Fina 1001 Lecture9 2024 Corporate Finance PDF

11/4/24 Introduction to Corporate Finance Introduction to Risk & Return McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 1 Key Concepts and Skills...

11/4/24 Introduction to Corporate Finance Introduction to Risk & Return McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 1 Key Concepts and Skills Know how to calculate portfolio rate of return and portfolio risk Understand the impact of diversification Understand the systematic risk principle 13-2 2 1  11/4/24 Portfolios A portfolio is a collection of assets An asset’s risk and return are important in how they affect the risk and return of the portfolio The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets 13-3 3 Example: Portfolio Weights Suppose you have $15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security? – $2000 of DCLK – $3000 of KO DCLK: 2/15 =.133 – $4000 of INTC KO: 3/15 =.2 – $6000 of KEI INTC: 4/15 =.267 KEI: 6/15 =.4 13-4 4 2  11/4/24 Systematic Risk Risk factors that affect a large number of assets Also known as non-diversifiable risk or market risk Includes such things as changes in GDP, inflation, interest rates, etc. 13-5 5 Unsystematic Risk Risk factors that affect a limited number of assets Also known as unique risk and asset-specific risk Includes such things as labor strikes, part shortages, etc. 13-6 6 3  11/4/24 Returns Total Return = expected return + unexpected return Unexpected return = systematic portion + unsystematic portion Therefore, total return can be expressed as follows: Total Return = expected return + systematic portion + unsystematic portion 13-7 7 Diversification Portfolio diversification is the investment in several different asset classes or sectors Diversification is not just holding a lot of assets For example, if you own 50 Internet stocks, you are not diversified However, if you own 50 stocks that span 20 different industries, then you are diversified 13-8 8 4  11/4/24 The Principle of Diversification Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion 13-9 9 Diversifiable Risk The risk that can be eliminated by combining assets into a portfolio Often considered the same as unsystematic, unique or asset-specific risk If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away 13-10 10 5  11/4/24 Total Risk Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk For well-diversified portfolios, unsystematic risk is very small Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk 13-11 11 Portfolio standard deviation 0 5 10 15 Number of Securities ©The McGraw-Hill Companies, Inc., 2000 12 6  11/4/24 Portfolio standard deviation Unique risk Market risk 0 5 10 15 Number of Securities ©The McGraw-Hill Companies, Inc., 2000 13 Portfolio Rate of Return The expected return of a two stock portfolio: Expected Portfolio Return = (x1 r1 ) + (x 2 r2 ) Portfolio rate fraction of portfolio rate of return = x of return in first asset on first asset fraction of portfolio rate of return + x in second asset on second asset 14 7  11/4/24 Expected Portfolio Return Suppose that 60% of your portfolio is invested in Goddard Ltd. and the remainder is invested in BICO. You expect that over the coming year Goddard Ltd will give a return of 3.1% and BICO, 9.5%. The expected return on your portfolio is simply a weighted average of the expected returns on the individual stocks: Expected portfolio return (0.60 x 3.1) + (0.40 x 9.5) = 5.7% 15 Portfolio Expected Returns The expected return of a portfolio is the weighted average of the expected returns of the respective assets in the portfolio m E ( RP ) = å w j E ( R j ) j =1 13-16 16 8  11/4/24 Example: Expected Portfolio Returns Consider the portfolio weights computed previously. If the individual stocks have the following expected returns, what is the expected return for the portfolio? – DCLK: 19.69% – KO: 5.25% – INTC: 16.65% – KEI: 18.24% E(RP) =.133(19.69) +.2(5.25) +.267(16.65) +.4(18.24) = 15.41% 13-17 17 Portfolio Risk/Variance The variance of a two stock portfolio is the sum of these four boxes: Stock 1 Stock 2 x 1x 2σ 12 = Stock 1 x 12σ 12 x 1x 2ρ 12σ 1σ 2 x 1x 2σ 12 = Stock 2 x 22σ 22 x 1x 2ρ 12σ 1σ 2 Portfolio Variance = x 12σ 12 + x 22σ 22 + 2( x 1x 2ρ 12σ 1σ 2 ) 18 9  11/4/24 Portfolio Variance = x12σ 12 + x 22σ 22 + 2(x1x 2ρ 12σ 1σ 2 ) COVARIANCE Variances of stock returns ρ12 = correlation between Stock 1 and Stock 2 σ1 and σ2 = standard Proportions invested in deviation of Stock 1 and Stock 1 and Stock 2 Stock 2 19 Portfolio variance = [(0.6)2 x (15.8)2] +[(0.4)2 x (23.7)2] + 2(0.6 x 0.4 x 1 x 15.8 x 23.7) = 359.5 Standard deviation = (359.5)1/2 = 19% 20 10  11/4/24 Systematic Risk Principle There is a reward for bearing risk There is not a reward for bearing risk unnecessarily The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away 13-21 21 Measuring Systematic Risk How do we measure systematic risk? – We use the beta coefficient What does beta tell us? – A beta of 1 implies the asset has the same systematic risk as the overall market – A beta < 1 implies the asset has less systematic risk than the overall market – A beta > 1 implies the asset has more systematic risk than the overall market 13-22 22 11  11/4/24 Total vs. Systematic Risk Consider the following information: Standard Deviation Beta Security C 20% 1.25 Security K 30% 0.95 Which security has more total risk? Which security has more systematic risk? Which security should have the higher expected return? 13-23 23 Example: Portfolio Betas Consider the previous example with the following four securities Security Weight Beta DCLK.133 2.685 KO.2 0.195 INTC.267 2.161 KEI.4 2.434 What is the portfolio beta?.133(2.685) +.2(.195) +.267(2.161) +.4(2.434) = 1.947 13-24 24 12  11/4/24 Introduction to Corporate Finance The Time Value of Money McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 25 Key Concepts and Skills Be able to compute the future value of an investment made today Be able to compute the present value of cash to be received at some future date 5F-26 26 13  11/4/24 Chapter Outline Future Value and Compounding Present Value and Discounting 5F-27 27 Basic Definitions Time value of money refers to the fact that one dollar in hand today is worth more than a dollar promised at sometime in the future Present Value – earlier money on a time line Future Value – later money on a time line Interest rate – “exchange rate” between earlier money and later money – Discount rate – Cost of capital – Opportunity cost of capital – Required return 5F-28 28 14  11/4/24 Future Values Suppose you invest $1,000 for one year at 5% per year. What is the future value in one year? – Interest = 1,000(.05) = 50 – Value in one year = principal + interest = 1,000 + 50 = 1,050 – Future Value (FV) = 1,000(1 +.05) = 1,050 Suppose you leave the money in for another year. How much will you have two years from now? – FV = 1,000(1.05)(1.05) = 1,000(1.05)2 = 1,102.50 5F-29 29 Future Values: General Formula FV = PV(1 + r)t – FV = future value – PV = present value – r = period interest rate, expressed as a decimal – t = number of periods 5F-30 30 15  11/4/24 Effects of Compounding Simple interest Compound interest Consider the previous example – FV with simple interest = 1,000 + 50 + 50 = 1,100 – FV with compound interest = 1,102.50 – The extra 2.50 comes from the interest of.05(50) = 2.50 earned on the first interest payment 5F-31 31 Future Values – Example 2 Suppose you invest the $1,000 from the previous example for 5 years. How much would you have? – FV = 1,000(1.05)5 = 1,276.28 The effect of compounding is small for a small number of periods, but increases as the number of periods increases. (Simple interest would have a future value of $1,250, for a difference of $26.28.) 5F-32 32 16  11/4/24 Investment Investment in today the future PV FV COMPOUNDING Compounding: The process of reinvesting money and any accumulated interest in an investment for more than one period, thereby reinvesting the interest. This involves calculating the amount an investment will grow to over some period of time at some given interest rate. 33 Present Values How much do I have to invest today to have some amount in the future? FV = PV(1 + r)t Rearrange to solve for PV = FV / (1 + r)t When we talk about discounting, we mean finding the present value of some future amount. When we talk about the “value” of something, we are talking about the present value unless we specifically indicate that we want the future value. 5F-34 34 17  11/4/24 Present Value – One Period Example Suppose you need $10,000 in one year for the down payment on a new car. If you can earn 7% annually, how much do you need to invest today? PV = 10,000 / (1.07)1 = 9,345.79 5F-35 35 Investment Investment in today the future PV FV DISCOUNTING Discounting: The process of calculating the present value of a future cash flow to determine its worth today. 36 18  11/4/24 Introduction to Corporate Finance Capital Budgeting – NPV and Payback decision criteria McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 37 Key Concepts and Skills Be able to compute payback understand their shortcomings Be able to compute the net present value and understand why it is the best decision criterion 9-38 38 19  11/4/24 Chapter Outline Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting 9-39 39 Financial Management Decisions Capital budgeting – What long-term investments or projects should the business take on? Capital structure – How should we pay for our assets? – Should we use debt or equity? Working capital management – How do we manage the day-to-day finances of the firm? 1-40 40 20  11/4/24 Good Decision Criteria We need to ask ourselves the following questions when evaluating capital budgeting decision rules: – Does the decision rule adjust for the time value of money? – Does the decision rule adjust for risk? – Does the decision rule provide information on whether we are creating value for the firm? 9-41 41 Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? – The first step is to estimate the expected future cash flows. – The second step is to estimate the required return for projects of this risk level. – The third step is to find the present value of the cash flows and subtract the initial investment. 9-42 42 21  11/4/24 Project Example Information You are reviewing a new project and have estimated the following cash flows: – Year 0: CF = -165,000 – Year 1: CF = 63,120 CF1 – Year 2: CF = 70,800 CF2 – Year 3: CF = 91,080 CF3 Your required return for assets of this risk level is 12%. 9-43 43 NPV – Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. 9-44 44 22  11/4/24 Computing NPV for the Project Remember: We estimate the NPV by calculating the difference between the present value of the future cash flows and the cost of the investment. NPV = - COST + CF1/(1+R) + CF2/(1+R)2 + CF3/(1+R)3 NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 = 12,627.41 Do we accept or reject the project? 9-45 45 Decision Criteria Test - NPV Does the NPV rule account for the time value of money? Does the NPV rule account for the risk of the cash flows? Does the NPV rule provide an indication about the increase in value? Should we consider the NPV rule for our primary decision rule? 9-46 46 23  11/4/24 Payback Period How long does it take to get the initial cost back in a nominal sense? Computation – Estimate the cash flows – Subtract the future cash flows from the initial cost until the initial investment has been recovered Decision Rule – Accept if the payback period is less than some preset limit 9-47 47 Computing Payback for the Project Assume we will accept the project if it pays back within two years. – Year 1: 165,000 – 63,120 = 101,880 still to recover – Year 2: 101,880 – 70,800 = 31,080 still to recover – Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3 Do we accept or reject the project? 9-48 48 24  11/4/24 Decision Criteria Test - Payback Does the payback rule account for the time value of money? Does the payback rule account for the risk of the cash flows? Does the payback rule provide an indication about the increase in value? Should we consider the payback rule for our primary decision rule? 9-49 49 Advantages and Disadvantages of Payback Advantages Disadvantages – Easy to understand – Ignores the time value – Adjusts for of money uncertainty of later – Requires an arbitrary cash flows cutoff point – Biased toward – Ignores cash flows liquidity beyond the cutoff date – Biased against long- term projects, such as research and development, and new projects 9-50 50 25  11/4/24 End of Chapter 13-51 51 26