FIN 316 final study guide
FIN 316 final study guide FIN 316
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This 15 page Study Guide was uploaded by Theo Friedman on Thursday June 4, 2015. The Study Guide belongs to FIN 316 at University of Oregon taught by Albert Sheen in Spring 2015. Since its upload, it has received 1914 views. For similar materials see Financial Management in Finance at University of Oregon.
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Date Created: 06/04/15
FIN 316 study guide Midterm 1 Time Value of Money TVM Present Value PV the value of a cost or bene t also called a cash ow in today39s money Future Value FV the value of a cash ow at a speci ed time in the future FV1 the value of a cash ow in 1periodfromnow dollars FV2 the value of a cash ow in 2periodfromnow dollars FVn PV1i Interest rate r quotexchange ratequot between earlier money and later money also known as quotdiscount ratequot quotcost of capitalquot or quotrequired return FVn PV1i PV FVn 1 1i Compounding interest earns interest A perpetuity is a stream of equal cash ows made each period until the end of time C 1 1 39 PV Annul Cgtlt l PVPerpetu1ty r ty r 1r1v An annuity is a stream of equal cash ows made for a xed number of periods Converting rates to different time periods A of shorter in the lon er 1 r longer period r shorter period g N PVGr0wingAnnuityCgtlt 1 l Hgj r g 1r Annual Percentage Rate APR How much interest earned in a year without compounding Not usually the actual interest rate paid But rates are often quoted this way 1EARIamp rn Effective Annual Rate EAR also called Annual Percentage Yield APY How much actual interest is earned in a year 1 r 1 r 1 1 r z r i Th1s 1s the annual r we ve been us1ng Nominal Interest Rate r growth in actual In ation Rate i growth in prices Real Interest Rate r growth in purchasing power of your cash Bond vocab Par ValueF ace value Principal amount to be paid at maturity The big final payment Maturity Date Final repayment date of the bond Bond Price How much you need to pay to get the bond today Coupon Rate Percentage of par value that is paid every year Coupon Amount Coupon rate X Par Value of coupon payments per year Coupon Rate Face Value Cou on Amount p t of X coupon lS pald E 1 year PVAnnuity Cgtltl 1 N r 1 r Bond Pricing Zero coupon bonds Sometimes bonds come Without coupons There is only one cash ow the repayment of parface value at maturity These are even easier to price Zero coupon bonds are also called discount bonds because they must sell at a discount to par value Yield to Maturity YTM or just yield The discount rate that sets the present value of the bond payments equal to the current price of the bond In other words nding this is like solving for our trusty r It s always quoted like an APR annual terms with no compounding If YTM coupon rate then the bond s price will be the same as its parface value If YTM gt coupon rate then bond price lt par value If YTM lt coupon rate then bond price gt par value 1n price for the bond 1YTM 2 Face Value Price Yield to Maturity of a ZeroCoupon Bond We can graph the implied discount rates of zerocoupon bonds as a function of their time to maturity This is called the yield curve sometimes called term structure Rising yield curve Could mean investors think interest rates Will rise in the future Also could mean it s just riskier to invest longer so you get more return for buying longer term bonds Declining inverted yield curve very rare Means interest rates are expected to be lower in the future than they are today When interest rates go up bond prices go down and vice versa All else equal longer maturity bonds are more affected by interest rate changes All else equal bonds with lower coupons are more affected by interest rate changes Bond Ratings High Grade Moody s Aaa and SampP AAA capacity to pay is extremely strong Moody s Aa and SampP AA capacity to pay is very strong 0 Medium Grade Moody s A and SampP A capacity to pay is strong but more susceptible to changes in circumstances Moody s Baa and SampP BBB capacity to pay is adequate adverse conditions Will have more impact on the firm s ability to pay If NPV lt 0 don39t do it 1 Estimate expected incremental cash ows 2 Estimate the initial cash ow cost required to undertake the investment 3 Estimate the correct discount rate r for those cash ows Based on the rates of return offered by equivalent risk investments in the capital market learn this later 4 Add up PV of all cash ows positive and negative to get NPV Expected value If a cash ow is uncertain to get the expected value Expected value probability of outcome 1 outcome 1 probability of outcome 2 outcome 2 The IRR is the particular rate of return that makes the NPV of an investment zero C1 C2 CN 0NPVC0 1 2N 1IRR 1IRR 1IRR If IRR gt interest raterequired return do it If IRR lt interest raterequired return don39t do it IRR is similar to NPV but has a few shortcomings 1 IRR ignores scale of project D important when comparing across projects 2 Might get multiple IRR solutions if CFs ip sign Payback Period Rule 3 Select a payback cutoff number of years 4 Accept the project if cash coming in exceeds the initial cash going out before the cutoff number of years Free cash flow Cash ows freely available to all providers of capital bondholders and stockholders 0 Difference between a firm s future cash ows With the project and Without how much incremental does this add or subtract Cash ows that exist Whether or not a project is undertaken are irrelevant sunk costs 0 Free Cash Flow Sales COGS SGampA RampD other op expenses DampA l tax rate DampA capital expenditure change in Net Working Capital AR Inventory AP salvage value or net after tax proceeds from asset sales Net Working Capital Inv AR AP How depreciation works When you buy a longlived asset you don t record the Whole cost as an expense on the income statement Instead in straightline depreciation divide the asset s cost by the years of useful life as determined by IRS Post midterm 1 Risk amp Return oReaIized returns R The total return that occurs over a particular time period FVn PV1 i P the price of the stock or asset Dii the dividend paid if any Stocks have higher returns on average but they are quotriskierquot than bonds 1 T 1 Standard Deviation 039 VVariance Ural 1392 R2 42 RT 4W Variance Standard deviation 0 O tells us how variable outcomes are if the range of outcomes is normally distributed ie looks like a bell curve If returns have a bell curve shape then 68 of the time returns will end up within w 039 from the mean If returns have a bell curve shape then 95 of the time returns will end up within two 039 from the mean The meanstandard deviation rule is based on two assumptionsfacts 1 Individuals prefer higher returns to lower returns 2 Individuals prefer less risk to more risk Portfolios And DIcersitifaction The portfolio return is the weighted average of the two individual returns But the portfolio standard deviation is LESS than the weighted average 0 When you combine a bunch of risky things sometimes their zigs and zags cancel out Correlation p Ranges between 1 and 1 0 1 always move in the same direction 7 usually move in the same direction 0 1 always move in the opposite direction 0 uncorrelated no tendency to move together or opposite each other VarRp w1203912 w 022 2w1w203910392p12 Rp w1R1 sz2 Risk Market systematic risk Risks common to the entire market or economy Cannot be diversified away Idiosyncratic speci c risk Risks specific to a particular firm or industry Can be diversified away by investing in a wide variety of assets B amp required return The Market Portfolio 0 is a welldiversified blend of a little of everything Our Market Portfolio the SampP 500 it only has market risk which remember we can t escape If our project is AS risky as the market portfolio then we should only invest in the project if it has a return greater than or equal to the market portfolio If our project is MORE risky than the market then we require a return higher than the market to make it worthwhile If our project is LESS risky than the market then we d be ok investing if the return is lower than the market s R2 Rsquared Goodness of fit 0 How much of the variation in y is explained by the variation in x pswck gd V R2 Xsign of the slope of the line 0 Always between 01 B beta 0i 61quot pim X 0m The coefficient on SampP in the regression The slope of the line beta tells us how much systematic risk The beta of the overall market portfolio is l A beta of 1 implies the asset has the same systematic risk as the overall market A beta lt 1 implies the asset has lei systematic risk than the overall market A beta gt 1 implies the asset has more systematic risk than the overall market required retuml rrf BlErm rrf 0 i is a particular stock or investment rf is the riskfree rate rm is the return on the market SampP 500 0 E means expectation of over the next year 0 The market expected return is E rm 0 The market expected risk premium is E rm rf Portfolio beta h 39h f 139 h f139 w11stewe1gto asset 1nteport010 IBP W1161W2162 The Cost of Capital leverage 0 Debt gets paid first equity gets the leftover Even though the house price for both families moved the same amount their equity values moved different amounts because of leverage B for a firm s eguity will be higher than B for a firm s projects like the house if the company has any debt E 39 D q y 1 rgt e Debt Equtty Debt Equtty eighted Average Qost of Qapital WACC rE rEquity rrf IBEquizyErm Trf Rdebt the yield to maturity YTM 0 Equity Debt Equity is the equity weight in the capital structure Equity is shares stock price 0 Debt Debt Equity is the debt weight Net debt Debt Cash amp marketable securities The equity risk premium today is 5 Stock Valuation if you own stock in a company you are a part ownerAs a stockholder you bene t in 3 possible ways 1 Receive payments in the form of dividends 2 Enjoy capital gains increase in the stock price 3 Get to vote for board members FCFs in hand rms have 3 options 1 Pay required interest to debt holders 2 Give FCF to shareholders these are dividends 3 Invest FCF in more projects 0 Young growing firms pay lesszero dividends because they have plenty of uses for FCF 0 Mature firms pay larger dividends they are likely done with the heavy investment rm debt equity equity o fshares stock pr 1 Plug in the current equity value debt and cash and solve for the EV m tells us what the market thinks the business assets are worth 2 Figure out for ourselves what the business assets are worth EV plug in debt and cash solve for equity This tells us what we think the equitv should be wo h 1 Estimate the free cash ows that the firm will generate in the future 2 Discount the FCF at the firm s WACC to get the value of assets Enterprise Value 3 Use the EV equation to get market value of equity 4 Divide market value by the of shares outstanding to get M estimate of price per share Every minute people calculating how much theythink a stock is worth News is constantly coming out that changes what people think the FCFs are moving stock prices The Multiples Method Steps 1 Select comparable assets rms quotcompsquot a We want rms with similar risk growth and cash ow characteristics b Practically rms in the same industry selling the same products Use 35 rms 2 Choose and calculate appropriate multiples for these comps a 3 Get the average value of each multiple across the comps 4 Assume these averages hold for the company of interest and apply Pros of multiples Cons of multiples Easy to do easy to What if your comps are not understand good matches No need to project FCF If you have special insight or get WACC into the cash ows can t I I incorporate that Gives you an Idea of information how the market values something What if the market is wrong ahnlli DunnAnn Market ef ciency If markets are ef cient you can39t quotbeatquot the market by picking the right stocks 0 Information incorporated into prices no opportunities to earn higher returns Technical analvsispredict which stocks will do better or worse just by studying past stock prices Little evidence that anyone has consistently beaten the stock market using technical analysis News only matters to the extent it is unexpected Studies have found that stock prices react to news nearly immediately Within 15 minutes Active funds The managers pick and choose which stocks will do better than others Charge 12 of assets per year Indexfunds Buy and hold a proportional share of everything just match the SampP 500 or other benchmark Charge 025 of assets per year Fin 316 notes 527 Financing Decisions Where do we get the cash needed to pursue our wonderful investments Capital Structure the mix of debt and equity that a rm has used for nancing DebtTotal Book Assets Book Leverage DebtMarket Value of Assets Market Leverage Debtholder is safer paid rst but the upside is capped Equityholder is riskier but you get the upside Cost of Equity gt Cost of Debt OR rEquity gt rpebt As a rm takes on more debt the equity gets riskier Modigliani amp Miller39s MampM Perfect Capital Market Proposition 0 Assume there are NO taxes 0 Assume cash ows are not affected by whether you fund yourself with debt or equity No matter whether you use debt or equity The WACC stays the same Issuing debt allows the rm to reduce its taxable income and tax payments The rm39s value increases by the present value of all future income shielded from taxes So use all Debt No downside to debt is the interest payments are required if equity holders don39t get anything well that39s the chance they take o If a rm fails to make a debt payment it is in default and may have to declare bankruptcy 0 Loss of customersuppliersemployeesassets There is evidence that psychological factors among management can in uence debt usage How do equity investors get paid 1 85 of companies get bought buy someone bigger investors get paid off 2 Other companies go public 0 Pros Cons o More loss of control 0 Liquidity public pressure How lPO39s work gather info on how much rm is worthhow much people would pay to determine quotissue pricequot institutionspeople favored by the bank get to buy rst at the quotissue pricequot IPO stocks often rise the rst day Evidence shows that new IPO stocks do poorly over the next 3 to 5 years Takeovers Merger when two rms form a new company egDaimer Chrysler Acquisition Acquiring rm swallows target target rm disappears and acquiring rm survives Same thing in practice Horizontal two companies in the same industry Vertical target39s industry buys from or sells to acquirer s industry ConglomerateDiversifying acquirer and target in different industries Private equityLeveraged buyout LBO acquirer is a nancial not operating rm Use a lot of borrowed money goal is to sell for more than price paid in a few years Why do take overs happen Synergy Economies of scale 0 More buying power when buying in bulk 0 Better capacity utilization eg consolidating production from 2 plants to 1 o Combining marketing and distribution eg chips and drinks delivery to stores Access to new markets Vertical integration lets all be on the same team Expertisetalent Financial synergy Excess cash or tax ben ts Removing competition Undervaluation Bad management Diversi cation this does nothing for your shareholders Acquirer agency problems bad reasons to acquire o CEOs might acquire pet projects 0 CEOs mightjust want to run BIG companies for magazines covers quotEmpire Buildindquot when a rm gets acquired The stock price of targets jumps roughly 15 the day the takeover is announced The stock price of the acquiring rm on average is pretty at If you are buying because see synergy and you believe the market cap of target is its correct value 1 Value acquirer and target alone 2 Value the combined entity 3 Synergy is the difference between combined and both alone hopefully positive 4 A takeover will be positive NPV if price paid is less than target standalone synergy But target shareholders get all the synergies its share price goes up the acquirer s share price doesn39t Free rider problem Suppose the current price of target is 50 Buyer thinks the price should be 80 Buyer needs 51 of shares to make the changes to increase target value can39t buy out shareholders at 65 they hold on and wait for the stock to hit 80quot Many bidders If there39s competition for the target price bid up until synergy goes to target Are mergers good Judging by stock market reaction it appears on average they create value judging by long term pro tability there are big successes and failures
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