Lect 06 Fin 221 web

Lect 06 Fin 221 web - Managerial Finance Lecture 6 Equity...

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1 Managerial Finance Lecture 6 Equity and Firm Equity and Firm Valuation Orange County’s Investment Pool County Treasurer, Bob Citron Had reputation for delivering above normal returns on funds (about 2% over the State Treasury) He was able to do this while still investing in “safe” U.S. Treasuries and government-backed securities Some complained that he was taking hidden risks , but voters and other agencies in Orange County were quite happy December 1993 Fund has $ 7 5 Billion in equity 2 • Fund has $ 7.5 Billion in equity Steep Yield Curve : low short term / higher longer maturities
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2 Orange County’s Investment Pool Citron’s Strategy Invest in higher yielding medium term bonds 5% yield vs. 3% short-term rate Borrow additional funds at 3% • Use existing assets 3 as collateral • Invest borrowed funds in new bonds yielding 5% Do it again! 1.00 3.00 3m 6m 1yr 2yr 3yr 5yr 7yr 10yr 20yr 30yr Orange County Portfolio: Original investments $ 7.5 b Bi $13 0 b (th th T bill Borrowings $13.0 b (three-month T-bills) Investments $20.5 b (five year zeros, 5 percent) If yield stays constant: Gain = 20.5 * 5 % - 13 * 3 % = 0.635 b Return = 0.635 / 7.5 = 8.5 % Lots of money to spend ! 4
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3 Orange County’s Investment Pool What Happened? Interest rates Interest rates increased dramatically during 1994 What impact does this increase have on: 5 on: • The value of the fund’s assets ? • Value of liabilities ? 1.00 3.00 3m 6m 1yr 2yr 3yr 5yr 7yr 10yr 20yr 30yr Orange County Face value of zero coupon bonds: Investments: 164 . 26 ) 05 . 1 ( * 5 . 20 ) 1 ( * 5 5 r PV FV Debt: Present value of zero-coupons at the different rates: Current rates: + Investments 5 20 164 . 26 % 5 (@ PV 65 18 164 . 26 %) 7 (@ PV 39 . 13 ) 03 . 1 ( * 0 . 13 ) 1 ( * 1 1 r PV FV Higher rates (2 percentage points): + Investments - Debt = Net worth initially = $7.5b 6 . ) 05 . 1 ( %) 5 . ) 07 . 1 ( 5 0 . 13 ) 03 . 1 ( 39 . 13 %) 3 (@ 1 PV 75 . 12 ) 05 . 1 ( 39 . 13 %) 5 (@ 1 PV - Debt = Net worth after $5.9b Change Net worth = $5.9 - $7.5b=$ -1.6b
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4 Class 5: Summary Yield curve : plot of bond yields as a function of their maturity dates Yields are determined by market expectations Helpful in pricing (discounting) risk-free bonds Bonds : Fixed cash-flows: coupons (interest) and principal (or face value) Zero-coupon bonds: no coupon payments or pure discount bonds Yield to maturity: the IRR a bond investment that is held to maturity Bond prices and yields move in opposite direction Bond pricing and no-arbitrage: Law of one price: identical cash flows trade at identical prices We can price coupon bonds using zero-coupon (a) yields or (b) prices Bond prices : fixed income not fixed price! Bond prices change over time due to discounting and coupon payments Changing yields lead to changes in bond prices The sensitivity of bond prices to changes in interest rates is determined by the timing of the bonds’ cash-flows 7 Course roadmap: cash flows Part 1 : what is the value of future (“remaining life”) cash-flows ?
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Lect 06 Fin 221 web - Managerial Finance Lecture 6 Equity...

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