FM NOTES Table of Contents Seminar 1: An Overview of Financial Management ...................................................................................................................................... 8 Areas of Finance ........................................................................................................................................................................................................ 8 Forms of Business Organizations ................................................................................................................................................................................ 9 Main Financial Goal: Creating Value for Investors ..................................................................................................................................................... 10 Stockholder – Manager Conflicts .............................................................................................................................................................................. 11 Stockholder – Debtholder Conflicts........................................................................................................................................................................... 11 Qualitative Answers for Seminar Questions .............................................................................................................................................................. 12 Seminar 2: Time Value of Money .................................................................................................................................................................16 Future Value ............................................................................................................................................................................................................ 16 Present Value .......................................................................................................................................................................................................... 16 Future Value of Ordinary Annuity ............................................................................................................................................................................. 16 Present Value of Ordinary Annuity ........................................................................................................................................................................... 16 Uneven Cash Flows .................................................................................................................................................................................................. 16 Periodic Rate ........................................................................................................................................................................................................... 17 APR ......................................................................................................................................................................................................................... 17 Effective Annual Rate ............................................................................................................................................................................................... 17 How I/R affects Optimal Choice ................................................................................................................................................................................ 17 Loan Amortization ................................................................................................................................................................................................... 17 Reminders When Doing TVM Questions ................................................................................................................................................................... 18 Calculating Interest Payments @ t = x ....................................................................................................................................................................... 18 Calculating TVM Questions....................................................................................................................................................................................... 18 Sidenotes................................................................................................................................................................................................................. 18 Seminar 3: Financial Markets & Institutions and Interest Rates ...................................................................................................................19 The Capital Allocation Process .................................................................................................................................................................................. 19 How is Capital Transferred?...................................................................................................................................................................................... 19 Financial Markets..................................................................................................................................................................................................... 20 Types of Financial Markets ....................................................................................................................................................................................... 21 Recent Trends .......................................................................................................................................................................................................... 22 Types of Financial Institutions .................................................................................................................................................................................. 23 The Stock Market ..................................................................................................................................................................................................... 25 The Market for Common Stock ................................................................................................................................................................................. 26 Types of Stock Market Transactions.......................................................................................................................................................................... 26 Financial Statements and Reports ............................................................................................................................................................................ 27 Balance Sheet .......................................................................................................................................................................................................... 28 The Income Statement ............................................................................................................................................................................................. 30 Income Taxes ........................................................................................................................................................................................................... 31 Factors affecting Interest Rates ................................................................................................................................................................................ 32 Interest Rates .......................................................................................................................................................................................................... 33 Determinants of Market Interest Rates..................................................................................................................................................................... 33 Premiums Added to r* with Different Types of Debt ................................................................................................................................................. 35 Term Structure of Interest Rates............................................................................................................................................................................... 36 Determinants of the Shape of Yield Curve................................................................................................................................................................. 37 Constructing the Yield Curve .................................................................................................................................................................................... 37 Macroeconomic Factors that Affect I/R..................................................................................................................................................................... 38 Seminar 4: Bonds and Their Valuation .........................................................................................................................................................40 Key Characteristics of Bonds ..................................................................................................................................................................................... 41 Bond Valuation ........................................................................................................................................................................................................ 44 Opportunity Cost of Debt Capital.............................................................................................................................................................................. 45 Yield to Maturity...................................................................................................................................................................................................... 45 Changes in Bond’s Values Over Time ........................................................................................................................................................................ 45 Bonds with Semiannual Coupons .............................................................................................................................................................................. 47 Factors that Determines a Bond’s Riskiness .............................................................................................................................................................. 47 Comparing Price Risk & Reinvestment Risk ............................................................................................................................................................... 47 Default Risk ............................................................................................................................................................................................................. 49 Types of Corporate Bonds ........................................................................................................................................................................................ 49 Bond Ratings............................................................................................................................................................................................................ 49 Change in Ratings..................................................................................................................................................................................................... 50 Bankruptcy and Reorganization ................................................................................................................................................................................ 50 Notes from Tutorial.................................................................................................................................................................................................. 50 Seminar 5: Risks and Rates of Return ........................................................................................................................................................................ 52 The Risk Return Tradeoff .......................................................................................................................................................................................... 52 Stand Alone Risk ...................................................................................................................................................................................................... 52 Portfolio Risk: The CAPM.......................................................................................................................................................................................... 53 Relationship Between Risks and Rates of Return....................................................................................................................................................... 57 Notes from Tutorial.................................................................................................................................................................................................. 59 Seminar 6: Stocks and Their Valuation ........................................................................................................................................................60 Common Stockholders’ Control of the Firm............................................................................................................................................................... 60 Pre-emptive Right .................................................................................................................................................................................................... 60 Types of Common Stock ........................................................................................................................................................................................... 61 Stock Price VS Intrinsic Value.................................................................................................................................................................................... 61 Discounted Dividend Model ..................................................................................................................................................................................... 61 Expected Dividends as the Basis for Stock Values ...................................................................................................................................................... 63 Constant Growth Stocks ........................................................................................................................................................................................... 63 Dividends VS Growth ............................................................................................................................................................................................... 63 Current Dividend VS Growth .................................................................................................................................................................................... 64 Required Conditions For Actual Growth Model ......................................................................................................................................................... 64 Valuing Non-constant Growth Stocks........................................................................................................................................................................ 64 Multiples of Comparable Firms ................................................................................................................................................................................. 65 Preferred Stock ........................................................................................................................................................................................................ 65 Relative Risk of Stocks.............................................................................................................................................................................................. 66 Market Efficiency ..................................................................................................................................................................................................... 66 Notes from Tutorial.................................................................................................................................................................................................. 67 Seminar 7: The Cost of Capital.....................................................................................................................................................................69 Overview of WACC ................................................................................................................................................................................................... 69 Basic Definitions ...................................................................................................................................................................................................... 69 When Must External Equity Be Used? ....................................................................................................................................................................... 72 Factors That Affect WACC......................................................................................................................................................................................... 73 Adjusting Cost of Capital for Risk .............................................................................................................................................................................. 76 Other Problems with Cost of Capital Estimates ......................................................................................................................................................... 76 Notes from Tutorial.................................................................................................................................................................................................. 76 Seminar 8: The Basics of Capital Budgeting .................................................................................................................................................78 An Overview of Capital Budgeting ............................................................................................................................................................................ 78 Net present Value .................................................................................................................................................................................................... 79 Internal Rate of Return (IRR) .................................................................................................................................................................................... 80 Multiple Internal Rates of Return ............................................................................................................................................................................. 80 Reinvestment Rate Assumptions .............................................................................................................................................................................. 81 Modified Interest Rate of Return (MIRR) .................................................................................................................................................................. 81 NPV Profiles ............................................................................................................................................................................................................. 81 Payback Period ........................................................................................................................................................................................................ 82 Discounted Payback ................................................................................................................................................................................................. 83 Seminar 9: Free Cash Flow ..........................................................................................................................................................................84 Free Cash Flow ......................................................................................................................................................................................................... 84 Conceptual Issues in Cash Flow Estimation ............................................................................................................................................................... 85 Timing of Cash Flows ................................................................................................................................................................................................ 85 Incremental Cash Flows............................................................................................................................................................................................ 85 Replacement Projects .............................................................................................................................................................................................. 86 Sunk Cost................................................................................................................................................................................................................. 86 Opportunity Costs Associated with Asset the Firm Owns ........................................................................................................................................... 86 Externalities............................................................................................................................................................................................................. 86 Analysis of Expansion Projects .................................................................................................................................................................................. 87 Replacement Analysis .............................................................................................................................................................................................. 87 Risk Analysis in Capital Budgeting............................................................................................................................................................................. 88 Measuring Stand-Alone Risk ..................................................................................................................................................................................... 88 Within Firm and Beta Risk ........................................................................................................................................................................................ 89 Unequal Project Lives ............................................................................................................................................................................................... 89 Leasing .................................................................................................................................................................................................................... 90 Financial Statement Effects ...................................................................................................................................................................................... 91 Evaluation by Lessee ................................................................................................................................................................................................ 92 Other Factors that Affect Leasing Decisions .............................................................................................................................................................. 92 The Optimal Capital Budget ...................................................................................................................................................................................... 92 Notes from Tutorial.................................................................................................................................................................................................. 93 Capital Structure and Leverage ...................................................................................................................................................................96 Book, Market or “Target Weights”............................................................................................................................................................................ 96 Measuring the Capital Structure ............................................................................................................................................................................... 96 Capital Structure Changes Over Time ........................................................................................................................................................................ 97 Business Risk ........................................................................................................................................................................................................... 97 Operating Leverage .................................................................................................................................................................................................. 98 Financial Risk ........................................................................................................................................................................................................... 99 Determining the Optimal Capital Structure ............................................................................................................................................................. 100 Capital Structure Theory ........................................................................................................................................................................................ 100 Trade-off Theory .................................................................................................................................................................................................... 102 Signalling Theory.................................................................................................................................................................................................... 102 Using Debt Financing to Constrain Managers .......................................................................................................................................................... 103 Pecking Order Hypothesis ...................................................................................................................................................................................... 104 Windows of Opportunity........................................................................................................................................................................................ 104 Checklist of Capital Structure Decisions .................................................................................................................................................................. 104 Variations in Capital Structures .............................................................................................................................................................................. 105 Sidenotes............................................................................................................................................................................................................... 106 Seminar 1: An Overview of Financial Management Areas of Finance Financial Markets Capital Markets Focus on decisions related to… • How much / what type of assets to acquire • How to raise capital needed to purchase assets • How to run the firm to maximize values • • • • Investments Markets where interest rates, along with stock prices & bond prices are determined Financial Institutions that supply capital to businesses (Eg. Banks, Investment Banks, Stockbrokers, Mutual Funds, Insurance Companies) Government organizations (Eg. Federal Reserve System) regulates banks & controls supply of money Securities Exchange Commission (SEC), which regulates the trading of stocks and bonds in public markets Decisions concerning stocks and bonds • Security analysis – finding proper values of individual securities • Portfolio theory – best way to structure portfolios • Market analysis – Whether stock and bond markets at any given time are “too high”, “too low” or “about right” Forms of Business Organizations Description Proprietorships Partnerships Corporations Limited Liability Company Unincorporated business owned by 1 individual Unincorporated business owned by 2 or more individuals Incorporated business owned by many shareholders Hybrid between partnership and corporation. Investors have votes in proportion to their ownership interests Advantages • • • Ease of formation Subject to few regulations No corporate income taxes • • • • Ease of raising capital Ease of ownership transfer Unlimited life Limited Liability • • Limited liability No corporate income taxes Disadvantages • • • Difficult to raise capital Unlimited liability Limited life • • Cost of setup and report filing Double taxation • Difficult to raise capital to support growth If business is not a small one and they are organized as a corporation, the value is maximized because… 1. Limited liability reduced the risks borne by the investors. → Lower risk = Higher value 2. Firm’s value is dependent on growth opportunities, which are dependent on ability to attract investors. a. Corporations can attract capital more easily → Better able to take advantage of growth opportunities 3. The value of an asset depends on its liquidity. a. Stock of a corporation is easier to transfer + more investors are willing to invest in stocks due to limited liability → Relatively more liquid investment rate = Enhance value of corporation In Singapore, Companies pay 17% corporate tax. Proprietorship / partnership pays 0%-22% income tax. • There won’t necessarily be a tax disadvantage for corporations if personal income tax > corporate income tax Main Financial Goal: Creating Value for Investors Intrinsic Value Estimate of a stock’s “true” value based on accurate risk and return data, cannot be measured precisely • A long-run concept. Management should take actions to maximize intrinsic value, NOT current market price • Maximizing intrinsic value = Maximize over time!! Not a particular value. Market Price Stock value based on perceived by possibly incorrect information as seen by the marginal investor Marginal Investor An investor whose views determine the actual stock price Equilibrium The situation in which the actual market price equals the intrinsic value, so investors are indifferent between buying and selling a stock Sidenote • Companies should not aim to maximize accounting profits o Accounting profits are not cash (included non-cash items like depreciation) o In finance, cash is king o Accounting profits does not take into account risk of cash flow to risk-averse shareholders True Investor Cash Flows Managerial Actions + Economic Environment + Taxes + Political Climate True Risk Perceived Investor Cash Flows Perceived Risk Stock’s Intrinsic Value Stock’s Market Price Market Equilibrium: Intrinsic Value = Stock Price Stockholder – Manager Conflicts • Managers might be more interested in maximizing their own wealth than the stockholder’s wealth Solutions Description Compensation packages • • Should not go beyond what is needed, consistent over time Managers rewarded on the basis of the stock’s performance over the long run Direct Stockholder intervention • Large firm’s management might get ousted by stockholders Hostile takeovers • Corporate raiders may see firm’s undervalued stock as a bargain and attempt to capture the firm in a hostile takeover → Managers will be fired Stockholder – Debtholder Conflicts • Stockholders will receive whatever is left after bondholders gets paid o Higher risk = Higher returns for stockholders o Higher risk = Lower returns for bondholders βͺ Since they recognize that managers & stockholders have the incentive to shift to riskier projects, they will demand a higher ROR • o Stockholders typically more willing to take on risky projects The more debt a firm uses, the riskier it becomes o If firm uses more bonds than common stocks to finance debt, bondholders suffers a loss if firm values decreases slightly (and vice versa) o Bondholders include covenants in the bond agreements to limit firm’s use of additional debt and constrain managers’ actions Qualitative Answers for Seminar Questions In the U.S., corporations are subjected to double taxation. In Singapore, dividends to shareholders of corporations are not taxed. In this case, would there still be a tax disadvantage to setting up a corporation rather than a sole proprietorship in Singapore? In Singapore, Companies pay corporate tax rates of 17% on business income. Owners or sole proprietorships pay personal income tax rates ranging from 0% to 22% → Sole proprietorships may still pay less tax rates. Hence, setting up a corporation need not have a tax disadvantage if the personal income tax rate is higher than corporate tax Suppose three honest individuals gave you their estimates of Stock X’s intrinsic value. One person is your current roommate, the second person is a professional security analyst with an excellent reputation on Wall Street, and the third person is Company X’s CFO. If the three estimates differed, in which one would you have the most confidence? Why? You should have the most confidence in the company’s CFO’s estimate, because he is most likely to have access to better information relating the company’s performance and future prospects, and hence he should be in the best position to estimate the intrinsic value of the company’s shares. The president of Southern Semiconductor Corporation (SSC) made this statement in the company’s annual report: “SSC’s primary goal is to increase the value of our common stockholders’ equity.” The newspapers also reported the following news on SSC. a) Company contributed 1.5 million to symphony orchestra in Birmingham, Alabama, its headquarters city Everything that a company does must be driven towards maximizing shareholder’s wealth. Even if a company is very profitable / rich in cash, it is not reason enough to engage in any form of donations / philanthropic contributions, unless they are related (at least indirectly) to maximizing shareholders’ wealth. If shareholders of the company are not convinced that the contribution to the symphony orchestra can somehow indirectly improve the company’s performance and enhance shareholders’ wealth, then the stock price (and stock’s intrinsic value) is likely to decrease. b) In an effort to reduce cost, SSC’s plant released untreated industrial waste into the nearby river. • • • • If company breaks the law for polluting the river, then shareholders will be very concerned & the share price is likely to fall If the company is not breaking any laws, it may be difficult to tell how shareholders would view the situation + how the share price may be affected. Would there be negative effects from boycotts of the company products? (But SSC is not producing consumer end products → Lesser damage to its image in the eyes of general consumers) Lower costs of not treating the waste → Higher short-term profits & share price BUT share price may be adversely affected by tarnished image in the long-term True / False Questions a) If management maximizes the firm's expected profits for the for the current year, this will also maximize the stockholders' wealth as of the current year False. Stockholders’ wealth is determined by the intrinsic value of the stock, which reflects the prospects and future of the firm. Maximizing current year’s expected profit may be achieved at the expense of the future of the firm. For example: • • Managers can use accounting manipulation to maximize profits → no effect on the real cash flows of the firm (hence does not increase the firm’s value) Managers can also seek to minimize current expenses (eg. Marketing / R&D expenses) to maximize current year profits → adversely jeopardize the competitiveness of the firm in the future. b) The goal of financial management is to minimize the firm's risks because most stockholders dislike risk. In turn, this will maximize the firm's stock price. False. Minimizing risk will inevitably lead to firm not taking any risk at all → Firm will not engage in any business activity → Will not lead to maximum stock price. For example: • Managers of the firm may minimize risks by putting the corporate funds in the banks for “safekeeping”, instead of investing them in business activities with appropriate risks to generate returns. c) The goal of financial management is to maximize the long-run value of stockholder claims True. Consistent with the objective of maximizing shareholders’ wealth d) One reason a business might choose to operate as a corporation rather than a proprietorship is that corporations generally find it easier to raise large amounts of capital True. Investors of businesses are generally unwilling to be subjected to unlimited liability + they want to be able to sell their shares should they choose to do so. Businesses incorporated as corporations allow investors to enjoy such benefits. If a company’s board of directors wants management to maximize shareholder wealth, should the CEO’s compensation be set as a fixed dollar amount, or should the compensation depend on how well the firm performs? If it is to be based on performance, how should performance be measured? • • • The CEO should be compensated based on how well the firm performs, otherwise the CEO would have the tendency to act in his personal interests rather than the interest of the shareholders By linking CEO’s financial rewards to the firm’s performance, it will motivate him to act in the best interest of the firm & its shareholders Theoretically, performance of & reward for the CEO should be based on his ability to increase the intrinsic value of the firm’s shares. But since intrinsic values of shares is difficult to measure, increase in the firm’s share price in the long term could be used as a proxy to determine the CEO’s performance. o Executive stock options (vested over a period of 5-10 years). Seminar 2: Time Value of Money Future Value πΉππ = ππ(1 + πΌ)π Present Value πππ = Future Value of Ordinary Annuity FVAN =PMT(1+I)N-1 +PMT(1+I)N-2 +…+PMT(1+I)0 =PMT [ Present Value of Ordinary Annuity πππ΄π = (1+πΌ) + (1+πΌ)2 + β― + (1+πΌ)π = πππ[ Uneven Cash Flows 1 2 π π‘ ∑π ππ = (1+πΌ) + (1+πΌ) π‘=1 (1+πΌ)π‘ 2 + β― + (1+πΌ)π = πΉππ (1 + πΌ)π πππ πΆπΉ πππ πΆπΉ πππ πΆπΉ πΆπΉ (1+πΌ)π πΌ ] (1+I)N -1 ] I ππ‘ππ‘ππ π΄πππ’ππ π ππ‘ππ πΌ = ππ’ππππ ππ πππ¦ππππ‘π πππ π¦πππ π Periodic Rate πΌππΈπ = APR π΄ππ = πΌππΈπ ∗ π Effective Annual Rate If deposits & compounding is the SAME OR deposit period < compounding (eg Semiannual deposits & Semiannual compounding OR Annual deposit and Quarterly compounding) πΈπΉπΉ = [1 + πΌπππ π ] π − 1.0 , M = Compounding period If deposit period > compounding period (eg. Semiannual deposits & Quarterly compounding) π = (1 + How I/R affects Optimal Choice 0.08 2 ) − 1 = 4.04% 4 Higher interest rates = More advantageous to receive money as early as possible • Lumpsum can be invested with high rates of returns, making the total amount earned higher Loan Amortization • • • • Equal payments every period → An ordinary annuity PV of all the instalments = Initial loan principal PV of all the future unpaid instalments = Outstanding (remaining unpaid) loan principal To compute the remaining principal outstanding at any time, you need not prepare the amortization schedule. Simply DISCOUNT ALL FUTURE UNPAID INSTALLMENTS • • • Part of each instalment will go towards payment & the remaining will go towards reducing the loan principal Interest Payment = Interest rate * Price at t o If question gives you interest payment at t+1, that is interest rate*remaining unpaid principal at t The split is different for EVERY instalment Reminders When Doing TVM Questions Calculating Interest Payments @ t = x Find payment at t = x-1 Multiply it by the interest rate for the period (don’t anyhow take the nominal rate) OR Find payment at t = x-1 Find payment at t = x Find the difference Interest rate payment = PMT – difference Calculating TVM Questions Lookout for beginning / end Lookout for interest rates!! (Are they effective? Nominal? Periodic?) Calculate effective interest rates properly Sidenotes EAR cannot be used to compute dollar interest in a year Seminar 3: Financial Markets & Institutions and Interest Rates The Capital Allocation Process • Capital flows from suppliers to demanders o Suppliers: Institutions & individuals with excess funds (Saving money & looking for returns on investments) o Demanders: Institutions & individuals who need to raise funds (Willing to pay a rate of return on the capital borrowed) How is Capital Transferred? Direct Transfers Dollars Business Savers Securities • Business sell stocks / bonds directly to savers, without going through financial institution → Used by relatively small firms and raises little capital Investment Banks Dollars Dollars Business Securities • Savers Investment Banks Securities Transfers may go through an Investment Bank, which underwrites the issue • • • • Money merely “pass through” the investment banks An underwriter facilitates the issuance of securities Company sells stocks to Investment Banks, which sells the same securities to savers o Investment banks buys and holds the securities → Risk of not being able to sell for as much as they paid Primary Market Transaction o New securities involved and the corporation receives the sales proceeds Financial Intermediaries Business Business Securities • • • Financial Intermediaries Savers Intermediary Securities Financial intermediaries: Banks, Insurance Company, Mutual Fund Intermediary obtains funds from savers in exchange for its securities o Intermediary then makes use of such funds to buy and hold business securities Secondary Market Transaction o Intermediary create new forms of capital (eg. Certificates of deposits) which are safer and more liquid than mortgages and thus better for more savers to hold. o Greatly increases efficiency of money and capital markets Financial Markets • Dollars Dollars Market: Venue where goods and services are exchanges • Financial Market: Place where individuals & organizations wanting to borrow funds are brought together with those having a surplus of funds. Buyers and sellers trade debt instruments (bonds, which promise a fixed dollar amount every period) and equity instruments (stocks, which gives an uncertain dividend every period) o Vary depending on maturity of securities being traded and types of asset used to back securities Types of Financial Markets Physical Asset VS Financial Asset (based on tangibility of asset) Physical For tangible products (e.g. Wheat, Autos, Real Estate) Financial For Stocks, Bonds, Notes, Mortgages, Derivative Securities • Derivative Securities: Values derived from changes in prices of other assets • e.g. A share of ford stock is a “pure financial asset”, an option to buy ford shares is a “derivative security” whose value depends on the price of ford stock Spot VS Future (based on date of purchase / sale) Spot Assets are bought / sold for on-the-spot delivery • Future Assets bought / sold at a future date Reduces (or hedge) the risks faced by buyer / seller Money Market VS Capital Market (based on timespan of securities) Money Short-term, highly liquid debt securities (e.g. NY, London, Tokyo money markets). Less than / equal to ONE YEAR Capital Intermediate (1-10 years), long term (More than 10 years) debt and corporate stocks Primary VS Secondary (based on pre-existence of securities) Primary Markets in which corporations raise new capital Secondary Markets in which existing, already outstanding securities are traded among investors. Corporations DOES NOT receive funds from such trades. Private VS Public (based on number of parties involved in the purchase) Private Transactions are negotiated directly between two parties. (e.g. Bank loans and insurance companies) Public Standardized contracts are traded on organized exchanges (common stock & corporate bonds) → More liquid Recent Trends Globalization → Deregulation → Increased competition → More efficient, internationally linked markets Derivatives Security whose value is derived from the price of some other ‘underlying’ asset. 1. Option to buy stock – depends on price of stock 2. Contract to buy Jap Yen 6 months from now – depends on exchange rate 3. Why are derivatives important? Consider credit default swaps a. Contracts that offer protections against defaults of a particular security b. Used to reduce risks or to speculate i. Reduce risk because some derivatives’ value may increase when the dollar declines (hedging operation) ii. Speculation is buying derivatives in hopes of high returns → Raises risk exposure c. Very difficult to tell if derivatives are held as a hedge OR as a speculative bet → difficult to tell how it affects risk profile of firms Types of Financial Institutions Investment Banks • 1. 2. 3. • Help companies raise capital By designing securities with features that are currently attractive to investors Buy these securities from corporations Resell them to savers Investment bankers also = Underwriters Commercial Banks • • Serve a variety of savers and borrowers Major institutions that handled checking accounts and through which the Federal Reserve System expanded or contracted the money supply Financial Services Corporations • Large conglomerates that combine many different financial institutions within a single corporation o E.g. Citigroup owns Citibank (commercial bank), an investment bank, a securities brokerage organization, insurance companies, and leasing companies Mutual Funds • Corporations that pool money from savers and then use these funds to buy stocks, long-term bonds or shortterm debt instruments issued by businesses or government unit Achieve economies of scale in analyzing securities, managing portfolios, and buying and selling securities. Different funds meet objective of different people o Bond funds: Safety o Stock funds: Significant risks in exchange for higher returns o Money market funds: Interest-bearing checking accounts Actively Managed Funds: Try to outperform markets o Much higher fees, but difficult to predict → Better to rely on indexed funds Indexed Funds: Try to replicate the performance of a specific market index • • • • Credit Unions • Cooperative associations whose members are supposed to have a common bond (e.g. being members of the same firm). Cheapest source of funds available to individual borrowers Pension Funds • Retirement plans funded by corporations or government agencies for their workers & administered primarily by the trust departments of commercial banks or by life insurance companies. Investments in bonds, stocks, mortgages & real estate. Life Insurance Companies • Take savings in the form of annual premiums → Invest in stocks, bonds, mortgages & real estates → Make payments to the beneficiaries of the insured parties Exchange Traded Funds • • • Similar to regular mutual funds and often operated by mutual fund companies ETFs buy a portfolio of stocks of a certain type & sell their own shares to the public Generally traded in the public market Hedge Funds • • Similar to mutual funds because the accept money from savers and use the funds to buy various securities. Differences: Mutual funds & ETFs are registered and regulated by Securities and Exchange Commission (SEC), Hedge funds are largely unregulated o Because mutual funds target small investors, whereas hedge funds have large minimum investments and are marketed to individuals & institutions with high net worth Private Equity Companies • Organizations that operate much like hedge funds; but rather than purchasing some of the stock of a firm, private equity players buy and then manage entire firms. Most of the money used to buy target companies is borrowed. o Also unregulated The Stock Market Physical Location Stock Exchanges Formal organizations having tangible physical locations that conduct auction markets in designated (“listed”) securities (includes NYSE and several regional stock exchanges). • Large investment banks purchase seats on the exchanges and communicate with each other through firm’s representative on the NYSE • Exchange members with sell orders offer the shares for sale, and they are bid for the members with buy orders • Average investor is not interested in maintaining proportionate of share of ownership and control Over The Counter Stock Exchanges A large collection of brokers and dealers, connected electronically by telephones and computers, that provides for trading in unlisted securities • • • • Dealer markets: Includes all facilities that are needed to conduct security transactions not conducted on the physical location exchanges. Consist of… o The relatively few dealers who hold inventories of these securities and who are said to ‘make a market’ in these securities o The thousands of brokers who act as agents in bringing the dealors together with the investors o The computers, terminals and electronic networks that provide a communication link between dealors and brokers Price that dealors will buy the stock = bid price Price that dealors will sell the stock = ask price Bid-ask spread = Difference between bid and ask price → Increases when the stock is more volatile / stock trades infrequently → Compensates dealer for assuming the risk of holding them in an inventory The Market for Common Stock Closely Held Corporations Company so small that common stocks are not actively traded → Closely-held stocks owned by a few individuals who are typically associated with the firm’s management Publicly Owned Corporations Large companies owned by thousands of investors not actively involved in firm’s management → Publicly-held stock Types of Stock Market Transactions The Primary Market Additional / New shares sold by publicly owned companies The Secondary Market Outstanding shares of established publicly owned companies that are traded Initial Public Offerings When a closely held firm offers stock to public for the first time • It is possible for a firm to go public and not raise any new capital • When market is strong, IPO increases as companies go public to bring in new capital & give founders an opportunity to cash out on some of their shares • IPO deals are generally oversubscribed o Investment bankers favor large institutional investors & small investors will find it hard to get on the ground floor o IPOs can be bought after market but IPO underperforms the overall market over the long run Financial Statements and Reports • If a firm is more profitable than most other firms, we would normally expect to see its stock price exceed its book value per share. Balance Sheet Shows what assets the company owns and who has claims on those assets at a point in time • Depreciation in balance sheet is accumulated. Income Statement Shows the firm’s sales and costs (and thus profits) over a given period of time Statement of cash flows Shows how much cash the firm began and ended the year with + what it did to increase / decrease its cash • Maximize cash flow =/= Maximize shareholder value Statement of stockholder’s equity Shows the amount of equity that stockholders had at the start of the year, the items that increased or decreased equity, and the equity at the end of the year Balance Sheet Total Assets Current Assets Fixed Assets Cash and equivalents Actual, spendable money Account receivables Uncollected credit sales Inventories Cost of raw materials, WIP & finished goods Net cost of plant and equipment used in operations minus depreciation Total Liabilities Current Liabilities Accounts payable / Accruals Interest-free sources of short-term credit Notes payable Interest-bearing sources of credit (e.g. bank borrowings) Total Equity Definition 1 Stockholders’ equity = Paid-in capital / Common Stock + Retained Earnings • Definition 2 Retained earnings are the cumulative total of all the earnings kept by the company during its life Stockholders’ equity = Total Assets – Total liabilities Other Definitions Net Operating Working Capital (NOWC) Current Assets – (Current Liabilities – Notes Payable) • Notes payable is the one with interest Net Working Capital Current Assets – Current Liabilities Working Capital Current Assets • They are usually replaced throughout the year Total Debt Both short-term and long-term interest-bearing liabilities Total Liabilities Total debt + Account payable + Accruals Other sources of funds Preferred stocks Hybrid between common stock and debt • In times of bankruptcy, debts are paid off, then preferred stocks, then common stocks • Preferred stocks are mostly owned by corporations • One advantage to preferred stocks is that the control of the firm is not diluted (preferred stockholders have no voting rights) Convertible bonds Debt securities that give the bond-holder an option to exchange their bonds for shares of common stock Time dimension: balance sheet is a snapshot of s firm’s financial position at a point in time The Income Statement • A report summarizing a firm’s revenues, expenses and profits during a reporting period EPS (Earnings per share) Net Income / Common Share Outstanding • Most important to shareholders • Maximizing earnings per share =/= Maximizing firm’s price per share • Professionals look at operating income Sidenote: Book Value Per Share = Stockholders’ Equity / Common Share Outstanding • Lower than market value because book value is the original purchase cost, adjusted for subsequent changes like impairment or depreciation • Market value is the price obtained by selling on open, competitive markets • Book value is a historical cost → Should not be used in calculations Operating Income Income from firm’s core business, calculated before deducting interest expenses and taxes (non-operating costs). Also known as EBIT (earnings before interest and taxes) EBIT = Sales revenues – Operating costs • Best used to compare only operating performance o E.g. If firm’s EBIT is the same but one uses all equity while another uses more debt, the company with no debt will not have interest expense → Net income is higher Depreciation Charge to reflect the cost of assets depleted in the production process. Not a cash outlay. Amortization Noncash charge to reflect the decline in value of intangible assets EBITDA Earnings before interest, taxes, depreciation and amortization Income Taxes Progressive tax rate Higher income = Higher percentage paid in taxes Marginal tax rate Tax rate on the last dollar of income Average tax rate Taxes paid divides by taxable income Capital gain or loss Profit (loss) from the sale of a capital asset for more (less) than its purchase price Interest & Dividends Paid by Corporations • • Interest paid is tax-deductible and paid out of pre-tax income, which lowers taxable income Dividends paid are not tax-deductible and are paid out of their after-tax income, so it does not affect taxable income o Dividends are not an expense as it is decided by the company Interest & Dividends Received by Corporations • • 70% dividends received is excluded from taxable income, while the remaining is taxed at an ordinary rate Dividends are not taxed in Singapore o Rationale: Dividend shouldn’t be subjected to triple tax 1. Original corporate tax 2. Corporation taxed on dividends received 3. Individual taxed again Corporate Loss Carry Back and Carry Forward Rationale: Avoid penalizing corporations whose incomes fluctuate substantially from year to year Consolidated Corporate Tax Returns If a corporation owns 80% of more of another corporation’s stock, it can aggregate income and file one consolidated tax return → Allows losses of one company to be used to offset the profits of another • Makes it more feasible for large, multidivisional corporations to undertake risky new ventures Taxation of Small Business Corporations All income is reported as personal income and taxed at a personal income tax rate → Only taxed once Factors affecting Interest Rates Production Opportunities E.g. Investment opportunities in production of cash-generating asset Time Preference for Consumption Sets how much they are willing to save at different rates • Preference for current consumption VS Savings for future consumption Risk Chance that investment results in low / negative returns • Higher risk = Higher I/R Inflation Amount by which prices increase over time • Higher inflation =Higher I/R Interest Rates • Current rate of real interest = Current interest rate minus the current inflation rate Determinants of Market Interest Rates Quoted I/R = r = r* + IP + DRP + LP + MRP r required return on debt security (nominal I/R) r* risk free interest rate • Best forecast is the current one IP Inflation premium • Average expected inflation over LIFE of debt security =/= Current inflation • Inflation rate expected IN THE FUTURE not past • Expectations of inflation closely correlated with past inflation rates DRP Default risk premium • Compensation for possible default (borrower not making scheduled payments) • For corporate bonds, bond ratings are used to measure default risk • Difference between US treasury bonds and corporate bonds is the default risk LP Liquidity premium • Compensation for possible difficulty in selling debt security quickly at fair market value because some security cannot be converted to cash on short notice • Higher trading volume = Easier to sell = More liquid MRP / IRR Maturity risk premium / Interest Rate Risk • Compensation for possible loss in capital value due to increase in I/R over maturity of debt securities. • Affects longer term securities than short term o Prices of long-term bonds decrease when I/R increase → All long term bonds has interest rate risk o MRP reflects the IRR • Long term bonds are exposed to interest rate risk, short term bonds are exposed to reinvestment rate risk. o Risk that a decline in I/R will lead to lower income when bonds mature and funds are reinvested r_rf r* + IP • Represents the ROR of treasury securities (assumes that treasury does not go into default) STRICTLY speaking, Risk free rate = Nominal / Quoted rate • Free of default risk, maturity risk, liquidity risk, inflation caused risk Nominal / Real risk-free rate = Nominal rate with Inflation Premium But the risk-free rate in general is the nominal risk-free rate because there is no such thing as truly risk-free rates Side-note Links between expected inflation & I/R r_rf = r* + IP + (r* x IP) • r* x IP is normally quite small and insignificant if the I/R is low EXAMPLE: A loaf of bread costs $1 today Real I/R = 3% Inflation over the next year = 5% 100 bread today = 103 bread the next year But because expected inflation = 5%, a load of bread = $1.05 next year 103 load of bread = 103 x 1.05 = $108.15 next year To realize a real return of 3%, consumers will need to earn 8.15% as a nominal I/R Premiums Added to r* with Different Types of Debt IP S-T Treasury βοΈ L-T Treasury βοΈ S-T Corporate βοΈ L-T Corporate βοΈ MRP DRP LP βοΈ βοΈ βοΈ βοΈ βοΈ βοΈ Term Structure of Interest Rates • • • Relationship between bond yields and maturity Both borrowers and lenders should understand 1. How ST and LT I/R relate to each other 2. What causes a shift in their relative levels Yield curve shows R/S between bond yields and securities o Higher inflation = Higher Yield Curve o Corporate yields include DRP, and higher LP → Higher than treasury yield curves o Riskier = Higher Yield Curve βͺ Normal yield curve: Upward sloping (increase in expected inflation and increasing MRP) • The longer the company wants to borrow funds, the higher the i/r βͺ Inverted yield curve: Downward sloping (only if inflation decrease more than MRP) • Yield of 10 year corporate bond not necessarily higher than 3 year treasury bond βͺ Humped yield curve: I/R on intermediate term maturities are higher than ST and LT securities Determinants of the Shape of Yield Curve IP If IP is expected to decrease, LT bonds will have a smaller IP than ST bonds in the future If IP is expected to increase, LT bonds will have a larger IP than ST bonds in the future MRP MRP always increases with maturity because LT bonds tends to be riskier due to IRR LP LT bonds are less liquid because more credit checking would be necessary DRP ST bonds carry less default risk Normal Situation: ST securities have less MRP than LT. Hence, ST securities tend to have lower I/R Constructing the Yield Curve • INTERPRET YIELD CURVE CORRECTLY → x-axis is maturity (or loan period) NOT time 1. Find average expected inflation rate over years 1 to N πΌππ = ∑π π‘=1 πΌπππππ‘ππππ‘ π 2. Find appropriate maturity risk premium. Equation is linear, MRP increases as t increases ππ ππ‘ = 0.1% (π‘ − 1) 3. Add IP and MRP to find nominal rates Macroeconomic Factors that Affect I/R Federal Reserve Policy • • • Money supply has a significant effect on the level of economic activity, inflation and interest rates If Fed wants to stimulate economy, money supply increases o Initial effect: Short term interest rate decreases o Future effect: Increase inflation, LT rates increase, and vice versa Tighten monetary policy → Decrease money supply → Increase interest rates Government Deficits / Surplus • If government spends more than it takes in taxes, deficit is covered by additional borrowing (selling treasury bonds) o Government borrow → Increase in demand for funds → I/R increases o Government print more money → Increase inflation (more money for a fixed good) → I/R increases International Factors • • More M than X → Foreign trade deficits → Financed with borrowing from nations with X surpluses Larger trade deficit = Higher tendency to borrow Level of Business Activity • • Increased inflation = Increased I/R, will generally have a downward trend alter During recession, I/R will decrease. (because business borrowings will decrease and Fed increases money supply) o When economy rebounds, I/R increases due to federal reserve interventions During recession, ST I/R will decrease more than LT. Fed generally operates in the ST → Has a stronger effect there & so short-term IR is also more volatile o LT rates over 20-30 years will not change much because it reflects the average expected I/R over the next 20-30 years • Seminar 4: Bonds and Their Valuation General Definitions Bond Long-term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bonds. Long term debt instrument. Treasury Bonds Bonds issued by the federal government. • Assume that government will always pay its promised payments → No default risk BUT prices decline when I/R rises An increase in return on treasury bonds → Increase its appeal relative to common stocks → Investors sell stocks to buy Tbonds → Stock prices will fall Corporate Bonds Bonds issued by business firms / corporations • Exposed to default risk + have different levels of default risk depending on the issuing company’s characteristics and the terms of the specific bond. Larger risk = Higher I/R Municipal Bonds Bonds issued by state and local governments; exempt from tax so lower interest rates • Exposed to some default risk, but interest earned from munis is exempt from federal taxes & state taxes is holder is a resident of the issuing state. Market interest rate on a muni is considerably lower than on a corporate bond of equal risk. Foreign Bonds Bonds issued by foreign government or a foreign corporation • Concerns about possible defaults + additional exchange rate risk when the bonds are denominated in a currency other than that of the investor’s home currency Key Characteristics of Bonds Par Value • • Stated face value of the bond. Represents the amount of money firm borrows and promises to repay on the maturity date Coupon Interest Rate • • • Payment of a fixed number of dollars of interest each year Set at the time the bond is issued and remains in force during the bond’s life. Set at a level that will induce investors to buy the bond at or near its par value πΆππ’πππ πΌππ‘ππππ π‘ π ππ‘π = πΆππ’πππ πππ¦ππππ‘ πππ ππππ’π Fixed-rate Bonds Bonds whose interest rate is fixed for their entire life Floating-rate Bonds Bonds whose interest rate fluctuates with shifts in the general level of interest rates (set coupon rate for a period of time. After the period of time, the coupon rate will adjust based on open market rate) Zero coupon Bonds No coupons at all but are offered at a discount below their par values • Provide capital appreciation rather than interest income • As long as interest rates > 0, it will not trade below part Original Issue Discount (OID) Bond Bonds originally offered at a price significantly below its par value Maturity Date A specified date on which the par value of the bond must be repaid • Original Maturity: The number of years to maturity at the time a bond is issued Call Provisions A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms PRIOR to the normal maturity date • Companies not likely to call bonds unless interest rates have declined significantly since bonds were issued o Companies can sell a new issue of low-yielding securities → Proceeds of new issue can retire the high-yielding issue → Reduce interest expense (REFUNDING OPERATION, similar to refinancing mortgages) • Valuable to firm, detrimental to LT investors who will need to reinvest funds @ lower rates o Callable bonds = Higher interest rates than non-callable bonds Sinking Fund Provisions Call Premium • • Issuer must pay bondholders an amount > par value if the bonds are called, often = 1 year interest Call premiums decline over time as the bonds approach maturity Deferred Call • Bonds are not callable until 5-10 years after the issue → Has call protection A provision in a bond contract that requires the issuer to retire a portion of the bond issue each year • Facilitates the orderly retirement of the bond issue, mandatory payment • Failure to meet the sinking fund requirement = Default, may lead to bankruptcy • Handled in 2 ways – firms will choose the least cost methods 1. Call in for redemption at par value by lottery a. Used when I/R have fallen and bonds are selling in market for more than par value 2. Buy the required number of bonds in the open market a. Used when I/R have fallen and bonds are selling in market for less than par value • Designed to protect investors by ensuring bonds are retired in an orderly fashion BUT detrimental if bond’s coupon rate > current market rate o Anyway, it still is safer → Lower coupon rates than otherwise similar bonds w/o sinking bunds Callable Bonds Bonds with Sinking Fund Provision Purpose: Allow the company to switch to lower borrowing cost if interest rates fall Purpose: To retire the loan progressively Increases risk (uncertainty) for bond holders → Higher coupon rate Reduces default risk that bond holders face → Lower coupon rate Company has option to call the bonds Company has legal obligation to carry out the sinking fund contributions Pays call premium if bonds are called Does not pay premium when bonds are retired Entire bond issue is usually called if a call takes place Only partial reduction of bonds is made annually Other Features Convertible Bonds Exchangeable into shares of common stock at a fixed price at the option of the bondholder • Investors can get capital gains if stock price increases, but issuing company sets lower coupon rates than on nonconvertible debt with similar credit risk Warrants Similar to convertible bonds → Long-term options to buy a stated number of shares of common stock @ specified price • Investors can get capital gains if stock price increases, but issuing company sets lower coupon rates Putable Bonds Bonds with a provision that allows investors to sell them back to the company prior to maturity at a prearranged price • I/R increase → Investors sell the bonds back to the company & reinvest in higher coupon bonds Income Bonds Bond that pays interest only if issuer has earned enough money to pay interest → Cannot bankrupt a company BUT riskier than regular bonds Indexed (Purchasing Power) Bonds Bond that has interest payments based on inflation index to protect bondholder from inflation • Interest paid rises automatically when inflation rises • Issued by US Treasury Bond Valuation • • • Value of any financial asset = Present value of cash flows that the asset is expected to produce Bond price and return value is inversely related If you hold a bond until maturity, value of the bond is PV of all the future coupon payments and par value at maturity π΅πππ ′ π ππππ’π = ππ΅ = πΌππ πΌππ πΌππ π + +β―+ + 1 2 π (1 + ππ ) (1 + ππ ) (1 + ππ ) (1 + ππ )π rd Market interest rate INT Dollars of interest (from a borrower’s POV, interest paid on bonds is tax deductible) N Number of years before maturity M Par / Maturity value of the bond Discount Bond Bond that sells below par value (Interest Rate / YTM > Coupon Rate) Par Bond Bond that sells at par value (Interest Rate = Coupon Rate) Premium Bond Bond that sells above par value (Coupon Rate > Interest Rate/ YTM) Opportunity Cost of Debt Capital • • Discount rate, r, is the opportunity cost of debt capital (return that could be earned on alternative investments of equal risk) Two annual bonds with the same maturity and same risks must have the same YTM Yield to Maturity • • • • Rate of interest earned on a bond if it is held to maturity To find yield to maturity, just find rd (market interest rate) Also known as bond’s promised rate of return → return that investors will receive if all payments are made YTM only = Expected rate of return when 1. Probability of default is zero 2. Bond cannot be called Changes in Bond’s Values Over Time • • Lower coupon → Less willing to pay at par value Higher coupon → More willing to pay at par value • • • • New Issue = Bond that has just been issued → Usually sells at prices close to par Outstanding bond / seasoned issue = Bond that has been issued → Prices vary widely from par Bonds that are not floating bonds will generally sell at par value when it was issued & will sell at more or less thereafter Same firm = Same credit risk → Same market interest rates πΈπ₯ππππ‘ππ πΆπ’πππππ‘ πππππ = πΆππππ‘ππ πΊππππ πππππ = π΄πππ’ππ πΆππ’πππ πΌππ‘ππππ π‘ × 100% ππππππ‘ ππππππ‘+1 − ππππππ‘ × 100% ππππππ‘ YTM = CGY + CY only if I/R remains the same for the next 12 months. If it changes, this formula DOES NOT HOLD • • Expected Current Yield will = Actual Realized Current Yield even when I/R changes because the Price at t doesn’t change Expected Capital Gains Yield may not = Actual Realized Capital Gains Yield when I/R changes because Price at t+1 will change. o Interest rate increase → Price at t+1 decrease → Actual Realized CGY < Expected CGY o Interest rate decrease → Price at t+1 increase → Actual Realized CGY > Expected CGY • Price of bond 10% coupon bond will remain at $1000 if the market interest rate remains at 10% → Current yield = Bond’s total return and Capital Gains Yield = 0 7% bond trades at a discount, but sells at par at maturity because that is the amount that company will pay bondholders → Price rises over time. o Makes capital gain but current yield losses 13% bond trades at a premium, but sells at par at maturity → Price declined over time o Makes capital losses but current yield gains Ultimately, all will have the same total return (10%) • • • Total return = YTM = Market Rate Bonds with Semiannual Coupons ππ΅ = πΌππ/2 πΌππ/2 πΌππ/2 π + + β―+ + 1 2 2π (1 + ππ /2) (1 + ππ /2) (1 + ππ /2) (1 + ππ /2)2π 1. Divide annual coupon interest payment by 2 2. Multiply the years to maturity, N, by 2 3. Divide nominal interest rate, rd, by 2 Factors that Determines a Bond’s Riskiness 1. Price / Interest Rate Risk a. Risk of decline in bond values due to an increase in interest rates b. Higher on bonds with longer maturities (because you would be stuck with a lower interest rate for a longer period of time) 2. Reinvestment Risk a. Risk of income decline due to a decrease in interest rates b. High on callable bonds, but also high on short-term bonds because shorter bond’s maturity = fewer years before the relatively high old-coupon bonds will be replaced with the low-coupon issues Comparing Price Risk & Reinvestment Risk Price Risk Reinvestment Risk Relates to the current market value of the bond portfolio Relates to the income that bond portfolio produces More significant when you hold long-term bonds More significant when you hold short-term bonds Price Risk Reinvestment Risk Longer Maturity Bonds High Low Higher Coupon Bonds Low High • • • • • • Low coupon = A relatively larger portion of the cash flows will only occur at maturity with the repayment of the principal, whereas with high coupon, more of the cash flows occur in the early years due to the higher coupon payment. Therefore, when interest rates increase, low coupon bonds are penalized more, i.e., value decreases more, as a relatively larger portion of the cash flows are locked up in the bond. In contrast, due to the high coupon payments of high coupon bonds, the risk of reinvesting these high coupon payments at lower interest rates is higher A long-term zero-coupon bond will have a very high level of price risk and relatively low reinvestment risk Relevance of risk depends on how long investor plans to hold bonds (aka investor’s Investor Horizon) o Investors with shorter investment horizons view long-term bonds as being more risky o Investors with longer investment horizons view short-term bonds as being more risky Duration: the weighted average of the time it takes to receive each of the bond’s cash glows o Zero coupon bond = Duration is at maturity o Coupon bond = Duration less than maturity To manage price & reinvestment risk, buy a zero coupon treasury bond with a duration equal to investment horizon • Maturity risk premiums are generally positive → Investors on average regard long-term bonds as riskier that short-term bonds → Suggests that investors are more concerned with price risk BUT still impt to consider which is more relevant Default Risk • Higher probability of default = Higher premium = Higher YTM Types of Corporate Bonds Mortgage Bonds Indenture • • Corporation pledges specific assets as security for the bond If corporation defaults, bondholders can foreclose on asset and sell it for satisfy their claims All mortgage bonds are subject to this, a legal document that spells out in detail the rights of bondholders & corporation Debenture • • • • Unsecured Bond → No specific collateral for the obligation Debenture holders are general creditors whose claims are protected by property not otherwise pledged Depends on the credit strength of firm and nature of firm’s asset (usually issued by extremely strong companies) Can also be used by weak companies that have already pledged most of their assets as collateral for mortgage loans Subordinate Debentures • Bonds having a claim on asset only after the senior debt has been paid in full in the event of liquidations Bond Ratings Investment Grade Bonds • Triple B or higher • Banks and institutional investors are permitted by law to only hold investment grade bonds Junk Bonds • Double B or lower → High risk high yield Ratings are important! They have a direct, measurable influence on bond’s interest rates and firm’s cost of debt. If it falls below BBB, firms have a difficult time selling bonds → Lower grade bonds have higher rd Change in Ratings • Ratings do not adjust immediately to change in credit quality, there may be a considerable lag Bankruptcy and Reorganization • • When business doesn’t have enough cash to meet its interest and principal payments, a business becomes insolvent Decision must be made to dissolve the firm through liquidation or the permit it to reorganize and thus continue to operate → Made by federal bankruptcy court judge o Decision depends on whether the value of the reorganized business is likely to be greater than the value of its assets if they were sold off piecemeal o Reorganization may call for restructuring of debt → Reduce interest rates / lengthen term to maturity / exchange debt for equity βͺ Stockholders receive little in reorganizations and nothing in liquidation because the assets are usually worth less than the debt outstanding Notes from Tutorial • If 2 bonds are issued by the SAME COMPANY and have the SAME MATURITY, they have the SAME RISK → Yield the SAME EFFECTIVE YTM (NOT NOMINAL) • • • If they don’t have the same maturity, then they only yield the same NOMINAL YTM Bond price and market interest rate moves in opposite direction On maturity date, the bond must be worth it’s par value (regardless of the market interest rate) The CAPITAL LOSS from increase of interest rates < CAPITAL GAIN from the same value of decrease (as you can see from the exponential curve graph) Increase in interest rates→ Bond price fall → Investors make capital losses because YTM decreases Decrease in interest rates → Coupon rates lower → Investors reinvest at a lower rate Seminar 5: Risks and Rates of Return The Risk Return Tradeoff • • • Premise: Investors like returns and dislike risk → For investors to take risks, there must be higher expected returns Investor’s goal: Earn returns that are more than sufficient to compensate for the perceived risk of the investment. Higher security risk = Higher required return o Difference in returns between a risky and less risky asset = a risk premium (RP) Stand Alone Risk Stand Alone Risk • Stocks have higher returns but are generally riskier than bonds o Standalone risk = The risk an investment would face if he / she only held one asset o No investment should be undertaken unless the expected rate of return is high enough to compensate for the perceived risk Measures of Stand-Alone Risk Probability distributions Listing of possible outcomes or events with a probability (chance of occurrence) assigned to each outcome Expected rate of return The rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results The tighter (more peaked) the probability distributions, the more likely the actual outcome will be close to the expected value and, consequently, the less likely the actual return will end up far below the expected return. → Tighter probability distribution = Lower Risk Standard deviation π (sigma) used to quantify how far the actual return is likely to deviate from expected return • Smaller standard deviation = Tighter distribution = Lower risk 1. (Actual return – Expected return)^2 2. Multiply (1) by the relevant probability 3. Sum of (2) is the variance 4. Square root variance to find standard deviation Historical Data (r bar) Past results are often repeated in the future → Historical sigma used as an estimate of future risk Key question: • How far back in time should we go? • Information may be misleading if the level of risk in the future is likely to be very different from the level of risk in the past • Probabilistic data is not calculated Coefficient of Variation (Covariance) The standardized measure of the risk or unit of return (standard deviation divided by the expected return) π πΜ • More meaningful risk measure when the expected returns on two alternatives are not the same Portfolio Risk: The CAPM Expected Portfolio Returns • Weighted average of the expected returns of the individual assets in the portfolio, weights being the percentage of the total portfolio invested in the asset πΜπ = π€1 πΜ1 + π€2 πΜ2 + β― + π€π πΜπ • • If a stock with higher expected return is added → Portfolio’s expected return would increase If a stock with lower expected return is added → Portfolio’s expected return would decrease Additional Points 1. Expected returns would still be subjective and judgmental 2. Expected returns of relatively riskier companies will be relatively high, otherwise, investors will sell them, drive down their prices and force the expected returns above the returns on safer stocks 3. Actual realized rates of return on the individual stocks would be different from the initial expected values CAPM A model based on the proposition that any stock’s required rate or return is = risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification ππ = ππΉπ + (ππ΄ − ππΉπ )ππ Portfolio Risk • Investors dislike risk & risk can be reduced by holding portfolios → Most stocks are held in portfolios o Stock’s price increase / decrease is not important o Important thing is the return on portfolio and the portfolio risk o Risk and return should be analyzed in terms of how the security affects portfolio and the portfolio’s return βͺ E.g. debt collection agency will stabilize normal returns because their earnings move in opposite direction of the portfolio’s • • Portfolio Risk =/= Weighted average of standard deviations of its individual stocks How should risk of individual stock be measured? o Standard deviation is not appropriate because it includes risk that can be eliminated by holding the stock in a portfolio Correlation • • Tendency of two variables to move together, measured by correlation coefficient o Countercyclical stocks are perfectly negatively correlated: π = −1 → Can form a riskless portfolio o Opposite of negative correlation is perfect positive correlation π = 1 βͺ Diversification is useless in reducing risk is stocks are perfectly positively correlated o Unrelated stocks = Independent = π = 0 In reality, stocks are positively correlated but not perfectly so → Combining stocks into portfolios reduces risk but does not completely eliminate it o If stocks have low correlations with one another, portfolio risk will decline faster (reverse is also true) Number of Stocks • Portfolio risk declines as number of stocks in a portfolio increases o Even if enough partially correlated stocks were added, risk cannot be completely eliminated o Once 40-50 stocks are in portfolio, additional stocks do little to reduce risk Diversifiable Risk • Part of security’s risk associate with random events → CAN BE ELIMINATED through proper diversification (aka company / unsystematic risk) From lawsuits / strikes / unsuccessful marketing etc. • o Portfolio risk is generally smaller than the average of the stock’s standard deviation because diversification lowers the portfolio risk. o Why not hold a market portfolio consisting of all stocks? βͺ High administrative costs and commissions βͺ Index funds can be used by investors for diversification (and investors can and do get broad diversification) βͺ Some people think they can pick the stocks that will beat the market βͺ Some people can use superior analysis to beat the market → buy undervalued stocks and sell over valued ones Market Risk • • • Is risk that remains in a portfolio after diversification has eliminated all company specific risk (aka non-diversifiable / systematic / beta risk) From inflation / recession / macro factors o Compensation is required only for market risk Market Risk Premium Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk Beta In a well-diversified portfolio, Beta = Stock’s risk relative to market portfolio risk • Slope of the regression line o Y-axis is the change return on stocks, X-axis is the return on market o Uses historical data • If beta = 1.0, security has same risk as market portfolio • If beta > 1.0, security is riskier than market portfolio • If beta < 1.0, security is less risky than market portfolio • Beta of a portfolio = Weighted Average of each stock’s beta Factors Affecting Beta • • Caused by changes in composition of firm’s assets and through changes in the amount of debt it uses Can also be caused by increased competition in the industry or expiration of basic patents Relationship Between Risks and Rates of Return πΜπ EXPECTED rate of return on ith stock • πΜπ > ππ → Stock undervalued • πΜπ = ππ → Stock in equilibrium • πΜπ < ππ → Stock overvalued • Stock at current market price ππ REQUIRED rate of return on ith stock • If πΜπ < ππ , investors will not purchase stock • Return necessary to compensate investor for taking a specific beta risk of the stock πΜ REALIZED return ππ πΉ π½ RISK-FREE rate of return, generally measured by return on treasury securities. Use LT T-bonds (instead of ST T-bills) because maturity is closer to the average investor’s holding period for stocks BETA COEFFICIENT of the ith stock. Beta coefficient of average stock is 1.0 π½πππππππ¦ = (ππππππππ¦ /πππππππ‘ )(ππππππππ¦ & ππππππ‘ ) ππ • If ππππππππ¦ > πππππππ‘ , Beta definitely < 1 • If ππππππππ¦ < πππππππ‘ , Beta NOT definitely > 1 REQUIRED RATE OF RETURN ON MARKET PORTFOLIO (consisting all stocks, and also the required ROR of an average stock) π ππ ππ − ππ πΉ = RISK PREMIUM on market for average stock π ππ (ππ − ππ πΉ )π½ = RISK PREMIUM on ith stock SECURITY MARKET LINE EQUATION Required return = Risk-free return + (Market risk premium) (Beta) ππ = ππ πΉ + (ππ − ππ πΉ )π½ 1. 2. 3. 4. Required rate of return are shown on the vertical axis & risk as measured by beta is shown on the horizontal axis Riskless securities have beta = 0 Slope of the curve = Change in beta / Change in required rate of return Slope of the SML reflects the degree of risk aversion → steeper slope = greater risk premium = higher required rate of return Impact of Expected Inflation If inflation increases, real risk-free rate increases → SHIFT upwards Changes in Risk Aversion More risk averse = Steeper slope → Market risk increases (Market risk premium increases) Notes from Tutorial • • • • When diversified risk has been diversified away, inherent risk that remains is market risk. Different stocks have different market risks. If question assumes that market is not in equilibrium, use the question values with calculating expected returns Value of beta is NOT the criteria to choose whether we should add a stock to a portfolio. Investors choose based on how undervalued they are It is possible for a portfolio with less securities to be less risky than a portfolio with 100 securities If investors’ aversion to risk increases, would the risk premium on a high-beta stock increase by more or less than on a low-beta stock? Explain. • When investors' aversion to risk increases, this implies that the market risk premium will increase. Therefore, the risk premium, i.e., beta*market risk premium, of a high-beta stock will increase by more than the the risk premium of a low-beta stock. Is it possible to construct a portfolio of real-world stocks which has a required rate of return that is equal to the risk-free rate? • Although theoretically possible, however, in the real world, it is unlikely that we can form a portfolio of stocks that is riskless. In theory, we can combine two stocks which are perfectly negatively correlated with one another, and we will have a riskless portfolio. But in the real world, most stocks tend to move together and it is unlikely we can find two stocks which have correlation coefficient of -1. Treasury bills are zero beta Seminar 6: Stocks and Their Valuation Common Stockholders’ Control of the Firm • • Firm’s common stockholders have the right to elect directors → Directors elect officers who manage the business In large, publicly owned firms, managers typically have some stock but personal holdings are generally insufficient to give them voting control → Managements of most publicly owned firms can be removed by the stockholders if the management team is not effective 1. Corporations must hold elections of directors periodically, usually once a year, with the vote taken at the annual meeting. Each share of stock has one vote. a. Stockholders can appear at the annual meeting and vote in person, but typically they transfer their right to vote to another person by means of a proxy b. Management solicits stockholders’ proxies and usually receives them c. If earnings are poor, an outside group my solicit the proxies and overthrow the management → Proxy fight d. Takeover also occurs when one corporation tries to take over another by purchasing a majority of their outstanding stocks 2. Managers’ without more than 50% of stocks are concerned about proxy fights & takeovers → Attempt to obtain stockholder approval for changes in corporate charters, such as… a. Elect only one-third, rather than all of the directors each year b. To require 75% of stockholders, rather than 50%, to approve a merger c. To vote in a ‘poison pill’ provision that would allow the stockholders of a firm that is taken over by another firm to buy shares in the second firm at a reduced price → Makes acquisition unattractive → Ward off hostile takeover attempts Pre-emptive Right • • Common stockholders have the pre-emptive right to purchase on a pro rate basis any additional shares sold by the firm. Rationale: 1. Prevents the management of a corporation from issuing a large number of additional shares and purchasing those shares itself → Management can use this tactic to seize control of the corporation and frustrate the will of current stockholders 2. More importantly, protect stockholders from dilution of value. a. Selling common stock at a price below the market value would dilute a firm’s price and transfer wealth from present stockholders to those who were allowed to purchase the new shares Types of Common Stock • • Classified Stock – Common stock given a special designation such as Class A or Class B to meet special needs of the company o E.g. Class A stocks has 1 vote per share while Class B stocks has 10 votes per share Rationale: o Enables the company’s founders to maintain control over the company without having to own a majority of the common stock o Class B stocks are sometimes called founders’ shares Stock Price VS Intrinsic Value • • If the stock market is reasonably efficient, gaps between the stock price and intrinsic value should not be very large, and they should not persist for very long. When investing in common stocks, one’s goal is to purchase stocks that are undervalued (price below the intrinsic value) and avoid stocks that are overvalued. → Need to find models that predicts a stock’s intrinsic value o Discounted Dividend Model o Corporate Valuation Model Discounted Dividend Model • Value of share depends on the cash flows it is expected to received (1) Dividends that investor receives each year while he/she holds the stock (2) Price received when the stock is sold Final price includes the original price paid plus an expected capital gain πΜπ EXPECTED rate of return on ith stock • πΜπ > ππ → Stock undervalued • • πΜπ = ππ → Stock in equilibrium πΜπ < ππ → Stock overvalued ππ REQUIRED rate of return on ith stock • If πΜπ < ππ , investors will not purchase stock πΜ REALIZED return π·π‘ DIVIDEND that stockholder expects to receive at the end of year t • π·0 is known with certainty, but π·π‘ is forecasted by the marginal investor π0 ACTUAL MARKET PRICE of the stock today. • π0 is known with certainty, but ππ‘ are subjected to uncertainty πΜπ‘ EXPECTED PRICE AND INTRINSIC VALUE at the end of Year t • For the marginal investor, πΜπ‘ = π0 or a disequilibrium would exist π EXPECTED GROWTH RATE in dividends as predicted by the investor • This is also the E(CGY) of constant growth since this is the perpetual rate of intrinsic growth π·1 /π0 (πΜ1 − π0 ) / π0 DIVIDEND YIELD expected during the coming year CAPITAL GAINS YIELD expected during the coming year EXPECTED TOTAL RETURN = πΜπ = π·1 π0 + (πΜ1 − π0 ) π0 Expected Dividends as the Basis for Stock Values ππ‘πππ ′ π ππππ’π = πΜ0 = • π·1 π·2 π·∞ + +β―+ 1 2 (1 + ππ ) (1 + ππ ) (1 + ππ )∞ Unless the company is likely to be liquidated or sold and thus disappears, the value of the stock is determined by this equation even when you expect to hold the stock for a finite period Constant Growth Stocks • Using the assumption that dividends will grow at a constant rate ππ‘πππ ′ π ππππ’π = πΜ0 = • SO … πΜ0 = π·0 (1 + π)1 π·0 (1 + π)2 π·0 (1 + π)∞ π·0 (1 + π) π·1 + + β― + = = 1 2 ∞ (1 + ππ ) (1 + ππ ) (1 + ππ ) ππ − π ππ − π π·1 ππ −π o From here, derive πΜπ = π·1 π0 +π Dividends VS Growth • Higher stock price can be attributed to: higher dividend and higher growth rates o Dividends are paid out of earnings o Growth in dividends require growth in earnings βͺ Growth in earnings occur because firms retain earnings and reinvest them in the business → Higher percentage of earnings retained = Higher growth rate Growth Rate = (1-Payout Ratio) ROE Current Dividend VS Growth • A firm can pay a higher current dividend by increasing its payout ratio BUT that will lower its dividend growth rate o Firm can either provide high current dividend OR high growth rate o Some stockholders will prefer current dividends, while others prefer growth βͺ Stockholders should prefer company to retain more earnings if there are good investment opportunities βͺ Stockholders should prefer company to have a high payout if there are poor investment opportunities Required Conditions For Actual Growth Model • • ππ MUST BE GREATER THAN g o Stock prices cannot be infinite or negative π· Equation of a Zero Growth Stock: πΜ0 = (Current dividend divided by the required rate of return) ππ Valuing Non-constant Growth Stocks • • Inappropriate to assume constant rate for many companies as most firms go through life cycles where they experience different growth rates during different parts of each cycle o Growth is faster than economy in the early years, then they match the economy’s growth, and finally they grow at a slower rate than the economy. Assume that dividend will grow at a non-constant (generally a relatively high rate) for N periods → horizon / terminal date πΜ0 = π·1 π·2 π·π π·1 π·π+1 π·∞ + + β―+ + + + β―+ 1 2 π 1 π+1 (1 + ππ ) (1 + ππ )∞ (1 + ππ ) (1 + ππ ) (1 + ππ ) (1 + ππ ) πΜ0 = π·1 π·2 π·π πΜπ + + β―+ + 1 2 π (1 + ππ ) (1 + ππ ) (1 + ππ ) (1 + ππ )π πΜπ (π·π+1 )/ (ππ − π) = π (1 + ππ )π (1 + ππ ) 1. Find PV of non-constant dividend & sum them 2. Find PV of constant dividend 3. Sum (1) & (2) to find the intrinsic value Multiples of Comparable Firms • Analysts often use the following methods to value stocks o P/E o P/CF o P/Sales o Among the common multiples, PE ratio is the most widely used, especially in valuing shares in IPOs and in mergers and acquisitions in practice o Multiply the company’s EPS by estimated INDUSTRY’S PE ratio (such as average PE of similar firms) → But there are many reasons why PE estimates are not good ones. Nevertheless, it is very used in practice. o E.G. Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to estimate the stock price. Preferred Stock • Preferred stock is a hybrid – similar to a bond in some respects and to a common stock in others o Has a par value and fixed dividends that must be paid before dividends can be paid on the common stock. Directors can omit (or ‘pass’) the preferred dividend (but they must also skip common dividends) o Preferred stock calls for fixed payment like bonds but skipping the payment will not lead to bankruptcy • If payment lasts forever, the issue is a perpetuity whose value is found as follows: ππ = • ππ is the value of the preferred stock, π·π is the preferred dividend, ππ is the required rate of return on the preferred. • In equilibrium, πΜπ = ππ π·π ππ • πΜπ = π·π ππ Relative Risk of Stocks From Investor’s Perspective: Bonds < Preferred Stock < Common stock From Company’s Perspective Bonds > Preferred Stock > Common stock Market Efficiency Efficient Market Efficiency Continuum Prices close to intrinsic value, stocks seem to be in equilibrium • All relevant information is available to all participants at the same time and prices respond immediately to available information • Deviations are random → Investors cannot ‘beat the market’ except through good luck of better information o Rather than spending money to find undervalued stocks, it would be better to buy an index fund designed to match the overall market o But small undervaluation will still amount to a great deal when investing in millions • • The larger the firm, the more analyst tends to follow it, the faster new information is likely to be reflected in the stock price Smaller companies are not followed by many analysts → Market is inefficient Efficient Market Hypothesis Behavioral Finance Theory On average, asset prices are about equal to their intrinsic values (due to demand and supply factors) • If a stock’s price is ‘too low’ a rational trader will quickly take advantage of the opportunity to buy the stock (and vice versa) • EMH does not assume that all investors are rational Weak Form Efficiency The weak form of the EMH states that all information contained in past stock price movements is fully reflected in current market prices. Semi-strong Form Efficiency The semi-strong form of the EMH states that current market prices reflect all publicly available information. Strong Form Efficiency The strong form of the EMH states that current market prices reflect all pertinent information, whether publicly available or privately held. 1. Risky for traders to take advantage of mispriced assets (e.g. factors that pushed a price down may work to keep it artificially low for a long time) 2. Individuals view potential losses and gains differently → More averse to losses (e.g. would rather flip a coin to avoid losses than flip a coin to gain money) → Investors and managers behave differently in down markets than they do in up markets 3. Other evidence: Individuals tend to overestimate their true abilities. Notes from Tutorial If the period of supernormal growth increases, how would it affect the stock price, dividend yield and expected capital gains yield? 1. Longer period of supernormal growth → Stock price will be higher 2. Total annual return will remain the same, but distribution between DY and CGY will differ every year 3. E(CGY) will start out higher while the E(DY) will start out lower Of what interest to investors is the changing relationship between dividend and capital gains yields over time? 1. Regular cash payment vs long-term value term value – Some investors such as retired individuals and pension funds may prefer regular cash dividends (higher dividend yield), while other investors such as working individuals may prefer to gain from long-term share price appreciation instead (higher capital gains yield). 2. Tax consideration – In most In most countries, investors must countries, investors must pay taxes if they receive dividends, but they need not pay tax (or pay lower tax) if they achieve capital gains. In such situations, investors who want to avoid tax (or want to pay lower tax) may prefer higher capital gains to higher dividend yield. The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond. In the CAPM, a firm’s required rate of return depends on its beta. Therefore, unless the change in expected growth rate affects beta, it is unclear how a change in the expected growth rate, g, will affect required returns. Dividends on common stock is the most uncertain cash flow • Shareholders have residual claim, retained earnings increases residual claim • Cumulative dividend = Required dividends to preferred shareholders (paid before common shareholders) Portfolio should be diversified Seminar 7: The Cost of Capital Overview of WACC Use Target Capital Structure, not actual financing of project (unless firm expresses to maintain current capital structure) Desired optimal mix of debt, preferred stock and common equity the firm plans to raise to fund its future projects (often maximises stock prices) Use market value weights (calculated using market value), not book value weights (calculated using balance sheet accounting values) Use market value: 1. Represents actual amount of financing raised when firm sells stocks & bonds 2. Calculated based on current market conditions Use marginal cost (of raising an additional dollar today), not historical cost Cost of capital is used primarily to makes decisions involving raising new capital → focus on today’s cost Historical cost of existing financing irrelevant Use after-tax capital cost Shareholders focus on after-tax cash flows Only rd needs adjustment as interest tax-deductible (preferred & common stock dividends are not) Concepts Basic Definitions ππ Interest rate on the firm’s new debt = before-tax component cost of debt • Calculated with several ways, including the YTM of current outstanding bonds ππ (1 − π) After-tax component cost of debt • • • • • ππ Debt used to calculate the weighted average cost of capital Firms can estimate ππ by asking what it will cost to borrow or finding the yield to maturity on their current outstanding debt Interest is tax deductible Use after-tax cost of debt because we are interested in maximising the value of the firm’s stock & stock price depends on after-tax cash flows o Adjust the interest rates downwards due to debt’s preferential tax treatment Cost of debt is interest rate on the NEW DEBT, NOT outstanding one. o This is also why YTM on outstanding debt (which reflects current market conditions) is a better measure of the cost of debt than the coupon rate) Component cost of preferred stock ππ = • • ππ π·π ππ Yield investors expect to earn on the preferred stocks Preferred dividends are not tax deductible Component cost of common equity • Required return on a firm’s common stock Raise capital by retaining some of the current year’s earnings (ππ ) 1. Retained earnings has an opportunity cost as the net earnings remaining after paying interest and preferred dividends belong to the common stockholders, and these earnings serve to compensate them for the use of capital 2. Firm needs to earn at least as much on any retained earnings as the stockholders could earn on alternative investments of comparable risk a. Which is ππ since stocks are assumed to generally be in equilibrium CAPM DCF ππ = ππ πΉ + (ππ − ππ πΉ )ππ ππ = ππ πΉ + π π·1 = + π = πΜπ π0 Problems with CAPM: 1. If investors are not well diversified, they may be concerned with stand-alone risk rather than just market risk → true investment risk would not be measured by its beta & CAPM understate the correct value of ππ 2. Hard to obtain accurate estimates about the required inputs because a. Controversy about using ST or LT treasury yields for ππ πΉ b. Hard to estimate the beta that investors expect the company to have in the future c. Difficult to estimate the proper market risk premium Limitations • Stock prices fluctuate → Yield varies from day to day → Fluctuations in the DCF cost of equity • Difficult to determine a proper growth rate → May use historic growth rates if past growth was not abnormally high or low due to unique economic situations Assumption: g is expected to remain constant in the future Bond Yield ππ = π΅πππ πππππ + π ππ π ππππππ’π • • • • Not precise but it doesn’t matter because it’s just an estimate anyway Risk premium generally ranges from 3-5%, it is just anything above the usual cost of debt ππ is also estimated RISK PREMIUM HERE =/= Market Risk Premium From CAPM Limitations • Estimated ππ is judgemental ππ Component cost of external equity • ππ plus a factor that reflects the cost of issuing new stocks • Established firms rarely issue new stocks Raise capital by issuing new common stock (ππ ) 1. Higher costs due to flotation costs required to sell new common stock π·1 ππ = +π π0 (1 − πΉ) Retained Earnings Breakpoint When Must External Equity Be Used? • Firms should utilize retained earnings to the greatest extent because they cost less. However, if a firm has more good investment opportunities than whatever can be financed, it may need to issue new common stock • Amount of capital that can be raised before a new stock has to be issued = Retained Earnings Breakpoint Addition to retained earnings for the year / Equity fraction π€π , π€π , π€π WACC Target weights of debt, preferred stock, and common equity Firm’s cost of capital π€π ππ (1 − π) + π€π ππ + π€π ππ Factors That Affect WACC Controllable Changing capital structure Increase debt ratio may lower WACC because after-tax cost of debt is lower But it also increases riskiness that might offset the effects → Raise WACC Changing dividend payout ratio Higher ratio = Smaller addition to retained earnings = Higher cost of equity But investors may prefer dividends → Increase in required rate of returns due to higher demand Altering capital budgeting decision rules E.g. To accept projects with more or less risk than projects previously undertaken If firms invest in assets that is new and risky, the component of costs of debt and equity and thus WACC will change Uncontrollable Interest rates in the economy I/R increase = Cost of debt increase General level of stock prices Stock price decrease = Cost of equity increase Tax rates When tax rates on dividends and capital gains were lowered relative to rates on interest income, stocks became relatively more attractive than debt → Cost of equity and WACC declined , Adjusting Cost of Capital for Risk • • • • Projects should only be accepted if their estimated returns > costs of capital Cost of capital is a “hurdle rate” WACC needs to be adjusted up or down to account for risk differentials IMPORTANT because if a company always uses WACC as a hurdle rate, it will accept high risk project that it should have rejected & it will reject a low risk project that it should have accepted. It will UNINTENTIONALLY become a more risky company over that. (beta increases) → unplanned is no good. Some adjustment is better than no adjustment Other Problems with Cost of Capital Estimates Depreciation-generated funds Depreciation cash flows can either be reinvested or returned to investors (stockholders and creditors). Cost of depreciation-generated fund is an opportunity cost approximately equal to WACC → Ignored in WACC Privately Owned Firms How to measure cost of equity for a firm whose stock is not traded? Tax issues are also important → Apply the same principles in cost of capital estimations to both private and publicly owned firms Measurement Problems Practical difficulties when estimating the cost of equity. Difficult to obtain g, difficult to obtain risk premium → Inaccurate Cost of Capital for Projects of Differing Risk Difficult to measure differing risk of each project to adjust the hurdle rate accordingly Capital Structure Weights Establishing the capital structure is a major hurdle in itself Notes from Tutorial Factors that causes WACC to be different: 1. Using Different Calculation Model to calculate Cost of Equity a. Capital Assets Pricing Model (CAPM) vs Discounted Cash Flow (DCF) vs (Bond Yield Plus Risk Premium) 2. Different estimation on the same variable a. Analysts might have different estimates due to different component cost which can affects the value of the variable. b. For instance, company might not disclosure its capital structure, therefore the analyst will have to estimate the target capital structure. If bond uses quarterly coupon / semi-annual coupon, do we use effective YTM as rd ? • ONLY FOR WACC, use the nominal rate instead of the effective rate. • IRL, they only use the nominal one because the effective and nominal one is of marginal difference • WACC is an estimate, don't have to be that accurate. Seminar 8: The Basics of Capital Budgeting An Overview of Capital Budgeting • Same concepts used in security valuation, but there are 2 major differences Security Valuation Capital Budgeting Stocks and bonds exist in security markets and investors select from available sets Firms create capital budgeting projects Investors have no influence on the cash flows produced by their investments Corporations have a major influence on projects • • A firm’s growth & even ability to remain competitive and to survive depends on a constant flow of ideas relating to new products, to improvements in existing products, and to ways of operating more efficiently Analysing capital expenditure proposals come at a cost Replacement: needed to continue current operations Expenditures to replace worn-out or damaged equipment required in the production of profitable products. • Should the operation be continued? If so, should firm continue to use the same production process? Replacement: cost reduction Expenditures to replace serviceable but obsolete equipment and thereby to lower costs • Discretionary, fairly detailed analysis required Expansion of existing products or markets Expenditures to increase output of existing products or to expand retail outlets or distribution facilities in markets now being served. • They require an explicit forecast of growth in demand → More complex, a detailed analysis required Expansion into new products or markets Investments related to new products or geographic areas, and they involve strategic decisions the could change the fundamental nature of the business • A detailed analysis required Safety and/or environmental projects Expenditures necessary to comply with government orders, labour agreements or insurance policy terms • Depends on size, small ones treated like the Category 1 projects Other Projects Catch-all includes items such as office buildings, parking lots and executive aircrafts. How they are handled varies according to companies. Mergers A firm buts another one • Concepts of capital budgeting underlie a merger analysis Companies use the following to decide to accept or reject projects: 1. NPV 2. IRR 3. MIRR 4. Regular Payback 5. Discounted Payback Net present Value • • Cash flows =/= Accounting income Investors are concerned with free cash flow o The amount of cash available for all investors after taking into account the necessary investments in fixed assets and NOWC • • • • Tells us how much a project contributes to shareholder wealth o Larger NPV = More value added = Higher stock price Calculate using the uneven cash flows method If projects are independent, projects with positive NPVs can be accepted If projects are mutually exclusive, project with higher NPV should be accepted Internal Rate of Return (IRR) • • • • Rate that forces the PV of its inflows to equal to the cost o Equivalent of forcing NPV = 0 Estimate on the project’s rate of return and comparable to YTM on a bond If projects are independent, projects with IRR > WACC can be accepted If projects are mutually exclusive, project with the highest IRR should be accepted Multiple Internal Rates of Return • • • A project may he more than one IRR Normal cash outflow: One or more cash outflows followed by cash inflows Non-normal cash flows: Signs of the cash flows change more than once → Might result in multiple IRRs o The IRR method is appealing to some managers because it produces a rate of return upon which to base decisions rather than a dollar amount like the NPV method. Reinvestment Rate Assumptions 1. NPV: Cash inflows can be reinvested at the project’s risk adjusted WACC 2. IRR: Cash flows can be reinvested at IRR • WACC IS MORE REASONABLE o Firm has reasonably good access to the capital markets, it can raise all the capital it needs at the going rate o If firm has investment opportunities with positive NPVs, firm can obtain capital at 10% cost o If firm uses internally generated cash flows from past projects rather than external capital, this will save it a 10% cost of capital → 10% is also the opportunity cost of the cash flows and that is the effective return on reinvested funds • IRR’s assumption is generally incorrect and causes the IRR to overstate the project’s true return Modified Interest Rate of Return (MIRR) • 1. 2. 3. 4. • • • Similar to IRR except that it is based on assumption that cash flows are reinvested at WACC PV = Initial Cash outflow (DISCOUNT ALL CASH OUTFLOWS to PV) Find the future value of all inflows at the terminal year, compounded at WACC Add that up to find the FV Then using calculator, find the interest rate Resolves the IRR problem because there can never be multiple IRRs If projects are independent, NPV, IRR and MIRR always reach the same accept/reject conclusion o If independent projects have NORMAL CASH FLOWS, it is mathematically not possible to have conflicting recommendations o If IRR > WACC, NPV will be positive o If IRR < WACC, NPV will be negative If projects are mutually exclusive, NPV is still the best as it selects the project that maximises value (exact value of increase is found) NPV Profiles • Plot NPV for 2 different projects • o Project with cash flows that come later will see a higher decrease in NPV if interest rate changes → NPV profile will be steeper Crossover Rate: Rate at which project earns the NPV o Occurs due to time differences, when most cash flows from a project come earlier than another o This results in CONFLICT because if interest rate lies to the LEFT of cross over rate and is higher than IRR of the projects, NPV will rank the long term one higher while IRR will rank the short term one higher o → Choose NPV because it’s more reliable βͺ This can also happen when amount invested in one project is larger than the other CROSSOVER RATE = When difference between BOTH cash flows = 0 Key in value for the first one in L1 Key in value for the second one in L2 L1-L3 → Store to L3 Find IRR of L3 Payback Period • Length of time required for an investment’s cash flows to cover its cost → Shorter payback = Better project Payback = Number of Years prior to Full Recovery + Uncovered cost at start of year / Cash flow during full recovery year Limitations 1. All dollars received in different years are given the same weight (TVM is ignored) 2. Cash flows beyond the payback year are given no consideration regardless of how large they might be 3. Unlike the NPV, which tells us how much a project yields over the cost of capital, the payback merely tells us when we will recover our investment →No necessary relationship between given payback and investor wealth maximisation → Do not know what an acceptable payback is Discounted Payback • • Discount the cash flows at WACC before using it to find the payback o Only resolves the TVM issue Shorter payback = Greater liquidity → Important for smaller firms that don’t have ready access to the capital markets & also, less risky in terms of cost recovery o Because smaller firms have less capital and it is important for them to know the time period which investment would be returned to better plan investments Seminar 9: Free Cash Flow Free Cash Flow • • Accounting statements are used primarily by creditors and tax collectors, not managers and stock analysts Therefore, corporate decision makers often modify accounting data o Most important modification: Free Cash Flow – “the amount of cash that could be withdrawn without harming a firm’s ability to operate and produce future cash flows” FCF = [EBIT (1-T) + Depreciation and Amortization] – [ Capital Expenditures + Change in Net Operating Working Capital] EBIT (1-T) Often referred to as NOPAT (net operating profits after taxes) • Profit that company would generate if it had no debt and only hold operating assets Depreciation and Amortization Added back into the equation because they are noncash expenses that reduce EBIT but do not reduce amount of cash that company has available to pay investors. Capital Expenditure Amount of cash that company is investing in its fixed assets Change in NOWC Amount of cash company invests in operating working capital in order to sustain ongoing operations • • Positive FCF o Firm is generating more than enough cash to finance current investments in fixed assets and working capital Negative FCF o Company DOES NOT HAVE sufficient funds to finance investments in fixed assets and working capital → They have to raise money in capital market to pay for their investments o BUT • o Most rapidly growing companies have negative FCF → May not be as bad, provided that a firm’s new investment is eventually profitable and contributes to its FCF FCF is more important than net income because it shows how much cash the firm can distribute to its investors Conceptual Issues in Cash Flow Estimation • • • • Typical project requires firm to spend money upfront at t=0 to make the necessary investments in fixed assets and net working capital Firm may also need to make continued investments throughout the life of the project, particularly a growing one where company needs to steadily add fixed assets and inventory over time [EBIT (1-T) + Depreciation and Amortization] = Projects operating cash flows Once a project is over, company sells fixed assets and receives cash (salvage value) o Sale is a negative capital expenditure (selling assets to generate cash) o Company has to pay taxes if salvage value > book value βͺ Taxes paid on salvaged assets = T * (Salvage value – Book value) Timing of Cash Flows In theory: Deal with cash flows exactly when they occur → Daily cash flows theoretically better than annual flows In reality: Costly to estimate and analyse daily cash flows + not more accurate than annual estimates Therefore, assume that cash flows occur at the end of the year unless projects have highly predictable cash flows and can be assumed to occur at mid-year. Incremental Cash Flows • Cash flows that will occur if and only if firm takes on the project (e.g. Investments in building, equipment and capital) Replacement Projects • • Almost all cash flows are incremental E.g. Fuel bill for more efficient truck = 10k VS 15k now o 5k in savings = Incremental cash flow o Also need to find difference in depreciation, company image, pollution and other factors that may affect cash flows o Use in “regular” NPV analysis to decide whether to replace asset Sunk Cost • Cash outlay that has already been incurred and cannot be recovered regardless of whether project is accepted or rejected → NOT RELEVANT in capital budgeting analysis Opportunity Costs Associated with Asset the Firm Owns • Best return that could be earned on assets the firm already owns if those assets are not used for the new project Externalities • Effects on firm / environment that are not reflected in project’s cash flows 1. Negative within firm externalities a. E.g. Opening new stores that take customers away from existing stores (aka Cannibalisation) b. New projects reduce cash flows that the firm would otherwise have had 2. Positive within firm externalities a. New project complementary to old one b. New project increase cash flows of old projects when introduced → May change NPV from negative to positive 3. Environmental externalities a. E.g. New plant may meet environmental regulations but still emit pollution → Causes ill feelings b. If an additional expenditure decreases emissions, plant looks good relative to other plants in the area c. This creates goodwill that will help in firm’s sales and negotiations with governmental agencies Analysis of Expansion Projects 1. Effect of different depreciation rates o Total free cash flows from depreciation remains the same, BUT accelerated depreciation will have HIGHER NPV o In the early years, CF from straight line depreciation less than CF from accelerated depreciation βͺ This is due to TVM → Dollars received earlier will have a higher value o What would make companies increase capital expenditure to increase economic growth and employment? βͺ Increase acceleration of accelerated depreciation βͺ If firm can write off the 4-year equipment rates, its early tax payments would be lower, early cash flows will be higher and project’s NPV will be higher 2. Account for Cannibalisation / externalities by subtracting / adding after accounting for depreciation 3. Opportunity cost o Reflect opportunity cost by subtracting that value from the NPV calculated 4. Sunk cost o Don’t count! Because sunk cost may actually allow for losses to be less 5. Other changes o Just vary accordingly (e.g. unit sales, prices, fixed cost) Replacement Analysis • Find cash flow differentials between the old and new projects • Find old machine cash flows • Find new machine cash flows • Subtract the old from new to find incremental cashflows • Find the NPV from the cash flow differentials Risk Analysis in Capital Budgeting Stand-alone risk Assumption: • It is the only asset that the firm has • Firm is the only stock in each investor’s portfolio • Diversification is totally ignored Corporate, or within firm risk Risk considering diversification, but not stockholder diversification • Measured by the project’s impact on uncertainty of firm’s return Market / beta risk Consider both firm and stockholder diversification measured by project’s beta coefficient • Most relevant but most difficult to estimate because new projects usually don’t have “market prices” • • Project with high standalone risk or corporate risk may not affect beta BUT if project with high stand-alone risk is HIGHLY CORRELATED with returns on other asset / stocks → Project has a high degree of all risks With WACC as a starting point, assign risk-adjusted cost of capital to each category Measuring Stand-Alone Risk Sensitivity Analysis • • • • • Percentage change in NPV resulting from the given change in input variables, other things held constant Data used are most likely, base-case NPV Plot sensitivity graph based on each change in input Larger range of variable (e.g. Price) = Steeper variable slope = More sensitive NPV Change one base at a time Scenario Analysis • • Monte Carlo Simulation • Assign probabilities to good, bad and base-case scenarios • Base case scenarios = Most likely set of input values • Worst case scenarios = All the input variables are set at their worst reasonably forecasted values • Best case scenarios = All of the input variables are set at their best reasonably forecasted values Firm’s average-risk project has a coefficient of variation of 2.0 A risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes Within Firm and Beta Risk • • Project negatively correlated with firm’s other projects → Stabilize the firm’s total earnings and will be relatively safe Project negatively correlated with rate of return on most stocks → Reduce firm’s beta and correctly evaluated with a low WACC Limitations • Managers end up dealing with these risk because correlation coefficient requires historical data, which is non-existent for new projects • Based on manager’s judgement, if the correlation is high, stand-alone risk is a good proxy for within-firm risk + most project returns are positively correlated with returns on firm’s other assets and with returns on the stock market Unequal Project Lives Regular NPV may not indicate the better project if projects have 1. Significantly different lives 2. Are mutually exclusive 3. Can be repeated • Need to use replacement chains → Find NPV of project by assuming that each project can be repeated as many times as necessary to reach a common life • • Can also use Equivalent Annual Annuity method → Easier to implement • 1. Find the NPV of each cycle investment – the un-extended one • 2. Find the annual annuity payment that is equivalent to each project’s NPV • The annuity that is higher will be the better project Both will result in the same decision Leasing Sales and leaseback Firm sells land, buildings and equipment and simultaneously leases the property back for a specified period under specific terms • E.g. Sell to back then pay annual payments to continue using the property Operating leases A lease under which lessor maintains and finances the property (aka a service lease) • Cost of maintenance is built into lease payments • Not fully amortized – payments required under lease contract not sufficient to cover full cost of equipment o But lease contract written for a period considerably shorter than expected economic life of leased equipment o And Lessor expects to recover all investment costs through subsequent renewal payments / subsequent leases to other lessees / sale of leased equipment • Contains a cancellation clause → Lessee can cancel the lease before expiration of the basic agreement Financial Leases Do not provide for maintaining services • Not cancellable • Fully amortized • Similar to sale and leaseback, except that leased equipment is new and lessor bought it from a manufacturer / distributor rather than a user lessee Financial Statement Effects Classified as… Lease payment shown as operating expenses on firm’s income statement Off-balancesheet financing Under certain conditions, lease asset / liabilities do not appear on firm’s balance sheet • Lease may call for fixed charges as high / even higher than those on loan, and obligations assumed under the lease may be equally or more dangerous from the standpoint of financial safety; but the firm’s debt ratio remains the same → Misleading as investors may think firm’s financial position is stronger than it actually is • Failure to make lease payment could bankrupt a firm as equally as failure to make loan’s principle and interest payments → Financial lease should be identical to a loan Solution • If any one of the conditions is fulfilled → Lease must be capitalized and shown DIRECTLY on balance sheet Firms should o Report lease asset as a fixed asset o Show present value of lease payments as liabilities Under terms of lease, ownership is transferred from lessor to lessee Lessee can purchase property / renew lease at less than fair market price when lease expires Lease runs for a period equal to or greater than 75% of the asset’s life PV of lease payment >= 90% of initial value of asset Evaluation by Lessee Step 1 Firm decides to acquire particular building / equipment based on regular capital budgeting procedures → Asset has positive NPV Step 2 Now that firm has decided to acquire, should they do it by borrow and purchase OR lease? → Which method should be used to finance the project? Step 3 Use NPV to determine → Comparable to loan! (Failure to make loan payments can result in bankruptcy) → Compare cost of lease to debt financing Other Factors that Affect Leasing Decisions Residual Value Value of leased property at the end of the lease term. Not likely to bias the decision against leasing • Even if residual values are large, they may be under inflation for certain types of inflation as well as for real property • Competition among leasing companies will force leasing rates down to the point where potential residual values will be fully recognised in the lease contract rates Increase credit availability Lease financing can give firm a stronger appearance in superficial credit analysis (because some lease are not shown on the balance sheet) The Optimal Capital Budget 1. Treasurer estimate firm’s overall composite WACC at different amount of capital raised. Plot WACC line a. b. c. d. 2. 3. 4. 5. Marginal cost of capital Cost of equity from retained earnings < Cost of equity from external sources Once retained earnings are exhausted, WACC will rise As firm raises more capital, cost of debt and preferred stock will increase i. WACC line is upward sloping, WACC increases as capital budget increases Plot IRR schedule a. Graph of the marginal rates of return on investment at different levels of investment b. Marginal rates of return decrease as capital budget increases Value is maximised when marginal returns = Marginal costs → Optimal Capital Budget Treasurer reports WACC at optimal capital budget and various divisions make appropriate risk adjustments depending on risk factors assigned to those divisions (e.g. low risk has cost rate 90% of WACC) Divisions find the NPVs of their various projects, using the risk and size-adjusted cost of capital Assumption: • Firm would invest until marginal cost of return = marginal rates of return → True for large firms o For small firms, new firms & firms with dubious track records may have difficulty in raising capital, even for projects that appear to have highly positive NPVs o Some owners may not want to expand rapfidly βͺ Results in a situation called capital rationing : where firms can raise only a specified, limited amount of capital regardless of how many good projects it has Notes from Tutorial Financial analysts should ignore financing costs • They are already accounted for in WACC, which is charged to the cash flows → Avoid double counting Cash is used to value a project • All valuations are based on cash flows • Assets are purchased with cash Accounting profit such as net income, operating income includes noncash items (e.g. depreciation) → Does not accurately show cash flows Taxes change the net value of cash flows • Taxes on cash flows → reduce value of these receipts • Tax credits and deductions from accepting a project increases it’s attractiveness Things to take note 1. Change in NOWC = Change in Current Assets – (Change in Current Liabilities – Change in Notes Payable) 2. CAPEX = Equipment + Shipping 3. Depreciation = Rate + CAPEX a. Deduct depreciation before adding back 4. To find terminal value… a. Add back NOWC b. After-tax Salvage Value = Salvage Value – Tax * (Salvage Value – Book Value) 5. Book Value = Initial Value – All Depreciation Across the Years Seminar 10: Capital Structure and Leverage Book, Market or “Target Weights” Capital Investor-supplied funds – debt, preferred stock, common stock and retained earnings • Accounts payable & accruals are not included because they are not provided by investors Capital Structure Mix of debt, preferred stock, and common equity that is used to finance the firm’s assets Optimal Capital Structure Capital structure that maximises a stock’s intrinsic value Measuring the Capital Structure 1 For capital structure purposes, no distinction is made between common equity raised by issuing stock versus retaining earnings 2 It is better to use market values than book values. However, most financial analysts & bond rating agencies report data on a book-value basis. Also, stock prices are volatile → Weights used to calculate WACC will be volatile → Use of book values instead 3 Most firms focus on a target debt ratio range as opposed to a single number 4 A firm’s CFO considers the capital structures of the firms against which it benchmarks and performs an analysis 5 The greater the difference between stock’s book value and market value, the greater the difference in the WACC estimates • • Actual debt significantly below target range → Firm raises capital by issuing debt (bonds) and use the proceeds to repurchase stocks Actual debt significantly above target range → Firm raises capital by issuing equity and use the proceeds to retire debt Capital Structure Changes Over Time Due to deliberate actions If the firm is not currently at its target, it may deliberately raise new money in a manner that moves the actual structure towards the target Due to market actions The firm could incur high profits or losses that lead to significant changes in book value equity → Decline in stock price • Interest rates increase due to increase in general level / DRP Business Risk Business risk Riskiness of firm’s asset if no debt is issued ROIC EBIT(1-T)/Total Invested Capital • • πROIC After-tax return that company provides for all its investors Equals to ROE when company does not use debt Underlying risk of the firm before considering the effects of debt financing → Good indicator of business risk • Unlevered Firm More uncertainty about future EBIT and ROIC → Greater business risk Debt free (stockholders only face business risk) Factors that affect Business Risk Competition Other things held constant, less competition = Lower business risk Demand Variability More stable demand = Lower business risk Sales Price Variability Products sold in volatile markets = More business risk Input Cost Variability Input costs are uncertain = More business risk Product Obsolescence Faster obsolescence of products (in high-tech industries) = More business risk Foreign Risk Exposure Earnings decline due to exchange rate fluctuations = More business risk + Political risk Regulatory Risk & Business Exposure Financial services & utilities industry are subjected to changes in regulatory environments Other companies face legal exposure that could damage the company if they are forced to pay large settlements → More business risk Extent of Fixed Costs (aka operating leverage) High percentage of fixed costs → Increases business risk Operating Leverage Operating Leverage High percentage of fixed costs → Other factors held constant, a relatively small change in sales results in a large change in ROIC Operating Breakeven EBIT = 0 [Breakeven Quantity = F / (P – V)] Factors Affecting Operating Leverage Technology Large investments in fixed assets = High fixed costs = Operating leverage • E.g. Electric utilities, telephone companies, airlines, steel mills, and chemical companies Financial Risk Financial risk Additional risk placed on the common stockholders as a result of debt issue • Because debtholders are paid before the stockholders, the use of debt, or financial leverage, concentrates the firm’s business risk on the stockholders ROE (EBIT – I)(1 – T) / Total Number of Equity Use of debt • ROE =/= ROIC when there is debt due to the extra interest payments • Increases expected rate of return, but also increases risk Determining the Optimal Capital Structure Optimal Capital Structure Maximises price of firm’s stocks • Debt / Capital ratio that is lower than the one that maximises expected EPS • Higher debt levels raises expected EPS, financial leverage increases stock price • Increase in debt / capital ratio raises EPS but higher EPS can be offset by higher risk WACC Optimal capital structure also minimises WACC Hamada Equation Increase debt ratio → Increase bondholders risk → Increase cost of debt π· ππΏ = ππ [ 1 + (1 − π) ( )] πΈ ππΏ : Firm’s current beta (determined by the firm’s operating decisions) ππ : Firm’s beta if firm was debt free (unlevered), also known as the firm’s business risk D/E: Measure of financial leverage used in the Hamada equation Extra Notes • • wd = percentage of debt in the firm’s capital structure, so D/E = wd/(1-wd) conceptually, a firm’s cost of equity: ππ = ππ πΉ + ππππππ’π πππ ππ’π ππππ π πππ π + ππππππ’π πππ πππππππππ πππ π Capital Structure Theory No brokerage costs MM assumptions in order for firm’s value to be unaffected by capital structure No taxes No bankruptcy costs Investors can borrow at the same rate as corporations All investors have the same information as the management about the firm’s future investment opportunities EBIT not affected by the use of debt Effect of Taxes • • Corporations are allowed to deduct interest payments as an expense → Encourages corporations to use debt in capital structures However, returns on common stocks are taxed at lower effective rates than return on debts → Investors willing to accept lower before tax returns on stocks as compared to bonds o Bonds pay interest which is taxed as personal income, while income from stocks come partly from dividends and partly from capital gains o Long-term capital gains are taxed at a maximum rate but tax can be deferred until gain is realised (stock is sold) Sidenote: Interest deductibility is believed to have the stronger effect → Tax benefits associated with debt financing represent 7% of firm’s value Effect of Potential Bankruptcy Bankruptcy costs discourage firms from pushing their use of debt to excessive levels. 2 components of bankruptcy costs: 1. Probability of occurrence 2. Costs that will be incurred if financial distress arises Firms with volatile earnings → Greater chance of bankruptcy Firms with high operating leverage → Limit use of financial leverage Firms with illiquid assets → Limit use of financial leverage (debt financing) Trade-off Theory Trade-off Theory The firm trade off the tax benefits of debt financing against problems caused by potential bankruptcy 1. Interest paid is a deductible expense → Debt is less expensive than common / preferred stock • Using tax = Tax shelter benefits → Reduces taxes → Allow more EBIT to flow to investors → Increase stock price • Under the MM assumption, stock price is maximised at 100% debt 2. Firm’s have target debt ratios to limit the adverse effects of potential bankruptcy 3. Threshold debt level: Where bankruptcy costs become immaterial. Optimal capital structure: Marginal tax shelter benefits = Marginal bankruptcy related costs 4. Graphs to be taken as approximations and not precisely defined functions 5. However, some company use far less debt than the theory → Refer to signalling theory Signalling Theory Signalling Theory Assumption of symmetric information does not hold true • Firm with very favourable prospects will avoid selling stocks and instead raise any required new capital by selling new debt o Increase in stock prices will allow company to profit without sharing with stockholders • Firm with unfavourable prospects will finance with stocks and bring in new investors to share the losses o Announcement of stock offering = signal that a firm’s prospects as seen by its management are not bright o Firms should use more equity and less debt than the trade-off model Using Debt Financing to Constrain Managers Ways that firms can reduce excess cash flow and reduce wasteful expenditures • Funnelling back to shareholders through higher dividends / repurchasing stocks • Tilting target capital structure towards more debt → High debt service requirements will force managers to become more disciplined LBO (Leveraged Buyouts) Debt is used to finance the purchase of a high percentage of company’s shares Pros Managers are forced to be more careful with shareholders’ money Cons Firm may still go bankrupt in unforeseen circumstances (e.g. recession) Pecking Order Hypothesis Sequence in which firms prefer to raise capital: 1. Spontaneous debt (accounts payable and accruals) 2. Retained earnings 3. Other debt 4. New common stock Windows of Opportunity Windows of Opportunity When stock is overvalued → Issue new equity When stock is undervalued → Repurchase stock Checklist of Capital Structure Decisions Sales Stability Stable sales → Can take on more debt and incur higher fixed charges Asset Structure Company takes on more debt if it has more cash on the BS Net debt = Short-term Debt + Long-term Debt – Cash and Equivalents Operating Leverage Firm with less operating leverage is better able to employ financial leverage bc they have less business risk Growth Rate Faster-growing firms must rely more heavily on external capital → Flotation costs are involved in selling common stock → Encourages them to rely more heavily on debt → Higher uncertainty reduces willingness to use debt Profitability High rates of return → Very little debt (due to internally generated funds) Taxes Interest is a deductible expense → High tax rate = Greater advantage of debt Control If management has voting control, but is not in a position to buy new stocks → Choose debt If firm’s financial situation is weak → Choose equity bc managers will lose their jobs if firms bankrupt (but also have to consider risk of hostile takeover) Management Attitudes Management has to exercise own judgement about capital structure • Conservative → Less debt Lender and rating agency attitudes Advice of lenders and rating agencies influence the financial structure decisions Market Conditions During a credit crunch, bonds with low ratings did not have a ‘reasonable’ interest rate → Forced to go to stock market Firm’s internal condition Firm successfully completed R&D program and forecasts higher earnings in the immediate future → New earnings not anticipated by investors → Firms will want to finance with more debts (refer to Signalling) Financial Flexibility Maintaining adequate “reserve borrowing capacity” based on judgement, market conditions, management’s confidence and the consequences of capital shortage Variations in Capital Structures • Occur across industries and among individual firms in industries Times-InterestEarned Gives an indication of how vulnerable the company is to financial distress. Depends on… 1. Percentage of debt 2. Interest rate on debt 3. Company’s profitability Sidenotes • Dividend = EPS * (Payout Ratio) Seminar 11: Distributions to Shareholders: Dividend and Share Repurchases Dividends VS Capital Gains Target Payout Ratio The target percentage of net income paid out as cash dividends • Based on investor’s preference for dividends vs Capital gains Optimal Dividend Policy The dividend policy that strikes a balance between current dividends and future growth and maximises the firm’s stock price Dividend Irrelevance Theory Dividend Irrelevance Theory Theory that a firm’s dividend policy has no effect on either its value of its cost of capital • Hence, each shareholder can construct his / her own dividend policy (since they can sell off 5% of their stock for 5% dividend, or buy additional shares using their dividend) • May be unrealistic, but holds true for institutional investors who pay no taxes & buy / sell stocks at low costs. MM Assumptions – Firm’s value is determined only by its basic earning power and its business risk No taxes paid on dividends Stocks can be bought and sold with no transaction costs Everyone has the same information regarding firm’s future earnings Principal conclusion of MM Theory: Dividend policy does not affect stock prices / required rate of return on equity Reasons for Dividend Preference Reasons for Capital Gain Preference • Implies that investors are indifferent between dividends and capital gains Bird-inthe-Hand Fallacy A firm’s value will be maximised by setting a high dividend payout ratio • It’s a fallacy because in MM’s view, most investors plan to reinvest their dividends in stock • The riskiness of the firm’s cash flows to investors in the LR is determined by the riskiness of operating cash flows, not by dividend payout policy Keep in Mind MM’s theory relies on assumption that there are no taxes / transaction costs → Unrealistic • Most investors who are looking for steady stream of income will prefer regular dividends (e.g. retirees) • • • Investors are less interested in income and more interested in saving money for the long-term future Tax code encourages investors to prefer capital gains → taxes must be paid on dividend the year they are received but taxes on capital gains are not paid until the stock is sold + tax rate on dividends is higher than tax rate on capital gains Due to TVM, taxes paid in the future has a lower effective cost than taxes paid today Other Dividend Policy Issues Signalling Hypothesis • • • • An increase in dividend is often accompanies by an increase in stock price → Used to refute MM’s theory BUT MM’s argument is: a higher than expected dividend increase is a signal to investors that management forecasts good future earnings Therefore, such prices indicate that announcements have signalling content rather than investor’s preference for dividends Managers have consider signalling effects. E.g. when firm needs cash to increase available funds for investment, a decrease in dividend may signal poor future earnings when the opposite is true → stock prices will decline Clientele Effect Tendency for firm to attract different groups of stockholders who prefer their dividend payout policies • E.g. retirees prefer cash income → high payout ratio preferred o Usually in low / zero tax brackets, so taxes are of little concern • E.g. stockholders In their peak earning years prefer reinvestment → lower payout ratio o Less need for current investment income Catering Theory Investor’s preference for dividends vary over time → corporations adapt their dividend policies to cater to the current desires of the investors Establishing the Dividend Policy in Practice The Residual Dividend Model When deciding how much cash to distribute, consider… 1. The overriding objective is to maximize shareholder value 2. The firm’s cash flows really belong to its shareholders, so managers should not retain income unless they can reinvest those earnings at higher rates of return than shareholders can earn themselves Example Mature industry: Large cashflow but limited investment opportunities → Larger payout → Attract clienteles who prefer high dividends Optimal Payout Ratio A function of 4 factors… 1. Management’s opinion about investor’s preference for dividends VS capital gains 2. Firm’s investment opportunities 3. Firm’s target capital structure 4. Availability + cost of external capital Dividends = Net income – [(Target equity ratio)(Total capital budget)] Steps to establish target payout ratio 1 Determine the optimal capital budget 2 Determine the amount of equity needed to finance that budget 3 Use retained earnings to meet requirements to the extent possible 4 Pays dividends only if more earnings are available than are needed to support the optimal capital budget Cons of Residual Dividend Policy Strategy to Counter the Cons Low-Regular DividendPlus-Extras Most definitely: fluctuating, unstable dividends due to the different investment opportunities • Which investors do not like → Firms should only use it to set long-run target ratios 1. Estimate earnings and investment opportunities, on average, over the next 5 years 2. Use forecasted information to find the average dividends that would be paid using the residual model 3. Set a target payout policy based on the projected data Announce low, regular paying dividend policy that can be maintained no matter what and when • Give ‘extra’ dividend when times are good • Lack of ‘extra’ dividend won’t be regarded as a negative signal because they recognise that ‘extras’ may not be maintained in the future Earnings, Cash Flows and Dividends Importance Cashflow is the primary determinant of dividends, not earnings • Cash dividends are paid in cash → When earnings are insufficient, cash flows allow company to maintain a stable dividend policy Payment Procedures 1. Declaration date Date on which a firm’s directors issue a statement declaring dividend 2. Holderof-record date Company lists stockholder as owner, and stockholder receives dividend 3. Exdividend date Date on which the right to the current dividend no longer accompanies a stock 4. Payment date Date on which a firm actually mails dividend checks Dividend Reinvestment Plans (DRIP) Plans that enable stockholders to automatically reinvest dividends received back into the stocks of the paying firms • Stockholder must pay taxes on amount of dividends rather than cash received • High participation rate in DRIP → Better to reduce dividend payout ratio to save investors tax from dividends Plans that involve old, outstanding stock 1. Company gives the dividend to bank Plans that involve newly issued stock 1. Dividends invested in newly issued stock 2. Bank uses the money to buy corporations stock and allocates shares on pro rata basis 3. Transaction costs are low because of volume purchases 2. Companies offer discounts (since they save on flotation costs) Factors Influencing Dividend Policy 1. Constraints Bond Indentures Debt contract limit dividend payments to earnings generated after loan is granted + timesinterest-earned ratio meets the minimum requirements Preferred Stock Restrictions Common dividend cannot be paid if company omitted its preferred dividend Impairment of Capital Rule Dividend payments cannot exceed “retained earnings” • Designed to protect creditors bc without the rules the company might distribute most assets to stockholders rather than debtholders Availability of Cash Cash dividends can be paid only with cash Penalty Tax on Improperly Accumulated Earnings To prevent wealthy individuals from using corporations to avoid personal taxes, there is a surtax on improperly accumulated income 2. Investment Opportunities No. of profitable investment opportunities Large number of profitable investment opportunities → Low target payout ratio Possibility of accelerating / delaying projects Ability to accelerate projects → Firm to adhere more closely to stable dividend policy 3. Alternative Sources of Capital Cost of Selling New Stock Flotation costs are low → Higher dividend payout ratios Ability to substitute debt for equity Low stock flotation costs → More flexible dividend policy Adjust debt ratio without raising WACC sharply → More flexible debt policy → Pay expected dividend by additional borrowing 4. Effects of Dividend Policy on rs (mentioned earlier) Considered in terms of 1. Stockholders’ desire for current vs future income 2. Perceived riskiness of dividends vs capital gains 3. Tax advantage of capital gains 4. Information (signalling) on dividends 5. Stock Dividends and Stock Splits Stock Splits An action taken by a firm to increase the number of shares outstanding → Lowers price by increasing shares • Used after a sharp price run-up to produce a large price reduction Stock Dividends A dividend paid in the form of additional shares of stock rather than in cash → Lowers price by increasing shares • Used on a regular annual basis to keep the stock price constrained Effect on Stock Prices 1. 2. 3. 4. 5. Price rises shortly after announcement of stock split / dividend Because it is a signal of higher future earnings If company does not announce increase in earnings / dividends, price will drop More shares + lower prices = Higher liquidity → Increase firm’s value Proportion of trades made by individual investors tend to increase, while those made by institutional investors tend to fall → Unsure of how this affects stock value 6. Stock Repurchases Stock Repurchases Transactions in which a firm buys back shares of its own stock, thereby decreasing shares outstanding, increasing EPS and, often, increasing the stock price Types of Stock Repurchases Situations where the firm has cash available for distribution to its stockholders and it distributes this cash by repurchasing shares rather than paying dividends → Capital gains substitute dividends Firm concludes that capital structure is too heavily weighted with equity → Sells debt and uses proceeds to buy back its stock Firm has issued options to employees and it uses open market repurchases to obtain stock for use when the options are exercised Treasury Stock Stock that has been repurchased Effects of Stock Repurchases 1 Current EPS = Total Earnings / Number of Shares 2 PE Ratio= Price / EPS 3 EPS after purchasing shares = Total Earnings / Remaining Shares 4 PE Ratio = Price / New EPS → May drop because the repurchase works to increase debt ratio → Stocks considered to be riskier Advantages of Stock Repurchases 1. Motivated by management’s belief that firm’s shares are undervalues → Positive signal 2. When firm distributes cash by repurchasing stocks, investors have a choice to sell or not, while stockholders must accept dividend and pay tax if firm pays dividends 3. Remove “overhanging” block of stock and keeps price per share down 4. Dividends are ‘sticky’ in the short run because managements are reluctant to raise dividend if dividends cannot be maintained, and are reluctant to cut dividends due to negative signals → Temporary excess used to repurchase shares instead 5. Dividend payout ratio is low but is secure → Will grow → More flexibility in adjusting the total distribution since repurchases can vary without giving off negative signals 6. Can be used to produce large-scale changes in the capital structure 7. Companies can repurchase shares and reissue them when employees exercise their options → Avoids having to issue new shares which dilutes earnings per share Disadvantages of Stock Repurchases 1. Stockholders may not be indifferent and stock price might benefit more from cash dividends than from repurchases. Cash dividends are generally dependable by repurchases are not 2. Selling stockholders may not be fully aware of all the implications of the repurchase 3. Corporation may pay too high a price for the repurchased stock Conclusions Why repurchase Why dividends Capital gains have delayed tax advantage Cash dividends are more dependable Fluctuating dividends give off negative signalling Firms can make a large rapid shift in capital structure But company can set a low dividend level and distribute excess cash as and when they can
