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ADMS 3530 - Finance Textbook Notes.docx

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Administrative Studies
ADMS 3530
Kwok Ho

ADMS 3530 Finance Notes Ch 1- Goals and Governance of the Firm Investment and Financing Decisions -the financial manager is to make good investment and financing decisions Investment or Capital Budgeting Decision Def’n- decision about which real assets the firm should acquire -the financial manager identifies projects and decides how much to invest in each project -some investments are in tangible assets, while some are intangible (trademark, patents) Financing Decision Def’n- how to raise the money to pay for investments When deciding how to raise money, a company can: 1) invite investors to put up cash in exchange for a share of future profits -investors thus receive stock shares, becoming shareholders and known as equity investors 2) promise to pay back the investors’ cash along with a fixed rate of interest -investors are lenders, aka debt investors Capital structure- the choice between debt and equity financing -the financial manager has to identify risks and make sure they’re managed properly *Fig 1.1 for how money flows from investors to the firm and back to investors -the financial manager is b/n the firm and investors because they help manage the firm’s operations in making good investment decisions, as well as deal with investors Real assets- assets used to produce goods and services -tangible and intangible Financial assets- claims to the income generated by real assets; aka securities Eg. Share of stock, bank loans What is a Corporation? Public companies- corp whose shares are listed for trading on a stock exchange -they have a lot of flexibility; can sell shares to any investor -thus they’re required to provide detailed financial info Private companies- corp whose shares are privately owned -shares can’t be freely traded, and don’t raise money in the stock market Corporation- business owned by shareholders who aren’t liable for the business’s liabilities Limited liability- owners of the corp aren’t responsible for its obligations -to incorporate a firm, it can be done under the Canadian Business Corp Act (fed) or under prov laws -all corps have a board of directors that’s selected by shareholders -they oversee the activities of the corporation -shareholders can sell out to new investors without affecting the corp’s business -shareholders of private corporations can also sell, but the process takes up more time -public corps must pay stock exchanges for listing their shares, and abide by the rules of stock exchanges, accounting standards, securities laws -they have to engage in proper auditing, abide by guidelines for ensuring board independence -disadv of corps in taxing; corps have to pay tax on their profits, and shareholders are taxed again when they receive dividends from the company -income generated by businesses that aren’t incorporated are taxed just once as personal income Adv of corporationslimited liability, ease with ownership and management -financial flexibility of publicly traded shares Disadvdouble taxation Other Forms of Business Organizations Sole Proprietorship Def’n- sole owner of a business; personally liable for all the firm’s obligations Adv; easy to establish, lack of regulations to govern it Partnership Def’n- business owned by 2+ people who are responsible for all its liabilities -partners then pay personal income tax on their share of the profits -partners also have unlimited liability, like sole proprietorship Hybrid Forms of Business Organization -some bus forms don’t fit into one specific category, so they are a combo of others -limited liability partnerships (LLP) or limited liability companies (LLC) -professional corporation (PC) commonly used by doctors, lawyers -business has limited liability and taxed as a corp, but professionals can be sued personally -income trust; which is an investment fund aka mutual fund trust -they sell units to investors to raise money to purchase shares and debt of operating businesses Who is the Financial Manager? -financial manager is anybody responsible for a significant corporate investment or financing decision Treasurer- manager responsible for financing, cash management, relationships with financial markets, raising new capital, most directly responsible for looking after the firm’s cash -likely to be the only financial exec for small firms -focus is on obtaining and managing the firm’s capital Controller- responsible for budgeting, auditing, preparing financial statements, accounting -ensures money is used efficiently Chief Financial Officer (CFO)- oversees the treasurer and controller, sets overall financial strategy -those 3 are usually responsible for organizing and supervising capital budgeting process -since projects likely include other business areas, managers from those departments also engage -ultimate decisions often rest by law or by custom with the board of directors Goals of the Corporation Shareholders want Managers to Maximize Market Value -maximize the current value of their interest -increased wealth can either be saved or spent Do Managers really Maximize Firm Value? -in most large public companies the managers aren’t the owners and they might be tempted to act in ways that aren't in the best interests of the owners Agency problems- conflict of interest between the firm’s owners and managers -can sometimes lead to outrageous behaviour; charging large amounts towards a company Stakeholders- anybody with a financial interest in the firm There are diff arrangements to help ensure shareholders and managers work toward a common goal: Compensation Plansincentive schemes that provide big returns if shareholders gain but are valueless if they don’t -if employee compensation plans aren’t properly designed, they can create incentives for straying behaviour by management -some criticize exec stock options for being too favourable for managers, distorting mgmt’s incentives -backdating is when the date on the options isn’t the actual date of the option grant, but a date in the past when the stock price was lower Board of DirectorsSarbanes-Oxley Act requires corps place more independent directors on the board; more directors who aren’t managers not affiliated with management -they meet in sessions without the CEO present -if shareholders believe that the corp is underperforming, they can try to replace the board -shareholders convince others to vote for their candidates to the board Takeoverstaken over by another firm Specialist Monitoringmanagers’ actions are monitored by security analysts who advice investors to buy, hold, sell the company’s shares Legal and Regulatory Requirementslegal duty to act responsibly and in the interests of investors -sets accounting and reporting standards for public companies -Ontario securities Commission prohibits insider trading Ch 5- Time Value of Money Future Values and Compound Interest Future value- amount to which an investment will grow after earning interest Compound interest- interest earned on interest Simple interest- interest earned only on the original investment Future Value of $I interest = I x (1 + r) ^t To do it on a calculator: With a 6% interest rate and 10yr investment, Enter [1.06], press [y ], press [10], and [=], press [10], and [=] Future value interest factor- future value of a current cash flow of $1 FVIF(r, t) = (1 + r) ^t Future value of an investment: FV = I x (1 + r) ^t Eg. If you invest $1 for 20 years at 10% without withdrawing anything: $1 x [1.10] = $6.73 Eg. If you invested $50, then it would be $50 x [1.10] = $336.375 Eg. If a bank is paying 1% per month on deposits, and you invest $500 for 20 months, then the FV is 20 FV = $500 x (1.01) = $610.10 -compound growth means the value increase each period by the factor -the value after t periods will equal the initial value multiplied by (1 + growth rate)^t Present Values Def’n- the value today of a future cash flow PV = Future Value after t periods / (1 + r) t Discount rate- interest rate used to compute present values of future cash flows -present values are always calculated using compound interest -present values decline when future cash payments are delayed -the longer you wait for money, the less it is worth today Discount factor- present value of a $1 future payment -measures the present value of $1 to be received in t years from today at a discount rate of r% PV = I x [ 1 / (1+r) ] Level Cash Flows: Perpetuities and Annuities Annuity- equally spaced stream of cash flows Perpetuity- stream of cash payments that never ends; it lasts forever How to Value Perpetuities Cash payment from perpetuity = Interest Rate x Present Value PV of Perpetuity = C / r = Cash payment / interest rate -perpetuity formula tells us the value of a regular stream of payments starting one period from now -sometimes we might need to calculate the value of a perpetuity that doesn’t start to make payments for a few years -to find today’s value, we would need to multiply it by the three year discount factor; Eg. If the first payment is 4 years from now How to Value Annuities -two ways; first is to value each cash flow separately and add up the present values -quick way is in Fig 5.9 Value of an annuity that pays C dollars a year for each of t years: PV of t-annuity = C x [ (1/r) – [1 / r [(1+r) ] ] *last square bracket is the PV of a t-year annuity of $1 a year PV of t-annuity = payment x annuity factor = C x PVA (r, t) Annuity factor- present value of a $1 annuity -amortizing loan means that part of a monthly payment is used to pay interest on the loan -and another part is used to reduce the amount of the loan Annuities Due -the perpetuity and annuity formulas assume that the first payment occurs at the end of the period Def’n- level stream of cash flows starting immediately -the PV of an annuity due of t payments of $1 per period is the same as $1 + PV of a normal annuity giving the remaining t-1 payments PV annuity due = 1 + PV ordinary annuity of t-1 payments = 1 + [ (1/r) – 1 / [r(1+r)^t-1] ] Future Value of an Annuity -setting aside a certain amount at the end of every year and determining the FV based on I.R PV = (amount setting aside) x #yr annuity factor t FV of an annuity = [ (1+r) – 1 ] / r -ordinary annuity formulas assume first cash flow doesn’t occur until the end of the first period -if the first cash flow comes immediately, the FV cash flow stream is greater, since each flow has an extra year to earn interest FV of annuity due = FV of ordinary annuity x (1+r) Cash Flows Growing at a Constant Rate – Variations on Perpetuities and Annuities PV of a perpetual stream of payments growing at a constant rate = C / (r-g) 1 C1= payment to occur at the end of the first period r = discount rate g = growth rate of payments Growing perpetuity- infinite stream of cash flows growing at a constant rate PV of a finite stream of payments growing at a constant rate = [ C / (r-g1 ] x [ 1 – [(1+g)/(1+r)] ] t C1= payment to occur at the end of the first period r = discount rate t = number of payments g = growth rate of payments Growing annuity- finite stream of cash flows growing at a constant rate -can also calc the FV of a stream of cash flows that grow at a constant rate for a limited or finite period -the same way as calculating the FV of an annuity FV of a finite steam of payments growing at a constant rate = [ C / (r-g) ] x [ (1+r) – (1+g) ] t 1 Inflation and the Time Value of Money Real vs Nominal Cash Flows Inflation- rate at which prices as a whole are increasing -the general level of prices are tracked using diff price indexes; the CPI -it measures the number of dollars that it takes to buy a specified basket of goods and services Real value of $1- purchasing-power-adjusted value of a dollar -some expenditures are fixed in nominal terms, and therefore decline in real terms Eg. Buying a mortgage in 2005 with a monthly payment of $800 -even though CPI increased in 2009, the payment was still $800 -paying for the mortgage in 2009 was less than it did before Inflation and Interest Rates Nominal interest rate- rate at which money invested grows; market rate Real interest rate- rate at which the purchasing power of an investment increases 1 + real interest rate = (1+nominal i.r) / (1+inflation rate) Real Interest Rate ≈ nominal i.r – inflation rate Valuing Real Cash Payments -current dollar cash flows must be discounted by the nominal interest rate -real cash flows must be discounted by the real interest rate Real or Nominal? -in some cases, real cash flows are easier to deal with -if the cash flow stream is fixed in nominal terms, it is easiest to use all nominal quantites Effective Annual Interest Rates Eg. Paying interest on unpaid balances of a credit card at the rate of 1% per month 12 -borrowing $100, therefore repaying $100 x (1.01) = $112.68 Effective Annual Interest rate (EAR)- interest rate that is annualized using compound interest -the interest rate of 1% a month is equivalent to an EAR of 12.68% 1 + effective annual rate = (1+monthly rate) 12 -when comparing interest rates it is best to use effective annual rates -it compares interest paid and allows for possible compounding during the period Annual percentage rates (APRs)- interest rate annualized using simple interest Eg. The interest rate was 1% per month; since there are 12 months, then APR on the loan is 12% 1 + effective annual rate = [ 1 + (APR/m) ] -if you invest at the effective annual rate,t he payoff in one year will be same as investing at the per period rate compounded for the number of periods in the year Per-period interest rate = APR / m = (1+effective annual rate) 1/m– 1 -earning int using the above method will be the same as earning the effective annual rate paid annually -to convert the monthly rate to its APR, multiply by the number of compounding periods in the year -generally, if the frequency of payment is mentioned, the rate is likely an APR Eg. If the bank is charging 10% interest payable semi-annually, it is an APR 2 -interest of 5% is charged every 6 months and EAR is then (1.05) -1 = 0.1025, or 10.25% Ch 6- Valuing Bonds Bonds and the Bond Market Bond- security that obligates the issuer to make specified payments to the bondholder -corps borrow money by selling bonds to investors -the money when bonds are issued is the amount of the debt -they promise to make a series of interest payments, and to repay the debt at maturity date Coupon- the interest payment paid to the bondholder Face value- payment at bond maturity aka par value; maturity value -many bonds make a fixed coupon payment, but some have a flexible coupon payment Bond Market Data Coupon rate- annual interest payment as a percentage of face value Eg. If an asked price is 103.9 of $1000, it means that the price is 103.9% of the $1000 face value -therefore each bond costs $1039 If an investor wants to sell their bond, they would receive the bid price of 103.86, meaning $1038.60 -when you pay a bond, you pay more than the ask price if you don’t buy it on a coupon payment date -the only days that one actually pays the quoted price are the beginning and end date Accrued Int = Coupon Payment x ( #days from last coupon to settlement date / #days in coupon period ) -bond prices are usually quoted without accrued interest Accrued interest- interest earned from the last coupon payment to the purchase date of the bond Clean bond price- bond price excluding accrued interest Dirty bond price- bond price including accrued interest Interest Rates and Bond Prices -bond prices are usually expressed as a percentage of their face value PV (Bond) = PV (Coupons) + PV (Face Value) = (Coupon x Annuity Factor) + (Face Value x Discount Factor) How Bond Prices Vary With Interest Rates -as interest rates change, so do bond prices -when the discount rate is same as the coupon, the bond sells for its face value since they’re the same -when market int rates rises, the PV of payments received by the bondholder falls, and bond prices fall -there is a difference between the interest (coupon) payment and the interest rate -the coupon rate measures the coupon payment as a percentage of the bond’s face value Current Yield and Yield to Maturity -for bonds priced at face value, the rate of return is the coupon rate Current yield- annual coupon payment divided by current bond price Premium bond- bond that sells for more than its face value -investors who buy a bond at a premium face a capital loss Discount bond- bond that sells for less than its face value Yield to maturity- interest rate for which the PV of the bond’s payments equals the price -helps answer at what interest rate would the bond be correctly priced -the yield to maturity is a measure of a bond’s total return -is the discount rate that equates the bond’s current price to the PV of all its promised future cash flows -measures the ror that you will earn if you buy the bond today and hold it to maturity -if an investor buys the bond today and holds it to maturity, the return will be the yield to maturity -calculating yield to maturity is trial and error Bond Rates of Return Rate of return- total income per period per dollar invested Rate of Return = (Coupon Income + Price Change)/ Investment -the connection between yield to maturity and the rate of return; if the bond’s yield to maturity remains unchanged during an investment period, its ror will be that yield Taxes and Rates of Return -taxes reduce the rate of return on an investment Eg. A 5.5% annual coupon bond for $1024.69, to sell it a year later for $1067.95 -the before-tax ror would be 9.59% ($55 + ($1067.95-$1024.69)) / $1024.69 -interest income is taxable, and 50% of capital gains are taxable -personal tax rate is 35% Tax on coupon income= personal tax rate x coupon income = 0.35 x $55 = $19.25 Coupon income after tax = coupon income – tax on coupon income = $55 - $19.25 = $35.75 Tax on capital gain = personal tax rate x 0.5 x capital gain = 0.35 x 0.5 x ($1067.95-$1024.69) = $7.57 Capital gain after tax = capital gain – tax on capital gain = ($1067.95-%1024.69) - $7.57 = $35.69 After-tax Rate of Return = (After-tax Coupon Income + After-tax Capital Gain) / Investment Multi-period Rates of Return Eg. Buying 5.5% coupon bond for $1024.69 and selling it in 2years for $1015.50 -receiving cash flows at two different times; $55 coupon payment after a year, and another $55 coupon plus cash from selling the bond after two years -we need to calculate the future value of the first coupon payment at the end of the second year -when the first coupon payment is received, it is invested at 4% for one year -the coupon payment will be worth ($55 x 1.04) = $57.20 -at the end of the two years, the total value of coupon income received will be $57.20+$55 = $112.20 -the price change on the bond will be $1015.50-$1024.69 = -$9.19 Rate of return = Coupon Income + Price Change / Investment = $112.20 -$9.19 / $1024.69 = 0.1005, or 10.05% -it is a two year rate of return -to convert it back to one-year equivalent: 1/2 (1.1005) – 1 = 4.9%  thus 4.9% would be the annual rate of return The Yield Curve -the longer the maturity, the slightly higher the yield (is usually the case) Term structure of interest rates (yield curve)- r/n b/n time to maturity and yield to maturity -for bonds that differ only in their maturity dates; have the same coupon rate and risk 2 main characteristics of interest rates; -yields on bonds that differ only in their maturities are not the same -the general level of interest rate changes over time Nominal and Real Rates of Interest -a real rate of interest can be nailed down by buying a real return bond (RRB) Real return bond- bond with variable nominal coupon payments -determined by a fixed real coupon payment and the inflation rate -real cash flows are fixed but nominal cash flows are increased as CPI increases *Pg 199 for example* -real interest rates depend on the supply of savings and the demand for new investment -as the supply-demand balance changes, real interest rates change, but gradually Fisher effect- nominal int rate is determined by the real interest rate and the expected rate of inflation 1+Nominal Interest Rate = (1+Real I.R) x (1+Expected Inflation Rate) Approximation of it: Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate Determinants of The Yield Curve -real interest rate and the expected rate of inflation -the yield curve is generally upward-sloping Expectations Theory -a factor determining the shape of the eyelid curve is expected future interest rates -upward-sloping yield curve tells you that investors expect ST interest rates to rise -a downward-sloping yield curve means investors expect ST rates to fall Interest Rate Risk and the Liquidity Premium -expectations theory doesn’t consider risk Interest rate risk- risk in bond prices due to fluctuations in interest rates -all bonds aren’t equally affected by changing interest rates -a 30yr bond is more sensitive to interest rate fluctuations than a 3yr bond -if two bonds have the same maturity but unequal coupons, the bond with the lower coupon will have the greater interest rate risk -if investors don’t like price fluctuations, they invest their funds in ST bonds unless they receive a higher yield to maturity on LT bonds Corporate Bonds and the Risk of Default -distinction between bonds issued by corps and the Gov of Canada is that national govs don’t go bankrupts, since they can print more money or raise taxes -if they borrowed foreign currency and encounter a financial crisis, they may not be able to repay the debt; this is called sovereign debt -investors worry that in some future crisis the gov may not be able to come up with enough of the foreign currency to repay it -corps have less control over their cash flow than fed govs do -so the payments promised to corp bondholders rep that the firm will never pay more than the promised cash flows, but in hard times they may pay less Default risk- risk that a bond issuer will default on its bonds -difference between yield on a corp bond and a Canada bond is called the default premium Default premium- additional yield on a bond that investors need for bearing credit risk -the greater the chance the company will get into trouble, the higher it will be Investment-grade bond- bond that is rated Baa or above by Moody’s (good) Junk/Speculative-grade bond- bond with a rating below Baa (bad) Variations in Corporate Bonds Zero-Coupon bonds- investors receive $1000 face value at the maturity date but do not receive a regular coupon payment Strip bonds- instead of getting a regular income of a small amt, you’d get a final repayment of a lrg amt -are single payment bonds; also zero coupon bonds -if you hold them to maturity, the yield to maturity will be the ror on your investment Floating Rate bonds- coupon payments tied to some measure of current market rates Convertible bonds- can choose later to exchange it for a specified number of shares of common stock Callable bonds- the option to buy them back early for the call price Ch 14- Intro to Corporate Financing and Governance Corporate Debt -company’s payments of interest are regarded as a cost and are therefore deduced from taxable income -interest is paid out of before-tax income, where dividends on common and preferred stocks are paid out of after-tax income Debt comes in Many Forms Interest rate- coupon is fixed at the time of issue Prime rate- benchmark interest rate charged by banks -is for large customers with excellent credit -when the prime rate changes, the interest on your floating rate loan also changes Maturity- Funded debt- debt with more than one year remaining to maturity -debt that is due in less than a year is unfunded; aka ST debt Repayment provisions-Sinking fund- fund established to retire debt before maturity -firm puts aside a sum of cash that is used to buy back the bonds -when there is a sinking fund, investors are prepared to lend at a lower interest rate Callable bonds- bond that may be repurchased by the firm before maturity at a specified call price -gives the company the option to retire the bonds early -if interest rates decline and bond prices rise, the issuer may repay the bonds at the specified call price and borrow the money back at a lower rate of interest Refunding- replacing an old bond issue with a new one by the firm -done when interest rates decline and the firm can save on the interest cost of the new issue -some bonds give the investor the right to demand early repayment Seniority- Subordinated debt- debt that may be repaid in bankruptcy only after senior debt is paid -subordinated lender is paid only after all senior creditors are satisfied -when you lend money to a firm, you may assume you hold a senior claim unless the debt agreement says something else Security- Secured debt- debt that has first claim on specified collateral in the event of default Default Risk- seniority and security don’t guarantee payment’ depends on the value and the risk of the firm’s assets Country and Currency-Eurodollars- dollars held in a bank outside the US Eurobonds- bond denominated in the currency of one country but issued to investors in another Eg. A Cdn co could issue bonds denominated in CAD to investors in other countries Foreign bonds- bond issued in the currency of its country but the borrower is from another country Eg. LT debt issues in different currencies including USD, Swiss francs, euros Public vs Private Placements- Private Placement- sale of securities to a limited number of investors without a public offering Protective Covenants- when investors lend to a company, they expect the co to use the money well Protective covenant- restriction on a firm to protect bondholders A debt by any other name- accounts payable; short term debt Lease- LT rental agreement Innovation in the Debt Market Indexed bonds Asset-backed Bonds- borrower sets aside a group of assets and the income from the assets are then used to service the debt (David Bowie cd album example) -house and commercial mortgages, credit card loans, personal lines of credit, receivables -investors in asset backed securities include money market mutual funds, pension funds, corps, govs Reverse Floaters-are floating rate bonds that pay a higher rate of interest when other interest rates fall, and a lower rate when other rates rise -are riskier than normal bonds Convertible Securities Warrant- right to buy shares from a company at a stipulated price before a set date Convertible bond- bond that the holder may exchange for a specified amount of another security -gives its owner the option to exchange the bond for a predetermined number of common shares -company’s share price will go up so the bond can be converted at a big profit -if the shares go down, there will be no obligation to convert -a convertible bond sells at a higher price than a comparable bond that isn’t convertible Ch 7- Valuing Stocks Stocks and Stock Markets Common stock- ownership shares in a corporation -large firms sell or issue shares of stock to the public when they need money -they benefit if the company prospers, and suffer losses if it doesn’t Primary market- market for the sale of new securities issued by corporations Initial public offerings (IPO)- first offering of stock to the general public Seasoned equity offering (SEO)- sale of additional stock by a public company Secondary market- markets for second-hand stocks -it is common for large businesses with global corps to list their shares for trading on stock exchanges in different countries -stocks listed on more than one stock exchange are called interlisted stocks Reading Stock Market Listings Price-earnings multiple- ratio of stock price to earnings per share Dividend yield- stock’s cash dividend divided by its current price -how much divided income you receive for every $100 invested in the stock Preferred stock- stock that takes priority over common stock in regards to dividends -they typically have fixed dividends that must be paid before the common shareholders receive any dividends Market Values, Book Values, and Liquidation Values Book value- net worth of the firm according to the balance sheet Liquidation value- proceeds that would be realized by selling the firm’s assets and paying off creditors -going concern value is the difference between a co’s actual value and its book/liquidation value It refers to three main factors: Extra earning powera co may have the ability to earn more than an adequate rate of return on assets Intangible assetsaccounting rules don’t permit firms to put all assets on the balance sheet Value of future investmentsif investors believe a company will make profitable investments in the future, they will pay more for the company’s stock today -stocks virtually never sell at book values; investors buy shares on the basis of present and future earning power Two main features determine the profits the firm will be able to produce: -earnings generated by the firm’s current intangible/tangible assets -opportunities the firm has to invest that can increase future earnings Market-value balance sheet- balance sheet that uses the market value 2 classes of assets: Assets already in place; opportunities to invest in attractive future ventures -book value of a firm depends on the accounting rules the firm uses -liquidation value is what the company could net by selling its assets, and repaying its debts -market value is the amount that investors are willing to pay for the shares of the firm Valuing Common Stocks Valuation by Comparables -are used since book values are unreliable estimates of market value -price to earnings and price to book ratios are the most popular for judging the value of a common stock, but financial analysts sometimes look at other measures Eg. Infant firms may require the need to compare price to sales, not price to earnings Price and Intrinsic Value -instead of receiving coupon payments, investors may receive dividends; instead of receiving face value, they will receive the stock price at the time they sell their shares Intrinsic value- present value of the cash flows anticipated by the investor in the stock Intrinsic Value (V )0= (DIV + 1 ) /1(1+r) P 1s the predicted stock price in one year DIV 1s the expected dividend per share over the year r is the discount rate Expected Rate of Return = expected dividend yield + expected capital gain = (DIV 1P )0+ [ (P 1 –/0P ] 0 After-Tax Rate of Return = [ (DIV – di1idend tax)/ P ] + [ (0apital gain-capital gains tax)/ P ] 0 -when the stock is priced correctly (price = present value), the expected ror should also be the rate of return that investors require to hold the stock As r is the expected rate of return on all securities at a given level of risk, intrinsic value will be: P 0 (DIV + 1 ) /11+r Dividend Discount Model Def’n- model stating that today’s stock price equals the present value of all expected future dividends P 0 present value of (DIV , DI1 , …,2DIV ,…) t -for a one period investor, the formula would be P = (DIV +P )/ 1+r 0 1 1 -for a two period investor, the formula would be 2 P 0 [ (DIV +1 )/11+r ]+ [ (DIV +P 2 / (2+r) General formula would be: 2 H P 0 [ (DIV +1 )/11+r ]+ [ (DIV +P 2 / (2+r) ]+…+ [ (DIV +P ) / H1+rH ] Where H is the horizon date -the value of a stock is the present value of the dividends it will pay over the investor’s horizon plus the present value of the expected stock price at the end of that horizon Stock Price = PV (all future dividends per share) Simplifying the Dividend Discount Model Dividend Discount Model with No Growth -a company that pays out all its earnings to its common shareholders won’t be able to grow because it can’t reinvest anything -the discount rate is the ror demanded by investors in other stocks of the same risk P0= DIV /1r Value of a no-growth stock = P = E0S / r 1 -where EPS i1 next year’s earnings per share of stock Constant-Growth Dividend Discount Model P0= DIV /1(r-g) Def’n- dividend discount model where dividends grow at a constant rate -a stock with a constant-growth dividend will also have a constant-growth stock price -a higher g generates a higher stock price -the constant-growth formula is only valid when g is less than r -if g is greater than r, then it will give an enormous answer -it will obviously be wrong because far-distant dividends would have high present values Estimating Expected Rates of Return -constant-growth dividend discount model forecasts a constant growth rate -rearranging the constant-growth formula would give r = (DIV1/P 0 + g = dividend yield + growth rate Non Constant Growth -many companies grow at quick rates for a few years before settling down -when this happens, we can set the investment horizon (year H) at the year that you think the company will settle down, and then calculate the present value of dividends from now until that year -forecast the stock price in that year and discount it to present value as well -then add it up to get the total present value of dividends plus the ending stock price -the stock price in the horizon year is known as the terminal value 2 H H P0= [ (DIV 1P )1 1+r ]+ [ (DIV +2 ) 2 (1+r) ]+…+ [ (DIV +P H / H1+r) ] + [ P / (1Hr) ] *first 3 are PV of dividends from year 1 to horizon; last is PV of stock prize at horizon -not all companies list their stocks for trading on stock exchanges -small companies don’t do this; listing is expensive and public companies must then reveal financial information; some don’t like this because they like to keep it private -as a shareholder of a private company, you receive the same type of cash payments as the shareholder of a public company; dividends Growth Stocks and Income Stocks -people buy growth stocks in the expectation of capital gains and future growth of earnings -they also buy income stocks for the cash dividends Earnings per share = Initial book equity per share x return on equity Payout ratio- fraction of earnings paid out as dividends Plowback ratio- fraction of earnings reinvested in the firm Sustainable growth- steady rate at which a firm can grow Growth rate = return on equity x plowback ratio Present value of growth opportunities (PVGO)- net present value of a firm’s future investments -a high P/E suggests investors think that the firm has good growth opportunities -firms can have high P/E ratios though, not because the price is high but because earnings are temporarily depressed -a firm that earns nothing in a period will have an infinite P/E There are no Free Lunches on Bay Street Technical analysis- investors who attempt to identify undervalued stocks by searching for patterns in past stock prices Random walk- movement of security prices that change randomly Fundamental Analysis- investors who attempt to find mispriced securities by analyzing fundamental info, such as accounting data, business prospects -they focus on past stock price movements Inside information- info about a company known by its employees, management, board of directors but not the public Insider- member with a close relationship to a company, including lawyers, accountants -it is illegal to use information that is only known to insiders and not to the public Insider trading- illegal trading of securities, including stocks, bonds, options, by insiders or those tipped by insiders on the basis of insider information -insider trading laws are needed to help create a market in which investors have confidence they are not being taken advantage of by better informed market participants A Theory to Fit the Facts Efficient market- market in which prices reflect all available information Weak-form efficiency- market prices rapidly reflect all info contained in the history of past prices -share price changes are random, and technical analysis that searches for patterns in past returns is valueless Semi strong form efficiency- market prices rapidly reflect all publicly available info -impossible to earn consistently superior returns Strong-form efficiency- market prices rapidly reflect all info that could be used to determine true value -no investor could expect to earn superior profits Market Anomalies and Behavioural Finance Earnings Announcement Puzzle -in an efficient stock market, a company’s stock price should react instantly at the announcement of unexpectedly good or bad earnings -but in reality stocks with the best earnings news typically outperform stocks with the worst earnings New-Issue Puzzle -when firms issue stock to the public, investors typically rush to buy -on average, those who buy it first receive an immediate capital gain -but researchers have found that the early gains often turn into losses Ch 14 (14.2-14.3)- Intro to Corporate Financing and Governance Common Stock Issued shares- shares issued by the company Outstanding shares- shares issued by the company and are held by investors Authorized share capital- max number of shares that the company is permitted to issue Par value- value of security shown on certificate Additional paid-in capital- difference between issue price and par value of stock, aka capital surplus Retained earnings- earnings not paid out as dividends -the sum of common shares, retained earnings, foreign currency is the net common currency -it equals the total amount contributed directly by common shareholders when the firm issued new stock, and indirectly when it plowed back part of its earnings -in the US when a company repurchases some of its shares, it can continue to hold them as its own stock -in Canada treasury stock isn’t allowed; any shares repurchased must be cancelled -is done by reducing the co’s net equity acct to amount paid for any shares repurchased Book Value vs. Market Value -market value is usually bigger than book value, mainly because of inflation -also because firms raise capital to invest in projects with present values that exceed initial cost -those projects are what make shareholders better off Dividends -a company isn’t obliged to pay any dividends and the decision is up to the board of directors -because dividends are discretionary, they’re not considered to be a business expense -companies aren’t allowed to deduct dividend payments when they calculate their taxable income Ownership of the Corporation -a corp is owned by its common shareholders, as well as insurance companies, mutual funds, banks -the board usually consists of the co’s top management as well as non-executive directors that aren’t employed by the firm -the board is elected as an agent of the shareholders -it appoints and oversees the management of the firm Voting Procedures Majority voting- voting system in which each director is voted on separately Cumulative voting- system in which all the votes one shareholder is allowed to cast can be cast for one candidate for the board of directors -shareholders can save all their votes for just one candidate Proxy contests- takeover attempt in which outsiders compete with management for shareholders’ votes -in some special situations involving important corporate decisions such as mergers, the votes of most of the minority shareholders must be received Classes of Stock -many companies issue just one class of common stock -sometimes they may have 2+ classes outstanding -if a firm needs capital but shareholders don’t want to give up control, they may issue another class -thus existing shares would be class A, and the new ones would be class B -common shares without full voting rights are called restricted shares -they are called non-voting shares if they have no votes -they are called subordinate voting if the restricted shares have less votes per share than another class of common shares -you can also have limited voting shares that have fewer voting rights relative to another class of common shares -it is hard for a firm to convert common share class into two share classes with diff voting rights -to convert, most of the minority shareholders have to approve -the stock exchanges will not list a new class of non-voting shares unless the shares have the right to participate in takeover bids, called a coattail provision Corporate Governance in Canada and Elsewhere -shareholders own the company, but they don’t manage it -if shareholders don’t like the policies the management team pursues, they can try and vote in another board of directors -dishonest managers with large option packages may seek to hide the truth from investors -Ontario introduced the Bill C-198 aka Canada’s Sarbanes-Oxley -it provides for a healthy and ethical business environment Preferred Stock Def’n- stock that takes priority over common stock in regard to dividends Net Worth- book value of common shareholders’ equity plus preferred stock -most preferred stock promises a series of fixed payments to the investor -no dividends can be paid on the common stock until the preferred dividend has been paid -preferred stock usually doesn’t have a final repayment -a sizable number of issues tend to be redeemable, meaning the co has the right to acquire the shares at a set amount, called the call price -some preferred shares are convertible, meaning they can be converted into another class of shares -are usually common shares -preferred shares are listed on the TSX ending in “.PR” -preferred stock rarely confers full voting privileges Floating rate preferred- preferred stock paying dividends that vary with short term interest rates -any change in interest rates will be counterbalanced by a change in the dividend payment Ch 8- Net Present Value and Other Investment Criteria Net Present Value -it is the only price that satisfies both buyer and seller; is the only feasible price -aka market price or market value Opportunity cost of capital- the return being given up by investing in the project Net present value (NPV)- PV of cash flows minus initial investment NPV = PV – Required Investment -a risky dollar is worth less than a safe one -most investors avoid risk when they can do so without sacrificing them Valuing Long Lived Projects -Pentagon law of Large Projects states that anything big will take longer, and costs more than originally led to believe Using the NPV Rule to Choose Among Projects Mutually exclusive projects- 2+ projects that can’t be pursued simultaneously -calculate the NPV of each project and choose the highest NPV value Other Investment Criteria -the project’s payback or discounted payback and its internal rate of return Payback Payback period- the length of time before you recover your initial investment -payback rule states a proj should be accepted if its payback period is less than a specific cutoff period -to use the payback rule, a firm has to decide on an appropriate cutoff period -if it uses the same cutoff regardless of project life, it will accept too many short-lived projects and reject the projects that have long lives -the main attraction of the payback criterion is its simplicity -disadv of project evaluation is forecasting the cash flows -managers may think that payback is the easiest way to communicate an idea of project desirability -they may also favour quick payback projects even with a low NPV; -quick profits to them means quicker promotions Discounted Payback Discounted payback period- the number of periods before the present value of prospective cash flows equals the initial investment -cumulative discounted cash flows that are positive in a certain year mean that the project will pay back sometime during that year Adv over the normal payback; if a project meets a discounted payback cutoff, it must have a +ve NPV -any cash flows after that date ensures a positive NPV Disadv; it still ignores all cash flows occurring after the cutoff date, and will incorrectly reject some positive NPV opportunities Internal Rate of Return Rate of Return = Profit / Investment 2 Rules for deciding whether to proceed with an investment project: NPV Rule invest in a project that has a +ve NPV when its cash flows are discounted at the opportunity cost of capital Rate of Return Ruleinvest in a project that offers a higher ror than the opportunity cost of capital -if NPV% is the same as ROR%, the project wouldn’t have made you any richer or poorer Closer Look at the ROR Rule -the project ror is also the discount rate at which NPV = 0 -if the opportunity cost of capital < project ror, then the NPV of the project is positive -vice versa (O.C > Project ROR) Calculating the ROR for Long-Lived Projects ROR = Profit / Investment = (C1– Investment) / Investment = (C + C )/ - C 1 0 0 Internal rate of return (IRR)- discount rate at which a project NPV=0 -to calculate the IRR requires trial and error, so there are computer programs to find the rate -the ror rule will give the same answer as the NPV rule as long as the NPV of a project declines smoothly as the discount rate increases -NPV and IRR rules are both discounted cash flow methods of choosing between projects -both are concerned with finding projects that make shareholders better off, and recognize that companies always have a choice -project IRR measures profitability of the project; is an internal rate of return that depends on the project’s own cash flows Pitfalls of the IRR Rule -many firms use IRR instead of NPV; IRR presents some disadvantages Lending or Borrowing? -it’s hard to choose between projects unless you find out if you’re lending or borrowing at that rate -when NPV goes up as interest rate goes up, the ror rule becomes reversed; -when NPV is higher as the discount rate increases, a project is acceptable only if its internal ror is less than the o.c of capital Multiple Rates of Return -investment has an IRR of two different percentages -reason for this is due to the double change in the sign of the cash flows -there can be as many diff internal ror as there are changes in the sign of the cash flow stream -when the cash flow stream is expected to change sign more than once, the project will usually have more than one IRR, thus there will be no simple IRR rule -when this happens, a modified internal rate of return (MIRR) can be calculated Mutually Exclusive Projects -it wouldn’t make sense to choose the project that has the highest internal rate of return Mutually exclusive projects involving diff outlays comparing with same lives but diff outlays More Examples of Mutually Exclusive Projects Investment Timing -the better choice depends on the cost of capital -the sooner you can capture the savings the better, but if it costs you less to get those savings by postponing the investment, it may cost you more to do so Long vs. Short-Lived Equipment -would the annual cost of using one product be lower than that of another Equivalent annual cost- the cost per period with the same present value as the cost of buying and operating a machine Equivalent Annual Cost = Present Value of Costs / Annuity Factor Replacing an Old Machine -the point at which equipment is replaced reflects economics, not physical collapse Capital Rationing Soft Rationing Capital rationing- limit set on the amount of funds available for investment -imposed by top management -forces the manager to set their own priorities Hard Rationing -when the firm actually can’t raise the money it needs -in this case, it may be forced to pass up positive NPV projects -the manager would need to select proj within the company’s resources and gives the highest PV value Profitability Index- ratio of net present value to initial investment Profitability Index = NPV / Initial Investment -disadv; sometimes used to rank projects even when there is no soft or hard capital rationing -user may led to favour small projects over larger projects with higher NPVs A Last Look *Table 8.3* -NPV is the only rule that consistently can be used to rank and choose among mutually exclusive investments -only instance which NPV fails is when the firm faces capital rationing -IRR is a widely used measure that indicates ror on investment -despite its pitfalls, it will generally give the correct answer about project viability Ch 9- Using Discounted Cash Flows -to calculate NPV we need to discount cash flows, not accounting profits -accountant doesn’t deduct capital expenditure when calculating the year’s income, but depreciates it instead over several years -this can be tricky when working out NPV, whereas computing year by year profits it’d be fine -accountants try to show profit as it is earned, rather than when the co gets around to paying their bills Discount Incremental Cash Flows -a project’s present value depends on the extra cash flows that it produces Incremental Cash Flow = Cash Flow with Project – Cash Flow without Project Include all Indirect Effects -new products or projects; sometimes they can help the firm’s existing business -it can also hurt the company’s existing products as well though Forget Sunk Costs -they are past and irreversible outflows Include Opportunity Costs Def’n- the benefit or cash flow forgone as a result of an action Recognize the Investment in Working Capital Net working capital- current assets minus current liabilities -ST assets cash, A/R, inventories, finished goods -ST liabilitiesA/P, notes payable, accruals -most projects entail an additional investment
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