FM Bible.pdf

Chapter 1: An Overview of Financial Management Learning Objectives:  Recall the 3 basic ways businesses are organized  Discuss the advantages and disadvantages of each type of business organization  Understand what is double taxation  Understand that the goal of financi...

Chapter 1: An Overview of Financial Management Learning Objectives:  Recall the 3 basic ways businesses are organized  Discuss the advantages and disadvantages of each type of business organization  Understand what is double taxation  Understand that the goal of financial management is to maximize shareholder’s wealth  Explain and discuss the links between stock prices, intrinsic values, and market equilibrium  Discuss the conflicts between managers and shareholders and the various techniques firms can use to mitigate the conflicts Forms of Business Organization Form Advantages Disadvantages Proprietorship  Easily and inexpensively formed  Unlimited personal liability (Unincorporated business  Subject to few government regulations  Limited life of business owned by one individual)  Subject to lower income taxes than  Difficult to raise capital Partnership (Unincorporated business corporations owned by two or more  No corporate income tax persons)  Easy transfer of ownership  Cost of set-up and report filing Corporation  Unlimited life  Double taxation (U.S.) (Incorporated business owned by many  Limited liability - Corporation’s earnings taxed shareholders) - Only lose what they invest - Dividend earnings taxed again as  Ease of raising capital personal income Limited Liability  Limited liability like corporations  Still evolving. Requires hiring of a Company/Partnership  Taxed like partnerships (good) lawyer when establishing (Hybrid between partnership  Votes in proportion of their ownership and corporation) interest Balancing Shareholder Value and the Interest of Society  Financial Management: How companies conduct their business in order to maximize its value  Management’s primary goal: Shareholder Wealth Maximization (i.e. maximizing intrinsic value)  Decisions should be made to maximize the long-run value of the firm’s common stock (cash flow)  vs Proprietor’s goal to maximize his own interest  Not inconsistent with being socially responsible Corporation focuses on creating shareholder value  Unresponsive to employee and customers + Hostile to community + Indifferent to effects on environment  Hard to retain & recruit top-notch employees + Products boycotted + Face additional lawsuits + Confronted with negative publicity  Reduction in shareholder’s value  Maximize firm’s expected profits ≠ Maximize shareholder’s wealth  Managers can use accounting manipulations to maximize profits, which has no effect on the real cash flow of the company  Managers can seek to cut expenses (such as R&D), which maximizes current year profits but jeopardizes future survivability of the company © COPYRIGHT JIA HUI (JPOH008) Intrinsic values, Stock Prices  An estimate of the “true” value based on the best available information (accurate risk and return data) + Long Run Concept  Can be estimated, but not measured precisely Intrinsic Value  Changes when there’s new information  Investors try to estimate the intrinsic value and may come up with different estimates  Depends on firm’s future performance  Set by marginal investor based on perceived value of the stock Stock Prices  Information that they have may be inaccurate  Depends on demand and supply in the market  At market equilibrium, intrinsic value = stock price.  Equilibrium is where investors are indifferent between buying and selling the stock  Ideally, managers should avoid actions that reduces intrinsic value, even if it increases stock price in the short run  The difference is what makes the transactions occur  Effective communication is required to keep intrinsic prices and actual prices close Market price > Intrinsic Value Market Price < Intrinsic Value Market Price = Intrinsic Value  Overvalued  Undervalued  Market equilibrium  Not good to buy; may sell  Good to buy  No tendency to buy/sell Important Business Trends - Developments in communications technology Increased - Allows company to have branches/operations in other countries Globalization of - Increases income (e.g. IBM generates more than half of their sales & income Business overseas) Ever-Improving - Spurs globalization Information - Firms collect massive amount of data and use it for financial decisions (e.g. Technology considering and predicting results of a potential site for business) - Top managers operate and interface with stockholders Corporate - Active investors who control huge pools of capital (hedge funds and private equity Governance groups) are constantly looking for underperforming firms; and they quickly pounce on laggards, take control, and replace managers Business Ethics  Company’s attitude and conduct toward its employees, customers, community, and stockholders  Most firms have strong written codes of ethical behaviors + Conduct training programs to ensure that employees understand proper behavior in different situations  When conflicts arise involving profits and ethics, the right choice isn’t always clear © COPYRIGHT JIA HUI (JPOH008) Conflicts between Managers, Stockholders, and Bondholders  Managers inclined to act in their own best interests (which is not always the same as the interest of stockholders)  E.g. Managers pay themselves excessive salaries  Solving Agency Problems:  Reward managers based on long-run intrinsic value of the company stock, not the stock’s price on an option exercise data i.e. Options should be phased in over a number of years  Managers have the incentive to keep stock price high over time  Compensation must be based on stock’s market price because intrinsic value is not observable Reasonable  Price used should be an average over time compensation  Some managers paid via stocks packages - Not the best solution - Managers could receive stock on a set date, sell it and make profit. Once profit is based on stock price on the exercised Managers vs date, it may lead to managers trying to increase stock price on Stockholders: Agency that specific date and not in the long run. (e.g. Projects with Problems good long-term perspectives rejected because it penalizes profit and lower stock prices on the option exercise date) Direct  Majority of stocks owned by institutional investors, who have the intervention by clout to exercise considerable influence over firms’ operations shareholders  If firm’s stock is undervalued, corporate raiders may see it as a bargain and attempt to capture the firm in a hostile takeover. If raid is successful, target’s executive is likely to be managers  Threat of hostile Incentive for managers to maintain stock price. takeovers - Corporate raiders: Individuals who target a corporation for take-over because it is undervalued - Hostile takeover: Acquisition of a company over the opposition of its management Firing managers who don’t perform well  Bondholders: Generally receives fixed payments regardless of how well the company does  Stockholders: Do better when the company does better Stockholders vs  Problems: Bondholders 1) When taking on risky projects that may result in bankruptcy 2) Usage of additional debt  More debt a firm use, the riskier the firm © COPYRIGHT JIA HUI (JPOH008) Chapter 5: Time Value of Money Learning Objectives:  Explain how time value of money works and why it is important in Finance  Calculate the present value (PV) and future value (FV) of: - A lump sum - Annuity - Uneven cash flow stream - Perpetuity (only for PV)  Differentiate between annuity due and ordinary annuity  Explain the difference between nominal, periodic, and effective interest rates - Understand how to compare alternative investments with different compounding periods  Understand loan amortization and able to calculate the relevant outputs (e.g. payments, principal outstanding) - Construct a loan amortization schedule Time Value of Money  Idea that money available today is worth more than the same amount in future because we can invest the money Short Forms Meaning PV Present value, or beginning amount FVN Future value, or ending amount CF Cash flow I Interest rate earned per year INT Dollars earned during the year = Beginning amount x I N Number of periods Future Value (FV) Methods Finding FV from a cash flow or PV is called compounding 𝐹𝑉𝑁 = 𝑃𝑉 (1 + 𝐼)𝑁 Formula  𝐹𝑉1 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑉 + 𝑃𝑉(𝐼) = 𝑃𝑉 (1 + 𝐼) Key in N, I/YR, PV, PMT = 0 Calculator Solve for FV (Press “Alpha” + “Enter”) Present Value (PV) Methods Finding PV is called discounting 𝐹𝑉𝑁 𝐶𝐹1 𝐶𝐹 𝐶𝐹 𝐶𝐹 Formula 𝑃𝑉 = ; 𝑃𝑉 = 2 + (1+𝐼) 𝑁 2 + ⋯ + (1+𝐼)𝑁 = ∑𝑁 𝑡 𝑡=1 (1+𝐼)𝑡 (1+𝐼)𝑁 (1+𝐼)1 Key in N, I/YR, FV, PMT = 0 Calculator Solve for PV (Press “Alpha” + “Enter”) Annuities & Perpetuities  Annuities: Series of equal cash flows for fixed intervals for a specified number of periods  Perpetuities: An annuity that lasts forever Cash flows occur at the end of the periods  Calculator set to “End” mode 𝑃𝑀𝑇 Ordinary Annuity Solving for FV 𝐹𝑉 = [(1 + 𝐼 )𝑁 − 1] 𝐼 𝑃𝑀𝑇 1 Solving for PV 𝑃𝑉 = [1 − ] 𝐼 (1 + 𝐼)𝑁 Cash flow occur at the beginning of period  Calculator set to “Begin” mode Annuity Due Solving for FV 𝐹𝑉𝐴𝑑𝑢𝑒 = 𝐹𝑉𝐴𝑜𝑟𝑑 (1 + 𝐼) Solving for PV 𝑃𝑉𝐴𝑑𝑢𝑒 = 𝑃𝑉𝐴𝑜𝑟𝑑 (1 + 𝐼) © COPYRIGHT JIA HUI (JPOH008)  𝑃𝑀𝑇 𝑃𝑉 = Perpetuity Solving for PV 𝐼 1 Because as N  ∞, [1 − (1+𝐼)𝑁]  1 Uneven Cash Flows PMT (Payment) Equal cash flows at regular intervals CF (Cash Flow) Not part of an annuity Methods: 1. Step-by-Step discounting Finding PV of 2. Calculator: Use NPV Function Unequal CF - NPV (Rate, Initial outlay, {CF1, CF2, …, CFN}, {Cash flow counts}) - Rate: 10% key in as “10” - No spacing Finding FV of Method: Step-by-Step Unequal CF Method: Use IRR Function Finding Rate of - IRR (PV, {CF1, CF2, …, CFN}) Return (I/R) - E.g. IRR(-7250,{750,1000,850,6250}) - No spacing Semiannual and Other Compounding Periods Annual Semiannual 𝑆𝑡𝑎𝑡𝑒𝑑 𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑎𝑡𝑒 Periodic Rate Stated Annual Rate 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 (𝑖. 𝑒. 2) Number of Periods Number of Years (Number of Years)(Periods per year, i.e. 2) PV/FV No Change Comparing Interest Rates  Also called the quoted or stated rate  Annual rate, ignores compounding effects Nominal Interest - Assume INOM is interest rate per year Rate (INOM)  Periods must also be given  Unless otherwise stated, INOM always given  Amount of interest charged each period Periodic Rate (IPER) 𝐼  𝐼𝑃𝐸𝑅 = 𝑁𝑂𝑀𝑀 ; where M = number of compounding periods per year  Actual annual rate of interest, accounting for compounding 𝐼  𝐸𝐹𝐹% = [1 + 𝑁𝑂𝑀 𝑀 ]𝑀 − 1 Effective Annual Rate  Using GC, go to “Finance” and “C”. Insert (Nominal rate, Compounding periods) (EAR = EFF%)  Important to consider EFF% because: - Investments with different compounding intervals provide different effective returns - Allows comparison of investments with different compounding intervals © COPYRIGHT JIA HUI (JPOH008) Amortized Loans  Loan that is repaid in equal payments over its life  Outstanding Loan Principal = PV of all remaining payments  Interest paid declines with each payment as the balance declines  Constructing loan amortization schedule 𝑃𝑀𝑇 1 Step 1:  𝑃𝑉 = 𝐼 [1 − (1+𝐼)𝑁] Find the Required  Using GC, FV = 0 because the reason for making payments if to retire the loan Annual Payment  PMT = Principal + Interest Step 2:  𝐼𝑁𝑇𝑡 = (𝐵𝑒𝑔 𝐵𝑎𝑙𝑡 )(𝐼) Find the Interest Paid  i.e. Replace t with 1 in Year 1 Step 3: Find the Principal  Principal = PMT – INT Repaid in Year 1 Step 4: Find the Ending  End Bal = Beg Bal – Prin Balance after Year 1 Repeat steps 1 to 4 until end of loan Year Beg Bal PMT INT Prin End Bal Constructing a Table 1 2 Total - - © COPYRIGHT JIA HUI (JPOH008) Chapter 2: Financial Markets and Institutions (except 2.7) Chapter 3: Financial Statements, Cash Flow, and Taxes (except 3.7, 3.8) Chapter 7: Interest Rates (except 7.6) Learning Objectives:  Identify the different types of financial markets and financial institutions and explain how these markets and institutions enhance capital allocation  List each of the key financial statements and identify the information they provide  Understand the different in tax treatment for dividends and interest expense  List the various factors that influence the interest rates  Understand the term structure of interest  Explain what the yield curve is and what determines its shape Capital Allocation Process In a well-functioning economy, capital flows efficiently from suppliers to demanders  Suppliers: Individuals or Institutions with “excess funds”. In return, they are looking for a rate of return.  Demanders: Those who need to “raise funds”. Willing to pay a rate of return. - Without going through any financial institutions Direct Transfer - Usually used by small firms - Little capital is raised Indirect Transfers through - Investment banks are the intermediate (middleman) Transferring of Investment Capital Bankers Indirect - Capital made through a financial intermediary (such as a bank of Transfers mutual funds) through a - E.g. Saver deposits money into the bank & receives interests. Bank Financial lends the money to business. Intermediary Financial Markets A financial market is where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds  i.e. A market place where buyers and sellers trade debt instruments (such as bonds) and equity instruments (such as stocks), and also other assets  Bonds: Promises a fixed dollar amount for every period  Stocks: Gives uncertain dividend for every period Physical assets vs Physical: Tangible/Real, for products such as wheat, autos, real estate Financial assets Financial: Stocks, bonds, notes, mortgages Spot markets vs Spot: Assets are bought or sold for “on-the-spot” delivery Futures markets Future: Participants agree today to buy or sell an asset at some future date Money markets vs Money: Markets for short-term, highly liquid debt securities (generally less than 1 year) Capital markets Capital: Markets for intermediate- or long-term debt and corporate stocks Primary: Markets in which corporations raise capital by issuing new securities Primary markets vs Secondary: Markets in which existing, already outstanding securities are traded among Secondary markets investors, i.e. Listed shares (shares that are already in the market) Private markets vs Private: Transactions are negotiated directly between two parties Public markets Public: Standardized contracts are traded on organized exchanges Financial Institutions  Provides services for firm’s capital raising  Efficient and easier for large firms to raise capital through financial institutions  Regulated to ensure the safety of these institutions and to protect investors (except hedge funds and private equity companies) © COPYRIGHT JIA HUI (JPOH008)   Types of financial institutions:  Traditional “department store of finance” Commercial banks  Serves a variety of savers and borrowers  Underwrites and distributes new investment securities Investment banks  Helps businesses obtain financing Financial services  A firm that offers a wide range of financial services, including investment banking, corporations brokerage operations, insurance, and commercial banking  Cooperative associations where members have a common bond Credit unions  E.g. employees of same firm  Retirement plans funded by corporations or government agencies for their workers Pension funds  Invests primarily in bonds, stocks, mortgages and real estate Life insurance  Invests annual premiums collected companies  Organization that pool investor funds to purchase financial instruments Mutual funds  Reduces risk through diversification Exchange traded  Similar to mutual funds funds  Operated by mutual fund companies  Similar to mutual funds Hedge funds  But typically have large minimum investments, and marketed primarily to go institutions and individuals with high net worth Private equity  Similar to hedge funds companies  But buys and manage entire firms instead of stocks The Stock Market  Most active secondary market  Most important to financial managers - Prices of firms’ stocks established - Knowledge of stock market is important to managing a business Physical - i.e. NYSE, American Stock Exchange Location - Formal organizations having tangible physical locations that Exchange conduct auction markets in designated (“listed”) securities - i.e. Nasdaq Types of Market - Over-the-Counter Market: A large collection of brokers and Procedures Electronic dealers, connected electronically by telephones and computers, Dealer-based that provides trading in unlisted securities Markets - Dealer Market: Includes all facilities required to conduct security transactions not conducted on the physical location exchanges © COPYRIGHT JIA HUI (JPOH008) The Market for Common Stock  Corporation owned by a few individuals who are typically associated to a firm’s Closely Held management Corporations  Stocks called: Closely held stocks  Corporation that is owned by a large number of individuals not actively involved in Publicly Owned firm’s management Corporations  Publicly held stock 1. Outstanding shares of established publicly owned companies that are traded: the secondary market 2. Additional shares sold by established publicly owned companies 3. Initial public offerings made by privately held firms: the IPO market - Going public: The act of selling stock to the public by a closely held corporation or its principal stockholders Type of Stock Market - Initial Public Offering (IPO) market: The market for stocks of companies that are in Transactions the process of going public  When the market is going strong, many companies go public to bring in new capital and give their founders an opportunity to cash out some of their shares (selling occurs in primary market)  Essential to recognize that firms can go public without raising any additional capital Financial Statements and Reports Annual Report  Report issued annually by a corporation to stockholders  Contains financial statements, and a verbal section of the management’s analysis of firm’s past operations and future prospects  Presented as a letter from the chairperson Verbal Section  Describes firm’s operating results during the past year and discusses new developments that will affect future operations  Statement of firm’s financial position at one point of time Balance Sheet  Shows what assets the company owns and who has claims on the assets as of a date Income  Summarizes a firm’s revenues and expenses over a given period of Key Financial Statement time Statements Statement of  How much cash the firm began with, how much it ended with and Cash Flows what it did to increase/decrease its cash Statement of  Shows that amount of equity the stockholders’ had at the start of Stockholders’ the year, that items that increase or decrease equity, and equity at Equity the end of the year  Both balance sheet and income statement shows how the company performed in the past and this year  Provides information about future prospects The Balance Sheet  Statement of a firm’s financial position at a specific point in time  Total Assets = Total Liabilities and Equity Total Assets Total Liabilities and Equity Current Assets/Working Capital Current Liabilities - Less than one-year maturity - Less than one-year maturity - Cash and Equivalents - Accrued wages and taxes - Accounts Receivable - Accounts Payable - Inventory - Notes Payable Long-Term (Fixed) Assets Stockholders’ Equity - Net plant and equipment - Common Stock + Retained Earnings - Intellectual property (must equal) - Other long-term assets - Total Assets – Total Liabilities Long-Term Debt © COPYRIGHT JIA HUI (JPOH008)   Stockholders’ Equity: Amount that the shareholders paid the company when the shares were purchased and the amount of earnings that the company has retained since its organization  Retained Earnings: Represent the cumulative total of all earnings kept by the company during its life  Other things to note: Net Working Capital Current Assets – Current Liabilities Net Operating Working Capital Current Assets – (Current Liabilities – Notes Payable) - Accumulated Depreciation: Decrease in value of an asset over time - Market Value: Value if put up on sale vs Book Value: Accounting numbers The Income Statement  Report summarizing firm’s revenue, expenses and profits during a reporting period  Interest expense is tax deductible  Other things to note: Operating Income (or EBIT) Sales Revenue – Operating Costs Earnings Before Taxes (EBT) Earnings Before Income and Taxes – Interest Expense (i.e. Taxable Income) Net Income Operating Income – Interest - Tax Earning Per Share (EPS) 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 (most important to shareholders) 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦 Book Value Per Share (BVPS) 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 - EBITDA: Earnings before interest, taxes, depreciation and amortization - Amortization: Similar to depreciation, but used for intangible assets (i.e. copyrights, patents) Statement of Cash Flows  Report that shows how items that affect the balance sheet and income statement affect the firm’s cash flows  Managers strive to maximize cash flows available to investors  E.g. Net Income Depreciation and Amortization Increase in Inventories Operating Income Increase in Accounts Receivable Increase in Accounts Payable Increase in Accrued Wages and Taxes Net Cash provided by (used in) Operating Activities Long-Term Investing Additions to Property, Plant and Equipment Activities Net Cash used in Investing Activities Increase in Notes Payable Increase in Bonds Financing Activities Payment of Dividends to Stockholders Net Cash provided by Financing Activities Net Decrease in Cash (Sum of First 3) Summary Cash and Equivalents at the Beginning of the Year Cash and Equivalents at the End of the Year  Note: if during the year a company has high cash flows from its operations, it does not necessarily mean that cash on its balance sheet will be higher at the end of the year. This is especially so if there were negative cash flows from its investing and/or financing activities. i.e. If company used a lot of cash to purchase new equipment or to repurchase common stock, cash on the balance sheet could decline despite strong operating performance. Statement of Stockholders’ Equity  Statement that shows by how much a firm’s equity changed during the year and why it occurred © COPYRIGHT JIA HUI (JPOH008) Income Taxes Progressive Tax Tax system where tax rate is higher on higher incomes Marginal Tax Tax rate applicable to the last unit of a person’s income Rate Individual Average Tax Tax paid divided by taxable income Rate Capital Gain or Profit (loss) from the sale of a capital asset for more (less) than its Loss purchase price. In U.S., capital gains are taxed Interest Paid by Corporations: Tax deductible (paid out of pre-tax income) Corporations Double Taxation Dividends Paid by Corporations: Out of after-tax income Dividends Received by Investors: Taxed in the U.S. The Cost of Money Affected by: Production Investment opportunities in productive (cash-generating) assets Opportunities Time Preference for Preference for current consumption as opposed to saving for future Consumption Risk Chance that an investment will provide a low/negative return Amount by which prices increase over time (Expected) Inflation  Higher the EI, higher the required dollar return The Determinants of Market Interest Rates  𝑟 = 𝑟 ∗ + 𝐼𝑃 + 𝐷𝑅𝑃 + 𝐿𝑃 + 𝑀𝑅𝑃  𝑟 = 𝑟𝑅𝐹 + 𝐷𝑅𝑃 + 𝐿𝑃 + 𝑀𝑅𝑃 Required return on a debt security r - Nominal interest rate, takes into account expected inflation Real risk-free rate of interest r* - Interest rate of borrowing when there is zero expected inflation Inflation premium IP - Average expected inflation over life of debt security Nominal rate on risk-free security rRF - i.e. U.S. Treasury bill (very liquid and free of most types of risks) - r* + IP Default risk premium - Compensation for possible default that issuer will not pay principal and interests DRP on time and at stated amounts - Difference between interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability Liquidity premium LP - Compensation for possibility of difficulty of selling debt security quickly at market value Maturity risk premium - Compensation for possible loss in value due to increase in interest rates over MRP maturity of debt security - Affects longer term security more than shorter term - Longer the maturity, higher the MRP  Different premiums added to different types of debt IP MRP DRP LP S-T Treasury Added L-T Treasury Added Added S-T Corporate Added Added Added L-T Corporate Added Added Added Added © COPYRIGHT JIA HUI (JPOH008) The Term Structure of Interest Rates  Relationship between interest rates (or bond yields) and maturities  Yield curve are graphs showing the relationship “Normal” yield curve Upward sloping. Due to an increase in IP and increasing MRP Downward sloping; “Abnormal” yield curve Inverted yield curve When IP is expected to decrease, and decreases more than increase in MRP Yield curve where interest rates on intermediate-term maturities are higher than rates on Humped yield curve both short- and long-term maturities What Determines the Shape of the Yield Curve  Treasury bond yield = rt* + IPt + MRPt  Corporate bond yield = rt* + IPt + MRPt + DRPt + LPt  Corporate bond yield spread = Corporate bond yield – Treasury bond yield = DRPt + LPt - Spread widens as the corporate bond rating decreases  Corporate yield curves are higher than treasury securities - Because higher risk of default  Constructing the Treasury Yield Curve: ∑𝑁 𝐼𝑁𝐹𝐿 Step 1: Finding the average - 𝐼𝑃𝑁 = 𝑡=1𝑁 𝑡 expected inflation rate - Sum of expected inflation from year 1 to year N divided by number of years Step 2: Find the appropriate - MRPt = 0.1% (t-1) maturity risk premium - t = number of years to maturity Step 3: Adding the IP and MRP - Treasury bond yield = rt* + IPt + MRPt to r* to find appropriate nominal rates Macroeconomic Factors that Influence Interest Rate Levels  Control of money supply & to keep inflation at bay Federal Reserve  To stimulate the economy, Fed increases money supply policy (Fed promotes  Buy and sell short-term securities: economy growth) - Initial effect: Short-term rates declines - Larger money supply cause long-term rates to rise (even if short-term rates fall)  Govt spends more than it takes in as taxes  Deficit  Covered by additional borrowing or printing money Government budgets - Additional borrowing  Increases demand for funds  i/r increases deficits or surpluses - Printing money  Increased inflation  Increases i/r - Hence, larger the deficit, higher the level of i/r, ceteris paribus  More imports than exports  Run a foreign trade deficit International Factors  Larger the trade deficit, higher the tendency to borrow (Includes foreign  Foreigners will only hold U.S. debt if rates on U.S. securities are competitive with trade balance and other countries  U.S. i/r highly dependent on rates of other countries interest rates in - Interdependency limits the ability to use monetary policy to control economic other countries) activity in U.S.  Inflation increases, i/r tend to increase  Recessions  Demand for money & rate of inflation tend to fall + Fed tend to increase money supply to stimulate economy  Tendency for i/r to decline Level of Business  Recessions: Short-term rates decline more sharply than long-term rates (in U.S.) Activities - Fed operates mainly in short-term sector  Strongest effect there - Long-term rates reflect the average expected inflation rate over the next 20 to 30 years, and this expectation generally doesn’t change much Interest Rates and Business Decisions  If short-term interest rates are lower than long-term rates, a borrower might still choose to finance with long-term debt because: - Interest costs remain the same throughout  Increase in i/r in the economy will not affect us © COPYRIGHT JIA HUI (JPOH008) Chapter 9: Bonds and Their Valuations Learning Objectives:  Calculating the bond prices and discuss what the relationship is between interest rates and bond prices  Understand how a bond’s price changes over time as it approaches maturity  Calculate a bond’s yield to maturity  Understand the component of total return on bonds  Explain the different types of risks that bond investors and issuers face Who Issues Bonds? Bonds: Long-term debt instrument (or contract) (Borrower agrees to make payments of interest and principal on specific dates to holders of the bond) Treasury Bonds  Reasonable to assume govt makes good on its promised payments  No DRP (issued by govt)  Bonds’ prices do decline when i/r increases  Not completely riskless  Exposed to default risk (often referred as “credit risk”) - Issuing company runs into trouble  Unable to make promised interest and Corporate Bonds principal payments  Bondholders suffer losses  Larger the risk, higher the i/r investors demand  Exposed to some default risk Municipal Bonds  Interest earned in most munis exempted from federal tax and from state taxes (if (issued by state) holder is a resident)  Market interest rate on a muni is considerably lower than on a corporate of equivalent risk  Exposed to default risk Foreign Bonds  Additional risk when bonds are denominated in another currency Key Characteristics of Bonds Yield to Maturity Nominal rate of return earned on a bond held to maturity Stated face value of the bond, paid at maturity Par Value  Generally assumed to be $1,000 unless otherwise stated Coupon Specified number of dollars of interest paid each year Payment  Coupon i/r X Par Value Coupon Interest Stated annual i/r on a bond Rate Fixed-Rate Bond Bond’s i/r fixed for its entire life Floating-Rate Bond whose interest fluctuates with shifts in general level of i/r Coupon Interest Rate Bond Zero Coupon Pays no annual interest, but sold at discount below par Bond  Provides capital appreciation rather than interest income Original Issue Any bond originally offered at a price below its par value Discount (OID) Bond Maturity Date Specified date on which the par value must be repaid Provision that gives issuers the right to redeem the bonds under specified terms prior to the normal maturity date Call Provisions  Mainly in corporate and municipal bonds  Usually issuer must pay bondholders an amount greater than par value if called  Companies not likely to call bonds unless i/r declined significantly since bonds issuing Provision in the bond contract that requires the issuer to retire a portion of the bond issue Sinking Funds each year Convertible Bond that is exchangeable into shares of common stock at a fixed price Bond Other Features Long-term option to buy a stated number of shares of common stock Warrant at a specified price  Capital gain if stock’s price rises © COPYRIGHT JIA HUI (JPOH008)  Bond with provision that allows investors to sell it back to the company Putable Bond prior to maturity at a prearranged price Bond that pays interest only if it issuer earned enough money to pay Income Bond the interest Bond that has interest payments based on inflation index to protect Indexed Bond holder from inflation  Zero Coupon Bond: 𝐹𝑉 = 𝑃𝑉 (1 + 𝐼)𝑁 𝑃𝑀𝑇 1 1000  Coupon Bond: 𝑃𝑉 = [1 − (1+𝐼)𝑁] − (1+𝐼)𝑁 = PV of Annuity + PV of Par Value 𝐼 Bond Valuation 𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑁 𝑀 𝐶𝐹 𝑀  𝐵𝑜𝑛𝑑′ 𝑠 𝑉𝑎𝑙𝑢𝑒 = 𝑉𝐵 = (1+𝑟) 1 + (1+𝑟)2 + ⋯ + (1+𝑟)𝑁 + (1+𝑟)𝑁 = ∑𝑁 𝑡=1 (1+𝑟)𝑡 + (1+𝑟)𝑁 Required rate of return of shareholders = YTM = Discount price r (or rd)  Opportunity cost of debt capital  r ≠ Coupon rate unless bond price is at par CF Cash flow/Payment = Coupon rate X Par value N Number of years M Par value Par Bond YTM = Coupon Rate  Bond Price = Par Value Premium Bond YTM < Coupon Rate  Bond Price > Par Value Discount Bond YTM > Coupon Rate  Bond Price < Par Value Bond Yields  Finding r (or rd): 𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑁 𝑀 - 𝑉𝐵 = (1+𝑟) 1 + (1+𝑟)2 + ⋯ + (1+𝑟)𝑁 + (1+𝑟)𝑁 - Expected total return = YTM = (Expected CY) + (Expected CGY) 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑎𝑦𝑚𝑒𝑛𝑡  𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 (𝐶𝑌) = 𝑃𝑟𝑖𝑐𝑒 =𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑡 𝑃𝑟𝑖𝑐𝑒𝑡+1 −𝑃𝑟𝑖𝑐𝑒𝑡  𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑠 𝑌𝑖𝑒𝑙𝑑 = 𝑃𝑟𝑖𝑐𝑒𝑡 (= Percentage value; negative value means capital loss) Changes in Bond Value Over Time If required rate of return remains at 10%,  Par bonds: No gain nor loss  Premium bonds: Capital loss because bond value decrease over time  Compensated by high CY  Discounts bonds: Capital gain because bond value increase over time  Low coupon rates hence low CY Bonds with Semiannual Coupons 𝐼𝑁𝑇 2𝑁 2 𝑀 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑆𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑢𝑝𝑜𝑛 𝐵𝑜𝑛𝑑 (𝑉𝐵 ) = ∑ 𝑟𝑑 𝑡 + 𝑟 𝑡=1 (1 + 2 ) (1 + 2𝑑 )2𝑁 1. Multiply the years by 2 2. Divide nominal rates by 2 3. Divide annual coupon by 2 © COPYRIGHT JIA HUI (JPOH008) Assessing a Bond’s Riskiness Risk of a decline in bond’s price due to an increase in i/r Interest Rate (or  Bonds with longer maturity have higher i/r risk, ceteris paribus Price) Risk  Longer maturity bonds are more sensitive to i/r changes Risk that a decline in i/r will lead to a decline in income from a bond portfolio Reinvestment Risk  i/r falls, future CFs reinvested at lower rates  Reduces income  Which type of risk is more relevant to an investor depends on how long the investor plans to hold the bonds, referred to as his investment horizon Interest Rate Risk Reinvestment Risk Short-term Bonds Low High Long-term Bonds High Low Low Coupon Rates High Low High Coupon Rates Low High  Low coupon means relatively larger portion of cash flows will only occur at maturity with repayment of principal  High coupon means more of the cash flows occur in the early years due to higher coupon payment  When i/r increases, low coupon bonds are penalized more (i.e. value decreases more) as a relatively larger portion of cash flows are locked up in the bond  In contrast, due to higher coupon payment of high coupon bonds, risk of reinvesting these high coupons at a lower i/r is higher Default Risk  If issuer defaults, investors receive less than the promised return  Influenced by issuer’s financial strength and the terms of the bond contract  Bond ratings reflect the probability of a bond issue doing into default - Investment-Grade Bond: Bond rated Triple-B and above; Many banks and institutional investors are permitted by law to only hold investment-grade bonds - Junk Bond: High-risk, high-yield bond  Bond Rating Criteria: 1. Financial Ratios 2. Qualitative Factors: Bond Contract Terms 3. Miscellaneous Qualitative Factors i.e. Sensitivity of firm’s earnings to strength of the economy © COPYRIGHT JIA HUI (JPOH008) Chapter 8: Risk and Rates of Return Learning Objectives:  Explain the difference between stand-alone risk and portfolio risk  Understand how risk aversion affects a stock’s required rate of return  Calculate the expected return and risk when holding an individual stock  Calculate the coefficient of variation  Discuss the difference between diversifiable risk and market risk, and explain how each type of risk affects well-diversified investors  Understand what the capital asset pricing model (CAPM) is and how it is used to estimate a stock’s required rate of return  Calculate a portfolio’s expected return and its risk  Determine if a stock is undervalued or overvalued  Explain how expected inflation and investors’ risk aversion can affect the security market line (SML) The Risk-Return Trade-Off  To entice investors to take on more risk, have to provide them with higher expected returns  Most investors are risk averse - Dislike risks, and require higher rate of return to encourage them to hold riskier securities Difference between the return on a risky asset and a riskless asset Risk Premium  Serves as a compensation for investors to hold riskier securities Investment risk Probability of earning a return that is different from expected 𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒−𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 Rate of Return 𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 Stand-Alone Risk  The risk an investor faces if he only held one asset Probability Listing of all possible outcomes, and the probability of each occurrence Distributions 𝑟̂ = 𝑃1 𝑟1 + 𝑃2 𝑟2 + ⋯ + 𝑃𝑁 𝑟𝑁 = ∑𝑁 𝑖=1 𝑃𝑖 𝑟𝑖  N= Number of different states of economy Expected rates of  𝑟𝑖 = Stock’s expected return at i state of economy return, 𝑟̂  𝑃𝑖 = Probability of i state of the economy occurring Rate of return to be realized from an investment 𝜎 = √∑𝑁 ̂2 𝑖=1(𝑟𝑖 − 𝑟) 𝑃𝑖 where:  N= Number of different states of economy  𝑟𝑖 = Stock’s expected return at i state of economy  𝑃𝑖 = Probability of i state of the economy occurring Standard deviation, σ Used to measure volatility of stock’s returns  Measures whether returns are likely to be close to the expected return  Measures stand-alone risk  Tighter the probability distribution, lower the S.D., lower the stand-alone risk 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 σ 𝐶𝑉 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟̂ Coefficient of variation, CV Shows risk per unit of return  Useful when comparing investments with different expected returns  Highest CV = Highest stand-alone risk  If risk remains the same when economy changes, it means that returns are independent of the economy. - However, not completely risk free as it is still exposed to inflation and reinvestment risk. © COPYRIGHT JIA HUI (JPOH008) Risk in a Portfolio Risk 𝑟̂𝑝 = 𝑤1 𝑟̂1 + 𝑤2 𝑟̂2 + ⋯ + 𝑤𝑁 𝑟̂𝑁 = ∑𝑁 𝑖=1 𝑤𝑖 𝑟̂𝑖  N= Number of different states of economy Expected Return on  𝑤𝑖 = Stock’s weight Portfolio, 𝑟̂𝑝  𝑟𝑖 = Expected return on the ith stock Portfolio’s expected return is a weighted average of the returns of portfolio’s component assets. Portfolio’s Standard ̂2 Deviation σ𝑝 = √∑𝑁 𝑖=1(𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑎𝑣𝑔 − 𝑟𝑝 ) (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦)  σ𝑝 will be lower than σ𝑖 of individual stocks  There will be diversification benefits when combining stocks as long as the stocks are not perfectly positively correlated stocks (i.e. ρ = 1.0) - ρ is the correlation coefficient. Measures the degree of relationship between 2 variables Portfolio’s Risk - Correlation: Tendency of 2 variables to move together - When ρ = -1.0 (perfectly negatively correlated), all risks are diversified away  No risk because no σ  Combining stocks in a portfolio generally lowers risk  Eventually, diversification benefits of adding more stocks dissipates (after about 10 stocks), and for large companies, σ𝑝 tends to converge to 20% Sources of Risk Stand-alone risk Decomposed into diversifiable and market risk Portion of a security’s stand-alone risk that can be eliminated through proper Diversifiable risk diversification - Also called unsystematic/firm-specific risk Portion of a security’s stand-alone risk that cannot be eliminated through diversification. - Measured by beta Market risk - Caused by market-wide risk factors that affect all stocks - Also called systematic/undiversifiable risk © COPYRIGHT JIA HUI (JPOH008) CAPM: Capital Asset Pricing Model  Model based on proposition that any stock’s required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification  Primary conclusion: Relevant riskiness of a stock is its market risk as measured by beta  Security Market Line (SML): 𝑟𝑖 = 𝑟𝑅𝐹 + (𝑟𝑀 − 𝑟𝑅𝐹 )(𝑏𝑖 )  Additional return over the risk-free rate needed to compensate investors for Market Risk Premium assuming an average amount of risk (𝑟𝑀 − 𝑟𝑅𝐹 ) or (𝑅𝑃𝑀 )  Size depends on the perceived risk of the stock market and the investors’ degree of risk aversion  Measures a stock’s market risk  Shows stock volatility relative to market  It is the expected change in its return given a 1% change in the return of the market portfolio  Beta values: 1. Beta = 1.0  Just as risky as average stock 2. Beta > 1.0  Riskier than average 3. Beta < 1.0  Beta less risky than average 4. Beta = 0  Returns are independent of the economy Beta (𝑏𝑖 ) 5. Stocks can have a negative beta, especially if returns move counter-cyclically with market returns  Beta of a portfolio is the weighted average of each of the stock’s betas 𝑁 𝑏𝑝 = 𝑤1 𝑏1 + 𝑤2 𝑏2 + ⋯ + 𝑤𝑁 𝑏𝑁 = ∑ 𝑤𝑖 𝑏𝑖 𝑖=1 - 𝑤𝑖 : Fraction of the portfolio invested in the ith stock - 𝑏𝑖 : Beta coefficient of the ith stock  Calculating beta: - Run a regression of the security’s past returns against the past returns of the market - Slope of regression line is the beta coefficient of the security 𝑟𝑖  Required rate of return Risk Premium for  𝑅𝑃𝑖 = 𝑅𝑃𝑀 (𝑏𝑖 ) Stock i (𝑅𝑃𝑖 ) The Relationship between Risk and Rates of Return Factors that Change the SML Expected rate of inflation increases  Premium added to real risk-free rate of return to compensate investors for the loss of purchasing power Expected Inflation  Increase in rRF leads to equal increase in rates of return on all risky assets as the same inflation premium is built into the required rates of return  i.e. SML will move up parallel by the amount inflation increased by Steeper the slope of the line, more the average investor requires as compensation for Changes in Risk bearing risk Aversion  i.e. SML will become steeper when there’s greater risk aversion Returns an investor requires given the riskiness of the stock and returns available on Required returns other investments Returns an investor expects to get in the future Expected returns  Only buy the stock when expected returns > required returns  In equilibrium, expected and required returns should be the same Realized returns Returns an investor actually gets © COPYRIGHT JIA HUI (JPOH008) Chapter 10 & Appendix 10A: Stocks and their Valuation (except 10.7) Chapter 2.7: Stock Market Efficiency Learning Objectives:  Understand the difference between stock price and intrinsic value  Identify and explain the two models that can be used to estimate a stock’s intrinsic value: the discounted dividend model and multiples of comparable firms method  Calculate the intrinsic value of a stock with constant growth and non-constant growth  Calculate the stock’s expected return, expected dividend yield and expected capital gains yield  Understand the key features of preferred stock and calculate the estimated value of preferred stock or its expected return  Discuss the importance of market efficiency, and explain why some markets are more efficient than others  2 sources of returns from stocks: 1. Stock price appreciation (profits from increase in share price – capital gains) 2. Dividends 𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒−𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑡𝑒𝑑  𝑅𝑒𝑡𝑢𝑟𝑛 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 (from previous topics) Types of Common Stock Usually firms only have one type of common stock. Firms might use classified stock to seek funds from outside sources. Common stock that is given a special designated class such as Class A or Class B to meet special needs of the company - Different classes may have different votes per share + one Class sold to public but Classified stock another class retained by company’s insiders - Enables company’s founders to maintain control over the company without having to own a majority of common stock Stock owned by the firm’s founders that enables them to maintain control over the Founders’ Share company without having to own a majority of the stock Stock Price versus Intrinsic Value  At equilibrium, we assume that a stock’s price = its intrinsic value  Stock’s price < Intrinsic value  Undervalued - Goal when investing in common stock is to purchase undervalued stocks Stock Price Current market price, easily observed for publicly traded companies Represents the “true” value of the company’s stock, and cannot be directly observed  Have to be estimated Intrinsic Value 𝑃̂𝑜  Outsiders estimate intrinsic value to help determine which stocks are attractive to buy/sell The Discounted Dividend Model 𝐷1 𝐷 𝐷 𝐷  𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 = 𝑃̂𝑜 = (1+𝑟𝑠 )1 + (1+𝑟2 )2 + ⋯ + (1+𝑟∞)∞ = ∑∞ 𝑡 𝑡=1 (1+𝑟 )𝑡 = 𝑃𝑉 𝑜𝑓 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑠 𝑠 𝑠 Dividend stockholder expects to receive at the end of year t Dt  D0 is the last dividend paid P0 Actual market price of stock today 𝑃̂𝑡 Intrinsic value at the end of year t g Expected growth rate in dividends rs Required rate of return (Use CAPM to estimate) 𝑟̂𝑠 Expected rate of return = Dividend yield expected + Expected capital gains yield 𝐷1 Dividend yield expected 𝑃0 𝑃̂1 − 𝑃0 Expected capital gains yield on stock 𝑃0 © COPYRIGHT JIA HUI (JPOH008) Constant Growth Stocks (Gordon’s Model)  Stock whose dividends are expected to grow forever at a constant rate, g 𝐷 (1+𝑔) 𝐷  𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝐺𝑟𝑜𝑤𝑡ℎ 𝑆𝑡𝑜𝑐𝑘 = 𝑃̂𝑜 = 0 = 1 𝑟𝑠 −𝑔 𝑟𝑠 −𝑔 𝐷𝑛+1  i.e. 𝑃̂𝑛 = ; 𝑃̂𝑛+1 = 𝑃̂𝑛 (1 + 𝑔) 𝑟𝑠 −𝑔  g = (1 – Payout) (ROE) - Payout ratio = Dividends/Net Income - ROE: Return on Equity = Net Income/Total Common Equity  g = (Retention Ratio) (ROE)  Constant growth model can only be used if: 1. rs > g - g > rs, constant growth formula leads to negative stock price (which doesn’t make sense) 2. g is expected to stay constant forever  Calculating intrinsic value of a stock with constant growth: 1. Calculate the required rate of return rs using CAPM 2. Find the expected D1 3. Use the constant growth model Note: Estimated intrinsic value depends on future dividends at the growth rate, which comes from estimation & based on assumption Valuing Non-Constant Growth Stocks 𝐷1 𝐷 𝐷 𝑃̂  𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑁𝑜𝑛𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑆𝑡𝑜𝑐𝑘 𝐺𝑟𝑜𝑤𝑡ℎ, 𝑃̂𝑜 = (1+𝑟𝑠 )1 + (1+𝑟2 )2 + ⋯ + (1+𝑟𝑁 )𝑁 + (1+𝑟𝑁 )𝑁 𝑠 𝑠 𝑠 𝐷  𝑃𝑉 𝑜𝑓 ℎ𝑜𝑟𝑖𝑧𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = 𝑃̂𝑁 = 𝑁+1 𝑟𝑠 −𝑔  Calculating intrinsic value of a stock with non-constant growth: 1. Find PV of each dividend during the period of non-constant growth and sum them 2. Find the expected stock price at the end of the non-constant growth period. Discount the price back to present. 3. Add both components to find stock’s intrinsic value  For non-constant growth stocks: - Expected dividend yield and capital gains yield are not constant - Capital gains yield ≠ g Multiples of Comparable Firms Method 𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒 𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒 𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑆𝑎𝑙𝑒𝑠  I.e. Based on comparable firms, estimate the appropriate P/E. Multiply by expected earnings to back out an estimate of the stock price Preferred Stock  Hybrid security - Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders - Companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy  Preferred stock entitles its owners to regular, fixed dividends payments. If payments last forever, then: 𝐷 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 = 𝑉𝑃 = 𝑟 𝑃 ; where: 𝑃 - DP = Preferred stock’s dividend per share and - rp = required return on preferred stock 𝐷  𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟̂𝑃 = 𝑃 𝑉𝑃 © COPYRIGHT JIA HUI (JPOH008) Stock Market Equilibrium  At equilibrium, stock prices are stable and there is no general tendency for people to buy/sell  For a stock to be in equilibrium, two conditions must hold. 1. The current market stock price = intrinsic value (i.e. P0 = 𝑃̂𝑜 ) 2. Expected returns = Required returns (i.e. rs= 𝑟̂𝑠 ) 𝐷 𝑟̂𝑠 = 𝑃1 + 𝑔 = 𝑟𝑠 = 𝑟𝑅𝐹 + (𝑟𝑀 − 𝑟𝑅𝐹 )(𝑏) 0 - 𝑟̂𝑠 based on current stock prices, and estimating the expected dividends and expected capital gains - 𝑟𝑠 determined by estimating risk and applying CAPM  If stock price is below intrinsic: - Current price is “too low” and offers a bargain - Buy orders > Sell orders - Price bid up until expected return = required return  Equilibrium levels are based on the market’s estimate of intrinsic value and the market’s required rate of return, which are both dependent on the attitudes of the marginal investor (who makes the transactions occur) Stock Market Efficiency Market Price Current price of stock Price at which stock would sell at if all investors had all knowable information about a Intrinsic Value stock (based on expected future cash flows and its risk) Equilibrium Price Price that balances buy and sell orders at any given time A market in which prices are close to intrinsic values and stocks seem to be in equilibrium  Does not require market price = intrinsic value at every point of time Efficient Market  Just requires deviations between the two to be random  Implication: Investors cannot “beat the market” except through good luck or better information  Concepts of market efficiency are related to the assumptions about what information is available to investors and reflected in the price  It is also possible that some markets are efficient, while other are not. Key factors are: 1. Size of the company 2. Communication between company and analysts/investors - i.e. Larger companies are usually followed by many analysts + Good communication with investors  Highly efficient - Smaller companies are usually not followed by many analysts + Not much contact with investors  Highly inefficient © COPYRIGHT JIA HUI (JPOH008) Chapter 11: The Cost of Capital Learning Objectives:  Understand what is capital budgeting  Understand why a weighted average cost of capital (WACC) is needed for capital budgeting purposes  Determine the sources of long-term capital  Determine the weights of each capital component  Calculate the cost of long-term debt and cost of preferred stock  Calculate the cost of retained earnings and cost of new common stock  Calculate the composite WACC of the firm  Understand why the composite WACC needs to be adjusted to account for differential project risk Basic Definitions  Analysis of potential projects (especially long-term decisions involving large expenditures)  Steps to Capital Budgeting: 1. Estimate Cash Flows Capital Budgeting 2. Assess the riskiness of CFs and determine the appropriate risk-adjusted cost of capital for discounting cash flows 3. Find NPV and/or IRR (MIRR) - To determine profitability  Weighted average cost of each type of financing - Required returns of debtholders and equity holders become firm’s cost of capital Cost of Capital - i.e. Cost of borrowing and cost of savings (investing savings elsewhere)  Investment must give a return that is at least equal to cost of capital  Mix of debt, preferred stock and common equity used to finance the firm’s asset Capital Structure  Proportion of each long-term capital used  Desired optimal mix of equity and debt financing Target Capital  Often the optimal structure that maximizes stock price Structure  Always use target capital structure rather than actual financing  Interest rate on firm’s new debt rd  Before-tax component cost of debt  After-tax component cost of debt rd (1-T)  T is the firm’s marginal tax rate rp  Component cost of preferred stock rs  Component cost of common equity raised by retaining earnings  Component cost of common equity raised by issuing new stock re  Adds flotation cost wd, wp, we  Target weights of debt, preferred stock and common equity WACC  Firm’s weighted average, or cost of capital WACC = wdrd (1-T) + wprp + wcrs  Use target capital structure weights (affects the ‘w’s) - Desired optimal mix of debt and equity  Use market value weights (not book value) - Market value represents the actual amount of financing raised by the firm when they sell - Calculated based on current market conditions Basic Concepts  Use marginal cost (affect the ‘r’s) - Not historical cost - WACC is recorded at a point in time  Reflects marginal cost of raising an additional dollar of capital today  Use after-tax capital cost (affect ‘rd’ only) - Only rd needs adjustment because interest is tax deductible © COPYRIGHT JIA HUI (JPOH008)   rd = Marginal cost of debt capital  YTM on outstanding long-term debt is often used as a measure of rd Cost of Debt, - Good estimate because YTM reflects current market conditions. Hence good rd(1-T) proxy on the cost of new debt if the firm borrows from the market now  Interest is tax deductible  Need to adjust via (1-T) 𝐷𝑝 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 1. 𝑟𝑝 = 𝑃𝑝 = 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘 Cost of Preferred Stock, rp  rp = Marginal cost of preferred stock - Return investors require on a firm’s preferred stock  Preferred dividends not tax deductible  No adjustments 1. CAPM: 𝑟𝑠 = 𝑟𝑅𝐹 + (𝑟𝑀 − 𝑟𝑅𝐹 )𝑏 𝐷 2. DCF: 𝑟𝑠 = 𝑃1 + 𝑔 0  rs = Dividend yield + Capital gains yield  Assuming constant growth, CGY = Perpetual growth rate, g 3. Own-Bond-Yield-Plus-Risk-Premium: 𝑟𝑠 = 𝑟𝑑 + 𝑅𝑃 Cost of Retained  RP = Risk premium for firm’s common equity Earnings, rs  NOT the same as CAPM RPM (risk premium of whole market portfolio)  rs = Marginal cost of common equity using retained earnings - There is a cost because earnings can be retained and reinvested or paid as dividends - Investors can buy other securities and earn returns 𝐷0 (1+𝑔) 1. 𝑟𝑒 = 𝑃0 (1−𝐹) + 𝑔, where F is the flotation cost Cost of New Common Stock, re  re = Marginal cost of common equity using new common stock - re > rs because when issuing new stock, have to pay flotation cost Factors that Affect the WACC 1. Interest rate in the economy - i/r increases  Cost of debt increases (because firms pay more to borrow) 2. General level of stock prices - General stock price decreases  Firm’s stock price decreases  Cost of equity Factors the Firm increases Cannot Control 3. Tax rates - Affects cost of capital - i.e. When tax rates on dividends and capital gains lowered relative to rates on interest income  Stocks relatively more attractive than debt  Cost of equity and WACC decreases 1. Changing its capital structure 2. Changing its dividend payout ratio Factors the Firm Can - Dividend policy affects amount of retained earnings available to firm  Need to Control sell new stock & Incur flotation costs 3. Altering its capital budgeting decision rules (i.e. investment policy) - Firms with riskier projects generally have higher WACC © COPYRIGHT JIA HUI (JPOH008) Adjusting the Cost of Capital for Risk  Projects should only be accepted if estimated returns > cost of capital (hurdle rate)  Different projects have different risks, even for the same firm  Each project’s hurdle rate should reflect the risk of the project, not the risk associate with the firm’s average project as reflected in the composite WACC Hence, companies should not use the composite WACC as the hurdle rate for each of its projects, regardless of riskiness. The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with similar risk as the firm as a whole. As different projects have different risks, the project’s WACC should be adjusted to reflect the project’s risk. Some Other Problems with Cost of Capital Estimates Depreciation-  Largest single source of capital generated Funds  Opportunity cost as depreciation CF can be reinvested or returned to investors Privately Owned  Stock not traded Firms  Tax issues  Difficult to obtain good input data for CAPM, risk premium for rs  CAPM uses estimates on market risk premium + Estimates can differ Measurement  Different estimates of same variable Problems  i.e. Market rate  Different assumptions for target capital structure  The optimal mix Cost of Capital for  Difficult to measure a project’s risk Projects of Differing  To adjust the cost of capital for capital budgeting projects with different risk Risk Capital Structure  Difficult to establish target capital structure Weights © COPYRIGHT JIA HUI (JPOH008) Chapter 12: The Basics of Capital Budgeting Learning Objectives:  Understand the difference between normal and non-normal cash flow streams  Understand the different between mutually exclusive and independent projects  Calculate and use the major capital budgeting decision criteria for mutually exclusive and independent projects, which are the 1) Payback Period 2) Discounted Payback Period 3) Net Present Value (NPV) 4) Internal Rate of Return (IRR) 5) Modified IRR (MIRR)  Discuss strengths and weaknesses of each method (MCQ)  Understand and interpret the NPV profile  Calculate and understand the importance of the crossover point  Discuss the conflict between NPV and IRR when evaluating mutually exclusive projects  Understand why NPV is superior to IRR and MIRR  Understand the multiple IRRs problem An Overview of Capital Budgeting 1. Replacement: Needed to continue current operations - Expenditures to replace worn-out or damaged equipment required in the production of profitable products 2. Replacement: Cost reduction - Expenditure to replace serviceable but obsolete equipment 3. Expansion of existing products or markets - Expenditures to increase output of existing products or to expand retail outlets or distribution facilities in markets now being served - Requires explicit forecast of growth in demand Analyzing Capital 4. Expansion into new products or markets Expenditure - Investments related to new products or geographic areas Proposals - Involve strategic decisions that could change the fundamental nature of the business 5. Safety and/or environmental projects - Expenditures necessary to comply with government orders, labour agreements, or insurance policy terms 6. Other projects - Includes items such as office buildings, parking lots and executive aircraft 7. Mergers - One company buys another One change in sign Normal Normal vs Non-  E.g. Cost (negative CF) followed by a series of positive CF Normal Cash Flow Two or more changes of sign Streams Non-Normal  E.g. [Setting up a power plant] Cost (negative CF), then string of positive CF, then cost to close project (negative CF) Both projects can be accepted Independent vs Independent  CF of one unaffected by acceptance of another Mutually Exclusive Mutually Only one project can be accepted Projects Exclusive  If one is accepted, the other has to be rejected © COPYRIGHT JIA HUI (JPOH008) Capital Budgeting Criteria: Payback Period Length of time required to recover a project’s cost from investment’s CF 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠 𝑝𝑟𝑖𝑜𝑟 𝑡𝑜 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 To find Payback 𝑈𝑛𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑡ℎ𝑒 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 + 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟 Mutually Choose the one with shorter payback Exclusive  Shorter time to get back investment Which to Accept? Subjective benchmark (usually based on past projects) Independent  E.g. Only projects less than X years 1) Easy to calculate and understand Strengths 2) Provides an indication of a project’s risk and liquidity - Shorter payback considered less risky & more liquid 1) Ignores time value of money 2) Arbitrary benchmark set subjectively by management 3) Ignores CFs occurring after the payback period Weaknesses - Unlike NPV (tells us how much wealth a project adds), and the IRR (tells us how much the project yields over the cost of capital) - Payback only tells when we can recover our capital - No necessary relation between a given payback and investor wealth maximization Capital Budgeting Criteria: Discounted Payback Period Length of time required for investment’s CF discounted at the investment’s cost of capital (WACC), to cover its cost 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠 𝑝𝑟𝑖𝑜𝑟 𝑡𝑜 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 To Find Discounted 𝑈𝑛𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑡ℎ𝑒 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 Payback + 𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕𝒆𝒅 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟 Capital Budgeting Criteria: Net Present Value (NPV) Method of ranking investment proposals using NPV, which is equal to the present value of the project’s free cash flows (both inflow and outflow) discounted at the cost of capital  Indicates how much shareholders’ wealth would increase if project is taken up  Higher NPV = More value the project adds = Higher stock price = Higher increase in shareholders’ wealth 𝑁 𝐶𝐹𝑡 To find NPV 𝑁𝑃𝑉 = ∑ (1 + 𝑟)𝑡 𝑡=0 NPV (rate, initial outlay, {CFs}, {CF counts}) Using GC - No spacing - Initial outlay = CF0 Mutually Accept the project with highest positive NPV Which to Accept? Exclusive Independent Accept if NPV > 0  Direct measure of value the project adds to shareholder wealth Strengths  Does not discriminate size of projects (unlike IRR) Graphical representation of project NPVs at various different costs of capital  X-axis: Discount Rate (%)  Y-axis: NPV ($) 1. Downward sloping NPV profiles - As discount rate increases, NPV decreases (because of discounting in formula) NPV Profiles 2. Projects have different slopes  NPV profiles cross - Steeper slope has higher sensitivity to discount rates - Steeper slope usually long-term project, where bulk of CF comes in later years 3. At crossover points, NPVA = NPVB 4. If mutually exclusive, choose the one that is higher before/after crossover point. 5. If independent, choose any before x-intercept (where NPV = 0) Cost of capital at which the NPV profiles of two projects cross  Projects’ NPV equal Crossover Rates  Found by calculating the IRR of the differences in the project’s CF © COPYRIGHT JIA HUI (JPOH008) Capital Budgeting Criteria: Internal Rate of Return (IRR) The discount rate that forces a project’s NPV = 0 i.e. PV of CF = Investment costs 𝑁 𝐶𝐹𝑡 To find IRR 0= ∑ (1 + 𝐼𝑅𝑅)𝑡 𝑡=0 IRR (initial outlay, {CFs}) Using GC - No spacing - Initial outlay = CF0 Mutually Accept the project with highest IRR, provided IRR > Cost of Capital Which to Accept? Exclusive Independent Accept if IRR > Cost of Capital  Useful to know rates of return on proposed investments Strengths  Gives information concerning project’s safety margin  (Managers) More intuitive and gives indication of benefits obtained relative to cost  Suffers from Multiple IRR issue - Need to suspect multiple IRRs problem is CFs are non-normal and if cash inflows and outflows are of similar magnitude Weaknesses - NPV profiles intersects x-axis at 2 points - Use MIRR when there’s non-normal CF & there is more than one IRR value  Assumes intermediate CFs reinvested at IRR  Does not give accurate representation when comparing projects of different scales Comparing NPV and IRR Methods Independent Projects Both methods lead to the same accept/reject decisions Discount Rate > Leads to the same accept/reject decision Mutually Exclusive Crossover Rate Projects Discount Rate < Leads to different accept/reject decisions Crossover Rate (Hence better to rely on NPV results because of reinvestment rate) Conflict between NPV and IRR arises due to timing differences in CF and differences in project size  Rate at which intermediate CF are reinvested becomes a critical issue Timing Differences in CFs Differences in CF timing or project scale  Firms have different amounts to reinvest at Difference in Project various years Size NPV assumes intermediate CFs are reinvested at cost of capital (i.e. WACC) Reinvestment Rate  More realistic Assumption IRR assumes intermediate CFs are reinvested at IRR © COPYRIGHT JIA HUI (JPOH008) Capital Budgeting Criteria: Modified Internal Rate of Return (MIRR) The discount rate that causes the PV of a project’s terminal value to equal to PV of costs  TV found by compounding inflows at cost of capital (r) 𝑃𝑉 (𝐶𝑎𝑠ℎ 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔) = 𝑃𝑉 (𝐶𝑎𝑠ℎ 𝑰𝒏𝒇𝒍𝒐𝒘𝒔) 𝑁 To find MIRR 𝐶𝑂𝐹𝑡 ∑𝑁 𝑡=0 𝐶𝐼𝐹(1 + 𝑟) 𝑁−𝑡 ∑ = (1 + 𝑟)𝑡 (1 + 𝑀𝐼𝑅𝑅)𝑁 𝑡=0 1. To get FV of Assume CFs reinvested at cost of capital TV inflows 2. To get PV of Discount at MIRR to t = 0 Steps TV inflows Equate initial investment (or PV cash outflow, whichever is applicable) 3. Calculating to discounted TV inflow MIRR Calculate MIRR Mutually Accept the project with higher