MOS 1023 - All Finance Lecture Notes

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Western University
Management and Organizational Studies
Management and Organizational Studies 1023A/B
Maria Ferraro

Finance Lecture 1: Intro To Finance What is Finance? The science or study of the management of funds. Role of management  Management serves as an arbitrator and moderator between conflicting interest groups or stakeholders and objectives.  Creditors, managers, employees and customers hold contractual claims against the firm’s revenues.  Shareholders have residual claims against the company. Function of a Financial Manager Maximizing Shareholder Wealth The objective of financial management is to maximize shareholder wealth. Six Principles of Finance 1. Time Value of Money  Money in hand today is worth more than the promise of receiving the same amount of money in the future.  Time value of money exists because a sum of money today could be invested and “grow” over time. Computation of Present Value An investment can be viewed in two ways – its future value or its present value. Present Value Future Value The Theory of Interest Assume a bank pays 8% interest on a $100 deposit made today. How much will the $100 be worth in one year? Future Value of $1 Periods 8% 10% 12% 1 1.080 1.100 1.120 2 1.166 1.210 1.254 3 1.260 1.331 1.405 4 1.360 1.464 1.574 5 1.469 1.611 1.762 Present Value – an example If a bond will pay $100 in two years, what is the present value of the $100 if an investor can earn a return of 12% on investments? The Process is called discounting. We have discounted the $100 to its present value of $79.72. The interest rate used to find the present value is called discount rate. To Verify: Lets verify that if we put $79.72 in the bank today at 12% interest that it would grow to $100 at the end of two years. If $79.72 is put in the bank today and earns 12%, it will be worth $100 in two years. 2. Risk-Return Tradeoff  Risk is the uncertainty about the outcome or payoff of an investment in the future.  Rational Investors would choose a riskier investment only if they feel the expected return is high enough to justify the greater risk. 3. Diversification of Investments  All investment risk is not the same  Some risk can be removed or diversified by investing in several different assets or securities. o Firm Specific (unsystematic) o Market (systematic) 4. Efficient Financial Markets  A financial market is “information efficient” if at any point in time the prices of securities reflect all information available to the public  When new information becomes available, prices quickly change to reflect that information  Information efficient markets provide liquidity and fair prices. 5. Management vs. Owner Objectives  Management objectives may differ from owner objectives (called principle- agent problem)  Owners or equity investors want to maximize the returns on their investments.  Managers may seek to emphasize the size of firm sales, assets, or other perks.  Solution: tie manager compensation to performance measures beneficial to owners. 6. Reputation Matters!  Ethical Behavior: o How an individual or organization treats others legally, fairly, and honestly. o High reputation value reflects high quality ethical behavior, so employing high ethical standards is the “right” thing to do. Real Vs. Financial Assets  Real Assets are tangible things owned by persons and businesses o Residential structures and property o Major appliances and automobiles o Office towers, factories, mines o Machinery and equipment  Financial Assets are what one individual has lent to another o Consumer credit o Loans o Mortgages The Functions of Money  Medium of Exchange o How transactions are conducted: something that is generally acceptable in exchange for goods and services. In this function money removes the need for double coincidence of wants by separating sellers from buyers.  Standard of Value o How the value of goods and services are denominated: something that circulates and provides a standardized means of evaluating the relative price of goods and services.  Store of Value o How the value of goods and services are maintained in monetary terms: the ability of money to command purchasing power int eh future. The Financial System Financial Intermediaries  Banks and other deposit-taking institutions  Insurance Companies  Pensions Funds  Mutual Funds Channels of Intermediation Financial Markets Financial Instruments issued by Corporations  Commercial Paper  Bankers acceptance  Corporate Bonds Corporate Bonds  Debentures - unsecured debt. Backed only by the general assets off the issuing corporation.  Secured Debt (Mortgage Debt) – secured by specific assets.  Subordinated Debt – in default, holders get payments only after other debt holders get their full payment.  Senior Debt – in default holders get payment before other debt holders get.  Zero Coupon – pay face value at maturity only, sold at discounts.  Junk Bonds – bonds with below investment grade rating. Bond Features  Retractable  Convertible  Extendable  Callable (Redeemable) Financial Instruments issued by corporation: Common Stocks  The common stockholders are the owners of the corporation’s equity  Do not have a specified maturity date and the firm is not obliged to pay dividends to shareholders.  Returns come from dividends and capital gains. Preferred Stocks  Have face value, predetermined periodical (dividend) payments with priority over common stockholders o Cumulative o Non-Cumulative o Participating o Non-Participating  If dividend payment is NOT paid, preferred stockholders may get voting rights. Derivative Securities  Securities whose value is derived from the value of some underlying asset.  Most important derivatives are options and futures  Stock Options – not a tool of fundraising, it is a method of compensation.  Prices of financial instruments are determined in equilibrium by demand and supply forces.  They reflect market expectations regarding the future as a inferred from currently available information. Finance Lecture 2: Financing and Distributing Bootstrapping  Initial Funding of the Firm o The process by which many entrepreneurs raise “seed” money and obtain other resources necessary to start their businesses. o The initial “seed” money usually comes from the entrepreneur or other founders. Venture Capital  Venture capitalists are individuals or firms that help new businesses get started and provide much of their early-stage financing.  Individual venture capitalists or angel investors are typically wealthy individuals who invest their own money in emerging businesses at the very early stages in small deals.  Three reasons exist as to why tradition sources of funding do not work for new or emerging businesses: 1. The high degree of risk. 2. Types of productive assets. 3. Informational asymmetry problems.  The venture capitalists’ investments give them an equity interest in the company.  Often in the form of preferred stock that is convertible into common stock at the discretion of the venture capitalist. How Venture Capitalists Reduce their Risk:  Venture capitalists know that only a handful of new companies will survive to become successful firms  Tactics to reduce risk: o Funding the ventures in stages o Requiring entrepreneurs to make personal investments o Syndicating investments o and maintaining in-depth knowledge about the industry in which they specialize Syndication  It is a common practice to syndicate seed- and early-stage venture capital investments  Syndications occurs when the origination venture capitalist sells a percentage of a deal to other venture capitalists.  Syndications reduces risk in two ways: 1. It increases the diversification of the originating venture capitalist’s investment portfolio 2. The willingness of other venture capitalists to share in the investment provides independent corroboration that the investment is a reasonable decision. The Exit Strategy  Venture capitalists are not long-term investors in the companies, but usually exit over a period of three to seven years.  Every venture capital agreement includes provisions identifying who has the authority to make critical decisions concerning the exit process.  There are three principle ways in which venture capital firms exit venture- backed companies: o Sell part of the firm’s equity to a strategic buyer in the private market. o Sales to financial buyers. o Initial Public Offering: selling common stock in an initial public offering. Venture Capitalists Provide More Than Financing  The extent of the venture capitalists’ involvement depends on the experience of the management team.  One of their most important roles is to provide advice.  Because of their industry and general knowledge about what it takes for a business to succeed they provide counsel for entrepreneurs when a business is being started and during early stages of operation. Initial Public Offering One way to raise larger sums of cash or to facilitate the exit of a venture capitalist through and IPO of the company’s common stock.  First-time stock issues are given a special name because the marketing and pricing of these issues are distinctly different from those of seasoned offerings. Advantages of Going Public  The amount of the equity capital that can be raised in the public equity markets is typically larger than the amount that can be raised through private sources.  Once and IPO has been completed, additional equity capital can usually be raised through follow-on seasoned public offerings at a low cost.  Going public can enable an entrepreneur to fund a growing business without giving up control.  After the IPO, there is an active secondary market in which stockholders can buy and sell its shares.  Publicly traded firms find it easier to attract top management talent and to better motivate current managers if a firm’s stock is publicly traded. Disadvantages of Going Public  High cost of the IPO itself.  The costs of complying with ongoing SEC disclosure requirements.  The transparency that results from the compliance can be costly for some firms. *Managers may focus on short-term profits rather than long-term wealth maximization. Private Markets  Private vs. Public Markets o Because many smaller firms and firms of lower credit standing have limited access, or no access, to the public markets, the cheapest source of external funding is often the private markets. o When market conditions and unstable, some smaller firms that were previously able to sell securities in the public markets no longer can. o Bootstrapping and venture capital financing are part of the private market as well. o Many private companies are owned by entrepreneurs, families, or family foundations, and are sizeable companies of high credit quality, prefer to sell their securities in the private markets even though they can access public markets. Private Placements  Private placement occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals.  Private lenders are more willing to negotiate changes to a bond contract.  If a firm suffers financial distress, the problems are more likely to be resolved without going to a bankruptcy court.  Other advantages include the speed of private placement deals and flexibility in issue size.  The biggest drawback of private placements involves restrictions on the resale of the securities. Private Equity Firms  Like venture capitalists, private equity firms pool money from wealthy investors, pension funds, insurance companies, and other sources to make investments.  Private equity firms invest in more mature companies, and they often purchase 100 percent of a business.  Private equity firm managers look to increase the value of the firms they acquire by closely monitoring their performance and providing better management.  Once value is increased, they sell the forms for a full profit. Private equity forms generally hold investments for 3 to 5 years. Dividends  The term dividend policy is generally used to refer to a firm’s overall policy regarding distributions of value to stockholders.  A dividend is something of value that is distributed to a firm’s stockholders on a pro-rata.  A dividend can involve the distribution of cash, assets, or something else, such as discounts on the firm’s products that are available only to stockholders.  When a firm distributes value through a dividend it reduces the value of the stockholders’ claims against the firm.  A dividend reduces the stockholders investment in a firm by returning some of the investment to them.  Types of Dividends: o The most common form is the regular cash dividend. o These dividends are generally paid quarterly. o The size of a firm’s regular cash dividend is typically set at a level that management expects the company to be able to maintain in the long run, barring some major change in the fortunes of the company. o Management does not want to have to reduce the dividend. o Management can afford to err on the side of setting the regular dividend too low. o Extra dividends are often paid at the same time as regular cash. The Dividend Payment Process Time Line for a Public Company Stock Repurchases  They do not represent a pro-rata distribution of value to the stockholders, because not all stockholders participate.  When a company repurchases its own shares, is removes them from circulation.  Stock repurchases are taxed differently than dividends.  How Stock is Repurchased: o They can simply purchase shares in the market, o It can repurchase shares using a tender offer, which is an open offer by a company to purchase shares. o Through direct negotiation with a specific stockholder. Stock Dividends and Stock Splits Stock Dividends  One type of “dividend” that does not involve the distribution of value is known as a stock dividend.  When a company pays a stock dividend, it distributes new shares of stock on a pro-rata basis to existing stockholders.  Value of company does not change.  The stockholder is left with exactly the same value as before. Stock Splits  A stock split is quite similar to a stock dividend but it involves the distribution of a larger multiple of the outstanding shares.  We can often think of a stock split as an actual division of each share into more than one share.  One real benefit of stock splits is that they can send a positive signal to investors about the outlook that management has for the future and this, in turn, can lead to a higher stock price.  Management is unlikely to want to split the stock of a company two- for-one or three-for-one if it expects the stock price to decline.  Reverse Stock Splits – opposite of stock split. Practical Considerations in Setting a Dividend Policy  A company’s dividend policy is about how the excess value in a company is distributed to its stockholders.  It is extremely important that managers choose their firm’s dividend policies in a way that enables them to continue to make the investments necessary for the firm to compete in its product markets.  Managers should consider several practical questions when selecting a dividend policy: 1. Over the Long Term, how much does the company’s level of earnings (cash flows from operations) exceed its investment requirements? How certain is this level? 2. Does the firm have enough financial reserves to maintain the dividend payout in periods when earnings are down or investment requirements are up? 3. Does the firm have sufficient financial flexibility to maintain dividends if unforeseen circumstances wipe out its financial reserves when earnings are down? 4. Can the firm quickly raise equity capital if necessary? 5. If the company chooses to finance dividends by selling equity, will the increased number of stockholders have implications for the control of the company? Finance Lecture 3: Derivatives Derivatives  Financial Derivative Securities: derive all or part of their value from another (underlying) security  Why trade these indirect claims? o Expand investment opportunities o Lower cost o Increase leverage Options  Options are created by investors, sold to other investors  Call: Buyer has the right, but not the obligation, to purchase a fixed quantity from the seller at a fixed price up to a certain date.  Put: Buyer has the right, but not the obligation, to sell a fixed quantity to the seller at a fixed price up to a certain date. Option Terminology  Exercise (Strike) Price: the per-share price at which the common stock may be purchased or sold.  Expiration Date: last date at which an option can be exercised. o American o European o Bermudan  Option Premium: the price paid by the option buyer to the writer of the option, whether put or call. How Options Work  Call buyer expects the price of the underlying security to increase.  Call seller expects the price of the underlying security to decrease or stay the same.  Put buyer expects the price of the underlying security to decrease.  Put seller expects the price of the underlying security to increase or stay the same.  Possible courses of action o Options may expire worthless, be exercised, or be sold prior to expiry. Example- Call Options  Writer sells a call option for $1.00 to you to purchase 1000 shares at $10.00  You must expect shares to increase, writer expects shares to decrease  If shares increase to $15.00 you will exercise option – buy shares at $10.00 and sell for $15.00 (you earned $4.00 profit on option contract)  If shares decrease to below $10.00 you will not exercise – seller gets the $1.00 Example – Put Options  Writer sells a put option for $1.00 to you to sell 1000 shares at $10.00  You must expect shares to decrease, writer expects shares to increase  If shares decrease to $5.00 you will exercise option – buy shares at $5.00 and sell for $10.00 (you earned $4.00 profit on an option contract)  If shares rise over $10.00 you will not exercise – seller gets the $1.00 Options Trading  Options Exchanges o Montreal Exchange (ME) o Chicago Board Options Exchange (CBOE)  Standardized exercise dates, exercise prices and quantities o Facilitate offsetting positions through a clearing corporation o Clearing Corporation is guarantor, handles deliveries. Options Characteristics  In-the-money options have a positive cash flow if exercised immediately o Call options: Stock price (S) > Exercise price (E) o Put options: S < E  Out-of-the-money options should NOT be exercised immediately o Call options: S < E o Put options: S > E  If S = E, an option is money Factors Affecting Prices  Stock price  Exercise price  Time to maturity  Stock volatility  Interest rates  Cash dividends Rights and Warrants  Right – to purchase a stated number of common shares at a specified price with a specified time (often a few months) o Issued by the corporation o Are transferrable o Option to purchase shares a price often lower than the market price o Certificates mailed to current shareholders on a pro-rata basis  Warrant – to purchase a stated number or common shares at a specified price with a specified time (often several years) o Often attached to debt or preferred shares as a sweetener o Are detachable Understanding Future Markets  Spot or Cash Market o Price refers to item available for immediate delivery  Forward Market o Price refers to item available for delayed delivery  Futures Market o Sets features (contract size, delivery date, and conditions) for delivery **An obligation to buy or sell a fixed amount of an asset on a specified future date at a price set today  Future Market Characteristics o Centralized marketplace allows investors to trade with each other o Performance is guaranteed by a clearing house  Commodities – agricultural, metals, and energy related  Financials – foreign currencies as well as debt and equity instruments Future Exchanges  Where futures contracts are traded  Voluntary, nonprofit associations, typically unincorporated  Organized marketplaces where established rules govern conduct o Financed by membership dues and fees for services rendered  Members trade for self or for others The Clearing Corporation  A corporation separate from, but associated with, each exchange  Exchange members must be members or pay a member for these services o Buyers and sellers settle with clearing corporations NOT with each other  Helps facilitate an orderly market  Keeps track of obligations The Mechanics of Trading  Through open-outcry, seller and buyer agree to take or make delivery on a future date a price agreed on today o Short position (seller) commits a trader to deliver an item at contract maturity o Long position (buyer) commits a trader to purchase an item at contract maturity  Like options, futures trading is a zero-sum game Futures Margin  Good faith deposit made by both buyer and seller to ensure completion of the contract o NOT an amount borrowed from broker  Each clearing house sets its own requirements o Brokerage houses can require higher margin  Initial margin usually less than 10% of contract value  Margin calls occur when price goes against investor o Must deposit more cash or close account o Position marked-to-market daily o Profit can be withdrawn  Each contract has maintenance or variation margin level below which the investor’s net equity cannot drop Using Future Contracts  Hedgers o At risk with a spot market asset and exposed to unexpected price changes o Buy or sell future to offset the risk o Used as a form of insurance o Willing to forgo some profit in order to reduce risk  Hedges return has smaller chance of low return but also smaller change of high return. Speculating  Speculators o Buy or sell future contracts in an attempt to earn a return o Absorb excess demand or supply generated by hedgers o Assuming the risk of price fluctuations that hedgers wish to avoid o Speculation encouraged by leverage, ease of transacting, low costs Finance Lecture 4: Mergers and Acquisitions & International Finance General Terms  Takeover o The transfer
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