Investment & Financing Flashcards
1.1 Corporate Investment and Financing Decisions
- Real Assets
- Used to produce goods and services
- Financial Assets/Securities
- Financial claims on income generated by firm’s real assets
- Capital Budgeting/Capital Expenditure (CAPEX)
- Decision to invest in tangible or intangible assets
- Investment Decision
- Purchase of real assets
- Financing Decision
- Sale of financial assets
- Capital Structure
- Choice between debt and equity financing
- Capital Budgeting Examples
- Tangible Assets
• i.e. Expanding stores
* Intangible Assets
• i.e. Research and development for new drug
• What Is a Corporation?
- Legal entity, owned by shareholders
- Can make contracts, carry on business, borrow, lend, sue, and be sued
- Shareholders have limited liability and cannot be held personally responsible for corporation’s debts
Cash Flow between Financial markets and Firm‘s Operations
Stockholders Want Three Things
- To maximize current wealth
- To transform wealth into most desirable time pattern of consumption
- To manage risk characteristics of chosen consumption plan
Profit Maximization- Not a well-defined financial objective
• Which year’s profits?
- Shareholders will not welcome higher short-term profits if long-term profits are damaged
• Company may increase future profits by cutting year’s dividend, investing freed-up cash in firm
- Not in shareholders’ best interest if company earns less than opportunity cost of capital
- Shareholders desire wealth maximization
- Managers have many constituencies, “stakeholders”
- “Agency Problems” represent the conflict of interest between management and owners
The Investment Trade-off权衡资本
• Hurdle Rate/Cost of Capital
- Minimum acceptable rate of return on investment
• Opportunity Cost of Capital
- Investing in a project eliminates other opportunities to use invested cash
Agency Problems – Owners vs. Managements
Agency costs are incurred when:
- Managers do not attempt to maximize firm value
- Shareholders incur costs to monitor managers and constrain their actions
Tools to Ensure Management Pays Attention to the Value of the Firm
- Manager’s actions subject to the scrutiny of board of directors
- Shirkers are likely to find they are ousted by more energetic managers
- Financial incentives provided, such as stock options
Ch-2 Calculating Future Values
• Future Value
- Amount to which investment will grow after earning interest
Present Value
• Value today of future cash flow
Valuing an Office Building
Net Present Value
Risk and Present Value
- Higher risk projects require a higher rate of return
- Higher required rates of return cause lower PVs
Three Rules of Time and Travel
Financial decisions often require combining cash flows or comparing values. Three rules govern these processes.
Net Present Value Rule
Rate of Return Rule
- Accept investments that offer rates of return in excess of their opportunity cost of capital
- In the project listed below, the opportunity cost of capital is 12%. Is the project a wise investment?
Multiple Cash Flows
• Discounted Cash Flow (DCF) formula:
Perpetuity
Example： Perpetuity
Annuity
• Asset that pays fixed sum each year for specified number of years
Example：PV of Annuity
Example: Tiburon Autos offers payments of $5,000 per year, at the end of each year for 5 years. If interest rates are 7%, per year, what is the cost of the car?
Example：PV of Annuity 2
Example: The state lottery advertises a jackpot prize of $365 million, paid in 30 yearly installments of $12.167 million, at the end of each year. Find the true value of the lottery prize if interest rates are 6%.
Example: Future Value of an Annuity
What is the future value of $20,000 paid at the end of each of the following 5 years, assuming investment returns of 8% per year?
Constant Growth Perpetuity
Example: Constant Growth Perpetuity
What is the present value of $1 billion paid at the end of every year in perpetuity, assuming a rate of return of 10% and constant growth rate of 4%?
Example: Growing Annuities
Golf club membership is $5,000 for 1 year, or $12,750 for three years. Find the better deal given payment due at the end of the year and 6% expected annual price increase, discount rate 10%.
不确定
Present Value of Growing Annuities
EAR and APR
Example:Using the present value formula to value bonds
Today is October 1, 2010; what is the value of the following bond? An IBM bond pays $115 every September 30 for five years. In September 2015 it pays an additional $1,000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%).
Example: Semiannual paid bond
In February 2012 you purchase a three-year U.S. government bond. The bond has an annual coupon rate of 11.25%, paid semiannually. If investors demand a 0.085% semiannual return, what is the price of the bond?
Duration & Bond Prices：continuous case
Duration ：discrete case
Ch-3：Convexity
Modified Duration
Duration：solution steps
3.3 Term structure of interest rates
- Short- and long-term rates are not always parallel
- Spot Rate: Actual interest rate today (t = 0)
- Forward Rate: Interest rate, fixed today, on future loan at fixed time Future Rate: Spot rate expected in future
- Yield To Maturity (YTM): IRR on interest-bearing instrument
Law of One Price
- All interest-bearing instruments priced to fit term structure
- Accomplished by modifying asset price
- Modified price creates new yield, which fits term structure
- New yield called yield to maturity (YTM)
Expectations Theory
- Term Structure and Capital Budgeting
- CF should be discounted using term structure info
- When rate incorporates all forward rates, use spot rate that equalsproject term
- Take advantage of arbitrage
Classical Theory of Interest Rates (Economics)
- Developed by Irving Fisher:
- Nominal Interest Rate = Actual rate paid when borrowing money
- Real Interest Rate = Theoretical rate paid when borrowing money; determined by supply and demand
- Nominal r = Real r + expected inflation (approximation)
- Real r theoretically somewhat stable
- Inflation is a large variable
- • Term structure of interest rates shows cost of debt
Debt and Interest Formula:
3.6 The risk of default
Corporate Bonds and Default Risk
- Payments promised to bondholders represent best-case scenario
- Most bonds’ safety judged by bond ratings
Sovereign Bonds and Default Risk
- Sovereign debt is generally less risky than corporate debt
- Inflationary policies can reduce real value of debts
- Foreign Currency Debt
- Default occurs when foreign government borrows dollars
- If crisis occurs, governments may run out of taxing capacity and default•
- Affects bond prices, yield to maturity
- Own Currency Debt
- Less risky than foreign currency debt
- Governments can print money to repay bonds
- Eurozone Debt
- Can’t print money to service domestic debts
- Money supply controlled by European Central Bank
Example：Duration and Modified Duration 1
Example：Duration and Modified Duration 2
4.1 How common stocks are traded
- Primary Market
- New securities
- Secondary Market
- Previously-issued securities
- Common Stock
- Ownership shares in publicly-held corporation
- Electronic Communication Networks (ECNs)
- Computer networks that allow electronic trading
- Exchange-Traded Funds (ETFs)
- Stock portfolios bought/sold in single trade
- SPDRs (Standard & Poor’s Depository Receipts or “spiders”)
- ETFs tracking several S&P indexes
How common stocks are valued 1
- Book Value
- Net worth of firm according to balance sheet
- Dividend
- Periodic cash distribution from firm to the shareholders
- P/E Ratio
- Price per share divided by earnings per share
- Market Value Balance Sheet
- Financial statement that uses market value of assets and liabilities
How common stocks are valued 2
Example: expected return
Fledgling Electronics sells for $100 per share today; they are expected to sell for $110 in one year. What is expected return if dividend in one year is forecasted to be $5.00?
Price of share of stock
- Price of share of stock is present value of future cash flows
- For a stock, future cash flows are dividends and ultimate sales price
Market Capitalization Rate
- Estimated using perpetuity formula
- Also called cost of equity capital
Dividend Discount Model
Computation of today’s stock price: share value equals present value of all expected future dividends
Example: Dividend discount
Fledgling Electronics forecasted to pay $5.00 dividend at end of year 1 and $5.50 dividend at end of year 2. End-of-second-year stock will be sold for $121. Discount rate is 15%. What is the price of stock?
Dividend Yield:r-g
- Expected return on stock investment plus expected dividend growth
- Similar to capitalization rate
Example:Dividend yield r with 0 g
Northwest Natural Gas shares sold for $47.30 at start of 2012. Dividend payments for 2013 were $1.86 a share with no growth. What is dividend yield?
Example: divident yield r with g
Northwest Natural Gas shares sold for $47.30 at start of 2012. Dividend payments for 2013 were $1.86 a share with 4.6% growth. What is dividend yield?
Return Measurements
Dividend Growth Rate:g
- Derived by applying return on equity to percentage of earnings
- reinvested in operations
Valuing Non-Constant Growth
Example: valuing consecutive divident with g
Phoenix pays dividends in three consecutive years of 0, .31, and .65. Year-4 dividend is estimated at .67 with perpetuity growth at 4%. With 10% discount rate, what is stock price?
Payout Ratio& Plowback Ratio
- If firm pays lower dividend and reinvests funds, stock price may increase due to higher future dividends
- Payout Ratio
- Fraction of earnings paid out as dividends
- Plowback Ratio
- Fraction of earnings retained by firm
Example:Stock price and earnings per share
Company plans $8.33 dividend next year (100% of earnings). Investors will get 15% expected return. Instead, company plows back 40% of earnings at firm’s current return on equity of 25%. What is the stock value before and after plowback decision?
Present Value of Growth Opportunities (PVGO)
• Net present value of firm’s future investments
Sustainable Growth Rate
• Steady rate at which firm can grow: plowback ratio x return on equity
Valuing a Business or Project
Example: valuing PV of cash fows
Given cash flows for Concatenator Manufacturing Division, calculate PV of near-term cash flows, PV (horizon value), and total value of firm; r = 10% and g = 6%
CFO decision tools
Book Rate of Return
- Average income divided by average book value over project life
- Also called accounting rate of return
- Components reflect tax and accounting figures, not market values or cash flows
5.2 Payback
- Payback Period
- Number of years before cumulative cash flow equals initial outlay
- Payback Rule
- Only accept projects that pay back within desired time frame
- Ignores later year cash flows and present value of future cash flows
Example: Find disadvantage of only taking projects with payback period of two years or less
Example: IRR
Tool A costs $4,000. Investment will generate $2,000 and $4,000 in cash flows for two years. What is IRR?
Pitfall 2: Multiple Rates of Return
Pitfall 1: Lending or Borrowing?
Pitfall 3: Mutually Exclusive Projects
Pitfall 4: More than One Opportunity Cost of Capital
- Term Structure Assumption
- Assume discount rates stable during term of project
- Implies all funds reinvested at IRR
- False assumption
- Assume discount rates stable during term of project
Profitability Index (PI)
Choosing capital investments when resources are limited
- Tool for selecting between project combinations and alternatives
- Set of limited resources and projects can yield various combinations
• Highest weighted average PI indicates optimal project
Example：weighted average Profitablity Index
Select best projects for $300,000
Rationing
Choosing capital investments when resources are limited
- Capital Rationing
- Limit set on amount of funds available for investment
- Soft Rationing
- Imposed by management
- Hard Rationing
- Imposed by unavailability of funds in capital market
Ch-6 Applying net present value rule
Example: Inflation
Project produces real cash flows of -$100 in year zero and then $35, $50, and $30 in three following years. Nominal discount rate is 15% and inflation rate is 10%. What is NPV?
Separate Investment and Financing Decisions
- Regardless of financing, treat cash outflows required for project as coming from investors
- Regardless of financing, treat cash inflows as going to investors
Net cash flow= cash inflow - cash outflow
Problem 1: Investment Timing Decision
Problem 2: Choice between Long- and Short-Term Equipment
Example: Given the following cash flows from operating two machines and a 6% cost of capital, which machine has the higher value using the equivalent annual annuity method?
Equivalent Annual Cash Flow, Inflation, and Technological Change
- Inflation increases nominal costs of operating equipment, but real costs remain unchanged
- Real cash flows are not always constant
Equivalent Annual Cash Flow and Taxes
- Lifetime costs should be calculated after tax
- Operating costs are tax-deductible
- Capital investment generates depreciation tax shields
Problem 3: When to Replace an Old Machine
Example: A machine is expected to produce a net inflow of $4,000 this year and $4,000 next year before breaking. You can replace it now with a machine that costs $15,000 and will produce an inflow of $8,000 per year for three years. Should you replace now or wait a year?
Problem 4: Cost of Excess Capacity
Example: A computer system costs $500,000 to buy and operate at a discount rate of 6% and lasts five years
- Equivalent annual cost of $118,700
- Undertaking project in year 4 has a present value of 118,700/(1.06)4, or about $94,000
• Variance
• Average value of squared deviations from mean; measures volatility
• Standard Deviation
• Square root of variance; measures volatility
Measuring portfolio risk
• Diversification
• Strategy designed to reduce risk by spreading the portfolio across many investments
• Unique Risk
• Risk factors affecting only that firm; also called “diversifiable risk”
• Market Risk
• Economy-wide sources of risk that affect the overall stock market; also called “systematic risk”
diversification eliminates specific risk
variance of a two-stock portfolio
Variance of two-stock portfolio is sum of four boxes
Calculating portfolio risk
Example: Invest 60% of portfolio in Heinz and 40% in ExxonMobil. Expected dollar return on Campbell Soup stock is 6% and 10% on Boeing. Expected return on portfolio is:
Standard deviation of annualized daily returns are 14.6% and 21.9%, respectively. Assume correlation coefficient of 1.0 and calculate portfolio variance.
Portfolio calculation
Example: Calculating portfolio risk
• Market Portfolio
- Portfolio of all assets in economy
- Usually uses broad stock market index to represent market
• Beta
• Sensitivity of stock’s return to return on market portfolio
Harry Markowitz and the birth of portfolio theory
• Combining stocks into portfolios can reduce standard deviation below simple weighted-average calculation
- Correlation coefficients made possible
- Various weighted combinations of stocks that create specific standard deviation constitute set of efficient portfolios
Expected return and standard deviation
Efficient Frontier
Sharpe Ratio
• Ratio of risk premium to standard deviation
The relationship between risk and return
Security market line
Alternative to CAPM
Three-Factor Model
Example：Portfolio return
Example：NPV
