BU283: Financial Management
Taught by:
I
Max Haalboom
Josh Allegro
alle6100@mylaurier.ca
haal1070@mylaurier.ca
SOS Exam Aid products are created from the experience
and insights from students who have previously excelled in
the course. Instructors draw upon their own notes and
successful study practices to provide an engaging
opportunity for students to learn from their peers.
Did you know more than 100,000 students have
been helped by our
Exam-AIDs on 25 University campuses?
• SOS has raised $2.5 MILLION DOLLARS for
educational projects in Latin America.
• With more than 2,000 active volunteers, SOS is
one of the largest student organizations in
Canada.
See your donation in action!
Even through COVID-19, SOS is
still funding projects in Latin
America to support learning
through the pandemic.
Watch this video to get a glimpse
of what we do at SOS!
Youtube: We Are Students Offering Support
Instructor Profile – Max Haalboom
Program: 3rd year BBA
About Me:
•
In 1st co-op at OMAFRA
•
Leafs fan
•
Currently 6-3 in fantasy football
Instructor Profile - Josh Allegro
Program: 3rd year BBA + Fin Math
About Me:
• Played on Laurier Soccer Team
•
Senior Analyst at LIFA
•
Spent last summer at Slate A.M.
Agenda
1.
2.
3.
4.
Chapter 7: Interest Rates & Bonds
Chapter 8: Stock Valuation and Market Efficiency
Chapter 5: Intro to Risk and Return
Chapter 6: Portfolio Theory
Chapter 7:
Interest Rates & Bonds
Bond Qs - Key Points
●
Bond yields and bond prices are inversely related
○
●
Yield is the return received by an investor. Cheap bonds mean better returns (higher yields)
Longer term bonds have higher yields
○
○
Long term → more risk → higher yields
When longer term bonds don’t have higher yields, the yield curve is “inverted”
Bond Qs - Key Points
●
Real vs Nominal interest rates
○
○
●
Prices of longer term bonds are more sensitive to changes in yield
○
●
Real interest rate: interest rate if inflation was nonexistent
Nominal interest rate: interest rate adjusted for inflation
Longer term bonds → more interest rate risk
Bond returns come from 2 sources (bondholder perspective)
○
○
Capital gains/losses (comes from changes in the bond price)
Interest (coupons + interest on reinvested coupons)
% Return = capital gain yield/loss + coupon yield
Capital gain/loss = Yield to maturity - coupon yield
→ This implies that...
a) If yield > coupon rate → bond is sold at a discount (capital gains)
b) If yield < coupon rate → bond is sold at a premium (capital losses)
By inspection, we see that bond Z is
trading at a premium (P > FV), yet its
coupon rate is lower than its yield to
maturity.
→ Bond Z is reported incorrectly
B → Longer maturity bond prices are more sensitive to changes in interest rates
*Think of a change in interest rate as a change in yield*
*Upward sloping yield curve means longer maturity bonds have higher yields*
Maturity preference theory: investors prefer securities with shorter maturities (i.e. prefer to
“roll over” instead of “locking in”)
● Because of this preference, the “lock in” rate is increased by a premium
● This increased “lock in” rate means that longer term bonds have even higher yields
● Longer term bonds having higher yields makes the yield curve steeper
-Maturity preference theory assumes that investors care more about interest rate risk in
comparison to reinvestment rate risk.
● Interest rate risk: if interest rates rise, bond prices fall so you may have to sell at a loss
○ Associated with locking in
● Reinvestment rate risk: if interest rates fall, bond prices rise so you if you roll over you
will have to repurchase at a premium
○ Associated with rolling over
→ Since the bond is trading at par, we know that yield = coupon rate = 4%
→ This means that the bond price will not change over its entire life
(assuming yields remain constant)
→ Capital gain return = 0%
Say a bond holder purchases a bond today for $110 with a face value of $100 that pays annual 5%
coupons and matures in 10 years. What percentage of total cash flows received by the bondholder is
interest earned on reinvested coupons? Assume that the risk free rate is 2%.
Chapter 8:
Stock Valuation & Market Efficiency
Stocks
Stocks: A security that represents ownership in an incorporated company (Attend
general meetings, review financial statements and elect members to the board of directors)
Common Shares
Preferred Shares (Hybrid)
Typically give owner one vote per
share
•
Pay a fixed amount of dividends
•
Typically do NOT have voting rights
•
Have a claim on assets and income
after all liabilities (Residual
Claimant)
•
•
Receive anything left after all
liabilities have been covered
If Board of Directors choose to suspend
dividends (hard to do), they must pay
dividends to preferred before common
(Cumulative Dividends)
•
In areas of liquidation receive par value
•
•
Profit can be distributed through
dividends or stock repurchases
Capital Structure
Paid First
Bonds
Paid Last
Preferred
Common
Stock Markets
Primary Market: Market where securities are traded for FIRST time
Initial Public Offering (IPO): Where a firm first offers shares to the public
and the firm becomes a public company
Secondary Market: Market for trading securities after they have been issued
(Exg, NASDAQ and NYSE)
Seasoned Offering: An issue of stock that was offered in the past and has
been traded since
Public Company: Traded publicly on stock exchange
Private Company: Not actively traded and not listed on exchange
Long
Positions
Long Position: An investment where ownership is taken before the security is
sold. (Purchase Precedes Sale) (Buy Low, Sell High)
Exg: Buying a house and hoping price of house will rise and you sell at higher price
Sell
Buy
Calculation:
Bought: $903,800
Sold: $970,000
Capital Gain: $66,200
BUY ONLY IF YOU EXPECT INCREASE IN ASSET PRICE
Short Selling
Short Position: Investor borrows security. It is then sold. Later the
security is bought back to repay the loan.
Profitable only if you buy High and sell low.
Borrow
Buy
Calculation
Borrowed: $9,817
Bought: $8,567
Capital Gain: $1,250
SHORT ONLY IF YOU EXPECT DECREASE IN ASSET PRICE
Practice Question 1
Which of the following is false?
a.
In both long and short positions, the investor hopes that stock price
will rise
b.
Investors want stock prices to rise when they take a long position
and drop when they take a short position
c.
In a long position the investor owns the stock
In a short position the investor has sold stock that is borrowed
d.
Practice Question 1 Answer
Which of the following is false?
a.
In both long and short positions, the investor hopes that stock
price will rise
b.
Investors want stock prices to rise when they take a long position
and drop when they take a short position
c.
In a long position the investor owns the stock
In a short position the investor has sold stock that is borrowed
d.
Valuation of Preferred Stock
Simple preferred stock that is assumed to pay dividends in a perpetuity
(forever)
Practice Problem 2
If a preferred stock sold for $62 a share and $2.11 dividends were paid
annually, what would be the required rate of return?
Practice Problem Answers
If a preferred stock sold for $62 a share and $2.11 dividends were paid
annually, what would be the required rate of return?
Algebraically
Valuation of Common Stock Using
Dividend Discount Model
Calculate current price of stocks using Dividends and returns, allows
you to see if you want to invest or not dependent on assumptions
Practice Problem 3
An investor plans to buy a share of stock today, which will be held for 1 year. The
stock will pay a $1.85 dividend and should sell for $50. If the required return is
11%, how much should investor pay for the stock?
Practice Problem Answers
An investor plans to buy a share of stock today, which will be held for 1 year. The
stock will pay a $1.85 dividend and should sell for $50. If the required return is
11%, how much should investor pay for the stock?
Practice Problem 4
Solution
Constant Growth Model
Assume that dividends grow at a constant periodic rate forever
THE GROWTH RATE IS ASSUMED TO BE LESS THAN REQUIRED RETURN
Constant Growth Model Cont’d
●
●
●
FV = most recently occurring
dividend
PV = earliest occurring dividend
n = # intervals during which
dividends can grow
●
First term = dividend yield
○
●
High yield stocks pay a relatively high portion of
their income in form of dividends
Second term = capital gain yield
○
Zero / Low yield stocks pay out a low percentage
of income as dividends, instead investing in
growth
Constant Growth Model Practice (Q5)
Pan American Airlines pays annual dividends on December 31. Today is January 1.
Yesterday, PAN AM paid a dividend of $1.86. Dividends are expected to increase
by 27% this coming year and then drop a long-run (perpetual) growth rate of 2.5%.
Investors expect a return of 8.1% on PAN AM shares. What is the fair price for
PAN AM?
a.
b.
c.
d.
$29.53
$25.31
$33.74
$42.18
Constant Growth Model Answers
Practice Problem 6
Solution
Practice Problem 7 with non-constant
growth
Solution
Problem 8 with non-constant growth
The last dividend paid was $2 per share. They are expected to grow at a 20% rate
for the next 3 years, then at a constant 10% thereafter. The required return of
shareholders is 15%. What is the most you would be willing to pay for this stock?
Solution
McNally’s Solution
Stock Repurchases and Total Payout
Model
Stock Repurchase: The repurchase of stock by a firm from its existing
stockholders. It is a method to distribute cash without paying dividends
Open Market Share Repurchase: A company instructs its broker to buy shares on the open market prevailing
market prices. The shares are then cancelled and no longer outstanding. (Most Common)
Fixed-Price Tender Offer: A one-time offer by a company looking to acquire another company that includes
desire to purchase a certain number of shares at a fixed price. (Premium Price)
Dutch Auction Share Repurchase: A company announces a target repurchase quantity and invites
shareholders to offer their sales for sale.
Total Payout Model: Provides an estimate of stock price by discounting dividends
and share repurchases
Total Payout Model
TPM values a company’s total equity
Total Payout Model Practice Problem (Q9)
Analysts expect Sturk Industries to make payouts of $2.00 billion at the end of this year. Assume
that all payouts occur annually at the end of the year and that we are at the beginning of the year.
Analysts forecast that Sturk’s payouts will grow at 2.5% in perpetuity. Sturk stockholders required a
return of 12%. Sturk has 1.44 billion shares outstanding. What is the fair price for Sturk’s shares
today?
Total Payout Model Answers
Analysts expect Sturk Industries to make payouts of $2.00 billion at the
end of this year. Assume that all payouts occur annually at the end of the
year and that we are at the beginning of the year. Analysts forecast that
Sturk’s payouts will grow at 2.5% in perpetuity. Sturk stockholders
required a return of 12%. Sturk has 1.44 billion shares outstanding. What
is the fair price for Sturk’s shares today?
Practice Problem Q10
Solution
Price Earnings Valuation Method
The Price/Earnings (P/E): measure of how much the market is willing to pay for
$1 of earnings from a firm
It can be used to estimate the value of a firm’s stock
Alternative valuation model when dividend and repurchase data is not available
Typically going to use an industry P/E constant in calculations
P/E Theory Question (Q11)
Answer
P/E Question (Q12)
Company Z is currently priced at $29. They just reported
earnings per share of $0.75. What is the P/E ratio that
investors are willing to pay for a share of Company Z’s stock?
P/E Question Answers
Company Z is currently priced at $29. They just reported earnings per share of
$0.75. What is the P/E ratio that investors are willing to pay for a share of
Company Z’s stock?
PE Question (Q13)
Powell Motors has a P/E constant of 15 and 121 million shares
outstanding. Analysts forecast net income to be $257.7 million in the
next year. What is the fair price for a share of Powell Motors?
PE Question (14)
Powell Motors has a P/E constant of 15 and 121 million shares outstanding.
Analysts forecast net income to be $257.7 million in the next year. What is the fair
price for a share of Powell Motors?
Chapter 5:
Introduction to Risk and Return
Risk and Return - Key Points
*More risk → higher expected/required returns*
● Computing the return on a single asset
● Risk of a single asset
○ Components of risk: harm + uncertainty (must have both)
○ Standard deviation: measure of risk of a single asset (higher sd → more risk)
Risk and Return - Key Points
● Expected return of a portfolio
● Risk of a portfolio of assets
○ Correlation is the measure of risk used for a portfolio of assets
○ You lower risk by collecting stocks with low or negative correlations
What is bigger: geometric or arithmetic?
Chapter 6:
Portfolio Theory
Standard Deviation of a Two-Asset Portfolio
Portfolios with more assets are then calculated with risk driven by average
degree of covariance
Practice Question 1
Consider the data provided in the table for portfolio of assets A and B. The portfolio weights and
variances are given in the table. The variances are expressed in decimal form. For example, if
standard deviation is 50% then the variance is .5^ = .25. The correlation of returns of the two assets
is 0.39. What is the standard deviation of the portfolio?
Portfolio Weights
Variances
Standard Deviation
Asset A
0.53
0.1369
0.37
Asset B
0.47
0.4096
0.64
Practice Question Answer
Portfolio Weights
Variances
Standard Deviation
Correlation
Variance
Standard Deviation
A
B
0.53
0.1369
0.37
0.47
0.4096
0.64
0.65
0.205619
0.4535
Correlation Practice Problem (Q2)
● When the coefficient
correlation is equal to +1
(-1), assets are perfectly
positively (negatively)
correlated
○ No bonus from
diversification
● Assets with lower
correlation translate to a
lower standard deviation,
and a less risky portfolio!
Solution (Q2)
Types of Risk
𝑻𝒐𝒕𝒂𝒍 𝑹𝒊𝒔𝒌 = 𝑵𝒐𝒏𝒅𝒊𝒗𝒆𝒓𝒔𝒊𝒇𝒊𝒂𝒃𝒍𝒆 𝒓𝒊𝒔𝒌 + 𝑫𝒊𝒗𝒆𝒓𝒔𝒊𝒇𝒂𝒃𝒍𝒆 𝑹𝒊𝒔𝒌
Nondiversifiable/Market/Systematic Risk: Risk that cannot be eliminated
through diversification, system wide risk and risk of holding market portfolio
Exg: Wars, Oil Price Shocks, Monetary Policy, Sovereign Default (Coronavirus) (EXTERNAL)
Diversifiable/Firm-Specific/Unsystematic: Risk eliminated through
diversification, holding one or few firms in a portfolio, not system wide
Exg: Strikes, input shocks, major customer loss, technological obsolence (INTERNAL)
Practice Question (Q3)
What type of risk affects all stocks to a greater or lesser extent and is
due to macroeconomic shocks?
a.
b.
c.
Unsystematic (diversifiable)
Total risk
Systematic (nondiversifiable)
Practice Question Answer
What type of risk affects all stocks to a greater or lesser extent and is
due to macroeconomic shocks?
a.
b.
c.
Unsystematic (diversifiable)
Total risk
Systematic (nondiversifiable)
Efficient Set
Naïve Diversification: The strategy of investing equal amounts of money in a
portfolio of randomly selected stocks
Efficient Set: The set of all efficient portfolios across all levels of standard
deviation
New Efficient Set: The set of portfolios formed by combining the risk-free asset and market portfolio
Risk-Free Asset: An asset with no variation in its return and no risk of default. (TBills USA)
The standard deviation of returns is zero
The correlation of risk-free returns with returns of any other asset is zero
Market Portfolio
Market Portfolio: The portfolio that includes every capital asset held
in proportion to its market value relative to market value of all assets in
total
Value Weighted Portfolio: The portfolio weights are equal to the
value of each asset relative to the total value of the assets in the
portfolio
𝒌 𝒑 = 𝒘 𝑩 𝒌 𝑩 + 𝒘 𝒔𝒌 𝒔
All investors should optimally hold a portfolio with the same assets in the same proportion
The market portfolio is the aggregation on the individual investors portfolios
Practice Question (Q4)
Solution
Stock Market Indexes
Stock Market Index: A statistical indicator showing relative value of a basket of
stocks compared to their value in a base year
Measure the ups and downs of the stock market
Exg: Standard & Poor 500 (S&P500), NASDAQ
Exchange Traded Fund (ETF): Investment companies, like mutual funds that are
legally classified as open-end companies or trusts
Seek same return as a market index
Different from Mutual Funds (Shorted, traded within days, bought on margin)
Practice Question (Q5)
Solution
Systematic Risk
Beta: The measure of systematic risk
Measures the marginal change to the risk of the market from the
changing quantity of a given asset
Marginal Risk: Increase in a portfolio’s risk resulting from the
addition of one more unit of a particular asset to the portfolio
Practice Question (Q6)
Solution
Estimating Beta
To estimate beta, it is necessary to graph returns of an asset relative to
market portfolio (S&P500 most common)
Characteristic Line: Line of best fit (regression) when the return of an
asset is plotted against the return on the market portfolio
The slope of the characteristic line is the beta of the asset
Points that do not fall on-line result from firm-specific risk factors
Y-Axis: Return on Security
X-Axis: Return on Market
Properties of Beta
Market Beta is equal to 1
Risk Free Asset Beta is 0
Beta of a portfolio is the weighted average of the individuals beta
Practice Question (Q7)
Consider the following historic information on the market, the risk-free
rate (T-Bills) and two mutual funds, Templeton and Fidelity. If you had
invested 56.64% of your wealth in Fidelity and the remainder in
Templeton, what was your portfolio’s beta?
Average
Return
Beta
Templeton
Bills 9.93%
1.3
Fidelity Market
5.03% 8.96% 1.40%
0.5
1
0
T-
Practice Question (7) Answer
Practice Question 8
Solution
STAY IN THE LOOP!
@lauriersos
@lauriersos
Thank you!
Please fill out this survey: rb.gy/n5iifo