Professional Documents
Culture Documents
FINANCE
SALVADOR ROJ FERRARI
srojifer@ccee.ucm.es
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CONTENTS 1. Overview of Corporate Finance 1.1 What is Corporate Finance? 1.2 Forms of Business Organization 1.3 The Agency Problem
2. Financial Statements & Long-Term Financial Planning 2.1 Review of Financial Statements & taxes 2.2 Cash Flow 2.3 Financial Planning Models 2.4 External Financing and Growth
3. Introduction to Valuation: 3.1 Future & Present Value 3.2 Discounted Cash Flow Valuation 3.3 Effective Annual Rate 4. Interest Rates and Bond Valuation 4.1 Bond valuation, Features, types, and markets 4.2 Inflation and Interest Rates 4.3 Determinants of Bond Yields
5. Stock Valuation 5.1 Common Stock Valuation 5.2 Some Features of Common and Preferred Stock 5.3 The Stock Market 6. Net Present Value and other Investment Criteria 6.1 Net Present Value & Profitability Index 6.2 The (Discounted) Payback Rule 6.3 The Internal Rate of Return 7. Making Capital Investment Decisions 7.1 Project Cash Flow (CF): A First Look 7.2 Pro Forma Financial Statements and Project Cash Flows 7.3 Alternative Definitions of Operating CFs 7.4 Special Cases of Discounted CF Analysis 8. Project Analysis and Evaluation 8.1 Evaluating NPV Estimates 8.2 Scenario and Other What-if Analysis 8.3 Break-Even Analysis 8.4 Operating Leverage 9. Some Lessons from Capital Market History 9.1 Returns 9.2 The Variability of Returns 9.3 Capital Market Efficiency
10. Return, Risk, and the Security Market Line 10.1 Expected Returns and Variances 10.2 Announcements, Surprices, & Expected Returns 10.3 Diversification & Portfolio Risk 10.4 Systematic Risk and Beta 10.5 The Security Market Line 11. Cost of Capital 11.1 Cost of Equity 11.2 Cost of Debt & Prefered Stock 11.3 The Weighted Average Cost of Capital 12. Raising Capital 12.1 The Financing Life Cycle 12.2 Underwriters, IPOs & New Equity Sales 12.3 Rights & Dilution 12.4 Debt & Shelf Registration
13. Capital Structure 13.1 Capital Structure & the Cost of Equity Capital 13.2 M&M Propositions 13.3 Optimal Capital Structure 13.4 Other Models
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14. Dividend Policy 14.1 Cash Dividend 14.2 Does Dividend Policy Matter? 14.3 Establishing a Dividend Policy 14.4 Stock Repurchase & Stock Dividends, & Stock Splits 15. Other Topics 15.1 Short-Term Finance 15.2 Cash Management 15.3 Credit & Inventory Management
Ross, Westerfield, Jordan McGraw Hill Corporate Finance Fundamentals, 8th edition Fundamentals of Corporate Finance, 9th edition
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In a few months, I expect to see the stock market much higher than today Irving Fisher
(14 days before Wall Street crashed on Black Tuesday, october 29, 1929)
A severe depression such as 1920-21 is outside the range of probability. We are not facing a protracted liquidation The Harvard Economic Society
Group A. American Motors, Studebaker, Detroit Steel, Maytag and National Sugar Refining.
Group B. Boeing, Campbell Soup, Deere, IBM and Whirlpool.
Only 13.4% of the Fortune 500 companies in 1955 were still on the list 56 years later in 2011.
Comparing the Fortune 500 companies in 1955 and 2011, there are only 67 companies that appear in both lists. In other words, only 13.4% of the Fortune 500 companies in 1955 were still on the list 56 years later in 2011, and almost 87% of the companies have either gone bankrupt, merged, gone private, or still exist but have fallen from the top Fortune 500 companies (ranked by gross revenue). Most of the companies on the list in 1955 are unrecognizable, forgotten companies today. That's a lot of churning and creative destruction, and it's probably safe to say that many of today's Fortune 500 companies will be replaced by new companies in new industries over the next 56 years.
1) What long term investments should the firm take on? What (and where) real assets should the firm invest in?
2) Where will you take the long term financing? How should the cash for the investment be raised?
Corporation (Co)
Some disadvantages of the C corporation: Double taxation: corporate and personal level
an S Co: 100 or less shareholders is taxed as a partnership Limited Liability Company LLC:
a hybrid of partnership and Co.
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1.3. The Agency Problem.The Goal of Financial Management is... Profit maximization? Risk v profit? Short v long term? Accounting profit? Value creation? To maximize the current value per share of the existing stock or to maximize the market value of the existing ownersequity (not traded) Shareholder returns cant give purpose to corporate life in the lengh of time a stock is held GE 3.5 years; Microsoft 3.5 months; Yahoo! 3.5 days! Sarbanes-Oxley or Sarbox Act (2002) (for listed firms) To protect investors from corporate abuses
makes Cos management responsible for the accuracy of the Cos financial statements better internal controls
Some Co delist or go dark higher cost of capital or join the AIM
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possibility of conflict of interest between the stockholder & management The cost of conflict:
Indirect or lost opportunities (risky investments arent favor by agents) Direct: 1) Unneeded expenditures & 2) monitor management actions How closely are management goals aligned with stockholder goals? - Related to the way managers are compensated (Stock options / markets for managers) Can managers be replaced if they do not pursue stockholder goals? - Related to the control of the firm (proxy fights & takeovers)
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Financial statements in the USA generally shows assets at historical cost For current assets, small difference, for fixed, sometimes, huge Some changes in accounting rules affect the book value of assets...but not its market value Many valuable assets (reputation, talent...) dont appear on the BS The equity figure and the true value of the stock need not be related
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Revenue when it accrues (GAAP rules) recognized at the time of sale (not collection)
Expenses are based on the matching principle (match revenues with the costs associated with producing them)
the cash outflow may have occured at some different time the IS figures are not representatives of the actual cash in-out flows
A primary reason the IS contains noncash items, ie, depreciation Firms can vary output level by varying exp(fixed and variable), but accountants classify costs as product (COGS) & period (SG&AE), both fixed & variable The tax code is the result of political, not economic, forces
CF to creditors (bondholders) = interest paid less net new borrowing CF to stockholders = dividends paid less net new equity raised
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Ratio Analysis
Current ratio: current assets / current liabilities (in $ or times) It can be affected by some transactions: L-T borrowing current assets ratio
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The quick or acid test ratio Current assets CA Inventory) / Current liabilities CL
Inventory is the least liquid current asset Book and market values are not always similar Large inventories are a sign of overproduction tied up in slow-moving
Total Debt Ratio = (Total assets (TA) total equity (TE)) / TA Debt equity Ratio = Total debt (TD) / Total equity (sometimes only L-T D / Total equity )
- Market to book Ratio (focus on historical cost) - Tobins Q Ratio = Market value of firms assets / replacement cost The Du Pont Identity 1.- Multiply by TA ROE = NI / TE = NI / TE x TA / TA = NI / TA x TA / TE
ROE = ROA x Equity multiplier (EM) o ROA x (1+D/E ratio) ROA = profit margen x total asset turnover
2.- Multiply by TA & sales
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ROE is affected by
Operating efficiency, measured by profit margin Asset efficiency, measured by total asset turnover Financial leverage, measured by equity multiplier
Financial statement information is used for . Perfomance evaluation benchmark:Time trend & peer group analysis . Planning for the future (projections) . S-T & L-T analysis by creditors & potencial investors . The firm to evaluate suppliers and these to evaluate us to extend credit . The custormer to evaluate if the firm will be around in the future . Credit-rating agencies to evaluate creditworthiness . Competitors .M&A
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a worse case cost cutting, divestiture, liquidation a normal case a best case new products & expansion (detail the financing needed)
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(to see the interactions between sales growth & financial policy)
IS BS Sales $1000 Assets $500 Debt $250 Costs 800 Equity 250 ------------------------------------------------------------ NI 200 Total A 500 Total 500 Assuming all items grow at the same rate as sales by 20% Then, NI = $240; TA & TL+Equity = $600 We must reconcile these two pro formas.... If NI = $240, and Equity 50 190 goes as
Cash dividends (plug) or... Retained earnings 250 + 240 = 490 debt must be retired to keep 29 TA=$600debt must be 600-490= 110 250-110= $ 140 retired (plug)
the maximun growth rate achieved without any external financing The sustainable growth rate: the maximun growth rate achieved without external equity financing & keeping D/E constant ROE * b / (1-ROE*b) If total equity is taken from an ending balance If from the beginning, the g= ROE * b, if the average, another formula
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3. Introduction to valuation
Pure discount loan (T-bills) Interest-only loans (T-bonds) Amortized loans: (see chapter 6) The borrower repays parts of the loan amount over time
- pay the interest each period + some fixed amount (principal) - make a fixed payment each period the interest decline every period the most common way of amortizing loans & mortages 1) find out the payment C by using the annuity present value
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4. Interest rates & Bond Valuation. 4.1 Bonds and Bond Valuation
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Creditor or lender v, Debtor or borrower Debt: Promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance (Interest is payable semiannually) Hybrid securities:
bond + option
preferred= perpetual bond that pays only if money is earned tax benefit of bonds + bankrupcy benefits of stock
S-T: < 18 months; notes < 5 / 10 years; L-T Debt > 5 / 10 (Bonds)
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Some debt is subordinated In the event of default, they are paid off only after the specified creditors have been compensated senior / junior 4. Repayment At maturity or before through a sinking fund (early redemption) The Co makes annual payments to the trustee who retire a portion of the debt after a specified period of time (10 or more years) Two ways: buying in the market calling in a fraction of the outstanding bond
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5. Call provision
Allows the Co to repurchase or call part or all of the bond issue at stated prices over a specific period
The stated call price is above the par value call premium (becames smaller over time). For some period deferred call provision (protected) Make-whole call bondholders receive what the bond is worth: Yield to maturity of a T-bond + premium
6. Protective covenants Part of the indenture to limit actions a Co might wish to take
limitations to dividends limits pledging any assets to other lenders Limits M&A Limits sales or leases of any asset maintain WC & collateral furnish periodically audited financial statements
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6. Bond ratings
Other bonds:
Catastrophe or cat bonds Warrants: The buyer receives the right to purchase stock at a fixed price
Bond Markets Most are traded OTC through networks of dealers No transparency privately negociated, but improving: corporate bond dealers are now required to report trade info through TRACE Small liquidity Bid-ask spread the price a dealer is willing to pay & take Quoted in 32nds 1/32 or tick. If quoted 136:29 136 29/32136.906% face value or $1,369.06 If changed(previous day):+ 5 5/32 of 1%or 0.15625% face value The convention is to quote prices net of accrued interest (clean price) but the price actually paid includes it (dirty or invoice price) you pay more than the quoted price Inflation nominal v real rates
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It tells us what nominal IR are on default-free, pure discount bonds (single lump sum) of all maturities or the time value of money
Basic components:
1) Real rate or compensation for forgoing the use of money 2) the inflation premium or compensation for expected inflation 3) The IR-risk premium due to the potencial risk of loss resulting from changes in IR (IRP at a decreasing rate) The three interact producing upward / downward sloping
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The Yield curve or plot of the yields on T-notes & bonds relative to maturity (based on coupon bond yields)
(the TSIR are based on pure discount bonds) Components real rate + IR & inflation premiums The non-Treasury bonds represent the combined effect of 3 components (real rate, inflation, IR risk) and 3 premiums for 3 extra features:
default taxability liquidity
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5.1 Common Stock Valuation the Gordon model The required return= dividend yield + capital gains yieldk= D/P + g 5.2 Features of Common & Preferred Stock Shareholders elect directors who hire managers who hire workers. Shareholder rights Cumulative voting. The directors are elected all at once
If there are N directors for election, then 1/(N+1)% of the stock + one share garantees a seat. It permits minority participation
Some states have mandatory cummulative voting Its impact is minimized by staggered elections Straight voting. The directors are elected one at a time. The shareholder may cast all votes for each member of the board
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Classes of stock
Dual or multiple classes for control: A, B
Rights: to vote for directors, mergers, etc., dividends, liquidation, preemptive right (to maintain proportion in any new stock sold)
The board can defer dividends indefinitely (common also forgo) not debt
they have many debt features: sinking funds, credit ratings, convertible, callable Some firms issue securities that look like preferred but treated as debt for taxes
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It pays the bid price and sells the ask price spread
Broker:
brings buyers & sellers together
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Organization of the NYSE or the Big Board . merged with Euronext (Amsterdam, Brussels, Paris, Lisbon, LIFFE) & Arca (Archipelago Xch) . The largest in the world: It has 1,366 members who own trading licenses . Its 200 years old & It became a publicly owned corporation in 2006, The NYSE Co. is listed in the NYSE 1) Commission brokers (members of brokerage houses) . Execute customer orders & find the best price for the orders 2) Specialists (or market makers) . are dealers in charge of a small set of securities . maintain a fair market (inventoryliquidity) for their securities . buy/sell when there are quantity disparities 3) Floor brokers help commission brokers to execute orders . Less important because of the electronic order system SuperDOT
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Sometimes well over a billion shares change hands in a day The process of order flow NASDAQ
Is a computer network Has a multiple market maker system rather than a specialist system It is almost an OTC market Made up of the
Global Select Market (1200) for larger and more actively traded Global Market (1450) for large firms Capital Market (550) for small firms
ECN
A website that allows investors to trade directly with each other Orders are transmitted to the NASDAQ: dealers & individual investors enter orders increase liquidity & competition
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It becomes easier when we can compare the market price with roughly comparable investments
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Flaws: multiples rates of return Mutually exclusive investments (NPV profile) Investing or financing?
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2. Add them to the initial cost 3. Calculate de IRR CFs= -60, 155, -100 two IRRs: 25% & 33.3% If RR= 20% then, -60 100/1,2^2 = -129.44 -129.44 + 155/(1+r) = 0 r= 284.49/129.44 = 19.74%
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Some pitfalls:
The CFs of a new project that come at the expense of a firms existing project
( A positive spillover effect: An in consumables due to a reduction in prices)
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Net Working Capital NWC: The firm supplies it at the beguinning & recovers it toward the end Current Assets Current Liabilities
Financing costs
Other issues. We are interested in CFs that actually occurs, not accrued After-tax We start a project evaluation with a Pro Forma or projected financial statements Afterwords, we use the techniques described in chapter 9
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Machinery cost: 80,000, 5 year-live straight-line depreciation, market value= 20,000, savings: 22,000 / year, tax =34%, discount rate= 10%
The operating income increases by 22,000, and a depreciation of 80,000 / 5 = 16,000 / year EBIT= 22,000 16,000 = 6,000 Operating CF: EBIT taxes + depreciation = 6,000 2040 + 16,000 = 19,960 capital spending (year 0) = - 80,000 (year 5) = 20000 *(1-0,34)= + 13,200 CFs= -80,000 19,969 19,969 19,969 19,969 9,969 33160
NPV= 3,860
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A firm must choose between two machines. The CFs are (real costs) are:
Machine A costs 500 and 120 / year to operate. Replaced every 2 years Machine B: costs 600 and 100 / year to operate. Replaced every 3 years
WE must evaluate them with similar lives The discount rate= 10%VA(A): 798, VA(B): 917 is A better? Equivalent Annual Cost (EAC) or annuity We work out a cost per year for these two alternatives: What annual amount has the same PV of costs? PV= EAC * present value interest value factor or [1-(1/(1+R)^t)] / R we get EAC PV annuity= VA (A)=798= annual payment x1.7355 798/1.7355 = annual payment = 459.81 PV annuity= VA (B)=917= annual payment x (annuity factor (3 years): 2.4869) 917/2.4869 = annual payment = 368.73 We should purchase B because is cheaper
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- Worst / best cases will tell us the min / max NPV of the project by assigning the most / least favorable value to each item Sensitivity one variable takes many values: To freeze all the variables except one to pinpoint which ones deserve the most attention
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Simulation
Studies the relationship between the most important variable, sales, and profitability
Methods: 1) accounting net income is zero 2) cash operating CF is zero 3) financial NPV is zero 4) general EBIT is zero
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9. Some Lessons from Capital Market History about risk & return
$ returns: dividend income + capital gains % returns: dividend yield D1/ Po + capital gains yield= (P1-Po)/ Po Risk premiums RP: The excess return from an investment in a risky asset over a risk-free investment, or T-Bill What determines the relative sizes of the RPs for the different assets...?
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$1 invested in the USA in 1926 + investing dividends & interests it would have accumulated in year 2000 (before taxes): $6,402 (nominal) y $ 659.6 (real) 2,586 266.5 64 6.6 49 5 16,6 1.7
BUT, if you could each month know in advance which of the two options,T-bills or S&P 500 Index between 1926 y 1996, offer a higher return, and act accordingly, then, the final nominal return before taxes would be.....
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1) We draw a frequency distribution for the returns= to count up the # of times the annual return on the portfolio falls within a each range, lets say, 10% each
2) Measure the spread of returns how volatile the return is Variance how much the actual return deviates from the average in a typical year (standard deviation SD is the square root of the variance) Lesson 1: Risky assets, on average, earn a RP Lesson 2: Bearing risk, on average, is rewarded
Buy a stock for $100, after a year, it falls to $50, next year rises back to $100 Average return on investment? Arithmetic average return: (-50% + 100%) /2 = 25% ? Geometric average return: [(1+R1)*(1+R2).....(1+Rt)]^(1/t) -1= (50%*200%) -1= 0 It is compounded over a multiyear period, It is smaller than the arithmetic Geometric: what you actually earned per year on average compounded annually Arithmetic: what you earned in a typical year
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Returns are at least roughly normally distributed described by the average and the standard deviation (sd) Ie, if historically, the sd of returns on the large-company stocks is 20%, and the average return is 12.3%, then: For one sd: The probability that the return in a given year is in the range of -7.7 to 32.2% (12.3 +/- 20%) is 68%, or roughly, you should be outside this range in one year out of every three For two sd: There is a 5% chance that you should be outside the range -27.7 to 52.3% (12.3 +/- 2*20%) The historical average stock RP over a 106-year period is 7.1%. Nowdays is much smaller.... There is a stability of long-run real equity returns the compound annual geometric real return on US stocks averaged 6.8% (1802-2007)
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Coefficient of Variation:
For ex ante probabilidades, ie, variance * Prob For ex post, historical / (n-1) In financial analysis, we face two sources of risk:
1) the risk associated with uncertain outcomes 2) the additional risk that results from using an incorrect pd
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In an efficient capital market, current market prices fully reflect available information. Three possibilities:
Overreaction & correction Delayed reaction Efficient market reaction
Well-organized capital markets are efficient very small & uncommon Inefficiencies Other markets are less efficient real estate / real asset markets Due to competition among investors, the market becomes increasingly efficient
The investors study expectations about the firm (debt, clients, managers) + the environment (industry, macro, international)
They are zero NPV investments No arbitrage opportunities In the Long run intrinsic value = market value
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Efficiency = a fair price it reflects the value of that stock given the information available Forms of market efficiency Strong form.
All information, private and public, is reflected in stock prices
Weak form
The price reflects the stocks own past prices
Select between the returns a or b: - a) 10 m. euros - b) 10 m euros expected according to the following conditions: Economic state boom stagnant recession probability 1/3 1/3 1/3 return 20 m 10 m 0m
20*1/3 + 10*1/3 + 0*1/3 = 10 m which of the two options would you pick up?
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St. Petersburg Paradox / Nicolas y Daniel Bernoulli Consider the following game of chance: you pay a fixed fee to enter and then a fair coin is tossed repeatedly until a tail appears, ending the game. The pot starts at 1$ and is doubled every time a head appears. In short, you win 2k1 dollars if the coin is tossed k times until the first tail appears.
Consider what would be the average payout: With probability 1/2, you win 1 dollar;
with probability 1/4 you win 2 dollars; with probability 1/8 you win 4 dollars etc. The expected value is thus
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- The expected rate of return on a portfolio is simply a weighted average of the expected returns of the individual securities in the portfolio - However the sd of a portfolio is not a weighted average of the sd of the individual securities, and each stocks contribution to the portfolio sd is not x - Portfolio risk is measured by the weighted sum of all covariances between all the assets in the portfolio - To do so, a variance & covariance matrix is developed
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we present data on realized rates of return for stocks W & M for a portfolio invested 50% in each Year Stock W stock M portfolio WM --------------------------------------------------------------------------1 10% 2% 6% 2 2 10 6 3 9 3 6 4 3 9 6 --------------------------------------------------------------------return 6% 6% 6% sd 4,08% 4,08% 0% Given the same return....the risk has been eliminated The returns have a correlation coefficient of -1 If the returns were similar, the coefficient woulb be +1 The actual average correlation is between +0,5 and 0,7
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State of Economy Probability Return A Return B Return C --------------------------------------------------------------------------------------Boom 40% 10% 15% 20% Bust 60% 8% 4% 0%
Weights: A= 50%, B&C= 25% Boom/ E(R) = .5*10% + .25*15% + .25*20% = 13.75% bust/E(R) = 5% E(Rp)= 8,5% (p)= .4*(.1375-.085) + .6*(.05-.085) = 0,0018375 (p) = 5,4%
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16% M
100% A risks
Efficient frontier
100% B
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risk-return trade-offs
Portfolio risk
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Lets look at why there is a difference between the actual return on an asset or portfolio and the expected return
The return on a stock in the coming year is composed of:
Expected return. It depends on the information shareholders have that bears on the stock
Unexpected return. Based on the uncertainty & unexpected information actual return= expected + unexpected return (+ or -, on average= zero) actual return= expected An announcement = expected part + surprise The relevant inf is already reflected or discounted in the expected return markets are reasonably efficient in the semistrong form News represent the surprise part of an announcement, not discounted by the market
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Inditex increased in earnings= 19% whereas H&Ms just 14%, Inditex stock fell 4% why?
The unanticipated part of the return is the true risk. Two types:
systematic or market risk: influences a large number of assets unsystematic or specific risk: affects a small number of assets
Total return R = E(R) + (unexpected return= market m + specific )
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As the number of securities is increased, the portfolios standard deviation declines (from an average 49% to about 20%)
Some of the stocks will go up in value because of positive companyspecific events and some will go down because of negative events The net effect on the overall value is small cancel each other out
As the unsystematic risk is eliminated by diversification, the market will compensate investors,
not for bearing the total risk of a stock, but for bearing the nondiversifiable risk or portfolio risk
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To determine the optimal portfolio for a particular investor, we must know the investors attitude toward risk as reflected in his risk/return trade-off function or indifference curve
Risk
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A requires a higher expected return to compensate for a given amount of risk A higher risk aversion causes A to require a higher risk premium
The optimal portfolio for each investor is found at the tangency point between the efficient set of portfolios and one of the investors indifference curves. This tangency point marks the highest level of satisfaction the investor can attain
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utility
Portfolio risk
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If we assume that the return distribution of individual stocks follows a normal distribution, then, the portfolio risk could be derived based on the portfolio covariances we build a covariance matrix whose diagonal is made out of the portfolios variances. To estimate all the parameters = N*(N+3) /2 or 8000 for the 125 stocks in the IGBM. To calculate the weights of each stock requires a procedure cuadratic programming to maximize the return, given a specific risk, or minimize the risk, given a specific return 84
10.4 Systematic risk and beta There is a reward for bearing risk called risk premium It is based on the systematic or market risk The expected return on an asset depends only on that assets systematic risk It is measured by Beta or coefficient (how much systematic risk relative to an average asset) The average asset has a beta of 1 Coca cola = 0.52; Yahoo! = 2.30; 3M = .64; Google = 2.60 Security A SD= 40%, beta= 0.50 Security B SD= 20%, beta= 1.50 Which has greater total risk? Systematic? Unsystematic? Higher risk premium? The beta of the portfolio? A weight= 40%0.4*0.5+0.6*1.5= 1.1
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The higher slope, A, will attract investors away from the lower B As price would rise As expected return would decline, and vice versa The buying and selling would continue until the two assets plotted on the same line same reward per unit of risk
Bp
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The Capital Asset Pricing Model CAPM If we let E(Ri) and i stand for the expected return and beta on any asset, then, we know that asset must plot on the SML... Also, a market portfolio made up of all the assets with systematic risk or Bm= 1 slope = E(Rm) -Rf / 1 or market risk primium Therefore (E(Ri) Rf) / Bi = E(Rm) Rf, rearrange this...
E(Rm)
Bm = 1
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Any new investment must offer an expected return that is no worse than what the financial markets offer for the same risk
It must have a + NPV What is the appropiate discount rate?
The expected return offered in financial markets on investments with the same systematic risk We compare expected return on investment to what the financial markets offer on an investment with the same beta This return is the minimum an investment must offer to be attractive It is called the cost of capital associated with the investment It is an opportunity cost
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The return an investor receives is the cost of that security to the company that issued it
Required rate of return = appropiate discount rate = cost of capital
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Is the return the firms creditors demand & firm must pay on new borrowing
If the firm already has bonds outstanding, then the yield to maturity is the market-required rate on the firms debt If we know the rating, we can find the IR on newly issued bonds,
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The interest paid by a corporation is deductible for tax purposes we could add (P/V)Rp or cost of preferred stock...and flotation costs... Do not use WACC as a cutoff for investments sometimes different projects / divisions have different betas.
Flotation costs.
If we assume the firm uses a target capital structure, we have to - factor in the flotation costs for each of the amounts of D & E raised - the NPV is compared with this amount to see if the project is feasible
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A basic reason shareholder returns cant give purpose to corporate life is the length of time a stock is held... GE= 3.5 years Microsoft= 3.5 months Yahoo!= 3.5 days Can such customer serve as the proper focus for the corporate strategy?
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12.1 The Financing Life Cycle: Early-Stage Financing & Venture Capital VC The term Private Equity labels equity financing for nonpublic firms VC firms specialize in pooling funds from various sources provide financing in stages contingent on specified goals being met: - ground floor or seed money (step 1: to get a prototype) - mezzanine-level (step 2: manufacturing, marketing, distribution)
They participate in running the start-up firm due to their general business expertise:
- financial strength & resources - involved in operations & decision making, - good referrences & contacts with suppliers, customers, etc., - specialization, Exit strategy is key, also VC is very expensive
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Registration statement about financial information and file it with the SEC except
loans that mature within 9 months less than $ 5 million (regulation A, with less requirements) A private issue (fewer than 35 investors)
Preliminary Prospectus (red herring) given to potential investors The Registration is effective on the 20th day after its filing That day a price is determined & selling effort gets under way, along with a final prospectus Tombstone ads are used by underwriters (investment banks) during & after the waiting period
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- formulating the method used to issue the securities - pricing the new securities - selling
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Types of Underwriting
Firm Commitment. The issuer sells the entire issue to the underwriters, who then attempt to resell it. The most common.
Best Efforts. Beyond this, the underwriter does not guarantee any particular amount. Uncommon. Dutch (or Uniform Price) Auction Underwriting. The underwriter conducts an auction in which investors bid for shares. Very common in bond markets The Aftermarket: the period after a new issue is initially sold Green Shoe Options. Gives the underwriters the rights to buy additional shares at the offering price to cover overallotments (15% of the new shares) Lockup Agreements: How long insiders must wait after an IPO before they can sell their stock, usually, 180 days. The Quiet Period. The SEC requires a quiet period (40 days) = all communications are limited to ordinary announcements (no extra infor) logic: all relevant information is contained in the prospectus
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New Equity Sales Abnormal returns. On announcement of a seasoned issues, the existing stock drops on average 3% Why? 1. Managerial information: to issue stock when overvalued 2. Debt usage: it may reveal too much debt or too little liquidity 3. Bad signal: if the project is good. why should the firm let new shareholders in on it?.... better issue debt 4. Issue cost
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Gross spread. Direct fees paid to the underwriter or spread (7% average) between the price the issuer receives and the offer price
Other direct expenses. Filing & legal fees, taxes Indirect expenses. Management time Abnormal returns. Existing stock drops on average 3% Underpricing. IPOs lower price Green Shoe Options. Gives the underwriters the rights to buy additional shares at the offering price to cover overallotments There are economies of scale & Debt issues are less expensive
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12.3 Rights If a preemptive right is in the corporation the firm must offer any new issue to existing shareholders Each shareholder is issued rights to by a specified number of new shares at a specified price & time
The rights are traded in securities exchanges or OTC. Rare in the USA
Cheaper than cash offers No underwriter needed If the stock is sold before the ex-rights date the rights on-, the new owner will receive the rights It goes ex-rights two trading days before the record date or last day
Shareholders can exercise their rights or sell them: he will not lose or win because of the rights offering
The new market price of the stock will be lower than before the offeringit is like a stock split & the subscription price is arbitrary 101
Dilution
Loss in existing shareholdersvalue in terms of dilution of: Ownership. Avoided by using a Rights Offering Market value MV & book value BV
If MV< BV and # shares EPS go down
Three dilutions: Accounting, market, ownership Market dilution ONLY occurs if the projects NPV is negative (and MV>AV)
12.4 Debt Issuing Public L-T Debt. Similar procedures: Direct Private L-T Debt Financing (term loans & private placements) - dont require SEC registration - more restrictive covenants - life insurance companies & pension funds dominate the segment
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Direct Private L-T Debt Financing. Two types: Term loans. Direct business loans: 1-5 years Private placements. The maturity is longer Shelf Registration (for Equity & Debt)
A relaxed registration process that applies to well-known,
seasoned issuers The firm can fulfill all registration-related procedures beforehand and go to market quickly when conditions become favorable. Allows a Co to register all issues it expects to sell within two years It uses a dribs & drabs or step by step method Rated investment grade & MV > $150 m
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Under leverage, shareholders are more exposed to risk because ROE & EPS are more sensitive to changes in EBIT
Because of those factors, is capital structure a key consideration? It depends on homemade leverage: the use of personal borrowing or lending to change the overall amount of leverage so, the answer is NOT....see page 514 & table 16.5 104
If Kd < ke it does NOT mean it is always 1 mill; Ke= 12%, Kd= 8% Investment Equity 100% EBIT 150,000 Interest 0 Net Income 150,000 ROE 15% ROI 15%
attractive va
50% 150,000 40,000 110,000 22% = 15 + (15-8) 15%
ROE = ROI + (ROI-Kd) D/E If the net income is different & % D changes ROE is also different: (try D=75%36%) If EBIT= 0 & 100% Equity ROE= 0; 50% Equity; ROE -8% If EBIT= 200,000 & 100% Equity ROE=20%; 50% Equity 32% (see financial leverage, next slide) You can observe a greater variability with ROE than with ROI (no leverage) Debt Explicit cost in terms of a larger Kd (not under MM)
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Two settings EBIT: 12,000 & 36,000 Degree of financial leverage or DFL?
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If the assets and operations are the same: 40% E 60% D or 60% E 40% D
The size of the pie (the value of the firm) doesnt depend on how it is sliced M&M Proposition II
Re
Ra Rd D/E
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Proposition II: Ra is the required return on the firms assets & it depends on the operating activities. Its risk is the business risk (Ra-Rd) *D/E is determined by the financial structure. Its risk is the financial risk debt financing the risks borne by the stockholders the required rate of return rises
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Ebit: $ 4 mill (no-growth situation), T: 40%, the firm pays out all its income as dividends, Kd= 8%, constant; Ku= 12%
Vu= ebit (1-T) / ku = 4 mill / 0,12 = $20 mill With $10m debt Vl = Vu + Tc *D= 24m Equity E = V D = 14m kl= ku + (ku-kd) * (D/E) * (1-Tc) kl= 12% + (12% - 8%)*10m/14m*0.6= 13,71%
Bankruptcy & Financial Distress Costs In principle, a firm becomes bankrupt when the value of its assets equals the value of its debt
13.3 Optimal Capital Structure CS The static trade off theory of capital structure no changes
Firms borrow up to the point where the tax benefit from an extra $ = the cost in terms of probability of financial distress But...firms with losses, or with other tax shield sources, ie, depreciation, get none or little shield Also, firms with greater volatility in EBIT or intangible assets get debt at Re higher cost V
Vl= Vu+Tc*D Financial distress cost of capital Ru WACC Rd
Vu
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What is irrelevant, M&M or the capital structure? 13.4 Other models (besides MM, trade-off) (1) The Extended Pie Model Taxes & bankruptcy costs represent claims on the CFs
The total value = marketed + nonmarketed claims (unaltered by capital structure) The value of the marketed claims may be affected by changes in the structure in marketed claims implies an identical - in the nonmarketed
Many CFOs select: First, a specific credit rating. Second, the structure that better fits that rate
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(2) The Pecking-Order Theory Firms prefer to use internal financing first
If the stock is undervalued (a new project) dont sell it too cheaply
Wide variation across industries: drugs & computers v. airlines & cable TV
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Should the firm pay out money to its shareholders, or should the firm invest it for its shareholders?
It is a payment made out of a firms earnings to its owners It can be regular, extra, special, & liquidating Expressed in terms of 1) $, 2) % of market price, 3) % of net income A chronology:
Declaration date: the board of directors passes a resolution Ex-dividend date: two business days before the date of record Date of record: date of recorded shareholders (designated to receive it) Date of payment
If you buy the stock two days before date of record, then youll get the Dividend When the stock goes ex-dividend, then, we expect the value of the stock 117 will go down by about (because of taxes) the dividend amount
Taxes (see article # 1). Since 2002, 5%, (from january 1st, 2011, 39.6%)
Capital gains are deferred until the stock is sold Flotation costs (equity & debt)
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3) Factors favoring a high payout The desire for current income through the homemade dividend argument
if low payout, sell stock, but there are brokeage fees and transaction costs
Investors with substancial current consumption needs will prefer high current dividends
Based on expectations.
An signals to the market that the firm is expected to do well (not because of a payout policy) & vice versa The clientele effect Different investors desire different levels of dividends
14.3 Establishing a dividend policy The residual dividend approach: After meeting its investment needs while maintaining a desired D/E ratio it can become an unstable`policy A compromise dividend stability: Avoid cutting +NPV projects, dividend cuts, sell equity Maintain a target D/E & dividend payout ratios To avoid instability, create two types of dividends: regular & extra....
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3 ways: open market, tender offer (existing stockholders), targeted purchase (specific stockholders)
It is an alternative to cash dividends both are essentially the same thing. But if there are taxes & other imperfections... If dividends paid: stock price & PE fall, EPS doesnt change If repurchase: EPS goes up, PE is similar to dividends Net equity sales in the US have been negative in some years Under current tax law, a repurchase has a significant tax advantage:
A dividend is fully taxed as ordinary income
In a repurchase, the investor pays taxes only if sells & on the capital gain on the sale, whereas a dividend pays as ordinary income
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The stock split is expressed as a ratio: three for two one extra for two
The accounting treatment is different:
a stock split affects the par value & # shares outstanding A stock dividend affects # shares outstanding & retain earnings for small dividends (less than 25%), it affects capital in excess of par value In theory, stock dividends & splits should leave the value of the firm unaffected liquidity? Trading range (to buy a round lot)? For every share of Microsoft in 1986 you would own 288 shares today Reverse splits: one for four four old shares for one new respectability? Some exchanges delist companies under $1 price share
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Calculating the operating & cash cycles already studied in accounting? Cash flow time line
Some firms have negative cash cycles.(Amazon, 50 days, Boeing, 77 )....
Inventory purchased
Inventory sold
Inventory period
Accounts payable period
Cash cycle
Cash received
Operating cycle
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The longer the cash cycle, the more financing is required The gap between S-T inflows & outflows can be filled either by borrowing or by holding a liquidity reserve (marketable securities) The S-T financial policy that a firm adopts will be reflected in at least two ways: A flexible policy would maintain:
a high ratio of current assets to sales less S-T debt and more L-T debt a higher level of liquidity / NWC It is costly, but future CFs are expected to be higher ie, liberal financing
Managing current assets Involves a trade-off between costs that increases or decreases with current assets
carrying opportunity- costs shortage costs
cashout, stockout, lost customer goodwill brokerage costs
$
Carrying costs
Shortage costs
Current assets
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The firm borrows in the short term to cover peak financing needs, but maintains a cash reserve during slow periods....
Marketable securities
Flexible policy $
seasonal variation
time
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The Cash Budget A forecast of cash receipts and disbursements for the next planning period (see exercise) Short-term borrowing
Unsecured loans
A line of credit. The firm is authorized to borrow up to a specific amount A revolver. Similar for lower periods Committed lines of credit are more formal legal arrangements
Compensating balances. Money kept by the fitrm with a bank in low-interest bearing accounts as part of a loan agreement (2-5% of the amount borrowed
Letters of credit. The bank issuing the letter promises to make a loan if certain conditions are met (the international goods arrive as promised)
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Secured loans
Accounts receivable financing involves
Assigment: the lender has the receivables as security, but the borrower is still responsable Factoring. The receivable is discounted and sold to the lender Credit card receivable funding: A portion of each credit card sale is routed to the factor until the loan is paid off Inventory loans (to purchase inventory) Commercial paper. Issued by large, highly rated firms. Backed by a special line of credit Trade credit. To increase the account payable period. Expensive
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A cash balance must be maintained to provide the liquidity necessary for transaction needs: paying bills
Holding cash + marketable securities (cash equivalents) has an opportunity cost Cash managementoptimizing mechanisms for collecting and disbursing cash
Float: The difference between book cash and bank cash, representing the net effect of checks in the process of clearing
Two types: A firms payment generate a disbursement float, and its collection activities generate collection float The net effect or the sum of both is the net float
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Credit
Offering credit is a way of stimulating sales, but there are costs:
Carrying the receivables (trade & consumer) & not been paid
Components: terms of sale, credit analysis, collecting policy
The optimal amount of credit is determined by the point the CFs form sales are equal to the costs of carrying the in investment in accounts receivables Firms with excess capacity, low variable operating costs, repeat customers extend credit more liberally
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Inventory Management
Economic Order Quantity Model EOQM To determine what order size the firm should use when it restocks Assume that the inventory is sold off at a steady rate until it hits zero & restock back to some optimal level Total carrying costs= average inventory * carrying costs / unit (Q/2) * CC Total restocking costs= fixed costs per order * n orders F * (T/Q), T= total unit sales
Q Average inventory time
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The cost-mnimizing quantity occurs where carrying & restocking costs are the same or the two lines cross (Q/2) * CC = F * (T/Q), Solving for Q*= [(2T * F) / CC] But, the firm orders in advance of anticipated needs and keeps a safety stock of inventory
Delivery time Costs of holding inventory Carrying costs
Reorder point
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Derived-Demand Inventories
The ability to schedule backwards from finished goods to work-inprocess to raw materials inventories