Corporate Finance - IRC Files PDF

Risk and Return Calculating Return ❖ Risk is the possibility of loss of value. It is the uncertainty about a decision. ❖ Possibility or likelihood of an outcome to deviate from expectation ❖ Stand-alone risk is measured by Standard Deviation ❖ We all know that o High r...

Risk and Return Calculating Return ❖ Risk is the possibility of loss of value. It is the uncertainty about a decision. ❖ Possibility or likelihood of an outcome to deviate from expectation ❖ Stand-alone risk is measured by Standard Deviation ❖ We all know that o High risk -> High return o Low risk -> Low return ❖ Examples of Investment Risk: o Low-risk investments, lower returns ▪ Bank Saving accounts ▪ Money Market accounts ▪ Government Bonds o High-risk investments, higher returns ▪ Corporate bonds ▪ Stocks ▪ Mutual funds ▪ Exchange-traded funds What is investment risk? Two types of investment risk ❖ Stand-alone risk ❖ Portfolio risk RETURN Return is simply a profit earned on top of the investment made. It is the percentage of the growth of an investment 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝑜𝑟 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑅𝑒𝑡𝑢𝑟𝑛 (%) = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 The return is simply the percentage change equation. Investors measure return in terms of how much cash flow is generated when such investment is collected (proceeds) or how much is the current value of the investment. Fixed Return - a class of assets and securities that pay out a set level of cash flows to investors, typically in the form of fixed interest or dividends. Variable Return - A time series can be taken on any variable that changes over time. In investing, it is common to use a time series to track the price of a security over time  - The return is simply the average of the different expected rates of return STAND-ALONE RISK Investment Risk - related to the probability of earning a low or negative actual return - the greater the chance of lower than expected or negative returns, the risker the investment Probability Distributions ❖ Listing all possible outcomes and the probability of each occurrence Standard Deviation as a Measure of Risk ❖ Standard Deviation measures total or stand-alone risk ❖ The larger the SD the lower the probability that actual returns will be closed to expected returns ❖ A larger SD is associated with a wider probability distribution of returns Coefficient of Variation (CV) - It is quite difficult to compare investments which have different returns and different standard deviations. So to allow investors to compare different investments, the coefficient of variation may be utilized. The coefficient of variation is a formula to represent the relative level of risk (standard deviation) per unit of return ❖ As a standardized measure of dispersion about the expected value, that shows risk per unit of return 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝐶𝑉 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 Using the coefficient of variation, investors could easily compare several investments with different returns and risks. Mr. Dylan purchased a stock of Benguett Consolidated Mining Corp. which provided, in its prospectus, a pay-off table of the amount of return expected in a given market condition for copper which is its prime product. The pay-off table is as follows: Demand for copper Return on Probability of particular demand demand High (>10 billion metric tons) 18% 20% Normal (5-10 billion metric 12% 50% tons)  Low (10 billion metric 18% 20% 3.6% tons) Normal (5-10 billion 12% 50% 6% metric tons) Low ( take the amount with the lowest value on the expected value Risk neutral: take the expected outcome Risk seeking: take the higher value Risk Aversion - Ideally, investors do not want risk but if you provide them securities with a considerable amount of risk, they will ask for a higher return. Consequently, securities that have higher risk tend to have higher returns. Risk premium - is the additional or excess return provided to investors for taking on a more risky security Example: In the cases mentioned, the riskier asset (Benguett Consolidated Mining in Case 3) has a higher return at 6.99% than the less risky asset (the bond in Case 1) with a return of 4%. The difference of 2.99% is what we call the risk premium Type of Risk under Risk and return Unsystematic Risk - Diversifiable risk Company risk Each company faces a unique set of risks o Financial leverage o Effectiveness of business operations o Strategy o Sales cycle and seasonality o Credit risk of customers o Labor stoppages o Company management Systematic Risk - Undiversifiable risk (Will bear the risk regardless) Market risk Arises from high level economic cycles and political environments o Factors that affect all companies o Interest rates o Inflation o Growth rates of gross domestic product  o Currency exchange rates o Government rules and regulations o Public policies Portfolio Risk - A portfolio is a collection of assets or securities that a particular firm has for it investors. If you can remember that a security is a piece of paper, then a portfolio is figuratively a place where you put all your “paper” securities. Diversified portfolio: one with a mix of investments from different industries where the only risk of an individual asset comes from systematic risk. o Only systematic risk o Less risky for a given level of expected returns than an individual asset o Pose less risk Beta measures the correlation between the returns on an individual asset and the returns of the broader stock market. - a measure of a stock's risk (volatility of returns) reflected by measuring the fluctuation of its price changes relative to the overall market. In other words, it is the stock's sensitivity to market risk. Other Types of Risk Risk is a broader term. o Credit or Default Risk- Risk that a firm will be unable to pay their obligatory loans o Interest Rate Risk - The market for interest rates will go up and down; shift on interest rates; risks that a firm has if they have debts. - The risk that market interest rate will vary and impact the value of interest-bearing securities, such as bonds o Foreign Exchange Risk - When the company is selling their products/services to various countries o Industry Risk - Certain industries are prone to higher level of risks and returns may be uncertain o Political Risk - Risk that certain political policies may change Capital Asset Pricing Model - CAPM describes the relationship between risk and expected return (How much return do investors require for an investment given its systematic risk (Beta)?) Required Rate of Return = rf + β(rm − rf) Three Market Conditions used in Capital Asset Pricing Model Market Risk Premium - The “market risk premium“ is the difference between the expected return on the risky market portfolio (RM) and the risk-free interest rate (Rf) Additional return over the risk-freer was needed to compensate investors for assuming an average amount of risk The “premium” refers to the amount of return expected from the market above and beyon the return that could be ear from a risk-free security. Risk-free rate of return - the interest rate an investor can expect to earn on an investment that carries zero risk The risk-free rate of return is equal to the real rate plus the inflation premium. Beta - indicate how much, and in what direction, a rational investor expects an investment to move in a given 1% chang in the market Basic Assumptions in CAPM 1. All assets/securities in the world are traded. 2. All assets/securities are infinitely divisible. 3. All investors in the world collectively hold all assets. 4. For every borrower, there is a lender. 5. There is riskless security in the world. 6. All investors borrow and lend at a riskless rate. 7. Everyone agrees on the inputs to the Mean-STD (the return and risk in astand-alone context) picture.* 8. Preferences are well-described by simple utility functions.* 9. Security distributions are normal, or at least well described by two parameters.* 10. There are only two periods of time in our world If we add more securities to the portfolio of Security A and B, we expect that the relevant risk of the whole portfolio is decreasing. We should note, though, that while the risk decreases as we add more securities to the portfolio, we can never eliminate risk. The process of adding more securities and thus decreasing the risk is what we call diversification.  The risk that can be eliminated through diversification is called unsystematic or diversifiable risk. On the other hand, the risk that can never be eliminated even if the investment is fully diversified is called the systematic, non-diversifiable, or market risk. Beta is exactly 1.0 (Average Beta) ❖ The expected return is equal to the required rate of return Beta is above 1.0 (AggressiveBeta) ❖ The expected return is more than the required rate of return ❖ More volatile Beta is below 1.0 ( ConcervativeBeta) ❖ The expected return is less than the requires rate of return ❖ Less volatile Conclusion: the higher the Beta, the higher the required rate of return THE SECURITY MARKET LINE SML - the interaction between the Beta (risk and the required rate of return ❖ As Beta increases, the required rate of return plotted along the Security Market Line also increases consistent with how Beta behaves in CAPM formula. When do SML change? ❖ Increase or decrease in inflation expectation SHOULD NOT CHANGE the market risk premium. Change in inflation changes market return and risk-free rate ❖ The change in the risk aversion fo the investors manifest through an increase in the risk premium they are demanding for “risky” securities. Change in market return only is called risk aversion TERM STRUCTURE OF INTEREST RATES Term Structure of Interest Rates ❖ Time until the principal balance of debt instrument is due ❖ Time is an important risk factor. More time = more risk ❖ More distant payoffs usually require higher interest rates. ❖ How much the debt instrument pays in interest Term to maturity is the amount of time until the debt instrument is due. Yield to maturity is the interest rate being paid. Yield Curve Yield curve shows the relationship between time to maturity and interest rates being paid. ❖ As the time to maturity gets longer, the interest rate gets higher. ❖ Yield curves usually have an upward slope. ❖ Longer-term securities have a higher yield than shorter-term securities. Time is a risk factor -> more uncertainty. Can yield curves have a downward shape? - Shorter-term securities would have a higher yield than longer-term securities. - Not common, but this is a sign that an economy is going into a recession. Factors that influence both the shape and level of yield curves: 1. Real rate of interest - Affects the level of yield curve but not the slope - Affected by the preferences that individuals have for spending vs. spending 2. Expected rate of inflation - Affects the slope of yield curve - Investors’ beliefs about whether the prices are increasing in the future and how much 3. Interest rate risk - Affects the shape of the yield curve Uncertainty about future bond prices - Bond prices move inversely with the interest rates ↑ Bond prices = ↓ Interest rates ↓ Bond prices = ↑ Interest rates BOND AND THEIR VALUATION Bond - a fixed-income instrument that represents a loan made by an investor to an institutional borrower. A bond is a security that represents a loan made by an investor (lendor) to an institution such as a business or government agency (borrower or issuer) 1. Mortgage Bond - With collateral 2. Debenture - Bond without collateral - Fixed income instrument that represents a loan made by an investor to an institutional borrower - Generally pays a fixed coupon rate - The investor can be anyone in the public who wishes to lend money for earnings of interest - Borrows of money are institutional meaning they are either corporate or government agency borrower Governments, corporations, and municipalities issue bonds when they need capital. An investor who buys a government bond is lending the government money. If an investor buys a corporate bond, the investor is lending the corporation money. Bonds are among several investments known as fixed-income securities. They are debt obligations, meaning that the investor loans a sum of money (the principal) to a company or a government for a set period, and in return receives a series of interest payments (the yield). Par Value - face amount at which the issuing entity will redeem the bond certificate on the maturity date (this is not necessarily the bond market value rather this is the amount stated in the bond certificate) Coupon Interest Rate - The stated annual interest rate on the bond (generally paid semi-annually) Indenture - Bond Contracts  - Contains Covenants (promises that restrict the actions of the borrower that can be detrimental to the lenders) Point of view: Company Issuing the bond - Liability Point of view: Investor - Asset Valuation of Asset - The value of an asset is the present value of the future cash flows it is expected to generate Valuation of Bonds - The value of a bond is the present value of the future coupon rate it is expected to generate - The discount rate: yield to maturity (required rate of return) Price Risk and Reinvestment Risk Debt instruments especially bonds are said to be safer than equity instruments such as stock - But it doesn't mean that the investor won't face risk if they purchase a bond What are the risks that the investors are incurring when holding a bond? The risk that a rise in market interest rate will decrease the value of the bond - Interest market risk or Price risk - The value of an asset is the present value of the future cash flows it is expected to generate - The reason why you want to buy an asset is due to the fact that you have an anticipated future cash flow that will flow from this asset. - Get the present value of the asset to arrive at the value that you are willing to pay for the asset - In case of Bonds, this will be in the form of coupon payments and the par value to be receive in the future Additional information: More commonly, the market rate is not equal to the stated rate. If the market rate is higher than the stated rate when the bonds are sold, the bonds will be sold at a discount. If the market rate is lower than the stated rate when the bonds are sold, the bonds will be sold at a premium. Consider the following bonds issued by ABC Corp. Bond A Bond B Par 1,000 1,000 Coupon Rate/ 10% 10% Stated Rate Market Interest/ 10% 10% Effective Rate Yrs. to Maturity 1 year 3 years 1. Calculate the Value of both bonds now (yr.0 ) Bond A Bond B - When the coupon rate is identical to the market interest rate there is nothing to calculate the bond’s value it will automatically be equal to the par value - We require a rate of return of 10% and the bond is giving us 10% so at the end of the day we are willing to pay the principal at its par value  2. Calculate their values if the market rate went up to 15% (ST < MR = premium) Bond A Bond B - Under both bond A and bond B the investor is now willing to pay lower than the par value this is because the market requires a 15% rate while the bond is only giving 10% - This is a result of a rise in market interest rate. The market interest rate increases the value of the bond decreases. - Bond B is more affected than Bond A since Bond B takes more time to mature than Bond A when rising interest rates (this is a price risk) - The longer the maturity of the bond the more affected is it by the price risk Reinvestment rate risk - The risk that a decline in market interest rates will decrease the income from a bond portfolio Bond A Bond B Par 1,000 1,000 Coupon Rate/ Stated Rate 10% 10%  Market Interest/ 10% 10% Effective Rate Yrs. to Maturity 1 year 3 years 1. Calculate the interest income for both bond after 1 year (yr.1) Bond A Bond B 2. Calculate the interest income for both bonds after another 1 yr (yr. 2) if the market rate goes down to 5% Preferred Stock & their valuation Preferred Stock - Similar to Debt Charges fixed rate of dividends similar to coupon interest No voting rights in the company’s board Similar to Equity Cannot legally enforce payment of dividend Dividends are not tax deductible Generally doesn’t mature Cumulative Feature - A feature that requires dividends not Pais in the prior years, to be paid to P/S holders before common share dividends are paid Dividends in Arrears Unpaid dividends that accumulate until paid Participating P/S  A types of preferred stock that give the holder the right to receive dividends equal to its usual rate plus an additional dividends on a certain condition Adjusting P/S Its dividend rate is adjusted regularly Although general rule is fixed rate, adjustable p/s are those adjusted regularly Pros and Cons of P/S to Issuers Advantage: 1. Nonpayment cannot lead to bankruptcy 2. Prevent dilutions (vs common equity) 3. Reduce cash train (if no maturity) Disadvantage: 1. Issuer can’t claim tax deductions on dividend payment 2. They need to be paid before common equity dividends become payable Valuation of Asset - The value of an asset is the present value of the future cash flows it is expected to generate Preferred Stock - Generally do not mature we are to use Perpetuity (the present value of a constant cash flows that last until forever. Value of P/S = Dividends / required rate of return This formula will bring us to the present value of an infinite stream of constant cash flows Case 1: Batten Inc. has an outstanding P100 par perpetual preferred shares issue with an annual dividend rate of 8.0%. If the required rate of return is 10%. What is the value of the preferred stock Value of P/S = Dividends / required rate of return This means that the investor is willing to pay 80 pesos to purchase a preferred share The value of the stock is below par since the required rate of return is 10% but only gives 8% dividends If the investor will purchase the stock at 80 pesos (below par) it will generate dividends of 10% (equal to the required rate of return) of 8 pesos Case 2: Batten Inc. has an outstanding issue of P100 par perpetual preferred shares with an annual dividend rate of 8.0%. If the required rate of return is 5%. What is the value of the preferred stock Value of P/S = Dividends / required rate of return The stock price is greater than the par because the required rate of return is 5% but the dividend is much greater @ 8% Common stocks & their valuation Common stocks - represent ownership in the corporation Common stockholders have: 1. Control of the firm - elect the board of directors 2. Preemptive right - a right of existing shareholders in a corporation to purchase newly issued stock before it is offered to others. Issue on Valuation They have no maturity date Dividend payment is not fixed Constant Growth Model or Gordon Growth Model We can take the present value of all dividend payments from one year from now until every using the following formula P0 - Value of Shares today or as of year zero D1 - Dividends one year from now Rs - required rate of return on equity G - growth rate CASE: Sato is expected to pay a P1 per share dividends at year end. The dividend is expected to grow at a constant rate of 3% a year. The requires rate of return on the stock is 14%. What is the current value of stock per share? If we are to project the cash flows of the path one year from now we would have 1 peso one year from now it will grow to 1.03 2 years from now and another 3% on year3 until forever so the present value of the stock is 9.09 at year 0 Common Stock - if the company is not yet matured Terminal Year - In finance, the terminal value (also known as “continuing value” “horizon value” or "TV") of a security is the present value at a future point in time of all future cash flows when we expect a stable growth rate forever. Case: Peso Enterprises just paid a dividend of P5.00. It expects a non-constant growth of 20% for 2 years followed by a constant rate of 3% thereafter. The equity’s required rate of return is 10% EQUITY VALUATION MODEL- A valuation technique which calculates the free cash flows to equity participants, then finds their present values to determine the equity’s value Equity Value xx /no. of share outstanding xx —————————————————————— Stock Value xx CASE: West Corp. expects to generate 25 million in free cash flows to equity next year. This is expected to grow ay a constant rate of 2.5% annually for an indefinite period. West Corp. has a cost of equity capital, rs, of 15%. Assuming it has a 12.5 million common stock outstanding, what is it intrinsic value? Value of equity = FCF-E1/ rs-g FCF - Free cash flows E1 - equity next year Free cash flows to equity Cash flows that are due to the owners of the company (stockholders/ common stockholders) Exclude the bond holders in the cash flow Sales Revenue Cash Expense Depre & Amort expense ——————————————— EBIT (Interest Expense) ——————————————— EBT EBT (1-T) - EARNINGS AFTER TAX (also known as Net Income) + Depre & Amort expense - Capital Expense - Increases in Net working capital (Cash outflows that is not reflected in the income statement) + New Debt Issuance - Debt repayments ——————————————— Free Cash Flows Today is 31 December 2020, and the following figures are forecasted for Virginia Trucking in 2021: - Net income before taxes (a.k.a. EBT) is expected to be P600 million - The depreciation expense for that same year is projected to be P200 million - Planned capital expenditures are at P200 million - The non-cash net working capital is expected to grow by P50 million in that same year. - No movements on the debt principal are expected.  - The free cash flow is expected to grow at a constant rate of 3% per year. The cost of common equity is 16% - The weighted average cost of capital is 9% - The market value of its debt is P3 billion 200 million shares of stock are outstanding. - The effective income tax rate is 20%. Assume that today is December 31, 2020, and that the following information applies to Georgia Tours: Free cash flows to equity 2021 P50,000,000 2022 P70.000.000 2023P80.000.000 After year 2023, the cash flows are expected to grow at a constant growth rate of 5%.The cost of equity capital is 14%. There are 50M shares outstanding. International Finance The principles of finance are the same whether we look at it in the domestic context or international context - However, there are additional challenges one would face when exposed to international operations such as foreign exchange risk - However, there are additional opportunities as well All of the following are valid reasons for the expansion of international business by U.S multinational corporations, except: a. Secure new sources for raw materials b. Protect their domestic market from competition from foreign manufacturers c. Minimize their costs of production d. Find additional areas where their products can be successfully marketed You cannot protect the inside from the outside letter B is not connected. NO connection for expansion just triggering competitors Foreign Exchange Rate Foreign Exchange rate is the price of the domestic currency stated in terms of another currency It compares one currency with another to show their relative values How is this foreign exchange rate being set? It depends on the INTERNATIONAL MONETARY SYSTEM INTERNATIONAL MONETARY SYSTEM - Regime of how exchange rates are set Fixed exchange rate system - a nominal exchange rate that is set firmly by the monetary authority (government) with respect to a foreign currency or a basket of foreign currencies - Mostly for communist countries Floating exchange rate system - determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly - The law of demand and supply dictates the value of the currency Most of us (aside from communist countries) it is not a purely floating system because sometimes the government will intervene called Managed Float Managed Float - market-based but the government may intervene from time to time Foreign Exchange Rates influence how firms will source and sell their goods and services. Example: How many $ for €? Foreign exchange rates may be fixed, flexible or floating. Factors that influence exchange rates: Inflation rates Interest rates Public debt Current account deficits Ratio of imports to exports Political and economic stability The type of foreign exchange system allows for governments to intervene and influence exchange rates - Managed Floating exchange rate. In a managed floating exchange rate system: the currency rate is supposed to be by interventions by central banks in order to stabilize alter rates Which of the following are methods used to maintain a managed floating exchange rate system? 1. Government intervention in foreign exchange markets 2. Governments purchased a devaluing currency against unchanging demand 3. Trade policies decreasing a trade deficit or increasing a trading surplus 4. Placing controls on currency exchnage 5. Making domestic macroeconomic adjustments that decrease the supply of the country’s currency in the market Hindi lahat ibig sabihin gagawin lahat but they can do it to managed the exchange rate Type of foreign exchange system requires a country to maintain its currency at or near a benchmark value: Fixed Exchange Rate Exchange Rate Quotation Direct Exchange Rate States how much domestic exchange per ONE UNIT of foreign currency $0.80:1.00 Euro Indirect Exchange Rate States how much foreign currency per ONE UNIT of domestic currency 1.25 Euro: $1.00 Cross Exchange Rate Any exchange of any two currencies that are not the official currency of the country in which the quote is published In practice any currency exchange in which neither of the currencies is the U.S. Dollar is considered a cross rate Example of a cross-exchange rate from an American perspective: 115.23 YEN/EURO International Trade InternationalTrade is the exchange of goods and services between countries Trading globally gives consumers and countries the opportunity to be exposed to goods and services not available to one their own countries, or more expensive domestically. The importance of international trade was recognized early on by political economists susch as Adam Smith and David Ricardo. Counter Trading (Barter) - a form of trade where goods and services are exchanged for goods and services rather than cash Letter of Credit - a contractual commitment by the foreign buyer's bank to pay once the exporter ships the goods and presents the required documentation to the exporter's bank as proof - Very details information - A piece of letter Example: A U.S. based infant clothing company is interested in importing fabric from China. Which of the following should the company arrange first for the Chinese company to ship the merchandise? a. Letter of Credit b. Time Draft c. Bill of Lading d. Sight Draft A financial tool involves an exporter sending goods to an importer before the goods have been sold to a customer a. Letter of Credit b. Countertrading c. Consignment e. Sight Draft Forfaiting - method of trade finance that allows exporters to obtain cash by selling their medium and long-term foreign accounts receivable at a discount to a forfeiture, a specialized finance firm or a department in a bank. - Long-term receivable from foreign buyer Fortailing is: a. A method of stalling payment on an import by requiring a certain amount of time before payment is due b. A purchase of trade debt by a bank from an exporter c. Making a written agreement where an importer agrees to sell products for an importer and remit proceeds of sale when completed d. Parment of a note at a specified time in the future upon completion of specified requirements bu the exporter Determinants of Exchange rate Inflation Increases in the inflation rate = lower purchasing power of local currency = local currency decrease in value (depreciates Note: pag inflation mataas ma depreciate yung value ng currency natin. BAKIT? Kung tumataas ang inflation bumababa ang halaga ng pera natin. Mababa ang halaga ng pera natin mas lumakalas ang ibang currency Inverse relationship between NIG to local currency value Real Interest rate Increase in the real interest rate = attracted foreign investors locally to invest in bonds = increase in the demand of local currency = local currency increases in value (appreciate) Note: when real interest rate goes up other or foreign country will purchase our currency. It will increase the demand for our currency hence it will appreciate the value Direct relationship between NIG to local currency value National Income Growth Increase in national income growth = more imports than exports = increase in the demand of foreign currency = local currency will decrease in value (depreciate) Inverse relationship between NIG to local currency value Notes: Increase in national income growth means that mas madami na ang import natin kesa sa exports. So when we import more there will be an increase in the demand of foreign currency so napapabayaan nag local currency kaya bumababa Assuming exchange rated are allowed to fluctuate freely, which of the following factors would likely cause a nation’s currency to appreciate on the foreign exchange market? a. A relatively rapid rae of growth of income that stimulates imports b. A slower raye of growth in income than in other countries, which causes to imports to lag behind c. Foreign real interest rates that are higher than domestic real interest rates d. Domestic real interest rates that are lower real interest rates abroad Due to mismanagement of its domestic economic policies, country A is experiencing a drastic increase in inflation in relation to its neighbor country B, which happens to be its major trading partner. How will the increased inflation in country A affect the exchange rate between the two countries? a. Country A's currency will not change against Country B's currency. b. Country A's currency will depreciate against country B's currency. c. There is insufficient information to determine the impact on the exchange rate d. Country A's currency will appreciate against country B's currency. If the central bank of a country raises interest rates sharply, the country's currency will most likely: - Papasok ang foreign investors pag mataas nag real interest rate therefore our foreign currency will increase. a. decrease sharply in value at first and then return to its initial value. b. decrease in relative value. c. lose much of its intrinsic value. d. increase in relative value. Country R's currency would tend to depreciate relative to Country T's currency when: a. Country T has a rapid rate of growth in income that causes imports to lag behind exports b. Country R switches to a more restrictive monetary policy. c. Country R has a rate of inflation that is lower than the rate of inflation in Country T. d. Country R has real interest rates that are lower than real interest rates in Country T. Effects of changing currency value Appreciation: Makes the price of the domestic goods EXPENSIVE abroad; this one harms the exports Makes the foreign goods CHEAPER at home; helps importers (because our local currency appear to have higher value than usual) Depreciation: Makes the price of the domestic goods CHEAPER abroad; this one helps the exports Makes the foreign goods EXPENSIVE at home; harm importers (di makapag import ng marami dahil mukang mahal pag binibili nila abroad) What is the effect on prices of U.S. imports and exports when the dollar depreciates? a. Import prices and export prices will decrease. b. Import prices will decrease and export prices will increase. c. Import prices will increase and export prices will decrease. d. Import prices and export prices will increase What is the effect when a foreign competitor's currency becomes weaker compared to the U.S. dollar? a. The foreign company will have an advantage in the U.S. market. b. The foreign company will be disadvantaged in the U.S. market. c. The fluctuation in the foreign currency's exchange rate has no effet on the U.S. company's sales or cost of goods sold. d. It is better for the U.S. company when the value of the U.S. dollar strengthens. Risk Management (for international finance) Forwards - ustomized contract between two parties to buy or sell an asset at a specified price on a specified future date. Futures - Standardized contracts similar to forwards traded at exchanges. Long Party Short Party Buyer of the underlying asset Seller of the underlying asset An American importer of English clothing has contracted to pay an amount fixed in British pounds three months from now. If the importer worries that the U.S. dollar may depreciate sharply against the British pound in the interim, it would be well advised to: A. Buy pounds in the forward exchange market. B. Sell dollars in the forward exchange market. C. Buy dollars in the forward exchange market. D. Sell pounds in the forward exchange market. - This is in terms of payables A U.S. company has an account receivable from a Swiss company for 100,000 Swiss Francs (CHF) due in three months. At the time of contract, the exchange rate was 1.0 CHF = 1.0 USD. The U.S. company wishes to manage its foreign exchange exposure and therefore: A. buys a currency swap. B. sells Swiss-Franc futures. C. sells a Swiss-Franc interest rate swap. D. buys Swiss France futures. - This is account receivables A company has a foreign-currency-denominated trade payable, due in 60 days. In order to eliminate the foreign currency exchange rate risk associated with the payable, the company could a. Wait 60 days and pay the invoice by purchasing foreign currency in the spot market at that time. b. Borrow foreign currency today, convert it to domestic currency on the spot market, and invest the funds in a domestic bank deposit until the invoice payment date c. Buy foreign currency forward today. d. Sell foreign currency forward today. Palermo, Corp. sold equipment to a French firm. Palermo will be paid €4,275,000 in 90 days. The bank has given the firm a 90-day forward quote of $1.5487/€ to purchase Euros forward, and $1.5922/€ to sell Euros forward. Palermo decided to wait 90 days to sell the Euros, when the spot rate was $1.5645/€. How much additional dollar revenue did Palermo gain or lose by waiting to sell the Euros on the spot market instead of selling forward the Euros? Round your final answer to the nearest dollar.) A. $118,417 gain B. $118,417 loss C. $67,545 gain D. $67,545 loss Carrington Industries sold equipment to a Mexican firm. Carrington will be paid 41,275,000 pesos in 30 days. The bank has given the firm a 30-day forward quote of $0.09739/peso to purchase Mexican pesos forward, and $0.09322/peso to sell Mexican pesos forward. Carrington decided to wait 30 days to sell the pesos, when the spot rate was $0.09596/peso. How much additional dollar revenue did Carrington gain or lose by waiting to sell the pesos on the spot market instead of selling forward the pesos? (Round your final answer to the nearest dollar. A. $113,093 gain B. $113,093 loss C. $59,023 gain D. $59.023 loss Given a spot rate of $1.8655 and a 90-day forward rate of $1.8723, the pound sterling in the forward market is: A. Being quoted at a discount. B. Overvalued. C. Being quoted at a premium. D. Undervalued. Note: Being quoted at a premium dahil mas mababa talaga yung spot rate niya pero antaas ng forward Given a spot exchange rate for the U.S. dollar against the pound sterling of $1.4925/£ and a 90-day forward rate of $1.4775/£: a. The pound sterling is selling at a discount against the dollar and is undervalued in the forward market. b. The forward pound sterling is selling at a premium against the dollar in the forward market. c. The pound sterling is selling at a premium against the dollar and is overvalued in the forward market. d. The forward pound sterling is selling at a discount against the dollar in the forward market. Given that the spot rate is ¥106.74/S and the 180-day forward quote is ¥100.37/S, we can say which of the following? a. The U.S. dollar is at a forward premium against the Yen. b. The Yen is at a forward premium against the U.S. dollar. c. The Yen is at a forward discount against the U.S. dollar. d. The U.S. dollar is at neither a premium nor a discount against the Yen. Note: yung yen yung nakapremium tas if pag balikatid yung exchange rte yung dollars ang naka discount kung dollars per yen The spot rate on the London market was £0.5434/$, while the 90-day forward rate was £0.5519/S. What is the annualized forward premium discount on the U.S. dollar for the period? (Round your final answer to the decimal place.) A. 1.6% Prem B. 6.3% Prem C. 6.3% Disc D. 1.6% Disc Forward Rate £0.5519/S Spot Rate £0.5434/$ 0.0085 more£/$ on forward rate ➗0.5434 0.015642 X 360/90 6.26% Premium Bank of America quoted the 190-day forward rate on the Japanese Yen at $0.009702/Y. The spot -rate was quoted at $0.009466/Y. What is the forward premium or discount on the Japanese Yen? A. 2.5% Prem B. 2.5% Disc C. 5.0% Pre D. 5.0% Disc Forward Rate $0.009702/Y Spot Rate $0.009466/Y 0.000236 more $/Y on forward rate ➗$0.009466 0.024931 X 360/180 4.99% Premium Video 2 One U.S. dollar is being quoted at 120 Japanese yen on the spot market and at 123 Japanese yen on the 90-day forward market; hence, the annual effect in the forward market is that the a. U.S. dollar is at a premium of 0.025%. b. U.S. dollar is at a premium of 10%. c. U.S. dollar is at a premium of 2.5%. d. U.S. dollar is at a discount of 10%. Which of the following financial instruments is a contract that fixes a currency exchange rate at a future date? a. Currency swap b. Currency option c. Currency insurance d. Currency future Option - a contract that gives the holder the right to buy or sell an underlying asset at a specified price within a specified period of time. Right to buy - Call Option Right to Sell - Put Option What is the fundamental difference between options and forwards? - The seller of an option contract is obligated to perform, while the buyer is not; forward terms are typically binding to both the buyer and the seller. Long Party Short Party Call option - option to BUY Buyer (Holder) of the Option Seller (Writer) of the Option the underlying Asset to buy the underlying asset to buy the underlying asset Put option - option to Sell the Buyer (Holder) of the Option Seller (Writer) of the Option underlying Asset to sell the underlying asset to sell the underlying asset In options - the words long and short does not pertain to the buyer or seller of the underlying asset rather the buyer or seller of the OPTION (as it was in the futures and forwards). - What this tells us is whether ikaw ba yung buyer or seller ng OPTION. A proper way for a U.S. firm to hedge accounts payables denominated in pesos is through: A. call options on pesos. B. a forward contract to sell pesos. C. any of the other options. D. put options on pesos. You need to buy an amount in peso. Bakit ka mag bebenta in peso eh kailangan mo nga ng pero kasi may papayaran ka in peso. You need to buy peso to pay the AP. - Kaya ka mag enter in an call option dahil ayaw mo tumaas yung presyo ng peso (underlying asset) kaya bibili ka ng call option para may right ka to buy it when the time comes Exercise Call option: Strike price < Underlying Asset - Mas mababa yung underlying asset At the time an option expires, the value of the option is: a. the difference between the Black-Scholes option value and the exercise price. b. the price at which the option is exercised.  c. not determinable because of the difficult valuing options. d. the difference between the exercise price and the value of the underlying asset. The option’s value cannot be lower than 0 or ZERO kasi hindi ka naman pinipilit mag exercise if lugi ka eh di pwede mag negative. What is the payoff for a put option with a strike price of $22 if the price of the underlying stock at expiration is $19? a. $3 b. $19 c. $22 d. $41 What is the payoff for the owner of a call option with a strike price of $35 if the underlying stock price at expiration is $30? A. $30 B. $(5) C. $5 D. $0 Consider a corn farmer who expects to produce 55,000 bushels of corn at the end of this season. To hedge the risk associated with corn prices, the farmer purchases put options to cover his entire crop. The put options have a strike price of $8.50 per bushel and a premium of $0.40 per bushel. He also sells an equal amount of call options with a strike price of $8.50 per bushel and a premium of $0.53 a bushel. Which of the following statements is correct? a. From this transaction the farmer can pocket $7,500 immediately. b. If corn prices increase substantially, the farmer will earn more than the strike price. c. If corn prices decrease substantially, the farmer will earn less than the strike price. d. The farmer has guaranteed that he will sell his corn for $8.50 a bushel. Pag tumaas naman yung market price ng option to 9.00 tas ang exercise price niya is 8.50 pwede naman wag siya mag sell as holder ng put option. Which of the following statements about option payoffs is false? Assume S = stock price and X = strike price. a. S= X, a put option is at-the-money. b. S> X, a put option is in-the-money. c. S- X>0, a call option is in-the-money. d. S-X= 0, a call option is at-the-money. The price of the underlying asset increases, what happens to the value of call and put options? a. Put options will be worth more, and call options will be worth less. b. Put options will be worth less, call options will be worth more. c. Both call and put options will be worth more. d. Both call and put options will be worth less. Tumaas ang price ng underlying asset eh pwede ka makabili ng mas mababa so mangyayari mas okay siya sa call option. Derivatives Derivatives are securities that drive their value from an underlying asset or benchmark - Common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes. - Common Derivatives includes: 1. Futures 2. Forwards 3. Options 4. Swaps Futures and Forwards The primary difference between futures and forwards is in their nature as contracts. Forwards are non-standard over-the-counter contracts, drawn between parties to buy or sell an asset on a future date at a predetermined price. Futures contracts are standardized agreements traded on the exchanges. Futures - Standardized contracts similar to forwards traded at exchanges Notes: 1. A future contract has standardized terms and fixed maturity dates 2. Futures are traded on an exchange and are guaranteed by clearing houses (required 10% margin deposit) 3. The market of futures is highly liquid because futures are settled daily Forwards - Customized contracts between two parties to buy or sell an asset t a specified price on a specified future date - Has a default risk Notes: 1. Forward contracts (directly transacted) require no cash transactions until the delivery date, while future contracts require deposit margim when the position is opened 2. Future contracts are highly standardized 3. Forward contracts have default risk Swaps - involves the exchange of interest and in some instances principal - in one current for the same in another country Currency Swap - financial instruments is a c contract whereby organizations assume the foreign risk of another party Example: Bank of Amuero Kita niya is in U.S. Dollars BUT Most of the Debt is in Euro so Interest income is in Euro Bank of Eurica Income is in Euro BUT Most of the Debt is in U.S. Dollars so Interest income is in U.S. Dollar What is the problem? When the dollar goes up the euro goes down - kawawa si bank of Eurica kasi tataas yung expense niya conversely kapag tumaas yung euro yung tumaas tas dollar bumaba tataas naman expenses ni Amuero siya naman kawawa. What to do to resolve the problem? Use swaps no more exposure to highs and lows of each currency You cannot analyze these transactions by looking at the FS. The swap transactions are not seen them in the FS Options - A contract that gives the holder the right to buy or sell an underlying asser at a specific price within a specified period of time Long Party Short Party CALL OPTION - option to Buyer (holder) of the Option Seller (witter) of the Option buy the underlying asset to buy underlying asset to buy underlying asset PUT OPTION - option to sell Buyer (holder) of the option Seller (witter) of the Option the underlying asset to sell the underlying asset to sell underlying asset The fundamental different between options and forwards - The seller of an option contract is obligated to perform, while the buyer is not; forward terms are typically binding to both the buyer and seller Put option from a seller - the buyer has the right to sell the underlying asset and the seller has obligation to buy it Call option - the buyer has the right to buy the underlying asset and the seller has obligation to sell it 1. At-the-money - walang lugi or walang talo (no gain or loss) - The underlying asset price is equal to the strike price 2. In-the -money - gains/ profit - The underlying asset price is lower to the strike price 3. Out-of-the-money- loss - The underlying asset price is greater to the strike price Concern regarding prices: Pricing may fall in the future - used put option Pricing may increase in the future - used buy option Example PUT OPTION Long - put option sell when gain (exercise) which is underlying asset < strike price Long - put option hold (dont exercise) when loss which is underlying asset > strike price Exercise Price. Strike Price 205 Underlying Asset Price 210 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 0 because dont exercise No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 0 - Do not exercise Exercise Price. Strike Price 210 Underlying Asset Price 205 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 5 exercise No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 100 When there is an option premium for put option of 1 per share (Disregard the option premium) Exercise Price. Strike Price 205 Underlying Asset Price 210 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 0 because dont exercise No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 0 - Do not exercise Exercise Price. Strike Price 210 Underlying Asset Price 205 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 5 exercise No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain/ 100 DO NOT Disregard the option premium Exercise Price. Strike Price 205 Underlying Asset Price 210 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 0 because dont exercise Option Premium (1) No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Loss -20 - Do not exercise but still have loss on maturity date of the stock due to the option premium Exercise Price. Strike Price 210 Underlying Asset Price 205 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 5 exercise Option Premium (1) No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain 80 On the point of view of short-put option What is gain on long-put option is loss on short-option and what is loss on long-option is gain on short-option Example CALL OPTION Long - call option sell when gain (exercise) which is underlying asset > strike price Long - put option hold (dont exercise) when loss which is underlying asset < strike price Exercise Price. Strike Price 205 Underlying Asset Price 210 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 5 exercise No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain 100 - Exercise Exercise Price. Strike Price 210 Underlying Asset Price 205 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 0 DO NOT exercise No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 0 When there is an option premium for put option of 1 per share (Disregard the option premium) Exercise Price. Strike Price 205 Underlying Asset Price 210 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 5 exercise No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain 100 - Exercise Exercise Price. Strike Price 210 Underlying Asset Price 205 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 0 DO NOT exercise No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 0 - DO NOT Exercise DO NOT Disregard the option premium Exercise Price. Strike Price 205 Underlying Asset Price 210 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 5 Exercise Option Premium (1) No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain/ Loss -20 Exercise Price. Strike Price 210 Underlying Asset Price 205 —-------------—-------------—-------------—-------------—------------- Gain/ Loss 0 exercise Option Premium (1) No of Shares x 20 —-------------—-------------—-------------—-------------—------------- Gain -80 - Even if hindi nag exercise still have loss on maturity date of the stock due to the option premium  WEIGHTED AVERAGE COST OF CAPITAL (WACC) Capital Structure - mix of debt and equity the firm uses to finance operations and asset purchases All long term funding encompasses debt and equity Cost of Capital Investors Pov Company Pov Cost of Debt Debt Holder rd Cost of Preferred P/S Holder rp Stocks Asset Cost of Common C/S Holder rs Stocks For the company’s point of view the riskiest is DEBT For the investors’s point of view the riskiest is COMMON STOCK INVESTOR’S POV - these are RETURNS COMPANY’S POV - these are COST - Yung hinihingin return ng investor is a cost for a company sa investor income/return yun - The dividends asked by the P/S and C/S holders are cost to the company or outflow - COMPANY’S POV capital has a cost To take the overall cost of capital - get the weighted average cost of capital. Overall cost of capital is the rate of return in assets that covers the costs associated with the funds employed It is also the minimum rate a firm must earn on average asset Cost of long-term debt - costs of borrowing for a firm Cost of capital - weighted average cost of capital Cost of Common Stock - the appropriate cost of Retained Earnings, ignoring flotations costs is equal to Cost of Common Stock when calculating the component costs of long terms funds. HIGHER RISK - rate of return is more than the WACC LOWER RISK - rate of return is less than the WACC Weighted Average Cost of Capital (1-T) - tax savings because when the company pays interest the net income is reduced nababawasan ang taxable income which is note true for preferred stock and common stock. Only cost of debt is affected by taxes Debt to equity ratio is not equal to the debt ratio and it is not the debt ratio For Example Debt to equity ratio is.5 0r 50% Debt Equity 50% or.50 33.33% debt 100% or 1 66.67% equity ratio ratio 150% or 1.50 150% or 1.50 Cost of Retained Earning vs Cost of Common Stocks in case of retained earnings, the amount is financed through the income of the company so no issue needs to be made of new stock. In the case of new common stock, The issue needs to be made which will result in some costs such as underwriting costs, legal charges, documentation charges, etc Joint Products Inc., a corporation with a 40% marginal tax rate, plans to issue $1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8% bonds currently outstanding. The firm's total liabilities and equity are equal to $10,000,000. The effect of this exchange on the firm's weighted average cost of capital is likely to be: - Increase, since a portion of the debt payments is tax deductible - 8% bonds will be replaced by 8% of preferred stock if this happens it will increase the WACC since mawawala yung tax savings mo from the bonds  Bonds Preferred 8% (1-T) 8% only This is why the WACC will increase because mawawala ang tax savings. Replaces your bonds with preferred stocks will have the effect of increasing the WACC because you would lose a portion of the tax savings. The cost of the bonds “8% (1-T)” would be less to the company because of the tax savings replacing with P/S the WACC will increase Growth rate g - the growth rate of both stocks and dividends - The growth of the dividend is constant forever and therefore the growth of the stock price is the same (constant growth model) Examples on growth rate: Dividend 10% Is this a possible scenario Growth for next next year? Yes! this is year possible Stock Growth 4% for next year Dividend 10% Is this a possible scenario Growth forever forever? No! Because if this happens the stock price will Stock Growth 4% be taken over by the forever dividends. Pag nangyari yun, mangyayari if 100,000 yung dividend magiging 40,000 lang yung stock price. Impossible to happen  Dividend 3% Is this a possible scenario Growth forever forever? No! Yung company mo parang hindi na Stock Growth 11% nagbabayad ng dividends forever mo forever. The tendency is that the company will grow so big without even distributing income. The only realistic example of “assuming forever” is that the stock price and dividends is growing at the same time. American Outlook, Inc. will issue bonds to fund the acquisition of a major competitor. American Outlook has previously issued preferred and common stock. Which component cost(s) should American Outlook use in evaluating the financial cost of acquiring the new firm? Which of the following, when considered individually, would generally have the effect of increasing a firm's cost of capital? 1. The firm reduces its operating leverage. 2. The corporate tax rate is increased 3. The firm pays off its (only)outstanding debt. 4. The Treasury bond yields increase The firm reduces its operating leverage Use of fixed cost for operating leverage If the fixed cost goes down; common stock will go down then will reduce WACC Why FC IS RISKY? - No matter if you sell something or not you need to pay this one Then lower the required rate of return The corporate tax rate is increased T will go up the rd (1-T) goes down and as well tas the WACC Which of the following statements about capital structure is true?  The optimal capital structure maximizes the market value of the firm’s common stock The capital structure is a function of the degree of debt used by the firm, hence, business risk (inherent without debt) is a factor in the capital structure decision. - The lower the business risk mas willing ka kumuha ng debt since mas constant naman yung income mo rather tha aid mataas ang business risk mo that is why it is a factor The tax shield on the interest expense of debt is normally a factor when a firm's management is making capital structure decisions. - If mataas ang tax mas okay na mas mag acquire ng debt since nakakatawas sa taxable net income. The target and the optimal capital structure are generally equal to each other. - The target should be equal to the optimal capital structure Raising Capital Financial markets come in various forms and sizes. This lesson reviews different types of financial markets and their role in the economy. This lesson also discusses regulation of financial markets, including restrictions on insider training. Financial Markets A financial market exists to facilitate the flow of money from investors. It facilitate exchange. Market exist for almost anything. Assets being exchanged: Stocks Bonds Options Commodities Currency Primary market is a market in which new security issues, either debt or equity, are sold directly to investors. A key characteristic of primary markets is that issuance of the new security results in new money for the issuing firm. Primary markets are often less accessible for everyday investors because they are wholesale markets taken up by large institutional investors. Secondary market is a market in which owners of securities can sell them to other investors. Secondary markets are more familiar to most people. Stock Exchanges: New York Stock Exchange NASDAQ London Stock Exchange Euronext Hong Kong Stock Exchange Shanghai Stock Exchange Commodities (oils, metals, food, etc.) Chicago Mercantile Exchange Hong Kong Mercantile Exchange London Metal Exchange Futures Chicago Board of Trade New York Board of Trade Options Chicago Board Options Exchange Money Market is a specific type of secondary market wherein short-term debt instruments, meaning those with a maturity within one year, are traded. Money markets are highly liquid, almost like regular cash holdings while maintaining a high level of liquidity.  Earn a higher interest rate than regular cash holdings Pay higher interest rates = more risks Capital markets are typically longer-term and offer greater risk but potential for greater rewards Key terms to understanding financial Markets 1. Marketability: means that I can convert my asset into cash 2. Liquidity: refers to the same conversion of an asset to cash, however without loss of value 3. Broker: brings two investors together and facilitates the exchange; does not bear a risk; pays a premium or fee for facilitating the exchange 4. Dealer: takes ownership of the asset; they make money by buying the asset at a lower price and selling them at a higher price; bears the risk Regulation Insider Trading is an illegal practice where individuals with confidential information trade on investments for profits. Blackout Periods restrict when employees can buy or sell shares in their own company. Example: quarter-end - When the management knows the company’s financial performance that has not been released to the public Tipping takes place when an insider provides information that is material and confidential to another individual who trades based on that information. Don’t trade based on insider information. Onsite Lecture Corporation - a business organization that can most easily raise capital - Has a life of 50 years, renewable forever, and renewed 5 years before the expiration of the contract) Sole Proprietorship - easy to form The presence of a financial market increases the marketability of financial security by reducing the transaction costs for selling the security - The use of a financial market is like paying someone (an institution) to acquire information for you this is cheaper than doing it by yourself - It is costly for an investor to find a business to invest in. It is easier to find a broker who knows a business even if you are going to pay them extra or a small percentage Money Market - short-term debt instruments Capital Market - longer securities Bond market Money Market How do corporations raise capital? Large corporations would approach investment banks. Investment Banks are banks whose specialty is helping companies sell new debt and equity in the primary markets. They help firms issue securities. Raise capital for business expansion Underwriting: is the process by which investment banks help a company complete the sale of security. The investment bank buys the new security from the company, and then resells the security to investors Underwriting Spread - This happens in a two-step process. For the firm, they get a fixed price or set price. This is beneficial for the firm because they can know and plan for future expenses. The investment banks, get a spread called an underwriting spread. Best Efforts - Banks became a consignee to avoid risk but with a commission Underwriting - the investment bank will purchase the stock to the company at a BID PRICE and sell it to an ASK PRICE/ OFFER PRICE to the public. Note: An underwriting agreement involves the investment bank buying the firm's security and sell to the investors, while a best-effort sale involves the investment bank giving its highest effort sell as much as possible of the securities and getting a commission on the full transaction. Total Issuance Cost Legal and Administrative Fee xx Underwriting Spread xx Underpricing cost xx Total Issuance Cost Credit Rating Agencies Credit rating agencies provide assessments of the risk that a company will default on its debt obligations. Credit Agencies assign credit ratings or assess the company’s default risk Ability of the company to pay the debt the higher the credit rating the lower the default risk Reduce information asymmetry Moody’s, S&P, and Fitch are the three major credit rating agencies. Because si borrows alam niya yung capabilities niya mag bayad pero ang lender hindi niya yun alam. One way to lessen this information asymmetry is thru credit rating agencies —--------------------------------------------------------- February 21, 2024 Spread: the spread is the addition to the risk premium (risk premium on bonds) Basis Points: 100 BPS = 1% More risky then higher required rate of return Nag add ka ng mas malaki sa risk-free rate which is 1% since mas mataas yung risk mo. 75 BPS =.75% 50 BPS = - Less risky since maliit lang yung risk.50% then maliit lang yung required rate of  return mo - Smallest Spread only.50% add sa risk free rate Auction Markets possess the following characteristics: 1. In an auction market, buyers and sellers confront each other directly and bargain over price 2. Can transact technically to each other (seller and buyer) 3. The New York Stock Exchange is a well-known example of an auction market (in the Philippines it is PSE) 4. The auctioneer in an auction market is a specialist, who is designated by the exchange to represent orders placed by public customers Auction Market VS Dealer Market An auction market trades directly between a buyer and a seller. A dealer market uses a middleman or “market maker,” who buys and sells securities to create liquidity in the market. The market makers are typically referred to as brokers and profit from the bid-ask spread (Bid at a lower bid price and ask at a higher ask price). Dealer - a market specialist who facilitates exchanges by buying and selling securities from their own holdings Dealer Market - trade stocks and bonds (specifically bonds) that are not actively traded and can guarantee an order because they have an inventory of securities. - For example, You want to buy stock X kaso lang nagbebenta lang daw si stock X yung transaction lang is every end of the month (buy and sell). - If you are going to face a stock in a very low volume might as well go to the dealer market. (not actively traded ang stocks) - In the dealer market “through broker” The dealer will buy it if you sell it and The dealer will sell if you buy it Broker Market possesses the following characteristics: 1. Brokers bring buyers and sellers together to earn a fee called a commission. 2. Brokers’ extensive contacts provide them with a pool of price information that individual investors could not economically duplicate themselves.  3. Investors have an incentive to hire a broker because what they charge as a commission is less than the cost of direct search 4. Brokers cannot guarantee an order Working Capital Management Working Capital Management Management of the daily activities of the business What are the items that move on a day-to-day basis? It is the current accounts or items that fluctuate on a day-to-day basis such as - Cash and Marketable Securities - Accounts Receivable - Inventory - Accounts Payable The inventory when buying or purchasing goes up when selling inventory goes down and AR goes up Gross Working Capital = Current Asset Net Working Capital = Current Asset - Current Liabilities Working capital is the management of short-term cash inflows and outflows. What is the goal of managing working capital? - Manage the firm’s short-term cash inflows and cash outflows. - Maintain normal business operations with the smallest possible net investment in working capital - Liquidity means there is no loss of value when the assets are converted into cash. Operating Cycle - The period between the purchase of inventory to its eventual realization (collection of cash) Cash Conversion Cycle - The period between payment for inventory purchase to the eventual collection of cash Used to know how much money to invest in the working capital of the company The longer the operating cycle and cash conversion cycle are the more cash should be invested in the working capital Working Capital Policy Moderate Working Capital Policy Match the maturity of financing with that of the assets it finances (hedging approach The maturity of the asset should be the maturity of the fund Why? If ever na mag bibili ka ng 20 days na inventory it should be funded by a loan that is good for 20 days Conservative Working Capital Policy Putting liquidity first by having to incur more costs (more current assets, less current liabilities) “VALUE LIQUIDITY” That is why we are incurring costs since long term funding is more expensive Maintain more current assets than current liability What is the danger in this set up? Since you have a lot of current assets you are incurring opportunity costs even tho you are so liquid If current liabilities are low it is save however current liabilities are cheaper than the long term counterparts that is why the company will end up on having more long-term liabilities (more expensive) In summary, you are incurring less RISK but incurring more COST Aggressive working Capital Policy Putting profitability first by taking more risks (less current assets, more current liabilities) “HIGHER LEVEL OF SHORT TERM FUNDS” Taking more risk Current Asset low to be able to fund other projects thus less liquidity. More current liabilities since less costly CASH MANAGEMENT Motives for Holding Cash 1. Transaction Motive- A readily available cash for satisfying the day-to-day transactions such as purchases of supply 2. Precautionary Motive - Emergency Funding Example when a machine suddenly breaks down there is available cash to fix it. 3. Speculative Motive - Taking advantage of future opportunities Float Management Speeding up the collection and slowing down disbursements to make way for investment purposes. - It is beneficial to the company to have faster cash collection and slower cash disbursements (this would be more advantageous) Sample Case: HAI Corp's payment to HAI Corp's collection from suppliers customers Mail time 3 Days 2 Days Processing time 1 Day 1 Day Clearing time 1 Day 1 Day HAI Corp's daily payments average P1 000; daily collections average P1 500 Collection Float Mailing 2 days Processing 1 day Clearing 1 day Total Delay 4 days Daily Collection x 1,500 Collection Float P 6,000 Disbursement Float Mailing 3 days Processing 1 day Clearing 1 day Total Delay 5 days Daily Collection x 1,000 Disbursement Float P 5,000 Disbursement Float P 5,000 Collection Float P 6,000 Net Float (1000) For company, it would be favorable to: 1. Decrease the collection float - Faster collections of payment 2. Increase the Disbursement float - Slowing down disbursements ARV Insurance uses a lockbox to speed up collections. ARV also makes its disbursements from remote disbursement centers so checks written by ARV take longer to clear the bank. Collection time went down by two days and disbursement time went up by one day because of these changes. Excess funds are being invested in securities earning 12% per annum. AV has daily collections of P5 million and daily disbursements of P3 million. In total, it costs P760,000 to operate these systems. Daily Collection 5,000,000 Collection days x2 Collection Float 10,000,000 - Decrease collection float by 10,000,000 Daily Disbursement 3,000,000 Increase Disbursement days x1 Disbursement Float 3,000,000 - Increased disbursement float by 3,000,000 Overall the Cash Freed up: 13,000,000 - This is now available for investments Cash Freed up 13,000,000 Interest Rate x 13% Interest Income 1,560,000 Cost (760,000) Net Gain P 800,000 Speed-up collection thru: Lock Box System - the creditor asks its debtors to send their payments directly to a post office box that is emptied regularly by the creditor's bank. The funds are immediately paid into the banking system, without first being processed by the creditor's accounting department. Checks written by customers will sent directly to a Post Office Banks rather than to the company in that way it is the banks who will do the actual processing which will cut collection time and processing time to a shorter period of time therefore speeding-up collection thus decreasing the collection float Delay Disbursement thru: Remote disbursement centers - The company draws the check that is far away from the supplier so that the supplier instead of encashing the check in the bank that would be force to pass thru the clearing system thus slowing down the disbursement that will increase disbursement float What to do with the extra cash? The following investments ay mas better and liquidity than profitability. Hindi man ganon ka profitable at least hindi natutulog yung money. These are also classified as temporary investments of money 1. Invest in marketable Securities 2. Commercial Paper (70 days) 3. U.S. Treasury Bills (90 days) 4. Eurodollars - time deposit in U.S dollars outside the U.S Accounts Receivable Management Accounts Receivable Management Setting the Credit Policy 1. Credit Standard  - To whom shall we allow credit? - What criteria do we put in place to allow customer be granted the credit? - Sino lang ba ang papahiramin or allowed pahiramin ng company 2. Credit Term - terms that indicate when payment is due for sales that are made on credit, possible discounts, and any applicable interest or late payment fees - 2/10 (2% discount within the first 10 days), n/30 (must pay within 30 days) 3. Collection Policy - How collections should be handled - To motivate customers to pay - How the organization would collet the money - an official strategy your business uses to meet and exceed its accounts receivable goals. This written document includes clear and detailed guidelines identifying who to extend credit to, how much, and why. It also includes the protocol for tackling owed debts The Receivable Balance Determined by the amount of credit sales and the period such sales are outstanding AR = Daily Cr Sales x DSO Example E Corp sells on terms 3/5, net 20. Sales for the year total 912,500. All Customers take the discount. AR = Daily Cr Sales x DSO AR = (912,500/365) x 5 AR = 12,500 Day 1 2500 Day 2 2500 Day 3 2500 Day 4 2500 Day 5 2500 12,500 Example: MLA Corporation is considering changing its credit terms from n/20 to n/30. On average, customers pay 10 days late. Because of these changes, sales are expected to go up from P1,277,500 to P1,533,000. Regardless of the terms, 3% of the sales revenue ends up in bad debts. Variable cost ratio is 70%. The relevant interest rate is 10%. Income taxes are at 30%. Use 365 days a year. Note: When changing credit policy we are actually changing the AR Balance as well as the profits of the company Credit Terms n/20 n/30 Daily Credit Sales 1,277,500 / 365 days 1,533,000/ 365 days 3,500 4,200 DSO (10 days late) 10 + 20 = 40 10 + 30 = 40 3,500 x 40 = 4,200 x 40 AR 105,000 168,000 This is the AR Balance before and after the change. Note that there is a difference between the AR Balance and the investment in AR How to arrive at in investment in AR? Just look at the Relevant Cost for each peso of AR balance - a term that describes the changing costs of a particular decision. Businesses use relevant costs to determine if one decision is more cost-effective than another. Credit Terms n/20 n/30 Daily Credit Sales 1,277,500 / 365 days 1,533,000/ 365 days 3,500 4,200 DSO (10 days late) 10 + 20 = 40 10 + 30 = 40 3,500 x 40 = 4,200 x 40 AR 105,000 168,000 Var. Cost Ratio X 70% X 70% Investment in AR 73,500 117,600 The amount in Investment in AR can be used for some other purpose rather than putting them trap in the AR balance we could have use it for 1. Investment securities 2. Or any other investment But because this is not what is happening there is an opportunity cost Credit Terms n/20 n/30 Daily Credit Sales 1,277,500 / 365 days 1,533,000/ 365 days 3,500 4,200 DSO (10 days late) 10 + 20 = 40 10 + 30 = 40 3,500 x 40 4,200 x 40 AR 105,000 168,000 Var. Cost Ratio X 70% X 70% Investment in AR 73,500 117,600 Interest rate X 10% X 10% Cost of Carrying AR 7,350 11,760 Increase in Carrying cost of AR = 7,360 - 11,760 = 4,410 As a result of the changes the cost of carrying AR increased from 7,360 to 11,760 or by 4,410. What the impact of this change (the change of AR policy) in the overall profitability of the company? Increase in sales revenue (1.533 - 1.2775) 255,500 Increase in Variable Cost (178,850) Increase in Contribution Margin 76,650 Increase in discount taken (0) Increase in bad debts (1.533 - 1.2775) x 3% (7,665) Increase in collection cost (0) Increase in carrying cost of AR (4,410) Increase in profit before tax 64,575 Increase in tax (19,372.5) Increase in profit after tax 45,202.50 Bad debts - there will be an additional bad debts expense of 3% of the difference between n/20 and n/30 (before and after the change). Summary: This is how the change in credit policy would impact on profitability. When we talk about AR Management it is about setting a credit policy and monitoring the receivable. Changing any compotents from credit policy and monitoring the receivable would have a bearing in the AR Balance, carrying cost, and overall profitability of the business operation. INVENTORY MANAGEMENT Inventory Management starts with the purchase of raw materials and ends with the sale of finished goods. Important Concerns: Arriving at an inventory level that minimizes total carrying costs and stock-out cost Arriving at an order size that minimizes total carrying costs and ordering cost - Economic Order Quantity Arriving at an inventory level that triggers the need to order - Reorder point model Arriving at an inventory level that minimizes total carrying costs and stock-out cost 1. Inventory level is too high the Carrying cost goes up - Costs like storage, insurance, deposit of obsolescence, spoilage, and opportunity cost 2. Inventory level is too low the stock-out costs go up. - Going out of stock - The customer would not be able to buy the product Arriving at an order size that minimizes total carrying costs and ordering cost - Economic Order Quantity How many unit should we order when we are making an order for inventory? - If we order too much edi taas yung inventory as a result increase carrying costs  - If we order too little edi mababa yung inventory as a result increase in ordering costs (dahil konti mas madami kang beses bibili na inventory edi increase nga in ordering costs). Sample: CHN Corporation projects its sales to be 12,000 units this year. As a result of carrying inventories: insurances, taxes, storage, opportunity cost of funds tied up, as well as losses due to theft and obsolescence amount to P1.60 each unit. Each time CHN makes an order, P6.00 is incurred. (Use 360 days/year). 2 𝑋 12,000 𝑋 6 EOQ = 1.60 EOQ = 300 units This means that everytime we make an order it should be 300 units at a time. Average inventory = 300/2 = 150 units is the average inventory Annual Carrying Cost = 150 units x 1.60 = P 240 #orders per year = 12,000/300 = 40 orders per year Annual ordering cost = 40 x 6 = P240 What does EOQ tells us? 1. We should order 300 units everytime we do so because it would minimize the sum of the annual carrying cost 240 and annual ordering cost 240 which is 420 pesos (the lowest possible total of both cost) 2. The lowest possible cost of 480 ay nangyayari everytime bumibili tayong 300 units every order Arriving at an inventory level that triggers the need to order - Reorder point model Aguila Corporation material X has the following details Annual usage in units 720 tonnes Working days per year 240 davs Normal lead time in days 30 days Maximum lead time in days 45 days The tonnes of material X will be required evenly throughout the year Daily Usage = 720t/ 240 days = 3t per day (daily or avrage usage) NLT - 30 days MLT - 45 days Safety Stock = 3 (45-30) = 45 units - 45 units is good for the 15 days that the supplier will be late in deliverity the inventory - an additional quantity of an item held in the inventory to reduce the risk that the item will be out of stock Re-order point = 3 x 45 days = 135 units - When we reach 135 units this signals the company to re-order or make another order of inventory Working Capital Management 1. Management of Current Assets (Cash, Accounts Receivable, and Inventory) - Left side of the balance sheet Where to put the funds 2. Financing Decision for working capital (Accounts Payable and External Sources of Credit - Right side of the balance sheet where the funds came from Trade Credit - Financing source from trade suppliers - Also known as Accounts Payable - Appears to be free - Implicit cost or interest SAMPLE CASE MCC Corp. is offered by its supplier HMM Inc. trade credit terms of 2/10, n/50. MCC Corp. does not take advantage of the discount and pays the account after 62 days. Using a 365-day- year, what is MCC Corp's approximate annual cost of not taking the discount?.02/.98 x 365/52 = 0.143 or 14.3% 365/52 - annualization adjustment Cost of Financing = 14.3% Bank Loans - Financing Sources from banks - The cost of financing is stated but needs to consider the effective interest rate The interest rate can be misleading due to terms involving 1. Discounts 2. Compensating Balance Note: The true financing cost is not necessarily the same as the stated interest considering that there is a chance that discounting and compensating balance. MCC Corp. wishes to borrow funds amounting to P10.000 from GNB Inc. at an annual interest rate of 10% for one year. For a simple loan, what is the stated rate of interest is the effective interest rate of the loan. For discounted rates take note that the effective rate is always higher than the stated interest rate. the discounted notes or loan means that the interest is already (beginning) and immediately deducted at the time of borrowing the amount of principal is not to be given in full to the borrower. The borrower will simply receive the Principal less the interest. - In substance, the amount that the borrower borrowed is not equal to the principal For compensating balances, this is the amount that the bank requires or restricts the borrower from withdrawing to their account as such the actual the amount that they borrow is the principal amount less the compensating balance. - Just like discounted notes or terms it can increase the effective or true cost of financing without presenting it to the borrower as such. What is the Effective annual rate? YMD Corp. wishes to borrow funds amounting to P10,000 from GNB Inc. at an annual interest rate of 10% If it is a discounted loan due in 3 months and has a compensating balance requirement of P1,000. (.10 𝑥 1000) 𝑥 3/12 EAR = 10,000 −.10 𝑥 1000 𝑥 3/12 − 1,000 𝑥 12/3 EAR= 11.43% What is the Effective annual rate? If it is due in a year and has a compensating balance requirement of P1,000 earning interest income of 3%?.10 𝑥 1000 − 3% 𝑥 1000 EAR = 10,000 −1000 = 10. 78% JFR Inc. issues P5,000,000 of commercial paper with a maturity of 3 months at an effective annual interest rate of 8%. What is the amount of proceeds (borrowed) in this issue? 5,000,000 1.02 = 4, 901, 961 2% = 8% x 2/12 Principal 5,000,000 Proceeds 4,901,961 Interest 98,039 Commercial Paper - short term debt instrument that is only issued by large and stable companies (companies are known here as the borrower) Max: 270 days Who can lend the money: All, open to the PUBLIC Who can borrow: Only the Large and Stable Corporation Advantage: interest rates are low because there is a lesser default risk Which of the following is not an advantage to a corporation that uses the commercial paper market for short-term financing? a. This market provides more funds at lower rates than other methods provide b. The borrower avoids the expense of maintaining a compensating balance with a commercial bank. c. There are no restrictions as to the type of corporation that can enter into this market. d. This market provides a broad distribution for borrowing LINE OF CREDIT - a type of loan that lets you borrow money up to a pre-set limit. You don't need to use the funds for a specific purpose. You may use as little or as much of the funds as you like, up to a specified maximum. You may pay back the money you owe at any time. Revolving Credit Agreement - with a commitment to the fee because of the banks holding the available money (to be borrowed) for the borrower  allow borrowers to have flexible access to funds; however, they are subjected to interest rates that must be paid to the lender. Revolving credit agreements will often include information like the total amount of funds available, a set interest rate, and a payment due date The prime rate refers to the interest rate that large commercial banks charge on loans and products held by their customers with the highest credit rating. - Additional or above prime rating interest is given to a not-so-large and not-so-stable corporation as additional interest. KAN Corporation to arrange a revolving credit agreement amounting to P10,000,000 with a group of small banks. The firm paid an annual commitment fee of ½% of the unused balance of the loan commitment. On the used portion of the loan, KAN paid 1.5% above prime for the funds actually' borrowed on an annual simple interest basis. The prime rate was at 9% for the year. 1. IF KAN Corp. borrowed P10,000,0000 immediately after the agreement was signed and repaid the loan at the end of one year, what was the total peso cost of the loan agreement for one year? 10,000,000 x 10.5% = 1,050,000 2. If KAN Corp. does not borrow at all, what was the total peso cost of the loan agreement for one year? 10,000,000.5% = 50,000 3. If KAN Corp. borrowed P6,000,000 immediately after the agreement is signed and repaid the loan at the end of one year, what was the total peso cost of the loan agreement for one year? 6,000,000 x 10.5% = 630,000 4,000,000 x 0.5% = 20,000 Megatech Inc. is a large publicly held firm. The treasurer is analyzing the short-term financing options available for the third quarter, as the company will need an average of $8 million for July, $12 million for August, and $10 million for September. The following options are available. 1. Issue commercial paper on July 1 in an amount sufficient to net Megatech $12 million at an effective rate of 7% per year. Any temporarily excess funds will be deposited in Megatech's investment account at First City Bank and earn interest at an annual rate of 4%. July August September Interest Expense 12,000,000 x 7% x 12,000,000 x 7% x 12,000,000 x 7% x  1/12 1/12 1/12 = 70,000 = 70,000 = 70,000 Interest Income 4,000,000 x (4% x 0 2,000,000 x 1/12) (4% x 1/12) =13,333 =6,667 Net Financing 56,667 70,000 63,333 Cost Total 190,000 Utilize a line of credit from First City Bank with interest accruing monthly on the amount utilized at the prime rate, which is estimated to be 8% in July and August and 8.5% in September. July August September Interest Expense 8,000,000 x 8% x 12,000,000 x 8% x 10,000,000 x 8.5% x 1/12 1/12 1/12 Net Financing 53,333 80,000 70,833 Cost Total 204,166 Commercial Paper 190,000 Line of Credit 204,166 CP CHEAPER BY 14,166 Based on this information, which one of the following actions should the treasurer take? a. Issue commercial paper, since it is approximately $14,200 less expensive than the line of credit. b. Use the line of credit, since it is approximately $5,800 less expensive than issuing commercial paper. c. Use the line of credit, since it is approximately $15,000 less expensive than issuing commercial paper.  d. Issue commercial paper, since it is approximately $35,000 less expensive than the line of credit. Corporate Restructuring Business Combination 1. Merger - A + B = either A or B 2. Consolidation - A + B = C Cobines with another firm to create a new firm 3. Acquisition Acquisition of Net Asset - Purchase the asset and assume the liabilities Stock Acquisition - The Acquirer will purchase voting stocks by 50% plus 1% Acquisition takes place when a firm buys a controlling interest in another firm called stock acquisition Common reason that business combinations takes place 1. Increase revenue 2. Decrease Costs 3. Expand Market Share Note that the government regulation does not want businesses to combine. Gusto paghiwalayain ang mga businesses to promote divestiture Against business combination Business Combination Unfavorable to the Management - Will be definitely unfavorable to the management - Will contest for business combination Can be favorable or unfavorable to the shareholders Goo