MODULE 1

INTRODUCTION TO FINANCIAL MANAGEMENT

Basic Areas of Finance

1. Investments - The second area of business finance is investments or the investment

decision, which also involves the financial markets and financial institutions. This type of
marketplace and company, respectively, makes easy transfer of money possible when
investments are made.

Here are some examples of investments that a small business may make.
 Stocks - Businesses can invest in the stocks, or equity securities, of other
businesses. The return may include dividends and capital gains.
 Bonds - Businesses can invest in the bonds, or debt securities, issued by other
companies. The return will include the return of the principal at maturity and
interest payments.
 Marketable Securities - These are short-term, liquid investments, usually made at
a bank or other financial institution, that have a maturity of one year or less.
 Commodities - Commodities are products with relatively volatile price swings,
like pork bellies or coffee. Their prices rise and fall rapidly.
 Derivatives - Derivatives are products from adjacent markets. The trade is
conducted in the form of a contract between two parties, and the value of the
derivative is based on the value of the original investment.

2. Financial institutions - A financial institution (FI) is a company engaged in the business

of dealing with financial and monetary transactions such as deposits, loans, investments,
and currency exchange. Financial institutions encompass a broad range of business
operations within the financial services sector including banks, trust companies,
insurance companies, brokerage firms, and investment dealers.

Types of Financial Institutions

 Commercial Banks - A commercial bank is a type of financial institution that

accepts deposits, offers checking account services, makes business, personal, and
mortgage loans, and offers basic financial products like certificates of deposit
(CDs) and savings accounts to individuals and small businesses.

 Investment Banks - Investment banks specialize in providing services designed to

facilitate business operations, such as capital expenditure financing and equity
offerings, including initial public offerings (IPOs).

 Insurance Companies - Among the most familiar non-bank financial institutions

are insurance companies. Providing insurance, whether for individuals or
corporations, is one of the oldest financial services.
  Brokerage Firms - Investment companies and brokerages, such as mutual fund and
exchange-traded fund (ETF) provider Fidelity Investments, specialize in providing
investment services that include wealth management and financial advisory
services. They also provide access to investment products that may range from
stocks and bonds all the way to lesser-known alternative investments, such as
hedge funds and private equity investments.

3. International finance - International finance, sometimes known as international

macroeconomics, is the study of monetary interactions between two or more countries,
focusing on areas such as foreign direct investment and currency exchange rates.
International finance deals with the economic interactions between multiple countries,
rather than narrowly focusing on individual markets.

4. Corporate finance - Corporate finance is a broad description of the planning,

management, and control of a company's money. Corporate finance includes working
capital management, financial statement analysis, cash budgeting, capital budgeting, and
more. In a small business, the owner/manager conducts the daily financial operations of
the company. In larger businesses, daily finance decisions may be made by the
owner/manager, along with a finance committee. Larger financial transactions may need
to be approved by the Board of Directors of the firm.
Corporate finance includes the management of the following areas of the finance
function:
o Working Capital Management
o Cash Budgeting
o Financial Analysis
o Financial Statement Development
o Capital Budgeting
o Dividend Policy

Why Study Finance?

1. Marketing
a. Financial Management Provides Funds for the Right Campaign at the Right Time
- By keeping a check on various marketing spends, a financial manager can save
funds on marketing investments that matter.
b. Financial Management Helps Keep Marketers on a Budget - Financial managers
can help forecast the marketing spends and plan for various marketing elements.
They also help the marketing team in compliance of the best practices in
accounting.
c. Financial Management Adds Financial Acumen to Creativity - Financial
management enables marketing and advertising function to stay on track, manage
the financial aspects of business accurately and avoid any financial blunders that
may cost the company.

2. Management
 a. Financial implications in business plans – Management need to know the
financial needs for business planning.
b. Management roles should be aware of their effect is profitability – The financial
implications or costs of business plans affects the profitability of the entity.

3. Accounting
a. Implications of many of the newer types of financial contracts on financial
statements.
b. Understand what is valuable and how accounting knowledge is used.

4. YOU
a. Personal finance
b. Everyday Financial decisions

Financial Manager

Financial managers try to answer some or all the corporate finance questions. The top
financial manager within a firm is usually the Chief Financial Officer (CFO). The treasurer
oversees cash management, credit management, capital expenditures, and financial planning.
And the controller oversees taxes, cost accounting, financial accounting, and data processing.

Financial Management Decisions

 Capital budgeting– What long-term investments or projects should the business take
on?
 Capital structure – How should we pay for our assets?
– Should we use debt or equity?
 Working capital management– How do we manage the day-to-day finances of the
firm?

Forms of Business Organization

1. Sole proprietorship - Most small businesses start out as sole proprietorships. These
businesses are owned by one person, usually, the individual who has day-to-day
responsibility for running the business. Sole proprietors can be independent
contractors, freelancers, or home-based businesses.
o Sole proprietorship advantages

 Owner receives all the profits.

 Profits are taxed only once.
 Owner makes all decisions and is in complete control of the company
(could also be a disadvantage)
 Easiest and least expensive form of ownership to organize.

o Sole proprietorship disadvantages

  Unlimited liability if anything happens in the business. Your personal
assets are at risk.
 Limited in raising funds and may have to acquire consumer loans.
 No separate legal status

2. Partnerships - In a Partnership, two or more people share ownership of a single

business. Like proprietorships, the law does not distinguish between the business and
its owners. The partners should have a legal agreement that sets forth how decisions
will be made, profits will be shared, disputes will be resolved, how future partners
will be admitted to the partnership, how partners can be bought out or what steps will
be taken to dissolve the partnership when needed.
o Partnership advantages
 Easy to establish (with the exception of developing a partnership
agreement)
 Separate legal status to give liability protection.
 Profits taxed only once.
 Partners may have complementary skills.
o Partnership disadvantages
 Partners are jointly and individually liable for the actions of the other
partners.
 Profits must be shared with the partners.
 Divided decision making
 Business can suffer if the detailed partnership agreement is not in
place.

3. Corporations - A corporation is considered by law to be a unique entity, separate from

those who own it. A corporation can be taxed, sued, and enter into contractual
agreements. The corporation has a life of its own and does not dissolve when
ownership changes.

Three types of Corporation

1. C-corporation - A C-corporation is a corporation that is taxed separately from its
owners. It gives the owners limited liability encouraging more risk-taking and
potential investment.

C-corporation advantages
o Limited liability
o Transfer of ownership, shareholders can sell their shares.
o Capital is easier to raise through the sale of stock.
o Company paid fringe benefits.
o Tax benefits

C-corporation disadvantages
o Double taxation (corporation and shareholder earnings taxed)
o Can be costly to form.
 o More administrative duties - required by law to have annual meetings, notify
stockholders of the meeting, must keep minutes of meetings, and turn in.
o Pay corporate taxes at a different time than other forms of business.

2. S-Corporation - An s corporation also known as subchapter S-corporation offers

limited liability to the owners. S-corporations do not pay income taxes rather the
earnings and profits are treated as distributions. The shareholders must report their
income on their individual income tax returns.

S-Corporation advantages
o Limited liability
o Avoids double taxation.
o Profits taxed only once.
o Capital is easier to raise through the sale of stock.
o Transfer of ownership.

S-Corporation disadvantages
o Can be costly to form.
o Stockholders limited to individuals, estates, or trustees.
o Required administrative duties.
o Cannot provide company paid fringe benefits.
o Stockholders are limited to citizens or resident aliens of the United States.

3. Limited Liability Company - A limited liability company or LLC is a hybrid

business structure that provides the limited legal liability of a corporation and the
operational flexibility of a partnership or sole proprietorship. However, the
formation is more complex and formal than that of a general partnership.

Forming an LLC requires the business owner to file legal paperwork. You may
want to consult an attorney to assist you with the process. Here is a list of service
providers in Missouri that provide legal assistance.

Limited liability company advantages

o Most common business structure and specifically created for small businesses.
o Must have insurance in case of a suit.
o Separate legal entity.
o Usually taxed as a sole proprietorship.
o Unlimited number of owners.

Limited liability company disadvantages

o Can be costly to form.
o Yearly administrative costs.
o Personal tax liability.
o Legal and accounting assistance is recommended.

Goal of Business Finance/Corporate Finance

For any business, it is important that the finance it procures is invested in a manner that the
returns from the investment are higher than the cost of finance. In a nutshell, financial
management –

 Endeavors to reduce the cost of finance.

 Ensures sufficient availability of funds.
 Deals with the planning, organizing, and controlling of financial activities like the
procurement and utilization of funds.

What Is Agency Theory?

Agency theory is a principle that is used to explain and resolve issues in the relationship
between business principals and their agents. Most commonly, that relationship is the one
between shareholders, as principals, and company executives, as agents.

An agency, in broad terms, is any relationship between two parties in which one, the agent,
represents the other, the principal, in day-to-day transactions. The principal or principals
have hired the agent to perform a service on their behalf.

Principals delegate decision-making authority to agents. Because many decisions that affect
the principal financially are made by the agent, differences of opinion, and even differences
in priorities and interests, can arise. Agency theory assumes that the interests of a principal
and an agent are not always in alignment. This is sometimes referred to as the principal-agent
problem.

An agent is using the resources of a principal. The principal has entrusted money but has
little or no day-to-day input. The agent is the decision-maker but is incurring little or no risk
because any losses will be borne by the principal.

Financial Markets
1. Primary Markets - The primary market is where securities are created. It is in this
market that firms sell (float) new stocks and bonds to the public for the first time. An
initial public offering, or IPO, is an example of a primary market. These trades provide
an opportunity for investors to buy securities from the bank that did the initial
underwriting for a particular stock. An IPO occurs when a private company issues stock
to the public for the first time.

2. Secondary Markets - For buying equities, the secondary market is commonly referred
to as the "stock market."

o Auction Markets - In the auction market, all individuals and institutions that want to
trade securities congregate in one area and announce the prices at which they are
willing to buy and sell. These are referred to as bid and ask prices. The idea is that an
efficient market should prevail by bringing together all parties and having them
publicly declare their prices.
o Dealer Markets - In contrast, a dealer market does not require parties to converge in a
central location. Rather, participants in the market are joined through electronic
networks. The dealers hold an inventory of security, then stand ready to buy or sell
with market participants. These dealers earn profits through the spread between the
prices at which they buy and sell securities.

o Over-the-counter Market - Nowadays, the term "over-the-counter" generally refers to

stocks that are not trading on a stock exchange.
MODULE 2

SOME LESSONS FROM CAPITAL MARKET HISTORY

Understanding Risk-Return Tradeoff

 The risk-return tradeoff is an investment principle that indicates that the higher the risk,
the higher the potential reward.
 To calculate an appropriate risk-return tradeoff, investors must consider many factors,
including overall risk tolerance, the potential to replace lost funds and more.
 Investors consider the risk-return tradeoff on individual investments and across portfolios
when making investment decisions.

Definition of Terms
 Total dollar return - on a nondollar investment, which includes the sum of any
dividend/interest income, capital gains or losses, and currency gains or losses on the
investment.
 Dividend yield - expressed as a percentage, is a financial ratio (dividend/price) that
shows how much a company pays out in dividends each year relative to its stock price.
The reciprocal of the dividend yield is the price/dividend ratio.
 Capital gains yield - is the percentage price appreciation on an investment. It is
calculated as the increase in the price of an investment, divided by its original acquisition
cost.

Financial Investments
 Stocks
 Bonds
 Treasury Bills

There is a REWARD for bearing RISK

Variability of Returns
 Frequency distribution - Number of instances in which a variable takes each of its
possible values.
 Variance - Average squared difference between the actual return and the average return.
The bigger the variance, the more actual returns differ from average returns.
 Standard deviation - The positive square root of the variance. A way to understand
more the variance.
 Normal distribution (bell curve) - Symmetric, bell-shaped frequency distribution that is
completely defined by its average and standard deviation.

The greater the potential REWARD, the greater is the RISK

 Average Returns
1. Geometric Average Return - Average compound return earned per year over a
multiyear period. It is a more useful for long-term periods. What was your
average compound return per year over a particular period?
 2. Arithmetic Average Return - Return earned in an average year over a particular
period. It is a more useful for short-term periods. What was your return in an
average year over a particular period?

 Capital Market Efficiency

 Efficient Capital Market - Market in which security prices reflect available
information.
 Efficient Market Hypothesis - Hypothesis that actual capital markets are efficient.

Types of Market Efficiency

1. Efficient market reaction - price instantaneously adjusts to and fully reflects
new information; there is no tendency for subsequent increases and decreases.
2. Delayed reaction - price partially adjusts to the new information; eight days
elapse before the price completely reflects the new information.
3. Overreaction and correction - price over-adjusts to the new information; it
overshoots the new price and subsequently correct.

Forms of Market Efficiency

1. Strong Form Efficiency - All information of every kind is reflected in stock
prices
2. Semi-strong Form Efficiency - All public information is reflected in the stock
price.
3. Weak Form Efficiency - The current price of a stock reflects its own past prices

Efficient Market Hypothesis Misconceptions

 EMH does not mean that you can’t make money
 On average, you will earn a return appropriate for the risk undertaken
 There is no bias in prices that can be exploited to earn excess returns
 Market efficiency will not protect you from wrong choices if you do not diversify.

Capital Market History

 Prices do appear to respond very rapidly to new information, and the response is
at least not grossly different from what we would expect in an efficient market
 The future of market prices, particularly in the short run, is very difficult to
predict based on publicly available information.
 If mispriced stocks do exist, then there is no obvious means of identifying them.
Chapter 10 Lessons from capital market history
The chapter tells us what to expect when we invest in stocks and bonds, How to
determine the required return on an investment. The required return depends on the
risk of the investment, the greater the risk, the greater is the required return. What
return should we expect from financial assets and what are the risks from such
investments?
Returns-
Dollar return- this return has two components: First is receiving cash directly while
holding the investment which is called the income component of the return.(Dividend
income) Second, is the change in the fair value of the asset which maybe a capital gain
or capital loss on such investment.
Example 1: A the investor, acquired 100 shares of stock at a price of $37 per share.
Total cost is $3,700. ( 100 x $37) . Over the year, the stock pays a dividend of $1.85 per
share. By the end of the year, the investor shall receive $185 dividend income. Also, the
value of the stock rises to $40.33 at the end of the year. Value of the investment ( 100 x
$40.33) is $4,033., Then the capital gain is equal to 333 (4,033-3,700). But if the price
drop to $34.78, here will be capital loss of $222( 3,478-3,700).
Total dollar return = 185 + 333 =$518
And if the stock is sold at the end of the year, total cash flows will be
$3,700 + 518 = $4,218
Percentage returns
How much do we get for each dollar we invest ?
Example 2 : Price of the stock at the beginning of the yar was $37 per share and the
dividend per share was $1.85. At the end of the year, the stock price rises to
$40.33/share.
Dividend yield = 1.85/37= .05 or 5%
Capital gains yield = ( 40.33-37)/37
= .09 or 9%
Total Percentage returns = 5% + 9% = 14%
Or based on example 1, wherein the total return is 518, we divide 518/3,700 =14%
Example 3 You buy some stock for $25 per share. At the end of the year, the price is
$35 per share. During the year, you get $2 dividend per share.
What is the dividend yield ?
Dividend yield = 2/25 =.08 or 8%
What is the capital gains yield ?
Capital gains yield =(35-25)/25=.4 or 40%
What is the total percentage return ?
8% + 40% = 48%
If the total investment was $1,000, how much do you have at the end of the year?
1,000 x 1.48 =$1,480
Average returns and the Variability of returns ( Measure of the volatility of returns)
The variance and its square root, the standard deviation are the most commonly used
measures of volatility.
The variance essentially measures the average squared difference between the actual
returns and the average return. The bigger the difference is, the more the actual returns
tend to differ from the average return. Also, the larger the variance or standard
deviation is, the more spread out the returns will be.
Illustration :
A particular investment has returns of 10 percent, 12 percent, 3 percent, and a -9
percent over the last four years.
Average returns = (.10 +.12+.03-.09)/4 =4%
Table :
Year Actual return Average return Deviation Squared Deviation
1 .1 .04 .06 .0036
2 .12 .04 .08 .0064
3 .03 .04 -.01 .0001
4 -.09 .04 -.13 .0169
Total .16 .00 .0270
Variance = .0270(sum of the squared deviation)
4- 1 (number of returns less 1)
= ,009

Standard deviation =√0.009

=.09487 or 9.487%
Another illustration :
Given the following data for Supertech Company :
Calculate the average returns, the variance and the standard deviation.
Year Actual Return Ave return Deviation Squared deviation
1 -.2 .175 -.375 .140625
2 .50 .175 .325 .105625
3 .30 .175 .125 .015625
4 .10 .175 -.075 .005625
Total ,70 .000 .267500
Variance =.2675/4-1 = .0892
Standard deviation = .2986

1. Using the following returns, calculate the average returns, the variances, and the
standard deviations for X and Y.
YEAR RETURNS
X Y
1 16% 36%
2 (17%) ( 8%)
3 13% 21%
4 15% (15%)
5 24% 39%

The average return is the sum of the returns, divided by the number of returns. The average return for
each stock was:

N 
X =  xi  N =
.16 − .17 + .13 + .15 + .24 = .1020, or 10.20%
 i =1  5

N  .36 − .08 + .21 − .15 + .39 = .1460, or14.60%


Y =  yi  N =
 i =1  5
we calculate the variance of each stock as:

 N

 X 2 =  (xi − x )2  (N − 1)
 i =1 
X2 =
1
5 −1
 
(.16 − .102 )2 + (− .17 − .102 )2 + (.13 − .102 )2 + (.15 − .102 )2 + (.24 − .102 )2 = .02487
Y 2 =
1
5 −1
 
(.36 − .146 )2 + (− .08 − .146 )2 + (.21 − .146 )2 + (− .15 − .146 )2 + (.39 − .146 )2 = .06203

The standard deviation is the square root of the variance, so the standard deviation of each stock is:

X = .024871/2
X = .1577, or 15.77%

Y = .062031/2
Y = .2491, or 24.91%

2. You’ve observed the following returns on Barnett Corporation’s stock over the past
five years: (12) percent; 23 percent, 18 percent, 7 percent and 13 percent.
a. What was the arithmetic average return on the stock over this five-year period.
b. What was the variance of the returns over this period? The standard deviation?

a. To find the average return, we sum all the returns and divide by the number of
returns, so:

Arithmetic average return = (–.12 + .23 + .18 + .07 + .13) / 5

Arithmetic average return = .0980, or 9.80%

b. Using the equation to calculate variance, we find:

Variance = 1/4[(–.12 – .098)2 + (.23 – .098)2 + (.18 – .098)2 + (.07 – .098)2 +

(.13 – .098)2]
Variance =.01837

So, the standard deviation is:

Standard deviation = .018371/2

Standard deviation = .1355, or 13.55%

3. A stock has had returns of (23) percent, 9 percent, 37 percent, (8) percent , 28
percent and 19 percent over the last six years. What are the arithmetic average
returns for the stock? Variance? Standard deviation?
The arithmetic average return is the sum of the known returns divided by the number
of returns, so:

Arithmetic average return = (–.23 + .09 + .37 –.08 + .28 +.19) / 6

Arithmetic average return = .1033, or 10.33%
1. Suppose a stock had an initial price of P72 per share, paid a dividend of P1.65 per
share during the year, and had an ending share price of P85. Compute the
percentage total return. What was the dividend yield? The capital gains yield?

The return of any asset is the increase in price, plus any dividends or cash flows, all divided
by the initial price. The return of this stock is:

R = [(85 – 72) + 1.65] / 72

R = .2035, or 20.35%

The dividend yield is the dividend divided by price at the initial period price, so:

Dividend yield = 1.65 / 72

Dividend yield = .0229, or 2.29%

And the capital gains yield is the increase in price divided by the initial price, so:

Capital gains yield = (85 – 72) / $72

Capital gains yield = .1806, or 18.06%

2. Rework Problem 1 assuming the ending share price is P62.

Using the equation for total return, we find:

R = [(62 – 72) + 1.65] /72

R = –.1160, or –11.60%

And the dividend yield and capital gains yield are:

Dividend yield = 1.65 / 72

Dividend yield = .0229, or 2.29%

Capital gains yield = ($62 – 72) / $72

Capital gains yield = –.1389, or –13.89%
3. You purchased 250 shares of a particular stock at the beginning of the year at a
price of P87.25. The stock paid a dividend of P1.15 per share, and the stock price at
the end of the year was P94.86. What was the peso return on this investment?

To calculate the peso return, we multiply the number of shares owned by the
change in price per share and the dividend per share received. The total return is:

return = 250(P94.86 – 87.25 + 1.15)

Peso return = 2,190

4. Suppose you bought a bond with an annual coupon rate of 6.5 percent one year ago
for P1,032. The bond sells for P1,020 today.
a. Assuming a P1,000 face value, what was your total peso return on this
investment over the past year?
b. What was your total nominal rate of return on this investment over the past year?
c. If the inflation rate last year was 3 percent, what was your total real rate of return
on this investment?
The total return is the change in price plus the coupon payment, so:

Total peso return = P1,020 – 1,032 + 65

a. Total return = 53

b. The nominal percentage return of the bond is:

R = [(1,020 – 1,032) + 65] / 1,032

R = .0514, or 5.14%

c.Using the Fisher equation, the real return was:

(1 + R) = (1 + r)(1 + h)
 r = (1.0514 / 1.03) – 1
r = .02077, or 2.08%
or 1.0514= (1 + r) ( 1.03)
1.0514= 1.03 + 1.03r
.0214 = 1.03r
R = .02077, or 2.08%
Note : The Fisher equation shows the relationship between nominal interest rates, real
interest rates, and inflation. The formula is
(1+R) = (1+ r) (1 +h) or
R =r +h + (rxh)
Where R =Nominal rate. r= real rate, h= inflation rate

5. Using the following returns, calculate the average returns, the variances, and the
standard deviations for X and Y.
YEAR RETURNS
X Y
1 16% 36%
2 (17%) ( 8%)
3 13% 21%
4 15% (15%)
5 24% 39%

The average return is the sum of the returns, divided by the number of returns. The average return for
each stock was:

N 
X =  xi  N =
.16 − .17 + .13 + .15 + .24 = .1020, or 10.20%
 i =1  5

N  .36 − .08 + .21 − .15 + .39 = .1460, or14.60%


Y =  yi  N =
 i =1  5

we calculate the variance of each stock as:

  N

 X 2 =  (xi − x )2  (N − 1)
 i =1 
X2 =
1
5 −1
 
(.16 − .102 )2 + (− .17 − .102 )2 + (.13 − .102 )2 + (.15 − .102 )2 + (.24 − .102 )2 = .02487
Y 2 =
1
5 −1
 
(.36 − .146 )2 + (− .08 − .146 )2 + (.21 − .146 )2 + (− .15 − .146 )2 + (.39 − .146 )2 = .06203

The standard deviation is the square root of the variance, so the standard deviation of each stock is:

X = .024871/2
X = .1577, or 15.77%

Y = .062031/2
Y = .2491, or 24.91%

6. You’ve observed the following returns on Barnett Corporation’s stock over the past
five years: (12) percent; 23 percent, 18 percent, 7 percent and 13 percent.
a. What was the arithmetic average return on the stock over this five-year period.
b. What was the variance of the returns over this period? The standard deviation?

a. To find the average return, we sum all the returns and divide by the number of
returns, so:

Arithmetic average return = (–.12 + .23 + .18 + .07 + .13) / 5

Arithmetic average return = .0980, or 9.80%

b. Using the equation to calculate variance, we find:

2 2 2 2 2
Variance = 1/4[(–.12 – .098) + (.23 – .098)+ (.18 – .098) + (.07 – .098) + (.13 – .098)]
Variance =.01837

So, the standard deviation is:

1/2
Standard deviation = .01837
Standard deviation = .1355, or 13.55%
7. For problem 6, suppose the average inflation rate over this period was 3.2 percent,
and the average T-bill rate over the period was 4.3 percent.
a. What was the average real return on the stock?
b. What was the average nominal risk premium on the stock?

a. To calculate the average real return, we can use the average return
of the asset, and the average inflation rate in the Fisher equation. Doing so,
we find:

(1 + R) = (1 + r)(1 + h) or r = ( 1+ R)/(1 + h) – (1)

= (1.0980 / 1.032) – 1
= .0640, or 6.40%
Or :
1.0980= (1 + r) (1 +.032)
1.0980 = (1 + r) (1.032)
1.0980 = 1.032 + 1.032r
1.032r = .066
r =.0639 . or 6.4%

b. The average risk premium is simply the average return of the asset, minus
the average risk-free rate, so, the average risk premium for this asset would
be:

–
= .0980 – .0430
= .0550, or 5.50%
8. Given the information in Problem 7, what was the average real risk-free rate over
this time period? What was the average real risk premium?

We can find the average real risk-free rate using the Fisher equation. The average
real risk-free rate was:

(1 + R) = (1 + r)(1 + h) or r= (1 +R)/(1 + h) –(1)

= (1.043 / 1.032) – 1
= .0107, or 1.07%
And to calculate the average real risk premium, we can subtract the average risk-
free rate from the average real return. So, the average real risk premium was:

– = 6.40% – 1.07%
= 5.33%
9. You purchased a zero-coupon bond one year ago for P302.41. The market interest
rate is now 5.4 percent. If the bond had 20 years to maturity when you originally
purchased it, what was your total return for the past year? Assume semi-annual
compounding.
To find the return on the zero-coupon bond, we first need to find the price of the
bond today. We need to remember that the price for zero-coupon bonds is
calculated with semiannual periods. Since one year has elapsed, the bond now has
19 years to maturity, so the price today is:

38
P1 = 1,000 / 1.027
P1 = 363.35
There are no intermediate cash flows on a zero-coupon bond, so the return is the
capital gain, or:

R = (363.35 – 302.41) / 302.41

R = .2015 or 20.15%

10. You bought a share of 5.5 percent preferred stock for P104.18 last year. The market
price for your stock is now P102.67. What is your total return for last year?

The return of any asset is the increase in price, plus any dividends or cash flows,
all divided by the initial price. Since preferred stock is assumed to have a par value
of P100, the dividend was P5.50, so the return for the year was:

R = (102.67 – 104.18 + 5.50) / 104.18

R = .0383, or 3.83%

11. You bought a stock 3 months ago for P42.67 per share. The stock paid no
dividends. The current price if P45.38. What is the APR of your investment? The
EAR?
The return of any asset is the increase in price, plus any dividends or cash flows, all
divided by the initial price. This stock paid no dividend, so the return was:

R = (45.38 – 42.67) / 42.67

R = .0635, or 6.35%
This is the return for three months, so the APR is:
 APR = 4(6.35%)
APR = 25.40%
And the EAR is:
4
EAR = (1 + .0635) – 1
EAR = .2793, or 27.93%

12. A stock has had returns of (23) percent, 9 percent, 37 percent, (8) p ercent , 28
percent and 19 percent over the last six years. What are the arithmetic and
geometric returns for the stock?
The arithmetic average return is the sum of the known returns divided by the number
of returns, so:

Arithmetic average return = (–.23 + .09 + .37 –.08 + .28 +.19) / 6

Arithmetic average return = .1033, or 10.33%
Using the equation for the geometric return, we find:

Geometric average return = [(1 + R1) × (1 + R2) × … × (1 + RT)]1/T – 1

Geometric average return = [(1 – .23)(1 + .09)(1 + .37)(1 – .08)(1 + .28)(1 +
.19)](1/6) – 1
Geometric average return = .0828, or 8.28%

Remember that the geometric average return will always be less than the
arithmetic average return if the returns have any variation.

13.You find a certain stock that had returns of 17 percent, -13 percent, 26 percent,
and 8 percent for four of the last five years. If the average return of the stock over
this period was 10 percent, what was the stock’s return for the missing year ? What
is the standard deviation of the stock’s returns ?

We know the average stock return, and four of the five returns used to compute the
average return. We can work the average return equation backward to find the
missing return. The average return is calculated as:

.10 = (.17 – .13 + .26 + .08 + R) / 5

.50 = .17 – .13 + .26 + .08 + R
R = .12 or 12%
 The missing return has to be 12 percent. Now, we can use the equation for the
variance to find:
2 2 2 2 2
Variance = 1/4[(.17 – .10) + (–.13 – .10) + (.26 – .10) + (.08 – .10) + (.12 – .10)]
Variance = .02105

And the standard deviation is:

1/2
Standard deviation = .02105
Standard deviation = .1451, or 14.51%

14. A stock had an initial price of P58.27 per share.

A stock had the following year end price and dividends :
Year Price Dividend

1 67.32 1.10
2 61.46 1.25
3 69.32 1.45
4 75.18 1.60
5 84.32 1.75
What are the arithmetic and geometric returns of the stock ?

To calculate the arithmetic and geometric average returns, we must first calculate the return for each
year. The return for each year is:

R1 = (67.32 – 58.27 + 1.10) / 58.27 = .1742, or 17.42%

R2 = (61.46 – 67.32 + 1.25) / 67.32 = –.0685, or –6.85%
R3 = (69.32 – 61.46 + 1.45) / 61.46 = .1515, or 15.15%
R4 = (75.18 – 69.32 + 1.60) / 69.32 = .1076, or 10.76%
R5 = (84.32 – 75.18 + 1.75) / 75.18 = .1449, or 14.49%

The arithmetic average return was:

RA = (.1742 – .0685 + .1515 + .1076 + .1449) / 5

RA = .1019, or 10.19%

And the geometric average return was:

RG = [(1 + .1742)(1 – .0685)(1 + .1515)(1 + .1076)(1 + .1449)]1/5 – 1

RG = .0982, or 9.82%
1/5
Or : (1.1742) x(,9315) x(1.1515)x( 1.1076) x(1.1449) =1.5971 -1 x100 =9.82%
Or ; 1.5971press√ 12 times minus 1 divide by 5 plus 1 press x=1twelve times minus 1 x 100
1. Suppose you bought a bond with an annual coupon rate of 13 percent one year ago
for P2,064. The bond sells for P2,040 today.
a. Assuming a P1,000 face value, what was your total peso return on this
investment over the past year?
b. What was your total nominal rate of return on this investment over the past year?
c. If the inflation rate last year was 3 percent, what was your total real rate of return
on this investment?
The total peso return is the change in price plus the coupon payment, so:

Total peso return = $2,040 – 2,064 + 130

a. Total peso return = P106
Note: P130 is interest income (P1,000 x 13%)
The nominal percentage return of the bond is:

R = [(2,040 – 2,064) + 130] / 2,064

b. R = .0514, or 5.14%

Notice here that we could have simply used the total d return of 106 in the
numerator of this equation. (106/2,064 =.0514 x 100 = 5.14%

c. Using the Fisher equation, the real return was:

(1 + R) = (1 + r)(1 + h)

r = (1.0514 / 1.03) – 1
r = .0208, or 2.08%
Note : The Fisher equation shows the relationship between nominal interest rates, real
interest rates, and inflation. The formula is
(1+R) = (1+ r) (1 +h) or
R =r +h + (rxh)
Where R =Nominal rate. R= real rate, h= inflation rate