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# FIN MANAGEMENT ECON 134A

UCSB

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This 64 page Class Notes was uploaded by Arno Leuschke on Thursday October 22, 2015. The Class Notes belongs to ECON 134A at University of California Santa Barbara taught by Staff in Fall. Since its upload, it has received 41 views. For similar materials see /class/227167/econ-134a-university-of-california-santa-barbara in Economcs at University of California Santa Barbara.

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Date Created: 10/22/15

UCSB ECON 134A Introductory Finance Lecture 13 Efficient Capital Markets and Corporate Financing Corresponds to Ch 13 in textbook Spring quarter 2009 Instructor Ragnar Arnason Can Financing Decisions Create Value Financing decisions Capital Structure How much and what types of debt to hold How much equity and what types to have Before established that it is possible to create value by judicious investment decisions Capital budgeting What about financing decisions Capital structure How much debt and equity to sell When to sell debt and equity When or if to pay dividends Nota bene We can use PV to evaluate financing decisions Creating Value through Financing To create value must get the investor to pay more for the asset eg stocks or bonds than it is worth fair price Main methods Fool Investors 0 Empirical evidence suggests it is hard to fool investors consistently Reduce Taxes or Increase Subsidies 0 Certain forms of financing have tax advantages or generate subsidies Create a New Security 0 Sometimes a firm can find a previouslyunsatisfied demand clientele for particular type of securities and sell them at favorable prices 0 In the longrun this value creation is relatively small The Efficient Market Hypothesis EMH An efficient capital market is one in which capital asset eg stock prices fully reflect available information gt Asset prices are fair in this sense EMH Real capital markets are efficient If EHM is true gt implications for investors and firms Firms may expect to receive a fair value for securities they trade You cannot fool investors in an efficient market Since information is reflected in security prices knowing information when it is released does an investor little good Example Stock price reaction to good news Stock Price Overreaction to good news with reversion o belayed response on to good news Ef uent market response to good news I I I I I I I 30 20 10 0 10 20 30 Days before and after announcement Why should there be market efficiency Investor Rationality and Efficiency Investors are rational and they systematically collect and analyze relevant information gt Not a strong argument Independence of events Investors are not rational but the overly optimistic are cancelled out by the overly pessimistic gt Weak argument Arbitrage Some investors are rational and efficient and their trades bring the prices to the fair level gt Strong argument Different Types of Market Efficiency Weak Form Security prices reflect all historical information about security prices and volumes Semistrong Form Security prices reflect all publicly available information relevant to security prices Strong Form Security prices reflect all information public and private relevant to security prices Information Sets Information 39 set of past prices What the EMH Does and Does NOT Say Investors can throw darts to select stocks This is almost but not quite true An investor must still decide how risky a portfolio he wants based on risk aversion and expected return Prices are random or uncaused Prices are not random but price changes may be The price CHANGE is driven by new information which tends to arrive randomly Therefore financial managers cannot quottimequot stock and bond sales The Empirical Evidence The record on the EMH is extensive and in large measure it is reassuring to advocates of the efficiency of markets Studies fall into three broad categories 1 Are changes in stock prices random Are there profitable quottrading rules 2 Event studies does the market quickly and accurately respond to new information 3 The record of professionally managed investment firms Are Changes in Stock Prices Random Weak form of market efficiency suggests unpredictable ie random stock price movements The random walk hypothesis pt 2 p1au ur ID So ut is independent identically distributed stochastic term It is possible to test whether actual stock price movements conform with random walk A random walk p010 utNDO1 14 A A quotquot39vxK 1M IJv 8 YJ Generally it is found that the random walk hypothesis cannot be rejected 0 n n l n n a n u a a a n a n n l n n H 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 Event Studies Event Studies are one type of test of the semistrong form of market efficiency Recall this form of the EMH implies that prices should reflect all publicly available information To test this event studies examine prices and returns over time particularly around the arrival of new information Test for evidence of underreaction overreaction early reaction or delayed reaction around the event Example of Event Studies Dividend Omissions Cumulative Abnormal Returns for Companies Announcing Dividend Omissions Ef cient market response HCWS Cumulative abnormal returns 449 Days relative to announcement of dividend omission Event Study Results Over the years event study methodology has been applied to a large number of events including Dividend increases and decreases Earnings announcements Mergers Capital Spending New Issues of Stock The studies generally support the view that the market is semistrong form efficient Studies suggest that markets may even have some foresight into the future ie news tends to leak out in advance of public announcements The Record of Mutual Funds If the market is semistrong form efficient then no matter what publicly available information average returns of mutual funds should be about the market as a whole We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of a market index The record of different types of mutual funds relative to the market index l 1 fun 5 Small Ith Income Gro and Maximum grovvth mcome Capltal gams 1 O6 0 39 O51 213 217 229 541 845 So underperformance after fees relative to the market average This also conforms with the semi strong EMH The Strong Form of the EMH One group of studies of strong form market efficiency investigates insider trading A number of studies support the view that insider trading is abnormally profitable Generally the available evidence does not support strong form of the EMH Empirical Challenges Crashes On October 19 1987 the stock market dropped between 20 25 on a Monday following a weekend during which little surprising news was released A drop of this magnitude for no apparent reason is inconsistent with market efficiency Bubbles Consider the tech stock bubble of the late 1990s Consider the bubble burst in 2008 Bubbles require a modification of the EMH But they do not by any means invalidate the hypothesis Implications for Corporate Finance Because information is reflected in security prices quickly investors should only expect to obtain a normal rate of return Awareness of information when it is released does an investor little good The price adjusts before the investor has time to act on it Firms should expect to receive the fair value for securities that they sell Fair means that the price they receive for the securities they issue is the present value Thus valuable financing opportunities that arise from fooling investors are unavailable in efficient markets Implications for Corporate Finance The EMH has three implications for corporate nance 1 The price of a company s stock cannot be affected by a change in accounting 2 Financial managers cannot quottimequot issues of stocks and bonds using publicly available information 3 A firm can sell as many shares of stocks or bonds as it desires without depressing prices There is conflicting empirical evidence on all three points UCSB ECON 134A Introductory Finance Lecture 3 Discounting and present values Corresponds to Ch4 in textbook Spring quarter 2009 Instructor Ragnar Arnason Why do we need discounting Cash flows or incomesoccur at different times Eg 525435 or C1C2C3 Empirical fact People and companies do not value cash at different times equallyll Why cont Generally people companies value current cash more highly than certain future cash Example Ct preferred to Cts gt Discounting discounting the future 0 Even ifthey did not markets offerdemand interest gt0 gt Costly to wait for payments one could earning interest in the meantime The key concept in discounting The rate of interest is like a percentage Measured as a fraction gt5005 gt1001 etc Example Consider cash C Let rate of interest be r rgtO eg 0110 Consider two periods tO now t1 next year gtCO is cash now C1 same cash next year gt COC1C Get cash now gt will have next year CO1r Get cash next year gt will have next year CO So richer if get cash now Difference rCO gt Cash now is more valuable Example Also richer if can pay debt later Consider payment C Let rate of interest be r rgtO eg 0110 Consider two periods tO now t1 next year gtCO is pay now Cl pay same amount next year Pay C now gt will have next year CO Pay next year gt will have next year rCOCO So richer if can postpone payments DifferencerCO gtPayments now are more costly Present value Definition The value today of a future flow of something valuable eg cash Present Value the one period case The present value of C1 to be paid after one period may be written as C1 1r Where C1 is cash flow at date 1 PV r is the appropriate interest rate Present Value Example If you were to be promised 10000 due in one year when interest rates are 5 percent the present value of that promise would be 952381 10000 10000 z 952381 1005 105 Suggestion Do a number of your own examples Future value Definition The value at some point in the future of a flow of something valuable eg cash Useful eg to calculate deposits or other interest assets bearing in the future Future Value The one period case The future value of CO paid now in period one may be written as FVCOlr Where CO is cash payment at date 1 r is the appropriate interest rate Future Value Example If you were to paid 10000 now the future value of this amount in one year when interest rates are 5 percent would be 10500 10 000 105 10500 Suggestion Do a number of your own examples The Multiperiod Case Still one amount C but any number of periods Present Value the multiperiod case The present value of CT to be paid after T period may be written as PVZLT 1rT Where CT is cash flow at date T r is the appropriate interest rate Why this formula A kind of derivation or mathematical proof Consider the PV of CT ie payment at time T Step 1 PVT1CT1r Step 2 PVT2PVT1 1rCT1r 1r CT1r2 Step 3 PVT3PVT2 1rCT1r21r CT1r3 Step T PVOPV1 1rCT1rT3911r CT1rT Present Value Example If you are promised 10000 due in 5 years and interest rates are 5 percent the present value of that promise would be 783526 10 000 1 0055 r 63 How to do this kind of calculation a Simple scientific calculator b Simple spreadsheet program c Simple mathematical program Do your own examples Future Value The multiperiod case The future value of CO paid now in period T may be written as FVCO1rT Where CO is cash payment at date 1 r is the appropriate interest rate Why this formula A kind of derivation or mathematical proof Consider the FV of CO after T periods Step 1 FV1CO1r Step 2 FV2FV1 1rCOc1r 1r CO1r2 Step 3 FV3FV2 1rCOc1r21r CO1r3 Step T FVTFVT1 1rCO1rT3911r CO1rT Future Value Example If you were to paid 10000 now the future value of this amount in 5 years when interest rates are 5 percent would be 12763 10000 1000012763 12763 How to do this kind of calculation a Simple scientific calculator b Simple spreadsheet program c Simple mathematical program Do your own examples Compounding At positive rates of interest future values grow faster and faster This is because of interest on accumulated interest This is called compounding or compound interest Compounding is a attribute of reality Economic life Growth of living things The effects of compounding Example Future value of 10000 at 5 interest Future value of 10000 at 5 interest 3500000 3000000 2500000 2000000 1500000 1000000 500000 000 0123456789101112131415161718192021222324 Easy to do in EXCEL The effects of compounding Example Annual growth of additions to 10000 at 5 interest Growth of 10000 at 5 interest 180000 160000 140000 120000 100000 80000 60000 40000 20000 000 1234S6789101112131415161718192021222324 The counter intuitive effects of compounding Consider 1 at 5 interest In 10 years 162 In 100 years 13150 In 500 years 393 billion In 1000 years 15109 trillion The impact of compounding on present values Present value of 1000 paid at given dates in the future r005 Present value of 10000 at 5 interest 1200000 1000000 800000 600000 400000 200000 000 0 l 23 4S6789101112131415161718192021222324 Converges gradually to zero I Easy to do in EXCEL Interesting questions about growing assets deposits bonds etc 1 How much must I set aside now to own X in year 2 2 How long do I have to wait to own X if I deposit Y now 3 What rate of interest is necessary to own X in year 2 if I deposit Y now All these questions and others can be answered by a simple application ofthe basic FVequation Basic FVequation FVCO1rT Four variables FV CO r T Assuming three we can always calculate the fourth How much would an investor have to set aside today in order to have 20000 five years from now if the rate of interest is 5 U nits iTiiQWiiiquoti i FV 2 C0 1 rT gt C0 1 FV rT 1567052 Waiting time If I deposit 5000 today in an account paying 10 how long does it take to grow to 10000 FV CO 1 1 rT E gt T1n1 r 1nFVC0 CO T 1nFVCO ln1 r 1n2 N06931 1n110 00953 z 727 years What Rate Is Enough Assume the total cost of a college education will be 50000 when your child enters college in 12 years You have 5000 to invest today What rate of interest must you earn on your investment to cover the cost of your child s education 00mm FV CO 1 in I r3 12 FV 50000 1H C0 5000 1o 1r10112 r210112 1z12115 12115 About 2115 The General Case Multiple variable cash flows More generally A series of cash flows 00 01 02 CT 50 3200 75 We still need to find PV and FV Fortunately that is conceptually easy albeit sometimes computationally difficult Present value PV PVOPV1 PVT 2 CT r 1 2 W1rT PV Example PV 1501 r01 43 112 11 0 1 3 Easy to do in Excel Future value FV FVOFV1 FVT FV C1 1 rT 1 C21 rT 2 CT Example FV 1501 r01 FViCr1r t0 0 111 1 572 Easy to do in Excel Useful Simple Cases 1 Perpetuity A constant stream of cash flows that lasts forever 2 Growing perpetuity A stream of cash flows that grows at a constant rate forever 3 Annuity A stream of constant cash flows that lasts for a fixed number of periods 4 Growing annuity A stream of cash flows that grows at a constant rate for a fixed number of periods Perpetuity A constant stream of cash flows that lasts forever C C C V 2 3 1r 1r 1 r NB Different specifications gt slightly different formulae Perpetuity Example What is the value of a British consol that promises to pay 15 every year for ever The interest rate is 10 percent PVE 150 10 Growing Perpetuity A growing stream of cash flows that lasts forever C C 1 91 1 o3 NB Different specifications gt slightly different formulae Growing Perpetuity Example The expected dividend next year is 130 and dividends are expected to grow at 5 forever If the discount rate is 10 what is the value of this promised dividend stream V 2600 lO 05 Annuhy A constant stream of cash flows with a fixed maturity C C C C V I 2 3 m T 1 r 1 r 1 r 1 r Annuity Example If you can afford a 400 monthly car payment how much car can you afford if interest rates are 7 on 36 month loans 7 annual is approximately 00712 monthly 400 1 V 1 1295459 0712 1071236 Annuity Example 2 What is the present value of a fouryear annuity of 100 per year that makes its first payment two years from today if the discount rate is 9 WW 100 100 22222 22 1094 1095

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