Course Outline
I.
II.
III.
IV.
V.
Course Code
Descriptive Title
Credit Unit
Time Allocation
Pre-requisite
FIN 072
FINANCIAL MARKETS
3 units
3 hours per week
FIN 081
VI. Course Description:
This course considers how companies can better meet the ever-increasing changes in the marketplace
while ensuring value creation in the financial business. Investment decisions must be carefully made to
ascertain corporate value. Financing choices must be optimal to take advantage of least cost
alternatives. Financial Management has become increasingly a challenging field as companies are facing
economic challenges, political uncertainties, ethical issues, and new developments in doing business.
VII. Course Objectives:
At the end of the course, the students should be able to:
1.
Understand the function and nature of financial markets and institutions;
2.
Apply the fundamental concepts in financial markets;
3.
Evaluate financial assets;
4.
Analyze investments in long-term assets;
5.
Conceptualize capital structure and dividend policy; and
6.
Appreciate special topics in financial markets.
Week
1
2
3
4
5
6
7
8
9
10
11
12
13
In/Out
In
Days
1, 2
Topics
Orientation
Financial Markets (Parts 1 and 2)
Out
3, 4
Time Value of Money (Parts 1 and 2)
In
5, 6
Risk and Rates of Return (Parts 1 and 2)
Graded Quiz 1
Out
7, 8
Long-term Financing: Debts (Parts 1 and 2)
In
9
FIRST PERIODICAL EXAMINATION
Out
10, 11
Long-term Financing: Equities (Parts 1 and 2)
In
12, 13
Valuation of Bonds
Graded Quiz 2
Out
14*
Valuation of Stocks
In
15*
Graded Quiz 3
Out
16*
Cost of Capital (Part 1)
In
17
SECOND PERIODICAL EXAMINATION
Out
18, 19
Cost of Capital (Part 2)
Capital Budgeting (Part 1)
In
20, 21, 22
Capital Budgeting (Parts 2 and 3)
Graded Quiz 4
Out
23, 24, 25
Dividend Policy and Risk Management and Derivatives
In
26
THIRD PERIODICAL EXAMINATION
Allowance for students’ compliance in case of lockdowns and community quarantines.
14
15
16
17
* Prepare to adjust the schedule of the SAS due to non-working holidays like the Holy Weeks and Araw
ng Kagitingan.
Course
Requirements
Grading
System
Assessment and Performance Tasks
Compilation of SAS
FG = (0.20×P1) + (0.20×P2) + (0.20×P3) + (0.40×FE)
Composition:
PG = Quizzes-40% + Periodic Exams*-40% + Other Components **-20%
*Periodic exams are comprehensive exams covering topics during the
period.
**May be in the form of recitation, essay tests, assignments, projects, etc.
Textbook
References
Percentile Mark = (Raw Score/Perfect Score) x 100
Brigham, E. F., Houston, J. F., Hsu, J.-M., Kong, Y. K., & Bany-Ariffin, A. (2018).
Essentials of Financial Management. Pasig City: Cengage Learning Asia Pte. Ltd.
Smart, S. and Graham, J. (2012). Introduction to Financial Management
McGuigam, J. et.al. (2012). Contemporary Corporate Finance
Timbang, F. (2016). Financial Management Part 2. Quezon City: C & E Publishing, Inc.
Prepared by:
JUCARLO L. GERMINAL, CPA, CTT, MBA
Head, Accountancy Program
jlgerminal@coc.phinma.edu.ph
Approved by:
CLYDE F. GAMOLO, CPA, MBA
Dean, College of Management and Accountancy
FIN 072 | Financial Markets
Module #1 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Orientation & Financial Markets (Part 1)
Learning Targets:
At the end of this module, I should be able to:
1. Recall and elaborate the Ten Axioms of Financial
Management;
2. Explain the necessity of a financial intermediary;
3. Differentiate a financial intermediary from financial market;
and
4. Identify the advantages and disadvantages of using a
financial intermediary.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
A. LESSON PREVIEW/REVIEW
Introduction (5 mins)
Course Description: This course considers how companies can better meet the ever-increasing changes in
the marketplace while ensuring value creation in the financial business. Investment decisions must be carefully
made to ascertain corporate value. Financing choices must be optimal to take advantage of least cost
alternatives. Financial Management has become increasingly a challenging field as companies are facing
economic challenges, political uncertainties, ethical issues, and new developments in doing business.
Course Objectives: At the end of the course, the students should be able to:
1. Understand the function and nature of financial markets and institutions;
2. Apply the fundamental concepts in financial markets;
3. Evaluate financial assets;
4. Analyze investments in long-term assets;
5. Conceptualize capital structure and dividend policy; and
6. Appreciate special topics in financial markets.
B. MAIN LESSON
Content and Skill-Building (40 mins)
Ten Axioms of Financial Management
1. The Risk-Return Trade-Off
 We will not take on additional risk unless we expect to be compensated with additional return
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Module #1 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
2.
3.
4.
5.
6.
7.
8.
9.
Class number: ______
Date: _______________
 The more risk an investment has, the higher will be its expected return
 Expected Return vs. Actual (Required) Return
The Time Value of Money
 A peso received today is worth more than a peso received in the future
 Economics: Opportunity cost of passing up the earning potential of a peso today
 Without this 2nd principle, it is impossible to evaluate projects with future benefits and costs in
a meaningful way.
Cash – Not Profits – Is King
 It is cash flows, not profits, that are received by the firm and can be reinvested
 Cash flows and accounting profits may not occur together
 Concern: Money on hand – when we can invest it and start earning interest on it and when
we can give back to shareholders in the form of dividends
Incremental Cash Flows
 It is only what changes that counts
 The difference between the cash flows if the project is taken on versus what they will be if the
project is not taken on
 Guiding Rule whether a Cash Flow is Incremental or Not: Look at the company with and
without the new product
The Curse of Competitive Markets
 Why it is hard to find exceptionally profitable projects
 Corporate Philosophy: Capitalize on market imperfection by product differentiation and cost
leadership
 Competition forces you to innovate and to explore other possibilities
Efficient Capital Markets
 The markets are quick, and the prices are right
 These are markets in which the values of all assets and securities at any instant in time fully
reflect all available information
 Efficient Market: It has something to do with the speed by which information is impounded
into security prices
The Agency Problem
 Managers will not work for the firm’s owners unless it is in their best interest
 The agency problem results from the separation of the management and the ownership of the
firm
 Prevention: Put an incentive structure that aligns the interests of managers and shareholders
Taxes Bias Business Decisions
 The cash flows we consider are the after-tax incremental cash flows to the firm as a whole
 Government realizes taxes can bias business decisions and uses taxes to encourage
spending in certain ways
 The government can use taxes as a tool to direct business investments
All Risk Is Not Equal
 Some risk can be diversified away, and some cannot
 Process of diversification and risk reduction
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FIN 072 | Financial Markets
Module #1 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
 Standalone asset vs. portfolio of assets
10. Ethical Behavior Means Doing the Right Thing, But Ethical Dilemmas are Everywhere in Finance
 People have set of values which forms the basis for personal judgments about what is the
right thing to do
 Unethical behavior eliminates trust and without trust, businesses cannot interact
 Beyond the question of ethics is the question of social responsibility
What is a market?
• A market is a venue where goods and services are exchanged.
• A financial market is a place where individuals and organizations wanting to borrow funds are brought
together with those having a surplus of funds.
The Importance of Financial Markets
• Well-functioning financial markets facilitate the flow of capital from investors to the users of capital.
 Markets provide savers with returns on their money saved/invested, which provide them money
in the future.
 Markets provide users of capital with the necessary funds to finance their investment projects.
• Well-functioning markets promote economic growth.
• Economies with well-developed markets perform better than economies with poorly functioning
markets.
Illustration 1. The Circular Flow of Markets and its Components
The Capital Allocation Process
•
In a well-functioning economy, capital flows efficiently from those who supply capital to those who
demand it.
• Suppliers of capital: individuals and institutions with “excess funds.” These groups are saving money
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Module #1 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
•
Class number: ______
Date: _______________
and looking for a rate of return on their investment.
Demanders or users of capital: individuals and institutions who need to raise funds to finance their
investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.
Types of Financial Institutions
• Investment banks
• Commercial banks
• Financial services corporations
• Credit unions
• Pension funds
• Life insurance companies
• Mutual funds
• Exchange traded funds
• Hedge funds
• Private equity companies
Skill-building Activities (with answer key)
Activity 1: Identify the advantages and disadvantages of using a financial intermediary
Direction: Complete the diagram.
Advantages
Disadvantages
Activity 2: Identify the stock market transaction
Direction: Understand the transaction and identify the classification of the transaction. Explain your answer.
1. Apple Computer decides to issue additional stock with the assistance of its investment banker.
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An
FIN 072 | Financial Markets
Module #1 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
investor purchases some of the newly issued shares. Is this a primary market transaction or a secondary
market transaction?
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
_______________________________________________________________________________________
2. What if instead an investor buys existing shares of Apple stock in the open market. Is this a primary or
secondary market transaction?
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
_______________________________________________________________________________________
Check for Understanding
Write your answers here:
1
2
3
4
5
Score:
6
7
8
9
10
11
12
13
14
15
True or False. Write TRUE if the statement is correctly stated, otherwise, write FALSE.
1. A financial intermediary is a corporation that takes funds from investors and then provides those funds
to those who need capital. A bank that takes in demand deposits and then uses that money to make
long-term mortgage loans is one example of a financial intermediary.
2. The NYSE is defined as a "spot" market purely and simply because it has a physical location. The
NASDAQ, on the other hand, is not a spot market because it has no one central location.
3. The NYSE is defined as a "primary" market because it is one of the largest and most important stock
markets in the world.
4. Primary markets are large and important, while secondary markets are smaller and less important.
5. Private markets are those like the NYSE, where transactions are handled by members of the
organization, while public markets are those like the NASDAQ, where anyone can make transactions.
Conceptual Multiple-Choice Questions. Write the letter of your answer.
6. You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion, your
brother gave you a check for the stock and you gave your brother the stock certificates. Which of the
following best describes this transaction?
a. This is an example of a direct transfer of capital.
b. This is an example of a primary market transaction.
c. This is an example of an exchange of physical assets.
d. This is an example of a money market transaction.
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FIN 072 | Financial Markets
Module #1 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
e. This is an example of a derivative market transaction.
Which of the following statements is CORRECT?
a. The NYSE does not exist as a physical location. Rather it represents a loose collection of dealers
who trade stock electronically.
b. An example of a primary market transaction would be your uncle transferring 100 shares of
Walmart stock to you as a birthday gift.
c. Capital market instruments include both long-term debt and common stocks.
d. If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los
Angeles, this would be a primary market transaction.
e. While the two frequently perform similar functions, investment banks generally specialize in lending
money, whereas commercial banks generally help companies raise large blocks of capital from
investors.
8. Which of the following is a primary market transaction?
a. You sell 200 shares of IBM stock on the NYSE through your broker.
b. You buy 200 shares of IBM stock from your brother. The trade is not made through a broker; you
just give him cash and he gives you the stock.
c. IBM issues 2,000,000 shares of new stock and sells them to the public through an investment
banker.
d. One financial institution buys 200,000 shares of IBM stock from another institution. An investment
banker arranges the transaction.
e. IBM sells 2,000,000 shares of treasury stock to its employees when they exercise options that were
granted in prior years.
9. Which of the following is an example of a capital market instrument?
a. Commercial paper.
b. Preferred stock.
c. U.S. Treasury bills.
d. Banker's acceptances.
e. Money market mutual funds.
10. Money markets are markets for
a. Foreign currencies.
b. Consumer automobile loans.
c. Common stocks.
d. Long-term bonds.
e. Short-term debt securities such as Treasury bills and commercial paper.
7.
C. LESSON WRAP-UP
Frequently Asked Questions
1. What is an IPO?
• An initial public offering (IPO) occurs when a company issues stock in the public market for the first
time.
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FIN 072 | Financial Markets
Module #1 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
2. What is Going Public?
• “Going public” enables a company’s owners to raise capital from a wide variety of outside investors.
Once issued, the stock trades in the secondary market.
• Public companies are subject to additional regulations and reporting requirements.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
ANSWER KEY
Activity 1
CATEGORY
Content
Accuracy
Grammar &
Spelling
(Conventions)
4 points
The paper contains
at least 5 accurate
facts about the
topic.
Writer makes no
errors in grammar
or spelling.
Sentences and
Paragraphs
Sentences
and
paragraphs
are
complete,
wellconstructed and of
varied structure
Ideas
Ideas
were
Success Criteria
3 points
2 points
1 point
The paper contains The paper contains at The paper contains
at least 3-4 accurate least 1-2 accurate facts no accurate facts
facts about the topic. about the topic.
about the topic.
Writer makes 1-3 Writer
makes
4-6 Writer makes more
errors in grammar errors in grammar than 6 errors in
and/or spelling.
and/or spelling.
grammar
and/or
spelling.
All Sentences and Most sentences are Many
sentence
paragraphs
are complete and well- fragments or run
complete,
well- constructed.
sentences
or
constructed
(no Paragraphing
needs paragraphing need
fragments, no run- some work.
lot of work.
ons). Paragraph is
generally done well.
Ideas
were Ideas were somewhat The paper seemed
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #1 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
expressed in a
clear
and
organized fashion.
It was easy to
figure out what the
paper was about.
expressed in a clear
manner,
but
the
organization
could
have been better.
Class number: ______
Date: _______________
organized but were not
noticeably clear. It
looks more than one
reading to figure out
what was the paper
was about.
be a collection of
unrelated sentences.
It was difficult to
figure out what the
paper was about.
Activity 2
1. Since new shares of stock are being issued, this is a primary market transaction.
2. Since no new shares are created, this is a secondary market transaction.
Check for Understanding
1.
TRUE
2.
FALSE – Spot market, also referred to as "liquid market" or "cash market", is where financial
instruments are exchanged for immediate delivery. The New York Stock Exchange (NYSE) is an
example of a spot market where traders buy and sell stocks.
3.
FALSE - The primary market is where securities are created. The secondary market is basically the
stock market and refers to the New York Stock Exchange, the NASDAQ, and other exchanges
worldwide.
4.
FALSE - Both are of equal importance. The capital markets would be much harder to navigate and
much less profitable without them.
5.
FALSE - Private markets refer to investments in equity and debt of privately owned companies.
6.
A
7.
C
8.
C
9.
B
10. E
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #2 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Financial Markets (Part 2)
Learning Targets:
At the end of this module, I should be able to:
1. Discuss the different types of financial markets;
2. Enumerate the different financial instruments used in the
money market;
3. Distinguish the primary market from the secondary market;
and
4. Describe the function of an investment banker.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
A. LESSON PREVIEW/REVIEW
Let us review the lesson on the previous day.
Direction: Complete the illustration.
B. MAIN LESSON
Content and Skill-Building (40 mins)
Basic Functions of the Financial System
1. Promote savings
2. Enable payment
3. Protect against risks
4. Present a means to wealth
5. Provide liquidity
6. Provide credit facilities
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FIN 072 | Financial Markets
Module #2 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Financial Intermediaries
1. Financial intermediaries hire highly qualified people to assess risky investments.
2. Financial intermediaries know how to diversify.
3. Hiring financial intermediaries has a cost advantage or economy of scale.
4. Financial intermediaries reconcile the conflicting interest of the users and lender of funds.
5. Financial intermediaries provide savers with liquidity.
Functions of Investment Banker
1. Originate securities issues through negotiations between the officer of the issuing firm and officers of
the investment bank.
a. Initial discussion
b. Investigation
c. Negotiation
d. Registration
2. Underwrite the issues by guaranteeing their sale in the primary capital market.
3. Manage the distribution of the securities to the ultimate investors. Members of the underwriting
syndicate form a selling group consisting of dealers who will contact the ultimate investors.
4. Give advice to the corporate clients on long-term financial matters.
Skill-building Activities
Activity 1: Discuss the different types of financial markets
Direction: Discuss the diagram. (5 minutes)
Finacial Markets
Money Market
Certificate of
deposits
Capital Market
Elements
Commercial
papers
Organized
security
exchanges
Repurchase
agreement
Over-thecounter (OTC)
Markets
Others
Types
Primary market
Issuers
Bond Market
Secondary
market
Aftermarket
Commodity
Market
Stock Market
Treasury bills
Financial
Instruments
Derivatives
Market
Banker's
acceptance
Financial
Intermediaries
ForeignExchange
Market
Investors
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #2 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
_______________________________________________________________________________________
Activity 2: Enumerate the different financial instruments used in the money market
Direction: Explain the different financial instruments used in the money market. (5 minutes)
1. ______________________________ ______________________________________________________________________________
2. ______________________________ ______________________________________________________________________________
3. ______________________________ ______________________________________________________________________________
4. ______________________________ ______________________________________________________________________________
5. ______________________________ ______________________________________________________________________________
Activity 3: Distinguish the primary market from the secondary market
Direction: Explain the difference between the primary market and secondary market. (5 minutes)
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________
Activity 4: Describe the function of an investment banker
Direction: What are the procedures when investing? (5 minutes)
1. __________________________________________________________________________________
_________________________________________________________________________________
2. __________________________________________________________________________________
_________________________________________________________________________________
3. __________________________________________________________________________________
_________________________________________________________________________________
4. __________________________________________________________________________________
_________________________________________________________________________________
5. __________________________________________________________________________________
_________________________________________________________________________________
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #2 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Check for Understanding (5 mins)
Write your answers here:
1
2
3
4
5
Score:
6
7
8
9
10
11
12
13
14
15
True or False. Write TRUE if the statement is correctly stated, otherwise, write FALSE.
1. A share of common stock is not a derivative, but an option to buy the stock is a derivative because the
value of the option is derived from the value of the stock.
2. Financial institutions are more diversified today than they were in the past, when federal laws kept
investment banks, commercial banks, insurance companies, and similar organizations quite separate.
Today the larger financial services corporations offer a variety of services, ranging from checking
accounts, to insurance, to underwriting securities, to stock brokerage.
3. Hedge funds are somewhat like mutual funds. The primary differences are that hedge funds are less
highly regulated, have more flexibility regarding what they can buy, and restrict their investors to
wealthy, sophisticated individuals, and institutions.
4. Trades on the NYSE are generally completed by having a brokerage firm acting as a "dealer" buy
securities and adding them to its inventory or selling from its inventory. The NASDAQ, on the other
hand, operates as an auction market, where buyers offer to buy, and sellers to sell, and the price is
negotiated on the floor of the exchange.
5. The "over-the-counter" market received its name years ago because brokerage firms would hold
inventories of stocks and then sell them by literally passing them over the counter to the buyer.
Conceptual Multiple-Choice Questions. Write the letter of your answer.
6. Which of the following statements is CORRECT?
a. If you purchase 100 shares of Disney stock from your brother-in-law, this is an example of a
primary market transaction.
b. If Disney issues additional shares of common stock through an investment banker, this would be a
secondary market transaction.
c. The NYSE is an example of an over-the-counter market.
d. Only institutions, and not individuals, can engage in derivative market transactions.
e. As they are generally defined, money market transactions involve debt securities with maturities of
less than one year.
7. You recently sold 200 shares of Disney stock, and the transfer was made through a broker. This is an
example of:
a. A money market transaction.
b. A primary market transaction.
c. A secondary market transaction.
d. A futures market transaction.
e. An over-the-counter market transaction.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #2 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
8.
Which of the following statements is CORRECT?
a. Hedge funds are legal in Europe and Asia, but they are not permitted to operate in the United
States.
b. Hedge funds are legal in the United States, but they are not permitted to operate in Europe or Asia.
c. Hedge funds have more in common with investment banks than with any other type of financial
institution.
d. Hedge funds have more in common with commercial banks than with any other type of financial
institution.
e. Hedge funds are not as highly regulated as most other types of financial institutions. The
justification for this light regulation is that only "sophisticated investors" (i.e., those with high net
worths and high incomes) are permitted to invest in these funds, and these investors supposedly
can do any necessary "due diligence" on their own rather than have it done by the SEC or some
other regulator.
9. Which of the following statements is CORRECT?
a. While the distinctions are becoming blurred, investment banks generally specialize in lending
money, whereas commercial banks generally help companies raise capital from other parties.
b. The NYSE operates as an auction market, whereas NASDAQ is an example of a dealer market.
c. Money market mutual funds usually invest their money in a well-diversified portfolio of liquid
common stocks.
d. Money markets are markets for long-term debt and common stocks.
e. A liquid security is a security whose value is derived from the price of some other "underlying"
asset.
10. Which of the following statements is CORRECT?
a. The New York Stock Exchange is an auction market, and it has a physical location.
b. Home mortgage loans are traded in the money market.
c. If an investor sells shares of stock through a broker, then it would be a primary market transaction.
d. Capital markets deal only with common stocks and other equity securities.
e. While the distinctions are blurring, investment banks generally specialize in lending money,
whereas commercial banks generally help companies raise capital from other parties.
C. LESSON WRAP-UP
Frequently Asked Questions
1. Economists are concerned about how financial intermediaries can generate shocks to the economy, i.e.,
“bumps” that disrupt the normal flow of economic life. What are the reasons of this concern?
• First, bank debts function as money, so disruptions in banks can affect the amount of money in
circulations. Second, financial intermediaries are tied together through chains of debts and assets.
2. What is meant by stock market efficiency?
• Securities are normally in equilibrium and are “fairly priced.” Investors cannot “beat the market” except
through good luck or better information. Efficiency continuum
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #2 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #2 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Activity 1, 2 & 3
CATEGORY
Content
Accuracy
Grammar &
Spelling
(Conventions)
4 points
The paper contains
at least 5 accurate
facts about the
topic.
Writer makes no
errors in grammar
or spelling.
Sentences and
Paragraphs
Sentences
and
paragraphs
are
complete,
wellconstructed and of
varied structure
Ideas
Ideas
were
expressed in a
clear
and
organized fashion.
It was easy to
figure out what the
paper was about.
Success Criteria
3 points
2 points
1 point
The paper contains The paper contains at The paper contains
at least 3-4 accurate least 1-2 accurate facts no accurate facts
facts about the topic. about the topic.
about the topic.
Writer makes 1-3 Writer
makes
4-6 Writer makes more
errors in grammar errors in grammar than 6 errors in
and/or spelling.
and/or spelling.
grammar
and/or
spelling.
All Sentences and Most sentences are Many
sentence
paragraphs
are complete and well- fragments or run
complete,
well- constructed.
sentences
or
constructed
(no Paragraphing
needs paragraphing need
fragments, no run- some work.
lot of work.
ons). Paragraph is
generally done well.
Ideas
were Ideas were somewhat The paper seemed
expressed in a clear organized but were not be a collection of
manner,
but
the noticeably clear. It unrelated sentences.
organization
could looks more than one It was difficult to
have been better.
reading to figure out figure out what the
what was the paper paper was about.
was about.
Activity 4
Investing procedures
1. Choose a stockbroker.
2. Open an account and fill out a customer account information form and submit identification papers for
verifications.
3. Give the order to the trader, and then ask for the confirmation receipt.
4. Pay before the settlement date.
5. The investor shall receive from his/her broker either the proceeds of the sale of his/her stocks (after 3
business days) or proofs of ownership of the stocks he/she bought (confirmation receipt and invoice).
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #3 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Time Value of Money (Part 1)
Learning Targets:
At the end of this module, I should be able to:
1. Understand the concept of time value of money; and
2. Compute the time value of money in various situations; and
3. Solve problems using the time value of money.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
A. LESSON PREVIEW/REVIEW
Let us review the lesson on the previous day.
Direction: What are the procedures when investing?
1.______________________________________________________________________________________
2.______________________________________________________________________________________
3.______________________________________________________________________________________
4.______________________________________________________________________________________
5.______________________________________________________________________________________
B. MAIN LESSON
Content and Skill-Building (40 mins)
Timelines
• Show the timing of cash flows.
• Tick marks occur at the end of periods, so Time 0 is today; Time 1 is the end of the first period (year,
month, etc.) or the beginning of the second period.
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FIN 072 | Financial Markets
Module #3 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Drawing Timelines
Future Value
What is the future value (FV) of an initial P100 after 3 years, if I/YR = 4%?
• Finding the FV of a cash flow or series of cash flows is called compounding.
• FV can be solved by using the step-by-step, financial calculator, and spreadsheet methods.
Solving for FV: The Step-by-Step and Formula Methods
• After 1 year:
FV1
= PV(1 + I) = P100(1.04) = P104.00
• After 2 years:
FV2
= PV(1 + I)2 = P100(1.04)2 = P108.16
• After 3 years:
FV3
= PV(1 + I)3 = P100(1.04)3 = P112.49
• After N years (general case):
FVN
= PV(1 + I)N
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Module #3 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Present Value
What is the present value (PV) of P100 due in 3 years, if I/YR = 4%?
• Finding the PV of a cash flow or series of cash flows is called discounting (the reverse of compounding).
• The PV shows the value of cash flows in terms of today’s purchasing power.
Solve the general FV equation for PV:
PV
= FVN /(1 + I)N
PV
= FV3 /(1 + I)3
= P100/(1.04)3
= P88.90
What is the difference between an ordinary annuity and an annuity due?
Skill-building Activities
Activity 1: Understand the concept of time value of money
Direction: Write TRUE if the statement is correctly explained, otherwise, write FALSE. (2 minutes)
1. ________ - Starting to invest early for retirement increases the benefits of compound interest.
2. ________ - A timeline is meaningful even if all cash flows do not occur annually.
3. ________ - If the discount (or interest) rate is positive, the present value of an expected series of
payments will always exceed the future value of the same series.
4. ________ - Disregarding risk, if money has time value, it is impossible for the future value of a given
sum to exceed its present value.
5. ________ - If a bank compounds savings accounts quarterly, the effective annual rate will exceed the
nominal rate.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #3 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Activity 2: Compute the time value of money in various situations
Direction: Write all the necessary formulas related to time value of money. (10 minutes)
Simple Interest
Future value of ordinary annuity (intra-year
compounding)
Compound Interest
Future value of annuity due (annual compounding)
Future value of a single amount
Future value of annuity due (intra-year
compounding)
Future value of a single amount (Intra-year
Compounding)
Present Value for Ordinary Annuity (Annual
Discounting)
Present value of single amount (annual discounting)
Present Value for Ordinary Annuity (Intra Year
Discounting)
Present Value of single amount (Intra-year
discounting)
Present Value of Annuity Due (Annual Discounting)
When time (n) is unknown
Present Value for Annuity Due (Intra-year
Discounting)
When i (interest) is unknown
Present Value of Perpetuity
Future value of ordinary annuity (annual
compounding)
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FIN 072 | Financial Markets
Module #3 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Activity 3: Solve problems using the time value of money
Direction: Solve the given problems. (25 minutes)
1. Mr. Salman has three options for investment. Option first offered by Allied Bank is deposit P100 in a
five-year certificate of deposit paying 10% simple interest. How much will have at the end of the fiveyear?
Clue: Simple Interest
Answer:
Solution:
2. Mr. Salman has second option offered by National Bank is deposit P100 in a five-year certificate of
deposit paying 10% discrete compound interest. How much will have at the end of the five-year? Find
out the difference of interest between compound and simple interest?
Clue: Compound Interest
Answer:
Solution:
3. Ms. Nosheen puts P10,000 in a savings account today, that pays 5% compounded annually. How much
will she have in her account after ten years?
Clue: Future value of a single amount
Answer:
Solution:
4. Mr. Naveed purchase a 3-year, 6-percent savings certificate for P25,000. If interest is compounded
semi-an-nually, what will be the value of the certificate when it matures?
Clue: Future value of a single amount (intra-year compounding)
Answer:
Solution:
5. Designs Co. is opening a showcase office to display and sell its computer designed poster art. Designs
expect cash flows to be P100,000, 6 years hence, if Designs uses 10 percent as its discount rate, what
is the present value of the cash flow?
Clue: Present value of single amount (annual discounting)
Answer:
Solution:
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Module #3 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
6. Your brother, who is 6 years old, just received a trust fund that will be worth P25,000 when he is 21
years old. If the fund earns 10 percent interest discounted semi-annually, what is the value of the fund
today?
Clue: Present Value of single amount (intra-year discounting)
Answer:
Solution:
7. If you invested P40,000 at one point in time and received back P100,000 at 13.98% rate, how much
time required?
Clue: When time (n) is unknown
Answer:
Solution:
8. If you invested P40,000 at one point in time and received back P100,000 seven years later, what
annual interest rate would you have obtained?
Clue: When i (interest) is unknown
Answer:
Solution:
9. If an employee deposits P1,000 at the end of each year into his company’s plan which pays 7%
interest compounded yearly, how much will he have in the account at the end of 5 years?
Clue: Future value of ordinary annuity (annual compounding)
Answer:
Solution:
10. Mohammad Ali Corporation started making sinking fund deposits of P20,000 at end of year. Its bank
pays 6% compounded semi-annually. What will the fund be worth at the end of that time by factor
formula and general formula?
Clue: Future value of ordinary annuity (intra-year compounding)
Answer:
Solution:
11. An annuity makes 5 annual payments of P1,000 with the first payment coming today. What is the
future value of this from now if the interest rate is 7%?
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Module #3 Student Activity Sheet
Name: _________________________________________________________________
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Class number: ______
Date: _______________
Clue: Future value of annuity due (annual compounding)
Answer:
Solution:
12. If 10 annual payments of P900 are made into saving account that pays 6 percent interest per year.
What is the future value of this annuity due if compounding take place semi-annually?
Clue: Future value of annuity due (intra-year compounding)
Answer:
Solution:
13. You want to buy an ordinary annuity that will pay you P1,000 a year for the next 5 year. You expect
annual interest rates will be 7 percent over that period. What is maximum price you would be willing to
pay today?
Clue: Present value for ordinary annuity (annual discounting)
Answer:
Solution:
14. Mr. Bengish has signed a contract which pays him P100,000 per year for five year. Using a discount
rate of 8% and discounting take place semi-annually, what is the present value of his contract?
Clue: Present value for ordinary annuity (intra year discounting)
Answer:
Solution:
15. What is the value today of a 5-year annuity due that pays P1,000 a year assuming that rate is 7%?
Clue: Present value of annuity due (annual discounting)
Answer:
Solution:
16. Find the present value of due annuity with periodic payments of P3,000, for a period of 5 years at an
interest rate of 16%, discounted quarterly?
Clue: Present value for annuity due (intra-year discounting)
Answer:
Solution:
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FIN 072 | Financial Markets
Module #3 Student Activity Sheet
Name: _________________________________________________________________
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Class number: ______
Date: _______________
17. Mr. Karim wishes to find out investments which return P10,000 forever, discounted at 10 percent?
Clue: Present Value of Perpetuity
Answer:
Solution:
Check for Understanding (5 mins)
Write your answers here:
1
2
3
4
5
Score:
6
7
8
9
10
11
12
13
14
15
True or False. Write TRUE if the statement is correctly stated, otherwise, write FALSE.
1. Starting to invest early for retirement increases the benefits of compound interest.
2. A timeline is meaningful even if all cash flows do not occur annually.
3. Timelines can be constructed in situations where some of the cash flows occur annually, but others
occur quarterly.
4. Some of the cash flows shown on a timeline can be in the form of annuity payments while others can be
uneven amounts.
5. If the discount (or interest) rate is positive, the future value of an expected series of payments will
always exceed the present value of the same series.
Conceptual Multiple-Choice Questions. Write the letter of your answer.
6. Which of the following statements is CORRECT?
a. A timeline is not meaningful unless all cash flows occur annually.
b. Timelines are useful for visualizing complex problems prior to doing actual calculations.
c. Timelines cannot be constructed in situations where some of the cash flows occur annually, but
others occur quarterly.
d. Timelines cannot be constructed for annuities where the payments occur at the beginning of the
periods.
e. Some of the cash flows shown on a timeline can be in the form of annuity payments, but none can
be uneven amounts.
7. You plan to analyze the value of a potential investment by calculating the sum of the present values of
its expected cash flows. Which of the following would lower the calculated value of the investment?
a. The cash flows are in the form of a deferred annuity, and they total to P100,000. You learn that the
annuity lasts for only 5 rather than 10 years, hence that each payment is for P20,000 rather than
for P10,000.
b. The discount rate increases.
c. The riskiness of the investment's cash flows decreases.
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FIN 072 | Financial Markets
Module #3 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
d. The total amount of cash flows remains the same, but more of the cash flows are received in the
earlier years and less are received in the later years.
e. The discount rate decreases.
8. Which of the following statements is CORRECT?
a. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods.
b. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is
an annuity.
c. The cash flows for an annuity due must all occur at the ends of the periods.
d. The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as
once a year or once a month.
e. If some cash flows occur at the beginning of the periods while others occur at the ends, then we
have what the textbook defines as a variable annuity.
9. Your bank account pays a 6% nominal rate of interest. The interest is compounded quarterly. Which of
the following statements is CORRECT?
a. The periodic rate of interest is 1.5% and the effective rate of interest is 3%.
b. The periodic rate of interest is 6% and the effective rate of interest is greater than 6%.
c. The periodic rate of interest is 1.5% and the effective rate of interest is greater than 6%.
d. The periodic rate of interest is 3% and the effective rate of interest is 6%.
e. The periodic rate of interest is 6% and the effective rate of interest is also 6%.
10. Your bank account pays an 8% nominal rate of interest. The interest is compounded quarterly. Which of
the following statements is CORRECT?
a. The periodic rate of interest is 2% and the effective rate of interest is 4%.
b. The periodic rate of interest is 8% and the effective rate of interest is greater than 8%.
c. The periodic rate of interest is 4% and the effective rate of interest is less than 8%.
d. The periodic rate of interest is 2% and the effective rate of interest is greater than 8%.
e. The periodic rate of interest is 8% and the effective rate of interest is also 8%.
Problem Solving. Provide the necessary complete information.
11. Sue now has P125. How much would she have after 8 years if she leaves it invested at 8.5% with
annual compounding?
12. Suppose a State of New York bond will pay P1,000 ten years from now. If the going interest rate on
these 10-year bonds is 5.5%, how much is the bond worth today?
13. Suppose the U.S. Treasury offers to sell you a bond for P747.25. No payments will be made until the
bond matures 5 years from now, at which time it will be redeemed for P1,000. What interest rate would
you earn if you bought this bond at the offer price?
14. Last year Thomson Inc's earnings per share were P3.50, and its growth rate during the prior 5 years
was 9.0% per year. If that growth rate were maintained, how many years would it take for Thomson's
EPS to triple?
15. You want to buy a new sports car 3 years from now, and you plan to save P4,200 per year, beginning
one year from today. You will deposit your savings in an account that pays 5.2% interest. How much
will you have just after you make the 3rd deposit, 3 years from now?
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #3 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
C. LESSON WRAP-UP
Frequently Asked Questions
1. Will the FV of a lump sum be larger or smaller if compounded more often, holding the stated I% constant?
2. How to compute effective interest rate?
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #3 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
KEY TO CORRECTIONS
Review
Investing procedures
1. Choose a stockbroker.
2. Open an account and fill out a customer account information form and submit identification papers for
verifications.
3. Give the order to the trader, and then ask for the confirmation receipt.
4. Pay before the settlement date.
5. The investor shall receive from his/her broker either the proceeds of the sale of his/her stocks (after 3
business days) or proofs of ownership of the stocks he/she bought (confirmation receipt and invoice).
Activity 1
1. TRUE
2. TRUE
3. FALSE - If the discount (or interest) rate is positive, the future value of an expected series of payments
will always exceed the present value of the same series.
4. FALSE - Disregarding risk, if money has time value, it is impossible for the present value of a given sum
to exceed its future value.
5. TRUE
Activity 3
1. P150
2. P161.05
3. P16,289
4. P29,852.50
5. P56,450
6. P5,785
7. 7 years
8. 13.98%
9. P5,750.74
10. P1,508,020
11. P6,153.29
12. P24,908.49
13. P4,100.20
14. P811,090
15. P4,387.21
16. P42,401.74
17. P100,000
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #4 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Time Value of Money (Part 2)
Learning Targets:
At the end of this module, I should be able to:
1. Explain the importance of the time value of money in the
decision-making process; and
2. Enumerate the other areas in financial management where
the time value of money is applied.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
A. LESSON PREVIEW/REVIEW
Let us review the lesson on the previous day.
1. You want to go to Europe 5 years from now, and you can save P3,100 per year, beginning one year from
today. You plan to deposit the funds in a mutual fund that you think will return 8.5% per year. Under these
conditions, how much would you have just after you make the 5th deposit, 5 years from now?
Solution
Answer:
2. You just inherited some money, and a broker offers to sell you an annuity that pays P5,000 at the end of
each year for 20 years. You could earn 5% on your money in other investments with equal risk. What is the
most you should pay for the annuity?
Solution
Answer:
B. MAIN LESSON
Content and Skill-Building (40 mins)
This document is the property of PHINMA EDUCATION
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Module #4 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Classification of Interest Rates
• Nominal rate (INOM): also called the quoted or stated rate. An annual rate that ignores compounding
effects.
 INOM is stated in contracts. Periods must also be given, e.g. 4% quarterly or 4% daily interest.
• Periodic rate (IPER): amount of interest charged each period, e.g. monthly or quarterly.
 IPER = INOM/M, where M is the number of compounding periods per year. M = 4 for quarterly and
M = 12 for monthly compounding.
• Effective (or equivalent) annual rate (EAR = EFF%): the annual rate of interest actually being earned,
considering compounding.
 EFF% for 4% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.04/2)2 – 1 = 4.04%
 Excel: =EFFECT(nominal_rate,npery)
=EFFECT(.04,2)
 Should be indifferent between receiving 4.04% annual interest and receiving 4% interest,
compounded semiannually.
Why is it important to consider effective rates of return?
• Investments with different compounding intervals provide different effective returns.
• To compare investments with different compounding intervals, you must look at their effective returns
(EFF% or EAR).
• See how the effective return varies between investments with the same nominal rate, but different
compounding intervals.
EARANNUAL
4.00%
EARSEMIANNUALLY
4.04%
EARQUARTERLY 4.06%
EARMONTHLY 4.07%
EARDAILY (365) 4.08%
When is each rate used?
• INOM: Written into contracts, quoted by banks and brokers. Not used in calculations or shown on time
lines.
• IPER: Used in calculations and shown on time lines. If M = 1, INOM = IPER = EAR.
• EAR: Used to compare returns on investments with different payments per year. Used in calculations
when annuity payments don’t match compounding period
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #4 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
What is the FV of P100 after 3 years under 4% semiannual compounding? Quarterly compounding?
 I

FVN  PV1  NOM 
M


MN
23
0.04 

FV3S  $1001 

2 

FV3S  $100(1.02) 6  $112.62
FV3Q  $100(1.01)12  $112.68
What is the FV of a 3-year P100 annuity, if the quoted interest rate is 4%, compounded semiannually?
• Payments occur annually, but compounding occurs every 6 months.
• Cannot use normal annuity valuation techniques.
Method 1:
Compound Each Cash Flow
FV3 = P100(1.02)4 + P100(1.02)2 + P100
FV3 = P312.28
Loan Amortization
• Amortization tables are widely used for home mortgages, auto loans, business loans, retirement plans,
etc.
• Financial calculators and spreadsheets are great for setting up amortization tables.
EXAMPLE: Construct an amortization schedule for a P1,000, 4% annual rate loan with 3 equal
payments.
Step 1:
Find the Required Annual Payment
• All input information is already given, just remember that the FV = 0 because the reason for amortizing
the loan and making payments is to retire the loan.
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Module #4 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Excel: =PMT(.04,3,-1000,0,0)
Step 2:
Find the Interest Paid in Year 1
• The borrower will owe interest upon the initial balance at the end of the first year. Interest to be paid in
the first year can be found by multiplying the beginning balance by the interest rate.
INTt = Beg balt(I)
INT1 = P1,000(0.04) = P40
Step 3:
Find the Principal Repaid in Year 1
• If a payment of P360.35 was made at the end of the first year and P40 was paid toward interest, the
remaining value must represent the amount of principal repaid.
PRIN = PMT – INT
= P360.35 – P40 = P320.35
Step 4:
Find the Ending Balance after Year 1
• To find the balance at the end of the period, subtract the amount paid toward principal from the
beginning balance.
END BAL
= BEG BAL – PRIN
= P1,000 – P320.35
= P679.65
Constructing an Amortization Table:
Repeat Steps 1-4 Until End of Loan
•
Interest paid declines with each payment as the balance declines. What are the tax implications of
this?
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Module #4 Student Activity Sheet
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Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Illustrating an Amortized Payment: Where does the money go?
•
•
•
Constant payments
Declining interest payments
Declining balance
Skill-building Activities
Activity 1: Explain the importance of the time value of money in the decision-making process; and
Enumerate the other areas in financial management where the time value of money is applied
Direction: Using the concept organizer, list down six applications of the time value of money.
Applications of Time Value of Money
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #4 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Check for Understanding (5 mins)
Write your answers here:
1
2
3
4
5
Class number: ______
Date: _______________
Score:
6
7
8
9
10
11
12
13
14
15
True or False. Write TRUE if the statement is correctly stated, otherwise, write FALSE.
1. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to
exceed its future value.
2. If a bank compounds savings accounts quarterly, the nominal rate will exceed the effective annual rate.
3. The greater the number of compounding periods within a year, then (1) the greater the future value of a
lump sum investment at Time 0 and (2) the greater the present value of a given lump sum to be
received at some future date.
4. Suppose Sally Smith plans to invest P1,000. She can earn an effective annual rate of 5% on Security A,
while Security B has an effective annual rate of 12%. After 11 years, the compounded value of Security
B should be more than twice the compounded value of Security A. (Ignore risk, and assume that
compounding occurs annually.)
5. When a loan is amortized, a relatively high percentage of the payment goes to reduce the outstanding
principal in the early years, and the principal repayment's percentage declines in the loan's later years.
Conceptual Multiple-Choice Questions. Write the letter of your answer.
6. A P50,000 loan is to be amortized over 7 years, with annual end-of-year payments. Which of these
statements is CORRECT?
a. The annual payments would be larger if the interest rate were lower.
b. If the loan were amortized over 10 years rather than 7 years, and if the interest rate were the same
in either case, the first payment would include more pesos of interest under the 7-year amortization
plan.
c. The proportion of each payment that represents interest as opposed to repayment of principal
would be lower if the interest rate were lower.
d. The last payment would have a higher proportion of interest than the first payment.
e. The proportion of interest versus principal repayment would be the same for each of the 7
payments.
7. A P150,000 loan is to be amortized over 7 years, with annual end-of-year payments. Which of these
statements is CORRECT?
a. The annual payments would be larger if the interest rate were lower.
b. If the loan were amortized over 10 years rather than 7 years, and if the interest rate were the same
in either case, the first payment would include more pesos of interest under the 7-year amortization
plan.
c. The proportion of each payment that represents interest as opposed to repayment of principal
would be higher if the interest rate were lower.
d. The proportion of each payment that represents interest versus repayment of principal would be
higher if the interest rate were higher.
This document is the property of PHINMA EDUCATION
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Module #4 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
e. The proportion of interest versus principal repayment would be the same for each of the 7
payments.
8. Which of the following statements regarding a 15-year (180-month) P125,000, fixed-rate mortgage is
CORRECT? (Ignore taxes and transactions costs.)
a. The remaining balance after three years will be P125,000 less one third of the interest paid during
the first three years.
b. Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and
principal payments) are constant.
c. Interest payments on the mortgage will increase steadily over time, but the total amount of each
payment will remain constant.
d. The proportion of the monthly payment that goes towards repayment of principal will be lower 10
years from now than it will be the first year.
e. The outstanding balance declines at a slower rate in the later years of the loan's life.
9. Which of the following investments would have the highest future value at the end of 10 years? Assume
that the effective annual rate for all investments is the same and is greater than zero.
a. Investment A pays P250 at the beginning of every year for the next 10 years (a total of 10
payments).
b. Investment B pays P125 at the end of every 6-month period for the next 10 years (a total of 20
payments).
c. Investment C pays P125 at the beginning of every 6-month period for the next 10 years (a total of
20 payments).
d. Investment D pays P2,500 at the end of 10 years (just one payment).
e. Investment E pays P250 at the end of every year for the next 10 years (a total of 10 payments).
10. Which of the following bank accounts has the highest effective annual return?
a. An account that pays 8% nominal interest with monthly compounding.
b. An account that pays 8% nominal interest with annual compounding.
c. An account that pays 7% nominal interest with daily (365-day) compounding.
d. An account that pays 7% nominal interest with monthly compounding.
e. An account that pays 8% nominal interest with daily (365-day) compounding.
Problem Solving. Provide the necessary complete information.
11. Your father is about to retire, and he wants to buy an annuity that will provide him with P85,000 of
income a year for 25 years, with the first payment coming immediately. The going rate on such
annuities is 5.15%. How much would it cost him to buy the annuity today?
12. Your father's employer was just acquired, and he was given a severance payment of P375,000, which
he invested at a 7.5% annual rate. He now plans to retire, and he wants to withdraw P35,000 at the end
of each year, starting at the end of this year. How many years will it take to exhaust his funds, i.e., run
the account down to zero?
13. Suppose you just won the state lottery, and you have a choice between receiving P2,550,000 today or
a 20-year annuity of P250,000, with the first payment coming one year from today. What rate of return
is built into the annuity? Disregard taxes.
14. Suppose Community Bank offers to lend you P10,000 for one year at a nominal annual rate of 8.00%,
but you must make interest payments at the end of each quarter and then pay off the P10,000 principal
amount at the end of the year. What is the effective annual rate on the loan?
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Module #4 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
15. Your brother's business obtained a 30-year amortized mortgage loan for P250,000 at a nominal annual
rate of 7.0%, with 360 end-of-month payments. The firm can deduct the interest paid for tax purposes.
What will the interest tax deduction be for Year 1?
C. LESSON WRAP-UP
Frequently Asked Questions
1. Can the effective rate ever be equal to the nominal rate?
• Yes, but only if annual compounding is used, i.e., if M = 1.
• If M > 1, EFF% will always be greater than the nominal rate.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review
1. P18,369
N
5
I/YR
8.5%
PV
P0.00
PMT
P3,100
FV
P18,369
2. P62,311
N
I/YR
PMT
FV
PV
20
5.0%
P5,000
P0.00
P62,311
This document is the property of PHINMA EDUCATION
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Module #4 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Skill Building Activity Activity 1
CATEGORY
Content
Accuracy
Grammar &
Spelling
(Conventions)
4 points
The paper contains
at least 5 accurate
facts about the
topic.
Writer makes no
errors in grammar
or spelling.
Sentences and
Paragraphs
Sentences
and
paragraphs
are
complete,
wellconstructed and of
varied structure
Ideas
Ideas
were
expressed in a
clear
and
organized fashion.
It was easy to
figure out what the
paper was about.
Success Criteria
3 points
2 points
1 point
The paper contains The paper contains at The paper contains
at least 3-4 accurate least 1-2 accurate facts no accurate facts
facts about the topic. about the topic.
about the topic.
Writer makes 1-3 Writer
makes
4-6 Writer makes more
errors in grammar errors in grammar than 6 errors in
and/or spelling.
and/or spelling.
grammar
and/or
spelling.
All Sentences and Most sentences are Many
sentence
paragraphs
are complete and well- fragments or run
complete,
well- constructed.
sentences
or
constructed
(no Paragraphing
needs paragraphing need
fragments, no run- some work.
lot of work.
ons). Paragraph is
generally done well.
Ideas
were Ideas were somewhat The paper seemed
expressed in a clear organized but were not be a collection of
manner,
but
the noticeably clear. It unrelated sentences.
organization
could looks more than one It was difficult to
have been better.
reading to figure out figure out what the
what was the paper paper was about.
was about.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #5 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Risk and Rates of Return (Part 1)
Graded Quiz 1
Learning Targets:
At the end of this module, I should be able to:
1. Compare expected return with required and realized return;
2. Identify the types of risks; and
3. Discuss the concept of standard deviation.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
Your grandmother just died and left you P100,000 in a trust fund that pays 6.5% interest. You must spend the
money on your college education, and you must withdraw the money in 4 equal installments, beginning
immediately. How much could you withdraw today and at the beginning of each of the next 3 years and end up
with zero in the account?
Solution:
Answer:
B. MAIN LESSON
Content and Skill-Building (40 mins)
What four factors affect the level of interest rates?
• Production opportunities
• Time preferences for consumption
• Risk
• Expected inflation
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Module #5 Student Activity Sheet
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Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
“Nominal” vs. “Real” Rates
r
= represents any nominal rate
r*
= represents the “real” risk-free rate of interest. Like a T-bill rate, if there was no inflation.
Typically ranges from 1% to 4% per year.
rRF
= represents the rate of interest on Treasury securities.
Determinants of Interest Rates
r
= r* + IP + DRP + LP + MRP
r
= required return on a debt security
r*
= real risk-free rate of interest
IP
= inflation premium
DRP = default risk premium
LP
= liquidity premium
MRP = maturity risk premium
Premiums Added to r* for Different Types of Debt
Constructing the Yield Curve: Inflation
• Step 1: Find the average expected inflation rate over Years 1 to N:
N
IPN 
 INFL t
t 1
N
Assume inflation is expected to be 5% next year, 6% the following year, and 8% thereafter.
IP1  5% / 1  5.00%
IP10  [5%  6%  8%(8)] / 10  7.50%
IP20  [5%  6%  8%(18)] / 20  7.75%
Must earn these IPs to break even vs. inflation; these IPs would permit you to earn r* (before taxes).
Constructing the Yield Curve: Maturity Risk
• Step 2: Find the appropriate maturity risk premium (MRP). For this example, the following equation will
This document is the property of PHINMA EDUCATION
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Module #5 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
be used to find a security’s appropriate maturity risk premium.
MRPt = 0.1% (t – 1)
Using the given equation:
MRP1  0.1%  (1  1)  0.0%
MRP10  0.1%  (10  1)  0.9%
MRP20  0.1%  (20  1)  1.9%
Notice that since the equation is linear, the maturity risk premium is increasing as the time to maturity
increases, as it should be.
Add the IPs and MRPs to r* to Find the Appropriate Nominal Rates
• Step 3: Adding the premiums to r*.
rRF, t = r* + IPt + MRPt
Assume r* = 3%,
rRF,1  3%  5%  0.0%  8.0%
rRF,10  3%  7.5%  0.9%  11.4%
rRF,20  3%  7.75%  1.9%  12.65%
Hypothetical Yield Curve
• An upward-sloping yield curve.
• Upward slope due to an increase in expected inflation and increasing maturity risk premium.
Relationship Between Treasury Yield Curve and Yield Curves for Corporate Issues
• Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the
Treasury curve.
• The spread between corporate and Treasury yield curves widens as the corporate bond rating
decreases.
• Since corporate yields include a default risk premium (DRP) and a liquidity premium (LP), the corporate
bond yield spread can be calculated as:
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Module #5 Student Activity Sheet
Name: _________________________________________________________________
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Corporate bond
 Corporate bond yield  Treasury bond yield
yield spread
 DRP  LP
Illustrating the Relationship Between Corporate and Treasury Yield Curves
Macroeconomic Factors That Influence Interest Rate Levels
• Federal reserve policy
• Federal budget deficits or surpluses
This document is the property of PHINMA EDUCATION
Class number: ______
Date: _______________
FIN 072 | Financial Markets
Module #5 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
•
•
Class number: ______
Date: _______________
International factors
Level of business activity
Skill-building Activities
Activity 1: Compare expected return with required and realized return
Direction: Define the following. (3 minutes)
1. Risk -_____________________________________________________________________________
2. Expected Return-____________________________________________________________________
3. Required Return-____________________________________________________________________
4. Realized Return-____________________________________________________________________
Activity 2: Identify the types of risks
Direction: Write SR if the risk is a Systematic Risk. Write UR if the risk is an Unsystematic Risk. (5 minutes)
1. ____________ - Interest Rate Risk
2. ____________ - Purchasing Power Risk
3. ____________ - Event Risk
4. ____________ - Principal Risk
5. ____________ - Currency Risk
6. ____________ - Credit Risk
7. ____________ - Equity Risk
8. ____________ - Liquidity Risk
9. ____________ - Inflation Risk
10. ____________ - Call Risk
11. ____________ - Country Risk
12. ____________ - Business Risk
Activity 3: Discuss the concept of standard deviation
Direction: Solve the problems. (20 minutes)
3.1 Using the 5-year annualized total returns for five investment managers if the managers' individual returns
were 30%, 12%, 25%, 20%, and 23%, answer the following questions:
1. Population variance
= _________________
2. Population standard deviation
= _________________
3. Sample variance
= _________________
4. Sample standard deviation
= _________________
This document is the property of PHINMA EDUCATION
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Module #5 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
1. Solution:
2. Solution:
3. Solution:
4. Solution:
Class number: ______
Date: _______________
3.2
Assume that Conrado Corporation is considering the possible rates of return it might earn next year on
a P100,000 investment on the stocks of Buenos Aires or a P75,000 on those of Jessa. The future returns
depend on the state of the economy with their corresponding probability distribution.
Stock Buenos Aires
Stock Jessa
State of Economy
Return (r)
Probability (p)
Return (r)
Probability (p)
Bad
-8%
15%
-10%
20%
Normal
15%
70%
20%
80%
Good
35%
15%
40%
20%
1. What is the Expected Return of Stock Buenos Aires? ___________________
2. What is the Expected Return of Stock Jessa?
___________________
3. What is the Variance of Stock Buenos Aires?
___________________
4. What is the Variance of Stock Jessa?
___________________
5. What is the Standard Deviation of Stock Buenos Aires?
___________________
6. What is the Standard Deviation of Stock Jessa?
___________________
7. What is the Coefficient of Variation of Stock Buenos Aires? ___________________
8. What is the Coefficient of Variation of Stock Jessa?
___________________
State of the
Economy
Bad
Normal
Good
Total
State of the
Economy
Bad
Normal
Good
Total
r
-8%
15%
35%
rp
(r-mean)
(r-mean)^2
[(r-mean)^2]
(p)
p
rp
(r-mean)
(r-mean)^2
[(r-mean)^2]
(p)
15%
70%
15%
r
-10%
20%
40%
p
20%
80%
20%
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #5 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Check for Understanding
Graded Quiz 1
Write your final answers here:
1
2
3
4
5
Score:
6
7
8
9
10
11
12
13
14
15
Part 1. Modified True or False. Write:
A – Both statements are true
B – Both statements are false
C – Only statement A is true
D – Only statement B is true
1
A
If you decide to buy 100 shares of Google, you would probably do so by calling your broker and
asking him or her to execute the trade for you. This would be defined as a secondary market
transaction, not a primary market transaction.
B
The term IPO stands for "individual purchase order," as when an individual (as opposed to an
institution) places an order to buy a stock.
2
A
In a "Dutch auction" for new stock, individual investors place bids for shares directly. Each
potential bidder indicates the price he or she is willing to pay and how many shares he or she will
purchase at that price. The highest price that permits the company to sell all the shares it wants
to sell is determined, and this is the "market clearing price." All bidders who specified this price or
higher can purchase their shares at the market clearing price.
B
When a corporation's shares are owned by a few individuals who are associated with the firm's
management, we say that the stock is closely held.
3
A
A publicly owned corporation is a company whose shares are held by the investing public, which
may include other corporations as well as institutional investors.
B
If you wanted to know what rate of return stocks have provided in the past, you could examine
data on the Dow Jones Industrial Index, the S&P 500 Index, or the NASDAQ Index.
4
A
The annual rate of return on any given stock can be found as the stock's dividend for the year
plus the change in the stock's price during the year, divided by its beginning-of-year price.
B
As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always
equal to or greater than the nominal rate on the deposit (or loan).
5
A
Midway through the life of an amortized loan, the percentage of the payment that represents
interest must be equal to the percentage that represents repayment of principal. This is true
regardless of the original life of the loan or the interest rate on the loan.
B
The payment made each period on an amortized loan is constant, and it consists of some
interest and some principal. The closer we are to the end of the loan's life, the smaller the
percentage of the payment that will be a repayment of principal.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #5 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Part 2. Problem Solving. Provide the required information.
6
You are considering investing in a bank account that pays a nominal annual rate of 7%, compounded
monthly. If you invest P3,000 at the end of each month, how many months will it take for your account
to grow to P150,000?
7
Your child's orthodontist offers you two alternative payment plans. The first plan requires a P4,000
immediate up-front payment. The second plan requires you to make monthly payments of P137.41,
payable at the end of each month for 3 years. What nominal annual interest rate is built into the
monthly payment plan?
8
You just deposited P2,500 in a bank account that pays a 4.0% nominal interest rate, compounded
quarterly. If you also add another P5,000 to the account one year (4 quarters) from now and another
P7,500 to the account two years (8 quarters) from now, how much will be in the account three years
(12 quarters) from now?
9
Suppose you borrowed P15,000 at a rate of 8.5% and must repay it in 5 equal installments at the end
of each of the next 5 years. By how much would you reduce the amount you owe in the first year?
10 Your brother's business obtained a 30-year amortized mortgage loan for P250,000 at a nominal annual
rate of 7.0%, with 360 end-of-month payments. The firm can deduct the interest paid for tax purposes.
What will the interest tax deduction be for Year 1?
11 Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a
maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the
number of years to maturity, hence the pure expectations theory is NOT valid. What rate of return
would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is
required, use the arithmetic average.
12 Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation
Protected Security (TIPS) is 2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that
no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this
information, what is the expected rate of inflation over the next 10 years? Disregard cross-product
terms, i.e., if averaging is required, use the arithmetic average.
13 Koy Corporation's 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is
r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Koy's bonds
is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the
formula MRP = (t − 1) × 0.1%, where t = number of years to maturity. What is the default risk premium
(DRP) on Koy's bonds?
14 Niendorf Corporation's 5-year bonds yield 8.00%, and 5-year T-bonds yield 4.80%. The real risk-free
rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for
Niendorf's bonds is DRP = 1.20% versus zero for T-bonds, and the maturity risk premium for all bonds
is found with the formula MRP = (t − 1) × 0.1%, where t = number of years to maturity. What is the
liquidity premium (LP) on Niendorf's bonds?
15 Kop Corporation's 5-year bonds yield 6.50%, and T-bonds with the same maturity yield 4.40%. The
default risk premium for Kop's bonds is DRP = 0.40%, the liquidity premium on Kop's bonds is LP =
1.70% versus zero on T-bonds, the inflation premium (IP) is 1.50%, and the maturity risk premium
(MRP) on 5-year bonds is 0.40%. What is the real risk-free rate, r*?
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #5 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
C. LESSON WRAP-UP
Frequently Asked Questions
1. What is Pure Expectations Theory?
• The pure expectations theory contends that the shape of the yield curve depends on investors’
expectations about future interest rates.
• If interest rates are expected to increase, L-T rates will be higher than S-T rates, and vice-versa. Thus,
the yield curve can slope up, down, or even bow.
2. What are the Assumptions of Pure Expectations?
• Assumes that the maturity risk premium for Treasury securities is zero.
• Long-term rates are an average of current and future short-term rates.
• If the pure expectations theory is correct, you can use the yield curve to “back out” expected future
interest rates.
An Example: Observed Treasury Rates and Pure Expectations
If the pure expectations theory holds, what does the market expect will be the interest rate on one-year
securities, one year from now? Three-year securities, two years from now?
One-Year Forward Rate
•
•
(1.062)2
= (1.060) (1 + X)
1.12784/1.060 = (1 + X)
6.4004%
=X
The pure expectations theory says that one-year securities will yield 6.4004%, one year from now.
Notice, if an arithmetic average is used, the answer is still very close. Solve: 6.2% = (6.0% + X)/2, and
the result will be 6.4%.
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Module #5 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Three-Year Security, Two Years from Now
•
(1.065)5
= (1.062)2 (1 + X)3
1.37009/1.12784
= (1 + X)3
6.7005%
=X
The pure expectations theory says that three-year securities will yield 6.7005%, two years from now.
Conclusions About Pure Expectations
• Some would argue that the MRP ≠ 0, and hence the pure expectations theory is incorrect.
• Most evidence supports the general view that lenders prefer S-T securities, and view L-T securities as
riskier.
– Thus, investors demand a premium to persuade them to hold L-T securities (i.e., MRP > 0).
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #5 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
KEY TO CORRECTIONS
Review
P27,408.71
Skill Building Activtiy
Activity 1: Compare expected return with required and realized return
Risk - The probability that an actual return on an investment will be lower than the expected return
Read more: http://www.businessdictionary.com/definition/risk.html
Expected Return - The process of determining the average expected probability of various different rates of
return that are possible on a given asset. Factors in this determination include different market conditions as
well as an asset's beta. Read more: http://www.businessdictionary.com/definition/expected-return.html
Required Return - Minimum acceptable rate of return on an investment proposal that is comparable with the
rate of return obtainable effortlessly and at a low level of risk in the financial markets (such as on a time deposit
in a bank). Read more: http://www.businessdictionary.com/definition/required-rate-of-return.html
Realized Return - This simple rate of return is sometimes called the basic growth rate, or alternatively, return
on investment, or ROI. If you also consider the effect of the time value of money and inflation, the real rate of
return can also be defined as the net amount of discounted cash flows received on an investment after
adjusting for inflation. https://www.investopedia.com/terms/r/rateofreturn.asp
Activity 2: Identify the types of risks
Systematic risk is the probability of a loss associated with the entire market or the segment,
whereas, Unsystematic risk is associated with a specific company or industry.
Read more: https://www.wallstreetmojo.com/systematic-risk-vs-unsystematic-risk/
1
2
3
4
5
6
SR
SR
SR
UR
SR
UR
7
8
9
10
11
12
SR
UR
SR
UR
SR
UR
Activity 3: Discuss the concept of standard deviation
Activity 3.1:
35.60%; 5.97%; 44.5%; 6.67%
Activity 3.2:
14.55%; 22%; 139.16%; 272.80%; 11.80%; 16.52%; 81.10%; 75.10%
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #6 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Risk and Rates of Return (Part 2)
Learning Targets:
At the end of this module, I should be able to:
1. Diversify a portfolio to minimize risk;
2. Use the beta coefficient as a measure of risk;
3. Compute the required rate of return using the CAPM; and
4. Explain the value of the security market line.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
What are the determinants of interest rates?
B. MAIN LESSON
Content and Skill-Building (40 mins)
What is investment risk?
• Two types of investment risk
– Stand-alone risk
– Portfolio risk
• Investment risk is related to the probability of earning a low or negative actual return.
• The greater the chance of lower than expected, or negative returns, the riskier the investment.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #6 Student Activity Sheet
Name: _________________________________________________________________
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Probability Distributions
• A listing of all possible outcomes, and the probability of each occurrence.
• Can be shown graphically.
Selected Realized Returns, 1926-2013
Source: Based on Ibbotson Stocks, Bonds, Bills, and Inflation: 2014 Classic Yearbook (Chicago:
Morningstar, Inc., 2014), p. 40.
Hypothetical Investment Alternatives
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Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return?
• T-bills will return the promised 5.5%, regardless of the economy.
• No, T-bills do not provide a completely risk-free return, as they are still exposed to inflation. Although,
very little unexpected inflation is likely to occur over such a short period of time.
• T-bills are also risky in terms of reinvestment risk.
• T-bills are risk-free in the default sense of the word.
How do the returns of High Tech and Collections behave in relation to the market?
• High Tech: Moves with the economy, and has a positive correlation. This is typical.
• Collections: Is countercyclical with the economy, and has a negative correlation. This is unusual.
STAND-ALONE RISK
Calculating the Expected Return
r̂  Expected rate of return
N
r̂   Piri
i 1
r̂  (0.1)(-27%)  (0.2)(-7%)  (0.4)(15%)
 (0.2)(30%)  (0.1)(45%)
 12.4%
Summary of Expected Returns
Expected Return
High Tech
12.4%
Market
10.5%
US Rubber
9.8%
T-bills
5.5%
Collections
1.0%
High Tech has the highest expected return, and appears to be the best investment alternative, but is it really?
Have we failed to account for risk?
Calculating Standard Deviation
  Standard deviation
  Variance   2

N
 (r  r̂ )2 Pi
i 1
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Standard Deviation for Each Investment

N
 (r  r̂ )2 Pi
i 1
 T -bills
 (5.5  5.5)2 (0.1)  (5.5  5.5)2 (0.2) 
 (5.5  5.5)2 (0.4)  (5.5  5.5)2 (0.2)


 (5.5  5.5)2 (0.1)


1/ 2
 T -bills  0.0%
Comparing Standard Deviations
Comments on Standard Deviation as a Measure of Risk
• Standard deviation (σi) measures total, or stand-alone, risk.
• The larger σi is, the lower the probability that actual returns will be close to expected returns.
• Larger σi is associated with a wider probability distribution of returns.
Comparing Risk and Return
Coefficient of Variation (CV)
• A standardized measure of dispersion about the expected value that shows the risk per unit of return.
CV 
Standard deviation 

Expected return
r̂
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Illustrating the CV as a Measure of Relative Risk
σA = σB , but A is riskier because of a larger probability of losses. In other words, the same amount of risk (as
measured by σ) for smaller returns.
Risk Rankings by Coefficient of Variation
CV
T-bills
0.0
High Tech
1.6
Collections
13.2
US Rubber
1.9
Market
1.4
• Collections has the highest degree of risk per unit of return.
• High Tech, despite having the highest standard deviation of returns, has a relatively average CV.
Investor Attitude Towards Risk
• Risk aversion: assumes investors dislike risk and require higher rates of return to encourage them to
hold riskier securities.
• Risk premium: the difference between the return on a risky asset and a riskless asset, which serves as
compensation for investors to hold riskier securities.
PORTFOLIO RISK
Portfolio Construction: Risk and Return
• Assume a two-stock portfolio is created with P50,000 invested in both High Tech and Collections.
• A portfolio’s expected return is a weighted average of the returns of the portfolio’s component assets.
• Standard deviation is a little more tricky and requires that a new probability distribution for the portfolio
returns be constructed.
r̂p is a weighted average :
Calculating Portfolio Expected
r̂ isReturn
a weighted average :
p
r̂p is aN weighted average :
r̂p  
N w ir̂i
i

r̂p  1 w ir̂i
iN
1
r̂p   w ir̂i
r̂p  0i.15(12.4%)  0.5(1.0%)  6.7%
r̂p  0.5(12.4%)  0.5(1.0%)  6.7%
r̂p  0.5(12.4%)  0.5(1.0%)  6.7%
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An Alternative Method for Determining Portfolio Expected Return
r̂p  0.10 (0.0%)  0.20 (3.0%)  0.40 (7.5%)
 0.20 (9.5%)  0.10 (12.0%)  6.7%
Calculating Portfolio Standard Deviation and CV
 0.10 (0.0 - 6.7) 2 


2
 0.20 (3.0 - 6.7) 


 p   0.40 (7.5 - 6.7) 2 
 0.20 (9.5 - 6.7) 2 


 0.10 (12.0 - 6.7) 2 
CVp 
1
2
 3 .4 %
3 .4 %
 0.51
6 .7 %
Comments on Portfolio Risk Measures
• σp = 3.4% is much lower than the σi of either stock (σHT = 20.0%; σColl = 13.2%).
• σp = 3.4% is lower than the weighted average of High Tech and Collections’ σ (16.6%).
• Therefore, the portfolio provides the average return of component stocks, but lower than the average
risk.
• Why? Negative correlation between stocks.
General Comments About Risk
• σ  35% for an average stock.
• Most stocks are positively (though not perfectly) correlated with the market (i.e., ρ between 0 and 1).
• Combining stocks in a portfolio generally lowers risk.
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Creating a Portfolio: Beginning with One Stock and Adding Randomly Selected Stocks to Portfolio
• σp decreases as stocks are added, because they would not be perfectly correlated with the existing
portfolio.
• Expected return of the portfolio would remain relatively constant.
• Eventually the diversification benefits of adding more stocks dissipates (after about 40 stocks), and for
large stock portfolios, σp tends to converge to  20%.
Breaking Down Sources of Risk
Stand-alone risk = Market risk + Diversifiable risk
• Market risk: portion of a security’s stand-alone risk that cannot be eliminated through diversification.
Measured by beta.
• Diversifiable risk: portion of a security’s stand-alone risk that can be eliminated through proper
diversification.
Failure to Diversify
• If an investor chooses to hold a one-stock portfolio (doesn’t diversify), would the investor be
compensated for the extra risk they bear?
– NO!
– Stand-alone risk is not important to a well-diversified investor.
– Rational, risk-averse investors are concerned with σp, which is based upon market risk.
– There can be only one price (the market return) for a given security.
– No compensation should be earned for holding unnecessary, diversifiable risk.
CAPITAL ASSET PRICING MODEL (CAPM)
• Model linking risk and required returns. CAPM suggests that there is a Security Market Line (SML) that
states that a stock’s required return equals the risk-free return plus a risk premium that reflects the
stock’s risk after diversification.
ri = rRF + (rM – rRF)bi
• Primary conclusion: The relevant riskiness of a stock is its contribution to the riskiness of a welldiversified portfolio.
Beta
•
•
Measures a stock’s market risk, and shows a stock’s volatility relative to the market.
Indicates how risky a stock is if the stock is held in a well-diversified portfolio.
Comments on Beta
• If beta = 1.0, the security is just as risky as the average stock.
• If beta > 1.0, the security is riskier than average.
• If beta < 1.0, the security is less risky than average.
• Most stocks have betas in the range of 0.5 to 1.5.
Calculating Betas
• Well-diversified investors are primarily concerned with how a stock is expected to move relative to the
market in the future.
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•
•
Class number: ______
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Without a crystal ball to predict the future, analysts are forced to rely on historical data. A typical
approach to estimate beta is to run a regression of the security’s past returns against the past returns of
the market.
The slope of the regression line is defined as the beta coefficient for the security.
Illustrating the Calculation of Beta
Beta Coefficients for High Tech, Collections, and T-Bills
Comparing Expected Returns and Beta Coefficients
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SECURITY MARKET LINE (SML)
The Security Market Line (SML): Calculating Required Rates of Return
SML: ri
= rRF + (rM – rRF)bi
ri = rRF + (RPM)bi
• Assume the yield curve is flat and that rRF = 5.5% and
RPM = rM  rRF = 10.5%  5.5% = 5.0%.
What is the market risk premium?
• Additional return over the risk-free rate needed to compensate investors for assuming an average
amount of risk.
• Its size depends on the perceived risk of the stock market and investors’ degree of risk aversion.
• Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per year.
Calculating Required Rates of Return
Expected vs. Required Returns
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Illustrating the Security Market Line
An Example: Equally Weighted Two-Stock Portfolio
• Create a portfolio with 50% invested in High Tech and 50% invested in Collections.
• The beta of a portfolio is the weighted average of each of the stock’s betas.
bP = wHTbHT + wCollbColl
bP = 0.5(1.32) + 0.5(-0.87)
bP = 0.225
Calculating Portfolio Required Returns
• The required return of a portfolio is the weighted average of each of the stock’s required returns.
rP = wHTrHT + wCollrColl
rP = 0.5(12.10%) + 0.5(1.15%)
rP = 6.625%
• Or, using the portfolio’s beta, CAPM can be used to solve for the portfolio’s required return.
rP = rRF + (RPM)bP
rP = 5.5% + (5.0%)(0.225)
rP = 6.625%
Factors That Change the SML
• What if investors raise inflation expectations by 3%, what would happen to the SML?
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•
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What if investors’ risk aversion increased, causing the market risk premium to increase by 3%, what
would happen to the SML?
Verifying the CAPM Empirically
• The CAPM has not been verified completely.
• Statistical tests have problems that make verification almost impossible.
• Some argue that there are additional risk factors, other than the market risk premium, that must be
considered.
More Thoughts on the CAPM
• Investors seem to be concerned with both market risk and total risk. Therefore, the SML may not
produce a correct estimate of ri.
ri = rRF + (rM – rRF)bi + ???
• CAPM/SML concepts are based upon expectations, but betas are calculated using historical data. A
company’s historical data may not reflect investors’ expectations about future riskiness.
Skill Building Activities
Activity 1: Diversify a portfolio to minimize risk
Direction: Solve the case. (5 minutes)
A portfolio manager is holding the following investments:
Stock
Amount Invested
Beta
X
P10 million
1.4
Y
20 million
1.0
Z
40 million
0.8
The manager plans to sell his holdings of Stock Y. The money from the sale will be used to purchase another
P15 million of Stock X and another P5 million of Stock Z. The risk-free rate is 5 percent and the market risk
premium is 5.5 percent. How many percentage points higher will the required return on the portfolio be after
he completes this transaction?
Solution:
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Answer:
Activity 2: Use the beta coefficient as a measure of risk
Direction: Complete the statements. (2 minutes)
A ________________________________ is computed as the weighted average of the beta of all the
individual assets in a portfolio. If an asset with a beta greater than 1 is added to a portfolio with a beta
equivalent to 1, the beta and ―riskiness‖ of the portfolio will __________________. Likewise, if an asset with a
beta less than 1 is added to a portfolio with a beta equivalent to 1, the beta and ―riskiness‖ of the portfolio will
___________________.
Activity 3: Compute the required rate of return using the CAPM
Direction: Encircle your answer. (3 minutes)
1. The risk-free rate is 6 percent. Stock A has a beta of 1.0, while Stock B has a beta of 2.0. The market
risk premium (kM – kRF) is positive. Which of the following statements is most correct?
a. Stock B’s required rate of return is twice that of Stock A.
b. If Stock A’s required return is 11 percent, the market risk premium is 5 percent.
c. If the risk-free rate increases (but the market risk premium stays unchanged), Stock B’s required
return will increase by more than Stock A’s.
d. Statements b and c are correct.
e. All the statements above are correct.
2. In
recent
years,
both
expected
inflation
and
the
market
risk
premium
(kM – kRF) have declined. Assume that all stocks have positive betas. Which of the following is likely to
have occurred as a result of these changes?
a. The average required return on the market, k M, has remained constant, but the required returns
have fallen for stocks that have betas greater than 1.0.
b. The required returns on all stocks have fallen by the same amount.
c. The required returns on all stocks have fallen, but the decline has been greater for stocks with
higher betas.
d. The required returns on all stocks have fallen, but the decline has been greater for stocks with
lower betas.
e. The required returns have increased for stocks with betas greater than 1.0 but have declined for
stocks with betas less than 1.0.
3. Assume that the risk-free rate is 5 percent. Which of the following statements is most correct?
a. If a stock’s beta doubles, the stock’s required return will also double.
b. If a stock’s beta is less than 1.0, the stock’s required return is less than 5 percent.
c. If a stock has a negative beta, the stock’s required return is less than 5 percent.
d. All of the statements above are correct.
e. None of the statements above is correct.
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Date: _______________
Activity 4: Explain the value of the security market line
Direction: What is the value of the security market line? (3 minutes)
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
_______________________________________________________________________________________
Check for Understanding
Write your final answers here:
1
2
3
4
5
Score:
6
7
8
9
10
11
12
13
14
15
True or False. Write TRUE if the statement is correctly stated, otherwise, write FALSE.
1
The tighter the probability distribution of its expected future returns, the greater the risk of a given
investment as measured by its standard deviation.
2
The coefficient of variation, calculated as the standard deviation of expected returns divided by the
expected return, is a standardized measure of the risk per unit of expected return.
3
Market risk refers to the tendency of a stock to move with the general stock market. A stock with
above-average market risk will tend to be more volatile than an average stock, and its beta will be
greater than 1.0.
4
Risk-averse investors require higher rates of return on investments whose returns are highly uncertain,
and most investors are risk averse.
5
When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the
degree of correlation between the new stock and stocks already in the portfolio, the less the additional
stock will reduce the portfolio's risk.
Problem Solving. Provide the necessary complete information.
6
Taggart Inc.'s stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10%
return, and a 20% chance of producing a −28% return. What is the firm's expected rate of return?
7
Cheng Inc. is considering a capital budgeting project that has an expected return of 25% and a
standard deviation of 30%. What is the project's coefficient of variation?
8
Tom O'Brien has a 2-stock portfolio with a total value of P100,000. P37,500 is invested in Stock A with
a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is his portfolio's beta?
9
Assume that you hold a well-diversified portfolio that has an expected return of 11.0% and a beta of
1.20. You are in the process of buying 1,000 shares of Alpha Corp at P10 a share and adding it to your
portfolio. Alpha has an expected return of 13.0% and a beta of 1.50. The total value of your current
portfolio is P90,000. What will the expected return and beta on the portfolio be after the purchase of
the Alpha stock?
10 Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock
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market is 11.00%, and the risk-free rate is 4.25%. What is the difference between A's and B's required
rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.)
C. LESSON WRAP-UP
Frequently Asked Questions
1. What are the tips to solve problems about interest rates?
Interest rates are important in finance, and it is important for all students to understand the basics of
how they are determined. However, the chapter really has two aspects that become clear when we try to write
test questions and problems for the chapter. First, the material on the fundamental determinants of interest
rates—the real risk-free rate plus a set of premiums—is logical and intuitive, and easy in a testing sense.
However, the second set of material, that dealing with the yield curve and the relationship between 1-year
rates and longer-term rates, is more mathematical and less intuitive, and test questions dealing with it tend to
be more difficult, especially for students who are not good at math.
As a result, problems on the chapter tend to be either relatively easy or relatively difficult, with the
difficult ones being as much exercises in algebra as in finance. In the test bank for prior editions, we tended to
use primarily difficult problems that addressed the problem of forecasting forward rates based on yield curve
data. In this edition, we leaned more toward easy problems that address intuitive aspects of interest rate
theory.
We should note one issue that can be confusing if it is not handled carefully—the use of arithmetic
versus geometric averages when bringing inflation into interest rate determination in yield curve related
problems. It is easy to explain why a 2-year rate is an average of two 1-year rates, and it is logical to use a
compounding process that is essentially a geometric average that includes the effects of cross-product terms.
It is also easy to explain that average inflation rates should be calculated as geometric averages. However,
when we combine inflation with interest rates, rather than using the formulation rRF = [(1 + r*)(1 + IP)]0.5 – 1,
almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation r RF = r* +
IP. Understandably, this can confuse students when they start working problems. In both the text and test bank
problems we make it clear to students which procedure to use.
Quite a few of the problems are based on this basic equation: r = r* + IP + MRP + DRP + LP. We tell
our students to keep this equation in mind, and that they will have to do some transposing of terms to solve
some of the problems.
The other key equation used in the problems is the one for finding the 1-year forward rate, given the
current 1-year and 2-year rates: (1 + 2-year rate)2 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)2/(1
+ 1yr) – 1, where X is the 1-year forward rate. This equation, which is used in a few problems, assumes that
the pure expectations theory is correct and thus the maturity risk premium is zero.
2. Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free
return?
• T-bills will return the promised 5.5%, regardless of the economy.
• No, T-bills do not provide a completely risk-free return, as they are still exposed to inflation. Although,
very little unexpected inflation is likely to occur over such a short period of time.
• T-bills are also risky in terms of reinvestment risk.
• T-bills are risk-free in the default sense of the word.
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3. Can the beta of a security be negative?
• Yes, if the correlation between Stock i and the market is negative (i.e., ρi,m < 0).
• If the correlation is negative, the regression line would slope downward, and the beta would be
negative.
• However, a negative beta is highly unlikely.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review
r
= r* + IP + DRP + LP + MRP
r
= required return on a debt security
r*
= real risk-free rate of interest
IP
= inflation premium
DRP = default risk premium
LP
= liquidity premium
MRP = maturity risk premium
Skill Building Activities
Activity 1: Diversify a portfolio to minimize risk Answer: 0.39%
Activity 2: Use the beta coefficient as a measure of risk
A portfolio beta is computed as the weighted average of the beta of all the individual assets in a portfolio. If an
asset with a beta greater than 1 is added to a portfolio with a beta equivalent to 1, the beta and ―riskiness‖ of
the portfolio will increase. Likewise, if an asset with a beta less than 1 is added to a portfolio with a beta
equivalent to 1, the beta and ―riskiness‖ of the portfolio will decrease.
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Activity 3: Compute the required rate of return using the CAPM
Class number: ______
Date: _______________
Answers: B; C; C
Activity 4: Explain the value of the security market line
The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the
capital asset pricing model (CAPM), which shows different levels of systematic, or market, risk of various
marketable securities plotted against the expected return of the entire market at a given point in time. Also
known as the "characteristic line," the SML is a visual of the capital asset pricing model (CAPM), where the xaxis of the chart represents risk in terms of beta, and the y-axis of the chart represents expected return. The
market risk premium of a given security is determined by where it is plotted on the chart in relation to the SML.
(https://www.investopedia.com/terms/s/sml.asp)
Check for Understanding
1. FALSE - The more unpredictable the price action and the wider the range, the greater the risk.The higher
the standard deviation, the riskier the investment
2. TRUE
3. TRUE
4. TRUE
5. TRUE
6.
Conditions
Good
Average
Poor
Prob.
0.50
0.30
0.20
1.00
Return
25.0%
10.0%
−28.0%
Prob.
× Return
12.50%
3.00%
−5.60%
9.90% = Expected return
7.
Expected return
Standard deviation
Coefficient of variation = std dev/expected return =
25.0%
30.0%
1.2
8.
Company
Stock A
Stock B
Investment
$ 37,500
$ 62,500
$100,000
Port.
weight
0.375
0.625
1.00
Beta
0.75
1.42
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Weight
× beta
0.28
0.89
1.17 = Portfolio beta
FIN 072 | Financial Markets
Module #6 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
9.
Old portfolio return
Old portfolio beta
New stock return
New stock beta
% of portfolio in new stock = $ in New/($ in old + $ in new)
= $10,000/$100,000 =
New expected portfolio return = rp = 0.1 × 13% + 0.9 × 11% =
New expected portfolio beta = bp = 0.1 × 1.50 + 0.9 × 1.20 =
10.
Beta: A
Beta: B
Market return
Risk-free rate
Market risk premium
Required return A = rRF + bA(RPM) =
Required return B = rRF + bB(RPM) =
Difference
0.70
1.20
11.00%
4.25%
6.75%
8.98%
12.35%
3.38%
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11.0%
1.20
13.0%
1.50
10%
11.20%
1.23
Class number: ______
Date: _______________
FIN 072 | Financial Markets
Module #7 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Long-term Financing: Debts (Part 1)
Learning Targets:
At the end of this module, I should be able to:
1. Define the term long-term debt;
2. Determine the advantages and disadvantages of issuing
long-term debts;
3. Enumerate the types of long-term debts; and
4. Differentiate a secured loan from an unsecured loan.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
Given the following returns on Stock Q and ―the market‖ during the last three years, what is the difference in
the calculated beta coefficient of Stock Q when Year 1-Year 2 data are used as compared to Year 2-Year 3
data? (Hint: Think rise over run.)
Year Stock Q
Market
1
6.30%
6.10%
2
-3.70
12.90
3
21.71
16.20
Answer:
Solution:
B. MAIN LESSON
Content and Skill-Building (40 mins)
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Module #7 Student Activity Sheet
Name: _________________________________________________________________
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Date: _______________
INTRODUCTION
What is a bond?
• A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on
specific dates, to the holders of the bond.
Bond Markets
• Primarily traded in the over-the-counter (OTC) market.
• Most bonds are owned by and traded among large financial institutions.
• The Wall Street Journal reports key developments in the Treasury, corporate, and municipal markets.
KEY FEATURES
Key Features of a Bond
• Par value: face amount of the bond, which is paid at maturity (assume P1,000).
• Coupon interest rate: stated interest rate (generally fixed) paid by the issuer. Multiply by par value to
get peso payment of interest.
• Maturity date: years until the bond must be repaid.
• Issue date: when the bond was issued.
• Yield to maturity: rate of return earned on a bond held until maturity (also called the ―promised yield‖).
Effect of a Call Provision
• Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor).
• Bond investors require higher yields on callable bonds.
• In many cases, callable bonds include a deferred call provision and a declining call premium.
What is a sinking fund?
• Provision to pay off a loan over its life rather than all at maturity.
• Similar to amortization on a term loan.
• Reduces risk to investor, shortens average maturity.
• But not good for investors if rates decline after issuance.
How are sinking funds executed?
• Call x% of the issue at par, for sinking fund purposes.
– Likely to be used if rd is below the coupon rate and the bond sells at a premium.
• Buy bonds in the open market.
– Likely to be used if rd is above the coupon rate and the bond sells at a discount.
The Value of Financial Assets
Value 
CF1
1  r 
1

CF2
1  r 
2
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
CFN
1  r N
FIN 072 | Financial Markets
Module #7 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Skill-building Activities
Activity 1: Define the term long-term debt
Direction: Define the following terms (5 minutes).
Long-term debts -__________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
There are two major forms of long-term debts:
1. Publicly-issued obligations __________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
2. Direct or private placement __________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
Direction: Write P if it is an example of Publicly Issued Obligation and D if is it is an example of Direct or
Private Placement (3 minutes).
1. _________ Promissory note
2. _________ Bonds
3. _________ Certificate
4. _________ Long-term commercial papers
Activity 2: Determine the advantages and disadvantages of issuing long-term debts
Direction: Write A if it is an advantage of issuing long-term debts and D if it is a disadvantage of issuing longterm debt (5 minutes).
1. _________ A scheduled interest payment is required regardless of the firm’s actual earnings.
2. _________ A firm with a considerable amount of outstanding loans does not project a ―healthy‖
financial position.
3. _________ Companies with high financial leverage normally pay a higher interest due to their low credit
rating.
4. _________ Unlike dividends declared, the interest can serve as a ―tax shield‖.
5. _________ Long-term debts help increase a firm’s EPS.
6. _________ The repayment of a long-term debt (in pesos) is cheaper during times of inflation.
7. _________ The outstanding shares of stock are not diluted because new shares of stock are not
issued.
8. _________ The issuer of the bonds enjoys financial flexibility because of the call provision in the bond
indenture. A call provision permits a firm to redeem the bonds before the maturity date.
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FIN 072 | Financial Markets
Module #7 Student Activity Sheet
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Class number: ______
Date: _______________
9. _________ A covenant provision in the indenture which subjects a firm to certain constraints is very
common.
Activity 3: Enumerate the types of long-term debts
Direction: Encircle the best answer (5 minutes).
1. Which of the following is/are examples of long-term debts?
a. Mortgage
b. Bonds
c. Both a and b
d. Neither a nor b
2. All the following are advantages of using mortgage, except
a. Lower interest rate
b. Less covenants on financing
c. Extended maturity dates on the payment of the principal and interest
d. NIL
3. All the following are requisites of a mortgage contract, except
a. The mortgage is constituted to secure the fulfillment of the obligation
b. The absolute owner of the property to be mortgages is the mortgagor him/herself
c. The mortgagor has the free disposal of the asset to be mortgage
d. NIL
4. All the following are features of bonds, except
a. A bond indenture or deed of trust is a broad document which contains the essential information
regarding the bond issued
b. A bond certificate which represents a portion of the total loan is used
c. If property is pledged as a security for the bond issue, a trustee who will hold the title to the
property serving as the security is identified
d. A bank or trust company is appointed as the registrar or disbursing agent
5. Which of the following statements is most correct?
a. Junk bonds typically have a lower yield to maturity relative to investment grade bonds.
b. A debenture is a secured bond that is backed by some or all of the firm’s fixed assets.
c. Subordinated debt has less default risk than senior debt.
d. All the statements above are correct.
e. None of the statements above is correct.
Activity 4: Differentiate a secured loan from an unsecured loan
Unsecured loans and financial products can come in many different forms, but the underlying premise and
agreement is the same. Consumers are not required to put down any of their assets to obtain an unsecured
loan, but they do have to agree to repay the monies they borrow — plus interest, of course.
Advantages of unsecured loans and lines of credit:
 When you apply for an unsecured loan or credit card, you won't have to put down a cash deposit as
collateral.
 If you default on an unsecured debt, the bank won't be able to seize your assets.
 The application process is usually quick and painless. You can apply for unsecured personal loans and
credit cards online and from the comfort of your home.
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FIN 072 | Financial Markets
Module #7 Student Activity Sheet
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Date: _______________
Disadvantages of unsecured loans and lines of credit:
 While the bank cannot seize your assets if you default on an unsecured debt, they can try to obtain a
judgment against you. Defaulting on your loan will also result in severe damage to your credit score that
may be difficult to overcome.
 Requirements for approval are tighter. You need good or excellent credit (usually a FICO score of
740+) and a solid work history to qualify for unsecured loans and credit cards with the best interest
rates, terms, and perks. You may be able to qualify for some unsecured loans with fair credit, but you'll
typically pay a higher interest rate and more fees.
 Interest rates tend to be higher on unsecured debts when compared to some types of secured debts.
Unsecured debts can come in many forms, the most common being:
 Unsecured credit cards (the vast majority of credit cards)
 Most personal loans
 Student loans
 Other debts that are considered unsecured include telephone and electric bills (and other utilities), court
judgments, gym memberships, and even medical bills. Unsecured debts are any type of debt that is not
secured by an asset.
Secured debts are any type of debt that is held with an underlying form of collateral. This could be a cash
deposit you put down, an automobile, your home, stock you own, or any other asset that has significant value.
Advantages of secured loans and lines of credit:
 You may be able to qualify with poor credit or a limited credit history.
 Many secured loan options (HELOCs, home equity loans, mortgages, and auto loans) come with low
interest rates and fair terms since they're secured by collateral.
 Putting down collateral may let you borrow more money than you could qualify for otherwise.
 Secured loans can help you build credit.
Disadvantages of secured loans and lines of credit:
 Secured credit cards tend to come with high interest rates and fees.
 If you default on a secured loan, your assets will be seized. Failing to repay a mortgage, home equity
loan, or HELOC will ultimately lead to foreclosure, and failing to repay your car loan will lead to the
repossession of your car.
 Many unsecured loan options, such as mortgages and home equity loans, have a time-consuming
application process.
 As with any other loan, failing to repay the money you borrow can cause damage to your credit score
and overall credit health.
Secured loans and lines of credit can work very differently depending on the type of secured debt you're
dealing with. The most common types include:
 Secured credit cards
 Secured personal loans
 Home equity loans
 Home Equity Lines of Credit (HELOCs)
 Auto loans
 Mortgages
Read more: https://www.businessinsider.com/unsecured-loans-vs-secured-loans-what-is-the-difference
This document is the property of PHINMA EDUCATION
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Module #7 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Reflection:
In simple and personal experience, what is security? When was the last time you feel that you were
secured?
Check for Understanding
Write your final answers here:
1
2
3
4
5
Score:
6
7
8
9
10
11
12
13
14
15
True or False. Write TRUE if the statement is correctly stated, otherwise, write FALSE.
1
If a firm raises capital by selling new bonds, it could be called the "issuing firm," and the coupon rate is
generally set equal to the required rate on bonds of equal risk.
2
A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically,
companies call bonds if interest rates rise and do not call them if interest rates decline.
3
Sinking funds are provisions included in bond indentures that require companies to retire bonds on a
scheduled basis prior to their final maturity. Many indentures allow the company to acquire bonds for
sinking fund purposes by either (1) purchasing bonds on the open market at the going market price or
(2) selecting the bonds to be called by a lottery administered by the trustee, in which case the price
paid is the bond's face value.
4
The market interest rate is usually different from the coupon rate which is set at the time of bond
issuance.
5
The desire for floating-rate bonds, and consequently their increased usage, arose out of the
experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus
caused sharp declines in the prices of outstanding bonds.
6
The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope
of selling it at a profit, may be estimated by determining future cash flows and then discounting them
back to the present.
7
The price sensitivity of a bond to a given change in interest rates is generally greater the longer the
bond's remaining maturity.
8
A bond that had a 20-year original maturity with 1 year left to maturity has more price risk than a 10year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk
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Module #7 Student Activity Sheet
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9
10
Class number: ______
Date: _______________
and equal coupon rates, and they cannot be called.)
When a bond's coupon rate is less than the prevailing market rate of interest on similar bonds, the
bond will sell at a premium.
As a general rule, a company's debentures have higher required interest rates than its mortgage bonds
because mortgage bonds are backed by specific assets while debentures are unsecured.
C. LESSON WRAP-UP
Frequently Asked Questions
1. What are the other types (features) of bonds
• Convertible bond: may be exchanged for common stock of the firm, at the holder’s option.
• Warrant: long-term option to buy a stated number of shares of common stock at a specified price.
• Putable bond: allows holder to sell the bond back to the company prior to maturity.
• Income bond: pays interest only when interest is earned by the firm.
• Indexed bond: interest rate paid is based upon the rate of inflation.
2. What is the opportunity cost of debt capital?
• The discount rate (ri) is the opportunity cost of capital, and is the rate that could be earned on
alternative investments of equal risk.
ri = r* + IP + MRP + DRP + LP
What is the value of a 10-year, 10% annual coupon bond, if rd = 10%?
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #7 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review
9.17
Skill Building Activities
Activity 1: Define the term long-term debt
Long-term debt is debt that matures in more than one year. Long-term debt can be viewed from two
perspectives: financial statement reporting by the issuer and financial investing. In financial statement
reporting, companies must record long-term debt issuance and all its associated payment obligations on its
financial statements. On the flip side, investing in long-term debt includes putting money into debt investments
with maturities of more than one year. https://www.investopedia.com/terms/l/longtermdebt.asp
A private placement is a sale of stock shares or bonds to pre-selected investors and institutions rather than on
the open market. It is an alternative to an initial public offering (IPO) for a company seeking to raise capital for
expansion. https://www.investopedia.com/terms/p/privateplacement.asp
Answers: D, P, D, P
Activity 2: Determine the advantages and disadvantages of issuing long-term debt
1. D
6. A
2. D
7. A
3. D
8. A
4. A
9. D
5. A
Activity 3: Enumerate the types of long-term debts
1. C
2. D
3. D
4. A
5. E
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #7 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Activity 4: Differentiate a secured loan from an unsecured loan
CATEGORY
Content
Accuracy
Grammar &
Spelling
(Conventions)
4 points
The paper contains
at least 5 accurate
facts about the topic.
Writer makes no
errors in grammar or
spelling.
Sentences and
Paragraphs
Sentences and
paragraphs are
complete, wellconstructed and of
varied structure
Ideas
Ideas were
expressed in a clear
and organized
fashion. It was easy
to figure out what the
paper was about.
Success Criteria
3 points
2 points
The paper contains at
The paper contains at
least 3-4 accurate facts least 1-2 accurate facts
about the topic.
about the topic.
Writer makes 1-3
Writer makes 4-6 errors
errors in grammar
in grammar and/or
and/or spelling.
spelling.
All Sentences and
paragraphs are
complete, wellconstructed (no
fragments, no run-ons).
Paragraph is generally
done well.
Ideas were expressed
in a clear manner, but
the organization could
have been better.
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Most sentences are
complete and wellconstructed.
Paragraphing needs
some work.
1 point
The paper contains no
accurate facts about
the topic.
Writer makes more
than 6 errors in
grammar and/or
spelling.
Many sentence
fragments or run
sentences or
paragraphing need lot
of work.
Ideas were somewhat
organized but were not
noticeably clear. It looks
more than one reading to
figure out what was the
paper was about.
The paper seemed be
a collection of
unrelated sentences. It
was difficult to figure
out what the paper was
about.
FIN 072 | Financial Markets
Module #8 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Long-term Financing: Debts (Part 2)
Learning Targets:
At the end of this module, I should be able to:
1. Explain the importance of bonds;
2. Show the effects of bond premium and discount in issuance
of bonds; and
3. Compute the costs and benefits of bond refunding.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
Marie Snell recently inherited some bonds (face value P100,000) from her father, and soon thereafter she
became engaged to Sam Spade, a University of Florida marketing graduate. Sam wants Marie to cash in the
bonds so the two of them can use the money to “live like royalty” for two years in Monte Carlo. The 2 percent
annual coupon bonds mature on December 31, 2022, and it is now January 1, 2003. Interest on these bonds
is paid annually on December 31 of each year, and new annual coupon bonds with similar risk and maturity are
currently yielding 12 percent. If Marie sells her bonds now and puts the proceeds into an account that pays 10
percent compounded annually, what would be the largest equal annual amounts she could withdraw for two
years, beginning today (that is, two payments, the first payment today and the second payment one year from
today)?
Answer:
Solution:
B. MAIN LESSON
Content and Skill-Building (40 mins)
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FIN 072 | Financial Markets
Module #8 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
MEASURING YIELD
What is the YTM on the following bond?
• 10-year; 9% annual coupon; P1,000 par value; selling for P887.
• Must find the rd that solves this model.
VB 
$887 
INT
1  rd 

90

1
1  rd 
1
INT
1  rd 
N
90
1  rd 
10
M

1  rd N

1,000
1  rd 10
Solving for I/YR, the YTM of this bond is 10.91%. This bond sells at a discount, because YTM > coupon rate.
Find YTM If the Bond Price is P1,134.20.
Solving for I/YR, the YTM of this bond is 7.08%. This bond sells at a premium, because YTM < coupon rate.
Definitions
Current yield (CY) 
Annual coupon payment
Current price
Capital gains yield (CGY) 
Change in price
Beginning price
Expected total return  YTM  Expected CY  Expected CGY
What is reinvestment risk?
• Reinvestment risk is the concern that rd will fall, and future CFs will have to be reinvested at lower rates,
hence reducing income.
EXAMPLE: Suppose you just won P500,000 playing the lottery. You intend to invest the money and live off
the interest.
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Module #8 Student Activity Sheet
Name: _________________________________________________________________
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Class number: ______
Date: _______________
Reinvestment Risk Example
• You may invest in either a 10-year bond or a series of ten 1-year bonds. Both 10-year and 1-year
bonds currently yield 10%.
• If you choose the 1-year bond strategy:
– After Year 1, you receive P50,000 in income and have P500,000 to reinvest. But, if 1-year rates
fall to 3%, your annual income would fall to P15,000.
• If you choose the 10-year bond strategy:
– You can lock in a 10% interest rate, and P50,000 annual income for 10 years, assuming the
bond is not callable.
Conclusions about Price Risk and Reinvestment Risk
•
CONCLUSION: Nothing is riskless!
Default Risk
• If an issuer defaults, investors receive less than the promised return. Therefore, the expected return on
corporate and municipal bonds is less than the promised return.
• Influenced by the issuer’s financial strength and the terms of the bond contract.
Types of Bonds
• Mortgage bonds
• Debentures
• Subordinated debentures
• Investment-grade bonds
• Junk bonds
Evaluating Default Risk: Bond Ratings
•
Bond ratings are designed to reflect the probability of a bond issue going into default.
Factors Affecting Default Risk and Bond Ratings
• Financial performance
– Debt ratio
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Module #8 Student Activity Sheet
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•
Class number: ______
Date: _______________
– TIE ratio
– Current ratio
Qualitative factors: Bond contract terms
– Secured vs. unsecured debt
– Senior vs. subordinated debt
– Guarantee and sinking fund provisions
– Debt maturity
Other Factors Affecting Default Risk
• Miscellaneous qualitative factors
– Earnings stability
– Regulatory environment
– Potential antitrust or product liabilities
– Pension liabilities
– Potential labor problems
Bankruptcy
• Two main chapters of the Federal Bankruptcy Act:
– Chapter 11, Reorganization
– Chapter 7, Liquidation
• For large organizations, reorganization occurs more frequently than liquidation, particularly in those
instances where the business is worth more “alive than dead.”
Chapter 11 Bankruptcy
• If company can’t meet its obligations …
– It files under Chapter 11 to stop creditors from foreclosing, taking assets, and closing the
business and it has 120 days to file a reorganization plan.
– Court appoints a “trustee” to supervise reorganization.
– Management usually stays in control.
• Company must demonstrate in its reorganization plan that it is “worth more alive than dead.”
– If not, judge will order liquidation under Chapter 7.
Skill-building Activities (with answer key)
Activity 1: Explain the importance of bonds
Direction: Write T if the statement is true and F if the statement is false (5 minutes).
1. ________ A call provision gives bondholders the right to demand, or "call for," repayment of a bond.
Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the
principal amount back and reinvest it elsewhere at higher rates.
2. ________ Sinking funds are devices used to force companies to retire bonds on a scheduled basis
prior to their maturity. Many bond indentures allow the company to acquire bonds for a sinking fund by
either purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered
by the trustee through a call at face value.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #8 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
3. ________ A zero-coupon bond is a bond that pays no interest and is offered (and subsequently sells
initially) at par. These bonds provide compensation to investors in the form of capital appreciation.
4. ________ There is an inverse relationship between bonds' quality ratings and their required rates of
return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the
ratings get lower.
5. ________ Junk bonds are high risk, high yield debt instruments. They are often used to finance
leveraged buyouts and mergers, and to provide financing to companies of questionable financial
strength.
6. ________ A bond that is callable has a chance of being retired earlier than its stated term to maturity.
Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield
to maturity than an otherwise identical noncallable bond.
7. ________ If a firm raises capital by selling new bonds, it is called the "issuing firm," and the coupon
rate is generally set equal to the required rate on bonds of equal risk.
8. ________ Floating-rate debt is advantageous to investors because the interest rate moves up if market
rates rise. Since floating-rate debt shifts interest rate risk to companies, it offers no advantages to
issuers.
9. ________ "Restrictive covenants" are designed primarily to protect bondholders by constraining the
actions of managers. Such covenants are spelled out in bond indentures.
10. ________ As a general rule, a company's debentures have higher required interest rates than its
mortgage bonds because mortgage bonds are backed by specific assets while debentures are
unsecured.
Activity 2: Show the effects of bond premium and discount in issuance of bonds
Direction: Complete the table (5 minutes).
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FIN 072 | Financial Markets
Module #8 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Effects
At Par
1. Relationship of Price of the P _____ MV
bond and Maturity Value
(Settlement Value)
2. Relationship of Coupon Rate C _____ YTM
and YTM
3. Cash flow from operating
activities
4. In
amortization,
interest
expense versus interest paid
5. In amortization, net income
(on cash basis)
6. In amortization, carrying
amount
7. In
amortization,
interest
expense
8. In
amortization,
cash
payment
9. Amortization
of
bond
discount/bond premium
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Class number: ______
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Bond Premium
P _____ MV
Bond Discount
P _____ MV
C _____ YTM
C _____ YTM
FIN 072 | Financial Markets
Module #8 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Activity 3: Compute the costs and benefits of bond refunding
1. The Morrissey Company's bonds mature in 7 years, have a par value of P1,000, and make an annual
coupon payment of P70. The market interest rate for the bonds is 8.5%. What is the bond's price?
Solution:
2. Assume that you are considering the purchase of a 15-year bond with an annual coupon rate of 9.5%.
The bond has face value of P1,000 and makes semiannual interest payments. If you require an 11.0%
nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for
the bond?
Solution:
3. Taussig Corp.'s bonds currently sell for P1,150. They have a 6.75% annual coupon rate and a 15-year
maturity, but they can be called in 6 years at P1,067.50. Assume that no costs other than the call
premium would be incurred to call and refund the bonds, and also assume that the yield curve is
horizontal, with rates expected to remain at current levels on into the future. Under these conditions,
what rate of return should an investor expect to earn if he or she purchases these bonds, the YTC or
the YTM?
Solution:
4. You are the owner of 100 bonds issued by Euler, Ltd.
These bonds have
8 years remaining to maturity, an annual coupon payment of P80, and a par value of P1,000.
Unfortunately, Euler is on the brink of bankruptcy. The creditors, including yourself, have agreed to a
postponement of the next 4 interest payments (otherwise, the next interest payment would have been
due in 1 year). The remaining interest payments, for Years 5 through 8, will be made as scheduled.
The postponed payments will accrue interest at an annual rate of 6 percent, and they will then be paid
as a lump sum at maturity 8 years hence. The required rate of return on these bonds, considering their
substantial risk, is now 28 percent. What is the present value of each bond?
Solution:
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #8 Student Activity Sheet
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Check for Understanding
Write your final answers here:
1
2
3
4
5
Class number: ______
Date: _______________
Score:
6
7
8
9
10
11
12
13
14
15
True or False. Write TRUE if the statement is correctly stated, otherwise, write FALSE.
1
Junk bonds are high-risk, high-yield debt instruments. They are often used to finance leveraged
buyouts and mergers, and to provide financing to companies of questionable financial strength.
2
There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus,
the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get
lower.
3
Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus,
these securities cannot bankrupt a company, and this makes them safer from an investor's perspective
than regular bonds.
4
You are considering 2 bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest
investment-grade rating), both mature in 20 years, both have a 10% coupon, neither can be called
except for sinking fund purposes, and both are offered to you at their P1,000 par values. However,
Bond SF has a sinking fund while Bond NSF does not. Under the sinking fund, the company must call
and pay off 5% of the bonds at par each year. The yield curve at the time is upward sloping. The
bond's prices, being equal, are probably not in equilibrium, as Bond SF, which has the sinking fund,
would generally be expected to have a higher yield than Bond NSF.
5
Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise.
Since floating-rate debt shifts price risk to companies, it offers no advantages to corporate issuers.
6
A bond has a P1,000 par value, makes annual interest payments of P100, has 5 years to maturity,
cannot be called, and is not expected to default. The bond should sell at a premium if market interest
rates are below 10% and at a discount if interest rates are greater than 10%.
7
You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local
newspaper that you can buy a P1,000 par value bond for P800. The coupon rate is 10% (with annual
payments), and there are 10 years before the bond will mature and pay off its P1,000 par value. You
should buy the bond if your required return on bonds with this risk is 12%.
8
If the required rate of return on a bond (rd) is greater than its coupon interest rate and will remain
above that rate, then the market value of the bond will always be below its par value until the bond
matures, at which time its market value will equal its par value. (Accrued interest between interest
payment dates should not be considered when answering this question.)
9
The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than lowcoupon bonds, other things held constant.
10 Restrictive covenants are designed primarily to protect bondholders by constraining the actions of
managers. Such covenants are spelled out in bond indentures.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #8 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
C. LESSON WRAP-UP
Frequently Asked Questions
1. When is a call more likely to occur?
• In general, if a bond sells at a premium, then (1) coupon > rd, so (2) a call is more likely.
• So, expect to earn:
– YTC on premium bonds.
– YTM on par and discount bonds.
2. What is the priority of claims in liquidation?
1. Secured creditors from sales of secured assets
2. Trustee’s costs
3. Wages, subject to limits
4. Taxes
5. Unfunded pension liabilities
6. Unsecured creditors
7. Preferred stock
8. Common stock
3. What is reorganization?
• In a liquidation, unsecured creditors generally receive nothing. This makes them more willing to
participate in reorganization even though their claims are greatly scaled back.
• Various groups of creditors vote on the reorganization plan. If both the majority of the creditors and the
judge approve, the company “emerges” from bankruptcy with lower debts, reduced interest charges,
and a chance for success.
KEY TO CORRECTIONS
Review
P13,255
Skill Building Activities
Activity 1: Explain the importance of bonds
1. F
2. T
3. F
4. T
5. T
6. F
7. T
8. F
9. T
10. T
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FIN 072 | Financial Markets
Module #8 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Activity 2: Show the effects of bond premium and discount in issuance of bonds
Effects
At Par
Bond Premium
1. Relationship of Price of the P = MV
P > MV
bond and Maturity Value
(Settlement Value)
2. Relationship of Coupon Rate C = YTM
C > YTM
and YTM
3. Cash flow from operating No effect
Increasing
activities
4. In
amortization,
interest No effect
Interest Expense > Interest
expense versus interest paid
Paid
5. In amortization, net income No effect
Understated
(on cash basis)
6. In amortization, carrying No effect
Decreasing
amount
7. In
amortization,
interest No effect
Decreasing
expense
8. In
amortization,
cash No effect
Constant
payment
9. Amortization
of
bond No effect
Decreasing (in negative
discount/bond premium
amount)
Increasing
(in
absolute
value)
Activity 3. Compute the costs and benefits of bond refunding
1. P923.22
2. P891.00
3. 4.81%
4. P266.88
This document is the property of PHINMA EDUCATION
Bond Discount
P < MV
C < YTM
Decreasing
Interest Expense <
Interest Paid
Overstated
Increasing
Increasing
Constant
Increasing
FIN 072 | Financial Markets
Module #10 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Long-term Financing: Equities (Part 1)
Learning Targets:
At the end of this module, I should have:
1. Described characteristics of types of equity securities
2. Described differences in voting rights and other ownership
characteristics among different equity classes
3. Distinguished between public and private equity securities
4. Described methods for investing in non-domestic equity
securities
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
Schweser. (2012). Schwesernotes
CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
Do you believe on the principle – higher risk provides higher return? Can we achieve high return with no risk at
all? Explain your answer. Success criteria is provided at the key to correction.
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
B. MAIN LESSON
Content and Skill-Building (40 mins)
LT 1: Describe characteristics of types of equity securities
Common shareholders have a residual claim on firm assets and govern the corporation through voting
rights. Common shares have variable dividends which the firm is under no legal obligation to pay.
Callable common shares allow the firm the right to repurchase the shares at a prespecified price.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #10 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Puttable common shares give the shareholder the right to sell the shares back to the firm at a pre-specified
price.
Preferred stock typically does not mature, does not have voting rights, and has dividends that are fixed
in amount but are not a contractual obligation of the firm.
Cumulative preferred shares require any dividends that were missed in the past (dividends in arrears)
to be paid before common shareholders receive any dividends. Participating preferred shares receive extra
dividends if firm profits exceed a prespecified level and a value greater than the par value if the firm is
liquidated. Convertible preferred stock can be converted to common stock at a pre-specified conversion ratio.
LT 2: Describe differences in voting rights and other ownership characteristics among different equity
classes
Some companies' equity shares are divided into different classes, such as Class A and Class B shares.
Different classes of common equity may have different voting rights and priority in liquidation.
LT 3: Distinguish between public and private equity securities
Compared to publicly traded firms, private equity firms have lower reporting costs, greater ability to
focus on long-term prospects, and potentially greater return for investors once the firm goes public. However,
private equity investments are illiquid, firm financial disclosure may be limited, and corporate governance may
be weaker.
LT 4: Describe methods for investing in non-domestic equity securities
Investors who buy foreign stock directly on a foreign stock exchange receive a return denominated in a
foreign currency, must abide by the foreign stock exchange's regulations and procedures, and may be faced
with less liquidity and less transparency than is available in the investor's domestic markets. Investors can
often avoid these disadvantages by purchasing depository receipts for the foreign stock that trade on their
domestic exchange.
Direct investing in the securities of foreign companies simply refers to buying a foreign firm's securities
in foreign markets. Some obstacles to direct foreign investment are that:
• The investment and return are denominated in a foreign currency.
• The foreign stock exchange may be illiquid.
• The reporting requirements of foreign stock exchanges may be less strict, impeding analysis.
• Investors must be familiar with the regulations and procedures of each market in which they invest.
Global depository receipts are issued outside the United States and outside the issuer's home country.
American depository receipts are denominated in U.S. dollars and are traded on U.S. exchanges.
Global registered shares are common shares of a firm that trade in different currencies on stock
exchanges throughout the world.
Baskets of listed depository receipts are exchange-traded funds that invest in depository receipts.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #10 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Skill-building Activities (with answer key)
Activity 1: Describe characteristics of types of equity securities
Directions: Complete the Venn Diagram. Identify the similarities and differences of the two general types of
equities. Success criteria is provided at the key to correction.
Common Shares
Preference Shares
Activity 2: Describe differences in voting rights and other ownership characteristics among different
equity classes
Directions: Complete the table. Success criteria is provided at the key to correction.
Common Shares
Preference Shares
Ownership Characteristics
Voting Rights
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #10 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Activity 3: Distinguish between public and private equity securities
Directions: Create a concept map about public and private equity securities. Success criteria is provided at the
key to correction.
Activity 4: Describe methods for investing in non-domestic equity securities
Directions: Watch the video using the link. Then, write your reflection about the video. Success criteria is
provided at the key to correction.
Link - https://drive.google.com/file/d/1vVmQoOkVDV31utwfDurxInJW2naDBCWJ/view?usp=sharing
Check for Understanding
1. Which of the following best describes the benefit of cumulative share voting?
A. It provides significant minority shareholders with proportional representation on the board.
B. It prevents minority shareholders from exercising excessive control.
C. If cumulative dividends are not paid, preferred shareholders are given voting rights.
2. The advantage of participating preferred shares versus non-participating preferred shares is that
participating preferred shares can:
A. obtain voting rights.
B. receive extra dividends.
C. be converted into common stock.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #10 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
3. Compared to public equity, which of the following is least likely to characterize private equity?
A. Lower reporting costs.
B. Potentially weaker corporate governance.
C. Lower returns because of its less liquid market.
C. LESSON WRAP-UP
Frequently Asked Questions
1. Compared to public equity, whare the characteristics of private equity?
• liquidity because no public market for the shares exists.
• Share price is negotiated between the firm and its investors, not determined in a market.
• More limited firm financial disclosure because there is no government or exchange requirement to do
so.
• Lower reporting costs because of less onerous reporting requirements.
• Potentially weaker corporate governance because of reduced reporting requirements and less public
scrutiny.
• Greater ability to focus on long-term prospects because there is no public pressure for short-term
results.
• Potentially greater return for investors once the firm goes public.
2. What are the three main types of private equity?
Venture capital refers to the capital provided to firms early in their life cycles to fund their development
and growth. Venture capital financing at various stages of a firm's development is referred to as seed or startup, early stage, or mezzanine financing. Investors can be family, friends, wealthy individuals, or private equity
funds. Venture capital investments are illiquid, and investors often must commit funds for three to ten years
before they can cash out (exit) their investment. Investors hope to profit when they can sell their shares after
(or as part of) an initial public offering or to an established firm.
In a leveraged buyout (LBO), investors buy all a firm's equity using debt financing (leverage). If the
buyers are the firm's current management, the LBO is referred to as a management buyout (MBO). Firms in
LBOs usually have cash flow that is adequate to service the issued debt or have undervalued assets that can
be sold to pay down the debt over time.
In a private investment in public equity (PIPE), a public firm that needs capital quickly sells private
equity to investors. The firm may have growth opportunities, be in distress, or have large amounts of debt. The
investors can often buy the stock at a sizeable discount to its market price.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #10 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review and Skill Building Activities
CATEGORY
Content
Accuracy
Grammar &
Spelling
(Conventions)
Sentences and
Paragraphs
Ideas
Success Criteria
4 points
3 points
2 points
1 point
The paper contains The paper contains The paper contains at The paper contains
at least 5 accurate at least 3-4 accurate least 1-2 accurate facts no accurate facts
facts about the facts about the topic. about the topic.
about the topic.
topic.
Writer makes no Writer makes 1-3 Writer
makes
4-6 Writer makes more
errors in grammar errors in grammar errors in grammar than 6 errors in
or spelling.
and/or spelling.
and/or spelling.
grammar
and/or
spelling.
Sentences
and All Sentences and Most sentences are Many
sentence
paragraphs
are paragraphs
are complete and well- fragments or run
complete,
well- complete,
well- constructed.
sentences
or
constructed and of constructed
(no Paragraphing
needs paragraphing need
varied structure
fragments, no run- some work.
lot of work.
ons). Paragraph is
generally done well.
Ideas
were Ideas
were Ideas were somewhat The paper seemed
expressed in a expressed in a clear organized but were not be a collection of
clear
and manner,
but
the noticeably clear. It unrelated sentences.
organized fashion. organization
could looks more than one It was difficult to
It was easy to have been better.
reading to figure out figure out what the
figure out what the
what was the paper paper was about.
paper was about.
was about.
Check for Understanding
1. A - Cumulative voting allows minority shareholders to gain representation on the board because they can
use all of their votes for specific board members.
2. B - Participating preferred shares can receive extra dividends if firm profits exceed a prespecified level
and a value greater than the par value if the firm is liquidated.
3. C - Private equity has less liquidity because no public market for it exists. The lower liquidity of private
equity would increase required returns.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #11 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Long-term Financing: Equities (Part 2)
Learning Targets:
At the end of this module, I should have:
1. Compared the risk and return characteristics of types of
equity securities
2. Explained the role of equity securities in the financing of a
company's assets
3. Distinguished between the market value and book value of
equity securities
4. Compared a company's cost of equity, its (accounting) return
on equity, and investors' required rates of return
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
Schweser. (2012). Schwesernotes
CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
What are the types of equity securities? Differentiate each type.
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
B. MAIN LESSON
Content and Skill-Building (40 mins)
LT 1 - Compare the risk and return characteristics of types of equity securities
Equity investor returns consist of dividends, capital gains or losses from changes in share prices, and
any foreign exchange gains or losses on shares traded in a foreign currency. Compounding of reinvested
dividends has been an important part of an equity investor's long-term return.
Preferred stock is less risky than common stock because preferred stock pays a known, fixed dividend
to investors; preferred stockholders must receive dividends before common stock dividends can be paid; and
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #11 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
preferred stockholders have a claim equal to par value if the firm is liquidated. Puttable shares are the least
risky and callable shares are the riskiest. Cumulative preferred shares are less risky than non-cumulative
preferred shares, as any dividends missed must be paid before a common stock dividend can be paid.
LT 2 - Explain the role of equity securities in the financing of a company's assets
Equity securities provide funds to the firm to buy productive assets, to buy other companies, or to offer
to employees as compensation. Equity securities provide liquidity that may be important when the firm must
raise additional funds.
LT 3 - Distinguish between the market value and book value of equity securities
The book value of equity is the difference between the financial statement value of the firm's assets and
liabilities. Positive retained earnings increase the book value of equity. Book values reflect the firm's past
operating and financing choices. The market value of equity is the share price multiplied by the number of
shares outstanding. Market value reflects investors' expectations about the timing, amount, and risk of the
firm's future cash flows.
LT 4 - Compare a company's cost of equity, its (accounting) return on equity, and investors' required
rates of return
The accounting return on equity (ROE) is calculated as the firm's net income divided by the book value of
common equity. ROE measures whether management is generating a return on common equity but is affected
by the firm's accounting methods. The firm's cost of equity is the minimum rate of return that investors in the
firm's equity require. Investors' required rates of return are reflected in the market prices of the firm's shares.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #11 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Skill-building Activities
Activity 1: Compare the risk and return characteristics of types of equity securities
Directions: Answer the following question using the success criteria:
1. Are you a risk-taker or risk-averse? Explain your answer.
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #11 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
2. With your risk appetite, what type of equity security you will invent in? Why do you choose this
investment?
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
3. How will you minimize the risk in your investment?
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
Activity 2: Explain the role of equity securities in the financing of a company's assets
Directions: Complete the concept organizer. List the different roles of equity securities. Success criteria is
provided at the key to correction.
Role of Equity
Securities in the
Financing of a
Company's
Assets
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #11 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Activity 3: Distinguish between the market value and book value of equity securities
Directions: Complete the concept organizer. Differentiate market value from book value. Success criteria is
provided at the key to correction.
Book Value
Market Value
Activity 4: Compare a company's cost of equity, its (accounting) return on equity, and investors'
required rates of return
Directions: Complete the concept organizer. Compare the following concepts. Success criteria is provided at
the key to correction.
Required Rates of
Return
Cost of Equity
Return on Equity
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #11 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Check for Understanding
1. Global depository receipts are most often denominated in:
a. the currency of the country where they trade and issued outside the United States.
b. U.S. dollars and issued in the United States.
c. U.S. dollars and issued outside the United States.
2. Which of the following types of preferred shares has the most risk for investors?
a. Putable shares.
b. Callable shares.
c. Non-putable, non-callable shares.
3. Which of the following best describes the book value of equity?
a. Management should attempt to maximize book value of equity.
b. Book value of equity decreases when retained earnings increase.
c. Book value of equity reflects investors' perceptions of the firm's future.
4. Which of the following causes of an increase in return on equity is most likely a positive sign for a
firm's equity investors?
a. A firm issues debt to repurchase equity.
b. Net income is increasing at a faster rate than book value of equity.
c. Net income is decreasing at a slower rate than book value of equity.
C. LESSON WRAP-UP
Frequently Asked Questions
1. What is the primary goal of firm management?
The primary goal of firm management is to increase the book value of the firm's equity and thereby
increase the market value of its equity.
2. Why is callable shares are the riskiest?
Callable shares are the riskiest because if the market price rises, the firm can call the shares, limiting
the upside potential of the shares. Callable shares, therefore, usually have higher dividend yields than noncallable shares.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #11 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review and Skill Building Activities
CATEGORY
Content Accuracy
Grammar &
Spelling
(Conventions)
Sentences and
Paragraphs
Ideas
4 points
The paper contains at
least 5 accurate facts
about the topic.
Writer makes no errors
in grammar or spelling.
Sentences
and
paragraphs
are
complete,
wellconstructed and of
varied structure
Ideas were expressed
in
a
clear
and
organized fashion. It
was easy to figure out
what the paper was
about.
Success Criteria
3 points
The paper contains at
least 3-4 accurate facts
about the topic.
Writer makes 1-3 errors in
grammar and/or spelling.
All
Sentences
and
paragraphs are complete,
well-constructed
(no
fragments, no run-ons).
Paragraph is generally
done well.
Ideas were expressed in
a clear manner, but the
organization could have
been better.
2 points
The paper contains at least
1-2 accurate facts about the
topic.
Writer makes 4-6 errors in
grammar and/or spelling.
Most
sentences
are
complete
and
wellconstructed. Paragraphing
needs some work.
Ideas
were
somewhat
organized but were not
noticeably clear. It looks
more than one reading to
figure out what was the
paper was about.
1 point
The paper contains no
accurate facts about the
topic.
Writer makes more than 6
errors in grammar and/or
spelling.
Many sentence fragments
or run sentences or
paragraphing need lot of
work.
The paper seemed be a
collection of unrelated
sentences. It was difficult
to figure out what the
paper was about.
Check for Understanding
1. C
Global Depository Receipts are not listed on U.S. exchanges and are most often denominated in U.S.
dollars. They are not issued in the United States.
2. B
Callable shares are the riskiest because if the market price rises, the firm can call in the shares,
limiting the investor's potential gains. Putable shares are the least risky because if the market price
drops, the investor can put the shares back to the firm at a predetermined price. The risk of nonputable, non-callable shares falls in between.
3. A
The primary goal of firm management is to increase the book value of equity. It increases when
retained earnings are positive. The market value of equity reflects the collective expectations of
investors about the firm's future performance.
4. B
Net income increasing at a faster rate than book value of equity generally would be a positive sign. If a
firm issues debt to repurchase equity, this decreases the book value of equity and increases the ROE.
However, now the firm becomes riskier due to the increased debt. Net income decreasing at a slower
rate than book value of equity would increase ROE, but decreasing net income is not a positive sign.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #12 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Valuation of Bonds
Learning Targets:
At the end of this module, I should have:
1. Explained steps in the bond valuation process.
2. Described types of bonds for which estimating the expected
cash flows is difficult.
3. Calculated the value of a bond (coupon and zero-coupon).
4. Explained how the price of a bond changes if the discount
rate changes and as the bond approaches its maturity date.
5. Calculated the change in value of a bond given a change in
its discount rate.
6. Explained and demonstrated the use of the arbitrage-free
valuation approach and describe how a dealer can generate
an arbitrage profit if a bond is mispriced.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
Schweser. (2012). Schwesernotes
CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
Explain the risk associated to the types of equity securities.
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
_______________________________________________________________________________________
B. MAIN LESSON
Content and Skill-Building (40 mins)
LT 1 - Explain steps in the bond valuation process.
To value a bond, one must:
• Estimate the amount and timing of the bond's future payments of interest and principal.
• Determine the appropriate discount rate(s).
• Calculate the sum of the present values of the bond's cash flows.
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LT 2 - Explain steps in the bond valuation process.
Certain bond features, including embedded options, convertibility, or floating rates, can make the estimation of
future cash flows uncertain, which adds complexity to the estimation of bond values.
LT 3 - Calculate the value of a bond (coupon and zero-coupon).
To compute the value of an option-free coupon bond, value the coupon payments as an annuity and add the
present value of the principal repayment at maturity. The value of a zero-coupon bond calculated using a
semiannual discount rate, i (one-half its annual yield to maturity), is:
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LT 4 - Explain how the price of a bond changes if the discount rate changes and as the bond
approaches its maturity date.
When interest rates (yields) do not change, a bond's price will move toward its par value as time passes and
the maturity date approaches. To compute the change in value that is attributable to the passage of time,
revalue the bond with a smaller number of periods to maturity.
LT 5 - Calculate the change in value of a bond given a change in its discount rate.
The change in value that is attributable to a change in the discount rate can be calculated as the change in the
bond's present value based on the new discount rate (yield).
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LT 6 - Explain and demonstrate the use of the arbitrage-free valuation approach and describe how a
dealer can generate an arbitrage profit if a bond is mispriced.
A Treasury spot yield curve is considered "arbitrage-free" if the present values of Treasury securities
calculated using these rates are equal to equilibrium market prices. If bond prices are not equal to their
arbitrage-free values, dealers can generate arbitrage profits by buying the lower-priced alternative (either the
bond or the individual cash flows) and selling the higher-priced alternative (either the individual cash flows or a
package of the individual cash flows equivalent to the bond).
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Skill-building Activities
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Check for Understanding
For the next three items:
An analyst observes a 20-year, 8% option-free bond with semiannual coupons. The required semiannual-pay
yield to maturity on this bond was 8%, but suddenly it drops to 7.25%.
1. As a result of the drop, the price of this bond:
A. will increase.
B. will decrease.
C. will stay the same.
2. Prior to the change in the required yield, what was the price of the bond?
A. 92.64.
B. 100.00.
C. 107.85.
3. The percentage change in the price of this bond when the rate decreased is closest to:
A. 7.86%.
B. 7.79%.
C. 8.00%.
4. Treasury spot rates (expressed as semiannual-pay yields to maturity) are as follows: 6 months = 4%, 1 year
= 5%, 1.5 years = 6%. A 1.5-year, 4% Treasury note is trading at $965. The arbitrage trade and arbitrage profit
are:
A. buy the bond, sell the pieces, earn $7.09 per bond.
B. sell the bond, buy the pieces, earn $7.09 per bond.
C. sell the bond, buy the pieces, earn $7.91 per bond.
5. A $1,000, 5%, 20-year annual-pay bond has a yield of 6.5%. If the yield remains unchanged, how much will
the bond value increase over the next three years?
A. $13.62.
B. $13.78.
C. $13.96.
6. The value of a 17 -year, zero-coupon bond with a maturity value of $100,000 and a semiannual-pay yield of
8.22% is closest to:
A. $24,618.
B. $25,425.
C. $26,108.
C. LESSON WRAP-UP
Frequently Asked Questions
1. How a dealer can generate an arbitrage profit?
Recall that the Treasury STRIPS program allows dealers to divide Treasury bonds into their coupon
payments (by date) and their maturity payments to create zero coupon securities. The program also allows
reconstitution of Treasury bonds/notes by putting the individual cash flows back together to create Treasury
securities. Ignoring any costs of performing these transformations, the ability to separate and reconstitute
Treasury securities will ensure that the arbitrage-free valuation condition is met.
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The STRIPS program allows for just the arbitrage we outlined previously. If the price of the bond is
greater than its arbitrage-free value, a dealer could buy the individual cash flows and sell the package for the
market price of the bond. If the price of the bond is less than its arbitrage-free value, an arbitrageur can make
an immediate and riskless profit by purchasing the bond and selling the parts for more than the cost of the
bond.
Such arbitrage opportunities and the related buying of bonds priced too low and sales of bonds priced
too high will force the bond prices toward equality with their arbitrage-free values, eliminating further arbitrage
opportunities.
2. How are bond values and bond yields related?
Bond values and bond yields are inversely related. An increase in the discount rate will decrease the
present value of a bond's expected cash flows; a decrease in the discount rate will increase the present value
of a bond's expected cash flows. The change in bond value in response to a change in the discount rate can
be calculated as the difference between the present values of the cash flows at the two different discount rates.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review
Preferred stock is less risky than common stock because preferred stock pays a known, fixed dividend
to investors; preferred stockholders must receive dividends before common stock dividends can be paid; and
preferred stockholders have a claim equal to par value if the firm is liquidated. Puttable shares are the least
risky and callable shares are the riskiest. Cumulative preferred shares are less risky than non-cumulative
preferred shares, as any dividends missed must be paid before a common stock dividend can be paid.
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Skill Building Activity
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FIN 072 | Financial Markets
Module #14 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Valuation of Stocks
Learning Targets:
At the end of this module, I should have:
1. Described the features of common stock
2. Calculated intrinsic value and stock price
3. Determined common stock values using - Discounted
Dividend Model; Corporate Valuation Model; and Other
Approaches
4. Described preferred stock
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
Schweser. (2012). Schwesernotes
CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.s
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
What are the steps of bonds valuation?
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
B. MAIN LESSON
Content and Skill-Building (40 mins)
Features of Common Stock
Facts About Common Stock
• Represents ownership
• Ownership implies control
• Stockholders elect directors
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•
•
Class number: ______
Date: _______________
Directors elect management
Management’s goal: Maximize the stock price
Intrinsic Value and Stock Price
• Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stock’s
intrinsic value (P0).
• In equilibrium we assume that a stock’s price equals its intrinsic value.
– Outsiders estimate intrinsic value to help determine which stocks are attractive to buy and/or
sell.
– Stocks with a price below (above) its intrinsic value are undervalued (overvalued).
Different Approaches for Estimating the Intrinsic Value of a Common Stock
• Discounted dividend model
• Corporate valuation model
• P/E multiple approach
• EVA approach
Discounted Dividend Model
• Value of a stock is the present value of the future dividends expected to be generated by the stock.
P̂0 
D3
D1
D2
D



...

(1  rs )1 (1  rs )2 (1  rs )3
(1  rs )
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Constant Growth Stock
• A stock whose dividends are expected to grow forever at a constant rate, g.
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
• If g is constant, the discounted dividend formula converges to:
P̂0 
D 0 (1  g)
D1

rs  g
rs  g
Use the SML to Calculate the Required
Rate of Return (rs)
• If rRF = 7%, rM = 12%, and b = 1.2, what is the required rate of return on the firm’s stock?
rs
= rRF + (rM – rRF)b
= 7% + (12% – 7%)1.2
= 13%
Find the Expected Dividend Stream for the Next 3 Years and Their PVs
D0 = P2 and g is a constant 6%.
What is the stock’s intrinsic value?
Using the constant growth model:
P̂0 
D1
$2.12

rs  g 0.13  0.06
$2.12
0.07
 $30.29

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What is the stock’s expected value, one year from now?
• D1 will have been paid out already. So, expected P1 is the present value (as of Year 1) of D2, D3, D4,
etc.
P̂1 
D2
$2.247

rs  g 0.13  0.06
 $32.10
•
Could also find expected P1 as:
P̂1  P0 (1.06)  $32.10
Find Expected Dividend Yield, Capital Gains Yield, and Total Return for First Year
• Dividend yield
= D1/P0 = P2.12/P30.29 = 7.0%
• Capital gains yield
= (P1 – P0)/P0
= (P32.10 – P30.29)/P30.29 = 6.0%
• Total return (rs)
= Dividend yield + Capital gains yield
= 7.0% + 6.0% = 13.0%
What would the expected price today be,
if g = 0?
The dividend stream would be a perpetuity.
P̂0 
PMT $2.00

 $15.38
r
0.13
Supernormal Growth: What if g = 30% for 3 years before achieving long-run growth of 6%?
• Can no longer use just the constant growth model to find stock value.
• However, the growth does become constant after 3 years.
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Valuing Common Stock with Nonconstant Growth
Find Expected Dividend and Capital Gains Yields During the First and Fourth Years
• Dividend yield (first year)
= P2.60/P54.11 = 4.81%
• Capital gains yield (first year)
= 13.00% – 4.81% = 8.19%
• During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains
yield ≠ g.
• After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
Nonconstant Growth: What if g = 0% for 3 years before long-run growth of 6%?
Find Expected Dividend and Capital Gains Yields During the First and Fourth Years
• Dividend yield (first year)
= P2.00/P25.72 = 7.78%
• Capital gains yield (first year)
= 13.00% – 7.78% = 5.22%
• After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
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If the stock were expected to have negative growth (g = -6%), would anyone buy the stock, and what is its
value?
• Yes. Even though the dividends are declining, the stock is still producing cash flows and therefore has
positive value.
P̂0 

D (1  g)
D1
 0
rs  g
rs  g
$2.00 (0.94) $1.88

 $9.89
0.13  (-0.06) 0.19
Find Expected Annual Dividend and Capital Gains Yields
• Capital gains yield
= g = -6.00%
• Dividend yield
= 13.00% – (-6.00%) = 19.00%
• Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant.
Dividend yield is sufficiently large (19%) to offset negative capital gains.
Corporate Valuation Model
• Also called the free cash flow method. Suggests the value of the entire firm equals the present value of
the firm’s free cash flows.
• Remember, free cash flow is the firm’s after-tax operating income less the net capital investment.
Depr. and   Capital


FCF  EBIT(1  T) 



NOWC

amortization expenditures

Applying the Corporate Valuation Model
• Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs.
• Subtract MV of firm’s debt and preferred stock to get MV of common stock.
• Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value).
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Use the Corporate Valuation Model to Find the Firm’s Intrinsic Value
What is the firm’s intrinsic value per share?
The firm has P40 million total in debt and preferred stock and has 10 million shares of common stock.
Firm Multiples Method
• Analysts often use the following multiples to value stocks.
– P/E
– P/CF
– P/Sales
• EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected
earnings to back out an estimate of the stock price.
EVA Approach
EVA = Equity capital (ROE – Cost of equity)
MVEquity = BVEquity + PV of all future EVAs
Value per share = MVEquity/# of shares
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Preferred Stock
• Hybrid security.
• Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid
to common stockholders.
• However, companies can omit preferred dividend payments without fear of pushing the firm into
bankruptcy.
If preferred stock with an annual dividend of P5 sells for P50, what is the preferred stock’s expected return?
Vp 
$50 
D
rp
$5
rp
$5
$50
 0.10  10%
r̂p 
Skill-building Activities (with answer key)
1. An analyst estimates a value of P45 for a stock with a market price of P50. The analyst is most likely to
conclude that a stock is overvalued if:
A. few analysts follow the stock, and the analyst has less confidence in his model inputs.
B. few analysts follow the stock, and the analyst is confident in his model inputs.
C. many analysts follow the stock, and the analyst is confident in his model inputs.
2. An analyst estimates that a stock will pay a P2 dividend next year and that it will sell for P40 at year-end. If
the required rate of return is 15%, what is the value of the stock?
A. P33.54.
B. P36.52.
C. P43.95.
3. What would an investor be willing to pay for a share of preferred stock that pays an annual P7 dividend if the
required return is 7.75%?
A. P77.50.
B. P87.50.
C. P90.32.
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4. The constant growth model requires which of the following?
A. g< k.
B. g > k.
C. g is not equal to k.
5. What is the intrinsic value of a company's stock if dividends are expected to grow at 5%, the most recent
dividend was P1, and investors' required rate of return for this stock is 10%?
A. P20.00.
B. P21 .00.
C. P22.05.
6. Next year's dividend is expected to be P2, g = 7%, and k = 12%. What is the stock's intrinsic value?
A. P28.57.
B. P40.00.
C. P42.80.
7. The XX Company paid a P1 dividend in the most recent period. The company is expecting dividends to grow
at a 6% rate into the future. What is the value of this stock if an investor requires a 15% rate of return on stocks
of this risk class?
A. P1 0.60.
B. P11.11.
C. P1 1.78.
Check for Understanding
1. Assume that a stock is expected to pay dividends at the end of Year 1 and Year 2 of P1 .25 and P1 .56,
respectively. Dividends are expected to grow at a 5% rate thereafter. Assuming that ke is 1 1%, the value of
the stock is closest to:
A. P22.30.
B. P23.42.
C. P24.55.
2. An analyst feels that Brown Company's earnings and dividends will grow at 25% for two years, after which
growth will fall to a constant rate of 6%. If the projected discount rate is 10%, and Brown's most recently paid
dividend was P1, the value of Brown's stock using the multistage dividend discount model is closest to:
A. P31.25.
B. P33.54.
C. P36.65.
3. A firm has an expected dividend payout ratio of 60% and an expected future growth rate of 7%. What should
the firm's fundamental price-to-earnings (PIE) ratio be if the required rate of return on stocks of this type is
15%?
A. 5.0x.
B. 7.5x.
C. 10.0x.
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4. Which of the following firms would most likely be appropriately valued using the constant growth DDM?
A. An auto manufacturer.
B. A producer of bread and snack foods.
C. A biotechnology firm in existence for two years.
5. Which of the following is least likely a rationale for using price multiples?
A. Price multiples are easily calculated.
B. The fundamental P/E ratio is insensitive to its inputs.
C. The use of forward values in the divisor provides an incorporation of the future.
6. Which of the following firms would most appropriately be valued using an asset-based model?
A. An energy exploration firm in financial distress that owns drilling rights for offshore areas.
B. A paper firm located in a country that is experiencing high inflation.
C. A software firm that invests heavily in research and development and frequently introduces new products.
C. LESSON WRAP-UP
Frequently Asked Questions
1. What happens if g > rs?
• If g > rs, the constant growth formula leads to a negative stock price, which does not make sense.
• The constant growth model can only be used if:
– rs > g.
– g is expected to be constant forever.
2. What are the issues regarding the Corporate Valuation Model?
• Often preferred to the discounted dividend model, especially when considering number of firms that do
not pay dividends or when dividends are hard to forecast.
• Like discounted dividend model, assumes at some point free cash flow will grow at a constant rate.
• Horizon value (HVN) represents value of firm at the point that growth becomes constant.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
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Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review
To value a bond, one must:
• Estimate the amount and timing of the bond's future payments of interest and principal.
• Determine the appropriate discount rate(s).
• Calculate the sum of the present values of the bond's cash flows.
Skill Building Activity
1. B
If the analyst is more confident of his input values, he is more likely to conclude that the security is overvalued.
The market price is more likely to be correct for a security followed by many analysts and less likely correct
when few analysts follow the security.
2. B
(P40 + P2) I 1.15 = P36.52
3. C
The share value is 7.0 I 0.0775 = P90.32.
4. A
For the constant growth model, the constant growth rate (g) must be less than the required rate of return (k).
5. B
Using the constant growth model, P1(1.05) I (0. 10 - 0.05) = P21 .00.
6. B
Using the constant growth model, P2 I (0.12 - 0.07) = P40.00.
7. C
Using the constant growth model, P1 (1.06) I (0. 15 - 0.06) = P11.78.
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Lesson Title: Cost of Capital (Part 1)
Learning Targets:
At the end of this module, I should have:
1. Identified the sources of capital.
2. Enumerated component costs
3. Adjusted WACC for flotation costs
4. Calculated WACC
5. Adjusted WACC for risk
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
Schweser. (2012). Schwesernotes
CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
What are the issues regarding the Corporate Valuation Model?
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
B. MAIN LESSON
Content and Skill-Building (40 mins)
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What sources of capital do firms use?
Calculating the Weighted Average Cost of Capital
WACC = wdrd(1 – T) + wprp + wcrs
• The w’s refer to the firm’s capital structure weights.
• The r’s refer to the cost of each component.
Component Costs
• Firm calculating cost of capital for major expansion program.
– Tax rate = 40%.
– 15-year, 12% coupon, semiannual payment noncallable bonds sell for P1,153.72. New bonds
will be privately placed with no flotation cost.
– 10%, P100 par value, quarterly dividend, perpetual preferred stock sells for P111.10.
– Common stock sells for P50. D0 = P4.19 and g = 5%.
– b = 1.2; rRF = 7%; RPM = 6%.
– Bond-Yield Risk Premium = 4%.
– Target capital structure: 30% debt, 10% preferred, 60% common equity.
Review of Coleman’s Capital Structure
Number of shares not given in problem, so actual calculations cannot be done. Analysis is meant for
illustration. Typically, book value capital structure will show a higher percentage of debt because a typical
firm’s M/B ratio > 1.
Component Cost of Debt
• rd is the marginal cost of debt capital.
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•
•
Class number: ______
Date: _______________
The yield to maturity on outstanding L-T debt is often used as a measure of rd.
Why tax-adjust; i.e., why rd(1 – T)?
A 15-year, 12% semiannual coupon bond sells for P1,153.72. What is the cost of debt (rd)?
• Remember, the bond pays a semiannual coupon, so rd = 5.0% x 2 = 10%.
•
•
•
Interest is tax deductible, so
A-T rd = B-T rd(1 – T)
= 10%(1 – 0.40) = 6%
Use nominal rate.
Flotation costs are small, so ignore them.
Component Cost of Preferred Stock
• rp is the marginal cost of preferred stock, which is the return investors require on a firm’s preferred
stock.
• Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal rp.
• Our calculation ignores possible flotation costs.
•
The cost of preferred stock can be solved by using this formula:
rp
= Dp/Pp
= P10/P111.10
= 9%
Is preferred stock more or less risky to investors than debt?
• More risky; company not required to pay preferred dividend.
• However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult
to raise additional funds, (3) preferred stockholders may gain control of firm.
Why is the yield on preferred stock lower than debt?
• Preferred stock will often have a lower B-T yield than the B-T yield on debt.
– Corporations own most preferred stock, so 70% of preferred dividends are excluded from
corporate taxation.
• The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred stock than on debt.
Consistent with higher risk of preferred stock.
Component Cost of Equity
• rs is the marginal cost of common equity using retained earnings.
• The rate of return investors requires on the firm’s common equity using new equity is r e.
Why is there a cost for retained earnings?
• Earnings can be reinvested or paid out as dividends.
• Investors could buy other securities, earn a return.
• If earnings are retained, there is an opportunity cost (the return that stockholders could earn on
alternative investments of equal risk).
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–
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Investors could buy similar stocks and earn rs.
Firm could repurchase its own stock and earn rs.
Three Ways to Determine the Cost of Common Equity, rs
• CAPM:
rs = rRF + (rM – rRF)b
• DCF: rs = (D1/P0) + g
• Bond-Yield-Plus-Risk-Premium:
rs = rd + RP
Find the Cost of Common Equity Using the CAPM Approach
The rRF = 7%, RPM = 6%, and the firm’s beta is 1.2.
rs
= rRF + (rM – rRF)b
= 7.0% + (6.0%)1.2 = 14.2%
Find the Cost of Common Equity Using the DCF Approach
D0 = P4.19, P0 = P50, and g = 5%.
D1
= D0(1 + g)
= P4.19(1 + 0.05)
= P4.3995
rs
= (D1/P0) + g
= (P4.3995/P50) + 0.05
= 13.8%
Can DCF methodology be applied if growth is not constant?
• Yes, nonconstant growth stocks are expected to attain constant growth at some point, generally in 5 to
10 years.
• May be complicated to calculate.
Find rs Using the Bond-Yield-Plus-Risk-Premium Approach
rd = 10% and RP = 4%.
• This RP is not the same as the CAPM RPM.
• This method produces a ballpark estimate of rs, and can serve as a useful check.
rs = rd + RP
rs = 10.0% + 4.0% = 14.0%
What is a reasonable final estimate of rs?
Range = 13.8%-14.2%, might use midpoint of range, 14%.
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Why is the cost of retained earnings cheaper than the cost of issuing new common stock?
• When a company issues new common stock they also have to pay flotation costs to the underwriter.
• Issuing new common stock may send a negative signal to the capital markets, which may depress the
stock price.
Approaches for Flotation Adjustment
• Include costs as part of the project’s upfront cost.
– This reduces the project’s estimated return.
• Adjust cost of capital to include flotation in DCF model.
– Commonly done by incorporating flotation in DCF model. (See slide 11-26.)
If new common stock issue incurs a flotation cost of 15% of the proceeds, what is re?
D (1  g)
re  0
g
P0 (1  F)
$4.19(1.05)
 5 .0 %
$50(1  0.15)
$4.3995

 5 .0 %
$42.50
 15.4%

Flotation Costs
• Flotation costs depend on the firm’s risk and the type of capital raised.
• Flotation costs are highest for common equity. However, since most firms issue equity infrequently, the
per-project cost is fairly small.
• We will frequently ignore flotation costs when calculating the WACC.
What is the firm’s WACC (ignoring flotation costs)?
WACC = wdrd(1 – T) + wprp + wcrs
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%
What factors influence a company’s composite WACC?
Factors the firm cannot control:
• Market conditions such as interest rates and tax rates.
Factors the firm can control:
• Firm’s capital structure.
• Firm’s dividend policy.
• The firm’s investment policy. Firms with riskier projects generally have a higher WACC.
Should the company use the composite WACC as the hurdle rate for each of its projects?
• NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore,
the WACC only represents the “hurdle rate” for a typical project with average risk.
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•
•
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Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s
risk.
The next slide illustrates the importance of risk-adjusting the cost of capital. Note, if the company
correctly risk-adjusted the WACC, then it would select Project L and reject Project H. Alternatively, if
the company didn’t risk-adjust and instead used the composite WACC for all projects, it would
mistakenly select Project H and reject Project L.
Skill-building Activities (with answer key)
1. A company has P5 million in debt outstanding with a coupon rate of 12%. Currently, the yield to maturity
(YTM) on these bonds is 14%. If the firm's tax rate is 40%, what is the company's after-tax cost of debt?
A. 5.6%.
B. 8.4%.
C. 14.0%.
2. The cost of preferred stock is equal to:
A. the preferred stock dividend divided by its par value.
B. [(1 - tax rate) times the preferred stock dividend] divided by price.
C. the preferred stock dividend divided by its market price.
3. A company's P100, 8o/o preferred is currently selling for P85. What is the company's cost of preferred
equity? A. 8.0%.
B. 9.4%.
C. 10.8%.
4. The expected dividend is P2.50 for a share of stock priced at P25. What is the cost of equity if the long-term
growth in dividends is projected to be 8%?
A. 15%.
B. 16%.
C. 18%.
5. A company is planning a P50 million expansion. The expansion is to be financed by selling P20 million in
new debt and P30 million in new common stock. The before-tax required return on debt is 9o/o and 14% for
equity. If the company is in the 40% tax bracket, the company's marginal cost of capital is closest to:
A. 7.2%.
B. 10.6%.
C. 12.0%.
Check for Understanding
Answer the following questions using the given problem.
• The company has a target capital structure of 40% debt and 60% equity.
• Bonds with face value of P 1,000 pay a 10% coupon (semiannual), mature in 20 years, and sell for P849.54
with a yield to maturity of 12%.
• The company stock beta is 1.2.
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• Risk-free rate is 10%, and market risk premium is 5%.
• The company is a constant-growth firm that just paid a dividend of P2, sells for P27 per share, and has a
growth rate of 8%.
• The company's marginal tax rate is 40%.
1. The company's after-tax cost of debt is _______.
2. The company's cost of equity using the capital asset pricing model (CAPM) approach is _______.
3. The company's cost of equity using the dividend discount model is _______.
4. The company's weighted average cost of capital (using the cost of equity from CAPM) is closest to _______.
C. LESSON WRAP-UP
Frequently Asked Questions
1. Should our analysis focus on before-tax or after-tax capital costs?
• Stockholders focus on after-tax CFs. Therefore, we should focus on after-tax capital costs, i.e., use
after-tax costs of capital in WACC. Only rd needs adjustment because interest is tax deductible.
2. Should our analysis focus on historical (embedded) costs or new (marginal) costs?
• The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on
today’s marginal costs (for WACC).
3. How are the weights determined?
WACC = wdrd(1 – T) + wprp + wcrs
• Use accounting numbers or market value (book vs. market weights)?
• Use actual numbers or target capital structure?
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
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KEY TO CORRECTIONS
Review
• Often preferred to the discounted dividend model, especially when considering number of firms that do
not pay dividends or when dividends are hard to forecast.
• Like discounted dividend model, assumes at some point free cash flow will grow at a constant rate.
• Horizon value (HVN) represents value of firm at the point that growth becomes constant.
Skill Building Activity
1.
2.
3.
4.
5.
Check for Understanding
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Lesson Title: Cost of Capital (Part 2)
Learning Targets:
At the end of this module, I should have:
1. Calculated and interpreted the weighted average cost of
capital (WACC) of a company; and
2. Described how taxes affect the cost of capital from different
capital sources.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
Schweser. (2012). Schwesernotes
CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
What factors influence a company’s composite WACC?
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
_________________
B. MAIN LESSON
Content and Skill-Building (40 mins)
The capital budgeting process involves discounted cash flow analysis. To conduct such analysis, you
must know the firm's proper discount rate. This topic review discusses how, as an analyst, you can determine
the proper rate at which to discount the cash flows associated with a capital budgeting project. This discount
rate is the firm's weighted average cost of capital (WACC) and is also referred to as the marginal cost of capital
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(MCC).
Basic definitions. On the right (liability) side of a firm's balance sheet, we have debt, preferred stock,
and common equity. These are normally referred to as the capital components of the firm. Any increase in a
firm's total assets will have to be financed through an increase in at least one of these capital accounts. The
cost of each of these components is called the component cost of capital.
Throughout this review, we focus on the following capital components and their component costs:
In many countries, the interest paid on corporate debt is tax deductible. Because we are interested in
the after-tax cost of capital, we adjust the cost of debt, kd, for the firm's marginal tax rate, t. Because there is
typically no tax deduction allowed for payments to common or preferred stockholders, there is no equivalent
deduction to kps or kce·
How a company raises capital and how it budgets or invests it are considered independently. Most
companies have separate departments for the two tasks. The financing department is responsible for keeping
costs low and using a balance of funding sources: common equity, preferred stock, and debt. Generally, it is
necessary to raise each type of capital in large sums. The large sums may temporarily overweight the most
recently issued capital, but in the long run, the firm will adhere to target weights. Because of these and other
financing considerations, each investment decision must be made assuming a WACC, which includes each of
the different sources of capital and is based on the long run target weights. A company creates value by
producing a return on assets that is higher than the required rate of return on the capital needed to fund those
assets.
The WACC, as we have described it, is the cost of financing firm assets. We can view this cost as an
opportunity cost. Consider how a company could reduce its costs if it found a way to produce its output using
fewer assets, like less working capital. If we need less working capital, we can use the funds freed up to buy
back our debt and equity securities in a mix that just matches our target capital structure. Our after-tax savings
would be the WACC based on our target capital structure multiplied by the total value of the securities that are
no longer outstanding.
For these reasons, any time we are considering a project that requires expenditures, comparing the
return on those expenditures to the WACC is the appropriate way to determine whether undertaking that
project will increase the value of the firm. This is the essence of the capital budgeting decision. Because a
firm's WACC reflects the average risk of the projects that make up the firm, it is not appropriate for evaluating
all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for
projects with less-than-average risk.
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The weights in the calculation of a firm's WACC are the proportions of each source of capital in a firm's
capital structure.
Skill-building Activities (with answer key)
Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics,
including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of
capital. The balance sheet and some other information are provided below.
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Assets
Current assets
Net plant, property, and equipment
Total assets
P 38,000,000
101,000,000
P139,000,000
Liabilities and Equity
Accounts payable
Accruals
Current liabilities
Long-term debt (40,000 bonds, P1,000 par value)
Total liabilities
Common stock (10,000,000 shares)
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
P 10,000,000
9,000,000
P 19,000,000
40,000,000
P 59,000,000
30,000,000
50,000,000
80,000,000
P139,000,000
The stock is currently selling for P15.25 per share, and its noncallable P1,000 par value, 20-year, 7.25% bonds
with semiannual payments are selling for P875.00. The beta is 1.25, the yield on a 6-month Treasury bill is
3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%,
but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
1. What is the best estimate of the after-tax cost of debt?
2. Based on the CAPM, what is the firm's cost of equity?
3. Which of the following is the best estimate for the weight of debt for use in calculating the WACC?
4. What is the best estimate of the firm's WACC?
Solution for No. 1
Answer for No. 1
Solution for No. 2
Answer for No. 2
Solution for No. 3
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Answer for No. 3
Solution for No. 4
Answer for No. 4
Check for Understanding
True or False. Shade true if the statement is correctly stated. Shade false if the statement is incorrectly stated.
True False The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on
new debt.
True False The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of
dividends received by a corporation may be excluded from the receiving corporation's taxable
income.
True False The cost of perpetual preferred stock is found as the preferred's annual dividend divided by
the market price of the preferred stock. No adjustment is needed for taxes because preferred
dividends, unlike interest on debt, are not deductible by the issuing firm.
True False For capital budgeting and cost of capital purposes, the firm should always consider retained
earnings as the first source of capital (i.e., use these funds first) because retained earnings
have no cost to the firm.
True False Funds acquired by the firm through retaining earnings have no cost because there are no
dividend or interest payments associated with them, and no flotation costs are required to
raise them, but capital raised by selling new stock or bonds does have a cost.
C. LESSON WRAP-UP
Frequently Asked Questions
1. Explain the marginal cost of capital's role in determining the net present value of a project.
One cautionary note regarding the simple logic behind Figure 1 is in order. All projects do not have the
same risk. The WACC is the appropriate discount rate for projects that have approximately the same level of
risk as the firm's existing projects. This is because the component costs of capital used to calculate the firm's
WACC are based on the existing level of firm risk. To evaluate a project with greater than (the firm's) average
risk, a discount rate greater than the firm's existing WACC should be used. Projects with below-average risk
should be evaluated using a discount rate less than the firm's WACC.
An additional issue to consider when using a firm's WACC (marginal cost of capital) to evaluate a
specific project is that there is an implicit assumption that the capital structure of the firm will remain at the
target capital structure over the life of the project.
These complexities aside, we can still conclude that the NPVs of potential projects of firm-average risk
should be calculated using the marginal cost of capital for the firm. Projects for which the present value of the
after-tax cash inflows is greater than the present value of the after-tax cash outflows should be undertaken by
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the firm.
2. Explain and demonstrate the correct treatment of flotation costs.
Flotation costs are the fees charged by investment bankers when a company raises external equity
capital. Flotation costs can be substantial and often amount to between 2% and 7% of the total amount of
equity capital raised, depending on the type of offering.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
________________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
________________________________________________________________________________________
KEY TO CORRECTIONS
Review
Factors the firm cannot control:
• Market conditions such as interest rates and tax rates.
Factors the firm can control:
• Firm’s capital structure.
• Firm’s dividend policy.
• The firm’s investment policy. Firms with riskier projects generally have a higher WACC.
Skill Building Activity
1.
Coupon rate
7.25%
Periods/year
2
Maturity (yr)
20
Bond price
P875
Par value
P1,000
Tax rate
40%
Calculator inputs:
N = 2 × Years =
40
PV = −Bond Price =
−P875.00
PMT = (Coupon rate × Par)/2 =
P36.25
FV = Par value =
P1,000
Yield = I/YR, which we solve for =
4.28%
Before-tax cost of debt = rd = yield × 28.57%
=
After-tax cost of debt = rd(1 − T) =
5.14%
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2.
rRF
Expected rM
RPM = rM − rRF =
b
rs = rRF + b(RPM)
Class number: ______
Date: _______________
5.50%
11.50%
6.00%
1.25
13.00%
3.
Bond price
Number of bonds
MV of debt = D
Stock price = P0
Shares outstanding
MV of equity = E
Total MV = D + E
Weight debt = wd = D/Total MV
P875.00
40,000
P35,000,000
P15.25
10,000,000
P152,500,000
P187,500,000
18.67%
4.
wd
18.67%
rd(1 − T)
5.14%
wc = 100.00% − wd =
81.33%
rs
13.00%
WACC = wd(rd)(1 − T) + wc(rs)11.53%
=
Check for Understanding
True
The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on
new debt.
False
The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of
dividends received by a corporation may be excluded from the receiving corporation's taxable
income.
True
The cost of perpetual preferred stock is found as the preferred's annual dividend divided by
the market price of the preferred stock. No adjustment is needed for taxes because preferred
dividends, unlike interest on debt, are not deductible by the issuing firm.
False
For capital budgeting and cost of capital purposes, the firm should always consider retained
earnings as the first source of capital (i.e., use these funds first) because retained earnings
have no cost to the firm.
False
Funds acquired by the firm through retaining earnings have no cost because there are no
dividend or interest payments associated with them, and no flotation costs are required to
raise them, but capital raised by selling new stock or bonds does have a cost.
This document is the property of PHINMA EDUCATION
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Module #19 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Capital Budgeting (Part 1)
Learning Targets:
At the end of this module, I should have:
1. Defined the concept of capital budgeting;
2. Differentiated independent and mutually exclusive projects
3. Calculated payback period, NPV, IRR.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
Schweser. (2012). Schwesernotes
CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
What is the formula in solving the Weighted Average Cost of Capital?
What is the formula in solving the cost of debt?
What is the formula in solving the cost of preference shares?
What is the formula in solving the cost of newly issued common shares?
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What is the formula in solving the cost of retained earnings?
B. MAIN LESSON
Content and Skill-Building (40 mins)
What is capital budgeting?
• Analysis of potential additions to fixed assets.
• Long-term decisions; involve large expenditures.
• Very important to firm’s future.
Steps to Capital Budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
What is the difference between independent and mutually exclusive projects?
• Independent projects: If the cash flows of one are unaffected by the acceptance of the other.
• Mutually exclusive projects: If the cash flows of one can be adversely impacted by the acceptance of
the other.
What is the difference between normal and nonnormal cash flow streams?
• Normal cash flow stream: Cost (negative CF) followed by a series of positive cash inflows. One
change of signs.
• Nonnormal cash flow stream: Two or more changes of signs. Most common: Cost (negative CF), then
string of positive CFs, then cost to close project. Examples include nuclear power plant, strip mine, etc.
Net Present Value (NPV)
• Sum of the PVs of all cash inflows and outflows of a project:
N
CFt
t
t 0 ( 1  r )
NPV  
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Example
What is Project L’s NPV?
What is Project S’ NPV?
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Solving for NPV:
Financial Calculator Solution
Enter CFs into the calculator’s CFLO register.
CF0 = -100
CF1 = 10
CF2 = 60
CF3 = 80
Enter I/YR = 10, press NPV button to get NPVL = P18.78.
Rationale for the NPV Method
NPV
= PV of inflows – Cost
= Net gain in wealth
• If projects are independent, accept if the project NPV > 0.
• If projects are mutually exclusive, accept project with the highest positive NPV, one that adds the most
value.
• In this example, accept S if mutually exclusive (NPVS > NPVL), and accept both if independent.
Internal Rate of Return (IRR)
• IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:
• Solving for IRR with a financial calculator:
– Enter CFs in CFLO register.
– Press IRR; IRRL = 18.13% and IRRS = 23.56%.
• Solving for IRR with Excel:
=IRR(CF0:CFn,guess for rate)
How is a project’s IRR similar to a bond’s YTM?
• They are the same thing.
• Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project.
• EXAMPLE: Suppose a 10-year bond with a 9% annual coupon and P1,000 par value sells for
P1,134.20.
– Solve for IRR = YTM = 7.08%, the annual return for this project/bond.
Rationale for the IRR Method
• If IRR > WACC, the project’s return exceeds its costs and there is some return left over to boost
stockholders’ returns.
If IRR > WACC, accept project.
If IRR < WACC, reject project.
• If projects are independent, accept both projects, as both IRR > WACC = 10%.
• If projects are mutually exclusive, accept S, because IRRs > IRRL.
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NPV Profiles
Independent Projects
Mutually Exclusive Projects
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Finding the Crossover Rate
• Find cash flow differences between the projects. See Slide 12-7.
• Enter the DCFs in CFj register, then press n IRR. Crossover rate = 8.68%, rounded to 8.7%.
• If profiles don’t cross, one project dominates the other.
Reasons Why NPV Profiles Cross
• Size (scale) differences: The smaller project frees up funds at t = 0 for investment. The higher the
opportunity cost, the more valuable these funds, so a high WACC favors small projects.
• Timing differences: The project with faster payback provides more CF in early years for reinvestment.
If WACC is high, early CF especially good, NPVS > NPVL.
Reinvestment Rate Assumptions
• NPV method assumes CFs are reinvested at the WACC.
• IRR method assumes CFs are reinvested at IRR.
• Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the
best. NPV method should be used to choose between mutually exclusive projects.
• Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.
Managers prefer the IRR to the NPV method; is there a better IRR measure?
• Yes, MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of
costs. TV is found by compounding inflows at WACC.
• MIRR assumes cash flows are reinvested at the WACC.
Calculating MIRR
Why use MIRR versus IRR?
• MIRR assumes reinvestment at the opportunity cost = WACC. MIRR also avoids the multiple IRR
problem.
• Managers like rate of return comparisons, and MIRR is better for this than IRR.
This document is the property of PHINMA EDUCATION
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Module #19 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
What is the payback period?
• The number of years required to recover a project’s cost, or “How long does it take to get our money
back?”
• Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns
positive.
Calculating Payback
Discounted Payback Period
Strengths and Weaknesses of Payback
• Strengths
– Provides an indication of a project’s risk and liquidity.
– Easy to calculate and understand.
• Weaknesses
– Ignores the time value of money (TVM).
– Ignores CFs occurring after the payback period.
– No relationship between a given payback and investor wealth maximization.
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Module #19 Student Activity Sheet
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Date: _______________
Discounted payback considers TVM, but other 2 flaws remain.
Find Project P’s NPV and IRR
Multiple IRRs
Why are there multiple IRRs?
• At very low discount rates, the PV of CF2 is large and negative, so NPV < 0.
• At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0.
• In between, the discount rate hits CF2 harder than CF1, so NPV > 0.
• Result: 2 IRRs.
When to use the MIRR instead of the IRR? Accept Project P?
• When there are nonnormal CFs and more than one IRR, use MIRR.
– PV of outflows @ 10% = -P4,932.2314.
– TV of inflows @ 10% = P5,500.
– MIRR = 5.6%.
• Do not accept Project P.
– NPV = -P386.78 < 0.
– MIRR = 5.6% < WACC = 10%.
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Module #19 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Skill-building Activities (with answer key)
Tesar Chemicals is considering Projects S and L, whose cash flows are shown below. These projects are
mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion,
while the CFO advocates the NPV. If the decision is made by choosing the project with the higher IRR rather
than the one with the higher NPV, how much, if any, value will be forgone, i.e., what's the chosen NPV versus
the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions
the choice of IRR vs. NPV will have no effect on the value gained or lost.
WACC:
Year
CFS
CFL
7.50%
0
−P1,100
−P2,700
1
P550
P650
2
P600
P725
3
P100
P800
4
P100
P1,400
Solution
Answer
Yonan Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually
exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the shorter
payback, some value may be forgone. How much value will be lost in this instance? Note that under some
conditions choosing projects on the basis of the shorter payback will not cause value to be lost.
WACC:
Year
CFS
CFL
10.25%
0
−$950
−$2,100
1
$500
$400
2
$800
$800
This document is the property of PHINMA EDUCATION
3
$0
$800
4
$0
$1,000
FIN 072 | Financial Markets
Module #19 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Solution
Answer
Check for Understanding
True False Because "present value" refers to the value of cash flows that occur at different points in time,
a series of present values of cash flows should not be summed to determine the value of a
capital budgeting project.
True False Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project
whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount
rate than the NPV of a project whose cash flows come in later in its life.
True False Other things held constant, an increase in the cost of capital will result in a decrease in a
project's IRR.
True False The phenomenon called "multiple internal rates of return" arises when two or more mutually
exclusive projects that have different lives are being compared.
True False For a project with one initial cash outflow followed by a series of positive cash inflows, the
modified IRR (MIRR) method involves compounding the cash inflows out to the end of the
project's life, summing those compounded cash flows to form a terminal value (TV), and then
finding the discount rate that causes the PV of the TV to equal the project's cost.
C. LESSON WRAP-UP
Frequently Asked Questions
1. What are the 3 types of project risk?
• Stand-alone risk
• Corporate risk
• Market risk
2. What is stand-alone risk?
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•
•
•
Class number: ______
Date: _______________
The project’s total risk, if it were operated independently.
Usually measured by standard deviation (or coefficient of variation).
However, it ignores the firm’s diversification among projects and investors’ diversification among firms.
3. What is corporate risk?
• The project’s risk when considering the firm’s other projects, i.e., diversification within the firm.
• Corporate risk is a function of the project’s NPV and standard deviation and its correlation with the
returns on other firm projects.
4. What is market risk?
• The project’s risk to a well-diversified investor.
• Theoretically, it is measured by the project’s beta and it considers both corporate and stockholder
diversification.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Skill Building Activities
Problem A.
First, recognize that NPV makes theoretically correct capital budgeting decisions, so the highest NPV tells us
how much value could be added. We calculate the two projects' NPVs, IRRs, and MIRRs, but the MIRR
information is not needed for this problem. We then see what NPV would result if the decision were based on
the IRR (and the MIRR). The difference between the NPV is the loss incurred if the IRR criterion is used. Of
course, it's possible that IRR could choose the correct project.
0
1
2
3
4
TV
MIRR
Year
CFS
−$1,100
$550
$600
$100
$100
Compounded CFs:
673.77
686.94
107.00
100.00
$1,567.71 9.5469%
CF L
−$2,700
$650
$725
$800
$1,400
Compounded CFs:
796.28
830.05
856.00
1400.00
$3,882.33 9.6663%
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Module #19 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
MIRR, L = 9.67%
MIRR, S = 9.55%
MIRR Choice: L
NPV using MIRR: $224.31
IRR, L = 10.71181%
IRR, S = 12.24157%
IRR Choice: S
NPV using IRR: $86.20
Lost value using IRR versus MIRR: $138.10
Lost value using MIRR versus NPV: $0.00
Lost value using IRR versus NPV: $138.10
Problem B.
WACC:
Year
CFS
CFL
Cumulative CF, S
Cumulative CF, L
Payback S = 1.56
Payback L = 3.10
NPV, L =
NPV, S =
Value lost
10.250%
0
−$950
−$2,100
−$950
−$2,100
−
−
Class number: ______
Date: _______________
NPV, L = $224.3065
NPV, S = $86.2036
NPV Choice: L
NPV using NPV: $224.31
Loss below: 7.9850%
Loss below: 10.1638%
Loss below: 10.1638%
Crossover = 11.093%
1
2
$500
$800
$400
$800
−$450
$350
−$1,700
−$900
−
1.56
−
−
3
$0
$800
$350
−$100
−
−
4
$0
$1,000
$350
$900
−
3.10
$194.79
$161.68
$ 33.11
Note that the WACC is not constrained to be less than the crossover point, so there may not be a conflict
between NPV and payback, hence following the IRR rule may not result in a loss of value, so the correct
answer may be $0.00.
Check for Understanding
False
Because "present value" refers to the value of cash flows that occur at different points in time,
a series of present values of cash flows should not be summed to determine the value of a
capital budgeting project.
False
Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project
whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount
rate than the NPV of a project whose cash flows come in later in its life.
False
Other things held constant, an increase in the cost of capital will result in a decrease in a
project's IRR.
False
The phenomenon called "multiple internal rates of return" arises when two or more mutually
exclusive projects that have different lives are being compared.
True
For a project with one initial cash outflow followed by a series of positive cash inflows, the
modified IRR (MIRR) method involves compounding the cash inflows out to the end of the
project's life, summing those compounded cash flows to form a terminal value (TV), and then
finding the discount rate that causes the PV of the TV to equal the project's cost.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #20, 21 & 22 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Capital Budgeting Part 2 and 3
Graded Quiz 4
Learning Targets:
At the end of this module, I should have:
1. Applied the importance of cash flows in solving the capital
budgeting problems;
2. Enumerated and described types of risk; and
3. Performed risk analysis.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
Schweser. (2012). Schwesernotes
CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
Complete the Venn Diagram comparing the differences and similarities of Net Present Value Method and
Internal Rate of Return Method in solving capital budgeting problems?
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Module #20, 21 & 22 Student Activity Sheet
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Section: ____________ Schedule: _______________________________________
B. MAIN LESSON
Content and Skill-Building (40 mins)
Proposed Project
• Total depreciable cost
– Equipment: P200,000
– Shipping and installation: P40,000
• Changes in net operating working capital
– Inventories will rise by P25,000
– Accounts payable will rise by P5,000
• Effect on operations
– New sales: 100,000 units/year @ P2/unit
– Variable cost: 60% of sales
• Life of the project
– Economic life: 4 years
– Depreciable life: MACRS 3-year class
– Salvage value: P25,000
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Class number: ______
Date: _______________
FIN 072 | Financial Markets
Module #20, 21 & 22 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
•
•
Class number: ______
Date: _______________
Tax rate: 40%
WACC: 10%
Determining Project Value
• Estimate relevant cash flows
– Calculating annual operating cash flows.
– Identifying changes in net operating working capital.
– Calculating terminal cash flows: after-tax salvage value and recovery of NOWC.
Initial Year Investment Outlays
• Find NOWC.
–  in inventories of P25,000
– Funded partly by an  in A/P of P5,000
– NOWC = P25,000 – P5,000 = P20,000
• Initial year outlays:
Equipment cost
-P200,000
Installation
-40,000
CAPEX
-240,000
NOWC
-20,000
FCF0
-P260,000
Determining Annual Depreciation Expense
Year Rate x
Basis
Deprec.
1
0.33 x
P240
P 79
2
0.45 x
240
108
3
0.15 x
240
36
4
0.07 x
240
17
1.00
P240
Due to the MACRS ½-year convention, a 3-year asset is depreciated over 4 years.
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Module #20, 21 & 22 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Project Operating Cash Flows
Terminal Cash Flows
Terminal Cash Flows
Q. How is NOWC recovered?
Q. Is there always a tax on SV?
Q. Is the tax on SV ever a positive cash flow?
Should financing effects be included in cash flows?
• No, dividends and interest expense should not be included in the analysis.
• Financing effects have already been taken into account by discounting cash flows at the WACC of
10%.
• Deducting interest expense and dividends would be ―double counting‖ financing costs.
Should a P50,000 improvement cost from the previous year be included in the analysis?
• No, the building improvement cost is a sunk cost and should not be considered.
• This analysis should only include incremental investment.
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Module #20, 21 & 22 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
If the facility could be leased out for P25,000 per year, would this affect the analysis?
• Yes, by accepting the project, the firm foregoes a possible annual cash flow of P25,000, which is an
opportunity cost to be charged to the project.
• The relevant cash flow is the annual after-tax opportunity cost.
A-T opportunity cost:
= P25,000(1 – T)
= P25,000(0.6)
= P15,000
If the new product line decreases the sales of the firm’s other lines, would this affect the analysis?
• Yes. The effect on other projects’ CFs is an ―externality.‖
• Net CF loss per year on other lines would be a cost to this project.
• Externalities can be positive (in the case of complements) or negative (substitutes).
Proposed Project’s Cash Flow Time Line
If this were a replacement rather than a new project, would the analysis change?
• Yes, the old equipment would be sold, and new equipment purchased.
• The incremental CFs would be the changes from the old to the new situation.
• The relevant depreciation expense would be the change with the new equipment.
• If the old machine was sold, the firm would not receive the SV at the end of the machine’s life. This is
the opportunity cost for the replacement project.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #20, 21 & 22 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Skill-building Activities (with answer key)
Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment
has a 3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1
through 4. Revenues and other operating costs are expected to be constant over the project's 10-year
expected operating life. What is the project's Year 4 cash flow?
Equipment cost (depreciable basis)
Sales revenues, each year
Operating costs (excl. depreciation)
Tax rate
P70,000
P42,500
P25,000
35.0%
Solution
Answer
Check for Understanding
True False Although it is extremely difficult to make accurate forecasts of the revenues that a project will
generate, projects' initial outlays and subsequent costs can be forecasted with great accuracy.
This is especially true for large product development projects.
True False Since the focus of capital budgeting is on cash flows rather than on net income, changes in
noncash balance sheet accounts such as inventory are not included in a capital budgeting
analysis.
True False Any cash flows that can be classified as incremental to a particular project—i.e., results
directly from the decision to undertake the project—should be reflected in the capital
budgeting analysis.
True False The primary advantage to using accelerated rather than straight-line depreciation is that with
accelerated depreciation the present value of the tax savings provided by depreciation will be
higher, other things held constant.
True False Accelerated depreciation has an advantage for profitable firms in that it moves some cash
flows forward, thus increasing their present value. On the other hand, using accelerated
depreciation generally lowers the reported current year's profits because of the higher
depreciation expenses. However, the reported profits problem can be solved by using
different depreciation methods for tax and stockholder reporting purposes.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #20, 21 & 22 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Graded Quiz 4
1
2
3
4
5
Class number: ______
Date: _______________
6
7
8
9
10
1. Van Auken Inc. is considering a project that has the following cash flows:
Year
Cash Flow
0
P1,000
1
400
2
300
3
500
4
400
The company's WACC is 10%. What are the project's payback, internal rate of return, and net present value?
a. Payback = 2.4; IRR = 10.00%; NPV = P600.
b. Payback = 2.4; IRR = 21.22%; NPV = P260.
c. Payback = 2.6; IRR = 21.22%; NPV = P300.
d. Payback = 2.6; IRR = 21.22%; NPV = P260.
e. Payback = 2.6; IRR = 24.12%; NPV = P300.
2. O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity
from retained earnings based on the CAPM?
3. Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 =
P0.67; P0 = P27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the
DCF approach?
4. Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have
been provided with the following data: D1 = P1.45; P0 = P22.50; and g = 6.50% (constant). Based on the DCF
approach, what is the cost of equity from retained earnings?
5. Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of
15%, while Project L's IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the
following statements is CORRECT?
a. If the WACC is 10%, both projects will have positive NPVs.
b. If the WACC is 6%, Project S will have the higher NPV.
c. If the WACC is 13%, Project S will have the lower NPV.
d. If the WACC is 10%, both projects will have a negative NPV.
e. Project S's NPV is more sensitive to changes in WACC than Project L's.
This document is the property of PHINMA EDUCATION
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Module #20, 21 & 22 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
6. You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15%
preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the
cost of retained earnings is 12.00%. The firm will not be issuing any new stock. What is its WACC?
7. Lasik Vision Inc. recently analyzed the project whose cash flows are shown below. However, before Lasik
decided to accept or reject the project, the Federal Reserve took actions that changed interest rates and
therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the
change in the WACC affect the project's forecasted NPV? Note that a project's projected NPV can be negative,
in
which
case
it
should
be
rejected.
Old WACC:
8.00%
New WACC: 9.75%
Year
Cash flows
0
−P1,000
1
P410
2
P410
3
P410
8. You were hired as a consultant to Kroncke Company, whose target capital structure is 40% debt, 10%
preferred, and 50% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and
the cost of retained earnings is 13.25%. The firm will not be issuing any new stock. What is its WACC?
9. Edelman Electric Systems is considering a project that has the following cash flow and WACC data. What is
the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in
which case it will be rejected.
WACC: 10.00%
Year:
0
1
2
3
Cash Flows
P800
P350
P350
P350
10. Lovely Services is now at the end of the final year of a project. The equipment originally cost P26,500, of
which 75% has been depreciated. The firm can sell the used equipment today for P6,000, and its tax rate is
40%. What is the equipment's after-tax salvage value for use in a capital budgeting analysis? Note that if the
equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the
sale.
C. LESSON WRAP-UP
Frequently Asked Questions
1. Which type of risk is most relevant?
• Market risk is the most relevant risk for capital projects, because management’s primary goal is
This document is the property of PHINMA EDUCATION
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Module #20, 21 & 22 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
•
Class number: ______
Date: _______________
shareholder wealth maximization.
However, since corporate risk affects creditors, customers, suppliers, and employees, it should not be
completely ignored.
2. What is sensitivity analysis?
• Sensitivity analysis measures the effect of changes in a variable on the project’s NPV.
• To perform a sensitivity analysis, all variables are fixed at their expected values, except for the variable
in question which is allowed to fluctuate.
• Resulting changes in NPV are noted.
3. What are the advantages and disadvantages of sensitivity analysis?
• Advantage
– Identifies variables that may have the greatest potential impact on profitability and allows
management to focus on these variables.
• Disadvantages
– Does not reflect the effects of diversification.
– Does not incorporate any information about the possible magnitude of the forecast errors.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review
CATEGORY
Content
Accuracy
Success Criteria
4 points
3 points
2 points
1 point
The paper contains The paper contains The paper contains at The paper contains
at least 5 accurate at least 3-4 accurate least 1-2 accurate facts no accurate facts
facts about the facts about the topic. about the topic.
about the topic.
topic.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #20, 21 & 22 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Grammar &
Spelling
(Conventions)
Sentences and
Paragraphs
Ideas
Class number: ______
Date: _______________
Writer makes no Writer makes 1-3 Writer
makes
4-6 Writer makes more
errors in grammar errors in grammar errors in grammar than 6 errors in
or spelling.
and/or spelling.
and/or spelling.
grammar
and/or
spelling.
Sentences
and All Sentences and Most sentences are Many
sentence
paragraphs
are paragraphs
are complete and well- fragments or run
complete,
well- complete,
well- constructed.
sentences
or
constructed and of constructed
(no Paragraphing
needs paragraphing need
varied structure
fragments, no run- some work.
lot of work.
ons). Paragraph is
generally done well.
Ideas
were Ideas
were Ideas were somewhat The paper seemed
expressed in a expressed in a clear organized but were not be a collection of
clear
and manner,
but
the noticeably clear. It unrelated sentences.
organized fashion. organization
could looks more than one It was difficult to
It was easy to have been better.
reading to figure out figure out what the
figure out what the
what was the paper paper was about.
paper was about.
was about.
Skill Building Activity
Answer: P13,090
Check for Understanding
False
Although it is extremely difficult to make accurate forecasts of the revenues that a project will
generate, projects' initial outlays and subsequent costs can be forecasted with great
accuracy. This is especially true for large product development projects.
False
Since the focus of capital budgeting is on cash flows rather than on net income, changes in
noncash balance sheet accounts such as inventory are not included in a capital budgeting
analysis.
True
Any cash flows that can be classified as incremental to a particular project—i.e., results
directly from the decision to undertake the project—should be reflected in the capital
budgeting analysis.
True
The primary advantage to using accelerated rather than straight-line depreciation is that with
accelerated depreciation the present value of the tax savings provided by depreciation will be
higher, other things held constant.
True
Accelerated depreciation has an advantage for profitable firms in that it moves some cash
flows forward, thus increasing their present value. On the other hand, using accelerated
depreciation generally lowers the reported current year's profits because of the higher
depreciation expenses. However, the reported profits problem can be solved by using
different depreciation methods for tax and stockholder reporting purposes.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #23 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Dividend Policy
Learning Targets:
At the end of this module, I should have:
1. Described the dividend policy;
2. Explained the dividend theories;
3. Solved problems using Residual Dividend Model; and
4. Applied the effects of stock dividends, stock splits, and stock
repurchases.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
Schweser. (2012). Schwesernotes
CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
Clemson Software is considering a new project whose data are shown below. The required equipment has a 3year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years.
Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the
project's Year 1 cash flow?
Equipment cost (depreciable basis)
Straight-line depreciation rate
Sales revenues, each year
Operating costs (excl. depreciation)
Tax rate
P65,000
33.333%
P60,000
P25,000
35.0%
Solution
Answer
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FIN 072 | Financial Markets
Module #23 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
B. MAIN LESSON
Content and Skill-Building (40 mins)
What is dividend policy?
• The decision to pay out earnings versus retaining and reinvesting them.
• Dividend policy includes
– High or low dividend payout?
– Stable or irregular dividends?
– How frequent to pay dividends?
– Announce the policy?
Dividend Irrelevance Theory
• Investors are indifferent between dividends and retention-generated capital gains.
• Investors can create their own dividend policy
– If they want cash, they can sell stock.
– If they don’t want cash, they can use dividends to buy stock.
• Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes or brokerage costs),
hence may not be true. Need an empirical test.
Why Investors Might Prefer Dividends
• May think dividends are less risky than potential future capital gains.
• If so, investors would value high-payout firms more highly, i.e., a high payout would result in a high P0.
Why Investors Might Prefer Capital Gains
• May want to avoid transactions costs
• Maximum tax rate is the same as on dividends, but …
– Taxes on dividends are due in the year they are received, while taxes on capital gains are due
whenever the stock is sold.
– If an investor holds a stock until his/her death, beneficiaries can use the date of the death as the
cost basis and escape all previously accrued capital gains.
What’s the information content, or signaling, hypothesis?
• Investors view dividend increases as signals of management’s view of the future.
– Since managers hate to cut dividends, they won’t raise dividends unless they think the increase
is sustainable.
• However, a stock price increase at the time of a dividend increase could reflect higher expectations for
future EPS, not a desire for dividends.
What’s the clientele effect?
• Different groups of investors, or clienteles, prefer different dividend policies.
• Firm’s past dividend policy determines its current clientele of investors.
• Clientele effects impede changing dividend policy. Taxes and brokerage costs hurt investors who have
to switch companies.
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FIN 072 | Financial Markets
Module #23 Student Activity Sheet
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Class number: ______
Date: _______________
What’s catering theory?
• A theory that suggests that investors’ preference for dividends varies over time and that corporations
adapt their dividend policy to cater to the current desires of investors.
– Corporate managers are more likely to initiate dividends when dividend-paying stocks are in
favor.
– Corporate managers are more likely to omit dividends when capital gains are preferred.
The Residual Dividend Model
• Find the retained earnings needed for the capital budget.
• Pay out any leftover earnings (the residual) as dividends.
• This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.
Residual Dividend Model
Residual Dividend Model: Calculating Dividends Paid
• Calculate portion of capital budget to be funded by equity.
– Of the P800,000 capital budget, 0.6(P800,000) = P480,000 will be funded with equity.
• Calculate excess or need for equity capital.
– There will be P600,000 – P480,000 = P120,000 left over to pay as dividends.
• Calculate dividend payout ratio.
– P120,000/P600,000 = 0.20 = 20%.
Residual Dividend Model: What if net income drops to P400,000? Rises to P800,000?
• If NI = P400,000 …
Dividends = P400,000 – (0.6)(P800,000) = -P80,000.
Since the dividend results in a negative number, the firm must use all of its net income to fund its budget, and
probably should issue equity to maintain its target capital structure.
Payout = P0/P400,000 = 0%.
• If NI = P800,000 …
Dividends = P800,000 – (0.6)(P800,000) = P320,000.
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Module #23 Student Activity Sheet
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Class number: ______
Date: _______________
Payout = P320,000/P800,000 = 40%.
How would a change in investment opportunities affect dividends under the residual policy?
• Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout.
• More good investments would lead to a lower dividend payout.
Comments on Residual Dividend Policy
• Advantage
– Minimizes new stock issues and flotation costs.
• Disadvantages
– Results in variable dividends
– Sends conflicting signals
– Increases risk
– Doesn’t appeal to any specific clientele.
• Conclusion: Consider residual policy when setting long-term target payout, but don’t follow it rigidly
from year to year.
Setting Dividend Policy
• Forecast capital needs over a planning horizon, often 5 years.
• Set a target capital structure.
• Estimate annual equity needs.
• Set target payout based on the residual model.
• Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital
structure somewhat if necessary.
What’s a dividend reinvestment plan (DRIP)?
• Shareholders can automatically reinvest their dividends in shares of the company’s common stock. Get
more stock than cash.
• There are two types of plans:
– Open market
– New stock
Open Market Purchase Plan
• Pesos to be reinvested are turned over to trustee, who buys shares on the open market.
• Brokerage costs are reduced by volume purchases.
• Convenient, easy way to invest, thus useful for investors.
New Stock Plan
• Firm issues new stock to DRIP enrollees (usually at a discount from the market price), keeps money
and uses it to buy assets.
• Firms that need new equity capital use new stock plans.
• Firms with no need for new equity capital use open market purchase plans.
• Most NYSE listed companies have a DRIP. Useful for investors.
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Module #23 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Stock Dividends vs. Stock Splits
• Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares for
each 100 shares owned.
• Stock split: Firm increases the number of shares outstanding, say 2:1. Sends shareholders more
shares.
Stock Dividends vs. Stock Splits
• Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided
into smaller pieces.”
• Unless the stock dividend or split conveys information, or is accompanied by another event like higher
dividends, the stock price falls so as to keep each investor’s wealth unchanged.
• But splits/stock dividends may get us to an “optimal price range.”
When and why should a firm consider splitting its stock?
• There’s a widespread belief that the optimal price range for stocks is P20 to P80. Stock splits can be
used to keep the price in this optimal range.
• Stock splits generally occur when management is confident, so are interpreted as positive signals.
• On average, stocks tend to outperform the market in the year following a split.
Skill-building Activities (with answer key)
Del Grasso Fruit Company has more positive NPV projects than it can finance under its current policies without
issuing new stock, but its board of directors had decreed that it cannot issue any new shares in the foreseeable
future. Your boss, the CFO, wants to know how the capital budget would be affected by changes in capital
structure policy and/or the target dividend payout policy. You obtained the following data, which shows the
firm's projected net income (NI), its current capital structure and dividend payout policies, and three possible
new policies. Projected net income for the coming year will not be affected by a policy change. How much
larger could the capital budget be if (1) the target debt ratio were raised to the indicated amount, other things
held constant, (2) the target payout ratio were lowered to the indicated amount, other things held constant, or
(3) the debt ratio and dividend payout were both changed by the indicated amounts?
Projected NI
% Debt
% Equity
% Payout
Current
Policy
P175.0
25.0%
75.0%
65.0%
______________
Increase Debt
P175.0
75.0%
25.0%
65.0%
This document is the property of PHINMA EDUCATION
Policy Changes
Lower Payout
P175.0
25.0%
75.0%
20.0%
___________
Do Both
P175.0
75.0%
25.0%
20.0%
FIN 072 | Financial Markets
Module #23 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Solutions
Answers:
(1)
(2)
(3)
Check for Understanding
True False Other things held constant, the higher a firm's target payout ratio, the higher its expected
growth rate should be.
True False If investors prefer firms that retain most of their earnings, then a firm that wants to maximize
its stock price should set a low payout ratio.
True False One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend
yield must be offset by a more than proportionate increase in growth in order to keep a firm's
required return constant, other things held constant.
True False Some investors prefer dividends to retained earnings (and the capital gains retained earnings
bring), while others prefer retained earnings to dividends. Other things held constant, it makes
sense for a company to establish its dividend policy and stick to it, and then it will attract a
clientele of investors who like that policy.
True False If the information content, or signaling, hypothesis is correct, then a change in a firm's
dividend policy can have an important effect on its stock price and cost of equity.
C. LESSON WRAP-UP
Frequently Asked Questions
1. What are stock repurchases?
Stock Repurchases
• Buying own stock back from stockholders
• Reasons for repurchases:
– As an alternative to distributing cash as dividends.
– To make a large capital structure change.
– To obtain stock for use when options are exercised.
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Module #23 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
2. What are the advantages of repurchases?
Advantages of Repurchases
• Stockholders can tender or not.
• Helps avoid setting a high dividend that cannot be maintained.
• Repurchased stock can be used in takeovers or resold to raise cash as needed.
• Remove a large block of stock “overhanging” the market and depressing the stock price.
• Stockholders may take as a positive signal; management thinks stock is undervalued.
3. What are the disadvantages of repurchases?
Disadvantages of Repurchases
• May be viewed as a negative signal (firm has poor investment opportunities).
• IRS could impose penalties if repurchases were primarily to avoid taxes on dividends.
• Selling stockholders may not be well informed, hence be treated unfairly.
• Firm may have to bid up price to complete purchase, thus paying too much for its own stock.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review
Equipment life, years
Equipment cost
Depreciation: Rate = 33.333%
Sales revenues
− Basis × rate = depreciation
− Operating costs (excl. deprec.)
Operating income (EBIT)
− Taxes
Rate = 35.0%
EBIT(1 − T)
+ Depreciation
Cash flow, Year 1
3
P65,000
P21,667
P60,000
21,667
25,000
P13,333
4,667
P 8,667
21,667
P30,333
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Module #23 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Skill Building Activity
Current
Found as:
Maximum
NI
Given
% Debt
"
% Equity
"
% Payout
"
Dividends
Payout % × NI
Ret. earnings, RE NI − Dividends
Max. cap. budget RE/% Equity
Increase: New max. − Current max. =
Percentage increase:
New max./Current max. − 1.0 =
New Maximum If
Increase Debt
P175.0
25.0%
75.0%
65.0%
P113.8
P61.3
P81.7
Class number: ______
Date: _______________
New Maximum IfNew Maximum If
Lower Payout
Do Both
P175.0
P175.0
P175.0
75.0%
25.0%
75.0%
25.0%
75.0%
25.0%
65.0%
20.0%
20.0%
P113.8
P35.0
P35.0
P61.3
P140.0
P140.0
P245.0
P186.7
P560.0
P163.3
200.0%
P105.0 P478.3
128.6%
585.7%
Answer: P163.3; P105.0; P478.3
Check for Understanding
False
Other things held constant, the higher a firm's target payout ratio, the higher its expected
growth rate should be.
True
If investors prefer firms that retain most of their earnings, then a firm that wants to maximize
its stock price should set a low payout ratio.
True
One implication of the bird-in-the-hand theory of dividends is that a given reduction in
dividend yield must be offset by a more than proportionate increase in growth in order to keep
a firm's required return constant, other things held constant.
True
Some investors prefer dividends to retained earnings (and the capital gains retained earnings
bring), while others prefer retained earnings to dividends. Other things held constant, it
makes sense for a company to establish its dividend policy and stick to it, and then it will
attract a clientele of investors who like that policy.
True
If the information content, or signaling, hypothesis is correct, then a change in a firm's
dividend policy can have an important effect on its stock price and cost of equity.
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #24 & 25 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Lesson Title: Risk Management and Derivatives
Learning Targets:
At the end of this module, I should have:
1. Described the motivations for risk management;
2. Applied the fundaments of risk management in solving
problems.
Materials:
Calculator,
textbook
Class number: ______
Date: _______________
reviewer
notebook,
References:
Timbang, F. (2016). Financial
Management Part 2. Quezon City:
C & E Publishing, Inc.
Brigham, E. F., Houston, J. F.,
Hsu, J.-M., Kong, Y. K., & BanyAriffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.
Schweser. (2012). Schwesernotes
CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.
A. LESSON PREVIEW/REVIEW
Welcome back! Let us review the lesson on the previous day.
Complete the diagram. How to set dividend policy?
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Module #24 & 25 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
B. MAIN LESSON
Content and Skill-Building (40 mins)
Why might stockholders be indifferent to whether a firm reduces the volatility of its cash flows?
• Diversified shareholders may already be hedged against various types of risk.
• Reducing volatility increases firm value only if it leads to higher expected cash flows and/or a reduced
WACC.
Reasons That Corporations Engage in Risk Management
• Reduced volatility reduces bankruptcy risk, which enables the firm to increase its debt capacity.
• By reducing the need for external equity, firms can maintain their optimal capital budget.
• Reduced volatility helps avoid financial distress costs.
• Managers have a comparative advantage in hedging certain types of risk.
• Reduced volatility reduces the costs of borrowing.
• Reduced volatility reduces the higher taxes that result from fluctuating earnings.
• Certain compensation schemes reward managers for achieving stable earnings.
What is an option?
• A contract that gives its holder the right, but not the obligation, to buy (or sell) an asset at some
predetermined price within a specified period of time.
• It’s important to remember:
– It does not obligate its owner to take action.
– It merely gives the owner the right to buy or sell an asset.
Option Terminology
• Call option: an option to buy a specified number of shares of a security within some future period.
• Put option: an option to sell a specified number of shares of a security within some future period.
• Exercise (or strike) price: the price stated in the option contract at which the security can be bought or
sold.
• Option price: option contract’s market price.
• Expiration date: the date the option expires.
• Exercise value: the value of an option if it were exercised today (Current stock price – Strike price).
• Covered option: an option written against stock held in an investor’s portfolio.
• Naked (uncovered) option: an option written without the stock to back it up.
• In-the-money call: a call option whose exercise price is less than the current price of the underlying
stock.
• Out-of-the-money call: a call option whose exercise price exceeds the current stock price.
• Long-term Equity AnticiPation Securities (LEAPS): similar to normal options, but they are longer-term
options with maturities of up to 2½ years.
Option Example
• A call option with an exercise price of P25, has the following values at these prices:
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Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Determining Option Exercise Value and Option Premium
How does the option premium change as the stock price increases?
• The premium of the option price over the exercise value declines as the stock price increases.
• This is due to the declining degree of leverage provided by options as the underlying stock price
increases, and the greater loss potential of options at higher option prices.
Call Premium Diagram
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Module #24 & 25 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
What are the assumptions of the Black-Scholes Option Pricing Model?
• The stock underlying the call option pays no dividends during the call option’s life.
• There are no transactions costs for the sale/purchase of either the stock or the option.
• Unlimited borrowing and lending at the short-term, risk-free rate (rRF), which is known and constant.
• No penalty for short selling and sellers receive immediately full cash proceeds at today’s price.
• Option can only be exercised on its expiration date.
• Security trading takes place in continuous time, and stock prices move randomly in continuous time.
Using the Black-Scholes Option Pricing Model

  2 
ln(P/X)  rRF   ( t )
 2 

d1 
σ t
d2  d1  σ t
V  P[N(d1 )]  Xe -rRF t [N(d2 )]
Use the B-S OPM to Find the Option Value of a Call Option
Solving for Option Value
V  P[N(d1 )]  Xe rRF t [N(d2 )]
V  $27[0.7168]  $25e ( 0.06 )( 0.5 ) [0.6327]
V  $4.0036
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Module #24 & 25 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Create a Riskless Hedge to Determine Value of a Call Option
Create a Riskless Hedge to Determine Value of a Call Option
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Class number: ______
Date: _______________
FIN 072 | Financial Markets
Module #24 & 25 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
How do the factors of the B-S OPM affect a call option’s value?
Forward and Futures Contracts
• Forward contract: one party agrees to buy a commodity at a specific price on a future date and the
counterparty agrees to make the sale. There is physical delivery of the commodity.
• Futures contract: standardized, exchange-traded contracts in which physical delivery of the underlying
asset does not actually occur.
– Commodity futures
– Financial futures
Swaps
• The exchange of cash payment obligations between two parties, usually because each party prefers
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Module #24 & 25 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
•
Class number: ______
Date: _______________
the terms of the other’s debt contract.
– Fixed for floating
– Floating for fixed
Swaps can reduce each party’s financial risk.
Definitions of Different Types of Risk
• Speculative risks: offer the chance of a gain as well as a loss.
• Pure risks: offer only the prospect of a loss.
• Demand risks: risks associated with the demand for a firm’s products or services.
• Input risks: risks associated with a firm’s input costs.
• Financial risks: result from financial transactions.
• Property risks: risks associated with loss of a firm’s productive assets.
• Personnel risk: result from human actions.
• Environmental risk: risk associated with polluting the environment.
• Liability risks: connected with product, service, or employee liability.
• Insurable risks: risks that typically can be covered by insurance.
What are the three steps of corporate risk management?
1. Identify the risks faced by the firm.
2. Measure the potential impact of the identified risks.
3. Decide how each relevant risk should be handled.
Skill-building Activities (with answer key)
1. A 6-month call option on Romer Technologies' stock has a strike price of P45 and sells in the market for
P8.25. Romer's current stock price is P48. What is the exercise value of the option?
Solution
Answer:
2. A 6-month call option on Meyers Inc.'s stock has a strike price of P45 and sells in the market for P8.25.
Meyers' current stock price is P48. What is the option premium?
Solution
Answer:
3. A 6-month put option on Makler Corp.'s stock has a strike price of P45 and sells in the market for P8.90.
Makler's current stock price is P41. What is the exercise value of the option?
Solution
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Module #24 & 25 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
Answer:
4. A 6-month put option on Smith Corp.'s stock has a strike price of P45 and sells in the market for P8.90.
Smith's current stock price is P41. What is the option premium?
Solution
Answer:
5. Lissa Co.'s stock price is currently P30.25. A 6-month call option on Lissa's stock has a strike price of P25
and has an expected volatility of 40% (i.e., expected standard deviation = 40%). The risk-free rate is 6%.
According to the Black-Scholes option pricing model, what is the value of the option?
Solution
Answer:
Check for Understanding
True False Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as
a loss, while pure risks are those that can only lead to losses.
True False One objective of risk management can be to reduce the volatility of a firm's cash flows.
True False In theory, reducing the volatility of its cash flows will always increase a company's value.
True False Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap
cannot reduce actual net interest expenses.
True False The two basic types of hedges involving the futures market are long hedges and short
hedges, where the words "long" and "short" refer to the maturity of the hedging instrument.
For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month
T-bills.
C. LESSON WRAP-UP
Frequently Asked Questions
1. What is hedging?
• Hedging is usually used when a price change could negatively affect a firm’s profits.
– Long hedge: involves the purchase of a futures contract to guard against a price increase.
– Short hedge: involves the sale of a futures contract to protect against a price decline.
2. How can commodity futures markets be used to reduce input price risk?
• The purchase of a commodity futures contract will allow a firm to make a future purchase of the input at
today’s price, even if the market price on the item has risen substantially in the interim.
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FIN 072 | Financial Markets
Module #24 & 25 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Class number: ______
Date: _______________
3. What is corporate risk management, and why is it important to all firms?
• Corporate risk management relates to the management of unpredictable events that would have
adverse consequences for the firm.
• All firms face risks, but the lower those risks can be made, the more valuable the firm, other things held
constant. Of course, risk reduction has a cost.
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________
KEY TO CORRECTIONS
Review
CATEGORY
Content
Accuracy
Grammar &
Spelling
(Conventions)
4 points
The paper contains
at least 5 accurate
facts about the
topic.
Writer makes no
errors in grammar
or spelling.
Sentences and
Paragraphs
Sentences
and
paragraphs
are
complete,
wellconstructed and of
varied structure
Ideas
Ideas
expressed
clear
were
in a
and
Success Criteria
3 points
2 points
1 point
The paper contains The paper contains at The paper contains
at least 3-4 accurate least 1-2 accurate facts no accurate facts
facts about the topic. about the topic.
about the topic.
Writer makes 1-3 Writer
makes
4-6 Writer makes more
errors in grammar errors in grammar than 6 errors in
and/or spelling.
and/or spelling.
grammar
and/or
spelling.
All Sentences and Most sentences are Many
sentence
paragraphs
are complete and well- fragments or run
complete,
well- constructed.
sentences
or
constructed
(no Paragraphing
needs paragraphing need
fragments, no run- some work.
lot of work.
ons). Paragraph is
generally done well.
Ideas
were Ideas were somewhat The paper seemed
expressed in a clear organized but were not be a collection of
manner,
but
the noticeably clear. It unrelated sentences.
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FIN 072 | Financial Markets
Module #24 & 25 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
organized fashion. organization
could
It was easy to have been better.
figure out what the
paper was about.
Class number: ______
Date: _______________
looks more than one It was difficult to
reading to figure out figure out what the
what was the paper paper was about.
was about.
Skill Building Activities
1.
Strike price
P45.00
Option value
P8.25
Stock price
P48.00
Exercise value = Current price of stock − Strike price Exercise value = P48.00 − P45 Exercise value = P3.00
2.
Strike price
P45.00
Option value
P8.25
Stock price
P48.00
Exercise value = Current price of stock − Strike price Exercise value = P48.00 − P45 Exercise value = P3.00
Option premium = Option value − Exercise value Option premium = P8.25 − P3.00 Option premium = P5.25
3.
Strike price
Option value
Stock price
Put exercise value = Strike price −
value = P4.00
P45.00
P8.90
P41.00
Current price of stock Put exercise value = P45.00 − P41.00 Put exercise
4.
Strike price
P45.00
Option value
P8.90
Stock price
P41.00
Exercise value = Strike price − Current price of stock Exercise value = P45.00 − P41 Exercise value = P4.00
Option premium = Option value − Exercise value Option premium = P8.90 − P4.00 Option premium = P4.90
5.
Stock price, P
Strike price, X
rRF
Time to expiration
Std deviation
P30.25
P25.00
0.06
0.50
0.40
d1
N(d1)
d2
N(d2)
0.9214
0.8216
0.6386
0.7385
This document is the property of PHINMA EDUCATION
FIN 072 | Financial Markets
Module #24 & 25 Student Activity Sheet
Name: _________________________________________________________________
Section: ____________ Schedule: _______________________________________
Option value
= P30.25(0.8216) −P25e−0.03(0.7385)
= P24.8534 − P17.9169
= P6.9365 ≈ P6.94
This document is the property of PHINMA EDUCATION
Class number: ______
Date: _______________