INTRODUCTION TO INVESTMENT AND SECURITY ANALYSIS

Compiled by: KADRA ISMAIL MOHAMED

1
Preface
This compilation has initiated as learning source for bachelor of business
administration in university of Djibouti. This compilation consist of six chapters,
which are a foundation of investment and securities analysis. I will illustrate the
investment concepts and recent trend of stock, bond and derivative markets.

I have used three books to produce this investment manual:

Fundamental of investment and valuation management 15 th edition by Bradford D.

jardan/ Thomas W. Miller, jr

Investment and portfolio management 10 Eedition By Reilly & Brown

2
 Table of content
CHAPTERS PAGE NUMBERS
Introduction to investment 4-10
Organization and Functioning of Securities 11-16
Markets

Common stock valuation 17-24

Stock Price Behavior & Market Efficiency 25-30
Bond Valuation 31-39
Portfolio analysis 40-47

3
 Chapter one
1.1 What is investment?
Investment is the current commitment of dollars for a period in order to derive
future payments that will compensate the investor for (1) the time the funds are
committed, (2) the expected rate of inflation during this time, and (3) the
uncertainty of the future payments. The “investor” can be an individual, a
government, a pension fund, or a corporation. The investors intend to make a
return and minimize the likelihood of risk. There are methods to measure the risk
and return that associate with given investment opportunity. The following section
we will elaborate the measurement of risk and return.

1.2 MEASURES OF RETURN AND RISK

To select among alternatives we should consider the trade-off between expected

risk and return. Therefore, you must understand how to measure the rate of return
and the risk involved in an investment accurately. To do so we consider historical
measures of return and risk. The first measure is the historical rate of return on an
individual investment that is, its holding period. Next, we consider how to measure
the average historical rate of return for an individual investment over a number of
times. The third subsection considers the average rate of return for a portfolio of
investments

1.2.1 Measures of Historical Rates of Return

When we invest, we defer current consumption in order to add to our wealth so

that we can consume more in the future. Therefore, when we talk about a return on

4
 an investment, we are concerned with the change in wealth resulting from this
investment. This change in wealth either can be due to cash inflows, such as
interest or dividends, or caused by a change in the price of the asset (positive or
negative). We call it holding period return. (HPR)

1.1 Formula of holding period return

HPR = Ending Value of Investment/ Beginning

Value of Investment

For example, if you commit $200 to an investment at the beginning of the year
and you get back $220 at the end of the year, what is your return for the period?

HPR= 200/220= 1.10

This HPR value will always be zero or greater—that is, it can never be a negative
value. A value greater than 1.0 reflects an increase in your wealth, which means
that you received a positive rate of return during the period. A value less than 1.0
means that you suffered a decline in wealth, which indicates that you had a
negative return during the period. An HPR of zero indicates that you lost all your
money (wealth) invested in this asset.

Although HPR helps us express the change in value of an investment, investors

generally evaluate returns in percentage terms on an annual basis. This conversion
to annual percentage rates makes it easier to compare alternative investments that
have markedly different characteristics. The first step in converting an HPR to an
annual percentage rate is to derive a percentage return, referred to as the holding
period yield (HPY). The HPY is equal to the HPR minus 1. We also need to
calculate the annual HPR

1.2: HPY = HPR – 1

1.3: Annual HPR = HPR^1/n * n: it is the number of the years

5
1.2.2 Computing Mean Historical Returns

Now that we have calculated the HPY for a single investment for a single year, we
want to consider mean rates of return for a single investment and for a portfolio of
investments. Over a number of years, a single investment will likely give high rates
of return during some years and low rates of return, or possibly negative rates of
return, during others.

Single Investment Given a set of annual rates of return (HPYs) for an individual
investment, there are two summary measures of return performance. The first is the
arithmetic mean return, the second is the geometric mean return. To find the
arithmetic mean (AM), the sum (Σ) of annual HPYs is divided by the number of
years (n) as follows:

1.4 AM = ΣHPY/n

An alternative computation, the geometric mean (GM), is the nth root of the
product of the HPRs for n years minus one.

1.4.1 GM = [ πHPR]^1/n – 1

π = the product of the annual holding period returns as follows: (HPR1)×(HPR2)...

(HPRn)

To illustrate these alternatives, consider an investment with the following data:

YEARS BEGINNING ENDING HPR HPY

1 100.0 115.0 1.15 0.15
2 115.0 138.0 1.2 0.2
3 138.0 110.4 0.8 -0.2
AM= 5%

GM= 0.03353=3:353%

6
Investors are typically concerned with long-term performance when comparing
alternative investments. GM is considered a superior measure of the long-term
mean rate of return because it indicates the compound annual rate of return based
on the ending value of the investment versus its beginning value.

A Portfolio of Investments: The mean historical rate of return (HPY) for a

portfolio of investments is measured as the weighted average of the HPYs for the
individual investments in the portfolio, or the overall percent change in value of
the original portfolio. The weights used in computing the averages are the relative
beginning market values for each investment; this is referred to as dollar-weighted
or value-weighted mean rate of return.

Calculating Expected Rates of Return

Risk is the uncertainty that an investment will earn its expected rate of return. In
the examples in the prior section, we examined realized historical rates of return. In
contrast, an investor who is evaluating a future investment alternative expects or
anticipates a certain rate of return. An investor determines how certain the
expected rate of return on an investment is by analyzing estimates of possible
returns. To do this, the investor assigns probability values to all possible returns.
These probability values range from zero, which means no chance of the return, to
one, which indicates complete certainty that the investment will provide the
specified rate of return.
n

∑ ¿( probability return)×( possible return)

I=1

E (Ri)= ( P1 )(R1)+ ( P2 )(R2)+ ( P3 )(R3)+(Pn)(Rn)

1.2.4 Measuring the Risk of Expected Rates of Return

These statistical measures allow you to compare the return and risk measures for
alternative investments directly. Two possible measures of risk (uncertainty) have
received support in theoretical work on portfolio theory: the variance and the
standard deviation of the estimated distribution of expected returns.

7
 n

Variance σ = 2
∑ ¿ probability × ( possible return−expected return)2
i=1

Variance The larger the variance for an expected rate of return, the greater the
dispersion of expected returns and the greater the uncertainty, or risk, of the
investment.

Standard Deviation The standard deviation is the square root of the variance:

√∑
n
2
STD= ¿ p ( Ri−E ( ri ) )
i=1

1.2.5 Risk Measures for Historical Returns

To measure the risk for a series of historical rates of returns, we use the same
measures as for expected returns (variance and standard deviation) except that we
consider the historical holding period yields (HPYs) as follows:
n

σ = ∑ ¿ [ HPYi−E ( HPY ) ] /n
2
2
i=1

σ2 =the variance of the series

HPYi =the holding period yield during period i

E(HPYi)=the expected value of the holding period yield that is equal to the arithmetic mean of
the series

n=the number of observations

DETERMINANTS OF REQUIRED RATES OF RETURN

In this section, we continue our discussion of factors that you must consider when selecting
securities for an investment portfolio. You will recall that this selection process involves finding
securities that provide a rate of return that compensates you for: (1) the time value of money
during the period of investment, (2) the expected rate of inflation during the period, and (3) the
risk involved. The summation of these three components is called the required rate of return.
This is the minimum rate of return that you should accept from an investment to compensate you
for deferring consumption. However, the analysis and estimation of the required rate of return
are influenced by the behavior of market rates over time. First, a wide range of rates is available

8
for alternative investments at any time. Second, the rates of return on specific assets change
dramatically over time. Third, the difference between the rates available (that is, the spread) on
different assets changes over time.

1.3.1 The Real Risk-Free Rate The real risk-free rate (RRFR) is the basic interest rate,
assuming no inflation and no uncertainty about future flows. An investor in an inflation-free
economy who knew with certainty what cash flows he or she would receive at what time would
demand the RRFR on an investment. This RRFR of interest is the price charged for the risk-free
exchange between current goods and future goods.

1.3.2 Factors Influencing the Nominal Risk-Free Rate (NRFR)

investor would be willing to forgo current consumption in order to increase future consumption
at a rate of exchange called the risk-free rate of interest. This rate of exchange was measured in
real terms because we assume that investors want to increase the consumption of actual goods
and services rather than consuming the same amount that had come to cost more money.
Therefore, we need to differentiate between real rates of interest that adjust for changes in the
general price level, as opposed to nominal rates of interest that are stated in money terms.so
investors expected the price level to increase (an increase in the inflation rate). Therefore, an
investor’s nominal required rate of return on a risk-free investment should be:

 1.32 NRFR = [(1 + RRFR) × (1 + Expected Rate of Inflation)] – 1

Rearranging the formula, you can calculate the RRFR of return on an investment as follows:

1.3.1 . RRFR= {(1+NRFR of Return/ 1+ Rate of Inflation)}-1

For example, assume that the nominal return on U.S. government T-bills was 9 percent during a
given year, when the rate of inflation was 5 percent. In this instance, the RRFR of return on these
T-bills was 3.8 percent, as follows:

RRFR= {(1+0.09/1+0.06)}-1

= 1.038-1= 0.038

9
 TURTORIAL

1. On February 1, you bought 100 shares of stock in the Francesca Corporation for $34 a share
and a year later you sold it for $39 a share. During the year, you received a cash dividend of
$1.50 a share. Compute your HPR and HPY on this Francesca stock investment.

2. On August 15, you purchased 100 shares of stock in the Cara Cotton Company at $65 a share
and a year later you sold it for $61 a share. During the year, you received dividends of $3 a
share. Compute your HPR and HPY on your investment in Cara Cotton.

3. At the beginning of last year, you invested $4,000 in 80 shares of the Chang Corporation.
During the year, Chang paid dividends of $5 per share. At the end of the year, you sold the 80
shares for $59 a share. Compute your total HPY on these shares and indicate how much was due
to the price change and how much was due to the dividend income.

4. The rates of return computed in Problems 1, 2, and 3 are nominal rates of return. Assuming
that the rate of inflation during the year was 4 percent, compute the real rates of return on these
investments. Compute the real rates of return if the rate of inflation was 8 percent.

5. Discuss the overall purpose people have for investing. Define investment.

6. as a student, are you saving or borrowing? Why?

7. Discuss why you would expect the saving-borrowing pattern to differ by occupation (for
example, for a doctor versus a plumber).

10
 CHAPTER TWO
Organization and Functioning of Securities Markets

WHAT ISAMARKET?

A market is the means through which buyers and sellers are brought together to aid in the
transfer of goods and/or services. Several aspects of this general definition seem worthy of
emphasis. First, a market need not have a physical location. It is only necessary that the buyers
and sellers can communicate regarding the relevant aspects of the transaction. Second, the
market does not necessarily own the goods or services involved. The important criterion for a
good market is the smooth, cheap transfer of goods and services. Those who establish and
administer the market do not own the assets but simply provide a system that allows potential
buyers and sellers to interact. They help the market function by providing information and
facilities to aid in the transfer of ownership. Finally, a market can deal in any variety of goods
and services. For any commodity or service with a diverse clientele, a market should evolve to
aid in the transfer of that commodity or service. Both buyers and sellers benefit from the
existence of a market.

Characteristics of a Good Market

One attribute of a good market is timely and accurate information on past transactions and
prevailing buy and sell orders. Another prime requirement is liquidity, the ability to buy or sell
an asset quickly and at a known price—that is, a price not substantially different from the prices
for prior transactions, assuming no new information is available. An asset’s likelihood of being
sold quickly, sometimes referred to as its marketability, is a necessary, but not a sufficient,
condition for liquidity. The expected price should also be fairly certain, based on the recent
history of transaction prices and current bid-ask quotes. A component of liquidity is price
continuity, which means that prices do not change much from one transaction to the next unless
substantial new information becomes available. Another factor contributing to a good market is
the transaction cost. Lower costs (as a percent of the value of the trade) make for a more
efficient market. Lastly, Prices that rapidly adjust to new information, so the prevailing price is
fair since it reflects all available information regarding the asset.

11
Organization of the Securities Market

Before we discuss the specific operation of the securities market, we need to understand its
overall organization. The principal distinction is between primary markets, where new securities
are sold, and secondary markets.

PRIMARY CAPITAL MARKETS

The primary market is where new issues of bonds, preferred stock, or common stock are sold by
government units, municipalities, or companies who want to acquire new capital.

Government Bond Issues U.S.

government bond issues are subdivided into three segments based on their original maturities.
Treasury bills are negotiable, non-interest-bearing securities with original maturities of one year
or less. Treasury notes have original maturities of 2 to 10 years. Finally, Treasury bonds have
original maturities of more than 10 years.

Municipal Bond Issues

New municipal bond issues are sold by one of three methods: competitive bid, negotiation, or
private placement. Competitive bid sales typically involve sealed bids. The bond issue is sold to
the bidding syndicate of underwriters that submits the bid with the lowest interest cost in
accordance with the stipulations set forth by the issuer. Negotiated sales involve contractual
arrangements between underwriters and issuers wherein the underwriter helps the issuer prepare
the bond issue and set the price and has the exclusive right to sell the issue. Private placements
involve the sale of a bond issue by the issuer directly to an investor or a small group of investors
(usually institutions).

SECONDARY FINANCIAL MARKETS

Secondary markets permit trading in outstanding issues; that is, stocks or bonds already sold to
the public are traded between current and potential owners. The proceeds from a sale in the
secondary market do not go to the issuing unit (the government, municipality, or company), but
rather to the current owner of the security.

Why Secondary Markets Are Important

Because the secondary market involves the trading of securities initially sold in the primary
market, it provides liquidity to the individuals who acquired these securities. The point is, after

12
acquiring securities in the primary market, investors may want to sell them again to acquire other
securities, buy a house, or go on a vacation.

Secondary markets are also important to those selling seasoned securities because the prevailing
market price of the securities (price discovery) is determined by transactions in the secondary
market. New issues of outstanding stocks or bonds to be sold in the primary market are based on
prices and yields in the secondary market. Notably, the secondary market also affects market
efficiency and price volatility.

Secondary Bond Markets

The secondary market for bonds distinguishes among those issued by the federal government,
municipalities, or corporations.

Secondary Markets for U.S. Government and Municipal Bonds

U.S. government bonds are traded by bond dealers that specialize in either Treasury bonds or
agency bonds. Treasury issues are bought or sold through a set of 35 primary dealers, including
large banks in New York and Chicago and some large investment banking firms like Goldman
Sachs and Morgan Stanley.

Secondary Corporate Bond Markets

Currently, all corporate bonds are traded over the counter by dealers who buy and sell for their
own accounts. The major bond dealers are the large investment banking firms that underwrite the
issues: firms such as Goldman Sachs, J.P. Morgan, Barclay Capital, and Morgan Stanley.
Because of the limited trading in corporate bonds compared to the fairly active trading in
government bonds, corporate bond dealers do not carry extensive inventories of specific issues

ALTERNATIVE TYPES OF ORDERS AVAILABLE

MARKET ORDER

The most frequent type of order is a market order, an order to buy or sell a stock at the best
current price. An investor who enters a market sell order indicates a willingness to sell
immediately at the highest bid available at the time the order reaches an exchange.

Limit Orders

The individual placing a limit order specifies the buy or sell price. You might submit a limit
order bid t opurchase100 shares of Coca-Cola (KO)stock at $60a share when the current market
is 65 bid–65.10 ask, with the expectation that the stock will decline to $60 in the near future

13
Special Orders

In addition to these general orders, there are several special types of orders. A stop loss order is a
conditional market order whereby the investor directs the sale of a stock if it drops to a given
price. Assume you buy a stock at $50 and expect it to go up. If you are wrong, you want to limit
your losses. To protect yourself, you could put in a stop loss order at $45.

Margin Transactions

When investors buy stock, they can pay for the stock with cash or borrow part of the cost,
leveraging the transaction. Leverage is accomplished by buying on margin, which means the
investor pays for the stock with some cash and borrows the rest through the broker, putting up
the stock for collateral. After the initial purchase, changes in the market price of the stock will
cause changes in the investor’s equity, which is equal to the market value of the collateral stock
minus the amount borrowed. Obviously, if the stock price increases, the investor’s equity as a
proportion of the total market value of the stock increases

Assume you acquired 200 shares of a $50 stock for a total cost of $10,000. A 50 percent initial
margin requirement allowed you to borrow $5,000, making your initial equity $5,000. If the
stock price increases by 20 percent to $60 a share, the total market value of your position is
$12,000, and your equity is now $7,000 ($12,000 − $5,000), or 58 percent ($7,000/ $12,000). In
contrast, if the stock price declines by 20 percent to $40 a share, the total market value would be
$8,000, and your investor’s equity would be $3,000 ($8,000 − $5,000), or 37.5 percent
($3,000/$8,000

In addition to the initial margin requirement, another important concept is the maintenance
margin, which is the required proportion of your equity to the total value of the stock after the
initial transaction; the maintenance margin protects the broker if the stock price declines. At
present, the minimum maintenance margin specified by the Federal Reserve is 25 percent, but,
again, individual brokerage firms can dictate higher margins for their customers. If the stock
price declines to the point where your investor’s equity drops below 25 percent of the total value
of the position, the account is considered undermargined, and you will receive a margin call to
provide more equity. If you do not respond with the required funds in time, the stock will be sold
to pay off the loan.

For example, If the price of the stock is P and you own 200 shares, the value of your position
is 200P and the equity in your account is(200P−$5,000). The percentage of margin is
(200P−5,000)/200P. you solve for P

14
P = 200P-5,000$/ 200P= $33.33 Therefore, when the stock is at $33.33, the equity
value is exactly 25 percent; so if the stock declines from $50 to below $33.33, you
will receive a margin call.

Short Sales
A short sale is the sale of stock that you do not own with the intent of purchasing it back later at
a lower price. Specifically, you would borrow the stock from another investor through your
broker and sell it in the market. Subsequently you would replace it by buying at a price lower
(you hope) than the price at which you sold it (this is referred to as covering your short position)

Two technical points affect short sales. The first technical point concerns dividends. The short
seller must pay any dividends due to the investor who lent the stock. The purchaser of the short-
sale stock that you borrowed receives the dividend from the corporation, so the short seller must
pay a similar dividend to the person who lent the stock. Secondly, short sellers must post the
same margin as an investor who had acquired stock. This margin can be in cash or any
unrestricted securities owned by the short seller.

Percent Margin= Value of Your Equity / Value of Stock Owed

To illustrate this technique consider the following example using Cara Corporation stock that is
currently selling for $80 a share. You believe that the stock is overpriced and decide to sell 1,000
shares short at $80. Your broker borrows the Cara Corporation stock on your behalf, sells it at
$80, and deposits the $80,000 in your account. Although the $80,000 is in your account, you
cannot withdraw it. In addition, you must post 50 percent margin ($40,000) as collateral

Percent of margin= 80,000+40,000-80,000/80,000= 0.50

For example, if we assume that the price of Cara Corporation stock declines to $70, the percent
margin would increase as follows: $80,000+$40,000−$70,000 / $70,000=0.71 Alternatively, if
the stock price increases to $90 a share, the percent margin would experience a decline as
follows: $80,000+$40,000−$90,000 / $90,000= 0.33. Notably, if the stock price increases, the
percent margin would experience a decline and contrary if the price of stock decrease the
margin would increase.

15
 Tutorial

1. You have $40,000 to invest in Sophie Shoes, a stock selling for $80 a share. The
initial margin requirement is 60 percent. Ignoring taxes and commissions, show in
detail the impact on your rate of return if the stock rises to $100 a share and if it
declines to $40 a share assuming: (a) you pay cash for the stock, and (b) you buy
it using maximum leverage.

2. Lauren has a margin account and deposits $50,000. Assume the prevailing margin
requirement is 40 percent, commissions are ignored, and the Gentry Wine
Corporation is selling at $35 per share.
a) How many shares can Lauren purchase using the maximum allowable
margin?
b) What is Lauren’s profit (loss) if the price of Gentry’s stock i. rises to $45?
ii. falls to $25?
c) If the maintenance margin is 30 percent, to what price can Gentry Wine
fall before Lauren will receive a margin call?

3. Suppose you buy a round lot of Francesca Industries stock on 55 percent margin
when the stock is selling at $20 a share. The broker charges a 10 percent annual
interest rate, and commissions are 3 percent of the stock value on the purchase
and sale. A year later you receive a $0.50 per share dividend and sell the stock for
$27 a share. What is your rate of return on Francesca Industries?

4. You decide to sell short 100 shares of Charlotte Horse Farms when it is selling at
its yearly high of $56. Your broker tells you that your margin requirement is 45
percent and that the commission on the purchase is $155. While you are short the
stock, Charlotte pays a $2.50 per share dividend. At the end of one year, you buy
100 shares of Charlotte at $45 to close out your position and are charged a
commission of $145 and 8 percent interest on the money borrowed. What is your
rate of return on the investment?

16
 Chapter Three
Common stock valuation
Common stock valuation is one of the most challenging tasks in financial analysis. A
fundamental assertion of finance holds that the value of an asset is based on the present value of
its future cash flows. Accordingly, common stock valuation attempts the difficult task of
predicting the future. This chapter discussed the fundamental analysis of stock. There are
different model to do common stock valuation. We are going to discuss in depth the different
models of common stock valuation.

1.3 DIVIDEND DISCOUNT MODEL

A fundamental principle of finance says that the value of a security equals the sum of its future
cash flows, where the cash flows are adjusted for risk and the time value of money. A popular
model used to value common stock is the dividend discount model, or DDM. The dividend
discount model values a share of stock as the sum of all expected future dividend payments,
where the dividends are adjusted for risk and the time value of money. the present value of a
share of this company’s stock is measured as this sum of discounted future dividends:

P0 ={[D1 / (1 + k) ] +[D2 / (1 + k)2] + [ D3/ (1 + k)3] + . . . + DT / (1 + k)T}

In equation , we assume that the last dividend is paid T years from now. The value of T depends
on the time of the terminal, or last, dividend. Thus, if T = 3 years and D1 = D2 = D3 = $100 .If
the discount rate is k = 10 percent, then a quick calculation yields P 0 = $248.69. Thus, the stock
price should be about $250 per share.

CONSTANT PERPETUAL GROWTH

A particularly simple and useful form of the dividend discount model is called the constant
perpetual growth model. In this case, we assume the firm will pay dividends that grow at the
constant rate g forever. In the constant perpetual growth model, stock prices are calculated using
this formula:

17
 P0 = D0 (1 + g) / (k – g) (k>g)

Because D0 (1 + g) = D1, we can also write the constant perpetual growth model as:

P0 = D1/ (k – g) (k>g)

To illustrate the constant perpetual growth model, suppose that the growth rate is g = 4 percent,
the discount rate is k = 9 percent, and the current dividend is D0 = $10. In this case, a simple
calculation yields P0= $208

APPLICATIONS OF THE CONSTANT PERPETUAL GROWTH MODEL:

In practice, the constant perpetual growth model is the most popular dividend discount model
because it is so simple to use. Certainly, the model satisfies Einstein’s famous dictum: “Simplify
as much as possible, but no more.” However, experienced financial analysts are keenly aware
that the constant perpetual growth model can be usefully applied only to companies with a
history of relatively stable earnings and if dividend growth is expected to continue into the
distant future

HISTORICAL GROWTH RATES

In the constant growth model, a company’s historical average dividend growth rate is frequently
taken as an estimate of future dividend growth. Sometimes historical growth rates are provided
in published information about the company. Other times it is necessary to calculate a historical
growth rate yourself. There are two ways to do this: (1) using a geometric average dividend
growth rate or (2) using an arithmetic average dividend growth rate. Both methods are
relatively easy to implement

Geometric = (Dn/D0 )1/n – 1

Arithmetic= sum of growth/the number of the year

Example

Years Dividend Growth %

2007 $2.20 10
2006 $2.00 11.11
2005 $1.8 2.68
2004 $1.75 2.94
2003 $1.7 13.33
2002 $1.5
1/5
Geometric= (1.5/2.2) -1 = 80%

18
THE SUSTAINABLE GROWTH RATE

As we have seen, when using the constant perpetual growth model, it is necessary
to come up with an estimate of g, the growth rate of dividends. In our previous
discussions, we described two ways to do this: (1) using the company’s historical
average growth rate or (2) using an industry median or average growth rate. We
now describe a third way, known as the sustainable growth rate, which involves
using a company’s earnings to estimate g.

As we have discussed, a limitation of the constant perpetual growth model is that

it applicable only to companies with stable dividend and earnings growth.
However, a company’s earnings can be paid out as dividends to its stockholders or
kept as retained earnings within the firm to finance future growth. The proportion
of earnings paid to stockholders as dividends is called the payout ratio. The
proportion of earnings retained for reinvestment is called the retention ratio.

If we let D stand for dividends and EPS stand for earnings per share, then the
payout ratio is simply D/EPS. Because anything not paid out is retained, the
retention ratio is just one minus the payout ratio. For example, if a company is
current dividend is $4 per share, and its earnings per share are currently $10, then
the payout ratio is $4/$10 = .40, or 40 percent, and the retention ratio is 1 - .40
= .60, or 60 percent.

Thus, A firm’s sustainable growth rate is equal to its return on equity (ROE) times
its retention

Sustainable growth rate = ROE × Retention ratio

= ROE × (1 - Payout ratio)

19
 Calculating sustainable growth
For example , In 2007, American Electric Power (AEP) had a return on equity
(ROE) of 10.17 percent, earnings per share (EPS) of $2.25, and paid dividends of
D0 = $1.56. What was AEP’s retention rate? Its sustainable growth rate

AEP’s dividend payout was $1.56/$2.25 = .693, or about 69.3 percent. Its
retention ratio was thus 1 - .693 =.307, or 30.7 percent. Finally, AEP’s sustainable
growth rate was .1017 × .307 = .03122, or 3.122 percent.
The Two-Stage Dividend Growth Model

A two-stage dividend growth model assumes that a firm will initially grow at a rate
g1 during a first stage of growth lasting T years and thereafter grow at a rate g2
during a perpetual second stage of growth. The formula for the two-stage dividend
growth model is stated as follows:

P0 = D0 (1 + g) / (k – g) *[1-(1+g1/1+k)t] + (1+g1/1+k)t * [ D0 (1 + g2) / (k – g2)]

The two-stage growth formula requires that the second-stage growth rate be strictly less
than the discount rate, that is, g2 >k. However, the first-stage growth rate g1 can be
greater than, less than, or equal to the discount rate.

NONCONSTANT GROWTH IN THE FIRST STAGE

The last case we consider is non-constant growth in the first stage. As a simple example
of non-constant growth, consider the case of a company that is currently not paying
dividends. You predict that, in five years, the company will pay a dividend for the first
time. The dividend will be $.50 per share. You expect that this dividend will then grow at
a rate of 10 percent per year indefinitely. The required return on companies such as this
one is 20 percent. What is the price of the stock today? To see what the stock is worth
today, we first find out what it will be worth once dividends are paid. We can then
calculate the present value of that future price to get today’s price. The first dividend will
be paid in five years, and the dividend will grow steadily from then on. Using the
dividend growth model, we can say that the price in four years will be:

P4 = D4 × (1 +g)/ (k -g) =
D5/ (k -g) = $.50/(.20 - .10) = $5

20
The problem of non-constant growth is only slightly more complicated if the dividends
are not zero for the first several years. For example, suppose that you have come up with
the following dividend forecasts for the next three years:

Years Dividend
1 $1.00
2 $2.00
3 $2.5
P3 =D3 * (1 +g)/ (k -g) = $2.50 * 1.05/ (.10 - .05) = $52.50

P0= (D1/1+k) 1 + (D2/1+k) 2 + (D3/1+k) 3+ (P3/( k-g)3

Fill this formula with example

= $.91 + 1.65 + 1.88 + 39.44= $43.88

DISCOUNT RATES FOR DIVIDEND DISCOUNT MODELS

You may wonder where the discount rates used in the preceding examples come from.
The answer is that they come from the capital asset pricing model (CAPM). Although a
detailed discussion of the CAPM is deferred to a later chapter, we can point out here that,
based on the CAPM, the discount rate for a stock can be estimated using this formula:

Discount rate = U.S. T-bill rate + (Stock beta× Stock market risk premium) The
components of this formula, as we use it here, are defined as follows:

1. U.S. T-bill rate: Return on 90-day

2. U.S. T-bills: Stock beta: Risk relative to an average stock
3. Stock market risk premium: Risk premium for an average stock

Price Ratio Model

Price ratios are widely used by financial analysts, more so even than dividend discount models.
Of course, all valuation methods try to accomplish the same thing, which is to appraise the
economic value of a company’s stock. However, analysts readily agree that no single method can
adequately handle this task on all occasions. In this section, we therefore examine several of the
most popular price ratio methods and provide examples of their use in financial analysis

PRICE-EARNINGS RATIOS

21
 The most popular price ratio used to assess the value of common stock is a company’s price-
earnings ratio, abbreviated as P/E ratio. Price-earnings ratio is calculated as the ratio of a
firm’s current stock price divided by its annual earnings per share (EPS).

To give an example, Starbucks Corporation is a specialty coffee retailer with a history of

aggressive sales growth. Its stock trades on NASDAQ under the ticker symbol SBUX. In mid-
2007, SBUX stock traded at $26.88 with earnings per share (EPS) of $.87, and so had a P/E ratio
of $26.88/$.87 = 30.90.

PRICE-CASH FLOW RATIOS

Instead of price-earnings (P/E) ratios, many analysts prefer to look at price-cash fl ow (P/CF)
ratios. A price-cash fl ow (P/CF) ratio is measured as a company’s current stock price divided
by its current annual cash fl ow per share. Like earnings, cash fl ow is normally reported
quarterly and most analysts multiply the last quarterly cash fl ow figure by four to obtain annual
cash fl ow. Again, like earnings, many published data sources report annual cash fl ow as a sum
of the latest four quarterly cash flows. Here are a variety of definitions of cash fl ow. In this
context, the most common measure is simply calculated as net income plus depreciation, so this
is the one we use here.

PRICE-SALES RATIOS

An alternative view of a company’s performance is provided by its price-sales (P/S) ratio. A

price-sales ratio is calculated as the current price of a company’s stock divided by its current
annual sales revenue per share. A price-sales ratio focuses on a company’s ability to generate
sales growth. Essentially, a high P/S ratio would suggest high sales growth, while a low P/S ratio
might indicate sluggish sales growth. For example, Starbucks Corporation had sales per share of
$12.65 to yield a price-sales ratio of P/S = $26.88/$12.65 = 2.12. GM had sales per share of
$317.95 for a price-sales ratio of P/S = $31.08/$317.95 =.10. Notice the large variation in price-
sales ratios for the two companies.

PRICE-BOOK RATIOS

A very basic price ratio for a company is its price-book (P/B) ratio, sometimes called the
market-book ratio. A price-book ratio is measured as the market value of a company’s
outstanding common stock divided by its book value of equity. Price-book ratios are appealing
because book values represent, in principle, historical cost. The stock price is an indicator of
current value, so a price-book ratio simply measures what the equity is worth today relative to
what it cost. A ratio bigger than 1.0 indicates that the firm has been successful in creating value

22
for its stockholders. A ratio smaller than 1.0 indicates that the company is actually worth less
than it cost.

APPLICATIONS OF PRICE RATIO ANALYSIS

Price-earnings ratios, price-cash fl ow ratios, and price-sales ratios are commonly used to
calculate estimates of expected future stock prices. This is done by multiplying a historical
average price ratio by an expected future value for the price-ratio denominator variable. For
example, Table 6.1 summarizes such a price ratio analysis for Intel Corporation (INTC) based on
mid-2007 information.

In Table 3.2, the five-year average ratio row contains fi ve-year average P/E, P/CF, and P/S
ratios. The current value row contains values for earnings per share, cash fl ow per share, and
sales per share; and the growth rate row contains five-year projected growth rates for EPS, CFPS,
and SPS. The expected price row contains expected stock prices one year hence. The basic idea
is this. Because Intel had an average P/E ratio of 27.30, we will assume that Intel’s stock price
will be 27.30 times its earnings per share one year from now. To estimate Intel’s earnings one
year from now, we note that Intel’s earnings are projected to grow at a rate of 8.5 percent per
year. If earnings continue to grow at this rate, next year’s earnings will be equal to this year’s
earnings times 1.085. Putting it all together, we have

Expected price = Historical P/ E ratio × Projected

EPS = Historical P/E ratio × Current EPS × (1 +
Projected EPS growth rate) = $27.30 +$.86 + $1.085
=$25.47

Table: 1.3

Earnings Cash flow Sales

Five-year average price 27.30 14.04 4.51
ratio
Current value per share $.86 1.68 $1.68

23
 Growth rate 8.5% 7.5% 7.5%
Expected stock rate $25.47 $25.36 $25.36

Tutorial
1. The Perpetual Growth Model Suppose dividends for Tony’s Pizza Company are projected to
grow at 6 percent forever. If the discount rate is 16 percent and the current dividend is $2, what
is the value of the stock?

2. The Two-Stage Growth Model Suppose the Titanic Ice Cube Co.’s dividend grows at a 20
percent rate for the next three years. Thereafter, it grows at a 12 percent rate. What value would
we place on Titanic assuming a 15 percent discount rate? Titanic’s most recent dividend was $3.

3. Residual Income Model Suppose Al’s Infrared Sandwich Company has a current book value
of $10.85 per share. The most recent earnings per share were $2.96 per share, and earnings are
expected to grow at 6 percent forever. The appropriate discount rate is 8.2 percent. Assume the
clean surplus relationship is true. Assuming the company maintains a constant retention ratio,
what is the value of the company according to the residual income model if there are no
dividends?

4. Price Ratio Analysis The table below contains some information about the Jordan Air Co.
Provide expected share prices using each of the two price ratio approaches we have discussed.

PRICE RATIO ANALYSIS FOR JORDAN AIR (CURRENT STOCK PRICE: $40)
Five-year average price 25 (P/E 7 (P/CF)
ratio
Current value per share $2.00 (EPS $6.00 (CFPS
Current value per share 10% 16%

24
 CHAPTER FOUR
Stock Price Behavior & Market Efficiency
Introduction
Market efficiency is probably the most controversial and intriguing issue in investments. The
debate that has raged around market efficiency for decades shows few signs of abating. The
central issue in the market efficiency debate is: Can you (or anyone else) consistently “beat the
market”? If the answer to this question is no, then the market is said to be efficient. The efficient
markets hypothesis (EMH) asserts that, as a practical matter, organized financial markets like the
New York Stock Exchange are efficient. The controversy surrounding the EMH centers on this
assertion.

In the sections that follow, we discuss many issues surrounding the EMH. You will notice that
we focus our discussion on stock markets. The reason is that the debate on the EMH and the
associated research have largely centered on these markets. However, the same principles and
arguments would also apply to any organized financial market, such as the markets for
government bonds, corporate bonds, commodity futures, and options.

Foundation of market efficiency

25
Three economic forces can lead to market efficiency: (1) investor rationality, (2) independent
deviations from rationality, and (3) arbitrage. These conditions are so powerful that any one of
them can result in market efficiency. We discuss aspects of these conditions in detail throughout
this chapter. Given their importance, however, we briefly introduce each of them here. In our
discussions, we use the term “rational” to mean only that investors do not systematically
overvalue or undervalue financial assets in light of the information that they possess.

Forms of market efficiency

Now that we have a little more precise notion of what beating the market means, we can be a
little more precise about market efficiency. A market is efficient with respect to some particular
information if that information is not useful in earning a positive excess return. Notice the
emphasis we place on “with respect to some particular information.” For example, On the other
hand, if you have prior knowledge concerning impending takeover offers, you could most
definitely use that information to earn a positive excess return. Thus, the market is not efficient
with regard to this information. We hasten to add that such information is probably “insider”
information, and insider trading is generally, though not always, illegal (in the United States, at
least). using insider information illegally might well earn you a stay in a jail cell and a stiff
financial penalty. Thus, the question of whether a market is efficient is meaningful only relative
to some type of information. Three general types of information are particularly interesting in
this context, and it is traditional to define three forms of market efficiency: weak, semi-strong,
and strong.

A weak-form efficient market is one in which the information reflected in past prices and
volume figures is of no value in beating the market. semi-strong-form efficient market, publicly
available information of any and all kinds is of no use in beating the market Finally, in a strong-
form efficient market no information of any kind, public or private, is useful in beating the
market. Notice that if a market is strong-form efficient, it is necessarily weak- and semi-strong-
form efficient as well.

Some Implication Of Market Efficiency

DOES OLD INFORMATION HELP PREDICT FUTURE STOCK PRICES?

In its weakest form, the efficient market hypothesis is the simple statement that stock prices
fully reflect all past information. If this is true, this means that studying past price movements in
the hopes of predicting future stock price movements is really a waste of time. In addition, a very
subtle prediction is at work here. That is, no matter how often a particular stock price path has
related to subsequent stock price changes in the past, there is no assurance that this relationship
will occur again in the future. In short, although some researchers have been able to show that

26
future returns are partly predictable by past returns, the predicted returns are not economically
important, which means that predictability is not sufficient to earn an excess return. In addition,
trading costs generally swamp attempts to build a profitable trading system on the basis of past
returns. Researchers have been unable to provide evidence of a superior trading strategy that uses
only past returns. That is, trading costs matter, and buy-and-hold strategies involving broad
market indexes are extremely difficult to outperform.

RANDOM WALKS AND STOCK PRICES

If you were to ask people you know whether stock market prices are predictable, many of them
would say yes. To their surprise, and perhaps yours, it is very difficult to predict stock market
prices. In fact, considerable research has shown that stock prices change through time as if they
are random. That is, stock price increases are about as likely as stock price decreases.

HOW DOES NEW INFORMATION GET INTO STOCK PRICES?

In its semi-strong form, the efficient market hypothesis is the simple statement that stock prices
fully reflect publicly available information. Stock prices change when traders buy and sell shares
based on their view of the future prospects for the stock. The future prospects for the stock are
influenced by unexpected news announcements. Examples of unexpected news announcements
might include an increase or decrease in the dividend paid by a stock, an increase or decrease in
the forecast for future earnings, lawsuits over company practices, or changes in the leadership
team news announcement in three basic ways.

• Efficient market reaction: The price instantaneously adjusts to, and fully reflects, new
information. There is no tendency for subsequent increases or decreases to occur.
• Delayed reaction: The price partially adjusts to the new information, but days elapse before the
price completely reflects new information.
• Overreaction and correction: The price over-adjusts to the new information; it overshoots the
appropriate new price but eventually falls to the new price
EVENT STUDY

27
Researchers use a technique known as an event study to test the effects of news announcements
on stock prices. When researchers look for effects of news on stock prices, however, they must
make sure that overall market news is accounted for in their analysis. The reason is simple.
Suppose the whole market had fallen drastically on May 29, 2007. How would researchers be
able to separate the overall market decline from the isolated news concerning Advanced Medical
Optics? To answer this question, researchers calculate abnormal returns. The equation to
calculate an abnormal return is simple.
Abnormal return = Observed return -Expected return

The expected return can be calculated using a market index (like the NASDAQ 100 Index or the
S&P 500 Index) or by using a long-term average return on the stock. Researchers then align the
abnormal return on a stock to the days relative to the news announcement. Usually, researchers
assign the value of zero to the day a news announcement is made. One day after the news
announcement is assigned a value of =1, two days after the news announcement is assigned a
value of =2, and so on. Similarly, one day before the news announcement is assigned the value of
=1. According to the efficient market hypothesis, the abnormal return today should relate only to
information released on that day. Any previously released information should have no effect on
abnormal returns because this information has been available to all traders. Also, the return today
cannot be influenced by information that traders do not yet know.

Informed Traders and Insider Traders

Recall that if a market is strong-form efficient, no information of any kind, public or private, is
useful in beating the market. However, inside information of many types clearly would enable
you to earn essentially unlimited returns. This fact generates an interesting question: Should any
of us be able to earn returns based on information that is not known to the public? In the United
States (and in many other countries, though not all), making profits on nonpublic information is
illegal. This ban is said to be necessary if investors are to have trust in U.S. stock markets. The
United States Securities and Exchange Commission (SEC) is charged with enforcing laws
concerning illegal trading activities. As a result, it is important for you to be able to distinguish
between informed trading, insider trading, and legal insider trading.

INFORMED TRADING

When an investor makes a decision to buy or sell a stock based on publicly available information
and analysis, this investor is said to be an informed trader. The information that an informed
trader possesses might come from reading The Wall Street Journal, reading quarterly reports

28
issued by a company, gathering financial information from the Internet, talking to other traders,
or a host of other sources

INSIDER TRADING

Some informed traders are also insider traders. When you hear the term insider trading, you most
likely think that such activity is illegal. However, as you will see at the end of this section, not all
insider trading is illegal.

WHO IS AN INSIDER?

For the purposes of defining illegal insider trading, an insider is someone who has material
nonpublic information. Such information is both not known to the public and, if it were known,
would impact the stock price. A person can be charged with insider trading when he or she acts
on such information in an attempt to make a profit.

LEGAL INSIDER TRADING

A company’s corporate insiders can make perfectly legal trades in the stock of their company. To
do so, they must comply with the reporting rules made by the U.S. Securities and Exchange
Commission. When they make a trade and report it to the SEC, these trades are reported to the
public. In addition, corporate insiders must declare that trades that they made were based on
public information about the company, rather than “inside” information. Most public companies
also have guidelines that must be followed. For example, companies commonly allow insiders to
trade only during certain windows throughout the year, often sometime after earnings have been
announced.

How Efficient Markets?

Financial markets are one of the most extensively documented human endeavors. Colossal
amounts of financial market data are collected and reported every day. These data, particularly
stock market data, have been exhaustively analyzed to test market efficiency. You would think
that with all this analysis going on, we would know whether markets are efficient, but really we
don’t. Instead, what we seem to have, at least in the minds of many researchers, is a growing
realization that beyond a point, we just can’t tell. For example, it is not difficult to program a
computer to test trading strategies that are based solely on historic prices and volume figures.
Many such strategies have been tested, and the bulk of the evidence indicates that such strategies
are not useful. More generally, market efficiency is difficult to test for four basic reasons:

29
1. The risk-adjustment problem. 2. The relevant information problem. 3. The dumb luck
problem. 4. The data snooping problem

The first issue, the risk-adjustment problem, is the easiest to understand. We noted that beating
the market means consistently earning a positive excess return. To determine whether an
investment has a positive excess return, we have to adjust for its risk. The truth is that we are not
even certain exactly what we mean by risk, much less how to measure it precisely and then
adjust for it. Thus, what appears to be a positive excess return may just be the result of a faulty
risk-adjustment procedure.

The second issue, the relevant information problem, is even more troublesome. Remember that
the concept of market efficiency is meaningful only relative to some particular information. As
we look back in time and try to assess whether some particular market behavior was inefficient,
we have to recognize that we cannot possibly know all the information that may have been
underlying that market behavior.

Summary & Conclusion Of The Chapter

1. The foundations of market efficiency.
A. The efficient markets hypothesis (EMH) asserts that, as a practical matter, organized financial
markets like the New York Stock Exchange are efficient. B. Researchers who study efficient
markets often ask whether it is possible to “beat the market.” We say that you beat the market if
you can consistently earn returns in excess of those earned by other investments having the same
risk. C. I f a market is efficient, earning these excess returns is not possible, except by luck. The
controversy surrounding the EMH centers on this assertion.
2. The implications of the forms of market efficiency.
A. T he EMH states that the market is efficient with respect to some particular information if that
information is not useful in earning a positive excess return. B. The forms of market efficiency
and their information sets are:• Weak form: Past price and volume information. • Semi-strong

30
form: All publicly available information. • Strong form: All information of any kind, public or
private.
C. We discuss how information affects market prices by influencing traders to act on the arrival
of information. We show you how to distinguish among informed trading, illegal insider trading,
and legal insider trading.
3. Market efficiency and the performance of professional money managers.
A. Testing market efficiency is difficult. We discussed four reasons for this: (1) the risk
adjustment problem, (2) the relevant information problem, (3) the dumb luck problem, and (4)
the data snooping problem.

CHAPTER FIVE
Bond Valuation
Introduction
A bond essentially is a security that offers the investor a series of fixed interest payments during
its life, along with a fixed payment of principal when it matures. So long as the bond issuer does
not default, the schedule of payments does not change. When originally issued, bonds normally
have maturities ranging from 2 years to 30 years, but bonds with maturities of 50 or 100 years
also exist. Bonds issued with maturities of less than 10 years are usually called notes. A very

31
small number of bond issues have no stated maturity, and these are referred to as perpetuities or
consols.

STRAIGHT BONDS

The most common type of bond is the so-called straight bond. By definition, a straight bond is an
IOU that obligates the issuer to pay the bondholder a fixed sum of money at the bond’s maturity
along with constant, periodic interest payments during the life of the bond. The fixed sum paid at
maturity is referred to as bond principal, par value, stated value, or face value. The periodic
interest payments are called coupons. Perhaps the best example of straight bonds are U.S.
Treasury bonds issued by the federal government to finance the national debt. However,
corporations and municipal governments also routinely issue debt in the form of straight bonds.
In addition to a straight bond component, many bonds have additional special features. These
features are sometimes designed to enhance a bond’s appeal to investors. For example,
convertible bonds have a conversion feature that grants bondholders the right to convert their
bonds into shares of common stock of the issuing corporation. As another example, “putable”
bonds have a put feature that grants bondholders the right to sell their bonds back to the issuer at
a special put price.

COUPON RATE AND CURRENT YIELD

A familiarity with bond yield measures is important for understanding the financial
characteristics of bonds. As we briefly discussed in Chapter 3, two basic yield measures for a
bond are its coupon rate and current yield. A bond’s coupon rate is defined as its annual coupon
amount divided by its par value, or, in other words, its annual coupon expressed as a percentage
of face value:

Coupon rate =Annual coupon / Par value

For example, suppose a $1,000 par value bond pays semiannual coupons of $40. The annual
coupon is then $80, and, stated as a percentage of par value, the bond’s coupon rate is
$80/$1,000 = 8%. A coupon rate is often referred to as the coupon yield or the nominal yield.
Notice that the word “nominal” here has nothing to do with inflation. A bond’s current yield is
its annual coupon payment divided by its current market price:

CURRENT YIELD = ANNUAL COUPON / BOND PRICE

For example, suppose a $1,000 par value bond paying an $80 annual coupon has a price of
$1,032.25. The current yield is $80/$1,032.25 = 7.75%. Similarly, a price of $969.75 implies a
current yield of $80/$969.75 =8.25%. Notice that whenever there is a change in the bond’s price,

32
the coupon rate remains constant. However, a bond’s current yield is inversely related to its
price, and it changes whenever the bond’s price changes.

THE FUNDAMENTALS OF BOND VALUATION

The value of bonds can be described in terms of dollar values or the rates of return they promise
under some set of assumptions. In this section, we describe both the present value model, which
computes a specific value for the bond using a single discount value, and the yield model, which
computes the promised rate of return based on the bond’s current price and a set of assumptions.

The Present Value Model

we saw that the value of a bond (or any asset) equals the present value of its expected cash flows.
The cash flows from a bond are the periodic interest payments to the bondholder and the
repayment of principal at maturity. Therefore, the value of a bond is the present value of the
semiannual interest payments plus the present value of the principal payment. Notably, the
traditional valuation technique is to use a single interest rate discount factor, which is the
required rate of return on the bond. We can express this in the following present value formula
that assumes semiannual compounding.

2n
Ci 2 Pp
Pm  t
 2n
t 1 (1  i 2) (1  i 2)
Pm =the current market price of the bond
n=the number of years to maturity
Ci =the annual coupon payment for Bond i
i=the prevailing yield to maturity for this bond issue Pp =the par value of the bond

We can demonstrate this formula using an 8 percent coupon bond that matures in 20 years with a
par value of $1,000. Therefore, an investor who holds this bond to maturity will receive $40
every 6 months (one half of the $80 coupon) for 20 years (40 periods) and $1,000 at the maturity
of the bond in 20 years. If we assume a yield to maturity for this bond of 10 percent (the
market’s required rate of return on the bond), the bond’s value using Equation would be:
The total value of the bond is equal = $828.36
Straight Bond prices and yield to Maturity

33
The single most important yield measure for a bond is its yield to maturity, commonly
abbreviated as YTM. By definition, a bond’s yield to maturity is the discount rate that equates
the bond’s price with the computed present value of its future cash flows. A bond’s yield to
maturity is sometimes called its promised yield, but, more commonly, the yield to maturity of a
bond is simply referred to as its yield. In general, if the term “yield” is being used with no
qualification, it means yield to maturity. STRAIGHT BOND PRICES For straight bonds, the
following standard formula is used to calculate a bond’s price given its yield:
Bond price = C/2 / (YTM/2) [1 - (1 / (1+YTM/2)2M)] + FV / (1 +YTM/2)2M
C =Annual coupon, the sum of two semiannual coupons
FV = Face Value M =Maturity in years YTM = Yield to maturity
The straight bond pricing formula has two separate components. The first component is the
present value of all the coupon payments. Since the coupons are fixed and paid on a regular
basis, you may recognize that they form an ordinary annuity, and the first piece of the bond
pricing formula is a standard calculation for the present value of an annuity. The other
component represents the present value of the principal payment at maturity, and it is a standard
calculation for the present value of a single lump sum.
Calculating bond prices is mostly “plug and chug” with a calculator. In fact, a good fi nancial
calculator or spreadsheet should have this formula built into it. In any case, we will work through
a few examples the long way just to illustrate the calculations. Suppose a bond has a $1,000 face
value, 20 years to maturity, an 8 percent coupon rate, and a yield of 9 percent. What’s the price?
Using the straight bond pricing formula, the price of this bond is calculated as follows:

1. Present value of semiannual coupons

$80 / .09 {1 - (1 / (1.045)40) } = $736.06337
2. Present value of $1,000 principal:
$1,000 / (1.045)40= $171.92871
The price of the bond is the sum of the present values of coupons and principal:
Bond price = $736.06 + $171.93 = $907.99

PREMIUM AND DISCOUNT BONDS

Bonds are commonly distinguished according to whether they are selling at par value or at a
discount or premium relative to par value. These three relative price descriptions—premium,
discount, and par bonds—are defined as follows:
1. Premium bonds: Bonds with a price greater than par value are said to be selling at a
premium. The yield to maturity of a premium bond is less than its coupon rate.
2. Discount bonds: Bonds with a price less than par value are said to be selling at a discount.
The yield to maturity of a discount bond is greater than its coupon rate.

34
 3. Par bonds: Bonds with a price equal to par value are said to be selling at par. The yield to
maturity of a par bond is equal to its coupon rate.
The important thing to notice is that whether a bond sells at a premium or discount depends on
the relation between its coupon rate and its yield. If the coupon rate exceeds the yield, the bond
will sell at a premium. If the coupon is less than the yield, the bond will sell at a discount.
The important thing to notice is that whether a bond sells at a premium or discount depends on
the relation between its coupon rate and its yield. If the coupon rate exceeds the yield, the bond
will sell at a premium. If the coupon is less than the yield, the bond will sell at a discount

COMPUTING BOND YIELDS

Nominal Yield
Nominal yield is the coupon rate of a particular issue. A bond with an 8 percent coupon has an 8
percent nominal yield. This provides a convenient way of describing the coupon characteristics
of an issue.
Current yield : is to bonds what dividend yield is to stocks. It is computed as: CY =Ci/ Pm
CY =the current yield on a bond
Ci =the annual coupon payment of Bond i
Pm =the current market price of the bond
Because this yield measures the current income from the bond as a percentage of its price, it is
important to income-oriented investors (e.g., retirees) who want current cash flow from their
investment portfolios. Current yield has little use for investors who are interested in total return
because it excludes the important capital gain or loss component.

Promised Yield to Maturity

Promised yield to maturity is the most widely used bond yield figure because it indicates the
fully compounded rate of return promised to an investor who buys the bond at prevailing prices,
if two assumptions hold true. Specifically, the promised yield to maturity will be equal to the
investor’s realized yield if these assumptions are met. The first assumption is that the investor
holds the bond to maturity. This assumption gives this value its shortened name, yield to
maturity (YTM). The second assumption is implicit in the present value method of computation.

To compute the YTM for a bond, we solve for the rate i that will equate the current price (Pm) to
all cash flows from the bond to maturity. As noted, this resembles the computation of the internal
rate of return (IRR) on an investment project. Because it is a present value-based computation, it
implies a reinvestment rate assumption because it discounts the cash flows. That is, the equation
assumes that all interim cash flows (interest payments) are reinvested at the computed YTM.
This is referred to as a promised YTM because the bond will provide this computed YTM (i.e.,
you will realize this yield) only if you meet its conditions:

35
1. You hold the bond to maturity.
2. You reinvest all the interim cash flows at the computed YTM rate.

Computing the Promised Yield to Maturity

The promised yield to maturity can be computed by using the present value model with
semiannual compounding. The present value model gives the investor an accurate result and is
the technique used by investment professionals. the present value equation is a variation of the
internal rate of return (IRR) calculation where we want to find the discount rate, i, that will
equate the present value of the cash flows to the market price of the bond (Pm). Using the prior
example of an 8 percent, 20-year bond, priced at $900, the equation gives us a semiannual
promised yield to maturity of 4.545 percent, which implies an annual promised YTM of 9.09
percent.
40(18.2574)+ 10000(0.1702) = 900
YTM for a Zero Coupon Bond
Zero coupon bonds that only have the one cash inflow at maturity. This single cash flow means
that the calculation of YTM is substantially easier, as shown by the following example. Assume
a zero coupon bond maturing in 10 years with a maturity value of $1,000 selling for $311.80.
Because you are dealing with a zero coupon bond, there is only the one cash flow from the
principal payment at maturity. Therefore, you simply need to determine what the discount rate is
that will discount $1,000 to equal the current market price of $311.80 in 20 periods (10 years of
semiannual payments). The equation is as follows:
Pc= FV/ (1+I/2) n
$311.80=$1000/(1+I/2)40 = 6% , which implies an annual rate of 12 percent

YIELD TO CALL
When a bond issue is callable, the issuer can buy back outstanding bonds before the bonds
mature. In exchange, bondholders receive a special call price, which is often equal to face value,
although it may be slightly higher. When a call price is equal to face value, the bond is said to be
callable at par. Then a bond is called, the bondholder does not receive any more coupon
payments. Therefore, some callable bonds are issued with a provision known as a make-whole
call price

36
If a bond is callable, its yield to maturity may no longer be a useful number. Instead, the yield to
call, commonly abbreviated YTC, may be more meaningful. Yield to call is a yield measure that
assumes a bond issue will be called at its earliest possible call date. We calculate a bond’s yield
to call using the straight bond pricing formula we have been using with two changes. First,
instead of time to maturity, we use time to the first
Callable bond price = C /YTC [1 - (1 ÷ (1 +YTC/2)2T)] + CP (1 + YTC/2)2T
C =Constant annual coupon
CP = Call price of the bond
T =Time in years until earliest possible call date
YTC = Yield to call assuming semiannual coupons
To give a trial-and-error example, suppose a 20-year bond has a coupon of 8 percent, a price of
98, and is callable in 10 years. The call price is 105. What are its yield to maturity and yield to
call? Based on our earlier discussion, we know the yield to maturity is slightly bigger than the
coupon rate. (Why?) After some calculation, we find it to be 8.2 percent. To find the bond’s yield
to call, we pretend it has a face value of 105 instead of 100 ($1,050 versus $1,000) and will
mature in 10 years. With these two changes, the procedure is exactly the same. We can try 8.5
percent, for example:
Callable bond price= .08/.85*[1- (1/(1.0425)^40)]+ $1,050 / (1.0425)^40 = $988.51

Because $988.51 is a little too high, the yield to call is slightly bigger than 8.5 percent. If we try
8.6, we find that the price is $981.83, so the yield to call is about 8.6 percent (it’s 8.6276
percent). A natural question comes up in this context. Which is bigger, the yield to maturity or
the yield to call? The answer depends on the call price. However, if the bond is callable at par (as
many are), then, for a premium bond, the yield to maturity is greater. For a discount bond, the
reverse is true.

CALCULATING FUTURE BOND PRICES Dollar bond prices need to be calculated in two
instances: (1) when computing realized (horizon) yield, you must determine the future selling
price (Pf) of a bond if it is to be sold before maturity or first call, and (2) when issues are quoted
on a promised yield basis, as with municipals. You can easily convert a yield-based quote to a

37
dollar price by using Equation 18.1, which does not require iteration. (You need only solve for
Pm.) The coupon (Ci) is given, as is par value (Pp) and the promised YTM, which is used as the
discount rate. Consider a 10 percent, 25-year bond with a promised YTM of 12 percent. You
would compute the price of this issue as:

2 n  2 hp
Ci / 2 Pp
Pf   t 1 (1  i 2) t

(1  i 2) 2 n  2 hp
Pf =the future selling price of the bond
Pp =the par value of the bond n=the number of years to maturity
hp =the holding period of the bond (in years)
Ci =the annual coupon payment of Bond i
i=the expected (estimated) market YTM at the end of the holding period

Realized (Horizon)Yield with Differential Reinvestment Rates

The realized yield equation—Equation 18.4—is the standard present value formula with the
changes in holding period and ending price. As such, it includes the implicit reinvestment rate
assumption that all cash flows are reinvested at the computed i rate. There may be instances
where such an implicit assumption is not appropriate, given your expectations for future interest
rates. Assume that current market interest rates are very high and you invest in a long-term bond
(e.g., a 20-year, 14 percent coupon) to take advantage of an expected decline in rates from 14
percent to 10 percent over a 2-year period. Computing the future price of a 14 percent 18year
bond yielding 10 percent (equal to $1,330.95) and using the realized yield equation to estimate
the realized (horizon) yield, we will get the following fairly high realized rate of return:
2 hp
Ct / 2 Pf
Pm  t

t 1 (1  i 2) (1  i 2) 2 hp
Pm =$1,000 hp=2years
Pf= =$1,330:95
I= 27.5%

MACAULAY DURATION
There are several duration measures. The original version is called Macaulay duration. The
usefulness of Macaulay duration stems from the fact that it satisfi es the following approximate
relationship between percentage changes in bond prices and changes in bond yields:
Percentage change in bond price= {- Duration × Change in YTM / (1 +YTM/2)}

38
 Consequence, two bonds with the same duration, but not necessarily the same maturity, have
approximately the same price sensitivity to a change in bond yields. This approximation is quite
accurate for relatively small changes in yields, but it becomes less accurate when large changes
are considered. To see how we use this result, suppose a bond has a Macaulay duration of six
years, and its yield decreases from 10 percent to 9.5 percent. The resulting percentage change in
the price of the bond is calculated as follows:

-6 ×(.095 - .10 ) /1.05=2.86% Thus, the bond’s price rises by 2.86 percent in response to a
yield decrease of 50 basis points.

MODIFIED DURATIONS
Come analysts prefer to use a variation of Macaulay duration called modified duration. The
relationship between Macaulay duration and modified duration for bonds paying semiannual
coupons is simply:
Modified duration = Macaulay duration / (1 + YTM/2)

CALCULATING MACAULAY DURATION

Macaulay duration is often described as a bond’s effective maturity. For this reason, duration
values are conventionally stated in years. The first fundamental principle for calculating the
duration of a bond concerns the duration of a zero coupon bond. Specifically, the duration of a
zero coupon bond is equal to its maturity. Thus, on a pure discount instrument, such as the U.S.
Treasury STRIPS, no calculation is necessary to come up with Macaulay duration. The second
fundamental principle for calculating duration concerns the duration of a coupon bond with
multiple cash flows. The duration of a coupon bond is a weighted average of individual
maturities of all the bond’s separate cash flows. The weights attached to the maturity of each
cash fl ow are proportionate to the present values of each cash flow.
D=( ∑ Pv (ct) ÷ p0)× t
D = Duration
C = Cash flow
R = Current yield to maturity
T = Number of Years
PV (C) = Present value of the Cash flow
P = Sum of the present values of cash flow

Tutorial

1. Four years ago, your firm issued $1,000 par, 25-year bonds, with a 7 percent coupon rate
and a 10 percent call premium.

39
 a. If these bonds are now called, what is the approximate yield to call for the
investors who originally purchased them?
b. If these bonds are now called, what is the actual yield to call for the investors who
originally purchased them at par?
c. If the current interest rate on the bond is 5 percent and the bonds were not
callable, at what price would each bond sell?
2. Assume that you purchased an 8 percent, 20-year, $1,000 par, semiannual payment bond
priced at $1,012.50 when it has 12 years remaining until maturity.
Compute:
a. Its promised yield to maturity
b. Its yield to call if the bond is callable in three years with an 8 percent premium
3. Calculate the Macaulay duration of an 8 percent, $1,000 par bond that matures in three
years if the bond’s YTM is 10 percent and interest is paid semiannually.
Calculate this bond’s duration.

4. Two years ago, you acquired a 10-year zero coupon, $1,000 par value bond at a 12
percent YTM. Recently, you sold this bond at an 8 percent YTM. Using semiannual
compounding, compute the annualized horizon return for this investment.

CHAPTER SIX

PORTFOLIO ANALYSIS
40
SOME BACKGROUND ASSUMPTIONS
We begin by clarifying some general assumptions of portfolio theory. This includes not only
what we mean by an optimum portfolio but also what we mean by the terms risk aversion and
risk. One basic assumption of portfolio theory is that investors want to maximize the returns
from the total set of investments for a given level of risk. To understand such an assumption
requires certain ground rules. First, your portfolio should include all of your assets and liabilities,
not only your marketable securities but also your car, house, and less marketable investments
such as coins, stamps, art, antiques, and furniture. The full spectrum of investments must be
considered because the returns from all these investments interact, and this relationship among
the returns for assets in the portfolio is important. Hence, a good portfolio is not simply a
collection of individually good investments.

Risk Aversion
Portfolio theory also assumes that investors are basically risk averse, meaning that, given a
choice between two assets with equal rates of return, they will select the asset with the lower
level of risk. Evidence that most investors are risk averse is that they purchase various types of
insurance, including life insurance, car insurance, and health insurance. Buying insurance
basically involves an outlay of a known dollar value to guard against an uncertain, possibly
larger, outlay in the future.

MARKOWITZ PORTFOLIO THEORY

in the early 1960s, the investment community talked about risk, but there was no specific
measure for the term. To build a portfolio model, however, investors had to quantify their risk
variable. The basic portfolio model was developed by Harry Markowitz (1952, 1959), who
derived the expected rate of return for a portfolio of assets and an expected risk measure.
Markowitz showed that the variance of the rate of return was a meaningful measure of portfolio
risk under a reasonable set of assumptions. More important, he derived the formula for
computing the variance of a portfolio. This portfolio variance formula not only indicated the
importance of diversifying investments to reduce the total risk of a portfolio but also showed
how to effectively diversify.

The Markowitz model is based on several assumptions regarding investor behavior: 1. Investors
consider each investment alternative as being represented by a probability distribution of
expected returns over some holding period. 2. Investors maximize one-period expected utility,

41
and their utility curves demonstrate diminishing marginal utility of wealth. 3. Investors estimate
the risk of the portfolio on the basis of the variability of expected returns. 4. Investors base
decisions solely on expected return and risk, so their utility curves are a function of expected
return and the expected variance (or standard deviation) of returns only. 5. For a given risk level,
investors prefer higher returns to lower returns. Similarly, for a given level of expected return,
investors prefer less risk to more risk.

Expected Rates of Return

We compute the expected rate of return for an individual investment as discussed in Chapter 1..
The expected rate of return for a portfolio of investments is simply the weighted average of the
expected rates of return for the individual investments in the portfolio. The weights are the
proportion of total value for the individual investment. Expected return of portfolio is equal t=
n

∑ ¿(wi)×(ri)6.1
I=1

where:
wi =the weight of an individual asset in the portfolio,
or the percent of the portfolio in Asset i
Ri =the expected rate of return for Asset i
PORTFOLIO WEIGHTS
There are many equivalent ways of describing a portfolio. The most convenient approach is to
list the percentages of the total portfolio’s value that are invested in each portfolio asset. We call
these percentages the portfolio weights. For example, if we have $50 in one asset and $150 in
another, then our total portfolio is worth $200. The percentage of our portfolio in the fi rst asset
is $50/$200 = .25, or 25%. The percentage of our portfolio in the second asset is $150/$200
= .75, or 75%. Notice that the weights sum up to 1.00 (100%) because all of our money is
invested somewhere
Variance (Standard Deviation) of Returns for a Portfolio
Covariance of Returns In this subsection we discuss what the covariance of returns is intended to
measure, give the formula for computing it, and present an example of its computation.
Covariance is a measure of the degree to which two variables move together relative to their
individual mean values over time. In portfolio analysis, we usually are concerned with the
covariance of rates of return rather than prices or some other variable
The covariance statistic provides an absolute measure of how they moved together over time. For
two assets, i and j, we define the covariance of rates of return as

Covij = E {[Ri − E(Ri)][Rj − E(Rj)]}

42
Covariance and Correlation
Covariance is affected by the variability of the two individual return indexes. It might indicate a
weak negative relationship if the two individual indexe were volatile. It might indicate strong
negative relationship if index of two stock indexe are stable obviously we want to standardize
this covariance we do so by taking into consideration the variability of the two individual return
index
as follows:
rij = Covij / σiσj
rij =The correlation coefficient of returns
σi =the standard deviation of Rit
σj =the standard deviation of Rjt
Thus the covariance is at follow
Covij =rij *σi* σj

Standardizing the covariance by the product of the individual standard deviations yields the
correlation coefficient rij, which can vary only in the range −1 to +1. A value of +1 indicates a
perfect positive linear relationship between Ri and Rj, meaning the returns for the two assets
move together in a completely linear manner. A value of −1 indicates a perfect negative
relationship between the two return indexes, so that when one asset’s rate of return is above its
mean, the other asset’s rate of return will be below its mean by a comparable amount. . A value
of zero means that the returns had no linear relationship, that is, they were uncorrelated
statistically. That does not mean that they are independent. To calculate this standardize
measured of the relationship we need the standard deviation the two individual return indexes.
Standard Deviation of a Portfolio
Portfolio Standard Deviation Formula Now that we have discussed the concepts of covariance
and correlation, we can consider the formula for computing the standard deviation of returns for
a portfolio of assets, our measure of risk for a portfolio. In Exhibit 7.2, we showed that the
expected rate of return of the portfolio was the weighted average of the expected returns for the
individual assets in the portfolio; the weights were the percentage of value of the portfolio. One
might assume it is possible to derive the standard deviation of the portfolio in the same manner,
that is, by computing the weighted average of the standard deviations for the individual assets.
This would be a mistake. Markowitz (1959) derived the general formula for the standard
deviation of a portfolio as follows:

n n n

∑ w i2 . Q j2+∑ ∑ wi . wj .Covij
i=1 i=1 j=1

43
σport = the standard deviation of the portfolio
wi =the weights of an individual asset in the portfolio, where weights are determined by the
proportion of value in the portfolio σ2
i =the variance of rates of return for asset i
Covij =the covariance between the rates of return for assets i and j,
where Covij = rij. σi.σj
This formula indicates that the standard deviation for a portfolio of assets is a function of the
weighted average of the individual variances (where the weights are squared), plus the weighted
covariance between all the assets in the portfolio. The very important point is that the standard
deviation for a portfolio of assets encompasses not only the variances of the individual assets but
also includes the covariance between all the pairs of individual assets in the portfolio. Further, it
can be shown that, in a portfolio with a large number of securities, this formula reduces to the
sum of the weighted covariance.

Impact of a New Security in a Portfolio

Although in most of the following discussion we will consider portfolios with only two assets
(because it is possible to show the effect in two dimensions), we will also demonstrate the
computations for a three-asset portfolio. Still, it is important at this point to consider what
happens in a large portfolio with many assets. Specifically, what happens to the portfolio’s
standard deviation when we add a new security to such a portfolio? As shown by the formula, we
see two effects. The first is the asset’s own variance of returns, and the second is the covariance
between the returns of this new asset and the returns of every other asset that is already in the
portfolio. The relative weight of these numerous covariance is substantially greater than the
asset’s unique variance; the more assets in the portfolio, the more this is true. This means that the
important factor to consider when adding an investment to a portfolio that contains a number of
other investments is not the new security’s own variance but the average covariance of this asset
with all other investments in the portfolio.

Portfolio Standard Deviation Calculation

Because of the assumptions used in developing the Markowitz portfolio model, any asset or
portfolio of assets can be described by two characteristics: the expected rate of return and the
expected standard deviation of returns. Therefore, the following demonstrations can be applied to

44
two individual assets, two portfolios of assets, or two asset classes with the indicated rate of
return-standard deviation characteristics and correlation coefficients.

Equal Risk and Return—Changing Correlations Consider first the case in which both
assets have the same expected return and expected standard deviation of return. As an example,
let’s assume
E(R1)=0:20, E(Q2) =0:10 E(R2) =0:20, E(Q2)=0:10 To show the effect of different covariance,
we assume different levels of correlation between the two assets. We also assume that the two
assets have equal weights in the portfolio (w1 = 0.50; w2 = 0.50). Therefore, the only value that
changes in each example is the correlation between the returns for the two assets.
Now consider the following five correlation coefficients and the covariance they yield. Since
Covij =rij.* σi*σj, the covariance will be equal to r1,2(0.10)(0.10) because the standard deviation
of both assets is 0.10. For r1,2 = 1.00, Cov1,2 = (1.00)(0.10)(0.10) = 0.01

Qport= {w12.Q12+w22.Q22+2w1.w2.r12.Q1.Q2}1/2 or
Qport= {w12.Q12+w22.Q22+2w1.w2.cov12}1/2
Example : E(R1)=0:20, E(Q2) =0:10 E(R2) =0:20, E(Q2)=0:10 we assume different levels of
correlation between the two assets. We also assume that the two assets have equal weights in the
portfolio (w1 = 0.50; w2 = 0.50).
With the following cases:

a. For r1,2 = 1.00, Cov1,2 = (1.00)(0.10)(0.10) = 0.01

b. For r1,2 = 0.50, Cov1,2 = (0.50)(0.10)(0.10) = 0.005

c. For r1,2 = 0.00, Cov1,2 = (0.00)(0.10)(0.10) = 0.000

d. For r1,2 = −0.50, Cov1,2 =( −0.50)(0.10)(0.10) = −0.005

e. For r1,2 = −1.00, Cov1,2 =( −1.00)(0.10)(0.10) = −0.01

Thus case (A) applying formula 6.6

Qport= 0.10

A Three-Asset Portfolio

45
A demonstration of what occurs with a three-asset portfolio is useful because it shows the
dynamics of the portfolio process when assets are added. It also shows the rapid growth in the
computations required, which is why we will stop at three! In this example, we will combine
three asset classes we have been discussing: stocks, bonds, and cash equivalents. We will assume
the following characteristics:

Asset classes E(Ri) E(qi) Wi

stock 0.12 0.20 0.60
Bond 0.08 0.10 0.3
Equivalent cash 0.04 0.03 0.10
The correlations are

rS,B = 0.25; rS,C = −0.08; rB,C = 0.15

E(Rport)= (0.6)(0.12)+(0.3)(0.08)+(0.10)(0.04)= (0.072+0.024+0.004)= 0.100

When we apply the generalized formula from Equation 7.6 to the expected standard deviation of
a three-asset portfolio, it is

Q2PORT= (ws2 *Qs2 + wc2*Qc2+ wB2*QB2)+ (2 ws *wB *Qs* QB *rs,B +2 ws *wc* Qs* Qc
* rs,c +2 wB* wc* Qc*QB* rB,c)
σport =(0:0170784)^1/2 =0:1306=13:06%

Summary

46
The basic Markowitz portfolio model derives the expected rate of return for a portfolio of assets
and a measure of expected risk, which is the standard deviation of expected rates of return.
Markowitz showed that the expected rate of return of a portfolio is the weighted average of the
expected return for the individual investments in the portfolio. The standard deviation of a
portfolio is a function not only of the standard deviations for the individual investments but also
of the covariance between the rates of return for all the pairs of assets in the portfolio. In a large
portfolio, these covariances are the important factors.

• Different weights or amounts of a portfolio held in various assets yield a curve of potential
combinations. Correlation coefficients among assets are the critical factor to consider when
selecting investments. Investors can maintain their rate of return while reducing the risk level of
their portfolio by combining assets or portfolios that have low-positive or negative correlation.

•Assuming numerous assets and a multitude of combination curves, the efficient frontier is the
envelope curve that encompasses all of the best combinations. It defines the set of portfolios that
has the highest expected return for each given level of risk or the minimum risk for each given
level of return. From this set of dominant portfolios, investors select the one that lies at the point
of tangency between the efficient frontier and their highest utility curve. Because risk–return
utility functions differ, the point of tangency and, therefore, the portfolio choice will differ
among investors. At this point, you understand that an optimum portfolio is a combination of
investments, each having desirable individual risk–return characteristics that also fit together
based on their correlations.

Tutorial

47
 1. These are a set of expected risk and return of three different stock
Stock Expected rate of Expected RISK% Correlation
return% coefficient
A B C
A 12 15 1 0.8 0.2
B 10 8 0 1 0.6
C 10 9 0.2 0.6 0
 0.7 invest in Stock A and B,C equally weighted
 0.5 invest in Stock B and 0.5 in stock c
 0.25 invest in stock A and 0.75 in stock B

Calculate the expected risk and return.

2. Considering the world economic outlook for the coming year and estimates of sales and
earning for the pharmaceutical industry, you expect the rate of return for Lauren Labs
common stock to range between −20 percent and +40 percent with the following
probabilities.
Probability Possible return
0.10 -(0.20)
0.15 -(0.05)
0.20 (0.01)
0.25 (0.15)
0.20 0.20
0.10 0.40
Compute the expected rate of return E(Ri) for Lauren Labs.
3. You are considering two assets with the following characteristics. E(R 1)=0:15
E(σ1)=0:10 w1 =0:5 E(R2)=0:20 E(σ2)=0:20 w2 =0:5 Compute the mean and standard
deviation of two portfolios if r1,2 = 0.40 and −0.60, respectively. Plot the two portfolios
on a risk–return graph and briefly explain the results

48