power point slides - week 1

8/3/2019 Power Point Slides - Week 1

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Michael Rafter, MBA, Doctoral Candidate

(818) 264-5850

[email protected]


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Tonights Agenda

Introductions

Review syllabusForm teams

Break

Current EventsReview this weeks content

In class exercises / discussions

Review whats up for next week


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Introductions

Name

Your day job

Undergrad degree

On a scale of 1 to 10;

Comfort level with financial statements

Comfort level with MS Excel?


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Syllabus


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Learning Teams


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Break


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Current Events


8/895-8 Prentice Hall, 2007

2Corporate Financial Management 3e

Emery Finnerty Stowe

The Financial

Environment:

Concepts and

Principles


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The Principle of Self-Interested

Behavior

With all else equal, people choose the action that

is financially most advantageous to themselves.

Does not imply that making money is the most

important criteria. Consider charitable contributions.

People Act in Their Own

Financial Self-Interest


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Behavior

Taking the most advantageous course ofaction requires us to forego other possible

actions.Every action has an Opportunity Cost: The difference in value of the chosen action and

the next best alternative. For example, you give up your part-time job to

concentrate on your education.


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Behavior

Self-Interested behavior can lead to conflicts ofinterest in Principal-Agent relationships.

The agent can take unseen actions that are costlyto the principal.

The principal thus faces a Moral Hazardproblem.

The principal can reduce the severity of thisproblem through more effective contract

provisions.


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Agency Theory

There are costs connected with controlling conflicts of interest Monitoring (audits)

Incentives (stock options and bonuses)

Missing a good investment

Loss due to misbehavior

Excessive expense account, personal time, wasted resources

The principal can reduce the total cost by balancing

monitoring and incentive costs against other costs.Primary goal is to control such problems by using goodcontracts.


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Principal-Agent Relationships

The Firm

Consumers

StockHolders Debt

Holders

Managers************PrimaryDecision

Makers***********

Agent -------------------------------------------- Principal

Agent -------- Principal Agent --------- Principal

Agent -------------- Principal

Free-Rider Problem

Service/guarantee Problem

Principal ----------- Agent


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The Principle of Two-Sided

Transactions

While we act in our best interest, there is at leastone other person in this transaction who is actingin his/her best interest.

Underestimating the counterparty can lead to sub-optimal decisions. Corporate executives often suffer from hubris.

Every Financial Transaction has at

Least Two Sides


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The Principle of Two-Sided

Transactions

Media reports of stock market transactions

sometimes refer to profit takers selling offtheir

holdings and thereby causing a drop in stock

prices.

There cant be more selling than buying.

The same news story could have instead spoke of

investors making a huge mistake buying into adropping stock.


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The Signaling Principle

When a firm increases its dividend, it is generally

signaling a more optimistic future for the firm.

When actions conflict with words, pay attention to

the actions.

If one party has information not known to theother party, there is asymmetric information.

Actions Convey Information


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The Behavioral Principle

Analyzing complex transactions can be very

difficult and/or expensive.

In such cases, look at what others are doing.

But be aware of the blind leading the

blind!

When All Else Fails, Look at What

Others Are Doing for Guidance


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The Behavioral Principle

In a competitive environment, this principle

can lead to the free-riderproblem:

The leader expends resources to determine

the best course of action.

The followers imitate the leader and reap the

benefits without expending the resources.


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The Principle of Valuable Ideas

Over time, the value of merely imitating others isdriven out by competition from others doing thesame thing.

Truly successful people / businesses have used atleast one new idea.

Every new idea not automatically valuable:Consider the dot-com craze.

Extraordinary Returns Are Achievable

with New Ideas


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The Principle of Comparative

Advantage

This is the basis for our economic system.

Economic efficiency results from everyone

doing what they do best.

Expertise Can Create Value


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The Options Principle

An option is the right(without the obligation) totake some action.

Depending on circumstances, the optionholdermay decide to: take the action (exercise the option) or

forego the action (let the option expire).

Options Are Valuable


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Explicit Option Contracts:

Call Option:

Gives the holder the right to buy the specified

asset at a pre-specified price (within a specified

time period).

Put Option: Gives the holder the right to sell the specified

asset at a pre-specified price (within a specified

time period).


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Hidden or Embedded Options: These options may be a part of another financial

contract.: Bankruptcy laws provide debtors legal protection from

creditors - the limited liability provision.

Debtors have the option to not fully repay the debtIFtheydeclare bankruptcy.

Privately negotiated options

Corporate options: expand, shrink, delay, abandon, etc. Real options: hotel reservations, rain checks, tickets, etc.

The most common option is insurance, which is aform of put option.


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The Principle of Incremental Benefits

Incremental costs and benefits are those that occur

with a particular action, minus those that occur

without the action.

Sunk costs (costs that have already been incurred)are irrelevant to financial decision making.

Financial Decisions Are Based on

Incremental Benefits


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The Principle of Incremental Benefits

Incremental cost of proposed advertising budget

= $0.5 million. Incremental annual sales = $0.6 million

AdvertisingBudget Status

Total AnnualSales

$1.0 million

$1.5 million

Current

Proposed

$12.0 million

$12.6 million


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The Principle of Risk-Return

Trade-Off

In order to earn higher returns, you must bewilling to bear higher risk. You can sleep well or you can eat well, but you cant

do both at the same time.

High risk brings with it a greater chance of a reallygood outcome as well asa greater chance of areally bad outcome.

There is a trade-off between

Risk and Return


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Risk Averse Behavior

When all else is equal, people prefer higher

returns and lower risk.

People will choose the high-risk alternativeonly if they expect to earn a sufficiently

high return.

Individuals would accept a lower return inexchange for lower risk.


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Application of Risk-Averse

Behavior

Consider the following Alternatives:

Choice Expected Return Risk Units

A 10% 20B 10% 25

C 16% 25

Comparing A & B, which would you choose?

Comparing B & C, which would you choose?

Comparing A & C, which would you choose?


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The Principle of Diversification

Dont put all your eggs in one basket!

Spreading your investments (diversifying) can

reduce risk without decreasing the return.

A prudent investor will not invest her entirewealth in a single asset (for example, one firm).

Diversification Is Beneficial


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The Principle of Capital Market

Efficiency

Capital markets are markets in which financialsecurities like stocks and bonds are bought andsold (traded). NYSE and NASDAQ

Market prices of financial assets that are tradedregularly in the capital markets: Reflect all available information, and

Adjust quickly to new information.

The Capital Markets Reflect

All Information Quickly


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The Principle of Capital Market

Efficiency

New information is information that was notpreviously known. Note that information maythought possible, expected, or even anticipated.

Markets dont wait for the supply to be interrupted;prices fall or rise as soon as a change in supply ispossible, the greater the chance, the greater the pricechange. For example, orange juice and the weather.

Prices are made on expectations.

Trading by astute investors in response to newinformation causes prices to change quickly.


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Capital Market Efficiency

competition among a large number of participants

the information revolution

trading convenience

low cost of trading

rapid execution of trades

Some reasons for capital market efficiency:


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Capital Market Efficiency

The price of an asset is the same everywhere in the

market.The law of one price holds.

Equivalent securities must sell at the sameprice.

Arbitrage opportunities cannot exist. Arbitrage allows you to earn riskless profits

without any capital commitments.

If capital markets are efficient, then:


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The Time Value of Money Principle

A dollar today is worth more than a dollar

tomorrow.

The time value of money derives from the

opportunity to earn interest on it.

Money Has Time Value


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The Time Value of Money Principle

The jackpot in your states lotto is $20

million, to be paid out in 20 equal annual

installments of $1 million each. Is the jackpot worth $20 million to the

winner?


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Security Markets

Money versus Capital Markets

Primary versus Secondary Markets


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Money Markets

Market for short-term claims with original

maturity of one year or less.

High-grade securities with little or no risk ofdefault.

Examples:

U.S. Treasury Bills (T-Bills)

Commercial Paper

Certificates of Deposit

Bankers Acceptances


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U.S. Treasury Bills

Issued by the U.S. Treasury.

Original maturities of 13, 26 and 52 weeks.

Generally sold in $10,000 denominations.Sold on a discount basis - at a discount fromtheir face value.

Difference between the face value and thepurchase price represents interest earned bythe investor.


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Commercial Paper

A promissory note sold by very large,

creditworthy corporations.

Original maturity up to 270 days.Face value is generally $100,000.

Backed by a standby letter of credit from

a bank.


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Certificates of Deposit (CDs)

Written by commercial banks.

Issuing bank promises to pay the face value

plus a fixed interest rate.Negotiable CDs have denominations of

$100,000 or more and can be traded in the

market.


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Capital Markets

Market for long-term securities with

original maturity of more than one year.

Securities may be of considerable risk.Examples:

Stocks

Corporate bonds Government bonds


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Stocks

Shares of a stock represent equity (or ownership)

in a corporation.

Stockholders have the right to vote and the right todividends.

Common stock shares represent residual

ownership in the firm.

Dividends on preferred stock shares are usuallyfixed, and generally must be paid before dividends

are paid to common stockholders.


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Bonds

Represent long-term debt securities - a promise to

pay interest and repay the borrowed money

(principal) on prespecified terms..

Issued by corporations as well as governments.

Notes are like bonds, but have a maturity between

1 and 10 years.

Bonds are also referred to as fixed incomesecurities.


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Derivative Securities

These derive their value from another

security.

Examples:Options

Futures

Forward contracts


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Options

Grants the holder the right to buy (or sell) theunderlying security at a fixed price, within a fixedtime period.

There is no obligation on the part of the optionholder.

There is obligation on the part of the option seller.

A call option gives the holder the right to buy theunderlying security.

A put option gives the holder the right to sell theunderlying security.


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Primary Markets

A primary market is a market for newly

created securities.

The proceeds from the sale of securities inprimary markets go to the issuing entity.

A security can trade only once in the

primary market.


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Secondary Markets

A secondary market is a market forpreviously issued securities.

The issuing firm is not directly affected bytransactions in the secondary markets.

A security can trade an unlimited number oftimes in secondary markets.

The volume of trade in secondary markets ismuch higher than in primary markets.


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5-48 Prentice Hall, 2007



Accounting, Cash

Flows and Taxes


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The Annual Report

Narrative description of the firms activities during

the year.The firms accounting statements:

The balance sheet

The income statement

The statement of cash flows

Notes to the financial statements

The Auditors report.

A firms annual report contains:


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Financial Statements

Prepared according to Generally AcceptedAccounting Principles (GAAP) GAAP guidelines established in the U.S. by the Financial

Accounting Standards Board (FASB)Used by the firm to: Communicate with stakeholders outside the firm.

Help plan and organize the firms activities.

Monitor and evaluate the firms performance. Used by the Internal Revenue Service to determine the

firms taxes.


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The Balance Sheet

Reports the financial position of a firm at aparticular point in time.

Shows assets held by the firm on the lefthand side.

Shows the liabilities and the stockholdersequity on the right hand side.

The balance sheet identity always holds:

Assets = Liabilities + Shareholders Equity


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The Income Statement

Reports revenues, expenses, and profit (or

loss) during the year.

Also reports earnings and dividends on aper share basis.


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The Statement of Cash Flows

Reports how the cash position of the firmchanged during the year.

It itemizes the cash flows experienced bythe firm.

Increase (decrease) in an asset consumes(provides) cash flow.

Decrease (increase) in a liability consumes(provides) cash flow.


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Notes to Financial Statements

Other income, interest expenses, provisionfor income taxes.

Earnings per share calculations.

Inventories, property, plant and equipment,and other assets.

Employee pension and stock option plans.

Business segment information

Five-year summary of financialperformance.

3 2 Market Values versus Book


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3.2 Market Values versus Book

Values

Accounting statements are invaluable aids

to analysts and managers.

But the statements do not provide certaincritical information, and have inherent

limitations.


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Historical Accounting Statements

Accounting statements dont provideinformation about future income and cash

flows.Assets and liabilities as reported do notreflect current market values.

So the value shown as Total Assets is NOTthe current market value of the firm.


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Market vs. Book Value of Assets

The market value of an asset can differ

from its book value for several reasons:

Accounting depreciation differs from economicdepreciation.

Book values ignore the effects of inflation.

Book values ignore the assets liquidity (e.g.,

tangible assets are more liquid than intangible

assets and generic assets are more liquid than

unique assets.)


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Market vs. Book Value of Liabs.

The market value of a liability can differ

from its book value. If market interest rates

change the liabilitys market value changes.

When current and/or expected future economic

conditions change all market interest rates can

change.

When a particular firms current and/or

expected future financial health changes market

interest rates on that firms securities can

change.


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Market vs. Book Value of Equity

Stockholders Equity = Assets - Liabilities

The market and book values of assets andliabilities are not equal.

So the value of the Shareholders Equityshown is NOT the current market value ofthe shareholders equity.

3 3 Accounting Net Income Versus


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3.3 Accounting Net Income Versus

Cash Flow

Net income is not an accurate measure of

cash flow since it contains noncash items

such as depreciation.


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Net Income versus Cash Flow

Certain cash flows occur before the item is

recorded. Example: depreciation expenses

Certain cash flows occur after the item isrecorded:

Example: accrued wages and taxes, sale ofmerchandise on credit

Net income does not measure cash flow since:


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Taxes

Taxes are very important because theyaffect value and therefore affect decisions

Interest is an expense, dividends are not anexpense

capital gains tax-timing option

Tax laws change from time to time


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Ratios and Ratio Analysis

There are an unlimited number of alternatives.

They are not useful for picking winners.

They are useful for understanding the current

situation and perhaps how it developed to thispoint.


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Ratios and Ratio Analysis

Widely cited ratios in finance

Market-to-book ratio

Market value per share divided by book value per share P/E: price-earnings ratio

Market value per share divided by earnings per share

Historical

Forward looking (based on expectations) Dividend yield

Dividend divided by market value

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Team Activities

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Team A

ProblemA3

Team B

ProblemA4

Both TeamsProblemA5


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Valuing Bonds

and Stocks


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5.1 Bonds

Bonds represent loans extended by investors tocorporations and/or the government.

Bonds are issued by the borrower, and purchasedby the lender.

The legal contract underlying the loan is called abond indenture.


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Key Features of Bonds

Thepar (or face or maturity) value is the amountrepaid (excluding interest) by the borrower to thelender (bondholder) at the end of the bonds life. Thepar value for U.S. corporate bonds is $1000.

Thecoupon rate determines the interest payments.Total annual amount = coupon rate x par value. U.S.corporate bonds pay semi-annually.

A bondsmaturity is its remaining life, which

decreases over time. Original maturity is its maturitywhen its issued. The firm promises to repay the parvalue at the end of the bonds life (also calledmaturity).

Most bonds have semi-annual coupon payments


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5.2 Bond Valuation

The bonds fair value is the present value of

the promised future coupon and principal

payments.At issue, the coupon rate is set such that the

fair value of the bonds is very close to its

par value.Later, as market conditions change, the fair

value may deviate from the par value.


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Example of Bond Valuation

Semi-annual coupon payment

= [coupon rate / 2] x par value

= [0.09 / 2] x $1,000 = $45

Number of payments = 12 x 2 = 24

Semiannual required rate of return = 3%

Find the fair value of a bond with a $1,000 par value,

a remaining life of 12 years, and a coupon rate of 9%

per year paid semi-annually. The required return on

bonds like this one is currently 6% APR.


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Yield To Maturity (YTM)

The Yield to Maturity is the APR (Annual

Percentage Rate) that equates the bonds market

price to the present value of its promised future

cash flows.

This assumes that promised payments will bemade in full and exactly on time.


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5.3 Bond Riskiness

The YTM is the bondspromisedreturn.

But what if the bond issuer defaults?

Another source of risk lies with changinginterest rates.

As the interest rate rises, the price of a

fixed-coupon bond falls.


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Interest Rate Risk

How does the value of a bond change as interest

rates rise?

Bond values are inversely related to interest rates.

Changes in bond values as interest rates change is

known as interest rate risk.

How much interest rate risk does a bond have?

It depends on the maturity of the bond.


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5.4 Stock Valuation

There are two basic types of stock: common

and preferred.

Common stock represents the residualownership interest in a firm.

Common stockholders get whatever is left over

in the event of a bankruptcy.

They are last in line to get paid.


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Preferred Stock

Claims of preferred stockholders are junior to claims

of debtholders, but senior to those of common

stockholders.Limited voting rights compared to common stock.

Preferred stock has a par value and a dividend rate.

Failure to pay the dividend does not force the issuing

firm into bankruptcy.


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Common Stock

Represents residual ownership of the firm.

Common stockholders have important voting

rights.The issuer may pay dividends to common

stockholders. However, it is not required to do

so. Moreover, there is no pre-set dividend rate.

Future dividends are uncertain.

We need a way to forecast future dividends.

5.5 Applying the Dividend


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5.5 pp y g t e v de d

Valuation Model

Investors look at a firm as a source of

growing wealth.

Therefore, they are interested in theunderlying growth of a firm and the

implications of that growth rate for the

stocks value.


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The Dividend Discount Model

The value of a share of stock is the present

value of the expected dividends over the

holding period plus the expected sale priceat the end of the holding period.

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The Dividend Discount Model

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Common Stock Dividends

Future Dividends depend on:

the firms earnings

dividend policy

Payout Ratio = Dividends / Earnings

5.6 Obtaining Common Stock


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g

Information

Sources of information include on-line

sources, such as Yahoo! Finance and

Google Finance (go to more and theneven more).

Traditional sources include newspapers,

such as The Wall Street Journal and stock

and bond guides, such as Standard &

Poors.


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5.7 The Price-Earnings Ratio

Like participants in conversations about

football and the weather, many investors

will join into a discussion concerning theinvestment potential of a stock and feel

good about their contribution, regardless of

any knowledge they might have about the

stock.

These types always bring up the P-E ratio.

Th P i E i R i


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The Price-Earnings Ratio

Conventional wisdom holds that a high P/E

is good and a low P/E is bad.

What is the logic behind this statement?

ShareperEarnings

ShareperPriceP/E

S W i b h P/E


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Some Warnings about the P/E

The logic of the P/E depends on expectations, but

the P/E is usually based on historical numbers.

Currently reported accounting earnings do not

reflect the actual timing of the earnings.

The P/E may be high because recent earnings arelow!

Measuring the NPV of Future


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Measuring the NPV of Future

Investments

the value due to assets already in place.

the NPV of future investments expected to

be made by the firm.

The fair value of a stock can be thought of as being

made up of two components:

Some Final Comments on


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S C

Security Valuation

Mathematical models of security valuation rely on

estimates of various parameters.The estimated value is only as good as the quality

of the input parameters.

In an efficient market, the market price is a good

estimate of the securitys value.

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Team Activities

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Team A

ProblemA3

Team B

ProblemA4

Both TeamsProblemA5

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