Laying a Foundation
FIN 461: Financial Cases & Modeling
George W. Gallinger
Associate Professor of Finance
W. P. Carey School of Business
Arizona State University
Let’s Get Started on
Materials

Partially covered in your FIN 361
textbook

Chapters 1, 29 & 14.
W. P. Carey School of Business
Slide 2
What is Finance?

Finance is derived from the Latin word finis



During Roman times, finis meant the completion of a
contract between parties with either a transfer of money or
barter (exchange) or a credit agreement
Much the same meaning today
Finance encompasses the analysis of, the issuance
of, the distribution of, and the purchase of financial
contracts written against real assets (e.g., land,
buildings, equipment, and inventories)

Implicit in these activities is the determination of value;
deciding what something is worth.
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Slide 3
Areas of Finance


Finance is a multifaceted discipline, international in
scope, and bound together by contracts
It includes the areas of:



Managerial finance
Investments
Financial markets.
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Slide 4
Managerial Finance
W. P. Carey School of Business
Slide 5
Investments

Closest many people
get to finance



So much news about
investments

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Personal portfolios
Try to “beat the market”
Markets open 24 hours
per day.
Slide 6
Financial Markets

A brief discussion later

Key to value creation.
W. P. Carey School of Business
Slide 7
Relationships

Financial management, investments, and financial
markets are closely related:


Management's actions influence the firm’s market
value


Accepted financial objective of a company: Maximization of
its market value  maximization of shareholder value
Simultaneous interplay of supply and demand for financial
securities in financial markets determines market value
Through the mechanism of these financial markets,
companies participate as suppliers of securities and
investors participate as demanders for securities

Interactions of the demands of all investors determine
market values.
W. P. Carey School of Business
Slide 8
Finance Principles

Finance is an integrated
body of knowledge

Built around guiding
principles: wealth
maximization, time value
of money, expected return
versus risk, leverage, &
diversification

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Principles provide the
foundation for
integrating the areas of
finance and provide
guidance for the issues.
Slide 9
Maximization of Wealth


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Pursue valueadding activities
Conduct business
in an ethical
manner.
Slide 10
Time Value of Money
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Slide 11
Expected Return vs. Risk
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Slide 12
Operating Leverage
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Slide 13
Financial Leverage
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Slide 14
Diversification
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Slide 15
Common Elements Used
in Finance
See next
slide
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Slide 16
Organizational Form
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Slide 17
Finance & Other Disciplines

As you prepare to
study finance, and
managerial finance in
particular, keep the
following perspective
in mind

Finance relies on:




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Economics
Accounting
Quantitative methods
Management.
Slide 18
How Ethics & Finance Relate
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Slide 19
Transition to an Accounting
Review

Finance is not accounting!


Many firms call the accounting function the
finance department
Focus different in finance.
W. P. Carey School of Business
Slide 20
Accounting Information



Every company has a history—good, bad, or
neutral—that is important to managers and potential
investors, bankers, or creditors
Firm's history  track record of accomplishments
From a financial perspective, you measure a firm's
history by the company's principal financial
statements


Balance sheet, income statement, and statement of cash
flows
These statements evolve from the accrual accounting
process, following accepted principles, procedures,
and standards of the accounting profession.
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Slide 21
Manipulation of Earnings
Survey
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Slide 22
Funds vs. Profits

Finance is more concerned about funds than about
income, or profit


Funds represent financial resources the firm uses to buy
inputs (such as material, labor, and assets) and pay
investors
Funds come from many sources



Revenue from operations, monies received from lenders, new
investments by shareholders, or from the sale of assets
Money represents funds, but so does buying on credit
Profit is the return on investment


The amount received, or benefit gained, by making the
investment
Return of investment  recapture of the initial investment
as a result of generating cash flows to repay the initial cost.
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Slide 23
EBITDA

Many people define cash flow as
EBITDA




What is its relevance?
What is it missing?
Does it do a reasonably good job?
Why not use the statement of cash
flows?
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Slide 24
W. T. Grant


Accounting profits versus cash
operating profits
Cash flow frequently defined as:
Net income + depreciation



Poor definition.
Look at W. T. Grant’s trend...
And then at Salton…
W. P. Carey School of Business
Slide 25
What Happened to W. T.
Grant?
100
50
0
-50
NI + depr.
NI
CFFO
-100
-150
-200
'66
'67
'68
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'69
'70
'71
'72
'73
'74
'75
Slide 26
What Happened to Salton?
80
60
40
20
0
EBITDA
CFFO
-20
-40
-60
'93
'94
'95
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'96
'97
'98
'99
Slide 27
Rules for Identifying Cash
Flows
Balance Sheet
Assets increase Use
Financing increases Source
Assets decrease Source
Financing decreases Use
Revenues = Source
Expenses = Use
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Slide 28
W. P. Carey School of Business
Slide 29
Sustainable Growth

What differentiates firms that create value from those
that destroy value?

Ability to manage growth!
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Slide 30
What Does Value Mean?


A central theme of this course is that management’s
decisions are directed toward increasing the value
of the firm
Necessary to carefully define what value means


The logic of accounting is different from the logic of
finance
Accounting often refers to book value of assets


Has little meaning in finance
Finance uses economic value and market value.
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Slide 31
Transition to Economic
Foundations

Economics provide theoretical
underpinnings.
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Slide 32
Operate in an Economic
System


Each financial player or participant purses its
goals within the economic system
Economic system allows for the exchange of
goods or services and money


Consists of business, government, and household
sectors of the economy, all of which interact with each
other
While all societies or countries have such sectors, they
relate in very different ways in different countries

Government sector is much more predominant in
determining outcomes of the economic system in China or
Cuba than it is in the United States.
W. P. Carey School of Business
Slide 33
Fiscal & Monetary Policies



Implementation of fiscal policy and
monetary policy are means the government
sector uses to alter economic activity of
households and businesses
Fiscal policy refers to policies or laws that
affect the government budget
Monetary policy involves changes in the
economy’s money supply

Responsibility of the nation’s central bank.
W. P. Carey School of Business
Slide 34
Importance of Finance


A simple model economy to clarify the forces that
shape finance
Economy initially has just one person, you, who
lives on a deserted island




Your wealth consists of 100 pounds of seed corn
Must meet your needs both now and in the near future
No opportunity exists to produce or increase your initial
wealth position, nor can you exchange goods or services
with anyone else
Decision:


You must decide how to allocate your wealth between
consumption of corn this period and next period
You cannot save corn past the next period.
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Slide 35
Neither Production Nor
Markets Exist

You must make a
decision:

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Consumption this
period vs. next
period?
Slide 36
Neither Production Nor
Markets Exist
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Slide 37
Introduce Production

Assume 1 lb. of
planted seed corn
reaps 1.25 lbs. of
corn next period:


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55 x 1.25 = 68.75
Availability increases
13.75 pounds, or
25%, over the earlier
situation of no
production
opportunities
Slide 38
Introduce Exchange
Between Participants

With the growth in the number
of people, the single-sector
economy divides into two
sectors



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Business sector and household
sector
Business sector produces
goods and services
Household sector purchases
goods and services from the
business sector and provides
inputs to the business sector so
that it can produce the goods
and services
To facilitate exchanges of goods
and services between sectors,
all participants in the economy
agree on a form of money.
Slide 39
Introduce a Financial System

Function of the financial system


This function is made more
important by the fact that
methods of production often
require a volume of money
greater than can be generated
by the producing firm itself in its
early stages of production


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Accept excess money of savers
and lend it to deficit units in
need of funds
E.g.: a firm needs to construct
buildings and equipment to
manufacture a product
How does the financial system
meet the needs of firms by
locating, securing, and
channeling the money to them?
Slide 40
Financial Markets &
Interest Rates

Interest rate  a reflection of the time value of
money


Central to this discussion  supply of money and
its effect on interest rates



Many factors, including inflation and the risk of default by
the borrower, influence the time value of money
There are in fact several different interest rates: money
rates, consumer savings rates, government treasury rates,
government agency rates, and corporate rate, among
others
Generally, interest rates move in the same direction in
response to economic activity
Necessary to distinguish between nominal interest
rates and real interest rates.
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Slide 41
Interest Rates Play Key Role
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Slide 42
Example of Resource
Allocations
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Slide 43
Example Continued…
and DeGrazia
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Slide 44
Types of Financial Markets

Money markets: Short-term maturities of less than one year
Capital markets: Long-term maturities exceeding one year
Primary market: Initial issuance of newly created securities
Secondary market: Transactions subsequent to inital issuance
of securities
W. P. Carey School of Business
Slide 45
Primary Market



Initial sale of securities
Investment bankers major players
Functions:



Investigative
Risk bearing
Selling.
W. P. Carey School of Business
Slide 46
2003 Investment Banking
Rankings
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Slide 47
Investigative Function




Researches the firm wanting to issue new
securities
Is link between the capital markets, the firm
issuing the securities, and other investment
bankers (i.e., the syndicate)
Draws the covenants and ensures
compliance with the laws
Establishes the securities' issuing price.
W. P. Carey School of Business
Slide 48
Risk-Bearing Function

Basically two extremes: "Take it or leave it“



Taking it - the investment banker assumes the
risk and underwrites the security issue (called a
firm-commitment offer)
Leaving it - risk is left with the issuer (called a
best-efforts offer)
Investment banker compensated by the
spread

Market price minus price to company.
W. P. Carey School of Business
Slide 49
Selling Function


Securities sold through selling divisions
of the underwriters and invited
brokerage houses
Formal announcement by:



Red Herring - preliminary and unofficial
Prospectus - official SEC document
Tombstone - an after-the-fact
advertisement.
W. P. Carey School of Business
Slide 50
Secondary Markets


Consists of four
submarkets
3rd Market


Trading of
exchange-listed
stocks in the OTC
market
4th Market

Electronic trading
system without
brokers.
W. P. Carey School of Business
Slide 51
Money Market Instruments




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T-Bills - These are issued by the federal government and are short-term (less than one year).
They are discounted and interest is exempt from state income tax. The word "discounted"
means that the buyer pays less than the face amount of the securities and receives the face
amount when the securities mature. The difference represents the implicit interest earned
Federal Funds - These are funds that commercial banks borrow from each other when their
reserves are low. These funds are repaid with interest in 1 to 3 days (very short-term
securities).
Federal Agency Notes - These are debt securities that various agencies issue to fund
operations. They are both short-term and long-term securities and are usually discounted.
Commercial Paper - This is an unsecured note issued by large companies with high credit
rating (e.g., General Motors). They are short-term and can be discounted or interest bearing.
Negotiable Certificates of Deposit - These are issued by commercial banks with a maturity
of 14 days or more. They are interest bearing with interest paid at maturity.
Eurodollar - Non-US banks from Europe and Cayman Islands issue these. They can mature
overnight, but maturity is no more than one year. They are interest bearing with interest paid
at maturity.
Banker's Acceptance - These are issued by commercial banks with maturity up to 6 months
and are discounted.
Repurchase Agreements - These are issued by U.S. government securities dealers with an
agreement to repurchase. They can mature overnight or up to 180 days and interest is paid at
maturity in the form of a higher repurchase price.
Money Market Mutual Funds - Investment companies issue these. There is no maturity for
these instruments, and interest is earned daily.
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Slide 52
Capital Market Instruments



Debt
Preferred stock
Common stock.
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Slide 53
Different Forms of Debt
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Slide 54
Bond Ratings
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Slide 55
Corporate Bonds

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IBM bond: coupon of 9%; matures in 2008
Closing price is $1027.50 (= 102.75 x 10)
Current yield is 8.8% (= $90 / $1027.50)
$151,000 worth traded
Closing price is up $5 from the previous day
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Slide 56
Federal Status of Agency
Securities
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Slide 57
Preferred Stock
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Slide 58
Common Stock



Represents an “ownership” claim
Perpetual life
Dividends and capital gains/losses.
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Slide 59
Stock Market Reporting
52 WEEKS
YLD
VOL
NET
HI
LO STOCK SYM DIV % PE 100s HI LO CLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75
Gap has
been as high
as $52.75 in
the last year.
Gap pays a
dividend of 9
cents/share
Given the current
price, the
dividend yield is
Given the
½%
current price,
Gap has been as
the PE ratio is
low as $19.06 in
15 times
the last year.
earnings
W. P. Carey School of Business
Gap ended trading at
$19.25, down $1.75 from
yesterday’s close
6,517,200 shares traded
hands in the last day’s
trading
Slide 60
52 WEEKS
YLD
VOL
NET
HI
LO STOCK SYM DIV % PE 100s HI LO CLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75
5.9 Stock Market Reporting
Gap Incorporated is having a tough year, trading near their 52week low. Imagine how you would feel if within the past
year you had paid $52.75 for a share of Gap and now had a
share worth $19.25! That 9-cent dividend wouldn’t go very
far in making amends.
Yesterday, Gap had another rough day in a rough year. Gap
“opened the day down” beginning trading at $20.50, which
was down from the previous close of $21.00 = $19.25 +
$1.75
Looks like cargo pants aren’t the only things on sale at Gap.
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Slide 61
Why Use Debt Financing?
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Slide 62
Bypass the Covenants



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Drexel Burnham Lambert, a former investment banking company and buyout specialist,
controlled more than 50% of the equity in a company called Rexene. The remaining
50% was owned by investors solicited by Drexel. About six months before announcing
that Rexene had serious financial difficulties, Drexel had Rexene make a $7 per share
payment to equityholders--Drexel and its solicited investors. This payment exceeded the
original equity investment.
The buyout specialist firm Kohlberg Kravis Roberts (KKR) managed to return to the
equity investors in the buyout of Beatrice Company all of their original investment.
However, many debt investors found themselves holding securities of a financially
distressed company called the E-II Corporation.
KKR refinanced a leveraged buyout of Storer Communications and paid itself and other
equity investors $1 billion. The unfortunate debt investors of the new SCI
Communications were left with debt securities selling for only a fraction of their par
values.
May Department Stores and Houston Lighting & Power Company retired high-coupon
debt before the first call date allowed by the indenture. The companies offered to pay
premium prices to bondholders who voluntarily tendered, while simultaneously
announcing that any bonds not tendered voluntarily would be "cash called" at a lower
price. Even though the debt covenants forbade the companies from issuing lowercoupon debt to retire higher-coupon debt, the firms ignored this fact and claimed any
recent new low-cost debt financing was not the source of funds to retire the called debt.
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Slide 63
Return to Interest Rates
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Slide 64
Structure of Interest Rates
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Slide 65
Calculating the Real Reate
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Slide 66
Factors Influencing Interest
Rates
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Slide 67
Federal Reserve


Central banks  great influence on nominal
interest rates
In the USA, the central bank is the Federal
Reserve Bank—often simply called the "Fed"




The Fed drives nominal interest rates up or down through
its attempts to control the nation's money supply
The Fed has the responsibility of providing a flow of
money and credit for the nation, to foster orderly
economic growth, and attempt to maintain stable prices
The Fed uses monetary policy to control inflation
Monetary policy can be either tight or loose


Restrictive monetary policy  interest rates higher in an
effort to fight inflation
Monetary ease  provides a boost to the economy.
W. P. Carey School of Business
Slide 68
Managing Monetary Policy


Fed’s Federal Open Market Committee (FOMC)
sets monetary policy
It conducts monetary policy through:


Setting reserve requirements for banks
Changing the borrowing rate—or "discount rate“


Rate the Fed charges banks to borrow from it
Buying and selling federal government securities

Inject or reduce, respectively, liquidity in the money system
(carried out by the New York Fed).
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Slide 69
Changing Reserve
Requirements
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Creation of Money
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Slide 71
Changing the Discount Rate
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Slide 72
Fed Open Market Operations
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Slide 73
Introduce the Concept of
Market Efficiency

Extremely important concept for pricing
assets.
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Slide 74
Competition at the
Turnstiles
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Slide 75
Degrees of Market Efficiency


If a security is strong-form efficient, it is also semi-strong and weak-form
efficient
The reverse logic is not true.
W. P. Carey School of Business
Slide 76
Some Events Supporting
Market Efficiency
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Slide 77
Simulated & Real Price
Movements: Which Is Which?
Simulated market levels for 52 weeks
Actual DJIA closing prices for 52 weeks
Source: Harry V. Roberts, “Stock Market “Patterns” and Financial Analysis: Methodological
Suggestions,” Journal of Finance 14 (March 1959), pp. 1-10.
W. P. Carey School of Business
Slide 78
Price Adjustment Patterns


Current price reflects all public knowledge about the company - including
historical information
New information is immediately impounded in the price.
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Slide 79
Potential Returns from an
Overreaction Strategy
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Slide 80
Can Security Analysts Beat
the Market?
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Slide 81
Market Efficiency Anomalies
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Slide 82
October 1987 Market Crash

Troubling signs were evident before Black Monday's market crash. The Dow hit a
record in August and then proceeded to give back gains on fears of it being
overvalued. Inflation fears led to a massive sell off on October 19,1987.
W. P. Carey School of Business
Slide 83
Let’s Summarize
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Slide 84
Overview of Managerial
Finance
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Slide 85
Overview of Value
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Slide 86
The End
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Slide 87