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# Corporation Finance FIN 301

Penn State

GPA 3.74

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This 0 page Class Notes was uploaded by Dagmar Dicki on Sunday November 1, 2015. The Class Notes belongs to FIN 301 at Pennsylvania State University taught by Woolridge in Fall. Since its upload, it has received 17 views. For similar materials see /class/232987/fin-301-pennsylvania-state-university in Finance at Pennsylvania State University.

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Date Created: 11/01/15

Fin 301 Final Exam Review Professor Gray Fin 301 Final Exam Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 40 Questions Each Question is worth 25 Discounted Cash Flow Capital Budgeting Risk and Return and CAPM Ef cient Capital Markets Bonds Stocks Management of Risk Introduction to DCF ValuationDefinitions I Discount multiply a number by less than one I Discount rate a function of time and risk discount rate f time risk I Discount factor a function of both time and the discount rate discount factor f time discount rate I Present value PV of an investment is the sum of the expected cash ows multiplied by their respective discount factors Introduction to DCF Valuation Mortgage Example Table 97 I Gary borrows 100000 from a bank at 8 and 25 year mortgage What is his annual payment I n 25 years PV 100000 r or i 8 FV 0 IPV PMT PVMP Factor 25 8 39100000 PMT 106748 39100000106748 PMT IPMT 9368year ITotal Payments 25 9368 234197 IInterest 134197 Principal Repayment 100000 Introduction to DCF Valuation The ThreeStep Approach 1 Develop a set of expectec zsh ows 2 Estimate the discount rate and calculate the discount factors 3 Multiply the cash ows by the discount factors and add them to determine the value of the asset Decision Rule I If the value of an asset is greater than its price Buy it I If the value is less than its price Sell it Valuing Level Cash Flows Amortizing a loan I Example Randy likes fast women and expensive cars He wants to buy a BMW for 5 0000 He can nance it with a bank loan at 10 for 4 years His annual payment is 15 774 What is his amortization schedule Interest Rate 1000 Discount Rate 1000 Beginning Interest Principal Annual Discount Ending M Principal Payment Payment Payment Factor E Principal 1 50000 5000 10774 15774 09091 14340 39226 2 39226 3923 11851 15774 08264 13036 27375 3 27375 2737 13037 15774 07513 11851 14338 4 14338 1434 14340 15774 0683 10774 Totals 13094 50002 63096 50001 Valuing Uneven Cash FlowsProj ects Most real world investments such as projects stocks and bonds do not have a single cash ow or level expected cash ows A Qrol39ect or venture is an investment to produce a product or provide a service that will generate money in the future Cash In ows additional revenues coming into the company as a result of the project Cash Out ows additional expenses being spent by the company as a result of the project Valuing Uneven Cash FlowsBonds A bond is a debt instrument Corporations the US Government and municipalities issue bonds Bonds are payable from taxes from US government or the general revenues of a corporation Cash in ows to an investor are bond interest payments usually every 6 months and repayment of principal Valuing Uneven Cash FlowsStocks Astock represents ownership interest in a corporation The cash in ows consist of dividends and increase or decrease in stock price There is no maturity associated with a stock the life of a stock is in nite The risk of a stock is hard to quantify making it dif cult to determine the proper discounting rate Capital Budgeting and Measures of Investment Return 111 Capital Budgeting 39 Capital budgeting is the process of planning and managing a rm s longterm investment in projects and ventures 39 Capital Budgeting involves estimating the amount timing and risk of future cash ows 39 Capital budgeting starts with estimation of incremental cash ows from a project creating a time line of expected cash ows and comparing the value of the cash ows to the cost of project Capital Budgeting and Measures of Investment Return 112 Net Present Value NPV I NPV of an investment is the difference between the value of an investment and its cost 39 The value of any project venture or investment is equal to the present value of its expected cash ows discounted for their risk and timing 39 NPV Rule or the appropriate criterion for the capital budgeting decision is to invest in projects if the NPV of the project is positive and do not invest in projects if the net present value is negative Capital Budgeting and Measures of Investment Return 113 Internal Rate of Return IRR I IR is the rate of return that is expected to be earned on a project I IR is the discounting rate that makes the net present value of an investment equal to zero I IRR Rule as an investment criterion is that if the investment has an IRR that is higher than some pre determined required rate of return accept the investment and if the IRR is lower than the required rate of return reject the investment Capital Budgeting and Measures of Investment Return 114 Other Measures Payback Period 39 Payback period is the length of time for the return on an investment to cover the cost of the investment 39 Payback period calculation involves only gross cash ows and not discounted cash ows 39 Payback rule as an investment criterion is to accept the investment if its payback period is less than a predetermined number of years and to reject the investment if its payback period is greater than the predetermined number of years Capital Budgeting and Measures of Investment Return Pro tability Index Problem Calculate the pro tability Index for the 3 projects given below Project PV Cost NPV Profitability Index 1 5000 4200 800 8004200 019 2 2500 2000 500 5002000 025 3 3000 2700 300 3002700 011 Based on Pro tability Index Project 2 will be chosen rst followed by project 1 and then by project 3 A Principle of Finance Relating to Valuation Higher Returns Require Taking More Risk The results of the Ibbotson and Sinquefield study is shown below Stock Return Std Dev Treasury Bills 38 32 Government Bonds 53 94 Corporate Bonds 58 86 Large Company 107 202 Stock Small Company 125 332 Hi disk Stock E RlSk and Return Hm sported J thurn Lawrisk Stock Risk A Principle of Finance Relating to Valuation Ef cient Capital Markets are Tough to Beat 39 According to the theory of ef cient capital markets ECM the stock market is brutally ef cient current stock prices re ect all publicly available information and stock prices react completely correctly and almost instantaneously to incorporate the receipt of new information I If the stock market is ef cient it would be useless to forecast future prices by technical analysis and fundamental analysis Simple Averages of Percentages are Never Simple The math underlying investment returns and percentages computes investment gains more favorably than comparable losses Problem is embedded in calculation of simple averages If there is a negative percentage return the calculation of a simple average is biased upwards Simple average returns can hide very poor performance Simple Averages of Percentages are Never Simple Martha s Investment Performance Simple 3i Cempeund uerege Returns Beginning Ending nnuel quotr39ear 1lul39alue 1Int39alue Return 1 10 20 100 2 20 1 20 Simple uerege Return 1011 Cempeund ueraue Return 3553911 A Principle of Finance Relating to Valuation Asset Diversi cation Will Reduce Risk I To reduce the risk of your portfolio it is important to diversify your holdings I Diversification means to spread your wealth among a number of different investments I The goal of diversification is to invest in a group of assets that provides you with the best return possible given a level of risk A Principle of Finance Relating to Valuation Asset Diversi cation Will Reduce Risk I A correlation coefficient of 1 0 between two stocks mean that when one stock is up 10 the other stock will also go up 10 and correlation of 10 means that when one stock is up 5 the other stock is down 5 I Assets that are highly correlated offer less risk reduction from diversification than assets that are less correlated I Diversification reduces the unsystematic risk of a portfolio Unsystematic risk is specific to a company and Systematic risk represents the risk of the stock market Total Risk Systematic Risk Unsystematic Risk A Principle of Finance Relating to Valuation Asset Diversi cation Will Reduce Risk The table below shows how many stocks your portfolio needs to hold to diversify risk Number of Stocks in Average Std DeV of Ratio of Portfolio Std Portfolio Annual Portfolio Returns Dev of a Single Stock 1 4924 100 10 2393 49 5 0 2020 41 100 1969 40 3 00 19 3 4 3 9 5 00 1927 3 9 1000 19 2 l 3 9 A Principle of Finance Relating to Valuation An Asset Pricing Model Should be Used to Value Investments I The Capital Asset Pricing Model CAPM is a simple model that estimates the rate of return an investor should expect to receive on a risky asset I In valuation its principal purpose is to determine the discount rate to use when valuing an asset I CAPM states that the expected return of a risky asset ERi such as a common stock is equal to the return on the riskfree asset Rf plus a risk premium A Principle of Finance Relating to Valuation An Asset Pricing Model Should be Used to Value Investments CAPM Example Suppose the risk free rate is 4 and an expected return on the stock market is 6 and if beta of XYZ Inc is 12 calculate the expected return of XYZ Inc EKyz ZRr Bi ERm Rf Edgy 4 12 6 4 64 CAPM is a very simple yet powerful way to estimate the cost of equity which is usually the most significant component of a company s weighted cost of capital Using Beta to determine Expected Returns What is a risk premium The amount by which an investment is expected to outperform TBills or the average amount by which an investment has outperformed TBills in the past The Market has averaged 12 a year TBills have averaged 4 a year The market risk premium is 8 Alpha measures performance A positive alpha is g00da negative alpha is not so good n P0s1t1veAlpha Average Retur egative Alph 1 Beta A Practice Problem TBills averaged 4 over last few years SampP 500 averaged 14 The XYZ Fund had an average return of 16 and a beta of 14 Find XYZ S alpha The CAPM riskreturn line for a beta of 14 is at 4 14 144 18 XYZ S alpha is 1618 2 Review of Some De nitions CAPM ER Rf t Rm Rf Market Risk Premium Rm Rf Risk m Observed Return of Asset Expected Return of Asset Unsvstematic Risk or rm speci c risk the risk that can be diversi ed away Systematic Risk market related risk as measured by Beta Can not be diversi ed away An Important Principle of Finance Eff1cient Capital Markets Asset prices react very quickly to the receipt of new information New information is random and can either be good and drive stock prices higher or bad and propel stock prices lower The quick reaction of many market participants to the new information tends to drive prices to their correct level What is an EFFICIENT MARKET A market where all investments are accurately priced This means there are no good investments Also there are no bad investments Each investment offers an expected return to match its level of risk Definition If a market is efficient all investments lie on the riskexpected return line ATampT Expected Return Microsoft One investment is as USX good as another 1 Beta Ef cient Capital Markets and Random Walks Random Walk Hypothesis I A random walk is a path that a variable takes such as the observed price of a stock where the future direction of the path up or down can t be predicted solely on the basis of past movements I Share prices react immediately to news so that there is no predictable trend implied by a more gradual share price adjustment Also the next news event leading to the next immediate adjustment cannot be predicted Therefore in an ef cient market share price changes are random Ef cient Capital Markets and Random Walks 13 3 Tests of Market Ef ciency The Fama and French Study 39 Fama and French study compares the performance of the returns associated with portfolios of stocks that have certain similar characteristics 39 The study showed among other things portfolios of stock with a high book value BE to market value ME ratio consistently outperformed portfolios with low BEME ratios and called to question the validity of ef cient capital markets Bond Valuation and Interest Rates Fixed Rate Structures 39 The interest rates and coupon payments are xed over the life of the bond and the investors and the issuer are certain of the payments I In a Fixed Rate Par Bond the issuer issues the bond at par value 100 and pays xed interest semi annually on predetermined dates and repays the full par value of the bond on maturity Market yield Bond Coupon IDiscount Bond Market yield greater than bond s coupon IPremium Bond Market yield less than bond s coupon Bond Valuation and Interest Rates 142 Bonds and Risk Four types of risk involved while investing in fixedrate or fixedcoupon debt obligations are I Default risk the risk that the bond will not pay interest or principal when due I Reinvestment risk the unknown rate at which cash in ows may be reinvested I Prepayment risk when an issuer calls a bond prior to its maturity I Interest rate risk the risk that a change in market interest rates will affect the value of the bond Bond Valuation and Interest Rates Spread to Treasuries I The difference between the yield on a noncallable US Treasury bond and the yield on a noncallable corporate bond with an identical maturity is called the spread to Treasuries and is a measure of the default premium associated with the corporate bond I The spread to Treasuries is a function of the type of industry the issuer belongs the credit rating of the corporate bond and a function of the time to maturity of the bond Bond Valuation and Interest Rates Prepayment Risk I Prepayment risk is the risk that a bond will be retired or redeemed at a time earlier than its maturity date I The call options and redemption features in debt instruments introduce uncertainty into the expected cash ows This uncertainty has a cost in the way of a higher rate of interest on the bonds Bond Valuation and Interest Rates Interest Rate Risk I Interest rate risk is often the most difficult risk to assess I The price volatility of a bond is the extent to which its price changes with uctuations in market levels of interest rates I Bond prices and yields move in opposite directions other things being equal The magnitude of price movements will differ based on specific bond characteristics Bond Valuation and Interest Rates Municipal Bonds and the Municipal Market I Municipal bonds are debt instruments issued by states cities municipal authorities and other entities I Municipal bond interest income are exempt from federal and certain state and local income taxation I Investor can compare Municipal Bonds interest income with aftertax income of other fixedincome securities taking into account the investor s marginal taX bracket I The municipal bond market is a huge diverse and extremely complicated marketplace Bond Valuation and Interest Rates The Term Structure of Interest Rates I The yield curve also known as the term structure of interest rates describes the relationship between the yield on a security and its maturity I The shaI of the yield curve depending on the rate of in ation or de ation the economy and monetary policies can be upward sloping which is the most common downward sloping when a significant slowdown in in ation is anticipated m or humped Bond Valuation and Interest Rates Calculating Bond Yield I A bond is valued by discounting bond s cash ows at the yield level that is required by securities of comparable maturity risk liquidity and call features Hence the computation of a required yield level is a function of all of these factors I The yield on a risky security can be represented by the yield on a comparable maturity riskfree security plus a measure of the spread to Treasuries for default risk plus a bond specific spread ie I Bond Yield Rf Spread t0 Treas Bond Speci c Spread Bond Valuation and Interest Rates 145 Valuing a Bond I Two important facts associated with valuation and bond prices in the marketplace are I Bond prices and changes in interest rates move in opposite directions 39 Investors and traders value and bonds based on a price to worst call feature scenario ie issuer of the bond will act in its own best interest in calling or managing the bond s call features and will exercise the call at the rst available opportunity that is economically advantageous to the issuer Bond Valuation and Interest Rates Using a Financial Calculator to Value a Bond I A 10 year bond has a 10 coupon rate 5 semi annually and current market yields for a 10year bond of similar risk is 9 Calculate the value of the bond I We input values in the financial calculator n 20 since payments are received semi annually pmt 50 i 45 fv 1000 Then solve for PV which is equal to 106504 How to Value a Stock 151 Introduction to Stock Valuation I Common stock represents a proportionate ownership interest in a corporation I The Llue of a stock is crucially dependent upon the future pro ts or cash ows that the rm is expected to generate and the interest rate or required yield level that is expected from the investment I Higher pro ts increase a stock s market value and lower pro ts decrease its value a direct relationship I Higher interest rates decrease market value and lower yields and interest rates increase value an inverse relationship How to Value a Stock Stock Value and Dividend Policy I The dividend policy of the rm should not affect the current value of a stock 39 However the expected future value of a stock is greatly affected by dividend policy 39 When a company does not pay dividends and reinvests its earnings in projects the investors receive no current dividend but instead receive an increase in stock price 39Informational Content of Dividends How to Value a Stock Technical Analysis I Technical analysts believe that stock prices are in uenced more by investor psychology and emotions of the crowd than by changes in the fundamentals of the company I Technical analysts chart historic stock price movements volume of trading activity and the pricevolume aspects of related equity and debt markets to predict or anticipate the stock buying behavior of other market participants I Technical analysts generally have a shorterterm stock holding orientation and more frequent trading activity Sample TA Chart for Microsoft vs NASDAQ TBChnical Analwis Get Technical Analysis Charlis for I E MICROSOFT CP NasdaqHMjI Edil Range m E 3m 5rn 1y 2 in max Type E Line E Scale Linear Log Size M I l MovingAvg il l l ll mo EMA mg 1uo2uo Indicators MACD l ROG 1 1 Slow Stash Fast Sta3h m VDIMA mmR Overlays Bullinger Bands Parabolic SAR Sglits Volume Compar31MSFTvs l sap l7 Nasdaq E Dow Compare I NHSK NMS CDMPSITE NHSDHU STUCK as 0F 21 Nov 2003 402 I if I I 203 UK 203 4103 Copyright 2003 Yahoo Inc http f Finance yahou comr How to Value a Stock Fundamental Analysis I According to Fundamental Analysis approach the company s current and future operating and financial performance determine the value of the company s stock I The assumption underlying this approach is that a company s stock has a true or intrinsic value to which its price is anchored When there is an price divergence the price over time will gravitate to its intrinsic value I To assess a company39s prospects fundamental analysts evaluate overall economic industry and company data to estimate a stock39s value How to Value a Stock Fundamental Analysis Target Stock Price I Examples of fundamental analysis approach include DCF valuation target stock price and relative valuation I Target Stock Price technique forecasts earnings per share EPS of a firm and multiplies EPS by the projected PE ratio to arrive at a target stock price I Example Suppose the projected EPS of XYZ Inc is 250 and the market PE ratio is 10 The target stock price of XYZ Inc is 25 If the current market price of the stock is 20 a financial analyst would recommend buying the stock How to Value a Stock Fundamental Analysis DCF Valuation I In the DCF approach a stock s value is the sum of the expected cash ows of the company discounted at an appropriate interest rate I The most basic DCF approach is the dividend discount model DDM under which an analyst estimates future dividend growth and the required rate of return on the stock and discounts those expected dividends to arrive at a stock s value I Other DCF approaches are the free cash ow to equity FCFE model and free cash ow to the firm FCFF model How to Value a Stock Modern Portfolio Theory I Efficient capital markets is a cornerstone of MPT and is the belief that stock prices always re ect intrinsic value and that any type of fundamental or technical analysis is already embedded in the stock price I As such MPT devotees tell investors not to bother to search for undervalued stocks but instead to pick a risk level that they can live with and diversify holdings among a portfolio of stocks I However empirical evidence shows that there is value to careful stock selection Management of Risk Diversifying Hedging Insuring and Derivative Securities 161 The management of risk Investors are usually risk averse Ways to reduce risk associated with financial assets Diversi cation Spread the risk by investing in a number of risky assets Hedging By using techniques to lockin a price or return Insurance Pay a premium to purchase a contract to protect Sell the assets Management of Risk Diversifying Hedging Insuring and Derivative Securities 161 The management of risk Investors are usually risk averse Ways to reduce risk associated with financial assets Diversi cation Spread the risk by investing in a number of risky assets Hedging By using techniques to lockin a price or return Insurance Pay a premium to purchase a contract to protect Sell the assets Management of Risk Diversifying Hedging Insuring and Derivative Securities 164 Insurance pay a premium to protect against loss Option Strike price Also known as exercise price predetermined Expiration date After which the option can no longer be exercised 0 Call option Call option contracts enable the owner to buy an asset 0 Put option Put option contracts enables the owner to sell an asset Management of Risk Diversifying Hedging Insuring and Derivative Securities 164 Insurance pay a premium to protect against loss Option S current market price of security underlying the option Xc exercise price or strike price on the call option Xp exercise price or strike price on the put option The call option is in the money if S gtXc The put option is in the money if S lt Xp An option has positive value to its owner before expiration The price or value of a call or put option has two components Intrinsic value and Time value Management of Risk Diversifying Hedging Insuring and Derivative Securities 164 Insurance pay a premium to protect against loss Value of Option Intrinsic value The amount the option is in the money and is the difference between the current price and the strike price of the option Time value Re ects expectations of an option s pro tability associated with exercising it at some future point in time Fin 301 Final Exam Review Professor Gray Fin 301 Final Exam Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 40 Questions Each Question is worth 25 Discounted Cash Flow Capital Budgeting Risk and Return and CAPM Ef cient Capital Markets Bonds Stocks Management of Risk Introduction to DCF ValuationDefinitions I Discount multiply a number by less than one I Discount rate a function of time and risk discount rate f time risk I Discount factor a function of both time and the discount rate discount factor f time discount rate I Present value PV of an investment is the sum of the expected cash ows multiplied by their respective discount factors Introduction to DCF Valuation Mortgage Example Table 97 I Gary borrows 100000 from a bank at 8 and 25 year mortgage What is his annual payment I n 25 years PV 100000 r or i 8 FV 0 IPV PMT PVMP Factor 25 8 39100000 PMT 106748 39100000106748 PMT IPMT 9368year ITotal Payments 25 9368 234197 IInterest 134197 Principal Repayment 100000 Introduction to DCF Valuation The ThreeStep Approach 1 Develop a set of expectec zsh ows 2 Estimate the discount rate and calculate the discount factors 3 Multiply the cash ows by the discount factors and add them to determine the value of the asset Decision Rule I If the value of an asset is greater than its price Buy it I If the value is less than its price Sell it Valuing Level Cash Flows Amortizing a loan I Example Randy likes fast women and expensive cars He wants to buy a BMW for 5 0000 He can nance it with a bank loan at 10 for 4 years His annual payment is 15 774 What is his amortization schedule Interest Rate 1000 Discount Rate 1000 Beginning Interest Principal Annual Discount Ending M Principal Payment Payment Payment Factor E Principal 1 50000 5000 10774 15774 09091 14340 39226 2 39226 3923 11851 15774 08264 13036 27375 3 27375 2737 13037 15774 07513 11851 14338 4 14338 1434 14340 15774 0683 10774 Totals 13094 50002 63096 50001 Valuing Uneven Cash FlowsProj ects Most real world investments such as projects stocks and bonds do not have a single cash ow or level expected cash ows A Qrol39ect or venture is an investment to produce a product or provide a service that will generate money in the future Cash In ows additional revenues coming into the company as a result of the project Cash Out ows additional expenses being spent by the company as a result of the project Valuing Uneven Cash FlowsBonds A bond is a debt instrument Corporations the US Government and municipalities issue bonds Bonds are payable from taxes from US government or the general revenues of a corporation Cash in ows to an investor are bond interest payments usually every 6 months and repayment of principal Valuing Uneven Cash FlowsStocks Astock represents ownership interest in a corporation The cash in ows consist of dividends and increase or decrease in stock price There is no maturity associated with a stock the life of a stock is in nite The risk of a stock is hard to quantify making it dif cult to determine the proper discounting rate Capital Budgeting and Measures of Investment Return 111 Capital Budgeting 39 Capital budgeting is the process of planning and managing a rm s longterm investment in projects and ventures 39 Capital Budgeting involves estimating the amount timing and risk of future cash ows 39 Capital budgeting starts with estimation of incremental cash ows from a project creating a time line of expected cash ows and comparing the value of the cash ows to the cost of project Capital Budgeting and Measures of Investment Return 112 Net Present Value NPV I NPV of an investment is the difference between the value of an investment and its cost 39 The value of any project venture or investment is equal to the present value of its expected cash ows discounted for their risk and timing 39 NPV Rule or the appropriate criterion for the capital budgeting decision is to invest in projects if the NPV of the project is positive and do not invest in projects if the net present value is negative Capital Budgeting and Measures of Investment Return 113 Internal Rate of Return IRR I IR is the rate of return that is expected to be earned on a project I IR is the discounting rate that makes the net present value of an investment equal to zero I IRR Rule as an investment criterion is that if the investment has an IRR that is higher than some pre determined required rate of return accept the investment and if the IRR is lower than the required rate of return reject the investment Capital Budgeting and Measures of Investment Return 114 Other Measures Payback Period 39 Payback period is the length of time for the return on an investment to cover the cost of the investment 39 Payback period calculation involves only gross cash ows and not discounted cash ows 39 Payback rule as an investment criterion is to accept the investment if its payback period is less than a predetermined number of years and to reject the investment if its payback period is greater than the predetermined number of years Capital Budgeting and Measures of Investment Return Pro tability Index Problem Calculate the pro tability Index for the 3 projects given below Project PV Cost NPV Profitability Index 1 5000 4200 800 8004200 019 2 2500 2000 500 5002000 025 3 3000 2700 300 3002700 011 Based on Pro tability Index Project 2 will be chosen rst followed by project 1 and then by project 3 A Principle of Finance Relating to Valuation Higher Returns Require Taking More Risk The results of the Ibbotson and Sinquefield study is shown below Stock Return Std Dev Treasury Bills 38 32 Government Bonds 53 94 Corporate Bonds 58 86 Large Company 107 202 Stock Small Company 125 332 Hi disk Stock E RlSk and Return Hm sported J thurn Lawrisk Stock Risk A Principle of Finance Relating to Valuation Ef cient Capital Markets are Tough to Beat 39 According to the theory of ef cient capital markets ECM the stock market is brutally ef cient current stock prices re ect all publicly available information and stock prices react completely correctly and almost instantaneously to incorporate the receipt of new information I If the stock market is ef cient it would be useless to forecast future prices by technical analysis and fundamental analysis Simple Averages of Percentages are Never Simple The math underlying investment returns and percentages computes investment gains more favorably than comparable losses Problem is embedded in calculation of simple averages If there is a negative percentage return the calculation of a simple average is biased upwards Simple average returns can hide very poor performance Simple Averages of Percentages are Never Simple Martha s Investment Performance Simple 3i Cempeund uerege Returns Beginning Ending nnuel quotr39ear 1lul39alue 1Int39alue Return 1 10 20 100 2 20 1 20 Simple uerege Return 1011 Cempeund ueraue Return 3553911 A Principle of Finance Relating to Valuation Asset Diversi cation Will Reduce Risk I To reduce the risk of your portfolio it is important to diversify your holdings I Diversification means to spread your wealth among a number of different investments I The goal of diversification is to invest in a group of assets that provides you with the best return possible given a level of risk A Principle of Finance Relating to Valuation Asset Diversi cation Will Reduce Risk I A correlation coefficient of 1 0 between two stocks mean that when one stock is up 10 the other stock will also go up 10 and correlation of 10 means that when one stock is up 5 the other stock is down 5 I Assets that are highly correlated offer less risk reduction from diversification than assets that are less correlated I Diversification reduces the unsystematic risk of a portfolio Unsystematic risk is specific to a company and Systematic risk represents the risk of the stock market Total Risk Systematic Risk Unsystematic Risk A Principle of Finance Relating to Valuation Asset Diversi cation Will Reduce Risk The table below shows how many stocks your portfolio needs to hold to diversify risk Number of Stocks in Average Std DeV of Ratio of Portfolio Std Portfolio Annual Portfolio Returns Dev of a Single Stock 1 4924 100 10 2393 49 5 0 2020 41 100 1969 40 3 00 19 3 4 3 9 5 00 1927 3 9 1000 19 2 l 3 9 A Principle of Finance Relating to Valuation An Asset Pricing Model Should be Used to Value Investments I The Capital Asset Pricing Model CAPM is a simple model that estimates the rate of return an investor should expect to receive on a risky asset I In valuation its principal purpose is to determine the discount rate to use when valuing an asset I CAPM states that the expected return of a risky asset ERi such as a common stock is equal to the return on the riskfree asset Rf plus a risk premium A Principle of Finance Relating to Valuation An Asset Pricing Model Should be Used to Value Investments CAPM Example Suppose the risk free rate is 4 and an expected return on the stock market is 6 and if beta of XYZ Inc is 12 calculate the expected return of XYZ Inc EKyz ZRr Bi ERm Rf Edgy 4 12 6 4 64 CAPM is a very simple yet powerful way to estimate the cost of equity which is usually the most significant component of a company s weighted cost of capital Using Beta to determine Expected Returns What is a risk premium The amount by which an investment is expected to outperform TBills or the average amount by which an investment has outperformed TBills in the past The Market has averaged 12 a year TBills have averaged 4 a year The market risk premium is 8 Alpha measures performance A positive alpha is g00da negative alpha is not so good n P0s1t1veAlpha Average Retur egative Alph 1 Beta A Practice Problem TBills averaged 4 over last few years SampP 500 averaged 14 The XYZ Fund had an average return of 16 and a beta of 14 Find XYZ S alpha The CAPM riskreturn line for a beta of 14 is at 4 14 144 18 XYZ S alpha is 1618 2 Review of Some De nitions CAPM ER Rf t Rm Rf Market Risk Premium Rm Rf Risk m Observed Return of Asset Expected Return of Asset Unsvstematic Risk or rm speci c risk the risk that can be diversi ed away Systematic Risk market related risk as measured by Beta Can not be diversi ed away An Important Principle of Finance Eff1cient Capital Markets Asset prices react very quickly to the receipt of new information New information is random and can either be good and drive stock prices higher or bad and propel stock prices lower The quick reaction of many market participants to the new information tends to drive prices to their correct level What is an EFFICIENT MARKET A market where all investments are accurately priced This means there are no good investments Also there are no bad investments Each investment offers an expected return to match its level of risk Definition If a market is efficient all investments lie on the riskexpected return line ATampT Expected Return Microsoft One investment is as USX good as another 1 Beta Ef cient Capital Markets and Random Walks Random Walk Hypothesis I A random walk is a path that a variable takes such as the observed price of a stock where the future direction of the path up or down can t be predicted solely on the basis of past movements I Share prices react immediately to news so that there is no predictable trend implied by a more gradual share price adjustment Also the next news event leading to the next immediate adjustment cannot be predicted Therefore in an ef cient market share price changes are random Ef cient Capital Markets and Random Walks 13 3 Tests of Market Ef ciency The Fama and French Study 39 Fama and French study compares the performance of the returns associated with portfolios of stocks that have certain similar characteristics 39 The study showed among other things portfolios of stock with a high book value BE to market value ME ratio consistently outperformed portfolios with low BEME ratios and called to question the validity of ef cient capital markets Bond Valuation and Interest Rates Fixed Rate Structures 39 The interest rates and coupon payments are xed over the life of the bond and the investors and the issuer are certain of the payments I In a Fixed Rate Par Bond the issuer issues the bond at par value 100 and pays xed interest semi annually on predetermined dates and repays the full par value of the bond on maturity Market yield Bond Coupon IDiscount Bond Market yield greater than bond s coupon IPremium Bond Market yield less than bond s coupon Bond Valuation and Interest Rates 142 Bonds and Risk Four types of risk involved while investing in fixedrate or fixedcoupon debt obligations are I Default risk the risk that the bond will not pay interest or principal when due I Reinvestment risk the unknown rate at which cash in ows may be reinvested I Prepayment risk when an issuer calls a bond prior to its maturity I Interest rate risk the risk that a change in market interest rates will affect the value of the bond Bond Valuation and Interest Rates Spread to Treasuries I The difference between the yield on a noncallable US Treasury bond and the yield on a noncallable corporate bond with an identical maturity is called the spread to Treasuries and is a measure of the default premium associated with the corporate bond I The spread to Treasuries is a function of the type of industry the issuer belongs the credit rating of the corporate bond and a function of the time to maturity of the bond Bond Valuation and Interest Rates Prepayment Risk I Prepayment risk is the risk that a bond will be retired or redeemed at a time earlier than its maturity date I The call options and redemption features in debt instruments introduce uncertainty into the expected cash ows This uncertainty has a cost in the way of a higher rate of interest on the bonds Bond Valuation and Interest Rates Interest Rate Risk I Interest rate risk is often the most difficult risk to assess I The price volatility of a bond is the extent to which its price changes with uctuations in market levels of interest rates I Bond prices and yields move in opposite directions other things being equal The magnitude of price movements will differ based on specific bond characteristics Bond Valuation and Interest Rates Municipal Bonds and the Municipal Market I Municipal bonds are debt instruments issued by states cities municipal authorities and other entities I Municipal bond interest income are exempt from federal and certain state and local income taxation I Investor can compare Municipal Bonds interest income with aftertax income of other fixedincome securities taking into account the investor s marginal taX bracket I The municipal bond market is a huge diverse and extremely complicated marketplace Bond Valuation and Interest Rates The Term Structure of Interest Rates I The yield curve also known as the term structure of interest rates describes the relationship between the yield on a security and its maturity I The shaI of the yield curve depending on the rate of in ation or de ation the economy and monetary policies can be upward sloping which is the most common downward sloping when a significant slowdown in in ation is anticipated m or humped Bond Valuation and Interest Rates Calculating Bond Yield I A bond is valued by discounting bond s cash ows at the yield level that is required by securities of comparable maturity risk liquidity and call features Hence the computation of a required yield level is a function of all of these factors I The yield on a risky security can be represented by the yield on a comparable maturity riskfree security plus a measure of the spread to Treasuries for default risk plus a bond specific spread ie I Bond Yield Rf Spread t0 Treas Bond Speci c Spread Bond Valuation and Interest Rates 145 Valuing a Bond I Two important facts associated with valuation and bond prices in the marketplace are I Bond prices and changes in interest rates move in opposite directions 39 Investors and traders value and bonds based on a price to worst call feature scenario ie issuer of the bond will act in its own best interest in calling or managing the bond s call features and will exercise the call at the rst available opportunity that is economically advantageous to the issuer Bond Valuation and Interest Rates Using a Financial Calculator to Value a Bond I A 10 year bond has a 10 coupon rate 5 semi annually and current market yields for a 10year bond of similar risk is 9 Calculate the value of the bond I We input values in the financial calculator n 20 since payments are received semi annually pmt 50 i 45 fv 1000 Then solve for PV which is equal to 106504 How to Value a Stock 151 Introduction to Stock Valuation I Common stock represents a proportionate ownership interest in a corporation I The Llue of a stock is crucially dependent upon the future pro ts or cash ows that the rm is expected to generate and the interest rate or required yield level that is expected from the investment I Higher pro ts increase a stock s market value and lower pro ts decrease its value a direct relationship I Higher interest rates decrease market value and lower yields and interest rates increase value an inverse relationship How to Value a Stock Stock Value and Dividend Policy I The dividend policy of the rm should not affect the current value of a stock 39 However the expected future value of a stock is greatly affected by dividend policy 39 When a company does not pay dividends and reinvests its earnings in projects the investors receive no current dividend but instead receive an increase in stock price 39Informational Content of Dividends How to Value a Stock Technical Analysis I Technical analysts believe that stock prices are in uenced more by investor psychology and emotions of the crowd than by changes in the fundamentals of the company I Technical analysts chart historic stock price movements volume of trading activity and the pricevolume aspects of related equity and debt markets to predict or anticipate the stock buying behavior of other market participants I Technical analysts generally have a shorterterm stock holding orientation and more frequent trading activity Sample TA Chart for Microsoft vs NASDAQ TBChnical Analwis Get Technical Analysis Charlis for I E MICROSOFT CP NasdaqHMjI Edil Range m E 3m 5rn 1y 2 in max Type E Line E Scale Linear Log Size M I l MovingAvg il l l ll mo EMA mg 1uo2uo Indicators MACD l ROG 1 1 Slow Stash Fast Sta3h m VDIMA mmR Overlays Bullinger Bands Parabolic SAR Sglits Volume Compar31MSFTvs l sap l7 Nasdaq E Dow Compare I NHSK NMS CDMPSITE NHSDHU STUCK as 0F 21 Nov 2003 402 I if I I 203 UK 203 4103 Copyright 2003 Yahoo Inc http f Finance yahou comr How to Value a Stock Fundamental Analysis I According to Fundamental Analysis approach the company s current and future operating and financial performance determine the value of the company s stock I The assumption underlying this approach is that a company s stock has a true or intrinsic value to which its price is anchored When there is an price divergence the price over time will gravitate to its intrinsic value I To assess a company39s prospects fundamental analysts evaluate overall economic industry and company data to estimate a stock39s value How to Value a Stock Fundamental Analysis Target Stock Price I Examples of fundamental analysis approach include DCF valuation target stock price and relative valuation I Target Stock Price technique forecasts earnings per share EPS of a firm and multiplies EPS by the projected PE ratio to arrive at a target stock price I Example Suppose the projected EPS of XYZ Inc is 250 and the market PE ratio is 10 The target stock price of XYZ Inc is 25 If the current market price of the stock is 20 a financial analyst would recommend buying the stock How to Value a Stock Fundamental Analysis DCF Valuation I In the DCF approach a stock s value is the sum of the expected cash ows of the company discounted at an appropriate interest rate I The most basic DCF approach is the dividend discount model DDM under which an analyst estimates future dividend growth and the required rate of return on the stock and discounts those expected dividends to arrive at a stock s value I Other DCF approaches are the free cash ow to equity FCFE model and free cash ow to the firm FCFF model How to Value a Stock Modern Portfolio Theory I Efficient capital markets is a cornerstone of MPT and is the belief that stock prices always re ect intrinsic value and that any type of fundamental or technical analysis is already embedded in the stock price I As such MPT devotees tell investors not to bother to search for undervalued stocks but instead to pick a risk level that they can live with and diversify holdings among a portfolio of stocks I However empirical evidence shows that there is value to careful stock selection Management of Risk Diversifying Hedging Insuring and Derivative Securities 161 The management of risk Investors are usually risk averse Ways to reduce risk associated with financial assets Diversi cation Spread the risk by investing in a number of risky assets Hedging By using techniques to lockin a price or return Insurance Pay a premium to purchase a contract to protect Sell the assets Management of Risk Diversifying Hedging Insuring and Derivative Securities 161 The management of risk Investors are usually risk averse Ways to reduce risk associated with financial assets Diversi cation Spread the risk by investing in a number of risky assets Hedging By using techniques to lockin a price or return Insurance Pay a premium to purchase a contract to protect Sell the assets Management of Risk Diversifying Hedging Insuring and Derivative Securities 164 Insurance pay a premium to protect against loss Option Strike price Also known as exercise price predetermined Expiration date After which the option can no longer be exercised 0 Call option Call option contracts enable the owner to buy an asset 0 Put option Put option contracts enables the owner to sell an asset Management of Risk Diversifying Hedging Insuring and Derivative Securities 164 Insurance pay a premium to protect against loss Option S current market price of security underlying the option Xc exercise price or strike price on the call option Xp exercise price or strike price on the put option The call option is in the money if S gtXc The put option is in the money if S lt Xp An option has positive value to its owner before expiration The price or value of a call or put option has two components Intrinsic value and Time value Management of Risk Diversifying Hedging Insuring and Derivative Securities 164 Insurance pay a premium to protect against loss Value of Option Intrinsic value The amount the option is in the money and is the difference between the current price and the strike price of the option Time value Re ects expectations of an option s pro tability associated with exercising it at some future point in time

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