Corporate Financial Policy

Semester A 2012-13
City University of Hong Kong
AC4331 Week 3

Topic 3
.
1-2
Introduction to Financial Management
Free Cash Flow
Financial Planning and Forecasting
Financial Assets and Time Value of Money
Risk and Return
Bond and Stock Valuation
Cost of Capital
Cash Flow Estimation and Risk Analysis
Capital Structure and Leverage
Treasury and Valuation
Enterprise Risk Management
Dividends and Share Repurchase
Merger and Acquisitions
Working Capital Management
Extra Ref:
Financial Management, Theory and Practice, 12e Eugene and
Brigham
Topic 3a:
Financial Assets
Be able to:
Understand Cost of Money and
Interest Rate Levels
Understand the determinants of
Interest Rates
Explain the Term Structure and
Yield Curves
Use Yield Curve to Estimate Future
Interest Rates
4
Production
opportunities
Time preferences
for consumption
Risk
Expected inflation
6-5
6-6
r = represents any nominal rate
r* = represents the real risk-free rate of
interest. Like a T-bill rate, if there was
no inflation. Typically ranges from 1%
to 5% per year.
r
RF
= represents the rate of interest on
Treasury securities.
6-7
r = r* + IP + DRP + LP + MRP

r = required return on a debt security
r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
6-8
IP MRP DRP LP
S-T Treasury
L-T Treasury
S-T Corporate
L-T Corporate
6-9
Term structure
relationship between
interest rates (or yields)
and maturities.
The yield curve is a
graph of the term
structure.
The October 2008
Treasury yield curve is
shown at the right.
0%
2%
4%
6%
8%
10%
12%
14%
0 10 20 30
Interest
Years to Maturity
March 1980
February 2000
October 2008
6-10
N
INFL
IP
N
1 t
t
N

=
=
Step 1 Find the average expected inflation
rate over Years 1 to N:
6-11
Assume inflation is expected to be 5% next
year, 6% the following year, and 8% thereafter.




Must earn these IPs to break even vs. inflation;
these IPs would permit you to earn r* (before
taxes).
% 75 . 7 20 / )] 18 %( 8 % 6 % 5 [ IP
% 50 . 7 10 / )] 8 %( 8 % 6 % 5 [ IP
% 00 . 5 1 / % 5 IP
20
10
1
= + + =
= + + =
= =
6-12
Step 2 Find the appropriate maturity risk
premium (MRP). For this example, the
following equation will be used to find a
securitys appropriate maturity risk
premium.

MRP
t
= 0.1% (t 1)
6-13
Using the given equation:




Notice that since the equation is linear, the
maturity risk premium is increasing as the
time to maturity increases, as it should be.
% 9 . 1 ) 1 20 ( % 1 . 0 MRP
% 9 . 0 ) 1 10 ( % 1 . 0 MPP
% 0 . 0 ) 1 1 ( % 1 . 0 MRP
20
10
1
= =
= =
= =
6-14
Step 3 Adding the premiums to r*.
r
RF,
t
= r* + IP
t
+ MRP
t
Assume r* = 3%,

% 65 . 12 % 9 . 1 % 75 . 7 % 3 r
% 4 . 11 % 9 . 0 % 5 . 7 % 3 r
% 0 . 8 % 0 . 0 % 0 . 5 % 3 r
20 , RF
10 , RF
1 RF,
= + + =
= + + =
= + + =
6-15
An upward
sloping yield
curve.
Upward slope due
to an increase in
expected inflation
and increasing
maturity risk
premium.
Years to
Maturity
Real risk-free rate
0
5
10
15
1
Interest
Rate (%)
Maturity risk premium
Inflation premium
10 20
6-16
Corporate yield curves are higher than that
of Treasury securities, though not
necessarily parallel to the Treasury curve.
The spread between corporate and
Treasury yield curves widens as the
corporate bond rating decreases.
6-17
0
5
10
15
0 1 5 10 15 20
Years to
Maturity
Interest
Rate (%)
5.2%
5.9%
6.0%
Treasury
Yield Curve
BB-Rated
AAA-Rated
6-18
The PEH contends that the shape of the
yield curve depends on investors
expectations about future interest rates.
If interest rates are expected to increase,
L-T rates will be higher than S-T rates, and
vice-versa. Thus, the yield curve can slope
up, down, or even bow.
6-19
Assumes that the maturity risk premium
for Treasury securities is zero.
Long-term rates are an average of current
and future short-term rates.
If PEH is correct, you can use the yield
curve to back out expected future interest
rates.
6-20
If PEH holds, what does the market expect
will be the interest rate on one-year
securities, one year from now? Three-year
securities, two years from now?
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%
6-21
(1.062)
2
= (1.060) (1 + X)
1.12784/1.060 = (1 + X)
6.4004% = X
0 1 2
6.0% x%
6.2%
PEH says that one-year securities will yield
6.4004%, one year from now.
Notice, if an arithmetic average is used,
the answer is still very close. Solve: 6.2% =
(6.0% + X)/2, and the result will be 6.4%.
6-22
(1.065)
5
= (1.062)
2
(1 + X)
3

1.37009/1.12784 = (1 + X)
3

6.7005% = X
0 1 2 3 4 5
6.2% x%
6.5%
PEH says that three-year securities will yield
6.7005%, two years from now.
6-23
Some would argue that the MRP 0, and
hence the PEH is incorrect.
Most evidence supports the general view
that lenders prefer S-T securities, and view
L-T securities as riskier.
Thus, investors demand a premium to persuade
them to hold L-T securities (i.e., MRP > 0).
6-24
Federal reserve policy
Federal budget deficits or surpluses
International factors
Level of business activity
1-
25
Introduction to Financial Management
Free Cash Flow
Financial Planning and Forecasting
Financial Assets and Time Value of Money
Risk and Return
Bond and Stock Valuation
Cost of Capital
Cash Flow Estimation and Risk Analysis
Capital Structure and Leverage
Treasury and Valuation
Enterprise Risk Management
Dividends and Share Repurchase
Merger and Acquisitions
Working Capital Management
Extra Ref:
Financial Management, Theory and Practice, 12e Eugene and
Brigham
Topic 3b:
Risk and Return
Key Concepts and Skills

Be able to understand and apply the
following concepts:

Stand-Alone Risk
Portfolio Risk
Risk and Return: CAPM/SML
7-27
The rate of return on an investment can be
calculated as follows:



For example, if $1,000 is invested and $1,100
is returned after one year, the rate of return
for this investment is:
($1,100 $1,000)/$1,000 = 10%.
7-28
( )
Cost
Cost value ending Expected
Return

=
Two types of investment risk
Stand-alone risk
Portfolio risk
Investment risk is related to the probability
of earning a low or negative actual return.
The greater the chance of lower than
expected or negative returns, the riskier
the investment.
7-29
A listing of all possible outcomes, and the
probability of each occurrence.
Can be shown graphically.
Expected Rate of Return
Rate of
Return (%)
100 15
0
-70
Firm X
Firm Y
7-30
Average Standard
Return Deviation
Small-company stocks 17.1%
32.6%
Large-company stocks 12.3
20.0
L-T corporate bonds 6.2 8.4
L-T government bonds 5.8 9.2
U.S. Treasury bills 3.8 3.1
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation
Edition) 2008 Yearbook (Chicago: Morningstar, Inc., 2008), p 28.
7-31
Economy Prob. T-Bill HT Coll USR MP
Recession 0.1 5.5% -
27.0%
27.0% 6.0% -
17.0%
Below avg 0.2 5.5% -7.0% 13.0% -
14.0%
-3.0%
Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0%
Above avg 0.2 5.5% 30.0% -
11.0%
41.0% 25.0%
Boom 0.1 5.5% 45.0% -
21.0%
26.0% 38.0%
7-32
T-bills will return the promised 5.5%,
regardless of the economy.
No, T-bills do not provide a completely
risk-free return, as they are still exposed to
inflation. Although, very little unexpected
inflation is likely to occur over such a short
period of time.
T-bills are also risky in terms of
reinvestment rate risk.
T-bills are risk-free in the default sense of
the word.

7-33
HT Moves with the economy, and has a
positive correlation. This is typical.
Coll. Is countercyclical with the economy,
and has a negative correlation. This is
unusual.
7-34
7-35

N
i i
i=1
r =Expected rate of return
r = rP
r =( 27%)(0.1) +( 7%)(0.2) +(15%)(0.4)
+(30%)(0.2) +(45%)(0.1)
=12.4%
Expected return
HT 12.4%
Market 10.5%
USR 9.8%
T-bill 5.5%
Coll. 1.0%
HT has the highest expected return, and
appears to be the best investment alternative,
but is it really? Have we failed to account for
risk?
7-36
2
Variance

o
o o
o
= =
=

N
2
i
i=1
=Standard deviation
(r - r) P
7-37
7-38
% 0 . 0
) 1 . 0 ( ) 5 . 5 5 . 5 (
) 2 . 0 ( ) 5 . 5 5 . 5 ( ) 4 . 0 ( ) 5 . 5 5 . 5 (
) 2 . 0 ( ) 5 . 5 5 . 5 ( ) 1 . 0 ( ) 5 . 5 5 . 5 (
P ) r r (
bills - T
2 / 1
2
2 2
2 2
bills - T
N
1 i
i
2
= o
(
(
(

+
+
+
= o
= o

=

HT
= 20%

M
= 15.2%
USR
= 18.8%

Coll
= 13.2%
USR
Prob.
T-bill
HT
0 5.5 9.8 12.4 Rate of Return (%)
7-39
Standard deviation (
i
) measures total, or
stand-alone, risk.
The larger
i
is, the lower the probability
that actual returns will be closer to
expected returns.
Larger
i
is associated with a wider
probability distribution of returns.
7-40
7-41
Security Expected Return, Risk, o
T-bills 5.5% 0.0%
HT 12.4 20.0
Coll* 1.0 13.2
USR* 9.8 18.8
Market 10.5 15.2
*Seems out of place.

r
7-42
A standardized measure of dispersion
about the expected value, that shows the
risk per unit of return.
r return Expected
deviation Standard
CV
o
= =
CV
T-bill 0.0
HT 1.6
Coll. 13.2
USR 1.9
Market 1.4
Collections has the highest degree of risk per
unit of return.
HT, despite having the highest standard
deviation of returns, has a relatively average
CV.

7-43

A
=
B
, but A is riskier because of a larger
probability of losses. In other words, the
same amount of risk (as measured by ) for
smaller returns.
7-44
0
A B
Rate of Return (%)
Prob.
Risk aversion assumes investors dislike
risk and require higher rates of return to
encourage them to hold riskier securities.
Risk premium the difference between the
return on a risky asset and a riskless asset,
which serves as compensation for investors
to hold riskier securities.
7-45
Assume a two-stock portfolio is created
with $50,000 invested in both HT and
Collections.
A portfolios expected return is a weighted
average of the returns of the portfolios
component assets.
Standard deviation is a little more tricky
and requires that a new probability
distribution for the portfolio returns be
devised.

7-46

p
N
^
i
p i
i=1
p
r is a weighted average:
r = w r
r = 0.5 (12.4%) + 0.5 (1.0%) = 6.7%
7-47
Economy Prob. HT Coll Port.
Recession 0.1 -27.0% 27.0% 0.0%
Below avg 0.2 -7.0% 13.0% 3.0%
Average 0.4 15.0% 0.0% 7.5%
Above avg 0.2 30.0% -11.0% 9.5%
Boom 0.1 45.0% -21.0% 12.0%
6.7% (12.0%) 0.10 (9.5%) 0.20
(7.5%) 0.40 (3.0%) 0.20 (0.0%) 0.10 r
p
= + +
+ + =
7-48
0.51
6.7%
3.4%
CV
3.4%
6.7) - (12.0 0.10
6.7) - (9.5 0.20
6.7) - (7.5 0.40
6.7) - (3.0 0.20
6.7) - (0.0 0.10

p
2
1
2
2
2
2
2
p
= =
=
(
(
(
(

+
+
+
+
= o
7-49

p
= 3.4% is much lower than the
i
of
either stock (
HT
= 20.0%;
Coll.
= 13.2%).

p
= 3.4% is lower than the weighted
average of HT and Coll.s (16.6%).
Therefore, the portfolio provides the
average return of component stocks, but
lower than the average risk.
Why? Negative correlation between stocks.
7-50
~ 35% for an average stock.
Most stocks are positively (though not
perfectly) correlated with the market (i.e.,
between 0 and 1).
Combining stocks in a portfolio generally
lowers risk.
7-51
7-52
Stock M
0
15
25
-10
Stock M
0
15
25
-10
Portfolio MM
0
15
25
-10
7-53
7-54

p
decreases as stocks added, because they
would not be perfectly correlated with the
existing portfolio.
Expected return of the portfolio would
remain relatively constant.
Eventually the diversification benefits of
adding more stocks dissipates (after about
10 stocks), and for large stock portfolios,

p
tends to converge to ~ 20%.
7-55
7-56
Stand-alone risk = Market risk + Diversifiable
risk

Market risk portion of a securitys stand-
alone risk that cannot be eliminated through
diversification. Measured by beta.
Diversifiable risk portion of a securitys
stand-alone risk that can be eliminated
through proper diversification.
7-57
If an investor chooses to hold a one-stock
portfolio (doesnt diversify), would the
investor be compensated for the extra risk
they bear?
NO!
Stand-alone risk is not important to a well-diversified
investor.
Rational, risk-averse investors are concerned with
p
,
which is based upon market risk.
There can be only one price (the market return) for a
given security.
No compensation should be earned for holding
unnecessary, diversifiable risk.
7-58
Model linking risk and required returns.
CAPM suggests that there is a Security
Market Line (SML) that states that a stocks
required return equals the risk-free return
plus a risk premium that reflects the
stocks risk after diversification.
r
i
= r
RF
+ (r
M
r
RF
)b
i

Primary conclusion: The relevant riskiness
of a stock is its contribution to the
riskiness of a well-diversified portfolio.
7-59
Measures a stocks market risk, and shows
a stocks volatility relative to the market.
Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
7-60
If beta = 1.0, the security is just as risky as
the average stock.
If beta > 1.0, the security is riskier than
average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5
to 1.5.
7-61
Yes, if the correlation between Stock i and
the market is negative (i.e.,
i,m
< 0).
If the correlation is negative, the regression
line would slope downward, and the beta
would be negative.
However, a negative beta is highly unlikely.
7-62
Well-diversified investors are primarily
concerned with how a stock is expected to
move relative to the market in the future.
Without a crystal ball to predict the future,
analysts are forced to rely on historical
data. A typical approach to estimate beta
is to run a regression of the securitys past
returns against the past returns of the
market.
The slope of the regression line is defined
as the beta coefficient for the security.
7-63
.
.
.
r
i
_
r
M
-5 0 5 10 15 20

20

15

10

5
-5

-10
Regression line:
r
i
= -2.59 + 1.44 r
M
^ ^
Year r
M
r
i

1 15% 18%
2 -5 -10
3 12 16
7-64
7-65
r
M
r
i
-20 0 20 40

40



20




-20
HT: b = 1.32
T-bills: b = 0
Coll: b = -0.87
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87
Riskier securities have higher returns, so the
rank order is OK.
7-66

SML: r
i
= r
RF
+ (r
M
r
RF
)b
i

r
i
= r
RF
+ (RP
M
)b
i


Assume the yield curve is flat and that r
RF
=
5.5% and RP
M
= 5.0%.
7-67
Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
Its size depends on the perceived risk of
the stock market and investors degree of
risk aversion.
Varies from year to year, but most
estimates suggest that it ranges between
4% and 8% per year.
7-68
7-69
r
HT
= 5.5% + (5.0%)(1.32)
= 5.5% + 6.6% = 12.10%
r
M
= 5.5% + (5.0%)(1.00) = 10.50%
r
USR
= 5.5% +(5.0%)(0.88) = 9.90%
r
T-bill
= 5.5% + (5.0)(0.00) = 5.50%
r
Coll
= 5.5% + (5.0%)(-0.87) = 1.15%
7-70
r
HT 12.4% 12.1% Undervalued ( >r)
Market 10.5 10.5 Fairly valued ( =r)
USR 9.8 9.9 Overvalued ( < r)
T-bills 5.5 5.5 Fairly valued ( = r)
Coll. 1.0 1.15 Overvalued ( < r)
r
r
r
r
r
r
.
.
Coll.
.
HT
T-bills
.
USR
SML
r
M
= 10.5

r
RF
= 5.5
-1 0 1 2
.
SML: r
i
= 5.5% + (5.0%)b
i

r
i
(%)
Risk, b
i
7-71
Create a portfolio with 50% invested in HT
and 50% invested in Collections.
The beta of a portfolio is the weighted
average of each of the stocks betas.

b
P
= w
HT
b
HT
+ w
Coll
b
Coll

b
P
= 0.5(1.32) + 0.5(-0.87)
b
P
= 0.225
7-72
The required return of a portfolio is the
weighted average of each of the stocks
required returns.
r
P
= w
HT
r
HT
+ w
Coll
r
Coll

r
P
= 0.5(12.10%) + 0.5(1.15%)
r
P
= 6.625%
Or, using the portfolios beta, CAPM can be
used to solve for expected return.
r
P
= r
RF
+ (RP
M
)b
P

r
P
= 5.5%

+ (5.0%)(0.225)
r
P
= 6.625%

7-73
What if investors raise inflation
expectations by 3%, what would happen to
the SML?
SML
1
r
i
(%)
SML
2
0 0.5 1.0 1.5

13.5
10.5
8.5
5.5
I = 3%
Risk, b
i
7-74
What if investors risk aversion increased,
causing the market risk premium to
increase by 3%, what would happen to the
SML?
SML
1
r
i
(%)
SML
2
0 0.5 1.0 1.5

13.5
10.5

5.5
RP
M
= 3%
Risk, b
i
7-75
The CAPM has not been verified
completely.
Statistical tests have problems that make
verification almost impossible.
Some argue that there are additional risk
factors, other than the market risk
premium, that must be considered.
7-76
Investors seem to be concerned with both
market risk and total risk. Therefore, the
SML may not produce a correct estimate of
r
i
.
r
i
= r
RF
+ (r
M
r
RF
)b
i
+ ???
CAPM/SML concepts are based upon
expectations, but betas are calculated
using historical data. A companys
historical data may not reflect investors
expectations about future riskiness.
7-77