Finance 1. The Corpora on and Financial Markets 1.1 The Four Types of Firms Sole Proprietorships = a business owned and run by one person (most common) -usually very small (few employees) -no separa on between firm and owner -unlimited liability Partnerships = iden cal to a sole proprietorship but it has mul ple owners -all partners have unlimited personal liability Limited Liability Company (LLC) = a limited partnership without a general partner -> all the owners have limited liability (Germany: GmbH) Corpora ons = legally defined company, separate from owners (not liable) -> enter contracts, acquire assets, incur obliga ons, and is protected under the U.S. Cons tu on 1.2 The Corporate Management Team agency problem: when managers, put their own self-interest ahead of the interest of the shareholders -> solu on: minimize the number of decision managers 1.3 The Stock Market private companies: limited set of shareholders, and shares are not regularly traded public companies: shares are traded on organized markets (stock exchange) primary market: corpora ons sell stocks to investors secondary market: trade between investors (no change in the book equity) market makers: match buyers and sellers bid price: the price they were willing to buy ask price: the price they were willing to sell transac on price: payment made by investors in order to trade Equity Debt legal ownership contract no dividends interest payment more risk, more reward Less risk, less reward shares loans or bonds 2. Introduc on to Financial Statement Analysis 2.1 Firm’s Disclosure of Financial Informa on Financial statements: accoun ng reports with past performance informa on that a firm issues periodically (usually quarterly and annually) -> firms also need to send an annual report annually to their shareholders GAAP: General Accepted Accoun ng Standards auditor: neutral third party checking the financial statements -> reliable and faithfully represented 1. Balance Sheet 2. Income Statement 3. Statement of cash flows 4. Statement of Stockholder’s equity 2.2 The Balance Sheet = lists the firm’s assets and liabili es at a given point in me assets: cash, inventory, property, plant, and equipment, and other investments (future benefit) liabili es: firm’s obliga ons to creditors equity: difference between the firm’s assets and liabili es (firm’s net worth) Assets 1. current assets: either cash or assets that could be converted into cash within one year -> securi es: short-term, low-risk investments that can be easily sold -> accounts receivable: amounts owed to the company -> inventories: raw materials, work-in-progress, finished goods 2. long term assets: PPE (real estate, machinery, equipment) deprecia on expense: reduce the value recorded for this equipment each year accumulated deprecia on: total amount deducted over its life book value: the value shown in the firm’s financial statements (acquisi on cost - deprecia on) Liabili es 1. current liabili es: liabili es that will be sa sfied within one year -> accounts payable: amounts owed to a supplier -> short-term debt: repayments of debt that will occur within the next year -> other expenses that have not been paid yet: salary or taxes 2. long term liabili es: liabili es that extend beyond one year -> long term debt: loan or debt obliga ons (more than one year) -> capital leases: long-term lease contracts -> deferred taxes: taxes that have not yet been paid Conclusion of the Balance Sheet -many assets are valued on historical data rather than their value today (inaccurate) Market value of equity = outstanding shares x price per share for most successful firms > 1 Market-to-book Ra o = low ra o: value stocks high ra o: growth stocks 2.3 The Income Statement = list of firm’s revenues and expenses over a period of me net income: revenues - expenses net gain: R > E net loss: R < E 2.4 The Statement of Cash Flows = determines how much cash the firm has generated, and how that cash has been allocated, during a set period Opera ng Ac vi es 1. Opera ng Ac vity 1. Investment Ac vity 2. Financing Ac vity cash ac vi es related to net income (current assets, current equity) cash ac vi es related to non-current assets (long-term investments, PPE) cash ac vi es related to non-current liabili es and equity (dividends) 2.5 Financial Statement Analysis Profitability Ra os the ability to sell a product for more than the produc on cost how much a company earns before interest and taxes from each dollar of sales revenue available to equity holders a er the firm pays interest and taxes Liquidity Ra os assesses whether a firm has sufficient working capital to meet its short-term needs measure of a firm’s cash posi on Working Capital Ra os the speed at which a company turns sales into cash how many mes its current stock of inventory is sold during the year 3. Financial Decision Making and the Law of One Price 3.1 Valuing Decisions good decisions: benefits > costs first step: iden fy costs and benefits next step: quan fy the costs and benefits compe ve market: a market in which a product can be bought and sold at the same price Valua on Principle: the value of an asset is determined by its compe ve market price -> if benefits exceed costs, the decision will increase the market value of the firm 3.2 Interest Rates and the Time Value of Money me value of money: difference in value between money today and money in the future Example: Success Formula receives a payment of 1000€ in 2 years. The interest rate at which we can borrow and invest is 12%. 1. Worth today: ( , )² = 797.19€ 2. Worth in 3 years: 1000 x (1 + 0,12) = 1.120 € Risk-free interest rate (rf): interest rate for a given period at which money can be borrowed or lent without risk (also called discount rate) Present Value (PV): the value of money today Future Value (FV): the value of money in the future 3.3 Present Value and the NPV Decision Rule Net Present Value (NPV): difference between the present value of its benefits and its costs -> NPV = PV(Benefits) - PV(Costs) Accept and Reject a Project Reject: nega ve NPV because accep ng them would reduce the wealth of investors, whereas not Neutral: NPV = 0 investment has no cost Accept: posi ve NPV because accep ng them is equivalent to receiving their NPV in cash today NPV Decision Rule: when making an investment decision, take the alterna ve with the highest NPV 3.4 Arbitrage and the Law of One Price arbitrage: buying and selling similar goods in different markets to take advantage of a different prices arbitrage opportunity: to make profit without taking any risk or making any investment normal market: a compe ve market with no arbitrage opportuni es Law of One Price: two similar goods in different markets must be valued at the same price 3.5 No-Arbitrage and Security Prices financial security: an investment opportunity that trades in a financial market bond: a security sold by governments and corpora ons to raise money from investors today in exchange for the promised future payment short sale: the person who intends to sell the security first borrows it from someone who already owns it. later, that person must either return the security by buying it back or pay the owner the cash flow (s)he would have received por olio: a collec on of securi es 3.6 Appendix Risk premium: the addi onal return that investors expect to earn to compensate them for the risk transac on costs: 1. Pay the broker a commission on the trade 2. Pay a bid-ask spread 4. The Time Value of Money 4.1 The Timeline stream of cash flows: a series of cash flows las ng several periods meline: a linear representa on of a stream of cash flows 4.2 The Three Rules of Time Travel Rule 1 It is only possible to compare or combine values at the same point in me Rule 2 To move a cash flow forward in me, it must be compounded Rule 3 To move a cash flow back in me, it must be discounted 4.3 Calcula ng FV = NPV = PV (benefits) - PV (costs) = PV (benefits - costs) 4.4 Perpetui es and Annui es perpetuity: a stream of equal cash flows that occur at regular intervals and last forever -> the first cash flow arrives at the end of the first period annuity: a stream of N equal cash flows paid at regular intervals 4.5 Growing Perpetuity and Annuity growing perpetuity: a stream of cash flows that occur at regular intervals and grow constantly forever growing annuity: a stream of N growing cash flows, paid at regular intervals 4.6 Using an Annuity Spreadsheet or Calculator 4.7 Non-Annual Cash Flows Everything about annual cash flows applies to monthly cash flows as long as: 1. The interest rate is specified as a monthly rate 2. The number of periods is expressed in months 4.8 The Internal Rate of Return internal rate of return (IRR): the IRR sets the net present value of the cash flows equal to zero 5. Interest Rates 5.1 Interest Rate Quotes and Adjustments Annual Percentage Rates (APR): the amount of simple interest earned in one year (no compounding) Effec ve Annual Rate (EAR): the actual amount of interest that will be earned at the end of one year 5.2 The Determinants of Interest Rates Real vs. Nominal Rates nominal interest rates: the rate at which your money will grow if invested for a certain period real interest rate: the rate of growth of your purchasing power, a er adjus ng for infla on The Yield Curve and Discount Rates term structure: the rela onship between the investment term and the interest rate yield: income generated by an investment rela ve to its cost If interest rate goes If interest rate goes long-term interest rates tend to be higher -> increasing yield short-term interest rates tend to be higher -> decreasing yield 5.3 Risk and Taxes A er-Tax Interest Rates a er-tax interest rate: reduce the amount of interest the investor can keep, due to taxes 5.4 The Opportunity Cost of Capital opportunity cost of capital: the poten al return on investment choosing one par cular investment over another => the benchmark against which cash flows should be evaluated with new investment 6. Valuing Bonds 6.1 Terminology bond: a security sold by governments and corpora ons to raise money from investors today in exchange for promised future payments bond cer ficate: a cer ficate about the amounts and dates of all payments to be made maturity date: payments made un l a final repayment date (maturity date) Bonds payments to their holders: 1. coupons: the promised interest payments of a bond 2. face value: the no onal amount we use to compute the interest payments coupon rate: the amount of each coupon payment Zero-Coupon Bonds zero-coupon bond: doesn’t make coupon payments but traded at discount (lower than face value) -> simplest type of bond -> only cash payment the investor receives is the face value on the maturity date Example: treasury bills: U.S. government (zero-coupon) bonds with a maturity of up to one year Yield to Maturity (YTM) yield to maturity: the total return an investor would expect to receive if they hold the bond un l its maturity date (and reinvest all interest payments at the same rate) -> more accurate measure of the return Coupon bonds coupon bonds: pay investors their face value at maturity -> two types: Treasury notes: have original maturi es from one to 10 years Treasury bonds: have original maturi es of more than 10 years 6.2 Dynamic Behavior of Bond Prices Bond price is… Bond trades at… less than face value discount equal to face value par greater than face value premium Occurs when… coupon rate < YTM coupon rate = YTM coupon rate > YTM 6.3 Corporate Bonds corporate bonds: bonds issued by corpora ons (might not pay back the full amount) sovereign bonds: bonds issued by na onal governments credit risk: the bond’s cash flows are not known with certainty 7. Investment Decision Rules 7.1 NPV and Stand-Alone Projects NPV Investment Rule: “When making an investment decision, take the alterna ve with the highest NPV. Choosing this alterna ve is equivalent to receiving its NPV in cash today.” 7.2 The Internal Rate of Return Rule IRR investment rule: “Take any investment opportunity where the IRR exceeds the discount rate.” => there can be mul ple IRR (or none) 7.3 The Payback Rule payback investment rule: you should only accept a project if its cash flows pay back its ini al investment within a pre-specified period payback period: the amount of me it takes to pay back the ini al investment -> payback period < pre-specified length of me: reject! -> payback period > pre-specified length of me: accept! 7.4 Choosing between Projects 1. Pick the project with the highest NPV (most important) 2. IRRs cannot always be compared IRRs cannot be meaningfully when projects differ in their scale of investment, the ming of their cash flows, or their riskiness. 3. The Incremental IRR The incremental IRR tells us the discount rate at which it becomes profitable to switch from one project to the other (tells you the cross-over point) 7.5 Project Selec on with Resource Constraints In principle, the company should take over all investments with posi ve NPV, but in prac ce there are o en restric ons on the number of projects profitability index: the index to iden fy the op mal combina on of projects to undertake 9. Valuing Stocks 9.1 The Dividend-Discount Model Two poten al sources of cash flows from owning a stock: 1. Dividends 2. Cash generated from selling the shares dividend yield: the expected annual dividend of the stock divided by its current price capital gain: the difference between the expected sale price and purchase price for the stock capital gain rate: dividing the capital gain by the current stock price to express the capital gain in % total return: the sum of the dividend yield and the capital gain rate 9.2 Constant Dividend Growth dividend payout rate: the frac on of its earnings that the firm pays as dividends each year The firm can increase its dividends in three ways: 1. higher earnings (net income) 2. higher dividend pay-out rate 3. lower shares outstanding 9.3 Total Payout and Free Cash Flow Valua on Models share repurchase: the firm uses excess cash to buy back its own stock total payout model: an alterna ve, more reliable method when a firm repurchases shares the discounted free cash flow model: goes one step further and begins by determining the total value of the firm to all investors - both equity and debt holders -> advantage: allows you to value a firm without forecas ng dividends, shares, or use of debt weighted average cost of capital (WACC): average cost of capital the firm must pay to all its investors, both debt and equity holders -> firm has no debt: r wacc = r E -> firm has debt: r wacc < r E 9.4 Valua on Based on Comparable Firms method of comparables: es ma ng the value of the firm based on the value of other, comparable firms or investments that will generate very similar cash flows in the future Mul ples valua on mul ple: a ra o of the value to some measure of the firm’s scale Limita ons: -it doesn’t include the important differences among firms -it only compares the value of the firm in comparison to the other firms 9.5 Informa on, Compe on, and Stock Prices Given accurate informa on about two of these variables, a valua on model allows us to make inferences statements about the third variable Lessons for Investors The investor may have exper se or access to informa on that is known to only a few people. S ll, they need to focus on NPV and free cash flow, avoid accoun ng illusions, and use financial transac ons to support investment. 10. Capital Markets and the Pricing of Risk 10.1. Risk and Return Small stocks had the highest long-term returns, however, that performance came at a cost - the risk of large losses. 10.2 Common Measures of Risk and Return probability distribu on: when an investment is risky, there are different returns it may earn expected (or mean) return: calculated average of the possible returns, where the weights correspond to the probabili es There are two common measures of risk: variance: the expected squared devia on from the mean standard devia on: the square root of the variance 10.3 Historical Returns of Stocks and Bonds realized return: of all possible returns, it is the one that actually occurs over a par cular me period Assump ons: all dividends are reinvested and are used to buy shares of the same stock immediately average annual return: the return of an investment during some historical period is simply the average of the realized returns for each year Difficul es 1. We don’t know what investors expected in the past. 2. The average return is just an es mate of the true expected return. Es ma on Error standard error: the standard devia on of the es mated value of the mean of the actual distribu on around its true value 10.4 Returns of Large Por olios excess return: the difference between the average return for the investment and the average return for Treasury bills, a risk-free investment, and measures the average risk premium investors earned for bearing the risk of the investment 10.5 Types of Risk common risk: risk that is perfectly correlated (example: insurance for earthquake) independent risks: risks that share no correla on diversifica on: the averaging out of independent risks in a large por olio 10.6 Diversifica on in Stock Por olios 1. systema c, or market risk fluctua ons of a stock’s return that are due to market-wide news represent common risk -> earthquakes, all stocks are affected simultaneously by the news -> we only get compensated for systema c risk (in beta) 2. idiosyncra c, firm-specific risk fluctua ons of a stock’s return that are due to firm-specific news are independent risks -> the across homes, unrelated risks across stocks only systema c risk both types of risk only idiosyncra c risk 10.7 Measuring Systema c Risk Efficient por olio: cannot be further diversified, there is no way to reduce the risk of the por olio without lowering its expected return market por olio: a natural candidate for an efficient por olio which is a por olio of all stocks and securi es traded in the capital markets beta: the systema c risk of a security by calcula ng the sensi vity of the security’s return to the return of the market por olio 11. Op mal Por olio Choice and the Capital Asset Pricing Model 11.1 The Expected Return of a Por olio por olio weights: the frac on of the total investment in the por olio held in each individual investment in the por olio 11.2 Covariance and Correla on -combining stocks into a por olio, reduces the risk through diversifica on -the amount of eliminated risk in a por olio depends on the degree to which degree the stocks face common risk and their prices move together Measuring Co-Movement covariance: the expected product of the devia ons of two returns from their means correla on: rela onship, defined as the covariance of the returns divided by the standard devia on of each return 11.3 The Vola lity of a Large Por olio equally weighted por olio: a por olio in which the same amount is invested in each stock 11.4 Risk Versus Return: Choosing an Efficient Por olio The Effect of Correla on inefficient por olio: another por olio that is be er in terms of both expected return and vola lity Short Sales long posi on: a posi ve investment in a security short posi on: a nega ve investment in a security -> short sale: a transac on in which you sell a stock today that you do not own, with the obliga on to buy it back in the future Vola lity = √ Var = SD² Efficient fron er: the line with the efficient por olios -> above the line: efficient -> below the line: inefficient 11.5 Risk-Free Saving and Borrowing buying stocks on margin (or using leverage): borrowing money to invest in stocks Op mal por olio: highest Sharpe ra o -> tangent por olio: the line with the risk-free investment just touches and so is tangent to, the efficient fron er of risky investments 11.6 The Efficient Por olio and Required Returns required return: the expected return that is necessary to compensate for the risk investment I will contribute to the por olio 11.7 The Capital Asset Pricing Model (CAPM) CAPM allows us to iden fy the efficient por olio of risky assets without having any knowledge of the expected return of each security (not perfectly accurate but it gets managers to think) Assump ons 1. Investors can buy and sell all securi es at compe ve market prices (no taxes or transac on costs) and can borrow and lend at the risk-free interest rate. 2. Investors hold only efficient por olios of traded securi es. 3. Investors have homogenous expecta ons about vola li es, correla ons, and expected return. homogeneous expecta ons: a special case all investors have the same es mates concerning future investments and returns Capital market line (CML): the tangent line through the market por olio 11.8 Determining the Risk Premium security market line (SML): the line along which all individual securi es should lie when plo ed according to their expected return and beta Stocks over SML: undervalued (posi ve Alpha & MPV) Stocks below SML: overvalued (nega ve Alpha & MPV) -> can be short sold to become posi ve 12. Es ma ng the Cost of Capital 12.1 The CAPM Equa on for the Cost of Capital (SML) Total risk: measured by vola lity Systema c risk: measured by beta 12.2 The Market Por olio value-weighted por olio: a por olio in which each security is held in propor on to its market capitaliza on equal-ownership por olio: we hold an equal frac on of the total number of shares outstanding of each security in the por olio passive por olio: very li le trading is required to maintain it, aka value-weighted por olio Market Indexes market index: reports the value of a par cular por olio of securi es (i.e.: S&P 500) price-weighted por olio: holds an equal number of shares of each stock, independent of their size index funds: many mutual fund companies offer funds, that invest in these por olios exchange-traded fund (ETF): a security that trades directly on an exchange, like a stock, but represents ownership in a por olio of stocks 12.3 Beta Es ma on Beta: it corresponds to the slope of the best fi ng line in the plot of the security’s excess returns vs. the market excess return -> based on historical sensi vity Linear regression: the sta s cal technique that iden fies the best-fi ng line through a set of points Alpha: the distance the stock’s average is above or below the SML 12.4 The Debt Cost of Capital debt cost of capital: the cost of capital that a firm must pay on its debt 12.5 A Project’s Cost of Capital Most common method es ma ng a project’s beta: iden fying comparable firms in the same line 20. Financial Op ons 20.1 Op on Basics financial op on: contract gives its owner the right to purchase or sell an asset at a fixed price at some future date (two different types) -> call op on: gives the owner the right to buy the asset -> put op on: gives the owner the right to sell the asset op on holder: holds the right to exercise the op on and has a long posi on in the contract op on writer: the person who takes the other side of the contract strike price (or exercise price): price at which the holder buys or sells the share of stock when the op on is exercised Understanding Op on Contracts 1. American op ons: allow their holders to exercise the op on on any date up to and including a final date called the expira on date (the most common kind) -> should be worth more 2. European op ons: allow their holders to exercise the op on only on the expira on date -> holders cannot exercise before the expira on date => the names have nothing to do with the loca on where the op ons are traded op on premium: the market price of the op on (compensates the seller for the risk of loss) Op ons and financial securi es Out-of-the-money op on exercise price > stock price At-the-money op on exercise price = stock price In-the-money op on exercise price < stock price (nega ve payoff and beta) (posi ve payoff, and beta) Deep-in-the-money or deep-out-of-the-money: strike price and stock price are very far apart hedging: using an op on to reduce risk in this way speculate: place a bet on the direc on in which they believe the market is likely to move 20.2 Op on Payoffs at Expira on Payoff por olio insurance: holding stocks and put op ons in this combina on Short Combina ons of Op ons Straddles: the solid line provides a posi ve payoff as long as it is not equal to the strike price (more vola le stock) Strangle: red line represents the payout and the blue line call payout Bu erfly Spread: black line represents the payoffs of the combina ons -> less vola le stock Protec ve put: an op on that insures against a loss without relinquishing the upside Por olio insurance: strategies to insure against -> buying mul ple stocks and using put op ons on the por olio as a whole -> same effect: purchasing a bond and a call op on! 20.3 Put-Call Parity put-call parity: the rela onship between the value of the stock, the bond, and call and put op ons 20.4 Factors Affec ng Op on Prices -Strike Price and Stock Price -Arbitrage Bounds on Op on Prices -Op on Prices and the Exercise Date -Op on Prices and Vola lity Credit default swap (CDS): the buyer pays a premium to the seller and receives a payment in return to make up for the loss if the bond defaults Powered by TCPDF (www.tcpdf.org)
