(5)
ROSENGARTEN CORPORATION
Pro forma balance sheet after 25% sales increase
($)
(Δ,$)
($)
Assets
Current assets
Cash
A/R
Inventory
Total
Liabilities and Owner's Equity
$200
$40
550
750
$1,500
110
150
$300
Fixed assets
Net plant and
equipment
Total assets
(Δ,$)
$2,250
$450
$3,750
$750
Current liabilites
A/P
$375
$75
Notes payable
Total
100
$475
0
$75
Long-term debt
Owner's equity
$800
$0
$800
1,100
$1,910
$0
110
$110
$3,185
$185
Common stock
Retained earnings
Total
Total liabilities and
shareholder's equity
External financing
needed
$565
1
EFN and Capacity Usage
Suppose Rosengarten is operating at 80%
capacity:
1. sales at full capacity 1000/.8=1250
2. What is the capital intensity ratio at full
capacity? 3300/1250 =2.64
3. What is EFN? 300
Conclusion: excess capacity reduces the
need for external financing and capital
intensity ratio

http://www.potashcorp.com/stakeholder_communications/2010/09/07/774/
2
Chapter 12
SOME LESSONS FROM
CAPITAL MARKET
HISTORY
HTTP://WWW.YOUTUBE.COM/WATCH?V=MZJMTCYMO9G
3
Chapter Overview

Return of an investment: arithmetic and
geometric

The variability of returns

Efficiency of capital markets
4
Return from a Security (1)
Dollar return vs. percentage return
 Two sources of return

◦ dividend income
◦ capital gain (loss)
 realized or unrealized
Div Pt 1  Pt
Ri 

Pt
Pt
Dividend Payout
Capital Gain
5
Mean

Assume the distribution is normal

Mean return - the most likely return

A measure of centrality

Best estimator of future expected returns
6
The First Lesson

The difference between T-bills and other
investment classes can be interpreted as a
measure of the excess return on the risky asset
Risk premium = the excess return
required from an investment in a risky
asset over a risk-free investment
7
Arithmetic vs. Geometric
Averages (1)

Geometric return = the average
compound return earned per year over
multiyear period
Geometric average return =
 T (1  R1 ) * (1  R2 ) *...* (1  RT ) 1

Arithmetic average return = the return
earned in an average (typical) year over a
multiyear period
8
Arithmetic vs. Geometric
Averages (2)

The geometric average tells what an investor
has earned per year on average, compounded
annually.

The geometric average is smaller than the
arithmetic (exception: 0 variability in returns)

Geom. average ≈ arithmetic average – Var/2
9
Which Average to Use?

Geometric mean is appropriate for making
investment statements about past performance
and for estimating returns over more than 1
period

Arithmetic mean is appropriate for making
investment statements in a forward-looking
context and for estimating average return over
1 period horizon
10
The Variability of Returns

Variance = the average squared deviation
between the actual return and the
average return
(R  R )

Var ( R) 
2
i
T 1

Standard deviation = the positive square
root of the variance
  Var
11
Standard Deviation

Measure of dispersion of the returns’
distribution

Used as a measure of risk

Can be more easily interpreted than the
variance because the standard deviation is
expressed in the same units as
observations
12
The Normal Distribution (1)

A symmetric, bell-shaped frequency
distribution

Can be completely described by the mean
and standard deviation
13
The Normal Distribution (2)
14
Z-score

For any normal random variable:
X 
Z

Z – z-score
 X – normal random variable

- mean


15
Yet Another Measure of Risk
VaR = statistical measure of maximum
loss used by banks and other financial
institutions to manage risk exposures
•
How much can a bank lose during one
year?
•
Usually reported at 5% or 1% level
16
The Second Lesson

The greater the potential reward the
greater the risk

Which types of securities have higher
potential reward?
17
Capital Market Efficiency

Efficient capital market - market in
which security prices reflect available
information

Efficient market hypothesis - the
hypothesis that actual capital markets are
efficient
18
What assumptions imply efficient
capital market?
1.
Large number of profit-maximizing
participants analyze and value securities
2.
New information about the securities
come in random fashion
3.
Profit-maximizing investors adjust
security price rapidly to reflect the
effect of new information
19
Forms of Market Efficiency

Weak form – the current price of a
stock reflects its own past prices

Semistrong form – all public
information is reflected in stock price

Strong form – all information (private
and public) is reflected in stock prices
20
Weak Form Efficiency
Current stock price reflects all security market
information
 You should gain little from the use of any trading
rule that decides whether to buy/sell security
based on the passed security market data
 Major markets (TSX, NYSE, NASDAQ) are at
least weak form efficient

January
effect
21
Semistrong Form Efficiency

Mutual fund managers have no special ability to
beat the market

Event studies (IPO, stock splits) support the
semistrong hypothesis
Quarterly
earnings surprise – test results
indicate abnormal returns during 13-26 weeks
following the announcement of large
unanticipated earnings change (earnings
surprise) in a company
22
Strong Form Efficiency

No group of investors has access to private
information that will allow them to consistently
experience above average profits
Evidence
shows that corporate insiders and
stock exchange specialists are able to derive
above-average profits
23