UNIVERSITY OF MINDANAO

Tagum College

Department of Accounting Education

Accountancy Program

Physically Distanced but Academically Engaged

Self-Instructional Manual (SIM) for Self-Directed Learning (SDL)

Course/Subject: ACCE 412 – Valuation Concepts and Methods

Name of Teacher:
Joe Mari N. Flores, CPA, MSA and Argem Jay Porio, CPA

THIS SIM/SDL MANUAL IS A DRAFT VERSION ONLY; NOT FOR

REPRODUCTION AND DISTRIBUTION OUTSIDE OF ITS INTENDED USE.
THIS IS INTENDED ONLY FOR THE USE OF THE STUDENTS WHO ARE
OFFICIALLY ENROLLED IN THE COURSE/SUBJECT.
EXPECT REVISIONS OF THE MANUAL.
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Table of Contents

Page

Part 1. Course Outline and Policies................................................................. 5

Part 2. Instruction Delivery
CC’s Voice............................................................................………….. 9
Course Outcomes................................................................................. 9
Big Picture A: Unit Learning Outcomes ........................................... 10
Big Picture in Focus: ULOa………………………………………………... 10
Metalanguage......................................................................................... 10
Essential Knowledge............................................................................ 10
Self-Help............................................................................................... 22
Let’s Check........................................................................................... 22
Let’s Analyze......................................................................................... 25
In a Nutshell.......................................................................................... 27
Keywords Index.................................................................................... 28

Big Picture in Focus: ULOb…………………………………………….. 29

Metalanguage....................................................................................... 29
Essential Knowledge............................................................................ 29
Self-Help............................................................................................... 37
Let’s Check........................................................................................... 38
Let’s Analyze......................................................................................... 40
In a Nutshell.......................................................................................... 41
Q&A List................................................................................................ 41
Keywords Index.................................................................................... 41

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Big Picture in Focus: ULOc…………………………………………….. 42

Metalanguage....................................................................................... 42
Essential Knowledge............................................................................ 42
Self-Help............................................................................................... 50
Let’s Check........................................................................................... 51
Let’s Analyze......................................................................................... 52
In a Nutshell.......................................................................................... 54
Q&A List................................................................................................ 55
Keywords Index.................................................................................... 55

Big Picture B: Unit Learning Outcomes .......................................... 56

Big Picture in Focus: ULOa…………………………………………….. 56
Metalanguage....................................................................................... 56
Essential Knowledge............................................................................ 56
Self-Help............................................................................................... 75
Let’s Check........................................................................................... 75
Let’s Analyze......................................................................................... 77
In a Nutshell.......................................................................................... 77
Q&A List................................................................................................ 78
Keywords Index.................................................................................... 78

Big Picture in Focus: ULOb…………………………………………….. 79

Metalanguage....................................................................................... 79
Essential Knowledge............................................................................ 79
Self-Help............................................................................................... 97
Let’s Check........................................................................................... 98
Let’s Analyze......................................................................................... 99
In a Nutshell.......................................................................................... 100
Q&A List................................................................................................ 100

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Keywords Index.................................................................................... 101

Big Picture C: Unit Learning Outcomes ............................................ 102

Big Picture in Focus: ULOa…………………………………………….. 102
Metalanguage....................................................................................... 102
Essential Knowledge............................................................................ 102
Self-Help............................................................................................... 120
Let’s Check........................................................................................... 120
Let’s Analyze......................................................................................... 121
In a Nutshell.......................................................................................... 123
Q&A List................................................................................................ 124
Keywords Index.................................................................................... 124

Part 3. Course Schedule................................................................................. 125

Online Code of Conduct...................................................................... 127
Monitoring of OBD and DED............................................................... 229

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Course Outline: ACCE 412 – Valuation Concepts and Methods

Course Facilitator : Joe Mari N. Flores, CPA, MSA

Email : joemari_flores@umindanao.edu.ph
Student Consultation : Done online (LMS) or traditional contact
(calls, text,emails)
Mobile : 09773877098
Phone : None
Effectivity Date : June 2021
Mode of Delivery : Distance Education Delivery (DED)
Time Frame : 54 hours
Student Workload : Expected Self-Directed Learning
Pre-requisite : FIN 22
Credit : 3 units
Attendance Requirement : For online sessions: minimum of 95% attendance
For 1-day on campus/onsite review: 100%
attendance; for 1-day on-campus/on-site final
exam: 100% attendance

Course Outline Policies

Areas of Concern Details

Contact and Non-contact Hours This 3-unit course self-instructional manual is
designed for distant learning mode of instructional
delivery with scheduled face to face or virtual
sessions which can be done using Quipper,
traditional contact (via cellphone/telephone and
SMS) and social media platforms (e.g. email,
private messenger, Facebook, Viber, WhatsApp,
Line, Zoom and other similar applications)
depending on what is available for both teachers
and students. The expected number of hours will
be 54 including the face to face or virtual sessions.
The face to face sessions shall include the
summative assessment tasks (exams) since this
course is included in the licensure exam for CPAs.

Assessment Task Submission Submission of assessment tasks shall be on the

2nd, 4th, and 6th week of the term class.
Moreover, specific dates of submission are
specified in the Course Schedules Section of this
manual. The assessment paper shall be attached
with cover page including the title of assessment
task (if the task is performance), the name of the
course coordinator, date of submission and name
of the student. The document shall be submitted
to the course coordinator thru LMS (Schoology),

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

email, FB messenger or thru any means

accessible tostudents. It is also expected that you
already paid your tuition and other fees before the
submission of the assessment task.

If the assessment task is done in real time through

the features of LMS accessible to students, the
schedule shall be arranged ahead of time by the
course coordinator.

Since this course is included in the licensure

examination for CPAs, you will be required to take
the Multiple Choice Question Exam inside the
school. This should be scheduled ahead of time
by your course coordinator. This is non-negotiable
for all licensure-based programs.

Turnitin Submission To ensure honesty and authenticity, all

(if necessary) assessment tasks are required to be submitted
thru Turnitin with a maximum similarity index of
30% allowed. This means that if your paper goes
beyond 30%, the students will either opt to redo
her/his paper or explain in writing addressed to the
course coordinator the reasons for similarity. In
addition, if the paper has reached more than 30%
similarity index, the student may be called for a
disciplinary action in accordance with the
University’s OPM on Intellectual and Academic
Honesty.

Please note that academic dishonesty such as

cheating and commissioning other students or
people to complete the task for you have severe
punishments (reprimand, warning, and expulsion).

Penalties for Late Assignments/ The score for an assessment item submitted after
Assessments the designated time on the due date, without an
approved extension of time, will be reduced by 5%
of the possible maximum score for that
assessment item for each day or part day that the
assessment item is late.

However, if the late submission of assessment

paper has valid reason, a letter of explanation
should be submitted and approved by the course
coordinator, If necessary, you will also be required
to present/attach evidences.

Return of Assignments / Assessment tasks will be returned to you one (1)

Assessments week after the submission. This will be returned by

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Quipper, email, FB messenger or any other

communication platforms available for both
teacher and students.

For some group assessment tasks, the course

coordinator will require some or few of the
students for online or virtual sessions to ask
clarificatory questions to validate the originality of
the assessment task submitted and to ensure that
all the group members are involved.

Assignment Resubmission You should request in writing addressed to the

course coordinator his/her intention to resubmit an
assessment task. The resubmission is premised
on the student’s failure to comply with the
similarity index and other standards or other
reasonable circumstances e.g. illness, accidents,
financial constraints.

Re-marking of Assessment You should request in writing addressed to the

Papers and Appeal program coordinator your intention to appeal or
contest the score given to an assessment task.
The letter should explicitly explain the
reasons/points to contest the grade. The program
coordinator shall communicate with the students
on the approval or disapproval of the request.

If disapproved by the course coordinator, you can

elevate your case to the program head or the
dean with the original letter of request. The final
decision will come from the Dean of College.

Grading System You shall be evaluated based on the following:

Assessment methods Weights

EXAMINATIONS 60%
A. Exam – Prelims & Midterm 30%
B. Final Exam 30%
CLASS PARTICIPATIONS 40%
C. Quizzes 10%
D. Assignments 5%
E. Research/Requirement 15%
F. Oral recitation 10%
Total 100%

Submission of the final grades shall follow the

usual University system and procedures.
Preferred Referencing Style Use the general practice of APA 6th edition.
Student Communication The course coordinator shall create Group Chat in
FB messenger for the class.Each student shall

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

create a Quipper account. The course coordinator

will then provide a Quipper access code to the
studentsfor them to enroll to have access to the
materials and resources of the course. All
communication formats: chat, submission of
assessment tasks, request, etc. may be done thru
any platforms available for the convenience of
teacher and students.

You can also meet the course coordinator in

person through the scheduled face to face
sessions to raise your issues and concerns.

Contact Details of the Dean Dr. Gina Fe G.Israel

Email: deansofficetagum@umindanao.edu.ph
Mobile: 09099942314

Contact Details of the Program For Accountancy:

Heads
Mary Cris L. Luzada, CPA, MSA
Email: luzadacris@umindanao.edu.ph
Mobile: 09228321794

For Accounting Technology:

Maria Teresa A. Ozoa, CPA, MBA
Email: ozoamateresa@umindanao.edu.ph
Mobile: 09472657119

Students with Special Needs Students with special needs shall communicate
with the course coordinator about the nature of his
or her special needs. Depending on the nature of
the need, the course coordinator with the approval
of the program coordinator may provide alternative
assessment tasks or extension of deadline of
submission of assessment tasks. However, the
alternative assessment tasks should still be in the
service of achieving the desired course learning
outcomes.

Library Contact Details Clarissa R. Donayre, MSLS

Chief Librarian
Email: lictagum@umindanao.edu.ph
Mobile: 0927-395-1639

Well Being Welfare Support Rochen D. Yntig, RGC

Help Desk Contact Details Head
Email: chenny.yntig@gmail.com
Number: 0932 7717 219
Mersun Faith A. Delco, RPm
Psychometrician

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Email: mersunfaithdelco@gmail.com
Number: 0927 6086 037

Alfred Joshua M. Navarro

Facilitator
Email: is40fotb@gmail.com
Number: 0977 3416 064

Course Information –see/download course syllabusfromQuipper or

other available platforms

CC’s Voice: Hello there! Welcome to this course ACCE 412:Valuation

Concepts ad Methods. This course is part of the
Management Services in the CPA board examination.and
provides a conceptual framework within which key
financial decisions and risks relating to corporations are
analyzed. This course will teach you different methods in
giving values debts, equity and the firm in general..I am
confident that you will find this course relevant as this
applies not only to business organizations, but this also
gives you limitless ideas for your desired career or
investments in the future.I hope that you enjoy while
learning this course!
Course Outcome (CO):As a student of this course you are expected to discuss the
importance of risk management and explain alternative
potential risk treatments relevant to management decision
making; and apply different valuation models to evaluate
financial assets such as bonds and stocks;

Let us begin!

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Big Picture A
Week 1–3: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to:
a. Understand, quantify risk and analyse risk-return relationship.
b. Apply commonly used techniques in assessing investment under
uncertainty.
c. Apply Capital Asset Pricing Model (CAPM) concepts in evaluating
investments.

Big Picture in Focus: ULOa. Understand, quantify risk and

analyze risk-return relationship.

Metalanguage
For you to demonstrate ULOa, you will need operational understanding of the terms
enumerated below.
❖ Risk refers to the chance that some unfavorable event will occur.
❖ Expected portfolio return is the weighted average of the expected returns
from the individual assets in the portfolio.
❖ Standard deviation can be used as a measure of the amount of absolute
risk associated with the outcome.
❖ Coefficient of variation is a standardized measure of the risk per unit of
return.
❖ Portfolio is an investment consists of different assets.
❖ Portfolio risk is the variability of returns of the portfolio as a whole.
❖ Diversification is investing in more than one type of asset to reduce risk.
❖ Correlation coefficient is a relative statistical measure of correlation in the
degree and direction of change between two variables.

Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the 1st to 3rd weeks
of the course, you need to fully understand the following essential knowledge laid
down in the succeeding pages. Please note that you are not limited to exclusively
refer to these resources. Thus, you are expected to utilize other books, research
articles and other resources that are available in the university’s library e.g. ebrary,
search.proquest.com etc., and even online tutorial websites.
1. Basic Risk and Return Concept

Risk refers to the chance that some unfavorable event will occur. There is risk
whenever future outcomes are not completely certain. In finance, risk is associated
with the variability of an asset’s return. Hence, if there is possibility that the actual
return of an asset could differ fr1om the expected return, then, the investment

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

involves risk. The greater the variability, the higher the risk. While actual return may
be above or below than the expected return, it should be noted that risk is usually
associated to the probability of loss or earning less than expected.

2. Risk and Return Relationship

Investment risk is related to the probability that the actual return is less than the
expected return and the greater the chance of low or negative returns, the riskier
the investment.

Generally, investors are risk averse, which means as much as possible investor
will try to avoid risk. However, it is possible to persuade the investors will be
persuaded to take the risk when they will be compensated for it.

Risk and return have direct relationship to each other. If the investment involves
lower risk, you can expect that it will also give you lower returns. On the other hand,
if the investment involves higher risk, you can expect that such investment will give
you higher returns; otherwise, you will not plunge in that particular investment.
Returns are higher for high risk investments as compared to low risk investments
and the difference is considered a risk premium to compensate the investors for
taking the risk.

3. Using Probability and Probability Distribution in Evaluating Investments

Probability and probability distribution can be used in evaluating investments by

computing the expected return. As an illustration, assume that two investment
projects are available to Mr. Martinez who has P100,000 investible funds. He is
considering the following:

a. Investment in XO Products, Inc., a manufacturer and distributor of computer

terminals and equipment for a rapidly growing data transmission industry; or

b. Investment in Tagum Electric Company which supplies an essential service.

The rates of return probability distribution for the two companies are as follows:

XO PRODUCTS, INC.

State of the Probability Rate of Return Expected Rate

Economy of Occurrence (%) of return
(a) (b) (a x b)
Boom 0.30 100 30
Normal 0.40 15 6
Recession 0.30 (70) (21)
Expected Value of Outcome= 15%

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Tagum Electric Company

State of the Probability Rate of Return Expected Rate

Economy of Occurrence (%) of return
(a) (b) (a x b)
Boom 0.30 20 6
Normal 0.40 15 6
Recession 0.30 10 3
Expected Value of Outcome= 15%

Based on the payoff matrix presented above, both companies have the same
expected return of 15%. Suppose the investor wishes to invest his money to only
one company, which of the two companies would he invest in? Perhaps, we might
suggest that Mr. Martinez can just invest to any of the two companies since both will
give the same expected return.

If we will only consider the expected value criteria, the suggestion to invest to any of
the companies may seem to be appropriate. However, if we will take a closer look
of the variability of the possible outcomes, we might offer a different proposition.

The range of probable returns for XO Products is from +100% to -70%. This means
that if the economy is in a boom state, it can give the investor earnings of as much
as 100%; however, if the economy is in recession state, investor can incur a loss in
as much as 70% of the investment. On the other hand, the probable returns for
Tagum Electric Company is from +20% to +10%. This means that if the economy is
in a boom state, it can give the investor earnings of 20%, which is far lower than
what XO Products can offer. However, the good thing about Tagum Electric
Company is that even if the economy is in recession, the investor can still earn 10%
of his investment as compared to XO Products where investor will already incur a
loss.

We can say that range of returns of XO Products is more dispersed as compared to

Tagum Electric Company. It can be recalled that risk is associated with the
variability of an investment’s return. Hence, we can conclude that XO Products is
riskier as compared to Tagum Electric Company because of the variability of its
returns.

Using the expected return criteria, we suggested that investor can just invest to any
of the companies since they have the same expected rate of return of 15%.
However, after evaluating the variability of the returns, we have concluded that XO
Products is riskier than Tagum Electric Company. With this, a risk averse investor
would normally decide that it would be better to invest to Tagum Electric Company
because it will give the same expected return at a lower risk.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Expected Portfolio Returns

In the previous section, the expected return computed is applicable for a stand-
alone investment. However, stock investments are usually held in a portfolio. For
example, an investor who has P100,000 investable funds decides to diversify his
investment and purchased three stocks allocated as follows:

Percentage
Amount Allocation
Jollibee Foods Corporation (JFC) P50,000 50%
Ayala Land Inc. (ALI) 25,000 25%
DITO Telecommunity Corporation (DITO) 25,000 25%
Total P100,000 100%

Assuming that the rate of return for each stock in the portfolio is as follows: JFC:
10%; ALI: 15% and DITO: 5%, the expected return of this portfolio can be
computed as follows:

Percentage Rate of Expected

Allocation Return Rate of Return
(a) (b) (a x b)
JFC 50% 10% 5.00%
ALI 25% 15% 3.75%
DITO 25% 5% 1.25%
Expected Portfolio Return 10.00%

The expected portfolio return is the weighted average of the expected returns
from the individual assets in the portfolio.

Another Illustration – Computation for Expected Portfolio Returns

Robinsons Land Corporation is evaluating two opportunities, each having the same
initial investment. The project’s risk and return characteristics are shown below:
Project E Project F
Expected return 0.10 0.20
Proportion invested in each project 0.50 0.50

The expected return of a portfolio combining Project E and Project F is computed

as follows:

Percentage Rate of Expected

Allocation Return Rate of Return
(a) (b) (a x b)
Project E .50 0.10 0.05
Project F .50 0.20 0.10
Expected Portfolio Return 0.15 or 15%

The expected portfolio returns can also be computed using the following formula:
n
řp=∑wi ři

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

i=1
Where:

řp = expected portfolio return

wi= proportion of portfolio invested in asset, i
ři = expected return of asset, i
n = the number of assets in the portfolio

Substituting the formula, the expected portfolio return can be alternatively computed
as follows:

řp = (0.50) (0.10) + (0.50) (0.20) = 0.15 or 15%

Standard Deviation

In the previous sections, it was noted that the riskiness of an investment can be
gauged with the variability of its returns. While we can observe the variability of
returns by considering how scattered or narrow the range is, it would be a big help if
we can quantify the risk. In this section, we will discuss how we can quantify risk
using standard deviation.

Standard deviation, σ (pronounced as “sigma”), is a statistical measure of the

variability of a probability distribution around its expected value. It can be used as a
measure of the amount of absolute risk associated with the outcome.

Standard deviation also measures the tightness of a probability distribution. A tight

probability distribution is one in which the set of possible returns is close to the
expected value of the return. If the probability distribution is tight, then the range of
the difference between the highest and lowest value in the distribution is relatively
small. Thus, the smaller the standard deviation, the tighter the probability
distribution, the smaller the range of returns and the lower the risk.

There are two types of probability distribution: symmetrical distribution and skewed
distribution.
Symmetrical distribution – one in which each half of the distribution is a mirror
image of the other half.
Skewed distribution – one in which half of the distribution is not a mirror image of
the other half.
It is to be noted that standard deviation is an appropriate risk measure of variability
only if the probability distribution is reasonably symmetrical. Also, when you are to
compare different investments using standard deviation, the size of the initial
investments and the expected value of their probability distributions should be
equal to make the risk comparison; otherwise, the use of standard deviation may be
misleading.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

The standard deviation is calculated as follows:

1. Compute the expected value (ř).
2. Subtract the expected value from each possible return to obtain the
deviations (ri - ř).
3. Square each deviation (ri - ř)2.
4. Multiply each squared deviation by its probability of occurrence,
pi(ri - ř)2 then add. The result is called the variance (σ2), which is the
standard deviation squared.
5. Take the square root of the variance to get the standard deviation.
Where:
pi=probability of outcome
ri= return or value of outcome
n = total number of possible outcomes

Computation of Standard Deviation of XO Products, Inc.

Using in data from the previous section, the standard deviation can be computed
using the steps enumerated:

(1) The expected rate of return as previously computed is 15% (ǩ).

(2) (3) (4)

ki – ǩ (ki – ǩ)2 (ki – ǩ)2 pi
100% - 15% = 85% 7,225% (7,225%) (0.30) = 2,167.5%
15% - 15% = 0 0 (0) (0.40) = 0.0
-70% - 15% = -85% 7,225% (7,225%) (0.30) = 2,167.5%
Variance = 4,335.0%

(5) Standard deviation (σ) =√4,335% = 65.84%

Hence, XO Product’s standard deviation is 65.84%. For this to be meaningful, try to

compute the standard deviation of Tagum Electric Company. Show your computation
in the “Let’s Check” section of this manual.

Calculation of Expected Portfolio Returns and Portfolio Standard Deviation

The computation for expected portfolio returns was already presented in the previous
section. In this section, computation of the standard deviation shall be discussed with
an illustration presented below:

Suppose the following projections are available for three alternative stock
investments.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

State of the Probability Rate of Return if State Occurs

Economy of Occurrence Stock A Stock B
Stock C
Boom 0.40 10% 15% 20%
Recession 0.60 8% 4% 0%

Required:

1. What would be the expected return on a portfolio with equal amounts invested in
each of the three stocks (Portfolio 1)?
2. What would be the expected return if half of the portfolio were in A and the
remainder to be equally divided between B and C (Portfolio 2)?
3. Compute the standard deviation of Portfolio 1 and Portfolio 2?
4. Based on the portfolio standard deviation computation, which portfolio would
you recommend pursuing? Justify your decision.

Solution:

1. Expected Return on Portfolio 1 (wherein: A=1/3; B=1/3; C=1/3)

1.1 Compute first the portfolio expected return of each state.

a. Portfolio Expected Return (Boom)

= (1/3)(10%) + (1/3)(15%) + (1/3)(20%)
= 3.33% + 5% + 6.67%
= 15%

b. Portfolio Expected Return (Recession)

= (1/3)(8%) + (1/3)(4%) + (1/3)(0)
= 2.67% + 1.33% + 0
= 4%

1.2 Then, expected return on Portfolio 1 can be computed using the formula
given in the previous section, to wit:
n
řp=∑wi ři
i=1

Expected Return on Portfolio 1 (řp1) = (.40)(15%) + (.60)(4%)

= 6% + 2.4%
= 8.4%

2. Expected Return on Portfolio 2 (wherein: A=50%; B=25%; C=25%)

2.1 Computation of the portfolio expected return of each state.

a. Portfolio Expected Return (Boom)
= (.50)(10%) + (.25)(15%) + (.25)(20%)

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

= 13.75%

b. Portfolio Expected Return (Recession)

= (.50)(8%) + (.25)(4%) + (.25)(0)
= 5%

2.2 Computation of the expected return on Portfolio 2:

Expected Return on Portfolio 2 (řp2) = (.40)(13.75%) + (.60)(5%)

= 5.5% + 3%
= 8.5%

3. Portfolio Standard Deviation Computation

3.1 Standard Deviation – Portfolio 1

σ = √. 40 𝑥 (15% − 8.4%)² + .60 𝑥 (4% − 8.4%)²

= √. 40 𝑥 (. 004356) + .60 𝑥 (. 001936)
= √. 002905
= 5.4%
3.2 Standard Deviation – Portfolio 2

σ = √. 40 𝑥 (13.75% − 8.5%)² + .60 𝑥 (5% − 8.5%)²

= √. 40 𝑥 (. 002756) + .60 𝑥 (. 001225)
= √. 0018375
= 4.3%
4. Based on the portfolio standard deviation computation, it would be better to
invest to Portfolio 2 since it has a lower standard deviation which implies that this
Portfolio is less risky compared to Portfolio 1.

Coefficient of Variation

Coefficient of variation (CV) is another useful measure of risk. It is a standardized

measure of the risk per unit of return; calculated as:
Coefficient of Variation (CV) = Standard Deviation (σ)
Expected return (ř)

The coefficient of variation of XO Products and Tagum Electric Company is

computed as follows:
For XO Products: CV = 65.84% = 4.39
15%

For Tagum Electric Company: CV = 3.87% = .26

15%

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

The coefficient of variation provides a more meaningful basis for comparison when
expected returns on two or more alternatives are not the same. Based on the above
computations, XO Products is almost 17% riskier than Tagum Electric Company.

Portfolio Risk (σp)

Portfolio risk is the variability of returns of the portfolio as a whole. The riskiness of
the portfolio may be less than the riskiness of any individual assets contained in the
portfolio because of diversification.

Diversification is investing in more than one type of asset to reduce risk. It could
also be investment in several different assets of the same type, but this would be
less effective. Diversification reduces risk by combining assets such as, securities
with different risk-return characteristics.

The amount of risk reduction achieved through diversification depends on the

correlation of the individual assets’ returns with one another. This could be measured
by computing for the correlation coefficient (ρ or rho). This is a relative statistical
measure of correlation in the degree and direction of change between two variables.
It ranges from + 1.0 to – 1.0.

Generally:

• If ρ = + 1.0, the two variables move in the same direction exactly to the same
degree and are perfectly positively correlated.
• If ρ = - 1.0, the two variables move in opposite directions exactly to the same
degree and are perfectly negatively correlated.
• If ρ = 0, the two variables are uncorrelated or independent to each other.

Risk reduction can be achieved through diversification if the returns of the assets
combined in a portfolio are not perfectly positively correlated. Hence, greater benefits
are achieved with less positive or more negative correlation among asset returns.

The following formula could be used to solve for the standard deviation of portfolio
returns for a two-asset portfolio:

σp= √w₁² σ₁² + w₂² σ₂² + 2 w₁ w₂ ρ₁, ₂ σ₁ σ₂

where:
w₁ = proportion invested in asset 1
w₂ = proportion invested in asset 2
σ₁ = standard deviation of asset 1
σ₂ = standard deviation of asset 2
ρ₁, ₂ = correlation coefficient between asset 1 and asset 2

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Illustration. Assume that the investor decided to invest in a 2-asset portfolio

allocating 50% of the total investment to each asset. The information of the assets
are as follows:

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 Department of Accounting Education
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Telefax: (084) 655-9591, Local 116

Asset 1 Asset 2
Standard deviation (σ) 8% 8%

Case 1: Correlation coefficient (ρ₁, ₂) = + 1.0

σp= √(0.5)² (0.08)² + (0.5)² (0.08)² + 2 (0.5)(0.5)(1.0)(0.08)(0.08)

σp= √0.0016 + 0.0016 + 0.0032
σp= √0.0064
σp = 0.08

Case 2: Correlation coefficient (ρ₁, ₂) = + 0.2

σp= √(0.5)² (0.08)² + (0.5)² (0.08)² + 2 (0.5)(0.5)(0.2)(0.08)(0.08)

σp= √0.0016 + 0.0016 + 0.00064
σp= √0.00384
σp = 0.062

As observed, risk reduction occurs through diversification when the assets combined
are not perfectly positively correlated. With a low correlation of +0.2, the portfolio risk
is reduced from 0.08 to 0.062.

Risk Preferences

Investors want to be compensated for the risk associated with an investment. The
greater the risk, the more the demanded return. The actual amount of compensation
demanded is referred as the required rate of return. Such required rate of return is
influenced by the individual decision maker’s attitude towards risk.

Decision makers may be classified into the following groups:

• Risk averse investors – those that require higher rates of return on higher-risk
securities. The are not willing to pay an amount as much as the expected
value of an uncertain investment.
• Risk-neutral – those that are willing to pay the expected value.
• Risk-takers – those that are willing to pay more than the expected value.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Illustration for Risk Averse, Risk-Neutral and Risk Taker Decision Makers

The following data are available for Project A and Project B.

State of the Rate of Return if State Occurs

Economy Probability Project A Project B

1 Weak 0.2 P 800 P 200

2 Moderate 0.6 1,000 1,000
3 Strong 0.2 1,200 1,800

Expected value (ř) 1,000 1,000

Standard deviation (σ) 126 506
Coefficient of variation (cv) 0.13 0.51

Decisions based on attitude towards risk:

• A risk averse investor would select project A because it involves the same
expected return as Project B but has a less risk.

• A risk-neutral investor would be indifferent between the two investments.

• A risk-taker investor would prefer Project B because although the expected of

each project is equal, Project B has a greater potential return and more risk.
Hence, if the economy is strong, the maximum return for Project B is P1,800
as compared to Project A with only P1,200.

Risk and Return Portfolio

In the previous sections, risk and return analysis focus only on both a single asset
and a portfolio or collection of two or more assets. It is noteworthy to mention that
there is what we call portfolio theory. Portfolio theory involves selection of efficient
portfolios. An efficient portfolio provides the highest return for a given level of risk or
the least risk for a given level of return. While portfolio theory originated in the
context of financial assets such as investment in equity shares, the general concepts
also apply to physical assets such as the capital budgeting projects.

21
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Self-Help: You can also refer to the sources below to help you
further understand the lesson.

Cabrera, M. B. (2015). Financial management principles and applications volume 2.

Manila: GIC Enterprises & Co., Inc.

Saunders, A., & Cornett, M. M. (2019). Financial markets and institutions (7th ed.).
New York: McGraw Hill Education.

Let’s Check

Activity 1: Read and answer the problem.

You are considering purchasing two stocks. A brokerage firm has provided
estimated returns for the next year on these two stocks:

Rate of Return
State of Economy Probability Stock A Stock B

Recession 0.20 -0.15 0.20

Normal 0.50 0.20 0.30
Boom 0.30 0.60 0.40

Required:

1. Compute the expected return of each stock.

Stock A Stock B

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 Department of Accounting Education
Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

2. Compute the standard deviation of each stock.

Stock A Stock B

3. Compute the coefficient of variation of each stock.

Stock A Stock B

4. Which stock would you recommend if the investor wishes to take the less
risky stock? Briefly discuss the basis of your recommendation.

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Activity 2: Read and answer the problem.

Consider the following information:

Rate of Return
State of Economy Probability Stock A Stock B Stock C

Boom 0.15 0.30 0.45 0.33

Normal 0.45 0.12 0.10 0.15
Poor 0.35 0.01 -0.15 -0.05
Recession 0.05 -0.06 -0.30 -0.09

Required:

1. Assume that your portfolio is invested 30% each in A and C, and 40% in B.
What is the expected return of the portfolio?

2. What is the portfolio standard deviation?

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 Department of Accounting Education
Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

Let’s Analyze
Activity 1. Read and answer the problem.

Mary Enterprises is evaluating two projects whose returns are normally distributed.
These projects have the following characteristics:
Project X Project Y
Net investment P50,000 P250,000
Expected return 100,000 500,000
Standard deviation 20,000 100,000
Coefficient of variation 0.20 0.20

1. Which project will you choose if decision is based on:

1.1 Standard deviation?

__________________________________________________________

__________________________________________________________

__________________________________________________________

1.2 Coefficient of variation?

__________________________________________________________

__________________________________________________________

__________________________________________________________

2. Which is more appropriate risk measure in the situation – standard deviation

or coefficient of variation? Justify your answer.

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

Activity 2. Analyze and answer the problem.

You plan to form a portfolio of two stocks, Gigabyte Computers and Mega Value
Food Stores, and are considering two different options involving the weight of each
stock in your portfolio. You estimate the correlation coefficient of the returns
between Gigabyte and Mega Value to be ρ₁, ₂ = + 0.5. Other characteristics of the
two stocks are as shown on the succeeding page:

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 Department of Accounting Education
Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

Gigabyte Mega Value

Computers Food Stores
Expected return (ř) 24% 8%
Standard deviation (σ) 16% 2%
Weight of each stock in the portfolio (wi)
Plan A 60% 40%
Plan B 20% 80%

1. Compute the expected portfolio return of Plan A and Plan B.

Plan A Plan B

2. Compute the portfolio standard deviation of Plan A and Plan B.

Plan A Plan B

3. How will the results of the computation affect your investment decision?
Discuss your portfolio of choice.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

In a Nutshell

To summarize the key concepts in this section, answer the following questions:

1. Discuss the relationship between risk and return?

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

2. The following are the statistical tools that can be used to quantify risk.
Discuss when they are applicable and how to apply them in making
investment decisions.

Statistical Tool When applicable and how to apply in investment

decisions?

Standard deviation

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Coefficient of variation

Correlation coefficient

Keywords Index
✓ Risk
✓ Expected portfolio return
✓ Standard deviation
✓ Coefficient of variation
✓ Portfolio
✓ Portfolio risk
✓ Diversification
✓ Correlation coefficient

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Big Picture in Focus: ULOb.Apply commonly used techniques in

assessing investment under uncertainty.

Metalanguage
For you to demonstrate ULOb, you will need operational understanding of the terms
enumerated below.
❖ Risk Management is the process of measuring or assessing risk and
developing strategies to manage it.
❖ Decision Making under Certainty means that for every decision to make
there is only one event and therefore only a single outcome for each action.
❖ Decision Making under Uncertainty involves several events for each
action with its probability of occurrence.
❖ Probability provides a method for mathematically expressing doubt or
assurance about the occurrence of a chance event.
❖ Payoff (decision) tables are helpful tools for identifying the best solution
given several decision choices and future conditions that involve risk.
❖ Perfect information is the knowledge that a future state of nature will occur
with certainty, being sure of what will occur in the future.
❖ Sensitivity analysis describes how sensitive the linear programming
optimal solution is to a change in any one number.
❖ Simulation is a technique for experimenting with logical and mathematical
models using a computer.
❖ Decision tree is an analytical tool used in a problem in which a series of
decision has to be made at various time intervals, with each decision
influenced by the information that is available at the time it is made.

Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the 1st to 3rdweeks
of the course, you need to fully understand the following essential knowledge laid
down in the succeeding pages. Please note that you are not limited to exclusively
refer to these resources. Thus, you are expected to utilize other books, research
articles and other resources that are available in the university’s library e.g. ebrary,
search.proquest.com etc., and even online tutorial websites.

1. Risk Managementis the process of measuring or assessing risk and developing

strategies to manage it. It is a systematic approach in identifying, analyzing and
controlling areas with a potential for causing unwanted change.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

According to the International Organization of Standardization (ISO 3100), risk

management is the identification, assessment and prioritization of risks followed by
a coordinated and economical application of resources to minimize, monitor and
control the probability and/or impact of unfortunate events and to maximize the
realization of opportunities.

ISO identifies the basic principles of risk management and that risk management
should:
1. Create value
2. Address uncertainty and assumptions
3. Be an integral part of the organizational processes and decision-making
4. Be dynamic, iterative, transparent, tailorable, and responsive to change
5. Create capability for continuous improvement
6. Be systematic, structured, and continually or periodically reassessed.

2. Risk Management Process. According to ISO, the risk management process

has the following steps:
1. Establishing the context.This involves identification of risks; planning the
risk management process;mapping out the social scope, identity and
objectives of stakeholders and basis upon risk will be evaluated; establishing
a framework; anddeveloping risks analysis and mitigation or solution of risks.
2. Identification of potential risks. This begins with the analysis of the source
of problem or the problem itself.
3. Risk assessment. After identifying the risk, the next thing to do is to
evaluate the potential severity of impact and the probability of occurrence of
the risk.

3. Elements of Risk Management. Ideal risk management should minimize

spending of manpower or other resources and the same time minimizing the effect
of risks. The performance of assessment methods should include the following
elements:
1. Identification, characterization and assessment of threats.
2. Assessment of the vulnerability of critical assets to specific threats
3. Determination of the risk
4. Identification of ways to reduce identified risks
5. Prioritization of risk reduction measures based on a strategy

4. Potential Risk Treatments. As suggested in ISO 3100, once risks have been
identified and assessed, techniques to manage them should be applied. The
following are the four categories of risk:

1. Risk Avoidance. This includes performing an activity that could carry risk.
However, avoiding risks would also mean losing the opportunity to earn that
accepting (retaining) the risk may have allowed.

2. Risk Reduction. This is also referred as risk optimization which involves

reducing the severity of loss or the likelihood of the loss from occurring.

3. Risk Sharing. This means sharing with another party the burden ofloss or the
benefit of gain and the measures to reduce a risk.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

4. Risk Retention. This involves accepting the loss or benefit of gain from a risk
when it occurs.

5. Investment Risks. The required return of an investment increases as the risk of

the investment increases. An investor would probably require risk premium as
compensation for taking the uncertainty associated with the investment. Some of
the factors that contribute to the investment uncertainty are the following:

1. Business risk. This refers to the uncertainty about the rate of return caused
by the nature of the business.
2. Financial risk. This is determined by the firm’s capital structure or sources
of financing.
3. Liquidity risk. This is associated with the uncertainty created by the inability
to sell the investment quickly for cash.
4. Default risk. This is related to the probability that some or all of the initial
investment will not be returned.
5. Interest rate risk. This is the risk that fluctuations in interest rates will cause
fluctuations to the value of the investment.
6. Management risk.This is the risk associated with the decisions made the
management and board of directors of the firms.
7. Purchasing power risk. This is the risk that the value of the return from
investment has declined as a result of inflation.

6. The most used Techniques and Models in assessing investment

alternatives under risk or uncertainty are as follows:

1. Probability
2. Value of Information
3. Sensitivity Analysis
4. Simulation
5. Decision Tree
6. Standard deviation and Coefficient of Variation
7. Project Beta

Probability

Decision Making under Certaintymeans that for every decision to make there
is only one event and therefore only a single outcome for each action. There is
100% chance of occurrence; hence, the probability is 1.0.

Decision Making under Uncertaintyinvolves several events for each action

with its probability of occurrence. The probability of occurrence maybe known to
the decision maker because of mathematical proofs and historical evidence;
otherwise, the decision maker may resort to subjective assignment of
probabilities.

Pay-off is the value assigned to different outcomes from a decision which may
be positive or negative. Information is deemed to meet the cost-benefit test if the
expected value of a decision increases as a result of obtaining additional

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Telefax: (084) 655-9591, Local 116

information. The process in deciding whether the cost-benefit criterion has been
met is called information economics.

Assigning Probabilities. Decision makers must assign probabilities to the

various outcomes that represent the likelihood of their occurrence. A probability
distribution describes the chance or likelihood of each of the collectively
exhaustive and mutually exclusive set of events. Probability provides a method
for mathematically expressing doubt or assurance about the occurrence of a
chance event. The probability of an event varies from 0 to 1.

• A probability of 0 means that the event cannot occur, whereas a probability

of 1 means that event is certain to occur.
• A probability between 0 and 1 indicates the likelihood of the event’s
occurrence.

Basic terms used with probability

1. Mutually exclusive. This is the case when two events cannot occur
simultaneously.
2. Joint probability. This is the probability that the two events will both occur.
3. Conditional probability. This is the probability that one will occur given that
the other has already occurred.
4. Independent.This meansthat the occurrence of one has no effect on the
probability of the other.

Illustrative problem. Decision Making under Uncertainty

M & O Corporation is considering two new designs for their kitchen utensil
products – Product A and Product B. Either can be produced using the present
facilities. Each product requires an increase in annual fixed cost of P4,000,000.
The products have the same selling price of P1,000 and the same variable costs
per unit of P800.

After studying past experience with similar products, management has prepared
the following probability distribution:

Event Probability for

(Units Demanded) Product A Product B

5,000 0.0 0.1

10,000 0.1 0.1
20,000 0.2 0.1
30,000 0.4 0.2
40,000 0.2 0.4
50,000 0.1 0.1
1.0 1.0

Management would like to know which product should be chosen, assuming

the objective is to maximize the expected operating income.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Solution:
❖ Using the given probability distribution, determine the expected
demand for the two products:

❖ After determining the expected demand of each product, the expected

operating income should be computed:

Based on the computations presented, Product B should be chosen

because its expected income is higher by P100,000 compared with
Product A.

Payoff (Decision) Tables

Payoff (decision) tables are helpful tools for identifying the best solution given
several decision choices and future conditions that involve risk. It presents the
outcomes (payoffs) of specific decisions when certain states of nature (events not
within the control of the decision maker) occur.

Illustration. A dealer in luxury yachts may order 0, 1 or 2 yachts for this season’s
inventory. The cost of carrying each excess yacht is P50,000 and the gain for each
yacht sold is P200,000. The situation may be described by a payoff table as follows:

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Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

The payoff table can be interpreted as follows: If the dealer decides not to order
yacht, it means that regardless of the actual demand, he will not incur any gain or
loss. However, he misses an opportunity to earn in case there will be actual
demand.If the dealer decides to order 1 yacht and there is no actual demand, he
will be incurring a carrying cost of P50,000 and will report a loss of the same
amount. However, if there will be 1 actual demand, he will earn P200,000. Also, if
there will be 2 actual demands of yacht, the dealer would still be earning P200,000.
Lastly, if the dealer decides to order 2 yachts and there will be no actual demand,
the dealer will be incurring carrying cost of P50,000 for each yacht. Hence, he will
be reporting a loss of P100,000. If there is an actual demand for 1 yacht, the dealer
will earn P200,000; however it will also incur P50,000 for the carrying cost of unsold
yacht. Hence, he will have net earnings of P150,000. Lastly, if the actual demand
for yacht is 2 then the dealer will maximize his earnings to P400,000.
Assuming the probabilities of the season’s demand are as follows:
Demand Probability
0 0.10
1 0.50
2 0.40

The expected value (EV) of each decision can be computed as follows:

Order 0 Order 1 Order 2

0.1 x 0 = 0 0.1 x P(50,000) = ( P5,000) 0.1 x P(100,00) = P(10,000)
0.5 x 0 = 00.5 x 200,000 = 100,000 0.5 x 150,000 = 75,000
0.4 x 0= 0 0.4 x 200,000 = 80,000 0.4 x 400,000 = 160,000
EV = 0 EV = P175,000 EV = P225,000

If the decision will be based on expected value, the dealer should order 2 yachts
since it has the greatest expected value.

Expected Value of Perfect Information

Based on the previous illustrations, management can decide under uncertainty

using the expected value. The alternative that has higher expected value should be
chosen if management wants to maximize its earnings potential. However, there
are times wherein the management or owners do not want to be exposed to risk
and wish to decide only when they are already certain of the conditions at hand. In
this case, the management may decide to hire market analysts to obtain additional
information on the environmental situation; hence, trying to find a perfect
information.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Perfect information is the knowledge that a future state of nature will occur with
certainty, being sure of what will occur in the future. Before deciding to obtain the
perfect information, the management should consider how much is the expected
value of perfect information (EVPI) which can be computed as follows:

EVPI = EV without PI – Expected Value of Return for best action to take with PI

The expected value of perfect information represents that amount the company is
willing to pay to the market analysts’ error-free advice. The company should
evaluate whether it is worthy to obtain perfect information and they will just pursue
marketing research if the amount they will spend in it is less than the benefits that
they will get if they will have perfect information. However, it should be noted that
“perfect information” is not perfect in the sense of absolute predictions.

Illustration.Using the information of the yacht dealer, assume that he was able to
poll all potential customers and they truthfully stated that whether they would
purchase a yacht this year, what is the greatest money that the dealer should pay
for this information? What is EVPI?

EVPI can be computed as follows:

1. Based on the payoff table, compute the expected value of the best choice
under each state of nature.
Best Action Expected Value
Pr State of Nature Best Action Pay-off (Pr x Pay-off)
0.1 Demand =0 Buy =0 P 0 P 0
0.5 Demand =1 Buy =1 200,000 100,000
0.4 Demand =2 Buy =2 400,000 160,000
EV of the best choice = P260,000

Hence, with perfect information about future demand, the dealer expects to
make P260,000. While the choice with best expected value under uncertainty is
P225,000 as previously computed.

2. The expected value of perfect information (EVPI) can then be computed as

follows:

Expected value with perfect information P260,000

Less: Expected value of the best choice (under uncertainty) 225,000
Expected value of perfect information (EVPI) P 35,000

This means that the dealer will NOT pay more than P35,000 to obtain
information about future demand because it will be more profitable to make the
expected value choice than to pay more to obtain the perfect information.

35
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Sensitivity Analysis

Sensitivity analysis describes how sensitive the linear programming optimal solution
is to a change in any one number. It answers what-if questions about the effect of
change in prices or variable costs; changes in value; addition or deletion of
constraints, such as available machine hours; and changes in industrial coefficients,
such as the labor-hours required in manufacturing in a specific unit.

A trial and error method may be adopted in which sensitivity of the solution to
changes in any given variable, parameter or other assumption is calculated. In
linear programming problems, sensitivity is the range within which a constraint
value, such as a cost efficient or any other variable, may be changed without
changing the optimal solution.

Simulation

Simulation is a technique for experimenting with logical and mathematical models

using a computer. It involves experimentation that is an organized trial and error
using a model of the real world to obtain information prior to full implementation.
Models can be classified as:

a. Physical models include automobile mockups, airplane models used for

wind-tunnel tests and breadboard models of electronic circuit
b. Abstract models may be pictorial (architectural plans), verbal (a proposed
procedure), or a logical-mathematical.

Five steps in simulation procedure are as follows:

1. Define the objectives
2. Formulate the model
3. Validate the model
4. Design the experiment
5. Conduct the simulation

SIMULATION
Advantages Limitations
1. Time can be compressed. 1.Simulation model can be costly to
2. Alternative policies can be explored. develop.
3. Complex system can be analyzed. 2. Risk of error.

Decision Tree

A decision tree is an analytical tool used in a problem in which a series of decision

has to be made at various time intervals, with each decision influenced by the
information that is available at the time it is made. It is a diagram that shows the
several decisions or acts and the possible consequences called events of each act.
In a more elaborate form, the probabilities and the revenue and costs of each
event’s outcome are estimated and these are combined to give an expected value
for the event.

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 Department of Accounting Education
Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

DECISION TREE ANALYSIS

Advantages Limitations
1. An effective means of presenting the 1. It does not give management the
relevant information needed in an answers to investment problem.
investment problem. 2. It does not identify all the possible
2. Combination of action choices with events or does it list all the decisions
different events or results of action that must be made on a subject under
chance or other uncontrollable analysis.
circumstances partially affect can be 3. The interactions of such decision with
better presented and studied. the objective of other parts of the
3. The interactions of the impact of the business organization would be too
future events, decision alternatives, complicated to compute manually.
uncertain events and their possible 4. It treats uncertain alternatives as if
payoffs can be shown with greater ease they were discrete well-defined
and clarity. possibilities when uncertain situations
4. Data are presented in a manner that depend on several variables subject to
enables systematic analysis and better such chance influences.
decisions.

Self-Help: You can also refer to the sources below to help you
further understand the lesson.

Cabrera, M. B. (2015). Financial management principles and applications volume 2.

Manila: GIC Enterprises & Co., Inc.

Saunders, A., & Cornett, M. M. (2019). Financial markets and institutions (7th ed.).
New York: McGraw Hill Education.

Let’s Check

Activity 1:Multiple Choice. Write the letter of your choice in the space provided
before the number.

_______ 1. The risk that securities cannot sold at a reasonable price on short
notice is called
a. Default risk c. Purchasing-power risk
b. Interest rate risk d. Liquidity risk
_______ 2. The type of risk that is not diversifiable and affects the value of a
portfolio
a. Purchasing-power risk c. Non-market risk
b. Market risk d. Interest rate risk
_______ 3. Which of the following are components of interest rate risk?
c. Purchasing-power risk and default risk

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Telefax: (084) 655-9591, Local 116

d. Price risk and market risk

e. Portfolio risk and reinvestment-rate risk
f. Price risk and reinvestment-rate risk
_______ 4. This is a helpful tool for identifying the best solution given several
decision choices and future conditions that involve risk.
a. Sensitivity analysis c. Payoff table
b. Decision tree analysis d. Simulation
_______ 5. This is a technique for experimenting with logical and mathematical
models using a computer.
a. Sensitivity analysis c. Payoff table
b. Decision tree analysis d. Simulation
_______ 6. This describes how sensitive the linear programming optimal solution to
a change in any one number.
a. Sensitivity analysis c. Payoff table
b. Decision tree analysis d. Simulation
_______ 7. This is an analytical tool used in a problem in which a series of decision
has to be mage at various time intervals.
a. Sensitivity analysis c. Payoff table
b. Decision tree analysis d. Simulation

_______ 8. The amount that an investor is willing to pay to reduce if not eliminate
uncertainty.
a. Payoff c. Expected value of perfect information
b. Fixed cost d. Expected value of net investment
_______ 9. This describes the chance or likelihood of each of the collectively
exhaustive and mutually exclusive set of events.
a. Expected value c. Payoff
b. Probability d. Probability distribution
_______ 10. Two events that cannot occur simultaneously
a. Joint Probability c. Conditional probability
b. Mutually exclusive d. Independent

Let’s Analyze
Activity 1. Read and answer the problems.

Problem 1. 3K Company is considering the introduction of a new product. The

anticipated demand, probability of demand and profits for each are given below.

Product X Product Y
Product Probability of Profit Product Probability of Profit
Demand Demand (Peso) Demand Demand (Peso)
(units) % %

50,000 20 -8,000 30,000 15 -12,000

60,000 10 -5,000 40,000 15 -10,000
70,000 30 11,000 50,000 40 14,000
80,000 20 14,000 60,000 20 16,000
90,000 20 17,000 70,000 10 16,000

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Required:

1. Compute the expected value of the profits of Product X and Product Y.

Product X Product Y

2. Based on the computation, which product would you choose to pursue?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

Problem 2. A beverage stand can sell either soft drinks or coffee on any given day.
If the stand sells soft drinks and the weather is hot, it will make P2,500; if the
weather is cold, the profit will be P1,000. If the stand sells coffee and the weather
is hot, it will make P1,900; if the weather is cold, the profit will be P2,000. The
probability of cold weather on a given day at this time is 60%.

Required:

2.1 Compute for theexpected payoff for selling coffee.

2.2 Compute for the expected payoff if the vendor has perfect information.

39
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

2.3 Compute for the expected value of perfect information.

2.4 What advise can you give to the beverage stand owner, if somebody offered him
to do research and obtain the perfect information at a cost of P1,000?

In a Nutshell

Based on the concepts presented, write the three remarkable lessons you learned
in this section.

1. _____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________

2. _____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________

3. _____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________

40
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Q&A List
In this section you are going to list what boggles you in this unit. You may indicate
your questions but noting you have to indicate the answers after your question is
being raised and clarified. You can write your questions below.

Questions/Issues Answers

1.

2.

3.

4.

5.

Keyword Index

✓ Risk Management
✓ Decision Making under Certainty
✓ Decision Making under Uncertainty
✓ Probability
✓ Payoff (decision) tables
✓ Perfect information
✓ Sensitivity analysis
✓ Simulation
✓ Decision tree

41
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Big Picture in Focus: ULOc. Apply Capital Asset Pricing Model

(CAPM) concepts in evaluating investments.

Metalanguage
For you to demonstrate ULOc, you will need operational understanding of the terms
enumerated below.
❖ Capital Asset Pricing Model (CAPM) is a model based on the proposition that
any stocks required rate of return is equal to the risk-free rate of return plus a
risk premium that reflects only the risk remaining after diversification.
❖ Diversifiable risk also called unsystematic risk or company risk, is a type of
risk can be diversified away.
❖ Undiversifiable risk also called systematic or market risk, is a type of risk
cannot be eliminated by diversification.
❖ Beta coefficient (or beta) is the measure of risk when assets are held in a
portfolio.
❖ Risk-free rate is the rate of return that an investor would require in a riskless
investment. This is composed of the real rate and inflation premium.
❖ Market rate of return is the expected rate of return of the market as a whole.
❖ Market risk premium (or price per unit of risk) is the difference between the
market rate of return and the risk-free rate; computed as: (rm–rf).
❖ Risk premium is the return required as compensation to investors for taking
risk; computed as: [(rm – rf)(bi)]
❖ Security Market Line (SML) a graphical presentation of CAPM.

Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the 5 th and 6th
weeks of the course, you need to fully understand the following essential
knowledge laid down in the succeeding pages. Please note that you are not limited
to exclusively refer to these resources. Thus, you are expected to utilize other
books, research articles and other resources that are available in the university’s
library e.g. ebrary, search.proquest.com etc., and even online tutorial websites.
1. The previous sections focused only on the riskiness of stand-alone assets which
is generally appropriate for small businesses, many real estate investments, and
capital budgeting projects. However, the same may not be applicable for banks,
insurance companies, pension funds and other financial institutions as they are
required by law to hold diversified portfolio. It is believed that the risk of a stock
held in portfolio is typically lower than the stock’s risk when it is held alone. Since
most investors dislike risk, they are inclined to hold portfolio to reduce risk. The
next discussion is an attempt to explain how risk should be considered when
stocks are held in a portfolio using the Capital Asset Pricing Model (CAPM).

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Capital Asset Pricing Model (CAPM) is a model based on the proposition that
any stocks required rate of return is equal to the risk-free rate of return plus a risk
premium that reflects only the risk remaining after diversification. It provides a
general framework for analyzing risk-return relationships for all types of assets.
CAPM uses only one part of the total risk called the systematic risk, in evaluating
the risk-return relationship.

The total risk (previously measured by standard deviation) can be separated into
two major components:

• Diversifiable risk – also called unsystematic risk or company risk. This is

the part of the security’s risk caused by factors unique to a particular firm.
This type of risk can be diversified away because it represents essentially
random events. Sources of diversifiable or unsystematic risk include
lawsuits, strikes, company management, marketing strategies and research
and development programs, operating and financial leverage and other
events that are unique to a particular firm. Because these events are
random, their effects on a portfolio can be eliminated by diversification.

• Undiversifiable risk – also called systematic or market risk. This is the part
of a security’s risk caused by factors affecting the market as a whole. This
type of risk cannot be eliminated by diversification because it affects all firms
simultaneously. Some companies are sensitive than others to factors that
1affect systematic risk. Hence, systematic risk is the only relevant risk and
is affected by such factors as wars, inflation, interest rates, business cycles,
fiscal and monetary policies and therefore cannot be eliminated by
diversification.

Effect of Diversification on Systematic and Unsystematic Risk

The effect of diversification can be shown on the figure below:
Figure 8. Effect of diversification

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 Department of Accounting Education
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Telefax: (084) 655-9591, Local 116

It can be observed that as the number of stocks held in a portfolio increases,

the diversifying effect of each additional stock on unsystematic risk
diminishes. However, one should be careful in selecting stocks to be included
in the portfolio taking into consideration their correlations with one another. If
the investor chooses stocks with correlations with one another and with low
stand-alone risk, the portfolio’s risk will decline faster rather than if stocks will
be randomly added.

If increasing the number of stocks held in a portfolio, then is it advisable for an

investor to just hold a portfolio consisting all stocks? Probably not, because of
the following reasons:

❖ It entails high administrative costs and commissions would be more

than offset the income for individual investors.
❖ Index fund can be used for diversification and many individuals can
and do get broad diversification through these funds.
❖ Some people believe that they can pick stocks that will “beat the
market” so they buy them rather than the broad market.
❖ Some people can, through superior analysis, beat the market; so they
find and buy undervalued stocks and sell overvalued ones.

Capital Asset Pricing Model Illustrated

The CAPM uses beta as a measure of risk. It is a model developed to help

determine a share’s required rate of return for a given level of risk. It can be
computed as:

Required rate of return = risk-free rate + risk premium

If an investor chooses to invest his money, then he must postpone

consumption. Then at what rate of return will an investor be persuaded to
postpone consumption and invest his money instead?If the investor takes no
risk whatsoever, but merely postpones consumption, he wanted to be
compensated for the wait plus an additional return for any inflationary
pressures (an inflation premium).
If the investor demands a 3% return to postpone consumption, and another
2% to cover the expected rate of inflation, he will require 5% rate of return
which is a risk-free rate. In actual market scenario, we can consider treasury
securities as a good proxy or benchmark for a riskless asset because there is
no default risk. At this point we can say that, risk-free rate is composed of:
• real rate that excludes any inflationary expectations; and
• inflation premium that equals the expected inflationary rate.

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 Department of Accounting Education
Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

To continue the illustration, an investor would get to move from a risk-free

asset if he will be given an additional compensation that he requires for
investing in a risky asset. The additional compensation required referred as
risk premium can be computed as follows:

Risk Premium = (Price per unit of Risk) (Beta)

The price per unit of risk is the difference between return on the market and
the risk-free rate, that is:

Price per unit of risk = Return on the Market – Risk-free Rate

Therefore, the formula to compute for the required rate of return under CAPM,
can be expressed as follows:
ri = rf+ (rm – rf) (bi)
Where:
ri= required (or expected) return on security, i
rf=expected risk-free rate of return
rm= expected return on the market portfolio
bi= beta coefficient of security, i

Illustration 1. Suppose a particular stock has a risk-free rate of 5%, a rate of return
on the market of 12% and a beta coefficient (quantity of risk) of 1.5. What would be
the investor’s required rate of return?
Solution: ri = rf+ (rm – rf) (bi)
ri = 5% + (12% - 5%) (1.5)
ri = 5% + 10.5%
ri = 15.5%

The investor would require a risk premium of 10.5%. Thus, the required rate of
return is 15.5%.

Illustration 2.Using the same illustration, except that the beta coefficient is2.0,
what would be the required rate of return?
Solution: ri = rf+ (rm – rf) (bi)
ri = 5% + (12% - 5%) (2)
ri = 5% + 14%
ri = 19%

The investor would demand for a greater rate of return because of the increase in
risk. The additional compensation (risk premium) required is 14%. Thus, the
required rate of return is 19%. As can be observed, the higher the risk, the greater
would be the required rate of return.

45
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

The Beta Coefficient Concept

The risk of a stock when it is held by itself can be measured using the standard
deviation of its expected returns. However, this is not applicable if stocks are held in
a portfolio. Hence, the systematic risk can be measured by a stock’s beta
coefficient.
Beta is a measure of the sensitivity of a security’s return relative to the returns of a
broad-based market portfolio securities. It measures the co-movement between a
stock and the market portfolio. The tendency of the stock to move with the market is
reflected in its beta coefficient (b), which is the measure of the stock’s volatility
relative to an average stock.
An average-risk stock is defined as one that tends to move up and down in step
with the general market as measured by some index, such as PSE Index, Dow
Jones Industrials, the S&P 500 or the New York Stock Exchange Index.
An average stock generally has a beta (b) of 1.0 which means that is the market
moves up by 10%, the stock will also move up by 10%; on the other hand, if the
market falls by 10%, the stock will likewise fall by 10%. Hence, a portfolio of stocks
with beta of 1.0
, will move up and down with the broad market averages, and it will be just as risky
as the averages.
If the beta is equal to 0.50, the stock is only half as volatile as the market – it will
riseand fall only half as much – and a portfolio of such stocks will be half as risky as
a portfolio of stocks with beta of 1.0.
If the beta is equal to 2.0, the stock is twice as volatile as an average stock, so a
portfolio of such stocks will be twice as risky as an average portfolio. The value of
such portfolio could double – or halve – in a short time; hence, very risky.
Figure 9. Relative Volatility of Stocks A, B and C

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 Department of Accounting Education
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Telefax: (084) 655-9591, Local 116

Figure 9 presents the relative volatility of three stocks. The data below the graph
assume that in 2009 the market, defined as the portfolio consisting of all stocks,
had a total return (dividend yield plus capital gains yield) of k m= 10%, and stocks A,
B and C (for High, Average and Low risk) also had returns of 10%. In 2013, the
market went up sharply, and the return on the market portfolio was km= 20%.
Returns on the three stocks also went up: A soared to 30%; B went to 20%, the
same as the market; and C only went up to 15%. Now suppose that the market
dropped in 2014, and the market return was km= -10%. The three stocks’ return also
fell, A plunging to -30%; B falling to -10% while C reported 0%. Thus, the three
stocks all moved in the same direction as the market, but A was by far the most
volatile; B was a volatile as the market; and C was less volatile.
If a higher-beta-than-average stock is added to an average-beta portfolio, then the
beta and consequently, the riskiness of the portfolio will increase. Conversely, if a
lower-beta-than-average stock is added to an average-risk portfolio, the portfolio’s
beta and risk will decline.
To summarize, the market risk of a stock is measured by its beta coefficient, which
is an index of the stock’s volatility. Some benchmark betas follow:
b = 0.5 : Stock is only half as volatile, or risky, as the average stock.
b = 1.0 : Stock is of average risk.
b = 2.0 : Stock is twice as risky as the average stock.

Portfolio Beta Coefficient

Portfolio beta coefficient can be computed as the weighted average of the individual
securities’ betas. The beta of the portfolio reflects how volatile the portfolio is in
relation to the market.
For example, if an investor holds P1,500,000 portfolio consisting of P500,000
invested in each of 3 stocks and each of the stock has a beta of 0.8, then the
portfolio’s beta will be:
bp = (1/3)(0.8) + (1/3)(0.8) + (1/3)(0.8)
= .8

Since the portfolio beta is lower than 1, we can safely say that this portfolio is less
risky than the market. Hence, it should experience relatively narrow price swings
and have relatively small rate of return fluctuations.

Suppose one of the existing stocks is sold and replaced by a stock with b 1 = 2, what
will happen to the portfolio beta? In this case, since, one of the stocks has
increased its beta, we can expect that the portfolio beta will also increase as
computed as follows:

bp = (1/3)(0.8) + (1/3)(0.8) + (1/3)(2)

= 1.2

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 Department of Accounting Education
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Telefax: (084) 655-9591, Local 116

Hence, from a portfolio beta of 0.80, it increased to 1.2 as a stock with higher beta
was added in the portfolio.

Another illustration. Calculation of Portfolio Beta

An investor decided to invest his P350,000 as follows:

Amount % Allocation Beta

Diversified Stocks P200,000 57.1% 1.00
Bonds 100,000 28.6% 0.18
Treasury bills 50,000 14.3% 0.00
Total P350,000 100.0%

The beta for this portfolio can be computed as follows:

b = (0.571)(1) + (.286)(0.18) + (.143)(0)
b = .62

With a portfolio beta of .62, a market return of 11% and a risk-free rate of 5%, an
investor can expect a return of:

ri = rf+ (rm – rf) (bi)

= 5% + (11%-5%)(.62)
= 8.7%

Security Market Line (SML)

The CAPM is expressed graphically by the security market line (SML). The security
market line represents the linear relationship between a security’s required rate of
return and its risks as measured by beta.

Figure 10. The Security Market Line (SML)

Figure 10 shows the SML and the risk-return tradeoff of Stock 1 and Stock 2. As can
be gleaned, the risk-free rate is 8% whereas the market rate of return is 14%;

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Telefax: (084) 655-9591, Local 116

therefore, the market risk premium is 6% (14%-8%). Stock 1 with a beta coefficient
of 2 would require a high risk premium of 12%; hence, its required rate of return is
20%. On the other hand, Stock 2 with a beta coefficient of 0.5 would require a low
risk premium of 3%, hence, its required rate of return is 11%.

The required rate of return computed under CAPM can also be used as a market-
based hurdle rate for the purpose of evaluating investments. A hurdle rate is the
minimum rate of return required for a project to be accepted. Hence, if an assets’
expected rate of return equals or exceeds the required return (falls on or above the
SML), as computed by CAPM, the asset is accepted; otherwise, it is rejected.

Illustration on Investment Decision based on SML

Based on the previous illustration, Stock 1 and Stock 2 have required rates of return
of 20% and 11%, respectively. Assume that the expected return for Stock 1 is 18%
and for Stock 2 is 15%. Should the investments be acquired based on the SML?

Figure 11 shows that Stock 2’s expected return of 15% is above the SML and
therefore should be acquired because it is higher than the required rate of return
(hurdle rate) of 11%. On the other hand, Stock 1 is rejected because it is expected
return is only 18% which is lower than the required rate of return of 20%. Also, based
on the graph, the expected return of Stock 1 of 18% is under the SML; hence, should
be rejected.

Figure 11. Using Security Market Line (SML) to Select Securities

49
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Telefax: (084) 655-9591, Local 116

Concerns About CAPM

The CAPM is based on restrictive assumptions about investor behavior and the
securities market.
❖ Assumptions about investor behavior include:
• Investors are risk-averse and expect to be rewarded for taking risks;
• Investors act rationally and prefer a security with the highest return for a given
level of risk, or the lowest risk for a given level of return;
• Investors make their decisions based on a single time horizon; and
• Investors share the same expectations about the risk and return
characteristics of securities.

2. Assumptions about the securities market include:

• All investors can borrow or lend in unlimited amounts at the risk-free rate;
• Financial markets are frictionless in that there are no taxes or transaction
costs;
• All assets are perfectly divisible and perfectly liquid and
• Information is freely available to all investors.

CAPM’s limitation lies on the fact that some of its assumptions do not all reflect
reality. There is also greater possibility that we may not be able to determine the
average return on market portfolio since they could be many possible bases and we
may not be able to determine which is most representative of the market. Another
concern is related to beta estimation because the applicability and relevance of a
company’s beta will depend on the futureplans of the firm.

With these limitations, finance researchers have introduced other asset pricing
models which considers other risk factors to the predictive relationship of risk and
return other than the market risk. These factors such as firm size and book-to-market
ratio are used along with beta as measure of market risk.

Self-Help: You can also refer to the sources below to help you
further understand the lesson.

Cabrera, M. B. (2015). Financial management principles and applications volume 2.

Manila: GIC Enterprises & Co., Inc.

Saunders, A., & Cornett, M. M. (2019). Financial markets and institutions (7th ed.).
New York: McGraw Hill Education.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Let’s Check

Activity 1: Classify the following events whether they can be distinguished as

systematic or unsystematic.

_________________ 1. Short-term interest rates increase unexpectedly.

_________________2.The interest rate a company pays on its short-term debt
borrowing is increased by its bank.
_________________ 3.Oil prices unexpectedly declined.
_________________ 4. An oil tanker ruptures, creating a large oil spill.
_________________ 5. A manufacturer loses a multimillion-peso product liability
suit.
_________________6. A Supreme Court decision substantially broadens producer
liability for injuries suffered by product users.
_________________7. A company suffered losses due to employees strike.
_________________ 8. Companies reported losses due to Covid-19 Pandemic.
_________________9. Inflation rate increased sharply.
_________________10. The stock price of a company declined due to reported
losses.

Activity 2:Apply CAPM concepts in answering the problems below.

Problem 1.Assume that the risk-free rate is 8%. The expected return on the market
is 16%. If a particular stock has a beta of .7, what is the expected return based on
the CAPM?

Problem 2.The ordinaryequity share of Cebu Air, Inc. (CEB) has an estimated beta
of 1.2. The risk-free rate is 7% and the expected return on the market is 12%.

Show your computations in answering the following:

2.1. What is the market risk premium?

2.2. What is the required rate of return using CAPM?

2.3. Assume that the risk-free rate of 7% includes an inflation premium of 4%. What
would happen to the required rate of return if the inflationary expectations of
investors will increase to 6%?

51
 Department of Accounting Education
Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

Activity 3. Computation of Portfolio Beta

An investor owns an equity share portfolio invested in the following manner:

% Allocation Beta
Stock A 25% 0.84
Stock B 20% 1.17
Stock C 15% 1.11
Stock D 40% 1.36

What is the portfolio beta?

Let’s Analyze

Activity 1. Investment Evaluationusing Beta Coefficient

Joel Securities plans to purchase equal amount of four of the following equity
shares for one of its clients. The client already holds a highly diversified portfolio.
The risk-free rate of return is estimated at 8% and the expected market return at
14%. The beta coefficients of the equity shares are as follows:

Equity Share 1 2 3 4 56
Betai 1.5 1.0 0.8 2.0 0.3 1.2

Questions:

1. What is the required rate of return of the each security?

Stock 1: ______________________________________________________
Stock 2: ______________________________________________________
Stock 3: ______________________________________________________
Stock 4: ______________________________________________________
Stock 5: ______________________________________________________
Stock 6: ______________________________________________________

2. If the client wants to have the lowest risk portfolio, what four (4) equity shares
should be selected?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

3. What is the required rate of return of the four-equity shares portfolio selected?

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Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

Assume an equal investment in each equity share.

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

Activity 2. Investment Evaluationusing Security Market Line

The following information pertains to Stock A, B and C:

Stock A Stock B Stock C

Beta 0.5 1.0 1.2
Expected return 11% 12% 20%
Risk-free rate 5%
Expected return on market 15%

The following information is plotted in the following graph and draws a

security market line:

1. What does the SML represent?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

2. How can you use this graph to select securities?

_____________________________________________________________

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 Department of Accounting Education
Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

3. How much is the required rate of return of Stocks A, B and C?

Stock A: ______________________________________________________

Stock B: ______________________________________________________

Stock C: ______________________________________________________

4. Which of the stocks should be selected? Explain your answer.

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

In a Nutshell

Based on the concepts presented, answer the following questions.

1. Distinguish between systematic risk and unsystematic risk?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

2. What the significance of Capital Asset Pricing Model (CAPM)?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

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 Department of Accounting Education
Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

_____________________________________________________________

3. What will happen to the required rate of return when beta coefficient increases?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

4. How do you make investment decisions using CAPM?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

5. How do you make investment decisions using Security Market Line (SML)?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

Keywords Index
✓ Capital Asset Pricing Model (CAPM)
✓ Diversifiable risk
✓ Undiversifiable risk
✓ Beta coefficient (or beta)
✓ Risk-free rate
✓ Market rate of return
✓ Market risk premium (or price per unit of risk)
✓ Risk premium
✓ Security Market Line (SML)

55
 Department of Accounting Education
Mabini Street, Tagum City
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Telefax: (084) 655-9591, Local 116

Big Picture B
Week 3-4: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to:
a. Evaluate factors that can influence optimal capital structure.
b. Calculate the cost of capital.

Big Picture in Focus: ULOa. Evaluate factors that can influence

optimal capital structure.

Metalanguage
For you to demonstrate ULOa, you will need operational understanding of the terms
enumerated below.
❖ Capital is the aggregation of items appearing on the left-hand side of the
balance sheet minus current liabilities except short-term bank loans.
❖ Capital structure refers to the mix of debt, preferred stock and ordinary
(common) equity that the firm uses to finance the firm's assets.

Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the 4 th to 5th
weeks of the course, you need to fully understand the following essential
knowledge laid down in the succeeding pages. Please note that you are not limited
to exclusively refer to these resources. Thus, you are expected to utilize other
books, research articles and other resources that are available in the university’s
library e.g. ebrary, search.proquest.com etc., and even online tutorial websites.

1. CAPITAL AND CAPITAL STRUCTURE. The term capital refers to investor-

supplied funds, debt, preferred shares, ordinary (common) equity and retained
earnings. Capital is frequently defined to include only long-term debt, that is, debt
due in more than year. Capital is the aggregation of items appearing on the left-
hand side of the balance sheet minus current liabilities except short-term bank
loans.
Capital structure refers to the mix of debt, preferred stock and ordinary (common)
equity that the firm uses to finance the firm's assets. So far, we have assumed that
a firm's capital structure that a firm uses to finance its operations is either already
given or is irrelevant to the capital investments budgeting decisions we have been
making. Although this assumption can be appropriately used in the very short term,
firms can and do change their capital structures in the longer term. It is therefore

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 Department of Accounting Education
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Telefax: (084) 655-9591, Local 116

necessary to analyze factors that affect the firm's decision to change the funding
mix.
The financial manager's objective in making capital structure decisions is to find the
financing mix that maximizes the value of the firm. This structure is called the
optimal capital structure.

WHY CAPITAL STRUCTURE CHANGES OVER TIME

Firm's actual capital structure change over time and for two quite different reasons:

Deliberate Management Actions

If a firm is not currently at its target, it may deliberately raise new money in a
manner that moves the actual structure towards the target.

Market Actions
Changes in the market value of the debt and/or equity capital could result in large
changes in its measured capital structure. For example, a firm could incur high
profits or losses that could lead to significant changes in book value equity as
shown on its balance sheet and to a significant change in its stock price. Also,
interest rates could change due to change in general level of rates or the firm's
default risk that could result to changes in the debt's market values.
Still, at any given moment, most firms have a specific target range of capital
structure in mind. If the actual debt ratio has surpassed the target, a firm can sell a
large stock issue and use the proceeds to retire debt. Or if the debt ratio falls below
the target, a firm can issue bonds and use the proceeds to repurchase stock. A
firm can gradually move toward its target through its annual financing to support its
capital budget.

CAPITAL STRUCTURE THEORY

There are numerous theories that attempt to explain how changes in financial
leverage, or the use of debt, affect the value of a firm and its cost of capital. These
theories address two questions: Can a firm increase shareholder wealth by
replacing some of its equity with debt, and, if so, how much debt should it
use? Three theories of capital structure are examined: (1) the traditional approach,
(2) the Franco Modigliani and Merton Miller approach, and (3) the contemporary
approach.

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a.) THE TRADITIONAL APPROACH

The traditional approach to capital structure suggests that a firm can lower its
weighted average cost of capital and increase its market value by the judicious use
of financial leverage.
This theory suggests that there is a tradeoff between cheaper debt and higher
priced equity that leads to an optimal capital structure. Thus, the cost of capital and
the firm's value are not independent of its capital structure.
Figure 1 shows the relationship of the cost of debt and cost of equity and average
cost of capital to the firm's total value.
The total market value of the firm can be determined as follows:
1. Value of the firm = Market Value of debt + *Market value of common shares
outstanding or equity

or

2. Value of the firm= EBIT (1-T)

**Weighted average cost of capital

*Market value of equity= EBIT-Interest ___

Cost of Equity

**Weighted average cost of capital= EBIT________

Market value of the firm

Figure 1. Relationship of the Cost of Debt and Cost of Equity and Average
Cost of Capital to the Firm’s Total Value

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The chart shows that as lower cost of debt (Kd) is substituted for higher cost of
equity (Ks), the weighted average cost of capital (Ka) declines to a minimum, D/V
and then increases as the amount of debt increases. These relationships produce
a U-shaped weighted average cost of capital curve.

Figure 2. Relationship between the Market Value of the Firm and the amount
of Debt
Figure 2 shows the relationship between the market value of the firm (P) and the
amount of debt.
The above chart shows that the market value of the firm first rises, reaches its peak
at point D/V where Ka, is minimized and finally declines as leverage or debt
increases.
The traditional approach attributes the cost of debt and equity to changing investor
attitudes toward risk. Both Kd and Ks, are almost constant under "moderate
amounts of debt". However, when debt becomes excessive both K d and Ks,
increase in response to the risk.
Illustrative Case. Determination of the Optimal Capital Structure Using the
Traditional Approach
Brandon’s Health Center (BHC) has no debt but is considering two plans to add
leverage.
Plan A – Issue P200,000 bonds
Plan B – Issue P300,000 bonds
The proceeds from both proposals shall be used to return the same amount of
common stock. Management wants to evaluate the impact of increasing BHC’s

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financial leverage. Data about the corporation’s current and proposed capital
structure follow:

Using the Traditional Approach, determine the Market value of the equity, Market
Value of the Firm, and the Weighted Average Cost of Capital. Which plan is
preferable? Why? What is the firm’s optimal capital structure?
Solution:

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It can be observed that the market value of the firm increased from P1,000,000 to
P1,019.048 under Plan A but decreased to P908,333 under Plan B. The weighted
average cost of capital decreased from 10% to 9.8% under Plan A and increased to
11% under Plan B.
Plan A is preferred over both the current capital structure and Plan B.
Plan A has the highest market value of the firm and the lowest cost of capital of the
three capital structures.
Based on the data provided, the firm's optimal capital structure is not determinable.
However, BHC's optimal capital structure must be less than the debt/value ratio of
about 33% (P300,000/P908,333) of Plan B.

b.) THE MODIGLIANI AND MILLER (PERFECT WORLD) APPROACH I

This approach that the firm's value is determined by its real assets, not by the
securities it issues. Thus capital structure is irrelevant and all capital structures are
equally desirable. This theory assumes no taxes, no chance of bankruptcy, and no
brokerage costs investors can borrow at the same rate as corporations. EBIT is not
affected by the use of debt perfectly efficient markets. Symmetric information sets
for all participants. Symmetric information is the situations where investors and
managers have identical information about a firm's prospects. These assumptions
however carry little credibility in practice.
Figure 3 and Figure 4 shows the Modigliani and Miller Approach to Capital
Structure without Corporate Taxes.
This original theory is depicted in Figure 3 which shows that at all levels of debt, the
higher cost of equity, Ks is sufficient to exactly offset the lower cost of debt, K, and
thus leads to a constant weighted average cost of capital Ka.

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Figure 4 on the other hand indicates that the value of the firm is independent of its
financial leverage.

Figure 3

Figure 4
MM's original theory was criticized harshly but despite the fact that some of the
assumptions are unrealistic, MMs' irrelevance result is extremely important. By
indicating the conditions under which capital structure is irrelevant, MM provided
clues about what is required to make capital structure and therefore to affect the
firm's value.
Subsequent research focused on relaxing the MM assumptions to develop a more
robust and realistic theory.

THE MM APPROACH II TO CAPITAL STRUCTURE WITH CORPORATE TAXES

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The MM model with corporate income taxes shows that the use of financial
leverage lowers a firm's cost of capital and raises the firm's value because interest
on debt is tax deductible. Thus, in a world of corporate income taxes, there is a
substantial advantage when debt is used.
The value of an unlevered firm with taxes is determined as follows:
Value of an Unlevered Firm = EBIT (1-T)___________
With Corporate Taxes Cost of equity of an unlevered firm

While the market value of a levered firm with corporate taxes is determined as
follows:
Value of a Levered Firm with = Value of the + Present Value of the
Corporate Taxes Unlevered Firm Interest Tax Shield

Figure 5 and Figure 6 present the Modigliani and Miller Approach to Capital
Structure With Corporate Taxes.
Figure 5 shows that if the cost of debt, Kd (1 - T) is unaffected by financial leverage
then the weighted average cost of capital, K, declines as the firm borrows more.
Figure 6 indicates that value is maximized with virtually 100% debt financing. This
result is consistent with MM assumptions, but it is not observed in practice.

Figure 5

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Figure 6

c.) THE CONTEMPORARY APPROACH - TRADE-OFF THEORY

The contemporary approach to capital structure asserts that there is an optimal
capital structure or at least an optimal range of structures for every firm. This
approach identifies several factors that can lead to an optimal capital structure tor a
given firm such as tax effects (corporate and personal), financial distress and
related costs.

Corporate Income Taxes

The use of debt in the capital structure of a corporation reduces its cost of raising
capital because interest on debt is tax deductible.

Financial Distress and Related Costs

The contemporary approach allows for the possibility that the firm may go bankrupt.
This implies that the firm's debt holders will have to allow for the possibility that they
might not receive everything they have been promised. In this move realistic type
of situation, bondholders will be asked to bear some firm risk and therefore in turn
will ask for a little more return. If a financial distress occurs or firms are perceived
as being close to bankruptcy, the firm could incur some substantial costs such as
fees to lawyers, consultants and accountants, loss of efficiency in the firm's
operations, reduced sales because of post-sales support concerns, lightening of
credit terms from suppliers, etc.

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The risks of bankruptcy as well as the probability of a bankruptcy - related loss of

value, increase with financial leverage. The inclusion of financial distress and
related costs partially offsets the tax advantage and explains why firms do not
finance entirely by debt.
Figure 7 shows the effects of financial leverage on the value of the firm.

Figure 7. Effect of Financial Leverage on the Value of the Firm

Trade-off Theory of Leverage states that firm's trade off the tax benefits of debt
financing against problems caused by potential bankruptcy. With this theory, the
optimal debt level exists at which point the marginal benefits of financial leverage
equal the marginal costs. Thus the value of the levered firm considering tax effects,
financial distress and related costs could be determined as follows:

Value of the Levered Value of the Present Present Value

Firm with Taxes, = Levered Firm + Value of Net - of Financial
Financial Distress, with Taxes Tax Savings Distress and
and Related costs Related Costs

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Figures 8 and Figure 9 show the Contemporary Approach to Capital Structure With
Taxes, Financial Distress and Related Costs.
Figure 8 shows that weighted average cost of capital declines because of the
favorable net tax treatment given debt, and then at relatively high degrees of
financial leverage because of high bankruptcy costs and related cost.
Figure 9 shows the value of the firm with taxes, financial distress, and related costs.

Figure 8

Figure 9
The MM model without corporate taxes leads to the conclusion that there is no one
optimal capital structure. Both the traditional and contemporary approaches hold
that there is an optimal capital structure for each firm, but for different reasons.
Empirical research on the exact relationship among leverage, value, and cost of
capital has not produced definitive results. However, managers generally subscribe
to the concept of an optimal capital structure.

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The differences among the three approaches result from differing

assumptions about how investors value a firm's debt and equity.
Both Traditional and Modigliani and Miller (MM) theories share several common
assumptions.
1. Financing occurs only through two types of capital: long-term debt and
common stock.
2. The firm's investment decision is fixed, but its capital structure can be
changed by issuing bonds repurchase stock or issuing stock to retire debt.
3. There are no taxes or bankruptcy costs.
4. All earnings are paid out as dividends.
5. Net operating income, also called earnings before interest and taxes (EBIT),
is constant
6. Business risk is constant.
The MM model also assumes perfect capital markets, which implies no transaction
costs and rational investor behavior. This set of assumptions holds constant all
influences on firm value and cost of capital other than capital structure. These
restrictive assumptions reduce the realism of the Traditional and MM approach but
provide a starting point for understanding the theory of capital structure. The
contemporary approach relaxes some of these simplifying assumptions.

CHECKLIST FOR CAPITAL STRUCTURE DECISIONS

In addition to the types of analyzes discussed previously, business establishments
generally consider the following factors when making capital structure decisions.

Factors Influencing Optimal Capital Structure

In reality the following factors have a great practical implication for capital structure.
• Control
The management control over the firm is one of the major determinants of capital
structure decisions. If equity shareholders do not wish to dilute their control, the
firm will rely more on debt funds rather than issuing additional equity shares.
• Risk
In capital structure decisions, two elements of risk (1) business risk, and (2)
financial risk are considered. Business risk is the riskiness of the firm's assets if
no debt is used while financial risk is the additional risk placed on the common
stockholders as a result of using debt.

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• Income
Another factor to consider is the impact of the method of financing on the
common shareholders' earning per share (EPS) and return on equity (ROE). For
example, if the earnings before income tax (EBIT) is low from EPS point of view,
equity financing is preferable to debt financing. If the EBIT is high from EPS point
of view, debt financing is preferable to equity. If the return on assets (ROA) is
less than the return on the cost of debt, financial leverage depresses ROE. When
the ROA is more than the cost of debt, financial leverage enhances ROE.
• Cost of Capital
Cost of different components of capital will influence the capital structure
decisions. A firm should possess easing power to generate revenues not only to
meet its cost of capital but also to finance its future growth. Generally, the cost of
equity is higher than the cost of debt since the debtors are assured of fixed rate
of return and repayment of principal amount and the maturity date. Firms that
adjust their capital structure in order to keep the riskiness of their debt and equity
reasonable should have a lower cost of capital.
• Financial Leverage
Capital structure decisions should always aim and having debt component in
total component in order to increase the earnings available for equity
shareholders. Generally, the cost of debt (net of tax) is lower than the cost of
equity. Any excess over cost of debt will redound to benefit the equity
stockholders. Trading on equity or leverage is the use of debt at low cost with a
view of enhancing the earnings of the equity shareholder.
Flexibility
Debt capital is considered to have better flexibility than equity capital. When
funds are required, debt may be raised and programmed for repayment after a
fixed period. Pre-termination of debt can also be worked out with the creditors.
In case of equity capital, once the funds are raised through issue of equity
shares, it cannot ordinarıly be reduced except with the permission of the court
and compliance with legal requirements.
• Tax Consideration
The debt has tax advantage over equity because interest charges are deductible
from income and thereby could reduce a firm's tax liabilities.
• Timing
The time at which the capital structure decision is taken will be influenced by the
conditions of the economy. In times of expansion / recovery it would be easier for
the firm to raise equity, but in times of recession, the equity investors will not
show much interest in investing. Generally, firms have to rely on raising debt.

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• Profitability
A company with higher profitability will have low reliance on outside debt and it
will meet its additional requirement through internally generated funds.
• Marketability
The balancing of debt and equity is possible when the marketability is created for
the company's securities. The company's ability to market its securities will affect
the capital structure decisions.
• Company Size
Companies with small capital base will rely more on owner's funds and internal
earnings. But large companies have to depend on capital market and can top
finances by issue of different varieties of securities and instruments.
• Sales Stability
A firm whose sales are relatively stable can safely take on more debt and incur
higher fixed charges than a company with unstable sales. Utility companies,
because of their stable demand, have historically been able to use more financial
leverage than can industrial firms.
• Operating Leverage
Other things the same, a firm with less operating leverage is better able to
employ financial leverage because it will have less business risk.
• Growth Rate
Other things the same, faster-growing firms must rely more heavily on external
capital. Further, the flotation cost involved in selling common stock exceeds that
incurred when selling debt, which encourages rapidly growing firms to rely more
heavily on debt. At the same time, however, those firms often face higher
uncertainty, which tends to reduce their willingness to use debt.
• Management Attitudes
No one can prove that one capital structure will lead to higher stock prices than
another. Management, then, can exercise its own judgment about the proper
capital structure. Some managers tend to be relatively conservative and thus
use less debt than an average firm in the industry, whereas aggressive
managers use a relatively high percentage of debt in their quest for higher profits.

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2. BUSINESS AND FINANCIAL RISK

From the viewpoint of the corporation, there are two dimensions of risk, namely:
a.) Business risk- refers to the riskiness of the firm's assets if no debt is used; and
b.) Financial risk- refers to the additional risk placed on the ordinary equity
shareholders as a result of using debt.

2.1 BUSINESS RISK

Business risk is the single most important determinant of capital structure and it
represents the amount of risk that is inherent in the firm's operations even it uses no
debt financing. It is the equity risk that comes from the nature of the firm's
operating activities. The most commonly used measure of business risk is the
standard deviation of the firm's return on invested capital or ROIC.
ROIC is determined as follows:

ROIC = EBIT (1-T)_______

Investor Supplied Capital

ROIC measures the after tax return that the firm provides for all of its investors.
Since ROIC does not vary with changes in capital structure, the standard deviation
of ROIC measures the underlying risk of the firm considering the effects of debt
financing, thereby providing a good measure of business risk.
A firm's ROIC fluctuations could be caused by many factors - booms and recession
in the economy, successful new products introduced by the company and its
competitors, labor strikes, fire and so on. Similar events will doubtless occur in the
future and when they do, the realized ROIC will be higher or lower than expected.
Further, there is always the possibility that a long-term disaster- earthquake, flood,
fire will strike, permanently depressing a company's earning power. Or, a
competitor might introduce a new product that would make the firm's products
totally obsolete and puts the company out of business.
The more uncertainty there is about Earnings before Interest and Taxes (EBIT) and
thus ROIC, the greater the company's business risk. So, if the firm has no debt, its
shareholders would face the existing business risk plus some additional financial
risk.

Factors that Affect Business Risk

• Variability of demand for the firm's product
The more stable the demand for a firm's products, other things held constant,
the lower its business risk.

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• Competition
If a firm has a monopoly on a necessary product, it will have little risk from
competition and thus have stable sales and sales prices. However,
monopolistic firms' prices are often regulated, and they may not be able to
raise prices enough to cover rising costs. Still, other things held constant,
less competition lowers business risk.

• Variability of sales price

Firms whose products are sold in volatile markets are exposed to more
business risk than firms whose output prices are stable, other things held
constant.

• Product obsolescence
Firms in high-tech industries like pharmaceuticals and computers depend on
a constant stream of new products. The faster its products become
obsolete, the greater a firm's business risks.

• Variability of production costs

Firms whose input (materials, labor) costs are uncertain have higher
business risk.

• Foreign risk exposure

Firms that generate a high percentage of their earnings overseas are subject
to earnings declines due to exchange rate fluctuations. They are also
exposed to political risks.

• Legal exposure and regulatory risk

Firms that operate highly regulated industries such as financial services and
utilities are subject to changes in the regulatory environment which may have
a profound effect on the company's current and future probability. Other
companies face significant legal exposure that could damage the company if
they are forced to pay large settlements. For example, in the aftermath of
the massive oil spill in the Gulf of Mexico, BP is facing huge cleanup costs
and future legal costs for lost wages, damages to area tourism, and possible
legal violations. Tobacco companies and pharmaceutical companies have
also incurred huge legal costs after being sued for damages created by their
products.

• Degree of operating leverage

When a high percentage of total costs are fixed, the firm is said to have a
high degree of operating leverage, a high degree of operating leverage.
other factors held constant, implies that a relatively small change in sales
results in a large change in ROIC.

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2.2 FINANCIAL RISK

Financial risk is the additional risk placed on the ordinary equity shareholders
as a result of the decision to finance with debt. Conceptually, shareholders face
a certain amount that is inherent in the firm's operations - this is its business risk
which is the uncertainty inherent in projections of future operating income.

3. CAPITAL STRUCTURE POLICY

Capital structure policy involves a choice between risk and expected returns
associated with the firm's financing mix. In planning its capital structure, the firm's
first major decision policy is the determination of the appropriate level of debt. As
debt increases, the expected return on the firm's equity due to increased risk.
Therefore, there should be a trade-off between risk and return when making capital
structure decisions.
The capital structure that balances risk and return to maximize the value of the firm
is the "optimal capital structure".
The determination of a firm's optimal capital structure is theoretically possible but
financial managers cannot determine with precision the percentage of debt that will
maximize the market value of the firm. In practice, finance managers set a desired
or target capital structure using informed judgment and some analytical
approaches. This structure consists of a range of values over which the firm's
financial leverage varies. To the left of the range, the firm should sell debt
instruments; to the right of this range, it should sell equity instruments.

4. EBIT-EPS ANALYSIS
One commonly used analytical technique used to evaluate various capital
structures in order to select the one that maximizes a firm's earnings per share is
the EBIT - EPS analysis. This approach measures the impact of financing
alternatives on EPS at different levels of EBIT.
Another objective of EBIT - EPS analysis is to determine the EBIT EPS indifference
or breakdown points between the various financing choices. An indifference point
is the level of EBIT where EPS of a firm is the same, regardless of which alternative
capital structures are employed.
At EBIT levels above the indifference point, firms with more financially levered
capital structures will produce higher levels of EPS; at EBIT levels below the
indifference point, firms with less financially levered capital structures will produce
higher levels of EPS. The indifference point between two methods of financing can
be determined either graphically or mathematically.

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Illustrative Case. Financing Expansion Program

Lavida Equipment Company's current capital structure consists of 8% debt with a
market value and book value of P4,000.000 and 200,000 shares of outstanding
common stock with a market value of P15,000.000. The firm is considering a
P6,000,000 expansion program using one of the following financing plans.
Plan I: Sell additional debt at 10% interest
Plan II: Sell preferred shares with a 10.5% dividend yield
Plan III: Sell new ordinary equity securities at P150 per share
The corporate tax rate is 34%. Ignore flotation costs.
(a) If the expected level of EBIT after the expansion is P2,500,000, the EPS for
each financing plan is calculated as follows:

The financial break-even point is the level of EBIT at the firm’s EPS equals zero.

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On a graph, the EBIT – EPS analysis chart for the three capital structure is
presented as follows:

Figure 10. EBIT – EPS Analysis Chart for Lavida Equipment Company
Figure 10 shows that there is one indifference point between debt and ordinary
equity share and another between preferred share and ordinary equity share.
There is no indifference point between debt and preferred share because debt
dominates preferred share by the same margin throughout the EBIT and EPS.
Mathematically, the indifference point can be found by solving for EBIT.
a.) EPS (debt) = EPS (Ordinary equity share)

P000’s

Cross multiplying:
P000’s

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b.) EPS (Preferred shares) = EPS (Ordinary equity share)

Cross multiplying:
P000’s

Plan I (debt) is favored over Plan II (preferred share) at all levels of EBIT. Plan I is
favored over Plan III (ordinary equity share) when EBIT is above the indifference
point of P2,420,000.

Self-Help: You can also refer to the sources below to help you
further understand the lesson.

Cabrera, M. B. (2015). Financial management principles and applications volume 2.

Manila: GIC Enterprises & Co., Inc.

Let’s Check

Activity 1: Multiple Choice. Write the letter of your choice in the space provided
before the number.

_____1. An optimal capital structure occurs under the

a. traditional approach.
b. Modigliani and Miller approach without corporate taxes.
c. contemporary approach.
d. Both traditional and contemporary approaches.

_____2. The traditional approach to capital structure management assumes

a. no taxes.
b. all earnings are paid out as dividends.
c. EBIT is constant.
d. all of the given choices.

_____3. The Modigliani and Miller approach without corporate taxes suggests that
the firm's weighted average cost of capital
a. remains constant as the proportion of debt changes.
b. Increases as the proportion of debt increases.
c. Decreases as the proportion of debt increases.

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d. Increases as the proportion of debt decreases.

_____4. According to the Modigliani and Miller approach with corporate taxes, all of
the following occur as the use of debt financing increases except
a. cost of equity increases.
b. cost of debt decreases.
c. weighted average cost of capital increases.
d. market value of the firm increases.

_____5. Which approach asserts that the value of the firm is independent of its
capital structure?
a. Traditional approach
b. Modigliani and Miller approach without taxes
c. Modigliani and Miller approach with taxes
d. Contemporary approach

_____6. The contemporary approach to capital structure management recognizes

a. tax effects.
b. bankruptcy costs.
c. agency costs.
d. all of the given choices.

_____7. The inclusion of bankruptcy risk in firm valuation

a. partially offsets the tax advantage of debt.
b. recognizes an upper limit to debt financing.
c. has no impact on the firm's value.
d. Both partially offsets the tax advantage of debt and recognizes an
upper limit to debt financing.

_____8. EBIT - EPS analysis is used for

a. evaluating the likelihood of financial distress or bankruptcy.
b. determining the impact of a change in sales on EBIT.
c. examining EPS results of alternate financing plans at varying EBIT
levels.
d. analyzing the variability of EBIT for cash alternative financing plan.

_____9. For EBIT levels beyond the indifference point,

a. Debt EPS increases faster than equity EPS
b. equity EPS increases faster than debt EPS.
c. Both debt EPS and equity EPS Increase at the same rate.
d. Both debt EPS and equity EPS remain constant.

_____10. Everything else held constant, management may prefer debt financing if.
a. dilution of control is a concern.
b. Both interest rates and the firm's stock price are low.
c. the proportion of debt in the firm's capital structure is relatively low by
industry standards.
d. all of the given choices.

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Let’s Analyze
Activity 1. Read and answer the problems.

Problem 1

Chandee Company has expected earnings before interest and taxes (EBIT) of
P800,000 and interest costs of P80,000. The firm's equity and debt capitalization
rates are 12 percent and 8 percent, respectively. Assume no corporate income
taxes. What is the market value of the firm?

Problem 2

Ross Company is financed entirely with 400,000 shares of common stock selling at
P25 per share. The firm pays 100 percent of its earnings as dividends. EBIT is
expected to remain constant at P1,500,000 in the future. Ignore taxes and assume
no growth.

a. What is the total market value of the firm?

b. What is the cost of equity?

In a Nutshell

Based on the concepts presented, explain the lessons you learned by answering
the questions below.

1. What are the factors other than wealth considerations that may influence
capital structure decisions?
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________

2. What are the factors other than wealth considerations that may influence
capital structure decisions?
__________________________________________________________
__________________________________________________________
_________________________________________________________

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Q&A List
Do you have any question or clarification? Write them here.

Questions/Issues Answers

1.

2.

3.

4.

5.

Keywords Index
✓ Capital
✓ Capital structure
✓ Capital Structure Theory
✓ Market value of equity
✓ Business risk
✓ Financial risk

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Big Picture in Focus: ULOb. Calculate the cost of capital.

Metalanguage
For you to demonstrate ULOc, you will need operational understanding of the terms
enumerated below.
❖ Cost of debt is the minimum rate of return required by suppliers of debt.
❖ Cost of capital is the required return necessary to make a capital budgeting
project, such as building a new factory, etc.
❖ Cost of preferred stock is the rate of return required by holders of a
company's preferred stock.
❖ WACC (Weighted Average Cost of Capital) is computed by multiplying the
specific cost of each type of capital by its proportion (weight) in the firm's
capital structure and summing the weighted values.
❖ Preferred share is a class of equity shares which has preference over
ordinary (common) equity shares in the payment of dividends and in the
distribution of corporation assets in the event of liquidation.
❖ Ordinary share (traditionally known as common stock) is a form of long-term
equity that represents ownership interest of the firm.

Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the 4 th to 5th
weeks of the course, you need to fully understand the following essential
knowledge laid down in the succeeding pages. Please note that you are not limited
to exclusively refer to these resources. Thus, you are expected to utilize other
books, research articles and other resources that are available in the university’s
library e.g. ebrary, search.proquest.com etc., and even online tutorial websites.

1. SPECIFIC CAPITAL COMPONENT COSTS

A. Cost Of Debt (Kd)
The cost of debt is the minimum rate of return required by suppliers of debt.
The before-tax cost of debt is the interest rate a firm must pay on its new debt.
Firms can estimate this rate by inquiring from their bankers what it will to borrow or
by finding the yield to maturity on their currently outstanding debt. However, the
after-tax cast of debt should be used to calculate the WACC. This is the interest
rate on new debt less the tax savings that result because interest is tax deductible.

After-tax cost of debt = Interest rate (1-Tax rate)

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In effect, the government pays part of the cost of debt because interest is tax
deductible. If XYZ Corporation can borrow at an interest rate of 12% and its
marginal corporate tax rate is 35%, its after-tax cost of debt will be 7.8%.
After-tax cost of debt = 12%(1-35%)
= 7.8%
Computing the Cost of a New Bond Issue
The computation requires three steps:
1. Determine the net proceeds from the sale of each bond.

Net proceeds of a = Market - Flotation

bond sale Price costs

2. Compute the before-tax cost of the bond.

If the flotation costs are required and the bond sells at par, the before tax cost of the
bond is simply its coupon rate which is the interest rate paid on the bond's par
value. It is important to emphasize that the cost of debt is the interest rate on new
debt not on already outstanding debt because our primary concern with the cost of
capital is its use in capital budgeting decision. For instance, would a new machine
cam a return greater than the cost of capital needed to acquire the machine? The
interest rate at which the firm has borrowed in the past is irrelevant when answering
this question because we need to know the cost of new capital. For these reasons,
the yield to maturity on outstanding debt (which reflects current market condition) is
a better measure of the cost of debt than the coupon rate.
The before-tax cost of the debt issue is the rate of return that equates the present
value of the future interest payments and principal payment with the net proceeds
from the sale of the bond using the equation.

NPd = 1 (PVIFAkd,n) + Pn (PVIFkd,n)

Where:
NPd = Net proceeds from the sale of bond, Pd - f
I = Annual Interest Payment in Pesos
Pn= Par or Principal repayment required in period n
Kd = Before-tax cost of a new bond issue
n = length of the holding period of the bond in years

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t = Time period in years

PVIFA = Present value interest factor of an annuity
PVIF = Present value interest factor of a single amount
Pd - f = (Market price- Flotation costs)

The before-tax cost of a new bond issue also means cost to maturity or yield to
maturity.

3. Compute the after-tax cost of debt using the following equation:

kdt = kd (1 – T)

Where:
kdt = After-tax cost of debt
kd = Before-tax cost of debt
T = Marginal tax rate

Illustrative Case. Financing Through Issuance of Bonds

Prime Pipe Company plans to issue 25-year bonds with a face value of P4,000,000.
Each bond has a par value of P1,000 and carries a coupon rate of 9.5 percent.
However, the bond is expected to sell for 98 percent of par value. The flotation
costs are estimated to be approximately P26 per bond and the firm's marginal tax
rate is 34 percent. (Assume that interest payments are made annually.)

Required:
Management wants to calculate the
(a) net proceeds per bond,
(b) the before-tax cost of this bond issue, and
(c) the after-tax cost of the bond issue's flotation costs.

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Solution:
(a) The selling price of the bond P980 (0.98 x P1.000). The net proceeds per bond
are calculated by subtracting the P26 flotation cost from the bond's P980 selling
price.
NPd = P980 - P26 = P954

(b) Using the trial and errors approach, the before-tax cost of debt is computed as
follows:
P954 = (P95) (PVIFAi,n) + P1,000 (PVIFi,n)
Trial at 10%:
P954 = P95 (PVIFA0,10,25) + P1,000 (PVIF0,10,25)

P954 = P95 (9.077) + P1,000 (0.092)

P954 = P962.32 + P92 = P1,054.32
Based on the results, the approximate cost of debt is less than 10%. It can be
computed as follows:
95+(1,000−954)
25 96.84
k𝑑 = 1,000+954 = = 9.91%
977
2

(c) The after-tax cost of new debt is computed as follows:

kdt = 9.91 (1-.34) = 6.54%

B. Cost of Preferred Share (Kp)

Although preferred share is a part of a firm's permanent financing mix but is not
frequently issued, preferred share is a hybrid security that has characteristics of
both debt and equity. However, if the preferred shares have fixed dividend
payments and no stated maturity dates, the component cost of new preferred share
is computed as follows:

D𝑝
Kp =
NP𝑝

Where:
Dp = Annual dividend per share on preferred share.

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NPp = Net proceeds from the sale of preferred share, (Market price less
flotation costs)

The cost of existing preferred share is determined by substituting the current market
price per share of preferred in the denominator in the above equation that is, in lieu
of net proceeds from sale of preferred share.

Illustrative Case. Determination of Cost of New Preferred Share

Prime Pipe Company plans to sell preferred share for its par value of P25.00 per
share. The issue is expected to pay quarterly dividends of P0.60 per share and to
have flotation costs of 3 percent of the par value or P1.50 (0.03 x P25.00).
Substituting Dp = P2.40 (4 x P0.60), NPp = P23.50 (P25.00 – P1.50), the cost of
new preferred share is:
Solution:

P2.40
K p = P23.50= 0.1021 or 10.21%

C. Cost of Ordinary Equity Share

Ordinary equity share does not represent a contractual obligation to make specific
payments thus making it more difficult to measure its costs than the cost of bonds
or preferred share.
Business firms raise equity capital externally through the sale of new ordinary
equity shares and internally through retained earnings. Retained earnings represent
the portion of accumulated after-tax profits that the firm has not distributed to its
shareholders and therefore is reinvested in itself.
Cost of existing ordinary equity share is the same as the cost of retained earnings.
No adjustment is made for flotation costs in determining either the cost of existing
ordinary equity share or the cost of retained earnings.
The costs of new ordinary equity share and retained earnings are similar but not
equal. The cost of new ordinary equity share is higher than the cost of retained
earnings because of the flotation costs involved in selling new ordinary equity share
which reduce the net proceeds to the firm. Thus, firms will use the lower-cost
retained earnings before they issue new ordinary equity share.

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C.1 Cost of Equity

C.1.1 The CAPM Approach
The most widely used method for estimating the cost of ordinary equity is the
Capital Asset Pricing Model (CAPM).

Step 1: Estimate the risk-free rate (rRF). We generally use the 10- year
Treasury bond rate as the measure of the risk-free rate, but some
analysis use the short-term Treasury bill rate.

Step 2: Estimate the stock's beta coefficient (bi) and use it as an index of the
stock's risk. The i signifies the ith company's beta. Beta coefficient, b
is a metric that shows the extent to which a given stock's returns
move up and down with the stock market. Beta thus measures
systematic market risk of the asset relative to average.

Step 3: Estimate the expected market risk premium. Recall that the market
risk premium is the difference between the return that investors
require on an average stock and the risk-free rate.

Step 4: Substitute the preceding values in the CAPM equation to estimate

the' required rate of return on the stock in question:

rs = rRF + (RPm) bi
= rRF + (rM – rRF) bi

Thus, the CAPM estimate of r, is equal to the risk-free rate (rRF) plus a risk premium
that is equal to the risk premium on an average stock (rM – rRF), scaled up or down
to reflect the particular stock's risk as measured by its beta coefficient (b i).

Illustrative Case. Calculation of Cost of Equity Shares Using the CAPM

Approach
Assume that in today's market, rRF = 5.6%, the market risk premium is RPm = 5.0 %,
and Zeta's beta is 1.48. Using the CAPM approach, Zeta's cost of equity is
estimated to be 13.0%.

Solution: rs = 5.6% + (5.0%) (1.48) = 13.0%

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Illustrative Case. Calculation of Cost of Equity

ABC Company's ordinary equity shares sell for P32.75 per share. ABC expects to
set their next annual dividend at P1.54 per share. If ABC expects future dividends
to grow by 6% per year, indefinitely, the current-risk-free rate is 3%, the expected
return on the market is 9%, and the stock has a beta of 1.3, what should the firm's
cost of equity be?

Solution: rs = 0.3 + (.09-.03)1.3 = .1080 or 10.80%

This approach is also used to measure the cost of retained earnings.

C.1.2. Bond Yield Plus Risk Premium Approach

In situation such as closely held companies where reliable inputs for the
CAPM approach are not available, analysts often use a somewhat subjective
procedure to estimate the cost of equity.
The generalized risk premium or bond-yield-plus-risk premium required rate
of return on shareholder's equity. The equation below shows that the
required rate of return is equal to some base rate (kd) plus a risk premium
(rp). The base rate is often the rate on Treasury bonds or the rate on the
firm's own bonds. The risk premium on a firm's own stock over its own bonds
is based on a judgmental estimate but empirical studies suggest that it
ranges between 3 to 5 percentage points above the base rate. However, risk
premiums are not stable over time, hence the estimated value of k s is also
judgmental.
Ks = kd + rp
Where:
kd = Base rate of long-term bonds of bond yield
rp = Risk premium
Illustrative Case. Determination of Cost of Equity Using the Bond Yield plus
Risk Premium Approach
Prime Pipe Company's long-term bond rate is 9.5 percent. The firm's management
estimates that its cost of equity should require a 3 percentage point risk premium
above the cost of its own bonds. Using the generalized risk premium approach, the
cost of ordinary equity would be 12.5 percent. This is found by substituting k d =
0.095 and rp = 0.03.

Solution: Ks = 0.095 + 0.03 = 0.1250 or 12.50%

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C.1.3. Dividend Yield Plus Growth Rate Approach

Generally, both the price and the expected rate of return on an ordinary
equity share, depend ultimately on the share's expected cash flows. For
business firms that expect to remain in business indefinitely the cash flows
are the dividends.
The required rate of return on ordinary equity which for the marginal investor
is also equal to the expected rate of return. The equation that could be used
is as follows:

D
K𝑠 = P 𝑙 + g
𝑜

Where:
Ks = Cost or required rate of return of ordinary equity
Dl = Dividend expected to be paid at the end of year 1
Po = Current stock price
g = Expected dividend growth rate

C.1.4. Discounted Cash Flow (DCF) Approach

The method of estimating the cost of equity called the discounted cash flow
or DCF method considers not only the dividend yield (Dl / Po), but also a
capital gain (g) for a total expected return of Ks and in equilibrium this
expected return is also equal to the required rate of return.

D
K 𝑠 = P 𝑙 + expected g
𝑜

It is not difficult to calculate the dividend yield but if stock prices fluctuate, the
yield shall vary from day to day which leads to fluctuations in the DCF cost of
equity. Also, it is not easy to determine the proper growth rate. If part growth
rate in earnings and dividend have been relatively stable, and if investors
expect a continuation of past events, g may be based on the firm’s historic
rate.

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Illustrative Case. Determination of Cost of Equity Under the DCF Approach

Zeta stock sells for P23.06, its next expected dividend is P1.25, and analysts
expect its growth rate to be 8.3%. Thus, Zeta's expected and required rates of
return (hence, its cost of retained earnings) are estimated to be 13.7%.
Solution:
P1.25
K𝑠 = + 8.3%
P23.06

= 5.4% + 8.3%
= 13.7%

Based on the DCF method, 13.7% is the minimum rate of return that should be
earned on retained earnings to justify plowing earnings back into the business
rather than paying them out to shareholders as dividends. In other words, since the
investors are thought to have an opportunity to earn 13.7% if earnings are paid out
as dividends, the opportunity cost of equity from retained earnings is 13.7%.

C.1.5. Earnings-Price Ratio Method

The earnings-price ratio method is a simplistic technique used to estimate
the cost of ordinary equity, which is based on the inverse of the firm's price-
earnings ratio. The earnings-price ratio is easy to compute because it is
based on readily available information, but there is little economic logic to
support the use of the earnings-price ratio to measure the cost of ordinary
equity. For example, this technique is unsuitable for a firm that is operating at
a loss because it would generate a negative cost of ordinary equity. The
following equation shows that the earnings- price ratio is found by dividing
the current earnings per share (E) by the current market price of the firm's
ordinary equity share (Po).

E
Ks =
P𝑜

Where :
E = Current earnings per share
Po = Current market price of ordinary equity share

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Illustrative Case. Determination of Cost of Equity Using the Earnings Price

Ratio
Prime Pipe Company had earnings per share for the past year of P6.50, and the
firm's ordinary equity share is currently priced at P45.00. Using the earnings-price
ratio method, the cost of retained earnings would be 14.44%. This is found by
substituting E = P6.50 and Po = P45.00.
Solution:
P6.50
Ks = = 0.14444 𝑜𝑟 14.44%
P45.00

C.2 Cost of New Ordinary Equity Shares

The Constant Growth Model for New Ordinary Equity Shares is generally used in
measuring the cost of new ordinary equity share.
The equation is:
D
K 𝑠 = NP𝑖 + g
𝑠

Where:
Ks = Cost of new ordinary equity shares
Di = Dividends to be received during the year [Do (1+g)]
Do = Dividend Yield
g = Dividend growth rate
NPs = Net proceeds of the new ordinary equity shares, (Po - F)
Po = Current Market price of the firm's Ordinary equity shares
F = Flotation costs
The cost of new ordinary equity (Ks) is higher than the cost of retained earnings
(K^) because of the new issue must be adjusted for flotation costs. These flotation
costs include both underpricing and an underwriting fee. Underpricing occurs
when new ordinary equity share sells below the current market price of outstanding
ordinary equity share, in order to attract investors and to compensate for the dilution
of ownership that will take place. An underwriting fee covers the cost marketing the
new issue.
The Constant Growth Model assumes that dividends grow perpetually at a constant
annual rate, g. Estimates of g are usually based on historical growth rates, if
earnings and dividend growth rates have been stable in the past, or on analysts’
forecasts.

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Illustrative Case. Computation of Flotation-Adjusted Cost of Equity

Suppose that ABC Company's ordinary equity shares are selling for P32.75 per
share, and the company expects to set its next annual dividend at P1.54 per share.
All future dividends are expected to grow by 6% per year, indefinitely. In addition,
let's also suppose that ABC faces a flotation cost of 20% on new equity issues.
Calculate the flotation-adjusted cost of equity.
Solution:
Twenty percent of P32.75 will be P6.55, so the flotation-adjusted cost of equity will
be:

D𝑖
K𝑠 = P +g
𝑜 −F

P1.54
K 𝑠 = P32.75−P6.55 + .06

= .1188 or 11.88%

Illustrative Case.
Prime Pipe Company's ordinary equity share has a current market price of P45.00
and an expected dividend growth rate of 5%. The firm is expected to pay P3.60 per
share in ordinary equity share dividends during the next year. The sale of new
ordinary equity share involves underpricing of P1.00 per share and underwriting fee
of P0.80 per share. What is the cost of the new ordinary equity share?
Solution:
D
K 𝑠 = NP𝑖 + g
𝑠

P3.60
= + 0.05
P43.20

= 0.0833 + 0.05
= 0.1333 or 13.33%

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C.3 Cost of Retained Earnings

Some have argued that retained earnings should be "cost-free" because they
represent money that is "left-over" after dividends are paid. While it is true that no
direct costs are associated with retained earnings, this capital still has a cost,
an opportunity cost. The managers who work for the shareholders can either pay
out earnings in the form of dividend or retain earnings for reinvestment in the
business. When the decision is made, the manager should recognize that there is
an opportunity cost involved, that is, the shareholders could have received the
earnings as dividend and invested this money in other stocks, bonds, in real estate,
etc. Therefore the firm needs to earn at least as much as any earnings retained as
the stockholder could earn an alternative investment of comparative risk.
The cost of retained earnings is similar to the cost of existing ordinary equity share.

When Must External Equity Be Used?

Because of flotation costs, pesos raised by selling new stock must "work harder"
than pesos raised by retaining earnings. Moreover, because no flotation costs are
involved, retained earnings cost less than new shares. Therefore, firms should
utilize retained earnings to the greatest extent possible. However, if a firm has more
good investment opportunities than- can be financed with retained earnings plus the
debt and preferred share supported by those retained earnings, it may need to
issue new ordinary equity or ordinary share. The total amount of capital that can be
raised before new shares must be issued is defined as the retained earnings
breakpoints and it can be calculated as follows:

Illustrative Case. Determination of Retained Earnings Breakpoint

Zeta's addition to retained earnings in 2014 is expected to be P66 M, and its target
capital structure consists of 45% debt, 2% preferred, and 53% ordinary equity.
Therefore, its retained earnings breakpoint for 2014 is as follows:
Retained earnings breakpoint = P66M /0.53 = P124.5M
To prove that this is correct, note that a capital budget of P124.5M could be
financed as 0.45 (P124.5M) = P56M of debt, 0.02 (P124.5M) P2.5M of preferred
share, and 0.53 (P124.5M) = P66M of equity raised from retained earnings. Up to a
total of P124.5M of new capital, equity would have a cost of Ks = 13.5%. However, if
the capital budget exceeded P124.5M, Zeta would have to obtain equity by issuing
new ordinary equity share at a higher cost because of the flotation costs.

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2. PROBLEMS TO CONSIDER WITH ESTIMATES OF COST OF CAPITAL

There are a number of issues related to the cost of capital estimation that an
analyst should be aware of and choice of the applicable method would require the
use of the analyst's considerable judgment.
• Privately Owned Firms
The discussion of the cost of equity generally focused on publicly owned
firms and concentration was made on the rate of return by public
shareholders. What about the measurement of the cost of equity for a firm
whose shares are not traded? As a general rule, the same principles of cost
of capital estimation apply to both privately held and publicly owned firms,
but the problem of obtaining input data are somewhat different. Tax issues
are also especially important in these cases.

• Measurement Problems
There are practical difficulties that are encountered in estimating the cost of
equity. For example, it is quite a formidable task to obtain good import for the
CAPM, for g in the formula K, = D, / P, + g, and the risk premium in the
formula K, = Bond Yield + Risk Premium. As a result, we can never be sure
of the accuracy of our estimated cost of capital.

• Capital Structure Weights

In the previous illustrations we took as given the target capital structure. The
establishment of the target capital structure is a major task in itself.

• Cost of Capital for Projects of Differing Risk

Different projects can differ in risk and, thus in their required rates of return.
Also it is difficult to measure a project's risk hence to adjust the cost capital
for capital budgeting projects with different risks would also present some
problems.

• Although the list of problems appears formidable, the procedures presented

in this section can be used to obtain costs of capital estimates that are
sufficiently accurate for practical purpose. Also, the problems listed
previously merely indicate the desirability of refinements. The refinements
are important but the problems noted do not necessarily invalidate the
usefulness of the procedures outlined in this chapter.

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3. DETERMINATION OF WEIGHTED AVERAGE COST OF CAPITAL

Once the specific cost of capital of each long term financing source is measured,
the firm's weighted average cost of capital (WACC), Ka, can be determined.
The target proportions of debt, preferred share, and ordinary equity along with the
costs of those components are used to calculate the firm's weighted average cost of
capital.
Assuming that all new ordinary equity is raised as retained earnings, as is true for
most companies, the WACC can be computed as follows:

Note that only debt has a tax adjustment factor (I- T). As discussed in this section,
this is because interest on debt is tax deductible but preferred dividends and returns
on ordinary equity share (dividends and capital gains) are not.
A WACC can be computed for either the firm's existing financing or new financing.
The cost of capital acquired by the firm in earlier periods is not relevant for current
decision making because it represents a historical or sunk cost. Thus, only the
WACC for new financing is generally calculated.
WACC is computed by multiplying the specific cost of each type of capital by its
proportion (weight) in the firm's capital structure and summing the weighted values.
There two major schemes in computing the weighted average cost of capital,
namely.

A. Historical Weights
a). Book value weights
b) Market value weights

B. Target Weights

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A. HISTORICAL WEIGHTS
Historical weights are based on the firm's existing capital structure. Firms that
believe their existing capital structure is optimal should use historical weights. An
optimal capital structure is the combination of debt and equity that simultaneously
maximizes the firm's market value and minimizes its weighted average ernge cost
of capital. There are two types of historical weights: (a) Book value weights, and (b)
Market value weights.
a) Book value weights measure the actual proportion of each type of
permanent capital in the firm's structure based on accounting values shown
on the firm's balance sheet. This basis however may misstate the WACC
because they ignore the changing market values of bonds and equity over
time, and may not provide a useful cost of capital for evaluating current
strategies.
b) Market value weights measure the actual proportion of each type of
permanent capital in the firm's structure at current market prices. This is
considered more superior to book value weights because they provide
estimates of investors' required rates of return. However, market value
weights are less stable than book value weights in computing cost of capital
because market prices change frequently.

Illustrative Case. WACC Determination Using Historical Weights and Market

Value Weights
A. The following data are available for Copper Pipe Company.

Required: Determine the WACC if the firm obtains new capital in Book Value
Proportions

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Solution: The WACC is computed as follows:

B. In addition to the data provided in A, assume that the security market prices
of Copper Pipe Company are:

Bonds = P980 per bond

Preferred shares = P25 per share
Ordinary equity shares = P45 per share

Solution: The WACC is computed as follows:

Allocation of Ordinary Equity Share’s Market Value of P45,000,000 using the

proportion to the sum of their book value.

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B. TARGET WEIGHTS
Target weights are based on a firm's desired capital structure. Firms using target
weights establish these proportions on the basis of optimal capital structure they
wish to attain. Thus, the firm raises additional funds so as to remain constantly on
target with its optimal capital structure. The preferable approach though is to use
target weight based on market values rather than historical weights. If these
weights (market values) are used, the share price will be maximized and the cost of
capital simultaneously will be minimized.

Illustrative Case. Calculation of WACC Using Target Weights

In addition to the data provided in A and B, Copper Pipe Company has determined
that its optimal capital structure is as follows:

Bonds 40%
Preferred share 10%
Ordinary equity share 50%
100%
The firm wants to maintain its optimal capital structure increasing future long-term
capital. The firm also expects to have sufficient retained earnings so that it can use
the cost of retained earnings as the ordinary equity cost component. If Copper Pipe
Company raises new capital in target proportions, the firm's WACC can be
computed as follows:

lllustrative Comprehensive Case: Calculation of Cost of Capital Components

Suppose that Whaller Corporation has a beta of 80. The market risk premium is
6%, and the risk-free rate is 6%. Whaller's last dividend w PL.20 per share and the
dividend is expected to grow at 8% indefinitely The stock currently sells for P45 per
share.
Required:
1. Using the CAPM approach, what is Whaller's cost of equity capital or expected
return on Whaller's ordinary equity share?

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2. Using the dividend growth model, what the expected return on Whaller's ordinary
equity share?
3. What is the average cost of equity?
4. In addition to the information given in the previous problem, Whaller has a target
debt-equity ratio of 50 percent. Its cost of debt is 9 percent before taxes. If the tax
rate is 35%, what is the WACC?
5. Suppose that Whaller is seeking P30 million for a new project. The necessary
funds will have to be raised externally. Whaller's flotation costs for selling debt and
equity are 2% and 16%, respectively. If flotation costs are considered, what is the
true cost of the new project?

Solution:
1. Using CAPM approach, the expected return on Whaller's ordinary equity share is
computed as follows:
Ks = rf + bi (rm - rf)
Where:
rf = Risk-free rate of return
rm = Expected return on the market portfolio
rm - rf = Market risk premium
bi = Beta coefficient of ordinary equity share i
Ks = 6% + .80 (6%) = 10.80%
2. Using the dividend growth rate approach, the expected return on ordinary equity
is:
D
K𝑠 = 𝑖 + g
P𝑜
Where:
Di = Projected dividend per share
Po = Current price of ordinary equity share
g = Dividend growth rate

P1.20 x 1.08
K𝑠 = + .08
P45
P1.296
= + . 08
P45

= 10.88%

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3.
The average cost of = 10.8% +10.88%
ordinary equity share 2

= 10.84%
4. The target debt-equity ratio is 50%; hence, Whaller uses P.50 debt for every PI in
equity. The firm's target capital structure is therefore 13 debt and 2/3 equity.

The WACC is thus:

WACC= (10.84%) (2/3)+ [(9% (1-35%)] (1/3)
= 7.23% +1.95%
= 9.18%
5. Since Whaller uses both debt and equity to finance the operations, the weighted
average flotation costs (fA) should first be computed.
fA = (16%)(⅔) + 2%(⅓)
= 11.33%

If Walter needs P30 million after flotation costs, then the true cost in the project is:
= P 30M
1-.1133

= P 30M
. 8867

= P33.83M

Self-Help: You can also refer to the sources below to help you
further understand the lesson.

Cabrera, M. B. (2015). Financial management principles and applications volume 2.

Manila: GIC Enterprises & Co., Inc.

Bobadilla, D. (2015). Comprehensive reviewer in management advisory services.

Manila, Philippines: Lares Bookstore.

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Let’s Check

Activity 1: Multiple Choice. Write the letter of your choice in the space provided
before the number.

_____1. The cost of capital may be used

a. to help identify the discount rate to be used in evaluating capital
budgeting projects.
b. to help establish the firm's optimal capital structure.
c. to determine the firm's degree of operating leverage.
d. both to help identify the discount rate to be used in evaluating capital
budgeting projects and to help establish the firm's optimal capital
structure.

_____2. Which of the following is generally excluded in estimating the weighted

average cost of capital?
a. Short-term debt
b. Long-term debt
c. Preferred stock
d. Ordinary equity

_____3. The source of capital that has a special tax advantage to the firm is
a. preferred share.
b. ordinary equity share.
c. debt.
d. retained earnings.

_____4. Which of a firm's sources of new capital has the highest after-tax cost?
a. Preferred share
b. Debt
c. Ordinary equity share
d. Retained earnings.

_____5. Specific costs of capital may vary over time, due to changes in
a. the supply and demand for funds,
b. the risk characteristics of the firm.
c. the marketability of the securities
d. all of the given choices.

_____6. The cost of new preferred share is equal to

a. the preferred share dividend divided by the net proceeds
b. the preferred share dividend divided by the market price.
c. the preferred share dividend divided by the par value.
d. (1- tax rate) multiplied by the preferred shared dividend divided by the
net proceeds.

_____7. When the constant dividend growth model is used, the cost of retained
earnings equals
a. the current dividend plus the expected growth in sales.
b. the current market price plus expected growth rate in dividends

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c. the expected dividend yield plus the expected growth rate in

dividends.
d. the expected dividend payout plus the expected growth rate in
dividends.

_____8. Which of the following approaches can be used to estimate the cost of
ordinary equity?
a. The constant dividend growth model
b. The capital asset pricing model
c. Generalized risk premium approach
d. All of the given choices

_____9. In developing a weighted marginal cost of capital schedule, the levels at

which a specific cost of capital increases are called
a. flotation costs.
b. market value weights.
c. break points.
d. target weights.

_____10. The dividend growth model

a. is only as reliable as the estimated rate of growth.
b. can only be used if historical dividend information is available.
c. considers the risk that future dividends may vary from their estimated
values.
d. applies only when a firm is currently paying dividends.

Let’s Analyze
Activity 1. Read and answer the problems.

Problem 1

Nelson's Landscaping has 1,200 bonds outstanding that are selling for P990 each.
The company also has 2,500 shares of preferred stock at a market price of P28 a
share. The common stock is priced at P37 a share and there are 28,000 shares
outstanding. What is the weight of the common stock as it relates to the firm's
weighted average cost of capital?

a. 43.08 percent
b. 45.16 percent
c. 47.11 percent
d. 54.00 percent

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Problem 2

Phillips Equipment has 80,000 bonds outstanding that are selling at par. Bonds with
similar characteristics are yielding 6.75 percent. The company also has 750,000
shares of 7 percent preferred stock and 2.5 million shares of common stock
outstanding. The preferred stock sells for P53 a share. The common stock has a
beta of 1.34 and sells for P42 a share. The Philippine Treasury bill is yielding 2.8
percent and the return on the market is 11.2 percent. The corporate tax rate is 38
percent. What is the firm's weighted average cost of capital?

a. 10.39 percent
b. 10.64 percent
c. 11.18 percent
d. 11.30 percent

In a Nutshell

Based on the concepts presented, discuss your insights regarding the topic below.

What role does the weighted average cost of capital play when
determining a project’s cost of capital?
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________

Q&A List

Do you have any question or clarification? Write them here.

Questions/Issues Answers

1.

2.

3.

4.

5.

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Keywords index
✓ Cost of debt
✓ Cost of capital
✓ WACC (Weighted average cost of capital)
✓ Preferred share
✓ Ordinary share
✓ Bond financing
✓ Cost of preferred share

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Big Picture C
Week 5-6: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to:
a. Apply different valuation models to evaluate financial assets such as bonds
and stocks.

Big Picture in Focus: ULOa. Apply different valuation models to evaluate

financial assets such as bonds and stocks.

Metalanguage
For you to demonstrate ULOa, you will need operational understanding of the terms
enumerated below.
❖ Debt financing includes loans from friends and relatives as well as external
capital
❖ Bonds are fixed income instrument that represents a loan made by an
investor to a borrower.
❖ Preferred share is a class of equity shares which has preference over
ordinary (common) equity shares in the payment of dividends and in the
distribution of corporation assets in the event of liquidation.
❖ Ordinary share (traditionally known as common stock) is a form of long-term
equity that represents ownership interest of the firm.

Corporate Bonds
• Corporate bond is a security sold by corporation that has promised future
payments and a maturity date.
• If the firm fails to make its promised interest and principal payments, then the
bond trustee can classify the firm as insolvent and force it into bankruptcy.

Borrowing Money in the Public Financial Market

Corporations engage the services of an investment banker while raising long-term
funds in the public financial market. The investment banker performs three basic
functions:
– Underwriting: assuming risk of selling a security issued. The client is
given the money before the securities are sold to the public.
– Distributing or selling securities to ultimate investors
– Advising such as on source of capital, timing of the sale of securities

Basic Bond Features

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• The basic features of a bond include the following:

– Bond indenture
– Claims on assets and income
– Par or face value
– Coupon interest rate
– Maturity and repayment of principal
– Call provision and conversion features

VALUING CORPORATE DEBT

Valuing Corporate Debt
The value of corporate debt is equal to the present value of the contractually
promised principal and interest payments (the cash flows) discounted back to the
present using the market’s required yield to maturity on bonds of similar risk.

1. Valuing Bonds by Discounting Future Cash Flows

Step 1: Determine bondholder cash flows, which are the amount and timing of the
bond’s promised interest and principal payments to the bondholders.
Annual Interest = Par value × coupon rate
• Example: The annual interest for a 10-year bond with coupon interest rate of
7% and a par value of P1,000 is equal to P70, (.07 × P1,000 = P70). This
bond will pay P70 every year and P1,000 at the end of 10-years
Step 2: Estimate the appropriate discount rate on a bond of similar risk. Discount
rate is the return the bond will yield if it is held to maturity and all bond payments are
made.

Calculating a Bond’s Yield to Maturity (YTM)

We can think of YTM as the discount rate that makes the present value of the bond’s
promised interest and principal equal to the bond’s observed market price.

Interest year 1 Interest year 2 Interest year 3 Interest year n Principal

Bond Price = + + + + +
(1 + YTM ) 1
(1 + YTM ) 2
(1 + YTM ) 3
(1 + YTM ) n
(1 + YTM )n

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Step 3: Calculate the present value of the bond’s interest and principal payments
from Step 1 using the discount rate in step 2.

 Present Value of the   Present Value of the 

Bond    
=  Bond's Coupon Interest  +  Principal Amount (par Value) 
Value    
 Payments   of the Bond Issue 

Calculating the Yield to Maturity on a Corporate Bond

Calculate the YTM on the Ford bond where the bond price rises to $900 (holding all
other things equal).

Step 1: Picture the Problem

Years 0 1 2 3… Blank 11

Cash flow −$900 $65 $65 $65 Blank $1

Purchase price = P900

Interest payments = P65 per year for years 1-11
Final payment = P1,000 in year 11 of principal.

Step 2: Decide on a Solution Strategy

We can use equation to find YTM. YTM is the rate that makes the present value of
all future expected cash flows equal to the current market price. We can also solve
for YTM using a calculator and a spreadsheet.

Step 3: Solve
Using a Mathematical Equation

‘
Interest year 1 Interest year 2 Interest year 3 Interest year n Principal
Bond Price = + + + + +
(1 + YTM ) 1
(1 + YTM ) 2
(1 + YTM ) 3
(1 + YTM ) n
(1 + YTM )n
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• It is cumbersome to solve for YTM by hand using the equation. It is more

practical to use the financial calculator or the spread sheet.
Step 4: Analyze
The yield to maturity on the bond is 7.89%. The yield is higher than the coupon rate
of interest of 6.5%. Since the coupon rate is lower than the yield to maturity, the
bond is trading at a price below $1,000. We call this a discount bond.

2. Using Market—Yield—to—Maturity Data

Market-yield-to-maturity data are regularly reported by a number of investor services
and are often quoted in terms of credit spread, or yield spread, or spread over
Treasury bonds. Table 9-4 contains some examples yield to maturity by credit rating
– this directly provides us with the yield to maturity on bonds with different levels of
risk.
Example:
Valuing a Bond Issue
Calculate the present value of the AT&T bond if the market’s required yield to
maturity for comparable-risk bonds rises to 9% (holding all other things equal).
Step 1: Picture the Problem
i = 9%

Step 2: Decide on a Solution Strategy

• Here we know the following:

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– Annual interest payments = $85

– Principal amount or par value = $1,000
– Time = 20 years
– YTM or discount rate = 9%
• We can use the above information to determine the value of the bond by
discounting future interest and principal payment to the present.
Step 3: Solve

Step 4: Analyze.

• The value of AT&T bond falls to $954.36 when the yield to maturity rises to
9%. The bonds are now trading at a discount as the coupon rate on AT&T
bonds is lower than the market yield.

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• An investor who buys AT&T bonds at its current discounted price will earn a
promised yield to maturity of 9%.

BOND VALUATION: FOUR KEY RELATIONSHIPS

Relationship 1
• First Relationship The value of bond is inversely related to changes in the
market’s required yield to maturity.
•

Figure 9-1 Bond Value and the Market’s Required Yield to Maturity (5—Year Bond,
12% Coupon Rate)

Relationship 2
The market value of a bond will be less than the par value (discount bond) if the
market’s required yield to maturity is above the coupon interest rate and will be more
than the par valued if the market’s required yield to maturity is below the coupon
interest rate.

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Relationship 3
As the maturity date approaches, the market value of a bond approaches its par
value.
Figure 9.2 clearly demonstrates the value of a bond, whether a premium or a
discount bond, approaches
its par value as the maturity date becomes closer in time.

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Relationships 4
• Long term bonds have greater interest-rate risk than short-term bonds.
• While all bonds are affected by a change in interest rates, the prices of longer-
term bonds fluctuate more when interest rates change than do the prices of
shorter-term bonds (see Table 9.6)

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PREFERRED SHARE VALUATION

Preferred share valuation is relatively simple if the firm pays fixed dividends at the
end of each year. If this condition holds, then the stream of dividend payments can
be treated in perpetuity and be discounted by the investor's required rate of return on
a preferred share issue. A perpetuity is an annuity with an infinite life span. If the
preferred share has high risk, investors normally require a higher rate of return. This
is because creditors have priority over preferred shareholders in their claims to both
income and assets.

Thus, the intrinsic value of a share of preferred share (P.) is the sum of the present
values of future dividends discounted at the investor's required rate of return. This
also can be determined using the following valuation model.

Po=

Where:
Dp = Per share cash dividend
Kp = Investor’s required rate of return on preferred share

1. ORDINARY EQUITY SHARE (traditionally known as common stock)- is a

form of long-term equity that represents ownership interest of the firm. Ordinary

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equity shareholders are called residual owners because their claim to earnings
and assets is what remains after satisfying the prior claims of various creditors
and preferred stockholders. Ordinary (common) equity shareholders are the true
owners of the corporation and consequently bear the ultimate risks and rewards
of ownership.

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FEATURES OF ORDINARY EQUITY SHARES

1. Par value / No par value

Ordinary equity share may be sold with or without par value. Whether or not
ordinary equity share has any par value is stated in the corporation's charter. Par
value of ordinary equity share is the stated value attached to a single share at
issuance. It has little significance except for accounting and legal purposes. If
ordinary equity share is initially sold for more than its par value, the issue price in
excess of par is recorded as additional paid-in capital, capital surplus, or capital
in excess of par. A firm issuing no par share may either assign a stated value or
place it on the books at the price at which the equity share is sold.

2. Authorized, issued, and outstanding

Authorized shares are the maximum number of shares that a corporation may
issue without amending its charter. Issued shares are the number of authorized
shares that have been sold. Outstanding shares are those shares held by the
public. Both the firm's dividends per share and earnings per share are based on
the outstanding shares. The number of issued shares may be greater than the
number of outstanding shares because shares may be repurchased by the
issuing firm. Previously issued shares that are reacquired and held by the firm
are called treasury shares. Thus, outstanding share is issued share less treasury
share.

3. No maturity

Ordinary equity share has no maturity and is a permanent form of long- term
financing. Although ordinary share is neither callable nor convertible, the firm can
repurchase its shares in the secondary markets either through a brokerage firm a
tender offer. A tender offer is a formal offer to purchase shares of a corporation.

4. Voting rights

Each share of ordinary equity generally entitles the holder to vote on the selection
of directors and in other matters. Shareholders unable to attend the annual
meeting to vote may vote by proxy. A proxy is a temporary transfer of the right to
vote to another party. Proxy voting is done under the rules and regulations of the
Securities and Exchange Commissions, but proxy solicitations are the firm's
responsibility. Not all common shareholders have equal voting power. Some
firms have more than one class of share. Class A ordinary (common) equity
share typically has limited or no voting rights while Class B has full voting rights.

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There are two common systems of voting:

a) Majority Voting

Majority voting is a voting system that entitles each shareholder to cast

one vote for each share owned. Majority voting is used to indicate the
ordinary (common) equity shareholders' approval or disapproval of
most proposed managerial actions on which shareholders may vote.
The directors receiving the majority of the votes are elected. If a group
controls over 50 percent of the votes, it can elect all of the directors
and prevent minority shareholders from electing any directors.

b) Cumulative voting

Cumulative voting is a voting system that permits the shareholder to

cast multiple votes for a single director. Cumulative voting assists
minority shareholders in electing at least one director. Cumulative
voting is required in some jurisdictions for electing the board of
directors.

5. Book value per share

The accounting value of an ordinary equity share is equal to the ordinary share
equity (ordinary share plus paid-in capital plus retained earnings) divided by the
number of shares outstanding.

6. Numerous rights of stockholders

Collective and individual rights of ordinary equity shareholders include

among others:

a) Right to vote on specific issues as prescribed by the corporate charter such as

election of the board of directors, selecting the firm's independent auditors,
amending the articles of incorporation and bylaws, increasing the amount of
authorized stock, and so forth.

b) Right to receive dividends if declared by the firm's board of directors.

c) Right to share in the residual assets in the event of liquidation.

d) Right to transfer their ownership in the firm to another party.

e) Right to examine the corporate banks.

f) Right to share proportionally in the purchase of any new issuance of equity

shares. This is known as the pre-emptive right.

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COMPARATIVE FEATURES OF ORDINARY EQUITY SHARES, PREFERRED

SHARES AND DEBT

The characteristics of ordinary shares, preferred shares and bonds are compared in
the following table.

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF ORDINARY

EQUITY SHARES OVER PREFERRED SHARES AND BONDS?

The advantages of ordinary equity share stem from placing minimum constraints on
the firm and include:

1. No mandatory fixed charges

2. No definite maturity date

3. Potentially greater ease of sale

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4. Increased creditworthiness

5. Avoidance of restrictive provisions

6. From a social viewpoint

Some of the more significant disadvantages of issuing ordinary equity share are:

1. Dilution of control and earnings

2. Higher issue costs

3. Causes increase in component cost of capital

TYPES OF ORDINARY EQUITY SHARES

Although most firms have only one type of ordinary equity share, in some instances
classified share is used to meet the special needs of the company. Generally, when
special classifications of shares are used, one type is designated as Class A,
another Class B, and so on.

VALUATION OF ORDINARY EQUITY SHARES AS A SOURCE OF FUNDS

Ordinary Equity Share Valuation Models Based on Holding Periods

A. Finite-Period Dividend Valuation

This model is one in which an investor plans to purchase an ordinary equity share
and hold it for a specific length of time. For example, the holding period may be for
one or more periods. During the holding period, the investor expects to receive cash
dividends and to sell the stock for a price at the end of the holding period. The
equation to estimate the value of ordinary equity share is:

n
Po = D𝑡 P𝑛
∑ +
(1 + k 𝑠 ) (1 + k s )n
t=1

where: Dt = Per share cash dividend paid on ordinary equity in

period t

Pn = Per share price of ordinary equity in period n

Ks = Investor’s required rate of return on ordinary

equity share

Illustrative Case. Calculation of Intrinsic Value of Ordinary Equity Share Under

the Finite-Period Dividend Valuation

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An investor plans to but ordinary share of Borgara Farms and to sell it at the end of
one year. The investor expects Borgara to pay P5.20 cash dividend and to sell for
P50 at the end of the year. If the investor's required rate of return is 15 percent, the
value of the stock to this investor would be computed as follows:

This indicates that the investor should pay no more than P48 per share for a share of
Borgara’s ordinary share to realize an expected return of 15 percent.

B. Infinite-Period Dividend Valuation

This model assumes that an investor plans to purchase an ordinary share and hold it
indefinitely. Hence, returns are only in the form of dividends over multiple periods.
The following equation is an infinite-period model that shows the intrinsic value of a
share of ordinary share is equal to the expected stream of dividends discounted at
the investor's required rate of return.

∞
Po = D𝑡
∑
(1 + k s )t
t=1

The above equation can be simplified into the following valuation model:

Po =

where: Dp = Per share cash dividend paid on a perpetuity

ks = Investor’s required rate of return on ordinary equity share

∞ = Sign for infinity

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Ordinary Equity Share Valuation Models Based on Dividend Growth Rates

The valuation models to determine the value of ordinary equity shares based on
dividend growth rates include the following:

A. Zero Growth Dividend Model

A zero growth dividend model assumes dividends remain a fixed amount over time.
The formula is:

Po =

Illustrative Problem. Calculation of Share Value Using the Zero Growth

Dividend Model

XYZ Company expects to pay a P3.00 cash dividend at the end of the year
indefinitely into the future. If investors in this stock require a 15 percent return, the
value of a share of XYZ would be computed as by substituting D p = P3.00 and ks =
0.15.

B. Gordon Constant Growth Dividend Model

A Gordon constant growth dividend model assumes that dividends grow at a

constant rate each period. The formula is:

𝐷𝑙
Po =
k𝑠 − g

where: Dl = Expected dividend

ks = Investor’s required rate of return on common equity share

g = Constant dividend growth rate

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Illustrative Problem. Calculation of Share Value Using the Gordon Constant

Growth Dividend Model

RST Corporation currently pays P2.00 per share in ordinary equity share dividends.
The firm's dividends are expected to grow at a constant rate of 5 percent per year.
Investors require a 15 percent return on RST's ordinary equity share.

Dl is calculated by using Do (1+g)t where Do is the per share dividend in the current
period.

Dl (P2.00) (1 + 0.05)1 = P2.10

Substituting Dl = P2.10, ks = 0.15, and g = 0.05 in the above equation produces an

ordinary equity share value of P21.00

Po =
P2.10 = P21.00
0.15 − 0.05

C. Supernormal Growth Dividend Model

A supernormal growth dividend model assumes that dividends grow at an above

normal rate over some time period and then grow at a normal rate thereafter. This
two-stage model is more flexible than the zero or constant growth rate models and
can be adjusted to allow for any number of different expected growth rates. This
model states that the value of the firm's ordinary equity share equals the present
value of the expected dividends during the above normal growth period plus the
present value of the sale price at the end of the above normal growth period.

m
D𝑜 (1 + g 𝑠 )𝑡
Po = ∑
(1 + k 𝑠 )𝑡
t=1

where: gs = Supernormal growth rate

m = Period of supernormal growth

Illustrative Problem. Calculation of Share Value Using the Supernormal Growth

Dividend Model

QC Company expects dividends to grow at a rate of 10 percent a year for the next
five years and 6 percent a year thereafter. The firm's current dividend is P2.00 per
share. An investor, who requires a 16 percent rate of return, would compute the
value of QC's ordinary equity shares four steps.

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Step 1: Find the present value of the dividends during the above-normal growth
period.

Step 2: Find the present value of the stock price in year 5. This step involves
calculating the share value at the end of year 5.

Ps = P3.22 x . 06
10%

P3.413
=
10%
= P 34.13

Step 3: Discount the share value at the end of year 5 to the present at the 16%
required rate of return.

PV (Ps) = P34.13 (0.476)

= P16.25

Step 4: Add the present value of the 5 years dividends and the present value of the
share value in year 5 to get the value of the share at the end of the above normal
growth period.

Po = P8.56 + P16.25

= P24.81

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Self-Help: You can also refer to the sources below to help you further
understand the lesson.

Cabrera, M. B. (2015). Financial management principles and applications volume 2.

Manila: GIC Enterprises & Co., Inc.

Let’s Check

Activity 1: Multiple Choice. Write the letter of your choice in the space provided
before the number.

1. The par value of a bond

a. never equals its market value.

b. is determined by the investor.

c. generally is P1,000.

d. is never returned to the bondholder

2. The interest on corporate bonds is typically paid

a. semiannually.

b. annually.

c. quarterly.

d. monthly.

3. On any given day, a bond can be issued at

a. a discount.

b. a premium.

c. par.

d. any of the above.

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4. The yield to maturity on a bond

a. is fixed in the indenture.

b. is lower for higher-risk bonds.

c. is the required return on the bond.

d. is generally equal to the coupon interest rate.

5. The accounting value of an asset or a firm is called

a. market Value.
b. book value.
c. intrinsic value.
d. liquidating value.

6.. In an efficient marketplace, the market value of a security should equal its
a. going-concern value.
b. liquidating value.
c. book value.
d. intrinsic value.

8. In the basic valuation model, the value or price of a security is influenced by

all of the following except the
a. amount of expected future returns.
b. book value of the security.
c. Timing of expected future returns.
d. investor's required rate of return.

9. Bond payments on corporate bonds are typically made

a. monthly.
b. quarterly.
c. semiannually.
d. annually

10. If the market interest rate is below the coupon rate, a bond will sell at
a. its par value.
b. a discount.
c. a premium
d. a price of P1,000

11. Assuming that two bonds are similar except for their maturities, what is the
sensitivity of the price movements of the shorter-term bond to a given
change in the market interest rate relative to the
longer-term bond?
a. More sensitive
b. Less sensitive
c. Equally sensitive

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

d. More information is needed to determine relative sensitivity

12. The yield to maturity computation assumes that

a. all interest payments are reinvested at a rate equal to the bond's yield
to maturity.
b. bond interest is paid semiannually.
c. the coupon rate is the same as the market interest rate.
d. none of the above.

13. If the investor's required rate of return for a particular preferred share issue
increases, then the value or price of this preferred share should
a. increase.
b. decrease.
c. remain the same.
d. more information is needed.

14. The valuation of ordinary equity shares is more difficult than bonds primarily
because
a. ordinary equity share generally sells at lower prices than bonds.
b. there are fewer investors in ordinary equity shares than bonds.
c. dividend expenses are not tax deductible whereas interest is.
d. the cash flows are more uncertain for equity shares than bonds.

Let’s Analyze

Activity 1. Read and answer the problems.

1. A $1,000 par value 10-year bond with a 10% coupon rate recently sold for $900.
The yield to maturity
a. is 10%.
b. is greater than 10%.
c. is less than 10%.
d. cannot be determined.

2. The Blackburn Group has recently issued 20-year, unsecured bonds rated BB by
Moody's.These bonds yield 443 basis points above the U.S. Treasury yield of
2.76%. The yield to maturity on these bonds is
a. 4.43%.
b. 7.19%
c. 12.23%
d. mortgage bonds.

3. MI has a $1,000 par value, 30-year bond outstanding that was issued 20 years
ago at an annual coupon rate of 10%, paid semiannually. Market interest rates on
similar bonds are 7%. Calculate the bond's price.
a. $956.42
b. $1,000.00
c. $1,168.31
d. $1,213.19

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

4. What is the yield to maturity of a nine-year bond that pays a coupon rate of 20%
per year, has a $1,000 par value, and is currently priced at $1,407? Assume annual
coupon payments.
a. 21.81%
b. 6.14%
c. 12.28%
d. 11.43%

4. What is the value of a bond that matures in three years, has an annual coupon
payment of $110, and a par value of $1,000? Assume a required rate of return of
11%, and round your answer to the nearest $10.
a. $970
b. $1,330
c. $330
d. $1,000

In a Nutshell

Based on the concepts presented, write your insights about the topic below.

Define the sources of Capital for Business Firms and their importance.
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
___________________________________________________________

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Q&A List

Do you have any question or clarification? Write them here.

Questions/Issues Answers

1.

2.

3.

4.

5.

Keywords Index
✓ Bonds
✓ Preferred share
✓ Ordinary share
✓ Yield to maturity

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Course Schedules

Activities Date Where to Submit

Big Picture (Week 1-3) ULOa: Let’s Check June 2, 2021 CF email/Quipper
Activity
Big Picture (Week 1-3) ULOa: Let’s Analyze June 2, 2021 CF email/Quipper
Activity
Big Picture (Week 1-3) ULOa: In a Nutshell June 2, 2021 CF email/Quipper
Activity
Big Picture (Week 1-3) ULOb: Let’s Check June 7, 2021 CF email/Quipper
Activity
Big Picture (Week 1-3) ULOb: Let’s Analyze June 7, 2021 CF email/Quipper
Activity
Big Picture (Week 1-3) ULOb: In a Nutshell June 7, 2021 CF email/Quipper
Activity
Big Picture (Week 1-3) ULOc: Let’s Check June 10, 2021 CF email/Quipper
Activity
Big Picture (Week 1-3) ULOc: Let’s Analyze June 10, 2021 CF email/Quipper
Activity
Big Picture (Week 1-3) ULOc: In a Nutshell June 10, 2021 CF email/Quipper
Activity
PRELIM EXAM June 11, 2021 Quipper
Big Picture (Week 4-5) ULOa: Let’s Check June 16, 2021 CF email/Schoology
Activities
Big Picture (Week 4-5) ULOa: Let’s Analyze June 16, 2021 CF email/Quipper
Activity
Big Picture (Week 4-5) ULOa: In a Nutshell June 16, 2021 CF email/Quipper
Activities
Big Picture (Week 4-5) ULOb: Let’s Check June 23, 2021 CF email/Quipper
Activity
Big Picture (Week 4-5) ULOb: Let’s Analyze June 23, 2021 CF email/Quipper
Activity
Big Picture (Week 4-5) ULOb: In a Nutshell June 23, 2021 CF email/Quipper
Activities
MID TERM EXAM June 25, 2021 Quipper
Big Picture (Week 6-7) ULOa: Let’s Check June 28, 2021 CF email/Quipper
Activity
Big Picture (Week 6-7) ULOa: Let’s Analyze July 5, 2021 CF email/Quipper
Activities
Big Picture (Week 6-7) ULOa: In a Nutshell July 7, 2021 CF email/Quipper
Activities
FINALS July 9, 2021 Quipper

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Online Code of Conduct

1) All teachers/Course Facilitators and students are expected to abide by an honor

code of conduct, and thus everyone and all are exhorted to exercise self-
management and self-regulation.

2) Faculty members are guided by utmost professional conduct as learning facilitators

in holding OBD and DED conduct. Any breach and violation shall be dealt with
properly under existing guidelines, specifically on social media conduct (OPM
21.15) and personnel discipline (OPM 21.11).

3) All students are likewise guided by professional conduct as learners in attending

OBD or DED courses. Any breach and violation shall be dealt with properly under
existing guidelines, specifically in Section 7 (Student Discipline) in the Student
Handbook.

4) Professional conduct refers to the embodiment and exercise of the University’s

Core Values, specifically in the adherence to intellectual honesty and integrity;
academic excellence by giving due diligence in virtual class participation in all
lectures and activities, as well as fidelity in doing and submitting performance tasks
and assignments; personal discipline in complying with all deadlines; and
observance of data privacy.

5) Plagiarism is a serious intellectual crime and shall be dealt with accordingly. The
University shall institute monitoring mechanisms online to detect and penalize
plagiarism.

6) All borrowed materials uploaded by the teachers/Course Facilitators shall be

properly acknowledged and cited; the teachers/Course Facilitators shall be
professionally and personally responsible for all the materials uploaded in the
online classes or published in SIM/SDL manuals.

7) Teachers/Course Facilitators shall devote time to handle OBD or DED courses and
shall honestly exercise due assessment of student performance.

8) Teachers/Course Facilitators shall never engage in quarrels with students online.

While contentions intellectual discussions are allowed, the teachers/Course
Facilitators shall take the higher ground in facilitating and moderating these
discussions. Foul, lewd, vulgar and discriminatory languages are absolutely
prohibited.

9) Students shall independently and honestly take examinations and do assignments,

unless collaboration is clearly required or permitted. Students shall not resort to

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

dishonesty to improve the result of their assessments (e.g. examinations,

assignments).

10) Students shall not allow anyone else to access their personal LMS account.
Students shall not post or share their answers, assignment or examinations to
others to further academic fraudulence online.

11) By handling OBD or DED courses, teachers/Course Facilitators agree and abide by
all the provisions of the Online Code of Conduct, as well as all the requirements
and protocols in handling online courses.

12) By enrolling in OBD or DED courses, students agree and abide by all the
provisions of the Online Code of Conduct, as well as all the requirements and
protocols in handling online courses.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Monitoring of OBD and DED

(1) The Deans, Asst. Deans, Discipline Chairs and Program Heads shall be responsible
in monitoring the conduct of their respective OBD classes through the Blackboard
LMS. The LMS monitoring protocols shall be followed, i.e. monitoring of the conduct
of Teacher Activities (Views and Posts) with generated utilization graphs and data.
Individual faculty PDF utilization reports shall be generated and consolidated by
program and by college.

(2) The Academic Affairs and Academic Planning & Services shall monitor the conduct
of LMS sessions. The Academic Vice Presidents and the Deans shall collaborate to
conduct virtual CETA by randomly joining LMS classes to check and review online
the status and interaction of the faculty and the students.

(3) For DED, the Deans and Program Heads shall come up with monitoring instruments,
taking into consideration how the programs go about the conduct of DED classes.
Consolidated reports shall be submitted to Academic Affairs for endorsement to the
Chief Operating Officer.

Course prepared by:

JOE MARI N. FLORES, CPA, MSA

Name of Course Facilitator/Faculty

ARGEM JAY M. PORIO, CPA

Name of Course Facilitator/Faculty

Course reviewed by:

MARY CRIS L. LUZADA, CPA, MSA

Assistant Dean

Approved by:

GINA FE G. ISRAEL, EdD

Name of Dean

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

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