The Modified Objective Function

(A Damodaran)

For publicly traded firms in reasonably efficient markets,

where bondholders (lenders) are protected
Maximize Stock Price: This will also maximize firm value
For publicly traded firms in inefficient markets, where
bondholders are protected
Maximize Stockholder Wealth: This will also maximize firm
value, but
might not maximize the stock price
For publicly traded firms in inefficient markets, where
bondholders are not fully protected
Maximize Firm Value, though stockholder wealth and stock
prices may not be maximized at the same point
For private firms, Maximize Stockholder Wealth (if lenders
are protected) or Maximize Firm Value (if they are not)
 Corporate Finance First
Principles
Investment Principle
Invest only in assets that are expected to earn a return greater than a
minimum acceptable return (hurdle rate)
The hurdle rate should reflect
the riskiness of the project
the debt :equity mix and
what returns those investing that money could have got elsewhere on similar
investments
Financing Principle
The mix of debt and equity chosen to finance investments should maximize
the value of investments made
Choosing a debt : equity mix that minimizes hurdle rate
Match the financing to the nature of assets being financed
Dividend Principle
Firms sometimes cannot find investments that earn their minimum required
rate (hurdle rate )
In such cases , excess money returned to the owners (shareholders)
Approaches
Accounting Corporate Finance
Liabilities Assets Liabilities Assets

Equity Current Equity Existing

Assets Residual claim Assets
Existing on cash flows , Generate cash
significant flows today
management
Debt Fixed Assets
role
Existing
Debt Growth
Fixed claim on Assets
cash flow , no Expected value
management from future
control assets
 Some Relevant Present
Value Concepts Revisited
TVM & DCF
 Time & Risk
Time
Cash flows now are different from cash flows
later
Time flows only in one direction
How should we model these timing differences
Risk
Under perfect certainty , finance theory is
complete
Risk creates significant challenges
How should we model the unknown
 Time Preference
If I offer you
a) Rs 1000 today
b) Rs 1000 1 year later
Which would you prefer ?
People normally would prefer money
today rather than later
The value of a rupee received later is
less than a rupee received today
 Motivating the topic of Risk
If I offer you an investment with
a) 10 % return and no risk
b) 10 % return with low risk
c) 10 % return with high risk
Where would you invest ?
What should I do to make you interested in ( b ) or ( c
)
The relationship between risk and return is
fundamental to Corporate Finance
Principle is that investors need the inducement
of a higher reward (return) to take on
perceived higher risks
 Time Preference for
Money
Time preference for money is an
individuals preference for
possession of a given amount of
money now, rather than the same
amount at some future time.
Three reasons may be attributed to
the individuals time preference for
money:
risk
preference for consumption
investment opportunities
9
 Time Value Adjustment
Two most common methods of
adjusting cash flows for time value
of money:
Compoundingthe process of calculating
future values of cash flows and
Discountingthe process of calculating
present values of cash flows.

10
 Present Value
Present value of a future cash flow
(inflow or outflow) is the amount of
current cash that is of equivalent
value to the decision-maker.
Discounting is the process of
determining present value of a series
of future cash flows.
The interest rate used for
discounting cash flows is also called
the discount rate.
11
 What Is an asset worth?
An asset is a sequence of cash flows
Different at different points of time
Some examples of assets
Business entity
Property & Machinery
Patents , R&D
Stocks , Bonds
Knowledge , reputation , opportunities
 Value of an asset
Conceptually, an asset should be
worth the present value of the
assets cash flows.
NOT THE PAST CASH FLOWS BUT CURRENT
AND FUTURE
The tricky part is determining the
size, timing, and risk of those cash
flows.
Always draw a timeline to visualize
the timing of cash flows
The One-Period Case: Present Value
In the one-period case, the formula
for PV can be written as:
C1
PV
1 r
Where C1 is cash flow at date 1 and r is the
appropriate interest rate.

C1/(1 + r)
PV = $9,523.81 C1 = $10,000
$10,000/1.05

Year 0 1
 Present Value of an Uneven Periodic
Sum

In most instances the firm receives a

stream of uneven cash flows.
The procedure is to calculate the
present value of each cash flow and
aggregate all present values.

15
 PV of Uneven Cash Flows: Example

16
The One-Period Case: Present Value
If you were to be promised $10,000 due in
one year when interest rates are at 5-
percent, your investment would be worth
$9,523.81 in todays dollars.
$10,000
$9,523.81
1.05
The amount that a borrower would need to set aside today to be
able to meet the promised payment of $10,000 in one year is call
the Present Value (PV) of $10,000.

Note that $10,000 = $9,523.81(1.05).

 The One-Period Case: Net Present
Value
The Net Present Value (NPV) of an
investment is the present value of
the expected cash flows, less the
cost of the investment.
Suppose an investment that
promises to pay $10,000 in one year
is offered for sale for$10$9,500.
,000 Your
NPV $9,500
interest rate is 5%. Should
1.05 you buy?
NPV $9,500 $9,523.81
NPV $23.81 Yes!
 The One-Period Case: Net Present
Value
In the one-period case, the formula for NPV
can be written as:
NPV Cost PV
If we had not undertaken the positive NPV project
considered on the last slide, and instead invested our
$9,500 elsewhere at 5-percent, our FV would be less
than the $10,000 the investment promised and we
would be unambiguously worse off in FV terms as
well:
$9,500(1.05) = $9,975 < $10,000.
 Present Value and
Compounding
How much would an investor have
to set aside today in order to have
$20,000 five years from now if the
current rate is 15%?
PV $20,000

0 1 2 3 4 5

$20,000
$9,943.53
(1.15) 5
Some important formulae
Perpetuity
A constant stream of cash flows that lasts
forever.
Growing perpetuity
A stream of cash flows that grows at a
constant rate forever.
Annuity
A stream of constant cash flows that lasts for
a fixed number of periods.
Growing annuity
A stream of cash flows that grows at a
constant rate for a fixed number of periods.
 Perpetuity
A constant stream of cash flows that lasts
forever. C C C

0 1 2 3

C C C
PV
(1 r ) (1 r ) (1 r )
2 3

The formula for the present value of a perpetuity is:

C
PV
r
 Perpetuity: Example
What is the value of a British consol that
promises to pay 15 each year, every
year until the world comes to an end ?
The interest rate is 10-percent.

15 15 15

0 1 2 3

15
PV 150
.10
 Growing Perpetuity
A growing stream of cash flows that lasts
forever. C C(1+g) C (1+g) 2

0 1 2 3

C C (1 g ) C (1 g )
2
PV
(1 r ) (1 r ) 2
(1 r ) 3

The formula for the present value of a growing

perpetuity is:
C
PV
rg
 Growing Perpetuity:
The expectedExample
dividend next year is $1.30
and dividends are expected to grow at
5% forever.
If the discount rate is 10%, what is the
value of this promised
$1.30 $1.30(1.05)
dividend stream?
$1.30 (1.05)
2

0 1 2 3

$1.30
PV $26.00
.10 .05
 Annuity
A constant stream of cash flows with a
fixed maturity.
C C C C

0 1 2 3 T

C C C C
PV
(1 r ) (1 r ) (1 r )
2 3
(1 r )T
The formula for the present value of an annuity is:

C 1
PV 1 T
r (1 r )
 Annuity: Example
If you can afford a $400 monthly car payment,
how expensive a car can you buy if interest
rates are 7% on 36-month loans?
$400 $400 $400 $400

0 1 2 3 36

$400 1
PV 1 36
$12,954.59
.07 / 12 (1 .07 12)
 Growing Annuity
A growing stream of cash flows with a fixed
maturity.
C C(1+g) C (1+g) C(1+g) 2 T-1

0 1 2 3 T

C C (1 g ) C (1 g )T 1
PV
(1 r ) (1 r ) 2
(1 r )T
The formula for the present value of a growing annuity:

C
T
1 g
PV 1
rg (1 r )

 Growing Annuity
A retirement plan offers to pay $20,000 per year for
40 years and increase the annual payment by 3-
percent each year. What is the present value at
retirement if the discount rate is 10-percent?

$20,000 $20,000(1.03) $20,000(1.03)39

0 1 2 40

$20,000
40
1.03
PV 1 $265,121.57
.10 .03 1.10
 Recap on Formulae
66.67
50.19

C C 1
PV PV 1 T
r r (1 r ) Annuity

C
T
Perpetuity
1 g
PV 1
rg (1 r ) 59.74

C
PV
rg Growing Perpetuity Growing
Annuity
10
0 C =10 r = 15 % g =5% T = 10 years
 Value of the Firm
The value of a firm is the present
value of its expected cash flows ,
discounted back at a rate that
reflects both the riskiness of the
projects of the firm and the
financing mix used to finance
them
( Aswath Damodaran)
 Defining Return
We invest with the hope of a positive return on
the investment
In general , returns for a period on stocks =
Capital gains yield + Dividend yield
Assume you bought a share for 100 Rs one year
back , and that you received a dividend of 9 Rs
and sold the share for 115 Rs today
15 (capital gain yield) + 9 (dividend yield) is the
rate of return
15/100+9/100
Rate of return Dividend =24%
yield Capital gain yield
DIV1 P1 P0 DIV1 P1 P0
R1
P0 P0 P0
 The Present Value of Common
Stocks
Dividends versus Capital Gains
Valuation of Different Types of Stocks
Zero Growth
Constant Growth
Differential Growth
Constant Dividend understanding
the formula
Assume the stock is held for 1 year
The value of the stock today is
The PV of the dividend that is received at
the end of year 1
PLUS
The PV of the stock price that is received at
the end of year 1 when the stock is sold
D1 V0 = +

V1
V0

0 1 2 3 4
Constant Dividend understanding
the formula
How do we know what V1 will be at
the end of one year
What will the buyer be willing to pay
at Year 1 suppose he calculates the
same way
V = + +
0

D2
D1
V2
V1
V0

0 1 2 3 4
 Required Rate of Return
The time preference for money is
generally expressed by an interest
rate. This rate will be positive even
in the absence of any risk. It may be
therefore called the risk-free rate.
An investor requires compensation
for assuming risk, which is called
risk premium.
The investors required rate of
36 return is:
 Implication of using opportunity
cost of capital
It is the return shareholders could
have got by investing the same
amount in some other financial
asset withCash
equivalent risk

Invest in
Invest in Financial Shareholde other
Project Manager r financial
assets

Invest in Pay dividend Shareholder

new to shareholder invests for himself
project
Risk & Return
 Defining Return
We invest with the hope of a positive return on
the investment
In general , returns for a period on stocks =
Capital gains yield + Dividend yield
Assume you bought a share for 100 Rs one year
back , and that you received a dividend of 9 Rs
and sold the share for 115 Rs today
15 (capital gain yield) + 9 (dividend yield) is the
rate of return
15/100+9/100
Rate of return Dividend =24%
yield Capital gain yield
DIV1 P1 P0 DIV1 P1 P0
R1
P0 P0 P0
 Historic versus Expected
Returns
The return of 24% you saw just now
was historic return .
However , prior to investing we have
an expectation of what we want as
return
This is called expected or required
returns
 Average Rate of Return
The average rate of return is the
sum of the various one-period rates
of return divided by the number of
periods.
Formula for1 the average n
1 rate of
R = [R R L R ] R
return is as
n follows:
1 2 n
t =1 n t

41
 Defining Risk
The fact that what actually happens
may differ from expectations is
defined as risk
Danger & Opportunity
Useful to have a tool to measure risk
Mathematically, tool used is variance
or standard deviation
The larger the volatility the greater
the risk
 Probability Distribution of 2 stocks
with same average returns

Stock X

Stock Y

Rate of
-20 0 15 50 return (%)
Which stock is riskier? Why?

The greater the volatility ,the

greater the risk
 Normal Distribution and Standard Deviation

In explaining the risk-return

relationship, we assume that returns
are normally distributed.
The spread of the normal distribution
is characterized by the standard
deviation.
Normal distribution is a population-
based, theoretical distribution.

44
 Properties of a Normal Distribution

The area under the curve sums to1.

The curve reaches its maximum at the expected
value (mean) of the distribution and one-half of the
area lies on either side of the mean.
Approximately
50 per cent of the area lies within 0.67 SDs of the
expected value;
68 per cent of the area lies within 1.0 SDs of the
expected value
95 per cent of the area lies within 1.96 SDs of the
expected value
99 per cent of the area lies within 3.0 SDs of the
expected value.

45
 Normal Distribution
A large enough sample drawn from a
normal distribution looks like a bell-
shaped curve.
Probability

68%

95%

> 99% Return

3 2 1 0 +1 +2 +3
 Risk of Rates of Return: Variance and
Standard Deviation

The expected rate of return on an

investment is a weighted average of
the expected returns
Formulae for calculating variance
and standard
Standard deviation:
deviation = Variance
1 n

2
Variance
2

n 1 t 1
Rt R

47
 Expected Rate of Return

State pi Ri pi*Ri
Scenario
1 10% (8.00) (0.80)
Scenario
2 20% 10.00 2.00
Scenario
3 40% 8.00 3.20
Scenario
4 20% 5.00 1.00
Scenario
5 10% (4.00) (0.40)

E ( R ) 100% 5.00

E ( R ) =expected return Ri = return of ith possible outcome

Pi = probability associated with Ri E ( R ) = Weighted average of
Expected Rate of Return & Standard
Deviation of Return
Ri-E (Ri-E pi *(Ri-E
State pi Ri pi*Ri (R) ( R ))^2 ( R ))^2
Scenario
1 10% (8.00) (0.80) (13.00) 169.00 16.90
Scenario
2 20% 10.00 2.00 5.00 25.00 5.00
Scenario
3 40% 8.00 3.20 3.00 9.00 3.60
Scenario
4 20% 5.00 1.00 - - -
Scenario
5 10% (4.00) (0.40) (9.00) 81.00 8.10

100% 5.00 33.60

5.80%
 Investment worth 1981-
2008
1,000.00
Stocks
Call
Money
LT Govt
91 Tbill
100.00 Inflation

10.00

1.00
Yearly Stock Returns India

95.00

75.00

55.00

35.00

15.00

(5.00)

(25.00)
Yearly LT Govt Bond Returns
LT Bonds
95

75

55

35

15

-5

-25
 Summary Indian Returns 1980/81
2007/08
Series Arithmetic Mean Standard
Returns Deviation
Stock Market Return 21.7% 28.2%
Long Term 9.8% 1.9%
Government
91 day T Bills 6.2% 2.2%
Inflation 7.7% 3.1%
 Summary Indian Volatility Period Wise
Time Period Standard Deviation

1980-85 16.68%

1985-90 37.84%

1990-95 28.79%

1995-00 23.13%

2000-05 26.04%

2005-10 28.30%

In shorter periods, market turbulence can be extremely higher still .

2005 was 15%
Early 1993 was 48%
During the week around 2004 parliament elections 117% , 30% the
next week
Summary US Returns 1926 -
2005
Series Arithmetic Mean Standard
Returns Deviation
Large Company 12.3% 20.2%
Stocks
Small Company 17.4% 32.9%
Stocks
Long Term Company 6.2% 8.5%
Bonds
Long Term 5.8% 9.2%
Government
Intermediate 5.5% 5.7%
Government
US Treasury Bills 3.8% 3.1%
Inflation 3.1% 4.1%
 Diversifying Risk - Portfolios
Higher risk comes with higher
expected returns
More volatility should have higher
returns
We can reduce risk (volatility) for a
given level of return by grouping
assets into portfolios
This is known as diversifying risk

56
Example Diversifying Risk
A pharmaceutical company
May fail to get approval for a drug
Unlikely every pharmaceutical company will fail
On an average some pharmaceutical companies
may succeed and some may fail
Which is less risky , investment in one
pharmaceutical company or several
pharmaceutical companies ?
Are there still any risks ?
Whole pharmaceutical industry may have risks
Example Diversifying Risk
(contd)
What if we instead held not just
pharmaceutical but pharmaceutical +
financial + manufacturing + software + real
estate + commodity sector investments too
Would the risk be lower ?
Yes , it would intuitively be less risky
Lets carry this logic further and now say we
have a market portfolio of all investments
available
Would the risk be now even lower ?
The Importance of Diversification: Risk
Types
Figure 3.5: A Break Down of Risk

Competition
may be stronger
or weaker than Exchange rate
anticipated and Political
risk
Projects may
do better or Interest rate,
worse than Entire Sector Inflation &
may be affected news about
expected
by action economy

Firm-specific Market

Actions/Risk that Actions/Risk that

affect only one Affects few Affects many affect all investments
firm firms firms

Firmcan Investing in lots Acquiring Diversifying Diversifying Cannot affect

reduce by of projects competitors across sectors across countries

Investors Diversifying across domestic stocks Diversifying globally Diversifying across

can asset classes
mitigate by

Aswath Damodaran
 Diversifying Risk
Higher risks come with the potential for higher
returns
More volatile stocks should on average have a
higher return
We can reduce risk by grouping assets into
portfolios
This is called diversifying risk
Remember the pharmaceutical example !
Risk has 2 components
Can be diversified away
Firm specific risk ( or asset specific risk)
Cannot be eliminated
Market level risk
 PORTFOLIO RETURN: TWO-ASSET
CASE

The return of a portfolio is equal to the weighted

average of the returns of individual assets (or
securities) in the portfolio with weights being
equal to the proportion of investment value in
each asset.
We can use the following equation to calculate
the expected rate of return of individual asset:

61
 PORTFOLIO RISK: TWO-ASSET CASE

Risk of individual assets is measured by

their variance or standard deviation.

We can use variance or standard

deviation to measure the risk of the
portfolio of assets as well.

The risk of portfolio would be less than

the risk of individual securities

62
 Probability distribution of
returns
State of the Probability Return % Return %
Economy Distribution Stock A Stock B
Scenario 1 10% (8.00) 14.00
Scenario 2 20% 10.00 (4.00)
Scenario 3 40% 8.00 6.00
Scenario 4 20% 5.00 15.00
Scenario 5 10% (4.00) 20.00

Overall 100% 5.00 8.00

 Expected Return & Standard
Deviation
State of Probabili Return Return Return
the ty % % on sqrd sqrd
Distribut Stock Portfoli Stock Stock
Economy ion Stock A B o A B
Scenario
1 10% (8.00) 14.00 3.00 16.9 3.6
Scenario
2 20% 10.00 (4.00) 3.00 5.0 28.8
Scenario
3 40% 8.00 6.00 7.00 3.6 1.6
Scenario
4 20% 5.00 15.00 10.00 - 9.8
Scenario
5 10% (4.00) 20.00 8.00 8.1 14.4

Overall 100% 5.00 8.00 6.50 33.6 58.2

5.80% 7.63%
 Expected Return & Standard
Deviation
State of Probabili Return Return Return
the ty % % on sqrd sqrd sqrd
Distribut Stock Portfoli Stock Stock Portfoli
Economy ion Stock A B o A B o
Scenario
1 10% (8.00) 14.00 3.00 16.90 3.60 1.23
Scenario
2 20% 10.00 (4.00) 3.00 5.00 28.80 2.45
Scenario
3 40% 8.00 6.00 7.00 3.60 1.60 0.10
Scenario
4 20% 5.00 15.00 10.00 - 9.80 2.45
Scenario
5 10% (4.00) 20.00 8.00 8.10 14.40 0.23

Overall 100% 5.00 8.00 6.50 33.60 58.20 6.45

5.80% 7.63% 2.54%
 Measuring Portfolio Risk for Two
Assets

The portfolio variance or standard deviation

depends on the co-movement of returns on two
assets.
Covariance of returns on two assets measures
their co-movement.
Three steps are involved in the calculation of
covariance between two assets:
Determining Determining
the deviation of the sum of the
Determining possible product of each
the expected returns from deviation of
returns on the expected returns of two
assets. return for each assets and
asset. respective
probability.

66
 Correlation
State of Probabil Return Return Deviati
the ity on on Deviation on Product
Pi*Dx*D
Economy pi X Y X Y y
Scenario
1 10% (8.00) 14.00 (13.00) 6.00 (7.80)
Scenario
2 20% 10.00 (4.00) 5.00 (12.00) (12.00)
Scenario
3 40% 8.00 6.00 3.00 (2.00) (2.40)
Scenario
4 20% 5.00 15.00 - 7.00 -
Scenario
5 10% (4.00) 20.00 (9.00) 12.00 (10.80)
Covarian
ce (33.00)
SD *SD 44.25
Correlati
Covariance Calculation
Matrix
 Correlation
The value of correlation, called the correlation
coefficient, could be positive, negative or zero.
It depends on the sign of covariance since
standard deviations are always positive
numbers.
The correlation coefficient always ranges
between 1.0 and +1.0.
A correlation coefficient of +1.0 implies a
perfectly positive correlation while a correlation
coefficient of 1.0 indicates a perfectly negative
correlation.

69
 PORTFOLIO RISK-RETURN ANALYSIS:
TWO-ASSET CASE

70
Perfect Negative Correlation
Perfect Positive Correlation
Partial Average Positive
Correlation
The Effects of
Diversification
Firm-specific risk can be reduced, if not eliminated, by
increasing the number of investments in your portfolio
(i.e., by being diversified).
Market-wide risk cannot.
On economic grounds, diversifying and holding a larger
portfolio eliminates firm-specific risk for two reasons-
Each investment is a much smaller percentage of the
portfolio, muting the effect (positive or negative) on the
overall portfolio.
Firm-specific actions can be either positive or negative. In a
large portfolio, it is argued, these effects will average out to
zero. (For every firm, where something bad happens, there
will be some other firm, where something good happens.)
 RISK DIVERSIFICATION:
SYSTEMATIC AND UNSYSTEMATIC RISK

When more and more securities are

included in a portfolio, the risk of individual
securities in the portfolio is reduced.
This risk totally vanishes when the number
of securities is very large.
But the risk represented by covariance
remains.
Risk has two parts:
1. Diversifiable (unsystematic)
2. Non-diversifiable (systematic)

75
 Systematic Risk
Systematic risk arises on account of the
economy-wide uncertainties and the
tendency of individual securities to move
together with changes in the market.
This part of risk cannot be reduced through
diversification.
It is also known as market risk.
Investors are exposed to market risk even
when they hold well-diversified portfolios of
securities.
76
 Examples of Systematic
Risk

77
 Unsystematic Risk
Unsystematic risk arises from the unique
uncertainties of individual securities.
It is also called unique risk.
These uncertainties are diversifiable if a
large numbers of securities are combined to
form well-diversified portfolios.
Uncertainties of individual securities in a
portfolio cancel out each other.
Unsystematic risk can be totally reduced
through diversification.
78
 Examples of
Unsystematic Risk

79
 Total Risk

80
Portfolio Risk as a Function of the
Number of Stocks in the Portfolio

Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Non diversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the risk of
individual securities.
 How does diversification work and
implication
When stocks are not perfectly
correlated
Price movements counteract each other
This will form the basis now for our
discussion on portfolio theory