corporate finance. objectives of the course on successful completion of this course, you should be...

Corporate Finance

Objectives of the Course

On successful completion of this course, you should be able to:

Identify the purpose and relevance of Corporate Finance;

Explain the use of a variety of advance capital budgeting techniques;

Discuss the importance of risk and return in Corporate Finance;

Discuss the process determining the capital structure and dividend policy;

Apply financial derivatives in risk management; and

Discuss factors that affect shareholders’ wealth.

Topic 1: Value and Capital Budgeting

Net Present Value How to Value Bonds and Stocks Some Alternative Investment Rules Net Present Value and Capital Budgeting Risk Analysis, Options and Capital Budgeting

Topic 2: Risk and Return

Capital Market Theory: An Overview Return & Risk: The Capital Asset Pricing

Model (CAPM) An Alternate View of Risk and Return: The

Arbitrage Pricing TheoryRisk, Cost of Capital, and Capital Budgeting

Topic 3: Capital Structure and Dividend Policy

Corporate Financing Decisions and Efficient Capital Markets

Long-Term Financing: An IntroductionCapital Structure: Basic ConceptsCapital Structure: Limits to the Use of Debt Valuation and Capital Budgeting for the

Levered FirmDividend Policy: Why Does It Matter?

Topic 4&5: Long-Term Financing & Derivatives

Issuing Securities to the Public Long-Term Debt Leasing

Topic 5: Options, Futures, and Corporate Finance Options and Corporate Finance: Basic Concepts -Warrants and Convertibles , Derivatives and Hedging Risk

Research!

Research is the art of seeing what everyone else has seen, and doing what no-one else has done.

The Time Value of Money

Which would you rather have -- $1,000 today or $1,000 in 5 years?

Obviously, $1,000 today.

Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred to as the TIME VALUE OF MONEY!!

Why TIME?

NOT having the opportunity to earn interest on money is called OPPORTUNITY COST

Remember, one CANNOT compare numbers in different time periods without first adjusting them using an interest rate.

Compound Interest

When interest is paid on not only the principal amount invested, but also on any previous interest earned, this is called compound interest.

FV = Principal + (Principal x Interest)

= 2000 + (2000 x .06)

Future Value

If you invested $2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals?

FV1 = PV (1+i)n = $2,000 (1.06)2

= $2,247.20FV = future value, a value at some future point in

timePV = present value, a value today which is usually

designated as time 0i = rate of interest per compounding period n = number of compounding periods

Future Value Example

John wants to know how large his $5,000 deposit will become at an annual compound interest rate of 8% at the end of 5 years.

FVn = PV (1+i)n FV5

= $5,000 (1+ 0.08)5 = $7,346.64

Present Value

Since FV = PV(1 + i)n.

PV = FV / (1+i)n.

Discounting is the process of translating a future value or a set of future cash flows into a present value.

Present Value Example

Joann needs to know how large of a deposit to make today so that the money will grow to $2,500 in 5 years. Assume today’s deposit will grow at a compound rate of 4% annually.

Calculation based on general formula: PV0 = FVn / (1+i)n

PV0 = $2,500/(1.04)5 = $2,054.81

Finding “n” or “i” when one knows PV and FV

If one invests $2,000 today and has accumulated $2,676.45 after exactly five years, what rate of annual compound interest was earned?

Annuities

An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.

Examples of Annuities Include:Student Loan PaymentsCar Loan PaymentsInsurance PremiumsMortgage PaymentsRetirement Savings

Dividend Policy

Learning ObjectivesImportant TermsMechanics of Dividend PaymentsCash Dividend PaymentsM&M’s Dividend Irrelevance TheoremThe “Bird in the Hand” ArgumentDividend Policy in PracticeRelaxing the M&M AssumptionsStock Dividends and Stock SplitsShare RepurchasesSummary and Conclusions

Dividend PolicyWhat is It?

Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation. This decision is considered a financing decision

because the profits of the corporation are an important source of financing available to the firm.

Types of Dividends

Dividends are a permanent distribution of residual earnings/property of the corporation to its owners.

Dividends can be in the form of: Cash Additional Shares of Stock (stock dividend) Property

If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders – this is known as a liquidating dividend.

Dividends a Financing Decision

In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm.

When a cash dividend is declared, those funds leave the firm permanently and irreversibly.

Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.

Corporate Profits After Tax Retained Earnings

Dividends

Dividends versus Interest Obligations

Interest Interest is a payment to lenders for the use of their funds for a

given period of time Timely payment of the required amount of interest is a legal

obligationFailure to pay interest (and fulfill other contractual commitments

under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies

Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcy

DividendsA dividend is a discretionary payment made to shareholdersThe decision to distribute dividends is solely the responsibility of

the board of directorsShareholders are residual claimants of the firm (they have the last,

and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)

Dividend Payments

Cash Dividend - Payment of cash by the firm to its shareholders.

Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.

Record Date - Person who owns stock on this date received the dividend.

Mechanics of Cash Dividend Payments

Declaration Date this is the date on which the Board of Directors meet and declare the dividend. In

their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class.

when CARRIED, this resolution makes the dividend a current liability for the firm.

Date of Record is the date on which the shareholders register is closed after the trading day and all

those who are listed will receive the dividend.

Ex dividend Date is the date that the value of the firm’s common shares will reflect the dividend

payment (ie. fall in value) ‘ex’ means without. At the start of trading on the ex-dividend date, the share price will normally open for

trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend.

Date of Payment is the date the cheques for the dividend are mailed out to the shareholders.

Dividend PolicyDividends, Shareholders and the Board of Directors

There is no legal obligation for firms to pay dividends to common shareholders

Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision because: Board members are jointly and severally liable for any

damages they may cause Board members are constrained by legal rules affecting

dividends including: Not paying dividends out of capital Not paying dividends when that decision could cause the firm to

become insolvent Not paying dividends in contravention of contractual

commitments (such as debt covenant agreements)

Dividend Reinvestment Plans (DRIPs)

Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm DRIPs will buy as many shares as the cash dividend allows

with the residual deposited as cash Leads to shareholders owning odd lots (less than 100

shares)

Firms are able to raise additional common stock capital continuously at no cost and fosters an on-going relationship with shareholders.

Dividend PaymentsStock Dividends

Stock dividends simply amount to distribution of additional shares to existing shareholders

They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account.

Because of the capital impairment rule stock dividends reduce the firm’s ability to pay dividends in the future.


Implications reduction in the R/E account reduced capacity to pay future dividends proportionate share ownership remains unchanged shareholder’s wealth (theoretically) is unaffected

Effect on the Company conserves cash serves to lower the market value of firm’s stock modestly promotes wider distribution of shares to the extent that current owners divest

themselves of shares...because they have more adjusts the capital accounts dilutes EPS

Effect on Shareholders proportion of ownership remains unchanged total value of holdings remains unchanged if former DPS is maintained, this really represents an increased dividend payout


ABC CompanyEquity Accounts

as at February xx, 20x9Common stock (215,000) $5,000,000Retained earnings 20,000,000Net Worth $25,000,000

The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share.

This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is:

$40.00 (21,500) = $860,000

This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:


After the stock dividend:

ABC CompanyEquity Accounts

as at March 1, 20x9

Common stock (236,500)$5,860,000Retained earnings 19,140,000Net worth $25,000,000

The market price of the stock will be affected by the stock dividend:

New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36

The individual shareholder’s wealth will remain unchanged.

Cash Dividend PaymentsThe Macro Perspective

Aggregate after-tax profits run at approximately 6% of GDP but are highly variable

Aggregate dividends are relatively stable when compared to after-tax profits. They are sustained in the face of drops in profit during

recessions They are held reasonably constant in the face of peaks in

aggregate profits.

Aggregate Dividends and Profits

Cash Dividend PaymentsThe Macro Perspective - Question

Why are dividends smoothed and not matched to profits? The companies chosen here illustrate the dramatic

differences between companies: Some pay no dividends Some pay consistent cash dividends representing

substantial yields on current shares prices The highest yields are found in the case of Income

Trusts and large stable ‘blue-chip’ financials and utilities

Cash Dividend PaymentsDividend Yields

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average% % % % % % % % % %

BCE 4.69 3.42 2.52 1.41 1.07 3.15 3.99 4.08 4.29 4.44 3.31Celestica Inc. 0 0 0 0 0 0 0 0 0 0 0.00CIBC 3.67 3.07 2.85 3.37 3.17 2.9 3.48 3.28 3.31 3.57 3.27Cott Corporation 0.23 0.53 0.54 0 0 0 0 0 0 0 0.13Kinross Gold Corporation 0 0 0 0 0 0 0 0 0 0 0.00TransAlta Corporation 6.22 5.16 4.52 5.35 5.59 4.06 4.92 5.73 5.88 4.51 5.19Yellow Pages Income Fund 7.34 7.09 7.22

Table 22-1 S&P/TSX 60 Index Dividend Yields

Modigliani and Miller’s Dividend Irrelevance Theorem

The value of M&M’s Dividend Irrelevance argument is that in the end, it shows where value can be created with dividend policy and why.

M&M’s Dividend Irrelevance TheoremAssumptions

No TaxesPerfect capital markets

large number of individual buyers and sellers costless information no transaction costs

All firms maximize valueThere is no debt

M&M’s Dividend Irrelevance TheoremResidual Theory of Dividends

The Residual Theory of Dividends suggests that logically, each year, management should:

Identify free cash flow generated in the previous period

Identify investment projects that have positive NPVs Invest in all positive NPV projects

If free cash flow is insufficient, then raise external capital – in this case no dividend is paid

If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.

M&M’s Dividend Irrelevance TheoremResidual Theory of Dividends - Implication

The implication of the Residual Theory of Dividends are:

Investment decisions are independent of the firm’s dividend policy No firm would pass on a positive NPV project because of

the lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken.

If the firm can’t make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own.

The firm should operate where Marginal Cost equals Marginal Revenue as seen in Figure on the following slide:

CHAPTER 22 – Dividend Policy

22 - 38

M&M’s Dividend Irrelevance TheoremInternal Funds, Investment, and Dividends

FIGURE

$11,976 Million

Rate of Return

WACC

Internal Funds Available

OPTIMAL INVESTMENT

$177,607 Million

MC=MR

The “Bird-in-the-Hand” ArgumentM&M’s Assumptions Relaxed

Risk is a real world factor.Firm’s that reinvest free cash flow, put that

money at risk – there is no certainty of investment outcome – those forfeit dividends that are reinvested…could be lost!

Remember the two-stage DDM?

The “Bird-in-the-Hand” ArgumentM&M’s Assumptions Relaxed

Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued by investors.

This implies that investors perceive non-dividend paying firms to be riskier and apply a higher discount rate to value them causing the share price to fall.

The difference between the M&M and Gordon arguments are illustrated in Figure 2 on the following slide: M&M argue that dividends and capital gains are perfect

substitutes


22 - 41

The “Bird-in-the-Hand” ArgumentM&M versus Gordon’s Bird in the Hand Theory

0

1

P

D

FIGURE 2

Gordon

OPTIMAL INVESTMENT

M&M

0

01

P

PP

The “Bird-in-the-Hand” ArgumentM&M versus Gordon’s Bird in the Hand Theory

Conclusions: Firms cannot change underlying operational

characteristics by changing the dividend The dividend should reflect the firm’s operations

through the residual value of dividends

Dividend Policy in Practice

Firms smooth their dividends Firms tend to hold dividends constant, even in the

face of increasing after-tax profit Firms are very reluctant to cut dividends

Relaxing the M&M AssumptionsWelcome to the Real World!

Dividends and Signalling Under conditions of information asymmetry, shareholders

and the investing public watch for management signals (actions) about what management knows.

Management is therefore very cautious about dividend changes…they don’t want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they don’t want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)

(The Signalling Model is explained in Figure 3 found on the next slide.)

Relaxing the M&M AssumptionsThe Signalling Model

FIGURE 3

et

$

1 2 3 Time

et*

dt*

dt


Agency Theory Investors are wary of senior management so they seek to

put controls in place. There is a fear that managers may waste corporate

resources by over-investing in low or poor NPV projects. Gordon Donaldson argued this is the reason for the pecking

order managements tend to use when raising capital Shareholders would prefer to receive a dividend and then have

management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend.

Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess management.


Taxes and the Clientele Effect Table (on the following slide) illustrates that different

classes of investors face different tax brackets Preference for dividends versus capital gains income

depends on the province of residence and taxable income level leading to tax clienteles. High income earners tend to prefer capital gains (there is an

additional tax incentive for such individuals in that they can choose the timing of the sale of their investment…remember only ‘realized’ capital gains are subject to tax

Low income earners tend to prefer dividends

Conclusion – firm’s should not change dividend policy drastically since it upsets the existing ownership base.

Relaxing the M&M AssumptionsTaxes

Income Level $25,000 $50,000 $75,000 $100,000

British Columbia Dividends 2.52 6.19 15.69 20.04Capital gains 12.45 15.58 18.85 20.35

Alberta Dividends 3.63 8.03 13.83 13.83Capital gains 12.63 16.00 18.00 18.00

Ontario Dividends 0.00 8.24 20.74 20.74Capital gains 10.65 15.58 21.71 21.71

Quebec Dividends 5.95 15.42 26.06 26.06Capital gains 14.37 19.19 22.86 22.86

Nova Scotia Dividends 0.00 8.75 17.05 19.06Capital gains 12.02 18.48 21.34 22.63

Table 22-3 Individual Tax Rates (% ) on Dividends and Capital Gains

Share Repurchases

Simply another form of payout policy.An alternative to cash dividend where the

objective is to increase the price per share rather than paying a dividend.

Since there are rules against improper accumulation of funds, firms adopt a policy of large infrequent share repurchase programs.

Share Repurchases

reasons for use: Offsetting the exercise of executive stock options Leveraged recapitalizations Information or signalling effects Repurchase dissident shares Removing cash without generating expectations for

future distributions Take the firm private.

Disadvantages of Share Repurchases

they are usually done on an irregular basis, so a shareholder cannot depend on income from this source.

if regular repurchases are made, there is a good chance that Revenue Canada will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax

there may be some agency problems - if managers have inside information, they are purchasing from shareholders at a price less than the intrinsic value of the shares.

Methods of Share Repurchases

tender offer: this is a formal offer to purchase a given number of shares at a

given price over current market price. open market purchase:

the purchase of shares through an investment dealer like any other investor

this is not designed for large block purchases. private negotiation with major shareholders

In any repurchase program, the securities commission requires disclosure of the event as well as all other material information through a prospectus.

Repurchase Example

Current EPS= [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00

Current P/E ratio= $20 / $4 = 5X

EPS after repurchase of 100,000 shares= $4.4 m / 1.0 = $4.40

Expected market price after repurchase:= [p/e][EPSnew] = [5][$4.40] = $22.00 per share

Effects of A Share Repurchase

EPS should increase following the repurchase if earnings after-tax remains the same

a higher market price per outstanding share of common stock should result

stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price.

Advantages of Share Repurchases

signal positive information about the firm’s future cash flows

used to effect a large-scale change in the firm’s capital structure

increase investor’s return without creating an expectation of higher future cash dividends

reduce future cash dividend requirements or increase cash dividends per share on the remaining shares, without creating a continuing incremental cash drain

capital gains treated more favourably than cash dividends for tax purposes.

Disadvantages of Share Repurchases

signal negative information about the firm’s future growth and investment opportunities

the provincial securities commission may raise questions about the intention

share repurchase may not qualify the investor for a capital gain

Borrowing to Pay Dividends

Is this legal? is it possible to do? Yes

the firm must have the ability and capacity to borrow the firm must have sufficient retained earnings to

allow it to pay the dividend the firm must have sufficient cash on hand to pay the

cash dividend the firm must NOT have agreed to any limitations on

the payment of dividends under the bond indenture. Why?

A possible answer is to signal to the market that the board is confident about the firm’s ability to sustain cash dividends into the future.


22 - 59

Assets: Liabilities:

Cash 10 Long-term Debt 0Fixed Assets 140 Common Stock 50

Retained Earnings100

Total Assets $150 Total Claims $150

After Borrowing…before cash dividend:Assets: Liabilities:


Retained Earnings100


Before Borrowing: 0% Debt

25% Debt

Borrowing to Pay DividendsAn Example

CHAPTER 22 – Dividend Policy22 - 60

Assets: Liabilities:

Cash 60 Current liabilities 50Fixed Assets 140 Long-term Debt 50

Common Shares 50Retained earnings 50


After Cash Dividend payment of $50Assets: Liabilities:


Retained earnings 50


After Dividend Declaration…before date of payment.

50% Debt

33% Debt

Borrowing to Pay DividendsAn Example …

The foregoing example illustrates: it is possible for a firm with ‘borrowing capacity’ to

borrow funds to pay cash dividends. this is not possible if the lenders insist on restrictive

covenants that limit or prevent this from occurring. the cash for the dividend must be present in the cash

account. payment of dividends reduces both the cash account on

the asset side of the balance sheet as well as the retained earnings account on the ‘claims’ side of the balance sheet.

in the absence of restrictions, it is possible to transfer wealth from the bondholders to the stockholders. (Bondholders in this example may have thought their firm would have only a 25% debt ratio….after the dividend the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.)

Borrowing to Pay DividendsAn Example

Summary and Conclusions

In this chapter you have learned:

About the different types of dividends including, regular and special cash dividends, stock dividends, and share repurchases.

M&M’s dividend irrelevance argument and the real world factors such as transactions costs, taxes, clientele effects and signalling tend to favour real-world dividend relevance

Tax motives and other reasons explain why firms might want to repurchase their shares.

Concept Review Questions

Define four important dates that arise with respect to dividend payments.

Past year Qs

Leasing

Types of LeasesThe Basics

– A lease is a contractual agreement between a lessee and lessor.

– The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor.

– The lessor is either the asset’s manufacturer or an independent leasing company.

Operating Leases

• Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor.

• Usually require the lessor to maintain and insure the asset.

• Lessee enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.

Financial Leases

The exact opposite of an operating lease.1. Do not provide for maintenance or service by the lessor.

2. Financial leases are fully amortized.

3. The lessee usually has a right to renew the lease at expiry.

4. Generally, financial leases cannot be cancelled, i.e., the lessee must make all payments or face the risk of bankruptcy.

Sale and Lease-Back

• A particular type of financial lease.• Occurs when a company sells an asset it already owns

to another firm and immediately leases it from them.• Two sets of cash flows occur:

– The lessee receives cash today from the sale.– The lessee agrees to make periodic lease payments, thereby

retaining the use of the asset.

Leveraged Leases

• A leveraged lease is another type of financial lease.• A three-sided arrangement between the lessee, the

lessor, and lenders.– The lessor owns the asset and for a fee allows the lessee to

use the asset.– The lessor borrows to partially finance the asset.– The lenders typically use a nonrecourse loan. This means that

the lessor is not obligated to the lender in case of a default by the lessee.

Accounting and Leasing

• In the old days, leases led to off-balance-sheet financing.

• In 1979, the Canadian Institute of Chartered Accountants implemented new rules for lease accounting according to which financial leases must be “capitalized.”

• Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides.

Accounting and Leasing

Balance SheetTruck is purchased with debtTruck $100,000 Debt $100,000Land $100,000 Equity $100,000Total Assets $200,000 Total Debt & Equity $200,000

Operating LeaseTruck DebtLand $100,000 Equity $100,000Total Assets $100,000 Total Debt & Equity $100,000

Capital LeaseAssets leased $100,000 Obligations under capital lease$100,000Land $100,000 Equity $100,000Total Assets $200,000 Total Debt & Equity$200,000

Capital Lease

• A lease must be capitalized if any one of the following is met:– The present value of the lease payments is at least 90-percent

of the fair market value of the asset at the start of the lease.– The lease transfers ownership of the property to the lessee by

the end of the term of the lease.– The lease term is 75-percent or more of the estimated

economic life of the asset.– The lessee can buy the asset at a bargain price at expiry.

Taxes and Leases

• The principal benefit of long-term leasing is tax reduction.• Leasing allows the transfer of tax benefits from those who need

equipment but cannot take full advantage of the tax benefits of ownership to a party who can.

• If the CCRA (Canada Customs and Revenue Agency) detects one or more of the following, the lease will be disallowed.

1. The lessee automatically acquires title to the property after payment of a specified amount in the form of rentals.

2. The lessee is required to buy the property from the lessor.

3. The lessee has the right during the lease to acquire the property at a price less than fair market value.

The Cash Flows of Leasing

Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck.

The truck is expected to reduce costs by $4,500 per year.

The truck costs $25,000 and has a useful life of five years.

If the firm buys the truck, they will depreciate it straight-line to zero.

They can lease it for five years from Tiger Leasing with an annual lease payment of $6,250.

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McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited


• Cash Flows: BuyYear 0 Years 1-5

Cost of truck –$25,000

After-tax savings 4,500×(1-.34) = $2,970

Depreciation Tax Shield 5,000×(.34) = $1,700

–$25,000 $4,670

• Cash Flows: LeaseYear 0 Years 1-5

Lease Payments –6,250×(1-.34) = –$4,125

After-tax savings 4,500×(1-.34) = $2,970

–$1,155

• Cash Flows: Leasing Instead of BuyingYear 0 Years 1-5

$25,000 –$1,155 – $4,670 = –$5,825

21-75



• Cash Flows: Leasing Instead of BuyingYear 0 Years 1-5

$25,000 –$1,155 – $4,670 = –$5,825

• Cash Flows: Buying Instead of Leasing Year 0 Years 1-5

–$25,000 $4,670 –$1,155 = $5,825

• However we wish to conceptualize this, we need to have an interest rate at which to discount the future cash flows.

• That rate is the after-tax rate on the firm’s secured debt.

NPV Analysis of the Lease-vs.-Buy Decision

• A lease payment is like the debt service on a secured bond issued by the lessee.

• In the real world, many companies discount both the depreciation tax shields and the lease payments at the after-tax interest rate on secured debt issued by the lessee.

• The various tax shields could be riskier than lease payments for two reasons:

1. The value of the CCA tax benefits depends on the firm’s ability to generate enough taxable income.

2. The corporate tax rate may change.

21-77


NPV Analysis of the Lease-vs.-Buy Decision

20.219$)05.1(

825,5$000,25$

5

1

t

tNPV

20.219$)05.1(

825,5$000,25$

5

1

t

tNPV

NPV Buying Instead of Leasing Year 0 Years 1-5

-$25,000 $4,670 – $1,155 = $5,825

• There is a simple method for evaluating leases: discount all cash flows at the after-tax interest rate on secured debt issued by the lessee. Suppose that rate is 5-percent.

NPV Leasing Instead of BuyingYear 0 Years 1-5

$25,000 –$1,155 – $4,670 = -$5,825

Reasons for Leasing

• Good Reasons– Taxes may be reduced by leasing.– The lease contract may reduce certain types of uncertainty.– Transactions costs can be higher for buying an asset and

financing it with debt or equity than for leasing the asset.• Bad Reasons

– Leasing and accounting income– 100% financing

Summary and Conclusions

• There are three ways to value a lease.1. Use the real-world convention of discounting the

incremental after-tax cash flows at the lessor’s after-tax rate on secured debt.

2. Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate. The increase in debt capacity from a purchase is compared to the extra outflow at year 0 from a purchase.

3. Use APV (presented in the appendix to this chapter).• They all yield the same answer.• The easiest way is the least intuitive.

Capital Structure

capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

A firm's capital structure is then the composition or 'structure' of its liabilities.

In reality, capital structure may be highly complex and include dozens of sources.

An optimal capital structure: maximizes the value of the firm.

The impact of capital structure on value depends upon the effect of debt on:

WACCFCF

Modigliani-Miller theorem,

The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value.

perfect capital market;-no transaction or bankruptcy costs; -perfect information- firms and individuals can borrow at the

same interest rate; -no taxes; -and investment decisions are not affected

by financing decisions.

Capital structure in the real world

The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model.

1. Trade-off theory - bankruptcy cost Vs. Tax benefit but it (doesn't explain differences within the same industry).

2. Pecking order theory -companies prioritize their sources of financing (from internal financing to equity) / costs of asymmetric information

3. Agency Costs - Underinvestment problem / Free cash flow management issues

Capital structure Ratios

Capital structure ratios compare a company's debt and its equity.

Debt and equity are the two methods companies acquire capital. Debt refers to money borrowed, while equity refers to money invested or earned.

Financial ratios that measure capital structure include the debt-to-equity ratio the ratio of fixed assets to long-term liabilities.Gearing ratioEPS and PE ratioCapital gearing ratio = (Capital Bearing Risk) : (Capital

not bearing risk)

Factors to be considered

Debt ratios of other firms in the industry.Pro forma coverage ratios at different capital

structures under different economic scenarios.Lender and rating agency attitudes

(impact on bond ratings).Reserve borrowing capacity.Effects on control.Type of assets: Are they tangible, and hence

suitable as collateral?Tax rates.

why investors should establish portfolios

This is neatly captured in the old saying ‘don’t put all your eggs in one basket’.

The logic

The logic is that an investor who puts all of their funds into one investment risks everything on the performance of that individual investment. A wiser policy would be to spread the funds over several investments (establish a portfolio) so that the unexpected losses from one investment maybe offset to some extent by the unexpected gains from another.

EXPECTED RETURN

Investors receive their returns from shares in the form of dividends and capital gains/ losses.

formula

The formula for calculating the annual return on a share is:

Annual return = D 1 + (P1 - P 0)/P0where:D1 = dividend per shareP1 = share price at the end of a yearP0 = share price at the start of a year.

Example

Suppose that a dividend of 5p per share was paid during the year on a share whose value was 100p at the start of the year and 117p at the end of the year:

Annual return =5 + (117 - 100)/100 × 100 = 22%

dividend yield and capital gain

The total return is made up of a 5% dividend yield and a 17% capital gain. We have just calculated a historical return, on the basis that the dividend income and the price at the end of year one is known .

The future expected return

Calculating the future expected return is a lot more difficult because we will need to estimate both next year ’s dividend and the share price in one year ’s time. Analysts normally consider the different possible returns in alternate market conditions and try and assign a probability to each.

Example 1 shows the calculation of theexpected return for A plc.

The current share price of A plc is 100p and the estimated returns for next year are shown .

The investment in A plc is risky.

Risk refers to the possibility of the actual return varying from the expected return, ie the actual return may be 30% or 10% as opposed to the expected return of 20%.

Required return

The required return consists of two elements,which are:

Required return = Risk-free return + Risk premium

Risk-free return

The risk-free return is the return required by investors to compensate them for investing in a risk-free investment.

The risk-free return compensates investors for

inflation and consumption preference, ie the fact that they are deprived from using their funds while tied up in the investment.

The return on treasury bills is often used as a surrogate for the risk-free rate.

Risk premium

Risk simply means that the future actual return may vary from the expected return.

If an investor undertakes a risky investment he needs to receive a return greater than the risk-free rate in order to compensate him.

The more risky the investment the greater the compensation required.

This is not surprising and it is what we would expect from risk averse investors.

The Barclay Capital Equity Gilt Study 2003

The Barclay Capital Study calculated the average return on treasury bills in the UK from 1900 to 2002 as approximately 6%.

It also calculated that the average return on the UK stock market over this period was 11%.

Thus if an investor had invested in shares that had the same level of risk as the market, he would have to receive an extra 5% of return to compensate for the market risk.

Thus 5% is the historical average risk in the UK.

The required return calculation

Suppose that Joe, the investor believes that the shares in A plc are twice as risky as the market and that the use of long-term averages are valid.

Calculate the required return

The required return may be calculated as follows:

Required return of A plc = Risk free + Risk premium16% = 6% + (5% × 2)

Thus 16% is the return that Joe requires to compensate for the perceived level of risk in A plc, i.e. it is the discount rate that he will use to appraise an investment in A plc.

THE NPV CALCULATION

Suppose that Joe is considering investing £100 in A plc with the intention of selling the shares at the end of the first year.

Assume that the expected return will be 20% at the end of the first year.

Given that Joe requires a return of 16% should he invest?

THE NPV CALCULATION

Cash flows year 0 (100), year end 120

Discount factor – 16%, year 0 = 1, year 1= 0.862

(100) 103

NPV=3

Decision criteria:

accept if the NPV is zero or positive.

The NPV is positive, thus Joe should invest.

A positive NPV opportunity is where the expected return more than compensates the investor for the perceived level of risk, i.e. the expected return of 20% is greater than the required return of 16%.

An NPV calculation compares the expected and

required returns in absolute terms.

Calculation of the risk premium

Calculating the risk premium is the essential component of the discount rate.

This in turn makes the NPV calculation possible.

To calculate the risk premium, we need to be

able to define and measure risk.

THE STUDY OF RISK

The definition of risk that is often used in finance literature is based on the variability of the actual return from the expected return.

Statistical measures of variability are the variance and the standard deviation (the square root of the variance).

The variance and standard deviation of the returns.

Example 1 - A plc,

Market conditions [Actual return Probability – expected return]2

Boom [30 - 20]2 0.1 10Normal [20 - 20]2 0.8 0Recession [10 - 20]2 0.1 10Variance σ2 20Standard deviation σ = 4.47

The variance

The variance of return is the weighted sum of squared deviations from the expected return.

The reason for squaring the deviations is to ensure that both positive and negative deviations contribute equally to the measure of variability.

Thus the variance represents ‘rates of return squared’.

The standard deviation

Standard deviation is the square root of the variance, its units are in rates of return.

As it is easier to discuss risk as a percentage rate of return, the standard deviation is more commonly used to measure risk.

A choice of investing in either A plc or Z plc,

Shares in Z plc have the following returns and associated probabilities:

Probability Return %0.1 350.8 200.1 5

A choice of investing in either A plc or Z plc,

Let us then assume that there is a choice of investing in either A plc or Z plc, which one should we choose?

To compare A plc and Z plc, the expected return and the standard deviation of the returns for Z plc will have to be calculated.

Calculation

The expected return is: (0.1) (35%) + (0.8)(20%) + (0.1) (5%) = 20%

The variance is: = σ2, z = (0.1) (35% - 20%)2 + (0.8) (20% - 20%)2 + (0.1) (5% - 20%)2 = 45%

The standard deviation is: = σz = 6.71%

Summary table

Investment Expected return Standard deviation

A plc 20% 4.47%Z plc 20% 6.71%

Given that the expected return is the same for both companies, investors will opt for the one that has the lowest risk, ie A plc.

The decision

The decision is equally clear where an investment gives the highest expected return for a given level of risk.

However, these only relate to specific instances where the investments being compared either have the same expected return or the same standard deviation.

Where investments have increasing levels of return accompanied by increasing levels of standard deviation, then the choice between investments will be a subjective decision based on the investor ’s attitude to risk.

RISK AND RETURN ON TWO-ASSETPORTFOLIOS

So far we have confined our choice to a single investment. Let us now assume investments…

The risk-return relationship will now be measured in terms of the portfolio’s expected return and the portfolio’s standard deviation.

Information about four investments: A plc, B plc, C plc, and D plc.

Assumption

Assume that our investor, Joe has decided to construct a two-asset portfolio and that he has already decided to invest 50% of the funds in A plc.

He is currently trying to decide which one of the other three investments into which he will invest the remaining 50% of his funds.

The expected return of a two-asset portfolio

The expected return of a portfolio (Rport) is simply a weighted average of the expected returns of the individual investments.

Return on investments (%)

Market conditions Probability A plc B plc C plc D plc

Boom 0.1 30 30 10 10Normal 0.8 20 20 20

22.5Recession 0.1 10 10 30 10

Expected return 20 20 20 20

Standard deviation 4.47 4.47 4.47 4.47

E.g. 3 - Return on investments (%)

Market Conditions A plc B plc Portfolio A + B

Boom 30 30 30Normal 20 20 20Recession 10 10 10

Portfolio Expected Return calculation

Rpor t = x.RA + (1 - x).RB

x = the proportion of funds invested in A(1 - x) = the proportion of funds invested in B

RA + B = 0.5 × 20 + 0.5 × 20 = 20RA + C = 0.5 × 20 + 0.5 × 20 = 20RA + D = 0.5 × 20 + 0.5 × 20 = 20

Portfolio Expected Return

Given that the expected return is the same for all the portfolios, Joe will opt for the portfolio that has the lowest risk as measured by the portfolio’s standard deviation.

The standard deviation of a two-asset portfolio

We can see that the standard deviation of all the individual investments is 4.47%.

Intuitively, we probably feel that it does not matter which portfolio Joe chooses, as the standard deviation of the portfolios should be the same (because the standard deviations of the individual investments are all the same).

The standard deviation of a two-asset portfolio

However, the above analysis is flawed, as the standard deviation of a portfolio is not simply the weighted average of the standard deviation of returns of the individual investments but is generally less than the weighted average.

So what causes this reduction of risk?

What is the missing factor?

The missing factor is how the returns of the two investments co-relate or co-vary, i.e. move up or down together. There are two ways to measure co variability.

The first method is called the covariance and the second method is called the correlation coefficient.

Before we perform these calculations let us review the basic logic behind the idea that risk may be reduced depending on how the returns on two investments co-vary.

Portfolio A+B – perfect positive correlation

The returns of A and B move in perfect lock step, (when the return on A goes up to 30%, the return on B also goes up to 30%, when the return on A goes down to 10%, the return on B also goes down to 10%), ie they move in the same direction and by the same degree.

Example 3.

This is the most basic possible example of perfect positive correlation , where the forecast of the actual returns are the same in all market conditions for both investments and thus for the portfolio (as the portfolio return is simply a weighted average).

Example 3.

Hence there is no reduction of risk. The portfolio’s standard deviation under this theoretical extreme of perfect positive correlation is a simple weighted average of the standard deviations of the individual investments:

σpor t (A,B) = 4.47 × 0.5 + 4.47 × 0.5= 4.47

Portfolio A+C – perfect negative correlation

The returns of A and C move in equal but opposite ways (when the return on A goes up to 30%, the return on C goes down to 10%,

when the return on A goes down to 10%, the return on C goes up to 30%). See Example 4.

EXAMPLE 4-Return on investments (%)

Market Conditions A plc C plc Portfolio A + C

Boom 30 10 20Normal 20 20 20Recession 10 30 20

Portfolio A+C – perfect negative correlation

This is the utopian position, i.e. where the unexpected returns cancel out against each other resulting in the expected return. If the forecast actual return is the same as the expected return under all market conditions, then the risk of the portfolio has been reduced to zero.

This is the only situation where the portfolio’s standard deviation can be calculated as follows:

σport (A,C) = 4.47 × 0.5 - 4.47 × 0.5 = 0

EXAMPLE 5

Market Conditions A plc D plc Portfolio A + D

Boom 30 10 20Normal 20 22.5 21.25Recession 10 10 10

Market conditions

The forecast actual return is the same as the expected return under normal market conditions and almost the same under boom market conditions (20 v 21.25).

Therefore, we can say that the forecast actual and expected returns are almost the same in two out of the three conditions.

Market conditions

This compares with only one condition when there is perfect positive correlation (no reduction of risk) and all three conditions when there is perfect negative correlation (where risk may be eliminated).

Therefore, when there is no correlation between the returns on investments this results in the partial reduction of risk.

Measuring co-variability

Co-variability can be measured in absolute terms by the covariance or in relative terms by the correlation coefficient.

The covariance

A positive covariance indicates that the returns move in the same directions as in A and B.

A negative covariance indicates that the returns move in opposite directions as in A and C.

A zero covariance indicates that the returns are independent of each other as in A and D.

The correlation coefficient

Using the covariance formula, we can easily determine the formula for the correlation coefficient.

ρA,B = Cov a,b/σaσbThe correlation coefficient as a relative

measure of co-variability expresses the strength of the relationship between the returns on two investments.

It is strictly limited to a range from -1 to +1. See Example 6.

Reality

In reality, the correlation coefficient between returns on investments tends to lie between 0 and +1.

It is the norm in a two-asset portfolio to achieve a partial reduction of risk (the standard deviation of a two-asset portfolio is less than the weighted average of the standard deviation of the individual investments).

Reality

Therefore, we will need a new formula to calculate the risk (standard deviation of returns) on a two -asset portfolio. The formula will obviously take into account the risk (standard deviation of returns) of both investments but will also need to incorporate a measure of co-variability as this influences the level of risk reduction .

The formulae for the standard deviation ofreturns of a two-asset portfolio

Version 1Version 2

Summary table

Investment Expected return (%) Standard deviation (%)

Port A + B 20 4.47Port A + C 20 0.00Port A + D 20 3.16

Summary

A + C is the most efficient portfolio as it has the lowest level of risk for a given level of return.

Perfect negative correlation does not occur between the returns on two investments in the real world, ie risk cannot be eliminated, although it is useful to know the theoretical extremes.

However, as already stated, in reality the correlation coefficients between returns on investments tend to lie between 0 and +1.

Investments in different industries

Indeed, the returns on investments in the same industry tend to have a high positive correlation of approximately 0.9, while the returns on investments in different industries tend to have a low positive correlation of approximately 0.2.

Thus investors have a preference to invest in different industries thus aiming to create well diversified portfolio, ensuring that the maximum risk reduction effect is obtained.

Initial understanding

Based on our initial understanding of the risk-return relationship, if investors wish to reduce their risk they will have to accept a reduced return. However, portfolio theory shows us that it is possible to reduce risk without having a consequential reduction in return.

Initial understanding

This can be proved quite easily, as a portfolio’s expected return is equal to the weighted average of the expected returns on the individual investments, whereas a portfolio’s risk is less than the weighted average of the risk of the individual investments due to the risk reduction effect of diversification caused by the correlation coefficient being less than +1.

By investing in just two investments wecan reduce the risk

We can see from Portfolio A + D above where the correlation coefficient was zero, that by investing in just two investments we can reduce the risk from 4.47% to just 3.16% (a reduction of 1.31 percentage points).

Imagine how much risk we could have diversified away, had we created a large portfolio of say 500 different investments or indeed 5,000 different investments.

10 KEY POINTS TO REMEMBER

1 The expected return on a share consists of a dividend yield and a capital gain/loss in percentage terms.

2 The required return on a risky investment consists of the risk-free rate (which includes inflation) and a risk premium.

3 Total risk is normally measured by the standard deviation of returns (σ).

KEY POINTS TO REMEMBER

4 Portfolio theory demonstrates that it is possible to reduce risk without having a consequential reduction in return, i.e. the portfolio’s expected return is equal to the weighted average of the expected returns on the individual investments, while the portfolio risk is normally less than the weighted average of the risk of the individual investments.


5 The extent of the risk reduction is influenced by the way the returns on the investments co-vary. Co-variability is normally measured in the exams by the correlation coefficient.

6 In reality, the correlation coefficient between returns on investments tend to lie between 0 and +1. Thus total risk can only be partially reduced, not eliminated.


7 A portfolio’s total risk consists of unsystematic and systematic risk.However, a well-diversified portfolio only suffers from systematic risk, as the unsystematic risk has been diversified away.

8 An investor who holds a well-diversified portfolio will only require a return for systematic risk. Thus their required return consists of the risk-free rate plus a systematic risk premium.


9 Investors who have well-diversified portfolios dominate the market. Thus the market only gives a return for systematic risk.

10 The preparation of a summary table and the identification of the most efficient portfolio (if possible) is an essential exam skill.

The Efficient Market Hypothesis

What is Efficient Market?

A market where there are large numbers of rational profit maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.


Efficient Market Hypothesis

• Securities prices always fully reflect all available, relevant information about the security.

Note the key words of the definition: “always,” “fully,” and “information.”

• Two important questions – What is all available information? – What does it mean to “Reflect all available information?”


All available information

• Past Price : Weak Form

• All public information : Semi Strong Form – Past price, news etc..

• All information including inside information : Strong Form

Forms of the EMH

Weak Information Set The relevant information is historical prices and other

trading data such as trading volume. If the markets are weak form efficient, use of such

information provides no benefit “at the margin.”Semi-strong Information set :

The relevant information is "all publicly available information, including past price and volume data."

If the markets are semi-strong form efficient, then studying past price and volume data & studying earnings and growth forecasts provides no net benefit in predicting price changes at the margin.

Forms of the EMH

• Strong information set:– The relevant information is “all information” both public

and private or “inside” information. – If the markets are strong form efficient, use of any

information (public or private) provides no benefit at the margin.

• SEC Rule 10b-5 limits trading by corporate insiders, (officers, directors and major shareholders). Inside trading must be reported.

Forms of the EMH

Relationships between forms of the EMH

Revision –Investment analysis

Explain the usefulness of financial derivatives to business organization?

What is the difference between money market and capital market?

What is meant by market portfolio?Define Security Market Line (SML)?What is the advantage of using margin

facility in share trading to an investor?

Revision –Exam style questions

Which security is an example of a hybrid security?

A. Ordinary shareB. Commercial paperC. BondD. Convertible share


The share of Medex Ltd. is currently trading at $3.35. You expect the share price to go up to $3.80 in the next few days.

What type of order would you give to your broker to purchase the shares now?

A. Margin order B. Market orderC. Stop-loss orderD. Limit order


Which is the definition for an optimal portfolio?

A. The portfolio that has the lowest risk.B. The portfolio that gives the best set of

returns.C. The portfolio that has the best set of

returns within its specific risk level.D. The portfolio that comprises of assets

that are risk-free.


Assuming a portfolio has 3 assets. How many variances and co-variances need to be calculated to compute the portfolio risk?

A. The number of variance is 3 and the number of covariance is also 3.

B. The number of variance is 6 and the number of covariance is 3.

C. The number of variance is 3 and the number of covariance is 6.

D. The number of variance is 6 and the number of covariance is also 6.


A share has a beta of 1.1. The risk-free rate is 2.5% and the return on the market is 12%. The estimated return for the share is 14%.

Based on the Capital Asset Pricing Model (CAPM), what should an investor do?

A. Sell the share because the required return is 9.95%.B. Sell the share because the required return is 16.5%.C. Buy the share because the required return is 11.5%.D. Buy the share because the required return is 12.95%.


On 13 October 2010, Mr. Aik bought 2,000 shares of Zee Ltd. (Zee) at $3 per share. He receives a dividend of $0.06 per share on 15 December 2010 and later sold the shares for $3.30 per share on 29 December 2010.

Based on this information, how much is

the dividend yield and capital gain of Zee’s shares?


You have a portfolio consisting of 30% of Share Ae and the balance in Share Be. The beta coefficient of Share Ae and Share Be are 0.7 and 1.5 respectively. The risk-free rate is 4% and the expected market return is 12%.

What is your portfolio’s expected return?


Mr. Kasim, an investor wishes to construct a portfolio consisting of 40% index share and 60% risk-free asset. The return on the risk-free asset is 2% and the expected return on the index share is 10%. If the standard deviation of returns on the index share is 8%, what is the expected standard deviation of the portfolio?

VALUATION PROCESS

There are two approaches to evaluate security. They are:

(a) Top to Bottom Approach(b) Bottom Up Approach

Two approaches

In the Top to Bottom Approach, we begin by analysing the economy followed by the industry and then proceed to the firms in the industry.

In the Bottom Up Approach, analysts will try to identify firms that are undervalued. These firms were chosen without taking into account the economic situation and environment.

The basic valuation model

In the basic valuation model, we will look at:(a) the Discounted Dividend Model(b) the Constant Growth Model(c) the Relationship between Share Price and

Growth(d) Multistage Growth

Discounted Dividend Model

In the Discounted Dividend Model, the share price is calculated by finding the present value of the predicted dividend and the predicted selling price of the share.

Constant Growth Model

If there is a rise in the dividend, the Discounted Dividend Model (formula 5.6) will have to be adjusted. For example, let’s assume the dividend of the company rise at a rate of 5% per year. So, if we take 3 years ahead, the dividend will be:

D1 = 0.50(1.05) = 0.525D2 = 0.525(1.05) = 0.55125 or 0.05(1.05)2D3 = 0.55125 (1.05) = 0.579 or 0.05(1.05)3

Constant Growth Model

Generally, the situation above is the same as:D1 = D0(1+g)D2 = D1(1+g) or D0 (1+g)2D3= D2(1+g) or D1(1+g)3

Note: g is the growth rate.

PRICE EARNING (PE) RATIO MODEL

This model is also known as the earnings multiplier model. This is because the PE ratio is also known as the earning multiplier

ECONOMIC ANALYSIS

The prospect and future of a firm depends on the economic situation and business environment where the firm operates. Sometimes, the environment plays a great role on the performance of a firm.

In the evaluation of share prices, we have to evaluate the following economic and industrial situations:

(a) World Environment(b) Domestic Economy(c) Government Policy

INDUSTRY ANALYSIS

A simple definition of industry would be where a group of firms run the same business.

The purpose of industrial analysis is to understand the characteristics and structure of an industry.

There is a relationship between the character and structure of the industry with earnings that can be generated by firms in the industry.

In addition, a good firm usually is in a healthy and growing industry.

Sales Level and Industry Life Cycle

Competitive Structure in Industry

We can complete the industry analysis by examining the competitive structure of an industry.

The competitive structure can give insight into the earning of firms in the industry. The tighter the competition, the harder it will be for firms to get or maintain high profit.

Michael Porter, 5 forces model

COMPANY ANALYSIS

The objective of company analysis is to examine the nature and characteristics of a company.

SWOT analysis

It also involves examining the financial affairs of that company and determining the quality of its earnings.

Company analysis - 3 main financial statements

There are 3 main financial statements. They are:

(a) Balance Sheet which is a statement of the company’s assets, liabilities and stockholders’ equity.

(b) Income Statement which provide a summary of operating results.

(c) Statement of Cash Flows which provide a summary of cash flow and events that caused the cash position to change.

Financial statements

To increase earnings

There are two main strategies that a company can use in order to increase earnings.

They are:(a) Low Cost Strategy(b) Differentiation Strategy

Low Cost Strategy

Through this strategy the company endeavors to increase earnings by controlling costs.

This is only done when there is no opportunity to increase the price of the product.

Through this strategy the company will maintain its pricing policy, being confident that customers will not stop buying its products as it is perceived to be different and maybe of high quality.

Differentiation Strategy

Porters Generic Strategies

Fixed Income Security

A bond is a fixed income security which promises the investor a fixed stream of income for a specific time period.

CHARACTERISTICS OF BONDS

Maturity PeriodMaturity ValueCoupon RatesFloating RateZero-coupon BondsEmbedded Options

A floating rate indicates that the coupon rate may change according to the current interest rate. This current interest rate is dependent on the state of the economy.

Floating Rate

Embedded Options

Embedded options are specific characteristics stipulated in the bond indentures. These characteristics may include the option to call the bond at an earlier date before maturity.

Another type of option is when bonds can be converted to equity.

The latter is known as convertible bonds.

RISKS ASSOCIATED WITH BONDS

Interest Rate RisksReinvestment RisksRedemption Risks (or Risk of a Call)Default RisksInflation RisksLiquidity Risks

BOND PRICING

The price/value of a bond is the present value of the expected cash flow from the bond.

The expected cash flows are the coupon

payments and the face value.

These cash flows are then discounted at the required rate of return. This rate of return is normally called the yield of the bond.

Yield

This yield will depend vastly on the present market interest rate.

The present market interest rate will consider the risk-free rate of return and compensate its investor for the expected inflation.

Depending on the risk structure of the bond, the investor will also be compensated for additional risks faced throughout the life of the bond.

These risks may include liquidity, default or call risk which are normally specific to the security and firms.

Example

For example, a three-year RM1,000 bond with 10% coupon rate with a yield of 8% will have a value of:

Calculate…

Bond value = Present value of coupons + Present value of face value

Yield to Maturity

The rate of return earned from investing in bonds until the bond matures is termed as yield to maturity. Yield to maturity is also viewed as the promised rate of return accruing to investors.

However, investors can only expect the promised

return only if: -the probability of the issuer defaulting in

payment is zero; and -the bond cannot be called before maturity.

Current Yield and Holding period return

The current yield of a bond is just the coupon payment divided by the price.

The holding period return equals income earned over a period (including capital gains or losses) as a percentage of the bond price at the start of the period.

The return can be calculated for any holding period based on the income generated over that period.

VOLATILITY IN BOND PRICES

The most important factor that influences the value of the bond is the market interest rate, which directly influences the yield that an investor is looking for.

Changes in this interest rate will affect the changes in the prices of bonds referred to as the volatility of bond prices.

Bond Prices Move Inversely with InterestRates

Generally, the price of bonds will move counter cyclical to the movements in interest rates. In other words, if the price of bonds has a tendency to fall, then it may be due to the upward movements of interest rates in the market.

Go through the exmple.

Volatility of Bond Prices for Longer TermMaturity Bonds

Bonds with longer maturity periods, experience a more volatile price movement.

Table 7.1 shows that the rate of change in price is higher for a ten-year bond compared to a one-year bond.

Observe also that the rate of change in price reduces at a decreasing rate as the maturity period increases given the same level of interest rate.

Modified Duration

Modified duration is used to estimate the sensitivity of bond price as a result of a change in interest rates. It is calculated as:

Use the formula…Where D* is the Macaulay Duration, i is the

yield and n is the number of times the coupon rate is paid in a year.

If a bond is sold at RM1,000, and has Macaulay Duration of 5 years with a yield of 8% and pays the coupon twice in a year.

Calculate the modified duration.Macaulay duration, named for Frederick Macaulay

who introduced the concept, is the weighted average maturity of a bond

Modified Duration = Macaulay Duration /( 1 + y/n), where y = yield to maturity and n = number of discounting periods in year ( 2 for semi - ann pay bonds )

BOND PORTFOLIO MANAGEMENT

Investors can put their money in more than one bond to create a bond portfolio.

There are two types of management strategies namely the passive and active.

a) Passive Strategy;-Buy and Hold Strategy-Index Strategy

b) Active Strategy

Active Strategy

There are 4 sources of active management strategies namely:

i) Interest Rates Forecastingii) Choosing a Sectoriii) Movements Between Sectoriv) Choosing a ‘Wrongly’ Priced Bond

Active Bond Management

In an active bond portfolio management, there is always a need to change the portfolio of bonds. A bond manager may have to switch from one sector to another, or from one bond to another. Sometimes there is no need to actually buy and sell bonds. Instead the manager can just enter a swap.

A swap is an exchange between one bond with another.

Go through the examples of swap…

Liability Funding Strategy

Apart from maximising profits given a specific level of risk, investments in bonds provide a buffer against contingent claims.

An insurance company for example, receiving premiums must be able to pay its customers’ claims at the end of the life of the insurance. This does not include any unexpected claims made by the clients.

Derivatives

This topic explains derivative securities: forward contracts, futures, and both call and put options.

Among the most innovative and most rapidly growing markets to be developed in recent years are the markets for financial futures and options. This is known as Derivative market.

Futures and options trading are designed to protect the investor against interest rate risks, exchange rate risks and price risks.

A derivative security is a financial contract written on an underlying asset.

The underlying asset

The underlying asset may be a share, Treasury Bill, foreign currency or even another derivative security.

Go through the examples…Two types of derivative security, futures and

options are actively traded on organized exchanges.

These contracts are standardized with regard to description of the underlying asset, the right of the owner, and the maturity date.

Not standardized contracts

Forward contracts, on the other hand, are not standardized; each contract is customized to its owner, and they are traded in what is called the inter-bank market.

Options can be found embedded in other securities, convertible bonds and extendible bonds being two such examples.

A convertible bond contains a provision that gives an option to convert the security into common share. As extendible bond contains a provision that gives an option to extend the maturity of the bond.

A forward contract and A futures contract

A forward contract is an agreement to buy or sell a specified quantity of asset at a specified price, with delivery at a specified time and place.

A futures contract is an agreement to buy or sell a specified quantity of an asset at a specified price, and at a specified time and place.

This part of the definition of a futures contract is identical to that of a forward contract. But futures contracts differ from forward contracts in four important ways.

The differences are

(a) Futures contracts allow participants to realise gains or losses on a daily basis, while forward contracts are cash settled only at delivery.

(b) Futures contracts are standardised with respect to the quality and the quantity of the asset underlying the contract, the delivery date or period, and the delivery place if there is physical delivery. In contrast, forward contracts are customised on all these dimensions to meet the needs of the two counterparties.

The differences are

Futures contracts are settled through a clearing house. The clearing house acts as a middleman. This minimises credit risk as the second party to a futures contract is always the clearing house.

Futures markets are regulated, while forward contracts are unregulated.

Now let’s look at an example of a futures contract.

Clearing House

This intervention of the clearing house means that the futures market has no counterparty risk.

If A plans to buy futures and B plans to sell futures, both parties will refer to the clearing house to fulfil their intentions. The clearing house is thus the counter party to every contract.

In this case, B is not the counter party to A.

Settlement Price

A futures contract is marked-to-market each day. When each trading is closed, the exchange will establish the closing price, which is the settlement price.

This settlement price is used to compute the investor’s position, whether a loss or a gain compared to the initial settlement price agreed upon at the inception of the contract.

Daily Margin

When a person enters into a futures contract, the individual is required to deposit funds in an account with the broker.

This account is called the margin account.The exchange sets the minimum amount of margin

required, but brokers can increase the margin if they feel that the risk of the investors’ default is increased.

This margin account may earn interest or may not earn interest.

The economic role of the margin account is to act as collateral to minimise the risk of default by either party in the futures contract.

Basis

The difference between the futures price and the spot price is known as the basis.

Basis t = F(t, T) -S(t).

Basis with respect to maturity

Using Futures for Hedging

Futures are usually used to hedge our investment or lock the price of the underlying asset.

Thus with hedging, we can construct a portfolio consisting of assets on both the spot and the derivatives markets.

It is important to understand that in the spot market, we are dealing with the price risk whereas in the futures market, we are faced with the basis risk.

Hedging is easier to understand by using examples

An options contract

An options contract is a contract where the writer (or seller) of the options gives the right to the buyer of the options, but not an obligation, to buy (call options) or sell (put options) to the writer ‘something’ (or the underlying) at a specified price, during a specified period (or specific time).

Options Moneyness

Options moneyness refers to a situation of whether it is profitable or not when we initiate the contract.

Moneyness is always viewed from the buyer or the long position viewpoint and not from the seller’s

view point. Further, moneyness is obtained by comparing

the exercise price with the spot value of the underlying asset.

Difference between Options and FuturesContracts

Only the sellers (not the buyer) are obliged to buy or sell. The buyer of options need not buy or sell the underlying. In the futures contract, the buyers and sellers are obliged to buy or sell.

Thus, the main advantage of options is where the holder or the buyer of options will benefit from an upside benefit while limiting a downside loss.

Difference between Options and FuturesContracts

The buyer of options must pay a fee or the price of the options to the seller to get the right. In the futures contract, there is no exchange of money when the contract is initiated.

The buyer of the options will decide on the price of the options to buy (for call options) or to sell (for put options) but can take the opportunity if the price of the options is low. In the futures contract, the price is already fixed and the parties to the contract cannot obtain profit or suffer losses from any price movement.

The Binomial Pricing Model

In this model, we will use a riskless portfolio (S - C) where we buy a unit of the underlying asset and sell a call option on the asset.

We further assume that there are only two possible states, market goes up or market goes down.

The assumptions used in this model

(a) There are no market frictions.

(b) Market participant entails no counterparty risk.

(c) Markets are competitive.

(d) Market participants prefer more wealth to less.

(e) There are no arbitrage opportunities.

The Black-Scholes Model

The Black-Scholes model for pricing put (p) and call (c) options is as follow:

Formula.. N(d1), N(d2), = the cumulative probability density. The value for N(.)

is obtained from a normal distribution that is tabulated in most statistics

textbooks. c = European call option price p P = European put option price S0 = Share price today ST = Share price at option maturity K = Strike price T = Life of option R = Risk-free rate for maturity T with cont comp σ = Volatility of stock price

TOPIC 9

Mutual Fund Investment and PerformanceMeasurement

INTRODUCTION

This topic discusses another alternative approach to investment.

In this topic we will mainly discuss investment in mutual funds.

These mutual funds are basically portfolios that are managed by professional financial service organisations.

There are various kinds of funds available in the market. To manage the portfolio, they will need to go through a

process. Finally, we will discuss performance evaluation of

investments.

PROCESS OF PORTFOLIO MANAGEMENT

Asset Classification

Go through table 9.1 Asset Classification

INVESTORS’ OBJECTIVES

As we mentioned earlier, there are many investors with different risk tolerance.

Therefore, each major group of investors will have different portfolios that suit their needs.

The easiest way to determine an investors profile is by their age.

Table 9.1: Investors Needs Categorised According to Age

MUTUAL FUNDS: PROFESSIONALLYMANAGED INVESTMENT PORTFOLIOS

A mutual fund is a financial service that collects money from shareholders and invests those funds on their behalf in a diversified portfolio of securities.

Characteristics of a Fund

An open-end fund is a type of fund where investors can buy shares from the fund.

A close-end fund is a fund where the number of shares is fixed. Investors can buy these shares initially from the fund, but they cannot sell it back to the fund.

Types of Funds

A growth fund’s specific objective is price appreciation. They target securities that will have long-term growth and capital gains and less on securities that give dividends or income.

Because of this, growth fund is risky. This type of fund is suitable for investors between the age group of 25 to 40. Their objective is to accumulate capital.

Types of Funds

Income funds emphasise on current income. They will invest in securities that provide stable income. Shares that provide high dividends are normally the

favourite choice as well as established blue chip companies.

They however do hold a few growth shares. Apart from shares, these types of funds also invest in

bonds. The investment is less risky than growth

shares.

Types of Funds

Index fund is a portfolio that replicates the combination of shares in an index.

For example the KLCI contain 100 shares, with predetermine weight for each share.

A portfolio can be built to replicate that index and use the same 100 shares and weights.

PERFORMANCE EVALUATION

Sharpe’s MeasureSharpe’s Differential ReturnTreynor’s MeasureTreynor’s Differential Return

Revision

1. Calculate the price of a bond with a per value of $1000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. Assume that coupon payments made annually to bond holders and that the next coupon payment is expected in six months.

Calculate bond price…2. Bond investors are exposed to interest rate

risk and redemption risk.Explain these risks…

Revision

What do you understand by the term top-down security analysis?

What is the consequence of an increase in interest rates?

What is the consequence of an increase in inflation?

What type of stocks the constant growth-model is best suited for?

Define an expansionary economic policy?

Revision

List some of the popular tools for technical analysis?

What is the implication of random walk hypothesis?

Describe the term “efficient market” ?Briefly explain the main objectives of

technical analysis?Write the difference between ‘bond at a

premium’ and ‘bond at a discount’?

Revision

What makes the bond prices to be most volatile?

Explain zero coupon bond?What do you understand by the term T-

Bill? Explain what is a passive bond portfolio

strategy with some examples?Explain what is an active bond portfolio

strategy with some examples?

Revision

What is an immunization strategy?What is forward contract?What is the main difference between

future contract and forward contract?How does a call option differ from a put

option?What is growth fund?

Revision

1. If XYZ Ltd. has a price earnings (P/E) ratio of 10 and an earnings per share (EPS) of $0.90, what is the current price of the share?

A. $11.11 per share.

B. $17.07 per share.

C. $09.00 per share. D. $19.35 per share

Revision

2. A common stock is expected to pay a $0.85 annual dividend next year. If the dividends are expected to grow at 5% annually and the current stock price is $8.50, what is the required rate of return of the stock?

A. 15.00% B. 8.91% C. 10.73%

D. 11.38%

Revision

3. The constant-growth dividend valuation model is best suited for what type of stocks?

A. Stocks of new or emerging companies. B. Small-cap stocks within growing industries. C. Stocks of mature, dividend-paying

companies.

D. Stocks of cyclical companies.

Revision

4. Which one describes the point-and-figure approach in technical analysis?

A. A point-and-figure chart depicts all of the closing prices of a stock over a period of time.

B. A point-and-figure chart consists of columns of X’s and O’s.

C. A typical bar chart uses vertical bars to show the closing price as well as the change in price from the previous day.

D. A sell signal occurs when prices break through a resistance line on a chart pattern.

Revision

5. If the market is strong-form efficient, what types of information will be reflected in the stock price?

A. Only historical information.

B. Only the information related to events that have already occurred.

C. All publicly known information related to past

events and announced future events.

D. All information including both public and private.

Revision

6. Which one signals a strong market?

A. A greater number of advancing stocks than declining stocks and a greater volume of declining stocks than advancing stocks

B. A greater number of advancing stocks than declining stocks and a greater volume of rising stocks than declining stocks

C. A greater number of declining stocks than advancing stocks and a greater volume of rising stocks than declining stocks

D. A greater number of declining stocks than advancing stocks and a greater volume of declining stocks than advancing stocks

Revision

7. If investors can use past share prices to predict the future prices of the share, what does this indicate?

A. The security market is weak-form efficient

B. The security market is semi-strong efficient

C. The security market is strong-form efficient

D. The security market is inefficient

Revision

8. If you expect market interest rates to rise, what type of bonds should you purchase?

A. Short term, low coupon bonds.

B. Short term, high coupon bonds. C. Long term, low coupon bonds. D. Long term, high coupon bonds.

Revision

9. What is the current price of a bond if its par value is $1,000, coupon rate of 6% and pays interest semi-annually, matures in 10 years and has a yield-to-maturity of 7.1325%?

A.$567

B.$920

C.$1,030

D.$1,080

Revision

10. What does the duration of a bond measure?

A. The sensitivity of bond price against interest rate.

B. The average return of a bond.

C. The relationship between bond price and money supply.

D. The movement of bond price in response to changes in foreign exchange rate.

Revision

11. A $1,000 par value, 6% annual coupon bond matures in 3 years. The bond is currently priced at $993.35 and has a yield to maturity of 6.25%.

What is the duration of this bond?

A.1 year

B.2.67 years

C.2.83 years

D.2.89 years

Revision

12.What is the expression for put-call parity?

A.Stock price + Call Price = Put Price + Risk Free Bond Price

B.Stock price + Put Price = Call Price + Risk Free Bond Price

C.Put price + Call Price = Stock Price + Risk Free Bond Price

D.Stock price - Put Price = Call Price + Risk Free Bond Price

Revision

13. A stock currently sells for $15 per share. Assume that a call option on the stock with an exercise price $15.50 currently sells for $2.50.

What is the terminology used to describe this situation?

A.In-the-money

B.Out-of-the-money

C.At-the-money

D.Break-even point

Revision

14Ali owns a portfolio that has a standard deviation of 13%, a beta of 1.05, and a total return of 10.5%. The risk-free rate is 4% and the overall market return is 9.8%.

What is the value of Sharpe’s measure for Ali’s portfolio?

A.0.05

B.0.06

C.0.50

D.0.81

Revision

15.A portfolio has a total return of 10.5%, a beta of 0.72 and a standard deviation of 6.3%. Assume that the risk free rate is 3.8% and the market return is 12.4%.

What is Jensen’s measure of this portfolio’s performance?

A. 4.3%.

B. 7.9%.

C. 9.3%.

D. 0.5%

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