Study guide exam 2
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This 8 page Study Guide was uploaded by odette antabi on Tuesday March 29, 2016. The Study Guide belongs to FIN302 at University of Miami taught by Stuart Webb in Fall 2015. Since its upload, it has received 27 views. For similar materials see Fundamentals of Finance in Finance at University of Miami.
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Date Created: 03/29/16
Equity Valuation Equity securities Basic Facts – Stocks are equity securities certificates of ownership in a corporation Households hold the largest share of equity securities, more than 36% of corporate equity Pension funds are largest institutional investors in equities (21%), followed by mutual funds (20%), and foreign investors (10%) Common Stock and Preferred Stock Represent ownership interest in a corporation Are the two most frequently used types of equity securities. Dividend payments do not affect a firm’s taxes and are not “guaranteed” but are “promised” to preferred stockholders. Have limited liability so claims made against the corporation cannot include a stockholder’s personal assets. Are generally viewed as perpetuities because they do not have maturity dates. Common stock – Is the basic ownership claim in a corporation – Has the right to vote on matters such as electing a board of directors, setting a capital budget, and proposed mergers or acquisitions – Has the right to a firm’s residual assets after creditors, preferred stockholders, and others with higher priority claims have been satisfied Warren Buffet Intrinsic value (or fundamental value) is an all important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.” Valuation Based on Comparable Firms Estimate Stock price based on the price of comparable firms – Match on characteristics including industry, cost structure, capital structure, growth potential, lifecycle and presence or absence of strategic/growth options. – – But no two investments are identical you must assess the extent to which the differences across assets are likely to have a material effect on the valuation multiples and adjust. Where does growth come from? Growth comes from earning a high return on reinvested earnings b is the percentage of earnings that are not paid as dividends – reinvestment rate – ROI is the return on – Growth rate g = b x ROI – ROE = return on investment within the firm Arbitrage In finance theory an “arbitrage” is defined as: a zeroinvestment trading strategy that generates a sure profit no initial investment nonnegative cash flows at all times a positive cash flow at some times On Wall Street “arbitrage” also often means – a trading strategy that is expected to make a profit – – This is also called a “statistical arbitrage” (stat. arb.) – In this class: financetheory tradition Important insight in finance: – there cannot be arbitrage opportunities – – if there were, arbitrageurs would trade aggressively to exploit the arbitrage. – – called the “NoArbitrage Condition” Perhaps surprisingly, using the noarbitrage condition alone we can: – – compute restrictions on security prices – – compute explicitly prices of derivatives. Implications of NO arbitrage 1. If two securities have the same payoffs, they must have the same price: Law of One Price. 2. If a portfolio has the same payoff as a security, the price of the security must be equal to the price of the portfolio – That portfolio is called a replicating portfolio 3. If a selffinancing trading strategy has the same final payoff as a security, the price of the security must be equal to the cost of the strategy – This is called a dynamic hedging strategy Arbitrage Pricing with Transactions Costs – If there are transactions costs, it is more difficult to make an arbitrage trading strategy – Therefore, we cannot determine prices exactly using the NoArbitrage Condition – But, we can find an upper and lower bound for the price. RealWorld Arbitrage Strategies Relative mispricing and convergence trades – index arbitrage – – fixedincome securities, e.g. ontherun vs. offtherun Treasuries Special situations – mergers and acquisitions (“risk arb.”) – – devaluations of currency – – IPOs – – announcements (e.g. of earnings or macro news) CAPITAL BUDGETING: NPV & ALTENATIVES The Importance of Capital Budgeting Corporations create value by making “good” real investment decisions – Real Investments == projects (usually spend now, cash later) – – So the first thing you might ask is, “Hey, what’s a project?” – – Pretty much everything… – • Building a factory – • Advertising campaigns – • When and how often to replace machinery – • Purchasing a company – • Building a toll road – • Lease airplanes or buy them – • Whether to drill for oil – • Do not trade in financial markets (by contrast to financial investments) – Capital budgeting is the most important issue in corporate finance Net present value A project is just a collection of cash flows Projects are worth undertaking if Benefits > Costs We want to make more money (profits) than we spend (invest) Net Present Value : is the PV considering all cash flows, both positive (profits) and negative (investments) Decision Criteria: Investment projects should be accepted if the NPV of project is positive and should be rejected if the NPV is negative. Following this rule increases firm value Why? Because the firm is just a portfolio of existing and potential projects! A corporation that maximizes shareholder value should undertake all investments with NPV > 0 Thus, capital budgeting is the search for projects with positive NPV Investors value a firm taking into account: – How good are existing projects – – The ability of the firm to find new projects with positive NPV (growth opportunities) Calculating NPV: Three Steps Step 1: Plot cash flows in a timeline Step 2: Discount all cash flows using appropriate discount rate Step 3: Sum the discounted values to find the NPV Step 4: Do project if NPV > 0 – 4a: If deciding between to positive NPV, mutually exclusive projects, choose the project with the larger NPV Projects with Different Lives An efficient method of choosing between mutually exclusive projects with different lives is to compute their equivalent annual annuity (EAA) Payback period – Length of time until the accumulated cash flows equal or exceed the original investment Payback rule: Quicker is Better – Accept if payback is less than some prespecified number of years Discounted Payback Criterion We should at least try to account for the time value of money (Discounted Payback) Discounted Payback Period – The length of time required for an investment’s discounted cash flows to become as large as or larger than the initial investment – Lower weights for distant cash flows (we are taking time value of money into account) IRR – Discount rate that gives a project a zero NPV IRR rule – Accept investment if IRR > Required rate of return The IRR technique is very widely used, even as a primary method There is a simple reason for that: communication – People like percentage measures – But percentages assume that you can scale up your project! IRR will in most cases give the same answer as NPV It can be used to determine a percent return on your investment Useful to get an idea of the risk in a project Profitability Index Profitability index (PI) is computed for each project Firm chooses the set of projects with the largest profitability indices until it runs out of resources –Profitability Index is a measure of the value a project generates for unit of resource invested in that project. Objective is to identify the bundle or combination of positiveNPV projects that creates the greatest total value for stockholders DCF Analysis The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project Relevant cash flows = incremental cash flows These are the right cash flows to consider to evaluate our project! Common Types of Cash Flows Sunk costs Opportunity costs Side effects – Erosion/Cannibalization – – Spillover Net working capital Financing costs Taxes Sunk Costs: A cost that is already paid and cannot be recovered Opportunity Costs: cost of lost options Erosion – A negative impact on the cash flows of an existing product from the introduction of a new product – – If another firm would (or could) produce this new product in any case, then any sales erosion should be ignored Spillover A positive impact on the cash flows of an existing product from the introduction of a new product Net Working Capital Investment needed to start operations – Cash on hand to pay any expense that may arise directly from operations – – Initial investment in inventories – – Accounts receivables to cover credit sales – – Accounts payable to pay for credit purchases Working capital is always recovered at the end of the project for finite lived projects Financing cost We will not include financing costs in our evaluations We are interested in the cash flows generated by the assets of the project In any case, all financing activities should have an NPV = 0 since it is a competitive market taxes Taxes affect project cash flows Be careful, taxes are always changing Marginal vs. average tax rates – Marginal tax rate – the percentage paid on the next dollar earned – – Average tax rate – – the tax bill / taxable income We will usually assume a marginal tax rate around 35% depreciation The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes Depreciation itself is a noncash expense; consequently, it is only relevant because it affects taxes Depreciation tax shield = DT – D = depreciation expense – T = marginal tax rate If the salvage value is different from the book value of the asset, then there is a tax effect Book Value = Initial Cost – Accumulated Depreciation AfterTax Salvage = Salvage – Tax*(Salvage – Book Value) Cash Flow (CF) = Operating Cash Flow (OCF) – Capital Expenditure (CAPEX) – – Change in Net Working Capital (∆NWC) We will compute OCF from the Income Statement CAPEX can be negative (real asset sales) Risk and Return Higher risk higher expected returns Statistics Review: Expected Value The expected value is the average outcome if the event was repeated infinitely often. It is probabilityweighted average of the possible outcomes. Suppose the return Ri on an asset i is equal to Ri (s) with probability p(s) for scenarios/events s = 1,…,S Variance and Standard Deviation The variance measures how much a variable fluctuates around its mean The variance is the average squared deviation from the expected value: The standard deviation (SD) is the square root of the variance: ‘volatility’ is another word for ‘standard deviation’ Covariance The covariance between two random variables is the average of the products of their deviations from the mean: The covariance is – Positive if the random variables tend to be unusually high at the same time – Negative if the one variable tends to be high when the other is low correlation Intuitively, the correlation measures the same thing as the covariance It is defined as the covariance between two random variables, divided by the product of their standard deviations: The correlation is always between 1 and +1: Portfolio theory Portfolio A combination of N assets, with returns R1,…, RN. Portfolio p, with portfolio weights w1 ,…, wN: – wi is percentage of wealth invested in asset i: – – Portfolio weights sum to one: w1 +…+ wN = 1. – – A negative weight indicates a short position. Portfolio Terminology The investment opportunity set consists of all available riskreturn combinations. An efficient portfolio is a portfolio that has the highest possible expected return for a given standard deviation The efficient frontier is the set of efficient portfolios. It is the upper portion of the minimum variance frontier starting at the minimum variance portfolio. The minimum variance portfolio (mvp) is the portfolio that provides the lowest variance (standard deviation) among all possible portfolios of risky assets.
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