CHAP 1

1.1 Definition of Investment and Reasons for Individual Investment

Investment is the allocation of capital into an asset with the expectation of generating a positive
income or increasing the value of that asset. Individuals invest for a variety of reasons, including:
- Generating income: For example, interest from a savings account or dividends from common
stock.
- Appreciating value: Hoping that the price of an asset increases, such as a stock price.
- Protecting assets from inflation: Ensuring that the value of an asset does not decrease due to
inflation.
1.2 Distinguishing between types of investments
(a) Securities and Real Estate
- Securities are investments issued by companies, governments, or other organizations,
representing financial ownership of the issuer's assets. Examples include stocks and bonds. The
advantage of securities is that they are highly liquid, easy to buy and sell, and can be converted
into cash.
- Real estate is an investment in real estate or tangible personal property. Examples: land, houses,
gold, works of art, antiques. Real estate is generally less liquid than stocks.
(b) Direct and Indirect Investments
- Direct investment is when the investor directly owns the property. For example, buying shares
of Apple Inc., you become a part owner of the company.
- Indirect investment is when the investor invests in a portfolio of securities or assets managed by
a professional investor. For example, putting money into a mutual fund.
(c) Debt, Equity, and Derivatives
- A debt security is a loan that the borrower is obligated to make periodic interest payments and
repay in full at a future date. For example, a bond.
- Equity securities represent ownership in a business or asset. For example, common stock.
- Derivatives are neither debt nor equity but have a value that depends on an underlying security
or asset. For example, a stock option.
(d) Short-term and long-term investments
- Short-term investments typically mature within one year.
- Long-term investments have longer maturities or no maturities, such as common stocks.
1.3 Relationship between risk and return
The higher the return, the greater the risk. Investors must accept more risk to achieve higher
potential returns.
1.4 Defining risk and how to differentiate investments based on risk
Risk reflects the degree of uncertainty surrounding the return that a particular investment will
generate. High-risk investments have higher average returns but also have a greater potential for
loss.
1.5 Foreign investment and its role for individual investors
Foreign investment is investing in securities or assets abroad. Role:
- More attractive profit opportunities.
- Diversify investment portfolio, help limit risks.
1.6 Structure of investment process and role of financial institutions and financial markets
The investment process connects capital suppliers (usually households) and capital demanders
(usually businesses and governments).
- Financial institutions: For example, banks, insurance companies, pool resources from
households and use them for lending and investment.
- Financial markets: Where capital suppliers and demanders trade financial assets. For example,
stock markets, bond markets.
Financial markets play an important role:
- Effectively connecting investors.
- Determine transparent market prices.
- Provide information that reflects investors' expectations about business prospects.
1.7 The role of government, businesses and individuals in capital supply and demand
- Government: Usually spends more than it collects in taxes, so it is a net demander of capital.
- Businesses: Usually a net demander of capital to finance investment activities.
- Individuals: Usually a net supplier of capital when saving and investing.
1.8 Distinguishing between individual and institutional investors
- Individual investors: Manage their own funds to achieve personal financial goals.
- Institutional investors: Investment professionals who manage other people's money, often with
large amounts of capital and more complex analytical skills. Examples: pension funds, mutual
funds.
1.9 Short-term investments and liquidity
Short-term investments are investments with a maturity of less than one year.
Liquidity is the ability to convert an investment into cash quickly without losing value.
Short-term investments are often highly liquid, so they are used as:
- Temporary "stores" for idle funds.
- Emergency reserves.
- A choice for cautious investors who do not want to take on high risks.
1.10 Common stocks and two potential sources of profit
Common stocks represent ownership in a company.
Potential profits:
- Dividends: Payments made by a company to shareholders.
- Capital gains: The difference between the selling price and the purchase price of the stock.
1.12 Investment Policy Statement (IPS)
Before developing and implementing an investment program, investors should establish an
investment policy statement (IPS). An IPS is a document that outlines how investors will invest,
helping them to be disciplined, avoid mistakes, and focus on their investment goals.
Key elements of an IPS:
- Summary of current situation: List existing assets, monthly savings goals, investment sources,
risk tolerance, investment time frame.
- Define investment goals: State the financial goals you want to achieve through investing, the
amount of money you need to invest each year, and the time frame for each goal.
- Express investment philosophy: State your views on investment types, frequency of portfolio
adjustments, risk tolerance, level of diversification, exclusion of unsuitable investments,
transaction and management costs.
- Set investment selection guidelines: Identify investment selection criteria for each asset class,
such as mutual funds, stocks, or bonds.
- Assign responsibilities: Identify who will select and monitor investments, how often investment
performance will be evaluated, and the evaluation criteria.
1.13 Types of income and federal income taxes
(a) Business income: Includes wages, bonuses, tips, retirement income, and pensions. (b)
Portfolio income and passive income:
- Portfolio income: Interest, dividends, and capital gains from the sale of securities.
- Passive income: Income from real estate, partnerships, and other tax-advantaged investment
vehicles. (c) Capital gains: Profits from the sale of capital assets for more than the original
purchase price. (d) Capital Loss: A loss incurred when a capital asset is sold for less than its
original purchase price. (e) Tax Planning: Analyze current and projected income and develop
strategies to minimize and defer taxes. (f) Tax-Advantaged Retirement Investing: Programs such
as 401(k), Traditional IRAs, and Roth IRAs allow employees to save for retirement with tax
advantages.
Relationship to Federal Income Tax:
- These types of income are all subject to federal income tax, but the tax rates and tax treatment
may differ.
- Tax planning is important to optimize after-tax returns.
1.14 Life Cycle Investment Philosophy
(a) Young people (20-45 years old): Prioritize growth investments, accept high risks to increase
capital, often choose high-risk common stocks. (b) Middle age (46-60 years old): Balance
between growth and income, focus on family responsibilities, choose dividend stocks, high-
quality bonds, mutual funds. (c) Retirement age (61 years old and above): Prioritize capital
preservation and stable income, minimize risks, choose low-income stocks, government bonds,
bank deposit certificates and other short-term investments.
1.15 Relationship between stock prices and business cycles
- Stocks are sensitive to the business cycle, stock prices often increase before the economy
improves and decrease before recession.
- The reason is that stock prices reflect investors' expectations about the economic outlook.
- Bonds are also affected by the business cycle, because bond prices fluctuate inversely with
interest rates.
- Advice: Do not overreact to market fluctuations, apply a consistent investment strategy in the
long term.
1.16 Liquidity and reasons for holding liquid assets
Liquidity is the ability to convert assets into cash quickly without losing value.
Reasons for holding liquid assets:
- Meet unexpected spending needs (illness, unemployment).
- Seize unexpected investment opportunities.
- Temporary "warehouse" for idle funds.
Are 100 shares of IBM considered a liquid investment?
- IBM shares are quite liquid, as they are shares of a large company, which are traded frequently
on the market.
- However, compared to checking accounts, stocks are less liquid, because:
+ Do not guarantee quick sale without a discount.
+ Transaction costs arise.
1.17 Characteristics of short-term investments in terms of purchasing power and default
risk
- Inflation risk: The risk of losing purchasing power when the investment interest rate is lower
than the inflation rate.
- Default risk: The risk of not being able to repay principal and interest.
For short-term investments:
- Inflation risk: Possible, especially in a low-interest environment.
- Default risk: Almost non-existent due to reputable issuers and government deposit insurance
programs.
1.18 Characteristics and differences between types of deposit accounts
(a) Savings account: Savings account provided by banks, low interest rate, prioritized for
convenience. (b) NOW account (Negotiated Order of Withdrawal): Bank checking account that
pays interest, usually requires a minimum balance. (c) Market deposit account (MMDA): A bank
deposit account with limited check-writing privileges, and an interest rate that is typically higher
than a savings account. (d) Asset management account: An account that combines checking,
investing, and borrowing, automatically transferring excess balances into short-term investments
and borrowing to cover shortfalls.
1.19 Definition, comparison, and contrast of short-term investments
(a) I-bonds: Savings bonds issued by the U.S. Treasury, interest rates vary with inflation, exempt
from state and local income taxes. (b) U.S. Treasury bills (T-bills): Issued weekly through
auction, sold at a discount, strong secondary market, exempt from state and local income taxes.
(c) Certificates of deposit (CDs): Time deposits at commercial banks, flexible terms and
amounts, higher interest rates than T-bills. (d) Commercial paper: Unsecured bills issued by
companies with high creditworthiness, large denominations, short maturities. (e) Bankers'
acceptances: Similar to post-paid checks, guaranteed by the bank, negotiable. (f) Money market
mutual funds (money funds): Expertly managed portfolio of securities, highly liquid, higher
interest rates than T-bills.
CHAP 2
2.1 Distinguish between the following pairs of terms:
a. Money market and capital market
●
Money market: This is the market where short-term debt securities (with maturities of less than
one year) are bought and sold. Investors use the money market to lend and borrow short-term.
●
Capital market: Investors turn to the capital market to buy and sell long-term securities (with
maturities of more than one year), such as stocks and bonds.
b. Primary market and secondary market
●
Primary market: The market where investors buy securities that are issued for the first time. In
the primary market, the issuer of the securities receives the proceeds from the sale.
●
Secondary market: The market where securities are traded after they have been issued. Unlike
the primary market, transactions in the secondary market do not involve the company that issued
the securities.
c. Brokerage Market and Exchange Market
●
Brokerage Market: In a brokerage market, the two parties to a transaction, the buyer and the
seller, are matched with each other—the seller sells their securities directly to the buyer. With the
help of a broker, the securities are effectively transferred on an exchange.
●
Exchange Market: When a transaction is made on an exchange, the buyer's buy and sell orders
are never matched directly. Instead, their buy/sell orders are executed by market makers, who are
securities traders who "make a market" by offering to buy or sell a certain amount of securities at
a stated price.
2.2 Briefly describe the IPO process and the role of investment banks in underwriting an
initial public offering. Distinguish between the terms public offering, rights offering, and
private placement.

The IPO (initial public offering) process is the process by which a private company sells its stock
to the public for the first time. This process typically involves several steps:

●
Getting shareholder approval: The company must get approval from its existing shareholders.
●
Auditing and legal: The company's auditors and lawyers must confirm that all financial
disclosure documents for the company are legal.
●
Selecting an investment bank: The company finds an investment bank willing to underwrite the
offering.
●
Filing the prospectus: The investment bank assists the company in filing a prospectus with the
Securities and Exchange Commission (SEC).
●
Quiet period: While the prospectus is being approved by the SEC, potential investors may
receive a preliminary prospectus.

●
Roadshow: Investment banks and company executives promote the company's stock offering
through a roadshow, which involves a series of presentations to potential investors.

●
SEC approval and IPO: Once all the terms of the offering have been set, including the price, the
SEC must approve the offering before the IPO can take place.

Roles of investment banks:

●
Underwriting: The investment bank buys securities from the issuing company at an agreed-upon
price and takes on the risk of reselling them to the public.
●
Advising: The investment bank also provides the issuer with advice on pricing and other
important aspects of the offering.
●
Forming a selling group: The lead investment bank and members of the underwriting group form
a selling group, which typically includes themselves and a large number of brokerage firms.
Differentiate between the types of offerings:
●
Public offering: The company offers its securities for sale to public investors.
●
Rights offering: The company offers shares to existing shareholders on a pro rata basis (each
outstanding share is divided into an equal number of new shares).
●
Private offering: The company sells securities directly without SEC registration to selected
groups of private investors, such as insurance companies, investment funds, and pension funds.
2.4 Explain how the exchange market works. Be sure to mention market makers, bid and
ask prices, the Nasdaq market, and the OTC market. What role does the exchange play in
initial public offerings (IPOs) and secondary distributions?
The exchange market operates through a network of market makers, who are securities traders
who “make a market” by offering to buy or sell a specified amount of securities at a stated price.

The bid price is the highest price that can be paid for a given security.
The ask price is the lowest price that can be paid for a given security.

The Nasdaq market is the largest exchange, consisting of a large list of stocks listed and traded
on the National Association of Securities Dealers’ Automated Quotation System.
The OTC (off-exchange) market includes non-Nasdaq securities, primarily small companies that
are unable or unwilling to comply with Nasdaq listing requirements.

Role of the Exchange Market in IPOs and Secondary Distributions:

The exchange market serves as the primary market for both IPOs and secondary distributions
because all new issues—IPOs and secondary distributions—are sold to the investing public by
securities dealers acting on behalf of investment banks.

2.5 What are the Third and Fourth Markets?

Third Market: Includes off-exchange transactions conducted for securities listed on the NYSE,
NYSE Amex, or one of the other exchanges.

Fourth Market: Includes transactions conducted via computer networks, rather than on an
exchange, directly between large institutional buyers and sellers of securities.
2.6 Distinguish between bull and bear markets.
●
Bull markets: Usually associated with rising prices, investor optimism, economic recovery, and
government stimulus.
●
Bear markets: Usually associated with falling prices, investor pessimism, economic recession,
and government restraint.
2.7 Why is stock market globalization important today? How have international
investments performed in recent years?
Stock market globalization is important today because it allows investors to seek profit
opportunities from rapidly growing economies around the world.
International investment performance:
Foreign stock markets tend to be riskier than the U.S. market. However, even in years of
depressed stock markets, many foreign exchanges have yielded higher returns than NYSE
Euronext.

2.8 Describe how to invest in foreign securities, both directly and indirectly.

Indirect investment:

●
Buying shares of a U.S.-based multinational corporation with significant operations abroad.

●
Buying shares in a mutual fund or ETF that invests primarily in foreign securities.

Direct investment:
●
Buying securities on foreign exchanges.
●
Buying securities of foreign companies that trade on U.S. exchanges.
●
Buying American Depositary Shares (ADS).
2.9 Describe the risks of investing internationally, especially exchange rate risk.

International investment risks:

●
Changing trade policies, labor laws, and taxes.
●
Government instability.
●
Lack of reliable investment information.
●
Different accounting standards.
Exchange rate risk:
Exchange rate risk is the risk of exchange rate changes between the currencies of two countries.
Trading profits are affected not only by fluctuations in the price of securities but also by
fluctuations in the value of currencies.
2.10 How is after-hours trading typically handled? What are the prospects for after-hours
trading?
After-hours trading:
●
Offered by most stock exchanges and ECNs.
●
Usually a cross market, where orders are only matched if they can be matched by identical
opposite buy and sell orders at the desired price.
●
Less liquid than day trading.
●
Allows traders to react to information they receive after the market closes at the official 4:00
p.m. close.
●
Allows the U.S. stock market to compete more effectively with foreign stock markets.
Prospects for After-Hours Trading:
Both individual and institutional investors can now trade stocks outside the traditional 9:30 a.m.
to 4:00 p.m. trading day.
Question 2.12
●
Long purchase: Is a transaction in which an investor buys securities with the expectation that
their price will increase in the future and can resell them for a profit. The goal of long purchase is
to buy low and sell high.
●
Expectation: The investor expects the price of the securities to increase during the holding
period, the profit comes from dividends or interest received during the ownership period, plus the
difference (capital gain or loss) between the purchase price and the sale price.
●
Margin trading: Is an activity in which an investor uses money borrowed from a brokerage firm
to buy securities.
●
Reason for use: The main purpose of margin trading is to amplify profits. By borrowing money,
investors can buy more securities than they can afford, thereby amplifying potential profits if the
price of the securities increases.

Question 2.13
●
Profit and loss amplification: Margin trading uses financial leverage, which means using
borrowed capital to amplify investment profits. When the price of a security increases, the profits
earned will be higher than if it were invested in cash. Conversely, when the price of a security
decreases, the losses will also be amplified.
●
Advantages:
○
Profit amplification.
○
Allows greater portfolio diversification because the investor can spread his limited capital across
more investments.
●
Disadvantages:
○
Potentially incurs a large loss if the price of a security decreases.
○
Interest must be paid on the margin loan, which reduces profits (or increases losses).
Question 2.14
●
Procedures and regulations:
○
Investors must open a margin account with a minimum initial balance of $2,000 or 100% of the
purchase price, whichever is lower, in cash or securities.
○
The brokerage firm will hold any securities purchased on margin as collateral for the loan.
○
The Federal Reserve (Fed) sets an initial margin requirement, which determines the minimum
amount of capital an investor must put up. Currently, the margin requirement for stocks is 50%.
○
Restricted account: An account with equity that is less than the initial margin. When the account
is restricted, the investor cannot purchase more on margin and must add capital until the margin
returns to the original level when selling the securities.
○
Maintenance margin: The minimum amount of capital that an investor must maintain in a margin
account at all times. The current maintenance margin for securities is 25%.

○
Margin call: When the capital in the margin account falls below the maintenance margin, the
investor will receive a margin call, requiring them to add more capital within a short period of
time to bring the equity above the maintenance margin. If not met, the brokerage firm is allowed
to sell a portion of the investor's securities to bring the equity back to the standard level.

○
Debit balance: The amount borrowed in a margin loan.
●
Uses:
○
Profit amplification: Margin trading allows investors to use financial leverage to amplify
investment profits.
○
Pyramiding: Using paper profits in a margin account to partially or fully fund the purchase of
additional securities. This allows the investor to execute trades with a margin ratio lower than the
initial requirement, sometimes significantly lower.

Question 2.15
●
Primary motive: To profit when the price of a security is expected to fall.
●
Basic short selling procedure:
○
The investor borrows securities from a broker and sells them on the market.
○
When the price of the security falls, the investor buys back the securities and returns them to the
lender.
●
Reason for initial capital deposit: The deposit plus the proceeds from the sale of the borrowed
securities assures the broker that there is enough money to buy back the shorted securities later,
even if their price increases.
Question 2.16
●
Margin Relevance: Margin applies to short sales, just like it does to purchases. Investors must
deposit an amount equal to the initial margin (currently 50%) against the proceeds from the short
sale.
●
Margin Call Conditions: A margin call occurs when the actual margin on a short sale falls below
the maintenance margin. This occurs when the price of the security being shorted increases.
●
Remedy:
○
Deposit additional funds to the broker to bring the total deposit equal to the current value of the
security plus the maintenance margin.
○
Buy the security back and return it to the broker to close the short position.
Question 2.17
●
Advantages: Opportunity to profit when the price of the security falls.
●
Disadvantages:
○
Limited profit opportunities: The stock price can only go down to zero, while the upside
potential is unlimited, leaving the short seller at risk of large losses.
○
No dividends (or interest): Conversely, the short seller must pay the lender any dividends (or
interest) that are paid while the trade is in progress.
●
How it makes money: The short seller sells the stock at a high price and buys it back at a lower
price to make a profit. For example, selling 100 shares at $50/share and buying them back at
$30/share would generate profit of $2,000 (excluding dividends and brokerage fees). However, if
the market moves against the investor, the investor could lose all or most of the $5,000
investment.
CHAP 4
4.1 Explain what investment returns are. Distinguish between the two components of
returns - income and capital gains (or capital losses).
Investment returns are the returns earned on an investment - that is, the reward for investing. It
consists of two components:
●
Income: are the periodic payments received from an investment, such as dividends and interest.
●
Capital gains (or capital losses): are the change in the price of an investment from its original
purchase price. Capital gains occur when the selling price is higher than the purchase price,
while capital losses occur when the selling price is lower than the purchase price.

For example:
●
Investment A: Bought for $1,000, received $80 in income during the year, and sold for $1,100 at
the end of the year. Return = $80 (income) + $100 (capital gains) = $180, or 18%.
●
Investment B: Purchased for $1,000, received $120 in income during the year, and sold for $960
at the end of the year. Profit = $120 (income) - $40 (capital loss) = $80, or 8%.
4.2 What role does historical performance data play in estimating the expected return on an
investment? Discuss the main factors that influence investment returns - intrinsic characteristics
and external forces.
Historical performance data provides information about the average returns that different types
of investments have generated in the past. By analyzing historical data, investors can compare
the performance of different types of assets (stocks, bonds, etc.) and determine the trend of
returns over time. However, past returns are no guarantee of future returns.
Key factors affecting investment returns:
●
Internal characteristics:
○
Type of investment (stocks, bonds).
○
Quality of management of the enterprise.
○
Capital structure of the enterprise (debt or equity).
●
External forces:
○
General level of price changes (inflation or deflation).
○
Macroeconomic factors (economic growth, interest rates, exchange rates).
4.3 What is an adequate investment? When the present value of benefits exceeds the cost of
the investment, what can you conclude about the rate of return the investor is earning
compared to the discount rate?
An adequate investment is one in which the present value of benefits (discounted at the
appropriate discount rate) equals or exceeds its cost.
When the present value of benefits exceeds the cost of the investment, we can conclude that the
rate of return the investor is earning is higher than the discount rate. This means that the
investment is generating an adequate return and is worth considering.
For example, an investment has the following 7-year income streams:

Năm Thu nhập

1 $90

2 $100

3 $110

4 $120

5 $100

6 $100

7 $1.200

At an 8% discount rate, the present value of the income stream is $1,175.85. If the cost of the
investment today is $1,175.85 or less, the investment is considered satisfactory. If the cost of the
investment is higher, the rate of return will be less than 8% and the investor should look for
another investment.
4.4 Define the following terms and explain how they are used to find the risk-free rate of return
and the required rate of return for a given investment.
a. Real rate of return b. Expected inflation premium c. Risk premium for a given investment
●
):* Measures the increase in purchasing power that an investment provides, after adjusting for
the effects of inflation.
○
Formula: Real rate of return ≈ Nominal rate of return - Inflation rate.
●
Expected inflation premium (IP): Represents the expected rate of inflation over the life of the
investment.

●
Risk premium (RPj): Is the compensation an investor receives for accepting the risk of a
particular investment. This premium varies depending on the characteristics of the investment
and the issuer.
How to use it to find the risk-free rate of return (rf) and required rate of return (rj):
●
Risk-free rate of return (rf): Is the rate of return that can be earned on a risk-free investment,
such as a short-term U.S. Treasury bond.
○
Formula: rf = r* + IP.
●
Required rate of return (rj): Is the rate of return that an investor requires to be fully compensated
for the risk of the investment.
○
Formula: rj = rf + RPj = r* + IP + RPj.
4.5 What is a holding period and why should equal holding periods be used when
comparing alternative investments? Define holding period yield and explain which holding
period is commonly used.
●
Holding period: The period over which an investor wants to measure the return on an investment.
●
Equal holding periods should be used when comparing investments because comparing the
return on a stock over 6 months with the return on a bond over 1 year can lead to poor
investment decisions.
●
Holding period yield (HPR): The total return earned from holding an investment for a specified
period (holding period).
○
Formula: HPR = (Income during the period + Capital gain (or loss) during the period) / Initial
investment value.

●
HPR is often used with holding periods of one year or less.

4.6 Determining the internal rate of return. When should IRR be used instead of HPR to
measure the profitability of an investment?

●
Internal rate of return (IRR): Is the discount rate that makes the present value of all cash flows of
an investment equal to 0. In other words, IRR is the rate of return that an investment brings,
calculated based on the principle of time value of money.

●
IRR should be used instead of HPR to measure the profitability of an investment when:
○
The holding period of the investment is greater than 1 year.

○
Need to calculate the annual rate of return on an investment, taking into account the time value
of money.
○
Need to compare the investment performance of projects with complex cash flows and different
payback periods.
HPR is simpler and easier to use, but IRR provides a more accurate measure of the long-term
profitability of an investment.
4.7 Explain why you must earn 10% on all income received from the investment over its
holding period for the IRR to actually equal the 10% value you calculated. The IRR
calculation assumes that you can reinvest all the income the investment generates and that
the rate of return earned on the reinvested income is equal to the rate of return on the
original investment. If you cannot reinvest the income at a rate of 10%, your actual IRR
will be less than 10%. For example, you buy a $1,000 US Treasury bond that pays 8%
annual interest ($80) over a 20-year life. Each year you receive $80 and at maturity you
receive your $1,000 principal back. To earn an 8% IRR on this investment, you must be
able to reinvest the $80 in annual interest income for the remaining 20 years at the same
8% annual rate of return.

4.8 Explain how to use the present value (benefits versus costs) or IRR measure to find a
sound investment. Given the following data, indicate which, if any, investments are
acceptable. Explain your findings.

Methods
There are two methods for determining whether an investment is sound:

●
Present value: An sound investment is one whose present value of benefits (discounted at an
appropriate discount rate) equals or exceeds its cost.
●
IRR: An sound investment is one whose IRR is equal to or greater than the required rate of
return.

Analyzing Investments

Khoản đầu Lợi nhuận yêu Giá trị hiện tại của thu Có thể chấp nhận
Chi phí IRR
tư cầu nhập được

200 đô
A 7% — 8% Có
la

160 đô
B 10% 150 đô la — Không
la

500 đô
C 9% — 8% Không
la

Investment A: IRR (8%) is greater than the required return (7%), so this investment is
acceptable.
●
Investment B: The present value of income ($150) is less than the cost ($160), so this investment
is not acceptable.
●
Investment C: IRR (8%) is less than the required return (9%), so this investment is not
acceptable.
4.9 Define risk. Explain what is meant by the trade-off between risk and return. What
happens to the required return as risk increases? Explain.
●
Risk: is the uncertainty surrounding the actual return an investment will generate.
●
Risk-Return Trade-Off: The risk associated with a given investment is directly related to its
expected return. Generally, the greater the risk of an investment, the higher the expected return it
must provide to attract investors. Investors typically want the highest possible return for the level
of risk they are willing to accept.
●
Required return: is the rate of return that fully compensates for the risk of an investment. As risk
increases, the required return also increases. This is because investors demand higher
compensation for accepting higher levels of risk.

4.10 Define and briefly discuss each of the following sources of risk.

●
a. Business risk: is the degree of uncertainty associated with the return on an investment and the
ability of investors to pay the returns (interest, principal, dividends). Business risk is related to
the industry in which the company operates.

●
b. Financial risk: is the increased uncertainty caused by a company borrowing money. Debt is
considered leverage because it can magnify both profits and losses. The more debt a company
uses to finance its finances, the greater its financial risk.
●
c. Purchasing power risk: is inflation risk. Inflation erodes the purchasing power of money. To
increase purchasing power over time, investors must earn returns that exceed the rate of inflation.
●
d. Interest rate risk: Most investments are subject to interest rate risk. Holding all other factors
constant, the higher the interest rate, the lower the value of the investment, and vice versa.
●
e. Liquidity risk: is the risk that an investment cannot be sold (or liquidated) quickly without
reducing its price. A liquid investment is one that investors can sell quickly without adversely
affecting its price.
●
f. Tax risk: is the risk that changes in tax laws may affect the after-tax return of an investment.
g. Event risk: is the risk that an unexpected event may negatively affect the value of an
investment.

h. Market risk: is the overall risk that affects the entire market, such as an economic recession or
political change.
4.11 Briefly describe standard deviation as a measure of risk or volatility.

Standard deviation, denoted by s, measures the dispersion (volatility) of returns around the mean
or expected return of an asset. The formula for calculating standard deviation is shown in
Equation 4.6a:
s = √(Σ(rt - r)² / (n - 1))
Where:
●
s: Standard deviation
●
rt: Return for outcome t
●
r: Average or expected return
●
n: Total number of outcomes
The larger the standard deviation, the higher the risk of the investment. For example, over the
period 2005 to 2014, Target stock had a standard deviation of 21.5%, while American Eagle
Outfitters stock had a standard deviation of 51.9%. This suggests that American Eagle Outfitters
stock is more volatile and riskier than Target stock.
4.12 Distinguish between three basic risk preferences: risk indifference, risk aversion, and
risk preference. Which of these attitudes toward risk best describes most investors?
●
Risk indifference (or risk neutral): For risk indifferent investors, the required return does not
change as risk changes.
●
Risk aversion: For risk averse investors, the required return increases as risk increases.
●
Risk preference: For risk-loving investors, the required return decreases as risk increases.
Most investors are risk averse. They require higher returns to compensate for taking on higher
levels of risk.
4.13 Describe the steps involved in the investment decision process. Be sure to mention how
returns and risks can be evaluated together to determine acceptable investments.

The investment decision process consists of the following four steps:

1.
Estimating expected returns: Using historical or projected return data to estimate expected
returns over a given holding period.

2.
Assessing risk: Assessing the risk associated with the investment by making a subjective
judgment, calculating the standard deviation of the investment's returns, or using one of the more
complex methods.

3.
Assessing risk-return characteristics: Assessing the risk-return characteristics of each investment
option to ensure that the return you expect is reasonable for the level of risk you are taking.

4.
Investment Selection: Choose investments that will yield the highest return relative to the level
of risk you are willing to take.
4A.1 What is the time value of money? Explain why investors should be able to earn a
positive return.
The time value of money refers to the idea that as long as there is an opportunity to earn interest,
the value of money depends on when it is received and that a dollar received today is worth more
than a dollar in the future. This is because a dollar received today can be invested and earn
interest, whereas a dollar received in the future cannot.
Investors should be able to earn a positive return because they are taking on risk when they
invest. Positive returns compensate for that risk and provide investors with a reward for delaying
consumption.
4A.2 Define, discuss and contrast the following terms: a. Interest b. Simple interest c.
Compound interest d. Real Interest Rate (or Return)

●
a. Interest Rate: The cost of borrowing money or the reward for lending money. It is usually
expressed as an annual percentage rate.
●
b. Simple Interest: Interest calculated only on the principal amount.
●
c. Compound Interest: Interest calculated on both the principal amount and the accumulated
interest.
●
d. Real Interest Rate (or Return): An interest rate that has been adjusted for inflation.
Compound interest is more beneficial than simple interest because the accumulated interest also
earns interest. The real interest rate shows the real purchasing power of an investment after
inflation has been taken into account.
4A.3 When interest is compounded more than annually, what happens to the real interest rate?
Under what conditions will the stated interest rate and the real interest rate be equal? What is
continuous compounding?
●
When interest is compounded more than annually, the real interest rate will be higher than the
stated interest rate.
●
The stated interest rate and the effective interest rate will be equal when interest is compounded
only once per year.
●
Continuous compounding is the practice of compounding interest indefinitely each year. It
produces the highest possible effective interest rate for a given stated interest rate.

4A.4 Describe, compare, and contrast the concepts of future value and present value. Explain the
role of the discount rate in calculating present value.

●
Future value (FV): The value of a sum of money or cash flow at some point in the future, based
on a given interest rate.

Present value (PV): The present value of a sum of money or cash flow to be received in the
future, based on a given discount rate.
The discount rate used to calculate present value reflects the time value of money. It represents
the return an investor could earn from an alternative investment of equivalent risk. The higher
the discount rate, the lower the present value of a future sum of money.
4A.5 What is an annuity? How to simplify the calculation of the future value of an annuity?
What about the present value of an annuity?
An annuity is a regular stream of cash flows that occurs regularly over a period of time. The cash
flows can be either an investment stream for future profits or an income stream from an
investment. An example of an annuity is investing $1,000 each year at the end of each year for
the next 8 years.
To simplify the calculation of the future value of an annuity, you can use a financial calculator or
an Excel spreadsheet. When using a financial calculator, you need to enter the annuity cash flows
using the PMT key. The PMT key tells the calculator that a series of N (number of years entered)
deposits at the end of the year in the amount of PMT dollars represents the annuity. Similarly,
Excel also has a built-in function to calculate the future value of an annuity.
For the present value of an annuity, you can also use a financial calculator or an Excel
spreadsheet. Both of these tools have built-in functions to handle all of the annuity's cash flows
at once.
4A.6 What is a Mixed Income Stream? Describes the process used to find the present value of
such an income stream.
A mixed income stream is a series of payments with no particular pattern (unlike an annuity that
makes equal payments each period). For example, an income stream might consist of payments
of $30, $40, $50, $60, and $70, paid at the end of each year from 2017 to 2021.
To find the present value of a mixed income stream, you must calculate the present value of each
payment and then add them together.
CHAP 5
Question 5.1: Efficient Portfolio
An efficient portfolio is one that provides the highest level of return for a given level of risk. The
ultimate goal of an investor is to create an efficient portfolio. Determining an efficient portfolio
is not always easy, and investors often have to look for alternative investments to achieve the
best combination of risk and return.
Question 5.2: Calculating Portfolio Return and Standard Deviation
Portfolio return (rp) is calculated as the weighted average of the returns on the assets that make
up the portfolio. The formula for calculating portfolio return is shown in Equations 5.1 and 5.1a.
The standard deviation of a portfolio is calculated by applying the same formula as the formula
for calculating the standard deviation of a single asset. However, the difference is that instead of
using the return of an asset, we use the return of the portfolio for each period.

Question 5.3: Correlation Coefficient and Its Importance

The correlation coefficient is a statistical measure of the relationship between two series of
numbers. The correlation coefficient is important in building an investment portfolio because it
affects the degree to which the portfolio diversifies risk.

●
Positive correlation: The two series of numbers tend to move in the same direction. For example,
the number of hours of sunshine and the average daily temperature.

●
Negative correlation: The two series of numbers tend to move in opposite directions. For
example, the number of hours of sunshine and the amount of rainfall.
●
No correlation: The two series of numbers have no relationship with each other. For example, the
number of hours of sunshine and the fluctuation in the value of the US dollar against other
currencies.
Distinguish between perfect positive and perfect negative correlations:
●
Perfect positive correlation (+1.0): The two series move perfectly in sync. For example, two
companies in the same industry or two mutual funds that invest in the same stocks.
●
Perfect negative correlation (-1.0): The two series move perfectly in opposite directions.
In reality, it is rare to find two investments with a perfect correlation coefficient. The correlation
coefficients between most assets usually exhibit a high to low degree of positive correlation.
Negative correlations are the exception.

Question 5.4: Diversification

Diversification is the practice of including a number of different investments in a portfolio.
Diversification is an important aspect of creating an effective portfolio.
Effect of Diversification of Risk: In general, the lower the correlation coefficient between two
assets, the greater the risk reduction an investor can achieve by combining those assets into a
portfolio. Figure 5.2 illustrates two negatively correlated assets (F and G) with the same average
return of r. A portfolio containing both F and G has the same return of r, but has lower risk
(volatility) than any of the individual assets. This is because some of the volatility of asset F is
offset by the volatility of G.
Question 5.5: Correlation Coefficient and Its Effect on Risk and Return
The correlation coefficient between asset returns affects the risk and return behavior of the
resulting portfolio.
●
Perfect positive correlation (+1.0): As the investor reduces the proportion of low-risk assets
invested in order to hold more of high-risk assets, the expected return of the portfolio increases,
but so does the standard deviation.

●
No correlation (0): The portfolio lies along a curve (the blue line in Figure 5.4), providing higher
returns for the same level of risk than if the portfolio were perfectly positively correlated.

●
Perfect negative correlation (-1.0): The two risky assets can be combined in the right proportions
so that the portfolio returns are completely predictable (i.e., risk-free).
Question 5.6: Benefits of International Diversification
International diversification provides greater benefits than investing only domestically. This is
true for both U.S. investors and investors in countries with more limited capital markets than the
U.S. The benefits of international diversification come from two sources:
1.
Returns in different markets around the world do not move in sync. The correlation coefficient
between markets is less than +1.0. However, globalization has brought about greater integration
of markets around the world, increasing the correlation coefficient of returns between national
markets, thereby reducing the benefits of international diversification.
2.
The number of stock markets in the world is increasing. This enhances the benefits of
international diversification.
Comparison of international diversification methods:
●
Investing abroad:
○
Provides the greatest diversification benefits.
○
Less convenient, costly and risky than investing domestically.
○
Requires investors to be knowledgeable about foreign markets and have enough time to monitor.
○
Exchange rate risk: Investors face the risk of exchange rate fluctuations.
●
Domestic investments:
○
Buy shares of foreign companies listed on US exchanges: Many foreign companies issue shares
in the form of American depositary shares (ADSs).
○
Buy bonds of foreign governments or companies issued in the US (Yankee bonds).
○
Invest in international mutual funds: Provide a list of diversified foreign portfolio and the
expertise of fund managers.

Investing in US-based multinational corporations:

●
Provides some of the benefits of international diversification because multinational corporations
generate revenues, expenses, and profits in many different markets and currencies.
●
Does not provide the full benefits of international diversification because the majority of their
revenues and expenses are still concentrated in the US.
Question 5.7: Components of Total Risk
Total Risk = Diversifiable Risk + Undiversifiable Risk
●
Unsystematic risk: Derives from company-specific factors, such as the success or failure of a
new product, the performance of senior managers, or the company's relationships with customers
and suppliers. For example, a technology company is sued for patent infringement.
●
Systematic risk: Relates to broad forces such as economic growth, inflation, interest rates, and
political events that affect all investments. For example, a recession reduces overall consumer
demand.
Important types of risk: Non-diversifiable risk is important because it cannot be eliminated
through diversification. Investors cannot eliminate systematic risk, so they demand a higher risk
premium for investments with higher systematic risk.
Question 5.8: Beta
Beta is a measure of non-diversifiable risk. A security's beta indicates how sensitive the security's
returns are to changes in market returns. The higher the beta, the more sensitive the security is to
market movements.
●
Market Return: Usually measured by the return of a broad stock portfolio or a stock index, such
as the S&P 500.
●
Interpretation of beta:
○
Beta = 1.0: The security moves in sync with the market.
○
Beta > 1.0: The security is more sensitive than average to market movements and is therefore
riskier than average.
○
Beta < 1.0: The security is less risky than average.
Question 5.9: Range of Beta Values
Most stocks have betas that range from 0.50 to 1.75. Positive betas are more common than
negative betas because most stocks tend to move in the same direction as the market.
Question 5.10: Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) is a model that quantifies the relationship between risk
and return for different investments. The CAPM predicts the expected return of a stock
depending on three factors: the risk-free rate of return, the expected return of the market, and the
beta of the stock.

●
CAPM formula:
rj = rrf + bj * (rm - rrf)
Where:
●
rj = Expected return of investment j
●
rrf = Risk-free rate of return
●
bj = Beta of investment j
●
rm = Expected return of the market
●
Role of beta: Beta is used to measure the non-diversifiable risk of an investment.
●
Risk premium: The return an investor requires above the risk-free rate to compensate for the non-
diversifiable risk of an investment.

Security market line (SML): A graph of the CAPM. The SML shows the expected return (y-axis)
for any security given its beta (x-axis).
5.11 Is the Capital Asset Pricing Model (CAPM) a Predictive Model? Why Are Beta and the
CAPM Still Important to Investors?
The CAPM is typically based on historical data, as the beta values used in the model are
typically based on calculations using past returns. A company's risk profile can change at any
time as it changes its business model, issues or retires debt, or takes other actions that affect the
risk of its common stock. Therefore, the CAPM is not an exact predictive model, and the
required return specified by the model can only be viewed as an approximation.

The CAPM is typically based on historical data, since the beta values used in the model are
typically based on calculations using past returns. A company's risk profile can change at any
time as it changes its business model, issues or retires debt, or takes other actions that affect the
risk of its common stock. Therefore, the CAPM is not an exact predictive model, and the
required return specified by the model can only be considered an approximation.
Despite their limitations, beta and CAPM remain important tools for investors for the following
reasons:
●
Simple and practical: CAPM provides a useful conceptual framework for assessing and relating
risk and return, helping investors measure risk and relate it to the required return on the stock
market.
●
Widely used: CAPM is widely used in corporate finance to determine the required rate of return
for shareholders before spending on large investment projects.
5.12 Describe traditional portfolio management. Give three reasons why traditional portfolio
managers prefer to invest in established companies.
Traditional portfolio management emphasizes balancing the portfolio by gathering a variety of
stocks and/or bonds. The typical focus is on cross-industry diversification, creating a portfolio
with securities of companies from many different industries.
Traditional portfolio managers often prefer to invest in established companies for three reasons:

●
Lower risk: They may believe that investing in well-known companies is less risky than
investing in lesser-known companies.

●
High liquidity: Securities of large companies are more liquid and available in large quantities.

●
Easier to sell: Institutional investors prefer successful and well-known companies because it is
easier to convince clients to invest in them. This is called “window dressing,” which makes it
easier for institutional investors to sell their services.

5.13 What is Modern Portfolio Theory (MPT)? What is the feasible or achievable set of all
possible portfolios? How is it derived for a given investment group?
Modern Portfolio Theory (MPT) is a mathematical approach based on quantitative analysis to
guide investment decisions. MPT uses a number of basic statistical measures to develop a
portfolio plan, estimating the mean return, standard deviation, and correlation between multiple
combinations of investments to find the optimal portfolio. According to MPT, the maximum
benefit from diversification occurs when investors find relatively uncorrelated securities and
combine them into a portfolio.
The feasible (or achievable) set is all the portfolios that can be obtained by combining assets in
different proportions, represented by the shaded region in Figure 5.7. To create this set, we need
to calculate the return and risk of each possible portfolio and plot each risk-return combination
on a graph.
5.14 What is the Efficient Frontier? How does it relate to the achievable set of all possible
portfolios? How can it be used with the investor's utility function to find the optimal portfolio?
The efficient frontier is the boundary of the feasible set, representing all efficient portfolios that
provide the best trade-off between risk and return.
Every portfolio on the efficient frontier is better than all other portfolios in the feasible set.
To find the optimal portfolio using the efficient frontier, we can use the investor's indifference
curve, which represents the set of risk-return combinations that the investor is indifferent to for a
given level of utility (satisfaction). The optimal portfolio is the point where the investor's highest
indifference curve is tangent to the efficient frontier.
5.15 Define and differentiate between diversifiable risk, non-diversifiable risk and total portfolio
risk. What is considered relevant risk? How is it measured?
●
Unsystematic risk: The risk that is specific to a particular investment, which can be eliminated
through diversification. For example, the risk of a new product succeeding or failing, the
performance of senior management or the company's relationships with customers and suppliers.
●
Systematic risk: The unavoidable part of an investment, which remains even if the portfolio is
well diversified. For example, the risk associated with common factors such as economic growth,
inflation, interest rates and political events that affect all investments.
●
Total risk: The sum of diversifiable risk and non-diversifiable risk.
Relevant risk is non-diversifiable risk, because it cannot be eliminated through diversification.
This risk is measured by beta.
5.16 Define beta. How can you find the beta of a portfolio when you know the beta for each asset
included in it?

Beta is a measure of systematic risk, indicating the sensitivity of a security's return to changes in
market returns. The higher the beta, the more sensitive the security is to changes in the market.

To calculate the beta of a portfolio (bp), we use a weighted average of the betas of the individual
assets in the portfolio, where the weights represent the proportion of the portfolio's value
invested in each security. The formulas are presented in Equations 5.4 and 5.4a.

5.17 Explain how you can reconcile traditional and modern portfolio approaches.

Individual investors can combine both traditional and modern portfolio approaches by:
●
Determining the level of acceptable risk.
●
Diversifying the portfolio: Diversifying across securities and sectors, paying attention to the
relationship between the returns of different securities.
●
Using beta to manage risk: Looking at how securities react to the market and using beta to
diversify the portfolio to the level of acceptable risk.
●
Evaluating alternative portfolios: Ensuring that the selected portfolio provides the highest return
for the acceptable level of risk
CHAP 6
6.1 What is common stock? What does the phrase “the holders of common stock are the residual
owners of the company” mean?
Common stock represents ownership (or equity) in a company. Each share entitles the holder to
ownership and participation in the company’s profits and dividends, equal voting rights (usually),
and an equal say in management.
The phrase “the holders of common stock are the residual owners of the company” means that
their claim to the company’s assets is satisfied only after all of the company’s other financial
obligations, including debt and preferred dividends, have been paid.
6.2 What are two or three key investment attributes of common stock?
Key investment attributes of common stock include:
●
Capital appreciation potential: Investors hope that the stock price will increase over time,
generating capital gains.
●
Dividends: Many stocks pay dividends, providing investors with a regular source of income.

Liquidity: Common stocks are typically highly liquid, meaning they can be easily bought and
sold on the market.

6.3 Briefly describe the performance of the U.S. stock market in the late 20th and early 21st
centuries.

The U.S. stock market experienced significant volatility in the late 20th and early 21st centuries.

●
A period of strong growth: From 1950 to 1999, the U.S. stock market, as measured by the S&P
500 Index, experienced significant growth, with an average annual growth rate of about 11.4%.
●
Decline: The market saw a significant decline in the early 2000s and again during the 2008
financial crisis, with the S&P 500 falling more than 50% in both cases.

●
Recovery: The market has recovered from each downturn, reaching a new record high in 2015.
6.4 How important are dividends as a source of return for common stocks? What about capital
gains? Which is more important to total returns? Which causes greater volatility in total returns?
Dividends provide a regular source of income for common stock investors, but in general, capital
gains (the difference between the purchase price and the sale price) contribute more to a stock's
total return.
Variations in stock prices (and therefore capital gains) cause greater volatility in total returns.
6.5 What are some of the advantages and disadvantages of owning common stocks? What are the
main types of risks faced by shareholders?
Advantages:
●
High return potential: Common stocks typically offer higher returns than other investments such
as long-term corporate bonds and U.S. Treasury securities over the long term.
●
Inflation protection: Stock returns over time often exceed the rate of inflation, increasing
purchasing power.
●
High liquidity: Stocks are easy to buy and sell with low transaction costs.
●
Widely available information: Information about stock prices and the stock market is widely
available in the media.
●
Low unit costs: Common stocks typically have a relatively low price per share, making them
more accessible to retail investors.
Disadvantages:
●
Risk: Stocks are subject to a variety of risks, including business and financial risks, purchasing
power risks, market risks, and event risks. These factors can negatively impact a stock's earnings,
dividends, price appreciation, and return.
●
High volatility: Stock returns are highly volatile and difficult to predict, making it difficult to
choose the best performing stocks.
●
Low current earnings: Stocks typically pay out less current earnings than some other
investments, such as bonds.
The main types of risks faced by shareholders:
●
Business risk: The risk that a company will not perform as well as expected.
●
Financial risk: The risk that a company will have difficulty managing its debt.
●
Purchasing power risk: The risk that inflation will erode the value of the investment.
●
Market risk: The risk that the stock market as a whole will decline.

Event risk: The risk that an unexpected event, such as a natural disaster or a change in
government policy, will negatively affect the company.

6.6 What is a stock split? How does a stock split affect the market value of a stock? Do you think
it would make any difference (in terms of price behavior) if the company also changed its
dividend payout ratio? Explain.
A stock split is when a company increases the number of shares outstanding by exchanging a
certain number of new shares for each outstanding share. For example, in a 2-for-1 stock split,
two new shares are exchanged for each old share.
The purpose of a stock split is to make the stock more attractive to investors by lowering the
market price. Typically, the stock price falls roughly in proportion to the split ratio (unless the
split is accompanied by a large increase in the dividend).

For example, a $100 stock would trade at around $50 after a 2-for-1 split.
Changes in dividend ratios can affect behaviorprice after the stock split.

If a company increases its dividend rate along with the stock split, it can support the price and
offset the price drop caused by the stock split.

If a company does not change or reduces its dividend rate, the stock price may fall by more than
the split rate.

6.7 What is a stock split? In very general terms, explain how a stock split works. What value do
these splits have for investors? Explain.
A stock split occurs when a company spins off one of its subsidiaries or divisions. Instead of
selling the subsidiary to another company, the company creates a new, independent company and
then distributes shares in that company to its existing shareholders.

For example, Time Warner spun off its Time Inc. subsidiary in June 2014. Each Time Warner
shareholder received 1 share of Time Inc. newly created (and now publicly traded) for every 8
shares of Time Warner they hold.

A stock allotment is often done if a company believes that a subsidiary is no longer relevant or if
they feel they have become too diversified and want to focus on their core products.

Benefits to Investors: A stock allotment often benefits investors. The newly created company’s
shares may be worth more as part of a more focused company. Additionally, investors have the
opportunity to invest in a new company with independent growth potential.

6.8 Identify and differentiate between the following pairs of terms. a. Treasury stock vs.
classified stock b. Round lot vs. odd lot c. Par value vs. market value d. Book value vs.
investment value
●
a. Treasury Stock vs. Classified Stock
○
Treasury Stock: Stock that has been issued and then repurchased by the issuing company. The
company retains the treasury stock and may use it for various purposes in the future, such as
paying for mergers and acquisitions, satisfying employee stock option plans, or paying stock
dividends.
○
Classified Stock: Different classes of common stock issued by the same company, each of which
gives the holder different privileges and benefits. Classified stock is often used to grant different
voting rights to different groups of investors.
●
b. Round Lot vs. Odd Lot
○
Round Lot: Trading 100 shares or multiples of 100 shares.
○
Odd Lot: Trading fewer than 100 shares.
●
c. Par Value vs. Market Value
○
Par Value: The nominal value assigned to a share of stock when it is first issued. Par value has
nothing to do with the market price of the stock and is usually set very low.
○
Market Value: The current market price of a share, reflecting what investors are willing to pay to
buy the company today.
●
d. Book Value vs. Investment Value
○
Book Value: The shareholder's equity in a company reported on the balance sheet (and
sometimes expressed on a per-share basis). Book value represents the amount of capital that
shareholders contributed to the company when they initially sold the shares, as well as any
profits that have been reinvested in the company over time.
○
Investment Value: The value that investors place on a share of stock, reflecting what they think
the stock should trade for. Determining investment value is a complex process based on the
expected return and risk characteristics of the stock, including potential dividends and capital
gains.
6.9 What is odd-lot spread? How can you avoid odd-lot spreads? Which of the following
transactions would involve odd-lot spreads? a. Buying 90 shares b. Selling 200 shares c. Selling
125 shares
Odd-lot spreads are additional fees that investors pay when buying or selling an odd-lot of stock.
In the past, odd-lot trades required a specialist called an odd-lot trader, who would charge the
odd-lot spread.
Today, electronic trading systems make it easier to process odd-lot trades, so these trades do not
increase transaction costs as much as they did in the past.
To avoid odd-lot spreads, investors should buy or sell stocks in round lots (multiples of 100
shares).
In the transactions provided, transaction (a) buying 90 shares would involve odd lot spread as it
is less than 100 shares.
6.10 How are dividend decisions made? What company and market factors are important in
deciding whether and how much to pay a dividend?
A company's board of directors decides how much to pay as a dividend, usually quarterly, to
share profits with shareholders. In making this decision, they consider a number of company and
market factors.
Company factors:
●
Profitability: Although a company does not necessarily have to be profitable to pay dividends,
profitability is still considered an important factor. The board of directors will look at earnings
per share (EPS) to assess the amount of earnings available to shareholders.
●
Growth prospects: The company needs a portion of its profits to invest and fund future growth.
●
Cash position: The board of directors will ensure that paying dividends will not result in a cash
shortage.
●
Loan agreements: The company may be bound by loan agreements that limit the amount of
dividends it can pay.

Market factors:
●
Investor expectations: Investors expect the company to reinvest retained earnings to achieve
higher growth and returns. If the company cannot reinvest effectively, investors will demand that
profits be distributed through dividends.
●
Investor preferences: Different types of investors are attracted to different types of companies.
Boards of directors must try to meet shareholder dividend expectations. For example, income-
oriented investors are attracted to companies that typically pay high dividends.
●
Institutional investor restrictions: Some institutional investors, such as mutual funds and pension
funds, are only allowed to invest in companies that pay dividends.
6.11 Why is the ex-dividend date important to shareholders? If a share is sold on the ex-dividend
date, who receives the dividend – the buyer or the seller? Explain.

The ex-dividend date is important because it determines who is the official shareholder and
therefore eligible to receive the declared dividend. Anyone who sells shares on or after the ex-
dividend date will receive the dividend. This is because the buyer of the shares (the new
shareholder) will not be holding the shares on the record date.

For example:
If you buy 200 shares on June 15 (before the ex-dividend date of June 16), you will receive a
dividend check sometime after June 30.
If you buy shares on June 16 (the ex-dividend date) or later, the person who sold the shares will
receive the check because they, not you, will be recognized as the stockholder.
6.12 What is the difference between a cash dividend and a stock dividend? Which will be more
valuable to you? How do stock dividends compare to stock splits? Is a 200% stock dividend the
same as a two-for-one stock split? Explain.
Cash dividend: A company pays a dividend by distributing cash to shareholders. This is the most
common type of dividend and tends to increase over time as the company's earnings grow.
Stock Dividends: A company pays a dividend by distributing additional shares. For example, if
the board of directors declares a 10% stock dividend, you will receive 1 new share for every 10
shares you currently own.
Value:
Both cash dividends and stock dividends can be valuable to investors. Cash dividends provide
immediate income, while stock dividends can provide a tax benefit because they are not taxed
until you sell the shares. The value of each type of dividend will depend on the investor’s
individual circumstances and their investment goals.
Comparison to Stock Splits:
Both stock dividends and stock splits increase the number of shares outstanding and reduce the
price of the stock. However, a 200% stock dividend is not the same as a two-for-one stock split.
In the case of a 200% stock dividend, you would receive 2 new shares for each share you
currently own, resulting in a total of 3 shares. Meanwhile, a two-for-one stock split would give
you 1 new share for each share you currently own, resulting in a total of 2 shares.
6.13 What are dividend reinvestment plans and how do they benefit investors? Are there any
disadvantages?
A dividend reinvestment plan (DRIP) allows shareholders to automatically reinvest their cash
dividends into additional shares of the company's common stock.
Benefits:
●
Convenient and inexpensive: Shares in most DRIPs are purchased without paying brokerage
commissions, and most plans allow for partial participation.
●
Buying shares at a discount: Some plans even sell shares to their DRIP investors at a discount to
the market—often at a discount of 3% to 5%.

●
Capital accumulation: DRIPs provide investors with a convenient and inexpensive way to
accumulate capital over time.
Disadvantages:
●
Tax liability: Even though these dividends are in the form of additional shares, you still have to
pay taxes on them as if they were cash dividends in the year they are received.

CHAP 7

7.1 Identify the three main parts of security analysis and explain why security analysis is
important to the stock selection process.

The three main parts of security analysis are:

●
Economic analysis: Assesses the general state of the economy and its potential impact on stock
returns.

●
Industry analysis: Focuses on the operations of one or more industries. Of particular importance
is the competitive position of a particular industry relative to other industries and which
companies within the industry have particular potential.

●
Fundamental analysis: Closely examines the financial and operating characteristics of a company
- its competitive position, its revenue and profit margins, its asset structure, its capital structure,
and finally its future prospects.
Security analysis is important to the stock selection process because it helps investors assess the
intrinsic value (fundamental value) of a stock. By comparing intrinsic value to the current market
price, investors can determine whether a stock is undervalued, fairly valued, or overvalued. The
insights gained from stock analysis allow investors to make more informed stock selection
decisions and increase their chances of success when investing in stocks.
7.2 What is intrinsic value? How does it fit into the stock analysis process?
Intrinsic value is a measure of a stock's fundamental value, determined by considering all aspects
of a business, including tangible and intangible assets. It provides a benchmark to help you judge
whether a particular stock is undervalued, fairly valued, or overvalued.
Intrinsic value fits into the stock analysis process by serving as the goal of the process. The goal
of stock analysis is to determine the intrinsic value of a stock and then compare that value to the
stock's market price. If the intrinsic value is greater than the market price, the analyst will
recommend that the client buy the stock, and when the opposite is true, the analyst may
recommend that the client sell.
7.3 How would you characterize a suitable investment? How does security analysis help identify
investment candidates?
A suitable investment is one that provides an expected return that is commensurate with the level
of risk involved. In other words, the investment should not only be profitable, but it should be
sufficiently profitable—in the sense that you expect it to generate a return high enough to
compensate for the risk.
Security analysis helps identify investment candidates by addressing the question of what to buy
by determining the value of a stock and comparing that value to the market price of the stock.
Suppose an investor will only buy a stock if its current market price does not exceed its value—
its intrinsic value.
7.4 Is Security Analysis Necessary if We Operate in an Efficient Market Environment? Explain.

Even in an efficient market, where securities are priced close to their intrinsic value, security
analysis is still necessary. There are two main reasons for this:

1.
Financial markets are as efficient as they are because a large number of people and financial
institutions invest a lot of time and money in analyzing the fundamentals of most widely held
investments. In other words, markets tend to be efficient, and securities tend to trade at or near
their intrinsic value simply because a lot of people have done the research to determine their
intrinsic value.

2.
Although financial markets are generally quite efficient, they are by no means perfectly efficient.
Pricing errors are inevitable. Those individuals who have done the most thorough research into
the fundamentals of a particular security are most likely to profit when things go wrong.
7.5 Describe the general concept of economic analysis. Is this type of analysis necessary and
does it really help individual investors make decisions about stocks? Explain.

Economic analysis is a general study of the current economic environment, usually on both a
global and domestic basis. The purpose of this analysis is to help investors understand the
underlying state of the economy and its impact on the behavior of stock prices. It may go so far
as to include a detailed examination of each sector of the economy, or it may be done on a very
informal basis. However, from a security analysis perspective, the purpose is always the same: to
establish a solid foundation for valuing common stocks.

Economic analysis is necessary because stock prices are heavily influenced by the state of the
economy and by economic events. As a rule, stock prices tend to rise when the economy is
strong and fall when the economy begins to weaken. The overall performance of the economy
has a significant impact on the performance and profitability of most companies. As the fortunes
of companies change with economic conditions, so do their stock prices.
Economic Analysis
Economic analysis can help individual investors make decisions about stocks by providing them
with a clearer picture of the current and future economic environment. This insight can be used
to identify potential areas for further analysis or to look at specific industries or companies and
ask, “How will they be affected by expected developments in the economy?”
7.6 Why is the business cycle important to economic analysis? How does the business cycle
affect the stock market?
The business cycle is important to economic analysis because it reflects changes in overall
economic activity over time. The business cycle consists of a series of alternating periods of
contraction and expansion, which affect the performance and profitability of most companies.
The business cycle affects the stock market. Stock prices tend to fall in the early stages of a
recession and tend to recover sometime before the economy recovers. This is because investors
tend to look ahead when buying or selling stocks. If their perceptions of the future change, stock
prices are likely to change as well. Therefore, tracking the performance of stock prices as well as
the performance of the economy as a whole can help make more accurate investment forecasts.
7.7 Briefly describe each of the following: a. Gross Domestic Product b. Leading Indicators c.
Money Supply d. Producer Prices
●
a. Gross Domestic Product (GDP): This is the broadest measure of economic performance. GDP
is an estimate of the total dollar value of all goods and services produced in a country over a
given period of time.
●
b. Leading Indicators: These are statistics that tend to predict—or “lead”—changes in GDP. For
example, some leading indicators include the average weekly hours worked by manufacturing
employees, weekly initial jobless claims, stock prices, and consumer expectations.
●
c. Money Supply: The amount of money in circulation reported weekly by the Federal Reserve is
called the money supply. M2, the most widely followed measure, is equal to M1 plus savings
deposits, money market deposit accounts, and money market mutual funds.
●
d. Producer Prices: The Producer Price Index (PPI) shows the change in the price of goods at
different stages of production. For example, it measures the changing price of raw materials such
as raw cotton to finished goods such as clothing and furniture.
7.8 How Does Inflation Affect Common Stocks?
Inflation has an adverse effect on stock prices when inflation is high. High inflation leads to
higher interest rates and lower price-to-earnings multiples, and generally makes equity securities
less attractive.
7.9 What is industry analysis and why is it important?
Industry analysis is the second step in the top-down approach. It looks at the overall outlook for a
particular industry in which a company operates and how companies compete in that industry.
Industry analysis is important because it helps investors assess the riskiness of a company and
therefore determine the appropriate risk-adjusted rate of return to use in valuing the company's
stock. Additionally, industry analysis also helps investors assess the riskiness of a company and
therefore determine the appropriate risk-adjusted rate of return to use in valuing the company's
stock.
7.10 Identify and briefly discuss some aspects of an industry that are important to its behavior
and operating characteristics. Note in particular how economic issues fit into industry analysis.

Some aspects of an industry that are important to its behavior and operating characteristics
include:
●
Nature of the industry: Is the industry a monopoly or is there a large number of competitors?

●
Regulation: Is the industry regulated? If so, how and by what agency?

●
Role of labor: Are labor unions important? Are there good labor relations in the industry?
●
Technological developments: What new developments are taking place?
●
Economic forces: Is the demand for the industry's goods and services related to key economic
variables? Is foreign competition important to the health of the industry?
●
Financial and operational considerations: Is there an adequate supply of labor, materials, and
capital? What are the industry's capital expenditure plans and needs?
Economic considerations are relevant to industry analysis because the outlook for an industry is
influenced by the overall economic outlook. For example, if the economy is expected to be
strong, the outlook for economically sensitive industries such as automobile manufacturing is
likely to be favorable. On the other hand, if the economy is expected to be weak, the outlook for
defensive industries such as consumer staples is likely to be more favorable.
7.11 What are the four stages of an industry growth cycle? Which stage is most profitable for
investors? Which stage is most affected by economic factors?
The four stages of an industry growth cycle reflect the vitality of the industry over time:
1.
Early growth stage: This stage is new and unproven, the risk is very high, and the investment
opportunity is usually not available to most investors.
2.
Rapid expansion stage: This stage marks increasingly widespread product acceptance, investors
can see the future of the industry more clearly, and economic and financial variables have little
impact on the overall performance of the industry. This is the stage that brings the most profits to
investors, as they will be interested in investing regardless of the economic environment.
3.
Mature Growth Stage: This stage is most influenced by economic developments, with expansion
coming from economic growth, creating a slower overall growth source than in stage two. The
long-term nature of the industry becomes apparent, including defensive industries such as food
and apparel, and cyclical industries such as automobiles and heavy equipment.
4.
Stabilization or Decline Stage: The decline stage marks a gradual decline in demand for the
industry's products, companies exiting the industry, and investment opportunities are virtually
non-existent unless you are looking solely for dividend income. Growth-oriented investors will
want to stay away from industries in the decline phase of the cycle, while other investors may
find some investment opportunities if the industry (such as tobacco) is locked in a mature, stable
stage.
7.12 What is fundamental analysis? Does a company's performance affect the value of its stock?
Explanation.
Fundamental analysis is the study of a company's financial condition with the aim of
understanding the company that issued the common stock. Fundamental analysis is based on the
belief that the value of a stock is influenced by the performance of the company that issued the
stock.
If the company's prospects look good, the market price of the stock is likely to reflect that and be
pushed up. Conversely, if the company is performing poorly, the stock price is likely to fall.
Therefore, the performance of the company has a direct impact on the value of its stock.
Fundamental analysis captures the risk and return aspects and incorporates them into the
valuation process, starting with a historical analysis of the company's financial strength, known
as the company analysis stage. Using the insights gained, along with economic and industry
analysis, investors can make predictions about the company's growth and profitability.
7.13 Why do investors bother looking at a company's historical performance when future
behavior is what really matters? Explain.

Although future behavior is the most important factor in stock value, investors still look at a
company's historical performance for a number of reasons:

●
Understanding the business: Past performance provides insight into how a company operates,
how management makes decisions, and how the company responds to different market
conditions.

●
Identifying trends: Analyzing historical data helps investors identify trends in revenue, profits,
and other key financial metrics.

●
Assessing risk: Past performance can be an indicator of a company's risk level. For example, a
company with a history of high earnings volatility may be riskier than a company with stable
earnings.

●
Forecasting future performance: Although past performance is no guarantee of future results, it
can provide a basis for making predictions. By examining past performance, investors can
identify factors that are likely to influence a company's future performance.
7.14 What is ratio analysis? Describe the contribution of ratio analysis to the study of a
company's financial condition and performance.
Ratio analysis is the study of the relationships between different accounts in a financial
statement, with the aim of expanding the information content of a company's financial
statements. Each ratio relates one balance sheet (or income statement) item to another, usually a
balance sheet account to an operating item (income statement). This allows investors to consider
not only the absolute size of financial statement accounts but also their implications for the
company's liquidity, operations, or profitability.
Ratio analysis contributes to the study of a company's financial condition and performance by:

Providing insights into operating performance: Ratio analysis helps investors assess how
effectively a company manages assets, controls costs, and generates profits.

Comparing to benchmarks: Investors can use ratio analysis to compare a company's performance
to its own historical benchmarks or to benchmarks that are industry aggregates.
Identify strengths and weaknesses: Ratio analysis can help investors identify a company's
strengths and weaknesses, thereby making better investment decisions.

7.15 Compare historical performance standards with industry standards. Briefly note the role of
each standard in analyzing a company's financial condition and operating results.
To evaluate financial ratios accurately, investors use two types of performance standards:
historical and industry.

●
Historical standards: Financial ratios and other figures calculated for a company over a period of
three to five years (or longer). This allows investors to assess developing trends in the company's
operations and financial condition, determine whether they are improving or deteriorating, and
where the company's strengths and weaknesses lie.
●
Industry Benchmark: This benchmark allows investors to compare a company's financial ratios
with similar companies or with the average results of the entire industry. This helps investors
determine the company's relative strengths compared to its competitors.
CHAP 8
8.1 What is the purpose of stock valuation? What role does intrinsic value play in stock
valuation?
The basic purpose of stock valuation is to obtain an estimate of the intrinsic value of a stock,
allowing investors to assess whether the stock is undervalued or overvalued. Investors attempt to
resolve the question of whether a stock is undervalued or overvalued by comparing its current
market price with its intrinsic value.
Intrinsic value, based on expected returns and risk, is the value that a stock should have. This
intrinsic value acts as a performance benchmark based on the stock's predicted behavior, which is
used to evaluate the investment potential of a particular security.
The price of a stock at any given time depends on investors' expectations of the company's future
performance. Therefore, stock valuation involves using historical data to predict important
financial variables in the future.
8.2 Are the company's expected future earnings important in determining the investment value of
its stock? Discuss how these and other estimates of the future fit into the stock valuation
framework.
The company's expected future earnings are important in determining the investment value of its
stock. The main reason for looking at past performance is to gain insight into the company's
future direction. While past performance is no guarantee of what the future holds, it can provide
a good idea of the company's strengths and weaknesses.
To value a stock, investors must determine several key inputs, including:
●
Amount of future cash flows: Based on the company's earnings forecast, investors need to
estimate the future dividend payout ratio, the number of common shares outstanding during the
forecast period, and the future price-to-earnings (P/E) ratio.
●
Timing of these cash flows: The timing of future dividends and sales of shares affects the present
value of the cash flows.
●
Required rate of return on the investment: The required rate of return is determined based on the
riskiness of the stock, using the Capital Asset Pricing Model (CAPM).
All of these factors are combined in various stock valuation models, such as the dividend
valuation model (DVM) and the free cash flow to equity method, to determine the intrinsic value
of the stock.
8.3 Can a company's growth prospects affect its price-to-earnings (P/E) ratio? Explain. What
about the amount of debt a company uses? Are there other variables that affect a company's P/E
level?

A company's growth prospects can certainly affect its P/E ratio. Generally speaking, higher P/E
ratios are associated with higher earnings growth, more optimistic market outlooks, and lower
debt levels (less debt means lower financial risk).

The amount of debt a company uses also affects its P/E ratio. Higher debt increases a company's
financial risk, causing investors to demand a higher rate of return and thus lowering the P/E ratio.
In addition to growth prospects and debt levels, several other variables can affect a company's
P/E ratio:
●
General market conditions: In a bull market, investors are willing to pay more for each dollar of
earnings, resulting in a higher P/E ratio.

●
Current and expected inflation rates: Inflation affects the P/E ratio in a complex way. Rising
inflation typically leads to rising bond yields. When bond yields rise, investors demand higher
stock returns because stocks are riskier than bonds. Future stock returns may increase if a
company earns higher profits and pays higher dividends, but if earnings and profits remain the
same, investors will only earn higher future returns if the stock price is lower today. Therefore,
inflation typically puts downward pressure on the P/E ratio.

●
Dividend level: Holding all other factors constant, a higher dividend payout ratio leads to a
higher P/E ratio. However, in reality, most companies with high P/E ratios have low dividend
payout ratios because companies with rapid growth opportunities tend to reinvest most of their
earnings.

8.4 What is a market multiple and how can it help in evaluating a stock's P/E ratio? Is a stock's
relative P/E the same as its market multiple? Explain.

A market multiple is the average P/E ratio of all stocks in a given market index, such as the S&P
500 or DJIA. It indicates the overall state of the market, indicating how aggressively the market,
as a whole, is pricing the stock.
A market multiple can help evaluate a stock's P/E ratio by providing a benchmark for
comparison. By comparing a stock's P/E ratio to the market multiple, investors can get an idea of
whether the stock is overvalued or undervalued relative to its market value. the market in
general.

A stock's relative P/E is not the same as its market multiple. Relative P/E is calculated by
dividing the stock's P/E by its market multiple. It shows how aggressively the stock has been
priced in the market relative to the average market multiple.
8.5 In the context of stock valuation, how can you tell whether a particular security is a
worthwhile investment candidate? What role does the required rate of return play in this process?
Would you invest in a stock if all you could earn was a rate of return equal to your required rate
of return? Explain.

In the context of stock valuation, a security is considered a worthwhile investment candidate if:

●
The expected rate of return equals or exceeds the rate of return considered reasonable for the risk
level of the stock.

●
The fair price (intrinsic value) is equal to or greater than the current market price.
The required rate of return plays an important role in this process by establishing a compensation
that is appropriate to the amount of risk involved. A higher required rate of return indicates
higher risk and therefore a higher expected return is needed for the security to be considered a
viable investment.
You should not invest in a stock if all you can earn is a return equal to your required rate of
return. This is because, while the security appears to meet the minimum standards, it does not
provide any return that is more than enough to compensate you for the risk you take.
The goal of investing is to maximize returns while minimizing risk. Therefore, you should look
for investments that have the potential to provide returns in excess of your required rate of
return, which will compensate you for the risk you take and increase your chances of financial
success.
8.6 Briefly describe the dividend valuation model and its three versions. Explain how the CAPM
fits into the DVM.
The dividend valuation model (DVM) is based on the principle that the intrinsic value of any
investment is equal to the present value of its expected cash flow benefits. For common stocks,
this is equivalent to the cash dividends received each year plus the future selling price of the
stock. According to the DVM, the value of a stock is equal to the present value of all future
dividends it is expected to provide over an infinite period of time.
The DVM has three versions, each based on different assumptions about the future growth rate
of dividends:
1.
No-growth model: It assumes that dividends will not increase over time. The value of a no-
growth stock is calculated simply by dividing the annual dividend by the required rate of return.
2.
Constant growth model: Assumes that dividends will grow at a constant rate over time. The value
of a constant growth stock is calculated by dividing the next year's expected dividend by the
difference between the required rate of return and the dividend growth rate.

3.
Variable growth model: Assumes that the dividend growth rate will change over time. This model
calculates the stock price in two stages:

First stage: Dividends grow rapidly, but not necessarily at a single rate.

Second stage: The firm matures and the dividend growth rate stabilizes at a long-term,
sustainable level. At this point, the stock can be valued using the constant growth version of the
DVM.

The CAPM fits the DVM by providing the required rate of return (r) used in the model. The
CAPM looks at the riskiness of a stock, represented by its beta (β), to determine the rate of return
that an investor should require on that stock. This required rate of return is then used in the DVM
to discount future dividends to their present value, allowing the intrinsic value of the stock to be
calculated.

8.7 What is the difference between the variable growth dividend valuation model and the free
cash flow to equity method? Which process would work better if you were trying to value a
growth stock that pays little or no dividends? Explain.
The variable growth dividend valuation model (VGDVM) and the free cash flow to equity
(FCFE) method are both current valuation models, but they differ in their approach to valuation:
●
The VGDVM focuses on dividends as the primary cash flow to the investor. It calculates the
value of a stock by discounting the expected future dividend stream to its present value, taking
into account the growth rate of dividends that may change over time.
●
FCFE focuses on the free cash flow that a company generates for its common shareholders,
regardless of whether it pays dividends. It estimates the cash flows that a company generates
over time for its shareholders and discounts those cash flows back to the present to determine the
total value of the company's equity.
The FCFE method works better for valuing growth stocks that pay little or no dividends.
For growth companies, especially those in their early stages, a growth cycle, it is common to
reinvest earnings back into the business to fuel future growth. Therefore, they may pay little or
no dividends. In these cases, VGDVM would not be appropriate because it relies on dividends as
its primary input.
FCFE is a better choice because it focuses on the free cash flow generated for shareholders,
regardless of whether the company pays dividends or not. It captures the growth potential of the
company by looking at the cash flow available for reinvestment or distribution to shareholders in
the future.
8.8 How would you find out the expected rate of return of a stock? Note how such information
would be used in the stock selection process.
To find out the expected rate of return of a stock, you can use the IRR (Internal Rate of Return)
method. This method involves finding the discount rate that makes the present value of the
company's future free cash flows to equity (or its future dividends if the company pays
dividends) equal to the current market value of the company's common stock.

To estimate the expected rate of return, you can follow these steps:

1.
Forecast future free cash flows to equity (or dividends): Use appropriate forecasting techniques,
such as the variable growth model, to estimate the company's future cash flows.

2.
Determine the current market price of the stock: Consult the current market price of the stock
from reliable sources.

3.
Use trial and error to find the IRR: Using a spreadsheet or financial calculator, try different
discount rates until you find the rate that makes the present value of the future cash flows equal
to the current market price. This discount rate is the IRR, which represents the expected rate of
return on the stock.

Once the expected rate of return on the stock has been estimated, the investor will decide
whether that rate of return is sufficient to justify purchasing the stock, based on its level of risk.

Information about the expected rate of return is used in the stock selection process by comparing
it to the investor's required rate of return. If the expected rate of return equals or exceeds the
required rate of return, the stock may be considered a viable investment. Conversely, if the
expected rate of return is lower than the required rate of return, the investor may want to avoid
the stock because it does not adequately compensate for the risk involved.
8.8 How to find the expected rate of return on a stock? Note how this information is used in the
stock selection process.
To find the expected rate of return on a stock, an investor can use trial and error to find the
discount rate that makes the present value of the company's future free cash flows equal to the
current market value of the company's common stock. In other words, the investor needs to find
the discount rate "r" so that the following equation holds:
PV = FCF1/(1+r) + FCF2/(1+r)^2 + ... + FCFn/(1+r)^n
Where:
●
PV is the current market value of the company's common stock
●
FCF1, FCF2, ..., FCFn are the company's future free cash flows in years 1, 2, ..., n
After estimating the expected rate of return on the stock, the investor will decide whether that
return is sufficient to justify buying the stock, based on the stock's risk level.
For example, suppose a company has a current stock price of $12 per share and its future free
cash flows are expected to be as follows:
●
2016: $2,832,000
●
2017: $3,115,200
●
2018 onwards: 2% growth per year
Using trial and error, we find a discount rate of "r" of approximately 8.34%. This means that,
based on the company's cash flow forecast and the current stock price, the expected rate of return
is 8.34%. If an investor believes that the stock should return 9% based on its risk level, they
would not consider the stock an attractive investment at the market price of $12 per share.
8.10 Briefly describe the price-to-earnings ratio and explain how it is used to value a stock. Why
not just use the P/E ratio? How is the P/S ratio different from the P/BV metric?
P/S Ratio
The P/S ratio, also known as the price-to-earnings ratio, is calculated by dividing the market
price of a stock by its earnings per share. This ratio tells you how much investors are willing to
pay for each dollar of the company's earnings.
The P/S ratio is often used to value high-tech startups that are not yet profitable or have highly
volatile earnings. In these cases, valuation methods based on earnings or cash flow are not
appropriate.
Many investors look for stocks with a P/S ratio of 2.0 or less, believing that these stocks have the
potential to increase in price in the future. Extremely low P/S ratios, of 1.0 or less, are
particularly attractive.
Why not just use the P/E ratio?
The P/E ratio is only appropriate for companies that are already profitable. For companies that
are not yet profitable or have highly volatile profits, the P/S ratio is a better alternative.
Comparing P/S and P/BV
The P/BV ratio, also known as the price-to-book value ratio, is calculated by dividing the market
price of a stock by the book value per share. This ratio shows how much investors are willing to
pay for each dollar of the company's book value.
Both the P/S and P/BV ratios are relative valuation metrics, but the P/S ratio focuses on revenue,
while the P/BV ratio focuses on book value. Revenue is a measure of a company's current
performance, while book value is a measure of the company's net asset value.
Depending on the industry and stage of development of the company, investors can choose a
more suitable ratio to value the stock.
8.9 Briefly describe the P/E method for valuing stocks and note how this approach differs from
the variable growth DVM. Describe the P/CF method and note how it is used in the stock
valuation process. Compare the P/CF method with the P/E method, noting the relative strengths
and weaknesses of each method.
P/E Method
The P/E method, also known as the price-to-earnings ratio method, is one of the most popular
stock valuation methods used by professional securities analysts. Its main advantages are its
simplicity and ease of use.
This method is based on the standard P/E formula:
P/E = Market Price of Stock / Earnings Per Share (EPS)
To use the P/E method, investors need to estimate expected EPS for the coming year and
determine the appropriate P/E ratio for the stock based on factors such as:
●
Expected earnings growth rate
●
Potential changes in the company's capital structure or dividends
●
Relative market or industry P/E ratio
Once the P/E ratio is determined, investors can calculate the price the stock should be trading at
by multiplying the expected EPS by the P/E ratio. By comparing this target price to the current
market price of the stock, investors can decide whether the stock is a good investment.
P/CF Method
The P/CF method, also known as the price-to-cash-flow method, is similar to the P/E method,
but uses cash flow instead of earnings to value a stock. This method is favored by investors who
believe that cash flow provides a more accurate picture of a company's true value than net
income.
The most commonly used cash flow in this method is EBITDA (earnings before interest, taxes,
depreciation, and amortization), which represents "cash income before taxes." The P/CF ratio is
calculated as follows:
P/CF = Market Price of Stock / Cash Flow per Share
To use the P/CF method, investors need to forecast cash flow per share for the coming year and
determine an appropriate P/CF ratio. They can then multiply the P/CF ratio by the projected cash
flow to find the price the stock should trade at.
So sánh P/CF và P/E

Phương
Điểm mạnh Điểm yếu
pháp

Vulnerable to manipulation by
P/E Simple, easy to use
accounting techniques

Provides a more accurate picture of the More difficult to determine appropriate

P/CF
company's true value cash flows

The P/E method is susceptible to manipulation by accounting techniques, while the P/CF method
is more difficult to determine the appropriate cash flow. Depending on the specific situation,
investors may choose the more appropriate method to value a stock.
Comparison with the Variable Growth DVM Model
Both the P/E and P/CF methods are relative valuation methods, based on comparisons to other
companies in the industry or market. In contrast, the Variable Growth DVM model is an absolute
valuation method, based on forecasting the company's future cash flows.
The P/E and P/CF methods are simpler and easier to use than the Variable Growth DVM model,
but they are also less accurate. The Variable Growth DVM model requires forecasting future cash
flows, which can be difficult and prone to error.