Theoretical Foundations of Finance – Formulas

1. CAPITAL MARKETS, CONSUMPTION, AND INVESTMENT

∞
CF
Assets = ∑ i
n =1 (1+ R)

∞
Dividends
Equity = ∑
n =1 (1+ ℜ)i
n
Coupon Nominal Value
Debt = ∑ i
+
n =1 (1+ Rd ) (1+ Rd )n

Assets = Equity + Debt

Marginal Rate of Substitution

−δ C 1
MRS CC10= =−(1+r )
δC0
 r = subjective time preference

Marginal Rate of Transformation

P0 −δ P1
MRT P 1 = =−(1+r )
δ P0
 r = marginal rate of return

Y1 - endowment at the end of the period.

Y0 - endowment at the beginning of the period.
C0 - consumption at the beginning of the period.
Y0 - C0 – savings/investment

Y1 CML – C1 = W1 – (1+r) C0
W0 = Y0 +
(1+r )
Slope of CML = - (1+market rate)
W1 = Y0 (1+r) +Y1

2. PORTFOLIO THEORY

P 1+ D 1−PO P 1−PO D1
Total shareholder return = = +
PO PO PO

Asset View
n
ra = ∑ pi ×r i
i=1

n
σ =∑ pi ×(r ¿ ¿i−E[r ])¿ 2
2

i=1

√∑
n
2
σ= pi ×(r ¿ ¿i−E[r ]) ¿
i=1

√
n

σ= ∑ (r ¿¿ i−E [r ])2
i=1
¿
n−1

n
COV (ra, rb) = ∑ pi [r a−R(¿ r a )][r b −R ( r b ) ]¿
i=1

COV (r a , r b )
P a , b= , -1 ≤ Pa , b ≤ 1
σ a ×σ b

Portfolio View

rp = w a × r a + wb ×r b
2 2
σ p=w a σ a +¿ w b σ b +2 w a ( 1−w b ) cov (r a , r b)
2 2 2

σ p = √ σ 2p
Minimum Variance Portfolio
2
¿ σ b−cov (r a , r b)
wa = 2 2
σ a + σ b−2 cov (r a , r b )

With risk free asset Optimal Risky Portfolio

σ p=w a × σ a wa = ¿ ¿¿
r a−r f wb = 1 - wa
rp = r f +σ p
σa

N>2

n returns
n variances

n(n−1)
covariances
2
 3. PORTFOLIO THEORY IN MATRIX FORM

cov (i,j) =σ ij
2
σ i =σ ii

rp = ¿  u’ X

2
σp=¿ =¿
2 2
= x 21 σ 21+ ¿ x 2 σ 2+ 2 x 1 ( 1−x 2 ) cov (r 1 ,r 2 )  X’ ∑ X

Cov (Rx, Ry) = ¿ = x 1 y 1 σ 11 + x1 y 2 σ 12+ x 2 y 1 σ 21+ x 2 y 2 σ 22

y = vector of weights in portfolio Y (Ya = weight of asset 1 in portfolio Y)

Minimum Variance Portfolio

Minimize

Subject to

 Aw = B
w= −1
A B
Aw = B 

Global minimum variance

 4. Capital Structure Theory

n
EBIT ( 1−T ) + Depreciations−Capex−△ WC
Firm Value = ∑ ¿
t =1
¿¿
n
EBIT ( 1−T ) EBIT ( 1−T )
Depreciation = Capex, △ WC = 0, Firm Value = ∑ ¿ , Firm Value = ~
t =1
¿¿ k

No taxes

VL = VU  EL + D = EU  α[EBIT-RDD] + α RDD = α EBIT  α EBIT = α EBIT

E D D
WACC = RA = RE + RD  RE = RA + (RA - RD)
E+ D E+ D E

With Taxes

VL = VU + Tc D  EL + D = EU + Tc D  [EBIT-RDD] [1- Tc] + RDD = EBIT [1- Tc]

EBIT [1- Tc] + RDDTc = EBIT [1- Tc]

EBIT [1−T c] R D D T C EBIT [ 1−T c]

+ =
RA RD RA

EL D D
WACC = RA = RE + RD [1- Tc]  RE = RA + (RA - RD) [1- Tc]
EL + D E L+D EL

TCD ( EBIT −R¿¿ D D)(1−T C )

WACC = RA [1 - ] RE = ¿=
EL + D EL
R A V U −R D D(1−T C )
EL
With taxes on investors revenue

VL = VU + D T*

[ 1−T c ][ 1−T e ]
VL = VU + D (1− )
( 1−T D )

[EBIT-RDD] [1- Tc] [1- Te] + RDD [1- TD] = EBIT [1- Tc] [1- Te]

 EBIT [1- Tc] [1- Te] + RDD [[1- TD] - [1- Tc] [1- Te]] = EBIT [1- Tc] [1- Te]

EBIT [1−T c] R D D[[1−T D ]−[ 1−T c] [1−T e ]] EBIT [1−T c][1−T e ]

 + =
RA R D (1−T D ) RA

EBIT [1−T c] [[1−T D ]−[1−T c ][1−T e ]] EBIT [1−T c][1−T e ]

 +D =
RA (1−T D ) RA

VL = VU + Tc D  Te = TD = 0 , Te = TD

VL = VU  [1- Tc] [1- Te] = [1- TD]

5. Asset Pricing Theory

n
CF CF CF CF
V0 = ∑ i = + 2 + 3
1 (1+ r) (1+r ) (1+r ) (1+r )
n
I P
V0 = ∑ i
+¿ i
¿
(1+ kd)
1 (1+ kd )
∞
Dividend
P0 = ∑
1 (1+ ks)i
n
Dividend
P0 = ∑ r −g
1

FCFF = EBIT(1-T) + Dep – Capex - △ WC

EQV0 = EV0 + NOA0 - DEBT0

ri = α i + b i rm + Ɛ i
E[ri] = αi + bi rm
2 2 2 2
σ i = bi σ m + σ Ɛ

Cov (ri , rj) = bi bj σ 2m

n
E[rp] = αp + bp E[rm] = αp + ∑ wi bi R (r ¿¿ m)¿
i=1

2 2 2 2
σ p = b p σ m + σ Ɛp
n N
σ =∑w σ ∑ ∑ wi w j cov (¿ Ɛ i Ɛ j) ¿
2 2 2
Ɛp i Ɛi
i=1 j=1

E (ri) = rf + βi (E(rm) - rf)

cov (r i r m )
βi =
Var (r m )

E ( r m ) −r f
E[r] = rf + σp
σM

E (ri) = rf + βiC (E(rC) - rf)