Principle of Finance Notes PDF

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Principle of Finance Notes Lecture 1 What is finance?  The study of how individuals, businesses and institutions acquire, spend and manage financial resources  Seels to identify the value and benefits and costs of a decision Flow of Funds  From surplus units to deficit units (connected via contracts) Intermediation  Indirect financing - Involves the transfer of funds between ultimate savers and ultimate borrowers via deposit-taking institutions  Adv: o Asset transformation, maturity transformation, economies of scale Direct financing  The transfer of funds from ultimate savers to ultimate borrowers without an intermediary  Adv o Avoids intermediation costs, increases assets to diverse range of markets  Dis Adv o Matching of preferences, liquidity and marketability of a security

Accounting Vs. Finance  Accounting focuses on profit  Finance focuses on cash flows and is more forward looking What is a security?  Financial contract that can be traded in a financial market o Asset involved o Quantity and unit o Price, date and payment and settlement terms Primary market  Issue of a new financial instrument to raise funds to purchase goods, services or assets o Funds are obtained by issuer

Secondary market  The buying and selling of existing financial securities o Transfer of ownership from one saver to another saver INTRODUCTORY CONCEPTS Law of One price  If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets Market value of a firm

Main factors to consider when valuing a firm... o Magnitude of expected cash flows - E(CFt) o Timing of cash flows - n o Risk of expected cash flows - r o Efficiency of capital markets Risk and return  The observed (realized) return of an asset or security is measured as the change in cash flows (interest/dividend/cash flow received during the period and the change in capital value of the investment) divided by the initial investment o Risk is the uncertainty of receiving the above cash flow in one years time o Return for a risky asset would be risk free return plus risk premium Simple interest  Value of a cash flow is calculated without including any accrued interest to the principal 

Compound interest  Interest is accrued is added to the principal and reinvested Effective interest rate  Annualized rate that takes account of compounding within the year

Present value

Factors influencing Present and Future Values  Time period (n) o Future value increases as n increases o Present value decreases as n increases  Interest rate (r) o Future value increases as r increases o Present value decreases as r increases  Method of computing interest o Future value increases as comp frequency increases o Present value decreases as comp frequency increases

Lecture 2 Perpetuity  An equal periodic cash flow that goes on forever o Present value of a perpetuity P0 = C/r

Deferred perpetuity  Deferred perpetuity is an equal periodic cash flow that starts at some future date

Growth perpetuity  Perpetuity of C dollars today growing at a constant rate of g percent per period  Cash flow stream  C(1+g)^n  Present value P0= C(1+g)/(r-g) Ordinary annuity  Series of equal, periodic cash flows occurring at the end of each period, and lasting for n periods, with n cash flows

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Future value

Deferred ordinary annuities  Series of equal, periodic cash flows occurring at the end of each period, occurring at a future date Annuities due  Series of equal, periodic cash flows occurring at the beginning of each period  n cash flows  n-1 periods

Characteristics of Debt Securities  Short term debt o matures within the year o issuer has contractual obligation to make promised payments o lower risk than equity because you must make payments o face (par) value  dollar amount paid at maturity  Long term debt o Typically mature after several years o May or may not promise a regular interest (coupon) payment o Coupon rate  interest rate promised by the issuer, expressed as percentage of face value o Interest (coupon) payment  periodic (annual/semi-annual) payment made to debtholders o Coupon payment = coupon rate x face value Valuation of principle  The price of a security today is the present value of all future expected cash flows discounted at the “appropriate” required rate of return (or discount rate) Valuing discount securities  Bank accepted bills o Short term debt instruments where the acceptor (or endorser) of the bill is a bank, that is, the bank promised to pay the holder the face value of the bill at maturity  Price of discount security is computed as the present value of the face value at a market determined yield to maturity o Yield to maturity is the rate of return earned by an investor who holds the security until it matures Relating coupon rate to YTM

Lecture 3 VALUATION OF EQUITY SECURITIES AND INTRODUCTORY CAPITAL STRUCTURE 

Characteristics of ordinary shares o Shares are classified as equity of the firm  Firms not obligated to pay share holder interest (unlike debt) o Most companies do (dividends) o Capital gain (increase in share price) o Ordinary shares  part ownership in a corporation o Preference shares normally have a fixed dividend o Limited liability: most shareholder can lose, is the amount of their investment in the firm o Voting right: right to vote for firms directors o Residual claim: if the firm is liquidated, ordinary shareholders are paid last o Claim order: Creditors  preference share holder  ordinary share holder o Typically provide investors with an infinite stream of uncertain cash flows or dividends

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Pricing ordinary shares o One period framework  stock price is equal to the sum of the next periods dividend and the expected discounted at the appropriate required rate of return

Constant Dividend Growth Model

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Can be used to estimate the required rate of return and growth in dividends

Is All Growth Profitable?  D=axE

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o a is the payout ratio (proportions of earnings paid out as dividends) o if the payout ratio does not change over time, the growth rate in dividends (g) will equal the growth rate in earnings Firm can do one of two things with earnings o Pay them out to shareholders o Retain earnings and reinvest them Any increase in future earnings will results from new investments made from earnings retained by the firm o Change in earnings = New investment x return on investment  Amount of new investment is determined by what the firm retains o Earnings = New investment/retention rate o Earning growth rate (g) = Change in earnings / earnings   retention rate x return on investment

Characteristics of Preference shares  give their holders preference over ordinary shareholders with regard to payment of dividends (and repayment of capital in case liquidation)

Earnings, Dividends and Prices  P/E multiple is the ratio of the current market price to expected (or current) earnings per share  Defined as the amount investors are willing to pay now, for $1.00 of future expected earnings

Capital Structure and Financial Leverage  Company decision to fund their operation

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o Debt: borrowed money such as short term instruments, bonds and bank loans o Equity: money belongs to the company usually provided by share holders Capital structure = mix of securities which serve to divide those cash flows between different classes of investors o Interest is deductable (tax)

What is Financial Leverage  Business (or operational) risk o Variability of future net cash flows attributed to the nature of the firm’s operations or assets it holds  Financial risk o Risk attributed to the use of debt as a source of financing Effects of Financial Leverage  Increasing leverage involves a trade-off between risk and return

Lecture 4 CAPITAL BUDGETING I Capital budgeting process  Generation of investment proposals  Evaluation and selection of investment proposals (our focus)  Approval and control of capital expenditures  Post-completion audit of investment projects Methods of project evaluation  Main methods used by managers to evaluate projects: o Net present value o Internal rate of return o Accounting rate of return o Payback period Net present value method  Involves: o Computing difference between present value of the net cash flows from an investment and the initial investment outlay o All cash flows are discounted at the required rate of return which reflects the projects risk  Projects net cash flows o Identify the size and timing of incremental cash flows as a result of the project o Net cash flows after corporate taxes need to be evaluated o Incremental cash flows = flows earned by the firm if the project is undertaken - cash flows earned by the firm if the project is not undertaken

Internal rate of return  IRR (r) is the rate of return that is earned by the project over its economic life

No internal rate of return  In rare cases a project may not have an internal rate of return  The NPV of the project remains positive or negative no matter what discount rate is applied to cash flows Comparing the IRR and NPV methods  Independent projects are projects that can be evaluated on their own, that is, independently of each other o The decisions to accept a project does not affect the decision to accept or reject other projects o Assume that there are enough funds for all potential independent projects being considered  Mutually exclusive projects are projects where the acceptance of one project rules out the acceptance of other (competing) projects o E.g. piece of land is used to build a factory, which rules out an alternative project of building a warehouse on the same land  Decision rule for mutually exclusive

o Assuming the projects being considered are worth undertaking (that is, they are positive NPV projects) o Invest in the HIGHEST NPV projects Accounting rate of return  The average earnings generated by the project, after deducting depreciation and taxes, expressed as a percentage of the investment outlay  Decision rule o Project is acceptable if its ARR exceeds a respecified minimum rate of turn o Mutually exclusive  projects with highest ARR is preferred

Problems with ARR  Earnings are not net cash flows  Time value of money ignored  Hurdle is arbitrary  ARR tends to favour projects with shorter lines o Smaller N would increase the numerator and hence the ARR Payback Period  Time it takes for the initial cash outlay on a project to be recovered from the net after-tax cash flows  Decision rule o Acceptable if its payback period is less than a prespecified maximum payback period o Mutually exclusive projects  project with the shortest payback period is preferred

Problems with Payback Period  Fails to account for cash flows that occur after payback  Biased against projects that have longer development periods

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Ignores time value of money Hurdle is arbitrary

Lecture 5 CAPITAL BUDGETING II Issues in cash flow estimations  Timing of cash flows o Exact timing of project cash flows can affect valuation of a project o Simplifying assumption  net cash flows are received at the end of a period  Financing charges o Cash outflows relating to how the project is to be financed are not included in the analysis o Value of a project is independent of how it will be financed o Discount rate used  represents rate of return required by equity holders  Incremental cash flows o Only cash flows that change if the project is accepted are relevant in evaluating the project  Sunk costs o No included as they have been incurred in the past and will not be affected by the project’s acceptance or rejection  Allocated costs o Overhead costs allocated by management to firm’s divisions o Costs do not vary with decisions and are usually ignored  Taxes and tax effects o Taxes need to be included where they have an effect on the net cash flows generated o Three main effects  Corporate income taxes  Depreciation tax shield  Taxes on disposal of assets  Corporate income tax o After tax cash flow = before tax cash flow x (1 – t (effective corporate tax rate))  Depreciation tax savings or depreciation tax shield o Depreciation itself is not an operating expense and is excluded from the next cash flows o Depreciation tax savings (or shield) = t x depreciation

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Disposal or salvage value assets o Taken into account after taxes  Taxes are payable when an asset is sold for more than its book value

Tax saving when an asset is sold for less than its book value (loss offset against taxable income) o Books value = acquisition cost – accumulated depreciation o Gain (or loss) = disposable value – book value  Taxes payable of gain = t x gain on sale  Tax saving on loss = t x loss on sale 

Inflation and capital budgeting  It is important to be consistent in your treatment of inflation o For nominal cash flows use the nominal discount rate o For real cash flows use the real discount rate  From the Fisher relationship we have…

Weighted average cost of capital  WACC or k0 is the benchmark required rate of return used by a firm to evaluate its investment opportunities o It is the discount rate used to evaluate projects of similar risk to the firm  It takes into account how a firm finance its investments o How much debt vs equity does the firm employ  The WACC depends on o Market values of the alternative sources of funds o Market costs associated with these sources of funds Estimating the WACC  Main steps involved in estimation of the WACCS o Identify the financing components

o Estimate the current (that is, market) values of the financing o Estimate the cost of each financing component o Estimate the WACC Identify the financing components  Debt o Identify all externally supplied debt items o Do not include creditors and accruals as these costs are already included  Ordinary shares o Obtain number of issued shares from balance sheet o Do not include reserves/retained earnings  Preference shares o Obtain number of issued shares from the balance sheet Valuing the financing components  Use market values and not book values Estimating the cost of capital  Cost of capital is the rate of return that investors expect for providing capital to the company  The costs of a firm’s financing instruments can be obtained as follows o Use observable market rates o Use effective annual rates o For the cost of debt use the market yield  Focus here is on the costs of debt, ordinary shares and preference shares Cost of ordinary shares  Common to sue CAPM (covered after MST) to estimate the cost of equity capital, where the cost of equity is

Weighted Average Cost of Capital

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Uses the cost of each component of the firms capital structure and weights these according to their relative market

Taxes and the WACC  under the classical tax system o interest on debt is tax deductible o dividends have no tax effect for the firm  the after-tax cost of debt kd = (1-tc) kd  the cost of equity (ke) is unaffected  the after-tax WACC

Limitations on using the WACC  WACC cannot be used in the following situations o If the project alters the operation (business) risk of the firm o If the project alters the financial risk to the firm by dramatically altering its capital structure  What should the firm do if the WACC cannot be used? o Adjust costs appropriate to project risk (pure play) o Adjusted weights by expected capital structure

Lecture 6 RISK AND RETURN PORTFOLIO THEORY I Returns on Financial Securities  Change in cash flows divided by the initial investment

Geometric vs Arithmetic Average Returns  Arithmetic Average return  measures returns earned from a single, one period investment

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Geometric average  measures returns earned per period from and investment over its entire time horizon

The Probability Distribution Approach  Assume that investors can specify the possible outcomes, and associate probabilities or likelihoods with these outcomes

Measures of Risk and Expected Return  Expected return  expected outcome measured as the weighted average of the individual outcomes

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Variance or standard deviation of returns is the measure of dispersion around the expected return

o Greater the dispersion, higher the risk and uncertainty

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Stock X is $10

Specifying Investor Preferences  Risk averse (main assumption): Averse to risk so return variability is bad o Higher the variance or standard deviation of returns, the worse off the investor  Risk neutral: Neutral attitude to risk so return variability is irrelevant o Higher or lower variance or standard deviation of returns is not relevant  Risk seeking: prefer risk so return variability is good! o Higher the variance or standard deviation of returns the better off the investor Portfolios and Risk Diversification  Risk averse investors objective o Minimize the risk of portfolio of investments, given a desired level of expected return o Maximize the expected return of portfolio of investments  Simplest (naïve) way to minimize risk is to diversify across different securities o Portfolio risk falls, as the number of securities in the portfolio increases o Portfolio risk cannot be entirely eliminated using this method (systematic risk) Portfolio Risk and Return: Two securities  Ports expected return is the weighted average of the expected returns of its component securities o Weights are %’s of investors original wealth invested in each security

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Ports variance is the weighted average of the variance of its components securities and the covariance between the securities return’s

Covariance between security returns  Measures the level of comovment between security returns

Correlation between security returns  correlation coefficient is a standardized measure of comovment between two securities Risk-Return trade-offs: two securities

Lecture 7 MORDERN PORTFOLIO THEORY II Leveraging  strategy where an investor borrows funds at the risk-free rate of return and invests all the available funds in a risky security

Short selling  Borrowing (typically via a broker) shares, selling them now with a contractual promise to buy them back later at (an expected) lower price o Risky borrowing to leverage a portfolio o Leveraging increases portfolio risk

Market portfolio  In equilibrium, portfolio X must be the (value-weighted) market portfolio of all risky securities  Why is X the market portfolio? o Suppose stock A is 5% of total of risky securities by market value o Suppose that only 2% of portfolio X is composed of stock A  Stock A is in excess supply  The price of stock A will fall and its expected return will rise, reducing its weight in portfolio M and increasing its weight in portfolio X Capital market line  Can only be used to price efficient portfolios o “pricing: a portfolio is used in the context of obtaining the portfolios expected return  The CML assumes portfolios are fully-diversified and efficient with zero unsystematic risk o Recall that: An efficient portfolio has the lowest level of risk for given level of expected return  CML cannot be used to price individual securities because these are not efficient and will always have some unsystematic (or diversifiable or firm-specific) risk

Lecture 8 CAPITAL ASSET PRICING MODEL CAPM  Theoretical model that can be used to “price” individual securities o Pricing  estimating its required rate of return and then obtaining a price estimate based on the security’s future expected cash flows  Dividends/ future price  CAPM relates a security’s required retur...