MBA 515
Financial Management
Today’s class...
• Introductions and house keeping
• Review of 507 concepts
My Background
• NAME: Ken Shah
• PhD: University of Oregon
• INDUSTRY EXPERIENCE:
– 4 yrs Floor Trader / Stock Broker - Bombay Stock
Exchange
– 3 yrs Quantitative Portfolio Management Research,
Portland, Oregon
Academic Experience
• Taught at
– University of Oregon
– University of Auckland
– Southern Methodist University
• Courses in capital budgeting, corporate finance,
investments, and money and banking
Recent Research
• Analyst Forecasts
• Bond Returns
• Capital Structure
• Initial Public Offerings
Please Introduce yourself...
• Please fill out the student information sheet
• Drop by my office!
• Information sheet with photo next class
Information Sheet
• Attach a photo/photocopy of a photo
• Tell me about yourself, if you like – present
career, goals, etc.
• Tell me about any anticipated absences
• Any other special concerns/considerations
Course Objectives
• Build on MBA 507 concepts
• How investment and financing decisions affect
firm value
• Valuation, Sources of financing, and Capital
structure
Course Prerequisites
• Understanding of:
–
–
–
–
Financial statements
Discounting of cash flows
Spreadsheets
Rudimentary statistics
• Pre-requisites: MBA 500-512
Texts
• Required:
– Class packet at CopyMart
– Lecture notes on the class web page
• Optional:
– Brealey & Myers, Principles of Corporate Finance
– Damodaran, Investment Valuation (Advanced
reading)
Evaluation
•
•
•
•
Final Exam
Homeworks
Class Participation
TOTAL
300
600
100
1000
Grading Policy
• If you attend all classes and diligently complete
all required work, you would be assured of a Bgrade
• In order to get an A/A-, you must show work of
superior quality and make a meaningful
contribution to the class discussions
– roughly 15% of the class
Class Attendance
• Mandatory
• Please inform me of anticipated absences
– First absence will not affect your grade
– Each subsequent absence will adversely affect your
grade by half grade point for each absence
HW Assignments
• A group of 3 students turns in one solution
– Group work is required
• Each member should make copies of
assignment prior to turning in to facilitate
discussion
Review
•
•
•
•
•
•
Discounted Cash Flow/Time Value of Money
Bond Valuation
Stock Valuation
NPV
CAPM
Capital Budgeting
DCF/TVM
• PV and FV of a lump sum
• PV and FV of Annuities
• PV and FV combined
• Perpetuities
PV and FV of a lump sum
FVt  PV  1  r 
t
• ‘r’ and ‘t’ must match
• If t is # of months, r must be a monthly rate
TVM example
• How many years does it take to double your
$100,000 inheritance if you can invest the
money earning 11% compounded annually?
Answer: 6.64 years
PV of Annuity
1  1 
 (1  r ) t 
PVofAnnuity  C  

r




• Again: ‘r’ and ‘t’ must match
• If t is # of months, r must be a monthly rate, and C is the
payment per month
PV of Annuity: Mortgage payments
•
•
•
•
House cost $250,000
Mortgage Rate = 7.5% annually
Term of loan = 30 years
Payments made monthly
• What are your payments?
• Answer: $1748.04
FV of Annuity
 1  r   1
FVofAnnuity  C  

r


t
• Again: ‘r’ and ‘t’ must match
• If t is # of months, r must be a monthly rate, and
C is the payment per month
FV of Annuity Example
• You will contribute $400 per month for the next
35 years into a retirement savings plan. If your
money earns 12% interest per year, how much
will you have accumulated at retirement?
• Answer: $2,572,383
• How much must you contribute in an IRA per
month to have an amount in 20 years that will
provide an annual income of $200,000 per year
for 10 years? Interest rate is 8% per year.
• Answer: $2,278.28
Perpetuity
C
PV 
r
• Note: C and r measured over same interval
Perpetuity Example
• Preferred stock pays $1.00 dividend per quarter.
The required return, r, is 10% per year.
• What is the stock value?
• Answer: $40.00
Review: Bond Valuation
• Fixed periodic coupon payments
– Typically semi-annual
• Principal payment at maturity
• Yield to maturity (YTM) is that discount rate
which makes the PV of all cash flows equal to
the price
Bond Price
C
C
1
2
F+C
T
1
1
C
F
BondValue  C .
 C.
...

2
T
1 r
(1  r )
(1  r )
(1  r ) T
T
C
BondValue  
t
t  1 (1  r )
F

(1  r ) T
Example
• $1000 par bond maturing 15 years from today has an
annual coupon rate of 53/4 % paid semiannually.
Required return on bond (r) is 7.5% per year
compounded semiannually.
•
•
•
•
What is the value today?
Answer: $843.99
If price is 104% of par, what is its YTM?
Answer: 5.36%
Coupon Rate
• Coupon Rate
= Annual Coupon Payment
Face Value
• Coupon rate is always quoted annually
• Example: 4 3/4% ATT 09
– 4 3/4% is the coupon rate
Yield to Maturity (YTM)
• It is the yield ‘r’ calculated when market price of bond is
known
• If
– bond is held to maturity, AND
– bond does not default, AND
– bond is not called
• then,
– YTM is the return an investor earns on the bond
– YTM is the ‘best guess’ of an investor’s expected return
Current Yield
• An approximation of YTM
Curr. Yld. = Annual Coupon Payment
Market Price
• Reported for Corporate bonds in the WSJ
Important to...
• Distinguish between:
– Yield To Maturity
– Coupon Rate
– Current Yield
• They are not all the same!!
Bond Rates and Yields
• Suppose a bond currently sells for $932.90. It pays a semi-annual
coupon of $35, and it matures in 10 years. It has a face value of $1000.
What are its coupon rate, current yield, and yield to maturity (YTM)?
1. The coupon rate (or just “coupon”) is the annual dollar coupon
expressed as a percentage of the face value:
Coupon rate = $____ /$_____ = 7.00%
2. The current yield is the annual coupon divided by
the current market price of the bond:
Current yield = $___ _/_____ = 7.50%
3. The yield to maturity is = 7.99%
Review Stock Valuation
• Residual ownership
• Uncertain dividends
– Dividends must be estimated
• Voting rights
• CAPM gives us a way to estimate the required
return on a stock
Dividend Discount Model (DDM)
Dm
D1
D2
P0 

...
 .........
2
m
1  r (1  r )
(1  r )
• r = required rate of return on stock
• ALL future dividends must be estimated
– “ from here to eternity!!!”
• Of little practical importance
Note
• Stock value is the PV of all future expected
dividends
• Stock value is NOT the PV of all future expected
earnings or EPS
– Unless a company pays out all earnings as
dividends
• Which implies that there is no growth
Constant Growth DDM
D1
P0 
rg
• Notice it is much simpler to estimate:
• You need only THREE inputs: D1, r, g
Caution
• Constant growth model is simple but
inappropriate model to use for many or most
companies that have abnormal growth phases
• Constant growth model is appropriate only for
stable, mature companies like utilities
• Constant growth model is often used to estimate
the steady-state terminal values in a multi-stage
growth model of valuing stocks
Example
• Kinesis Keyboard: D0 = $0.50
Super growth in years 1 to 5: 55%
Thereafter, constant growth of 11%
r = 18%
What is the current stock price?
• Answer: ________
Calculate dividends and terminal
value
0
1
2
3
4
5
+
• Now you have all the numbers needed
• Fill in the boxes
• Show all the dividends and P5 on the time line
6
Using your calculator (HP 10B/12B)
• Enter CF0 as:
Enter CF1 as:
• Enter CF2 as:
• Enter CF3 as:
• Enter CF4 as:
• Enter CF5 as D5 + P5:
• Enter interest rate
• Hit
• Answer: $ 49.68
$0.0000
$0.7750
$1.2013
$1.8619
$2.8860
$75.4071
11
Shift
CFj
CFj
CFj
CFj
CFj
CFj
I/YR
NPV
Review of NPV
• NPV is the dollar value added to the enterprise
– it’s the amount by which the enterprise is richer!
• For public companies, NPV is the increase in total
market value of equity
• Managers should not take negative NPV projects
since it reduces the firm value
NPV Formula
CF1
CF2
CF3
CFn
NPV  CF0 


 ....
2
3
1  r (1  r )
(1  r )
(1  r ) n
• ‘r’ has many names:
– ‘r’ is called the discount rate or
– ‘r’ is called the required return or
– ‘r’ is called the cost of capital
Computing NPV on calculator
• Use the CFj key
– First entry is at time 0
– Subsequent entries are time 1, 2, 3, ... and so on
– make sure the cash flows have the proper signs
• Enter ‘r’ as the I/YR
NPV
• Use the
keys
Discounting Cash Flows
• ALWAYS USE A DISCOUNT RATE THAT
REFLECTS THE RISK OF THE CASH FLOWS
THAT YOU ARE DISCOUNTING
• ‘r’ in the denominator should reflect the risk of
the CFt in the numerator
• ‘r’ reflects the risk of the investment, not the risk
of the investor!
CAPM
• The main contribution of CAPM is to derive an
exact relation between risk and return
• The main message of CAPM is that
– Investors hold fully diversified (market) portfolio
– Diversified portfolios have no unsystematic risk
– Therefore, for individual securities, risk is measured
by the contribution that security makes to the risk of
the (market) portfolio, i.e., systematic risk or beta
Portfolio Diversification
Average annual
standard deviation (%)
49.2
Diversifiable risk
23.9
19.2
Non-diversifiable
Risk
1
10
20
30
40
1000
Number of stocks
in portfolio
CAPM Equation


E ( Ri )  R f  E  Rm   R f   i
• [E(Rm) – Rf] = Market Risk Premium (MRP)
• Rf = Risk Free rate
• βi = stock beta
Asset expected
return E (Ri)
The Security Market Line (SML)
= E (RM ) – Rf
E (RM)
Rf
Asset
beta
0
M
= 1.0
Review of Compounding
• To compound or not to compound - that is the
question!!
• Compounding means reinvesting the proceeds
• SEC requires funds and investment managers to
report returns that account for compounding
EAR
m
(QuotedRate) 

EAR  1 

1

m

m = number of compounding periods in a year
EAR on Calculator
• What is the EAR for quoted rate of 15% per year
compounded quarterly?
• Set number of periods per year: 4 P/YR
I/YR
• Enter quoted annual rate: 15
EFF%
• Compute EAR:
• Answer: 15.865%
EAR Example
• Compute EAR for 12% compounded
–
–
–
–
Annually
Quarterly
Monthly
Daily
• Answers: ____ , ____ , ____ , ____
Holding Period Return
• A measure of how you did as a result of
investing at P0, selling at Pt and receiving a cash
flow of Dt (e.g. dividends, interest)
Pt  P0  Dt
HPR 
P0
• Can be measured over any interval
Example
• Purchased ITT March 5, 2000:
• Sold ITT June 5, 2002:
• Total Dividends:
• HPR = _________%
• Note: This is a 9-quarter return
$46.00
$68.25
$ 6.00
Average Return (from large to small
interval)
• Average Return:

R  1  HPR
1/ n
 1
ITT Example (contd.)
• What is the average quarterly return?
Ans:_________%
• What is the average annual return?
Ans:_________%
Total Return (from small to large
interval)
• Example:
1st year return:
2nd year return:
+100%
-50%
• What is the average annual return?
• What is the terminal value of $100 investment
above?
Example shows...
• Simple averages are misleading
• Simple averages do not take into account the
effect of compounding
Total Return (from small to large
interval)
HPR1ton
 n

 (1  R1 )(1  R2 )(1  R3 )...(1  Rn )  1   (1  Ri )  1
 i1

PERIOD
1998
1999
2000
2001
2002
HPR
-0.31
0.96
0.19
0.41
0.55
SIMPLE AVG
0.14
PRODUCT OF (1+R)
CMPD AVG ANNUALLY
CMPD AVG QTRLY
CMPD AVG MNTHLY
1+Ri
0.69
1.96
1.19
1.41
0.45
VALUE OF
$100 INVESTMENT
$69.00
$135.24
$160.94
$226.92
$102.11
= 14%
1.0211
= 2.11% HPR OVER
5 YEARS
0.004192 = 0.4% ANNUALLY
0.001046 = 0.1% QUARTERLY
0.000349 = 0.03% MONTHLY
Capital Budgeting
•
A transportation company is considering the replacement of several trucks to
reduce down-time, thus providing better on-time delivery service. The existing
trucks were purchase three years ago for $75,000 and are depreciated
straight-line over their 8-year life to a book value of 15,000. They could be
sold today for $35,000. New trucks would cost $100,000, have a five-year life
and be depreciated for tax purposes to a $20,000 book value, also using
straight-line depreciation. The company forecasts that the new trucks would
reduce operating costs by $5,000 per year, in addition, increased customer
satisfaction would add $20,000 per year to cash revenues. As long as the new
trucks are around, the company must increase its inventory of spare parts
which would cost $2,5000. At the end of five years, the new trucks would be
sold for $25,000. The appropriate discount rate is 12 percent and the firm is in
the 35% tax bracket. Should they invest in the new trucks?
Cash flow calculation
•
•
•
•
•
Only incremental after-tax cash flows matter
Ignore sunk costs, non-cash expenses
Include all opportunity costs
Include tax implication of depreciation
Include inflow/outflow due to change in net
working capital