Adv. Finance Weekly Meetings. Meeting 1 Year 15-16

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1 Adv. Finance Weekly Meetings Meeting 1 Year 15-16

2 1 Weekly Meeting I Finance

3 2 Agenda Introduction What can you expect from the following meetings Four types of firms Ownership Liability Conflicts of Interest Focus on corporations Further topics Time value of money Net Present Value (NPV) Interest rates: Effective Annual Rate (EAR), Annual Percentage Rate (APR) Annuities and Perpetuities

4 3 Program outline Session Task(s) Topic(s) Chapter(s) Corporation, Financial decision making, Time Value of Money, Interest rate Financial Statement Analysis, Bond Valuation Investment Decision rules Capital budgeting Valuing Stocks 4 12 &13 Capital Markets and Pricing of Risk Optimal Portfolio Choices 5 14 Estimate Cost of Capital Investor Behavior and Capital Market Efficiency M&M 6 15 Debt and taxes Options Ch1, Ch3, Ch4, Ch5 Ch2, Ch6, Ch7 Ch8 & Ch9 Ch10 & Ch11 Ch12, Ch13, Ch14 Ch15 & Ch20

5 4 Different between Finance and advance finance More advanced slides M.Sc. in Corporate Finance & Banking as tutor Potential side track depending on the students questions and any current news Challenging atmosphere: challenge yourself and most important challenge your tutor with your questions!

6 5 The different types of firms Sole Proprietorships Ownership: One owner Liability: Owners has unlimited personal liability Partnerships Ownership: Divided among the partners Liability: All partner have unlimited personal liability Special case: Limited Partnerships General Partners has unlimited personal liability; Limited partners liability is limited to their investment Corporations (limited liability companies) Ownership: Stockholders Liability: Corporations are separate legal entities; Owners are not liable Generate the largest percentage of revenue and second least common form

7 6 Types of firms Sole proprietorship Characteristics Size Owned & run by one person One or few employees No separation between owner and firm Most frequent type of company Low revenue generation Advantages Disadvantages Owner has unlimited liability for firm s debt Easy to set up Relatively low cost to operate Existence of company limited to life of owner As company is increasing and ease of borrowing increases sole proprietorship tend to switch type of firm

8 7 Types of firms Partnership Characteristics Size Identical to sole proprietorship except of having more than one owner All partners are liable for firm s debt Popular for firms with high reputation needs (lawyer, accounting etc.) Least common form of company Low revenue generation Advantages and Disadvantages + Easy to set up + Relatively low cost to operate + One partner can be withdrawn or liquidation through buyout - Partner has unlimited liability for firm s debt Limited partnership General partner: liable for firm s debt Managing authority Limited partner: Limited liability (private assets cannot be seized) No managing authority E.g. Private Equity, Venture Capitalist

8 Types of firms Corporation Characteristics Characteristics Corporation Entity separated from owner Owners are not personally liable No limitation on number of owners (shareholders) Private Public

9 8 Types of firms Corporation Characteristics Characteristics Corporation Entity separated from owner Owners are not personally liable No limitation on number of owners (shareholders) Private Public Second least frequent type of company Highest revenue generation Advantages and Disadvantages Shares not traded in stock markets e.g. GmbH (Ger); SARL (Fr) Can be traded in public stock markets e.g. AG (Ger); SA(Fr) + Public companies can raise more easily money via stock market (issuing shares) - Higher cost compared to sole proprietorship or partnership - Double taxation - Profit taxation - Income taxation (dividends) - Special case (S-shares only once taxed)

10 9 Conflicts of Interest in Corporations Stakeholders Employees Managers Board of directors Shareholders Conflict of interest The different owners of a corporation are likely to have different interests and goal. Common goal: Increasing the value of their ownership, hence raising share price A conflict of interest might arise between owners and managers Owners elect board of director and tie managers compensation to performance Managers are risk averse and therefore require higher compensation if it s tied to performance Threat of hostile takeover Further conflicts of interest exist between different stakeholders, e.g. employees and shareholders

11 10 Stock market Primary and secondary markets Primary market: Market where corporations sell stocks to investors - IPO: Initial public offerings (first sale of stocks) - SEO: Seasonal equity offering (following sale of stocks) SEO are faster to do than IPO since the company is already listed Secondary market: Trade of already issued stocks between investors without direct involvment of the corporation (no change of book equity) How it works Primary market: Corporation through investment banks decide a share price and the banks sell the newly created shares to investors directly Secondary market: Market makers (dealers) sell and buy already issued stocks in the market Post a ask price (buy price) and a bid/offer price (sale price) Create liquidity in the market Bid-ask spread (dealer spread): difference between sale and buy price (compensation for market maker)

12 11 Market forms Stock exchange: Physical places where market makers operate at one place (e.g. New York Stock Exchange (NYSE)) one share has only one market makers Over the counter (OTC) markets (dealer market): Collection of dealers or market makers connected by phone or computer Less rules and unregulated assets can be traded share can have multiple market makers that compete against each other

13 12 Debt vs Equity Debt Equity Contractual agreement Legal ownership of a company Legal obligation to repay No legal repayment Interest payment required No dividends required No upside Upside available Less risk, less reward More risk, more reward Loan (from one individual) or bond (from market participants) Shares

14 13 Common hybrid (debt and equity composed) instruments Convertible bond Bond with warrants

15 14 Some lingo Discount rate Interest rate Cost of capital

16 15 Financial market concepts Competitive markets Bid and ask price in different market are the same no arbitrage should exist Arbitrage Risk-less profit e.g. buying an asset with the certainty to resell it for more right away Law of one price An asset should be priced at the same price in different markets (incl. transaction costs) One of the most important finance concepts for valuation purpose Holds within the boundaries of transaction costs

17 16 Arbitrage - Example Example Coffee in Brazil 150$ per pound Coffee in Europe 190$ per pound Risk free profit of 40$ per pound (assuming no transaction cost) Idea If the same good has two different prices in two different markets an investor could create a profit without any form of risk. The market would regulate the price No arbitrage condition 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 Idea that the same goods should have the same value across various markets

18 17 Interest rates Risk free rate Risk free rate (r f ) : Rate at which we can borrow and lend without any risk Expected return Expected value: Sum of Probability * Outcome Option 1: 1100/1.06= 1038 Option 2: 0.5* *1450 = 1100 PV= 1100/1.06 = 1038 Investor would not be willing to pay this amount due to the additional risk Investors tend to be risk averse Risk Caused by uncertainty of possible outcomes Simplified: More than one outcome is possible Example: Option 1: Pay 1000 and get 1100 after one year Option 2: Get either 750 in bad times (50%) or get 1450 in good times r f = 6% Risk averse vs risk seeking Risk averse: Investor would be willing to pay more money for safer investments (risk seeking is the inverse) The weight potential losses (loosing 350 in bad times) more than potential gains (winning 350 in good times) Prospect theory Interest rate of a security: r s = r f + risk premium

19 18 APR and EAR APR and EAR EAR Effective annual rate (EAR) = the rate with the compounding effect Annual percentage rate (APR) = the rate without the compounding effect In general terms you should use the discount rate including compounding as the investor is entitled to the compounding effect Example 1 + EAR = (1 + APR k )k EAR > APR (holds true if and only if the return is positive and that there is a compounding effect) A investment pays an annual interest of 4% paid quarterly, what is the Effective annual rate and the annual percentage Rate 1 + EAR = (1 + 4% 4 )4

20 19 Forms of the interest rate Continously compounding When reducing the frequency of payment to infinity within one year. Formula: e r 1 Permanent payment of the interest rate Real interest rate After tax interest rate Real interest rates is the nominal interest rate adjusted for inflation Formula: r = i π More precise when making a financial decision Only an approximation In case cash flows of investment are taxed. Formula: r (t x r) = r(1 t) Taxes reduce the amount of interest the investor can keep

21 20 Time value of money Situation Since money you can invest or earn interest on money that you own today compared to money that you would own tomorrow, $100 today is worth more than $100 tomorrow. The difference is called the time value of money. We need to discount future cashflows with the interest rate at which we can invest or borrow. Representation January 1, 2014 $100 December 31, 2014 $115 June 1, 2014 $110

22 21 Time value of money 3 rules 1. Comparison Compare only cash flows at the same point in time 100 now 100 in one year To calculate the value of the cash flow in the future 2. Compounding Compounding: interest on interest payment FV= C(1+r)*(1+r)*..., where C=Cash flow To move cash flows back in time 3. Discounting Discounting: used to calculate the Present Value (PV) PV= FV/(1+r)

23 22 Representation CF 0 (1 r) t Present 0 CF CF0 *(1 r)t Past Future

24 23 How do we value future cashflows? Characteristics Assume we receive a payment of $1000 in 2 years (n = 2). The risk free interest rate at which we can borrow and invest is 10% (r = 0.10) Time value of money 1. What is this payment worth in terms of dollars today? 2. What is this payment worth in dollars in 3 years? 1. $1000 / ( ) 2 = $ $1000 * ( ) = $ * ( ) 3 = 1100 Impact of interest rates How would the value of the payment in terms of dollars today change if the interest rate rose from 10% to 12%? $1000 / ( ) 2 = $ The value of the payment in terms of dollars today would decrease.

25 24 What is the NPV? Net present value NPV = Net Present Value The NPV of an investment is the equivalent of the cash you would receive/pay today. Therefore as long as the NPV is positive the investment should be pursued. Calculation: Subtract the present value of an investment s costs from the present value of its benefits. NPV = PV(Benefits) PV(Costs) NPV Decision rule: When you have to choose between different investment alternatives and they are mutually exclusive, choose the one with the highest NPV. When you have to choose different investment alternatives and they are not mutually exclusive, choose the all options with a positive NPV.

26 25 NPV calculation Characteristics An investor has two mutually exclusive investment opportunities: 1: Invest $100 today, get $140 in two years. 2: Invest $100 today, get $65 in one year and $65 after two years. The interest rate is 8%. What is the NPV of the two investment opportunities? NPV 1: -$100 + $140 / = $ : -$100 + $65 / $65 / = $15.91 The investor should choose investment opportunity 1. Timing of payments The investor will need to make a payment of $50 in one year and therefore prefers to receive cash earlier in time. Is this circumstance changing the optimal investment decision, hence is the timing of payments important? No, the investor should always maximize NPV since he can borrow or lend in order to shift the payments.

27 26 Pricing risk, are you risk averse? Proposition 1 Proposition 2 & 3 Price =? Payoff next year = 1050 Pricing the securities Price =? Payoff next year = 0 or 4200 Likelihood: 75/25 OR Price =? Payoff next year = 950 or 1150 Likelihood: 50/50 Knowing that the interest risk free rate is 5% What is the price of the first security? What is the price of the second security? Hard to do price isn t it? The market is currently trading the second security at and the third at Can you make an arbitrage out of this? What is the market implied discount rate in security 2? What about the security risk premium? What is the market implied discount rate in security 3? What about the security risk premium

28 27 Solution Proposition 1 Price = FV 1+r t Price = = 1000 Expected Value= probability x outcome E(V)= 0.75*0+0.25*4200= 1050 Proposition 2 Price = r=0.15 FV 1050 t = 1+r risk premium=10% 1+r E(V)= 0.5* *1150= 1050 Proposition 3 Price = FV r t = 1+r r=0.10 risk premium = 5%

29 28 How to value a stream of cash flow Finite life: Annuity Annuity formula A rather long approach using the previous method. Shortcut: PV (finite stream of cash flows) = annuity Formula = A r (1 1 1+r n) FV (annuity) = A r ( 1 + r n 1) Solve for the annuity = 4329 Infinite life: Perpetuity In case of a perpetuity it would be impossible to find the present value of all the individual payments. Solution: Perpetuity formula = A r Perpetuity can only be present value

30 29 Testing your understanding Project opportunities Project Investment Next year cash flow Expand the factory 2,500,000 3,000,000 New training program 1,000,000 1,100,000 Open 10 new stores 6,500,000 10,000,000 Questions Knowing you have 10,000,000 in cash and that the risk free rate is 10%. 1. Which projects should you undertake? 2. What is the investment return you would make on those projects? (ROI=Profit/Initial investment) 3. We revised our investment projection and the investment cost of the 3 rd investment is now 8,000,000, which projects should you undertake?

31 30 Investment choices Investment 1 Investment 2 Investment 3 NPV = 2,500, ,000,000 = 227, Return on investment = 500,000 = % 2,500,000 NPV = 1,000, ,100,000 = Return oninvestment= 100,000/1,000,000=0.1 NPV = 6,500, ,000,000 = 2,590, Return on investment = 3,500,000 = % 6,500,000 Choice Question 1&2: With the 10,000,000 in cash, the optimal distribution would be: 6,500,000 in Project 3 & 2,500,000 in project 1 and the rest into risk free bonds Question 3: NPV = 8,000, ,000,000 = 1,090, Return on investment = 2,000,000 = % 8,000,000 We invest all in project 3 and 2,000,000 in risk free bonds

32 31 Financial decision making IRR The interest rate that equates your PV and the Cash flows (NPV = 0) need to solve for r Used often in order to get the return on your investment that would create a break even investment when the NPV is equal to 0 Annuity PV(Annuity): Formula = C r (1 1 1+r n) FV (annuity) = C r ( 1 + r n 1) Growing annuity In case of a growing annuity Formula need to be adjusted Can be used to derive all the other formulas C r g g n 1 + r Where, C= first payment, g=growth rate, r=interet rate, n=number of periods Perpetuity PV(Perpetuity): PV(growing perpetuity): C r C r g

33 32 One step further: Toothbrush Parameters Investment: 1000 Cash flow year 1 to 5: 0 Cash flow year 6: 300 Cash flow year 7-10: CF(6) growing at 2% per year Prevailing discount rate: 5% Find the NPV of this investment Solution NPV = % (1 5% 2% 1 + 5% 5 ) 1 + 5% 5 = Never forget that the PV(Annuity) formula assumes payment starting the next period

34 We wish you Success! 33

Disclaimer: This resource package is for studying purposes only EDUCATION

Disclaimer: This resource package is for studying purposes only EDUCATION Chapter 1: The Corporation The Three Types of Firms -Sole Proprietorships -Owned and ran by one person -Owner has unlimited liability