LECTURE 1 :CHAPTER 1 Introduction to Financial Management
LECTURE 1A :CHAPTER 1 Introduction to Financial Management
Forms of Businesses Goals of the Corporation Stock Prices and Intrinsic Value Conflicts Between Managers and Shareholders 1-1
Alternative Forms of Business Organization
Proprietorship
Partnership
Unincorporated business owned by one individual Legal arrangement between 2 or more persons to do business together
Corporation (listed and unlisted)
Legal entity created that is separate and distinct from its owners and managers
1-2
Proprietorships & Partnerships
Advantages
Easy to set up Subject to few regulations No corporate income taxes
Disadvantages
Difficult to raise capital Unlimited liability Limited life 1-3
Corporation
Advantages
Unlimited life Easy transfer of ownership Limited liability Ease of raising capital
Disadvantages
Higher tax rate (typically) Double taxation: one at corporate level, one on dividends received by individual shareholders Cost of set-up and report filing 1-4
Financial Goals of the Corporation
The primary financial goal is shareholder wealth maximization.
How? Through maximizing stock price Is stock price maximization good or bad for society?
1-5
Factors that affect stock price
Projected cash flows
to shareholders
Timing of the cash
flow stream
Riskiness (Volatility)
20 0 Yr 1
Yr 2
Yr 3
20 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
$200
$200
of the cash flows 1-6
Determinants of Intrinsic Value and Stock Prices (Figure 1-1)
1-7
Stock Prices and Intrinsic Value
Intrinsic value is an estimate of “true” value as calculated by a fully informed analyst based on accurate risk and return data; market price is value based on perceived (possibly incorrect) information as seen by the marginal investor. “True” means the return and risk that most investors expect if they had all information about the company. In equilibrium, a stock’s price should equal its “true” or intrinsic value. To the extent that investor perceptions are incorrect, a stock’s price in the short run may deviate from its intrinsic value. Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run. 1-8
Conflicts Between Managers and Stockholders
Managers are inclined to act in their own best interests (which are not always the same as the interest of stockholders). To help align managerial interests with those of shareholders:
Managerial compensation based on stock’s performance over long-term Direct intervention by shareholders (institutional) The threat of firing by current shareholders The threat of takeover if share price is low/cheap and manager is fired by new shareholders 1-9
LECTURE 1B : CHAPTER 6 Interest Rates
Determinants of interest rates The term structure and yield curves Investing overseas 1-10
Why are interest rates important
Low rates result in cheap funds which are used by companies to increase investments. Low rates encourage consumers to spend more (Why?). Low rate mean new borrowers can borrow larger loan amounts: Why? Low rates leads to mortgage refinancing resulting in more money in borrower’s hands to spend.
You borrow $300,000 mortgage from a bank at a rate of 12% p.a, the monthly installment is $ 4,304 If rates are lower, you can return the $300,000 and reborrow from another bank at 6%. Monthly installment is reduced to $ 3,331. You now have spare cash of $ 973. 1-11
What four factors affect the level of interest rates?
Production opportunities Time preferences for consumption Risk Expected inflation
1-12
What four factors affect the level of interest rates?
Production opportunities:
Affects Demand for funds: those with higher rate of return from investment are more prepared to pay higher cost of borrowing. Limit how much borrower is willing to pay savers in the form of interest rate. If economy booms, more attractive projects means more need for capital. Greater competition for funds pushes up interest rates. Demand for funds declines during recessions. Lesser competition for funds leads to lower interest rates.
Time preferences for consumption
Preference for Current Consumption (Spend Now) vs Future Consumption (Spend Later). If current consumption is preferred, lower savings means less funds available for investment. Borrowers competing for limited funds lead to higher interest rates and lesser investments. 1-13
What four factors affect the level of interest rates?
Risk
Higher risk means higher required rate of return.
Expected inflation
To maintain real purchasing power, higher expected inflation will lead to higher interest rate. Higher oil prices tend to lead to higher expected inflation. Lower US$ exchange rate tends to lead to higher US (imported) inflation. 1-14
Determinants of interest rates r = r* + IP + MRP + DRP + LP r = r* = IP = MRP= DRP = LP =
required return on a debt security real risk-free rate of interest Inflation Premium Maturity Risk Premium Default Risk Premium Liquidity Premium 1-15
Determinants of interest rates r = r* + IP + MRP + DRP + LP r*
=
IP
=
rRF
=
real risk-free rate of interest, is the rate on a riskless security in a world without inflation. Inflation Premium. It is the average expected inflation rate over the life of the security. Although U.S. inflation peaked in 1980, interest rates remained high until 1985 as people feared (expect) another increase in inflation because of past bad inflation experience. r* + IP, is the nominal risk free rate. For short-term, refers to T-Bill nominal rate. For long-term, refers to T-Note or T-Bond nominal rate 1-16
Determinants of interest rates r = r* + IP + MRP + DRP + LP MRP =
DRP =
LP
=
Maturity Risk Premium. Longer bonds face greater price declines when interest rates or inflation spike, hence higher return is required to compensate for this risk. Default Risk Premium. It is the risk of non-payment of interest or principal (Credit Risk). Practically, it depends on the rating of the bonds. Liquidity Premium. Liquidity measures how easily a security can be converted to cash at short notice at reasonable price. LP is low for U.S. Treasuries, large strong firms (liquid assets) but high for small, privately owned firms (illiquid assets). 1-17
Premiums added to r* for different types of DEBT IP S-T Treasury
L-T Treasury
S-T Corporate Bond L-T Corporate Bond
MRP DRP
LP
1-18
Yield curve and the term structure of interest rates
Term structure – relationship between interest rates (or yields) and maturities. The yield curve is a graph of the term structure. The November 2005 Treasury yield curve is shown at the right.
Yield (%) 6 5 4 3 2 1 0 0.25
0.5
2
5
10
30
Maturity (years)
1-19
Constructing the (TR) yield curve: Inflation
Step 1 – Find the average expected inflation rate over years 1 to N: N
IPN
INFL t 1
t
N
1-20
Constructing the yield curve: Inflation Assume inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. IP1 = 5% / 1 = 5.00% IP10= [5% + 6% + 8%(8)] / 10 = 7.50% IP20= [5% + 6% + 8%(18)] / 20 = 7.75% Must earn these IPs to break even vs. inflation; these IPs would permit you to earn r* (before taxes). 1-21
Constructing the yield curve: Maturity Risk
Step 2 – Find the appropriate maturity risk premium (MRP). For this example, the following equation will be used find a security’s appropriate maturity risk premium.
MRPt 0.1% ( t - 1 )
1-22
Constructing the yield curve: Maturity Risk Using the given equation: MRP1 = 0.1% x (1-1) = 0.0% MRP10 = 0.1% x (10-1) = 0.9% MRP20 = 0.1% x (20-1) = 1.9% Notice that since the equation is linear, the maturity risk premium is increasing as the time to maturity increases, as it should be. 1-23
Add the IPs and MRPs to r* to find the appropriate Treasury yield Step 3 – Adding the premiums to r*. rRF, t = r* + IPt + MRPt For short-term, it refers to T-Bill yield For long-term, it refers to T-note or T-bond yield MRP often taken to be zero for T-Bill as it is short-term
Assume r* = 3%, rRF, 1 = 3% + 5.0% + 0.0% = 8.0% rRF, 10 = 3% + 7.5% + 0.9% = 11.4% rRF, 20 = 3% + 7.75% + 1.9% = 12.65% 1-24
Hypothetical (TR) yield curve Interest Rate (%) 15
Maturity risk premium
10
Inflation premium
5 Real risk-free rate
0 1
10
An upward sloping yield curve. Upward slope due to an increase in expected inflation and increasing maturity risk premium.
Years to 20 Maturity 1-25
What is the relationship between the Treasury yield curve and the yield curves for corporate issues?
Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the Treasury curve. The spread (or difference) between corporate and Treasury yield curves increases if the corporate bond has a lower or lousier rating. 1-26
Illustrating the relationship between corporate and Treasury yield curves Interest Rate (%) 15
BB-Rated 10
AAA-Rated
5
Treasury 6.0% Yield Curve
5.9%
5.2%
Years to
0
Maturity 0
1
5
10
15
20 1-27
Pure Expectations Hypothesis
The PEH states that the shape of the yield curve depends on investor’s expectations about future interest rates.
If interest rates are expected to increase, Long-Term rates will be higher than Short-Term rates, and vice-versa. Thus, the yield curve can slope up, down, or even humped (see Fig 6.4). 1-28
Assumptions of the PEH
Assumes that the maturity risk premium for Treasury securities is zero. Long-term rates are a (geometric) average of current and future short-term rates. If PEH is correct, you can use the yield curve to calculate/infer expected future interest rates. 1-29
An example: Observed Treasury rates and the PEH Maturity 1 year 2 years 3 years 4 years 5 years
Yield 6.0% 6.2% 6.4% 6.45% 6.5%
If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now? 1-30
One-year forward rate 6.0% p.a. 0
x% p.a. 1
2
6.2% p.a.
(1.062)2 1.12784/1.060 6.4004%
= (1.060) (1+x) = (1+x) =x
PEH says that one-year securities will yield 6.4004%, one year from now. Notice, if an arithmetic average is used, the answer is still very close. Solve: (2 x 6.2%) = (6.0% + x), and the result will be x = 6.4%. 1-31
Three-year security, two years from now 6.2% p.a. 0
1
x% p.a. 2
3
4
5
6.5% p.a.
(1.065)5 = (1.062)2 (1+x)3 1.37009/1.12784 = (1+x)3 6.7005% = x
PEH says that three-year securities will yield 6.7005%, two years from now. 1-32
Conclusions about PEH
Some would argue that the MRP ≠ 0, and hence the PEH is incorrect. Most evidence supports the general view that lenders prefer S-T securities, and view L-T securities as riskier.
Thus, investors demand a premium to persuade them to hold L-T securities (i.e., MRP > 0). 1-33
Risks associated with investing overseas
Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment. Includes risk that property is expropriated without adequate compensation, changes in tax rates, regulations, and currency repatriation. Also includes changes in host-country requirements on local production and employment, danger of internal strife. 1-34
Risks associated with investing overseas
Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates.
Return on foreign investment depends on both performance of foreign security (in local currency terms) and on changes in exchange rates. 1-35
Return to US investor investing in Japan (measured in US$)
Invest in 1000 shares of Japanese stock priced at Yen 200 when the US$/Yen exchange rate is US$1 = Yen 100. Next week, the stock price rose to Yen 220, a 10% increase in Yen terms. However, the Yen has depreciated by about 3% against the US$ i.e. US$1 = Yen 103 Initial Yen Amount = 1,000 x 200 = Yen 200,000 Initial US$ required = 1,000 x 200 / 100 = US$2,000 Final US$ Amount = 1,000 x 220 / 103 = US$2,135 US$ Return = (2,135 – 2,000) / 2,000 = 6.8% This can be approximated by 10% (increase in Yen terms) – 3% (exchange rate loss) = 7% 1-36
Interest rates and Business and Personal Financing Decisions
1-year interest rate is 3%, 30-year rate is 5%. If your company needs to finance a building with 30-year lease, should you borrow shortterm (and reborrow every year) or long-term at fixed rates? Should you borrow mortgage loans from the bank on floating interest rate or fixed interest rate? Difficult to predict level of interest rates: have a mix of short- and long-term debt and equity. 1-37
Review/Recap & Thinking Questions
What is the “Golden Formula” on interest rates? What type of securities have significant MRP? What type of securities have significant DRP? What type of securities have significant LP? 1-38
Review/Recap & Thinking Questions
What is the “Golden Formula” on interest rates? r = r* + IP + DRP + LP + MRP What type of securities have significant MRP? Long-Term What type of securities have significant DRP? Corporate What type of securities have significant LP? Corporate 1-39
Forms of Businesses Goals of the Corporation Stock Prices and Intrinsic Value Conflicts Between Managers and Shareholders 1-1
Alternative Forms of Business Organization
Proprietorship
Partnership
Unincorporated business owned by one individual Legal arrangement between 2 or more persons to do business together
Corporation (listed and unlisted)
Legal entity created that is separate and distinct from its owners and managers
1-2
Proprietorships & Partnerships
Advantages
Easy to set up Subject to few regulations No corporate income taxes
Disadvantages
Difficult to raise capital Unlimited liability Limited life 1-3
Corporation
Advantages
Unlimited life Easy transfer of ownership Limited liability Ease of raising capital
Disadvantages
Higher tax rate (typically) Double taxation: one at corporate level, one on dividends received by individual shareholders Cost of set-up and report filing 1-4
Financial Goals of the Corporation
The primary financial goal is shareholder wealth maximization.
How? Through maximizing stock price Is stock price maximization good or bad for society?
1-5
Factors that affect stock price
Projected cash flows
to shareholders
Timing of the cash
flow stream
Riskiness (Volatility)
20 0 Yr 1
Yr 2
Yr 3
20 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
$200
$200
of the cash flows 1-6
Determinants of Intrinsic Value and Stock Prices (Figure 1-1)
1-7
Stock Prices and Intrinsic Value
Intrinsic value is an estimate of “true” value as calculated by a fully informed analyst based on accurate risk and return data; market price is value based on perceived (possibly incorrect) information as seen by the marginal investor. “True” means the return and risk that most investors expect if they had all information about the company. In equilibrium, a stock’s price should equal its “true” or intrinsic value. To the extent that investor perceptions are incorrect, a stock’s price in the short run may deviate from its intrinsic value. Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run. 1-8
Conflicts Between Managers and Stockholders
Managers are inclined to act in their own best interests (which are not always the same as the interest of stockholders). To help align managerial interests with those of shareholders:
Managerial compensation based on stock’s performance over long-term Direct intervention by shareholders (institutional) The threat of firing by current shareholders The threat of takeover if share price is low/cheap and manager is fired by new shareholders 1-9
LECTURE 1B : CHAPTER 6 Interest Rates
Determinants of interest rates The term structure and yield curves Investing overseas 1-10
Why are interest rates important
Low rates result in cheap funds which are used by companies to increase investments. Low rates encourage consumers to spend more (Why?). Low rate mean new borrowers can borrow larger loan amounts: Why? Low rates leads to mortgage refinancing resulting in more money in borrower’s hands to spend.
You borrow $300,000 mortgage from a bank at a rate of 12% p.a, the monthly installment is $ 4,304 If rates are lower, you can return the $300,000 and reborrow from another bank at 6%. Monthly installment is reduced to $ 3,331. You now have spare cash of $ 973. 1-11
What four factors affect the level of interest rates?
Production opportunities Time preferences for consumption Risk Expected inflation
1-12
What four factors affect the level of interest rates?
Production opportunities:
Affects Demand for funds: those with higher rate of return from investment are more prepared to pay higher cost of borrowing. Limit how much borrower is willing to pay savers in the form of interest rate. If economy booms, more attractive projects means more need for capital. Greater competition for funds pushes up interest rates. Demand for funds declines during recessions. Lesser competition for funds leads to lower interest rates.
Time preferences for consumption
Preference for Current Consumption (Spend Now) vs Future Consumption (Spend Later). If current consumption is preferred, lower savings means less funds available for investment. Borrowers competing for limited funds lead to higher interest rates and lesser investments. 1-13
What four factors affect the level of interest rates?
Risk
Higher risk means higher required rate of return.
Expected inflation
To maintain real purchasing power, higher expected inflation will lead to higher interest rate. Higher oil prices tend to lead to higher expected inflation. Lower US$ exchange rate tends to lead to higher US (imported) inflation. 1-14
Determinants of interest rates r = r* + IP + MRP + DRP + LP r = r* = IP = MRP= DRP = LP =
required return on a debt security real risk-free rate of interest Inflation Premium Maturity Risk Premium Default Risk Premium Liquidity Premium 1-15
Determinants of interest rates r = r* + IP + MRP + DRP + LP r*
=
IP
=
rRF
=
real risk-free rate of interest, is the rate on a riskless security in a world without inflation. Inflation Premium. It is the average expected inflation rate over the life of the security. Although U.S. inflation peaked in 1980, interest rates remained high until 1985 as people feared (expect) another increase in inflation because of past bad inflation experience. r* + IP, is the nominal risk free rate. For short-term, refers to T-Bill nominal rate. For long-term, refers to T-Note or T-Bond nominal rate 1-16
Determinants of interest rates r = r* + IP + MRP + DRP + LP MRP =
DRP =
LP
=
Maturity Risk Premium. Longer bonds face greater price declines when interest rates or inflation spike, hence higher return is required to compensate for this risk. Default Risk Premium. It is the risk of non-payment of interest or principal (Credit Risk). Practically, it depends on the rating of the bonds. Liquidity Premium. Liquidity measures how easily a security can be converted to cash at short notice at reasonable price. LP is low for U.S. Treasuries, large strong firms (liquid assets) but high for small, privately owned firms (illiquid assets). 1-17
Premiums added to r* for different types of DEBT IP S-T Treasury
L-T Treasury
S-T Corporate Bond L-T Corporate Bond
MRP DRP
LP
1-18
Yield curve and the term structure of interest rates
Term structure – relationship between interest rates (or yields) and maturities. The yield curve is a graph of the term structure. The November 2005 Treasury yield curve is shown at the right.
Yield (%) 6 5 4 3 2 1 0 0.25
0.5
2
5
10
30
Maturity (years)
1-19
Constructing the (TR) yield curve: Inflation
Step 1 – Find the average expected inflation rate over years 1 to N: N
IPN
INFL t 1
t
N
1-20
Constructing the yield curve: Inflation Assume inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. IP1 = 5% / 1 = 5.00% IP10= [5% + 6% + 8%(8)] / 10 = 7.50% IP20= [5% + 6% + 8%(18)] / 20 = 7.75% Must earn these IPs to break even vs. inflation; these IPs would permit you to earn r* (before taxes). 1-21
Constructing the yield curve: Maturity Risk
Step 2 – Find the appropriate maturity risk premium (MRP). For this example, the following equation will be used find a security’s appropriate maturity risk premium.
MRPt 0.1% ( t - 1 )
1-22
Constructing the yield curve: Maturity Risk Using the given equation: MRP1 = 0.1% x (1-1) = 0.0% MRP10 = 0.1% x (10-1) = 0.9% MRP20 = 0.1% x (20-1) = 1.9% Notice that since the equation is linear, the maturity risk premium is increasing as the time to maturity increases, as it should be. 1-23
Add the IPs and MRPs to r* to find the appropriate Treasury yield Step 3 – Adding the premiums to r*. rRF, t = r* + IPt + MRPt For short-term, it refers to T-Bill yield For long-term, it refers to T-note or T-bond yield MRP often taken to be zero for T-Bill as it is short-term
Assume r* = 3%, rRF, 1 = 3% + 5.0% + 0.0% = 8.0% rRF, 10 = 3% + 7.5% + 0.9% = 11.4% rRF, 20 = 3% + 7.75% + 1.9% = 12.65% 1-24
Hypothetical (TR) yield curve Interest Rate (%) 15
Maturity risk premium
10
Inflation premium
5 Real risk-free rate
0 1
10
An upward sloping yield curve. Upward slope due to an increase in expected inflation and increasing maturity risk premium.
Years to 20 Maturity 1-25
What is the relationship between the Treasury yield curve and the yield curves for corporate issues?
Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the Treasury curve. The spread (or difference) between corporate and Treasury yield curves increases if the corporate bond has a lower or lousier rating. 1-26
Illustrating the relationship between corporate and Treasury yield curves Interest Rate (%) 15
BB-Rated 10
AAA-Rated
5
Treasury 6.0% Yield Curve
5.9%
5.2%
Years to
0
Maturity 0
1
5
10
15
20 1-27
Pure Expectations Hypothesis
The PEH states that the shape of the yield curve depends on investor’s expectations about future interest rates.
If interest rates are expected to increase, Long-Term rates will be higher than Short-Term rates, and vice-versa. Thus, the yield curve can slope up, down, or even humped (see Fig 6.4). 1-28
Assumptions of the PEH
Assumes that the maturity risk premium for Treasury securities is zero. Long-term rates are a (geometric) average of current and future short-term rates. If PEH is correct, you can use the yield curve to calculate/infer expected future interest rates. 1-29
An example: Observed Treasury rates and the PEH Maturity 1 year 2 years 3 years 4 years 5 years
Yield 6.0% 6.2% 6.4% 6.45% 6.5%
If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now? 1-30
One-year forward rate 6.0% p.a. 0
x% p.a. 1
2
6.2% p.a.
(1.062)2 1.12784/1.060 6.4004%
= (1.060) (1+x) = (1+x) =x
PEH says that one-year securities will yield 6.4004%, one year from now. Notice, if an arithmetic average is used, the answer is still very close. Solve: (2 x 6.2%) = (6.0% + x), and the result will be x = 6.4%. 1-31
Three-year security, two years from now 6.2% p.a. 0
1
x% p.a. 2
3
4
5
6.5% p.a.
(1.065)5 = (1.062)2 (1+x)3 1.37009/1.12784 = (1+x)3 6.7005% = x
PEH says that three-year securities will yield 6.7005%, two years from now. 1-32
Conclusions about PEH
Some would argue that the MRP ≠ 0, and hence the PEH is incorrect. Most evidence supports the general view that lenders prefer S-T securities, and view L-T securities as riskier.
Thus, investors demand a premium to persuade them to hold L-T securities (i.e., MRP > 0). 1-33
Risks associated with investing overseas
Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment. Includes risk that property is expropriated without adequate compensation, changes in tax rates, regulations, and currency repatriation. Also includes changes in host-country requirements on local production and employment, danger of internal strife. 1-34
Risks associated with investing overseas
Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates.
Return on foreign investment depends on both performance of foreign security (in local currency terms) and on changes in exchange rates. 1-35
Return to US investor investing in Japan (measured in US$)
Invest in 1000 shares of Japanese stock priced at Yen 200 when the US$/Yen exchange rate is US$1 = Yen 100. Next week, the stock price rose to Yen 220, a 10% increase in Yen terms. However, the Yen has depreciated by about 3% against the US$ i.e. US$1 = Yen 103 Initial Yen Amount = 1,000 x 200 = Yen 200,000 Initial US$ required = 1,000 x 200 / 100 = US$2,000 Final US$ Amount = 1,000 x 220 / 103 = US$2,135 US$ Return = (2,135 – 2,000) / 2,000 = 6.8% This can be approximated by 10% (increase in Yen terms) – 3% (exchange rate loss) = 7% 1-36
Interest rates and Business and Personal Financing Decisions
1-year interest rate is 3%, 30-year rate is 5%. If your company needs to finance a building with 30-year lease, should you borrow shortterm (and reborrow every year) or long-term at fixed rates? Should you borrow mortgage loans from the bank on floating interest rate or fixed interest rate? Difficult to predict level of interest rates: have a mix of short- and long-term debt and equity. 1-37
Review/Recap & Thinking Questions
What is the “Golden Formula” on interest rates? What type of securities have significant MRP? What type of securities have significant DRP? What type of securities have significant LP? 1-38
Review/Recap & Thinking Questions
What is the “Golden Formula” on interest rates? r = r* + IP + DRP + LP + MRP What type of securities have significant MRP? Long-Term What type of securities have significant DRP? Corporate What type of securities have significant LP? Corporate 1-39
