Investment & Financing Flashcards
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1.1 Corporate Investment and Financing Decisions
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- 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
2
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• What Is a Corporation?
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- 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
3
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Cash Flow between Financial markets and Firm‘s Operations
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4
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Stockholders Want Three Things
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- To maximize current wealth
- To transform wealth into most desirable time pattern of consumption
- To manage risk characteristics of chosen consumption plan
5
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Profit Maximization- Not a well-defined financial objective
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• 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
6
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The Investment Trade-off权衡资本
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• 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
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Agency Problems – Owners vs. Managements
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8
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Agency costs are incurred when:
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- Managers do not attempt to maximize firm value
- Shareholders incur costs to monitor managers and constrain their actions
9
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Tools to Ensure Management Pays Attention to the Value of the Firm
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- 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
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Ch-2 Calculating Future Values
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• Future Value
- Amount to which investment will grow after earning interest
11
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Present Value
• Value today of future cash flow
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12
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Valuing an Office Building
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13
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Net Present Value
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14
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Risk and Present Value
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- Higher risk projects require a higher rate of return
- Higher required rates of return cause lower PVs
15
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Three Rules of Time and Travel
Financial decisions often require combining cash flows or comparing values. Three rules govern these processes.
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16
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Net Present Value Rule
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17
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Rate of Return Rule
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- 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?
18
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Multiple Cash Flows
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• Discounted Cash Flow (DCF) formula:
19
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Perpetuity
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20
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Example： Perpetuity
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21
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Annuity
• Asset that pays fixed sum each year for specified number of years
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22
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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?
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23
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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%.
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24
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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?
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Constant Growth Perpetuity
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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%?
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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
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Present Value of Growing Annuities
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EAR and APR
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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%).
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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?
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Duration & Bond Prices：continuous case
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Duration ：discrete case
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Ch-3：Convexity
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Modified Duration
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Duration：solution steps
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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
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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)
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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
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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
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Debt and Interest Formula:
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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
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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
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Example：Duration and Modified Duration 1
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Example：Duration and Modified Duration 2
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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
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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
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How common stocks are valued 2
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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?
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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
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Market Capitalization Rate
* Estimated using perpetuity formula
* Also called cost of equity capital
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Dividend Discount Model
Computation of today’s stock price: share value equals present value of all expected future dividends
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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?
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Dividend Yield:r-g
* Expected return on stock investment plus expected dividend growth
* Similar to capitalization rate
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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?
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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?
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Return Measurements
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Dividend Growth Rate:g
* Derived by applying return on equity to percentage of earnings
* reinvested in operations
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Valuing Non-Constant Growth
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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?
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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
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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?
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Present Value of Growth Opportunities (PVGO)
• Net present value of firm’s future investments
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Sustainable Growth Rate
• Steady rate at which firm can grow: plowback ratio x return on equity
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Valuing a Business or Project
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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%
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CFO decision tools
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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
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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
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Example: Find disadvantage of only taking projects with payback period of two years or less
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Example: IRR
Tool A costs $4,000. Investment will generate $2,000 and $4,000 in cash flows for two years. What is IRR?
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Pitfall 2: Multiple Rates of Return
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Pitfall 1: Lending or Borrowing?
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Pitfall 3: Mutually Exclusive Projects
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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
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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
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Example：weighted average Profitablity Index
Select best projects for $300,000
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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
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Ch-6 Applying net present value rule
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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?
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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**
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Problem 1: Investment Timing Decision
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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
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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?
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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
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• Variance
• Average value of squared deviations from mean; measures volatility
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• Standard Deviation
• Square root of variance; measures volatility
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Measuring portfolio risk
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• Diversification
• Strategy designed to reduce risk by spreading the portfolio across many investments
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• Unique Risk
• Risk factors affecting only that firm; also called “diversifiable risk”
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• Market Risk
• Economy-wide sources of risk that affect the overall stock market; also called “systematic risk”
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diversification eliminates specific risk
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variance of a two-stock portfolio
Variance of two-stock portfolio is sum of four boxes
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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.
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Portfolio calculation
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Example: Calculating portfolio risk
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• Market Portfolio
* Portfolio of all assets in economy
* Usually uses broad stock market index to represent market
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• Beta
• Sensitivity of stock’s return to return on market portfolio
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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
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Expected return and standard deviation
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Efficient Frontier
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Sharpe Ratio
• Ratio of risk premium to standard deviation
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The relationship between risk and return
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Security market line
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Alternative to CAPM
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Three-Factor Model
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Example：Portfolio return
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Example：NPV
