Lecture 1: Introduction to Business Finance Four Basic Areas of ...
Lecture 1: Introduction to Business Finance Four Basic Areas of Finance • Corporate Finance: basic theories and ideas of finance • Investment: financial assets such as shares and bonds • Financial Institutions: firms dealing in financial matters • International finance: area of specialization consisting of the above three areas Corporate Finance à What equipment to buy? à Will you use your money or someone else’s to buy it? à When do you pay suppliers and when do you require customers to pay you? • Financial Manager: responsible for accounting and treasury duties − must optimally allocate scarce resources for the benefit of the business Goals of Financial Management • Maximize shareholder wealth • Profit maximization is not shareholder wealth maximization − No time frame − Ignores uncertainty − Depends on accounting standards • Wealth is measured in terms of cash flow • Accounting solution: finding the best possible solutions for all types of business Factors in any financial decision • Cash flows: dollar amount of the actual cash flow − Some cash flows take a long time to come in, others don’t • Time: when cash flow occurs − Time and value of money (TVM) • Risk: amount of uncertainty − Risk and return − Take one with higher risk, want a higher rate of return − Things are unexpected (for the good or bad) Risk-‐Return Trade off • Risk − Projected outcome different to actual • Wealth maximization takes into account risk involved • Investment’s risk increases = investors require higher returns • Finance assumes risk-‐averse investors – must be rewarded Financial Manager’s responsibilities • Investment decision: WHAT to buy à Capital budgeting
• • •
Financial decision: HOW to pay à Capital structure Working Capital decision à Short term assets and liabilities Each task requires planning and forecasting – keep to the themes of sustainability and ethics
The Investment Decision • How to determine the value to the business of a long term asset • Evaluate size, time and risk of cash flows • Select the assets that create most shareholder wealth • Composition of assets which will best facilitate the operations of the firm • Hard to reverse if wrong The Financial Decision • How to finance an investment? • Determine the best mix between − Debt: (loans funds) à contractual claim on business assets − Equity: (owner’s funds) à residual claim on business assets • Trade-‐off between risk and return • Use of debt is called gearing or leverage (more debt means higher gearing or higher leverage) The Working Capital Decision • Managing short-‐term assets and liabilities − Forms part of the investment decision − Inventory management − When to allow credit sales? − When to pay suppliers? Forms of Business • Sole trader/Proprietorship − Individual owner – may employ other people − Unlimited liability − Success or failure relies on the individual owner − Raising debt finance usually from financial institutions − Equity component limited to sole trader’s wealth – tend to be undercapitalized − Life is limited – lasts as long as the owner is alive or until owner sells business • Partnership − Similar to sole trader except several individuals − All share in gains and losses − Characterized by a partnership agreement − If one wants to leave, partnership ends
•
Company − Most important form − Separate legal entity − Unlimited life − Many formal and legal requirements − Limited liability for shareholders – not liable for company debts beyond their investments − Superior form when raising capital − Few companies are listed on stock exchange à problems with size of firm and control
Corporate Governance • Objectives of management may differ from that of shareholders • Managers may be satisfied rather than maximized àManagement play it safe, rather than maximizing the value of the firm • Management are agents for the owners • Introduces a potential conflict àAgency problem à Ethical decision making • Management only make optimal decisions if adequately compensated − Incentive payments − Share options, bonuses • Efficient capital markets provide signals about the value of a company’s shares à reflection of the performance of its managers • Maximization of shareholder wealth is the appropriate goal for managers of a firm Principal and Agent Law • Agency law is part of commercial law • Agency law: a contractual relationship between a person (the agent) who is authorized to act on behalf of another (the principal) • Agent can create a legal relationship with a third party • Creation of agency: − Expressly in writing or verbally − Implied by law à as part of a necessity or by cohabitation, by status (such as a partnership) or working relationship • Employer – employee relationships • Not all employees are agents for the employer • This will depends on the type of work carried out − Sales people are agent for the employer as they are arranging sales − Managers tend to be agent as they enter into contracts for the employer • Agents can be Special, General or Universal • Duties of an agent: − Follow principal’s instructions − Act personally (not delegate to one)
− − − −
Exercise reasonable skill and diligence Act in the principal’s best interest Not to make a secret profit Not divulge confidential information
Financial Markets Role of Financial Markets • Facilitates transactions in financial securities • Markets exists to efficiently allocate funds for alternative uses • Without efficient financial markets à funds would lay idle à good investment opportunities may not be able to be financed Primary Market • Security or instrument issued to an investor for the first time eg. New car dealers • Funds are raised by the firm and flow to it • Fund raising between investors and firm • Can be debt or equity funding • Public offering: equity offered to any interested investor • Private placement: equity offered only to selected parties Secondary Market • Financial securities that are already issued are bought and sold eg. Used car dealer eg. Securities exchange – Australian Securities Exchange ASX • Financial security: piece of paper that states what is owed and when it will be repaid • Investor-‐to-‐investor trading • No additional funds are raised by the firm Financial Statements • Firms produce financial statements for their owners − Balance sheet − Income statement − Cash flow statement
•
Annual report produced after the event − Contains director’s commentaries − Reduced impact under ASX continuous disclosure regulations
Balance Sheet • Reflects the position of a company at a point in time • Cash and other assets − Listed in liquidity order (ease of converting to cash) − Amount of cash they raise depends on type of asset • Balance sheet identity Ø Assets – Liabilities = Equity • Net Working Capital = Current Assets – Current Liabilities Market Values and Book Values • Balance sheet is historical accounting • Real or productive assets à produce the cash flows over time • Financial or paper assets à claim on cash flows of productive assets • Balance Sheet for finance à no concerned with past à what is the value of the asset today? (market value)
Income Statement • For a period of time • Lists income received and costs incurred in producing that income • Due to different accounting treatments the net income (profit) may be different to actual cash flows à Expenses such as depreciation or amortization are not a cash flow Cash Flow Statement • Reveals where the funds came fro and what they were applied to • Identifies sources and uses of funds/cash − Increase in assets = use of funds − Decrease in liability = use of funds − Increase in liabilities = source of funds − Decrease in assets = source of funds • Various ways that cash flows can be viewed • Accounting and finance perspectives differ
Lecture 2: Time Value of Money 1 Time Value of Money • The financial manager makes decisions about proposals with cash flows over periods of time. • An important consideration is the timing of these cash flows -‐ The time value of money must be recognized • It is based on the fact that a dollar today, is worth more than a dollar tomorrow. -‐ Prefer $5million today or $5million in one year? Example 1 • I invest $1000 in a bank today for a period of one year and the interest rate id 5% pa. à How much will I have in the bank next year? -‐ Interest = $1000 x 5% (or 0.05) = $50 -‐ Add interest to the original investment $1000 + $50 = $1050 Variables • A dollar amount today -‐ Present value àAnd an interest rate àAnd a period of time à Gives a dollar ‘n’ the future -‐ Future value Terminology PV = Present Value i = interest rate per period sometimes we use ‘r’ n = number of periods, sometimes we use ‘t’. FV = Future Value PMT = Periodic Payment
Simple Interest • Calculated on the original principal -‐ Takes no account of changes in principle -‐ Sometimes called Flat Rate interest • Used in valuation of short term financial instruments in the money market -‐ Terms (time period) under 12 months -‐ Securities are usually called Bills Future Value with Simple Interest FV = PV + INT FV = future value at end of the term PV = Principal interest at beginning INT = Interest in dollar terms over the time period INT = PV x i x n i = simple interst rate per year n = number of years FV = PV + PV x i x n = PV (1 + i x n ) Present Value with Simple Interest PV = FV / ( 1 + i x n) Example 2 What is the future value of $100,000 invested for 180 days at 10% pa simple interest FV = PV (1 + i x n) = 100,000 (1 + 10% x 180/365) = 100,000 (1+ 0.0493) = $104,930 Compound Interest • Interest earned in one period is added to the principal to form a new principal on which the next calculation of interest is based -‐ The calculation • The calculationà lots of calculations • Interest is computed at the end of each period on the starting principle of the period. • Interest is added to the principle each period -‐ Interest on interest -‐ Called compounding • The compounding period can be any designated length of time -‐ Yearly, half-‐yearly, quarterly, monthly Remember: Simple interest is calculated only on the original amount
Future Value FV = PV ( 1 + i ) ^ n Where: i = interest rate per period n = the number of compounding periods PV = the original principal Example 3 Alice deposits $1000 today in a savings account that pays interest once a year. How much will Alice have in three years if he interest rate is 12%pa? Year Opening Balance Interest Closing Balance 1 1000 120 1120 2 1120 134 1254.40 3 1254.40 150.53 1404.93 à Interest = Opening balance x interest rate i.e. 1000 x 12% = 120.00 FV= PV ( 1 + i )^n = 1000(1+0.12)^3 = 1404.93 Using the calculator Example 4 You own bank fixed term deposits that guarantees to pay you $230,000 in six years time, however you are not prepared to wait. What amount of cash would you receive today if someone buys the fixed term deposit today? The buyer applies a discount rate of 20% pa ( in this context to discount means to subtract the interest from the future value to calculate the present value) Discount rate = interest rate FV=230,000 I = 20% N= 6 PV= FV (1 + i )^-‐n = 230,000 (1 + 0.20) ^-‐6 = $77,026.53 Using the Calculator 2nd F ; CA ; 230,000 ; PV ; 20 ; I/Y ; 6 ; N ; COMP ; PV
Frequency of compounding • Interest rate normally quoted as per annum but the compounding frequency is not always annual. • A nominal rate is when interest is compounded more frequently than annually. • If the compounding period is not annual the rate in the calculations must be adjusted to the rate per compounding period. à E.g. 16% pa compounded monthly – the nominal rate is not the same as 16% pa. Example 5 What is compounding rate for each time period for an 18% annual interest rate, compounding monthly? The number of compounding periods each year is 12 -‐ Rate per period = 18% = 12 = 1.5% Example 6 Two years ago, a company invested $32,000 in a bank account with an interest rate of 14% pa compounding quarterly. The investment matures in five years time from today. à What is the value of this investment in five years time? PV = 32,000 N = (2+5) x 4 = 28 i = 14/4 = 3.5% FV = PV (1 + i ) ^n FV= 32,000 (1.035) ^ 28 = $83,845. 50 Using the calculator 2nd F ; CA ; 32,000 ; PV ; 2.5 ; I/Y ; 28 ; N ; COMP ; FV Effective Annual Rates (EAR) • An effective rate is an interest arte that compunds annually (once a year) • To convert a nominal rate to an effective rate EAR = (1 + i ) ^m-‐1 M = number of compounding periods per year i = interest rates per period Example 7 Which interest rate is higher? • 12.5% annual interest rate, compounded half yearly, or • 12.3% annual interest rate, compounded monthly • Convert both nominal rates to EARs à EAR = (1 + i )^m-‐1 = (1 + 0.625)^2-‐1 = 12.89% à EAR = (1 + i )^m-‐1 = (1 + 0.1025) ^12-‐ 1 = 13.02%
Example 8 A company has the opportunity to buy an asset today for $70,000 The company expects to be able to sell his asset in three years for $87,500 The company wants to earn 9.5% pa on its investment. Should the firm buy the asset? i = 9.5% PV = *7500 (1 + 0095)^3 = $66,644.71 à The firm should not buy the asset for $70,000 because in order to earn 9.5% pa it should pay only $66,644.71 Using the calculator FV ; 87500 ; N ; 3 ; I/Y 9.5 ; COMP ; PV Example 9 • Thunderbirds Production Company (TPC) is offering investors an opportunity to invest in its movie production business • TPC is asking investors to invest $5 000 now and $4,000 in two years’ time • TPC has projected the cash inflows from its movie to investors would be $6,000 in year four, $2,500 in year six and a final amount in year eight of $2,000 • Investments with similar risks have a return of 20% pa. Ø Is it worth investing in the TPC project? CASH FLOWS: -‐5000 -‐4000 6000 2500 2000 |___|___|___|___|___|___|___|___| 0 1 2 3 4 5 6 7 8 • -‐5,000 = -‐5,000 PV of Year 0 cash flow • -‐4,000(1.2)-‐2 = -‐2,778 PV of Year 2 cash flow • +6,000(1.2)-‐4 = 2,894 PV of Year 4 cash flow • +2 500(1.2)-‐6 = 837 PV of Year 6 cash flow • +2,000(1.2)-‐8 = 465 PV of Year 8 cash flow • Total of Present Values = -‐$3,582 Thunderbirds is a poor investment because the PVs of the positive cash flows are less than the PVs of the negative cash flows!
Lecture 3: Time Value of Money 2 Annuities • A special case of multiple cash flows • A number of EQUAL cash flows occurring at EQUAL time intervals • An ordinary annuity assumes all cash flows occur at the end of each period Future Value Formula Example 1: Jim plans to deposit $250 each month for the next 7 years at an interest rate at 6% pa compounded monthly. What is the accumulated value? Example 2: You must pay $7,500 for medical expenses in five years. You want to deposit an equal amount each quarter to satisfy this expense. If the interest rate is 8% pa compounded, how much should you deposit each quarter?
Present Value of Annuities • The present value is calculated at the beginning of the annuity period • Assumes the first payment made is at the end of the first period − Beginning of period one = time zero − Beginning of period three = end of period two ⎡1 − (1 + i)− n ⎤ PV = PMT ⎢ ⎥ i
⎣
⎦
Example 3: What is the present value of a series of $100 payments received at the end of each month for 10 years? The interest rate is 18% pa compounded monthly? Example 4: You require $350,000 to buy a house. The bank will lend you the money with a repayment period of 15 years at an interest rate of 6% ps compounded monthly. What are your monthly loan repayments? Example 5: NSW lotteries offers an instant lottery ticket with a maximum prize of $1,000,000. The prize winner receives $500,000 immediately and $50,000 at the end of each year for the next 10 years. If money is work 10% pa, what is the true value of the $1,000,000 prize? Perpetuity • A special type of annuity − A perpetual annuity − Continues forever • Present value of an annuity PV = PMT (1-‐ (1+i)^-‐n / i à as n approached infinity, (1+i)^-‐n approaches 0 • PV of perpetuity PV = PMT / i • There is no future value
Example 6: What amount would have to be invested today to provide $7,000 each year forever? Assume that you can earn a return of 7% pa. PV = PMT / i PV = 7,000 / 0.07 = $100,000 Example 7: Jason will receive $500 forever with the first $500 received exactly 5 years from today. If the interest rate is 13% pa, what is the value today of this series of cash flows? Example 8: Your brother just graduated from UTS and begun employment with an investment bank. He intends to retire in 35 years’ time and wants to withdraw $20,000 annually starting at t=36 for the next 30 years. Interest rate is 7.5% per annum. What is the equal yearly deposit your brother must save during his 35 year working life?
Lecture 4: Debt and Valuation Introduction • Contractual rather than residual claim • Commits firm to interest principal repayments (equity has no commitments) • No voting power (equity has voting power) • Interest payments (none with equity) -‐ Business expense: tax deductible • Unpaid debt is a iability of the firm • Debt is a loan of money to be repaid in the future (equity not repayable) Key distinguishing features • Maturity: Short-‐term or long –term debt • Security: Secured or unsecured • Ranking: Subordinate or senior • Interest rate: fixed rate, floating rate or combination • Repayment pattern: interest only, principal and interest, capitalized interest • Currency: Domestic (AUD), foreign • Source: markets or financial institutions Risk associated with Debt • Interest Rate Risk: changes in prices of debt due to interest rate changes • Default Risk: insufficient cash to make interest and/or principal repayments • Currency Risk: changes in prices of debt due to movements in exchange rates Loan Security and agreements • Many forms of security: - Floating charge over assets of firm - Mortgage over land/buildings - Specific charge over an asset • Loan agreements - Positive and negative covenants à Maintain minimum financial ratios à Can’t sell certain assets without consent - Guarantees Short Term Debt • Securities with a term of less than one year • Instruments in the money raise funds when they are first issued - Purchaser is lender and issuer is borrower • Types of short-‐term debt: - Commercial Bills - Promissory Notes - Overdrafts
Commercial Bills • Also called bills of exchange • Source of short-‐term finance for companies • A bill must state - Amount payable (face value) and date payable • Bills are discount instruments - Issued at a price less than their face value - Do not make an explicit interest payment - Interest is the difference between the security’s price and face value Legal implications of bills • They are a negotiable instrument that mean there are legal rights attached to the bill • They can be transferred from one person to another - The new holder has “good” title • A bill is a safe substitute for money • Document which provides proof • Parties to a bill are not liable for the debt unless they have signed it Legally a bill is • An unconditionally order in writing • Addressed by one person to another • Signed by the person to whom it is addressed to pay on demand, or at a fixed determinable future time: - A sum certain in money to or to the order of a specified person, or to bearer Parties to a bill – Acceptor • Provides an acceptance (guarantee) of the credit facility to be offered • Acceptor agrees to accept the bill and pay the holder its face value at maturity • The bill is retired (cancelled) once it has been paid • Considered as a guarantor by lenders - May hold bill and provide funds to drawer Parties to a bill – Drawer • The drawer is the party that want the funds-‐ also called the issuer of the bill or the borrower • The drawer’s liability is secondary to the acceptor (guarantor) - If the acceptor dishonors payment the drawer will compensate the holder • Liability to repay the bill is the responsibility of the acceptor - The drawer agrees to repay the acceptor
Parties to a bill-‐ Discounter • Discounter (also called investor or lender) initially provides cash to the drawer - Buys the bill at a discount to its face value • May sell the bill before maturity - If discount sells the bill must endorse (sign) it: - Agrees to compensate the holder in the event of its dishonor • Bill can be traded until it matures Bill facility • Borrower can raise funds for longer periods through a bill facility • A bill facility is a sequence of bills - When the first bill matures it is ‘rolled over’ by issuing second bill with the same face value for the same period (e.g. 90 days). - The new bill is issued at the prevailing interest rate à Which may be different form the rate when the first may issued. à Therefore, the discounted value if the second bill may be different from the discounted value of the first bill, even through the face value is the same. Example A two year bill facility financed on 180 day terms would have three roll-‐overs – at 180, 360 and 540 days. After 2 years (720 days) the last bill would be repaid and no new bill issued. Long-‐Term Debt • Long term debt provide funds for longer than one year - Public (government) or private (company) funding • Australian market is mainly government bonds - Companies tend to use overseas debt-‐capital markets • Long term debt is generally in the form of term loans or bonds Features of a Bond • Long term securities - Pay a fixed amount of interest at specified dates - Redeemed at maturity by payment of their à Face value - Interest payment made periodically and on the maturity date Corporate Bonds • Issued to the public - Requires a prospectus • Secured debt - Specific or floating charge over assets of firm • Usually has a trust deed and trustee
• Unsecured debt has all above features but no security Foreign Currency Loans • Firm borrows money in a currency different to its home country’s currency - Used to finance overseas ventures - Or assets that generate overseas sales - Adds currency risk to a firm Convertible Bonds • Debt that can be swapped into equity at a predetermined price before maturity - Advantage to holder is if share price increase above conversion price - Has a lower interest rate than conventional debt - Often subordinated to indicate ranking in event of company failure Valuing Short-‐Term Debt • Securities with a term less than one year are usually discounted securities - No explicit interest paid. Interest is the difference between face value and purchase price • Valuation (uses SIMPLE INTEREST): PV = FV / (1 + rt) r = annual interest rate t = time (measured in years) to maturity Example A trader at a market rate of 8% pa purchases a bank bill originally issued with 180 days to maturity and a $100,000 face value. It has 120 days until maturity. PV = FV / (1 + rt) PV = 100,000 / (1 + 0.08 * 120/365) = $97,437.27 • Price of security increases as term to maturity shortens • PV/price approaches Future Value/Face Value Valuing Bonds • Bonds are an example of long term debt • A firm sells a bond to raise capital/funds • Bonds are fixed income securities - Pay constant amount of interest at regular time intervals - Repay an amount at maturity • The regular interest payments are called coupons
Parts to a bond valuation • Valuing a bond requires - The number of periods to maturity - The face value - The coupon amount - The market interest rate • The coupon payment is the coupon rate multiplied by the face value - The present value of all the coupon payments is found by using an annuity formula • The market interest rate, or yield to maturity (YTM), fluctuates Example A bond has a face value of $10,000. There are three years to maturity and the coupon rate is 7% pa and coupons are paid semi-‐annually. What is the coupon payment? PMT = 7% / 2 x 10,000 = $350 What is the number of coupons remaining? n = 3 x 2 = 6 Bond Valuation • Timeline for a bond’s cash flows FV PMT PMT PMT PMT PMT |_______|_______|_______|__......___|_______| 0 1 2 3 n-‐1 n Bond valuation formula
⎡1 − (1 + i)−n ⎤ PV = PMT ⎢ + FV(1 + i)−n ⎥ i ⎣ ⎦
Using the calculator FV; PMT ; N ; I/Y ; COMP ; PV Example What is the price of a bond that was issued two years ago and has eight years to maturity? • Coupons are paid half yearly and a coupon payment was made today. • The coupon rate is 5% pa and the current market yield is 6% pa. • The face value is $200,000
Number of payments per year = 2 FV = $200,000, coupon rate = 5% pa PMT = $200,000 x 0.05/2 = $5,000 What is the market yield? i = 6%/2 =3% Years to maturity = 8 Number of compounding periods = 2 x 8 = 16 Bond Values and Yields • In previous example the bond price is less than the face value, this is known as a discount bond. - As the market rate is greater than the coupon rate, the market price is less than face value. - If the market rate is less than the coupon rate then the bond trades at a premium Coupon Rate < YTM < Face Value = Discount Bond Coupon Rate = YTM = Face Value = Par Value Bond Coupon Rate < TYM > Face Value = Premium Bond Example What is the price of a bond if: The bond has a face value of $100,000 and has five years until maturity. It has a coupon rate of 5% p.a. payable semi-‐annually? Step 1 Calculate the coupon payments and term Coupon Pmt’s =$100,000 x 5% ÷ 2 = $2,500 Term = 5 x 2 = 10 A) Yield is 6% p.a. compounding semi-‐annually n=10; i=?; FV=100,000; PMT=2,500 Price at 6% = $95,734.90 If coupon rate < Yield then Price < Face value = Discount Bond B) Yield is 5% p.a. compounding semi-‐annually Price at 5% = $100,000.00 If coupon rate = Yield then Price = Face Value = Par Value Bond C) Yield is 4% p.a. compounding semi-‐annually Price at 4% = $104,491.29 If coupon rate > Yield then Price > Face Value =Premium Bond
Yield to Maturity • A bonds price, coupon rate and maturity date are easily observed • However, the yield is not so easily found • Yield to maturity is the discount rate which equates the present value of all future coupon payment and the face value with the market price. Example A bond with a face value of $100 matures in five years. The current price is $96.50 and the annual coupon payments are $12.50. What is the YTM? 100 96.50 12.50 12.50 12.50 12.50 12.50 |_______|_______|_______|_______|_______|_________| 0 1 2 3 4 5
⎡1 − (1 + i ) −5 ⎤ −5 96.50 = 12.50 ⎢ ⎥ + 100(1 + i ) i ⎣ ⎦ i = 13.51%
Example Centurion Ltd has a 90-‐day bank bill facility with ANZ. Today, Centurion wants to sell $1,000,000 worth of bank bills to fund an increase in inventory. The current market yield on 90-‐day bank bills is 6.37% pa. A) Who is the drawer of this Bill? Centurion Ltd B) Who will pay the face value of $1,000,000 at Maturity? ANZ Bank
Lecture 5: Equity and Valuation Equity • Permanent Risk Capital − No assurance owners will profit − Not repayable • Most important source of funds − All companies must have equity • Limited liability • Shareholders have a residual claim on company assets • Publicly listed companies trade on the Australian Securities Exchange ASX Dividends • Represent a distribution of profit • One type of shareholder return • Payment is at discretion of company directors • Dividends are not tax deductible à paid from profits after tax • Retained earnings (profits) are funds not distributed to shareholders • Used to finance expansion • Accumulated retained earnings is total of past retained earnings Shareholder rights • Dividend rights: − Shareholders receive an amount calculated as dividend per share multiplied by number of shares owned • Voting rights: − Board, significant changes in business • Asset rights: − Residual claim to assets after all debts have been paid • Participate in rights issues Equity • Equity can be raised in ways which include the following: − Primary issue − Rights issue − Private placement • Type of equity − Ordinary shares/common stock − Preference shares à certain preferences compared to ordinary shares Primary Issue • Sale of new shares à Initial Public Offering (IPO) • Corporate adviser appointed − Marketing valuation
• •
•
•
•
− Which price would you advise to sell at? à the estimated market price à above the estimated market price à below the estimated market price Corporations Act requires a prospectus Usually also apply to become listed on the stock exchange − Expensive way to obtain finance − Corporate advisory, legal, accounting fee Underwriter sometimes appointed − Must purchase unsold shares − Part of underwriting agreement − Ensures firm obtains required finance Advantages: − Access to capital markets − Raises the firm’s profile − Align managers’ goals with shareholders’ − Market valuation − Institutional investment Disadvantages: − Dilute control of existing owners − Directors have additional responsibility à act in interests of all shareholders − Greater demand for disclosure of information − Increased cost
Preference Shares • Different to ordinary shares according to preferences à Preferential treatment for dividends à preferential treatment in liquidation • Usually a fixed dividend, but can be variable • Sometimes considered as debt finance − Regular payments and redeemable − Legally, equity • Expected return on preference shares lower than return on equity Preference Shares conditions • Cumulative − Any dividend not paid is carried forward − Must be paid before ordinary shareholders can be paid • Non cumulative: no such rights • Voting − Can vote in relation to the company’s affairs – may be limited • Non-‐voting – no say in company’s affairs • Redeemable − Face value is repaid at a later date − Funds must be from equity • Non-‐redeemable – no obligation to repay
Rights Issue • Secondary issue of shares to existing shareholders • Shareholders offered right to buy new shares • Number of new shares based in proportion to the current number owned (i.e. pro rata) à ‘1 for 2’, ‘1 for 7’ • Percentage shareholding is not diluted • May be underwritten • Shareholders can sell right if the issue is renounceable • Set the terms of the issue so there is an incentive for shareholders to take up their rights − Subscription price below current share price − Price should not be too low because it causes excessive dilution of existing share value Trading on securities exchange • When rights issue announced, shares trade cum-‐rights (“with” rights) à buyer of the shares are entitled to the rights • After a period of time, shares trade ex-‐rights (“without” rights) à buyer not entitled to the rights • Shareholders have a period of time to decide whether or not to purchase new shares Rights valuation • The price of a share when it trades ex-‐rights is related to: − M= current market price of existing shares − S= subscription price of the new shares − N= number of existing shares that entitles the shareholder to one new share • The value of a right – this is the price at which rights holders should be able to sell their rights if they don’t want to buy the new shares: R = N (M-‐S)/(N+1) Ex-‐rights price • The ex-‐rights share price – this is the price at which existing shares are expected to trade after the ex-‐rights date: Px = M – (R/N) or Px = S + R
Private placement • Issue of shares to an individual or group − May or may not be shareholder of firm − Usually sold to institutions or investors considered friendly or fun • Advantages: − Quicker to implement and for smaller amounts − Greater certainty in pricing − Placed in friendly hands − Lowest costs for issuer • Disadvantages: − Dilutes interest of existing shareholders − Can lower share price à issued at a discount to market price − Cannot place more than 15% of total equity without shareholder approval Valuation of shares • Constant dividend model • Dividend growth model Equity Valuation • Value of a company’s shares à Equal to discounted cash flows • Future cash flows à dividends • Capital is not repaid • Equity mature not mature à dividends are perpetual (continue throughout the life of the firm) • Dividends are not usually constant • Current value of a share is present value of all future dividend payments Constant dividend model
Example 1: A company has just paid a dividend of $0.50 and its not expected to change. The current share price is $4.50. What is the rate of return that investors require to invest in the company? Po = D/r $4.50 = $0.50/r r= 11.11% Constant Growth Model (Dividend Growth Model) • If dividends are expected to change at a constant rate, and the rate is less than the discount rate, then the share price is given by: Example 2: A company just paid it dividend of $0.60. Its required rate of return in 25%. The company expects its dividends to grow by 8% indefinitely. What is the current value of the shares? Po= D1/(r-‐g) =0.60 (1+0.08)/(0.25-‐0.08) = $0.648/0.17 = $3.81
Lecture 6: Capital Budgeting 1 • Financial managers objective – maximize shareholder wealth • Success of a business depends on the investment decisions made today • Investment decision − Projects generate future uncertain cash flows − Estimation of cash flows is difficult − First need to identify valuable investments Balance Sheet Assets = Investment decision à Must produce income to pay debt and equity Liabilities and Equity = Financing decision à Debt Investment Decision • Assets normally represent large commitments of resources à A need for working capital • Fixed assets have a long lifespan à Forecast incremental cash flows • Future growth of the firm relies on good projects à Allocating scarce resources • Directors responsible for final decision à Accountable for all decisions • All investments have costs à Working Capital (stock) à New buildings and/or plant à Replacement decisions – now or later • All investments should have benefits à Increased sales à Reduced costs (lower inventory required) à Improved productivity • Costs and benefits are measured in terms of cash flow Evolution of Investments • Generation of proposals • Evaluations and selection of capital projects 1. Assembly of data 2. Forecasts of cash flows 3. Timing of cash flows • Approval and implementation • Monitoring • Selection – judged in relation to whether it provides a return at least equal to that required by investors • Most important step is estimation of future cash flows • Quality of decision depends on the quality of cash low estimates àpreparation of submissions should be unbiased
Accounting Rate of Return (ARR) • Measure of efficiency à Ration of income to asset cost • ARR = Average Net Profit / (initial cost + salvage)/2 • The result is compared to some pre-‐set return the company require − If ABOVE or EQUAL à ACCEPT − If BELOW à REJECT Example: A firm can buy a machine costing $18,000 and this will result in an increase in its net cash flows by $5,600 per year for 5 years. At the end of 5 years, the machine will have no value. Assume straight-‐line depreciation of$3,600 per year. What is the accounting rate of return? Accounting profit = 5,600 -‐3,600 = 2,000 per year Average Book Value = ($18,000 +0)/2 =9,000 ARR = 2,000/9,000 = 22% • Advantages: − Simple to calculate − Profit figures are usually available − Considers income for each year of the project’s life • Disadvantages: − Time value of money is ignored à All cash flows are given equal weight − Related to net profit (differs from actual cash flow) − Profit dependent on depreciation changes à Can be arbitrary and not related to replacement costs − ARR ignores required rate of return − Does not consider risk − Cut-‐off rate is subjective Payback Period • Simplest and one of the most frequently used methods • The length of time required for investment’s stream of cash flows to equal the investments initial cost • Determined by adding he expected cash flows for each year until the total equals original outlay • ACCEPT a project if payback period < specified payback period • REJECT a project if payback period > specified cut off • Income beyond payback date is ignored Example: (Using example 1), the investment cost $18,000 and the cash flows are $5,600 for 5 years. Payback period = 18,000/5,600 = 3.2 years After 3 years cumulative cash flows are: %5,600x3 = $16,800 An additional $1,200 cash flow is needed during year 4 to reach break-‐even point. Assume the cash flows within each year are spread evenly throughout the year 1,200/5,600 = 0.2years – breakeven occurs 20% of the way through the 4th year
•
•
Advantages: − Relatively simple to calculate − Provides an insight into risk à Shorter payback = less risky − Used for small investment amount − Useful as supplementary information − A measure of liquidity Disadvantages: − Fails to give any consideration to cash flows after payback − Time value of money is ignored − Selection of cut-‐off period for acceptance is arbitrary − Biased against projects which don’t yield the highest cash flows for a number of years − Does not always maximize shareholders’ wealth
Discounted Payback • Can use a discounted payback – cash flows are converted to present values • Calculate the payback period • Removes one
• • •
Financial decision: HOW to pay à Capital structure Working Capital decision à Short term assets and liabilities Each task requires planning and forecasting – keep to the themes of sustainability and ethics
The Investment Decision • How to determine the value to the business of a long term asset • Evaluate size, time and risk of cash flows • Select the assets that create most shareholder wealth • Composition of assets which will best facilitate the operations of the firm • Hard to reverse if wrong The Financial Decision • How to finance an investment? • Determine the best mix between − Debt: (loans funds) à contractual claim on business assets − Equity: (owner’s funds) à residual claim on business assets • Trade-‐off between risk and return • Use of debt is called gearing or leverage (more debt means higher gearing or higher leverage) The Working Capital Decision • Managing short-‐term assets and liabilities − Forms part of the investment decision − Inventory management − When to allow credit sales? − When to pay suppliers? Forms of Business • Sole trader/Proprietorship − Individual owner – may employ other people − Unlimited liability − Success or failure relies on the individual owner − Raising debt finance usually from financial institutions − Equity component limited to sole trader’s wealth – tend to be undercapitalized − Life is limited – lasts as long as the owner is alive or until owner sells business • Partnership − Similar to sole trader except several individuals − All share in gains and losses − Characterized by a partnership agreement − If one wants to leave, partnership ends
•
Company − Most important form − Separate legal entity − Unlimited life − Many formal and legal requirements − Limited liability for shareholders – not liable for company debts beyond their investments − Superior form when raising capital − Few companies are listed on stock exchange à problems with size of firm and control
Corporate Governance • Objectives of management may differ from that of shareholders • Managers may be satisfied rather than maximized àManagement play it safe, rather than maximizing the value of the firm • Management are agents for the owners • Introduces a potential conflict àAgency problem à Ethical decision making • Management only make optimal decisions if adequately compensated − Incentive payments − Share options, bonuses • Efficient capital markets provide signals about the value of a company’s shares à reflection of the performance of its managers • Maximization of shareholder wealth is the appropriate goal for managers of a firm Principal and Agent Law • Agency law is part of commercial law • Agency law: a contractual relationship between a person (the agent) who is authorized to act on behalf of another (the principal) • Agent can create a legal relationship with a third party • Creation of agency: − Expressly in writing or verbally − Implied by law à as part of a necessity or by cohabitation, by status (such as a partnership) or working relationship • Employer – employee relationships • Not all employees are agents for the employer • This will depends on the type of work carried out − Sales people are agent for the employer as they are arranging sales − Managers tend to be agent as they enter into contracts for the employer • Agents can be Special, General or Universal • Duties of an agent: − Follow principal’s instructions − Act personally (not delegate to one)
− − − −
Exercise reasonable skill and diligence Act in the principal’s best interest Not to make a secret profit Not divulge confidential information
Financial Markets Role of Financial Markets • Facilitates transactions in financial securities • Markets exists to efficiently allocate funds for alternative uses • Without efficient financial markets à funds would lay idle à good investment opportunities may not be able to be financed Primary Market • Security or instrument issued to an investor for the first time eg. New car dealers • Funds are raised by the firm and flow to it • Fund raising between investors and firm • Can be debt or equity funding • Public offering: equity offered to any interested investor • Private placement: equity offered only to selected parties Secondary Market • Financial securities that are already issued are bought and sold eg. Used car dealer eg. Securities exchange – Australian Securities Exchange ASX • Financial security: piece of paper that states what is owed and when it will be repaid • Investor-‐to-‐investor trading • No additional funds are raised by the firm Financial Statements • Firms produce financial statements for their owners − Balance sheet − Income statement − Cash flow statement
•
Annual report produced after the event − Contains director’s commentaries − Reduced impact under ASX continuous disclosure regulations
Balance Sheet • Reflects the position of a company at a point in time • Cash and other assets − Listed in liquidity order (ease of converting to cash) − Amount of cash they raise depends on type of asset • Balance sheet identity Ø Assets – Liabilities = Equity • Net Working Capital = Current Assets – Current Liabilities Market Values and Book Values • Balance sheet is historical accounting • Real or productive assets à produce the cash flows over time • Financial or paper assets à claim on cash flows of productive assets • Balance Sheet for finance à no concerned with past à what is the value of the asset today? (market value)
Income Statement • For a period of time • Lists income received and costs incurred in producing that income • Due to different accounting treatments the net income (profit) may be different to actual cash flows à Expenses such as depreciation or amortization are not a cash flow Cash Flow Statement • Reveals where the funds came fro and what they were applied to • Identifies sources and uses of funds/cash − Increase in assets = use of funds − Decrease in liability = use of funds − Increase in liabilities = source of funds − Decrease in assets = source of funds • Various ways that cash flows can be viewed • Accounting and finance perspectives differ
Lecture 2: Time Value of Money 1 Time Value of Money • The financial manager makes decisions about proposals with cash flows over periods of time. • An important consideration is the timing of these cash flows -‐ The time value of money must be recognized • It is based on the fact that a dollar today, is worth more than a dollar tomorrow. -‐ Prefer $5million today or $5million in one year? Example 1 • I invest $1000 in a bank today for a period of one year and the interest rate id 5% pa. à How much will I have in the bank next year? -‐ Interest = $1000 x 5% (or 0.05) = $50 -‐ Add interest to the original investment $1000 + $50 = $1050 Variables • A dollar amount today -‐ Present value àAnd an interest rate àAnd a period of time à Gives a dollar ‘n’ the future -‐ Future value Terminology PV = Present Value i = interest rate per period sometimes we use ‘r’ n = number of periods, sometimes we use ‘t’. FV = Future Value PMT = Periodic Payment
Simple Interest • Calculated on the original principal -‐ Takes no account of changes in principle -‐ Sometimes called Flat Rate interest • Used in valuation of short term financial instruments in the money market -‐ Terms (time period) under 12 months -‐ Securities are usually called Bills Future Value with Simple Interest FV = PV + INT FV = future value at end of the term PV = Principal interest at beginning INT = Interest in dollar terms over the time period INT = PV x i x n i = simple interst rate per year n = number of years FV = PV + PV x i x n = PV (1 + i x n ) Present Value with Simple Interest PV = FV / ( 1 + i x n) Example 2 What is the future value of $100,000 invested for 180 days at 10% pa simple interest FV = PV (1 + i x n) = 100,000 (1 + 10% x 180/365) = 100,000 (1+ 0.0493) = $104,930 Compound Interest • Interest earned in one period is added to the principal to form a new principal on which the next calculation of interest is based -‐ The calculation • The calculationà lots of calculations • Interest is computed at the end of each period on the starting principle of the period. • Interest is added to the principle each period -‐ Interest on interest -‐ Called compounding • The compounding period can be any designated length of time -‐ Yearly, half-‐yearly, quarterly, monthly Remember: Simple interest is calculated only on the original amount
Future Value FV = PV ( 1 + i ) ^ n Where: i = interest rate per period n = the number of compounding periods PV = the original principal Example 3 Alice deposits $1000 today in a savings account that pays interest once a year. How much will Alice have in three years if he interest rate is 12%pa? Year Opening Balance Interest Closing Balance 1 1000 120 1120 2 1120 134 1254.40 3 1254.40 150.53 1404.93 à Interest = Opening balance x interest rate i.e. 1000 x 12% = 120.00 FV= PV ( 1 + i )^n = 1000(1+0.12)^3 = 1404.93 Using the calculator Example 4 You own bank fixed term deposits that guarantees to pay you $230,000 in six years time, however you are not prepared to wait. What amount of cash would you receive today if someone buys the fixed term deposit today? The buyer applies a discount rate of 20% pa ( in this context to discount means to subtract the interest from the future value to calculate the present value) Discount rate = interest rate FV=230,000 I = 20% N= 6 PV= FV (1 + i )^-‐n = 230,000 (1 + 0.20) ^-‐6 = $77,026.53 Using the Calculator 2nd F ; CA ; 230,000 ; PV ; 20 ; I/Y ; 6 ; N ; COMP ; PV
Frequency of compounding • Interest rate normally quoted as per annum but the compounding frequency is not always annual. • A nominal rate is when interest is compounded more frequently than annually. • If the compounding period is not annual the rate in the calculations must be adjusted to the rate per compounding period. à E.g. 16% pa compounded monthly – the nominal rate is not the same as 16% pa. Example 5 What is compounding rate for each time period for an 18% annual interest rate, compounding monthly? The number of compounding periods each year is 12 -‐ Rate per period = 18% = 12 = 1.5% Example 6 Two years ago, a company invested $32,000 in a bank account with an interest rate of 14% pa compounding quarterly. The investment matures in five years time from today. à What is the value of this investment in five years time? PV = 32,000 N = (2+5) x 4 = 28 i = 14/4 = 3.5% FV = PV (1 + i ) ^n FV= 32,000 (1.035) ^ 28 = $83,845. 50 Using the calculator 2nd F ; CA ; 32,000 ; PV ; 2.5 ; I/Y ; 28 ; N ; COMP ; FV Effective Annual Rates (EAR) • An effective rate is an interest arte that compunds annually (once a year) • To convert a nominal rate to an effective rate EAR = (1 + i ) ^m-‐1 M = number of compounding periods per year i = interest rates per period Example 7 Which interest rate is higher? • 12.5% annual interest rate, compounded half yearly, or • 12.3% annual interest rate, compounded monthly • Convert both nominal rates to EARs à EAR = (1 + i )^m-‐1 = (1 + 0.625)^2-‐1 = 12.89% à EAR = (1 + i )^m-‐1 = (1 + 0.1025) ^12-‐ 1 = 13.02%
Example 8 A company has the opportunity to buy an asset today for $70,000 The company expects to be able to sell his asset in three years for $87,500 The company wants to earn 9.5% pa on its investment. Should the firm buy the asset? i = 9.5% PV = *7500 (1 + 0095)^3 = $66,644.71 à The firm should not buy the asset for $70,000 because in order to earn 9.5% pa it should pay only $66,644.71 Using the calculator FV ; 87500 ; N ; 3 ; I/Y 9.5 ; COMP ; PV Example 9 • Thunderbirds Production Company (TPC) is offering investors an opportunity to invest in its movie production business • TPC is asking investors to invest $5 000 now and $4,000 in two years’ time • TPC has projected the cash inflows from its movie to investors would be $6,000 in year four, $2,500 in year six and a final amount in year eight of $2,000 • Investments with similar risks have a return of 20% pa. Ø Is it worth investing in the TPC project? CASH FLOWS: -‐5000 -‐4000 6000 2500 2000 |___|___|___|___|___|___|___|___| 0 1 2 3 4 5 6 7 8 • -‐5,000 = -‐5,000 PV of Year 0 cash flow • -‐4,000(1.2)-‐2 = -‐2,778 PV of Year 2 cash flow • +6,000(1.2)-‐4 = 2,894 PV of Year 4 cash flow • +2 500(1.2)-‐6 = 837 PV of Year 6 cash flow • +2,000(1.2)-‐8 = 465 PV of Year 8 cash flow • Total of Present Values = -‐$3,582 Thunderbirds is a poor investment because the PVs of the positive cash flows are less than the PVs of the negative cash flows!
Lecture 3: Time Value of Money 2 Annuities • A special case of multiple cash flows • A number of EQUAL cash flows occurring at EQUAL time intervals • An ordinary annuity assumes all cash flows occur at the end of each period Future Value Formula Example 1: Jim plans to deposit $250 each month for the next 7 years at an interest rate at 6% pa compounded monthly. What is the accumulated value? Example 2: You must pay $7,500 for medical expenses in five years. You want to deposit an equal amount each quarter to satisfy this expense. If the interest rate is 8% pa compounded, how much should you deposit each quarter?
Present Value of Annuities • The present value is calculated at the beginning of the annuity period • Assumes the first payment made is at the end of the first period − Beginning of period one = time zero − Beginning of period three = end of period two ⎡1 − (1 + i)− n ⎤ PV = PMT ⎢ ⎥ i
⎣
⎦
Example 3: What is the present value of a series of $100 payments received at the end of each month for 10 years? The interest rate is 18% pa compounded monthly? Example 4: You require $350,000 to buy a house. The bank will lend you the money with a repayment period of 15 years at an interest rate of 6% ps compounded monthly. What are your monthly loan repayments? Example 5: NSW lotteries offers an instant lottery ticket with a maximum prize of $1,000,000. The prize winner receives $500,000 immediately and $50,000 at the end of each year for the next 10 years. If money is work 10% pa, what is the true value of the $1,000,000 prize? Perpetuity • A special type of annuity − A perpetual annuity − Continues forever • Present value of an annuity PV = PMT (1-‐ (1+i)^-‐n / i à as n approached infinity, (1+i)^-‐n approaches 0 • PV of perpetuity PV = PMT / i • There is no future value
Example 6: What amount would have to be invested today to provide $7,000 each year forever? Assume that you can earn a return of 7% pa. PV = PMT / i PV = 7,000 / 0.07 = $100,000 Example 7: Jason will receive $500 forever with the first $500 received exactly 5 years from today. If the interest rate is 13% pa, what is the value today of this series of cash flows? Example 8: Your brother just graduated from UTS and begun employment with an investment bank. He intends to retire in 35 years’ time and wants to withdraw $20,000 annually starting at t=36 for the next 30 years. Interest rate is 7.5% per annum. What is the equal yearly deposit your brother must save during his 35 year working life?
Lecture 4: Debt and Valuation Introduction • Contractual rather than residual claim • Commits firm to interest principal repayments (equity has no commitments) • No voting power (equity has voting power) • Interest payments (none with equity) -‐ Business expense: tax deductible • Unpaid debt is a iability of the firm • Debt is a loan of money to be repaid in the future (equity not repayable) Key distinguishing features • Maturity: Short-‐term or long –term debt • Security: Secured or unsecured • Ranking: Subordinate or senior • Interest rate: fixed rate, floating rate or combination • Repayment pattern: interest only, principal and interest, capitalized interest • Currency: Domestic (AUD), foreign • Source: markets or financial institutions Risk associated with Debt • Interest Rate Risk: changes in prices of debt due to interest rate changes • Default Risk: insufficient cash to make interest and/or principal repayments • Currency Risk: changes in prices of debt due to movements in exchange rates Loan Security and agreements • Many forms of security: - Floating charge over assets of firm - Mortgage over land/buildings - Specific charge over an asset • Loan agreements - Positive and negative covenants à Maintain minimum financial ratios à Can’t sell certain assets without consent - Guarantees Short Term Debt • Securities with a term of less than one year • Instruments in the money raise funds when they are first issued - Purchaser is lender and issuer is borrower • Types of short-‐term debt: - Commercial Bills - Promissory Notes - Overdrafts
Commercial Bills • Also called bills of exchange • Source of short-‐term finance for companies • A bill must state - Amount payable (face value) and date payable • Bills are discount instruments - Issued at a price less than their face value - Do not make an explicit interest payment - Interest is the difference between the security’s price and face value Legal implications of bills • They are a negotiable instrument that mean there are legal rights attached to the bill • They can be transferred from one person to another - The new holder has “good” title • A bill is a safe substitute for money • Document which provides proof • Parties to a bill are not liable for the debt unless they have signed it Legally a bill is • An unconditionally order in writing • Addressed by one person to another • Signed by the person to whom it is addressed to pay on demand, or at a fixed determinable future time: - A sum certain in money to or to the order of a specified person, or to bearer Parties to a bill – Acceptor • Provides an acceptance (guarantee) of the credit facility to be offered • Acceptor agrees to accept the bill and pay the holder its face value at maturity • The bill is retired (cancelled) once it has been paid • Considered as a guarantor by lenders - May hold bill and provide funds to drawer Parties to a bill – Drawer • The drawer is the party that want the funds-‐ also called the issuer of the bill or the borrower • The drawer’s liability is secondary to the acceptor (guarantor) - If the acceptor dishonors payment the drawer will compensate the holder • Liability to repay the bill is the responsibility of the acceptor - The drawer agrees to repay the acceptor
Parties to a bill-‐ Discounter • Discounter (also called investor or lender) initially provides cash to the drawer - Buys the bill at a discount to its face value • May sell the bill before maturity - If discount sells the bill must endorse (sign) it: - Agrees to compensate the holder in the event of its dishonor • Bill can be traded until it matures Bill facility • Borrower can raise funds for longer periods through a bill facility • A bill facility is a sequence of bills - When the first bill matures it is ‘rolled over’ by issuing second bill with the same face value for the same period (e.g. 90 days). - The new bill is issued at the prevailing interest rate à Which may be different form the rate when the first may issued. à Therefore, the discounted value if the second bill may be different from the discounted value of the first bill, even through the face value is the same. Example A two year bill facility financed on 180 day terms would have three roll-‐overs – at 180, 360 and 540 days. After 2 years (720 days) the last bill would be repaid and no new bill issued. Long-‐Term Debt • Long term debt provide funds for longer than one year - Public (government) or private (company) funding • Australian market is mainly government bonds - Companies tend to use overseas debt-‐capital markets • Long term debt is generally in the form of term loans or bonds Features of a Bond • Long term securities - Pay a fixed amount of interest at specified dates - Redeemed at maturity by payment of their à Face value - Interest payment made periodically and on the maturity date Corporate Bonds • Issued to the public - Requires a prospectus • Secured debt - Specific or floating charge over assets of firm • Usually has a trust deed and trustee
• Unsecured debt has all above features but no security Foreign Currency Loans • Firm borrows money in a currency different to its home country’s currency - Used to finance overseas ventures - Or assets that generate overseas sales - Adds currency risk to a firm Convertible Bonds • Debt that can be swapped into equity at a predetermined price before maturity - Advantage to holder is if share price increase above conversion price - Has a lower interest rate than conventional debt - Often subordinated to indicate ranking in event of company failure Valuing Short-‐Term Debt • Securities with a term less than one year are usually discounted securities - No explicit interest paid. Interest is the difference between face value and purchase price • Valuation (uses SIMPLE INTEREST): PV = FV / (1 + rt) r = annual interest rate t = time (measured in years) to maturity Example A trader at a market rate of 8% pa purchases a bank bill originally issued with 180 days to maturity and a $100,000 face value. It has 120 days until maturity. PV = FV / (1 + rt) PV = 100,000 / (1 + 0.08 * 120/365) = $97,437.27 • Price of security increases as term to maturity shortens • PV/price approaches Future Value/Face Value Valuing Bonds • Bonds are an example of long term debt • A firm sells a bond to raise capital/funds • Bonds are fixed income securities - Pay constant amount of interest at regular time intervals - Repay an amount at maturity • The regular interest payments are called coupons
Parts to a bond valuation • Valuing a bond requires - The number of periods to maturity - The face value - The coupon amount - The market interest rate • The coupon payment is the coupon rate multiplied by the face value - The present value of all the coupon payments is found by using an annuity formula • The market interest rate, or yield to maturity (YTM), fluctuates Example A bond has a face value of $10,000. There are three years to maturity and the coupon rate is 7% pa and coupons are paid semi-‐annually. What is the coupon payment? PMT = 7% / 2 x 10,000 = $350 What is the number of coupons remaining? n = 3 x 2 = 6 Bond Valuation • Timeline for a bond’s cash flows FV PMT PMT PMT PMT PMT |_______|_______|_______|__......___|_______| 0 1 2 3 n-‐1 n Bond valuation formula
⎡1 − (1 + i)−n ⎤ PV = PMT ⎢ + FV(1 + i)−n ⎥ i ⎣ ⎦
Using the calculator FV; PMT ; N ; I/Y ; COMP ; PV Example What is the price of a bond that was issued two years ago and has eight years to maturity? • Coupons are paid half yearly and a coupon payment was made today. • The coupon rate is 5% pa and the current market yield is 6% pa. • The face value is $200,000
Number of payments per year = 2 FV = $200,000, coupon rate = 5% pa PMT = $200,000 x 0.05/2 = $5,000 What is the market yield? i = 6%/2 =3% Years to maturity = 8 Number of compounding periods = 2 x 8 = 16 Bond Values and Yields • In previous example the bond price is less than the face value, this is known as a discount bond. - As the market rate is greater than the coupon rate, the market price is less than face value. - If the market rate is less than the coupon rate then the bond trades at a premium Coupon Rate < YTM < Face Value = Discount Bond Coupon Rate = YTM = Face Value = Par Value Bond Coupon Rate < TYM > Face Value = Premium Bond Example What is the price of a bond if: The bond has a face value of $100,000 and has five years until maturity. It has a coupon rate of 5% p.a. payable semi-‐annually? Step 1 Calculate the coupon payments and term Coupon Pmt’s =$100,000 x 5% ÷ 2 = $2,500 Term = 5 x 2 = 10 A) Yield is 6% p.a. compounding semi-‐annually n=10; i=?; FV=100,000; PMT=2,500 Price at 6% = $95,734.90 If coupon rate < Yield then Price < Face value = Discount Bond B) Yield is 5% p.a. compounding semi-‐annually Price at 5% = $100,000.00 If coupon rate = Yield then Price = Face Value = Par Value Bond C) Yield is 4% p.a. compounding semi-‐annually Price at 4% = $104,491.29 If coupon rate > Yield then Price > Face Value =Premium Bond
Yield to Maturity • A bonds price, coupon rate and maturity date are easily observed • However, the yield is not so easily found • Yield to maturity is the discount rate which equates the present value of all future coupon payment and the face value with the market price. Example A bond with a face value of $100 matures in five years. The current price is $96.50 and the annual coupon payments are $12.50. What is the YTM? 100 96.50 12.50 12.50 12.50 12.50 12.50 |_______|_______|_______|_______|_______|_________| 0 1 2 3 4 5
⎡1 − (1 + i ) −5 ⎤ −5 96.50 = 12.50 ⎢ ⎥ + 100(1 + i ) i ⎣ ⎦ i = 13.51%
Example Centurion Ltd has a 90-‐day bank bill facility with ANZ. Today, Centurion wants to sell $1,000,000 worth of bank bills to fund an increase in inventory. The current market yield on 90-‐day bank bills is 6.37% pa. A) Who is the drawer of this Bill? Centurion Ltd B) Who will pay the face value of $1,000,000 at Maturity? ANZ Bank
Lecture 5: Equity and Valuation Equity • Permanent Risk Capital − No assurance owners will profit − Not repayable • Most important source of funds − All companies must have equity • Limited liability • Shareholders have a residual claim on company assets • Publicly listed companies trade on the Australian Securities Exchange ASX Dividends • Represent a distribution of profit • One type of shareholder return • Payment is at discretion of company directors • Dividends are not tax deductible à paid from profits after tax • Retained earnings (profits) are funds not distributed to shareholders • Used to finance expansion • Accumulated retained earnings is total of past retained earnings Shareholder rights • Dividend rights: − Shareholders receive an amount calculated as dividend per share multiplied by number of shares owned • Voting rights: − Board, significant changes in business • Asset rights: − Residual claim to assets after all debts have been paid • Participate in rights issues Equity • Equity can be raised in ways which include the following: − Primary issue − Rights issue − Private placement • Type of equity − Ordinary shares/common stock − Preference shares à certain preferences compared to ordinary shares Primary Issue • Sale of new shares à Initial Public Offering (IPO) • Corporate adviser appointed − Marketing valuation
• •
•
•
•
− Which price would you advise to sell at? à the estimated market price à above the estimated market price à below the estimated market price Corporations Act requires a prospectus Usually also apply to become listed on the stock exchange − Expensive way to obtain finance − Corporate advisory, legal, accounting fee Underwriter sometimes appointed − Must purchase unsold shares − Part of underwriting agreement − Ensures firm obtains required finance Advantages: − Access to capital markets − Raises the firm’s profile − Align managers’ goals with shareholders’ − Market valuation − Institutional investment Disadvantages: − Dilute control of existing owners − Directors have additional responsibility à act in interests of all shareholders − Greater demand for disclosure of information − Increased cost
Preference Shares • Different to ordinary shares according to preferences à Preferential treatment for dividends à preferential treatment in liquidation • Usually a fixed dividend, but can be variable • Sometimes considered as debt finance − Regular payments and redeemable − Legally, equity • Expected return on preference shares lower than return on equity Preference Shares conditions • Cumulative − Any dividend not paid is carried forward − Must be paid before ordinary shareholders can be paid • Non cumulative: no such rights • Voting − Can vote in relation to the company’s affairs – may be limited • Non-‐voting – no say in company’s affairs • Redeemable − Face value is repaid at a later date − Funds must be from equity • Non-‐redeemable – no obligation to repay
Rights Issue • Secondary issue of shares to existing shareholders • Shareholders offered right to buy new shares • Number of new shares based in proportion to the current number owned (i.e. pro rata) à ‘1 for 2’, ‘1 for 7’ • Percentage shareholding is not diluted • May be underwritten • Shareholders can sell right if the issue is renounceable • Set the terms of the issue so there is an incentive for shareholders to take up their rights − Subscription price below current share price − Price should not be too low because it causes excessive dilution of existing share value Trading on securities exchange • When rights issue announced, shares trade cum-‐rights (“with” rights) à buyer of the shares are entitled to the rights • After a period of time, shares trade ex-‐rights (“without” rights) à buyer not entitled to the rights • Shareholders have a period of time to decide whether or not to purchase new shares Rights valuation • The price of a share when it trades ex-‐rights is related to: − M= current market price of existing shares − S= subscription price of the new shares − N= number of existing shares that entitles the shareholder to one new share • The value of a right – this is the price at which rights holders should be able to sell their rights if they don’t want to buy the new shares: R = N (M-‐S)/(N+1) Ex-‐rights price • The ex-‐rights share price – this is the price at which existing shares are expected to trade after the ex-‐rights date: Px = M – (R/N) or Px = S + R
Private placement • Issue of shares to an individual or group − May or may not be shareholder of firm − Usually sold to institutions or investors considered friendly or fun • Advantages: − Quicker to implement and for smaller amounts − Greater certainty in pricing − Placed in friendly hands − Lowest costs for issuer • Disadvantages: − Dilutes interest of existing shareholders − Can lower share price à issued at a discount to market price − Cannot place more than 15% of total equity without shareholder approval Valuation of shares • Constant dividend model • Dividend growth model Equity Valuation • Value of a company’s shares à Equal to discounted cash flows • Future cash flows à dividends • Capital is not repaid • Equity mature not mature à dividends are perpetual (continue throughout the life of the firm) • Dividends are not usually constant • Current value of a share is present value of all future dividend payments Constant dividend model
Example 1: A company has just paid a dividend of $0.50 and its not expected to change. The current share price is $4.50. What is the rate of return that investors require to invest in the company? Po = D/r $4.50 = $0.50/r r= 11.11% Constant Growth Model (Dividend Growth Model) • If dividends are expected to change at a constant rate, and the rate is less than the discount rate, then the share price is given by: Example 2: A company just paid it dividend of $0.60. Its required rate of return in 25%. The company expects its dividends to grow by 8% indefinitely. What is the current value of the shares? Po= D1/(r-‐g) =0.60 (1+0.08)/(0.25-‐0.08) = $0.648/0.17 = $3.81
Lecture 6: Capital Budgeting 1 • Financial managers objective – maximize shareholder wealth • Success of a business depends on the investment decisions made today • Investment decision − Projects generate future uncertain cash flows − Estimation of cash flows is difficult − First need to identify valuable investments Balance Sheet Assets = Investment decision à Must produce income to pay debt and equity Liabilities and Equity = Financing decision à Debt Investment Decision • Assets normally represent large commitments of resources à A need for working capital • Fixed assets have a long lifespan à Forecast incremental cash flows • Future growth of the firm relies on good projects à Allocating scarce resources • Directors responsible for final decision à Accountable for all decisions • All investments have costs à Working Capital (stock) à New buildings and/or plant à Replacement decisions – now or later • All investments should have benefits à Increased sales à Reduced costs (lower inventory required) à Improved productivity • Costs and benefits are measured in terms of cash flow Evolution of Investments • Generation of proposals • Evaluations and selection of capital projects 1. Assembly of data 2. Forecasts of cash flows 3. Timing of cash flows • Approval and implementation • Monitoring • Selection – judged in relation to whether it provides a return at least equal to that required by investors • Most important step is estimation of future cash flows • Quality of decision depends on the quality of cash low estimates àpreparation of submissions should be unbiased
Accounting Rate of Return (ARR) • Measure of efficiency à Ration of income to asset cost • ARR = Average Net Profit / (initial cost + salvage)/2 • The result is compared to some pre-‐set return the company require − If ABOVE or EQUAL à ACCEPT − If BELOW à REJECT Example: A firm can buy a machine costing $18,000 and this will result in an increase in its net cash flows by $5,600 per year for 5 years. At the end of 5 years, the machine will have no value. Assume straight-‐line depreciation of$3,600 per year. What is the accounting rate of return? Accounting profit = 5,600 -‐3,600 = 2,000 per year Average Book Value = ($18,000 +0)/2 =9,000 ARR = 2,000/9,000 = 22% • Advantages: − Simple to calculate − Profit figures are usually available − Considers income for each year of the project’s life • Disadvantages: − Time value of money is ignored à All cash flows are given equal weight − Related to net profit (differs from actual cash flow) − Profit dependent on depreciation changes à Can be arbitrary and not related to replacement costs − ARR ignores required rate of return − Does not consider risk − Cut-‐off rate is subjective Payback Period • Simplest and one of the most frequently used methods • The length of time required for investment’s stream of cash flows to equal the investments initial cost • Determined by adding he expected cash flows for each year until the total equals original outlay • ACCEPT a project if payback period < specified payback period • REJECT a project if payback period > specified cut off • Income beyond payback date is ignored Example: (Using example 1), the investment cost $18,000 and the cash flows are $5,600 for 5 years. Payback period = 18,000/5,600 = 3.2 years After 3 years cumulative cash flows are: %5,600x3 = $16,800 An additional $1,200 cash flow is needed during year 4 to reach break-‐even point. Assume the cash flows within each year are spread evenly throughout the year 1,200/5,600 = 0.2years – breakeven occurs 20% of the way through the 4th year
•
•
Advantages: − Relatively simple to calculate − Provides an insight into risk à Shorter payback = less risky − Used for small investment amount − Useful as supplementary information − A measure of liquidity Disadvantages: − Fails to give any consideration to cash flows after payback − Time value of money is ignored − Selection of cut-‐off period for acceptance is arbitrary − Biased against projects which don’t yield the highest cash flows for a number of years − Does not always maximize shareholders’ wealth
Discounted Payback • Can use a discounted payback – cash flows are converted to present values • Calculate the payback period • Removes one
