Business Finance Semester of Notes
Business Finance Semester of Notes FIN 350
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FN35O Notes 101 Competitive market market in which the good can be bought and sold at the same price Interest rate factor 1r Discount factor 11r Discount rate interest rate NPV value PVBenefits PVCosts As long as NPV is positive the decision increases the value of the firm and is a good decision regardless of your current cash needs or preferences regarding when to spend the money NPV decision rule take the alternative with the highest NPV Choosing this alternative is equivalent to receiving its NPV in cash today Regardless of our preferences for cash today versus cash in the future we should always maximize NPV first We can then borrow or lend to shift cash flows through time and find our most preferred pattern of cash flows Arbitrage practice of buying and selling equivalent goods or portfolios to take advantage of a price difference Arbitrage opportunity any situation in which it is possible to make a profit without taking any risk or making any investment Law of one price in competitive markets securities or portfolios with the same cash flows must have the same price If equivalent investment opportunities trade simultaneously in different competitive markets then they must trade for the same price in both markets The price of a security should equal the present value of the future cash flows obtained from owning that security FIN35O Notes 930 CHAPTER 1 Valuation Principle show how to make the costs and bene ts of a decision comparable so that we can weigh them properly Sole proprietorship owned and run by one person 0 Advantage of being straightforward to set up 0 No separation between the rm and the owner 0 Owner has unlimited personal liability for any of the rm s debts Life of sole proprietorship limited to the life of the owner Dif cult to transfer ownership of a sole proprietorship For most growing businesses disadvantages of sole proprietorship outweigh the bene t Partnerships owned and run by more than one owner 0 All partners are liable for the rm s debt Lender can require any partner to repay all the rm s outstanding debts 0 Partnership ends in the event of the death or withdrawal of any single partner 0 can avoid liquidation if the partnership agreement provides for alternatives 0 Such as a buyout of a deceased or withdrawn partner Limited partnership partnership with 2 kinds of owners general partners and limited partners Limited partners have limited liability liability limited to their investment Has no management authority and cannot legally be involved in the management decision making for the business Limited liability company limited partnership without a general partner Can also run business Corporation legally de ned arti cial being separate from its owners Must be legally formed Stock ownership or equity of a corporation divided into shares Equity collection of all the outstanding shares of a corporation Shareholder also stockholder or equity holder owner of a share of stock or equity in a corporation Dividend payments payments made at the discretion of the corporation to its equity holders Corporate double taxation S corporations corporations that elect subchapter S tax treatment and are allowed by the US Internal Revenue Tax code an exemption from double taxation C corporations have no restrictions on who owns their shares or the number of shareholders therefore they cannot qualify for subchapter S treatment and are subject to direct taxation 3 main tasks of nancial manager 1 Make investment decisions 2 Make nancing decisions 3 Manage cash ow from operating activities Goal of nancial management to maximize the wealth of the owners the stockholders Board of directors group of people elected by shareholders who have the ultimate decision making authority in the corporation CEO charged with running the corporation by instituting the rules and policies set by the board of directors Agency problem when managers despite being hired as the agents of shareholders put their own self interest ahead of the interest of those shareholders Hostile takeover situation in which an individual or organization sometimes referred to as a corporate raider purchases a large fraction of a target corporation s stock and in doing so gets enough votes to replace the target s board of directors and its CEO Stock market stock exchangebourse organized market on which the shares of many corporations are traded Liquid investment that can easily be turned into cash bc it can be sold immediately at a competitive market price NYSE largest stock exchange Primary market When a corporation issue new shares of stock and sells them to investors Secondary market NYSE or NASDAQ shares are traded between investors Wout the involvement of corporation Market makers individuals on the trading floor of a stock exchange Who match buyers W sellers Specialists individuals on the trading floor of the NYSE Who match buyers W sellers Bid price price at Which a market maker or specialist is Willing to buy a security Ask price the price at which a market maker or specialist is Willing to sell a security Bidask spread amount by which the ask price exceeds the bid price Transaction cost in most markets an expense such as a broker commission and the bid ask spread investors must pay in order to securities Transaction cost expense such as a broker commission and the bid ask spread investors must pay in order to trade securities FIN35O Notes 105 Ch 4 NPV and the Time Value of Money Stream of cash ows a series of cash ows lasting several periods Timeline a linear representation of the timing of potential cash ows Rule 1 it is only possible to compare or combine values at the same point in time Rule 2 to calculate a cash ow s future value you must compound it Future value value of a cash ow that is moved forward in time Compounding computing the return on an investment over a long horizon by multiplying the return factors associated with each intervening period Compound interest effect of earning interest on interest Rule 3 to calculate the value of a future cash ow at an earlier point in time we must discount it Discounting nding the equivalent value today of a future cash ow by multiplying by a discount factor or equivalently dividing by 1 plus the discount rate Perpetuity a stream of equal cash ows that occurs at regular intervals and lasts forever Consol a bond that promises its owner a xed cash ow every year forever Payment in arrear end of the period Present value of a Perpetuity PVC in perpetuity Cr Annuity a stream of equal cash ows arriving at a regular interval over a speci ed time period Present value of an annuity PV C 1rl l1 r A N FVannuityPVl r A N FVannuityC1r1 r A N 1 Growing perpetuity stream of cash ows that occurs at regular intervals and grows at a constant rate forever Present Value of a Growing Perpetuity PV growing perpetuity C r g Loan Payment CP1r1 l1 r A N Internal rate of return The interest rate that sts the ent present value of the cash ows equal to zero Ch 51 Effective annual rate EAR or annual percentage yield APY total amount of interest that will be earned at the end of one year Equivalent n period Discount Rate 1 r A n 1 When computing present or future values you should adjust the discount rate to match the time period of the cash ows Annual percentage rate APR indicates the amount of interest earned in one year without the effect of compounding Simple interest interest earned without the effect of compounding Interest Rate per Compounding Period APRm m number of compounding periods per year 1EAR 1 APRm A m FIN35O Notes 1016 Ch 6 More than 45 trillion of bonds outstanding Bond certi cate states the terms of a bond as Well as the amounts and dates of all payments to be made Maturity date the nal repayment date of a bond Term the time remaining until the nal repayment date of a bond Face Value par value notional amount of a bond used to compute its interest payments The face value of the bond is generally due at the bond s maturity Also called par value or principal amount Coupons the promised interest payments of a bond paid periodically until the maturity date of the bond Coupon rate determines the amount of each coupon payment of a bond The coupon rate expressed as an APR is set by the issuer and stated on the bond certi cate CPN Coupon Rate Face Value Number of Coupon Payments per Year Zerocoupon bonds a bond that makes only one payment at maturity Treasury bills zero coupon bonds issued by the US govt With a maturity of up to one year Discount a price at Which bond trade that is less than their face value Pure discount bonds zero coupon bonds Yield to maturity The IRR of an investment in a bond that is held to its maturity date or the discount rate that sets the present value of the promised bond payments equal to the current market price for the bond 1 YTM Face Value Price A 1n Risk free interest rates Spot interest rates default free zero coupon yields Zerocoupon yield curve a plot of the yield of risk free zero coupon bonds STRIPS as a function of the bond s maturity date Coupon bonds bonds that pay regular coupon interest payments up to maturity when the face value is also paid Treasury notes a type of US Treasury coupon security currently traded in nancial markets With original maturities from one to ten years Treasury bonds a type of US treasury coupon security currently traded in nancial markets With original maturities of more than ten years Premium a price at Which coupon bonds trade that is greater than their face value Par a price at Which coupon bonds trade that is equal to their face value If a bond s yield to maturity does not change then the IRR of an investment in the bond equals its yield to maturity even if you sell the bond early Dirty price invoice price a bond s actual cash price Clean price a bond s cash price less an adjustment for accrued interest the amount of the next coupon payment that has already accrued Corporate Bonds Corporate bonds bonds issued by a corporation Credit risk the risk of default by the issuer of any bond that is not default free it is an indication that the bond s cash ows are not known With certainty Bc the yield to maturity of GM s bonds is computed by comparing the price to the promised cash ows the yield to maturity increased as the probability of being paid as promised decreased 1 Investors pay less for bonds With credit risk than they Would for an otherwise identical default free bond 2 Because the maturity for a bond is calculated using the promised cash ows instead of the expected cash ows the yield of bonds with credit risk will be higher than that of otherwise identical default free bonds Yield to maturity of a defaultable bond is not equal to the expected return of investing in the bond A higher yield to maturity does not necessarily imply that a bond s expected return is higher Investment grade bond bonds in the top four categories of creditworthiness with a low risk of default Speculative bonds junk bond or high yield bonds bonds in one of the bottom ve categories of creditworthiness that have a high risk of default Default spread credit spread the difference between the risk free interest rate on US Treasury notes and the interest rates on all other loans The magnitude of the credit spread will depend on investors assessment of the likelihood that a particular rm will default FIN 350 Notes 1017 Ch 7 NPV pro le a graph of the project s NPV over a range of discount rates Payback investment rule only projects that pay back their initial investment Within the payback period are undertaken 1 Calculate the amount of time it takes to pay back the initial investment called the payback period 2 Accept the project if the payback period is less than a prespeci ed length of time usually a few years 3 Reject the project if the payback period is grater than the prespeci ed length of time Payback period the amount of time until the cash flows from a project offset the initial investment The time it takes to pay back the initial investment 1 Ignores the time value of money 2 Ignores cash flows after the payback period 3 Lacks a decision criterion grounded in economics Internal rate of return investment rule a decision rule that accepts any investment opportunity Where the IRR exceeds the opportunity cost of capital and otherwise ejects the opportunity Modi ed internal rate of return MIRR the discount rate that sets the NPV of modi ed cash flows of a project equal to zero Cash flows are modi ed so there is only one negative cash ow and one sign change to ensure that only one IRR exists 1 Discount all of the negative cash flows to time 0 and leave the positive cash flows alone 2 Leave the initial cash ow alone and compound all of the remaining cash flows to the nal period of the project Mutually exclusive projects projects that compete With one another by accepting one you exclude the others CF r g initial investment Equivalent annual annuity the level annual cash ow that has the same present value as the cash flows of a project Used to evaluate alternative projects With different lives Pro tability index measures the NPV per unit of resource consumed value created resource consumed 2 NPV resource consumed FIN35O Notes 1021 Ch 8 Fundamentals of Capital Budgeting Capital budget lists all of the projects that a company plans to undertake during the next period Capital budgeting the process of analyzing investment opportunities and deciding which ones to accept Incremental earnings the amount by which a rm s earnings are expected to change as a result of an investment decision Straightline depreciation a method of depreciation in which an asset s cost is divided equally over its life We are evaluating how the project will CHANGE the cash ows of the rm That is why we focus on INCREMENTAL revenues and costs Marginal corporate tax rate the tax rate a rm will pay on an incremental dollar of pre tax income Income tax 2 EBIT the rm s marginal corporate tax rate Pro forma statement that is not based on actual data but rather depicts a rm s nancials under a given set of hypothetical assumptions Generally do not include interest expenses Unlevered net income net income that does not include interest expenses associated with debt Free cash ow the incremental effect of a project on a rm s available cash Net working capital CA CL Cash amp Inventory amp Receivbles Payables Trade credit the difference between receivables and payables that is the net amount of a rm s capital consumed as a result of those credit transactions the credit that a rm extends to its customers When a project causes a change in NWC that change must be subtracted from incremental earnings to arrive at incremental free cash ows Depreciation tax shield the tax savings that result form the ability to deduct depreciation Opportunity cost the value a resource could have provided in its best alternative use Project externalities indirect effects of a project that may increase or decrease the pro ts of other business activities of a rm Cannibalization when sales of a rm s new product displace sales of one of its existing products Sunk cost any unrecoverable cost for which a rm is already liable If your decision does not affect CF then CF should not affect your decision Overhead expenses associated with activities that are not directly attributable to a single business activity but instead affect many different areas of a corporation MACRS depreciation the most accelerated cost recovery system allowed by the IRS Based on the recovery period MACRS depreciation tables assign a fraction of the purchase price that the rm can depreciate each year Tax loss carryforwards and carrybacks 2 features of US tax code that allow corporations to take losses during a current year and offset them against gains in nearby years Since 1997 companies can carry back losses for 2 eyras and carry forward losses for 20 years Sensitivity analysis an important capital budgeting tool that determines how the NPV varies as a single underlying assumption is changed Break even the level for which an investment has an NPV of zero Break even analysis a calculation of the value of each parameter for which the NPV of the project is zero EBIT break even the level of a particular parameter for which a project s EBIT is zero Scenario Analysis an important capital budgeting tool that determines how the NPV varies as a number of the underlying assumptions are changed simultaneously Real option the right to make a particular business decision such as a capital investment Option to delay commitment the option to time a particular investment Which is almost always present Option to expand option to start With limited production and expand only if the project is successful Abandonment option an option for an investor to cease making investments in a project Abandonment options can add value to a project bc a rm can drop a project if it turns out to be unsuccessful If you can build greater flexibility into your project you Will increase the NPV of the project FlN35O Notes 1029 CH 9 Stock Valuation Ticker symbol unique abbreviation assigned to each publicly traded company Common stock a share of ownership in the corporation which confers rights to any common dividends as well as rights to vote on election of directors mergers or other major events Equity cost of capital the expected rate of return available in the market on other investments that have equivalent risk to the risk associated with the rm s shares Dividend yield the expected annual dividend of a stock divided by its current price the percentage return an investor expects to earn from the dividend paid by the stock Capital gain the amount by which the selling price of an asset exceeds its initial purchase price Capital gain rate an expression of capital gain as a percentage of the initial price of the asset Total return the sum of a stock s dividend yield and its capital gain rate Dividend discount model a model that values shares of a rm according to the PV of the future dividends the rm will pay Constant dividend growth model a model for valuing a stock by viewing its dividends as a constant growth perpetuity Dividend payout rate the fraction of a rm s earnings that the rm pays out as dividends each year Retention rate the fraction of a rm s current earnings that the rm retains Cutting the rm s dividend to increase investment will raise the stock price if and only if the new investments have a positive NPV Share repurchase a situation in which a rm uses cash to buy back its own stock Total payout model a method that values shares of a rm by discounting the rm s total payouts to equity holders ie all the cash distributed as dividends and stock repurchases and then dividing by the current number of shares outstanding Discounted free cash ow model a method for estimating a rm s enterprise value by discounting its future free cash ow Weighted average cost of capital WACC the cost of capital that re ects the risk of the overall business which is the combined risk of the rm s equity and debt Method of comparables an estimate of the value of a rm based on the value of other comparable rms or other investments that are expected to generate very similar cash ows in the future Valuation multiple a ratio of a rm s value to some measure of the rm s scale or cash ow Trailing earnings a rm s earnings over the prior 12 months Forward earnings a rm s anticipated earnings over the coming 12 months Trailing PE 2 the computation of a rm s PE using its trailing earnings Forward PE a rm s PE ratio calculated using forward earnings P306 FN35O Notes Ch1O Risk and Return in Capital Markets Realized return total return that occurs over a particular time period Rt1 Dividend Yield Capital Gain Yield We assume that all dividends are immediately reinvested and used to purchase additional shares of the same stock or security Average Annual Return the arithmetic average of an investment s realized returns for each yean Standard Deviation a common method used to measure the risk of a probability distribution it is the square root of the variance Variance a method to measure the variability of returns it is the expected squared deviation of returns from the mean Compound annual return is a better description of the long term historical performance of an investment Arithmetic average return should be used when trying to estimate an investment s expected return over a future horizon based on its past performance Normal distribution a symmetric probability distribution that is completely characterized by its average and standard deviation 95 of all possible outcomes fall within 2 standard deviation above and below the average 95 confidence interval a range of values that is likely to include an unknown parameter If independent samples are taken repeatedly from the same population then the true parameter will lie outside the 95 confidence interval 5 of the time 1 There is a relationship between size and risk on average larger stocks have lower volatility than smaller stocks 2 Even the largest stocks are typically more volatile than portfolio of large stocks such as the SampP5OO 3 All individual stocks have lower returns andor higher risk than the portfolios in Figure 106 The individual stocks in Figure 106 all lie below the line While volatility standard deviation seems to be a reasonable measure of risk when evaluating a large portfolio the volatility of an individual security doesn39t explain the size of its average return FN35O Notes 1118 Common Versus Independent Risk Earthquake insurance and theft insurance different type of risk have to cover more people in earthquake even though they might have same chance of occurrence Common risk risk that is linked across outcomes Independent risk risks that bear no relation to each other If risk are independent then knowing the outcome of one provides no information about the other Diversification the averaging of independent risks in a large portfolio Usually stock prices and dividends fluctuate due to 2 types of news 1 Company or industry specific news This is good or bad news about a company or industry itself For example a firm might announce that It has been successful in gaining market share within its industry Or the home building industry may be damaged by a real estate slowdown 2 Market wide news This is news that affects the economy as a whole and therefore affects all stocks For instance the Fed might announce that it will lower interest rates in an attempt to boost the economy Unsystematic risk fluctuations of a stock s return that are due to firm or industry specific news and are independent risks unrelated across stocks Systematic risk fluctuations of a stock s return that are due to market wide news representing common risk When firms carry both types of risk only the unsystematic risk will be eliminated by diversification when we combine many firms into a portfolio The volatility will therefore decline until only the systematic risk which affects all firms remains The risk premium of a stock is not affected by its diversifiable unsystematic risk The risk premium for diversifiable risk is zero Thus investors are not compensated for holding unsystematic risk The risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk Thus there is no relationship between volatility and average returns for individual securities Ch 11 Portfolio weights the fraction of the total investment in a portfolio held in each individual investment in the portfolio Return of portfolio the weighted average of the returns on the investments in a portfolio where the weights correspond to the portfolio weights Expected return of a portfolio the weighted average of expected returns of the investments in a portfolio where the weights correspond to the portfolio weights Volatility of a portfolio the total risk measured as standard deviation of a portfolio 1 By combining stocks in to a portfolio we reduce risk through diversification 2 Amount of risk that is eliminated in a portfolio depends upon the degree to which the stocks face common risks and move together Correlation a measure of the degree to which returns share common risk It is calculated as the covariance of the returns divided by the standard deviation of each return The expected return of a portfolio is equal to the weighted average expected return of its stocks but the volatility of a portfolio is less than the weighted average volatility As a result it s clear that we can eliminate some volatility by diversifying Equally weighted portfolio a portfolio in which the same dollar amount is invested in each stock 1 The amount of a stock39s risk that is removed by diversification depends on its correlation with other stocks in the portfolio 2 If you build a large enough portfolio you can remove all unsystematic risk by diversification but you will still be left with systematic risk Market portfolio the portfolio of all risky investments held in proportion to their value Market capitalization the total market value of equity equals the market price per share times the number of shares Valueweighted a portfolio in which each security is held in proportion to its market capitalization Market proxy a portfolio whose return is believed to closely track the true market portfolio Market index the market value of a broad based portfolio of securities Beta the expected percent change in the excess return of a security for a 1 change in the excess return of the market or other benchmark portfolio Expected Return Risk Free Rate Risk Premium for Systematic Risk Expected Return for Investment I Risk Free Rate B Risk Premium Per Unit of Systematic Risk Market risk premium equity risk premium the historical average excess returns on the market portfolio Capital Asset Pricing Model CAPM an equilibrium model of the relationship between risk and return that characterizes a security39s expected return based on its beta with the market portfolio Required return the expected return of an investment that is necessary to compensate for the risk of undertaking the investment Security market line the pricing implication of the CAPM it specifies a linear relation between the risk premium of a security and its beta with the market portfolio Beta of portfolio is the weighted average beta of the securities in the portfolio FN35O Notes 1120 Determining the Cost of Capital Capital a firm s sources of financing debt equity and other securities that it has outstanding Capital structure the relative proportions of debt equity and other securities that a firm has outstanding Weighted average cost of capital WACC the average of a firm s equity and debt costs of capital weighted by the fractions of the firm s value that correspond to equity and debt respectively Must use market value of the debt and equity to determine the proportion of debt and equity Marketvalue balance sheet all values are current market values rather than historical costs Unlevered a firm that does not have debt outstanding Levered a firm that has debt outstanding Leverage the relative amount of debt on a firm s balance sheet Effective cost of the debt a firm s net cost of interest on its debt after accounting for the interest tax deduction rD1 Tc cost of preferred stock capital Div P net debt total debt outstanding minus any cash balances and risk free securities leverage value the value of an investment including the benefit of the interest tax deduction given the firm s leverage policy WACC method discounting future incremental FCF using the firm s WACC This method produces the levered value of a project Key assumptions 1 Average risk assume initially that the market risk of the project is equivalent to the average market risk of the firm s investments In that case we assess the project39s cost of capital based on the risk of the firm 2 Constant Debt Equity Ratio assume that the firm adjusts its leverage continuously to maintain a constant ratio of the market value of debt to the market value of equity 3 Limited leverage effects assume initially that the main effect of leverage on valuation follows from the interest tax deduction Assume that any other factors are not significant at the level of debt chosen
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