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02_PreFinal.ppt
1.
Stangeland © 2002
1 Pre-final review For 9.220, Term 1, 2002/03 02_PreFinal.ppt
2.
Stangeland © 2002
2 Introduction Today’s Goal Highlight important topics to review Work through more difficult concepts Answer questions raised by students No new material No extra exam hints
3.
Stangeland © 2002
3 Lecture 1 Material
4.
Stangeland © 2002
4 II. Types of Businesses 1. Sole Proprietorship 2. Partnership 3. Corporation
5.
Stangeland © 2002
5 Value of Debt at time of Repayment (repayment due = $10 million) 0 5 10 15 20 25 30 35 0 5 10 15 20 25 30 35 40 45 Value of the Firm's Assets at the time the debt is due ($ millions) Contingent Value of the Firm's Securities ($ millions)
6.
Stangeland © 2002
6 Value of Equity at time of Debt Repayment (repayment due = $10 million) 0 5 10 15 20 25 30 35 0 5 10 15 20 25 30 35 40 45 Value of the Firm's Assets at the time the debt is due ($ millions) Contingent Value of the Firm's Securities ($ millions) Never Negative – Limited Liability
7.
Stangeland © 2002
7 Total Value of the Firm = Debt + Equity 0 5 10 15 20 25 30 35 0 5 10 15 20 25 30 35 40 45 Value of the Firm's Assets at the time the debt is due ($ millions) Contingent Value of the Firm's Securities ($ millions) Debt Equity Total Firm Value
8.
Stangeland © 2002
8 IV. The Principal-Agent (PA) Problem Corporations are owned by shareholders but are run by management There is a separation of ownership and control Shareholders are said to be the principals Managers are the agents of shareholders and are are supposed to act on behalf of the shareholders The PA problem is that managers may not always act in the best way on behalf of shareholders.
9.
Stangeland © 2002
9 V. Self study – will be examined Financial Institutions Financial Markets Money vs. Capital Markets Primary vs. Secondary Markets Listing Foreign Exchange Trends in Finance
10.
Stangeland © 2002
10 Lecture 2 Material
11.
Stangeland © 2002
11 Arbitrage Defined Arbitrage – the ability to earn a risk-free profit from a zero net investment. Principal of No Arbitrage – through competition in markets, prices adjust so that arbitrage possibilities do not persist.
12.
Stangeland © 2002
12 III. Two-period model Consider a simple model where an individual lives for 2 periods, has an income endowment, and has preferences about when to consume. Endowment (or given income) is $40,000 now and $60,000 next year
13.
Stangeland © 2002
13 $0 $20 $40 $60 $80 $100 $120 $0 $20 $40 $60 $80 $100 $120 Thousands Thousands Consumption Today Consumption t+1 Two-period model: no market Without the ability to borrow or lend using financial markets, the individual is restricted to just consuming his/her endowment as it is earned: i.e., consume $40,000 now and consume $60,000 in one year. Income Endowment
14.
Stangeland © 2002
14 $0 $20 $40 $60 $80 $100 $120 $0 $20 $40 $60 $80 $100 $120 Thousands Thousands Consumption Today Consumption t+1 Intertemporal Consumption Opportunity Set Assume a market for borrowing or lending exists and the interest rate is 10%. This opens up a large set of consumption patterns across the two periods.
15.
Stangeland © 2002
15 Intertemporal Consumption Opportunity Set 1. What is the slope of the consumption opportunity set? 2. What is the maximum possible consumption today and how is this achieved? 3. What is the maximum possible consumption in t+1 and how is this achieved?
16.
Stangeland © 2002
16 $0 $20 $40 $60 $80 $100 $120 $0 $20 $40 $60 $80 $100 $120 Thousands Thousands Consumption Today Consumption t+1 Intertemporal Consumption Opportunity Set Slope = Maximum @ t+1 = ? Maximum Today = ?
17.
Stangeland © 2002
17 $0 $20 $40 $60 $80 $100 $120 $0 $20 $40 $60 $80 $100 $120 Thousands Thousands Consumption Today Consumption t+1 Intertemporal Consumption Opportunity Set A person’s preferences will impact where on the consumption opportunity set they will choose to be. Patient Hungry
18.
Stangeland © 2002
18 An increase in interest rates A rise in interest rates will make saving more attractive … …and borrowing less attractive. The equilibrium interest rate in the economy exactly equates the demands of borrowers and savers. As demands change, the interest rate adjusts to equate the supply and demand for funds across time. $0 $20 $40 $60 $80 $100 $120 $0 $20 $40 $60 $80 $100 $120 Thousands Thousands Consumption Today Consumption t+1
19.
Stangeland © 2002
19 Real Investment Opportunities – Example 1 Consider an investment opportunity that costs $35,000 this year and provides a certain cash flow of $36,000 next year. Is this a good opportunity? Time 0 1 Cashflows -$35,000 +$36,000
20.
Stangeland © 2002
20 $0 $20 $40 $60 $80 $100 $120 $0 $20 $40 $60 $80 $100 $120 Thousands Thousands Consumption Today Consumption t+1 Real Investment Opportunities – Example 1 Original Endowment New Cash flows if the real investment is taken
21.
Stangeland © 2002
21 $0 $20 $40 $60 $80 $100 $120 $0 $20 $40 $60 $80 $100 $120 Thousands Thousands Consumption Today Consumption t+1 Real Investment Opportunities – Example 1 Consumption Opportunity Set by borrowing or lending against the original endowment Consumption Opportunity Set after real investment is taken Should the individual take the real investment opportunity? No! It leads to dominated consumption opportunities.
22.
Stangeland © 2002
22 VI. The Separation Theorem The separation theorem in financial markets says that all investors will want to accept or reject the same investment projects by using the NPV rule, regardless of their personal preferences. Separation between consumption preferences and real investment decisions Logistically, separating investment decision making from the shareholders is a basic requirement for the efficient operation of the modern corporation. Managers don’t need to worry about individual investor consumption preferences – just be concerned about maximizing their wealth.
23.
Stangeland © 2002
23 Lecture 3 Material
24.
Stangeland © 2002
24 PV of a Growing Annuity n n r g r g C g r C PV ) 1 ( 1 ) 1 ( 1 1 0 n n r g r C g r C PV ) 1 ( 1 1 1 0 n n r g g r C PV ) 1 ( ) 1 ( 1 1 0 PV of the whole growing perpetuity Subtract off the PV of the latter part of the growing perpetuity PV0 is the PV one period before the first cash flow
25.
Stangeland © 2002
25 Simple (non-growing) series of cash flows For constant annuities and constant perpetuities, the time value formulas are simplified by setting g = 0. r C PV0 regular perpetuity n 0 r) (1 1 1 r C PV 1 r) (1 r C FV n n regular annuity We can use the PMT button on the financial calculator for the annuity cash flows, C
26.
Stangeland © 2002
26 IV. Some final warnings Even though the time value calculations look easy there are many potential pitfalls you may experience Be careful of the following: PV0 of annuities or perpetuities that do not begin in period 1; remember the PV formulas given always discount to exactly one period before the first cash flow. If the cash flows begin at period t, then you must divide the PV from our formula by (1+r)t-1 to get PV0. Note: this works even if t is a fraction.
27.
Stangeland © 2002
27 Be careful of annuity payments Count the number of payments in an annuity. If the first payment is in period 1 and the last is in period 2, there are obviously 2 payments. How many payments are there if the 1st payment is in period 12 and the last payment is in period 21 (answer is 10 – use your fingers). How about if the 1st payment is now (period 0) and the last payment is in period 15 (answer is 16 payments). If the first cash flow is at period t and the last cash flow is at period T, then there are T-t+1 cash flows in the annuity.
28.
Stangeland © 2002
28 Be careful of wording A cash flow occurs at the end of the third period. A cash flow occurs at time period three. A cash flow occurs at the beginning of the fourth period. Each of the above statements refers to the same point in time! 0 1 2 3 4 C If in doubt, draw a time line.
29.
Stangeland © 2002
29 Lecture 4&5 Material
30.
Stangeland © 2002
30 Annuities and perpetuities The annuity and perpetuity formulae require the rate used to be an effective rate and, in particular, the effective rate must be quoted over the same time period as the time between cash flows. In effect: If cash flows are yearly, use an effective rate per year If cash flows are monthly, use an effective rate per month If cash flows are every 14 days, use an effective rate per 14 days If cash flows are daily, use an effective rate per day If cash flows are every 5 years, use an effective rate per 5 years. Etc.
31.
Stangeland © 2002
31 Step 1: finding the implied effective rate In words, step 1 can be described as follows: Take both the quoted rate and its quotation period and divide by the compounding frequency to get the implied effective rate and the implied effective rate’s quotation period. The quoted rate of 60% per year with monthly compounding is compounded 12 times per the quotation period of one year. Thus the implied effective rate is 60% ÷ 12 = 5% and this implied effective rate is over a period of one year ÷ 12 = one month.
32.
Stangeland © 2002
32 Step 2: Converting to the desired effective rate Example: if you are doing loan calculations with quarterly payments, then the annuity formula requires an effective rate per quarter. Once we have done step 1, if our implied effective rate is not our desired effective rate, then we need to convert to our desired effective rate.
33.
Stangeland © 2002
33 Step 2: continued Effective to effective conversion In the previous example, 5% per month is equivalent to 15.7625% per 3 months (or quarter year). This result is due to the fact that (1+.05)3=1.157625 As a formula this can be represented as where rg is the given effective rate, rd is the desired effective rate. Lg is the quotation period of the given rate and Ld is the quotation period of the desired rate, thus Ld/Lg is the length of the desired quotation period in terms of the given quotation period. 1 ) r (1 r or ) r (1 ) r (1 g d g d L L g d d L L g
34.
Stangeland © 2002
34 Step 3: finding the final quoted rate In words, step 3 can be described as follows: Take both the implied effective rate and its quotation period and multiply by the compounding frequency of the desired final quoted rate. This results in the desired final quoted rate and its quotation period. In our example, the desired quoted rate is a rate per year compounded quarterly. Therefore the compounding frequency is 4. We multiply 15.7625% per quarter by 4 to get 63.05% per year compounded quarterly.
35.
Stangeland © 2002
35 Continuous Compounding – self study (continued) Using the previous formula and mathematical limits … ) r ln(1 r , r to r from ... direction other in the convert To interest of rate compounded ly continuous the be to said is r , m As e r 1 , m As period per effective g compoundin continuous with period per g compoundin continuous with period per period per effective quoted r effective quoted
36.
Stangeland © 2002
36 Mortgage continued How much will be left at the end of the 5-year contract? After 5 years of payments (60 payments) there are 300 payments remaining in the amortization. The principal remaining outstanding is just the present value of the remaining payments. How much interest and principal reduction result from the 300th payment? When the 299th payment is made, there are 61 payments remaining. The PV of the remaining 61 payments is the principal outstanding at the beginning of the 300th period and this can be used to calculate the interest charge which can then be used to calculate the principal reduction.
37.
Stangeland © 2002
37 Lecture 6 Material
38.
Stangeland © 2002
38 Bond valuation and yields A level coupon bond pays constant semiannual coupons over the bond’s life plus a face value payment when the bond matures. The bond below has a 20 year maturity, $1,000 face value and a coupon rate of 9% (9% of face value is paid as coupons per year). Year 0 0.5 1 1.5 . . . 19.5 20 (Maturity Date) $45 $45 $45 . . . $45 $45 + $1,000
39.
Stangeland © 2002
39 Lecture 7 Material
40.
Stangeland © 2002
40 Definitions – Spot Rates The n-period current spot rate of interest denoted rn is the current interest rate (fixed today) for a loan (where the cash is borrowed now) to be repaid in n periods. Note: all spot rates are expressed in the form of an effective interest rate per year. In the example above, r1, r2, r3, r4, and r5, in the previous slide, are all current spot rates of interest. Spot rates are only determined from the prices of zero-coupon bonds and are thus applicable for discounting cash flows that occur in a single time period. This differs from the more broad concept of yield to maturity that is, in effect, an average rate used to discount all the cash flows of a level coupon bond.
41.
Stangeland © 2002
41 Definitions – Forward Rates (continued) To calculate a forward rate, the following equation is useful: 1 + fn = (1+rn)n / (1+rn-1)n-1 where fn is the one period forward rate for a loan repaid in period n (i.e., borrowed in period n-1 and repaid in period n) Calculate f2 given r1=8% and r2=9% Calculate f3 given r3=9.5%
42.
Stangeland © 2002
42 Forward Rates – Self Study The t-period forward rate for a loan repaid in period n is denoted n-tfn E.g., 2f5 is the 3-period forward rate for a loan repaid in period 5 (and borrowed in period 2) The following formula is useful for calculating t-period forward rates: 1+n-tfn = [(1+rn)n / (1+rn-t)n-t]1/t Given the data presented before, determine 1f3 and 2f5 Results: 1f3=10.2577945%; 2f5=10.4622321%
43.
Stangeland © 2002
43 Definitions – Future Spot Rates Current spot rates are observable today and can be contracted today. A future spot rate will be the rate for a loan obtained in the future and repaid in a later period. Unlike forward rates, future spot rates will not be fixed (or contracted) until the future time period when the loan begins (forward rates can be locked in today). Thus we do not currently know what will happen to future spot rates of interest. However, if we understand the theories of the term structure, we can make informed predictions or expectations about future spot rates. We denote our current expectation of the future spot rate as follows: E[n-trn] is the expected future spot rate of interest for a loan repaid in period n and borrowed in period n-t.
44.
Stangeland © 2002
44 Term Structure Theories: Pure-Expectations Hypothesis The Pure-Expectations Hypothesis states that expected future spot rates of interest are equal to the forward rates that can be calculated today (from observed spot rates). In other words, the forward rates are unbiased predictors for making expectations of future spot rates. What do our previous forward rate calculations tell us if we believe in the Pure- Expectations Hypothesis?
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45 Liquidity-Preference Hypothesis Empirical evidence seems to suggest that investors have relatively short time horizons for bond investments. Thus, since they are risk averse, they will require a premium to invest in longer term bonds. The Liquidity-Preference Hypothesis states that longer term loans have a liquidity premium built into their interest rates and thus calculated forward rates will incorporate the liquidity premium and will overstate the expected future one-period spot rates.
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46 Liquidity-Preference Hypothesis Reconsider investors’ expectations for inflation and future spot rates. Suppose over the next year, investors require 4% for a one year loan and expect to require 6% for a one year loan (starting one year from now). Under the Liquidity-Preference Hypothesis, the current 2-year spot rate will be defined as follows: (1+r2)2=(1+r1)(1+E[1r2]) + LP2 where LP2 = liquidity premium: assumed to be 0.25% for a 2 year loan (1+r2)2 = (1.04)x(1.06) + 0.0025 so r2=5.11422%
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47 Liquidity-Preference Hypothesis Restated, if we don’t know E[1r2], but we can observe r1=4% and r2=5.11422%, then, under the Liquidity-Preference Hypothesis, we would have E[1r2] < f2 = 6.24038%. From this example, f2 overstates E[1r2] by 0.24038% If we know LP2 or the amount f2 overstates E[1r2], then we can better estimate E[1r2].
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48 Projecting Future Bond Prices Consider a three-year bond with annual coupons (paid annually) of $100 and a face value of $1,000 paid at maturity. Spot rates are observed as follows: r1=9%, r2=10%, r3=11% What is the current price of the bond? What is its yield to maturity (as an effective annual rate)? What is the expected price of the bond in 2 years? under the Pure-Expectations Hypothesis under the Liquidity-Preference Hypothesis assume f3 overstates E[2r3] by 0.5%
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49 Lecture 8&9 Material
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50 IRR Problem Cases: Borrowing vs. Lending Consider the following two projects. Evaluate with IRR given a hurdle rate of 20% For borrowing projects, the IRR rule must be reversed: accept the project if the IRR≤hurdle rate Year Project A Cash Flows Project B Cash Flows 0 -$10,000 +$10,000 1 +$15,000 -$15,000 Conventional Cash Flows or Lending/Investing Type Project Unconventional Cash Flows or Borrowing Type Project
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51 The non-existent or multiple IRR problem Example: Do the evaluation using IRR and a hurdle rate of 15% IRRA=? IRRB=? Year Cash flows of Project A Cash flows of Project B 0 -$312,000 +$350,000 1 +$800,000 -$800,000 2 -$500,000 +$500,000
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52 NPV Profile – where are the IRR's? -$60,000 -$40,000 -$20,000 $0 $20,000 $40,000 $60,000 $80,000 0% 20% 40% 60% 80% 100% Discount Rate NPV Project A Project B
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53 No or Multiple IRR Problem – What to do? IRR cannot be used in this circumstance, the only solution is to revert to another method of analysis. NPV can handle these problems. How to recognize when this IRR problem can occur When changes in the signs of cash flows happen more than once the problem may occur (depending on the relative sizes of the individual cash flows). Examples: +-+ ; -+- ; -+++-; +---+
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54 Special situations for DCF analysis When projects are independent and the firm has few constraints on capital, then we check to ensure that projects at least meet a minimum criteria – if they do, they are accepted. NPV≥0; IRR≥hurdle rate; PI≥1 If the firm has capital rationing, then its funds are limited and not all independent projects may be accepted. In this case, we seek to choose those projects that best use the firm’s available funds. PI is especially useful here. Sometimes a firm will have plenty of funds to invest, but it must choose between projects that are mutually exclusive. This means that the acceptance of one project precludes the acceptance of any others. In this case, we seek to choose the one highest ranked of the acceptable projects.
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55 Incremental Cash Flows: Solving the Problem with IRR and PI As you can see, individual IRR's and PIs are not good for comparing between two mutually exclusive projects. However, we know IRR and PI are good for evaluating whether one project is acceptable. Therefore, consider “one project” that involves switching from the smaller project to the larger project. If IRR or PI indicate that this is worthwhile, then we will know which of the two projects is better. Incremental cash flow analysis looks at how the cash flows change by taking a particular project instead of another project.
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56 Using IRR and PI correctly when projects are mutually exclusive and are of differing scales IRR and PI analysis of incremental cash flows tells us which of two projects are better. Beware, before accepting the better project, you should always check to see that the better project is good on its own (i.e., is it better than “do nothing”).
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57 Incremental Analysis – Self Study For self-study, consider the following two investments and do the incremental IRR and PI analysis. The opportunity cost of capital is 10%. Should either project be accepted? No, prove it to yourself! Year Cash flows of Project A Cash flows of Project B Incremental Cash flows of A instead of B (i.e., A-B) 0 -$100,000 -$50,000 1 +$101,000 +$50,001
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58 Capital Rationing Recall: If the firm has capital rationing, then its funds are limited and not all independent projects may be accepted. In this case, we seek to choose those projects that best use the firm’s available funds. PI is especially useful here. Note: capital rationing is a different problem than mutually exclusive investments because if the capital constraint is removed, then all projects can be accepted together. Analyze the projects on the next page with NPV, IRR, and PI assuming the opportunity cost of capital is 10% and the firm is constrained to only invest $50,000 now (and no constraint is expected in future years).
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59 Capital Rationing – Example (All $ numbers are in thousands) Year Proj. A Proj. B Proj. C Proj. D Proj. E 0 -$50 -$20 -$20 -$20 -$10 1 $60 $24.2 -$10 $25 $12.6 2 $0 $0 $37.862 $0 $0 NPV $4.545 $2.0 $2.2 $2.727 $1.4545 IRR 20% 21% 14.84% 25% 26% PI 1.0909 1.1 1.11 1.136 1.145
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60 Capital Rationing Example: Comparison of Rankings NPV rankings (best to worst) A, D, C, B, E A uses up the available capital Overall NPV = $4,545.45 IRR rankings (best to worst) E, D, B, A, C E, D, B use up the available capital Overall NPV = NPVE+D+B=$6,181.82 PI rankings (best to worst) E, D, C, B, A E, D, C use up the available capital Overall NPV = NPVE+D+C=$6,381.82 The PI rankings produce the best set of investments to accept given the capital rationing constraint.
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61 Capital Rationing Conclusions PI is best for initial ranking of independent projects under capital rationing. Comparing NPV’s of feasible combinations of projects would also work. IRR may be useful if the capital rationing constraint extends over multiple periods (see project C).
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62 Other methods to analyze investment projects – self study Payback – the simplest capital budgeting method of analysis Know this method thoroughly. Discounted Payback Not Required. Average Accounting Return (AAR) You will not be asked to calculate it, but you should know what it is and why it is the most flawed of the methods we have examined.
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63 Lecture 10 Material
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64 Relevant cash flows The main principles behind which cash flows to include in capital budgeting analysis are as follows: 1. Only include cash flows that change as a result of the project being analyzed. Include all cash flows that are impacted by the project. This is often called an incremental analysis – looking at how cash flows change between not doing the project vs. doing the project.
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65 Which cash flows are relevant to the project analysis, which are not? Examples Type of Cash Flow Is it Relevant to the analysis? Why? Sunk Costs Opportunity Costs Side Effects (or incidental effects) Interest Expense (or financing charges)
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66 Conclusions on real and nominal cash flows It is possible to express any cash flow as either a real amount or a nominal amount. Since the real and nominal amounts are equivalent, the PV’s must be equivalent, so remember the rule: Discount real cash flows with real rates. Discount nominal cash flows with nominal rates.
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67 Use of real cash flows If a project’s cash flows are expected to grow with inflation, then it may be more convenient to express the cash flows as real amounts rather than trying to predict inflation and the nominal cash flows.
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68 Tax consequences and after tax cash flows (assume a tax rate, Tc, of 40%) Item Before-tax amount Before-tax cash flow After-tax cash flow Revenue Rev $10 Rev $10 =Rev(1-Tc) =$10(1-.4) =$6 Expense Exp $10 -Exp -$10 =-Exp(1-Tc) =-$10(1-.4) =-$6 CCA CCA $10 $0 =+CCATc =+$10 0.4 =+$4
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69 Yearly cash flows after tax Normally we project yearly cash flows for a project and convert them into after-tax amounts. CCA deductions are due to an asset purchase for a project. CCA is calculated as a % of the Undepreciated Capital Cost (UCC). Since a % amount is deducted each year, the UCC will never reach zero so CCA deductions can actually continue even after the project has ended (and thus shelter future income from taxes). All CCA-caused tax savings should be recognized as cash inflows for the project that caused them.
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70 Lecture 11 Material
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71 PV CCA Tax Shields C = cost of asset D = CCA rate Tc = Corporate tax rate k = Discount rate for CCA tax shields Sn = Salvage value of asset sold in period n with lost CCA deductions beginning in period n+1 n c n c k 1 1 d k T d S k 1 2 k 1 d k T d C PV Shields Tax CCA
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72 Summary of Capital Budgeting Items and Tax Effects The following formula may help summarize the project’s NPV calculation. NPV = -initial asset cost1 + PVSalvage Value or Expected Asset Sale Amount 1 + PVincremental cash flows caused by the project 2 + PVincremental working capital cash flows caused by the project 1 – PVCapital Gains Tax 3 + PVCCA Tax Shields Footnotes: 1. These items usually have the same before-tax amounts and after-tax amounts. I.e., there is no tax effect. For asset purchases/sales the tax effect is done through CCA effects. 2. These items usually have the after-tax cash flow equal to the before tax cash flow multiplied by (1-Tc). 3. Capital gains tax is only triggered when the asset is sold for an amount greater than its initial cost.
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73 Qualitative checks (continued) Remember, a positive NPV indicates wealth is being created. This is equivalent to the economic concept of “positive economic profit”. When does positive economic profit occur? When there is not perfect competition; i.e., when there is a competitive advantage. Sources of competitive advantage include: Being the first to enter a market or create a product Low cost production Economies of scale and scope Preferred access to raw materials Patents (create a barrier to entry, or preserve a low- cost production process). Product differentiation Superior marketing or distribution, etc.
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74 Midterm 2 Question
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75 1. Fritz, of Fritz Plumbing, has been given the opportunity to carry Moen fixtures for the next 10 years. He needs your advice and has supplied the following information for your analysis of the “Moen Project”: Current Office Lease Costs$30,000 per yearCurrent Insurance Costs$8,000 per yearCurrent Wages of Employees$200,000 per yearCurrent Required Inventory$60,000 Current revenue $500,000 per year No working capital changes are expected due to the project. Revenues are expected to rise to $800,000 per year over the life of the project and will fall back to their original levels following the project. One more employee will be required for the life of the project and the salary will be $30,000 per year. In addition, Fritz will need to upgrade his fleet of trucks to accommodate the new Moen fixtures. If the Moen project is accepted he will sell his current trucks now for $100,000 and purchase new trucks now for $500,000; the new trucks would then be sold for $50,000 in 10 years. If the Moen project is not accepted, he will sell his current trucks in 10 years for scrap value of $5,000. If the project is accepted Fritz will take out a bank loan to partially finance the truck and the bank will require annual interest charges of $1,000 per year for the next 5 years.
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76 (a)Specify all relevant incremental after-tax cash flows (and their timing) that would occur if the Moen project is accepted. Assume a corporate tax rate of 40%. (Ignore CCA tax shields at this point.) Do not do any discounting at this point. (b)What is the present value of the incremental CCA tax shields if the Moen project is accepted? Assume a CCA rate of 30% and the appropriate discount rate is equal to the risk free rate of 4%.
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77 Note: from Lecture 15 material (c) Assume that the incremental cash flows in (a) are of the same risk level as the other assets of Fritz Plumbing. Currently, Fritz Plumbing is financed as follows: 40% debt, 60% equity. The debt has a market price of $1,462 per bond and pays semiannual coupons of $60 each. The debt matures in 8 years and has a par value of $1,000 per bond. The stock of Fritz Plumbing has a of 1.5. The expected return on the market is 12%, Rf is 4% and TC is 40%. What discount rate should be used for the NPV analysis of the incremental cash flows specified in (a).
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78 (d) Assume your answer to (c) is 12%, your answer to (b) is $150,000, and you determined the following after tax cash flows in (a) to be as follows: Time of cash flowAfter-tax amountYear 0 (now)-$500,000Each of Years 1- 10$250,000Year 10$50,000 What is the NPV of the project? What is your advice to Fritz?
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79 (e) Suppose that the risk of the Moen project was much higher than the risk of the firm. (i) Without doing any calculations, explain how your analysis, NPV, and advice would likely change assuming the above risk difference was due to high unsystematic risk? (2 points) (ii) Without doing any calculations, explain how your analysis, NPV, and advice would likely change assuming the above risk difference was due to high systematic risk?
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80 Lecture 12-14 Material
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81 Examples What would be your portfolio beta, βp, if you had weights in the first four stocks of 0.2, 0.15, 0.25, and 0.4 respectively. What would be E[Rp]? Calculate it two ways. Suppose σM=0.3 and this portfolio had ρpM=0.4, what is the value of σp? Is this the best portfolio for obtaining this expected return? What would be the total risk of a portfolio composed of f and M that gives you the same β as the above portfolio? How high an expected return could you achieve while exposing yourself to the same amount of total risk as the above portfolio composed of the four stocks. What is the best way to achieve it?
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82 Lecture 15
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83 Conclusions on factors that affect β The three factors that affect an equity β are as follows Cyclicality of Revenues Operating Leverage Financial Leverage Note: the financial leverage does not affect asset β, it only affects equity β. Only these two affect asset β
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84 Lecture 16 Material
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85 Relationship among the Three Different Information Sets All information relevant to a stock Information set of publicly available information Information set of past prices
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86 Conclusions on Informational Efficiency Market is generally regarded as being weak-form informationally efficient. Market is generally regarded as being semi-strong-form informationally efficient. Market is generally regarded as NOT being strong-form informationally efficient.
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87 Lecture 17&18 Material
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88 Self Study – fill in the blank cells Construction of a Synthetic European Put: initial transactions at date t where St is the stock price at time t Cet is the price at time t of the European call option Initial Transactions: fill in the empty cells short 1 share of stock Invest the present value of the exercise price (E) at the risk free rate (or long the risk-free asset) Buy a call option on the stock with same exercise price and same expiration date Initial net cash flow (will be an outflow):
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89 Self Study – fill in the blank cells Synthetic European Put: transactions on the expiration date (T) Final cash flows given the different relevant states of nature (which depend on whether ST is less than or greater than E): ST < E ST ≥ E liquidate the short stock position (buy the stock) liquidate the long risk-free asset position (collect the proceeds from the investment) liquidate the long call option position (discard or exercise depending upon which is optimal) Net cash flow at the expiration date T: E-ST 0
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90 Lecture 19-20 Material
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91 Integration of all effects on capital structure Costs Distress financial Expected Equity of Costs Agency of Savings PV PV 1 ) 1 ( ) 1 ( 1 B T T T V V B S C U L
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92 Lecture 21 Material
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93 Speculating Example Zhou has been doing research on the price of gold and thinks it is currently undervalued. If Zhou wants to speculate that the price will rise, what can he do? Give a strategy using futures contracts. Zhou can take a long position in gold futures; if the price rises as he expects, he will have money given to him through the marking to market process, he can then offset after he has made his expected profits. Give a strategy using options. Zhou can go long in gold call options. If gold prices rise, he can either sell his call option or exercise it.
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94 Compare Speculating Strategies (assuming contracts on one troy ounce of gold) Derivative Used: Long Futures Contract @ $310 Long Call Option, E=$310 Initial Cost $0 -$12 Net amount received (final payoff net of initial cost) given final spot prices below: Spot = $280 -$30 -$12 Spot = $300 -$10 -$12 Spot = $320 $10 -$2 Spot = $340 $30 $18 Spot = $360 $50 $38
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95 Speculating: Futures vs. Options Net Profit Received from Speculating in Gold -$125 -$100 -$75 -$50 -$25 $0 $25 $50 $75 $100 $200 $225 $250 $275 $300 $325 $350 $375 $400 Final Spot Price of Gold Profit from Speculating Long Futures Contract Profit Long Call Option Profit
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96 Should hedging or speculating be done? Speculating: If the market is informationally efficient, then the NPV from speculating should be 0. Hedging: Remember, expected return is related to risk. If risk is hedged away, then expected return will drop. Investors won’t pay extra for a hedged firm just because some risk is eliminated (investors can easily diversify risk on their own). However, if the corporate hedging reduces costs that investors cannot reduce through personal diversification, then hedging may add value for the shareholders. E.g., if the expected costs of financial distress are reduced due to hedging, there should be more corporate value left for shareholders.
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