ADMS 3530 Notes PDF

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ADMS 3530 NOTES1, Jan 3-9, Ch - Goals and Governance of the Firm //Sections: 1; 1; 1; 1; 1; 1. 1 Investment and Financing decisions - The investment (capital budgeting decision) o The investment decision starts with the identification of investment opportunities often referred to as capital investme...

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ADMS 3530 NOTES 1, Jan 3-9, Ch.1 - Goals and Governance of the Firm //Sections: 1.1; 1.2; 1.3; 1.4; 1.5; 1.6 1.1 Investment and Financing decisions - The investment (capital budgeting decision) o The investment decision starts with the identification of investment opportunities often referred to as capital investment projects.  The finance manager has to help the firm identify promising projects and decide how much to invest in each project  The investment decision is also called the capital budgeting decision (because most firms prepare an annual budget listing authorized capital investments. - The financing decisions o The financial manager's second main: responsibility is to raise the money the firm needs for its investments and operations. This is the financing decision.  When a company needs to raise money, it can invite investors to put up cash in exchange for a share of future profits or it can promise to pay back the investors’ cash plus a fixed rate of interest.  In first case, the investors in this case are referred to as equity investors who contribute equity financing. In the second case the investors are lenders that is debt investors who one day have to be repaid  The choice between debt and equity financing is often called the capital structure decision o Figure 1.1, slide 10 in powerpoint distinguishes real from financial assets  Real assets are used to produce the firm’s products and services. They include tangible assets such as machinery, factories, and offices and intangible assets such as technical knowledge, trademarks, and patents.  Assets used to produce a good or service  The firm finances its investments in real assets by issuing financial assets to investors. A share of stock is a financial asset which has value as a claim on the firm’s real assets and the income that those assets will produce.  Claims to the income generated by real assets, also called “securities” 1.2 what is a corporation? o A public company has a lot of flexibility when raising financing. They can offer shares for sale to any and all investors.

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Access to information is crucial for making decisions on whether to buy or sell the shares of a public company o In In contrast, a private company, of which hundreds of thousands exist, cannot be freely traded among investors and do not raise money in the stock market.  Consequently, private companies are not required to provide much financial information, so little information is publicly available.  You cannot purchase the shares of these private companies, except by negotiation with existing owners. o A corporation is a permanent entity, legally distinct from ire turners, who are called shareholders or stockholders.  A corporation confers limited liability to its owners: shareholders cannot be held personally responsible for the corporation’s debts. o Why aren’t all businesses public?  One reason is the cost, in both time and money, of managing the corporation's legal machinery  Public corporations must pay stock exchanges for listing their shares and also must abide by the rules of stock exchanges, accounting standards, and securities laws.  There is also an important tax drawback to corporations. Because the corporation is a separate legal entity, it is taxed separately.  So corporations pay tax on their profits, and shareholders are taxed again when they receive dividends from the company or sell their shares at a profit. 1.3 other forms of businesses - A sole proprietorship is a business owned and operated by one individual. As the sole proprietor you bear all of the costs and keep all of the profits after the Canada Revenue Agency has taken its cut. o The advantages of a proprietorship are the ease with which it can be established and the lack of regulations governing it - Partnership: Business owned by two or more people who are personally responsible for all its liabilities. o Partners then pay personal income tax on their share of these profits. Both sole proprietorships and partnerships are flow-through entities because the businesses do not pay income tax on operating profits and do not have to file a tax return, unlike corporations. - Hybrid forms of business orgs o Another variation is the professional corporation (PC) which is commonly used by doctors lawyers, and accountants. In this case, the business has limited liability

and is taxed as a corporation, but the professionals can still be sued personally, for example for malpractice. 1.4 who is the financial manager? o In this book we will use the term financial manager to refer to anyone responsible for a significant corporate investment or financing decision. o But except there are managers who specialize in finance, and their functions are summarized in Figure 1.2. o The treasurer is usually the person most directly responsible for looking after the firm’s cash, raising new capital and maintaining relationships with banks and other investors who hold the firm's securities. o Larger corporation’s usually also have a controller, who prepares the financial statements, manages the firm’s internal accounting, and looks after its tax affairs. o The largest firms usually appoint a chief financial officer (CFO) to oversee both the treasurer’s and the controller’s work. 1.5 goals of the corporation - shareholders want managers to maximize market value o How can shareholders decide how to delegate decision making when they all have different tastes, wealth, time horizons, and personal opportunities? Delegation can work only If the shareholders have a common objective. o Fortunately there is a natural financial objective on which almost all shareholders can agree: to maximize the current value of their investment. o The term “maximize profits” is very broad:  Does this mean cut costs now to increase this years profit but can damage the corp years to come? o In a free economy, a firm is unlikely to survive if it pursues goals that reduce the firm’s value. o Ethics of maximizing profit  Some argue that they managers should blindly listen shareholder, other think they ought to do what they ought to do  By striving to enrich themselves and their shareholders businesspeople have to provide their customers with the products and services they truly desire.  Written rules and laws can help only so much. In business as in other dayto-day affairs.  There are also unwritten rules of behaviour, These work because everyone knows that such rules are in the general interest. But they are reinforced because good managers know that their firm's reputation is one of its most important assets and therefore

playing fair and keeping one’s word are simply good business practices.  Reputation is particularly important in finance. in financial transactions the other party may have more information than you and it is less easy to be sure of the quality of what you are buying. o Do managers really maximize firm value?  In most large public companies, the managers are not the owners and they might be tempted to act in ways not in the best interests of the owners.  Such problems can arise because the managers of the firm, who are hired as agents of the owners might have their own axes to grind. Therefor these conflicts are called agency problems. o Ethical disputes  Short selling  Investors who take a short position are betting that securities they do not own will fall in price. Often, they do this by borrowing the security and selling it in the hope that they will be able to buy it back cheaply.  Corporate raiders  They target companies whose assets can be profitably sold and redeployed.  Creative accounting  Shareholders like to see steady growth in earnings, and corporations try to provide it Sometimes when earnings look likely to fall short of expectations, corporations turn to creative accounting to solve the problem.  Tax avoidance  Stock options have also drawn the attention of securities regulators because of the practice of backdating, which occurs when the date on the options is not the actual date of the option grant but rather a date in the past when the stock price was lower.  Board of directors  The Sarbanes Oxley Act requires that corporations place more independent directors on the board, that is, more directors who are not managers or not affiliated with management. 

Specialist monitoring

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Managers are subject to the scrutiny of specialists. Their actions are monitored by the security analysts who advise investors to buy, hold, or sell the company’s shares.  Shareholder pressure  Disgruntled stockholders also take the Wall Street Walk' by selling out and moving on to other investments. This damages top management’s reputation and compensation. A large part of top managers’ paycheques comes from stock options which pay off if the stock price rises but are worthless if the price falls below a stated threshold. Week 2 Jan 10-16 Ch.5 – The Time Value of Money, Part 1 Sections 5.1; 5.2; 5.3 5.4 (to page 148) 5.1 Future Values and Compound Interest - Interest= interest rate * initial investment - Value of investment after 1 year= interest + initial investment - Value after 1 year= initial investment * (1+r) o NOTE: In general, for any interest rate, r, the value of the investment at the end of 1 year is (1+r) times the initial investment - Future value (FV): amount to which an investment will grow after earning interest o For an interest rate of “r” and a horizon of “t” years, the future value (FV) of your investment will be: o Future value of $100= 100 * (1+r)^t  (the power of t) - The interest income in your second year will be higher then your first; this is bc your earning interest on your interest which is called compounding or compound interest: interest earned on interest o This is contrasted by simple interest: interest earned only on the original investment, no interest is earned on interest

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The FV of any investment can be calculated with the FV formula. The formula for the FV of “I” dollars at r% interest per period for “t” periods is o FV of $I investment= I * (1 + r)^t 5.2 Present Values

o Financial managers male the same point when they say that money in hand today has a time value of perhaps when they quote the most basic financial principal, that a dollar today is worth more than a dollar tomorrow o How much do we need to invest today to make $106? This is called present value (PV): value today of a future cash flow FV o PV= (1+r ) Future value after t periods o PV= t (1+r ) o Discount rate: interest rate used to compute present values of future cash flows  To calculate PV, we discounted the future value at the interest rate r payment∗1 o PV can also be written: future t (1+r ) 1  is called the discount factor or present value interest factor t (1+r ) (PVIF (r,t): present value of a $1 future payment

o EXAMPLE OF THIS EQUATION

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Finding the interest rate o This simply means solve for “r”, and once you do this you get your interest rate 5.3 Multiple Cash Flows - Most real world investments involve many different cash flows, hence you’ll here businesspeople refer to a stream of cash flows 5.4 Level cash flows: perpetuities and annuities o Annuity: equally spaced and level stream of cash flows o Perpetuity: stream of level cash payments that never ends - How to value perpetuities  Cash payment from perpetuity= interest rate * present value  OR: C=r∗ PV o This formula can be rearranged to derive the present value of a perpetuity: C cash payment  PV of perpetutiy= = r interest rate

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How to value annuities o

o The expression in square brackets shows the present value of t-year annuity of $1 a year. It is generally known as the t-year annuity factor: present value of a $1 annuity; it can be written as PVA(r,t) o

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Annuity due: level stream of cash flows starting immediately o The present value of an annuity due in t payments of $1 per period is the same as $1 plus the present value of an ordinary annuity providing the remaining t – 1 payments. o The present value of an annuity due of $1 for t periods, PVAD (r, t) is therefore

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future value of an annuity o EX: you set aside $3000 at the end of every year to buy a car, interest is 8% o The sum of the future value is:

o present value of this 4-year annuity is

o the general formula for the future value of a stream of cash flows of $1 per year for each of t years, FVA (r, t) is,

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cash flows growing at a constant rate- variations on perpetuities and annuities

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C1: the payment to occur at the end of the first period R: discount rate G: growth rate for the payments  If “g” is zero, the formula become the familiar perpetuity formula, C/r o Growing perpetuity: an infinite stream of cash flows growing at a constant rate

o the variables have the same meaning as the formula above o if g is zero, this becomes the familiar annuity formula o growing annuity: a finite stream of cash flows growing 3 Jan 17-23

Ch.5 – The Time Value of Money, Part 2 Sections: 5.4; 5.5; 5.6

5.5 Inflation and the time value of money - real versus nominal cash flows o inflation: rate at which prices as a whole are increasing  CPI index in 1950= 100, index in 2003 was 821, meaning prices increased by 8.21 times  1970 index was 162, 2012 index was 974, (947/162)= 6.01 so prices increased by 6.01 times o real value of $1: purchasing-power-adjusted value of a dollar - inflation and interest rates o nominal interest rate: rate at which money invested grows

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when quoted a interest rate, it’s a nominal rate not a real rate (meaning there’s no offset for future inflation)

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o Real interest rate: rate at which the purchasing power of an investment increases 

o The real interest rate approx. equals the difference between the nominal rate and the inflation rate  -

Valuing real cash payments o You can find the PV of money in 1 years time (if you know the nominal interest rate) by using the basic PV formula

 o You get exactly the same result if you discount the real payment by the real interest rate

5.6 effective annual interest rates

o If an interest rate is quoted as a certain percentage per month, then we must define the number of periods in our future value calculation as a number of months o Effective annual interest rate (EAR): interest rate that is annualized using compounded interest 

o When comparing interest rates, it is best to use effective annual rates, this compares interest paid or received over a common period (1 year) o Lending laws in Canada require that rates be annualized in this manner, such a rate is called annual percentage rates (APR): interest rate that is annualized using simple interest  Step 1: take the apr and divide by the number of compounding periods in a year to recover the rate per period actually charged 

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Step 2: now convert to an annually compounded interest rate 

o SIMPLIFIED FORMULA

 4 Jan 24- 30

Ch.6 – Valuing Bonds Sections: 6.1; 6.2; 6.3; 6.4; 6.5; 6.6; 6.7 Ch.14 – Introduction To Corporate Financing and Governance Sections: 14.4; 14.5

Ch. 6 Valuing bonds - when companies issue bonds, they promise to make a series of fixed interest payments and then repay the debt . o bond valuation involves straight forward time-value-of-money valuation o however there is some risk of defaulting on a bond 6.1 bonds and the bond market

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bonds: securities that obligate the issuers to make specified payments to the bondholder o the money governments or companies collect when bonds are issued is the same amount of the debt. As borrowers, they promise to make a series of interest payments and then repay the debt at the maturity date o coupon: the interest payment paid to the bondholders o at maturity, the debt is repaid, when the borrower pays the bond’s face value: payment at the maturity of the bond. Also called par value or maturity value when you buy a bond, you pay more than the ask price if you do not happen to buy the bond on a coupon payment date o the reason is that the buyer has to compensate the seller for the coupon interest earned from the last coupon payment to the settlement date, the date when the buyer must pay for the bond o this extra payment is called accrued interest o

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Bonds are typically quoted without the accrued interest: coupon interest earned from the last coupon payment to the purchase date of the bond  Such a price is known as the clean price: bond price excluding accrued interest  This contrasts dirty price: bond price including accrued interest 6.2 interest rates and bond prices - Bond prices are usually expressed as a percentage of their face value o 1.25% Canada bond is worth 102.348% of face value, price would be quoted -

102.348% Bonds are a package of 2 investments  1) provides a level stream of coupon payments of $12.5 a year for each of the 3 years  2) the final repayment of the 1000$ face value o Use the annuity formula to value coupon payments and then add on the present value of the final payment of face value

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As interest rates change, so do bond prices. o Ex: suppose investors demand interest rate of 1.25% of govt bond. What would be the price of the Canada 1.25s of 2018, paying annual coupons? 

o When the cash flows are discounted at a rate that is higher than the bond’s coupon rate, the bond is worth less than its face value. When a market interest rate rises, the present value of the payments to be received by the bondholder falls, and bond prices fall. Conversely, declines in the interest rate increase the present value of those payments and result in higher bond prices

6.3 current yield and yield to maturity - For bonds priced at face value the answer is easy, the rate of return is the coupon rate o

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EX: market price of a 3 year bond is $1,136.16

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o 100/ 1,136.16= 0.088 or 8.8%  this is sometimes called the bond’s current yield: annual coupon payment divided by current bond prices o A price decline (that is, a capital loss) of $136.16 is guaranteed, so the overall return over the next 3 years must be less than the 8.8% current yield Bond types o Premium bonds: bonds that sells for more then its face value  An investor who buys a bond at a premium face a capital loss over the life of the bond so the current is always less than the current yield o Discount bonds: bonds that sells for less than its face value We need a measure of return that takes account of both current yield and the change in a bond’s value over its life o Yield to maturity: interest rate for which the present value of the bond’s payments equals the price o ex: 3 year bond, the yield to maturity is the coupon rate, 10% 

o Ex: 3 year bond for 1136.16, yield of maturity is only 5%. At that discount rate, the bond’s present value equals its actual market value, 1136.16: 

6.4 bond rates of return

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o Rate of return: total income per period per dollar invested Is there any connection between yield of maturity and the rate of return during a particular period? o Yes, if the bond’s yield to maturity remains unchanged during the investment period, its rate of return will equal that yield o Ex: yield on that 5.5% Canada bond stays at 3%; when bond matures in 4 years the value is: 

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Your total profit is $55 + (1092.93 – 1114.49)= 33.44 The return on your investment is therefore 33.44/ 1114.49 = 3% just equal to the yield of maturity Taxes and rates of returns

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Multiperiod rates of return o

6.5 the yield curve o Note that the longer the maturity, the slightly higher the yield. Sometimes long term bonds o...