Marginal Cost-Benefit Analysis

Example: ABC is a financial manager for Nord Department Stores, a large chain of upscale department stores
operating primarily in the western United States. She is currently trying to decide whether to
replace one of the firm’s computer servers with a new, more sophisticated one that would both speed
processing and handle a larger volume of transactions. The new computer would require a cash outlay of $8,000,
and the old computer could be sold to net $2,000. The total benefits from the new server
(measured in today’s dollars) would be $10,000. The benefits over a similar period from the old computer
(measured in today’s dollars) would be $3,000. Applying marginal cost–benefit analysis, ABC organizes the data as
follows:

Accrual Basis and Cash Basis

Interest Rate Fundamentals

Example: DEF has $10 that she can spend on candy costing $0.25 per piece. DEF could buy 40 pieces of candy
($10.00 / $0.25) today. The nominal rate of interest on a 1-year deposit is currently 7%, and the expected rate of
inflation over the coming year is 4%. Instead of buying the 40 pieces of candy today,
DEF could invest the $10. After one year she would have $10.70 because DEF would have earned 7% interest—an
additional $0.70 (0.07 x $10.00) —on the $10 deposit. During that year, inflation would have increased the cost of
the candy by 4%—an additional $0.01(0.04 x $0.25) —to $0.26 per piece. As a
result, at the end of the 1-year period DEF would be able to buy about 41.2 pieces of candy ($10.70 /
$0.26), or roughly 3% more (41.2 / 40.0 = 1.03). The 3% increase in DEF’s buying power represents the real rate of
return. The nominal rate of return on investment (7%), is partly eroded by inflation (4%), so the real return during
the year is the difference between the nominal rate and the inflation rate (7% - 4% = 3%).
Income Statement Balance Sheet

Statement of Retained Earnings

Statement of Cash Flow

Current Ratio Quick Ratio

Inventory Turnover Average Collection Period

Average Payment Period Total Asset Turnover

Debt Ratio Times Interest Earned Ratio

Fixed-Payment Coverage Ratio

Gross Profit Margin Operating Profit Margin

Net Profit Margin Earnings per Share (EPS)

Return on Total Assets (ROA) Return on Common Equity (ROE)

Price/Earnings (P/E) Ratio Market/Book (M/B) Ratio

Horizontal Analysis
Vertical Analysis
 Lesson 5: Risk, Return and Valuation

Total Rate of Return

Example: Robin wishes to determine the return on two stocks that she owned during 2009,
Apple Inc. and Wal-Mart. At the beginning of the year, Apple stock traded for $90.75 per share, and
Wal-Mart was valued at $55.33. During the year, Apple paid no dividends, but Wal-Mart shareholders
received dividends of $1.09 per share. At the end of the year, Apple stock was worth $210.73 and Wal-
Mart sold for $52.84. Substituting into equation, we can calculate the annual rate of return, r, for each
stock.

Robin made money on Apple and lost money on Wal-Mart in 2009 but notice that her losses on Wal-
Mart would have been greater had it not been for the dividends that she received on her
Wal-Mart shares. When calculating the total rate of return, it is important to take into account the
effects of both cash disbursements and changes in the price of the investment during the year.

Range – a measure of an asset’s risk, which is found by subtracting the return associated with the
pessimistic (worst) outcome from the return associated with the optimistic (best) outcome.

Example: Norman Company, a manufacturer of custom golf equipment, wants to choose the better of
two investments, A and B. Each requires an initial outlay of $10,000, and each has a most likely annual
rate of return of 15%. Management has estimated returns associated with each investment’s pessimistic
and optimistic outcomes. The three estimates for each asset,
along with its range, are given in the next table. Asset A appears to be less risky than asset B; its range
of 4% (17% minus 13%) is less than the range of 16% (23% minus 7%) for asset B.
The risk-averse decision maker would prefer asset A over asset B, because A offers the same most likely
return as B (15%) with lower risk (smaller range).
 o Bar Chart – the simplest type of probability distribution; shows only a limited
number of outcomes and associated probabilities for a given event.

• Standard Deviation – the most common statistical indicator of an asset’s risk; it

measures the dispersion around the expected value.

o Expected Value of a Return – the average return that an investment is

expected to produce over time.

Example: Norman Company’s past estimates indicate that the probabilities of the pessimistic, most
likely, and optimistic outcomes are 25%, 50%, and 25%, respectively. Note that the sum of these
probabilities must equal 100%; that is, they must be based on all the alternatives considered.
Expected Values of Returns and Standard Deviation for Assets A and B
Possible Outcomes Probability Return Weighted Value Deviations
(1) (2) [(1) x (2)] = (3) [(2) – (r)]2 x (1)
ASSET A
Pessimistic 0.25 13% 3.25% 4 x 0.25 = 1%
Most Likely 0.50 15% 7.50% 0 x 0.50 = 0%
Optimistic 0.25 17% 4.25% 4 x 0.25 = 1%
Total 1.00 15% 2%
Standard Deviation = √2 = 1.41%

ASSET B
 Pessimistic 0.25 7% 1.75% 64 x 0.25 = 16%
Most Likely 0.50 15% 7.50% 0 x 0.50 = 0%
Optimistic 0.25 23% 5.75% 64 x 0.25 = 16%
Total 1.00 15% 32%
Standard Deviation = √32 = 5.66%

• Coefficient of Variation – a measure of relative dispersion that is useful in comparing the

risks of assets with differing expected returns.

Example: When the standard deviations and the expected returns for assets A and B are substituted into
the equation, the coefficients of variation for A and B are 0.094 (1.41% / 15%) and 0.377 (5.66% / 15%),
respectively. Asset B has the higher coefficient of variation and is therefore riskier than asset A—which
we already know from the standard deviation.

Beta coefficient is a relative measure of non-diversifiable risk. An index of the degree of

movement of an asset’s return in response to a change in the market return. Market return is the return
on the market portfolio of all traded securities.

Portfolio Betas. The beta of a portfolio can be easily estimated by using the betas of the
individual assets it includes. Letting wj represent the proportion of the portfolio’s total dollar value
represented by asset j, and letting bj equal the beta of asset j, we can use the below equation to find the
portfolio beta, bp:

Example: Mario Austino, an individual investor, wishes to assess the risk of two small portfolios he is
considering V and W. Both portfolios contain five assets, with the proportions and betas
shown in the table
The betas for the two portfolios, bv and bw, can be calculated by substituting date from the table into the
equation.

Portfolio V’s beta is about 1.20, and portfolio W’s is 0.91. These values make sense because portfolio V
contains relatively high-beta assets, and portfolio W contains relatively low-beta
assets. Mario’s calculations show that portfolio V’s returns are more responsive to changes in
market returns and are therefore riskier than portfolio W’s. He must now decide which, if either,
portfolio he feels comfortable adding to his existing investments.

The Equation
Bond Valuation

Most corporate bonds pay interest semiannually (every 6 months) at a stated coupon interest rate,
have an initial maturity of 10 to 30 years, and have a par value, or face value, of $1,000 that must be
repaid at maturity.

Basic Bond Valuation

The basic model for the value, B0, of a bond is given by the below equation:

Example: Tim Sanchez wishes to determine the current value of the Mills Company bond.
Assuming that interest on the Mills Company bond issue is paid annually and that the required return is
equal to the bond’s coupon interest rate, I = $100, r d = 10%, M = $1,000, and n = 10 years.

B0 = $100 x {1 – [1 / (1 + 0.10)10] / 0.10} + $1,000 x [1 / (1 + 0.10) 10]

= ($100 x 6.1446) + ($1,000 x 0.38554)

= $614.46 + $385.54

B0 = $1,000.00

The computations involved in finding the bond value are depicted graphically on the following timeline.
Bond Value Behavior

• Discount – the amount by which a bond sells at a value that is less than its par value.

Example: When the required return is 12%

B0 = $100 x {1 – [1 / (1 + 0.12)10] / 0.12} + $1,000 x [1 / (1 + 0.12) 10]

= ($100 x 5.6502) + ($1,000 x 0.32197)

= $565.02 + $321.97

B0 = $886.99

• Premium – the amount by which a bond sells at a value that is greater than its par value.
Example: When the required return is 8%

B0 = $100 x {1 – [1 / (1 + 0.08)10] / 0.08} + $1,000 x [1 / (1 + 0.08) 10]

= ($100 x 6.7101) + ($1,000 x 0.46319)

= $671.01 + $463.19

B0 = $1,134.20
 Semiannual Interest and Bond Values

The procedure used to value bonds paying interest semiannually involves:

1. Converting annual interest, I, to semiannual interest by dividing I by 2.

2. Converting the number of years to maturity, n, to the number of 6-month periods to
maturity by multiplying n by 2.
3. Converting the required stated annual return for similar-risk bonds that also pay
semiannual interest from an annual rate, rd, to a semiannual rate by dividing rd by 2.

Example: If Mills Company bond pays interest semiannually and that the required stated annual return is
12% for similar-risk bonds that also pay semiannual interest:

B0 = ($100 / 2) x {1 – [1 / (1 + 0.06) 20] / 0.06} + $1,000 x [1 / (1 + 0.06) 20]

= ($50 x 11.470) + ($1,000 x 0.31180)

= $573.50 + $311.80

B0 = $885.30

Stock Valuation

• Zero-growth model – an approach to dividend valuation that assumes a constant,

nongrowing dividend stream.

Example: Chuck Swimmer estimates that the dividend of Denham Company, an established textile
producer, is expected to remain constant at $3 per share indefinitely. If his required return on its stock is
15%, the stock’s value is $20 ($3 / 0.15) per share.

• Constant-growth model – a widely cited dividend valuation approach that assumes that
dividends will grow at a constant rate, but a rate that is less than the required return.

Example: Lamar Company, a small cosmetics company, from 2007 through 2012 paid the following per-
share dividends:
The company estimates that its dividend in 2013 will equal $1.50 and the require return is 15%.

• Variable-growth model – a dividend valuation approach that allows for a change in the
dividend growth rate. To determine the value of a share of stock in the case of variable
growth, we use a four-step procedure:
1. Find the value of the cash dividends at the end of each year, during the initial
growth period, years 1 to N.
2. Find the present value of the dividends expected during the initial growth
period.
3. Find the value of the stock at the end of the initial growth period, which is the
present value of all dividends expected from year N + 1 to infinity, assuming a
constant dividend growth rate.
4. Add the present value components found in steps 2 & 3 to find the value of the
stock.
Example: Victoria Robb is considering purchasing the common stock of Warren Industries, a rapidly
growing boat manufacturer. She finds that the firm’s most recent (2012) annual dividend payment was
$1.50 per share. Victoria estimates that these dividends will increase at a 10%
annual rate, over the next 3 years (2013, 2014, and 2015) because of the introduction of a hot
new boat. At the end of the 3 years (the end of 2015), she expects the firm’s mature product line to
result in a slowing of the dividend growth rate to 5% per year, for the foreseeable future. Victoria’s
required return is 15%.

Step 1: The 2013, 2014, and 2015 dividends are $1.65, $1.82, and $2.00, respectively.

Step 2: The sum of the present values of the three dividends is $4.12.
 Step 3: The value of the stock at the end of the initial growth period (N = 2015) can be found by first
calculating DN+1 = D2016:

Step 4: Adding the present value of the initial dividend stream (found in Step 2) to the present value of
the stock at the end of the initial growth period (found in Step 3), the current (end-of2012) value of
Warren Industries stock is:

• Free cash flow valuation model – a model that determines the value of an entire
company as the present value of its expected free cash flows discounted at the firm’s
weighted average cost of capital, which is its expected average future cost of funds over
the long run.

Example: Dewhurst, Inc., wishes to determine the value of its stock by using the free cash flow valuation
model. To apply the model, the firm’s CFO developed the data given in the below table:

Application of the model can be performed in four steps:

Step 1: Calculate the present value of the free cash flow occurring from the end of 2018 to infinity,
measured at the beginning of 2018 (that is, at the end of 2017). Because a constant rate of growth in
FCF is forecast beyond2017, we can use the constant-growth dividend valuation model to calculate the
value of the free cash flows from the end of 2018 to infinity:
Step 2: Add the present value of the FCF from 2018 to infinity, which is measured at the end of 2017, to
the 2017 FCF value to get the total FCF in 2017.

Step 3: Find the sum of the present values of the FCFs for 2013 through 2017 to determine the value of
the entire company.

Step 4: Calculate the value of the common stock.

• Book value per share – the amount per share of common stock that would be received if
all the firm’s assets were sold for their exact book (accounting) value and the proceeds
remaining after paying all liabilities (including preferred stock) were divided among the
common stockholders.
 • Liquidation value per share – the actual amount per share of common stock that would
be received if all the firm’s assets were sold for their market value, liabilities (including
preferred stock) were paid, and any remaining money were divided among the common
stockholders.

• Price / earnings multiple approach – a popular technique used to estimate the firm’s
share value; calculated by multiplying the firm’s expected earnings per share (EPS) by
the average price/earnings (P/E) ratio for the industry.

Example: Ann Perrier plans to use the price/earnings multiple approach to estimate the value of Lamar
Company’s stock, which she currently holds in her retirement account. She estimates that Lamar
Company will earn $2.60 per share next year (2013). This expectation is based on an analysis of the
firm’s historical earnings trend and of expected economic and industry
conditions. She finds the price/earnings (P/E) ratio for firms in the same industry to average 7.
Multiplying Lamar’s expected earnings per share (EPS) of $2.60 by this ratio gives her a value for the
firm’s shares of $18.20, assuming that investors will continue to value the average firm at 7 times its
earnings.