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Unformatted text preview: Introductory Finance (363)
Tuesday, Thursday: 11:00-12:15 12:30-1:45
Readings: Text Chapters 1, 2, 3, 4 (through page 109), 6 (up to p.169) Syllabus for 363
Professor Tim Koch Office: BA 460 Phone: 777-6748 [email protected] Objective Prerequisites Required Materials Lecture Notes Homework Exams Grading Expectations Tentative Schedule Syllabus for 363: Topics
This course serves as your introduction to the world of finance. Primary topics include: How do firms use capital markets to obtain funding? How do we calculate the value today of cash flows in the future? How are prices determined for the standard financial claims (stocks, bonds) issued by firms and bought by investors? What should be the equilibrium relationship between risk and expected return? How do firms decide which projects to pursue? What determines the mix of financial claims issued by the firm? Introduction to "exotic" financial products such as options, swaps and futures. International finance. Syllabus for 363: Objective We will emphasize the underlying principles and theories that pertain to each of these areas while at the same time presenting the context in which they operate. What we observe in the "real" world of finance results from the interaction of underlying principles with the current financial environment. The financial environment is bound to change, however, basic principles will remain the same. Understanding these basic principles will prepare you to operate in the financial environment of tomorrow, whatever tomorrow brings! Our objective, therefore, will be to understand why things happen in finance as opposed to memorizing historical facts. Syllabus for 363: Pre-Req's & Materials Prerequisites: ECON 221/222, ACCT 225/226, and 3 hours of statistics at the 200 level. Required Materials
Principles of Finance 3rd edition by Besley and Brigham (It is strongly recommended that you complete assigned readings prior to class.) Note if you can pick up a 2nd edition text at a cheap price that would be fine. A financial calculator is strongly recommended. It should have the ability to do Time Value of Money (TVM) problems. The textbook demonstrates the use of the Texas Instruments BAII plus (about $29). Another alternative is the Hewlett Packard 17BII (about $89). Finally, the TI-83 graphing calculator has a finance module that will meet most of your needs. Syllabus for 363: Lecture Notes
In order to reduce your note-taking, lecture notes will be available on the class web-site. Note: these lecture notes are a very poor substitute for actually attending class the notes that are posted on the website don't contain any solutions. Syllabus for 363: Homework All problem sets will be done on the Blackboard system (this significantly reduces the resources that must be devoted to grading.) I will announce them in class when they are posted to the Blackboard system, however, you are ultimately responsible for periodically checking the system to see whether you have work that is due. Each individual must submit their own entry, however, I encourage you to collaborate and work in groups. Detailed solutions will be posted on the web-site after the homeworks are collected. It is your responsibility to make sure that your homework has been accepted by the system. Every once in a while someone's internet connection is severed while completing the homework. If this happens, send the professor an e-mail immediately and I will reset your account. If it is after 6 pm on the deadline date and I have not reset your account, you can e-mail the answers to the instructor as a last resort. No late homeworks are accepted, EVER! Syllabus for 363: Exams It is your responsibility to show up on time for the exams. You may not make-up any exams after the scheduled exam dates unless for a valid reason such as illness (written proof required; a job interview is not a valid reason). There will be 3 mid-term exams and one cumulative final. Syllabus for 363: Grading Exam I: 20%, Exam II: 20%, Exam III 20%, Final: 30%, Homework 10%. For each exam, I will add a set number of points to every score so that the median grade is an 82 (augmented scores above 100 will be capped at 100.) To calculate final grades I will take a weighted average of exam and homework grades and assign letter grades according to the following scale: Each exam and the Final will be curved based on overall student performance on the exam. The assignment of final grades will be based on the curves for each exam and the Final Exam. Syllabus for 363
Work Environment and Attendance Policy Belk Auditorium is not an ideal space to hold a class. The ambient noise is high and the depth of the room makes it difficult for me to connect with everyone. Thus, it is imperative that we work together to make Belk as conducive a learning environment as possible.
Endeavor to arrive on time. Turn cell phones, beepers, etc off. In deference to those around you, refrain from talking. I will never end late on purpose, thus, don't pack up early. Remove trash and garbage at the end of class. Due to the large size of the class, attendance will not be taken. If you can't abide by these policies, just don't come to class! Syllabus for 363: Honesty
University of South Carolina Honor Code: It is the responsibility of every student at the University of South Carolina Columbia to adhere steadfastly to truthfulness and to avoid dishonesty, fraud, or deceit of any type in connection with any academic program. Any student who violates this Honor Code or who knowingly assists another to violate this Honor Code shall be subject to discipline. All forms of academic dishonesty are prohibited. These include cheating, plagiarism, lying in academic matters, fraud, bribery, unauthorized access to tests and examinations. Syllabus for 363: Exam Schedule
Exam 1: Tuesday, Sept 18 Exam 2: Thursday, October 23 Exam 3: Thursday, November 20 Final: for 11:00 class, Friday Dec 12 @ 9 a.m. for 12:30 class, Thursday Dec 11 @ 2:00 p.m. What is Finance? Economics: the science of how scarce resources - land, labor, capital - are allocated. Finance: the sub-field focused on the allocation of capital. Alternative View of Finance $ Ideas No $ ? No Ideas The Primary Players in Capital Allocation Firms:
08/2004: Google sets $2.7 billion IPO Popular search engine company files for its eagerly anticipated initial public offering. 12/2005: Harley-Davidson sells $200m 5-yr NC bonds due 2010 at 99.982. 12/2003: Cemex Completes Equity Offering: The company announced that it and certain holders of its American depositary shares sold a total of 29.3 million ADSs. Primary Players II Individuals Primary Players III Markets Primary Players IV Financial Institutions Primary Players V Governments and Regulatory Bodies Organization of Firms
Typical legal structures for ownership and control: Sole Proprietorship (default legal structure). 1 owner/manager Unlimited liability Taxation at the individual level Multiple owner/managers Unlimited liability Taxation at the individual level Separation of ownership and control Limited liability for owners (shareholders) Double taxation Partnership (General and Limited) Corporations (U.S: Inc, France: SA, Italy: SpA, Sweden: AB, etc.) Limited Liability Companies (LLC) and S-Corps Organization of Firms II Composition of U.S. Firms - 2003
100% 80% 60% 40% 20% 0% # of Revenue Net Total Returns Income Assets Proprietor Partner S Corp Corp Source: IRS Corporate Form of Organization
Benefit: Ability to raise capital is much better. No special skills needed to be a shareholder Shareholders delegate managerial responsibilities. Ownership is divisible so investors can diversify Liquid public shares are a "currency" for acquisitions. But requires a liquid secondary market + legal protection for minority shareholders + adequate disclosure. Costs: Principal-agent conflict Board of Directors "supervises" managers. Disclosure laws + financial institutions alleviate problem Asymmetric information Double taxation (partial relief is usually available) A Typical Corporation
Assets Current Assets Cash Marketable Sec Receivables Inventories Other Long-Term Assets Financial Rec. PPE Net Other/Goodwill 238 658 2,318 288 49 3,551 726 1,024 231 1,981 Liabilities Current Liabilities Accounts Payable Accrued & Other Current Debt 283 480 833 1,596 LT Liabilities Finance Debt Other LT Liabs Retiree Healthcare Shareholders Equity Par Value Paid-in Capital Retained Earning 870 109 201 1,180 3 766 1,987 2,756 5,532 Total Assets 5,532 Total Liabilities Characteristics of Debt
Bonds Principal, Face Value, Maturity Value, Par Value. Coupon Rate, Interest rate. Maturity. Control Rights. Restrictive Covenants. Default Risk Rating. Usually relatively short term Coupon Rate is often floating Not publicly traded, therefore much less standardized Bank Loans Characteristics of Common Stock No maturity date. Receive (hopefully) periodic dividends. Rightful owners of residual firm value. Residual rights of control. Delegate day-to-day decisions to managers. Board of Directors elected to supervise managers. Retain responsibility for voting on a few major decisions. Limited Liability. Usually only 1 class of common shares. Financing A Typical Corporation Debt: 12/08 Medium Term Notes (3 5/8%): $800 m. 12/10 Medium Term Notes (5%): $200m Bank Loans (2009) Common Stock (Equity): 258 million shares @ ~ $55 per share ~25,000 reasonably dispersed shareholders
Management owns ~0.75% of shares Institutions & Mutual Funds own ~ 81%: Davis
Advisors LP (9.2%), Capital Research (6.3%), UBS (3.2%), Janus (3.1%), Barclay's Bank PLC (3.1%), State Street (3.0%) A Typical Corporation (III) Board of Directors: Barry Allen: VP Ops, Qwest Communications Richard Beatie: Lawyer (Corp Gov. Specialist) Jeffrey Bleustein: HD Chairman (former CEO) George Conrades: Chairman of Akamai Technologies Judson Green: CEO of NAVTEQ Corp (digital mapping) Donald James: Chairman & CEO of Deeley HD Canada Sara Levinson: Former Pres of Women's Group of Rodale George Miles: CEO of WQED Multimedia James Norling: Former Motorola Executive James Ziermer: HD CEO Characteristics of Preferred Stock No maturity date. Periodic, contractually specified dividends. Usually cumulative. Some dividends are "floating", determined by special formulas. Junior to debt but senior to common equity. Control/voting rights kick in if dividends are missed. Limited Liability Multiple classes are typical. What About Derivative Securities?
Examples: Call and Put Options Forward Contracts Futures Contracts Interest Rate and Currency Swaps Special Characteristics: Relatively short maturities. Payoffs at maturity are a function of "price" of some underlying asset these are essentially 2 sided bets. While derivative payoffs might be linked to a firm's stock price, they are usually not issued by the firm. Derivatives are very useful for managing exposure to risk. Typical Capital Structure
Bank Debt 100% 80% 60% 40% 20% 0% Full Sample Has Public Debt Retained Earnings Par Value + Additional Paid-in Capital Non-Bank Debt Public Debt When Dispersed Ownership Goes Bad...
Recent Examples: Worldcom: The company filed for Chapter 11 bankruptcy protection July 21 2002--the largest-ever U.S. bankruptcy filing, claiming $107 billion in assets--after admitting in late June that it overstated its cash flow by $3.8 billion. Enron: tops the list of America's biggest corporate collapses. The giant energy group filed for bankruptcy protection last December (2001) after admitting that its profits over the previous few years had been nearly $600m lower than what had been claimed. Enron's standing was battered when it was revealed that it had used "special purpose vehicles", or off-balance sheet entities, to enhance its earnings and reduce its debt. Even worse, it emerged that Andrew Fastow had a role in running one of the off-balance sheet partnerships in an apparent conflict with his role as Enron's chief financial officer.
Parmalat: ...an Italian company specialising in long-life milk, is suspected of
having perpetrated a massive fraud. Billions of euros have gone missing from its books in a scandal that has drawn parallels with the collapse of Enron, the US energy giant. The company has admitted that the true level of its debt is 14.3bn (10bn) - eight times more than it claimed. Corporate Scandal Sheet through 2002: http://www.forbes.com/2002/07/25/accountingtracker.html How Are Securities Issued Primary Markets
Hire an Investment Bank: Citigroup, Merrill Lynch, Morgan Stanley, Goldman Sachs, etc. Advises on market conditions, timing, and pricing. Files necessary legal documents with SEC (registration statement + prospectus). Forms an Underwriting Syndicate to spread risk plus potentially a Selling Group. Advertises offering to potential investors Road Shows. Sets offering price, sells the securities
Underwritten Offer: Underwriting Syndicate buys entire security issue from firm (at a discount) then immediately begins to sell to investors. Best Efforts Offer: Underwriting Syndicate simply intermediates. Often commits to support offering in the after-market and to provide analyst coverage Why Are Secondary Markets so Important?
Fact #1: Most securities (common stock, preferred stock, bonds) have relatively long lives. Fact #2: Most investors have relatively short investment horizons (Harley shares are held for less than 5 months on average.) Implication: A "short-term" investor will only purchase a "long-term" security if there is a market in which they can sell that security to another investor Separation of Ownership and Control requires a wellfunctioning secondary market! Secondary Financial Markets Key Functions/Characteristics of Markets: Minimize transactions costs Location low search costs Rules & regulations Security standardization & specialization Presence of dealers Provide liquidity/volume Provides information that helps establish fair prices Transparency Record keeping & display New York Stock Exchange
Characteristics (2006): Largest stock exchange by $ volume ($11 tr/yr). Lists about 2,747 corporations (market value $25 tr.) including 453 non-U.S. corporations Volume of ~ 1.6 billion shares per day. ( All trades are secondary trades.) Located in downtown Manhattan. Trade occurs Monday-Friday, 9:30 - 4:00. Hybrid market now combines the traditional auction & dealer process with electronic trading. Smaller orders (95% of trades, 45% of volume) are electronically routed to the specialists workstation via SuperDOT and are automatically executed. Bigger orders are transmitted to brokers hand-helds on the floor and are "worked" by the broker. Joined with Euronext April 4, 2007. American & Regional Stock Exchanges
Amex Characteristics: Established in 1921 - trade used to occur on a curb on Wall Street - moved inside and became AMEX in 1953. Operates similarly to NYSE. Firms on AMEX tend to be younger and smaller than on NYSE. Lists 1,022 firms with average total daily volume of ~50m shares, total market capitalization of $565 Bn. Philadelphia, NSX (formerly Cincinnati), Chicago, Pacific... Regional Exchanges: Over The Counter Markets NASDAQ: North American Securities Dealers Automatic Quotation System. Computer network of brokers and dealers posting bid & ask prices. Brokers will execute trades for you. Dealers maintain an inventory of shares that they trade. Firms tend to be younger, smaller and high tech. Trading started in 1971. ~3,200 firms list on NASDAQ, 335 are non U.S. 2nd in size after NYSE (was #1 for a while) NASDAQ Workstation Screen ECN's
Electronic Communication Networks Subscribers submit buy and sell orders (market and limit). If your buy order crosses with a sell order, execution occurs automatically. Subscribers see entire order book. Best bid and ask quotes are displayed in NASDAQ system. As of 2003, account for ~40% of volume for NASDAQ stocks, ~5% of volume for NYSE stocks. Offer round the clock trading, however, markets are lacking in liquidity and order. Examples: INET, Archipelago, Redi-Book, BATS, Brut. Yahoo on Island ECN Equity Market Data: 2005
Market NYSEc NASDAQ London Deutsche Brse Euronext Borse Italiana Tokyo Shanghai Shenzhen Hong Kong Sao Paulo Cap. 15,421 3,865 3,794 1,638 3,708 1,027 4,614 918 228 1,715 710 $ Value Traded 21,790 11,807 7,571 2,737 3,853 1,591 5,822 736 422 832 276 Firms (Foreign Firms) 2,280 (451) 3,133 (321) 3,256 (343) 760 (104) 1,210 (256) 311 (27) 2,416 (25) 842 (0) 579 (0) 1,173 (8) 350 (3) New List/Delist 128/150 156/NA 576/428 35/NA 52/54 45/17 114/49 13/4 52/7 62/23 32/25 All figures in US $ billions Financial Markets: Fixed Income Bond Markets Almost always "over-the-counter". Size of global bond market (2005): ~ $59 trillion U.S. ~ $25 trillion. (U.S. GDP ~ $12.5 trillion)
~ 2/3 of the value of all securities in the U.S. capital market Europe ~ $19 trillion. Japan ~ $9 trillion. Capital Market = long-term, Money Market = short-term. U.S. Bond Market Breakdown
$ Amount by Issuer
Municipal: 8.6% U.S. T reas.: 16.2% Agency: 11.9% MBS: 24.0% ABS: 7.7% Corporate: 31.6% Keeping Track of Equity Markets We usually think in terms of rates of return (r) rather than absolute price levels
r= End Price - Beginning Price + Cash Flow Beginning Price Example: Diageo Plc ADR. 82.32 - 71.17 + 1.457 + 0.981 r= 9/13/06: $1.457 dividend 71.17 = .1909 or 19.09% 3/7/07: $0.981 dividend 8/14/06: $71.17 per share 8/14/07: $82.32 per share Keeping Track of Equity Markets (II)
Indexes provide better summaries than individual securities for each market
Country United States Japan China United Kingdom Germany France Mexico Brazil Index DJIA, S&P500, NASDAQ Composite Nikkei 225, Topix Shanghai Composite, Shenzen Component FTSE 30, FTSE 100, FTSE 250 Frankfurt Xetra DAX Paris CAC 40 I.P.C. All Shares Bovespa Various Equity Indexes Since 1990
Index Cumulative Returns
1400% 900% 400% -100% May-90 DJIA S&P NASDAQ CAC40 DAX Shanghai Nikkei
May-95 May-00 May-05 Keeping Track of Fixed Income Markets While bond price indexes exists, we generally don't focus on prices...why? Hint: what do we know about a bond that we don't know about a common stock? For bonds, we usually focus on what is their yield-to-maturity or yield. Given today's price, the yield is the rate of return that you will earn if you hold the bond to maturity and the bond does not default. Various Yield Curves The U.S. Investment Experience G-7 Capital Markets: 2005
Country Domestic Bank Assets to GDP 75% 96% 125% 245% 146% 290% 143% Stock Market Capitalization to GDP 136% 165% 44% 73% 45% 137% 131% Corporate Bond Market Capitalization to GDP 114% 44% 42% 42% 44% 39% 21% United States Japan Germany France Italy United Kingdom Canada Sources: IMF-IFS annual reports, World Bank Databases Financial Institutions
Financial Institutions provide financial intermediation Example: Investor opens a checking account, bank makes a 5 year term loan to a local business. Primary types of Financial Institutions:
1. 2. 3. 4. "Banks": Commercial Banks, Credit Unions, S&L's Insurance Companies Pension Funds Mutual Funds Investors: Who Owns What?
Households State & Local Gov. Banks Trusts & Estates Life Insurance Other Insurance Private Pensions Gov Pensions Mutual Funds Broker - Dealers U.S. Monetary Auth. Non-U.S. Others Corporate Equity 38% <1% <1% 1% 6% 1% 11% 9% 21% <1% 10% Corporate Bonds 6% 1% 9% <1% 25% 3% 6% 6% 10% 3% 24% 6% Treasury Securities 12% 8% 5% 1% 4% "" 7% "" 6% 17% 37% 2% Government Regulation: The SEC
Two major laws govern trading of securities: Securities Act of 1933: Requires firms to file a registration statements and a prospectus when publicly selling securities. Securities Exchange Act of 1934: Established the SEC. Required firms with publicly traded securities to periodically file financial reports/statements. Required disclosure of insider security transactions. Empowered the SEC to regulate exchanges, OTC trading, brokers, dealers, etc. State "Blue Sky" laws, the Federal Reserve, FDIC, CFTC have a secondary impact on securities markets. Government Regulation: Financial Intermediaries Banks Federal Reserve monitors and regulates Commercial Banks. Office of Thrift Supervision and National Credit Union Administration regulate thrifts and credit unions. FDIC insures deposits up to $100,000. Primarily regulated by state in which incorporated. National Association of Insurance Commissioners helps coordinate activities. Insurance Companies: Mutual Funds: SEC Pension Funds: SEC, Department of Labor Employee Retirement Income Security Act Pension Benefit Guarantee Corporation. The Federal Reserve
Details: Created in 1913 to supervise banking system and ensure stability. Consists of 12 regional district Fed banks Board of Governors and Fed Chairman appointed by the President and confirmed by the Senate. Tasks: Supplies clearance mechanism/system Provides loans and deposit services to banks Holds the U.S. "checking account" Supervises banks Manages the money supply. The Fed has a huge impact on the economy through its control of the money supply and subsequent impact on interest rates! Summary Separation of ownership and control in corporations demands the existence of well developed financial markets. Primary financial claims sold by corporations: Debt Common Equity Preferred Equity Common share-holders are the owners of the corporation. Control is delegated to managers who are supervised by a board of directors elected by share-holders. National Distillers: 25 year 4 % Sinking Fund Debenture due May 1, 1983. COUPONS CALL FEATURE ABILITY TO MODIFY The Reading Co.
3 1/8% First and Refunding Mortgage Bond Due May 1, 1995 CALL FEATURE Seatrain Lines Common Stock NYSE: Facade NYSE: Trading Floor No More Paper! NYSE: Trading Floor ...
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This note was uploaded on 06/22/2011 for the course FINA 363 taught by Professor Masoudie during the Fall '10 term at South Carolina.
- Fall '10