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BADM 3501- Financial Management Lecture Notes (Whole Semester)

by: Kerrigan Unter

BADM 3501- Financial Management Lecture Notes (Whole Semester) BADM 3501

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Kerrigan Unter
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This bundle contains all of the lecture notes for this course for the whole semester. Notes include terminology, concepts, examples, problems, etc.
Financial Management and Markets
Senan Uyanik
finance, Management, business, Lecture Notes
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This 37 page Bundle was uploaded by Kerrigan Unter on Friday September 2, 2016. The Bundle belongs to BADM 3501 at George Washington University taught by Senan Uyanik in Spring 2016. Since its upload, it has received 5 views. For similar materials see Financial Management and Markets in Accounting, Finance at George Washington University.


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Date Created: 09/02/16
The Cost of Capital Weighted Average Cost of Capital: w= firm’s capital structure weights; weight of d, p, or c r= cost of each component WACC = w r (1d dT) + w r  + p p   c s rd= marginal cost of debt capital rp= marginal cost of preferred stock; return investors require on a firm’s preferred stock rs= marginal cost of common equity using retained earnings re= rate of return investors require on the firm’s common equity using new equity d= debt p= preferred stock c=common equity T= tax rate A­T= after tax B­T= before tax ­the cost of capital is used primarily to make decisions that involve raising new capital Example: A 15 year, 12% semiannual coupon bond sells for $1153.72. What is the cost of debt  (rd)? N= 15 x 2= 30 I=? PV= $1153.72 PMT= .12x$1000= $120/2= $60 FV= $1000 I= 5% x 2= 10%= r d ­interest is tax deductible:  A­T r d B­T r (d – T) ­use nominal rate ­preferred dividends are not tax­deductible so no tax adjustments are necessary use nominal r p rp= D pP p ­preferred stock is more risky to investors than debt ­companies are not required to pay preferred dividends ­preferred stock will often have a lower B­T yield than the B­T yield on debt ­the A­T yield to an investor, and the A­T cost to the issuer, are higher on preferred stock than on debt which is consistent with the high risk of preferred stock ­earning can be reinvested or paid out as dividends ­investors could buy other securities and earn a return ­if earnings are retained, there is an opportunity cost (the return that stockholders could earn on  alternative investments of equal risks) investors could buy similar stocks and earn r  or firs  could repurchase its own stock and earn r s CAPM: r  =sr  +RFr  –Mr )b RF DCF: r  s (D /1 )0+ g D = D1(1 +0g) Bond­yield­plus­risk­premium: r  = rs + Rd ­RP is not the same as the CAPM RP M ­this method produces a ballpark estimate of r  andscan serve as a useful check ­to determine a final estimate of r ,sfind the midpoint of the range of the highest and lowest  values determined by the different methods ­when a company issues new common stock, they also have to pay flotation costs to the  underwriter ­issuing new common stock may send a negative signal to the capital markets, which may  depress the stock price Example: If D  =0$4.19, P  = 050, and g = 5 and if new common stock issue incurs a flotation  cost (F) of 15% of the proceeds, what is r ? e D 01 g) re  g P0(1F) $4.19(1.05)  5.0% $50(10.15) $4.3995  5.0% $42.50 15.4% ­flotation costs depend on the firm’s risk and the type of capital being raised ­flotation costs are highest for common equity however, since most firms issue equity  infrequently, the per­project cost is fairly small ­flotation costs are frequently ignored when calculating WACC ­Factors influencing a company’s composite WACC: ­market conditions ­firm’s capital structure and dividend policy ­firm’s investment policy firm’s with riskier projects generally have a higher WACC ­composite WACC should not be used as the hurdle rate for each of its projects ­WACC reflects the risk of an average project undertaken by the firm BADM 3501 Time Value of Money *Assignment: practice problems are posted on Blackboard *Calculators: tutorials for financial calculators are posted on Blackboard Reasons why Monday is more valuable today than a year from now: 1. Need 2. Instantaneous gratification 3. Investment value 4. Risk 5. Inflation ­focus is on investment value of money ­Present Value: current value of money ­Future Value: future value of money ­Time Value of Money: interest rate, rate of return FV= PV (1+ i)  where n= # of years, i= interest rate, PV= Present Value, and FV= Future Value compounding formula n PV= FV/ [(1+ i) ]  discounting formula Example: Calculate the future value of $100 left in an account with 10% interest rate per year for 3 years. PV= $100 i= 10%= 0.1 FV=? n= 3 FV = 100 (1+ .1) = 110 1 FV = 100 (1+ .1) = 121 2 FV 3 100 (1+ .1) = 133.1 Year Value 0 $100 1 $110 2 $121 3 $133.10 Example: Sales are growing 20% a year. How long will it take sales to double? PV= x i= 20%= 0.2 FV=2x n= ? 2x= x (1+ .2)n n 2x= x (1.2) n 2= (1.2) log1.2 n log10  log10 2= n n=3.8 years Example: McDonald’s had 823 restaurants in 1975, now (2016) they have 2055 restaurants.  What is the restaurant growth rate per year? PV= 823 i= ? FV=2055 n= 41 41 2055= 823 (1+ i) 2.49= (1+ i)41 i= 0.023= 2.3% ­Annuity: equal payments at equal intervals ­Balloon payment: a larger sum of money due at the end of a payment ­payment schedule must match the interest rate convert interest rate to match the timeframe of  the payments 1 1 − n ­present value of annuity: PVA= PMT  (i i(1+i) ) Uneven Cash Flows ­unequal payments occur at intervals *completed on calculator: instructions on Blackboard ­to calculate by hand, use PV= FV/ (1+i)  for each time interval and sum the intervals ­paying more payment at same interest per year, increases final accumulated interest ­nominal interest rate: estimated interest ­effective interest rate: actual interest ­Effective Annual Rate (EAR) nominalratem EAR=  (1+ )−1  where m= # of times interest is paid per year m Example: Borrow $100 for a mortgage. 10% interest per year. Pay over 3 years in 3 payments.  What should be the payment (PMT) amounts? PV A $1000 FV= $0 PMT= ? n= 3 i= 10%= .10 1 1 1000= PMT  − 3 (.1 .11+.1) ) 1000= PMT( 10­ 7.51) PMT= $401.61 Example: Condo price is $500,000. Down payment is 20%. Borrow rest from bank with an  interest rate of 7% paid over 10 years with monthly payments. a) What is the payment amount? b) 5 years later, you are selling the condo. How much do you owe to the bank? c) How much interest is being paid over 10 years? th d) At the end of the 5  year, how much principle was paid? e) What is the effective annual rate? Basics of Capital Budgeting ­analysis of potential additions to fixed assets ­involves long­term decisions and involve large expenditures ­very important to the firm’s future Steps to Capital Budgeting: 1. Estimate Cash Flows (inflows and outflows) 2. Assess riskiness of Cash Flows 3. Determine the appropriate cost of capital 4. Find NPV and/ or (Internal Rate of Return)IRR 5. Accept NPV>0 and/or IRR> WACC ­independent projects: if the cash flows of one are unaffected by the acceptance of the other ­mutually exclusive projects: if the cash flows of one can be adversely impacted by the  acceptance of the other ­normal cash flow stream: cost (negative cash flows) followed by a series of positive cash  inflows; one change of signs ­nonnormal cash flow stream: two or more changes of signs; most common­ cost (negative cash  flows), then strong positive cash flows, then cost to close project N NPV   CF t t0( 1  r ) ­sum of all of the PVs of all cash inflows and outflows of a project CF= CF ­ SF L Excel: =NPV(rate, CF :CF )+CF 1 n 0 Example: What is the project L’s NPV? WACC= 10% Excel: =NPV(.1, 10:80)+ (­100)= $18.79 What is the project S’s NPV? WACC= 10% Excel: =NPV(.1, 70:20)+ (­100)= $19.98 Calculator: enter into the calculator’s CFLO register CF 0 ­100 CF 1 10 CF 2 60 CF = 80 3 Enter I/YR= 10, press NPV button to get NPV = $L8.78 Rational for the NPV Method: NPV= PV of inflows­ Cost= Net gain in wealth ­if projects are independent, accept if the project NPV>0 ­if projects are mutually exclusive, accept projects with the highest positive NPV, those that add  the most value ­in the above example, accept S if mutually exclusive (NPV > sPV ) anL accept both if  independent Internal Rate of Return (IRR) ­IRR is the discount rate hat forces PV of inflows equal to cost, and the NPV=0 N 0   CF t t0(1  IRR) t Solving IRR with a calculator:  Enter CFs in CFLO register Press IRR; IRR = 18.13% and IRR = 23.56% L S Solving for IRR with Excel: =IRR(CF :CF0, gunss for rate) used 10% as the guess for rate  based on previous example ­YTM on the bond would be the IRR of the “bond” project ­if IRR> WACC, the project’s return exceeds its cost and there is some return left over to boost  stockholder’s returns ­if IRR> WACC, accept project ­if IRR< WACC, reject project ­if projects are independent, accept both projects, as both IRR> WACC= 10% ­if projects are mutually exclusive, accept project with greater IRR Crossover Rate: Enter CF in CF register, then press IRR Crossover rate=8.68% Use IRR function on excel ­if projects don’t cross, one project dominates the other Reasons Why NPV Profiles Cross: ­size (scale) difference: the smaller project frees up funds at t=0 for investment; the  higher the opportunity cost, the more valuable these funds, so a high WACC favors small  projects ­timing difference: the project with fast payback provides more CF in early years for  reinvestment; if WACC is high, early CF especially good, NPV > NPs L Reinvestment Rate Assumptions: ­NPV method assumes CFs are reinvested at the WACC ­IRR method assumes CFs are reinvested at IRR ­Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best NPV method should be used to choose between mutually exclusive projects ­perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed ­MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV  of costs TV is found by compounding inflows at WACC ­MIRR assumes cash flows are reinvested at the WACC   Excel: =MIRR(CF :CF0, Fnnance_rate, Reinvest_rate) Assume that both rates= WACC ­MIRR assumes reinvestment at the opportunity cost= WACC; avoids multiple IRR problem ­managers like rate of return comparisons and MIRR is better for this than IRR ­payback period: number of years required to recover a project’s cost calculated by adding  project’s cash inflows to its cost until the cumulative cash flow for the project turns positive Strengths of Payback: provides an indication of a project’s risk and liquidity; easy to calculate  and understand Weaknesses of Payback: ignores time value of money; ignores CFs occurring after payback  period Discounted Payback Period: uses discounted cash flows rather than raw CFs Multiple IRRs: ­at very low discount rates, the PV of CFs can be large and negative, so NPV< 0 ­at very high discount rates, the PV of CFs can be low, so CF can dominate and NPV < 0 ­there can be two IRRs ­when there are nonnormal CFs and more than one IRR, use MIRR Stock Valuation ­common stock: represents ownership ­management’s goal is to maximize stock price ­Stock’s intrinsic value: P 0 ­in equilibrium, we assume that a stock’s price equals its intrinsic value ­if a stock is priced below its intrinsic value, then it is undervalued ­if a stock is priced above its intrinsic value, then it is overvalued Discounted Dividend Model ˆ D 1 D 2 D 3 D  P 0  1    2    3  ...    (1 r s (1 rs) (1 r s (1 r s t where D= Dt(1+g0 ­If g is constant, then the formula becomes the constant growth model: D (1g) D P 0  0    1 rsg rsg ­if g> rs, the constant growth formula leads to a negative stock price, which does not make sense ­the constant growth model can only be used if r >g andsg is expected to be constant forever rs= rate of return rs= rRF+ (r M– r RF Example: 1 D 1 D (0+0.06) = 2.12 2 D 2 $2(1+0.06) = 2.2347 D P 0  1 1 (1 r s =2.12/ (1+ 0.13) = 1.8761 To find the stock’s intrinsic value using the constant growth model: P    D 1    $2.12 0 r   g 0.130.06 s $2.12         0.07     $30.29 What is the expected market price of the stock, one year from now? P   D 2    $2.247 1 r g 0.130.06 s     $32.10 Dividend yield: D/P tExt­1le: Expected dividend for year one would be D /P 1 0 Capital gains yield: (P­P t/ t­1 t­1 Total return: r s dividend yield + capital gains yield ˆ P0   ­if g=0, then payment installments do not change from year to year and  PMT/r Non­constant Growth Model: ­capital gains yield and dividend yield are not constant and must be adjusted when growth  changes ­even if stocks are having a negative growth, people still might buy the stock because it could  still be producing positive cash flows Corporate Valuation Model (free cash flow method): ­the value of the entire firm equals the PV of the firm’s Free Cash Flows (FCF)  Depr. and   Capital  FCF   EBT(1T)         NOWC   amortization  expenditures  ­find the market value (MV) of the firm by finding the PV of the firm’s future FCF’s ­subtract MV of firm’s debt and preferred stock to get MV of common stock ­divide MV of common stock by the number of shares outstanding to get intrinsic stock price ­assumes at some point FCF will grow at a constant rate ­Horizon Value (HV ): valuN of firm at the point that growth becomes constant ­MV of equity= MV of firm­ MV of debt and preferred stock ­Value per share= MV of equity/ # of shares EVA Approach:  EVA = Equity capital (ROE – Cost of equity) MV Equity= BV Equity+ PV of all future EVAs Value per share = MV Equity# of shares  ­preferred stock: preferred stockholders receive a fixed dividend that must be paid before  dividends are paid to common stockholders D V p rp $50  $5   rp $5 rp  $50  0.10 10%  Where V = vapue or price at which stock sells for, D= dividend, r = preferred stockps expected  return Working Capital Management -working capital: current assets -net operating workings capital: current assets - (current liabilities – notes payable) -current assets investment policy: deciding the level of each type of current -working capital management: controlling cash, inventories, and accounts receivable, plus short-term liability management -current assets investment policy is reflected in the current ratio, turnover of -Working capital financing policiesover, and days sales outstanding -moderate: match the maturity of the assets with the maturity of the financing -conservative: use permanent capital for permanent assets andsets temporary assets -cash conversion style focuses on the length of time between when a payments from its customersts creditors and when a company receives Inventory Average Payables CC Cconv ersioncollection deferral period pe riod period Daysperye ar D ayssales Pay ables CC C outstanding  deferral Inventoryturnover period used to plan loans needed or funds available to investding cash balances; -collections would be reduced by the amount of the bad debt losses -Types of Inventory Costs:ead to higher borrowing requirements CC C-carrying costs: storage and handling costs, insurance, property taxes, depreciation, and obsolescence -costs of running short: loss of sales or customer goodwill, and thes disruption of production schedules -reducing inventory levels generally reduces carrying costs, increases ordering costs and may increase the costs of running short -Elements of Credit Policy: -cash discounts: lowers priceay -credit standards: restrictive standards tend to reduce sales, but reduce bad debt expense -Trade credit: credit furnished by a firm’s suppliers; largest source of short- term credit; easy to get, but costs can be high Nominal Cost of Trade Credit Formulait= Costly Trade Credit r  Disount%  365days NOM 100D isount% Dayscredit D isount outstnding pe riod Effective cost of trade credit 1 365 N EAR 1e ridicrate) 1 Where N= time12.1667ds per year) -simple interest 1 NOM EAR *use12.29% calculatorNOM find EAR and r Risk and Return -types of investment risk: -stand-alone risk: market risk + diversifiable risk -portfolio risk Stand Alone Risk -investment risk: the probability of earning a low or negative actual return -the greater the chance of lower than expected or negative returns, the riskier the investment -T-bills give a promised rate of return regardless of the economy -however, T-bills are not risk free ad they can still be affected by inflation -T-bills are risky in terms of reinvestment risk, but they are risk-free in the default sense of the word Example: Calculated the expected rate of return of the High Tech (HT) industry. -standard deviation measures total risk -the larger standard deviation is, the lower the probability that actual returns will be closer to expected returns Example: Calculate the total risk of T-bills. -coefficient of variation (CV) measures the risk per unit of return of expected value -the higher CV is, the higher the degree of risk per unit of return -risk aversion: assumes investors dislike risk and require higher rates of return to encourage them ro hold risker securities -risk premium: the difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold riskier securities Portfolio Risk -a portfolio’s expected return is a weighted average of the returns of the portfolio’s component assets σ = w r^ −^ 2 p √∑ ( i i p) CV = σ p p ^p -having a portfolio of stocks can lower risk -most stocks are positively correlated with the market (p between 0 and 1) σ p - decreases as stocks are added because they would not be perfectly correlated with the existing portfolio expected return of the portfolio would remain relatively constant *refer to Table 6-9 of integrative problem packed to view how diversification effects a stock portfolio Stand-alone risk= market risk + diversifiable risk -market risk (): systematic risk; nondiversifiable risk; cannot be eliminated through diversification; slope of relationship between return of stock and market return; measures stock’s market risk and shows a stock’s volatility relative to the market; indicates how risk a stock is if the stock is held in a well-diversified portfolio -if = 1.0, the security is just as risky as the average stock -if >1.0, the security is riskier than average - if <1.0, the security is less risky than average -negative  is highly unlikely -diversifiable risk: nonsystematic risk; company specific risk; can be eliminated through proper diversification Capital Asset Pricing Model -Capital Asset Pricing Model (CAPM): model linking risk and required returns; suggests that there is a Security Market Line (SML) that states that a stock’s required return equals the risk-free return plus a risk premium that reflect the stock’s risk after diversification ri required rate of return ri= r RF(r – M )b RF i MRP= (r – r )b M RF i rRF expected rate of return rM= expected rate of return from market b=i -the relevant riskiness of a stock is its contribution to the riskiness of a well- diversified portfolio -if required rate of return is less than or equal to the expected rate of return, you buy the stock -market risk premium: additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk; size depends on perceived risk of stock -if ^ > r, then the stock is undervalued - if ^ < r, then the stock is overvalued - if ^ = r, then the stock is fairly valued *CAPM has not been verified completely Capital Structure and Leverage -business risk: riskiness inherent in the firms operations if it uses no debt; measured by ROIC -what determined business risk: -competition -uncertainty about demand, output prices, and costs -product obsolescence -foreign risk exposure -regulatory risk and legal exposure -operating leverage -operating leverage: the use of fixed costs rather than variable costs -more operating leverage leads to more business risk -can use operating leverage to get a higher Return on Invested Capital (ROIC) -ROIC measures the after-tax return that the company provides for all its investors doesn’t vary with changes in capital structure R O IC E BIT(1T ) Inve stor-su ppliedc apital -financial leverage: the use of debt and preferred stock -finanial risk: the additional risk concentrated on common stockholders as a result of financial leverage; depends only on the types of securities issued -more debt means more financial risk 1 2% firm is leveraged, the interest on debt is accounted forebt accounted for; when a interest expense will be higher than the after-tax operating income produced bytax debt-financed assets, so leverage will express income by debt, but interest expense increasesd(Interest expense= r D)e EBIT is unaffected -ROIC is unaffected by financial leverage Optimal Capital Structure -capital structure: mix of debt, preferred and common equity -capital struct0re at which P is maximized -trade off higher ROE and Earnings per Share (EPS) against higher risk -the target capital structure is the mix of debt, preferred tock, and common equity with which the firm intends to raise capital -as the firm borrows more money, the firm increases financial risk causing the firm’s bond rating to decrease, and its cost of debt to increase Recapitalization: 1. Firm announced recapitalization 2. New debt is issued 3. Proceed are used to repurchase stock (EBITrD )(1T ) EPS d Sharesoutsta nding D= sha($400,000c)(0.)  EBIT $ 400,000 TIE 80,00 20 x $n3.00p. $20,000 Hamada Equation bL=Ub [1 + (1 – T)(D/E)] U= unleveraged L= leveraged P  D1  EPS  PS 0 r g r r s s s -If all earnings are paid out as dividens, E(g)= 0 -EPS=DPS P debt levelse expectewe must find thesappropriate r at each of the -managers should issue stock if they think stock is overvalued, issue debt if they think stock is undervalued Cash Flow Determination Project Risk: -stand-alone risk: project’s total risk, if it were operated independently; measure by standard deviation or coefficient of variation; ignores firm’s diversification among projects and investors’ diversification among firms -corporate risk: project’s risk when considering the firm’s other projects; function of the project’s NPV and standard deviation and its correlation with the returns on other firm projects -market risk: project’s risk to a well-diversified investor; measured by the project’s beta and it considers both corporate and stockholder diversification -market risk is the most relevant risk for capital projects because management’s primary goal is shareholder wealth maximization -stand-alone risk is the easiest to measure -the three types of risk are highly correlated -since most projects the firm undertakes are in its core business, stand-alone risk is likely to be highly correlated with its corporate risk Example: Proposed Project • Total depreciable cost – Equipment: $200,000 – Shipping and installation: $40,000 • Changes in operating working capital – Inventories will rise by $25,000 – Accounts payable will rise by $5,000 • Effect on operations – New sales: 100,000 units/year @ $2/unit – Variable cost: 60% of sales • Life of the project – Economic life: 4 years – Depreciable life: MACRS 3-year class – Salvage value: $25,000 • Tax rate: 40% • WACC: 10% Estimate the relevant cash flows calculate annual operating cash flows, identify changes in net operating working capital, and calculate terminal cash flows (after-tax salvage value and return of NOWC) Find NOWC (Net Operating Working Capital) -inventories increase $25,000 -funded partly by an increase in accounts payable of $5,000 NOWC= $25,000-$5,000= $20,000 Initial year outlays: Equipment cost- installation= capital expenditures CAPEX- NOWC= Free Cash Flows Determine Annual Depreciation Expense Project Operating Cash Flows Revenue- operating costs- depreciation expenses= earnings before income tax EBIT-tax= EBIT(1-T) EBIT(1-T)+ Depreciation expense= EBIT(1-T)+ DEP Terminal Cash Flows Salvage Value- Tax on Salvage Value= After tax Salvage Value After tax salvage value+ NOWC= Terminal Cash Flow -financing effects (dividends and interest expense) should not being included in cash flows -sunk costs should not be considered *enter Cash Flows into calculator -stand-alone risk: project’s total risk -corporate risk: project’s risk when considering the firms other projects -market risk: project’s risk to a well-diversified investor -market risk is most relevant, stand-alone risk is the easiest to measure -the three types of risk are highly correlated -sensitivity analysis: measures the effect of changes in a variable on the project’s NPV; all variables are fixed at their expected values, except for the variable in question which is allowed to fluctuate and resulting changes in NPV are noted Financial Forecasting Steps in Financial Forecasting: 1. Forecast sales 2. Project the assets needed to support sales 3. Project internally generated funds 4. Project outside funds needed 5. Decide how to raise funds 6. See effects of plan on ratios and stock price -A*/S : assets required to support sales; called capital intensity ratio; 0 slope -∆S: increase in sales -L*/S0: spontaneous liabilities ratio -M: profit margin (Net income/sales) -RR: retention ratio; percent of net income not paid as dividend Additional Funds Needed (AFN) AFN = (A*/S )∆0 - (L*/S )∆0 - M(S )(1R) -higher sales increases asset requirements and increases AFN -higher dividend payout ratio reduces funds available internally and increases AFN -higher profit margin increases funds available internally and decreases AFN -higher capital intensity ratio (A*/S 0 increases asset requirements and increases AFN -paying suppliers sooner decreases spontaneous liabilities and increases AFN -project sales based on forecasted growth rate in sales -Additionally Funds Needed (AFN)= required assets- specified sources of financing -if AFN is positive, then you must secure additional financing -if AFN is negative, then you have more financing than is needed use it to pay off debt, buy back stock, and buy short-term investments -interest expense is actually based on the daily balance of debt during the year -three ways to approximate interest expense: -debt at end of year will over-estimate interest expenst if debt is added throughout the year instead of all on January 1  causes financial feedback (positive feedback loop between debt , interest, income, and retained earnings) -debt at beginning of year will under-estimate interest expense st if debt is added throughout the year instead of all on December 31  no financial feedback -average of beginning and ending debt will accurately estimate the interest payments if debt is added smoothly throughout the year financial feedback issue -base interest expense on beginning debt, but use a slightly higher interest rate Capacity Sales= Actual Sales/ % of capacity -excess capacity lowers AFN -economies of scale leads to less-than-proportional asset increases -lumpy assets leads to large periodic AFN requirements, recurring excess capacity BADM 3501 Investment decisions and Interest Rates ­financial decisions ­­> capital budgeting decisions ­inventory, accounts receivable, cash­­> working capital decisions Financing Decisions ­capital structure decisions: sell securities­­> bonds (debt) or stocks (equity) T­chart: left hand side (user side)­ investment decisions; real assets right hand side(sources side)­ financing decisions Dividend Decisions ­dividends, coupon payments, loan payments ­Balance Sheet: Income Sales Revenue­ Cost Of Goods Sold= Earnings Before Interest and Tax­  Investment= Earnings Before Tax­ Tax= Net Income ­Net Income­ Dividends= Retained Earnings Areas of Finance: 1. Financial Management (Corporate Finance): financial management of nonfinancial  institutions 2. Financial Institutions: financial management of financial institutions; ex: banks 3. Portfolio Theory: how individuals make decisions in the stock market ad how the stock  market grows Interest Rates: ­Financial Assets: securities; bonds, stocks, loan obligations, commercial paper, treasury  notes/bills, etc. ­Real Assets: provide benefits based on their fundamental qualities ­saving vs dissaving ­dissaving: spending ­businesses borrow and households lend BADM 3501 Interest Rates Flow of Payments: Financial Market: Components of Interest Rate:  ­represented by i or k ­rate of return, yield, cost of money, rent on money ­cost to businesses ­rate of return on investment to households ireal risk free rate­term government securities with no inflation i= ireal risk free ratepremiums Risk and Return the grater the risk, the higher the return Types of risk premiums: ­default risk premium (DRP): probability of company failing; if company is reliable, then DRP is low ­liquidity premium (LP): ability to convert into cash/ how fast; if very liquid, then LP is low ­maturity risk premium (MRP): length of time for loan; if loan is long term, then MRP is high ­inflation risk premium (IRP): if inflation is high, then IRP is high Risk premiums= DRP + LP + MRP + IRP Example: i=12% from a well­known company for 50 years with high inflation potential i= ireal risk free ratelow) + LP (low) + MRP (high) + IRP (high) Treasury bill: government bond less than a year maturity i= ireal risk free rate0) + LP (0) + MRP (0) + IRP (very low) ­when inflation is high, interest rates are high (1+ i nominal (1+ i real(1+ inflation rate)  Fisher Formula Nominal: interest rate with inflation Real: interest rate without inflation Inflation rate= average expected inflation inominali realflation rate + (i real ratenflation rate) If inflation rate is less than 10%, then it is small. If the inflation rate is small, then i nominal ireal inflation rate  approximation formula Inflation: lost purchasing power of money Term structure of interest rates: relationship between maturity and interest rate ­the longer the maturity, the higher the interest rate Yield Curves: ­when the yield curve is very steep, then high inflation is expected (2011) *Optional Assignment: look at today’s yield curve and predict expected market from it. Google:  dynamic yield curves ­rates given by the yield curve are spot rates ­spot rates ( Ka):cinterest rate is determined by the current yield curve at the time of the loan; a is  the first year of the loan and c is the end year of the loan ­hedging: lowering the interest rate risks by forward contracting ­forward contracting: making a deal to borrow at a later time at a previously agreed interest rate  in order to decrease risk ­forward interest rate (K): expicted future interest rate c­a b­a c­b (1+  a )c= (1+  K ) a (b+  K ) b c Spot= Spot + forward Example: 5 year spot rate is 12%, 3 year spot rate is 8%. What is the forward rate for a 2 year  maturity loan 3 years from today? 0K 3 8% 3K 5 ? 0K 5 12% (1+  K ) = (1+  K ) x (1+  K ) 2 0 5 0 3 3 5 (1.12) = (1.08) x (1+  K ) 3 5 2 [(1.12) / (1.08) ] ­1 = K  3 5 3K 5 18.28% Bond Valuation ­the firm is borrowing ­the household is lending ­Terms of contract for bond: ­maturity ­Face Value (Par Value, Nominal Value, principal) ­Coupon Rate ­Market Interest Rate: required rate of return, yield ­coupon payments determined by coupon rate ­equal payments occur at equal intervals ­pay Face Value at end of maturity of the bond ­if Face Value of bond is not stated, assume it is $1,000 ­coupon payment= Face Value x coupon rate ­coupon rate does not equal interest ­If the value is greater than or equal to the price, then you buy ­Value of Bonds: present value of expected future cash flows Example: Annual Bond. Coupon rate of 10%. 10 year bond. Market interest rate of 6%. FV= $1000 PMT= $100 N= 10 I= 6% PV=? *use calculator PV= $1294 ­premium bond: coupon rate> market rate ­discount bond: coupon rate < market rate ­par bond: coupon rate= market rate ­semi­annual bonds: payment is twice a year ­value: highest amount a person is willing to pay for a bond *yield to maturity must be calculated through a calculator ­use Time Value of Money equations to calculate value of bonds


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