Financial Management

Definition:

• Based on book: Fundamentals of corporate finance fifth edition (Wiley)
• Net working capital = current asset - current liabilities

1. Financial manager and the firm:

Role of the financial manager:

• Maximizing the price of firm’s stock will maximize value of a firm and the wealth of its shareholders/owners
• 3 fundamental decisions in financial management
  • Capital budgeting: identify which long-term assets to acquire to maximize net benefits for the firm
    • affect long-term assets (productive assets, tangible or intangible)
  • Financing: determine best way to pay for for short-term and long-term assets
    • determine firm’s cpital structure
    • affect long-term debt and equity thatwill be used to finance firm’s long-term productive asset and net working capital
  • Working capital: decide how to manage short-term resources and obligations by adjusting current assets and current liabilities to promote growth in cash flow
    • affect current asset and current liabilities
• BOD is representative of all shareholders
  • mostly large shareholders
  • sometimes independent experts
  • Consists of:
    • audit comittee
    • governance comittee
    • remuneration committee: manage composation and performance policies
    • Nomination committee
    • Risk committe
    • Investment committee

Forms of business organization

Managing the financial function:

• Positions reporting to the CFO
  • Treasurer
  • Risk manager
  • Controller
  • Internal Auditor
• External auditor: creditors and investors require independent audits
• The audit committee: powerful subcomittee of the BOD
  • Oversee accounting function and preparation of firm’s financial statements
  • conducts investigations of significant fraud, theft
• The Compliance and Ethics Director: oversees three mandated programs
  1. a compliance program that ensures that the firm complies with federal and state laws and regulations
  2. an ethics program that promotes ethical conduct among executives and other employees
  3. a compliance hotline, which must include a whistleblower program

Goal of the firm

• Why not maximize market share? Giving away for free will increase market share but not cash flow
• Why not maximize profit? Sell everything now and receive cash in far future → no cash flow
• Maximizing value of firm’s stock, consider
  • future cash flows
  • timing of future cash flows
  • risk of having to wait for cash flows
• Good cash flow → have positive residual cash flow → greater firm value
• Management decisions affect cash flows → affect stock prices

Agency Conflict: separation of ownership and control:

• Managers might act in their own self-interest rather than long term value of the firm
• An Agency relationship is created when the owner (a principal) of a business hires an employee (agent)
  • → separate control and ownership → agency conflict
• Agency cost: costs that arise from incurring and preventing conflicts of interest between a firm’s owners and its managers
  • might reduce positive residual cash flow, stock price, and shareholder wealth
  • can be reduced by:
    • increased oversight
    • aligning incentives
      • Board of directors
      • Management compensation
      • Managerial labor market
      • Internal competition among managers
      • Large stockholders
      • Corporate raiders search for takeover targets
      • Legal and regulatory constraints limit managerial behavior

2. Financial System:

Definition:

• Financial markets include markets for trading financial assets such as stocks and bonds rather than real assets
• Financial institutions include banks, credit unions, insurance companies, and finance companies

Financial system at work

• Money is collected from small amounts (borrowed) and invested in large amounts (loaned)
• System directs money to the best investment opportunities in the economy (return and risk)
• → Lenders earn profit from lending and borrowing spread

How funds flow through the financial system

• Directly vs Indirectly:
  • Directly through financial markets: creation and sale of financial securities directly to leader/saver
    • borrower/spedner deals with lender/savers
    • Investment Bank and money center banks help with origination, underwriting and distribution of new debt and equity
      • Origination is the process of preparing a security issues for sale
      • Underwriting is a service to assist firms in selling their debt or equity securities in a direct financing market
      • Distribution is the process of marketing and reselling the securities to investors
  • Indirectly through financial institution: institutions invest in Financial Assets by collect money from lender/saver and make loans in larger amounts to borrower/spender

Types of financial markets

• The major types of markets include:
  • Primary Market and Secondary Market
    • Primary: Wholesale market where firms’ new securities are issued and sold for the first time
    • Secondary: Retail market where previously issued securities are resold (traded)
      • enable investors to buy and sell securities frequently
      • active secondary markets → higher price in primary market
        • → companies whose securities have active secondary markets enjoy lower funding costs than similar firms whose securities do not have active secondary markets.
      • no new money goes into the firm when a secondary market transaction takes place.
    • Marketability vs Liquidity
      • Marketability is the ease with which a security can be sold and converted into cash. A security’s marketability depends in part on the costs of trading and searching for information, so-called transaction costs
      • Liquidity is the ability to convert an asset into cash quickly without loss of value
    • Broker vs Dealer:
      • Broker bring buys and sellers together and learn commission fee
      • Dealers buy from sellers, store to inventory and sell to buyers
  • Exchanges and over-the-counter markets
    • Exchange: location where sellers and buyers meet to conduct transactions
      • New York Stock Exchange (NYSE)
      • Chicago Board Options Exchange (CBOE)
    • Over-the-Counter Market: dealers conduct transactions over the phone or via computer
      • National Association of Securities Dealers Automated Quotations (NASDAQ)
  • Money and capital markets
    • Money market: market for low-risk securities with maturities of less than one year
      • Treasury bills (T-Bills), Commercial paper
    • Capital market: market for securities with maturities longer than one year
      • Bonds, Common stock
    • Capital market are less marketable, higher defauft risk and have longer maturities
  • Public and private markets
    • Public markets are organized financial markets where the general public buys and sells securities through their stockbrokers
    • Private markets involve direct transactions between two parties, often called private placements
      • Advantages: faster, lower transaction costs
      • Disadvantages:
        • Privately placed securities cannot legally be sold in the public markets because they lack SEC registration
        • Dollar amounts that can be raised tend to be smaller
  • Futures and options markets
    • Derivative securities derive their value from some underlying asset
    • Futures Contract: contracts for the future delivery of assets such as securities, foreign currencies, interest cash flows, or commodities
    • Options Contract call for the option writer to buy or sell an asset if called upon to do so by the option buyer
    • Both futures and options can be used to hedge risk

Market efficiency

• A market where prices reflect the knowledge and expectations of all investors, true value
  • for a security, the present value of the cash flows an investor who owns that security can expect to receive in the future
• Overall efficiency of a market depends on its:
  • Market Operational efficiency: degree to which transtion costs of bringing buys and sellers together are minimized
  • Marlet Informational efficiency: degree to which current market prices reflect relevant information and, therefore, the true value of the security
• Efficient market hypotheses:
  • Efficient market hypothesis a theory concerning the extent to which information is reflected in security prices and how information gets incorporated into security prices
  • Strong-Form Efficiency
    • Security prices reflect all information, both public and private
    • Even inside information is reflected in prices
  • Semistrong-Form Efficiency
    • Security prices always reflect all public information
    • Inside, or confidential information, is not reflected in prices
  • Weak-Form Efficiency
    • Security prices only reflect historical information

Financial Institutions and Indirect Financing

• Financial Institutions
  • Provide lending and borrowing opportunities at the retail level for small customers and wholesale level for large customers
  • Efficiently collect funds in small amounts and lend them in larger amounts
  • Tailor loan amounts and contract terms to fit the needs of consumers, corporations, and small businesses
• Types of Financial Institutions
  • Commercial banks: FinTech companies
  • Credit unions
  • Life and casualty insurance companies
  • Pension funds
  • Investment funds
  • Business finance companies

5. The Time Value of Money

TVM

• Present Value: value of dollar today
• Future Value: value of dollar in the future
• Compounding: converting from future value to present value
• the difference in value between a dollar in hand today and a dollar promised in the future; a dollar today is worth more than a dollar in the future
• Comsuming today or tomorrow
  • Receiving money today → better for cashflow
  • Invest
  • avoid inflation

Future value and compounding

• Single-period: $F{V}_1=P_0\times (1+i)$
• Future value equation: $F{V}_n=PV\times (1+i{)}^n$
  • more frequently than once a year: $F{V}_n=PV\times (1+i/m{)}^{m.n}$
  • every interest rate is usually annualized
• Continuous compounding: $F{V}_{\infty }=PV\times e^{i\times n}$

Present value and discounting

• The PV is often referred to as the discounted value of future cash flows
  • Discounting is the process and the interest rate i is called the discount rate
• Time and the discount rate affect present value

Additional concepts and application

• Finding interest rate:
  • An investor or analyst may want
    • The growth rate in sales
    • The rate of return on an investment
    • The effective interest rate on a loan
  • 1. Rule of 72: Time to double money, $TDM=\frac{72}{i}$ for $i\%$ interest rate
    • only for work $i$ = 5% - 20%
  • 2. Reverse compounding formula

6. Discounted cash flows and Valuation:

Multiple cash flows

• Future value of multiple cash flows:
  • draw a time line to make sure that each cash flow is placed in the correct time period
  • calculate the future value of each cash flow for its time period
  • add up the future values
• Present value of multiple cash flows:
  • Reverse of calculating future value of multiple cash flows
  • Calculate Present Value of each future cash flows
  • Sum of all PV is the total present value
• PV and FV can be quickly converted to 1 another

Level cash flows: Annuities

• Terms:
  • Annuity: A series of equally-spaced and level cash flows extending over a finite number of periods
  • Perpetuity: A series of equally-spaced and level cash flows that continue forever
  • Ordinary Annuity: Cash flows occur at the end of a period
    • Examples include mortgage payments and interest payments to bondholders
  • Annuity Due: Cash flows occur at the beginning of a period
    • Examples include leases and car insurance
• Present Value of an Annuity (PVA):
  • The amount needed to produce the annuity (equally)
  • The current fair value or market price of the annuity
  • The amount of a loan that can be repaid with the annuity
  • ${PVA}_n=\frac{CF}{i}\times [1-\frac{1}{(1+i{)}^n}]=CF\times \left[\frac{1-1/(1+i{)}^n}{i}\right]=CF\times \text{FV annuity factor}$
    • $i$: interest/discount rate, period-based (not annualized)
      • it is annual interest in some calculator
    • $n$: number of periods
    • $CF$: cashflow, monthly payment over period, PMT
  • Preparing a Loan Amortization Schedule:
    • amortization describes the way in which the principal (the amount borrowed) is repaid over the life of a loan.
    • amortization schedule a table that shows the loan balance at the beginning and end of each period, the payment made during that period, and how much of that payment represents interest and how much represents repayment of principal
    • With an amortizing loan, some portion of each loan payment goes to paying down the principal
      • Columns:
        • Year
        • Beginning principal balance (1), last year’s Ending Principal Balance
        • Total monthly/annual payment (2), same every period (CF)
        • Interest payment (3)
        • Principal paid (2) - (3) - (4)
        • Ending Principal Balance (1) - (4) - (5)
    • Finding interest rate: must use trial and error or calculator
• Future value of an Annuity
  • Future value of an annuity computations typically involve some type of saving activity, such as a monthly savings plan
  • Another application is computing future values for retirement or pension plans with constant contributions
  • Given that $FV{A}_n=PV{A}_n\times (1+i{)}^n$, substituting $PVA$
    • $FV{A}_n=\frac{CF}{i}\times [1-\frac{1}{(1+i{)}^n}]\times (1+i{)}^n$
    • $FV{A}_n=\frac{CF}{i}\times [(1+i{)}^n-1]$
    • $FV{A}_n=CF\times \left[\frac{(1+i{)}^n-1}{i}\right]=CF\times \text{FV annuity factor}$
• Annuities due:
  • an annuity in which payments are made at the beginning of each period
  • The present or future value of an annuity due is always higher than that of an ordinary annuity that is otherwise identical
  • the first cash flow occurs at the beginning of the first period
  • Annuity transformation method:
    • $\text{Annuity due value}=\text{Ordinary annuity value}\times (1+i)$

Level cash flows: perpetuities:

• A perpetuity is a series of equally spaced and level cash flows that goes on forever
  • The most important perpetuities in the securities markets today are preferred stock issues
• Perpetuities:
  • A stream of equal cash flows that goes on forever
  • Equation for the present value of a perpetuity can be derived from the present value of an annuity equation
  • $\text{PVP}=\frac{\text{CF}}{i}$ if cash flow is at the end of the first period

Cash flows that grow at a constant rate

• Growing annuity
  • Equally-spaced cash flows that increase in size at a constant rate for a finite number of periods
  • ${\text{PVA}}_n=\frac{{\text{CF}}_i}{i-g}\times [1-(\frac{1+g}{1+i}{)}^n]$ where ${\text{CF}}_i$ is cash flow one period in the future ($C{F}_0\ast (1+i\%)$)
    • only when the growth rate is less than the discount rate
• Growing perpetuity:
  • Equally-spaced cash flows that increase in size at a constant rate forever
  • $\text{PVP}=\frac{{\text{CF}}_i}{i-g}$ where ${\text{CF}}_i$ is cash flow one period in the future ($C{F}_0\ast (1+i\%)$)

The affective annual interest rate

• Annual Percenrage Rate, APR: periodic rate $\times$ nb of periods
• effective annual interest rate, EAR: annual interest rate that takes compounding over the course of a year into account
  • EAR = $(1+\frac{\text{APR}}{m}{)}^m-1$
• The Appropriate Interest Rate Factor: any time you do a future value or present value calculation, either use the interest rate per period (quoted rate/m) or the EAR as the interest rate factor

8. Bond valuation and structure of interest rate

Corporate bonds

• Market for corporate bonds
  • The most important investors are life insurance companies, pension funds, and mutual funds
  • Transactions tend to be in very large dollar amounts
  • less efficient compared to stocks or U.S. treasury bills and bond
• Bond price information:
  • Only a small fraction of the bonds outstanding are traded each day
  • Mostly negotiated directly between the buyer and seller, with limited centralized reporting of the sales
• Corporate bond:
  • A type of Fixed-income securities: debt instruments that pay interest in amounts that are fixed for the life of the contract
  • Features of corporate Bonds:
    • Long-term claims against company assets
    • Face, or par, value is $1,000
    • Coupon rate is the annual coupon payment (C) / bond’s face value (F)
    • Coupon payment is a fixed amount paid to lenders for the life of the contract (typically with a semiannual or annual payment)
• Types of corporate bonds:
  • Vanilla bonds, debentures, are unsecured:
    • Coupon payments fixed for the life of the bond
    • Repay principal and retire the bonds at maturity
    • Contracts have the features and provisions found in most bond covenants
    • Annual or semiannual coupon payments
  • Zero coupon bond:
    • No coupon payment, only face value at maturity
    • Sold at a discount compared to face value
  • Convertible bonds:
    • May be exchanged for shares of the firm’s stock
    • Sell for a higher price than a comparable non- convertible bond
    • Bondholders benefit if the market value of the company’s stock gets high enough

Bond valuation

• Steps:
  • estimate the expected future cash flows
  • determine the required yield, rate of return, or discount rate (depends on riskiness of the future cash flows)
    • market interest rate
  • compute present alue of future cash flows
• Bond valuation formula:
  • Then $P_B$ (current value/price of a bond = $PV$ (present value of coupon payments) + $PV$ (present value of Principal payment)
  • $P_B=\frac{C_1}{(1+i)}+\frac{C_2}{(1+i{)}^2}+...+\frac{C_n+F_n}{(1+i{)}^n}$
• Par, premium and discount bonds
  • Par bond: If a bond’s coupon rate is equal to its yield, the price will equal the face value
  • Premium bond: If a bond’s coupon rate is more than its yield, the price will be higher than the face value
    • Likely to happen when interest rates are falling
  • Discount bond:
    • If a bond’s coupon rate is less than its yield, the price will be less than the face value
    • Likely to happen when interest rates are rising
• Semiannual compounding:
  • $i=i/m$
  • $C=C/m$
• Zero coupon bonds: discount simply
  • $P_B=\frac{F_{mn}}{(1+i/m{)}^{mn}}$

Bond yields:

• YTM, Yield to maturity:
  • actual rate of return (if buy bond now) != interest rate (used to calculate what bond price should be)
• EAY, Effective annual yield:
  • $EAY=(1+\frac{\text{quoted interested rate}}{m}{)}^m-1$
  • quoted interested rate = nb of periods * YTM
• Realized Yield: return earned on a bond given cash flow actually received

Interest rate risk

• uncertainty about future bond values due to the unpredictability of interest rates
• Bond theorems:
  1. Bond prices are inversely related to interest rate movements
     • interest rate increase → more discount → cheaper present value
  2. For a given change in interest rates, prices on longer-term bonds change more than prices of shorter-term bonds
     • longer-term bond’s present value discount much more or much less compared to shot-term bond
  3. For a given change in interest rates, prices of lower-coupon bonds change more than prices of higher-coupon bonds
     • more capital concentrate at longer period discounts
  • → long term, zero coupon is most sentitive
• Bond theorem application: if interest rates are expected to increase, avoid long-term bonds
• If interest rates are expected to decrease, buy zero-coupon bonds

The determinants of corporate borrowing costs:

• Marketability:
  • depends on
    • selling price varies directly
    • transaction cost varies inversely
    • YTM varies inversely
  • MRP, marketability risk premium, $=i_{\text{low market}}-i_{\text{hgh market}}$
    • MRP > 0
• Call provision: allow bond issuer to purchase a bond from bondholder at a pretermined price before maturity
  • more likely to be called when interest rates decline
  • $CIP$, call premium, $=i_{\text{callable}}-i_{\text{non-callable}}>0$
• Default risk: borrow might not pay back interest and or principal
  • $DRP$, default risk premium, $=i_{dr}-i_{rf}>0$
    • interest for default risk - interest for risk-free rate
  • Bond ratings: rank bonds in order of probability of default
    • Investment grade / noninvestment grade
    • State and federal laws typically require commercial banks, insurance companies, pension funds, certain other financial companies, and government agencies to purchase only investment-grade securities

The term structure of interest rate

• refers to the relationship between yield to maturity and term-to-maturity on a bond
• Yield curve:
  • Ascending or normal yield curves slope upward from left to right and imply higher interest rates are likely
  • Descending or inverted yield curves slope downward from left to right and imply lower interest rates are likely
  • Flat yield curves imply interest rates are unlikely to change
• Factors that shape the yield curve:
  • Real rate of interest
  • Expected rate of inflation:
    • if higher inflation is forecast, the YC slope upward because longer-term yields will contain larger inflation premium than shorter-term yields
  • interest rate risk
    • The longer the maturity of a security, the greater its interest rate risk (the risk of selling the security at a lower price) and the higher the YTM
    • The interest rate risk premium adds upward bias to the slope of the yield curve
• Cumulative effect of factors that shape the yield curve:
  • In an economic expansion
    • The real rate of interest and inflation premium increase monotonically
    • Interest rate risk increases
  • In an economic contraction
    • The real rate of interest and inflation premium decrease monotonically
    • Interest rate risk decreases
• Yield curve to recession:
  • expectation: investors expect long-term to have lower interest rate and inflation rate

9. Stock valuation:

Market for stocks:

• secondary market
  • NASDAQ
  • NYSE
  • The world’s stock exchange
• Efficiency of secondary markets
  • 4 types of secondary market, order from least to most efficient:
    • Direct search: cost of locating and negoriating
    • Broker: cost of commission paid to broker who bears the cost
    • Dealer: cost of spread
    • Auction
• Stock market indexes

Common and preferred stock

• Common Stock:
  • basic ownership claim on a corporation
  • has right to vote on:
    • electing BOD
    • capital budgeting
    • proposed mergers and acquisitions
• Preferred Stock:
  • no voting right
  • quite similar to Corporate Bond, hybrid-instructment (both debt and equity)
    • dividends are due regardless of earnings
    • frequently has a credit rating
    • maybe convertible or callable

Common stock valuation:

• A One-period model:
  • assume stock is bought today and sold 1 year later
  • $P_0=\frac{D_1+P_1}{1+R}$
    • R: discount rate, required rate of return, not market rate for similar stock
• Multi-period model:
  • $P_0=\frac{D_1}{1+R}+\frac{D_2}{(1+R{)}^2}+\frac{D_3}{(1+R{)}^3}+\cdots +\frac{D_t}{(1+R{)}^t}+\frac{P_t}{(1+R{)}^t}$
• A perpetuity model: ${\mathrm{P}}_0=\sum _{t=1}^{\infty }\frac{{\mathrm{D}}_t}{(1+\mathrm{R}{)}^t}$

The general dividend-valuation model

• ${\mathrm{P}}_0=\sum _{t=1}^{\infty }\frac{{\mathrm{D}}_t}{(1+\mathrm{R}{)}^t}$ where R is required rate of return
  • doesnt yet account for selling stock
  • only for dividend forecasts
  • doesnt include assumptions:
    • growth rate is constant
    • forecasting dividends or when shares are sold
• Growth stock pricing paradox
  • stock of a company whose earnings are growing at an above-average rate and are expected to continue to do so for some time
  • Rapidly-growing firms
    • Typically pay no dividends on common stock in the growth phase
    • Have many high-return investment opportunities, making investors are better off if firms reinvest earnings
  • shares of a company that will never pay cash to investors are worthless
    • In reality, high-growth firms will eventually pay dividends
    • If investments made with reinvested funds succeed, a firm’s net cash inflows should increase significantly and investors can sell their stock at a much higher price than what they paid

Stock valuation: some simplifying assumptions

• These apply for both common stock and preferred stock
• Zero-growth dividend model:
  • $P_0=\frac{D}{R}$
• Constant growth dividend model:
  • $D_t=D_0\times (1+g{)}^t$
  • $P_0=\frac{D_1}{R-g}$ where $D_1$ is dividend in year 1
  • Computing future stock prices:
    • $P_t=\frac{D_{t+1}}{R-g}$
• Mixed (supernormal) growth dividend model:
  • If the supernormal growth occurs first and is followed by constant dividend growth, we can combine equations
    • $P_0=P{V}_{\text{constant dividend growth 1}}+P{V}_{\text{constant dividend growth 2}}$
• The relation between R and g: R > g
• Timeline for nonconstantnt dividend growth pattern:
  • example: first 3 years we have mixed growth dividends, then constant growth dividend after ward
  • → discount 3rd years onward with constant growth model, $P_3=D_4/(R-g)$
  • → discount back to present value with 3 mixed dividends and

Determinants of dividend growth:

• $g=b\times \text{ROE}$
  • divident growth rate = retention rate * return on equity
  • r and b remain constant over the year
• dividend growth and stock valuation
  • $P_0=\frac{D_1}{r-g}=\frac{E_1\times (1-b)}{r-ROE\times b}$
  • → increase growth by
    • increase ROE
    • increase b when ROE > r
      • because when we calculate $\delta P_0/\delta b>0⟹ROE>r$

Valueing preferred stock

7. Risk and return

Holding Period Returns

• Capital appreciation, $R_{CA}=\frac{P_1-P_0}{P_0}=\frac{\Delta P}{P_0}$
• Income, $R_I=\frac{C{F}_1}{P_0}$
• Total holding period return, $R_t=R_{CA}+R_1=\frac{\Delta P}{P_0}+\frac{C{F}_1}{P_0}$
• doesnt account for Time Value Money

Expected return

• Expected value of return
• $E(R_{\text{Asset}})=\sum _{i=1}^n(p_i\times R_i)$

Variance and Standard Deviation as Measures of Risk

• Measures of risk are :
  • Variance: $Var(R)={\sigma }_R^2=\sum _{i=1}^n\{p_i\times [R_i-E(R){]}^2\}$
  • Standard deviation: ${\sigma }_R=({\sigma }_R^2{)}^{1/2}$
• Sharpe Ratio: $S=\frac{E(R_i)-R_{rf}}{{\sigma }_{R_i}}$
• Stock prices typically follows Normal distribution

Risk and diversification

• Single-asset portfolios:
  • Coefficient of Variation: $C{V}_i=\frac{{\sigma }_{R_i}}{E(R_i)}$
    • a measure of the risk associated with an investment for each 1 percent of expected return
• Portfolios with more than one asset
  • Expected return: $E(R_{\text{portolio}})=\sum _{i=1}^n[x_i\times E(R_i)]$
  • Variance of returns: ${\sigma }_{R_{\text{2 assets}}}^2=x_1^2{\sigma }_{R_1}^2+x_2^2{\sigma }_{R_2}^2+2x_1{x}_2{\sigma }_{R_{1,2}}$
  • Covariance of return: $Cov(R_1,R_2)={\sigma }_{R_{1,2}}=\sum _{i=1}^n\{p_i\times [R_{1,i}-E(R_1)]\times [R_{2,i}-E(R_2)]\}$
    • a measure of how the returns on two assets covary, or move together
  • Correlation of return: ${\rho }_{R_{1,2}}=\frac{{\sigma }_{R_{1,2}}}{{\sigma }_{R_1}{\sigma }_{R_2}}$
    • has value -1 ⇐ correlation ⇐ 1
• Limits of diverification:
  • It can be proven that portfolios with more than one asset is always less risky
  • Risk can be reduced by creating a portfolio using assets having different risk charatersistics
  • Limits:
    • When the number of assets in a portfolio is large, adding another stock has almost no effect on the standard deviation
    • Most risk-reduction from diversification may be achieved with 15 to 20 assets
    • Diversification can virtually eliminate risk unique to individual assets, but the risk common to all assets in the market remains
  • unsystematic or diversifiable: risk that can be eliminated through diversification
  • systematic or nondiversifiable: risk that cannot be eliminated through diversification

Systematic risk (market risk)

• Well-diversified portfolios contain only systematic risk
  • Competition among diversified investors will drive the prices of assets to the point where the expected returns will compensate investors for only the systematic risk
• Measuring systematic risk:
  • The market’s influence on a stock’s return is quantified in the stock’s beta
  • If the beta of an asset is:
    • Zero, the asset has no measurable systematic risk
    • Greater than one, the systematic risk for the asset is greater than the average for assets in the market
    • Less than one, the systematic risk for the asset is less than the average for assets in the market
• Risk Premium:
  • Compensation for Bearing Systematic Risk
  • $\mathrm{E}\left({\mathrm{R}}_{\mathrm{i}}\right)={\mathrm{R}}_{\mathrm{rf}}+$ Compensation for bearing Systematic risk${}_i$
    • returned on risky asset = risky free rate + risk premium
  • $E(R_i)=R_{rf}+{\beta }_i[E(R_m)-R_{rf}]$
    • $E(R_m)$ is expected return on market
• Beta of a stock: ${\beta }_s=\frac{{\rho }_{\text{w market}}\ast {\sigma }_s}{{\sigma }_{\text{market}}}$

The Capital Asset Pricing Model, CAPM

• Describe the relation between risk and expected return for an asset
  • $E(R_i)=R_{rf}+{\beta }_i[E(R_m)-R_{rf}]$
    • $E(R_m)-R_{rf}$ is called market risk premium
• Security market line (SML):
  • the graph of CAPM equation, a Linear Function
  • illustrates the CAPM’s prediction for the required expected total return for various values of beta
    • expected return greater than the required return estimated with the CAPM → the expected return plot above the SML → underpriced
    • expected return less than the required return estimated with the CAPM → the expected return plot below the SML → overpriced

10. Fundamental of capital budgeting

Introduction:

• The Capital Budgeting Process
  • Starts with the firm’s strategic plan which describes its strategy for the next three to five years
  • Division managers then convert the firm’s strategic objectives into business plans
  • The capital budget is generally prepared jointly by the CFO’s staff and financial staff at the divisional and lower levels, reflecting the activities outlined in the divisional business plans
  • steps:
    1. Idea generation
    2. Investment analysis
    3. capital allocation planning
    4. monitoring and post-audit
  • Key Reasons for Making Capital Expenditures: ranked from least to most risky
    1. replacement: an asset will have to be replaced rather than repaired or overhauled
    2. an expansion: new equipment to produce more products or expansion of the firm’s distribution system.
    3. new products and services: involve more stakeholders and higher degrees of risk
    4. regulatory, safety and environmental: required by third party, such as the gov or insurance company, to meet specified standards.
    5. Others: such as management pet proejects and high-risk investments which falls outside normal project analyses
• Source of information:
  • generated internally, often beginning with the sales force
  • Next the production team gets involved, followed by accountants
  • All the information is reviewed by financial managers who evaluate the feasibility of the project
• Classification of investment projects;
  • Independent projects: accept or reject doesnt influence decision about other projects being considered
    • when resources are not limited
  • Mutually exclusive projects: only 1 or the other
  • Contingent projects: one project depends on on another’s acceptance
• Basic capital budgeting terms:
  • cost of capital: rate of return that a project must earn to be accepted by management
    • riskier → higher cost of capital
  • capital rationing: a firm with limited funds choose the best projects to undertake

Net Present Value (NPV)

• definition:
  • best capital budgeting technique
  • NPV compares the PV of expected benefits and cash flows from a project tp the PV of expected costs
    • if benefit > cost, the project is feasible
• NPV techniques
  • NPV = PV of expected inflow - PV of expected cash outlow = Cash inflow - Cash outflow
    • when NPV = 0, IRR = cost of capital → still profit (atleast beat inflation)
  • 5 steps:
    • Determine the intial cost of starting the project? next lec
    • estimate the project’s future cashflows over its expected lift? next lec
    • find the riskiness of the project and appropriate cost of capital
      • the risker a project, the higher its cost of capital
    • compute the project’s NPV
    • make a decision
• Mutually exclusive projects and NPV
  • managers should allocate capital to the project that has the most positive dollar impact on the value of the firm—in other words, the project with the highest NPV
• Key advantage:
  • use discounted cash flow valuation
  • provide a direct (dollar) measure of how much capital that project will increase firm’s value
  • consistent with the goal of maximizing stockholder value
• Key disad:
  • difficult to understand

Payback period

• definition:
  • the amount of time it takes for the sum of the net cash flows from a project to equal the project’s initial investment
    • the shorter, the better
    • serve as a risk indicator
  • popularly used
• Computing the payback period
  • PB = Years before cost recovery + $\frac{\text{remaining cost to recover}}{\text{cash flow during the year}}$
• how the payback period performs?
  • no economic rational that is consistent with shareholder maximization
  • ignores Time Value Money
  • doesnt account for differences in the overall risk of projects
  • cash flows occuring after payback perid are not considered
• Discounted payback period
  • PB period with consideration for Time Value Money
    • → DPBP is always higher
  • DPBP is the point where NPV is 0
• Evaluating the payback rule
  • Decision: Payback period ⇐ payback cutoff point → accept
  • advantages:
    • easy to calculate and understand
    • simple measure of a project’s liquidity risk
  • disadvantages:
    1. Simple payback period doesnt account for TVL
    2. doesnt consider cash flows past payback period
    3. bias against long-term projects
    4. arbitrary cutoff point

Internal Rate of Return (IRR)

• Definition:
  • The discount rate which a firm’s cost of capital to the rate-of-return that makes the net cash flows from a project equal its cost
  • discount rate that makes NPV = 0
• Calculating IRR: with trial and error method
• When IRR and NPV agree?
  • evaluating independent projects
  • projects’ cashflows are conventional, ones with intial cash outflow followed with cash one or more inflows
• When IRR and NPV disagree?
  • unconvential cash flows → might have multiple IRR
  • mutually exclusive project
  • → always go for NPV
• IRR for mutually exclusive projects:
  • a discount rate at which the NPVs of two mutually exclusive projects will be equal
    • that rate is the crossover point
  • Depending on whether the required rate of return is higher or lower than the crossover rate, the ranking of the projects will be different
  • It is easy to identify the superior project based on NPV, but it cannot be done using IRR due to ranking conflicts
  • → if cost of capital < crossover rate: take project A
• IRR vs NPV:
  • IRR assumes that cash flows from a project are reinvested to earn with the rate of IRR while NPV assumes that it will earn the firm’s cost of capital
    • explain for IRR: for example, positive cashflow at somewhere in the middle is discounted forward, that means it is assumed to be reinvested at same rate
  • optimistic assumption in the IRR method leads to some projects being accepted when they should not
    • because the reinvested cash flows cannot earn the IRR
• Summary for IRR:
  • if IRR > cost of capital → accept
  • advantages:
    • intuitive and easy to understand
    • based on discounted cash flow technique
  • disadvantages:
    • With nonconventional cash flows, IRR approach can yield no usable answer or multiple answers
    • A lower IRR can be better if a cash inflow is followed by cash outflows
    • With mutually exclusive projects, IRR can lead to incorrect investment decisions
    • IRR calculation assumes cash flows are reinvested at the IRR
• Modified IRR (MIRR)
  • IRR is too optimistic → MIRR assumes the cash flow to be reinvested at firm’s cost of capital
  • TV = Sum of FV value
  • MIRR is the rate for which $P{V}_{\text{cost}}=\frac{TV}{(1+MIRR{)}^n}$

Investment Decisions with Capital Rationing

• Capital rationing in a single period
  • Profitability Index (PI) provides a measure of the value of project generates for each dollar invested in that project
  • Useful for capital rationing when firms have limited resources and therefore cannot invest in all projects that have a positive NPV
  • Consistent with the idea of shareholder wealth maximization
• $PI=\frac{\text{Benefits}}{\text{Costs}}=\frac{\text{PV of future free cash flows}}{\text{Initial investment}}=\frac{\text{NPV + Initial investment}}{\text{Initial investment}}$

Capital budgeting in practice

• Practitioners’ Methods of Choice: IRR is currently popular
• Postaudit and Periodic Reviews:
  • Management should systematically review the status of all ongoing capital projects and perform post-audits on completed capital projects
  • A review should challenge the business plan, including cash flow projections, cost assumptions, and the performance of people responsible for implementing the capital project
  • A post-audit examination may reveal why a project was successful or failed to achieve its financial goals