FIN-365 Business Finance PDF

Preview

Summary

Notes from the book and lectures...

Description

Business Finance

Chapter 18 Exchange rate: the price of one currency in terms of another Cross-Rate: implicit exchange rate between two currencies when both are quoted in a third (usually dollars) American Depositary Receipt (ADR): security issued in U.S. representing shares of foreign stocks can be traded in the U.S.

Types of Bonds Eurobond bond issued in multiple countries but denominated in the issuer’s home currency Foreign Bonds sold by foreign borrower denominated in a currency of the country of issue Eurocurrency (Eurodollars) money deposited in a financial center outside the country of the currency involved “Eurodollars”= dollar-denominated deposits in banks outside the U.S. banking system LIBOR: rate that international banks charge one another for loan in the London Market Swaps interest rate swap: two parties exchange a floating-rate payment for a fixed-rate payment currency swap: agreement to deliver one currency in exchange for another

Global Capital Markets number of exchanges in foreign countries continues to increase, as does the liquidity on those exchanges

exchanges facilitate the flow of capital extremely important to developing countries differences: market structure regulation trading values United States has the most developed capital market in the world, but: foreign markets becoming more competitive often more willing to innovate FOREX Trading foreign exchange largest financial markets in the world trading = 24/7 over-the-counter most trading in USD, euros, yen, and pounds FOREX quotations direct= USD per foreign currency indirect= units of foreign currency per USD

Exchange Rates the price of one country’s currency in terms of another Direct Quotation: price of foreign currency expressed in U.S. dollars (dollars per currency) Indirect Quotation: the amount of a foreign currency required to buy one U.S. dollar (currency per dollar) Forward and Spot Rates types of contracts traded in FX markets spot: outright exchange of one currency at the current market price with a twoday settlement date the exchange involves bank deposits future transactions: swaps, forward contract derivatives: futures and options Spot rate (S) the exchange rate for an immediate trade Forward Rate (F) the exchange rate specified today in a forward contract to exchange currency at some future date normally reported as indirect quotations

The forward rate at a discount to the spot rate F < S -> Foreign currency selling at a discount look at slide

Theories of Exchange Rate Determination how does the exchange rate market determine what the exchange rate will be? many theories, but we will limit ourselves to: the monetary approach: based upon purchasing power parity the asset approach: based upon interest rate parity parity conditions can be thought of as international financial “benchmarks” or “breakeven values” because parity conditions are heavily based on arbitrage (possibility of diskless investment), a violation of parity often implies that a profit opportunity or cost advantage is available to the decision-maker exchange rate is the price of money in terms of money The Law of One Price and Purchasing Power Parity assume: no transactions costs, no barriers to trade, frictionless markets (perfect information), identical goods in each location then, prices must be equal in all locations for any good when express in a common currency else there would be an arbitrage opportunity from buying low and selling high Absolute Purchasing Power Parity price of an item is the same regardless of the currency used to purchase it or where it is selling (an extension of the “law of price” to all goods in an economy) Absolute PPP rarely holds in practice (only in the very long run) If you make more in Dollars than Euros, borrow in Euros and invest in Dollars Economic vs. Translation Risk Translation or Accounting exposure: effects of exchange rate changes on a firm in terms of accounting data Economic risk: effects of exchange rate changes on cash flows transaction risk: exposure of known flows (contractual exposure– short term exposure)

economic risk: possible exposure on future cash flow (non-contractual exposure– long-term exposure) Transaction Risk– more likely to happen in the short-run risk from day-to-day fluctuations in exchange rates and the fact that companies have contracts to buy and sell goods in the short-run at fixed prices Economic Risk– more likely to happen in the long-run economic risk concerns the effect of exchange rate changes on revenues (domestic sales and exports) and operating expenses (cost of domestic inputs and imports) managing risk: more difficult to hedge try to match long-run inflows and outflows in the currency borrowing in the foreign country may mitigate some of the problems Managing Exchange Rate Risk

Political Risk changes in value due to political actions in the foreign country investment in countries that have unstable governments should require high returns extent of political risk depends on the nature of the business the more dependent the business is on the other operations within the firms, the less variable it is to others (i.e. less likely to be nationalized) natural resource development with a lot of the ground work done is more likely to be nationalized local financing can often educe political risk

Efficient Market Hypothesis

systematic risk comes from the volatility of the entire economy

Chapter 12 Map Cost of Capital Basics the cost to a firm for capital funding = the return the providers of those funds the return on assets depends on the risk of those assets a firm’s cost of capital indicates how the market views the risk of the firm’s assets a firm must earn at least the required return to compensate investors for the financing they have provided the required return is the same as the appropriate discount rate we will use cost of capital, required return or appropriate discount rate interchangeably because they all mean the same thing the key lesson is that the cost of capital depends on the use of future risk of the investment… Financial Policy and Cost of Capital managers choose the mixture of debt and equity to employ i.e. the firm’s capital structure in this chapter we will assume that the firm’s financial policy is given i.e. the firm has a fixed debt-to-equity ratio (reflects the firm’s target capital structure) target capital structure: the mix of debt, preferred stocks and common equity the firm plans to raise to fund its future projects Cost of Equity the cost of equity is the return required by equity investors given the risk of cash flows from the firm two major methods for determining the cost of equity dividend growth model SML or CAPM The SML Approach use the following information to compute the cost of equity risk free rate, Rf market risk premium, E(Rm)-RF systematic risk of asset, Beta

Chapter 11: Risk and Return Map standard deviation is a measure of risk prices change because of surprises systematic risk=“non-diversifiable risk”=market risk unsystematic risk=diversifiable risk=unique risk=asset-specific risk market risk for individual risk securities is measured by a stock’s beta coefficient beta cash income selling –> capital gains stock value = PV of Dividends D grows out of constant rate G Estimating Dividends: Special Cases Constant dividend/Zero Growth Constant dividend growth Supernormal growth

Valuation using Multiples for stocks that don’t pay dividends (or have erratic dividend growth rates), we can value them using the price-earnings (PE) ratio and/or the price-sales ratio: Price at time t = Pt =Benchmark PE Ratio x Earnings per share, PE fo similar companies, own historical values Price at time t = Pt =Benchmark price-sales ratio x Sales per share the price-sales ratio can be especially useful when earnings are negative When growing at a constant rate, capital gains yield equals the dividend growth rate

If a firm pays a constant annual dividend, capital gains yield must equal zero

Chapter 6: Bonds Map lower interest rate is lower risk less risk means lower return bond indenture (or Deed of Trust): contract between issuing company and bondholders includes: basic terms of bonds total amount of bonds issued Secured versus Unsecured sinking fund provision Bond Classification Registered vs. bearer bonds the registrar of a company records who owns each bond Security collateral: secured by financial securities mortgage: secured by real property, normally land or buildings debentures: unsecured notes: unsecured debt with original maturity less than 10 years Seniority: position over other lenders Senior vs Junior, Subordinated more Senior debt usually has lower interest rates Call Provision agreement giving the issuer the option to buy back bond at a pre-specified price prior to maturity call premium: the amount by which the call price exceeds the par value of the bond deferred call provision: call provision prohibiting the company to redeeming the bond prior to a certain date (the bond is said to be call protected)

yield to call: the yield until the bond can be called back

Protective Covenant limits certain a actions that the company might otherwise wish to take during the term of the loan negative covenant (prohibits): limit the amount of dividends, assets cannot be pledged to other lenders, no merger, no sell of major assets without approval, firm cannot issue other LT debt positive covenant (encouraged) maintain working capital at or above some minimum, periodically furnish financial statements to the lender, maintain collateral in good condition Bond Ratings– Investment Quality High Grade Moody’s Aaa and S&P AAA – capacity to pay is extremely strong Moody’s Aa and S&P AA4– capacity to pay is very strong Medium Grade Moody’s A and S&P A – capacity to pay is… Low Grade Ba, B, Aaa, and C BB, B, CCC, CC considered speculative with respect to capacity to pay Very Low Grade C and C– income bonds with no interest being paid D and D– in default with principal and interest arrears Types of Bonds Municipal Securities debt of state and local government varying degrees of default risk, rated similar to corporate debt interest received is tax-exempt at the federal level interest usually exempt from state tat\x in issuing state Treasury Securities = Federal Government Debt Treasury Bill oure discount original maturity of one year or less Treasury Notes coupon debt original maturity between one and ten years Treasury Bonds coupon debt original maturity greater than ten years

Zero Coupon Bonds make no periodic interest payments (Coupon Rate = 0%) entire YTM comes form the difference between the purchase price and the par value (capital gains) cannot sell for more than par value sometimes called zeroes, or deep discount bonds T-Bills and U.S. Savings bonds are good examples of zeroes Floating Rate Bonds coupon rate floats depending on some index value ex.) adjustable rate mortgages and inflation-linked Treasuries less interest rate risk with floating bonds coupon floats, so is less likely to differ substantially from the YTM coupons may have a “collar”: the rate cannot go above a specified “ceiling” or below a specified “floor” Other Bond Types Structured Notes: payoffs derived from the performance of one or more underlying assets Put Bonds: allows the holder to force the issuer to buy the bond back at a stated price Convertible Bonds: bond can be swapped for a fixed number of shares of stock Many types of provisions can be added to a bond Bond Markets primarily over-the-counter transactions with dealers connected electronically extremely large number of bond issues, but generally…

Quoted Price vs Invoice Price quoted bond prices = “clean” price net of accrued interest invoice price = “dirty” or “full” price price actually paid includes accrued interest accrued interest interest earned since last coupon payment is owed to bond seller at time of sale

Inflation and Interest Rates real rate of interest =change in purchasing power nominal rate of interest =quoted rate of interest, =change in purchasing power and inflation the ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation

The Fisher Effect the fisher effect defines the relationship between real rates, nominal rates, and inflation (1 + R) = (1 + r)(1 + h) R= nominal rate (quoted rate) r= real rate h= expected inflation rate approximation: R = r + h Risk Structure of Interest Rates examines why bonds with same term to maturity have different interest rates – risk structure of interest rate Term Structure of Interest Rates term structure: the relationship between time to maturity and yields, all else equal the effect of default risk, different coupons, etc. has been removed so, it tells us what nominal interest rates are on default-free, pure discount bonds of all maturities yield curve: graphical representation of the term structure normal= upward sloping inverted= downward sloping What determines the shape of the term structure: 1. real interest rate reflects the pure time value of money after adjusting for the effects of inflation doesn’t determine the shape of the term structure but rather the overall of interest rates 2. expected future inflation the prospect of future strongly influences the shape when investors lend money for longer periods they recognize that inflation

erodes the purchasing power and demands to be compensated (inflation premium) 3. interest risk premium the longer the maturity the longer the interest rate risk – investors want to be compensated (interest rate risk premium) Summary: Factors that affect the required return – summary bond yields represent the combined effect of no fewer than six things real interest rate default risk premium – bond ratings taxability premium – municipal versus taxable liquidity premium – bonds that have more frequent trading will generally have lower required returns expected future inflation interest rate risk premium

Chapter 5: Discounted Cash Flow Valuation Map Net Present Value: NPV= CF0 + CF1/(1+r) + CF2/(1+r)2

Annuity: finite series of equal payments that occur at regular intervals ordinary annuity:if the first payment occurs at the end of the period annuity due: if the first payment occurs at the beginning of the period PV= PMT [(1- (1/1+r)t)/r] FV= PMT [((1+r)t-1)/r] perpetuity: infinite series of equal payments PV= PMT/ r Quoted (stated) interest rate: the interest rate expressed in terms of the interest payment made each period

APR: the interest charges per period multiplied by the number of periods per year effective annual rate: the interest expressed as if it were compounded once per year can be used to compare loans with different compounding periods EAR= (1 + r/m)m – 1 r= stated annual interest rate m= compounding periods

Chapter 4: Introduction to Valuation: The Time Value of Money Map Future Value and Compounding Future Value:The amount an investment is worth after one or more periods the cash value of an investment in the future

Future Value= $1 x (1 + r)t Future Value Interest Factor= (1 + r)t

Present Value and Discounting Present Value:The current value of future cash flows discounted at the appropriate discount rate Discount:Calculation of the present value of some future amount PV= $1 x [1/(1 x r)] = $1/(1 + r)

for multiple periods, PV= $1 x [1/(1 x r)t] = $1/(1 + r)t discount rate:The rate used to calculate the present value of future cash flows Discounted Cash Flow (DCF) Valuation:(a) Calculating the present value of a future cash flow to determine its value today. (b) The process of valuing an investment by discounting its future cash flows More on Present and Future Values Present Value vs Future Value Basic Present Value Equation:

Determining the Discount Rate PV= Ft/(1 + r)t

Finding the Number of Periods

Timelines

Chapter 3: Working with Financial Statements

Map Standardized Financial Statements common-size statements:A standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales Common-Size Balance Sheets the total change has to be zero because the beginning and ending numbers must add up to 100 percent

Common-Size Income Statements

Ratio Analysis financial ratios:Relationships determined from a firm's financial information and used for comparison purposes financial ratios are typically grouped into these categories: short-term solvency, or liquidity, ratios long-term solvency, or financial leverage, ratios asset management, or turnover, ratios profitability ratios market value ratios Short-Term Solvency, or Liquidity, Measures provides information about a firm’s liquidity primary concern is the ability of the firm to pay its bills over the short-run with undue stress current ratio=current assets/ current liabilities ex.) 1.31 means a firm has $1.31 in current assets for every dollar of current liabilities, or you could also say firm has its current liabilities covered 1.31 times over for short-term creditors (such as a supplier), the higher the current ratio the better quick (or acid test) ratio= (current assets – inventory)/current liabilities cash ratio= cash / current liabilities Long-Term Solvency Measures intended to address a firm’s long-run ability to meet its obligations, or, more generally, its financial leverage total debt is total assets – total equity total debt ratio= (total assets - total equity) / total assets ex.) a .28 times total debt ratio means that a firm uses 28% debt. Or, $.28 in debt for every $1 in total assets, meaning there is $.72 (1-.28) in equity for every $.28 in debt variations:

debt-equity ratio= total debt / total equity equity multiplier= total assets / total equity or,1 + debt-equity ratio anall equity firm (firm with no debt) has an equity multiplier of 1 times interest earned= EBIT / Interest cash coverage= (EBIT + Depreciation) / Interest Asset Management, or Turnover, Measures aka asset utilization ratios describe how efficiently, or intensively, a firm uses its assets to generate sales inventory turnover= COGS / inventory the higher the ratio, the more efficiently a firm is managing inventory, as long as the firm doesn’t run out of inventory and therebyforego sales days’ sales in inventory= 365 days / inventory turnover how long it took a firm to turnover its inventory on average receivables turnover and days’ sales in receivables= sales / accounts receivables how fast firm collects on sales days’ sales in receivables (average collection period)= 365 / receivables turnovers total asset turnover=sales / total assets ex.) .64 means for every dollar in assets, a firm generates $.64 in sales Profitability Measures profit margin= net income / sales return on assets (ROA)= net income / total assets how efficiently a firm uses its assets return on equity (ROE)= net income / total equity Market Value Measures earnings per share (EPS)= net income / shares outstanding price earnings (PE) ratio= price per share / earnings per share how much investors are willing to per for $1 of earnings market-to-book ratio= price per share / book value per share book value per share= total equity / shares outstanding DuPont Analysis The DuPont Identity ROE= net income / total equity basic formula ROE= PM x TAT x EM= (Net income/ Sales) x (sales / total assets) x (total assets / total equity)= net income / total equity DuPont Identity profit margin (PM)= net income / sales totalasset turnover (asset use) (TAT)= sales / total assets

equity multiplier (leverage) (EM)= total assets / total equity The DuPont System shows the relationships among the profitability ratios, asset management, and debt management ROE= PM x TAT x EM profit margin: measures firm’s operating efficiency how well it controls costs total asset turnover: measures the firm’s asset use efficiency how well it manages assets equity multiplier: measures the firm’s financial leverage EM= TA / TE = 1 + DE ratio Internal and Sustainable Growth Payout and Retention Ratios divid...