Quote from Siri…
 “I hate the way they teach Math in the school. All the
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teacher does is put lots of examples on the board for
the students to memorize.
He does not explain the theory so that we could apply
the theory to ANY numbers rather than memorizing
10 problems without understanding.
I much prefer learning why and how and working
different problems hands on, like at my school at
home, rather than memorizing specific problems that
I’ll never see after school”
17-year old Exchange Student from Finland at Shullsburg High (home of the
“Miners”), Shullsburg, WI
1
Business 173A:
Intermediate Financial Management
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Professor Introduction
COB Policies Review/Professor Policies Review
Schedule/Requirements Review/Key Dates
Course Grading
Roll call and Student Intros
Finance Overview and Risk Return Tradeoff Review
Reminder: You MUST change your WebCT password
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Professor Contact Information
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Anu Vuorikoski
WebCT E-mail: Response usually same day,
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guaranteed within 24hrs.
Web page: Go to Faculty home pages/V
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Office: Business Tower (BT) 961
Physical Office hours (e-mail works) :
As I live 148 miles away, only on campus M/W:
12:00a-1:20p and 4:20-5:20p in Office
Informal time before 12:00 as traffic allows
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Professor Background
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Teaching at SJSU since Spring 98
-Undergraduate: 170, 173A, 173B, 177
-MBA: Intro and High Tech Financial Analysis
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Have continued teaching because of letters/e-mail I get “long after”
Teaching in corporate settings prior to that
Formerly CFO of venture firm, start-up etc, and big company
corporate finance AND Logistics/supply chain re-engineering, AND
project management assignments
Consulting (Bain, McKinsey, Touche Ross) and for start-ups
MBA - Harvard, BA - Williams College
CMA, CPIM, CIRM, PMP (all inactive)
20+ yrs global experience: Finance, Business Development,
Logistics, Consulting, etc.
Always real world focus even when students want “easier”
4
COB Policies Review
B. College of Business Policies and Procedures, which will be enforced.
To ensure that every student, current and future, who takes courses in the Boccardo Business Center has the opportunity
to experience an environment that is safe, attractive, and otherwise conducive to learning, the College of Business at
San José State has established the following policies:
Eating
Eating and drinking (except water) are prohibited in the Boccardo Business Center. Students with food will be asked to
leave the building. Students who disrupt the course by eating and do not leave the building will be referred to the
Judicial Affairs Officer of the University.
Cell Phones
Students will turn their cell phones off or put them on vibrate mode while in class. They will not answer their phones in
class. Students whose phones disrupt the course and do not stop when requested by the instructor will be referred to
the Judicial Affairs Officer of the University.
Computer Use
In the classroom, faculty will allow students to use computers only for class-related activities. These include activities such
as taking notes on the lecture underway, following the lecture on Web-based PowerPoint slides that the instructor has
posted, and finding Web sites to which the instructor directs students at the time of the lecture. Students who use
their computers for other activities or who abuse the equipment in any way, at a minimum, will be asked to leave the
class and will lose participation points for the day, and, at a maximum, will be referred to the Judicial Affairs Officer of
the University for disrupting the course. (Such referral can lead to suspension from the University.) Students are
urged to report to their instructors computer use that they regard as inappropriate (i.e., used for activities that are not
class related).
Academic Honesty
Faculty will make every reasonable effort to foster honest academic conduct in their courses. They will secure
examinations and their answers so that students cannot have prior access to them and proctor examinations to
prevent students from copying or exchanging information. They will be on the alert for plagiarism. Faculty will provide
additional information, ideally on the green sheet, about other unacceptable procedures in class work and
examinations. Students who are caught cheating will be reported to the Judicial Affairs Officer of the University, as
prescribed by Academic Senate Policy S98-1.
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My Policies
C. My Class Room Policies
1. Due to assistance in adhering to COB policies and to the
demonstrated – by past classes – learning/attendance benefits it
affords, classes will be run as back to back sessions with the “break” at
the end. Thus the classes will run as follows:
1:30 to 3:50/55 (with “break” from 3:55 to 4:15)
5:30 to 7:50/55 (with “break” from 7:55 to 8:15)
2. Class will go full time. If something runs shorter than anticipated, an
unscheduled class exercise that will further enhance learning will be
added
3. Short courteous “bio” breaks are allowed during the class EXCEPT
during exams.
4. Courtesy to your class mates and the professor requires on-time
arrival and informing the professor of early departures or missing class
ahead of time (due to in class group exercises)
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Why I do things the way I do..
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From industry – looking to teach something
that will help you on the job and, hopefully,
ensure it is not exported offshore….
Six 6-hour exams at end of HS (at 18) on
EVERYTHING ever learned: Only tools
pencil, eraser, slide rule. No M/C
CMA exam (Four 4-hour exams; no M/C),
PLUS CPIM, CIRM and PMP exams
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Primary Goals:
Challenge to Grow
Improve Analytical/Modeling Skills
PLUS
 Deepen/Expand Discipline Specific
Knowledge & Skills
PLUS
 Prepare for lifelong learning
EQUALS
 Work and Career Preparation
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Schedule/Key Dates
Exam Dates
1. Feb 21 (Ch 1-8)
2. Mar 21 (Ch 9-14, 25)
3. Final Date, Wed May 23 (do
NOT book flights earlier, no
exceptions will be made)
Jeopardy Date
May 2
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Grading
Homework
Midterm 1
Midterm 2
Jeopardy
Final Exam
5
15
20
10
50
100
Total Max: One to Five assignments "quiz" (i.e. surprise dates). Credible effort counts
75-90 m in class Exam, followed by 60 minute Excel assignment at home
75-90 m in class Exam, followed by 60 minute Excel assignment at home
5 For submitted stunners, 5 for playing (up to 5 bonus for winners)
Comprehensive Exam on Exam Date
You cannot do well in exams without doing the homework. There are no MC or TF questions. Only short
answer open questions and calculations. If we can get lab, it may be all in lab on computer using Excel
ONLY EC opportunity: Presenting correct homework solutions to the class. 1 Point for each presentation.
First come first served so you have to decide you want to do it before everyone else does.
INCENTIVE: IF you take the two midterms and participate in Jeopardy and are carrying an "A" of any
type on percent basis, you are exempted from the Final Exam.
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What grades are possible
 All
grades from A+ to F
 Grades are based on points at the
end of the semester (break point
system)
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So, how do I get an A?
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A typical A student in this class has the following profile:
* Thinks of themselves as a responsible adult and likes being treated
as such
* Works hard AND smart (usually had high grades in previous classes
for the same reasons) uses time management tools
* Submits work on time without excuses or whining
* Tries to solve problems that, on the surface, may seem like “new”
because they are in an unfamiliar format or ask for new information
* Asks questions when does not understand
* Fully participates in in class team exercises, etc.
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Can I fail this class?
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Of course.
A student who fails this class typically:
* Feels like school work interferes with other more important
activities/feels entitled to a C or above regardless.
* Has a poor record (lots of C-/D/F/U/W) when I check
* Feels professors should focus on only what will be on
exam, and spoon feed all answers and that cheat sheets
should be allowed etc.
* Use lots of excuses for not doing work/missing class
* Does not contribute to the in class exercises choosing to
talk about other matters during them
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Why don’t you show us exactly how to do the
analysis and forecast and give “right answer”
and test on the same numbers?
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Answer: You are here to learn how to
approach a problem when you have not done
exactly that problem before but have learned
the tools previously.
Do you suppose your boss would pay you if
he/she had to do the project first?
In real life, there are no “single right answers”
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TOOO Much Work? Ch 1-3
Review from 170, mostly
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The basic goal of management: to create
stock-holder value (measured by stock
price!!!)
Agency relationships get in the way:
1. Stockholders versus managers
2. Stockholders versus creditors
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What is an agency relationship?
An agency relationship arises
whenever one or more individuals, call
(1) hires another individual or
organization, to perform some service
(2) delegates decision-making
authority to that agent.
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There are TWO potential
agency conflicts:
Conflicts between stockholders and
managers.
 Conflicts between stockholders and
creditors.
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Would going public in an IPO increase or
decrease agency problems?
.
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Why might you want to inflate your
reported earnings or use off balance
sheet financing to make your financial
position look stronger?
A manager might inflate a firm's reported
earnings or make its debt appear to be
lower if he or she wanted the firm to look
good temporarily. For example just prior to
exercising stock options or raising more
debt.
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What are the potential
consequences of inflating
earnings or hiding debt?
If the firm is publicly traded, the stock price
will probably drop once it is revealed that
fraud has taken place. If private, banks
may be unwilling to lend to it, and investors
may be unwilling to invest more money.
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What kind of compensation program might
you use to minimize agency problems?
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“Reasonable” annual salary to meet
living expenses
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Cash (or stock) bonus
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Options to buy stock or actual shares of
stock to reward long-term performance
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Tie bonus/options to EVA
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EVA????
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Economic Value Added
Profit over and beyond paying for the cost of capital
$NOPAT - $Cost of Capital
NOPAT=EBIT-Taxes
$Cost of Capital = Capital (NWC+FA) * % WACC
Capital: CA-CL+FA=LTD+Equity (CA+FA=CL+D+E)
CofC: cost of debt after tax, cost of equity, impact of
risk
How do you impact the components???
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Why might someone interviewing for an entry level
job have a better shot at getting a good job if he or
she had a good grasp of financial management?
Managers want to hire people who can
make decisions with the broader goal of
corporate value maximization in mind
because investors are forcing top
managers to focus on value
maximization.
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What are investment returns?
Investment returns measure the
financial results of an investment.
Returns may be historical or
prospective (anticipated).
Returns can be expressed in:
$$$$.
%.
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What is the return on an investment that
costs $1,000 and is sold
after 1 year for $1,100?
Dollar return ?
Percentage return ?
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What is investment risk?
Risk Return Tradeoff
Investment returns are not known with
certainty.
 Risk refers to the probability of earning
a return different from that expected.
“Variability” of outcome.
The greater the chance of a return far
below the expected return, the greater
the risk. The corollary is that, typically,
there is also probability of high return.
27
Probability distribution
Stock X
Stock Y
-20
0
15
50
Rate of
return (%)
 Which stock is riskier? Why?
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What about these?
Economy
Prob.
T-Bill
A
B
C
D
Recession
0.10
8.0% -22.0%
28.0%
10.0% -13.0%
Below avg.
0.20
8.0
-2.0
14.7
-10.0
1.0
Average
0.40
8.0
20.0
0.0
7.0
15.0
Above avg.
0.20
8.0
35.0
-10.0
45.0
29.0
Boom
0.10
8.0
50.0
-20.0
30.0
43.0
1.00
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How to calculate the expected rate of
return on each alternative.
^
r = expected rate of return.

r=
n
 rP .
i i
i=1
^
rA = 0.10(-22%) + 0.20(-2%)
+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%.
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What is the standard deviation
of returns for each alternative?
  Standard deviation
  Variance  
2
 2


   ri  r  Pi .

i 1 
n
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Standard deviation measures the
stand-alone risk of an investment.
 The larger the standard deviation, the
higher the probability that returns will
be far below the expected return.
 Coefficient of variation is an
alternative measure of stand-alone
risk.
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Coefficient of Variation:
CV = Expected return/standard
deviation.
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Portfolio Risk and Return
Assume a two-stock portfolio with
$50,000 in each
^
Calculate rp and p.
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^
Portfolio Return, rp
^
rp is a weighted average:
n
^
^
rp =  wiri
i=1
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Two-Stock Portfolios
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Two stocks can be combined to form a
riskless portfolio if r = -1.0.
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Risk is not reduced at all if the two stocks
have r = +1.0.
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In general, stocks have r  0.65, so risk
is lowered but not eliminated.
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Investors typically hold many stocks.
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What happens when r = 0?
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What would happen to the risk of an
average 1-stock portfolio as more
randomly selected stocks were added?
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p would decrease because the added
stocks would not be perfectly correlated, but
rp would remain relatively constant.
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Prob.
Large
2
1
0
15
Return
1 35% ; Large 20%.
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p (%)
Company Specific
(Diversifiable) Risk
35
Stand-Alone Risk, p
20
Market Risk
0
10
20
30
40
2,000+
# Stocks in Portfolio
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Risk: Stand-alone, Market, Diversifiable
Market risk is that part of a security’s
stand-alone risk that cannot be eliminated
by diversification.
Firm-specific, or diversifiable, risk is that
part of a security’s stand-alone risk that
can be eliminated by diversification.
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Conclusions
As more stocks are added, each new
stock has a smaller risk-reducing impact
on the portfolio.
p falls very slowly after about 40 stocks
are included. The lower limit for p is
about 20% = M .
By forming well-diversified portfolios,
investors can eliminate about half the
riskiness of owning a single stock.
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Can an investor holding one stock earn
a return appropriate to its risk?
No. Rational investors will minimize risk
by holding portfolios.
 They bear only market risk, so prices and
returns reflect this lower risk.
 The one-stock investor bears higher
(stand-alone) risk, so the return is less
than that required by the risk.
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42
How is market risk measured for
individual securities?
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Market risk, which is relevant for stocks held in
well-diversified portfolios, is defined as the
contribution of a security to the overall riskiness
of the portfolio.
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It is measured by a stock’s beta coefficient.
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In addition to measuring a stock’s contribution of
risk to a portfolio, beta also measures the stock’s
volatility relative to the market.
43
What is the CAPM from 170?
The CAPM is an equilibrium model
that specifies the relationship
between risk and required rate of
return for assets held in welldiversified portfolios.
It is based on the premise that only
one factor affects risk.
What is that factor?
44
What are the assumptions
of the CAPM?
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Investors all think in terms of
a single holding period.
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All investors have identical
expectations.
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Investors can borrow or lend unlimited
amounts at the risk-free rate.
(More...)
45
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All assets are perfectly divisible.
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There are no taxes and no
transactions costs.
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All investors are price takers, that is,
investors’ buying and selling won’t
influence stock prices.

Quantities of all assets are given and
fixed.
46
How are betas calculated?
Run a regression line of past returns
on Stock i versus returns on the
market.
 The regression line is called the
characteristic line.
 The slope coefficient of the
characteristic line is defined as the
beta coefficient.
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47
Regression to Estimate Beta
Run a regression with returns on the
stock in question plotted on the Y axis
and returns on the market portfolio
plotted on the X axis.
 The slope of the regression line,
which measures relative volatility, is
defined as the stock’s beta
coefficient, or b.
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48
Calculating Beta in Practice
Many analysts use the S&P 500 to
find the market return.
 Analysts typically use four or five
years’ of monthly returns to establish
the regression line.
 Some analysts use 52 weeks of
weekly returns.
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49
How is beta interpreted?
If b = 1.0, stock has average risk.
 If b > 1.0, stock is riskier than average.
 If b < 1.0, stock is less risky than average.
 Most stocks have betas in the range of
0.5 to 1.5.
 Can a stock have a negative beta?
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50
Finding Beta Estimates on the
Web
 Go
to www.bloomberg.com.
 Enter the ticker symbol for a
“Stock Quote”, such as IBM or
Dell.
 When the quote comes up,
look in the section on
Fundamentals.
51
Expected Return versus Market Risk
Security
1
Market
2
T-bills
3
Expected
return
17.4%
15.0
13.8
8.0
1.7
Risk, b
1.29
1.00
0.68
0.00
-0.86
 Which of the alternatives is best?
52
Use the SML to calculate each
alternative’s required return.
The Security Market Line (SML) is
part of the Capital Asset Pricing
Model (CAPM).
 SML: ri = rRF + (RPM)bi .
 Assume rRF = 8%; rM
^ = rM = 15%.
 RPM = (rM - rRF) = 15% - 8% = 7%.

53
Required Rates of Return
r1
= 8.0% + (7%)(1.29)
= 8.0% + 9.0%
rM
=
15.0%.
r2.
=
12.8%.
rT-bill =
r3
=
= 17.0%.
8.0% + (7%)(1.00)
=
8.0% + (7%)(0.68)
=
8.0% + (7%)(0.00) =
8.0% + (7%)(-0.86) =
8.0%.
2.0%.
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Expected versus Required
Returns
1
r^
17.4%
r
17.0% Undervalued
Market
15.0
15.0
Fairly valued
2
13.8
12.8
Undervalued
T-bills
8.0
8.0
Fairly valued
3
1.7
2.0
Overvalued
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Impact of Inflation Change on SML
Required Rate
of Return r (%)
 I = 3%
New SML
SML2
SML1
18
15
11
8
Original situation
0
0.5
1.0
1.5
2.0
56
Impact of Risk Aversion Change
Required Rate
of Return (%)
After increase
in risk aversion
SML2
rM = 18%
rM = 15%
SML1
18
 RPM =
3%
15
8
Original situation
1.0
Risk, bi
57
The SML Equation

The measure of risk used in the SML is
the beta coefficient of company i, bi.

The SML equation:
ri = rRF + (RPM) bi
58
Illustration of beta calculation
_
ri
.
.
20
15
10
Year rM
1
15%
2
-5
3
12
ri
18%
-10
16
5
-5
0
-5
.
-10
5
10
15
20
_
rM
^
ri = -2.59 + 1.44 k^M
59
Method of Calculation

Analysts use a computer with statistical
or spreadsheet software to perform the
regression.
– At least 3 year’s of monthly returns or 1
year’s of weekly returns are used.
– Many analysts use 5 years of monthly
returns.
(More...)
60
Interpreting Regression Results

The R2 measures the percent of a
stock’s variance that is explained by the
market. The typical R2 is:
– 0.3 for an individual stock
– over 0.9 for a well diversified portfolio
61
Interpreting Regression Results
(Continued)
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The 95% confidence interval shows the
range in which we are 95% sure that the
true value of beta lies. The typical
range is:
– from about 0.5 to 1.5 for an individual stock
– from about .92 to 1.08 for a well diversified
portfolio
62

Betas of individual securities are not
good estimators of future risk.

Betas of portfolios of 10 or more
randomly selected stocks are
reasonably stable.

Past portfolio betas are good estimates
of future portfolio volatility.
63

CAPM/SML concepts are based on
expectations, yet betas are calculated
using historical data. A company’s
historical data may not reflect investors’
expectations about future riskiness.

Other models are being developed that
will one day replace the CAPM, but it
still provides a good framework for
thinking about risk and return.
64