IB235 Finance 1 Seminar 1, Autumn Term

_________________________
Solutions Basics

Theory

T1. Denote today’s share price by Pt and the expected share price one year and two years
from now by Pt+1 and Pt+2, respectively.

(a) The expected rate of return Rt between t and t+1, and the expected rate of return Rt+1
between t+1 and t+2, are defined as follows:

P -P P - Pt +1
Rt = t +1 t , Rt +1 = t +2
Pt Pt +1

(b) The arithmetic average rate of return RA is given by:

R + Rt +1
R = t
A 2

It is commonly used to forecast future rates of return because it provides an unbiased

estimate.

The geometric average rate of return RG is given by the solution to:

(1 + RG ) 2 = (1 + Rt ) × (1 + Rt +1 )

Note the square on the left-hand side. This is there because R represents a rate of
return i.e. return per year.

The geometric average is commonly used when dealing with past returns.

Can you show that the arithmetic average is always at least as great as the geometric
average? [Hint: Convince yourself that (1 + R ) 2 - (1 + R ) 2 > 0 ].
A G

T2. Now assume that rates of return are continuously compounded.

(a) The expected rate of return Rt between t and t+1, and the expected rate of return Rt+1
between t+1 and t+2, are defined as follows:

æP ö æP ö
Rt = lnçç t +1 ÷÷ = lnPt +1 - lnPt , Rt +1 = lnç t +2 ÷ = lnPt +2 - lnPt +1
çP ÷
è Pt ø è t +1 ø

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IB235 Finance 1 Seminar 1, Autumn Term

(b) The continuously-compounded rate of return R between t and t+2 is defined as follows:

Pt +2 = Pt × exp(2 × R)
1 æP ö
Þ R = × ln çç t +2 ÷÷
2 è Pt ø

Note the factor of 2 in the exponent because the holding period is now two years.

Re-write the expression for R as follows:

æP ö
R =
1
2
× ln çç t +2 ÷÷ =
1
[
× ln Pt +2 - ln Pt ]
è Pt ø 2

=
1
2
[
× ln Pt +2 - ln Pt +1 + ln Pt +1 - ln Pt ]
1
= ( R + Rt +1 )
2 t

So, the two-period rate of return is the arithmetic average of the two single-period rates
of return. The dichotomy between arithmetic and geometric averages has disappeared.

Applications

A1. The expected rate of return on Company Y’s shares equals:

( Pt +1 - Pt ) + Dt +1
Rt =
Pt
(15.00 - 12.00) + 1.20
= = 0.35 i.e. 35%
12.00

A2. The rates of return on each asset in each of the three possible scenarios are as follows:

Rate of Return R

Scenarios: Cars Gold

1. Recession -8% 20%

2. Normal 5% 3%

3. Growth 18% -20%

(a) The expected return and variance of returns on car manufacturing stocks are as follows:

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IB235 Finance 1 Seminar 1, Autumn Term

1 1 1
E[ Rcars ] = ´ (-8%) + ´ (5%) + ´ (18%) = 5%
3 3 3

1 1 1
var[ Rcars ] = ´ (-8% - 5%) 2 + ´ (5% - 5%) 2 + ´ (18% - 5%) 2 = 112.7%%
3 3 3

Note the double percentage sign! In decimals, var[Rcars] = 0.01127

The standard deviation of returns on car manufacturing stocks equals:

σ cars = 112.7%% = 10.6%

The expected return and variance of returns on gold are as follows:

1 1 1
E[ Rgold ] = ´ (20%) + ´ (3%) + ´ (-20%) = 1%
3 3 3

1 1 1
var[ Rgold ] = ´ (20% - 1%) 2 + ´ (3% - 1%) 2 + ´ (-20% - 1%) 2 = 268.7%%
3 3 3

Again, note the double percentage sign! In decimals, var[Rgold] = 0.02687

The standard deviation of returns on gold equals:

σ gold = 268.7%% = 16.4%

(b) The covariance between the returns on car manufacturing stocks and the returns on
gold equals:

1 1
cov[ Rcars , Rgold ] = ´ (-8% - 5%) × (20% - 1%) + ´ (5% - 5%) × (3% - 1%)
3 3
1
+ ´ (18% - 5%) × (-20% - 1%) = - 173.3%%
3

(c) The correlation coefficient rcars,gold between the returns on car manufacturing stocks
and the returns on gold equals:

cov[ Rcars , Rgold ] -0.01733

ρcars, gold º = = - 1.0
scars × sgold 0.106 ´ 0.164

The returns on car manufacturing stocks and the returns on gold are perfectly negatively
correlated. This makes owning gold a good hedge against the risk inherent in owning
shares in car manufacturing stocks.

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IB235 Finance 1 Seminar 1, Autumn Term

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Solutions Financial Arithmetic
Theory

T1. The stream of expected future cash flows associated with an N-period annuity, starting
one period from now:

C C C C
…

0 1 2 3 … N

can be thought of as the difference between the following two cash-flow streams:

C C C C C
… …
0 1 2 3 … N N+1 …

C
…

0 1 2 3 … N N+1 …

The present value (at t = 0) of the first perpetuity equals:

C
PV =
R

This is also the present value (at t = N) of the second ‘(delayed start’) perpetuity.

The present value (at t = 0) of the second perpetuity therefore equals:

1 C
PV = ´
(1 + R) N R

It follows that the present value (at t = 0) of an N-period annuity equals:

C 1 C
PV = - ´
R (1 + R) N R

C é 1 ù
= ´ ê1 - ú
R êë (1 + R) N úû

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IB235 Finance 1 Seminar 1, Autumn Term

T2. Today’s share price P0 equals the present value of the stream of expected future
dividends D1, D2, D3, … per share:

D1 D2 D3
P0 = + + + ×××
1+ R (1 + R) 2 (1 + R) 3

Since dividends per share are expected to grow indefinitely at rate G:

D = D × (1 + G ), D = D × (1 + G ) 2 , D = D × (1 + G ) 3 , ...
1 0 2 0 3 0

Substituting for D1, D2, D3, …

D0 × (1 + G ) D0 × (1 + G ) 2 D0 × (1 + G ) 3
P0 = + + + ×××
1+ R (1 + R) 2 (1 + R) 3
D0 × (1 + G ) é 1+ G 2 ù
æ1+ G ö
= × ê1 + + ç ÷ + ...ú
1+ R ê 1+ R è1+ R ø ú
ë û

The expression in the square brackets is an infinite geometric series. Provided R > G:

1+ G æ 1+ G ö 1 1+ R 1+ R
1 + + ç ÷ + ... = = =
1+ R è 1+ R ø 1+ G (1 + R) - (1 + G ) R -G
1 -
1+ R

Hence:
D0 × (1 + G ) 1+ R D × (1 + G )
0
P0 = ´ =
1+ R R-G R-G

T3. Since only a fraction b of the firm’s earnings Et per share are re-invested in the
company, and those re-invested funds are expected to earn a rate of return ROI:

E t +1 = (1 - b) × E t + b × E t × (1 + ROI) = E × (1 + b × ROI)
t

The growth rate in earnings per share therefore equals:

E t +1 - E t [ E + b × (ROI) × E ] - E
t t t
= = b × (ROI)
Et E
t

The firm pays out a proportion (1-b) of its earnings per share as dividends per share:

Dt = (1 - b) × E t

The growth rate in dividends Dt per share therefore equals:

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IB235 Finance 1 Seminar 1, Autumn Term

Dt +1 - Dt (1 - b) × E t +1 - (1 - b) × E t E t +1 - E t
= = = b × (ROI)
Dt (1 - b) × E t Et

Since the dividends Dt per share are expected to grow indefinitely at a constant rate G,
the firm’s share price Pt is given by the Gordon growth formula:

Dt +1
Pt =
R-G

Here, R is the firm’s cost of equity capital i.e. the minimum rate of return that the firm’s
shareholders require on their investment.

The growth rate in the firm’s share price Pt equals:

Dt + 2 Dt +1
Pt +1 - Pt - Dt + 2 - Dt +1
= R-G R-G = = b × (ROI)
Pt Dt +1 Dt +1
R-G

T4. The Gordon growth formula applies, so:

D
P = 1
0 R-G

where D1 = D0∙(1+G) is the dividend per share that the firm expects to pay next period.

Since the company intends to pay its shareholders a fixed proportion (1–b) of its
earnings per share as dividends per share:

D1 = E1 × (1 - b)

Thus, the prospective (or forward) price-to-earnings ratio:

P 1- b
0
=
E1 R - b × (ROI)

(a) Differentiate P0/E1 with respect to ROI, holding b fixed:

¶ ( P /E ) b × (1 - b)
0 1
=
¶ (ROI) [ R - b × (ROI)]2

This is positive since 0 < b < 1.

(b) Differentiate P0/E1 with respect to b, holding ROI fixed:

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IB235 Finance 1 Seminar 1, Autumn Term

¶ ( P /E ) [ R - b × (ROI)] × (-1) - (1 - b) × [-ROI]

0 1
=
¶b [ R - b × (ROI)]2

ROI - R
=
[ R - b × (ROI)]2

This is positive, provided ROI > R.

Thus, the prospective P/E ratio increases with the plough-back ratio b, provided
the surplus earnings that are retained are re-invested in positive-NPV projects.

Together, (a) and (b) imply that the prospective price-earnings ratio is a proxy
measure of growth rate.

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IB235 Finance 1 Seminar 1, Autumn Term

Applications

A1.(a)

End of Year
0 1 2 3 4
Cash Flow (CF) -10,000 2,000 3,000 4,000 5,000
Discount factor @ 10% 1.0000 0.9091 0.8265 0.7513 0.6830
Discounted CF -10,000 1,818.18 2,479.34 3,005.26 3,415.07
NPV 717.85

1
The discount factor is calculated using , where R = 10% is the discount rate
(1 + R )T
and T = 0, 1, 2, 3 or 4 is the number of years to wait for the cash flow.

(b) Substitute R = 12.83% in the expression for NPV:

2, 000 3, 000 4, 000 5, 000

NPV = - 10, 000 + + 2
+ 3
+ = 0
1.1283 (1.1283) (1.1283) (1.1283)4

(c) Use the Goal-Seek facility within Excel to find the value of the discount rate that makes
the NPV equal zero. This value of the discount rate is the IRR. It equals 12.83%.

A2.(a)

End of Year
0 1.5
Cash Flow (CF) -1000 1150
Discount factor @ 15% 1.0000 0.8109
Discounted CF -1,000.00 932.50
NPV -67.50

The discount factor for the cash flow in 18 months’ time is obtained as follows:

1 1
= = 0.8109
(1 + R )1.5 (1 + 0.15)1.5
(b) The annualised rate of return R is given by:

1000 ´ (1 + R )
1.5
= 1150 i.e. R = 9.8%

Note that this is the same value as the IRR since:

1150
0 = NPV = - 1000 +
(1 + IRR )1.5
A3. The annual effective rate (AER) is calculated as follows in each case.

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IB235 Finance 1 Seminar 1, Autumn Term

4
æ 0.05 ö
(a) 1 + AER = ç1 + ÷ i.e. AER = 5.09% .
è 4 ø

(b) 1 + AER = e 0.05 i.e. AER = 5.13% .

To understand the answer to (b), you need to know that the limiting value as N ® ¥ of:

N
æ 1ö
ç1 + ÷ = e = 2.718 ...
è Nø

A4. The present value of a perpetuity is given by the formula:

C £10,000
PV = = = £100,000
R 0.10

Hence, NPV = £100,000 – £90,000 = £10,000.

(b) The present value of a growing perpetuity is given by the Gordon growth formula:

C £10,000 ´ (1 + 0.05)
PV = = = £210,000
R -G 0.10 - 0.05

Hence, NPV = £210,000 – £90,000 = £120,000.

Note that C in the Gordon growth formula is next period’s expected cash flow.

In the present case, this equals £10,500 since the £10,000 is expected to grow at 5%
over the course of the coming year.

(c) The present value of an annuity is given by the formula:

1 é 1 ù
PV = C ´ A = C ´ × ê1 - ú
N , R% R ê (1 + R) N úû
ë

The annuity factor A10,10% is given by:

1 é 1 ù
A = × ê1 - ú = 6.144567
10,10% 0.10 ê (1 + 0.10)10 ú
ë û

Hence, NPV = 6.144567 × £10,000 – £90,000 = – £28,554.33.

(d) The present value of a growing annuity is given by the formula:

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IB235 Finance 1 Seminar 1, Autumn Term

C é (1 + G ) N ù
PV = ´ ê1 - Nú
R -G ëê (1 + R) ûú

Again, C in the above formula is next period’s expected cash flow, so:

10, 000 ´1.05 é (1 + 0.05)10 ù

PV = ´ ê1 - ú = 210, 000 ´ 0.371991 = 78,118.03
0.10 - 0.05 êë (1 + 0.10)10 úû

Hence, NPV = £78,118.03 – £90,000 = – £11,881.97

A5. Today’s share price equals the PV of the stream of expected future dividends per share

The stream of expected future dividends per share is as follows:

D1 = D0 × (1+ G1 ) = 2× (1+ 0.10) = 2.20

D2 = D0 × (1+ G 1 ) 2 = 2× (1+ 0.10) 2 = 2.42
D3 = D0 × (1+ G1 )3 = 2× (1+ 0.10)3 = 2.662
D4 = D0 × (1+ G1 ) 4 = 2× (1+ 0.10) 4 = 2.9282
D5 = D0 × (1+ G1 )5 = 2× (1+ 0.10)5 = 3.2210

D6 = D5 × (1+ G2 ) = 3.2210× (1+ 0.06) = 3.4143 , etc.

The present value of the dividends per share in Years 1-5 equals:

2.20 2.42 2.662 2.9282 3.2210

PV1-5 = + + + +
1+ 0.15 (1+ 0.15) 2
(1+ 0.15) 3
(1+ 0.15) 4
(1+ 0.15)5
= 1.9130 + 1.8299 + 1.7503 + 1.6742 + 1.6014 = 8.77

However, a quicker way of obtaining this result is to recognise that the first five
expected dividends per share form a 5-year growing annuity (with G1 = 10%):

D1 é æ 1+ G ö N ù
PV1-5 = × ê1 - ç 1
÷ ú
R - G1 ê è 1+ R ø ú
ë û

é 5
2.20 æ 1+ 0.10 ö ù
= × ê1 - ç ÷ ú = 8.77
0.15 - 0.10 ê è 1+ 0.15 ø ú
ë û

The expected dividends per share from Year 6 onwards form a (delayed start)
perpetuity. The present value (at t = 5) can be calculated using the Gordon growth
formula (with G2 = 6%):

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IB235 Finance 1 Seminar 1, Autumn Term

D6 3.4143
= = 37.9367
R - G2 0.15 - 0.06

The present value (at t = 0) is then obtained by discounting this result back 5 years:

37.9367
PV = = 18.86
6+ 5
(1 + 0.15)

It is necessary to multiply by the 5-year discount factor of 1/(1+0.15)5 because the

Gordon growth formula on its own gives us the present value of the expected future
dividend per share stream at t = 5 i.e. exactly one period before the dividend per share
of £3.4143 is paid.

Today’s share price is the sum of the two contributions:

P0 = PV1-5 + PV6+ = 8.77 + 18.86 = 27.63

A6.

(a) Company Y’s earnings per share equal:

£24,000,000
eps = = £2.40
10,000,000

Since Company Y pays out all of its after-tax earnings each year as dividends, the
stream of expected future dividends forms a perpetuity.

The share price equals the PV of this stream of expected future dividends per share:

£2.40
P = = £20.00
0.12

since the cost of equity capital equals 12%.

The (historical) price-to-earnings ratio equals:

P £20.00
= = 8.33
eps £2.40

(b) Company Z’s earnings per share equal:

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IB235 Finance 1 Seminar 1, Autumn Term

£24,000,000
eps = = £2.40
10,000,000

Company Z pays out a dividend of £1.60 per share and re-invests £0.80 per share in
capital projects. Its plough-back ratio b therefore equals:

£0.80 1
b = =
£2.40 3

Since these capital projects are expected to return 15%, the growth rate of Company Z’s
earnings per share, dividends per share and share price equals:

1
G = b × (ROI) = ´ 0.15 = 0.05
3

Since its dividend per share stream forms a growing perpetuity, Company Z’s share
price is given by the Gordon growth formula:

£1.60 ´ (1 + 0.05)
P = = £24.00
0.12 - 0.05

Note that next period’s expected dividend per share appears in the numerator.

Company Z’s (historical) price-to-earnings ratio equals:

P £24.00
= = 10
eps £2.40

(c) The present value (per share) of Company Z’s growth opportunities equals the
difference between the share prices of Company Y and Company Z:

PVGO = £24.00 - £20.00 = £4.00

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