Corporate Finance and Investment Analysis

Prof. Lieven De Moor

Session 1

Fundamental valuation principle: Discounted cash flow valuation (DCF)

“The value of an asset is the price you are willing to pay for it, given your expectations of the
future cashflows and your required expected return”
• The price you are willing to pay depends on: 1) what you expect that your future
cashflows will, and 2) the returns you want from the asset.

Same idea of the general valuation principle above but in symbols:

Simple one-period case:

Return is often calculated as a percentage

Investment: What you have to pay
r: Return
Numerator (up): profit (partly a cashflow that you get and
partly a profit that you make because the selling price is
different from buying price)
CF1: Certain cash flow
P1: Selling price
P0: What you paid (investment) – price you paid at period 0
1+r: Required expected return
• P0 formula: The price you are willing to pay for something depends on two things:
Ø Numerator: What are your expectations about the future cashflows à you
expect a cashflow at period 1 but also a selling price
Ø Denominator: Return that you want (required expected return).
Ø Price you are willing to pay depends on your expectations about the future
cashflows that your investment will bring to you and the required expected
return that you want.

Multi-period case:

Same formula as before but for multiple periods.

Numerators: Expected cashflows

• The price or value of something is the sum for t=1 to t=H. In the numerators are all the
cashflows (period (t) 1 to H) divided by the required expected return and you also have
the selling price discounted (divided) on the required expected return).
• This is the general valuation principle and this formula can be applied to value a bond, a
share and an investment project.

What are the expected cashflows and end-value?

“Fundamental Analysis” = Thinking about what your expectations for future cashflows are. It s
economic analysis.

What is the required expected return?

Required expected rate of return depends on:

1) What is the return if you do not take any risk (rf: risk-free return).
 Ø The return that you get from an investment you know for sure what the future
cashflows will be e.g., treasury bill of a stable Government (short-term government
bond).
2) Risk premium: You are prepared to buy an asset if you get a risk premium for it.
Ø Extra (on top of risk-free rate) return (money) that you get due to the uncertainty of
the future cashflows.
Ø The more uncertain the future cashflows are, the riskier they are.
Ø The riskier the investment, the higher the risk premium.

Individual valuation versus market valuation?

• You can use this formula for individual valuation e.g., if you go to an auction
• You can also use it for market valuation, how does the market in general thinks about
the future cashflos and the expected returns

Price volatility and bubbles?

• Formula can also be used to understand price volatility
Ø e.g., why is the price of a stock going up: It can only be for two reasons: The market
revises the numerator or denominator
1) Either the market has new information and revises expectations about future
cashflows (there is news about the economy and/or the company and people think
the future looks more bright) à = Market revises numerators (better cashflows in
the future)
2) Or the market revises the denominator (e.g., there is news that the company is in a
fraud scandal and the future cashflows are at risk) à Revision of the riskiness of
the company
• The price or value of something depends on the future and the riskiness of the future
e.g., IT bubble in the early 2000s
Ø If our beliefs of the future change, prices change. It is all about how we think about
the future and the riskiness of the future.
• Bubble: Irrationally high price
Ø Because the numerators are irrationally high, people think that the future looks
extremely bright.
Ø Irrationally low risk premium. Denominator is too low, risk is underestimated.
Ø Bubble can burst when people realize they were wrong.

Chapter 3: Valuing Bonds

Terminology

• Bond: Security that obligates the issuer to make specified payments to the bondholder.
Ø Large loan divided in smaller pieces, which investors can buy
Ø Like loans, bonds have a limited life
• Face value (par value or principal value): Payment at the maturity of the bond.
Ø Money you get at maturity
• Coupon: The interest payments made to the bondholder.
Ø Interest payments investors get
• Coupon rate: Annual interest payment, as a percentage of face value.
Ø Coupon payment in percentages
Ø The coupon payment in dollars is calculated by applying the coupon rate to the
face value (not to the price).

Valuing a bond

The price of a bond is the present value of all cash flows generated by the bond (coupons and
face value) discounted at the required expected return (or discount rate)
 Numerators: future cashflows

• PV: Present value à We are calculating the present value of the future cashflows that
we get from the bond.
• Cpn: Coupon abbreviation (in money units)
• (cpn + par): coupon payment plus face value
Ø Every year we have a coupon payment and at the last year, the last payment is
a coupon payment plus the par value (face value)
Ø This is discounted by the required expected return (1+r)^x
• (1+r): Discount of future cashflows à r: discount rate
• ^1, ^2, etc.: Year 1, year 2, etc.

⇒ Same formula as seen on the general valuation principle but applied to a bond!

WARNING [coupon rate (numerator) ≠ Discount rate or required expected return that we use to
discount future cashflows (denominator)]
The coupon rate (= numerator) IS NOT the discount rate (= denominator) used in the present
value calculations.
• The coupon rate merely tells us what cash flow the bond will produce
• Since the coupon rate is listed as a %, this misconception is quite common

Example - France
In October 2014 you purchase 100 euros (face value) of bonds in France which pay a 4.25%
coupon every year. If the bond matures in 2018 and the required expected return (or discount
rate) is 0.15%, what is the value of the bond?

2015 2016 2017 2018

4.25%: Coupon rate

0.15%: Discount rate = Yield to
maturity (YTM)
116.34 euros: Price

• Coupon payment: coupon rate x face value à 100 x 0.0425

• r= 0.15%
• Denominator (1+r)= (1+0.0015)

The required expected return (or discount rate) is also often called the ‘yield to maturity’ (YTM)
and can also be interpreted as the expected return given the current price and the expected
payments. This will actually also be the realized return if you buy the bond at the current price,
keep the bond until maturity and receive all expected payments (coupons and face value)
• In this case, the denominator (r) would be unknown
• R as YTM: Expected return given the current price and the expected payments
• If I buy this bond at its current market price and I keep the bond until maturity, the r is
also known as YTM because the r would be the expected return, and it will also be the
actual realized return if you keep the bond until maturity and receive all the promised
payments back.

Q: How did the calculation change, given semi-annual coupons versus annual coupon
payments?
R: Twice as many payments, cut in half, over the same time period.
• Most of the times the payments are done annually. But sometimes coupon payments
are also semiannually, especially in the US.
• Coupon rates and expected required returns are most of the time put forward on an
annual basis (per annum)
 • P.a., paid semi-annually = You get that coupon rate every sox months
Ø The 4.25% coupon rate is divided by two (you want to know the rate for a
period of 6 months), then you multiplied by the face value [1000 x (0,0425/2) =
21.25]
• The required expected return is also divided by two (because the 0.965% is per year
and we want to know the return for six months), then summed plus 1 (because the
formula is (1+r) )
• Even though it is a 3 year bond, we have here six periods of a half a year because the
coupon is paid semi-annually, which means every six months.
• The powers ^x is the number of periods, in this case six periods (3 years, every 6
months).

Maturity and prices

Bonds with different maturities have different interest rate risk i.e. how sensitive is the bond
price with respect to a change in the required expected return (or discount rate or YTM)

Graphic below:
• Two identical bonds: same coupon rate, same face value but a different maturity
• Blue curve: price of a 30 year bond
• Brown curve: 3 year bond
• Both curves are declining, which means: If r (discount rate) goes up, the price goes
down
• Blue curve is much steeper: Longer maturity bonds are more sensitive to changes in the
discount rate.
Ø This means that bond prices of long maturity bonds are more sensitive to
changes in e.g., the risk premium, the interest rate
Ø If interest rate goes down, then bond prices go up but longer maturity bonds will
go up more
Ø If interest rate goes up, then bond prices go down but longer maturity bonds will
go down more.
 • Longer maturity bonds have more interest rate risks = Their price is more sensitive to
changes in the r (YTM)
• If the r or YTM (x-axis) equals coupon rate (4.25%) [coupon rate = r], in that case, the
price of the bond will be equal to face value
• But, when the YTM (discount rate) is larger than the coupon rate, the bond price is
lower than the face value
Ø The denominator is the YTM, it’s the yield (return) of the bond if kept until
maturity.
Ø Now the yield that you get from a bond has two sources: 1) Coupon payments
2) Difference between the price that you pay for the bond and the face value. If
the price of the bond is lower than the face value, then you will generate part of
the yield just because the price you paid (buying price) for the bond is lower
than the selling price. Plus, you get the coupon payment, so the yield will be
larger than just the coupon rate. You will have the yield of the coupon rate plus
an extra yield because buying price < face value.
• If buying price is larger that face value (selling price) you make a loss à yield will be
smaller
• YTM is the expected return and can also be the realized return if you keep the bond
until maturity. The yield is generated by two sources: coupon rate and the difference
between price and face value.

Interest rates and inflation

In the presence of inflation, an investor’s real interest rate is always less than the nominal
interest rate.
• Real rate: Interest rate in real terms (purchasing power), what you really have as a
return
• It depends on the nominal rate (rate that you get in dollars) and on whether the prices
has risen or not (inflation)
• E.g., you buy a security with a 10% interest, which means you buy a 100€ security and
get 10€ interest. Are you happy with the 10% return? If in the meantime prices have
risen by 6%, life has become more expensive (due to inflation). Then actually your
purchasing power (what you can buy with your money) is lower than 10%. The real rate
is what you really have as a return, what your money can really buy, taking into account
the inflation.
Example: If you invest in a security that pays 10% interest annually and inflation is 6%, what is
your real interest rate?

Yield curve

Short- and long-term yields (short for “yields to maturity”) do not always move in parallel.
Between September 1992 (normal yield curve – expect inflation) and April 2000 (inverted yield
curve – expect deflation/recession), U.S. short-term yields rose sharply while long-term rates
declined.
• Blue curve:
Ø Normal situation: bonds with a longer maturity, have a higher YTM
Ø Reason: Long-term bonds are more exposed to more inflation, therefore, the
curve goes up
Ø If investors expect that there will be inflation in the future, they want to be
compensated for that future inflation. Therefore, YTM of longer maturity bonds
are higher.
• Brown curve:
Ø Sometimes there are yield curves that go down (inverted yield curves).
Ø If the market thinks that there will be a deflation in the future (prices will go
down), there will be an inverted yield curve à Periods of deflation are typically
periods of recession (prices go down, people don’t buy goods anymore,
overcapacity, etc.) à An inverted yield curve could be a signal that a recession
is coming

Yield curve and recession in the US

 • Inverted yield curves have some forecasting value for recession
• Grey zones: periods of recession à Before recessions there have historically been
inverted yield curves
• Yield of above 0: Normal situation e.g., blue curve of previous graph

Current yield curve: negative yields

Current yield curve of triple A-rated

bonds

There are negative yields, which means

that if you buy those bonds and keep
them until maturity, you will have a loss.

Expected loss, why would anyone

invest?

h,p://www.ecb.europa.eu/stats/money/yc/html/index.en.html

Why do investors choose to step into bonds if there is a negative yield i.e. negative expected
return?

• Obligation: Insurance companies (investment obligation), pension funds (benefit

obligation), banks (liquidity requirements, collateral in loan transactions on foreign
exchange markets)
Ø Type of investors that need to have bonds in their portfolio obliged by law.
• Currency speculation: Currency that rises in value, may more than offset a negative
yield by a positive currency effect
Ø Expectation that foreign currency will rise (currency of bond), so if you
transform that to your own currency you will still have a positive yield.
 • Safe haven: Better take a small loss, then risk losing much more (averse investors)
Ø You prefer a certain small loss rather than a possible large loss.
• Rising price: If market yields continue to decrease, the value of the bonds will increase.
In fact, yields and bonds are moving opposite
Ø Because people think prices of the bond will go up
Ø People who do not expect/plan to hold bond until maturity

Chapter 4: The value of common stocks

à The application of the general valuation principle to stocks

How common stocks are traded à Common stocks are traded in two types of markets

• Primary Market: Market for the sale of new securities by corporations i.e. investment
banks contacting potential investors (IPO – initial public offering)
Ø Market for where stocks are sold for the first time, market where companies
issue new stocks
Ø A company hires an investment banker and that investment banker will contact
their clients, they will do announcements in newspapers declaring that the
company will issue new stocks and promote them.
Ø ≠ Stock exchange
• Secondary Market: Market in which previously issued securities are traded among
investors i.e. the stock Exchange
Ø Stock exchange à market where existing stocks are traded among investors

How common stocks are valued

• Book Value: Value of the equity according to the balance sheet

• Dividend: Periodic cash distribution from the firm to the shareholders (no obligation,
often only if there is profit >< coupon payments)
Ø Periodic payments that investors get on their stock
Ø Dividend ≠ Coupon payments
Ø Coupon payment (bonds) are obligatory
Ø Dividends do not have to be paid every year, the company decides

• Market Value: Value of the equity according to the market i.e. stock price multiplied by
number of stocks
Ø Market value = Real value
Ø Market value of company= Real value of the company: Stock price x number of
stocks

• Dividend Discount Model: Computation of today’s stock price which states that stock
value equals the present value of all expected future dividends and selling price.

H: Time horizon for your

investment.

• Price of a stock is the same as the present value of future cashflows in the general
valuation principle
• Cashflows in this case: Dividend payments and selling price (PH), which are discounted
at the required expected return
⇒ Problem: We do not know what the dividends will be and we also do not know the
future selling price

Example: Fledgling Electronics is forecasted to pay a $5.00 dividend at the end of year one
and a $5.50 dividend at the end of year two. At the end of the second year the stock is expected
to be sold for $121. If the discount rate or required expected return is 15%, what is the price of
the stock?

• Problem: future payments (dividends and selling price) are unknown

Ø We do not know what the dividends will be because every year the company
decides what will be the dividends.
Ø We do not know the future selling price since stocks have no maturity it is up to
the shareholder when to sell the stock.

• Solution: assume growth structure of infinite dividends

and à Growth pace

Ø Div0 is the last dividend that has been paid

Ø We assume a certain growth structure (we assume that the dividends will grow at a
certain pace) à parameter g
Ø The dividend at time t equals the dividend at time 0. Dividend at time 0 is the last
dividend that has been paid, so it is known. The next dividend we grow 1 time,
dividend 2 we grow 2 times and so on. à We assume a certain growth pace.
Ø If this assumption is included in the formula until infinity, we get the first formula (the
first one starting with p0)

Three possible scenarios:

One assumes…
Ø Zero growth à g = 0 (no growth)
§ Mature company with stable profits (no new investments anymore)
§ Stable no-growth company
§ Profit is paid out in dividends

Ø Constant-normal growth à g < r (=normal growth)

§ There is growth every year but at a small pace

Ø Non-constant growth
§ Consecutive dividends + constant-normal growth
§ Temporary above-normal growth + constant-normal growth
§ First abnormal growth (fast growth) & then a constant normal growth (constant
and at a small pace) growth

Zero Growth: g = 0 (Assumption that dividends will be stable until infinity)

Formula for
perpetuity (every
year the same
until infinity)

Example: A stock will pay $1.50 dividend next year. If the required expected return is 12%, the
value of the stock is:
Constant Growth : g < r à Constant normal growth

⇒ g needs to be smaller than r because otherwise this formula would go to infinity and
would have no value (or infinite value)

A will pay $1.76 dividend next year. The dividend will grow at a 6.5% annual rate. If the required
expected return is 12%, the value of the stock is:
⇒ Next year means that it already refers to dividend 1

Non-Constant Growth
Consecutive dividends (Div1 to DivH) + constant normal growth (DivH+1 and following)
• First abnormal growth period (fast growth) and then it was a smaller growth (or no
growth)

• Discount of each dividend separately during the abnormal period

• From period H on, the company becomes mature and it has a constant normal growth.

Example: Phoenix produces dividends in three consecutive years of 0, .31, and .65,
respectively. As of year four dividends grow in perpetuity at 4%. Given a discount rate of 10%,
what is the price of the stock?
• First three years abnormal growth (abnormal dividends)
• From the dividend of .65 on, the company becomes mature and has a normal growth
• 0.65 is the last abnormal dividend and then it grows at a pace à First dividends are
discounted separately and after the 0.65, the next dividend is 0.67 (calculated as the
previous dividend 0.65, which has grown one time at 4%)
• Temporary above-normal growth (g1) + constant-normal growth (g2)

⇒ General formula is cut in two: abnormal growth part and normal growth part
⇒ G1 period: abnormal growth
⇒ The dividend has grown n-times at the pace g1 and one time at the normal pace (g2)

Some thoughts about growth rates

• It is the job of financial analysts to estimate growth rates (g) from multiple sources
Ø Financial analysts need to think about what will be the growth rate
Ø Fundamental analysis = Thinking about the future

• For example, growth rates may depend on the profitability of the firm (ROE) and the
dividend policy (pay-out ratio)
Ø ROE = Return on equity
Ø How do financial analysts try to find out what the growth rate is in the future of
the company? It depends on:
§ What is the profitability of the company (e.g., measured by ROE)
§ How much of that profit is paid out as dividend and how much of that
profit is kept in the company to reinvest.
§ If the company has a lot of profits but the payout ratio is small (a lot of
profits are kept within the company to reinvest) it can be a sign of high
growth.

“If a firm elects to pay a lower dividend (numerators), and reinvest the funds, the stock price
may increase because future dividends may be higher”
• If dividends are lowered in order to reinvest, the price can go up in the future

• Stock prices equal the value of the firm under no-growth policy (i.e. future cash flows
from existing investments) PLUS value of growth opportunities (i.e. future cash flows
from future investments)
Ø The value of a company can be divided in two parts: 1) no growth value (the
 part that is generated by the existing investments that will generate cashflows in
the future – value of the company as it is now, no growth, current investments
and products); 2) Value generated from future investments (investments that
are still yet to come)
• Income stocks versus growth stocks
Ø Income stocks: stocks (companies), which are, mature and don’t have many
investments opportunities anymore. Most of their value is the no-growth value.
Ø Growth stocks: stocks for which the value mainly consists of the growth part, of
investments that still have to come.

Chapter 6: Making investment decisions with the net present value rule

A firm´s cash flow generation process (overview of cash flow of a company)

⇒ Investment analysis is about the valuation of investment projects, of assets in such a

way that you can decide whether that investment is a good investment or a bad
investment.
⇒ Good investment: Investment that creates value (makes the value of the firm higher)
⇒ Bad investment: Investment that destroy value (makes the value of the firm lower)
⇒ Investment analysis is about analyzing potential investments and seeing which
investments create or destroy value. Those investments that create value should be
executed and those that destroy value should not be executed.
⇒ Investments: Long term investments and working capital (inventory, accounts
receivable, etc.)
⇒ Internal financing: Financing yourself by the profits that you keep in your company (cash
flow from operations)

How investment projects are valued

Net Present Value (NPV): Equals the present value of all expected future net cash flows (NCF)

H: Time horizon for your

investment

⇒ Formula for the valuation of investment projects
⇒ The value of an investment project is what we call Net Present Value (NPV)
⇒ NPV: Application of the general valuation principle. It is the present value of future cash
 flows that an investment project will generate.
⇒ These cash flows have different names but are usually called “net cash flows”
⇒ The NPV (value of an investment project) is just the future cash flows (net cash flows of
that investment project) discounted at your required expected return where H is the
investment horizon (what you think how long will that project last).
• If NPV > 0 (positive), the investment project is expected to create value and should be
acquired
• If NPV < 0 (negative), the investment project is expected to destroy value and should be
abolished
• The required expected return (or discount rate) is also often called the ’cost of
capital’ (more on this in CH9)

How to calculate the NCF´s

• How to estimate the numerators
• To calculate the net cash flows for an investment project, it is necessary to follow
certain rules:

Rule 1: Only cash flow is relevant

• The numerators are all about the cash flows (all about paying or receiving money –
physically money that goes out of the firm due to that project or money that goes into
the firm due to that project)
• Record capital investment (cash-out) and disposal (cash-in) when they are paid for, not
when they are recorded in the accounting sheets
• For instance a revenue that has been recorded but money has not been received yet
would not be part of the cash flows. As cash flows, only money that is physically paid or
received counts.
• Take into account working capital
Ø Working capital = Inventory + A/R - A/P
§ An investment project is also about buying working capital (inventory +
accounts receivable – accounts payable)
§ Net cash flows is not only the investment but also includes your investment in
working capital
Ø Investment at beginning of project à cash-out
§ The money is included as cash flow when it is really paid out
Ø Disposal at ending of project à cash-in
§ At the end of the project, the investment is sold and you receive money (cash-in
flow)
Ø Changes in working capital during project
§ Rise in working capital à cash-out
§ Drop in working capital à cash-in
Ø Do not include depreciation
Ø Include taxes

Rule 2: Estimate Cash Flows on an Incremental Basis: “with versus without the project”
⇒ Think incremential (increamential means that if you calculate those net cash flows you
have to think what are the cash flows in the company without the project and what will
be the cash flows in the company with the project – what is the impact of the project on
the company cash flows)
⇒ Those net cash flows in the numerator are the difference between the company cash
flows without the project and the company cash flows with the project.
• First practical application of this principle: Include all incidental effects (ex. PS5)
§ Example: Will producing and selling a PlayStation 5 value creating? (evaluation
of investment project by Sony)
§ Sony needs to look to the future and think about what will be the future cash
flows of the ps5.
§ It is important for the company to not only think about what the sales of the ps5
 will be, but also about the impact on the sales of the ps4. The changes of the
cash flows of the ps4 (due to the introduction of the new ps) need to be
included in the cash flows of the ps5 project. This is the application of the
incremental thinking: Without the project we will have high cash flows of the
ps4, without the project, we will have low cash flows of the ps4.
§ This reduction in cash flows in the ps4 due to the investment in the ps5 project
needs to be included and taken into account when evaluating the investment of
the ps5 project.
§ Include not only the direct cash flows on the project we are evaluating but also
the impact on other cash flows
• Do not confuse average with incremental payoffs (ex. good money after bad/good
money)
§ Example: you are the CEO of a company and this company has different
divisions. There is a certain division that is making a loss. The manager of that
division comes to you and tells you that he has a good project but needs money
to invest in it. However, the CEO does not want to invest in a division that is
making losses. But that might be a mistake since that project could have a
positive NPV and thereby help that division make money. Therefore, it is
important to understand what is the effect of the project on the company cash
flows.
• Forecast product sales but also recognize after-sales cash flows (ex. service and spare
parts)
§ Suppose you are building and producing airplanes and you want to introduce a
new kind of aircraft.
§ How many planes will you be able to sell at what price?
§ Remember: For this type of products, do not only think about selling the planes
but also look at the whole company. E.g., do not only think about the
manufacturing and marketing division but think about what will be the impact on
the service division. Also the service division will have an impact because if you
sell more planes, every year these planes will need services and repairs.
Therefore, the introduction of the new model of planes will have an impact on
the cash flows of the maintenance division, so also take into account the impact
on the aftersales.
§ Broad view: Think about cash flows in the whole company without the project,
and about the impact with the project.
• Include opportunity costs (ex. rent building, sell land)
§ Suppose your company has a building but it actually does not need it, so it rents
it out to another company (there are cash flows from the rent). Now, there is an
investment project but the company needs the building for the investment.
§ Does the building cost our company something? At the moment not since there
is another company renting the building (our company is receiving cash flows).
§ Think incremental: what are the cash flows without the project, what are the
cash flows with the project. If our company decides to use the building for the
investment, the extra cash flows from the rent will disappear. If our company
does not do the project, it can continue renting it out.
§ The foregone renting income should be taken into account (in the net cash
flows), it needs to be subtracted (it’s a cash-out flow) its an opportunity cost.
§ Opportunity costs: An income you are not able to generate due to the project.
Due to the project you have forgone income (rent the company does not have
anymore).
• Forget sunk costs (ex. R&D costs)
§ Do not include sunk costs
§ Suppose that before investing into a new project, you have R&D costs. In the
first phase you do research and then once research is done and you need to
decide whether you will produce and sell the product. You need to calculate the
NPV and the net cash flows.
§ It might be tempting to say that those R&D costs are cash outflows from the
project since they were incurred for the project.
 § The answer is that they should not be included. Think incrementially: What are
the costs without the project? Those R&D costs are already paid for. Whether
you do the project or not, you already incurred those costs, they are sunk. The
project has no incremential effect on those costs. So they should not be
included in the net cash flows, they are sunk.
• Beware of allocated overhead costs (ex. heating costs)
§ Suppose that on an existing building we already have two production lines. You
have an investment opportunity to start up a third production line. We need to
calculate the net cash flows of the third production line.
§ That building needs to be heated. It is typical to divide those overhead costs
into 3 (production line 1, 2 and 3). So if we need to calculate the NPV, it is
tempting to include those (1/3) heating costs in the net cash flows.
§ But: Whether we do the project or not, the heating costs of the building will be
the same. Think in cash flows: What is the impact of the project on the cash
flows. Whether we do the project or not, the heating costs will be the same.
• Remember salvage value net of tax (sale price ≠ book value)
§ When you sell a machine, you need to compare the selling price with the book
value. Remember in accounting if you invest in something, it goes to the asset
side and it will be depreciated every year. The original buying price minus the
accumulated depreciation is the book value.
§ If at the end you sell the machine and the selling price is higher than the book
value, on that amount you pay taxes. So you have to include those extra taxes
that you pay.
§ The other way around, if the selling price is lower, you will receive a tax
deduction. Take that into account.

Rule 3: Treat Inflation Consistently

• Often made mistake!!!

Ø Often future cash flows are estimated using current prices à i.e. you estimate
future real cash flows
Ø And often you set your required expected return (discount rate) based on % interest
rates à i.e. you set a nominal discount rate
⇒ Suppose that you need to think about future net cash flows. What do you do? It
depends on how many products I will be able to sell in the future at what price. What
does it cost to make that product, etc. (you think about revenues and costs).
⇒ BUT: Intuitively, you do that at current prices. If we calculate future cash flows at current
prices, then we are actually calculating real cash flows and we are not taking into
account inflation, we are not taking into account the fact that maybe the price per hour
of an employee in three years will be higher, we calculate with current prices. à This
means that we are actually calculating with current prices future cash flows, we are
calculating the REAL future cash flows.
⇒ We also have to estimate the discount factor (required expected return). To estimate
our required expected return we intuitively look at the returns of financial markets but
they are nominal interest rates. That is a mistake! à Either real, real or nominal,
nominal (do not mix)

• BEWARE: Treat inflation consistently!!!

Ø Use nominal discount rate to discount nominal cash flows
Ø Use real discount rate discount real cash flows
• You will get the same results, whether you use nominal or real figures

Inflation

Example: You invest in a project that will produce real cash flows (estimated at current prices) of
- $100 in year zero and then $35, $50, and $30 in the three respective years. If the nominal
discount rate is 15% and the inflation rate is 10%, what is the NPV of the project?
Example (Nominal figures)

Example (Real figures)

Rule 4: Separate Investment and Financing Decision

Question: Suppose you finance a project partly with debt. How should you treat the proceeds
from the debt issue and the interest and principal payments on the debt?
Answer: You should neither subtract the debt proceeds from the capital investment nor
recognize the interest and principal payments on the debt as cash outflows.

• Suppose that you finance an investment by taking a loan. By taking a loan, you receive
money from the bank (cash flow) due to that project.
• Think incrementially: Without the project you would not have taken that loan, with that
project you take that loan and you also have to pay interests.
• So, it is tempting to include also this type of financing cash flows into the net cash flows
of the numerator.
• The answer is do not do it! In those net cash flows, do not include any type of financing
cash flows even if those financing cash flows are because of the project. Do not include
cash inflows from getting the loan, do not include cash outflows from paying interests or
dividends due to that project.
• Why? Because the investment decision and the financing decision have to separated.
First, you need to see whether it is a value creating or a value-destructing project and
afterwards decide how you will finance it. So, the finance decision is separated from the
investment decision.
• Deciding whether a project is a good or a bad investment is separated from how you will
finance it.
How to calculate Net Cash Flows and NPV (Calculating grid)

⇒ How net cash flows are calculated practically

⇒ This grid shows how exactly to come to those net cash flows
⇒ We have 4 steps and there are two important moments: 1) At the beginning when you
buy the machine and 2) At the end when you sell it.
⇒ First step: Cash flow from capital investment
⇒ Then we come to the cash flows that are generated by producing and selling products:
First line: revenues (we think for the future how many products we will be able to sell at
what price – line 5). Take into account opportunity costs (which need to be subtracted
from the revenues)
⇒ Depreciation: We just saw that depreciation is not included in the net cash flows, why is
it included here? Because we need the depreciation to be able to calculate taxes. The
aim is to come to profit after taxes.
⇒ In the pretax profit (revenues – cost of goods sold and other costs – depreciation
⇒ Operating cash flows: We re-add depreciation because depreciation is not a cash
outflow
⇒ Investment in working capital is cash outflow (-) and disinvestment in working capital is
cash inflow
⇒ NPV is positive so we invest

Recap: Annuity factor

Annuity: A series of equal cash flows (PMT) for a specified number of periods
• Series of equal payments into the future (every year the same payment)
Present Value of an Annuity

• How do you calculate the present value of an annuity? You can calculate it how you
would calculate the present value of any cash flows, just discounting each cash flow
separately.
• Example: 1000 during 5 years: Calculate the present value of each cash flow separately
(discount the first 1000 plus the present value of the second 1000 and so on, just
calculate in a simple way the PV of each cash flow separately)
• The calculation could be rearranged by moving the numerator in front and then between
brackets the structure above.
• The red square is the annuity factor
• The annuity factor has two parameters: 1) Interest rate (in this case 6%) and 2) Number
of periods (in this case 5) à the annuity factor is defined by these 2 parameters
• There is a formula for this (see below)

Formula: Annuity factor

Shortcut to calculate the present value of the annuity

• Can also be used to calculate the PMT that generates a certain PV (cf. EAC CH6)

• PMT= payment (yearly equal payment = annuity)

• AF = Annuity factor

Table: Annuity factor

 • There is also this table for the annuity factor, which is nothing more tan the formula
applied for different n (number of periods) and i
• (Table and formulas will be included in the formulary of the exam)

Finish recap annuity factor

Application: why do we need the above?

• Suppose that you know what the present value should be and you know what the
interest rate is, you know how many periods there are
• Question: What should the annuity be to generate that certain present value

Using the NPV to choose among mutually exclusive projects with unequal lives:
• Mutually exclusive projects = You have two projects but you cannot invest in both, you
have to choose the best one
• Those projects have unequal lives = One system has a longer life than the other one
• Situation: you need to choose the best project taking into account the one project needs
a replacement faster than the other one
• To help us choose we have a tool called “equivalent annual cash flow”

Equivalent Annual Cash Flow : The annual cash flow over the project’s life with an
equivalent NPV.

• Equivalent annual cash flow: The equivalent annuity during the life of the project (the
payment annual cash flow) which generates the same NPV as project option1 or project
option 2

Equivalent Annual Cash Flow:

Example: Given the following net cash flows from two mutually exclusive projects, which
project is preferred? (with r = 9%).
 • We have project A and B and we need to choose the best one because they are
mutually exclusive
• Project A lasts for 4 years (needs replacement after 4 years) and project B lasts for 3
years (needs replacement after 3 years), so it is difficult to compare
• We need to calculate the equivalent annual cash flow
• First step to take: calculate the NPV of both projects
• NPV of project A: 2.82 & NPV of project B: 2.78
• Now we have to calculate the yearly payment of project A and B so that that annuity
generates the same NPV of each project (EAC)
• EAC (project A): 2.82 (NPV) / 3.240 (table: n:4, i: 9%) = 0.87
• EAC (project B): 2.78 (NPV) / 2.531 (table: n:3, i: 9%) = 1.098 (1.10)
• C0 = first investment (cash outflows (negative cash flows) which generates positive
cash flows (cash inflows) in the future)
• This is an income project (project that generates income): Therefore, the project with
the highest equivalent annual cash flow (EAC) is the best one

Example: Given the following costs from operating two machines and a 6% discount rate,
which machine is preferred?

• Type of project: cost project (about a machine) à Best machine is the one with the
lowest costs
• We have two machines: Machine A and machine B
• For B you have to reinvest earlier than for A
• All number should all have negative signs because they are all cash outflows

Chapter 7: Introduction to risk

• What is risk and risk diversification

The value of an investment of $1 in 1900

 • Suppose that in the 1900s you would have $3 and that $1 you invest in treasury bills
(short-term government bonds), the other $1 you invest in bonds (long-term government
bonds) and $1 you invest in equity (stocks).
• You hold this until 2010
• The first thing we see is where the graph ends: One dollar invested in bills has become
$74 after 100 years, the investment in bonds would have earned more ($145) and the
investment in stocks would have earned much more ($21,978).
• There is a difference between bills, bonds and equity when we look at the return in the
long run.
• This is also the way that we should look at the expected return. If we say that the
expected return on equity is higher than the expected return on bonds, we do not mean
that equity will earn more in a period on one week or year. We mean that in the long run
(5-20 years) that investment in equity will earn more than in bonds.
• Expected return = Average return in the long run
• In the long run, equity investments have a higher expected return than
bills or bonds.
• Expected return (average expected return in the long run) comes with more bumpiness
(there are a lot of ups and downs).

Stock market index returns

⇒ Yearly returns of investment in common stocks seen above

• During the great recession there was a return of minus 40%

• The bumpiness is what we call risk.
Ø Risk = bumpiness (volatility) of the returns
• Volatility = Ups and downs of the returns
 • For stock returns, the volatility is much higher than for bond returns

Measuring portfolio risk

• Risk can be viewed as the volatility of returns

• Variance is the statistical tool for measuring volatility
• Volatility can be measured by:
Ø Variance = Average value of squared deviations from mean
Ø Standard Deviation = square root of variance
• In order to know what variance is, you need to know what the mean value is. If you
have a number of data points e.g., yearly returns over the past 100 years (you have 100
data points), you can calculate the mean, sum all the 100, divide by 100 (that is the
mean) and then some of your data points will be above the mean and others will be
below the mean. The variance is the sum of all the deviations of the mean. The
variance is the average deviation of the mean. If all data points are close to the mean,
then your average distance to the mean is small. If your data points are very far away
from the mean, then your average distance to the mean is larger and your variance is
larger. The distance is calculated as the square distance because you cannot have
positive or negative distances.
• The variance is the sum of all average squared distances.
• That variance or the squared root of that variance (standard deviation) is the measure
of risk or volatility of returns.

Annualized standard deviation of DJIA over preceding 52 weeks, 1900-2011

• This graph shows that the risk is time variant (it changes through time), there are risky
periods and less risky periods. There can be times of stress in financial markets, where
prices go up and down during one day (high variance and high standard deviation) as
well as calm times.
• The standard deviation of the risk is not equal all the time

Calculating portfolio risk

• Each stock (also applicable on bonds) has its own expected value and its own standard
deviation.
• You can describe a stock with two parameters: 1) expected value of that stock’s return
and 2) standard deviation (risk) of that stock’s return
• What happens if you put them together? What if you have $100 and you buy for $40
stock A and for $60 stock B. What is then the expected value of your portfolio?
• Portfolio = Investment in multiple stocks
• What is the relationship between the expected return of the portfolio and the expected
return of the individual stocks?
 • r1 and r2 = expected returns of stock 1 an stock 2
• x = weight
• Weight = what is your invested capital and how much of that capital is in stock 1 and
how much of that capital is in stock 2
• Weights always have to sum to 1 (if you know x1, you know x2)

• The risk or variance of the portfolio is not the simple weighted average
• The variance of the portfolio is not just the weighted average of the variance of the
individuals
2
• X = weighted squared
• σ (sigma) = standard deviation
2
• σ = variance
• ρ = correlation coefficient (a number that lies between minus 1 and plus 1)
• A correlation coefficient of plus 1 means that if the one stock goes up, the other one
also goes up, and if the one stock goes down, the other one goes down too à perfectly
positive correlated
• Correlation coefficient of minus 1 = If one stock goes up, the other one goes down and if
the one goes down, the other one goes up (they move in opposite ways)
• Correlation coefficient of 0 = no correlation (no link between the two)
• Correlation coefficient of e.g., 0.6 = When one stock goes up, most of the time the other
one also goes up.

Example:
Invest 60% of portfolio in Heinz and 40% in ExxonMobil. Expected dollar return on Heinz stock
is 6% and 10% on ExxonMobil. Expected return on portfolio is:

• The expected return of a portfolio is the weighted average of the expected return of the
individual stocks

Variance of a two-stock portfolio

• Variance of two-stock portfolio is sum of four boxes

• The formula above can be also seen in the structure of a matrix

• The matrix has the number of rows and the number of columns equal to the number of
stocks in the portfolio.
 • First row and first column are for stock 1 and second row and second column for stock
2
• On the diagonal there is the variance
• The sum of the four cells is the formula seen before
• The same structure can be applied to more stocks

Portfolio variance

• Shaded boxes contain variance terms

• Unshaded boxes contain covariance terms

• Red cells are the variances

• In the white cells are the correlation coefficient
• The risk of that portfolio is the sum of all those cells
• The white cells are in the majority. So, if you have many stocks in your portfolio, what
has a larger impact on the risk of your portfolio? Is it the individual risks of the stocks or
the way the stocks move together? Answer: the correlation coefficient
• The risk of your portfolio is mainly driven by the way the stocks move together
(correlation coefficient). The individual risks are less important, how the individual
stocks behave is much less important for the risk of your portfolio than the way your
stocks move together.

Calculating portfolio risk

Example:
Invest 60% of portfolio in Heinz and 40% in ExxonMobil. Expected dollar return on Heinz stock
is 6% and 10% on ExxonMobil. Standard deviation of annualized daily returns are 14.6% and
21.9%, respectively. Assume correlation coefficient of 1.0 and calculate portfolio variance.
• What is the variance of the portfolio? à You can either apply the formula directly or use
the matrix
• This is a very particular case: We just saw that the expected return of a portfolio is
always the weighted average of the expected returns of the individual stocks.
• We can say the same for the variance but only in one particular case. Only if the
correlation coefficient is plus 1, will the standard deviation of your portfolio be equal to
the weighted average of the standard deviations of your individual stocks.
• In all other cases, the risk of your portfolio (the standard deviation of your portfolio) will
be lower than the weighted average

• Correlation coefficient is lower than 1 (0.3). This means that to some extent the stocks
move together but not much.
• 33.6 à standard deviation if the correlation coefficient would have been +1 (weighted
average of the stocks)
• Since the correlation coefficient is below 1 (0.3), the resulting risk of the portfolio is only
26.4. In contrast to that, the risk of the individual stocks is 28 and 40. So you have two
risky stocks (28 and 40), you put them together and the risk of the resulting portfolio is
something with a lower risk. à “The magic of financial market”
• If you cleverly combine stocks with a low correlation coefficient, you are able to reduce
the risk.
• The portfolio is better than the separate stocks.
• Portfolio management is trying to cleverly combine securities (stocks) with a low
 correlation coefficient. à You will keep a nice expected return (weighted average) but
the lower the correlation coefficient, the lower the combined risk will be.
• This effect is called risk diversification
• Risk diversification = The magic in financial markets by combining stocks with lower
correlation (lower than +1) coefficient to reduce the risk of portfolio by keeping a good
expected return

Risk diversification

• In the graph above, we have two risky stocks. They both go up and down but they have
a very low correlation coefficient (negative correlation coefficient).
• The graph underneath is the resulting portfolio: if you add the two curves above, you
have a more stable curve à That is risk diversification

Risk diversification: The standard deviation of the portfolio return is lower than the weighted
average the standard deviations of the individual securities, which is the case if the correlation
coefficient is < +1. The lower the correlation coefficient the more risk diversification.

Risk diversification in practice

• Risk diversification: combining stocks with low correlation coefficient to lower risks
• The effect of risk diversification will be larger, the lower the correlation is.
• In order to combine stocks with a low correlation coefficient in practice, you need to
invest in stocks of different sectors.
o If you invest in only stocks of one sector, they will all have a high correlation
coefficient because they are of the same sector.
o If you diversify in different sectors, you will generate lower correlation
coefficient.

• Combining securities with low correlation coefficients i.e. combining securities from:
o Different sectors
o Different countries or regions

Types of risk

1. Total Risk

The volatility of returns, measured by the variance of standard deviation

Total risk (of stock or portfolio) = Market risk + Specific risk
• You can divide that total risk in two parts: 1) market risk and 2) specific risk

2. Market Risk

The part of the volatility driven by economy wide shocks that affect the overall market
 • Market risk = The part of the total risk (volatility) which is caused by market wide shocks
• Things that happen in the world where every company is exposed to => marker risk
(e.g., financial crisis, rising oil prices, recession, etc.)

3. Specific Risk (firm/ region/ country/ industry/ sector specific)

The part of the volatility driven by firm-specific or local shocks affecting only that particular firm
or its immediate peers
• Volatility (ups and downs) generated by events that are particular to the company (e.g.,
strike, fraud scandals, etc.)

• The total ups and downs are driven by those two types of events: market wide shocks
and firm-specific shocks
• You can divide the total amount of volatility (standard deviation) into partly the market
shocks and partly firm-specific shocks. This is what we call market risks.

Diversification eliminates specific risk

Total risk = Market risk + Specific risk

• Another difference between market risk and specific risk is that specific risk you can
diversify it away. You can get rid of it. This graph shows that.
• X axis: number of stocks in portfolio (you start with one and then 10, 20, 30 randomly)
• Y axis: total risk (standard deviation)
• If you add stocks randomly, it means that you add stocks form different sectors, from
different regions and types of companies, etc. This means that if some sector/company
goes well for a specific reason, another sector/company will be doing bad and the other
way around. Therefore, specific risk is balanced.
• You can get rid of specific risk as long as your portfolio is diversified enough.
• There are limits to risk diversification: The red line does not go to 0.
Ø At some point all specific risk is away but the volatility does not go to 0.
Ø That is because every company, region and sector is exposed by market events
Ø Specific risk goes away but market risk stays

How is market risk measured?

• Market risk means: How sensitive is my stock or portfolio for market-wide shocks
o If the general economy goes up, will the stock of my company go up? Yes but
how much?
• To measure that, you first need to quantify what the general economy is: What are the
ups and downs of the general economy. Therefore, we need the concept of market
portfolio.

• Market Portfolio
 o Portfolio of all assets in economy
o Usually a broad stock market index as a proxy (e.g. MSCI World Index)
• The portfolio where everything (whole economy) is in it (every company is in it)
• Theoretical concept, therefore, we need a proxy for that (something that exists and that
mimics the general economy).
o For that, we take a broad world index
o W orld index = Portfolio of stocks where all sectors/ regions are in
o There are different providers of such world index. The most known is the MSCI
world index.
o MSCI index = stock index that goes up and down. The ups and downs of that
index are a proxy for the ups and downs as a whole.
• Our measure of market risk should show us how sensitive is the return of my stocks for
the MSCI world index.
o That is calculated by the regression coefficient
o

• Beta
o Sensitivity of stock’s (or portfolio’s) return to return on market portfolio
o Ri = αi + βi*Rm + ei

• X axis: return of your market index

• Dots: data points
• Regression: drawing a line through the data points (dots) which fits the dots best (trying
to find a straight line that fits best the dots)
• Alpha: Where the line cuts the Y axis (the intersect)
• Beta: the slope of the regression line
o We are looking for the beta
o The beta tells us what the market is doing if the market portfolio goes up and
down
o If beta is 2, it means that on average if the return of the market portfolio goes up
 by 1%, the return of my stock goes up by 2%. If beta is 2, it means that on
average if the return of the market portfolio goes down by 1%, the return of my
stock goes down by 2%.
o The Beta tells me what my stock is doing if the market portfolio goes up and
down: How sensitive is the return of my stock of my portfolio for changes in the
general economy.
o If Beta is lower that 1 it means that my stock on average reacts less intense
o Beta is our measure for market risk
• Example: We would expect that Colruyt Beta would be lower than 1 since regardless
how good or bad the times are, we still need to eat and drink.

WHERE TO FIND BETA’S: HTTP://FINANCE.YAHOO.COM/

Summary:

• Ri = αi + βi*Rm + ei
o Regression to calculate the Beta
2
• var(Ri) = βi *var(Rm) + var(ei)
o Var: variance
o The Beta of a portfolio or market risk of a portfolio is always the weighted
average of the betas of the individual securities
 • Total risk = market risk + specific risk

• Well-diversified portfolio: var(ei) = 0

o Specific risk is diversified away
• Individual stock: var(ei) ≠ 0
o You are exposed to both specific risk and market
• When is the variance (total risk) most relevant risk measure of a stock?
o Variance = Total risk
• When is beta (market risk) most relevant risk measure of a stock?
o Beta = Market risk
• If you want to invest all your investable money and your aim is to put all that money in
one stock, what is then the most relevant risk number to look at? Standard deviation or
beta?
o Standard deviation/variance because you will be exposed to both market and
specific risks
• Suppose that you have already a good diversified portfolio. That portfolio has a certain
Beta but you want to add an extra stock in the portfolio since you have extra money left.
The most relevant risk to consider here is the Beta since the specific risk of that stock is
irrelevant. Only the beta is relevant since as soon as you add that stock of your
portfolio, the specific risk will be diversified away. However, the beta of that stock will
have an influence on the beta of your portfolio because the beta of your portfolio is the
weighted average.
• Beta timing: technique in portfolio management
o If you are expecting good financial times ahead, you would try to sell stocks
with a low beta and buy stocks with a high beta. à To profit more from the
good financial times
o The other way around, if you expect bad financial times, you would sell socks
with a high beta and buy stocks with a low beta in order to not get hurt.

Chapter 8: Portfolio theory and the capital asset pricing model

• Introduction to portfolio theory and portfolio management

• Introduction to the capital asset pricing model

Expected return and standard deviation: Heinz and Exxon Mobil

 • Graph with the two important characteristics of a stock in a portfolio: expected return
and (total) risk
• Y-axis: expected return
• X-axis: total risk
• Total risk is measured by the standard deviation or variance. Both are the same but we
use more the standard deviation because it is in percentages, whereas variance is in
percentages squared.
• The two characteristics can be shown graphically for a stock just by a dot (see arrows)
• Example Heinz: if you straight down to the x-axis you have the standard deviation of
Heinz and if you move horizontally, you have the expected return. A dot corresponds to
what is the risk of that stock and what is the expected return.
• Exxon Mobil has a higher standard deviation but also a higher expected return.
• It is possible to draw a line between Heinz and Exxon Mobil. The two extremes are the
yellow dotted line and the red dotted line. The shape of the line (whether it is the yellow
one, the red one or the blue one) between those two corresponds to the correlation
coefficient.
Ø If the correlation coefficient between those two stocks is +1 (no risk diversification),
the connection between the two is the yellow-dotted line and every possible portfolio
that you can make with Heinz and Exxon Mobil will be on that yellow-dotted line.
Ø If the correlation coefficient is -1, every possible portfolio that you can make with
Heinz and Exxon Mobil will be on the red-dotted line.
Ø If the correlation coefficient is between +1 and -1, it will be on every possible curve
that you can make for example the blue line. The blue line is the line corresponding
to e.g., a correlation coefficient of 0.5.
Ø The lower the correlation coefficient, the more the line will cut to the left (so, the
more risk diversification).

Examples of coefficient portfolios

 • There are ten stocks and each stock has its own expected return and standard
deviation. With them you can make portfolios.
• In this example, we have three possible portfolios: A, B and C
Ø A: Extreme portfolio where you put all your money in Dow Chemical. So, the
expected return and the standard deviation are those of Dow Chemical.
Ø B: Balanced portfolio where you invest a bit in everything and there are diverse
stocks each with different weights. The expected return of the portfolio is the
weighted average and the standard deviation cannot be calculated based on the
given information because the correlations are not given.
Ø C: Less diverse portfolio with each stock with different weights.

Four efficient portfolios from ten stocks

• The three portfolios and ten stocks in the table above can be put together in an air
graph.
• Y-axis: expected return
• X-axis: total risk (standard deviation)
• Each stock can be shown separately (squares) and the portfolios are the dots
• If you only have two stocks, all possible combinations of the two stocks lie on a curve
but as soon as you have more than two stocks, all possible combinations (portfolios that
you can make with the stocks) lie in the surface below the red line.
 Ø The red line is the frontier of that surface and the portfolios do not lie above of the
red line.
Ø The red line is interesting for investors because the portfolios that lie on the red line
(frontier) are the best portfolios that you can make.
§ That is because they have a higher expected return
§ The portfolios on the red line are called efficient portfolios
§ Efficient portfolio: Combination of stocks that have the lowest standard
deviation for a given expected return. Or:
§ Correlation coefficient: Combination of stocks that have the highest
expected return for a given standard deviation (risk).

Harry Markowitz and the birth of portfolio theory

• Combining stocks into portfolios can reduce standard deviation below weighted-average
standard deviation
• Correlation coefficients below +1 make this possible
• The combinations of stocks that have the lowest standard deviation for a given
expected return are called efficient portfolios
• All efficient portfolios together make up the efficient frontier (red line)
• Portfolio managers try to combine stocks so that are as close as possible to the efficient
frontier. They want to form efficient portfolios.

Example:

Y-axis: expected return

X-axis: standard
deviation (risk)

• You start with stock A and stock B. You can make a lot of combinations (portfolios) with
those stocks depending on the weights that you give to each.
• The portfolio should be on the red line. How do you choose?
o The good direction to go with your portfolio is left and up (more expected return
with lower risk.
o You try to combine A and B so that you move to the left upper side as much as
possible. For example, you can take portfolio AB (see graph below).

• You take portfolio AB of two stocks but now you want a third one (N) that brings the
portfolio more to the left.
• You try to find a stock N that has a low correlation coefficient because then the curve
 will be even more to the left (see graph below).

• If you see at stock N individually, you see that the stock is quite risky but since it
has a low correlation coefficient with the AB portfolio it makes it possible to go to
the upper left side even more.
• The lower the correlation coefficient, the more I am able to move to the upper-left
side (less risk, more return).

• This shows visually what portfolio managers do: They try to combine stocks to go as
much as possible to the upper left side.
• Goal: To move up and left (less risk, more return)

Performance indicator: Sharpe ratio

• Sharpe Ratio
• Ratio of risk premium to standard deviation
 • Sharpe ratio tells us how good we have gone to the upper-left side.
• Numerator: Return of the portfolio – risk-free return
• Denominator: Standard deviation of the portfolio
• The larger the ratio, the more the fund manager was able to go to the upper-left
side.
Ø The sharpe ratio is a performance measure that tells us how good was the
portfolio made (how good was the return compared to the risk).
Ø The sharpe ratio becomes better the more return that you generate but it also
becomes better if you have lower risk.
• rf: risk-free rate à rate of return that you get if you do not take any risk

The relationship between risk and return

• Capital Asset Pricing Model (CAPM)

• Expected returns are observable for bonds but unobservable for stocks
• Expected return of a bonds = Yield to maturity (denominator of the formula of a bond)
Ø Yield to maturity = Return that you will have if you buy the bond at the current price
and keep it until maturity (expected return). If at the end you indeed get the return
that you expected it will be the realized return.
• Capital asset pricing model: Model that tries to estimate the expected return of a stock
Ø The expected return of a stock has two parts: 1) risk-free return (expected return if
you do not take any risks – proxy for that is the yield on a good government treasury
bill) + 2) Risk premium (extra amount of expected return that you get from the
financial markets as a reward for taking a risk)
§ rf = risk free return
§ ß (rm – rf) = risk premium
Ø Risk premium depends on the beta (ß) of the stock: The higher the beta, the higher
the expected return.
Ø The risk premium also depends on the market risk premium (the expected return of
the market portfolio that is in the brackets rm-rf )
Ø There is a graphical representation of the asset pricing model that shows the model
in a graph (see below):

Security market line

 • Y-Axis: expected return
• X-Axis: ß (market risk)
• Black line = Graphical representation of the capital asset pricing model or security
market line
Ø Security market line = Line that shows us graphically what is the expected return for
a given beta
• The intercept is rf
• If you want to know that is the expected return of a stock with a ß of 1, you go to the ß
of 1 then up to the black line and there is the expected return.
• The market portfolio has the ß of 1
• The capital asset pricing model gives us a tool to estimate the expected return of
stocks. We try to find out the beta of a stock but the real beta of a stock is
unobservable.
• Where do I find the expected return of the market for my model? à One way to the
website below

Where to get risk-free rate and market premium

https://www2.deloitte.com/be/en/pages/accountancy/articles/financieel-kompas.html

• Link to the financial compass of deloitte

 • In this list there are two important things that we can use for our capital asset pricing
model:
Ø 1: OLO = Yield of the government bond of the Belgian government (can be used as
a risk-free rate rf)
Ø 2: Marktrisicopremie (Market risk premium) which is the (r m -r f )

⇒ Capital asset pricing model: Important to estimate the expected returns

on the financial markets based on the ß of the stock

Size and book-to-market

• The red line shows the value of a portfolio that is long in small stocks. That means you
 buy small stocks and you go short in big stocks.
Ø Calculated as what is the return in small stocks. You can put all the companies next
to each other, sort them from small to large. If you take the 50% smallest, you can
calculate portfolio return from those stocks and you can make a second portfolio
with all the big stocks (50% big stocks) and you can calculate portfolio return.
§ Small stocks: stocks with a low market capitalization
Ø They identified that if you calculate the portfolio return of small stocks minus return
of big stocks, you see that the value of that portfolio goes up.
Ø That means that the average return on the long run (to be interpreted as expected
return) of small stocks is higher than the average return of large stocks even if they
control for ß (portfolio with equal ß).
• Experiment 1: In the experiment, they made two portfolios with the same ß, one with
small stocks and another one with long stocks. If the capital asset pricing model were
100% correct, then the average return on the long run from those two portfolios should
be the same since they have the same ß. However, the result was that the small stock
portfolio had a higher average return.
Ø So, apparently there is something missing in the capital asset pricing model, a
market force that the model is not picking up.
• Experiment 2: They made two portfolios with same ß but one portfolio consisted of high
book to market stocks and another one with a low book to market value. Although they
both had the same ß, the portfolio with the high book-to-market stocks had on average
in the long run a higher expected return although they had the same ß.
Ø Book-to market: ratio in which the numerator is the book value of the stock and
the denominator is the market value.
Ø Book value: value of the stock in the accounting books
Ø Market value: the value of the stock in the market
Ø High book to market stocks are stocks with a high book to market value but a low
market value. They are stocks in financial distress or almost bankrupt.
Ø Market capital of a company = stock price x number of stocks

⇒ These are two market anomalies: Something in financial market that cannot be
explained with existing models.
⇒ According to the capital asset pricing model, those two portfolios should have the same
expected value in the long run but clearly there is something missing
⇒ Therefore, they have come up with an extension of the capital asset pricing model with
not only one factor but two extra factors (ß) (see below).

Alternative theories

• Extension of CAPM: Fama-French 3-factor Model

• Extension of the capital asset pricing model with not only one factor ßm(rm-rf) but with
two extra factors ßsize(SMB)+ßbtm(HML)
• ßsize(SMB): measures size, so small stocks will have a high size ß and large stocks will
have a low size ß
• ßbtm(HML): Book-to-market beta, so high book-to-market stocks will have a high book-
to-market ß and low book-to-market stocks will have a low book-to-market ß.

Chapter 9: Risk and cost of capital

Re-take from chapter 7

 • Ri = αi + βi*Rm + ei
• var(Ri) = βi
• 2*var(Rm) + var(ei)
• Total risk = Market risk + Specific risk
• For well-diversified portfolio: specific risk is diversified, only market risk remains
• For individual stock: you are exposed to both market risk and specific risk
• Adding more stocks (with corr.coef. < +1) to portfolio: specific risk goes down to zero,
but market risk remains à nice expected return but reduced risk
o Market is risk is measured by the ß
o ß of a portfolio = weighted average of the ß of the individual stocks:

Citigroup return

• Here we can see how a ß is calculated: two columns in excel, one with the return of the
stock (y-axis) and another one with the return of the market e.g., MSCI world index (x-
axis).
• Y axis: returns of your stock
• X axis: returns of the market
• Each dot is a data point for e.g., a certain week or month à each dot represents a line
in the excel sheet
• Then it is possible to do a regression. Graphically, a regression is drawing a straight
line through the dots, which fits the dots best (like an average line between those dots).
Ø Beta = slope between of that line.
• New information for us: When you do a regression on excel or another econometric
2
program, you also get the r-squared (R )
2
Ø R = How much percentage of the variance can be explained by the regression
model.
Ø In this example: How much of the variance of citigroup can be explained by the ß
and the variance of the market portfolio.
2
Ø If you apply this, you get a very interesting interpretation if the R

Let’s take it a step further

 • Ri = αi + βi*Rm + ei
2
• var(Ri) = βi *var(Rm) + var(ei)
• Total risk = Market risk + Specific risk
2 2
• R = βi *var(Rm) / var(Ri) = Market risk / Total risk
2
⇒ R tells u show much percentage of the variance of the model is explaining the total
2
variance. So, the R tells us the (market risk / total risk) à How much of the total risk is
market risk.
2
⇒ In the example above, we can see that 64% of the variability of citigroup (R ) is due to
market shocks. So, the market risk of citigroup is 64%, the other part is specific risk.
⇒ R2 tells us which part of the total risk is market risk, which part of the variability is due to
market shochs.

Campbell’s return

2
• R = 22% : This means that the variability of Campbell’s soup is only 22% due to
market fluctuations, so Campbell’s soup is less sensitive to market shocks.
2
• R is a number between 0 and 1 and it tells you how much percent of the variance is
due to market risk (market risk / total risk).

Recall from chapter 6

Until lesson 2 Corporate finance and investment analysis 04.03 00:37:40:39

 • In this slide of chapter 6, we applied the general valuation principle on an investment
project
Ø Same principle, we look at the future, what are the expected future cashflows (net
cash flows) and we discount it at the discount rate (required expected return). Then
we had the net present value (NPV). If the net present value is positive, it is a good
project that creates. If the NPV is negative, it is a bad project that destroys value.
• In the case of an investment project, the required expected return is the also called the
cost of capital.
• Now we will see: How to estimate the cost of capital of an investment project for the use
in the NPV (what numbers should we take).

The cost of capital

 • Cost of capital: Required expected return (or discount rate) for the investment project.
Ø The discount rate or required expected return is calculated as the expected return
on the financial markets.
§ Why? Because the expected return on the financial markets is actually the
opportunity cost of the investors.
§ Opportunity cost: The return that you do not get because you do something else
with your money.
§ As an investor, you have two options: you either put your money in the
investment project or you invest in the financial markets. Therefore, investors
will only invest in the investment project if the required expected return of the
project is at least equal or higher that the expected return on the financial
markets.
• What is the expected return on the financial markets? We can divide the financial
market in two because there are two types of investors: 1) Investors via stock or equity
and 2) investors via bonds.
Ø Since you have two types of investors, you also have two expected returns, one
from the bond investors (observable = yield to maturity) and one from the equity
investors (unobservable, but can be estimated with a model).
§ We need to use the capital asset pricing model
§ Capital asset pricing model: model to estimate the expected return on equity
markets (stock).
§ W e use the capital asset pricing model to estimate the cost of
equity capital (required expected return for the equity investor).
§ Capital asset pricing model: tool for estimating the required investment return of
the equity investors.
• What is the cost of capital? It is the weighted average between the cost of debt capital
and the cost of equity capital.
•

Weighted average cost of capital (WACC)

• WACC = weighted average cost of capital

• rdebt = required expected return of the debt investor
• requity = cost of equity capital (opportunity cost for the equity investor) à unobservable
but we can use the capital asset pricing model for this.
• V = Total value (D+E)
• D = Value of the bonds of the company à market value of debt
• E = market value of equity (stock price x number of stocks)
• (1-Tc) r debt = after tax cost of debt capital
o Tc = corporate tax rate (what percentage of tax the company pays). This is
because the financial costs of a company for paying its interests, part of its
interests it receives back as a tax shield because interest payments are tax
deductible. Interests are part of

• YTM on bonds = Yield to maturity on bonds

Two important issues with the formula before

• Which D and E (weights)? Company’s or project’s? Answer: company’s (weights how

the company is financed as a whole)
⇒ Use the D and E of the company, NOT the particular financing of the investment project.

• Which β and YTM? Company’s or project’s? Answer: project’s (It should reflect the risk
of the project)
• Example: Suppose that Colruyt (food industry) has to evaluate a new kind of investment
project in electricity offshore (electricity industry) and it needs to calculate the NPV.
Colruyt has to calculate the required expected return for that project. The ß of Colruyt
reflects the risk of the food industry (food industry projects) but now it is investing in an
electricity project, so it would be unfair to calculate the required expected return of that
project based on the risk of the food industry. The required expected return should
reflect the risk of that project (electricity industry).
• The r reflects the risk of the numerators, the more risky the numerators are, the higher
the expected eturn. If the numerators are risky in the sense of an electricity project, you
have to calculate the required expected return as the return for an electricity project. If
you would use the ß of Colruyt, you would be calculating the required expected return
for a food industry project. It is important to calculate the cost of equity capital
based on the project ß.
• Similarly, it would not be correct to calculate the rdebt by looking at the YTM of the
bonds of Colruyt because the YTM of the bonds of Colruyt reflect the requied expected
return for the bond investor for the bonds in food industry projects. In this case, it is
needed to look at the YTM of bonds of other companies, which are specialized in
electricity projects.

⇒ Use the β and YTM of the company (i.e. company cost of capital) ONLY if the
investment project is an expansion of existing business i.e. project risk = company risk
⇒ Use a lower β and YTM for cost improvement projects i.e. project risk < company risk
⇒ Use a higher β and YTM for speculative ventures i.e. project risk > company risk

How high or how low? (Regarding above)

• There are two directions that can be taken: 1) Start from the own company ß or own
company cost of capital. You can start from there and you mark-up or a mark-down,
how much is not defined. Or 2) You can look at companies that are specialized in that
type of projects.
• Via markup/-down on the β and YTM of the company
• Via β and YTM of another company (i.e. company cost of capital of another company)
for which the investment project is an expansion of this other company’s existing
business i.e. project risk = other company’s risk

⇒ The ß and the YTM that you are using to calculate the cost of equity capital and the cost
of debt capital should reflect the risk of the project. Only when the project is an
extension of the existing business of the company, the own ß and YTM can be used. If
the risk of that project is higher or lower than your existing project is, you cannot use
your own. You need to do a mark-up or mark-down or look at the ß and/ or YTM from
companies whose existing business is in that kind of project.

Mistake: Using company cost of capital for each project

 • Y-axis: expected or required return calculated by means of the capital asset pricing
model (graphical representation of the capital asset pricing model is the security market
line (black line))
• X-axis: ß
• The security market line (black line) tells what is the expected return on the financial
markets for a certain ß.
• Example 1: A company needs to evaluate a new project that different from existing
business, a speculative venture with higher risk than existing business. What would be
the correct cost of equity capital? It would be higher up in the security market line. So,
the correct cost of equity capital is larger than the company cost of capital.
What if the company, however, would use the company cost of capital? The company
would think that the project is good because the expected return of the project would be
higher than the company cost of capital. By blind fully using the own company’s cot of
capital to evaluate a high risk project, the company makes the mistake of accepting a
bad project.
⇒ Type II error: It would be correct to say that this project is bad but the manager
wrongfully says this project is a good project.
• Example 2: A low risk project (cost-improvement project) that is a good project since the
required expected return is above the security market line. The company manager
wrongfully uses the own company’s cost of capital as discount rate and decides it is a
bad project because by doing that, the expected return of the project according to him is
lower than the company cost of capital.
⇒ Type I error: It would be correct to say that this project is a good project. But since the
manager wrongfully used his company`s cost of capital, he believes that this project is
bad.

Using the ‘Company CoC’ for each project will result in two types of errors :

• Error Type I: Rejecting low-risk (for example, cost improvement) projects that should
be accepted.
• Error Type II: Accepting high-risk (for example, speculative venture) projects that
should be rejected.

Session 5

Chapter 10: ERM

What does EUR/USD mean?

• Two possibilities:
1. NAME meaning “EURO against USD” (/ means against)
⇒ It tells you what the value is of one EURO in units of USD’s à The value of the EURO
 expressed in the units of USD
⇒ In most cases, when we read EUR/USD, it refers to the name of the currency

2. DIMENSION meaning “EURO per USD”

⇒ It tells you how many EURO’s you need to pay/receive for one USD
⇒ EURO is on the numerator and the USD is in the denominator: How much EUROS do
you pay or receive per USD

When are both used?

• NAME is used to name an exchange rate, for example, in newspapers, on webpages, in
graphs, on quotation boards, …
• DIMENSION (ratio) is used in international financial exercises and calculations.

⇒ The EURO against the USD equals 1.3346 USD per EURO (how many USD are
received per EURO)

Bid and Ask Quotes

• There are two quotes: BID quote and ASK quote

• Example: EUR/USD = 1.3345 (BID) – 1.3347 (ASK) USD/EUR
o Name (what is the value of EURO against the USD) can be 1.3345 or 1.3347
o How many USD do I have to pay if I buy a EUR or how many USD will I receive
if I sell a EUR
• You buy at ASK (high quote), you sell at BID (low quote)
o If you sell a EUR to the bank, what will be the price? Answer: The highest price
because banks want to earn money.
o If you sell a EUR to the bank, you will sell at the lowest price.
o ASK price = price that you pay if you buy (buy at a high price)
o BID price = price you receive if you sell (sell at how price)
⇒ You pay 1.3347 USD (ASK) per EURO you buy
⇒ You receive 1.3345 USD (BID) per EURO you sell BID ASK
⇒ The difference between 1.3347 and 1.3345 is the bid-ask spread, which is the
commission of the bank. à The compensation of the risk the bank is taking.

Transaction types
There are also two types of exchange rates: Spot rate and forward rate

• A spot rate St is the exchange rate for which the (1) time of agreement and (2) time of
the execution is the same.
o If you buy or sell currency to the bank, that action, can be divided in two parts:
1) the agreement in quantity and prices with the bank and 2) the exchange (the
execution of the agreement).
o If the two parts fall together, you do the agreement and immediately do the
transaction, then that is a spot transaction. The price of a spot transaction is the
spot rate.
o S = spot rate
o t = the time at which the agreement was made for buying or selling at spot
o This is the most common form of buying or selling currency, a person or firm
goes to the bank and does the agreement and execution at spot with the bank.

• A forward rate Ft,T is the exchange rate for which the (1) time of agreement (at time t)
and (2) time of the execution (at time T) is different.
 o In the forward rate, or forward agreement, the two parts are not at the same
time. E.g., you go to the bank and agree to buy EUROS at a certain price but
the actual execution takes place at a different time like in one or three months.
o t = time at which the agreement was made
o T = time at which the agreement is executed

Solving international finance problems

• This diagram links the home currency with the foreign currency every time you look at a
problem from the perspective of a certain home currency.
• It is always two currencies that are linked together but the home is your home currency
and the other one is a foreign currency.
• The first thing needed to do is to determine which is the home currency (from which
currency do I look to the world) and which is the foreign currency.
• The home currency is linked to the foreign currency by means of the exchange rate.
• HCt = home currency today
• FCt = foreign currency today
• HCT = home currency in the future e.g., with three months
• FCT = foreign currency in the future
• These blocks can to be see as pidgeonholes of the bank where you can put-in money
or receive money
• An arrow always has a beginning (INPUT) and an end (OUTPUT). The pidgeonhole
where the arrow begins is where you give money to the bank. The end of the arrow is
where you receive money.
• Example transaction: If I give home currency to the bank and I receive foreign currency,
it is buying foreign currency at spot. How much foreign currency will I receive?
o That depends on: 1) How much home currency I give to the bank (the more
home currency I give to the bank, the more foreign currency I receive); 2) the
exchange rate (the price of the foreign currency).
o OUTPUT (foreign currency) = Amount of INPUT (amount of home currency) x
ask
transformation factor (1/St )
⇒ If it is a spot rate, you need to answer two questions: Do you need to multiply
by St or multiply by (1/St)
⇒ To know what to do, it is necessary to know the dimensions. The dimension of
foreign currency is foreign currency, the dimension of home currency is home
currency and the dimension of the spot rate is how many units of home
 currency do I pay or receive for one unit of foreign currency.

SUMMARY: How to use the diagram?

• Draw the diagram and fill in the data

• Identify the INPUT position (i.e. where you put money into the diagram or give money to
the bank)
• Identify the OUTPUT position (i.e. where you pull money out of the diagram or receive
money from the bank)
• Identify the two routes starting from the INPUT and going to the OUTPUT position
o You always have two routes and you have to decide which of them is the best
or most efficient one.
o The most efficient route is the route, where a certain input generates the most
output.
• Calculate the two output values by multiplying the arrows of the two routes
o By multiplying the appropriate transformation factors and the route with the
highest combined transformation factor is the route that will generate the most
output for a certain input.
• Choose the route that generates the highest output value (i.e. the route that generates
the highest output for a given input)

Exercise:

• Spot rate = St
• Spot rate: 99.95 Japanese Yen per Dollar (How much JPY do I pay per USD)
• In this case, the JPY is the home currency; USD is the foreign currency

Three important issues on interest rates:

• Also for interest rates, there is a bid and an ask quote. The bid (lowest) quote is the one
you receive on a deposit, the ask (highest) is the one you pay on a loan.
• These interest rates are on yearly basis “p.a.”. You should first calculate the appropriate
returns. In this case, calculate the 6-month returns by dividing the p.a. interest rates by
2. (For 3-month returns: divide by 4, etc.)
o Do not forget to transform the per annum interest rate into a 6-month interest
rate by dividing it by 2.
• Always use decimal interest rates in your calculations, not percentages
o In the transformation factors
 • First step: write diagram with data

Exercise: Ms. Takeshita, treasurer of the Himeji Golf & Country Club faces following problems:
• Example1: A foreign customer has promised a large amount of USD (within 6 months),
but today the Club needs JPY cash to pay its workers and suppliers.
• The club can use the accounts receivable in USD to pay JPY today for its costs. How
can the club do that?
o The INPUT is USD (the club can give to the bank USD within 6 months) – right
down corner
o The OUTPUT is JPY today to pay costs – Upper-left corner
o There are two routes to achieve the output: 1) taking a USD loan and change
that to JPY; 2) Do a forward sell and take a home currency JPY loan.
o The best option is the one that for a certain input, the club gets the most JPY
o The first route would be the best one (see solution) because it has the highest
transformation factor.

• Example 2: There are excess JPY liquidities that should be deposited, risk-free.
• The club has spare cash that it wants to deposit (set aside) risk-free.
• The INPUT is JPY today and the OUTPUT is JPY in the future (6 months) à This is a
home currency deposit.
• There are two routes: 1) direct deposit; 2) Buy USD, then do a USD deposit and then do
a forward sale.
• The best route will be the one with the highest transformation factor
• The direct deposit is the best option (see solution).

• Example 3: The club wants to set aside JPY cash to pay a USD liability expiring in six
months.
• Within 6 months the club needs to pay USD and it therefore wants to set aside JPY to
be able to pay that back.
• The INPUT is JPY today and the OUTPUT is USD within 6 months.
• There are again two routes and the best one will be the one with the highest
transformation factor combined.

• Example 4: The club receives USD from a customer, and orders new golf clubs payable
in USD within six months.
• The club has USD now (INPUT) and wants to receive USD within 6 months (OUTPUT)
to pay the bill.
• There are again two routes and the best one will be the one with the highest
transformation factor combined.

Solution:
Extra DIY exercise: A foreign customer has promised a large amount of USD in six months, but
the Club wants to hedge this A/R i.e. it wants to be sure how much JPY it will receive in six
months from this A/R.
• Hedging: eliminate the exchange rate risk
• INPUT is the USD within 6 months
• OUTPUT is JPY within 6 months
• The club will receive USD from its customer within 6 months but it wants to know now
how much JPY it will receive in 6 months when it exchanges the currency.
• Two routes: 1) Direct forward sale; 2) Take a USD loan, with that money sell it for JPY
and with that JPY do a deposit.

Porsche case study

Currency Exposure at Porsche: A case study of how a euro-based cost structure must deal with
foreign currency pricing in target markets.

• Porsche manufactures its cars and Europe and has therefore its manufacturing costs
and accounting in €. However, a large part of its business is in the US and sells its cars
in USD. à Porsche is an exporting firm
• What is the risk of any export firm?
o The firm receives USD but the accounting is in € (home currency €; foreign
currency USD). If the USD raises in value, it is beneficial for Porsche since that
means that the firm would receive more Euros per Dollar sale. However, if the
Dollar depreciates, the firm receives less Euros per sale.
o An exporting firm is at risk if the foreign currency lowers in value (depreciates).

Porsche’s problem defined

 • Porsche needs to determine the Dollar selling price of the cars already in April.
• In order for Porsche to know what the USD selling price is, it first has to calculate what
the Euro selling price would be (based on the firms costs as well as a certain profit
margin).
• The manufacturing costs of Porsche are given: € 74,696
• Profit margin of 15%: 0,25 x €74.696 = €11.204,4
• Euro selling prices: €74.696 + €11.204,4 = 85.900,4
• Spot rate in April is used to transform that Euro selling price into Dollar selling price:
o Spot rate: 0.9206 €/$ (How many Euros does the firm receive per Dollar) à
Number is 0.9206 and dimension is €/$
o Question: Is it necessary to multiply €85,900 by the spot rate or divide the Euro
sales price by the spot rate?
§ To answer that, it is necessary to look at the dimensions. If we multiply, we
2
would have a number in $ , so that cannot be right.
o USD selling price: €85,900 / 0.9206 €/$ = 93.308,71

Managing currency risk at Porsche

Q1: Describe the nature of Porsche’s foreign currency exposure?

• Porsche is exporting cars to the U.S., thus the company will have dollar receivables,
meaning that the company will profit if the dollar appreciates and will lose money if the
dollar depreciates.

Suppose that in July, Porsche receives 20 orders for the 911 4S Cabriolet from the U.S. As of
April, the evolution of the spot rate is as follows:

• Evolution of the spot rate (how many Euros are paid per Dollar)
 • It is possible to see that the Euro has devaluated, which is bad for the exporting firm.
• Due to the depreciation of the Dollar, the profit margin of Porsche will go down from
15% (April) to 7.5% (October).

Q2: What happens if Porsche sticks to the USD price of $ 93,309?

• If Porsche sticks to that USD price, the profit margin will go down from 15% (April) to
7.5% (October).
• In order to maintain a 15% profit margin, Porsche could increase the USD price.

Q3: What happens if Porsche adjusts the USD sales price each month, in correspondence with
the change in the exchange rate?

• Order received in July for a total amount of: 20 x $ 93,309 = $ 1,866,180

• This amount is to be received in October.
• In October they receive: $ 1,866,180 x 0.8602 €/$ = € 1,605,288
• Total production cost is: 20 x € 74,696 = € 1,493,920 => the profit margin is only 7.5%
instead of 15%
• If Porsche sticks to a fixed USD price, profits margin declines.

• If Porsche increases the dollar price according to the exchange rate, the price for a 911
4S Cabriolet in October is equal to: € 85,900 / 0.8602 €/$ = $ 99,860 => maintaining a
profit margin of 15%

Q4: Is it a good idea to increase the dollar price in order to maintain the profit margin at 15%?
• NO !!! à Stick to price and swallow the decline in profit margin
• Future sales may decrease as demand will fall in response to the price increases.
• Customers dislike price variability; frequent price adjustments are detrimental for
company’s credibility.
• Consumer products must present some price stability and predictability in order to gain
customer trust and interest.
• It is therefore much more important for Porsche to maintain a U.S. dollar price over
some periods of time in order for prospective buyers to have some concept of the price
and value.

Q5: In the long run, what do most automobile manufacturers do to avoid these large exchange
rate squeezes? (Apart from hedging)
• Automobile manufacturers can move the manufacturing to the selling market, such that
both costs and revenues are in the same currency.
• However, only if they are convinced that the market is of significant size and
sustainability to justify such a sizeable investment in manufacturing.
• European-based manufacturers like BMW and Mercedes years ago concluded that the
U.S. automobile market was of such size and significance that it justified their
investment in manufacturing in that market.
• Porsche, however, is both a small volume manufacturer, and a company which still
believes the EU location of its manufacturing and assembly is inherently part of its
brand.

Extra DIY question:

Suppose Porsche would have offered the 911 at € 85,900 instead of $ 93,309. So the US
customers need to pay in euros. Would then total profits be save for the decline of the
USD?

• Yes per card sold. Per car sold the firm will have a profit margin of 15%.
• However, it is very likely that the company will sell overall less cars because the product
becomes more expensive for them. If the USD declines, customers will have to pay
more for the cars.
Session 6

Guest Lecture: Real Estate Finance

• In this chapter, we look at real as an investment object that will be then rented

What is real estate?

Real estate in the investment landscape

Investments can be divided into 4 broad asset classes:
• The four asset classes below are the most important types of asset classes

1. Equities
2. Fixed income
3. Real estate
4. Cash
Real estate as an asset class appeals to certain investors because of their unique
characteristics
• Real estate as an asset class has some appealing characteristics that differentiate it
from other asset classes e.g., bonds and equities

Characteristics of real estate (five characteristics that are typical for real estate investments):

1. Long life cycle

• Buildings last for many decades
• Rigid supply => potential for disequilibrium in the short run
• When you build a property, it lasts for many decades. Thus, people that invest in real
estate have a long term view in mind
• Because of this long-term life cycle, the supply of real estate projects in the real estate
market is rigid (it cannot change from one month to the other because it takes time to
build new properties).
• Since the supply is very rigid, there is the potential of disequilibrium in the short term.

2. Heterogeneity
• Strong differences across and within subsectors
• Every property is unique (design, location, financing, etc.)
• There are many different real estate projects with their own specific characteristics.
There are different subsectors in the real estate asset class e.g., shopping centers,
warehouses, etc.
• Even within the real estate subsectors there are many differences between individual
projects because every property is unique e.g., design, location, financing. These
factors make every property a unique investment opportunity.

3. High transaction costs (TC)

• TC = all expenses you make to do an economic transaction (e.g. search costs, real
estate fees, moving costs, legal fees, land transfer taxes, registration fees, etc.)
• When you want to invest in real estate, you need to make sure that all contracts are in
place and that the building is in good shape, etc. Since investors are not experts in legal
contracts or maintenance of buildings, you need to hire people that can help and they
need to be paid.
4. Illiquidity
• It takes time to purchase or sell a property
• Real estate is a very illiquid asset class, it takes time to buy or sell a property.
• When buying or selling real estate it is necessary to make sure that the property is in
good shape and due diligence is needed, which is a process that takes time.
5. Lack of transparency
• Other markets, such as stocks, are strongly regulated and investors have access to
real-time market information
• Risk that the seller is withholding information, or that the seller is unaware of problems
• There might be issues with the properties, which are not communicated. This could
make the investor lose money in the future

• Meir street in Antwerp, which is the main shopping street in Antwerp.

• This slide shows the importance of location.
• The red dots show the number of visitors that each day pass by the street.
• In the middle of the Meir there are much more visitors passing by than at the extremes
of the streets. This means that the shops in the center of the Meir have much more
value (more people in the streets means more revenue, which also means that you can
ask a higher rent).
• The value of a real estate project depends on the cash flows that it is projected to
generate in the future. These cash flows are the rental income. The price of the property
depends on the rental income that the project will generate in the future. The bigger the
expected rental income, the higher the price of the property.

• A good location for a shop is not necessarily a good location for a warehouse.
• What a good location is depends on the type of real estate that you want to invest in.
 • A good location for a shop is somewhere in the city center where a lot of people are
passing by.
• For a warehouse, a good location is outside the city center but close to a canal or a
highway so it can easily distribute goods to the neighboring cities.

Basic micro-level valuation: “DCF” & “NPV”

• Valuation: How to calculate the price of real estate projects

Why investing in real estate?

• Investors buy real estate because they expect that the property is going to generate
future cash flows
o When you invest in a financial product (real estate, bond, stock), you as an
investor always expect that this product is going to generate future cash flows.
For bonds the future cash flows are the coupons that you get each year and the
par value at the end of the investment period, for stocks the cash flows are the
dividends that you get each year and for a real estate investment the cash flows
are the same as the rental income.
• There are 3 types of cash flows in real estate investments:
o Investment value
§ Price that you want to pay as an investor for this project. For the investor, this
is a negative cash outflow.
o Cash flow from operations (rent paid by tenants)
§ Cash inflow of rental income (cash flow linked to real estate investment)
o Cash flow from sale of the asset at the end of holding period
§ At the end of the investment period, you decide to sell the project again on the
real estate market. The price that you get at the end of the investment period is
called terminal value.

§ To calculate the price or investment value of a real estate project, it is

necessary to discount all the future cash flows to the present vale (we have to
discount the stream of rental income to the present).
§ The terminal value also needs to be discounted to the present value. The
investment value is the same as the sum of all discounted values of future
cash flows.

What is the value of a property?

• Mathematically, the DCF procedure can be written as follows, where V = value of the
investment today

• The formula says that the value of V of a real estate project is the same as the
discounted value of all future cash flows.
• At the end of the investment period, the last cash flow is the sum of the rental income
 that you will get in year T plus the terminal value at the price that you get at the end of
the investment period of the real estate project.

• Where:
o CFT = Net cash flow generated by the property in period “t”;
o V= Property value at the end of period “t”;
o E0[r] = Expected average multi-period return (per period) as of time “zero” (the
present), also known as the “going.in IRR”;
o T = The terminal period in the expected investment holding period, such that CFT
would include the re-sale value of the property at that time, in addition to normal
operating cash flow.

DCF Example:

Imagine a single-tenant office building with a six-year lease that includes a rent “step-up” in the
4th year that will generate the following net cash flows to the property owner:
• Years 1, 2 and 3: $1,000,000 per year
• Years 4, 5 and 6: $1,500,000 per year

In addition, the property is expected to be sold for 10x current rent (10 times the current rent) at
the end of the 6th year (this is the terminal value or the price that you get at the end of the
holding period).
Suppose that the investor’s required rate of return is 10% (appropriate expected average total
return for properties with this risk-return profile).
What is the value/price of the building? (The required rate of return in 10%, which is the
discount rate that we are going to use to discount all cash flows to the present value).

The value is calculated as follows:

• First, we have to calculate all the cash flows linked to this project.

Terminal value = 10 * 1.5 mio = 15 mio (The terminal value is 10 times the current rent at the
end of the sixth year)
• We now know all cash flows related to this real estate investment. So, now we need to
discount all the cash flows to the present.

V = 1 mio * PVIFA10%,3
+ 1.5 mio * PVIFA10%,3 * PVIF10%,3
+ 15 mio * PVIF10%,6
= 13,757,000
• Discount of the stream of rental income of 1 million to the present.
• Discount of the stream of rental income of 1.5 million to the present.
• Discount of the terminal value of 15 million to the present.
• See above: 1 mio * PVIFA10%,3 --> (Discount the stream of cash flows to the present
with the help of the present value interest factor of the annuity)
o Multiply 1 million by the present value interest factor of the annuity (discount
rate is 10% and you get the 1 million for a period of 3 years).
• The rental income of the next 3 years (1.5 million) is discounted with the help of the
present value interest factor of the annuity too. We multiply the 1.5 million by the
present value interest factor of the annuity (discount rate is 10% and period is 3 years).
o We know the present value of the stream of 1.5 million in year 3 but we do not
 want to know it in year 3 but in year 0. Therefore, we discount the amount of
year 3 to year 0. We do this by multiplying this amount by the present value
interest factor with a discount rate of 10% and for a period of 3 years. In that
way we go from year 3 to year 0 (which is a period of 3 years).
o The present value interest factor is nothing else than dividing the amounts by
1+10% to the power of 3.
• Then the terminal value needs to be discounted to the present. We discount the
terminal value to the present by multiplying it by the present value interest factor
(discount rate 10% for a period of 6 years – since it has to be discounted from year 6 to
year 0).
o The present value interest rate means dividing the 15 million by 1+10% to the
power of 6.
• In that way, the price for the real estate project is found: 13,757,000

How much are investors willing to pay for a project? What is the value of a property?

The DCF (discounted cash flow) procedure consists of three steps:

1. Forecast the expected future cash flows (is not always given) à investor-specific (depends
on the negotiation skills and efforts of the investor to rent the property)
2. Determine the required rate of return (discount rate) à same for all investors (= average
return that investors earn on similar properties with same risk over full investment period)
• Required rate of return: minimum return that the investor wants to get on the real estate
investment.
• The required rate of return will be used as the discount rate to discount all cash flows to
the present.
3. Discount all cash flows (forecasted in step 1) to present at the required rate of return
(discount rate forecasted in step 2).

⇒ When all discounted values are summed up, the price and value of the property is
found.
DCF method depends on the value of its inputs: cash flow forecast and discount rate
assumptions (garbage in = garbage out)

Forecasting expected future cash flows (like in step 1)

• Formula to estimate future cash flows linked to the real estate investment

• First, calculate the gross income (maximum total rental income generated by the
property)
• Subtract from that the loss of rent due to vacancy e.g., 5% of building that has not being
 rented out.
• Add other income streams e.g., laundry or parking services
• In a final step, subtract operating expenses like cleaning costs, maintenance costs, tax
registration fees, insurance, etc.
• After these steps, we find the Net Operating Income (cash flow that will be used in
the discounted cash flow model)

Forecasting expected future cash flows à Forecasting vacancy rate

How do you forecast vacancy (v)?

• Vacancy rate (v) = vac months / total number of months in typical cycle
• Look at typical v in rental market, or historical v in subject building
• Occupancy rate = 1 – vacancy rate

Example: Suppose you have a shopping center with 10 similar units.

• For some shops (units) of the supping center, no tenants could be found
• During 16 months, one of the shops was empty (vacant) of a total of 120 months.

Vacancy rate = 16 / 120 = 13,33%

• When dividing 16 by 120, we find the vacancy rate of 13%.
• On average, 13% of the shopping center was not rented out over the past year.
• The occupancy rate is the contrary of the vacancy rate (if the vacancy rate of a property
is 5%, the occupancy rate is then 95%).
• Investors always aim to improve the occupancy rate or to reduce the vacancy rate. The
better the occupancy rate of your building, the more rental income you get from the
property and the larger the return that you realize from the real estate investment.

Forecasting expected future cash flows – Operating income

Operating expenses that you need to take into account when you calculate the net operating
income (when you calculate all the cash flows related to the real estate project).
Operating Expenses (OE) include:

• Fixed:
o Property Taxes
o Property Insurance
o Security
o Management (even if self-managed!*) *Why? Opportunity cost, “apples-to-apples”
comparison with alternative investments that you don’t have to manage yourself.
o Advertising

• Variable:
o Maintenance & Repairs
o Utilities (not paid by tenants)
o Cleaning
 • NOT: capital expenses or depreciation
o In the operating expenses you never include capital expenses or depreciation
o Capital expenses = Investments in the building that increase the value of the
property.

Example 1: Anna invests in a fourplex (apartment complex with 4 units). The purchase price is
$325,000. Taxes and insurance cost $1,943/month. Anna considers a 6 percent vacancy rate
(Anna thinks that 6% of the building will on average be vacant). The units are all identical and
rent for $900 each/month. Expenses for maintenance & repairs are estimated at $ 1,700 a year.
Advertising & other costs at $ 400 a year. Calculate the net operating income of the property.

• Anna can expect a gross income of 43,200 USD a year

Example 2: An investor bought a property for $300,000. He is renting the property for $2,400 a
month and estimates a vacancy rate of 5%. Suppose these costs: annual insurance cost of
$1,200; annual taxes of $1,400; annual repairs budget of $600; a rent management fee of 5.7
percent of gross income. Calculate the NOI of the property.

Valuation shortcuts
• So far, we calculated the price of property by using the discounted cash flow (DCF)
technique. So, first, we forecasted all future cash flows, then we discounted all the
future cash flows to the present value and the sum of the discounted future cash flows
is the price that we as an investor want to pay for a property.
o That is a very time-consuming process. Therefore, in practice some shortcut
approaches are used, which allow to quickly calculate the value of a building.
BUT these approaches are less precise.
While DCF analysis is the theoretically correct approach to valuation, it is very time consuming
Therefore, two shortcut approaches commonly used in real estate are:
1. Direct capitalization
2. Gross income multiplier (GIM)

Shortcuts can be useful in practice, but we should realize that they may omit important
information that could be relevant to the valuation decision.

Direct capitalization (First shortcut technique)

• The cap rate is defined as: CAP rate = NOI / V

o Where V is value, NOI is net operating income, and CAP is the overall
capitalization rate.
o CAP rate differs from required return used in DCF as it doesn’t include growth
expectations

• This formula can be used to calculate the property value: V = NOI / CAP rate

⇒ Most appropriate for buildings with short-term leases in less cyclical markets, like
apartments

⇒ Suppose that we want to invest in a property for which the price is unknown. Then, this
shortcut approach can be used to calculate the price of the building by dividing the NOI
by the CAP rate (formula).
⇒ The data for the Net Operating Income can be forecasted by looking at lease contracts,
etc.
⇒ The CAP rate can be found by looking at similar buildings in the neighborhood of the
investment project. We need to find the CAP rate of the similar buildings and use this
CAP rate in our formula to calculate the price of our building.

Example: An investor has an opportunity to invest in an office building that will provide a net
operating income of $300,000 per year for three years (backed by leasing contracts). After three
years the owners expect to sell the property at its market value. The cap rate for similar offices
in this area is 6%. The investor believes that an annual return of 10 percent should be earned
on this investment. How much should the investor pay for the rental property?

The investor should pay no more than $4,500,800 for the investment property. With that
amount, a 10 percent return will be earned.

• First, we need to calculate all the cash flows that are related to the real estate
investment. In this case, operating income is given, so the only thing we need to
calculate is the terminal value after 3 years.
 • The terminal value is equal to the market value since the case says that the investor will
sell the property at its market value after 3 years. We can easily find the terminal value
after 3 years by applying the formula of the CAP rate: V = NOI / CAP rate (300,000 /
0.06 = 5,000,000). The terminal value is 5,000,000 USD, so, I the investor can sell the
property at the end of the investment period at that price.
• To calculate how much the investor should pay for the property, it is necessary to
discount all future cash flows to the present. In this case, the CAP rate formula cannot
be used to calculate the present value because the investor expects an annual return of
10% and 10% is higher that the CAP rate. This is because the CAP rate only looks at
the rental income and the annual return of 10% also includes increases in the value of
the building (every year properties gain value and the annual return includes this).

Gross income multiplier (second shortcut technique)

Gross Income Multiplier Technique

V = GI x GIM
Where V is value: GI is gross income
GIM is the gross income multiplier observed in the market

• You can calculate the value/ price of a building by multiplying the gross income by the
gross income multiplier.
• The gross income is something that can be calculated by looking at lease contracts of
similar projects in the same area.

Example:

• With the CAP rate formula we can calculate the value of the building

Real estate market

• Real estate market is not only one market but it consists of several different
submarkets, which are all interlinked to each other.
• To understand the real estate market, you need to understand the dynamics in each of
the submarkets.
• One of the submarkets is the space market, which is the rental market. In this market,
there is on the one side the supply of real estate from the owners and on the other side
there is the demand of real estate from the tenants.
o E.g., Office markets: You have real estate investors who own office buildings
and you have firms who are looking for office space to rent.
o Thanks to the interplay between supply and demand, as a result you get an
average rental income for this market.
• Another submarket is the asset market or investment market. In this market, you have
on the one hand the supply (owners of buildings who aim to sell their properties) and on
the other hand the demand (the investors who are looking for an investment project to
invest in).
• The graphic shows that the output of the rental market is input for the investment
market. This is because the rental income that is the result of the space market defines
the amount of cash flows that the real estate investor will realize on an investment
project. The bigger these cash flows, the bigger the market value of its properties.
o The price of a property is nothing else than the discounted sum of all future
cash flows (future rental income). So, the market value of a property depends
on the rental income that the investor can get from the space market. The
bigger this rental income, the bigger the cash flows that the investor gets each
year and the bigger the value, the larger the price of the investment project.
• The link between both the space market and the asset market is the development
industry. The development industry is responsible for developing new real estate
projects.
o When is the development industry going to develop new projects?: When they
can make a profit out of it.
o For each project, there is a construction cost. As long as the price that investors
want to pay for a property is lower than the minimum construction cost that the
developer has to make to construct a new building, then developer is not going
to develop any new projects.
o Developers will develop new projects when the price that investors are willing to
pay is bigger than the construction costs to build the project. Only then it
becomes profitable for the development industry to develop a new project
(when the price they get is higher than the costs that they have to make).
o The bigger the property value (the price that investors want to pay in the
market), the more profitable it becomes for developers to construct new
buildings. If it is profitable to construct new buildings, then new properties will
come to the market in one or two years (because it takes time to build new
properties).
o In the nest phase, the supply of properties in the space market will shift to the
right (will increase).
• The real estate market consists of different submarkets, which are interlinked to each
other (the output of one market is always the input for another submarket).
Two types of real estate markets (summing up what said before)

• Real Estate Space Market

• Real Estate Asset Market
• Link between both markets is the development industry
= REAL ESTATE SYSTEM

• The real estate system or the real estate market consists of three different submarkets,
which are all interlinked to each other: Space market or rental market, asset market or
investment market and the link between both markets, the development industry.
Real estate space market

• The real estate space market has on the one side the supply of properties (property
owners who are looking for tenants) and on the other hand the demand for properties
(tenants looking for space to rent).
• Both property renters and property tenants come together in the space market, which
results in market rent (average rent in the market).

• Market for the usage of

real property
• Tenants exchange rent
with the property owners
for the right to use a
property
• Demand from tenants and
supply of landlords results
in equilibrium rent and
vacancy rate

• See closeup to these graphs below

• Households or firms looking for space
• Downward sloping curve
• Users prefer more space when rents are low than when rents are high
⇒ In the space market of tenant market, the real estate demand curve is downward
sloping because prefer more space when rents are low. The higher the rent price, the
lower the space that tenants will ask for.

• Property owners looking to “rent” space

• Vertical “inelastic” supply curve (fixed in short run)
• Shifts in demand lead to substantial changes in the rent
⇒ What is special about this market is that the supply curve is perfectly vertical, perfectly
inelastic. This is because the supply curve cannot move in the short term, it takes time
to build new properties so the supply curve cannot react to a change in the market rent.
o On the short term, the supply curve is fixed, it cannot move.
⇒ The consequence of that is that shifts in the demand curve will lead to a substantial
change in the market rent (price) because the quantity cannot adapt to changes in
demand.
 • In equilibrium: market rent = price of the right to use space for certain period
o Price that tenants want to pay to make use of the space for a certain period.
o In equilibrium, you get the market rent where these two lines cross each other.
• In fact, there are many different asset markets as they differ across locations and
subsectors
o In practice, there are many different space markets, so the equilibrium of rental
income depends on the type of real estate project and also on the location or
area you are looking out. There is no one market rent that can be applied e.g.,
for Belgium as a whole for all types of real estate projects.
o There are many different submarkets and each of those has its own supply and
demand curve as well as its own market rent.

Characteristics of the space market: Segmentation

• Space market is highly segmented:

o Location is key
o What a good location is differs across subsectors
• (Users require specific types of space at specific locations)
• Equilibrium varies across subsectors and locations
 • The graphic above shows a map of Brussels and a table with the market rent for office
space of different neighborhoods in Brussels.
• In the city center of Brussels, the market rent of office space is much higher than in the
periphery.
o Companies prefer to be located in the center of Brussels and are willing to pay
a higher rent to find an office building in the center of Brussels.
o There is no one market rent for office in Brussels but there are different
submarkets and each area has its own market rent.

Real estate asset market (or investment market)

• In the real estate asset market or investment market, you have on the one hand the
supply (investors who want to sell) and on the other hand you have the demand
(investor who are looking for a real estate project to invest in).
• Investors wanting to sell and investors wanting to buy meet each other in the real estate
asset market and the result is a market property price that they agree on.

• Market for the exchange

of ownership of property
(rather than the use of
space in properties)
• In this market, buyers
exchange money with
sellers for ownership
rights of properties
• The market where
investors are looking for
properties to invest in

Real estate asset market

⇒ On the vertical axis of the graph above is rent and on the horizontal axis is the property
value.
⇒ The figure shows the real estate asset market. Thus, the real estate asset market
translates rent into a price. The higher the market rent, the higher the value of a
property. The lower the market rent, the lower the value of a property.
 o The price of a property depends on the cash flows (rental income) that you can
get on the property. The bigger the rental income, the bigger the value of the
property i.e. the more money investors are willing to pay to become owners of
the property.

• The figure translates Ro (rental income) into V (property value) à this is done with the
formula of the CAP rate, which states that you can find the value of a building by
dividing the net operating income by the CAP rate.
⇒ Here we assume that the net operating income equals to the market rent (R). In this
case, we ignore vacancy and we ignore operating expenses (we take the gross income
instead of the net operating income). We do this in order to simplify things.

o V = Ro/CAP rate  = Price investors want to pay

o You use the CAP rate that is observed in other similar transactions
o RO is rough estimate of NOI

⇒ The bigger the market rent, the bigger the price investors are willing to pay for a real
estate project.

• The RE asset market is part of the larger capital market.

o Slope depends on the appreciation of RE relative to other asset classes (and this
depends on risk appreciation, supply of new investable assets, economic forecasts,
etc.)
o The flatter this curve, the more investors prefer to invest in RE

⇒ The curve in the graphic above, always goes through the origin i.e. always starts from 0.
⇒ The slope of the curve can vary. The steeper the curve, the less investors are willing to
pay for the real estate project. The flatter the curve, the more investors are willing to pay
for the real estate project.
⇒ The slope of the curve depends on the relative appreciation of real estate to other asset
classes. E.g., in the market, the yields of bonds are going down, then it becomes less
interesting for investors to invest in bonds and maybe they reallocate a part of their
investment portfolio in real estate. If they reallocate part of their investment portfolio to
real estate, then the demand for real estate projects increases. When demand
increases, the price goes up and investors are willing to pay a higher price for the same
property with the same rental income. The slope of the curve flattens then a bit.
Development industry

• Link between asset and space markets

o The development industry is the link between the asset market/ investment market
and the space market/ rental market.
• = Market where new properties are developed
o The development industry is the market where new properties are developed
(construction of new buildings).

⇒ Developers translate financial resources into new buildings

⇒ The financial resources come from the investment market. When the real estate
investors are willing to pay a high price, it becomes profitable for developers to build
new buildings and they are going to develop new properties.
⇒ On the vertical axis of the graph above, is the number of new constructions and on the
horizontal axis is the property value (the price investors are willing to pay for a
property).
⇒ Va* is the minimum construction cost (the minimum cost that developers have to incur
to construct new properties).
⇒ If the price that investors are willing to pay for a property is lower than Va*, then it is not
profitable for developers to construct new buildings and the number of new
constructions equals 0.
⇒ When the price that investors are willing to pay is higher than the minimum construction
costs of the developers, then it becomes profitable for them to construct new buildings.
The profit margin is then the distance between Va and Va*. à Developers will start
developing new projects.

• The higher the value Va, the more new developments are started
• The equilibrium amount of new developments is equal to Do
o If V > CC => Profitable
o If V < CC => not profitable
Real estate supply

⇒ When the development industry develops new projects, this will have an impact on the
real estate supply in the next period (because after 1-2 years the buildings come to the
market and will have an impact on the supply of real estate).
⇒ The graph above shows the real estate demand curve (downward sloping) and the real
estate supply curve (vertical, perfectly inelastic because it cannot move in the short
term).
⇒ Since the supply curve cannot move in the short term, when the number of new
developments is bigger than the number of outdated buildings, then the supply curve
will shift to the right. Thus, the supply curve is influenced by two opposing forces:

• RE supply is influenced by 2 opposing forces:

o New developments => shifting supply to the right
o Outdated buildings => shifting supply to the left
§ Each year there are a few buildings that are too old to rent out and are therefore
demolished.
• Net effect determines the impact on real estate supply
o The net effect of the two opposing forces will determine if the supply curve
shifts to the right or to the left.
o If the market is in a long-term equilibrium, then the number of new
developments is equal to the number of outdated (and demolished) buildings à
supply curve stays constant.
o When the number of new developments is bigger than the number of outdated
buildings, then the supply curve will slightly shift to the right.

⇒ We have discussed the three different submarkets, which altogether form the real
estate system/ real estate market.
⇒ In the four-quadrant model, we bring together this three different markets in one
quadrant.
The 4-quadrant model

• RE system can be translated into a “4-Quadrant Model”, which shows

1. How the three different segments interact
2. How the whole system evolves to a long-run equilibrium

• The outcome of one quadrant is the input for another one

⇒ In the 4-quadrant model it is possible to see how the three different submarkets interact
with each other and how the whole system, the whole real estate market, will evolve to
a long-run equilibrium.
⇒ The model also shows that the outcome of one market or quadrant is always the input
of another one.

Northeast quadrant: Rent determination

• First quadrant shows space market or rental market

o The second quadrant shows the investment market/ asset market, the third
quadrant shows the development industry and the fourth quadrant shows the stock
of space.
o The stock of space translates the number of new constructions into the supply of
real estate projects in the market.
• Demand is downward sloping
o The demand curve in the space market is downward sloping
• Supply is perfectly inelastic: existing space is shown as Q
o The supply curve in the space market is perfectly inelastic (vertical) because it
cannot move in the sort term. In the short term supply is fixed since it takes time to
build new projects (Q will not react on a change in market rent).
• The intersection of demand and supply results in:
o Equilibrium Rent: Ro
o Equilibrium Stock: Q

⇒ Where the supply and demand curves cross each other is the market rent.
⇒ The market rent is the average rent that tenants are willing to pay for space that they
can use.
Northwest quadrant: Valuation

• Second quadrant shows investment market

o This market translates the market rent (output of the space market) in property
value.
o The output of the space market (market rent) is the input of the investment market.
• Demand curve for investment properties translates rental income in a price investors
are willing to pay for properties.
o The demand curve always goes through the origin but the slope can vary (can be
steeper or flatter depending on how attractive the real estate is for investors
compared to other asset classes).
• Va = Ro/CAP rate 
o With the help of the formula of the CAP rate we can calculate the value of a building
with the market rent R.
o If we divide the market rent R by the CAP rate, then we can calculate the price or
value of the building.

Southwest quadrant: Some developments

• In the third quadrant, we include the development industry

o The development industry translates a property value (a price investors are willing
 to pay for a project) into new constructions.
o The higher the price that investors are willing to pay, the more profitable it becomes
for developers to construct new buildings and the more new developments they will
realize.
• Va determines whether it is profitable to start new developments or not
o When the price is lower than Va*, it is not profitable for the developers to construct
new buildings because the price they would get is lower than the cost they would
have to incur.
• The curve defines the link between property value and the number of new
developments
• Do = amount of new developments

Southeast quadrant: Stock adjustment

• In fourth quadrant, we show the impact of new developments on the stock level
o The stock of space quadrant translates the number of new constructions into a new
stock of space, a new supply curve in the space market.
o The bigger the number of new constructions, the more the supply curve will shift to
the right.
• Current stock = stock last year + number of new developments – stock that is outdated
• The line shows the impact of new developments on RE supply
• In long-term equilibrium: number of new developments = the number of outdated
buildings, so that RE supply is constant
o In this case, the market is in a long-term equilibrium. There is no submarket that
has an incentive to move because all markets are in a long-term equilibrium. This
means that the number of outdated buildings equals to the number of new
constructions. Thus, the supply curve remains constant.

External shocks in four-quadrant model: Boom & bust cycle

• The 4-quadrant model can explain the boom-bust cycle in real estate markets
External shocks can trigger a boom-bust cycle: The 4-Quadrant explains how external shocks
can lead to a boom-bust cycle

• Real estate markets always have a very cyclical pattern. There is a phase with declining
vacancy (a lot of new constructions) and when it reaches a peak, the vacancies start to
increase and the number of new constructions declines sharply.
• The 4-quadrant model allows to explain how external shocks can lead to a boom and
bust cycle (cyclical pattern in the real estate market).

In the following slides, we consider three different shocks:

1. Shock in the space market
2. Shock in the asset market
3. Shock in the development industry

1. External shock in the space market: Economic growth

• Acceleration of economic growth spurs RE demand
o Demand curve shifts to the right
o Supply stays constant (inelastic)
• Increase in demand leads to substantial increase in the market rent
o Equilibrium rent rises to R1
⇒ When there is acceleration in the economic growth, the demand curve will shift to the
right (increase) in the space market. E.g., more companies are looking for office space.
⇒ The increase in demand leads to an increase in the market rent (in the graph from 0 to
1).
⇒ The supply curve stays constant because it is not able to move in the short term.

• Increase market rent raises the prices investors are willing to pay in the investment
market
• Valuations of the existing property stock increase to Va1
o When the market rent increases, real estate investors will be more willing to pay a
higher price for real estate projects because when the rental income increases, the
cash flows that they can get from the real estate project increases too.
o Property value increases from Va0 to Va1
• Value increase induces the development industry to start new constructions
o When the prices that investors are willing to pay increase, it becomes more
profitable to construct new buildings so they start developing new projects.
o The number of new constructions increases from D0 to D1.
• Once complete, new developments are added to the real estate stock, resulting in a
new level of Q1
o When developers start to construct more buildings, then the number of new
developments will be bigger that the number of outdated buildings, so the net effect
will be positive and the supply curve will shift to the right after 1-2 years (once new
constructions are finished).
o Supply curve shifts from Q0 to Q1.
o As a result, the space market will reach a new equilibrium. We get a new market
rent that is bigger than R0 but lower than R1 (see red lines in graph below).
• Supply curve shifts to Q1
• Increase in supply exercises downward pressure on rents, which reduce from R1 to R2
• Decrease in rent lowers property valuations from Va1 to Va2
• Lower prices result in less new constructions (from D1 to D2)
• Less new constructions reduces the real estate supply from Q1 to Q2
• This raises rents, and so on…
⇒ There is a new market rent, which leads to a new market price that investors are willing
to pay for a real estate project.
⇒ Investors are not longer willing to pay the price Va1 because the cash flows that they
can get out of the investment declined from R1 to R2.
⇒ When the price declines, it becomes also less profitable for the development industry to
construct new buildings and so the number of new constructions decreases from D1 to
D2.
⇒ Since the number of new constructions decreases, there is a new supply curve, which is
lower than the previous supply curve and there is a new equilibrium. This leads to a
new market rent.
⇒ This process continues over and over again until all markets reach again a long-term
equilibrium
 • This process continues until all markets find a new equilibrium
• New equilibrium levels are all at lower levels than immediately after the shock
o The three submarkets reach a new long-term equilibrium and at this stage no
submarket has an incentive to move again.
o The new equilibrium levels are all lower than immediately after the shock
• The market first overreacts (on the shock) and then falls slightly back to (lower) new
equilibrium levels
• This adjustment mechanism after a shock shows (explains) a cyclical pattern in real
estate markets
• Real estate markets always have an incentive to overreact on a shock and then to
slightly fall back to lower new equilibrium levels. This is because the supply curve is
fixed in the short-term, it cannot reach on a shock. à It takes time for the supply curve
to react to a shock.

In the short run

• The initial reaction is a dramatic price increase (boom) à Overreaction by the market

In the long run

• Prices slightly fall back a bit (bust) as the markets move to a new long-run steady state
(long run equilibrium)
• A demand increase in the space market in the long run results in
o A rent increase
o A price increase in the property market
o An increase in construction activity
o An increase in the equilibrium stock of space

2. External shock in the investment market: Shift in preferences

• For this shock, we go back 12 years in time to the financial crisis of 2008
• After this financial crisis, the European central back decided to launch an easing
program, which resulted in the purchase of €80bn bonds per month.

• QE program ECB resulted in the purchase of €80bn bonds a month, dropping bond
yields to almost zero
o The demand for bonds increased but the yields dropped.
o The return that investors could realize on a bond investment was almost 0. Thus,
investing in bonds was not attractive anymore for investors `,

• Extra money has led to a "wall of money" searching for investments

• Investors started looking for more attractive investments, such as RE
• Consequently, the demand for real estate investments increased => Investors were
willing to pay higher prices for the same property
o When the demand for real estate increases, also the prices for real estate increases
because investors are willing to pay higher prices for the same property.
• QE program increases demand in the asset market, spurring up the price
• Investors are willing to pay more for the same rental income
• The investment curve rotates downwards
⇒ Due to the quantitative easing program of the European Central Bank, the demand
curve rotates downwards à Investors are willing to pay a higher price for the same
property with the same market rent.
⇒ Price or value of the properties increases from Va0 to Va1

• Higher prices motivates construction companies to build additional properties

• Additional properties shifts RE supply curve to the right
• The increase in supply on the space market will initially exercise a downward pressure
on the rent (demand is constant)
• And so on…
⇒ When the prices investors are willing to pay for real estate increase, it also becomes
more profitable for the development industry to construct more buildings. à Number of
new developments increase from D0 to D1.
⇒ When the number of new developments increases, then after 1-2 years when the
constructions are finished this will have an impact on the supply of real estate in the
space market. Thus, the supply curve in the space market will shift to the right from Q0
to Q1.
 ⇒ So, there is a new equilibrium. The market rent will decrease from R0 to R1.
⇒ When the market rent decreases, then the price that investors are willing to pay will also
decrease from V1 to V0.
⇒ This process will continue until all markets reach a new long-term equilibrium.

• In red we can see the new long-term equilibrium

• This process continues until all markets find a new long-term equilibrium
• New equilibrium values are all at a lower level than immediately after the shock
• The market again first overreacts (boom) and then falls slightly back to lower (bust)
equilibrium levels

3. External shock in the development industry: Increase in registration fees

• Suppose that higher costs are imposed on building new real estate, such as stricter
environmental regulation, an increase in registration fees, etc.
• How do you think that this will impact the development industry?

• Vertical axis: number of new constructions

• Horizontal axis: Property value (price that investors are willing to pay for property).
• The curve translates the price that investors are willing to pay into a number of new
constructions.
• When registration fees increase, the curve will shift parallel to the right.
• The distance from the origin to Va* is the minimum construction cost that developers
have to incur to develop new buildings.
o When registration fees increase, the costs will increase. Thus, developers will want
a higher price for their projects.
o Thus, the curve will shift parallel outwards

• Increase in registration fees makes it more expensive to build new properties

• The curve shifts to the left (they require a higher price for new constructions)
• Less development activity reduces RE supply after some time, leading to higher rents
and higher valuations
⇒ Since it becomes more costly to develop new buildings, the number of new
developments will decrease from D0 to D1. à It becomes less profitable to develop
new projects
⇒ If the number of new developments decreases, then the supply curve after 1-2 years
will shift to the left (the number of outdated buildings becomes bigger than the number
of new developments). Since the net effect is negative, the supply curve shifts to the
left.
⇒ Because of the shift, there is a new equilibrium and the market rent will increase.
⇒ Due to the higher market rent, investors will be willing to pay a higher price because
they can get more cash flows from the real estate investment. Thus, property values go
up.
⇒ This process goes on until all markets reach a new equilibrium.
• This process continues until all markets reach a new equilibrium
• In the new equilibrium: D1 < D* < D0
⇒ The market first overreacted to the shock and then slightly fell back to a lower
equilibrium