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Chapter 7
PORTFOLIO THEORY

1. Introduction
In this and the following chapter on Capital Asset Pricing Model, we will look at what determines the
return that shareholders require and therefore the cost of equity.

You cannot be asked for calculations on portfolio theory, but you are expected to be aware of the
ideas involved, and this chapter is a vital lead-in to capital asset pricing model which certainly does
involve calculations.

2. What determines the rate of return that shareholders

require?
Why is it that shares in some companies are viewed as inherently more risky than shares in other
companies? It is because the nature of their business is more risky. As a result, the potential
fluctuations in profits (and hence dividends) in the future are greater. If things go well shareholders
may well expect much higher dividends, but the risk is that things may go badly in which case they
will receive much lower dividends. The greater the potential fluctuations in returns, the greater we
say that the risk is.

3. What do we mean by risk?

The reason that we regard companies as risky is that their future earnings are not certain - they may
increase or they may decrease. If we were certain that a company was going to earn $100,000 per
year in the future then we would say that there was zero risk. However, this is obviously not the
case in practice - we may be expecting an average of $100,000 a year, but clearly the actual earning
may end up being higher or lower. That is the risk inherent in every company, and the more the
potential fluctuations in earnings then the more risk there is in the company.

4. What creates the risk?

There are two reasons for the potential fluctuations in earnings and hence the risk.

The first reason relates to the industry within which the company operates. For example, the
accountancy industry may be less risky that the oil industry. All companies are affected by the same
general economic factors (such as the rate of inflation, the exchange rate) but different industries
are affected to different degrees. Companies that import and export a lot will be affected by
changes in exchange rates to a much greater degree than companies that do little or not importing
and exporting.

This risk is known as systematic or market risk. Again, this is risk due to general economic factors,
occurs in all companies, but the level of this risk differs between different types of businesses
(different sectors).

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So why therefore do not all oil companies have exactly the same level of risk?

This is because there is a second factor involved which is factors in the specific company. For
example, a company (whatever sector it is in) may have just appointed a new managing director
who may turn out to be excellent or may not. A company may have has poor labour relations in the
past and lots of strikes - in the future things may get worse or, of course may improve. These are
both examples of factors that create extra risk in the company over and above the systematic risk of
the industry.

This risk is known as unsystematic or company specific risk.

5. How can an investor minimise the risk?

Rather than invest all ones money just in one share (and therefore being subject to both the
systematic and unsystematic risk), and investor should spread their money between several shares.
In this way the unsystematic risk can be removed - some companies may do better, some may do
worse, but they ‘cancel’ each other out. We call this diversifying away the risk by creating a portfolio
of shares.

The systematic risk cannot be removed - all companies are affected by general economic factors
and there is nothing we can do about this. We can choose the level of systematic risk that we want,
by deciding which sectors (or mix of sectors) that we choose to invest in, and it is then the level of
systematic risk that will determine the return required - more systematic risk then greater return,
and vice versa.

This is the basis of the capital asset pricing model that we will look at in the next chapter. We
assume that shareholders of large quoted companies are well-diversified, and have therefore
diversified away the unsystematic risk. The only risk they are therefore concerned about is the level
of systematic risk, and it is this that will determine the required return.

A well-diversified investor is one who has created a portfolio where the unsystematic risk has been
fully diversified away. The only risk remaining will be systematic risk and it is the level of systematic
risk that will determine the return required by the investor. It is this statement that forms the basis
of the Capital Asset Pricing Model which will be covered in the next chapter.

Risk

Total Risk

Unsystematic
Risk

Systematic Risk

Diversity of Portfolio

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Chapter 8
THE CAPITAL ASSET PRICING MODEL

1. Introduction
In the previous chapter on Portfolio Theory we looked at the nature of risk in share investments,
and described what is meant by a well-diversified portfolio. In this chapter we will look at the
importance of the systematic risk in relation to the return given by quoted shares and then discuss
its relevance to project appraisal.

2. The return from quoted shares

Shareholders (as a whole) can get whatever return they require from a quoted share because they
determine the market value of the share. The market value is determined by the expected future
dividends and the investors’ required rate of return.

We assume that the shareholders in a large quoted company are overall well-diversified (partly
because there are many shareholders, but also because many of the shareholders will be pension
funds and unit trusts that will have large portfolios).

If the shareholders’ are well-diversified, then they will have diversified away all the unsystematic
risk (portfolio theory) and will therefore only be concerned with the level of systematic risk. It is
therefore the level of systematic risk that will determine the return that they require (and hence the
return actually given) from the share.

Instead of measuring the systematic risk in isolation as a %, we normally measure it relative

to the risk of the market as a whole (i.e. the stock exchange as whole). We call this the β of the
share.

Since it is the level of the systematic risk in a share that determines the return required, we would
expect that the higher the β the higher the required return (and the lower the β, the lower the
required return!).

The most important formula of all in CAPM is the formula expressing the required return,
which is as follows:

E(ri) = Rf + βi[E(rm) – Rf]

where: E(ri) = return from investment

Rf = risk free rate

rm = return from the market

βi = β of the investment

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Example 1
Q plc has a beta of 1.5.
The market is giving a return of 12%,
The risk free rate is 5%.

What will be the required return from Q plc?

Example 2
T plc is giving a return of 20%.
The stock exchange as a whole is giving a return of 25%, and the return on government securities is
8%.

What is the β of T plc?

3. Calculating β in practice
In practice, it is assumed that CAPM ‘works’ and that therefore the return given by a share is
determined by its β. It is therefore possible to calculate a β by working backwards (as in example 2
above).

However, even assuming that CAPM does work, it would be too perfect to assume that the formula
works exactly from day-to-day – market imperfections will mean that on any one day the actual
return may be slightly ‘wrong’. In practice therefore the returns from a share are compared with
those from the market over a long period and a β calculated in this way.

You will not be expected to do this in the examination.

4. Combining investments
If an investment is made in a combination of several shares with different levels of systematic risk,
then the overall β will be the weighted average of the individual share β’s.

Example 3
Matiss decides to invest his money as follows:
20% in A plc which has a β of 1.2
40% in B plc which has a β of 1.8
30% in C plc which has the same risk as the market
10% in government securities.
The market return is 20% and the risk free rate is 8%.

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(a) What will be the overall β of his investments?

(b) What overall return will he be receiving?

5. Alpha values
We have already stated that even assuming that CAPM ‘works’ in practice, it would be unrealistic in
the real world to expect that it works precisely at each moment in time. Even if it does work overall,
it will not be surprising if some days the actual return is a little higher than it should be, and some
days a little lower.

The alpha value is simply the difference between the actual return and the theoretical return (using
CAPM).

Example 4
D plc has a β of 0.6 and is giving a return of 8%.
The market return is 10% and the risk free rate is 4%.

What is the alpha value of D plc?

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6. Ungearing B’s
Until now, we have been ignoring gearing and assuming that the companies in our examples have
been all equity financed. In this case the risk of a share is determined solely by the risk of the actual
business.

If, however, a company is geared, then a share in that company becomes more risky due to the
gearing effect.

If, therefore, we are given the β of a share in a geared company, then the gearing in that company
will have made the β higher than it would have been had there been no gearing. The β of a share
measures not simply the riskiness of the actual business but also includes the gearing effect.

We therefore need to be careful when comparing the β’s of shares in different companies. A higher
β certainly means that the share is more risky, but it may be due to the fact that the company is
more highly geared, or due to the fact that the business is inherently more risky, or a combination
of the two!

The formula for removing the gearing effect is given in the examination and is:

⎡ Ve ⎤ ⎡ Vd (1−T ) ⎤
βa = ⎢ βe ⎥ + ⎢ βd ⎥
⎢ (Ve +Vd (1−T )) ⎥ ⎢ (Ve +Vd (1−T )) ⎥
⎣ ⎦ ⎣ ⎦

where: βa is the ungeared β (also knows as the asset β or earnings β)

βe is the geared β (also known as the equity β or share β)

Ve and Vd are the market value of equity and debt

βd is the β of debt

Note that although you are given this formula in full in the examination, we normally assume that
debt is risk free and that therefore βd = 0, which makes the formula much shorter! In every relevant
examination question so far we have been expected to make this assumption.

Example 5
P plc has a gearing ratio (debt to equity) of 0.4 and the β of its shares is 1.8.
Q plc has a gearing ratio of 0.2 and the β of its shares is 1.5.
The rate of corporation tax is 30%.
(a) Which is the more risky share?
(b) Which company has the more risky business activity?

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7. The implications of CAPM for project appraisal

If the shareholders of a company are well-diversified, then their shares in this company are just part
of their overall portfolio.

If the company is to invest the shareholders money in a new project, then the project should be
appraised in the same way as the shareholders themselves would appraise the investment if they
were invested their money in it directly.

If they were investing directly, then they would base their required return simply on the β of that
investment (not on how it related to any particular other investment in their portfolio).

Therefore, when the company is appraising a new project they should calculate the β of the
project, determine the required return for that β, and appraise the project at that required return.

How to calculate the β of a project? Find a similar quoted company and use the β of that company
(ungeared if relevant).

We will illustrate the above with a full example:

Example 6
X plc is an oil company with a gearing ratio (debt to equity) of 0.4. Shares in X plc have a β of 1.48.
They are considering investing in a new operation to build ships, and have found a quoted
shipbuilding company – Y plc. Y plc has a gearing ratio (debt to equity) of 0.2, and shares in Y plc
have a β of 1.8.
The market return is 18% and the risk free rate is 8%.
Corporation tax is 25%

At what discount rate should X plc appraise the new project, if it is to be financed
(a) entirely from equity?
(b) by equity and debt in the ratio 50%/50%

Do note, however, that when there is a major change in gearing (as in the example) it is far better to
take an Adjusted Present Value (APV) approach. This is commonly asked in the exam and will be
explained in a later chapter.

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Chapter 9
DISCOUNTED CASH FLOW TECHNIQUES

1. Introduction
Most of this chapter should be revision for you. It is however extremely important and so make sure
that you revise it properly.

Of the few new items in this chapter, the most important is Modified Internal Rate of Return and
you should make sure that you learn the technique involved.

2. Net present value calculations

Here is a list of the main points to remember when performing a net present value calculation.
After we will look at a full example containing all the points.

๏ Remember it is cash flows that you are considering, and only cash flows. Non-cash items
(such as depreciation) are irrelevant.
๏ It is only future cash flows that you are interested in. Any amounts already spent (such as
market research already done) are sunk costs and are irrelevant.
๏ There is very likely to be inflation in the question, in which case the cash flows should be
adjusted in your schedule in order to calculate the actual expected cash flows. The actual
cash flows should be discounted at the actual cost of capital (the money, or nominal rate).
(Note: alternatively, it is possible to discount the cash flows ignoring inflation at the cost of
capital ignoring inflation (the real rate). We will remind you of this later in this chapter, but it
is much less likely to be relevant in the examination.)
๏ There is also very likely to be taxation in the question. Tax is a cash flow and needs bringing
into your schedule. There are two ways of dealing with tax (both giving the same end result).
One way is to calculate the tax on the operating cash flows (an outflow) and then calculate
the tax saving on the tax allowable depreciation (an inflow). The alternative is to subtract the
tax allowable depreciation (capital allowances) to get the taxable profit. Then calculate the
tax on the taxable profit, but then add back the capital allowances, because they are not a
cash flow. For this exam, the second way is generally preferable for two reasons: firstly is is
very common in the exam for the examiner to state that an investment is needed each year of
an amount equal to the tax allowable depreciation for the maintenance of non-current assets
- in which case we do not add back the tax allowable depreciation. Secondly, if there is a
taxable loss, then there is no tax in that year but the loss is carried forward and subtracted
from future taxable profits.
๏ You are often told that cash is needed to finance additional working capital necessary for
the project. These are cash flows in your schedule, but they have no tax effects and, unless
told otherwise, you assume that the total cash paid out is received back at the end of the
project.

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Example 1
Rome plc is considering buying a new machine in order to produce a new product.
The machine will cost $1,800,000 and is expected to last for 5 years at which time it will have an
estimated scrap value of $1,000,000.
They expect to produce 100,000 units p.a. of the new product, which will be sold for $20 per unit in
the first year.

Production costs p.u. (at current prices) are as follows:

Materials $8
Labour $7
Materials are expected to inflate at 8% p.a. and labour is expected to inflate at 5% p.a..
Fixed overheads of the company currently amount to $1,000,000. The management accountant has
decided that 20% of these should be absorbed into the new product.
The company expects to be able to increase the selling price of the product by 7% p.a..
An additional $200,000 of working capital will be required at the start of the project.
Capital allowances: 25% reducing balance
Tax: 25%, payable immediately
Cost of capital: 10%

Calculate the NPV of the project and advise whether or not it should be accepted.

3. Internal rate of return

One problem with decision making using the Net Present Value is that the Cost of Capital is at best
only an estimate and if it turns out to be different that the rate actually used in the calculation, then
the NPV will be different. Provided that the NPV remains positive then the project will still be
worthwhile, but if the NPV were to become negative that the wrong decision will have been made.

The Internal Rate of Return (IRR) is that rate of interest at which the NPV of the project is zero (i.e.
breakeven).

In order to estimate the IRR we calculate the NPV at two different rates of interest, and then
approximate between the two assuming linearity. (In fact, the relationship is not linear and so any
estimate will only be approximate)

Example 2

For the project in example 1, calculate the Internal Rate of Return.

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4. Problems with the use of the internal rate of return

Although the IRR is the ‘breakeven’ rate of interest for the project, and as such can be useful when
we are not certain of the Cost of Capital for the company, it does have many drawbacks.

It is only a relative measure of wealth creation, it can have multiple solutions, and it does
effectively assume that the cash flows produced by the project are re-invested at the IRR if it is used
to choose between investments.

A possible better measure is the Modified Internal Rate of Return (MIRR).

5. Modified internal rate of return

The MIRR is quicker to calculate than the IRR and effectively assumes that the cash flows are re-
invested at the Cost of Capital.

There are several ways of calculating it, but the method suggested by the examiner is to calculate
the Present Value of the ‘investment phase’ (the flows in the years when the company is investing
in the project); to calculate the Present Value of the ‘return phase’ (the flows in the years when the
project is generating returns) and then to use the following formula (which is provided for you in
the examination):

1
⎡ PV ⎤ n
MIRR = ⎢ R ⎥ (1+ re )−1
⎢ PV1 ⎥
⎣ ⎦

where: PVR = the PV of the return phase

PVI = the PV of the investment phase

n = the life of the project in years

and, re = the cost of capital

We will illustrate the calculation of the MIRR using the previous example.

Example 3

For the project in example 1, calculate the MIRR.

The MIRR is usually lower than the IRR, because it assumes that the proceeds are re-invested at the
Cost of Capital. However in practice the proceeds are often re-invested elsewhere within the firm. It
does however have the advantage of being much quicker to calculate than the IRR.

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6. Foreign investment appraisal

One way in which the examiner can create more work in a NPV question is for it to be a company
investing in a project in another country - the other country using a different currency. Although
there are not really any extra techniques involved, we will work through an example in order to
illustrate the approach needed.

Example 4
James plc, a company in the U.K, is considering investing in a project in Oblivia, a country that uses
the Euro.
They have prepared the following forecasts over the 5 year planning horizon:

Year 1 2 3 4 5
Revenue (€‘000’s) 2,000 2,500 4,000 3,000 2,000
Operating costs (€‘000’s) 500 800 1,000 1,000 500
In addition. the subsidiary will pay royalties to James plc of £100,000 per year.
Tax in Oblivia is 20%, payable immediately, and tax allowable depreciation is at the rate of 20% p.a.
straight line. An amount equal to the amount of the tax allowable depreciation is required each
year for the maintenance of non-current assets.
The initial investment in the operation is €5,000,000 and there is no residual value at the end of the
planning horizon.
All net cash surpluses will be remitted to the U.K. each year. The tax rate in the UK is 25%, payable
immediately, and a double taxation treaty exists between the U.K. and Oblivia.
The forecast exchange rates are as follows (€’s per £):

Year
0 1.10
1 1.15
2 1.20
3 1.20
4 1.25
5 1.25
James plc’s cost of capital is 15%.

Calculate the NPV of the project and advise whether or not it should be accepted.

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7. Inflating perpetuities
Although the majority of investment appraisal questions are over a fixed time period as in the
previous examples, it is reasonably common to be required to calculate the present values of cash
flows continuing into perpetuity. We can use the ‘growth model’ formula given on the formula
sheet in order to deal with this.

Example 5
Cash flows have been forecast at $5,000 p.a. in perpetuity, inflating at 4% p.a..
The cost of capital is 20%.

Calculate the present value of the cash flows.

This example was perhaps a little bit too easy, and so to introduce a common ‘complication’, let us
look at another example.

Example 6
Cash flows have been forecast as an actual $5,000 in the first year; an actual $6,000 in the second
year; and an actual $7,000 in the third year, thereafter inflating at 5% per year.
The cost of capital is 20%.

Calculate the present value of the cash flows.

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8. Multi-Period Capital Rationing

Capital rationing is the situation when the company has several projects that they wish to invest it,
but only have a limited amount of capital available for investment.

You will remember that when there is limited capital in only one year (single-period capital
rationing) then we rank the projects based on the NPV per $ invested (the profitability index).

However, it is more likely in practice that investment is needed in more than one year and that
capital is rationed also in more than one year. This situation is known as multi-period capital
rationing and the solution requires using linear programming techniques. As you will see in the
example that follows, you will not be required to solve the problem, but you may be required to
formulate the problem.

Example 7
Paris plc is has three projects available for investment with the following cash flows and NPV’s (at a
cost of capital of 10%):

Year A B C
0 (5,000) (8,000) (6,000)
1 (4,000) 2,000 (6,000)
2 8,000 6,000 4,000
3 4,000 5,000 12,000
NPV at 10% +976 +2529 +862

The projects are infinitely divisible (note: this means we can invest in any fraction of a project and that
all the cash flows (and therefore the NPV) will also be this fraction of those above).
Paris plc has cash available for investment as follows:
Year 0 $14,000
Year 1 $5,000

You are required to formulate the linear programming model necessary to decide how best
to invest the capital available. Any capital not used in Year 0 may be put on deposit for one
year and earn interest at 7%.

As stated earlier, you will not be expected to solve the problem (it cannot be solved graphically
because there are more than 2 variables, and therefore would need a more advanced technique).

Also, you should remember that there are two reasons why capital may be limited:

Hard capital rationing – which is where the company is unable to borrow more, and

Soft capital rationing – which is where the company can borrow more, but has chosen to limit the
amount it is prepared to borrow.

The formulation of the problem is the same, whatever the reason for the capital rationing.

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9. Free cash flows

The free cash flow is the cash available for distribution to lenders (shareholders and debt lenders).

When appraising a project (as in the first example in this chapter) the net cash flow that we
calculated each year is the free cash flow.

However, it is also possible to use NPV techniques in exactly the same way to arrive at the value of
the company and for this we need to estimate the net cash flows (or free cash flow) each year from
the company as a whole.

In this situation we are more likely to be given the forecast profits of the company (as opposed to
forecasts of each individual cash flow) in which case we can estimate the free cash flows as follows:

Free cash flow = Earnings before interest and tax (EBIT)

less: tax on EBIT
plus: non-cash items (depreciation)
less: cash required for capital expenditure
less (or plus): working capital changes

We will look at an example of this in a later chapter when we consider the valuation of a company.

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Chapter 10
RISK AND UNCERTAINTY

1. Introduction
A major reservation of any investment appraisal decision is that the figures used in the calculations
are only estimates and stand to be uncertain. Clearly if any of the cash flows used in the decision
turn out to be different from what was estimated, the decision itself could be affected.

In this chapter we will revise three approaches that you should already be aware of from the earlier
Financial Management exam, and then look at one more approach - Value at Risk.

2. Sensitivity analysis
Sensitivity analysis analyses the effect of changes made to variables in the problem in order to
determine their effect on the decision.

First we calculate the NPV of the project on the basis of the best estimates.

Then we calculate what % change (or sensitivity) in each of the variables would result in a NPV of
zero (i.e. the breakeven position – any further change would change the decision).

By considering the sensitivity of each variable we can ascertain which variables are the most critical
and therefore perhaps need more work confirming our estimates.

Example 1
Daina has just set up a new company and estimates that the cost of capital is 15%.
Her first project involves investing in $150,000 of equipment with a life of 15 years and a final scrap
value of $15,000.
The equipment will produce 15,000 units p.a. generating a contribution of $2.75 each. She
estimates that additional fixed costs will be $15,000 p.a..
(a) Determine, on the basis of the above figures, whether the project is worthwhile
(b) Calculate the sensitivity to change of:
i. the initial investment
ii. the sales volume p.a
[Link] contribution p.u.
[Link] fixed costs p.a.
v. the scrap value

Comment on the results

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3. Simulation
Simulation is a technique which allows more than one variable to change at the same time.

You will not be required in the examination to actually perform a simulation, but you should be
aware of the principle involved.

Essentially, the stages are as follows:

๏ identify the major variables

๏ specify the relationship between the variables
๏ attach probability distributions to each variable and assign random numbers to reflect the
distribution
๏ simulate the environment by generating random numbers
๏ record the outcome of each simulation
๏ repeat the simulation many times to be able to obtain a probability distribution of the
possible outcomes

4. Expected values
With this approach, we identify the various possible outcomes for each uncertain variable, together
with the associated probability.

We then use for each uncertain variable the weighted average outcome (or expected outcome),
and use these figures in our investment appraisal calculation.

Example 2
Daiga plc is considering launching a new product.
This will require additional capital investment of $200,000.
The selling price of the product will be $10 p.u.. Daiga has ascertained that the probability of a
demand of 50,000 units p.a. is 0.5, with a probability of 0.4 that it will be 20% higher, and a 0.1
probability that it will be 20% lower.
The company expects to earn a contribution of 50% and expects fixed overheads to increase by
$140,000 per year.
The time horizon for appraisal is 4 years. The machine will be sold at the end of 4 years for $50,000.
The cost of capital is 20% p.a.
Calculate the expected NPV of the project

5. Value at Risk (VaR)

When we calculate the NPV of a project, the problem is, of course, that the cash flows are uncertain
and that therefore the actual NPV may turn out to be higher or lower. We have looked at the

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sensitivity - the % changes that will result in an NPV of zero. However, Value at Risk is a method of
calculating with a certain degree of confidence what the greatest fall in the NPV will be.

The VaR is the maximum amount that an investment might lose at a given level of confidence. For
example, we might be able to say that the VaR is $100,000 at the 95% confidence level. This would
mean that there would be only a 5% chance of losing more than $100,000.

Although we are able to calculate the VaR for a project, it is much more applicable to an institution
(for example a bank) holding a portfolio of investments. The current value may be, say, $500,000,
and obviously the value may increase or decrease over time. It will be of use to the bank to be able
to calculate that they are 95% confident that the value will not fall by more than $300,000 (i.e. to
less than $200,000) so as to be able gauge the amount of assets needed to be able to cover
possible losses.

In order to be able to calculate the VaR, we need to know the volatility of the values (the standard
deviation) and to assume that they values are normally distributed. We will explain the calculation
with an example.

Example 3
James has estimated an annual standard deviation of $750,000 on one of its projects, based on a
normal distribution of returns. The average annual return is $2,400,000.

Estimate the value at risk (VAR) at a 95% confidence level for one year, and also over the
project’s life of six years.

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Chapter 11
THE VALUATION OF DEBT FINANCE,
THE MACAULAY DURATION AND THE
MODIFIED DURATION

1. Introduction
In your previous studies you have seen what factors determine the market price of debt finance
(bonds). In this chapter we will revise this and also look at how future changes in interest rates
effect the market prices.

2. The valuation of debt

In theory, the market value of debt will be determined by the returns that investors expect to
receive, and the rate of interest that they require – it will be the present value of the expected
receipts discounted at the investors’ required rate of return.

Example 1
A company has 8% bonds in issue, redeemable in 5 years time at a premium of 10%.
The investors’ required rate of return is 10%.

Calculate the market value of the bonds (for a nominal value of $100)

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3. The redemption yield

You have also seen before that in the case of quoted debt, we can calculate the return that
investors are receiving from a bond by effectively ‘working backwards’. If we know the market
value and we know the expected receipts, then we can calculate the return to investors by working
out the internal rate of return (this is known as the gross redemption yield).

Example 2
A company has 8% bonds in issue, redeemable in 10 years time at a premium of 10%.
The market value (for $100 nominal) is currently $91.61.

Calculate the redemption yield.

(Note that in this example we calculated the gross return to the investor. The cost of debt to the
company would be different because we would then take into account the tax relief on the interest
payments.)

4. Comparing bonds
In the previous two examples, the bonds were both giving the same return to investors (gross
redemption yield). This clearly need not be the case, and the gross redemption yield will be a factor
for investors when choosing between different bonds.

However, since the bonds in both our examples are giving the same return, it is tempting to say
that potential investors would be indifferent between them.

There is however one big problem in that interest rates may change in the future, and if they do
change then investors’ required returns will change, which will in turn effect the market price of the
bonds.

Although required returns would change for all potential investments, the extent of the change in
the market value will differ depending on the length of life of the bond.

Example 3

For each of the bonds in the two previous examples, calculate the new market value (for $100
nominal) if the gross redemption yield were to change to 15%. Hence calculate the %’age
change in the market values of each.

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5. The Macaulay Duration

The Macaulay duration measures the average time it takes for a bond to pay its interest and
principal.

The calculation is as follows:

(1) Calculate the present value of the cash flows, and add them up.
(2) Multiply the present value of each cash flow by the time period, and add them up.
(3) Divide the result from (b) by the result from (a)

Example 4
A company has 8% bonds in issue, redeemable in 5 years time at a premium of 10%. The current
market value is $98.63 (for $100 nominal)

Calculate:
(a) the gross redemption yield, and
(b) the Macaulay duration

If you look again at this example, the following should be clear for each of the variables:

๏ Time to maturity: as the time to maturity increases, the Macaulay duration will also increase
๏ Coupon rate: as the coupon rate increases, the Macaulay duration decreases
๏ Yield to maturity (or gross redemption yield): as the yield to maturity increases, the Macaulay
duration decreases

Example 5

Calculate the Macaulay duration for the bond in Example 2.

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6. The Modified Duration

The Modified Duration measures the sensitivity of the market value of a bond to changes in interest
rate.

It is calculated by dividing the Macaulay duration by (1 + gross redemption yield).

Example 6

Calculate the modified duration for the bonds in Example 4

The equation linking modified duration (D), and the relationship between the change in interest
rates (∆i) and change in price

or value of a bond or loan (∆P) is given as follows: ∆P = [–D x ∆i x P]

(P is the current value of a loan or bond and is a constant)

The size of the modified duration will determine how much the value of a bond or loan will change
when there is a change in interest rates. A higher modified duration means that the fluctuations in
the value of a bond or loan will be greater, hence the value of 3.94 means that the value of the loan
or bond will change by 3.94 times the change in interest rates multiplied by the original value of
the bond or loan.

7. Limitations of the modified duration

Duration is only useful in assessing small change in interest rates. This is because although as
interest rates increase, bond prices will fall (and vice versa) the relationship is non-linear. In fact, the
relationship between the changes in bond values and changes in interest rates is in the shape of a
convex curve.

Bond
value
Actual
relationship

Relationship
predicted by
duration

Interest rates

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8. Project Duration
Although this chapter is primarily concerned with bonds, we can calculate the duration of a project
using exactly the same was as we calculated the Macaulay Duration for a bond.

Example 7
Lola plc is considering a project which requires an initial investment of $240,000. Projected cash
flows, discounted at Lola’s cost of capital of 10% are as follows:

Year 0 1 2 3 4 5
Present Value (240,000) 109,092 87,274 63,110 32,784 14,902

Calculate the project duration.

The project duration is a measure of the average time over which a project delivers it’s value, and
has the same duration as a project that delivers 100% of its cash inflows over the same period. The
lower the duration the lower the risk of the project. This method looks at the cash flows over the
whole life of the project, unlike the payback period which only considers the flows during the
payback period.

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