ADVANCED CORPORATE FINANCE. Dr. Marta Wisniewska

Transcription

1 ADVANCED CORPORATE FINANCE Dr. Marta Wisniewska

2 Introduction Module Outline Literature Grading

3 Introduction Course Outline Literature Grading The purpose of this course is to give a solid foundation in principles of corporate finance in order to understand and analyze the major issues affecting the financial policies of corporations. This course deals with (1)investment, (2)financing, (3)payout and (4)corporate governance decisions from the point of view of maximizing shareholder value.

4 Introduction Course Outline Literature Grading Corporate Finance: Bigger Picture OBJECTIVE Maximize shareholder wealth/firm s value Investment Investment decision decision Financial decision Financial decision Dividend decision Dividend decision What projects? Debt or equity? Active role? What projects? Debt or equity? Active role?

5 Introduction Course Outline Literature Grading Corporate Finance: Bigger Picture These decisions are highly inter-related Suppose a firm wishes to invest in a new project The project needs financing This can be paid with retained earnings (cash), by borrowing more (debt) or by a share issue (equity) Cash: the investment decision affects the Dividend decision Debt/Equity: the investment decision affects the Financial decision

6 Introduction Course Outline Literature Grading Day Time Topic Book (1) Goal of the firm (2) Present value calculations (3) Capital budgeting BM (1) Risk and return (2) Market efficiency (3) Valuing stocks and bonds BM (1) Dividend policy (2) Capital structure (3) Options 7.10 (1) Leasing (2) Mergers (3) Corporate control and corporate governance 3.11 BM BM 25, Presentation Test

7 Introduction Course Outline Literature Grading Corporate Finance: Bigger Picture OBJECTIVE Maximize shareholder wealth/firm s value LECTURE 1&4 Investment Investment decision LECTURE decision 1&2 Financial decision Dividend decision Financial decision Dividend decision LECTURE 3 What projects? Debt or equity? Active role? What projects? Debt or equity? Active role?

8 Introduction Course Outline Literature Grading Brealey, Richard A. and Myers, Stewart C. (2013), Principles of Corporate Finance 11th edition (or older), McGrawHill Additional articles can be provided during the course

9 Introduction Course Outline Literature Grading BOOK Lecture NOTES Seminar Solutions (REMIND ME 7 th OCT!)

10 Introduction Course Outline Literature Grading (1)Group (of 2) Presentation*: Business Plan Project due 4 th to be presented 5 th Oct 30% *obligatory (2) TEST: 70% Oct (word/ pdf file, via )

11 Introduction Course Outline Literature Grading Business Plan should include the following: 1. Cover page & Executive summary & Company overview 2. Industry analysis & Customer analysis & Competitive analysis 3. Operations Plan & Management team 4. Financial Analysis incl. Cash flow prediction (solid grounds) 5. Sensitivity analysis It is not a task who gets the best business idea It is a task of how to implement the tools you learn at the module in order to prepare investment decision

12 Introduction Course Outline Literature Grading TEST min test 2. closed books test 3. 2 sections: Section 1 Calculation question 5 questions All questions obligatory Section 2 Essay questions Choose 2 out of 3 questions Each question worth 20% of the mark see sample exam paper

13 Introduction Course Outline Literature Grading Questions?

14 Lecture 1: (1)Goal of the firm (2)Present value calculations (3)Capital budgeting

15 Goal of the firm

16 Goal of the firm What is a Corporation? The Role of The Financial Manager Maximizing Shareholders Value

17 Goal of the firm What Is A Corporation? Corporate Finance vs Managerial Finance Corporations vs All companies Sole Proprietorships Partnerships Unlimited Liability Personal tax on profits (US) Corporations Limited Liability Corporate tax on profits + personal tax on dividends (US) Separation of ownership and management A corporation is a legal entity (technically, a juristic person) which has a legal personality distinct from those of its members

18 Goal of the firm The Role of Financial Manager Firm s operations cash invested in firm Fundamental financial objective of a firm: Maximize the value of cash invested in the firm by shareholders Financial manager cash raised from investors cash reinvest ed Financial markets cash generated by operations cash returned to investors What real assets should the firm invest in? => investment, capital budgeting decision How should the cash for investment be raised? => financing decision

19 Introduction Course Outline Literature Grading Corporate Finance: Bigger Picture OBJECTIVE Maximize shareholder wealth/firm s value Investment Investment decision decision Financial decision Financial decision Dividend decision Dividend decision What projects? Debt or equity? Active role? What projects? Debt or equity? Active role?

20 Goal of the firm Maximizing Shareholders Value Choose an Objective Function Maximizing shareholders wealth Maximizing firm s value Maximizing share price The strength of the stock price maximization objective function is its internal self correction mechanism.

21 Goal of the firm Maximizing Shareholders Value Choose a Different Objective Function Firms can always focus on a different objective function. Examples would include maximizing revenues maximizing firm size maximizing market share Is maximizing shareholders value easy to achieve? The key thing to remember is that these are intermediate objective functions. To the degree that they are correlated with the long term health and value of the company, they work well. To the degree that they do not, the firm can end up with a disaster NO

22 Goal of the firm Maximizing Shareholders Value Corporation: separation of ownership and management=> AGENCY COSTS &problems Hire & fire managers - Board - Annual Meeting STOCKHOLDERS Maximize stockholder wealth Difference in Information Difference in Objectives BONDHOLDERS/ LENDERS Lend Money Protect bondholder Interests Reveal information honestly and on time Managers Markets are efficient and assess effect on value No Social Costs SOCIETY All costs can be traced to firm FINANCIAL MARKETS

23 Goal of the firm Maximizing Shareholders Value What can go wrong? Have little control over managers STOCKHOLDERS Managers put their interests above stockholders BONDHOLDERS/ LENDERS Lend Money Bondholders can get ripped off Managers Significant Social Costs SOCIETY Some costs cannot be traced to firm Delay bad news or provide misleading information Markets make mistakes and can over react FINANCIAL MARKETS 23

24 Goal of the firm Maximizing Shareholders Value I. Managers and Shareholders In theory: The stockholders have significant control over management. The two mechanisms for disciplining management are (a) the annual meeting and (b) the board of directors. Specifically, we assume that Stockholders who are dissatisfied with managers can not only express their disapproval at the annual meeting, but can use their voting power at the meeting to keep managers in check. The board of directors plays its true role of representing stockholders and acting as a check on management. In Practice: Neither mechanism is as effective in disciplining management.

25 Goal of the firm Maximizing Shareholders Value I. Managers and Shareholders The power of stockholders to act at annual meetings is diluted: Most small stockholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings. For large stockholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet (buy other company stocks). Annual meetings are also tightly scripted and controlled events, making it difficult for outsiders and rebels to bring up issues that are not to the management s liking.

26 Goal of the firm Maximizing Shareholders Value I. Managers and Shareholders Board of Directors as a disciplinary mechanism In 2010, the median board member at a Fortune 500 company was paid $212,512, with 54% coming in stock and the remaining 46% in cash. If a board member is a non-executive chair, he or she receives about $150,000 more in compensation. A board member works, on average, about hours a year (and that is being generous), or 4.4 hours a week, according to the National Associate of Corporate Directors. Of this, about 24 hours a year are for board meetings. Many directors serve on three or more boards, and some are full time chief executives of other companies.

27 Goal of the firm Maximizing Shareholders Value I. Managers and Shareholders The CEO often hand-picks directors A 1992 survey by Korn/Ferry revealed that 74% of companies relied on recommendations from the CEO to come up with new directors; Only 16% used an outside search firm. While that number has changed in recent years, CEOs still determine who sits on their boards. While more companies have outsiders involved in picking directors now, CEOs still exercise significant influence over the process. Directors often hold only token stakes in their companies. The Korn/Ferry survey found that 5% of all directors in 1992 owned less than five shares in their firms. Most directors in companies today still receive more compensation as directors than they gain from their stockholdings. While share ownership is up among directors today, they usually get these shares from the firm (rather than buy them). Many directors are themselves CEOs of other firms. Worse still, there are cases where CEOs sit on each other s boards.

28 Goal of the firm Maximizing Shareholders Value I. Managers and Shareholders Board of Directors as a disciplinary mechanism Calpers, the California Employees Pension fund, suggested three tests in 1997 of an independent board Are a majority of the directors outside directors? Is the chairman of the board independent of the company (and not the CEO of the company)? Are the compensation and audit committees composed entirely of outsiders? Disney (1997) was the only S&P 500 company to fail all three tests.

29 Goal of the firm Who s on Board? The Disney Experience

30 Goal of the firm S&P500

31 Goal of the firm Maximizing Shareholders Value Inside stockholders -% of stock held -voting & non voting shares -control structure I. Managers and Shareholders Application Test: Who owns/runs your firm? Who are the top stockholders in your firm? What are the potential conflicts of interests that you see emerging from this stockholding structure? Outside Stockholders -size of holding -active or passive -short or long term Government Control of the firm Managers -length of tenue -links to insiders Employees Lenders

32 Goal of the firm Maximizing Shareholders Value I. Managers and Shareholders Disney s top stockholders in 2003

33 Goal of the firm Maximizing Shareholders Value I. Managers and Shareholders Things change.. Disney s top stockholders in 2009

34 Goal of the firm Maximizing Shareholders Value I. Managers and Shareholders When managers do not fear stockholders, they will often put their interests over stockholder interests Maximizing the size of the company (prestige) Increasing managerial power Making their jobs more secure Increasing personal remuneration Personal projects

35 Goal of the firm Maximizing Shareholders Value II. Shareholders objectives vs. Bondholders objectives In theory: there is no conflict of interests between stockholders and bondholders. In practice: Stockholder and bondholders have different objectives. Bondholders are concerned most about safety and ensuring that they get paid their claims. Stockholders are more likely to think about upside potential

36 Goal of the firm Maximizing Shareholders Value II. Shareholders objectives vs. Bondholders objectives Examples of the conflict Increasing dividends significantly: When firms pay cash out as dividends, lenders to the firm are hurt and stockholders may be helped. This is because the firm becomes riskier without the cash. Taking riskier projects than those agreed to at the outset: Lenders base interest rates on their perceptions of how risky a firm s investments are. If stockholders then take on riskier investments, lenders will be hurt. Borrowing more on the same assets: If lenders do not protect themselves, a firm can borrow more money and make all existing lenders worse off.

37 Goal of the firm Maximizing Shareholders Value II. Shareholders objectives vs. Bondholders objectives An Extreme Example: Unprotected Lenders?

38 Goal of the firm Maximizing Shareholders Value III. Firms and Financial Markets In theory: Financial markets are efficient. Managers convey information honestly and in a timely manner to financial markets, and financial markets make reasoned judgments of the effects of this information on 'true value'. As a consequence- A company that invests in good long term projects will be rewarded. Short term accounting gimmicks will not lead to increases in market value. Stock price performance is a good measure of company performance. In practice: There are some holes in the 'Efficient Markets' assumption.

39 Goal of the firm Maximizing Shareholders Value III. Firms and Financial Markets Managers control the release of information to the general public Information (especially negative) is sometimes suppressed or delayed by managers seeking a better time to release it. In some cases, firms release intentionally misleading information about their current conditions and future prospects to financial markets.

40 Goal of the firm Maximizing Shareholders Value III. Firms and Financial Markets Evidence that managers delay bad news?

41 Goal of the firm Maximizing Shareholders Value III. Firms and Financial Markets Some critiques of market efficiency... Investors are irrational and prices often move for no reason at all. As a consequence, prices are much more volatile than justified by the underlying fundamentals. Earnings and dividends are much less volatile than stock prices. Investors overreact to news, both good and bad. Financial markets are manipulated by insiders; Prices do not have any relationship to value. Investors are short-sighted, and do not consider the long-term implications of actions taken by the firm

42 Goal of the firm Maximizing Shareholders Value IV. Firms and the Society In theory: All costs and benefits associated with a firm s decisions can be traced back to the firm. In practice: Financial decisions can create social costs and benefits. A social cost or benefit is a cost or benefit that accrues to society as a whole and not to the firm making the decision. Environmental costs (pollution, health costs, etc..) Quality of Life' costs (traffic, housing, safety, etc.) Examples of social benefits include: creating employment in areas with high unemployment supporting development in inner cities creating access to goods in areas where such access does not exist

43 Goal of the firm Maximizing Shareholders Value IV. Firms and the Society Social Costs and Benefits are difficult to quantify because... They might not be known at the time of the decision. In other words, a firm may think that it is delivering a product that enhances society, at the time it delivers the product but discover afterwards that there are very large costs. (Asbestos was a wonderful product, when it was devised, light and easy to work with It is only after decades that the health consequences came to light) They are person-specific, since different decision makers can look at the same social cost and weight them very differently. They can be paralyzing if carried to extremes.

44 Goal of the firm Maximizing Shareholders Value IV. Firms and the Society A test of your social consciousness: Put your money where you mouth is Assume that you work for Disney and that you have an opportunity to open a store in an inner-city neighborhood. The store is expected to lose about a million dollars a year, but it will create much-needed employment in the area, and may help revitalize it. Would you open the store? Yes No If yes, would you tell your stockholders and let them vote on the issue? Yes No If no, how would you respond to a stockholder query on why you were not living up to your social responsibilities?

45 Goal of the firm Maximizing Shareholders Value Conclusions In the context of our discussion: managers taking advantage of stockholders has led to a much more active market for corporate control. stockholders taking advantage of bondholders has led to bondholders protecting themselves at the time of the issue. firms revealing incorrect or delayed information to markets has led to markets becoming more skeptical and punitive firms creating social costs has led to more regulations, as well as investor and customer backlashes.

46 Goal of the firm What is a Corporation? The Role of The Financial Manager Maximizing Shareholders Value

47 Present Value Calculations

48 Present Value Calculations Time Value of Money Type of Interest / Compounding Present Value Simple Cash flows Perpetuity Growing Perpetuity Annuity Growing Annuity Asset

49 Present Value Calculations Time Value of Money Which would you prefer: (a) $ today or (b) $ in 5 years time?

50 Present Value Calculations Time Value of Money Reasons why a cash flow in the future is worth less than a similar cash flow today: Individuals prefer present consumption to future consumption. People would have to be offered more in the future to give up present consumption. When there is monetary inflation, the value of currency decreases over time. The greater the inflation, the greater the difference in value between a cash flow today and the same cash flow in the future. Any uncertainty (risk) associated with the cash flow in the future reduces the value of the cashflow. A promised cash flow might not be delivered for a number of reasons: the promisor might default on the payment, the promisee might not be around to receive payment; or some other contingency might intervene to prevent the promised payment or to reduce it.

51 Present Value Calculations Time Value of Money The process by which future cash flows are adjusted to reflect these factors is called discounting, and the magnitude of these factors is reflected in the discount rate. t=0 Present value (PV)? < $ t=5 Future value (FV) $10 000

52 Present Value Calculations Time Value of Money Cash flows at different points in time cannot be compared and aggregated. All cash flows have to be brought to the same point in time before comparisons and aggregations can be made.

53 Present Value Calculations Types of Interest Simple Interest Interest paid (earned) on only the original amount, or principal, borrowed (lent). Compound Interest Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).

54 Present Value Calculations Types of Interest Simple Interest If and P = principal, r = annual interest rate, t = time (in years), then the simple interest I is given by I = Prt

55 Present Value Calculations Types of Interest Simple Interest Assume that you deposit $4,800 in an account earning 7% simple interest for 6 months. What is the interest at the end of the 6 th month? I = P(r)(t) = $4,800(.07)(6/12) = $168

56 Present Value Calculations Types of Interest Simple Interest What is the Future Value (FV) of the deposit? FV = P + I = $4,800 + $168 = $4,968 Future Value is the value at some future time of a present amount of money, or a series of payments, evaluated at a given interest rate.

57 Present Value Calculations Types of Interest Simple Interest What is the Present Value (PV) of the previous problem? The Present Value is simply the $4,800 you originally deposited. That is the value today! Present Value is the current value of a future amount of money, or a series of payments, evaluated at a given interest rate.

58 Present Value Calculations Types of Interest Compound Interest If P = principal R m = annual interest rate compounded m times a year and n = number of periods of time then the FV n is given by FV n = P 1 + R m m mn

59 Present Value Calculations Types of Interest Compound Interest

60 Present Value Calculations Continuous compounding Types of Interest Compound Interest As m : FV n = P e R cn where: R c is the annual interest rate n is time period (expressed as a fraction of year)

61 Present Value Calculations Types of Interest Value of 1 GBP years annual semi quarter month continous 5% interest rate % interest rate

62 Present Value Calculations Types of Interest

63 Present Value Calculations Present Value Types of Cash Flows Simple cash flows Perpetuities Growing perpetuities Annuities Growing annuities

64 Present Value Calculations Present Value Simple Cash Flow A simple cash flow is a single cash flow in a specified future time period; it can be depicted on a time line: 0 t CF t where CF t = the cash flow at time t. This cash flow can be discounted back to the present using a discount rate that reflects the uncertainty of the cash flow. Concurrently, cash flows in the present can be compounded to arrive at an expected future cash flow.

65 Present Value Calculations Present Value Simple Cash Flow The present value (PV) of a cash flow (CF t ): Compounding m times a year: PV = CF t R m 1 + R mn = CF t 1 + m m m mn Continuous compounding: PV = CF t e rn where CF t = Cash Flow at the end of time period t Other things remaining equal, the present value of a cash flow will decrease as the discount rate increases and continue to decrease the further into the future the cash flow occurs.

66 Present Value Calculations Present Value Perpetuity A perpetuity is a constant cash flow (CF) at regular intervals forever. The present value of a perpetuity can be written as PV of Perpetuity = CF r

67 Present Value Calculations Example: Valuing a Console Bond Present Value Perpetuity A console bond is a bond that has no maturity and pays a fixed coupon. Assume that you have a 6% coupon console bond. The value of this bond, if the interest rate is 9%, is as follows: Value of Console Bond = $60 /.09 = $667 The value of a console bond will be equal to its face value (which is usually $1000) only if the coupon rate is equal to the interest rate.

68 Present Value Calculations Present Value Growing Perpetuity A growing perpetuity is a cash flow that is expected to grow at a constant rate forever. The present value of a growing perpetuity can be written as: PV of Growing Perpetuity = CF 1 r g where CF 1 is the expected cash flow next year, g is the constant growth rate and r is the discount rate. The fact that a growing perpetuity lasts forever puts constraints on the growth rate. It has to be less than the discount rate for this formula to work.

69 Present Value Calculations Present Value Growing Perpetuity Example: Valuing a Stock with Stable Growth in Dividends In 1992, Southwestern Bell paid dividends per share of $2.73. Its earnings and dividends had grown at 6% a year between 1988 and 1992 and were expected to grow at the same rate in the long term. The rate of return required by investors on stocks of equivalent risk was 12.23%. Current Dividends per share = $2.73 Expected Growth Rate in Earnings and Dividends = 6% Discount Rate = 12.23% Value of Stock = $2.73 *1.06 / ( ) = $46.45 As an interesting aside, the stock was actually trading at $70 per share. This price could be justified by using a higher growth rate. The value of the stock is graphed in figure 3.7 as a function of the expected growth rate. The growth rate would have to be approximately 8% to justify a price of $70. This growth rate is often referred to as an implied growth rate.

70 Present Value Calculations Present Value Annuity An annuity is a constant cash flow that occurs at regular intervals for a fixed period of time. Defining A to be the annuity, the time line for an annuity may be drawn as follows: $10 $10 $10 $10 $ An annuity can occur at the end of each period, as in this time line, or at the beginning of each period.

71 Present Value Calculations Present Value Annuity The present value of an annuity can be calculated by taking each cash flow and discounting it back to the present and then adding up the present values. Alternatively, a formula can be used in the calculation. In the case of annuities that occur at the end of each period, this formula can be written as: PV of an Annuity = PV A, r, n = A r r n where A = Annuity r = Discount Rate n = Number of years the present value of an annuity will be PV(A,r,n).

72 Present Value Calculations Present Value Annuity An annuity vs. a difference between 2 perpetuities $10 $10 $10 $10 $ CF r r n CF r $10 $10 $10 $10 $10 $10 $ CF r r n $10 $ Since the cash flows are the same, the values must be the same

73 Present Value Calculations Present Value Annuity Example: Estimating the Present Value of Annuities Assume that you are the owner of Compnay X, and that you have a choice of buying a copier for $10,000 cash down or paying $ 3,000 a year for 5 years for the same copier. If the opportunity cost is 12%, which would you rather do? PV of $3000 each ofr next 5 year = $ = $10,814 The present value of the installment payments exceeds the cashdown price; therefore, you would want to pay the $10,000 in cash now.

74 Present Value Calculations Present Value Annuity Alternatively, the present value could have been estimated by discounting each of the cash flows back to the present and aggregating the present values as illustrated below:

75 Present Value Calculations Example : Present Value of Multiple Annuities Present Value Annuity Suppose you are the pension fund consultant and that you are trying to estimate the present value of the expected pension obligations, which amount in nominal terms to the following: Years Annual Cash Flow 1-5 $ million 6-10 $ million $ million If the discount rate is 10%, the present value of these three annuities can be estimated as follows: Present Value of 1 st annuity = $ 200 million * PV (A, 10%, 5) = $ 758 million Present Value of 2 nd annuity = $ 300 million * PV (A,10%,5) / = $ 706 million Present Value of 3 rd annuity = $ 400 million * PV (A,10%,10) / = $ 948 million The present values of the second and third annuities can be estimated in two steps: First, the standard present value of the annuity is computed over the period that the annuity is received. Second, that present value is brought back to the present. Thus, for the second annuity, the present value of $ 300 million each year for 5 years is computed to be $1,137 million; this present value is really as of the end of the fifth year. It is discounted back 5 more years to arrive at today s present value which is $ 706 million. Cumulated Present Value = $ 758 million+$706 million+$948 million = $2,412 million

76 Present Value Calculations Present Value Annuity In some cases, the present value of the cash flows is known and the annuity needs to be estimated. This is often the case with home and automobile loans, for example, where the borrower receives the loan today and pays it back in equal monthly installments over an extended period of time. This process of finding an annuity when the present value is known is examined below Annuity given Present Value = PV 1 r r n

77 Present Value Calculations Present Value Annuity Example: Calculating The Monthly Payment On A House Loan Suppose you are trying to borrow $200,000 to buy a house on a conventional 30-year mortgage with monthly payments. The annual percentage rate on the loan is 8%. The monthly payments on this loan can be estimated using the annuity due formula: Monthly interest rate on loan = APR/ 12 = 0.08/12 = Monthly Payment on Mortgage = $200, = $ This monthly payment is an increasing function of interest rates. When interest rates drop, homeowners usually have a choice of refinancing, though there is an up-front cost to doing so.

78 Present Value Calculations Present Value Growing Annuity A growing annuity is a cash flow that grows at a constant rate for a specified period of time. If A is the current cash flow, and g is the expected growth rate, the time line for a growing annuity appears as follows: Note that, to qualify as a growing annuity, the growth rate in each period has to be the same as the growth rate in the prior period.

79 Present Value Calculations Present Value Growing Annuity In most cases, the present value of a growing annuity can be estimated by using the following formula: PV of a Growing Annuity = A 1 + g r g g n 1 + r n The present value of a growing annuity can be estimated in all cases, but one - where the growth rate is equal to the discount rate. In that case, the present value is equal to the nominal sums of the annuities over the period, without the growth effect: PV of a Growing Annuity for n years (when r=g) = n A Note also that this formulation works even when the growth rate is greater than the discount rate.

80 Present Value Calculations Present Value Growing Annuity Example: The Value Of A Gold Mine Suppose you have the rights to a gold mine for the next 20 years, over which period you plan to extract 5,000 ounces of gold every year. The current price per ounce is $300, but it is expected to increase 3% a year. The appropriate discount rate is 10%. The present value of the gold that will be extracted from this mine can be estimated as follows: PV of extracted gold = $ ( ) ( ) 1 ( )20 ( ) 20 The present value of the gold expected to be extracted from this mine is $ million; it is an increasing function of the expected growth rate in gold prices.

81 Present Value Calculations Present Value Asset Price of an asset (or a value of a project) = PV of future cash flows generated by the asset and discounted at the appropriate rate (opportunity cost of capital) Price = PV PV depends on: i) Future cash flows ii)discount rate iii)number of periods

82 Present Value Calculations Time Value of Money Type of Interest / Compounding Present Value Simple Cash flows Perpetuity Growing Perpetuity Annuity Growing Annuity Asset

83 Capital Budgeting

84 Capital Budgeting Introduction to Capital Budgeting Investment appraisal methods Payback Period ROCE NPV IRR Investment appraisal applications & risk Taxation Inflation Sensitivity analysis

85 Capital Budgeting Introduction Shareholders invest in companies to make money. We are interested in how to chose which project to invest in? Investment decision = Capital Budgeting

86 Capital Budgeting Introduction Investment is an important component of GDP Y = C + I + G Why do firms invest? How do they decide what to invest in?

87 Capital Budgeting Introduction Shareholders invest in companies to make money. Cash Investment Opportunity (real asset) Firm Shareholder Investment Opportunities (financial assets) Invest Alternative: Pay divident to shareholders Sharehoders can invest for themselves

88 Capital Budgeting Introduction Types of projects Projects vary in level on analysis needed to take the decision Replacement projects (no need for very careful analysis) Expansion projects, i.e. increasing the size of the firm (involves more uncertainty) New products or services (probably even riskier) Regulatory, safety and environmental projects (often imposed by regulatory agencies, so must be undertaken) Pet projects (CEO getting a new aircraft!)

89 Capital Budgeting Introduction Types of projects by compatibility Independent projects - undertaking one does not necessarily exclude the others (provided that there is sufficient capital) Mutually exclusive projects - only one of the potential candidates may be undertaken e.g. planning to buy a new machine, and there are two which meet the requirements In reality, company has a limited amount of capital to fund potentially many recommended projects Capital rationing

90 Capital Budgeting Introduction Managers undertake valuations to allocate capital (i.e. money tied up in the form of equity / debt) between investment projects: Is Project A better than doing nothing? Is A better than B? Although A is better than B, should we still carry on B? Appraisal methods help us in decision making. They take into account: Cash flows measure of value creation Time opportunity cost of investing

91 Capital Budgeting Investment Appraisal Methods Traditional techniques (1) Payback Period (2) Return on Capital Employed (ROCE) Discounted cash flows methods (3) Net Present Value (NPV) (4) Internal Rate of Return (IRR)

92 Capital Budgeting Investment Appraisal Methods Payback Period How long does it take the project to payback its initial investment? Payback Period = number of years required for the future cumulative cash flows to match the initial outlay The payback rule says only accept projects that payback in the desired time frame. A modified version that takes time value of money into account: Discounted Payback Period = number of years required for the future cumulative discounted cash flows to match the initial outlay

93 Capital Budgeting Example Investment Appraisal Methods Payback Period A conventional cash flow: A cash investment initially, followed by a series of cash inflows over the life of a project Year Cash flow ($) Cumulative cash flow ($) 0 (450) (450) (350) (150) (50) Payback Period = between 3 and 4 years Payback Period ~ 3.5 years Ranking criterion: Select the project with the lowest payback period Zero (payback period) is between 3&4 years

94 Capital Budgeting Investment Appraisal Methods Payback Period Advantages Easy to understand, calculate, and communicate In fact so straightforward that it is frequently used (but should really only be used to get an initial indication) Useful for companies that face cash flow constraints (e.g. small companies) since it is biased toward liquidity Arguably takes account of risk (since it assumes that a shorter payback period is better than a longer one) and assuming that more distant cash flows are less certain (i.e. more risky)

95 Capital Budgeting Investment Appraisal Methods Payback Period Disadvantages Ignores cash flows after the payback period Income after the payback period is not considered, e.g. increasing the cash flow in yr5 in our example must make the project better? Biased against long-term projects Ignores the time value of money Think back to our example: a cash flow of [ 0, 0, 400] is considered equal to a cash flow of [ 400, 0, 0] Arbitrary acceptance criterion (i.e. when there is a single project to consider) Why pick 3.5yrs over, say, 3yrs, or 4yrs? Accepted projects may not actually add value to the company (or the shareholders wealth) All the Payback method really tells us is whether the company has the liquidity to finance the project (although this can be important, particularly to small companies)

96 Capital Budgeting Investment Appraisal Methods Return on Capital Employed (ROCE) Also known as return on investment (ROI) and accounting rate of return (ARR) All definitions relate accounting profit to some measure of the capital employed We will follow this formula: ROCE = Average annual accounitng profit Average investment 100 Accounting profits = before-tax operating cash flows adjusted to take account of depreciation Average investment must take account of scrap value: Average investemnt = Initial investemnt + Scrap value 2

97 Capital Budgeting Investment Appraisal Methods Return on Capital Employed (ROCE) Example Project A generates annual cash flows (receipts less payments) of $210,000 for 5 years The initial cost of machinery is $500,000; no scrap value Total cash profit = 210,000 5 = 1,050,000 Total accounting profit (after depreciation) = 550,000 Average accounting profit = 550,000/5 = 110,000 Average investment = (500, )/2 = 250,000 ROCE = = 44% Ranking criterion: Select the project with the highest ROCE first

98 Capital Budgeting Investment Appraisal Methods Return on Capital Employed (ROCE) Advantages Percentage returns are familiar, and can be compared with the ROCE of the company to determine if a new project is acceptable Accounting information readily available Reasonably simple to apply and can be used to compare mutually exclusive projects Unlike the payback method, ROCE considers all cash flows

99 Capital Budgeting Disadvantages Investment Appraisal Methods Return on Capital Employed (ROCE) Accounting profits are not cash flows, since depreciation is an accounting adjustment Ignores time value of money Arbitrary acceptance criterion: Compare ROCE to some target rate of return Is 44% ROCE high enough? Accounting profits are not linked directly to maximising shareholder wealth Because average profits are used, the timing of profits is not taken fully into consideration

100 Capital Budgeting Investment Appraisal Methods Net Present Value (NPV) NPV = I 0 + C 1 (1 + r) + C r 2 + C r C n 1 + r n where: I 0 is the initial investment C 1, C 2, C 3 are the cash flows expected in time 1, 2, 3, r is the cost of capital or required rate of return Minimum acceptance criterion: Accept if NPV > 0 A positive NPV indicates that the investment offers a return in excess of the cost of capital Ranking criterion: Select the project with the highest NPV first

101 Capital Budgeting Investment Appraisal Methods Net Present Value (NPV) NPV is based in solid theory It makes use of the time value of money And the PV concept we considered earlier in the module NPV measures actual wealth creation because It uses cash flows It uses ALL cash flows during the project life It discounts ALL cash flows during the project life, using the cost of capital (or the required rate of return)

102 Capital Budgeting Investment Appraisal Methods Net Present Value (NPV) Example Can be done very easily in a spreadsheet using Excel Notice that NPV has an inverse relationship with r As r increases the NPV of a given project falls This makes sense; the higher the rate of return we require the fewer projects we would expect to be profitable

103 Capital Budgeting Investment Appraisal Methods Net Present Value (NPV) C8 =NPV(0.1, C3:C6) NPV in EXCEL calculates PV

104 Capital Budgeting Investment Appraisal Methods Net Present Value (NPV) To estimate NPV we need to: Estimate the initial cost Usually this is known for certain Estimate future cash flows Expected future cash flows, so subject to errors Risk of appraisal methods in general, not only NPV Estimate discount rate Required rate of return CAPM We will do that at the next lecture

105 Capital Budgeting Investment Appraisal Methods Net Present Value (NPV) Advantages Takes account of the time value of money Uses cash flows rather than accounting profit Uses all relevant cash flows Academically(!) preferred method: grounded in consumption theory If capital is available NPV gives good investment advice

106 Capital Budgeting Investment Appraisal Methods Net Present Value (NPV) Disadvantages Hard to forecast future cash flows But this is true of all investment appraisal techniques! Cost of capital may change over the lifetime of the project

107 Capital Budgeting Investment Appraisal Methods Internal Rate of Return (IRR) It is defined implicitly as the discount rate at which NPV is equal to zero C r + C r 2 + C r C n 1 + r n I 0 = 0 where r* is the Internal Rate of Return Minimum acceptance criterion: Accept a project if its IRR exceeds the cost of capital (or required rate of return) Ranking criterion: Select the project with the highest IRR first

108 Capital Budgeting Investment Appraisal Methods Internal Rate of Return (IRR) Example: You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment? NPV 2,000 4,000 4,000 2 (1 IRR) (1 IRR) 1 0 IRR 28.08% 2500 IRR= 28% NPV (,000s) Discount rate (%)

109 Capital Budgeting Investment Appraisal Methods Internal Rate of Return (IRR) C r + C r 2 + C r C n 1 + r 4 I 0 = 0 (1) Equation (1) is not easy to solve (even if C = C 1 = C 2 = C 3 = = C n ) I 0 = C r r n (2) We would need to solve equation (2) to find r* PV of Annuity Before we had Excel the solution was basically to guess...

110 Capital Budgeting Investment Appraisal Methods Internal Rate of Return (IRR) Of course mathematicians don t guess! Instead they use Numerical Analysis... and in this case Linear Interpolation Which sounds far more sophisticated than guessing Let s see how it works

111 Capital Budgeting Investment Appraisal Methods Internal Rate of Return (IRR) Suppose we know the two end points [x 0, y 0 ],[x 1,y 1 ] Substituting for y and x in the standard formula for a straight line, y = ax+b, gives: a = y 1 y 0 x 1 x 0 and b = y 0 y 1 y 0 x 1 x 0 x 0 This means the formula for a straight line becomes: y = y 1 y 0 x 1 x 0 x + y 0 y 1 y 0 x 1 x 0 x 0

112 Capital Budgeting Investment Appraisal Methods Internal Rate of Return (IRR) To find the approximation of a true IRR, i.e. IRR* is equivalent with solving the below for x: NPV y = y 1 y 0 x 1 x 0 x + y 0 y 1 y 0 x 1 x 0 x 0 + A(R 1,NPV 1 ) we obtain: x = x 0 y 0 x 1 x 0 y 1 y IRR (IRR*, 0) Discount rate B(R 2,NPV 2 ) which can be written in terms of points A and B as: IRR = R 1 NPV 1 R 2 R 1 NPV 2 NPV 1

113 Capital Budgeting Investment Appraisal Methods Internal Rate of Return (IRR) To finding the IRR*, which is an approximation is called Linear Interpolation. NPV A(R 1,NPV 1 ) Of course the closer the NPV 1 and NPV 2 are to zero (from above and below) the closer the approximation IRR (IRR*, 0) Discount rate B(R 2,NPV 2 ) Since the relationship between NPV and the discount rate of a conventional cash flow is negatively sloped and convex the estimate will always be an over-estimate

114 Capital Budgeting Investment Appraisal Methods Internal Rate of Return (IRR) Generally, very computationally challenging, i.e. no formula, not as straightforward as NPV Trial & error keep trying different discount rates untill NPV=0 Use Solver in Excel

115 Capital Budgeting Pitfall 1 - Lending or Borrowing? With some cash flows (as noted below) the NPV of the project increases as the discount rate increases. This is contrary to the normal relationship between NPV and discount rates. NPV C C C IRR NPV@10% C ,000 3,600 4,320 Investment Appraisal Methods Internal Rate of Return (IRR) 1,728 20%.75 Discount Rate Pitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=0 at both (-50%) and 15.2%. C0 C1 C2 C3 C4 C5 C6 1, NPV IRR=-50% IRR=15.2% Discount Rate

116 Capital Budgeting Investment Appraisal Methods Internal Rate of Return (IRR) Pitfall 3 - Mutually Exclusive Projects IRR sometimes ignores the magnitude of the project. The following two projects illustrate that problem. At 10% IRRA=19.5% while IRRB= 17%. As the discount rate decreases, and before the lines cross, NPV suggests B, while IRR suggests A. Pitfall 4 - Term Structure Assumption We assume that discount rates are stable during the term of the project. This assumption implies that all funds are reinvested at the IRR. This is a false assumption. NPV allows for change in discount rate.

117 Capital Budgeting Investment Appraisal Methods NPV vs. IRR There is no conflict between these two methods when a single project with conventional cash flows is being considered But for non-conventional (strange cash flows) mutually exclusive projects, a conflict might arise NPV is academically preferred because it measures the absolute increase in value of the company In all cases where there is no constraint on capital, the NPV decision rule offers sound investment advice

118 Capital Budgeting Investment Appraisal Application NPV vs. IRR There are a number of issues that we need to take into account when applying NPV in practice (i.e. how do we come up with the cash flows and what considerations do we need to make?): Relevant project cash flows Ask whether a cash flow occurs as a result of undertaking a project (Incremental cash flows) Taxation what effect does taxation have on the cash flow from the project Inflation reduces the real value of future cash flows Investment risk when things don t go as you expect

119 Capital Budgeting Investment Appraisal Application Incremental Cash Flows Include: Cash in- and outflows resulting from the project, including additional investment or working capital Opportunity costs / benefits foregone Side effects: Erosion or synergy e.g. by launching Coke Zero, demand for Diet Coke will drop; by launching iphone, demand for Mac will increase Ignore: Sunk costs(e.g. market research takes place whether the project goes ahead or not) Apportioned fixed costs unless incremental / additional Any interest expenditure, even if debt financing Adjustments for cost of debt reflected in r

120 Capital Budgeting Opportunity Cost- Example Project A requires 500 kg of material A Suppose we have 1,000 kg of material A in inventory, which cost $2,000 when purchased 6 months ago The supplier now quotes a price of $2.2 per kg, and the material can be resold at $1.9 per kg What is the relevant cost of material A? a) $1,000 (no, a sunk cost since the company has bought material A already) b) $1,100 c) $950 Investment Appraisal Application Incremental Cash Flows (yes, but only if the company has other projects that could use material A) (yes, but only if there is no other use for material A, which would have to be resold if the project were not undertaken)

121 Capital Budgeting Investment Appraisal Application Effects of taxation Companies pay corporate tax Estimate after-tax incremental cash flows for NPV The amount and timing of tax payments affect NPV Corporate tax is based on taxable profit which is not the same as cash flow (see next slide) For taxation purposes, capital expenditure is written off against taxable profits by means of annual capital allowances

122 Capital Budgeting Investment Appraisal Application Effects of taxation Timing of tax liabilities and benefits : UK Tax liabilities taken as being paid one year after the originating taxable profits Tax benefits also received one year in arrears Small UK companies (taxable profit < 1.5 m) pay tax nine months after the end of the relevant accounting year Large UK companies pay most of their tax close to the end of the relevant accounting year Tax liabilities & benefits treated as occurring in the same year

123 Capital Budgeting Investment Appraisal Application Effects of inflation Inflation can have a serious effect on investment decisions by reducing the real value of future cash flows Deflate nominal cash flows by the general rate of inflation to obtain real cash flows Relationship between real and nominal costs of capital 1 + Real cost of capital = 1 + Nominal cost fo capital 1 + Inflation rate Golden rule of discounting: Use real rates to discount real cash flows Use nominal rates to discount nominal cash flows

124 Capital Budgeting Investment Appraisal Application Effects of inflation Example: Nominal discount rate = 10% Expected inflation = 4% Real discount rate = 1.10/ = 5.8% Next year s sales = 100 in today s prices PV using real cash flow = 100/1.058 ~ PV using nominal cash flow = /1.10 ~ This example illustrates how NPV obtained by discounting real cash flows with a real cost of capital is identical to NPV obtained by discounting nominal cash flows with a nominal cost of capital

125 Capital Budgeting Investment Appraisal Application Sensitivity Analysis Sensitivity Analysis is a method of assessing an investment project by evaluating how responsive the outcome of the project appraisal is to changes in relevant variables Conventional approaches: Change each project variable by a set amount and recalculate NPV Change each project variable such that NPV = 0, and evaluate the magnitude of change required Some rules: Change one variable at a time, and change it in the direction that adversely affects NPV

126 Capital Budgeting Investment Appraisal Application Sensitivity Analysis Example: Equation 1

127 Capital Budgeting Example cont.: Investment Appraisal Application Sensitivity Analysis Using Equation 1, we can show that NPV S = N CPVF 12,4 = 800, = 2,429,600 So, a one $ drop in sales price leads to a $2.4 m drop in NPV (which will make it negative) This implies that a percent drop in price (=$0.092) will lead to a $223,523 drop in NPV = 29% drop A similar analysis shows that if the initial cost increases by a percent, NPV drops by 9% only Sales price is therefore a key variable

128 Capital Budgeting Investment Appraisal Application Sensitivity Analysis A similar process could be carried out for changes to any other of the variables (for example, how low would volume of sales need to get for NPV to be zero, and so forth) The hard part is interpreting the interaction between all these uncertainties!...but if you look at impact of 1% change on the NPV you should be quick to identify the main risk factors USE IN YOUR BUSINESS PLAN

129 Capital Budgeting Investment Appraisal in Practise Companies don t always make use all of the sorts of analysis we have looked at today In part this almost certainly reflects the large amount of uncertainty associated with predicting the future! The payback method is most common (although often accompanied by some sort of discounted cash flow method)

130 Capital Budgeting Investment Appraisal in Practise It is surprising how few companies formally adjust calculations for inflation Drury et al, 1993, suggest only some 27% The use of more advanced sensitivity or probability analysis also appears to be relatively rare Although surely in part because managers see it as being of relatively little practical benefit

131 Capital Budgeting Conclusions Traditional techniques (1) Payback Period (2) Return on Capital Employed (ROCE) Discounted cash flows methods (3) Net Present Value (NPV) (4) Internal Rate of Return (IRR) Main conclusions: (3) & (4) preferred to (1) & (2) (3) preferred to (4)

132 Capital Budgeting Introduction to Capital Budgeting Investment appraisal methods Payback Period ROCE NPV IRR Investment appraisal applications & risk Taxation Inflation Sensitivity analysis

133 EXERCISES

134 Capital Budgeting Profitability Index When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives A set of limited resources and projects can yield various combinations. The highest weighted average PI can indicate which projects to select. Profitability Index NPV Investment Example We only have $300,000 to invest. Which do we select? Select projects with highest Weighted Avg PI Project NPV Investment PI A B C D *(125) 1.08*(150) 0*(25) WAPI ( BD) WAPI (A) = 0.77 WAPI (BC) = 1.12

135 Capital Budgeting Equivalent Annual Cost Equivalent Annual Cost (EAC) The cost per period with the same present value as the cost of buying and operating a machine. EAC is the annual cash flow sufficient to recover a capital investment, including the cost of capital for that investment, over the investment s economic life. Equivalent annual cost = present value of costs annuity factor Example Given the following costs of operating two machines and a 6% cost of capital, select the lower cost machine using equivalent annual cost method. Machine Year 1 Year 2 Year 3 Year 4 PV@6% EAC A B

136 Capital Budgeting Timing Even projects with positive NPV may be more valuable if deferred. The actual NPV is then the current value of some future value of the deferred project. Current NPV Net future value as t (1 r) of date t Example You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV? Harvest Year Net FV($1000s) % change in value Solution NPV if harvested in year Harvest Year NPV ($1000s)

137 Question 1

138 Question 2

139 Question 3

140 Question 4 Show by a simple graph-theoretic procedure how linear interpolation can be used to determine the internal rate of return of a project.

141 Question 5 ABC plc is comparing two investment projects. The expected cash flows are given below. Assume the cost of capital is 10 per cent. (a) Calculate the payback period, net present value, internal rate of return, and return on capital employed on each project. (b) Show the rankings of the projects by each of the four methods. Comment on your findings.

142 Question 6 XYZ plc is evaluating the purchase of a new machine and has the following information: Initial investment: Residual value: nil Expected life: 10 years Sales volume: units per year Sales price: 8.50 per unit Variable cost: 3.50 per unit Fixed costs: per year Cost of capital: 15% (a) Calculate the IRR of the project. (b) Assess the sensitivity of the purchase evaluation to a change in project life. (c) Assess the sensitivity of the purchase evaluation to a change in sales price.

143 Lecture 2: (1)Risk, Return and Portfolio Theory (2)Market efficiency (3)Valuating stocks and bonds

144 Risk, Return and Portfolio Theory

145 Risk, Return... For NPV we need discount rate. The opportunity cost of capital. Rate of return that you would earn on capital market for investing in something of equivalent level of risk

146 Risk, Return... Financial Markets Measuring Risk and Return Diversification Optimal Portfolio Capital Asset Pricing Model

147 Risk, Return... Financial Markets

148 Risk, Return... Financial Markets Purpose of Financial Markets To facilitate the transfer of funds between borrowers and lenders To trade time & risk Price discovery: Trading on secondary markets provides public information on asset prices (market price = last traded price of an asset) Lower search costs: Since all trading parties converge to the same location, matching is made easier Provides liquidity: investors can sell assets prior to maturity on secondary markets to satisfy their time preference for consumption and diversification needs.

149 Risk, Return... Financial Markets time to maturity 1 year Money Market for short-term debt securities with maturities shorter than 1 year Capital Market for long-term debt or equity securities with maturities greater than 1 year

150 Risk, Return... Financial Markets Primary Market Markets that involve the issue of new securities Capital formation occurs Secondary Market Markets that involve buyers and sellers of existing securities No capital formation occurs

151 Risk, Return... Financial Markets Types of Secondary Markets Exchanges or Auction Markets Secondary markets that involve a bidding process that takes place in specific location For example TSX, NYSE Dealer or Over-thecounter (OTC) Markets Secondary markets that do not have a physical location and consist of a network of dealers who trade directly with one another. For example FX market

152 Risk, Return... Financial Markets What are securities? Definition: a legal representation of the right to received prospective future benefits under stated conditions.

153 Risk, Return... Financial Markets There are two major categories of financial securities: Debt Instruments Commercial paper Bankers acceptances Treasury bills Mortgage loans Bonds Debentures Equity Instruments Common stock Preferred stock

154 Risk, Return... Financial Markets Non-marketable securities Cannot be traded between or among investors May be redeemable (a reverse transaction between the borrower and the lender) Examples: Savings accounts Term Deposits Guaranteed Investment Certificates Marketable securities Can be traded between or among investors after their original issue in public markets and before they mature or expire

155 Risk, Return... Financial Markets Marketable Securities Securities categorized by the time to maturity: time to maturity 1 year Money Market Securities short-term debt securities with maturities shorter than 1 year Bankers acceptances Commercial Paper Treasury Bills Capital Market Securities long-term debt or equity securities with maturities greater than 1 year Bonds Debentures Common Stock Preferred Stock

156 Index Risk, Return... Measuring Risk and Return The Value of an Investment of $1 in S&P Small Cap Corp Bonds Long Bond T Bill 10 0, Source: Ibbotson Associates Year End

157 Index Risk, Return... Measuring Risk and Return The Value of an Investment of $1 in S&P Small Cap Corp Bonds Long Bond T Bill Real returns 10 0, Source: Ibbotson Associates Year End

158 Percentage Return Risk, Return... Measuring Risk and Return Rates of return Common Stocks Long T-Bonds T-Bills Year Source: Ibbotson Associates

159 Risk, Return... Measuring Risk and Return

160 Risk, Return... Measuring Risk and Return

161 Risk, Return... Measuring Risk and Return What investors care about when making the investments? Return Risk

162 Risk, Return... Measuring Risk and Return What is return (R)? Income received on an investment plus any change in market price, usually expressed as a percent of the beginning market price of the investment. R = D t + (P t - P t-1 ) P t-1 simple return or R = ln D t + P t P t 1 logarithmic return additive properties

163 Risk, Return... Measuring Risk and Return What is risk? Risk, in traditional terms, is viewed as something negative. Webster s dictionary, for instance, defines risk as exposing to danger or hazard. The Chinese symbols for risk, reproduced below, give a much better description of risk 危機 The first symbol is the symbol for danger, while the second is the symbol for opportunity, making risk a mix of danger and opportunity. You cannot have one, without the other

164 Risk, Return... Measuring Risk and Return What is risk? In finance it is something different than expected. It is measured by standard deviation of returns. In finance, we call this measure volatility σ = n i=1 R i R 2 p i

165 Risk, Return... Measuring Risk and Return The variance on any investment return measures the disparity between actual and expected (mean) returns. Low Variance Investment Probability High Variance Investment NO RISK Expected Return

166 Risk, Return... Measuring Risk and Return Example: Coin Toss Game-calculating variance and standard deviation (1) (2) (3) Percent Rate of Return Deviation from Mean Squared Deviation Variance = average of squared deviations = 1800 / 4 = 450 Standard deviation = square of root variance = 450 = 21.2%

167 Risk, Return... Measuring Risk and Return Mean-variance framework expected returns measured by mean of returns and risk measured by standard deviation of returns Basis for Portfolio Theory Mean-variance approach holds when: investors maximize the expected utility, prefer more to less, are risk averse, and when either security returns are normally distributed or utility function is quadratic

168 Risk, Return... Measuring Risk and Return Risk-return trade off If volatility V[A] is a correct measure of risk, then in theory V[A] > V[B] E[A] > E[B] Otherwise, there won t be any incentive to take risk The underlying assumption is: Investors are risk-averse Expected return is liked variance is disliked This is the essence of the so-called mean-variance analysis

169 Risk, Return... Measuring Risk and Return Risk-return trade off Sometimes, historical estimates don t conform to the theoretical risk-return tradeoff STOCK MEAN (%) VARIANCE IBM GM Clearly, GM is preferable Is it better to hold IBM too? i.e. a portfolio of two stocks

170 Risk, Return... Measuring Risk and Return Portfolio return: n R p = R i w i i=1 2 asset portfolio: Expected Portfolio Return (R1w1 ) (R 2w 2)

171 Risk, Return... Measuring Risk and Return Portfolio risk: 2 asset portfolio: Portfolio Variance w1σ1 w 2σ2 2(w1w 2ρ12σ1σ 2) The variance of a two stock portfolio is the sum of these four boxes Stock 1 Stock 2 w w 1 2 Stock 1 w cov σ w w ρ 12 σ σ 1 2 Stock 2 w w cov 1 2 w 12 w w σ ρ 12 σ σ 1 2

172 Risk, Return... Measuring Risk and Return The shaded boxes contain variance terms; the remainder contain covariance terms. STOCK To calculate portfolio variance add up the boxes N N STOCK

173 Risk, Return... Measuring Risk and Return Example Suppose you invest 65% of your portfolio in Coca-Cola and 35% in Reebok. The expected dollar return on your CC is 10% x 65% = 6.5% and on Reebok it is 20% x 35% = 7.0%. The expected return on your portfolio is = 13.50%. Assume a correlation coefficient of 1. Coca - Cola Reebok w 2 1 w w 1 σ Coca - Cola (.65) ρ 12 σ σ (31.5) Portfolio Valriance [(.65) [(.35) 2 2 x(31.5) Reebok w w ρ σ σ w x(58.5) σ (.35) 2(.65x.35x1x31.5x58. 5) 2 2 ] ] 2 (58.5) 2 1,006.1 Standard Deviation 1, %

174 Risk, Return... Measuring Risk and Return Back to Risk-return trade off Example STOCK MEAN (%) Variance Corr. IBM GM If we hold half IBM and half GM: Expected return = 4% Volatility = 5% Compared with holding GM alone, this portfolio achieves 1% less expected return, but about 2% lower risk! But is it better? Depends on investors risk preferences

175 Risk, Return... Measuring Risk and Return Risk-return trade off Which portfolio is the best and why? Expected Return (%) C A B Standard Deviation

176 Risk, Return... Measuring Risk and Return Expected Returns and Standard Deviations of Portfolio vary given different weighted combinations of the stocks Expected Return (%) Reebok Minimum Variance Portfolio (MVP) 35% in Reebok Coca-Cola Short sale allowed Standard Deviation Portfolio possibility curve Efficient frontier (higher return for the same risk)

177 Risk, Return... Diversification Example Correlation Coefficient =.4 Stocks s % of Portfolio Avg Return ABC Corp 28 60% 15% Big Corp 42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Return = weighted avg = Portfolio = 17.4% Let s add New Corp to the portfolio Correlation Coefficient =.3 Stocks s % of Portfolio Avg Return Portfolio % 17.4% New Corp 30 50% 19% NEW Standard Deviation = weighted avg = NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION Strategy designed to reduce risk by spreading the portfolio across many investments.

178 Risk, Return... Diversification The shape of the portfolio possibility curve depends on the correlation coefficient (ρ) between the returns of the assets 1 ρ 1 Expected Return (%) ρ=-1 ρ=0.2 ρ=1 Standard Deviation The lower the correlation, the higher risk reduction

179 Risk, Return... STD DEV OF PORTFOLIO RETURN Diversification Total Risk = Systematic Risk + Unsystematic Risk Total Risk Factors unique to a particular company or industry. For example, the death of a key executive or loss of a governmental defense contract. Unsystematic risk (Unique risk) Systematic risk (Market risk) Factors such as changes in nation s economy, tax reform by the Congress, or a change in the world situation. NUMBER OF SECURITIES IN THE PORTFOLIO

180 Risk, Return... Diversification Benefits of a well-diversified portfolio Optimal exposure to risky assets with respect to their riskreturn tradeoff Generally, a well-diversified portfolio has lower volatility than more concentrated portfolios of similar levels of expected returns Smaller random noise due to errors in data Unsystematic risks are neutralised

181 Risk, Return... Optimal Portfolio Selection A theoretic approach is to try to maximise the investor s utility subject to the risk-return tradeoff (constraints) We will consider the investor s indifference curve on the riskreturn plane A more practical approach is to come up with a target expected return, and then find the weights that minimise portfolio risk This approach is due to Markowitz (1952) who was awarded a Nobel Prize in 1990

182 Risk, Return... Optimal Portfolio Selection Investors utility curves

183 Risk, Return... Optimal Portfolio Selection Degree of risk aversion

184 Risk, Return... Optimal Portfolio Selection Markowitz Portfolios Modern portfolio theory Investors do (or should) consider: Expected return as a desirable thing and Variance of return as an undesirable thing So, either Min variance s.t. the required rate of return Maximising the expected return s.t. the acceptable risk Intuitive and can be easily handled in Excel

185 Risk, Return... Basic Markowitz problem: Optimal Portfolio Selection Markowitz Programming N N N min w i V R p = i=1 w i 2 V R i + 2 i=1 j>1 w i w j C R i, R j N s. t. E R p = w i E R i = x% i=1 N i=1 w i = 1 Optional constraints: w i 0 < k% w i

186 Risk, Return... Optimal Portfolio Selection Markowitz Programming

187 Risk, Return... Optimal Portfolio Selection Expected Return (%) Reebok Minimum Variance Portfolio (MVP) r f Tangency Portfolio (TG) Coca-Cola Short sale allowed Standard Deviation Portfolio possibility curve Efficient frontier (higher return for the same risk)

188 Risk, Return... Optimal Portfolio Selection Sharpe ratio is a measure of portfolio performance and can be defined as Sharpe. ratio R P r F P The portfolio that has the highest Sharpe ratio optimally balance returns against risk Thus the optimal risky assets portfolio (the Tangency Portfolio) is the one that maximize Sharpe ratio.

189 Risk, Return... Capital Asset Pricing Model From Markowitz to equilibrium models Portfolio theory = Normative theory Given the portfolio inputs, what should investors do? If we are willing to assume that everyone acts similarly, then it might be possible to draw some implication about aggregate behaviour of investors That is, if demand & supply (the portfolio weights) are known, then we may be able to determine the clearing (market) price or return Equilibrium concept Asset pricing models = Positive theory

190 Risk, Return... Capital Asset Pricing Model Assumptions Rational investors with mean-variance preferences (i.e. they don t care about higher moments) No transaction costs (otherwise, buyers and sellers may face different prices) No tax, in particular personal income tax No price impact (price taking behaviour) Unlimited short sales allowed ** Unlimited borrowing / lending at the risk-free rate **

191 Risk, Return... Capital Asset Pricing Model More Assumptions Homogenous expectations About portfolio inputs About the relevant period of investment Can be interpreted as all information being freely available All assets are marketable, i.e. can be bought and sold including all stocks and bonds, real estate, commodities and even human capital!

192 Risk, Return... Capital Asset Pricing Model Risk free asset By definition, this is an asset whose return is known with certainty, i.e. with probability one (Levy & Post, 2005) As a result, the expected return is constant The variance of the risk-free asset is zero The covariance with other assets is zero (Can you prove these?) It is common among practitioners to use the rate of return on short-term Treasury bills as a proxy for the risk-free interest rate

193 Risk, Return... Tobin s separation theorem (1958) Capital Asset Pricing Model Capital Market Line (CML) Since we assume that all investors face the same risk-free rate, and the same efficient set, all investors will face the same CML All investors, regardless of their risk preferences, will choose a portfolio from the CML Separation of investment process into two stages: 1) Locate the tangency portfolio TG 2) All investors maximise their utility by choosing the right mix of TG and the risk-free asset

194 Risk, Return... Capital Asset Pricing Model From Separation Theorem to CAPM CML is merely a tool, but not particularly useful in practice Separation theorem gives a rather boring (and probably erroneous) yet very strong implication on portfolio allocation It implies the information for aggregate investment behaviour Equilibrium concept This is the basis for CAPM

195 Risk, Return... Capital Asset Pricing Model E R i = r F + β i (E R M r F ) Return on asset i, R i Market return, R M Risk-free rate, r F Risk measure β i, rather than volatility of i β i = C[R i, R M ] V[R M ]

196 Risk, Return... Capital Asset Pricing Model Total risk = diversifiable risk + market risk Market risk is measured by beta, the sensitivity to market changes Expected stock return +10% -10% Beta the slope - 10% + 10% -10% Expected market return i im 2 m im 2 m where σ im = a=1 n Covariance of asset i returns with the market Variance of the market returns I a I M a M n 1 returns

197 Risk, Return... Capital Asset Pricing Model An average stock (or the market portfolio) has a beta = 1.0. Beta shows how risky a stock is if the stock is held in a well-diversified portfolio. β=1 stock has average risk. β>1 stock is riskier than average. β<1 stock is less risky than average. β=0 risk free assets (e.g., Treasury bills)

198 Risk, Return... Capital Asset Pricing Model The beta of a portfolio (β P ) is the weighted average of the betas from its constituent securities. Example: You have $6,000 invested in IBM, $4,000 in GM. You estimate that IBM has a beta of 0.95 and GM has a beta of What is the beta of your portfolio? β P = 0.6* *1.15 = 1.03

199 Risk, Return... Capital Asset Pricing Model Beta estimates: Betas are sometimes as large as 2-3 for highly volatile stocks Low beta: Stable stocks, less affected by business cycles, e.g. consumer products, and utilities High beta: Tech stocks, financial sector Negative beta: precious metals and precious-metal-related stocks, e.g. gold and gold exchange-traded funds (ETF)

200 Risk, Return... Capital Asset Pricing Model Industry estimates (US: Jan93-Dec02) Portfolio Mean Volatility Alpha Beta Beer & Liquor Utilities Food products Petroleum & Gas Helthcare Consumer goods Financial sector Automobiles Machinery Services Market portfolio Source: Levy & Post (2005)

201 Risk, Return... Capital Asset Pricing Model Applications Investors use CAPM to calculate the expected rate of return on a security asset valuation (pricing) Let s look a the following data: Beta of British Airways plc = 1.17 Yield of short-dated Treasury bills = 3.1% Market risk premium = 4.2% The expected return on BA = 3.1% + ( %) = 8% This is also the cost of equity for BA!

202 Risk, Return... Capital Asset Pricing Model Decomposition of return E R i = R F + β i (E R M R F ) Return to time Size of risk Return to risk Some special cases Risk-free asset: β i = 0 Return is due solely to time value of money Market: β i > 0 Return comes from the risk component Counter-cyclical stock: β i < 0 Expected return below the market! Why?

203 Risk, Return... Capital Asset Pricing Model Ex post CAPM specification R i R F = β i R M R F + e i idiosyncracy e i ~iid(0, σ e 2 ) We have introduced a random error term to account for the difference between the expected and the actual return on asset I This reflects the idiosyncratic component, which is not priced in equilibrium

204 Risk, Return... Return Capital Asset Pricing Model Security Market Line A Risk Free Return = r f A C Security Market Line (SML) Beta SML Equation = r f + B ( r m - r f )

205 Risk, Return... Capital Asset Pricing Model Jensen s Alpha (1968) α i = R i [R f + β i R M R f ] Alpha measures the abnormal return above (or below) the level explained by the market return Risk-adjusted performance index If i represents a portfolio, then positive alpha could signify the investment skills of the fund managers - Asset allocation / stock selection - Market timing

206 Risk, Return... Capital Asset Pricing Model Decomposition of risk V R i = β i 2 V R M + V e i systematic risk idiosyncratic risk High risk, high return is correct provided that you know the correct measure of risk In theory, beta (economic concept) is preferred to volatility (statistical concept) Stocks with high volatilities may not always be highly valued

207 Risk, Return... Capital Asset Pricing Model Testing CAPM Checking if idiosyncratic risk is relevant Checking if the relationship is not linear

208 Risk, Return... Capital Asset Pricing Model Testing CAPM. regress rbar beta sig, robust Linear regression Number of obs = 101 F( 2, 98) = 2.54 Prob > F = R-squared = Root MSE = Robust rbar Coef. Std. Err. t P> t [95% Conf. Interval] beta sig _cons no idiosyncratic risk

209 Risk, Return... Capital Asset Pricing Model Testing CAPM. regress rbar beta beta2, robust Linear regression Number of obs = 101 F( 2, 98) = 2.28 Prob > F = R-squared = Root MSE = Robust rbar Coef. Std. Err. t P> t [95% Conf. Interval] beta beta _cons quadratic relation

210 Risk, Return... Capital Asset Pricing Model CAPM in Investment Appraisal: Asset beta The betas discussed so far are equity betas The company s asset beta is the weighted average of its liability betas: equity and debt β a = β e E E + D(1 C T ) + β d D(1 C T) E + D(1 C T ) where: β a = asset beta or ungeared beta β e = equity beta ot geared beta E = market value of equity D = market value of debt C T = corporate tax rate β d = debt rate

211 Risk, Return... Capital Asset Pricing Model CAPM in Investment Appraisal: Asset beta with no default risk The asset beta is always lower than the equity beta, unless a company is all-equity financed If we assume that companies do not default on their interest payments we can take the debt beta to be zero, and hence β a = β e E E + D(1 C T ) We can use this formula to determine the new equity beta when there is a change in capital structure β e = β a E + D(1 C T) E

212 Risk, Return... Capital Asset Pricing Model CAPM in Investment Appraisal: (Un)Leveraged Beta Unlevered Beta = levered beta / (1+(1-tax rate)(d/e)) Levered Beta = Unlevered Beta (1+(1-tax rate)(d/e)) Example: Company X which owns and operates grocery stores across the United States, currently has $50 million in debt and $100 million in equity outstanding. Its stock has a beta of 1.2. It is planning a leveraged buyout, where it will increase its debt/equity ratio of 8. If the tax rate is 40%, what will the beta of the equity in the firm be after the LBO? Unlevered Beta = 1.20 / (1 + (1-0.4) (50/100)) = New Beta = (1 + (1-0.4) (8)) = 5.35

213 Risk, Return... Capital Asset Pricing Model CAPM Alternative Arbitrage Pricing Model (Arbitrage Pricing Theory APT) E(R i ) = R F + β 1i I 1 + β 2i I 2 + β 3i I 3 where I is the risk premium on the factor Estimated risk premiums for taking on risk factors ( ) Factor Yield spread Interest rate Exchange rate Real GNP Inflation Mrket Estimated Risk Premium (rfactor r 5.10% f )

214 Risk, Return... Dollars Capital Asset Pricing Model CAPM in Investment Appraisal: Asset beta Return vs. Book-to-Market High-minus low book-tomarket 5 Low minus big

215 Risk, Return... Financial Markets Measuring Risk and Return Diversification Optimal Portfolio Capital Asset Pricing Model

216 Market Efficiency

217 Market Efficiency Market Efficiency Tests of EMH: Empirical investigation

218 Market Efficiency Market Efficiency A perfect market has the following characteristics: No taxes or transaction costs to inhibit buying or selling Similar expectations amongst participants regarding asset prices, interest rates and other economic factors Free entry and exit to and from the market All information available freely to everyone Many buyers and sellers (perfect competition)

219 Market Efficiency Market Efficiency Since no capital market can possibly meet these requirements it is normally said to be enough for capital markets to offer fair prices & to be efficient in order to allow reasoned investment and financial decisions In practice an efficient capital market should satisfy: Operational efficiency: fast trading at low cost Pricing efficiency: prices should reflect all available information Allocational efficiency: efficient pricing leads to optimal allocation of investment funds)

220 Market Efficiency Market Efficiency This is a hypothesis originated by Fama (1965), The Behaviour of Stock Market Prices, Journal of Business How efficiently do markets process information? EMH: Security prices fully reflect all relevant information If a financial market is efficient, the best estimate of the true value of a security is its current market price

221 Market Efficiency Market Efficiency Relationship with allocation efficiency: Assumptions: No transaction costs Information acquisition incurs no cost If the information suggests that a share is undervalued, i.e. P* > P t, then some investors will buy it, and the price will rise Similarly, when the stock is overvalued If every investor shares the same set of information, the market will be in equilibrium at any time: P* = P t

222 Market Efficiency Market Efficiency Relationship with allocation efficiency: Assumptions: No transaction costs Information acquisition incurs no cost Very strong assumptions More realistic EMH: Prices reflect information untill the marginal cost of obtaining information and traiding no longer exceed the marginal benefit.

223 Market Efficiency Market Efficiency Three forms of market efficiency Weak form ~ Historical prices Investors could not use historical stock price information to make (abnormal) profit Semi-strong form Strong Form ~ Publicly available information Neither stock price nor firms financial statements orsemi-strong supplementary information Strong from ~ ALL available information Not even insider trading Weak Form

224 Market Efficiency Market Efficiency Three forms of market efficiency Weak form ~ Historical prices test whether all information contained in historical prices is fully reflected in current prices tests of return predictability Semi-strong form ~ Publicly available information test whether publicly available information is fully reflected in current prices event studies or studies of announcements Strong from ~ ALL available information test whether all information, public or private, is fully reflected in current prices

225 Market Efficiency Market Efficiency Can investors beat the market? If prices reflect all relevant information, any changes must be due to an arrival of new information which seems to be random EMH rules out any possibilities of investors making sustained abnormal profit EMH does not rule out the possibility of obtaining profit from the arrival of new information If there is actually some opportunity to make extra money, it should disappear very quickly (thanks to the quick dissemination of information)

226 Market Efficiency Market Efficiency An Efficient Market Hypothesis (EMH) joke What would you do if you found a 1 PLN coin on the street? Answer: it should not have been there in the first place!

227 Market Efficiency Market Efficiency Investment strategies Active - Fundamental analysis, e.g. ratio analysis - Technical Chartism analysis Global macro Momentum: Long winners & short losers Market timing / rotational strategies Multiple strategies If market is efficient non of them should work

228 Market Efficiency Market Efficiency Any changes in price are random What would be your best estimate of P t+1? Answer: P t because you don t know what the news term is going to be We say that price is a martingale: E[p t+1 Ω t ] = p t where the expectation is conditional on all available information at t (Ω t )

229 Market Efficiency Market Efficiency A simple example: p t+1 = p t + ε t+1, with E[ε t+1 Ω t ] = 0 Random term = noise term = news term We can then study the property of return p t+1 = ε t+1 E p t+1 p t Ω t = E ε t+1 p t Ω t = 1 p t E ε t+1 Ω t = 0

230 Market Efficiency Market Efficiency The movement of stock prices from day to day DOES NOT reflect any pattern. Statistically speaking, the movement of stock prices is random (skewed positive over the long term).

231 Coin Toss Game Market Efficiency Heads $ Heads $ $ Tails Heads $ $ Tails $97.50 Tails $95.06

232 Market Efficiency Is FTSE 100 a martingale?

233 Market Efficiency Is FTSE 100 a martingale?

234 Market Efficiency Market Efficiency If price is a martingale, then return is a martingale difference: E R t+1 Ω t = 0 By the law of iterated expectation, it follows that E R t+1 = 0 But this barely makes any senses economically. Dividend is an important part of total return E R t+1 + dividend yield > 0

235 Market Efficiency Market Efficiency This random walk model assumes that the news term is identically and independently distributed: ε t ~IID(0, σ 2 ) A step from P t to P t+1 is random, thus the terminology Return will also be iid since p t+1 = ε t+1 This implies that return shows no autocorrelation, i.e. return at time t+1 must not show any correlation with return at time t

236 Market Efficiency Market Efficiency Louis Bachelier is a pioneer in the study of financial mathematics His model assumes further that ε t ~NID(0, σ 2 ) i.e. news is normally and independently distributed with mean zero and constant variance Normality is convenient (two-parameter distribution), but also highly controversial This has been a building block of modern finance

237 Market Efficiency Market Efficiency Price simulation Anything goes! log p t = log p t 1 + ε t p 0 = 1 ε t ~NID(0, )

238 Market Efficiency Market Efficiency Trending

239 Market Efficiency Market Efficiency Cyclical movements

240 Market Efficiency Market Efficiency nid returns

241 Market Efficiency Market Efficiency Estimated distribution of returns

242 Market Efficiency Market Efficiency Estimated distribution of prices

243 Market Efficiency Market Efficiency Predictability as an evidence of inefficiency The random walk model implies that returns must not be predictable If returns are predictable, then it might be possible to systematically generate excess returns Long positive return / short negative return Unpredictability is sufficient, but not necessary, for market efficiency Small average excess returns might not generate net gains once costs have been taken into account

244 Market Efficiency Market Efficiency Testing for return predictability Examine whether one can forecast R t+1 with a certain degree of accuracy One may use all sorts of predictors e.g. past returns, macroeconomic variables, some dummy variable associated with certain events (calendar effects), stock characteristics Most of the time, the relevant techniques are very simple! Linear regression

245 Market Efficiency Market Efficiency Testing for return predictability: Examples Day-of-the-week effects R t = c 0 + c 1 D 1t + c 2 D 2t + c 3 D 3t + c 4 D 4t + ε t Autoregressive time-series model R t = α + γr t k + ε t Factor model R t = β 1 x 1t + β 2 x 2t + β k x kt + ε t Then, we can conduct simple hypothesis tests (t or F)

246 Market Efficiency Tests of EMH: Empirical investigation Tests of return predictability Time paterns in security returns Predicting returns from the past Returns and firm characteristics Announcement and price return Investment funds performance

247 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Time patterns in security returns Intraday and day of the week paterns Returns on Monday are much lower than on other days Some evidence of large possitive returns on Wednesday and Friday (Gibbons and Hess, 1981) Monthly paterns January higher returns than in other months, especially for small stocks Explanation: market microstructure (bid- ask spread), taxselling hypothesis Turn of the callender effect Bulk of the return comes form last trading day of the month and the first few of the following month

248 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Comparison of Returns on the S&P 500, and the Smallest Quintile of CRSP Stocks: and Source: Elton, Gruber, Brown, and Goetzman (2011)

249 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Predicting returns from the past Short term predictability Correlation tests r t = a + br t 1 T + e t (returns are log returns) Run tests If we denote price increase as + and price decrease as (no change as 0), then a sequence of the same signs is called run Compare the numer of actual runs with the number attributed to chance Trading rules (eg. Filter rule) Formulate trading rule appropriate to particular patern and check what will happen if the rule is followed Filter rule example: Purchase if incerwased by X% from previous low, sell if decreased by Y% from subsequent high Relative strength Current price/average price

250 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Daily Correlation Coefficients (from Fama [78]), (1/2) Small number Source: Elton, Gruber, Brown, and Goetzman (2011)

251 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Daily Correlation Coefficients (from Fama [78]), (2/2) Source: Elton, Gruber, Brown, and Goetzman (2011)

252 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Correlation of Return with Returns in Prior Periods for Various Countries (1/2) Source: Elton, Gruber, Brown, and Goetzman (2011)

253 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Correlation of Return with Returns in Prior Periods for Various Countries (2/2) Source: Elton, Gruber, Brown, and Goetzman (2011)

254 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Total Actual and Expected Numbers of Runs for One-, Four-, Nine-, and Sixteen- Day Differencing Intervals (from Fama [75]), (1/2) Fewer runs than we expected: evidence of small possitive relationship between returns Source: Elton, Gruber, Brown, and Goetzman (2011)

255 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Total Actual and Expected Numbers of Runs for One-, Four-, Nine-, and Sixteen- Day Differencing Intervals (from Fama [75]), (2/2) Source: Elton, Gruber, Brown, and Goetzman (2011)

256 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Security Price and Time, Implementation of Filter Rule Source: Elton, Gruber, Brown, and Goetzman (2011)

257 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Comparison of rates of Return, before Commissions, under the Filter Technique and under a Buy and Hold Policy, (1/2) Source: Elton, Gruber, Brown, and Goetzman (2011)

258 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Comparison of rates of Return, before Commissions, under the Filter Technique and under a Buy and Hold Policy, (2/2) Source: Elton, Gruber, Brown, and Goetzman (2011)

259 Market Efficiency Tests of EMH: Empirical investigation Testing for return predictability Returns and firm characteristics The size effect Excess returns would be earned if hold small cap stocks (Branz, 1981) Additional variable in APT Market to book Hight book to market stock returns higher than low book to market Earnings price Once size and market to book are coounted for E/P ratio doenst matter? Stocks with low PE ratios provide higher returns than stock with higher PE

260 Market Efficiency Tests of EMH: Empirical investigation Announcements and returns Announcement and price return (abnormal return) e.g. stock splits, cash dividends, stock dividend Excess return around announcement day. stock prices will respond to announcements only when the information being announced is new and unexpected Source: Elton, Gruber, Brown, and Goetzman (2011)

261 Market Efficiency Tests of EMH: Empirical investigation Announcements and returns Cumulative excess return around split date. Source: Elton, Gruber, Brown, and Goetzman (2011)

262 Market Efficiency Tests of EMH: Empirical investigation Announcements and returns Cumulative excess return around announcement date. Source: Elton, Gruber, Brown, and Goetzman (2011)

263 Market Efficiency Tests of EMH: Empirical investigation Announcements and returns Excess return around publication date Source: Elton, Gruber, Brown, and Goetzman (2011)

264 Market Efficiency Tests of EMH: Empirical investigation Announcements and returns At 10AM EST, the U.S. Supreme Court refused to hear an appeal from MSFT regarding its anti-trust case. The stock immediately dropped. This example, one of hundreds available every day, illustrates that prices adjust extremely rapidly to new information. But, did the price adjust correctly? Only time will tell, but it does seem that over the next hour the market is searching for the correct level.

265 Market Efficiency Tests of EMH: Empirical investigation Investment funds performance Average Annual Return on 1493 Mutual Funds and the Market Index Return (% Funds Market -40 Source: Brealey and Myers (2006)

266 Market Efficiency Tests of EMH: Empirical investigation Investment funds performance Source: Barber, and Odean (2000)

267 Market Efficiency Tests of EMH: Empirical investigation Investment funds performance

268 Market Efficiency Testing procedure Tests of EMH: Empirical investigation Testing for random walk (prieces behave as random with a drift as we have inflation) H0: β 2 =1 (EMH holds) Aviva Example P t = β 1 + β 2 P t 1 + u t (1) P t = β 1 + β 2 P t 1 + β 3 P t 2 + β 4 P t 3 + u t (2) H0: β 3 =0 and β 4 =0 (EMH holds) Testing for serial correlation in error term durbina test: H0: no serial correlation (EMH holds) Testing for day of the day of the week effect Serching for patterns in residuals: ARCH and GARCH

269 Market Efficiency Tests of EMH: Empirical investigation Aviva Example AVIVA jul jul jul jul jul jul2012 date

270 Market Efficiency. regress x10 l.x10 day1-day4 Source SS df MS Number of obs = F( 5, 1299) = Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE = x10 Coef. Std. Err. t P> t [95% Conf. Interval] x10 L day day day day _cons test l.x10=1. test day1 day2 day3 day4 ( 1) L.x10 = 1 F( 1, 1299) = 9.20 Prob > F = ( 1) day1 = 0 ( 2) day2 = 0 ( 3) day3 = 0 ( 4) day4 = 0. durbina Durbin's alternative test for autocorrelation F( 4, 1295) = Prob > F = lags(p) chi2 df Prob > chi H0: no serial correlation

271 Market Efficiency Market Efficiency Tests of EMH: Empirical investigation

272 Valuating Stocks and Bonds

273 Valuing Stocks and Bonds Bond Valuation Stock Valuation: DCF valuation Relative Valuation

274 Valuing Stocks and Bonds Bond Valuation Bonds have a par value or principal (which is typically 100 units of currency) Bonds pay interest payments (the coupon) based on the par value Zero coupon bond pay no coupon Yield (YTM) of a bond is a discount rate that makes the PV of bond payments equal to todays price

275 Valuing Stocks and Bonds Example: Bond Valuation If today is October 2002, what is the value of the following bond? An IBM Bond pays $115 every Sept for 5 years. In Sept 2007 it pays an additional $1000 and retires the bond.the bond is rated AAA (WSJ AAA YTM is 7.5%) Cash flows: Sept PV , $1,161.84

276 Valuing Stocks and Bonds Bond Valuation Fair value of Financial Instrument: Present value of the Cash Flows the instrument is generating DCF Valuation

277 Valuing Stocks and Bonds Stock Valuation Discounted Cashflow (DCF) valuation: Relates the value of an asset to the present value of expected future cashflows on that asset. Relative valuation: Estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales. Contingent claim valuation: Uses option pricing models to measure the value of assets that share option characteristics.

278 Valuing Stocks and Bonds Valuing a Business The value of a business is usually computed as the discounted value of FCF out to a valuation horizon (H). The valuation horizon is sometimes called the terminal value and is calculated like PVGO. PV FCF1 (1 r) 1 FCF2 (1 r) 2... FCF (1 r) H H PV (1 r) H H PV (free cash flows) PV (horizon value)

279 Valuing Stocks and Bonds

280 Valuing Stocks and Bonds Stock Valuation DCF valuation CASH FLOW: The difference between money received and money paid. Often confused with accounting profits. 2 issues: 1. Profits are shown as they are earned, not when the cash is paid 2. The cash outflows are divided into: current expenses and capital expenses. Current expenses are deducted when calculating profit. Capital expenses are not (they are deducted over number of years). Thus profits include some cash flows and excludes others, they are reduced by depreciation charges (which are not cash flows at all) Always estimate cash flows on after tax basis. Cash flows are recorded when they occure and not when work is undertaken or liability is incured.

281 Valuing Stocks and Bonds Stock Valuation Example: Given the cash flows for Company X calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6% Year Asset Value Earnings Investment Free Cash Flow.EPS growth (%) PV(horizon value) PV(FCF) PV(business) PV(FCF) PV(horizon value) $18.8

282 Valuing Stocks and Bonds Stock Valuation DCF valuation To use discounted cash flow valuation, you need: to estimate the life of the asset to estimate the cash flows during the life of the asset to estimate the discount rate to apply to these cash flows to get present value

283 Valuing Stocks and Bonds Stock Valuation Dividend Discount Model Computation of today s stock price which states that share value equals the present value of all expected future dividends. P 0 Div1 Div2 DivH P H ( 1 r) ( 1 r) ( 1 r) H H investment time horizon

284 Valuing Stocks and Bonds Stock Valuation Example: Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $ What is the price of the stock given a 12% expected return? PV PV ( 1. 12) ( 1. 12) $ ( 1. 12) 1 2 3

285 Valuing Stocks and Bonds If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY. Perpetuity Stock Valuation P 0 Div r or EPS r 1 1 Assumes all earnings are paid to shareholders. Constant Growth DDM A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).

286 Valuing Stocks and Bonds Example - continued: If the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends? $100 $ g Stock Valuation g.09 Answer: The market is assuming the dividend will grow at 9% per year, indefinitely. If a firm elects to pay a 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 dividents. PlowbackRatio Fraction of earnings retained by the firm. Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations. g = return on equity * plowback ratio

287 Valuing Stocks and Bonds Stock Valuation Example: Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to plow back 40% of the earnings at the firm s current return on equity of 20%. What is the value of the stock before and after the plowback decision? No growth 5 P With growth $ g P $75.00 If the company did not plowback some earnings, the stock price would remain at $ With the plowback, the price rose to $ The difference between these two numbers ( =33.33) is called the Present Value of Growth Opportunities (PVGO). Present Value of Growth Opportunities (PVGO) Net present value of a firm s future investments. Sustainable Growth Rate Steady rate at which a firm can grow: plowback ratio X return on equity.

288 Valuing Stocks and Bonds Bond Valuation Stock Valuation: DCF valuation Relative Valuation

289 EXERCISES

290 Question 1 A company is financed by bonds and ordinary shares. The 12% bonds are redeemable in 5 years time at par. Annual interest has just been paid. The current ex-interest market price of the bond is 114. Corporation tax is 28%. The ex-dividend ordinary share price is 3.14 and the most recent dividend was 35 pence per share. Both dividend and share price are expected to increase by 7% per year for the foreseeable future. The company has 5,000 redeemable bonds (par value 100) and 225,000 ordinary shares (par value 1). (a) Calculate the cost of debt. [Hint: remember the tax-shield.] (b) Calculate the cost of equity. (c) Calculate the company s WACC.

291 Question 2 At January 2012 a company s sources of debt and equity finance are summarised as follows: 7% (D P ) preference shares ( 1) 400,000 8% bonds (redeemable January 2021, par [ ] 100) 600,000 9% bank loan 500,000 Ordinary shares ( 1) 400,000 By making use of this and the following information calculate the company s WACC at market prices. [Hint: remember the tax-shield.]

292 Question 3 Explain the term diversification in finance, and give a few examples.

293 Question 4 You are considering investing in two securities, X and Y, and have the following information. a) Draw the probability distribution for X, and for Y. Comment on their shape. b) Calculate the expected return for each security. c) Calculate the expected risk of each security.

294 Question 5 You are considering investing in two securities, X and Y, and have the following information. a) Do the above data conform to the risk-return trade-off? b) Calculate the expected return and standard deviation for the following portfolios: i. 100 per cent X; ii. 75 per cent X and 25 per cent Y; iii. 50 per cent X and 50 per cent Y; iv. 25 per cent X and 75 per cent Y; v. 100 per cent Y. c) Plot your answers on the risk-return plane, and comment on the benefit of diversification.

295 Question 6 Stock A has a beta of 1.0, and very high idiosyncratic risk. If the expected return on the market is 20%, what will be the expected return on Stock A according to the CAPM?

296 Question 7 Suppose you estimate the CAPM model for Stock B. Your result shows that this stock has beta of 1.4, and the standard deviation of the error term of 7%. Assume that the standard deviation of the market is 12%. What is the total standard deviation of Stock B?

297 Question 8 Suppose you invested 600 in Stock C, and 400 in Stock D. Stock C s beta is 1.2, and Stock D s beta is 0.9. What is the beta of your portfolio?

298 Question 9 You formed a portfolio by combining the risk-free asset and Stock Z. The risk-free rate is 6%, while the expected return of Stock Z is 22%. The volatility of Stock Z is 40%. If your portfolio shows the standard deviation of 30%, what is the expected return on your portfolio?

299 Question 10 A firm has an equity beta of 1.3, and is currently financed by 25% debt and 75% equity. What will be the company s new equity beta if the company changes its financing to 33% debt and 67% equity? Assume corporate tax is 30%.

300 Question 11 A company has in issue bonds which are convertible in 3 years time into 25 ordinary shares per bond. If not converted, they will be redeemed in 6 years time at par. The bonds pay 9% interest per year and currently have a market price of The current ordinary share price is If holders of ordinary bonds of a similar risk class require a return of 13% per annum: (a) Are bond holders likely to convert? (b) What is the expected annual growth rate of the ordinary share price? (c) Calculate the minimum growth rate in the ordinary share price necessary to make conversion an attractive option. (d) Calculate the implicit conversion premium

301 Lecture 3: (1) Capital Structure (2) Dividend policy (3) Options

302 Capital Structure

303 Capital Structure Does it matter which source of capital company chooses? If some forms of capital costs less than others this suggests there could be a capital structure that maximizes shareholder wealth

304 Capital Structure WACC Gearing, risk and required rate of return Theories of capital structure: Traditional approach MM Conflicts of interest Pecking order theory Valuations/ WACC cont.

305 Capital Structure Weighted Average Cost of Capital (WACC) combines the individual costs of capital with the weights each source of financing takes in forming the company's capital structure Simple debt/equity example: After tax WACC: WACC r A WACC D V r D E V r E We can extend the formula for as many source of finance as the company has D WACC ra rd (1 CT ) V E V r E

306 Capital Structure WACC Expected Return.20=r E.15=r A Equity.10=r D All assets Debt Risk B D B A B E

307 Capital Structure WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm s WACC? D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = = $5 million WACC D V r D E V or 12.2% r E

308 Capital Structure WACC When WACC can be used as the discount rate in investment appraisal? The business risk of the investment project needs to be the same as the company s overall risk profile Finance is raised such that capital structure is preserved The marginal investment project must preserve the risk/return relationship

309 Capital Structure Gearing, risk and required rate of return Risk (a summary) Business risk the risk associated with profits and earnings changing due to the sector the company operates in (systematic risk) Financial risk the risk associated with increased gearing due to uncertainty over interest payments on debt capital Bankruptcy risk the risk of a company becoming insolvent due to an inability to meet interest payments on debt capital Risk-free rate the return that can be achieved for certain (on say government bonds)

310 Capital Structure Gearing, risk and required rate of return Gearing and required rate of return The diagram illustrates how investors required rates of return on equity increase with a company s gearing: i. The risk-free rate remains constant ii. Business risk remains constant, the level reflecting the company s sector iii. Financial risk increases with gearing, reflecting the increasing effect of interest rate changes as the company s debt levels increase (potentially adversely affecting profits) iv. Bankruptcy risk is shown for high levels of gearing as investors start to face risks of the company entering liquidation (and potentially losing everything)

311 Capital Structure Gearing, risk and required rate of return That was for equity holders For holders of debt the only risk is that of bankruptcy, since interest payments on debt are guaranteed Even then, debt holders face less bankruptcy risk than equity holders because they are higher in the hierarchy of creditors if the company were to be liquidated

312 Capital Structure Traditional approach is often referred to as trade-off theory Some simplifying assumptions: No taxation Theories of Capital Structure Traditional approach Finance is either perpetual debt (interest payments only) or ordinary shares Companies can change their financial structure costlessly All earnings paid as dividends Constant risk over time Earnings and dividends do not grow

313 Capital Structure Theories of Capital Structure Traditional approach With no gearing the WACC is equal to the cost of equity Cost of capital r E As gearing increases the WACC decreases to reflect the cheaper cost of finance WACC At some point the increased financial risk (interest rate) associated with ever higher gearing starts to increase WACC At very high levels of gearing bankruptcy risk further increases WACC r D optimal capital structure exists (min WACC) D V

314 Capital Structure Theories of Capital Structure Miller and Modigliani (i) Miller & Modigliani (M&M) (1958) proposed a model that suggested that WACC remains constant for all levels of gearing By adding the additional assumption of perfect capital markets to the previous model (which means firms can always borrow more) M&M assumed away bankruptcy risk Since M&M(i) implies a constant WACC it is often referred to as their irrelevance theory, i.e. the choice of capital structure doesn t matter

315 Capital Structure Theories of Capital Structure Miller and Modigliani (i) Cost of capital With no bankruptcy risk the cost of debt remains constant. The cost of debt is independent of the level of gearing r E As gearing increases the cost of equity increases linearly to reflect increased financial risk WACC The WACC remains constant. The reduced cost of debt finance is exactly offset by the increased financial risk associated with higher gearing levels r D WACC is independent of capital structure (capital structure is irrelevant) D V

316 Capital Structure Assumptions Theories of Capital Structure Miller and Modigliani (i) By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives

317 Capital Structure M&M (Debt Policy Doesn t Matter) Theories of Capital Structure Miller and Modigliani (i) Example - Macbeth Spot Removers - All Equity Financed Data Number of shares Price per share Market Value of Shares 1,000 $10 $10,000 Outcomes Operating Income Earnings per share A $500 $.50 B 1, C 1, D 2, Expected outcome Return on shares (%) 5 %

318 Capital Structure Example cont. M&M (Debt Policy Doesn t Matter) 50% debt Theories of Capital Structure Miller and Modigliani (i) Data Number of Price per share Market Value shares of Market value of Shares debt 500 $10 $ 5,000 $ 5,000 Outcomes A B C D Operating Income $500 1,000 1,500 2,000 Interest $ Equity earnings $ ,000 1,500 Earnings per share $ Return on shares (%) 0%

319 Capital Structure M&M Theories (Debt of Policy Capital Doesn t Structure Matter) Miller and Modigliani (i) Example - Macbeth s - All Equity Financed - Debt replicated by investors Outcomes A B C D Earnings on twoshares $ LESS : Net earnings Since investors can replicate what oncompany investment does, why would they pay more for firm with leverage? (%) Return on $10 investment $1.00 $ 0 0%

320 Capital Structure Theories of Capital Structure Miller and Modigliani (i) The many assumptions of M&M(i) are clearly implausible In their paper Miller & Modigliani acknowledge that the simplifications are implausible, yet necessary in order to start developing formal models of capital structure Their second capital structure paper, Miller & Modigliani (ii) (1963), considers the tax shield associated with debt finance

321 Capital Structure Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why? Theories of Capital Structure Miller and Modigliani (ii) Interest Tax Shield- Tax savings resulting from deductibility of interest payments. All Equity 1/2 Debt EBIT 1,000 1,000 Interest Pmt Total Cash Flow All Equity = 600 Pretax Income 1, % Net Cash Flow $600 $540 *1/2 Debt = 640 ( )

322 Capital Structure Theories of Capital Structure Miller and Modigliani (ii) PV of Tax Shield = (assume perpetuity) D x r D x Tc r D = D x Tc Example: Tax benefit = 1000 x (.10) x (.40) = $40 PV of 40 perpetuity = 40 /.10 = $400 PV Tax Shield = D x Tc = 1000 x.4 = $400

323 Capital Structure Firm Value = Theories of Capital Structure Miller and Modigliani (ii) Value of All Equity Firm + PV Tax Shield Example All Equity Value = 600 /.10 = 6,000 PV Tax Shield = 400 Firm Value with 1/2 Debt = $6,400

324 Capital Structure Theories of Capital Structure Miller and Modigliani (ii) Cost of capital The tax shield reduces the cost of debt r E Holding everything else equal that leads to downward slopping WACC. The tax advantage of debt finance means that WACC decreases as gearing increases. r D WACC The implications of MM(ii) is that companies should be financed entirely by debt r D (1-C T ) D V

325 Capital Structure Theories of Capital Structure Miller and Modigliani (ii) with bankruptcy Since we don t see all-debt companies presumably all-debt is not optimal (and in fact taxpayers & banks recently learnt the hard way what can happen if companies are too highly geared) The final model adds bankruptcy risk to M&M(ii)

326 Capital Structure Market Value of The Firm Theories of Capital Structure Miller and Modigliani (ii) with bankruptcy Market value of an all equity company As the company increases debt levels the value of the company increases reflecting the benefits of the tax-shield At some point increased bankruptcy risk more than off-set the tax advantage of debt. Again there is (theoretically) an optimal capital structure D/V At high level of gearing bankruptcy risk starts to reduce the value of the company

327 Capital Structure Theories of Capital Structure Miller and Modigliani (ii) with bankruptcy Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress

328 Capital Structure Market Value of The Firm Theories of Capital Structure Miller and Modigliani (ii) with bankruptcy Maximum value of firm Costs of financial distress PV of interest tax shields Value of levered firm Value of unlevered firm Optimal amount of debt D/V

329 Capital Structure How much leverage? Theories of Capital Structure Miller and Modigliani (ii) with bankruptcy In principle, yes be as highly geared as is feasible in order to maximise the value However, a company needs to make enough profits to fully benefit from the tax-shield advantages of debt (this is tax exhaustion) Agency costs: if shareholders hold too small a part of a company they may start to prefer higher risk projects

330 Capital Structure Theories of Capital Structure Conflicts of interest Company X has $50 of 1-year debt. Company X (Book Values) Net W.C Bonds outstanding Fixed assets Common stock Total assets Total liabilities

331 Capital Structure Theories of Capital Structure Conflicts of interest Company X has $50 of 1-year debt. Company X (Market Values) Net W.C Bonds outstanding Fixed assets 10 5 Common stock Total assets Total liabilities Why does the equity have any value? Shareholders have an option: they can obtain the rights to the assets by paying off the $50 debt.

332 Capital Structure Theories of Capital Structure Conflicts of interest Company X may invest $10 as follows. Now Invest $10 Possible Payoffs Next Year $120 (10% probability) $0 (90% probability) Assume the NPV of the project is (-$2). What is the effect on the market values?

333 Capital Structure Theories of Capital Structure Conflicts of interest Company X value (post project) Company X (Market Values) Net W.C Bonds outstanding Fixed assets 18 8 Common stock Total assets Total liabilities Firm value falls by $2, but equity holder gains $3

334 Capital Structure Theories of Capital Structure Conflicts of interest Company X value (assumes a safe project with NPV = $5) Company X (Market Values) Net W.C Bonds outstanding Fixed assets 25 3 Common stock Total assets Total liabilities While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value.

335 Capital Structure Consider the following story: Theories of Capital Structure Pecking order theory The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced. Therefore firms prefer internal finance since funds can be raised without sending adverse signals. If external finance is required, firms issue debt first and equity as a last resort. The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

336 Capital Structure Some Implications: Theories of Capital Structure Internal equity may be better than external equity. Financial slack is valuable. Pecking order theory If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).

337 Capital Structure Valuations WACC: How are costs of financing determined? Return on equity can be derived from market data Cost of debt is set by the market given the specific rating of a firm s debt Preferred stock often has a preset dividend rate

338 Capital Structure Valuations If you discount at WACC, cash flows have to be projected just as you would for a capital investment project. Do not deduct interest. Calculate taxes as if the company were all equity financed. The value of interest tax shields is picked up in the WACC formula.

339 Capital Structure Valuations Discounting at WACC values the assets and operations of the company. If the object is to value the company's equity, that is, its common stock, don't forget to subtract the value of the company's outstanding debt.

340 Capital Structure Valuations Cost of equity depends on financial leverage, if financial lavarage change significantly, discounting cash flows at today s cost of equity capital will not give the right answer

341 Capital Structure What if project is finance at different D/E than the whole company? Step 1 : Unlevering the WACC: calculate r (opportunity cost of capital) at current debt rate r=r D *(D/V) +r E (E/V) Step 2 calculate new r E after the change in capital structure, use new D/V (use new r D ) Step 3 Calculate New WACC Valuations r E =r+(r-r D )(D/E) WACC = r D (1-T C )(D/V)+r E (E/V)

342 Capital Structure Valuations Adjusted Present Value (APV) = Base Case NPV + PV Impact Base Case = All equity finance firm NPV PV Impact = all costs/benefits directly resulting from project

343 Capital Structure Valuations Example: Project A has a NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000. Project NPV = 150,000 Stock issue cost = -200,000 Adjusted NPV - 50,000 don t do the project

344 Capital Structure Valuations Example: Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option. Project NPV = - 20,000 Stock issue cost = 60,000 Adjusted NPV 40,000 do the project

345 Capital Structure Valuations Equivalent loan PV (CF avail for debt) Disocunting the safe, nominal cash flow at an after-tax borrowing rate

346 Capital Structure WACC Gearing, risk and required rate of return Theories of capital structure: Traditional approach MM Conflicts of interest Pecking order theory Valuations/ WACC cont.

347 Dividend Policy

348 Capital Structure

349 Dividend Policy How Dividends Are Paid How Do Companies Decide on Dividend Payments? Information in Dividends and Stock Repurchases Dividend irrelevance: MM Dividend relevance

350 Dividend Policy How dividends are paid Cash Div Regular Cash Div Special Cash Div (one off special div) Stock Div Stock Repurchase (3 methods) 1. Buy shares on the market 2. Tender Offer to Shareholders 3. Private Negotiation (Green Mail)

351 Dividend Policy How dividends are paid Cash Dividend - Payment of cash by the firm to its shareholders. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. Record Date - Person who owns stock on this date received the dividend.

352 Dividend Policy When dividend is announced share is said to be cum dividend How dividends are paid When dividend entitlement recedes the share goes ex dividend Note: the stylised share price (the green line) implies the market reacted positively to the dividend announcement, since initially the share price increases. (It could have fallen initially if the market reacted negatively to the dividend announcement). When the share goes ex dividend its price will always drop.

353 Dividend Policy Dividend decision Lintner s Stylized Facts (How Dividends are Determined) 1. Firms have longer term target dividend payout ratios. 2. Managers focus more on dividend changes than on absolute levels. 3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings. 4. Managers are reluctant to make dividend changes that might have to be reversed.

354 Dividend Policy Dividend decision Attitudes concerning dividend targets vary DIV 1 target dividend Dividend Change target ratio EPS 1 DIV 1 - DIV 0 target change target ratio EPS 1 - DIV 0 Dividend changes confirm the following DIV 1 - DIV 0 adjustment rate target change adjustment rate target ratio EPS 1 - DIV 0

355 Dividend Policy Information content Investors do not worry about the level of company s dividend, but about change in that level. Dividend cuts are usually taken by investors as bad news (stock price fall) Dividend increases are good news Share repurchase, one off happening, done when: Company accumulated more cash then they can invest profitably, or When company wishes to increase its debt level

356 Dividend Policy Dividend irrelevance Assumptions: No transaction costs for investors No transaction costs for companies (issuing new shares) No taxation Perfect capital markets Under these assumptions Miller & Modigliani (M&M) suggest that investors don t mind whether returns to equity come from capital gains or dividend payments what matters is simply the overall return on equity

357 Dividend Policy Dividend irrelevance Since investors do not need dividends to convert shares to cash they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm. P 0 = d 1 + P 1 P 0 the market price before dividend is announced P 1 expected ex-dividend share price d 1 - cash value of the dividend paid to shareholders

358 Dividend Policy Dividend irrelevance Example - Assume Company X has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record Date Pmt Date Post Pmt Cash 1, ,000 (91 $11) Asset Value 9,000 9,000 9,000 Total Value 10, ,000 10,000 New Proj NPV 2,000 2,000 2,000 # of Shares 1,000 1,000 1,091 price/share $12 $11 $11 NEW SHARES ARE ISSUED

359 Dividend Policy Dividend irrelevance Example - continued - Shareholder Value Record Pmt Post Stock 12,000 11,000 12,000 Cash 0 1,000 0 Total Value 12,000 12,000 12,000 Stock = 1,000sh $11 $12 = 12,000 11,000 Assume stockholders purchase the new issue with the cash dividend proceeds.

360 Dividend Policy Dividend relevance MM assumptions don t hold in real world Investors cant replicate what the company does Bird in the hand argument (Linter, 1956 and Gordon 1959) Dividends are certain (thus valuable) vs. uncertain capital gains Dividends as signals to investors The clientele effect Investors might prefer dividends over capital gains Taxation issues

361 Dividend Policy Dividends as Signals Dividend relevance Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news. Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company s good fortune and its manager s confidence in future cash flows.

362 Dividend Policy Dividend relevance Clientele Effect There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from. These clients increase the price of the stock through their demand for a dividend paying stock.

363 Dividend Policy Dividend relevance Tax Consequences Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably. In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.

364 Dividend Policy Dividend relevance Next year's price Dividend Total pretax payoff Today's stock price Capital gain Pretax rate of return (%) Tax on 50% Tax on Cap 20% Total After Tax income (div cap gain - taxes) After tax rate of return (%) Firm A ( ) (no dividend) Firm B ( ) (4 0.94) (high dividend)

365 Dividend Policy Dividend relevance 2000 Marginal Income Tax Brackets Income Baracket Marginal Tax Rate Single Married (joint return) 15% $0 - $26,250 $0 - $43, ,251-63,550 43, , , , , , , , , , over 288,350 over 288,350

366 Dividend Policy Dividend relevance In U.S., shareholders are taxed twice (figures in dollars) Different investors might have different tax advantages Cash Flow Operating Income 100 Corporate tax at 35% 35 After Tax income (paid as div) 65 Income tax paid by investors at 39.6% 25.7 Cash to Shareholder 39.3

367 Dividend Policy Dividend relevance Under imputed tax systems, such as that in Australia, Shareholders receive a tax credit for the corporate tax the firm pays (figures in Australian dollars) Rate of Income tax 15% 30% 47% Operating Income Corporate tax (Tc=.30) After Tax income Grossed up Dividend Income tax Tax credit for Corp Pmt Tax due from shareholder Cash to Shareholder

368 Valuations After Tax WACC Example - Sangria Corporation - continued WACC (1 Tc) D V r D E V r E WACC (1.35) %

369 Dividend Policy How Dividends Are Paid How Do Companies Decide on Dividend Payments? Information in Dividends and Stock Repurchases Dividend irrelevance: MM Dividend relevance

370 Options

371 Options

372 Options

373 Options A derivative is a financial instrument whose value derives from the value of something else, generally called the underlying(s). Underlying: a barrel of oil, a financial asset, an interest rate, the temperature at a specified location... Derivatives: Options Futures/Forwards Swaps

374 Options

375 Options

376 Options Calls and Puts Pay-off diagrams How to price an option: Binomial model No-Arbitrage Argument Valuation Risk Neutral Valuation Put-Call Parity

377 Options Calls and Puts Call Option Right to buy an asset at a specified exercise (strike) price on or before the exercise date. Put Option Right to sell an asset at a specified exercise (strike) price on or before the exercise date.

378 Options Calls and Puts Option Obligations Buyer Seller Call option Right to buy asset Obligation to sell asset Put option Right to sell asset Obligation to buy asset

379 Options Pay-off diagrams The value of an option at expiration is a function of the stock price and the exercise price. Example - Option values given a exercise price of $55 Stock Price $ Call Value Put Value

380 Options Call option pay-off (value) Pay-off diagrams Call option value (graphic) given a $55 exercise price (strike price). $ Share Price

381 Options Put option payoff ( value) Pay-off diagrams Put option value (graphic) given a $55 exercise price. $ Share Price

382 Options Call option $ payoff Pay-off diagrams Call option payoff (to seller) given a $55 exercise price. 55 Share Price

383 Options Put option $ payoff Pay-off diagrams Put option payoff (to seller) given a $55 exercise price. 55 Share Price

384 Options Payoff diagram for a Call Option Pay-off diagrams If you are the holder of a call option, you want the stock price at expiry to exceed the strike price. Then, you exercise the option to buy at the strike price, and immediately sell at a profit S T - K. If the stock price at expiry is less than the strike price, you let the option die. Payoff K Long position in a Call Option max 0, S T K A call option for which the current stock price St is above the strike price K is said to be in the money. A call option for which the current stock price St is below the strike price K is said to be out of the money. out of the money K S T A call option for which the current stock price St is equals the strike price K is said to be at the money. at the money

385 Options Pay-off diagrams Payoff diagram for a Put Option Long position in a Put Option max 0, K S T Payoff K at the money K out of the money S T

386 Options Consider an European put option with time to expiry of 1 year, and a strike price of 110. The current price of the underlying is 100. Divide the time to expiry into two 6-month intervals. Suppose that in each interval, the price can either rise by 10 or fall by 10, with equal probabilities. The risk-free rate is 5% per annum, simply compounded. Binomial model t=0 t=0.5 t= What is the value of the option? Risk-neutral valuation on objective probabilities. 0*0.5+10*0.5= * *0.5 = The price movements can be represented by a diagram called a binomial tree. An underlying assumption is that the underlying price follows a binomial process *0.5+30*0.5=20 The value calculation proceeds backwards from T to t. Each step involves: finding the terminal value of the option; calculating its expected value of the option; and finally discounting it by the risk-free rate (make sure that you use the right rate).

387 Options Binomial model Suppose that the probabilities of rise& fall were 40/60 instead of 50/50. Without doing any further calculation, can you determine how the option price would change? t=0 t=0.5 t=1 100 > > * * = > *0.5+10*0.5= *0.5+30*0.5=20 0.6

388 Options Binomial model Now, let s redo the question above, but assuming an European call option instead. Suppose that the probabilities of rise & fall were 60/40 instead of 50/50. Without doing any further calculation, can you determine how the option price would change? t=0 t=0.5 t=1 5exp(-0.05*0.5)= *0.5+0*0.5= *0.5+0*0.5= *0.5+0*0.5=0 What if we don t know the probabilities? 1. No-Arbitrage Argument Valuation 2. Risk Neutral Valuation with Risk Neutral Probabilities

389 Options Binomial model No arbitrage argument Consider a stock whose price is S 0 and option on the stock whose current price is f. Option lasts for time T, and in that time the stock price moves to either S 0 U (where U > 1) or to S 0 D (where D < 1). f U is option payoff if stock moved to S 0 U and f D option payoff is stock moved to S 0 D. S 0 S 0 Δ - f f S 0 UΔ - f U S 0 DΔ - f D Consider a portfolio consisting of a long position in Δ shares and a short position in one option. Calculate Δ that makes the portfolio riskless (i.e. portfolio has the same payoff regardless if the stock price increased or decreased): S 0 U f U = S 0 D f D = f U f D S 0 U S 0 D

390 Options Binomial model No arbitrage argument For arbitrage opportunities not to exist the riskless portfolio must earn risk-free interest rate. If r is the risk-free interest rate, then the present value of the portfolio is: (S 0 U f U )exp( rt) = (S 0 D f D )exp( rt) whereas the cost of creating this portfolio today is: S 0 f Therefore: S 0 f = (S 0 U f U )exp( rt) f = S 0 (1 Uexp rt ) + f U exp( rt) Let s substitute f U f D S 0 U S 0 D for Δ: f = S 0 f U f D S 0 U S 0 D (1 Uexp rt ) + f U exp( rt)

391 Options Binomial model No arbitrage argument f = S 0 f U f D S 0 U S 0 D (1 Uexp rt ) + f U exp( rt) = f U f D Uexp rt f U + Uexp rt f D + f U exp rt U f U exp rt D U D = f U 1 Dexp( rt) + f D Uexp( rt) 1 U D = exp( rt) f U exp(rt) D + f D U exp(rt) U D = exp( rt) pf U + (1 p)f D where: p = exp(rt) D U D The model allows to price an option when stock price movements are given by a one-step binominal tree, under the assumption there are no arbitrage opportunities in the market.

392 Options Binomial model No arbitrage argument Example: Stock price today is equal to 20, and in 3 months it will be either 22 or 18. What is a value of 3 month European call option with a strike price of 21. The risk free rate is 12% (continuous compounding). 20 f 22 f U =1 18 f D = 0 Step 1: Calculate Δ 22 1 = = 1 = 0.25 Step 2: Calculate portfolio value at horizon 18 0 = = 4.5 Step 3: Calculate portfolio value today, and thus calculate f 4.5 exp rt = 20 f 4.5 exp = 5 f = 5 f f =

393 Options Binomial model Risk Neutral Valuation In risk-neutral world, risk-neutral investors do not increase the expected return they require from an investment to compensate for increased risk. Utility Function Utility: in economics it is the fundamental measure of value. Utility function u(x): tells us the unit of satisfaction that x gives us. in finance, x usually represents the amount of money or profit. two assumptions are normally required regarding the function u(.) : 1) slope of the function; 2) curvature, i.e. how the function bends. The usual assumptions are that u (.) > 0 and u (.) < 0. This implies positive but decreasing marginal utility. When x is random, then u(x) becomes a random variable. The assumption about the curvature becomes critical as it implies the view towards risks. In this aspect, we may classify utility functions according to their risk preferences.

394 Options Risk Neutral Valuation Suppose that an individual holds a lottery that yields $0 or $100 with equal probabilities. This lottery gives the expected return of $50 = 0.5*$ *$100 Risk Preferences Risk neutral Individuals who are indifferent between the lottery and the sure sum of $50 U(X) Binomial model Risk-averse individuals prefer receiving the sure sum of $50 to being given a lottery whose expected return is $50. u 50 > 0.5 u u(100) Risk-loving individuals prefer the lottery to the sure sum of $50. u 50 < 0.5 u u(100) u 50 = 0.5 u u(100) A general condition for risk neutrality is that u (.) = 0 (linear). Real-life examples of risk preferences: Risk-averse: Individual investors, pension funds; Risk-loving: Hedge funds; E(W)=C E X Risk-neutral: Institutional investors, large companies Management being riskloving while owners being risk-averse.

395 Options Binomial model Risk Neutral Valuation Risk neutrality proves very interesting since it implies that investors only care about expected returns, and not risks associated with the investment. Suppose there are only two assets in the economy: one risky ( stock ) and the other riskless ( bond ). Risk-neutral investors will hold the stock alone no matter how risky it is provided that such a stock gives a higher expected return than the bond. If we re willing to assume that everybody in the world is risk-neutral, then it must be the case that the returns on both assets must be equal. A risk-neutral world has two features that facilitate pricing derivatives: (1) Expected return on stock (or any other instrument) is risk-free (2) The discount rate used for the expected payoff on an option (or any other instrument) is risk-free rate. Let p = erτ D U D be interpreted as the probability of an up movement in a risk-neutral world.. Thus the expected future payoff from an option in risk neutral world is: pf U + (1 p)f D

396 Options Binomial model Risk Neutral Valuation Example Stock price today is equal to 20, and in 3 months it will be either 22 or 18. What is a value of 3 month European call option with a strike price of 21. The risk free rate is 12% (continuous compounding). 20 f 22 = 1 f U 18 f D = 0 p could be calculated as: 22p p = 20e p = 20e p = or as: p = erτ D U D 3 = e = thus: f = ( ) 0 e = e = Thus non-arbitrage arguments and risk-neutral valuation give the same results.

397 Options Two-Step Binominal Trees t=0 t=1 t=2 50 C Binomial model In order to calculate the option price at the initial node of the tree, one needs to start with calculating option price at the final nodes and then working out option price at the earlier nodes. Example:Consider 2-year European put option with a strike price of 52, whose stock is currently trading at 50. There are two 1-year steps. In each step stock price can increase by 20% or decrease by 20%. The risk-free interest rate is 5%. 60 A p = e = Is p constant in the whole tree? A: * *4= *exp(-0.05)= B: * *20= B B C: * * = *exp(-0.05) = *exp(-0.05)=

398 Options Binomial model n steps n Binomial Model Black-Scholes Formula

399 Options Binomial model Put-Call Parity The put-call parity defines a relationship between the price of a call and a put both with identical K and t. It allows us to calculate c from p, and vice versa. The underlying assumption is that there is no arbitrage opportunities. The parity is given by: p t + S t = c t + Ke rτ We can prove this by considering two portfolios which always give the same payoffs at maturity: (1) A put & a stock (2) A call & a zero-coupon bond (or cash) It can be shown that both portfolios give the same payoffs regardless of the terminal stock price. S T > K S T < K put stock 0 S T S T K-S T S T K call bond S T -K K = = S T 0 K K Therefore, their current values must be identical.

400 Options Calls and Puts Pay-off diagrams How to price an option: Binomial model No-Arbitrage Argument Risk Neutral Valuation Put-Call Parity

401 EXERCISES

402 Question 1 The ordinary shares of NTC currently trade at 80p. The dividend per share is 15p and has been constant at this level for 10 years. NTC plans to finance a new investment opportunity out of retained earnings. This will mean that for the next two years the dividend per share will fall to 10p. The benefits of the investment will mean that from year 3 onwards dividend per share will increase to 18p per share for year 3 and subsequent years. Assuming all this information is known to shareholders; use the dividend growth model to calculate a fair share price.

403 Question 2 It is 31 January 2009 and the managers of Watsons are considering a change in the company s dividend policy. Earnings per share for 2008 for the company were 22.8 pence, and the finance director has said that he expects this to increase to 25.0 pence per share in The increase in earnings per share is in line with market expectations of the company s performance. The pattern of recent dividends, which are paid each year on 31 December, is as follows: The Managing Director has proposed that 70% of earnings in 2009 and subsequent years should be retained for investment in new product development. It is expected that, if this proposal is accepted, the dividend growth rate will be 8.75%. Watson s cost of equity capital is estimated to be 12%. Calculate the share price of Watson s in the following circumstances. (a) The company decides not to change its current dividend policy. (b) The company decides to change its dividend policy as proposed by the Managing Director and announces the change to the market.

404 Question 3 & 4 3 4

405 Question 5 & 6 5 6

406 7 Question 7 & 8 8

407 Question 9 Pfizer, one of the largest pharmaceutical companies in the United States, is considering what its debt capacity is. In March 1995, Pfizer had an outstanding market value of equity of $ billion, debt of $ 2.8 billion and a AAA rating. Its beta was 1.47, and it faced a marginal corporate tax rate of 40%. The treasury bond rate at the time of the analysis was 6.50%, and AAA bonds trade at a spread of 0.30% over the treasury rate. a. Estimate the current cost of capital for Pfizer. b. It is estimated that Pfizer will have a BBB rating if it moves to a 30% debt ratio, and that BBB bonds have a spread of 2% over the treasury rate. Estimate the cost of capital if Pfizer moves to its optimal. c. Assuming a constant growth rate of 6% in the firm value, how much will firm value change if Pfizer moves its optimal? What will the effect be on the stock price? d. Pfizer has considerable research and development expenses. Will this fact affect whether Pfizer takes on the additional debt?

408 Question 10 GenCorp, an automorive parts manufacturer, currently has $25 million in outstanding debt and has 10 million shares outstanding. The book value per share is $10, while the market value is $ 25. The company is currently rated A, its bonds have a yield to maturity of 10%, and the current beta of the stock is The six-month T.Bill rate is 8% now, and the company's tax is 40%. a. What is the company's current weighted average cost of capital? b. The company is considering a repurchase of 4 million shares at $25 per share with new debt. It is estimated that this will push the company's rating down to a B (with a yield to maturity of 13%). What will the company's weighted average cost of capital be after the stock repurchase?

409 Question 11 Current price of the stock is 100. The stock price can either go up by 10 or down by 10 each month. What is the value of European call option with a strike price 95 and 2 month to expiry? Assume the continuous compounding risk free rate is 5%

410 Lecture 4: (1) Leasing (2) Mergers (3) Corporate control and corporate governance

411 Leasing

412 Leasing What is a Lease? Why Lease? Equivalent annual cost

413 Leasing Lease terms Operating leases Short-term or cancellable during the contract period (by the lessee), usually full-service lease Common examples are cars and photocopiers Usually full-service lease where lessor is responsible for maintenance and servicing Finance leases Extend over most of the estimated economic life of the asset, cant be cancelled or if can lessor is reimbursed for any losses. The lessee owns the item in all but name. Usually net lease where lessee is responsible for maintenance and servicing

414 Leasing Why lease? Sensible Reasons for Leasing Short-term leases are convenient Cancellation options are valuable Maintenance is provided Standardization leads to low costs

415 Leasing Why lease? Dubious Reasons for Leasing Leasing avoids capital expenditure controls Leasing preserves capital Leases may be off balance sheet financing Leasing effects book income

416 Leasing Equivalent annual cost The annual rental payment sufficient to cover the present value of all the costs of owning and operating it.

417 Leasing Example: Operating Lease Equivalent annual cost Acme Limo has a client who will sign a lease for 7 years, with lease payments due at the start of each year. The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it our for 7 years. Year Initial cost -75 Maintenance, insurance, selling, and administrative costs Tax shield on costs Depreciation tax shield Total % = - $98.15 Break even rent(level) Tax Break even rent after-tax % = - $98.15

418 Leasing Example: Financial Lease Equivalent annual cost Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs. Should Greymare Buy or Lease the bus? Cash flow consequences of the lease contract to Greymare Year Cost of new bus Lost Depr tax shield (7.00) (11.20) (6.72) (4.03) (4.03) (2.02) - Lease payment (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) Tax shield of lease Cash flow of lease (17.98) (22.18) (17.70) (15.01) (15.01) (13.00) (10.98)

419 Leasing Example: Financial Lease Equivalent annual cost Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs. Should Greymare Buy or Lease the bus? Cash flow consequences of the lease contract to Greymare : Greymare saves the $100,000 cost of the bus Loss of depreciation benefit of owning the bus $16,900 lease payment is due at the start of each year Lease payments are tax deductible

420 Leasing Example - cont Equivalent annual cost Greymare Bus Lines Balance Sheet with out lease Greymare Bus Lines (figures in $1,000s) Bus Loan secured by bus All other assets Other loans 550 Equity Toital Assets Total liabilities Equivalent lease balance sheet Greymare Bus Lines (figures in $1,000s) Bus Financial lease All other assets Other loans 550 Equity Toital Assets Total liabilities

421 Leasing Example - cont Equivalent annual cost Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6.5% or.10 x (1-.35). The result will tell us if Greymare should lease or buy the bus. NPV lease or - $

422 Leasing Example - cont Equivalent annual cost Greymare Bus Lines lease cash flows can also be thought of as loan equivalent cash flows. Year Amount borrowed at year end Interest 10% Tax 35% Interest paid after tax Principal repaid Net cash flow of equivalent loan

423 Leasing Equivalent annual cost Example - cont The Greymare Bus Lines lease cash flows can also be treated as a favorable financing alternative and valued using APV. APV NPV of project NPV of lease APV -5,000 8,000 $3,000

424 Leasing What is a Lease? Why Lease? Equivalent annual cost

425 Mergers

426 Mergers Sensible Motives for Mergers Some Dubious Reasons for Mergers Estimating Merger Gains and Costs The Mechanics of a Merger Takeover Battles and Tactics

427 Mergers Mergers: type HORIZONTAL VERTICAL CONGLOMERATE

428 Mergers Sensible Reasons for Mergers Economies of Scale A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units. $ $ $ Reduces costs

429 Mergers Sensible Reasons for Mergers Economies of Vertical Integration Control over suppliers may reduce costs. Over integration can cause the opposite effect. Pre-integration (less efficient) Post-integration (more efficient) Company Company S S S S S S S S

430 Mergers Sensible Reasons for Mergers Combining Complementary Resources Merging may results in each firm filling in the missing pieces of their firm with pieces from the other firm. Firm A Firm B

431 Mergers Sensible Reasons for Mergers Mergers as a Use for Surplus Funds If your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.

432 Mergers Diversification Dubious Reasons for Mergers Investors should not pay a premium for diversification since they can do it themselves.

433 Mergers Dubious Reasons for Mergers The Bootstrap Game Acquiring Firm has high P/E ratio Selling firm has low P/E ratio After merger, acquiring firm has short term EPS rise Long term, acquirer will have slower than normal EPS growth due to share dilution.

434 Mergers Dubious Reasons for Mergers The Bootstrap Game World Enterprises (before merger) Muck and Slurry World Enterprises (after buying Muck and Slurry) EPS $ 2.00 $ 2.00 $ 2.67 Price per share $ $ $ P/E Ratio Number of shares 100, , ,000 Total earnings $ 200,000 $ 200,000 $ 400,000 Total market value $ 4,000,000 $ 2,000,000 $ 6,000,000 Current earnings per dollar invested in stock $ 0.05 $ 0.10 $ 0.067

435 Mergers Dubious Reasons for Mergers Earnings per dollar invested (log scale) World Enterprises (after merger) World Enterprises (before merger) Muck & Slurry Now Time

436 Mergers Estimating Merger Gain Questions Is there an overall economic gain to the merger? Do the terms of the merger make the company and its shareholders better off? PV(AB) > PV(A) + PV(B)

437 Mergers Economic Gain Estimating Merger Gain Economic Gain = PV(increased earnings) = New cash flows from synergies discount rate

438 Mergers Accounting for Merger

439 Mergers Take-over Methods Tools Used To Acquire Companies Proxy Contest Tender Offer Acquisition Merger Leveraged Buy-Out Management Buy- Out

440 Mergers Take-over Defence White Knight Friendly potential acquirer sought by a target company threatened by an unwelcome suitor. Shark Repellent Amendments to a company charter made to forestall takeover attempts. Poison Pill Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.

441 Goal of the firm Take-over Defence When managers do not fear stockholders, they will often put their interests over stockholder interests Greenmail: The (managers of ) target of a hostile takeover buy out the potential acquirer's existing stake, at a price much greater than the price paid by the raider, in return for the signing of a 'standstill' agreement. Golden Parachutes: Provisions in employment contracts, that allows for the payment of a lump-sum or cash flows over a period, if managers covered by these contracts lose their jobs in a takeover. Poison Pills: A security, the rights or cashflows on which are triggered by an outside event, generally a hostile takeover, is called a poison pill. Shark Repellents: Anti-takeover amendments are also aimed at dissuading hostile takeovers, but differ on one very important count. They require the assent of stockholders to be instituted. Overpaying on takeovers: Acquisitions often are driven by management interests rather than stockholder interests.

442 Mergers Take-over Defence

443 Mergers Sensible Motives for Mergers Some Dubious Reasons for Mergers Estimating Merger Gains and Costs The Mechanics of a Merger Takeover Battles and Tactics

444 Control, Governance and Financial Architecture

445 Control, Governance and Financial Architecture Leveraged Buyouts, Spin-offs and Restructurings Fusion and Fission in Corporate Finance Conglomerates Control and Governance

446 Control, Governance and Financial Architecture Definitions Corporate control The power to make investment and financing decisions. Corporate governance Refers to the role of the board of directors, shareholder voting, proxy fights, etc. and to other actions taken by shareholders to influence corporate decisions.

447 Control, Governance and Financial Architecture Leverage Buyouts The difference between leveraged buyouts and ordinary acquisitions: A large fraction of the purchase price is debt financed. The LBO goes private, and its share is no longer trade on the open market.

448 Control, Governance and Financial Architecture Leverage Buyouts The three main characteristics of LBOs High debt Incentives Private ownership

449 Control, Governance and Financial Architecture Leverage Buyouts 10 Largest LBOs in 1980s and 2000s examples Acquirer Target Year Price ($mil) KKR RJR Nabisco 1989 $ 24,720 KKR Beatrice 1986 $ 6,250 KKR Safeway 1986 $ 4,240 Thompson Co. Southland 1987 $ 4,000 AV Holdings Borg-Warner 1987 $ 3,760 Wing Holdings NWA, Inc $ 3,690 KKR Owens-Illinois 1987 $ 3,690 TF Investments Hospital Corp of America 1989 $ 3,690 FH Acquisitions For Howard Corp $ 3,590 Macy Acquisition Corp. RH Macy & Co 1986 $ 3,500 Bain Capital Sealy Corp $ 811 Cyprus Group (w/mgmt) WESCO Distribution Inc $ 1,100 Clayton, Dublier & Rice North Maerican Van Lines 1998 $ 200 Kohlberg & Co. (w.mgmt) Holley Performance Products 1998 $ 100 Doughty Hanson Trend Technologies 2000 $ 318 Berkshire Partners William Carter Co $ 450 Heartland Industrial Partners Springs Industries 2001 $ 846

450 Control, Governance and Financial Architecture Spin offs Spin off Independent company created by detaching part of a parent company's assets and operations. Carve-outs Similar to spin offs, except that shares in the new company are not given to existing shareholders but sold in a public offering. Privatization The sale of a government-owned company to private investors.

451 Control, Governance and Financial Architecture Spin offs Motives for Privatization Increased efficiency Share ownership Revenue for the government

452 Control, Governance and Financial Architecture Spin offs Examples of Privatization Amount Issued, Country Company and Date $ millions France St. Gobain (1986) $ 2, France Paribas (1987) $ 2, Germany Volkswagon (1961) $ Jamaica Caribbean Cement (1987) $ Jpan Japan Airlines (1987) $ 2, Mexico Telefonos de Mexico (1990) $ 3, New Zealand Air New Zealand (1989) $ Singapore Neptune Orient Lines ( ) $ United Kingdom British Gas (1986) $ 8, United Kingdom BAA (Airports)(1987) $ 2, United Kingdom British Steel (1988) $ 4, United States Conrail (1987) $ 1,650.00

453 Control, Governance and Financial Architecture The largest US conglomerates in 1979 Conglomerates Sales Rank Company Numebr of Industries 8 ITT Tenneco Gulf & Western Industries Litton Industries LTV Illinois Central Industries Textron Greyhound Marin Marietta Dart Industries U.S. Industries Northwest Industries Walter Kidde Ogden Industries Colt Industries 9

454 Control, Governance and Financial Architecture Corporate Control and Governance Financial architecture US &UK: capital market oriented financing disperse ownership structure Europe: bank oriented financing more concentrated ownership Japan: crossholdings: Keiretsu

455 Control, Governance and Financial Architecture Ownership of Daimler Benz Daimler Benz AG 28.3% 14% 25.23% 32.37% Deutsch Bank Kuwait Government Mercedes Automobil Holding AG Widely Held Widely Held Stern Auto Beteilig 25% 25% 50% Stella Automobil Beteiligungsges Widely Held 25% 25% 25% 25% Bayerishe Landesbank Robert Bosch Komet Automobil Beteiligungsges Dresdner Bank

456 Control, Governance and Financial Architecture Japanese Bank Ownership 3.4% Sumitomo Corporation 4.8% Sumitomo Bank 3.4% Sumitomo Trust 1.8% 2.4% 5.9% keiretsu

457 Control, Governance and Financial Architecture Leveraged Buyouts, Spin-offs and Restructurings Fusion and Fission in Corporate Finance Conglomerates Control and Governance

458 Revision

459 Revision 7 Most Important Ideas in Finance Net Present Value Capital Asset Pricing Model (CAPM) Efficient Capital Markets Project Appraisal Techniques Capital Structure Theory Option Theory Agency Theory

460 Revision WACC & Debt Ratios Example continued: Sangria and the Perpetual Crusher project at 20% D/V Step 1 : unlevering the WACC: calculate r (opportunity cost of capital)at current debt of 40% r. 08(.4).146(.6).12 Step 2 D/V changes to 20% r E. 12 (.12.08)(.25).13 Step 3 New WACC WACC. 08(1.35)(.2).13(.8).114

461 Revision 8. GenCorp, an automorive parts manufacturer, currently has $25 million in outstanding debt and has 10 million shares outstanding. The book value per share is $10, while the market value is $ 25. The company is currently rated A, its bonds have a yield to maturity of 10%, and the current beta of the stock is The six-month T.Bill rate is 8% now, and the company's tax is 40%. a. What is the company's current weighted average cost of capital? b. The company is considering a repurchase of 4 million shares at $25 per share with new debt. It is estimated that this will push the company's rating down to a B (with a yield to maturity of 13%). What will the company's weighted average cost of capital be after the stock repurchase?

462 Revision 9. Pfizer, one of the largest pharmaceutical companies in the United States, is considering what its debt capacity is. In March 1995, Pfizer had an outstanding market value of equity of $ billion, debt of $ 2.8 billion and a AAA rating. Its beta was 1.47, and it faced a marginal corporate tax rate of 40%. The treasury bond rate at the time of the analysis was 6.50%, and AAA bonds trade at a spread of 0.30% over the treasury rate. Market premium equals 5.5%. a. Estimate the current cost of capital for Pfizer. b. It is estimated that Pfizer will have a BBB rating if it moves to a 30% debt ratio, and that BBB bonds have a spread of 2% over the treasury rate. Estimate the cost of capital if Pfizer moves to its optimal. c. Assuming a constant growth rate of 6% in the firm value, how much will firm value change if Pfizer moves its optimal? What will the effect be on the stock price? d. Pfizer has considerable research and development expenses. Will this fact affect whether Pfizer takes on the additional debt?

463 EXERCISES

464 Question 1 1

465 Question 2 2