Review of 305W Spring 1997. copyright Jim Mahar (slightly changed 9/11/98)
NOTE: knowing this does not guarantee 100% on the test. This is a review, nothing more, nothing less. I hope it helps. I think it should. I would also recommend that you keep this and use it in other classes you take both at the graduate and undergraduate level. It will serve as a good memory refresher.
Chapter I Introduction
What is finance? Why does finance matter? NPV can explain everything. Most important topic! It can explain what we do, what we don't do, what jobs we take, etc. For the purpose of Corporate Finance it will allow us to determine how much assets are worth and to "keep score." These assets may be financial securities, or real assets.
Balance sheet: LHS real assets RFIS: financial assets (equity, debt, etc.)
Two basic questions of the financial manager:
1. a. How much to invest b. what specific assets to invest in
2. How should tile cash required for investment be raised?
How is a financial manager deemed successful? (in other words what is job of financial manager?)
Maximizing SH value thus purchasing real assets that cost less than they are worth. However this is difficult since many are looking for the same thing….therefore it is not a simple recipe but rather an art and a science. Financial manager is go-between (and hence must understand both sides) between financial markets and firm's operations. Although the financial manager is a go4etwe en, (s)he is also a part of the firm which leads to information asymmetry problems and potential conflicts of interest. As a result most financial information must be certified by a neutral third party (accounting firms).
Look at Fig 1.1 of Brealy and Myers.
Firms raise capital, invest in real assets which generate returns. The returns are either returned to investors or reinvested.
Shareholders have residual claim on assets.
Do financial managers always act in SH best interests? NO. (example of an agency cost). This will be a reoccurring theme. Basic idea is that people act in their own best interests.
what is a firm? Can you shoot a firm? Can you hit a firm? No. A firm is a nexus of contracts: employees, SH, BR, customers, suppliers, managers. Can have conflicts between any of these.
What is anything worth? What does the price depend on? supply and demand but break it down further: what does supply and demand depend on? (expected) Future cash payoffs, required-return(risk)
Know how to calculate Present values. The basic idea is that $1 tocdy> $1 tomorrow. So if everything else is equal you would rather get money now, pay it later. Of course the other side knows this also.
Discount rate = required rate of return = hurdle rate = opportunity cost of capital discount factor: rate that brings fliture cash back to present
NET PRESENT VALUE is THE MOST IMPORTANT TOPIC, explains everything, if you know this inside and out you know business/life... everything in life boils down to this simple formula. ('just how you define things)
NPV=PV-required investment (required investment a fancy way of say cost
=PV(of future cash flows)-PV(costs) cost=cash outflow
=PV(Benefits)-PV( costs)
Two very important things needed to before you can decide the worth of anything:
proper discount rate
what benefits you will be receiving from it. In business: benefits=cash
costs= negative cashflow How will you decide the proper discount rate? based on risk Risk and Present Value: riskier things command higher returns. (return=profit/investment)
Capital markets allow financial managers to concentrate on maximizing current SH wealth since the capital market interprets news etc. and creates a PV...the price of the security Thus we can use value and price interchangeably and financial manager has an "easy" goal: maximize SH wealth
Chapter 3
Like chapter 2, this is largely a review of present value techniques.
Row to calculate Present values: main thing is to alwavs draw a timeline
Present value=summation of discounted cashflows= S C/( 1 +r)'A
*discounting puts everything in same terms so we can add it up with no problems (apples and apples). This method of valuing an asset is called the discounted cash flow method (DCF). [t is the most common way of pricing any long lived asset, including companies.
Know what happens as discount rate changes...what a yield curve is, term structure, perpetuity annuity etc. Also know formulae and definitions etc.!
Perpetiuties and annuities what is an annuity? same payment every year for a number of yrs.
Ex. you want to retire and have the equivalent of $50K a year to live on. How much would you need to set aside now? assume
4% inflation and a 10% return PV=C1 /(r-g) =$50l/(.l0-.04)
Simple interest vs compound interest: difference gets large as time frame increases.
In USA interest on bonds is paid semiannually (in Germany an France yearly), know differences.
what if you could get pd interest every minute/second? would that be better? You would be able to reinvest and hence earn interest every minute/second. This is the basic idea of continuously compounded interest.
The formula is 10[l + r/m]m where m is the number of periods. If you take the time to figure out you will find that this equals:
ert where e is the base for natural logarithms (2.718)
For capital budgeting you may find that cash flows occur throughout the year so you may want to use continuously compounded returns. (rare however since most of what we so will just be a model so all we need to be is in the ballpark) BUT know Effective annual rate and how to find it.
Chapter 4. How are Bonds and Stocks Valued?
Like anything else we value financial securities by discounting the expected cash flows.
Terminology *perpetjiity constant Cash Flows forever. PV=CF/r
*Annuity: constant CF for a set number of periods Know tables and how to use the discount factors
*Growing perpetuities: must consider the growth rate.
*Bonds= type of debt instrument
*Common Stock = equity ownership (residual claimants) Price of Bond-~present value of annuity + present value of principle payment
Discount rate =YTM
Price of stocks: current value of dividends plus price appreciations P(O)=div( I )/(r-g)
Return on Equity ROE=EPS/(Book value of equity per share)
g =dividend growth rate =plowback rate *ROE=(I -payout ratio)* ROE
Price/earnings ratio =P/E ratio =Mkt. price/EPS (higher growth stocks generally have higher P/F ratios why? Have Pow earnings.)
*Problems with using price-earnings ratios include historical earnings and earnings "estimates" (Accountants' fiction)
*Know how to calculate the Present Values of growth options. (total share value less the perpetuity value of the current cash flow)
* Also know the problems with using constant growth formulas and when they can not be used
* Free Cash Flow"'total cash flow less cash flow necessary to finance positive NPV project. Free cash flow problem laid out by Jensen et al is that firms with excess free cash waste the money. Firms should give the money back to investors.
Chapter5 NPV and its Competitors (or Why NPV is best!)
*NPV is really a cost-benefit analysis. However unlike others it compares present values of costs and present values of benefits.
*Many alternatives to NPV exist. However NPV is The best. NPV allows us to determine how much a project will add to our value. It brings future dollars back to present day-dollars and allows us to compare "apples and apples." Gives a single number that if positive, then the project should be done as it adds to our value.
Know how to calculate and the advantages and disadvantages of the various alternatives: Payback period, discounted payback period, average return on book value, Internal Rate of Return, Profitability Index.
*The various alternatives have different problems when dealing with mutually exclusive projects.
*The problems of IRR were throroughly discussed. what are they?
*what is MIRR? Modified IRR: sets PV benefits = PV of costs
*Know why NPV is considered the standard. What must the standard do? Does NPV do these things? Explain.
* test taking hint: you most likely will have several questions from this area. They make very easy MC questions.
Chapter 6:
Using the NPV rule
*this chapter looks at how the
NPV rule should be applied. It is a practical chapter which explains HOW and not just why we should use the NPV rule.*The guidelines for using NPV include (there are others)
Discount CASH FLOWS not profits
account for project interactions such as "cannibalism" or synergy
treat inflation consistently
understand the importance of different types of depreciation. (also know how to do various methods)
*Finding incremental Cash flows is often difficult. Must account for depreciation, accrual basis accounting, projects interactions
*often times firms ration their investments. (soft vs. hard rationing) Know how this should be handled.
*evaluating projects of different lives (ex 2 year vs. 3 year). Generally find a multiple so that each project can be valued over a similar life span. For example you would go 6 years in the 2 and 3 year case. Second method is to calculate the effective annuaL cost. (this is often easier)
Chapter7 Risk
: basically a review of things you already know. This is a basic tenet of life. look at drug dealers. They have high earnings. Or look at horse racing. why do you win more if a longshot wins? It was a riskier bet. This chapter formatizes this basic concept. Remember: more risk, more EXPECTED return.
In finance we have many years of records that allow us to quantity risk and return. Best way to start is to look at historicat returns.
Average annual return Average annual rate of Average risk premium
(nominal) return (real) (cx tra return vs. T-bil Is)
t-bills 3.6 .5 0
gov't bonds 4.7 1.7 1.1
corporate bonds 5.3 2.4 1.7
common stocks 12.1 8.8 8.4
(Ibbotson Associates) TABLE 7.1
Types of risk: diversifable and undiversifiable...investors are only rewarded for holding undiversifiable risks. ..thus market risk is important...total portfolio risk is what matters.
Calculating portfolio risk: Know to calculate expected return, portfolio variance, beta of portfolio, be able to explain Beta and why it is important, and the implications.
CAPM: E(R)=Rf + Beta*((Rm)~ER(m))
Chapter 8 Risk and Return
Risk can be broken into market(systematic, undiversifiable etc.) and unique(firm specific, diversifiable, unsystematic) risk. Diversified investors are concerned with market risk.. Beta is an asset's contribution to the risk of a fully diversified portfolio...Markowitz (1952) began the modern age of Finance by showing how increasing diversification lowers portfolio's standard deviation and variance.. based on idea that stock returns are normally distributed. People like returns do not like risk. Thus want a high mean, low standard deviation....Combining assets into a portfolio will yield mean-variance portfolio:
give highest expected return based for given level of risk or equivalently those assets that give lowest risk given an expected return
* If borrow lending, then efficient-set extends beyond the tangency point....RF-rate does not vary with the market. CAPM was developed by Sharpe, Lintner, and Treynor and is the most widely used MODEL in Finance.
* = CAPM (security Market Line) x= old efficient set
From this we can determine the expected return on any asset expected risk premium on an asset = beta * expected risk premium on market
(r-d) = B*(Rm~Rf) (play around for other versions) This allows us to estimate the investors required return....
*We do know:
Tests of CAPM: generally CAPM has not worked well for recent years.
Joint hypothesis problem: is the market inefficient or is the test wrong? Further does the Market portfolio even exist?(Richard Roll 1976)..
Farna and French 1992 find beta to be insignificant.
Alternatives to CAPM: I. Consumption CAPM 2. Arbitrage Pricing Theory 3. PE~MB rations (Farna, French 1992)4. Intertemporal CAPM
*All show promise, not standard now exists, for many academic tests we are now just subtracting off market return (not a serious problem for short-term studies)…still have problems in the longer run. (no pun intended! ;-) )
Chapter 9 Capital Budgeting and Risk
*This chapter focuses on beta and a firms cost of capital.
* Weighted average cost of capital = WACC = company’s average cost of capital. Using WACC leads to very poor
decisions if risk is different from average. You should always use the risk for that individual project!
*Firm value=sum of the value of a firm's projects
*Beta of assets = Beta (assets)= portfolio beta = weighted average beta of each of a firm's projects
How to find Beta: Run a regression: company’s return as dependent variable, independent variable is market return
*easier to let someone figure beta for us. Published in Beta books, Value line, most security houses.
*Know the various terrns we have discussed: alpha, R-squared, adjusted beta, industry betas
*increasjng debt increases the beta of equity. It does not change the overall asset beta. (you should be able to tie this to MMII)
*41f you are uncertain over cash flows: you should adjust expected cash flows, not the discount rate.
*Asset Beta is a function of operating leverage, cyclicality, industry
Chapter 10 Sensitivity Analysis, Scenario Analysis, and Simulations
This chapter was just touched tangentially. The key things to know is that when we are making financial decisions we should do sensitivity analysis which involves changing one variable at a time, scenario analysis which involves changing many variables at once, and simulations which try to mimic what will occur in the real world. Many simulation packages are currently available for the financial executive. (we spoke of @RISK)
Break-even analysis is also in this chapter. Be able to calculate a break even problem. (both break even from an accounting perspective as well as an economic (ie Finance) perspective)
Remember break-even (in Units) -Fixed costs/contribution margin per unit. The higher the break-even point, the nskier an investment GENERALLY is.
Chapter 11: Oh where, oh where are the positive NPV projects? Oh where oh where can they be?
* The point was that no matter how much we talk about formulae and precision algorithms, finance and in particular capital budgeting, is still as much of an art as it is a science. We can NOT blindly and stupidly apply NPV or any other rule.
* any analysis should begin with market price (a theme we come back to when discussing mergers and acquisitions). If we are paying a price different (more than) the market price we should be able to justify why. What advantage do we have?
*There are many projects that appear to have positive NPVs Oust ask any marketing department!) yet many of these are in fact poor investments. Play devils advocate: what can go wrong? What else can go wrong? Anything else? Are you sure?
* Generally we can only have positive NPV projects where we have a competitive advantage: in class we talked about no positive NPV projects in commodities. Who would pay more for identical oil? Thus we can get a positive NPV until we can be copied, or if we have differentiated ourselves, or if we somehow have market power (example no competition, barriers to entry, legal restrictions etc.) These competitive advantages are almost always on the operations side of the balance sheet.
Chapter 13: Market Efficiency
* Repeat after me: markets are efficient, markets are efficient, markets are efficient, markets are efficient, most of the time.
* Market efficiency means that no one can consistently "beat the market" after transaction costs are considered.
* If markets (all markets) are always efficient then no positive (or negative) NPVs
* types of efficiency: Weak forms, semi-strong form, and strong form
* most agree the market is semi-strong form efficient. Thus it incorporates all publicly available information. However, some including Summers 1986 (and most managers when discussing their own company) feel that market can take wide variations away from "true" value. However, this is very difficult to test.
* Insiders consistently beat the market thus it is not strong form efficient.
* Small firms may be less efficient since they are not as widely followed and less active. However, any and large any divergence from market efficiency is definitely the exception.
* Crash of 1987 is a slight problem to "efficient marketers". However it could have been a chance event or it could have been
from the new news (how is that for redundancy and repeating myself?) that forced the markets to reevaluate both future growth as well as their discount rates.
* Understand the 6 lessons of market efficiency. Especially the "do-it-yourself," "no financial illusions," "markets have no memory," and substituability of stocks. ("seen one, seen them all")
Chapter 14 Financing Alternatives
* This chapter is largely a glossary of terms. As such we did not need to spend much time on it in class. I strongly suggest you read it and expect some definition type questions from it.
* among the more notable terms are funded debt, subordinated debt, secured debt, investment grade debt, junk, floating rate, fixed, prime rate, LIBOR, Eurobonds, Eurodollars, Preferred stock, Convertible debt, calls, puts, warrants, swaps, forwards, futures (many of these were discussed in great detail in chapters 20,21,25), sinking funds, bond covenants, callable debt, and anything else
* most bonds are rated by Moody's and/or Standard and Poors.
* International differences were discussed. US firms tend to use slightly less debt than Japanese and German firms. However the difference is MUCH less than early studies suggested. Especially when measured using market values.
* there is a trend towards more debt in US firms.
* It is possible there are lower bankruptcy/distress costs for foreign firms. This would explain debt levels.
Chapter 15:How corporations issue securities
* start-ups need seed capital, then venture capital
* initial Public Offerings tend to be underpriced for a variety of potential reasons. Several theories were discussed. Investment
bankers may be afraid of law suits, they may be taking advantage of firms, they may want to create "news" so people want more of the stock when they need more money (thus their seasoned issues will be better received), need to keep avenge investor in the
market and if it weren't for underpricing they would not stay since the "good firms" are oversubscribed.
* Steps in an IPO include: selecting an investment banker, creating a "red herring" prospectus, registering with the SEC, going on a "road show" to market the company, pricing the issue, and finally selling shares to the public.
* cheaper to raise debt than equity. Both in transaction costs and in market reactions
* shelf registration, firm commitment vs. best efforts underwriting, negotiated vs competitive bid,
* market react negatively to equity issues, virtually no reaction to debt (possibly slightly negative) first introduced pecking order
here. Know what pecking order is and be able to explain it in terms of free-cash flow.
* private placements: sold to a small number of investors. Often insurance firms. Less liquidity, slightly higher yields but lower
issue costs.
Chapter 16: The Dividend Controversy
* famous quote: "dividend policy is the sound of one hand clapping," because dividends cause firm to adjust investment policy and/or raise more capital.
* Dividends are generally paid quarterly. Most concerned with cash dividends since stock dividends are just mini-stock splits and should have no effect on firm value.
* Lintner paper (1956) looked at how dividend policy is set. Found that dividends are sticky and track sustainable earnings. Firms hate to cut dividends. (even when such a cut is to be used to finance positive NPV projects)
* Dividends are taxed as ordinary income further they are not deductible to the firm.
* in lieu of cash dividends many firms are moving towards share repurchases. This allows investors to avoid taxes if they wish. However, if the IRS views the repurchase plan as away of avoiding dividends they may crack down.
* dividends are largely important as a signal. They help investors predict future earnings. Thus a dividend cut is interpreted as a negative and the stock price typically falls.
* MM show that in perfect markets dividends are irrelevant since investors could sell a portion of their shares and create their own "dividend." However it not necessarily the case where transaction costs are involved.
* Some argue dividends lower the cost of capital by lowering risk (This is called the bird-in-hand hypothesis) whereas other say the tax implications hurt dividend paying stocks and cause investors to demand a higher return.
* Easterbrook (1984) attempts to explain why some firms pay debt at the same time as issuing new securities. He hypothesizes that the dividends "keep the firms in the market" where it can be better disciplined by Investors and investment bankers.
* There appears that there is an optimal level of dividend paying stocks. For an individual firm it is unlikely that dividend policy will have any great impact on firm value. However it does appear that certain clienteles prefer dividends.
Chapter 17 Does Debt Policy Matter?
· This chapter looks at the capital structure decision. What mix of debt and equity is "optimal?"
· Modigliani and Miller proposition I is the classic in this area. They say that capital structure does not matter. We used the text
example of looking at the firm's cash flows if it were all equity or if it had debt. The investor could effectively undo anything the
firm did. Thus the important thing is the firm's cash flows, not how we "Slice the pie."
· Example from the text: If you own 1% of an all equity firm you get 1% of profits (assume profits cash flows). The firm then issues debt and buys back your 10% of all the shares on a pro-rata basis. You use the proceeds to invest in the company's newly issued debt. You buy 1% of it as well. Here you would get 1% (profits-interest) from your equity stake, and l% (interest) from your bonds, Thus ignoring taxes, you would still get 1% of the firms profits which was the same as before.
· Another way to say MM I is to say that operating cash flow is the deciding factor in firm valuation
·
As risk increases so does required return. Mathematically this relation can be shown asE(return on assets)=Weight of debt (expected return on debt) + weight of equity (cost of equity)
This is summed over all outstanding financial claims. Since the overall return on assets is not changing, the return on equity must rise as more debt is added to the capital structure. This is the same for the WACC.
· MM II is just restating the above relationship: as debt increases, the required return on equity increases.
· MM assume a perfect world. In the real world as we relax assumptions, capital structure may matter. In deed it will matter to the degree that capital structure effects cash flows, transaction costs, or taxes. when the no-tax assumption is relaxed, the
· Traditional view is to minimize the weighted average cost of capital. Since debt has tax advantages the WACC would be minimized at near 100% debt. This is obviously not the case in the real world. Why? We have assumed away some important costs--notably the cost of bankruptcy and financial distress, the IRS will not allow such capital structures if it is for tax reasons, leverage has drawbacks that effect a firm's cash flows.
Chapter 18: How much should a firm borrow? Determinants of debt capacity
'This chapter was spoken about concurrently with chapter 17. This chapter is concerned with relaxing assumptions of MM.
· If capital structure truly were irrelevant then firms could randomly pick their capital structure. In fact we see capital structures varying across industries but often being quite similar within a given industry.
· Corporate taxes give debt an important tax advantage: PV(tax shield) = corporate tax rate' amount of debt. Thus MM once taxes are considered becomes value of firm = value of an all equity firm + PV oft ax shield.
· Investors are only concerned with after Tax returns. Thus municipal bonds have a lower stated return. Further this argument makes it difficult to determine the true tax benefits of debt. Reason? Debt has tax benefits to the company but equity has tax advantages for investors. The relative tax rates are what is important.
· Miller (1977) in Debt and Taxes looks at aggregate debt levels and shows that as the difference between personal and corporate tax rates changes, so too does the amount of debt in an economy. However it is unlikely that an individual firm can influence this. Implication: highly taxed individuals would hold more equity. Problem: very difficult to test.
· A tax shield is worth more to some firms than others. Example a firm that loses money and/or has other tax credits may not have any use for the tax shield of debt. As a result, profitable firms should have more debt. This is NOT the case!
· Costs of financial distress must he included. Firm value = value of all equity firm + PV tax shield - PV (financial distress costs)
· Bankruptcy costs (both direct and indirect) occur when a firm declares bankruptcy. Financial distress costs are a broader topic that can occur well before any legal bankruptcy proceedings occur. Financial distress costs will be greater for firms who have specialized assets, many growth options, sell credence goods, and are privately held (assuming an undiversified portfolio). Thus for these firms we see less debt. Empirically we showed this by looking at the computer industry.
· Direct bankruptcy costs do not seem that large (Warner 1977) but indirect bankruptcy and financial distress costs may be large. These are very difficult to measure since many of the costs are opportunity costs and not out-of-pocket costs per Se.
· here we began our discussion of the Bondholder-shareholder conflict. And first looked as levered equity as a call option. this conflict can take many shapes. Shareholders may try to change the riskiness of the firm, they may try to pay themselves large dividends, they may forgoe positive NPV projects that would accrue to BR. To protect themselves BR price protect (ic assume the worst when first investing) and/or write restrictive bond covenants.
· We also came back to the pecking order theory here and looked at the market reactions to various financing announcements.
Chapter 19: Interactions of investment and financing decisions
· Classical financial theory says investment and financing decisions should not be made together. Thus they should not influence
each other. However in the real world they do. (as we have seen in chapter 1 g)
· Raising capital has costs: issue costs, underpricing, and market reaction costs. These costs must be accounted for in any
investment decision. Thus the concept of adjusted present value, APV or ANPV
ANPV = base case NPV + PV tax shield -issue costs
· Accept projects with a positive ANPV. The idea behind this is similar to concept of using cost of new equity. Where the issue costs are included in the marginal cost of capital
· Easy to imagine a firm passing up a positive NPV project if the issue costs are too great. Thus financial slack may prevent
positive NPV projects from being skipped. However, financial slack is often close to free-cash flow. Be careful.
· How much is the tax shield worth? It is difficult to say. MM assume that once a firm issues debt it remains outstanding. MilesEzzell assume a firm maintains a constant debt-equity level. Thus Miles and Ezzell allow firms to adjust their amount of debt
outstanding depending on the success of a project.
Chapter 20: (and some from chapter 21)
· Derivatives have grown dramatically in the past 20 years. They are very misunderstood in business world and in press.
· Derivatives are securities which derive their value based the value of another asset. Options, futures, forwards, swaps were discussed. These can be "nested" so that you have options on indices etc.
· Calls give you the right, but not the obligation, to buy an asset at a predetermined price. Puts give you the right, but not the obligation, to sell an asset at a predetermined price. This predetermined price is called the strike price or exercise price.
· American options can be exercised at any time up to the time of expiration. European options can only be exercised at expiration. However, this is not a major difference since it is rarely optimal to exercise an American option early unless dividends are involved.
· Options can be priced according to the Black-Scholes Option pricing model.
· Forward contracts are customized contracts that create an obligation to buy or sell an asset to or from a specific second party. These contracts are more flexible but you must find a counter-patty that has needs that are opposite yours. Thus transaction and default costs could be greater for forwards. As a result forwards, especially financial forwards, are generally reserved for creditworthy customers.
· Future contracts create the obligation to buy or sell an asset. For example if you buy a September corn contract you are then obligated to buy corn in September. Futures are marked to market daily and each contract is made through a clearinghouse. These institutional details lower the risk of default and provide for more liquid markets.
· A wide range of assets make up the underlying asset category for derivatives. You can buy derivatives on interest rates, stock indices, commodity prices, precious metals, and other derivatives.
· It is important to understand how various corporate transactions and events reflect the option pricing models. Notably we discussed how the BH-H conflict can be modeled using the Black-Scholes model. Further option theory can be used to explain why R&D can be considered an option. (You have the option to continue or not)
· Call price is a positive function of risk, time to maturity, the risk-free rate, and value of the firm. It is a negative function of dividends and strike price.
· Warrants and Leaps are long-term options.
· A common trait of all derivative securities is their leverage effects. (Example where $5000 would return $60, 000 in 5 days)
· Test taking tips: be sure you know how to calculate payoffs of the various positions at expiration and that you know how to read the Wall Street Journal's option tables.