase by 5% annually
Maintenance, including real estate taxes = $300 per month, expected to increase by 4% per
year
Expected rate of appreciation of the value of property = 5% per year
Plan to sell the property after 10 years
Borrow 80% of the value of the house and pay 2 points
Fixed closing costs at the beginning of the project = $335
Transfer tax rate = 1.85%
Fixed costs at the time of selling of the house = $100
Realtor's commission = 6%
Ordinary income tax rate = 28%
Capital gains tax rate = 14%
Risk-adjusted discount rate = 10%
243
_____________________________________________________________________________
Is it a worthwhile investment?
Divide the problem into the following simpler problems.
(1) What is the initial investment?
(2) What is the present value of the tax benefits of depreciation?
(3) What is the present value of rental income, including taxes and inflation?
(4) What is the present value of expenses, including taxes and inflation?
(5) What is the present value of final sales price, including taxes and inflation?
(1) To find the initial investment, consider the following expenses:
(a) Purchase price of the house, $150,000
(b) Payment of transfer taxes, .0185(150,000) = $2775
(c) Points paid to the bank, .02(.8)(150,000) = $2400
(d) Fixed cost at the time of purchase of the house (title insurance, lawyers fee, deed
recording fee, etc.) = $335
Adding these numbers, we get 150,000 + 2775 + 2400 + 335 = $155,510. The expenses
associated with buying the house, $5510 are tax deductible. Their tax benefit, available at
the end of the first year, is .28(5510) = $1542.80. Its present value = 1542.80/1.1 =
$1402.55. Subtracting it from the total expenses of buying the house, we get 155,510
1402.55 = $154,107.45, which is the initial investment. (Negative cash flow)
Let us define: H = purchase price of the house
tt = transfer tax rate
p = points paid to the bank. For 2 points, p = .02
= loan-to-value ratio; the amount of mortgage loan divided by the property value
F1 = fixed closing costs at the time of buying the property
r = risk-adjusted discount rate used to discount all cash flows
t = income tax rate
Assume that the tax benefit of the expenses occurs at the end of the year. This gives the
first cash flow C1 as
t[H(tt + p) + F1]
C1 = [H(1 + tt + p) + F1] +
(14.5)
(1 + r)
Using Maple, one can write it as
C1:=-(H*(1+tt+p*gamma)+F1)+t*(H*(tt+p*gamma)+F1)/(1+r);
subs(H=150000,tt=.0185,p=.02,gamma=.8,F1=335,r=.1,t=.28,C1);
(2) Only the building can be depreciated for tax purposes, not the land. The depreciation
per year is 120,000/25 = $4800. Its tax benefit is .28*4800 = $1344. The present value of
this amount over the 10-year holding period, discounted at the rate 10%, is
244
_____________________________________________________________________________
10
1344
1.10i = $8258.30 (Positive cash flow)
i=1
Using the following symbols,

L = value of the land
N = number of years for depreciation
n = holding period of the property
one can write C2 as
t(H L)/N t(H L)[1 (1 + r)n]

C2 =
=
rN
(1 + r)i
i=1
n
(14.6)
In Maple notation, it becomes,

C2:=t*(H-L)*(1-1/(1+r)^n)/r/N;
subs(t=.28,H=150000,L=30000,r=.1,n=10,N=25,C2);
(3) Consider only the first years rent. The monthly rent is $1200 and the monthly discount
rate is .1/12. The present value of the first-year rent is thus
12
1200
(1 + .1/12)i = $13,649.41
i=1
The total rent for the first year is 12(1200) = $14,400. Since the taxes are paid at the end
of the year, they are .28(14,400) = $4032. The present value of the taxes is 4032/1.1 =
$3665.45.
The present value of the first year rental income, after taxes, is 13,649.41 3665.45 =
$9,983.96.
The rental income will go up by 5% annually for several years, and it will be discounted
by 10% annually. The present value of 10-year rental income, including taxes, and
inflation, is thus
9,983.96 + 9,983.96(1.05/1.1) + 9,983.96(1.05/1.1)2 + ... 10 terms
This is a geometric series, with a = 9,983.96, x = 1.05/1.1, and n = 10. Do the summation
by using (1.4).
9983.96[1 (1.05/1.1)10]
= $81,706.63 (positive cash flow)
1 1.05/1.1
Using the following symbols,
245
_____________________________________________________________________________
R = rent per month, collected at the end of the month

fr = annual rent inflation
we can write C3 as
Or,
R
12tR 1 [(1 + fr)/(1 + r)]n
12
C3 =
i=1 (1 + r/12) 1 + r 1 (1 + fr)/(1 + r)
12
t 1 [(1 + fr)/(1 + r)]n
1 1/(1 + r/12)
C3 = 12R
1 + r
1 (1 + fr)/(1 + r)
(14.7)
In Maple notation, it becomes,

12*R*((1-1/(1+r/12)^12)/r-t/(1+r));
C3:=%*(1-((1+fr)/(1+r))^n)/(1-(1+fr)/(1+r));
subs(R=1200,r=.1,t=.28,fr=.05,n=10,C3);
(4) The calculation of the expenses proceeds in a similar way. The present value of the
first-year expenses is
12
300
(1 + .1/12)i = $3412.35
i=1
The annual tax benefit due to expenses is .28(3600) = $1008, and its present value is
1008/1.1 = $916.36. The present value of the first-year expenses, after taxes, is 3412.35
916.36 = $2495.99.
Use an inflation rate of 4%, and discount rate of 10% to find the present value of the
expenses for ten years as
2495.99 + 2495.99(1.04/1.1) + 2495.99(1.04/1.1)2 + ... 10 terms
Use (1.4) again to find the sum as
2495.99[1 (1.04/1.1)10]/(1 1.04/1.1) = $19,644.76 (Negative cash flow)
Defining the quantities,
M = monthly expenses, at the end of each month
fm = annual inflation rate for expenses
one can write C4 as,
M
12tM 1 [(1 + fm)/(1 + r)]n
12
C4 = (1 + r/12)i (1 + r) 1 [(1 + f )/(1 + r)]
m
i=1
Or,
12
t 1 [(1 + fm)/(1 + r)]n
1 1/(1 + r/12)
C4 = 12M
r
(1 + r) 1 (1 + fm)/(1 + r)
246
(14.8)
_____________________________________________________________________________
In Maple notation, it is
-12*M*((1-1/(1+r/12)^12)/r-t/(1+r));
C4:=%*(1-((1+fm)/(1+r))^n)/(1-(1+fm)/(1+r));
subs(M=300,r=.1,t=.28,fm=.04,n=10,C4);
(5) Assume that the property values are increasing at the rate of 5% per year. After 10
years, the selling price of the house is 150,000(1.05)10 = $244,334.19. The realtor will take
6% of this amount, namely, .06(244,334.19) = $14,660.05. Since the transfer taxes are
applied to both the buyer and the seller, you have to pay transfer tax again, which amounts
to .0185(244,334.19) = $4520.18. You pay another $100 as fixed costs at selling.
After paying the realtor, the county transfer taxes, and fixed cost, you get 244,334.19
14660.05 4520.18 100 = $225,053.96. Defining,
fp = rate of appreciation of property values
one could write it as
H(1 + fp)n(1 c tt) F2
In Maple notation, it looks like this

H*(1+fp)^n*(1-c-tt)-F2;
subs(H=150000,fp=.05,n=10,c=.06,tt=.0185,F2=100,%);
The total amount of depreciation for ten years is 10(4800) = $48,000. The book value of
the house is thus 150,000 48,000 = $102,000. The capital gain on the house is 225,053.96
102,000 = 123,053.96. The tax on the capital gain is .14(123,053.96) = $17,227.55.
{H(1 + fp)n(1 c tt) F2 [H n(H L)/N]}tg
-(H*(1+fp)^n*(1-c-tt)-F2-(H-n*(H-L)/N))*tg;
subs(H=150000,fp=.05,n=10,c=.06,tt=.0185,%);
subs(F2=100,L=30000,N=25,tg=.14,%);
The selling expenses on the house (realtors fee, transfer taxes, and fixed amount) add up
to 14660.05 + 4520.18 + 100 = $19,280.23. Using this expense as a deduction against
ordinary income, its tax benefit is .28(19,280.23) = $5398.47.
[H(1 + fp)n(c + tt) + F2]t
(H*(1+fp)^n*(c+tt)+F2)*t;
subs(H=150000,fp=.05,n=10,c=.06,tt=.0185,F2=100,t=.28,%);
After paying taxes, the cash from selling the house is 225,053.96 17,227.55 + 5398.47 =
$213,224.87. The present value of this sum is 213,224.87/1.110 = $82,207.42 (positive cash
flow)
247
_____________________________________________________________________________
C5 = [H(1 + fp)n(1 c tt) F2 {H(1 + fp)n(1 c tt) F2 [H n(H L)/N]}tg

In Maple notation, it becomes
+ [H(1 + fp)n(c + tt) + F2]t]/(1 + r)n
(14.9)
H*(1+fp)^n*(1-c-tt)-F2;
%-(%-(H-n*(H-L)/N))*tg;
%+(H*(1+fp)^n*(c+tt)+F2)*t;
C5:=%/(1+r)^n;
subs(H=150000,fp=.05,c=.06,tt=.0185,F2=100,n=10,L=30000,%);
subs(N=25,tg=.14,r=.1,t=.28,%);
Adding all five cash flows, marked by a red diamond , we get
NPV = 154,107.45 + 8258.30 + 81,706.63 19,644.76 + 82,207.42
NPV = $1,579.87
In Maple notation, it is
NPV:=C1+C2+C3+C4+C5;
Considering the NPV, it is not a profitable project.
Examples
14.1. Suppose your marginal income-tax rate is 25%. Assume that 60% of the capital gains
and the first $200 in dividends are tax exempt. The interest paid on borrowed funds and
the transaction costs are tax deductible. On November 1, 2007, you borrow $8,000 from
the bank at 7.5% interest rate. You already have $10,000 of your own funds. With this
$18,000, you buy 100 shares of IBM at 90, with a dividend of $1.20 per share. You invest
the remaining funds in PP&L 8s2018 bonds at 90. On November 1, 2008, you liquidate
your portfolio, IBM at 100, and PP&L bonds at 96, and pay off the bank loan. The total
transaction costs are $20 for stock and $50 for bonds. Calculate the after-tax rate of return
on your own funds.
Consider the stock investment first. Money invested in IBM stock = $9000.
Capital gain on IBM, including transaction costs = 10,000 9000 20 = $980.
Since 60% of the capital gain is tax-exempt, the tax is due on 40% of the gain.
Thus tax due = .4(980)(.25) = $98
Dividends received on IBM stock = $120 (all tax exempt)
After-tax capital gain on stock, plus dividends = 980 + 120 98 = $1002 (A)
You bought the bonds at 90, that is, 90% of their face value. Thus, you buy $10,000 face
value of bonds for $9000. You sell the bonds at 96, meaning, 96% of their face value.
Capital gain on bonds, including transaction cost = 10,000(0.96 0.90) 50 = $550.
The tax due = .4(550)(.25) = $55.
248
_____________________________________________________________________________
The after-tax capital gain on bonds = 550 55 = $495 (B)

Interest received on bonds = 0.08 (10,000) = $800
Interest paid to the bank = 0.075 (8,000) = $600
Net interest income = 800 600 = $200
Tax due on interest income = 200(0.25) = $50
After-tax interest income = 200 50 = $150 (C)
Adding (A), (B), and (C), the total dollar return = 1002 + 495 + 150 = $1647
Overall percentage rate of return on your own investment = 1647/10,000 = 16.47%
14.2. You are looking into the possibility of operating a Laundromat. You will rent a
storefront and buy the washing machines and dryers. You expect to generate $20,000
annually in revenue. The rent of the building is $3,000 annually, payable in advance for
the next five years. You will depreciate the machines on a straight-line basis over 5 years,
with no resale value. You are in a 30% tax bracket, and your after-tax required rate of return
is 12%. Assuming that the cash inflows occur at the end of the year, how much should you
pay for the equipment?
To simplify the problem, assume that other expenses such as electricity and water are zero.
To break even, the NPV of this investment is zero, arranged as follows:
Action
Buy the Laundromat
Present value
1
x
5 20000(1 .3)
2 PV of after-tax cash from machines
1.12i
i=1
3
PV of rent payments, in advance
Equals
x
50,466.86683
4 3000
3000 1.12i 12,112.04804
i=1
3000(.3)
(x/5)(.3)
1.12i
i=1
PV of tax benefit of rent
PV of tax benefit of depreciation
NPV
1.12i
i=1
3,244.298582
.2162865721 x
Sum of the above
=0
Write the numbers in the last column as an equation,

x + 50466.86683 12112.04804 + 3244.298582 + .2162865721 x = 0
Simplify it to get
.7837134279 x = 41599.11737
This gives x = 53,080. You should pay $53,080 for the equipment.
You may do the problem on WolframAlpha as follows.
249
_____________________________________________________________________________
-x+sum(20000*(1-.3)/1.12î,i=1..5)sum(3000/1.12î,i=0..4)+sum(3000*.3/1.12î,i=1..5)+sum(x/5*
.3/1.12î,i=1..5)=0
To do the problem using Maple, enter the following instructions:
-I0;
%+sum(20000*(1-.3)/1.12î,i=1..5);
%-sum(3000/1.12î,i=0..4);
%+sum(3000*.3/1.12î,i=1..5);
%+sum(I0/5*.3/1.12î,i=1..5)=0;
solve(%);
To do the problem using Excel, set up the spreadsheet as follows. Adjust the value of the
initial investment in cell B2 until the NPV in cell B15 becomes close to zero.
11
12
A
Time, years
Initial investment, $
Project life, years
Cost of capital
Income tax rate, t
Cash from
machines, $
After-tax cash from
machines, $
Annual rent, $
Depreciation for year
Tax benefit of
depreciation
Tax benefit of rent
Total cash flow
13
14
15
Discount factor
PV of cash flows
NPV
1
2
3
4
5
6
7
8
9
10
B
0
53080
5
0.12
0.3
3000
=-B2-B8
1
=B12*B13
=SUM(B14:G14)
1t
20000
=1-B5
=C6
=C6
=C6
=C6
=C6*D5
=D6*D5
=E6*D5
=F6*D5
=G6*D5
=B8
=B2/B3
=B5*C9
=B8
=B2/B3
=B5*C9
=B8
=B2/B3
=B5*C9
=B8
=B2/B3
=B5*C9
=B2/B3
=B5*C9
=B5*B8
=C7C8+C10+C11
=1/(1+B4)
=C12*C13
=B5*B8
=D7D8+D10+D11
=1/(1+B4)^2
=D12*D13
=B5*B8
=E7E8+E10+E11
=1/(1+B4)^3
=E12*E13
=B5*B8
=F7F8+F10+F11
=1/(1+B4)^4
=F12*F13
=B5*B8
=G7+G10+G11
=1/(1+B4)^5
=G12*G13
Video 14.3 14.3. Elbridge Gerry is planning to buy a house and rent it out for the next 5
years, collecting an annual rent of $6,000 in advance each year. He is in the 22% tax
bracket. He will depreciate the house on a straight-line basis for 25 years. Gerry plans to
sell the house after 5 years at a price that will be 20% higher than the purchase price, taking
the profit as a long-term capital gain. Assume 60% of such capital gains are tax exempt.
The after tax cost of capital for Gerry is 8%. Ignore the maintenance expenses of the house
and real estate taxes. How much should Gerry pay for the house to break even?
Suppose the purchase price of the house is H. We can find the NPV by considering these
factors and their respective present values:
(1) The initial investment = H
4 6000
(2) PV of rents, in advance annually = 6000 + 1.08i = $25,872.76
i=1
(3) Assume that the taxes are due at the end of each year at the rate of 22% of rents.
250
_____________________________________________________________________________
6000(.22)
1.08i = $5270.38
i=1
5
PV of taxes paid on the rental income =

(4) The annual depreciation is H/25.
(H/25)(.22)
= .03514 H
1.08i
i=1
5
The PV of tax benefits of depreciation =
(5) The sale price of the house is 1.2H. Gerry has already taken 20% of the depreciation of
the house leaving its book value to be .8H. The profit on the sale is (1.2H .8H). Only
40% of it is taxable at the rate of 22%.
PV of after-tax sales price =
1.2H (1.2H .8H)(.4)(.22)

= .7927433078 H
1.085
NPV is the sum of all these figures, and to break even, it should be zero. Thus
H + 25872.76104 5270.377249 + .03513584833 H + .7927433078 H = 0
Solving for H, we have H = $119697.2041, or approximately, $119,700
We can also do the problem by using (14.4)
n1
n (M + D R)t M
R
Hn (Hn H + nD)t
NPV = H + (1 + r)i +
+
(14.4)
i
(1 + r)
(1 + r)n
i=0
i=1
We have to modify the equation slightly to accommodate the following changes:

(1) There are no maintenance expenses, which makes M = 0.
(2) The tax benefit of depreciation is available at the end of year 1-5. He pays the taxes on
rental income at the end of the year.
(3) Since 60% of capital gain is tax exempt, we should take 40% of the capital gain, and
pay taxes on it at the rate of 22%.
Incorporating these changes, equation (14.3) becomes
n1
n (D R)t
R
Hn (Hn H + nD)(.4)t
NPV = H + (1 + r)i + (1 + r)i +
(1 + r)n
i=0
i=1
Now, put n = 5 years, R = $6000, t = .22, r = .08, Hn = 1.2H, D = H/25, and NPV = 0. This
gives
4 6000
5 .22(H/25 6000)
1.2H (1.2H H + 5H/25)(.4)(.22)
H + 1.08i +
+
=0
i
1.08
1.085
i=0
i=1
The WolframAlpha instruction to solve the equation is as follows.
251
_____________________________________________________________________________
-H+sum(6000/1.08î,i=0..4)+sum(.22*(H/256000)/1.08î,i=1..5)+(1.2*H-(.2H+H/5)*.4*.22)/1.08^5=0
The result is $119,697.
To do the problem on Excel, set up the spreadsheet as follows. Adjust the value of the
house in cell B2 until the NPV in cell B18 is almost zero.
11
12
13
14
15
A
Time, years
Purchase price of
house, $
Project life, years
Cost of capital
Income tax rate, t
Rent, $
Tax on rent, $
After-tax rent, $
Depreciation for year
Tax benefit of
depreciation
Sale price of house, $
Book value of house
Capital gain
Tax on capital gain
Total cash flow
16
17
18
Discount factor
PV of cash flows
NPV
1
2
3
4
5
6
7
8
9
10
B
0
119700
5
0.08
0.22
6000
=B6
C
1
Depreciable life,
years
2
25
1t
=B6
=B5*B6
=C6-C7
=B2/D2
=B5*C9
=1-B5
=B6
=B5*B6
=C6-C7
=B2/D2
=B5*C9
E
3
Price
appreciation
4
0.2
=B6
=B5*B6
=C6-C7
=B2/D2
=B5*C9
=B6
=B5*B6
=C6-C7
=B2/D2
=B5*C9
=-B2+B8
=C8+C10
=C8+C10
=C8+C10
=C8+C10
1
=B15*B16
=SUM(B17:G17)
=1/(1+B4)
=C15*C16
=1/(1+B4)^2
=D15*D16
=1/(1+B4)^3
=E15*E16
=1/(1+B4)^4
=F15*F16
G
5
=B5*B6
=-C7
=B2/D2
=B5*C9
=(1+F2)*B2
=B2-B3*B2/25
=G11-G12
=0.4*B5*G13
=G8+G10+G11G14
=1/(1+B4)^5
=G15*G16
To do the problem using Maple, we let

-H+sum(6000/1.08î,i=0..4);
%-sum(.22*6000/1.08î,i=1..5);
%+sum(.22*H/25/1.08î,i=1..5);
%+(1.2*H-(1.2*H-.8*H)*.4*.22)/1.08^5=0;
solve(%);
14.4. Ralph Boston plans to buy a house and rent it out for a period of 5 years collecting
an annual rent of $6,000 in advance each year. He will sell the house after five years and
he believes that the price of the house will appreciate at the compound rate of 6% per
annum. The maintenance and real estate taxes, paid at the end of each year, will be $1,000
annually. Boston's income tax rate is 30%, and his after-tax cost of capital is 12%. He will
depreciate the house on a straight-line basis over a 20-year period. How much should he
pay for the house so that the NPV of this project is $5,000?
Suppose the purchase price of the house is H.
Increasing at the rate of 6% annually, its value after 5 years will become 1.06 5H =
1.338225578H.
The depreciation per year is H/20 and the accumulated depreciation for 5 years will be
5(H/20) = .25H.
252
_____________________________________________________________________________
The book value of the house after 5 years will be H .25H = .75H.
The capital gain on the house will be (1.338 .75)H = .5882H.
The tax on this capital gain will be .3(.5882H) = .1765H.
The after-tax proceeds from the sale will be (1.338 .1765)H = 1.162H, with present
value = (1.162/1.125)H = .6592H. Write the cash flows in a table as follow.
1
Action
Buy the house
Tax benefit of depreciation
Present value of cash flow

H
5 .3H/20
+ 1.12i
i=1
Rent for 5 years, in advance
Equal to
H
+ .05407H
4 6000
+ 6000 + 1.12i
+ 24,224
5 .3(6000)
1.12i
i=1
6489
i=1
Tax on rental income
Maintenance expenses, after

taxes
Sell the house
Required NPV
(1000)(1 .3)
1.12i
i=1
5
1.065H [1.065H (H .25H)](.3)

1.125
Sum of the above
2523
+ .6592H
= 5000
Adding (1) through (7) and equating it to (8), we get

H + .05407H + 6000 + 18224 6489 2523 + .6592H = 5000
Solve for H,
H = $35,617.70

-H+sum(6000/1.12î,i=0..4)+sum((.3H/20-.3*6000-1000*(1.3))/1.12î,i=1..5)+(1.06^5-(1.06^5-(1.25))*.3)*H/1.12^5=5000
The Maple code to solve the problem is as follows.
-H+sum(.3*H/20/1.12î,i=1..5)+6000+sum(6000/1.12î,i=1..4);
%-sum(.3*6000/1.12î,i=1..5)-sum(1000*(1-.3)/1.12î,i=1..5);
%+(H*1.06^5-.3*(H*1.06^5-.75*H))/1.12^5=5000; solve(%);
You may do this problem by using equation (14.4), which assumes that the rents are
collected in advance each year.
n1
n (M + D R)t M
R
Hn (Hn H + nD)t
NPV = H + (1 + r)i +
+
(14.4)
i
(1 + r)
(1 + r)n
i=0
i=1
253
_____________________________________________________________________________
In the above equation, put NPV = $5000, R= $6000, n = 5 years, r = 12%, t = 30%, M =
$1000, D = H/20, Hn = 1.065H. This gives
4 6000
5 (1000+ H/20 6000)(.3) 1000
5000 = H + 1.12i +
1.12i
i=0
i=1
1.065H [1.065H H + 5(H/20)](.3)

1.125

5000=-H+sum(6000/1.12î,i=0..4)+sum(((1000+H/20-6000)*.31000)/1.12î,i=1..5)+(1.06^5*H-(1.06^5*HH+5*H/20)*.3)/1.12^5
14.5. Hart Co intends to buy an office building for $2 million and depreciate it on a
straight-line basis over a 20-year period. However, Hart plans to sell the building after 5
years for $2.5 million. The tax rate of the company is 30% and its WACC is 8%. What is
the minimum acceptable rental income (after paying expenses) calculated at the end of
each year? The capital gains are fully taxable.
Write the cash flows in $million. Include the initial investment, PV of tax benefit of
depreciation, PV of after-tax rental income, PV of after-tax resale value of building. To
break even, set the NPV equal to zero. Arrange the items in a table.
Action
Buy the building

2
5 .3(2/20)
+ 1.08i
i=1
2 Tax benefit of depreciation

3
After-tax rental income
Sell the building
NPV
R(1 .3)
1.08i
i=1
5
+
+
2.5 [2.5 (2 5*2/20)](.3)

1.085
Sum of the above
Equal to
2
+ .1197813011
+ 2.794897026 R
+ 1.497283033
=0
From the terms in the last column,

2 + .1197813011 + 2.794897026 R + 1.497283033 = 0
This gives
R = .1370124418 = $137,012 annually
The company must generate $137,012 in annual rental income, after paying all expenses.
254
_____________________________________________________________________________
-2+sum((.3*2/20+R*(1-.3))/1.08î,i=1..5)+(2.5-(2.5-(25*2/20))*.3)/1.08^5=0
The Maple code for this problem is as follows:
-2+sum(2/20*.3/1.08î,i=1..5);
%+sum(R*(1-.3)/1.08î,i=1..5);
%+(2.5-(2.5-2+5*2/20)*.3)/1.08^5=0;
solve(%);
14.6. Binghamton Company is planning to buy ATM machines and install them
nationwide inside supermarkets. Each machine costs $6,000 and the company will
depreciate it on a straight-line basis over 5 years, although the useful life of each machine
is expected to be 10 years. Binghamton will charge the users $1 per withdrawal. The
company expects the expenses to be as follows: annual rent to the supermarket $3,000,
payable in advance each year; maintenance, insurance, and service $2000 per year; and 25
cents per transaction to the banks whose cards are used at the machine. The income tax rate
of Binghamton is 30% and its cost of capital 12%. Find the minimum transactions per year
to break even. Realistically, is it a good project?
Suppose x is the number of annual withdrawals per machine to break even. Arrange the
items in a table.
1
Action
Buy the machine
Tax benefit of depreciation
3 After-tax transaction fees collected

6000
5 .3(6000/5)
+ 1.12i
i=1
Equal to
6000
+ 1297.719433
(1 .25)(1 .3)x
1.12i
i=1
+ 2.966367090 x
3000(1 .3)
1.12i
i=0
13,289.32456
2000(1 .3)
1.12i
i=1
7910.312240
10
After-tax rent paid
After-tax maintenance cost
NPV
10
Sum of the above
=0
Write the terms in the last column as an equation as follows,

NPV = 6000 + 1297.719433 + 2.966367090 x 13,289.32456 7910.312240 = 0
It gives
x = 8732 withdrawals/year
255
_____________________________________________________________________________
-6000+sum(.3*6000/5/1.12î,i=1..5)-sum(3000*(1.3)/1.12î,i=0..9)+sum(((1-.25)*(1-.3)*x-2000*(1.3))/1.12î,i=1..10)=0
The Maple solution is as follows:
-6000;
%+sum(.3*6000/5/1.12î,i=1..5);
%+sum((1-.25)*(1-.3)*x/1.12î,i=1..10);
%-3000*(1-.3)-sum(3000*(1-.3)/1.12î,i=1..9);
%-sum(2000*(1-.3)/1.12î,i=1..10);
solve(%=0);
8732 withdrawals per year are equal to 8732/365 = 24 transactions per day. It may work
out as a reasonable project.
14.7. Ardmore Corporation wants to set up a car wash. It will buy the land for $50,000,
build a building for $150,000, and buy the car-wash equipment for $50,000. The machine
will last for 5 years with no resale value. The company uses straight-line depreciation.
Ardmore will depreciate the building over a 20-year period, but will sell the building and
land for $200,000 after 5 years. The WACC for Ardmore is 12% and its income tax rate
30%. The company plans to charge $4.00 per car. Ardmore estimates per car expenses as,
electricity 25, water 25, detergent 25, labor 50. Assume that all revenues and expenses
are available at the end of each year. In order to break even, how many cars should Ardmore
wash per year?
Including machinery, land, and building, the initial investment in the car-wash business is
$250,000. (1)
The depreciation for the building per year is 150,000/20 = $7500, and for equipment
50,000/5 = $10,000, with a total of $17,500 per year. You cannot depreciate land. The
present value of the tax benefit of depreciation for 5 years is
.3(17,500)
= 18,925.07506 (2)
1.12i
i=1
5
Suppose the company washes x cars per year to break even. The profit per car is (4.00
.25 .25 .25 .50) = $2.75. After taxes it becomes 2.75(1 .3) = $1.925. The present
5 1.925x
value of after-tax income for 5 years = 1.12i = 6.939194190x (3)
i=1
The original value of building and land was $200,000. The total amount of depreciation
taken on building and land is 7500*5 = $37,500. Its book value is thus 200,000 37,500 =
$162,500. The taxable profit on building and land is 200,000 162,500 = $37,500. The
taxes due are .3(37,500) = $11,250. The company sells the building and land for $200,000.
256
_____________________________________________________________________________
PV of after-tax sales =
200000 11250
= 107,101.8190 (4)
1.125
Combine the cash flows (1) through (4), and set the total equal to zero to break even. Thus
250,000 + 18,925.07506 + 6.939194190 x + 107,101.8190 = 0
Solve for x,
x = 17,866
The car-wash must wash 17,866 cars every year to break even. If it is open 300 days a year,
it should have 17,866/300 = 60 customers every day. It is unlikely to have that kind of
traffic. To verify the answer at WolframAlpha, try this:
-250000+sum(.3*(150000/20+50000/5)/1.12î,i=1..5)+sum(2.75*(1.3)*x/1.12î,i=1..5)+(200000-.3*(200000-(200000-5*7500)))/1.12^5=0
Problems
14.8. John Fulton is planning to buy a house for $50,000 by borrowing money at the rate
of 9%. He expects to rent the house for 5 years, collecting $4,000 annual rent in advance
each year. He thinks that he can sell the house for $55,000 after five years. Fulton has
income tax rate of 40%. He will have to pay $2,000 annually in maintenance and real estate
taxes, and he will depreciate the house on a straight-line basis for 20 years. The riskadjusted discount rate in this project is 10%. If all the expenses are fully deductible, and all
gains are taxable, should he undertake this project?
No, NPV = $10,340
14.9. Texas Company is interested in buying a house and renting it out for $6000 a year,
collecting the rent in advance each year. It will depreciate the house over 25 years, but sell
it after 15 years at twice its purchase price. The maintenance expenses and real estate taxes,
at the end of each year, are $1000 annually. The after tax cost of capital for Texas is 10%
and its income tax rate 25%. Find the price of the house that Texas should pay so that it
can make $5000, in current dollars, from this project.
$51,924
14.10. John Lewis is looking into the possibility of buying several coin-operated vending
machines and placing them in the local hospitals. Each machine costs $2000, which he will
depreciate on a straight-line basis over 8 years. The machine will dispense Coke cans at 75
cents each and Coca Cola Company will replenish them at 40 cents each. Each machine is
expected to sell 1500 cans a month. The hospitals will provide the space and electricity for
the machines for $200 a month at the end of every month. The tax rate of John Lewis is
25% and the after tax cost of capital 12%. Assume that the income and bills occur at the
end of each month, but the taxes are paid annually. Should John Lewis get into this venture?
NPV = $13,464, yes
14.11. Bahrah Corporation is interested in buying a 50-unit apartment complex, and
renting out the individual apartments at $600 per month. The tenants pay their own heat
and utilities. The company estimates the land value as 20% of the total value of the
257
_____________________________________________________________________________
complex. Bahrah expects to sell the property after 10 years at a price that is 50% higher
than its current value. Bahrah will depreciate the buildings on a straight-line basis over 25
years. Bahrah estimates maintenance expenses, including real estate taxes, to be 20% of
the rental income. Assume that all cash flows occur at the end of each year. The discount
rate for this investment is 12%, and the tax rate of Bahrah is 30%. Calculate the price that
Bahrah should pay for the complex just to break even.
$2,101,620
14.12. Ace Car Rental plans to start its business by buying 10 cars at the average price of
$18,000 each, depreciating them completely over 5 years using the straight-line method. It
will rent space in a parking lot for $300 a month, paying the rent in advance each month.
Ace expects that it will rent five cars on an average day, charging $40 per day per car. The
maintenance expense for each car is $60 a month. After 5 years, Ace will sell the cars at
40% of the original value. Ace receives all the income and pays all the bills, (except rent)
at the end of each month, but it pays the taxes once a year. Its income tax rate is 25% and
it will use 12% as the discount rate. Assume that there are 30 days in a month. Is it a
worthwhile project for Ace?
Yes, NPV = $57,067
14.13. Barquisimeto Corporation is interested in buying a 50-room hotel that costs $1.5
million. The value of the building is $1 million and that of the land $500,000. It will
depreciate the building over 20 years using the straight-line method. However,
Barquisimeto expects to sell the property after 5 years for $2 million. The average
occupancy rate in the hotel is 80%, that is, on the average only 40 rooms are rented out
daily. The cost of cleaning a room after the use by a guest is $12 (maid-service, laundry,
etc.) The total bill for major expenses (maintenance, heating, electricity, real estate taxes,
etc.) for the hotel is estimated to be $60,000 annually. The salary of the manager is $40,000
annually. The tax rate of Barquisimeto is 30%, and the proper discount rate for this project
is 12%. Find the daily room rent to break even. Assume that there are 365 days in a year.
$30.76
14.14. Judy Garland is planning to open a stall at the local mall, paying $2500 rent, in
advance each month. She will buy $25,000 in costume jewelry as the initial inventory, and
buy the display cases for $4000. She expects that the average sales per month will be
$15,000, of which she will use $5000 to replenish her inventory. She will hire an assistant
for $2000 a month. At the end of five years, she plans to sell the entire business, including
inventory and display cases, for $30,000. Her income tax rate is 25% and she will use a
discount rate of 12%. Assume that all the cash flows occur at the end of the month, except
rent, and the taxes are due at the end of the year. Ignore depreciation and capital gains. Is
it a worthwhile project?
Yes, NPV = $174,673
Key Terms
appreciation, 226, 230, 235
closing costs, 226, 227
deed, 226, 227
discount rate, 225, 226, 227,
228, 229, 240, 241
investment, 225, 226, 227,

231, 232, 233, 235, 237,
238, 239, 240
points, 226, 227
258
real estate, 225, 226, 233,

235, 240, 241
title insurance, 226, 227
transfer taxes, 226, 227, 230
15. REVIEW PROBLEMS

15.1. Alger Corp wants to buy a bulldozer for $50,000, which has a useful life of 4 years
with no salvage value. Alger uses straight-line depreciation, has a tax rate of 30%, and an
after-tax cost of capital of 10%. The machine will generate a pretax income of $16,000
for the first year, but this figure will decline by 5% annually for the remaining three
years. Should Alger buy this machine?
NPV = $4,985, don't buy
15.2. Bierce Company stock is not paying any dividend at present. However, you feel
that it may start paying an annual dividend of $1 after one year (probability is 30%). If it
does not start the dividend after one year then it may start the dividend after two years,
with a probability of 50%. It will certainly start paying dividends after three years. Once
the dividend start, they will continue uniformly in the future. If your required rate of
return is 15%, how much should you pay for a share of Bierce stock? $5.79 per share
15.3. Togo Company follows the residual theory of dividends. It expects to have $45
million in earnings after taxes next year, and $45 million in profitable projects at that
time. Togo must maintain its optimal capital structure with debt-to-assets ratio at 45%.
The company has 4.5 million shares of common stock. Find the expected dividend per
share next year.
$4.50
15.4. You have developed the following information about two stocks, whose correlation
coefficient is 0.5:
Name
Burroughs Corp
Chandler Corp
E(R)
14%
16%
(R)
20%
23%
0.85
1.10
(A) Make a portfolio that simulates the market. Find the expected return on the market,
E(Rm), and the standard deviation of this return, (Rm).
E(Rm) = .152, (Rm) = .191
(B) Find the probability that the actual return on the market is more than 20%. 40.08%.
15.5. Annapolis Corporation needs a machine, which costs $100,000. Annapolis will
depreciate it completely on a straight-line basis over 5 years, and then sell it for $5,000.
Alternatively, it may lease the same machine for 5 years, paying the lease payments in
advance each year and taking their tax benefits at the end of each year. The cost of debt
to Annapolis is 15%, and its income tax rate is 30%. Find the amount of annual lease
payments that will make the cost of buying equal to that of leasing the machine.
L = $25,031
15.6. Columbus Corporation needs $12 million in new capital, which it may acquire by
selling 12% coupon bonds at par, or by selling stock at $14 net per share after paying the
flotation costs. At present Columbus has 2 million shares of common and $10 million
face amount of bonds with 11% coupon. After the new financing, Columbus expects to
259
15. Review Problems
_____________________________________________________________________________
have an EBIT of $4 million, with a standard deviation of $1.5 million. Which method of
financing is better, if the objective is to maximize the EPS of the company? What is the
probability that you have made the right choice? What is the probability that the company
may default on its interest payment, if it uses the method decided above?
Use stock, P(being right) = 89.74%, P(default) = 2.66%
15.7. Austin Co has the following capital structure: $56 million (face value) of bonds
with coupon of 9%, maturing after 11 years, selling at 79; $40 million, 12% coupon
bonds, selling at par; 36 million shares of common selling at $6 each; and 1 million
shares of preferred stock which pays a dividend of $2.50 and sells at $17 each. The beta
of the common stock is 1.24, the expected return of the market is 16%, and the riskless
rate is 9%. The tax rate of Austin is 25%. Find the WACC of Austin. WACC = 15.24%
15.8. Albany Corp has zero coupon bonds maturing after 15 years. The overall value of
the firm is 3 times the face value of the bonds. The company has sigma of .25 and the
riskless rate is 8%. Using the option pricing theory, find the market value of a $1000
bond.
B = $298.74
15.9. Richmond Corporation needs a new machine, which is expected to add $15,000
annually to the EBIT of the company, with a standard deviation of $3,000. The machine
will run for 5 years. Richmond will depreciate it on a straight line with no salvage value.
The tax rate of Richmond is 30% and its after-tax cost of capital is 12%. If the cost of
machine is $50,000, find the probability that it will be a profitable investment.
NPV = $1335.52, P(NPV>0) = 43%, reject
15.10. Aquascutum Company is planning to acquire Austin Reed using its existing
capital. Both companies sell men's clothing. Aquascutum currently has $40 million in
debt at an average rate of 8%, and $60 million in equity. The beta of Aquascutum is 1.35,
its tax rate is 35%, the expected return on the market is 13%, and the riskless rate is 7%.
The additional earnings (before taxes) due to this acquisition will be $1 million for the
first year, and they will rise 3% annually thereafter. Find the price of Austin Reed that
Aquascutum should pay.
$7,985,285
15.11. Dickins & Jones, Inc is a company formed by two partners. Dickins owns the
entire stock of the company, but Jones has lent some money to the company with the
understanding that the company will pay him $100,000 after 5 years. The of the
company is 0.4, and the riskless rate is 7%. Dickins and Jones are interested in selling the
company to a buyer for $200,000. Based on option pricing theory, what is an equitable
distribution of the proceeds of the sale between Dickins and Jones?
Dickins $135,500, Jones $64,500
15.12. Comcast Corporation has the following capital structure: $40 million face amount
of 4% bonds due in 10 years, selling at 60; 4 million shares of common stock selling at
$16 each; and 1 million shares of preferred stock selling at $15 a share. The of Comcast
is 1.35, the riskless rate is 6%, and the expected return on the market is 12%. The tax rate
260
15. Review Problems
_____________________________________________________________________________
of Comcast is 30%, and the cost of capital for the preferred stock is exactly halfway
between that of debt and equity. Find the WACC of Comcast.
12.15%
15.13. Christies has debt/assets ratio of 30%, but the management believes that it should
be raised to 40%. However, the additional debt will add $5 million to the bankruptcy
costs of the company. The current value of Christies is $77 million, and its tax rate is
35%. Should the company move to higher debt level?
New V = $74.32 million, stay at 30% level
15.14. Harrod's is a department store with $50 million in debt and $60 million in equity.
Its tax rate is 40%, cost of debt 8%, and beta 1.35. The riskless rate is 6% and the
expected return on the market 12%. Harrod's would like to start a limousine service using
its existing capital. Lillywhite provides only limousine service. Lillywhite has $1 million
in debt and $4 million in equity, with tax rate of 30% and beta 1.2. Find the required rate
of return for Harrod's in the new venture?
10.47%
15.15. Selfridges Corporation is in need of a corporate jet, which costs $5 million. The
jet has a useful life of 10 years. Selfridges will depreciate it on a straight line. The tax rate
of Selfridges is 30%, and its cost of debt is 10%. It may also lease the jet by making a
certain lease payment in advance each year and take the tax credit of the lease payments
immediately. Find the annual lease payments which will make leasing or buying to be
equal in cost.
$750,184
15.16. You have assembled the following information about two stocks:
Stock
Harrison Co.
Johnson Co.
0.8
1.6
E(R)
12.4%
18.8%
(R)
0.15
0.3
The correlation coefficient between the companies is 0.6. Find riskless rate and the
expected return on the market. Construct a portfolio with = 1 and find its (Rp).
r = .06, E(Rm) = .14 and (Rp) = .1685
15.17. Marks & Spencer is planning to get a new machine for $18,000. The expected
income from the machine is $4,000 annually, with the standard deviation of $2,000. The
machine will run for 6 years and M&S will depreciate it on a straight line. The tax rate of
M&S is 30%, and the after tax cost of capital 9%. Find the probability that this machine
will be profitable.
41.16%
15.18. Sixty-five years old Ashley Taylor has received $300,000 as a lump sum pension
settlement. She has invested the money in an account that pays 6% interest per annum,
compounded monthly. Ashley plans to withdraw $2,000 per month from this account.
The first withdrawal will be after one month. How long will it be before this money is
exhausted? If Ashley expects to live another 17 years, with a standard deviation of 7
years, what is the probability that the money will be used up during her life?
18.93%
261
15. Review Problems
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15.19. You are considering the following two bonds in 2011: Moosic Corporation 8.5s30
selling at 95 and Duryea Company 8.75s33 selling at 99. Both the bonds are rated by
S&P as BBB. Your required rate of return is 9%. Which bond(s) will you buy?
First
15.20. Wyoming Coal Company is interested in buying a machine for $40,000, which it
will depreciate uniformly over a four-year period. An analysis of the life expectancy of
such machines reveals that 30% break down after 3 years, 60% run for 4 years, and 10%
last for 5 years. The tax rate of Wyoming is 35% and its cost of capital is 9%. If the
machine can generate $10,000 per year in pretax earnings, should Wyoming buy it?
No, NPV = $8,494.83
15.21. Pittston Corporation is considering the following three projects:
Project
A
B
C
Investment
$10,000
$20,000
$50,000
E(R)
0.15
0.14
0.12
(R)
0.20
0.18
0.16
Correlation coefficient
A, B = 0.3
A, C = 0.5
B, C = 0.7
Pittston may take one, or two, or all three projects. The company wants to maximize the
ratio E(R)/(R). What do you recommend?
Take A and B together.
15.22. Ghana Company expects to have $40 million in EBIT next year, with standard
deviation $10 million. The company has $100 million in long-term bonds with coupon
9%, and it has to pay $6 million in preferred dividends. Ghana has dividend payout ratio
40%, and 10 million shares of common stock. The income tax rate of the company is
35%. Find the probability that the dividend next year is more than 60 per share.
44.80%
15.23. Mountaintop Corporation expects to pay a dividend of $3.00 next year, $3.25
after two years, $3.50 after three years, and $3.75 after the fourth and subsequent years.
The required rate of return for the stockholders is 16%. Find the price of the stock now,
and just after the payment of the first $3.00 dividend.
$22.26, $22.82
15.24. Churchill Corporation has total value of $100 million. It has $50 million (face
amount) of zero-coupon bonds outstanding in 2008, which will mature in 2030. The
riskless rate is 6% at present. The risk of Churchill measured in terms of its is .30.
Using option pricing theory, find the debt/assets ratio of Churchill.
B/V = .1188
15.25. Attlee Company stock has 25 million shares of stock selling at $15 each. The of
stock is estimated to be 1.25. Attlee also has $625 million (face amount) of zero-coupon
bonds maturing after 25 years. These bonds are selling at $150 each. The riskless rate is
6%. The expected return on the market is 12%. The income tax rate of Attlee is 30%.
Find the weighted average cost of capital of Attlee.
11.90%
15.26. Heath, Inc. has $45 million in long-term bonds, selling at par. It also has 3 million
shares of common stock priced at $25 each. The bankruptcy costs of the company are
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15. Review Problems
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estimated to be $10 million. The tax rate of the company is 30%. Mr. Heath has proposed
that the company should reduce its debt/assets ratio to 30% by selling some stock and
buying back bonds from the proceeds. The new capital structure will also reduce the
bankruptcy costs to $5 million. Is it a good proposal? What is the new debt and equity of
the company after implementing this proposal?
Yes. New debt = $36.758 million, new equity = $85.769 million
15.27. Thatcher Airlines is estimated to be 1.5. Thatcher has $700 million in equity
and $300 million in debt and its tax rate is 30%. Major Airlines has $800 million in
equity and $400 million in debt and has income tax rate 25%. The riskless rate is 7% and
the expected return on the market is 12%. Find the cost of equity capital for Major.
14.93%
15.28. Chamberlain Leasing Corporation would like to buy a computer for $125,000,
depreciate it fully over a five year period, and then sell it for $10,000. Chamberlain can
lease the computer to Macmillan Company for 5 years, charging them $30,000 annually,
in advance each year. The maintenance expenses, $3,000 annually, will be paid by
Chamberlain. The tax rate of Chamberlain is 30%, and the cost of debt 10%. Will this
lease be profitable to Chamberlain?
NPV = $3,153.47, no
15.29. Baldwin Company is interested in buying a new corporate jet for $6 million. It
will depreciate the jet fully in 5 years and then sell it for $5 million. The jet will use
$60,000 in fuel annually, and its maintenance will be $40,000 annually. The tax rate of
Baldwin is 35% and its WACC 10%. Find the minimum annual savings generated by the
jet to justify its purchase.
$1.167 million
15.30. Callaghan Company stock is selling at $45 a share and its price/earnings ratio is
15. The P/E ratio is based on current price and the earnings for the last 12 months. The
earnings for next year is uncertain. It is expected to be $4 a share, with a standard
deviation of $1. Assuming that the stock maintains its current P/E ratio, find the
probability that Callaghan stock will be selling for more than $55 a share next year.
63.06 %
15.31. Turin Corporation is borrowing $200,000 from the bank with the understanding
that the loan will be paid off in 12 monthly installments, and the interest will be
calculated at the rate of 12% per annum on the unpaid balance. Turin has decided to
structure the payments so that they will increase at the rate of 4% every month, in line
with the increasing cash flow at the company. Find the first month's payment.
$14,257.38
15.32. Milan Corporation is interested in buying a machine that will cost $50,000, and it
will be completely depreciated on the straight line basis over a 5 year period. The
machine is expected to last for 7 years and then it would be sold for $5,000. The expected
earnings before taxes from the machine is $15,000 with a standard deviation of $5,000.
The income tax rate of Milan is 35%, and its after-tax cost of capital 10%. Find the
probability that this machine will be profitable.
78.39%
263
15. Review Problems
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15.33. Rome Corporation is planning to acquire a machine for $20,000. The life of the
machine is uncertain: it may last for 4 years (probability 30%), 5 years (probability 50%),
or 6 years (probability 20%). The machine will be fully depreciated in five years on a
straight line basis with no residual value. The after-tax cost of capital for Rome is 12%
and its tax rate 30%. Rome will not buy the machine unless it has a NPV of $3000. Find
the minimum earnings before taxes that this machine must generate to justify its
purchase.
$7,534.91
15.34. A portfolio is made of 400 shares of Naples Corporation, selling at $20 each, and
1700 shares of Palermo Corporation that sell at $10 each. The returns of these securities
under different conditions are presented below:
State of Economy Probability Return of Naples Return of Palermo
Good
25%
22%
25%
Fair
50%
15%
15%
Poor
25%
5%
0%
Find the expected return and standard deviation of return of the portfolio.
13.91%, 8.008%
15.35. Abington Corporation is valued at $50,000, and is owned equally by two brothers
John and Bill. John would like to sell his share of business to Bill. Bill accepts that, and
offers to pay him $25,000 in cash. Or, John can take a note guaranteed by the
corporation, payable after 5 years, with a face value of $35,000. The riskless rate of
interest is 6%, and the of the company is .3. Using option pricing theory, what is your
suggestion for John?
Value of the note = $23,910, take cash.
15.36. Pfizer Incorporated has 2 million shares of common stock, selling at $18 each.
The of the stock is 1.5, T-bill rate is 6%, and the expected return on the market is 12%.
Pfizer also has $20 million (face amount) of bonds, with coupon 6%, which will mature
after 8 years. The required rate of return for the bondholders is 10%. Use equation (3.1)
to find the market value of the bonds. The income tax rate of Pfizer is 40%. Find the
WACC of Pfizer.
12.27%
15.37. Ambridge Company has 6 million shares of common stock selling at $26 a share,
and $50 million in bonds, selling at par, with coupon 7%. The company needs $50
million in new capital which can be raised by selling stock at $25 a share, or by selling
bonds with 8% coupon. After the new financing, the expected EBIT of the company is
$60 million, with a standard deviation of $20 million. Ambridge has to pay $6 million in
preferred dividends and $10 million in sinking fund payments. The income tax rate of
Ambler is 30%. By calculating the EBIT that will make it indifferent to debt or equity
financing for the new capital, find the preferred method of financing. What is the
probability that you are right?
E* = 42.357 million, P(being right) = 81.12%
264
15. Review Problems
_____________________________________________________________________________
15.38. Archbald Corporation can buy a computer of $70,000, depreciate it fully over 7
years, and then sell it for $5,000. There is a 6% investment tax credit available. The
income tax rate of Archbald is 40%, and its cost of debt is 12%. Archbald can also lease
the computer for 7 years, paying a certain lease payment in advance each year whose tax
benefit is available at the end of the year. Find the annual lease payment that will make
leasing or buying to be equally costly.
$12,187.68
15.39. Arnold Corporation wants to buy a machine that costs $50,000, which is expected
to run for 5 years. Arnold will depreciate it on straight-line basis over that period, with no
resale value. However, there is a 20% chance that the machine may break down after just
4 years. In that case, Arnold will buy a used machine for $15,000 and use it for only one
year, without any resale value. The tax rate of Arnold is 30%, and its after-tax cost of
capital is 12%. The machine will generate an income of $13,000 annually. Should Arnold
buy the machine?
No, NPV = $7,737.22
15.40. Dayton Corporation is considering these three projects whose returns are
normally distributed:
Project Investment E(R)
A
$20,000
12%
B
$30,000
14%
C
$50,000
16%
(R) Correlation coefficient

20%
A, B = 0.4
20%
A, C = 0.5
30%
B, C = 0.6
Find the probability that the return on the portfolio is more than 20%.
40.11%
15.41. Garfield Corporation bonds will mature after 3 years and they pay interest
annually at the rate of 8%. The first interest payment is due a year from now. The bonds
are regarded as junk because there is a 25% probability that the company may go
bankrupt in a given year, provided it survives the previous year. In case of bankruptcy,
the company will not pay any interest on the bonds and it is expected to pay only 20% of
the principal to bondholders one year after the bankruptcy. If your required rate of return
is 15%, how much should you pay for a Garfield bond?
$464.33
15.42. Arthur Company is planning to acquire a machine for $90,000 which has an
uncertain life. The machine may break down after 4 years (probability 10%), 5 years
(probability 20%), or 6 years (probability 70%). The machine will be depreciated on a
straight line basis for 5 years with no resale value. The income tax rate of Arthur is 30%,
and its after-tax cost of capital 8%. Find the pre-tax annual earnings generated by this
machine so that its NPV is $10,000.
$25,657
15.43. Grant Corporation is interested in buying a machine which costs $60,000, and
which will be depreciated linearly to zero value in 5 years, but then it will be sold for
$5,000. The earnings from this machine are expected to be $15,000 per year, with
standard deviation $5,000. The income tax of Grant is 35%, and its after-tax cost of
capital 9%. Find the probability that this machine will turn out to be profitable. 38.71%
265
15. Review Problems
_____________________________________________________________________________
15.44. Cleveland Company has made a portfolio of three projects as follows:

Project
Cost
E(R)
A
$25,000 10%
B
$35,000 12%
C
$40,000 15%
(R) Correlation coefficient

20%
(A,B) = .3
25%
(A,C) = .4
30%
(B,C) = .5
Find the probability that the return of the portfolio is more than 15%.
45.56%
15.45. Cuman Company is interested in acquiring a computer. It can buy the computer
for $150,000, depreciate it fully over 4 years using straight line depreciation, use it for 5
years, and then sell it for $30,000. Or, it can lease the computer for 5 years by paying
$25,000 annual lease payments in advance. The tax benefits of lease payments are
available immediately. In case of leasing, the company also has to pay a non-refundable
fee of $10,000 in advance. The cost of debt for Cuman is 10%, whereas its income tax
rate is 35%. Which method of acquisition is better for Cuman, buying or leasing?
NPV(buy) = $90,803.72, NPV(lease) = $78,419.23, leasing
15.46. The following information is available for two corporations. The debt and equity
are in millions.
Equity Debt Cost of debt Tax rate Business
Cabimas $500 $300
10%
35%
1.4
Retail
Caracas
$100
$20
9%
30%
1.5 Fast food
The riskfree rate is 5%, and the expected return on the market is 12%. Cabimas Company
would like to start fast food restaurants within their stores, using their existing capital.
13.56%
Find the required rate of return for the new venture.
15.47. Maturn Corporation is owned by two brothers Jos and Miguel. Jos is a
stockholder in the company, but Miguel holds a promissory note that entitles him to
receive $3 million from the corporation after 5 years. They have decided to sell the
company for $5 million and split the proceeds according to the Black-Scholes model. The
of Maturn is estimated to be .3 and the riskfree rate is 6%. Find the amount of money
that each brother should receive.
Jos $2,896,191, Miguel $2,103,809
15.48. Merck & Co has the following capital structure. It has 5 million shares of
common stock that sell at $26 each. The stock just paid its annual dividend of $1.75, and
it is expected to grow at annual rate of 7% in the foreseeable future. The company also
has $150 million (face amount) in zero-coupon bonds that will mature after 8 years, and
they sell at $500 for each $1,000 bond. The income tax rate of Merck is 30%. Find its
weighted average cost of capital.
11.32%
15.49. Maracaibo Company is interested in buying a machine that costs $50,000. The
company will depreciate the machine on straight-line basis over 4 years. The machine,
however, is expected to run for 5 years (probability 30%) or 6 years (probability 70%).
266
15. Review Problems
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While the machine is running, it will generate pretax revenue of $10,000 annually. The
income tax rate of Maracaibo is 35%, and the proper discount rate for this machine is
10%. Should Maracaibo buy this machine?
NPV = $8,923.37, no
15.50. Maracay Corporation is interested in a project that will cost $100,000. The cost of
capital for Maracay is 10%. The annual after-tax income from this project is uncertain.
However, its expected value is $20,000, with a standard deviation of $10,000. This
project will run for 6 years.
(a) Find the probability that the project will turn out to be profitable.
38.36%
(b) How much should Maracay spend on this project so that the probability of it being
profitable is 80%?
$50,443
15.51. Niger Company is interested in buying an apartment and renting it out for
$12,000 a year, collecting the rent in advance each year. Niger will depreciate the
apartment over 20 years, but sell it after 5 years at a price, which is 20% more than its
purchase price. The maintenance expenses and real estate taxes, paid at the end of each
year, are $2000 annually. The after tax cost of capital for Niger is 10%, and its income
tax rate is 25%. Find the price of the apartment that Niger should pay so that it can make
$10,000 in current dollars from this project.
$82,851.09
15.52. Zaraza Company is in financial distress. Its bonds are not paying interest at
present, and are trading at 23% of their face value. You have estimated that there is a
25% probability that Zaraza will go bankrupt after 1 year. If it does not become bankrupt,
then there is a 50% probability that it will become bankrupt after 2 years. It will certainly
go bankrupt after 3 years. You believe that one year after the bankruptcy, the company
will pay $400 per bond to settle with the bondholders. If your required rate of return is
11%, should you buy these bonds?
Yes, B = $289.65
15.53. Barranquilla Corporation has borrowed $200,000 from Bogot bank with the
following terms:
(a) Bogot Bank will charge interest at 12% per annum, with monthly compounding.
(b) Barranquilla will make $10,000 monthly installments to pay off the loan.
Find the balance of the loan after 1 year.
$98,539.98
15.54. Bucaramanga Company is in financial distress. The probability of it becoming

bankrupt in a given year is 20%, provided it survives the previous year. The bonds of the
company have a 9% coupon, but they pay interest only once a year, on October 15, and
they will mature on October 15, 2012. In case of bankruptcy, you do not expect to get
interest for that year, and only 30% of the face amount of the bond. You are thinking of
buying one of these bonds on October 16, 2009. How much should you pay for a bond, if
your required rate of return is 12%.
$626.60
267
15. Review Problems
_____________________________________________________________________________
15.55. Buenaventura Corporation stock is selling at $55 a share. The company will pay a
dividend of $3 at the end of one year, $4 at the end of two years, and then $5 at the end of
three years. However this last dividend is expected to grow at the rate of 8% forever. If
your required rate of return is 16%, do you think you should buy this stock? No, $52.01
15.56. Cartagena Company is planning to get a machine that will save the company
$50,000 annually, with a standard deviation of $10,000. The company uses straight line
depreciation. The tax rate of Cartagena is 30%, and the proper discount rate in this case is
10%. The machine will cost $300,000 and is expected to last for 8 years. Calculate the
probability that the machine will turn out to be profitable.
7.69%
15.57. Cali Company is planning to buy a machine for $80,000 that is expected to save
the company $20,000 annually. The tax rate of Cali is 30%, and the proper discount rate
in this case is 12%. Cali will depreciate the machine on straight-line basis over the next 4
years. The useful life of the machine is uncertain. The probability that the machine will
become obsolete after a certain number of years, and the resale value of the equipment at
that time, is given in the following table. Should Cali buy this equipment?
Probability
30%
30%
40%
Expected life
4 years
5 years
6 years
Resale value
$12,000
$8,000
$3,000
No, NPV = $7,874.74
15.58. Ibagu Company stock sells at $35 a share. It has = 1.54 and = .4. The riskfree
rate is 6%, and the expected return on the market is 12%. You have formed a portfolio
with these two items in it:
(1) 1000 shares of Ibagu stock.
(2) A zero-coupon riskfree bond with face value $50,000, maturing after 1 year.
Calculate the following:
(a) Initial value of the portfolio.
(b) Expected value of the portfolio after one year.
(c) The of the portfolio.
$82,169.81
$90,334
17.04%
15.59. Manizales Corporation stock sells at $73 a share. The of the stock is .4, and the
riskfree rate is 6% at present. Find the value of a call option on this stock with exercise
price $75, and expiring after 73 days.
$4.71
15.60. The value of Senegal Corporation is $200 million. It has $100 million (face
amount) in zero-coupon bonds that will mature in 10 years. The of Senegal is estimated
to be 0.4, and the riskfree rate is 6%. Using the option pricing theory, calculate the debtto-assets ratio of the company.
22.78%
268
15. Review Problems
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15.61. You have assembled the following information about two companies, with dollar
figures in millions:
Equity Debt Tax rate Cost of debt
Algerian Airlines 1.6
$80
$20
30%
9%
Libyan Car Rental 1.5
$30
$20
$35
10%
The riskfree rate is 6%, and the expected return on the market 14%. If Algeria wants to
start a car rental subsidiary, with its existing capital, find the minimum acceptable rate of
return on the new project.
13.93%
15.62. Monsanto Company has 3 million shares, selling at $25 each. The company has
just paid a dividend of $1.35 and the next year's dividend is expected to be $1.50, which
is in line with its long-term growth rate. Monsanto has $50 million (face amount) of
bonds, maturing in 10 years, with coupon 8%. The yield to maturity for the bonds is 10%.
(Use the definition of yield to maturity on page 36 of the textbook.) The income tax rate
of the company is 30%. Find its WACC.
13.38%
15.63. The debt-to-assets ratio of Mali Corporation is 45%. The chief financial officer at
the company feels that it should be reduced to 40%. This should result in lowering the
bankruptcy costs by $20 million. The total value of Mali is $200 million, and its tax rate
35%. Should the change be implemented? If so, what is the value of the stock that should
be sold to buy back the bonds? Yes, V2 = $219.2 million, sell stock for $2.326 million
15.64. Suppose you borrow $12,000 from the bank at the rate of 10% simple interest.
You already have $12,000 of your own money. You take this $24,000 and buy 200 shares
of Apple stock at $120 a share. The of Apple is 1.35. The expected return on the market
is 9% and the risk-free rate is 3%. You plan to sell the stock after one year and pay off
the bank loan, with interest. Ignore any transaction costs and dividends.
(A) Find the expected amount of money in your hand after one year.
(B) What is the expected rate of return on your own money?
$13,464
12.2%
15.65. (Advanced) Consider example 2.5. Axel Heiberg has just accepted a job with an
annual salary S. He has decided to put a fraction a of his gross monthly income into a
retirement account at the beginning of every month. The retirement account pays interest
at the rate of r% every month. Axel also expects to receive an annual raise of g% each
year for the next n years. Show that the amount in his retirement fund at the end of n
years will be
n1 12 aS(1 + r)i+12(nj1)(1+g)j
12
j=0 i=1
15.66. (Advanced) A bank offers the following program to its customers. If you deposit
C at the beginning of every month for the next n years, then in return the bank will give
you C a month forever, starting a month after your last monthly payment. Find the
269
15. Review Problems
_____________________________________________________________________________
minimum value of r, the interest rate per year, which will make depositors join this
program.
r = 12[21/(12n) 1]
15.67. (Advanced) A loan L is payable in n months, with a monthly interest rate r. The
unpaid balance after k months is B. Show that
B + (L B)(1 + r)
ln
k=
ln(1 + r)
n
15.68. (Advanced) A bond with face value F will mature after n years. Its coupon rate is
c and it pays interest semiannually. An investor who buys this bond pays taxes annually,
at the rate T for interest income and t for the capital gain. The investor uses r as the aftertax annual discount rate. Show that the value of this bond for the investor is
B=
F[cT + r(1 t) 22nc(1 + r)n(2 + r)2n + c(1 T)(1 + r)n]

r[(1 + r)n t]
15.69. (Advanced) An employee plans to work for n years at a company and will
contributes a fraction x of his salary to a retirement plan. His earnings will increase
annually by b in real terms. His first pension payment will be of his last salary. The
pension payments increase by a every year in real terms and he will get m annual pension
payments. The plan administration invests the funds in bonds that earn r per year in real
terms. Show that
(1 + b)n1 b r(1 + a)m/(1 + r)m 1
x = (1 + r)n a r (1 + b)n/(1 + r)n 1
Suppose the employee works for 45 years and his earnings increase annually by 2% in
real terms. His first pension payment is 70% of his last salary. The pension payments
decrease by 1% every year in real terms. He will get 18 annual pension payments. Bonds
in the pension portfolio earn 1.5% in real terms. What percentage of his salary should he
invest in the pension plan to fund it properly?
25.02%
15.70. (Advanced) Adams Autos uses 60% equity and 40% debt in its capital structure.
Its cost of debt is 5% and the income-tax rate is 30%. The company buys a car for
$20,000 and leases it to Brown Company for 60 months, collecting $300 as lease
payment in advance each month. Adams Company depreciates the car completely over
five years using straight-line depreciation and then sells the car for $12,000. Find the
return on equity for Adams.
14.06%
270
16. FORMULAS AND TABLES

Assets equal liabilities plus equity
Quadratic equation
Roots of a quadratic equation
Geometric series,
V=B+S
(1.1)
ax2 + bx + c = 0
(1.2)
x=
b b2 4ac
2a
S = a + ax + ax2 + ax3 + ... + axn1
Sum of geometric series, n terms
Sn =
(1.4)
(1.5)
a
S = 1 x
(1.6)
E(X) = PiXi = X
(1.7)
Sum of infinite geometric series,

Expected value of X,
a (1 xn)
1x
(1.3)
i=1
n
var(X) = Pi(Xi X )2
Variance of X,
(1.8)
i=1
Standard deviation of X,
Covariance between X and Y,
(X) = var(X)
n
cov(X,Y) = Pi(Xi X )(Yi Y )
(1.9)
(1.10)
i=1
cov(X,Y)
Correlation coefficient between X and Y, r(X,Y) = (X)(Y)
(1.11)
Covariance
(1.12)
cov(X,Y) = r(X,Y)(X)(Y)
Range of the correlation coefficient, 1 < r(X,Y) < 1

Future value of a sum of money,
FV = PV (1 + r)n
(1.13)
(2.1)
FV with continuous compounding,
FV = PV ern
(2.4)
Present value of a future payment,
FV
PV = (1 + r)n
(2.5)
Present value of an annuity,
C
C[1 (1 + r)n]
=
(1 + r)i
r
i=1
Present value of a perpetuity,
(1 + r)i = r
i=1
271
(2.6)
(2.7)
16. Formulas and Tables
_____________________________________________________________________________
n
1
C
PV of n cash flows, starting after k periods, PV = (1 + r)k1 (1 + r)i
i=1
(2.8)
C(1 + r)[(1 + r)n 1]

r
(2.9)
Future value of n cash flows, starting now, FV =
n
P
L = (1 + r)i
Loan amortization,
(2.10)
i=1
n
P
B
Loan amortization with balloon payment B, L =
(1 + r)i + (1 + r)n
(2.11)
n
w
Future value, including withdrawals, FV = A (1 + r)i(1 + r)n
i=1
(2.12)
i=1
w
lnw Ar
n = ln(1 + r)
Time to exhaust savings,
n
C
F
Present value of a coupon bond, B = (1 + r)i + (1 + r)n
(2.13)
(3.1)
i=1
C
B= r
Present value of a perpetual bond,

Present value of a zero-coupon bond,
Current yield of a bond,
(3.2)
F
B = (1 + r)n
(3.3)
y = cF/B
(3.4)
cF + (F B)/n
(F + B)/2
(3.5)
D1
P0 = R g
(3.6)
n
C
NPV = I0 + (1 + r)i
(4.1)
n
C
NPV = 0 = I0 + (1 + IRR)i
(4.2)
Yield-to-maturity of a bond,
Gordon's growth model,

Net present value,
i=1
Internal rate of return,
i=1
After-tax cash flow,

With maintenance cost M,
C = E(1 t) + tD
C = (1t)(E M) + tD
(4.3)
(4.4)
Book value of an asset,
B = I0 nD
(4.5)
Tax due on the sale of an asset,
T = t(S B)
(4.6)
After-tax value of resale price,
W = S(1 t) + tB
(4.7)
272
_____________________________________________________________________________
For a two-security portfolio,
w1 + w2 = 1
(6.6)
E(Rp) = w1 E(R1) + w2 E(R2)
(6.7)
(Rp) = w12 12 + w22 22 + 2w1w2 12r12
(6.8)
Covariance between i and j,
cov(i,j) = ijrij
(6.5)
wi = 1
For an n security portfolio,
(6.12)
i=1
n
E(Rp) = wi E(Ri)
Expected return of portfolio,
(6.13)
i=1
(Rp) = wiwjcov(i,j)
Its standard deviation,
i=1 j=1
1/2
(6.5)
E(Rp) = E(Ri)
For dollar amounts,
(6.18)
i=1
(Rp) = cov(i,j)
Return on a stock,
Return on the market,
Definition of ,
i=1 j=1
1/2
(6.19)
Rj =
P1 P0 + D1
P0
(7.1)
Rm =
M1 M0
M0 + d1
(7.2)
cov(Rj,Rm) rjmmj rjmj

j = var(R ) = 2 =
m
m
m
Calculation of ,
Calculation of ,
Beta of a portfolio,
(7.3)
n(xy) (x)(y)
nx2 (x)2
=
(7.4)
y x
(7.5)
n
n
p = w11 + w22 + w33 + ... = wii
(7.6)
i=1
Capital Asset Pricing Model,
E(Ri) = r + i [E(Rm) r]
(7.7)
Black-Scholes model,
(8.3)
where
d1 =
ln(S/X) + (r + 2/2)T
T
273
(8.4)
_____________________________________________________________________________
and
d2 =
ln(S/X) + (r 2/2)T
= d1 T
T
P + S = C + X erT
Put-Call Parity Theorem,
(8.7)
Value of a European put, P = S [N(d1) 1] X erT [N(d2) 1]
(8.11)
V=B+S
(9.4)
B
S
WACC = (1 t) kd V + ke V
(9.5)
EAT
EPS = N
(10.1)
EAT = (EBIT I)(1 t)
(10.2)
N
(10.3)
(EBIT I r F) (1 t) SF PD
N
(10.4)
Total value of a firm,
Earnings per share,

Earnings after taxes,
Earnings per share,
Bond financing,
Stock financing,
EPS =
EPS(bonds) =
EPS(stock) =
Critical EBIT,
N + F/P
E* = I + r(NP + F) +
For SF = PD = 0,
(8.8)
C
h = S = N(d1)
Hedge ratio,
WACC,
(8.5)
SF + PD
1t
(10.5)
(10.6)
E* = I + r (N P + F)
(10.7)
Tax shield = tB
(10.8)
Value of a leveraged firm,
VL = VU + tB b
(10.9)
Change in the value of a firm
VL = tB b
House, H
B
L = U 1 + (1 t) S
Leveraged beta,
12(R M)(1 t) + tD Hn (Hn H + nD)t

+
(1 + r)i
(1 + r)n
i=1
n
NPV = H +
274
(10.10)
(11.3)
(14.2)
_____________________________________________________________________________
16.1
How to Use the Probability Tables
In some finance problems, you need to estimate the probability of something happening.
For example, a typical question is to find the probability that a given machine may run
for more than 5 years. If we assume that the life of the machine is normally distributed,
and we know the two parameters that describe the distribution, namely the expected value
and the standard deviation, , then we can answer the question. Further, you need to
learn the use of the probability tables or the NORMDIST function in Excel. The tables
are a little easier to use, although Excel does the calculations automatically.
Suppose you have a portfolio whose expected return is 11%, with normal distribution and
a standard deviation of 7%. You want to find the probability that, by chance, it will
provide a return of 15% or higher. By reading the problem, you know that it is unlikely to
happen. You expect to have a return of 11%, but you require a return of 15%. The result
should be less than 50%.
Start by calculating the parameter z = | x|/. It comes out as z = |.11 .15|/.07 = 4/7 =
.5714285716. Let us truncate it to four figures because that is the accuracy of the tables.
Thus z = .5714.
Next, draw a bell-shaped probability distribution curve. Put z = 0 at the center and mark
off points at 3, 2, 1, 0, 1, 2, and 3. These points are , 2, and 3 from the center. The
required return is .15, which is equivalent to z = .5714. It is about away from the
center. Since we need the probability of return to be higher than .15, we need the area to
the right of z = .5714, which is under the tail of the curve.
The tables are set up to provide the area from the center to the point z. In our case, z =
.5714. To read the tables, first find the area for the first two digits, .57 and then add to it,
14% of the difference between the areas corresponding to .58 and .57. The number 14%
comes from the last two digits of z = .5714. This gives the required area for .5714.
Whatever area we get, we have to subtract it out .5 to find the area under the tail of the
curve. Put it all together as follows:
P(R > .15) = .5 [.2157 + .14(.2190 .2157)] = .2838 = 28.38%
275
_____________________________________________________________________________
The portfolio with expected return 11%, and standard deviation 7%, has 28.38%
probability that it may actually attain a return of 15% or higher. This is a reasonable
answer.
You will need the table to find the values of N(d1) and N(d2) for use in the Black-Scholes
model. In this case N(d1) and N(d2) represent the total area under the normal probability
curve, measured from up to the point d1 or d2. Suppose d1 = .5462, which is positive.
You can place it to the right of zero, or the midpoint of the curve. In this case the area
N(d1) will be somewhat more than .5, as shown in the following diagram.
By using the tables, we get

N(d1) = .5 + .2054 + .62(.2088 .2054) = .7075
If d2 is negative, say, .4142, then it will lie on the left side of the center of the curve.
The shaded area will be less than .5, as seen the next diagram.
The result in this case will be

N(d2) = .5 [.1591 + .42(.1628 .1591)] = .3393
276
_____________________________________________________________________________
Area under the normal probability curve, from the center to a point z, where z =
z
0.01
0.02
0.03
0.04
0.05
Area
.0040
.0080
.0120
.0160
.0199
z
0.51
0.52
0.53
0.54
0.55
Area
.1950
.1985
.2019
.2054
.2088
z
1.01
1.02
1.03
1.04
1.05
Area
.3438
.3461
.3485
.3508
.3531
z
1.51
1.52
1.53
1.54
1.55
Area
.4345
.4357
.4370
.4382
.4394
z
2.01
2.02
2.03
2.04
2.05
Area
.4778
.4783
.4788
.4793
.4798
z
2.51
2.52
2.53
2.54
2.55
Area
.4940
.4941
.4943
.4945
.4946
0.06
0.07
0.08
0.09
0.10
.0239
.0279
.0319
.0359
.0398
0.56
0.57
0.58
0.59
0.60
.2123
.2157
.2190
.2224
.2257
1.06
1.07
1.08
1.09
1.10
.3554
.3577
.3599
.3621
.3643
1.56
1.57
1.58
1.59
1.60
.4406
.4418
.4429
.4441
.4452
2.06
2.07
2.08
2.09
2.10
.4803
.4808
.4812
.4817
.4821
2.56
2.57
2.58
2.59
2.60
.4948
.4949
.4951
.4952
.4953
0.11
0.12
0.13
0.14
0.15
.0438
.0478
.0517
.0557
.0596
0.61
0.62
0.63
0.64
0.65
.2291
.2324
.2357
.2389
.2422
1.11
1.12
1.13
1.14
1.15
.3665
.3686
.3708
.3729
.3749
1.61
1.62
1.63
1.64
1.65
.4463
.4474
.4484
.4495
.4505
2.11
2.12
2.13
2.14
2.15
.4826
.4830
.4834
.4838
.4842
2.61
2.62
2.63
2.64
2.65
.4955
.4956
.4957
.4959
.4960
0.16
0.17
0.18
0.19
0.20
.0636
.0675
.0714
.0753
.0793
0.66
0.67
0.68
0.69
0.70
.2454
.2486
.2517
.2549
.2580
1.16
1.17
1.18
1.19
1.20
.3770
.3790
.3810
.3830
.3849
1.66
1.67
1.68
1.69
1.70
.4515
.4525
.4535
.4545
.4554
2.16
2.17
2.18
2.19
2.20
.4846
.4850
.4854
.4857
.4861
2.66
2.67
2.68
2.69
2.70
.4961
.4962
.4963
.4964
.4965
0.21
0.22
0.23
0.24
0.25
.0832
.0871
.0910
.0948
.0987
0.71
0.72
0.73
0.74
0.75
.2611
.2642
.2673
.2704
.2734
1.21
1.22
1.23
1.24
1.25
.3869
.3888
.3907
.3925
.3944
1.71
1.72
1.73
1.74
1.75
.4564
.4573
.4582
.4591
.4599
2.21
2.22
2.23
2.24
2.25
.4864
.4868
.4871
.4875
.4878
2.71
2.72
2.73
2.74
2.75
.4966
.4967
.4968
.4969
.4970
0.26
0.27
0.28
0.29
0.30
.1026
.1064
.1103
.1141
.1179
0.76
0.77
0.78
0.79
0.80
.2764
.2794
.2823
.2852
.2881
1.26
1.27
1.28
1.29
1.30
.3962
.3980
.3997
.4015
.4032
1.76
1.77
1.78
1.79
1.80
.4608
.4616
.4625
.4633
.4641
2.26
2.27
2.28
2.29
2.30
.4881
.4884
.4887
.4890
.4893
2.76
2.77
2.78
2.79
2.80
.4971
.4972
.4973
.4974
.4974
0.31
0.32
0.33
0.34
0.35
.1217
.1255
.1293
.1331
.1368
0.81
0.82
0.83
0.84
0.85
.2910
.2939
.2967
.2995
.3023
1.31
1.32
1.33
1.34
1.35
.4049
.4066
.4082
.4099
.4115
1.81
1.82
1.83
1.84
1.85
.4649
.4656
.4664
.4671
.4678
2.31
2.32
2.33
2.34
2.35
.4896
.4898
.4901
.4904
.4906
2.81
2.82
2.83
2.84
2.85
.4975
.4976
.4977
.4977
.4978
0.36
0.37
0.38
0.39
0.40
.1406
.1443
.1480
.1517
.1554
0.86
0.87
0.88
0.89
0.90
.3051
.3078
.3106
.3133
.3159
1.36
1.37
1.38
1.39
1.40
.4131
.4147
.4162
.4177
.4192
1.86
1.87
1.88
1.89
1.90
.4686
.4693
.4699
.4706
.4713
2.36
2.37
2.38
2.39
2.40
.4909
.4911
.4913
.4916
.4918
2.86
2.87
2.88
2.89
2.90
.4979
.4979
.4980
.4981
.4981
0.41
0.42
0.43
0.44
0.45
.1591
.1628
.1664
.1700
.1736
0.91
0.92
0.93
0.94
0.95
.3186
.3212
.3238
.3264
.3289
1.41
1.42
1.43
1.44
1.45
.4207
.4222
.4236
.4251
.4265
1.91
1.92
1.93
1.94
1.95
.4719
.4726
.4732
.4738
.4744
2.41
2.42
2.43
2.44
2.45
.4920
.4922
.4925
.4927
.4929
2.91
2.92
2.93
2.94
2.95
.4982
.4982
.4983
.4984
.4984
0.46
0.47
0.48
0.49
0.50
.1772
.1808
.1844
.1879
.1915
0.96
0.97
0.98
0.99
1.00
.3315
.3340
.3365
.3389
.3413
1.46
1.47
1.48
1.49
1.50
.4279
.4292
.4306
.4319
.4332
1.96
1.97
1.98
1.99
2.00
.4750
.4756
.4761
.4767
.4772
2.46
2.47
2.48
2.49
2.50
.4931
.4932
.4934
.4936
.4938
2.96
2.97
2.98
2.99
3.00
.4985
.4985
.4986
.4986
.4987
277

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ANALYTICAL TECHNIQUES IN

Kania School of Management

Finance and Analytical Tools

Formulas and Tables

1. Finance and Analytical Tools

Liabilities and Equity

Total Assets are equal to

Total Liabilities and Equity

In symbols, one can write it as

V = total market value of the company

MBA 503C FIN 508

FIN 581 Financial Institutions

Study the material in

Study the worked out

Can I write these

Is there a similar problem,

Is it possible to break this

Video 01A, Linear Equations

200 + 10 + 7810 = 300x

x = 8020/300 = 26.73333333 $26.73

Substituting this value of x in the first equation, we have 12*2 + 6 y = 33

Mathematica is a useful analytical software, which has capabilities similar to Maple. It

The roots of this equation are

Consider the following examples of non-linear equations.

First, we recall the basic property of logarithm functions, namely,

You can verify the answer at WolframAlpha as follows:

1.4. Find the roots of

ax + ax2 + ax3 + ... + axn1 + axn

S(1 x) = a(1 xn)

We identify a = 3, x = 2, and n = 13. Putting these in (1.4), we get

a (1 xn) 1.7 (1 1.311) 1.7(1.311 1)

At WolframAlpha, use the following instruction.

1.12i = 1.12 + 1.122 + 1.123 + 1.124 + ... + 1.12100

Video 01B Elements of Statistics

To find the expected cash flow, we compute

In the above example the standard deviation of the cash flow is

Covariance between X and Y, cov(X,Y) = Pi(Xi X )(Yi Y )

Y = .6($12,000) + .3($8,000) + .1($6,000) = $10,200

We already know (X) to be $2683. We also evaluate (Y) to be

1 < r(X,Y) < 1

Video 01C Maple

Here we use % as a symbol to designate the previous expression.

Fig. 1.1: Plot of sin x for 0 < x < 2

Solve the following equations for x and y:

1.22. 2.5 + (2.5)(.3) + (2.5)(.3)(.3) ..., infinite terms

Find the roots of

Find the sum of the following series:

2. TIME VALUE OF MONEY

Video 02A, Single Payment Problems

PV = present value, or the initial deposit

When k approaches infinity, we see that

To verify the results at WolframAlpha, try these expressions.

FV = 10,000(1 + .09/4)40 = $24,351.89

(B) A $10,000 certificate of deposit maturing in 10 year, with 9% interest rate,

Put PV = $10,000, r = .09, and n = 10,

Video 02B, Multiple Payment Problems

To check equation (2.6), send the following instruction to WolframAlpha,

(1 + r)k1 1 + r (1 + r)2 (1 + r)3

C(1 + r)n[1 1/(1 + r)n]

With some simplification, it becomes

C(1 + r)[(1 + r)n 1]

100 (1.005)100 [1 1.005100]

Another way to look at the problem is to use (2.9)

PV = 100/1.05^5 + 1001.03/1.05^6 + 1001.03^2/1.05^7 + 12 terms