Bus 311 - Finance

What is the market risk premium? Risk premium?

(ERM -RF) - MRP RP- (ERM -RF)xB

What is a growing annuity?

- Growing Annuity - stream of n growing cash flows, paid at regular intervals. Eventually comes to end - Present Value Today (date 0) of an n-period growing annuity with discount rate r, growth rate g, and first cash flow C1, starting in one period (date 1) o PVo=C1/r-g[1-(1+g/1+r)^n] - Future value at Time of Last Payment of an n-period Growing annuity with Discount Rate, r, Growth Rate, g, And First Cash Flows, C1 o FVn = C1/r-g[(1+r)^n - (1+g)^n]

What are hedge funds?

- Hedge Funds (Pershing Square/Sprott/Bridgewater $80B) - • For "sophisticated" investors - tolerance to lose lots of money - • Leverage/vulture/short position/arbitrage - • Restructure- CP/JC Penny/Dell - • Active investors - want to change board of directors and CEO - Private equity- invest in private companies

What are ETF's?

- Shares that hold shares - Price of ETF goes up and down moment by moment as underlying stocks change like a share-tracked on an exchange - Sell and buy like a share - no management fees/sales loads but brokerage fees - Operating expenses - Tax efficiencies with respect to redemptions - More cost effective then mutual funds

What is an underwriting spread?

- underwriting spread - fee paid to the underwriters - underwriters appear to use the information they acquire during the book-building stage to intentionally underprice the IPO, thereby reducing their exposure to losses

What is the impact of leverage? What are the two types?

Leverage multiplies both profits and losses- increases volatility § There are two types: operating leverage and financial leverage. Operating leverage is the increased volatility in operating income caused by fixed operating costs. § This is commonly accomplished by a firm choosing to become more capital intensive and less labour intensive, thereby increasing operating leverage. -ex. car manufacturers, lots of factories, make lots in good times but dont in bad times cause high fixed costs -When a firm increases the use of fixed costs it increases the volatility of operating income -higher fixed costs = higher break even Financial leverage increases volatility in operating income due to financial obligations with fixed annual payments (interest) § Proceeds from the debt can be used to retire equity- buybacks (buy back shares from debt)§ Shareholders bear the added risks associated with the use of leverage. § The higher the use of leverage, the higher the risk to the shareholder. -using debt can create higher ROE and EPS - make shareholders richer -Both equity cost and debt cost rise with leverage

How is NPV affected by IRR and cost of capital?

If the IRR > the hurdle rate (cost of capital) (acceptable rate for investments), then the project is acceptable because it is forecast to yield a rate of return on invested capital that is greater than the cost of the funds invested in the project. § If the IRR < the hurdle rate, the project should not be accepted because the investment will not earn its cost of capital. § If our hurdle rate was 14% we would decline the project because the IRR is 13.1%...it would create a negative NPV(see NPV profile) at our cost of capital (the hurdle rate)

What do different values of beta represent?

If βj = 1, that stock j has the same systematic risk as the market portfolio (that is, it is as volatile as the market). - The market we knows has a beta of 1- it is the market 1:1 relationship. Responds exactly to the market § If βj > 1, that stock j is more volatile than the market. (goes up or down more depending on market) § If βj < 1, that stock j is less volatile than the market. § If βj = 0, it is a risk-free asset- Treasury bills § Note also that beta can be positive (direct relationship) or negative (inverse relationship)....gold

What is Capital Rationing?

In an ideal world, a firm can accept all projects that exceed the hurdle rate. § In the real world, firms have a limited supply of capital, so they must choose among acceptable projects. § Capital rationing is "the corporate practice of limiting the amount of funds dedicated to capital investments in any one year." - In the absence of capital rationing, NPV, IRR and PI will select value-maximizing projects. -Look at TOTAL NPV of all possible combinations

What is a true tax lease and a non-tax lease?

True Tax Lease (Operating Lease) § Lessor receives CCA (depreciation) (CCA - capital cost allowance - deduction allowed to take to reduce income taxes) § Lessee expenses the lease payments (operating lease) § Lease payments are revenue for lessor Non-tax lease (Capital/Finance Lease) § The lessee receives CCA deduction (treat as asset, get depreciation reduction for tax purpose) § Ownership with lessor § Lessee can only deduct interest portion of lease payment (only get to deduct interest portion on income statement) § Like a loan

Why pay dividends in a start up?

why pay dividends in start up: 1) eventually pay dividend 2) sell company (other company do share buyback or dividend payment) 3) liquidate

How do you calculate the net present value?

- Central goal: calculating the NPV of future cash flows to evaluate an investment decision - NPV - net present value: o NPV = PV(benefits) - PV(costs) ♣ Benefits are the cash inflows and the costs are outflows - NPV of an investment opportunity is also the present value of the stream of cash flows of the opportunity: o NPV = PV(benefits) - PV(costs) = PV(benefits - costs) o Positive NPV means good investment o Negative NPV means poor investment

What is a limited liability partnership?

- Limited Liability Partnership (LLP) - active in management and unlimited liability o Limitations on a partner's liability takes effect only in cases related to actions of negligence of other partners or those supervised by other partners o Assets of the business are potentially at risk of seizure due to the actions of anyone within the partnership

What is a limited partnership?

- Limited Partnership - two kinds of owners, general partners and limited partners o Must be at least one general partner - same rights and privileges as partners in a general partnerships - personally liable for the firm's debt's obligations o Limited partners - limited liability - limited to their investment o Death or withdrawal of limited partner does not dissolve the partnership, limited partner's interest is transferable o Limited partner has no management authority and cannot legally be involved in the managerial decision making for the business

What is a lock-up?

- Lockup - pre-existing shareholders cannot sell their shares for 180 days after the IPO -A restriction (Lock up) that prevents existing shareholders from selling their shares for some period, usually 180 days, after an IPO • If the company was overhyped and the stock tanks, current shareholders (VCs, Founders, and Private Equity) feel the pain

How does the NPV affect stand-alone project decisions?

- NPV 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 - Stand-alone project - choose between accepting and rejecting the project. Compare the NPV to 0 (NPV of doing nothing), accept project if NPV positive

What are the largest stock markets?

- New York Stock Exchange o Market makers/specialists o Recently combined electronic trading with the trading on the floor - NASDAQ o Does not meet in a physical location - Toronto Stock Exchange - Tokyo stock exchange - London stock exchange

What are private and public companies? What does it mean to be liquid?

- private Companies - have a limited set of shareholders and their shares are not traded regularly, the value of their shares can be difficult to determine - public companies -shares trade on organized markets (stock markets/stock exchanges) - these markets provide liquidity and determine market price for the company's shares - Liquid - possible to sell quickly and easily for a price very close to the price at which you could contemporaneously buy it - Corporation issues new shares of stock and sells them to investors on primary market - Shares continue trade in secondary market between investors without the involvement of the corporation

What are the advantages and disadvantages of going public?

- process of selling stock to the public for the first time Advantages and Disadvantages of Going Public - two advantages: greater liquidity, better access the capital - disadvantage: when investors diversify their holdings, the equity holders of the corporation become more widely dispersed. Undermines the investor's ability to monitor the company's management and thus represents a loss of control - once goes public, must satisfy all requirements of public companies

What is a road show?

- road show - senior management and the lead underwriters travel around the country promoting the company and explaining their rationale for the offer price to the underwriters largest customers - institutional investors such as mutual funds and pension funds

What is a timeline and stream of cash flows?

- stream of cash flows - series of cash flows lasting several periods - timeline - linear representation of the timing of the expected cash flows - a financial decision may involve both inflows and outflows: o inflows are positive cash flow o outflows are negative cash flows

What is the difference between dividends and investment growth?

- to maximize share price, firm wants to increase current dividend level and expected growth rate - increasing growth rate may require investment, but money spent on investment cannot be used to pay dividends

What is the weighted average cost of capital?

- weighted average cost of capital (WACC) rWACC- cost of capital the firm must pay to all investors, both debt and equity holders - if firm has no debt rWACC = rE - if has debt, rWACC is an average of the firm's debt and equity cost of capital - debt is less risky then equity, rWACC generally less the rE - forecast the firms free cash flow up to some horizon, together with a terminal (continuation) value of the enterprise - terminal value is estimated by assuming a constant long-run growth rate gFCF for free cash flows beyond year n - long-run growth rate gFCF typically based on expected long-run growth rate of firms revenues

What is the principal agent problem?

- when managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of shareholders ♣ Shirking or consuming perquisites does little to benefit shareholders even though the manager can benefit a lot ♣ Ethical dilemma ♣ Addressed by minimizing the number of decisions managers must make for which their own self-interest substantially differs from the interests of the shareholders ♣ Limitations: • Tying compensation too closely to performance, the shareholders might be asking managers to take on more risk than they are comfortable taking - managers may not make decisions that shareholder want them to, or it might be hard to find talented managers willing to accept the job • Compensation tied to profits or share price may lead to short-sighted behaviour by managers who can pursue a strategy that may artificially boost short-term results and compensation

How does one solve a loan payment?

- when solving for a loan payment, think of the amount borrowed (the loan principal) as the present value of the payments - Loan Payment o C = PV/1/r(1-[1/(1+r)^n])

What is involved in ownership of a corporation?

- No limit on number of owners - Each owner owns fraction - Entire ownership divided into shares - stock - Equity - collection of all the outstanding shares of a corporation - Owner of a share of stock in the corporation is known as shareholder, stockholder, equity holder, and is entitled to dividend payments (payments made at the discretion of the corporation's board of directors to the equity holders) - Shareholders receive voting rights and dividend rights proportional to the amount of stock they own - No limitation on who can own its stock - need not any special expertise or qualification - Corporations can raise substantial amounts of capital because they can sell ownerships to anonymous outside investors

What is the dividend dicsount model for a multi-year investor?

- Po = [div1/1+rE] + [div2+P2/(1+rE)^2] - If investor sells the stock to another one-year investor with same beliefs, new investor will expect to receive the dividend and stock price at the end of year 2

What is a pre- and post-money valuation?

- Pre-money valuation - value of the prior shares outstanding at the price in the funding round - Post money valuation - value of the whole firm (old plus new shares) at the funding round price - Difference between the pre-money value and post-money value is the amount invested - Post money valuation = pre money valuation + amount invested

What is the dividend discount model equation?

- Replace final stock price with value that the next holder of the stock would be willing to pay - Po = [div1/1+rE] + [div2/(1+rE)^2]+...+ [div n/(1+rE)^n] + [Pn/(1+rE)^n] - n = years - special case in which the firm eventually pays dividends and is never acquired, possible to hold shares forever - can let n go to infinity - the price of the stock is equal to the present value of the expected future dividends it will pay

How do you determine the risk-free interest rate?

- Risk-free rate at which investors can both borrow and save - Most investors must pay a substantially higher rate to borrow funds - If even the loan is essentially risk free, this premium compensates lenders for the difference in liquidity compared with an investment in treasuries - Risk free rate chosen should correspond to the yield for an average horizon - May also be appropriate to use a rate that exceeds the rate on government bonds to account for cost of borrowing

What is issuance cost?

- SEO expensive - Underwriting fees 5% of proceeds of issue - Rights offers have lower costs than cash offers - One advantage of cash offer is underwriter takes on larger role and therefore, can credibly certify the issue's quality

What is a regular perpetuity?

- Stream of equal cash flows that occur at constant time intervals and last forever o University endowment/scholarship - Consol - perpetual bond which promise owner fixed cash flow every year, forever - First cash flow does not occur immediately; it arrives at the end of the first period - Timing referred to as payment in arrears and is a standard convention - Cash flows in the future are discounted for an ever increasing number of periods, so their contribution to the sum eventually becomes negligible - Present value today (date 0) of a perpetuity with discount rate, r, and constant cash flows, C, starting in one period (date 1): PVo = C/r

What is important about the declaration of dividends?

- The amount and timing of future dividends is uncertain because dividends, unlike interest payments, are not a fixed obligation of the firm. - Instead, dividends are declared at the discretion of the board of directions. - Although share prices can fall substantially if dividends are cut or eliminated, there is no guarantee or requirement for boards to approve a dividend. - once dividend declared, legal liability need to pay no matter how bad things are going

How do you measure total return for the dividend discount model?

- Total Return: o rE =[(div1 + P1)/Po] -1 = [div1/Po] + [P1-Po/Po] - dividend yield - expected annual dividend of the stock divided by its current price o percentage return the investor expects to earn from the dividend paid by the stock - capital gain - earning on stock. Difference between the expected sale price and purchase price for the stock P1 -Po o divide the capital gain by the current stock price to express the capital gain as a percentage return - capital gain rate - total return - sum of the dividend yield and the capital gain rate o expected return investor will earn from 1 year of investment o stock's total return should equal the equity cost of capital o the expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk

What is the total payout model?

- Total payout model - allows us to ignore firms choice between dividends and share repurchases - Discounted free cash flow model - focuses on the cash flows to all of the firm's investors, both debt and equity holders, and allows us to avoid estimating the impact of the firm's borrowing decisions on earnings - total payout model - values all of the firm's equity, rather than a single share o discount the total payouts that the firm makes to shareholders, which is the total amount spent on dividends and share repurchases, then divide by the current number of shares outstanding to determine the share price o Po = PV(future total dividends and repurchases)/ shares outstanding - Discount total dividends and share repurchases and use the growth rate of total earnings (rather than earnings per share) when forecasting the growth of the firm's total payouts

What are the drawbacks to using historical data to estimate risk premium?

- Using historical data to estimate market risk premium suffers from two drawbacks: o Standard errors of the estimates are large o Backward looking, so we cannot be sure they are representative of current expectations - Given an assessment of the firm's future cash flows, we can estimate the expected return of the market by solving for the discount rate that is consistent with the current level of the index - R(market) = Div1/Po +g = dividend yield + expected dividend growth rate - Assumption of constant expected growth is more reasonable when considering the overall market

How do you value a stream of cash flows?

- Using time travel techniques, compute the present value of cash flow stream in two steps - 1) compute the present value of each individual cash flow - 2) once in common units, combine them - the present value today of the cash flow stream is the sum of the present values of each cash flow - the present value is the dollar amount you would need to invest today to produce the single cash flow in the future - receiving those cash flows is equivalent to having their present value in the bank today - Future value of a cash flow stream with a present value of PV o FVn = PVo X (1+r)^n

What are the 3 puzzles of an IPO?

- 1) on average IPOs appear to be underpriced - 2) number of issues is highly cyclical - 3) costs of the IPO are very high, unclear why firms willingly incur such high costs - 4) long-run performance of a newly public company is poor(three to five years from the date of issue) - Winner's curse - you win (get all the shares you requested) when demand for the shares by others is low, and the IPO is more likely to perform poorly - Implies that may be necessary for the underwriter to under-price its issues on average in order for less informed investors to be willing to participate in IPOs -Generally, underwriters set the issue price so that the average first-day return is positive. § As mentioned previously, research has found that the majority of first-day returns are positive. -The underwriters benefit from the underpricing as it allows them to manage their risk - "firm commitment" § Incentive for early intuitional buyers § The pre-IPO shareholders bear the cost of underpricing. In effect, these owners are selling stock in their firm for less than they could get in the aftermarket. § Underpricing in Canada is significant but the magnitude is not as large as for many other countries

How does one deal with non-annual time intervals?

- 1) the interest rate used correspond to the specific time interval - 2) the number of periods used corresponds to the specific time interval - any time interval with corresponding interest rate and number of periods can be used for a time value calculation for one single cash flow - time value calculations involving annuities or perpetuities: o necessary that both the interest rate and number of periods correspond to the time period between cash flows

What are the limitations on the dividend discount model?

- Values the stock based on a forecast of the future dividends paid to shareholders - Tremendous amount of uncertainty is associated with any forecast of a firm's future dividends - Even small changes in assumed dividend growth rate can lead to large changes in the estimated stock price - Difficult to know which estimate of the dividend growth rate is more reasonable - Rapid rate of dividend growth is not likely to be sustained - Forecasting dividends requires forecasting the firm's earnings, dividend payout rate, and future share count - Future earnings depend on interest expenses - Share count and dividend payout rate depend on whether firm uses a portion of its earnings to repurchase shares Borrowing and repurchase decisions are at managements discretion, can be more difficult to forecast reliably then other, more fundamental aspects of the firm's cash flows

What is the historical risk premium?

- Can use the historical average excess return of the market over the risk-free interest rate to estimate the market risk premium - Data that are very old may have little relevance for investors' expectations of the market risk premium today - Several explanations for the market risk premium's decline over time: o More investors participate in the stock market today, so that the risk can be shared more broadly o Financial innovations such as mutual funds and exchange traded funds have greatly reduced costs of diversifying o Prior to the recent increase in the wake of the 2008 financial crisis, overall volatility of the market has declined over time o All theses reasons may have reduced risk of holding stocks, and so diminished the premium investors require

What is an aggressive stock?

- agreesive stock - in good times do much better but in bad times do much worse - Market changes from 5% to10% Fund changes 8.15% (1.63X 5%) - beta X market return change

How does the dividend discount model apply to constant dividend growth and with growth?

- assume in long run that dividends will grow at a constant rate Constant Dividend Growth - Po = Div1/rE- g g - dividends grow at a constant rate - Constant Dividend Growth model - the value of the firm depends on the current level divided by the equity cost of capital adjusted by the growth rate - rE = (Div1/Po) +g - g = expected capital gain rate - with constant expected dividend growth, the expected growth rate of the share price matches the growth rate of individuals

What is book building?

- book building - coming up with the offer price based on customers' expressions of interest

What is the connection to capital budgeting?

- can interpret firms enterprise vale as the total NPV that the firm will earn from continuing its existing projects and initiating new ones - NPV of any individual project represents its contribution to the firm's enterprise value - To maximize firms share price, accept projects that have a positive NPV - Estimating free cash flows gives us flexibility to incorporate many specific details about the future prospects of the firm - Important to conduct a sensitivity analysis to translate this uncertainty into a range of potential values for the stock - Sensitivity analysis shows how our final calculated value changes with respect to changes in one of the input variables in our model - Value of the stock is determined by the present value of its future dividends - Can estimate total market capitalization of the firm's equity form the present value of the firms total payouts, includes dividends and share repurchases - Present value of the firms free cash flow, which is the cash the firm has available to make payments to equity or debt holders, determines the firm's enterprise value

What is important about the prices of points above and below the SML?

Above - priced too low - Investors will buy security A which will increase its price and "drop" it down to the SML Below - priced too high - investors will sell security B which will decrease its price and "raise" it up to the SML

What are the advantages and disadvantages of financial leverage?

Advantages: • Magnification of profits to shareholders • Lower cost of capital at low to moderate levels of financial leverage because interest expense is tax deductible Cost of :Debt*(1-tax rate) Disadvantages: • Magnification of losses to shareholders • Higher break even point ex. fixed expense high loan payment • Bankruptcy

What are the advantages and disadvantages of operating leasing?

Advantages: • Magnification of profits to shareholders • Operating efficiencies, such as faster production, fewer errors and higher quality, usually result in increasing productivity Disadvantages: • Magnification of losses to shareholders • Higher break even point • High capital cost of equipment • Equipment can be illiquid

What is involved in the total payout model?

Allows share repurchases and dividends § Share Repurchases: § Reduces dividends available to shareholders § Reduces the number of shares § Increases earnings per share § But shareholders are still getting money- just in two ways § Some dividends § Some of shares or all of their shares are bought Calculate the payments made to all shareholders § Not using dividends per share (Dividend Discount Model) P0 = PV(Future Total Dividends and Repurchases) Shares outstanding0

What is the best efforts basis?

Best-Efforts Basis § For smaller IPOs, a situation in which the underwriter does not guarantee that the stock will be sold, but instead tries to sell the sock for the best possible price § Often such deals have an all-or-none clause: either all of the shares are sold on the IPO or the deal is called off. -- the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price o all or none clause: either all of the shares are sold in the IPO, or the deal is called off

What is a lease?

A lease is a contractual agreement between a lessor and a lessee that gives the lessee the right to use specific property, owned by the lessor, for a specific period of time in return for stipulated, often periodic, cash payments (rents). § Sales type Lease- lessor is the manufacturer- ex. ford leasing car § Direct Lease- not the manufacturer. ex. G/E buy planes then lease to airlines § Leveraged lease- the lessor borrows to buy the asset it plans to lease

What 4 criteria qualify a lease as a capital/finance lease?

A lease qualifies as a capital/finance lease if any of the following criteria are met: 1.The lease transfers ownership of the asset to the lessee by the end of the lease term (get to keep asset at end of lease) 2.The lease term is for the major part of the asset's economic life (use up all value of lease by end, pretty much bought) 3.The asset is essentially being paid for through its lease payments (lease payments equal loan payment or price today) 4.The leased asset is of such a specialized nature that without major modifications, only the lessee can use it (if nobody else can use after you. Only specific use)

What is a tax shield?

Depreciation is not deducted in computing the present value of a project because it is not a cash outflow....the cash flows out when buy the machine § While depreciation does not directly affect cash flows, it does affect the taxes that must be paid § This indirect effect is known as the tax shield. Tax shield = depreciation amount X tax rate The depreciation expense reduced our taxes paid and thus increased cash flow

What is the equation of the security market line?

Equation of the line: Y= a + bx , a= RF b= slope of the line b= Slope = y2-y1 x2-x1 b= Slope = (ERM -RF) (1-0) Y= RF + (ERM-RF)* X ki= RF + (ERM-RF)Bi The security market line [SML] is the trade-off between market risk and the required rate of return for any risky investment, whether an individual security or a portfolio, and is given as: ki =RF+(ERM -RF)xbi • "Higher risk, higher return" - as beta increases gonna get higher risk premium, gonna requrie higher return • In other words, the required return on security ki is the risk- free rate plus a market risk premium. • .....remember as an investor we require a higher return for market risk (systematic) because we cannot diversify it away

What are the determinants of stock prices?

Equity securities can be valued based on approaches using: 1. thepresentvalueofexpectedfuturedividends (DDM-dividend discount model) 2. Free cash flow 3. Relative valuation models

What is an exit strategy?

ExitStrategy § It details how investors will eventually realize the return from their investment. § Investors exit in two main ways: through an acquisition or through an initial public offering (IPO). § Often large corporations purchase successful start-up companies by purchasing the outstanding stock of the private company, allowing all investors to cash out. -- how they will eventually realize the return from their investment - investors exit in two ways: o through an acquisition or through an initial public offering (IPO)

What is a final prospectus?

Final Prospectus • Part of the final registration statement prepared by a company prior to an IPO that contains all the details of the offering, including the number of shares offered and the offer price -- once company has satisfied the regulators disclosure requirement, regulators approve the stock for sale to the general public - final prospectus - contains all the detail of the IPO, including the number of shares offered and the offer price - develop reasonable valuation of the price range - two ways to value a company: o estimate the future cash flows and compare the present value o estimate the value by examining comparable companies

How do finance leases look like for the lessee?

Finance leases are included on the balance sheet (PV of lease payments) and liability (PV of lease payments) of the lessee Equipment under lease(A) XX Finance lease (L) XX • Operating leases are not on the balance sheet — they provide off-balance-sheet financing for the lessee.

What is Financial Leverage?

Financial leverage is a measure of the degree to which business is utilizing borrowed money- debt. § Financial costs are inflexible (loans, bond interest and principal) rather than flexible common share dividends. § Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt. § Leverage can be used to obtain high returns-LBOs- in the right circumstances - The more highly levered a company is, the more susceptible it is to downturns when the economy goes south. - Leverage increases risk

What is a bought deal?

Firm Commitment- "bought deal" § Underwriter guarantees that it will sell all of the stock at the offer price § Risk for the Investment Bank---if issue is below agreed price -- the underwriter guarantees that it will sell all of the stock at the offer price o underwriter purchases the entire issue and then resells it at the offer price o if doesn't sell entire issue, remaining shares must be sold at a lower price and then underwriter must take the loss

What is Systematic risk?

First we have systematic risk, which is sometimes called market risk, aggregate risk, or undiversifiable risk. § It is the risk associated with aggregate market returns and it cannot be eliminated; it is caused by factors such as changes in interest rates and consumer prices that affect the prices of virtually all securities, although to different extents.

How does the dividend discount model deal with preferred shares?

For a constant dividend---like preferred shares Share Price Today = Dividend/(1+k) + Dividend/(1+k)^2 + Dividend/(1+k)^3+.. - A perpetuity formula - Price today = Dividend/k -k - required return - Risk goes up what happens to k and share price - k would go down, share price would go down? - Like bonds, when the required return equals the dividend rate, the price will equal the par value.

For uncertain cash flow, how are probabilities used?

For uncertain cash flows assign each a probability, such that the total probabilities assigned equals one. § This estimate would be used in the capital budgeting model to project the revenue and cost of the investment project - for mutually exclusive alternatives, pick one "What will my profits be if sales are only 90% of the plan?" § If the analysis explores the effect of a change in a parameter on an decision, we call this investigation a sensitivity analysis. § For example, "What must the cash flows be to make this project (un)attractive?"---cut sales by 20%

What is involved in formation of a corporation?

Formation of a Corporation - must be legally formed - articles of incorporation must be filed with the relevant registrar of corporations - Corporate constitution that sets out the terms of the corporation's ownership and existence - Most costly than setting up a sole proprietorship - Lawyers hired to create formal articles of incorporation and set of bylaws

What are index funds?

Index Funds (mutual funds) - Buy everything in S&P 500 (standards and poors) or TSX 60 or a bond index - Lower management fees - End of day value, when sell, don't really know what will get at end of day (may be lower value). Can be problem when trying to liquidate or purchase - Diversity - Should correlate to returns of the market

What are institutional investors?

Institutional investors such as pension funds, insurance companies, endowments, and foundations are active investors in private companies § Institutional investors may invest directly in private firms or they may invest indirectly by becoming limited partners in venture capital firms. -- pension funds, insurance companies, endowments, foundations manage large quantities of money o May invest directly in private firms, or may invest indirectly by becoming limited partners in venture capital firms

What does a scatter of points represent on a security market line? What about with no scatter?

Not diversified enough All points not on the line Other risks than market - everything should be on line if fully diversified. This example isn't diversified, scatter indicates firm specific risk. IF portfolio diversified enough only change is market risk? - Fully diversified-no points off the line 1:1 relationship. No firm specific risk (no scatter) - only thing impact returns in makret changes. Diversified way from firm specific risk. All driven by exposure to the market

What is Operating Leverage?

Operating leverage shows the degree to which operating costs are fixed, not variable with revenue. § Generally, the higher the operating leverage, the more a company's income is affected by fluctuation in sales volume- positively and negatively- higher risk § Higher breakeven point - higher fixed cost higher break even. Operating leverage increases firm specific risk and systematic risk cause high fixed costs and if market tanks still need to make payments - increases firm specific and systematic risk

What is a private equity firm?

Organized very much like a venture capital firm, but it invests in the equity of existing privately held firms rather than start-up companies.- charge fees § Private equity firms initiate their investment by finding a publicly traded firm and purchasing the outstanding equity, thereby taking the company private in a transaction called a leveraged buyout (LBO). In most cases, the private equity firms use debt as well as equity to finance the purchase. § Much larger dollar amounts---buying public companies Often have some turn around strategy § New management/downsize § Take public again - firms that invest in the equity of existing privately held firms rather than start up companies o leveraged buyout (LBO) - find a publicly traded firm, purchase all the outstanding equity, take the company private o private equity firms are buying existing mature businesses, the investment size is often over 100 times the size of a typical venture capital investment

What are sovereign wealth funds?

Pools of money controlled by a government § Usually raised from royalty, resource revenue, or taxes that have been collected § SWFs play an active role in the private equity market and are the largest limited partners in global private equity markets -- pools of money controlled by a government o Raised from royalty, resource revenue, taxes that have been collected o Play an active role in the private equity market and are the largest limited partners in global private equity markets

What is a preferred stock?

PreferredStock § Preferred stock issued by mature companies usually has a preferential fixed dividend and seniority in any liquidation and sometimes special voting rights. § Steady cash flow § Preferred stock issued by young companies has seniority in any liquidation but typically does not pay regular cash dividends and often contains a right to convert to common stock. -- issued by mature companies such as banks usually has a preferential dividend and seniority in any liquidation and sometimes special voting rights

What is preliminary prospectus?

Preliminary Prospectus (Red Herring) • Part of the registration statement prepared by a company prior to an IPO that is circulated to investors before the stock is offered -o preliminary prospectus (red herring) - circulates to investors before stock is offered o first step in Canada o red writing on the prospectus indicates that not yet final, information may not be complete, securities may not be sold until a receipt for the final prospectus is obtained from the relevant securities regulators

How is relative valuation performed?

Price/Earnings Ratio =Share price /Earnings per share - Market price is just the sum of future profits. So if current future earnings are expected to grow, the numerator will be large compared to the denominator (current earnings). ex. Earnings per share = $1 $100 $200 $200 $200 Share Price = Sum of earnings = market price = $1,100 PE = 1,101/1= 1100---high growth indicator (today $1...growing to $200) ex. Earnings per share =$200 $200 $200 $200 $200 $200 $200 Share Price = Sum of earnings =market price= $1400 PE = 1400/ 200= 7 ---low growth indicator---earnings are flat * For simplicity-No risk adjusted time value of money in the above (k) The P/E ratio tells us how long you have to hold a share to make back your investment. § If shares are trading at a P/E of 10 ( 10 times earnings), it should take 10 years, assuming constant earnings, to recover your investment. § Or what you are paying for each dollar of current earnings---i.e. $10 for each dollar of earnings § Note that this analysis ignores the time value of money. Share Price = EPS*P/E ratio

What is a primary and secondary offering in an IPO?

Primary Offering (IPO) • New shares available in a public offering that raise new capital § Secondary Offering • Shares sold by existing shareholders in an equity offering • Exit strategy (for initial investors) -- Primary offerings - shares that raise new capital - Secondary offerings - existing shares that are sold by current shareholders (as part of exit strategy)

What is the profitability index?

Profitability index = NPV(cash inflows) / Resource consumed § "Bang for your buck"—I put this out and I get this back § Constraint could be factory space or labour § Rank by PI and select until used us the resource § A couple of good examples in the book The profitability index is the PV of the future cash flows from a project, divided by the initial investment required in the project. Profitability index =PV(cash inflows) / PV(cash outflows) § if the PI > 1, then NPV > 0 § if the PI < 1, then the NPV is < 0 Choosing between two: take the one that NPV is greater. USe NPV

What is the return on assets?

ROA = (Net income + (1-tax rate)* interest expense)/Assets No taxes ROA = (Net income + interest expense)/ Assets Two sources of funds debt (has interest expense) or equity Don't care how you got the money----care how you use the money you are given so we add back the cost of interest AFTER TAX -measures effectiveness of management. How well going to use -The variability in both ROE and EPS increases when financial leverage is increased § % change of EPS and ROE are the same

What is a registration statement?

Registration Statement • A legal document that provides financial and other information about a company to investors prior to a security issuance

What is the risk adjusted discount rate?

Risk adjusted discount rate [RADR] approach for evaluation of investments or projects • What is the correct discount rate?- it was given up to now • If your estimate is too low, you will undertake some projects that should not have been taken on; as a result, your investment returns will be sub-optimal. • Similarly, if your RADR is too high, you will pass on some profitable projects. - You could use our company's expected cost of capital Ki (what we just did using CAPM/Beta )but the project could be higher or lower risk than our business as a whole If the investment is similar to current business than you should use it if not, you should use another rate

What is unsystematic risk?

Second, we have unsystematic risk, which is sometimes called firm-specific risk or diversifiable risk. § It is the risk associated with the unique circumstances of a specific security, as opposed to the overall market. § This risk can be virtually eliminated from a portfolio through diversification (can be eliminated by buying more shares) unlike systematic risk .

What are the problems with IRR?

Some projects have more than one IRR - when cash flows are not conventional (first negative and rest positive) § The problem is to determine which is correct. § It turns out is that none of them are correct — you cannot interpret the IRR of a project that has more than one IRR. Mutually exclusive projects (alternative projects) if more then one IRR, IRR in between both will produce positive NPV

What is an efficient market?

Stock prices reflect the value of the share based on many investors (some who have better info than you) Efficient Market Hypothesis "Securities will be fairly priced, based on their future cash flows, given all information that is currently available to investors"---you cannot find an underpriced stock or overpriced stock—can't beat the market. - everyone has same information so cant do any better than the market Private Information/Difficult to Interpret § Gathering info not available publicly- employees, suppliers § Information is difficult to understand by public but experts can (legal, regulatory, tax accountants, medical) § Hedge funds often consult the above—"What does this mean?" Insiders (illegal) § Corporate insiders---officers register with SEC § Lawyers/suppliers (Apple) § Patent agents/FDA § Investment banks ("Chinese walls")

How do you measure the sensitivity of IRR?

The difference between the cost of capital and the IRR is the maximum amount of estimation error in the cost of capital estimate that can exist without altering the original decision

What is the dividend discount model?

The discount rate, k, is used to discount future cash flow (DIVIDENDS) § k is be based on the risk-free rate, plus a risk premium that represents the riskiness of the stock § How much are the future dividends we will receive worth today (annuity) - increased risk = increased return. Want me to take more risk, need a higher return. Return should match the risk

What is the capital budgeting process? What is the Net Present Value?

The expenditures associated with long-term assets create risk for an organization: § The costs remain even if the asset does not generate the anticipated benefits; and/or § These expenditures reduce an organization's flexibility. § Technology risk § Therefore, organizations need to approach investments in long-term assets with considerable care. The net present value (NPV) is the sum of the present values of a project's cash flows. § This method considers the time value of money. The net present value (NPV) is the sum of the present values of a project's cash flows. (Inflows - Outflows) § Net present value analysis emphasizes cash flows and not accounting net income. § Why? § Accounting net income is based on accruals and non- cash items such as depreciation that ignore the timing of cash flows into, and out of, an organization. § Income does not equal cash flow

How does the discount dividend model apply to common shares?

The value of a share is equal to: - the sum of the present value of all future dividends - The value of the share at that time in the future P0 = the estimated share price today D1 = the expected dividend at the end of year 1 Pn = the expected share price after n years kC = the required return on the common shares P=D1/1+kc+D2/(1+kc)^2 +...+Dn+Pn(1+kc)^n - instead of holding the stock for n years, we hold the stock forever, the equation becomes

What is the weighted cost of capital used for?

The weighted average cost of capital is an appropriate hurdle rate for new capital budgeting projects- we need to exceed this rate § If the project earns a return that is higher than this cost of capital, then the residual gain will accrue to the firm and increase common shareholders' wealth.

What are the 3 alternatives for NPV?

There are three main alternatives to the use of NPV as capital budgeting criteria: 1. The payback period is the number of periods needed to recover a project's initial investment. 2. The profitability index is the PV of the future cash flows from a project, divided by the initial investment required in the project. 3. The internal rate of return (IRR) is the discount rate that equates the present value of future cash inflows and outflows with the initial cost of investment.

How does a company value an IPO?

There are two ways to value a company: • Compute the present value of the estimated future cash flows. • Estimate the value by examining comparables to recent IPOs- example in the text § P/E ratio § Price/revenue ratio (some companies have negative earnings)

How do you determine NPV?

To determine net present value: 1. Calculate the present value of cash inflows. 2. Calculate the present value of cash outflows. 3. Subtract the present value of the outflows from the present value of the inflows. § If NPV is positive at the appropriate cost of capital (k), the project will create value

What is a convertible preferred stock?

ConvertiblePreferredStock § Preferred stock that gives the owner an option to convert it into common stock on some future date -usually exchange for 1:1. Can add value to the preferred share - gives the owner an option to convert it into common stock on some suture date o Will have all the future rights and benefits of common stock if things go well and investors convert it into common stock - If company runs into financial difficulties, preferred stockholders have senior claim on the assets of the firm relative to any common stockholders

What is a corporation?

Corporations - legally defined, artificial being (judicial persons or legal entity), separate from its owners - Can enter contracts, acquire assets, incur obligations, receives similar protection against the seizure of its property as received by an individual - Solely responsible for its own obligations - Owners of a corporation (shareholders), have limited liability; not liable for any obligations the corporation enters into - Corporation not liable for personal obligations of its owners

What is lightly or unregulated funding?

CrowdSourceFunding § Perks § Equity • ICO(InitialCoinOffering)-$3.2Bin2017 • New projects sell their underlying crypto tokens in exchange for bitcoin and ether. It's somewhat similar to an Initial Public Offering ( IPO ) in which investors purchase shares of a company.

What happens to price of stock while risk increases?

We assume that investors are, as a group, risk-averse: other things being equal, the higher the risk associated with a security, the lower it will be priced, so as to provide a higher expected return.

How does the dividend discount model account for growth? When does the model work?

We can modify the DDM to derive the value of a share when dividends grow at a constant rate of growth g forever. § This is what the equation reduces down to (take my word for it): We have seen before: A growing perpetuity P0 =D1/kC −g This model only holds when: a) kC > g, otherwise the answer is undefined- you are dividing by zero or it is negative. b) when dividends are expected to indefinitely grow at a constant rate (g). if growth = 0 Po=D1/kc (perpetuity) - The required return (kc) on an equity consists of the return you get in dividends and how much the value of your share will increase in value (as a percentage)

How do you choose to lease or purchase?

We look at the difference between what we would have to pay now and the associated tax savings and compare THAT against the present value of the lease payments.

What are the weaknesses for the payback period?

While the payback criterion is an easy-to-use approach and easy to understand, it has three key weaknesses. 1. It ignores the time value of money 2. It also ignores any cash outflows that occur after the initial investment 3. Ignores cash outflows that occur after the payback period...i.e. huge cash outflow a year after the payback period (i.e. mine clean up costs) 4. It has an arbitrary target payback period- 2 years/ 3 years/5 years? Creates a pre-occupation with short-run performance. Despite these limitations, surveys show that the payback calculation is often used by organizations for capital budgeting.

What is the cost of capital to a firm? How do you determine it?

cost of capital to a firm is the cost, in terms of required payments to investors, of raising additional investment capital. - cost of capital should always be defined on an after-tax basis. (debt is tax deductible) The overall market value of the firm is the market value of its debt, preferred equity and common equity sources of financing: V = D + P + S § Assets= LIAB + SE § Debt D, Preferred Equity P, Common Equity S § The cost of capital depends on the components of equity and debt.

Why is the CEO's performance crucial?

♣ If shareholders unhappy, pressure board to oust CEO ♣ Stock price of the corporation is a barometer for corporate leaders that continuously gives them feedback on their shareholders opinion of their performance. ♣ When stock performs poorly, board may replace CEO ♣ Hostile takeover - an individual or organization (corporate raider) - can purchase a large fraction of the stock and in doing so get enough votes to replace the board of directors and the CEO ♣ Threat of being removed enough to discipline bad managers and motivate boards of directors to make difficult decisions ♣ If dominant shareholder; may be impossible for the market for corporate control to work as desired because not enough shares can be purchased on the market to accumulate enough votes to change control

What is corporate bankruptcy?

♣ Management given opportunity to reorganize the firm and renegotiate with debt holders ♣ If fails, control of the corporation passes to debt holders ♣ Liquidation of the firm - involves shutting down the business and selling off its assets ♣ As long as corporation can satisfy the claims of the debt holders, ownership remains in the hands of the equity holders ♣ If fails satisfy debt holders claims, debt holders may take control of the firm ♣ Corporate bankruptcy thought of as a change in ownership of the corporation and not necessarily a failure of the underlying business

Who are stakeholders? What is stakeholder satisfaction?

♣ Stakeholders - groups and others (including shareholders and debt holders), each have an interest (or stake) in how the corporation operates ♣ Stakeholder Satisfaction - corporations that take care of their stakeholders also add true value for their stockholders, so there is a convergence between shareholder wealth maximization and stakeholder satisfaction

What is the second rule of time travel?

- 2) To move a cash flow forward in time, you must compound it o if the market interest rate for the year is r, then we multiply by the interest rate factor, (1+r), to move the cash flow from the beginning to the end of the year o compounding - process of moving a value or cash flow forward in time o an arrow on a timeline that points to the right indicates that the value is being moved forward in time (compounded) o future value - value of cash flow that is moved forward in time ♣ value grows as we move the cash flow further in the future o time value of money - equivalent value of two cash flows at two different points in time ♣ generally want things sooner than later (some deferral can build anticipation) ♣ cost to wait for something o simple interest - if an investment only earns interest on principal and no interest on accrued interest o compound interest - investments earn interest on the original principal amount invested and earn interest on the accrued interest o Future value of a cash flow: ♣ FVn = Co(1+r)^n ♣ Co - cash now ♣ N - periods ♣ R - interest rate o Type of growth that results from compounding is called geometric or exponential growth

What is the third rule of time travel?

- 3) To move a cash flow backward in time, you must discount it o divide it by the interest rate factor, (1+r), where r is the interest rate o same as multiplying the discount factor 1/(1+r) o discounting - process of moving a value or cash flow backward in time, finding the equivalent value today of a future cash flow o discount rate - interest rate used to find the present value ♣ discount rates (interest rates) rise... value today drops o on a timeline, an arrow pointing to the left indicates that the value is being moved backward in time or discounted o Present value of a cash flow: ♣ PVo= Cn/[(1+r)^n]

What is important about mutual fund performance?

- 78.7% of the funds underperformed the index. Always show funds that did well. - Funds generally (professionally managed) do worse then index. Should do it yourself - Index funds will generally do better then managed funds - Buy low cost S&P 500 index funds

What is a sole proprietorship?

- A business owned and run by one person - Very small with few employees - Most common - Small in terms of revenues and profits produced and people employed - Characteristics: o 1) straightforward to set up o 2) no separation between the firm and the owner; the firm can have only one owner and business income is taxed at the personal level. Investors cant hold ownership in the firm; limits the ability of the owner to raise money for the business o 3) owner has unlimited personal liability of any of the firm's debts. Must declare bankruptcy if cant afford pay debt o 4) life of sole proprietorship limited to life of the owner. Difficult to transfer owenership - disadvantages outweigh advantages when firm reaches point which it can borrow without owner agreeing to personal liability, converted into form that limits personal liability

What are mutual funds?

- Allows you to diversify - Bonds/equity - End of day value - Management fee -% - "professionally managed"

What is an annuity?

- An investment that involves a series of identical cash flows at the end of each year is called an annuity - A bond is an annuity of interest payments - • A share is an annuity of dividend payments - ex. Lotteries, insurance, RRSP - regular annuity - stream of n equal cash flows paid over constant time intervals - difference between annuity and perpetuity is that an annuity ends after some fixed number of payments - Present value today (date 0) of an n-period annuity with discount rate, r, and constant cash flows, C, startgin in one period (date 1) o PVo = C X 1/r (1-[1/(1+r)^n] - If we want to know the value n years in the future, we move the present value n periods forward on the timeline; compound the present value for n periods at interest rate r - Future value at time of last payment of an n-period annuity with discount rate, r, and constant cash flows, C o FVn = C X 1/r((1+r)^n -1)

How do you deal with changing growth rates?

- As firms mature, growth slows to rates more typical of established companies - their earnings exceed their investment needs and they begin to pay dividends - Cannot use constant dividend growth model on such a firm because: o These firms often pay not dividends when they are young o Their growth rate continues to change over time until they mature - Can use the general form of the dividend-discount model to value such a firm by applying the constant growth model to calculate the future share price of the stock Pn once the firm matures and its expected growth rate stabilizes - If the firm is expected to grow at a long-term rate g after year n +1: - Pn=(divn+1/rE-g)

What is the internal rate of return rule? How does it differ for unconventional cash flow?

- Average return for taking on the investment opportunity - Based on: if the average return on the investment opportunity (IRR) is greater than the return on other alternatives in the market with equivalent risk and maturity (ex. Project's cost of capital), then you should undertake the investment opportunity - IRR Investment Rule: take any investment opportunity where the IRR exceeds the opportunity cost of capital. Turn down any opportunity whose IRR is less than the opportunity cost of capital - IRR rule works for a stand-alone project if all of the project's negative cash flows precede its positive cash flows - unconventional cash flows (borrowing style cash flows): projects should be accepted if their IRR is less than the cost of capital - cannot apply IRR rule when there is more than one IRR. Both IRR's can be used as bounds during the NPV rule - when IRR is non-existent, must use the NPV rule

What is the discounted free cash flow model?

- Begins by determining the total value of the firm to all investors - both equity and debt holders - Estimating the firms enterprise value - Enterprise value = market value of equity + debt - cash - Enterprise value is the value of the firms underlying business, unencumbered by debt and separate from any cash or marketable securities. o Net cost of acquiring the firm's equity, taking its cash, and paying off al debt, owning the unlevered business - Advantage: allows us to value a firm without explicitly forecasting its dividends, share repurchases, or its use of debt

What is the equity cost of capital?

- Best expected return available in the market on investments with similar risk - Cost of capital of any investment opportunity equals the expected return of available investments with the same beta - Investors will require a risk premium comparable to what they earn taking the same market risk through an investment in the market portfolio - Total risk measured by volatility. Systematic risk measured by beta

What is a net investment?

- Compute the present value of the free cash flow (FCF) that the firm has available to pay all investors, both debt and equity holders - net investment - capital expenditures in excess of depreciation o investment intended to support the firm's growth, above and beyond the level needed to maintain the firm's existing capital - free cash flow measures the cash generated by the firm before any payments to debt or equity holders are considered - estimate firm's current enterprise value by computing the present value of the firm's free cash flow - Vo = PV(future free cash flow of firm) - Estimate share price by solving for value of equity and then divide the total number of shares outstanding - Difference between the discounted free cash flow model and dividend discount model is that in the dividend discount model, firm's cash and debt are included indirectly through the effect of interest income and expenses on earnings - In discounted free cash flow model, ignore interest income and expenses because free cash flow is based on EBIT, but then adjust for cash and debt directly

What are the tax implications for corporate entities? What are the different types of trusts?

- Corporations profits are subject to taxation separate from its owner's tax obligations o Shareholders of a corporation pay taxes twice o 1st - corporation pays tax on its profits, and then when the remaining profits are distributed to the shareholders, the shareholders pay their own personal income tax on this income - Double Taxation - Flow through entities - all income produced by the business flowed to the investors and virtually no earnings were retained within the business - Income trusts - 3 forms o Business income Trust - holds all debt and equity securities of a corporation (the underlying business) in trust for the trust's owners - unit owners o Energy trust - holds resource properties directly or holds all the debt and equity securities of a resource corporation within the trsut o Real-estate Investment Trust (REIT) - holds real estate properties directly or holds all the debt and equity securities of a corporation that owns real estate properties

Who does the corporate management team consist of?

- Electing board of directors - group of people that has the ultimate decision-making authority in the corporation o Make rules on how corporation should be run, sets policy, monitors performance o Delegates day to day running to management headed by CEO - Each share of stock gives a shareholder one vote in the election of each position of board of directors - When one or two shareholders own a very large proportion of the outstanding stock, these shareholders might either be on the board of directors themselves or they may have the right to appoint a number of directors - CEO - runs the corporation by instituting the rules and policies set by the board of directors Chief financial Officer (CFO) - most senior financial manager, reports to the CEO

What is the TSX?

- Electronic exchange - bid price - highest price being quoted to buy a stock - ask (offer)price - lowest price being quoted to sell a stock - when these are the same, trade is completed - Bid-ask spread - difference between the posted ask price and bid price - limit order - buy at specified price, but until order matches ask price, no trade will take place - Market Order - transact immediately because it automatically takes the best ask price already posted - Bid-ask spread is an implicit transaction cost investors are frequently traded and many investors put in orders to buy and sell the stock - thinly traded - attract less investor interest o bid-ask spread tend to be much larger - Most stock trading in Canada, particularly by value, takes place through the TSX - Generally trades the securities of larger firms (senior) - A lower value of trading in the securities of junior and early-stage firms occurs through TSX Venture Exchange, owned by the TSX.

What is the market risk premium?

- Expected excess return of the market portfolio - Provides the benchmark by which we assess investors' willingness to hold market risk

What is profitable growth?

- Firm can increase its growth rate by retaining more of its earnings - Effect of cutting firm's dividend to grow crucially depends on new investment - Cutting the firms dividend to increase investment will raise the stock price if, and only if, the new investment has a positive NPV

What is involved in project selection with resource constraints?

- If fixed amount resource, picking highest NPV may not lead to best decision o Ex. Taking on two projects that share space and combine to have higher NPV then one project with Highest NPV but uses whole space would be better - Profitability Index - measures the bang for your buck - value created in terms of NPV per unit of resource consumed o PI = (Value Created/resource consumed) = NPV/resource consumed o After calculating, can rank projects on it, start with highest index then work way down till resource used up - capital rationing constraint - when funds are limited. Ranking projects be profitability index - shortcomings: o may not fully use resource. Extra resource could be used on small projects with small index not normally considered o multiple resource constraints - need to search through all projects

Who has ownership and control in a corporation?

- In a corporation, direct control and ownership are often separate - The board of directors and chief executive officer possess direct control of the corporation o Goal of the firm should be determined by firms owners o Interests of shareholders are aligned for many, if not most, important decisions o Shareholder Wealth Maximization - the one goal that generally unites shareholders because they all benefit from a higher stock pric

What is share repurchase?

- Increasing number of firms replaced dividend payouts with share repurchases - share repurchase - the firm uses excess cash to buy back its own stock o 2 consequences: ♣ the more cash the firm uses to repurchase shares, the less it has available to pay dividends ♣ repurchasing shares, the firm decreases its share count, which increases its earnings and dividends on a per-share basis - Po = PV(future dividends per share)

What is the incremental Internal rate of return? What are its shortcomings?

- Incremental IRR - the IRR of the difference between the cash flows of the two alternatives (the increment to the cash flows of one investment over the other) o Tell us the IRR associated with switching from one project to another, can then evaluate decision to switch as stand-alone decision and apply the IRR rule using incremental IRR - Shortcomings of Incremental IRR: o Must keep track of which project is the incremental project and ensure that the incremental cash flows are initially negative and then become positive o Incremental IRR need not exist o Many incremental IRR's could exist o Does not imply better project should be accepted. Need to consider NPV o Assumes that the riskiness of the two projects is the same. Only NPV gives reliable answer

What is the dividend payout rate and retention rate?

- dividend payout rate - fraction of its earnings that the firm pays as dividends each year - div t = (Earnings t/Shares Outstanding t) X Dividend payout rate t - t = date - the dividend each year is the firm's earnings per share (EPS) multiplied by its dividend payout rate - firm can increase dividend in 3 ways: o 1) increase earnings (net income) o 2) increase dividend payout rate o 3) decrease shares outstanding - if # outstanding shares fixed, 2 things firm can do with earnings: o pay them out to investors o retain and reinvest them - investing cash today, firm can increase its future dividends - change in earnings = new investment X return on new investment - retention rate - fraction of current earnings that the firm retains - New investment = earnings X retention rate - Earnings growth rate = (change in earnings/earnings) = retention rate X return on new investment - If firm chooses to keep its dividend payout rate constant, growth in dividends will equal growth of earnings: g = retention rate X return on new investment

What is the first rule of time travel?

- financial decisions often require comparing or combining cash flows that occur at different points in time - 3 important rules: - 1) Only cash flow values at the same point In time can be compared or combined o dollar today and dollar in one year are not equivalent o having money now is more valuable then having money in the future, can earn interest on it o to compare different points of time, need to convert cash flows into same units or move them to the same point in time

What is a growing perpetuity?

- growing Perpetuity - stream of cash flows that occur at regular intervals and grow at a constant rate forever - infinite present value means that no matter how much money you start with, it is impossible to reproduce those cash flows on your own - only viable growing perpetuities are those where the growth rate is less than the interest rate, each successive term in the sum is less than the previous term and the overall sum is finite - assume g<r for growing perpetuity - withdrawing less than the full amount of interest earned each period, using the remaining interest to increase our principal - Present Value Today (date 0) of a Growing Perpetuity with Discount Rate, r, Growth rate, g, and First Cash Flow, C1, Starting in one period (date1) o PVo = C1/r-g o First cash flow divided by the difference between the interest rate and growth rate

What is the NYSE?

- last major stock exchange to have an active trading floor to which orders are routed for the trading of shares of stocks - specialists (market makers) - given preferential access to orders but must also stand ready to buy or sell shares at their own posted bid and ask prices - combined electronic trading with the trading floor

What is price reaction?

- market greets the news of an SEO with a price decline - by offering a rights offer, company can mitigate the adverse selection - companies underperform following a seasoned offering - when a firm invests, exercising its growth options - growth options are riskier than projects, upon exercise the firm's beta decreases, which explains the post-SEO lower returns

What is a partnership?

- more than one owner - Features: o 1) Income is taxed at the personal level. Split among partners acoording to their ownership o 2) all partners have unlimited liability. Lender can require any partner to rapy all the firm's outstanding debts o 3) partnership ends on death or withdrawal of any single partner. Can avoid liquidation is partnership agreement provides for alternatives such as buyout of a deceased or withdrawn partners

How does one choose between mutually exclusive projects?

- mutually exclusive projects - firm must choose just one project from among several possible projects o need to determine which projects have positive NPV, then rank to identify best one: pick the project with highest NPV - when projects differ in their scale of investment, the timing of their cash flows, or their riskiness, then their IRRs cannot be meaningfully compared - shortcoming of IRR: because it is a return, you cannot tell how much value will actually be created without knowing the scale of the investment - if project has positive NPV, if double size, NPV will double: Law of one price - doubling the cash flows of an investment opportunity must make it worth twice as much - IRR rule unaffected by the scale of the investment opportunity because the IRR measures the average return of the investment. Cannot be used to compare projects of different scales - IRR expressed as return - dollar value of earning a given return (NPV) depends on how long the return is earned - IRR that is attractive for a safe project need not be attractive for a much riskier project - Riskier - higher cost of capital means that despite having a higher IRR, its expected future cash flows are not sufficiently high to make the investment as attractive as the safer alternatives

What is an over-allotment allocation?

- over-allotment allocation (greenshoe provision) - allows the underwriter to issue more stock, amounting to 15% of the original offer size, at the IPO offer price - Once IPO process complete, company's shares trade publicly on an exchange - Lead underwriter usually makes a market in the stock and assigns an analyst to cover it - increases liquidity of the stock in the secondary market - Over-Allotment Allocation (Greenshoe Provision) • In an IPO, an option that allows the underwriter to issue more stock, usually amounting to 15% of the original offer size, at the IPO offer price -Underwriters initially market both the initial allotment and the allotment in the greenshoe provision by short selling the greenshoe allotment. • Iftheissueisasuccess,theunderwriterexercises the greenshoe option, thereby covering its short position. • If the issue is not a success, the underwriter covers the short position by repurchasing the greenshoe allotment in the aftermarket, thereby supporting the price.

What is the payback rule?

- payback investment rule - based on notion that an opportunity that pays back its initial investment quickly is a good idea o first calculate the amount of time is takes to pay back the initial investment payback period o if payback period less than a prespecified length of time - cut-off period - accept the project - not as reliable as NPV because: 1) ignores the project's cost of capital and the time value of money 2) ignores cash flows after the payback period 3) relies on an ad hoc decision criterion (what is the right number of years to require for the payback period?) - typically used for small investment decisions - provides budgeting information regarding the length of time capital will be commited to a project - if required payback period short (one or two years), most projects that satisfy the payback rule will have a positive NPV

When you can use IRR to Compare Alternative Projects?

1. Projects have the same scale 2. The same timing---longer term create higher NPV (page 261) 3. Same risk i.e. a security (bond/stock)-pick scale, timeframe and risk

What are the end of term lease options?

1. Fair Market Value (FMV) Lease - lessor has the option purchase asset at fair market value at the end of the lease. No effect on lease cost as you are buying at a price that creates no NPV. 2. $1 out lease - lessor has option to buy lease at the end of lease for $1---this will increase the cost of lease as you are getting something of value at the end. 3. Fixed Price Lease- lessor has the option to buy the asset at the end for a set price- this will increase the lease amount as there is a potential gain to made if the price is less than the market price 4. Fair market value cap lease- purchase at the minimum of a capped amount or fair market value. A little more flexible than fixed price lease

Why firms will choose to lease an asset?

1. Tax differences: • If the lessor is better able than the lessee to take advantage of CCA tax savings associated with asset ownership (i.e. CIBC and rail cars), may pass the savings on to the lessee • Different tax rates 2. Reduced resale cost of asset (can sometimes to resell asset, may not have abilities too. Leasing transfers responsibility to sell and manage risk to lessor) 3. Maintenance and service efficiencies 4. Vendor can seize and resell asset easier---can finance for less 5. Vendor has incentive to make good product---high residual value---they are taking it back (want a good product at end to resell) 6. Reduces the risks of asset ownership/residual value — Equipment can be acquired and used without assuming resale and obsolescence risks. 7. Internal capital controls of lessee 8. Lack of cash or ability to get a loan by lessee 9. Make balance sheet /ratios look better (operating lease)-lessee 10. Maintenance — Efficiencies can be realized if the lessor specializes in maintaining the leased equipment and offers a full-service lease arrangement. 11. Convenience — Assets that are needed only for a short period of time, which are very specialized or relatively hard to sell in the future are more easily leased than purchased.

What is a defensive stock?

A change in the market rate causes a smaller change in the stock (slope is 0.85)---less than a 1:1 Relationship—"defensive stock" - not going to change as much as the economy. Also when economy increases not going to increase as much

What are corporate investors?

A corporation that invests in private companies § Also known as Corporate Partner, Strategic Partner, and Strategic Investor § While most other types of investors in private firms are primarily interested in the financial returns of their investments, corporate investors might invest for corporate strategic objectives, in addition to the financial returns. - corporation that invest in private companies o Might invest for corporate strategic objectives in addition to the desire for investment returns

What is a venture capital firm?

A limited partnership that specializes in raising money to invest in the private equity of young firms § The firm has institutional investors (pensions) who are limited partners § Allows diversification by investors § Utilize expertise of general partners § General partners manage firm- take management fee (1.5%-2.5%) of invested capital and 20%-30% of profits

What are the costs of issuing an IPO?

A typical spread is 7% of the issue price. • By most standards this fee is large, especially considering the additional cost to the firm associated with underpricing. • It is puzzling that there seems to be a lack of sensitivity of fees to issue size. • One possible explanation is that by charging lower fees, an underwriter may risk signaling that it is not the same quality as its higher-priced competitors. -- Total cost of issuing stock for the first time is substantially larger than the costs for other securities - A large issue requires some additional effort, one would not expect the increased effort to be rewarded as lucratively - By attempting to undercut its rivals, an underwriter may risk signalling that it is not the same quality as its higher-priced competitors, making firms less likely to select that underwriter

What is an underwriter?

An investment banking firm that manages a security issuance and designs its structure § Takes a % of issue -7%- the "spread" § Sets the price § The road show (company management sells the IPO price) § "Book building"- lines up institutional buyers (pensions, mutual funds) and assesses demand and price of IPO

What is an auction IPO?

Auction IPO § A method of selling new issues directly to the public § Rather than setting a price itself and then allocating shares to buyers, the underwriter in an auction IPO takes bids from investors and then sets the price that clears the market. - not common -(openIPO) - market determines the price of the stock be auctioning off the company o auction IPO then sets the highest price such that the number of bids at or above that price equals the number of offered shares

What does Beta measure?

Beta (ß) measures the risk of an individual security (or portfolio) relative to the market portfolio. § Betas (ß) vary between companies and industries because of risk profile differences. § The beta (ß) of a common stock is the relevant measure of systematic risk for that stock § Beta (ß) depends on that component of a firm's business risk that is related to the overall market or economy, and is magnified by operating and financial leverage. Beta (ß) is typically estimated by plotting the returns on an individual security on the vertical axis (Y axis) relative to the returns for the market on the horizontal axis (X axis). § The best-fit line though the observations is the characteristic line whose slope is the beta coefficient. § In the example on the next slide, the slope turns out to be 0.85 — which means that for every 1% change in the market return, security A's return will change by 0.85%.

What is the CAPM?

Capital Asset Pricing Model (CAPM) § When pricing a security we only care about market risk (systematic risk) because firm specific risk can be removed through diversification- buy several stocks § Investors therefore only should be compensated (higher returns) for risk they cannot diversify against i.e. market risk/systematic risk - k = RF + Risk Premium k = Real Return + Expected Inflation Rate + Risk Premium When pricing a stock we care only about systematic risk because we can diversify away firm specific risk K= RF + risk premium So... We want to know the extent to which the return on a security moves with that of the overall market. - when the market changes, how much does your stock change - Beta [ß] is a measure of the extent to which the return on a security moves with that of the overall market. We can use the Capital Asset Pricing Model [CAPM] to assess the risk on a particular security. § Doing so allows us to derive the risk premium associated with that particular security. § We can derive ki and then get the price of the stock § ki = RF + risk premium Once we have ki we can price the security using pricing models in chapter 4 (AKA Chapter 7) P0= D1/k i

Which project do you select if they are mutually exclusive?

Choose using best NPV. Highest IRR does not always lead to best outcome - We want to create value for the shareholders, so the option with the higher NPV is preferred, regardless of the relative returns (IRR).

What are perfect capital markets?

Competitive market § All securities fairly priced § No transaction costs § As a result, "The cost of leasing is the same as the cost of buying the asset and reselling it"

How do you determine the weighted cost of capital?

If the firm has both common and preferred shares, along with debt, the equation is: §V=S+P+D WACC=Ke S/v+Kp P/V+Kd(1-T)D/V Ratio of each component - 1-tax rate because tax deductible WACC: weighted average cost of capital Ke = cost of common equity Kp = cost of preferred equity Kd = cost of debt V - equity+common shares+prefeered shares (total value) - weights that are applied to the component costs of capital are meant to reflect the optimal mix of sources of funds that the firm can employ. -optimal mix of the three sources (Preferred, Common, Debt) minimizes the WACC...get money cheapest! ...the difference between what you invest at and cost of funds increases---creates more value

What is the difference between an operating and financing lease?

In an operating leases it is presumed that the benefits of ownership do not transfer to the lessee but remain with the lessor — along with the risks. (asset on balance sheet of lessor) § In finance leases (or capital leases) it is presumed that almost all of the benefits (and the risks) of ownership transfer to the lessee. (treated as asset on balance sheet of lesse)

How does increasing debt affect cost of capital?

Increasing debt financing will make the new debt riskier, raising the required rate of return on bonds-Kd § As the firm takes on more debt, it becomes riskier as its leverage increases, so investors will demand a higher return to compensate for that risk. § As a result when you issues bonds and shares you will get less for them---yield (YTM) higher---price of bond lower § And share price lower: P0=D1/ke ---get less for shares you issue (cost of equity lower - share price higher) - After-tax cost of debt is significantly lower than the cost of equity primarily because of the tax- deductibility of interest expense. (5% at a 30% tax rate only cost (1-.3)*5%= 3.5% (Remember last lecture) § The tax advantage to debt is offset at higher levels of financial leverage by costs associated with financial distress and bankruptcy. § Lenders seek to protect themselves from excessive use of corporate leverage through the use of protective covenants. - Protective covenants examples § Debt/equity § Cash on hand § Current ratio § Dividend payout ratio § EPS § Cash flow - The expected EPS and ROE rises as more debt is added as long as the firm earns more than the interest cost on the money borrowed-Need ROA to exceed the cost of borrowing § However more volatile earnings

What are the 2 most important ways managers can add value to the firm?

It is the manager's job to maximize shareholders' wealth. (get money as cheap as possible) § Two of the most important ways managers can add value to the firm: 1. Changing the mix of financing used by the firm (changing the relative proportions of debt and equity), and 2. Determining the minimum rate of return needed to maintain the current market value.

What is a lead underwriter and syndicate?

LeadUnderwriter § The primary investment banking firm responsible for managing a security issuance • Syndicate § A group of underwriters who jointly underwrite and distribute a security issuance -- managed by group of underwriters - lead underwriter - primary investment banking firm responsible for managing the deal o arranges the syndicate - group of other underwriters to help market and sell the issue - relevant securities commission require that companies file certain legal documents that provide financial and other information about the company to investors prior to an IPO - registration statement

What is the internal rate of return?

The NPV method uses a specific discount rate to determine whether a project should be considered. § Sometimes an organization wishes to know what rate of return is associated with an investment. § The internal rate of return is the discount rate that equates the present value of future cash inflows and outflows with the initial cost of investment. § NPV = 0 - IRR is the discount rate that "solves" the NPV equation such that the NPV is equal to zero. - All your future cash flows discounted at the IRR interest rate subtract the initial investment equals zero" - if your required return is Less than this you will Have a positive NPV...you are dividing by a smaller number - if your required return is More than this you will have a negative NPV

What are the limitations of the price/earnings ratio?

The P/E ratio has some limitations: § P/E ratios are uninformative when companies have negative (or very small) earnings. § Volatility in earnings causes volatility in P/E ratios throughout the business cycle. § Firms are not identical § Accounting definitions of earnings (US/Canada)

How does the constant growth dividend discount model predict an increase in stockprice?

The constant growth dividend discount model predicts that stock prices will increase if: • dividends are increased; • the growth rate increases; or • the investor's required return decreases. The dividend discount model's estimate of prices is highly sensitive to changes in forecast growth (g) and the investor's required rate of return (k). - The dividend discount model is unable to value firms that do not pay dividends.

What is a venture capitalist?

The general partners who work for and run a venture capital firm Venture Capitalist want high level of control • Board seats • Managementteam • %ownership Venture Capitalist need to make lots of money (for the general partners and limited partners) on successful deals as many deals do not work out • Working with "20 somethings" not always most experienced individuals. need to be re-focused on money • They are not writing blank cheques • Obligation to their investors (partners) to take care of their money Canberuthless..."Venture Capitalists"!! • "Vulture Capitalists" § Struggling companies § Takes the business from founders • They are about making money ---they may not share the passion for your product • They .are not in for the long term ---waiting for the IPO general partners work for the venture capital firm and run the venture capital firm o venture firms invest in many startups, so limited partners get the benefit of this diversification o limited partners benefit from expertise of general partners o general partners charge substantial fees to run the firm o Carried interest - share of any positive return generated by the fund to the general partners o Demand greater deal of control. Use control to protect their investments

How does a new company raise capital?

The initial capital that is required to start a business is usually provided by the entrepreneur and their immediate family. •Often a private company must seek outside sources that can provide additional capital for growth. § However the infusion of outside capital will affect the control of the company.

What is the payback period?

The payback period is the number of periods needed to recover a project's initial investment. § It is sometimes considered a measure of the project's risk. § The longer the payback period, the higher the risk. § Organizations compare a project's payback period with a target that reflects the organization's acceptable level of risk. "When do I get my money back?" The payback period is the number of periods needed to recover a project's initial investment. Payback period* = Investment required Net annual cash inflow § The payback period is sometimes considered a measure of the project's risk. * Only works with even cash flows

What is an initial public offering?

The process of selling stock to the public for the first time § Public companies typically have access to much larger amounts of capital through the public markets. § Exit for private equity and venture capital or chance to diversity by selling their shares § The equity holders become more widely dispersed. • This makes it difficult to monitor management. -The firm must satisfy all of the requirements of public companies. • SEC filings, Sarbanes-Oxley, etc. • Shareholder communications • Dissident shareholders - shareholders who invest and dont like what you are doing - can sue you, make life difficult§ Small investors seldom have access to the "good" IPOs § Usually by after starts trading on the exchange

What is the required rate of return made up of?

The required rate of return (ke) is the sum of two components: the risk-free return (RF) and a risk premium (RP): § As the risk-free rate (RF) changes, ke will also change. § The risk premium — the additional return required by investors over the RF rate to induce investors to hold a stock - additional percentage needed to invest in your risky company

How will the required return increase?

The required return ke will increase due to: 1. Business risk--- exposure to systematic risk (economy) 2. Operating leverage- spending a lot on a factory etc. 3. Financial leverage- borrowing a lot of money

What is business risk?

The risk that the company will fail to meet the goals and objectives it sets for itself (profits). - arent able to pay dividends or pay debt payments. May eventually go bankrupt § Every company carries the business risk that it will produce insufficient cash flow in order to maintain operations. - Business risk can come from a variety of sources, some systematic and others that are firm-specific. § Every company has the business risk that the broader economy will perform poorly (systematic) and therefore that sales will be poor - macro-economic changes can affect systematic - Every company also has the risk that the market simply will not like its products or it mismanages the company (firm specific). § Business risk affects investors, since a firm may be unable to pay dividends and/or interest (bonds).

What is involved with the free cash flow model?

We want to value of the cash generating assets of the firm- Enterprise Value to calculate share value • Enterprise Value =Market Value of Equity + Debt - Cash OR Assets (includes cash) = Liabilities + Shareholders' Equity (Bus 251) Enterprise Assets + Cash= Debt + market value of equity (i.e. what we pay for the company) Look at the cash to pay all investors- equity and debt § What is available to all investors: Free Cash Flow = EBIT (1-tax rate) + depreciation -capital expenditures-change in working capital - EBIT - earnings before interest and tax § Have not deducted dividend or interest payments in the above Enterprise Value (V0 )= PV (Future Free Cash Flows of Firm) § Enterprise Value + Cash = Debt + Market Value of Equity (Assets= Liabilities + Shareholders' Equity (BUS251)) § Market Value of Equity0 = Enterprise Value (V0)+ Cash0-Debt0 (what we pay for firm) § 0n a per share basis P0 = V0 + Cash0 - Debt0 Shares Outstanding

What is the seasoned equity offering?

When public company offers new shares for sale. • To raise additional equity. • Follows many of the same steps as for an IPO. • A market price for the stock already exists, so the price-setting process is not necessary. -- Firms return to equity markets and offer new shares for sale - Many of the same steps as IPO - Market price for the stock already exists, price-setting process not necessary PrimaryShares § New shares issued by a company in an equity offering • SecondaryShares § Shares sold by existing shareholders in an equity offering • Onaverage,themarketgreetsthenewsofan SEO with a price decline- "adverse selection" -veiwed negatively - if doing really well shoulndt have to go to the market to raise money -Underwriting fees amount to 5% of the proceeds of the issue. -- Primary Shares - new shares issued by the company - secondary Shares - shores sold by existing shareholders, including the company's founder - tombstones - advertisement of sale of stock (newspapers) - cash offer - firm offers the new shares to investors at large - rights offer - firm offers new shares only to existing shareholders o protect existing shareholders from underpricing -Therearetwotypesofseasonedequityofferings. • CashOffer § An SEO in which a firm offers the new shares to investors at large • RightsOffer § An SEO in which a firm offers the new shares only to existing shareholders § Rights offers protect existing shareholders from underpricing.

What is cyclicality?

When times are good, the market is flooded with new issues; when times are bad, the number of issues dries up. § Other funding options are used in bad times -- Number of IPOs not solely driven by the demand for capital

What are the tasks of the financial manager?

o 3 main tasks: making investment decisions, making financial decisions, managing firms cash flows o Investment Decisions - weigh the costs and benefits of each investment or project and decide which of them qualify as good uses of the money shareholders have invested in the firm ♣ Shape what the firm does and whether it will add value o Financing Decisions - decides how to pay investments ♣ Raise money from new or existing owners by selling more shares of stock (equity) or to borrow money instead o Cash Management - ensure enough cash on hand to meet its obligations from day to day ♣ Managing working capital ♣ Make sure access to cahs does not hinder firm's success

What is the dividend discount model for a 1 year investor?

o Two potential cash flows from owning stock: ♣ Dividends ♣ Investor might generate cash by choosing to sell the shares at some future date o Investor pays current market price for share (Po), receives dividends throughout the year (div1) and then sells at new market price (P1) o Investor will be willing to pay a price today up to the point which current price equals the present value of the expected future dividend and sale price (NPV) o equity cost of capital (rE) - expected return of other investments available in the market with equivalent risk to the firm's shares o Stock Price: ♣ PO = (div1 + P1) / 1 + rE) o If stock price less then this amount, investors would rush to buy o If stock price exceeded this amount, selling would have positive effect and stock price would fall o In competitive market, buying or selling a share of stock must be a zero-NPV investment opportunity

What are the effects of the different classifications of leases?

§ Income Statement Effects: net income will rise for finance leases in the latter years because the interest expense charged for finance leases declines as the lease obligation is amortized (typical loan amortization table) § Balance Sheet Effects: finance leases cause a firm's assets and liabilities to be higher than operating leases because operating leases are not on the balance sheet (off-balance-sheet financing). Financial Ratio Effects: If a lease is classified as finance rather than operating, a firm will have: • Lower current ratios (you have a current liability) • Higher debt and leverage ratios (lease obligation is a liability) • Lower asset turnover ratios (more assets) (sales/assets) Asset under lease XX Finance lease (liab) XX

What are angel investors?

§ Individual Investors who buy equity in small private firms § Can provide expertise • Finding angels is typically difficult. • May not be enough individual investors who buy equity in small private firms o Frequently friends and acquaintances of the entrepreneur o Receive sizeable equity share in the business in return for their funds o Substantial influence in business decisions o Difficult to find