Session 1 Refresher finance course PDF

Preview

Summary

Refresher finance lecture notes containing topics like time value of money...

Description

ESSEC Pre-M.Sc. Finance

FING31081 FINANCE REFRESHER

CLASS HANDOUTS SESSION 1

Romain Boulland

1/20

Overview

Outline

 What Finance is about  Debt (Bond) and Equity (Stock)  Financial Markets

2/20

An overvie overview w of Cor Corporate porate Fi Finance nance

3/20

An overvie overview w of Cor Corporate porate Fi Finance nance

1. Corporate Finance mainly addresses the following three questions:  What long-term investments should the firm engage in?  How can the firm raise the money for the required investments?  How much short-term cash flow does a company need to pay its bills? 2. Firm should create more cash flow than it uses. To create value, the financial manager should:  Try to make smart investment decisions.  Try to make smart financing decisions. The size, timing and risk of the cash flows should all be evaluated.

4/20

Debt ((Bond) Bond) and Equit Equity y (Stock (Stock)) 1. Issuing

debt

is

borrowing

from

creditors.

The

issuer

(borrower) has the contractual obligation to make periodic fixed or floating interest payments (ccoupons oupons) to the bond holder (lender/creditor) and to repay the bond’s principal (face face value) at maturity date 2. Issuing equity is selling ownership of the firm.

Security issued

Issuer

Payments to investors

Debt

Equity

Bonds

Shares of stock

Government And Corporation

Corporation

Contractually fixed (interest)

Common Stock: Discretionary (dividends)

Maturity of securities Tax deductability of payments for firms* Control over the firm Priority in case of bankruptcy

Fixed, finite life

Infinite life

Yes

No

No

Yes

(only in case of bankruptcy)

(voting rights)

High

Low

(senior claimants)

(residual claimants)

* For corporate investors, the interest received is taxable, but 70% of the dividend received is tax deductible. For individual investors, both interest and dividend are taxable.

5/20

Debt (Bo (Bond) nd) and Equity (Stock) 3. The value of the firm can be thought of as a pie: V ≡ D+E 4. The Capital Structure decision can be viewed as how best to slice up the pie.  How you slice the pie affects the size of the pie, and the goal of the manager is to increase the size of the pie. 5. Corporate Securities can be seen as Contingent Claims on Total Firm Value  The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount by a certain date.  The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid (E≡VD). If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.

6/20

Debt (Bo (Bond) nd) and Equity (Stock)

6. Types of Bond: 1) A domestic–currency bond issued by a government is often referred to as a risk risk– –free bon bond d because the taxing power (raise taxes or print money) allows the issuer to meet its obligations

 Bond names vary according to country, maturity, issuer… U.S. Treasury Securities

Maturity

Bills

Less than 1 year

Notes

1 year up to 10 years

Bonds*

10 to 20 years

* Other countries: Gilts (U.K.), Bunds (Germany), OAT (France) 7/20

Debt (Bo (Bond) nd) and Equity (Stock)

Interest Rates on Treasury Bills and Treasury Bonds (January of each year) Source: Mishkin, Frederic S., and Stanley G. Eakins, 2005, Financial Markets and Institutions 5th ed., Addison-Wesley.

 Although interest rates are determined in the market, monetary authorities have great influence over them, for instance through open market purchases of government bonds (Open Market Operations): - ECB buys bonds = injects liquidity  money supply , interest rate

- ECB sells bonds = reduce liquidity  money supply , interest rate

8/20

Debt (Bo (Bond) nd) and Equity (Stock) 2) Corporate Bonds (short-term and Long-term) are issued by a corporate entity

 The yield on a debt security is based on the risk-free rate with adjustments to capture various characteristics: o Credit (default) risk [DP] o Liquidity [L] o Tax status [TA] o Special provisions (e.g. callable bond or convertible bond) [SP]

9/20

Debt (Bo (Bond) nd) and Equity (Stock)

Rn  R f ,n  DP  L  TA  SP The difference between the yield on a debt security and the risk free rate of the same maturity is called ris risk k premium premium..  The

firm’s

creditworthiness

is

the

most

important

determinant of the interest rate the company will pay. o Rating agencies (e.g., Standard & Poor’s, Moody’s, Fitch) perform credit analysis to measure default risk of specific issues and/or issuers. The result is a rati rating ng grade.

Investment grade

Speculative grade (high-yield or junk)

Debt (Bo (Bond) nd) and Equity (Stock)

o Agencies

periodically

monitor/revise

ratings.

Sometimes they announce a specific issuer is on credit watch – the issuer’s rating is under review and an upgrade/downgrade can result. Default rates for 20-year maturity bonds, 1983 to 2005 Moody’s

S&P

Default Rate

Aaa

AAA

0.64%

Aa

AA

0.65

A

A

1.55

Baa

BBB

4.27

Ba

BB

13.84

B

B

25.20

Caa

CCC

41.23

Source: Moody’s investor service

11/20

Debt (Bo (Bond) nd) and Equity (Stock) o Credit Risk Premium is a negative function of rating Average risk premium implicit in corporate spot rates (1987-1996)

o Risk Premium of different ratings evolves over time:

12/20

Debt (Bo (Bond) nd) and Equity (Stock) 7. Bond issuance or bank financing?  In practice, there are two main sources of debt: bank loans and corporate debt: o Bank

loans

imply

a

systematic

monitoring

of

borrowers, and a limited number of homogeneous lenders (mostly banks). Choice that is prevalent among small, non-listed (private) firms; o Corporate debt is often and “unmonitored” lending with a pool of dispersed investors. It is prevalent among listed (public) firms and large private firms;  There are significant cross-country variations in the choice of debt. Computation of the bank finance to bond finance ratio over 1997-2003 (source: De Fiore and Uhlig 2005) o US firms: 0.74 o European firms: 7.3 (or ten times higher)

13/20

Debt (Bo (Bond) nd) and Equity (Stock) 8. A share of stock represents partial ownership in a corporation.  Shareholders are resid residual ual owners – Have a residual claim on the firm’s assets if the company fails or is dissolved after all debt and tax liabilities are paid.  Corporate stock offer investors a two-part rate of return: o Capital gains o Periodical dividend payments  Two type of stock: Common stock & Preferred stock

Voting Right

Dividend

Residual claim in case of bankruptcy

Common Shareholder

Preferred Shareholder

Yes

Generally No

Potentially unlimited, but not guaranteed. Can not force the corporation into bankruptcy for not paying dividend.

Fixed, has higher priority than the common shareholder, but not guaranteed. Can not force the corporation into bankruptcy for not paying dividend.

Lowest Priority

Senior to common stockholder, but junior to debtholder

(residual claimants)

14/20

Debt (Bo (Bond) nd) and Equity (Stock) 9. Equity analysts

 Equivalent of credit rating agencies for the Equity market. Equity analysts rate company stocks: o Often work for a broker affiliated to a bank (e.g. Bank of America) but there are (some) independent research firms; o Give investment recommendations from “Sell” to “Buy” (or a similar wording) in the form of an “Analyst Note”; o Forecast earnings, attend major corporate event (earnings announcements, M&A meeting …)

 Important source of stock price variations. Look at the following graph of Google shares (GOOGL):

15/20

16/20

01 ju n2 01 5 01 ju l2 01 5 01 au g2 01 5 01 se p2 01 5

01 500 ja n2 01 5 01 fe b2 01 5 01 m ar 20 15 01 ap r2 01 5 01 m ay 20 15

550

600

650

700

Google stock price in 2015

??

 If you need detailed information about a company and its stock price performancelook at analyst notes!  ESSEC is a subscriber to the largest database on analyst report (Investext). Go to Thomson One through the library website (Company views>Research).

17/20

Financial M Market arket A financial market is a market in which financial assets (securities) can be purchased or sold 1. Financial markets can be distinguished by the maturity structure and trading structure of its securities. Types of Financial Market: 1) Money versus Capital Markets o Money Markets: For short-term debt instruments o Capital Markets: For long-term debt and equity 2) Primary versus Secondary Markets o Primary Market: facilitate the issuance of new securities • When a corporation issues securities, cash flows from investors to the firm. • Public offering (Most publicly offered debt and equity securities are underwritten) and Private placements

18/20

Financial M Market arket o Secondary Markets facilitate the trading of existing securities • Cash flows from one investor to another. Securities may be exchange traded (Listed) or trade over-thecounter (an informal network of dealers and brokers who negotiate sales of securities). Major Equity Stock Exchanges 2015, USD Millions Rank Exchange 1 NYSE 2 NASDAQ OMX 3 Japan Exchange Group - Tokyo 4 Shanghai SE 5 Hong Kong Exchanges 6 Euronext 7 Shenzhen SE 8 TMX Group 9 Deutsche Börse 10 BSE India 11 National Stock Exchange India 12 SIX Swiss Exchange 13 Australian SE 14 Korea Exchange 15 NASDAQ OMX Nordic Exchange 16 Johannesburg SE 17 BME Spanish Exchanges 18 Taiwan SE Corp. 19 BM&FBOVESPA 20 Singapore Exchange Source: www.world-exchanges.org

Market Capitalization Number of firms 19,222,876 2,464 6,830,968 2,786 4,485,450 3,470 3,986,012 1,007 3,324,641 1,763 3,320,992 1,054 2,284,728 1,628 1,938,630 3,762 1,761,713 663 1,681,712 5,576 1,641,717 1,718 1,515,761 275 1,271,697 2,071 1,251,054 1,859 1,212,040 790 950,663 381 942,036 3,460 860,628 882 823,903 362 755,415 774

19/20

20/20...