What Conclusion: We Do and Do Not Know About Finance
Richard A. Brealey and Stewart C. Myers McGraw-Hill Readings Book
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Topics Covered
What we do know What we do not know
Its not what you dont know thats going to get you, its what you dont know you dont know. Satchel Paige
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7 Most Important Ideas in Finance
Net Present Value Capital Asset Pricing Model (CAPM) Efficient Capital Markets Value Additivity & Law Conservation of Value Capital Structure Theory Option Theory Agency Theory
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Net Present Value
Is the project worth more than it costs?
We calculate what its cash flows would be worth if a claim on them were offered separately to investors and traded in the capital markets
NPV = CF 0 +
n CF1 CF2 CFn CFt 1 + 2 + ... + n = t t 0 (1 k ) (1 k ) (1 k ) (1 k )
NPV = discounted cash flows at the opportunity cost of capital
Opportunity cost of capital = required return for securities of the same risk
Leads to the universal axiom: MAXIMIZE PRESENT VALUE!
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Capital Asset Pricing Model (CAPM)
Manageable way to think about the required return on a risky investment Two kinds of risk:
Risk you can diversify away (business, diversifiable) Risk you cant diversify away (market, nondiversifiable) Measure market risk with beta How the value of an investment is affected by a change in value of all the investments in the economy
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Portfolio Risk (%) 35
Diversifiable Risk
20
Market Risk Diversifiable Risk
0 10 20 30 40 2,000+
# Stocks in Portfolio
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Capital Asset Pricing Model (CAPM)
k = Rf + ( m - Rf) k Required rate of return = Rf + risk premium Risk premium = #units of risk X price per unit of risk # Units of risk = Price per unit of risk = risk premium on the market Risk premium on the market = (km - Rf)
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Efficient Capital Markets
Prices accurately reflect available information
Weak form: prices reflect all of the information in past prices Semistrong form: prices reflect all publicly available information Strong form: prices reflect all information, public and private
Implies
Competition in the capital markets is tough! Prices reflect underlying value given the information available You can beat the market if You have information that no one else has You are better at using available information than anyone else to predict value
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Value Additivity & Law Conservation of Value
Value additivity: value of the whole is equal to the sum of the values of the parts PVproject = PV(C1 ) + PV(C2 ) + ... + PV(C t ) + ... Implies that you cannot increase value by merging two companies together, unless you thereby increase the total cash flow
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Capital Structure Theory
If the law of conservation of value works when you add cash flows, it should also hold when you subtract them Value of a company is independent of its capital structure The size of the pie remains the same no matter how you slice it! Modigliani and Miller Proposition I
In perfect capital markets, capital structure does not affect value In perfect markets: No transactions costs or taxes; No single investor can influence security prices; Investors and firms can borrow and lend at the risk free rate, All information costless and known by all participants
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Option Theory
The ability to trade in the future on terms that are fixed today Components of the option price
underlying value of the asset striking or exercise price risk of the underlying assets time to option expiration time value of money
Real options
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Agency Theory
Do all players act in the best interest of the stockholders?
Managers Employees Stockholders Bondholders, etc
Agency Theory
What are the conflicts of interest? How do companies deal with them?
Corporate Governance
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10 Unsolved Problems In Finance
1. 2. 3. 4. How are major financial decisions made? What determines project risk and preset value? Risk and return - what have we missed? How important are the exceptions to the efficient market theory? 5. Is management and off-balance-sheet liability? 6. How can we the explain success of new securities and new markets? 7. How can we resolve the dividend controversy? 8. What risks should a firm take? 9. How can we explain merger waves? 10. How can we explain difference in financial architecture?
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1. How Are Major Financial Decisions Made?
We dont know why one company will accept a project and another reject it We are especially ignorant regarding strategic decisions
Capital budgeting on a grand scale!
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2.
What determines project risk and present value?
Why are some companies able to realize positive NPVs while others are not? Why are some real assets risky and other relatively safe? Assessing project risk is an art not an science
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3. Risk and Return - What Have We Missed?
CAPM is hard to prove or disprove
Average returns on low beta stocks are above what is predicted by the CAPM Average returns on high beta stocks are below what is predicted by the CAPM
Have we misestimated the inputs for the model?
Beta, risk-free rate, etc.
Is the model wrong? Is something left out?
Fama and French found that expected returns appear to be related to firm size and the ration of market value of assets to book value
Extension of the model that includes hedging implies a more complicated risk-return relation Basic premise of CAPM is broadly accepted.
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4. How important are the exceptions to the efficient market theory?
Stock of firms just gone public underperform the market over the next five years No rule has been found that could be used to consistently beat the market However, stocks could be substantially mispriced Psychologists find that people put too much weight on recent events when predicting the future Investors tend to overreact to new information
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5. Is management and off-balance-sheet liability?
Closed end funds are firms whose only asset is a portfolio of common stocks
Stock in closed end funds often sell for substantially less that the value of the funds portfolio
Real estate firms tend to sell for less than the value of the firms underlying net real assets At times, the market value of oil companies is less than the value of its oil reserves Is the cost of management more that its worth?
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6. How can we explain the success of new securities and new markets?
Why do investment bankers continue to invent and successfully sell securities that the current technology cannot value?
Securities help investors hedge against some new risk Transactions costs for differ for different securities
Why are some new markets and new securities successful and other are not?
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7. How can we resolve the dividend controversy?
Some people believe that dividends are good Some people believe that dividends are bad Some people believe that dividends are irrelevant
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8. What risks should a firm take?
Some decision reduce risk but less risk isnt always better The goal of risk management is not to reduce risk but to add value
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9. How can we explain merger waves?
Also, hot cycles for initial public offerings There were five major mergers wave in the 20th century
The first merger wave occurred between the enactments of the Sherman Antitrust Act in 1890 and the Clayton Act of 1914. The stock markets receptiveness to new security issues in the late 1920s bolstered the second wave. The third wave, which occurred in the 1960s, actually motivated many of the mergers that took place during the fourth merger wave of the 1980s. The merger wave of the 1960s was the only period in which corporate diversification was the primary reason for acquisitions. The resumption of the bull stock market in the early-to-mid 1990s fueled the fifth major merger wave of the last century.
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10. How can we explain difference in financial architecture?
Important difference in the legal form of the business, its ownership, governance, and sources of financing
More closely held than US Banks are a more important source of funding and play a larger role in governance More diversified conglomerates which fund each other
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