Chapter 4 --Value-driven

Management -- Arbitrage

Explain how arbitrage works to ensure that the prices of

financial claims are equal to the present value of the
expected future cash flows.
You have two investments of equal risk below:
Investment A -- price $120 with a $10 return forever.
Investment B -- price $80 with a $10 return forever.
What should happen in the market?
Answer -- equal financial claims of equal risk sell for equal
prices in the market.

Arbitrage

Explain how arbitrage works to ensure that the prices of

financial claims are equal to the present value of the
expected future cash flows.

Two investments of equal risk below:

Investment A -- price $100 with a $12 return forever.
Investment B -- price $100 with a $8 return forever.

What should happen in the market?

Answer -- financial claims of equal risk sell for equal rates
of return in the market.

Price Terminology

What is the difference between bid prices, the

highest bid price, asked prices, the lowest asked
price and market price?

What role does the existence of different

information sets play in determining the different
prices above?

Information Sets

Who probably has the better information set

pertaining to the future cash flows of Microsoft?
Bill Gates -- the Chairman of the Board and
Chief Executive of Microsoft
A typical stockholder of Microsoft
When we refer to the intrinsic value of Microsoft,
to whose intrinsic value are we referring?
What happens when the intrinsic value is different
than the market price of the stock?

Information Sets Financing Decisions &

Capital Investment

When the information set of management does not match

the information set of the stockholders, two situations may
exist that have an impact on the financing decision.
Managers may be more optimistic than the market about
the future cash flows of the company:
What influence does this have on the financing of new
investment opportunities?
The market may be more optimistic than management
about the future cash flows of the company:
What influence does this have on the financing of new
investment opportunities?

Bonds
Bonds are one claim on the value of a firm
Know how to find the present value of a
bond
Know how to use the IRR function on the
calculator to find the market return or yield
to maturity
Know how to use the IRR function on the
calculator to find the yield to call

Bond Terminology

Bond yield terminology

Yield to maturity
Yield to call
Current yield
Coupon rate

Preferred Stock

Preferred stock is another claim on the value of a

firm
The value of preferred stock can be found using
the perpetual no-growth model in chapter 3
Value today = Expected dividend / required rate of
return for preferred shareholders
Market typically tells you the price and the
dividend in know work backwards to get the
required return

Common Stock

Common stock is another claim on the value of a

firm:
A short-cut method to value common stock is to
use the constant dividend growth model
Value today = Expected dividend /(required return
for common shareholders - growth)
Weaknesses of the model:
constant growth
companies that do not pay dividends

Asset View: Variables That Drive Stock

Value

Looking at value from the asset side instead of the

financing side, the firm value is driven by:
Existing projects -- dividends or cash flows from existing
projects
NPV of new investment opportunities expected to be taken
in the future -- with perfect information
Competitive advantage --> Economic Profit --> taken to
present leads to net present value --> which measures the
increase in value of the stock (with perfect information)

Other Events

Factors that do not influence value -- smoke and

mirrors
Stock splits
Stock dividends
Factors that influence value
Earnings
Investment announcements