The McGraw-Hill Companies, Inc.,20011- 1Irwin/McGraw-HillThe McGraw-Hill Companies, Inc.,20011- 2Irwin/McGraw-HillThe McGraw-Hill Companies, Inc.,20011- 3Irwin/McGraw-HillIrwin/McGraw-HillChapter 1Fundamentals of Corporate FinanceThird EditionThe Firm and The Financial ManagerBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 4Irwin/McGraw-HillIrwin/McGraw-HillTopics CoveredOrganizing a BusinessThe Role of The Financial ManagerFinancial MarketsWho Is The Financial ManagerCorporate Goals & IncentivesValue MaximizationThe McGraw-Hill Companies, Inc.,20011- 5Irwin/McGraw-HillIrwin/McGraw-HillOrganizing a BusinessTypes of Business OrganizationsSole ProprietorshipsPartnershipsCorporationsThe McGraw-Hill Companies, Inc.,20011- 6Irwin/McGraw-HillIrwin/McGraw-HillOrganizing a BusinessThe McGraw-Hill Companies, Inc.,20011- 7Irwin/McGraw-HillCorporate StructureThe McGraw-Hill Companies, Inc.,20011- 8Irwin/McGraw-HillIrwin/McGraw-HillFinancialmanagersFirmsoperationsFinancialmarkets(1) Cash raised from investors(1)(2) Cash invested in firm(2)(3) Cash generated by operations(3)(4a) Cash reinvested(4a)(4b) Cash returned to investors(4b)The Role of The Financial ManagerThe McGraw-Hill Companies, Inc.,20011- 9Irwin/McGraw-HillIrwin/McGraw-HillThe Role of The Financial ManagerInvestment Decisions“Capital Budgeting”Buy real assets that are worth more than they costThe McGraw-Hill Companies, Inc.,20011- 10Irwin/McGraw-HillIrwin/McGraw-HillThe Role of The Financial Manager“Capital Budgeting”The McGraw-Hill Companies, Inc.,20011- 11Irwin/McGraw-HillIrwin/McGraw-HillThe Role of The Financial ManagerFinancing DecisionsSource of Funds “Capital Markets”Capital StructureMoney MarketsEurosThe McGraw-Hill Companies, Inc.,20011- 12Irwin/McGraw-HillFinancial MarketsMoneyThe McGraw-Hill Companies, Inc.,20011- 13Irwin/McGraw-HillIrwin/McGraw-HillFinancial MarketsCompanyIssue DebtCashInvestorsThe McGraw-Hill Companies, Inc.,20011- 14Irwin/McGraw-HillIrwin/McGraw-HillFinancial MarketsFundsFundsBanksInsurance Cos.Brokerage FirmsObligationsDepositorsPolicyholdersInvestorsObligationsCompanyIntermediaryInvestorThe McGraw-Hill Companies, Inc.,20011- 15Irwin/McGraw-HillIrwin/McGraw-HillFinancial MarketsBanksDepositors$2.5 milCashLoanDepositsCompanyIntermediaryInvestorThe McGraw-Hill Companies, Inc.,20011- 16Irwin/McGraw-HillIrwin/McGraw-HillFinancial MarketsInsurance CompanyPolicyholders$250 milCashLoanSell policies Issue StockCompanyIntermediaryInvestorThe McGraw-Hill Companies, Inc.,20011- 17Irwin/McGraw-HillCareers in FinanceThe McGraw-Hill Companies, Inc.,20011- 18Irwin/McGraw-HillCareers in FinanceWageweb - www.wageweb.comWall Street Journal - careers.wsj.comBureau of Labor Statistics - www.bls.govWetfeet - www.wetfeet.comOhio State University - www.cob.ohio-state.edu/fin/osujobs.htmClick to access web sitesClick to access web sitesInternet connection requiredInternet connection requiredThe McGraw-Hill Companies, Inc.,20011- 19Irwin/McGraw-HillGoals of The CorporationShareholders desire wealth maximizationDo managers maximize shareholder wealth?Mangers have many constituencies “stakeholders”“Agency Problems” represent the conflict of interest between management and ownersThe McGraw-Hill Companies, Inc.,20011- 20Irwin/McGraw-HillGoals of The CorporationAgency Problem Solutions1 - Compensation plans2 - Board of Directors3 - Takeovers4 - Specialist Monitoring5 - AuditorsThe McGraw-Hill Companies, Inc.,20011- 21Irwin/McGraw-HillWho is The Financial Manager?Chief Financial OfficerTreasurerControllerThe McGraw-Hill Companies, Inc.,20011- 22Irwin/McGraw-HillWeb Resourceswww.financewise.comwww.forbes.comwww.wiso.gwdg.de/ifbg/finance.htmlwww.edgeonline.comwww.corpmon.comcrcse.business.pitt.edu/pages/biblio.htmlpw1.netcom.com/jstorres/internalaudit/resources.htmlClick to access web sitesClick to access web sitesInternet connection requiredInternet connection requiredThe McGraw-Hill Companies, Inc.,20011- 23Irwin/McGraw-Hill金融機構之角色金融機構之角色The McGraw-Hill Companies, Inc.,20011- 24Irwin/McGraw-Hill資本形成之方式資本形成之方式The McGraw-Hill Companies, Inc.,20011- 25Irwin/McGraw-Hill資金成本資金成本-利率利率利率之組成real risk-free rate of interestinflation premiumdefault risk premiumliquidity premiummaturity risk premiumThe McGraw-Hill Companies, Inc.,20011- 26Irwin/McGraw-Hill資金成本資金成本-利率利率( (續）續）影響利率之因素production opportunities and time preferencesexpected inflationdefault riskliquidityterm structurematuritycentral bank policybalance of paymenttax & government deficitThe McGraw-Hill Companies, Inc.,20011- 27Irwin/McGraw-Hill資金成本資金成本-利率利率( (續）續）利率期間結構與理論市場區隔理論流動性偏好理論預期理理論The McGraw-Hill Companies, Inc.,20011- 28Irwin/McGraw-Hill外匯市場外匯市場重要性:投資與融資活動之全球化生產與分派成本之降低國外資金之募集(資本注入與風險分散) 匯率: 外匯之價格表示 NT$/1US$: 33.25 NT$/US$ 決定:供給與需求The McGraw-Hill Companies, Inc.,20011- 29Irwin/McGraw-Hill外匯市場（續）外匯市場（續）影響匯率之因素決定:供給與需求利率差異物價水準差異其他 (GNP、貿易障礙、央行干預、赤字、國際收支)The McGraw-Hill Companies, Inc.,20011- 30Irwin/McGraw-HillIrwin/McGraw-HillChapter 10Fundamentals of Corporate FinanceThird EditionRisk, Return, and Capital BudgetingBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 31Irwin/McGraw-HillTopics CoveredMeasuring BetaPortfolio BetasCAPM and Expected ReturnSecurity Market LineCapital Budgeting and Project RiskThe McGraw-Hill Companies, Inc.,20011- 32Irwin/McGraw-HillMeasuring Market RiskMarket Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market.Beta - Sensitivity of a stocks return to the return on the market portfolio.The McGraw-Hill Companies, Inc.,20011- 33Irwin/McGraw-HillMeasuring Market RiskExample - Turbo Charged Seafood has the following % returns on its stock, relative to the listed changes in the % return on the market portfolio. The beta of Turbo Charged Seafood can be derived from this information.The McGraw-Hill Companies, Inc.,20011- 34Irwin/McGraw-HillMeasuring Market RiskExample - continuedThe McGraw-Hill Companies, Inc.,20011- 35Irwin/McGraw-HillMeasuring Market RiskWhen the market was up 1%, Turbo average % change was +0.8%When the market was down 1%, Turbo average % change was -0.8% The average change of 1.6 % (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8.Example - continuedThe McGraw-Hill Companies, Inc.,20011- 36Irwin/McGraw-HillMeasuring Market RiskWhen the market was up 1%, Turbo average % change was +0.8%When the market was down 1%, Turbo average % change was -0.8% The average change of 1.6 % (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8.Example - continuedThe McGraw-Hill Companies, Inc.,20011- 37Irwin/McGraw-HillMeasuring Market RiskExample - continuedThe McGraw-Hill Companies, Inc.,20011- 38Irwin/McGraw-HillPortfolio BetasDiversification decreases variability from unique risk, but not from market risk.The beta of your portfolio will be an average of the betas of the securities in the portfolio.If you owned all of the S&P Composite Index stocks, you would have an average beta of 1.0 The McGraw-Hill Companies, Inc.,20011- 39Irwin/McGraw-HillMeasuring Market RiskMarket Risk Premium - Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills. Market PortfolioThe McGraw-Hill Companies, Inc.,20011- 40Irwin/McGraw-HillMeasuring Market RiskCAPM - Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium.The McGraw-Hill Companies, Inc.,20011- 41Irwin/McGraw-HillMeasuring Market RiskSecurity Market Line - The graphic representation of the CAPM.01Beta02040Expected Return (%) . RfRmSecurity Market LineThe McGraw-Hill Companies, Inc.,20011- 42Irwin/McGraw-HillCapital Budgeting & Project RiskThe project cost of capital depends on the use to which the capital is being put. Therefore, it depends on the risk of the project and not the risk of the company. The McGraw-Hill Companies, Inc.,20011- 43Irwin/McGraw-HillCapital Budgeting & Project RiskExample - Based on the CAPM, ABC Company has a cost of capital of 17%. (4 + 1.3(10). A breakdown of the companys investment projects is listed below. When evaluating a new dog food production investment, which cost of capital should be used?1/3 Nuclear Parts Mfr. B=2.01/3 Computer Hard Drive Mfr. B=1.31/3 Dog Food Production B=0.6AVG. B of assets = 1.3 The McGraw-Hill Companies, Inc.,20011- 44Irwin/McGraw-HillCapital Budgeting & Project RiskExample - Based on the CAPM, ABC Company has a cost of capital of 17%. (4 + 1.3(10). A breakdown of the companys investment projects is listed below. When evaluating a new dog food production investment, which cost of capital should be used?R = 4 + 0.6 (14 - 4 ) = 10% 10% reflects the opportunity cost of capital on an investment given the unique risk of the project.The McGraw-Hill Companies, Inc.,20011- 45Irwin/McGraw-HillDerivation of CAPM Capital Market LineIndividuals Efficient Frontier with Risk Free AssetThe McGraw-Hill Companies, Inc.,20011- 46Irwin/McGraw-HillDerivation of CAPMHomogeneous Expectation-One Market Efficienf Frontier:Capital market Line (CML)The Slope of Capital Market Line is: The McGraw-Hill Companies, Inc.,20011- 47Irwin/McGraw-HillDerivation of CAPMSeurity Market Line (CAPM)If a portfolio is consisted of A and market portfolio M with asset A, W%, and M, (1-W%), thenThe McGraw-Hill Companies, Inc.,20011- 48Irwin/McGraw-HillDerivation of CAPM對 W 取一階導數:When in equilibrium, W=0 and .The McGraw-Hill Companies, Inc.,20011- 49Irwin/McGraw-HillDerivation of CAPMThe slope of the portfolio in equilibrium then is:Since in equilibrium, the portfolio is equal the market portfolio, the slope of the portfolio in CML must equal to that of the market portfolio, the equation can constructed as follows:The McGraw-Hill Companies, Inc.,20011- 50Irwin/McGraw-HillDerivation of CAPM簡化上式：In market model:SMLThe McGraw-Hill Companies, Inc.,20011- 51Irwin/McGraw-HillDerivation of CAPMThe McGraw-Hill Companies, Inc.,20011- 52Irwin/McGraw-Hill 第二講 財務報表分析與證券 價值之評定廖咸興臺灣大學財務金融系/所The McGraw-Hill Companies, Inc.,20011- 53Irwin/McGraw-Hill證券分析之類型證券分析之類型技術分析 線型分析基本分析總體經濟情勢分析產業分析公司競爭策略與財務分析 The McGraw-Hill Companies, Inc.,20011- 54Irwin/McGraw-Hill影響公司股價的內外在因素影響公司股價的內外在因素管理當局無法控制之外在限制股票市場情勢1.經濟景氣2.匯率水準3.利率水準4.所得稅5.公交法6.勞基法7.環保法規8.其他管理當局可控制之決策1.融資決策2.投資決策3.股利政策4.產品與服務5.生產方法6.行銷方式7.其他預期獲利現金流量風險程度股票價格The McGraw-Hill Companies, Inc.,20011- 55Irwin/McGraw-Hill產業分析產業分析市場競爭程度現有競爭者1.成長性; 2.集中度; 3.差異性; 4.超額產能 5.學習/規模經濟新競爭者威脅1.通路; 2.法定障礙; 3.規模經濟;4.政商關係.替代品威脅1.相對價格; 2.績效; 3.顧客轉換意願產業獲利性顧客議價能力1.轉換成本; 2.差異性;4.成本與品質重要性 5.顧客數量及批量供應商議價能力1.轉換成本; 2.差異性;4.成本與品質重要性 5.顧客數量及批量議價能力The McGraw-Hill Companies, Inc.,20011- 56Irwin/McGraw-Hill公司競爭策略分析公司競爭策略分析成本優勢1.成本較低2.規模經濟3.生產效率4.原料成本低5.通路成本低6.產品簡單產品差異化1.高品質2.產品多樣化3.售後服務4.彈性送貨5.品牌形象6.產品創新競爭利基1.公司的核心能力與成功因子能配合執上述策略2.公司進行的計畫能配合執上述策略 3.競爭優勢之持續性 The McGraw-Hill Companies, Inc.,20011- 57Irwin/McGraw-Hill公司財務報表分析公司財務報表分析-目的與用途目的與用途財務分析之目的透過對公司財務報表之分析，來了解該公司營運績效及風險與報酬之狀況，以利投資人進行投資決策（或經營之績效管理）。財務分析之用途股票評價(估計與評估系統風險)預測信用或債券評等預測破產績效管理The McGraw-Hill Companies, Inc.,20011- 58Irwin/McGraw-Hill 財務會計之假設與原則財務會計之假設與原則假設 經濟個體，永續經營，貨幣衡量，期間原則 成本原則，收入承認原則，費用配合原則 充份揭露原則 The McGraw-Hill Companies, Inc.,20011- 59Irwin/McGraw-Hill公司財務分析之標的公司財務分析之標的-財務報表財務報表資產負債表某特定時點公司帳面之資產、負債與權益狀況損益表某特定時段公司帳面經營之損益現金流量表某特定時段，公司由營運、投資與融資三種活動而來的現金流量The McGraw-Hill Companies, Inc.,20011- 60Irwin/McGraw-Hill閱讀財務報表應注意事項閱讀財務報表應注意事項會計方法的一致性存貨計價方法折舊方法建築業利潤之完工入帳法其他不尋常的存貨上升不尋常的應收帳款上升The McGraw-Hill Companies, Inc.,20011- 61Irwin/McGraw-Hill閱讀財務報表應注意事項閱讀財務報表應注意事項(續續)淨利與營運而來之現金流量差異不尋常擴大不尋常之獲利增加未預期的大規模資產沖銷關係人(企業)交易但書:不尋常有問題; 會計改變管理操弄The McGraw-Hill Companies, Inc.,20011- 62Irwin/McGraw-Hill財務分析主要工具財務分析主要工具-財務比率分析財務比率分析共同比率分析營運能力之比率分析流動性之比率分析長期償債能力之比率分析獲利能力之比率分析市場基本面比率The McGraw-Hill Companies, Inc.,20011- 63Irwin/McGraw-HillThe McGraw-Hill Companies, Inc.,20011- 64Irwin/McGraw-HillThe McGraw-Hill Companies, Inc.,20011- 65Irwin/McGraw-Hill營運能力之比率分析營運能力之比率分析存貨週轉率 =應收帳款週轉率 =總資產週轉率 =營運比率 =The McGraw-Hill Companies, Inc.,20011- 66Irwin/McGraw-Hill流動性之比率分析流動性之比率分析流動比率 = 速動比率 =現金流量流動比率 =防禦區間=現金循環長度 = 平均存貨天數平均應收帳款 天數平均應付帳天數The McGraw-Hill Companies, Inc.,20011- 67Irwin/McGraw-Hill現金循環長度個案比較現金循環長度個案比較（裕隆、中華、國產車）（裕隆、中華、國產車）The McGraw-Hill Companies, Inc.,20011- 68Irwin/McGraw-Hill長期償債能力之比率分析長期償債能力之比率分析負債權益比 = 利息（償債支出）保障比率 = 現金基礎 =現金流量流動比率 =The McGraw-Hill Companies, Inc.,20011- 69Irwin/McGraw-Hill獲利能力之比率分析獲利能力之比率分析銷貨利潤率 = 權益報酬率 = 資產報酬率 =The McGraw-Hill Companies, Inc.,20011- 70Irwin/McGraw-Hill市場基本面比率市場基本面比率本益比 =淨值市價比 = 市價現金流量比=市價營收比=The McGraw-Hill Companies, Inc.,20011- 71Irwin/McGraw-HillThe McGraw-Hill Companies, Inc.,20011- 72Irwin/McGraw-Hill財務比率分析之應用財務比率分析之應用優劣之判定與同業比較與本身前幾期比較(趨勢)與同業作趨勢比較股票評價(P/E, EPS)預測信用或債券評等預測破產(Z-模型(1966)及ZETA模型）Z= The McGraw-Hill Companies, Inc.,20011- 73Irwin/McGraw-Hill 金融機構比率分析金融機構比率分析獲利性流動性安全性授信品質資本適足性The McGraw-Hill Companies, Inc.,20011- 74Irwin/McGraw-Hill金融機構獲利能力之比率分析金融機構獲利能力之比率分析權益報酬率資產報酬率利差比率=淨營運費用比率=The McGraw-Hill Companies, Inc.,20011- 75Irwin/McGraw-HillThe McGraw-Hill Companies, Inc.,20011- 76Irwin/McGraw-Hill金融機構流動性之比率分析金融機構流動性之比率分析放款佔資產比率=存放比率=短期資產比率=短期融通比率=The McGraw-Hill Companies, Inc.,20011- 77Irwin/McGraw-Hill放款佔資產比率放款佔資產比率The McGraw-Hill Companies, Inc.,20011- 78Irwin/McGraw-Hill存放比率存放比率The McGraw-Hill Companies, Inc.,20011- 79Irwin/McGraw-Hill金融機構安全性之比率分析金融機構安全性之比率分析授信品質 逾放比率=資本適足性 自有資本比率= 自有資本對風險性資產比率=The McGraw-Hill Companies, Inc.,20011- 80Irwin/McGraw-Hill逾放比率逾放比率The McGraw-Hill Companies, Inc.,20011- 81Irwin/McGraw-Hill自有資本對風險性資產比率自有資本對風險性資產比率The McGraw-Hill Companies, Inc.,20011- 82Irwin/McGraw-HillIrwin/McGraw-HillChapter 3Fundamentals of Corporate FinanceThird EditionThe Time Value of MoneyBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 83Irwin/McGraw-HillTopics CoveredFuture ValuesPresent ValuesMultiple Cash FlowsPerpetuities and AnnuitiesInflation & Time ValueEffective Annual Interest RateThe McGraw-Hill Companies, Inc.,20011- 84Irwin/McGraw-HillFuture ValuesFuture Value - Amount to which an investment will grow after earning interest.Compound Interest - Interest earned on interest.Simple Interest - Interest earned only on the original investment.The McGraw-Hill Companies, Inc.,20011- 85Irwin/McGraw-HillFuture ValuesFuture Value of $100 = FVThe McGraw-Hill Companies, Inc.,20011- 86Irwin/McGraw-HillFuture ValuesExample - FVWhat is the future value of $100 if interest is compounded annually at a rate of 6% for five years?The McGraw-Hill Companies, Inc.,20011- 87Irwin/McGraw-HillFuture ValuesExample - FVWhat is the future value of $100 if interest is compounded annually at a rate of 6% for five years?The McGraw-Hill Companies, Inc.,20011- 88Irwin/McGraw-HillFuture Values with CompoundingInterest RatesThe McGraw-Hill Companies, Inc.,20011- 89Irwin/McGraw-HillManhattan Island SalePeter Minuit bought Manhattan Island for $24 in 1626. Was this a good deal? To answer, determine $24 is worth in the year 2000, compounded at 8%. FYI - The value of Manhattan Island land is FYI - The value of Manhattan Island land is well below this well below this figurefigure. . The McGraw-Hill Companies, Inc.,20011- 90Irwin/McGraw-HillPresent ValuesPresent ValueValue today of a future cash flow.Discount RateInterest rate used to compute present values of future cash flows.Discount FactorPresent value of a $1 future payment.The McGraw-Hill Companies, Inc.,20011- 91Irwin/McGraw-HillPresent ValuesThe McGraw-Hill Companies, Inc.,20011- 92Irwin/McGraw-HillPresent ValuesExampleYou just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?The McGraw-Hill Companies, Inc.,20011- 93Irwin/McGraw-HillPresent ValuesDiscount Factor = DF = PV of $1Discount Factors can be used to compute the present value of any cash flow.The McGraw-Hill Companies, Inc.,20011- 94Irwin/McGraw-HillThe PV formula has many applications. Given any variables in the equation, you can solve for the remaining variable. Time Value of Money(applications)The McGraw-Hill Companies, Inc.,20011- 95Irwin/McGraw-HillValue of Free CreditImplied Interest RatesInternal Rate of ReturnTime necessary to accumulate fundsTime Value of Money(applications)The McGraw-Hill Companies, Inc.,20011- 96Irwin/McGraw-HillPV of Multiple Cash FlowsExampleYour auto dealer gives you the choice to pay $15,500 cash now, or make three payments: $8,000 now and $4,000 at the end of the following two years. If your cost of money is 8%, which do you prefer?The McGraw-Hill Companies, Inc.,20011- 97Irwin/McGraw-HillPV of Multiple Cash FlowsPVs can be added together to evaluate multiple cash flows.The McGraw-Hill Companies, Inc.,20011- 98Irwin/McGraw-HillPerpetuities & AnnuitiesPerpetuity A stream of level cash payments that never ends.Annuity Equally spaced level stream of cash flows for a limited period of time.The McGraw-Hill Companies, Inc.,20011- 99Irwin/McGraw-HillPerpetuities & AnnuitiesPV of Perpetuity FormulaC = cash payment r = interest rate The McGraw-Hill Companies, Inc.,20011- 100Irwin/McGraw-HillPerpetuities & AnnuitiesExample - PerpetuityIn order to create an endowment, which pays $100,000 per year, forever, how much money must be set aside today in the rate of interest is 10%?The McGraw-Hill Companies, Inc.,20011- 101Irwin/McGraw-HillPerpetuities & AnnuitiesExample - continuedIf the first perpetuity payment will not be received until three years from today, how much money needs to be set aside today?The McGraw-Hill Companies, Inc.,20011- 102Irwin/McGraw-HillPerpetuities & AnnuitiesPV of Annuity FormulaC = cash payment r = interest rate t = Number of years cash payment is receivedThe McGraw-Hill Companies, Inc.,20011- 103Irwin/McGraw-HillPerpetuities & AnnuitiesPV Annuity Factor (PVAF) - The present value of $1 a year for each of t years. The McGraw-Hill Companies, Inc.,20011- 104Irwin/McGraw-HillPerpetuities & AnnuitiesExample - AnnuityYou are purchasing a car. You are scheduled to make 3 annual installments of $4,000 per year. Given a rate of interest of 10%, what is the price you are paying for the car (i.e. what is the PV)?The McGraw-Hill Companies, Inc.,20011- 105Irwin/McGraw-HillPerpetuities & AnnuitiesApplicationsValue of paymentsImplied interest rate for an annuityCalculation of periodic payments Mortgage paymentAnnual income from an investment payoutFuture Value of annual paymentsThe McGraw-Hill Companies, Inc.,20011- 106Irwin/McGraw-HillPerpetuities & AnnuitiesExample - Future Value of annual paymentsYou plan to save $4,000 every year for 20 years and then retire. Given a 10% rate of interest, what will be the FV of your retirement account? The McGraw-Hill Companies, Inc.,20011- 107Irwin/McGraw-HillInflationInflation - Rate at which prices as a whole are increasing.Nominal Interest Rate - Rate at which money invested grows.Real Interest Rate - Rate at which the purchasing power of an investment increases.The McGraw-Hill Companies, Inc.,20011- 108Irwin/McGraw-HillInflationapproximation formulaThe McGraw-Hill Companies, Inc.,20011- 109Irwin/McGraw-HillInflationExampleIf the interest rate on one year govt. bonds is 5.0% and the inflation rate is 2.2%, what is the real interest rate?SavingsBondThe McGraw-Hill Companies, Inc.,20011- 110Irwin/McGraw-HillEffective Interest RatesAnnual Percentage Rate - Interest rate that is annualized using simple interest.Effective Annual Interest Rate - Interest rate that is annualized using compound interest.The McGraw-Hill Companies, Inc.,20011- 111Irwin/McGraw-HillEffective Interest RatesexampleGiven a monthly rate of 1%, what is the Effective Annual Rate(EAR)? What is the Annual Percentage Rate (APR)?The McGraw-Hill Companies, Inc.,20011- 112Irwin/McGraw-Hill基本財務數學摘要基本財務數學摘要現值與未來值年金（Annuity）的未來值和現值貸款常數（mortgage constant） 與沉入基金因子（sinking fund factor）The McGraw-Hill Companies, Inc.,20011- 113Irwin/McGraw-Hill現值與未來值現值與未來值現值與未來值之關係FVn=PV(1+r)nFVn=PV(1+r/m)nmEffective Annual Yield (EAY)EAY=(1+r/m)m -1未來值因子：FV(r/m,nm)=(1+r/m)nm現值因子：PV(r/m,nm)=1/(1+r/m)nmThe McGraw-Hill Companies, Inc.,20011- 114Irwin/McGraw-Hill年金的未來值和現值（年金的未來值和現值（I I）永久年金(Annuity)的現值：年金現值因子(Annuity Present Value Factor)為：The McGraw-Hill Companies, Inc.,20011- 115Irwin/McGraw-Hill年金的未來值和現值（年金的未來值和現值（IIII）年金未來值因子為The McGraw-Hill Companies, Inc.,20011- 116Irwin/McGraw-Hill貸款常數貸款常數(mortgage constant)與與沉入基金因子沉入基金因子(sinking fund factor)貸款常數PV=APVA(r,n) A=PV1/PVA(r,nMC=11/PVA(r,n沉入基金因子FV=AFVA(r,n) A=FV1/FVA(r,nSFF=11/FVA(r,nThe McGraw-Hill Companies, Inc.,20011- 117Irwin/McGraw-HillIrwin/McGraw-HillChapter 4Fundamentals of Corporate FinanceThird EditionValuing BondsBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 118Irwin/McGraw-HillIrwin/McGraw-HillTopics CoveredBond Characteristicsreading the financial pagesBond Prices and YieldsBond prices and interest ratesYTM vs. current yieldRate of ReturnInterest Rate RiskThe Yield CurveNominal and Real Rates of InterestDefault RiskThe McGraw-Hill Companies, Inc.,20011- 119Irwin/McGraw-HillBondsTerminologyBond - Security that obligates the issuer to make specified payments to the bondholder.Coupon - The interest payments made to the bondholder.Face Value (Par Value or Maturity Value) - Payment at the maturity of the bond.Coupon Rate - Annual interest payment, as a percentage of face value.The McGraw-Hill Companies, Inc.,20011- 120Irwin/McGraw-HillBondsWARNINGThe coupon rate IS NOT the discount rate used in the Present Value calculations. The coupon rate merely tells us what cash flow the bond will produce. Since the coupon rate is listed as a %, this misconception is quite common. The McGraw-Hill Companies, Inc.,20011- 121Irwin/McGraw-HillBond PricingThe price of a bond is the Present Value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return.The McGraw-Hill Companies, Inc.,20011- 122Irwin/McGraw-HillBond PricingExampleWhat is the price of a 6 % annual coupon bond, with a $1,000 face value, which matures in 3 years? Assume a required return of 5.6%. The McGraw-Hill Companies, Inc.,20011- 123Irwin/McGraw-HillBond PricingExample (continued)What is the price of the bond if the required rate of return is 6 %?The McGraw-Hill Companies, Inc.,20011- 124Irwin/McGraw-HillBond PricingExample (continued)What is the price of the bond if the required rate of return is 15 %?The McGraw-Hill Companies, Inc.,20011- 125Irwin/McGraw-HillBond PricingExample (continued)What is the price of the bond if the required rate of return is 5.6% AND the coupons are paid semi-annually?The McGraw-Hill Companies, Inc.,20011- 126Irwin/McGraw-HillBond PricingExample (continued)Q: How did the calculation change, given semi-annual coupons versus annual coupon payments?Time PeriodsPaying coupons twice a year, instead of once doubles the total number of cash flows to be discounted in the PV formula.Discount RateSince the time periods are now half years, the discount rate is also changed from the annual rate to the half year rate.The McGraw-Hill Companies, Inc.,20011- 127Irwin/McGraw-HillBond YieldsCurrent Yield - Annual coupon payments divided by bond price.Yield To Maturity - Interest rate for which the present value of the bonds payments equal the price.The McGraw-Hill Companies, Inc.,20011- 128Irwin/McGraw-HillBond YieldsCalculating Yield to Maturity (YTM=r)If you are given the price of a bond (PV) and the coupon rate, the yield to maturity can be found by solving for r.The McGraw-Hill Companies, Inc.,20011- 129Irwin/McGraw-HillBond YieldsExampleWhat is the YTM of a 6 % annual coupon bond, with a $1,000 face value, which matures in 3 years? The market price of the bond is $1,010.77The McGraw-Hill Companies, Inc.,20011- 130Irwin/McGraw-HillBond YieldsWARNINGCalculating YTM by hand can be very tedious. It is highly recommended that you learn to use the “IRR” or “YTM” or “i” functions on a financial calculator. The McGraw-Hill Companies, Inc.,20011- 131Irwin/McGraw-HillBond YieldsRate of Return - Earnings per period per dollar invested.The McGraw-Hill Companies, Inc.,20011- 132Irwin/McGraw-HillInterest Rate RiskPremium BondDiscount BondThe McGraw-Hill Companies, Inc.,20011- 133Irwin/McGraw-HillInterest Rate Risk30 yr bond3 yr bondThe McGraw-Hill Companies, Inc.,20011- 134Irwin/McGraw-HillNominal and Real ratesYield on UK nominal bondsYield on UK indexed bondsThe McGraw-Hill Companies, Inc.,20011- 135Irwin/McGraw-HillDefault RiskCredit riskDefault premiumInvestment gradeJunk bondsThe McGraw-Hill Companies, Inc.,20011- 136Irwin/McGraw-HillDefault RiskThe McGraw-Hill Companies, Inc.,20011- 137Irwin/McGraw-HillCorporate BondsZero couponsFloating rate bondsConvertible bondsThe McGraw-Hill Companies, Inc.,20011- 138Irwin/McGraw-HillThe Yield CurveTerm Structure of Interest Rates - A listing of bond maturity dates and the interest rates that correspond with each date.Yield Curve - Graph of the term structure.The McGraw-Hill Companies, Inc.,20011- 139Irwin/McGraw-HillWeb Resourceswww.finpipe.comwww.investinginbonds.comwww.bloomberg.com/markets/C13.htmlwww.bondmarkets.com/publications/IGCORP/what.htmwww.moodys.comwww.standardandpoors.com/ratingsClick to access web sitesClick to access web sitesInternet connection requiredInternet connection requiredThe McGraw-Hill Companies, Inc.,20011- 140Irwin/McGraw-HillIrwin/McGraw-HillChapter 5Fundamentals of Corporate FinanceThird EditionValuing StocksBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 141Irwin/McGraw-HillIrwin/McGraw-HillTopics CoveredStocks and the Stock MarketBook Values, Liquidation Values and Market ValuesValuing Common StocksSimplifying the Dividend Discount ModelGrowth Stocks and Income StocksThe McGraw-Hill Companies, Inc.,20011- 142Irwin/McGraw-HillStocks & Stock MarketPrimary Market - Place where the sale of new stock first occurs.Initial Public Offering (IPO) - First offering of stock to the general public.Seasoned Issue - Sale of new shares by a firm that has already been through an IPOThe McGraw-Hill Companies, Inc.,20011- 143Irwin/McGraw-HillStocks & Stock MarketCommon Stock - Ownership shares in a publicly held corporation.Secondary Market - market in which already issued securities are traded by investors.Dividend - Periodic cash distribution from the firm to the shareholders.P/E Ratio - Price per share divided by earnings per share.The McGraw-Hill Companies, Inc.,20011- 144Irwin/McGraw-HillStocks & Stock MarketThe McGraw-Hill Companies, Inc.,20011- 145Irwin/McGraw-HillStocks & Stock MarketBook Value - Net worth of the firm according to the balance sheet.Liquidation Value - Net proceeds that would be realized by selling the firms assets and paying off its creditors.Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.The McGraw-Hill Companies, Inc.,20011- 146Irwin/McGraw-HillValuing Common StocksExpected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the holding period return (HPR). The McGraw-Hill Companies, Inc.,20011- 147Irwin/McGraw-HillValuing Common StocksThe formula can be broken into two parts.Dividend Yield + Capital Appreciation The McGraw-Hill Companies, Inc.,20011- 148Irwin/McGraw-HillValuing Common StocksDividend Discount Model - Computation of todays stock price which states that share value equals the present value of all expected future dividends.H - Time horizon for your investment.The McGraw-Hill Companies, Inc.,20011- 149Irwin/McGraw-HillValuing Common StocksExampleCurrent forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?The McGraw-Hill Companies, Inc.,20011- 150Irwin/McGraw-HillValuing Common StocksExampleCurrent forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?The McGraw-Hill Companies, Inc.,20011- 151Irwin/McGraw-HillValuing Common StocksIf we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.Assumes all earnings are paid to shareholders.The McGraw-Hill Companies, Inc.,20011- 152Irwin/McGraw-HillValuing Common StocksConstant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).Given any combination of variables in the equation, you can solve for the unknown variable. The McGraw-Hill Companies, Inc.,20011- 153Irwin/McGraw-HillValuing Common StocksExampleWhat is the value of a stock that expects to pay a $3.00 dividend next year, and then increase the dividend at a rate of 8% per year, indefinitely? Assume a 12% expected return.The McGraw-Hill Companies, Inc.,20011- 154Irwin/McGraw-HillValuing Common StocksExample- continuedIf the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends?AnswerThe market is assuming the dividend will grow at 9% per year, indefinitely.The McGraw-Hill Companies, Inc.,20011- 155Irwin/McGraw-HillValuing Common StocksIf a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher.Payout Ratio - Fraction of earnings paid out as dividendsPlowback Ratio - Fraction of earnings retained by the firm.The McGraw-Hill Companies, Inc.,20011- 156Irwin/McGraw-HillValuing Common StocksGrowth can be derived from applying the return on equity to the percentage of earnings plowed back into operations.g = return on equity X plowback ratioThe McGraw-Hill Companies, Inc.,20011- 157Irwin/McGraw-HillValuing Common StocksExampleOur company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to plow back 40% of the earnings at the firms current return on equity of 20%. What is the value of the stock before and after the plowback decision? The McGraw-Hill Companies, Inc.,20011- 158Irwin/McGraw-HillValuing Common StocksExampleOur company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to blow back 40% of the earnings at the firms current return on equity of 20%. What is the value of the stock before and after the plowback decision?No GrowthWith GrowthThe McGraw-Hill Companies, Inc.,20011- 159Irwin/McGraw-HillValuing Common StocksExample - continuedIf the company did not plowback some earnings, the stock price would remain at $41.67. With the plowback, the price rose to $75.00. The difference between these two numbers (75.00-41.67=33.33) is called the Present Value of Growth Opportunities (PVGO).The McGraw-Hill Companies, Inc.,20011- 160Irwin/McGraw-HillValuing Common StocksPresent Value of Growth Opportunities (PVGO) - Net present value of a firms future investments.Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity. The McGraw-Hill Companies, Inc.,20011- 161Irwin/McGraw-HillWeb Resourceswww.ganesha.org/invest/index.htmlwww.nasdaq.comwww.nyse.comwww.fool.com/School/HowtoValueStocks.htmwww.zacks.comInvestools.comwww.morningstar.netwww.brill.comClick to access web sitesClick to access web sitesInternet connection requiredInternet connection requiredThe McGraw-Hill Companies, Inc.,20011- 162Irwin/McGraw-HillIrwin/McGraw-HillChapter 6Fundamentals of Corporate FinanceThird EditionNet Present Value and Other Investment CriteriaBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 163Irwin/McGraw-HillTopics CoveredNet Present ValueOther Investment CriteriaProject InteractionsCapital RationingThe McGraw-Hill Companies, Inc.,20011- 164Irwin/McGraw-HillNet Present ValueOpportunity Cost of Capital - Expected rate of return given up by investing in a project. Net Present Value - Present value of cash flows minus initial investments.The McGraw-Hill Companies, Inc.,20011- 165Irwin/McGraw-HillNet Present ValueExampleSuppose we can invest $50 today and receive $60 in one year. What is our increase in value given a 10% expected return?This is the definition of NPVInitial InvestmentAdded Value$50$4.55The McGraw-Hill Companies, Inc.,20011- 166Irwin/McGraw-HillNet Present ValueNPV = PV - required investmentThe McGraw-Hill Companies, Inc.,20011- 167Irwin/McGraw-HillNet Present ValueTerminologyC = Cash Flowt = time period of the investmentr = “opportunity cost of capital”The Cash Flow could be positive or negative at any time period.The McGraw-Hill Companies, Inc.,20011- 168Irwin/McGraw-HillNet Present ValueNet Present Value RuleManagers increase shareholders wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value.The McGraw-Hill Companies, Inc.,20011- 169Irwin/McGraw-HillNet Present ValueExampleYou have the opportunity to purchase an office building. You have a tenant lined up that will generate $16,000 per year in cash flows for three years. At the end of three years you anticipate selling the building for $450,000. How much would you be willing to pay for the building?The McGraw-Hill Companies, Inc.,20011- 170Irwin/McGraw-HillNet Present Value0 1 2 3$16,000$16,000$16,000$450,000$466,000Present Value 14,953 14,953 380,395$409,323Example - continuedThe McGraw-Hill Companies, Inc.,20011- 171Irwin/McGraw-HillNet Present ValueExample - continuedIf the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building?The McGraw-Hill Companies, Inc.,20011- 172Irwin/McGraw-HillNet Present ValueExample - continuedIf the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building?The McGraw-Hill Companies, Inc.,20011- 173Irwin/McGraw-HillOther Investment CriteriaInternal Rate of Return (IRR) - Discount rate at which NPV = 0.Rate of Return Rule - Invest in any project offering a rate of return that is higher than the opportunity cost of capital.The McGraw-Hill Companies, Inc.,20011- 174Irwin/McGraw-HillInternal Rate of ReturnExampleYou can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment?IRR = 12.96%The McGraw-Hill Companies, Inc.,20011- 175Irwin/McGraw-HillInternal Rate of ReturnIRR=12.96%The McGraw-Hill Companies, Inc.,20011- 176Irwin/McGraw-HillPayback MethodPayback Period - Time until cash flows recover the initial investment of the project.The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period. The following example will demonstrate the absurdity of this statement.The McGraw-Hill Companies, Inc.,20011- 177Irwin/McGraw-HillPayback MethodExampleThe three project below are available. The company accepts all projects with a 2 year or less payback period. Show how this decision will impact our decision.Cash FlowsPrj. C0 C1 C2 C3 Payback NPV10%A-2000 +1000 +1000 +100002+7,249B-2000 +1000 +1000 02- 264C-2000 0+2000 02- 347The McGraw-Hill Companies, Inc.,20011- 178Irwin/McGraw-HillBook Rate of ReturnBook Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return.Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows. The McGraw-Hill Companies, Inc.,20011- 179Irwin/McGraw-HillProject InteractionsWhen you need to choose between mutually exclusive projects, the decision rule is simple. Calculate the NPV of each project, and, from those options that have a positive NPV, choose the one whose NPV is highest.The McGraw-Hill Companies, Inc.,20011- 180Irwin/McGraw-HillMutually Exclusive ProjectsExampleSelect one of the two following projects, based on highest NPV. Proj01234NPVA-155.55.55.55.5 B-20999assume 9% discount rateThe McGraw-Hill Companies, Inc.,20011- 181Irwin/McGraw-HillMutually Exclusive ProjectsExampleSelect one of the two following projects, based on highest NPV. Proj01234NPVA-155.55.55.55.52.82 B-209992.78assume 9% discount rateThe McGraw-Hill Companies, Inc.,20011- 182Irwin/McGraw-HillInvestment TimingSometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision. A common example involves a tree farm. You may defer the harvesting of trees. By doing so, you defer the receipt of the cash flow, yet increase the cash flow.The McGraw-Hill Companies, Inc.,20011- 183Irwin/McGraw-HillInvestment TimingExampleYou may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer?YearCostPV SavingsNPV at PurchaseNPV Today050702020.0145702522.7240703024.83367034Date to purchase 25.5433703725.3531703924.2The McGraw-Hill Companies, Inc.,20011- 184Irwin/McGraw-HillEquivalent Annual CostEquivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.The McGraw-Hill Companies, Inc.,20011- 185Irwin/McGraw-HillEquivalent Annual CostExampleGiven the following costs of operating two machines and a 6% cost of capital, select the lower cost machine using equivalent annual cost method. YearMach.1234PV6%Ann. CostD-15-4-4-4-25.69-9.61E-10-6-6-21.00-11.45The McGraw-Hill Companies, Inc.,20011- 186Irwin/McGraw-HillEquivalent Annual CostExample (with a twist)Select one of the two following projects, based on highest “equivalent annual annuity” (r=9%). Proj01234NPVEq. AnnA-155.55.55.55.52.82.87 B-209992.781.10The McGraw-Hill Companies, Inc.,20011- 187Irwin/McGraw-HillInternal Rate of ReturnExample You have two proposals to choice between. The initial proposal (H) has a cash flow that is different than the revised proposal (I). Using IRR, which do you prefer?The McGraw-Hill Companies, Inc.,20011- 188Irwin/McGraw-HillInternal Rate of ReturnExample You have two proposals to choice between. The initial proposal (H) has a cash flow that is different than the revised proposal (I). Using IRR, which do you prefer?The McGraw-Hill Companies, Inc.,20011- 189Irwin/McGraw-HillInternal Rate of Return50403020100-10-20NPV $, 1,000sDiscount rate, %8 10 12 14 16Revised proposalInitial proposalThe McGraw-Hill Companies, Inc.,20011- 190Irwin/McGraw-HillInternal Rate of ReturnPitfall 1 - Mutually Exclusive ProjectsIRR sometimes ignores the magnitude of the project.The following two projects illustrate that problem.Pitfall 2 - Lending or Borrowing?With some cash flows (as noted below) the NPV of the project increases s the discount rate increases. This is contrary to the normal relationship between NPV and discount rates. Pitfall 3 - Multiple Rates of ReturnCertain cash flows can generate NPV=0 at two different discount rates.The following cash flow generates NPV=0 at both (-50%) and 15.2%. The McGraw-Hill Companies, Inc.,20011- 191Irwin/McGraw-Hill內部報酬率法內部報酬率法內部報酬率(Internal Rate of Return Md.;簡稱 IRR)法方法: 內部報酬率:使淨現值(NPV)為0之折現率NPV= 或CFt：t 期淨現金流量 (即各期稅後現金入)IRR：內部報酬率(即投資人之報酬率)The McGraw-Hill Companies, Inc.,20011- 192Irwin/McGraw-Hill內部報酬率法內部報酬率法( (續續) )決策準則 :單一計劃 : IRR R; 互斥計劃: Max(IRR1, IRR2,) R優劣 : 缺: (1)複雜 (2)某些狀況未符合價值最大化原則(3)可能無解或(4)有多重解(5)再投資報酬率問題優點: (1)考慮風險因素 （2）考慮整時間價值因素 (3）考慮投資人之機會成本 （4）考慮整個投資期間之現金流量 (5)考慮整個投資期末處分資產之現金流量The McGraw-Hill Companies, Inc.,20011- 193Irwin/McGraw-Hill修正內部報酬率法修正內部報酬率法修正內部報酬率(Modified Internal Rate of Return Md.;簡稱 MIRR)法方法: 修正內部報酬率:使各期淨現金流出現值之和等於未來各期現金流入現值之和之折現率PV cost = PV (terminal value)The McGraw-Hill Companies, Inc.,20011- 194Irwin/McGraw-Hill修正內部報酬率法修正內部報酬率法( (續續) )決策準則 :單一計劃 : MIRR R; 互斥計劃: Max(MIRR1, MIRR2,) R優劣 : 缺: (1)複雜 (2)某些狀況未符合價值最大化原則優點: (1)考慮風險因素 （2）考慮整時間價值因素 (3）考慮投資人之機會成本 （4）考慮整個投資期間之現金流量 (5)考慮整個投資期末處分資產之現金流量The McGraw-Hill Companies, Inc.,20011- 195Irwin/McGraw-HillCapital RationingCapital Rationing - Limit set on the amount of funds available for investment.Soft Rationing - Limits on available funds imposed by management.Hard Rationing - Limits on available funds imposed by the unavailability of funds in the capital market.The McGraw-Hill Companies, Inc.,20011- 196Irwin/McGraw-HillProfitability IndexThe McGraw-Hill Companies, Inc.,20011- 197Irwin/McGraw-HillIrwin/McGraw-HillChapter 7Fundamentals of Corporate FinanceThird EditionUsing Discounted Cash Flow Analysis to Make Investment DecisionsBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 198Irwin/McGraw-HillTopics CoveredDiscounted Cash Flows, NetProfitsIncremental Cash FlowsTreatment of InflationSeparation of Investment & Financing DecisionsExample: Blooper IndustriesThe McGraw-Hill Companies, Inc.,20011- 199Irwin/McGraw-HillCash Flow vs. Accounting IncomeDiscount actual cash flowsUsing accounting income, rather than cash flow, could lead to erroneous decisions.ExampleA project costs $2,000 and is expected to last 2 years, producing cash income of $1,500 and $500 respectively. The cost of the project can be depreciated at $1,000 per year. Given a 10% required return, compare the NPV using cash flow to the NPV using accounting income.The McGraw-Hill Companies, Inc.,20011- 200Irwin/McGraw-HillCash Flow vs. Accounting IncomeThe McGraw-Hill Companies, Inc.,20011- 201Irwin/McGraw-HillCash Flow vs. Accounting IncomeThe McGraw-Hill Companies, Inc.,20011- 202Irwin/McGraw-HillIncremental Cash FlowsDiscount incremental cash flowsInclude All Indirect EffectsForget Sunk CostsInclude Opportunity CostsRecognize the Investment in Working CapitalBeware of Allocated Overhead CostsIncremental Cash Flowcash flow with projectcash flow without project=-The McGraw-Hill Companies, Inc.,20011- 203Irwin/McGraw-HillIncremental Cash FlowsIMPORTANTAsk yourself this question Would the cash flow still exist if the project does not exist?If yes, do not include it in your analysis.If no, include it.The McGraw-Hill Companies, Inc.,20011- 204Irwin/McGraw-HillInflationINFLATION RULEBe consistent in how you handle inflation!Use nominal interest rates to discount nominal cash flows.Use real interest rates to discount real cash flows.You will get the same results, whether you use nominal or real figuresThe McGraw-Hill Companies, Inc.,20011- 205Irwin/McGraw-HillInflationExampleYou own a lease that will cost you $8,000 next year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?The McGraw-Hill Companies, Inc.,20011- 206Irwin/McGraw-HillInflationExample - nominal figuresThe McGraw-Hill Companies, Inc.,20011- 207Irwin/McGraw-HillInflationExample - real figuresThe McGraw-Hill Companies, Inc.,20011- 208Irwin/McGraw-HillSeparation of Investment & Financing DecisionsWhen valuing a project, ignore how the project is financed.Following the logic from incremental analysis ask yourself the following question: Is the project existence dependent on the financing? If no, you must separate financing and investment decisions.The McGraw-Hill Companies, Inc.,20011- 209Irwin/McGraw-HillBlooper Industries(,000s)The McGraw-Hill Companies, Inc.,20011- 210Irwin/McGraw-HillBlooper IndustriesCash Flow From Operations (,000s)or $3,950,000The McGraw-Hill Companies, Inc.,20011- 211Irwin/McGraw-HillBlooper IndustriesNet Cash Flow (entire project) (,000s)NPV 12% = $3,564,000The McGraw-Hill Companies, Inc.,20011- 212Irwin/McGraw-HillIrwin/McGraw-HillChapter 8Fundamentals of Corporate FinanceThird EditionProject AnalysisBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 213Irwin/McGraw-HillTopics CoveredHow Firms Organize Their Investment ProcessSome “What If” QuestionsSensitivity AnalysisBreak Even AnalysisFlexibility in Capital BudgetingDecision TreesOptionsThe McGraw-Hill Companies, Inc.,20011- 214Irwin/McGraw-HillCapital Budgeting ProcessCapital Budget - The list of planned investment projects.The Decision Process1 - Develop and rank all investment projects2 - Authorize projects based on:Govt regulationProduction efficiencyCapacity requirementsNPV The McGraw-Hill Companies, Inc.,20011- 215Irwin/McGraw-HillCapital Budgeting ProcessCapital Budgeting ProblemsConsistent forecastsConflict of interestForecast biasSelection criteria (NPV and others)The McGraw-Hill Companies, Inc.,20011- 216Irwin/McGraw-HillHow To Handle UncertaintySensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project.Scenario Analysis - Project analysis given a particular combination of assumptions.Simulation Analysis - Estimation of the probabilities of different possible outcomes.Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even. The McGraw-Hill Companies, Inc.,20011- 217Irwin/McGraw-HillSensitivity AnalysisExampleGiven the expected cash flow forecasts listed on the next slide, determine the NPV of the project given changes in the cash flow components using an 8% cost of capital. Assume that all variables remain constant, except the one you are changing.The McGraw-Hill Companies, Inc.,20011- 218Irwin/McGraw-HillSensitivity AnalysisExample - continuedNPV= $478The McGraw-Hill Companies, Inc.,20011- 219Irwin/McGraw-HillSensitivity AnalysisExample - continued Possible OutcomesThe McGraw-Hill Companies, Inc.,20011- 220Irwin/McGraw-HillSensitivity AnalysisExample - continuedNPV Calculations for Pessimistic Investment ScenarioNPV= ($121)The McGraw-Hill Companies, Inc.,20011- 221Irwin/McGraw-HillSensitivity AnalysisExample - continuedNPV PossibilitiesThe McGraw-Hill Companies, Inc.,20011- 222Irwin/McGraw-HillBreak Even AnalysisExampleGiven the forecasted data on the next slide, determine the number of planes that the company must produce in order to break even, on an NPV basis. The companys cost of capital is 10%.The McGraw-Hill Companies, Inc.,20011- 223Irwin/McGraw-HillBreak Even AnalysisThe McGraw-Hill Companies, Inc.,20011- 224Irwin/McGraw-HillBreak Even AnalysisAnswerThe break even point, is the # of Planes Sold that generates a NPV=$0. The present value annuity factor of a 6 year cash flow at 10% is 4.355Thus, The McGraw-Hill Companies, Inc.,20011- 225Irwin/McGraw-HillAnswerSolving for “Planes Sold”Break Even AnalysisThe McGraw-Hill Companies, Inc.,20011- 226Irwin/McGraw-HillOperating LeverageOperating Leverage- The degree to which costs are fixed.Degree of Operating Leverage (DOL) - Percentage change in profits given a 1 percent change in sales. The McGraw-Hill Companies, Inc.,20011- 227Irwin/McGraw-HillOperating LeverageExample - A company has sales outcomes that range from $16mil to $19 mil, Depending on the economy. The same conditions can produce profits in the range from $550,000 to $1,112,000. What is the DOL? The McGraw-Hill Companies, Inc.,20011- 228Irwin/McGraw-HillFlexibility & OptionsDecision Trees - Diagram of sequential decisions and possible outcomes.Decision trees help companies determine their Options by showing the various choices and outcomes.The Option to avoid a loss or produce extra profit has value.The ability to create an Option thus has value that can be bought or sold.The McGraw-Hill Companies, Inc.,20011- 229Irwin/McGraw-HillDecision TreesNPV=0Dont testTest (Invest $200,000)SuccessFailurePursue project NPV=$2millionStop projectNPV=0The McGraw-Hill Companies, Inc.,20011- 230Irwin/McGraw-HillIrwin/McGraw-HillChapter 9Fundamentals of Corporate FinanceThird EditionIntroduction to Risk, Return, and the Opportunity Cost of CapitalBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 231Irwin/McGraw-HillTopics CoveredRates of Return73 Years of Capital Market HistoryMeasuring RiskRisk & DiversificationThinking About RiskThe McGraw-Hill Companies, Inc.,20011- 232Irwin/McGraw-HillRates of ReturnThe McGraw-Hill Companies, Inc.,20011- 233Irwin/McGraw-HillRates of ReturnThe McGraw-Hill Companies, Inc.,20011- 234Irwin/McGraw-HillRates of ReturnThe McGraw-Hill Companies, Inc.,20011- 235Irwin/McGraw-HillRates of ReturnNominal vs. RealThe McGraw-Hill Companies, Inc.,20011- 236Irwin/McGraw-HillMarket IndexesDow Jones Industrial Average (The Dow)Value of a portfolio holding one share in each of 30 large industrial firms.Standard & Poors Composite Index (The S&P 500)Value of a portfolio holding shares in 500 firms. Holdings are proportional to the number of shares in the issues.The McGraw-Hill Companies, Inc.,20011- 237Irwin/McGraw-HillThe Value of an Investment of $1 in 1926Source: Ibbotson AssociatesIndexYear EndThe McGraw-Hill Companies, Inc.,20011- 238Irwin/McGraw-HillRates of Return 1926-1998Source: Ibbotson AssociatesYearPercentage ReturnThe McGraw-Hill Companies, Inc.,20011- 239Irwin/McGraw-HillExpected ReturnThe McGraw-Hill Companies, Inc.,20011- 240Irwin/McGraw-HillMeasuring RiskVariance - Average value of squared deviations from mean. A measure of volatility.Standard Deviation - Average value of squared deviations from mean. A measure of volatility.The McGraw-Hill Companies, Inc.,20011- 241Irwin/McGraw-HillMeasuring RiskCoin Toss Game-calculating variance and standard deviationThe McGraw-Hill Companies, Inc.,20011- 242Irwin/McGraw-HillRisk and DiversificationDiversification - Strategy designed to reduce risk by spreading the portfolio across many investments.Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk.”Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.”The McGraw-Hill Companies, Inc.,20011- 243Irwin/McGraw-HillRisk and DiversificationThe McGraw-Hill Companies, Inc.,20011- 244Irwin/McGraw-HillRisk and DiversificationThe McGraw-Hill Companies, Inc.,20011- 245Irwin/McGraw-HillStock Market Volatility 1926-1998Std DevThe McGraw-Hill Companies, Inc.,20011- 246Irwin/McGraw-HillRisk and DiversificationThe McGraw-Hill Companies, Inc.,20011- 247Irwin/McGraw-HillRisk and DiversificationThe McGraw-Hill Companies, Inc.,20011- 248Irwin/McGraw-HillIrwin/McGraw-HillChapter 11Fundamentals of Corporate FinanceThird EditionThe Cost of CapitalBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 249Irwin/McGraw-HillTopics CoveredGeothermals Cost of CapitalWeighted Average Cost of Capital (WACC)Capital StructureRequired Rates of ReturnBig Oils WACCInterpreting WACCFlotation CostsThe McGraw-Hill Companies, Inc.,20011- 250Irwin/McGraw-HillCost of CapitalCost of Capital - The return the firms investors could expect to earn if they invested in securities with comparable degrees of risk.Capital Structure - The firms mix of long term financing and equity financing.The McGraw-Hill Companies, Inc.,20011- 251Irwin/McGraw-HillCost of CapitalExample Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?The McGraw-Hill Companies, Inc.,20011- 252Irwin/McGraw-HillCost of CapitalExample - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?The McGraw-Hill Companies, Inc.,20011- 253Irwin/McGraw-HillCost of CapitalExample - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?The McGraw-Hill Companies, Inc.,20011- 254Irwin/McGraw-HillCost of CapitalExample - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65).The McGraw-Hill Companies, Inc.,20011- 255Irwin/McGraw-HillWACCWeighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firms securities.Company cost of capital = Weighted average of debt and equity returns.The McGraw-Hill Companies, Inc.,20011- 256Irwin/McGraw-HillWACCThe McGraw-Hill Companies, Inc.,20011- 257Irwin/McGraw-HillWACCThree Steps to Calculating Cost of Capital1. Calculate the value of each security as a proportion of the firms market value.2. Determine the required rate of return on each security.3. Calculate a weighted average of these required returns.The McGraw-Hill Companies, Inc.,20011- 258Irwin/McGraw-HillWACCTaxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated. The McGraw-Hill Companies, Inc.,20011- 259Irwin/McGraw-HillWACCWeighted -average cost of capital=The McGraw-Hill Companies, Inc.,20011- 260Irwin/McGraw-HillWACCExample - Executive Fruit has issued debt, preferred stock and common stock. The market value of these securities are $4mil, $2mil, and $6mil, respectively. The required returns are 6%, 12%, and 18%, respectively.Q: Determine the WACC for Executive Fruit, Inc. The McGraw-Hill Companies, Inc.,20011- 261Irwin/McGraw-HillWACCExample - continuedStep 1 Firm Value = 4 + 2 + 6 = $12 milStep 2Required returns are givenStep 3The McGraw-Hill Companies, Inc.,20011- 262Irwin/McGraw-HillWACCIssues in Using WACC Debt has two costs. 1)return on debt and 2)increased cost of equity demanded due to the increase in riskBetas may change with capital structureCorporate taxes complicate the analysis and may change our decision The McGraw-Hill Companies, Inc.,20011- 263Irwin/McGraw-HillMeasuring Capital StructureIn estimating WACC, do not use the Book Value of securities.In estimating WACC, use the Market Value of the securities.Book Values often do not represent the true market value of a firms securities.The McGraw-Hill Companies, Inc.,20011- 264Irwin/McGraw-HillMeasuring Capital StructureMarket Value of Bonds - PV of all coupons and par value discounted at the current interest rate.Market Value of Equity - Market price per share multiplied by the number of outstanding shares.The McGraw-Hill Companies, Inc.,20011- 265Irwin/McGraw-HillMeasuring Capital StructureThe McGraw-Hill Companies, Inc.,20011- 266Irwin/McGraw-HillMeasuring Capital StructureIf the long term bonds pay an 8% coupon and mature in 12 years, what is their market value assuming a 9% YTM?The McGraw-Hill Companies, Inc.,20011- 267Irwin/McGraw-HillMeasuring Capital StructureThe McGraw-Hill Companies, Inc.,20011- 268Irwin/McGraw-HillRequired Rates of ReturnBondsCommon StockThe McGraw-Hill Companies, Inc.,20011- 269Irwin/McGraw-HillRequired Rates of ReturnDividend Discount Model Cost of EquityPerpetuity Growth Model =solve for reThe McGraw-Hill Companies, Inc.,20011- 270Irwin/McGraw-HillRequired Rates of ReturnExpected Return on Preferred StockPrice of Preferred Stock =solve for preferredThe McGraw-Hill Companies, Inc.,20011- 271Irwin/McGraw-HillFlotation CostsThe cost of implementing any financing decision must be incorporated into the cash flows of the project being evaluated.Only the incremental costs of financing should be included.This is sometimes called Adjusted Present Value.The McGraw-Hill Companies, Inc.,20011- 272Irwin/McGraw-HillIrwin/McGraw-HillChapter 12Fundamentals of Corporate FinanceThird EditionCorporate Financing and the Lessons of Market EfficiencyBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 273Irwin/McGraw-HillTopics CoveredInvestment Decision vs. Financing DecisionMarket EfficiencyWeak form efficiencySemi-strong form efficiencyStrong form efficiencyLessons of Market EfficiencyThe McGraw-Hill Companies, Inc.,20011- 274Irwin/McGraw-HillInvestment vs. FinancingInvestment decision are made based on the risk of the project, with total disregard for how the project will be financed (flotation costs being the exception).Financing decisions are made based on the conditions in the capital markets, with little consideration for the investment being made (project specific funding being the exception. IRBs are a good example). The McGraw-Hill Companies, Inc.,20011- 275Irwin/McGraw-HillMarket Efficiency Theory Capital markets reflect all relevant information. You cannot consistently earn excess profits. Market EfficiencyThe McGraw-Hill Companies, Inc.,20011- 276Irwin/McGraw-HillMarket EfficiencyEfficient Capital Markets - Financial markets in which security prices rapidly reflect all relevant information about asset values.Random Walk - Security prices change randomly, with no predictable trends or patterns.The McGraw-Hill Companies, Inc.,20011- 277Irwin/McGraw-HillRandom Walk TheoryThe movement of stock prices from day to day DO NOT reflect any pattern. Statistically speaking, the movement of stock prices is random (skewed positive over the long term).The McGraw-Hill Companies, Inc.,20011- 278Irwin/McGraw-HillRandom Walk Theory$103.00$100.00$106.09$100.43$97.50$100.43$95.06Coin Toss GameHeadsHeadsHeadsTailsTailsTailsThe McGraw-Hill Companies, Inc.,20011- 279Irwin/McGraw-HillRandom Walk TheoryThe McGraw-Hill Companies, Inc.,20011- 280Irwin/McGraw-HillRandom Walk TheoryThe McGraw-Hill Companies, Inc.,20011- 281Irwin/McGraw-HillMarket EfficiencyTechnical Analysts - Investors who attempt to identify over- or undervalued stocks by searching for patterns in past prices.Fundamental Analysts - Analysts who attempt to fund under- or overvalued securities by analyzing fundamental information, such as earnings, asset values, and business prospects.The McGraw-Hill Companies, Inc.,20011- 282Irwin/McGraw-HillEfficient Market TheoryLast MonthThis MonthNext Month$907050EIs Stock PriceCycles disappear once identifiedThe McGraw-Hill Companies, Inc.,20011- 283Irwin/McGraw-HillMarket EfficiencyWeak Form Efficiency - Market prices rapidly reflect all information contained in the history of past prices.Semi-Strong Form Efficiency - Market prices reflect all publicly available information.Strong Form Efficiency - Market prices reflect all information that could in principle be used to determine true value.The McGraw-Hill Companies, Inc.,20011- 284Irwin/McGraw-HillEfficient Market TheoryAnnouncement DateThe McGraw-Hill Companies, Inc.,20011- 285Irwin/McGraw-HillMarket EfficiencyThe McGraw-Hill Companies, Inc.,20011- 286Irwin/McGraw-HillLessons of Market EfficiencyMarkets have no memoryTrust market pricesThere are no financial illusionsDo it yourself diversificationSeen one stock, seen them allReading the entrailsThe McGraw-Hill Companies, Inc.,20011- 287Irwin/McGraw-HillIrwin/McGraw-HillChapter 13Fundamentals of Corporate FinanceThird EditionAn Overview of Corporate FinancingBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 288Irwin/McGraw-HillTopics CoveredCommon StockPreferred StockCorporate DebtConvertible SecuritiesPatterns of Corporate FinancingThe McGraw-Hill Companies, Inc.,20011- 289Irwin/McGraw-HillCommon StockTreasury StockStock that has been repurchased by the company and held in its treasuryIssued SharesShares that have been issued by the company.Outstanding SharesShares that have been issued by the company and held by investors.The McGraw-Hill Companies, Inc.,20011- 290Irwin/McGraw-HillCommon StockAuthorized Share Capital Maximum number of shares that the company is permitted to issue, as specified in the firms articles of incorporation.Par ValueValue of security shown on certificate.Retained EarningsEarnings not paid out as dividends.The McGraw-Hill Companies, Inc.,20011- 291Irwin/McGraw-HillCommon StockBook Value vs. Market ValueBook value is a backward looking measure. It tells us how much capital the firm has raised from shareholders in the past. It does not measure the value that shareholders place on those shares today. The market value of the firm is forward looking, it depends on the future dividends that shareholders expect to receive. The McGraw-Hill Companies, Inc.,20011- 292Irwin/McGraw-HillCommon StockExample - H.J. Heinz Book Value vs. Market Value (4/99)Total Shares outstanding = 358 millionThe McGraw-Hill Companies, Inc.,20011- 293Irwin/McGraw-HillCommon StockExample - H.J. Heinz Book Value vs. Market Value (4/99)Total Shares outstanding = 358 millionThe McGraw-Hill Companies, Inc.,20011- 294Irwin/McGraw-HillCommon StockExample - No-name News can be established by investing $10 million in a printing press. The newspaper is expected to generate a cash flow of $2 million a year for 20 years. If the cost of capital is 10 percent, is the firms market or book value greater? The McGraw-Hill Companies, Inc.,20011- 295Irwin/McGraw-HillCommon StockExample - No-name News The McGraw-Hill Companies, Inc.,20011- 296Irwin/McGraw-HillPreferred StockPreferred Stock - Stock that takes priority over common stock in regards to dividends. Net Worth - Book value of common shareholders equity plus preferred stock.Floating-Rate Preferred - Preferred stock paying dividends that vary with short term interest rates. The McGraw-Hill Companies, Inc.,20011- 297Irwin/McGraw-HillCorporate DebtDebt has the unique feature of allowing the borrowers to walk away from their obligation to pay, in exchange for the assets of the company.“Default Risk” is the term used to describe the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily. “Bond Ratings”are issued on debt instruments to help investors assess the default risk of a firm.The McGraw-Hill Companies, Inc.,20011- 298Irwin/McGraw-HillCorporate DebtPrime Rate - Benchmark interest rate charged by banks.Funded Debt - Debt with more than 1 year remaining to maturity.Sinking Fund - Fund established to retire debt before maturity.Callable Bond - Bond that may be repurchased by firm before maturity at specified call price. The McGraw-Hill Companies, Inc.,20011- 299Irwin/McGraw-HillCorporate DebtSubordinate Debt - Debt that may be repaid in bankruptcy only after senior debt is repaid.Secured Debt - Debt that has first claim on specified collateral in the event of default. Investment Grade - Bonds rated Baa or above by Moodys or BBB or above by S&P.Junk Bond - Bond with a rating below Baa or BBB.The McGraw-Hill Companies, Inc.,20011- 300Irwin/McGraw-HillCorporate DebtEurodollars - Dollars held on deposit in a bank outside the United States.Eurobond - Bond that is marketed internationally.Private Placement - Sale of securities to a limited number of investors without a public offering.Protective Covenants - Restriction on a firm to protect bondholders.Lease - Long-term rental agreement. The McGraw-Hill Companies, Inc.,20011- 301Irwin/McGraw-HillConvertible SecuritiesWarrant - Right to buy shares from a company at a stipulated price before a set date.Convertible Bond - Bond that the holder may exchange for a specified amount of another security.Convertibles are a combined security, consisting of both a bond and a call option. The McGraw-Hill Companies, Inc.,20011- 302Irwin/McGraw-HillPatterns of Corporate FinancingFirms may raise funds from external sources or plow back profits rather than distribute them to shareholders.Should a firm elect external financing, they may choose between debt or equity sources.The McGraw-Hill Companies, Inc.,20011- 303Irwin/McGraw-HillPatterns of Corporate FinancingThe McGraw-Hill Companies, Inc.,20011- 304Irwin/McGraw-HillPatterns of Corporate FinancingThe McGraw-Hill Companies, Inc.,20011- 305Irwin/McGraw-HillIrwin/McGraw-HillChapter 14Fundamentals of Corporate FinanceThird EditionHow Corporations Issue SecuritiesBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 306Irwin/McGraw-HillTopics CoveredVenture CapitalThe Initial Public OfferingThe UnderwritersGeneral Cash OffersThe Private PlacementThe McGraw-Hill Companies, Inc.,20011- 307Irwin/McGraw-HillVenture CapitalSince success of a new firm is highly dependent on the effort of the managers, restrictions are placed on management by the venture capital company and funds are usually dispersed in stages, after a certain level of success is achieved.Venture CapitalMoney invested to finance a new firmThe McGraw-Hill Companies, Inc.,20011- 308Irwin/McGraw-HillVenture CapitalThe McGraw-Hill Companies, Inc.,20011- 309Irwin/McGraw-HillVenture CapitalThe McGraw-Hill Companies, Inc.,20011- 310Irwin/McGraw-HillInitial OfferingInitial Public Offering (IPO) - First offering of stock to the general public.Underwriter - Firm that buys an issue of securities from a company and resells it to the public.Spread - Difference between public offer price and price paid by underwriter.Prospectus - Formal summary that provides information on an issue of securities.Underpricing - Issuing securities at an offering price set below the true value of the security.The McGraw-Hill Companies, Inc.,20011- 311Irwin/McGraw-HillInitial OfferingAverage Expenses on 1767 IPOs from 1990-1994The McGraw-Hill Companies, Inc.,20011- 312Irwin/McGraw-HillThe UnderwritersThe McGraw-Hill Companies, Inc.,20011- 313Irwin/McGraw-HillThe UnderwritersThe McGraw-Hill Companies, Inc.,20011- 314Irwin/McGraw-HillGeneral Cash OffersSeasoned Offering - Sale of securities by a firm that is already publicly traded. General Cash Offer - Sale of securities open to all investors by an already public company.Shelf Registration - A procedure that allows firms to file one registration statement for several issues of the same security.Private Placement - Sale of securities to a limited number of investors without a public offering.The McGraw-Hill Companies, Inc.,20011- 315Irwin/McGraw-HillRights IssueRights Issue - Issue of securities offered only to current stockholders.Example - YRU Corp currently has 9 million shares outstanding. The market price is $15/sh. YRU decides to raise additional funds via a 1 for 3 rights offer at $12 per share. If we assume 100% subscription, what is the value of each right?The McGraw-Hill Companies, Inc.,20011- 316Irwin/McGraw-HillRights IssueCurrent Market Value = 9 mil x $15 = $135 milTotal Shares = 9 mil + 3 mil = 12 milAmount of new funds = 3 mil x $12 = $36 milNew Share Price = (136 + 36) / 12 = $14.25/shValue of a Right = 15 - 14.25 = $0.75Example - YRU Corp currently has 9 million shares outstanding. The market price is $15/sh. YRU decides to raise additional funds via a 1 for 3 rights offer at $12 per share. If we assume 100% subscription, what is the value of each right?The McGraw-Hill Companies, Inc.,20011- 317Irwin/McGraw-HillIrwin/McGraw-HillChapter 15Fundamentals of Corporate FinanceThird EditionThe Capital Structure DecisionBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 318Irwin/McGraw-HillTopics CoveredDebt and Value in a Tax Free EconomyCapital Structure and Corporate TaxesCost of Financial DistressExplaining Financial ChoicesThe McGraw-Hill Companies, Inc.,20011- 319Irwin/McGraw-HillM&M (Debt Policy Doesnt Matter)Modigliani & MillerWhen there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.The McGraw-Hill Companies, Inc.,20011- 320Irwin/McGraw-HillM&M (Debt Policy Doesnt Matter)AssumptionsBy issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securitiesCapital structure does not affect cash flows e.g.No taxesNo bankruptcy costsNo effect on management incentivesThe McGraw-Hill Companies, Inc.,20011- 321Irwin/McGraw-HillExample - River Cruises - All Equity FinancedM&M (Debt Policy Doesnt Matter)The McGraw-Hill Companies, Inc.,20011- 322Irwin/McGraw-HillExample cont.50% debtM&M (Debt Policy Doesnt Matter)The McGraw-Hill Companies, Inc.,20011- 323Irwin/McGraw-HillExample - River Cruises - All Equity Financed- Debt replicated by investorsM&M (Debt Policy Doesnt Matter)The McGraw-Hill Companies, Inc.,20011- 324Irwin/McGraw-HillWeighted Average Cost of Capitalwithout taxes (traditional view)rDVrDrEIncludes Bankruptcy RiskWACCThe McGraw-Hill Companies, Inc.,20011- 325Irwin/McGraw-HillWeighted Average Cost of Capitalwithout taxes (M&M view)rDVrDrEIncludes Bankruptcy RiskWACCThe McGraw-Hill Companies, Inc.,20011- 326Irwin/McGraw-HillFinancial Risk - Risk to shareholders resulting from the use of debt.Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.Interest Tax Shield- Tax savings resulting from deductibility of interest payments.C.S. & Corporate TaxesThe McGraw-Hill Companies, Inc.,20011- 327Irwin/McGraw-HillExample - You own all the equity of Space Babies Diaper Co. The company has no debt. The companys annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why?C.S. & Corporate TaxesThe McGraw-Hill Companies, Inc.,20011- 328Irwin/McGraw-HillC.S. & Corporate Taxes All Equity1/2 DebtEBIT1,0001,000Interest Pmt 0 100 Pretax Income1,000 900Taxes 40% 400 360Net Cash Flow$600$540Total Cash Flow All Equity = 600*1/2 Debt = 640*1/2 Debt = 640 (540 + 100)Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The companys annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why?The McGraw-Hill Companies, Inc.,20011- 329Irwin/McGraw-HillCapital StructurePV of Tax Shield = (assume perpetuity) D x rD x Tc rD= D x TcExample:Tax benefit = 1000 x (.10) x (.40) = $40 PV of 40 perpetuity = 40 / .10 = $400PV Tax Shield = D x Tc = 1000 x .4 = $400The McGraw-Hill Companies, Inc.,20011- 330Irwin/McGraw-HillCapital StructureFirm Value = Value of All Equity Firm + PV Tax ShieldExampleAll Equity Value = 600 / .10 = 6,000 PV Tax Shield = 400Firm Value with 1/2 Debt = $6,400The McGraw-Hill Companies, Inc.,20011- 331Irwin/McGraw-HillFinancial DistressCosts of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.Market Value =Value if all Equity Financed + PV Tax Shield - PV Costs of Financial DistressThe McGraw-Hill Companies, Inc.,20011- 332Irwin/McGraw-HillFinancial DistressDebtMarket Value of The FirmValue ofunleveredfirmPV of interesttax shieldsCosts offinancial distressValue of levered firmOptimal amount of debtMaximum value of firmThe McGraw-Hill Companies, Inc.,20011- 333Irwin/McGraw-HillFinancial ChoicesTrade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.The McGraw-Hill Companies, Inc.,20011- 334Irwin/McGraw-HillIrwin/McGraw-HillChapter 16Fundamentals of Corporate FinanceThird EditionDividend PolicyBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 335Irwin/McGraw-HillTopics CoveredHow Dividends are PaidHow Do Companies Decide on Dividend PaymentsWhy Dividend Policy Should Not MatterWhy Dividends May Increase Firm ValueWhy Dividends May Reduce Firm ValueThe McGraw-Hill Companies, Inc.,20011- 336Irwin/McGraw-HillDividend PaymentsRecord Date - Person who owns stock on this date received the dividend.Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.Cash Dividend - Payment of cash by the firm to its shareholders.The McGraw-Hill Companies, Inc.,20011- 337Irwin/McGraw-HillDividend PaymentsStock Repurchase - Firm buys back stock from its shareholders.Stock Dividend - Distribution of additional shares to a firms stockholders.Stock Splits - Issue of additional shares to firms stockholders.The McGraw-Hill Companies, Inc.,20011- 338Irwin/McGraw-HillDividend Payments Jul 28 Aug 10 Aug 11Aug 13Sept 10Declaration With- Ex-dividend Record Paymentdate dividend date date datedate Share price fallsThe McGraw-Hill Companies, Inc.,20011- 339Irwin/McGraw-HillStock DividendExample - Amoeba Products has 2 million shares currently outstanding at a price of $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid?Answer2 mil x .50 = 1 mil + 2 mil = 3 mil shares The McGraw-Hill Companies, Inc.,20011- 340Irwin/McGraw-HillStock DividendExample - cont - After the stock dividend what is the new price per share and what is the new value of the firm?AnswerThe value of the firm was 2 mil x $15 per share, or $30 mil. After the dividend the value will remain the same.Price per share = $30 mil / 3 mil sh = $10 per sh.The McGraw-Hill Companies, Inc.,20011- 341Irwin/McGraw-HillStock RepurchaseExample - Cash dividend versus share repurchaseThe McGraw-Hill Companies, Inc.,20011- 342Irwin/McGraw-HillStock RepurchaseExample - Cash dividend versus share repurchaseThe McGraw-Hill Companies, Inc.,20011- 343Irwin/McGraw-HillStock RepurchaseExample - Cash dividend versus share repurchaseThe McGraw-Hill Companies, Inc.,20011- 344Irwin/McGraw-HillThe Dividend Decision1. Firms have longer term target dividend payout ratios.2. Managers focus more on dividend changes than on absolute levels.3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings.4. Managers are reluctant to make dividend changes that might have to be reversed. Lintners “Stylized Facts”(How Dividends are Determined)The McGraw-Hill Companies, Inc.,20011- 345Irwin/McGraw-HillDividend Policy is IrrelevantExample - Assume ABC Co. has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record DatePmt DatePost PmtCash1,00001,000 (40sh $25)Asset Value5,0005,0005,000Total Value6,0005,0006,000# of Shares 200200240price/share $30 $25$25NEW SHARES ARE ISSUEDThe McGraw-Hill Companies, Inc.,20011- 346Irwin/McGraw-HillDividend Policy is Irrelevant Example - continued - Shareholder Value RecordPmt PostStock6,0005,0006,000Cash 01,000 0Total Value6,0006,0006,000Stock = 240sh $25 = 6,000Assume stockholders purchase the new issue with the cash dividend proceeds.The McGraw-Hill Companies, Inc.,20011- 347Irwin/McGraw-HillDividends Increase ValueMarket Imperfections and Clientele EffectThere are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from. These clients increase the price of the stock through their demand for a dividend paying stock. The McGraw-Hill Companies, Inc.,20011- 348Irwin/McGraw-HillDividends Increase ValueDividends as SignalsDividend increases send good news about cash flows and earnings. Dividend cuts send bad news.Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a companys good fortune and its managers confidence in future cash flows.The McGraw-Hill Companies, Inc.,20011- 349Irwin/McGraw-HillDividends Decrease ValueTax ConsequencesCompanies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably.In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.The McGraw-Hill Companies, Inc.,20011- 350Irwin/McGraw-HillDividends Decrease ValueThe McGraw-Hill Companies, Inc.,20011- 351Irwin/McGraw-HillIrwin/McGraw-HillChapter 22Fundamentals of Corporate FinanceThird EditionMergers, Acquisitions, and Corporate ControlBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 352Irwin/McGraw-HillTopics CoveredThe Market for Corporate ControlSensible Motives for MergersDubious Reasons for MergersEvaluating MergersMerger TacticsLeveraged Buy-OutsMergers and the EconomyThe McGraw-Hill Companies, Inc.,20011- 353Irwin/McGraw-HillThe Merger MarketProxy battle for control of the board of directorsFirm purchased by another firmLeveraged buyout by a group of investorsDivestiture of all or part of the firms business unitsMethods to Change ManagementThe McGraw-Hill Companies, Inc.,20011- 354Irwin/McGraw-HillRecent MergersThe McGraw-Hill Companies, Inc.,20011- 355Irwin/McGraw-HillThe Merger MarketTools Used To Acquire CompaniesProxy ContestAcquisitionLeveraged Buy-OutManagement Buy-OutMergerTender OfferThe McGraw-Hill Companies, Inc.,20011- 356Irwin/McGraw-HillSensible Reasons for MergersEconomies of ScaleA larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units.$Reduces costsThe McGraw-Hill Companies, Inc.,20011- 357Irwin/McGraw-HillSensible Reasons for MergersEconomies of Vertical IntegrationControl over suppliers “may” reduce costs.Over integration can cause the opposite effect. Pre-integration (less efficient)CompanySSSSSSSPost-integration (more efficient)CompanySThe McGraw-Hill Companies, Inc.,20011- 358Irwin/McGraw-HillSensible Reasons for MergersCombining Complementary ResourcesMerging may results in each firm filling in the “missing pieces” of their firm with pieces from the other firm.Firm AFirm BThe McGraw-Hill Companies, Inc.,20011- 359Irwin/McGraw-HillSensible Reasons for MergersMergers as a Use for Surplus FundsIf your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.The McGraw-Hill Companies, Inc.,20011- 360Irwin/McGraw-HillDubious Reasons for MergersDiversificationInvestors should not pay a premium for diversification since they can do it themselves.The McGraw-Hill Companies, Inc.,20011- 361Irwin/McGraw-HillDubious Reasons for MergersThe Bootstrap GameAcquiring Firm has high P/E ratioSelling firm has low P/E ratio (due to low number of shares) After merger, acquiring firm has short term EPS riseLong term, acquirer will have slower than normal EPS growth due to share dilution.The McGraw-Hill Companies, Inc.,20011- 362Irwin/McGraw-HillDubious Reasons for MergersThe Bootstrap GameThe McGraw-Hill Companies, Inc.,20011- 363Irwin/McGraw-HillEvaluating MergersQuestionsIs there an overall economic gain to the merger?Do the terms of the merger make the company and its shareholders better off?The McGraw-Hill Companies, Inc.,20011- 364Irwin/McGraw-HillEvaluating MergersEconomic GainThe McGraw-Hill Companies, Inc.,20011- 365Irwin/McGraw-HillEvaluating MergersExample - Given a 20% cost of funds, what is the economic gain, if any, of the merger listed below? The McGraw-Hill Companies, Inc.,20011- 366Irwin/McGraw-HillEvaluating MergersEstimated net gainThe McGraw-Hill Companies, Inc.,20011- 367Irwin/McGraw-HillMerger TacticsWhite Knight - Friendly potential acquirer sought by a target company threatened by an unwelcome suitor.Shark Repellent - Amendments to a company charter made to forestall takeover attempts.Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.The McGraw-Hill Companies, Inc.,20011- 368Irwin/McGraw-HillLeveraged Buy-OutsUnique Features of LBOsLarge portion of buy-out financed by debtShares of the LBO no longer trade on the open marketThe McGraw-Hill Companies, Inc.,20011- 369Irwin/McGraw-HillLeveraged Buy-OutsJunk bond marketLeverage and taxesOther stakeholdersLeverage and incentivesFree cash flowPotential Sources of Value in LBOsThe McGraw-Hill Companies, Inc.,20011- 370Irwin/McGraw-HillIrwin/McGraw-HillChapter 24Fundamentals of Corporate FinanceThird EditionOptionsBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies, Inc.,2001The McGraw-Hill Companies, Inc.,20011- 371Irwin/McGraw-HillTopics CoveredCalls and PutsWhat Determines Option ValuesSpotting the OptionThe McGraw-Hill Companies, Inc.,20011- 372Irwin/McGraw-HillOption TerminologyPut OptionRight to sell an asset at a specified exercise price on or before the exercise date.Call OptionRight to buy an asset at a specified exercise price on or before the exercise date.The McGraw-Hill Companies, Inc.,20011- 373Irwin/McGraw-HillOption ObligationsThe McGraw-Hill Companies, Inc.,20011- 374Irwin/McGraw-HillOption ValueThe value of an option at expiration is a function of the stock price and the exercise price.Example - Option values given a exercise price of $30The McGraw-Hill Companies, Inc.,20011- 375Irwin/McGraw-HillOption ValueCall option value (graphic) given a $30 exercise price.Share PriceCall option value30 40$10The McGraw-Hill Companies, Inc.,20011- 376Irwin/McGraw-HillOption ValuePut option value (graphic) given a $30 exercise price.Share PricePut option value25 30 $5The McGraw-Hill Companies, Inc.,20011- 377Irwin/McGraw-HillOption ValueCall option payoff (to seller) given a $30 exercise price.Share PriceCall option $ payoff30 The McGraw-Hill Companies, Inc.,20011- 378Irwin/McGraw-HillOption ValuePut option payoff (to seller) given a $30 exercise price.Share PricePut option $ payoff 30 The McGraw-Hill Companies, Inc.,20011- 379Irwin/McGraw-HillOption ValueProtective Put - Long stock and long put Share PricePosition ValueLong StockThe McGraw-Hill Companies, Inc.,20011- 380Irwin/McGraw-HillOption ValueProtective Put - Long stock and long put Share PricePosition ValueLong PutThe McGraw-Hill Companies, Inc.,20011- 381Irwin/McGraw-HillOption ValueProtective Put - Long stock and long put Share PricePosition ValueProtective PutLong PutLong StockThe McGraw-Hill Companies, Inc.,20011- 382Irwin/McGraw-HillOption ValueProtective Put - Long stock and long put Share PricePosition ValueProtective PutThe McGraw-Hill Companies, Inc.,20011- 383Irwin/McGraw-HillOption ValueStraddle - Long call and long put - Strategy for profiting from high volatility Share PricePosition ValueLong callThe McGraw-Hill Companies, Inc.,20011- 384Irwin/McGraw-HillOption ValueStraddle - Long call and long put - Strategy for profiting from high volatility Share PricePosition ValueLong putThe McGraw-Hill Companies, Inc.,20011- 385Irwin/McGraw-HillOption ValueStraddle - Long call and long put - Strategy for profiting from high volatility Share PricePosition ValueStraddleThe McGraw-Hill Companies, Inc.,20011- 386Irwin/McGraw-HillOption ValueStraddle - Long call and long put - Strategy for profiting from high volatility Share PricePosition ValueStraddleThe McGraw-Hill Companies, Inc.,20011- 387Irwin/McGraw-HillOption ValueStock PriceUpper LimitLower Limit(Stock price - exercise price) or 0which ever is higherThe McGraw-Hill Companies, Inc.,20011- 388Irwin/McGraw-HillOption ValueComponents of the Option Price1 - Underlying stock price2 - Striking or Exercise price3 - Volatility of the stock returns (standard deviation of annual returns)4 - Time to option expiration5 - Time value of money (discount rate)The McGraw-Hill Companies, Inc.,20011- 389Irwin/McGraw-HillOption ValueBlack-Black-ScholesScholes Option Pricing Model Option Pricing Model OC = PsN(d1) - SN(d2)e-rtThe McGraw-Hill Companies, Inc.,20011- 390Irwin/McGraw-HillOptions on Real AssetsReal Options - Options embedded in real assetsOption to ExpandOption to AbandonThe McGraw-Hill Companies, Inc.,20011- 391Irwin/McGraw-HillOptions on Financial AssetsWarrants - Right to buy shares from a company at a stipulated price before a set date.Convertible Bond - Bond that the holder may exchange for a specific number of shares.Callable Bond - Bond that may be repurchased by the issuer before maturity at specified call price.