Professional Documents
Culture Documents
Topics in Chapter
Financial management
Forms of business organization Objective of the firm: Maximize wealth Determinants of stock pricing Financial instruments, markets and institutions Interest rates and yield curves
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Identify and select the corporate strategies and individual projects that add value to their firm. Forecast the funding requirements of their company, and devise strategies for acquiring those funds.
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Starting as a Proprietorship
Advantages:
Ease of formation Subject to few regulations No corporate income taxes Limited life Unlimited liability Difficult to raise capital to support growth
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Disadvantages:
A partnership has roughly the same advantages and disadvantages as a sole proprietorship.
Becoming a Corporation
A corporation is a legal entity separate from its owners and managers. File papers of incorporation with state.
Charter Bylaws
Advantages:
Unlimited life Easy transfer of ownership Limited liability Ease of raising capital Double taxation Cost of set-up and report filing
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Disadvantages:
Raises cash Allows founders and pre-IPO investors to harvest some of their wealth
Subsequent issues of debt and equity Agency problem: managers may act in their own interests and not on behalf of owners (stockholders)
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The primary objective should be shareholder wealth maximization, which translates to maximizing stock price.
Should firms behave ethically? YES! Do firms have any responsibilities to society at large? YES! Shareholders are also members of society.
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Employment growth is higher in firms that try to maximize stock price. On average, employment goes up in:
firms that make managers into owners (such as LBO firms) firms that were owned by the government but that have been sold to private investors
(Continued)
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Consumer welfare is higher in capitalist free market economies than in communist or socialist economies. Fortune lists the most admired firms. In addition to high stock returns, these firms have:
high quality from customers view employees who like working there
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Amount of expected cash flows (bigger is better) Timing of the cash flow stream (sooner is better) Risk of the cash flows (less risk is better)
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Available (or free) for distribution To all investors (stockholders and creditors) After paying current expenses, taxes, and making the investments necessary for growth.
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Sales revenues
Current level Short-term growth rate in sales Long-term sustainable growth rate in sales
Operating costs (raw materials, labor, etc.) and taxes Required investments in operations (buildings, machines, inventory, etc.)
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The weighted average cost of capital (WACC) is the average rate of return required by all of the companys investors (stockholders and creditors)
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Capital structure (the firms relative amounts of debt and equity) Interest rates Risk of the firm Stock market investors overall attitude toward risk
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A financial asset is a contract that entitles the owner to some type of payoff.
In general, each financial asset involves two parties, a provider of cash (i.e., capital) and a user of cash.
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Terms
Terms
CBOE
CBOT
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Derivatives Options
Stock Indexes Futures Currency
Equity
Futures
Indexes Commodities Interest Rates Currency
T-Bonds
LEAPS
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(More . .)
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Preferred stocks
Common stocks (expected)
6 to 9%
9 to 15%
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Dow Jones Industrial Average Standard & Poors 500 Composite Nasdaq Composite NYSE Composite Wilshire 5000
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Nikkei 225 Tokyo FTSE 100 London Dax 30 Germany Hang Seng Hong Kong Region and Country Indexes
Price weighted
Market-value weighted
Equally weighted
See
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Households: Net savers Non-financial corporations: Net users (borrowers) Governments: Net borrowers Financial corporations: Slightly net borrowers, but almost breakeven
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Direct transfer (e.g., corporation issues commercial paper to insurance company) Through an investment banking house (e.g., IPO, seasoned equity offering, or debt placement) Through a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company)
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Commercial banks Savings & Loans, mutual savings banks, and credit unions Life insurance companies Mutual funds Pension funds
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A market is a method of exchanging one asset (usually cash) for another asset. Physical assets vs. financial assets Spot versus future markets Money versus capital markets Primary versus secondary markets
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Primary
New issue (IPO or seasoned) Key factor: issuer receives the proceeds from the sale. Existing owner sells to another party. Issuing firm doesnt receive proceeds and is not directly involved.
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Secondary
Underwritten: firm commitment on proceeds to the issuing firm. Best Efforts: no firm commitment. Negotiated: issuing firm negotiates terms with investment banker. Competitive bid: issuer structures the offering and secures bids.
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Public offerings: registered with the SEC and sale is made to the investing public.
Shelf registration (Rule 415, since 1982) allows firms to register an offering and sell parts of the offering over time. UnderpricingAverage increase is 14% on first day. Performance Underperforms similar stock during three years after IPO.
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Sale to a limited number of sophisticated investors not requiring the protection of registration.
- Dominated by institutions. - Very active market for debt securities. - Not active for stock offerings.
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By location
By the way that orders from buyers and sellers are matched
Open outcry auction Dealers (i.e., market makers) Electronic communications networks (ECNs)
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Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock Exchange Computer/telephone: e.g., Nasdaq, government bond markets, foreign exchange markets
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Types of Orders
Market Order Transact as quickly as possible at current price Limit Order Transact only if specific situation occurs. For example, buy if price drops to $50 or below during the next two hours.
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Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer
Price Impact Large sales or purchase might cause prices to change. Payment for Order Flow Exchange will pay brokers to direct orders to them.
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Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid
Auction Markets
NYSE and AMEX are the two largest auction markets for stocks. Participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients; e.g., CBOT. NYSE is a modified auction, with a specialist.
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One per stock (each specialist handles around 10-20 stocks) All trades in these stocks at the specialists post Makes a market by matching buyers/seller and by buying/selling from own inventory Goal is to maintain a fair and orderly market so that price changes are smooth
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Dealer Markets
Dealers keep an inventory of the stock (or other financial asset) and place bid and ask advertisements, which are prices at which they are willing to buy and sell. Often many dealers for each stock Computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers. Examples: Nasdaq National Market, Nasdaq SmallCap Market, London SEAQ, German Neuer Markt.
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ECNs:
Computerized system matches orders from buyers and sellers and automatically executes transaction. Low cost to transact Examples: Instinet, Island, and Archipelago (US, stocks); Eurex (Swiss-German, futures contracts); SETS (London, stocks).
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In the old days, securities were kept in a safe behind the counter, and passed over the counter when they were sold. Now the OTC market is the equivalent of a computer bulletin board (e.g., Nasdaq Pink Sheets), which allows potential buyers and sellers to post an offer.
Institutional market: to facilitate trades of larger blocks of securities. Involves services of dealers and brokers
Investor uses only a portion of own capital for an investment. Borrows remaining component. Margin arrangements differ for stocks and futures.
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Currently 50% Set by the Fed Minimum level of equity margin if prices change Call for more equity funds
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Maintenance margin
Margin call
Borrow stock through a dealer. Sell it Deposit proceeds and margin in account. Buy the stock Return to the party from which it was borrowed.
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Purpose: to profit from a decline in the price of a stock or security. Uptick restrictions Unlimited loss potential
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Government Regulation such as SEC. Self-Regulation such as NASD. Circuit Breakers automatic halt in trading if stock prices have exceptional changes. Insider trading oversight ECNs and Fragmentation makes regulation more difficult
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Cost of Capital
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r = r* + IP + DRP + LP + MRP.
Here: r = Required rate of return on a debt security. r* = Real risk-free rate. IP = Inflation premium. DRP = Default risk premium. LP = Liquidity premium. MRP = Maturity risk premium.
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ST Treasury: only IP for ST inflation LT Treasury: IP for LT inflation, MRP ST corporate: ST IP, DRP, LP LT corporate: IP, DRP, MRP, LP
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Term structure of interest rates: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve.
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Estimate the inflation premium (IP) for each future year. This is the estimated average inflation over that time period. Step 2: Estimate the maturity risk premium (MRP) for each future year.
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Step 1: Find IPn, the average expected inflation rate (INFLt) over years 1 to n.
IPn =
t=1
INFLt
n
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Assume investors expect inflation to be 5% next year, 6% the following year, and 8% per year thereafter. IP1 = 5%/1.0 = 5.00%. IP10 = [5 + 6 + 8(8)]/10 = 7.5%.
Assume the MRP is zero for Year 1 and increases by 0.1% each year:
Interest Rate
10% 8% 6% 4% 2% 0%
MRP IP r*
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Years to Maturity
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This constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity risk premium.
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Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not necessarily parallel to the Treasury curve. The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases.
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Interest Rate
8.0% 6.0% 4.0% 2.0% 0.0% 1 10 Years to Maturity 20 5.2% 5.9% 6.0%
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Shape of the yield curve depends on the 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 or down. PEH assumes that MRP = 0.
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Country risk: Arises from investing or doing business in a particular country. It depends on the countrys economic, political, and social environment. Exchange rate risk: If investment is denominated in a currency other than the dollar, the investments value will depend on what happens to exchange rate.
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Changes in relative inflation will lead to changes in exchange rates. An increase in country risk will also cause that countrys currency to fall.
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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.
Yield
6.0%
2 years - y0,2
3 years - y0,3 4 years - y0,4 5 years - y0,5
6.2%
6.4% 6.5% 6.5%
Yields on a Time-Line
Y0,1 = 6.0%
Y0,2 = 6.2%
Y0,5 = 6.5%
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$100 invested now (t=0) for 2 years will yield 6.2% per year:
$100(1.062)2 = $112.78
$100 invested now (t=0) for 5 years will yield 6.5% per year:
$100(1.065)5 = $137.01
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If PEH holds, what does the market expect will be the interest rate on:
One-year securities, one year from now? (y1,2 ) Three-year securities, two years from now? (Y2,5 )
PEH tells us that one-year securities will yield 6.4%, one year from now (x%).
x%
6.0%
1
6.2%
PEH tells us that three-year securities will yield 6.7%, two years from now (x%).
6.2% x%
3 4 5 6.5% [ 2(6.2%) + 3(x%) ] 6.5% = 5 32.5% = 12.4% + 3(x%) 20.1% = 3(x%) 75 6.7% = x%.
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