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Unformatted text preview: Review material for the Finance section of ETS exam Index Corporate Finance 0B Time Value of money 15B Capital Budgeting 16B Working capital management 17B Financial statement analysis 18B Cost of capital and capital structure 19B Investments 1B Risk and return 20B Valuation of securities 21B Financial markets and environments 2B International Finance 2B Finance review for ETS 11/10/08 1 Corporate Finance Time Value of Money 3B Future Value and Compounding Investing for a single period If you invest $X today at an interest rate of r, you will have $X + $X(r) = $X(1 + r) in one period. Example: $100 at 10% interest gives $100(1.1) = $110 Investing for more than one period Reinvesting the interest, we earn interest on interest, i.e., compounding FV = $X(1 + r)(1 + r) = $X(1 + r)2 Example: $100 at 10% for 2 periods gives $100(1.1)(1.1) = $100(1.1)2 = $121 In general, for t periods, FV = $X(1 + r)t where (1 + r)t is the future value interest factor, FVIF(r,t) Example: $100 at 10% for 10 periods gives $100(1.1)10 = $259.37 13B Present Value and Discounting The Single‐Period Case Given r, what amount today (Present Value or PV) will produce a given future amount? Remember that FV = $X(1 + r). Rearrange and solve for $X, which is the present value. Therefore, PV = FV / (1 + r). Example: $110 in 1 period with an interest rate of 10% has a PV = 110 / (1.1) = $100 Discounting – the process of finding the present value. Present Values for Multiple Periods PV of future amount in t periods at r is: PV = FV [1 / (1 + r)t] where [1 / (1 + r)t] is the discount factor or the present value interest factor, PVIF(r,t) Example: If you have $259.37 in 10 periods and the interest rate was 10%, how much did you deposit initially? PV = 259.37 [1/(1.1)10] = 259.37(.3855) = $100 Discounted Cash Flow (DCF) – the process of valuation by finding the present value More on Present and Future Values Present versus Future Value 14B Finance review for ETS 11/10/08 2 Present Value factors are reciprocals of Future Value factors: PVIF(r,t) = 1 / (1 + r)t and FVIF(r,t) = (1 + r)t Example: FVIF(10%,4) = 1.14 = 1.464 PVIF(10%,4) = 1 / 1.14 = .683 Basic present value equation: PV = FV [1 / (1 + r)t] Determining the Discount Rate Start with the basic time value of money equation and rearrange to solve for r: FV = PV(1 + r)t r = (FV / PV)1/t – 1 Or you can use a financial calculator to solve for r (I/Y on the calculator). It is important to remember the sign convention on most calculators and enter either the PV or the FV as negative. This is where most students run into difficulties when solving for r. One way to help them remember the sign convention is to have them enter all cash inflows as positive and cash outflows as negative, regardless of the type of problem being solved. Example: What interest rate makes a PV of $100 become a FV of $150 in 6 periods? r = (150 / 100)1/6 – 1 = 7% or PV = ‐100; FV = 150; N = 6; CPT I/Y = 7% Finding the Number of Periods FV = PV(1 + r)t – rearrange and solve for t. Remember your logs! t = ln(FV / PV) / ln(1 + r) Or use the financial calculator, just remember the sign convention. Example: How many periods before $100 today grows to $150 at 7%? t = ln(150 / 100) / ln(1.07) = 6 periods Rule of 72 – the time to double your money, (FV / PV) = 2.00 is approximately (72 / r%) periods. The rate needed to double your money is approximately (72/t)%. Example: To double your money at 10% takes approximately (72/10) = 7.2 periods. Example: To double your money in 6 years takes approximately (72/6) = 12%. Future and Present Values of Multiple Cash Flows Future Value with Multiple Cash Flows 23B Finance review for ETS 11/10/08 3 There are two ways to calculate the future value of multiple cash flows: compound the accumulated balance forward one period at a time, or calculate the future value of each cash flow and add them up. Present Value with Multiple Cash Flows There are two ways to calculate the present value of multiple cash flows: discount the last amount back one period and add them up as you go, or discount each amount to time zero and then add them up. A Note on Cash Flow Timing In general, we assume that cash flows occur at the end of each time period. This assumption is implicit in the ordinary annuity formulas presented. Valuing Level Cash Flows: Annuities and Perpetuities Present Value for Annuity Cash Flows Ordinary Annuity – multiple, identical cash flows occurring at the end of each period for a fixed number of periods. The present value of an annuity of $C per period for t periods at r percent interest: PV = C[1 – 1/(1 + r)t] / r Example: If you are willing to make 36 monthly payments of $100 at 1.5% per month, what size loan can you obtain? PV = 100[1 – 1/(1.015)36] / .015 = 100(27.6607) = 2,766.07 or use the calculator: PMT = ‐100; N = 36; I/Y = 1.5; CPT PV = 2,766.07 (Remember that P/Y = 1 when using period rates.) 24B Finding the payment, C, given PV, r and t PV = C[1 – 1/(1 + r)t] / r C = PV {r / [1 – 1/(1 + r)t]} Example: If you borrow $400, promising to repay in 4 monthly installments at 1% per month, how much are your payments? C = 400 {.01 / [1 – 1/(1.01)4]} = 400(.2563) = 102.51 or use the calculator: PV = 400; N = 4; I/Y = 1; CPT PMT = ‐102.51 Finance review for ETS 11/10/08 4 Finding the number of payments given PV, C, and r PV = C [1 – 1/(1 + r)t] / r t = ln[1 / (1 – rPV/C)] / ln(1 + r) Example: How many $100 payments will pay off a $5,000 loan at 1% per period? t = ln[(1 / 1 ‐ .01(5000)/100)] / ln(1.01) = 69.66 periods or use the calculator: PV = 5000; PMT = ‐100; I/Y = 1; CPT N = 69.66 periods (remember the sign convention; you will receive an error if you don’t enter either the PMT or the PV as negative) Finding the rate given PV, C, and t There is no analytical solution. Trial and error requires you to choose a discount rate, find the PV and compare to the actual PV. If the computed PV is too high, then choose a higher discount rate and repeat the process. If the computed PV is too low, then choose a lower discount rate and repeat the process. Or you can use a financial calculator. Example: A finance company offers to loan you $1,000 today if you will make 48 monthly payments of $32.60. What rate is implicit in the loan? N = 48; PV = 1000; PMT = ‐32.60; CPT I/Y = 2% (Remember the sign convention.) This is a monthly rate, consistent with N as number of months, and PMT as payment per month. Future Value for Annuities FV = C[(1 + r)t – 1] / r Example: If you make 20 payments of $1,000 at the end of each period at 10% per period, how much will you have in your account after the last payment? FV = 1,000[(1.1)20 – 1] / .1 = 1,000(57.275) = $57,275 or use the calculator: PMT = ‐1,000; N = 20; I/Y = 10; CPT FV = 57,275 (Remember to clear the registers before working each problem.) A Note on Annuities Due Annuity due – the first payment occurs at the beginning of the period instead of the end. Perpetuities Perpetuity – series of level cash flows forever PV = C / r Finance review for ETS 11/10/08 5 Preferred stock is a good example of a perpetuity. Comparing Rates: The Effect of Compounding Periods Effective Annual Rates and Compounding Stated or quoted interest rate – rate before considering any compounding effects, such as 10% compounded quarterly Effective annual interest rate – rate on an annual basis, that reflects compounding effects, e.g., 10% compounded quarterly has an effective rate of 10.38% Calculating and Comparing Effective Annual Rates (EAR) EAR = [1 + (quoted rate)/m]m – 1 where m is the number of periods per year Example: 18% compounded monthly is [1 + (.18/12)]12 – 1 = 19.56% EARs and APRs Annual percentage rate (APR) = period rate times the number of compounding periods per year The quoted rate is the same as an APR. 25B Loan Types and Loan Amortization Pure Discount Loans Borrower pays a single lump sum (principal and interest) at maturity. Treasury bills are a common example of pure discount loans. 26B Interest‐Only Loans Borrower pays only the interest each period and then pays the entire principal at maturity. Corporate bonds are a common example of interest‐only loans. Amortized Loans Borrower repays part or all of principal over the life of the loan. Two methods are (1) fixed amount of principal to be repaid each period, which results in uneven payments, and (2) fixed payments, which results in uneven principal reduction. Traditional auto and mortgage loans are examples of the second type of amortized loans. Finance review for ETS 11/10/08 6 Capital Budgeting 4B Net Present Value The Basic Idea Net present value – the difference between the market value of an investment and its cost. While estimating cost is usually straightforward, finding the market value of assets can be tricky. The principle is to find the market price of comparables or substitutes. Estimating Net Present Value Discounted cash flow (DCF) valuation – finding the market value of assets or their benefits by taking the present value of future cash flows by estimating what the future cash flows would trade for in today’s dollars. 27B The Payback Rule Defining the Rule Payback period – length of time until the accumulated cash flows equal or exceed the original investment. Payback period rule – investment is acceptable if its calculated payback is less than some prespecified number of years. Analyzing the Rule ‐No discounting involved ‐Doesn’t consider risk differences ‐How do we determine the cutoff point ‐Bias for short‐term investments Redeeming Qualities of the Rule ‐Simple to use ‐Bias for short‐term promotes liquidity Summary of the Rule Advantages: Easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity Disadvantages: Ignores the time value of money 28B Finance review for ETS 11/10/08 7 Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long‐term projects The Internal Rate of Return Internal rate of return (IRR) – the rate that makes the present value of the future cash flows equal to the initial cost or investment. In other words, the discount rate that gives a project a $0 NPV. 29B IRR decision rule – the investment is acceptable if its IRR exceeds the required return. NPV and IRR comparison: If a project’s cash flows are conventional (costs are paid early and benefits are received over the life), and if the project is independent, then NPV and IRR will give the same accept or reject signal. Problems with the IRR Non‐conventional cash flows – the sign of the cash flows changes more than once or the cash inflow comes first and outflows come later. If the cash flows are of loan type, meaning money is received at the beginning and paid out over the life of the project, then the IRR is really a borrowing rate and lower is better. If cash flows change sign more than once, then you will have multiple internal rates of return. This is problematic for the IRR rule, however, the NPV rule still works fine. Mutually exclusive investment decisions – taking one project means another cannot be taken Redeeming Qualities of the IRR ‐People seem to prefer talking about rates of return to dollars of value ‐NPV requires a market discount rate, IRR relies only on the project cash flows The Profitability Index Profitability index – present value of the future cash flows divided by the initial investment (both numerator and denominator are positive). This definition assumes no negative cash flows after year zero. Technically, PI = PV of inflows / PV of outflows, thus a nonconventional project’s PI will have a PV in both the numerator and the denominator. If a project has a positive NPV, then the PI will be greater than 1. 30B Finance review for ETS 11/10/08 8 The Practice of Capital Budgeting It is common among large firms to employ a discounted cash flow technique such as IRR or NPV along with payback period or average accounting return. It is suggested that this is one way to resolve the considerable uncertainty over future events that surrounds the estimation of NPV. 31B Finance review for ETS 11/10/08 9 Working Capital Management 5B Float and Cash Management Reasons for Holding Cash Speculative motive – take advantage of unexpected opportunities Precautionary motive – cash for emergencies Transaction motive – day‐to‐day cash requirements to meet expenses Costs of Holding Cash – The opportunity cost of holding cash is the return that could be earned by investing the cash in other assets. However, there is also a cost to convert between cash and other assets. The optimal cash balance will balance these costs to minimize the overall cost of holding cash. Understanding Float Book balance – the amount of cash recorded in the accounting records of the firm Available balance – the amount of cash the bank says is available to be withdrawn from the account (may not be the same as the amount of checks deposited minus amount of checks paid, because deposits are not normally available immediately) Float = Available balance – book balance Negative float implies that checkshave been deposited that are not yet available. The firm needs to be careful that it does not write checks over the available balance, or the checks may bounce. Positive float implies that checks have been written that have not yet cleared. The company needs to make be sure to adjust the available balance so it does not think that there is more money to spend than there actually is. Disbursement float – generated by checks the firm has written that have not yet cleared the bank; arrangements can be made so that this money is invested in marketable securities until needed to cover the checks. Collection float – generated by checks that have been received by the firm but are not yet included in the available balance at the bank Managers need to be more concerned with net float and available balances than with the book balance. 32B The three components of float are: ‐Mail float – the time the check is in the mail ‐Processing float – handling time between receipt and deposit Finance review for ETS 11/10/08 10 ‐Availability float – time to clear the banking system Float management – speeding up collections (reducing collection float) and slowing down disbursements (increasing disbursement float) Cash Management: Collection, Disbursement, and Investment Cash Collection and Concentration Collection Time = mailing time + processing delay + availability delay Cash collection policies depend on the nature of the business. Firms can choose to have checks mailed to one location, or many locations (reduces mailing time), or allow preauthorized payments. Many firms also accept online payments either with a credit card or with authorization to request the funds directly from your bank. 3B Lockboxes – special post office boxes that allow banks to process the incoming checks and then send the information on account payment to the firm; that reduces processing time and often reduces mail time because several regional lockboxes can be used. Cash concentration is the practice of moving cash from multiple banks into the firm’s main accounts. This is a common practice that is used in conjunction with lockboxes. Managing Cash Disbursements Increasing disbursement float – slowing payments by increasing mail delay, processing time, or collection time. May not want to do this from both an ethical standpoint and a valuation standpoint. Slowing payment could cause a company to forgo discounts on its accounts payable. As we will see later in the chapter, the cost of forgoing discounts can be extremely high. Controlling disbursements – minimize liquidity needs by keeping a tight rein on disbursements through any ethical means possible. Zero‐balance accounts – maintain several sub‐accounts at regional banks and one master account. Funds are transferred from the master account when checks are presented for payment at one of the regional accounts. This reduces the firm’s liquidity needs. Controlled disbursement accounts – the firm is notified on a daily basis how much cash is required to meet that day’s disbursements and the firm wires the necessary funds. Investing Idle Cash Temporary cash surpluses: ‐seasonal or cyclical activities Finance review for ETS 11/10/08 11 ‐planned or possible expenditures The goal is to invest temporary cash surpluses in liquid assets with short maturities, low default risk, and high marketability Credit and Receivables Components of Credit Policy ‐Terms of sale – defines credit period and any available discounts ‐Credit analysis – estimating probability of default for individual customers to determine who receives credit and at what terms ‐Collection policy – what steps will be taken to collect on receivables, particularly when customers are late with their payment Terms of the Sale ‐Credit period – amount of time allowed for payment ‐Cash discount and discount period – percent of discount allowed if payment is made during the discount period ‐Type of credit instrument Basic form: 2/10 net 60 means 2% discount if paid in 10 days; total amount is due in 60 days if the discount is not taken. In this example, the 60 days is the net credit period, the 10 days is the discount period and the 2% is the cash discount amount. The invoice date is the date for which the credit period starts. This is normally the shipping date, but some companies may post‐date the invoice to encourage customers to order early. 34B Length of the credit period depends on: ‐Buyer’s inventory and credit cycle ‐Perishability and collateral value ‐Consumer demand ‐Cost, profitability, and standardization ‐Credit risk ‐Size of the account ‐Competition ‐Customer type Cash discounts – offered by sellers to induce early payment. Not taking the discount involves a cost of credit for the purchaser. Finance review for ETS 11/10/08 12 Cost of credit – the cost of not taking discounts offered (this is a benefit to the company granting credit) Periodic rate = (discount %) / (100% – discount %) Number of periods per year = m = 365 / (net credit period – discount period) APR = m(periodic rate) EAR = (1 + periodic rate)m – 1 Example: Consider terms of 1/15 net 45 (assume payment is made on time in 45 days when the discount is forgone) Periodic rate = 1/99 = .0101 Number of periods per year = m = 365 / (45 – 15) = 12.166667 APR = 12.166667(.0101) = 12.288% EAR = (1.0101)12.166667 – 1 = 13.01% Offering discounts generally reduces the average collection period and thus the cash cycle. This reduces the amount of financing required, but the company loses sales in the amount of the discount taken. Consequently, the firm needs to look at the size and timing of the expected cash flows to determine what, if any, discount should be offered. Credit instruments – evidence of indebtedness ‐Open account – invoice only ‐Promissory note – basic IOU, may be used when the order is large or the purchasing firm has a history of late payments ‐Commercial draft – request for funds sent directly to the purchaser’s bank ‐Sight draft – payable immediately ‐Time draft – payment required by some future date ‐Trade acceptance – buyer accepts draft with agreement to pay in the future ‐Bankers’ acceptance – bank accepts draft and guarantees payment Optimal Credit Policy An optimal credit policy is one in which the incremental cash flows from sales are equal to the incremental costs of carrying the increased investment in accounts receivable. The cost of granting credit is described by the total credit cost curve, which depicts the trade‐off between two kinds of costs: Carrying costs – required return on receivables, losses from bad debts, costs of managing credit and collections Opportunity costs – potential profit from credit sales that is lost Credit Analysis Finance review for ETS 11/10/08 13 Credit information: ‐Financial statements ‐Credit reports (i.e., Dun and Bradstreet) ‐Banks ‐Customer’s payment history Credit evaluation – trying to estimate probability of default Five Cs of Credit ‐Character – evidence of willingness to pay ‐Capacity – ability to pay out of operating income ‐Capital – financial reserves ‐Collateral – assets that can be pledged as security ‐Conditions – economic conditions that may affect the firm’s ability to pay Credit scoring – assigning a numerical rating to customers based on credit history Collection Policy Monitoring receivables – keeping track of payments to try and spot potential problems (chronic late‐payers and possible defaults) to reduce losses. Aging schedule – a break‐down of receivables accounts by age Collection effort – the sequence of steps taken in collecting overdue accounts. Typical steps: ‐Send delinquency letter ‐Call customer ‐Employ collection agency ‐Initiate legal proceedings Inventory Management The Financial Manager and Inventory Policy Many people, not just those in the finance function, influence the level of inventory. Nonetheless, financial managers see the results of inventory decisions in many places – ROA, inventory turnover, and Days’ Sales in Inventory ratios, to name a few. Inventory Types For a manufacturer, inventory is classified into one of three categories: ‐Raw materials 35B Finance review for ETS 11/10/08 14 ‐Work‐in‐progress ‐Finished goods Classification into one of these categories depends on the firm’s business; raw materials for one firm may be finished goods for another. Inventory types have different levels of liquidity. Demand for raw materials and work‐in‐progress depends on the demand for finished goods. Inventory Costs There are two basic types of costs associated with current assets in general and inventory in particular – carrying costs and shortage costs. Finance review for ETS 11/10/08 15 Financial Statement Analysis 6B Standardized Financial Statements Standardized statements allow users to compare companies of different sizes or better compare a company as it grows through time. 36B Common‐Size Balance Sheets All accounts are expressed as a percent of total assets. Common‐Size Income Statements All items are expressed as a percent of sales. Ratio Analysis Categories of Financial Ratios: • Short‐term solvency, or liquidity, ratios attempt to measure a firm’s ability to pay bills in the short‐
run Current Ratio = current assets / current liabilities Quick Ratio = (current assets – inventory) / current liabilities Cash Ratio = cash / current liabilities • Long‐term solvency, or financial leverage, ratios attempt to measure a firm’s ability to meet long‐
term obligations Total debt ratio = (total assets – total equity) / total assets = total debt / total assets variations: debt/equity ratio = (total assets – total equity) / total equity = total debt / total equity equity multiplier = 1 + debt/equity ratio Times interest earned ratio = EBIT / Interest Cash coverage ratio = (EBIT + depreciation) / interest • ‐Asset management, or turnover, ratios attempt to measure how efficiently, and effectively, a firm uses its assets Inventory turnover = cost of goods sold / inventory Days’ sales in inventory = 365 days / inventory turnover Receivables turnover = sales / accounts receivable 37B U Finance review for ETS 11/10/08 16 Days’ sales in receivables = 365 days / receivables turnover This ratio may also be called “average collection period” or “days’ sales outstanding.” Total asset turnover = sales / total assets • • ‐Profitability ratios attempt to measure how efficiently a firm operates and how that translates to the “bottom line” These measures are based on book values, so they are not comparable with returns that you see on publicly traded assets. Profit margin = net income / sales Return on assets = net income / total assets Return on equity = net income / total equity ‐Market value ratios attempt to measure how the market views the firm value relative to its book value Price‐earnings ratio = price per share / earnings per share Market‐to‐book ratio = market value per share / book value per share The Du Pont Identity The Du Pont identity provides a way to breakdown ROE and investigates what areas of the firm need improvement. ‘ROE = (NI / total equity) multiply by one (assets / assets) and rearrange ROE = (NI / assets) (assets / total equity) multiply by one (sales / sales) and rearrange ROE = (NI / sales) (sales / assets) (assets / total equity) ROE = profit margin x total asset turnover x equity multiplier These three ratios indicate that a firm’s return on equity depends on its operating efficiency (profit margin), asset use efficiency (total asset turnover), and financial leverage (equity multiplier). 38B Finance review for ETS 11/10/08 17 Internal and Sustainable Growth Dividend Payout and Earnings Retention Net income = dividends paid + additions to retained earnings divide through by net income and you get: 1 = dividend payout ratio + retention ratio retention ratio = b = 1 – dividend payout ratio 39B ROA, ROE, and Growth The internal growth rate is the growth rate that the firm can maintain without raising additional external capital. Note that the debt/equity ratio will decrease when only internally generated funds are used. internal growth rate = (ROA x b) / [1 – ROA x b] The sustainable growth rate is the maximum growth rate that the firm can achieve without external equity financing while maintaining a constant debt/equity ratio. sustainable growth rate = (ROE x b) / [1 – ROE x b] Based on the Du Pont identity, the following factors affect the growth rate: ‐profit margin – an increase in profit margin increases the ability to generate funds internally, increasing both the internal and sustainable growth rate ‐total asset turnover – increasing the TAT increases sales per dollar of assets and thus decreases the need to purchase additional assets, increasing both the internal and sustainable growth rate ‐financial policy – increasing the debt/equity ratio makes additional debt financing available, increasing the sustainable growth rate ‐dividend policy – decreasing the dividend payout ratio allows the firm to retain more internally generated funds, increasing both the internal and sustainable growth rate Using Financial Statement Information Why Evaluate Financial Statements Internal Uses – evaluate performance, look for trouble spots, generate projections External Uses – making credit decisions, evaluating competitors, assessing acquisitions Choosing a Benchmark 40B Finance review for ETS 11/10/08 18 Time‐Trend Analysis – look for significant changes from one period to the next Peer Group Analysis – compare to other companies in the same industry, use SIC or NAICS codes to determine the industry comparison figures Problems with Financial Statement Analysis ‐no underlying financial theory ‐finding comparable firms ‐what to do with conglomerates, multidivisional firms ‐differences in accounting practices ‐differences in capital structure ‐seasonal variations, one‐time events Finance review for ETS 11/10/08 19 Cost of Capital and Capital Structure 7B The Cost of Capital: Some Preliminaries 41B Required Return versus Cost of Capital Cost of capital, required return, and appropriate discount rate are different phrases that all refer to the opportunity cost of using capital in one way as opposed to alternative financial market investments of the same systematic risk. ‐required return is from an investor’s point of view ‐cost of capital is the same return from the firm’s point of view ‐appropriate discount rate is the same return used in a PV calculation Financial Policy and Cost of Capital Capital structure – the firm’s combination of debt and equity. The capital structure decision is discussed later; here, a firm’s cost of capital reflects the average riskiness of all of the securities it has issued. The Cost of Equity The Dividend Growth Model Approach According to the constant growth model, P0 = D1 / (RE – g) Rearranging terms and solving for the cost of equity gives: RE = (D1 / P0) + g which equals the dividend yield plus the growth rate (capital gains yield). Implementing the Approach Price and latest dividend are directly observed – g must be estimated. Estimating g – typically use historical growth rates or analysts’ forecasts. Advantages and Disadvantages of the Approach ‐Approach only works for dividend paying firms ‐RE is very sensitive to the estimate of g ‐Historical growth rates may not reliably predict future growth rates ‐Risk is only indirectly accounted for by the use of this approach 42B Finance review for ETS 11/10/08 20 The SML Approach RE depends on: ‐The risk‐free rate, Rf ‐The expected market risk premium, E(RM) ‐ Rf ‐The amount of systematic risk, measured by βE By CAPM, RE = Rf + βE(E(RM) – Rf) Implementing the Approach Betas are widely available and T‐bill rates are often used for Rf. The expected market risk premium is the more difficult number to come up with. Nonetheless, the historical average is often used as an estimate for the expected market risk premium. Advantages and Disadvantages of the Approach ‐This approach explicitly adjusts for risk in a fashion that is consistent with capital market history ‐It is applicable to virtually all publicly‐traded stocks ‐The main disadvantage is that the past is not a perfect predictor of the future, and both beta and the market risk premium vary through time The Costs of Debt and Preferred Stock The Cost of Debt Cost of debt (RD) – the interest rate on new debt can easily be estimated using the yield to maturity on outstanding debt or by knowing the bond rating and looking up rates on new issues with the same rating. 43B The Cost of Preferred Stock Preferred stock is generally considered to be a perpetuity, so you rearrange the perpetuity equation to get the cost of preferred, RP RP = D / P0 The Weighted Average Cost of Capital The Capital Structure Weights E = market value of the firm’s equity = # outstanding shares times price per share 4B Finance review for ETS 11/10/08 21 D = market value of the firm’s debt = # bonds times price per bond V = combined market value of the firm’s equity and debt = E + D (Assuming that there is no preferred stock and current liabilities are negligible. If this is not the case, then you need to include these components as well. This is really just the market value version of the balance sheet identity. The market value of the firm’s assets = market value of liabilities + market value of equity.) Taxes and the Weighted Average Cost of Capital After tax cash flows require an after tax discount rate. Let TC denote the firm’s marginal tax rate. Then the weighted average cost of capital is: WACC = (E/V)RE + (D/V)RD(1‐TC) WACC – overall return the firm must earn on its assets to maintain the value of its stock. It is a market rate that is based on the market’s perception of the risk of the firm’s assets. Divisional and Project Costs of Capital The SML and the WACC The WACC is the appropriate discount rate only if the proposed investment is of similar risk as the firm’s existing assets. 45B Divisional Cost of Capital When a firm has different operating divisions with different risks, its WACC is an average of the divisional required returns. In such cases, the cost of capital for projects of average risk in each division needs to be established. If you do use the firm’s WACC across divisions, then riskier divisions will receive the bulk of the funding while less‐risky divisions will have to forego what would be good projects if the appropriate discount rate were used. This will lead to an increase in risk for the overall firm. The Pure Play Approach Pure play – a company that has a single line of business. The idea is to find the required return on a near substitute investment. The Subjective Approach Assigns investments to “risk” categories that have higher or lower risk premiums than the firm as a whole. Finance review for ETS 11/10/08 22 Investments Risk and return 8B Returns Dollar Returns Income component – direct cash payments such as dividends or interest Price change – loosely, capital gain or loss Total dollar return = income component + capital gain (loss) The decision is unaffected by the decision to sell or hold securities. Percentage Returns Percentage return = dividend yield + capital gains yield = dollar return / initial investment Dividend yield = Dt+1 / Pt Capital gains yield = (Pt+1 – Pt) / Pt Average Returns: The Historical Record 46B Investment Large stocks Small stocks Long‐term corporate bonds Long‐term government bonds U.S. Treasury bills Inflation 47B Average Return 12.3% 17.4% 6.2% 5.8% 3.8% 3.1% Risk 48B Risk return tradeoff: The greater the potential reward, the greater is the risk. Using the T‐bill rate as the risk‐free return and aggregate common stocks as an average risk, define excess return as the difference between an average‐risk return and returns on T‐bills. Risk premium – reward for bearing risk, the difference between a risky investment return and the risk‐free rate. Finance review for ETS 11/10/08 23 Risky investments earn a risk premium. For large company stocks, the average annual risk premium has been approximately 8.5% since 1926. For smaller (and presumably riskier) firms, the average annual risk premium has been 13.6% over the same period. The average annual risk premium for long‐term corporate and government bonds have been 2.4% and 2.0%, respectively. Expected Returns and Variances Expected Return Let n denote the total number of states of the economy, Ri the return in state i, and pi the probability of state i. Then the expected return, E(R), is given by: 49B n E(R) = ∑ p i R i i =1 Projected risk premium = expected return minus risk‐free rate = E(R) – Rf Calculating the Variance n Var(R) = σ 2 = ∑ p i ( R i − E(R)) 2 i =1 Variance measures the dispersion of points around the mean of a distribution. In this context, we are attempting to characterize the variability of possible future security returns around the expected return. In other words, we are trying to quantify risk and return. Variance measures the total risk of the possible returns. Risk: Systematic and Unsystematic Systematic and Unsystematic Risk Risk consists of surprises. There are two kinds of surprises: Systematic risk is a surprise that affects a large number of assets, although at varying degrees. It is sometimes called market risk. Unsystematic risk is a surprise that affects a small number of assets (or one). It is sometimes called unique or asset‐specific risk. Example: Changes in GDP, interest rates, and inflation are examples of systematic risk. Strikes, accidents, and takeovers are examples of unsystematic risk. 50B Finance review for ETS 11/10/08 24 Systematic and Unsystematic Components of Return Total return = expected return + unexpected return Total return = expected return + systematic portion + unsystematic portion Diversification and Portfolio Risk Portfolio variability can be quite different from the variability of individual securities. A typical single stock on the NYSE has a standard deviation of annual returns around 49%, while the typical large portfolio of NYSE stocks has a standard deviation of around 20%. The Principle of Diversification Principle of Diversification – principle stating that combining imperfectly correlated assets can produce a portfolio with less variability than the typical individual asset. The portion of variability present in a single security that is not present in a portfolio of securities is called diversifiable risk. The level of variance that is present in collections of assets is nondiversifiable risk. Diversification and Unsystematic Risk When securities are combined into portfolios, their unique or unsystematic risks tend to cancel out, leaving only the variability that affects all securities to some degree. Thus, diversifiable risk is synonymous with unsystematic risk. Large portfolios have little or no unsystematic risk. Diversification and Systematic Risk Systematic risk cannot be eliminated by diversification since it represents the variability due to influences that affect all securities to some degree. Therefore, systematic risk and nondiversifiable risk are the same. Total risk = systematic risk + unsystematic risk = nondiversifiable risk + diversifiable risk Systematic Risk and Beta The Systematic Risk Principle The systematic risk principle – The reward for bearing risk depends only on the systematic risk of the investment. 51B Finance review for ETS 11/10/08 25 The implication – The expected return on an asset depends only on that asset’s systematic risk. A corollary – No matter how much total risk an asset has, its expected return depends only on its systematic risk. Measuring Systematic Risk Beta coefficient – measures how much systematic risk an asset has relative to an asset of average risk. What does beta tell us? A beta of 1 implies the asset has the same systematic risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market A riskless asset has a beta of 0. The Security Market Line The line that gives the expected return/systematic risk combinations of assets in a well‐functioning, active financial market is called the security market line. It is also known as the capital asset pricing model (CAPM) The capital asset pricing model (CAPM) defines the relationship between risk and return E(Rj) = Rf + (E(RM) – Rf)(βj) ‐The time value of money, as measured by Rf ‐The reward per unit risk, as measured by E(RM) ‐ Rf ‐The asset’s systematic risk, as measured by β If we know an asset’s systematic risk, we can use the CAPM to determine its expected return 52B Finance review for ETS 11/10/08 26 Valuation of securities 9B Bonds and Bond Valuation 12B Bond Features and Prices Bonds – long‐term IOUs, usually interest‐only loans (interest is paid by the borrower every period with the principal repaid at the end of the loan). Coupons – the regular interest payments (if fixed amount – level coupon). Face or par value – principal, amount repaid at the end of the loan Coupon rate – coupons per year quoted as a percent of face value Maturity – time until face value is paid, usually given in years 53B Bond Values and Yields The cash flows from a bond are the coupons and the face value. The value of a bond (market price) is the present value of the expected cash flows discounted at the market rate of interest. Yield to maturity (YTM) – the required market rate or rate that makes the discounted cash flows from a bond equal to the bond’s market price. Example: Suppose Wilhite, Co. issues $1,000 par bonds with 20 years to maturity. The annual coupon is $110. Similar bonds have a yield to maturity of 11%. Bond value = PV of coupons + PV of face value Bond value = 110[1 – 1/(1.11)20] / .11 + 1000 / (1.11)20 Bond value = 875.97 + 124.03 = $1000 or N = 20; I/Y = 11; PMT = 110; FV = 1000; CPT PV = ‐1000 Since the coupon rate and the yield are the same, the price should equal face value. 54B Discount bond – a bond that sells for less than its par value. This is the case when the YTM is greater than the coupon rate. Example: Suppose the YTM on bonds similar to that of Wilhite Co. (see the previous example) is 13% instead of 11%. What is the bond price? Finance review for ETS 11/10/08 27 Bond price = 110[1 – 1/(1.13)20] / .13 + 1000/(1.13)20 Bond price = 772.72 + 86.78 = 859.50 or N = 20; I/Y = 13; PMT = 110; FV = 1000; CPT PV = ‐859.50 The difference between this price, $859.50, and the par value of $1000, is $140.50. This is equal to the present value of the difference between bonds with coupon rates of 13% ($130) and Wilhite’s coupon: PMT = 20; N = 20; I/Y = 13; CPT PV = ‐140.50. Premium bond – a bond that sells for more than its par value. This is the case when the YTM is less than the coupon rate. Example: Consider the Wilhite bond in the previous examples. Suppose that the yield on bonds of similar risk and maturity is 9% instead of 11%. What will the bonds sell for? Bond value = 110[1 – 1/(1.09)20] / .09 + 1,000/(1.09)20 Bond value = 1004.14 + 178.43 = $1,182.57 General Expression for the value of a bond: Bond value = present value of coupons + present value of par Bond value = C[1 – 1/(1+r)t] / r + FV / (1+r)t Semiannual coupons – coupons are paid twice a year. Everything is quoted on an annual basis so you divide the annual coupon and the yield by two and multiply the number of years by 2. Example: A $1,000 bond with an 8% coupon rate, with coupons paid every 6 months, is maturing in 10 years. If the quoted YTM is 10%, what is the bond price? C = .08(1,000)/2 = 40; r = .1/2 = .05; t = 10*2 = 20 Bond value = 40[1 – 1/(1.05)20] / .05 + 1,000 / (1.05)20 Bond value = 498.49 + 376.89 = $875.38 or PMT = 40; FV = 1,000; N = 20; I/Y = 5; CPT PV = ‐875.38 Interest Rate Risk Interest rate risk – changes in bond prices due to fluctuating interest rates. All else equal, the longer the time to maturity, the greater the interest rate risk. It takes longer to receive the large cash flow at the end and we know from previous chapters that the present value decreases as time increases. All else equal, the lower the coupon rate, the greater the interest rate risk. The par value makes up a larger portion of the bond’s cash flows and it comes at the end. Finance review for ETS 11/10/08 28 Finding the Yield to Maturity: More Trial and Error It is a trial and error process to find the YTM via the general formula above. Knowing if a bond sells at a discount (YTM > coupon rate) or premium (YTM < coupon rate) is a help, but using a financial calculator is by far the quickest, easiest, and most accurate method. Common Stock Valuation Cash Flows Stock valuation is more difficult than bond valuation because the cash flows are uncertain, the life is forever and the required rate of return is unobservable. The cash flows to stockholders consist of dividends plus a future sale price. However, the future sale price depends on the dividends paid after that point. Therefore, you can illustrate that the current stock price is ultimately the present value of all expected future dividends: P0 = D1/(1+R) + D2/(1+R)2 + D3/(1+R)3 + … 5B Some Special Cases Zero‐growth – implies that D0 = D1 = D2 … = D Since the cash flow is always the same, the PV is that for a perpetuity: P0 = D / R Example: Suppose a stock is expected to pay a $2 dividend each period, forever, and the required return is 10%. What is the stock worth? P0 = 2 / .1 = $20 Constant growth – Dividends are expected to grow at a constant percentage rate each period. D1 = D0(1+g); D2 = D1(1+g); in general Dt = D0(1+g)t Note, that this is the same as the future value formula. Example: If the current dividend is $2 and the expected growth rate is 5%, what is D1? D5? D1 = 2(1+.05) = $2.10 D5 = 2(1+.05)5 = $2.55 Finance review for ETS 11/10/08 29 An amount that grows at a constant rate forever is called a growing perpetuity. Under this assumption, the value of a stock now becomes: P0 = D1 / (R – g) and more generally, Pt = Dt+1 / (R – g) Example: Consider the stock given above. If the required return is 10%, what is the expected price today? In 4 years? P0 = 2.10 / (.1 ‐ .05) = $42 P4 = 2.55 / (.1 ‐ .05) = $51 Components of the Required Return Rearrange P0 = D1 / (R – g) to find R: R = (D1 / P0 ) + g Dividend yield = D1 / P0 Capital gains yield = g and R = dividend yield + capital gains yield Finance review for ETS 11/10/08 30 Financial markets and environments 10B More on Bond Features 56B Is It Debt or Equity? In general, debt securities are characterized by the following attributes: ‐Creditors (or lenders or bondholders) generally have no voting rights. ‐Payment of interest on debt is a tax‐deductible business expense. ‐Unpaid debt is a liability, so default subjects the firm to legal action by its creditors. Long‐Term Debt: The Basics Major forms are public and private placement. Long‐term debt – bonds with a maturity of one year or more. Short‐term debt – less than a year to maturity, also called unfunded debt. Bond – strictly speaking, secured debt; but used to describe all long‐term debt. The Indenture Indenture – written agreement between issuer and creditors detailing terms of borrowing. (Also deed of trust.) The indenture includes the following provisions: ‐Bond terms ‐The total face amount of bonds issued ‐A description of any property used as security ‐The repayment arrangements ‐Any call provisions ‐Any protective covenants Terms of a bond – face value, par value, and form Registered form – ownership is recorded, payment made directly to owner Bearer form – payment is made to holder (bearer) of bond Security – debt classified by collateral and mortgage Collateral – strictly speaking, pledged securities Mortgage securities – secured by mortgage on real property Debenture – an unsecured debt with 10 or more years to maturity Note – a debenture with 10 years or less maturity Seniority – order of precedence of claims Finance review for ETS 11/10/08 31 Subordinated debenture – of lower priority than senior debt Repayment – early repayment in some form is typical Sinking fund – an account managed by the bond trustee for early redemption Call provision – allows company to “call” or repurchase part or all of issue Call premium – amount by which the call price exceeds the par value Deferred call – firm cannot call bonds for a designated period Call protected – the description of a bond during the period it can’t be called Protective covenants – indenture conditions that limit the actions of firms Negative covenant – “thou shalt not” sell major assets, etc. Positive covenant – “thou shalt” keep working capital at or above $X, etc. Some Different Types of Bonds Government Bonds Long‐term debt instruments issued by a governmental entity. Treasury bonds are bonds issued by a federal government; a state or local government issues municipal bonds. In the US, Treasuries are exempt from state taxation and “munis” are exempt from federal taxation. 57B Zero Coupon Bonds Zero coupon bonds are bonds that are offered at deep discounts because there are no periodic coupon payments. Although, no cash interest is paid, firms deduct the implicit interest while holders report it as income. Interest expense equals the periodic change in the amortized value of the bond. Floating‐Rate Bonds Floating‐rate bonds – coupon payments adjust periodically according to an index. Also, ‐put provision – holder can sell back to issuer at par ‐collar ‐ coupon rate has a floor and a ceiling Other Types of Bonds Income bonds – coupon is paid if income is sufficient Convertible bonds – can be traded for a fixed number of shares of stock Put bonds – shareholders can redeem for par at their discretion Finance review for ETS 11/10/08 32 Bond Markets 58B How Bonds are Bought and Sold Most transactions are OTC (over‐the‐counter) The OTC market is not transparent Daily bond trading volume exceeds stock trading volume, but trading in individual issues tends to be very thin Inflation and Interest Rates Real versus Nominal Rates Nominal rates – rates that have not been adjusted for inflation Real rates – rates that have been adjusted for inflation 59B The Fisher Effect The Fisher Effect is a theoretical relationship between nominal returns, real returns and the expected inflation rate. Let R be the nominal rate, r the real rate, and h the expected inflation rate; then, (1 + R) = (1 + r)(1 + h) A reasonable approximation, when expected inflation is relatively low, is R = r + h. A definition whereby the real rate can be found by deflating the nominal rate by the inflation rate: r = [(1 + R) / (1 + h)] – 1. Determinants of Bond Yields The Term Structure of Interest Rates Term structure of interest rates – the relationship between nominal interest rates on default‐free, pure discount securities and time to maturity Inflation premium – portion of the nominal rate that is compensation for expected inflation Interest rate risk premium – compensation for bearing interest rate risk 60B Bond Yields and the Yield Curve: Putting It All Together Treasury yield curve – plot of yields on Treasury notes and bonds relative to maturity Default risk premium – the portion of a nominal rate that represents compensation for the possibility of default Finance review for ETS 11/10/08 33 Taxability premium – the portion of a nominal rate that represents compensation for unfavorable tax status Liquidity premium – the portion of a nominal rate that represents compensation for lack of liquidity Conclusion The bond yields that we observe are influenced by six factors: (1) the real rate of interest, (2) expected future inflation, (3) interest rate risk, (4) default risk, (5) taxability, and (6) liquidity. Some Features of Common and Preferred Stocks Common Stock Features 61B Shareholders have the right to elect corporate directors who set corporate policy and select operating management. 1. Cumulative voting – when the directors are all elected at once. Total votes that each shareholder may cast equals the number of shares times the number of directors to be elected. In general, if N directors are to be elected, it takes 1 / (N+1) percent of the stock + 1 share to assure a deciding vote for one directorship. Good for getting minority shareholder representation on the board. 2. Straight (majority) voting – the directors are elected one at a time, and every share gets one vote. Good for freezing out minority shareholders. 3. Staggered elections – directors’ terms are rotated so they aren’t elected at the same time. This makes it harder for a minority to elect a director and complicates takeovers. 4. Proxy voting – grant of authority by a shareholder to someone else to vote his or her shares. A proxy fight is a struggle between management and outsiders for control of the board, waged by soliciting shareholders’ proxies. Other rights usually include: 1. Sharing proportionately in dividends paid 2. Sharing proportionately in any liquidation value 3. Voting on matters of importance (e.g., mergers) 4. The right to purchase any new stock sold – the preemptive right Dividends – return on shareholder capital. 1. Payment of dividends is at the discretion of the board. A firm cannot default on an undeclared dividend, nor be forced to file for bankruptcy because of nonpayment of Finance review for ETS 11/10/08 34 dividends. 2. Dividends are not tax deductible for the paying firm. 3. Dividends received by individuals are usually considered ordinary income, while dividends received by a corporation are at least 70% tax‐exempt. Preferred Stock Features Preferred stock has precedence over common stock in the payment of dividends and in liquidation. Its dividend is usually fixed and the stock is often without voting rights. The stated value is the value paid to preferred stockholders in the event of liquidation. Cumulative dividends – current preferred dividend plus all arrearages (unpaid dividends) to be paid before common stock dividends can be paid. Non‐cumulative dividend preferred does not have this feature. The Stock Markets 62B Dealers and Brokers Primary market – the market in which new securities are originally sold to investors Secondary market – market in which existing securities trade among investors Broker – one who arranges security transactions among investors Dealer – one who buys and sells security from inventory Bid price – the price at which a dealer is willing to buy a security Ask price – the price at which a dealer is willing to sell a security Spread – the difference between the bid and ask prices Organization of the NYSE Exchange member – the owner of a seat on the NYSE. Commission brokers – those who execute customer orders to buy and sell stock on the floor of the exchange Specialist – NYSE member who acts as a dealer on the exchange floor, often called a market maker Finance review for ETS 11/10/08 35 Floor brokers – NYSE members who execute orders for commission brokers on a fee basis SuperDOT – electronic NYSE system allowing orders to be transmitted directly to the specialist Floor Traders – those who trade for their own accounts, trying to anticipate and profit from temporary price fluctuations Order flow – the flow of customer orders to buy and sell securities Specialist’s post – fixed place on the exchange floor where the specialist operates Trading in the crowd – trading that occurs directly between brokers around the specialist’s post Nasdaq Operations NYSE operations represent a premier example of the trading of “listed” securities. Nasdaq operations, on the other hand, represent the evolution of “over‐the‐counter” trading of securities that does not rely on a physical market place. Nasdaq – National Association of Securities Dealers Automated Quotation system – computer network of securities dealers who disseminate timely security price quotes to Nasdaq subscribers. ECN – electronic communications network; website that allows trading directly between investors without using either a dealer or a broker Capital Market Efficiency 63B The Efficient Markets Hypothesis Efficient markets hypothesis (EMH) – asserts that modern U.S. stock markets are, as a practical matter, efficient. An important implication of the EMH is that financial securities are zero NPV investments. The expected return on securities is their risk‐adjusted required return. Key insight – competition among investors and traders makes a market efficient. Finance review for ETS 11/10/08 36 Some Common Misconceptions about the EMH Market efficiency does NOT imply that it doesn’t make a difference how you invest, since the risk/return trade‐off still applies, but rather that you can’t expect to consistently earn excess returns using costless trading strategies. Stock price fluctuations are evidence that the market is efficient since new information is constantly arriving – prices that don’t change are evidence of inefficiency. The EMH doesn’t say prices are random. Rather, the influence of previously unknown information causes randomness in price changes. As a result, price changes can’t be predicted before they happen. The Forms of Market Efficiency Strong form efficiency – All information, both public and private is already incorporated in the price. Empirical evidence indicates that this form of efficiency does NOT hold. Semistrong form efficiency – All public information is already incorporated in the price. It says that you cannot consistently earn excess returns using available information to do fundamental analysis. Evidence is mixed, but suggests that it holds for widely‐held firms. Weak form efficiency – All market information, including prices and volume, is included in the price. It says that you cannot consistently earn excess returns by looking for patterns in past price and volume information, such as is done by technical analysts. Evidence suggests that markets are weak form efficient based on the trading rules that we have been able to test. U U Finance review for ETS 11/10/08 37 International Finance Terminology 1B •
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• ‐American Depositary Receipt (ADR) – security issued in the U.S. that represents shares in a foreign company ‐Cross‐rate – exchange rate between two currencies implied by the exchange rates of each currency with a third ‐Eurobond – bonds issued in many countries but denominated in a single currency ‐Eurocurrency – money deposited in the bank of a foreign country (dollars deposited in a French bank are called Eurodollars) ‐Foreign bonds – bonds issued by a foreign company in a single country and in that country’s currency ‐Gilts – British and Irish government securities ‐London Interbank Offer Rate (LIBOR) – rate banks charge each other for overnight Eurodollar loans; often used as an index in floating rate securities ‐Interest rate swap – agreement between two parties to periodically swap interest payments on a notional amount; often one party pays a fixed rate and the other pays a floating rate Currency swap – agreement between two parties to periodically swap currencies based on some notional amount Foreign Exchange Markets and Exchange Rates 64B Foreign exchange market – market for buying and selling currencies. Foreign exchange market participants: ‐Importers and exporters ‐International portfolio managers ‐Foreign exchange brokers ‐Foreign exchange market markers ‐Speculators Exchange Rates Finance review for ETS 11/10/08 38 Most currency trading is done with currencies being quoted in U.S. dollars. Cross rates and triangle arbitrage – implicit in exchange rate quotations is an exchange rate between non‐U.S. currencies. The exchange rate between two non‐U.S. currencies must equal the cross rate to prevent arbitrage. Example of Triangle Arbitrage: Suppose the Japanese Yen is quoted at 133.9 Yen per dollar and the South Korean Won is quoted at 666.0 Won per dollar. The exchange rate between Yen and Won is .1750 Yen per Won. The cross rate is (133.9 Yen/$) / (666.0 Won/$) = .201 Yen/Won Buy low, sell high: 1) Have $1,000 to invest; buy yen = $1,000(133.9 Yen/$) = 133,900 Yen 2) Buy Won with Yen = 133,900 Yen / (.1750 Yen/Won) = 765,142.86 Won 3) Buy dollars with Won = 765,142.86 Won / (666 Won/$) = $1,148.86 4) Pocket the risk‐free profit of $148.86 Types of Transactions Spot trade – exchange of currencies at immediate prices (spot rate) Forward trade – contract for the exchange of currencies at a future date at a price specified today (forward rate) Premium – if the forward rate > spot rate (based on $ equivalent or “direct” quotes), then the foreign currency is expected to appreciate and is selling at a premium; its dollar price is expected to rise Discount – if the forward rate < spot rate (based on $ equivalent or “direct” quotes), then the foreign currency is expected to depreciate and is selling at a discount; its dollar price is expected to fall Purchasing Power Parity Absolute Purchasing Power Parity Absolute PPP indicates that a commodity should sell for the same real price regardless of currency used. Absolute PPP can be violated due to transaction costs, barriers to trade, and differences in the product. 65B Relative Purchasing Power Parity Finance review for ETS 11/10/08 39 The change in the exchange rate depends on the difference in inflation rates between countries. Relative PPP says that: E(St ) = S0[1 + (hF – hUS)]t assuming that rates are quoted as foreign currency per dollar. Currency appreciation and depreciation – Appreciation of one currency relative to another means that it takes more of the second currency to buy the first. For example, if the dollar appreciates relative to the yen, it means it will take more yen to buy $1. Depreciation is just the opposite. Exchange Rates and Interest Rates Covered Interest Arbitrage A covered interest arbitrage exists when a riskless profit can be made by buying low and selling high. In this example the U.S. dollar can be borrowed relatively cheaply, so we borrow in the U.S. at the risk‐free rate, convert the borrowed dollars into a foreign currency, invest at that country’s rate of interest, enter into a forward contract to convert the currency back into U.S. dollars, and then repay the loan. Example: S0 = 2 SF/$ RUS = 10% F1 = 1.9 DM/$ RS = 5% 1) Borrow $100 at 10% 2) Buy $100(2 SF/$) = 200 SF and invest at 5% (RS) 3) At the same time, enter into a forward contract 4) In 1 year, receive 200(1.05) = 210 SF 5) Convert to $ using forward contract; 210 SF / (1.9 SF/$) = $110.53 6) Repay loan and pocket profit: 110.53 – 100(1.1) = $.53 Interest Rate Parity To prevent covered arbitrage: 6B F1 1 + RFC =
S 0 1 + RUS Approximation: Ft = S0[1 + (RFC – RUS)]t Example: Finance review for ETS 11/10/08 40 Suppose the Swiss Franc spot rate is 2 SF / $. If the risk‐free rate in Switzerland is 6% and the risk‐free rate in the U.S. is 8%, what should the forward rate be to prevent arbitrage? Exact: F = 2(1.06)/(1.08) = 1.963 SF / $ Approximation: F = 2[1 + (.06 ‐ .08)] = 1.96 SF/$ Exchange Rate Risk Short‐Run Exposure Exchange rate risk – the risk of loss arising from fluctuations in exchange rates A great deal of international business is conducted on terms that fix costs or prices while at the same time calling for payment or receipt of funds in the future. One way to offset the risk from changing exchange rates and fixed terms is to hedge with a forward exchange agreement. Another hedging tool is to use foreign exchange options. An option will allow the firm to protect itself against adverse exchange rate movements and still benefit from favorable exchange rate movements. Long‐Run Exposure Long‐run changes in exchange rates can be partially offset by matching foreign assets and liabilities, inflows, and outflows. Translation Exposure U.S.‐based firms must translate foreign operations into dollars when calculating net income and EPS. Managing Exchange Rate Risk For large multinational firms, the net effect of fluctuating exchange rates depends on the firm’s net exposure. This is probably best handled on a centralized basis to avoid duplication and conflicting actions. 67B Political Risk Blocking funds and expropriation of property by foreign governments are among routine political risks faced by multinationals. In some places, political terrorism is also a concern. Financing the subsidiaries operations in the foreign country can reduce some risk. Another option is to make the subsidiary dependent on the parent company for supplies; this makes the company less valuable to someone else. 68B Finance review for ETS 11/10/08 41 ...
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This note was uploaded on 02/26/2012 for the course MGMT 4340 taught by Professor Uz during the Spring '12 term at University of HoustonVictoria.
 Spring '12
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 Management

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