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Corporate finance

P. Frantz, R. Payne, J. Favilukis


FN3092, 2790092

2011

Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk

This guide was prepared for the University of London International Programmes by:
Dr. P. Frantz, Lecturer in Accountancy and Finance, The London School of Economics and
Political Science
R. Payne, Former Lecturer in Finance, The London School of Economics and Political Science
Dr. J. Favilukis, Lecturer, The London School of Economics and Political Science
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

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Contents

Contents
Introduction to the subject guide .......................................................................... 1
Aims of the course......................................................................................................... 1
Learning outcomes ........................................................................................................ 1
Syllabus......................................................................................................................... 2
Essential reading ........................................................................................................... 3
Further reading.............................................................................................................. 3
Online study resources ................................................................................................... 5
Subject guide structure and use ..................................................................................... 6
Examination advice........................................................................................................ 7
Glossary of abbreviations used in this subject guide ....................................................... 8
Chapter 1: Present value calculations and the valuation of physical investment
projects ................................................................................................................... 9
Aim .............................................................................................................................. 9
Learning outcomes ........................................................................................................ 9
Essential reading ........................................................................................................... 9
Further reading.............................................................................................................. 9
Overview ..................................................................................................................... 10
Introduction ................................................................................................................ 10
Fisher separation and optimal decision-making ............................................................ 10
Fisher separation and project evaluation ...................................................................... 13
The time value of money .............................................................................................. 14
The net present value rule ............................................................................................ 15
Other project appraisal techniques ............................................................................... 17
Using present value techniques to value stocks and bonds ........................................... 21
A reminder of your learning outcomes.......................................................................... 23
Key terms .................................................................................................................... 23
Sample examination questions ..................................................................................... 23
Chapter 2: Risk and return: meanvariance analysis and the CAPM.................... 25
Aim of the chapter....................................................................................................... 25
Learning outcomes ...................................................................................................... 25
Essential reading ......................................................................................................... 25
Further reading............................................................................................................ 25
Introduction ................................................................................................................ 25
Statistical characteristics of portfolios ........................................................................... 26
Diversification.............................................................................................................. 28
Meanvariance analysis ............................................................................................... 30
The capital asset pricing model .................................................................................... 34
The Roll critique and empirical tests of the CAPM ......................................................... 37
A reminder of your learning outcomes.......................................................................... 40
Key terms .................................................................................................................... 40
Sample examination questions ..................................................................................... 40
Solutions to activities ................................................................................................... 41
Chapter 3: Factor models ..................................................................................... 43
Aim of the chapter....................................................................................................... 43
Learning outcomes ...................................................................................................... 43
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92 Corporate finance

Essential reading ......................................................................................................... 43


Further reading............................................................................................................ 43
Overview ..................................................................................................................... 43
Introduction ................................................................................................................ 44
Single-factor models .................................................................................................... 44
Multi-factor models ..................................................................................................... 46
Broad-based portfolios and idiosyncratic returns........................................................... 47
Factor-replicating portfolios ......................................................................................... 48
The arbitrage pricing theory ......................................................................................... 50
Multi-factor models in practice..................................................................................... 51
Summary ..................................................................................................................... 52
A reminder of your learning outcomes.......................................................................... 52
Key terms .................................................................................................................... 53
Sample examination question ...................................................................................... 53
Chapter 4: Derivative securities: properties and pricing ..................................... 55
Aim of the chapter....................................................................................................... 55
Learning outcomes ...................................................................................................... 55
Essential reading ......................................................................................................... 55
Further reading............................................................................................................ 55
Overview ..................................................................................................................... 55
Varieties of derivatives ................................................................................................. 56
Derivative asset payoff profiles ..................................................................................... 57
Pricing forward contracts ............................................................................................. 59
Binomial option pricing setting .................................................................................... 60
Bounds on option prices and exercise strategies ........................................................... 64
BlackScholes option pricing ....................................................................................... 66
Putcall parity ............................................................................................................. 68
Pricing interest rate swaps ........................................................................................... 69
Summary ..................................................................................................................... 69
A reminder of your learning outcomes.......................................................................... 70
Key terms .................................................................................................................... 70
Sample examination questions ..................................................................................... 71
Chapter 5: Efficient markets: theory and empirical evidence .............................. 73
Aim of the chapter....................................................................................................... 73
Learning outcomes ...................................................................................................... 73
Essential reading ......................................................................................................... 73
Further reading............................................................................................................ 73
Overview ..................................................................................................................... 74
Varieties of efficiency ................................................................................................... 74
Risk adjustments and the joint hypothesis problem ...................................................... 75
Weak-form efficiency: implications and tests ................................................................ 76
Weak-form efficiency: empirical results......................................................................... 78
Semi-strong-form efficiency: event studies .................................................................... 81
Semi-strong-form efficiency: empirical evidence ............................................................ 83
Strong-form efficiency .................................................................................................. 83
Long horizon forecastability ......................................................................................... 83
Summary ..................................................................................................................... 85
A reminder of your learning outcomes.......................................................................... 85
Key terms .................................................................................................................... 85
Sample examination questions ..................................................................................... 86
ii

Contents

Chapter 6: The choice of corporate capital structure ........................................... 89


Aim of the chapter....................................................................................................... 89
Learning outcomes ...................................................................................................... 89
Essential reading ......................................................................................................... 89
Further reading............................................................................................................ 89
Overview ..................................................................................................................... 89
Basic features of debt and equity ................................................................................. 90
The ModiglianiMiller theorem .................................................................................... 91
ModiglianiMiller and BlackScholes ........................................................................... 93
ModiglianiMiller and corporate taxation..................................................................... 94
ModiglianiMiller with corporate and personal taxation ............................................... 97
Summary ..................................................................................................................... 98
A reminder of your learning outcomes.......................................................................... 99
Key terms .................................................................................................................... 99
Sample examination questions ..................................................................................... 99
Chapter 7: Leverage, WACC and the Modigliani-Miller 2nd proposition ........... 101
Aim of the chapter..................................................................................................... 101
Learning outcomes .................................................................................................... 101
Essential reading ....................................................................................................... 101
Further reading.......................................................................................................... 101
Overview ................................................................................................................... 101
Weighted average cost of capital ............................................................................... 102
Modigliani and Millers 2nd proposition ..................................................................... 103
A CAPM perspective .................................................................................................. 107
Summary ................................................................................................................... 108
Key terms .................................................................................................................. 108
A reminder of your learning outcomes........................................................................ 108
Sample examination questions ................................................................................... 109
Chapter 8: Asymmetric information, agency costs and capital structure .......... 111
Aim of the chapter..................................................................................................... 111
Learning outcomes .................................................................................................... 111
Essential reading ....................................................................................................... 111
Further reading.......................................................................................................... 111
Overview ................................................................................................................... 112
Capital structure, governance problems and agency costs ........................................... 112
Agency costs of outside equity and debt .................................................................... 112
Agency costs of free cash flows.................................................................................. 118
Firm value and asymmetric information ...................................................................... 119
Summary ................................................................................................................... 123
Key terms .................................................................................................................. 123
A reminder of your learning outcomes........................................................................ 124
Sample examination questions ................................................................................... 124
Chapter 9: Dividend policy ................................................................................. 127
Aim of the chapter..................................................................................................... 127
Learning outcomes .................................................................................................... 127
Essential reading ....................................................................................................... 127
Further reading.......................................................................................................... 127
Overview ................................................................................................................... 128
ModiglianiMiller meets dividends ............................................................................. 128
Prices, dividends and share repurchases ..................................................................... 129
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92 Corporate finance

Dividend policy: stylised facts ..................................................................................... 129


Taxation and clientele theory ..................................................................................... 131
Asymmetric information and dividends ....................................................................... 132
Agency costs and dividends ....................................................................................... 133
Summary ................................................................................................................... 133
A reminder of your learning outcomes........................................................................ 134
Key terms .................................................................................................................. 134
Sample examination questions ................................................................................... 134
Chapter 10: Mergers and takeovers ................................................................... 135
Aim of the chapter..................................................................................................... 135
Learning outcomes .................................................................................................... 135
Essential reading ....................................................................................................... 135
Further reading.......................................................................................................... 135
Overview ................................................................................................................... 136
Merger motivations ................................................................................................... 136
A numerical takeover example ................................................................................... 137
The market for corporate control ................................................................................ 138
The impossibility of efficient takeovers ....................................................................... 139
Two ways to get efficient takeovers ............................................................................ 140
Empirical evidence ..................................................................................................... 141
Summary ................................................................................................................... 143
A reminder of your learning outcomes........................................................................ 143
Key terms .................................................................................................................. 143
Sample examination questions ................................................................................... 144
Appendix 1: Perpetuities and annuities ............................................................. 145
Perpetuities ............................................................................................................... 145
Annuities .................................................................................................................. 146
Appendix 2: Sample examination paper ............................................................ 147

iv

Introduction to the subject guide

Introduction to the subject guide


This subject guide for 92 Corporate finance, a 300 course offered on
the Economics, Management, Finance and Social Sciences programme,
provides you with an introduction to the modern theory of finance.
As such, it covers a broad range of topics and aims to give a general
background to any student who wishes to do further academic or practical
work in finance or accounting after graduation.
The subject matter of the guide can be broken into two main areas.
The first section covers the valuation and pricing of real and financial
assets. This provides you with the methodologies you will need to fairly
assess the desirability of investment in physical capital, and price spot
and derivative assets. We employ a number of tools in this analysis.
The coverage of the risk-return trade-off in financial assets and mean
variance optimisation will require you to apply some basic statistical
theory alongside the standard optimisation techniques taught in basic
economics courses. Another important part of this section will be the
use of absence-of-arbitrage techniques to price financial assets.
In the second section, we will examine issues that come under the
broad heading of corporate finance. Here we will examine the key
decisions made by firms, how they affect firm value and empirical
evidence on these issues. The areas involved include the capital
structure decision, dividend policy, and mergers and acquisitions.
By studying these areas, you should gain an appreciation of optimal
financial policy on a firm level, conditions under which an optimal
policy actually exists and how the actual financial decisions of firms
may be explained in theoretical terms.

Aims of the course


This course is aimed at students interested in understanding asset
pricing and corporate finance. It provides a theoretical framework used
to address issues in project appraisal and financing, the pricing of risk,
securities valuation, market efficiency, capital structure and mergers and
acquisitions. It provides students with the tools required for further studies
in financial intermediation and investments.

Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
explain how to value projects, and use the key capital budgeting
techniques (NPV and IRR)
understand the mathematics of portfolios and how risk affects the
value of the asset in equilibrium under the fundaments asset pricing
paradigms (CAPM and APT)
know how to use recent extensions of the CAPM, such as the Fama
and French three-factor model, to calculate expected returns on risky
securities

92 Corporate finance

explain the characteristics of derivative assets (forwards, futures and


options), and how to use the main pricing techniques (binomial methods
in derivatives pricing and the BlackScholes analysis)
discuss the theoretical framework of informational efficiency in financial
markets and evaluate the related empirical evidence
understand the trade-off firms face between tax advantages of debt and
various costs of debt
understand and explain the capital structure theory, and how information
asymmetries affect it
understand and explain the relevance, facts and role of the dividend policy
understand how corporate governance can contribute to firm value
discuss why merger and acquisition activities exist, and calculate the
related gains and losses.

Syllabus
Note: A minor revision was made to this syllabus in 2009.
Students may bring into the examination hall their own hand-held
electronic calculator. If calculators are used they must satisfy the
requirements listed in the Regulations.
If you are taking this course as part of a BSc degree, courses which must
be passed before this course may be attempted are 2 Introduction to
economics and 5A Mathematics 1 or 5B Mathematics 2 or 174
Calculus.
Project evaluation: Hirschleifer analysis and Fisher separation; the NPV rule
and IRR rules of investment appraisal; comparison of NPV and IRR; wrong
investment appraisal rules: payback and accounting rate of return.
Risk and return the CAPM and APT: the mathematics of portfolios; meanvariance analysis; two-fund separation and the CAPM; Rolls critique of the
CAPM; factor models; the arbitrage pricing theory; recent extensions of the
factor framework.
Derivative assets characteristics and pricing: definitions: forwards and futures;
replication, arbitrage and pricing; a general approach to derivative pricing
using binomial methods; options: characteristics and types; bounding and
linking option prices; the BlackScholes analysis.
Efficient markets theory and empirical evidence: underpinning and definitions
of market efficiency; weak-form tests: return predictability; the joint
hypothesis problem; semi-strong form tests: the event study methodology
and examples; strong form tests: tests for private information; long-horizon
return predictability.
Capital structure: the ModiglianiMiller theorem: capital structure irrelevancy;
taxation, bankruptcy costs and capital structure; weighted average cost
of capital; Modigliani-Miller 2nd proposition; the Miller equilibrium;
asymmetric information: 1) the under-investment problem, asymmetric
information; 2) the risk-shifting problem, asymmetric information; 3) free
cash-flow arguments; 4) the pecking order theory; 5) debt overhang.
Dividend theory: the ModiglianiMiller and dividend irrelevancy; Lintners
fact about dividend policy; dividends, taxes and clienteles; asymmetric
information and signalling through dividend policy.
Corporate governance: separation of ownership and control; management
incentives; management shareholdings and firm value; corporate governance.
Mergers and acquisitions: motivations for merger activity; calculating the gains
and losses from merger/takeover; the free-rider problem and takeover
activity.
2

Introduction to the subject guide

Essential reading
There are a number of excellent textbooks that cover this area. However,
the following text has been chosen as the core text for this course due
to its extensive treatment of many of the issues covered and up-to-date
discussions:
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) European edition
[ISBN 978007119027].

At the start of each chapter of this guide, we will indicate the reading that
you need to do from Hillier, Grinblatt and Titman (2008).
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.

Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass., London: McGraw-Hill, 2008) ninth international edition [ISBN
9780071266758].
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) fourth edition
[ISBN 9780321223531].

A full list of all Further reading referred to in the subject guide is


presented here for ease of reference.

Journal articles
Asquith, P. and D. Mullins The impact of initiating dividend payments on
shareholders wealth, Journal of Business 56(1) 1983, pp.7796.
Ball, R. and P. Brown An empirical evaluation of accounting income numbers,
Journal of Accounting Research 6(2) 1968, pp.15978.
Bhattacharya, S. Imperfect information, dividend policy, and the bird in the
hand fallacy, Bell Journal of Economics 10(1) 1979, pp.25970.
Blume, M., J. Crockett and I. Friend Stock ownership in the United States:
characteristics and trends, Survey of Current Business 54(11) 1974,
pp.1640.
Bradley, M., A. Desai and E. Kim Synergistic gains from corporate acquisitions
and their division between the stockholders of target and acquiring firms,
Journal of Financial Economics 21(1) 1988, pp.340.
Brock, W., J. Lakonishok and B. LeBaron Simple technical trading rules and
stochastic properties of stock returns, Journal of Finance 47(5) 1992,
pp.173164.

92 Corporate finance
Campbell, J. and R. Shiller The dividend-price ratio and expectations of future
dividends and discount ractors, Review of Financial Studies 1 1988.
Chen, N-F. Some empirical tests of the theory of arbitrage pricing, The Journal
of Finance 38(5) 1983, pp.1393414.
Chen, N-F., R. Roll and S. Ross Economic Forces and the Stock Market, Journal
of Business 59 1986, pp.383403.
Cochrane, J.H. Explaining the variance of price-dividend ratios, Review of
Financial Studies 5 1992, pp.24380.
DeBondt, W. and R. Thaler Does the stock market overreact?, Journal of
Finance 40(3) 1984, pp.793805.
Fama, E. The behavior of stock market prices, Journal of Business 38(1) 1965,
pp.34105.
Fama, E. Efficient capital markets: a review of theory and empirical work,
Journal of Finance 25(2) 1970, pp.383417.
Fama, E. Efficient capital markets: II, Journal of Finance 46(5) 1991,
pp.1575617.
Fama, E. and K. French Dividend yields and expected stock returns, Journal of
Financial Economics 22(1) 1988, pp.325.
French, K. Stock returns and the weekend effect, Journal of Financial
Economics 8(1) 1980, pp.5570.
Fama, E. and K. French The cross-section of expected stock returns, Journal of
Finance 47(2) 1992, pp.42765.
Fama, E. and K. French Common risk factors in the returns on stocks and
bonds, Journal of Financial Economics 33 1993, pp.356.
Fama, E. and J. MacBeth. Risk, return, and equilibrium: empirical tests,
Journal of Political Economy 91 1973, pp.60736.
Gibbons, M.R., S.A. Ross, and J. Shanken. A test of the efficiency of a given
portfolio, Econometrica 57 1989, pp.112152.
Grossman, S. and O. Hart Takeover bids, the free-rider problem and the theory
of the corporation, Bell Journal of Economics 11(1) 1980, pp.4264.
Healy, P. and K. Palepu Earnings information conveyed by dividend initiations
and omissions, Journal of Financial Economics 21(2) 1988, pp.14976.
Healy, P., K. Palepu and R. Ruback Does corporate performance improve after
mergers?, Journal of Financial Economics 31(2) 1992, pp.13576.
Jegadeesh, N. and S. Titman Returns to buying winners and selling losers,
Journal of Finance 48 1993, pp.6591.
Jarrell, G. and A. Poulsen Returns to acquiring firms in tender offers: evidence
from three decades, Financial Management 18(3) 1989, pp.1219.
Jarrell, G., J. Brickley and J. Netter The market for corporate control: the
empirical evidence since 1980, Journal of Economic Perspectives 2(1) 1988,
pp.4968.
Jensen, M. Some anomalous evidence regarding market efficiency, Journal of
Financial Economics 6(23) 1978, pp.95101.
Jensen, M. Agency costs of free cash flow, corporate finance, and takeovers,
American Economic Review 76(2) 1986, pp.32329.
Jensen, M. and W. Meckling Theory of the firm: managerial behaviour, agency
costs and capital structure, Journal of Financial Economics 3(4) 1976,
pp.30560.
Jensen, M. and R. Ruback The market for corporate control: the scientific
evidence, Journal of Financial Economics 11(14) 1983, pp.550.
Lakonishok, J., A. Shleifer and R. Vishny Contrarian investment, extrapolation,
and risk, Journal of Finance 49(5) 1994, pp.154178.
Lettau, M. and S. Ludvigson Consumption, aggregate wealth, and expected
stock returns, Journal of Finance 56 2001, pp.81549.
Levich, R. and L. Thomas The significance of technical trading-rule profits in
the foreign exchange market: a bootstrap approach, Journal of International
Money and Finance 12(5) 1993, pp.45174.
4

Introduction to the subject guide


Lintner, J. Distribution of incomes of corporations among dividends, retained
earnings and taxes American Economic Review 46(2) 1956, pp.97113.
Lo, A. and C. McKinlay Stock market prices do not follow random walks:
evidence from a simple specification test, Review of Financial Studies 1(1)
1988, pp.4166.
Masulis, R. The impact of capital structure change on firm value: some
estimates, Journal of Finance 38(1) 1983, pp.10726.
Miles, J. and J. Ezzell The weighed average cost of capital, perfect capital
markets and project life: a clarification, Journal of Financial and
Quantitative Analysis 15 1980, pp.71930.
Miller, M. Debt and taxes, Journal of Finance 32 1977, pp.26175.
Modigliani, F. and M. Miller The cost of capital, corporation finance and the
theory of investment, American Economic Review (48)3 1958, pp.26197.
Modigliani, F. and M. Miller Corporate income taxes and the cost of capital: a
correction, American Economic Review (5)3 1963, pp.43343.
Myers, S. Determinants of corporate borrowing, Journal of Financial Economics
5(2) 1977, pp.14775.
Myers, S. and N. Majluf Corporate financing and investment decisions when
firms have information that investors do not have, Journal of Financial
Economics 13(2) 1984, pp.187221.
Poterba, J. and L. Summers Mean reversion in stock prices: evidence and
implications, Journal of Financial Economics 22(1) 1988, pp.2759.
Roll, R. A critique of the asset pricing theorys texts. Part 1: on past and
potential testability of the theory, Journal of Financial Economics 4(2)
1977, pp.12976.
Ross, S. The determination of financial structure: the incentive signalling
approach, Bell Journal of Economics 8(1) 1977, pp.2340.
Shleifer, A. and R. Vishny Large shareholders and corporate control,
Journal of Political Economy 94(3) 1986, pp.46188.
Shleifer, A. and R. Vishny Managerial entrenchment: the case of managementspecific investment, Journal of Financial Economics 25, 1989 pp.12339.
Travlos, N. Corporate takeover bids, methods of payment, and bidding firms
stock returns, Journal of Finance 42(4) 1990, pp.94363.
Warner, J. Bankruptcy costs: some evidence, Journal of Finance 32(2) 1977,
pp.33747.

Books
Allen, F. and R. Michaely Dividend policy in Jarrow, R., W. Maksimovic and
W.T. Ziemba (eds) Handbook of Finance. (Amsterdam: Elsevier Science,
1995) [ISBN 9780444890849].
Haugen, R. and J. Lakonishok The Incredible January Effect. (Homewood, Ill.:
Dow Jones-Irwin, 1988) [ISBN 9781556230424].
Ravenscraft, D. and F. Scherer Mergers, Selloffs, and Economic Efficiency.
(Washington D.C.: Brookings Institution, 1987) [ISBN 9780815773481].

Online study resources


In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should receive your login details in your study pack. If you have not,
or you have forgotten your login details, please email uolia.support@
london.ac.uk quoting your student number.
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92 Corporate finance

The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a sense
of community. It forms an important part of your study experience with the
University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own
understanding of subject material.
Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
Past examination papers and Examiners commentaries: These provide
advice on how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials and
conclusions.
Recorded lectures: For some courses, where appropriate, the sessions from
previous years Study Weekends have been recorded and made available.
Study skills: Expert advice on preparing for examinations and developing
your digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we are
expanding our provision all the time and you should check the VLE regularly
for updates.

Making use of the Online Library


The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either need
to use your University of London Student Portal login details, or you will be
required to register and use an Athens login: http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the Online
Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php

Subject guide structure and use


You should note that, as indicated above, the study of the relevant chapter
should be complemented by at least the Essential reading given at the chapter
head.
The content of the subject guide is as follows.
Chapter 1: here we focus on the evaluation of real investment projects
using the net present value technique and provide a comparison of NPV
with alternative forms of project evaluation.
6

Introduction to the subject guide

Chapter 2: we look at the basics of risk and return of primitive


financial assets and meanvariance optimisation. We go on to derive
and discuss the capital asset pricing model (CAPM).
Chapter 3: we present the arbitrage pricing theory, proposed as an
alternative to the CAPM and discuss multifactor models. We study
several recent multifactor models, such as the Fama and French threefactor model, and observe that they can explain a large fraction of the
variation in risky returns.
Chapter 4: here we look at derivative assets. We begin with the
nature of forward, future, option and swap contracts, then move on to
pricing derivative assets via absence-of-arbitrage arguments. We also
include a description of binomial option pricing models and end with
the BlackScholes analysis.
Chapter 5: in this chapter, we examine the efficiency of financial
markets. We present the concepts underlying market efficiency and
discuss the empirical evidence on efficient markets. We also note that
returns may be predictable even in efficient markets if risk is also
predictable and discuss evidence in support of predictability of long
horizon returns.
Chapter 6: here we turn to corporate finance issues, treating the decision
over a corporations capital structure. The essential issue is what levels of
debt and equity finance should be chosen in order to maximise firm value.
Chapter 7: this chapter is complementary to Chapter 6, however, rather
than looking at values, as in Chapter 6, this chapter analyses discount
rates. We learn that if there are no taxes, while the return on equity gets
riskier as the level of debt increases, the average rate the firm pays to
raise money is unchanged. In the presence of taxes, as debt increases, the
average rate the firm pays to raise money decreases due to tax shields.
Chapter 8: we look at more advanced issues in capital structure
theory and focus on the use of capital structure to mitigate governance
problems known as agency costs and how capital structure and
financial decisions are affected by asymmetric information.
Chapter 9: here we examine dividend policy. What is the empirical
evidence on the dividend payout behaviour of firms, and theoretically,
how can we understand the empirical facts?
Chapter 10: we look at mergers and acquisitions, and ask what
motivates firms to merge or acquire, what are the potential gains from
this activity, and how can this be theoretically treated? We also explore
how hostile acquisitions may serve as a discipline device to mitigate
governance problems.
There is no specific chapter about corporate governance, but the
agency-related topics of Chapters 8 and 10 are inherently motivated by
the existence of such problems. See also Hillier, Grinblatt and Titman
(2008) Chapter 18 for a broad overview on governance-related issues.

Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
7

92 Corporate finance

check the rubric/instructions on the paper you actually sit and follow
those instructions.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
This course will be evaluated solely on the basis of a three-hour
examination. You will have to answer four out of a choice of eight
questions. Although the Examiners will attempt to provide a fairly
balanced coverage of the course, there is no guarantee that all of the
topics covered in this guide will appear in the examination. Examination
questions may contain both numerical and discursive elements. Finally,
each question will carry equal weight in marking and, in allocating your
examination time, you should pay attention to the breakdown of marks
associated with the different parts of each question.

Glossary of abbreviations used in this subject guide

APT

arbitrage pricing theory

CAPM

capital asset pricing model

CML

capital market line

IRR

internal rate of return

MM

ModiglianiMiller

NPV

net present value

Chapter 1: Present value calculations and the valuation of physical investment projects

Chapter 1: Present value calculations


and the valuation of physical investment
projects
Aim
The aim of this chapter is to introduce the Fisher separation theorem, which
is the basis for using the net present value (NPV) for project evaluation
purposes. With this aim in mind, we discuss the optimality of the NPV
criterion and compare this criterion with alternative project evaluation
criteria.

Learning outcomes
At the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
analyse optimal physical and financial investment in perfect capital
markets setting and derive the Fisher separation result
justify the use of the NPV rules via Fisher separation
compute present and future values of cash-flow streams and appraise
projects using the NPV rule
evaluate the NPV rule in relation to other commonly used evaluation
criteria
value stocks and bonds via NPV.

Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapters 9 (Discounting
and Valuation), 10 (Investing in Risk-Free Projects), 11 (Investing in Risky
Projects).

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 2 (Present Values), 3 (How to
Calculate Present Values), 5 (The Value of Common Stocks), 6 (Why NPV
Leads to Better Investment Decisions) and 7 (Making Investment Decisions
with the NPV Rule).
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,
Mass.; Wokingham: Addison-Wesley, 2005) Chapters 1 and 2.
Roll, R. A critique of the asset pricing theorys texts. Part 1: on past and potential
testability of the theory, Journal of Financial Economics 4(2) 1977,
pp.12976.

92 Corporate finance

Overview
In this chapter we present the basics of the present value methodology
for the valuation of investment projects. The chapter develops the
NPV technique before presenting a comparison with the other project
evaluation criteria that are common in practice. We will also discuss the
optimality of NPV and give a number of extensive examples.

Introduction
For the purposes of this chapter, we will consider a firm to be a package
of investment projects. The key question, therefore, is how do the
firms shareholders or managers decide on which investment projects to
undertake and which to discard? Developing the tools that should be used
for project evaluation is the emphasis of this chapter.
It may seem, at this point, that our definition of the firm is rather limited.
It is clear that, in only examining the investment operations of the firm,
we are ignoring a number of potentially important firm characteristics.
In particular, we have made no reference to the financial structure or
decisions of the firm (i.e. its capital structure, borrowing or lending
activities, or dividend policy). The first part of this chapter presents what
is known as the Fisher separation theorem. What follows is a statement
of the theorem. This theorem allows us to say the following: under
certain conditions (which will be presented in the following section), the
shareholders can delegate to the management the task of choosing which
projects to undertake (i.e. determining the optimal package of investment
projects), whereas they themselves determine the optimal financial
decisions. Hence, the theory implies that the investment and financing
choices can be completely disconnected from each other and justifies our
limited definition of the firm for the time being.

Fisher separation and optimal decision-making


Consider the following scenario. A firm exists for two periods
(imaginatively named period 0 and period 1). The firm has current funds
of m and, without any investment, will receive no money in period 1.
Investments can be of two forms. The firm can invest in a number of
physical investment projects, each of which costs a certain amount of cash
in period 0 and delivers a known return in period 1. The second type of
investment is financial in nature and permits the firm to borrow or lend
unlimited amounts at rate of interest r. Finally the firm is assumed to have
a standard utility function in its period 0 and period 1 consumption. (By
consumption we mean the use of any funds available to the firm net of any
costs of investment.)
Let us first examine the set of physical investments available. The firm
will logically rank these investments in terms of their return, and this will
yield a production opportunity frontier (POF) that looks as given in Figure
1.1. This curve represents one manner in which the firm can transform
its current funds into future income, where c0 is period 0 consumption,
and c1 is period 1 consumption. Using the assumed utility function for the
firm, we can also plot an indifference map on the same diagram to find the
optimal physical investment plan of a given firm. The optimal investment
policies of two different firms are shown in Figure 1.1.
It is clear from Figure 1.1 that the specifics of the utility function of
the firm will impact upon the firms physical investment policy. The
10

Chapter 1: Present value calculations and the valuation of physical investment projects

implication of this is that the shareholders of a firm (i.e. those whose


utility function matters in forming optimal investment policy) must dictate
to the managers of the firm the point to which it invests. However, until
now we have ignored the fact that the firm has an alternative method for
investment (i.e. using the capital market).

Figure 1.1
The financial investment allows firms to borrow or lend unlimited
amounts at rate r. Assuming that the firm undertakes no physical
investment, we can define the firms consumption opportunities quite
easily. Assume the firm neither borrows nor lends. This implies that
current consumption (c0) must be identically m, whereas period 1
consumption (c1) is zero. Alternatively, the firm could lend all of its funds.
This leads to c0 being zero and c1 = m (1 + r). The relationship between
period 0 and period 1 consumption is therefore:
c1 = (1 + r)(m c0).

(1.1)

This implies that the curve which represents capital market investments is
a straight line with slope (1 + r). This curve is labeled CML on Figure 1.2.
Again, we have on Figure 1.2 plotted the optimal financial investments for
two different sets of preferences (assuming that no physical investment is
undertaken).

Figure 1.2
11

92 Corporate finance

Now we can proceed to analyse optimal decision-making when firms


invest in both financial and physical assets. Assume that the firm is at the
beginning of period 0 and trying to decide on its investment plan. It is
clear that, to maximise firm value, the projects undertaken should be those
with the greatest return. Knowing that the return on financial investment
is always (1+r), the firm will first invest in all physical investment projects
with returns greater than (1+r ). These are those projects on the production
possibility frontier (PPF) between points m and I on Figure 1.3.1 Projects
above I on the PPF have returns that are dominated by the return from
financial investment.
Hence, the firm physically invests up to point I. Note that, at this point,
we have not mentioned the firms preferences over period 0 and period
1 consumption. Hence, the decision to physically invest to I will be taken
by all firms regardless of the preferences of their owners. Preferences
come into play when we consider what financial investments should be
undertaken.
The firms physical investment policy takes it to point I, from where it can
borrow or lend on the capital market. Borrowing will move the firm to
the south-east along a line starting at I and with slope (1+r); lending will
take the firm north-west along a similarly sloped line. Two possible optima
are shown on Figure 1.3. The optimum at point X is that for a firm whose
owners prefer period 1 consumption relative to period 0 consumption (and
have hence lent on the capital market), whereas a firm locating at Y has
borrowed, as its owners prefer date 0 to date 1 consumption.
Figure 1.3 demonstrates the key insight of Fisher separation. All firms,
regardless of preferences, will have the same optimal physical investment
policy, investing to the point where the PPF and capital market line are
tangent. Preferences then dictate the firms borrowing or lending policy
and shift the optimum along the capital market line. The implication of
this is that, as it is physical investment that alters firm value, all agents
(i.e. regardless of preferences) agree on the physical investment policy that
will maximise firm value. More specifically, the shareholders of the firm
can delegate choice of investment policy to a manager whose preferences
may differ from their own, while controlling financial investment policy in
order to suit their preferences.

Figure 1.3

12

The absolute value of


the slope of the PPF can
be equated with the
return on physical
investment. For all points
below I on the PPF, this
slope exceeds that of
the capital market line
and hence defines the
set of desirable physical
investment projects.

Chapter 1: Present value calculations and the valuation of physical investment projects

Fisher separation and project evaluation


Fisher separation can also be used to justify a certain method of project
appraisal. Figure 1.3 shows a suboptimal physical investment decision
(I) and the capital market line that borrowing and lending from point I
would trace out. Clearly this capital market line always lies below that
achieved through the optimal physical investment policy. Hence, one could
say that optimal physical investment should maximise the horizontal
intercept of the capital market line on which the firm ends up. Let us,
then, assume a firm that decides to invest a dollar amount of I0. Given that
the firm has date 0 income of m and no date 1 income, aside from that
accruing from physical investment, the horizontal intercept of the capital
market line upon which the firm has located is:

where (I0) is the date 1 income from the firms physical investment.
Maximising this is equivalent to the following maximisation problem:
.

The prior objective is the NPV rule for project appraisal. It says that an
optimal physical investment policy maximises the difference between
investment proceeds divided by one plus the interest rate and the
investment cost. Here, the term optimal is being defined as that which
leads to maximisation of shareholder utility. We will discuss the NPV rule
more fully (and for cases involving more than one time period) later in
this chapter.
The assumption of perfect capital markets is vital for our Fisher separation
results to hold. We have assumed that borrowing and lending occur at the
same rate and are unrestricted in amount and that there are no transaction
costs associated with the use of the capital market. However, in practical
situations, these conditions are unlikely to be met. A particular example
is given in Figure 1.4. Here we have assumed that the rate at which
borrowing occurs is greater than the rate of interest paid on lending (as
the real world would dictate). Figure 1.3 shows that there are now two
points at which the capital market lines and the production opportunities
frontier are tangential. This then implies that agents with different
preferences will choose differing physical investment decisions and,
therefore, Fisher separation breaks down.

Figure 1.4
13

92 Corporate finance

Agents with strong preferences for future consumption will physically


invest to point X and then financially invest to an optimum on the
capital market lending line (CML). Those with strong preferences for
current consumption physically invest to point Y and borrow (along
CML). Finally, a set of agents may exist who value current and future
consumption similarly, and these will optimise by locating directly on the
PPF and not using the capital market at all. An example of an optimum of
this type is point Z on Figure 1.4.

The time value of money


In the preceding section we demonstrated the Fisher separation theorem
and the manner in which physical and financial investment decisions can
be disconnected. The major implication of this theorem is that the set of
desirable physical investment projects does not depend on the preferences
of individuals. In the following sections we shall focus on the way in
which individual physical investment projects should be evaluated. Our
key methodology for this will be the NPV rule, mentioned in the preceding
section. In the following sections we will show you how to apply the rule
to situations involving more than one period and with time-varying cash
flows.
To begin, let us consider a straightforward question. Is $1 received today
worth the same as $1 received in one years time? A nave response to
this question would assert that $1 is $1 regardless of when it is received,
and hence the answer to the question would be yes. A more careful
consideration of the question brings the opposite response however. Lets
assume I receive $1 now. If I also assume that there is a risk-free asset in
which I can invest my dollar (e.g. a bank account), then in one years time
I will receive $(1+r), assuming I invest. Here, r is the rate of return on the
safe investment. Hence $1 received today is worth $(1+r) in one year. The
answer to the question is therefore no. A dollar received today is worth
more than a dollar received in one year or at any time in the future.
The above argument characterises the time value of money. Funds are
more valuable the earlier they are received. In the previous paragraph we
illustrated this by calculating the future value of $1. We can similarly
illustrate the time value of money by using present values. Assume I
am to receive $1 in one years time and further assume that the borrowing
and lending rate is r. How much is this dollar worth in todays terms?
To answer this second question, put yourself in the position of a bank.
Knowing that someone is certain to receive $1 in one year, what is the
maximum amount you would lend him or her now? If I, as a bank, were to
lend someone money for one year, at the end of the year I would require
repayment of the loan plus interest (at rate r). Hence if I loaned the
individual $x, I would require a repayment of $x(1+r). This implies that the
maximum amount I should be willing to lend is implicitly defined by the
following equation:
$x(1+r) = $1

(1.2)

such that:
(1.3)
The value for x defined in equation 1.3 is the present value of $1
received in one years time. This quantity is also termed the discounted
value of the $1.

14

Chapter 1: Present value calculations and the valuation of physical investment projects

You can see the present and future value concepts pictured in Figure 1.2.
If you recall, Figure 1.2 just plots the CML for a given level of initial funds
(m) assuming no funds are to be received in the future. The future value
of this amount of money is simply the vertical intercept of the CML (i.e.
m(1+r)), and obviously the present value of m(1+r) is just m.
The present and future value concepts are straightforwardly extended
to cover more than one period. Assume an annual compound interest rate
of r. The present value of $100 to be received in k years time is:
(1.4)
whereas the future value of $100 received today and evaluated k years
hence is:
FVK (100) = 100(1 + r)K.

(1.5)

Activity
Below, there are a few applications of the present and future value concepts. You should
attempt to verify that you can replicate the calculations.
Assume a compound borrowing and lending rate of 10 per cent annually.
a. The present value of $2,000 to be received in three years time is $1,502.63.
b. The present value of $500 to be received in five years time is $310.46.
c. The future value of $6,000 evaluated four years hence is $8,784.60.
d. The future value of $250 evaluated 10 years hence is $648.44.

The net present value rule


In the previous section we demonstrated that the value of funds depends
critically on the time those funds are received. If received immediately,
cash is more valuable than if it is to be received in the future.
The NPV rule was introduced in simple form in the section on Fisher
separation. In its more general form, it uses the discounting techniques
provided in the previous section in order to generate a method of
evaluating investment projects. Consider a hypothetical physical
investment project, which has an immediate cost of I. The project
generates cash flows to the firm in each of the next k years, equal to Ck.
In words, all that the NPV rule does is to compute the present value of all
receipts or payments. This allows direct comparisons of monetary values,
as all are evaluated at the same point in time. The NPV of the project is
then just the sum of the present values of receipts, less the sum of the
present values of the payments.
Using the notation given above and again assuming a rate of return of r,
the NPV can be written as:
.

(1.6)

Note that the cash flows to the project can be positive and negative,
implying that the notation employed is flexible enough to embody both
cash inflows and outflows after initiation.
Once we have calculated the NPV, what should we do? Clearly, if the NPV
is positive, it implies that the present value of receipts exceeds the present
value of payments. Hence, the project generates revenues that outweigh its
costs and should therefore be accepted. If the NPV is negative the project
should be rejected, and if it is zero the firm will be indifferent between
accepting and rejecting the project.
15

92 Corporate finance

This gives a very straightforward method for project evaluation. Compute


the NPV of the project (which is a simple calculation), and if it is greater
than zero, the project is acceptable.
Example
Consider a manufacturing firm, which is contemplating the purchase of a new piece of
plant. The rate of interest relevant to the firm is 10 per cent. The purchase price is 1,000.
If purchased, the machine will last for three years and in each year generate extra revenue
equivalent to 750. The resale value of the machine at the end of its lifetime is zero. The
NPV of this project is:
NPV = 750 + 750 + 750 1000 = 865.14.
(1.1)3 (1.1)2 (1.1)1
As the NPV of the project exceeds zero, it should be accepted.
In order to familiarise yourself with NPV calculations, attempt the following
activities by calculating the NPV of each project and assessing its desirability.
Activity
Assume an interest rate of 5 per cent. Compute the NPV of each of the following projects,
and state whether each project should be accepted or not.
Project A has an immediate cost of $5,000, generates $1,000 for each of the next six
years and zero thereafter.
Project B costs 1,000 immediately, generates cash flows of 600 in year 1,
300 in year 2 and 300 in year 3.
Project C costs 10,000 and generates 6,000 in year 1. Over the following years, the
cash flows decline by 2,000 each year, until the cash flow reaches zero.
Project D costs 1,500 immediately. In year 1 it generates 1,000. In year 2 there is a
further cost of 2,000. In years 3, 4 and 5 the project generates revenues of 1,500
per annum.
Up to this point we have just considered single projects in isolation,
assuming that our funds were enough to cover the costs involved. What
happens, first of all, if the members of a set of projects are mutually
exclusive?2 The answer is simple. Pick the project that has the greatest
NPV. Second, what should we do if we have limited funds? It may be the
case that we are faced with a pool of projects, all of which have positive
NPVs, but we only have access to an amount of money that is less than the
total investment cost of the entire project pool. Here we can rely on
another nice feature of the NPV technique. NPVs are additive across
projects (i.e. the NPV of taking on projects A and B is identical to the NPV
of A plus the NPV of B). The reason for this should be obvious from the
manner in which NPVs are calculated. Hence, in this scenario, we should
calculate all project combinations that are feasible (i.e. the total investment
in these projects can be financed with our current funds). Then calculate
the NPV of each combination by summing the NPVs of its constituents, and
finally choose the combination that yields the greatest total NPV.
Finally, we should devote some time to discussion of the interest rate
we have used to discount future cash flows. Until now we have just
referred to r as the rate at which one can borrow or lend funds. A more
precise definition of r is that r is the opportunity cost of capital. If we are
considering the use of the NPV rule within the context of a firm, we have
to recognise that the firm has several sources of capital, and the cost of
each of these should be taken into account when evaluating the firms
16

By this we mean that


taking on any one of the
set of projects precludes
us from accepting any of
the others.

Chapter 1: Present value calculations and the valuation of physical investment projects

overall cost of capital. The firm can raise funds via equity issues and
debt issues, and it is likely that the costs of these two types of funds will
differ. Later on in this chapter and in those that follow, we will present
techniques by which the firm can compute the overall cost of capital for its
enterprise.

Other project appraisal techniques


The NPV methodology for project appraisal is by no means the only
technique used by firms to decide on their physical investment policy. It is,
however, the optimal technique for corporate management to use if they
wish to maximise expected shareholder wealth. This result is obvious from
our Fisher separation analysis. In this section we talk about three of NPVs
competitors, the payback rule, the internal rate of return (IRR) rule,
and the multiples method, which are sometimes used in practice.

The payback rule


Payback is a particularly simple criterion for deciding on the desirability
of an investment project. The firm chooses a fixed payback period, for
example, three years. If a project generates enough cash in the first three
years of its existence to repay the initial investment outlay, then it is
desirable, and if it doesnt generate enough cash to cover the outlay, it
should be rejected. Take the cash-flow stream given in the following table as
an example.
Year
Cash flow

1,000

250

250

250

500

Table 1.1
A firm that has chosen a payback period of three years and is faced with
the project shown in Table 1.1 will reject it as the cash flow in years 1 to
3 (750) doesnt cover the initial outlay of 1,000. Note, however, that if the
firm used a payback period of four years, the project would be acceptable,
as the total cash flow to the project would be 1,250, which exceeds the
outlay. Hence, its clear that the crucial choice by management is of the
payback period.
We can also use the preceding example to illustrate the weaknesses
of payback. First, assume that the firm has a payback period of three
years. Then, as previously mentioned, the project in Table 1.1 will not be
accepted. However, assume also that, instead of being 500, the project
cash flow in year 4 is 500,000. Clearly, one would want to revise ones
opinion on the desirability of the project, but the payback rule still says
you should reject it. Payback is flawed, as a portion of the cash-flow
stream (that realised after the payback period is up) is always ignored in
project evaluation.
The second weakness of payback should be obvious, given our earlier
discussion of NPV. Payback ignores the time value of money. Sticking with
the example in Table 1.1, assume a firm has a payback period of four years.
Then the project as given should be accepted (as total cash flow of 1,250
exceeds investment outlay of 1,000). But whats the NPV of this project?
If we assume, for example, a required rate of return of 10 per cent, then
the NPV can be shown to be negative. (In fact the NPV is 36.78. As a
self-assessment activity, show that this is the case.) Hence application of
the payback rule tells us to accept a project that would decrease expected
shareholder wealth (as shown by application of the NPV rule). This flaw
could be eliminated by discounting project cash flows that accrue within
17

92 Corporate finance

the payback period, giving a discounted payback rule, but such a


modification still wouldnt solve the first problem we highlighted.

The internal rate of return rule


The IRR rule can be viewed as a variant on the apparatus we used in the
NPV formulation. The IRR of a project is the rate of return that solves the
following equation:
(1.7)
where Ci is the project cash flow in year i, and I is the initial (i.e. year 0)
investment outlay. Comparison of equation 1.7 with 1.6 shows that the
project IRR is the discount rate that would set the project NPV to zero.
Once the IRR has been calculated, the project is evaluated by comparing
the IRR to a predetermined required rate of return known as a hurdle
rate. If the IRR exceeds the hurdle rate, then the project is acceptable,
and if the IRR is less than the hurdle rate it should be rejected. A graphical
analysis of this is presented in Figure 1.5, which plots project NPV against
the rate of return used in the NPV calculation. If r* is the hurdle rate used
in project evaluation, then the project represented by the curve on the
figure is acceptable as the IRR exceeds r*. Clearly, if r* is also the correct
required rate of return, which would be used in NPV calculations, then
application of the IRR and NPV rules to assessment of the project in Figure
1.5 gives identical results (as at rate r* the NPV exceeds zero).

Figure 1.5
Calculation of the IRR need not be straightforward. Rearranging equation
1.7 shows us that the IRR is a solution to a kth order polynomial in r.
In general, the solution must be found by some iterative process, for
example, a (progressively finer) grid search method. This also points to
a first weakness of the IRR approach; as the solution to a polynomial,
the IRR may not be unique. Several different rates of return might satisfy
equation 1.7; in this case, which one should be used as the IRR? Figure 1.6
gives a graphical example of this case.

18

Chapter 1: Present value calculations and the valuation of physical investment projects

Figure 1.6
The graphical approach can also be used to illustrate another weakness
of the IRR rule. Consider a firm that is faced with a choice between two
mutually exclusive investment projects (A and B). The locus of NPV-rate of
return pairings for each of these projects is given on Figure 1.7.
The first thing to note from the figure is that the IRR of project A exceeds
that of B. Also, both IRRs exceed the hurdle rate, r*. Hence, both projects
are acceptable but, using the IRR rule, one would choose project A as
its IRR is greatest. However, if we assume that the hurdle rate is the
true opportunity cost of capital (which should be employed in an NPV
calculation), then Figure 1.7 indicates that the NPV of project B exceeds
that of project A. Hence, in the evaluation of mutually exclusive projects,
use of the IRR rule may lead to choices that do not maximise expected
shareholder wealth.

Figure 1.7

19

92 Corporate finance

The multiples method


An alternative to using forecasts of a firms or projects cash flows to
calculate value, market information can be used to estimate the value.
The multiples method assesses the firms value based on the value of a
comparable publically traded firm. For example, consider the firms market
value to earnings ratio, this ratio tells us how much a dollar of earnings
contributes to the present value according to the markets consensus
view. For publically traded firms, this ratio is available. The firm we wish
to value may not have a publically available market value, however we
are likely to know its earnings. If we assume that these two firms should
have similar market value to earnings ratios, then we can value the firm
by taking the publically available ratio and multiplying it by the firms
earnings.
Common multiples to use are market value to earnings, market value
to EBITDA, market value to cash flow, and market value to book value.
Some firms, especially younger firms, have no earnings or even negative
earnings. In this case it may be better to value the firm as of some future
date in which the firms cash flows have stabilised, and then to discount to
todays value. An alternative is to use more creative multiples, for example
price to patent ratio, price to subscriber ratio, or price to Ph.D. ratio. It is
often better to take an average over several comparable firms to calculate
the multiple. If you believe the firm being valued is better or worse than
the comparable firms, you can shade the multiple down or up, as in the
example below. The multiples method is not an exact science but rather a
convenient way to incorporate market beliefs. It should always be used in
conjunction with another method, such as NPV.
Example
Below are the equity values, debt values, and earnings (in billions) for several large US
retailers. Additionally provided is earnings growth for the past 10 years.
E (10 yr) %

Equity

Debt

JCP

17.48

3.81

1.10

7.8

COST

24.08

2.22

1.10

15.5

HD

82.08

12.39

6.01

21.2

WMT

47.44

11.88

15.7

TGT

50.14

14.14

2.58

19.2

Walmarts (WMTs) equity value is excluded as this is the quantity we wish to estimate.
We can first calculate the market value of equity to earnings ratio for the average firm
in the industry (excluding Walmart), this is: [(17.48/1.1) + (24.08/1.1) + (82.08/6.01) +
(50.14/2.58)]/4 = 17.72
We now multiply this number by Walmarts earnings to get Walmarts equity value
estimate: 17.72*11.88=210.49. Walmarts actual equity value was $192.48 billion.
In the example above we used multiples to value equity, we sometimes
wish to the value of the full business (sometimes called enterprise value),
in this case we would need to use the full business value (for example,
debt plus equity) in the numerator instead of just equity value.
Notice that the debt to equity ratio of Costco (COST) was 9.2% while that
of Target (TGT) was 28.2%. In this example, we have ignored the effects
of leverage (debt in the capital structure), however as we will see in a later
chapter, leverage affects both firm value and the expected return on equity.
Therefore, firms with different leverage ratios that look otherwise similar
20

Chapter 1: Present value calculations and the valuation of physical investment projects

may have very different value to earnings ratios. We will learn how to
adjust the multiples method for the effects of leverage later.
The multiples method allows us to check whether the value of a
conglomerate is equal to the sum of its parts. To estimate the value of
each business division of a conglomerate we can calculate each divisions
earnings and multiply it by the average value to earnings multiple of stand
alone firms in the same sector. Adding up the value of all divisions gives
us an estimated value for the conglomerate, this estimate is on average
12% greater than the traded value of the conglomerate. This is called the
conglomerate discount. The reasons for the conglomerate discount
are not fully understood. It is possible that conglomerates are a less
efficient form of organisation due to inefficient capital markets. It is also
possible that the multiples method is inappropriate here because single
segment firms are too different from divisions of a conglomerate operating
in the same industry.
The strength of the multiples approach is that it incorporates a lot of
information in a simple way. It does not require assumptions on the
discount rate and growth rate (as is necessary with the NPV approach)
but just uses the consensus estimates from the market. A weakness is
the assumption that the comparable companies are truly similar to the
company one is trying to value; there is no simple way of incorporating
company specific information. However, its strength is also its biggest
weakness. By using market information, we are assuming that the market
is always correct. This approach would lead to the biggest mistakes
in times of biggest money making opportunities: when the market is
overvalued or undervalued.
The lesson of this section is therefore as follows. The most commonly
used alternative project evaluation criteria to the NPV rule can lead to
poor decisions being made under some circumstances. By contrast, NPV
performs well under all circumstances and thus should be employed.

Using present value techniques to value stocks and


bonds
To end this chapter, we will discuss very briefly how to value common
stocks and bonds through the application of present value techniques.

Stocks
Consider holding a common equity share from a given corporation. To
what does this equity share entitle the holder? Aside from issues such as
voting rights, the share simply delivers a stream of future dividends to
the holder. Assume that we are currently at time t, that the corporation is
infinitely long-lived (such that the stream of dividends goes on forever)
and that we denote the dividend to be paid at time t+i by Dt+i. Also
assume that dividends are paid annually. Denoting the required annual
rate of return on this equity share to be re, then a present value argument
would dictate that the share price (P) should be defined by the following
formula:
.

(1.8)

Note that in the above representation we have assumed that there is no


dividend paid at the current time (i.e. the summation does not start at
zero). In plain terms, what equation 1.8 says is that an equity share is
worth only the discounted stream of annual dividends that it delivers.
21

92 Corporate finance

A simplification of the preceding formula is available when we assume


that the dividend paid grows at constant percentage rate g per annum.
Then, assuming that a dividend of D0 has just been paid, the future stream
of dividends will be D0(1+g), D0(1+g)2, D0(1+g)3 and so on. This type of
cash-flow stream is known as a perpetuity with growth, and its
present value can be calculated very simply.3 In this setting the price of the
equity share is:
0

See Appendix 1.

(1.9)

This is the Gordon growth model of equity valuation. As is obvious


from the preceding discussion, it is only valid if you can assert that
dividends grow at a constant rate.
Note also that if you have the share price, dividend just paid and an
estimate of dividend growth, you can rearrange equation 1.9 to give the
required rate of return on the stock that is:
.

(1.10)

The first term in 1.10 is the expected dividend yield on the stock, and the
second is expected dividend growth. Hence, with empirical estimates of
the previous two quantities, we can easily calculate the required rate of
return on any equity share.
Activity
Attempt the following questions:
1. An investor is considering buying a certain equity share. The stock has just paid a
dividend of 0.50, and both the investor and the market expect the future dividend to
be precisely at this level forever. The required rate of return on similar equities is 8 per
cent. What price should the investor be prepared to pay for a single equity share?
2. A stock has just paid a dividend of $0.25. Dividends are expected to grow at
a constant annual rate of 5 per cent. The required rate of return on the share
is 10 per cent. Calculate the price of the stock.
3. A single share of XYZ Corporation is priced at $25. Dividends are expected
to grow at a rate of 8 per cent, and the dividend just paid was $0.50. What is
the required rate of return on the stock?

Bonds
In principle, bonds are just as easy to value.
A discount or zero coupon bond is an instrument that promises
to pay the bearer a given sum (known as the principal) at the end of
the instruments lifetime. For example, a simple five-year discount bond
might pay the bearer $1,000 after five years have elapsed.
Slightly more complex instruments are coupon bonds. These not
only repay the principal at the end of the term but in the interim entitle
the bearer to coupon payments that are a specified percentage of
the principal. Assuming annual coupon payments, a three-year bond
with principal of 100 and coupon rate of 8 per cent will give annual
payments of 8, 8 and 108 in years 1, 2 and 3.
In more general terms, assuming the coupon rate is c, the principal is P
and the required annual rate of return on this type of bond is rb, the price
of the bond can be written as:4
.
22

(1.11)

4
In our notation a
coupon rate of 12
per cent, for example,
implies that c = 0.12;
the discount rate used
here, rb , is called the
yield to maturity of the
bond.

Chapter 1: Present value calculations and the valuation of physical investment projects

Note that it is straightforward to value discount bonds in this framework


by setting c to zero.
Activity
Using the previous formula, value a seven-year bond with principal $1,000, annual
coupon rate of 5 per cent and required annual rate of return of 12 per cent.
(Hint: the use of a set of annuity tables might help.)

A reminder of your learning outcomes


Having completed this chapter, and the Essential reading and activities,
you should be able to:
analyse optimal physical and financial investment in a perfect capital
markets setting and derive the Fisher separation result
justify the use of the NPV rules via Fisher separation
compute present and future values of cash-flow streams and appraise
projects using the NPV rule
evaluate the NPV rule in relation to other commonly used evaluation
criteria
value stocks and bonds via NPV.

Key terms
capital market line (CML)
consumption
Fisher separation theorem
Gordon growth model
indifference curve
internal rate of return (IRR) rule
investment policy
net present value (NPV) rule
payback rule
production opportunity frontier (POF)
production possibility frontier (PPF)
time value of money
utility function

Sample examination questions


1. The Toyundai Motor Company has the opportunity to invest in new
production line equipment, which would have a working lifetime of 10
years. The new equipment would generate the following increases in
Toyundais net cash flows.
In the first year of usage the new plant would decrease costs by
$200,000. For the following six years the cost saving would fall at a
rate of 5 per cent per annum. In the remaining years of the equipments
lifetime, the annual cost saving would be $140,000. Assuming that the
cost of the equipment is $1,000,000 and that Toyundais cost of capital
is 10 per cent, calculate the NPV of the project. Should Toyundai take
on the investment? (15%)
23

92 Corporate finance

2. Describe two methods of project evaluation other than NPV. Discuss the
weaknesses of these methods when compared to NPV. (10%)
3. The CEO and other top executives of a firm with no nearby commercial
airports make approximately 300 flights per year with an average
cost per flight of $5,000. The firm is considering buying a Gulfstream
jet for $15 million. The jet will reduce the cost of travel to $300,000
(including fuel, maintenance, and other jet-related expenses).
The firm expects to be able to resell the jet in five years for $12.5
million. The firm pays a 25% corporate tax on its profits and can offset
its corporate liabilities by using straight line depreciation on its fixed
assets. The opportunity cost of capital is 4%.
a. Should the firm buy this jet if it has sufficient taxable profits in
order to take advantage of all tax shields?
b. Should the firm buy this jet if it does not have sufficient taxable
profits in order to take advantage of new tax shields?
c. Suppose the firm could lease an airplane for the first year, with
an option to extend the lease. Within that year they would find
out whether the local government has decided to build an airport
nearby which would reduce travel costs. How would this change
your calculations?
4. Suppose that you have a 10,000 student loan with a 5 per cent
interest rate. You also have 1,000 in your zero interest checking
account which you do not plan to use in the foreseeable future. You are
considering three strategies: (i) payoff as much of the loan as possible,
(ii) invest the money in a local bank at 3.5 per cent interest, (iii) invest
in the stock market. The expected return on the stock market is 6 per
cent for the foreseeable future. Your personal discount rate is 4 per
cent for risk-free investments. For simplicity assume all investments are
perpetuities.
a. What is the NPV of strategy (i)?
b. What is the NPV of strategy (ii)?
c. What is the NPV of strategy (iii) if you are risk neutral?
d. What is the NPV of strategy (iv) if your subjective market risk
premium is 3 per cent?

24

Chapter 2: Risk and return: meanvariance analysis and the CAPM

Chapter 2: Risk and return:


meanvariance analysis and the CAPM
Aim of the chapter
The aim of this chapter is to derive the capital asset pricing model (CAPM)
enabling us to price financial assets. In order to do so, we introduce the
meanvariance analysis setting, in which investors care solely about
financial assets expected returns and variances of returns, as well as the
statistical tools enabling us to calculate portfolios expected returns and
variances of returns.

Learning outcomes
At the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
discuss concepts such as a portfolios expected return and variance as
well as the covariance and correlation between portfolios returns
calculate portfolio expected return and variance from the expected
returns and return variances of constituent assets with confidence
describe the effects of diversification on portfolio characteristics
derive the CAPM using meanvariance analysis
describe some theoretical and practical limitations of the CAPM.

Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapters 4 (The Mathematics
and Statistics of Portfolios) and 5 (Mean-Variance Analysis and the CAPM).

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 8 (Introduction to Risk,
Return, and the Opportunity Cost of Capital) and 9 (Risk and Return).
Copeland, T. and J. Weston Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 5 and 6.
Roll, R. A critique of the asset pricing theorys texts. Part 1: on past and
potential testability of the theory, Journal of Financial Economics 4(2)
1977, pp.12976.

Introduction
In Chapter 1 we examined the use of present value techniques in the
evaluation of physical investment projects and in the valuation of primitive
financial assets (i.e. stocks and bonds). A key input into NPV calculations
is the rate of return used in the construction of the discount factor but,
thus far, we have said little regarding where this rate of return comes
from. Our objective in this chapter is to demonstrate how the risk of a
given security or project impacts on the rate of return required from it and
hence affects the value assigned to that asset in equilibrium.

25

92 Corporate finance

We begin by introducing the basic statistical tools that will be needed


in our analysis, these being expected values, variances and
covariances. This leads to an analysis of the statistical characteristics
of portfolios of financial assets and ultimately to a presentation of the
standard meanvariance optimisation problem. The key result of mean
variance analysis is known as two-fund separation, and this result
underlies the CAPM, which we will present next.

Statistical characteristics of portfolios


A portfolio is a collection of different assets held by a given investor. For
example, an American investor may hold 100 Microsoft shares and 650
shares of Bethlehem Steel and therefore holds a portfolio comprising
two assets. The objective of this section is to arrive at the statistical
characteristics of the return on the entire portfolio, given the statistical
features of each of the constituent assets. The key statistical measures used
are expected returns and return variances or standard deviations.
The expected return on a given asset can be thought of as the reward
gained from holding it, whereas the return variance is a measure of total
asset risk.
Let us define notation. First, we should clarify the way in which we are
thinking about asset returns. The return on an asset is assumed to be a
random variable with known distributional characteristics. Each individual
asset is assumed to have an expected return of E(rj) and return variance
2j. Assets i and j are assumed to have covariance ij . Similarly, we denote
the expected return of the portfolio held as E(Rp) and its variance by 2P.
Finally, we assume that an investor can pick from N different stocks when
forming their portfolio.
Returning to the example of the American investor given above, assume
that the market price of Microsoft shares is 130 and that of Bethlehem
Steel is 10.1 Hence, given the numbers of each share held, the total value
of this investors portfolio is $195. We further assume that the expected
returns on Microsoft and Bethlehem Steel are 10 per cent and 16 per cent
respectively, whereas their variances are 0.25 and 0.49.
We are now in a position to define the share of the entire portfolio value
that is contributed by each individual stockholding. These are referred
to as portfolio weights. The portfolio weight of Bethlehem Steel, for
example, is simply the value of the Bethlehem Steel holding divided by
$195 (i.e. 1/3 or approximately 33.3 per cent). Hence our US investor
allocates 1/3 of every dollar invested to Bethlehem Steel stock.
Activity
Calculate the portfolio weight for Microsoft, using the method presented above.
From the calculations undertaken it is clear that the sum of portfolio
weights must be unity. Each portfolio weight represents the share of total
portfolio value contributed by a given asset. Obviously, aggregating these
shares across all assets held will give a result of unity. Hence, extending
the notation presented above, we denote the portfolio weight on asset i by
ai, and the preceding argument implies that 1= 1.

26

These prices are in US


cents.

Chapter 2: Risk and return: meanvariance analysis and the CAPM

Our American investor now knows the statistical characteristics of the


return on each of the assets held, plus how to calculate the portfolio
weight on each of the assets. What they would really like to know now
is how to construct the return characteristics for the entire portfolio (i.e.
they are concerned about the risk and reward associated with their entire
investment). In order to do this we will need to introduce some basic
properties of expectations, variances and covariances.

Expectations, variances and covariances


Consider two random variables, x and y. The expected values and
variances of these variables are E(x), E(y), 2x and 2y. The covariance
between the random variables is xy.
Form an arbitrary linear combination of these two random variables and
denote it P (i.e. P = ax + by, where a and b are constants). We wish to
know the expected return and variance of the new random variable P.
These are calculated as follows:
E(P) = aE(x) + bE(y)

(2.1)

P = a x + b y + 2abxy.

(2.2)

2 2

2 2

The preceding results are readily extended to the case where more than
two random variables are linearly combined. Consider N random variables
denoted xi, where i runs from 1 to N. Denote their expected values and
variances as E(xi) and 2i. The covariance between xi and xj is ij. Again
we form a linear combination of the random variables, denoted again by
P, using an arbitrary set of constants denoted ai. The expected value and
variance of the random variable P are given by:
(2.3)
.

(2.4)

Given that the returns on individual assets are assumed to be random


variables with known distributional characteristics, the statistical results
given above allow us to calculate portfolio returns and variances very
simply.
In addition to the data on Microsoft and Bethlehem Steel provided earlier,
we also need to know the covariance between Microsoft and Bethlehem
Steel returns in order to determine the statistical characteristics of
portfolios of these two assets. However, rather than using covariances, we
shall work throughout the rest of this analysis with correlation coefficients.
The relationship between correlations and covariances is given below.

Covariances and correlations


Assume two random variables, x and y, with variances denoted by 2x and
2y. The covariance between the random variables is xy. The correlation
coefficient is defined as follows:
,

(2.5)

that is, the correlation between the two random variables is simply the
covariance, divided by the product of the respective standard deviations.
Clearly, knowledge of the correlation and the variances of the two random
variables allows one to retrieve the covariance between the two random
variables.
If we again define a linear combination of the two random variables, P,
using arbitrary constants a and b, the expression for the variance of the
27

92 Corporate finance

linear combination can be rewritten using the correlation as follows:


2p = a22x + b22y + 2abxyxy.

(2.6)

This is a straightforward substitution of equation 2.5 into equation 2.2.


Now we are in a position to calculate the characteristics of our American
investors portfolio. Let us take the simplest possible case first and assume
that the returns are uncorrelated (i.e. xy = 0). Recalling that the portfolio
weights on Microsoft and Bethlehem Steel are 2/3 and 1/3 respectively, we
can use equations 2.1 and 2.6 to derive the expected return and variance
of the investors portfolio. These calculations yield:
(2.7)
.

(2.8)

Hence, as we would anticipate, the expected portfolio return lies between


the returns on the individual assets. The portfolio variance, however, is
actually less than that on the return of either of the component assets (i.e.
the risk associated with the portfolio is lower than the risks associated
with either individual asset). This result is one that should be kept in mind
and is the focus of the next section.
Now lets change our assumption regarding the correlation between the
two asset returns. Assume now that xy = 0.5. Obviously, the expected
portfolio return wont change (as equation 2.1 doesnt involve the
correlation or covariance at all). The portfolio variance now becomes:
.

(2.9)

The portfolio variance has obviously increased, although it is still less than
the return variances of either component assets.
Activity
Assume that xy = 0.5. Calculate the portfolio return variance in this case, using the
data on portfolio weights and asset return variances given above.
Now, given the expected returns, return variances and covariances for
any set of assets, we should be able to calculate the expected return and
variance of any portfolio created from those assets. At the end of this
chapter, you will find activities that require you to do precisely this, along
with solutions to some of these activities.

Diversification
A point that we noted from the calculations of expected portfolio returns
and variances above was that, in all of our calculations, the variance of the
portfolio return was lower than that on any individual components asset
return.2 Hence, it seems as though, by forming bundles of assets, we can
eliminate risk. This is true and is known as diversification: through holding
portfolios of assets, we can reduce the risk associated with our position.
Why is this the case? The key is that, in our prior analysis and in real stock
return data, the correlations between returns are less than perfect. If two
returns are imperfectly correlated it implies that when returns on the first are
above average, those on the second need not be above average. Hence, to an
extent, the returns on such assets will tend to cancel each other out, implying
that the return variance for a portfolio of these stocks will be smaller than
the corresponding weighted average of the individual asset variances.
28

Note that this result


does not hold in general
(i.e. it may be the case
that the return variance
of a portfolio exceeds
the return variance of
one of the component
assets).

Chapter 2: Risk and return: meanvariance analysis and the CAPM

To illustrate this point in a general setting, consider the following scenario.


An investor holds a portfolio consisting of N stocks, with each stock having
the same portfolio weight (i.e. each stock has portfolio weight N1). Denote
the return variances for the individual assets by 2i where i = 1 to N, and
the covariance between returns on assets i and j by ij. Using equation 2.4,
the variance of the investors portfolio return can be written as:
.

(2.10)

Examining the second term of equation 2.10, the existence of N


component assets implies that the summation for all i not equal to j
involves N(N 1) terms. Obviously the summation in the first term of
equation 2.10 involves N terms. Hence, defining the average variance of
the N assets as 2 and average covariance across all assets as C, equation
2.10 can be rewritten as:
.

(2.11)

Equation 2.11 obviously simplifies to the following:


.

(2.12)

Now we ask the following question. How does the portfolio variance
change as the number of assets combined in the portfolio increases
towards infinity (i.e. N ). It is clear from equation 2.12 that, as the
number of assets held increases, the first term will shrink towards zero.
Also, as N increases the second term in equation 2.12 tends towards C.
Together, these observations imply the following:
1. The portfolio variance falls as the number of assets held increases.
2. The limiting portfolio return variance is simply the average covariance
between asset returns: this average covariance can be thought of as
the risk of the market as a whole, with the influence of individual asset
return variances disappearing in the limit.
The moral of the preceding statistical story is clear. Holding portfolios
consisting of greater and greater numbers of assets allows an investor
to reduce the risk that they bear. This is illustrated diagrammatically in
Figure 2.1.

Figure 2.1

29

92 Corporate finance

Meanvariance analysis
In the preceding two sections, we have demonstrated two important facts:
1. The expected return on a portfolio of assets is a linear combination of
the expected returns on the component assets.
2. An investor holding a diversified portfolio gains through the reduction
in portfolio variance, when asset returns are not perfectly correlated.
In this section, we use these facts to characterise the optimal holding of
risky assets for a risk-averse agent. Our fundamental assumption is that all
agents have preferences that only involve their expected portfolio return
and return variance. Utility is assumed to be increasing in the former
and decreasing in the latter. For illustrative purposes we begin using the
assumption that only two risky assets are available. The results presented,
however, generalise to the N asset case.
To begin, assume there is no risk-free aset. The investor can hence only
form their portfolio from risky assets named X and Y. These assets have
expected returns of E(Rx) and E(Ry) and return variances of 2x and 2y.
The first question the investor wishes to answer is how the characteristics
of a portfolio of these assets (i.e. portfolio expected return and variance)
change as the portfolio weights on the assets change. Given equation 2.6,
the answer to this question is obviously dependent on the correlation
between the returns on the two assets.
First assume that the assets are perfectly correlated and, further, assume
asset X has lower expected returns and return variance than asset Y. We
form a portfolio with weights on asset X and 1 on asset Y. Equation
2.6 then implies that the portfolio variance can be written as follows:

2P = (x + (1 )y)2.

(2.13)

Taking the square root of equation 2.13, it is clear that the portfolio
standard deviation is linear in . As the portfolio expected return is linear
in , the locus of expected returnstandard deviation combinations is a
straight line. This is shown in Figure 2.2.

Figure 2.2
If the correlation between returns is less than unity, however, the investor
can benefit from diversifying their portfolio. As previously discussed, in
this scenario, portfolio standard deviation is not a linear combination of
x and y. The reduction of portfolio risk through diversification will imply
that the meanstandard deviation frontier bows towards the y-axis. This
30

Chapter 2: Risk and return: meanvariance analysis and the CAPM

is also shown on Figure 2.2. The final curve on Figure 2.2 represents the
case where returns are perfectly negatively correlated. In this situation, a
portfolio can be constructed, which has zero standard deviation.
Activities
1. Assuming asset returns are perfectly negatively correlated, use equation 2.6 to find
the portfolio weights that give a portfolio with zero standard deviation. (Hint: write
down 2.6 with the correlation set to minus one and a = and b = 1 . Then
minimise portfolio variance with respect to .)
2. Assume that the returns on Microsoft and Bethlehem Steel have a correlation of 0.5.
Using the data provided earlier in the chapter, construct the meanvariance frontier
for portfolios of these two assets. Start with a portfolio consisting only of Microsoft
stock and then increase the portfolio weight on Bethlehem Steel by 0.1 repeatedly,
until the portfolio consists of Bethlehem Steel stock only.
From here on we will assume that return correlation is between plus and
minus one. The expected returnstandard deviation locus for this case
is redrawn in Figure 2.3. In the absence of a risk-free asset, this locus is
named the meanvariance frontier. As our investors preferences are
increasing in expected return and decreasing in standard deviation, it
is clear that their optimal portfolio will always lie on the frontier and to
the right of the point labelled V. This point represents the minimumvariance portfolio. They will always choose a frontier portfolio at or to
the right of V, as these portfolios maximise expected return for a given
portfolio standard deviation. In the absence of a risk-free asset, this set of
portfolios is called the efficient set.

Figure 2.3
We can now, given a set of preferences for the investor, find their optimal
portfolio. The condition characterising the optimum is that an investors
indifference curve must be tangent to the meanvariance frontier.3 Two
such optima are identified on Figure 2.3 at R and S. The investor locating
at equilibrium point R is relatively risk-averse (i.e. their indifference curves
are quite steep), whereas the equilibrium at S is that for a less risk-averse
individual (with correspondingly flatter indifference curves). Figure 2.3
also shows suboptimal indifference curves for each set of preferences.
Hence, as Figure 2.3 demonstrates, in a world of two risky assets and no
risk-free asset, the optimal portfolio of risky assets held by an investor
depends on their preferences towards risk and return. The same is true

In technical terms, the


optimum is characterised
by the marginal rate of
substitution being equal
to the marginal rate of
transformation (i.e. the
slope of the indifference
curve equals the slope of
the frontier).

31

92 Corporate finance

when there are N risky assets available. Figure 2.4 depicts the same type of
diagram for the N asset case.

Figure 2.4
Note that the meanvariance frontier is of the same shape as that in
Figure 2.3. However, unlike the two-asset case, the interior of the frontier
now consists of feasible but inefficient portfolios (i.e. those that do not
maximise expected return for given portfolio risk). The meanvariance
frontier now consists of those portfolios that minimise risk for a given
expected return, whereas those portfolios on the efficient set (i.e. on the
frontier but to the right of V) additionally maximise expected return for a
given level of risk.
We now reintroduce a risk-free asset to the analysis (i.e. we assume the
existence of an asset with return rf and zero returnstandard deviation).
A key question to address at this juncture is as follows. Assume that
we form a portfolio consisting of the risk-free asset and an arbitrary
combination of risky assets. How do the expected return and return
standard deviation of this portfolio alter as we vary the weights on the
risk-free asset and the risky assets respectively?
Denote our arbitrary risky portfolio by P. We combine P with the risk-free
asset using weights 1 a and a to form a new portfolio Q. The expected
return and variance of Q are given by:
E(RQ) = (1 a)rf + aE(RP) = rf + a[E(RP) rf ]

(2.14)

2Q = a22P .

(2.15)

In order to analyse the variation in the risk and expected return of the
portfolio Q with respect to changes in the portfolio weights, we construct
the following expression:
.

(2.16)

Using equations 2.14 and 2.15 we find that:


.

(2.17)

As this slope is independent of a, the riskreturn profile of the portfolio


Q is linear. This is known as the capital market line (CML), and two such
CMLs are shown in Figure 2.5 for two different portfolios of risky assets.
32

Chapter 2: Risk and return: meanvariance analysis and the CAPM

Figure 2.5
We now have all the components required to describe the optimal portfolio
choice of an investor faced with N risky assets and a risk-free investment.
Figure 2.6 replots the feasible set of risky asset portfolios. The key question
to answer is, what portfolio of risky assets should an investor hold? Using
the analysis from Figure 2.5, it is clear that the optimal choice of risky asset
portfolio is at K. Combining K with the risk-free asset places an investor on
a capital market line (labelled rf KZ), which dominates in utility terms the
CML generated by the choice of any other feasible portfolio of risky assets.4
The optimal portfolio choice and a suboptimal CML (labelled CML2) are
shown on Figure 2.6 along with the indifference curves of two investors.

That is, choosing


portfolio K places an
investor on a CML with
greater expected returns
at each level of return
variance than does any
other.

Figure 2.6
Recall that we previously defined the efficient set as the group of portfolios
that both minimised risk for a given level of expected return and maximised
expected return for a given level of risk. With the introduction of the riskfree asset, the efficient set is exactly the optimal CML.
The key result that is depicted in Figure 2.6 is known as two-fund
separation. Any risk-averse investor (regardless of their degree of riskaversion) can form their optimal portfolio by combining two mutual funds.
The first of these is the tangency portfolio of risky assets, labelled K, and the
second is the risk-free asset. All that the degree of risk-aversion dictates is
the portfolio weights placed on each of the two funds. The investor with the
33

92 Corporate finance

optimum depicted at X on Figure 2.6, for example, is relatively risk-averse


and has placed positive portfolio weights on both the risk-free asset and K.
An investor locating at Y, however, is less risk-averse and has sold the
risk-free asset short in order to invest more in K.5
Two-fund separation is the result that underlies the CAPM, which is
developed in the next section.

The capital asset pricing model


To begin our derivation of the CAPM, we present the assumptions that
underlie the analysis. These assumptions formalise those implicit in the
preceding section.
Investors maximise utility defined over expected return and return
variance.
Unlimited amounts may be borrowed or loaned at the risk-free rate.
Investors have homogenous expectations regarding future asset returns.
Asset markets are perfect and frictionless (e.g. no taxes on sales or
purchases, no transaction costs and no short sales restrictions).
We next need to extend slightly our analysis of the previous section in
order to derive the familiar form of the CAPM.

A mathematical characterisation of meanvariance optimisation


Consider Figure 2.6, which graphically identifies the optimal portfolio
of risky assets (K), held by an arbitrary risk-averse investor. The key
condition for optimality is that the capital market line and the mean
variance frontier are tangent. The following equations give a mathematical
description of this optimality condition.
From equation 2.17, we know that the slope of the capital market line at
the optimum is:
(2.18)
We also need the slope of the meanvariance frontier at the point of
tangency. To derive this, consider a position (called I) with portfolio
weight a in an arbitrary portfolio of risky assets (called j) and (1 a) in the
optimal portfolio K. The expected return and standard deviation of this
position are:
E(RI) = aE(Rj) + (1 a)E(RK)

(2.19)

1 = [a2 2j + (1 a)2 2K + 2a(1 a)jK]0.5.

(2.20)

Using the same method as shown in equation 2.16 to derive the risk
return trade-off at the point represented by portfolio I, we get:
.

(2.21)

(2.22)
The slope of the meanvariance frontier at K will be the ratio of 2.21 to
2.22 in the limit as a 0. Note that equation 2.21 does not depend on a.
Taking the limit of equation 2.22 as a 0 we get:
.
34

(2.23)

A short sale is the sale


of an asset that one
does not actually own.
One borrows the asset
in order to complete
the transactions and
immediately receives the
sale price. Subsequently,
one uses the proceeds
from the sale to
repurchase a unit of the
asset, and deliver it to
the creditor. If the price
of the asset has dropped
in the interim, one
makes a cash profit.

Chapter 2: Risk and return: meanvariance analysis and the CAPM

The slope of the meanvariance frontier at K is the ratio of 2.21 to 2.23,


that is,
.
(2.24)
The optimum in Figure 2.6 equates the slope of the meanvariance
frontier at K with the slope of the CML. Hence, equating 2.18 and 2.24
and rearranging the resulting expression, we arrive at:
(2.25)
Defining j = jK / 2K, equation 2.26 can be rewritten as:
E(Rj) = rj + j[E(RK) rf ].

(2.26)

Equation 2.26 is the standard -representation of the meanvariance


optimisation problem. The equation translates as follows: the expected
return on a given asset (or portfolio of assets) is equal to the risk-free rate
plus a risk premium multiplied by the assets .6 Assets that have large
values of will have large expected returns, whereas those with smaller
values of will have low expected returns with defined as the ratio of
the covariance of an assets returns with those on the market to the
variance of the market return.

The risk premium is


defined as the excess of
the expected return on
the tangency portfolio
over the risk-free rate.

Equilibrium and the CAPM


Equation 2.26 is simply derived from meanvariance analysis, and as
yet we have said nothing regarding equilibrium in asset markets. Capital
market equilibrium requires that the demand for risky securities be
identical to their supply. The supply of risky assets is summarised in the
market portfolio, which is defined below.

Definition
The market portfolio is the portfolio comprising all assets, where the
weights used in the construction of the portfolio are calculated as
the market capitalisation of each asset divided by the sum of market
capitalisations across all assets.
Two-fund separation gives us the fundamental result that all investors
hold efficient portfolios and, further, that all investors hold risky securities
in the same proportions (i.e. those proportions dictated by the tangency
portfolio (K)).7 For demand to be equal to supply in capital markets, it
must be the case that the market portfolio is constructed with identical
portfolio weights. The implication of this is simple: the market portfolio
and the tangency portfolio are identical. This allows us to express the
CAPM in the following form.

The capital asset pricing model

All investors perceive


the same efficient
set and tangency
portfolio due to our
assumption that they
have homogeneous
expectations regarding
asset returns.

Under the prior assumptions, the following relationship holds for all
expected portfolio returns:
E(Rj ) = Rf + j [E(rM ) rf ],

(2.27)

where E(RM ) is the expected return on the market portfolio, and j is the
covariance of the returns on asset j with those on the market divided by
the variance of the market return.
Equation 2.27 gives the equilibrium relationship between risk and return
under the CAPM assumptions. In the CAPM framework, the relevant
35

92 Corporate finance

measure of an assets risk is its , and equation 2.27 implies that expected
returns increase linearly with risk.
To clarify the source of the CAPM equation, note that the identification of
the tangency portfolio and the linear -representation are implied by mean
variance analysis. The CAPM then imposes equilibrium on capital markets
and identifies the market portfolio as identical to the tangency portfolio.

The security market line


Given equation 2.27, the equilibrium relationship between risk and return
has a very simple graphical depiction. In equilibrium expected returns are
linear in . The expected return on an asset with a of zero is rf , whereas
an asset with a of unity has an expected return identical to that on the
market. Plotting this relationship, known as the security market line, we
get Figure 2.7.
Comparison of Figures 2.6 and 2.7 implies that, in equilibrium, two assets
with identical expected returns must have identical s, although their
return variances can differ. The reason that their variances can differ
is that a proportion of asset return variance can be eliminated through
diversification. Agents should not be rewarded for bearing such risk and,
hence, diversifiable risk will not affect expected returns. Undiversifiable
risk is that which is driven by variation in the return on the market as a
whole, and an assets exposure to such risk is summarised by . Hence
an assets measures its relevant risk and, via equation 2.27, determines
equilibrium expected returns.
The key message of the preceding paragraph is that measures asset risk.
A high asset is risky as it has high returns when market returns are high.
An asset with a low tends to have high returns when market returns are
low. Hence a low asset, when included in ones portfolio, can provide
insurance against low market returns and hence is low risk.

Figure 2.7

Systematic and unsystematic risk


To mathematically illustrate the sources of asset risk we can use the CAPM
equation to decompose the variance of a given asset. Equation 2.27 gives
the equilibrium expected return for asset j. Actual returns on asset j will
follow a similar relationship but will also include a random error term.
Denoting this error by j we have the following equation:
rj = rf + j [rM rf ] + j.
36

(2.28)

Chapter 2: Risk and return: meanvariance analysis and the CAPM

The variance of the risk-free return is zero by definition. Assuming that j


is fixed we can represent the variance of asset j as:
2j = 2j2M + 2.

(2.29)

The final term on the right-hand side of equation 2.29 is the variance of
the error term and represents diversifiable risk. This source of risk is also
known as unsystematic and idiosyncratic risk. As emphasised previously,
this risk is unrelated to market fluctuations and, therefore, does not affect
expected returns. The first term on the right-hand side of equation 2.29
represents undiversifiable risk, also known as systematic risk. This is risk
that cannot be escaped and hence increases equilibrium expected returns.
Activities8
1. An investor forms a portfolio of two assets, X and Y. These assets have expected
returns of 9 per cent and 6 per cent and standard deviations of 0.8 and 0.6
respectively. Assuming that the investor places a portfolio weight of 0.5 on each
asset, calculate the portfolio expected return and variance if the correlation between
returns on X and Y is unity.

You will find the


solutions to these
activities at the end of
this chapter.

2. Using the data from Question 1, recalculate the portfolio expected return and
variance, assuming that the correlation between returns is 0.5.
3. An investor forms a portfolio from two assets, P and Q, using portfolio weights of
one-third and two-thirds respectively. The expected returns on P and Q are
5 per cent and 7 per cent, and their respective return standard deviations are 0.4 and
0.5. Assuming that the return correlation is zero, calculate the expected return and
variance of the investors portfolio.
4. Assuming identical data to that in Question 3, recalculate the statistical properties of
the portfolio, assuming the return correlation for P and Q is 0.5.

The Roll critique and empirical tests of the CAPM


The final topic we touch on in this chapter is the empirical validity of the
CAPM. The model of equilibrium expected returns that we have developed
in the preceding sections of this chapter is obviously not guaranteed to
hold in practice and, hence, rather than just blindly accepting its output,
we should examine how it holds up when applied to real data. However,
this task brings us face-to-face with a problem first pointed out by Richard
Roll and hence known as the Roll critique.9

See Roll (1977).

The statement of the CAPM is identical to the proposition that the market
portfolio is meanvariance efficient. Hence, Roll pointed out that empirical
tests of the CAPM should seek to examine whether this is indeed the case.
However, he also noted that the market portfolio (or the return on the
market) is not observable to an econometrician, who wishes to conduct a
test. Empirical researchers generally use a broad-based equity index such
as the FTSE-100, S&P-500 or Nikkei 250 to proxy the market. But the true
market portfolio will contain other financial assets (such as bonds and
stocks not included in such indices) as well as non-financial assets such as
real estate, durable goods and even human capital. Hence, the validity of
tests of the CAPM depend critically on the quality of the proxy used for the
market portfolio.
Based on the above, Rolls critique is simply that, due to the fact that
the market portfolio is not observable, the CAPM is not testable. We can
understand this through the following arguments. First, it might be the
case that the market portfolio is efficient (and hence the CAPM is valid),
but our chosen proxy for the market is not efficient, and hence our
37

92 Corporate finance

empirical test rejects the CAPM. Second, our proxy for the market might
be efficient whereas the market portfolio itself is not. In this case our test
will falsely indicate that the CAPM is valid. Put simply, the fact that we
cant guarantee the quality of our proxy for the market implies that we
cant place any faith in the results that tests based upon it generate, and
hence its impossible to test the CAPM.
The Roll critique is clearly damaging in that it implies that we cant judge
the predictions of the CAPM against reality and trust the results. However,
many researchers have disregarded the prior discussion and estimated
the empirical counterpart of equation 2.27. From these estimates, such
researchers pass judgement on the CAPM.

The CAPM as a one-factor model


As we saw above, idiosyncratic risk should not matter for pricing of assets
because investors are able to diversify it away. Only common risk matters.
A one-factor model states that all common risk can be summarised by a
single variable, or factor. Specifically, the return on any asset is given by:
Rit = ai + bi*Ft + eit

E[eit ] = 0

E[Ft*eit ]= 0

(2.30)

Note that ai is an asset specific constant, bi is an asset specific factor


loading, and eit is an idiosyncratic variable uncorrelated across assets. On
the other hand Ft is a factor common to all assets.
We will now see that the CAPM implies a one-factor model with the factor
being the excess market return. Note that for any two random variable
Xt = E[Xt] + et where et is independent of E[Xt], therefore Rit Rf = E[Rit Rf ]
+ it and Rmt Rf = E[Rmt Rf ] + t where and are idiosyncratic.
E[Rit Rf ] = i*E[Rmt Rf ]

(2.31)

Rit Rf it = i*(Rmt Rf) i*t

(2.32)

Rit Rf =i*(Rmt Rf ) + (it i*t) = i*(Rmt Rf ) + eit

(2.33)

Thus we can write the CAPM as a one-factor model where the excess
market return is the factor.
Suppose we were to regress the excess return on asset i on the excess
market return:
Rit Rf = Ai + Bi*(Rmt Rf )

(2.34)

By definition of a regression, Bi = Cov(Rit Rf , Rmt Rf )/Var(Rmt Rf ), which


is equal to the CAPM for asset i. The CAPM implies that Ai = 0 for each
asset i. This is one way to test the CAPM (or any factor model). This is
referred to as a first stage test of the CAPM: for each asset we run a time
series regression of that assets returns on the market excess return. If we
find that many assets have Ai not equal to zero, we would infer that the
CAPM does not work well.
There is also another test of the CAPM, referred to as the second stage.
As opposed to the first stage test, where we ran a time series regression
for each asset, this test will produce a single cross-sectional regression for
all assets. Note that the CAPM implies that assets with higher betas have
higher expected returns, furthermore, the relationship is linear. We can
test this by regressing the average historical return for each asset on the
for each asset, which we found in the first stage regression. We run the
cross-sectional regression: E[Ri Rf ]= G0+ G1*i
The CAPM implies that G0 is zero and G1 is the average market premium
E[Rm Rf ].

38

Chapter 2: Risk and return: meanvariance analysis and the CAPM

The data are generally not supportive of the CAPM. The relationship
between an assets and its average return is usually positive, as the CAPM
suggests, but typically flatter than it should be, as can be seen in Figure 2.8.
In this figure the s are plotted against average returns for 17 portfolios
based on industry (such as food, chemicals or transportation). The dotted
line plots against *E[Rm Rf ], this is the CAPM predicted expected
return. The solid line plots the actual relationship between and industry
returns, this relationship is positive but flatter than the dotted line. That is
high stocks have returns that are lower than predicted by the CAPM while
low stocks have returns that are higher than predicted by the CAPM.
Furthermore, there are certain assets (to be discussed in the next chapter)
that appear to consistently have non-zero Ai in time series regressions.10
0.9

10

See pp.18586 of
Brealey and Myers
(2008).

0.85
0.8
0.75

E[R]

0.7
0.65
0.6
0.55
0.5
0.45
0.4
0.7

0.8

0.9

1.1

1.2

1.3

1.4

Figure 2.8

One possible explanation for the too flat relationship between and
average return is measurement error. Suppose we do not observe an assets
true , but rather its true plus some measurement error which is mean
zero. Then assets with very high observed are likely to be assets with very
positive measurement error; therefore their true is below their observed
, perhaps consistent with the low observed expected return. Similarly,
assets with very low observed are likely to be assets with very negative
measurement error and therefore their true is above the observed .
It is also possible that one factor is simply not enough to explain all of the
variation in expected returns. The CAPM implies that the a firms loading
on the market () is the only variable that should cause expected returns to
differ. Adding extra explanatory variables to regression 2.34 will not result
in significant coefficients. In the next chapter we will see that loadings on
other factors, including firm size, book-to-market ratios, P/E ratios and
dividend yields have been shown to explain ex-post realised returns.
Amalgamating the above evidence implies that, if you are willing to
disregard the Roll critique, you should probably conclude that the CAPM
does not hold. This has led certain authors to investigate other asset-pricing
pradigms such as the APT (which we discuss in the next chapter). An
alternative viewpoint would be to argue that such results tell us little or
nothing about the validity of the CAPM due to the insight of Roll (1977).
39

92 Corporate finance

A reminder of your learning outcomes


Having completed this chapter, and the Essential reading and activities,
you should be able to:
discuss concepts such as a portfolios expected return and variance as
well as the covariance and correlation between portfolios returns
calculate portfolio expected return and variance from the expected
returns and return variances of constituent assets with confidence
describe the effects of diversification on portfolio characteristics
derive the CAPM using meanvariance analysis
describe some theoretical and practical limitations of the CAPM.

Key terms
beta ()
capital asset pricing model (CAPM)
correlation
covariance
diversification
expected return
market portfolio
meanvariance analysis
Roll critique
security market line
standard deviation
systematic risk
two-fund separation
unsystematic risk
variance

Sample examination questions


1. Detail the assumptions that underlie the CAPM and provide a
derivation of the CAPM equation. Support your derivation with
graphical evidence. (15%)
2. The returns on ABC stock and on the market portfolio in three
consecutive years are given in the following table:
Year

ABC return (%)

Market return (%)

24

12

28

15

Showing all your workings, compute the for ABCs equity. (7%)
4. Assume that the risk-free rate is 5 per cent. What is the expected return
on ABCs stock? (3%)
5. The risk-free rate is 4 per cent, firm A has a market of 2 and an
expected return of 16 per cent.
a. What is the expected return on the market according to the CAPM?

40

Chapter 2: Risk and return: meanvariance analysis and the CAPM

b. Draw a graph with on the x-axis and the expected return on the
y-axis. Indicate the risk-free rate, the market, and firm A. What is
the slope of the securities market line?
c. The standard deviation of the market return is 16 per cent and the
standard deviation of the return of firm A is 40 per cent. What is the
standard deviation of As idiosyncratic component?
6. You have 50 years of monthly data on short-term treasury rates and
portfolios of 10-year bond returns, an aggregate index of US equities,
a mutual fund focusing on tech firms, a mutual fund focusing on
commodities, a mutual fund focusing on manufacturing, and a hedge
fund index. Describe how you would test the CAPM and the results you
would expect to find.

Solutions to activities
1. The expected return on the equally weighted portfolio is 7.5 per cent.
The portfolio return variance is 0.49, and hence the portfolio return
standard deviation is 0.7.
2. Obviously, the expected return is the same as in Question 1. With
correlation of 0.5, the portfolio return variance is 0.37.
3. The expected return on the portfolio is 6.33 per cent, and the portfolio
has a return variance of 0.1289.
4. When the correlation changes to 0.5, the portfolio return variance
drops to 0.0844. The expected return on the portfolio doesnt change
from that calculated in Question 3.

41

92 Corporate finance

Notes

42

Chapter 3: Factor models

Chapter 3: Factor models


Aim of the chapter
The aim of this chapter is to derive arbitrage pricing theory, an alternative
to the capital asset pricing model, enabling us to price financial assets.

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
understand single-factor and multi-factor model representations
derive factor-replicating portfolios from a set of asset returns
understand the notion of arbitrage strategies and that well-functioning
financial markets should be arbitrage-free
derive arbitrage pricing theory and calculate expected returns using the
pricing formulas
know how to test multifactor models.

Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapter 6 (Factor Models and
the APT).

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapter 9 (Risk and Return).
Chen, N-F. Some empirical tests of the theory of arbitrage pricing, The Journal
of Finance 38(5) 1983, pp.1393414.
Chen, N-F., R. Roll and S. Ross Economic forces and the stock market, Journal
of Business 59 1986, pp.383403.
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapter 6.
Fama, E. and K. French The cross-section of expected stock returns, Journal of
Finance 47(2) 1992, pp.42765.
Fama, E. and K. French Common risk factors in the returns on stocks and
bonds, Journal of Financial Economics 33 1993, pp.356.
Fama, E. and J. MacBeth Risk, return, and equilibrium: empirical tests, Journal
of Political Economy 91 1973, pp.60736.
Gibbons, M.R., S.A. Ross and J. Shanken A test of the efficiency of a given
portfolio, Econometrica 57 1989, pp.112152.
Jegadeesh, N. and S. Titman Returns to buying winners and selling losers,
Journal of Finance 48 1993.

Overview
Empirically, expected returns appear to depend on several factors. For
this reason, multifactor models, such as the Fama and French three-factor
model are commonly used in practice to calculate expected returns. The
arbitrage pricing theory gives a theoretical basis for using such models.
As its name suggests, it rests on the notion that well-functioning financial
markets should be arbitrage-free. This, using a factor model of asset
43

92 Corporate finance

returns, implies restrictions on the relationship between asset returns and


generates and equilibrium pricing relationship.

Introduction
As we saw in the previous chapter, the CAPM was not sufficient to explain
the cross-section of expected asset returns. The CAPM was a one-factor
model and we can improve on the CAPM by including additional factors.
However, the CAPM was derived from micro-economic foundations, why
should additional factors matter for risk?
The arbitrage pricing theory (APT) gives an alternative to the CAPM as a
method to compute expected returns on stocks. The basis for the APT is a
factor model of stock returns, and we will define and discuss these models
first. From there we will demonstrate how to derive expected returns using
the idea that the returns on stocks, which are exposed to a common set of
factors, must be mutually consistent, given each stocks sensitivity to each
factor.
To give structure to what we mean by mutually consistent, we need to
define the notion of an arbitrage. An arbitrage strategy is a strategy that
delivers non-negative returns in all states of the world, and strictly positive
returns in at least one state of the world. For example, a strategy that
yields an immediate, positive cash inflow and, further, is guaranteed not to
make a loss tomorrow. Faced with an investment strategy with this payoff
structure, any investor who prefers more to less would try to invest on an
infinite scale.
The idea that underpins the APT is that investment situations, such
as those described above, should not be permitted in well-functioning
financial markets. Then, if financial markets do not permit the existence
of arbitrage strategies, this places restrictions on the relationships between
the expected returns on assets given the factor structure underlying
returns.
Although the APT gives justification for why there may be multiple factors,
it does not identify specific factors. Factors should proxy for risk and may
be identified from economic fundamentals (such as the CAPM), or from
empirical observation. Eugene Fama and Ken French identified three
factors that do a relatively good job at explaining much of the variation
in expected stock returns. We will learn about their model, as well as
improvements on it, at the end of the chapter.

Single-factor models
Before using the notion of absence of arbitrage to provide pricing
relations, we need a basis for the generation of stock returns. Within
the context of the APT, this basis is given by the assumption that the
population of stock returns is generated by a factor model. The simplest
factor model, given below, is a one-factor model:
ri = i + i F + i

E(i) = 0.

(3.1)

In equation 3.1, the returns on stock i are related to two main components:
1. The first of these is a component that involves the factor F. This
factor is posited to affect all stock returns, although with differing
sensitivities. The sensitivity of stock is return to F is i. Stocks that
have small values for this parameter will react only slightly as F
changes, whereas when i is large, variations in F cause very large
movements in the return on stock i. As a concrete example, think of F
44

Chapter 3: Factor models

as the return on a market index (e.g. the S&P-500 or the FTSE-100),


the variations in which cause variations in individual stock returns.
Hence, this term causes movements in individual stock returns that are
related. If two stocks have positive sensitivities to the factor, both will
tend to move in the same direction.
2. The second term in the factor model is a random shock to returns,
which is assumed to be uncorrelated across different stocks. We have
denoted this term i and call it the idiosyncratic return component for
stock i. An important property of the idiosyncratic component is that
it is also assumed to be uncorrelated with F, the common factor in
stock returns. In statistical terms we can write the conditions on the
idiosyncratic component as follows:
Cov(i, j) = 0 i j Cov(i, F) = 0
i
A

An example of such an idiosyncratic stock return might be the unexpected


departure of a firms CEO or an unexpected legal action brought against
the company in question.
The partition of returns implied by equation 3.1 implies that all common
variation in stock returns is generated by movements in F (i.e. the
correlation between the returns on stocks i and j derives solely from F). As
the idiosyncratic components are uncorrelated across assets they do not
bring about covariation in stock price movements.
Application exercise
Consider an economy in which the risk-free rate of return is 4 per cent and the expected
rate of return on the market index is 9 per cent. The variance of the return on the market
index is 20 per cent. Two portfolios A and B have expected return 7 per cent and 10 per
cent, and variance 20 per cent and 50 per cent, respectively.
a. Work out the portfolios coefficients.
According to the CAPM:
E(rA) = rF + A [E(rM) rF ]
and
E(rB) = rF + B [E(rM) rF ].
Hence:

A = [E(rA) rF]/[E(rM) rF ] = (7% 4%)/(9% 4%) = 0.6


B = [E(rB) rF]/[E(rM) rF ] = (10% 4%)/(9% 4%) = 1.2.
b. The risk of a portfolio can be decomposed into market risk and idiosyncratic risk.
What are the proportions of market risk and idiosyncratic risk for the two portfolios
A and B?
From the market model:
rA = A + A rM + A
rB = B + B rM + B
with cov(rM , A) = cov(rM , B) = 0.
It hence follows that the variance of portfolio As returns, 2A, has two
components, systematic and idiosyncratic risk:
2A = 2A 2M + 2A.
Similarly:
2B = 2B 2M + 2B.
The proportion of systematic risk for A is hence
2A 2M / 2A = (0.6)2*20%/20% = 36%.
45

92 Corporate finance

The proportion of idiosyncratic risk for A is hence


1 [2A 2M / 2A] = 64%.
The proportion of systematic risk for B is hence
2B 2M / 2B = (1.2)2*20%/50% = 58%.
The proportion of idiosyncratic risk for B is hence
1 [2B 2M / 2B] = 42%.
Portfolio B is much riskier than portfolio A as the variance of its returns is 50 per
cent compared with 20 per cent for A. The main reason why it is riskier is that it is
much more sensitive to the return of the market index than portfolio A as its is 1.2
compared with 0.6 for portfolio A.
c. Assume the two portfolios have uncorrelated idiosyncratic risk. What is the
covariance between the returns on the two portfolios?
Cov(rA,rB) = Cov(A +A rM + A, B +B rM + B) = A B 2M = 0.6*1.2*20% = 14%.
The returns of portfolios A and B are hence (positively) correlated even though their
idiosyncratic return components are not. These returns are positively correlated
because they are positively correlated with the returns of the market index.

Multi-factor models
A generalisation of the structure presented in equation 3.1 posits k factors
or sources of common variation in stock returns.
ri = i + 1iF1 + 2iF2 + .... + kiFk + i

E(i) = 0.

(3.2)

Again, the idiosyncratic component is assumed uncorrelated across stocks


and with all of the factors. Further, well assume that each of the factors
has a mean of zero. These factors can be thought of as representing news
on economic conditions, financial conditions or political events. Note that
this assumption implies that the expected return on asset i is just given by
the constant in equation 3.2 (i.e. E(ri) = i). Each stock has a complement
of factor sensitivities or factor s, which determine how sensitive the
return on the stock in question is to variations in each of the factors.
A pertinent question to ask at this point is how do we determine the return
on a portfolio of assets given the k-factor structure assumed? The answer
is surprisingly simple: the factor sensitivities for a portfolio of assets are
calculable as the portfolio weighted averages of the individual factor
sensitivities. The following example will demonstrate the point.
Example
The returns on stocks X, Y, and Z are determined by the following two-factor model:
rX = 0.05 + F1 0.5F2 + X
rY = 0.03 + 0.75 F1 + 0.5F2 + Y
rz = 0.04 + 0.25 F1 0.3F2 + z
Given the factor sensitivities in the prior three equations, we wish to derive the factor
structure followed by an equally weighted portfolio of the three assets (i.e. a portfolio
with one-third of the weights on each of the assets). Following the result mentioned
above, all we need to do is form a weighted average of the stock sensitivities on the
individual assets. Subscripting the coefficients for the equally weighted portfolio with
a p we have:
p = (1/3) (0.05 + 0.03 + 0.04) = 0.04
1p = (1/3) (1 + 0.75 0.25) = 0.5
46

Chapter 3: Factor models

2p = (1/3) (0.5 + 0.5 0.3) = 0.1


and hence; the factor representation for the portfolio return can be written as:
rp = 0.04 + 0.5F1 0.1F2 + p
where the final term is the idiosyncratic component in the portfolio return. Note that
the idiosyncratic volatility of the portfolio is p = (1/3)(X + Y + z) smaller than the
idiosyncratic volatilities of portfolios X, Y or Z because the idiosyncratic components are
independent.
Activity
Using the data given in the previous example, compute the return representation for a
portfolio of assets X, Y and Z with portfolio weights 0.25, 0.5 and 0.75.
An important implication of the result is the following. Assume a twofactor model, and also assume that we are given the factor representations
for three stocks. I can construct a portfolio of these three assets, which has
any desired set of factor sensitivities through appropriate choice of the
portfolio weights.1 What underlies this result? Well, to illustrate lets use
the data from the prior example. Assume I wish to construct a portfolio
with a sensitivity of 0.5 on the first factor and a sensitivity of 1 on the
second factor. Denoting the portfolio weights on the individual assets by
X, Y and Z it must be the case that:
X + 0.75Y 0.25Z = 0.5

(3.3)

0.05X + 0.5Y 0.3Z = 1.

(3.4)

In general, if I have
a k-factor model I will
need k+1 stocks to
do this.

Finally, it must also be the case that the portfolio weights add up to unity,
so we must also satisfy the following equation:
X + Y + Z = 1.
Equations 3.3, 3.4 and 3.5 are three equations in three unknowns, and
we can find values for the portfolio weights which satisfy all three
simultaneously. This illustrates the fact that (as the portfolio factor
sensitivities were arbitrarily set at 0.5 and 1) we can derive any
constellation of factor sensitivities. A particularly interesting case is when
the portfolio is sensitive to one of the factors only. We call this a factorreplicating portfolio and discuss it below.

Broad-based portfolios and idiosyncratic returns


In what follows we will assume that the basic securities that were going
to work with are themselves broad-based portfolios. The reason for this
is that it allows us to lose the idiosyncratic risk terms associated with
single stocks. Why is this the case? Well, consider the idiosyncratic risk
term for an equally weighted portfolio of 100 stocks. Call the ith
idiosyncratic term i and assume that all idiosyncratic terms have variance
2. The variance of the idiosyncratic element of the portfolio return is
then:

Note that, under these assumptions the variance of the idiosyncratic


portfolio return is only one-hundredth of the variance of any individual
assets idiosyncratic return. In a general case, where one forms an equally
weighted portfolio of n assets, the variance of the idiosyncratic term for
the portfolio return is n-12. This is a diversification result just like those we
used in Chapter 2. The fact that the idiosyncratic returns are uncorrelated
with one another means that their influence tends to disappear when one
groups assets into large portfolios.

47

92 Corporate finance

Factor-replicating portfolios
An important application of the technology developed previously in this
chapter is the construction of a factor-replicating portfolio. A factorreplicating portfolio is a portfolio with unit exposure to one factor and
zero exposure to all others. For example, the portfolio replicating factor
1 in model 3.2 would have 1 = 1 and j = 0 for all j = 2 to k. We will use
factor-replicating portfolios to show that a factor structure for asset returns
implies a pricing model. In such a model, expected returns depend only
on s, or risk loadings.
Activity
Assume that stock returns are generated by a two-factor model. The returns on three
well-diversified portfolios, A, B and C, are given by the following representations:
rA = 0.10 + F1 0.5F2
rB = 0.08 + 2F1 + F2
rC = 0.05 + 0.5F1 + 0.5F2.
Determine the portfolio weights you need to place on A, B and C in order to construct
the two factor-replicating portfolios plus a portfolio which has zero exposure to both
factors. What are the expected returns of the factor-replicating portfolios and what is the
expected return of the risk-free portfolio?
The question to ask at this point is: why bother constructing factorreplicating portfolios? The reason is as follows. Suppose I want to build
a portfolio that has identical factor exposures to a given asset, X. Assume
a two-factor world and that asset X has exposure of 0.75 to factor 1
and 0.3 to factor 2. Assume also that I know the two factor-replicating
portfolios.
Building a portfolio with the same factor exposures as X is now simple.
Construct a new portfolio, Y, which has portfolio weight 0.75 on the
replicating portfolio for the first factor, portfolio weight 0.3 on the
replicating portfolio for the second factor and the rest of the portfolio
weight (i.e. a weight of 1 0.75 + 0.3 = 0.55) on the risk-free asset. Via
the results on the factor representations of a portfolio of assets and
the definition of a factor-replicating portfolio it is easy to see that Y is
guaranteed to have identical factor exposures to X.
The replication in the preceding paragraph forms the basis for the APT. For
absence of arbitrage we require all assets with identical factor exposures
to earn the same return. If they did not, then we would have the chance to
make unlimited amounts of money. For example, assume that the expected
return on the replicating portfolio Y was greater than that on asset X.
Then I should short X and buy Y. The risk exposures of the two portfolios
are identical and hence risks cancel out and I am left with an excess return
that is riskless (i.e. an arbitrage gain).
In order to progress, let us introduce some notation. Denote the riskfree rate with rf. Denote the expected return on the ith factor-replicating
portfolio with rf + i such that i is the risk premium associated with the
ith factor. Again, for simplicity, assume that the world is generated by a
two-factor model, and assume that I wish to replicate asset X, which has
sensitivity 1X to the first factor and 2X to the second factor. Finally, we will
assume that the primary securities being worked with are well-diversified
portfolios themselves. Hence, we will ignore any idiosyncratic risk in this
derivation.
48

Chapter 3: Factor models

Using the prior argument, to replicate asset Xs factor sensitivities, we


construct a portfolio with weight 1X on the first factor-replicating portfolio,
weight 2X on the second factor-replicating portfolio and weight 1 1X 2X
on the risk-free asset. The expected return of the replicating portfolio is
hence:
1X (rf + 1) + 2X (rf + 2) + (1 1X 2X) rf = rf + 1X 1+ 2X 2.

(3.6)

Hence, using our factor-replicating portfolios we can write the expected


return on a portfolio which replicates Xs factor exposures as the riskfree rate plus each factor exposure multiplied by the risk premium on the
relevant factor-replicating portfolio.
Note that equation 3.6 can be used to test the factor model. This is the
second stage test of factor models mentioned in the previous chapter in the
context of the CAPM. Equation 3.6 states that average returns on assets are
higher if those assets have higher factor loadings (s); the factors are the
same for all assets. This is a cross-sectional statement as it compares average
returns for different assets. We can regress average returns on assets in
excess of rf on the historical s of these assets (here is the regressor, not
the coefficient). If the factor model performs well then the intercept of this
regression should be close to zero.
The reason this regression is called a second stage regression is because we
must first find s by running a time series regression for each asset on the
factor mimicking portfolios. These regressions can also be used to test the
factor model, these are called first stage tests. We can use equation 3.6 to
derive this equation as well. Combine equations 3.2 and 3.6 by noting that
the i in equation 3.6 is the expected return on asset i, given by equation
3.2:
rit= (rf + 1i 1 + 2i 2 ) + 1i F1t + 2i F2t + it

(3.7)

rit rf = 1i (1 +F1t )+2i (2 + F2t ) + it = 2t(1 + F1t ) + 2i(2 + F2t ) + it ,


(3.8)
where j+Fjt is the excess return on the jth factor-replicating portfolio
(plus some idiosyncratic risk if markets are incomplete). Thus a time series
regression of rit rf on excess factor returns implies that the intercept must
be zero; this must be true for each asset.
A practical question is how close to zero must the intercept be in both the
first and second stages in order for us to accept a model as being close to
the data? Consider the first stage which states that every asset must have
a zero intercept. Suppose we found that 15 out of 100 tested assets had
intercepts different from zero at 5 per cent significance. A nave application
of statistics would suggest rejection of the factor model. However, rejection
is not as clear cut as it might appear.
Suppose you were told that one of the assets with a non-zero intercept was
McDonalds. It would then not be surprising if we also found Burger King to
have a non-zero intercept because the two are likely to be highly correlated
even when controlling for standard factors. The 100 tested assets may not
all be truly independent and we are likely to see highly correlated assets
both be rejected or both not be rejected. If the 15 assets that are rejected
are all highly correlated, while the remaining 85 are not, we should not
reject the model. Gibbons, Ross and Shanken (1989) provide a procedure
to test the intercepts jointly for many assets, some of which are potentially
correlated.
Let us now turn to the second stage test which also states that the intercept
(this time in a cross-sectional regression) must be zero. We can check for
the significance of the intercept in the usual way. However, when doing
49

92 Corporate finance

this we are implicitly making an assumption about the cross-sectional


distribution of returns. Fama and MacBeth (1973) suggested an alternative
implementation of the second stage test which avoids making such
assumptions. Instead of running a single regression of average historical
returns on historical s they suggest running a separate regression each
year; for each year regress the realised returns on s calculated over some
recent period. As a result for each year there will be a separate estimate of
the intercept. They suggest using the distribution of intercepts to calculate
significance.

The arbitrage pricing theory


Consider an arbitrary asset. The previous subsection tells us that its
simple to replicate this assets risk (i.e. its factor exposures) using factorreplicating portfolios. The key to the APT is that absence of arbitrage
requires that such a pair of portfolios must have identical expected returns
in a financial market equilibrium. If they did not, it would be possible to
make unlimited amounts of money without incurring any risk.
This implies that the expected return on asset X, rX, must be identical to
the expression arrived at in equation 3.6, that is:
(3.9)

E(rX) = rf + 1X 1+ 2X 2.

Equation 3.7 is the statement of the APT. The expected return on a


financial asset can be written as the risk-free rate plus sum of the assets
factor sensitivities multiplied by the factor-risk premiums (which are
invariant across assets). If such an expression does not hold at all times,
arbitrage opportunities exist. Note the assumptions that are required
to achieve this result. First, we require that asset returns are generated
by a two-factor (or in general k-factor) model. Second, we assume that
arbitrage opportunities cannot exist. Lastly, we assume that enough assets
are available such that firm-specific risk washes away when portfolios are
formed.
Example
In the previous two-factor example, we determined the expected returns on the two
factor-replicating portfolios. Denoting the expected return on the i th factor-replicating
portfolio by E(ri) we have:
E(r1) = 8.29%

E(r2) = 1.71%

E(r3) = 5.14%.

Hence, the premiums associated with the two factors are:


1 = 8.29 5.14 = 3.15%,

2 = 1.71 5.14 = 3.43%.

This implies that the expected return on any asset in this world can be written as:
E(ri) = 5.14 + 3.151i 3.432i .
To check that this works, substitute (for example) portfolio Cs factor sensitivities into the
preceding expression. This gives:
E(rC) = 5.14 + 3.15 (0.5) 3.43 (0.5) = 5%,
and hence, agrees with the expected return implied by the original representation for
asset C. Check that the expected returns on assets A and B also come out correctly.
To analyse an arbitrage opportunity that might arise in markets, attempt
the following activity.

50

Chapter 3: Factor models

Activity
Assume that a new well-diversified portfolio, D, is added to our world. This asset has
sensitivities of 3 and 1 to the two factors and an expected return of 15 per cent.
Using the equilibrium expected return equation given above, derive the equilibrium
expected return on an asset with identical factor exposures to D. Is there now an
arbitrage opportunity available? If so, dictate a strategy that could be employed to exploit
the arbitrage opportunity.

Multi-factor models in practice


As discussed earlier, the CAPM is a one-factor model where the only factor
is the excess market return. Securities with higher loading () on the
market return should have higher expected returns; nothing else should
matter for expected returns. Furthermore, the of each security should be
zero.
Eugene Fama and Ken French illustrated the failure of the CAPM by
forming portfolios of securities in a particular way. First, for each security
they calculated the firms size (market cap) and its market-to-book ratio
(a ratio of the firms market value to its book value). They then formed
cut-offs based on size and book-to-market, and assigned firms to one of
five quintiles for each trait. This resulted in 25 different portfolios (i.e.
large size and small book-to-market, small size and medium size book-tomarket, etc.), this is called a double sort. Once a year the portfolios would
be updated to take into account any changes to firm characteristics.
Fama and French showed that portfolios of small firms tended to have
larger returns than portfolios of large firms, portfolios of high book-tomarket (value) firms tended to have larger returns than portfolios of low
book-to-market (growth) firms. Interestingly, these patterns remained even
once controlling for market risk.
Recall that the first stage test of the CAPM implies that for any asset or
portfolio, a regression of that assets returns on the market should have
an intercept () of zero. Portfolios of small firms and value firms had
positive implying their returns were higher than predicted by the CAPM,
conversely portfolios of large and growth firms had negative s implying
their returns were lower than predicted by the CAPM. This is evident in
Table 3.1, which shows CAPM s for portfolios double sorted on size and
book-to-market.
Growth

Value

Small

0.573

0.105

0.151

0.362

0.528

0.213

0.146

0.295

0.312

0.363

0.136

0.160

0.262

0.291

0.276

0.005

0.049

0.156

0.209

0.163

Big

0.014

0.022

0.038

0.013

1.020

Table 3.1

Since the CAPM could not adequately explain the cross-section of returns,
Fama and French looked for additional risk factors. Given the performance
of small and value stocks, it was natural to think those two characteristics
were related to risk. They constructed a zero cost portfolio which took a
long position in small stocks and a short position in large stocks and called
it SMB (small minus big). Similarly, they constructed a zero cost portfolio
which took a long position in value stocks and a short position in growth
stocks and called it HML (high minus low).
51

92 Corporate finance

Fama and French augmented the CAPM by these two additional factors,
creating what is known as the Fama and French three-factor model. As
before with the CAPM, multifactor models can be tested by a first stage
time series test, in which each assets return is regressed on the factors;
each should be near zero. The Fama and French three-factor model
performed much better than the CAPM on the 25 portfolios defined
above, Fama and French could not statistically reject that the 25 s
were different from zero. The Fama and French model is commonly
used as a replacement to the CAPM to assess risk as well as managerial
performance.
Narasimhan Jegadeesh and Sheridan Titman found another set of
portfolios whose returns could not be explained by the CAPM or the Fama
and French three-factor model. Jegadeesh and Titman sorted stocks into
portfolios based on their past performance, they held these portfolios for
a year and then reassigned stocks to new portfolios. They found that a
portfolio long in stocks that performed well in the past, and short in stocks
that performed poorly in the past, had positive s in both CAPM and
three-factor regressions, they called this portfolio MOM (momentum). The
momentum factor was added to the Fama and French three-factor model
by Mark Carhart. This augmented four-factor model does a somewhat
better job than the three-factor model at explaining the cross-section
of expected stock returns, it is also commonly used to assess risk and
managerial performance.

Summary
The APT gives us a straightforward, alternative view of the world from
the CAPM. The CAPM implies that the only factor that is important
in generating expected returns is the market return and, further, that
expected stock returns are linear in the return on the market. The APT
allows there to be k sources of systematic risk in the economy. Some
may reflect macroeconomic factors, like inflation, and interest rate risk,
whereas others may reflect characteristics specific to a firms industry or
sector.
Empirical research has indicated that some of the well-known empirical
problems with the CAPM are driven by the fact that the APT is really the
proper model of expected return generation. Chen (1983), for example,
argues that the size effect found in CAPM studies disappears in a multifactor setting. Chen, Roll and Ross (1986) argue that factors representing
default spreads, yield spreads and gross domestic product growth are
important in expected return generation. Fama and French (1992, 1995),
show that size and book-to-market factors can help explain the crosssection of stock returns while other factors, such as momentum, also
appear to be important. Work in this area is still progressing.

A reminder of your learning outcomes


Having completed this chapter, and the Essential reading and activities,
you should be able to:
understand single-factor and multi-factor model representations
derive factor-replicating portfolios from a set of asset returns
understand the notion of arbitrage strategies and that well-functioning
financial markets should be arbitrage-free

52

Chapter 3: Factor models

derive arbitrage pricing theory and calculate expected returns using the
pricing formulas
know how to test multifactor models.

Key terms
arbitrage pricing theory
factor-replicating portfolio
factor sensitivity
multi-factor model
single-factor model

Sample examination question


1. Assume that stock returns are generated by a two-factor model. The
returns on three well-diversified portfolios, A, B and C, are given by the
following representations:
rA = 0.10 + F1
rB = 0.08 + 2F1 F2
rC = 0.05 0.5F1 + 0.5F2
a. Discuss what the factor representations above imply for the
variation and comovement in the three stock returns. Show how the
returns of the stocks should be correlated between themselves.
b. Find the portfolio weights that one must place on stocks A, B and
C to construct pure tracking portfolios for the two factors (i.e.
portfolios in which the loading on the relevant factor is +1 and the
loadings on all other factors are 0).
c. If one was to introduce a new portfolio, D, with loadings of +1 on
both of the factors, what would the expected return on D have to be
to rule out arbitrage?
d. Explain the concepts of idiosyncratic risk and factor risk in the APT.
What role does diversification play in the APT?
2. Explain the first and second stage tests of factor models. Discuss how
you would look for significance.
3. Explain how Fama and French form their portfolios and factors. What
does it mean for a factor model to work well? What is Fama and
Frenchs explanation for why their factor model works well?

53

92 Corporate finance

Notes

54