Intermediate Corporate Finance



Intermediate Corporate Finance

Spring 2007

Chapter 1-5 Review

Goal of the Manager of the Firm:

a) Maximize shareholder wealth

b) Minimize risk

c) Maximize profits (max dividends; max after-tax cash flows over time)

d) Maximize his or her salary

e) All of the above

f) All of the above, except d

Are these valid objectives?

Minimize Risk:

Maximize Profits:

What is S/H wealth and why does it weigh the risk/return trade-off?

Stock Price = PV of future expected dividends. Why not include stock price appreciation?

Summation formulas:

T

P0 = ∑[Dt/(1+rs)t] + PT/(1+rs)T (1)

t=1

P0 = Div1 / (r –g) (2)

r =

g =

– Dividends reflect return (in dollar metric)

– Discount rate of divs, r, reflects risk.

Another formula for Stock Price:

P0 = EPS1 / r + PVGO (3)

EPS/r = capitalized value of earnings with no-growth policy

PVGO = NPV of growth opportunities (per share)

EXAMPLE:

Current stock price = $50

1 million shares outstanding

Managers accept a project with an NPV of $10 million.

What should the stock price be when S/H’s learn of the project?

When will the stock price react, assuming that the s/h’s correctly value the project?

a) When rumors circulate about a positive NPV project available to the firm

b) When the S/H’s learn of mgmt’s decision to accept the project

c) When the project is “officially” accepted (done deal: contracts signed, etc)

d) When the cash inflows from the project occur

Recall that P0 = EPS1 / r + PVGO. Can stock price ever be less than EPS1/r?

Such firms can become takeover targets. Why?

Moral to the Story:

What about the interests of other stakeholders of the firm (who has an interest in the firm’s success other than the firm’s shareholders?) (pg 23-29)

• What is the goal IF maximizing shareholder wealth conflicts other stakeholder interests? (How could this happen?)

Percentage of firms in the given country that claim shareholder dividends come before job security of employees: (figure 2.3)

|Japan |3% dividends |

|France |40% dividends |

|Germany |41% dividends |

|UK |89% dividends |

|USA |89% dividends |

| | |

Why is it important for US firms to understand corporate objectives for firms located in other countries?

Chapter 8: Risk, Return & the Opportunity Cost of Capital (OCC)

Chapter 8: Practice Questions: 11, 12, 22

(8th ed. Prin of Corp Fin text: Chapter 7: Practice question 2, 3 13)

Discount rates should reflect the project’s risk….but what kind of risk?

– Market risk?

– Business risk?

– Total risk?

How would you define the investor’s risk for a given investment?

____T-bills

____Government bonds (long-term)

____Common stocks

Which is riskier: Typical corporate bonds vs. long-term gov’t bonds?

Small firm stocks vs. avg firm stocks?

The Value of an Investment of $1 in 1900:

The Risk Premium (RP): Required rate in excess of the risk-free rate (to compensate for added risk).

Add to RF rate to get a discount rate for projects, or use market risk premium and project beta.

Historical average (1900-2000) for stocks:

Use arithmetic averages, not compound rates of return

Stock return = 11.7%; T-bill rate = 4.1%;

RISK PREMIUM for stocks = 11.7-4.1 = 7.6%

RP estimates differ; range: 5-8%

RP’s vary by country; from 4.3% in Denmark to 10.7% in Italy.

Do Risk Premiums vary over time?

• Why would they?

– Reduced risk from availability of international investments

– Access to mutual funds (pension funds)

• Why wouldn’t they?

– Investors do not diversify internationally as much as they should.

– No reason to expect stocks are getting riskier over time.

What effect does inflation have on returns?

On stock prices?

• CAPM: E[Ri] = Rf + (i [E(Rm) – Rf]

• If risk premium is assumed constant, what effect will higher interest rates have on the expected return of stock i?

• What happens to stock prices, in general, when interest rates go up?

• How can rates of return on stocks go up when prices go down?

Definitions:

Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments.

Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk”, “unsystematic risk” and “business risk”

Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk” and “undiversifiable risk”.

Is there a limit to risk reduction through diversification? Or can we reduce all risk (variability) by adding different investments into our portfolio?

Note: Greater risk reduction going from 1 to 2 securities, than from 5 to 6 securities.

Chapter 9: Risk and Return, The CAPM, The SML, Other Models

Recommended problems Chapter 9: 6, 7, 8, 15 (not part a); challenge question 1

(8th ed. Prin of Corp Fin text: Chapter 8: Quiz 6 & ,7; Practice question 1 & 8 (not part a); Challenge Question 1)

When and why is diversification desirable?

Individual perspective:

Corporate perspective:

• An investor fails to diversify her portfolio. She earns returns on this undiversified investment based on:

a) Total Risk

b) Unique (business) risk only

c) Market risk only

What do YOU think?

An investor diversifies her portfolio nationally, but holds no foreign stocks. Her expected portfolio returns are based upon:

A. The amount of risk in her portfolio assuming she had diversified to the fullest extent, internationally

B. The amount of risk in her portfolio based on the amount of typical international diversification for investors within her country

C. The amount of risk based on market risk within her country only

Firms in countries whose investors fail to diversify internationally have a higher cost of capital (b/c their cost of equity is higher)

Note: this can make firms less competitive …higher WACC means more projects are negative NPV.

Stock Return Distributions

Standard Deviation VS. Expected Return

Investment A (top) and B (bottom)

% return

Investment C:

Which is preferable, B or C?

Which has a greater variance, B or C?

Which has a higher beta, B or C?

Which offers the higher expected return, B or C?

Of A, B or C, which would be reasonable investments to recommend, assuming the investor will not diversify further?

…what if you assume the investor is fully diversified?

Return Distributions:

➢ Stocks: symmetric, normal distributions

➢ “flatness” of distribution indicates risk (std dev).

➢ Mean return can be used to infer market risk (beta); (higher E[ret], higher beta.)

➢ Non-symmetric distributions (skewed distributions):

Do Investors prefer (right / left) skewness?

What types of investments could have a skewed distribution?

[pic]

Project, firm or stock correlation:

• You combine a low risk stock with a high risk stock* (50% invested in each) The resulting risk of the portfolio will be__________

a) Between that of the high and low risk stocks

b) The average of that of the high and low risk stock

c) Less than that of the low risk stock

d) Potentially a, b or c

Implications for project risk:

Query: You are considering a project that is riskier than your firm’s average project (i.e., higher variance of after tax cash flows). Will the addition of the new project increase the overall risk of your firm or decrease it? Is it possible to know with certainty from the above information?

Now assume that the risky project is negatively correlated with the other lines of business in our firm? Can we know whether the new project will increase or decrease the overall risk of our firm?

MUST the new project be negatively correlated to reduce the overall risk of our firm?

Will the addition of a new, higher-risk project increase our firm’s equity beta?

Portfolio return = weighted average return of all stocks in the portfolio =

x1 E[ret1] + x2 E[ret2]

Portfolio variance is the sum of the following boxes: (“x” is the % of the money invested in stocks 1 and 2.)

Example

Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The expected return on your portfolio is:

Assume the same example above: The standard deviation of Exxon and Coca Cola’s annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

[pic]

Lending or Borrowing at the risk free rate (rf) allows us to exist outside the efficient frontier.

Led to development of CAPM:

Best investment is some % in tangency portfolio (M), and rest in risk free asset or engage in riskless borrowing

Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market.

Beta - Sensitivity of a stock’s return to the return on the market portfolio.

What is done with the borrowed money (to obtain a point on the CML above M)?

Return exg:

RM = 20%; Rf = 5%,

$100 borrowed, $100 own

Ret = ($ ret on M – $ int) / own $

SML: Plot of the CAPM:

Diagram:

Intercept:

Y-axis:

X-axis:

Slope:

.

Stocks (investments) that plot above the SML are:

a) overvalued

b) Undervalued

c) neither

What can we learn from the SML?

• Overvalued / Undervalued investments (Can use with project betas as well as equity betas).

• Illustration of undiversifiable risk & beta

• Do returns plot, roughly around the actual SML? (If not, evidence against the CAPM)

– Purists would say that you can’t test a model that measures expected returns by plotting “actual returns.”

-----------------------

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

Markowitz Portfolio Theory

Exxon Mobil

Coca Cola

Standard Deviation

Expected Return (%)

40% in Coca Cola

%+56=>a 7 @ A E ] ¡ ¢ ­ Ï Ò ú ÿ &4:LNXZ\^h Expected Returns and Standard Deviations vary given different weighted combinations of the stocks

[pic]

Expected Return (%)

Efficient Frontier (a.k.a. mean variance efficient frontier)

Standard Deviation

rf

Lending Borrowing

T

S

M

MVP

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download