FD (1) - ???? Introduction to Financial Decisions ????...

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Unformatted text preview: ???? Introduction to Financial Decisions ???? Welcome to the Introduction Financial Decisions e-lecture series. ?? This e-Lecture system will enable you to listen to a lecture provided as part of Financial Decisions course at Hosei University. These lectures have been developed as part of the Good Practice Project supported by MEXT (Ministry of Education, Culture, Sports, Science and Technology): http://www.mext.go.jp/a_menu/koutou/kaikaku/gp.htm in conjunction with HURIC (Hosei University Research Institute, California). To view a lecture, choose the chapter you wish to study and simply click the bottom on your left This course is an introduction to the underlying theory that drives the tools of financial decisions-making within a business. It shows how corporate finance works, the range of issues involved and how to perform financial analysis. XML書書書書 ????? ?????? Henry Wong Financial Decisions Chapter1 ????? 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Introduction 1 00:00 Introduction to Financial Management00:00 1 Forms of Business Organization 2 00:00 Proprietorships 3 00:00 Partnerships 4 00:00 Partnerships (continued) 5 00:00 Corporations 6 00:00 Limited Liability Companies (LLCs) 7 00:00 Bases for Comparing Various Business00:00 8 Organizational Forms Number of Owners & Ease of Startup 9 00:00 Number of Owners & Ease of Startup (continued) 10 00:00 Investor Liability 11 00:00 Investor Liability (continued) 12 00:00 Equity Capital Sources 13 00:00 Equity Capital Sources (continued) 00:00 14 Firm Life & Liquidity of Ownership 00:00 15 Firm Life & Liquidity of Ownership (continued) 16 00:00 Taxation 17 00:00 Taxation (continued) 18 00:00 Corporate and Personal Taxes 19 00:00 Summary: Sole proprietorships & Partnerships 20 00:00 Summary: Corporation 21 00:00 Summary: Hybrid Business Entities 22 00:00 (LLCs) Why We Focus on Corporations 23 00:00 Why Corps. Maximize Value 24 00:00 Self Test 1.1 25 00:00 26 00:00 Self Test 1.2 27 00:00 Self Test 1.2 Answer 28 00:00 Self Test 1.3 29 00:00 Self Test 1.3 Answer 30 00:00 Financial Goals of the Corporation 00:00 31 Self Test 1.4 32 00:00 Self Test 1.4 Answer 33 00:00 Self Test 1.5 34 00:00 Self Test 1.5 Answer 35 00:00 Self Test 1.6 36 00:00 Self Test 1.6 Answer 37 00:00 Self Test 1.7 38 00:00 Self Test 1.7 Answer 39 00:00 Self Test 1.8 40 00:00 Self Test 1.8 Answer 41 00:00 Self Test 1.9 42 00:00 Self Test 1.9 Answer 43 00:00 Factors that affect stock price 44 00:00 Is stock price maximization the same00:00 45 as profit maximization? Stock Prices and Intrinsic Value 46 00:00 Determinants of Intrinsic Value and 00:00 Prices (Figure 1-1) 47 Stock Self Test 1.10 48 00:00 Self Test 1.10 Answer 49 00:00 Self Test 1.11 50 00:00 Self Test 1.11 Answer 51 00:00 Self Test 1.12 52 00:00 Self Test 1.12 Answer 53 00:00 Self Test 1.13 54 00:00 Self Test 1.13 Answer 55 00:00 Self Test 1.14 56 00:00 Self Test 1.14 Answer 57 00:00 Some Important Trends 58 00:00 Percentage of Revenue and Net Income00:00 Overseas Operations for 10 59 from Self Test 1.15 60 00:00 Self Test 1.15 Answer 61 00:00 Business Ethics 62 00:00 Self Test 1.16 63 00:00 Self Test 1.16 Answer 64 00:00 Self Test 1.17 65 00:00 Self Test 1.17 Answer 66 00:00 Self Test 1.18 67 00:00 Self Test 1.18 Answer 68 00:00 Agency/Fiduciary relationships 69 00:00 Conflicts Between Managers and Stockholders 70 00:00 Self Test 1.19 71 00:00 Self Test 1.19 Answer 72 00:00 Self Test 1.20 73 00:00 Self Test 1.20 Answer 74 00:00 Role of Finance in a Typical Business Organization 75 00:00 Responsibility of the Financial Staff 76 00:00 Self Test 1.21 77 00:00 Self Test 1.21 Answer 78 00:00 Self Test 1.22 79 00:00 Self Test 1.22 Answer 80 00:00 Every Job is a Finance Job! 81 00:00 CHAPTER 1 ANSWER SET Introduction 82 00:00 to Financial Management Question 1-1 83 00:00 Question 1-1 Answer 84 00:00 85 00:00 Question 1-2 Answer 86 00:00 87 00:00 Question 1-3 Answer 88 00:00 89 00:00 Question 1-4 Answer 90 00:00 91 00:00 Question 1-5 Answer 92 00:00 93 00:00 Question 1-6 Answer 94 00:00 95 00:00 Question 1-7 Answer 96 00:00 97 00:00 Question 1-8 Answer 98 00:00 99 00:00 Question 1-9 Answer 100 00:00 101 00:00 Question 1-11 Answer 102 00:00 103 00:00 Question 1-15 Answer 104 00:00 105 00:00 Question 1-16 Answer 106 00:00 ? ? Script ? ? ? Script This Page is Menu? of ?Lectrue.? ? ? ? ???? Welcome to Financial? Decisions? and ? ? ? ? ? ?I? am ?Professor Henry ?Wong ?and? today ?we ? ? ? going ? ? ? ? discussing ?Chapter ? ? ? ? ? ? ? ? ? ? to? Financial? Management. In? this? chapter ?we ? ? ? ? ? ? ? a ? ? ? ? overview ? ? what financial management is all about. We start off in this chapter by discussing the different forms of business organizations that are available in the market place. ? ? ? ? ? ? ? ? ? Markets. ? ? ? Henry Wong ? ? ? ? 1 ? ? are ? ? ? to be ? ? ? ? ? ? ? ? ? ? 1: Introduction ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? will cover ? brief ? ? ? ? ? of ? ? ? ? ? ? And then number 2,organization. specifically about corporations and the goals of the corporation, and then 3 we will talk about how we maximize shareholder value in corporations. Then we will talk about some recent trends affecting corporations that all financial managers should be aware of. And finally, we end the chapter discussing some of the inherent conflicts between managers and shareholders within corporations. will talk Forms of business? ?we ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 3 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? There are four primary types or forms of about whatorganizations. First is the sole proprietorship, or sometimesby one sole individual who is solely unincorporated company that has only one owner. Compare that with as liable for all of the venture’s liabilities. This ais what we call unlimited liability. Soas a sole proprietorship except it is It is the personal business with the sole owner of a proprietorship to coupleventure’s liabilities not covered by that venture itself.aware of.does that mean? That means that if you openand“mom mean pop” shop or a 7-11 store down the a partner yourself, then that is called a sole unlimited liability, and weslips and on and in that store,unlimited only can sue the store but they cansecond type of partnership which is called sue the limited partnership, can come after your personal assets.general you own athat or a house or any other kind of has unlimited liability,person second form of business two owners. Now, there are a pay a of different of partnerships the should be So there the general partnership, we “general” because who an owner will what liability means. partner car manages but Proprietorships. ? ? ? ? ? ? ? ? first ? ? ? ? business ? a proprietorship ? ? (sole is. It is a business venture ?owned ? called proprietorships. ? ? ? ? ? an( responsible )for? the day-to-day ?operations of? that? business as? well? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?organization, which1is ? ?partnership, which is the same ?thing ? what? exactly ?is ? ? ? ? ? ? ? ? ? ? ? ? ? an? unincorporated? obligation ? ? ? ? ?or ?more 2 ? ? ? ? ? ? ? ? ? ? (limited partnership)? ? ? ? kinds ? ? ? ? ? ? ? ? ? ? ? ? ? you ? ? ? ? (generalwhat First, ? ? ? ? is(limited partners)? ? ? ? ? ?a? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? everyone ? ? ? is ?street? by ?or ? ? ? ? ? ? in ?this ?partnership2 has ? ? ? ? ? ? ? ? 1 ? If C-corporations?go ? falls ?discuss ? ? ? ? they not ? ? ? ? ? ? ? ? ? ? ?But there is the sue you personally, ? ? ? not ? ? ? can ? C-corporations ? ? ? ? ? ? ? ?they and in this partnership? there ?is ? ? ? ? if? ? ? S-corporation ? ? 7the? partnership,? which ? ? ? ? ?they ?can? sue ? ? ? S-cor First, let's ? ? ? talk ? ? 4 ? ? ? ? ? 1 ? ? ? ? ? actually proprietorship)? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 2 ? ? ? ? ? ? This is ? you personally, but ? S-corporations ? ? ? ? ? ? ? ? ? ? a So ? partnership ? ? ? ? ? ? ? ? 2 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??????????? ? ? ? ? ? (partnership-general)? ? ? ? ? ? ? ? ? ? ? unlimited liability? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? of ? ?? ??? ?? partner)? ? ? ?? ????? ? ??? ? ? ? ? ? ? ? ? ? ? ? ? ? proprietorship. ? someone ? ??? ?90% ????? 1 ? ? Sub Chapter S corporations? ? ? and ? ? only ? ? they 5 ? ? ? ? ? ? ? ? ? ? asset, ? ? ? ? ? you More on partnerships. Let’s ?compare ? ? ? ? ? ? ? ? ? ? ? ? 2 with ?what? a? partnership? ?? ??????????????????????????????? ?? ?? ?? ?? ?? ? ? ? ? ? ? by? two? or? more? individuals? who ? ? ?jointly ? ? ?personally ? ? ? ? ? ? ? the ? ? ? ? ? ? liabilities.? So ?this ?is ?? ?? ?? ?? ?“joint???????????????????is?? ?? ?1 ?? ?? ?? ? ? action? treats ? ? ?of ? ? ?partners’ ?equally ? ? a ? ? ? ? ? ? ?what ?does ?this ?actually? mean? ? ? ? ? ? ? ? that? if ?for? some? reason a ? ? ? ? ? ? a ? ? ? ? ? ? ? ? ?company ? ? the ? ? ? ? ? ? ? ? ? ? borrowed money ?from ?all? of ?a? sudden decides ?to ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? not paid the ? ? ? ? ? ? ? ? ?is ? ? ? ? ? ? ? ? ? ? ? ? ? ? that not ? ? ? ? ? one ? ? ? ? ? liable,? but all ? ? ? owners are ? ? ? ? ? liable ? ? ?that ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ?? ?? ? is. A partnership is a business venture owned ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? are ? ? ? ? and ? ? ? ? ? ? liable ? ? ? ? ? venture’s? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? called ??????? liability.” It ?? where legal ? ? ? ? ? ? ? ? ? all ? ? the ? ? ? ? ? ? ? ? ? ? ? as ? group. Now ? ? ? ? ? ? ? ? ? ? ? ? ? This means ? ? ? ? ? ? ? ? ? ? ? creditor, ? bank that the ? ? ? ? or ? ? partnership has ? ? ? ? ? ? ? ? ? ? ? ? ????? ? ? ? ?? ?????? ??? ? ??? ?????? ??? ????? ?? ? ? sole proprietorships ? ? ? ? ??? ? for ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? sue ? ? partnership because ? ? partnership has ? ? ? ? ? ? ? loan back and ? in default, that means ? ? ? ? ? only is ? ? partner ? ? ? ? ? ? ? ? the ? ? ? ? ? ? jointly ? ? ? ? for ? ? loan as well. More on partnerships. ? ? ? ? compare joint liability with joint and several liability. In this case it allows a subset of the partners to be the object of the legal action related to the partnership and excludes specifically other partners that are not part of it. This is called joint and several liability. So for example if a creditor is suing a partnership because it has defaulted on a loan, under joint and several liability the banks can go after only a couple of the partners instead of all of the partners if the partnership agreement has outlined joint and several liability. ? ? ? Let’s Finally,talkend with limited partnerships. Before we were talking about general partnerships, which again in a general partnership, everyone is liable for the firm’s liabilities. In the limited partnership, however, it is actually managed by a general partnership which again has unlimited liability, but it’s investors are called limited partners, and in this sense, they limit their limited partner liabilities in that partnership to only the amount of their equity capital contribution to the partnership. So, if you are a limited partner in a limited partnership, you are an investor in that partnership and if the partnership is ever sued by a creditor or a customer or anyone else and they decide to come after the owners of the partnership, then all you would stand to lose as a limited partner is just what you invested in the first place. This is the ideal benefit of being in limited partner Next we we about ?corporations.? ? ? ? ? ? ? and ? ? ? ??????? joint ? ? several liability? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? A corporation the discussion ? ? ? ? hybrids, the as many? people ? ? ? ? ? ?owners? which ? shareholdersLLC( this case, from theCompanies) ? ? ? assets.? companiesvery business organizations partnership or a ? ? ? entity that ? ? ? ? ? or assets of the actual firm’s LLC? ? ? it ? ? ? different than a ? ? owned by “members” ? ? ? ? of ?shareholders with ? ? ? ? liability. Now? for all ? ? ?Andand ? again ?is called are ?the same thing as shareholders, but in ? legal sense, ? ? ? ? their investors “members”? instead ? shareholders. LLC? ? ? ? ? ? takes ? ? ? ? ? 1 9 7 0 ? ? ? ? ? 8 0 ? ? ? ? ? the partnership you essentially have a division liability. ? this ? ? ? liability. It means that creditors can seize the corporation’s assets but have no ? ? LLCagainst the ? ? ? ? Now again, it ? ? ? assets. Finally we end is ? ?legal ? ? ? with? theseparates ? ? ? personal ? ? ? call them, ?LLCs, or ?the stands?for? “limited liability companies.” Limited? liability ?So?? ?? ?is? ??are? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?sole ?? ?? ?? ?? ?? ?? ?? ?? ?? ?a?? ??instead?? ??because?? ?? ?? ?? ?? ?? ?? limited?? ?? ?? ?? LLC??????of?????????intents??????purposes, ???????????limited??????????????????????????????????????????the?????????????????LLCs ?call????????????????????????????recourse ? ??of?? ?? ? ?? ?shareholder’s? personal ? ? ? the most? favorable? aspects ?of ? ? ? ? ? ? ? ?different ? ? ? ? ? ? ? ? ?from ?partnership ?law and ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? ? ? ? into? a? hybrid entity ? ? form? whatLLC? now? ? ? ? C-corporation?is ? ? ? ? ? ?a? relatively ? ? ?phenomenon ???? ?? ???? ( ? Sub Chapter? in ?? ?? ??American ?? ?? ?? ?? ?? ?? ?? ?S-corporation ? ? ? ? ? ? ? taking? off ? ? ? IRS?? ? ? ( Sub Chapter S) 80s ? ? ?that’s ?when ?you saw ? ?lot? of ?these ? ? ? 2 ? ? ? ? ? ? ??? ? ? ? ? ? ? ? ? ? in ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ? LLC ? ? ???????? ???? ?????? ? ? ? ? ? ? ? ? ? ? ? start ? ? ? ? ? until ? ? ? ? ? ?? ? ? ? ?? ? ? ??? ? ???? ? ?? ?? ?? ???? ?? ? ? ? ? ? ? ? ? ? ? ? ? ? members ??? ???? ??? ?? ????? ????? ? ? ? ? ? ? ? ? ? ? ? ?? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?each of LLC ? ? ? ? ? organizations ? ? ? ? ? ? ? ? ? ? ? ? corporation law ? ? combines them together? ? ? ? ? ? ? ? ? ? ? ? ? to? ? ? ? ? ? ? we ? ? ? call a ? ? ? ? ? LLC ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? new ? ? ? IRS???? business organization C) the ?? ?? ?? ?? ?? marketplace. It? actually didn’t ? ? ? ? ? ? ? ? ? ? ? ? ? ? the late 70s and early ? ? and ? ? ? ? ? ? ? ? ? a ? ? ? ? ? organizations starting to get formed. The major incentive to form a company as a limited l ???????? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? LLC. An ? ? ? actually ??????? a ??? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? limited ?liability after ? ? ? ? ? ????? So, a person in ? ? ? ? ? ? ? ? ? ? ?businesswith ? ? ? first ? ? ? ? ? ? ? have to? ? ?sue the ? kind of? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? Well, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?different ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? And ? ? ? ? ? ? ? ? ? ? alone ?this ?is ? ? ? ? majority ? ? ? ? ? ? ? ? ? ? ?in ? ? ? ? ? ? ? ? ? ? ?growing ? whether? or ?not they should ? to ?maximize shareholder ? ? ? ? ?are organized? as? corporations. ? ? ?or ? ? ? ? ? ? ? ? ? ? ?the liability ?those ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? are directly, they cannot come whatever various assets that you this limited liability status. ? ? in this chapter ? ? ? ? ? ? why for of organizations ? America that are ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? wealth ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? It Whenalthough you ? ? ? breaching? a? contract ? for ? ?customer? and ? theysue? you ? decide whatcompany ? business ? ? ? ? ? ? ? ? ? ? ? ? ? ? your car, house ?or ? ? ? ? arepersonal ? ? ? ? for ? ? ? ? have? because ?of ? ?business organization? forms, and ? ? ? this5 reason we? discuss five ofathe major criteria affecting how a person should decideand prosperous and that wantbe formed as a proprietorship, as a partnership, as a corporation,is because it of hybrid entity. Andof their owners. And of course there are some disadvantages to being a corporation which we’ll discuss in a few slides. But before we talk about that, let’s talk about the other kinds of corporation. The corporation that we have been discussing so far has been called a C-corporation, for Sub Chapter C of the IRS code. There is also a S-corporation - ‘S” as in Superman, and this is from Sub Chapter S from the IRS code, and this is basically the sa America starts a ? time,they ? form. some kind limits five things are: ? ? the? ? ? ? ? ????? ? ? ? ? ? entity they want to start? ? ? ? ? ? ? ? ? there ? ? ? ? ? ? ? bases ? ? comparing the ? ? ? ? ? ?? ? ????5??????? ?????? ?? ????? ???? 1 ) C-corporation? ? ? ? ? ? ? ? number ? ? investors. ? ? ? ?? 1/ in C-corporation ? ? ? can have ? ? ? ease? of ? ? ? ? ? ? So, ? ? ? ? ? ? ? ? some people ? ? ? ? ? go into? business you ? ? an Numbera1. The number? of ?owners? and ? ? unlimitedstartup.of 1 ? ? ? example, ? ? ? ? ? ? ? ?like ?to ? ? ? ? ? ? ? ? ? ? ? for ? ? ? ? ? ? ? and ? ? ? ? ? ? ? like to? ask ? ? ? ? ? else ? ? a ? ? ? ? ? whether? or? not ? ? ? ? ? ?do ? ? ? ? ? ? ? ? ? they like to? manage the ?business themselves. ? ? in? this case, ?you can ? ? ? why ? ?proprietorship ?would ? ? an? ideal ?business organization? for ? ? ? ? ? ? ? ? ? ? ? ? ? And ?also ?the ease of1 starting ? ? ?organization ?up ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Some? business ? ? ? ? ? ? ? ? ? like? corporations? take? a lot ? ? ? ? ? ? ? ? ? cost a ? ? ?of ? ? ? ? ?and take ? ? ? ? of ?time ?in ? ? ? ? to? get ? ? ? ? ? ? ? ? ? whereas ?a? proprietorship or? a partnership ? ? ? ? ? ? ? ? the ? for that kind of person. ? ? ? ? S-corporation? ? can ? ? ? ? ? ? ? ? ? ? 75? accredited ? ? ? ? ? ? ? ? the???? ???? S-corporation? ? finally? the ? ? ? ?major point of ?why? a company? would? wantor? ?be organized ?as an? S-corporation ??? something, ?so ?? ?? ?? ??is?? ?? ? ? the? taxation ? ? ? 2 ? ? ? ? ? ? ? So the ?personal level ?so see ? ? adon’t ?have ?what is ? ? be ?“double taxation,” ? ? ? ? is ?what? we will talk about a little ?bit ? ? ? ? as ?well. ? ? ? the ? ? ? 1 ? ? ? ? is very important as well. ? 1 ? ? ? ? ? organizations ? ? ? ? ? ? ? ? ? ? ? ? ? ? of expertise, ? ? ? ? lot ? money, ? ? ? ? ? a lot ? ? ? ? order ? ? ? them started; ? ? ? ? ? however, ? ? ? ? ? ? ? ? ? 7 5 ? ? ? ? ? ? ? ? ? ? ? ? ? C-corporation?? ? corporation. And then ? ? ? themselves ? ? they don’t ? ? ? 1 ? ? ? someone? ? ? ? ?to ? partner? ? ? ? ? ? ? ? ?? ?? they? can versus ? ?C-corporation ?? that ? ? ??? ? ??? ? ? ? ? ? ? ? ? ? ? that you ? ? ? ? ? ? ? called ? ? ? ? ? ? ? ? ? which ? ? ? later ? ?? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? is much easier to start. So that is the first thing that business people think about when they decide what kind of business organization they want to form. ? ? ? ? only have ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? up ? ? ? investors in ? ?? 2/ then S-corporation you a 2) ? ? ? ? liability and limited ? ? ? ? ? ?? ? you ? ? ?? ?? ? ?? Andin an the second thing that they often think aboutto ?investor liability. So we have ? ? discussing what unlimited ? last S-corporation liability ?means,? so therefore ?if ? ? are a ? is been business person and you? have? a lot of personal assets, such asis house or a car,to a flowed through basically anything that you declare as an asset, then you would want that somehow protected and shielded from any kind of dispute that arises from not being able to satisfy the company’s liabilities or obligations And in that case you might prefer a corporation because it has limited liability versus a proprietorship which again has unlimited liability. Third: One of the major reasons why people choose one entity over another entity is what available capital sources are out there to fund the growth of the company. So if you are a proprietorship, and you don’t need a lot of money to start a little soda shop down the street, then you don’t need to approach a lot of people and ask for money or ask for equity capital. In that case, you wouldn’t need to go through the expense of forming a corporation. But the benefit and advantage of forming a corporation is that it has many more equity capital sources. More people are willing to invest in a corporation than they are in a proprietorship, and there are various reasons why that we will talk about when we discuss this very important factor. Fourth is how long the firm is going to last and the liquidity of the ownership in the firm. So in a proprietorship for example, when the owner dies, the company dies. In a corporation, it’s an ongoing entity. So you can have shareholders or the owners die within a corporation and the entity will continue to survive. And that has a lot to do with the liquidity of ownership and the ease or ability to be able to transfer your shares to someone else in an open marketplace. And if you are an investor in a big corporation like IBM, there is a liquid market place out there where you can buy and sell their stock freely. But if you are a shareholder in some sort of soda shop down the street started by a small business owner, there isn’t a freely tradeable marketplace for you to sell your shares if you ever choose to do so. So this is a very important factor that investors think about and which influences what the business person ultimately is going to decide to pick as a business entity. And finally, the last reason that affects business owners’ decisions in forming a business entity is a very economic one, and that is taxation. With some entities there is a single level of taxation, while as in corporations as we will see, C-corporations in particular, we will see that there is actually double taxation, and maybe in some cases we may see even triple taxation. So of course the less times you are taxed by the Government, the better, and this obviously has again an influence on what type of business entity people choose Now if you compare that with corporations and hybrids, there is going to be a big difference. In C-corporations, the investors in these corporations are institutional investors or venture capitalists and common shareholders, so you have a much bigger market of investors that want to invest in C-corporations. S-corporations are the same – you have venture investors and other kinds of institutional investors who want to invest in this entity, but remember we have to limit those investors to only 75, or no more than 75 investors, which of course is one of the disadvantages of being in an C-corporation. And then finally, in LLCs, you can have venture investors as well as equity offerings to the members themselves in order to gain capital. But all in all, the net-net [summary] here is that by far, corporations are much easier to attract outside capital than sole proprietorships or partnerships are. The next thing we? look?at ?is ? ? ?life ?of ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? of? ownership? provided ? ? each of? the ? ? ? ? ? ? business ? ? ? ? ? ? ? ? ? ? ? ? 1 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? owned ?only ?by ? ? ? person, ?therefore ?the? life? is ?determined ? ? just this one ? ? ? ? ? So? if ?this ?person? passes away then the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?It ? ? ? ? ? ? very?difficult ?to ? ? ? ? ? ? ownership? in ?a? sole? proprietorship ?to ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? because? there ? ? ? ? freely ? ? ? ? ? ?marketplace ?for the ? ? ? ? ? ? ? or? the ? ? ? ? of ?this ?proprietorship. And ? ? ? same? things go? for partnerships? and ? ? ? ? ? partnerships? as ?well. In? a general? partnership, ?the life is? determined ? ? its ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the partnership ? ? not ? ? ? ? ? ? to ?dissolve if? they?all decide ? ? advance, ? ? ? ? ? ? ? ?case ?of ? ? ?partner’s ?death ? ? some kind of? withdrawal.? And ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ?partnerships, it? is ?like ?a? marria ? ? ? ? the ? ? ? this firm and ? ? liquidity ? ? ? ? ? ? ? ? ? ? ? by ? 1 ? ? ? ? different ? ? ? ? ? organizations. We know that a proprietorship is ? ? ? ? ? ? one ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? by ? ? ? ? ? ? ? ? person. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? entity will no longer exist. ? is often ? ? ? ? ? ? ? ? transfer ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? another person and ? ? reason is ? ? ? ? ? ? ? is no ? ? ? ? tradable ? ? ? ? ? ? ? ? ? ? securities ? ? ? stock ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? limited ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? by ? ? partners. If a partner dies, ? ( ? ? ? ? ? ) ? is ? ? required ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? in ? ? ? ? ? even in the ? ? ? one ? ? ? ? ? ? ? ? or ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? again, because of ? ? structure of these ? ? ? ? ? ? ? ? ? ? ? ? ??? Finally, we talk ? ? ? ?the last important economic ? ? ? ? in? choosing the ?correct ? ? ? ? ? ?entity, ? ? ? that? is ?of ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ? and ? ? ? ? ? partnership,? you ? ? ( taxed ? ? personal ? ? ? ? )tax? rates. So, ? ? ? ? ? ? you make at? the ? ? ?of ? ? ? year1 based ? ? ? ? ?of ? ? ? ? three ? ? ? ? ? ? ? ? about ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? point ? ? ? ? ? ? ? ? ? ? ? ? business ? ? ? ? and ? ? ? ? taxation. With proprietorships ? ? partnerships ? ? limited ? ? 3 ? ? ? ? ? ? are ? ? ? at ? ? ? ? ? income ? ? ? ? ? ? ? whatever ? ? ? ? ? ? ? ? end ? the ? ? ? ? ? on any ? these 1 ? ? different structures, the government will put a tax on the earnings of your proprietorship, partnership or limited partnership. So it is subject essentially to one single level of taxation. You only get taxed once on the money that you make. Let’s give you a little bit more information and background on U.S. corporate and personal taxes. Both have a very progressive structure. What does that mean when we say it has a “progressive structure”? That means the higher the income, then the higher the marginal tax rate. Thus if you are a corporation, the more money you make, the higher amount of taxes % that you are going to pay. And that is the same again for personal and individuals as well. The more money you make in any given year, the more taxes you are going to pay on that. So, in terms of corporations, rates generally begin at about 15% of your earnings and rise to 35% for corporations with income over $10,000,000. It is also subject to an additional state-level tax of around 5%. What about for individuals? Rates generally begin at 10% and rise to around 40% for individuals with incomes over $300,000. And depending on the state you are living in % % % % % % % % % % % % Self-test question 1.2: How do some firms get to enjoy the benefits of the corporate for of organization and yet avoid income taxes? Why don’t all firms such as IBM and GE do this? Please take a moment and write down your answer and go to the next slide when you are ready to see the answer. Self-test 1.2 answer. Sub chapter S corporations are exempt from corporate income tax and therefore enjoy the benefits of the corporate form of organization. Also, not all firms such as IBM and GE would choose to be an S-corporation because these entities can have no more than 75 stockholders, which limits their use to small privately owned companies. S-corporations would not be an ideal structure to go public because of the small number of shareholder allowed. Self-test question 1.3: Why is the value of business, other than a small one, generally maximized if it is organized as a corporation? Please take a moment and write down your answer and go to the next slide when you are ready to see the answer. Again we pause here to take a self test. This is self test 1.24: What is management’s primary goal anyway? Please take a moment to note down your answer before you go to the next slide when you are ready to see the answer. Self test 1.24 answer. Management’s primary goal is to maximize value for shareholders and owners. Self test 1.5. What do investors expect to receive when they buy stock? Do investors know for sure what they will receive? Please explain. Jot down your answer and when you are ready, go to the next slide. Self test 1.5 answers. Investors actually expect to receive a financial return on the investment when they make an investment in stock in a corporation. Now investors do not know for sure what they will receive because of the firm’s specific and market specific factors which affect the value of the stock. In other words, they can make a large financial return, or they can lose everything. Self test 1.6. Based just on the name, which company would you regard as being riskier? General Foods, or South Seas Oil Exploration Company? Explain. Take a moment, jot down your answer and go to the next slide when you are ready. Self test 1.6 answer. Based on the name you would expect South Seas Oil Exploration Company to be riskier because its investment decisions and projects that it undertakes would be more speculative in nature than a food company. Self test question 1.7: When a company like Boeing decides to invest $5 billion in a new jet airliner, are its managers positive about the project’s affect on Boeing’s future profits and stock price? Please explain and take a moment and write down your answer and go to the next slide when you are ready. Self Self Self Self test test test test Self test Self test Self test Self test Self test Self-test Self-test Self-test Self-test question 1.8: Would Boeings’ managers or its stockholders be better able to judge the affects of a new airliner on profits and the stock price? Explain. Please jot down your answer and when you are ready to go to the next slide, please do so. 1.8 answer. We presume that the managers are better able to judge the future success of a project because they are hired to run the company on a day-to-day basis based on their experience and background and enhance the shareholder value. Thus, they are going to have better “insider knowledge” that outsiders will, and thus they would be better able to judge the future success of any project. question 1.9: Would all Boeings stockholders expect the same outcome from an airliner project, and how would these affect the stock price? Please explain, jot down your answer and go to the next slide when you are ready. 1.9 answer. Not every stockholder’s viewpoint is going to be alike. Some stockholders may think that the project will be a success, while others many think it will fail. Those investors that are encouraged by the prospects of the project may choose to hold onto their stock or purchase even more stock because of this. On the other hand, those with low expectations may choose to sell their stock as a result of their feelings about whether or not the project will be successful. Now this buying and selling occurs on a massive scale in the market place and ultimately increases or decreases the stock price of the company when supply equals demand for the company stock. 1.10 answer. The current market price represents the value of the stock based upon the perceived but possibly incorrect information seen by the marginal investor. Whereas the intrinsic value of the stock is represented by educated estimates of the stock’s true value based on accurate risk and return data. The intrinsic value cannot be measured precisely however. question 1.11: Do stocks have a known and provable intrinsic value or might different people reach different conclusions about intrinsic values? Please explain, jot down your answer and go to the next slide when you are ready. 1.11 answer: Although intrinsic value cannot be measured precisely, it can be known or provable based upon accurate risk and return data. However, risk data requires assumptions which may differ depending on the analyst. Thus different people may reach different conclusions about the intrinsic value of the stock. question 1.12: Should a firm’s manager estimate his firm’s intrinsic value, or should he leave this to outside analysts? Explain. Please jot down your answer and go to the next slide when you are ready. 1.12 answer: Managers have the best information about the company’s future prospects, so managers estimates of intrinsic value are generally better than outside analysts. Even analysts, though, can be wrong. In reality, managers do give guidance on their estimates of intrinsic value either through purchasing or selling the stock that they own. So thus, if they really believe that the stock is undervalued, they may choose to purchase the stock for their own account. If they believe the stock is overvalued, you can see a lot of insiders selling their stock. question 1.13: If a manager could maximize the current market price or the intrinsic value, but not both, which one should stockholders as a group want managers to maximize? Explain. Please jot down your answer and go to the next slide when you are ready. 1.13 answer: In general, stockholders as a group would not want to sacrifice short-term gain for long-term value appreciation. However, some investors are short-term investment strategy-orientated, like day traders for example, and they may wish to take their profits in a shorter time frame because of opportunity costs, ie: they believe they should take their profits and reinvest it somewhere else where they think they can generate a larger return. And in this case investors might differ when it comes to short-term versus long-term gains. question 1.14: Should a manager help investors improve their estimates of the firm’s intrinsic value? Please explain. Take a moment to jot down your answer and go to the next slide when you are ready. 1.14 answer: Regardless of what the stockholders desire, however, managers should always provide information that helps investors make more accurate estimates of the firms true or intrinsic value. For example, the firm may choose to take a hit on short-term profits by buying anther company, and even though long-term intrinsic value will increase, investors should understand this strategy in order to make correct financial decisions, and the management, of course, will benefit from communicating this information effectively because the stock price will reflect what the true intrinsic value is. Sometimes however, it should be noted that it is not in the best interests of the company to divulge information due to competitive concerns and letting competitors know what the company’s goals and strategies are going to be. This chart shows the percentage of revenue and net income from overseas corporations for 10 well-known companies in the year 2001. On the left hand side of the chart you will see the company names, and you will recognize a lot of these companies, because it is the big companies that drive the American economy, such as: Coca Cola, Exxon, General Electric, General Motors, IBM, JP Morgan, McDonald’s, Merck, 3M, and Sears. In the middle column we can see that the percent of revenue from these % companies that is derived from overseas, and as you can see,%a lot of these companies, for example Coca Cola, has more than 60% of its revenue coming from overseas in 2001. Exxon had more than 39% of revenue coming from overseas markets in 2001, and so on and so forth. And finally, the third column on your right is the percentage of actual net income which was derived from overseas. So, not only sales, but the actual bott Well-Known Corporations, 2001 % % Let’s take a moment and focus on business ethics in particular. What does business ethics mean? Well, it is really the company's attitude and conduct towards its employees, customers, the community, and its stockholders. We call these parties stakeholders. Now, what is the definition of a whistleblower and how does it affect corporate and business ethics? Well, whistleblowers are corporate employees who “sound the alarm” about illegal or unethical actions by their superiors. And as we have seen with the fallout of the Enron and the Worldcom etc. scandal, is that new legislation like the Sarbanes-Oxley act is likely for business entities in order to force managers to be more proactive in the area of business ethics. Self test 1.16 answer: Ethics is based on an individual’s point of view. The law typically tells us what is legal or illegal, which embodies the majority of the citizen's ethics at a given point in time. It is also fair to say that although all illegal acts are unethical, not all unethical acts are illegal - at least yet. Sometimes the law has to catch up with the current ethics of the time. In some countries, for example, it is legal for children to work in sweat shops and work for what we call “slave labor wages” or very minimum wages that barely sustain themselves, but this action in itself may not be ethical; so although it is legal for children to work in these sweat shops, it may not be ethical, and that is a good example. Self test question 1.17: Can a firm’s incentive compensation plan lead to unethical behavior? Think about that, jot down your answer and go to the next slide when you are ready. Self test 1.17 answer: A firm’s incentive compensation plan can lead to unethical behavior if it encourages greed above all else. Resulting employee actions may be fudging the books to make the numbers, holding back information about bad products that may depress the sales of the company, and failing to take costly but needed measures to protect the environment. Self test question 1.18: Unethical acts are generally committed by unethical people. What are some things companies can do to help ensure that employees behave ethically? Explain. Jot down your answer and go to the next slide when you are ready. Self test question 1.18: Companies can do a variety of things to incorporate positive business ethics into their business model. Things like incorporating positive business ethics messages into its mission statement; company employee manuals; they can train employees on ethical behavior; they can enact policy that protects whistleblowers, and they can also tie compensation to financial ethical performance of executives. Now we have talked ? ? ? ? ?about the ? ? ? ? ? ? conflicts? that? may exist?between ? ? ? ? ? ? of ?a? corporation and ? ? ? shareholders ? ? ? ? ? ? ? ? ? ? ?corporation. ? ? ? ? ? called ? ? agency ? ? fiduciary relationship?and the ? ? ? ? ?definition ? ? that the ? ? ? ? ?or ? ? ? ? ? ? ? ? ? ? ? ? ? ? exists ? ? ? ? ? ?a?principle ?hires ? ? agent ?to ? ? ? on ?their ? ? ? ? ? Thus, ? ? ? ? ?a? corporate? environment, ?agency relationships exist between shareholders and managers, since shareholders hire the managers to act in the best interests of the shareholders. But as we know, there are always some conflicts that will develop. ? before ? ? ? ? ? inherent ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? managers ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? or owners of the ? ? ? ? ? ? ? This is ? ? ? ? an ? ? ? ? or ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? actual ? ? ? ? ? ? is ? ? ? ? ? agency ? fiduciary relationship ? ? ? ? whenever ? ? ? ? ? ? ? ? an ? ? ? ? act ? ? ? ? behalf. ? ? ? within ????? ??????? ?? Self test question 1.20: Should managers focus directly on the actual stock price, on the stock’s intrinsic value, or are both important? Explain. Take a moment, jot down your answer and go to the next slide when you are ready. Self test 1.20 answer: Managers should try to maximize the stock’s intrinsic value and then communicate effectively with the stockholders. That is going to cause the intrinsic value to be high and the actual stock price to remain close to the intrinsic value over time. % m Let’s now review the topics that we have just covered by going over self test question 1.21. What are the principle responsibilities of the Board of Directors and the CEO? Jot down your answer and go to the next slide when you are ready. Self test 1.21 answer. The Board of Directors are responsible for corporate governance of the company and look after the shareholders They are elected by the shareholders. The CEO – Chief Executive Officer – is hired by the Board of Directors to run the company on a daily basis, and all the other officers and managers of the company report to the CEO directly. Self test question 1.22. What are the principal responsibilities of the Chief Financial Officer? Please jot down your answer and go to the next slide when you are ready. Now we will review the homework, which was assigned for Chapter One, Introduction to Financial Management. What we will do is go through each question and then answer each single question in the homework assignment. ― Question 1-1. If you bought a share of stock, what would you expect to receive, when would you expect to receive it, and would you be certain that your expectations would be met? Question 1-1 answer. When you purchase a stock, you expect to receive dividends plus capital gains. Not all stocks pay dividends immediately, but those corporations that do typically pay dividends quarterly. Capital gains or losses are received when the stock is sold. Stocks are risky, so you would not be certain that your expectations would be met as you would if you have if you purchased a U.S. Treasury Security, a risk-free security, which offers a guaranteed payment every 6 months plus repayment of the purchase price when the security matures. Question 1-2. Are the stocks of different companies equally risky? If not, what are some factors that would cause a company's stock to be viewed as being relatively risky? Please take a moment to answer this. Question 1-2 answer. No. The stocks of different companies are not equally risky. A company might operate in an industry that is viewed as relatively risky, such as biotechnology, where millions of dollars are spend on R&D that may never result in a profit. A company might also be heavily regulated, and this could be perceived as increasing its risk as well. Other factors that could cause a company's stock to be viewed as relatively risky include heavy use of debt financing versus equity financing, stock-price volatility and so on. Question 1-3. If most investors expect the same cash flows from company A and company B, but are more confident that A's cash flows will be close to their expected value, which should have the higher stock price? Explain your answer. Question 1-3 answer. If investors are more confident that company A's cash flows will be closer to their expected value than company B's cash flows, then investors will drive the stock price up for company A. Consequently, company A will have a higher stock price than company B. Question 1-4. Are all corporate projects equally risky, and if not, how do a firms investment decisions affect the riskiness of the stock? Question 1-4 answer. No. All corporate projects are not equally risky. A firm's investment decisions have a significant impact on the riskiness of the stock. For example, the types of assets a company chooses to invest in can impact the stock's risk, such as capital intensive versus labor intensive, specialized assets versus general or multi-purpose assets, and how they chose to finance those assets can also impact risk. Question 1-5. What is a firm's intrinsic value? Its current stock price. Is the stock's true long-run value more closely related to its intrinsic value or its current price? Question 1-5 answer. A firm's intrinsic value is an estimate of a stock's true value based on accurate risk and return data. It can be estimated but not measured precisely. A stock's current price is its market price, the value based on perceived but possibly incorrect information as seen by the marginal investor. From these definitions you can see that the stock's true long run value is more closely related to its intrinsic value rather than its current price. Question 1-6. When is a stock said to be in equilibrium? At any given time would you guess that most stocks are in equilibrium as you define it? Please explain. Question 1-6 answer. Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are indifferent between buying or selling a stock. If a stock is in equilibrium, then there is no fundamental imbalance, hence no pressure for a change in the stock's price. At any given time, most stocks are reasonably close to their intrinsic values, and thus are at or close to equilibrium. However, at times, stock prices and equilibrium values are different, so stocks can be temporarily undervalued or overvalued. Question 1-7. Suppose three completely honest individuals gave you their estimates of stock X's intrinsic value. One is current girlfriend or boyfriend, the second is a professional security analyst with an excellent reputation on Wall Street, and the third is company X's CFO. If the three estimates differed, which one would you have the most confidence in? Question 1-7 answer. If the three intrinsic value estimates for stock x were different, I would have the most confidence in company X's CFO's estimate. Intrinsic values are strictly an estimate, and different analysts with different data and different views of the future will form different estimates of the intrinsic value for any given stock. However, a firm's managers have the best information about the company's future prospects, so a manager's estimates of intrinsic value are generally better than the estimates of outside investors. Question 1-8. Is it better for a firm's actual stock price in the market to be under, over or equal to its intrinsic value? Would your answer be the same from the standpoints of both stockholders in general and a CEO who is about to exercise $1,000,000 in options and then retire. Please explain. Question 1-8 answer. If a stock market's price and intrinsic value are equal, then the stock is in equilibrium, and there is no pressure buying or selling to change the stock's price. So, theoretically, it is better that the two be equal. However, intrinsic value is a long-run concept. Management's goal should be to maximize the firm's intrinsic value, not it's current stock price. So, maximizing the intrinsic value will maximize the average price over the long run, but not necessarily the current price at each given point in time. So, stockholders in general would probably expect the firm's market price to be under the intrinsic value, realizing that if management is doing it's job, the current price at any point in time would not necessarily be maximized. However, the CEO would prefer that the market price be high, since it is the current price that he will receive when exercising his stock options. In a Question 1-9. If a company's board of directors wants management to maximize shareholder wealth, should the CEOs compensation be set as a fixed dollar amount, or should it depend on how well the company performs? If it is to be based on performance, how would or should performance be measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock's intrinsic value? Which would be the better performance measurer and why? Question 1-9 answer. The board of directors should set CEO compensation depending on how well the firm performs. The compensation package should be sufficient to attract and retain the CEO, but not go beyond what is needed. Compensation should be structure so that the CEO is rewarded on the basis of the stock's performance over the long-run, and not necessarily the stock's price on the option exercise day. This means that the options or the stock awards for the CEO should be phased in over a number of years so that the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, it is easier to measure the growth rate and reported profits than the intrinsic value, although procedures and report of profits can be manipulated through aggressive acco Question 1-11. Should stockholder wealth maximization be thought of as a long-term or a short-term goal? For example, if one action would probably increase the firm's stock price from a current level of $20 to $25 in 6 months and then to $30 in 5 years, but another action would probably keep the stock at $20 for several years but then increase it to $40 in 5 years, which action would be better? Can you think of some specific corporate actions that might have these general tendencies? Question 1-11 answer. Stockholder wealth maximization is a long-run goal. Companies and consequently their stockholders prosper by management making decisions that will produce long-term earnings increases. Actions that are continually short sighted often catch up with the firm, and as a result, may find itself unable to compete affectively against its competitors. There has been much criticism in recent years that US firms are too short-run profit oriented. A prime example is the US auto industry, which has been accused of continuing to build large gas-guzzling automobiles because they had higher profit margins, rather than re-tooling for smaller more fuel-efficient models like their Japanese counterparts have. Question 1-15. Edmonds Enterprises recently made a large investment to upgrade its technology. While these improvements won’t have much of an impact on performance in the short-run, they are expected to reduce future costs significantly. What effect will this investment have on Edmonds Enterprises' earning per share this year? What effect might this investment have on the companies' public intrinsic value and its stock price? Question 1-15 answer. Earning per share in the current year will decline due to the cost of the investment made in the current year, and no significant performance impact in the short-run. However, the companies stock price should increase due to the significant cost savings expected in the future. Question 1-16. Suppose you were a member of company X's board of directors and chairman of the companies' compensation committee. What factors would your committee consider when setting the CEO's compensation? Should the compensation consist of a dollar salary, stock options that depend on the firm's performance, or a mix of the two? If performance is to be considered, how should it be measured? Think of both theoretical and practical, that is measurable considerations. If you were a vice president of company X, might your actions be different that if you were the CEO of some other company? Question 1-16 answer. The board of directors would set the CEO compensation dependent upon how well the firm performs. The compensation package should be sufficient to attract and retain the CEO, but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock's performance over the long-run, not the stock's price on an option exercised day. This means that the options for direct stock grants or awards would be phased in over a number of years so that the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then a performance pay could be based on changes in intrinsic value. Since intrinsic value is hard to measure and not observable, compensation therefore must be based on the stock's actual market price. However, the price used should be an average over ti ????? ?????? 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Introduction 1 00:00 This Page is Menu? of ?Lectrue. ? ? ? ????? CHAPTER 2 Time Value of Money 1 00:00 Welcome back. I am Professor Henry Wong, and today we are going to be discussing Chapter 2, the time value of money. Now in every finance class, there are three major principles that every finance student should understand by the end of the semester. Time value of money is one of the three most important subjects in finance that we will cover. So it is very important that we have an understanding and a grasp of this topic and of this chapter before we go on to discuss the other topics in the remaining course. So in this course today, we are specifically going to talk about what future value and present value mean, how do we calculate that. We will go through some specific Microsoft Excel examples of how to calculate each of these different future value and present value topics, and then we will also talk about annuities: what they are and how we calculate them. And then we will talk about the different types and classifications of rates of interest, and then finally we will end our discussion by discussing amortization and specifically, describing how we set up an amortizatio “A Bird in Hand is Better Than Two 2in the Bush” 00:00 “A bird in hand is better than two in the bush.” Who here has actually heard of that saying before? What does it mean? Who has gone on to actually say this? Was it a., a safari hunter, someone who was looking for birds and hunting birds? Or was it b., a hall of fame basketball player by the name of Larry Bird? Or was it c., a United States Republican president by the name of George Bush, or was it the last one, d., an economist? Well the answer is really d. An economist actually stated this: A bird in hand is better than two in the bush. Now the question is, what does this actually mean? Well, if you think about it, it makes a lot of sense. It means that, if you have something in your hand today, it’s going to be worth more than something that you could or could not have in the future sometime. And there are a couple of reasons why it’s worth more today, in your hand. Number one is that, for certainty reasons, you actually have it in your hand, versus a year from now, you may not have whatever that thing is that you want in your hand. So it’s certain that you can have it toda Time lines 3 00:00 When we think about the time value of money, it is sometimes helpful for us to actually draw out a timeline with corresponding cash flows and when those cash flows occur. This is typically called a time line. As you can see from the slide next to me, this shows the timing of cash flows for 0-3 periods. On the top part of the timeline, you have what’s labeled 0, which means today, or right now, and then you have 1, 2 and 3. These 1, 2, and 3 on the top represent the end of each period. Now, you can think of these periods as 1, meaning the end of the first year, or 2, meaning the end of the second year, and 3, the end of the third year. But it’s important to note that these time periods do not have to delineate years; they can also be discussing months, they can be discussing days – they can basically be discussing any time period in which you are trying to show the actual occurrence of cash flows. So in this simple example we will think about this in years, but in real life, these are actually time periods that we have to consider. Now on the bottom of this time line you’ll no Drawing time lines: $100 lump sum due in 2 years; 3-year $100 ordinary annuity two examples show us how we would draw timelines under certain scenarios, to give you a feeling of how these cash flows occur. The first one is an example of $100 lump sum that is due in two years. Thus, you can see from the first example that if you have a timeline drawn and you have time periods of 0, 1 and 2, to signify the end of the second year. And on the bottom axis you can see that under the 0 timeline, there is no cash flow associated with that, and there is no cash flow associated with timeline 1, but at the end of the second year in timeline 2, you can see that there is a $100 payment that is due at the end of the second year. So this is a very basic but easy-to-understand example of a $100 lump sum due in two years. Now also you will have to note that the i interest rate again is stated there, but there is no actual interest that is stated in this example, but that i percentage represents what that interest would be. The second example of drawing a timeline is a three-year, $100 ordinary annuity. Now, the first thing is, what exactly is an ordinary annu 4 00:00 These next Self Test 2.1 5 00:00 Now that we’ve gone over timelines, let’s review the topic and make sure we understand it. The first question is Self test question 2.1: Do timelines deal only with years, or could other periods be used as well? Please take a moment and answer this question and go to the next slide when you’re ready. Self Test 2.1 Answer 6 00:00 Self test 2.1 answer: Time lines can be used with any period of time. It could be a year, a month, a day, etc. Self Test 2.2 7 00:00 Self test question 2.2: Set up a time line to illustrate the following situation: You currently have $2,000 in a three-year certificate of deposit, a CD, that pays a guaranteed 4% annually. Please take a moment and draw out this time line with its associated cash flow, and go to the next slide to see the answer. Self Test 2.2 Answer 8 00:00 Self test 2.2 answer: Your timeline should look like this, which is $2,000 deposited in a three-year CD that pays 4% a year. As you can see on the top line, I have marked 0, 1, 2 and 3, denoting the time periods of the first, second and third years. Now as you can see in time year 0, what happens is that you deposit $2,000 with a bank in order to get the certificate of deposit, so that cash flow is noted as a negative (-) $2000. It happens in time 0 because it happens today, or it happens at the time you deposit it. Now, you can also see that the interest rate that we are dealing with here is 4%, based on the previous question. So at the end of the first year, you earn 4% back, and that 4% would equal $80, and then on the end of the second year you also earn 4%, which is an additional $80 that you would get, and then on the third and final year you would earn your 4% for that year as well, and then you would also receive the entire $2,000 that you had deposited initially. So this is the time line for a $2,000 deposit in a three-year CD paying 4%. Future Value (FV) 9 00:00 Now that we understand? the ? ? ? ? ? ? ? ? ? ? ? time? lines, we? are ? ? ? ? to ?talk ?specifically ? ? ? ? future values:? what? exactly ? ? ? ? ? ? ? ?value,? and ? ? ?do ? ? calculate it? ? ? ? ? simply ? ? ? a ? ? ? ? ? ? ? ? tells ?us ? ? ? ? ? ? ? ? ? ? ? going ?to ? ? ? ? ? ? in ?the future,? and we? want? to ?know ?how to? calculate? that. ? ? if? we ?understand ? ? ? ? ? ?of ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? ? basics of drawing ? ? ? ? ? ? ? ? ? going ? ? ? ? ? ? ? ? ? ? about ? ? ? ? ? ? ? ? ? ? ? ? ? ? is a future ? ? ? ? ? how ? we ? ? ? ? ? ? ? ? Well, ? ? ? ? put, ? future value ? ? ? ? what something is ? ? ? ? be worth ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? So ? ? ? ? ? ? ? ? a series ? cash flow streams ? ? when they occur, then we can have an estimate as to what the future worth of that asset is going to be. What is the future value (FV) of an 00:00 10 initial $100 after 3 years, if I/YR = 10%? So for example, our first question deals with what is the future value of an initial $100 after three years, if the interest rate earned on that $100 is 10% a year? Well, finding the future value of any kind of cash flow or series of cash flows when compounding the interest is applied is called “compounding.” You can think of compounding like a snowball coming down a mountain. As the snowball comes down the mountain, it accumulates more snow and gets bigger and bigger and bigger, and this is essentially what compound interest does. It’s basically called the “snowball” effect. Now future value can be found using the arithmetic method, the financial calculator method, or using a spreadsheet solution. We will go through all three solutions in this lecture so that you can choose the way that you are most comfortable with in solving any kind of future value problem in the future. But as you can see, the first thing we must do is draw the time line for this problem to understand conceptually where the cash flows are occurring and in what time period. So if we draw the cash flow and Graphical View of Compounding Process 11 00:00 But before we get to the arithmetic method, let’s first take a look at a graphical view of the whole compounding process. You can see in this graph below that we are trying to calculate on the left axis, which is also called the Y-axis, the future value of a dollar. And on the bottom axis, or the X-axis, are the time periods corresponding to the future value of a dollar. Now, you can see under different interest rate scenarios there is an interest rate of 20%, you can see how much more quickly that dollar compounds, or has the snowball effect, and become a larger amount, in the future. Whereas in the current example that we’re using in the red, is the interest of 10%, you can essentially see that, at the end of the third period, it looks like the future value of that dollar is somewhere between $1.00 and $2.00, according to the Y-axis. Now we will figure out exactly what that cash flow is at the end of the third year and what the future value is, but right now, as you can see based on this graphical view, it’s probably somewhere between $1.00 and $2.00. And then also, beneath Solving for FV: The arithmetic method 12 00:00 So now let’s use the arithmetic method to solve for the future value of this problem. The arithmetic method involves the equation the future value equals the present value, multiplied by 1 plus the interest rate. So, in other words, if we take after the first year, we see that the present value of what we are talking about is $100, and we want to know what the future value is, so we’re solving for future value. And then the interest rate that we’re dealing with is 10%, so 1 plus 10% equals 1.10. If we multiply the present value of $100 by 1.10, we get a value of $110 as the future value after the first year. Now, we can continue to do this to see what the value is after the second year, and then finally get the answer of what the value is after the third year. So if we look at what the value of that $100 is after the second year, we see that the future value of the second year equals the present value multiplied by again, 1 plus the interest rate, but this time we square 1 plus the interest rate in order to get the value at the end of the second year. If we multiply 1.10 squa Solving for FV: The calculator method 13 00:00 If you have a financial calculator handy, it is also very easy to solve for this future value problem. In general, solving for the future value equation involves four inputs into the calculator, and then you will solve for the fifth. So what you want to do first is you want to set your financial calculator to make sure that the payments per year equal 1, and that you are at the end mode of your financial calculator. Please refer to the operating or the owner’s manual that came with your financial calculator in order to do this. Once you have done this, on the top line here you can see what the inputs are. You would type in 3, you would push n, which represents the number of periods, of course, and then you would type in 10, and you would push i/yr, which means interest rate per year, and this of course is 10%, and then next we would type in the present value, which in this case it is a negative (-) $100. Make sure that you put a negative (-) in front of the 100 here, okay? The reason is that, conceptually, you have to always think about these time value of money problems as d Spreadsheet Solution 14 00:00 slide/cap14.swf Self Test 2.3 15 00:00 Now that we’ve covered future value, let’s take a moment to review some of the topics we’ve covered, and answer Self test question 2.3: Explain why this statement is true: A dollar in hand today is worth more than a dollar to be received next year. Take a moment to answer this question and go to the next slide when you’re ready Self Test 2.3 Answer 16 00:00 Self test 2.3 answer: A dollar in hand today is certain, versus a dollar to be received a year from now. Also, a dollar in hand today can be invested, and you can earn an interest so that it can be worth more than a dollar a year from now. Self Test 2.4 17 00:00 Self test question 2.4: What is compounding? What’s the difference between simple interest and compound interest? What would the future value of $100 be after five years at 10% compounded interest, and what would it be at 10% simple interest? Please take a moment to write out your answers and go to the next slide when you’re ready. Self Test 2.4 Answer 18 00:00 Self test 2.4 answer: Compounding is calculating the value of cash flow when compounded interest is applied. This is a lot like thinking of money as being a snowball effect, where a snowball rolls down the mountain and it becomes larger and larger and larger, and this is essentially what compounding interest does. Now if you think of compounding interest as a snowball, then you can think of simple interest as just a huge boulder that just sits there, and doesn’t compound any interest, and doesn’t become larger but just rolls down the mountain and is the same size afterwards. So simple interest is when interest is not earned upon interest, and this is called the “boulder” effect, while compound interest is earned upon interest, which is the snowball effect. Self Test 2.4 Answer (cont’d) 19 00:00 slide/cap19.swf Self Test 2.5 20 00:00 Self test question 2.5: Suppose you currently have $2,000 and plan to purchase a three-year certificate of deposit that pays 4% interest compounded annually. How much will you have when the CD matures? Please take a moment to answer this question and go to the next slide when you’re ready. Self Test 2.5 Answer 21 00:00 slide/cap21.swf Self test 2.5 answer. In this one we are also looking for the future value so we would click our function bar and we would look for the FV and hit okay, enter our rate which is 4% and the periods are going to be three periods as that is how long we are investing for. The payment is going to be 2,000 we have to remember to put a negative in front of 2,000 and it gives us $249.73. Present Value (PV) 22 00:00 Now that we’ve covered future value, we turn our attention to the present value, which is basically the opposite of future value. It’s very important to note here that 99% of the work that financial managers do in the real world is using and calculating present value, and not future value. And the reason for this is that every kind of asset out there, whether you’re talking about a stock, a bond, or any kind of financial instrument, they have a series of expected future cash flows that is associated with them. Now, in order to value these assets effectively, we must take these cash flows and figure out what they’re worth to us today, and this is called present value. And this is exactly why we’re going to be discussing and focusing most of our attention on this time value of money concept. What is the present value (PV) of 23 00:00 $100 due in 3 years, if I/YR = 10%? We start off with the same example that we used for the future value problem except now we flip it, and we ask ourselves, what is the present value of $100 due in three years if our interest rate is 10%? Well, finding the present value of cash flows or a series of cash flows when compound interest is applied is called discounting, and this is the exact opposite of compounding interest, which we talked about in future value. So now we are discounting the cash flows and figuring out what they are worth to us today, or what the present value is. Of course, the present value shows the value of all these cash flows in terms of today’s purchasing powers. So again, the first thing we do is we draw a timeline of this problem, and as we can see, we start off on the top axis with our 0, 1, 2 and 3 periods, representing years. We know that our interest rate is equal to 10% so we write that on there as well. We know that we’re going to get $100 as a lump sum at the end of the third year, so that’s why you see that on the bottom right-hand side of the timeline, and then that leaves us the Graphical View of Discounting Process 24 00:00 This is the graphical view of the discounting process, which you’ll note is the exact opposite of the compounding process that we talked about in future value. As you can see, on the X-axis we have the periods (0-50 periods), and then on the Y-axis we have again the present value of $1.00. And as you can see, as time goes out into the further periods, that dollar becomes worth less and less. Thus it’s worth more today than it is 50 years from now, for example, which looks like it’s close to $0.00 under that scenario. And if we’re going to look at what the present value is at 10%, which is the red line, you can see that after three periods, it’s going to be slightly smaller. So our job is to figure out exactly what that $100 is going to be worth today, in the present value. And we will start by doing that with the arithmetic method in the next slide. Solving for PV: The arithmetic method 25 00:00 In order to solve for present value, and using the arithmetic method in doing so, all we need to do is take the inverse of the future value equation that was presented to us before. And thus, the present value equals the future value at the nth period divided by 1 plus the interest rate at the nth period. Thus in order to solve our equation, we simply plug in the present value equals the future value in the third period, which is $100, which we have already been given, and divide that by 1 plus the interest rate, which we know is 10%, and to the nth period again, which is going to be in year 3, so we cube 1.10, and the answer is that $100 three years from now is only worth $75.13 today, at today’s purchasing powers, and this is how we figure out the present value. We’ll next look at the calculator method of figuring out the present value. Solving for PV: The calculator method 26 00:00 Solving for the present value using a financial calculator is again very easy, and it requires the same steps as we took when solving for the future value. So if you have a financial calculator with you right now, then please take it out and follow these steps. It’s exactly like the future value, where you have to enter in four different inputs, but this time the output is going to be the present value. So what are these inputs? We first start off with our n periods. We know that we’re dealing with three years, so we type in first 3, and then push N. Also, we know what our interest rate is, so we can type in 10, and then push the I/YR button. And then next, again we’re not dealing with an annuity so we don’t have to type in anything for payment, but you can enter in a 0 here and push PMT, and then finally, for the future value, we know that it’s worth $100 three years from now, and we can push in 100 and then push in FV. Now again, let’s note that, when we type in the future value, and we type in 100, this is a positive 100 and not a negative 100 that we’re typing. And the re Spreadsheet Solution 27 00:00 slide/cap27.swf Self Test 2.6 28 00:00 Now that we’ve looked at both present value and future value, let’s review some of the topics we have covered in order to make sure we comprehend everything. The first question is Self test question 2.6, and the question is: What is the discounting process and how is it related to compounding? How is the future value equation related to the present value equation? Please take a moment to write down your answer and go to the next slide when you’re ready. Self Test 2.6 Answer 29 00:00 Self test 2.6 answer: Discounting is the reverse of compounding. Also, if you know the present value, you can compound to find the future value, or if you know the future value, you can discount it to find the present value. Self Test 2.7 30 00:00 Self test question 2.7: How does the present value of a future payment change as the time to receipt is lengthened as the interest rate increased? Please take a moment and think about the graph that we talked about, and go to the next slide when you’re ready. Self Test 2.7 Answer 31 00:00 Self test 2.7 answer: As the time is lengthened, the present value decreases because the future value becomes more uncertain. Also, the future value increases because of the increased interest rate, while causing the present value to decrease. Self Test 2.8 32 00:00 Self test question 2.8: Suppose a U.S. government bond promises to pay $2,249.73 three years from now. If the going interest rate on a three-year government bond is 4%, how much is the bond worth today, i.e., what is the present value? How would your answer change if the bond matures in five rather than three years? And finally, what if the interest rate on the five-year bond were 6% rather than 4%? Please take a moment to write down all of your answers and go to the next slide when you’re ready. Self Test 2.8 Answer 33 00:00 slide/cap33.swf Self Test 2.9 34 00:00 Self test question 2.9: How much would $1,000,000 due in 100 years be worth today, if the discount rate were 5%? Second, if the discount rate were 20%? Please take a moment to calculate your answers and go to the next slide when you’re ready. Self Test 2.9 Answer 35 00:00 slide/cap35.swf Solving for I: What interest rate 36 00:00 would cause $100 to grow to $125.97 So faryears? talked about how to calculate and solve for future value and present value, but what if we were trying to solve for interest, or the i? Here is an example to do this. What interest rate would cause $100 to grow to $125.97 in three years? Well, the way that we solve this is basically, using our financial calculator, we can type in the inputs that we know, then instead of typing in future value/ present value as the output, we simply push interest per year, which would give us our interest rate. Thus in this case, we are talking about three years, so we know that’s our n period, we know that we are depositing or letting go of $100 today in the present value, and then we know that there is no payment associated with this, and then in the future we know that it’s going to be worth $125.97, which is going to be our future value. So the question is at this point, what is the interest rate that gets us there, and all we need to do is type in I/YR and we see that the interest rate that gets us there is 8%. in 3 we’ve Spreadsheet Solution 37 00:00 slide/cap37.swf This time was are solving the rate or the RATE button so on the right hand side we hit okay and once that happens the rate window will pop up to help us solve for the interest rate. The rate in the first box asks us for N periods, we know it is three. We know the present value is $100.00 and we have to adjust this to a negative to get the correct answer and our future value is $125.97 after we hit okay we see the rate formula gives us 8% which matches our financial calculator as well. Self Test 2.10 38 00:00 Now let’s do a couple of problems involving the interest rate to ensure that we understand what we’ve just learned. Self test question 2.10: Feel free to do this example either with your financial calculator, or the arithmetic method, or using a spreadsheet. I highly recommend using a financial calculator or a spreadsheet to do this problem. The U.S. Treasury offers to sell you a bond for $585.43. No payments will be made until the bond matures ten years from now, at which time it will be redeemed for $1000. Thus, what interest rate would you earn if you bought this bond for $585.43? At what rate would you earn if you could buy the bond for $550? What about if you could buy it for $600? Please take a moment and use your financial calculator or Excel spreadsheet to calculate the answer, and go to the next slide when you’re ready. Self Test 2.10 Answer 39 00:00 slide/cap39.swf Self Test 2.11 40 00:00 Self test 2.11 question: Microsoft earned $0.12 per share in 1994. Ten years later, in 2004, it earned $1.04 per share. What was the growth rate in Microsoft’s earnings per share over the ten-year period? Also, if the earnings per share in 2004 had been $0.65 rather than $1.04, what would the growth rate have been? Please take a moment and use your Excel or financial calculator to solve for this, and go to the next slide to see the solution. Self Test 2.11 Answer 41 00:00 slide/cap41.swf Self test 2.11 answer. Again, we are solving for rates, we will choose the rate formula and hit okay and the rate window will pop up and we input the N periods of ten, the present value is -12 cents, which was given, the future value of the Microsoft stock is going to be and $1.04. The formula result is approx 24%. The second part of the question asks us if we want to change the future value from a dollar to 65 cents, what would our result be? 18% is our interest rate. Solving for N: If sales grow at 20% 00:00 42 per year, how long before sales double? Now that we’ve solved for future value, present value and interest rate, let’s turn our attention to solving for n periods. So the example we give here is that, if sales grow at 20% per year, how long will it be before the actual sales double? So, it solves the general future value equation for problem n, and it’s the same as the previous problems. Let’s type in everything that we know and then we can hit n to find our answer. We know that the interest rate is going to be 20%. The present value here, we’re going to start off with -1, because we want to know how long it takes basically $1.00 to double to $2.00, or 1 to 2, so if we deposited $1.00 today in a bank we’d want to know when it would become $2.00, and we can take that out, so thus the payment is going to be 0 and the future value is going to be 2, because it represents a doubling of the 1. And if we hit the n function on our calculator, we see that it will take approximately 3.8 years in order for it to double. Spreadsheet Solution 43 00:00 slide/cap43.swf Self Test 2.12 44 00:00 Now let’s take a moment to review. Self test question 2.12: How long would it take $1000 to double if it were invested in a bank that pays 6% per year? How long would it take if the rate were 10%? Please take a moment to use your financial calculators or Excel spreadsheets to figure this out, and go and see the solution on the next slide when you’re ready. Self Test 2.12 Answer 45 00:00 slide/cap45.swf Self Test 2.13 46 00:00 Self test question 2.13: Microsoft’s 2004 earnings per share were $1.04, and it’s growth rate during that prior ten years was 24.1 percent per year. If that growth rate were maintained, how long would it take for Microsoft’s earnings per share to double? Please take a moment to answer this question and go to the next slide when you’re ready. Self Test 2.13 Answer 47 00:00 slide/cap47.swf Drawing time lines: Uneven cash flow stream; CF0 = -$50, CF1 = $100, CF2 = $75, and CF3 = $50 48 00:00 So far, when we’re calculating the present value, future value, the interest rate and the n periods, we’ve been working with lump sum cash flows, or one cash flow and a time line. But this is not realistic of how cash flows actually result in real-life business scenarios. There are actually many different cash flows – some positive, some negative – throughout a given time period. These are called uneven cash flow streams, and in order to draw an uneven cash flow stream, you can see here under this example that we have a cash flow at time 0 of -$50, a cash flow at the end of period 1 of $100, a cash flow at the end of period 2 of $75, and a cash flow at the end of period three of (a positive) $50. For example, this would be a project that a company is choosing to invest $50 in, in order to buy all the equipment and pay for all the start-up costs, and then they would expect that after that time period, at the end of year 1, at the end of year 2 and at the end of year 3, there would be positive cash flows being generated because of this initial expense. So this is a very typical What is the PV of this uneven cash flow stream? 49 00:00 In this example we ask the question, what is the present value of this uneven cash flow stream? And very similar to the previous slide, we see that this cash flow stream at time 0 has no cash flow associated with it, there is a 10% interest rate associated with these cash flows, and at the end of the first time period there is a positive $100. At the end of the second and third time periods we have a positive $300, and at the end of the fourth period you actually have a negative cash outflow of (-)$50. So how would we figure out the present value of these cash flows? Well, very simply put, we would use the arithmetic method, the spreadsheet method or the financial calculator method and break down each individual cash flow and its specific time, and discount them back to present value. Thus $100 a year from now is worth $90.91 today if we apply our present value equation to it, and another way to do it is to use $300 at the end of year 2, at the second period, and take the present value of that or discount that back, and we’ll find that that is worth $247.93. At the end of the Solving for PV: Uneven cash flow stream 50 00:00 Another way to do this is to use the cash flow register on your financial calculator. If you have your financial calculator available, please take it out now and refer to the operating manual as to where your cash flow register is. Generally you’ll see your cash flow register as the CFLO button on your financial calculator. But essentially, you enter in each of the different cash flows associated with each of the different time periods, so we know there was no cash flow the occurred at time 0, there was a $100 positive payment at the end of year 1, there was a $300 payment at the end of year 2, another $300 payment at the end of year 3, and finally a -$50 at the end of year 4. If we also type in the interest rate at 10% and we push the NPV or the net present value button, we see that the net present value equals $530.09, which is the exact same number we got in the previous slide when we calculated the present value of each specific cash flow and summed them up together. So here, net present value equals the present value. On our next slide we will do this on a spreadsheet fo Spreadsheet Solution 51 00:00 slide/cap51.swf Self Test 2.14 52 00:00 Now let’s take a moment and review all of the topics we’ve just covered. Self test question 2.14: Could you use the present value equation once for each cash flow to find the present value of an uneven stream of cash flows? Please take a moment to answer this question and go to the next slide when you’re ready. Self Test 2.14 Answer 53 00:00 Self test 2.14 answer: Yes, you could discount each cash flow back to present value and sum it up in order to find the present value of all the cash flows. Self Test 2.15 54 00:00 Self test question 2.15: What is the present value of this following uneven cash flow stream, where the interest rate equals 8%, we are dealing with four periods, and at the end of the first period we have a positive cash inflow of $100, at the end of the second period we have a cash inflow of $200, at the end of the third period there is no cash flow, and at the end of the fourth period there’s a positive cash inflow of $400. Please take a moment to work this problem out and go to the next slide when you’re ready. Self Test 2.15 Answer 55 00:00 slide/cap55.swf Self Test 2.16 56 00:00 Self test question 2.16: Would a typical common stock provide cash flows more like an annuity, or more like an uneven cash flow stream? Explain, and go to the next slide to see the answer. Self Test 2.16 Answer 57 00:00 Self test 2.16 answer:? A typical? dividend stream ? ? ? ? ? ? ? ? ? ? ? would ?provide ? ? ? ? ? ? ? more? like? an ?uneven? cash? flow?stream? because ?dividends ?will ?typically ? ? ? ? ? ? over? time, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? from common stock ? ? ? ? ? ? ? cash flows ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? increase ? ? ? ? ? but will remain positive. Self Test 2.17 58 00:00 Self test question 2.17: Why are we more likely to calculate the present value of cash flows rather than the future value of cash flow streams? Please take a moment to answer the question and go to the next slide when you’re ready. Self Test 2.17 Answer 59 00:00 Self test 2.17 answer: The value of all financial assets, whether they be stocks, bonds, etc., are found as present values of their respective future cash flows. Thus we need to calculate present value more than we need to calculate future value in real life. Self Test 2.18 60 00:00 Self test question 2.18: What is the future value of this cash flow stream? We start off in year 0 with no cash flow associated, and then at the end of the first period $100, at the end of the second period $150, and at the end of the third period $300, and we note that the interest rate is 15%, and we want to know what the future value of all these cash flow streams is. Please take a moment to calculate and answer the question and go to the next slide when you’re ready. Self Test 2.18 Answer 61 00:00 slide/cap61.swf Self test 2.18 answer. Now we are looking for future value of these cash flows and we are looking at the net future value. Again, you can take the first approach of compounding the cash flows with its future period, which would give us the line items in black and then we could sum up the final net future value of $604.78. How FV/PV is used in Corporate Finance 62 00:00 Annuities (FVA and PVA) 63 00:00 What is the difference between an 64 00:00 ordinary annuity and an annuity due? I mentioned before,? an ?annuity ? ? ? ? ? ? ? ? ?payment ? ? ? ? ? ? ? it’s the ? ? ? ? same? amount paid over the ? ? ? ? ? ? ? ? time period ? ? ? ? ? ? ? ? ? ? ? ? frame. ? ? the ? ? ? ? ? ? is, ? ? ? ? ? ? ? difference ? ? ? ? ? an? ordinary ? ? ? ? ? and ? , annuity? due?? Well, ? ? ? only? basic ? ? ? ? ? ? ? is ?that ?the payments ? ? ?made ?either? at ?the beginning or? at ?the? end ? ? the ? ? ? ? ? ? ? ? ? in ?an ? ? ? ? ? ?annuity, payments ? ? ? being ? ? ? ? ? the ? ? ? of ?the period,? whereas ?in ? ? annuity? due,? payments ? ? ?being made at? the ? ? ? ? ? ? ? ? the ? ? ? ? ? You ? ? ? think ? ? ? ? ordinary ? ? ? ? ? as? your? payment ?to ? ? ? ? a ? ? ?or ? ? use ? ?car – ? ? ? ? ? ? ? ? ? ? kinds ? ? contracts require? payments ? ? be? made?at ? ? ? end ? ? the ? ? ? ? ? ? ? ? ? ? if?you rent a ? ? ? ? ? ? ? ? you ? As ? ? ? ? ? ? ? ? is a constant ? ? ? ? stream, so ? ? ? ? ? exact ? ? ? ? ? ? ? ? ? ? ? ? ? ? same kind of ? ? ? ? ? ? ? over a certain time ? ? ? ? So ? ? question ? ? what’s the ? ? ? ? ? ? between ? ? ? ? ? ? annuity ? ? an ? ? ? ? ? ? ? ? ? the ? ? ? ? ? difference ? ? ? ? ? ? ? ? ? ? are ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? of ? ? period. Thus, ? ? ordinary ? ? ? ? ? ? ? ? ? ? are ? ? ? made at ? ? end ? ? ? ? ? ? ? ? ? ? ? ? an ? ? ? ? ? ? ? ? ? ? , are ? ? ? ? ? ? ? ? ? beginning of ? ? period. ? ? can ? ? ? of an ? ? ? ? ? annuity ? ? ? ? ? ? ? ? lease ? car ? to ? ? a ? ? ? generally these ? ? ? of ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? to ? ? ? ? the ? ? of ? ? period. Whereas ? ? ? ? ? ? ? place, or if ? ? own a place and pay a mortgage, these payments are required to be made at the beginning of this period. Thus again, the difference between an ordinary annuity and an annuity due is that the payment that is made, or the cash outflow, which is a constant payment stream, is made at the beginning of the period for an annuity due, and for an ordinary an Self Test 2.19 65 00:00 Let’s take a moment now to cover the ground we’ve just talked about. Self test question 2.19: What’s the difference between an ordinary annuity and an annuity due? Please take a moment to answer this and go to the next slide when you’re ready. Self Test 2.19 Answer 66 00:00 Self test 2.19 answer: Ordinary annuity is a constant payment stream that occurs at the end of the period. Think about a car payment as an example. Whereas an annuity due is a constant payment stream that occurs at the beginning of the period. Think about a home mortgage or rent. Self Test 2.20 67 00:00 Self test question 2.20: Why would you rather receive an annuity due for $10,000 per year for ten years rather than a similar ordinary annuity? Please take a moment to answer this question and go to the next slide when you’re ready. Self Test 2.20 Answer 68 00:00 Self test 2.20 answer: Because of compounding interest, it is better to have an annuity due, in which interest compounds at the beginning of a period versus at the end of the period. This way, the snowball effect takes effect sooner, and you create a bigger snowball at the end of the day. Solving for FVA for car payment: 3-year ordinary annuity of $100 at 10% first example calls for us to solve for a future value of an annuity for a car payment. This is a three year ordinary annuity of $100 at a 10% interest rate, so thus the $100 payments again occur at the end of each period because this is an ordinary annuity; and when we were calculating future value of annuities, there is no present value, so we have to keep that in mind when we punch it into our calculator. So thus the input here is that we’re dealing with an end period of three, an interest rate of 10%, our present value equals zero because we want to know what the future value of our future annuity is, so thus the payments, which we haven’t used before are now 100 or –100 at the end of each of these different periods, and again this is basically saying that you are writing a check or having a cash outflow and depositing into a bank $100 at the end of each year for three years, and you want to know when you take it out how much it’s going to be worth. Thus the future value of this cash flow stream or this ordinary annuity stream at a 10% interest rate as we see when we 69 00:00 Our Spreadsheet Solution 70 00:00 slide/cap70.swf We can figure out using our spreadsheet what we can do is click on the function toolbar this time the function name is the future value of an annuity so FV. The rate is going to be 10% we know our N period is three and we also know there’s a constant payment of $100 so enter that in the PMT, then click on okay and the future value equals $331.00 approximately. Solving for PVA for car payment: 3-year ordinary annuity of $100 at 10% 71 00:00 Next we will solve for the present value of an annuity stream for the same car payment: again it’s a three year ordinary annuity, of $100 at 10%. We solve it the exact same way we solve it for the future value of annuity, but this time instead of the present value being equal to 0, this time the future value is equal to 0, because we want to know what the present value of the annuity stream is going to be. So $100 payments will still occur at the end of each of these periods because again, this is an ordinary annuity. So again the periods that we are dealing with are 3 for N, the interest rate is again at 10%, the payment again this time is $100 and it’s positive, and this should make sense to you because at the end of the day you’re getting, if you deposit money into an annuity today that would be negative and then you’re getting $100 back at the end of each of the years for three years and so the payment stream is positive in this respect, the future value again is going to be equal to 0 and if we hit our present value output key we see that the present value of this partic Spreadsheet Solution 72 00:00 slide/cap72.swf Self Test 2.21 73 00:00 Self test question 2.21 Now let’s take a review of the topics we have just covered. For an ordinary annuity of five payments of $100 and a 10% interest rate, how many years will the first payment earn interest? Also what will this payment’s value be at the end? And finally answer the same question for the 5th payment as well. Please take a moment and answer the following questions and go to the next slide when you are ready. Self Test 2.21 Answer 74 00:00 slide/cap74.swf Self Test 2.22 75 00:00 Self test question 2.22 – What is the present value of the annuity of an ordinary annuity with 10 payments of $100, if the appropriate interest rate is 10%? What would the present value of this annuity be if the interest rate were 4%, and what if the interest rate were 10%? And finally how would the present value of the annuity value differ if we were dealing with an annuity due instead of an ordinary annuity? Please take a moment to answer these questions, and go to the next slide when you’re ready. Self Test 2.22 Answer 76 00:00 slide/cap76.swf Self test 2.22 answers. We are looking for the present value of annuity stream so we simply first click on the present value function. It asks us for the rate of interest which is 10%, so that’s going to be simply, the payments in this annuity stream is $100.00 so once we click okay we see the present value of this annuity stream equals 16.4 something. If we change the function again on the interest rate we see the new present value is approximately $800.00 and if we change the interest rate again to zero percent the new present value will be $1000.00. Finally, it asks us what this would look like an annuity does? We have to click on the function again and type one in the box and then we would get a value $675.90 for the first and $843.53 for the next interest rate we are looking for. Finally, for zero percent we get $1,000.00 again, this is what it will look like from an annuity due perspective. Solving for FVA for apartment rent: 00:00 77 3-year annuity DUE of $100 at 10% So far the examples we have been talking about have been ordinary annuities, now let’s take a look at an annuity due. Again the difference between an annuity and an annuity due is that the ordinary annuity payments are made at the end of each period, and in an annuity due the payments are made at the beginning of each period. So, here we have the same example for a future value of an annuity question; this is for apartment rent, a three year annuity due of $100 at 10%. So again, the $100 payments are now again going to occur at the beginning of each period instead of at the end of each period. But really everything else is the same, we push the same numbers into the calculator, the only difference is we have to set our financial calculator now to the begin mode. Please refer to the owners manual on how to set your financial calculator to the begin mode. By setting your calculator to the begin mode which is usually (beg) button on your calculator, it tells your calculator that you want to calculate it based on payments occurred at the beginning of the period versus the end of Spreadsheet Solution 78 00:00 slide/cap78.swf So in order to find the annuity due in the situation we do as before we click on the FV for the future value of an annuity stream we seek and our future value window pops up. We know our rate is 10% so that the N period is going to be three; the investment stream is -$100.00 because it is a future inflow and outflow during the annuity stream. At the top of the box we have to push, the number one to tell the calculation it’s an annuity due not an annuity stream so then we get $364.10 which is the same amount as the previous slide. Solving for PVA for apartment rent: 00:00 79 3 year annuity DUE of $100 at 10% Now let’s take a look at the same example but let’s look at it and calculate the present value of an annuity for apartment rent which is a three year annuity due of $100 at 10%. Again we’ re talking about annuity dues, so we need to set our calculator to the begin mode to signify that we want the payments to occur at the beginning of the period versus end of the period, same inputs as before, this time the N periods is three, the interest rate is 10%, the payment is $100, the future value is 0. And if we hit the output for the present value we see that it equals $273.55, which has a negative in front of it, which is basically just a sign from the financial calculator, which says it thinks that this is a cash outflow. So again this particular payment stream, the present value of this annuity due would be worth $273.55 today. And we can also do this again using our Excel spreadsheets which we will do in the next slide. Spreadsheet Solution 80 00:00 slide/cap80.swf So again we can use Microsoft Excel to do the same thing as we were looking for future value with the annuity due with the present value. This time we click PV instead of FV, the interest rate is 10%, it asks for N periods which is three and finally they ask us for our payment streams and they are 100.00 and we don’t need to make it negative since we are looking at a present value and it automatically goes to zero but we need to go into the type box and enter one in order to let the Excel calculator know we are talking about annuity due. Then we get a present value of $273.55, which is the same thing we got using the financial calculator. Self Test 2.23 81 00:00 Now let’s take a moment to review the topics that we’ve just covered. Self test question 2.23 – If you know the present value on an ordinary annuity how could you find the present value of the corresponding annuity due. Please take a moment to answer this question then go to the next slide when you’re ready. Self Test 2.23 Answer 82 00:00 Self test 2.23 answer – You could find the present value of the corresponding annuity due by easily and simply setting your financial calculator to the begin mode or setting your spreadsheet and typing in ‘1’ in the mode box of the Excel wizard. Self Test 2.24 83 00:00 Self test question 2.24 – Why does an annuity due have a higher present value than an ordinary annuity? Please take a moment to answer this question and go to the next slide when you’re ready. Self Test 2.24 Answer 84 00:00 Self test 2.24 answer – An annuity due has a higher present value because payments are made at the beginning of the period versus the end of the period, which allows the interest on the cash flows to compound sooner than at the end of the period, thus the additional interest causes a higher present value. Self Test 2.25 85 00:00 Self test question 2.25 – Assume that you planned to buy a condo five years from now, and you estimate that you can save $2, 500 per year. You plan to deposit this money in a bank account that pays 4%, and you will make the first deposit at the end of this year. How much will you have at the end of five years? And how would your answer change if the interest rate were increased to 6%, and how would it change if it were decreased to 3%? Please take a moment and answer the following questions, and go to the next slide to see the solution. Self Test 2.25 Answer 86 00:00 slide/cap86.swf Self Test 2.26 87 00:00 Self test question 2.26- Assume that you are offered an annuity that pays $100 at the end of each year for 10 years. You could earn 8% on your money and other investments of equal risk. What is the most you should pay for this annuity? If the payments began immediately, how much would the annuity be worth? Here’s a hint – think about the 8% as an interest rate. Please take a moment to answer the question and go to the next slide to see the next solution. Self Test 2.26 Answer 88 00:00 slide/cap88.swf Rates of Interest 89 00:00 Now that we have ? ? ? ? ? annuities as? well? as ?all? the ? ? ? ? present ?value ? ? ?future?value ? ? ?time ?value ? ? ? ? ? ? we? now ? ? ? ? ? ?attention ?to ? ? ? ? on? interest. ?In ? ? ? ? ? ? ? ? ? ? are ? ? ? ? to?describe each of? the ? ? ? ? ? ? rates?of ? ? ? ? ? ? ? ? ? ? definition, and ?how do we calculate each of these different definitions, and the differences between them. covered ? ? ? ? ? ? ? ? ? ? ? ? ? basic ? ? ? ? ? ? ? and ? ? ? ? ? ? and ? ? ? ? ? concepts, ? ? ? turn our ? ? ? ? ? ? rates ? ? ? ? ? ? ? this section we ? ? going ? ? ? ? ? ? ? ? ? ? ? ? different ? ? ? ? interest, their ? ? ? ? ? ? ? ? ? ? The Power of Compound Interest 90 00:00 Before we begin, though, let’s agai ― ― ― ― ????? ?????? 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Introduction 1 00:00 This Page is Menu ?of ? ? ? ? ? ? ? ? ? Lectrue. Welcome back to Financial Decisions and Markets. I am Professor Henry Wong and today we are going to be discussing Chapter 3 - Financial Statements, Cash Flows and Taxes. We will first start of by reviewing some basic accounting concepts in which investors must understand, in order to interpret and analyze financial statements. Next we will talk about the key financial statements that investors must understand. These key financial statements include: the Balance Sheet; the Income Statement; the Statement of Retained Earnings, sometimes referred to as the Statement of Shareholder Equity; and of course the Cash Flow statement, or sometimes referred the Statement of Cash Flows. And then we will differentiate the difference between accounting income versus cashflow, and why investors are more concerned with cash flow, because cash flow has a direct impact on the value of the corporation, and hence investors can understand the value of the shares that they own in the corporation. Finally we end our discussion in the chapter with an overview of the Federal Tax System and how that affects investors’ perspectives on corporate value as well. ”So why is this important?,” you may ask yourself. If you are an investor and you are contemplating investing in some company, where would you go to look for information about that company and how would you go about determining whether or not that investment is a good investment? Most people would go on the internet and read about the actual corporation, but in this sect CHAPTER 3 Financial Statements, Cash 00:00 and Taxes 1 Flow, Basic Accounting Concepts 2 00:00 Basic Accounting Concepts (continued) 3 00:00 A couple other very important basic accounting concepts to understand is the idea of depreciation. What is depreciation? Depreciation is a reducing of the value of a firm’s fixed assets to reflect its true value based on its expected life to the shareholder. Why is this important? For example, when a corporation like GM buys heavy equipment in order to produce cars for its customers it will pay a certain price up front for that capital equipment. It is also a fixed asset. For the shareholder, they want to understand the value of that fixed asset. In the first year it is easy to understand that value because whatever the corporation paid for that big piece of machinery, that is typically the value that the shareholders would place on it. It becomes a little bit more difficult for the investor to understand the value of that same piece of machinery ten years from now. As you can imagine, 10 years from now, the value of that machinery has been used and its effective value and expected life is a lot shorter than it was when the company purchased the asset in the ten years before. So thus, depreciation is a mechanism in which shareholders can be told the true value of a fixed asset, so that they can make a determination of how much and how many and what kinds of fixed assets and what the value of those fixed assets are to the company and any given point in time. It is also important now to differentiate the difference between depreciation and amortization. Depreciation and amortization are similar because The annual report (“10-K”) 4 00:00 These basic accounting concepts that we have learned are important for investors when they are reading and reviewing company information disclosed to them. One of the most important documents disclosed to shareholders of a corporation is the Annual Report, which is published by the corporation to its shareholders, every year in order to show the past performance of the current/previous year. Sometimes this Annual Report is called the 10K. It is called a 10K because it is referred to as the filing name when the corporation files its annual report with the Securities Exchange Commission. The Securities Exchange Commission or the SEC requires companies to disclose information to its shareholders on a periodic basis. One of these requirements is that they disclose an annual report or a 10K filing to its shareholders on an annual basis. Corporations are also required to disclose information on a quarterly basis with the SEC and this report is called the 10Q or the 10 Quarterly report. The annual report is one of the most important documents for an investor to review and for a potential investor to read prior to making an investment. It has two very important and very critical pieces. The first part of an annual report is a management discussion and analysis of the performance of the corporation in the past year. This is generally qualitative in nature and not only do they review the past performance of the past year, but they will sometimes provide some sort of guidance as to future prospects of the corpora Financial Statements Reflect Business Activities 5 00:00 Now that we know and have an understanding of the basic financial statements included in an annual report, let’s examine exactly how each of these financial statements reflect business activities. We basically start our analysis with the column on the left which is the investing. As you can see from this column we are investing in assets. These assets include current assets, which are things such as cash, marketable securities, inventories and accounts receivable. We will go into depth a little bit later as to what each of these particular things mean, but just realize that right now that these are called current assets or assets that the corporation owns. Then there are non-current assets: things that the corporation owns and requires and needs in order to build its products and sell to consumers: things like land, buildings and equipment, patents and also any kinds of investments as well. Taken together, the corporation invests money into producing these kinds of assets. Why do they do that? It is because these assets are used to operate and run the business and generate net income for the shareholders. So on the left hand side under the investing side we see that these assets again are reflected on the Balance Sheet. We can look at the Balance Sheet and we know what kind of assets the corporation owns. And when we talk about how efficiently they are utilizing those assets we start looking at the Net Income Statement. If you go to the middle column you can see that under the Operating section we Example: Kodak -Financial Statement 6Links 00:00 In this slide, we see a real life example of the intertwining of the four different financial statements within an annual report and how they actually affect each other. This is an example of Kodak Corporation and their financial statements ending December 31, 2005. As you can see you can start off with the Balance Sheet or what the company owned at the end of 2004 on the left. They have got cash, which of course, flows through to what the remaining cash will be at the end of 2005, and they have changes in equity. If they have used up some of their retained earnings, which again is money in their own pocket, or maybe they had issued new equity in the marketplace and received the proceeds from this, this would be reflected in the Statement of Shareholders Equity or the Statement of Retained Earnings at the end of 2005. In the Income Statement for the given year 2005, you can see that any income derived would flow through into the Statement of Shareholders Equity as well. All of these would have some effect on the cash flow of the company, which again flows through back into the Balance Sheet at the end of 2005. Then we start this process all over again. This is the way that each of these different financial statements affects each other. Self Test 3.1 7 00:00 Now let’s take a moment and review the topics that we have just covered. Self test question 3.1 What is the annual report and what two types of information does it provide? Please write down your answer and go to the next slide when you are ready. Self test 3.1 answer The annual report is issued annually by the corporation to its stockholders. It has two parts. The first part is the basic financial statements which reflect the activities of the corporation in the past year. The second part is a management’s discussion and analysis of the performance of the company in the past year, as well as prospects for the future. This annual report is sometimes referred to as the 10K filing, referring to its filing name with the Securities Exchange Commission of the United States. Self Test 3.1 Answer 8 00:00 Self test question 3.2 What four financial statements are typically included in the annual report. Please think about it and write down your answer and go to the next slide when you are ready. Self Test 3.2 9 00:00 Self Test 3.2 Answer 10 00:00 Self test 3.2 answer. The four basic financial statements included in an annual report are: 1. Balance Sheet 2. Income Statement 3 Statement of Cash Flows 4. Statement of Retained Earnings. Self Test 3.3 11 00:00 Self test question 3.3 Why is the annual report of great interest to investors? Please write down your answer and go to the next slide when you are ready. Self Test 3.3 Answer 12 00:00 Self test 3.3 answer The annual report is the most important report corporations to their shareholders because it shows the operating results of the past year, and it gives a discussion from management about the prospects for the future earnings of the corporation. Also, it includes the financial statements which provide an accounting picture of the firms operations and financial health. Self Test 3.4 13 00:00 Self test question 3.4 Do public corporations provide quarterly as well? Please write down your answer and go to the next slide when you are ready. Self Test 3.4 Answer 14 00:00 Self test 3.4 answer Yes. Public corporations are required to file 10Q quarterly reports with the Securities Exchange Commission. These quarterly reports include the basic financial statements for both quarterly and year-to-date data, but overall, provide less comprehensive data than the annual report. You can access the 10K or the 10Q report of any public company by going to www.sec.gov. Now that we have discussed the annual report and the basic financial statements included in the annual report, we are going to investigate and analyze each one of these statements, one by one. The first one is the Balance Sheet. In order to understand the Balance Sheet we must understand a few basic concepts regarding the Balance Sheet. First things is - what exactly is a balance sheet? The Balance Sheet, remember, is a snapshot of the firm’s financial position at any specific time period or date. So, in a sense, it’s as if you would take a digital camera and take a quick snapshot of a corporation like IBM and you would know what IBM owns and how they finance it. The basic Balance Sheet equation is really in three parts. A balance sheet will first list off its assets. These are the things that the company actually owns. Then, the next section of the balance sheet will list how they were able to finance or pay for those assets of the company. In this section, there is the liabilities section and the equities section. The liabilities is any debt used or borrowed money in order to pay for assets and in the equity section it shows us of any investments taken in in order to pay for assets. Taken together, we have the basic balance sheet equation: which is the total assets of a corporation is equal to the total liabilities of the corporation plus the total equity of the corporation. If you think about why this is true, you will understand that the corporation owns its assets on the left hand side, which re Basic Balance Sheet Terms & Concepts 00:00 15 There are some more very important and basic balance sheet terms and concepts in which for us to understand. The first one has to do with the asset section of the balance sheet. These assets are listed in a certain order. The listing order of these assets are listed in declining order of liquidity. Liquidity basically means how quickly we can convert this asset into cash. So cash is usually at the top of the asset chain, because it is cash and there is no need to convert it into cash; but other things after assets, such as accounts receivable and inventories, which we will later discuss, take a little bit longer to actually convert into cash. Also, with the asset portion, there are the things called the current assets and the non-current assets. Current assets are all the assets that we believe we can convert into cash within one year. Non-current assets are assets that the company owns, that we believe will take longer than a year in order to convert into cash. On the other side of the balance sheet we have the liabilities and owners’ equity portion. Let's start off by discussing the liabilities. Much like the assets of the company, the liabilities are listed with short term liabilities first, followed by long-term debts owed by the venture in the future. So hence, we have current liabilities which are short term liabilities or debt that the company must pay within the current year. Anything that takes maybe longer than a year to finish paying, we move over into long-term liabilities or non-curre Basic Balance Sheet Terms & Concepts 00:00 16 (continued) Types of Balance Sheet Assets 17 00:00 Let’s look specifically at the asset portion of the balance sheet and talk about again the different types of balance sheet assets. The first ones are the current assets, again, are cash and other assets that are expected to be converted into cash in less than one year. This is different than the fixed assets which are assets of expected lives of greater than one year. For example, a fixed asset could be plant or machinery used by GM to build its cars. If the company had to liquidate tomorrow they would not be able to just sell this asset off right away and convert it into cash. So we expect this fixed asset is going to take a little bit longer to convert into cash and hence we break it out and talk about it in a different category called fixed assets. You may ask yourself, why is this important to an investor to understand the difference between assets that can be converted into cash in one year or less, versus assets that may not be able to be converted into cash in one year or greater? The answer is that the investor always wants to know what the potential ‘liquidity’ position of the company is, in case it runs into some kind of financial trouble or bankruptcy or is unable to pay its debts as it becomes due. In this case, they would want to understand how much of the assets that the company owns can actually turn into cash to help pay for those assets, versus how many are fixed assets or non-current assets that the company will not be able to turn into cash in a short period of time, in order to pay i Types of Current Assets 18 00:00 Now let’s focus on specifically the current assets and describe some of the normal current assets that you will find on a corporation’s balance sheet. The first one is obvious, it is cash. It is the amount of coin, currency or checking account balance that the corporation owns. This is typically listed as the first line item under the current asset portion of the balance sheet. The second current asset, typically listed right after cash, are accounts receivable. Again these are the credit sales made to the customers. So as a quick review, you will recall that in the past we have discussed that companies like GM may sell their cars to dealers or other buyers of their cars but may not collect the cash, the actual cash associated with that sale for some period after the actual good is delivered. In that case, that sale sits in accounts receivable and is said to be a credit sale made to the customer. Once that customer actually pays cash, then that credit sale actually converts into the cash. The last part of a normal current asset line item that you would see on the balance sheet is Inventories. So these are the goods that the corporation must store and sell in order to make money and generate net income and a profit for its shareholders. Things in the inventories can include raw materials, basically the materials that we need to produce the good, but we haven't produced it yet; Works In Progress or WIPs are inventories or goods that we are currently building, but not yet completely finished building Types of Current Liabilities 19 00:00 Now that we have taken a look at what current assets are, let’s compare that with what current liabilities are on the balance sheet. This again are the amounts owed to other people as they become due for the company. The current liabilities represent all of the amounts payable or due from the corporation within the current year. So a year or less time frame, any bills that need to be paid by the corporation will be listed in the current liabilities section. Again, this is also listed in the order of when and what bills need to be paid first. Let's start off with the payables. These are the short term liabilities owed to suppliers for purchases made on credit by the corporation. The corporation, again, when it buys its raw materials and supplies, promises to pay the supplier a certain amount after it is invoiced, and its particular policy maybe that, after we receive the goods from the supplier, we may want to wait 30 to 45 days before making the actual cash payment. Meanwhile, this bill sits in our accounts payable section of our current liabilities which is the exact opposite of the accounts receivable; so that these are the bills that we have to pay, and we have to pay relatively soon, i.e., within a year or less. This is our accounts payable section and it is typically the first line item because these are the immediate short term bills which need to be paid. The second line item that you typically see are accruals or accrued wages. Again, people are normally paid on a semi-monthly basis, so they g Types of Long-Term Liabilities 20 00:00 Next, let’s look at long-term liabilities which are different than current liabilities because long-term liabilities are the payments and the bills that the company must make that are a year or more out. In the long-term liabilities column, we typically have a couple of different line items. The first one is long-term debts. This, of course, represents any loans that the corporation has borrowed that have maturities of longer than one year. Right underneath that is typically capital leases. What exactly are capital leases? Capital leases are long-term non-cancelable leases, whereby the owner receives payments to cover the cost of the equipment, plus a return on investment in the equipment. Capital leases can be things like hardware or computers that a software company must use in order to run its business. Rather than purchasing the computers outright by themselves, they enter into one of these capital leases where they agree to a long-term loan of those computers and they cannot cancel those leases. In return they will make payments to, for example Dell, for leasing them the hardware or the computer equipment or hardware in the first place. Off-Balance-Sheet Financing: Operating Leases 21 00:00 We just finished talking about non-cancelable capital leases, but I want to point out that there is a thing called operating leases which you should be aware of as well. This is sometimes called ‘off the balance sheet’ financing. I will come back to it in just a minute as to why it is called ‘off the balance sheet’ financing. But operating leases are different than capital leases, because operating leases are generally cancelable, so the corporation can cancel their computer lease equipment with Dell for example. In addition for buying the hardware, Dell also agrees to provide any kind of maintenance in addition to financing, and, of course, they are cancelable once again. What is the effect of this kind of agreement on the company? Basically it allows the corporation to record the use of their items from Dell as an expense item versus an actual asset item on their balance sheet. This is why we call this ‘off the balance sheet’ financing. For operating leases, there are no assets or lease liabilities recorded on the balance sheet. Sometimes corporations will like to “window dress” their balance sheets by not showing this kind of liability or this kind of asset on the balance sheet. These off the balance sheet financing or operating leases are generally used for computers, copiers or automobiles and they are normally financed by these operating leases. Allied Corp. Balance sheet: Assets 22 00:00 Now as we go to the next slide we are looking at the second half of the balance sheet, or the liabilities and equities portion of the balance sheet. As I have stated before, in balance sheets we start off with the liabilities section and the owner’s equity section at the bottom. In the liabilities section as you will recall, we always start off with the current liabilities, or basically the bills that are due within the current year, that the corporation must pay. These are the liabilities that the corporation must pay. Again we have two years of reported financial information here: 2004 and 2005. The first line item on our current liabilities is the accounts payable. Again these are the bills that are coming due that the corporation must pay on the short term basis. As you can see on the accounts payable line item, we see that the bills that need to be paid from 2004 to 2005 have ballooned from approximately $145 million to now $524 million in short term bills that need to be paid. The next line item are the notes payable. These are the amounts that the corporation has borrowed and are going to come due within the current year. As you can see here too, the amount has ballooned from $200 million to approximately $636 million from 2004 to 2005. So looking at both of these current account balances, at the moment you can see that the current liabilities in the accounts payable column represents a huge spike from the previous year. This would probably reinforce our previous notion that the corporation Allied Corp. Balance sheet: Liabilities and Equity 23 00:00 Now let’s take a moment to review all the topics that we have covered. Let’s start with self test question 3.5 What is the balance sheet and what information does it provide. Please write down your answer and go to the next slide when you are ready. Self Test 3.5 24 00:00 Self Test 3.5 Answer 25 00:00 Self test 3.5 answer The balance sheet is a financial statement that provides a snapshot of a corporation’s financial position as of a specific date. The balance sheet shows all of the assets owned by the corporation at a specific date and how exactly those assets were financed, either through debt or equity. Self Test 3.6 26 00:00 Self test question 3.6 How is the order of the items shown on a balance sheet determined? Please think about this and go to the next slide when you are ready. Self Test 3.6 Answer 27 00:00 Self test 3.6 answer Items on the balance sheet are listed in order of their liquidity or the length of time it takes to convert these assets or liabilities to cash or their expected useful lives for fixed assets. Similarly, the claims are listed in the order in which they must be paid, which is in terms of current liabilities. Self Test 3.7 28 00:00 Self test question 3.7 A company has $2 million of cash and equivalents, $2 million of inventory, $3 million of accounts receivable, $3 million of accounts payable, $1 million of accruals and $2 million of notes payable. What is its net working capital? Please take a moment and write down your answer and go to the next slide when you are ready. Self Test 3.7 Answer 29 00:00 Self test 3.7 answer The net working capital of the corporation equals the current assets minus their current liabilities. As stated before, the current assets of the corporation are $2 million of cash and equivalence, $2 million of inventory and $3 million of accounts receivable. The current liabilities of the corporation include $3 million of accounts payable, $1 million of accruals and $2 million of notes payable. If you deduct the current assets minus the current liabilities, it gives you a net working capital of $1 million dollars. Self test question 3.8 Why might Allied’s December 31st balance sheet differ from its June 30 statement? Please take a moment to think about your answer and go to the next slide when you are ready. Self Test 3.8 30 00:00 Slide 3 - 31 (02:02:18) Self test 3.8 answer. The balance sheet again represents a snapshot in time of a firm’s financial position. The balance sheet changes everyday as assets, things like inventories, cash etc, increase or decrease because of the daily operations of the business. As liabilities such as loans and bills come due, increase and decrease as they are being paid and not being paid. Thus some companies are highly seasonal and experience large changes in inventories throughout the year. Think about a department store gearing up for the holiday sale season. Allied’s December 31 balance sheet may be very different from their June 30 balance sheet because of these seasonality issues. Self Test 3.8 Answer 31 00:00 Basic Income Statement Terms & Concepts 32 00:00 Basic Income Statement Terms & Concepts (continued) 33 00:00 Basic Income Statement Terms & Concepts (continued) 34 00:00 Before analyzing Allied Corporation’s income statement, we’ve got two more topics to cover. One is the idea of depreciation and two is amortization. If you recall from our discussion of balance sheets, the depreciation is the annual charge against income that reflects the estimated total dollar cost of the capital equivalent or fixed asset or any other tangible asset. This is different from amortization, because it is the annual charge against income for any intangible asset such as good will, intellectual property, copyright and trademarks, etc. Allied Corp. Income statement 35 00:00 Self Test 3.9 36 00:00 Let’stop for a moment and do a quick review on the topics we have covered. Self test question 3.9. What is an income statement and what information does it provide? Please write down your answer and go to the next slide when you are ready. Self Test 3.9 Answer 37 00:00 Self test answer 3.9. The income statement is the financial statement that reports the revenues generated and the expenses incurred over an accounting period. Typically this is a one-year report but it could be a quarterly report as well. Self test answer 3.9. The income statement is the financial statement that reports the revenues generated and the expenses incurred over an accounting period. Typically this is a one-year report but it could be a quarterly report as well. Self Test 3.10 38 00:00 Self test answer 3.10. Earnings or Net Income of the corporation is stated on the bottom of the income statement. Also, Earnings per Share denotes the amount of Net Income available to each holder of a share of stock of the company. Thus this is called the bottom line since it is the most important to its investors. Self Test 3.10 Answer 39 00:00 Self Test 3.11 40 00:00 Self test question 3.11. Differentiate between amortization and depreciation. Write down the answer and go to the next slide when you are ready. Self Test 3.11 Answer 41 00:00 Self test answer 3.11. Remember depreciation is the annual charge against income that reflects the estimated dollar cost of the capital equipment and other tangible assets. Amortization is the annual charge against income that reflects the estimated dollar cost of intangible assets such as patents, copyrights, trademarks or goodwill. Self Test 3.12 42 00:00 Self test question 3.12. What are EBIT, operating income, and EBITDA? Write down your answer and go to the next slide when you are ready. Self Test 3.12 Answer 43 00:00 Self test answer 3.12. The operating income and the EBIT are the same thing. They both indicate the firms’ profits after operating expenses excluding financing costs have been deducted from the net sales. EBITDA however is a measure of the firm’s profit after taking into account non-cash items like depreciation and amortization. Managers, investors, etc use EBITDA to look at how much cash a company is actually generating. For some industries, EBIT may be the best industry benchmark to look at, while other industries heavy in capital equipment and fixed assets, may choose to use EBITDA as the relative financial measure of the company. Self Test 3.13 44 00:00 Self test answer 3.13. The balance sheet is actually more like a snapshot of a firms' operations because it tells us the story at any point in time what asset the company owns and how they financed those assets. Income statements are more like a movie because it represents the financial performance over a given time period. Self Test 3.13 Answer 45 00:00 Statement of Cash Flows: Definition and Use 46 00:00 Allied Corp. Statement of Cash Flows 00:00 47 (2005) Allied Corp. Statement of Cash Flows 00:00 48 (2005) Our next part of our cash flow statement is our investment activities and the sources and uses of cash in those investment activities. Here we can see in the long-term investment activities are the investment and fixed assets of the corporation. We can see that in 2005, the corporation has actually invested approximately 712 million dollars in fixed assets for the long-term benefit of the corporation. The third part of the cash flow statement is our financing activities: where the cash has been generated or used. In our financing activities, we can see that our notes payable have increased approximately 437 million dollars, which means the corporation has borrowed some short-term liability notes by another 437 million dollars. We can also see in the next line item that the corporation has also increased the long-term debt borrowing as well by 400 million dollars. There has also been a payment of a cash dividend of approximately 11 million dollars to their current equity holders giving us the net cash from their financing activities as 826 million dollars being generated primarily through short-term and long-term debt. If we add in all three of our activities, the operating activities and investing activities and the financing activities, we get what we call our net change in cash. For Allied Corporation in 2005 this is negative 50 million dollars. Now that negative 50 million dollars has to be covered by someone or something and as we can see we have at the cash beginning of the year of 57 million dollars and at What can you conclude about Allied’s 00:00 49 financial condition from its statement of CFs? So again, what can we conclude about Allied Corporations' financial situation from its cash flow statement? No.1: we can tell that net cash flow from operations was approximately negative 164 million dollars mainly because of negative net income. No.2: we can recognize that the firm borrowed approximately 826 million dollars to meet its cash requirements. No.3: even after borrowing the money, the cash account fell by 50 million because we needed to pay for the additional liabilities that we had. Self Test 3.14 50 00:00 Self-test question 3.14. How do we estimate net cash flow and how does it differ from accounting profit? Please write down your answer and go to the next slide when you are ready. Self Test 3.14 Answer 51 00:00 Self test answer 3.14. Net cash flow is different from accounting profit or net income because depreciation is a non-cash charge and must be added back to get a net cash flow. An accounting profit includes depreciation. Thus net cash flow equals net income plus any kind of depreciation and amortization. Self test question 3.15. In accounting the emphasis is on net income but in finance the focus is on cash flow. Why is this so? Please write down your answer and go to the next slide when you are ready. Self Test 3.15 52 00:00 Self test answer 3.15. The managers’ goal is always to maximize value. The value of any asset including the stock of a corporation is always dependant upon the present and expected future cash flows available to its investors. Thus as investors we focus on cash flows because net income takes into account non-cash items like depreciation and amortization. Self Test 3.15 Answer 53 00:00 Self Test 3.16 54 00:00 Self test question 3.16. What is the statement of cash flows and what are some of the questions it is designed to answer? Please write down your answer and go to the next slide when you are ready. Self Test 3.16 Answer 55 00:00 Self test answer 3.16. The cash flow state reports the impact of a firms operating, investing and financing activities on cash flows over an accounting period. In other words it tells us where the cash was used and how the cash was generated over a certain time period. Self Test 3.17 56 00:00 Self test question 3.17. If a company has high cash flows does this mean that its cash and equivalents will also be high? Please explain. Please write down your answer and go to the next slide when you are ready. Self Test 3.17 Answer 57 00:00 Self test answer 3.17. The fact that a company generates high cash flow does not necessarily mean that the cash reported on its balance sheet is also high. Cash flow is not normally used just to build up the cash account. Rather it is used in a variety of ways including paying dividends, increasing inventories, financing accounts receivables, investing in fixed assets, retiring debt and also buying back common stock. Self Test 3.18 58 00:00 Self test question 3.18. Identify and briefly explain the three types of activities shown in the statement of cash flows. Please write down your answer and go to the next slide when you are ready. Self Test 3.18 Answer 59 00:00 Self test answer 3.18. Operating activities, which include net income, depreciation and changes of working capital other than cash and short-term debt. Then there is No.2: investing activities which, includes purchases and sales of fixed assets; and finally financing activities which includes raising cash by using short-term debt, long-term debt, stock or using cash to pay dividends or to buy back outstanding stocks or bonds. Now that we’ve talked? about ? ? ?balance ? ? ? ? ? ? ? income? statement, ? ? ?the cash? flow? statement, ? ? ? ?look ?at ? ? ?statement ?of ? ? ? ? ? ?earnings, ? ? ? ? ? ? ? as ?the? statement?of ? ? ? ? ? ? ? ? ?equity. ? ? ? ? ? ? ? ? is ?the statement? of ?retained? earnings? ?This ?shows how ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? were ?actually retained ? ? the ? ? ? ? ? ?rather ?than ?paid ? ? ? as ?dividends ? ? its ? ? ? ? ? ? ? ? ?Changes ? ? the ? ? ? ? ? ?earnings? occur ? ? ? ? ? common stockholders?allow ? ? ?management to?reinvest the ? ? ? back into the company so they can grow the company and invest in new products and projects that otherwise could be distributed as dividends to the common stockholders. These dividend distributions are called dividends, which are stock or cash given to shareholders of the corporation as determined by management. Statement of Retained Earnings: Definition and Use 60 00:00 ? ? ? ? ? the ? ? ? ? sheet, the ? ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? ? let’s ? ? ? the ? ? ? ? ? ? retained ? ? ? ? ? also known ? ? ? ? ? ? ? ? shareholders’ ? ? ? ? What exactly ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? much of ? ? firms’ earnings ? ? ? ? ? ? ? ? ? ? ? ? in ? ? business ? ? ? ? ? ? ? out ? ? ? ? ? ? to ? ? shareholders. ? ? ? ? in ? ? retained ? ? ? ? ? ? ? because ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? funds Now we turn to Allied Corporation’s statement of retained earnings for 2005. We first start off with the balance of retained earnings at the end of 2004, which was 204 million. Then we deduct our loss of Net Income in 2005 of approximately 160 million and then we also decide we were going to pay out dividends to our shareholders of 11 million. Thus the balance of retained earnings at the end of 2005 is only 33 million dollars approximately. Allied Corp. Statement of Retained 61 00:00 (2005) Earnings Self Test 3.19 62 00:00 Self test question 3.19. What is the statement of retained earnings and what information does it provide us? Please write down your answer and go to the next slide when you are ready. Self Test 3.19 Answer 63 00:00 Self test answer 3.19. The statement of retained earnings reports how much of the firms earnings were retained rather than paid out as dividends to shareholders in the past year. Self Test 3.20 64 00:00 Self test question 3.20. Why do changes occur in a retained earnings account? Please write down your answer and go to the next slide when you are ready. Self Test 3.20 Answer 65 00:00 Self test answer 3.20. Changes in the retained earrings occur because management chooses to reinvest funds that otherwise could be distributed as dividends to stockholders. Also changes in net income will affect the actual balance of the retained earnings at the end of the year as well. Self Test 3.21 66 00:00 Self test question 3.21. Explain why the following statement is true. The retained earnings account reported on the balance sheet does not represent cash and is not “available” for dividend payments or anything else. Please write down your answer and go to the next slide when you are ready. Self test answer 3.21. The retained earnings account in the balance sheet represents only a claim against assets of the corporation and is not an actual asset per say. Cash is an asset and that would be available for distribution or dividend payments. Self Test 3.21 Answer 67 00:00 Key Measures of Performance 68 00:00 What effect did the expansion have 69 00:00 operating working capital? on net So let’s look specifically at the NOWC. What effect did the expansion have on the NOWC on Allied corporation from 2004 and 2005? Again, as a reminder, the NOWC equals the operating current assets, which in this case would be cash, the accounts receivable and the inventories, minus non-interest bearing current liabilities which here includes these accounts payable and accrued liabilities. If you look at the NOWC for 2005 you can see that the operating current assets included 7.2 million in cash, 632 million in accounts receivable, and 1.3 billion approximately in inventories. You deduct the accrued liabilities plus the accounts payable. The accounts payable of approximately 524 million and accrued liabilities of approximately 489 million give us a net operating capital 2005 of 913 million. If we do the same for 2004 we can see that 2004’s net operating capital was slightly lower at 842 million. What effect did the expansion have 70 00:00 on operating capital? Now let’s turn our attention to operating capital. What effect did Allied’s expansion have on its operating capital from 2004 to 2005? Again, the operating capital of a corporation is the net operating working capital plus their net fixed assets. So thus, the operating capital for 2005 for Allied Corporation equals the NOWC which in the previous slide we figured out as 913 million dollars and we simply add in the fixed assets of the corporation which was 940 million dollars of products approximately in 2005 giving us a total of 1.85 billion dollars worth of operating capital. Again, this is slightly higher than the 2004 operating capital of Allied Corporation at just 1.2 billion dollars. Did the expansion create additional net operating after taxes (NOPAT)? 71 00:00 What effect did the expansion have 72 00:00 cash flow and operating cash flow? take a look at cash flow in particular and we want to know what effect did the expansion have on net cash flow and operating cash flow of the company. The net cash flow represents the net income plus the depreciation, and in 2005 Allied Corporation’s net income was negative 160 million and we add back in our non-cash expense of depreciation of 170 million approximately, giving us a total net cash flow in 2005 of negative 43.2 million dollars. We can see again that this is significantly lower for 2004 net cash flow to the company of 107 million dollars approximately. Operating cash flow is slightly different from net cash flow, in that instead of looking at net income plus depreciation we look at NOPAT plus depreciation. So the net operating profit after taxes plus depreciation and amortization, we see that in 2005 we had a NOPAT of approximately negative 79 million dollars and we add back in our depreciation of 117 million, giving us positive operating cash flow of 38.3 million; but again, we can see that this is significantly lower than 2004’s operating cash flow of 133 million dollars. on net We now What was the free cash flow (FCF) for 2005? 73 00:00 We started off our discussion saying that free cash flow was one of the most important things that an investor wants to look at. So the question becomes, what is the free cash flow for Allied Corporation for 2005 and how do we figure that out? Well the free cash flow equals the operating income after adjusting for the tax shield plus any kind of depreciation and amortization costs, because it’s a non-cash account, minus the change in fixed assets, which will represent the capital expenditures for the current year, plus any change in net operating capital. Thus the free cash flow for 2005 for Allied Corporation, we start off with an operating income of negative 130 million. They are in the 40% tax bracket so we add back in the depreciation of 170 million approximately and we deduct the change in fixed assets which was 1.2 billion in 2005 and 491 million in 2004 and then we add back in the change in NOWC, which we calculated previously giving us a free cash flow for 2005 of approximately negative 744 million dollars. Self Test 3.22 74 00:00 Self test question 3.22. So we’ve just seen that Allied Corporation’s free cash flow was negative 700 something million odd dollars. Is negative free cash flow always bad? Please explain and then go to the next slide when you are ready. Self test answer 3.22. Generally it’s a bad sign because it means that investors are actually putting in more money to keep the business going. But sometimes, negative free cash flow can be a good sign depending on why the free cash flow was negative. If it was negative because the NOPAT was negative then this is definitely bad. However, many high growth companies have positive NOPAT but negative free cash flows because they must invest heavily back into the operating assets to support rapid growth for the corporation. There is nothing wrong with negative free cash flow if it results from profitable growth. Self Test 3.22 Answer 75 00:00 Based on the following what is your assessment of the expansions effect on operations for Allied Corporation? We can see that sales grew immensely from 2004 to 2005 but we can also see that NOPAT decreased significantly from 2004 to 2005. The NOWC and the operating capital increased from 2004 to 2005. However the net income was a lot lower in 2005 than 2004. We can generally say that the expansion effect on the operations of Allied Corporation have been negative and you can primarily weigh against the increase in sales by the negative net operating profit for 2005. So it doesn’t matter that it doubled its sales from 04 to 05 because they were spending double the amount to achieve those sales; basically 2 dollars for every 1 dollar of sale. What is your assessment of the expansion’s effect on operations? 76 00:00 Does Allied pay its suppliers on time? 77 00:00 Another interesting question to ask ourselves is does Allied pay its suppliers on time? The answer is probably not, because the accounts payable increased 260% over the past year from 2004 to 2005 while sales increased by only 76%. If this continues suppliers may even cut off Allied’s trade credit. Does it appear that Allied’s sales 78 00:00 price exceeds its cost per unit sold? Does it appear that Allieds’ sales price exceeded its cost per unit sold? No, the negative NOPAT and the decline in the cash position shows that Allied is spending much more on its operations than it is taking in from its sales. What if Allied’s sales manager decided to offer 60-day credit terms to customers, considerthan 30-day credit sales manager decided to offer 60 day credit terms to its customers rather than the current 30 day terms. Well, there’s probably two scenarios that may happen. One is if competitors match these terms and the sales remain constant, then all that would happen in this case would be that the accounts receivable would increase because now they are collecting on a 60 day basis instead of a 30 day basis and the cash as a result would decrease as well. The other scenario is a little more interesting. If the competitors don’t match its current credit terms then sales could double. In the short term this would mean that inventories, fixed assets would have to increase so as to accommodate and meet the increased sales, accounts receivable would increase, cash would decrease and the company would have to seek additional financing. But in the long term collections increase and the company’s cash position may improve. 79 00:00 Now let’s rather what if Allied’s terms? How did Allied finance its expansion? 80 00:00 So after reviewing theses four financial statements how do you think Allied financed its expansion? The answer should be obvious by now because it has been stated many times. Allied financed its expansion with external capital. They issued long term debt which reduced its financial strength and flexibility. Would Allied have required external capital if they had broken even in 2005 (Net Income = required external capital if they had broken even in 2005? i.e., that they had a net income equal to zero. Well, probably yes, the company would still have to finance its increase in assets. Looking into the statement of cash flows we see that the firm made an investment of approximately 712 million in net fixed assets. Therefore they would have still needed to raise additional funds to fund this. 81 00:00 Would Allied have 0)? What happens if Allied depreciates 82 00:00 fixed assets over 7 years (as opposed to the current 10 years)? Let’s now take a review of the topics we have covered. Self test question 3.23. What is Net Operating Working Capital? Please write down your answer and go to the next slide when you are ready. Self Test 3.23 83 00:00 Self Test 3.23 Answer 84 00:00 Self Test 3.24 85 00:00 Self test question 3.24. What is total operating capital? Please write down your answer and go to the next slide when you are ready. Self Test 3.24 Answer 86 00:00 Self test answer 3.24. Operating capital equals the net operating working capital plus any net fixed assets. Thus the operating capital includes those assets, which are necessary to operate the business and not assets, which are unnecessary to run the business’ day-to-day operations, like long-term financial agreements, stock in other companies, etc Self Test 3.25 87 00:00 Self test question 3.25. What is NOPAT? Please write down your answer and go to the next slide when you are ready. Self Test 3.25 Answer 88 00:00 Self test answer 3.25. NOPAT equals the EBIT multiplied by the tax shield. NOPAT is the profit a company would generate if it had no debt and held only operating assets. Investors are concerned with the after tax cash flows generated by the operations in the firm. Self test question 3.26. What exactly is free cash flow and why is it the most important determinant of a firm’s value? Please write down your answer and go to the next slide when you are ready. Self Test 3.26 89 00:00 Self test answer 3.26 Self Test 3.26 Answer 90 00:00 ????? ?????? Henry Wong ????? ???? flv/fd_01vid000.flv 00:01 flv/fd_04vid001.flv 01:37.7 flv/fd_04vid002.flv 01:46.8 flv/fd_04vid003.flv 01:54.8 flv/fd_04vid004.flv 05:21.5 flv/fd_04vid005.flv 05:54.6 flv/fd_04vid006.flv 05:05.5 flv/fd_04vid007.flv 02:51.8 flv/fd_04vid008.flv 01:13.7 flv/fd_04vid009.flv 00:14.0 flv/fd_04vid010.flv 00:23.0 flv/fd_04vid011.flv 00:16.8 flv/fd_04vid012.flv 00:18.0 flv/fd_04vid013.flv 00:15.8 flv/fd_04vid014.flv 00:21.9 flv/fd_04vid015.flv 02:07.8 flv/fd_04vid016.flv 05:48.5 flv/fd_04vid017.flv 01:47.8 flv/fd_04vid018.flv 00:17.0 flv/fd_04vid019.flv 00:21.8 flv/fd_04vid020.flv 00:16.9 flv/fd_04vid021.flv 00:31.8 flv/fd_04vid022.flv 00:18.8 flv/fd_04vid023.flv 00:23.0 flv/fd_04vid024.flv 00:15.0 flv/fd_04vid025.flv 00:19.8 flv/fd_04vid026.flv 00:29.9 flv/fd_04vid027.flv 00:53.0 flv/fd_04vid028.flv 01:47.9 flv/fd_04vid029.flv 00:38.0 flv/fd_04vid030.flv 01:27.9 flv/fd_04vid031.flv 01:25.8 flv/fd_04vid032.flv 02:43.8 flv/fd_04vid033.flv 02:28.8 flv/fd_04vid034.flv 00:23.9 flv/fd_04vid035.flv 01:06.9 flv/fd_04vid036.flv 00:16.0 flv/fd_04vid037.flv 00:44.0 flv/fd_04vid038.flv 00:17.9 flv/fd_04vid039.flv 00:50.9 flv/fd_04vid040.flv 00:28.9 flv/fd_04vid041.flv 01:18.9 flv/fd_04vid042.flv 03:21.6 flv/fd_04vid043.flv 01:47.9 flv/fd_04vid044.flv 00:15.8 flv/fd_04vid045.flv 00:45.0 flv/fd_04vid046.flv 00:16.0 flv/fd_04vid047.flv 00:18.0 flv/fd_04vid048.flv 00:17.0 flv/fd_04vid049.flv 00:25.9 flv/fd_04vid050.flv 00:15.9 flv/fd_04vid051.flv 00:26.0 flv/fd_04vid052.flv 00:23.0 flv/fd_04vid053.flv 00:21.0 flv/fd_04vid054.flv 00:17.9 flv/fd_04vid055.flv 00:28.0 flv/fd_04vid056.flv 00:20.8 flv/fd_04vid057.flv 00:38.9 flv/fd_04vid058.flv 01:46.8 flv/fd_04vid059.flv 01:35.9 flv/fd_04vid060.flv 01:55.9 flv/fd_04vid061.flv 01:04.7 flv/fd_04vid062.flv 00:43.0 flv/fd_04vid063.flv 00:48.0 flv/fd_04vid064.flv 00:18.0 flv/fd_04vid065.flv 00:39.0 flv/fd_04vid066.flv 00:15.9 flv/fd_04vid067.flv 00:25.8 flv/fd_04vid068.flv 00:15.0 flv/fd_04vid069.flv 00:17.0 flv/fd_04vid070.flv 00:23.0 flv/fd_04vid071.flv 00:38.0 flv/fd_04vid072.flv 00:48.0 flv/fd_04vid073.flv 00:52.0 flv/fd_04vid074.flv 00:48.0 flv/fd_04vid075.flv 04:20.7 flv/fd_04vid076.flv 02:04.8 flv/fd_04vid077.flv 01:20.8 flv/fd_04vid078.flv 00:22.0 Push here to start ???????? ?????????? slide/fd_04slide.swf ???????? ???? ?? 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 ????? ?????? ???????? Introduction 1 00:00 This Page is Menu? of ?Lectrue.? ? ? ? ???? Welcome back to Financial Decisions and Markets. I am Professor Henry Wong. Today we are going to be discussing Chapter 4: Analysis of Financial Statements. In order to be able to look at financial statements and make a correct analysis and interpretation of those statements, financial managers often will use financial ratio analysis so as to highlight the strengths and weaknesses of a company’s financial performance. Now one of the things we are going to do first off is to talk about ratio analysis: what it is and what are some of the key important variables so we can decide what a company’s performance is? That is actually the easy part of financial statement analysis. The harder part is the qualitative or judgment function that goes along with each of these quantitative ratios that we calculate. With that, we talk about how do we improve these ratios that we calculate. We also talk about some of the limitations of using ratio analysis. Finally we talk about the qualitative or judgment factors that may influence whether a ratio is particularly good or bad. CHAPTER 4 Analysis of Financial Statements 1 00:00 We first start off with the question of why do we even use financial ratio analysis? Why is it helpful for analysts and financial managers? First off is that the ratio standardizes numbers and facilitates comparisons between different companies in the same industry. It’s a lot like being able to compare apples with apples instead of oranges with apples. Secondly ratios are used to highlight weaknesses as well as strengths within a corporation and we are going to go into detail about each of the different ratios and what exactly do they mean and what do they tell us as financial managers or analysts looking at a corporation? Finally ratio comparisons should be made through time and with competitors as well. This is done in two ways. The first way is called a Trend Analysis, by looking at the historical performance of the corporation. The second way to do that is through benchmarking or peer or industry analysis, which is a way to compare specific corporations’ results with the results of the rest of the industry. In this exercise we will attempt to look at Allied Corporation’s income statement and balance sheet information and derive specific financial ratios and analyze whether or not it is actually performing well or not, and why we would say that they are performing well or not compared to the industry. Why are ratios useful? 2 00:00 Trend analysis 3 00:00 Again the first thing we want to do when we look up the financial statements of any particular corporation is we want to look at a Trend analysis. What exactly does that mean? It means analyzing the firm’s financial ratios over time and we can use these financial ratios to estimate the likelihood of whether or not the company performance is likely to improve or deteriorate. As you can see from the slide on the right hand side is a chart and in blue is Allied Corporation’s performance in terms of return on equity from 2004 to 2005 and what they expect to do in 2006. You’ll note that in 2006 there is an “E” after it: so it reads 2006E. This signifies that it is the 2006 Estimate or forecast for the corporation, meaning that the year is not over yet but this is what they project will happen by the end of 2006. You can also lay this out on a graph and compare with the rest of the industry to see how well Allied Corporation is doing in relation to the rest of the industry. As you can see they took a dip in 2005 but expected to improve in 2006 in terms of the return on equity, that is still lower than the industry analysis. Thus the first thing we always want to do is to look at a financial statement and look at two or three historical years of performance and judge its overall performance. This is exactly what we will do in the next step when we look at Allied Corporation’s financial statements. Allied Corp. Balance Sheet: Assets 4 00:00 millions) (in $ Allied Corp. Balance sheet: Liabilities and Equity (in $ millions) 5 00:00 Income statement ($ in millions) 6 00:00 As we look at the top line of Allied’s income statement we see that it has actually improved on the sales and revenue front from 2005 of approximately 6 billion to approximately 7 billion in 2006. We also notice that the cost of goods sold has increased from 5.5 billion dollars in 2005 to approximately 5.9 billion dollars in 2006. This should make sense to us because as they are selling more, the variable costs of each of the units that they are selling will also increase as well. If we take a look at some of the other expenses, fixed expenses and general administrative expenses, we also see that that has increased as well from 520 million approximately to 550 million. This could mean a lot of different things. It could mean that they decided to invest more in marketing and advertising of the product in order to drive up the sales. If we add up these three line items we get our next line item of EBITDA. If you recall, this stands for Earnings Before Interest, Taxes, Depreciation and Amortization. As you can see, there is a significant change in the performance of the company from 2005 to 2006 and whereas they had a negative EBITDA where they were actually losing money on a cash flow basis in 2005, they actually generated 609 million dollars in cash for the corporation prior to any charges for interest, depreciation or taxes. The next line item is the depreciation and amortization. As you can see it is the same amount as 2005; so that has not changed at all. If we deduct this from our EBITDA of course, we get what is the operating income or EBIT of the company (the Earnings Before Interest and Taxes) and as you can see the operating income of Other data 7 00:00 As we look at the top line of Allied’s income statement we see that it has actually improved on the sales and revenue front from 2005 of approximately 6 billion to approximately 7 billion in 2006. We also notice that the cost of goods sold has increased from 5.5 billion dollars in 2005 to approximately 5.9 billion dollars in 2006. This should make sense to us because as they are selling more, the variable costs of each of the units that they are selling will also increase as well. If we take a look at some of the other expenses, fixed expenses and general administrative expenses, we also see that that has increased as well from 520 million approximately to 550 million. This could mean a lot of different things. It could mean that they decided to invest more in marketing and advertising of the product in order to drive up the sales. If we add up these three line items we get our next line item of EBITDA. If you recall, this stands for Earnings Before Interest, Taxes, Depreciation and Amortization. As you can see, there is a significant change in the performance of the company from 2005 to 2006 and whereas they had a negative EBITDA where they were actually losing money on a cash flow basis in 2005, they actually generated 609 million dollars in cash for the corporation prior to any charges for interest, depreciation or taxes. The next line item is the depreciation and amortization. As you can see it is the same amount as 2005; so that has not changed at all. If we deduct this from our EBITDA of course, we get what is the operating income or EBIT of the company (the Earnings Before Interest and Taxes) and as you can see the operating income of Now that we have taken a look at the trends and trend analysis in the historical performance of each of the balance sheet and income statement line items our next step is to do a comparative ratio or some kind of benchmarking. Benchmarking is the process of comparing a particular company with a group of other benchmark companies. Typically these are companies that are their competitors and that are in the same marketplace or industry as them. What you need to do is choose a representative set of benchmark companies and take the average of each of the ratios and compare it with our own focus company, in this case Allied Corporation. As we go through each of these different financial ratio calculations that we make, we have to compare it again with the rest of the industry to determine whether it is a healthy number or one that doesn’t look so good. Comparative Ratios and “Benchmarking” 8 00:00 Self test question 4.1. What is a trend analysis and what information does it provide? Please write down your answer and go to the next slide when you are ready. Self Test 4.1 9 00:00 Self test answer 4.1. A trend analysis is looking at the firm’s financial ratios over time. It is used to estimate the likelihood of improvement or deterioration in its financial condition. Self Test 4.1 Answer 10 00:00 Self Test 4.2 11 00:00 Self test question 4.2. Why is it useful to do comparative ratio analysis? Please write down your answer and go to the next slide when you are ready. Self Test 4.2 Answer 12 00:00 Self test answer 4.2. Comparative ratio analysis is important because it allows managers to see how its company stacks up against the rest of the competition in the industry. Self Test 4.3 13 00:00 Self test question 4.3. Differentiate between trend and comparative analysis. Please write down your answer and go to the next slide when you are ready. Self Test 4.3 Answer 14 00:00 Self test answer 4.3. Trend analysis looks at the financial performance of the company’s ratios over some historical time period while comparative analysis looks to the company’s ratio compared to the industry it is in. What are the five major categories of ratios, and what questions do they answer? 15 00:00 Calculate Allied’s forecasted current ratio and quick ratio for 2006. 16 00:00 So we are doing two things on this slide. No.1. We are looking at the historical performance of each of these ratios, both the current and the quick ratio, in 2004, 2005, and the estimate for 2006. In order to produce a correct analysis you need to look at two years of historical information and possibly one year of forecasted information, but at the very least three years of data in order to come up with a trend. We can see based on the current ratio that we started off with approximately 2.3 in 2004. It took a dip in 2005 when we had some financial troubles and it’s improved to 2.34x, which means that it is trending up and this is obviously a good sign. However, when we compare it with the industry average, we see that the industry average has a current ratio of approximately 2.7x. So there is still an improvement that can be made here. The next ratio is the quick ratio and as we can see the quick ratio again started off as .85x in 2004, took a dip in 2005 to .39x and then came back up to .84x in 2006. Again an improving condition, however when we benchmark it with the rest of the industry, we see that the industry is slightly higher at a 1x quick ratio. This tells us that the liquidity position is still weak compared to the rest to the industry and needs more improvement. Comments on liquidity ratios 17 00:00 Let’s take a moment to review the topics. Self test question 4.4. What are the characteristics of a liquid asset? Please give some examples. Write down your answer and go to the next slide when you are ready. Self Test 4.4 18 00:00 Self test answer 4.4. A liquid asset can be converted to cash quickly without having to reduce the assets’ price very much. Liquid assets include cash, marketable securities, accounts receivables and inventory. Self Test 4.4 Answer 19 00:00 Self Test 4.5 20 00:00 Self test question 4.5. What two ratios are used to analyze a firm’s liquidity position? Write out their equations. Take a moment to do this and go to the next slide when you are ready. Self Test 4.5 Answer 21 00:00 Self test answer 4.5. The two liquidity equations discussed in this chapter are No.1 the current ratio and No.2 the quick ratio. The current ratio is found by dividing the current assets over the current liabilities. The quick ratio is found by taking the current assets minus the inventories dividing it over the current liabilities. Self Test 4.6 22 00:00 Self test question 4.6. Why do you think that the current ratio is the most commonly used measure of short-term solvency for corporations? Please write down your answer and go to the next slide when you are ready. Self Test 4.6 Answer 23 00:00 Self test answer 4.6. The current ratio indicates the extent to which the current liabilities can be covered or paid by those assets, which are expected to be converted to cash in the near future. This is the most commonly used measure of liquidity. Self test question 4.7. Which current asset is typically the least liquid? Please write down your answer and go to the next slide when you are ready. Self Test 4.7 24 00:00 Self test answer 4.7. Inventories are typically the least liquid of a firm’s current assets. Hence they are the assets on which losses are most likely to occur in the event of a liquidation. Self Test 4.7 Answer 25 00:00 Self test question 4.8. A company’s current liability is approximately 500 million and its current ratio is 2.0. What is its level of current assets? If this firm’s quick ratio is 1.6 how much inventory does it have? Please write down your answer and go to the next slide when you are ready. Self Test 4.8 26 00:00 Self test answer 4.8. We can write down our current ratio equation as the current assets divided by the current liabilities. We were given that the current ratio equals 2.0 and the current liabilities equal 500 million. But by doing simple algebra we can see that the current assets of the corporation equals approximately 1 billion. Also the quick ratio formula is the current assets minus the inventories divided by the current liabilities. We were given the information that the quick ratio equals 1.6 and that the current assets were approximately 1 billion and the current liabilities were 500 million. Again by doing some simple algebra we can figure out that the inventories equals 200 million. Self Test 4.8 Answer 27 00:00 What is the inventory turnover vs. the industry average? 28 00:00 Our next four financial ratios deal with asset management. The first one is the inventory turnover ratio and in order to figure this out we take the total sales divided by the total inventories. In this case Allied had sales of approximately 7 billion in 2006 with inventories of approximately 1.7 billion. That means that the inventory turnover equals 4.10x. What does this 4.10x mean? It means roughly that Allied sold approximately four times its inventory over the course of the year. Another way to say this is that Allied sold out of all its inventory and turned over four times in 2006. Obviously the higher this number is the more reflective it is of customer demand and good sales numbers. So Allied Corporation would want a higher inventory ratio turnover vs. a lower one. As we can see when we look at the trend analysis in the inventory turnover ratio it started off as 4.8 times in 2004 and has been deteriorating from 4.7x in 2005 to now 4.1x and again when we compare that with the industry we see that it is significantly lower than the industry as well. So where does it leave us with the inventory turnover ratio? Well our next slide will discuss our thoughts here. Comments on Inventory Turnover 29 00:00 So after reviewing the trend analysis of the inventory turnover ratio and comparing it with the industry we know that the inventory turnover is well below the industry average. This could mean a couple of things. It could mean that Allied might have old inventory that it’s not selling or that its control over the inventory might be poor as well. Thus no improvement is actually currently forecasted given the trend analysis since they have been constantly deteriorating over the past three years as well. DSO is the average number of days 30 00:00 after making a sale before receivingOur next financial ratio is the DSO ratio or the Days Sales Outstanding ratio. The DSO ratio is the average number of days that it takes after making a sale before actually collecting and receiving the cash by Allied. We find the DSO by taking the accounts receivables and dividing it by the average sales per day. Thus the average sales per day is found by the total sales divided by 365 days in a calendar year. In this case we had accounts receivables in 2006 of approximately 878 million. We had annual total sales of 7 billion and divided that by 365 days and we get a total DSO ratio of 45.6 days. Again what does this mean? This means that from the time Allied Corporation makes a sale to a customer it takes approximately 45.6 days for them to actually receive cash for that sale that they made. Now the question might be, do you want your DSO higher or lower? I think the answer should be obvious by now. You want to be able to collect that cash as soon as possible so a lower day of sales outstanding is preferable to a higher days sales outstanding ratio. cash. Appraisal of DSO 31 00:00 Now that we’ve taken a look at the DSO ratio let’s look at the historical trend and compare it with the industry. We can see that it has been deteriorating from 2004 to 2006. Going from 37 days in terms of collecting the cash from sales to now 45 days. When you compare this with the industry it only takes 32 days to collect the cash it looks even poorer. So what do we know? We know that Allied collects on its sales too slowly and it’s getting worse. What this could mean is that Allied has a poor credit policy with the customer and is allowing them to basically pay on a 45 day basis instead of the industry average of the 32 day basis. It could also mean that the collections department within Allied Corporation is not doing a good enough job in terms of collecting sales. That could also question how much of those accounts receivables that they have on the books are actually bad customers who will never pay or are customers that the collections department of the company has just allowed for whatever reason to continue late payment. Fixed assets and total assets turnover ratios vs. the industry averageThe next two financial ratios that we look at to determine asset management efficiency are the fixed asset turnover ratio and the total asset turnover ratio. We can get the fixed asset turnover ratio by taking total sales and dividing it by the net fixed assets of the corporation. Again, we can get the sales from the top line in the income statement and we can understand the net fixed assets from the balance sheet. The $7,000,000,000 is noted in the top line sales revenue for 2006 for Allied Corporation and then, if you look in the balance sheet for the net fixed assets, we see that it was approximately $817,000,000. So the total sales divided by the net fixed assets gives us a fixed asset turnover ratio of 8.61x. So what does this 8.61x really mean? Well, what it means is that for every dollar Allied Corporation invests or spends on purchasing fixed assets, then it generates approximately $8.61 in revenue for the company. Obviously, the higher this number is, the more efficient they are at using the fixed assets of the corporation. The next financial ratio that we look at is the total asset turnover. And very similar to the fixed asset turnover ratio, we take the total sales and we divide it this time by the total assets of the company, instead of just the fixed assets. So in this case we’re taking the current assets plus the fixed assets, which equal the total assets of the corporation. And again, we have $7,000,000,000 in sales, we divide that by the current assets plus the fixed assets, which gives us approximately 3.5 billion in total assets for the company. This gives us a roughly 2.10x, which means that for every dollar that Allied Cor 32 00:00 Now that we have calculated the fixed asset and total asset turnover ratios, we can look at the trend analysis. And from the fixed asset turnover ratio, we see that it has actually been deteriorating from 2004 at 10x to now 2006 at 8.6x. Of course this was a drastic improvement from 2005’s fixed asset turnover of 6.4x, and actually, if we compare the current year’s 8.6x turnover to the industry average of 7.0x, we see that they’re actually doing better than the rest of the industry on average in choosing and picking their fixed assets and generating sales out of their fixed assets. The next ratio that we look at is the total asset turnover ratio, and again in the total asset turnover ratio, you can see that it took a dip in 2005 from 2.3x to 2.1x, and it continues to deteriorate slightly to 2.0x. And of course if we compare this with the industry, we can see that they are again below the industry average in terms of the total asset turnover ratio. So to say this another way, for the fixed asset turnover ratio, on average the industry produces roughly $7.00 in sales for every dollar they invest in fixed assets, whereas Allied Corporation receives 8.6 in revenue for every dollar they invest. And then for total asset turnover, for every dollar invested in assets by the company, the industry average is that you should get approximately $2.60 back in sales, and we can see that Allied Corporation is short there, getting back only $2.00 in sales for every dollar invested in assets. The fixed asset turnover projected is to exceed the industry average, so that looks pretty good. However, the total asset turnover is below the industry average, and if w Evaluating the FA turnover and TA 33 00:00 ratios turnover Now let’s take a moment again to review the materials that we have just covered. Self test question #4.9: Identify four ratios that are used to measure how effectively a firm manages its assets and write out their equations. Please take a moment to do so, and go to the next slide when you’re ready. Self Test 4.9 34 00:00 Self test 4.9 answer: The four equations that are used to measure how well a firm manages its assets are: 1. The inventory turnover ratio, 2. The DSO or day sales outstanding ratio, 3. The fixed asset turnover ratio, and 4. The total asset turnover ratio. The inventory turnover ratio is found by taking total sales and dividing by total inventories. The DSO ratio is found by accounts receivable divided by the average sales per day, and we find the average sales per day by taking the total sales and dividing it by the 365 days a year. The fixed asset turnover ratio is the sales divided by the net fixed assets, and the total asset turnover ratio is sales divided by total assets. Self Test 4.9 Answer 35 00:00 Self Test 4.10 36 00:00 Self test question 4.10: If you wanted to evaluate a firm’s DSO, with what would you compare it to? Please take a moment to answer this and go to the next slide when you’re ready. Self Test 4.10 Answer 37 00:00 Self test 4.10 answer: The firm’s DSO can be compared with the firm’s current credit collection policy. For example, if a firm’s collection policy calls for payment within 30 days, and the firm’s DSO is actually 45 days, then this indicates that customers are not paying their bills on time. We can also compare this DSO ratio to the industry and benchmark it to an industry average in order to determine whether or not the DSO ratio is better or worse than the industry. Self Test 4.11 38 00:00 Self test question 4.11: What problems might arise when comparing different firms’ fixed asset turnover ratios? Please take a moment to write down your answer and go to the next slide when you’re ready. Self Test 4.11 Answer 39 00:00 Self test 4.11 answer: Inflation has caused the value of many assets that were purchased in the past to be seriously undervalued. If we compare an old firm that has acquired many of its fixed assets years ago at low prices with a new company with similar operations that had acquired its fixed assets only recently, we would probably find that the old firm had a higher fixed assets turnover ratio than the new firm. However, this would be more reflective of when the assets were acquired than of inefficiency on the part of the new firm. Self test question 4.12: A firm has annual sales of approximately $100,000,000, $20,000,000 of the inventory and $30,000,000 of accounts receivable. What is the inventory turnover ratio, and what is its day sales outstanding ratio, based on a 365-day year? Please take a moment and write down your answer, and go to the next slide when you’re ready. Self Test 4.12 40 00:00 Self test 4.12 answer: We can find the inventory turnover ratio by taking the total sales and dividing it by the total inventories. The total sales of $100,000,000 divided by $20,000,000 of inventory gives us an inventory turnover ratio of 5.0x. What this means is that the company, on average, sells out five times throughout the year of its inventory. The next ratio is the day sales outstanding ratio, which is the accounts receivable divided by the average sales per day. Based on a 365-day period, we take $100,000,000 of sales and divide that by 365 days in order to get the average sale per day. We will use our receivables of $30,000,000 to divide upon the average sales per day, and we get a DSO of approximately 109.5 days. What this means is that, from the time that the sale is made to the customer, it takes the company on average another 110 days before it actually collects and receives cash from that sale. Self Test 4.12 Answer 41 00:00 Our next two ratios deal with debt management. The first one is the debt ratio, which is the total debt divided by the total assets. If we look at Allied Corporation’s balance sheet, we can find that the total debt, which is the current liabilities plus the long-term debt, is equal to the total debt, which was $1,100,000,000 plus $400,000,000. We take the total assets of approximately $3,500,000,000, and we find out that the debt ratio is essentially 44%. So what does this mean? This means that the company has decided to finance the purchase and ownership of the assets that it owns by approximately 44% debt, and then the rest with equity, or roughly 56% equity. So they’ve chosen to borrow funds, approximately 44% of the amount of the assets on the books. By itself the number doesn’t tell us much, but when we compare it with the rest of the industry, we can determine whether or not the company may be overleveraged, which means that the company is using debt, or it’s underleveraged, which means the company is not using enough debt. Next, we learn about the TIE ratio, T-I-E, which stands for times interest earned. We find the TIE ratio by taking the EBIT, which is the earnings before interest and taxes, also called the operating income of the company, and we divide that by the interest expense of the company. The interest expense of the company again is found on the income statement, and also can be calculated by looking at the debt that is outstanding on the books and the balance sheet as well. Thus, the operating income in this case was $493,000,000 approximately, and the interest expense was approximately $70,000. If we divide these by each o Calculate the debt ratio and times-interest-earned ratio. 42 00:00 So how does the debt management ratio compare to the rest of the industry? First off, when we look at the debt-to-asset ratio, and we look at it on a % basis, we see that we had about 55% of the firm’s balance sheet as debt in 2004, which ballooned all the way up to 80% in 2005, when we were rapidly expanding and borrowing a lot of money, and then we were able to pay some off in 2006, which has brought us back down to about 44%. Comparing that with the industry of 50%, we can see that if the company needed more cash and wanted to borrow more funds, it would have additional or reserve capacity to do so. So if the corporation is looking to expand into new product lines or projects and wants to raise more cash to do so, we can see that, in order to get to the industry average of 50%, they would roughly have about 8% more that they can put on their books, and borrow more versus issuing equity or using retained earnings. As for the TIE ratio, we see that that again had decreased significantly from ’04 to ’05, going into a negative state before coming back up significantly in 2006 to 7x, which represents again a much more healthy company. And if we compare with the industry average of 6.2x, you can see that we are also doing a lot better than the industry with the TIE ratio as well. So, in short, the debt-to-asset and the TIE ratio are better than the industry average. How do the debt management ratios 43 00:00 with industry averages? compare Self Test 4.13 44 00:00 Self test question 4.13: What are the three most important implications of financial leverage? Please take a moment to answer this question and go to the next slide when you’re ready. Self Test 4.13 Answer 45 00:00 Self test 4.13 answer: By using debt, or leverage, in a company, stockholders can control a firm with a limited amount of equity investment. Creditors look to the equity holders to provide a safety cushion, if you will, so that the more capital contributed by equity holders, the less risk debt holders face at the company defaulting on the debt. Also, if the firm earns more on its assets than the interest rate that it pays on its debt, then using debt can actually magnify the return on equity for shareholders. Self Test 4.14 46 00:00 Self test question 4.14: How does the use of financial leverage affect stockholders’ control position? Please take a moment to answer and go to the next slide when you’re ready. Self Test 4.14 Answer 47 00:00 Self test 4.14 answer: By using debt capital versus issuing new equity capital, stockholders do not have to dilute themselves and retain the same control, or ownership, in the firm. Self test question 4.15: How does the US tax structure influence a firm’s willingness to finance with debt? Please take a moment to answer the question and go to the next slide when you’re ready. Self Test 4.15 48 00:00 Self test 4.15 answer: By allowing corporations to deduct interest paid on debt borrowed, the US government is essentially subsidizing a portion of the capital. Therefore, the use of debt lowers the tax bill for the corporation and leaves more of the firm’s operating income to its investors. Self Test 4.15 Answer 49 00:00 Self test question 4.16: How does the decision to use debt involve a risk-versus-return trade-off? Please take a moment to answer the question and go to the next slide when you’re ready. Self Test 4.16 50 00:00 Self test 4.16 answer: The Corporation must balance the benefits of using debt, which include lowering the tax bill and protecting against dilution with the risks of using debt in the first place, which include increasing the financial distress if they are unable to make the payments on a timely basis. Self Test 4.16 Answer 51 00:00 Self Test 4.17 52 00:00 Self test question 4.17: Explain the following statement: Analysts look at both balance sheet and the income statement ratios when appraising a firm’s financial condition. Please take a moment to think about and write down your answer, and continue to the next slide when you are ready. Self Test 4.17 Answer 53 00:00 Self test 4.17 answer: Analysts look at the balance sheet to determine the proportion of total funds represented by the debt, and check the income statement as well to see the extent to which fixed charges are covered by the operating profits. Self Test 4.18 54 00:00 Self test question 4.18: Name two ratios that are used to measure financial leverage and write out their equations. Take a moment to do so and go to the next slide when you’re ready. Self Test 4.18 Answer 55 00:00 Self test 4.18 answer: The two ratios are 1. The debt ratio, which is found by taking the total debt and dividing it by the total assets, and 2. the TIE ratio, which is also called the times interest earned ratio, taking the operating income, or the EBIT (earnings before interest and taxes), dividing by the interest expense of the corporation. Self Test 4.19 56 00:00 Self test question 4.19: a company has EBIT of $500,000,000 and interest payments of approximately $50,000,000. What is its TIE ratio? Please take a moment to write down your answer and go to the next slide when you are ready. Self test 4.19 answer: The TIE ratio can be found by taking the operating income of the company and dividing it by the interest expense. The EBIT of the company is $500,000,000, and if we divide that by the interest expense of $50,000,000, then we get a TIE ratio of 10x [10 times], or 10.0x. What this tells us is that the operating income of the company could go down by 10 times before the company is no longer able to make its required interest payments. Self Test 4.19 Answer 57 00:00 Our next four financial ratios explain the profitability of a firm. Thus they are called the profitability ratios. The first one that we look at is the profit margin of the company, which equals the net income divided by the sales. The net income of Allied Corporation was approximately $253,000,000 in 2006, with total sales of $7,000,000,000, which gave us a profit margin of approximately 3.6%. What this tells us is that for every dollar of sales generated by the corporation, roughly 3.6 cents of that became a profit, or net income to the shareholders. The next financial ratio that we look at is the basic earning power of the corporation, or the BEP. This ratio seeks to analyze the raw earning power of the firm’s assets. Basically, it tells us how much cash the assets of the corporation are throwing off. We find that by taking the operating income, again the earnings before interest and taxes, and dividing that by the total assets. The EBIT of the corporation was approximately $492,000,000 in 2006, and the total assets were approximately $3,500,000,000, which gives us a basic earning power of 14%. Thus every dollar that was invested in assets of the corporation generated approximately $0.14 in actual cash flow, or operating income, to run the company’s operations. Profitability ratios: Profit margin00:00 Basic earning power 58 and Now we’ll look at the trend analysis and benchmark both of these ratios against the industry. As we can see from the profit margin side, 2004 was not that great and became considerably worse in 2005, but improved significantly in 2006, to 3.6%. Comparing that with the industry average of 3.5%, we see that it is actually going to exceed – or be above – the industry average for 2006 on the profit margin side. On the basic earning power of the company, you can see that again, we started off with 13% in 2004, took a big hit in 2005, but rebounded in 2006 to come back to 14%; but when we compare it to the industry average, we see that we’re still well below the industry average of 19%. So profit margin was very bad in 2005, but is projected to exceed the industry average in 2006. Overall, the profit margin looks pretty good. The basic earning power, because we’re looking at the earnings before interest and taxes for the operating income, it removes the effects of taxes and financial leverage interest charges on the corporation and is useful to compare apples to apples with another company. That is, the basic earning power is projected to improve again this year, to 14%, but is still below the industry average and there is definitely room for improvement. Appraising profitability with the 59 00:00 margin and basic earning power profit Profitability ratios: Return on assets and Return on equity 60 00:00 The final two profitability ratios that we look at are the return on assets ratio and the return on equity ratio. The return on assets ratio can be found by taking the net income and dividing it by the total assets of the corporation. The total net income, in 2006, of Allied Corporation was approximately $253,000,000, and again the total assets was approximately $3,500,000,000. This gave us a return on assets of approximately 7.3%. So what exactly does this ROA number mean to us? It means that, for every dollar that Allied Corporation invested in assets of the company, those assets produced approximately 7.3 cents back to the shareholders, or net income to the corporation, at the bottom line or the end of the day. The next ratio we discuss is the return on equity. This is found by taking the net income of the corporation and dividing it by the total common equity in the corporation. So thus the net income again was $253,000,000, and then the common equity in the corporation, if we look on the balance sheet, we’ll see that it’s approximately $1,950,000,000, which gives us a return on equity of approximately 13%. To say this another way is, for every dollar that was invested in the company and that had bought common stock in return, that share or that dollar produced approximately $0.13 in profits or net income for the shareholders at the end of the day. We will now look to the trend analysis and compare it with the rest of the industry in order to form a bigger view picture of what’s happening here. Appraising profitability with the 61 00:00 on assets and return on equity return When we compare the return on assets and the return on equity with the industry, we can see that both of these categories are below the industry average but have been improving from 2005 to 2006. So both ratios have rebounded from the previous year but are still well below the industry average; thus more improvement is necessary in both of these areas. It’s also important to note that wide variations of return on equity can happen based on the amount of debt capital or leverage that is taken in by the corporation, and that is because, if the corporation takes in more debt, and they are able to basically take that debt and employ it in projects which produce a basic earning power or a return that is higher than the cost of acquiring the debt in the first place, then the return on equity for the shareholders is going to be magnified. Effects of debt on ROA and ROE 62 00:00 So to sum up the effects of debt on return on equity and return on assets: For return on assets, the ROA is lowered by debt. Interest lowers the net income, which lowers the return on assets, because return on assets equals the net income divided by assets in the first place. For return on equity, however, it’s a little bit different. The use of debt also lowers the equity, but because of this, the use of debt could actually raise the return on equity because net income divides by the equity of the company. Problems with ROE 63 00:00 Some additional problems with looking specifically at the return on equity that you should be aware of: ROE and shareholder wealth are correlated, that is true, but problems do arise when ROE is the sole measure of the company’s performance, and the reason is that ROE does not consider risk. ROE also does not consider the amount of capital invested and it also might encourage managers to make investments and decisions based on ROE alone that would not necessarily benefit the shareholders. Thus ROE focuses only on returns, and a better measure would consider risk and return. Self Test 4.20 64 00:00 Now let’s take a moment to review the topics we have just covered. Self test question 4.20: Identify four profitability ratios and write out their equations. Please take a moment to do this and go to the next slide when you’re ready. Self test 4.20 answer: The four profitability ratios are the profit margin, the basic earning power, the return on assets and the return on equity. To find the profit margin, we take the net income and we divide it by sales; to find the basic earning power we take the EBIT and divide that by the total assets; to find the return on assets we take the net income and we divide it by the total assets; and for the return on equity we take the net income and we divide that by the total common equity. Self Test 4.20 Answer 65 00:00 Self test question 4.21: Why is the basic earnings power ratio useful to us? Please take a moment to answer this and go to the next slide when you’re ready. Self Test 4.21 66 00:00 Self test 4.21 answer: Basic earning power, or BEP, shows the raw earning power of the firm’s assets before the influence of taxes and leverage. Thus it’s useful when comparing firms in different degrees of financial leverage and tax situations. Self Test 4.21 Answer 67 00:00 Self Test 4.22 68 00:00 Self test question 4.22: Why does the use of debt lower the return on assets? Please take a moment to answer this and go to the next slide when you’re ready. Self Test 4.22 Answer 69 00:00 Self test answer 4.22: Leverage can lower return on assets because high-interest expenses will cause the net income to be relatively lower. Self Test 4.23 70 00:00 Self test 4.23 question: What does the ROE measure, and since interest expenses lower profits and thus the return on assets, does using debt necessarily lower the return on equity? Please explain your answer and go to the next slide when you’re ready. Self Test 4.23 Answer 71 00:00 Self test 4.23 answer: Return on equity measures the rate of return on common stockholders’ investments. Leverage can lower the ROE only if the basic earning power of the assets is lower than the cost of debt in the first place. Thus leverage can actually increase the return on equity if the basic earning power of the firm’s assets is greater than the interest paid on the debt, or what we call the cost of debt, which is typically equal to KD. Self Test 4.24 72 00:00 Self test 4.24 question: A company has $20,000,000 in sales and $1,000,000 of net income. Its total assets are $10,000,000,000, financed half by debt and the other half by common equity. Please answer the following questions: What is its profit margin? What is its return on assets? What is its return on equity? Would ROA increase if the firm used less leverage? Would ROE increase if the firm used less leverage? Please take a moment and answer the questions and go to the next slide when you’re ready. Self test 4.24 answer: What is its profit margin? Profit margin is found by taking net income and dividing it by sales. Net income of $1,000,000,000 divided by $20,000,000,000 gives us a 5% profit margin. What is its return on assets? Return on assets is found by taking the net income divided by the total assets. Net income of $1,000,000,000 divided by total assets of $10,000,000,000 equals a 10% return on assets. What is its return on equity? Return on equity is found by the net income divided by total common equity. Net income of $1,000,000,000 divided by $5,000,000,000 of common equity would give us a 20% return on equity. Self Test 4.24 Answer 73 00:00 Self test 4.24 answer (continued): Would the return on assets increase if the firm used less leverage? Yes, because the use of leverage drives down the net income, because of the associated higher interest rate payments. Would the ROE increase if the firm used less leverage? No, because ROE may increase if the company used more debt, not less debt. But again, if the basic earning power of the firm’s assets is greater than the cost of debt in acquiring debt capital in the first place, then in order for this to occur, then the ROE is actually going to increase if the company uses more debt. Self Test 4.24 Answer (cont.) 74 00:00 Our next three ratios look at the market value of a firm and answer the question: What are investors willing to pay for one share of the firm’s stock? So these three ratios, although expressed on a per-share basis, can be found on a market capitalization basis as well, by taking each share and multiplying the share price by the number of shares outstanding in order to get a market capitalization of the company. The first ratio we look at is the PE ratio, or the price to earnings ratio. This is the price of the firm’s stock (or what it’s trading at currently) divided by its earnings per share. We can find that the PE ratio is the $12.17 price, as indicated in the earlier slide, divided by the earnings per share, which is the net income divided by the number of shares outstanding. This gives us a price to earnings ratio of 12x. So what does this mean? This means that investors are willing to pay $12 for every dollar of positive net income that the corporation generates. Another way to figure out the price to earnings ratio is taking the market capitalization of the company and dividing it by the net income of the company. And again, the market capitalization of the company equals the number of shares outstanding multiplied by the share price. The next ratio we look at is called the PS ratio, also referred to as the price to sales ratio. This price to sales ratio is found by taking the price of the stock and dividing it by the total sales divided by the number of shares, or the sale price per share. Thus in this case, again the price of the stock is $12.17, we know that they did $7,000,000,000 in sales, and they had 250,000 shares outstanding, s Calculate the Price/Earnings, Price/Sales, and Market/Book ratios. 75 00:00 Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.As we look at the trend of the PE, PS and MB ratio, we notice that, in all three categories, it has gone up significantly from 2005 to 2006. For example, the price to earnings ratio started at 9.7x in 2004, took a big hit and was negative PE ratio in 2005, and came back strong at 112.0x. However, when we compare with the industry, we can see still that there is room for improvement, and the marketplace values the industry at a slightly higher PE ratio than the Allied Corporation at this point in time. The next ratio to consider is the price to sales ratio. We can see again that starting off as .5x in 2004, taking a dip to .04x in 2005 before rebounding to .43x in 2006, and we compare it with the rest of the industry, we see that it is significantly lower than what shareholders value the rest of the industry at, which is a 2x PS ratio and not a .43x. Our last ratio is the market to book ratio; we start off at 1.3x in 2004, we dip to .5x in 2005 before recovering to 1.56x in 2006 – again much lower than the industry average of 2.4x. So basically what these ratios tell us is that the shareholders are beginning to buy the story of management, and they are beginning to see the realized operational performance of the company, and starting to reward the company with a higher value in the PE, PS and MB ratio, but they still think that there is some improvement left to work on for the corporation, and that’s why they are undervalued when compared with the rest of the industry. 76 00:00 Analyzing the market value ratios 77 00:00 Again to sum up each of the three different variables and how we use them to analyze the market value, for the PE ratio, it tells us how much investors are willing to pay for a dollar of earnings. For the PS ratio, it tells us how much investors are willing to pay for a dollar of sales. For the MB ratio, it tells us how much investors are willing to pay for a dollar of book value equity. And for each ratio, the higher the number, the better, and for the PE and MB ratios, they are high if the ROE is high and the risk is low. Generally, early stage companies are valued on a price to sales ratio versus a price to earnings ratio. And the reason is that they typically have very little history of positive earnings, if any at all, and thus, looking at their sales growth, it’s more of a determining factor of the actual value of the company versus the actual earnings of the company. Thus the PE ratio is generally reserved for companies that are in non-technology industries, in old-line manufacturing industries, companies that have been around for a while and have been able to generate earnings and profits for their shareholders. Self Test 4.25 78 00:00 Now let’s take a moment to review the topics we have just covered. Se ????? ?????? Financial Decisions Chapter5 Henry Wong ????? Push here to start Home Work ???????? ?????????? slide/fd_05slide.swf flv? ? ? ? ???? flv/fd_01vid000.flv 00:01.0 flv/fd_05vid001.flv 00:49.0 flv/fd_05vid002.flv 02:12.8 flv/fd_05vid003.flv 02:47.8 flv/fd_05vid004.flv 00:20.9 flv/fd_05vid005.flv 00:53.9 flv/fd_05vid006.flv 00:17.0 flv/fd_05vid007.flv 00:30.0 flv/fd_05vid008.flv 00:44.8 flv/fd_05vid009.flv 03:28.8 flv/fd_05vid010.flv 00:46.0 flv/fd_05vid011.flv 01:00.9 flv/fd_05vid012.flv 00:14.0 flv/fd_05vid013.flv 00:32.0 flv/fd_05vid014.flv 00:12.0 flv/fd_05vid015.flv 00:35.9 flv/fd_05vid016.flv 00:13.0 flv/fd_05vid017.flv 00:37.9 flv/fd_05vid018.flv 00:13.8 flv/fd_05vid019.flv 00:45.9 flv/fd_05vid020.flv 00:15.9 flv/fd_05vid021.flv 01:01.9 flv/fd_05vid022.flv 00:15.0 flv/fd_05vid023.flv 00:26.9 flv/fd_05vid024.flv 04:37.7 flv/fd_05vid025.flv 00:15.9 flv/fd_05vid026.flv 01:03.8 flv/fd_05vid027.flv 00:16.0 flv/fd_05vid028.flv 00:13.0 flv/fd_05vid029.flv 00:13.9 flv/fd_05vid030.flv 00:34.0 flv/fd_05vid031.flv 02:52.8 flv/fd_05vid032.flv 00:19.0 flv/fd_05vid033.flv 00:20.9 flv/fd_05vid034.flv 00:11.9 flv/fd_05vid035.flv 00:31.9 flv/fd_05vid036.flv 00:59.9 flv/fd_05vid037.flv 00:43.0 flv/fd_05vid038.flv 00:17.9 flv/fd_05vid039.flv 00:41.9 flv/fd_05vid040.flv 00:12.6 flv/fd_05vid041.flv 00:23.9 flv/fd_05vid042.flv 00:21.8 flv/fd_05vid043.flv 01:07.9 flv/fd_05vid044.flv 01:03.9 flv/fd_05vid045.flv 04:24.7 flv/fd_05vid046.flv 00:24.0 flv/fd_05vid047.flv 00:31.0 flv/fd_05vid048.flv 00:21.0 flv/fd_05vid049.flv 00:23.9 flv/fd_05vid050.flv 01:03.9 flv/fd_05vid051.flv 00:43.8 flv/fd_05vid052.flv 00:50.8 flv/fd_05vid053.flv 00:51.9 flv/fd_05vid054.flv 01:00.9 flv/fd_05vid055.flv 00:50.0 flv/fd_05vid056.flv 01:27.9 flv/fd_05vid057.flv 00:17.9 flv/fd_05vid058.flv 00:26.0 flv/fd_05vid059.flv 00:19.0 flv/fd_05vid060.flv 00:41.0 flv/fd_05vid061.flv 00:16.8 flv/fd_05vid062.flv 00:52.0 flv/fd_05vid063.flv 00:18.0 flv/fd_05vid064.flv 01:33.9 flv/fd_05vid065.flv 00:53.9 flv/fd_hw05vid001.flv 00:12.2 flv/fd_hw05vid002.flv 00:11.6 flv/fd_hw05vid003.flv 00:42.5 flv/fd_hw05vid004.flv 00:12.8 flv/fd_hw05vid005.flv 01:34.4 flv/fd_hw05vid006.flv 00:11.7 flv/fd_hw05vid007.flv 00:28.7 flv/fd_hw05vid008.flv 00:26.0 flv/fd_hw05vid009.flv 00:58.5 flv/fd_hw05vid010.flv 00:15.8 flv/fd_hw05vid011.flv 00:21.6 flv/fd_hw05vid012.flv 00:10.3 flv/fd_hw05vid013.flv 00:58.0 flv/fd_hw05vid014.flv 00:10.5 flv/fd_hw05vid015.flv 00:20.2 flv/fd_hw05vid016.flv 00:07.7 flv/fd_hw05vid017.flv 00:59.4 flv/fd_hw05vid018.flv 00:43.6 flv/fd_hw05vid019.flv 00:57.9 flv/fd_hw05vid020.flv 00:51.4 flv/fd_hw05vid021.flv 01:00.7 ???????? ???? ?? 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 ????? ?????? ???????? captivate? ? ? ? ? ? Script ? ? ? Script Introduction 1 00:00 This Page is Menu of? Lectrue. ? ? ?? ????? Chapter 5. Welcome ?back. 5? am?Professor? Henry Wong, and ? ? 5 ? we ?are going ?to ?talk ?about ? ? ? ? ? 5:? Financial Markets? and ? ? ? ? ? ? ? In?this? chapter ?we ? ? ? ? ? ? ? ? ? will learn ?how the ? ? ? ? ?capital ?allocation ? ? ? ? ? works, ? ? ? different? kinds ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? which ?assets? or ?goods ? ? ? traded on, ? ? ? the kinds of financial institutions that facilitate the trading of this market place, and we talk specifically about stock markets, returns on stock markets, and about stock market efficiency. CHAPTER 5 Financial Markets and Institutions 1 00:00 ? ? ? ? I ? ? ? ? ? ? ? Henry Wong? ? today ? ? ? ? ? ? ? ? ? ? ? ? Chapter ? ? ? ? ? ? ? ? ? ? ? ? ? Decisions. ? ? ? ? ? ? ? ? hope that you ? ? ? ? ? ? ? ? ? ? entire ? ? ? ? ? ? ? ? ? ? process ? ? ? ? the ? ? ? ? ? ? ? ? of financial markets in ? ? ? ? ? ? ? ? ? ? are ? ? ? ? ? ? and ? ? The Capital Allocation Process 2 00:00 Let’s start talking about ?the capital? allocation ? ? ? ? ? ?Like ?any market,? there ? ? ? buyers? of?goods ? ? ?sellers ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? capital ?flows efficiently ? ? ? ? ? ? ? who ? ? ? ? ? ? ? ? ? ?or ? ? ? ? ? ? ? ?sell ?capital, to?those ? ? ?can demand ? ? those ?who purchase ? ? ? ? ? ?So ? ? ? ? ? ? yourself going ?in ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? you want to? buy ? ? ? ? ? ? ? ? Well you ? ? ? ? be ?the purchaser of? apples, ?and? the ? ? ? ? ? store ?would ? ? the ? ? ? ? ?of ? ? ? ? ? And ? ? ? ? the ? ? ? ? ? ? ? ?takes place ?is ? ? ? grocery ?market. ? ? ? ? ? a ? ? ?like ?the financial markets?that ?we ? ? ? ? ? ? ? ?but instead? of ?a?grocery ? ? ? ? ?there ? ? a ? ? ? ? ? ? market,? and ? ? ? ? ? of? apples, ?we ? ? ?talking ? ? ? ? capital, ? ? ? ? ? ? ? ? money ?is ? ? ? ? sought ? ? ? ? by ?people?who demand ? ? ?or ? ? ? ? ?who are ? ? ? ? ? for ? ? ? ? ?and then suppliers of?capital ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? process. ? ? ? ? ? ? ? ? ? ? ? are ? ? ? ? ? ? ? and ? ? ? ? of goods. In a well-functioning economy, ? ? ? ? ? ? ? ? ? ? ? ? ? ? from those ? ? supply capital, ? essentially ? ? ? ? ? ? ? ? ? ? ? who ? ? ? ? ? ? or ? ? ? ? ? ? ? ? ? ? capital. ? consider ? ? ? ? ? ? ? ? ? to a grocery store, and ? ? ? ? ? ? ? ? some apples. ? ? ? ? ? would ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? grocery ? ? ? ? ? ? be ? ? seller ? apples. ? ? where ? ? transaction ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? This is ? lot ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? have today, ? ? ? ? ? ? ? ? ? ? ? store, ? ? ? is ? financial ? ? ? ? ? ? instead ? ? ? ? ? ? are ? ? ? ? about ? ? ? ? ? or money. So ? ? ? ? being ? ? ? ? after ? ? ? ? ? ? ? ? ? ? it, ? people ? ? ? ? looking ? ? money, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? This is whatthiscall?suppliers? of ?capital. These ?are individuals ? ? ?institutions ? of? capital? ? ? ? ? in ?the They have moreexample,? it’s? pretty easy themselves ?andthe? groceryto? either loan out orapples, you go to the produce of capital or demanders of capitalthem a certain price. These groups are saving money and they are looking for a rate of return on their investment when they loan their capital out to other people. What are the demanders or the users of the capital? These are individuals and institutions that need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital that they borrow. Put these buyers and sellers together in the market place and you have essentially the entire capital allocation process. have “excess How is capital transferred between 00:00 and borrowers? 3 savers Now, how is we ? ? ? ? ? ? ? ? ? ? ? ? ? ? the buyers? of ?capital and? the ? ? ? ? that ? ? ? ? ? Well,funds.” grocery? store ? funds ?than ?they ?need ?for - ? ? ?go ? ? ? they want ?store,? you ? ? ? for make available to purchasers section, take the apples and take for to the cash register and purchase them. capital transferred between ? ? ? ? ? ? ? ? ? and ? ? sellers ? ? ?????? ??? ??? ? ? ? ? ? ? ? you ? into ? ? ? ? ? ? ? ? ? look Well,testthe financial markets, it’s a ? ?review? and ? ? complex. ? three? different? ways? that? capital? is ?transferred? between?savers and ? and ? ? ? ? ? of? capital. The first waymoments to jot down your answerwhere go to the a direct transaction are ready. party, who could be the buyer, and the other party, who is the seller of capital, in order to access the correct capital. So in the grocery store example, this would be a direct transfer. bit more ? ? ? ? There are really ? ? ways that capital is ? ? ? ? ? between ? ? ? ? ? sellers our ? ? transfer. This is Self Test 5.1 4 00:00 Self in question ?5.1: ?Let’s ?? ???? ?? ?? ?little?? ? ???? ?identify?the ???? ?? ? ?? ???? ?? ?? ? three 3? ?? ? ?? ?? ?3 ?? 1 ?? ? ?? ?? ??transferred? ?? ? ???? ??buyers borrowers? in ?? ? ??society. ?Take ?a? few ? is? a direct ? ? ? ? ? ? ? ? ? ? ? ?and there is next slide when you between one 5.1: ? ? ? ? ? ? now take a ?? ?? ? ??????? ??? ??????? ????????? ? ????? ?? ?? ? ????? ? The second5.1 answer: The three differentallowsthat capitalbe transferred is through a middleman, or what is called an investmentbusiness house.its stock directly to investors without going through are looking for capital to purchase the right capital for the right source. So imagine yourself again walking into the grocery store and looking for apples. But you are looking for a certain kind of apple – a Fuji apple. And you talk to one of the people who works in the grocery store in the produce section who provides a very expert opinion about apples and you say, “I am looking for a certain kind of Fuji apple,” and that person makes a recommendation and is able to facilitate a transaction with the correct source of apple that you are looking for. Well, this is essentially what investment banking houses do every day in the real finan Self test way that the ?financial? market ?ways ? capital to? ? ? ? ? ? ? ? ? ? ? ? our society is 1/ direct transfer, which is when a banking sells This middleman basically allows and helps buyers who any kind of financial institutions is transferred in Self Test 5.1 Answer 5 00:00 ? ? ? ? ? ? ? ? ? ? ? 3 2 ? transferred ? ? ? ? ? savers ? ? borrowers ? ? ? economy is ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Different from investment ? ? ? ? ? ? ? ? ? ? ? are ? ? ? ? ? ? ? ? ? ? banks ? ? ? if you ? ? ? go and ? ? ? loan for ? ? ? way 5.1 ? ? ? ? ? ? ? ? ? ? ? ???? ?? ? ? ? ? ? ? car, you ? ? ? talk to ? financial intermediary ? ? ? ? ? ? ? ? ? ? ? ? ? ? quote ? ? ? best ? ? ? ? ? essentially these ? ? ? ? ? ? direct transfer, investment ? ? ? ? ? ? ? ? ? ? financial intermediaries are ? ? most efficient ways that capital ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? sellers of ? ? ? ? ? ? ? ? ? ? ? place. Andan investmentthird ? ? ? that? capital? is ? ? ? ? ? ? ? ? between ? ? ? ? ?andcompany ? ? in? our ? ? ? ? the ? through ?financial ?intermediatories. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? banking? houses, ?these ? ? ?more ?like ?commercial ? ? ? ? where ? ? ? ? ?want ?to ? ? ? ? ?get a ? ? ? ? ? ?a? home? or ?for a ? ? ? ? ? ?would ? ? ? ? ? a ? ? ? ? ? ? ? ? ? ? ? ? ? ? who ?would be? able? to?give?you a ? ? ? ? on? the ? ? ? rate.? So, ? ? ? ? ? ? ? ? ? ? ? three ?ways, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? banking? houses and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? is? transferred between? buyers and ? ? ? ? ? ? ? capital? in ?our market ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 3 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 2/ finally the ? banking house which serves ? promote the globalization? of ? ? ? and facilitates ? ? ? ? ? ? ? ? ? ? stock jot downwhat we call and go to the a man between ? Self Test 5.2 6 00:00 Self test question ?5.2: ?Why do??policy? ?? ???? ?as ?? ?middle?? ???? ?? ?? ?? ????the ?? ??financial ?markets? Pleaseissuance moment? to ?through ? your answer underwriting. next slide when you are ready. take a of ? ? ? ? ? ? 5.2: 1 ? ? ? ? ? ???? ?? ? makers ?? ??? ?? ?? ?? ? ? ? ?? ??? ?? ?? ?? ? ? ? And finally, 3/ financial intermediaries help the capital allocation process becausefinancial markets and institutions. or in the fund managers impossible for an invest directly inits full potential if it does not have access to a full functioning and well functioning financial system. For this reason alone, policy makers often promote the globalization of financial markets. investors will invest the the Self Test 5.2 Answer 7 00:00 Self test 5.2 answer: ? ? ? 5.2? development ? ? ? ? ? ? ? ? ? ? ? ? ? with ? ? ? ? ? ? ? of ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?in ? ? ? banks ? ? ? ? ? ? ? ? ? ? ? ? not ? who ? ? turn will ? ? ? ? ? ? ? reach ? ? ? ? company ?themselves.? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? It is difficult if ? ? ? ? in ? ? ? ? economy to ? ? ? ? ? ? Economic ? ? ? ? ? is highly correlated ? ? ? efficiency ? ???? ?????? 2 ? ? ? ? that the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? capital is These are the three ways ? ? ? ? ? ? capital ?allocation process? is ?achieved and ? ? ? ? ? ? ? transferred between ? buyers ? ? ? sellers in our financial market place. ? ? and What is a market? 8 00:00 Now that we have ? ? ? ? ?about ? ? ? capital ?is ? ? ? ? ? ? ? ?in ?our marketplace ? ? ? ? ? ?buyers? of? capital ?to ? ? ? sellers ?of ?capital, let’s ?focus ? ? ? ? ? ? ? ? ? ? what a ? ? ? ? ? ? ? ? ? ? is. ? ?market? in ?simple? terms ?is ? ? ? ? goods ?and services ?are? exchanged. ?A? financial? market ? ? ? ? however, ? ? a ? ? ? ? where ?individuals? and ? ? ? ? ? ? ? ? ? wanting ?to ? ? ? ? ?funds ? ? ?bought ? ? ? ? ? ? with? those ?having? a surplus of funds. Transactions can occur in the physical realm on stock exchange boards, or even in the digital electronic realm. Think of things like eBay, which is essentially a digital market place of goods. talked ? ? ? how ? ? ? ? ? transferred ? ? ? ? ? ? ? ? ? ? from the ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? specifically on ? ? ? ? market actually ? ? A ? ? ? ? ? ? ? ? ? ? ? where ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? place ? ? ? ? ? is ? place ? ? ? ? ? ? ? ? ? ? ? organizations ? ? ? ? ? borrow ? ? ? are eBay? together ? ? ? ? ? ? ? ? ? ? ? ? 3??????????????????????????????????????????????????????????????????????????????????? Now let’s talk about the different types of financial markets that are out there. The first one we will discus are physical asset markets vs. financial asset markets. Physical asset markets, sometimes called real or tangible asset markets are for those products such as wheat, autos, real estate, computers, machinery, etc – anything that is tangible that you can actually touch. These are called physical asset markets. Now they are different from financial asset markets which deal in financial agreements between two parties, such as stocks, bonds, notes, mortgages, etc. and really any claim on real assets is really a financial asset as well.Money markets are really the markets for short term liquid securities and the New York, London and Tokyo stock exchanges represent the biggest money markets in the entire world. Now they are diff Types of financial markets 9 00:00 ???3??????????????????????????????????????????? The importance of financial markets00:00 10 The primary a market. Then there So between primary secondary markets. which of the What are derivatives? How can they 00:00 11 be used to reduce or increase risk? New York stock trend ?in ? ? ? ? example, ? financial markets? has ? ?capitaluse of? derivatives. ?is ? what exactly? are ? ? ? ? ? ? ? ?and? how ? ? ?they?be ?used ?to ? ? ? ? ?or ? are ?the? risk? ? A in ? ? ? ? companies raise valuecapital. ? ? ?corporation? receives these ?proceeds from any ? an ?option? or ?a? future contract. ?It ? ? ? be ?used ?to ? ? ? ? or? reduce risk. ?For example, ? ? ? ? ? ? ? ? ? ? ? ? profit falls ?when ?the dollar ? ? ? ? value, can ? ? ? ? ? ? ? ?currency futures? that? do ?well ?when?the dollar ? ? ? ? ? ? ? ? ? ? speculators can ?use? derivatives ? ? bet ? ? ? ? ?direction ?of ? ? ? ? ?stock ? ? ? ? ? interest ? ? ? ? ?exchange rates ?and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong. Here derivatives can increase risk. Another important ?exchange, for ?years ? is a ? ? ? ? ? example ?of been ? ? ? ? ? ? ? ? ? ? ? ? ? ? the? difference ? ? derivatives and ? ? can ? ? ? ? ?Primary markets ? ? ? markets ? derivatives ? ? ? ? ? ? ? ?new? ?is ? ? ? The ? ? ? ? ? ? price ? ? ? ? ? ? security, such as sale ? ? stock in ? ? ? primary ?market. can ? ? ? ? hedge ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? an importer, whose ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? loses ? ? ? ? ? ? re-purchase ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? weakens. Also, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? to ? ? on the ? ? ? ? ? ? future ? ? ? prices, ? ? ? ? ? rates, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? are recent ? ? in ? ? ?? ? the ? ? ??? ? ? reduce ? increase ? ? corporation does securities any funds or proceeds from the sales another ? ? ? ? in ?the secondary market from investors. The New York stock exchange, for example, is a secondary market. ? ? ? not receive ? ? "derived" from the ? ? of of securities ? ? ? ? ? ? ?? ???? ?? ? Now secondary markets ? ?the markets? in which existing ?already ? outstanding commodities have been traded ?among investors, after they have been issued by the corporations. Thus the ? Self Test 5.3 12 00:00 Now let’s take a moment and review the topics that we have learned. Self test question 5.3 Distinguish between physical asset and financial asset markets. Next, we differentiate the difference between spot and futures markets. Spot markets are markets in which assets are bought or sold for on the spot delivery, literally within a few days. That is where the name “spot markets” comes from, from “on the spot delivery.” Self Test 5.3 Answer 13 00:00 Self test 5.3 answer Physical asset markets or real or tangible markets are for those products that you can actually physically touch and feel; things such as cars, automobiles, and computers. Financial asset markets deal with financial and contractual agreements between two parties, like stocks, bonds, notes, mortgages or really any other claim on real assets themselves. Self test question 5.4 What's the difference between spot and future markets? Take moment physical or your answer and go future date. For when you are ready. Self Test 5.4 14 00:00 Futures markets, however, are markets in which participants agree to buy and sell anda asset – to jot down financial – at some to the next slide example, an oil company can enter into a futures contract in which it agrees today to sell 1,000 barrels of oil six months from now at a price today of $50 per barrel. This is an example of the futures market. Self Test 5.4 Answer 15 00:00 Self test 5.4 answer (previous says self test 5.4 - here says 5.14???) Spot markets are markets in which assets are bought or sold for “on the spot” delivery…literally, in a few days. Futures markets are markets in which participants agree today, to buy or sell an asset at some time in the future. For example, an oil company can enter into a futures contract in which it agrees today to sell 1,000 barrels of oil to a purchaser for some time in the future at a certain specified price, like $60 per barrel. Finally, question 5.5 What’ the difference between primary and secondary markets? Take a moment to they about your answer to go to the next slide two you are ready. Self Test 5.5 16 00:00 Self testlet’s differentiate the difference between private and public markets. In the private marketsthink allow transactions and be negotiated between when or more parties. Agreements can be tailored to fit the deal as it stands, or leasing agreements require more expertise to understand and are less liquid than public market securities. Whereas in the public markets, they have the markets in which corporations traded on organized first time. The corporation receives the proceeds appeal to a broad rage of investors which do Self Test 5.5 Answer 17 00:00 Self test 5.5 answer Primary markets are got standardized contracts that areraise capital for theexchanges and standardized contractual features that from any sale of stock in the primary market.not require expertise to the secondary market where average “Joes” can make purchases and sell And thus, the marketplace, are the areas and th gets none of these proceeds. The corporation does not receive any proceeds from the sale of stock in the secondary market to investors. The New York Stock Exchange is a great example of the secondary market. That's different than understand, and wide ownership allows for relatively easy liquidity. stock in these five areas and the corporation Self Test 5.6 18 00:00 Self test 5.6 Differentiate between private and public markets. Take a moment to jot down your answer and go to the next slide when you are ready. Self test 5.6 answer Private markets allow transactions to be negotiated directly between two or more parties. Agreements can be tailored to fit the deal. These agreements require more expertise to understand and are less liquid than the public market securities. Public markets have standardized contracts which are traded on organized exchanges. This standardization of contracts allows investors to quickly understand and comprehend the different agreements involved in public securities. Standard contractual futures appeal to a broad range of investors and do not require an expertise to understand. A wide ownership allows for a relatively easy liquidity. Self Test 5.6 Answer 19 00:00 Self Test 5.7 20 00:00 Self test question 5.7 Why are financial markets essential for a healthy economy and economic growth? Take a moment to think about your answer, jot it down and go to the next slide when you are ready. Self Test 5.7 Answer 21 00:00 Self test 5.7 answer A healthy economy is dependent on efficient fund transfers between people who are savers of capital to individuals and firms who are borrowers of financial capital. Without these efficient transfers the economy simply could not function. Think about an electrical company in your area. If the electrical company could not raise capital to run its operations, then the citizens would not get electricity and so on and so forth. You can see what kind of problem this represents if an efficient capital allocation process is not available in financial markets. And finally, financial markets spur efficient costs to consumers. So because you have financial markets and you have pricing which is dictated by supply and demand, consumers are always and hopefully going to pay the lowest cost for whatever good th Self Test 5.8 22 00:00 Self test question 5.8 What is a derivative and how is its value related to that of an underlying asset? Take a moment to think about your answer, jot it down and go to the next slide when you are ready. Self test 5.8 answer A derivative is any security whose value is derived from some price of some other underlying asset. Thus, the value of the derivative depends upon the value of the underlying asset. Generally speaking, these securities are very complex and require expertise and skill to understand and are very risky. Self Test 5.8 Answer 23 00:00 Now that we have discussed the different types of financial markets in the marketplace, now it is important to understand who the players are and the types of financial institutions that do business in these financial markets. First off, there are the commercial banks. These are generally the everyday banks that you can think about when you think about the American banking system such as the Bank of America or Wells Fargo bank, or really any commercial bank that you could walk down the street, deposit money with and in return they give you interest for the money being deposited. Now, what they do with your money is they take your money and they reinvest it into other individuals or institutions that require money from them and they loan it out at a higher interest rate. That's different than the investment banks, which Types of financial institutions 24 00:00 Self Test 5.9 25 00:00 Now let’s review the topics that we have covered so far. Self test question 5.9 What is the difference between a pure commercial bank and a pure investment bank? Jot down your answer and go to the next slide when you are ready. Self Test 5.9 Answer 26 00:00 Self test 5.9 answer Investment banking houses such as Merrill Lynch, Morgan Stanely, GoldmenSachs or Credit Suisse Group, provide a number of services to both investors and companies planning to raise capital, or offer merger and acquisition advice to these companies. Whereas commercial banks like Bank of America, Wells Fargo, etc., serve a variety of savers and borrowers. They offer many services, including broker services, lending services, and insurance services. In recent years you have seen a lot of commercial banks actually start to form investment banking arms, so that Bank of America now has Bank of America securities, which is essentially the investment banking arm of the commercial bank, Bank of America. As we will see in the future, more and more banks will move from traditional commercial lending, to the e Self Test 5.10 27 00:00 Self test question 5.10 List three major types of financial institutions and briefly describe the primary function of each. Take a moment to jot down your answer and go to the next slide when you are ready. Self test 5.10 answer Please refer to pages 150 - 152 in your text book for the various entities. Self Test 5.10 Answer 28 00:00 Self Test 5.11 29 00:00 Self test question 5.11 What are some of the important differences between mutual and hedge funds? How are they similar? Take a moment to answer this question and then go to the next slide when you are ready Self Test 5.11 Answer 30 00:00 Self test 5.11 answer Similarities are that they pool capital to invest in public securities, but the difference is that hedge funds have a much wider investment strategy; whereby they are allowed to invest in both public and private companies, and employ complex investment strategies, thus making it much more high risk than mutual funds. As well as this, they take on institutional investors, generally at a much higher capital commitment, than mutual funds do. Physical location stock exchanges vs. Electronic dealer-based markets 31 00:00 Next we look specifically at the stock market. In the stock market there are two different kinds of markets that we talk about. The first ones are the physical location stock exchanges, and the second one are the electronic dealer based markets. These physical location stock exchanges are the New York Stock Exchange, the American Stock Exchange in San Francisco, etc. These are also sometimes called auction markets. They are called auction markets because what happens is that buyers of securities will bid or ask a certain price of those securities, while sellers of those securities will sell those securities at whatever bid or ask price they deem appropriate. So there is a marketplace and a negotiation that occurs between buyers and sellers, and finally a price is reached. This is the same thing that actually happens Let’s review again the topics that we have covered. Self test question 5.12 What are the differences between the physical location exchanges and the NASDAQ stock market? Take a moment to jot down your answer and go to the next slide when you are ready. Self Test 5.12 32 00:00 Self test 5.12 answer The big difference is that the securities are bought and sold at a physical location like the New York Stock exchange, but that NASDAQ transactions can occur anytime or anywhere, because they are done electronically. Self Test 5.12 Answer 33 00:00 Self Test 5.13 34 00:00 Self test question 5.13 What is the bid ask spread? Take a moment to jot down your answer and go to the next slide when you are ready. Self Test 5.13 Answer 35 00:00 Self test 5.13 answer Dealers who make a market in a particular security, will quote a price for what they are willing to pay or buy for that stock. This is called the bid price. A price at which they are willing to sell is called the ask price. The bid - ask spread is essentially the difference between the bid and ask prices, and also represents the dealers market, or the profit they expect to receive in that particular security. Stock Market Transactions 36 00:00 Here are a couple more examples to help you differentiate between the difference between a primary stock market transaction and a secondary stock market transaction. The first example we have is Apple computers, which decides to sell additional stock with the assistance of an investment banker. An investor purchases some newly issued stock. Is this a primary market transaction or a secondary market transaction? Since new shares of stock are being issued, this is called a primary market transaction. The second example is, what if instead the investor buys existing shares of Apple stock in the open market, say from another investor. Is this a primary or secondary market transaction? Since no new shares are created in this instance, this is called a secondary market transaction. Another very common stock market transaction that you have probably heard or read about, is called the IPO or the Initial Public Offer. The question is - What exactly is an IPO? An initial public offering is where a company offers its securities to the public market for the first time. This is called “going public.” Going public enables a companies owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market. Public companies are subject to additional regulations and reporting requirements, as a result of going public. What is an IPO? 37 00:00 Self Test 5.14 38 00:00 Let’s review some of the topics that we have already covered. Self test question 5.14 Differentiate between closely held and publicly owned corporations. Take a moment to think about your answer and when you are ready, go to the next slide. Self Test 5.14 Answer 39 00:00 Self test 5.14 answer. Closely held corporations are privately owned corporations and the stock is held by a limited number of investors. It is typical that these investors are active in the management of the company as well. Closely held corporations stock is not traded on public exchanges. Now the difference between closely held corporations and public corporations, of course, is that publicly owned corporations are owned by thousands of investors who are not active in the day-to-day management of the company; but the public corporations’ stock is fully tradable on public exchanges. Self Test 5.15 40 00:00 Self test question 5.15 What is an IPO? Jot down your answer and go to the next slide when you are ready. Self test 5.15 answer An IPO is called an Initial Public Offer. It is the initial public offering of a corporation's stock for the first time to the public. Sometimes private companies are said to be 'going public,’ when they sell stock to the public for the first time. Self Test 5.15 Answer 41 00:00 Self test question 5.16 Another stock market transaction in the marketplace is called a “Dutch Auction.” What exactly is a Dutch Auction and why is it used? Think about your answer, jot it down and go to the next slide when you are ready. Self Test 5.16 42 00:00 Self Test 5.16 Answer 43 00:00 Self test 5.16 answer Rather than have an investment bank price the stock, the price of an IPO stock is set at the highest price, which causes all of the shares to be sold. This is called the clearing price. Investors who set their bid at or above the clearing price receive all the shares that they bid for at the offer price. Now many of you might have read that Google Inc. used the dutch auction in its 2004 IPO, because they believed it was a more fair way to price its stock, than the traditional route of allowing investment bankers to price it. Google was a special circumstance. They had a lot of leverage and they wanted to do things their way. We are not quite sure that companies in the future will be able replicate Google’s model of the Dutch Auction in pricing securities and going public. Most experts agree tha Historical stock market performance, S&P 500 (1968-2004) 44 00:00 Our next slide shows the historical stock market performance based on the S&P500. Now first thing is, what exactly does the S&P500 stand for? S&P stands for Standard and Poor's and the 500 represents 500 of the top companies that the Standards and Poor's track on the New York Stock Exchange. The Standard and Poor's 500 essentially is a composite index of some of the top companies in the American economy. When we look at the S&P500 index from 1968 to 2004 in the chart on the slide, what we see is that for most of the years the returns have been pretty good. There have been more up years than down years, but nonetheless, we can see that 9 out of these 37 years of the S&P500 index, we have had down years as well. Where can you find a stock quote, and what does one look like? 45 00:00 Now, we have been talking about a market index and the aggregate, and we were talking about the S&P500 index before. What if you wanted to know the specific performance of a certain stock within the S&P500, or any stock for that matter. Where would you find that stock quote? and What does one look like? Well stock quotes actually can be found in a variety of different journals and periodicals. Most easily they can be found on-line at Yahoo Finance or CNN Money or MSN Money central, and typically they look like what we see on the right. They will give you the name of the company, in this case we are looking at Glaxo-Smithkline’s stock quote, and you can see that next to the top of the company name we have the stock market symbol which is GSK. We know that it trades on the New York stock exchange because that is what it Now let’s review some of the topics that we just covered. Self test question 5.17 Would you expect a portfolio that consisted that consisted of the S&P500 stocks to be more or less risky than a portfolio of NASDAQ stocks? Take a moment to think about your answer, write it down and go to the next slide when you are ready. Self Test 5.17 46 00:00 Self Test 5.17 Answer 47 00:00 Self test 5.17 answer You would expect the NASDAQ portfolio actually to be more risky than the S&P500 because the NASDAQ is comprised of mainly new economy kinds of companies. These new economy companies rely on new technologies and new business models and therefore have more risk than old world economy companies that are typically represented in the S&P500 portfolio. Self Test 5.18 48 00:00 Self test question 5.18 If we constructed a chart like the one below for an average S&P stock, do you think it would show more or less volatility? Explain. Think about this for a moment, write down your answer and go to the next slide when you are ready. Self Test 5.18 Answer 49 00:00 Self test 5.18 answer Because the S&P500 is a composite index of the Standard and Poor's, the average stock would correlate directly with the composite index, thus the average S&P stock would be neither more or less volatile than the S&P500 composite index itself. We end our discussion of the overview of the financial markets and institutions by discussing efficient market hypothesis and what an impact and effect it has on our financial markets today. What is EMH or Efficient Markets Hypothesis? It basically states that securities are normally in equilibrium and are fairly priced. What does equilibrium mean again? It means that the expected values of each of the different stocks are basically the same as the actual values of the stocks, as well. Hence they are fairly priced. Investors therefore cannot beat the market except by through some kind of good luck or better information. There are really three levels of efficient market hypothesis that we are going to discuss today. One is weak form efficiency, second is semi-strong form efficiency, and third and finally is strong form What is the Efficient Market Hypothesis (EMH)? 50 00:00 So the first level of efficiency that we talk about is weak form efficiency. Weak form efficiency basically says that you cannot profit whatsoever by looking at the past trends. That a recent decline is no reason to think that stocks are going to go up or down in the future. Thus, all available information is already out there for you to make a decision. Evidence supports that weak form efficient market hypothesis is very prevalent in our marketplace, but however, analysts will still use technical analysis in order to try to achieve larger returns for their investors. Weak-form efficiency 51 00:00 Semistrong-form efficiency 52 00:00 Semi-strong form ? ? ? ? ? ? ? ?basically ?says ?that ?all publicly ? ? ? ? ? ? ? ? ? ? ? ? ? ?is ? ? ? ? ? ? ? ? ? ? ? ? ? the ?stock prices,? so ?it ?doesn't ? ? ?to ?over ?analyze ? ? ? ? ?reports ? ? any ?kind ?of ? ? ? ? ? ? ? ? ? ? by? the ? ? ? ? ? ? ? ? in? trying to? look? for ? ? ? ? valued stocks.? ? ? ? ? ? ? ? a ? ? ? ? ? makes ?an ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ?the price ?automatically will reflect? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? or? the ? ? ?news ?nature? of ?that ?announcement. Basically,?experts ?believe that this is largely true, but we have known that superior analysts can still profit by finding and using new information discovered in company reports and company discussions. efficiency, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? available information ? already reflected in ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? pay ? ? ? ? ? ? ? annual ? ? ? ? or ? ? ? ? ? company filings ? ? ? corporations ? ? ? ? ? ? ? ? ? ? under ? ? ? ? ? ? ? ? As soon as ? company ? ? ? ? announcement in ? ? marketplace ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? good news nature of that announcement ? ? ? bad ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Strong-form efficiency 53 00:00 The last form of ? ? ? ? ? ? ? that we? are ? ? ? ? to ?discuss ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? basically argues ? ? ? ? ? ?information, ?even ?insider ? ? ? ? ? ? ? ?is ? ? ? ? ? embedded ?in ? ? ? stock ? ? ? ? ?thus ?there ? ? no? way ? ? ? ? ? ?can profit ? ? having ? ? ?kind ?of ? ? ? ? ? ? ? ?because ? ? ? ? ? ? already ?has that information,? even? if ?it ? ? ? ? ? ? ? information.? ? ? ? what? we ?do ? ? ? ? ? ? ? ? ? ? ? ? ? not ? ? ? ? because? insiders ? ? ? ? and ? ? gain some kind of? advantage? by?trading ?on ? ? ?basis of their insider information. Again that is also illegal. So the question begs itself now - Which one of these forms of efficiency is actually applicable in the marketplace today? efficiency ? ? ? ? ? ? going ? ? ? ? ? is Strong Form Efficiency. Strong form efficiency ? ? ? ? ? ? ? ? ? ? that all ? ? ? ? ? ? ? ? ? ? ? ? ? information ? already ? ? ? ? ? ? the ? ? ? price, ? ? ? ? ? is ? ? ? that you ? ? ? ? ? ? by ? ? ? ? any ? ? ? information ? ? ? ? everyone ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? is insider ? ? ? ? ? ? ? But ? ? ? ? know is that this is ? ? true, ? ? ? ? ? ? ? ? ? still ? ? do ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? Conclusions about market efficiency00:00 54 What we can tell you is what the research shows us and gives us our conclusions about market efficiency. Empirical studies suggest that the stock market is: 1. Highly efficient in the weak form 2. Reasonably efficient in the semi-strong form. 3. Not efficient at all in the strong form. Insiders have made abnormal, but illegal profits that were based on insider information. Now, what again is behavioral finance? We discussed this earlier, but behavioral finance or psychological finance incorporates elements of cognitive psychology to better understand how individuals and markets respond to different situations. It tries to explain to us the reasons why a stock will go up or down, which is not necessarily based upon quantitative reasons alone. “OK, Professor Henry Wong” you say to yourself, “I think I get Efficient Market Hypothesis, but why is this even relevant?” What kind of implication does it have on me as an investor in the marketplace? Well there are many. Take the example of you hearing news that a medical research company received FDA [Federal Drug Administration] approval for one of its products. If the market is semi-strong efficient, can you expect to take advantage of this information by purchasing the stock? The answer is no, you can't. If the market is semi-strong efficient, all information available in the marketplace has already been taken into in the price of the security, so it is probably too late for you, if you believe in semi-strong efficiency. Implications of market efficiency 5 00:00 5 Implications of market efficiency 00:00 56 Here is another example of how market efficiency and its implications to investors. Let’s take for example, a small investor who has been reading about a hot IPO that is going to come into the market later this week. She wants to buy as many shares as she can, so she is planning on buying a lot of shares on the first day once the stock starts trading. Would you advise her to do this? The answer is probably not. The long run track record of hot IPOs is not that great unless you were able to get on the ground floor and receive an allocation of shares before the stock begins trading. It is usually hard for small investors to receive shares of hot IPOs before the stock begins trading. This is called ‘spinning,’ in stock market lingo, and the average “Joe” investor out there is not going to have shares of a hot IPO be sp Self Test 5.19 57 00:00 So, now let's take a review on the topics that we have covered. Self test question 5.19 What exactly is EMH or the Efficient Markets Hypothesis. Take a moment to write it down and go to the next slide when you are ready. Self Test 5.19 Answer 58 00:00 Self test 5.19 answer EMH is a hypothesis that securities are typically in equilibrium, that they are fairly priced in the sense that the price reflects all publicly available information on the security. There are three different forms however of EMH, weak form, semi-strong form and strong form. Self test question 5.20 What are the difference among the three forms of EMH. 1. Weak form 2. Semi-strong form 3. Strong form. Write down your answer and go to the next slide when you are ready. Self Test 5.20 59 00:00 Self test 5.20 answer 1 Weak form - You can't profit by looking at a past trend. A recent decline is no reason to think that the stock is going to go up or down in the future. 2. Semi-strong form - All publicly available regarding that stock is already reflected in the stock price, so it doesn't pay to over analyze annual reports for under valued companies. 3. Strong form - All information, even inside information, is embedded in stock prices, but we know that insider trading does occur anyway. Self Test 5.20 Answer 60 00:00 Self Test 5.21 61 00:00 Self test question 5.21 What are the implications of the Efficient Markets Hypothesis to financial decisions? Take a moment to think about it and go to the next slide when you are ready. Self Test 5.21 Answer 62 00:00 Self test 5.21 answer If EMH were correct, it would be a waste of time for us to seek bargains by analyzing stocks. But we know that bargains still and do exist through analysis, but this may also just be attributed to being lucky. Irrespective of EMH however, is that a portfolio should be diversified to ensure that you are earning the greatest amount of return with the lowest amount of risk. Now what does diversification mean? It means essentially not to keep all of your eggs in one basket. Generally smart investors will invest in numerous stocks, so that if one stock does poorly you have other stocks to average out the poor returns of the poor performing stock. Self Test 5.22 63 00:00 Self test question 5.22 What is behavioral finance and what do new ideas in this area tell us about stock markets? Take a moment to think about your answer and go to the next slide when you are ready. Self test 5.22 answer Behavioral or psychological finance incorporates elements of cognitive psychology into finance in an effort to better understand how individuals and entire markets respond to different circumstances in the marketplace. For example, the irrational exuberance of the late 90's when investors where going wild for internet stocks and driving up the prices of these stocks, that had no profits whatsoever. This new area tells us that prices may be driven by a herd mentality or some other kind of human psychological issue, such as “over-confidence” as opposed to publicly available information. What exactly is over-confidence? Over-confidence is the idea that investors tend to have a positive bias and believe that when they make an investment in the company, that investment is going to turn out for the bett Self Test 5.22 Answer 64 00:00 Summary 65 00:00 To sum it all up, let’s review what we have learned. 1. We have learned that financial markets help parties allocate capital efficiently. 2. We learned that these parties are financial institutions as well as individuals. We have buyers of capital and we have sellers of capital. 3. We realize that investors are looking for some kind of financial return in the stock market. 4. We learned that Efficient Market Hypothesis tells us how they are able to make that return on their money, either through weak form efficiency or semi-strong efficiency or just plain luck, or maybe even possible through some sort of behavioral or herd mentality of the investor group as a whole. CHAPTER 5 ANSWER SET Financial Markets and Institutions 66 00:00 We are now going to review the homework assigned for chapter 5, Financial Markets and Institutions. Question 5-1 67 00:00 Question 5-1. How does a cost-efficient capital market help to reduce the prices of goods and services? Question 5-1 answer. The prices of goods and services must cover the costs. Costs include labor, materials and capital. Capital costs to a borrower include a return to the saver who supplied the capital, plus a mark-up generally called a "spread" for the financial intermediary that brings the saver and borrower together, The more efficient the financial system, the lower the cost of the intermediation. The lower the cost of the borrower and hence the lower the prices of goods and services and costs to consumers Question 5-1 Answer 68 00:00 Question 5-2. Describe the different ways in which capital can be transferred from suppliers of capital to those who are demanding capita Question 5-2 69 00:00 Question 5-2 Answer 70 00:00 Question 5-2 answer. Transfer of capital can take place in 3 different ways. Number one, direct transfers of money and securities occur when a business sells its stocks or bonds directly to the savers without going through any type of financial institutions. The business delivers its securities to the savers who in turn give the firm the money that it requires. Secondly, transfers may go through an investment banking house which under-writes the issue. Underwriters serve as a middle man and facilitate the issuance of securities. The company sells its stocks or bonds to the investment bank, which in turn sells the same securities to savers. The businesses' securities and the saver's money merely pass through the investment banking house. Finally, third, transfers can also be made through a financial intermediary. Here, the Question 5-3 71 00:00 Question 5-3. Is an initial public offering an example of a primary or secondary market transaction? Question 5-3 Answer 72 00:00 Question 5-3 answer. A primary market is the market in which corporations raise capital by issuing new securities. An initial public offering is a stock issue in which privately held firms go public or issue stock to the public for the first time. Therefore, an IPO or and Initial Public Offering would be an example of a primary market transaction. Question 5-4. Indicate whether the following instruments are examples of money market or capital market transactions. a/ US treasury bills, b/ long-term corporate bonds, c/ common stocks, d/ preferred stock, and e/ dealer commercial paper. Question 5-4 73 00:00 Question 5-4 Answer 74 00:00 Question 5-4 answer. A money market transaction occurs in the financial market in which funds are borrowed or loaned for short periods, less than 1 year. A capital market transaction occurs in the financial market in which stocks and intermediate or long-term debt, one year or longer, are issued and traded. So, A/ a US treasury bill is an example of a money market transaction, B/ the long term corporate bonds are examples of capital market transactions, C/ common stocks are also examples of capital market transactions. D/ preferred stocks are an example of capital market transactions, and E/ dealer commercial paper is an example of a money market transaction. Question 5-5 75 00:00 Question 5-5. What would happen to the US standard of living if people lost faith in the safety of our financial institutions, and why? Question 5-5 Answer 76 00:00 Question 5-7. Differentiate between dealer markets and stock markets that have a physical location. Question 5-7 77 00:00 Question 5-7 answer. The physical location of exchanges are tangible physical entities. Each of the larger ones occupies its own building, has a limited number of members and has an elected governing body. A dealer market is defined to include all facilities that are needed to conduct security transactions not made on the physical location exchanges. These facilities include 1/ The relatively few dealers who hold inventories of the securities and who are said to make a market in these securities. 2/ The thousands of brokers who act as agents in bringing the sealer together with investors. 3/ The computers, terminals and electronic networks that provide a communication link between dealers and the brokers. Question 5-7 Answer 78 00:00 Question 5-8 79 00:00 Question 5-8. Identify and briefly compare the two leading stock exchanges in the United States today. Question 5-8 Answer 80 00:00 Question 5-9 81 00:00 Question 5-9. Describe the three different forms of market efficiency. Question 5-9 answer. The three forms or levels of market efficiency are weak-form efficiency, semi-strong form efficiency and strong-form efficiency. The weak form of efficient market hypothesis theory states that all information contained in past stock price movements is fully reflected in current market prices today. The semi-strong form of the efficient markets hypothesis theory states that the current market prices reflect all publicly available information. Finally, the strong form of the efficient markets hypothesis theory states that the current market prices reflect all pertinent information, whether publicly available or privately held. Question 5-9 Answer 82 00:00 Question 5-10 83 00:00 Question 5-10. Investors expect a company to announce a 10% increase in earnings, but instead the company announces a 1% increase. If the market is semi-strong efficient, which of the following would you expect to happen? A/ The stock's price increases slightly because the company had a slight increase in earnings. B/ The stock price falls because the earnings increase was less than expected. C/ The stock price stays the same because earnings announcements have no effect if the market is semi-strong efficient. Question 5-10 Answer 84 00:00 Question 5-10 answer. If the market is semi-strong form efficient and the company announces a 1% increase when investors are expecting a 10% earnings increase, then you would expect the stock's price to fall because the earnings increase was less than expected, which is statement B. In fact if the assumption were made that the weak form efficiency existed, then you would expect the stock price to increase slightly because the company had a slight increase in earnings, which is statement A. If the assumption were made that the strong form efficiency existed, then you would expect the stock price to remain the same, because earnings announcements have no effect because all information, whether publicity available or privately held is already reflected in the firm's stock price. Question 5-11 85 00:00 Question 5-11. Explain whether the following statements are true or false. A/ Derivative transactions are designed to increase risk and are used almost exclusively by speculators who are looking to capture high returns. B/ Hedge funds generally charge higher fees than mutual funds. C/ Hedge funds have traditionally been highly regulated. D/ The New York Stock Exchange is an example of a stock exchange that has a physical location. E/ A larger bid ask spread means that the dealer will realize a lower profit. F/ The efficient market hypothesis assumes that all investors are rational. Question 5-11 answer. A/ Is false. Derivatives can be used either to reduce risk or to speculate. B/ The answer is true. Hedge funds generally charge large fees, often a fixed amount plus 15-20% of the fund's capital gains. C/ The answer is false. Hedge funds are largely unregulated. D/ Answer is true. The New York Stock Exchange is a physical location exchange with a tangible physical location than can index auction markets in designated securities. E/ False. A larger bid ask spread means that the dealer will realize a higher profit. F/ Is false. The efficient markets hypothesis does not assume that all investors are rational. Question 5-11 Answer 86 00:00 ????? ?????? 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Introduction 1 00:00 This Page is Menu? of ?Lectrue. ? ? ? ????? Welcome back. I’m Professor Henry Wong and today we’re going to be discussing Chapter 7 – Bond Valuation. We will start off this chapter by first discussing what exactly a bond is, the different types of bonds, and some of the key features within these bonds. And then we will move on to discuss how we actually value or price these bonds. We will work through some examples in both a financial calculator method as well as a spreadsheet solution. And then finally we will talk about measuring yield, or some of the returns for investors who choose to invest in these bonds, and also measuring and assessing some of the risk associated with investing in the bond as well. CHAPTER 7 Bonds and Their Valuation 00:00 1 What is a bond? 2 00:00 Bond markets 3 00:00 Now let’s talk a little bit about the markets in which bonds are traded. So after one of the four entities – a Treasury or federal government, or a corporation, or local and state government (they’re called a municipality), or a foreign government – raises money by issuing these bonds in the marketplace, then these security instruments or these debt instruments are allowed to be traded into a free market as well and sold at their price. So that if a company is doing better, and you think that the risk of getting your money back is better for a certain company, then the price might increase relative to other kinds of bonds in the marketplace. So these bonds are primarily traded on over the counter exchanges or over the counter market which sometimes can be referred to as the OTC markets. Most bonds are owned by large institutions versus individuals. What you see happening is individuals tend to own a lot of equity instruments and not really debt instrumen Self Test 7.1 4 00:00 Self Test 7.1 Answer 5 00:00 Self Test 7.2 6 00:00 Self Test 7.2 Answer 7 00:00 Self Test 7.3 8 00:00 Self Test 7.3 Answer 9 00:00 Self Test 7.4 10 00:00 Self Test 7.4 Answer 11 00:00 Now let’s talk about some of the key characteristics of each bond. It doesn’t matter if you’re talking about the Treasury bond, a corporate bond, a muni bond or a foreign bond, all of these bonds will have these key features. The first key feature is the par value. This is essentially the face amount of the loan to the company or the face amount of the bond which is paid at its maturity. In our examples in this class we will assume that the par value will always be equal to $1000. So in a sense, you can think of the par value of the bond as a share of stock that’s being sold in the marketplace. But instead of being share equity, it’s essentially a bond that, at it’s issuance date, is worth $1000 – meaning that the investor, or the holder of the bond, loans the company $1000, and the company in return agrees to pay back that $1000 at the maturity of the bond and agrees to pay interest along the way. Well this interest is the second key feature of the bo Key Features of a Bond 12 00:00 Effect of a call provision 13 00:00 Another key feature of bonds that may or may not be included in the issuance of that bond is called a call provision. A call provision allows the issuer to refund the bond issue if the rates decline. This obviously is helpful to the issuer, but hurts the investor. So borrowers are willing to pay more – let’s take the example of corporations who are essentially the once issuing the bonds and thus borrowing the money. They’re willing to pay more to have this kind of flexibility and to include this call provision or buyback provision in the bond, and the lenders, who are really the investors in the bond, are requiring more as well for callable bonds because they have an added risk here in the sense that when they invest in the bond, they assume a certain coupon rate over the life of the bond, but if the corporation or the issuer decides to call back or buy back the bonds before the maturity date, then obviously that wouldn’t benefit them, so they would requi You may also sometimes? hear? someone ?refer ? ? a ? ? ? ? ? a ? ? ? ? ? fund. ? ? ? ? ? ? a ? ? ?like ?an ?amortized ?loan. ?So ?as ? ? discussed in? our ? ? ? ? ? ? ? ? ? ? when we? talked about ?the time value ?of ? ? ? ? and ? ? ? amortization ?table,? we ?knew ?that ?the borrower ? ? ? essentially paying ? ? ? ? ? ? ? ? ?and principle back over an? amortized? time, ? ? ? essentially at? the ? ? ?of ? ? ? amortization ?period? the ? ? ? ? ? would ?be ? ? ? But ? ? ? ? ? ? ? be ?a? constant ? ? ? ? ? stream ? ? ?it ?would be? the ? ? ? ? ? ? ? ? for ?every ? ? ? ? ? ?Well ?this ?is ? ?lot like a ? ? ? ? ? fund. ? ? ? is? a provision to? pay ? ? ?the loan over its ? ? ? ? ? ? ? ?than ?all at maturity. It’s very similar again to the amortization on a return loan. This obviously reduces risk to investors because they’re getting some of their principle back and it shortens the average maturity. However, it’s not good for the investors if for some reason rates decline after the issuance, and this would obviously devalue the bond in the inte This is ? lot ? ? ? ? ? ? ? ? ? ? ? ? ? we ? ? ? ? ? ? ? ? ? last discussion ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? money ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 0 ? ? ? ? ? ? was ? ? ? ? ? ? ? ? ? ? ? both interest ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? end ? the ? ? ? ? ? ? ? ? ? ? ? ? balance ? ? ? ? 0. ? ? this would ? What is a sinking fund? 14 00:00 ? ? ? ? ? ? ? ? ? ? ? ? to ? bond as ? sinking ? ? ? ? ? ? ? ? payment ? ? ? ? and ? ? ? ? ? ? ? same payment ? ? ? ? ? period. ? ? ? ? ? a ? ? ? ? ? ? sinking ? ? ? It ? ? ? ? ? ? ? ? ? ? ? off ? ? ? ? ? ? ? ? ? ? life rather ? ? ? Finally, some other features that you may find in bonds include a convertible bond which essentially may be exchanged for common stock of the firm at the holder’s option. So if you purchase a bond that’s convertible, then you can decide that instead of being repaid that bond, you want to convert that bond into common stock of that company – and of course you would do this if you thought that the value of the common stock was going to be greater than the principle amount that was going to be required to be repaid on the value of the bond. Another feature is called a warrant on a bond, which is essentially a long-term option to buy a stated number of shares of common stock at a specified price. And this specified price is sometimes referred to as the strike price. The term of these warrants are generally anywhere from 5 to 10 years, so if you are an investor in a bond that offers you a warrant, you essentially have 5 to 10 years to decide whether or not you Other types (features) of bonds 15 00:00 Self Test 7.5 16 00:00 Self Test 7.5 Answer 17 00:00 Self Test 7.6 18 00:00 Self Test 7.6 Answer 19 00:00 Now that we have a basic understanding of the different features of bonds, let’s talk about how bonds are actually valued or priced. Well, it’s really nothing new for us to learn here, because as we have discussed before in our discussions of present value and the time value of money, we’ve learned that the value of any financial asset is very straightforward. It’s essentially the present value of all of its cash flows – inflows and outflows expected in the future – discounted by some kind of discount rate. And as we can see here on the slide, we have exactly this. The value of a bond will equal its cash flows over a certain period – which we will call 0, 1, 2…n period – and again we will assume that the bonds in our lecture will be 10-year bond lives. And then there are cash flows associated with each of those time periods. And of course, the discounting at R% will be the discount rate, so thus the value equals the cash flow divided by 1 plus the disco The value of financial assets 20 00:00 What is the value of a 10-year, 10% 00:00 21 annual coupon bond, if rd = 10%? So now let’s take a specific example and try to figure out what the value is of a 10-year life, 10% annual coupon bond if the rate of debt equals 10% (or that’s our cost of debt as well). So as we know we can draw a timeline here – we’re trying to figure out the present value of this bond which is represented here as “the value of the bond equals ‘?’” And then we know that there’s a series of cash flows associated with this bond which is $100 every year for approximately 10 years. And so you can see that at end of the 10 years you’ll have not only the $100 payment that is due but also the initial bond par value – or the principle amount of the loan from the investor or holder of the bond – which in this case was $1000. So essentially, we take the present value of each of these cash flows in each of these specific years to find the present value of this bond. And if we do that, we can see that the value of this bond is essentially $1000 and that equals, o We can also use a financial calculator to solve for the same equation instead of the arithmetic method as we just solved for. In this example, we know what our inputs would be – we know N would equal 10 because it’s a 10-year bond, we know the interest rate which we’re discounting is equal to 10%, we know that the payments or the coupon payments are going to be $100 every year for 10 years, and we know that at the need of that time period or at maturity a future value of $1000 needs to be repaid to the investor. And all we would need to do is push our present value button and solve for that, and that would give us -1000, which of course represents the value of the bond today. Using a financial calculator to value a bond 22 00:00 Spreadsheet Solution 23 00:00 slide/cap7-23.swfWe can also use Microsoft Excel and use a spreadsheet to solve this problem as well. Well what we’re looking for is the present value so we click our ‘function’ box and our function window pops up and we choose ‘present value’ as our formula and our present value box pops up. In our rate, we know that the going rate is still 10%, that the N periods that we’re discussing is 10, and this time the payment is going to equal the coupon rate – which is 10% – multiplied by the par value of $1000. And finally, the future value of $1000 is required to be repaid to the investors upon maturity so that is our input for the future value. We simply click ‘OK’ and we see that the present value of this expected future cash flow stream is equal to $1000. Thus, we call this bond trading at par, or par value bond. This will always be the situation if the going rate is equal to the coupon rate. And again, just to make sure you’re not confused, the going rate is also the c Now let’s take a look at rate The same company also has 10-year 24 00:00 bonds outstanding with the same risk but a 13% annual couponanother example involving the same company. We’re looking at another set of outstanding bonds that this company has issued in the marketplace. These are 10-year bonds that are outstanding with the same risk – and when we say the same risk we mean that it has the same cost of debt or the same rate of return required by investors, which again is the yield-to-maturity. But, it has a 13% annual coupon rate instead of the 10% coupon rate. This, of course, will make the coupon on the bond $130 because it’s 13% multiplied by the par value of $1000 which equals $130. And since the risk is the same as before, we know that the yield-to-maturity or the cost of debt or the going rate is going to remain 10%. Thus when we push in our inputs here, we see that the N periods equals 10, the interest rate used will be 10, the payments (or the coupon) is going to be 130, and of course the future value which needs to be paid at the maturity is going Spreadsheet Solution 25 00:00 slide/cap7-25.swfAgain, we can use our spreadsheet solution to figure out the value of this bond as well. We start off by noting that the ‘present value’ function is what we want to use, and when the present value window pops up, we simply click on our going rate (or our yield-to-maturity or cost of debt rate) which is still 10%. The N periods is still 10 periods as we discussed before. However, the payment has changed now so this time we multiply the 13% coupon rate multiplied by the par value of $1000. If we look to the right of this box you will see that it equals $130, which should make sense. And finally, we enter in our future value of $1000, which is the amount that needs to be repaid back to the investors. When we click ‘OK’ on this we find that we get the same answer as the financial calculator on this which is $1184.34. Thus, this bond sells at a premium over the par value of bond because the coupon rate is greater than the going rate (or the yield-to-maturit % Now let’s annual coupon rate The same company also has 10-year 26 00:00 bonds outstanding with the same risk but a 7%take a look at another example where we have a decreasing coupon rate. So we’re talking about the same company, the same outstanding 10-year life of a bond, but this time the annual coupon is 7% and the risk remains the same. Well, this bond has an annual coupon we now know of $70 – and not $130 as before – and we simply get that again by multiplying the 7% coupon by the par value of $1000. And, in this case, when we punch in our numbers we know that N periods equals 10, the interest rate is going to be the same at 10 because the risk is unchanged, but this time our payment is going to be our new coupon payment of 70, and the future value of course if the maturity repaid at the maturity date and that’s going to be $1000. And so the present value in this case is less than the par value, or equal to $815.66. When this happens, we say that the bond is trading at a discount on par (or a discount bond) and this happens of course because the coupon r Spreadsheet Solution 27 00:00 slide/cap7-27.swfAgain we can use our spreadsheets in Microsoft Excel to figure out this problem as well. We start again off by clicking the ‘function’ button on the toolbar where the function window pops up and we find our ‘present value’ formula. Once we’ve located it, we click ‘OK’ and our present value window pops up. In the first line of our present value window again it asks us for the rate and of course the risk is unchanged since last time so we simply put 10% in. And then the N periods of course has remained unchanged – its still a 10-year life bond so we click on 10 – but of course this time the payment has changed again so we must multiply the new coupon rate of 7% by the new par value of $1000, and if we look to the right of this box we see that it equals $70 which is consistent with what we found with our financial calculator method. And finally, our future value equals $1000 of course – the amount that needs to be repaid at its maturity. And we click ‘OK’ An example: Increasing inflation and kd 28 00:00 Now, instead of increasing or decreasing the coupon rate, we’re going to show you an example of increasing or decreasing the cost of debt (or the going rate). And in this case we have an example of increasing inflation and how it would affect the cost of debt (or the yield-to-maturity or the going rate). So if we suppose inflation rose by 3%, the new cost of debt would equal 13%, up from 10% originally. Thus the cost of debt rises above the coupon rate again and the bond’s value again will fall below par value and sell at a discount as we’ve seen consistent with our previous examples. In terms of using our financial calculator, we simply enter 10 years for our N periods. This time our interest rate changes to 13%, and of course our payment of $100 remains consistent which is going to be 10% multiplied by $1000, and the future value equals $1000. You can see that the present value of this bond is approximately $837.21. Again, this is lower than the init Spreadsheet Solution 29 00:00 slide/cap7-29.swfWe again can take a look at Microsoft Excel and use our spreadsheet solution. We open up our ‘present value’ function formula and when we’re done we click ‘OK’ and the present value window pops up. The first thing it asks us for is our rate. Well we know that the rate has increased now to 13%, and the N periods remains the same at 10. Our payment is going to be our coupon rate of 10% multiplied by our par value of $1000 which again equals $100. And finally our future value is going to equal the par value which needs to be repaid at its maturity which is $1000, and when we click OK we see that we get the same answer we got in our financial calculator slide which is approximately $837.21. Again, this bond sells at a discount because the coupon rate is less than the going rate (or the yield-to-maturity rate). Let’s take another example now and talk about how decreasing inflation would affect the going rate or the cost of debt. Suppose inflation falls by 3% causing the cost of debt to now equal 7%. Well when the going rate falls below the coupon rate, we know that the bond’s value rises above par and thus trades at a premium. Our inputs into our financial calculator include 10 for the N periods, 7 now for our interest rate per year, and our payments equal the same which is the annual coupon rate of 10% multiplied by the par value of 1000 which equals 100, and the future value equals 1000. We see that when we click our present value button, our present value is now An example: Decreasing inflation and kd 30 00:00 Spreadsheet Solution 31 00:00 slide/cap7-31.swfWe can also use our Microsoft Excel and our spreadsheets to figure out the value of this bond. We simply start by clicking on the ‘function’ button. When we paste the function we will look for our ‘present value’ formula, and when we’re done with that we will click ‘OK’, and then our present value window will pop up afterwards. Once our present value window pops up we know that our rate is going to be 7% because of decreasing inflation, and our N periods remains at 10 periods, and the payment will remain the same as our coupon rate of 10% multiplied by our par value of $1000. And finally, our future value must equal the initial par value at maturity, so we know that that’s going to be $1000 as well. We click ‘OK’ we see that the value of the bond has increased – it is now $1210.71 – thus the bond is trading at a premium, and this will always happen because the coupon rate is greater than the going rate (or the cost of debt or the rate of debt). Self Test 7.7 32 00:00 Self Test 7.7 Answer 33 00:00 slide/cap7-33.swfWe can also use our Microsoft Excel and our spreadsheet to figure out this problem. As you can see, we first go into our ‘function’ tab and find our ‘present value’ function and click ‘OK’. Once our present value window pops up we choose our rate, which of course is 9% as given. Our periods is 8 which is also given. And then the payment is going to be the $70 as stated in the problem. The future value of the bond is going to be $1000 and that of course is the amount that is going to have to be repaid at its maturity. And once we have this information, we simply can just push ‘OK’ and once we push ‘OK’ we find out that the value of the bond is indeed $889.30. Thus, this bond sells at a discount rate to the par value because the coupon rate is less than the going rate (or the yield-to-maturity). Self Test 7.8 34 00:00 Self Test 7.8 Answer 35 00:00 slide/cap7-35.swfBy using our Excel spreadsheet again we would click on our function wizard, and once we are asked for which function to choose we would choose of course the ‘present value’. And once we’ve done that we just have to click ‘OK’ and our present value window pops up. The first thing it would ask us for is the rate, and the rate as we know is the going rate which is 8%, the N periods that we’re dealing with now is 12 periods, and our payment is going to be approximately 10% multiplied by 1000 which is going to be 100. And that means our future value is going to be 1000. And finally, if we input all this information and we see our present value result, you can see that it is approximately $1150.72. This of course represents a premium bond because it is above the par value, and also because the coupon rate of 10% is greater than the going rate of 8%. Self Test 7.9 36 00:00 Self Test 7.9 Answer 37 00:00 Changes in Bond Value over Time 38 00:00 This next chart shows us the values and the changes in the bond value over time. It examines three different bonds and what would happen to the bonds if the bonds’ required rate of return (or yield-to-maturity) remained at 10%. You can see that all of them would end up being equal to the par value at its maturity date – as you get closer and closer to the maturity date it would get closer and closer to the par value, which in this case is $1000. In all three of these instances, the require rate of return (or the yield-to-maturity or the going rate) is 10% and the only thing that is different in these three bonds is the coupon rate. You can see you have one coupon rate of 13% which the value today would equal $1184. This would represent the premium bond. You can have another discount bond with its present value of $816 at a 7% coupon rate, and over time as you get closer and closer to the end of the life of the bond or to the time of maturity, you can se Bond values over time 39 00:00 Now let’s for a look at solving for the yield-to-maturity, or the required rate of return from an investor’s standpoint, on a 10-year, 9% annual coupon, $1000 par value bond selling for $887. Remember, we can find the return on debt (or the cost of debt) in order to solve this model. And the way we do that, of course, is by using our present value formula and plugging in our constant discount rate in order to make the value of the bond equal to its current selling price of $887. So thus, as you can see in this slide adjoining, the value of the bond equals the coupon payment divided by 1 plus the cost of debt to the interval. And all you do is basically sum up all of these different cash flows that are discounted, and then you will get the value of the bond. And if we did this we would see that the value of the bond in this case is $887, and we would have to simply figure out the rate of debt that forces these cash flows to equal $887. What is the YTM on a 10-year, 9% annual coupon, $1,000 par value bond, selling take$887? 40 00:00 Again there’s a couple of different ways that we can use to solve this problem. Number one is using a financial calculator. If we just solve for the interest rate, the yield-to-maturity of this bond, as you can see, is 10.91%. We would use the inputs N for 10 years, we have a present value today selling at $887 – and we remember to put a negative in front of it – and we also have a constant payment stream of $90 of annual interest a year, and then finally a future value of $1000 that needs to be repaid. And we simply hit the ‘I/YR’ button and we get a 10.91% as the yield-to-maturity on this bond. This bond again sells at a discount because the yield-to-maturity is greater than the coupon rate. Using a financial calculator to solve for the YTM 41 00:00 Spreadsheet Solution 42 00:00 slide/cap7-42.swfWe can also solve this problem using Microsoft Excel. This time when we look into our function categories we’re looking for the formula ‘rate’. Once we find it we click ‘OK’ and the rate box appears. Under the first N periods we would use our 10 periods that are given to us. Under the payment we would use our annual payment of $90 which is the 9% coupon rate multiplied by the par value of 1000. And then for the present value it’s the current selling price of the bond, so that would be -887 and we remember to put a negative in front of it to signify to the financial calculator that it is a cash outflow today. And then finally a future value of $1000. If we click OK on all this, you can see that the going rate (or the yield-to-maturity) equals 10.91% for this bond. Find YTM, if the bond price is $1,134.20 43 00:00 We can also find the bond price in the yield-to-maturity for a bond which is at a premium. And if the bond price is trading at a premium at $1134.20, then we simply change the price or the present value in our financial calculator to arrive at the new yield-to-maturity. Again, we would use 10 as our N periods. Now, we would push in -1134.20 as our present value and our sales price, the payment remains the same at 90 and the future value remains the same at 1000. Thus, the interest per year (or the yield-to-maturity) for this premium bond would be 7.08%. And because the yield-to-maturity is less than the coupon rate, this signifies to us that it is indeed a premium bond. Spreadsheet Solution 44 00:00 slide/cap7-44.swfAgain, when we use our Microsoft Excel spreadsheet we were looking for the function ‘rate’ and once we’ve found the rate we can click ‘OK’ and then our rate formula box will op up. And in our first category in our rate formula box, it will ask us what our periods are and in this case as we know our N periods are going to be 10. The payment is going to be the coupon rate multiplied by the par value of $1000 which equals $90, and then the present value – we remember that it is set to a negative and it’s going to be the current price of negative $1134.20. And finally the future value will equal the par value which is $1000, and if we hit ‘OK’ we see we have a yield-to-maturity of 7.08%. This of course indicates a premium bond. You might also ask yourself, “What is actually included in this yield-to-maturity, or required rate of return, for investors in bonds?”, and it’s really the current yield plus the capital gains yield. The current yield or CY is defined as the annual coupon payment divided by the current price. The capital gains yield (or CGY) is the change in the price divided by the beginning price. So the expected total return (or the yield-to-maturity) for investors is going to be the current yield or the annual coupon payment divided by the current price plus the capital gains yield which represents the change in price over the beginning price. Intuitively, it should make sense to you gain that the expected rate of return is going to be whatever coupon payments the bond is going to throw off in cash to the investor, plus whatever increase in value the bond will provide to the investor will be equal to the total required rate of return for the investor. or also the yie Definitions 45 00:00 Let’s work on an example on calculating current and capital gains yield. We want to find the current and the capital gains yield for a 10-year annual coupon bond that sells for $887 and has a face value of $1000. Well, we know that in order to find the current yield, we simply take the current coupon payment of $90 and divide it by the price of $887 which gives us 10.15% as the current yield. An example: Current and capital 46 00:00 gains yield Now let’s calculate the capital gains yield. Well if we know the yield-to-maturity is, as we calculated before, is 10.91%, and we just calculated the current yield as 10.15%, then all we have to do is just do a little bit reverse algebra and see that the capital gains yield equals the yield-to-maturity minus the current yield, or in this case it would equal 0.76%. Now the other way to do it is to also find the expected price one year from now, and divide that change in price by the beginning price which also would give us the same answer of 0.76% Calculating capital gains yield 47 00:00 Self Test 7.10 48 00:00 Self Test 7.10 Answer 49 00:00 slide/cap7-49.swf Semiannual bonds 50 00:00 What is the value of a 10-year, 10% 00:00 51 semiannual coupon bond, if rd = 13%? Spreadsheet Solution 52 00:00 slide/cap7-52.swfBy using a spreadsheet we can see that we can find the value of the bond by simply using our ‘present value formula’ in our function wizard. Once we find the present value, the present value window will pop up and for the rate we will choose the going rate of 13% and we know we have to divide that by 2, which equals 6.5%, and of course the N periods we are dealing with are the 10 periods multiplied by 2, the payment is going to be found by using the coupon rate multiplied by the par value – which is 100 – and we divide that by 2, and finally the future value is going to be the par value. And when we hit ‘OK’ on our function box we see that the value of the bond is indeed $834.72. Next question is, coupon bond, all to equal? Would you prefer to buy a 10-year, 10% annual coupon bond or a 10-year, 10% semiannual “Would you preferelsebuy a 10-year, 10% annual coupon bond or a 10-year, 10% semi-annual coupon bond – all else being equal?” Well, your intuition should tell you that the more times the interest compounds, the bigger the value is going to be at the end of the day. So thus, your intuition should tell you already that the semi-annual coupon bond is going to be greater than the annual coupon bond. This is of course very similar to the compounding exercises that we discussed in our earlier chapter when we discussed time value of money in Chapter 2. Thus we can find the semi-annual bond’s annual effective rate in order to compare with the annual coupon bond to see if it is indeed higher, and we can use our effective rate formula – which again equals 1 plus the nominal divided by the N compounding periods to the N compounding power minus 1. In this case it would equal 1 plus 10% which is the nominal rate, we’re compounding semi-annually so t 53 00:00 If the proper price for this semiannual bond is $1,000, what would beAnother takeprice for theproblem is to suppose that the proper price of the semi-annual price we’re discussing is really $1000 or its present value. Then what would be the proper price for the annual coupon bond? Thus, we can use the semi-annual coupon bond and we know that it has an effective rate of 10.25%. All we would need to do is plug in the effective rate of 10.25% into our regular inputs in place of the rate, and we would find the present value. Thus, in this case the N periods would still be 10, the interest rate that we’re dealing with now will be the effective rate of 10.25%, our payments, we know, are going to be 100 because that’s the coupon interest rate times the par value, and finally the future value will equal the par value of 1000. If we hit our present value button, we see that the present value of this particular bond fro the annual coupon bond is $984.80 and that is the same as $1000 semi-annual coupon bond. 54 00:00 the proper on the same annual coupon bond? Spreadsheet Solution 55 00:00 slide/cap7-55.swfBy using Microsoft Excel we can see the same formula being used. We first start off by looking for the semi-annual coupon bond and the value of that semi-annual coupon bond. We do this, of course, by looking for our ‘present value’ function in our function wizard. Once we’ve found it we can click ‘OK’ and the present value window pops up. We will ask ourselves first, “What is the going rate?”, and we know that it is 10% but we also know that we have to divide that by 2 because it’s a semi-annual bond. Also the N periods in 10 periods but we have to multiply that by 2 to account for the semi-annual, and then the payment of course is going to be 10% multiplied by 1000 which is $100 but again we divide that by 2 because again we are talking about a semi-annual bond. And finally our future value is going to equal the par value of $1000 so that is going to remain the same. If we click ‘OK’ you can see that the value of the semi-annual coupon bond is precisel Self Test 7.11 56 00:00 Self Test 7.11 Answer 57 00:00 Self Test 7.12 58 00:00 slide/cap7-58.swf Self Test 7.12 Answer 59 00:00 So far 4 years for $1,050, YTM is its yield to call (YTC)? A 10-year, 10% semiannual coupon bond selling for $1,135.90 can be called inwe’ve been discussingwhat or the yield-to-maturity of a bond, but remember many of these bonds allow issuers to call back or buy back the bond at a certain time. What would an investor make if a company bought back – or called back – the bond after a certain period of time? The is called the yield-to-call – very similar to the yield-to-maturity except we would substitute the maturity or the bond life by the year in which the bond could be called back which again is the yield-to-call. So our example here is a 10-year, 10% semi-annual coupon bond selling for $1135.90. This bond can be called back by the issuer in 4 years for $1050. What is its yield to call or YTC? So the bond’s yield-to-maturity can be determined to be 8%. Solving for the yield-to-call, therefore, is identical to solving for the yield-to-maturity except this time the yield-to-call timeframe is used for N periods and the call premium is the future value. So $1050 would be the cal 60 00:00 Spreadsheet Solution 61 00:00 slide/cap7-61.swfNow let’s take a look at an example on Excel. As you see we are using the rate formula this time because we’re looking for a yield-to-call and for the N periods we know that we have 4 periods, we need to multiply that by 2 to account for the semi-annual coupon, we know that the payment is going to equal the semi-annual coupon rate multiplied by the par value of the bond which is $100, but we also need to divide that by 2 in order to get the semi-annual payment which is going to be $50. And finally, the present value is going be the current selling price of the bond which is negative $1135.90 (and we put a negative in front of that) and then finally our future value is going to be the call premium of $1050 and when we hit ‘OK’ we see we get the same answer that we get on our financial calculator or approximately 3.57%. A couple of points on the yield-to-call. The 3.57% that we just calculated represents the periodic semi-annual yield-to-call rate. Thus, the yield-to-call is the nominal rate, which means we need to multiply it by 2 in order to get it to an annualized rate, and that annualized rate will be a nominal annualized rate. So that 3.568% multiplied by 2 periods would give us 7.317%, and this is the rate that you would often hear a broker quote to you. However, you could also work out the effective yield-to-call and we can use that using our effective annual rate formula and that would equal 1.03568 squared minus 1 which would equal 7.26%, which of course is a little bit higher than the nominal rate which makes sense since we are dealing with a semi-annual compounding bond. Yield to Call 62 00:00 If you bought these callable bonds, 00:00 you be more likely to earn Now let’s compare the yield-to-maturity and yield-to-call and predict when an investor would likely see a yield-to-call occur. Let’s take the bonds that we just discussed as an example. If you bought these callable bonds, would you be more likely to earn the yield-to-maturity or the yield-to-call? Let’s think about this. The coupon rate, remember, equals 10% compared to the yield-to-call rate of 7.137%. Thus, the firm could raise new money by calling back the bonds and then reselling new bonds in the marketplace which pay only 7.137%. In terms of the actual cash difference they could replace those bonds paying $100 in coupon per year by bonds paying only $71.37 per year. Thus investors should expect a yield-to-call in this case and to earn the yield-to-call 7.317% versus the yield-to-maturity of 8%. 63 would the YTM or YTC? When is a call more likely to occur? 64 00:00 So when is a call? more? likely to? occur? ?Well ?in ? ? ? ? ? ? ? a ? ? ? ? ? ? ? at ?a? premium ?then ?the coupon ? ? ? (is going?to ?be ? ) ? ? ? than the ?rate ?of ? ? ? ? ? ? the ? ? ? ? ? debt), ? ? a ? ? ? ? ? more likely ? ? happen.? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? on ?premium ? ? ? ? and ? yield-to-maturity on par and discount bonds. So expect to earn a yield-to-call ? ? ? ? ? bonds ? ? a ? ? ? ? ? ? ? ? ? ? ? ? ? ? general if ? bond sells ? ? ? ? ? ? ? ? ? ? ? ? ? rate ? ? ? ? ? ? greater ? ? ? ? ? ? ? ? debt (or ? ? cost of ? ? ? ? so ? call is ? ? ? ? ? ? ? to ? ? ? ? Self Test 7.13 65 00:00 Self Test 7.13 Answer 66 00:00 Self Test 7.14 67 00:00 Self Test 7.14 Answer 68 00:00 slide/cap7-68.swf What is interest rate (or price) risk? 69 00:00 Now let’s talk a little bit about risk on bonds. We first start our topic off with discussing interest rate risk – or pricing risk as it is sometimes referred to. Interest rate risk is the concern that rising cost of debt and inflation will cause the value of the bond to fall. Thus, if we look at our chart below here, we can see that the cost of debt in the middle is increasing steadily form 5, to 10, to 15%. And on the left-hand side we’re comparing a 1-year bond versus a longer term bond on the right hand side of a 10-year bond. You can see that a 10 year bond is more sensitive to interest rate changes – in fact you can se that it actually decreases -25% as the cost of debt increased to 15% whereas the 1-year bond only increases 4.4%. Thus the longer term bond, or the 10-year bond, is going to have more interest rate risk than the shorter term bond. The following graph illustrates the interest rate risk as well. The green line on this chart represents a par value bond staying at $1000. As you can see from the blue line, as you get farther and farther out, the yield-to-maturity actually decreases and the value of the bond decreases as well. And you can see that the yield-to-maturity increases (or the time that it takes in order for the bond to mature), and then at the same time the value of the bond actually decreases below the par value line. Illustrating interest rate risk 70 00:00 Now we’re done talking about interest rate risk let’s talk about another kind of risk – it’s called reinvestment rate risk. Reinvestment rate risk is the concern that the cost of debt is going to fall this time and that future cash flows will have to be reinvested at lower rates, hence reducing our income. In order to crystallize this kind of concept to us let’s take an example of a lottery win. Suppose you just won the $500,000 lottery. You would tend to invest this money and live off the interest. In our next slide we look at an example of reinvestment rate risk based on this lottery example. What is reinvestment rate risk? 71 00:00 So let’s take a look at our lottery example as reinvestment rate risk. We really have two choices – we can either invest in a 10-year bond or a series of ten 1-year bonds. Both 10-year and 1-year bonds currently yield 10%. Thus if you choose the 1 year strategy, after 1 year you receive $50,000 dollars in income and you have $500,000 to reinvest. But if the 1-year rates decline to 3%, then your annual income would fall by $15,000 because you’d have to reinvest at the lower rate. But if you chose a longer-term strategy – chose the 10-year bond strategy – then you can lock in at a 10% interest rate and you would earn a $50,000 annual income for the life of the bond. Reinvestment rate risk example 72 00:00 So what kind of conclusions can we draw about interest rate and reinvestment rate risk? Well we see that interest rate risk is going to have a low impact on short-term or high-coupon bonds. But it’s going to have a high risk and high impact on long-term bonds. We saw that in our example where 10-year bonds were subject to more interest rate risk and more volatility than the shorter-term 1-year bonds. Well the reinvestment rate risk is going to be completely the opposite. In reinvestment rate risk, we have a high risk when we’re talking about the short-term because the rate of debt could decrease and we could earn less income by reinvesting at a lower rate, but in the long-term if we invested in the 10-year bond in our previous example we would be guaranteed to earn that higher interest rate going forward, so it is much lower of an impact, or lower risk, on long-term or low-coupon bonds. What kind of conclusions can we draw from this? We can draw the co Conclusions about interest rate and 00:00 73 reinvestment rate risk Self Test 7.15 74 00:00 Self-Test Answer 7.15. Interest rate risk is the concern that rising costs of debt or inflation will cause the value of a bond to fall; whereas, reinvestment rate risk is the exact opposite: it’s the concern that the cost of debt will fall and thus future cash flows will have to be reinvested at this lower rate hence reducing income. Self Test 7.15 Answer 75 00:00 Self-Test Question 7.16. To which type of risk are holders of long-term bonds more exposed? How about short-term bondholders? Please take a moment to think about your answer and go on to the next slide when you are ready. Self Test 7.16 76 00:00 Self-Test Answer 7.16. Long-term bondholders are more exposed to interest rate risk because they are locked in for a longer period. Whereas short-term bondholders are more exposed to reinvestment rate risk because they may lose money if the costs of debt or rate of debt decreases and they are stuck with smaller coupons in the future. Self Test 7.16 Answer 77 00:00 So far we have talked about interest rate risk and reinvestment rate risk. Finally we have a third risk for investing in bonds from investors and that is called Default Risk. This is if the issuer defaults and is unable to make the coupon payments or repay the maturity then investors are going to receive less than the promised return. Therefore the expected return on corporate and municipal bonds in particular is going to be less than the promised return since corporate and municipal bonds have default risk, whereas the treasury bonds do not have any default risk. This is going to be influenced by the issuer’s financial strength and the terms of the bond contract. Default risk 78 00:00 Types of bonds 79 00:00 The two major agencies that rate bonds and that evaluate default risk are No.1) Moody’s and No.2) Standard & Poor’s. You can see for Moody’s for investment grade bonds are bonds with a very good credit quality, they assign Triple A, Double A, A or BAA as the type of bond that is an investment grade. However if their junk bonds are very high risk we call them BA, BC, AA or C. Whereas S & P has a very similar rating scale except it’s called differently. They start off with Triple A, Double A, Single A and Triple B. Then the Junk bonds are Double B, B, Triple C and C. So these bond ratings are designed to reflect the probability of a bond issue going into default. In our next slide we talk about some of the issues, which may force a bond to go into default and some of the criteria in which Moody’s and Standard & Poor’s uses to evaluate these bonds. Evaluating default risk: Bond ratings 80 00:00 Factors affecting default risk and bond ratings 81 00:00 Other factors affecting default risk 82 00:00 Now lets take a moment to review some of the topics we have just covered. Self test Question 7.17. Differentiate between mortgage funds and debentures. Please take a moment to answer this and then go to the next slide. Self Test 7.17 83 00:00 Self Test 7.17 Answer 84 00:00 Self test answer 7.17. Mortgage bonds are secured by fixed assets whereas debentures are not secured by any specific property. Self Test 7.18 85 00:00 Self test question 7.18. Name the major rating agencies and list some factors that affect bond ratings. Please take a moment to answer this and then go to the next slide. Self test answer 7.18. Moodys and S & P are the major bond rating agencies. Among some of the things that they consider when they rank default risk are financial performance. What does the debt ratio, TIE ratio, and the current ratio look like? They also look at specific provisions within the bond contract. Is it a secure debt? Is it senior or junior to some other claim? Is there any type of guaranteed or any type of amortizing sinking fund provision within the loan? Finally, when does the debt mature? Self Test 7.18 Answer 86 00:00 Self test question 7.19. Why are bond ratings important to firms and investors? Please take a moment to answer this and then go to the next slide. Self Test 7.19 87 00:00 Self test answer 7.19. Firms care about bonds ratings because it has a direct impact on their costs of debt. Investors care about bond ratings because the lower grade bonds will have higher required rates of return i.e. no pain and no gain. Self Test 7.19 Answer 88 00:00 Self Test 7.20 89 00:00 Self test question 7.20. Do bond ratings adjust immediately to changes in credit quality? Please take a moment to answer this and then go to the next slide. Self Test 7.20 Answer 90 00:00 Self test answer 7.20. In theory bond ratings are updated periodically and subject to change depending on changes in credit quality. In reality and historically as we have seen, credit ratings do not adjust immediately and there can be some considerable lag time between changes in credit quality and the changes in the rating. We don’t have to look any further than the example of Enron. When Enron collapsed it caught most of the creditors off guard and it was because of this rapid deterioration. Now that we are talking about default risk let's look at what happens if a company is defaulting on their bond. They generally enter into bankruptcy. What exactly is bankruptcy? There are two main chapters of the Federal Bankruptcy Act, which seeks to either reorganize or disband a corporation. These 2 chapters are Chapter 11, which deals with reorganization and Chapter 7, which deals with liquidation. Typically a company wants Chapter 11 while creditors may prefer Chapter 7. Bankruptcy 91 00:00 Chapter 11 Bankruptcy 92 00:00 In Chapter 7 Liquidation the judge basically orders the company to disband itself and sell off all its assets and take whatever is remaining to pay back any types of creditors that it owes. Usually in this situation creditors get pennies on the dollar. Literally 4 to 6 cents per dollar if they are lucky. But if there was a liquidation of the assets and there were proceeds to be distributed it would be in this order. No.1 it would go to the secured creditors from the sale of the secured assets to repay any debts. No.2 if anything was left it would go to the trustee in its third party costs in order to administer the sale of these assets. No.3 it would pay the wages subject to limits of the employees. No.4 it would pay any unpaid taxes to the IRS. No.5 it would pay any unfunded pension liabilities. No.6 then it would pay any creditors who were not secured in the first place. No.7 we get to the equity holders and it would pay the preferred stockholders. No.8 it Priority of claims in liquidation 93 00:00 Reorganization 94 00:00 Self Test 7.21 95 00:00 Self test question 7.21. Please differentiate between Chapter 7 Liquidations and Chapter 11 Reorganizations. When should each be used? Please take a moment to answer this and then go to the next slide. Self test answer 7.21. Chapter 7 is essentially the end of a corporation. The assets are liquidated and sold off and distributed to its creditors. Chapter 11 is a new beginning for the company. The corporation is shielded from creditors while it’s under Chapter 11’s protection and establishes a restructuring plan, which is acceptable to the creditors. If the creditors and the judge agree then the corporation has a chance for survival. The litmus test for both these cases is whether the company is worth more to its creditors dead or alive. Self Test 7.21 Answer 96 00:00 Now we have come to the end of Chapter 7 Bonds and their Valuation. Let's summarize what we have learned. No.1 we learned that bonds are an important source of long-term capital for corporations. No.2 we learned how to value these bonds and we know that it depends on the cost or rate of debt of the bonds. We also learned that it is important for financial managers to understand the cost of debt and the core relating require Summary 97 00:00 ????? ?????? Henry Wong ????? ???? flv/fd_01vid000.flv 00:01 flv/fd_08vid001.flv 01:00.8 flv/fd_08vid002.flv 00:57.0 flv/fd_08vid003.flv 00:10.0 flv/fd_08vid004.flv 01:59.9 flv/fd_08vid005.flv 04:35.7 flv/fd_08vid006.flv 07:05.5 flv/fd_08vid007.flv 00:53.0 flv/fd_08vid008.flv 04:36.7 flv/fd_08vid009.flv 00:04.9 flv/fd_08vid010.flv 01:58.9 flv/fd_08vid011.flv 00:33.0 flv/fd_08vid012.flv 00:03.9 flv/fd_08vid013.flv 00:21.9 flv/fd_08vid014.flv 01:00.9 flv/fd_08vid015.flv 02:43.8 flv/fd_08vid016.flv 01:51.9 flv/fd_08vid017.flv 01:02.9 flv/fd_08vid018.flv 02:13.8 flv/fd_08vid019.flv 00:06.0 flv/fd_08vid020.flv 00:46.0 flv/fd_08vid021.flv 00:15.0 flv/fd_08vid022.flv 00:11.0 flv/fd_08vid023.flv 00:14.7 flv/fd_08vid024.flv 00:26.0 flv/fd_08vid025.flv 00:15.8 flv/fd_08vid026.flv 00:24.0 flv/fd_08vid027.flv 00:19.8 flv/fd_08vid028.flv 00:45.0 flv/fd_08vid029.flv 02:44.8 flv/fd_08vid030.flv 00:48.0 flv/fd_08vid031.flv 00:06.0 flv/fd_08vid032.flv 01:13.9 flv/fd_08vid033.flv 00:53.0 flv/fd_08vid034.flv 00:21.0 flv/fd_08vid035.flv 00:17.0 flv/fd_08vid036.flv 00:17.7 flv/fd_08vid037.flv 00:04.8 flv/fd_08vid038.flv 00:49.8 flv/fd_08vid039.flv 00:14.0 flv/fd_08vid040.flv 00:14.0 flv/fd_08vid041.flv 00:52.0 flv/fd_08vid042.flv 01:23.9 flv/fd_08vid043.flv 00:04.7 flv/fd_08vid044.flv 00:48.0 flv/fd_08vid045.flv 00:34.0 flv/fd_08vid046.flv 00:05.0 flv/fd_08vid047.flv 01:20.9 flv/fd_08vid048.flv 01:10.9 flv/fd_08vid049.flv 00:51.0 flv/fd_08vid050.flv 00:48.0 flv/fd_08vid051.flv 00:41.0 flv/fd_08vid052.flv 01:43.9 flv/fd_08vid053.flv 01:10.9 flv/fd_08vid054.flv 00:52.0 flv/fd_08vid055.flv 00:54.8 flv/fd_08vid056.flv 00:21.8 flv/fd_08vid057.flv 00:27.0 flv/fd_08vid058.flv 00:15.8 flv/fd_08vid059.flv 00:24.0 flv/fd_08vid060.flv 00:15.9 flv/fd_08vid061.flv 00:24.7 flv/fd_08vid062.flv 01:42.9 flv/fd_08vid063.flv 00:36.0 flv/fd_08vid064.flv 00:22.9 flv/fd_08vid065.flv 00:30.0 flv/fd_08vid066.flv 01:25.9 flv/fd_08vid067.flv 00:53.8 flv/fd_08vid068.flv 00:28.0 flv/fd_08vid069.flv 00:13.8 flv/fd_08vid070.flv 00:16.8 flv/fd_08vid071.flv 00:14.8 flv/fd_08vid072.flv 00:31.0 flv/fd_08vid073.flv 00:20.8 flv/fd_08vid074.flv 00:13.9 flv/fd_08vid Push here to start ???????? ?????????? slide/fd_08slide.swf ???????? ???? ?? 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 ????? ?????? ???????? Introduction 1 00:00 This Page is Menu ?of ? ? ? ? ? ? ? ? ? Lectrue. CHAPTER 8 Risk and Rates of Return 1 00:00 Welcome back. I am Professor Wong. And today we are going to be discussing Chapter 8 – risk and rates of return. We start this chapter off by discussing returns, and in particular and how do we calculate expected returns. And next we talk about investment risk, what exactly is investment risk? We will find out that there is stand-a-lone investment risk, and then there is portfolio risk. And finally we tie these two subjects together and talk about risk and return together, and we talk about some of the measurement of risk and return together. And finally we end our discussion with one of the most important topics in cooperate finance which is the use of the capital asset pricing model, or sometimes we refer to it as CAPM or the SML (security market line), which tells us what the required rate of return is for an investor in a diversified portfolio. Today’s Lesson: “No Pain, No Gain”2 00:00 If you recall from our last discussion the topic that we covered was “time is money” or to say it in another way, “a dollar today is worth more than a dollar in a year from now.” That was the lesson of time value money. Well, today’s lesson is, “no pain, no gain.” What exactly does that mean? That means in order for investors to take on additional risk, they require additional compensation for taking on additional risk. It basically has a premise that all investors are risk adverse, meaning that investors do not like to take on additional risk unless they are being fairly compensated for taking on additional risk. Hence in order to have a little and gain you are going to have a little pain, and that’s today’s lesson. No pain, No gain. Investment Returns 3 00:00 We begin our discussion ? ? focusing ? ? ? ? ? ? ? ? ? returns, ? ? ? ? ? ? ? ? are ?they ?and? how ? ? ?they?calculated. ? ? ? ? by ? ? ? ? ? on investment ? ? ? ? ? what exactly ? ? ? ? ? ? ? are ? ? ? ? ? Investment returns 4 00:00 Investment returns can be calculated, as a return equals the amount received from an investment minus the amount invested divided by the amount invested. So for example if we invested $1,000 and $1,100 is returned after one year, then the rate of return for this investment is essentially 10%; or to put it in a format as you can see from the slide we would say $1,100 is the amount received minus $1,000 which is the initial investment, divided by the initial investment which is $1,000, and this equals 10%. Now we made $100 on this deal, why don’t we express returns in terms of absolute dollar terms? For example instead of saying we made 10% why don’t we say that we made $100. Well the reason is really twofold. Number one is time value of money, just by knowing that we made $100 doesn’t really tell us exactly how long it took to make that $100, so time value of money plays a very important part in why we express returns in percentages. The second very important reason is the scale of investment. If we invested $5,000,000 today and we got $5,000,001 in ten years back from now, sure we would have made $1, but that would have been ten years later, and also it was the scale of investment, investing $5,000,000 to get $1 isn’t really quite an ideal investment. So it’s again expressing returns in terms of percentages allows us to actually quantify the scale of investment what we have in the first place. So making $100 on $1,000 is a lot more interesting than making $100 on $1,000,000. And hence it’s again the reason why we express our returns in percentages. Selected Realized Returns, 1926 – 5 00:00 2004 Now let’s take a look at some selected realized returns from some certain asset classes between 1926-2004. So, on the left you see some various asset classes, and on the right you have their annual average returns over these past 78 years or so. As you can see the small company stocks have an average return of approximately 17.5%. Now what do we mean when we say small company stocks? Generally we are speaking about small capitalization stocks or “small cap” stocks. If you recall from our financial ratio lecture we discussed what market capitalization means. It is essentially the number of shares outstanding multiplied by the actual share price which gives us a market value or market capitalization of the company’s stock. It basically tells us what the investors believe it is worth. As for small cap stocks they are generally stocks or companies with market caps of around $500,000,000 or less. For large company stocks, they are of companies of a $500,000,000 or up market capitalization. And as you can see the average annual rate of return for investing in large company stocks has been slightly lower at about 12.4%. Long term corporate bonds have an annual rate of return of around 6.2% and you might ask yourself what exactly are long term corporate bonds; well corporate bonds are a lot like stock in the fact that the company sells these securities to investors to the marketplace in order to raise money for the company. The differences, though, whereas equity implies some sort of ownership in the company, the bond offering does not imply any kind of ownership in the company. It is essentially an “I.O.U”. from the company to the investor that says I would agree to pay you an annual interest rate or coupon rate in return for you allowing me to borrow this money, and then when the bond matures on the maturity date, then at that point in time, I will repay you the full balance of your initial loan as well. So that is what a corporate bond is. A government bond is very similar to a corporate bond and sometimes you may hear people refer to these as “muni” bonds – that’s short for municipality bonds, and basically governments will want to raise money for government works and other kinds of infrastructure projects; and then they raise these funds through selling these debt securities in the marketplace, and as you can see these long term government bonds have a produced even a smaller annualized return of 5.8% over the previous approximate 80 years. A Investment Asset Alternatives 6 00:00 How do the returns of HP and “Gold”7 behave in relation to the market? So again how do the returns of HP and gold behave in relation to the marketplace? Really, HP moves with the economy as most of the other asset classes do that we pointed out in the previous slide. This means that it has a positive correlation with the economy that it moves in sync, that it moves one by one, step in step, with the economy. This is typical of most asset classes that are out there. Gold, however, is a commodity, and it is counter-cyclical to the economy and thus has a negative correlation with the economy and this is more unusual, so when the economy is doing really well gold is doing very poorly and vice versa, and when the economy is doing very poorly, gold is doing very well. So this is usually atypical or unusual in the marketplace to find these kinds of asset classes, but just to know that there are these kinds of asset classes available. 00:00 Return: Calculating the expected return for each asset alternative 8 00:00 Spreadsheet Solution 9 00:00 slide/cap8-9.swf Summary of expected returns for all assets 10 00:00 Now that we are done calculating the expected rates of return for each of the different asset classes, let’s summarize it and see what we have learned. We figured out that HP’s expected rate of return is 17.4%, that the standard S&P index or the average stock in the marketplace is going to return 15%, that McDonald's is going to return less at 13.8%, that T-bills give us a risk free rate of return of 8%, and that gold does the most poorly at 1.7%. So based on everything here, which asset has the highest expected return? Well the answer is simple; HP obviously at 17.4% has the highest expected rate of return. The next question is, which asset is the best investment alternative? Now that is a different question than asking which asset has the highest expected rate of return. The answer to it depends upon the level of risk that you are willing to take. If you don’t like risk at all, maybe you would prefer a T bill that produces 8% versus HP that produces 17.4%, because intuitively you should begin to remember and begin to think that the higher the returns are, the more risk there is going to be; in other words, “no pain, no gain.” Thus when I ask you which asset is the best investment alternative, at this point, it’s really difficult to understand or be able to tell because we haven’t accommodated risk in our scenario analysis; so the final question is what about risk for each of these different asset classes? How risky are each of these asset classes; and I think we need to begin to answer that question before we figure out which one is in fact the best investment alternative, and so next we are going to talk more about risk. Self Test 8.1 11 00:00 But before going onto risk, let’s cover the topics on investment returns, and to make sure that we comprehend them. Self test question 8.1 – an investment that as a 50% chance of producing a 20% return, a 25% chance of producing an 8% return, and a 25% chance of producing a –12% return, what is it’s expected return? Please take a moment to write down your answer and go to the next slide when you are ready. Self Test 8.1 Answer 12 00:00 slide/cap8-12.swf Self-test 8.1 answer. In this problem, we know that there are 3 scenarios. A, B and C There is a 50% chance that A will occur, a 25% chance that B will occur and a 25% chance that C will occur. We are asked to figure out the expected rate of return for this portfolio. We can do this simply by taking the probability of each scenario occurring, multiplied by its expected rate of return. If we do that for each of A, B and C, we see that the expected rate of return equals 10% for A, 2% for B, and negative 3% for C. As soon as we sum this up, we get our expected return of this overall portfolio of approximately 9%. Investment Risk 13 00:00 Remember today’s lesson ? ? called ? ? ?pain, ? ? gain.’ ? ? far ?all? we ?have ?been?talking ?about are ?the? returns, ? ? ? gain? part; ? ? ? we ?have ?to ? ? ? ? talking? about ? ? ? pain? part? which ? ? ? ? ?risk, ? ? ?thus ?we ? ? ? ? ? ? ? ? ? ? ?that ?in ? ? ? ? to? make? money, people have to take additional risk. ? ? ? ? is ? ? ? ? ‘no ? ? ? no ? ? ? ? So ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? now ? ? ? ? start ? ? ? ? ? ? ? the ? ? ? ? ? ? ? is the ? ? ? and ? ? ? have to remember ? ? ? order ? ? ? ? ? ? ? What is investment risk? 14 00:00 So let’s first start off by talking about what exactly is investment risk. Investment risk is essentially the risk or the probability of achieving low or negative returns on your asset class. There are really two types of investment risk that we focus on in this lecture. The first one is called stand-alone risk; the second one is called portfolio risk because lower or negative returns equal a riskier investment for us. Now what we will begin to do in this part of the lecture is we will describe specifically how we measure stand-alone risk and portfolio risk, but then as we come back around at the end of the lecture we start talking about how calculating the specific firm risk is really not important for an investor who is in a “diversified” portfolio, and we will talk about what exactly a diversified portfolio means. Selected Realized Returns, 1926 –15 00:00 2004 Here we are again looking at the different asset classes that we started off with earlier with selected realized returns from 1926-2004. You had small company stocks at 17.5%, large company stocks at 12.4%, long-term corporate bonds at 6.2%, and long-term government bonds at 5.8%, and U.S treasury bills at 3.8%. And the question at that point in time was which one was the best investment alternative? Well it was really tough to figure out because we didn’t understand the risk associated with each of these different returns. Now we see on the right hand column is a column called standard deviation. Standard deviation measures the specific risk of an asset class. Ok, so for the small company stocks, the expected average return was 17.5%, but it’s standard deviation was 33.5%, so what exactly does that mean? That means that although we expect the returns to be 17.5% it could fluctuate plus or minus 33.1% in either direction, so it could be 17.1 plus 33% or it could be 17.1 minus 33%, so that’s a huge swing, and we call that volatility, and the larger the volatility or the larger the swing has, the more risk the investor faces. So the higher the standard deviation, the higher the risk that the investor faces, and if you look at a large company’s stocks, you can see the same thing is happening, you’re getting an expected rate of 12%, but that 12% is subject to a plus or minus 20% in standard deviation, or in volatility, so it could be essentially 32% or 12 minus 20 would be: – 10%, so either or, these are the kinds of things that you would look for. Now long-term corporate bonds has a standard or average return of 6.2% but the standard deviation is 8.6% so on and so forth. So what you see here now, it’s not only one side of the picture which is the average returns of these asset classes, but you see the other side of the picture too, which is it’s volatility or it’s standard deviation. Now we will spend the next few slides specifically about how do we calculate standard deviation, and we will go back to our original assets, HP, gold, the S&P etc in order to do so. Comparing standard deviations 16 00:00 Again standard deviation is the possibility of earning low or negative returns. It is the volatility which occurs, plus or minus, from the expected rate of return. As we can see from this chart when we are comparing standard deviations of the T-bills to the McDonald's to the HP, what do we see? First off, let’s look at the T-bill. The T-bill has one straight line pointing up and it’s expected rate of return is 8%, notice that this in not a bell curve meaning that this is risk free, meaning there’s no way that you’re going to earn less than 8% and there’s no way that you’re going to earn more than 8%, thus the expected rate of return is 8% and the standard deviation here is 0. However when we look at McDonald's you can see that the expected rate of return is 13.8% and the expected rate of return for HP is 17.4%. Now the difference between these mushroom clouds or hills that you see is that HP is a little bit flatter, whereas McDonald's has a little bit more tight of a range of outcomes. The tightness or narrowness of McDonald's outcomes makes it less volatile, less risky, hence lower standard deviation than HP, which as a relatively flat kind of bell curve. So the flatter that your bell curve is, the more risk that you are going to have in terms of volatility. The tighter or more narrow the distributional probabilities of returns are, the more certain you are going to be and the less volatility or the less deviation you are going to have on your particular asset. Risk: Calculating the standard deviation for each alternative 17 00:00 So when we talk about risk, we talk about standard deviation. We want to calculate the standard deviation for each of these alternatives. First off, what exactly is a standard deviation is denoted by the sign that you see that looks like a little face with hair sticking up at the end (“σ”). That’s the standard deviation sign. Standard deviation is the square root of the variants, and the square root of the variants is the standard deviation square, so if we take the root of the variants we get the standard deviation square. So the standard deviation basically equals again the weighted sum of the required rate of return on each of the different assets, minus the expected rate of return – remember it’s the K^, squared, multiplied by the probability that that’s going to occur at each different interval. So again we will go through this for each of the different assets in the next slides. Standard deviation calculation 18 00:00 So here we are going to calculate the standard deviation of the T-bills. As you can see we are going to take the square root of the variants and the first thing that we are going to do to find the standard deviation of the T-bills is to differentiate between the Ki and the K^. The K^ is what we figured out before which is the expected rate of return, which is the weighted sum of everything else so for HP if would have been 17.4%, for T-bills of course it would have been 8%, and then the Ki is the expected return at each of the different “intervals.” So for example, for T-bills they are going to have 8% at each of the different intervals because that doesn’t change, and you’re going to deduct or minus the expected rate of return which is the K^ – 8% from each of those, square those, multiplied by each of the different probabilities at each interval; so there’s a 10% chance that in a recessionary period T-bills are going to return 8% and we know that the weighted sum expected return is also 8% and the probability is 10% at that time. We add that to our next component which again is the same thing in the front part “8-8” to the square which represents again the expected return in each interval minus the expected return overall, and this time there’s a 20% chance of that occurring because it’s the below average economy. If we take the square root of all this we find that the T-bills equal 0%, so the standard deviation for T-bills equals 0% which again should make a lot of sense because T-bills are risk free inherently; there is no risk to them so there is no fluctuation between the expected rate of return. However if we do the same for each of the separate asset classes we find out that HP has a standard deviation of 20%, gold has a standard deviation of 13.4%, McDonald's has a standard deviation of 18.4%, and finally the S&P has a standard deviation of 15.3%. Our next slide will actually go through the Excel calculation of each of these different variables. Spreadsheet Solution 19 00:00 slide/cap8-19.swf Comments on standard deviation as 20 measure of risk a 00:00 Now that we have calculated ?the standard ? ? ? ? ? ? ? ? ? ? ?risk ?for each of? the ? ? ? ? ? ? ? ? ? ? classes, ? ? ? ? go? ahead ? ? ? summarize? and ? ? ? ? ? some additional ?insight ? ? ? ? ? ? standard ? ? ? ? ? ? ? ? a ? ? ? ? ? of? risk. ? ? ? standard ? ? ? ? ? ? ? ? ? ? ? ?total ? ? stand ?alone ? ? ? ? ? ?each ?specific asset. ? ? ?larger? the ? ? ? ? ? ?deviation ?is, the ? ? ? ? the ? ? ? ? ? ? ? ?that ?the actual ? ? ? ? ? will be? closer to? expected ? ? ? ? ? ?The larger ? ? ? standard deviation is, it’s associated with a wider probability of distribution of returns, thus it’s more volatile. If we look at standard deviations alone, it’s very difficult to compare them because we haven’t accounted for the returns. ? ? ? ? ? ? ? ? ? ? ? ? ? deviation or the ? ? ? ? ? ? ? ? ? ? different asset ? ? ? ? ? let’s ? ? ? ? and ? ? ? ? ? ? ? provide ? ? ? ? ? ? ? ? ? ? ? ? ? into the ? ? ? ? ? deviation as ? measure ? ? ? ? The ? ? ? ? ? deviation measures ? ? ? or ? ? ? ? ? ? risk for ? ? ? ? ? ? ? ? ? ? ? The ? ? ? ? ? standard ? ? ? ? ? ? ? ? ? lower ? ? probability ? ? ? ? ? ? ? ? returns ? ? ? ? ? ? ? ? ? ? ? ? ? ? returns. ? ? ? ? ? ? the Self Test 8.2 21 00:00 Now let’s take a moment and review the topics that we have just covered. Self test question 8.2 – What does investment risk mean? Please take a moment to answer this question then go to the next slide when you are ready. Self Test 8.2 Answer 22 00:00 Self test 8.2 answer – Investment risk is the probability of earning low or negative returns. Self Test 8.3 23 00:00 Self test question 8.3 – Which of the two stocks on this graph are less risky and why? Please explain and then go to the next slide when you are ready. Self Test 8.3 Answer 24 00:00 Self test 8.3 answer –X is less risky because it’s standard deviation is less than Y. It has less volatility; we can also see this because front X has a tighter bell curve or probability of distribution within its return and front Y has a flatter bell curve. Self Test 8.4 25 00:00 Self test question 8.4 – Explain why you agree or disagree with the following statement. Most investors are risk adverse. Please answer this question and go to the next slide when you are ready. Self Test 8.4 Answer 26 00:00 Self test 8.4 answer – Most investors are risk adverse and do not like additional risk unless there is additional compensation associated with taking additional risk. If investors like to risk for the sake of risk without required compensation for taking on the additional risk this would be irrational. Risk & Return Together 27 00:00 Now that we have looked at returns and risk now we must look at them and compare them together in order to figure out which is the best investment alternative. But before we do that we will talk again about T-bills and why essentially they are essentially risk free. Why is the T-bill return independent 00:00 28 of the economy? Do T-bills promise a is the T-bill return independent of the economy? Do T-bills promise a completely risk free return? T-bills will return the promise 8% regardless of the economy. T-bills do not provide a risk free return, as they are also exposed to inflation, although very little expected inflation is likely to occur in such a short period of time. Thus, T-bills are also risky in terms of reinvestment rate risk. T-bills are risk free, though, in the default sense of the word, meaning the U.S. government has never defaulted on repaying any kinds of T-bills. Why completely risk-free return? Here we have a chart comparing the expected return and the standard deviation that we have previously calculated with each of the different asset classes. Just by looking line by line at each of these different asset classes and knowing what they return and knowing what the standard deviation or the associated risk is with those returns, what does common sense tell you about the investment alternatives above? Number one it should tell you that our fundamental principle here in that no pain, no gain continues to hold true in that the asset classes that have better gains or better returns are also going to have higher risk profiles. If you look at HP for example, you see that they have 17.4% as an expected return, but “wow,” what a large possible fluctuation in possible outcomes and that their standard deviation is plus or minus 20%. T-bills however, have an expected rate of return of 8% and they have a standard deviation of 0%, meaning that you are going to get that 8%, no more, no less, no matter what. And then if we compare gold to the rest of these asset classes, what do you find, we note that their expected return is 1.17%, but “wow,” they have a 13.4% standard deviation, that is pretty high, especially when you stack it up against S&P, or the average stock on the marketplace, you see that the average stock on the marketplace has a close standard deviation in 15.3% which is a little bit more than gold’s 13.4% but, “wow,” look at all the expected return that you can get out of the S&P at 15% versus the gold at only 1.7%. Furthermore if you want to compare McDonald's and S&P together, you can see that S&P out-performs McDonald's on a return basis 15 and 13.8%, but also it’s a lot less risky, you can see McDonald's is quite risky at 18.8% but the S&P a lot less risky at 15.3%. Thus now let me ask you the question: which one do you believe is the best investment alternative? Now I won’t tell you the answer yet because it’s coming up and we will figure it out in a second. But again it’s tough to actually make a judgment call here and answer that question without somehow being able to tie the expected return and the risk standard deviation together. Well there is a way to tie that together and that’s what we will discuss next. Comparing risk and return 29 00:00 Coefficient of Variation (CV) 30 00:00 The coefficient of variation or the CV allows us to basically tie the returns with the relative risk of each of those returns, so that it shows us, as we take on additional increment and units of return, what the additional increments of units of risk will be as well. The coefficient of variation is defined as the standard deviation of the asset divided by its expected rate of return or it’s mean. Thus it is the standard deviation divided by K^. In our next slide, we will actually go through an Excel model to actually calculate the coefficient of variation for each of our different asset classes. Spreadsheet Solution 31 00:00 slide/cap8-31.swf Risk rankings, by coefficient of 32 00:00 variation So again the coefficient of variation shows us the degree of risk per unit of return. As we can see, once we have calculated that for each of our different asset classes we see that T-bills of course have a coefficient variation of 0, again it’s risk free so it shouldn’t be anything higher, but HP has a coefficient variation of 1.1, gold has a coefficient variation of 7.8, McDonald's is 1.3 and the S&P is 1.020. So HP despite having the highest standard deviation of return, it has a relatively average coefficient of variation compared with McDonald's and the S&P. Gold of course has the highest degree of risk per unit of return so gold is clearly not the best investment alternative and it’s probably between HP and the Standard market index in terms of the best investment alternative. But I would say that HP is the best investment alternative because it offers us a relatively average coefficient of variation yet it provides us a little bit more upside in terms of returns. Illustrating the CV as a measure of relative risk 33 00:00 We can also illustrate the coefficient of variation as the measure of relative risk by looking at this graph below. In this graph we see that we have the rate of return on the X-axis and then the probability of that occurring on the Y-axis. We have two firms here, firm A and firm B; they have the exact same bell curve so thus firm A and firm B have the exact same standard deviation and the same kind of volatility for their expected returns. The difference though is that A is riskier because of the larger probability of losses in the negative portion of the graph versus firm B. In other words, the same amount of risk is measured for standard deviation for less returns for firm A, and that’s why firm B is a better investment at this point. Self Test 8.5 34 00:00 Now let’s review the topics that we have just covered. Self test question 8.5 – Which is a better measure of risk if the assets have different expected returns, the standard deviation or the coefficient of variation? Please take a moment to think about your answer and go to the next slide when you are ready. Self Test 8.5 Answer 35 00:00 Self test 8.5 answer. The coefficient of variation or the CV is a better measure of risk because it allows us to compare a unit of incremental risk with a unit of incremental return. Self Test 8.6 36 00:00 Self test question 8.6. An investment has an expected return of 10% and a standard deviation of 30%, what is its coefficient of variation? Please calculate this on a piece of paper and go to the next slide when you are ready. Self Test 8.6 Answer 37 00:00 slide/cap8-37.swf Self-test 8.6 answer. In order to find the answer to this solution, we are looking for the co-efficient of variation. That is again simply the standard deviation divided by the expected rate of return. In this case, 30% is our standard deviation and 10% is our expected return. If we take 30 and divide it by 10, then we get the answer of approximately 3. Investor attitude towards risk 38 00:00 Now that we have talked ? ? ? ? how ? ? calculate risk let’s ?now talk about ?the investor’s?attitudes?toward? risk. ?Like ?I? said? before people ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?mean? ? ? assumes? that? investors? dislike ?risk ?and require? higher rates ?of ? ? ? ? ?to ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? securities. ? ? ? ? ? called ? ? ? ? ? ? ? ? ? ? The ? ? ? ? ? ? ? ? is? the ? ? ? ? ? ? ? between ?the return ? ? a ? ? ? ? ? asset?and the ?less ?risky asset, ? ? ? ? serves as enough ? ? ? ? ? ? ? ? for ? ? ? ? ? ? ? ? ? ? ? ? ? ?riskier ? ? ? ? ? ? ? ?So ? ? ? ? ?they ?receive ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?investors ?are not likely to hold onto riskier securities because they are risk averse in the first place. ? ? ? ? about ? ? we ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? have a general risk aversion. What does risk aversion ? ? ? It ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? return ? encourage them to hold riskier ? ? ? ? ? ? ? This is ? ? ? ? a risk premium. ? ? risk premium ? ? ? difference ? ? ? ? ? ? ? ? ? ? on ? riskier ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? which ? ? ? ? ? ? ? ? ? ? compensation ? ? investors to hold the ? ? ? ? securities. ? unless ? ? ? ? ? ? some sort of risk premium, ? ? ? ? ? ? ? ? ? Self Test 8.7 39 00:00 Now let’s take a review of the review of the topic we just covered. Self test question 8.7 – How does risk aversion affect rates of return? Please answer this question and go to the next slide when you are ready. Self Test 8.7 Answer 40 00:00 Self test 8.7 answer. Investors require higher rates of return for taking on additional risk. Hence that’s why we say "no pain, no gain." Portfolio construction: Risk and return 41 00:00 So far we’ve been looking at risk and return on individual asset classes, now let’s look at risk and return from a portfolio perspective, so if we combine more than one stock together into a certain portfolio. Here we are going to assume a two-stock portfolio, meaning that it only consists of two stocks that we invest in, which is created with $50,000 invested in both HP and gold. The expected rate of return of the portfolio is the weighted average of each of the component assets within that portfolio, the standard deviation though is a little bit more tricky as requires that a new probability distribution for the portfolio returns be devised. So let’s first start with the returns portion of this portfolio. Calculating portfolio expected return 42 00:00 So in order to calculate the expected rate of return from the portfolio we have a new denotation which is K^p which stands for the expected rate of return for the portfolio, we must now take the weighted average of both of the different asset classes and expected returns and sum those up. So essentially, in the case that we have before us, we have $50,000 invested in HP and $50,000 invested in gold. That is $100,000 total invested which also means that 50% of our assets are invested in gold and 50% of our assets are invested in HP. Well in order to find the expected rate of return on the portfolio as you can see on the bottom of the equation, we take 50% of the HP’s expected return, and 17.4% and we add that to 50% weighted average multiplied by the expected rate of return of gold which is 1.7%, gives us a total weighted average sum of the expected rate of return of the portfolio of 9.6%. Our next example shows constructing and doing a portfolio expected return based on all of the assets in our investment portfolio that we were using before. Spreadsheet Solution 43 00:00 slide/cap8-43.swf Using Microsoft we can find the portfolio's expected rate of return simply by saying equals first, and multiplying the portfolio weight by the actual expected rate of return. Then we add that to the portfolio rate of the other asset, which is Gold, and multiplying that by the expected rate of return of 1.7%. This would give us a weighted, expected portfolio return of approximately 9.6%. An alternative method for determining portfolio expected return 44 00:00 There is an alternative way for determining the portfolio expected return. If we were given the expected portfolio return at each of the different economic states as we have in this chart here, then we could also take the weighted average sum of each of these different economic states and the probability of them occurring, and the expected rates of the return of the portfolio to get an expected rate of return on the portfolio as well. For example, in an economic state of a recession there is a 10% possibility that the portfolio will only return 3% and so on and so forth, in a boom state there’s a 10% chance that the portfolio could return at 15%, if we multiply each of these together and sum them up we see that the expected return on the portfolio is 9.6%. Calculating portfolio standard deviation and CV 45 00:00 Also based on the information on the following slide we can also calculate the portfolio’s standard deviation as well as the coefficient of variation. As you can see from this adjoining slide, the standard deviation for the portfolio given different economic states is 3.3% and the coefficient of variation for the portfolio is 0.34%. Our next slide will give you exactly how to do it in Microsoft Excel. Spreadsheet Solution 46 00:00 slide/cap8-46.swf Comments on portfolio risk measures7 00:00 4 There are some important things to point out here once we have calculated the standard deviation of the portfolio, and the coefficient of variation of the portfolio. Basically the standard deviation of the portfolio equaled 3.4% when we calculated it. This is of course much lower than the standard deviation of either stock by itself, HP had a standard deviation of 20%, and gold had a standard deviation of 13.4%, and also the standard deviation of 3.3% is lower that the weighted average of both HP and gold’s standard deviation, which would be 16.7%. So what have we noticed here? We noticed that when we combined stocks into a portfolio it provides an average return of each of the component stocks, but it provides also a lower than average risk. This is called “diversification,” and why does this happen? It happens because of the negative correlation between stocks, so that HP, although is pulling one way and going the right way in terms of up and to the right like a normal economy and normal stock market would, gold is pulling the other way, and as it pulls each other, the returns become the average but the average risk becomes a lot lower. Correlation Between Stocks 48 00:00 So what we have been talking about is essentially correlation between the two stocks. Correlation again is the tendency of two stocks to move together. Correlation coefficient, which looks like a small lower case cursive p (“ρ ”), is the measure of the degree of relationship between the two variables. If the correlation coefficient equals +1.0, we call this a perfectly correlated stock, then the two variable are basically moving one by one, step in step with each other. If the correlation coefficient is -1.0, however, the two variables are negatively correlated or moving apart on a one for one basis. And finally if there is a correlation coefficient equal to 0, we call this that the two variables are not correlated whatsoever, so that there’s not enough evidence to say that they are moving either together or not together. General comments about risk 49 00:00 So, more general comments about risk and correlation. Most common stocks are positive when correlated with the market, that means that correlation coefficient between different stocks, K and the market “M” would equal about approximately 0.65, so it’s not quite 1.0 moving in lockstep, but it’s moving in the same direction which is usually up and to the right at .65. The standard deviation is approximately 35% for an average stock. Combining stocks together like we did with HP and gold like we did and putting them in a portfolio is called diversification, this generally lowers the risk and we will spend the next few slides describing how diversification actually lowers the risk. Returns distribution for two perfectly negatively correlated stocks (ρ Here are the returns that should be issued for two perfectly negatively correlated stocks with a correlation coefficient of -1.0. You can see wherever stock W is peaking, stock M is doing the exact opposite, so if stock W is down, stock M is up, and if stock M is down, stock W is up. So they move in exact different paths or they are negatively correlated with each other. If you took these two stocks, stock W and stock M, and you put them together in a portfolio, what you would get is the median return of each of these different return points, or in the case of portfolio WM combining together you get a median return of 15%. 50 00:00 = -1.0) Returns distribution for two perfectly positively correlated stocks (ρ This next example shows return distributions for two perfectly correlated stocks, or with a correlation coefficient of positive one. As you can see stock M and stock W move in lockstep with each other, that when stock M is at its peak, stock W is at its peak, so on and so forth, when stock W is at its low point, stock M is at its low point, if you combine these return profiles together into one portfolio, we’ll call it MM, what you see here now is that the exact same profile of each of the individual asset classes is represented in the portfolio as well. 51 00:00 = 1.0) So, when we to creating Creating a portfolio: Beginning with 00:00stock and adding randomly selected stocks are portfolio a portfolio we begin with one stock and we start adding randomly selected stocks into that portfolio, this is called diversification. The standard deviation of the portfolio decreases as more stocks are added. Remember that the average standard deviation of a stock is around 35%. So as you add more stocks in, you see this 35% decrease because they are not perfectly correlated with the existing portfolio, or with the existing stocks inside the portfolio. This occurs and the expected return of the portfolio would remain relatively constant at its median. Eventually the diversification benefits of adding more stocks dissipate after adding ten stocks or so, and for large stock portfolios the standard deviation of the portfolio tends to converge to about approximately 20%, so as you can see by adding more stocks into the portfolio and through the use of diversification we can lower the firm’s specific or average stock standard deviation of 35% to approximately 20% without jeopardizing the expected or average returns of the certain portfolio. This again is one of the major benefits of diversification. So essentially what we have learned in the previous slides in regards to standard deviation and learning how to calculate it, now we are going to find out that actually that’s not important because you can actually eliminate all that kind of stuff, because actually what’s left is this plus or minus 20% that you could never eliminate and that’s what we are going to talk about next. 52 one Illustrating diversification effects 00:00 stock portfolio 53 of a This slide basically shows and illustrates diversification of effects of a stock portfolio. As you can see on the left hand side on the Y-axis we have the standard deviation of the portfolio with about 45% if you are starting off with one stock. If you add more stocks you can see on the X-axis you can see the number of stocks in the portfolio you can see that the standard deviation decreases, you basically can eliminate approximately 15% of the average standard stock deviation simply by putting it into a diversified portfolio. Thus what you’re doing is you’re eliminating all company related specific risk, which is represented underneath the blue line, and what you have left then is what’s called market risk shaded in green at 20% plus or minus, and that unfortunately you can never eliminate. But if you are a smart investor you know that you shouldn’t put all your “eggs in one basket” as they say, and that you should try to diversify because if you do you will be able to eliminate a big portion of the risk associated with each specific stock. Breaking down sources of risk 54 00:00 Now let’s break down the sources of risk that we just described. Stand-alone risk incorporates the market risk, which is that plus or minus 20% that we mentioned in our last slide, which was shaded in green, plus each firm’s specific risk. Now we’ve already said that we can eliminate a firm’s specific risk through diversification. Market risk is the portion of the security stand-alone risk that cannot be eliminated whatsoever through diversification. This market risk is measured by what we call “beta.” And what we are actually going to do next is talk about how we measure beta and calculate, but beta actually is the more relevant measurement versus standard deviation. A firm’s specific risk is the portion of the securities stand-alone risk that can be eliminated through proper diversification as we shown already. Failure to diversify 55 00:00 What happens if an investor fails to diversify? If an investor chooses to hold a one stock portfolio basically exposing them to more risk than a diversified investor is, would the investor be compensated for the risk that they bear? The answer is of course no, they wouldn’t. Stand-alone risk is not important to a well-diversified investor. Rational risk averse investors are concerned with the standard deviation of the overall portfolio which is based only upon market risk and again is measured by beta. So therefore there can be only one price, or one market return for a given security. No compensation should be earned for holding unnecessary, diversifiable risk that the investor could have diversified away in the first place. Self Test 8.8 56 00:00 Now let’s take a moment to review some of the complex topics that we have just covered. Self test question 8.8 – Explain the following statement – An asset held, as part of a portfolio is generally less risky than the same asset held in isolation. Please explain your answer and go to the next slide when you are ready. Self Test 8.8 Answer 57 00:00 Self test 8.8 answer. If stock held in a diversified portfolio were to allow an investor to eliminate all firm’s specific risk and hold only market risk, a stock held in isolation however would include both market and firm specific risk. Thus you would not be compensated for holding firm specific risk because it is a diversifiable risk. Self Test 8.9 58 00:00 Self test questions 8.9 – What is meant by perfect positive correlation, perfect negative correlation, and zero correlation? Please write down your answer and go to the next slide when you are ready. Self Test 8.9 Answer 59 00:00 Self test 8.9 answer. If the correlation is +1 then the two variables are perfectly correlated. If the correlation coefficient is –1 then the two variables are negatively correlated, and if the correlation coefficient equals 0 that means that the two variables are not correlated whatsoever. Self Test 8.10 60 00:00 Self test question 8.10 – In general can the riskiness of a portfolio be reduced to 0 by simply increasing the number of stocks in the portfolio? Explain your answer and go to the next slide when you are ready. Self Test 8.10 Answer 61 00:00 Self test 8.10 answer. Although you can diversify away all a firm’s specific risk, you can never diversify away market risk. Thus you cannot diversify away the riskiness of a portfolio to 0 by simply just increasing the number of stocks in the portfolio, because you will always have the market risk to deal with. CAPM & SML 62 00:00 Capital Asset Pricing Model (CAPM)63 00:00 So, what exactly is CAPM, or the capital asset pricing model? It is a model based on the concept that the stock’s required rate of return is equal to its risk free rate of return plus a risk premium that reflects the riskiness of the stock after diversification. The primary conclusion of CAPM is that the relevant riskiness of its stock is its contribution to the riskiness of the overall diversified portfolio. As I mentioned earlier ?beta ?represents ? ? ?market? risk? for ? ?company.? This? measures ? ? ?a? stock’s?market? risk, ?and? shows ?the? stocks ? ? ? ? ? ? ? relative ? ? the ? ? ? ? ? ? ? indicates how ? ? ? ? a ? ? ? ? is, ? ? the ? ? ? ? is? held? in ?a? well-diversified portfolio in relation to the market. Beta 64 00:00 ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? a ? ? ? ? ? ? ? ? ? ? ? how ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? volatility ? ? ? ? ? to ? ? market. It ? ? ? ? ? ? ? ? risky ? stock ? ? if ? ? stock ? ? ? ? ????????????????? Comments on beta 65 00:00 Some quick comments on beta, if the beta equals 1.0 for a stock then that stock is just as risky as the average stock. If the beta is greater than 1.0 then that security or that is riskier than the average stock and vice versa; if beta is lower than 1.0 then it’s less riskier than the average stock. Most stocks have betas somewhere in the range of 1.0 to 1.5. Calculating betas 66 00:00 Now you might ask yourself how do analysts calculate betas? Well before we get into that subject let’s first say that betas are calculated on all the major financial websites, so you can go to Yahoo finance, you can go to the Reuters website and you can just look up the beta of each particular company. So very rarely in your professional, financial career will you ever have to calculate a beta yourself, you always can just look on the Internet and find the beta of a particular company. However, to understand how that calculation works is important. It’s that well diversified investors are concerned with how well the stock is expected to move relative to the market in the future, but without a crystal ball to predict the future, analysts are forced now to rely on historical information in order to calculate the beta. A typical approach is to estimate the beta using a regression analysis using the securities’ past returns and the markets past returns. You can also use your chart wizard on your Microsoft Excel to do this as well and this is called a trend line that you can run. This slope of this regression line is defined as the beta coefficient for the security. Illustrating the calculation of beta 00:00 67 Here’s an illustration of how you could calculate a beta and on the right hand side you see a ledger, you see a year historically, the past three years, you have the actual return on the market for those past three years, and then you have Ki, the actual return on your specific stock i, so you can see that in year one the stock market returned 15% and stock i returned 18%, well if you run the graph you can see that the plot line for stock i and the market will equal a certain point, now you can find the three points for each of these different years, and then the regression line, the line that runs through these three points is called the regression line, and again the slope is the beta coefficient of that regression line. Can the beta of a security be negative? 68 00:00 Can the beta of this security be negative? Yes if the correlation between stock i and the market is negative, ie: there is a correlation coefficient between stock i and the market which is less than 0, and also that the correlation is negative, the regression line would slope downward and the beta would be negative, although a negative beta is highly unlikely in the marketplace. Self Test 8.11 69 00:00 Self test question 8.11 – What is an average risk stock, and what is the beta of such a stock? Please take a moment to answer this question and go to the next slide when you are ready. Self Test 8.11 Answer 70 00:00 Self test 8.11 answer. An average risk stock is a stock, which is just as risky as the average stock in the market; an average risk stock is a stock with a beta equal to 0. Self Test 8.12 71 00:00 Self test question 8.12: Why is it argued that beta is the best measure of the stock’s risk? Take a moment to answer this question then go to the next slide when you are ready. Self Test 8.12 Answer 72 00:00 Self test 8.12 answer. Beta determines how the stock affects the relative riskiness of a diversified portfolio, thus a diversified portfolio eliminates a diversifiable risk, and compensation is only required for risk that can not be eliminated by diversification or market risk, thus beta measures the market risk or risk that investors demand compensating for taking. Self Test 8.13 73 00:00 Self test question 8.13 – If you plotted a particular stock’s returns versus those of the Dow Jones index over the past five years what will the slope of the regression line indicate about the stock’s risk? Take a moment to answer this and go to the next slide when you are ready. Self Test 8.13 Answer 74 00:00 Self test 8.13 answer. The slope of the regression line would represent the beta of the stock or its relevant risk to a diversified portfolio. ????? ?????? Financial Decisions Chapter9 Henry Wong ????? Push here to start Home Work ???????? ?????????? slide/fd_09slide.swf flv? ? ? ? ???? flv/fd_01vid000.flv 00:01 flv/fd_09vid001.flv 01:04.9 flv/fd_09vid002.flv 00:54.0 flv/fd_09vid003.flv 01:04.8 flv/fd_09vid004.flv 02:01.6 flv/fd_09vid005.flv 01:20.9 flv/fd_09vid006.flv 00:18.0 flv/fd_09vid007.flv 00:44.9 flv/fd_09vid008.flv 00:15.0 flv/fd_09vid009.flv 00:29.0 flv/fd_09vid010.flv 01:15.9 flv/fd_09vid011.flv 00:24.0 flv/fd_09vid012.flv 01:20.9 flv/fd_09vid013.flv 01:37.9 flv/fd_09vid014.flv 01:03.9 flv/fd_09vid015.flv 00:36.0 flv/fd_09vid016.flv 01:18.9 flv/fd_09vid017.flv 01:58.9 flv/fd_09vid018.flv 00:42.8 flv/fd_09vid019.flv 01:20.8 flv/fd_09vid020.flv 00:16.9 flv/fd_09vid021.flv 00:26.0 flv/fd_09vid022.flv 00:29.0 flv/fd_09vid023.flv 00:25.9 flv/fd_09vid024.flv 01:47.9 flv/fd_09vid025.flv 00:29.9 flv/fd_09vid026.flv 00:32.0 flv/fd_09vid027.flv 00:19.0 flv/fd_09vid028.flv 00:22.8 flv/fd_09vid029.flv 00:30.9 flv/fd_09vid030.flv 01:14.9 flv/fd_09vid031.flv 00:16.0 flv/fd_09vid032.flv 00:29.0 flv/fd_09vid033.flv 00:57.0 flv/fd_09vid034.flv 00:21.0 flv/fd_09vid035.flv 00:36.0 flv/fd_09vid036.flv 00:28.0 flv/fd_09vid037.flv 00:35.9 flv/fd_09vid038.flv 00:55.9 flv/fd_09vid039.flv 03:39.6 flv/fd_09vid040.flv 02:11.8 flv/fd_09vid041.flv 01:23.8 flv/fd_09vid042.flv 00:50.8 flv/fd_09vid043.flv 01:19.9 flv/fd_09vid044.flv 00:48.0 flv/fd_09vid045.flv 00:17.0 flv/fd_09vid046.flv 00:30.0 flv/fd_09vid047.flv 00:15.9 flv/fd_09vid048.flv 00:15.0 flv/fd_09vid049.flv 01:10.9 flv/fd_09vid050.flv 00:37.0 flv/fd_09vid051.flv 00:55.0 flv/fd_09vid052.flv 03:22.6 flv/fd_09vid053.flv 01:01.7 flv/fd_09vid054.flv 00:16.0 flv/fd_09vid055.flv 00:49.0 flv/fd_09vid056.flv 00:15.9 flv/fd_09vid057.flv 00:23.9 flv/fd_09vid058.flv 00:14.0 flv/fd_09vid059.flv 00:40.8 flv/fd_09vid060.flv 00:23.0 flv/fd_09vid061.flv 00:32.0 flv/fd_09vid062.flv 01:00.8 flv/fd_09vid063.flv 01:11.9 flv/fd_09vid064.flv 02:40.7 flv/fd_09vid065.flv 00:40.0 flv/fd_09vid066.flv 00:17.8 flv/fd_09vid067.flv 00:31.8 flv/fd_09vid068.flv 00:33.0 flv/fd_09vid069.flv 00:17.0 flv/fd_09vid070.flv 00:18.0 flv/fd_09vid071.flv 00:14.8 flv/fd_09vid072.flv 00:39.8 flv/fd_09vid073.flv 00:28.8 flv/fd_09vid074.flv 00:38.6 flv/fd_09vid075.flv 01:01.9 flv/fd_hw09vid001.flv 00:07.8 flv/fd_hw09vid002.flv 00:24.3 flv/fd_hw09vid003.flv 02:24.1 flv/fd_hw09vid004.flv 00:27.5 flv/fd_hw09vid005.flv 00:41.9 flv/fd_hw09vid006.flv 00:24.8 flv/fd_hw09vid007.flv 01:06.9 flv/fd_hw09vid008.flv 00:34.4 flv/fd_hw09vid009.flv 01:47.3 flv/fd_hw09vid010.flv 00:32.9 flv/fd_hw09vid011.flv 01:28.7 flv/fd_hw09vid012.flv 00:19.4 flv/fd_hw09vid013.flv 00:37.1 flv/fd_hw09vid014.flv 00:24.7 flv/fd_hw09vid015.flv 00:54.1 flv/fd_hw09vid016.flv 00:34.9 flv/fd_hw09vid017.flv 00:51.0 flv/fd_hw09vid018.flv 00:28.1 flv/fd_hw09vid019.flv 00:59.2 ???????? ???? ?? 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 ????? ?????? ???????? captivate? ? ? ? ? ? Script ? ? ? Script Introduction 1 00:00 This Page is Menu of? Lectrue. ? ? ?? ????? CHAPTER 9 Stocks and Their Valuation 1 00:00 Welcome back. I’m? Professor? Henry ?Wong Henry Wong?we ? ? ? ? ? discussing Chapter? 9 Stocks ? ? ?their ? ? ? ? ? ? ? ? ? ? ? ?would ? ? ? ? ? ? ? ? ? ? last? lecture ?we ? ? ? ? ? ? ? ?to ? ? ? ? bonds ?(a ? ? ? ? ?debt ?security or? instrument that a company may offer to investors). ? ? ? ? ? ? ? ? ? ? and today ? will be 9? ? ? ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? Valuations. As you ? ? ? recall from our ? ? ? ? ? ? ? learned how ? value ? ? ? ? common ? ? ? ? ? ? ? ? ? ? ? ? So let's first start? off ? ? talking? about ?what ?exactly ? ? ? ? ? ? ? ? ? ? ?What? does? it ?mean ?if ? ? ? own ? ? ? ? ? of? common ? ? ? ? ( No.1 it? means ?that ?it ? ? ? ? ? ? ? ownership of? a firm or? ownership of? profits ?or ? ? ? ? ?of? a ? firm. ?No.2 ?it ? ? ? ? ? ? ? ? ? ? ? Ownership? implies ?control ? ? ? ? ? ? ?in ? ? ? ? ? ? ? ? ? ? ?50%? ? ? ? ? ? ? ? ? 3? ?? ?? ??than ?a? ????%??? ???? ???? ???? ??stock ???? ?order? ????control???? ?? ?? ?? ?? ????or?? ???? ???? ????of?? ??firm. ?No.3 ?the stockholders? elect ?the board ?of ? ? ? ? ? ? ?and? the ? ? ? ? ? ? ? ? ? the ? ? ? who appoint and elect the management to run the company on a day-to-day basis. We all know that the management’s goal is to maximize the Facts about common stock 2 00:00 ? ? ? ? ? ? implies ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? generally ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? by ? ? ? ? ? ? ? ? ? ? ? ? ? is Common Stock. ? ? ? ? ? ? ? ? you ? ? a share ? ? ? ? ? stock? ? ? ? ? ? ? ? ? ? ? ? represents ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? losses ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? control. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? most organizations? you have to? have? more ???? ? ? 50 ? ownership of ?? ?? ?? in ??? ??? to ???? ???? the actions ?? decisions ?? a ?? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? directors ? ? ? directors are ? ? ones ) 3 ? ????? ?? A very way for a company all commonmoney is by issuing or selling investors and if a that is what our chapter is new to be stock? What are some existing features of all how pre-emptive can we can dividend we use No.3 we value Another common feature ? ? ? to ?raise ? stock ?is ?what ?we ? ? ? ? ? ? ? ? stock ?to ? ? For ?example today ?corporation? decides? to ?issuegoing common discussing. What is? common ? ?you ? ? ?already ? ? of ?the principal stockholder ? ? ? common stock? and ? ? ado ? ? ? ? ? ? common stock? ? ? ? ?your? pro-rata ? ? ? do?of ? ? ? ? ?of ? ? ? ?offering. ?So ?thusgrowth ? ? the ?common? stockholders? the value ?method. ? ? ? ? ? ?pro-rata ? ?multiple method.? All ? ? ? ? of? these ? ? ? be ?used ?to ownershipcommon ?stock ? ? a ? ? ? and ?Finally ?we ? ? ? ourdilution? in ?terms ? ? ? ? ? ? ? ? ? preferred stock ? ? ? ? ? ? ? ? course ? ? ? ? ? ? ? ? ? management ?from ?issuing ?a? large ? ? given ? ? we value ?right ? ? ? ? There are 3 ?ways ?we number that. No.1 ? that use the ? ? ? ? ?it ? ? model. No.2 ? ? ? ?a? corporate ? ? ? to ?purchase the use ?a? firms ? ? of ?new shares ? ? common ? ? ? ? can their ?own? ? ? ? ? a ? of? the ? ? ? of ? company. hence it prevents ? ? ? ? ? ? today of ownership for? the ? ? ? ? ? of three stock given ? ? company today ? ? ? ? ? ? ? end ? discussion ? ? ? by discussing ? ? ? stockholder. This of ? ? ? ? No.1 prevents ? ? ? ? ? ? ? ? ? ? ? ? Preemptive Rights 3 00:00 ? ? ? of ? ? ? ? ? ? ? ? ? ? ? call preemptive ? ? ? ? rights. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? stock ?in ? ? ? marketplace ? ? ? ? ? the ? ? ? ? ? ? and ? ? are ? ? ? ? an ? ? ? ? ? common ? ? ? ? ? ? ? then ?you? would ?be ? ? ???? ? ??? ? ? ? to purchase ? ? ?? ? ? ? shares ???? ? gives ? ? ? ? ? ? ? ? ? right ? ? ? ? ? ? basis ? ? ? ? ? ? ??? ? ? ? number of shares to themsel Control of Firm 4 00:00 So we know what the common ? ? ? ? ? ?of ?common?stock ? ? ? ? ? know that they have preemptive ?rights. ?Another ? ? ? ? ?feature ? ? common ? ? ? ? is ?that ?it ?represents control? of ?a? firm. ?How? is ?this ?control ? ? ? ? ? ?played? out?? We ?must ?first ? ? ? ? ? ? ? a few ? ? ? terms ? ? ? ? ? ? in ?this ?chapter. The ? ? ? ? one ? ? ? ? ? ? ? ?This ?is ? ? ? ? ? ? ? ?document giving ? ? ?person? on ?behalf? of ?another ? ? ? ? ? ? ? ?the right ?to ? ? ? or ?vote ?in ? ? ? ? or? not,? of ?certain ? ? ? ? ? by the ? ? ? ? ? ? ? ? ? features ? ? ? ? ? ? ? is. We ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? common ? ? ? ? of ? ? ? ? stock ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??? ? ? ?? 2, 3? ? actually ? ? ? ? ? ? ? ? ? ? ? understand ? ? ? new ? ? ? that are ? ? ? ? ? ? ? ? ? ? first ? ? is a Proxy. ? ? ? basically a ? ? ? ? ? ? ? ? ? one ? ? ? ? ? ? ? ? ? ? ? ? stockholder ? ? ? ? ? ? act ? ? ? ? favor ? ? ? ? ? ? ? ? actions ? ? ? ? company. Usually you hear of people giving a Proxy to another shareholder if they are going to vote or elect management or the board of directors of a company. Anti-Takeover Measures 5 00:00 So we know what the common ? ? ? ? ? ?of ?common?stock ? ? ? ? ? know that they have preemptive ?rights. ?Another ? ? ? ? ?feature ? ? common ? ? ? ? is ?that ?it? represents ? ? ? ? ? ? ? a? ? ? ? ? How? ? ? this ?control? actually? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? understand ?a??????new ?terms ?that ?are? in? this? chapter. ? ? ?first ? ? ?is ? ?Proxy.? This? is ?basically ?a? document ? ? ? ? ?one? person on? behalf ? ? another? stockholder? the ? ? ? ? to? act ? ? vote? in? favor ? ? ? ? ? ? ? certain? actions ?by ? ? ? company. ? ? ? ? ? you ? ? ? ? ? ? ? ? ? ? ? ? ? ?a? Proxy ? ? ? ? ? ? ? shareholder ? ? they? are ? ? ? ? to? vote? or ?elect ? ? ? ? ? ? ? or ?the? board ?of ?? ? ?? ? ?? ? ?? ? ?? ? ?? ?? ?? ? ?? ? ?? ? ? ? ? ? ? ? ? ? ? ? 3 ?? ? ?????????? ? ? ?? ? ? ?? ??????? ????? ? a ??? ?? ? ????? ????????? ? ? 50% ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? right ? ? ? ? ? ? ? ? ? ? or ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? hear of ? ? ? ? giving ? ? ? ? ? ? features ? ? ? ? ? ? ? is. We ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? common ? ? ? ? of ? ? ? ? stock ? ? ? ? ? ? ? ? ? ? ? ? ? control? of ? ? firm. ? ? ? is ? ? ? ? ? ? ? ? ? ? ? ? ? ? played out? We? must? first ? ? ? ? ? 1/3 ? few ???? ???3? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? The ? ? ? ? one ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? giving ? ? 75%? ? ? ? ? ? ? ? of? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? or? ? ? ? ? ? ? ? ? ? ? not, of? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Usually? ? ? ? ? ? ? ? people ? ? ? ? ? ? ? ? ? ? ? another? ? ? ? ? ? ? ? if? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? management ? ? ? ? ? ? ? ? 67%directors of? a company. ? ??? ? ? ?? ???? ???? ???????? ?? ??? ?????? ? ? ? to ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? going ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??? ? ? What take a brief moment then? review. Self test to gain control getting a majority of to takeovers more difficult. Please take that group answer this and then of the rest of the stockholders and replace the current management team thereby gaining control of the firm that way. That’s what we call a takeover. This is where an action by a person or group succeeds in ousting the firm’s current management team and gains the voting control usually more than the majority of the company in order to implement their own management team. Its important to note here that although in typical situations a simple major Let'sis a proxy fight ? ? ? toThis? is?an ?attempt ?question ? ? ? ? of? a firm by?actions ?that ?companies the ?stockholders ? ? grant ?a? certain ?group a proxy in which a moment to can vote on the behalfgo to the next slide. Self Test 9.1 6 00:00 ??? ? ? ? ? ? ? ? ? ? ? 9.1? ? 9.1. Identify ?some ? ? ? ? ? ? ? ? ? ? ? ?have ?taken ? ? make ? ? ? ? ?? ?? ? ? ? ? to ? ???? ?? What is a proxy fight then? This 3is an attempt to gain control can a firm bya getting a majority using staggered elections so a certain elect oneproxy in which members each year instead of all of them in the same year. No.2 requires a supermajority vote of something greater than 50% in order the approve a merger. In some cases youa can have upThis 75% where an action by of person or group is you can have a poison firm’swithin the charter, team and gains the voting control usually more than the in the acquiring company in order to implementAll 3 of these measures would make it more difficult to take over a company. the grant that you group behalf of the replace the a Self test answer ? ? ? ? ? ? ? are ? ways? in? which ? ?corporation3? ? ?prevent ? ?takeover.? No.1? by ?of ? ? ? stockholders ?to ? ? ? ? ? 1/3? ? ? ? ? ? ? a ? third ? ? ? ? ? that group ?can vote on? the ? ? ? 50%? ? ? ? rest? of ?the stockholders? and 3/4? ? ? ? ? ?current ?management team thereby? gaining? control ?of ? to ? firm?that? way.? That’s? what? we? call? ? takeover.? ?to ? is? or three ?quarters ? ? the ? ? ? ? No.3 succeeds in ousting the pill current management which basically allows stockholders to purchase shares majority of the company at a reduced price. their own management team. Its important to note here that although in typical situations a simple major 9.1. There ? 9.1 ? ? ? ? ? ? a ? ? ? ? ? ? of ? ? ? ? Self Test 9.1 Answer 7 00:00 ????? ?? ? ? ??????? ? ? ? ? ? of new ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 75% ? ? ???? ????????????? ???? ???? ? ? ?? ?? ?? ??? ?? ? ?? ????? ?? 3? ? ? ? ? ? ? ? ? ? ? vote. ? ? Self test question ?9.2. ?What ?is the preemptive? right ? ? ? what? are ? ? ?2? primary reasons for ? ? ? existence? ? ? ? ? ?take? a? moment ? ? answer this and then go to the next slide. Self Test 9.2 8 00:00 ? ? ? ? ? 9.2? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? the ? ? 2? ? ? ? ? ? ? ? ? its ? ? ? ? ? ? Please ? ? ? ? ? ? to ? ? ? ? Self Test 9.2 Answer 9 00:00 Self test answer ? ? ? ? ? ? ? ? 9.2? ? ? ? ? ? common stockholders? the ? ? ? ? to ? purchase ? ? a ? ? ? ? ? ?basis ? ? ?new issues ? ? ? ? ? ? ? ? ? ? that the ?company ? ? ? 2? ? ? ? It? helps ? ? ? 2 reasons. ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? team? from? issuing? a? large ?amount? of ?stock ? ? themselves? and ? ? ? ? ? protects ? ? ? stockholders? against dilution so that the stockholders can maintain their current level of ownership in the firm. 9.2. It really gives the ? ? ? ? ? ? ? ? ? ? ? ? ? right ? ? ? ? ? ? on ? pro-rata ? ? ? the ? ? ? ? ? ? of common stock ? ? ? ? ? ? ? ? ? is issuing. ? ? ? ? for ? ? ? ? ? ? No.1 it prevents ? ? management ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? to ? ? ? ? ? ? ? ? No.2 it ? ? ? ? ? the ? ? ? ? ? ? ? Intrinsic Value and Stock Price 10 00:00 If you recall from ?our? lecture ?on ?Risk ?and? Return you ?will ?remember? the ? ? ? ? Intrinsic? Value ?and? the ? ? ? ? 2? ? ? ? Price. ? ? ? ? ? ? ? the ? ? ? ? ? ? ? between ?the two ? ? ? ? ?intrinsic ?value ? ? really ? ? ?long-term ?stock ? ? ? ? whereas ?the current stock price is a reflection of current market conditions but may not necessarily be the long-term or intrinsic value of the stock. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? terms ? ? ? ? ? ? ? ? ? ? ? Current Stock ? ? ? ? Well again ? ? difference ? ? ? ? ? ? ? ? is the ? ? ? ? ? ? ? ? is ? ? ? ? the ? ? ? ? ? ? ? ? price ? ? ? ? ? ? ? ? ? ? So there are different approaches ?estimating ? ? ? intrinsic? value ? ? ? ?? ? ?? ??stock.? We? will ?talk ?about ?three? ?? ?? ?? ??The ? ?? ? ??way ? ?? ? ?? ?? ?? ?? ?? ?? ??growth? ? ?? ? ?? ?the ?second? ?? ?? ?? ? ?? ? ??corporate??value ?? ?? ?? ?? ?? ? ?? ? ?? ? ?? ? the ?? ? ?? ? is ?using ? ? ?multiples ?of ?comparable ? ? ? ? which ? ? ? ? ? ? ? ? ? ? ? ? ? ? to ?as ? ?“Comps” ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 3? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? common ?? ?? ?? ? ?? ? ?? ? ? ? ?? ? ?? ? ?? ? ?? ?? ? ways. ? ?? first ? ?? is the dividend ? ?? ? ? model, ? ?? ? ?? ?? ?? ? way is the ? ?? ? ?? ? ? ?? ?? method and finally ? ?? ? third ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? firms ? ? ? is sometimes referred ? ? a ? ? ? ? analysis. Different approaches for estimating00:00intrinsic value of a common stock 11 the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? of 3 ? ?? ? ?????? ???? ?????? ??? ?? So thus outside investors, corporate insiders and analysts As a variety of approaches to estimate stocks long-term or intrinsic we have equilibrium the marketplace we assume that the price equals the intrinsic on the the intrinsic value help to determine which stocks are attractive to or sell. Based on their if the comes in as lower than the the then we say undervalued. If it higher its intrinsic value then we say that it will focus to figure Let's first start talking? about ?the dividend ?growth? model. use the ? ? ? ? of? any ? ? ? ? we? have? found ait ? ? ? ? ? ? ?the? present? or ?netvalue. ?If value ?of ?all future ?in ?expected ? ? ? ? then given ?by ? ? ? ? ? ? ?stockthe value ? of ?the stock ?basedvalue.? Thus? outsiders? estimate is? the ? ? ? ? ? value ?to ? the ? ? ? ? ? ? ? ? ? ? ?expected to? be? generated? bybuy ? ? ? ? ? and ? ? course ? ? estimate ? the ? ?stock price? or ?intrinsic ?value ? ?intrinsic? value ? ? ? ask ? ? ?the stock ?is it? also? not ? ? ? ? ? comes ?in ? ? ? ? ?than?payments from the ?dividends ?included ? ? is? overvalued. So? in ?this? lecture ?we ? ? ? ? ? actual the ? ?ways ?analysts use ? ? ? ? ? ? ? the the ? ? ?The ? ? value ? ? ? ? ? ? also the ? ? on? ? ? 3 ? Gains? or ?selling price of out? ? ? long ? ? ans stock? term o Dividend growth model 12 00:00 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? value ? ? ? asset ? ? ? ? ? ? ? ? is really ? ? ? ? ? ? ? ? present ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? cash flows? ? ? ? ? that asset.? So ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?dividend growth ? ? ? ? ? ? ? present ? ? ? of ? ? future dividends ? ? ? ? ? ? ? ? ? ? ? ? ? ? the stock ? ? of ? ? ? ? that ? ? ? ? ? ? current ? ? ? ? ? ? ? ? ? ? ? ? of ? ? ?stock.? You may ? ? yourself? why is ? ? ? ? ? only the? expected cash flow ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? in the ? ? ? ? of? the stock but ?why? not ? ??? ? ? ?? ? ? ? ? ? ? ? ? model ? ? ? equals ??? ?? ?? ?? ?? ? ?? ? ?? ? ?? ? Capital ? ? ? ? ? ? ? Constant growth stock 13 00:00 We start off the ? ? ? ? ? ?growth? model ?by ? ? ? ? discussing ?a ?constant growth ? ? ? ? ?What ?is ? ? ? ? Its ? ? ? ? ? ? ? ?stock ? ? ? ? the ? ? ? ? ? ? ? ? ? expected to? grow? forever at? a constant ? 1? ?at g? ? ? we ?will ?denote? as ?G. ? ? ? ? ? ? ? the ? ? ? ? 2? ? a year? from1now ?will 2? ? ? ? ? ? ? ? ? is?the dividend today multiplied by 1 + G (the growth rate) after one period. Thus the dividend 2 years from now would be D0 multiplied by 1 plus the growth rate squared. dividend ? ? ? ? ? ? ? first ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? stock. ? ? ? this? ? ? basically a ? ? g where ? ? dividends are ? ? ? D1? ? ? ? 1? ? ? ? ? ? ? ? ? ? D0 rate ? what ? ? ? ? ? ? ? ? Thus D1 or ? ? dividends ? ? ? D0? + ? ? ? equal D0 which ? ? ? Future dividends and their present 00:00 14 values So dividends like any ? ? ? ? ?? ?? D? flow? stream ? ? ? ???(1+g)??T? ? ? ? will have expected ?cash ?flows ?which? ? ? ?blue ?line ?here D1? ? ? ? ? ? ? ? ? ? ? dividends. ? ? ? ? are ?the? dividends ? ? ?­ ?g? the ? ? ? ? ? ? ? ?T? which ?equals? P^0????????????????? T? ? ? ? ? ? ? ? by? 1? plus ?the ???? (PVD? ? ? ? ? time period ?T. Dividend) ? ?? ?? ?? rs-g? ? on ?the red1+? ? ?in ?this??? ???? ??these ?? ?? ??the ?? ???? ???? ???? ????amounts?? ? ? ? ? ? expected ? ? ? ? ?cash ?dividends ?which ? ? denoted ? ? PVd ? ? ? ? is? the ? ? ? ? ? ? ? ? ? of ?the Dividends in each time period T and equals the dividends in each time period D discounted or divided by 1 plus the required rate of return to the T time period. Th based ? ? ? ? ?? ? ? ? ? ? ? ? T chart ?? ?? ?? are ?? ?? present value ???? ?? ?? of these ? ? ? ? ? future ? ? ? ? ? ? ? ? ? ? is ? T? ? ? by ? ? which ? ? ? Present Value ? ? ? ? ? ? ? line ? ? ? ? ? ? ? ? ? ? coming ? ? ? ? ? ? ?? ?? ? the dividends today ? ? ? ? ? ? ? ? ? ? ? 1+? ???? growth : Present Value? of?the ?As ? ? ? can see ? ? ?? ?? D ? ? ? other cash ? ? ? ? ? ? ? ? ? D0 from ?an asset ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? T ? ? ? 1 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? paid in ? ? time period T g ? ? ? ? ? ? ? ? ? ? ? ? represents future ? ? ? ? ? ? These ? (1+g) T ? ? ? ? ? ? rs P ? multiplied ? ? ? rate in ? ? ? 1 ? ? ? you ? Thus the dividend payment happens if the to D with the greater than the required equals today’s dividend D0 multiplied so then the constant growth the T interval or negative G is constant then doesn’t that dividend any sense and doesn’t exista D1 or the expected dividend price a year from now divided by if rate the required rate or equity holders, is greater minus the growth rate. Thus the ^P0 or the is expected is the price of the stock. This equals the dividends today multiplied by 1 plus the growth rate, in order to get to the dividend expected a year from now, divided by RS minus G. This again is the required rate of term on common You may ask yourself? what?stream? is?equal growth ? ? ? ? ?time ?period? of?T? and ? ? ? ? rate? of ?return? on ?equity? ?If ? ? ? ? ? by? 1 plus the ?growth ?rate ?to formula leads ?to a time. ?If ? stock ? ? ? ? ?which the ? ? ? make growth? formula ?converges ?to ? in? real? life. ?Thus the constant growth model can only be used the Rs or of return on equity of return on equity which is RS than the growth rate and 2. the growth rate “P Hat Zero” to be constant forever. What happens if g > rs? 15 00:00 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? rate is ? ? ? ? ? ? ?? ? ? ? ? ? ? ? ? ? ? ? ? this is ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? rs? ? ? ? ? ? ? ? price, ? ? ? ? ? ?????? ???? ????? ? ? ?? ??? If rRF = 7%, rM = 12%, and b = 1.2,00:00 is the required rate of return ontalk about rs? or?the required ?rate ?of ? ? ? ? ?on ? ? ? ? ?equity ?very ?quickly. As? you ? ? ?recall? from? our ? ? ? ? ? ? ? on ?Risk ?and Return ? CAPM? ?that? the ? ? ? ? ? asset ?pricing ? ? ? ? (or ? ? ? ? ?sometimes ?also ?referred to? as ?SML the ? ? ? ? ? ? market line, ?will ?tell ? ? what the ?required rate of? return ? ? common ? ? ? ? ? ? ? So ?thus ?in ? ? ? ? ? ? ? 16 what Let's the firm’sRS ? ? ? ? ? ? ? ? ? ? ? return ? common ? ? ? ? ? ? ? ? ? ? ? ? ? may ? ? ? ? ? ? ? discussion ? ? ? ? ? ? ? ? ? we know SML ? ? capital ? ? ? ? ? ? ? model ? ? CAPM), ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? security ? ? ? ? ? ? ? ? ? stock? 7%? us ? ? ? ? ? 12%? ? ? ? ? ? ? 1.2? ? on ? ? ? ? equity is. ? ? ? ? this example if we have a risk free rate of 7%, a return on the market of approx. 12% and a Beta of 1.2 then we can figure out the required rate of return on the firms stock. If D0 = $2 and g is a constant 6%, 00:00the expected dividend stream So now let's apply ?the? dividend ? PVs.? ?model? formula?? ???? ???? ???? ?+? ? ? growth ? ? ? ? ?into ?an ? ? ? ? ?example ?? ?? ?? ?? ?? ?? 6%? ? this? problem. ? ? we? know? that? the ? ? ? ? ? ?today ? ? $2 ??????the ???????????????2? ? ? ? at ?6% ? ? hence ?this ?is ? ? ? constant ?growth???? ???? ?? ?that ?we? ???? ???5%?using.?? ?? ?order?to??figure?out ?the1.2??????? 2? ?year ?from ?now? we ?essentially multiply ? ? 1? ? ? 2.12? by ?1? plus? the ? ? ? ? ? ? ? ? ? 1+g? one ?period? or 2time period. ? ? ? ? ? ? ? find the ? ? ? ? ? ? dividend ? 1+? ? ? 6%? 3? next 3 ? ? 3? ? ? ?their? present ?values. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 13%? ? ? ? ? ? ? ? 17 find for the next 3 years, ? CAPM? ? growth ? ? ? ? ? ???? ?? and the constant ? ? ? ? method ? ? ? actual ? ?? ?? ?? to figure ? ? ? ? ? ? ? ? ? ? ? So? ? ? ? ? ? ? ? ? ? ? dividend ? ? ? ? is? 1? and ???? growth is constant1+? ? 7%so ? ? ? ? ? ? 12% ? ? ? ? ? ? ? ? ? ?? formula ? ?? ?? ?? will be ? ?? ?? ?? In ? ?? ?? ? ?? ?? ?? ?? ? ?? ?? ? ?? ?dividend ? ? ? ? ? ? ? ? ? ? rs ? 1+g? ? ? ? ? ? ? ? ? $2 multiplied ? out ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the 3 ? ? ? ? ? 7% a ? ? ? ? ? ? 13%? ? ? ? ? their ? ? 2 ? ? ? ? ? ? ? ? growth rate to the 2? ? ? ? ? ? ? ? ? 2.25? We need to ? ? ? ? ? expected ? ? ? ? ? stream for the ? ? ? ? years and 2.38 ? ? ? ? ? ? ? ? SML? ? and ? ? ? ? ? ? ? ? ? rs ? Usingwe exactly is theequation intrinsic value? equals $2. We know that if we market model to to whichdividend today we the constant growth minus we know that equal the market expected a year approx. have a if wefree rate of rate of know thatbyequity minus the growth 12% andIn this the third period out that get approx. a as our market risk premiumofrequired our specific beta equity market stock on our capitaladd that pricing of returnsee that thewhich we calculated 13%. Thus on market is What our SML or CAPM ? ?is ? ? ? ?dividend today can use ? ? ? the ? ? ? ? multiply ?1? ?premium,? that? ?is ? ? ? ?using ?get ? ? the? market first period. ? free rate multiplied stock ? beta of ?the companies specific ? it to ? ? second ? ? ? dividend ? ? ? ? ? ? plus ?the ? ? ? ? ? of ?6% cube ? ? ? ? ? we ? that ? ? ? 1 ?? in case ? figured then we a dividend $2.38. We can discount each these What is the stock’s intrinsic value? 18 00:00 So what are given? again stocks ?we ?know ?that ?RS ?We ?is ?the? risk? free? plus? the ? growth riskplus? Gfigure ?that ?out. ?Byto ?the return ?on ? after ?the model ?the riskIf ? the ?price ? ?plus ?byand today ?should? equal ?the dividendwe ?know? risk.we2.12in this? case weFinally risk the required ? 7%. We13%? todayon our ?return 6%?growth? rate? rate. ? we? deduct 7%? from30.29? to ?give us a net of 5% year from now is $2.12. The and thendifferent return on onback to our presentis 1.2.using our required rate model. Finally we have RS growth rate of 6%. The following would give us andividend today of of this company’s stock today. But the dividend a year from now of $2.12 wou again ? constant ? ? ? ? return rate of cash flows this is 13% based value If we assets together we will on equity, a on the stock is as being 13% and we see that the intrinsic value $2 of course equals $2 of $30.29. ?? ? that the ? ? ? ? ? ? ? ? ?? ? ? ? ? 1 $2.12 ? ? ? ? ? ? ? ? ­ ? ? ? we multiply of the G? ? ? square ? ? the ? ? ? ?period? paymentthat ? get? $2.25 from? now,? divided? by ? ?multiply? the ? ? ? ?? ??? 1 ?? ?? 1? ? ? ? ??? ? ?? ???? ? ???? ? ??? What is the expected market price19 00:00 stock, one year from now? So what would be ? ? ? expected 1? ? ? ? price ?of ? ? ? stock ? ? ? ? ?from ?now? ?There 2? ? a ? ? ? ? ?of ? 1? ? we ?can figure ?this ?out.? One ? ? that ? ? ? dividend ? ? ? ? ? P1? ? ? ? will be paid out? already ?once we? have? figured2? ? ?the price ?a? year? from? now.? So? P1? or? the ? ? ? ? expected ? 2? ? ? from? now ? rs-g? ? ? ? ? ? the ? ? ? ? 2?value ? ? of? year? 1 of ?the second ? ? ? ? ? ? ? 13%­ ? ? dividend of? the ? ? ? ? 1period.? Thus? the expected? price ? ? ? ? ?stock ? ? year 1 is? going ?to ? ? the ?expected ? ? ? ? ? ? payment ?in ?year ?2? divided by ? ? ? ? ? ? the growth rate. Thus we again know that the dividend payment expected in year 2 is going to be $2.25 divided by the R of the the ? ? ? ? ? market ? ? ? ? the ? ? ? 1-year ? ? ? ? ? ? ? are ? couple ? ways ? ? ? 1? ? ? ? ? ? ? ? ? is ? ? 1 the ? ? ? ? ? a year from now 1? ? ? ? ? ? ? ? 1 ? ? ? ? 2? ? ? ? ? ? ? ? ? out ? ? ? ? ? ? ? ? ? ? ? ? 1 ? ? ? price ? ? ? ? ? a year ? ? ? ? is going to be ? ? present ? ? ? as ? ? ? 2.25 ? ? ? ? ? ? period or expected ? 6%? ? ? ? ? ? second ? ? ? ? ? ? 32.10? ? ? ? ? ? ? of the ? ? ? in ? ? 1+? ? ? ? ? ? be ? ? ? 1? ? ? dividend ? ? ? ? ? ? ? ? ? 32.10? RS minus ? ? Self test question ?9.3. ?What ?conditions ?must ?hold ?if ? ?stock ? ? to? be ?evaluated? using ? ? ? constant ? ? ? ? ? ? ? ? ? ? ? ? ? ?take ?a? moment to? answer this and then go to the next slide. Self Test 9.3 20 00:00 ? ? ? ? ? 9.3? ? ? ? ? ? ? ? ? a ? ? ? is ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? growth model? Please ? ? ????? ????? Self test answer ? ? ? ? ? ? constant ?growth? model ? ? ? only? be ?used ?if ? ? ? ?if ? ? ? rate? of ?return? on ?equity? is ?greater ?than ?the growth ? ? ? ? No.2? the ? ? ? ? ?rate ?is ? ? ? ? ? ? to ?be ? ? ? ? 9.3. The ? ? 9.3? ? ? ? ? ? ? can ? ? ? ? ? ? No.1 ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? rate. ? ? ? ? growth ? ? ? expected ? ? constant forever and No.3 the earnings, dividends and stock price grow by that constant growth rate. Self Test 9.3 Answer 21 00:00 Self Test 9.4 22 00:00 Self test question ?9.4. ?Now let's? suppose? an ?analyst ? ? ? ? ? ? ? ? ? values? GE ?based ? ? ? ? ? ? ? GE? ? growth rate of? 6% ?for earnings, ? ? ? ? 5%? and ? ? ?stock ? ? ? ? ?If ? ? ? growth rate next year turns ?out to? be? somewhere? between ?5? to ?7% ?would this ? ? ? ? ? ? ? ? ?analysts forecast was faulty? Please take a moment to answer this and then go to the next slide. ? ? ? ? ? ? 9.4 ? ? ? ? ? ? ? ? ? says that she ? ? 6% ? ? ? ? on a forecasted ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? dividends ? 7% the ? ? ? price. ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? mean that the ? ? ? ? ? ? ? Self Test 9.4 23 00:00 Self test answer ? ? ? ? ? ? analyst? is ?merely? saying ? ? ? ? ? ?statistically expected 6%? ? ? ? ? ? approx.? 6% ?in ? ? ? future year.? Not ? ? ? ? ? ?really ?believes or? expects? that? the ? ? ? ? ? ? ? ? ? ? ? ? ? to ? be ?exactly ? ? ? ? each future ? ? ? ? Thus the analyst’s forecast is not faulty. 9.4. The ? ? 9.4 ? ? ? ? ? ? ? ? that the ? ? ? ? ? ? ? ? ? ? ? ? ? outcome is ? ? ? ? ? ? any ? ? ? ? ? ? ? ? ? that she ? ? 6% ? ? ? ? ? ? ? ? ? ? ? ? ? ? growth rate is going ? ? ? ? ? ? 6% in ? ? ? ? ? ? ? year. What are the expected dividend yield, capital gains yield, and total There isduring the ?firstfigure ?out the ?required? rate? of?return? on?equity? for ? ? ? ? ?stock holders. ?We ? ? ?find ?this ?from ?the expected ?dividend? and ? ? ? ? ? gains ?yield ? ? ?thus ?figure? out ? ? ?total ? ? ? ? ? ? ? ? ?first ? ? ? ? First ?off, ? ? ? dividend ? ? ? ? represents ? ? ? return on? the ? ? ? ? ? ? ? ? ? ? ? or? the ? ? ? ? ? ?payments form investing in? a certain? security.? The ? ? ? ? ? gains ?yield ? ? ? ? ? ?the price ?that you make minus the price that you invested at. Thus the capital gains of the current stock after you sell it. If you add these together you would get an investors total return. 24 00:00 return another ? ?to ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? common ? ? ? ? ? ? ? ? ? can ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? capital ? ? ? ? ? ? and ? ? ? ? ? ? ? the ? ? ? return in the ? ? ? year. ? ? ? ? ? the ? ? ? ? ? yield ? ? ? ? ? ? the ? ? ? ? ? ? ? cash flow streams ? ? ? dividend ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? capital ? ? ? ? ? ? reflects ? ? ? ? ? way ? year? Now let's take a ? ? ? ? ?to ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 9.5.? Explain? the ? ? ? ? ? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ??a? promise30.29? ? ? ? ? ? ? ? ? ? ? ? 7%? ?common? stock ?typically ?provides?????????­ ??????????of??????????promise???????????????1? plus ?capital gains.? Please take a moment ? ? ? ? ? ? ? this and ?then ?go ? ? ? ? ?next ?slide.? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 6%? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? + ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 7%+6%? ? ? ? 13%? ? ? ? ? ? moment ? review. Self test question ? ? ? ? ? ? ? ? ? ? following statement. Whereas a bond contains ? ?? ?? ?? ?? ?to ? ? ? interest,? a share? of ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1? an expectation ?? but no ???????? of dividends ? ? ? ? ? 32.10? ? ? ? ? ? ? ? ? ? 30.29? ? to explain 30.29? ? ? ? ? to the ? ? ? ? ? Self Test 9.5 25 00:00 9.5 ? ? ? ? ? ? ? ? ? ? 2.12 ? pay ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Dividend yield can be found by taking the dividend by the present value of cash flows. by the current price an the stock can expectwe know is $2.12 is plus dividend expected in the first year and if wesale price of by the price of $30.29 today the dividendsa or cash flows expected The another future yield is the price of the stock a year from now as the the price of today divided by the price today. Thus if we expect that the price a year from now will be $32.10 and the current price is $30.29 and we divide both by $30.29 the capital gains yield or what we would make in terms of appreciation of the stock price would be 6%. So that’s the total then we 7%. by capital Self test answer ? ? ? ? ? ? ? prices ?are? determined ? expected ? ? the ?first year divided? ? ? ? cash? flows ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? as ? ? ? ? the ? ? ? ? ? ? ?the ? ? ? capital ?gains ? ? the ? ? ? ? ? However ?the ?divide? that? ? ? ? stock ?will ?depend? upon? ? ? ? ? ? get ? ?dividend yield ?of ? ? ? ? ? ? ? ? ? ? gains investor. Thus all investors expect dividends minus cash flows when valuing the company. 9.5. Stock ? 9.5? ? ? ? ? ? ? ? ? ? ? ? ? in ? ? ? ? ? ? ? ? ? ? ? ? The ? ? ? ? ? that of investor which ? are ? ? dividends ? ? the ? ? ? ? ? ? ? on ? ? stock. ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? Self Test 9.5 Answer 26 00:00 ?? ???????? ? ?? Self Test 9.6 27 00:00 Self test question ?9.6. ?What ?are ? ? ?2? parts ?of ? ? ? most? stocks ? ? ? ? ? ? total ?return? ? ? ? ? ?take ?a? moment to? answer this ? ? ? ? ? 9.6 the ? ? ? ? the ? ? ? ? ? 2 expected ? ? ? ? ? ? ? Please ? ? ? ? ? ? ? ? ? ? ? ? ? ? and then go to the next slide. Self test answer ? ? ? ? ? ? expected ?returns ? ? ? ? ?the expected ? ? ? ? ? ? ? from dividend ?streams ? ? ? capital ?gains ? ? ? ? ? ? sale? of ?stock.? Thus? the ? ? ? ? required rs? ? of? return ? ? ?any investor ? ? ? ? is? going to be the dividend yield plus the capital gains yield. 9.6. The ? ? 9.6? ? ? ? ? equals ? ? ? ? ? ? ? cash flows ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? from the ? ? ? ? ? ? ? ? ? ? total ? ? ? ? ? rate ? ? ? + ? for ? ? ? ? ? ? ? or Rs ? ? Self Test 9.6 Answer 28 00:00 Self test question ?9.7. ?If ? ? 9.7? ? ? ? ?payment? expected ?a? year? from6%? ? equals ? ? and ?the? growth rate equals ? ? and ?the? current? price ? ? ? ? ?stock is $40 then what are the stocks expected dividend yield, its capital gains yield and total expected return for the coming year? Please take a moment to calculate this and then go to the next slide. Self Test 9.7 29 00:00 ? ? ? ? the dividend 1? ? ? ? ? ? ? 2 ? ? ? ? now ? ? ? ? $2 ? ? 40 ? ? ? ? ? ? ? ? ? ? ? 6% ? ? ? ? ? ? ? ? ? ? of the Self test answer 9.7. We know that we can find the dividend yield by taking the expected dividend a year from today divided by the current selling price of the stock. Thus the dividend expected a year from now is $2.00 and the price today of the stock is $40.00, which gives us a dividend yield of approx 5%. The capital gains yield is again the price a year from now minus the price today divided by the price today. A price a year from now hasn’t been given to us so we need to calculate the expected price would be. We do this by taking $40.00, which is the price today, and multiplying it by 1 plus the growth rate or 1.06 if we mul Self Test 9.7 Answer 30 00:00 Self Test 9.8 31 00:00 Self Test 9.8 Answer 32 00:00 Self test answer 9.8. If the growth rate is constant then the dividend growth formula is basically the expected price today, which would equal the dividend payment a year from now or expected dividend divided by the Rs or the required rate of return minus the growth rate or G. So far we have been talking about a constant growth rate. But what would happen to the expected price if that constant growth rate equals zero? The dividend stream would be more like a perpetuity and if you recall from previous discussions on Time Value of Money then you will know that a perpetuity is a constant payment stream every period into infinity. Thus in this case as you can see from our timeline drawing we know that the required rate of return is 13% and there is a constant payment of $2.00 every period until infinity. Thus the expected value of this dividend stream or stock would equal simply the dividend payment of $ What would the expected price today00:00if g = 0? 33 be, Now let's take a moment to review. Self test question 9.9. Explain how the formula of a zero growth stock is related to that of a constant growth stock. Please take a moment to answer this and then go to the next slide. Self Test 9.9 34 00:00 Self test answer 9.9. A zero growth stock is one whose future dividends are not expected to grow at all - where the growth or G would equal zero. Thus if a constant growth stock formula is equal to a dividend a year from now divided by RS minus G then a zero growth stock must equal D divided by RS or the dividend divided by the constant rate of return required by equity holders. Self Test 9.9 Answer 35 00:00 Self Test 9.10 36 00:00 Self test question 9.10. A stock is expected to pay a dividend of a dollar at the end of the year. The required rate of return is 11%. What would the stocks price be if the growth rate were equal to 5%? What would the price be if the growth rate were equal to 0%? Please take a moment to answer this and then go to the next slide. Self test answer 9.10. If the growth rate is 5% then we know that the dividend expected a year from now is a dollar and we know that the required rate of return is 11%. Thus it would be a dollar over 6% or $16.67 if the growth rate were 5%. If the growth rate were 0% then we would simply take a dollar divided by the required rate of return of 11%, which would equal $9.09. Self Test 9.10 Answer 37 00:00 So far we have been growth about Supernormal or Nonconstant growth: 00:00if g = 30% for 3 years before achieving long-run talking of 6%? using the constant growth model in terms of looking for a growth rate, which becomes constant. What happens in supernormal or non-constant growth? What if the growth rate were equal to 30% for the first 3 years before achieving some kind of long-term growth at approx. 6%. In situations of supernormal or non-constant growth we can no longer use the constant growth model to find the stock value. However the growth does become constant after three years. Thus its a hybrid between a constant growth model and a present value technique of looking at the cash flows from the non-constant or supernormal 38 What Valuing common stock with nonconstant growth 39 00:00 Find expected dividend and capital 00:00 yields during the first and fourth years. 40 gains Nonconstant growth: What if g = 0% 00:00 years before long-run growth of 6%? 41 for 3 Find expected dividend and capital 00:00 yields during the first and Again weyears. 42 gains fourth can find the expected dividend and capital gains yield in the first and fourth years for this scenario as well. The dividend yield is going to be called the $2 dividend and expected after year 1 divided by the current price of $25.72, which equals 7.78%. For the capital gains yield in the first year we can simply take the required rate of return of 13% minus the 7.78% dividend yield which will give us a capital gains yield of 5.22%. Thus at time period 3 when the growth rate becomes constant we see that the stock has a constant growth and a dividend yield of approx. 7% and then a constant capital gains yield of approx. If the stock price was $2.00 and 43 00:00 was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value? So we can also find the expected annual dividend and capital gains yield for this stock as well. We know that the capital gains yield is going to be equal to the growth rate of negative 6% but looking for the dividend yield we know that the required rate of return equals 13% minus the capital gains yield which is going to be negative 6% thus giving us a dividend yield of 19%. So what’s happening here? The stock is experiencing constant growth. The dividend and capital gains yield are expected to stay constant thus the dividend yield is sufficiently large enough at 19% to offset the negative capital gains of negative 6%. Find expected annual dividend and44 00:00 gains yields. capital Self Test 9.11 45 00:00 Let's take a moment to review. Self test question 9.11. Explain how one would find the value of a non-constant growth stock. Please take a moment to answer this and then go to the next slide. Self test answer 9.11. First we would discount each dividend stream payment to present value using the required rate of return during the non-constant growth period. Secondly we would find the present value of the terminal value of the constant dividend stream during the constant growth period. If we sum this up together this would give us the value of a non-constant growth stock. Self Test 9.11 Answer 46 00:00 Self test question 9.12. Explain what is meant by terminal or horizon day and terminal and horizon value. Please take a moment to answer this and then go to the next slide. Self Test 9.12 47 00:00 Self test answer 9.12. The terminal day is the day when the growth rate becomes constant. The terminal value is the value of all dividends expected after the terminal day. Self Test 9.12 Answer 48 00:00 Corporate Value model 49 00:00 Now let's go to the second way of valuing stock called the Corporate Value Method. This is the most common method used in valuing any stock, assets or security. It’s also called the Free Cash Flow or FCF method as well. It suggests that the value of the entire firm equals the present value of all of the firm’s future and expected FCF. Remember FCF is the firms after tax operating income less the net capital investment thus FCF would equal Net Operating Profit After Taxes or NOPAT, minus the net capital investment. If you recall from our discussion on financial statement ratio analysis that NOPAT is equaled to the EBIT multiplied Applying the corporate value model 00:00 50 How do we apply the corporate value method? It’s essentially finding the market value of the firm by finding the firms FCFs. Then we subtract the market value of the firm’s debt and the preferred stock to get the market value of the common stock. We can divide the market value of the common stock by the number of shares outstanding to find the intrinsic stock price or the value. Again the market value of the firm can also be thought of as the "market cap" or market capitalization of the firm. There are some issues you should understand about the corporate value method. First and foremost it is the method by which 99.99% of all companies and their stocks are valued. It’s often preferred to the dividend growth model especially when considering the number of companies, which don’t pay any dividends or when dividends are difficult or hard to forecast. Its very similar to the dividend growth model in that it assumes at some point some cash flows will grow at a constant rate. Remember this point in the time is going to be called our terminal year and then the terminal value is going to represent the value of the firm’s cas Issues regarding the corporate value model 51 00:00 Given the long-run gFCF = 6%, and52 00:00 10%, use the corporate value model to find the firm’s intrinsic value. WACC of If the firm has $40 million in debt00:00has 10 million shares of stock, what is the firm’s intrinsic value per share? 53 and Self Test 9.13 54 00:00 Let's review some of the topics covered. Self test question 9.13. Write out the equation for FCF and explain it. Please take a moment to answer this and then go to the next slide. Self test answer 9.13. FCF equals net operating profit after taxes minus net capital investment. Thus NOPAT equals the EBIT multiplied by the tax shield of 1 minus T. We need to add back in our depreciation and amortization because of course these are non-cash expenses. We can also subtract the net capital investments which equals capital expenditures which is found by looking at the fixed assets capital asset expenditure line minus the change in net operating working capital. Which is essentially the changing current assets minus the change in current liabilities plus any surplus cash. Self Test 9.13 Answer 55 00:00 Self test question 9.14. Why might someone use the corporate valuation method even for companies that have a history of paying dividends? Please take a moment to answer this and then go to the next slide. Self Test 9.14 56 00:00 Self test answer 9.14. The corporation valuation model may even be used for companies that pay dividends because much can be learned about a company projecting its future financial statements. This analysis can provide insights into actions that might be taken in order to increase the company’s value in the future. Self Test 9.14 Answer 57 00:00 Self Test 9.15 58 00:00 Self test question 9.15. What steps are taken in order to find a stock price as based on the firm’s total value? Please take a moment to answer this and then go to the next slide. Self Test 9.15 Answer 59 00:00 Self test answer 9.15. First we find the free cash flows for the company including its terminal value. Second we discount these future cash flows by using the weighted average cost of capital. Third, we add the present value of the future cash flows plus the present value of the terminal value and then we deduct out the market value of the preferred stock and debt. Finally we divide the total number of common stock shares outstanding by the market value or market capitalization of the company to get its stock price. Self test question 9.16. Why might the calculated intrinsic stock value differ from the stocks current value? Which would be more correct and what does this correct actually mean? Please take a moment to answer this and then go to the next slide. Self Test 9.16 60 00:00 Self test answer 9.16. The calculation of intrinsic value inevitably depends upon the assumptions made in regards to the projection of future cash flows, the calculation of the weighted average cost of capital or the discount rate and finally the growth rate. This may differ from the actual stock price depending upon the assumptions used. They both can be correct depending on whom you ask and what assumptions are made to get there. Self Test 9.16 Answer 61 00:00 We come to the third methodology used in order to value common stock. This is called the Firm Multiples Method. Sometimes it is referred to as a Comparables Valuation Method and in short financial terminology it is referred to “Comps Analysis.” Thus analysts will often use the following multiples to value stocks. We will look at the price to earnings and price to sales, as these are the chief financial or market value ratios that financial analysts will use. So in order to calculate a projected stock price what we would do is based on comparable firms we would estimate the appropriate price to earnings. We would multiply this by Firm multiples method 62 00:00 Firm Multiples (cont.) 63 00:00 Spreadsheet Example 64 00:00 slide/cap9-64.swf So what exactly is ?market? equilibrium?? In ?an ?equilibrium? stock ?prices? are ? ? ? ? ?and there ?is ?no ? ? ? ? ? ? ? ? ? ? ? for ? ? ? ? ? ? ? ? ? vs. ? ? sell. ?In ?this ?situation ?we ?say the ? ? ? ? ? ? or? stock ? ? ? ? ? ? ?valued. ? ? ? can ? ? ? ? ? ? ? of? this? as? being ? ? ? intrinsic value ?equal ? ? ? ? ?expected ? ? ? ? or ?another ?way to? say ? ? the ?required rate of? return ? ? ? ? equal ?the expected ?return? in ?this ?case. So in this case the current market stock price would equal its intrinsic value. If this happens we would say the stock is in equilibrium. What is market equilibrium? 65 00:00 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? stable ? ? ? ? ? ? ? general tendency ? ? people to buy ? ? to ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? security ? ? ? ? is fairly ? ? ? ? You ? ? also think ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? to the ? ? ? ? ? value ? ? ? ? ? ? ? ? ? ? it ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? would ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Market equilibrium 66 00:00 How is market equilibrium established? 67 00:00 So how exactly is the ? ? ? ? ? equilibrium established? If? the ? ? ? ? is? below ? ? ? calculated ?intrinsic? value ? ? ? ?the? price ?is ? ? ? low ? ? ? offers a ? ? ? ? ? ? ? ?arbitrage? investors. ? ? ? ?the buy ? ? ? ? ?will? be ?greater ?than ?the sell orders ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? today ?of our stock will be bid up until the expected return equals the required return which is market equilibrium. This is how it is created. ? ? ? market ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? price ? ? ? ? our ? ? ? ? ? ? ? ? ? ? ? ? ? ? then ? ? ? ? ? too ? ? and ? ? ? ? ? bargain for ? ? ? ? ? ? ? ? ? ? ? Thus ? ? ? ? orders ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? in this case and ? ? price ? ? ? How are the equilibrium values determined? 68 00:00 So how are the equilibrium ?values? determined? ? ? ?equilibrium? intrinsic value ?and ? ? ? ? ? ?return? estimated by? managers ? ? ? ? ?they? determined ? ? ? ? ? ? ? ? ? ? ? ? Equilibrium ? ? ? ? ?are ? ? ? ? on ?the markets estimate ?of ? ? ? ? ? ? ? ? ? ? and ?the markets? required rate of return, which are both dependant upon the attitudes of the marginal investor. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Are ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? expected ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? or are ? ? ? ? ? ? ? ? by something else? ? ? ? ? ? ? ? levels ? ? based ? ? ? ? ? ? ? ? ? ? ? ? ? ? intrinsic value ? ? ? ? ? ? ? ? ? ? ? ? ? Let's review. Self test question 9.17. For a stock to be in equilibrium what 2 conditions must hold? Please take a moment to answer this and then go to the next slide. Self Test 9.17 69 00:00 Self test answer 9.17. In the equilibrium, 2 conditions must hold. No1 the current market stock price equals its intrinsic value. No.2 the expected returns must equal the required returns. Self Test 9.17 Answer 70 00:00 Self test question 9.18. If a stock is not in equilibrium explain how financial markets adjust to bring it into equilibrium. Please take a moment to answer this and then go to the next slide. Self Test 9.18 71 00:00 Self Test 9.18 Answer 72 00:00 Self test answer 9.18. If a price is below its intrinsic value then the current price is going to be too low and offers a bargain to marginal investors. These investors will submit these buy orders, which will be greater than the sell orders. Thus they will drive the price up until the expected return equals the required rate of return. The opposite of course happens if the price is above the intrinsic value and then these marginal investors would of course sell the stock until the sell orders equal the buy orders until market equilibrium is reached again. We end our discussion ? ? ? ? ? ? valuation with ? ? ? ? ? ? ? ? ? ? ?Preferred ?stock ? ? ? ? ? ? ? ?“hybrid” ? ? ? ? ? ? ? ? is? called ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?preferred ?stockholders ?receive ? ?fixed ? ? ? ? ? ? that? must be? paid? before ? ? ? ? ? ? ? ? ? paid? to ?common? stockholders. However companies can omit to pay preferred dividends without the fear of pushing the firm into bankruptcy. Preferred stock 73 00:00 ? ? ? of stock ? ? ? ? ? ? ? ? ? preferred stock. ? ? ? ? ? ? ? ? is called a ? ? ? ? ? security. It ? ? ? ? ? this because like bonds, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? a ? ? ? dividend ? ? ? ? ? ? ? ? ? ? ? ? dividends are ? ? ? ? ? ? ? ? ? ? ? If preferred stock with an annual74 00:00 dividend of $5 sells for $50, what So how do we calculate theexpected return? is the preferred stock’s value of preferred stock? Well if the preferred stock with an annual dividend of $5.00 sells for $50.00 then what is the preferred stocks expected return? The value of the preferred is going to equal the dividend payment divided by the rate of return on required on the preferred stock. In this case we know the value or price is $50 and the dividend is $5.00. If we do some reverse algebra we see that the expected return is going to be 5 divided by 50 dollars, which equals 10 Now we’ve reached the end of Chapter 9. Let’s summarize everything that we’ve learned about stocks and their valuation. No.1 we discussed what common stock was and essentially have found out that it represents ownership in a company. No.2 we found 3 ways of valuing common stock. First we used the discounted dividend model and we have looked at constant growth stocks and non-constant growth stocks. Second we looked at the corporate valuation model and we said that this model is the one used by most practitioners in the financial marketplace. Thirdly we learned about the Firm Multiples method or the “Comps” model. Finally we’ve le Summary 75 00:00 CHAPTER 9 Answer Set Stocks and Their Valuation 76 00:00 Now let's review the homework which was assigned to Chapter 9. Stock and valuations. Problem 9-1 77 00:00 Problem 9-1, Work Corporation just paid a dividend of $1.50 per share, the dividend is expected to grow in 7% per year for the next three years and then in 5% a year thereafter What is the expected dividend per share for the next five years? Problem 9-1 Answer 78 00:00 Problem 9-2, Thomas Brothers is expected to pay $0.50 per share dividend at the end of this year growing at a constant rate of 7% a year. The required rate of return on stock RS, is 15%, what is the stock value per share? Problem 9-2 79 00:00 Problem 9-2 Answer 80 00:00 Problem 9-3 81 00:00 Problem 9-3, Harrelson stock currently sells for $20.00 per share, it just paid a dividend of a dollar per share, the dividend is expected to grow at a constant rate of 6% a year. What stock price is expected one year from now? What is the required rate of return? Problem 9-3 Answer 82 00:00 Problem 9-4, Heart enterprises recently paid a dividend of $1.25 it expects to have non constant growth of 20% for two years followed by a constant rate of 5% thereafter. The firms required rate of return is 10%. How far is the terminal or horizon day? What is the firm's horizon value or the firm’s intrinsic value today? Problem 9-4 83 00:00 Problem 9-4 Answer 84 00:00 Problem 9-5 85 00:00 Problem 9-5, Smith Technologies is expected to generate $150 million in free cash flow next year and free cash flow is expected to grow at a constant rate of 5% of a year indefinitely. Smith has no debt or preferred stock and its WACC is 10%. If Smith has 15 million shares of stock outstanding, what is the stock value per share? Problem 9-5 Answer 86 00:00 Problem 9-6, Feefinders have perpetual stock outstanding that sells for $60.00 per share pays the dividends of five dollars at the end of each year, what is the required rate of return? Problem 9-6 87 00:00 Problem 9-6 Answer 88 00:00 Problem 9-7 89 00:00 Problem 9-7, What will be the nominal rate of return on a perpetual preferred stock with $100.00 par value a stated dividend of 8% per par and a market price of $60.00, $80.00, $100.00 and $140.00? Problem 9-7 Answer 90 00:00 Problem 9-7 answer, again the value of preferred stock equals the dividend of preferred stock divided by the rate of preferred stock, therefore the required rate of preferred stock equals the dividend of preferred stock divided by value of the preferred stock. In A it would be $8.00 divided by $60.00 which will be 13.33%. In B the return on preferred stick is $8.00 divided by $80.00 which will be 10%, and C the required return on the preferred stock would be $8.00 dollars divided by $100.00 which would be 8% and finally D the required return is $8.00 divided by $140.00 which would equal 5.71%. Problem 9-10, Martel mining companies oil reserves been depleted so it sales are falling, also its pit is getting deeper each year so its costs a rising as a result the companies and dividends are declining at a constant rate of 5% each year. If the dividend today equals $5.00 and the rate of return RS equals 15% what is value of Martel’s mining stock? Problem 9-10 91 00:00 Problem 9-10 answer, in order to find out the price for today stock we simply take our price formula of the dividend expected a year from now, divided by RS minus G. To state it another way that would be a dividend today multiplied by one plus the growth rate over RS over G. we have been given that $5.00 is the dividend today and we know that the growth rate is going at a negative 5% and of course the RS 15%and growth rate again is -5%, if we calculate this out we can see that the price of this stock even though you have a negative growth rate, is worth something because it has a dividend stream and that value is $23.75. Problem 9-10 Answer 92 00:00 Problem 9-11, a stock is expected to pay dividend of $0.50 as the end of the year that is D1 equals .50 and it should continue to grow at a constant rate of 7% per year, if its required rate is 12% what is this stocks expected price four years from today? Problem 9-11 93 00:00 Problem 9-11 Answer 94 00:00 ????? ?????? 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Script ? ? ? Script Introduction 1 00:00 This Page is Menu of? Lectrue. ? ? ?? ????? Welcome back. I ? ? Professor ? ? ? ? Wong and Wong? ? we ?are going ? –?be ? ? ? ­ ? ? ? Chapter? 10 ?–? The Cost of Capital. am ? ? ? ? ? ? Henry ? Henry today ? ? ? ? ? 10 to ? discussing ? ? ? ? ? CHAPTER 10 The Cost of Capital 1 00:00 ? As you know, in order for corporationsquick review ofthey need towe’ve learned–so far in moneysemester. come for free. This money has an associated cost with it and hence this is what this entire chapter will be discussing. make money money and does not Today’s Lesson: NO FREE LUNCH! 2 00:00 Before we proceed let’s ?go ? ? ? take? a? ?to ? ? ? ? ? ? ? ?everything ? spend ? ? ? ? ? ? ? ?this ?this ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ?????? ??? ?? ?? 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The first discussing ? ? out ? 3? ? three?most ? ? ? ?? ?? ?sources ??in?? ?? ?? 1? ? ? finance. ? capital? to? ?learned ? ? ? ? ? really ? ? ? ? ? ? ? ?up ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?in ? ? ? ? ? ? ? ? ? ? ?value ? ? that time ?we ? ? ? opportunity ?to ? ? ? ? ? ? ? ? ? ? ? ? ? ? and we’ve learned in particular what the net present value talk about financial managers will again and again is what ?? ? ? ? ? corporate long-term ? ? ? ? ? do ? ? ? ? that “Time? ? ? the ? ? ? ? ? into of it’s broken various pieces. Long-term capital the be: ? ? ????? ? ? investors ? ? ? ? ? ? ? we ? are ? ?? ? ?? ? ?? ? ? equity ? ? ? ? ? ? ? ? ? ? ? and ? ? capital calculation. ??? ? ???? ?? ? We will endlearned ?“No Pain, ?No ? ? ? ????whichflotation ?costs ?? ????theif ? ? ?? ? ? ?calculation? ?? ??need ?to?? ?? ? ?? ? ? ? ? issuance of? newthen? they? expect? to? be ?compensated? risktaking ? costs ? ? ? ? ? ? risk, ?and? we? also ?learned ?that ? ? ? ? ? ? ? the ? ? ? by talking ? ? ? ?? ? ? ? 2 adjusting for ? ? ? our ? ? additional ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? in reality ? ? capital asset pricing model (or CAPM) tells us the required rate of return an investor would require and demand if an asset was held in a diversified portfolio. Nextwe turn ourthe actual? calculation about ? in reality? means thataverage cost ?of ? ?going to be? asked makeit ?is sometimes ? ?risk ? ? referred ? finally, ? ? ? ? ? ? ? ? ?for ?in ? ? that ? of ? ? we’ve to discussion ? ? Gain”,of? calculating the ? ? and ? ? additional ? capital (or the WACCto ? in theadditional Now astake an commonly to). The ? ? ? equals ? ? ? weighted debt ? ? WACC the ? ? )×( multiplied by the cost + (? debt multiplied by its tax shield ? ? ? ? ?is one minus ? ? )tax rate), plus the weight of the preferred stock in the capital structure multiplied by the cost of preferred stock in the capital structure, plus the weight of the common stock in the capital structure multiplied by the cost of common stock in the capital structure. of (which the Calculating the weighted average cost of capital 4 00:00 ? ?????? ? ?? ??? (?? ? ? weighted ? ? ?? ? ? ? ? ? ? ? ? CAPM) ?? ? ?? ???? ? ? ? ? ? ? ? ?? ? ? ? ?? ? ??? ? ? Long-term ? ? ? ? ? ?be?? ? ? ?? ??a toToday’s ?? ?? or bond issuance into the ? ?? lifeorder ( ? figure describe )×(1 ? ? debt,do? few? ? ?look ? ? ? ? ? ? ? ? alsoWell ? ? ?kind ? ? ? ?what? ? ? debt-to-total a ? ?? ?? ? ? ? ? ? and ? ? ? )×( ?? ? ? ? ? ?= ? ? a ? Well today,see thelearnhere third ?and? final ?lesson.?? ??the ?? ?? lesson is? ?? ?? ? ?? ??finance?? ??asmarketplacethere ? we’ll ?????the ?weightNow ? is ?inwe+?(?mean ?by ? –tofree? lunch’? ?sheetsomeuntil? this? pointtheborrowing ? ? ?? ????bank. ?corporations ?)×(? ? ?give ?us ? ?had?the ? ? ? ? ?of ?to ? debt. ? but ? ? ? ? ? ? ? those ?resources ?and that capital has to come from somewhere. In order for the corporation to make money it needs to spend money and we need to ask ourselves the question”: “Where does that money come from and how much does it cost?” Well, in today’s lesson we are essentially going to figure out that the weighted average costs of capital encapsulates the weighted average costs of all the components of capital sources available to the firm. we’ll ?w’s ?the in? this? equation ?refer? debt? ?? firm’s ?? WACC)that? in ?? ?? ? ?? – ?? ? in ?? ?? WACC? – ? ? is? “No Free???? ?what­?thiswhat ? ) we ? ? slides‘no? ? ?itbalance ? ? be ? ? ? figureof ?long-term ? actually assumed ?that ??? ??is, ???? ?? or firm managers ? ? total resources ? ? invest, ? ? in reality ? ? ? ? ? ? ? ? ? ? ? ? –? Lunch.” up ? ? ? ? we ( ? ) 1) Long-term debt. moment to reviewcan debt either can ? from asset As youtake a quick ? ? ? ? ? ? ? ? ? ? some? of? the topics ? issuance ? covered. ? ? ? ? ? ? ? ? ? ? ? ? ? in? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?simply? ? ? ? and So which the weight Let’s can Self Test 10.1 5 00:00 1) ? ? ? ? ?? ???? ?? ?? ?? ????this ?lecture?? ???? ?? ?? ?? just? ?? ?? ???? ?? ? ? three ? ? ? ? pillars? of ?finance ? ? ? ? would ?be ? ? ? time? value ? ? ? ? ? ? ? ? ? ? ? ? the ? ? and ? ? ? ? –to ? ?cost ?outcapital.? ? ? ? ? ? ? ? else thatratio ?in ? ? ? ? would ? ? ? ? ? will? come? back? to ?onethe? these ? ? ? ? topics,? maybe ? ? ? out ? ? three, ? ? ?you will have to? build ?upon ?these three? basic ? ? ? ? ? ? ? going ?forward.? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?w?? ? ?? ? ? ? ? ? will ? ???? ?capital ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? structure ? ? ? ? ? ? ? ? ? ? ? ? ?to which ?out ? ? ? ? ? ?of ? ? ? ? ? money, risk and ? ? ? ? ? ? today ? ? ? ? ? ?of ? ? ? ? ? ?? ? ? ? ? ? ? ? ? the ? ? ? weights.? ? ? ? ??? ? ? ? ? ? 3 chapter and? company?? ?? ?? ?we ?we’vehave ?learned ? ? ? ? ? ? marketplace and ? ? ? ? ? ? ? ?proceeds fromthe? ? ? ? preferred? stock ? ? ? ? ? ? return ? ? ? and ? ? ? ? that is? a source ? Everything ? ? ? ?firm. ? do ? finance ? ? ? ? ? ? ? ? ? ? selling ? ? ? of ?? ? ? ? into the marketplace ? ? hence ?? ? ? ? ? ? ? ? ? of capital for the ? ? we ? Once we arepreferred stock stock. The done with the ? ? henceforth ? ? ? ? ? ? ? ? ? of ? ? ? three ? ? ? ? ? ? ? two ? ? of ? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? principles ? ? ? ? ? ? ? ? 2) Next there is ? ? preferred can issue preferred stock into total receive the Whereas in10.1 answer this we would take the preferred stock and divide it by the basic to the the preferred Self Test 10.1 Answer 6 00:00 Self-testvery important, ? ? ? ? ??that ?we ? ? ? ? in? and that we understand ?this ?final ? assetsin ? get ? ? ?weight? ofbefore ? ? startcapital? structure weight. other issues facing financial managers such as dividend policy, optimal capital structures, stock and bond valuation – all of this information we will cover in the next few lectures but it is important to have a framework in which to cover these bases. ?? 2) ? ? ? ? 10.1 ? ? ? ? we ? ? ? ? ? ? ? ? ? ? ? ? weight ? there ? ? So it is for thethere ?isstock,? we? ?? ? ? focusthe ?common? stockon? asdivide ? With? common? stockassets ? issuances? in?the marketplacetalkingare ? stock. ? ofthe ? ? ? ? ?variations ?that ?you? should 3? ?familiar ?with. ? The ? ? ? ? one is retained?earnings.? ? ? thus,? whenever a firm has cash sitting in its bank account or sitting in its retained earnings, they can technically use that to fund the future operations of the company. Secondly if they choose not to use what money they do have in their own bank then they can go out into the marketplace and sell new common stock into the marketplace as well. And, between retained earnings and common stock, these two are the different forms of common stock equity that the managers of the corporation have access to. finance some ? ? ? ? ? again, ? ?????? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? order ?? ? ? ? total ? ? 3) And finally, ? ?10.1? ? ? ? ? ???would takewe ?will ?focus in? ?and? ?well. that by? the ? ? ? ? ?equityin ? ? ? ?to ?get? the ? ? ? ? ?of ? ? ? commona ?coupleof ?different ? ? 3? ? ? ? ? ? ? 1? ? be ? ? ? 2? ? ? ? ? ? first ? ? ? ? 3? ? ? ? ? ? ? ? ? So ? ? ? ? ? ? ? And then of capital ? ? ? ? ? ? a ? ? ? ? which ? ? ? ?of ? ? ? various ?types ? ? funds ?usedlessontimecorporate ? ? ? the ?specific financing usedabout ? ? projects in a given year. By taking a long-term view, the firm can maintain its optimal capital structure over time. Now, we haven’t talked too much about what the optimal capital structure is for a corporation, but because there is a certain subsidy by the government of being able to deduct the interest of using debt, some debt in the corporation may be healthy if it maximizes the value of a corporation. We will talk about how managers go about calculating the optimal capital structure in a later lecture. common the ?3 Self-test question ?10.2. common stock ? ? average ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?over ? ? ? ?regardless of The cost question ? should 10.1? weighted ? be the of to fund ? ? ? Self Test 10.2 7 00:00 Self-test ? ? ? ? components? ? ? ? ? ? ? ? ? ? ? ? 10.2 ? ? ? ? ? ? ? weighted ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? generally ? ?? 3) of ? ? ? ? ? ???calculated each ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? that we? ? ?? ? ? ? firms in ? ? previous ? not e.g. ? ? ?? ? ??? specific ? ? ? ?is ? during be? ?????? year? Please borrowing money ?think bank or issuinganswer into ? ?marketplace. You might slide when you’re ? R’s ? ? ? ? ? ? K’s ? ? ? the ?? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? RD ? ? ? always ? ? ? ? the ? ? ? ? ? ? The R’s in eachcostthese ? ? ? ? be? ?? .? ? ? ?to ? ? a ? ? the ?different ?cost ?componentstypes ?? ?? had ?? ?? ?? ? ?? ?? ?? ?? ? ?? the ?? ? ?? ?? ?? ??slide ?? ?? ? cost? cost1of?????????????????????going ?to????given? ??????????????????????????????????to????????????????this? and ??bonds ??????question ???????????????????????????????????????????2?ready.? ? ? ? ?as ? ? ?–? they? all ? ? ? ? ? ?same? thing.? ?They ?are? either ? ? ? ? to ?be ? ? or? KD, ? ? ? ? ?meaning ? ? ? cost? of ?debt. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? three? ? ? ? ? ? refer ? ? as ? of ? ? ? ? ? ? ? of ? ? ? ? ? ? ? ? ? ? of ? ? talked symbols. Pleaseuse ?and moment ? the ? ? ? ? ? ? RD) ? go )? ? ? a ? the cost of ? ? ? ? take ? ?moment ? ? ? ? about ? ? ? ? ? ? ? the a ? ? ? and Why should the of ? ? ? capital? ?capital structure ? ? ? ? ? ? average ? ? ? ? ? various ? ? ?? ?? ? ? funds ?that ?about ? ? ?? ?? ? ? ? take? a? ?? ?? ? ? ? ?? ?? ??of? the? ? debt? (orfinancing????? ? ? ?next?slide ? ? either ? ?ready.? ? ? ? ?? from a ? ? ? ? ?????????? ? ?????? ? ? ? ?????????? ? ? ?go to the nextsometimes see these ? ? ?notated ? ? ? ? ? ? ? ? ? ? ? mean ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? going ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 2 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ??? ? ? when you’re ? a Identify the components ? ? give their ? ? ? ? ( cost Self-test 10.2 to what themajor ? means ? ? ? ? ? ? ? ?? money ? ? ? and ?? ? ? ? ? ? ?? respective componentthe question ? see that’s representedto write down your answer ?and ?? ?? to the“no ? ? answer. ? ? ? ? ? ? ? ? Self Test 10.2 Answer 8 00:00 So, the basicfirm’s here ?? ?? ???? ?? ?? ?? ????in?? ?? ?spend? ?? ???? ?? ?? ?? let’s?? ??makethe?? ???? ?? ??when ?we?? ?? ???? ?? ?? ?? ???? ?? ??again ?? ?? ??this ?capital?? ??by???? ?? ?? ?? ? ? ?company ? that there ?is ? ? ? free? lunch” in? this? world ? ?that ?there isit cost associatedcompany (sometimes you may seecomponents whether it be long-term debt, preferred stock or common stock. And when we’re talking about common stock there is a different cost for retained earnings and there’s going to be a different cost for using common equity. And in the foregoing slides we’ll discuss each and every one of these. free?,” obviously – these 10.2. ? ? ? ? ? is(1-T) ? ? have to ? a ? ? ? We’ll get backpoint ? ? ?? ? ? that you ? ? ?? R? ???? ??second,?in ?order? to ???? ??money ?and ?? ??? ?? ? askstock.? ? ? ? can? ???? ?“Is ???? ? ? ? ?? ???? ? ??? ? ? weIf the ? ? ? knowwas? issuing ?preferred ?stock ? ? the ? ? ? ? ? ? ? ?thisK? ? ? ? ? ?a would ?cost ?the? ?with ?each ?of ? ? ? ? different ?this ?as ? ? ? ? well). ? ? ? ? KD? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? just ? but ???? ? go ?to ? ?? ? cost? of ?preferred ? ? ? ? You ? ? ? ? marketplace ? ? is what 3 ? ?? ?? ?? ? ? ?? ? RP.is ? ? ? KD ? ? ? ? ? ? ? ? ? ?? ??? ? ?? ??? ? ? ? in ?? ? ? ? ? ? the ? ?? ??? ? KP as RD? ? ? two The three can see, ?10.3. theof? long-term? referred ?of ?cost of ? ?stockthestock? cost of? ? ? earnings. For the ?cost of ? (?to notesymbolthat sometimesthis or? RD. ? thisthe as ? ? ? ? ?take ?thestock the ? ? ? issuingis either ? in? ? RP. ? And the debt, ? RD)? preferred ? ? ? ? ? symbol R KP or of common ? ? ? ? ? broken is into could capital talking the cost retained which be KS the new Self-test componentshave RS (or?? ?? debt, ?? ? plus the ?? KS) ???? ?? is and ?? ?? ? of?? ? ?? ???? ?? ?? ??stock. Now it’s? important? RD ? ? ?here ? used ? ? ?for ? ? ? may ? So as youfinally ? ?the ?? ?? ?? ??cost??of???? ?? debt??? ?? ?? ?? ??as?? ?? ?? which?? ?? ???? ??cost ?plus ?thecommonof??? ?? ?? ?? ???? ?? ??is???? KD? ? ? be ?the cost of? capitaleitheryou firm. ? ? Forwe’recost ?oftoKE??????????weighted????of ?2?usedeach? of? these ? the ? ? ? ? ?finally ? ? ? cost? order ? ? ? stock ?RE ? ? whatdowncall? the ? components ?–?youcost ? ?either? be(WACC) ? ?about firm.? ? ?of ? ? ? ? ? ? earnings ? ? ? ? would ? ? ? ? or? RS ?or ? ? ? cost? of ?issuing ? ? ? common stock ?in the marketplace which would be either KE or RE. preferred cost ? common stock ? going to ? of Self Test 10.3 9 00:00 And then question ??? cost ?? sometimes?? the costto preferred we 3are RE new 10.3. ?? retained KP? ? goingor ? RP ?? KS? ? ? RS ? ? ? ? ? components ? ? ? ? ? ? to come up ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ???? ? ? ??? ?? ?? ?? ? ? seeNow ? ? RS ? ? ? ??????? which is??????cost ??? ? ? ? ? ? ? ?stock ? ? ? ? marketplace. ? ? ? ? ? in? ? ? ? ? ? KE? ? ? with ? ? ? we? ? ? ? ? ? weighted?average ? ? ? of ? ? ? ? ? ? ? ? for? the ? ? ? ? ? ? the ?? average ? ? ? ? ? ? ? ? ? different cost ? ? ? ? ?? ?? ? ????? ??? ??? ?? ? ???? ??????? ? ? 1-T “Why ?? ? ? ? a ? ? ? ? ? ? ? ? equity. ? ? ? is ? for ? ? ? common stock ? ? ? ? ? ? ? and versus ? ? ? ? ? ? retained second one ? ? ?? ? ???? ? KP? ? ? ???? ? ? ? in question and go to usually slide pay some type of Whyyou might askbe ?two differentis? there ? ?costs of common ? ? ? ? or ?Which ? ? the ? ?issuing ? ? ? RP? ? ? ? more relevant ? ? ? for ? ? ?using of firm is? theearnings?” ? more? likely to? beis(pretty ? ?Please ?take ?a? moment to? answer thisthe marketplace you the nexthave towhen you’re ready.underwriter or some type of intermediary to help complete the transaction. These are called “flotation costs,” which we’ll get back into later. Because of this reason alone, there’s a different cost calculation in order to find the KE or RE of a company versus the RS or KS simply using the retained earnings the company already has, which of course does not involve an underwriter. might thereanswer ? ? ?? 10.3? ?component different ?connotation ? denotation ? one? which is generally in?the marketplace ? ? what type your ? ? ? ? ? ? ? ? ? ? ? Well, ? ? ? answer ?relevant?simple. When you issue ?new? stock )? Self-test 10.3 So yourself, 2 ? ? ? the Self Test 10.3 Answer 10 00:00 ??? 2 ??? ? ? ? ? ? ? ? ??(? ? ? ? ? ? ? ? ? ? +? (? ? ? ? ? ? ? ? ? + (????????????????)? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ?? ?? ?? ?? ?? ?? ?? ?? ? ?? ?? ?? ?(WACC)? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ) ? ? ? ? ? ? ? ? )? ? ? ? ? ? KE ??? ???? ? The two types back ? of common ? ? ? ? are ? K-components represent the ? ? and ?the ? ?of ?these different sources? of ? ?The cost ? in ?the foregoing ? ? ? ? ?we’re ? more to? ? ? ? ? ? larger, more mature companies,starting they fund then typically through retained earnings. Whereas the cost of issuing different stock through the stock that is more relevant to early-stage companies seeking to issue new stock to finance growth. cost our different R-components ? ? weightedof retained ? ? capital. stock ? ? ? cost earnings ) and Should our analysis focus on before-tax or after-tax capital costs? So each ofget of ? ?to ? ? ? discussion???? ?orthe??? ????????????????KS? ?of ? ?cost??of?? ??cost ?of?? ?? ?? ?? ?? ?new?common? stock.capital ? ? of? retained ? ? ? ? slidesusuallygoing ? ? break ?down ?each ?of ? ? ? cost? components ? because? with? debt,growthwe’ll talk about ?preferred ?stock ? ? ?then ?we’ll ? ? ? ? ? ? ? the ? ? new ? ? ? ? ?versions of commonmarketplace we can calculate as well. 11 00:00 Now let’s these ? ? ? ? ? ? ? ? ? ? ?? ?? about ?? ?RS ( ? ? average ?cost ? ? ? ? ? ? each ? ? ? issuing ? RS ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? RE? earnings ?is ? ? ? ? ? ? ? ? relevant to ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? talk about ? ? two ? ? common ? ? ? ? ? ???2 ? ???? ? ? ? ??? ? ? ??? ??? ?? ??? ? And then finally we should ? allourselves? is, “Should our analysis? focus ? average cost ofcosts ?or new? (or ? costs?” But ? the the corporation?” talk about, ? ? aon after-taxbasis,of ? ? ?facts ? used primarily toafter-taxcost of that involve what ? ? actuallyavailable to distribute today’s marginal ? ? ? ? ? also think ? average cost ? capital. Another way Therefore, ?if ? is shareholders ?concerned RS? what ? ? ? ? ? ?we ? rate? ? RE? ?on the ?company ? ? ? ? costs – the ?other side of that interest rate could if the for ? ? marginal) costs ? ? answer that let’s Well the ? on A first question ? ? should ask this ? ? before-tax or ? (? ? ? ? is ? ? ? ? ? ? ? ? ? ? ? ? ? high-level ? ? ? ? flows. You ? ? ? think ? weighted ? ? ? ? ? cash? ? capitalbeing ? ? it ? ? capital. ? ? ? ? ? ? ? ? to shareholders. You for ? ? weighted ? ? ? as ? ? ? ? cash ? ? ? ? these net ? ? ? ? ? us. focus ? ? ? ? ? the with their after-tax firm today, use cash the costs of capital borrow money at today’s interest rate. That’s why, this respect only new (or of debt requires some historical costs. ? ?2? ? ? together? and calculate the ? “Should our analysis? focus ? ? historical after-tax ? ?the company.? ? Well? to? ? we ? ? ? ? that stockholders? focus ? is ?that ?the cost ? a few ? ? ? is about ?the ? ? ? ? ? ?make? decisionsflows ? ? ? and ? the ? ? ?income ? ? ? ? Thus? we? focus ? ? ? ? ? ? ? ? ? ? 5? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? returns? ? ? ? ? shareholders. ? ? ?saying? ? ? the? ? ? ? ? ? ? ? ? ? ? ? ? ? after-tax ?? KSthe ? ? ? ? ? ? KE? ? ? ? ? ? ? ? ? ? ? ? ? ? ?borrowed money? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?it ?could ? ? ? ? ? ? ? ? or? gone? down? since ? ? ? ? ? ? ? on? comparing? those ?? ? ? ? ???????? ? ??? ?? ? ? ? ? ? not ? ? on ? ? ? ? ? ? ? flows, ? ? ? ? ? Should our analysis focus on historical (embedded) costs or new (marginal) costs? 12 00:00 A secondquestion ? wecan ?tieask? ??ourselves ?is, ?? ?? ?? ?? ???? ?? ?? ?? ????weightedonon ?? ???? ?? ?? ?? ????capital?? ??capital?? ?? ?? ???? ?? ?? ??before? ?? ??do?? ?? ?? ???? ?? ?? ?? ???? ?? ?? ??answer??? ???? ?? ?? ?? ???? ?? ?? ?? ???capital???can??? ???? ??of?? ???? ?? ??average?? ?? ???? ?? ?? ?? ??as?? ?? ?? ??raising??new??? ?? ??tells ?? ???? ?? ?? ?? ???? ??on?? ???? ?? ?? ?? ???? ?? ?? ??costscan ??the ?? ?? ????of??these ?? ?? ?? ????of ?? to??the? ?? ?? ???? ?? ?? ?? ????of?? ?? ???? ??this? ?? ??that? we’re ?? ??focus ?? ???? ?? with? ?―cash ? ?interestshould was ?when ??after-tax? capital????????????five? years ?ago? – ? ? ? return? equation.? ?So ? ? ? ? ?shareholders ? ? ? ? on? after-tax? returns ?then ?we ? that? time? –? so? when?we? talk?(? ?after-tax ?returns?? ?? ?? ?? ? ? ?is ? ? ? the capital? costs. ?So ?we ? ? ?the after-taxwhat ? flows?orcost the firm today toand the weighted average cost of capital as well. In again, we focus on the cost marginal) costs versuskind of adjustment because inter ? ? ? ? ? ? ? ?? ? ? ? ?? ? ? ????? ? ? ? ??? ? ? focus ? ? ? up ? ? ? ? ? ? should focus ? ? ? ? ? ) ? ? ? ? ? ? 1? ? ? ? ? ? ? ? ? ? ??????? ? ? ? ?? ? ? ?? ?? )? ? ? ? ???? ? ?? ? ? ? ? ? ? ? ? ? ?? ????? ?? ? ? ??? ? ????? ?? ? ??? ? ? ?? ? ??? ?????? ??? ? ? ? ? ? ? ? ? ? ? ? ? ­― ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? have changed,? ? ? ? ? ? have gone ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? about ? ? ? ?? ? ?? ?? ?? ?? of capital ? for ? ? ? ? ? ? ? ? ?we’re more concerned ? ? ? ? ? ? it ? ? ? ??? ? what the cost ??? ? ? ? ? with ? would Another question ? ? ?might ? ? ? ? ? ? ? ? ?? asking K? ? ? ? ? ? ? ? the ? ? ? ? ? determined ?in ? ? ? weighted ? ? ? ? ? costs ? ? ? ? ? ? ??calculations?”, ?i.e. ??????wD, ?????????and ?the ????????????????? ? ? ? ? ? ? ? ? ? ? ? the different capital? structure? components ? the overall capital structure. ? ? ? ? ? ? ? ? ? ? ? ? ? R ?? ?? ?? ?? is, “How are ? ? ? weights? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? average? ? wD? wP? capital ?????????????????? ????? the ???? the wP ???? ???? wC which again represent each of 2? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? in you ? ? ? find yourself How are the weights determined? 13 00:00 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? of ? ? ? wC You might ask yourself, ?“Should ? ?firstaccounting ?? ?? ?? ?? ?? ?? ?? market ?? ?? ?? ??–? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ??theso ? ? ? ? ? cost of? debt? represents ? debt – ? ? ? ? would ? ? ? ? ?be ? ? same on a market value perspective as it would on the book value – but it may be a more interesting discussion when we talk about the book value of equity (or the paid-in value of equity) versus what the actual (or market) value of the equity is. Well in order to make this analysis coherent, we always start of by using our accounting numbers, or our book value weights. So simply just dividing the total debt by the total assets will give us the weight of debt, and dividing the total preferred stock by the total assets would give us the weight of the preferred stock, and then total common stock divided by the total assets would give us the total we we use ? ? ? ? ? ? numbers Now we’re ready to ?talk ?about ? ? ? ? ? ?? ?cost ?component ? ? or? is ?the value (? book versus market weights?”? ?This ?isn’t?? :? difficult? ? ? ? we? talk? about ?the? ? ? ? ? which ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? (? ? ? ? )? ? ? ? ? ? ? ? ? ? ? ? ? ? (? ? ? ? ? ? ? ? ? ? )? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 100%? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 100%? ? ? ? ? ? ? Component cost of debt 14 00:00 ? ? ? ? ? ? our ? ? ? ? ?? ?? ? ?? ?? ? ? ? which ?? ?? ?? ?? component cost of debt. ? As ?I’ve ?said before, ??? ? component? ? when ? ? ? ? ? ? ? ? ? ? either: ? ? ? ? ? ? likely ? the 1 ???? ???? ? ? ????? )? ? ? ? ? ?? ? ? ? ???? ??? ? ??? ? ???? The second question cost of ask yourself is, “Do because interest numberstax-deductible in the United States. Sothe after-tax cost of debt use our money target place?” Component cost of debt 15 00:00 We must multiply ? ? you ?mightdebt ?by ? ? ? tax shieldwe ?use actual ? ? ?is ? or? do ?we ? ? ? ? ?a? capital ?structure ?in ? thefirst ? ? ? ? ? ? So ?do?we ?would equal ? ?from ?our? accounting books multipliedwe calculateshield (or 1-T). the? ? the the before-tax ? ? ? of debt or should by the tax an optimal capital structure and set our average weighted cost of capital calculation to that target optimal capital structure which could differ with what our capital structure is today? Well in this chapter and in these exercises we will always assume that the weights given to us in the book and in the lecture are the target optimal capital structure weights. In reality what happens, though, is that a group of managers come together and they calculate the optimal capital structure of the corporation, and based on what they believe is the total and optimal capital structure, they will set that as the target and over time they wi cost ? ? ?? ? ? ? ???????? 2 ?? ? ? ?? ?? ?? ?? ?? ? ?? ? ?? ? ? ? ?? ? ? ? 1-T) ? ??? ? ? ? ? ? ? we are ?? ?? ?? ?? ? ?? ?????? Now again, we will ?spend ? ? of? ? ? ? ? ? ? ?? ?? ?terms? ?? ? ?? ?? ?? ?? the ?tax bracket?? ? ?? ? or ? ? ? ? ?? ?? ?? ?? ? structure buttax? ?? ?? ?? ? ? ?orto ?be ? ?(? 40% ? ? ? ??????? ? ????? ??? a ?future0.6. ? ? ? presentation.timesthis? chapter ?and in? this? lecture ?presentation ? ?is ? ?simply? going ? ? ? ? ? ? ? ? ? ? ? ? weights ?givenof ? us? are ? ? ?target? optimal ?capital ? ? ? ? ? ? ?for? the ? ? ? ? ? ? 4% ?of ? ? ? ? ? ?and ? ? ? ? ? ?cost ?of ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? lot ? ? ? ? than 10%. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 60%? ? ? ? 40%? ? ? ? ? ? ? ? ? ? ? 1? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 60? ? ? ? ? ? ? ? ? ? ? 40? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? some time talking about ? ? managers?? ?? ? ? ?? ? the optimal lecture ? ? ? ? ? ? ? ? ? In? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?debt ? 6%.? ? ? ? ? ? to assume that the ? ? ? ? cost ? ? debt ? ? the tax ? ? ? ? ? ? ? ? ? structure ? ? ? company. ? ? to ? the Thus costour before-tax the ? ?needs ? ? pay ? ? ? ? ? howout? that? ?calculate ? ? ? targetthe ? ? ? capital ? in ? ? ? ? that is going ? ? ? left to a future chapter and in 1-0.4tell us what Thus, before for A 15-year, 12% semiannual coupon 16 00:00 bond sells for $1,153.72. What is a) interest that a) out costcostdebt? is? 10%in ? ? we? of? borrowing? a? long-term? loan,?? ? ?? corporation ?is?????the ?40% ???1-0.4??0.6? ? ? theyAgain, 10%? ?taxes,? and ? ?to ? would ?be 6%? theWe ?multiply? 0.6 ? debt10%? for ? we?see that ? ? ?after-tax ?cost ?of ? ? ? ? 10%? ? ? 4%? ?although the ?corporation? has a ? ? ? 10%? ? ? ? ? ? ? 6%? ?of ?10%, ?the? government ?essentially? subsidizes ? ? ? ? that 10% ? ? ? thus? the ? ? ? ? ? debt ? ? ?the corporation?ends?up ?being 6%? - a ? ? ? lower ? ? ? ? ? ? And when we talk about looking at the interest rate, we always use the nominal rate (or the stated rate) from the bank – as we have discussed before in our time value of money discussion – and flotation costs are so small in these instances that we ignore them. We can also figure ? ? company ? ? ?of to? ? ? ? then ? ? know the ? ? ? ? ? ? ? ? ? 40%?? a long-term 40%?? ? the if of debt ? ? ? ? ? ? ? ? ? debt by figuring ? ? ? ? ? yield-to-maturitythat ? ? ? (rd)? current the ? ? ? ? ? our ? ? ??? ? on ? ? outstanding?bond for the corporation. ? ? pay ? that’s? also going ? ? ? ? ? ? ? ? will promise ? ? ? ? of ? ? ? 10% ?and? ? ?corporation. ? ? bracket, ? ? ? ? ? ? ?? ?? ? ? ? ? 10% ? 0.6 ? ? ? ? ? ? rate ? ? ? is ? ? ?? ????? ??? ? ?? ? ?? ? ?????? ?????? ?????? ????? ?? ?? ? (? ? ? ? )? ? ? ? ? ? ? ? ? ? ? ? ? ? ??? ? ???? ? ? ? transaction ? a ??? ? ? ? ? ? are ? ? ? ? ? ? ?? ? ? ? ? b) thewhat are flotation ? ? ? ? ? is? a? security ? ?into ?the marketplace ? ? investors, ?where ?? ? ? ? ? pay ? return???? ?borrow? the ? ? ? ? in ?the? ?with ?money ? ? ?the corporation ? ? ? ? ? ? ? made? tothey will repay?thatif? flotation 12% ? ?in ? ? thecouponmatures (which is? typically? 10?years)? anda? year there provide ? money Again this example ?bonds – which These ?are15-year ? ? ? ? ? ? ? ? ? ? ? to ? ? ? coupon ? ? ? investors ? in ? ? ? will ? ? ? ? the corporation that place and ?interest payments that are ? that ? ? ? minimal? we ?ignore we ?or ? ?a money after costs? middleman ? ? ? whichneed to ? in ? order so investor. So, loan ? that the of So in issuance of we ? ? ? 10.4.? ? ? outstanding ? the – with semi-annual bonddebt. bond, means that every in on top of that they willbe to pay an annual coupon or interest rate to the investor as well. So what the investor gets is an “IOU” from the company of certain interest payments every year for approximately 10 years, and then they get the repayment of their principle back at the maturity of the bond offering. The corporation, of course, gets access to the capital in the first place. 6% interest on can is Self-test question ?10.4. ? ?an ? ? ?? ?? ???? ?? ?? ?? ?? ?12%bond ? ? ? fees? orsemi-annualfees ?that ?we ??sells ??????$1153.72. ?to ???the coupon again?meansfirst ? ? ? ? to? get the ?deal ?done. ? Because ?they ?arethe?????????????????????6%? ? have ? ?costs 6%? ? ? ?cost ? ? ? ? ? ? ? that?? ?? ???? ?? ?? ?? ???? ?? ??6? months ? ? ? ? ? ? ? ? ? ? is? going IOU? ? a ? ? ? ? ? ? ? ?payment ? ? the ?principle ?amount? on ?the bond which ?we ? ? ? estimate ? ? 6% of $1000 equals $60. Self Test 10.4 17 00:00 ? we? ?have ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?12%? ? ? ? ? ?????? ?long-term ?bonds ? for? ? (??????10?Now ) ? ? ? ? ? ? ? ? ? ? the ? ? ? ?these ? ?? ? 1153.72 b) ? will? discuss ?how? this relates? to? the yield-to-maturity? on???? ? ???? ? ?? ? ?????? ? ?how? that? is? also? a? cost?of? debt? for ? ? ?corporation. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 6? ? ? ? ? ? ? ? ? ?? ? ? ? ?? ? ?? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ? ? ??? ? ? ? ? (1000? ? ? ? ? ? ? ? 60? ?? ??? ? 10?? ? ???? ?? ? ? ??? ? ???? ?? ????? ??? ? ???????? ? ????? ? 15 ? ? 12% )? ? ? ?? ??? ? ? and ?? ? ? ? ? In is next slide ? ? ? Nowour wantafter-tax?cost what therather than the the rate ofcost of debt the corporation. calculate the weighted ?average cost talking aboutPlease take a momenthereanswer this annual bond sonext slide when you’re ready. a semiannual coupon and that means that the rate of debt is going to be multiplied by 2 in order to get the annual rate for the corporation. So in terms of the periods that we are working with, we know that it’s a 15-year semi-annual bond – so 15 times 2 is 30 periods. The present value, or what the bond sells for at this moment, is $1153.72 and we enter that as a negative in our financial calculators or our Excel spreadsheets. And then again the payment is the 6% semi-annual coupon bond – which is 12% divided by 2 multiplied by a par value of $1000 – which gives us a payment of $60 every 6 months, and we know a semi-annual bond and Why we the10.4 figure out of debt ? actual cost or before-tax debt is for used in order to So we have to remember that we are of capital? go to the that Self-testareto answer. ? ? ? ? ?? ??? ? ? ? ? corporation can ? ? ? access to? long-term? debt? capital. ? Now,? each? of ?those ? ? ? ? ? ? ? ? ? ? ? still ?going ? ? be? the ? ? ? ? to ? ? ? ?not an andto be representedmeans that the bond paysor the cost of debt KD. It’s the marginal cost of debt as well so we have to remember, the question to ask is, “What would it cost the corporation to go out and raise debt capital or borrow debt capital in today’s market, and not necessarily 5 or 10 years ago or some time in the past?” Self Test 10.4 Answer 18 00:00 So there two ? ? ? ? specificallythe? ? ? ? ? ? ? ? ? ? get ? ? ? ? ? we ? ? ? ? ? ? ?? ? ? ? ? ?? ? ? essentially ?? ? you? ?? ???? different 10.4 that ways ?? ?? ? 1? ? ? ? ? ? ? ? ?? ? if ? different ?ways ? ? ? ? ? ? ? for ?? ? ? ?to ? ? ? ? It’s? maturity ? ? ? ? ? ? ? ? 2? ? as? ? ? rate ? as? ? ? RD ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? of? ? ? ? ? ? ? ? ? ? ? still going ? ?? ?? ? ? ? ? ? ? ? ? ?then ?that would suffice ? ? ?? ?? ? ?? ?? ?? ??? ? ? ? later ? ? ? Again, we will talk moreupon ?after-taxabout ?value ? ? bonds ?and how ? ? ? ? set?? ?? ?? ?? ? on?? ?? ?? ?the? ?? ?? ? ?? ??debt? by?? ?? ?? tax ?? ? rememberis ? ?? ?? ? that ?the ?? ? ?? ?? ?same. ?? ? portion?? ? ?thatacost ?of ? going to?bethe ? sameof debt ? debt. ? In? effect,of? debt? or ?the ratesubsidizes aany kind15? ?borrowingof?debt. 15? ? ? 2? 30? ? ? for ? ? ? ? But ? ? ? ? we? will? talk? more? about 1153.72? ? ? ? ? in a ? ? ? ?class.? ? ? ? ? ? ? ? ? ? ? Excel? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 12%? 2? ? ? 1000? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 60? ? ? ? ? ? ? ? 6%? ? ? ? ? ? ? ? ? ? ? ? ? ? 15? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1000? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 5%? ? ? ? ? ? 5%? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 2? ? ? ? 10%? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? binds, bond is The stock price depends ? ? ? ? ? ? ? ? ? what’s ? ? in ? ? ? ? ? the dothe ?? ? ? pricesthing ? ? ??but ? ? is ?? ?? ? ?? termsjusta bondwhich ? ?now ?because yield-to-long-term ? ?to ? ? ? on ?same ?cost ?of ? fromor ? the ? ? ? ? ? figuring out the cost ? the US ? ? ? ? ? ? ? ? ? debt on ? ? ? ? ? of the cost ? ? ? ? outstanding ? ? ? ? ? now. ? is again ? ? ? a ? ? ? ? of thebond valuationas well. So to adjust cost? the ? shield deduct of overall of Self-test question ?10.5. ? ? ? ? ? ? is ? ? ? ? ? available ? ? ? ? ? ?? ?? ?? importantWe ? ? ? ? ? ? ?? ?? ? ? of ? ? ? ? ? ? ? ? ? of? 1-T ? ? ? ? ?is ? and borrowing money, ?it’s? ?? ?? ? ? be the ? ? ? ? ? ?? ? ?? ? ? ?? rate of ? cost ? ? ? company. So ? ? the government Self Test 10.5 19 00:00 So the marginal cost?of ?debt ?capital ? ?cash ?flows ? ? ?? ?? ?? ? ?? ?? ?? ?? ?shareholders.? ?? ? ?? ?? ??here ?again,? ?? ??that ?in?? ?? ?? ? ?? ?? ?? ?? ? ???issuance?????????? ?? ?? ?we??? ???? ?KD??????going ????????????????????????debtdebt ??our ????????debt to? the ? ? ? ? ? ? 10? thus ? ? ?yield-to-maturity, or? theportion ? ? ? an ?investor, ?on ? ? ? ? ? ? ? ?long-term ?debt, ? ? often ?used ?as ? ?measure ? ? ? ? ?rate ?of ? ? ? ? ? ? ? ? ? ? ? if you see the long-term yield of the bond offering of a corporation you know that that’s also the cost of debt or the rate of debt for that company as well. important ? ? us. And ? ? ? ? ? 10.5.? ? ? 2 ? ? ? 1-T RD ? ? ? ? ?? can ? ? ? ? a ? ? ? ? ? ? of ?? ??? ? ? ? debt ? ? ? to ? ? ? ? ?? ?? ? ? ? ? ?? ? ? ? ?? ?? ??? ? ?? ? ?? ? ? ? and ? ? ready. ? ??? ? ? ? 5 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? return for ? ? ? ? Why is the10.5 answerthis? ? debt the ? ? ? ? ? ? rate? tax shield and ? ? ? ? ? ? ? ? interest ? ? not already take a ? ? ? ? ? ? when you’re ? ? ? ? ? Self Test 10.5 Answer 20 00:00 Self-test And finallyrelevant cost ? “1-T,” ?or? what? we ?call ?a? ?? ??new ? ?? )that ? ? ? the? ? ? ?the? cost? of? debt? from. ? Why ? ? ? Pleas ? ? ? ? need? to? taxanswer? this? questionthe? costto ? debt? by ?the tax ? ? ? ? ?1-T? ? ? ? ?next ?slide ? ? ? ? ? this question. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? there is? ? ? of ? ?? ? ?? ? ? ? ? ? (on ?? ?? debt? ? ? ? ? multiply ? ? ? outstanding (or ?old) ?debt? you ?think we? ?moment ?to ? ? ? ? ? ? ? multiply ? ? ? ?go ? ofthe ?next slide ? shield ? ? Our ? ? ? ? ? answers ? ? ? ? ? ? ? ? ? ?? 10.5 ? ?? ? ?? ? ? ? do ?? ? ? ? ? ? ? or ???? ? ? ? ? ? ? we ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? adjust ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??? The company is concerned with the marginal (or new) cost of debt compared with what it could have acquired debt for in the past. It is more relevant therefore in helping determine what the correct cost is today for acquiring debt in the marketplace. Self Test 10.6 21 00:00 Sel ?? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? )????????????????????????????????????? 1-T ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1-T ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ( ? ? ? ? ? ? ? ? Self Test 10.6 Answer 22 00:00 Component cost of preferred stock 00:00 23 What is the cost of preferred stock? 24 00:00 Is preferred stock more or less risky to investors than debt? 25 00:00 Why is the yield on preferred stock00:00 than debt? 26 lower % Self Test 10.7 27 00:00 Self Test 10.7 Answer 28 00:00 Self Test 10.8 29 00:00 Self Test 10.8 Answer 30 00:00 Component cost of equity 31 00:00 We have now come to the final cost component in our weighted average cost of capital calculation which is the component cost of equity. Again this is denoted either by RS or RE (or KS or KE as it may be) and it’s the marginal cost of common equity using retained earnings which would be denoted as KS or RS, and the rate of return investors require on issuing new common stock would be RE or KE. You may ask yourself, “It’s counterintuitive to think that there’s a cost associated with a company using the money that it already has, or the money in retained earnings.” Well the answer is that there is a cost for retained earnings and it’s really an opportunity cost argument on behalf of the investor. It’s that the earnings can either be reinvested or paid out as dividends to the shareholders. Those shareholders or investors could buy other securities and earn a return. So thus, if the earnings are retained in the corporation, there’s an opportunity cost that the investor loses out on because they can’t take that money and reinvest it into another company. The stockholders could have earned their return on an alternative investment of equal risk, so there is an opportunity cost which is lost on behalf of the inves Why is there a cost for retained 32 00:00 earnings? Two ways to determine the cost of common equity, rs 33 00:00 If the rRF = 7%, RPM = 6%, and the 00:00 beta is 1.2, what’s the cost of common equity based upon the CAPM? 34 firm’s If D0 = $4.19, P0 = $50, and g = 35 00:00 5%, what’s the cost of common equity based upon the DCF approach? What is the expected future growth 00:00 36 rate? One more problem with using the discounted cash flow methodology is that we ask ourselves, “Can it be applied to a cash flow stream and a growth that is not constant?” Well the answer is yes, non-constant growth stocks are expected to attain constant growth at some point, generally in five to ten years, but the downside of this is that is very difficult to calculate and compute. So, although you can calculate a non-constant growth rate for a company, it is generally preferred that you use a constant growth rate in the discounted cash flow model, and if that doesn’t work then you use the capital asset pricing model to figure out your cost of retained earnings. In our next slide we’ll be able to combine the two and determine what a reasonable estimate is of the cost of retained earnings for the company Can DCF methodology be applied if growth is not constant? 37 00:00 What is a reasonable final estimate00:00 38 of rs? Now that we have employed two different methods we have two different reasonable estimates of the cost of retained earnings (or RS). Under the CAPM method we figured out that the cost of retained earnings would be 14.2% and under the discounted cash flow approach we figure out that it would be 13.8%. If we take an average of those % estimates, we see that we have an average estimate of approximately 14%, which both of them seem to be right on or about. So as a reasonable estimate of the cost of retained earnings from this company, we could take these two estimates and average them to find out that it’s approximately 14%. Self Test 10.9 39 00:00 Self Test 10.9 Answer 40 00:00 Self Test 10.10 41 00:00 Self Test 10.10 Answer 42 00:00 Self Test 10.11 43 00:00 Self Test 10.11 Answer 44 00:00 Self Test 10.12 45 00:00 Self Test 10.12 Answer 46 00:00 ― ― Self Test 10.13 47 00:00 Self Test 10.13 Answer 48 00:00 Why is the cost of retained earnings cheaper than the cost of issuing new common stock? 49 00:00 So, the what is re? If issuing new common stock incurs 00:00 50 a flotation cost of 15% of the proceeds, difference again between the cost of retained earnings and the cost of issuing common stock is really the flotation cost. So all we need to do is make a slight adjustment to our regular discounted cash flow formula in order to find the cost of issuing new stock in the marketplace. In this case, if we are issuing new common stock and we incur a flotation cost of 15% of the proceeds, we want to know what our new cost of equity for issuing new common stock is going to be. We take the same information we had before – so we know that the dividend per share a year from now is $4.3995 and we know that the price today is $50. All we need to do in this case is multiply the price by 1 minus the flotation cost. So if we know that the flotation cost is 15% then it’s 1-0.15, which gives us a new stock price or an after-tax A few notes on actual flotation costs. Now flotation costs again depend upon the firm’s risk profile and the type of capital being raised. Flotation costs are highest for common equity, however since most firms issue equity infrequently, the per project cost is fairly small. And again, the cost is anywhere between 3 to 13%, depending upon how much you’re actually raising. We will typically and frequently ignore flotation costs when we are calculating our weighted average cost of capital. Flotation costs 51 00:00 Self Test 10.14 52 00:00 Self Test 10.14 Answer 53 00:00 Self Test 10.15 54 00:00 Self Test 10.15 Answer 55 00:00 Self Test 10.16 56 00:00 Self Test 10.16 Answer 57 00:00 Ignoring flotation costs, what is the firm’s WACC? 58 00:00 ― ― Self Test 10.17 59 00:00 Self Test 10.17 Answer 60 00:00 Self Test 10.18 61 00:00 Self Test 10.18 Answer 62 00:00 Self Test 10.19 63 00:00 Self Test 10.19 Answer 64 00:00 Self Test 10.20 65 00:00 Self Test 10.20 Answer 66 00:00 What factors influence a company’s 00:00 67 composite WACC? Self Test 10.21 68 00:00 Self Test 10.21 Answer 69 00:00 Self Test 10.22 70 00:00 Self Test 10.22 Answer 71 00:00 Self Test 10.23 72 00:00 Self Test 10.23 Answer 73 00:00 Should the company use the composite WACC as the hurdle rate for each of its projects? 74 00:00 Risk and the Cost of Capital 75 00:00 To illustrate this point a little further, let’s examine this chart on the right showing the risk and the costs of capital here. In this case ― have two firms – firm L and firm H – which are considering two separate projects – project A and project B. Let’s first take a look at firm L. For firm L you can see that its weighted average cost of capital is 8%. The expected return on project A is 10.5%. Therefore it’s obvious that accepting this project is going to be beneficial for the shareholders since the return on the project is going to be greater than the weighted average cost of capital for firm L. But now let’s look at project B. For firm L, project B is actually not a good investment choice because, although it has a higher rate of return – 9.5% versus the corporation’s WACC of 8% - it doesn’t meet the thresho we ― What are the three types of project00:00 76 risk? So how are each of ?these ? ? ? ? of ?risk ?used? ? Well, ? ? ? ? ?risk ?is ? ? ? ? ? ? ? ? ? the ? ? ? ? ? most situations, ? ? you ?can? figure out ?how? a project? is?going ? ? impact ? ? ? share ? ? ? ? ? However, ?creditors, ? ? ? ? ? ? ? supplier ? ? ?employees? are ? ? ? ? to ?be ? ? ? ? ? ? ? ? ? ? ? ? ? corporate risk – ? ? ?is ? ? ? ? ? ? to ?affect? the ? ? ? ? ? ? ? ? ?corporation? which may affect their job and their salary? Therefore corporate risk is also going to be relevant. How is each type of risk used? 77 00:00 ? ? ? ? types ? ? ? ? ? ? ? ? ? market ? ? ? theoretically ? ? best in ? ? ? ? ? ? ? ? ? ? if ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? to ? ? ? ? the ? ? ? price. ? ? ? ? ? ? ? ? ? ? ? customers, ? ? ? ? ? and – ? ? ? ? ? ? going ? ? more concerned about ? ? ? ? ? ? ? ? ? ­ how ? it going ? ? ? ? ? ? income of the ? ? ? ? ? ? ? ? ? Self Test 10.24 78 00:00 Self Test 10.24 Answer 79 00:00 Self Test 10.25 80 00:00 Self Test 10.25 Answer 81 00:00 So or divisions? rates – a low-, medium- and high-risk – in terms of benchmarking projects on. How would we calculate and risk-adjusted costs of capital for specific projects or divisions within a corporation? Well the answer is that it’s very qualitative in nature. We would have to use our subjective judgment and make some adjustments to the firm’s composite weighted average cost of capital and we would attempt to estimate what the cost of capital would be if the project or division were a standalone firm and not part of the overall corporation. This also requires, obviously, estimating the project or the special division’s beta and how it would move in relation to the stock market. How are risk-adjusted costs of capital determined for specific projectsfar we’ve been talking about calculating composite WACCs for corporations and using different levels of hurdle― 82 00:00 ― Finding a divisional cost of capital: Using similar stand-alone firms to estimate a project’s cost of capital 83 00:00 Calculating a divisional cost of 84 00:00 capital So this is how we would calculate a divisional cost of capital. We would always start off with our division’s required rate of return on equity or return on earnings. We would use our CAPM model to do this. Using the CAPM model, it is given that the risk-free rate is 7%, the market premium is 6% and the beta of the division that we’re talking about is approximately 1.7, which gives us a required rate of return on equity of 17.2%. We take this 17.2% and plug this into our WACC equation – we have a weighted debt of 40%, the cost of debt is 12%, the tax rate is 40% and we add that to the weight of common stock which would be 60% and then the cost of common stock would be 17.2% as we have just figured out in the above using CAPM. This would give us a weighted average cost of capital for this division of approximately 13.2 Self Test 10.26 85 00:00 Self Test 10.26 Answer 86 00:00 Problem areas in cost of capital 87 00:00 Self Test 10.27 88 00:00 Self Test 10.27 Answer 89 00:00 Summary 90 00:00 We have now reached the end of Chapter 10, so let’s summarize everything we’ve learned. At the beginning of today’s lecture I said the lesson was that there was no free lunch and what did that mean? There is always a cost associated with any kind of action that the corporation takes. So in order for a company to make money for its investors they must spend money. This money, of course, is not free – there is a cost associated with this money. We use the weighted average cost of capital formula to help calculate what this cost would be to the company. Join me next time as we discuss the basics of capital budgeting in Chapter 11. Chapter 10 homework. We will review the homework which was assigned for Chapter ten. The cost of capital. CHAPTER 10 Answer Set The Cost of Capital 91 00:00 Problem 10-1 92 00:00 Problem 10-1. The Hauser company’s currently outstanding bonds have a 10% coupon and a 12% yield to maturity. Hauser believes it could issue new bonds at par that will yield similar maturity. If its tax rate is the 35%, what is Hauser’s tax of debt? Problem 10-1 Answer 93 00:00 Problem 10 -1 answer. The before tax cost of debt equal is the after tax cost of debt which is the rate of debt multiplied by one minus the tax rate, or we call the tax shield. In this case we are given the cost of debt is 12% and the tax rate is 35% so one minus 35 is 0.65 we multiply this by the rate of debt it will give us cost of tax debt of approximately 7 .8%. Problem 10-2 94 00:00 Problem 10 -2. Tuny Industries can issue perpetual stock at a price of $47.50 per share, the stock will pay a constant annual dividend of $3.80 per share what is the company’s cost of preferred stock? Problem 10-2 Answer 95 00:00 Problem 10- 2 answer. We are given that the price of preferred stock is $47.50, we are also given that the dividend on the preferred stock is $3.80 our assignment is to find the cost of preferred stock in this case is the dividends of $3.80 divided by the price of $47.50, which will give us a cost of preferred stock approximately 8%. Problem 10-3. Percy Motors have a target capital structure 40% debt, and 16% common equity with no preferred stock. The yield to maturity of the company outstanding bonds is 9% and its tax rate is 40%. The CEO estimates the company's WACC is 9.96%, what is Percy’s cost of common equity? Problem 10-3 96 00:00 Problem 10-3 Answer 97 00:00 Problem 10-4 98 00:00 Problem 10-4, Javits and Sons, common stock current trades at $30 per share, it is expected to pay an annual dividends of $3.00 a share at the end of the year. Thus D1 equals $3.00 and the constant growth rate is 5% per year. What is the company's common equity if all of the equity comes from retained earnings, if the company were to issue new stock it would incur a 10% flotation cost. Will the common equity cost be from new stock? Problem 10-4 Answer 99 00:00 Problem 10-5 100 00:00 Problem 10-5 Answer 101 00:00 Problem 10-6 102 00:00 Problem 10-6 Answer 103 00:00 Problem 10-7 104 00:00 Problem 10-7. The Everneck company expected dividends, D1, is $3.18. Its growth rate is 6% and its common stock now sells for $36.00, new stock or external equity can be sold for net $32.40 per share. What is Evernecks cost of retained earnings? What is Everneck’s percentage flotation costs? and What is Everneck’s costs of new common stock? Problem 10-7 Answer 105 00:00 Problem 10-8 106 00:00 Problem 10-8. Patent Paints Corporation has a target capital structure of 40% debt and 60% equity, with no preferred stock. Its before tax cost of debt is 12% and its after marginal tax rate is 40%. The current stock price is $22.50, the last dividend was $2.00 and is expected to grow at a constant rate is of 7%. What is its cost of common equity and what is its weighted average cost of capital? Problem 10-8 Answer 107 00:00 Problem 10-9 108 00:00 Problem 10-9 the Patrick companies cost of common equity is 16%, its before cost of debt is 13% its marginal tax rate is 40%, the stock sells at book rate value, using the following balance sheet calculate Patrick’s weighted average cost of capital. Please refer to the balance sheet in the textbook. In order to solve this problem we need to figure out the capital source weights from the balance sheet, we know that long term debt equals $1.152 million and common equity equals $1.728 million, this would give us a total asset base of $2.880 million this 40% of our capital structure will be in long term debt and 60% of our capital structure will be in common equity. We can use this information to calculate our cost of common capital. The weight of debt now is 40% and the rate on the debt will be 13%. One minus the tax rate of 40% will give us .6 or 60% plus 60% will be the weight of the common stock and the cost of common equity or retained earnings will be approximately 1.69%, if we add these together, we get a total WACC of 12.72%. Problem 10-9 Answer 109 00:00 Problem 10-10 110 00:00 Problem 10-10 Answer 111 00:00 ????? ?????? Financial Decisions Chapter11 Wong Henry ????? Push here to start Home Work ???????? ?????????? slide/fd_11slide.swf flv? ? ? ? ???? flv/fd_01vid000.flv 00:01.0 flv/fd_11vid001.flv 00:55.0 flv/fd_11vid002.flv 01:49.9 flv/fd_11vid003.flv 01:07.9 flv/fd_11vid004.flv 01:29.9 flv/fd_11vid005.flv 01:03.9 flv/fd_11vid006.flv 01:39.7 flv/fd_11vid007.flv 00:18.8 flv/fd_11vid008.flv 01:18.9 flv/fd_11vid009.flv 00:15.0 flv/fd_11vid010.flv 00:12.0 flv/fd_11vid011.flv 00:14.0 flv/fd_11vid012.flv 00:29.0 flv/fd_11vid013.flv 00:35.0 flv/fd_11vid014.flv 00:29.7 flv/fd_11vid015.flv 02:20.8 flv/fd_11vid016.flv 01:33.7 flv/fd_11vid017.flv 02:35.8 flv/fd_11vid018.flv 00:21.9 flv/fd_11vid019.flv 01:02.9 flv/fd_11vid020.flv 00:28.8 flv/fd_11vid021.flv 01:13.7 flv/fd_11vid022.flv 01:21.9 flv/fd_11vid023.flv 00:37.8 flv/fd_11vid024.flv 00:58.8 flv/fd_11vid025.flv 00:57.0 flv/fd_11vid026.flv 01:06.9 flv/fd_11vid027.flv 01:03.9 flv/fd_11vid028.flv 00:18.0 flv/fd_11vid029.flv 00:16.0 flv/fd_11vid030.flv 00:41.9 flv/fd_11vid031.flv 02:13.8 flv/fd_11vid032.flv 01:31.9 flv/fd_11vid033.flv 01:12.9 flv/fd_11vid034.flv 01:23.9 flv/fd_11vid035.flv 00:53.0 flv/fd_11vid036.flv 00:49.8 flv/fd_11vid037.flv 00:19.0 flv/fd_11vid038.flv 00:17.9 flv/fd_11vid039.flv 00:44.0 flv/fd_11vid040.flv 01:58.9 flv/fd_11vid041.flv 01:29.7 flv/fd_11vid042.flv 01:15.9 flv/fd_11vid043.flv 00:42.7 flv/fd_11vid044.flv 00:52.0 flv/fd_11vid045.flv 01:37.9 flv/fd_11vid046.flv 00:20.0 flv/fd_11vid047.flv 00:45.8 flv/fd_11vid048.flv 00:22.0 flv/fd_11vid049.flv 00:33.0 flv/fd_11vid050.flv 00:18.9 flv/fd_11vid051.flv 00:51.0 flv/fd_11vid052.flv 00:24.0 flv/fd_11vid053.flv 00:46.8 flv/fd_11vid054.flv 00:55.0 flv/fd_11vid055.flv 02:59.8 flv/fd_11vid056.flv 00:49.0 flv/fd_11vid057.flv 00:18.0 flv/fd_11vid058.flv 00:19.9 flv/fd_11vid059.flv 00:14.7 flv/fd_11vid060.flv 00:28.9 flv/fd_11vid061.flv 00:37.0 flv/fd_11vid062.flv 04:27.7 flv/fd_11vid063.flv 01:03.8 flv/fd_hw11vid001.flv 00:08.0 flv/fd_hw11vid002.flv 00:20.4 flv/fd_hw11vid003.flv 00:37.5 flv/fd_hw11vid004.flv 00:09.7 flv/fd_hw11vid005.flv 00:35.9 flv/fd_hw11vid006.flv 00:10.1 flv/fd_hw11vid007.flv 01:13.4 flv/fd_hw11vid008.flv 00:10.3 flv/fd_hw11vid009.flv 00:27.4 flv/fd_hw11vid010.flv 00:09.9 flv/fd_hw11vid011.flv 00:59.8 flv/fd_hw11vid012.flv 01:03.2 flv/fd_hw11vid013.flv 01:03.5 flv/fd_hw11vid014.flv 01:05.6 flv/fd_hw11vid015.flv 01:04.8 flv/fd_hw11vid016.flv 01:00.7 flv/fd_hw11vid017.flv 00:53.8 flv/fd_hw11vid018.flv 01:09.8 flv/fd_hw11vid019.flv 01:03.3 flv/fd_hw11vid020.flv 01:48.1 flv/fd_hw11vid021.flv 00:43.1 flv/fd_hw11vid022.flv 01:04.1 flv/fd_hw11vid023.flv 00:43.5 flv/fd_hw11vid024.flv 01:48.9 ???????? ???? ?? 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 ????? ?????? ???????? captivate? ? ? ? ? ? Script ? ? ? Script Introduction 1 00:00 This Page is Menu of? Lectrue. ? ? ?? ????? Welcome back to Financial? Decisions and Markets.? ? ?am ? ? ? ? 11? ? ? ? ? Wong and ? ? ? ? we’re ?going ? ? ? ? ? ? Chapter ?11 ? ?The Basics ? ? ? ? ? ? ? Budgeting. ? ? ? ? ? we’re ?going ? ? start ?off by talking? about ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? essentially ? ? ? process ?or ? ? ? decision ? ? ? ? ? ? ? ? ? ? ? ? ? ?between ?projects that a ? ? ? ? ? ? ? ?may? invest ? ? ? ? ? talk about?how ? ? choose ? ? ? ? ? ? ? ? ?might be most favorable to the shareholders, and what methodologies we use to make that decision including the payback period, net present value, the internal rate or return and finally the modified internal rate of return. First ? ? ? ? ? ? to ? ? ? ? ? ? ? ? ? ? ? ? ? ? what capital budgeting is. It is ? ? ? ? ? ? ? the ? ? ? ? ? the ? ? ? ? ? framework in choosing ? ? ? ? ? ? ? ? ? ? ? ? ? corporation ? ? ? ? ? in. We ? ? ? ? ? ? ? ? we ? ? ? ? what projects ? ? ? CHAPTER 11 The Basics of Capital Budgeting 1 00:00 ? ? ? ? ? ? ? ? ? ? ? ? Henry Wong I ? Professor Henry ? ? ? ? ? today ? ? ? ? ? ? to cover ? ? ? ? ? – ? ? ? ? ? ? of Capital ? ? ? ? ? ? Today’s Lesson: “Not all ideas are 00:00 2 created equal” As you recall, we have covered3? ? ? three ? ? ? ―principles ?of ?finance ? ?the time value ?of ?money,? risk? and ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? also? mentioned ? ? ? ? ―? ? that once we? cover ? ? ? ? topics ? ? ? ­we ? ? ? ? ? ? ? to? move? on ?to ? ? ? ? parts ?and topics ? ? ? ? ?corporate ?finance ?in ? ? ? ? we? will? accumulate ?all? of? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? in? particular ?these ? ? ? ? topics that ? ? ? ? ? ? ? ? ? ? – ? ? ? ? ? capital, ?time ?value ? ? money?and ? ? ? ? ? ?return. ? In? today’s? lecture ?we ? ? ? ? ? ? ? ? ? ? budgeting,? and ? ? again ? ? ? ? ? ? ? in? on?cost? of ?capital?and ? ? ? ? ? ? ? of ?money. ? So ?everything ? ? ? ? learned? in ?those ? ? ? ? ? ? two ? ? ? ? ? ? ? ? will apply? again ? ? ? ? to? understand ?this ?lecture. ?So ? ? ? ? ? ? ? ? ? ?is ? ? ? ? ? ? ? ? ? ? ?ideas ? ? ? created 1? ? ? ? ? ? ? ? ? ? ? ? mean by? that? ? It means ?that ?a? financial? man ? ? ? ? ? ? ? ? the ? ? ? basic ? ? ? ? ? ? ? ? ? ? ? – ? ? ? ? ? ? ? ? ­ ― ? ? ? ? ? ? ? return and ? ? cost of capital. I had ? ? ? ? ? 3? ? previously ? ? ? ? ? ? ? ? ? ? these ? ? ? ? that ―? will begin ? ? ? ? ? other ? ? ? ? ? ? ? ? ? within ? ? ? ? ? ? ? ? ? ? which ? ? ? ? ? ? ? ? ? ? ? ? ? information we have learned in ? ? past, ? ? ? ? ? ? ? ? ? ? three ? ? ? ? ? 2? we have covered ? cost of ? ? ? ? ? ? ? ? ? ? of ? ? ? ? ? risk and ? ? ? ? ? ? ? ? ? ? ? ? ? ? discuss capital ? ? ? ? ? ? ? ? we ? ? ? will focus ? ? ? ? ? ? ? ? ( ? ? time value ? ? )? ? ? ? ? ? ? ? ? we’ve ? ? ? ? ? ? ? ? previous ? ? lectures, we ? ? ? ? ? ? ? ? ? today ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? today’s lesson ? really, “Not all ? ? ? are ? ? ? ? equal.” What do we ? ? ? ? ? ? ? ? ? ? ? ? ? ? ????? ?? What is capital budgeting? 3 00:00 We start off in this? lecture ?discussing ? ? a ? ? ? ? ? ? ? ? ? ? ? exactly? is ?capital ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? budgeting is? the ? ? ? ? ? ?of ?potential ?additions ?to ? ? ? ? assets for ?the? corporation.? ? ? ? ? ? ? ? involves ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? because? we’re ? ? ? ? ?very ?large ? ? ? ? ? ? ? ? in? each? of ?these ? ? ? ? assets, ?and therefore it? will? have? a long-term impact ? ? the ? ? ? ? ? ? ? ? ? also, ? ? ? ? ? ? ? ? ? ? has ? ?very ?important ?financial ?impact? to ?the value ?of ?the? firm? and ? ? ?firm’s? future.? ? ? ? the same principles? we’ve ? ? ? ? ? ? ? ? ? in ?capital ? ? ? ? ? ? ? ? ? ? ? ? ? making decisions whether or not we should purchase a certain plant or not we use the same basic framework when we talk about whether we should invest in a certain stock or not. So we use the same principles that allow us to analyze whether or not assets are going It usually ? ? ? ? ? very long-term decisions, ? ? ? ? ? ? ? making ? ? ? ? ? expenditures ? ? ? ? ? ? ? fixed ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? on ? ? company. And ? ? ? as a result, it ? ? a ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? But ? ? ? ? ? ? ? ? ? ? ? ? ? ? learned today ? ? ? ? ? budgeting when we’re ? ? ? ? ? ? ? ? ? ? ? ? ? on ? high level, “What ? ? ? ? ? ? ? ? ? budgeting?” Well capital ? ? ? ? ? ? ? ? ? analysis ? ? ? ? ? ? ? ? ? ? ? ? fixed ? ? ? ? ? ? ? ? ? ? ? ? ? ? There are really ? ? ? ? ? ? ? to? capital budgeting: ? ? ? ? : five steps ? ? ? ? 5? ? ? ? ? ? ? Steps to capital budgeting 4 00:00 First off though, let’s ?discuss ?what ?the difference ?is ? ? ? ? ? ? ? ? ? ? ? ? ?and mutually ?exclusive ?projects. ? ? ? ? ? ? ?have? independent projects, that means? that? the ? ? ? ? ? ? ? of?one ? ? ? ? ? are ? ? ? ? ? ? ? by? the ? ? ? ? project, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?projects you ?can likely ? ? ? ? ? ? ? accept both ? ? ? ? ? ?because ? ? ? ?don’t affect ? ? ? ? ? ? ? ? ? ? ?when?we ?have ?mutually exclusive projects, ? ? ?essentially? have? to? choose one ? ? ? ? ? ? ? ? ? ? ? other ? ? ? ? their ?cash ?flows ? ? ? dependent? upon? each? other ?–? so ?one particular ?project’s ?cash? flows ? ? ? adversely? affect the ?other ? ? accepted. 1? ?therefore, ? ? a ? ? ? ? ? ? exclusive? project ?scenario, ?we ?will ?only ?have ?one choice ? ? ?we ?can only choose ? ? ?project ?out of? the ? When you ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? cash flows ? ? ? another ? ? unaffected ? ? ? other ? ? ? ? ? so therefore with independent ? ? ? ? ? ? ? ? ? ? ? ? ? choose and ? ? ? ? ? ? ? projects ? ? ? ? they ? ? ? ? ? ? ? each other. But ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? you ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? project over the ? ? ? since ? ? ? ? ? ? ? ? are ? ? ? ? ? ? ? ? ? ? ? ? What is the difference between independent and mutually exclusive projects? 5 00:00 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? between independent ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? can ? ? ? ? ? ? ? ? ? ? ? ? ? ? if ? ? ? ? ? ? So ? ? ? ? ? ? in ? mutually ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? one ? ? ? ? ? ? ? ? ? mutually exclusive projects that we’re looking at. In an independent projects scenario we can choose as ma 1) the asset purchasing. well as outflows company. What is the difference between normal and nonnormal cash flow streams? We must estimate ? ? ?cash?flows ? ? ? ? ?potential?project ?or ? ? ? fixed ? ? ? ? that? webetween? normal ? ? These ?may? include? inflows ?as ? ? ? Well? first ?off, ?we ?know ?what ?a? normal cash flow stream ? ? ? ? like – ? ? ? ? ? ? ? ? ? ? is? a cost in? the ? ? ? ? ? ? ? ? ? ? ? ? ? )cash flow) ?followed ? ? a ? ? ? ? ? ? ? ? ? ? ? ?cash? flows ? ? ? ? ?remaining ?years.? ?There’s ? ? ? ? ? ? ? ?change? of ?sign ?in ? ?normal cash flow stream ?–? a negative ?and then a ? ? ? ? ? ? ? ?positive, ?a? positive ? ? ? ? In?a non-normal ?cash ?flow ?stream, ?we ? ? ? start ? ? ? with? a negative, ? ? ?we ? ? ? have? some? positive ? ? ? ? ? ? ? in? the ? ? ? ? ? but ?we ? 2? with a ? ? ? ? ? ?cash? flow? stream. ? ? ? ?in ? ?sense ? ? ? ? are ? ? ? or ?more ?changes ?of ? ? ? ? ? ? ? ? ? ? ? ? to ?negative,? negative ? ? positive. ?A? good example? of ?this ?is ? ?nuclear ?waste ? ? ? ? plant ? ? ? ? you ?have ?one negative ? ? ? ?flow ?in 6 00:00 Another question 1) the ? ? ? ask?ourselves ?before ? ? begin ?is ?“What ? ? the ? ? ? ? ? ? ? ? are ? ? ? ? ? ? and ?non-normal ? ? ? flow ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?for? the ? ? ? ? we ? to ? ? of the So, ? a ? ? ? there ? ? two ? ? ? ? ? ? ? ? sign from positive ? ? ? ? ? ? ? ? ? ? ? to ? ? ? ? ? ? ?? ?? ?? ? ? ? ? ? ? ? ? ? streams?” ? ? ? ? ? ?? ? ? ? ? have riskiness of ? ? ? ? ? ? we ? ? ? ? ? ? ? ? ? is? ? ? difference? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? cash ? ? ? ? ? ? ? 1? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? looks ? ? ? ? generally there ? ? ? ? ? ? (? beginning (a negative ? ? ? ? ? ? ? ? ? ? ? by ? series of positive ? ? ? ? ? in the ? ? ? ? ? ? ? ? ? ? ? ? usually one ? – ? ? ? ? ? a ? ? ? ? ? ? ? ? ? ? ­ ? ? ? ? ? ? ? ? ? ? ? ? ? ? positive, a ? ? ? ? ? ? ? ? ? ? etc. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? may ? ? ? off ? ? ? ? ? ? ? ? ? and ? may ? ? ? ? ? ? ? ? ? cash flows ? ? ? middle, ? ? ? end ? ? ? ? negative ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? a ? ? ? ? ? ? ? power ? ? ? where ? ? ? ? ? ? ? ? ? ? ? cash ? ? ? 2) We need to assess?the ? ? ? ? ? ? ? ? those ?cash flows. ? Self Test 11.1 7 00:00 Now let’s take a 2) ? ? ?to ?review? some? of ? ? ? topics we’ve? just ?covered. ? ? ? moment ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? cost of ? ? ? ? ? ? ? ? ? if? ? ? ? ? ? ? can 3) We need to determine?the appropriate ? ? ? ? ? capital? which, ? ? you ? ? ? recall from our last lecture "The Weighted Average Cost of Capital", is typically what we’ll use to discount the cash flows. Self-test 11.1 answer. ? ? ? ? ? ?? ?? ?? ? ? ? ? the ? ? ? ? ? ? ? ? of ? ? ? ? for ? ? ? ? ? ? ? ? Self Test 11.1 Answer 8 00:00 ? ? the ?? 4) And then we find ? ? ?net present value ?or ? ? ? internal rate ? ? return ? ? ?the projects. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 3) 11.1. ? 11.1 Self-test question 11.2similarities between security valuation and capital budgeting: There are reallywe accept if the 11.2 present value is greater than zero, and/or if the internal rate of return is greater than the weighted average cost of capital. three Self-test question ? ? ? ? ? ? ? ? ? net ? ? ? ? ? ? ? 3? ? ? ? ? ? ? ? ? ? : Self Test 11.2 9 00:00 5) Then finally ? 11.1. ? ? ?? ??????????? ???? ????? ? ?? How is capitalof 4) ? ways? that firmssecurity ? capital? projects ? ? it? different? Please taketake a momentanswer thisthis question go to the nextnext slide when you’re ready. What are some budgeting similar to generatevaluation and how is ideas for those? Please a moment to to answer question and and go to the slide when you’re ready. the Self-test 11.2 answer. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Self Test 11.2 Answer 10 00:00 11.2 ?? ? ? have to ????? ?? ??? ? 5) ? ? ? ? ? ? ? ? steps ? ? ? ? ??? ? ? ? ? 1) First off inseek ? security ? the ? ? ? ? of? capitalthrough? incentivizing ? ? sayexisting ? ? cash? flows. ? analyze ? ? ? security ? ? any ? ? ? ? where ?we ? ? ? ? ? ? Management can Again when we’rebothto developvaluation and simply? ?budgeting ?we ? ? ? ? ? forecast ?a? set of ? ? ? ? ? ? ? ? ? ? talking about projects you their? ? that ? ? employees. these steps or asset need to first forecast out the potential future cash flows of the company or asset, and then determine the riskiness and timing of those cash flows, and then we discount them back using an appropriate cost of capital, and we accept the investment if the net present value again is greater than zero or if the internal rate of return is greater than the WACC. Now again, we’ll talk about what the net present value actually means and what the internal rate of return means in a couple of slides. Self Test 11.3 11 00:00 Self-test question ?11.3. ? ? ? ? new ? ? ? ? ? ? capital ?budgeting, ? ? ?can? also? ? ? ? ? ? ? ? ? ? are ? ? ? ? to ? ? ? ? ? any 1) these ? ? have 11.3. ? ? ? ? ? ? ? ? ? ? ? ? ? ? at ?some? type? of ? ? ? ? ? ? rate. ? ? ? ? ? ? ? ? ? ? ? we ? ? ? ? ? discount both ? ? ? ? ? ? ? ? to ? ? ? ? ? cash flows ? ? ? ? ? ? ? ? discount ? ? ? ? ? ? 2) Also in both of ? ? ? What’s the difference an independent and exclusive project? Take a the when ready. Self Test 11.3 Answer 12 00:00 Self-test 11.3 answer.between ? ?? ?? ?? ? ? is ?always? a? mutually ? both? capital? budgeting? andmoment? to ?answer ?this ?and go? toonly next slidethe ? you’revalue is greater than the investment cost in the first place. 3) And finally our ?investment ? ? ? ? ? ? ? ? ? ? ? ?the same in? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? invest ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? WACC? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? decision ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? security ? ? ? ? ? 11.3 ? ?? ????? ? ?? ? ? ? ? ? ? valuation in that ??? ? ? ? ? ? ? ? ? ? if ? ?? ? present 2) ? ? ? ? ? ? ? ? ? ? are ? ? the ? ? ? ? ? ? ? of? one ? ? ? ? ? are ? ? ? ? ? ? ? by? the ? ? ? ? project. ? Hence ? ? ? ? ? ? weprojects? you ? ? ?choose all of them if they meet your criteria. Under mutually exclusive projects, one of the cash flows of the projects adversely affects the others. Therefore, you can only choose one out of the mutually exclusive projects. Independent projects with if flows unaffected can What is the payback period? 13 00:00 Now let’s start off ? ? ? ? ? ?of ?the ways in? which ? ? ? ? ? ? determine ?? ?? ?? ? ?? ?? ??not ?? ?? ?? ?? ? ?? ?is ?? 1? ? ? ? ? ? ? ? ? ? ? One ?of ? ? ? ways? that? they? measure?the? ? ? ? ? ? is? the ? ? ? ? ? period. ? ?So ? ? ? ? ? ? ? ? ? ? the ?payback ? ? ? ? ? ? It’s? simply? the ?number ?of?????????required ??????????????a??????????????????????????????????????????????????????????????????1take ?for ?me??????????my ? ? ? ? back?” ? It’s calculated ?by ? ? ? ? the project’s cash inflows to its cost until the cumulative cash flow for the project turns positive. one ? cash ? ? ? ? ? ? ? another managers ? ? ? ? ? whether or othera project ? a ? in independent ? ? ? the ? ? ? ? ? ? ? ? ? ? ? success ? ? ? payback ? ? ? ? good investment. years ?????????? to recover ? project’s cost – or in other words, “How long does it ????? ???? ?? to get ? money ? ? ? ? ? ? ? ? ? ? ? ? ? ? adding 1? ? ? what exactly is ? ? ? ? ? ? period? ?? ??? ?? ? ?? ?? ? ? ? 3) ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ? ? ? ? ? ? ? ?? ? ? ? ? ? ? ? ? ?? ? ? ???????????????????????????????????? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1????? ?? ?? ? There are a calculating ? differences, ?though, ? ? ? you ? ? ? equals? the ? ? ? )+ off is that?capital ?budget projects ? ?created, determined the developed by a ? ? of managers, ? ? ? ? ? ? ? ? ? are predetermined ? calculation, thenand ?end result ? ? ? ? exactly how long it atakes before we number ofmoney back, or essentially until we big difference is that capital budget projects are under control by the management team, so once the management team decides to purchase a fixed asset, that fixed asset is under their control, whereas when we invest in security valuation and stocks, they are of course under the control of other management teams. In terms of couple ?of ? ?payback ?it’s ?pretty? simple. ? ? ? should be(aware? of. ?First((?full ?recovery,?plus? the unrecovered ?cost ?at ?the))? ? ? ? ? ?and?year ?divided ?by set ? cash? flow? during the stocks ?If ?we ? ? ? ? ? ? ? by? other ? ? ? ? ? ? ? ? ? managers ? ? course,? and ? predetermined get our projects to invest in. The second get back our initial cost. Calculating Payback 14 00:00 ? ? key ? ? ? ? ? ? ? ? that Payback ? ? ? ? year before ? ? ? ? ? ? ? ? )÷(? ? ? ? ? are ? ? ? start of ? ? ? ? ? ? ? ? the ? ? ? ? ? whereas year. ? ? perform this ? ? ? companies the ? ? ? ? of will be ? ? there are hence Calculating payback 15 00:00 In this example there ? ? ? two ? ? ? ? ? ? in ?which 2? ? ? ? calculating ? ? ?payback ? ? L? ? for ? ?L? for ? ? ? ? ? ? ? ? S? ? ?and S ? ? ?short-term ? ? ? ? ? ? ? ? ? ? ? ? L? ?show?the ? ? ? ? ? ? ? ? ? ? ? ? ? ? in? the ? ? L? ? ? ? slides. ? ? ? ? ? ? L’s ?payback ? ? ? ? ? ? ? ?can be? determined ?by ? ? ? ? ? ? ? its ?cash ?flows ? ? each of? the ?different? periods. ? As? you ? ? ?see here there?is ?a? $-10010? ? ?or ? ? ? ? ? ? ? ? ? ? time ? ? 2There ? ? ? ? ? ? ? ? ? ? ?of ?$10 in? year3? ? another ?cash ?inflow? of? $60 ? ? year 2,? and ? ? ? ? ? ? ? year 3 ? ? ? ? ? a ? ? ? ? ? ? ? ?of ? ? ? ? We? simply take the ?cumulative amounts ? ? these cash flows ?by ?year ?and we ?see that under 1the ?cumulative cash flow line we? start? off ? 60? ? ? ? ? ? ? ? then? if we? add ? ­ 30? ? ?as ? ? ? ? ? ? ? ? 2? ? ?1, ?we ? ? ? up ?with ?$-90 ?at ? ? ? end ? ? ? ? ? ? ? ?And ? ? ? ? ? 2? ? end ?of ? ? ? ? ?we ? ? ? add ? ? ? ? ? $60, so there the period ? ? – L or long-term project foregoing ? ? ? ? Project ? ? ? ? ? ? calculation looking at at cost cash outflow at 0. ? ? 60 is a cash inflow 1, in ? ? ? ? ? ? finally in ? ? ? ? there’s ? cash inflow ? $80. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ­ 100? ? ? ? of ? ? 1? ? ? ? ? ? ? ? ? ? ? ? 10 ? ? ? ? ? ? ? ? ? ? ? ? ? ­ 90? ? ? ? ? ? ? ? ? ? ? ? 2? ? ? with $-100, and ? ? 2? ? ? ? $10 back ? an inflow in year ? ? end ? ? ? ? ? ? the ? ? of year 1. ? ? ? are ? ? projects ? ? ? ? we are ? ? long-term project ? ? ? for ? ? ? ? ? ? project. We will only ­ 100 ? ? ? ? ? ? ? ? ? ? can ? ? ? ? ? ? ? ? ? ? 2 then at the ? ? ? year 2 ? can ? ? back in ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ? ?? ?? ?? ?? ? ? ? ? ?? ? ?? ?? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ????? ????? ? ? ? ? ? ? ? ? ? ? ? ? ? ??? ????? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 2? ? ? ? ? ?? ?? ?? ? ?? ?? ?? ?? ?? ?? ? ?? ? ? ? ? ? ? ? ?? ?? ? ?? ?? ? ?? ?? ?? ? ? ?? ?? ?? ?? ? ?? ?0? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1???? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??? ??????? ????? ? ? 80? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??? Strengths and weaknesses of payback00:00 16 Here are some strengths ?and weaknesses ?of ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?for determining ? ? ? ? ? or? not ? ? ? ? ? ? ? ? a ? ? ? ? ? ? ? ? ? ? ? First off let’s talk about the strengths: ? ? ? ? ? ? ? ? ? ? ? ? ? using ? ? payback period as a method ? ? ? ? ? ? ? ? ? whether ? ? ? a project is ? good investment. : So one of the weaknesses ? ? ? 1? ? ? ? ? ? ? ? ? ? ? ?about ? ? that the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?time ?value ? ? money. ? Well, ? ? ? ? ? ? ? ? ? ? on? the ? ? ? ? ? period ? ? ? ? ? ? ? discounted ? ? ? ? ? ? ? ? ? ? ? ? ? we? can ? ? ? ? ? ? ? ? ? ? time? value ? ? ? ? ? ? so ?we ? ? ? ? ?more ?precise ? ? ? ? ?of ? ? ? ? ? ? payback ?period? is. ? So?basically ?in ? ? ? ? ? ? ? ? ? ?we ? ? ? ? ? ? the discounted cash? flows ?rather1than ? ? ?raw cash flows ?from ?the? project. ? And ? ­ simply ?is ? ? ? ? ?one? more? line under ?our cash flow analysis. ? So?in ? ? ? first ? ? ? ? ? have the ?cash 2? ? ? of60? ? ?project ? ? ? ? as? you ? ? ?see? is? $-100? as ?an outflow cost right ?now, ?that ?there ? ? a ? ? ?inflow? cash? flow? stream in? year? 1, ?there’s ? ? ? in ?year ?2? and ? ? 10%? $80 ?in ? ? ? ? ? ?Well? the next step ? ? we? take? the ? ? ? ? 10%? ? ? ? each ? ? these ?–? and in? each case we’re ?going ? ? assume that the dis Discounted payback period 17 00:00 ? ? ? ? ? that we have just talked ? ? ? is ? ? ? ? ? payback period ignores the ? ? ? ? ? of ? ? ? ? ? ? ? there’s a twist ? ? ? payback ? ? ? ? called the ? ? ? ? ? ? payback period where ? ? ? incorporate the ? ? ? ? ? of money ? ? have a ? ? ? ? ? ? answer ? when the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? this instance, ? will use ? ? 1? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? it 100? ? ? adding ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1? ? 10 the ? ? ? line we ? ? ? ? ? ? ? flow ? this ? ? ? ? which ? ? ? can ? ? ? 3? ? 80? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? is ? $10 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? $60 ? ? ? ? ? finally ? ? ? year 3. ? ? ? ? ? ? ? ? ? ? is ? ? ? ? ? present value of ? ? ? of ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? to ? ? ? ? : 1) It provides an indication of a projects risk and liquidity pretty easily Self-test question ?11.4. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Self Test 11.4 18 00:00 1) ? ? ? ? 11.4.? ? ? ?? 2)$-100 at time 0 to?calculate and ? as you • It’s very easy the benefits of understandpayback can see. We’re basically answering the question again “When can we get our money back?” 1) Discuss some of? ?? 0 ? ? 11.4 ? ? ? using and Self-test 11.4 answer. ??­ ?100? ? ? ? ? ? ? ? the ? ? ? ? ? method ? ? ? some? of ?the drawbacks. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Self Test 11.4 Answer 19 00:00 • ? ? ? 2) 1? ? ?? ? ?? ???? ?? ? ???????? 1) • The after year 2)$9.09benefits include payback provides an indication of a project’s risk and liquidity - we know not? Explain your to take for us to earn our money back – and obviously the 1) Do people follow the that the it whether or a is less risky if longer term payback period. it’s very easy to and We simply are question it even get money are the of money this by Self Test 11.5 20 00:00 Self-test question? 11.5.9.09? it method rigidly in a typical capital budgeting decision? Why or whyhow long it’s going answer and go to the next slide when you’re ready. ? ? ? ?shorter ? ? ? timeframe? is, ? ? will indicate ? ? ? ? ? ? ? not ? ?project ? ? ? ? ? ? ? ? ? or ?more ?risky ? ? it’s a ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?And then second ? ? ? ? ? ? ? ? ? ? ? calculate ? ? ?very ?easy ?to ?understand.? ? ? ? ? ? ? ? ? ? answering? the ? ? ? ? ? ?“How ?long ?does )? ?before I ? ? ? ? ? ?my ? ? ? ? back?” ? But ?the? drawbacks, ?though, ? ? ? that? it ?ignores ? ? ? time? value ? ? ? ? ? ? (although? we ?can account? for ? ? ? ? ? using ?the discounted ?payback period method) and secondly it ignores the cash flows occurring after the payback period which, regardless of the payback period or the discounted payback period, you still have this problem. Self-test • 1? ? ? question ? ? The weaknesses though ?are: ? ? ? ? 11.5. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1) ???? ????? ?? ???????? ?? ???? ? ?? ??? ???? ????????? ?????? ?? ?? ( ?????? ????? ?? ?? ?? ?? ????? ? ? ? ? ? 2? ? ? ? ? ? ? ? ? ? ? ? ?? ? ???? ?? ??? ????? ? ?????? ?? ??? ???????? ? 2) 2 ? ? ? ? ? ? ? ? ? ? There ? ? ? ? ? ? ? ? • So the 2)$49.59Pafterayear ? we?only?use ? cash? flows ?of ? ? 3?per ?don’tfor $300? ? rigidlyanother ?$1000 ? ? year decisions. ? ? ? ? ? is ?noof ?capital ? ? ? ? ? ? What? are ? ? ?regular ?and? discounted ?of ? ? ? ? cash flows ?areadue ? ? ? to ?write ? only? anyway. ? ? and ? ? to? the ? ? ? ? ? ? ? when you’re ready. benchmark, we need to calculate a ? ? ? ? ? ? ? ? ? ? ? ? ? because all these to Project has answer. ?$1000 ? answer. years in The ? ? ? ? ? ? ? is 15%. P’s Please take Self Test 11.5 Answer 21 00:00 Self-test net-net ? 2? ? ?year ?3. ? this ? ? a ? ? $300 ? ? year ?use3this ? plus ? in capital budgeting 4.? ? ? ? project’s? cost? ? ? ? ? ? ? ? ? ? ? 15%?precise payback period ? ? ? ? ? ? ? paybacks? ? ? ? ? ? ? ? ? ?momentestimationout ?your ?answer ? ? go ? ? ? next slide 11.5 cost?of ? ? ? $1,000 as Self-test P and ? : ? is ? ?? ? ? ? ?? ? ? ? • And finally $60.11? in?49.59???? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??????? ??? ? ? ? ? ? 4???? ?$1,000? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? P ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? • ? ? ? 11.5 2) ? ? ? ????????????? ???? ???? ? ? ? ? ?? Project P’s payback calculation ? ? ? be continued. Self-test 11.5 answer ? value ?of answer ? follows. We see ? ? P ? ? ? ? ? ? ? ? ? ? ? ? ? 0? ? ? ? ? ? $1,000? ? ? 3? ? ? ? $300 ? ? ? $300 every year for the ? ? Self-test 11.5 Self Test 11.5 Answer (cont.) 22 00:00 1) It ignores the timecontinued.money? ?as ? ? ? ? ? ? ? ? ? ? ?that ?the cash flows ?associated with ?this ?project P is? negative ?$1000 at ?time ?0, ? ? ? ? ? 4? ? ? ? $1,000? ?next ?3?years, and ? ? ? ? ? ? ? ? $1000? in ?year ?4. ? If? we ?take ?the cumulative ? $300? ? of ?these ? ? ? $700? ? ? see ?that we$300? ? ? ? ? ? ?$1000 ? ? ? ? ?we ? ? ? $300 back ? ? after time? 1 which ?gives ? ? cumulative ?cash flow of negative ? ? ? ? ?We ? ? ? in ?another4$300 ? ? year 2 ? ? ? ? ? ? ? ? ? ? ? ? ? 3? ? ? ? ? ? ? ? ? ? ? ? ? ?$400, and then we? add ? ? ? ? ? $300 at the? end ( 4? ? ) ? ?giving? us ?a? cumulative ? ? ? ? ? ? $1,000? $100. ? ? ? obviously ? ? ? ? ? that ? ? P ? ? ? ? ? ? 3.1? is ?going ? occur some time between year 3 and 4. The payback period 3 is the year immediately before recovery and we add that to the cumulative cash in year 3 which is negative $100, we divide that by $1000 which is th ? ? ? ? ? P ? can ? ? ? ? ? ? then finally ? ? ? ? ? ? ? ? ? ? ? ? $1,000? 1? ? amounts ? ? ? ? cash flows we ? ? 2? ? ? have negative ? ? ? today, ? add ? $400? ? in 3? ? ? $300 ? ? ? ? ? ? ? us ? ? ? ? ? ? ? $100? ? ? ? ? ? ? ? ? $700. ? add ? 3? ? ? ? ? ? in ? ? ? ? giving us a cumulative cash flow of negative ? ? ? 3? ? ? ? ? ? ? ? another ? ? ? $100? ? ? of year 3 ? ? ? ? ? ? ? ? ? ? cash of negative ? ? ? So ? ? ? 3? ? we know ? ? ? the payback period ? ? ? ? to • ? ? ? ? 3? 60.11? ? ? This ? 2) willalso use the discounted? ?flows? ?calculation of whether?or??not ?? project should ? acceptedwould? ?investment ? ? ? the corporation. ? We ?call ? ? ? ? ? ? ? ?second? line ? ? ? weAnd ? ? course, ? ? you recall ?from ?our ?these ? ? ? ? ? that ? ? ?you will ? ? ? ? ? ?that ? ? ? ? present value ?the following: R ? ? present values of all ? ? ? ? ? flows Nowcan take discount? any ? P these? cashof? these ? ? to ?calculate ?project?? ? ? ?? that: ? ?be ? We We don’t the cumulative ?cashpayback? flows back ? topresent? valuewe ?find ?out ?2? ? ? period.? ? ? ? ? as? aninclude? an ?insertion?of ?the? present? value ?this ?the? net ?present ? ? and ? ? canof ? ? ? ? ?present ? ? ? ? of? each? of time value? of ?money ? ? we ?have ?with ?our discount ? ? ?the net ?which ? ? ? ? beequals ? ? ?sum of( the ? ? ? ? ? ) ? ? ? ? ? ? ? ?the cash ? ? ? of the project, discounted at a certain rate. Hence we have the net present value equals the sum of the cash flows divided by 1+R (or the discount rate that we’re using). we now move 1) ? ? ? ? ?second? measure? in ? present ? ? ? on ? ? of ? for ? ? ? ? ? ? ? Net Present Value (NPV) 23 00:00 ? ? to our ? ? ? ? ? ? ? ? terms ? values and ? ? a P’s? payback ? ? 2? ? ? ? ? 15% ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? line as the ? ? ? ? ? ? ? ? ? ? ? :? take the if ? ? value ?? ?? ? ? ? ? ? value. ? ? ? ? ? cash flows ? lecture, ? ? ? remember rate of 15% ? ? ? would ? ? ? ? the 1 + 3) Itreview, let’s cash flows occurring after the payback period, inWe know that: is relevant in the analysis is when we get paid back which in the previous slide was 2.375 years. However we can get paid back in 2.375 years but it can generate whole lot more cash thereafter, and the payback period by itself doesn’t tell us that. As a also ignores ?figure? out ? ? ? netL present? value ? ? ? project ?L. ? ?that all that What is Project L’s NPV if r=10%? 00:00 24 ? ? ? ? ? ? ? the ? ?? ? ? ? ? ? ? for ? ? ? line ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? • negative $1000 2) ? ? ? ? ? ? ? ?out? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? • In the third wetoday we? start net ? with? spending using ? ? ? ? ?our ? ? ? ? ? ? : Solving for NPV: Financial calculator solution 25 00:00 Remember, we can 3) ?? ? ? ? ?the? ? ? ?present ? ? ? ? ? ? ? 2.375? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? or ?using ? ? ? Microsoft? Excel ? ? ? ? ? ? ? ? ? We? will? do ?both financial calculator? ? ? ? financial? calculator ?solution. ? ? ? simply ? ? ? ? the 0??????????????1?0?0???????????????????1???1?0???? ? register,? so ?in 6 0 ? ?0? it ?will ?be ? ? ? 3 ? ? 100,? the ? ? ? ? ? ? ? I/YR? ? 1 equal ?to ? ? ? the ? ? ? ? ? ? ? ?will ?be ? ? ? ? to? 60 ?and ? ? ?cash ?flow ?3? would ? ? ? ? ? ? to 80. ? ? ? enter ?our discount ? ? ? ?I/YR ?which ? ? ? ? be ?equal ? ? 10%, ? ? type in? 10, ? ? ? the net present value button on our calculator and we get a net present value again equal to $18.79. This again equals what we had just talked about in the previous slide of the long-term net present value. • ? solve ? ? $1000 for ? value $100 either? ? ? financial calculators ? ? ? ? spreadsheet. cash flow 2 ? ? ? ? ? ? ? ? negative 8 ? ? cash flow 1 will be is due 10, 1 flow estimation anywayequal ? can be very right or ? ? ? ? the ? ? ? very ? ? ? be equal $18.79 We ? ? ? ? ? ? ? ? ? ? rate ? ? ? ? ? would ? ? ? ? to ? ? ? we ? ? ? ? ? ? press ? ? only.our ? ? ? ? ? ? ? ? ? ? really ? need to ? ? ? ? the ? 2.375First, to the ? ? ? ? ? 2.375? ? ? ? ?? ? ? calculate examples. payback period ? ? ? ? ? ? ? ? ? ? ? ? ? ? We? ? real enter ? ? ? cash flows into the calculator’s cash flow ? ? ? ? ? 2 ? time ? ?? ??????? ? ? • Then after able1 ? ? ? ? back ? ? ? ? ? ? ? ?year$100, ? ? ? ?the payback period total? of ?$-90.91 ? ? So$261net-netyearinto ?make ? ? ? financial? managers1? giving us? a net Microsoft Excel benchmark ? ? ? ? ? ? ? ? ? ? ? there? is ? ? ? ? ?no ? ? ? ? ? ? ? ? ? ? ? ? ? ?precise ? ? ? ? ? ? ? ? ? ?such ?as ? ? ? ? years.? ? In ?normal ?and ? ? ? life you ?would just say that you’re getting paid back some time in year 2. And this is because the 0payback period, of course, 0 %? ?to cash 0 real life, $9.09 ? ? ? ? ? will use In reality which wrong. • inyear are as ? ? have cash flows ? after we time 0 cumulative as a Spreadsheet Solution 26 00:00 slide/cap11-26.swf infollowingyearwe 3?spreadsheet ? ?of ?negative?you can ? ? ? we?first ? ? ? ? on? our ? ? ?present ?value,? we ? ? ? ? on ?‘=’, ?we ? ? ? our ? ? ? ? ? ? key ? ? ?phase ? ? ? ? ? ?menu? pops? up ?where ? ? choose ? ? ? ? ? ? ? ?function categories?on ?the left-hand side – ? ? ?on ?the right-hand ?side we scroll value)to ? ? ?function ? ? OKtill we? get ? ? ‘NPV’. ? We? select the ? ? ? ? ? ? ? ? ? ? ? ? ?function at? this? time. ? When ? ? ? ? done? we ?click B6? ? ? ? ? ? ? ? ? ? ? ? up ?the equals ? ? ? formula ?in C 1 2 ? ? C 1 4 on ?our formula ? ? 3?and ? ? ? ? ? ?will ?pop up? where ?it ? ? ? ? ? ? ? ?the rate. ? ? ? choose ? ? ? ? ? ? ? ? ? is 100? ? ? ? ? OK? ? ? ? ? ? ? ? ? ? ? ? ? ? ? of? 10%,$18.78? ? ? ? ? ? values we? choose C12 ?through ? ? ? (which again represents all the cash flows in time 1 through time 3). We come back up to our formula bar and we add back in our initial cash outflow of 100 and c The227 after is ? ?1? ????$261? ? ? solution. ? As ? ? ? ? ? see ? ? ? ? click ? ? ? net ? ? ? ? ? ? ? ‘ =’click ? ? ? ? hit ? ? function ? ? – a ? ? ? function ? ? ? ? ? ? ? ? we ? ? ? ? ‘financial’ ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? N P V ? ? ? ? and ? ? ? ? ? ? ? ? ? ( net present down ? our ? ? ? ? ? name ? ? ? ? ? ? to ? ? ? ? ? ? ? ? N P V ‘net present value’ ? ? ? ? ? ? ? ? ? ? ? ? ? ? we’re ? ? ? ? ? ? ‘OK’. This will pop ? ? ? ? 10%? NPV ? ? ? ? ? parentheses ? ? ? ? ( 1? ? bar, ? ? a window ? ? ? ? ? ) ? ? ? asks us for ? ? ? ? ? the We ? ? ? ? B6 here which ? the weighted average cost of capital ? ? ? and under the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? C14 ? ? • 2 Excel ? ? 100? ? ? ? ? ? $ • Andyear timecanwe have ? ? ? another? $49.59 after ?year 2 and we get a net cumulative cash flow of $-41.32 in then we 1 • add back in flows?of ? ? ? ? ? ? ? cash $10, Rationale for the NPV method 27 00:00 Let’s again review3 ? ? even ? ? ? time?using ? ? because? we value ? ? ? ? in ? ? ? first can • And finallyyearwe the ? ? ? ?9.09 ? $100 $60,?the ?net present?have ? ? method? ? ? the ? ? ? ?place.? ?The net ? ? ? ? value again equals the ? ? ? ? cash flow is ? cash inflows minus ? ? ? cost. ? ? ? ? ? it ?is ? ? ? ? ? ? ? ?the net ?gain ?in ? ? ? ? ?for the ?investors. ? If ?the projects ? ? ? independent ? ? ?you can choose as many as you want, you accept the project if the net present value is greater than 0. Thus, any net present value greater than 0 means that the shareholders or the investors are making money, But if the project are mutually exclusive – meaning you have to choose one or the other – then we accept the project with the higher net present value, or the one that’s going to deliver the best value for the investor. So in this example that we talked about, we accept the S or short-term project if they are mutually exclusive – sinc $197 after ? the • 0 ? rationale for ? ? break ? ? ?? ?? ?? ? ? present ? ? ? ? that our ? ? present value of the ? ? ? ? ? up ? 2$18.89. ? ? ? Thus, ? ? essentially ? ? ? ? ? ? ? wealth ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? are 0 ? ? ? ? ? ? and ? ? ? ? 2.375 • in year timewe • ?2?? ? ?? 1???some ? ? of???? year? 3??? ????­ ? 90.91? ? ? another ?$60.11? that? we ? ? ? tack? on ?and in? year? 3 we? see ? ? ? ? ? ?cumulative ? ? ? ? ? ? ? ? that we? are ? ? or? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 0 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? S ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 0 ? ? ? ? ? ? ? ? ? ? ? 2 ? ? have $227 ? ? ? ? ? in ??? ?? ? ? ? ? cash flows ??? Now let’s finally 1? ?of ? 3 topics ?cash just ? ? ? • And thenreview ? ?$572?at ? ?weend of??? ?? flowscovered. some the Self Test 11.6 28 00:00 ?? • and finally in • ?3?? ?time $10?? ?? ?? ?? we’ve?? ?? ? ? of? $80.? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? year ? ?? 2? the ? have ?year ?4. ? ? ? ? ? ? ? ­ 41.32? ? $197? 49.59 ? ? ? • Self Test 11.6 Answer 29 00:00 Self-test 11.6 answer. So thus, the discounted payback answer. long-term is really the same formula – we take the year preceding the recovery period which is 2 and we add it to the cumulative cash flow at the year before the recovery period which is $41.32, and we divide that by the cash flow of the immediately proceeding year which is $60.11. We add these together and we have a discounted payback period of 2.7 years which is greater than 2.3 years which we initially calculated, but this one is a little bit more exact because it takes into account the time value of money. Self-test 11.6 of the • ? ? ? • ? ? $572 ? of • elf-test $60?the ? present ? ? ? ? ? ? ? ? ? it tells ? ? 18.89 how ? end ? ? year 1, $49.59 ? ?? ? Self-test question4 11.6. ? ?isto?? ?) primary?? ??value ?budgeting flows, ? ?becauseget? ? $9.09 ? ?$1000 right? ? ? 3? ? ? ? ? ? ? ? ? ? ? ? time year? toand ?finally wealth. the end of year 3. We add would sum these up and give us together which would 2, us a net present value total at this project L 3. So $315 divided the same the proceeding year would give would see that add that to the year for the project’s short term would equal $19.98. If we takequestion?2?V? ?? ? calculation??? ?? each? of??these ?cash? ? ? ? ? $100? at ?time ?0, ? ? ? usat? the? ? ? thenow,? negative ? ?at ? ? ?end of? period 1shareholder$60.11 in $261, and then we wouldnext back in $227 to $739 toadd them negative $512 in yeargiveand then finally negative $315for the end of yearof $18.79. If we didby $572 infor the project’s short-term we us 0.55, and wethe net present value immediately preceding recovery which would be year 3. So 3 plus 0.55 would equal 3.55 years – the discounted payback period for project P. when we add back at NPVwe discount cumulative? ? ?? 60.11? 11.6. ?capital ? ? ?? ? ?? 3 criteria ? would? ? negative ? ? ? much ? ?of potential ? ? $739 after? ? ? ? ? 2 ? ? present value) question ?11.7. ? ? ? S P of these ? the ? ? ? Self Test 11.7 30 00:00 Self-test If (or netthe each11.7. Self-test N ( ? we get negative we ? ? ? ? ? ? ? ? project will contribute ? the ? ? $80? ? ? ? the ? Why is the net present ? ? ? ? regarded as?being ? ? ?primary capital budgeting decision criteria? indicated cash momentbelow? Which ofand go to the next slide when you’reif they were independent or mutually exclusive? Please take a moment and review the chart below, indicating that the weighted average cost of capital equals 10%. The cash flows associated with each of the different projects in each of the given years is given here as well. Please take a moment and write out your answer, and go to the next slide when you’re ready. Please to ready. What are the net • ? ?? ? value ? 3? ? ? ? ? ? ? ? ?SS ? ? ? LL ?if ? ? ? ? ? ? ? ?10% cost of? capital ?in ? ? ? ? ? ? ? ?take?a? flows ? ? ? answer this ? these ? ? ? ? ? ? would ? ? ? recommend? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 10%? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? present you Self-test 11.7 answer. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? $1,000? ?? 1? ? ? ? ? ? ? ?? ?the10% ? ? ?? $739? ? ? ? ? ? ? ? ? ? ? ? ? ?? $227? ? ? ? ? 2??? ? ? ?? ?? ?? $512? ? ? ? ? ? ? ? ? ? 3? ? ? ? ? ? ? $315? ? ? ? ? ? ? ? ? ? ? ? $315? ? ? ? ? $572? ? ? ? 0.55? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 3? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 3 ? 0.55? ? ? ? 3.55? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? P ? ? ? ? ? ? ? ? ? ? Self Test 11.7 Answer 31 00:00 slide/cap11-31.swf ? ? ? values of projects ? and ? ? both have a ? ? ? ? ? ?? ? ? ? ? ? projects S ? ? ? ? ? ? ? S? L L ? ? ? ? ? ? ?? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ? ?? ? ? ? ? ??? ? $739 ????? ???? ? ??? ? ? $261 ? ? ? ? ? ? the ? ? ? ? 2.3 as of 2.7? ? or ? ? IRR. ? ? discount ? ? ? ? ? ? ? ? ? present value ? ? ? ? ? ? ? ? ? ? This is the spreadsheet ?solution. ? As ? ? can ?the ? first ? ? value ? ? ? ?theWe now turn ((41.32? ?SS ? ? we ? third ?we ? ? inour? function ? ? )÷(60.11? ?our project is under ?the? paste ? ? ? ? ? ? ? It’s called ? ?internal rate ? ? ?function ? the ? ? ? The ? ? is ?the ? ? present value of ? to ? hit ? ? ? push ? ? ? ? ? ? whether or not ? ? ? ? key ? ? ? ? ? ))? function So far we have covered the ?payback ? ? you ? ? ? see ? net ? ? ?want ?to (2? method. ? ? net ? ? ? )+ our attentionso ? the ? ?‘=’, method ? ? determining button on our?function ? ? ?and? an ?acceptable investment.window we? choose? ‘financial’ ? ? our return, ? category. ?On ?the? right ?hand ?si ? ? ?rate ?that ?forces? the ? ? ? ? ? ? ? ? ? of ?the inflows of? a particular project to be equal to its cost, so the at the net present value equals 0 at the end of the day. So we can take our former net present value equation – which was the sum of all cash flows divided by the discount rate. The only difference is that we know the net present value has to be equal to 0 in this case, and instead of discounting by the discount rate (or the weighted average cost of capital) we now discount by the internal rate of return. So whatever we plug into the internal rate periods and ? we ? present ? find out IRR ? Internal Rate of Return (IRR) 32 00:00 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 0? ? ? ? ? ? ? $100? 1? ? ? ? ? ? ? ? $9.09? 2? ? ? ? ? ? ? ? ? $49.59? ? ? ? ? ? ? 3? ? ? ? ? ? ? ? $60.11? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? L ? ? ? ? ? ? ? ? ? ? ? $18.79? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? $19.98? ? ? ? ? ? The Spreadsheet Solution 33 00:00 slide/cap11-33.swf following is the spreadsheet solution to how we can find the internal rate of return on Microsoft excel. In this case we are looking for the IRR of the previous example – the long-term project. We simply hit ‘=’, we open up our paste function window again by clicking our ‘function’ button, we click ‘financial’ on the left and this time on the right we scroll down and look for ‘IRR’ instead of ‘NPV’. When we find ‘IRR’, we highlight this and then we click ‘OK’, and then the IRR function argument box appears. This IRR argument function box first requests us to insert some values. All we have to do is insert the values of all of the cash flows including our initial cash flow at time 0. Once we’re done with that, we simply click ‘OK’ and the output (or the result) is the internal rate of return from this long-term pr Rationale for the IRR method 34 00:00 Now let’s again talk abut the rational for using the IRR method. If the internal rate of return of a project is greater than the weighted average cost of capital (or the WACC) then the project’s return exceeds the costs in the first place in investing in the project, and that means there are some returns left over to boost stockholders’ returns. So W the IRR is greater than the WACC, that means we should accept the project, but if the IRR is less than the WACC, that means we should reject the project. Intuitively, this should make sense – that if the returns on a project are greater than what it costs us to access the capital in the first place and get the capital together to invest, then we should invest in it. But if it costs us more to get the capital pulled together from our various different capital sources than if W W How is a project’s IRR similar to a00:00 35 bond’s YTM? Another very important thing to know when we start discussing IRR is that a project’s IRR is exactly the same thing as a bond’s yield-to-maturity rate. Think of a bond as a project if you will. The yield-to-maturity on that bond would be the internal rate of return (or the IRR) of the bond project itself. Thus, suppose a 10-year bond with a 9% annual coupon and a 1000 par value sells for $1134.20. If we solve for the IRR (or the yield-to-maturity) we would figure out that the IRR equals 7.08%. This is the annual return for this project or this bond. So it’s the exact same calculation and a project’s IRR is the exact same thing as calculating the yield-to-maturity on a bond. IRR Acceptance Criteria 36 00:00 Let us now review the acceptance criteria for internal rates of return. Again, if the internal rate of return is greater than the weighted average cost of capital, we accept the project. If the internal rate of return is less than the cost of capital, we reject the project. If projects are independent then we accept both projects if the projects are greater than the cost of capital (in this case the cost of capital is 10% so we accept both). But if the projects are mutually exclusive, we choose the project that will provide us with the higher internal rate of return – in this case it would be project S because the internal rate of return of project S is greater than the internal rate of return of project L. Self Test 11.8 37 00:00 Self Test 11.8 Answer 38 00:00 Self Test 11.9 39 00:00 Self Test 11.9 Answer 40 00:00 slide/cap11-40.swf Now that we’ve covered the payback period, the net present value and the internal rate of return, one question you may ask yourself is, “Do any of the results of any of these analyses conflict with each other?” To help answer that question, we will start by looking at what we call the net present profiles of a couple of different projects – project L for long-term and project S for short-term. It’s essentially a graphical representation of the project’s net present values at various different costs of capital. Thus, on the left-hand side we have the weighted average costs of capital for each of the different projects at 0, and at a zero cost of capital the net present value of long-term would be 50 while the net present value of short-term would be 40. At a cost of capital of 5%, the net present value of long-term woul NPV Profiles 41 00:00 If we plot the following data from our previous slide we would end up with this chart immediately to my right, which is the net present profile of both project L and project S. You can see, starting with the turquoise blue line of project L, that it starts of at a larger net present value but at some point – at the crossover point in particular at 8.7% – it becomes worth less than project S. Now, if the projects again are independent this will always lead to the same conclusion – that is if the net present value is greater than 0, or if the IRR is greater than the costs of capital, then we accept the project. However, if they are mutually exclusive and we have to choose one over the other then that is a little bit more of a problem for us, which we need to solve. Hence in this case, the crossover rate illustrates that Drawing NPV profiles 42 00:00 Comparing the NPV and IRR methods 00:00 43 Reasons why NPV profiles cross 44 00:00 Reinvestment rate assumptions 45 00:00 So that really begs the question, “When the net present value profiles cross – and we’re dealing with mutually exclusive projects – which one should we choose? Which one is of greater value to shareholders – the net present value or the internal rate of return?” Let’s look at the reinvestment rate assumptions for each of these different measures. First, the net present value method assumes the cash flows are reinvested at the weighted average cost of capital. How can we make that assumption? We know that because, if we had the money to reinvest today, it would be earning at X%. Therefore, as an inverse they must be discounted at the same rate, which would be the weighted average cost of capital. However, the IRR method assumes that the cash flows are reinvested at the internal rate of return, not the weighted averag Self Test 11.10 46 00:00 Self Test 11.10 Answer 47 00:00 Self Test 11.11 48 00:00 Self Test 11.11 Answer 49 00:00 Self Test 11.12 50 00:00 Self Test 11.12 Answer 51 00:00 Self Test 11.13 52 00:00 Self Test 11.13 Answer 53 00:00 Since managers prefer the IRR to 54 00:00 method, is there a better IRR measure? problem that we find with the IRR is that its reinvestment rate assumption is that the cash flows generated by a project are going to be reinvested at the internal rate of return versus the prevailing opportunity cost of capital. But managers prefer the IRR to the NPV method because they like to hear rates of return on certain projects. So is there a better IRR method out there? The answer is yes – the modified internal rate of return or the MIRR is the discount rate that causes the present value of a project’s terminal value to equal the present value of its cost. Terminal value is found by compounding the inflows at the weighted average cost of capital. The modified internal rate of return assumes that cash flows are reinvested at the WACC and not at the internal rate of return. the NPV So, the main So in order to calculate the modified internal rate of return, we have to know a couple of things. We have to know what the present values of the outflows are, and we have to know what all the terminal values of the cash inflows are. In this case, we can think of terminal inflows as the same as the future value of all these cash inflows at your last forecast year. The point at which the present value of the outflows equals the terminal or future value of the inflows gives us our modified internal rate of return. So, in particular this example has us going through 3 periods, a weighted average cost of capital rate of 10%, an outflow right now of -100, an inflow of 10 after the first year, an inflow of 60 after the second year and finally an inflow of 80 in the third year. Well we need to find the future value of each o Calculating MIRR 55 00:00 Why use MIRR versus IRR? 56 00:00 Self Test 11.14 57 00:00 Self Test 11.14 Answer 58 00:00 Self Test 11.15 59 00:00 Self Test 11.15 Answer 60 00:00 Self Test 11.16 61 00:00 Self Test 11.16 Answer 62 00:00 slide/cap11-62.swf Summary 63 00:00 Now we’ve reached the end of this Chapter 11- The Basics of Capital Budgeting. Let’s summarize what we’ve learned. We’ve learned that capital budgeting is a process that helps us choose between investment alternatives. Some of these investment alternatives may be independent projects or they could be mutually exclusive projects. We also know that steps of capital budgeting are the exact steps that we would use in valuing any kind of security. Also, we measure our success by looking at the payback period, the net present value, the internal rate of return or the modified internal rate of return – and we’ve learned how to calculate each one of these. And finally, the net present value is generally given the most weight between all of these different ways of valuing a project and it is the most used in business as well. Chapter 11 answer set. Now let’s review the homework that was assigned to Chapter 11. The basics of capital budgeting. CHAPTER 11 Answer Set The Basics 64 00:00 of Capital Budgeting Problem 11-1 65 00:00 Problem 11-1, Project K costs $52,125 its expected cash inflow are $1,200 per year for eight years with a WACC of 12%. What is project K’s net present value? Problem 11-1 Answer 66 00:00 Problem 11-1 answer, using a financial calculator we can simply input the cash flows into our cash flow registers and enter our interest rate of 12 solve for net present value to give us $7,486.68. An alternative way is the use Microsoft Excel spreadsheet and use the NPV formula included in Microsoft Excel, please refer to our lecture slides on instructions to do this. Problem 11-2 67 00:00 Problem 11-2, Refer problem 11-1 what is the project’s IRR? Problem 11-2 answer, using the financial calculator we can input that the cash flow in times zero $52,125 or the present value and the cash flows for year one to eight would be equal to $12,000 or we could hit the IRR button which gives us 16%. Of course the alternative way to do this is using Microsoft Excel and the IRR function wizard, please refer to the lecture slides on instructions to do this. Problem 11-2 Answer 68 00:00 Problem 11-3, please refer to problem 11-1 again, what is the project’s MIRR? Problem 11-3 69 00:00 Problem 11-3 Answer 70 00:00 Problem 11-3 answer, using our financial calculator and an understanding the modified internal rate of return is where the present value of how costs equal $52,125 so in order to use out financial calculator we start by inputting the end period which is eight, the interest rate which is 12%, the present value the zero, the payments of $12,000 and solve for the future value we gives us $147,596 the modified internal rate of return can be obtained by inputting end equals eight. A negative value equal to -125 payments of zero and a future value of 147,596 and solving for the interest rate per year which equals 13.89%. Of course, you can also solve this problem by using Microsoft Excel using the IRRMIRR function and solve for this rate of return problem. Problem 11-4 71 00:00 Problem 11-4, please refer to problem 11-1, what is the project’s payback? Problem 11-4 Answer 72 00:00 Problem 11-4 answer, since the cash flows are a constant payment stream it’s $12,000 a year, calculating the payback period is as easy as taking the $52,125 that we were given and dividing it by $12,000 this would give us 4.3438 so the pay period is about four years Problem 11-5, please refer to problem 11-1, what is the projects discounted payback? Problem 11-5 73 00:00 Problem 11-5 Answer 74 00:00 Problem 11-5 answer, we can calculate project K’s discounted payback period by first discounting each of the cash flows for each of the eight years back to present value using a 12% discount rate. If we do that we see that what happens in year six it is approximately the period in which the project gets paid back. Its simply six or the year before recovery plus the cash flow, the cumulative cash flow at the year of recovery was 2788.11 over the cash flow immediately after following recovery which is $5,428.19 this would give us a discounted payback period of 6.51 years. % Problem 11-6 75 00:00 Problem 11-6(a) Answer 76 00:00 Problem 11-6(b), (c) Answer (cont.)00:00 77 Problem 11-7, a firm with a 14% WACC is evaluating two projects for this year’s capital budget. After tax flows including depreciation are as follows, Project A would give us -$600 today but positive $2,000 for the remainder of its project life, which would be five years. Project B would give us -$18,000 today but would return $5,600 was towards its life, which would be five years so we want to calculate the net present value of the internal rate of return the modified internal rate of return payback at discounted payback for each of these projects. Assuming that these projects are independent which one or ones would we recommend? The projects have the cash flow timing and pattern why is there a conflict between the net present value and the internal rate of return? Problem 11-7 78 00:00 Problem 11-7(a) Answer 79 00:00 Problem 11-7(a) Answer (cont.) 80 00:00 Problem 11-7A answer continued, next we are calculating the payback and discounted payback for project A, we just need to figure out the cumulative cash flows for any given year and we can see that the regular pay period for project A is occurring at year three. For the discounted payback period we take the year before recovery, year four, which is going to pay $172.57 and divide that by the cash flow in the following year to be $1038.74 this means under our discounted payback we would be paid back in 4.17 years. Problem 11-7(a) Answer (cont.) 81 00:00 Problem 11-7(a) Answer (cont.) 82 00:00 Problem 11-7(b), (c), and (d) Answer (cont.) 83 00:00 Problem 11-12 84 00:00 Problem 11-12 Answer 85 00:00 Problem 11-13, a firm is considering two mutually exclusive projects X and Y with the following cash flow, project X returns -$1,000 in time period zero, $100.00 after year one, $300.00 after year two, $700.00 after year four. Project Y returns a -$1,000 times zero, $100.00 after year one, $50.00 after year two, three and four. The projects are equally risky, the WACC is 12% what is the MIRR of the better project? Problem 11-13 86 00:00 Problem 11-13 Answer 87 00:00 ????? ?????? Financial Decisions Chapter13 Wong Henry ????? 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Script ? ? ? Script Introduction 1 00:00 This Page is Menu? of ?Lectrue. ? ? ? ????? CHAPTER 13 Capital Structure and Leverage 1 00:00 Welcome back. I’m? Professor? Henry ?Wong Henry Wong?we ? ? ? going to? be?discussing ? ? ? ? ? 13? Capital? Structure? and Leverage. As you ? ? ? recall? from? our ? ? ? ? ? ? ? of? Weighted ? ? ? ? ? Cost of? Capital ?we ? ? ? ? ? ? ? ? ? ? ?weights ? ? ? ? to? us ?for the ? ? ? ? ? ? ? ? ? preferred? stock ? ? ? equity were basically the ? ? ? ? ? ? ? ? ? ? ? ? and today ? are ? 13? ? ? ? ? ? ? ? ? Chapter ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? may ? ? ? ? ? ? ? discussion ? ? ? ? ? ? Average ? ? ? ? ? ? ? ? ? assumed that the ? ? ? ? given ? ? ? ? ? ? cost of debt, ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? optimal capital structure of the firm. In reality managers have a way to actually calculate what the optimal capital structure of a firm is. Optimal versus target capital structure 2 00:00 Let's first differentiate ?the? difference ? ? ? ? ? ? ? ? ? ? capital ?structure ?and the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? The optimal? structure? is ?the structure? that? maximizes? the firm’s ? ? ? ? as ?defined ? ? the ?stock price. ? ? ?target? capital ? ? ? ? ? ? ? ? ? 40%? ? ? ? the ? ? ?of ? ? ? ? ? ? preferred? and? common ? ? ? ? in ?which? ? ? ?company ?intends?? ?? ?? ?? ?? ??capital. ? ?? ?? ?? ?? ?? ?? ??company ?? ?? ??a? ?? ?? ?? ?? ?? ?? 40? ? structure? of ?60%? equity and ?40%? debt? then? if ?they ?were ?raising ? ? ? ? ? ? ? ? ? ?capital ? ? fund new ? ? ? ? ? ? ? ? ? ? ?then ? ? ? ? ? ? of ?that ?dollar?would ? ? ? ? ? ? ? ? ? ? ? equity sources? or ?using ? ? ? ? ? ?earnings? and ? ? ? ? ? cents ?we ? ? ? ? use ? ? ? ? ? debt. ?This ? ? ? ? ? ? the ? ? ? ? ? ? ?between ? ? ? op Thus if the ?? ?? ?? ?? has ? target capital? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? a ? ? ? ? ? ? ? ? ? ? ? ) ? ? value ? ? ? ? ? by ? ? ? ? ? ? ? ? ? The ? ? ? ? ? ? ? structure is the ?mix? or? ? ? use ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? stock ? ? ? ? ? ? the ? ? 1? ?? ? ?? ?? ?? ?? to raise ?? ?? ?? ?? ?60 ? 60% ? ? ? ? ? ? ? ? ? ? ? ? between optimal ? ? ? ? ? ? ? ? ? ? ? ? ? target capital structure. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ( ? ? ? ? ? ? ? ? debt and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? dollar of new ? ? ? ? to ? ? ? ? ? capital projects ? ? 60 cents ? ? ? ? ? ? ? ? ? come from raising ? ? ? ? ? ? ? ? ? ? ? ? retained ? ? ? ? ? ? then 40 ? ? ? ? would ? ? through ? ? ? ? ? is again ? ? difference ? ? ? ? the ? Again thelearned whythe cost of capital it would be optimal oversome otherof debt fact that there are benefits of using debt in our optimal capital structure. If youare benefits our discussioncosts ascost of debt financing when we discussed thebenefits of using cost of capital you will recallis that No.1 interest the costthe debt we always tax adjust when we multiply that rate of debt by the tax shield because we can deduct the interest from a portion of that debt. Thus these are some of the benefits thatportion of the debt capital and not necessarily we will talk about business vs. financialis that debtfirm and by using debt what kind of business andyou raise capital th reason in one capital structure is beneficial to use the form is the because the government essentially subsidizes the interest on the debt. Thus there recall from but there are on the well as well when using debts. The 2 major weighted average debt in your capital structure that when we look at paid on of debt is tax deductible whereas dividends paid on equity is not. Thus if you have a choice between raising debt capital or equity capital you know that the government will subsidize a we will be discussing first and foremost. Then the equity capital. The 2nd major reason risk for a does not imply ownership in a firm. Whereas if financial risk does As we’ve Benefits and costs of using debt 3 00:00 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 2? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? (? ? ? ? )? ? ? ? ? (? ? ? ? )? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? associated with using ? ?reasons ? because?it ?increasesuse ? firms ?risk ?overall ? ?structure? ? ? ? ? are ? ? ? ? ? the ? ?equity? capital. ? ? a ? ? ? ? ? is? unable to? pay ? ? ?debt ?obligations? asand ? ?become? duebusiness risk. ?The riskiness inherent ? ? ? shortfall. ? ? ? ? ? ? is ?ifdo ?this ?thendebt company? will? be ?in ? the ? ? ? ? ? ? ? ? ? and ? ? likely ? ratio. Also the ? ? ? position ? ? the ? ? ? ? ? ? ? ? ? ? ? ? The ? ? ? ? ? ? ? then the ? ? So what are some ? ? the ? ? ? ? why?management ? ? ? ? ?thedebt ? their? capital ? raises the cost ? ? both debt ? following ? ? ? ? ? If ? companythese capital structure? decisions. ? ? ? ?they ? ? ? is ? ? ? ? ? ? ?equity? holders ?must ?make ?up thethe ?firms ? If they can't? ? ? ? ? ? ?the so? that the greaterfinancial distress lower the? debtto go? bankrupt.? tax ? ? ? ? ? of ? ? firm is important. ? ? deductibility of the interest is a very favorable alternative when you are raising debt capital but if most of the firm’s income is already protected by other kinds of tax shields then the additional debt will not be advantageous to the firm. of ? more debt, ? ? ? ? ? would factors that affect ? ? ? ? ? ? ? ? its it uses no Factors affecting capital structure 00:00 4 decisions ? ? ? in ? ? ? ? ? and ? ? ? ? ? Below of some of ? and ? ? ? ? ? ? ? ( First ? foremost ? ? ) ? ? ? ? ? ? ? in ? ? ? ? operations ? ? ? ? ? ? ? ? ? ? ? ? risk then the ? ? is ? ? ? ? ? ? ? ? ? ? Self Test 13.1 5 00:00 Now let's review.3?? ?? ?? ?? ?? ?? question ?? ?? ?? ??Define ? ? ? ? ? capital? structure? and differentiate ? ? ? ? ? ? ? ? ? ? ? ? ? ? structure. ?Please? take?a? moment? to? answer? this? and then go? to ?the next slide. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Self test ?? ?? ?? ?? ?? 13.1. ?? ?? ?13.1 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? from target ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? optimal ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? it ? ? ? ? ? ? ? capital ? ? ? ? ? ? ? ? ? ? ? ??? ? ?? 3rd test answer 13.1. The optimal capital structure is capital in adverse can have some debt or borrowing capacity when company is not Self Test 13.1 Answer 6 00:00 Selffinancial flexibility? which is? the ability? to? raise the ? ? ? on? reasonable ?terms ?which ? ? ? conditions. So? that? if ?you target? capital ?structure ? ? ? ? ?mixed ? ? ?of ? ?the preferred? and ? performing as well then it’s a good sign. Finally managerial actions are important. Specifically, conservative or aggressive actions on the part of management will affect the use of debt as well. ? ? ? ? ? ? ? 13.1 ? ? ? ? ? ? ? ? ? ? ? ? firm’s capital ? ? ? ? ? ? ? ? maximizes ? ? ?stock price. The ? ? ? ? ? ? ? ? ? ? ? ? ? is the ? ? ? use ? debt,? ? ? ? ? ? ? ? common ? ? ? with which the company intends to raise new capital ? ? ? ? ? structure, ? ? ? the ? ? ? ? ? ? ? ? ? ? stock Self Test 13.2 7 00:00 Self test question ? ? ? ? What? 4 factors ? ? ? ? ? ? ? ? ?target? capital structure? ?Please ?take ?a? moment to? answer? this? and ? ? ? ? ? to the next slide. ? 13.2. ? ? 13.2? ? ? influence the ? ? ? 4? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? then go ? Self test answer ? ? ? ? First ?and foremost? is? business risk - ? ? ?riskiness? inherent ? ? the ? ? ? ? operations ?if ? ? ? firm? starts using ?debt. ? ? ?is ? ? ? tax ? ? ? ? ? ?-? whether ?it ? ? ? ? be? advantageous ?to ? ? ? debt? in ?order ? ? receive? the ? ? ? ? ? ?of ? ? ? deductibility ? ? interest. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 13.2. ? ? ? 13.2? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? in ? ? firms ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? 2nd ? the ? ? position Self Test 13.2 Answer 8 00:00 ? ? ? ? ? would ? ? ? ? ? ? ? ? ? use ? ? ? ? ? ? to ? ? ? ? ? ? benefits ? the ? ? ? ? ? ? ? ? of ? ? ? ? ? ? 3rd test question 13.3. ? ?-13.3? ability the target ? ? ? ? structure ?adverse economic ? between ?risk ?and return? ? ? ? conservativeness or aggressiveness - actions on next of the flexibility the ? ? ? ? raise ? capital ? ? ? ? ? ? ? ? Self Test 13.3 9 00:00 Selfis financial ? ? ? ? ? In? what sense? does?to ? ? ? ? this? debt capital? in involve? a? trade ? ? conditions. Finally, ? ? ? ?Please? take? a moment to? answer this and then go to the behalfslide. managers which will affect the use of debt as well. ? ? ? off ? ? ? ? ? ? ? ? ? managerial ?? ?????? ??????? Self Test 13.3 Answer 10 00:00 Self test answer ? ? ? ? The ? ? 13.3risk associated? with? using ? ? ? ? ? ? ? ? ? ? to? lower ? ? ? stock ? ? ? ? ?However ? ? ? ? ? ? ? ? ? ? ? ? ? ?expected return,? which ? ? ? ? ? ? ? ?to ? ? ? ? ? ? using ? ? ? ? ? ? equity. ?Thus ?we ? ? ? ? ? ? ? ? ? ? ?capital ? ? ? ? ? ? ? ? 13.3. ? ? higher ? ? ? ? ? ? ? ? ? ? ? ? ? ? more debt tends ? ? ? ? the ? ? ? price. ? ? ? ? this is offset by the ? ? ? ? ? ? ? ? ? ? ? ? is expected ? increase ? ? ? debt vs. ? ? ? ? ? ? ? seek to find the ? ? ? ? structure that strikes the balance between this risk and this return in order to maximize the stock price. Self Test 13.4 11 00:00 Self test question ? ? ? ? Why ? 13.4? ? ? ? ?conditions cause?a? firm’s actual ? ? ? ? ? structure? to ?vary ?from ?that ?of ? ? ?target? capital ?structure? Please ? ? ? a moment to answer this and then go to the next slide. ? 13.4. ? ? might market ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? capital ? ? ? ? ? ? ? ? ? ? ? ? ? its ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? take Self test answer ? ? ? ? Market? conditions may ? ? ? ? management ? ? ? ? ? ? ? ? ? ? ? ? equity? or ?their ? ? ? ? is ?undervalued. ? ? this situation they? would ? ? ? ? more debt or?use debt capital? instead of equity instead of raising the overall debt target ratio in the firm. 13.4. ? ? ? 13.4? ? ? ? ? ? cause ? ? ? ? ? ? to feel that their ? ? ? ? ? ? ? stock ? ? ? ? ? ? ? ? In ? ? ? ? ? ? ? ? ? ? ? ? ? ? issue ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Self Test 13.4 Answer 12 00:00 Now let's talk about? some? of ?the risk? associated ?with ?using ? ? ? ? There’s ?of ? ? ? ? ?business and ? ? ? ? ? ? ? ? ? ? We? will? tackle business ? ? ? ? ? ? ? ?This ?is ? ? ? uncertainty ? ? ? ? future operating income ? ? how ?well? are ? ? able to? predict EBIT in? the ? ? ? ? ? As? you ? ? ?see from this ?slide ? ? have 2 ? ? ? ? ? ?of ? ? ? low-risk ? ? ?one high-risk company. ? ? ? can ? ? ?that ?they ?both ?have?an ?expected? operating? income equal? to ?EBIT. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? What is business risk? 13 00:00 slide/cap13-13.swf ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? debt. ? ? ? ? ? course ? ? ? ? ? ? ? financial risk. ? ? ? ? ? ? ? ? ? ? ? ? risk first. ? ? ? the ? ? ? (EBIT) about ? ? ? ? ? ? ? ? ? ? ? ? ? ? or ? ? ? 1 ? ? we ? ? ? ? 1? ? ? ? ? ? ? ? ? ? future? ? ? ? can ? ? ? EBIT? ? ? ? ? we ? ? ? ? examples ? one ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? ? ? You ? ? see ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? However the low risk? company ?willrisk? or?narrower ? ? ? ? ? ? ? ? of? probability around ? ? ?expected returnaboutthe higher ? the ? ? ? ? ? ?which ? ? forecast ? ? ? ? ? ? ? ? ? ? ? ? thus? indicating ? ?wider ? ? obviouslyof ? ? ? ? ? ? ? toaway fromimpact ?on ? ? ? return. ?Weincome. ?No.2 ?is ? ? ? ? ? ? ? ?aboutrisk ?does ?not include? anyin ? ? ? ? the ? ? ? ? ?which ? ? willus ? ? aboutmaterials in? order ? ? ? us ?to ? ? ? ? ? ? goods. For ? ? ? ? ? ? if ?we ?are? an ?airline ?company ? ? ?we ?are? relying ?on ?output ?prices? of? fuel, ? ? ? ? ? fuel prices ? ? up? then? this? is? going ? ? ? ? ? ? ? affect ? ? our ? ? ? ? ? ? ? ? ? ? ?as ? ? ? ? No.3 is? uncertainty about ?other ? ? ? ? of ?costs.? So ?whereas the ? ? ? ? Ford? about output? price have to note that this business output prices ? prices financing effects, ? supplying ? the ? ? ? ? ? What determines business risk? 14 00:00 What exactly determines ?business ?have ?a affect? the operating income ?of ? ?company? No. 1 is ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Ifrisk company, ? cannot ? ? ? ? ? flatter Bell curve sales ? ? ? going a ? ? then ? ? ? ? ? ? that’s going ? ?have ?an ? the ? ? the operating? ? ? ? ? ? ? ? uncertainty ? ? ? ? ? ? ? ? ? ?or ? ? ? ? ? which ? ? suppliers ? ? we ? ? ? talk ?raw ?later.? ? ? ? ? ? for ? ? make our ? ? ? ? ? ? example, ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? then if ? ? ? ? ? ? ? go ? ? ? ? ? ? ? ? ? to have an ? ? ? ? on ? ? operating income ? well. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? kinds ? ? ? ? ? ? ? ? ? 70? uncertainty ? Ford Pinto ? ? ? are ? ? ? to be ? probability ? distribution ?? ? ?? ?? ? ? ? ? ? distribution ? ? ? a ? ? ? ? ? ? the ? uncertainty vs. demand. ? ? ? management ? ? will have a correctly what the ? ? ? ? ? ? ? expected ? ? ? ? What is operating leverage, and how 00:00 it affect a firm’s business risk? exactly is operating? leverage and ?how? does? it?? ?Ford ?Pinto? ?????? ?business ?risk? ?Operating ?leverage ?is?? ?? ?????? ?of ?? ?? ????costs ?? ?????? ?? ???? ?? ?????? ?????? ?? ???? ?? ?????? ??????that if? most? of ?the costs ?are fixed?and hence ?do ?not? decline ?when?the demand ? ? ? ? then? the ? ? ? ? ? ? a? high? operating? leverage. Can ? ? ? think ? ? ? ? ?companies ?with ?high ?operating ?leverage? ?You might ?want ?to ? ? ? ? about ?companies ?or ? ? ? ? ? ? ? that take a ? ? ?of ? ? ? ? ? ? ? ? ? ? ? ? equipment. ? ? ? ? ? ? ? 15 does What ? ? ? ? ? firm’s ? ???? ?? ??? ?? ???? ? ???????? ?? ??? ?????? ? ?? the use ??? fixed ?? ???? rather than variable costs. This means ?(PL)? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? falls ? ? ? ? firm has ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? you ? ? ? ? of any ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? think ? ? ? ? ? ? ? ? ? industries ? ? ? ? ? ? ? lot ? machinery or plant ? ? ? ? ? ? ??? ? ?? ?? ? ? ?? ? ? ? ?? ? ?? ? ? ?? ?? ? ? ? ? ?? ?? ? ?? ? ?? ?? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Ford affect the ? There was rush toof the effects of operating leverage. In this this Ford Pinto, plans. had If and product risk. that small affectdecline causes or the operating income A well. that the fixed costs we lecture is on that is higher or lower operating will ultimately Let's look aat some ? production? in ?the? marketplace.? They? released example?? ?? ?? ?? ? ?2?? ? ?? ?? ?? ? Aaone ? ? the ?fuel ?tank. ? ? it? were? rear-ended ?the? entire car B.? Overall ? ? ? ? ? ? ? ? ? ?These are ?the? kinds ?of business ? ? ? ? For ? ? ? ? ? ? ? A????????????40? ? ? ? ? ?risk ?a?big? profit decline. ? ? the ?Planof ?section??????can ?see?? ?????????? 40? ? 80will are ? ?on ? at ?around? 40 and the ? 120? ? ? operating? leverage ?or ? ?we much? debt? a B which, takes ? involve ?more ?fixed costs ?then ?the fixed ?costs of? debt? or ?operating80?and our that break-even ? ? ? ? essentially increases companyvs. ? ?a? Plan? A of? 80. Clearly? Plan?income?and it?and? visually ? ? ?affect? business risk as? well. ? ? ? ? how ? ? ?possibility of operati we have ? which The? ?defective left ? ? ? ? ? A ? ? ? the ? ? ?on ? ? ?right ? ? Plan? ?would basicallyoperating ? ? ? ? ? ? leads ? ? more? ? ? ? ? ? liability issues ? ? a ? on? ? ? ? ? ? is Plan ? ? ? ? ? one ? ? ? ? ? ? ? is? ? ? ? ? ? ? ? ? ? ? ? ? ? explode. leverage ? ? ? ? to? ? ? ? ? ? ? ? ? ? ? ? ? ? ? companies ? would sales ? business ? ? ? ? ? ? ? ? overall ? ? ? ? In ? ? ? ? ? a ?company as ???? ??? Finally, what ? ? ? ? ? focus ? in this ? A? 80? ? called the ? ? ? ? ? is B? ? ? ? when ? ? ? to Plan? company? ? ? ? on.? We ?will ?see that depending upon the level increase ? ? ? ? ? ? ?leverage ? ? ? it? takes ? point ? ? going ?to ?make ?the? to? 120 ?have the ? ? ? ? ? more ? ? ? ? ? ? ? ? ? 80. Yet ? how go would ? ? from 40 to how ? ? ? charts illustrate ? ? the Effect of operating leverage 16 00:00 2 ? B???? you ? break-even point ?? ???? ? ?????? ?? ????? ???? ?? ? ? ? ? new ? ? ? ? ? ? ? ? ? ? ? ? + ? ? the ? ? ? ? ? ? ? ? ? ? ? ? B is? riskier ? ? ? ? ? ? you can see ? ? ? these ? ? ? ? ? ? ?? ??? ??? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ?? ?? ?? ?? ? ? ? ? ?? ? ? ? B? ? ? ? ? ?? ? ???? ??? ?????? ????? ?? ? ? ? ? 80? ??? ? ?? ? ? fixed ? ? ? So generally Auto or airline effect of will generally have a lot costs and therefore high operating leverage. Can you think of any low operating leverage You think of retail see such as Wal-Mart These L for low don’t of fixed costs can based L demand make that a function of demand as well. expected EBIT but affecting time the operating income necessarily a been magnified in the fixed costs of the fact that they are taking on a little bit more risk and debt. What exactly is the practical?industries using ? ? ? ? ? ? ? ? ? ? ? ? ? of ?fixed ? ? In? reality ? ? ? can ? ? ?operating ?leverage? to ?increase your operating? income but ? ? ? ? ?companies? ? ? ?might ? ? ? ? As ?you can chains L? this slide ?we ? and ?Costco. ? ?Firm companies generally and ? ?have ?a? lot ? Hleverage. Youand stock ?items ? ? ? ? on ?has a ? and ? ? distribution of probabilities from itsThus making it onlyat the same the variable costs and not for Firm H has huge investment or increased because of the company. Using operating leverage 17 00:00 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? more operating leverage vs. not? ? ? ? ? ? you ? ? use ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? your risk ? ? ? ? ? ? ??? ? also increases as well. ? ? ? ? ? ? ? ? from ? ? ? ? ? ? ? have 2? firms – L? EBIT? ? ? ? ?leverage? ? ? Firm ? for? high ? ? ? ? ? ? ? ? ? ? ? see that the Firm ? ? ? ? tighter ? ? ? ? ? ? ? ? 2? ? ?H ??? ???? ?H ? ?? ??? ?? What is financial leverage? Financial risk? 18 00:00 What exactly is financial ?leverage and ? ? ? ? ? opposed? to ?business risk? ?Financial ?leverage is? the use ?of ? ? ? ? ? ?preferred ?stock.? Financial? risk? is ?the additional ?risk ? ? ? ? ? ? ? ? ? ? common stock holders as a result of financial leverage. ? ? ? ? ? ? ? ? ? ? ? ? risk as ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? debt and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? concentrated on ? ? Business risk vs. Financial risk 19 00:00 Now let's compare? business risk and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? found ?out that business? risk? depends ?on ? ? ? ? ? such as? competition, ?product ? ? ? ? ? ? ? ? ?operating ?leverage? – all ? ? ? ? ? ? have?an ? ? ? ? ? ? ? ? ? ? ?of ? ?company.? We ?also ?just ?learned ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? only? on ?the types ?of ? ? ? ? ? ? ? being ? ? ? ? ? ? ? ? ? ? ? financial risk together. We ? ? ? ? ? ? ? ? ? (PL)? ? ? ? ? ? ? ? factors ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? liability and ? ? ? ? ? ? ? ? ? ? ? ? of which ? ? ? operating income ? a ? ? ? ? ? ? ? ? ? ? ? ? ? that financial risk depends ? ? ? ? ? ? ? ? ? securities ? ? ? issued. So that the more debt that’s issued the more financial risk the company is taking on and in No.2 it concentrates the business risk specifically on the stockholders of the corporation. Let's take an example ? ? ? illustrate ? ? ?effects ?of ? ? ? use ? ? financial leverage ? ? ? how ? ? places ? 2? risks ?specifically ? ? the ?stockholders. ? ? will compare? 2 firms ?–? Firm? U for? firm? unleveraged which ?means ?it ?has? no ?debt ?and Firm L ? ? ?leveraged ?which ? ? ? EBIT? firm? has ? ? ? ? ? An example: Illustrating effects of 00:00 20 financial leverage ? ? ? and ? ? ? ? ? ? the ? ? ? ? ? the ? ? of ? ? ? ? ? ? ? ? ? ? ? and ? ? it ? ? ? ? the ? ? ? ? ? ? ? ? ? ? on ? ? ? ? ? U? ? ? ? We ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? L ? ? ? ? ? ? ? ? ? ? ? ? 2? ? ? ? ? ? ? ? ? ? ? ? ? for ? ? ? ? ? ? ? ? means the ? ? ? ? some level of debt. These two firms have the same operating leverage, business risk and probability of distribution of operating income or EBIT. The only difference between ? ? ? can these? companiesare ?their ?use? ofeconomic ?the? capital? structure. ? is? aUbad, average, ?and has ?20,000 ?in ?assets, ? ? ? ? means ?it ?alsoamust ?have ?$20,000 ? ?chance?of ?anis ?at ? ?40%? tax ? ? ?chance? of ?L? uses? $10,000 worth ? ? debt in? its capital structure ateconomic scenarios we have thenfollowingin assets. That means that the equity infor acompany must equal $10,000 asone, $4,000 for the good a 40% tax bracket. in ? ? ? and average, Let's first look ? ? Firm U.? both ?? ??see ?that ?? ?? ?? ?? ?? ?? ? ?? ?? 3 ? U? ?? ?? ?? ?? ?? ?? states?possible - ? ? ? Firm 20,000? 25%?debt ? 50%a ?? ? ?? ?? ?? ? ?? 40%? ?? ?? ? which25%? chance? of? ? bad economy,? a ? ? ? ? ? ? ? ? ? ? ? ? ? ? 12%and ?? ?bracket. Firm ? ?good ?economy ? ? ? ? of? ? ? ? ? each of? these ? 40%? ? ? ? ? ? ? ? cost? of capital and the $20,000 operating income possibilities. $2,000 the bad one, $3,000 for average well and that’s also in economy. at ? ? ? ? ? You ? of ?? ?? ? ? ?? there is 3 different debt in ? ?? 20,000? ? ? ? there ? ? ? ?uses ? ? ? ?? ?? ? ?? good economy. 25% There is ?a? ?? L? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 50% equity ? ? ? ? a ? ? ? a 25% ?2,000 ? a ? ? ? ? ? 3,000 ? ? ? ? Under ? ? ? ? ? ? ? ? different a 12% ? ? Firm U: Unleveraged 21 00:00 U ?? ?? ? ? no ? ?? U ? ??? ? 10,000 ? ? ? ? ? 20,000? ? ? ? ? ? ? happening. 10,000 4,000? ? ? ? Firm L: Leveraged 22 00:00 Let's now look at? Firm? ?? ?? As??you ?? ?? ?? ?? ??the ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? U? ? remains ?exactly? ?? ?? ?? ?? ?? ?? ?? ?Firm ?U.? ?EBIT? ? ? difference ?now? is 2,000level ?of ? ? ? 3,000? ? ? ? ?of ?it ? 4,000? capital40%? ?? ?? ?? ?? ?? ?? ?you?? ?1,200??? 800? ?? ??now paying ?? ?1,200? ??on?? ?? ?? ?? ?? ?? ?? ?? ?? ?1,600??? ?????thus ?making??? ??$1,200??? ??a??10,000? ?$1,200? in ?an ? ? ? ? ? ? ? ?and 1200 in? a good economy. ?Of ? ? ? ? ?we ? 1,800? ? ? ? ? interest ? 2,800? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? was ? ? ? cost? of ?debt ?capital, multiplied ?by ? ? ? ? ? ? which ? ? ? the ? ? ? ? ? loan amount.? This? gives 480? ? ? ? ? ? ? ?Before Taxes ? ? ? ? ? ? 1,680? bad ? ? ? ? ? ? ? ? L. ?? ?? ?? can see ?? ?? probability and operating income ? ? ? 0? ?? ? ?? ?? ?? ? the same as ? ?? ?? ? ? The? only? ? ? ? ? ? ? ? ? ? ? ?the? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? this ? ? ? ? 1,200 L ??? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? debt and ? ? use ? ? by ? ? ? ? ? ? ? structure. As ? ?? can ? ? they’re ?? 1,200?? ?? interest ?? the debt they’ve borrowed ? ???? ? ?? 12% it ???? ??? in ? bad ?one, ? ? ? ? ? average one ? ? ? ? ? ? ? ? ? ? ? 2,400? ? ? ? ? ? ? ? ? ? ? ? ? ? ??? ??? (EBT)? 800 ? course ? calculate the ? ? ? ? ? simply by multiplying 12%, which ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? $10,000, ? ? ? was ? ? initial ? ? ? ? ? ? ? ? ? ? ? ? us an Earnings ? 1,080? ? ? of $800 for the ? ? one, $1,800 for the average and $2,800 for the good. Then if we pay taxes on these reduced earning ? ? see ? ? ??? ?? ?? 1,200 1,800 The interest line as youratios betweenshows that the company has no debts so itis that their to payearning power remains is zeroed out. The earnings before taxes, whichand 20% theaEBIT, is 2000 inis bad one, $3,000basic earning power andFirm L. in a good economy. The tax bracket of 40% makes them pay the $800 in a badthe actual basican average one,of the firm’s assets. economyrecall from ourbottom line or a net income possibility of $1,200 in a bad one, $1,800firman average one, and $2,400 inor good economy.by the total assets of the firm. can see here these 2 firms. What we notice in Firm U doesn’t need basic any income thus this at 10% in a bad economy, 15% in an average one equals in a the exact same in an average one, as $4,000 Thus we see that the use of debt in the capital structure does not affect one, $1,200 in earning power and $1,600 in a good If you giving them a discussion on financial ratio analysis, the basic earning power of a in equals the operating income a EBIT divided Ratio comparison between leveraged and unleveraged firms 23 00:00 Now let's compare? these ? ? ? 2? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? U? ? ? ? ? ? ? ? ? ? ? ? ? U? ? ? ? ? ? ? ? ? ? ? 10%? ? ? ? ? ? 15%? ? ? ? ? ? ? ? ? 20%? ? ? ? ? ? ? ? ? ? ? ? ? L? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? good? one.? This? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? EBIT? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??? ?? ?? ?? Risk and return for leveraged and 24 00:00 unleveraged firms Let's look specifically ?at ? ? ? expected or? average? economic ? ? ? and ?look ?at ? ? ? risk? in ?return? for ? ? ?leveraged ?and ? L? ? ? ? ? ? ? ? ? ? ? ? ? Let's ? U? ??at??the??? ?? ???6%?? values? ?? ?U9%? ? LU ?? ?? ??L. ?? ?? ?? ??in??a ?basic ?? ?? ?? ?? ?? ?power ?the L? ? ?????? ?basic earning? power ?remains ? ? ? ? ? ? ? ? ? ? ? ? ? ?Firm ?U? and Firm ? ? ? ? ?we’ve? ? ? ? ? ? that the ? ? ? ? ? ? return on? equity is? expected ? ? increase ? ? ? ? ?Firm ?L? from? 9% ?for Firm U ? ? ?? ?? ?? ??and ?? ?? ?? ?? ?? ?? L? ? this? ?? ?? ?? ?? ?? ?? ?6%?? ?? ?? ??equity? is ?based ? ? ? ? ? ?on ? ? ? fact? of ?the tax ? ? ? ? ?provided by? the (TIE? ? debt ? ? ? the ? ? ? ? ? ? ? ? ?of ? ? ? ? ? ? thus? lowering ? ? ?tax bill for ? ? ? ? ? ? ? ? ? ? look at? the ? ? ?ratio ? ? ? ? ? the ? ?we ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? case ? ? ? ? ? the ? ? ? ? ? ? ? ? the ? ? ? ? ? U? ? unleveraged? companies. ? ? ? ? look ?? ??? expected ?? ? ?? ? for ?Firm ?? and 12%Again ?? ? ?? ?? ?? earning ? ?? ?? ? ?? ?? expected ? ?U? ? ? ? ? ? ? ? ? ? ? ? ? unchanged from either ? ? L.? But ? ? ? ? noticed? ?L? ? ? ? expected ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? to ? ? ? ? ? on 9%? ? ? ? 10.8%? 12% ? ? ? ? ? ? to 10.8% ?? ?? we know what 2.5x? expected return on 4.8%? ? ? ? ? probably ? the ? ? ? ? ? ? ? shield ? ? ? ? ? ? ? ? use of )? ? and ? ? deductibility ? interest ? ? ? ? ? ? ? the ? ? ? ? ? ? ? Firm L. When we ? ? ? ? ? ? TIE ? ? ? between ? ? 2 ? know that the ? ? ? ? ? 10.8% L ?? ? ? ?? ???? ? ???? ???? ?????? ????? ?? ? 9% ?????? ?? ?? ???? 16.8% U ? ?? Of course this means what is the raw earning power of the firm’s assets? How much cash are the firm’s assetsWe really off? Secondly if wethe effect ofreturn on equity you can see than forcoverage. For leverage a bad, 9%expectedaverage and 12% foryougood economy. Again the return on equity is found by net income divided by common equity or another wayplace. Why?is what is the rate of returnis greater than theholders. By looking at Firm L we can also see that the return on equity is actually greater in the average andpower states ofinterest - 10.8 compared with 9 and 16.8 compared with 12.producedis actually doing a bit worse in a bad economy – 14.8 to 6%. Again this is be Firm U we have 6% an to for Why exactly do we? get ? ?higher? return? on?equity? for ? ? ? ? debt? in? our capital structure over using ?no ? ? ? ? ?throwing need to? understand ? look at? the ? leverage ? ? the ? U? 2.21%? ? in ?debt ? ? ? ? ? ? ? ? ? ? ? ? for ?to ?raise ? for ? ? ?returns ? ? ? ? ? ? ? a ? have? to ?have ?the basic ?earning power Lof0.39? ? ? ? ? ?assets? greater ?than ?the cost of? debt? in ?the first ? ? ? say ?it ? Because ?if ? ? ? cost? of ?debt ? ? ? ?common? equity ?cash or the return that your assets were throwing out into operating income as measured by the basic earning good then the economy expense will be higher than the operating income But it by the debt financed assets. The effect of leverage on profitability and debt coverage 25 00:00 ? ? a ? ? ? ? ? ? ? ? ? ? ? ? using ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? debt? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? on ? ? probability ? ? ? ?? L ??? ?? 4.24%? on equity ? ? ? ? ? ? ? ? ? ? ? ? U? 2.4? ? ? ? your firm’s ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ??? ???? ? We can look at other risk measures as well and they bear out the same kinds of data points that the previous slide was pointing to, which is No.1 if we look at the standard deviation beyond the return on equity of these 2 firms we see that Firm U has a tighter probability of distribution at 2.21% and Firm L is a little bit riskier at 4.24%. If we look at the coefficient variation for both these firms we see that Firm U is 2.4 and Firm L is .39. The big picture here is that when you take on debt you take on more risk but that there is also a better possibility of earning a higher return on equity than using no debt at all on your capital structure. Conclusions 26 00:00 So let's take that case is going Self test income. 13.5. What other way risk and that the be measured? power take a firm’s assets about your answer than on cost to finance and access the debt capital to finance those assets then your income or return on equity will increase. Thus as the debt increases the TIE ratio decreases because the operating income is unaffected by the debt whatsoever. The Self Test 13.5 27 00:00 Nowleverage in a moment to review. to depress question However the is businessis true inhow can it basic earning Please of your moment to thinkthrow more cash offand goits to the next slide when you are ready. Self Test 13.5 Answer 28 00:00 Self test answer 13.5. Business risk is the uncertainty about future operating income or the EBIT if it uses no debt. (i.e. how well can we predict operating income?) We can use ROE or the return on assets ROA if the firm uses no debt whatsoever as a measure of the business risk. Self test question 13.6. What are some of the determinates of business risk? Please take a moment to think about your answer and go on to the next slide when you are ready. Self Test 13.6 29 00:00 Self Test 13.6 Answer 30 00:00 Self test answer 13.6. Among the many factors contributing to business risk one is the uncertainty about sales. No.2 is uncertainty about output prices. No.3 is uncertainty about costs. No.4 is other products liability and No.5 operating leverage. Self Test 13.7 31 00:00 Self test question 13.7. Why does business risk vary from industry to industry? Please take a moment to think about your answer and go on to the next slide when you are ready. Self Test 13.7 Answer 32 00:00 Self test answer 13.7. Business risk varies from industry to industry because each one has specific demand constraints, sales price variability, input costs etc. Also business risk may vary between companies in the same industry because some management teams can influence to some degree the varying factors, which affect business risk depending on how conservative or aggressive of a stance they have on capital structure and use of leverage within that structure. Self test question 13.8. What is operating leverage? Please take a moment to think about your answer and go on to the next slide when you are ready. Self Test 13.8 33 00:00 Self test answer 13.8. Operating leverage is the use of fixed costs rather than variable costs. Self Test 13.8 Answer 34 00:00 Self Test 13.9 35 00:00 Self test question 13.9. How does operating leverage affect business risk? Please take a moment to think about your answer and go on to the next slide when you are ready. Self Test 13.9 Answer 36 00:00 Self test answer 13.9. If most costs are fixed, hence they do not decline when demand falls, then the firm has high operating leverage. More operating leverage in a company leads to more business risk because a small sales decline causes a big profit decline. Self test question 13.10. What is financial risk and how does it arise? Please take a moment to think about your answer and go on to the next slide when you are ready. Self Test 13.10 37 00:00 Self test answer 13.10. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage or the use of debt. Financial risk arises when the firm chooses to raise capital using debt vs. equity. Self Test 13.10 Answer 38 00:00 Self Test 13.11 39 00:00 Self test question 13.11. Explain this statement. “Using leverage has both good and bad effects”. Please take a moment to think about your answer and go on to the next slide when you are ready. Self Test 13.11 Answer 40 00:00 Self test answer 13.11. The benefits of using debt includes the interest paid on debt is tax deductible whereas dividends paid on equity is not. Secondly debt does not imply ownership thus stockholders do not have to share the firm’s profits if it is successful. The costs however are that using more debt increases the firms risk overall thus increasing the cost of debt and equity capital overall. Secondly if the company can’t pay its obligations then the equity holders must make up the shortfall and if they can’t then the company will go bankrupt. Optimal Capital Structure 41 00:00 Let's take a hypothetical example to try to answer the question of what is the right amount of debt in our capital structure that we should take? We always start with a sequence of events in a recapitalization of a company. No.1 the firm would announce this recapitalization and in this recapitalization they would announce that they are taking on more debt than they had previously. No.2 the new debt is going to be issued into the marketplace as perhaps a bond offering. No.3 the proceeds are used to repurchase stock in order to create that target capital structure the company is seeking to achieve. The number of shares we purchase is going to be equal to the amount of debt issued d Sequence of events in a recapitalization. 42 00:00 Cost of debt at different debt ratios 43 00:00 Why do the bond rating and cost of debt depend upon the amount of debt borrowed? 44 00:00 Before we go on let's ? ? ? ? ? important? point ?from ? ? ? previous ? ? ? ? ? ? ? ? ?company ? ? ? ? ? ? ? ? more debt we? saw ? ? ? ? ? ?bond ?rating? on ?the debt offering ? ? ? ? ? ?decreases ?in ? ? ? ? of? credit quality? of ?the bond. ?It ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ?other ? ? ? ? ? ?cost ?of ? ? ? ? ? rate of? debt? on ?each ?of ? ? ? ? levels ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?do ? ? ? ? bond ratings?and costs ?of ? ? ? ? ? ? ? ?upon ?the amount ? debt actually borrowed? The answer is simple. As the firm borrows more money it increases its financial risk causing the bond rating to decrease as well as its cost of debt to increase. It is an issue of risk. ? ? ? make an ? ? ? ? ? ? ? ? ? ? our ? ? ? ? ? slide. As the ? ? ? ? is borrowing ? ? ? ? ? ? ? ? ? that the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? actually ? ? ? ? ? ? terms ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? gets riskier ? ? that on the ? ? ? side the ? ? ? debt or ? ? ? ? ? ? ? ? ? ? those ? ? ? ? increases as ? ? company’s borrowing more money. So why ? these ? ? ? ? ? ? ? ? ? ? ? ? ? debt depend ? ? ? ? ? ? ? ? of Analyze the recapitalization at various debt levels and determine the EPS and TIE at each level. 45 00:00 Determining EPS and TIE at different00:00 46 levels of debt. (D = $250,000 and rd = 8%) Determining EPS and TIE at different00:00 47 levels of debt. (D = $500,000 and rd = 9%) need to determine the earnings per share and the TIE ratio of $500,000 level of debt and again the higher cost of debt of 9%. First thing we need to do is repurchase share in the marketplace at $25 per share for issuing $500,000 we can do that and buy back 20,000 shares thus when calculating per share we take operating income of 400,000 minus the 9% cost of debt multiply that by $500,000 and multiply that by the tax shield. We divide all of this again by our initial share of 80,000 but we just repurchased shares back of 20,000 which gives us 60,000 per share approx $3.55. If we calculate our TIE ratio we have an operating income of 400,000 and an interest payment of 45 So now, we Determining EPS and TIE at different00:00 48 levels of debt. (D = $750,000 and rd = we do the same for $750,000 level of debt and this new cost of debt 11.25% we will repurchase 30,000 shares based on $25.00 per share, of our $750,000 in cash, we will figure out the earnings per share which the only change now is the rate of debt at 11.25%, the debt new level is 750,000 and our tax shield remains the same and the shares repurchased is going to be $80,000 minus $30,000 or $50,000 shares net. This would give us a net share of $3.77 and when we calculate our TIE ratio we would take our operating income of 40,000 and divide by our interest expense of $86,250 which would give us 4.6x. Again 11.5%) Determining EPS and TIE at different00:00 49 levels of debt. (D = $1,000,000 and rd = 14%) last level of debt of $1,000,000 and the cost of that at 14%, we repurchase $25.00 of shares back in the marketplace divide that by one millionth, and we get 40,000 shares. Our new rate of debt would equal 14% our new debt level would equal 1,000,000; tax shield remains the same, operating income remains the same. Our shares outstanding would remain 80,000 minus 40,000 or 40,000 net. This would give us $3.90 per share and a TIE ration of 2.9x by taking the operating income of $400,000 and dividing it by the entry expense of $140,000. Finally, our Stock Price, with zero growth 50 00:00 So we need to find ? ? ? required ? ? ? ? ? return for ? ? ? equity holders? or ?the cost of? capital ?for our ? ? ? ? ?holders.? What? effect does raising? more? debt? have? on ?the? firm’s rate of? equity? ?Intuitively? as ?the debt of? the firm increases, ?then ?the risk of? the ? ? ? ? ? ? ? ? ? ? Thus, ? ? have already? observed ? ? ? ? ? ?increase in? the ? ? ? of? debt? however ?the cost of risk of the firm’s equity also increases because of the overall risk of the firm resulting in a higher rate of return for equity holders or a higher cost of capital for equity holders. What effect does more debt have on a00:00 51 firm’s cost of equity? ? the ? ? ? ? ? rate of ? ? ? ? ? ? our ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? equity ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? firm increases. ? ? ? we ? ? ? ? ? ? ? ? ? ? ? ? that the ? ? ? ? ? ? ? ? cost ? ? ? ? ? ? ? ? ? ? ? ? The Hamada Equation 52 00:00 The Hamada Equation 53 00:00 So the Hamada question is essentially this; the leveragedd beta of the firm will equal the unleveragedd beta of the firm multiplied by one plus the tax shield multiplied by the new debt equity ratio. If we suppose the risk free rate is 6% and so is the market risk premium, the leveragedunleveragedd beta of this firm we will assume is 1.0, we were previously told that the total assets of this firm were two million. Calculating levered betas and costs 00:00 54 of equity We can calculate the new cost of equity based on Hamada’s equation for each of the different levels and we will do this is a spreadsheet example for you later in this lecture; let’s assume we have gone through that calculation and these are the numbers we have come up with. As you can see the 250,000 level, we came up with 12.51% and at the levered beta level, we had equity of 12%. At 500,000, you can see the new cost of equity is 13.2% going to 14% at 75 and then 15.6% at a million. Intuitively this should make sense to everyone as the company takes on more debt the cost of debt is increasing and its cost of equity is increasing because of this new cost of debt as well. Table for calculating levered betas 00:00 55 and costs of equity Finding Optimal Capital Structure 56 00:00 Table for calculating levered betas 00:00 57 and costs of equity Determining the stock price maximizing capital structure 58 00:00 Spreadsheet Solution 59 00:00 slide/cap13-59.swf What debt ratio maximizes EPS? 60 00:00 Let's make an important distinction here, the debt ratio which maximize the earnings per share was at $3.90 and that was at a million dollar debt level the debt asset ratio at that time was 50% remember dividends per share equal Rs because our payout is 100%. The debt asset ratio of 50% is too high of a risk for the company. What is this firm’s optimal capital 00:00 61 structure? What exactly is the term optimal capital structure again? It is when the price is at $26.89 or the debt to asset ratio equals 500,000 divided by two million, which is 25%. So the optimal debt ratio is equal to 25% again, we know it’s maximized at 50% debt to asset ratio and the primary ratio is the stock price and not the earning per share. The EPS shows we can push up the share by taking on more debt but the risk resulting from increased leverage more than offsets the level of increase per share. Self Test 13.12 62 00:00 Self Test 13.12 Answer 63 00:00 Self Test 13.13 64 00:00 Self test question 13.13. Using the Hamada equation please explain the increase in financial risk on the beta. Please take a few moments to do so and go to the next slide when you are ready. Self Test 13.13 Answer 65 00:00 Self test 13.13 answers. The Hamada equation attempts to quantify the increased cost of equity due to financial leverage (uses the unleveraged beta of the firm which represents the business risk of the firm if it used no debt and to find a new levered beta based on a more levered capital structure). Self Test 13.14 66 00:00 Self test question 13.14 answer. The levered beta can be found by taking the unlevered beta of the firm and multiplying it by one plus the tax shield multiplied by the new debt equity ratio. Self Test 13.14 Answer 67 00:00 Self test question 13.15. Use the Hamada equation to calculate the unlevered beta for firm X with the following data. The levered beta equals 1.25, tax equals 40%, the debt to asset ratio is equal to 42% thus the equity ratio would be the asset ratio equals 58%. Self Test 13.15 68 00:00 Self Test 13.15 Answer 69 00:00 Self test question 13.15 answer. Using the Hamada equation we know that the levered beta equals the levered beta multiplied by one plus the tax shield by the new debt to equity ratio; thus if the levered beta is 1.25 and we are looking for the unlevered beta then we know that the rest of our information is one plus one minus the tax rate of 0.4. The new debt equity ratio of 0.42 divided by 0.58, by using simple reverse algebra we find that the unlevered beta equals 1.25 or the levered beta divided by one plus the tax shield multiplied by the new debt to equity ratio. Or the unlevered beta would equal 1.25 divided by 1.433 thus the unlevered beta would equal 0.8714. Self Test 13.16 70 00:00 Self test question 13.16. What would the cost of equity be for firm X at an equity to asset ratio of 1.0 (meaning no debt) and then at .5 (50%) assuming the risk free rate equals 5%, the risk free premium on the market is 4%, and then the taxes represent 40% and the unlevered beta of the firm currently equals 0.8714. Self test question 13.16 answer. First, let’s calculate the problem with equity asset ratio of 1.0 or no debt. You can tell the levered beta would equal 0.8714 which is the unlevered beta multiplied by one plus the tax shield which is 1.6 multiplied by the debt equity ratio, which would be zero in this case; thus the unlevered beta of 0.8714 if we plug this into out pricing model we assume the risk free rate is going to be 5% and then the risk premium on the market is going to be 4%, thus we multiply that by the levered beta of 0.8714, it should give us a cost of equity capital of 8.49%. Self Test 13.16 Answer 71 00:00 Self test question 13.16 answer continued, now let’s look at the problem where we have an equity to assets ratio of 0.58, we still take our value of the Hamada equation and we know that our levered beta equals our unlevered beta of 0.8714, we multiply this by one plus the tax shield which is 0.6, and multiply that by our new debt to equity ratio which is 0.42 divided by 0.58. this would give us a new levered beta of 1.25, we would then plug this levered beta into our CAPM equation would equal 5% and the market risk premium would equal percent would equal 1.25 giving us a new cost of equity of 10%. Self Test 13.16 Answer (cont) 72 00:00 Self Test 13.17 73 00:00 Self test question 13.17. Is expected earnings of shares generally maximized at the optimal capital structure? Please take a moment to answer this and go to the next slide when you are ready. Self Test 13.17 Answer 74 00:00 What if there were more/less business risk than originally estimated, Now let us the analysis be? affected?? ? ? ? ?more?or ? ? ? ? ? ? ? ? ? risk? than? originally ? ? ? ? ? ? ? ? How ?would this analysis ? ? ? ? ?our actual ? ? ?of ? ? ? ? ? the ?capital ? ? ? ? ? ? ? Typically, ? ? ? ? 1 ? were? higher business ? ? ? ? in ?general, then the ? ? ? ? ? ? ? ?of ? ? ? ? ? ? ? ? ? ? ? ?would ? greater at any debt level and the optimal capital structure would be one that has less debt. However lower risk companies would lead an optimal capital structure with more debt. 75 00:00 how would ask ourselves what if? there was ? ? ? less business ? ? ? ? ? ? ? ? ? ? anticipated? ? ? ? ? ? ? ? ? ? ? ? ? ? affect ? ? ? ? ? ? use ? debt in ? ? ? ? ? ? structure? ? ? ? ? ? ? if there ? ? ? ? ? ? ? ? ? ? ? risks ? ? ? ? ? ? ? ? ? ? ? probability ? financial distress ? ? ? be ????? ??? ? Other factors to consider when establishing the firm’s target capital structure 76 00:00 How would these factors affect the target capital structure? 77 00:00 Modigliani-Miller Irrelevance Theory00:00 78 Modigliani-Miller Irrelevance Theory00:00 79 Couple more points on the M&M irrelevance theory, the graph shows again M&Ms tax benefit vs. the bankruptcy cost theory. But of course we know in real life you can’t borrow money forever and take advantage of the tax savings as some point you get into financial distress and you get into bankruptcy of the whole capital structure story. The main problem is that it assumes investors have the same info as managers and based in insider trading info we know this is simply not true. Incorporating signaling effects 80 00:00 What are “signaling” effects in capital structure? 81 00:00 What can managers be expected to do?00:00 82 Conclusions on Capital Structure 83 00:00 Let’s review the topics we just covered. Self test question 13.18. Why does M&M theory with taxes lead to 100% debt? Please take a moment to answer this and go to the next side when you are ready. Self Test 13.18 84 00:00 Self test question 13.18 answer. Since you can deduct interest, thus lower your tax bill, M&M theory calls for a use of unlimited debt capital. We are also assuming there are no bankruptcy costs. Self Test 13.18 Answer 85 00:00 Self Test 13.19 86 00:00 Self test question 13.19. How would an increase in corporation taxes tend to affect the firms capital structure? What about personal taxes? Please take a moment to answer this and go to the next side when you are ready. Self Test 13.19 Answer 87 00:00 Self test question 13.19 answer. An increase in the firm’s corporation tax would cause the firm to increase the use of debt in order to lower their tax bill. Correspondingly, an increase in personal taxes will cause firms to lower their dividend payouts and reply on their retained earnings. Thus, firms would use less debt in this case. Self test question 13.20. Explain what asymmetric information means and how signaling theory affects capital structure decisions. Please take a moment to answer this and go to the next side when you are ready. Self Test 13.20 88 00:00 Self test question 13.20 answer. Asymmetric information is when managers have better inside information on the future prospects of the future company than outsiders. Outsiders look to the signaling effects for management regarding capital structure policies. They raise debt if they believe the equity is undervalued and they would raise equity if they believe the equity is overvalued. Self Test 13.20 Answer 89 00:00 Self Test 13.21 90 00:00 Self test question 13.22. What is meant by reserve borrowing capacity and what is meant by this? Please take a moment to answer this and go to the next side when you are ready. Self Test 13.21 Answer 91 00:00 Self test question 13.21 answer. Reserve borrowing capacity is the ability to borrow money at a reasonable cost when good opportunities arise. Those who often raise less debt than they are able to, canensure they can obtain debt capital later if necessary in adverse economic condition when adverse economic conditions arise. Self test question 13.22 question. How is debt used to discipline managers? Please take a moment to answer this and go to the next side when you are ready. Self Test 13.22 92 00:00 Self test question 13.22 answer. If left unchecked management tends to spend retained earnings on perks, thus when managers are forced to service debt this brings an unintended discipline to managers to manage the debt efficiently or risk losing their jobs if the company goes bankrupt. Self Test 13.22 Answer 93 00:00 Self Test 13.23 94 00:00 Self test question 13.23. Why do wide variations in capital structure occur in both industries and among individual firms within each industry. Please take a moment to answer this and go to the next side when you are ready. Self Test 13.23 Answer 95 00:00 Summary 96 00:00 Let's review the homework which was assigned to chapter 13, the capital structure and leverage. CHAPTER 13 Answer Set Capital Structure and Leverage 97 00:00 Problem 13-2 98 00:00 % % % % Problem 13-2 Answer 99 00:00 Problem 13-2 answer, the optimal capital structure is that capital structure where the WACC is minimized and the stock price is maximize because Jackson's stock price is maximized at a 30% debt ratio and the firms optimal capital structure is 30% debt and 70% equity, this is also the debt level where the firm’s WACC is minimized as well. Problem 13-4 100 00:00 Problem 13-4, Harley Motors has $10 million in asset which was financed with $2 million of debt and 8 million in equity, Harley’s beta is currently 1.2 and its tax rate is 40% use the Hamada equation to find Harvey's unlevered beta. Problem 13-4 answer, from the Hamada equation we know that the levered beta equals the unlevered beta multiplied by one plus the tax shield multiplied the new debt to equity ratio, we can calculate the unlevered beta as being the unlevered beta equals the beta divided by one plus the tax shields multiplied by the new debt to equity ratio. In this case the unlevered beta would equal 1.2 divided by one plus 1 minus the tax rate of 40% multiplied by the new debt to equity ratio of 2 million in debt and 8 million in equity, this would give us an unlevered beta of approximately 1.0435. Problem 13-4 Answer 101 00:00 Problem 13-8 102 00:00 Problem 13 -8, Cyclone software company is trying to establish its optimal capital structure, its current capital structure consists of 25% debt and 75% equity, however the CEO believes the firm should use more debt, the risk free rate is 5%, the marketplace premium is 6% and the firms tax rate is 40%. Currently Cyclone cost of equity is 14% which is determined by the capital asset pricing model or CAPM what would be Cyclones estimated cost of equity if it changed it structure to 50% debt and 50% equity? % % % % % % % Problem 13-8 Answer 103 00:00 % % % % % % Problem 13-8 Answer (cont.) 104 00:00 Problem 13-9 105 00:00 % % Problem 13-9(a), (b) Answer 106 00:00 Problem 13-9(b) Answer (cont.) 107 00:00 Problem 13-14 108 00:00 Problem 13-14 Answer 109 00:00 % Problem 13-14 Answer (cont.) 110 00:00 ????? ?????? Financial Decisions Chapter14 Wong Henry ????? Push here to start Home Work ???????? ?????????? slide/fd_14slide.swf flv? ? ? ? ???? flv/fd_01vid000.flv 00:01.0 flv/fd_14vid001.flv 01:17.9 flv/fd_14vid002.flv 00:42.8 flv/fd_14vid003.flv 01:06.8 flv/fd_14vid004.flv 00:52.7 flv/fd_14vid005.flv 00:51.0 flv/fd_14vid006.flv 01:02.9 flv/fd_14vid007.flv 01:22.9 flv/fd_14vid008.flv 01:53.9 flv/fd_14vid009.flv 00:33.9 flv/fd_14vid010.flv 00:24.0 flv/fd_14vid011.flv 00:52.9 flv/fd_14vid012.flv 00:19.0 flv/fd_14vid013.flv 00:22.0 flv/fd_14vid014.flv 00:16.8 flv/fd_14vid015.flv 00:19.0 flv/fd_14vid016.flv 00:13.7 flv/fd_14vid017.flv 00:23.8 flv/fd_14vid018.flv 00:13.8 flv/fd_14vid019.flv 00:37.0 flv/fd_14vid020.flv 00:53.0 flv/fd_14vid021.flv 01:10.7 flv/fd_14vid022.flv 00:20.0 flv/fd_14vid023.flv 00:42.0 flv/fd_14vid024.flv 01:06.9 flv/fd_14vid025.flv 00:42.0 flv/fd_14vid026.flv 01:06.7 flv/fd_14vid027.flv 01:22.9 flv/fd_14vid028.flv 00:58.0 flv/fd_14vid029.flv 01:17.9 flv/fd_14vid030.flv 00:27.0 flv/fd_14vid031.flv 00:32.0 flv/fd_14vid032.flv 00:15.0 flv/fd_14vid033.flv 00:25.0 flv/fd_14vid034.flv 00:27.0 flv/fd_14vid035.flv 00:41.0 flv/fd_14vid036.flv 00:34.7 flv/fd_14vid037.flv 00:24.0 flv/fd_14vid038.flv 00:35.0 flv/fd_14vid039.flv 00:14.0 flv/fd_14vid040.flv 00:18.0 flv/fd_14vid041.flv 00:17.0 flv/fd_14vid042.flv 00:34.0 flv/fd_14vid043.flv 00:55.0 flv/fd_14vid044.flv 00:17.0 flv/fd_14vid045.flv 00:50.0 flv/fd_14vid046.flv 00:13.0 flv/fd_14vid047.flv 00:26.0 flv/fd_14vid048.flv 00:14.9 flv/fd_14vid049.flv 00:26.0 flv/fd_14vid050.flv 00:15.0 flv/fd_14vid051.flv 00:45.0 flv/fd_14vid052.flv 00:52.0 flv/fd_14vid053.flv 01:05.9 flv/fd_14vid054.flv 00:40.0 flv/fd_14vid055.flv 00:17.0 flv/fd_14vid056.flv 00:42.0 flv/fd_14vid057.flv 00:13.0 flv/fd_14vid058.flv 00:20.0 flv/fd_14vid059.flv 00:13.0 flv/fd_14vid060.flv 00:31.0 flv/fd_14vid061.flv 00:40.0 flv/fd_14vid062.flv 01:21.9 flv/fd_14vid063.flv 00:30.0 flv/fd_14vid064.flv 00:45.0 flv/fd_14vid065.flv 00:46.0 flv/fd_14vid066.flv 00:21.7 flv/fd_14vid067.flv 00:42.0 flv/fd_14vid068.flv 00:11.9 flv/fd_14vid069.flv 00:18.0 flv/fd_14vid070.flv 00:13.9 flv/fd_14vid071.flv 00:38.0 flv/fd_14vid072.flv 00:16.7 flv/fd_14vid073.flv 00:32.0 flv/fd_14vid074.flv 01:38.9 flv/fd_hw14vid001.flv 00:09.1 flv/fd_hw14vid002.flv 00:13.4 flv/fd_hw14vid003.flv 00:45.5 flv/fd_hw14vid004.flv 01:07.5 flv/fd_hw14vid005.flv 01:02.9 flv/fd_hw14vid006.flv 01:19.2 flv/fd_hw14vid007.flv 00:53.4 flv/fd_hw14vid008.flv 00:31.7 flv/fd_hw14vid009.flv 01:17.8 flv/fd_hw14vid010.flv 01:00.0 flv/fd_hw14vid011.flv 01:12.8 flv/fd_hw14vid012.flv 01:05.0 flv/fd_hw14vid013.flv 01:28.5 ???????? ???? ?? 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 ????? ?????? ???????? captivate? ? ? ? ? ? Script ? ? ? Script Introduction 1 00:00 This Page is Menu? of ?Lectrue. ? ? ? ????? Welcome back. I am ?professor ?Henry Wong and today we? are ? ? ? 14? ?be ? ? ? ? ? ? ? Chapter? 14. Shareholders distributions, dividends and ? ? ? ? repurchasing. ? ? ? ? ? ? this? chapter ?off by? discussing ? ? ? difference ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? how ? ? ? ? ? ? ? ? ? ? prefer ? ? ? ? company ?set a ? ? CHAPTER 14 Distributions to shareholders: Dividends and share repurchases 1 00:00 ? ? ? ? ? ? ? ? ? ? ? Henry Wong? ? ? ? going to ? discussing ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? share ? ? ? ? ? ? ? ? We start ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? between dividends versus capital gains. We talk specifically ? ? some industries ? ? ? ? their ? ? ? ? ? ? ? divi Let’s first start? off ? ? ? ? ? ? ? ? ? question ? ? ? ? ? ? ? ? is dividend policy? What is dividend policy? 2 00:00 ? ? by asking the ? ? ? ? ? what exactly Nextmight have guessed already signalinganswers to the questions in thepolicies and finally we talksettingthedividend policy really depends onwe calculate that and why it providesthink about it. Somanagers in orderdo investors good payout ratio.low payout? the the specific previous about a residual a good basis You we talk about ?some ?of ? ? ? that? the ? effects ?of ? ? ? these ? ? ? ? ? ? ? ? ? ? ? ? slide ? ? ? ? ? ? of ? ? ? ? ? ? ? ? ? ? ? ? ?dividend model ?and how ? what the ? ? ? ? ? ? ? ? ? ? ?investors ? ? ? ? ? ? ? ? ? for ? the ? ? ? ? ? ? is ? to devise a require a high or Do investors prefer high or low dividend payouts? 3 00:00 ? ?? ? ?? ?? ???? ? ??? ? ? ? in terms ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? shareholders and ? ? ? ? ? ? ? ? ? question ? 1/Dividend policy is the management process intheory.the decision to eitheragainout earnings versus repurchasingaboutretainingdividends from a company or having the company just reinvest those dividends into retained earnings and accepting capital gains. which Which basically says pay that investors are indifferent and getting them. Let’s start off with? the? ? ? ? ? ? ?irrelevance? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Dividend irrelevance theory 4 00:00 1/? ? ? ? dividend ? ? ? ? and ?dividend? payouts. ? ? ? ? repurchases can ? ? ? ? ? ? ? ? ? ? ? repurchases? ? ? ? ? ? ? ? ? ? ? ? ? Share ? ? ? ? ? ? ? ? ? also involve stock splits and stock dividends. ??? ?? ?? ?? Finally we talk about sharewetheories a dividend yes or no? if we do,are going to discuss. low? 2/ Dividend policy:are three pay out to the dividend policy that we should it be high or Wellsecond theory isshould the bird in hand theory. If you recall our discussion on the time value of money, the first lesson we learned was a bird in the hand is better than two in the bush. Essentially this basically is applied to dividend policy as well. The really, there?? ?? called? Bird? in? Hand? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1? ? ? ? ? ? ? ? ? ? 2 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Bird-in-the-hand theory 5 00:00 ? ? ???? ? ?????? 3 2 2/ ? ? ? ? ? ? ? ? ? ? ? ? 3/ Should we make? it? a? ?? ?? ? ? ? ?their? own ? ? ? ? ? ? policy. ?If ? ? ? ? ? ? ? ? ? ? they just sell the stock; if they do not want cash, they can use the dividend to buy the stock itself. This was of course proposed by Modigliani & Miller and it was based on some very unrealistic assumptions such as no taxes or no brokerage co Investors in a sensethestable dividend or irregular dividend?is taxed atcash,same rate as dividends are, about 20%. The difference is that capital gains taxes can be deferred. An investor can decide when they want to sell simply by selling the stock. Whereas taxes must be paid in the same year that the management team create dividend want TheHow often to do ?wecantax? preference? theory. ?Capital ? ? ? ? ?they ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? final theory ? ? ? ? ? ? ? dividends to? ? ? ? ? ? ? ? ? is Tax Preference Theory 6 00:00 ? ? ? ? ? ? ? ? irrelevance ? ? gainsthis ? ? ? ? ? ? ? ? ? ? theory: ? says that investors don’t ? ? ? ? ? dividends one ? ? or ? ? ? ? ? 4/ The first one 3/ ? ?pay? out ? dividend ? ? shareholders? ? ? ? ? ? basically ? 20% ? ? ? ? ? ? ? ? ? ? ? ? care? about ? ? ? ? ? ? ? ? ? way ? ? another. ? ? ? ? ? ? ? ? ? Modigliani? Miller ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1nvestors thinks is called the less risky than future profits or higher capital gains hence they like dividends because it means cash to them today. If so then investors would prefer a high payout ratio from firms. The high payout would result in a higher stock price for the firm. The bird in hand theory tells managers I lets look again at theseare dividends So How do we announce ?it ? ? three? different? dividend theories, ? ? ?bird ?iSo? let’s ? ? ? ? ? ? ? at? these ? ? ? ? different? dividend ? ? ? ? ? ? ? ? ? bird? in ?hand, ? ? ? ? ? ? ? ? ? ? tax ? ? ? ? ? ? ? theory and ???????????? Bird? in ?hand? ? ? ? ?its? going ?to ? ? on? the ? ? ? ? price.? As? you ? ? ? see,? the? blue line represents ?the bird in? hand? t Possible stock price effects 7 00:00 1/? ? ? ? ? ? the ?marketplace? ? ? ? ? ? ? ? ? ? ? ? the ? ???? ? ?????????? look again? ? ? ? ? ? three? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? irrelevance ? ? ? ? ? preference Bird ? ? ? ? see what the ?possible effect ? ? ? ? ? ? ? ? be? ? ? ? ? stock? ? ? ? ? ? ? ? ? can ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 5/ in ? ? 3 ? ? ? ? ? ? ? 1 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? hand? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? theories, the ? ? ? ? ? ? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? in hand ? ? Bird in ? ? ? ? ?????? ? ??? ?? ? ????? ??? ? ???? ?? ? Thisus alsoforce 4/ ? ? ?possible ? ? ?firms with lowerof equitythus a high payout would resultin ourlower stock price for the firm. Implication for managers with the tax preference theory is setwe can see thatlow as possible. out and pay out the dividend then the higher cost of equity will be. The tax preference theory could look investors ?to ? ? effects? on the cost payouts given each of the assumptions in a dividend policies. First, let’s look at the tax preference theory. In tax preference theory, the payout as the higher we go prefer Let at ? ? Possible cost of equity effects 8 00:00 2/ The bird in hand theory:? This? says? investors? do? care? and ? ? ? want ? ? ? ? ? ? ? ? ?ratio.? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? they ? ? ? a high payout ? ? ? ??? ? Finallythat we is 5/ bird ? ? hand ?three theories, which theory is most correct? Empirical testing tax preference theorydetermine which theory, if any is correct; managers must use theiryour stock prices setting dividend policy. would rather analysis which is used, that we are going to see what thiscapital gains rather than di the? ? ? preference? ? ? ? ? represented by red line on this chart again. The has not been able to higher the for your shareholders then the lower own judgment will become. you reinvest back into firm and rather earn analysis entails; and in t So now there have ?? tax ?? ?? ?? ?? ?? ?? ?? theory? ?? ?? ?? ?? ?? ?? ?? ?? ?? ??the ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ??says ?the ?? ?? ?? ?? ?? ?? ??payout? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ??in?? ?? ?? ?? ?? ?? ?? ?? ??Investors ? ?? ?? ?? ?? ?? ??an?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ??and ?? ?? ?? ?? ?? ??they’d? ?? ?? ?? ?? ?? ?? ?? ?? ?? Which theory is most correct? 9 00:00 2/ looked at all ? ?? ?? ?? in 3 ?? ?? ?? ? ?? ?? ?? ?? ? ?? ?? ?? ?? ?? ? ?? ?? ?? ?? ?? ?? ? There is ?? ?? ?? ?? ?? ?? ? They can urge the theory: or might prefer butto useprefer a low gains, so the outside thus raise equity payout company. we A talking about preference you how you in terms 3/ let’s summarize: investors management ? ? dividends? to ?capital ?payout? ratio.company ?that ?dividendsto ?goless? risky ? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ??and ??????????????the ???????of??????????for ?????????? ??moreWhen? ?? ??are high? payout? firm? would ?result? in ?a? higher? payout price. ? ?the higher ? ? ?go ? ? ? ? ? ? of payout the more the cost of equity wi Tax preference? company? ? ? ? ? ? ? ? ? team ? they? ? ? ? ? ? ? earnings ?they ?may? think ? ? ? ? ? ? have? ?are? ? ? ? ? ? ? ? raise new equity ???? so, investors ?? cost value high ???? the firms ?? ?? ??highly.?? ?? ? ? ? ? ? ? ? ? ? tax? ? ? ? ? ? ? ?for the ?company ? ? ? see ? investors care ? ? ? ? retained? ? ? ? ? ? ? ? ? ? ? ? ? ? will not ? ? ? ? ? ? ? ? ? ? ? and So Why investors might prefer dividends 10 00:00 ?? ? ?? ? ??? ?? ? ??? ?? ? ?? ? than capital gains. If ?? ? ?? ?????? ? ???? ?? would ?? ? ? ? ? ? ? ?? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? In the next fewknow ? ? ?we ?will ?go ? ? ? ? ?low? a dividend ?payout? ratio; discuss someto sum up why investors may preferthese theories.we may see that investors want to avoid transaction costs. They know the max tax rate is the same on dividends; but unlike dividends, they aren’t due in the year received; whereas taxes in the Why investors might prefer capital gains 11 00:00 Then again, we slides, ? ? ? ? ? ? ? into each ? ? ? of ?these ? ? ? ? ? ?and? so ?in ? ? ? ? ?of ? ? ? different? implications ?in ? capital? gains ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 3/ some ? ? ? ? prefer ? ? one ? ? ? ? ? ? theories ? ? ? ? order ? ? hand investors ? ? says the ? ? ?we go ? ? in the payout ratio the lower ?the cost of? equity will be. ? ? ? ? ? ? ? theory which ? ? ? ? ? out ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? This should make sense because when you have the bird in hand theory, investors prefer a high payout ratio; and because they want the higher payout ratio, they would take the money that would otherwi Finally the bird in higher Now let’s take a ? ? ? ? ? ? ? ? hand? ? ? ? ? f ? ? ?topics ?we ? ? ? ? ? ? ? ? ? Self?test?question 14.1. ?Explain ? ? ? ? ? ? ? ?ideas behind ? ? ?dividend irrelevance ? ? ? ? ? Please take a ? ? ? ? ? ? answer this and go to the next slide when you are ready. moment to in ? ? ? ? ? to? ? the ? ? ? ? Self Test 14.1 12 00:00 Bird review some ? ? ? ? ? ? ? ? have covered. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? briefly the ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? theory. ? ? ? ? ? ? ? ? moment to If antest 14.1 answer.? Investors? are really ?her? death, ? ? ? ? ? ? ? ? ?can retentiondate? of ?their ? ? ? ? as ?theThus, investors create their own dividend policies, simply if so therefore it might can wiser the stock; and to choose capital gains over dividends.their stock. investor holds? the ? ? ? ? until ? ? ? or indifferent beneficiaries and ? use ? ? ? ?generated ? ? death gains. ? cost basis ?and escape all previously accrued capital gains; they want cash, they be sell for investors if they don’t want cash, they can hold stock answers. ? ? ? ? ? ? to dividends his the ???????????????????????????????????????????????????????????????????????????????????????????????? Self Self Test 14.1 Answer 13 00:00 Self ? ? test 14.1 ? ?? ? ?? ? ? ? capital ? ? ?????? Self test ? ? ? ? M&M? assume ? ? ? taxes ? ? brokerage costs ? ? ? ? ? ? ? ? ? ? ? ? dividend ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? to ? ? ? ? ? ? ? ? ? Self test question ? ? ? ? What did ? ?14.1. ? ? about ? ? ? ? and ? ? ? ? ? ? ? ? ? ? when? they? developed? their ? ? ? ? ? ? irrelevance? theory? ?Please? take? a moment ? ? answer this and go to the next slide when you are ready. Self Test 14.2 14 00:00 ? 14.2. ? question 14.2. ?? Self test questionM? ? ? ? ? ? ? ? ? ? ?assumes ? ? ? ? are ? ? taxes ?or ? ? ? ? ? ? costs. ? ? ? ? the ? ? ? ? ? ?irrelevance? theory? may ? ? incorrect, ?as ? ? reality, brokerage cost and taxes occur when buying or selling stock. Self Test 14.2 Answer 15 00:00 Self ? answer. ? ? ? ? ? ? ? ? ? ? ? test question ? ? ? ?answer. ? ? ? no? ? ? ? ? ? brokerage ? ? ? ? Thus, ? ? dividend ? ? ? ? ? ? ? ? ? ? ? be ? ? ? ? ? ? ? in M 14.2 ? ? ? ? ? M&M 14.2 ? ? there ? ? ? ? ? ? Self test questionM? ? ? ? Why ? ? ? ? ?14.3.? ? ? ? prefer high paying ? ? ? ? ? ?stocks? ? ? ? ? ? ? ? ? ?moment? to ?answer? this? and go to the next slide when you are ready Self Test 14.3 16 00:00 Self test ? ? ? some investors? ? ? ? ? ? ? ? ? ? ? ? dividend ? ? ? ? Please take a ? ? ? ? ? ? ? ? ? ? ? ? M 14.3. ? ? do ? ? ? ? ? ? ? ? ? ? question ? ? ? ? ? ? ? Self test question ? ? ? ? ? ? ? ? ? ? ?14.3 ?answer. ? ? that dividends are less risky than potential capital gains, this is called the bird in hand theory. If so, the investors would value high payout ratio firms; thus a higher payout means a higher stock price Self Test 14.3 Answer 17 00:00 Self test question ? ? ? ? think ? 14.3 answer. Investors may ? ? Self test question ? ? ? ? Why ? ? ? ? other ?investors ? ? ? ? ?low dividend ? ? ? ? ?stocks? ? Bird in theory? ? ? ? ? answer ? ? ? ? ? ?go ? ? ? ? ?next ?slide when you ? ? ? ready. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Self Test 14.4 18 00:00 Self test question ? ? ? 14.4. ? ? might ?14.4. ? ? ? ? ? prefer ? ? ? ? ? ? ? payout ? ? ? ? Please take a moment to ? ? ? ? this and ? to the ? ? ? ? ? ? ? ? ? ? are ? ? ? ? Self test question ? ? ? ? ? ? ? ? ? Investors?may want to avoid transaction costs also because the maximum tax rate is the same on dividends but the taxes on dividends are due in the year the dividends are received by the investor, whereas capital gains are due whenever the stock is actually sold. And also, if the investor h Self Test 14.4 Answer 19 00:00 Self test question ?14.4 ?answer? ? ? ? ? 14.4 answer. ? ?? ?? Now that we have ? ? ? ? ? ? ? ? some of? the issues ? ? ? ? ? ? ? ? ? ? when? they? choose? different? policies ? ? ? ? ? ? ? ? follow,?let’s ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? of?each ?of ? ? ? different? policies ? ? ? announce ? ? ? ? ?marketplace. ? ? ? ? ? ? ? ? ? ? ? hypothesis? ? ? basically says investors? view? dividend ? ? ? ? ? ? ? ? ?of ? ? ? ? talked about ? ? ? ? ? ? ? ? ? ? facing managers ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? they want to ? ? ? ? ? ? ? talk about ? ? signaling effects ? ? ? ? the ? ? ? ? ? ? ? ? ? ? they ? ? ? ? ? in the ? ? ? ? ? ? ? What is signaling ? ? ? ? ? ? ? It ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? distributions ? manag What’s the “information content,” 20 00:00 or “signaling,” hypothesis? What’s the “clientele effect”? 21 00:00 Let’s also talk about ? ? ? ? ? ? clientele? effect? means: ? ? means ?that ?different ?groups? or ?different ?investors ?or ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ?different ?dividend policies, thus a ? ? ? ? ? ? ? ? ? ? ? ? ? policies ? ? ? ? ? ? ? ? ?current ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Clientele? effects ?impedes ? ? ? ? ? ? dividend ? ? ? ? ? ?so ? ? ? ? ? ? ? ?ar ? ? ? what the ? ? ? ? ? ? ? ? ? ? ? ? it ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? clients of ? ? firm prefer ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? firm’s past dividend ? ? ? ? ? determine its ? ? ? ? clientele of investors. ? ? ? ? ? ? ? ? ? ? ? ? ? changing ? ? ? ? ? policies ? that if you ? Now let’s take a ? ? ? ? ? ? ? ? ? ? ? ? ? topics? we ?have ?just ?covered. Self test 14.5. ?Define ?information? content ?and the ? ? ? ? ? ? ? ? ? ? ? ? ? explain ?how they affect dividend ? ? ? ? ? Please take a moment to answer and go to the next slide when you’re ready. moment to review the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? clientele effect and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? policy. Self Test 14.5 22 00:00 Clientele 14.5 answers. Investors look to dividend because taxes information content of a managements’ view ofto switch companies; andmanagement hate to cut dividends so, so they want to minimize that for they are confident that the raise is going to be sustainable in the future. Also, the dividend policy will determine its impede changing dividend policy increases as and brokerage costs hurt investors who have the future. They know they [management] realize this and they wont raise dividends unless their clientele and investors. Self test effectsSelf test 14.5.answers. 14.5 Self Test 14.5 Answer 23 00:00 Given all these implications ?of ? ? ? ? ? ? policy, ?we ? ? ? ? ? ? come? to ?a? standard ? ? ? ? ? ?model ? ? dividend ? ? ? ? ?in ? ? ? ? all ? ? ? ? ? ? ? ? ? ? general? follow in? some? form? or ?another. This is? called the ? ? ? ? ? ? model. In? order ? ? ? ? ? ? ? ?residual dividends model ?and figure ? ? ? ? ? ?payout? should be, ? ? ? ? ? ? look? at ?th The residual dividend model 24 00:00 ? ? ? ? ? ? ? ? dividend ? ? ? ? ? have now ? ? ? ? ? ? ? ? dividend ? ? ? or ? ? ? ? ? policy ? which ? ? corporations in ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? residual ? ? ? ? ? ? ? ? to find the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? what the ? ? ? ? ? ? ? ? ? we first ? ? ? ? So now, let’s take ? ?numerical ?example ? ? the ? ? ? ? ? ? dividend ? ? ? ? ? ? ? dividends ?that ?are going ?to ? ? ? ? ? ? ? ?will ?be ? ? ? ? to ?the net ? ? ? ? ?minus ? ? ?target equity ratio ?multiplied by the ? ? ? 60%? ? ? ? budget required. So? if ?we ? ? ? ? $600,000? ? ? budget here required ? ? ? ? ? ? ? ?then ?the? target capital? structure? is Residual dividend model 25 00:00 ? a ? ? ? ? ? ? ? ? ? of ? ? residual ? ? ? ? ? model. The ? ? ? ? ? ? ? ? ? ? ? ? ? be paid out ? ? ? equal ? ? ? ? ? income ? ? ? the ? ? $800,000? ? ? ? ? ? ? ? ? 40%? ? ? total capital ? ? ? ? ? ? ? ? ? ? ? ? ? assume the capital ? ? ? ? ? ? ? ? ? ? ? ? is $800,000 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? This is the reason why it would minimizecalculate the dividends that are we are using a portion or our retained earning [instead of issuing new equity] it would also minimize and flotation costs in issuing new costs in the marketplace. Let’s go on with ? ? ? residual model? and ? any ? ? ? ? ? ? ? ? ? ? and because paid. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? our ? ? ? ? ? ? ? ? ? ? ? ? signaling cost, ? ? ? ? ? ? ? ? ? ? Residual dividend model: Calculating dividends paid 26 00:00 look at the ? ? ? ? ? ? ? ? $400,000? ? ? the ? ? ? ? ? ? ? $400,000, and what ? ? ? ? ? ? rises ? ? ? ? ? ? If net ? ? ? ? drops ? ? $400,000? ? ? ? dividends are going ? drop equal $400,000 ? ? ? ? ? target ? ? $80,000? ? ? ? ? ? ? ? 60% ? ? ? ? ? ? by ? ? ? ? ? ? ? ? ? ? ? capital ? ? ? ? need Residual dividend model: What if net income drops to $400,000? Rises Now $800,000? a ? ? ? ? ? ? ? ?residual? dividend model and ?if ? ? ? income? drops ?to ? ? ? ? $800,000? ? ? happens?if ?it ? ? ? ? to?$800,000? $400,000income ? ? ? ? to?$400,000, then? the ? ? ? ? ? ? ? 60%? ? ? ?to ? ? ? ? ? $800,000? ? ?minus the ? ? ? ? ?capital structure,? which ?is ? ? ?multiplied ? ? $800,000 ?which is? the ? ? ? ? ? budget ? ? ? 27 00:00 to let’s take / how would policy? portion of budget be by equity. we know $800,000 is going going funded So Calculate a change ? ? ? ? ? ? ? ? ? opportunities ? ? ? ? ? ? ? ? ? ? ? ? ? So, ? $800,000? residual policy? If? you ?? required and of ????? ?$480,000capital? budget, ? place,is ? ? ? ? to lead ? less ? ? ? ? ? or $480,000. How would a change in investment opportunities affect dividends under 1the residual the 1/ ? ?in ? ? the ?capital ? ? ? ? ?to ? ? funded ? ?the? dividends? under ? that ? ?? ?? ?? ?? ?? ? ?? ? ?? ? to ?be?????????????????????this ?$800,000invest ?in? the ? ? .6? of ?it ? that would ?be ? ?to ? ?with ?equity, ? ? ? ? ? ? ? ? ? ? ? ? ? to? a higher ? ? ? ? ? ?payout? ratio. Also, more good investments would lead to a lower payout ratio 28 00:00 0.6 have fewer good investments to? ? ? ? ? ? ? ? ? first ? ? ? ??? ? ? ? ? investment? ? ? ? ? ? ? ? ? also ? ? ? ?? ? ?? ? ? affect ? ? ? ? ? ? ? ? ? ? ? the? ?? ? ? ?? ? ??? ?? ? capital budget required; hence ? ? ? ? ? ? dividend ? ? ? ? ? ? ? So if they payout would be zero overon residual dividend policy or zero percent of the dividend payout ratio. Now if net incomewe know that it minimizes new stock issues to the $800,000 capital minus the initial equity capital structure of 60% multiplied by the capital budget of $800,000 which would give us the $320,000 the net income of $400,000 and the advantages and disadvantages of it. Of the advantages, increased to $800,000 the dividends equal and flotation costs. We are using what is left over from net income to fund our capital budget. Disadvantages are it results in variable dividends, tha Let’s find some closing ?conclusions ? ? ? ?? ?? ?? ?? ?? ?? ?? 0? ?? ?? ?? ?? ?? ?? ?? ?? ?? 0? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 60%? ? ? ? ? ? ? ? $700,000????????????????????$380,000? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? $800,000? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 40%? ? ? ? ? ? ? ? ? ? ? ? ? Comments on Residual Dividend Policy 29 00:00 ? /? ? ? ? ? ? ? ? $400,000 $800,000 ? ? ? needed ? funded ? equity ? ? ? ? ? ? ? ? 1 ? ? ? or ? ? ? for capital equity beyond that. So if we ?initially ?had? an?income? of 600,000 and we took away 480,000 which ? ? ? ? ?to ? ? ? ? ?by ? ? ? ? ?capital, then we know we have $120,000 left ?we ?can pay out as dividends if we want to. ? need ? ? ? ? ? ? ? ? ? ? ? ? ? ? $800,000 ? 2/gCalculate the excessin real life is Microsoft. Microsoft for a very long time didn’t pay out any dividends to its shareholders and only started doing so recently. The rationale from Microsoft was ? ? ? ? ? ? ? $380,000 A ood example a moment to review the topics we just covered. Self test question 14.6. explain the logic of the residual dividend model, the steps a firm would take to implement it and why it is more likelyour investors expect us to long term payout and reinvest to set high actual year by year on their behalf, they take a wan this Now let’s take of2/ ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? $600,000?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? $480,000? Microsoft? ?? ?? ?? ?? ?? ?$120,000? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?that ? ? ? be? used? to ?establish a take this money rather than it to the growth investments payout ratio? Please don’t mo to ? ? ? ? ? ? ? ? ? Self Test 14.6 30 00:00 ??????????????????????? Microsoft Microsoft ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ????? ????? ????? ??????????????? ?? It sends conflicting signals as answers. because of this irregularity investors don’t know why you chose to send one payout each year and a low payout next year so they can’t rely on the info to make a signaling theory judgment of how management feels of its future prospects. well, Self test 14.6 answers. ? dividends? as? and ? ? ? ratio? as ?taking? the ? ? ? ? ? ?or ? ? ? ? ? ? net ? ? ? ? ? ? ? ? ?of ? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? ?total ? ? ?income? of ?$600,000 that give us? .20 ? ? 20% ? ? ? ? ?ratio.? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Self test question 14.6.? Self Test 14.6 Answer 31 00:00 3/ We can calculate? this ? 14.6 ? ? a? payout ? ? ? ? ? ? ? ? ? leftover ? residual ? ? income amount ? $120,000 ? ? divide that by the ? ? ? new ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? or ? ? payout ? ? ? 2/ ? ? ??? Self test question ?14.7. ? ? ? ? are ? 14.7. ? ? ? ? ? to ?the? dividends? decisions? ? ? ?? ? ?? ? or? cash ?flow. ??????????0.2? ? ? ? take ?a? moment to? answer this and go to the next slide when you’re ready. Self ? ? ? ? ? ? ? ? ? critical ? ? ? ? ? Earnings Self Test 14.7 32 00:00 3/ ? ? ? Which? ? ? more ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? $120,000 ? ? ? ? ? $600,000 Explain. ?Please ? ? ? ????? ??? ? ? test question ?? ? ? ? 20% 3/ It also increasesfind ? overall, as? investors? becomefor the ? ? ? the ? ? ? of equity ? ? ? ? ? ? ? more unsure, ? ? cost will inevitably 1/ Wetest question/? ? risk? ? ?retained? earnings ? ? important? than? earnings.? ? ? long as? you ? ? ? ? ? ? ? ? rise.pay ? ? ? ? ? ? you should continue the dividend policy rather than base it on earnings. Some years you may have negative earnings but can still pay out dividends. This a very realistic scenario in the business wor to 1 ? ?? ?? ? ? ? ? ? ? ? ?14.7 ?answer. ?? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Self first need 3/ 14.7 ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ??more? ?? ?? ?? ?? ?? ?? ?? ?capital ? ? ? ?So ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? dividends, Self ? answer. Cash ? ? ? ? ? ? ? ? ? test question Self Test 14.7 Answer 33 00:00 ? ? ? ? ? the ? ? ? ? flow is? ?? ?needed ? ? ? ? ? ? ? budget. ? ? ? ? ? ? have cash flow to ? ? ??? Self doesn’t really? appealquestion clientele of ?30 million,? a net ? ? ? ? ? year. ? ? ? ? ? ? a target ? ? ? ? structure of ? ? ? ? and ? ? equity. ? ? ? residual ? ? ? ? ? ? ? ? ? ? ? Self Test 14.8 34 00:00 Self ? ? test ? 14.8. ? firm ? ? ?a? budget? ? ? ? ? ? ? has 14.8. ? if ? ? ? income ? 35 4/ Ittest question ? over A ? to? any–the ?residual-it? is ?moving? around each of ? ? million? and ? ? ? ? ? ?capital ? ? ? ? ? ? ? ? 45% ?debt ? ? ? 55% ? ? ? ? ? If? the ? ? ? ? ? ?dividend? policy were used what would its dividend payout ratio be? Please take a moment to answer this and go to the next slide when you’re ready. 2/ Pay out any left earnings as dividends 2/ ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? dividend 45%? ? where ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? net ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? by ? ? total ? ? ? ? ? ? ? ? Here Self test 14.8 answers. ?We ? ? ? ? simply? use ? ? ? residual ? ? ? ? ? ?model ? ? ? ?we ?know ?the? residual ? ? ? ? ? ? paid?equals? the ? ? ?income? minus ? ? ? target? equity? ratio ?multiplied ? ? the ? ? ? ? capital ?budget. ? ? ? we are given that the total net equity budget is 35 million the target is 55% and the total budget involved is 30 Self Test 14.8 Answer 35 00:00 Self test would ? ? ? ? ? ? ? $30million? ? ? ? ? our ? ? ? ? 55% ? ? ? ? ? ? ? ? dividend ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? 4/ ? ? ? ? 14.8 answers.? ? ? ? $35million? ? ? ? ? ? So the conclusion? is we ?considerthe ? ? ? and ?equity? signaling? set ? longhence target it ? ? ? ? ? we or ? ? follow it ? ? ofyou from ? ?DRIP is why it is used to? ? $30million? plan. ?In ? ? ? ? ? ? ? ? ? thethan ?to ?? ?? ?can?$35million yearreinvest ?52.86%dividends ? ? ? ? ? ? ? ? company’s common stock so they get stock instead of residual to ? ? when we costs and? ? either pay ? out but weighted average ? what ? capital.a This year. ? 55%? ? ? ? ? reinvestment ? ? ? term also minimizes the ? ? you ? ? have rigidly ?call In terms policy would?paying? out ? thedividends ? policy shareholders a ? ? can ? ? ? ? ? ? ?payout, in ?cash ?don’t ? can ? ? cost$35million? year to?policy? or ?a? dividend establish? a long run ?payout?ratio ? ? $18.5millionset??actual year by???? ????payout ?ratio. ? ?? ?? ?? ?? ?? ?in? shares of? the ? ? ? ? ? ? ? ? ? What’s a “dividend reinvestment plan (DRIP)”? 36 00:00 3/ This of actually minimize flotation ? ? rather 2? ? ? ? ? ?? ? ? its ? ? ? ? ? ? you ??? ?? ??? ? ? ? ? ? ? ? ? ? ? ? ? ? this DRIP plan, ? ? shareholder ? ?? automatically ???? ??? their ?? ?? ?2??? ??? 3/ ? ? ? ? ? dollars ? ? reinvested ? ? turned ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? An open market purchase ?plan: ? ? ? ? ? to?be ? ? ? ? ? ? ? are ? ? ? ? ?over ?to ? ? ? ? ? ? ? ? third?party ? ? ? ? ? ?the brokerage? costs ?are? reduced? because ?of ? ? ? ? ?purchases ?that ?the trustees are making, and it is a easy, convenient way to invest and thus very useful for the investors. some sort of ? ? ? ? ? ? trustee, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? volume ? ? ? ? ? ? ? ? Open Market Purchase Plan 37 00:00 ?????????????????????????????????? New Stock Plan 38 00:00 The second way is2? ?new? stock ?plan ?in ? ? ? ? the ? ? ? ? ? ? ? ?new stock ?to ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? at ?a? discount ? ? ? ? ? ?market? price) and ? ? ? ? the ? ? ? ? and ? ? ? ? ? ? ? buy ? ? ? ? ? ? ? ?firms ? ? ? ? ? ? ? ? ?equity? capital use these stock plans. Firms with no need for new equity capital use the open market purchases. a ? ? ? ? ? ? ? which ? ? firm issues ? ? ? ? ? ? DRIP enrollees (usually ? ? ? ? ? ? from the ? ? ? ? ? ? ? ? ? keeps ? ? money ? ? uses it to ? ? assets. The ? ? ? that need new ? ? ? Now let’s review ? ? ? ? ? the ? ? ? ? ?we ? ? ? ? ? ? ? some of ? ? topics ? have just covered. Self test question 14.9. What are DRIPs? Please take a moment to answer this and go to the next slide when you’re ready. Self Test 14.9 39 00:00 So most New York stock exchange DRIPs are answer. companies have some sort of DRIP or stockholder to purchase, and it is very useful for investors. Self test question ? ? ? ? ? ? ? ? ? ? ?14.9. reinvestment? plans ? ? ? plan the volume ? ? ? ? ? automatically ? ? ? ? ? its dividends back into the stock of the firm -- so they essentially get more stock instead of cash. Self Test 14.9 Answer 40 00:00 Self test question 14.9 ? ? ? ? ? ? ? ? ? ? ? enabling? ? ? ? ? ? ? ? 14.9 answer. ?? ?? ? ? ? ? ? ? ? ? reinvest Self test question ? ? ? ? ?What ?are the ? ? ? ? advantages ? ? ? disadvantages ? ? ? the ?stockholders’? and ? ? ? ? ? ? ? ? ? ? ? ? ?Please? take? a moment to answer this and go to the next slide when you’re ready. 14.10. question ? DRIPs ? ? ? ? ? ? and ? ? ? ? ? ? ? ? from ? ? ? ? ? ? ? ? ? ? ? firm’s perspectives? ? ? ? ? ? ? ? ? ? Self Test 14.10 41 00:00 Self test ? ? ? ? ?14.10. ? Self test 14.10 answers. Generally, ?it ? ? very beneficial ?for investors and saves them brokerage costs because of the large volume purchases made on their behalf, but the investors must pay taxes on the value even though the shares are what they are getting and not actual cash. Firms benefit by learning from the dividends Self Test 14.10 Answer 42 00:00 Self ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? answers. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? test 14.10 ? ? is Setting Dividend Policy 43 00:00 So how should a management ? ? ? ? ? company? consider ? ? ? ? ? ? ? its ? ? ? ? ? ? policy? ?Well ?there ? ? ?a? few ? ? ? ? that? every ? ? ? ? ? ? ? ? ? to ?achieve ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? team or ? ? ? ? ? ? ? ? ? setting up ? ? dividend ? ? ? ? ? ? ? ? ? are ? ? steps ? ? ? ? ? company needs ? ? ? ? ? this. Now let’s take a ? ? ? ? ? ? ? ? ? ? ? ? ? topics? we have just covered. Self test question 14.11. Identify the four broad sets of factors that affect dividend policy. Please take a moment to answer this and go to the next slide when you’re ready. moment to review the ? ? ? Self Test 14.11 44 00:00 1/ They should forecast the capital 14.11 answer. planning period, typicallypolicyyears. needs five is: Self Test 14.11 Answer 45 00:00 Self test question 14.11 ? ? 5? ? ?The? four? over? a that constrain ? ? ? ? ? ? Self test question 1/ ? ? ? answer. ? 14.11. things ? ? ? ? ? ? ? ? ? a dividend ?? ?? ? Self Test 14.12 46 00:00 Self test question ?14.12.? What? constraints? affect ? ? ? ? ? ?policy? Self ? ? ? ? ? ? 414.12 : ? ? ? dividend ? ? test question ? ? ? ? question. Please take a moment to answer this and go to the next slide when you are ready. 2/ Set a capital ? ? structure, 4 themselves, i.e., capital cash flows. tax recall from ? 1/ Constraints on? dividend ? ? ? ? The14.12 ? ?last ?discussion on optimal capital structure we understand how a company goes about setting that structure. Self Test 14.12 Answer 47 00:00 Self test question ?14.12 ? ?payment ? ?four ?things? that? constrain? dividend ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Self ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? policy is 2/ ? ? ? answer.? ? ? ? ? ? ? ? question ? ? ? ? answer. ? ? ? ? ? ? ? ? test ?? ? ?? ??? ?? ?? Self Test 14.13 48 00:00 Self test question 14.13.? How ? ? investment ? ? ? ? ? ? ? ? ? affect Self test question ? ? ? 1/ ? ? ? ? ? do ? 4 ? ? ? ? ? ? ? ? ? ?The more? investment ?opportunities a company policy? may choose not to distribute and go to the next slide when and instead to ? : ? ??????? 3/ Estimate annual ?equity? needs.? ? ? 14.13.? ? opportunities ? ? ? ? dividendhas, theyPlease take a moment to answerdividends to their shareholdersyou are ready. reinvest in their company and allow shareholders to earn higher capital gains. ? 2/ Investment opportunities. 1/ Stockholders desire? for ?current ? 14.13 ?future ?income. ? ? ? the investment opportunities the more disciplined management will be to paying dividends versus reinvesting them in investment opportunities. Many high growth technology companies follow this rationale and don’t pay out dividends and reinvest in the growth opp Self test question ? ? ? ? ? ? ? ? ? The ? ? ? available and ? Self Self Test 14.13 Answer 49 00:00 ? ? test question ? more answer. ? ? ? better ?? ?? ? ??? ??? 3/ 14.13 answer.? ? versus ? ? ? ? 4/ Set thequestion payoutthe? cost? ? residual? model. ? ? ? of ?capital,? instead? of ?using ? ? dividend ? ? ? (do ? ? ? ? ? ? ? ? ?moment ?to ? ? ? ? ? ? ? go ?to ? ? ? next? slide ?us)? ? ? ?are ready. 2/ and based? ? ? ? available? ? ? Self test target? ? ? ? ? ? ? ? does the ?availability ? ? ? ? ? ? ? ? ? ? ? capital? ? ? retain ? ? ? policy? Please ? ? ? ? ? ? ? ? ? ? ? and what ? Self Self Test 14.14 50 00:00 1/ ? test question ? ? ? ? ? ? ? ? ? ? earnings ? ? ? ? ? ? take a ? ? ? ? ? ?? ?? 3/ The availability14.14.? How ? onof? 14.14. capital ? and ?cost ?of ? ? ? ? ? ? ? ? ? ? affect? ? ? ? ? ? ? ? ? ? ? they have another? optionanswer and does ? the option ?cost when you ? ? ? ? ? that ? ? ? ?? ? ? gains. ? ? outside ? ? 2/ The perceived risk ? ? dividends versus ? ? sources of Self test question ?14.14 ? ? ? ? ? ? ? 14.14 ?of ? ? ? ? ? new ? ? ? ? ?if ? Self ? ? ? ? ? ? ? The ?cost ? ? ? ? ? ? ? ? ? stock: ? the flotation costs are high, set lower dividend payout to ensure that retained earnings can be used to fund opportunities in future growth. Also, the ability to substitute debt for equity: if a firm can borrow more without significantly changing their w Self Test 14.14 Answer 51 00:00 4/ ? ? ? answer. ? ? ? ? ? answer. ? ? test question ? ? ? selling ? 5/ Generally some3/ ? ? ? ? ?growth? rate? emerges. ? Maintain ? ? ? ? ? ? ? ? ? ? ? ?rate, ? ? possible, and ? ? ? ? ? ? ? ? ? ? ? ? structures somewhat; but overall its going to remain the same. dividend growth vary between 4/ The effects of2/ ? ? ? ? ? ? ? policy? andcost? of ?equity. ? that targetstock ? ? ? ? ? if? repurchases ? ? ? ? ? ? ? ? ? capital? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? NowThe moveadvantages dividend? ? gains ?over? dividends. ? ? ? ? towards ? ? ? ? dividends, ? ? ? ? ? ? ? and splits. from of capital? ? Stock dividends vs. Stock splits 52 00:00 ? ? ? ? ? ? ? ? ?? ? ? ?? ???? ???????? ???? 3/ we tax away ? dividend policy ?on ?the? ?turn ?our? attention ? ? ? ? Finally, the last5/ ? ? bit ?an ? ? ? ? of? control: selling stock ?means ? ? ? ? investors? would ? ? ? for ? ? this in? the ? ? setplace-- because ratiostockuse retained earningssplits increase the number of shares outstanding (so the pie divides into smaller pieces), but the pie remains the same, and no one is getting diluted. issue?is about stock dividends? vs. stock? splits and why ? ? ? ? ? (dilution) ? ? management, ? ? we ? ? ? ?lower payout both and dividends and stock instead. issue ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? losing control So let’s talk a little? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? first ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? care about ? ? ? ? so ? ? ? a ? ? Stock dividends vs. Stock splits 53 00:00 ??? ?? ??? A The and why 4/ ? ? ? firm ? ? ? ? ?policy. ? ? ? ? ? lieu of? paying ? ? ? ? ? ? ? ? ? ? ? ? it’s ? ? ? price ? ? ? ? ? ? stock ?you get ? ? shares for ? ? ? hundred? ? ? ? used to keep the price in this is cash dividend. If 10% stock dividend,then ? ? ? 4/swhen signalingshould? a ? ?firm ?issues?splitting ? ? ? stock?? There ? ? a ?wide ?belief ?that ?an ? ? a ? ? 100? ? range ?of ? ? ? ? ranges? from ?$20 ? ?$80. ?Stock? splits ? you ?already ? ? ? as ?a? shareholder. ? ? optimal ?range ? ? ?generally ?occurs?when ?management ? ? confident about ?the? future. ?On ? ? ? ? ? ? if ?you look at? the quantitative? res effects a ? ? ? ? So tock dividens 3/ when ? ? dividend ? ?new? shares ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? $20? ? $80? ? ? ? ? ? ? ? ? ? ? ? ? ten ? ? - ? ? ? every ? ? ? ? can ?be ? ? ? ? own ? When and why should a firm consider 00:00 54 splitting its stock? ? ? ? ? ? ? ? ? consider ? ? ? ? ? ? ? in ? ? ? ??? 10% ? ? ? ? ? of ? ? ? ? ? ? ? ? ? ? ? its ? ?? ? ? is a ? ? ? ? ? ? ? ? ? ? ? ? optimal ? ? ? ? 10 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??????? ? ? ? ? ? ? ? and ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? is ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? average, ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Unless thetake a moment split conveys some kind of information or accompanied question 14.15. What are stockdividends, and what are stock splits? Please take a moment to answer and go to theFrom an investor’s perspective, splits and stock dividends may get us to an optimal price range. This optimal price range has been sta dividend or to review the topics we have just covered. Self test by another event like higher dividends the stock price falls so as to keep each investor’s wealth unchanged. next slide when you are ready. Now let’s Self Test 14.15 55 00:00 ? ? is? when? a firm increases ? ? ?number? of ?shares? outstanding-- ? say ? ? ?-- ? ? ? every ? ? ? ? ?you will be? given ? ? ? shares or? it ?“splits” in? half? and ? ? ? ? shareholders ?more ?shares. ? ? ? ? ? ? ? a ? ? ? ? ? stock ?split ? ? the ? ? ? ? ? ? so ?if ? ? ? had ? ? ?shares? before, ?they ?would ? ? ? ? ? ?those ? ? ? ? ? ?back fo ? ? ? ? ? ? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 2:1 ? for ? ? ? share, ? ? ? ? ? ? ? ? ? two ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? gives ? ? ? ? ? ? ? ? ? ? ? ? ? Of course, ? reverse ? ? ? ? ? ? is ? ? opposite ? ? you ? ? two ? ? ? ? ? ? ? ? ? ? ? ? exchange ? ? ? 2 shares A share stock split 4/ 14.15 answer.? ? ? 14.15 ? ? ? ? are ? ? Self test question ? ? ? ? ? ? ? ? ? Stock ?dividends ? ? ?when ?a? firm? issues ? ? ?shares? in ?lieu ?of ? ? ? ? ?cash ?dividends; so? if ?you have a ? ? ?dividend, ?you? would ?get? ten ? ? ? ? ? ? 2every ?one hundred ? ? ? ? ? ? own as an investor. A stock split on the other hand increases the number of shares outstanding, so for every share yo Self ? ? ? ? ? ? ? ?14.15.answer. Self Test 14.15 Answer 56 00:00 ? ? test question ? ? ? ?? ? ? ? 2? ? new ? ? ? ? ? ? ? paying ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 10% ? ? ? ? ? ? ? ? ? ? ? ? shares for ? ? ? ? ? ? ? ? 1? shares you Self test question ? ? ? ? ?How do? stock ? ? ? ? ? ? ? ? ?stock ? ? ? ? ? ? ? ? ?prices? ? ? 10%?take ?a? moment to? answer? and ? ? to? the 100? ? ? ? 10? ? ? you are ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 2? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Self test question ? dividends and ? ? ? splits affect ? ? ? ? Please ? ? Self Test 14.16 57 00:00 ? 14.16. ? ? ? ? ?14.16. ? ? ? ? ? ? ? ? ? ? go ? ? ? next slide when ? ? ? ? ready. Self test question ? ? ? ? answer.? Stock ? ? ? ? ? ? ? ? ?stock ? ? ? ? are generally good signs and a company’s stock rises accordingly. Also, investors take the announcement as signals as higher future earnings from management. Self test ? ? ? ? ? ? ? ? answer.and ? ? ? splits 14.16 ? question ? dividends Self Test 14.16 Answer 58 00:00 ? ? ? ? ? ? ? ? ? ? ? ?14.16 ? ? ? ? ? ? ? ? ? ? ? ? ? Self test question ? ? ? ? ?In ? ? ? ? ?14.17.? ? ? ? ? ? ?firm ?split ? ? ?stock?? Please? take? a moment ? ? answer ? ? ?go ? ? ? ? ?next ?slide when you ? Self test question ? ? ? Self Test 14.17 59 00:00 ? 14.17. ? what situation should a ? ? ? ? ? its ? ? ? ? ? ? ? ? ? ? ? ? ? to ? ? ? ? and ? to the ? ? ? ? ? ? ? ? ? ? are ready. Self test question ? ? ? ? answer.? Firms ? ? ? ? ? ? ? ? ? ? stock splits after huge run ups in the share price in order to produce optically a more appealing price to the shareholder. There is a widespread belief that the optimal stock price is somewhere between $20-80. Stock splits can be used to keep it in this optimal range Self Test 14.17 Answer 60 00:00 Self test question ? typically ? 14.17 ? ? ? ? ? ?14.17 answer.issue ? ? Self test question ? ? ? ? question. Suppose?you have one ? ? ? ? ? ? ? ? ? ? ? ? ? ?of ? ? ? ? ? industries, ? ? ?earnings per ? ? ? ? are ? ? $80? ? ?dividends ?per? share ? ? ? ? ? ? and ? ? ?stock ? ? ? ?at ? ? ? per ? ? ? ? ? ? ? ? ? ? Self Test 14.18 61 00:00 Self test ? ? ? ? ? ?14.18 question. ? ? hundred common shares ? Tillman ? ? ? ? ? ? ? the ? ? ? ? ? ? ? share $20 $4.00 the ? ? ? ? ? ? ? ? ? is $2.00 ? ? the ? ? ? sells ? $60 ? ? share. Tillman announces a two for one split, immediately after the split how many shares will you have and what will be the ? 14.18 ? question ? ? ? ? ? ? ? ? Self Test 14.18 Answer 62 00:00 Self test question ?14.18 answer. We 14.18 answer. ? ? 100? ? ? ? of? shares would be? equal ?to $4.00? ? 1? ? ? ? ? ?the? spilt ?multiplied ?by $60? (or ? ? ?hundred multiplied ? ? two), so? it?will?be ?equal to? two ? ? ? ? ? shares.? Shares per ?earnings? after? the ? ? ? ? as ?it ? ? ? ? ?the earnings ?before ?split ? ? ? ? ? by? two,? so? $4.00 ? ? ? ? Self test question can figure ? ? ? ? Tillman industries ? ? ? out the number ? ? ? ? ? ? ? 1? ? ? ? ? ? the shares before ? $2.00 ? ? ? 1? ? ? two ? ? one ? ? ? Tillman? ? 1? by 2? ? ? ? ? ? ? ? ? ? ? ? ? ? hundred ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1? ? ? split ? ? equals ? ? ? ? ? ? ? ? ? ? ? ? ? divided ? ? ? ? ? ? ? divide Stock Repurchases 63 00:00 Now let’s talk about? stock ? ? ? ? ? ? ? ?? ?this ?? ?? ?? 100?the??2?????????????buys ?its shares? ? ? ? ? ? ? ? ? ?stockholder. ?The? reason why ?a? corporation2? ? ? ? want to ?conduct a repurchase is: ? ? ? ? ? repurchases, ? ?? ?? is when ??? corporation ????? ??200? ? ? ? back? from? the ? ? ? ? ? ? ? ? : ? ? ? ? 2 ? ? 2 ? ? $4.00? would $2.00? ? ? ? ? ?? ?? ?? ?? ?? ?1 ??????? We can also figure out therepurchasesper share after split by taking dividends share before the split dividingWhatso $2.00 divided byThe stockholders can ultimatelyprice after the splitwant to the price beforeshares to the company.two. The price before the split was $60, divide that by the price after the split would be dividends two equals sell back their the split divided by Advantages of Repurchases 64 00:00 Some of the advantages?of ? ? ? ? ? ? ? ? include: the ?stockholders ? ? ? ? ?whether ? ? ? ? ?to ? ? ? ? ?their ? ? ? ? ? ?it ? does tender ? ? ? ? ? ? ? is ?a? dollar. ?Finally, the ? decide ? 1/? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? decide ? ? ? ? or not ? tender ? ? ? shares. ? ? ? ? ? ? ? ? mean? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? whether they 1/ Useare as an alternativerepurchases as? well: ? as? dividends.? ? ? ? ? ? ? $2.00? 2 ? ? ? ? $1? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 2 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? $60? ? ? ? ? 2? ? ? ? ? ? ? ? ? ? ? $30? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? it disadvantages 1? ? ? ? distributing? cash ? ? ? ? 1? ? to ? ? ? ? ? ? Disadvantages of Repurchases 65 00:00 There ???? ? 1/ ? ? ?of ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ? ? ? ? ? ? ? 2/ It helps avoidmoment toareviewdividend that cannotjustmaintained. setting Self Test 14.19 66 00:00 Now let’s take a 2/? ? ? ? ? ? high? ?the? topics? ? ? have? ?be ? covered. Self test question 14.19. Explain how repurchases can: ? ? ? ? ? ? ? ? sale. ? ? ? ? ? ? ? we ? ? ?cash? ? ? 2/ Dispose of one? timeby? thefrom? an? asset ? ? ? ? ? ? ? a ? ? ? ? ? signal, that management thinks the firm has poor investment opportunities; thus this is what they are choosing to do… is to take some cash and repurchase stock instead. 1/ Ittest questionelf test question 14.19 answer. as investment community Self Test 14.19 Answer 67 00:00 Self could be viewed ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ? ? ? ? ? ? ? ? negative ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? S ? ?? 14.19 answer. 2/ 1/ ??? 3/ Repurchased stock can be used for takeovers or be used? to ?raise cash in the future. 1/ Help stockholders hold What is treasury stock? Please take a moment to amswer and go to the next slide when you are ready. Self ? test down taxes? question 14.19. Self test large capital?structure? change. ? ? ? ? ? ? ? ? ? ? ? ? ? Self Test 14.20 68 00:00 14.20. ? 3/ MakeIRSquestion 14.20.? ? ? penalties? if ?repurchases? were? primarily to avoid taxes on dividends. 2/ Theanaalternative? to some ? ? ? ?cash as dividends, thus stockholders can accept the tender offer and choose whether or not they pay taxes on it. For dividends, stockholders have no choice in the matter as they have to pay taxes when dividends are issued by management and when management chooses to pay those dividen could 3/ impose distributing 1/ Astest question ? ? ? ? answer.? Stock ? ? ? ? ? ?been ?repurchaed by? the ? ? ? ? ? ? ? ? ? called ? ? ? ? ? ?stock.? This? stock ? ? ?be ? ? ? ? ?at ? ?future? date. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1/ ? ?? ? ?? ? ? ? more ? resold ? a ? ? ? and Self treasury Self Test 14.20 Answer 69 00:00 Self test question ? 3/ take this ? ? ? ? ? answer. 2/ 14.20 ? ? ? as a ?14.20? ?? has ? ? ? ? ? ? ? ? ? ? ? the is ? ? 4/ Stockholders may? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?that ?? ?? ?? ?? ??that? the ?? ?? IRS????? corporation stock? is ?undervalued? and may ?drive ? can demand to purchase ?stock ? ? drive up the price. 2/ Change their capital structures?positive signal ? ? ? ? ? management thinks ? ? Self test stockholders?may? not ?be some? of? ? ? advantages? and ? ? ? ? ? ? ? ? ?in repurchasing? stock? Please ? ? Self Test 14.21 70 00:00 Self ? ? ? ? ? ? right ? ? ? ? ? ? ? ? 4/ 14.21.? ?structure ?chance. ? ? ? ? ? ? ? ? ? ? create the ? ? ? ? capital? ? ? ? ? ? ? ? ? ? ? take a stock price. ??? ? 3/ Sellingquestion ?capitalWhat? are ? 14.21.?the ? ? ? ? ? ? be? treated ?unfairly. ? ? ? ? ? ? structure? to? maximize ? ? ?moment?to answer and go to the next slide when you are ready. ? ? ? ? ? question well ? ? test ? ? ? ? ? ? ? informed, hence can? disadvantages ? ? ? ? Repurchases 2/ To make a large the 2/ ? ? answer. ? ? ? ? ? ? ? 1/ 14.21 ? ? ? ? Stock? repurchase slide ? ? ? ? ? ? ? ? ? ? ? Self Test 14.21 Answer 71 00:00 Self test questionelf to?answer? and ? 14.21 the ? ? ? ? ? ? ? when include? stockholders ?can tender ? ? not, it? helps ? S ? test question answer. ? 3/ ? ? ? ? ? ? ? ? are ? ? ? ? Please take a moment? ? ? ? ? ? ? ? ? go? to? ? ? next advantages you ? ? ? ready. ? ? ? ? ? ? ? ? ? or ? ? ? ? ? ? ? avoid setting a high dividend that cannot be sustained. Stockholders may take it as a positive signal that management thinks the stock is undervalued. 4/ The firm ups the14.22. to ? can stock? repurchases help a ? ? ? ? operate in ?accordance ?the the ? ? ? ? ? ? ? ? ? model? Please take a ? ? ? ? ? ? ? ? ? Self test question ? price?How make ?the? repurchase ?thus ?paying? too much ? ? ?their ? ? ? ? in with first ?place.? dividend ? ? ? ? ? ? ? ? ? ? ? ? ?moment? to ?answer? this? and go to the next slide when you are ready. Self Test 14.22 72 00:00 Self test question ? ? ? ? ? ? ? ?14.22.? ? ? ? ? ? ? ? company ? ? for ? ? stock ? ? ? ? ? residual ? Negatives question/ 14.22 ? be? viewed? 14.22 negative ? ? ? model ?sets ?a? target? cash? distributioninvestment opportunities and of distributing all the cash the cash, secondly, IRS can impose lower portion the repurchases were made primarily portion as a repurchase. This way the lower payout ratios can steadily increasing over ti 2 ? test ? ? ? residual ? ? signal ? ? ? Self test are that ?it ?cananswer.? The as? a? ? ? ?dividend? ? ?because the? company ?has very poor ?to ? Self Test 14.22 Answer 73 00:00 Self answer. 4/ ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? shareholders; so instead this is a way to dispose of from retained earnings, you set a penalties if from retained earnings and a higher to avoid taxes. ? ? question ? ?? We have now come ? ? the ?end? of? Chapter ?14.? So? let’s ? ? ? ? ? ? ? ? ? ? ? ? ? ?questions ?and? how ? ? ? ? ? ? ? ?them. ? ? investors? prefer ? ? ? ? ? ? ? ? capital? gains?? We? looked? at? three ?theories? in? particular,? one ? ? ?the? irrelevance ? ? ? ? ?that ?states ?investors?don’t ? ? ? ? ? ? ? dividends? versus capital? gains, the second ? ? ? tax to ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? summarize some ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? answered ? ? ? ? Do? ? ? ? ? ? ? ? ? ? ? dividends ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? was ? ? ? ? ? ? ? ? ? ? theory ? ? ? ? ? ? ? ? ? ? ? ? ? care about ? ? ? ? ? ? ? ? ? ? ? ? ? Summary 74 00:00 14 ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? of ? ? ? ? ? ? ? ? ? ? we ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? IRS ? ? ? ? ? or? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 2 ???????? ??3? ??? ? ??1 ? ??? ???? ? Bird in hand? ? ? was ? Now repurchases ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? for ? ? ? ? ? ? the ? ? 14? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 14, ? ? ? ? ? CHAPTER 14 Answer Set Distributions 00:00 75 to shareholders: Dividends and share let's review ? ? ?homework? which ?was? assigned ? ? ?Chapter ? ? ?Dividends ?and Share repurchases. Secondly, we asked the the pros and cons what message does dividend policy send to announce what a firm's talked policy will be in signaling effects the and we some of some of positive how Question 14-1. Discuss??question? ?? ?? ?? ?? ?? ?of? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ??marketplace? ?? ?? ?? ? dividendabout ? ? ? ? ? the ? the ? ? ? ? ? ? ? 3?to ? ? ? ? ? the ?marketplace?and whether? or? not it? was ? ? ? ? ? ? or ?negative. ?Thirdly, we? asked ? ? ? do ?firms set a residual dividend policy and we walked through the calculation of how Question 14-1 76 00:00 ? ? ? ?? ?? ?? ?? ? ?? ?? ?? ?? ?? ?? ? ???????? ? ? ? ? future. ? ?? ?????? ?????? ? ??? ?? ? ????? ?????? ??? ?? 14-1 ? ? having the directors formally Question 14-1 answer. The ? ? ? ? ? advantage? of ?having? an ?announced ?dividend policy is? that? it ?would ? ? ? ? ? ? ? ? ? ? uncertainty? and ? ? ? ? ? ? ? in ?uncertainty? are generally associated ?with ?lower ? ? ? ? ? costs ? ? ? higher stock ?prices. ? ? ? ? things being ?equal,? the ? ? ? ? ? ? ? ? is? that ?such ?a? policy might ?decrease corporate biggest ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? reduce investor ? ? ? ? ? ? ? ? reductions ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? capital ? ? ? and ? ? ? ? ? ? ? ? ? ? ? Other ? ? ? ? ? ? ? ? ? ? ? ? disadvantage ? ? ? ? ? Question 14-1 Answer 77 00:00 ?? ???? ? How do firms use ? 14-1?dividends, splits and repurchase to maximize the value of the firm, we see they use this by constantly splitting or sending more stock dividends out in order to reach an optimal price range as well as the effects of repurchases. By implementing large capital structural ?changes or keeping cost of e stock ? Question 14-5. How ?would? ?? ?? ?? of??the? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ??effect ? ? ?aggregate, ? ? ? ? ? the ?average ? ? ? all corporations' ?pay? out ? ? ? ? ? other? things? held? constant.? Explain ?your ?answers. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Question 14-5 78 00:00 ? 14-5? ? each ?? ?? ? following changes tend to ?? ?? ?(payout ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?? ? the ratio) ? ? that is ? ? ? ? ? ? for ? ? ? ? ? ? ? ? ? ? ? ? ? ratios, ? ? ? ? ? ? ? ? A/ An increase in? the personal ?income tax rate. Question 14-5A&B A)? ? ? ? ? ? ? ? ? answer. Question 14-5(a), (b) Answer 79 00:00 14-5A,B B/ A liberalization ofanswer continued. federal incomein the personalthat is faster tax write-offs. more desirable for a firm to retain and re-invest earnings. Consequently, an increase in personal tax rates should lower the aggregate payout ratio. A >From the stockholder's point? of ?for? ? an increase tax purposes, income tax rate would make it Question 14-5 C and D depreciation view, ? Question 14-5(c), (d) Answer (cont.) 80 00:00 ? 14-5C,D? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? A) B)? ? ? ? ? ? ? ? ? ? C/ A rise in interest rates Question 14-5 E, C)? ? ?G? answers. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? MCC? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? F 14-5E,F,G? ? ? ? ? and Question 14-5(e), (f), (g) Answer 81 00:00 (cont.) ? ?? ?? ?? ? ? B) ? ? ? ? with higher cash flows. ? ? ? ? way ? ? ? ? tend to ? ? ? ? ? as ? ? ? ? ? ratio ? ? be ? in ? ? ? ? increase ? ? of would on investment. Other and the required rate of return on equity and the and D/ An increase in? corporate? profits.?? ? raised, ?cash ?flows ? ? ? ? increaseearnings a ? ? ? ? ? ? ? attractive ? ? ? of ?would ? ? ?new increase ? ? ? ? ? ? but ? ? the ? payout ? ? ?the change ? ? tax ? ? ? ? ? ? ? ?On ? ? ? other ? ? ? would ? ? ? ? ? ? rates ? ? ? ? ? ? cause ? ? ? rate? of ?debtthings being equal, this might stimulate investmentfirm C) B/ If the depreciation?allowances? were the increase would wouldretained ? ? ? ? ? ? ? relatively ? ?Pay out ratios financing ? ? investment. well, ? ? on ?theother hand, ? may ? ? expected allowed depreciation charges ? higher interest ?rates return ? ? ? the ? ? ? ? C interestAxel ? ?? ? ?? ??to? increase, ? ? ? ? ? ? ? ? ? make decline. ? the ? ? ? Problem 14-1. inrates? were? ??opportunities. ? ? ? ? ? ?capital ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? of ?70% debt? and ? ? ?equity. ? ? ?company ? ? ? ? Axel? that Consequently,? ? ? ? ? ? ?the? upcoming ? ? ? ? ? ? ?to three ?million. If?Axel hand, Telecommunications? has a target ? ? ? ? structure that ? ? 30% income of two million and it follows a residual dividends payout policy, what will be its dividend Problem 14-1 82 00:00 ? 14-1? ? ? ? ? its capital budget ? ? 20 E/ A decline investment ?Axel ?Telecommunications ? ? ? ? ? ? ? ? ? ? 70%? consists ??? ????????? ????? 30% ???????30 The ? ? ? ? ? anticipates ? ? ? ? ? ?? ?? ?? ?? ?? ? ? ? ? ?for? ?? ? ?? ?? ?? ?? ?? ?year ?will ?be ?? ?? ?? ? ?? ?? ?? ?? ?? ?? ? ? ? ? reports? net ? ? ? E)? ? ? ? ? ? ? ? D)? ? ?? ?? ? ? ?? ??for? ?? ? ?? ??declined? while ?cash ?inflows ? ? ? ? ? ? relatively constant, ? ? increase ? ? ? be ?expected in? the payout ration. ? ??? ? ?? ? ? would ? ? ? ? ? ? ?? ??? ? E/ If investment D) The following firms ? ? ? is given to ? ? That? Axel Telecommunications has a 70% debt capital structure and ? ? equity. Its capital budget for the upcoming ? ? ? three million and its net ?income is ?two million. We are asked to find the payout ratio. opportunities remained ? ? and Problem 14-1 answer. ? ? ? ? ? ? ? deduct ? ? ? ? ? ? ? ? ? tax us. information 30% ? ? ? ? ? 20? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? year? is ? Problem 14-1 Answer 83 00:00 F/ Permission forF)? ? ? ? ? ? ? ?to ? would ?dividendslead to? an ?increase in? dividends,as?for interest ? ? ? ? ? ? ? increase ? ? ? ? ?payout? ratio. If? the ? ? ? ? ? ? ? ? ? purposes ? ? corporations 14-1 in profits ? ? ? ? ? ? ? ? ? ? Axel ? ? ? ? as ?they ?do ? 70% ? ? ? ? 30necessarily to ? ? ? ? ? ? in ? ? ? 30? ? ? now ? ? % ? ? ? charges. D/ A permanent increase ? ? ? ? ? ? ? ? ? probably? ?for ? ? Telecommunications? ? ? ?but? not ? ? ? ? ? ? ? ? ? an? ? ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? aggregate profit increase were ? ?cyclical increase that could be expected to be followed by a decline, then the payout ratio might fall because firms do not generally raise d a E)? ? Problem 14-5. Northern??code?Northern? both? realized? and ? ?Cooling ? capital? gains ?in ? ? ? year? are??taxed at????solar?heating? system. ?To ? ? ? ? ? ? ? ? ? ? ? management ?plans to? expand production ?capacity? by? 40%? ? ? ? ? ? 40% ? ? ? ? ? ? ? ? ? ? ? in ?plant ? ? ?machinery. The ? ? ? ? ? ? ? to? maintain ? ?40%? debt? to ?assets2005? ? ? ? ? ? ? 50? six month patented ? same rate ? ? dividends.? this ? ? ? Problem 14-5 84 00:00 G/ A change in the ?tax?Pacific ?Heating ? ?Cooling ? ? unrealized Inc.? ? backlog ? ? any ? ? ?for? its? ?? 30%? the????900,000?as ? ? ? ? ? ? meet ? ? ? demand,? ? ? ? ? ? ? ? ? ? ? ? 40%? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? with? a $10,000,000 investment ? ? ? ? and ? ? ? ? ? ? ? ? firm wants ? 45%? ? ? a ? ? ? ? ? ? ? capital structure so ? ? ? ? ? ? paidthat ?of and ? ? ? ? ? and has ?a?interest? ? ? ? ? ? of orders ? ? ? dollars. ? ?? ? ? firms ? ? ? ?? ??? ??? ? Inc. ? ?? ? 900,000? ? ? ? ? ? ? ? ? ? F/ Dividends arewe 14-5 ?to? ? ? ? ? ? the ? ? ? ? Heating ? ? ?The? equity ? ? charges? from ?before-tax 6 portion Permission? forweight? to? deduct100 currently know is? ? ? ? ? ? ? ? ? ? ? ? dividends as? a due ?interest? charges? wouldby thedividendsbudget, whichto pay for than before and would thusthe capital budgetthe payout ratio. paid in the next year, approximately $900,000 make capital less costly equals $900,000. In other words, of tend to increase that needs to be G)? ? ? ? ? ? ? ? out ? Pacific ? ?retained. ? ? ? ? ? ? ? retained ?will ? ? ?equity ? ? ? ? after-tax dollars and ? ? ? ? ? ? ? ? ? ? The first14-5 answer. In order to solveequityproblem we need to determine what the retained earnings will theand what the external capitalis needed. We start with the retained earnings. The retained earnings equal the net income multiplied by one minus the payout ratio. In this case we know that the net income is 5 mill be the of structure, is 30%, multiplied ? Problem 14-5 Answer 85 00:00 Question thing F) need ? ? ? ? ? ? ? ? ? ? this? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?or ? ? ? equity ? ? ? ? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? which ? ? ? ? ? ? 1-? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 50? ? ? ? ? ? ? ? ? ? ? ? ? 55%? ? ? ? ? ? ? ? ? ? ? ? ? ? 27.5? ? ? ? ? ? ? ? ? ? ?? ? ?? ? ?? 20? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 900,000? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? be? ? ? ? ? ? ? ? ?? ? ? equity ??? ? 14-5 11? ???? G)? ?makeCompany? isCompany ???3? ? three ? ?and? would ?lead ?to ? ?each ?of ? ?in ? requires aratio.? ? ? ? investment. ? ? ?estimated ?external IRR and? cost? of ?capital for these projects are presented below. The company’s optimal capital structure calls for 50% debt and 50% equity. ? ? ?capital ? ?considering ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? whichthe ? ? ? ? ? ? ? ? ?Weltch gains? less attractive ? ? ? ? projects, increase ? ? ? payout $5,000,000 ? ? ? ? ? IRR The ? ? ? ? ? ? ? ? ?? ?? Problem 14-6 86 00:00 Problem changeThe ? ? ?? ? 14-6. would G/ Thisknow that ? Weltch? ?? ? ? ? ? ? two ?million,? and ? ?independent?????20? ?? anof? ?????????55%? ? ? ? ?then ?we ? ? ? ? have? earnings ?remaining ?of ? ? ? million ? ? 40%? 60%??? ???????50%? ? ? ? ? ? ? ? ? ? dividends. ?So,? the ? ? ? ? ?ration?using ? ? ?residual? dividend? model ? ? ? ? be 1.1? million divided by the initial two million of net inc 14-6 ? ? ? ? 11 50 ? ? ? ? ? ?? ? ? ? 50% ?? ? ? ? ? 100 ? ?? ? the 60? ? ? ? 27.5? ? ? ? would 32.5? ? ? ? ? So, wewe need to ? ? ? netout? the is? ? ? ? ? equity ?required. ????????? $900,000? ?? 1the ? ? ? ? ? ? ? ? ? ? ? ? ? ? if? ? ? take out ? ? ? ? ? ? ? that net? income,new ? ? would multiplied ? ? ? ? ? ? ? 1.1 1-? ? ?Well, to be paid out to ?stockholdersis ? ? ? ? ? 60 ? ? ? payout one ? ? ? the left we ? ? ? ? ? ? ? we ? Next, figure income new investment as of 40% would is to funded Problem 14-6 Answer 87 00:00 Problem 14-6 answer. ? ? ? ? ? ? external ? ? ? ? ? ? ? ? ? ? ? The total equity? required equals the ? ? ? investment ? ? ? ? ? ? ? by? 1 minus ?the debt ratio. ? ? ? H? ? know that a ? ? 16%? IRR? 20%? ?required at? $10,000,000 and ? ? ? minus ? ? ? debt? ratio ? ? ? 12%? IRR?give? us ?60%, ?which ? ? required ? 8%beIRR? 9%? by? equity. This would be ? 14-6 Weltch? ? ? ? ? 72.875? ? ? ? ? Weltech? ? ? residual model ? ?????? ? ???? ????????? ??????? ?????? ????????? ??? ?? ??? 10% ? ? ? ? ? ? ????? ? ? Weltch expects to have net income of 7.2875 million. If Weltch establishes its dividends from the residual model, what will be its payout ratio? We can see in our graph or in our chart that with project H of high risk, there is a cost in capital of 16% and an IRR of 20%. With project of medium risk, there is a cost in ? ? ? ? ? ? 4? ? ? ? ? ? ? This problem involves four steps. 1)? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? H,L? ? ? ? ? ? ? ? ? ? ? ? H,L? IRR? WACC? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 100? ? ? ? ? ? ? 1/ We need to determine ? ? ? capital ?budget? by ?selecting ?only ?those ? ? ? ? ? ?whose ? ? ? ? ? are ? ? ? ? ? ? ? ? ? ? ?projects' ?risk ?adjusted50? ? ?of ?capital.? In?this?case, ? ? ? ? ? H ? ? ?L? should be? chosen because H and L's internal rates of return exceed the weighted average cost in capital. So the firm's capital budget in or 2)? ? ? the ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? projects ? ? ? returns ? ? greater than the ? ? ? ? ? ? ? ? ? ? ? cost ? ? ? ? ? ? ? ? ? ? ? project ? and ????? ????? ? ? ? ? 72.875? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 50? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 22.875? ? ? ? 4? ? ? ? ? ? ? ? ? 22.875? ? ? ? ? ? ? ? ? ? 78.725? ? ? ? ? ? ? ? ? ? 31.39%? ? ? ? ? ? 2/ Now we must determine how much of that capital budget will be financed by equity. We can tell that the capital budget multiplied by the equity capital structure weight of 50% equals the equity required of approximately 5 million. Step three. Now we need to determine the dividends through the residual model. We were given that there was 7.8725 million in net income and now we deduct the equity required of 5 million, which gives us 2.2875 million left to pay out as dividends. Step four. This 2.2875 million in dividend payouts divided by the initial net income of 7.8725 gives us a payout ratio of approximately 31.39%. ...
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This note was uploaded on 10/13/2010 for the course USMLE na taught by Professor Na during the Spring '10 term at St. Matthew's University.

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