Chapter 4 --Value-driven
Management -- Arbitrage
 Explain
how arbitrage works to ensure that the prices of
financial claims are equal to the present value of the
expected future cash flows.
 You have two investments of equal risk below:
 Investment A -- price $120 with a $10 return forever.
 Investment B -- price $80 with a $10 return forever.
 What should happen in the market?
 Answer
-- equal financial claims of equal risk sell for
equal prices in the market.
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Arbitrage
 Explain
how arbitrage works to ensure that the prices of
financial claims are equal to the present value of the
expected future cash flows.
 Two
investments of equal risk below:
 Investment A -- price $100 with a $12 return forever.
 Investment B -- price $100 with a $8 return forever.
 What
should happen in the market?
 Answer -- financial claims of equal risk sell for equal rates
of return in the market.
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Price Terminology

What is the difference between bid prices, the
highest bid price, asked prices, the lowest asked
price and market price?

What role does the existence of different
information sets play in determining the different
prices above?
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Information Sets
Who probably has the better information set
pertaining to the future cash flows of Microsoft?
 Bill Gates -- the Chairman of the Board and
Chief Executive of Microsoft
 A typical stockholder of Microsoft
 When we refer to the intrinsic value of Microsoft,
to whose intrinsic value are we referring?
 What happens when the intrinsic value is different
than the market price of the stock?

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Information Sets – Financing Decisions &
Capital Investment
 When
the information set of management does not match
the information set of the stockholders, two situations may
exist that have an impact on the financing decision.
 Managers may be more optimistic than the market about
the future cash flows of the company:
 What influence does this have on the financing of new
investment opportunities?
 The market may be more optimistic than management
about the future cash flows of the company:
 What influence does this have on the financing of new
investment opportunities?
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Bonds
 Bonds
are one claim on the value of a firm
 Know how to find the present value of a
bond
 Know how to use the IRR function on the
calculator to find the market return or yield
to maturity
 Know how to use the IRR function on the
calculator to find the yield to call
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Bond Terminology

Bond yield terminology
 Yield to maturity
 Yield to call
 Current yield
 Coupon rate
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Preferred Stock
Preferred stock is another claim on the value of a
firm
 The value of preferred stock can be found using
the perpetual no-growth model in chapter 3
 Value today = Expected dividend / required rate of
return for preferred shareholders
 Market typically tells you the price and the
dividend in know – work backwards to get the
required return

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Common Stock
Common stock is another claim on the value of a
firm:
 A short-cut method to value common stock is to
use the constant dividend growth model
 Value today = Expected dividend /(required return
for common shareholders - growth)
 Weaknesses of the model:
 constant growth
 companies that do not pay dividends

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Asset View: Variables That Drive Stock
Value
 Looking
at value from the asset side instead of the
financing side, the firm value is driven by:
 Existing projects -- dividends or cash flows from existing
projects
 NPV of new investment opportunities expected to be taken
in the future -- with perfect information
 Competitive advantage --> Economic Profit --> taken to
present leads to net present value --> which measures the
increase in value of the stock (with perfect information)
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Other Events
Factors that do not influence value -- smoke and
mirrors
Stock splits
Stock dividends
 Factors that influence value
 Earnings
 Investment announcements

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Value of Currency
 Purchasing
power parity (PPP) theory states
that equilibrium exchange rates between
two countries will result in identical goods
selling at identical prices.
 Ex.
The price of Big Macs.
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 Ert
= Ert-1(1 + INFd)/(1 + INFf)
but the differences in Interest Rates and
Perceived Safety between countries. Market
forces are not enough. And, the difficulty of
movement between two countries.
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Interest Rate Parity Theory
 Rf
= (ERspot/ERforward)(1 + Rd) -1
 See
these examples in p.122
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The Questions Are…
 Combine
thinking about purchasing power
and interest rate.
 And,
advanced thinking, expecting and
speculating, and expecting the expecting.
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