Essential Learning for CTP Candidates NY Cash Exchange 2017 Session #CTP-10

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1 NY Cash Exchange 2017: CTP Track Advanced CTP Math Session #10 (Fri. (6/02) 10:15 am Noon) Advanced CTP Math: ETM5 Calculations Part Two What to Do When Panic Sets In Essentials of Treasury Management, 5th Ed. (ETM5) is published by the AFP which holds the copyright and all rights to the related materials. As a prep course for the CTP exam, significant portions of these lectures are based on materials from the Essentials text. 1 ETM5: Calculations These slides cover most of the advanced calculations in ETM5 Examples include both those from the text and additional problems Due to time constraints, we will NOT be able to cover all of the examples in this session. Students are encouraged to spend some time on their own reviewing these problems at a later date. 2 ETM5: Chapters 12 & 14 Calcs Cash Management & Forecasting Breakeven Concentration Cost Receipts & Disbursements Forecast Distribution Forecast Pro-forma Financial Statements Moving Average Exponential Smoothing 3 1

2 More on Concentration Systems Two frequently used concentration systems in U.S. EDT: Electronic Depository Transfer Wire Transfer Assume the following: ACH Cost = $1.00; Wire Cost = $10.00 Opp Cost = 3.5%; 1-day speed-up with wire Wire Cost ACH Cost Min. Transfer = Opportunity Cost Days Accelerated 365 Days $10.00 $1.00 $9.00 = = $93, Day 365 Days 4 Receipts and Disbursements Forecast $ Amounts in $1,000 Week 1 Week 2 Week 3 Cash Receipts $1,000 $1,000 $950 Cash Disbursements (870) (1,350) (1,000) Net Cash Flow 130 (350) (50) Beginning Cash Balance (120) Ending Cash Balance 230 (120) (170) Minimum Cash Required (Target Balance) (50) (50) (50) Financing Needed (Negative = Deficit) $170 $220 Investable Funds (Positive = Surplus) $180 5 Distribution Method Forecast Example A company has used regression analysis to estimate the proportion of dollars that will clear on a given business day. It has determined that this proportion depends on the number of business days since the checks were distributed. The estimated proportions are given below. Business Days Since Distribution Percentage of $ Expected to Clear 1 13% 2 38% 3 28% 4 13% 5 8% Total 100% 6 2

3 Distribution Method Forecast Therefore, if $100,000 in checks are distributed on Wednesday, May 1, the checks are estimated to clear according to the schedule below. Date Business Days After Distribution Day of the Week % of Dollars Clearing Forecast Dollars Clearing May 2 1 Thur. 13% $ 13,000 May 3 2 Fri. 38% $ 38,000 May 6 3 Mon. 28% $ 28,000 May 7 4 Tues. 13% $ 13,000 May 8 5 Wed. 8% $ 8,000 Total 100% $ 100,000 7 Pro-Forma Financial Statements Medium and long-term forecasting Percentage-of-sales method Involves projecting financial statements based on the historical relationship between sales and balance sheet accounts that tend to change in value along with sales Cash, A/R, inventory and A/P are the most important accounts, followed by fixed assets 8 Three Steps to the Percentage-of- Sale Method 1. Forecast the income statement and balance sheet based on the relationships between revenues and balance sheet items 2. Calculate projected ending cash balance by determining how the forecasted income statement and balance sheet values impact cash 3. Compare the projected ending cash balance with the company s target cash balance and adjust the pro-format statement to show the source of funding for a cash shortfall or the investment of a cash surplus 9 3

4 Pro-Forma Statements Base Year 10 Pro-Forma Forecast - Assumptions Sales will increase by 10% to $2,200 in the year 2017 Costs of goods sold, selling and administrative expenses, non-cash current assets (receivables and inventory), and payables are a constant percentage of sales Cash balance is derived from the cash flow statement Additional fixed assets in the amount of $100 will be purchased Depreciation will be $50 Notes will be reduced to $100 at the beginning of the year Dividends will be $24 11 Pro-Forma Financial Statements All the projected account balances except cash are calculated based on the given assumptions. The ending cash balance is determined by evaluating the impact on cash of the income statement activity and balance sheet changes and adjusting the beginning cash balance accordingly. 12 4

5 Pro-Forma: Statement of Cash Flows If the projected ending cash balance is less than the company s established target balance, the shortfall must be funded through taking on additional debt, issuing equity of selling assets. Conversely, if the projected cash balance exceeds the target, the surplus may be invested in additional assets, used to reduce debt and/or distributed to shareholders. In the above example, if the target cash balance were $110, then $15 in additional cash would need to be raised. If this were accomplished though an increase in notes payables, then the projected balance sheet would appear as before, except that cash would be $110 and notes payable would be $ Five-Period Moving Avg Forecast Day Actual Cash Flow (X t ) 1 890, , , , ,000 Forecast (N = 5) Error (Act F) 6 748, ,500-41, ,009, , , , ,500 23, , ,300 63, , , ,620 Moving Average Forecast for Day 7 is: (812, , , , ,500) / 5 = 761,200 Which results in a forecast error of: 1,009, ,200 = 247, The Treasury Academy - 14 Forecast with Exponential Smoothing Day Actual Cash Flow (Xt) Forecast (α=0.40) (Ft) Error 6 $ 748,500 $ 789,500 - $ 5,400 7 $ 1,009,000 $ 773,100 $ 235,900 8 $ 824,000 $ 867,460 - $ 43,460 9 $ 874,400 $ 850,076 $ 24,324 F t+1 = αx t + (1 α)(f) t The exponential smoothing forecast begins with the Day 6 Forecast of $789,500 based on the moving average forecast. Then, the Day 7 forecast using exponential smoothing is: F 7 = 0.40(748,500) + (1 0.40)(789,500) = $773,100 This results in a forecast error of: $1,009,000 $773,100 = $235, The Treasury Academy

6 ETM5: Chapter 12 and 14 Calcs Concentration & Forecasting Additional Calculations The Treasury Academy, Inc Wire vs. ACH Concentration A company can concentrate funds using either a wire or an ACH transfer. The all-in cost for a wire transfer is $12.00 and the cost of an ACH transfer is $0.50. What is the approximate (to the nearest $1000) minimum transfer amount for funds going from a collection account to the concentration account on a Friday? (Assume opp. cost of 2.5%) A. $ 56,000 B. $ 58,000 C. $ 84,000 D. $167, Blank This slide intentionally blank 18 6

7 Wire vs. ACH Concentration A company can concentrate funds using either a wire or an ACH transfer. The all-in cost for a wire transfer is $12.00 and the cost of an ACH transfer is $0.50. What is the approximate (to the nearest $1000) minimum transfer amount for funds going from a collection account to the concentration account on a Friday? (Assume opp. cost of 2.5%) A.$ 56,000 B.$ 58,000 C.$ 84,000 D.$167, Concentration System Transfers 2 frequently used concentration systems in U.S. EDT vs. Wire Transfer Assume the following: ACH Cost = $0.50; Wire Cost = $12.00 Opp Cost = 2.5%; 3-day speed-up with wire Wire Cost ACH Cost Min. Transfer = Opportunity Cost Days Accelerated 365 Days $12.00 $0.50 $11.50 = = $55, Days 365 Days 20 ETM5: Chapter 17 Calculations Financial Risk Management Call/Put Option Pricing FX Rates FX Derivative Contracts Interest Rate Derivative Contracts 21 7

8 Relationship Between an Option Premium and Strike (Exercise) Price Call or put option Call option Put option Call option Put option At-the-money Out-of-themoney Out-of-themoney In-the-money In-the-money If the underlying asset price is equal to the strike price of the option If the asset price is less than the strike price of the option If the asset price exceeds the strike price of the option If the asset price is greater than the strike price of the option If the asset price is less than the strike price of the option 22 Call Option Pricing 23 Put Option Pricing 24 8

9 Foreign Exchange (FX) Risk Management in Treasury Challenges in International/Global Treasury Management Foreign Exchange (FX) Risk Cash Flow Complexity Tax Issues Foreign Exchange (FX) Rates FX rates are quoted in several ways, depending on the currencies and the markets involved An FX rate is expressed as the equivalent unit of one currency per unit of another currency at a given moment in time 25 Sample Foreign Currency Quotation Formats Currency USD Equivalent Unit of Currency per one USD GBP-British pound GBP/USD USD/GBP CAD-Canadian dollar CAD/USD USD/CAD EUR-Euro EUR/USD USD/EUR JPY-Japanese yen JPY/USD USD/JPY Most common formats are in Bold/Italic 2017 The Treasury Academy - 26 Foreign Exchange (FX) Rates Example: The quoted rate for the USD equivalent is EUR/USD How many euros would $2 million buy? $2,000,000 = EUR1,768, Example: The quoted rate for the USD equivalent is GBP/USD How many pounds would $2 million buy? $2,000,000 = GBP1,515, The Treasury Academy

10 Foreign Exchange (FX) Rates Example: The quoted rate for the Japanese yen USD/JPY How many yen would $2 million purchase? $2,000,000 x = JPY200,500,000 Example: The quoted rate for the Can. dollar is USD/CAD CAD2,000,000 would be equivalent to how many USD? CAD2,000,000 = USD1,548, The Treasury Academy - 28 Foreign Exchange (FX) Rates: Bid-Offer Spreads and Dealer Profit Bid rate: Dealer buys currency Offer rate: Dealer sells currency Bid/offer spread or bid/ask spread: Difference between rates (dealer s profit) Dealer bid-offer quote; e.g., USD/JPY /26 Scenario Company wants to buy JPY Company wants to sell JPY for USD Company Delivers USD Dealer Buys USD at bid rate (JPY100.22) Dealer Sells JPY JPY JPY USD at offer rate (JPY100.26) Company Receives JPY USD 2017 The Treasury Academy - 29 Pricing of Derivative Contracts for FX and Interest Rates This chapter provides some detailed examples of these items (See listed pages below); due the extreme complexity of these examples, coverage is provided through the on-line course Currency Derivatives (Pgs ) Currency or FX Forwards Currency Futures Currency Swaps Currency Options Interest Rate Derivatives ( ) Interest Rate Futures Interest Rate Swaps 30 10

11 ETM5: Chapter 17 Calculations Financial Risk Management Additional Calculations 31 FX Calculation A U.S. company has to pay one of their French suppliers EUR1.25M in the next 30 days. The dealer is quoting a forward rate of EUR/USD1.4215/325. What is the expected amount of dollars the company would be paying for this transaction? A. $ 872,600 B. $ 879,353 C. $1,776,875 D. $1,790, Blank This slide intentionally blank 33 11

12 FX Calculation A U.S. company has to pay one of their French suppliers EUR1.25M in the next 30 days. The dealer is quoting a forward rate of EUR/USD1.4215/325. What is the expected amount of dollars the company would be paying for this transaction? A. $ 872,600 B. $ 879,353 C. $1,776,875 D. $1,790, FX Calculation Quote: EUR/USD /325 Bid: EUR/USD Ask: EUR/USD Always use the quote side that is worst deal for the user and best for the dealer In this case, using the ask side of the quote will give the large amount of USD that will be needed for the transaction USD Amount = EUR Amount Ask Rate = EUR 1,250, = USD 1,790, Blank This slide intentionally blank 36 12

13 ETM5: Chapter 12 Calculations Working Capital Metrics Lockbox Cost/Benefit Analysis 37 Lockbox Selection Cost/benefit analysis: Lockbox versus company processing center Compare differences in collection (mail, processing and availability) float. Collection study estimates float savings (endpoint analysis). Obtain mail time studies from treasury consulting companies. Combine mail time studies with availability schedules from each bank. Compare differences between fixed and variable costs. 38 Lockbox Cost/Benefit Analysis Annual Sales = $108 Million ($9M/month) Average check size = $9,000 Annual vol. of checks = 12,000 Opportunity costs = 9% Internal processing = $0.25/item Lockbox costs = $10,000/yr plus $0.50 per item 39 13

14 Without Lockbox Batch Dollar Amount Calendar Days of Collection Float Total Dollar-Days 1 $1,500,000 X 4 = $6,000,000 2 $4,500,000 X 2 = $9,000,000 3 $3,000,000 X 6 = $18,000,000 Total Deposits $9,000,000 Total Float $33,000,000 Divided by 30 Calendar Days $1,100,000 Annual Cost of Float = Average Dollar-Days times Opportunity Cost = $1,100,000 x.09 = $99, Lockbox Assumptions Lockbox can deliver the following float reductions: Batch 1 from 4 days to 3 days Batch 2 from 2 days to 1 day Batch 3 from 6 days to 5 days Lockbox costs $10,000 annual fee $0.50 per item processing fee 41 With Lockbox Batch Dollar Amount Calendar Days of Collection Float Total Dollar-Days 1 $1,500,000 X 3 = $4,500,000 2 $4,500,000 X 1 = $4,500,000 3 $3,000,000 X 5 = $15,000,000 Total Deposits $9,000,000 Total Float $24,000,000 Divided by 30 Calendar Days $800,000 Annual Cost of Float = Average Dollar-Days times Opportunity Cost = $800,000 x.09 = $72,

15 Comparison of Alternatives Without Lockbox Float Cost = $99,000 With Lockbox Scenario Float cost savings = $99,000 $72,000 = $27,000 Fixed Costs of Lockbox = $10,000 Variable Costs of Lockbox = 12,000 x $0.50 = $6,000 Elimination of internal processing costs = 12,000 x $0.25 = $3,000 Net Benefit = Savings minus lockbox costs = ($27,000 + $3,000) ($10,000 + $6,000) = $30,000 $16,000 = $14, ETM5: Chapter 13 Calculations S/T Investing & Borrowing Tax Equivalent Yield Holding Period Yield Annual Yield Dollar Discount/Discount Rate Money Market Yield (MMY) Bond Equivalent Yield (BEY) T-Bill Quotes & Yield Calculation Cost for Commercial Paper (CP) Issue Cost for Bank Line of Credit Debt Financing 44 Tax Status When computing taxable vs. tax-exempt instruments, use the formula below Assume a taxable security with a 4.6% yield and a tax-exempt security with a 3.2% yield (both have similar risk and maturity) marginal tax rate is 35% Tax-exempt Yield Taxable Equivalent Yield = ( 1 Investor's Marginal Tax Rate) Taxable Equivalent Yield = or 4.92% ( ) After-Tax Yield = Taxable Yield x (1 Marginal Tax Rate) After-Tax Yield = 4.60% x (1 0.35) = 2.99% In this example the tax-exempt security should be chosen 45 15

16 Yield Calculations for S-T Investments Usually made on a simple interest basis Yield is usually a function of: Cash flows received from the investment Amount paid for that investment Maturity or holding period Different types of yield Holding period yield Money market yield ( day year basis) Bond equivalent yield (365 day year basis) 46 The Key Formulas for Investing and Borrowing What You Get What You Pay What You Pay What You Get 47 Yield Calculations Cash Rec. at Maturity Amt Invested Holding Period Yield = Amt Invested Days in Year Annual Yield = Holding Period Yield Days to Maturity Assume a $100,000, 90-day T-bill sells for $98,800 $100,000 $98,800 Holding Period Yield = $98,800 $1,200 = = or 1.215% $98,800 -Day Basis Yield = = = or 4.86% 48 16

17 Converting Year Basis To determine the yield on a 365-day basis versus a -day basis use the following: 365-Day Basis Yield = -Day Basis Yield 365 Using the information from the previous slide: Day Basis Yield = = or 4.93% 49 Discount Instruments T-bills, CP and BAs are discounted instruments Dollar discount = Par value purchase price Consider $1M, 182-day T-bill, sold for $974,216 $1,000,000 $974,216 $25,784 Holding Period Yield = = $974,216 $974,216 = or 2.65% -Day Basis Yield = = or 5.24% 182 Dollar Discount = $1,000,000 $974,216 = $25,784 Dollar Discount Discount Rate = Par Value Days to Maturity $25,784 = = or 5.10% $1,000, Re-arranging the Yield Equations Days to Maturity Dollar Discount = Discount Rate Par Value 182 = $1,000,000 = $25,784 Money Market Yield = Holding Period Yield Days to Maturity $1,000,000 $974,216 = $974, = = or 5.24% 365 Bond Equivalent Yield = Money Market Yield 365 = = or 5.31% 51 17

18 T-Bill Quotes Dealers typically utilize a bid-ask quote framework Bid quote is the price at which the dealer will BUY a T-Bill Ask quote is the price at which the dealer will SELL a T-Bill Ask yield is the yield to an investor purchasing a T-Bill at the ask discount Maturity Date Days to Maturity Bid Discount Ask Discount Ask Yield (Percent) April April May May Purchase Price = Par Value Dollar Discount 2017 The Treasury Academy - 52 T-Bill Quotes and Pricing Determine the purchase price an investor would pay for a $1,000,000 T-bill maturing on April 18 is based on the April 18 ask discount: 36 Dollar Discount = $1,000,000 = $65.00 Purchase Price = $1,000,000 $65 = $999,935 If the investor sold the T-bill, then the sale price paid to the investor by the dealer would be based on the April 18 bid discount of 0.075% as follows: 36 Dollar Discount = $1,000,000 = $75.00 Purchase Price = $1,000,000 $75 = $999, The Treasury Academy - 53 Calculation of the Ask Yield The ask yield, or 365-day annual yield to the investor is determined as follows: Cash Received at Maturity Amount Invested 365 Ask Yield = Amount Invested Maturity $1,000,000 $ = = % or 0.066% $ The Treasury Academy

19 Annual Cost for Commercial Paper (CP) Example: A company issues $50 million of CP with a 20-day maturity at a discount of 0.396%. Part 1 of 4: Days to Maturity Dollar Discount = Discount Rate Par Value 20 = $50,000,000 = $11,000 Usable Funds= Par Value Discount = $50,000,000 $11,000= $49,989, The Treasury Academy - 55 Annual Cost for Commercial Paper (CP) Fees include an annual dealer fee of 0.12% and a backup line of credit fee of 0.25%, both of which must be prorated. The dealer and LoC fees are calculated as follows: Part 2 of 4: Days to Maturity Prorated Dealer Fee = Annual Fee Rate CP Issue Size 20 =.0012 $50,000,000 = $3, Prorated Backup LoC = Annual Backup Line Rate Issue Size 20 =.0025 $50,000,000 = $6, The Treasury Academy - 56 Annual Cost for Commercial Paper (CP) The annual interest rate (including all costs) for the commercial paper issue is calculated as follows: Part 3 of 4: Dollar Discount + Dealer Fee + Backup Fee 365 Annual Int. Rate = Usable Funds 20 $11, $3, $6, = $49,989, = =.0078 or 0.78% The Treasury Academy

20 Annual Cost for Commercial Paper (CP) The nominal, or annual, yield to an investor is calculated as follows: Part 4 of 4: Dollar Discount 365 CP Nominal Yield= Purchase Price Days to Maturity $11, = =.0040 or 0.40% $49,989, The Treasury Academy - 58 Annual Cost for a Line of Credit A line of credit lender charges interest and a commitment fee on the line. Interest is charged on the used portion of the line. The commitment fee may be charged on the line or its unused portion. The overall interest rate on the line is determined by the total interest paid on the line s used portion and the amount paid per the commitment fee relative to the average used portion of the credit line over the borrowing period. 59 Annual Cost for a Line of Credit Example: A company expects to use $1.6 M of shortterm borrowings and wants a $3 M line of credit. A lender offers LIBOR (at 0.70%) plus a risk premium of 2.50% with a commitment fee of 0.30% on the unused portion of the line. The rate on the used portion of the line is LIBOR plus 2.50%, or 3.20% (the all-in rate). All interest and fees are calculated as follows: Part 1 of 5: Interest Paid = Average Borrowing All-in Rate = $1,600, = $51,200 Fee on Unused Portion = Unused Portion Commitment Fee = $1,400, = $4, The Treasury Academy

21 Annual Cost for a Line of Credit The annual interest rate as total costs relative to the amount used on the line is calculated as follows: Part 2 of 5: Interest Rate + Fee on Unused Portion Annual Int. Rate = Used Portion of Line $51,200 + $4,200 = =.0346 or 3.46% $1,600, The Treasury Academy - 61 Annual Cost for a Line of Credit The lender (a bank) requires a 10% compensating balance; the borrower must maintain a balance in its DDA (checking) account 10% of the amount borrowed on the credit line. The DDA is a zero balance account (ZBA). Part 3 of 5: Annual Int. Rate = Interest + Fee on Unused Portion Used Portion of the Line Compensating Balance $51,200+ $4,200 Annual Int. Rate = =.0385 or 3.85% $1,600,000 $160, The Treasury Academy - 62 Annual Cost for a Line of Credit The amount borrowed on the line is calculated as follows (assuming the available loan amount must be $1,600,000). Part 4 of 5: Available Amt = Borrowed Amt Compensating Balance % Borrowed Amt $1,600,000 = Borrowed Amount.10 Borrowed Amount.90 Borrowed Amount = $1,600,000 Borrowed Amount = $1,777, The larger amount increases the total interest and fees paid. Interest Paid = Average Borrowing All-in Rate = $1,777, = $56, Fee on Unused Portion = Unused Portion Commitment Fee = $3,000,000 $1,777, = $3, The Treasury Academy

22 Annual Cost for a Line of Credit The annual interest rate can be recalculated as a total cost relative to the borrowed amount that is actually usable as follows: Part 5 of 5: Interest Paid+ Fee on Unused Portion Annual Int. Rate = Amount Borrowed Compensating Balance = $56, $3, $1,777, $1,777, $60, = =.0378 or 3.78% $1,600, The Treasury Academy - 64 ETM5: Chapter 11 Calculations S/T Investing & Borrowing Additional Calculations 65 How much would you be willing to pay for 91-day $1M T-bill selling at a discount rate of 50 basis points? A. $987,361 B. $998,736 C. $998,753 D. $1,000,

23 How much would you be willing to pay for 91-day $1M T-bill selling at a discount rate of 50 basis points? A. $987,361 B. $998,736 C. $998,753 D. $1,000, T-Bill Pricing Determine the purchase price an investor would pay for a $1,000,000 T-bill maturing in 91 days at a discount rate of 50 bp: 91 Dollar Discount = $1,000,000 = $1,264 Purchase Price = $1,000,000 $1,264 = $998, What is the annual yield (365) to an investor for a 30-day $10M CP issue with a discount rate of 175 basis points (bp), a dealer fee of 30 bp and a credit enhancement fee of 45 bp? A. 1.75% B. 1.78% C. 2.50% D. 2.54% 69 23

24 What is the annual yield (365) to an investor for a 30-day $10M CP issue with a discount rate of 175 basis points (bp), a dealer fee of 30 bp and a credit enhancement fee of 45 bp? A. 1.75% B. 1.78% C. 2.50% D. 2.54% 70 CP Calculations The annual, yield (365) to an investor is calculated as follows: Days to Maturity Dollar Discount = Discount Rate Par Value 30 = $10,000,000 = $14,583 Purchase Price = Par Value Discount = $10,000,000 $14,583= $9,985,417 Dollar Discount 365 CP Yield = Purchase Price Days to Maturity $14, = =.0178 or 1.78% $9,985, Annual Cost for Commercial Paper (CP) Fees include an annual dealer fee of 0.30% and a backup line of credit fee of 0.45%, both of which must be prorated. Days to Maturity Prorated Dealer Fee = Annual Fee Rate CP Issue Size 30 =.0030 $10,000,000 = $2, Prorated Backup LoC = Annual Backup Line Rate Issue Size =.0045 $10,000, = $3,750 The annual interest rate (including all costs) for the commercial paper issue is calculated as follows: Dollar Disc. + Dealer Fee + Backup Fee 365 Annual Int. Rate = Usable Funds 30 $14,583 + $2,500 + $3, = =.0254 or 2.54% $9,985,

25 What is the annual cost for a $5M line of credit with an all-in rate of 4.5% and a commitment fee of 75 bp on the unused portion of the line? Assume an average outstanding loan amount of $3.5M. A. 4.50% B. 4.82% C. 5.25% D. 5.45% 73 Blank This slide intentionally blank 74 Blank This slide intentionally blank 75 25

26 What is the annual cost for a $5M line of credit with an all-in rate of 4.5% and a commitment fee of 75 bp on the unused portion of the line? Assume an average outstanding loan amount of $3.5M. A. 4.50% B. 4.82% C. 5.25% D. 5.45% 76 Annual Cost for a Line of Credit The annual interest paid & commitment fees are calculated as: Interest Paid = Average Borrowing All-in Rate = $3,500, = $157,500 Commitment Fee = Unused Portion Commitment Fee = $1,500, = $11,250 The annual interest rate including total costs relative to the amount used on the line is calculated as follows: Interest Rate + Commitment Fee Annual Int. Rate = Used Portion of Line $157,500 + $11,250 = =.0482 or 4.82% $3,500, Debt Financing & Management Costs of Borrowing Include costs of credit enhancements, fees paid to rating agencies, legal, etc. Basic Components in Interest Rates Base Rates Short-Term Versus Long-Term Borrowing Loan Agreements and Covenants Credit Rating Agencies 78 26

27 Basic Components in Interest Rates Interest rates depend on many factors r = r* RF + IP + DP + LP + MP Where: r* RF = Real risk-free interest rate IP = Inflation premium DP = Default premium LP = Liquidity premium MP = Maturity premium Some observations Treasuries: DP and LP = 0 Both corporate and muni s have DP and LP Most L-T bonds have some MP MP increases with issue s time to maturity 79 Calculation of Interest Rates Calculation of Interest Rates or Yields on Different Investments Investmen Real Risk- Inflation Default Liquidity t Free Rate Premium Premium Premium 1-year Treasury 5-year Treasury 10-year Treasury 1-year Corporate 5-year Corporate 10-year Corporate 1-year Municipal 5-year Municipal 10-year Municipal Maturity Premium Cost of Borrowing 2.0% 3.0% 0% 0% 0% 5.0% 2.0% 5.0% 0% 0% 0.4% 7.4% 2.0% 7.0% 0% 0% 0.9% 9.9% 2.0% 3.0% 2.5% 0.5% 0% 8.0% 2.0% 5.0% 2.5% 0.5% 0.4% 10.4% 2.0% 7.0% 2.5% 0.5% 0.9% 12.9% 2.0% 3.0% 1.5% 1.0% 0% 7.5% 2.0% 5.0% 1.5% 1.0% 0.4% 9.9% 2.0% 7.0% 1.5% 1.0% 0.9% 12.4% 80 ETM5: Chapter 19 Calculations Long-Term and Capital Instruments Capital Asset Pricing Model (CAPM) Portfolio Risk and Return Preferred Stock Valuation Common Stock Valuation 81 27

28 Equity (Stock) Portfolio Mgmt. Defining and Measuring Investment Risk Expected return and standard deviation Use of covariance in portfolio management Benefits of Diversification Reduces the overall riskiness of a portfolio Capital Asset Pricing Model (CAPM) Beta is a measure of relative market risk In a diversified portfolio, Beta is the only relevant measure to an investor CAPM Model Relationship re r RF (rm r RF) i Where: r Required rate of return on stockholder's equity E r Expected rate of return on the risk-free asset RF r Expected rate of return on the market portfolio M Beta value for stock i i 2017 The Treasury Academy - 82 CAPM Calculation Example Assume a risk-free rate (T-bill) of 2.0%, a market rate of return of 8.0%, and historic Beta for Apple Computer of 1.5: re r RF (rm r RF) i r 0.02 ( )(1.5) % E Assume the same information as above, but for H.J. Heinz with a Beta of 0.60: re r RF (rm r RF) i r 0.02 ( )(0.6) % E 2017 The Treasury Academy - 83 Determining Portfolio Risk & Return One of the biggest benefits of using CAPM and Beta is the ability to determine a portfolios average return and overall riskiness as a function of simple weighted averages Using the stocks from the previous slide with weights of Apple(A) = 70% and Heinz(H) = 30% Portfolio β = (% of A-Stock β ) + (% of H-Stock β ) = ( ) + ( ) = 1.23 Port. Return = (% of A-Stock r ) + (% of H-Stock r ) r r (r r ) E RF M RF Portfolio 84 A A = ( %) + ( %) = 9.38% =.02 + (.08.02)(1.23)= or 9.38% H H 28

29 Valuation of Long-Term Securities Publicly traded corporate securities are valued by financial markets The value is based on the cash flow stream expected by the investor as well as the relevant discount rate: CF CF CF CF PV... n t 1 2 n 0 t 1 2 n t 1(1 k i) (1 k i) (1 k i) (1 k i) Where: PV 0 = Current value of the asset CF t = Cash flow in period t k i = Opportunity cost for asset i 85 Bond or Fixed Income Valuation Valuation of bonds or any fixed income security is fairly easy because the cash flows and their timing is well known Required rate on a bond issue is typically called the Yield to Maturity (YTM) Some bonds have call provisions, and the Yield to Call (YTC) should also be computed Another approach with callable bonds is to compute Yield to Worst (YTW), where the lowest possible yield is determined YTW can also be used with other types of bonds to determine the impact of all potentially negative provisions (pre-payments, sinking funds, etc.) 86 Preferred Stock Valuation Preferred stock is equity, but has features of debt financing in its payments Assume a $50 par value, with a 6.6% annual dividend and an 8.0% required return Pref. Stock Div. = Pref. Stock Div. Rate Par Value = 6.6% $50 $3.30 Pref. Stock Annual Div. Price of Pref. Stock = Required Rate of Return $3.30 $ Now, assume required return increases to 10% $3.30 Price of Preferred Stock = $ The Treasury Academy

30 Common Stock Valuation Neither the timing or the amount of the cash flows are known with certainty To value common stock, it is necessary to estimate the dividend stream and liquidation price, as well as a required rate of return on the stock D D D D P 0 = (1+k s) (1+k s) (1+k s) (1+k s) Dt = t t=1 (1+k s ) Where: P 0 = Current value of the stock D t = Dividend in period t k s = Required rate of return for the stock 2017 The Treasury Academy - 88 Common Stock Valuation Common assumption is to assume that dividends will grow at some constant rate in the future Dividend in period t = D t = D 0 (1+g) t Substituting this into the general equation, we get: t D(1 0 g) P 0 = t t=1 (1+k s ) Assuming that D 1 = D 0 (1+g), we get: D1 Dt+1 P 0 = or P t = (ks g) (ks g) This formulation works well for companies paying a steadily growing dividend, which includes a significant portion of large cap firms in the U.S The Treasury Academy - 89 Common Stock Valuation - Example Assume the following: Last dividend (D 0 ) = $2.00 Estimate growth rate (g) = 6% Return on stock (k s ) = 13% D D(1 0 + g) (k g) (k g) 1 P 0 = = s s $2.00 (1 +.06) $2.12 = = = $30.29 ( ) The Treasury Academy

31 ETM5: Chapter 20 Cost of Debt Cost of Equity Weighted Average Cost of Capital (WACC) Firm Valuation (EVA) 91 Cost of Capital and Firm Value Cost of capital is the basic target number that asset returns must exceed if the company is to create shareholder value Capital Components and Costs Primary sources of permanent capital are long-term debt (bonds) and equity (common stock and retained earnings) The relevant costs of these sources are their marginal cost Be sure to use only after-tax values for the costs Typically calculated as WACC Weighted Average Cost of Capital 2017 The Treasury Academy - 92 Cost of Debt Relevant cost is after-tax YTM After-tax k d = Before-tax k d (1 T) Calculation Example Assume YTM of 5% and marginal tax rate of 30%: After-tax k d = 5%(1.3) = 3.5% In companies with complicated tax liabilities, the marginal tax rate may be difficult to estimate from standard financial statements Though flotation costs of debt are usually low, they should be considered if they are significant 2017 The Treasury Academy

32 Cost of Common Equity Two sources of common equity Retained earnings during the period Issue new common stock CAPM may be used to estimate the market s required rate of return on equity Flotation costs are usually not considered for retained earnings, but may be significant for new common stock issues 2017 The Treasury Academy - 94 Common Equity Calculation Example Assume a risk-free rate of 4.0%, a return on the stock market of 10.0% and a Beta of 1.2 In this case the cost of equity is: r r (r r ) E RF M RF =.04 + (.10.04)(1.2) =.112 or 11.2% 2017 The Treasury Academy - 95 Weighted Average Cost of Capital (WACC) WACC = W r (1 T) W r DD Assume 1/3 of total financing is from debt and 2/3 is from equity, and the costs of debt and equity are those found on previous slides: EE WACC = WDD r (1 T) WEE r [ (1 0.3)] ( ) 8.64% 2017 The Treasury Academy

33 Firm Value According to EVA (Economic Value Added) concepts, a firm must earn a rate of return on assets that exceeds the cost of capital in order to create shareholder value Assume a tax rate of 30%, $50M of capital employed and an operating profit of $6.8M EVA = EBIT(1 Tax Rate) (WACC)(L-T Debt + Equity) $6,800,000(1.30) (.0864)($50,000,000) $4,760,000 $4,320,000 $440, The Treasury Academy - 97 What to Do When the Panic Sets In!!! Remember that one of the answers IS the solution to the calculation Don t waste precious time, just come back to the question later Try to narrow down your choices using a little common sense When all else has failed, just take a guess you might get lucky 98 NY Cash Exchange 2017: CTP Track End of This Track Be sure to sign up for the on-line course available from The Treasury Academy djmasson@treasuryacademy.org Phone: