Fjármál Fyrirtækja

NPV decision rule

"When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today." When choosing among investment alternatives, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today - Accept positive-NPV projects : Accepting them is equivalent to receiving their NPV in cash today - Reject negative-NPV projects : Accepting them would reduce the value of the firm, whereas rejecting them has no cost (NPV = 0) If the NPV is exactly zero, then you will neither gain nor lose by accepting the project instead of rejecting it, which also has an NPV of zero. It is not a bad project because it does not reduce the firm's value, but it does not add value to the firm either

Financial Markets

Capital markets (Fjármálamarkaðir) - Stock market (Hlutabréfamarkaður) - Bond market (Skuldabréfamarkaður) Money market (Peningamarkaður) Foreign exchange market (Gjaldeyrismarkaður) Derivatives market (Afleiður markaður) Commodity market (Vörumarkaður)

Arbitrage

- Making a profit without taking any risk by exploiting different prices for the same good or financial instrument. - Borrow money, buy at the lower price, sell at the higher price, pay back the loan and keep the rest. - All steps are made at basically the same time. - Prices would adjust due to increased demand (and reduced supply) for the cheap good and increased supply (and reduced demand) for the expensive good. Arbitrage is the practice of buying and selling equivalent goods to take advantage of a price difference Arbitrage opportunity is any situation in which it is possible to make a profit without taking any risk or making any investment.

Example of how to compute loan payments

- Ten-year amortizing loan - Initial payment: 20 million ISK - APR: 6%, monthly compounding - Monthly loan payments Amortizing loan means that we can use the annuity formula: GLÆRA 10

Firms can increase its dividend in 3 ways

1. It can increase its earnings (net income) - A firm can do one of two things with its earnings: It can pay them out to investors, or it can retain and reinvest them. 2. It can increase its dividend payout rate 3. It can decrease its number of shares outstanding Change in earnings = New investment x return on new investment New investment = Earnings x Retention rate Earnings Growth rate = Change in Earnings / Earnings = Retention rate x return on new investment g = Retention Rate x Return on new investment

Bonds: the basic idea - Skuldabréf: grunnhugmyndin

A bond is a security issued (i.e. sold) by the government or a company to raise money today in exchange for promised future payments. Bonds are debt instruments. Promised future payments include the payment of the face value (i.e. the notional amount) at the maturity date and coupon payments (if any) on a regular basis (semiannual, annual) until the maturity date. In addition to the face value, some bonds also promise additional payments called coupons. The coupon will be paid periodically(for example semiannually) until the maturity date of the bond. It follows that the intereset payments on the bond are called coupon payments. The amount of each coupon payment is determined by the coupon rate of the bond. The coupon rate is expressed as an APR, so the amount of each coupon payment, CPN is CPN = Coupon Rate X Face Value / Number of Coupon Payments per year. Coupon payments are determined by the notional amount, the coupon rate and the number of coupon payments per year.

Bond

A bond is a security sold by governments and corporations to raise money from investors today in exchange for a promised future payments. It can be viewed as a loan from those investors to the issuer.

Competitive Market

A competitive market is a market in which a good can be bought and sold at the same price

Tax Implications for Corporate Entities

A corporation's profits are subject to taxation separate from its owners' tax obligations. Shareholders of a corporation pay taxes twice. - The corporation pays tax on its profits. - When the remaining profits are distributed to the shareholders, the shareholders pay their own personal income tax on this income.

Decision making based on Net Present Value vol3 - A note on the discount rate:

A note on the discount rate: - The discount rate reflects the cost of capital. - If we assume the project to be risk free, we use the risk-free interest rate. - If the project is risky, we need to use a risk-adjusted discount rate; this means we compare the project to an alternative project with the same risk characteristics.

Stock: the basic idea

A share of stock represents a share of ownership in a company. Shares are equity instruments Shares of public limited companies (public corporations) trade on a stock exchange (e.g., NYSE, NASDAQ, LSE). Shares of private limited companies do not trade on a stock exchange; you can buy and sell them privately. Shareholders are entitled to cash flow rights, i.e. dividend payments, and voting/control rights (common stock). Some companies issue preferred stock with preference over common shares in dividend payments, but typically without voting rights.

Hostile takeover

A situation in which an individual or organization - sometimes referred to as a corporate raider - purchases a large fraction of a company's stock and in doing so gets enough votes to replace the board of directors and its CEO

Financial Managers and Their Role in Corporations

Act on behalf of the owners: Make investment decisions: - Evaluate (new) projects, compare alternative projects and decide which one to choose. - The financial managers most important job is to make the firms investment decisions. Make financing decisions: - Finance via equity (e.g., issue new shares) or debt (issue bonds, take loans etc.)(Gefa út skuldabréf, taka lán); decide what to do with available cash: retain or pay out. - The financial manager must decide whether to raise more money from new and existing owners by selling more shares of stock (equity) or to borrow the money instead(bonds and other debts) Manage the corporation's cash (flows); liquidity management. (Lausafjárstýring.) These tasks are typically not independent of each other, although we often discuss them separately. Conflicts of interests to consider (Hagsmunaárekstrar sem þarf að huga að): - Between owners - Between owners and the financial manager - Between owners and "other" stakeholders (debtholders, employees, customers, suppliers, society, etc.) - Between "other" stakeholders Legal framework, social norms, environmental aspects - Many applications of models and concepts fail to incorporate legal, social, and environmental aspects - or they even try to exclude them using assumptions.

Common Stock

All rights of common stockholders are in proportion to the number of shares they hold; deviations from "one share, one vote" might exist (different classes of shares). Common stockholders are entitled to dividend payments (arðgreiðslur) (and liquidation proceeds), but they cannot force the company into bankruptcy. They only receive payments after debtholders and preferred stockholders (if any) have been paid. Common stockholders can exercise their voting rights in the company's annual meeting (vote directly or via proxy). Common stock is a share of ownership in the corporation, which confers rights to any common dividends as well as rights to vote on election of direectors, mergers, and other major events.

Interest Rates (Vextir)

Allow us to convert/"move" cash flows accross time and to compare cash flows that occur at different points in time. Reflect the alternative investment: Opportunity costs. Investment decisions are always based on a comparison of alternatives. Further assumptions (to be relaxed later on): - No risk, i.e. perfect certainty. - Equal interest rates/rates of return in all future periods. Interest rate is the rate at which money can be borrowed or lent over a given period. Interest rate factor is one plus the interest rate, it is the rate of exchange between dollars today and dollars in the future. It has units of $ in the future/$ today.

amortizing loan

An amortizing loan is a loan where the principal of the loan is paid down over the life of the loan (that is, amortized) according to an amortization schedule, typically through equal payments. Amortizing loan means that we can use the annuity formula

Changes in interest rates and valuation

An increase in the interest rate increases the FV of a project. A decrease in the interest rate decreases the FV of a project. An increase in the interest rate reduces the PV of a project, because the cash flows are more heavily discounted. A decrease in the interest rate increases the PV of a project, because the cash flows are less heavily discounted.

Promised vs. expected vs. realized yields/CFs

As investors will expect that the bond issuer will default with some probablility, they will expect that actual cash flows (coupon/face value payments) will be lower than promised. The expected yield is therefore lower than the promised yield. The realized yield can only be determined based on the actual payments that the investor receives; it will only be equal to the promised yield if all payments are made as promised.

Dividend-Discount Model

Assumption: A firm lives forever and pays a constant dividend at the end of every year. In a perfect market, the stock price is equal to the present value of all future dividend payments: P0 = Div / rE (Price of the share of stock) where rE is the opportunity cost of a similar equity investment or the equity cost of capital (assumed to be constant). P0 = Divn / (1 + rE)**n Let's assume that we plan to sell the share at time N: P0 = Divn/(1+rE)**n + PN/(1 + rE)**N PN = DivN + t / (1+rE)**t If the current stock price were less than this amount, the cost would be less than the PV of the benefits, so investors would rush in and buy it, driving up the stocks price. If the stock price exceeded this amount, selling would be attractive and the stock price would quickly fall. If the stock offered a higher return than other securities with the same risk, investors would sell those other investments and buy the stock instead. This activity would then drive up the stocks current price, lowering its dividend yield and capital gain rate. IF the stock offered a lower expected return, investors would sell the stock and drive down its price.

Coupon Rates, YTM, and Bond Prices

Assumption: the bond price is determined immediately after the coupon payment. When the coupon rate is equal to the YTM, the bond trades "at par" (bond price = face value) When the coupon rate is lower than the YTM, the bond trades "at a discount" (bond price < face value) When the coupon rate is higher than the YTM, the bond trades "at a premium" (bond price > face value) *YTM = The yield to maturity (YTM) is the percentage rate of return for a bond assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments. A bond's yield to maturity rises or falls depending on its market value and how many payments remain to be made.

Corporate bonds

Bonds issued by corporations With corporate bonds, the bond issuer may default: That is it might not pay back the full amount promised in the prospectus. For example a compnay with financial difficulties may be unable to fully repay the loan. This risk of default, which is knon as the credit risk of the bond, means that the bonds cash flows are not known with certainty.

Coupon Bonds Yield to Maturity of a Coupon Bond

Bonds that pay regular coupon interest payments up to maturity, when the face value is also paid. Coupon Bond Cash Flows 1. Difference between the purchase price and the principal value 2. Its periodic coupon payments. Yield to Maturity of a Coupon Bond One we have determined the coupon bonds cash flows, given tis market price we can determined its yield to maturity. Yield to maturity for a bond is the rate of return of investing in the bond and holding to it maturity The yield to maturity of the bond is the single discount rate that equates the present value of the bonds remaining cash flows to its current price. Coupon bonds have many cash flows Zero-coupon bonds have 2 cash flows

Financial Markets: Main players

Capital providers, Fjárveitendur (savers, investors, etc.) Capital seekers, Fjármagnsleitendur (borrowers, companies, municipalities, etc.) -demand site Financial intermediaries/institutions, Fjármálamiðlarar / stofnanir (e.g., banks, insurance companies, mutual funds, pension funds, dealers, brokers, stock exchange, rating agencies) - Financial institutions have a role beyond moving funds from those who have extra funds (savers) to those who need funds (borrowers and firms) - Financial institutions also help spread out risk-bearing. Insurance companies essentially pool premiums together from policyholders and pay the claims of those who have an accident, fire, medical need or who die.

Balance sheet information and insolvency (gjaldþrot)

Cash-flow insolvency (illiquidity): Gjaldþrot sjóðsstreymis: The firm is not able to meet current obligations, i.e. the firm has run out of cash. Use liquidity ratios, e.g.: Cash Ratio = Cash/ Current Liabilities (núverandi skuldir) Quick Ratio = Current Assets (veltufjármunir) - Inventory (birgðir) / Current Liabilites (núverandi skuldir) - If quick ratio is below 1 it tells us that if the company needed to cover current liabilities it would need to save some of the inventory Current Ratio = Current Assets (veltufjármunir) / Current Liabilites (núverandi skuldir) But these ratios only reflect one point in time! Balance-sheet insolvency: Gjaldþrot efnahagsreiknings: The firm has not enough assets to cover its liabilities. Use leverage ratios (based on book or market values), e.g.: Debt-Equity Ratio (Hlutfall skulda) = Total Debt ( Heildarskuldir) / Total Equity (Heildarhlutafé) Debt-to-Capital Ratio (Skuldsetningarhlutfall) = Total Debt / Total Equity + Total Debt *If the equity is 0 the company does not exist, the ownership in a company is defined by the equity. If there is no equity there is no owner. Profitability analysis: Gross margin = Gross profit / Revenues Operating margin = Operating income / Revenues Net profit margin = Net income / Revenues Interest coverage: Interest coverage ratio(s) = EBITDA or EBIT or Operating income / Interest

Statement of Changes in Shareholders' Equity

Change in shareholders' equity: = Retained earnings + Net sales of shares = Net income − Dividends + Sales of shares − Repurchases of shares

Financial Statements (Ársreikningur) Types of Financial Statements

Companies are typically required by law to prepare financial statements according to financial reporting standards (national/international (IFRS)). - If they are listed in the stock exchange market. Public companies are required to disclose them to the public. Provide information about past performance and the firm's financial position. Can be useful for investors, financial analysts, creditors, managers and others. Can they? Types of Financial Statements: - Balance sheet (Efnahagsreikningur) - Income statement (Rekstrarreikningur) - Statement of cash flows (Sjóðsstreymi) - Statement of changes in shareholders' equity (Yfirlýsing um breytingar á eigin fé)

What does balance sheet (Efnahagsreikningur) information tell us?

Corporate finance is about the valuation of projects/firms based on future cash flows. Balance sheets primarily contain historic information. In most cases, balance sheets do not help a lot for valuation purposes. But: balance sheet information can be used for a "quick and dirty" assessment of the firm's financial position and fair-value accounting brings the balance sheet closer to the ideas of corporate finance.

Credit Ratings and Yield Curves

Credit rating agencies try to assess the default risk in terms of default probabilities of bonds and/or issuers. They categorize into rating categories from AAA/Aaa to C/D. Based on these ratings, low default risk bonds are considered as investment-grade bonds, whereas high default risk bonds are considered as junk bonds or high-yield bonds. Yield curves for different rating categories plot the promised yields for different levels of default risk.

Default Risk (Credit Risk)

Default risk describes the "threat" that the issuer of a bond will not make the coupon and/or final payments as promised. The risk that the issuer will default on the payments. This means that we do not know the bond's cash flows with certainty. In this sense, both government and corporate bonds are "credit risky". The higher the default risk, the higher will be the required yield-to-maturity of the bond. The riskier the bond, the more yield it must promise. The difference in between the promised YTM of a risky bond and the YTM of a risk-free bond is the credit spread (default spread). Bond prices reflect promised yields-to-maturity: the riskier a bond, the lower will be the price.

Size of the Impact of Interest Rate Changes

Depends on how sensitive bond prices are to interest rate changes. The longer the maturity of the bond, the stronger will be the price effect (i.e. PV effect). The higher the coupon payments, the smaller will be the price effect. In this context, interest rate risk describes the "threat" of (unexpected) interest rate changes, because they will influence bond prices and therefore the yields that investors realize when they do not hold the bonds until maturity. Bonds with higher coupon rates - because they pay higher cash flows up-fort, are less sensitive to interest rate changes that otherwise identical bonds with lower coupon rates.

Classes (voting)

Different types of common stock for the same company, often carrying different voting rights. This is typical in companies that are family run , or where the founder is still active.

Dividend Yield vs. Capital Gains

Dividend Yield: Div1 / P0 or for an arbitrary period n: Divn / Pn-1 Capital Gain: P1-P0 / P0 Pn /Pn-1 - 1 or for an arbitrary period n: Pn - Pn-1 / Pn-1 Pn/Pn-1 -1 Dividend yield: The expected annual dividend of a stock divided by its current price; the percentage return an investor expects to earn from the dividend paid by the stock. Capital gain: The amount by which the selling price of an asset exceeds its initial purchase price. Capital gain rate: An expression of capital gain as a percentage of the initial price of the asset Total return: The sum of a stocks dividend yield and its capital gain rate.

Paying Dividends vs. Reinvesting the Money in the Firm

Dividend payout rate: fraction of earnings paid out as dividends. Retention rate: fraction of earnings the firm retains. As long as we assume a perfect market, it does not make a difference for the investor if the firm pays dividends or reinvests the money. To options: - The firm pays dividends and the investor invests them in a new project at the opportunity equity cost of capital. - The firm keeps the money and invests it in this new project ora similar one.

Zero-Coupon Bonds - Engar afborganir

Do not make any coupon payments. If we hold a zero-coupon bond until maturity, the interest earned on this bond is simply the difference between the current (market) price and the face value. The yield-to-maturity of a risk-free zero-coupon bond is the risk-free interest rate (or spot interest rate) for this maturity. As long as we assume a positive price of time (i.e. positive interest rates), zero-coupon bonds trade at a discount, i.e. a price lower than the face value. Bond without coupons are called zero-coupon bonds. These are the simplest type of bond. The only cash payment an inveestor in a zero-coupon bond reeceives is the face value of the bond on the maturity date. It is a bond that makees only one payment at maturity. There are only two cash flows if we purchase and hold a zero-coupon bond, first we pay the bonds current market price at the time we make purchase. Then, at the maturity date we receive the bonds face value. The price of a zero-coupon bond is always lwss than its face value. That is zero-coupon bond always trade at a discount (a price lower than the face value) so they are also called pure discount bonds.

Assumptions: Perfect Markets/Competitive Markets

For the time being, we will assume that markets are perfect/perfectly competitive. A market is assumed to be perfect (or: perfectly competitive) if the following conditions are fulfilled: - No transaction costs. (Enginn viðskiptakostnaður) - No taxes. (Engir skattar) - No differences in opinion; everyone has the same information. - No big sellers/buyers. The assumption of perfect markets simplifies things: - Goods can be sold and bought at the same market price. - No single buyer or seller can influence the market price. - The market price reflects the (true/fair) value of the good.

Discounting cont'd

General formula: GLÆRA 18

Compounding cont'd

General formula: Do not worry. Use the PV formula and: FVN =PV·(1+r)**N

Adjusting the EAR to different time periods

Generalization for the equivalent n-period effective rate: - Equivalent n-period effective rate = (1 + r )n − 1 By using this method, we can adjust the EAR to match the time period of the cash flow when calculating PV and FV .

Compounding

Generally describes the calculation of the future value of cash flows. Multiperiod example: 1. You invest a cash flow today for n periods: FVn = C0 · (1 + r)**n 2. You invest at the beginning of this and of the next period and determine the overall value at the end of the second period: FV2 = C0 ·(1+r)**2 +C1 ·(1+r)**1

Discounting

Generally describes the calculation of the present value of future cash flows. Multiperiod examples: 1. You receive a cash flow at the end of period n: PV = Cn/(1+r)**n (í veldinu n) 2. You receive a cash flow at the end of each of the next three periods: PV = C1/(1+r)**1 + C2/(1+r)**2 + C3/(1+r)**3

Interest Rates, YTM, and Bond Prices vol2

If interest rates fall, market participants will require a lower YTM. Bond prices will rise to provide a lower YTM. A new investor who buys the bond at the higher price (and holds it to maturity) will realize a lower YTM. An investor who sells the bond at the higher price (before maturity) will realize more return than the previously implied YTM.

Law of One Price

If markets are perfect, - The same good (or two goods with identical characteristics) must have the same price irrespective where you trade it (them). - Two financial instruments/securities that produce exactly the same cash flows must have the same price. Deviations from the law of one price create arbitrage opportunities. in competitive markets, securities with the same cash flows must have the same price

Investment-grade Speculative bonds, junk bond, or high-yield bonds

Investment-grade bonds: Bond in the top four categories of credit worthiness with a low risk of default Speculative bonds, junk bond, or high-yield bonds: Bonds in one of the bottom five categories of creditworthiness(below investment grade) that have a high risk of default.

Consol

Is a bond that promises its owner a fixed cash flow every year, forever.

Dividend-Discount Model with Dividend Growth *Constant dividend growth model

Let's now assume constant dividend growth,g: P0=Div1/rE−g If we solve for rE: rE=Div1/P0 + g which means thatgequals the capital gain rate.

Limited partnership Limited liability

Limited partnership: A partnership with two kinds of owners: general partners and limited partners. - General partners have the same rights and privileges as partners in any general partnership. - Limited partners however have limited liability that is, their liability is limited to their investment. Their private property cannot be seized to pay off the firms outstanding debts. They have no management authority and cannot legally be involved in the managerial decision making for the business. Limited liability: When an investors liability is limited to her investment.

Interest rates, inflation, and valuation - Vextir, verðbólga og verðmat

Quoted interest rates (APR/EAR) usually represent nominal interest rates (Nafnvextir), i.e. the growth in the amount of money invested. But inflation reduces the purchasing power of your money. To estimate the real growth in purchasing power of your money, we need to determine the real interest rate. 1 + rnominal = (1+rreal) · (1+inflationrate) 1+ rreal = 1+rnominal / 1 + inflation rate *inflation rate = Verðbólga Never discount cash flows stated in nominal terms by using the real interest rate! Never discount cash flows stated in real terms by using the nominal interest rate! Discounting nominal cash flows using the nominal interest rate results in the same present value as discounting real cash flows using the real interest rate! Unless stated otherwise, we will use nominal interest rates.

Market value vs. book value

Market value of equity: = market capitalization = market price per share * number of shares Market-to-book ratio: = Market value of equity / Book value of equity Enterprise value: = Market value of equity + Debt − Cash

Types of firms

Most concepts in (corporate) finance are applicable to all types of firms/organizations. We focus primarily on limited liability companies or corporations: - Owners' liability (ábyrgð) is limited to their investment. - No personal liability (ábyrgð) of the owners for the company's debt. - Private limited companies and public limited companies. - A limited partnership without a general partner. Public limited companies are those companies that are listed at stock exchange. Other types of firms: - Sole proprietorships: owned and run by one person who has unlimited personal liability for the firm's debt. There is no separation between the firm and the owner If the firm defaults on any debt payment, the lender can (and will) require the owner to repay the loan from personal assets. - Partnerships: more than one owner, all with unlimited personal liability for the firm's debt; special case: limited partnership. All partners are liable for the firms debt. That is, a lender can require any partner to repay all the firms outstanding debts.

Ownership of a Corporation

No general limit to the number of owners. Each owner owns a fraction of the corporation, a share of stock. The collection of all the outstanding shares represents the equity of the corporation. (Stendur fyrir eigið fé fyrirtækisins) Owners as shareholders/stockholders/equity holders. Shareholders usually receive a share of the dividend payments that is proportional to the amount of stock they own. Owners are entitled to dividend payments (Eiga rétt á arðgreiðslum) (cash flow rights) and have a say in corporate decision making (voting rights).

Statement of Cash Flows

Operating activities: Net income +Depreciation (Afskriftir) +/-Cash effect from changes in AccRec, AccPay, Inv., other items = Cash from operating activities Investment activities: (Fjárfestingarhreyfingar) -Capital expenditures (CAPEX) Financing activities: (Fjármögnunarhreyfingar) +/- Increase/decrease in share capital +/- Increase/decrease in borrowings -Dividend payments -Interest payments =Changes in cash and cash equivalents

The stock market

Organized market on which the shares of many corporations are traded. An investment in liquid if it can be easily turned into cash by selling it immediately at a competitive market price. An investor in a public company values the ability to turn hid investment into cash easily an quickly by simply selling his shares on one of these markets.

Perpetuities and Annuities

Perpetuities and Annuities reflect simple cash flow streams that allow us to use shortcut formulas to estimate their present value. - Perpetuity: Stream of equal cash flows at regular intervals that lasts forever. (Same cashflow at the end of each year) You get the same payment C at the end of each period forever PV = C / r 50.000 / 0,025 = 2.000.000 (this is the value) *Important: The first cash flow is paid at the end of the first period, not today. - Annuity: Stream of equal cash flows at regular intervals that lasts for a fixed number of periods. - You get the same payment C at the end of each period for a fixed number of periods, N C =C1 =C2 =...=CN Most car loans, mortgages and some bonds are annuities. *Important: The first cash flow is paid at the end of the first period, not today. - Growing Perpetuity: Stream of cash flows at regular intervals that lasts forever; the cash flows grow at a constant rate. You get a cash flow at the end of each period forever, but the cash flow grows at a fixed rate, g, C2 =C1 ·(1+g) C3 =C2 ·(1+g) PV = C1 / r-g *Important: The first cash flow is paid at the end of the first period, not today. - Growing Annuity: Stream of cash flows at regular intervals that lasts for a fixed number of periods; the cash flows grow at a constant rate. You get a cash flow at the end of each period for a fixed number of periods, N, but the cash flow grows at a fixed rate, g C2 =C1 ·(1+g) CN =CN−1 ·(1+g) *Important: The first cash flow is paid at the end of the first period, not today. FORMÚLUR Á GLÆRUM

Preferred Stock

Preference over common shares in dividend payments (and payment of liquidation proceeds), but typically without voting rights. There are two types of preferred stock: Cumulative vs. non-cumulative preferred stock. If company is in arrears on preferred dividend payments, preferred stockholders might get voting rights. But they cannot force the company into bankruptcy. They only receive payments after debtholders have been paid If the company can not make any dividend payments, then if it is a cumulative preferred stock than the company will need to make them in next period both the dividend payment for ? and the next period If the company is still not able to make the payments then the preferred stockholder might get his voting right back Preferred stock is a stock with preference over common shares in payment of dividends and in liquidation With cumulative preferred stock, any unpaid dividends are carried forward. With non-cumulative preferred stock, missed dividends do not accumulate, and the firm can pay current dividend payments first to preferred and then to common stock shareholder. - Almost all preferred stock is cumulative

Preferred Stock: Equity? or Debt?

Preferred stock is like a perpetual bond because it has promised cash flow to holders and there are consequences if those cash flows are not paid. However, unlike debtholders, preferred shareholdeers cannot force the firm into bankruptcy. Preferred shareholders stand in line in front of common shareholders fot annual dividends, but behind regular bondholdeers, because interest is paid before dividends. If the firm is bankrupt the same priority is followed in settling claims: bondholders, preferred shareholders, and then common shareholdeers. Finally as long as the firm is meeting its preffeerd dividend obligations the preferred shareholders have none of the control rights of owner, such as voting on directors or other important matters.

A Bond trades at a premium A Bond trades at a discount A Bond trades at a par

Premium: A price at which coupon bonds trade that is greater than their face value - A bond trades at a premium whenever its yield to maturity is less than its coupon rate - When the coupon rate of the bond is higher than its yield to maturity, it trades at premium. Discount: A price at which coupon bonds trade that is less than their face value - When its coupon rate is lower than its yield to maturity , it trades at a discount Par: A price at which coupon bonds trade that is equal to their face value - If a bond sells at a par(at its face value) the only return investors will earn is from the coupons that the bond pays. - When its coupon rate equals its yield to maturity, it trades at a par

Further analysis

Price-Earnings ratio = Share price/ Earnings per share Return on Equity = Net income / Book value of equity Return on Assets = Net income + Interest expense / Total assets Return on Invested Capital = EBIT · (1-Tax rate) / Book value of equity + Net debt

Coupon bonds

Promise to pay the face value and periodic coupon payments. The last coupon payment is made at the same time as the payment of the face value. The coupon rate is not identical to the risk-free interest rate! The coupon rate is not identical to the yield-to-maturity!

What does the statement of cash flows tell us?

Provides information about cash flows. Corporate finance is about the valuation of projects/firms based on future cash flows: the statement of cash flows might provide useful information, In particular when used for cash flow projections/forecasts.

Time Value of Money

Reflects that an amount of money received today does not have the same value as the same amount of money received at some point in the future. Typically, 1,000 ISK received today are worth more than 1,000 ISK received tomorrow. We need to account for this effect when comparing cash flows that occur at different points in time. There is a price of time: we will use the (risk-free) interest rate as price of time. Time value of money is the difference in value between money received today and money received in the future; also the observation that two cash flows at two different points in time have different values.

Present Value and Future Value

Relationship between Present Value and Future Value: One-period example: PV = FV1 / 1+r or FV1 = PV·(1+r)

Interest rates as opportunity cost of capital

Reminder: Investment decisions are always based on a comparison of alternatives. The interest rate reflects the (or one) alternative investment, and therefore represents the opportunity cost of capital. An investor could invest in your project/firm or in an alternative project that offers this interest rate (for the same investment horizon).

Income statement -jöfnur

Revenues - Cost of sales = Gross profit - Selling, general and administrative expenses (SG&A) -Depreciation +Other operating income =Operating income +Other income =Earnings before interest and taxes (EBIT) -Interest expenses =Earnings before taxes (EBT) -Taxes =Net income

Decision making based on Net Present Value vol4 - Sensitivity of the NPV to the discount rate.

Sensitivity of the NPV to the discount rate. - Assumption: one cash outflow at the beginning, followed by cash inflows. - The higher the discount rate, the lower will be the NPV. - Graph the project's NPV over a range of discount rates (NPV profile).

What does the income statement (Rekstrarreikningur) tell us?

Shows the earnings/net income/net profit or net loss. Determine earnings per share: EPS (Earnings per share) = Net income (Hreinar tekjur) / Number of shares Based on the net income, decisions can be made whether or not to pay dividends. Used to calculate the change in the shareholders' equity.

The Effective Annual Rate

So far, we assumed that all our interest rates represent effective annual rates (EAR). Using the EAR gives you the actual amount of interest that you earn at the end of the period/year. It allowed us to easily "translate" annual rates into two-year rates, monthly rates, daily rates etc. and vice versa.

Non-annual cash flows, interest rates

So far, we assumed that the length of each time period is identical to the length of the time period which the interest rate applies to, i.e. typically one year. Now we assume that - The interest rate is an annual interest rate but the cash flow is not paid at the end of the year, or -The interest rate is given for another interval, e.g., monthly or daily or ..., but the cash flow is paid at the end of the year, or - In general cash flow and interest rate do not refer to the same time period. We need to "synchronize", - Annual interest rate, but cash flow at the end of month 7: PV = Cmonth7 / (1+r)**7/12 -Cash flow at the end of the year, but monthly interest rate: PV = C / (1+rmonthly)**12 -Cash flow after 3 months, daily interest rate: PV = C0,25 / (1+rdaily)**90

Changes in the Growth Rate

Split up the cash flow stream and estimate the value of each part separately. Sum up the values, but make sure that you properly discount every part to time 0.

Total Return

Sum of dividend yield and capital gain total return1 = Div1/P0 + P1-P0/P0 = Div1 + P1-P0/P0 or for an arbitrary period n: total return n = Divn/Pn−1 + Pn−Pn−1/Pn−1 = Divn+Pn−Pn−1 / Pn−1 As long as we assume perfect markets and no risk, the total returnis equal to the equity cost of capital,rE. Total return: The sum of a stocks dividend yield and its capital gain rate.

Total Payout Model

Takes into account that firms can pay out money to investors in share repurchases. Share repurchase: The firm buys back its own shares. The money used in repurchases is not available for dividend payments. The total payout model includes both types of payout: P0 = PV (Future Dividends and Net Repurchases) / Number of Shares Outstanding0 The more cash the firm uses to repurchase shares, the less cash it has available to pay dividends. By repurchasing shares the firm decreases its share count, which increases its earnings and dividends on a per-share basis. When a firm repurchases shares we use the total payout model Total payout model values all of the firms equity rather than a single share.

Interest Rates, YTM, and Bond Prices

The YTM of a bond reflects market participants' return expectations/requirements for this bond. These expectations are based on the opportunity cost of capital, this means on the interest rates in the market. As long as you hold a bond until maturity (and the payments are made as promised), you will realize the YTM as implied at the time when you bought the bond. If interest rates increase, market participants will require a higher YTM. Bond prices will fall to provide a higher YTM (recall our discussion on PV effects of interest rate changes). A new investor who buys the bond at the lower price (and holds it to maturity) will realize a higher YTM. An investor who sells the bond at the lower price (before maturity) will realize less return than the previously implied YTM. If interest rates fall, market participants will require a lower YTM. Bond prices will rise to provide a lower YTM. A new investor who buys the bond at the higher price (and holds it to maturity) will realize a lower YTM. An investor who sells the bond at the higher price (before maturity) will realize more return than the previously implied YTM.

Net Present Value (NPV)

The difference between the present value of a projects or investments benefits and the present value of its costs. NPV = PV(Benefits) - PV(Costs) PV(Benefit) = In one year/1+interest rate -The present value is the amount you need to invest at the current interest rate to recreate the cash flow. If the NPV is positive, the benefits outweigh the costs, which means the firm should undertake this investment opportunity As long as the NPV is positive the decision increases the value of the firm and is a good decision regardless of your current cash needs or preferences regarding when to spend the money.

Internal Rate of Return (IRR)

The discount rate at which the project's NPV is equal to zero represents the internal rate of return, IRR. The IRR represents the maximum cost of capital for the project to be profitable. You should only invest in projects with a cost of capital below the IRR. This, however, is only true if the cash outflows occur at the beginning, followed by cash inflows. Internal rate of return(IRR): The interest rate that sets the net present value of the cash flows equal to zero.

Dark pools

Trading venues in which the size and price of orders are not disclosed to participants. Prices are within the best bid and ask prices available in public markets, but traders face the risk their orders may not be filled if an excess of either buy or sell orders is received.

Decision making based on Net Present Value

The present value represents the value today of all future cash flows from an investment project, i.e. the benefits from investing in the project. The present value is determined based on the opportunity cost of capital, i.e. the return that an alternative project would yield. When calculating the net present value, we compare the PV of the benefits with the costs (or: price) of this project, i.e. the amount that we need to invest to start the project today. NPV = Initial Costs + PV (Benefits) = C0 + PV (Cn) A positive NPV implies that the benefits outweigh the costs; the project yields more than the alternative investment. Positive NPV projects increase the value of the firm, you should invest. A negative NPV implies that the costs outweigh the benefits; the project yields less than the alternative investment. Negative NPV projects decrease the value of the firm, you should not invest.

Zero-Coupon Bonds and the Yield Curve

The prices of a series of risk-free zero-coupon bonds allows us to determine the risk-free (zero-coupon) yield curve. y = (FV/PV) ** 1/N - 1

Coupons

The promised interest payments of a bond, paid periodically until the maturity date of the bond. Coupon rate Determines the amount of each coupon payment of a bond. The coupon rate, expressed as an APR, is set by the issuer and states on the bond certificate.

Yield to maturity (YTM) - ávöxtunarkrafa

The rate of return of an investment in a bond that is held to its maturity date, or the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond. P = Face Value / 1 + YTM1 1 + YTMn = (Face Value / Price)**1/n

credit risk (default risk)

The risk of default by the issuer of any bond that is not default free; it is an indication that the bonds cash flows are not known with certainty

The corporate management team

The shareholders of a corporation exercise their control by electing a board of directors, a group of people who have the ultimate decision-making authority in the corporation. In most corporations each share of stock gives a shareholder one vote in the election of the board of directors, so investors with more shares have more influence. The board of directors makes rules on how the corporation should be run, sets policy, and monitors the performance of the company. The chief executive officer (CEO) is charges with running the corporation by instituting the rules and polices set by the board of directors. The CEO can also be the chairman of the board of directors

Valuation principle

The valuation principle ties together all types of financial decisions: - Should the firm take a new project, e.g., to launch a new product? (Capital Budgeting) - How to choose between many projects? How to set up a portfolio of projects? (Investments) - How to finance a new project or the firm, i.e. how to raise money? (Capital Structure) The valuation principle is applied to make costs and benefits comparable and to estimate the value of a project or financial decision. We need to be able to estimate cashflow based of the revenues of the sales based on the cost. It need to be positive at the end otherwise we are losing money. ESTIMATE THE VALUE

Future Value

The value of a cash flow moved forward in time. One-period example: FV1 = C0 · (1 + r)

Net Present Value

The value of a future cash flow today less the initial investment today. One-period example: NPV = C0 + C1/1+r Here we assume that C0 is negative (cash outflow, initial investment). Sometimes, you also see NPV = −I + C1/1+r * where I is the initial investment.

Present Value

The value of a future cash flow today. One-period example: PV = C1 / 1+r *C1 = Cashflow

The Yield Curve - Ávöxtunarkúrfan

The yield curve plots the term structure of interest rates. - Upward sloping yield curve (normal/steep) - Flat yield curve (our assumption so far) - Downward sloping yield curve (inverted) *Graf með t (time, years) á x-ás og r(vextir) á y-ás

The Yield-to-Maturity of Coupon Bonds

To calculate the yield-to-maturity, we consider the coupon payments as an annuity and additionally consider the payment of the face value. JAFNA (Þetta er ekki jafnan, þetta er bara til að finna hluta af henni) CPN = Coupon rate / number of coupon payments per year * FV (Face value, 100%) As we saw for solving the annuity for the rate of return, we need to use trial and error, a financial calculator or a spreadsheet.

Annual Percentage Rate

Typically, interest rates are quoted as annual percentage rates (APR). The APR does not take compounding into account. When using APR in FV or PV calculations, we need to first convert it to an EAR.

Cumulative voting

Voting for directors where each shareholdeer is allocated votes equal to the number of open spots multiplied by his or her number of shares for example If you have 600 shares and there are 10 directors up for election you have (10*600) 6000 votes.

Straight voting

Voting for directors where shareholders must vote for each director separately, with each sharholder having as many votes as shares held. for example If you have 600 shares you will have 600 votes

Limitations of the Dividend-Discount Model

We assume to know future dividend payments, growth rate and the constant opportunity cost of capital. Dividend forecasts are based on earnings forecasts; earnings, however, are an accounting figure that might be subject to earnings management. The decision how much to pay out in dividends does not necessarily depend on actual earnings. Estimations based on historic data are treacherous. What if the firm does not pay dividends?

The term structure of interest rates

We now relax the assumption of equal interest rates for all investment horizons. This means that different investment horizons result in different interest rates. Example: Your bank offers the following investment opportunities: - One-year investment: 1.5% p.a. - Two-year investment: 1.8% p.a. - Three-year investment: 2.0% p.a.

The term structure of interest rates and valuation

We still assume that there is no risk. This means that the price of time is different for different time periods. We need to discount each cash flow separately using the corresponding interest rate. - We cannot use our shortcut formulas (annuities, perpetuities) any longer.

Decision making based on Net Present Value vol2 - What if the project requires further investments in future periods?

What if the project requires further investments in future periods? - It does not change the logic behind the NPV. - We discount future investments, i.e. negative cash flows, the same way as positive cash flows. - We can generalize this to: NPV = PV (Costs) + PV (Benefits) Please note: PV (Costs) is a negative amount (cash outflow).

Agency problem

When managers, despite being hired as the agents of shareholders, put their self-interest ahead of the interests of those shareholders