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Title "The sky is falling". However, the inflation rate is falling along with interest rates. Labor is plentiful. Pent-up demand starts to build in the economy. Typically, raw material prices have fallen. Slowly, business and consumer confidence starts to rise. At this point in the cycle, the central bank is attempting to stimulate economic growth by easing credit. Short-term interest rates are reduced in an attempt to restart the economy. The investment strategy at this point in the cycle is to sell long-term bonds. Profits from long-term bonds should be repositioned by purchasing common stocks of cyclical industries that have fallen out of favor. The Phases of the Business Cycle Foreign exchange rates. Global economic conditions affect companies selling products into foreign markets, as witnessed by the "Asian flu" and its damage to the economy in the late 1990s. Additionally, the globalization of business may introduce new competitors and trading partners. A countries economy is unquestionably highly dependent upon foreign trade. This dependence on trading means that the value of the currency is vitally important to the livelihood and living standards of millions of citizens. Title (musical "perfect pitch" metaphor) Capital structure and company beta: risk-free rate=5%; market required rate=10% Unleveraged Firm Initial Price Market Goes Down Market Stays Constant Market Goes Up Value of Firm $1,000 $900 $1,100 $1,300 Value of Bonds $0 $0 $0 $0 Value of Stocks (beta=1; 10 percent expected return) $1,000 $900 $1,100 $1,300 Title [thus the value of an option increases with the rate of interest and the time to maturity]--buying on credit · The option price exceeds its minimum value--higher by an amount that depends on the variance Why DCF Doesn't Work for Options: Because the riskiness of an option changes every time the stock price moves. Valuing Options: Price options by constructing a synthetic option. Suppose we have our $65 Intel stock, and buy a call option with a strike price of $65 and an expiration date six months from now. r of 5% per year. If Intel stock can only (a) fall by 20% to $52 or rise by 25% to $81.25, then Option value = 0 in bad case; $16.25 in good case. Spread=5/9 spread of stock price. Suppose you bought 5/9 of a share and borrowed the PV of 5/9 of a share in the bad case from the bank--borrow $28.18, the PV of $28.89. Then you have the same payoffs as the option. Value of 5/9 of a share today is $36.11, minus $28.18 = $7. Title Real options encountered in practice areusually pretty complicated. Warrants and Convertibles A warrant is an American call option issued by a company on its own stock. Complications of warrants: · Exercise before maturity to capture the dividends · Dilution. If the warrants are exercised, the stock price goes down because the number of shares goes up. · If there are warrants outstanding, then ownership of a stock entails the obligation to satisfy a call from the holders of the warrants. A convertible bond is a close relative of the bond + warrant package. In 1991 Wendy's International issued $100 million of 7% convertible bonds due in 2006 convertible at any time to 81.3 shares of common stock. Face value of $1000; 1000/81.3 = $12.30 as the conversion price of the bond. Title Title · Current consumer consumption. Low and falling interest rates encourage consumers to spend now and therefore to increase their current consumption of goods and services particularly relatively expensive goods such as automobiles and appliances. · Savings rates of individuals. Rising interest rates encourage consumers to save rather than to consume. · The discretionary spending habits of consumers. Rising interest rates increase the cost of borrowing thereby increasing debt servicing costs. Rising debt service cost means that there is less discretionary income to be used for current consumption. The level of interest rates in a closed economy that does not engage in trade with foreigners, is determined primarily by the supply and demand for credit (loanable funds). The supply of loanable funds is determined by savers who invest their money, which is then, in turn, loaned to consumers. The willingness to save is based upon the individual's willingness to trade current consumption for future consumption. The price demanded for this tradeoff is the interest rate. The demand for loanable funds is a function of the desire for current consumption, and the lower the cost or interest rate, the greater the demand for loanable funds. Creditors will consider a debtor's credit risk in establishing the interest rate to be charged. Specifically, the higher the risk of default the higher the interest rate charged. Additionally, if a creditor believes that inflation will rise over the term of the loan, the nominal interest rate charged for the loan will be increased so that the debt will be repaid in real dollars. Title · In investment decisions, you are not facing a perfect, competitive market · In financial makets, you are facing a nearly perfect, competitive market · If selling a security has a positive NPV to you, it probably has a negative NPV to the purchaser. You probably will not find many such purchasers. If capital markets are efficient, then purchase or sale of any security at the prevailing maket price is never a positive (or negative) NPV transaction. What Is an "Efficient" Market? We assume that capital markets are efficient. By "efficient" we mean a bunch of things · that all relevant and ascertainable information is reflected in the market price already because it is widely and cheaply available to investors. · Stock prices are a random walk (with drift) Title · The option price must be less than the price of the stock. Effects of variables: · Increase in the stock price increases the value of the call option · Increase in the exercise price decreases the value of the call option · Increases in the risk-free rate r increase the value of the call option. · Increases in the time to expiration increase the value of the call option. · Increases in the per-period volatility of the stock price increases the value of the call option. A Restatement: 1. In order to exercise an option you have the pay the exercise price. Other things being equal, the less you are obliged to pay, the better. Therefore the value of an option increases as the ratio of the underlying asset price to the exercise price increases. 2. You do not have to pay the exercise price until you decide to exercise the option. Yet once you have bought the option you are "invested" in the underlying asset. Thus buying an option is a little bit like being offered an interest free loan of the amount of the strike price. The higher is the rate of interest and the longer is the time to maturity, the higher is the option value. Title Therefore: · sell 4/9 of a share; · lend out $35.23 (to collect $36.11--the price of 4/9 of a share in six months in the good state). $35.23 - 4/9 x $65 = $6.34. And we know that: V[call] + PV[exercise price] = V[put]+[share price] $7.93 +$65/1.025 = $6.34 + $65, which checks out. Let's suppose we start with a stock worth $553 dollars; a risk-free interest rate of 5%; a 60% chance that it will appreciate 33% to $738 in one year; a 40% chance that it will lose 25% of its value down to $415 a share in one year. Let's value a put option with a strike price of $500 (and an expiration date of 1 year). Value of put option = $85 in bad state; =$0 in good state. Title A change in the quantity supplied occurs when the price of the product itself changes, and this change is depicted as a movement along the existing supply curve. A change in supply occurs because of factors other than price. A change in supply is reflected by a movement or shift, of the entire supply curve, up or down. The factors that affect supply changes, and which can shift the supply curve include: · A change in the price of the inputs of production such as raw materials, labor, or capital. · Changes in production technology such as the use of additional or more efficient machinery or production methods. · Changes in fiscal or monetary policy such as the imposition of taxes or other incentives or disincentives introduced by governments. · Natural disasters such as fires, floods, ice storms, or tornadoes which reduce the availability of goods on hand and may interrupt production schedules. Profit is the major determinant of a supply curve. Therefore, a major factor that affects the supply curve is production cost. The law of supply says that, in the short run, producers will manufacture more of the product at higher prices. Supply curves normally slope upward and to the right. This relationship exists because companies will only produce more of a given product if the price at which they can sell the product covers the cost of production and yields a profit. Interest rates and yield curves Title Actually, you don't. Suppose it pays a dividend of zero. Then next year it is earning $10.80--and if it then starts paying out all of its earnings as dividends, it will be worth (with dividend) $135+$10.80=$145.80 per share. $145.80 per share next year has a P.V. of $135 this year--the with dividend price of the stock. Suppose it pays a dividend of $10 this year. Then its with-dividend value is the same $135. Only if the firm has the opportunity to invest at above-market rates of return (because of market position, monopoly power, some special edge, whatever) does its dividend policy matter. P(0) = EarningsPerShare/r + PresentValueofGrowthOpportunities or EPS/P(0) =r{1- PVGO/P(0)} If EPS/P(0) is less than r, then the firm had better have super-market return investment opportunities. Title At the same time, a weak currency means that products produced in the U.S. or EU are expensive when purchased by the weaker currency, which translates to mean that a weak currency puts importers at a comparative disadvantage relative to their U.S. counterparts. Factors influencing the foreign exchange rate. · Monetary policy. An easy monetary policy increases the money supply and tends to lower the currency's exchange rate. A tight monetary policy reduces the money supply and increases the exchange rate. It is the relative monetary policies between two countries that determines the relationship between the two currencies; therefore, from a foreign exchange perspective Your monetary policy can not be viewed in isolation. · Relative product prices. If goods are relatively cheap, they will be in high demand. Purchasing power parity states that currency exchange rates adjust to the relative price levels or the expected inflation rates between two countries. Everything else being equal, the country with the lowest inflation rate, will have the strongest currency. · Relative income levels. Title Convertible bond--a package of a corporate bond and a warrant Derivatives Traded options; Chicago Board of Trade Options Exchange Futures--an order you place in advance to buy or sell at a fixed price at some future date. Hillary Rodham Clinton. Forward--a tailor-made future contractnot traded on an exchange. Swap--currency swaps, or interest rate swaps. All these can be ways to hedge specific risks that threaten the corporation (why should a corporation worry about idiosyncratic risk? It should worry if it affects return--costs of bankruptcy, for example). Why so much innovation? Taxes and financial regulations are very important causes; a belief that wide investor choice is good for its own sake. But in a pure CAPM world there would be much, much, much less variety of securities. Patterns of corporate financing. Title Difference? Compound annual have you reinvesting last year's gains (or losses) in the market. Hence a bad year--you not only lose money; you also lose your capital and can take less advantage of future good years. But over 69 years, 1926-1995: Average inflation factor 9.347 Portfolio Cumulative real wealth(inflation-adjusted) Average inflation factor Treasury bills 1.46 9.347 Treasury bonds 3.09 Corporate bonds 4.55 Stocks (S&P 500) 96.99 Small stocks 340.17 So, why not invest in small stocks? Why doesn't everyone, all the time, invest in nothing but small stocks? Because they are risky. Start investng in a portfolio of small stocks in 1926; by 1933--even with compounded and reinvested dividends--you have lost70% of your real wealth. Invest in a porfolio of small stocks in 1967, and by 1974 you find that you have lost 70% of your real wealth has well. Yes, but aren't there offsetting gains that make these risks worthwhile? Maybe. The point is that when the value of your portfolio falls you become poor--and when you become poor, the money that you don't have matters a lot to you. By contrast, when you are rich your marginal dollar matters much less. Title For example when prices decline, the quantity of the product demanded by consumers will increase. This is called the law of demand, and explains why demand curves normally slope downward and to the right. When the demand curve shifts, this is known as a change in demand. Change in demand is caused by some factor other than price. The price elasticity of demand refers to the responsiveness of the quantity of goods that are demanded in relation to changes in the price of the product. Most products have elastic demand. Demand is said to be elastic when a given change in price produces a greater percent change in the quantity of the product that is demanded. The elasticity of demand is determined by the availability of substitute products and the percentage of the consumers total budget that is spent on the product. Necessities, in general, tend to be more inelastic than luxury goods. Gasoline represents a good example of a product with elastic demand. On the other hand, some products will be in demand no matter what the price; for example, insulin, which is used by diabetics. If the price of insulin were to double, in all probability the quantity of insulin demanded would remain constant. This situation is known as inelastic demand. The supply of a product is defined as the quantity of the product which producers or manufacturers are willing to produce and sell. A change in supply is different from the change in the quantity supplied. Title For the purposes of the GDP calculation, it does not matter whether residents own the resources; it matters only that the labor and other resources are located in a specific country. GDP is the most common measure or international standard of national economic performance that is used by governments and economists worldwide. Gross national product (GNP) is a measure of the goods and services that are produced by labor and property that is supplied by residents. It does not matter whether or not the laborers or the property is actually located in , so long as the resources are owned by Residents. Since there is more foreign investment in many countries than there is investment abroad, GDP is much larger than in some countries than GNP. By way of contrast, for the U.S., GDP and GNP are nearly identical. The economy's ability to produce is measured by its potential GDP. The growth in potential GDP is a function of: · The growth rate of the labor force. The growth rate of the labor force is determined by demographics (birth rate, death rate, and immigration), and labor force participation rates (the percentage of the population that chooses to work). · The growth rate in the number of hours worked per worker. The growth rate in the number of hours worked is determined by societal attitudes towards work and leisure. · The growth rate of productivity. Productivity growth rate is a function of the technology used, innovation, social attitude, competition, resource utilization, and the skill of the labor force. Title Full employment does not mean zero unemployment. There will always be a certain number of unemployed persons in the economy for various reasons. · Fictional unemployment refers to individuals who are unemployed because they are voluntarily between jobs. Certain demographic sectors of the labor market change jobs more often than others. Young people for example, tend to have higher unemployment rates as they search for "better jobs". · Structural unemployment refers to the individuals who are displaced because their skills are no longer in demand due to advances in technology or to societal changes. The advent of the automobile, for example, which created jobs for mechanics, displaced and eventually eliminated jobs for horse carriage makers. · Cyclical unemployment refers to the normal waxing and waning in the unemployment rate that occurs due to the normal fluctuations during a business cycle. Economics & Business cycles An understanding of the business cycle helps an investor to focus on the "big picture", and is essential in order to set both short and long-term investment strategies and policies. Business activity can be classified as having seasonal variations, cyclical fluctuations, and long-term secular trends. In addition, the economy and business activity can be affected by random and unexpected occurrences such as a war or "Asian flu". Over the long run, the economy has continued to expand and grow. However, this long-term growth has been volatile at times and the economy has experienced periodic fluctuations, which are known as the business cycle. There are no firm rules for identifying recessions or for dating business cycles; however, Statistics defines a recession as two consecutive quarters of declining GDP growth. Although each business cycle is itself unique, most business cycles follow a more or less predictable pattern. Title Low ROA may also indicate that further analysis of the firm's assets might reveal inefficient assets which can be disposed of and converted to cash. Operations Gross Profit Margin This ratio indicates the % of gross profit that is earned on each dollar of sales. The gross profit margin for a firm should be compared to the industry averages. Net Profit Margin This ratio indicates the % of net profit that is earned on each dollar of sales. The higher the net profit margin the better the ratio is considered to be. Low profit margins can be an indication of a highly competitive industry structure. Low profit margins indicate that the firm should increase its sales, decrease its costs, or both. Profit margin ratios should be based on the net income from continuing operations in order to accurately reflect the firms probable profitability into the foreseeable future. Resources Title On the other hand, the more the price rises above the strike price, the more profit you will make. Therefore the option holder does not lose from increased volatility if things go wrong, but does gain if things go right. The value of the option increases with the varaince per period of the stock return multiplied by the number of periods to maturity. Why DCF Doesn't Work for Options: Because the riskiness of an option changes every time the stock price moves. Valuing Options: Price options by constructing a synthetic option. Suppose we have our $65 Intel stock, and buy a call option with a strike price of $65 and an expiration date six months from now. Let the risk-free interest rate r be 5% per year. Suppose, further, that Intel stock can only (a) fall by 20% to $52 or rise by 25% to $81.25, then · Option value = 0 in bad case · Option value = $16.25 in good case. Title Option delta = 85/323 means that you go short -0.263 of a share and loan out $184.85 in order to replicate the option portfolio. Cost of the replicated portfolio = $39 is the value of the option. Suppose there are more than two possible outcomes? Suppose that in each six-month period the value of the stock could either rise by 22.6% or fall by 18.4% (values chosen so that the stock price a year hence has the same proportional standard deviation). Stock price could then rise to $832, remain unchanged at $553, or fall to $368. Suppose stock price rises over the next six months--so that after a year the stock price might be $832, might be $553. In either case the value of the option six months from now is zero. So if the stock price rises over the next six months, the option value falls to zero. Suppose the stock price falls over the next six months to $451. Then after a year the stock price might be $553 (in which case the option is worht zero) or might be $368 (in which case the option value at expiration would be $132). Option delta = 132/185 = -.7135 is the number of shares you sell short; and you loan out $384. Title Price changes independent of the most recent price change. What this means for "technical analysis". Competition among investment analysts should lead prices to reflect "true values"--true value does not mean future value, but an expected value that incorporates all he information available to investors at that time. If prices always reflect all information, they will only change when new "information" arrives. But by definition we don't know whether new information will be good or bad. Suppose analysts aren't competitive, and there are predictable cycles: we make money off these cycles--for a while. · Weak efficiency: the past pattern of prices doesn't allow you to make money · Semi-strong. Published information doesn't allow you to make money · Strong. All the hard work in the world doesn't allow you to make [much] money. One of the senior people on my brother's risk-arb desk, an equity analyst; trailing the S&P 500 The crash of '87 as a challenge to the efficient markets hypothesis. What was the news? Response seems to be (a) the market is better at relative prices than at absolute benchmarks, and (b) with P=D/(r-g) only a small shift in g is necessary to produce big shifts in P. Experts believe that the '87 crash does not undermine the evidence for market efficiency with respect to relative prices Title Should you invest? The right answer is that you should make your forecasting staff do more work: Variable Pessimistic Expected Optimistic Market size +$11 +$34 +$57 Market share -$104 +$34 +$173 Unit price -$42 $34 +$50 Unit variable cost -$150 +$34 +$111 Fixed cost +$4 +$34 +$65 The project is by no means a sure thing--if you can find information to improve your forecasts of unit variable costs and of market share, you should do so. Limits to sensitivity analysis: what does "optimistic" mean? What if variables are interrelated? Scenarios. Different consistent combinations. Capital Budgeting and Performance Title Standard deviation of value of the project is $463 million. Asset Value/PV(EP) = 0.68 sigma-root t = .61 Call value/asset value = .119; call value = .119 x $463 = $55 million. DCF analysis implicitly assumes that firms hold real assets passively. You could say that DCF does not reflect the value of management. Adding options pricing to DCF allows you to incorporate the value of alternative investment opportunities. The Option to Abandon: 1. Technology A uses computer-controlled machinery custom-designed to produce the complex shapes required for Wankel (rotary) engines in high volumes and at low costs. But if the Wankel engine doesn't sell, this equipment will be worthless. 2. Technology B uses standard machine tools. Labor costs are much higher, but the tools can be sold or shifted to another use if the engine doesn't sell. Title The delay can be several months. · Management choices regarding the reporting of financial activities will vary from company to company, making comparisons difficult for an investor. For example, 2 identical corporations in the same industry may choose different depreciation rates for their equipment, or they may choose different accounting techniques for reporting inventory. · Ratios do not necessarily disclose the quality of their components. For example, a high current ratio might mean that a company has high accounts receivable or inventories and not cash. · Financial statements are based on historic costs and therefore may be misleading during periods of inflation. Interpreting financial ratios · The long-term trend of the ratios can be as important as the absolute value of the ratio itself. · General economic conditions affect the ratios; therefore, the investor should study the ratios with respect to the stage of the business cycle. · Ratios should be compared to industry standards or norms. · Ratios should be compared to management's stated goals for the firm. Title The foreign exchange marketplace is global in scope and foreign exchange rates are based on the supply and demand for a particular currency. In the international foreign exchange markets, currencies are traded around the clock and the accepted convention is that all foreign exchange rates are established or measured relative to the U.S. dollar, which is considered to be an international standard. In the international arena, a country may employ either a fixed or a floating exchange rate system. Under a fixed exchange rate system the currency is pegged against other currencies, usually by imposing currency controls which preclude the citizens from holding foreign currencies; or the central bank will take measures to ensure that the currency stays within a fixed range by purchasing or selling currency in the foreign exchange market. Currently, an example of the fixed exchange rate system is the Hong Kong dollar. A floating exchange rate means that the central bank will only intervene in the foreign exchange marketplace when it considers the movement of the currency to be excessive. Central banks can either buy or sell in the foreign exchange market, or they can manipulate short-term interest rates. The dollar has been freely floating since the 1950s. When the currency is under downward pressure, a central bank will intervene in the foreign exchange market by purchasing their own currency in an attempt to increase the demand for the currency and thereby attempting to support the value and strengthening of the currency. When the currency is weak relative to the U.S. dollar, products produced in your country are relatively inexpensive to an American or EU consumer. In other words, a weak currency benefits the respective exporters. Title The higher the income levels are within a country, the more its people will tend to consume and the more they will desire imported goods. Therefore, the country with the highest real growth rates will tend to have the weakest currency because its people will spend a higher percentage of their disposable incomes to pay for imported goods. · Taste and quality considerations. A country whose goods are considered to be of high quality, or whose goods are highly desirable, will tend to have the stronger currency. · Interest rate differentials. The country with the highest real interest rate will attract foreign investment and therefore strengthen the currency. · Relative profit. A country that offers high rates of return on equity investment, assuming equal risk, will attract foreign capital and thereby strengthen the currency. · Relative political risk. A country that is viewed as a political safe haven tends to attract foreign capital, which serves to strengthen the currency. · Currency speculation. Foreign currency speculators can cause changes in the supply and demand of a currency. These changes in supply and demand will translate into either a strengthening or a weakening of the currency. When examined in isolation the effect of each of the above factors on the exchange rate seems obvious and straightforward. However, in the real world, these factors when considered together often obscure the resulting impact upon a currency. Title The liquidity theory claims that the yield curve should therefore, always be positively sloped. · Biased expectation theory. This theory combines both the pure expectations and liquidity theories. This theory can explain any shape of yield curve and because of the liquidity preference there is a natural bias towards a positive slope. Inflation Most people define inflation as the persistent rise in the cost of living over time. The most common measure of inflation is the consumer price index (CPI). The CPI measures the cost each month to buy a basket of consumer goods. This basket of goods supposedly represents the same goods that typically would be purchased by an average family. The calculation of the CPI assumes that the same type and quantity of goods are purchased each month or each year, and the price of this basket of goods is compared and measured relative to a predefined base period. Another important indicator of inflation, are the settlements of collective agreements for unionized employees wage demands. The economic consequences of inflation include: · The erosion of the standard of living of those collecting and living on fixed incomes. · Debtors benefit since loans are repaid with cheaper future dollars. · Higher interest rates, which often translate into recessions. · A transfer of wealth from the public to the government, if the government is a major debtor, and if the tax system is progressive and it is not indexed to inflation. Unemployment One on the goals of economic policy is to produce and maintain full employment. Title The other $44.44 must come from the "present value of growth opportunities". What are its growth opportunities? Well, this year it is the opportunity to invest $3.33 in earnings in investments that pay 25% rates of return (rather than the market's 15% rate of return). This is an above-market profit of $0.3333 per year forever--and discounting that above market return at 15% gives us a figure of $2.22 for the "value of the growth opportunity" this year. Next year we will have another growth opportunity--10% bigger--and so on for the year after that. So if we calculate the value of all growth opportunities: PVGO(0)/r-g we get $44.44 Which checks A growth stock: one in which the net present value of its opportunities to make above-market rate-of-return investments accounts for a large chunk of its stock price. Notice that it is not true to say that a share's value is equal to the discounted stream of future earnings per shares. Because retained earnings are not free cash flowing to the shareholders, but are themselves a source of some of the future dividends. Title The P/E multiple is one of the most widely used financial indicators or tools employed by investors. Book Value per Common The book value per common share is an indication of the margin of safety for common shareholders. This ratio indicates the dollar amount that would be available to be distributed to a common shareholder in the case of dissolution of the company. A more conservative estimate of the margin of safety would calculate the tangible net worth/per common share. Academic research has shown that the ratio which calculates price/book value is a good predictor of future investment results, and that stocks selling at low price/book value tend to outperform stocks selling at high price/book value multiples. Earnings per Common Share Earnings per common share or EPS is one of the most common financial ratios employed by investors and is frequently reported in the financial press. High net earnings per common share can indicate that management has the ability to pay dividends to the common shareholders. Conversely, low or negative EPS generally indicates that no dividends should be expected. Market Capitalization The market capitalization or market cap calculation computes the current fair market value (FMV) of the corporations common shares outstanding. Studies have shown that small cap stocks tend to outperform large cap stocks. Title The primary markets are the IPO market, or the new-issues markets. But almost all stock trades are secondary market trades: Trades unrelated to raising new capital for Ford Motor Company. What is the present value of a stock? PV(Stock) = PV(Expected Future Dividends) But don't people expect capital gains? Yes, but. Expected rate of return=required rate of return=market capitalization rate P(0) = (D + P(1))/(1+r) How do we know that that is the right P(0)? Because it the price were higher, people would have to be really dumb to buy the stock; if the price were lower, everyone would already be trying to buy it. But what determines next year's price? P(1)= (D(1) + P(2))/(1+r) Forward induction. Title This ratio can be used to assess the quality of an inventory. Inventory turnover ratios vary widely by industry and obvious deviations from the industry standard may indicate problems. Too much inventory can indicate improper purchasing, inadequate marketing, or an undesirable product. On the other hand, too little inventory can cause problems with product availability and can therefore hurt sales. Receivable Turnover The receivable turnover ratio measures the effectiveness of a firm's credit and collection policies. A high receivable turnover rate can indicate an effective credit and collection policy or alternatively it can indicate that a business operates on a cash basis. A low turnover rate indicates that the firm should pay more attention to collecting its accounts receivable. Accounts Receivable can amount to interest free loans to customers. The firm should analyze its accounts receivable in terms of its stated credit policy. Debt Total Debt to Equity This debt ratio measures a firm's leverage, and is therefore an estimate of its financial risk. A high-level of debt can be a warning sign of possible problems in the future and indicates high financial risk. A high-level of debt implies high fixed interest costs, which reduces the firm's financial flexibility and its ability to pay dividends to the common shareholders. A low level of debt can indicate that management is not optimizing the firm's capital structure and is therefore not maximizing total shareholder wealth Total Debt to Assets This ratio measures the level of support that is provided to the firm by its creditors. The reciprocal of this ratio is called the asset coverage ratio. The asset coverage ratio shows the amount of assets backing the companies debt and is a safety measure from a bondholder's perspective. Title This ratio should be calculated using total tangible assets in order to determine a conservative estimate of the firms ability to re-pay a bondholder. Times Interest Earned The times interest earned, or the interest coverage ratio, measures the margin safety for a corporation's bondholders. This ratio measures the firm's ability to pay its annual fixed interest charges from its ongoing business operations. There are no set rules determining an acceptable number of times earnings should cover interest. A bondholder should investigate the long-term trend of this ratio since it is a better indication of the firms continuing ability through good times and bad times to meet its interest obligations. As a rule of thumb, the more volatile a company's earnings, the higher the times interest earned ratio should be. Liquidity Current The current ratio measures the business's ability to meet its current obligations (due within the next 12 months) with its current assets. This ratio should be similar to the industry average. For many businesses, an acceptable level of coverage is on the order of 2:1. If the ratio is too low it can indicate possible solvency problems. Excessive investment in current assets, on the other hand, can indicate an ineffective use of the firm's short-term resources. A high current ratio can indicate uncollected accounts receivable, too much inventory, or it can indicate that management is stockpiling cash. Acid-Test (Quick) The acid test or quick ratio is used to determine the business's ability to pay its current liabilities using only the most highly liquid of its current assets. This ratio is a more stringent measure of a firm's liquidity since it ignores the value of the firm's inventory. A ratio of 1:1 is considered desirable, but no single standard exists. Title Tobin's q. Stockholders; majority voting; cumulative voting; Equity in disguise: "limited" partners, REITs, "Royalty Trust" Debt--can't vote, but interest is paid out of before tax income; and have rights to throw company into bankruptcy. funded debt--greater than one year maturity. Walt Disney has issued 100-year bonds. NatWest has issued "perpetuities". unfunded debt--less than one year commercial paper--usually backed by a bank "line of credit"; other uses of lines of credit. Sinking fund--for gradual repurchase of bonds Call--right to buy debt back at principal value. Typically five years of "call protection" Senior debt/subordinated debt Title Value of 5/9 of a share today is $36.11, minus $28.18 = $7.93. We have just valued our option. The number of shares to replicate the spread from an option is the hedge ratio or option delta. · If the option sells for more than $7.93, you have a money machine by selling options and then covering by (a) buying 5/9 times as many shares as you sold options, and (b) funding your purchase by borrowing $28.18 at the risk-free rate for each option you sold. The $28.18+$7.93 will pay for the 5/9 share of stock--and you are perfectly hedged. Anything more than $7.93 for the option that you sold is pure gravy. Did that go by too fast? Let's value the put option Value of put option payoff · = +$13 in low state; · = 0 in high state; · difference = -4/9 times the spread in the stock price between the bad and good states. Title When short-term rates are higher than long-term rates, the yield curve is said to be inverted. The yield curve will often be inverted at the peak of an economic cycle because the Bank of will attempt to slowdown the pace of economic activity by manipulating short-term interest rates upwards, through its intervention in the money-market and other open market operations. The term structure of interest rates is described by different theories, which attempt to elucidate the shape of the yield curve. · Segmented market theory. This theory states that different participants in the bond market tend to concentrate their activities into the particular maturity segments, which most closely match their needs. Although this theory can explain any shape of yield curve, it is based on the unrealistic assumption that the market participants will never move out of their preferred segment no matter what the interest rate. · Preferred habitat theory. This theory states that investors and borrowers prefer to invest in certain maturity segments along the yield curve. The theory states that investors will shift out of their preferred maturity segment (habitat) if they are rewarded for the risk of doing so, by higher interest rates. · Pure expectations theory. This theory states that the yield curve adjusts to the participants expectations regarding what the market believes that interest rates will be in the future. If the market expects interest rates to rise, the yield curve should be positively sloped and if the market expects that interest rates will fall, the yield curve will be inverted. · Liquidity theory. The liquidity theory is based upon an investors aversion to risk. This theory states that short-term rates should be lower than long-term rates because the long-term bond rates must include a premium for their lack of liquidity. Title To choose the risk characteristics of that consumption plan 7. But stockholders don't need your help--don't need the company's help, don't need the financial manager's help--to reach the best time pattern of consumption. They can do that on their own (provided they have access to capital markets). They don't need your help to reach the best risk pattern. 8. How then can you help? 9. By increasing the market value of each shareholder's stake--by seizing all investment opportunities that have a positive net present value. Other corporate goals? "Maximize profits"--which year's profits? How about trading off present for future profits? Which accountant? Do real managers actually maximize net present value? Experts are more sanguine about corporate control than we are; our system is not a great one. Valuation of Common Stock Rules of thumb from last time: Title ) Options: · Chicago Board of Trade Options Exchange was founded in 1973; an immediate success. · Buy options (if you are a firm) to offset idiosyncratic risk that may lead to financial distress. · Buy options (if you are an individual) if you need psychiatric help. · Options pricing theory also helps value growth opportunities. "Disguised" options. Calls, Puts, and Shares: · A call option gives its owner the right to buy stock at a specified exercise or strike price on or before a specified exercise date. European options--only on the particular date; American options--on or before that date. · A put option gives its owner the right to sell stock at a specified exercise or strike price on or before a specified exercise date. European options--only on the particular date; American options--on or before that date. Accountants and auditors ... and interpreting white collar crimes such as securities fraud and embezzlement ... combine their knowledge of accounting and finance with law and investigative ... legaljob.org/stats.bls.gov/oco/ocos001.htm - 64k - Supplemental Result - Accountants and auditors ... and interpreting white collar crimes such as securities fraud and embezzlement ... combine their knowledge of accounting and finance with law and investigative ... legaljob.org/stats.bls.gov/oco/ocos001.htm - 64k - Supplemental Result - Title Choose the portfolio S that just touches the line that goes through the riskfree-rate point and lies entirely to one side of the feasible portfolio set. Then borrow (and lend) until you get to the risk-return characteristics you want; simply combine the "best" efficient risky portfolio with the risk-free rate. Capital asset pricing model. : Plot beta on the horizontal axis; expected return on the vertical axis; start with the riskfree rate. Add the diversified market. Draw the security market line. Everything must yield the expected return that places it on the market line for its beta. Relationship between beta-return diagram and risk-return diagram: risk return diagram adds in idiosyncratic risk. Title Choosing between a long-lived and short-lived investment (discount rate of 6%): Machine C(0) C(1) C(2) C(3) PV @ 6% A -15 -5 -5 -5 -28.37 B -10 -6 -6 -21 Machine B has the lower cost, properly discounted; so you should buy machine B, right? Wrong. What do you do in year 3? You have to convert a cost into a cost-per-year Perhaps the best thing to do is to say that there are actually two things going on: first, you are in the machine purchase and rental business; second, you are in the business of producing goods and hence need to rent a machine. Suppose that you are in the machine purchase-and-rental business. You need to set a rate X that earns you a fair return--a 0 NPV investment at the margin. Title Book Measures are wrong because: Errors occur at different stages of project life; when true depreciation is decelerated, book measures understate profitability for new projects (and overstate it for old ones). Steady-state ROIs are biased unless the growth rate of the company equals the true rate of return even when you have a balanced mix of projects Errors occur because inflation shows up in revenues faster than in costs "Creative accounting" Experts wish that managers (and the stock market) didn't worry about accounting earnings so much Six Lessons of Market Efficiency You've learned how to spend money. Now let's figure out how to raise it. Title How Much Should a Firm Borrow? Dividend policy doesn't matter. Debt policy doesn't matter. Yet if debt policy were completely irrelevant, debt/equity ratios should vary at random. But almost all airlines, utilities, banks, and real estate development companies rely on debt, as do steel, aluminum, chemical, petroleum, and mining firms. By contrast it is rare to find a drug company, a computer company, or a service company that relies heavily on debt at all. Explanation? · Bankruptcy costs · Taxes · Conflicts of interest between holders of different classes of securities. Shooting for theory that combines MM with bankruptcy, taxes, and other complications. Taxes: the Deductibility of Interest Title Initial Public Offering Register with the SEC; SEC approval; prospectus "Red herring"; registrar; transfer agent; underwriters; substantial administrative costs; underpricing IPO's. Marvin sells 500,000 primary shares (for the company) and 400,000 secondary shares (from VCs and from founders) Assets Liabilities + Net Worth $72 0.9 m shares IPO Cashfrom new equity $37.5 $48 0.6 2nd Stage Equity Fixed assets $5 $80 1.0 1st Stage Equity "Intangible" $221.5 $64 0.8 Founders' Equity $264 $264 Title Other Theories: Consumption CAPM; risk premium oddly large APT--a bunch of different kinds of undiversifiable macroeconomic risk; oil price risk, inflation risk, recession risk, and so forth. APT doesn't tell you what the macroeconomic risk factors are. One such list: · Slope of yield curve · Level of short-run interest rate · Exchange rate · Real GDP · Inflation Title Risk and Return Now let me move on to risk and return proper. "State of the World" UniversalUtility MegaManufacturing ExcitingExports StartupSemiconductor HH +20% +40% +40% +20% HT +0% +10% +50% -20% TH +10% +10% -30% -20% TT -10% -20% -20% +20% Suppose WE am choosing portfolios from Mega Manufacturing and Startup Semiconductor: Title Summary: Larger is cheaper--bunch security issues, for transaction costs are considerable There are no issue costs for retained earnings Private placements are well suited for the small, risky, unusual, and complex Watch out for underpricing--the lion's share of costs come from underpricing New issues may depress price (and so should be coreographed to be information-free) shelf registration for large firms that don't need to be warranteed by IBs Issuing Securities/Dividend Policy Basics: Title Supply and Demand The demand for a product is defined as the quantity of the product which consumers are willing to purchase. Factors that affect the demand relationship of a product include: · The price of the product. Generally, the higher the product is priced, the lower the quantity demanded by consumers. · Consumer income. The higher the consumer's income, the more goods the consumer will demand. · The price and availability of related goods. If attractive substitute products are available at a lower price, less of a product will be in demand. · Consumer expectations. If consumers expect product prices to rise, the more of the product they will demand now. · Advertising. Effective advertising can promote and expand demand for the product of a company, or advertising can expand the marketplace for an entire industry. · Demographics. As the population demographics change over the years so do consumer tastes and the products that they consume. Title The Six Lessons of Market Efficiency Lesson 1: Markets have no memory (don't wait for recent price changes to be reversed; they probably will not be) Lesson 2: Trust market prices (more than your own hunches) Lesson 3: Look at market prices in detail to predict the future (term structure; market's unfavorable assessment of Viacom's takeover of Paramount; for the market price implicitly weights a lot of people's serious assessments) Lesson 4: Do not believe in financial illusions (dividends and stock splits; stock prices run up before a split) Lesson 5: Value is lost when the company does something that a shareholder can do on his own for smaller transaction costs Lesson 6: Demands for stocks should be highly, highly elastic. Note that the efficient markets hypothesis does not mean that the financing of a corporation will "take care of itself"; it provides a starting point, not an ending point, for analyis. Overview of Corporate Financing Title We Always Come Back to NPV The decision to sell a share of stock, and the decision to purchase an electromechanical capital good are basicly similar. Both involve the "valuation" of a risky asset, and the comparison of the value of a risky future stream with a present sum. The fact that one asset is "real" and the other "financial" shouldn't bother you. The present value of borrowing. Suppose the government agrees to lend your firm $100,000 for 10 years at an interest rate of 3%: NPV = +$100,000 - sum{$3,000/(1+r)^t} for ten years - $100,000/(1+r)^10 If the appropriate discount rate is 10%. = +$100,000 - $56,988 = +$43,012 //when the appropriate discount rate is 10%, an offer to loan you money for 10 years at 3% is truly an amazing deal. (Use the "rule of 72" to see that it is an amazing deal right off) · Financing decisions are easier to reverse than investment decisions · It's much harder to make or lose lots of money by making bad financing decisions. Title What is the return on the entire portfolio? That part is easy: it is just the weighted average of the individual returns. What is the risk of the entire portfolio. We set it out on a 2 x 2 grid: the risk--the variance-- is the sum of these four boxes security 1 security 2 security 1 x12s12 x1x2s12 security 2 x1x2s12 x22s22 E(x(1)r(1)+x(2)r(2))^2 = E(x(1)r(1))^2 + E(x(1)r(1)x(2)r(2))+E(x(1)r(1)x(2)r(2))+E(x(2)r(2))^2 Introduction to Portfolio Theory Basics: · Present value of a perpetuity: C/r Title 25%M+75%S Mega Manufacturing Startup Semiconductor 17.5% +40% +10% -12.5% +10% -20% 32.5% +10% +40% 2.5% -20% +10% EV = +10% EV = +10% EV = +10% SD= 16.8% SD = 21.2% SD = 21.2% 0M+1S .25M+.75S .5M+.5S .75M+.25S 1M+0S Expected Return +10% +10% +10% +10% +10% Title Year 1 2 3 4 5 6 7 thereafter "Harvest" Now: $1000 $900 $810 $729 $656 x.9 x.9 x.9 Build a road: -$100 $1300 $1170 $1053 $948 x.9 x.9 x.9 Build and wait: -$100 0 $1500 $1350 $1115 x.9 x.9 x.9 Build and wait 2 years: -$100 0 0 $1600 $1440 $1296 x.9 x.9 with a discount rate of 10%, what do you do? Future value. Opportunity cost--should be defined to include the value of waiting, because then you can do something else. Title C(0) C(1) C(2) C(3) Old Machine $4,000 $4,000 0 0 New Machine (Now) -$15,000 $8,000 $8,000 $8,000 New Machine (wait a year) -$15000 $8,000 $8,000, and same in year 4 New Machine (wait two years) -$15,000 $8,000, and same in 4 and 5 What do you do if you cannot use both the old machine and the new machine at the same time (New machine now an NPV of $6,380, an equivalent 3-year annuity of $2,387) Costs of using up excess capacity--and thus of accelerating machine replacement; even though it looks like all you are doing is using excess capacity, to the extent that you are imposing incremental costs they should be charged. Title (d) if the stock price falls over the next six months, extend your short position by selling an additional .438 of a share short, so your total position is .714 of a share short; loan out the proceeds from this second short sale (they are just enough to boost your total lending to $385). (e) if the stock price rises over the second six months, liquidate your portfolio for a gross return of zero. (f) if the stock price falls over the second six months, liquidate your portfolio for a gross return of $132. Voila. You have replicated the option. We can extend this analysis--make it more realistic--by considering finer and finer divisions of the year and smaller and smaller moves in the stock price. Don't try this at home: each time the price moves, you have to buy (or sell) more stock in order to construct the proper replicating portfolio for the next period. And calculating what these replicating portfolios are at every stage is not that easy. Intervals in a Year Upside Change Downside Change Calculated Option Value 1 33.3% 25.0% $39.40 2 22.6% 18. Title Working Capital The working capital or net current assets are used to finance the business's cash conversion cycle i.e., the time required to convert raw materials into finished goods, to sell the finished goods, and to collect the accounts receivable. The amount of working capital required by a firm varies by industry, season, and stage of the business cycle. Value Dividend Payout The payout ratio indicates the % of net earnings that the corporation pays out in the form of dividends to the equity owners. Growth company's usually have low or zero payout ratios. The Board of Directors of a corporation tends to prefer to maintain a steady payout ratio rather than allowing the payout ratio to fluctuate with corporations earnings. The Board of Directors of a blue-chip company does not increase dividends without considering the informational content of the dividend. Generally, when a blue-chip company increases its dividend, this signals that the Board believes that the future prospects for the business are expected to be good. The retention ratio (RR) is the % of earnings that are retained in order to finance the future operations of the business. The RR is calculated as (1-payout ratio) Title Derivation of the Variance of a Portfolio According to the Capital Asset Pricing Model [CAPM] Suppose that we are making up a portfolio by investing a fraction 1/N of the portfolio in each of N securities, with each individual security indexed by a different value of i, i=1.N. Suppose further that the realized return on an individual security i is: where ui denotes the particular "unique" risk associated with each particular security i alone (or, at least, not associated with too many of the other securities), r*i denotes the required rate of return on the i'th of the N securities, and rm and r*m denote the realized and required rates of return on the "market" portfolio. Add up all the N positions in each of the N securities to get the total realized return on the porfolio: Take expected values, note that the expected deviation of the realized market from the required market return is zero, note that the expected value of the "unique" risk of the i securities is zero, and find that the expected return on the portfolio is merely the average required return on each of the N securities: Title · A deep reason why you need to understand what creates stock market value: even if you are trying to act in the interest of your shareholders--to maximize shareholder value--it is very hard to do so if you are clueless about what maximizes shareholder value. Common stocks are traded; NYSE; AMEX; NASDAQ Professors will use Ford Motor Company as an example (from February 15, 1995): · 52 week high: 33 7/16 · 52 week low: 24 1/4 · Dividend per share: $1.04 · Yield (%): 4.0(%) · P/E: 5 · Volume: 4,014,300 · Daily high 26 5/8 Title · Go short the stock market $100,000; use your receipts to fund the extra construction money you need; and thus find yourself with the expected payoff (0, $288,000)--clearly better than the (0, $280,000) of "invest" · Alternatively, go short the stock market to the tune of $350,000; use your receipts to pay money to Anthony Aardvark and fund the new construction, and find yourself with the expected payoff ($250,000, $8,000)--clearly better than the ($250,000, 0) of Anthony Aardvark's choice · Thus maximizing net present value (and dipping into the capital markets either long or short) allows you to have your cake and eat it too: produce any relative pattern of "consumption" cash flows you wish at the highest level. So: First Principle: Opportunity cost: What else could you do with the money? Second Principle: Open access to capital markets allows you to shape your consumption profile Third Principle: Moving your possible consumption profile up and to the right is a good thing: Fourth Principle: Well-functioning capital markets mean that all present-future consumption possibility profiles are parallel. Title 3) Recession or contraction. When a recession is apparent and economically the outlook is gloomy. This phase is shorter in duration than the expansion phase normally is. Corporate profits are falling. Business failures increase. Industrial production falls. Business confidence deteriorates. Unemployment rises. Consumer confidence falls. Consumers stop spending and become more cautious. New home construction falls. Personal bankruptcies rise. The nightly News and newspapers are pessimistic about the future. Stock market activities weaken and decline. The central bank is using lower interest rates and is encouraging credit granting in order to attempt to stimulate economic activity. Title AEP's price at exercise date was $24 1/8--hence warrant were worth something, hence exercised by shareholders (or sold to people who then used them to buy the stock). 1-for-11 @ $22 1-for-5 1/2 @ $11 Before Issue # of shares: 11 11 Share price (rights on) $24 $24 Value of holding $264 $264 After Issue Number of new shares 1 2 New investment $22 $22 Total value of holding $286 $286 Title Although no business cycle will exactly match the previous cycle, some similarities and general conclusions can be drawn with respect to business and economic cycles and investment strategies in general. These strategies and phases can be tracked by watching certain economic indicators. · Leading economic indicators tend to anticipate the health of the general economy and include: building permits issued, housing starts, manufacturer's new orders for durable goods, stock prices, average number of hours worked per week, and commodity prices. · Coincident economic indicators change at approximately the same time and in the same direction as the overall economy. Examples of coincident economic indicators include: GDP, industrial production, personal income, and retail sales. · Lagging indicators tend to change after the economy has turned and include: the unemployment rate, labor costs, inventory levels, and the rate of inflation. The Phases of the Business Cycle The business cycle consists of four segments, which can be identified by the following signs or signals: 1) Recovery and expansion. Inflation is stable, or rising only slightly. Typically, these stages last longer than the contraction phase. Businesses are investing in new capacity to meet increased consumer demand. Corporate profits are rising because profit margins are increasing. Business is confident about the future and is planning production increases. New business start-ups outnumber bankruptcies. Inventories are under control. Retail sales are healthy. Title Black-Scholes Options II Basics: · Present value of a perpetuity: C/r · Present value of a growing (or shrinking) perpetuity: C/(r-g) · Present value of C dollars t years from now: C/[(1+r)t] · Present value of a C-dollar t-year annuity: C[(1/r)-(1/[r(1+r)t]) · "Rule of 72": (1+r)t = 2 (approximately) whenever rt=.72 · beta = [E((r1-r*1)(rm-r*m)]/[(rm-r*m)2] · r*i = r*f + betai(r*m-rf) Title Business revenues are down, profits are falling. Production costs are rising faster than prices, which causes profit margins to shrink. Business is no longer making large capital investment. Business output typically exceeds sales. Inventories start to build up due to falling sales. Accounts receivable start to rise, which causes a shortage of working capital and this forces businesses to seek bank financing. Business confidence erodes. Consumer confidence declines, housing sales fall, and big-ticket consumer spending drops as consumers worry about the future. Central bank intervention to control inflation, by raising short-term interest rates often causes inverted yield curves at this point in the cycle. Monetary policy bias is towards tightening credit, aimed at causing the economy to slow. Rising interest rates cause bond prices to fall. Stock prices have weakened and stock market activity drops off. New stock and bond issues are poorly accepted by investors and become rare. The investment strategy at this point in the cycle is to sell stocks of companies in cyclical industries, stocks with high P/E ratios, and low yielding stocks. Profits earned in the rising stock market should be invested in short term paper such as T-bills or money-market funds, which benefit from rising interest rates. Title Call option. Worth $70 million in the good state next year; worth zero in the bad state; call option today worth $22.9 million which is more than the $20 million payoff from immediate exercise. Is the binomial method for valuing options merely another application of decision tree analysis? Yes--with the proviso that option pricing theory is a very compact and powerful way of summarizing certain kinds of decision trees. Flexible Production: the opportunity to change your scale of operations. Option Value at a glance: · American calls--no dividends. Don't exercise it before maturity; treat it as a European call. · European puts--no dividends. Value of put = Value of call - value of underlying + PV(EP) · American puts--no dividends. It can sometimes pay to exercise an American put before maturity in order to reinvest the exercise price. For example, suppose that immediately after you buy an American put the price of the underlying falls to zero. In this case it is certainly better to exercise the put immediately; valuing it is not easy: Black-Scholes does not apply. · European calls on dividend-paying stocks; reduce the price of the stock in Black-Scholes by the PV of the dividends paid before the option matures, because some of today's stock value is made up of those dividends. Title Dividend increases are good news--signal managerial optimism. Dividend Controversy · Right wing: increasing payouts raise value · Middle of the road: who cares about dividend policy? · Left wing: increasing payouts lowers value Franco Modigliani and Merton Miller; //Homemade leverage proof: Assets Liabilities + NW Cash $1,000 0 Debt Fixed Assets $9,000 $10,000 + NPV Equity Title Dividend increases are good news--signal managerial optimism. Dividend Controversy · Right wing: increasing payouts raise value · Middle of the road: who cares about dividend policy? · Left wing: increasing payouts lowers value Franco Modigliani and Merton Miller; //Homemade leverage proof: Assets Liabilities + NW Cash $1,000 0 Debt Fixed Assets $9,000 $10,000 + NPV Equity Inv. Oppor. NPV Title EX is the exercise price of the option. PV() is the present value discounted at the continuously-compounded risk-free interest rate. d1 = [log(P/PV(EX))/(sigma x root(t)) + (sigma x root(t))/2] d2=d1 - sigma x root(t) root(t) is the square root of the number of periods until the exercise date sigma is the per period standard deviation of the return on the stock P is the price of the stock now Thus the Black-Scholes formula tells us that the value of a call is equal to the value of an investment (today) of N(d1) in the common stock, less borrowing of N(d2) x PV(EX). Tables 6 and 7 give the Black-Scholes formula values fror a range of P/PV(EX) and sigma x root(t) values. Table six gives the price (as a percent of P); table 7 gives the option delta or hedge ratio. If you take any more finance courses; you will see this a lot; you may see this on an exam--either asked to identify what it is, or (perhaps) asked to apply it (in which case we will give it to you). But from now on we are going to look only at simple two-case binomial options. T |