# CORPORATE FINANCE

CORPORATE FINANCE

Learning Goals &Topics to be

covered

i. 4 PRINCIPLES OF FINANCE

ii. THE OBJECTIVE OF CORPORATE FINANCE AND ETHICS

iii. CORPORATE GOVERNANCE AND ETHIC

iv. LEGAL FORMS OF BUSINESS ORGANIZATION

v. Corporation’s Management Decisions

vi. AGENCY PROBLEMS – ASYMMETRIC INFORMATION

© 2012 Pearson Prentice Hall. All rights reserved. 1-3

© 2012 Pearson Prentice Hall. All rights reserved. 1-4

What is Finance?

Finance can be defined as the science and art of managing money.

If we trace the origin of finance, there is evidence to prove that it is

as old as human life on earth. The word finance was originally a

French word. In the 18thcentury, it was adapted by English

speaking communities to mean “the management of money.”

Today, finance is emerged into an academic discipline of greater

significance and organized as a branch of Economics.

Finance is also the study of how and under what terms savings

(money) are allocated between lenders and borrowers. Finance is

concerned with the process institutions, markets, and instruments

involved in the transfer of money among and between

individuals, businesses and government.

Why you should study Finance

https://online.hbs.edu/blog/post/why-studyfinance

© 2012 Pearson Prentice Hall. All rights reserved. 1-5

… what is Finance?

At the personal level, finance is concerned with

individuals’ decisions about how much of their

earnings they spend, how much they save, and how

they invest their savings.

• In a business context, finance involves the same

types of decisions: how firms raise money from

investors, how firms invest money in an attempt to

earn a profit, and how they decide whether to

reinvest profits in the business or distribute them

back to investors as dividends.

© 2012 Pearson Prentice Hall. All rights reserved. 1-6

The 4 Principles of

Finance

1. Money Has a Time Value (TVM)

2. Risk-Return Trade-off

3. Cash Flows Are The Source of Value

4. Market Prices Reflect Information (EMH)

PRINCIPLE 1: Money Has a Time Value.

A dollar received today is more valuable than a

dollar received in the future.

– We can invest the dollar received today to earn

interest. Thus, in the future, you will have more

than one dollar, as you will receive the interest on

your investment plus your initial invested dollar.

PRINCIPLE 2: There is a RiskReturn Trade-off.

We only take risk when we expect to be

compensated for the extra risk with additional

return.

Higher the risk, higher will be the expected

return.

PRINCIPLE 3: Cash Flows Are The Source of

Value.

Profit is an accounting concept designed to

measure a business’s performance over an

interval of time.

Cash Flow (CF) is the amount of cash that can

actually be taken out of the business over this

same interval.

Profits versus Cash

It is possible for a firm to report profits but have

no cash.

For example, if all sales are on credit, the firm

may report profits even though no cash is

being generated.

Incremental Cash Flow

Financial decisions in a firm should consider

“incremental cash flow”, Δ(CF), i.e. the

difference between the cash flows the

company will produce with the potential new

investment it’s thinking about making and what

it would make without the investment.

CF(if Invest) – CF (if NO Invest)=Δ(CF)

PRINCIPLE 4: Market Prices Reflect

Information.

Investors respond to new information by buying and selling their

investments.

The speed with which investors act and the way that prices

respond to new information determines the efficiency of the

market. In efficient markets, this process occurs very quickly.

As a result, it is hard to profit from trading investments on

publicly released information.

PRINCIPLE 4: Market Prices Reflect

Information. (cont.)

Investors in capital markets will tend to react

positively to good decisions made by the firm

resulting in higher stock prices.

Stock prices will tend to decrease when there is

bad information released on the firm in the

capital market.

PRINCIPLE 4: Market Prices

Reflect Information.

EMH posits that in competitive financial markets

asset prices reflect the dispersed information

that is relevant to assets’ value, and thus,

market prices are aggregators of the publicly

available information in the market. Therefore,

no investor is able to beat the market and earn

abnormal profits, above the average market

returns at least in theory.

© 2012 Pearson Prentice Hall. All rights reserved. 1-16

The objective in Managerial and Corporate Finance, according

to the main international textbooks

Van Horne: “In this book, we assume that the objective of the firm is

to maximize its value to its stockholders”

Brealey & Myers: “Success is usually judged by value: Shareholders

are made better off by any decision which increases the value of

their stake in the firm… The secret of success in financial

management is to increase value.”

Copeland & Weston: The most important theme is that the objective

of the firm is to maximize the wealth of its stockholders.”

Brigham and Gapenski: Throughout this book we operate on the

assumption that the management’s primary goal is stockholder

wealth maximization which translates into maximizing the price of

the common stock.

© 2012 Pearson Prentice Hall. All rights reserved. 1-17

In traditional Corporate Finance …

In traditional corporate finance, the objective in

decision making is to maximize the value of the firm.

A narrower objective is to maximize stockholder

wealth. When the stock is traded and markets are

viewed to be efficient, the objective is to maximize

the stock price.

All other goals of the firm are intermediate ones

leading to firm value maximization, or operate as

constraints on firm value maximization.

Hillier et.al. “Corporate

Finance”

“The purpose of the firm is to create value for

the owner, who may or may not be the manager

of the firm”.

Shareholder interests

Prof Mervyn King said at the 15th BEN-Africa

Conference (November 2016, Stellenbosch, South

Africa):

“I realized long ago that the primacy of shareholders

could not be the basis in the rainbow nation“ (= multiculturalism).

The corporate governance theory of shareholder

primacy holds that shareholder interests should have

first priority relative to all other corporate

stakeholders.

Shareholder Primacy

Definition: Shareholder primacy is a shareholder-centric form of corporate

governance that focuses on maximizing the value of shareholders before considering

the interests of other corporate stakeholders, such as society, the community,

consumers, and employees.

Reference:

1). https://corpgov.law.harvard.edu/2019/08/22/so-long-to-shareholder-primacy/

“So Long to Shareholder Primacy”, Posted by Cydney Posner, Cooley LLP,

on Thursday, August 22, 2019, HARVARD LAW SCHOOL.

2). https://www.forbes.com/sites/dennisjaffe/2021/02/24/from-shareholder-primacyto-stakeholder-primacy-how-family-businesses-lead-the-way/?sh=3573711221ed

“From Shareholder Primacy To Stakeholder Primacy: How Family

Businesses Lead The Way”, Forbes, 4 Feb 2021.

1-21

Company’s responsibility

The doctrine of shareholder’s primacy is criticized for

being at odds with corporate social responsibility and

other legal obligations because it focuses solely on

maximizing shareholder profits.

According to the Wall Street Journal (WSJ, April 15,

2010):

“Ethics teaching should not just be about refraining

from cheating and corruption but recognizing that a

company has responsibility beyond its shareholders

wallets to employees, community, customers and the

environment”.

Contracts

Prof Vermaelen (INSEAD, 26 December 2008) adopts the old

view (1972, 1976) that “a company should be considered as

a nexus of contracts between various stakeholders. All

contracts have explicit and implicit characteristics,” (L.

Zingales, JoF, 2000). For example, the debt contract has a

large number of explicit terms such as maturity, interest rate,

seniority, covenants, collateral, and so on. However,

shareholders have a largely implicit contract. … In a

capitalist economy it is reasonable to assume that

shareholders have an implicit contract that the management

will maximize their interests. So, I believe that respect for

such implicit contracts is an ethical responsibility”.

Discussion: Implicit Contracts

Consider, for instance, a firm with the reputation of

rewarding employees on the basis of their contribution to

the firm, regardless of their value in the marketplace.

Counting on this reputation, the employees will make

investments that are different from those they would have

made in the marketplace.

Discussion: how is the reputation of that firm affected by

the outcome of employees’ investments?

1-24

Organizational Value

1). If these investments are indeed valuable and could

not have been elicited with an explicit contract, the

firm’s reputation adds value: it represents an

organizational asset.

2). If these investments are wasteful, the firm’s

reputation will destroy value; it represents an

organizational liability.

3). The firm, thus, can be worth more or less than the

sum of its parts, with the difference being the net of

value of organizational assets and liabilities.

1-25

© 2012 Pearson Prentice Hall. All rights reserved. 1-26

Goal of the Firm:

What About Stakeholders?

• Stakeholders are groups such as employees, customers,

suppliers, creditors, owners, and others who have a direct

economic link to the firm.

• A firm with a stakeholder focus consciously avoids

actions that would prove detrimental to stakeholders. The

goal is not to maximize stakeholder well-being but to

preserve it.

• Such a view is considered to be “socially responsible.”

2

7

Shareholders

and Investors

(millions)

Public

Corp.

Management

of the Firm

Regulators

(SEC)

Consumers and

Suppliers

The Press

& Mkt Partic.

Auditors

& Creditors

The

Board

The nexus of contracts between various stakeholders

and the (management of the) Firm

Management deals with daily operations, while

Governance is a set of policies and business processes that set the

way that the organization’s business is run. And includes the

underlying ethics of a corporation.

Poor management (PM) and Weak Gov (WG) can affect governance

Weak governance (WG) undermines the financial and

operational performance of a corporation

Weak governance affects investors’ faith in the company.

As a consequence, PM and WG affect share prices and the Value of the firms.

Management vs. Governance

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Governance and Agency:

Corporate Governance

• Corporate governance refers to the rules, processes, and

laws by which companies are operated, controlled, and

regulated.

• It defines the rights and responsibilities of the corporate

participants such as the shareholders, board of directors,

officers and managers, and other stakeholders, as well as

the rules and procedures for making corporate decisions.

• The structure of corporate governance was previously

described in Figure 1.1.

CIPE ©

2008

3

0

Corporate Governance Business Ethics

CORE VALUES

• Transparency

• Fairness

• Accountability

• Responsibility

Structure of decision-making Guide for behavior

Questions we would like to answer

in this course:

1. How financial markets determine asset prices?

2. How corporations make financial decisions?

• Investments:

– What projects to invest in?

• Financing:

– How to finance a project?

• Payout:

– What to pay back to shareholders?

• Risk management:

– What risk to take or to avoid and how?

© 2012 Pearson Prentice Hall. All rights reserved. 1-31

Function of Financial Manager

Operations

(plant,

equipment,

projects)

Financial

Manager

Financial

Markets

(investors)

1a.Raising

funds 2.Investments

3.Cash from

operational

activities

4.Reinvesting

1b.Obligations

(stocks, debt

securities)

5.Dividends or

interest

payments

Finance function – managing the cash flow

© 2012 Pearson Prentice Hall. All rights reserved. 1-33

Legal Forms of Business

Organization

• A sole proprietorship is a business owned by one person and operated for his or

her own profit. The sole proprietorship is not a legal entity. It simply refers to a

person who owns the business and is personally responsible for its debts

(disadvantage). Taxation is quite simple. The income earned by a sole

proprietorship is income earned by its owner.

• A partnership is a business owned by two or more people and operated for

profit.

• A corporation is an entity created by law. Corporations have the legal powers of

an individual in that it can sue and be sued, make and be party to contracts, and

acquire property in its own name.

• It might be the case that a simple family business may end up with a large public

limited liability company (corporation) with many shareholders.

© 2012 Pearson Prentice Hall. All rights reserved. 1-34

Table 1.1 Strengths and Weaknesses of the

Common Legal Forms of Business Organization

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Goal of the Firm:

Maximize Profit?

Profit maximization may not lead to the highest possible share price

for at least three reasons:

1. Timing is important—the receipt of funds sooner rather than later is preferred

2. Profits do not necessarily result in cash flows available to stockholders

3. Profit maximization fails to account for risk

Which Investment is Preferred?

Which Investment is Preferred in

terms of the profit maximization?

In terms of the profit maximization goal, Valve would

be preferred over Rotor because it results in higher

total EPS over the 3-year period.

. But what about risk? Which one is riskier?

. Which one would you prefer if timing (liquidity) is

important to you?

© 2012 Pearson Prentice Hall. All rights reserved. 1-36

© 2012 Pearson Prentice Hall. All rights reserved.

1-37

Rotor Valve (A-A5)^2 (B-B5)^2

1.4 0.6 0.217778 0.16

1 1 0.004444 0

0.4 1.4 0.284444 0.16

0.933333 1 0.253333 0.16 variance

0.503322 0.4 standard deviation

average EPS

Which Investment is Preferred in terms of

Risk? A-Rotor or B-Valve?

Coefficient of Variation (CV)

The coefficient of variation, CV, is a measure of spread

that describes the amount of variability of data relative

to its mean. It has no units and as such, we can use

it as an alternative to the standard deviation to

compare the variability of data sets that have different

means.

CV(x)=S(x)/x̄

Where S(x) is the standard deviation of a variable x,

and x̄ is the mean (or average) value of the variable.

© 2012 Pearson Prentice Hall. All rights reserved. 1-38

Coefficient of variation:

interpretation and usefulness

The coefficient of variation (COV) is the ratio of the standard deviation of a data set to

the expected mean. Investors use it to determine whether the expected return of the

investment is worth the degree of volatility, or the downside risk, that it may experience

over time.

The coefficient of variation is helpful when using the risk/reward ratio to select

investments. For example, an investor who is risk-averse may want to consider assets

with a historically low degree of volatility relative to the return, in relation to the overall

market or its industry. Conversely, risk-seeking investors may look to invest in assets

with a historically high degree of volatility.

An investor can calculate the coefficient of variation to help determine whether an

investment’s expected return is worth the volatility it is likely to experience over time.

A lower ratio suggests a more favorable tradeoff between risk and return.

A higher ratio might be unacceptable to a conservative or “risk-averse” investor.

1-39

Range = max – min

1-40

Alternative

Invetsment

Year 1 Year 2 Year 3 a). SUM b). Range c). TVM

A 21000 15000 10000 46000 11000 A

B 20000 25000 21000 66000 5000

C 9000 15000 21000 45000 12000

D 17000 15000 19000 51000 4000

a). An investor seeking to profir maximazation would choose the investment with the higher final

value over the 3 years. In the above example, she would choose investment B with 66,000 aed

b). An investor who is risk-averse would choose the investment with the lower risk. There are

various risk measures such as variance, standard deviation, coefficient of variation and range.

Range is the difference between the highest expected cash flow and lowest expected

cash flow for each investment alternative. The higher the value of the Range, the higher the risk

of the investment. Hence, a risk-averse investor would choose the investment with the lowest

value of range. In this example, a risk-averse investor would prefer investment D with 4,000 aed range.

c). If an investor is looking for an investment with the higher expected cash flow the first year (first

principle of finance TVM) she would choose investment A or investment D. However, investment A’s first

year expected cash flow is 21,000 aed, higher that investment’s D 17,000 aed. Therefere, she would

choose investment A.

Year

Marginal Cost-Benefit Analysis

Marginal Cost-Benefit Analysis is the primary

economic principle used in Corporate Finance

according to which financial decisions should be

made and actions taken only when the added

benefits exceed the added costs.

Take a decision IF added benefits > the added

costs

Figure 1.1 Corporate Organization

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Governance and Agency:

Government Regulation

• Government regulation generally shapes the corporate

governance of all firms and requires from them to diffuse

all relevant information relating to their performance.

• During the recent decade, corporate governance has

received increased attention due to several high-profile

corporate scandals involving abuse of corporate power

and, in some cases, alleged criminal activity by corporate

officers.

© 2012 Pearson Prentice Hall. All rights reserved. 1-44

Governance and Agency:

The Agency Issue

• A principal-agent relationship is an arrangement in

which an agent acts on the behalf of a principal. For

example, shareholders of a company (principals) elect

management (agents) to act on their behalf.

• Agency problems arise when managers place personal

goals ahead of the goals of shareholders.

• Agency costs arise from agency problems that are borne

by shareholders and represent a loss of shareholder

wealth.

© 2012 Pearson Prentice Hall. All rights reserved. 1-45

The Agency Issue:

Management Compensation Plans

• In addition to the roles played by corporate boards,

institutional investors, and government regulations,

corporate governance can be strengthened by ensuring

that managers’ interests are aligned with those of

shareholders.

• A common approach is to structure management

compensation to correspond with firm performance.

© 2012 Pearson Prentice Hall. All rights reserved. 1-46

The Agency Issue:

Management Compensation Plans

• Incentive plans are management compensation plans that

tie management compensation to share price; one example

involves the granting of stock options.

• Performance plans tie management compensation to

measures such as EPS or growth in EPS. Performance

shares and/or cash bonuses are used as compensation

under these plans.

Short-term and long-term

Decisions

1.1 What is Corporate Finance?

1.2 The Goal of Financial Management

(Decisions made to achieve the goal)

1.1 Capital Budgeting

Corporate Finance addresses the

following three questions:

1. What long-term investments should the firm

choose? CAPITAL BUDGETING

CB is used to describe the process of making

and managing expenditures on long-term

assets.

1.1 Capital Structure

2. How can the firm raise cash for required

capital expenditures? CAPITAL

STRUCTURE.

CS represents the proportions of the firm’s

financing from current and long-term debt and

equity.

1.1 Net Working Capital

3. How should short-term operating cash flows

be managed? NET WORKING CAPITAL.

NWC is the management of the mismatching

between the timing of cash inflows and cash

outflows. NWC is defined as Current Assets

minus Current Liabilities.

Balance Sheet Model of the Firm

Fixed Assets

1 Tangible (e.g.

machinery,

equipment)

2 Intangible

(e.g. patents,

trademarks)

Current Assets

(short-term

assets)

Total Value of Assets:

Shareholders’

Equity

Current

Liabilities

Long-Term

Debt

Total Firm Value to Investors:

The Capital Budgeting Decision

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders’

Equity

Current

Liabilities

Long-Term

Debt

What long-term

investments

should the firm

choose?

The Capital Structure Decision

How should the

firm raise funds

for the selected

investments?

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders’

Equity

Current

Liabilities

Long-Term

Debt

Short-Term Asset Management

How should

short-term assets

be managed and

financed?

Net

Working

Capital

Shareholders’

Equity

Current

Liabilities

Long-Term

Debt

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Corporation’s Management

Decisions

Capital budgeting

– What long-term investments or projects should the

business take on?

Capital structure

– How should we pay for our assets?

– Should we use debt or equity?

Working capital management

– How do we manage the day-to-day finances of the

firm?

Risk Management

– Use of derivative securities

Example

• Current Assets: AED 50 billion

• Current Liabilities: AED 40 billion

• Non-Current Assets:

• Tangible: AED 40 billion

• Intangible: AED 0.5 billion

• THEN:

• NWC = 50 – 40 = AED 10 billion

• Total Value of Assets = 50 + 40 + 0.5 = AED 90.5 bil.

• Total Value of firm to investors = 40 + Shareholders Equity

(=90.5 – 40 = 50.5, that is the Residual Claim)

Corporate Securities as Contingent

Claims on Total Firm Value

The basic feature of a debt is that it is a

promise by the borrowing firm to repay a

fixed dollar amount of by a certain date.

The shareholder’s claim on firm value is

the residual amount that remains after the

debtholders are paid.

If the value of the firm is less than the

amount promised to the debtholders, the

shareholders get nothing.

“The shareholder’s claim on firm value is the residual

amount …”: Example

For example, a firm might be having several factors

engaged directly or indirectly in production, such as

laborers, suppliers, bondholders, shareholders, etc.

The firm owes definite amounts to factors like

laborers, suppliers, etc. in order to compensate them

for the services provided. After making payment to all

other parties, the shareholders might be receiving

payment in the end, i.e., they might be receiving the

residual amount. Therefore, in this case, the

shareholders will be considered as the residual

claimants.

© 2012 Pearson Prentice Hall. All rights reserved. 1-58

Debt and Equity as Contingent Claims

$F

$F

Payoff to

debt holders

Value of the firm (X)

Debt holders are promised $F.

If the value of the firm is less than $F, they

get the whatever the firm if worth.

If the value of the firm

is more than $F, debt

holders get a

maximum of $F.

$F

Payoff to

shareholders

Value of the firm (X)

If the value of the

firm is less than $X,

share holders get

nothing.

If the value of the firm

is more than $F, share

holders get everything

Algebraically, the bondholder’s above $F.

claim is: Min[$F,$X] Algebraically, the shareholder’s

claim is: Max[0,$X – $F]

Combined Payoffs to Debt and Equity

$F

$F

Combined Payoffs to debt holders

and shareholders

Value of the firm (X)

Debt holders are promised $F.

Payoff to debt holders

Payoff to shareholders

If the value of the firm is less than

$F, the shareholder’s claim is:

Max[0,$X – $F] = $0 and the debt

holder’s claim is Min[$F,$X] = $X.

The sum of these is = $X

If the value of the firm is more than

$F, the shareholder’s claim is:

Max[0,$X – $F] = $X – $F and the

debt holder’s claim is:

Min[$F,$X] = $F.

The sum of these is = $X

Questions: After studying these slides you should

be able to answer the following questions …

Q1. Present and discuss the 4 principles in Finance (simple reference 20%

of the grade).

Q2. (a) What is the priority of a Manager seeking Profit maximization as the

goal of the firm? (b) Why Profit maximization as the goal of the firm is not

ideal? (c) Which investment’s characteristics should be taken into

consideration by a financial manager when evaluating decision alternatives

or potential actions? (d) What is the goal of business ethics

Q3. (a) Define Corporate Governance. (b) What are the consequences of a

poor management and a weak governance to the value of the firm?

© 2012 Pearson Prentice Hall. All rights reserved. 1-61

Questions …

Q4. A financial manager must choose between four alternative investments: 1, 2, 3,

and 4. Each investment costs $35,000 and is expected to provide earnings over a

three-year period as described below.

Y-1 Y-2 Y-3

Investment 1: 21,000; 15,000; 6,000;

Investment 2: 20,000; 15,000; 20,000;

Investment 3: 9,000; 20,000; 19,000; and

Investment 4: 7,000; 14,000, 9,000.

Based on the profit maximization goal, the financial manager would choose

……………., while based on the time value of money, the manager should choose

……………. If the manager is risk-averse which investment should avoid …………

and which one to choose …….

© 2012 Pearson Prentice Hall. All rights reserved. 1-62

Questions …

Q5. (a) Define agency problems and name two special

cases. (b) Define Agency costs.

Q6. A firm has just ended its calendar year making a

sale in the amount of $150,000 of merchandise

purchased during the year at a total cost of

$112,500. Although the firm paid in full for the

merchandise during the year, it has yet to collect at

year end from the customer. Calculate the net profit

and cash flow from this sale for the year.

© 2012 Pearson Prentice Hall. All rights reserved. 1-63

Questions.

Q7. Define Capital Budgeting, Capital Structre and Newt Working

Capital

Q8. Given the following information

Current Assets: AED 50 billion

Current Liabilities: AED 40 billion

Non-Current Assets:

Tangible: AED 40 billion

Intangible: AED 0.5 billion

Calculate, the Net Working Capital, the Total Value of Assets, the

Shareholders equity and the Total Value of firm to investors.

© 2012 Pearson Prentice Hall. All rights reserved. 1-64

Agency Problems and

Asymmetric Information

Principles of Managerial Finance

Asymmetric Information: Adverse Selection

and Moral Hazard

• Asymmetric information occurs when one party to a transaction has

more information than the other. We focus on two specific forms:

• Adverse selection

• Moral hazard

• The analysis of how asymmetric information problems affect

behavior is known as agency theory.

Asymmetric Information: Adverse Selection and Moral Hazard

• Adverse Selection

1. Occurs when one party in a transaction has better information than the

other party

2. Before transaction occurs

3. Potential borrowers most likely to produce adverse outcome are ones

most likely to seek loan and be selected

Asymmetric Information: Adverse Selection and Moral Hazard

• Moral Hazard

1. Occurs when one party has an incentive to behave differently once an

agreement is made between parties

2. After transaction occurs

3. Hazard that borrower has incentives to engage in undesirable (immoral)

activities making it more likely they won’t pay loan back

The Lemons Problem: How Adverse Selection Influences Financial

Structure

• Lemons Problem in Used Cars

1. If we can’t distinguish between “good” and “bad” (lemons) used cars, we

are only willing to pay the average price.

2. Result: Good cars won’t be sold, and the used car market will function

inefficiently.

• What helps us avoid this problem with used cars?

15-70

The Lemons Problem: How Adverse Selection Influences Financial

Structure

• Lemons Problem in Securities Markets

1. If we can’t distinguish between good and bad securities, we are only

willing to pay for the average of good and bad securities’ value.

2. Result: Good securities are undervalued and firms won’t issue them; bad

securities are overvalued so too many are issued

3. Investors won’t want to buy bad securities, so market won’t function well,

and as a result we observe that:

• Stocks are not the most important source of finance.

• Marketable securities are not the primary funding source.

15-71

Tools to Help Solve Adverse Selection (Lemons) Problems

1. Private Production and Sale of Information

– Free-rider problem interferes with this solution

2. Government Regulation to Increase Information

– For example, annual audits of public corporations (although Enron is a

shining example of why this does not eliminate the problem)

In economics, the free-rider problem occurs when those who benefit from

resources, public goods, or services do not pay for them, which results in

an under-provision of those goods or services. For example, a free-rider

may frequently ask for available parking lots (public goods) from those who

have already paid for them, in order to benefit from free parking.

15-72

Tools to Help Solve Adverse Selection (Lemons) Problems

3. Financial Intermediation

Analogy to solution to lemons problem provided by used car

dealers

4. Avoid free-rider problem by making private loans

Indirect finance is far more important than direct finance. Banks

are the most important source of external finance.

5. Collateral and Net Worth

Collateral is a prevalent feature of debt contracts.

15-73

How Moral Hazard Affects the Choice Between Debt and

Equity Contracts

• Moral Hazard in Equity Contracts:

the Principal-Agent Problem

1. Result of separation of ownership by stockholders (principals) from control

by managers (agents)

2. Managers act in their own rather than stockholders’ interest

How Moral Hazard Affects the Choice Between Debt and

Equity Contracts

Suppose you become a silent partner in an ice cream store,

providing 90% of the equity capital ($9,000).

The other owner, Steve, provides the remaining $1,000 and will act

as the manager.

If Steve works hard, the store will make $50,000 after expenses,

and you are entitled to $45,000 of the profits.

How Moral Hazard Affects the Choice Between Debt and

Equity Contracts

However, Steve doesn’t really value the $5,000 (his part), so he

goes to the beach, relaxes, and even spends some of the “profit”

on art for his office.

How do you, as a 90% owner, give Steve the proper incentives to

work hard?

How Moral Hazard Affects the Choice Between Debt and

Equity Contracts

• Tools to Help Solve the Principal-Agent Problem:

1.Production of Information: Monitoring

Costly State Verification makes equity less desirable than debt

2.Government Regulation to Increase Information

3.Financial Intermediation (e.g, venture capital)

4.Debt Contracts

• This explains why debt is used more than equity

How Moral Hazard Influences Financial Structure in Debt

Markets

• Even with the advantages just described, debt is still subject to moral

hazard. In fact, debt may create an incentive to take on very risky

projects. This is very important to understand and partially explains

the recent financial crisis.

How Moral Hazard Influences Financial Structure in Debt

Markets

• Most debt contracts require the borrower to pay a fixed amount

(interest) and keep any cash flow above this amount.

• What if General Growth owes $100m in interest and principle, but

only has $90m in assets? It is bankrupt. The firm “has nothing to

lose” by looking for “risky” projects to raise the needed cash.

How Moral Hazard Influences Financial Structure in Debt

Markets

• Tools to Help Solve Moral Hazard in Debt Contracts

1. Net Worth

2. Monitoring and Enforcement of Restrictive Covenants.

3. Financial Intermediation—banks and other intermediaries have special

advantages in monitoring

15-80

Asymmetric Information Problems and Tools to Solve Them

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Chapter 6: Bonds

LG1 Review the legal aspects of bond financing and bond cost.

LG2 Discuss the general features, yields, prices, popular types, and

international issues of corporate bonds.

LG3 Understand the key inputs and basic model used in the

valuation process, assess the impact of factors affecting the

Demand for and Supply of Bonds, and appreciate the impact of

inflation (Fisher Effect).

LG4 Apply the basic valuation model to bonds and describe the

impact of required return and time to maturity on bond values.

LG5 Explain yield to maturity (YTM), its calculation, and the

procedure used to value bonds that pay interest semiannually.

Chapter 6_BONDS

Learning Objectives

After reading this chapter, you will understand

the price-yield relationship of a bond, and estimate the

price of a bond

the factors that affect the price volatility of a bond

when yields change

the price-volatility properties of a bond

how to calculate and interpret the Macaulay duration,

modified duration, and dollar duration of a bond

why duration is a measure of a bond’s price sensitivity

to yield changes

Learning Objectives (continued)

After reading this chapter, you will understand

limitations of using duration as a measure of price

volatility

how price change estimated by duration can be adjusted

for a bond’s convexity

how to approximate the duration and convexity of a bond

the duration of an inverse floater

And you will be able to perform all these calculations

with EXCEL’s functions with numerical problems.

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Interest Rates and Required Returns: Interest

Rate Fundamentals

•The interest rate is usually applied to debt

instruments such as bank loans or bonds; the

compensation paid by the borrower of funds to the

lender; from the borrower’s point of view, the cost of

borrowing funds.

•The required return is usually applied to equity

instruments such as common stock; the cost of funds

obtained by selling an ownership interest.

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Interest Rates and Required Returns: Interest

Rate Fundamentals

• Several factors can influence the equilibrium interest rate:

1. Inflation, which is a rising trend in the prices of most goods and

services.

2. Risk, which leads investors to expect a higher return on their

investment

3. Liquidity preference, which refers to the general tendency of

investors to prefer short-term securities

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Matter of Fact

• Fear Turns T-bill Rates Negative

• Near the height of the financial crisis in December 2008, interest rates

on Treasury bills briefly turned negative, meaning that investors paid

more to the Treasury than the Treasury promised to pay back.

• Why would anyone put their money into an investment that they know

will lose money?

• Remember that 2008 saw the demise of Lehman Brothers, and fears

that other commercial banks and investments banks might fail were

rampant.

• Evidently, some investors were willing to pay the U.S. Treasury to

keep their money safe for a short time.

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Interest Rates and Required Returns: The

Real Rate of Interest

•The real rate of interest is the rate that creates

equilibrium between the supply of savings and the

demand for investment funds in a perfect world,

without inflation, where suppliers and demanders of

funds have no liquidity preferences and there is no

risk.

•The real rate of interest changes with changing

economic conditions, tastes, and preferences.

•The supply-demand relationship that determines the

real rate is shown in Figure 6.1 on the following

slide.

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Interest Rates and Required Returns:

Nominal or Actual Rate of Interest (Return)

• The nominal rate of interest is the actual rate of interest

charged by the supplier of funds and paid by the demander.

• The nominal rate differs from the real rate of interest, r* as a

result of two factors:

• Inflationary expectations reflected in an inflation premium (IP), and

• Issuer and issue characteristics such as default risks and contractual

provisions as reflected in a risk premium (RP).

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Interest Rates and Required Returns:

Nominal or Actual Rate of Interest (cont.)

• The nominal rate of interest for security 1, r1

, is given by the

following equation:

• The nominal rate can be viewed as having two basic

components: a risk-free rate of return, RF

, and a risk

premium, RP1

:

r1 = RF + RP1

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Interest Rates and Required Returns:

Nominal or Actual Rate of Interest (cont.)

• For the moment, ignore the risk premium, RP1

, and focus

exclusively on the risk-free rate. The risk free rate can be

represented as:

RF = r* + IP

• The risk-free rate (as shown in the preceding equation)

embodies the real rate of interest plus the expected inflation

premium.

• The inflation premium is driven by investors’ expectations

about inflation—the more inflation they expect, the higher

will be the inflation premium and the higher will be the

nominal interest rate.

Interest Rates:

“Nominal” vs. “Real” rates

r = represents any nominal rate

r* = represents the “real” risk-free rate of interest. Like a T-bill rate, if

there was no inflation. Typically ranges from 1% to 4% per year.

rRF = represents the rate of interest on Treasury securities.

Determinants of interest rates

r = r* + IP + DRP + LP + MRP

r = required return on a debt security

r* = real risk-free rate of interest

IP = inflation premium

DRP = default risk premium

LP = liquidity premium

MRP = maturity risk premium

Premiums added to r* for different

types of debt

IP MR

P

DR

P

LP

S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate

1

5

Bond Features

What is a bond –

debt issued by a corporation or a governmental body.

A bond represents a loan made by investors to the issuer.

In return for his/her money, the investor receives a legal claim on future cash

flows of the borrower.

The issuer promises to:

make regular coupon payments every period until the bond matures, and

pay the face (par) value of the bond when it matures.

Default

an issuer who fails to pay is subject to legal action on behalf of the lenders

(bondholders).

6-95

Why do investors buy bonds?

Investors buy bonds because:

•They provide a predictable income stream (coupon payment).

•If the bonds are held to maturity, bondholders get back the

entire principal (or face value), so bonds are a way to preserve

capital while investing.

•Bonds can help offset exposure to more volatile stock holdings.

Companies, governments and municipalities issue bonds to

get money for various things, which may include:

•Providing operating cash flow

•Financing debt

•Funding capital investments in schools, highways, hospitals,

and other projects

96

Examples

– Pure Discount Bonds

Q1. Consider a zero-coupon bond, with a face value of $1,000, maturing in 5 years. Suppose that the

appropriate discount rate is 8%. What is the current value of the bond?

A1. This is a simple TVM problem:

PV = F / (1 + r)T = 1,000 / (1.08)5 = $

Q2. Suppose 6 months have passed. What is the bond value now?

A1. PV = F / (1 + r)T = 1,000 / (1.08)4.5 = $

Note: As we get closer to maturity(T), the z.c. bond value increases (PV), since we have to wait less

time to receive $1,000

Bond Valuation

1). With bonds two “rates” that are involved:

(i) the coupon rate and

(ii) the Yield-To-Maturity (YTM) or discount rate.

The discount rate can take on many names — market rate of interest, interest rate, rate of return,

required return and yield-to-maturity, weighted average cost of capital — they all mean the same

thing. With bonds think of the coupon payment as a cash flow. The coupon rate tells us what our

yearly payment will be. It is not a rate of return and it doesn’t change over time.

The discount rate (or yield-to-maturity in bonds’ terminology) tells us what rate of return we

want to earn on our investment in this bond. It can (and will) change over time — sometimes

increasing and sometimes decreasing — depending on market conditions such as the inflation or

the default of the issuer.

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4

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9

8

Review of the Price-Yield Relationship for

Bonds

As illustrated in Exhibit 4-1:

An increase in the required yield decreases the present value

of its expected cash flows and therefore decreases the

bond’s price, and vis versa.

YTM leads to PV(bond) and Price of the bond

As shown in the diagram in the Exhibit 4-2:

The price-yield relation is negative, and not linear.

The shape of the price-yield relationship for any bond is

referred to as a convex relationship.

4

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9

9

Exhibit 4-1 Price–Yield Relationship for Six Hypothetical Bonds

Required

Yield (%)

Price at Required Yield (coupon/maturity in years)

9% / 5 9% / 25 6% / 5 6% / 25 0% / 5 0% / 25

6.00 112.7953 138.5946 100.0000 100.0000 74.4094 22.8107

7.00 108.3166 123.4556 95.8417 88.2722 70.8919 17.9053

8.00 104.0554 110.7410 91.8891 78.5178 67.5564 14.0713

8.50 102.0027 105.1482 89.9864 74.2587 65.9537 12.4795

8.90 100.3966 100.9961 88.4983 71.1105 64.7017 11.3391

8.99 100.0395 100.0988 88.1676 70.4318 64.4236 11.0975

9.00 100.0000 100.0000 88.1309 70.3570 64.3928 11.0710

9.01 99.9604 99.9013 88.0943 70.2824 64.3620 11.0445

9.10 99.6053 99.0199 87.7654 69.6164 64.0855 10.8093

9.50 98.0459 95.2539 86.3214 66.7773 62.8723 9.8242

10.00 96.1391 90.8720 84.5565 63.4881 61.3913 8.7204

11.00 92.4624 83.0685 81.1559 57.6712 58.5431 6.8767

12.00 88.9599 76.3572 77.9197 52.7144 55.8395 5.4288

4

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1

0

0

Exhibit 4-2

Shape of Price-Yield Relationship for an

Option-Free Bond Price

Maximum

Price

Yield

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reserved.

5-101

Risk Structure

of Long Bonds in the U.S.

Term Structure of Interest Rates

• Bonds with identical risk, liquidity, and tax characteristics may have

different interest rates because the time remaining to maturity is

different

Term Structure of Interest Rates_ Yield

curve

• Yield curve: a plot of the yield on bonds with differing terms to

maturity but the same risk, liquidity and tax considerations

• Upward-sloping: long-term rates are above

short-term rates (occurs frequently)

• Flat: short- and long-term rates are the same

• Inverted: long-term rates are below short-term rates (occurs infrequently)

Yield curve (YC) and firm’s financing decision

1. An inverted YC (also called downward-sloping) is often a sign

that the economy is weakening.

2. A financial manager who faces a downward-sloping curve may

be tempted to rely more heavily on cheaper, long-term

financing. A risk in that strategy is that interest rates may fall

in the future, so long-term rates that seem cheap today may

be more expensive tomorrow.

3. A financial manager who faces an upward-sloping curve may

feel that it is wise to use cheaper, short-term financing.

Facts Theory of the Term Structure of Interest Rates

Must Explain

1. Interest rates on bonds of different maturities move together over

time

2. When short-term interest rates are low, yield curves are more likely to

have an upward slope; when short-term rates are high, yield curves

are more likely to slope downward and be inverted

3. Yield curves almost always slope upward

Theories explaining yield curve

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a. According to the expectations theory, the yield curve reflects investor expectations about future

interest rates, with the differences based on inflation expectations. The curve can take any of the

three forms. An upward-sloping curve is the result of increasing inflationary expectations, and

vice versa.

b. The liquidity preference theory is an explanation for the upward-sloping yield curve. This theory

states that long-term rates are generally higher than short-term rates due to the desire of investors

for greater liquidity, and thus a premium must be offered to attract adequate long-term

investment.

c. The market segmentation theory is another theory that can explain any of the three curve shapes.

Since the market for loans can be segmented based on maturity, sources of supply and demand for

loans within each segment determine the prevailing interest rate. If supply is greater than demand

for short-term funds at a time when demand for long-term loans is higher than the supply of

funding, the yield curve would be upward sloping. Obviously, the reverse also holds true.

4

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7

Price Volatility Characteristics of Bonds

(i)Although the prices of bonds move in the opposite direction from the

change in yield required, the percentage price change is not the same for

all bonds (it depends on the convexity of the bond).

(ii)For very small changes in the yield required, the percentage price change

for a given bond is roughly the same, whether the yield required increases

or decreases.

(iii)For large changes in the required yield, the percentage price change is

not the same for an increase in the required yield as it is for a decrease in

the required yield.

(iv)For a given large change in basis points, the percentage price increase is

greater than the percentage price decrease.

An explanation for these four properties of bond price volatility

lies in the convex shape of the price-yield relationship.

4

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8

Characteristics of a Bond that Affect its Price

Volatility: Coupon and YTM

There are two characteristics of an bond that determine its price

volatility: coupon and term to maturity.

1) First, for a given term to maturity and initial yield, the price

volatility of a bond is greater, the lower the coupon rate.

This characteristic can be seen by comparing the 9%, 6%, and

zero-coupon bonds with the same maturity (see Exhibit 4-3).

2) Second, for a given coupon rate and initial yield, the longer the

term to maturity, the greater the price volatility. The price

sensitivity increases with bond’s maturity but at a decreasing

rate.

This can be seen in Exhibit 4-3 by comparing the five-year bonds

with the 25-year bonds with the same coupon.

4

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9

EXHIBIT 4-3 Instantaneous Percentage Price Change for Six Hypothetical Bonds

Six hypothetical bonds, priced initially to yield 9%:

9% coupon, 5 years to maturity, price = 100.0000

9% coupon, 25 years to maturity, price = 100.000

6% coupon, 5 years to maturity, price = 88.1309

6% coupon, 25 years to maturity, price = 70.3570

0% coupon, 5 years to maturity, price = 64.3928

0% coupon, 25 years to maturity, price = 11.0710

Yield (%)

Change to:

Change in

Basis Points

Percentage Price Change (coupon/maturity in years)

9% / 5 9% / 25 6% / 5 6% / 25 0% / 5 0% / 25

6.00 -300 12.80 38.59 13.47 42.13 15.56 106.04

7.00 -200 8.32 23.46 8.75 25.46 10.09 61.73

8.00 -100 4.06 10.74 4.26 11.60 4.91 27.10

8.50 -50 2.00 5.15 2.11 5.55 2.42 12.72

8.90 -10 0.40 1.00 0.42 1.07 0.48 2.42

8.99 -1 0.04 0.10 0.04 0.11 0.05 0.24

9.01 1 -0.04 -0.10 -0.04 -0.11 -0.05 -0.24

9.10 10 -0.39 -0.98 -0.41 -1.05 -0.48 -2.36

9.50 50 -1.95 -4.75 -2.05 -5.09 -2.36 -11.26

10.00 100 -3.86 -9.13 -4.06 -9.76 -4.66 -21.23

11.00 200 -7.54 -16.93 -7.91 -18.03 -9.08 -37.89

12.00 300 -11.04 -23.64 -11.59 -25.08 -13.28 -50.96

4

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1

1

0

Price Volatility Characteristics:

Effects of Yield to Maturity

Holding other factors constant, the higher the YTM at which a bond trades, the

lower the price volatility.

To see this, compare the 9% 25-year bond trading at various yield levels in

Exhibit 4-4 .

The 1st column of Exhibit 4-4 shows the yield level the bond is trading at, and the

2

nd column gives the initial price.

The 3rd column of Exhibit 4-4 indicates the bond’s price if yields change by 100

basis points.

The 4th and 5th columns of Exhibit 4-4 show the dollar price decline and the

percentage price decline.

The 4th and 5th columns of Exhibit 4-4 also show: higher the initial yield, the

lower the price volatility.

An implication of this is that for a given change in yields, price volatility is

greater (lower) when yield levels in the market are low (high).

4

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1

1

1

EXHIBIT 4-4 Price Change for a 100-Basis-Point Change in Yield for a 9% 25-Year

Bond Trading at Different Yield Levels

Yield Level (%) Initial Price New Price a Price Decline Percent Decline

7 $123.46 $110.74 $12.72 10.30

8 110.74 100.00 10.74 9.70

9 100.00 90.87 9.13 9.13

10 90.87 83.07 7.80 8.58

11 83.07 76.36 6.71 8.08

12 76.36 70.55 5.81 7.61

13 70.55 65.50 5.05 7.16

14 65.50 61.08 4.42 6.75

8 110.74 100.00 10.74 9.70

Price volatility is greater (lower) when YTM levels in the market are low (high).

1

1

2

Some Tips on Bond Pricing

Bond prices and market interest rates move in

opposite directions.

When coupon rate = market rate (r) => price = par value.

(par bond)

When coupon rate > market rate (r) => price > par value

(premium bond)

When coupon rate < market rate (r) => price < par value

(discount bond)

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Interest Rates and Required Returns:

• The interest rate is usually applied to debt instruments such

as bank loans or bonds; the compensation paid by the

borrower of funds to the lender; from the borrower’s point of

view, the cost of borrowing funds.

• The required return is usually applied to equity instruments

such as common stock; the cost of funds obtained by selling

an ownership interest.

• Several factors can influence the equilibrium interest rate:

1. Inflation, which is a rising trend in the prices of most goods and services.

2. Risk, which leads investors to expect a higher return on their investment

3. Liquidity preference, which refers to the general tendency of investors to

prefer short-term securities

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Risk Premiums: Issue and Issuer

Characteristics

Applying the general valuation formula to a

bond

• What component of a bond represents the future cash flows?

• Coupon Payment: The amount the holder of the bond receives in interest at the

end of each specified period.

• The Par Value: The amount that will be repaid to the purchaser at the end of the

debt agreement.

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Corporate Bonds

• A corporate bond is a long-term debt instrument indicating

that a corporation has borrowed a certain amount of money

and promises to repay it in the future under clearly defined

terms.

• The bond’s coupon interest rate is the percentage of a

bond’s par value that will be paid annually, typically in two

equal semiannual payments, as interest.

• The bond’s par / face value, is the amount borrowed by the

company and the amount owed to the bond holder on the

maturity date.

• The bond’s maturity date is the time at which a bond

becomes due and the principal must be repaid.

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Corporate Bonds: Legal Aspects of

Corporate Bonds

• The bond indenture is a legal document that specifies both

the rights of the bondholders and the duties of the issuing

corporation.

• Standard debt provisions are provisions in a bond indenture

specifying certain record-keeping and general business

practices that the bond issuer must follow; normally, they do

not place a burden on a financially sound business.

• Restrictive covenants are provisions in a bond indenture

that place operating and financial constraints on the

borrower.

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Corporate Bonds: Legal Aspects of

Corporate Bonds (cont.)

The most common restrictive covenants do the following:

1. Require a minimum level of liquidity, to ensure against loan

default.

2. Prohibit the sale of accounts receivable to generate cash. Selling

receivables could cause a long-run cash shortage if proceeds were

used to meet current obligations.

3. Impose fixed-asset restrictions. The borrower must maintain a

specified level of fixed assets to guarantee its ability to repay the

bonds.

4. Constrain subsequent borrowing. Additional long-term debt may

be prohibited, or additional borrowing may be subordinated to the

original loan. Subordination means that subsequent creditors

agree to wait until all claims of the senior debt are satisfied.

5. Limit the firm’s annual cash dividend payments to a specified

percentage or amount.

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Corporate Bonds: Legal Aspects of

Corporate Bonds (cont.)

• Subordination in a bond indenture is the stipulation that

subsequent creditors agree to wait until all claims of the

senior debt are satisfied.

• Sinking fund requirements are a restrictive provision often

included in a bond indenture, providing for the systematic

retirement of bonds prior to their maturity.

• A trustee is a paid individual, corporation, or commercial

bank trust department that acts as the third party to a bond

indenture and can take specified actions on behalf of the

bondholders if the terms of the indenture are violated.

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Corporate Bonds:

Cost of Bonds to the Issuer

•In general, the longer the bond’s maturity, the higher

the interest rate (or cost) to the firm.

•In addition, the larger the size of the offering, the

lower will be the cost (in % terms) of the bond.

•Also, the greater the default risk of the issuing firm,

the higher the cost of the issue.

•Finally, the cost of money in the capital market is

the basis form determining a bond’s coupon interest

rate.

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Corporate Bonds:

General Features of a Bond Issue

• The conversion feature of convertible bonds allows

bondholders to change each bond into a stated number of

shares of common stock.

• Bondholders will exercise this option only when the market price of

the stock is greater than the conversion price.

• A call feature, which is included in nearly all corporate bond

issues, gives the issuer the opportunity to repurchase bonds at

a stated call price prior to maturity.

• The call price is the stated price at which a bond may be repurchased,

by use of a call feature, prior to maturity.

• The call premium is the amount by which a bond’s call price exceeds

its par value.

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Corporate Bonds: General Features of a

Bond Issue (cont.)

•In general, the call premium is equal to one year of

coupon interest and compensates the holder for

having it called prior to maturity.

•Furthermore, issuers will exercise the call feature

when interest rates fall and the issuer can refund the

issue at a lower cost.

•Issuers typically must pay a higher rate to investors

for the call feature compared to issues without the

feature.

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Corporate Bonds: General Features of a

Bond Issue (cont.)

•Bonds also are occasionally issued with stock

purchase warrants, which are instruments that give

their holders the right to purchase a certain number

of shares of the issuer’s common stock at a specified

price over a certain period of time. Occasionally

attached to bonds as “sweeteners.”

•Including warrants typically allows the firm to raise

debt capital at a lower cost than would be possible in

their absence.

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Corporate Bonds: Bond Yields

The three most widely cited yields are:

• Current yield

• Yield to maturity (YTM)

• Yield to call (YTC)

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Corporate Bonds: Bond Prices

• Because most corporate bonds are purchased and held by

institutional investors, such as banks, insurance companies,

and mutual funds, rather than individual investors, bond

trading and price data are not readily available to individuals.

• Although most corporate bonds are issued with a par, or face,

value of $1,000, all bonds are quoted as a percentage of

par.

• A $1,000-par-value bond quoted at 94.007 is priced at $940.07

(94.007% $1,000). Corporate bonds are quoted in dollars and cents.

Thus, Company C’s price of 103.143 for the day was $1,031.43—that

is, 103.143% $1,000.

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Table 6.2

Data on Selected Bonds

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Table 6.3 Moody’s and Standard & Poor’s

Bond Ratings

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Focus on Ethics

Can We Trust the Bond Raters?

• Credit-rating agencies evaluate and attach ratings to credit instruments

(e.g, bonds). Historically, bonds that received higher ratings were

almost always repaid, while lower rated more speculative “junk”

bonds experienced much higher default rates.

• Recently, the credit-rating agencies have been criticized for their role

in the subprime crisis. The agencies attached ratings to complex

securities that did not reflect the true risk of the underlying

investments.

• What effect will the new legislation likely have on the market share of

the largest rating agencies? How will the new legislation affect the

process of finding ratings information for investors?

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Table 6.4a Characteristics and Priority of Lender’s Claim

of Traditional Types of Bonds

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Table 6.4b Characteristics and Priority of Lender’s Claim

of Traditional Types of Bonds

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Table 6.5 Characteristics of

Contemporary Types of Bonds

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Corporate Bonds:

International Bond Issues

• Companies and governments borrow internationally by

issuing bonds in two principal financial markets:

• A Eurobond is a bond issued by an international borrower and sold to

investors in countries with currencies other than the currency in which

the bond is denominated.

• In contrast, a foreign bond is a bond issued in a host country’s

financial market, in the host country’s currency, by a foreign borrower.

• Both markets give borrowers the opportunity to obtain large

amounts of long-term debt financing quickly, in the currency

of their choice and with flexible repayment terms.

© 2012 Pearson Prentice Hall.

All rights reserved. 6-133

Valuation Fundamentals

• Valuation is the process that links risk and return

to determine the worth of an asset.

• There are three key inputs to the valuation process:

1. Cash flows (returns)

2. Timing

3. A measure of risk, which determines the required

return

© 2012 Pearson Prentice Hall.

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Basic Valuation Model

• The value of any asset is the present value of all future cash flows it

is expected to provide over the relevant time period.

• The value of any asset at time zero, V0

, can be expressed as

where

v0

= Value of the asset at time zero

CFT

= cash flow expected at the end of year t

r = appropriate required return (discount rate)

n = relevant time period

© 2012 Pearson Prentice Hall.

All rights reserved. 6-135

Bond Valuation: Basic Bond Valuation

The basic model for the value, B0

, of a bond is given

by the following equation:

Where

B0

= value of the bond at time zero

I = annual interest paid in dollars

n = number of years to maturity

M = par value in dollars

rd

= required return on a bond

© 2012 Pearson Prentice Hall.

All rights reserved. 6-136

Bond Valuation: Basic Bond Valuation (cont.)

• Mills Company, a large defense contractor, on January 1,

2007, issued a 10% coupon interest rate, 10-year bond with a

$1,000 par value that pays interest semiannually.

• Investors who buy this bond receive the contractual right to

two cash flows: (1) $100 annual interest (10% coupon

interest rate $1,000 par value) distributed as $50 (1/2

$100) at the end of each 6 months, and (2) the $1,000 par

value at the end of the tenth year.

• Assuming that interest on the Mills Company bond issue is

paid annually and that the required return is equal to the

bond’s coupon interest rate, I = $100, rd = 10%, M = $1,000,

and n = 10 years.

© 2012 Pearson Prentice Hall.

All rights reserved. 6-137

Bond Valuation: Basic Bond Valuation (cont.)

© 2012 Pearson Prentice Hall.

All rights reserved. 6-138

Table 6.6 Bond Values for Various Required Returns (Mills Company’s

10% Coupon Interest Rate, 10-Year Maturity, $1,000 Par, January 1,

2010, Issue Paying Annual Interest)

Time to Maturity and Bond Values …

• The premium or discount will diminish over time as the bond approaches

maturity. This is because at maturity, the bond will be worth the $1000 par value.

Therefore, assuming required returns (market rates of interest) stay constant

until maturity, the bond price will follow the pattern in the graph of the next

slide.

6-139

© 2012 Pearson Prentice Hall.

All rights reserved. 6-140

… Figure 6.5 Time to Maturity and Bond

Values

An Approximation

n years to maturity

P present price of the bond

M maturity value of the bond

C annual coupon payment

where,

0.4 0.6

( )

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M P

n

M P

C

YTM

Use the same formula

with annual coupon

and n as no. of years

even if the coupon

payment is semiannual.

(To find out approx

YTM)

YTM: Example

• Consider a AED 1,000 par value bond, carrying a coupon rate of 9%,

maturing after 8 years. The bond is currently selling for AED 800.

What is YTM on this bond ?

© 2012 Pearson Prentice Hall.

All rights reserved. 6-142

Using approximate formula

13.1%

0.4 1000 0.6 800

8

(1000 800)

90

YTM

The YTM calculation considers the current

coupon income as well as the capital gain or loss

the investor will realize by holding the bond to

maturity. In addition, it takes into account the

timing of the cash flows.

Another Approximate Formula

2

M P

n

M – P

C

Approx YTM

3

M 2P

n

M – P

C

Approx YTM

or

Use the same formula

with annual coupon

and n as no. of years

even if the coupon

payment is semiannual.

(To find out approx

YTM)

Bond Yields: Formulas

CGY

Expected

CY

Expected Expected totalreturn YTM

Beginning price

Change in price Capital gains yield (CGY)

Current price

Annual coupon payment Current yield (CY)

An example:

Current and capital gains yield

Find the current yield and the capital gains yield for a 10-

year, 9% annual coupon bond that sells for $887, and has

a face value of $1,000.

Current yield = $90 / $887

= 0.1015

= 10.15%

Calculating capital gains yield

Find CGY if YTM = 10.91 %

YTM = Current yield + Capital gains yield

CGY = YTM – CY

= 10.91% – 10.15%

= 0.76%

Could also find the expected price one year from now and

divide the change in price by the beginning price, which

gives the same answer.

6-148

Factors That Shift Bond Demand

1. Wealth

• Increases in wealth shift the demand for bonds to the right.

2. Expected Inflation

• Declining inflation means promised payments have higher

value – bond demand shifts right.

3. Expected Returns and Expected Interest Rates

• If the return on bonds rises relative to the return on

alternative investments, bond demand will shift right.

• When interest rates are expected to fall, price prices are

expected to rise shifting bond demand to the right.

6-149

Factors That Shift Bond Demand

4. Risk Relative to Alternatives

• If bonds become less risky relative to alternative investments, demand

for bonds shifts right.

5. Liquidity Relative to Alternatives

• Investors like liquidity: the more liquid the bond, the higher the demand.

• If bonds become less risky relative to alternative investments, demand

for bonds shifts right.

Factors Affecting the Demand for Bonds

•Holding all other factors constant (including

• price), the quantity of bonds demanded is:

1. positively related to wealth

2. positively related to expected real return rate

3. negatively related to risk relative to other assets

4. positively related to liquidity

© 2012 Pearson Prentice Hall.

All rights reserved. 6-150

6-151

When bonds

become more

attractive for

investors, the

demand curve

shifts to the right.

This raises bond

prices, lowering

interest rates.

Factors That Shift Bond Demand: General

Principle

Scenario 1:Business Cycle Expansion

© 2012 Pearson Prentice Hall.

All rights reserved. 6-152

Scenario 2: Increase in Expected Inflation

© 2012 Pearson Prentice Hall.

All rights reserved. 6-153

6-154

Factors That Shift Bond Demand

6-155

Factors That Shift Bond Demand

Factors affecting the Supply of

Bonds

• Expected profitability of physical capital

• investment (hence of borrowing)

• Expected inflation rate (which affects the real cost of borrowing)

• Government deficits (requiring government

to sell bonds to finance expenditures)

© 2012 Pearson Prentice Hall.

All rights reserved. 6-156

… Factors affecting the Supply of Bonds

• Expected profitability of investment

opportunities— In an expansion, the supply curve

for bonds shifts to the right.

• Expected inflation rate— Given an increase in the

expected inflation rate, the supply curve for bonds

shifts to the right.

•Government deficit— Given an increase in the

government budget deficit, the supply curve for

bonds shifts to the right.

© 2012 Pearson Prentice Hall.

All rights reserved. 6-157

6-158

Duration

To deal with the ambiguity of the maturity of a bond making many

payments, we need a measure of the average maturity of the bond’s

promised cash flows to serve as useful summary statistics of the

effective maturity of a bond.

We would like use the measure as a guide to sensitivity of a bond to

interest rate changes.

Since we have noted that price sensitivity tends to increase with

time to maturity.

Duration

• Term to maturity is an imperfect measure of bond risk

because it ignores the valuation effects of differences

in coupon rate and principal payment schedule

•Duration: an estimate of economic life of a bond

measured by the weighted average time to receipt of

cash flows

• The shorter the duration, the less sensitive is a bond’s price

to fluctuations.

Rules for Duration

Rule 1 The duration of a zero-coupon bond equals its

time to maturity

Rule 2 Holding maturity constant, a bond’s duration is

higher when the coupon rate is lower

Rule 3 Holding the coupon rate constant, a bond’s

duration generally increases with its time to maturity

Rule 4 Holding other factors constant, the duration of a

coupon bond is higher when the bond’s yield to

maturity is lower The shorter the duration, the less

volatility present and vice versa.

Rules 5 The duration of a level perpetuity is equal to:

(1+YTM) / YTM

… Rules for Duration

© 2012 Pearson Prentice Hall.

All rights reserved. 6-162

There are two important components of Duration’s computation:

interest rate and time to maturity:

The higher the bond’s yield, the shorter the duration will be

and vice versa.

The shorter the maturity period, the shorter the duration will

be and vice versa.

Thus investing in bonds with higher yield and shorter maturity

will provide shorter duration and less price volatility in an

interest rate changing environment.

Duration: The Formula

That is :Duration (Years * Present Value)/Bon d price

(1 r)

C F

(1 r)

t(CF )

N

t 1

t

t

N

t 1

t

t

DMAC

© 2012 Pearson Prentice Hall.

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Duration Example

• 10% 30-year coupon bond, YTM=12%, semi-annual payments

1 7.3895 periods

(1 .0 6)

$1000

(1 .0 6)

5 0

(1 .0 6)

6 0($1000)

(1 .0 6)

($5 0)

6 0

1

6 0

6 0

1

6 0

t

t

t

t

MAC

t

D

Example continued

• Since the bond makes semi annual coupon payments, the duration of

17.389455 periods must be divided by 2 to find the number of years.

• 17.389455 / 2 = 8.6947277 years

• Duration indicates the average time taken by the bond, on a

discounted basis, to pay back the original investment.

Example_Duration

• Calculate duration of a bond with 3 years to maturity, an 8 percent

coupon rate paid annually, and a yield to maturity of 10%.

© 2012 Pearson Prentice Hall.

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Duration Calculations (concluded)

• Calculate duration of a bond with 3 years to maturity, an 8 percent

coupon rate paid annually, and a yield to maturity of 10%.

D years

$80( )

( . )

$80

( . )

$80( )

( . )

$80

( . )

$ 1, ( )

( . )

$ 1,

( . )

.

1

11 0

11 0

2

11 0

11 0

080 3

11 0

080

11 0

2 7 8

1

1

2

2

3

3

The Effect of Convexity

Price

Yield

P*

Y* Y Y**

P**

P

Y-Y**=Y*-Y, but

P-P**<P*-P

Convexity

• Convexity measures the sensitivity of modified duration to changes in interest rate (the rate of

“acceleration” in bond price changes)

• The degree of bend in the price–yield curve

Figure 15.3 The Price-yield Curve for a 30-year 6% Bond is More Convex to the Origin than the

Price-yield Curve for a 5-year 6% Bond

0

500

1,000

1,500

2,000

2,500

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Yield to maturity Bond Price ($)

30-year 6% Bond

5-year 6% Bond

4

–

1

7

0

Approximating Percentage Price Change Using Duration

and Convexity Measures

Using duration and convexity measures together gives a better

approximation of the actual price change for a large movement in the

required yield.

Some Notes on Convexity

i. Convexity refers to the general shape of the price-yield relationship,

while the convexity measure relates to the quantification of how the price

of the bond will change when interest rates change.

ii. The approximation percentage change in price due to convexity is the

product of three numbers:

½ , convexity measure, and square of the change in yield

i. In practice different vendors compute the convexity measure differently

by scaling the measure in dissimilar ways.

4

–

1

7

1

Value of Convexity

The following exhibit shows two bonds, A and B. The two

bonds have the same duration and are offering the same yield;

they have different convexities, however, Bond B is more

convex (bowed) than bond A.

4

–

1

7

2

Exhibit 4-16

Comparison of Convexity of Two Bonds

Price

Yield

Bond A

Bond B

Bond A

Bond B

Bond B Has Greater

Convexity Than Bond A

4

–

1

7

3

Value of Convexity

i. As portrayed in Exhibit 4-17, the required yield increases (decreases), the

convexity of a bond decreases (increases). This property is referred to as

positive convexity.

ii. For a given yield and maturity, lower coupon rates will have greater

convexity.

iii. For a given yield and modified duration, lower coupon rates will have smaller

convexity.

iv. Convexity indicates that as YTM increases, the price of a bond declines at a

declining rate.

4

–

1

7

4

Change in Duration as the

Required Yield Changes

Price

Yield

As yield ↓

Slope (duration) ↑

As yield ↑

Slope (duration) ↓

1

2

3

Bond pricing using convexity and duration

• % bond price change = – 1 × % Yield change × modified

duration + ½ × convexity × (Yield change)2

• Using both duration and convexity allows for a more

accurate estimation

2

1

2

Bond Price 1

1

Cash Payment

Convexity

Yield

Yield

t t

T

t

t

t

j

Convexity: The Formula

© 2012 Pearson Prentice Hall.

All rights reserved. 6-176

CHAPTER 9

NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

Key Concepts and Skills

• Be able to compute payback and discounted payback and

understand their shortcomings

• Understand accounting rates of return and their shortcomings

• Be able to compute internal rates of return (standard and

modified) and understand their strengths and weaknesses

• Be able to compute the net present value and understand why it is

the best decision criterion

• Be able to compute the profitability index and understand its

relation to net present value

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Chapter Outline

•Net Present Value

• The Payback Rule

• The Discounted Payback

• The Average Accounting Return

• The Internal Rate of Return

• The Profitability Index

• The Practice of Capital Budgeting

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Good Decision Criteria

• We need to ask ourselves the following questions when

evaluating capital budgeting decision rules:

Does the decision rule adjust for the time value of money?

Does the decision rule adjust for risk?

Does the decision rule provide information on whether we are

creating value for the firm?

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Net Present Value

• The difference between the market value of a project

and its cost

•How much value is created from undertaking an

investment?

The first step is to estimate the expected future cash flows.

The second step is to estimate the required return for

projects of this risk level.

The third step is to find the present value of the cash flows

and subtract the initial investment.

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Project Example Information

• You are reviewing a new project and have estimated

the following cash flows:

Year 0:CF = -165,000

Year 1:CF = 63,120; NI = 13,620

Year 2:CF = 70,800; NI = 3,300

Year 3:CF = 91,080; NI = 29,100

Average Book Value = 72,000

• Your required return for assets of this risk level is 12%.

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NPV – Decision Rule

•If the NPV is positive, accept the project

•A positive NPV means that the project is expected to

add value to the firm and will therefore increase the

wealth of the owners.

• Since our goal is to increase owner wealth, NPV is a

direct measure of how well this project will meet our

goal.

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Computing NPV for the Project

•Using the formulas:

NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 +

91,080/(1.12)3 = 12,627.41

•Using the calculator:

CF0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1;

C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41

•Do we accept or reject the project?

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Decision Criteria Test – NPV

•Does the NPV rule account for the time value of

money?

•Does the NPV rule account for the risk of the cash

flows?

•Does the NPV rule provide an indication about the

increase in value?

• Should we consider the NPV rule for our primary

decision rule?

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Calculating NPVs with a Spreadsheet

• Spreadsheets are an excellent way to compute

NPVs, especially when you have to compute the

cash flows as well.

•Using the NPV function

The first component is the required return entered as a

decimal

The second component is the range of cash flows

beginning with year 1

Subtract the initial investment after computing the NPV

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Payback Period

•How long does it take to get the initial cost back in a

nominal sense?

• Computation

Estimate the cash flows

Subtract the future cash flows from the initial cost until the

initial investment has been recovered

•Decision Rule – Accept if the payback period is less

than some preset limit

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Computing Payback

•Assume we will accept the project if it pays back

within two years.

Year 1: 165,000 – 63,120 = 101,880 still to recover

Year 2: 101,880 – 70,800 = 31,080 still to recover

Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3

•Do we accept or reject the project?

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Decision Criteria Test – Payback

•Does the payback rule account for the time value of

money?

•Does the payback rule account for the risk of the cash

flows?

•Does the payback rule provide an indication about the

increase in value?

• Should we consider the payback rule for our primary

decision rule?

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Advantages and Disadvantages of

Payback

• Advantages

Easy to understand

Adjusts for uncertainty of later

cash flows

Biased toward liquidity

• Disadvantages

Ignores the time value of

money

Requires an arbitrary cutoff

point

Ignores cash flows beyond

the cutoff date

Biased against long-term

projects, such as research

and development, and new

projects

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Discounted Payback Period

• Compute the present value of each cash flow and

then determine how long it takes to pay back on a

discounted basis

• Compare to a specified required period

•Decision Rule: Accept the project if it pays back on a

discounted basis within the specified time

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Computing Discounted Payback

• Assume we will accept the project if it pays back on a discounted

basis in 2 years.

• Compute the PV for each cash flow and determine the payback

period using discounted cash flows

Year 1: 165,000 – 63,120/1.121 = 108,643

Year 2: 108,643 – 70,800/1.122 = 52,202

Year 3: 52,202 – 91,080/1.123 = -12,627 project pays back in year 3

• Do we accept or reject the project?

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Decision Criteria Test – Discounted Payback

• Does the discounted payback rule account for the time value of

money?

• Does the discounted payback rule account for the risk of the cash

flows?

• Does the discounted payback rule provide an indication about

the increase in value?

• Should we consider the discounted payback rule for our primary

decision rule?

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Advantages and Disadvantages of Discounted

Payback

• Advantages

Includes time value of money

Easy to understand

Does not accept negative

estimated NPV investments when

all future cash flows are positive

Biased towards liquidity

• Disadvantages

May reject positive NPV investments

Requires an arbitrary cutoff point

Ignores cash flows beyond the cutoff

point

Biased against long-term projects,

such as R&D and new products

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Average Accounting Return

• There are many different definitions for average

accounting return

• The one used in the book is:

Average net income / average book value

Note that the average book value depends on how the asset

is depreciated.

•Need to have a target cutoff rate

•Decision Rule: Accept the project if the AAR is greater

than a preset rate

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Computing AAR

• Assume we require an average accounting return of 25%

• Average Net Income:

(13,620 + 3,300 + 29,100) / 3 = 15,340

• AAR = 15,340 / 72,000 = .213 = 21.3%

• Do we accept or reject the project?

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Decision Criteria Test – AAR

•Does the AAR rule account for the time value of

money?

•Does the AAR rule account for the risk of the cash

flows?

•Does the AAR rule provide an indication about the

increase in value?

• Should we consider the AAR rule for our primary

decision rule?

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Advantages and Disadvantages of AAR

• Advantages

Easy to calculate

Needed information will

usually be available

• Disadvantages

Not a true rate of return; time value

of money is ignored

Uses an arbitrary benchmark cutoff

rate

Based on accounting net income and

book values, not cash flows and

market values

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Internal Rate of Return

• This is the most important alternative to NPV

• It is often used in practice and is intuitively appealing

• It is based entirely on the estimated cash flows and is independent of

interest rates found elsewhere

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IRR – Definition and Decision Rule

•Definition: IRR is the return that makes the NPV

= 0

•Decision Rule: Accept the project if the IRR is

greater than the required return.

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Computing IRR

•If you do not have a financial calculator, then this

becomes a trial and error process

• Calculator

Enter the cash flows as you did with NPV

Press IRR and then CPT

IRR = 16.13% > 12% required return

•Do we accept or reject the project?

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NPV Profile for the Project

-20,000

-10,000

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

Discount Rate NPV

IRR = 16.13%

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Decision Criteria Test – IRR

•Does the IRR rule account for the time value of

money?

•Does the IRR rule account for the risk of the cash

flows?

•Does the IRR rule provide an indication about the

increase in value?

• Should we consider the IRR rule for our primary

decision criteria?

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Advantages of IRR

• Knowing a return is intuitively appealing

•It is a simple way to communicate the value of a

project to someone who doesn’t know all the

estimation details

•If the IRR is high enough, you may not need to

estimate a required return, which is often a difficult

task

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Calculating IRRs With A Spreadsheet

• You start with the cash flows the same as you

did for the NPV

• You use the IRR function

You first enter your range of cash flows, beginning

with the initial cash flow

You can enter a guess, but it is not necessary

The default format is a whole percent – you will

normally want to increase the decimal places to at

least two

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Summary of Decisions for the Project

Summary

Net Present Value Accept

Payback Period Reject

Discounted Payback Period Reject

Average Accounting Return Reject

Internal Rate of Return Accept

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NPV vs. IRR

• NPV and IRR will generally give us the same decision

• Exceptions:

Nonconventional cash flows – cash flow signs change more than once

Mutually exclusive projects

• Initial investments are substantially different (issue of scale)

• Timing of cash flows is substantially different

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IRR and Nonconventional

Cash Flows

•When the cash flows change sign more than

once, there is more than one IRR

•When you solve for IRR you are solving for the

root of an equation, and when you cross the xaxis more than once, there will be more than

one return that solves the equation

•If you have more than one IRR, which one do

you use to make your decision?

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Another Example: Nonconventional Cash

Flows

• Suppose an investment will cost $90,000

initially and will generate the following cash

flows:

Year 1: 132,000

Year 2: 100,000

Year 3: -150,000

• The required return is 15%.

• Should we accept or reject the project?

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NPV Profile

($10,000.00)

($8,000.00)

($6,000.00)

($4,000.00)

($2,000.00)

$0.00

$2,000.00

$4,000.00

0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55

Discount Rate NPV

IRR = 10.11% and 42.66%

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Summary of Decision Rules

• The NPV is positive at a required return of 15%, so you should Accept

• If you use the financial calculator, you would get an IRR of 10.11% which

would tell you to Reject

• You need to recognize that there are non-conventional cash flows and

look at the NPV profile

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IRR and Mutually Exclusive Projects

• Mutually exclusive projects

If you choose one, you can’t choose the other

Example: You can choose to attend graduate school

at either Harvard or Stanford, but not both

•Intuitively, you would use the following decision

rules:

NPV – choose the project with the higher NPV

IRR – choose the project with the higher IRR

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Example With Mutually

Exclusive Projects

Period Project

A

Project

B

0 -500 -400

1 325 325

2 325 200

IRR 19.43% 22.17%

NPV 64.05 60.74

The required return

for both projects is

10%.

Which project

should you accept

and why?

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NPV Profiles

($40.00)

($20.00)

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

$140.00

$160.00

0 0.05 0.1 0.15 0.2 0.25 0.3

Discount Rate NPV

A

B

IRR for A = 19.43%

IRR for B = 22.17%

Crossover Point = 11.8%

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Conflicts Between

NPV and IRR

•NPV directly measures the increase in value to the

firm

•Whenever there is a conflict between NPV and

another decision rule, you should always use NPV

•IRR is unreliable in the following situations

Nonconventional cash flows

Mutually exclusive projects

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Modified IRR

• Calculate the net present value of all cash outflows

using the borrowing rate.

• Calculate the net future value of all cash inflows

using the investing rate.

• Find the rate of return that equates these values.

• Benefits: single answer and specific rates for

borrowing and reinvestment

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Profitability Index

• Measures the benefit per unit cost, based on the time value of money

• A profitability index of 1.1 implies that for every $1 of investment, we

create an additional $0.10 in value

• This measure can be very useful in situations in which we have limited

capital

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Advantages and Disadvantages of Profitability Index

• Advantages

Closely related to NPV, generally

leading to identical decisions

Easy to understand and

communicate

May be useful when available

investment funds are limited

• Disadvantages

May lead to incorrect decisions

in comparisons of mutually

exclusive investments

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Capital Budgeting

In Practice

• We should consider several investment criteria when making

decisions

• NPV and IRR are the most commonly used primary investment

criteria

• Payback is a commonly used secondary investment criteria

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Summary – DCF Criteria

• Net present value

Difference between market value and cost

Take the project if the NPV is positive

Has no serious problems

Preferred decision criterion

• Internal rate of return

Discount rate that makes NPV = 0

Take the project if the IRR is greater than the required return

Same decision as NPV with conventional cash flows

IRR is unreliable with nonconventional cash flows or mutually exclusive projects

• Profitability Index

Benefit-cost ratio

Take investment if PI > 1

Cannot be used to rank mutually exclusive projects

May be used to rank projects in the presence of capital rationing

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Summary – Payback Criteria

• Payback period

Length of time until initial investment is recovered

Take the project if it pays back within some specified period

Doesn’t account for time value of money, and there is an arbitrary

cutoff period

• Discounted payback period

Length of time until initial investment is recovered on a discounted

basis

Take the project if it pays back in some specified period

There is an arbitrary cutoff period

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Summary – Accounting Criterion

• Average Accounting Return

Measure of accounting profit relative to book value

Similar to return on assets measure

Take the investment if the AAR exceeds some specified return level

Serious problems and should not be used

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Quick Quiz

• Consider an investment that costs $100,000 and has a cash

inflow of $25,000 every year for 5 years. The required return is

9%, and required payback is 4 years.

What is the payback period?

What is the discounted payback period?

What is the NPV?

What is the IRR?

Should we accept the project?

• What decision rule should be the primary decision method?

• When is the IRR rule unreliable?

9-223 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

Ethics Issues

• An ABC poll in the spring of 2004 found that one-third of students

age 12 – 17 admitted to cheating and the percentage increased as

the students got older and felt more grade pressure. If a book

entitled “How to Cheat: A User’s Guide” would generate a positive

NPV, would it be proper for a publishing company to offer the new

book?

• Should a firm exceed the minimum legal limits of government

imposed environmental regulations and be responsible for the

environment, even if this responsibility leads to a wealth reduction

for the firm? Is environmental damage merely a cost of doing

business?

• Should municipalities offer monetary incentives to induce firms to

relocate to their areas?

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Comprehensive Problem

• An investment project has the following cash flows: CF0 = –

1,000,000; C01 – C08 = 200,000 each

• If the required rate of return is 12%, what decision should be

made using NPV?

• How would the IRR decision rule be used for this project, and

what decision would be reached?

• How are the above two decisions related?

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CHAPTER 9

End of Chapter

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CHAPTER 13

RETURN, RISK, AND THE SECURITY MARKET LINE

Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

Key Concepts and Skills

• Know how to calculate expected returns

•Understand the impact of diversification

•Understand the systematic risk principle

•Understand the security market line

•Understand the risk-return trade-off

•Be able to use the Capital Asset Pricing Model

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Chapter Outline

• Expected Returns and Variances

• Portfolios

• Announcements, Surprises, and Expected Returns

• Risk: Systematic and Unsystematic

• Diversification and Portfolio Risk

• Systematic Risk and Beta

• The Security Market Line

• The SML and the Cost of Capital: A Preview

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Expected Returns

• Expected returns are based on the probabilities

of possible outcomes

•In this context, “expected” means average if the

process is repeated many times

• The “expected” return does not even have to be

a possible return

n

i

i

Ri

E R p

1

( )

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Example: Expected Returns

State Probability C T___

Boom 0.3 0.15 0.25

Normal 0.5 0.10 0.20

Recession ??? 0.02 0.01

• RC = .3(15) + .5(10) + .2(2) = 9.9%

• RT = .3(25) + .5(20) + .2(1) = 17.7%

13-231

• Suppose you have predicted the following

returns for stocks C and T in three possible

states of the economy. What are the

expected returns?

Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

Variance and Standard Deviation

• Variance and standard deviation measure the volatility of returns

• Using unequal probabilities for the entire range of possibilities

• Weighted average of squared deviations

n

i

pi

Ri

E R

1

2 2

σ ( ( ))

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Example: Variance and Standard

Deviation

• Consider the previous example. What are the variance

and standard deviation for each stock?

• Stock C

2 = .3(0.15-0.099)

2 + .5(0.10-0.099)

2

+ .2(0.02-0.099)

2 = 0.002029

= 4.50%

• Stock T

2 = .3(0.25-0.177)

2 + .5(0.20-0.177)

2

+ .2(0.01-0.177)

2 = 0.007441

= 8.63%

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Another Example

• Consider the following information:

State Probability ABC, Inc. Return

Boom .25 0.15

Normal .50 0.08

Slowdown .15 0.04

Recession .10 -0.03

•What is the expected return?

•What is the variance?

•What is the standard deviation?

13-234 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

Portfolios

•A portfolio is a collection of assets

•An asset’s risk and return are important in how they

affect the risk and return of the portfolio

• The risk-return trade-off for a portfolio is measured by

the portfolio expected return and standard deviation,

just as with individual assets

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Example: Portfolio Weights

• Suppose you have $15,000 to invest and you have

purchased securities in the following amounts. What

are your portfolio weights in each security?

$2000 of C

$3000 of KO

$4000 of INTC

$6000 of BP

C: 2/15 = .133

KO: 3/15 = .2

INTC: 4/15 = .267

BP: 6/15 = .4

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Portfolio Expected Returns

• The expected return of a portfolio is the weighted average of the

expected returns of the respective assets in the portfolio

• You can also find the expected return by finding the portfolio return

in each possible state and computing the expected value as we did

with individual securities

m

j

E RP

wj

E R j

1

( ) ( )

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Example: Expected Portfolio Returns

• Consider the portfolio weights computed previously. If the individual

stocks have the following expected returns, what is the expected return

for the portfolio?

C: 19.69%

KO: 5.25%

INTC: 16.65%

BP: 18.24%

• E(RP

) = .133(19.69%) + .2(5.25%) + .267(16.65%) +

.4(18.24%) = 15.41%

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Portfolio Variance

• Compute the portfolio return for each state:

RP = w1R1 + w2R2 + … + wmRm

• Compute the expected portfolio return using the same

formula as for an individual asset

• Compute the portfolio variance and standard

deviation using the same formulas as for an individual

asset

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Example: Portfolio Variance

• Consider the following information on returns and

probabilities:

Invest 50% of your money in Asset A

State Probability A B Portfolio

Boom .4 30% -5% 12.5%

Bust .6 -10% 25% 7.5%

•What are the expected return and standard deviation

for each asset?

•What are the expected return and standard deviation

for the portfolio?

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Another Example

• Consider the following information on returns and

probabilities:

State Probability X Z

Boom .25 15% 10%

Normal .60 10% 9%

Recession .15 5% 10%

•What are the expected return and standard deviation

for a portfolio with an investment of $6,000 in asset X

and $4,000 in asset Z?

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Expected vs. Unexpected Returns

•Realized returns are generally not equal to

expected returns

• There is the expected component and the

unexpected component

At any point in time, the unexpected return can be

either positive or negative

Over time, the average of the unexpected component

is zero

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Announcements and News

•Announcements and news contain both an expected

component and a surprise component

•It is the surprise component that affects a stock’s price

and therefore its return

• This is very obvious when we watch how stock prices

move when an unexpected announcement is made or

earnings are different than anticipated

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Efficient Markets

• Efficient markets are a result of investors trading on the unexpected

portion of announcements

• The easier it is to trade on surprises, the more efficient markets should

be

• Efficient markets involve random price changes because we cannot

predict surprises

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Systematic Risk

• Risk factors that affect a large number of assets

• Also known as non-diversifiable risk or market risk

• Includes such things as changes in GDP, inflation, interest rates, etc.

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Unsystematic Risk

• Risk factors that affect a limited number of assets

• Also known as unique risk and asset-specific risk

• Includes such things as labor strikes, part shortages, etc.

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Returns

• Total Return = expected return + unexpected

return

• Unexpected return = systematic

portion + unsystematic portion

• Therefore, total return can be expressed as follows:

Total Return =

expected return + systematic portion

+ unsystematic portion

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Diversification

• Portfolio diversification is the investment in several different

asset classes or sectors

• Diversification is not just holding a lot of assets

• For example, if you own 50 Internet stocks, you are not

diversified

• However, if you own 50 stocks that span 20 different industries,

then you are diversified

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Table 13.7

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The Principle of Diversification

•Diversification can substantially reduce the variability

of returns without an equivalent reduction in

expected returns

• This reduction in risk arises because worse than

expected returns from one asset are offset by better

than expected returns from another

•However, there is a minimum level of risk that cannot

be diversified away and that is the systematic portion

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Figure 13.1

13-251 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

Diversifiable Risk

• The risk that can be eliminated by combining assets

into a portfolio

•Often considered the same as unsystematic, unique or

asset-specific risk

•If we hold only one asset, or assets in the same

industry, then we are exposing ourselves to risk that

we could diversify away

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Total Risk

• Total risk = systematic risk +

unsystematic risk

• The standard deviation of returns is a measure of total

risk

• For well-diversified portfolios, unsystematic risk is very

small

• Consequently, the total risk for a diversified portfolio

is essentially equivalent to the systematic risk

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Systematic Risk Principle

• There is a reward for bearing risk

• There is not a reward for bearing risk unnecessarily

• The expected return on a risky asset depends only on that asset’s

• systematic risk since unsystematic risk can be diversified away

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Measuring Systematic Risk

•How do we measure systematic risk?

We use the beta coefficient

•What does beta tell us?

A beta of 1 implies the asset has the same systematic

risk as the overall market

A beta < 1 implies the asset has less systematic risk

than the overall market

A beta > 1 implies the asset has more systematic risk

than the overall market

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Table 13.8 – Selected Betas

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Total vs. Systematic Risk

• Consider the following information:

Standard Deviation Beta

Security C 20% 1.25

Security K 30% 0.95

•Which security has more total risk?

•Which security has more systematic risk?

•Which security should have the higher expected

return?

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Work the Web Example

•Many sites provide betas for companies

• Yahoo Finance provides beta, plus a lot of other

information under its Key Statistics link

• Click on the web surfer to go to Yahoo Finance

Enter a ticker symbol and get a basic quote

Click on Key Statistics

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Example: Portfolio Betas

• Consider the previous example with the following four securities

Security Weight Beta

C .133 2.685

KO .2 0.195

INTC .267 2.161

BP .4 2.434

• What is the portfolio beta?

• .133(2.685) + .2(.195) + .267(2.161) + .4(2.434) = 1.947

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Beta and the Risk Premium

•Remember that the risk premium = expected return

– risk-free rate

• The higher the beta, the greater the risk premium

should be

• Can we define the relationship between the risk

premium and beta so that we can estimate the

expected return?

YES!

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Example: Portfolio Expected Returns and

Betas

0%

5%

10%

15%

20%

25%

30%

0 0.5 1 1.5 2 2.5 3

Beta Expected Return

Rf

E(RA

)

A

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Reward-to-Risk Ratio: Definition and

Example

• The reward-to-risk ratio is the slope of the line

illustrated in the previous example

Slope = (E(RA

) – Rf

) / (A – 0)

Reward-to-risk ratio for previous example =

(20 – 8) / (1.6 – 0) = 7.5

• What if an asset has a reward-to-risk ratio of 8

(implying that the asset plots above the line)?

• What if an asset has a reward-to-risk ratio of 7

(implying that the asset plots below the line)?

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Market Equilibrium

•In equilibrium, all assets and portfolios must have

the same reward-to-risk ratio, and they all must

equal the reward-to-risk ratio for the market

M

M f

A

E RA

R f

E R R

( ) ( )

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Security Market Line

• The security market line (SML) is the representation of

market equilibrium

• The slope of the SML is the reward-to-risk ratio: (E(RM)

– Rf

) / M

•But since the beta for the market is always equal to

one, the slope can be rewritten

• Slope = E(RM) – Rf = market risk premium

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The Capital Asset Pricing Model (CAPM)

• The capital asset pricing model defines the

relationship between risk and return

• E(RA

) = Rf + A

(E(RM) – Rf

)

•If we know an asset’s systematic risk, we can use

the CAPM to determine its expected return

• This is true whether we are talking about

financial assets or physical assets

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Factors Affecting

Expected Return

• Pure time value of money: measured by the risk-free rate

• Reward for bearing systematic risk: measured by the market risk

premium

• Amount of systematic risk: measured by beta

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Example – CAPM

• Consider the betas for each of the assets given earlier. If the riskfree rate is 4.15% and the market risk premium is 8.5%, what is

the expected return for each?

Security Beta Expected Return

C 2.685 4.15 + 2.685(8.5) = 26.97%

KO 0.195 4.15 + 0.195(8.5) = 5.81%

INTC 2.161 4.15 + 2.161(8.5) = 22.52%

BP 2.434 4.15 + 2.434(8.5) = 24.84%

13-267 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

Figure 13.4

13-268 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

Quick Quiz

• How do you compute the expected return and standard deviation for an

individual asset? For a portfolio?

• What is the difference between systematic and unsystematic risk?

• What type of risk is relevant for determining the expected return?

• Consider an asset with a beta of 1.2, a risk-free rate of 5%, and a market

return of 13%.

What is the reward-to-risk ratio in equilibrium?

What is the expected return on the asset?

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Comprehensive Problem

• The risk free rate is 4%, and the required return on the

market is 12%.

• What is the required return on an asset with a beta of 1.5?

• What is the reward/risk ratio?

• What is the required return on a portfolio consisting of 40%

of the asset above and the rest in an asset with an average

amount of systematic risk?

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Chapter 13

End of Chapter

13-271 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

TIME VALUE OF MONEY

Prof. Costas Siriopoulos, Ph.D.

Konstantinos.Syriopoulos@zu.ac.ae

272

Topics covered

• Future Values, Present Values

• Multiple Cash Flows

• Arbitrage opportunities

• Discounting with Inflation

• Applications

273

•274

Money has time value because of the following reasons:

• 1. Risk and Uncertainty : Future is always uncertain and risky. Outflow of

cash is in our control as payments to parties are made by us. There is no

certainty for future cash inflows. Cash inflows is dependent out on our

Creditor, Bank etc. As an individual or firm is not certain about future cash

receipts, it prefers receiving cash now.

• 2. Inflation: In an inflationary economy, the money received today, has more

purchasing power than the money to be received in future. In other words, a

dirham today represents a greater real purchasing power than a dirham a

year hence.

• 3. Consumption: Individuals generally prefer current consumption to

future consumption.

• 4. Investment opportunities: An investor can profitably employ a dirham

received today, to give him a higher value to be received tomorrow or after a

certain period of time. This is because TIME allows the investor the

opportunity to postpone current consumption and earn INTEREST.

275

Compounding: Future Value

Example: Assume that you have 100AED in a deposit account in a bank

and that the interest rate is 10% p.a.

Year 1: What this means is that if you invest 1000AED for one year, you have

been promised 100*(1+10/100) = 100*(1+0.1) = 110AED next year.

Year 2: Investing this 100AE D for yet another year at the same interest rate

promises to produce 110 *(1+0.1) or 121AED in 2-years.

In other words: 110 *(1+0.1) =

100*(1+0.1) * (1+0.1) = 100*(1+0.1)2

= 100*1.21 = 121.

Year 3: Calculate the end value of the deposit account at the end of the third

year.

276

277

Generalizing the method

• Generalizing the method requires some definitions. Let

• i be the interest rate

• n be the life of the lump sum investment

• PV be the present value

• FV be the future value

278

Future Value of a Lump Sum

n FV PV * (1 i)

FV w ith grow ths from -6% to +6%

0

500

1,000

1,500

2,000

2,500

3,000

3,500

0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0

Y ears

Future V alue of $1000

6 %

4 %

2 %

0 %

-2 %

-4 %

-6 %

279

Example: Future Value of a Lump Sum

• Your bank offers an

asset with an interest

rate of 3% for a 5 year

investment.

• You wish to invest

$1,500 for 5 years, how

much will your

investment be worth?

$1738 .1111145

$1500 * (1 0.03)

* (1 )

5

n FV PV i

n 5

i 3%

PV 1,500

FV ?

Result 1738.911111

280

Discounting: Present Value

n

n

n

n

FV i

i

FV PV

i

FV PV i

*(1 )

(1 )

Divide both sides by (1 ) to obtain :

*(1 )

281

Example: Assume that one year from now you are

expecting to receive 100AED from your investment. Your

required rate of return is 10% p.a. What is the value today

(present value) of the future amount of 100AED?

Year 1: What this means is that if your are expecting 100AED

one year from now and your required return is 10%, then the

value of that amount today is:

PV = 100/(1+0.1) = 90.91AED.

Year 2: PV = 100/(1+0.1)

2= 82.64AED.

Year 3: Calculate the present value when you are expecting

100AED three years from now. Same required return.

To calculate Present Values,

you need three things:

•Amount of Payments – How much will be

received in future?

•Time Periods – At what time in the future will

the payments be received?

•Interest Rate – What is the risk and

opportunity cost associated with the

future values?

283

Example: Present Value of a Lump Sum

• You have been offered

$40,000 for your printing

business, payable in 2

years. Given the risk, you

require a return of 8%.

What is the present value

of the offer?

$34,293.55 today

34293.55281

(1 0.08)

40,000

(1 )

2

n

i

FV PV

When interest rate is different …

B. FUTURE VALUE WHEN RATES OF INTEREST CHANGE.

Example:

You invest $10,000. During the first year the investment earned 20% for the

year. During the second year, you earned only 4% for that year. How much

is your original deposit worth at the end of the two years?

FV = PV x (1+i1) x (1+i2)

= $10,000 x (1.20`) x (1.04) = $12,480.

FV = PV x (1+i1) x (1+i2) x (1+i3) x … x (1+it).

284

285

Solving Lump Sum Cash Flow for Interest Rate

• If you invest

$15,000 for ten

years, you receive

$30,000. What is

your annual

return?

7.18% (to the nearest basis point)

0.071773463

1 2 1 2 1

15000

30000

1

10

1

10 10

n

PV

FV i

286

Solving Lump Sum Cash Flow for Number of

Periods

Example. Mariam opened a deposit account with 10,000 AED in a bank that offered her 5% interest rate

per year, and when liquidated the balance of the account was 18,000 AED. How many months did

Mariam owned the account?

Answer. PV = 10,000 AED, FV = 18,000 AED, r = 0.03, n = ?

By applying the above formula, we get :

n = (LN(18000)-LN(10000))/(LN(1+0.05)) = 12.04724 years. That is, 144.57 months approximately.

FUTURE VALUE USING SIMPLE INEREST

Simple interest means that you earn interest only on the principal. Your total balance will go up

each period, because you earn interest each period, but the interest is paid only on the amount

you originally borrowed/deposited. Simple interest is expressed through the formula in.

Simple Interest Formula: Simple interest is when interest is only paid on the amount you

originally invested (the principal). You don’t earn interest on interest you previously earned.

Suppose you make a deposit of $100 in the bank and earn 5% interest per year. After one year,

you earn 5% interest, or $5, bringing your total balance to $105. One more year passes, and it’s

time to accrue more interest. Since simple interest is paid only on your principal ($100), you

earn 5% of $100, not 5% of $105. That means you earn another $5 in the second year and will

earn $5 for every year of the investment.

In simple interest, you earn interest based on the original deposit amount, not the account

balance.

Example

•What is the total amount accumulated after three

years if someone invests $1,000 today with a

simple annual interest rate of 5 percent? With a

compound annual interest rate of 5%?

•Simple interest rate:

$1,000 + ($1,000)(5%)(3) = =$1,150

•Compound interest rate:

$1,000(1.05)

3 = $1,1582.

289

The Frequency of Compounding

290

The Frequency of Compounding-continued

Find the future value of $8,000 at 4% compounded quarterly for 6 years. The

calc in excel is:

That is:

10157.88

=8000*(1+(0.04/4))^(6*4)

291

The Frequency of Compounding-continued

26.9735

=100*(10157.88-8000)/8000

Examples

1). If $10,000 is deposited in the bank today at 9% compounded annually, what will be the balance in 5

years?

Answer

Using the formula of excel FV:

15386.24

=10000*(1+0.09)^5

years 5

periodic rate 9%

future value $15,386.24 =FV(B2,B1,,B4)

present value -10000 292

…

2). Assume you want to have $1,000 in an account at the end of a three-year period. The account

pays interest at 5% per year. How much money do you need to initially invest in order to have

$1,000 at the end of three years?

Answer

In this case we know the Future Value, $1,000. What we are asked to find is the Present Value. Note that the

present value is negative because it is a cash outflow with respect to the investor.

Or you can reach the same result applying the formula:

𝑃𝑉 =

𝐹𝑉

1 + 𝑖

𝑛

=

$1,000

1 + 0.05

3

= $863.84

years 3

periodic rate 5%

future value $1,000.00

present value ($863.84)

=PV(B2,B1,,B3) 293

…

3). A company needs $100,000 to retire bonds. What amount must be deposited on November 1, 2015

at 10% interest compounded semiannually in order to accumulate the desired sum by November 2022?

Answer

PV = 100,000/(1+0.1/2)^(2*7) = $50,506.8

In this example the discount factor is 1

1+

𝑖

𝑚

𝑚𝑛 =

1

1+

0.1

2

2∗7

294

…

4). If $731,190 can be invested now, what annual interest rate must be earned in order to accumulate

$1,000,000 3 years from now?

Answer

𝑖 =

1,000,000

731,190

3

− 1= 1.110000699 – 1 =11%

295

Continuous compounding

296

Example: Generous Grandma

Your Grandma puts $1,000 in a bank for you, at 5% interest. Calculate the amount

after 20 years.

Simple interest:

A = 1000 (1 + 0.0520) = $2,000.00

Compounded annually:

A = 1000 (1 + .05)20 =$2,653.30

Compounded daily:

Compounded continuously:

A = 1000 e

(.05)(20) = $2,718.28 $2,718.10

365

.05 1000 1

(365)(20)

A

Exercise

What amount (to the nearest cent) will

an account have after 5 years if $100 is

invested at an annual nominal rate of

8% compounded :

(i) Annually?

(ii) Semiannually?

(iii) Continuously?

298

Present Value: Example 1

Single Period

Suppose you need $10,000 in one year for the down

payment on a new car. If you can earn 7% annually, how

much do you need to invest today?

Present Values: Example 2

Multi-Periods

You want to begin saving for your daughter’s college

education and you estimate that she will need $150,000 in

17 years. If you feel confident that you can earn 8% per

year, how much do you need to invest today?

Present Values: Example 3

Multi-Periods

Your parents set up a trust fund for you 10 years ago

that is now worth $19,671.51. If the fund earned 7%

per year, how much did your parents invest?

Discount Rate – Example 1

You are looking at an investment that will pay $1200

in 5 years if you invest $1000 today. What is the

implied rate of interest?

Discount Rate – Example 2

Suppose you are offered an investment that will allow

you to double your money in 6 years. You have

$10,000 to invest. What is the implied rate of interest?

Discount Rate – Example 3

Suppose you have a 1-year old son and you want to

provide $75,000 in 17 years towards his college

education. You currently have $5,000 to invest. What

interest rate must you earn to have the $75,000 when

you need it?

Number of Periods – Example

You want to purchase a new car and you are willing to

pay $20,000. If you can invest at 10% per year and you

currently have $15,000, how long will it be before you

have enough money to pay cash for the car?

Number of Periods – Example

•Formula Solution:

• FV/PV = 20,000/15,000 = 1.333

•ln(1.333) = 0.2877

•ln(1.10) = 0.0953

•t = 0.2877/0.0953 = 3.0189

ln(1 r)

PV

FV ln

t

Annuity

• An annuity is a contract between you and an insurance

company under which you make a lump-sum payment or

series of payments. In return, the insurer agrees to make

periodic payments to you beginning immediately or at some

future date. Annuities typically offer tax-deferred growth of

earnings and may include a death benefit that will pay your

beneficiary a guaranteed minimum amount, such as your

total purchase payments.

307

Examples of Annuities

• Student Loan Payments

• Car Loan Payments

• Insurance Premiums

• Mortgage Payments

• Retirement Savings

There are two basic questions with

annuities:

•Determine how much money will

accumulate over time given that equal

payments are made.

•Determine what periodic payments will

be necessary to obtain a specific amount

in a given time period.

309

310

Annuities

• Financial analysts use several annuities with differing assumptions

about the first payment. We will examine just two:

• regular (or ordinary) annuity with its first coupon one period from now

• annuity due with its first coupon today

RA vs AD

The difference between a regular annuity and an

annuity due is that:

• Given the same i, n and periodic payment, the AD will

always yield a

• greater present value

(less interest removed)

• and a

• greaterfuture value

(more interest added).

311

Discounting with inflation

312

313

314

315

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Chapter 7: Stocks

Differentiate between debt and equity.

Discuss the features of common and preferred stock and differentiate between internal

and external equity.

Describe the process of issuing common stock, including venture capital, going public and

the investment banker.

Understand the voting rights

Discuss the problems of a segmented capital markets and a potential solution of crosslisting

Understand the concept of market efficiency and basic stock valuation using zero-growth,

constant-growth, and variable-growth models.

Discuss the free cash flow valuation model and the book value, liquidation value, and

price/earnings (P/E) multiple approaches.

Explain the relationships among financial decisions, return, risk, and the firm’s value

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Differences Between Debt and Equity

•Debt and Equity are two different sources of external

financing used by corporations:

• Debt includes all borrowing incurred by a firm, including

bonds, and is repaid according to a fixed schedule of

payments.

• Equity consists of funds provided by the firm’s owners

(investors or stockholders) that are repaid subject to the

firm’s performance.

• Debt financing is obtained from creditors (banks or

bondholders) and equity financing is obtained from investors

who then become part owners of the firm.

• Creditors (lenders or debtholders) have a legal right to be

repaid, whereas investors only have an expectation of being

repaid.

Internal vs External Equity

• Internally: by retaining earnings rather than paying them out as

dividends to its stockholders;

• Externally: by selling common or preferred stock.

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Internal Equity vs External Equity

Capital Budget = B Target Capital Structure

Net Earnings = E (weight of Debt % and weight of Equity %)

Dividend payout ratio = k

Internal Equity External Equity

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Internal Equity vs External Equity: The criterion

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• If retained earnings are greater than the size of the capital budget to be financed by equity,

then equity is raised internally:

If E*(1 − k) ≥ (weight of equity) * B ⇒ internal equity.

In this case, cost of equity can be computed as

re = [D0(1 + g)/P0] +g or by the CAPM formula

• If retained earnings are LOWER than the size of the capital budget to be financed by equity,

then equity is raised externally:

If E*(1 − k) < (weight of equity) * B ⇒ external equity.

In this case, the cost of equity can be computed as

re = [D0(1 + g)/(P0-F)] +g where F is the flotation cost on external equity.

Example

A company finances its operations with 60 percent debt and 40 percent equity. Its net income is

$100 million and it has a dividend payout ratio of 10 percent. Due to an increasing market

share, company’s capital budget is $120 million this year, the company’s common stock trades

at $40 per share and its last dividend of $4.00 per share. It is expected to grow at a constant

rate of 5% a year. Find the cost of equity of the firm.

First, let’s see if equity will be internal or external:

E(1 − k) = 100 million(0.90) = 90 million.

(weight of equity) * B = (0.40)*120 million = 48 million.

Therefore, we have

E*(1 − k) > (weight of equity) * B ⇒ internal equity.

Now let’s find the cost of equity:

re = [D0(1 + g)/ P0] + g = 4*(1 + 0.05)/40 + 0.05 = 15.5%

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Table 7.1 Key Differences between Debt

and Equity Capital

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Differences Between Debt and Equity:

Voice in Management

•Unlike creditors, holders of equity (stockholders) are

owners of the firm.

•Stockholders generally have voting rights that

permit them to select the firm’s directors and vote on

special issues.

•In contrast, debtholders do not receive voting

privileges but instead rely on the firm’s contractual

obligations to them to be their voice.

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Differences Between Debt and Equity:

Claims on Income and Assets

•Equityholders’ claims on income and assets are

secondary to the claims of creditors.

• Their claims on income cannot be paid until the claims of

all creditors, including both interest and scheduled

principal payments, have been satisfied.

•Because equity holders are the last to receive

distributions, they expect greater returns to

compensate them for the additional risk they bear.

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Differences Between Debt and Equity:

Maturity

•Unlike debt, equity capital is a permanent form of

financing.

•Equity has no maturity date and never has to be

repaid by the firm.

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Differences Between Debt and Equity:

Tax Treatment

•Interest payments to debtholders are treated as taxdeductible expenses by the issuing firm.

•Dividend payments to a firm’s stockholders are not

tax-deductible.

•The tax deductibility of interest lowers the

corporation’s cost of debt financing, further causing

it to be lower than the cost of equity financing.

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Common and Preferred Stock:

Common Stock

• Common stockholders, who are sometimes referred to as

residual owners or residual claimants, are the true owners of

the firm.

• As residual owners, common stockholders receive what is

left—the residual—after all other claims on the firms income

and assets have been satisfied.

• They are assured of only one thing: that they cannot lose any

more than they have invested in the firm.

• Because of this uncertain position, common stockholders

expect to be compensated with adequate dividends and

ultimately, capital gains.

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Common Stock: Ownership

• The common stock of a firm can be privately owned by an

private investors, closely owned by an individual investor or

a small group of investors, or publicly owned by a broad

group of investors.

• The shares of privately owned firms, which are typically

small corporations, are generally not traded; if the shares are

traded, the transactions are among private investors and often

require the firm’s consent.

• Large corporations are publicly owned, and their shares are

generally actively traded in the broker or dealer markets .

Par Value

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Common Stock: Preemptive Rights

• A preemptive right allows common stockholders to

maintain their proportionate ownership in the corporation

when new shares are issued, thus protecting them from

dilution of their ownership.

• Dilution of ownership is a reduction in each previous

shareholder’s fractional ownership resulting from the

issuance of additional shares of common stock.

• Dilution of earnings is a reduction in each previous

shareholder’s fractional claim on the firm’s earnings resulting

from the issuance of additional shares of common stock.

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Common Stock: Preemptive Rights (cont.)

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Common Stock: Authorized, Outstanding,

and Issued Shares

• 1). If there are no potential growth opportunities in sight,

holding on to all that unused equity funding means

sharing ownership for no good reason.

• Shareholders demand returns on their investments in the

form of dividends which is a cost of equity – so the

business is essentially paying for the privilege of accessing

funds it isn’t using. Buying back some or all of the

outstanding shares can be a simple way to pay off

investors and reduce the overall cost of capital.

•

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Why would a company buyback its own

shares?

• 2). To take advantage of undervaluation. Due to investors

inability to assess the performance of the firm, to the

business cycle, investors’ behavior etc.

• If a stock is dramatically undervalued, the issuing company can repurchase

some of its shares at this reduced price and then re-issue them once the

market has corrected, thereby increasing its equity capital without issuing any

additional shares.

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Why would a company buyback its own

shares?

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Why would a company buyback its own

shares?

• 4). Because a share repurchase reduces the number of shares

outstanding, and increases the market value of the remaining shares.

Thus, the potential return for shareholders is greater.

• After repurchase, the shares are canceled or held as treasury shares,

so they are no longer held publicly and are not outstanding.

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Buybacks examples

• 1). In 2013, McDonald’s bought back 18.7 million

shares for $1.8 billion dollars — an average price of

$96.96. Without the share buyback, McDonald’s

would have finished the year with 1,008.7 million

shares outstanding. Each shareholder thus ended

that year owning a 1.8% greater share of the

company than they would have otherwise.

• 2). Walt Disney reduced its number of outstanding

shares in the market by buying back 73.8 million

shares valued at $7.5 billion in 2016.

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Buyback in U.A.E.

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Buyback in U.A.E.

• However the second paragraph of Article 168 of the Companies Law

does provide that the company may purchase some shares subject to

the following significant restrictions (for public companies):

– The shares bought back should not exceed (10%) of the company’s

share capital; and

– The shares should be bought back with the intention of re-selling

them.

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Buyback in U.A.E.

• However, in 2012 because private joint stock companies have

recently pressed to access the flexibility offered by share buy-back,

the Ministry of Economy has modified its position and has been

applying the provisions of Article 168 CCL to private joint stock

companies without imposing the general assembly approval

requirement (under the approval of the Ministry of Finance).

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Common Stock: Authorized, Outstanding, and

Issued Shares (cont.)

•Golden Enterprises, a producer of medical pumps,

has the following stockholder’s equity account on

December 31st

.

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Common Stock: Voting Rights

• Voting Rights – because the shareholders are owners of the firm, they are

entitled to elect the board of directors.

• Generally, each share of common stock entitles its holder to one vote

in the election of directors and on special issues.

• Votes are generally assignable and may be cast at the annual

stockholders’ meeting.

Methods of voting

• A proxy statement is a statement transferring the votes of a

stockholder to another party.

• Because most small stockholders do not attend the annual meeting to

vote, they may sign a proxy statement transferring their votes to

another party.

• Existing management generally receives the stockholders’ proxies,

because it is able to solicit them at company expense.

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• Two methods of voting: (1) in person or (2) by proxy

Proxy – A legal document giving one person(s) authority to act

for another.

Voting

Procedures Example

• Under majority-rule voting: You may cast 100 votes (1 per

share) for each of the 9 director positions open for a

maximum of 100 votes per position.

• Under cumulative voting: You may cast 900 votes (100 votes

x 9 positions) for a single position or divide the votes

amongst the 9 open positions in any manner you desire.

You are a shareholder of FunFinMan, Inc. You

own 100 shares and there are 9 director

positions to be filled.

Minimum Votes to Elect a Director –

Cumulative

• For example, to elect 3 directors out of 9 director positions at

FunFinMan, Inc., (100,000 voting shares outstanding) would

require 30,001 voting shares.

• (100,000 shares) x (3 directors)

10

Total number of

voting shares

Specific number of

directors sought

Total number of directors to be elected + 1

X

+ 1

+ 1 = 30,001 shares

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Common Stock: Voting Rights (cont.)

• A proxy battle is an attempt by a nonmanagement group to

gain control of the management of a firm by soliciting a

sufficient number of proxy votes.

• Supervoting shares is stock that carries with it multiple

votes per share rather than the single vote per share typically

given on regular shares of common stock.

• Nonvoting common stock is common stock that carries no

voting rights; issued when the firm wishes to raise capital

through the sale of common stock but does not want to give

up its voting control.

Segmented capital markets

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Market Segmentation

• In a segmented market, since there is no foreign

participants, the securities would be priced on the basis

of domestic rather than international standards

• In a word, escaping from a segmented market, a firm

could have a better price for its securities and thus a

lower cost of capital based on international rather than

domestic standards

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11-349

Local versus Global capital markets

Segmented domestic securities

market that prices shares

according to domestic standards

Access to global securities market

that prices shares according to

international standards

Illiquid domestic securities market

and limited international liquidity

Firm’s securities appeal only

to domestic investors

Firm’s securities appeal to

international portfolio investors

Highly liquid domestic market and

broad international participation

Firm-Specific Characteristics

Market Liquidity for Firm’s Securities

Effect of Market Segmentation on Firm’s Securities and Cost of Capital

Local Market Access Global Market Access

SMARIZING SEGMENTATION..

Cross-listing

•(1). There is a vast academic literature on the

impact of cross-listings on the value of the crosslisted firms. Most studies find that cross-listing in

official U.S. stock exchanges, but there are also

many cross-listings on exchanges in Europe and

Asia. Even U.S. firms are cross-listed in other

countries. In the 1950s there was a wave of crosslistings of U.S. firms in Belgium, in the 1960s in

France, in the 1970s in the U.K., and in the 1980s in

Japan.

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Cross-listing: Evidence

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Cross-listing: Evidence

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Cross-listing: Evidence

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Common Stock: Dividends

• The payment of dividends to the firm’s shareholders is at the

discretion of the company’s board of directors.

• Dividends may be paid in cash, stock, or merchandise.

• Common stockholders are not promised a dividend, but they

come to expect certain payments on the basis of the historical

dividend pattern of the firm.

• Before dividends are paid to common stockholders any past

due dividends owed to preferred stockholders must be paid.

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Common Stock:

International Stock Issues

• The international market for common stock is not as large as

that for international debt.

• However, cross-border issuance and trading of common

stock have increased dramatically during the past 30 years.

• Stock Issued in Foreign Markets

• A growing number of firms are beginning to list their stocks on

foreign markets.

• Issuing stock internationally both broadens the company’s ownership

base and helps it to integrate itself in the local business environment.

• Locally traded stock can facilitate corporate acquisitions, because

shares can be used as an acceptable method of payment.

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Common Stock: International Stock

Issues (cont.)

•Foreign Stocks in U.S. Markets

• American depositary receipts (ADRs) are dollardenominated receipts for the stocks of foreign companies

that are held by a U.S. financial institution overseas.

• American depositary shares (ADSs) are securities,

backed by American depositary receipts (ADRs), that

permit U.S. investors to hold shares of non-U.S.

companies and trade them in U.S. markets.

• ADSs are issued in dollars to U.S. investors and are

subject to U.S. securities laws.

• ADSs give investors the opportunity to diversify their

portfolios internationally.

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Preferred Stock

•Preferred stock gives its holders certain privileges

that make them senior to common stockholders.

•Preferred stockholders are promised a fixed periodic

dividend, which is stated either as a percentage or as

a dollar amount.

•Par-value preferred stock is preferred stock with a

stated face value that is used with the specified

dividend percentage to determine the annual dollar

dividend.

•No-par preferred stock is preferred stock with no

stated face value but with a stated annual dollar

dividend.

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Preferred Stock: Basic Rights of Preferred

Stockholders

• Preferred stock is often considered quasi-debt because, much

like interest on debt, it specifies a fixed periodic payment

(dividend).

• Preferred stock is unlike debt in that it has no maturity date.

• Because they have a fixed claim on the firm’s income that

takes precedence over the claim of common stockholders,

preferred stockholders are exposed to less risk.

• Preferred stockholders are not normally given a voting

right, although preferred stockholders are sometimes allowed

to elect one member of the board of directors.

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Issuing Common Stock (IPO)

•Initial financing for most firms typically comes from

a firm’s original founders in the form of a common

stock investment.

•Early stage debt or equity investors are unlikely to

make an investment in a firm unless the founders

also have a personal stake in the business.

•Initial non-founder financing usually comes first

from private equity investors.

•After establishing itself, a firm will often “go

public” by issuing shares of stock to a much broader

group.

3

6

0 Why Issue Equity Publicly

Advantages Disadvantages

1. Access to capital markets 1. Expensive

2. Improved liquidity for shareholders 2. Costs of dealing with shareholders

3. Allowing original owners to diversify 3. Allowing competitiors gain information

4. Monitoring by external capital markets 4. Public pressure

5. Information provided by capital markets

6. Enhanced credibility with stakeholders

The IPO Process

• Time 0: The firm decides to go public.

• Time 1: The firm chooses an underwriter (an

investment bank). The underwriter will advice the

firm on the type of security to issue, help with the

pricing, the marketing, and the registration of the

shares on an organized exchange.

• Time 2: The firm starts trading on the exchange.

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Issuing Common Stock:

Venture Capital

•Venture capital is privately raised external equity

capital used to fund early-stage firms with attractive

growth prospects.

•Venture capitalists (VCs) are providers of venture

capital; typically, formal businesses that maintain

strong oversight over the firms they invest in and

that have clearly defined exit strategies.

•Angel capitalists (angels) are wealthy individual

investors who do not operate as a business but invest

in promising early-stage companies in exchange for

a portion of the firm’s equity.

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Table 7.2 Organization of Institutional Venture

Capital Investors

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Going Public

•When a firm wishes to sell its stock in the primary

market, it has three alternatives.

1. A public offering, in which it offers its shares for sale

to the general public.

2. A rights offering, in which new shares are sold to

existing shareholders.

3. A private placement, in which the firm sells new

securities directly to an investor or a group of

investors.

•Here we focus on the initial public offering (IPO),

which is the first public sale of a firm’s stock.

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Going Public (cont.)

•IPOs are typically made by small, fast-growing

companies that either:

• require additional capital to continue expanding, or

• have met a milestone for going public that was established

in a contract to obtain VC funding.

•The firm must obtain approval of current

shareholders, and hire an investment bank to

underwrite the offering.

•The investment banker is responsible for promoting

the stock and facilitating the sale of the company’s

IPO shares.

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Going Public (cont.)

•The company must file a registration statement with

the SEC.

•The prospectus is a portion of a security registration

statement that describes the key aspects of the issue,

the issuer, and its management and financial

position.

•A red herring is a preliminary prospectus made

available to prospective investors during the waiting

period between the registration statement’s filing

with the SEC and its approval.

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Figure 7.1 Cover of a Preliminary

Prospectus for a Stock Issue

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Going Public (cont.)

• Investment bankers and company officials promote the company

through a road show, a series of presentations to potential investors

around the country and sometimes overseas.

• This helps investment bankers gauge the demand for the offering

which helps them to set the initial offer price.

• After the underwriter sets the terms, the SEC must approve the

offering.

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Going Public:

The Investment Banker’s Role

• An investment banker is a financial intermediary that

specializes in selling new security issues and advising firms

with regard to major financial transactions.

• Underwriting is the role of the investment banker in bearing

the risk of reselling, at a profit, the securities purchased from

an issuing corporation at an agreed-on price.

• This process involves purchasing the security issue from the

issuing corporation at an agreed-on price and bearing the risk

of reselling it to the public at a profit.

• The investment banker also provides the issuer with advice

about pricing and other important aspects of the issue.

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Going Public: The Investment Banker’s

Role (cont.)

•An underwriting syndicate is a group of other

bankers formed by an investment banker to share the

financial risk associated with underwriting new

securities.

•The syndicate shares the financial risk associated

with buying the entire issue from the issuer and

reselling the new securities to the public.

•The selling group is a large number of brokerage

firms that join the originating investment banker(s);

each accepts responsibility for selling a certain

portion of a new security issue on a commission

basis.

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Common Stock Valuation

• Common stockholders expect to be rewarded through

periodic cash dividends and an increasing share value.

• Some of these investors decide which stocks to buy and sell

based on a plan to maintain a broadly diversified portfolio.

• Other investors have a more speculative motive for trading.

• They try to spot companies whose shares are undervalued—meaning

that the true value of the shares is greater than the current market

price.

• These investors buy shares that they believe to be undervalued and

sell shares that they think are overvalued (i.e., the market price is

greater than the true value).

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Common Stock Valuation:

Market Efficiency

•Economically rational buyers and sellers use their

assessment of an asset’s risk and return to determine

its value.

•In competitive markets with many active

participants, the interactions of many buyers and

sellers result in an equilibrium price—the market

value—for each security.

•Because the flow of new information is almost

constant, stock prices fluctuate, continuously

moving toward a new equilibrium that reflects the

most recent information available. This general

concept is known as market efficiency.

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Common Stock Valuation:

Market Efficiency

• The efficient-market hypothesis (EMH) is a theory describing the

behavior of an assumed “perfect” market in which:

• securities are in equilibrium,

• security prices fully reflect all available information and react swiftly to new

information, and

• because stocks are fully and fairly priced, investors need not waste time

looking for mispriced securities.

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Common Stock Valuation:

Market Efficiency

•Although considerable evidence supports the

concept of market efficiency, a growing body of

academic evidence has begun to cast doubt on the

validity of this notion.

•Behavioral finance is a growing body of research

that focuses on investor behavior and its impact on

investment decisions and stock prices. Advocates are

commonly referred to as “behaviorists.”

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Common Stock Valuation:

Basic Common Stock Valuation Equation

•The value of a share of common stock is equal to the

present value of all future cash flows (dividends) that

it is expected to provide.

•where

• P0

= value of common stock

Dt

= per-share dividend expected at the end of year t

Rs

= required return on common stock

P0

= value of common stock

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Common Stock Valuation:

The Zero Growth Model

•The zero dividend growth model assumes that the

stock will pay the same dividend each year, year after

year.

•The equation shows that with zero growth, the value

of a share of stock would equal the present value of a

perpetuity of D1 dollars discounted at a rate rs

.

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Personal Finance Example

•Chuck Swimmer estimates that the dividend of

Denham Company, an established textile producer,

is expected to remain constant at $3 per share

indefinitely.

•If his required return on its stock is 15%, the stock’s

value is:

• $20= ($3 ÷ 0.15) per share

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Common Stock Valuation:

Constant-Growth Model

•The constant-growth model is a widely cited dividend

valuation approach that assumes that dividends will grow at a

constant rate, but a rate that is less than the required return.

•The Gordon model is a common name for the constantgrowth model that is widely cited in dividend valuation.

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Common Stock Valuation:

Constant-Growth Model (cont.)

•Lamar Company, a small cosmetics company, paid

the following per share dividends:

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Common Stock Valuation:

Constant-Growth Model (cont.)

•Using a financial calculator or a spreadsheet, we find that

the historical annual growth rate of Lamar Company

dividends equals 7%.

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Common Stock Valuation:

Variable-Growth Model

•The zero- and constant-growth common stock

models do not allow for any shift in expected growth

rates.

•The variable-growth model is a dividend valuation

approach that allows for a change in the dividend

growth rate.

•To determine the value of a share of stock in the

case of variable growth, we use a four-step

procedure.

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Common Stock Valuation:

Variable-Growth Model (cont.)

•Step 1. Find the value of the cash dividends at the

end of each year, Dt

, during the initial growth period,

years 1 though N.

•Dt = D0 × (1 + g1

)

t

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Common Stock Valuation:

Variable-Growth Model (cont.)

•Step 2. Find the present value of the dividends

expected during the initial growth period.

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Common Stock Valuation:

Variable-Growth Model (cont.)

•Step 3. Find the value of the stock at the end of the

initial growth period, PN = (DN+1)/(rs – g2

), which is

the present value of all dividends expected from year

N + 1 to infinity, assuming a constant dividend

growth rate, g2

.

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Common Stock Valuation:

Variable-Growth Model (cont.)

•Step 4. Add the present value components found in

Steps 2 and 3 to find the value of the stock, P0

.

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Common Stock Valuation:

Variable-Growth Model (cont.)

•The most recent annual (2012) dividend payment of Warren

Industries, a rapidly growing boat manufacturer, was $1.50 per

share. The firm’s financial manager expects that these

dividends will increase at a 10% annual rate, g1

, over the next

three years. At the end of three years (the end of 2015), the

firm’s mature product line is expected to result in a slowing of

the dividend growth rate to 5% per year, g2

, for the foreseeable

future. The firm’s required return, rs

, is 15%.

•

Steps 1 and 2 are detailed in Table 7.3 on the following slide.

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Table 7.3 Calculation of Present Value of Warren

Industries Dividends (2013–2015)

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Common Stock Valuation:

Variable-Growth Model (cont.)

•Step 3. The value of the stock at the end of the initial growth

period

(N = 2015) can be found by first calculating DN+1 = D2016.

•D2016 = D2015 (1 + 0.05) = $2.00 (1.05) = $2.10

•By using D2016 = $2.10, a 15% required return, and a 5%

dividend growth rate, we can calculate the value of the stock at

the end of 2015 as follows:

•P2015 = D2016 / (rs – g2

) = $2.10 / (.15 – .05) = $21.00

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Common Stock Valuation:

Variable-Growth Model (cont.)

•Step 3 (cont.) Finally, the share value of $21 at the end of

2015 must be converted into a present (end of 2012) value.

•P2015 / (1 + rs

)

3 = $21 / (1 + 0.15)3 = $13.81

•Step 4. Adding the PV of the initial dividend stream (found in

Step 2) to the PV of the stock at the end of the initial growth

period (found in Step 3), we get:

•P2012 = $4.14 + $13.82 = $17.93 per share

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Common Stock Valuation:

Free Cash Flow Valuation Model

•A free cash flow valuation model determines the value of an

entire company as the present value of its expected free cash

flows discounted at the firm’s weighted average cost of capital,

which is its expected average future cost of funds over the

long run.

•where

VC

= value of the entire company

FCFt

= free cash flow expected at the end of year t end of year t

ra

= the firm’s weighted average cost of capital

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Common Stock Valuation:

Free Cash Flow Valuation Model (cont.)

•Because the value of the entire company, VC

, is the

market value of the entire enterprise (that is, of all

assets), to find common stock value, VS

, we must

subtract the market value of all of the firm’s debt, VD

,

and the market value of preferred stock, VP, from VC

.

•VS = VC – VD – VP

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Table 7.4 Dewhurst, Inc.’s Data for the Free

Cash Flow Valuation Model

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Common Stock Valuation:

Free Cash Flow Valuation Model (cont.)

•Step 1. Calculate the present value of the free cash

flow occurring from the end of 2018 to infinity,

measured at the beginning of 2018.

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Common Stock Valuation:

Free Cash Flow Valuation Model (cont.)

•Step 2. Add the present value of the FCF from 2018 to

infinity, which is measured at the end of 2017, to the 2017

FCF value to get the total FCF in 2017.

•Total FCF2017 = $600,000 + $10,300,000 = $10,900,000

•Step 3. Find the sum of the present values of the FCFs for

2013 through 2017 to determine the value of the entire

company, VC

. This step is detailed in Table 7.5 on the

following slide.

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Table 7.5 Calculation of the Value of the Entire

Company for Dewhurst, Inc.

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Common Stock Valuation:

Free Cash Flow Valuation Model (cont.)

•Step 4. Calculate the value of the common stock.

•VS = $8,626,426 – $3,100,000 – $800,000 =

$4,726,426

•The value of Dewhurst’s common stock is therefore

estimated to be $4,726,426. By dividing this total by

the 300,000 shares of common stock that the firm has

outstanding, we get a common stock value of $15.76

per share ($4,726,426 ÷ 300,000).

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Common Stock Valuation:

Other Approaches to Stock Valuation

• Book value per share is the amount per share of common

stock that would be received if all of the firm’s assets were

sold for their exact book (accounting) value and the proceeds

remaining after paying all liabilities (including preferred

stock) were divided among the common stockholders.

• This method lacks sophistication and can be criticized on the

basis of its reliance on historical balance sheet data.

• It ignores the firm’s expected earnings potential and generally

lacks any true relationship to the firm’s value in the

marketplace.

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Common Stock Valuation: Other Approaches to

Stock Valuation (cont.)

•At year-end 2012, Lamar Company’s balance sheet

shows total assets of $6 million, total liabilities

(including preferred stock) of $4.5 million, and

100,000 shares of common stock outstanding. Its

book value per share therefore would be

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Common Stock Valuation: Other Approaches to

Stock Valuation (cont.)

•Liquidation value per share is the actual amount

per share of common stock that would be received if

all of the firm’s assets were sold for their market

value, liabilities (including preferred stock) were

paid, and any remaining money were divided among

the common stockholders.

•This measure is more realistic than book value

because it is based on current market values of the

firm’s assets.

•However, it still fails to consider the earning power

of those assets.

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Common Stock Valuation: Other Approaches to

Stock Valuation (cont.)

•Lamar Company found upon investigation that it

could obtain only $5.25 million if it sold its assets

today. The firm’s liquidation value per share therefore

would be

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Common Stock Valuation: Other Approaches to

Stock Valuation (cont.)

•The price/earnings (P/E) ratio reflects the amount

investors are willing to pay for each dollar of

earnings.

•The price/earnings multiple approach is a popular

technique used to estimate the firm’s share value;

calculated by multiplying the firm’s expected

earnings per share (EPS) by the average

price/earnings (P/E) ratio for the industry.

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Common Stock Valuation: Other Approaches to

Stock Valuation (cont.)

•Lamar Company is expected to earn $2.60 per share

next year (2013). Assuming a industry average P/E

ratio of 7, the firms per share value would be

•$2.60 7 = $18.20 per share

Stocks… details

• Debt Vs. Equity (table 7.1)

• Private Vs. Public Ownership

• Rights issue (Preemptive rights) and Dilution of Ownership

• Authorized, Outstanding, Treasury, and Issued shares (Outstanding + Treasury)

• Common Stock, International Issue, Dividends

• Preferred Stock (no voting, can elect board, pays dividend, seniority)

• Issuing CS (original owners, early debt or equity investors, private equity / VC, public)

• Going Public (Prospectus, road show, investment banker role, underwriting)

• Valuation (Thursday 30th April)

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Book Value

• At year-end 2012, Lamar Company’s balance sheet shows total assets of $6

million, total liabilities (including preferred stock) of $4.5 million, and 100,000

shares of common stock outstanding. Its book value per share therefore would be

• P/E

• Lamar Company is expected to earn $2.60 per share next year (2013). Assuming a

industry average P/E ratio of 7, the firms per share value would be

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Dividend Discount Model

• Constant Dividend

• Chuck Swimmer estimates that the dividend of Denham Company, an established textile producer, is expected

to remain constant at $3 per share indefinitely. If his required return on its stock is 15%, the stock’s value is:

• Growth Dividend

• Given the table on the side, we can calculate that the growth is 7% for dividends, what is the

• price of the stock?

• 2Stage Dividend (Not part of assignment)

• The most recent annual (2012) dividend payment of Warren Industries, a rapidly growing boat manufacturer, was $1.50

per share. The firm’s financial manager expects that these dividends will increase at a 10% annual rate, g1

, over the next

three years. At the end of three years (the end of 2015), the firm’s mature product line is expected to result in a slowing of

the dividend growth rate to 5% per year, g2

, for the foreseeable future. The firm’s required return, rs

, is 15%.

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