FINC201 Week 1-12 Lecture Notes PDF

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Lecture 1 Finance = art and science of managing money Finance is concerned with transfer of money among individuals, business and governments.Real v Financial assets: - Real assets used to produce goods and services e. factories and machineries - Financial assets (e. stock) have financial claims to ...

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Lecture 1 Finance = art and science of managing money Finance is concerned with transfer of money among individuals, business and governments. Real v Financial assets: - Real assets used to produce goods and services e.g. factories and machineries - Financial assets (e.g. stock) have financial claims to the income generated by the firm’s real assets Goal of firm: to maximise shareholder wealth Investments and Financing decisions: To carry on business, a corporation needs an almost endless variety of assets - Tangible assets such as plant and machinery - Intangible assets such as brand names and patents Corporations finance these assets by: - Borrowing - Reinvesting profits back into the firm - Selling additional shares to the firm’s shareholders Financial managers therefore, face broad questions: 1. What investments should the corporation make? 2. How should it pay for these investments?

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The firm and financial markets: Financial market: where securities are issued and traded - Primary market: market for the sale of new securities by corporations - Secondary market: market in which previously issued securities are traded amongst investors The relationship between institutions and markets: - Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. - Transactions in short term marketable securities take place in the money market - Transactions in long term securities are in capital mkt Bonds - long term debt instruments used by businesses and govt to raise large sums of money (interest payment) Common Stock - represents units of ownership interest or equity in a corporation (dividend) Preferred stock - A special form of ownership that has features of both a bond and common stock (dividend) Agency Problems Managers are agents for stockholders and are tempted to act in their own interests rather than maximising value. - Board of directors to separate ownership and control but can lead to board of directors and managers to act in their own interests rather than in the interest of shareholders.

Lecture 2 Financial Statements 1. Balance Sheet A note to shareholder’s equity Issued Shares - Shares that have been issued by the company Outstanding Shares - Shares that have been issued by the company and held by investors Treasury Stock - Stock that has been repurchased by the company and held in its treasury = number of shares issued - number of shares outstanding Firm has 1,000,000 Authorized Shares, 500,000 Issued Shares, Repurchase 100,000 Treasury Stock = 400,000 Shares Outstanding Common Size Balance Sheet: All items in the balance sheet are expressed as a percentage of total assets Market Value v Book Value Book value = value of assets or liabilities in balance sheet determined by: - IFRS - Backward looking - Assets: Purchase less depn - Equity: how much capital the firm has raised from shareholders in past Market value = the value of assets/liabilities were they to be resold in the mkt - Forward looking - Current mkt values - Assets: value of assets in mkt - Equity: value of future dividends that shareholders expect to receive - MV of equity = market price*number of shares outstanding Equity and assets mkt values are usually higher than book values Assets - Liabilities = Equity Shares/Bonds - From external sourcing Retained Earnings - Internal sourcing option

The Income Statement - Earnings Before Interest and Tax (EBIT) - EBIT = total revenues + other income - costs - depreciation Cash flow and Net income are not the same because: 1. Depreciation. In finance the cash flow is negative the day machinery is bought. In accounting, it is depreciated accordingly each year (annual non-cash expense). Finance is concerned with CASH FLOWS and MARKET VALUES Net working capital (NWC)=CA-CL Lecture 3 Measuring Corporate Performance using Profitability, Eciency, Financial leverage, Liquidity.

Market Capitalization - Total mkt value of equity, equal to share price times number of shares outstanding = (#shares) x (price per share) Market value added - The di between mkt value of the firm’s shares (todays value) and the amount of money that shareholders have invested in the firn. - MVA = market capitalization - equitybook value - Example: a firm’s total shareholder’s equity from the balance sheet is $9.322 billion, it has 1.307 billion shares outstanding and the price per share is $114.75, what is the firms MVA? Market capitalization = shares x price per share = 1.307bil x $114.75 = $149.978bill MVA = 149.978bil - 9.322bil = $140.656bil - The firms shareholders contributed about $9.3bil and ended up with shares worth almost $150bil. They have accumulated $140.7bil in MVA. Market to book ratio - Ratio of mkt value of equity to book value of equity - = mkt value of equity/book value of equity - From above example: $149.978bil/$9.322bil = 16.1 times - The firm has multiplied the value of its shareholders’ investment 16.1 times Economic value added (EVA) ● Not all the time mkt values are available - Private companies are not traded (no price) - Mkt values of divisions or plans that are part of larger companies are not observable ● So we use accounting measures of profitability ● Economic value added (EVA) - Net income minus a charge for the cost of capital employed; also called residual income ● Residual Income - Net dollar return after deducting the cost of capital EVA = Net income cost of capital ($) = After tax operating income - (cost of capital rate x total capitalization) After tax operating income = (1-tax rate) x interest expense + net income Total capitalization = long term debt + shareholder’s equity Accounting rate of returns - EVA measures how many dollars a business is earning after deducting the cost of capital - Sometimes we compare the performances of the manager of a small firm with a large firm - Therefore it is helpful to measure the firm’s profit per dollar of assets - The three common profitability measures are 1. Return on capital (ROC) = after-tax operating income/total capitalization 2. Return on assets (ROA) = after-tax operating income/total assets 3. Return on equity (ROE) = net income/equity Measuring eciency 1) Asset turnover ratio - How much sales are generated by each dollar of total assets, therefore it measures how hard the firm’s assets are working Asset turnover ratio = Sales / total assets at start of year = each $1 of assets.... 2) Inventory turnover - ecient firms don’t tie up more capital than they need in raw materials and finished goods Inventory turnover = COGS/inventory at start of year = how many times a company sold its total average inventory dollar amount during the year Average days in inventory = Inventory at start of year/COGS/365 = the firm has sucient inventories to maintain operations for X days 3) Receivables Turnover - measures the firm’s sales as a multiple of its receivables. A high ratio indicates an ecient credit dept. Receivables Turnover = sales/receivables at start of year Average collection period = receivables at start of year/average daily sales

Measuring Financial Leverage - Shareholder value depends not only on good investment decisions and profitable operations, but also on sound financing decisions. - Because debt increases returns to shareholders in good times and reduce them in bad times, it is said to create financial leverage. - Leverage ratios measure how much financial leverage the firm has taken on. 1) Debt ratio Long-term debt ratio = long-term debt/long-term debt + equity - X cents of every dollar of long term capital is in the form of debt. Long-term debt-equity ratio = long-term debt/equity Total debt ratio = total liabilities/total assets 2) Times interest earned - the extent to which interest obligations are covered by earnings. EBIT=Earnings before interest and taxes. Times interest earned = EBIT/interest payments Cash coverage ratio = EBIT + Depn/interest payments Measuring Liquidity - If you are extending credit to a customer or making a short-term bank loan, you are interested in more than the borrower’s financial leverage - You want to know whether the company can lay its hands on the cash to repay you - That is why credit analysts and bankers look at several measures of liquidity - Liquid assets can be converted into cash quickly and cheaply. Current Ratio = current assets/current liabilities Quick Ratio = cash+marketable securities+receivables/CL Cash Ratio = Cash + marketable securities/CL Interpreting financial ratios - In some cases there may be a natural benchmark e.g. if a firm has a negative value added or a return on capital that is less than the cost of that capital, it is not creating wealth for its shareholders. - For some of the ratios there is no right level and vary from year to year and industry to industry. Lecture 4 Time value of money - value of one dollar today is more than the value of the same dollar received in the future Future value = amount to which an investment will grow after earning interest Compound interest = interest earned on interest Simple interest = interest earned only on the original investment One period timeline - FV=PVx(1+r) Multiple period timeline = FV=PVx(1+r)t Discounted cash flow - PV=FVx1 / (1+r)t

Annuities applications - Values of pmts - Implied interest rate for an annuity - Calc. of periodic pmts

Solving problems: 1. Draw timeline 2. Determine what we’re trying to find - What do you need to know? - What info do you have? - How can you get what you need to know from what you have? Lecture 5 Other types of TVM Problems - Time for funds to accumulate - Compounding periods - Implied interest rates - Eective interest rates Periodic Interest rate (rPER) Annual percentage rate (APR) Eective annual interest rate (EAR)

APR: Period rates are annualized by multiplying the rate by the number of compounding periods per year. Periods per year (m) must be given. APR does not take compounding into account.

EAR: Interest rate that is being earned, considering compound interest. Only used to compare opportunities with dierent compounding.

Compounding is the process in which an asset’s earnings are reinvested to generate additional earnings over time. Continuous compounding = FV = C0 x er*t Amortization schedule - complete table of periodic loan payments, showing the amount of principal and the amount of interest that comprise each payment until the loan is paid o at the end of the term. Inflation - sustained increase in general price level of g+s In economy over period of time Nominal interest rate - rate before taking inflation into account - quoted on bonds and loans Real interest rate - rate takes inflation into account and gives real rate of bond and loan. Real=Nominal-Inflation

For discounting and compounding - be consistent e.g. if rate is real then $ should be in real terms too Lecture 7 Bond valuation - determination of the fair price of a bond Bond - long term debt instruments that obligates the issuer to make specified payments to the bondholder. Key features of a bond - Face value (par value or principal value) - payment at the maturity of the bond - Coupon payment (cpn) - the interest pmts made to the bondholder (dollar amount) - Coupon rate - annual interest pmt as a percentage of face value - Fixed - Maturity date (t or n) - years until bond must be repaid - Issue date - when the bond was issued - Yield to maturity (YTM or rd) - rate of return earned on bond each year if the bond is held until maturity (also called “the promise yield). WARNING: coupon rate is NOT discount rate. CR tells us what cash flow the bond will produce.

Lecture 8 - tue mar 9 1pm Coupon payment = coupon rate x face value For semi annual bonds CP=CRxFace/2 Inflation index bond - Zero coupon bond - Level coupon bond Valuation - what indicates the value (price) of an asset? = the earnings (cash flows) generated by asset in future Basic Valuation r = the return investors consider appropriate for holding such an asset - usually called required return - should reflect opportunity cost of capital Valuation of Bonds and Stock First principles - value of financial securities = PV of expected future cash flows To value bonds and stocks we need to: ● Estimate future cash flows: - Size (how much) - Timing (when) ● Discount future cash flows at an appropriate rate - The rate should be appropriate to the risk of alternative opportunities in the marketplace Bond pricing (valuation) Value of a bond is based on PV of: - Stream of Coupon Payments (CP) - Principal repayment at maturity - Principal generally refers to bond’s face value or par value - if not given - assume face value =$1000 -

The price of a bond is the present value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return

Two types of bonds: 1. Pure discount (zero-coupon) bonds - pay no interest but the value of bond is smaller than face value 2. Level coupon bond (fixed coupon)

Changes in bond values over time - If the mkt rate (rd) associated with a bond, equals the coupon rate of interest, the bond will sell (face value) at its par value - At time of issue cpn rate = YTM = rd - If interest rates in the economy fall after the bonds are issued, rd is below the cpn rate. So interest payments are high and the price will rise. - An increase in interest rates will cause the price of an outstanding bond to fall - The mkt value of a bond will always approach its par value as its maturity date approaches, if the firm does not go bankrupt Premium bonds sell more than par value - corporation pays more than what the market is paying - CR > YTM Discount bonds sell less than par value - corporation pays less than what the market is paying CR < YTM Lecture 9 Bond concepts Bond prices and market interest rates move in opposite directions - cpn rate = YTM, price = par value Q: What if interest pmts were semi-annual cpns instead of annual cpn pmts? Multiply years by 2, Divide rate by 2, Divide annual cpn by 2 Time periods - Paying coupons twice a year, instead of once doubles the total number of cash flows to be discounted in the PV formula Discount rate - Since the time periods are now half years, the discount rate is also changed from the annual rate to the half year rate. Yield - refers to earnings generated on an investment over a particular period of time, and is expressed in terms of percentage based on invested amount or on the market/face value Current yield = Annual C.P./Bond price Bond rates of return - Rate of return - total income per period per dollar invested Common stock Common stockholders are true owners of the firm As residual owners, common stockholders receive what is left after all other claims on the firms income and assets have been satisfied. Because of uncertain position, common stockholders expect compensation with adequate dividends and capital gains. - Authorized shares are the no. of shares of common stock that a firm’s corporate charter allows. - Outstanding shares are the no. of shares of common stock held by the public. - Treasury stock is the no. of outstanding shares that have been purchased by the firm. - Issued shares are the no. of shares that have been put into circulation and includes both outstanding shares and treasury stock. Preferred stock - Equity instrument that usually pays a fixed dividend and has a prior claim on the firm’s earnings and assets in case of liquidation. The dividend is expressed as dollar amount or percentage of par value.

Stocks and Stock mkt - Bid price - prices at which investors are willing to buy shares - Ask price - prices at which current shareholders are willing to sell their shares Market order = instruction to broker to execute trade at best available price Valuing common stocks - Intrinsic value - Returns - Dividend discount model - Valuation by comparables - ratios - multiples Basic valuation - price of an asset is the PV of all generated cash flows by that asset ● Intrinsic value/fair value - PV of firm’s expected future net cash flows discounted by ROR. Based on analysis of variables such as earnings, growth etc. Market price - Consensus value of all potential traders. Actual price observed in mkt. Can be driven by variables but also by emotions e.g. greed, fear. Discount cash flows from the stock - dividends - stock price at time investor sells their shares. What is the discount rate? - OCC - ROR - Return an investor can earn elsewhere in an investment with the same risk Returns - ROR (OCC) is minimum ROR on a common stock that stockholders consider acceptable, given its riskiness and returns available on other investments - Actual rate of return is the actual rate of return on a common stock that stockholders actually receive. Can be greater or less than the expected return. - Expected return = r = Div1 + P1 - P0/P0 so r=profit/initial investment OR Dividend yield (Div1/P0) + Capital gain (P1-P0/P0) - capital gain yield is also = g (growth rate) Lecture 11 Simplifying the dividend discount model 1. No (zero) growth DDM - assumes a common stock whose future dividends are not expected to grow at all - Perpetuity so P0 = D/r 2. Constant-growth DDM - dividends grow at constant rate - growing perpetuity = P0 = Div1/r-g 3. Non-constant (dierential) growth - part of life cycle in firm where growth is either much faster or much slower than that of the economy as a whole If firm elects to pay lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher ● Payout ratio - fraction of earnings paid out as dividends = Div1/EPS ● Plowback ratio - fraction of earnings retained by firm ● Sustainable growth rate - firms growth rate if it plows back a constant fraction of earnings, maintains a constant ROE and keeps debt ratio constant. g (sustainable growth rate) = ROE x Plowback ratio - Plowback ratio = Plowback earnings/Total earnings - ROE = Total earnings/Initial equity - If g = 0 then EPS/r because no growth. If there is plowback ratio then g not = to zero - Div1 = EPS x Payout ratio - Payout ratio = The remaining percentage that is not Plowback ratio PVGO = Present value of growth opportunities - dierence btw two prices

Non-constant dierential growth 1. Compute the value of the dividends that experience non-constant growth, and then find the PV of these dividends 2. Find price of stock at end of non-constant growth period at which time it becomes constant growth stock and discount price back to present 3. Add these two components to find the value of the stock Corporate value model/Free cash flow model - Similar to dividend growth model, assumes at some point free cash flow will grow at constant rate - Terminal value (TVn) represents value of firm at the point that growth becomes constant - Free Cash Flow (FCF) = int. Pmt to debt investors + shareholders operating cash flow capital expenditure Applying: 1. Find total (MV - market value) of the firm 2. Subtract MV of firm’s debt and preferred stock to get MV of common stock 3. Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value) Valuation by comparable - Estimate of what the firm’s shares are worth if it traded at similar ratios as other firms within its industry - Common ratio used: - Price/earnings ratio = Price per share/EPS= Market Value/Total earnings - How much investors are willing to pay for each dollar of earnings - Based on comparable firms - estimate P/E ratio, multiply this by stock’s expected earnings to estimate stock price. Ecient Market Hypothesis (EMH) - theory that asserts that financial markets are ecient Ecient market-reflects all available info Implications of EMH - prices follow a random walk - If prices already reflect all available info then prices will move only in response to NEW info but NEW info is random, thus prices are also random. Market Price = Intrinsic value Market eciency Beating the market means - earning a return higher than the expected return for a stock given its level of risk. This excess return is referred to as “abnormal return”. Investors can earn abnormal returns only if they find mispriced stocks (mkt price not equal to intrinsic value). In equilibrium, stock prices are stable and there is no general tendency for people to buy vs sell to earn...