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Basic Financial Management <ul><li>Importance of Financial Intelligence </li></ul><ul><li>Spreadsheet Financial Functions </li></ul><ul><li>Investment Risk and Portfolio </li></ul><ul><li>Stock Valuation </li></ul>
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Financial Intelligence <ul><li>Making more money will not solve your problem if money management is your problem. </li></ul><ul><li> 30 Year Investment Result </li></ul>
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Financial Intelligence <ul><li>“ Being Rich” versus “Being Wealthy” </li></ul><ul><li>Being Rich is about how much money you possess in a specific moment in time. </li></ul><ul><li>Being Wealthy is about . . . </li></ul><ul><ul><li>how much money you keep </li></ul></ul><ul><ul><li>how hard it works for you </li></ul></ul><ul><ul><li>how much is left for future generations (who know what to do with it) </li></ul></ul><ul><li>Being Wealthy is about exploding your Passive Income . (How long you can survive without ever having to go to work?) </li></ul>
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Financial Intelligence <ul><li>When money works for you, every dollar is an employee. Each dollar works to bring you even more dollars while you’re asleep. </li></ul><ul><ul><li>Passive Income: Interest, dividends, real estate income, royalties, residuals, annuities </li></ul></ul><ul><li>The key is “What investments do you own that will bring you passive income?” </li></ul><ul><li>Buy assets first, luxuries last. </li></ul><ul><li>Ask “how can I afford it?” This stimulates your creativity. </li></ul>
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Financial Intelligence Income Statement Balance Sheet Income Expenses (Payments) Assets (Own) Liabilities (Debt) Taxes, mortgage/rent, cards, car, food, fun, rent, clothes, child care, insurance, medical Paycheck, dividends, interest, rents, royalties, profits, advances Mortgage, car loan, credit cards, school loans Stocks, bonds, notes, real estate, business, intellectual property
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How The Wealthy Live They take the income of the poor and middle class, and buy assets that produce more income Income Statement Balance Sheet Income Expenses Assets Liabilities
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Rich Dad’s Cash Flow Quadrant Employee You have a job. Someone else is the boss. Security before money . Self-Employed You own a job. Loner/”boss.” Perfectionists. Small bus. Owners: Drs., restaurateurs. Independence before money. Developer You own a system that others operate. Coordinator. Delegator. Franchiser. Use other people's time and money. Investor Your money works for you. Make money with money. Other’s liabilities are your assets.
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<ul><li>A bond with a face value of $1,000 carries a coupon rate of 6.6%. The bond has 10 years till maturity and has a yield-to-maturity (YTM) of 7.6%. The bond pays coupons on a semiannual basis . What is market price? </li></ul><ul><ul><li>= PV(Rate, Nper, Pmt, FV) </li></ul></ul><ul><ul><li>= PV(0.076/2,20,33,1000)=$930.83 </li></ul></ul>Present Value Solution
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<ul><li>Peter saves 3k each month. Annual return is 8% APR compounded monthly . How much will Peter’s saving be 30 years from now. </li></ul><ul><ul><li>= FV(Rate, Nper, Pmt, PV) </li></ul></ul><ul><ul><li>= FV(0.08/12, 360, -3000, 0) = $4.47 M </li></ul></ul>Future Value Solution
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<ul><li>You have decided to buy a house for $312,000. You have saved enough money to make a 10% down payment, but you will need to borrow the remainder. You arrange for a 30-year mortgage (monthly payments) with a local bank at a stated rate of 6.3% APR compounded monthly. Assume that the first payment will be made one month from now </li></ul><ul><ul><li>PMT(0.063/12,360,280800,0)=$1,738.08 </li></ul></ul>Payment Function
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<ul><li>Your decide to loan your little sister $2,000 so she can buy a car. You require her to pay you back over 30 months, making payments of $85.00 at the end of each month. </li></ul><ul><ul><li>= RATE(Nper, Pmt, PV, FV) </li></ul></ul><ul><ul><li>interest rate per month=RATE(30,-85,2000,0,0)=1.645% </li></ul></ul><ul><ul><li>Annual rate: (1+1.645%)^12-1=21.6% </li></ul></ul>Interest Rate Function
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<ul><li>Has 1M at retirement, annual return is 8% APR compounded monthly , withdraw 8k each month, how long will the saving last. </li></ul><ul><ul><li>= NPER(Rate, Pmt, PV, FV) </li></ul></ul><ul><ul><li>= NPER(0.08/12, 8000, -1000000, 0) = 270 month=23 years </li></ul></ul>NPER Solution
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What is investment risk? <ul><li>Typically, investment returns are not known with certainty. </li></ul><ul><li>Investment risk pertains to the probability of earning a return less than that expected. </li></ul><ul><li>The greater the chance of a return far below the expected return, the greater the risk. </li></ul>
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Probability distribution Rate of return (%) 50 15 0 -20 Stock X Stock Y <ul><li>Which stock is riskier? Why? </li></ul>
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<ul><li>Standard deviation measures the stand-alone risk of an investment. </li></ul><ul><li>The larger the standard deviation, the higher the probability that returns will be far below the expected return. </li></ul><ul><li>Coefficient of variation is an alternative measure of stand-alone risk. </li></ul>
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Expected Return versus Risk 13.4 1.7 Repo Men 0.0 8.0 T-bills 18.8 13.8 Am. Foam 15.3 15.0 Market 20.0% 17.4% Alta Inds. Risk, return Security Expected
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Return vs. Risk (Std. Dev.): Which investment is best?
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Portfolio Return, r p r p is a weighted average: r p = 0.5(17.4%) + 0.5(1.7%) = 9.6% . r p is between r Alta and r Repo . ^ ^ ^ ^ ^ ^ ^ ^ r p = w i r i n i = 1
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<ul><li> p = ((3.0 - 9.6) 2 0.10 + (6.4 - 9.6) 2 0.20 + (10.0 - 9.6) 2 0.40 + (12.5 - 9.6) 2 0.20 + (15.0 - 9.6) 2 0.10) 1/2 = 3.3%. </li></ul><ul><li> p is much lower than: </li></ul><ul><ul><li>either stock (20% and 13.4%). </li></ul></ul><ul><ul><li>average of Alta and Repo (16.7%). </li></ul></ul><ul><li>The portfolio provides average return but much lower risk. The key here is negative correlation. </li></ul>
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Two-Stock Portfolios <ul><li>Two stocks can be combined to form a riskless portfolio if = -1.0. </li></ul><ul><li>Risk is not reduced at all if the two stocks have = +1.0. </li></ul><ul><li>In general, stocks have 0.65, so risk is lowered but not eliminated. </li></ul><ul><li>Investors typically hold many stocks. </li></ul><ul><li>What happens when = 0? </li></ul>
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Risk Relative to the Market <ul><li>Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis. </li></ul><ul><li>The slope of the regression line, which measures relative volatility, is defined as the stock’s beta coefficient , or b . </li></ul>
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Calculating Beta for PQU r PQU = 0.83r M + 0.03 R 2 = 0.36 -40% -20% 0% 20% 40% -40% -20% 0% 20% 40% r M r KWE
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<ul><li>If b = 1.0, stock has average risk. </li></ul><ul><li>If b > 1.0, stock is riskier than average. </li></ul><ul><li>If b < 1.0, stock is less risky than average. </li></ul><ul><li>Most stocks have betas in the range of 0.5 to 1.5. </li></ul><ul><li>Can a stock have a negative beta? </li></ul>How is beta interpreted?
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Finding Beta Estimates on the Web <ul><li>Go to www.thomsonfn.com. </li></ul><ul><li>Enter the ticker symbol for a “Stock Quote”, such as IBM or Dell, then click GO. </li></ul><ul><li>When the quote comes up, select Company Earnings, then GO. </li></ul>
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Use the SML to calculate each alternative’s required return. <ul><li>The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM). </li></ul><ul><li>SML: r i = r RF + (RP M )b i . </li></ul><ul><li>Assume r RF = 8%; r M = r M = 15%. </li></ul><ul><li>RP M = (r M - r RF ) = 15% - 8% = 7%. </li></ul>^
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Required Rates of Return r Alta = 8.0% + (7%)(1.29) = 8.0% + 9.0% = 17.0%. r M = 8.0% + (7%)(1.00) = 15.0%. r Am. F. = 8.0% + (7%)(0.68) = 12.8%. r T-bill = 8.0% + (7%)(0.00) = 8.0%. r Repo = 8.0% + (7%)(-0.86) = 2.0%.
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Expected versus Required Returns ^ Overvalued 2.0 1.7 Repo Fairly valued 8.0 8.0 T-bills Undervalued 12.8 13.8 Am. F. Fairly valued 15.0 15.0 Market Undervalued 17.0% 17.4% Alta r r
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<ul><li>Dividend growth model </li></ul><ul><li>Using the multiples of comparable firms </li></ul><ul><li>Free cash flow method </li></ul>Different Approaches for Valuing Common Stock
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One whose dividends are expected to grow forever at a constant rate, g. Stock Value = PV of Dividends What is a constant growth stock?
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For a constant growth stock, If g is constant, then:
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What happens if g > r s ? <ul><li>If r s < g, get negative stock price, which is nonsense. </li></ul><ul><li>We can’t use model unless (1) g r s and (2) g is expected to be constant forever. Because g must be a long-term growth rate, it cannot be r s . </li></ul>
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Assume beta = 1.2 , r RF = 7% , and RP M = 5% . What is the required rate of return on the firm’s stock? r s = r RF + (RP M )b Firm = 7% + (5%) (1.2) = 13% . Use the SML to calculate r s :
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What’s the stock’s market value? D 0 = 2.00, r s = 13%, g = 6%. Constant growth model: = = $30.29. 0.13 - 0.06 $2.12 $2.12 0.07
38.
What is the stock’s market value one year from now, P 1 ? <ul><li>D 1 will have been paid, so expected dividends are D 2 , D 3 , D 4 and so on. Thus, </li></ul>^
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<ul><li>The current stock price is $54.11. </li></ul><ul><li>The PV of dividends beyond year 3 is $46.11 (P 3 discounted back to t = 0). </li></ul><ul><li>The percentage of stock price due to “long-term” dividends is: </li></ul>Is the stock price based on short-term growth? ^ = 85.2%. $46.11 $54.11
40.
Why are stock prices volatile? D 1 = $2, r s = 10%, and g = 5%: P 0 = D 1 / (r s -g) = $2 / (0.10 - 0.05) = $40 . What if r s or g change? g g g r s 4% 5% 6% 9% 40.00 50.00 66.67 10% 33.33 40.00 50.00 11% 28.57 33.33 40.00
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In equilibrium, expected returns must equal required returns: r s = D 1 /P 0 + g = r s = r RF + (r M - r RF )b. ^
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What’s the Efficient Market Hypothesis (EMH)? Securities are normally in equilibrium and are “fairly priced.” One cannot “beat the market” except through good luck or inside information.
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