Chapter 1

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  • The simplest debt instruments to value are U.S. Treasury securities since there is no default risk. Instead, the discount rate to use, r , is the pure cost of borrowing. Assume you are asked to value two Treasury securities, when r f is 1.75 percent ( r = 0.0175 ): A (pure discount) Treasury bill with a $1,000 face value that matures in three months, and A 1.75% coupon rate Treasury note, also with a $1,000 face value, that matures in three years. For the T-Bill, three months is one-quarter year ( n=0.25) For 3-year bond, n = 3 Most U.S. corporate bonds: Pay interest at a fixed coupon interest rate Have an initial maturity of 10 to 30 years, and Have a par value (also called face or principal value) of $1,000 that must be repaid at maturity. Bond’s value has two separable parts: (1) PV of stream of annual interest payments, t=1 to t=10 (2) PV of principal repayment at end of year 10. Can thus also value bond as the PV of an annuity plus the PV of a single cash flow using PVFA and PVF from tables. P 0 = C x (PVFA 5%,10yr ) + Par x (PVF 5%,10yr ) = $50 (7.7220) + $1,000 (0.6139) = $1,000.00 Bonds with a few cash flows can be valued with Eq 4.1; for bonds with many cash flows, use PVFA/PVF factors, calculator or Excel.
  • Value of any financial asset is the PV of future cash flows Bonds: PV of promised interest & principal payments Stocks: PV of all future dividends Patents, trademarks: PV of future royalties Valuation is the process linking risk & return Output of process is asset’s expected market price A key input is the required [expected] return on an asset Defined as the return an arms-length investor would require for an asset of equivalent risk Debt securities: risk-free rate plus risk premium(s) Required return for stocks found using CAPM or other asset pricing model Beta determines risk premium: higher beta, higher reqd return
  • When r is greater than the coupon interest rate, P 0 will be less than par value, and the bond will sell at a discount For Sun, if r > 5%, P 0 will be less than $1,000 For practice: Value Sun Company, 10-year, 5% coupon rate bond if required return, r =6% and again if r = 4%. Premiums & discounts change systematically as r changes.
  • -Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P 0 and hold it until maturity. The YTM on a bond selling at par ( P 0 = Par ) will always equal the coupon interest rate. When P 0  Par , the YTM will differ from the coupon rate. YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P 0 , CFs, n known, can find YTM Use T-Bond with n=2 years, 2n=4, C/2=$20, P 0 =$992.43
  • -Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P 0 and hold it until maturity. The YTM on a bond selling at par ( P 0 = Par ) will always equal the coupon interest rate. When P 0  Par , the YTM will differ from the coupon rate. YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P 0 , CFs, n known, can find YTM Use T-Bond with n=2 years, 2n=4, C/2=$20, P 0 =$992.43
  • The relationship between nominal (observed) and real (inflation-adjusted) interest rates and expected inflation called the Fisher Effect (or Fisher Equation) Fisher said the nominal rate ( r ) is approximately equal to the real rate of interest ( a ) plus a premium for expected inflation ( i ). If real rate equals 3% (a = 0.03) and expected inflation equals 2% (i = 0.02): r  a + i  0.03 + 0.02  0.05  5% The true Fisher Effect is multiplicative, rather than additive: (1+r) = (1+a)(1+i) = (1.03)(1.02) = 1.0506; so r = 5.06%
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  • Chapter 1

    1. 1. The Scope Of Corporate Finance Professor Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics
    2. 2. Finance Career Opportunities Corporate Finance <ul><li>Budgeting, financial forecasting, cash management, credit administration, investment analysis, fund procurement </li></ul>Commercial Banking <ul><li>Consumer banking </li></ul><ul><li>Corporate banking </li></ul>Investment Banking <ul><li>High income potential </li></ul><ul><li>Very competitive industry </li></ul>Money Management <ul><li>Opportunities in investment advisory firms, mutual fund companies, pension funds, investment arms of financial departments </li></ul>Consulting <ul><li>Advise on business practices and strategies of corporate clients </li></ul>
    3. 3. Raising Capital: Key Facts Primary vs. secondary market transactions or offerings Most financing comes from internal rather than external sources (“pecking order”). Most external financing issued as debt Traditional financial intermediaries (banks) declining as a source of capital for large firms Securities markets growing in importance
    4. 4. Growth in Global Security Issues, 1990-2003 Global debt & equity U.S. Issuers worldwide $ Bn
    5. 5. Role of The Financial Manager Financial manager Firm's operations Financial markets (3) Cash generated by operations (3) (4a) Cash reinvested (4a) (4b) Cash returned to investors (4b) (1) Cash raised from investors (1) (2) Cash invested in firm (2)
    6. 6. Corporate Finance Functions <ul><ul><li>Corporate Finance Functions </li></ul></ul>Financial Management External Financing Capital Budgeting Risk Management Corporate Governance
    7. 7. Dimensions of the External Financing Function Equity vs. debt Funding via capital market vs. via financial intermediary Public vs. private capital markets Going public
    8. 8. The Capital Budgeting Function Select investments for which the marginal benefits exceed the marginal costs . Capital Budgeting – the process firms use to choose the set of investments that generate the most wealth for shareholders
    9. 9. The Financial Management Function Managing daily cash inflows and outflows Forecasting cash balances Building long-term financial plans Choosing the right mix of debt and equity
    10. 10. The Risk Management Function Managing the firm’s exposure to significant risks: Interest rate risk Exchange rate risk Commodity price risk
    11. 11. The Corporate Governance Function Ensuring that managers pursue shareholders’ objectives Takeover market disciplines firms that don’t govern themselves. Dimensions of corporate governance <ul><li>Boards of directors </li></ul><ul><li>Ownership structures </li></ul><ul><li>Capital structures </li></ul><ul><li>Compensation plans </li></ul><ul><li>Country’s legal environment - in U.S., Sarbanes-Oxley Act of 2002 </li></ul>
    12. 12. What Should Managers Maximize? <ul><li>Profit maximization as goal: </li></ul><ul><ul><li>Does not account for timing of returns </li></ul></ul><ul><ul><li>Profits - not necessarily cash flows </li></ul></ul><ul><ul><li>Ignores risk </li></ul></ul>Maximize shareholder wealth <ul><li>Maximize stock price, not profits </li></ul><ul><li>Accounts for risk </li></ul><ul><li>As “residual claimants,” shareholders have better incentives to force management to maximize firm value than do other stakeholders. </li></ul>
    13. 13. Separation of Ownership and Control Principal – Agent Relations Moral Hazard Fringe – Benefit Consumption Management Compensation Schemes Information Asymmetry Controlling Procedures (Agency Costs) Fringe – Benefit Consumption
    14. 14. Goals of The Corporation <ul><li>Shareholders desire wealth maximization </li></ul><ul><li>Do managers maximize shareholder wealth? </li></ul><ul><li>Managers have many constituencies “stakeholders” </li></ul><ul><li>“Agency Problems” represent the conflict of interest between management and owners </li></ul>
    15. 15. Managerial Goals <ul><li>Managerial goals may be different from shareholder goals </li></ul><ul><ul><li>Expensive perquisites </li></ul></ul><ul><ul><li>Survival </li></ul></ul><ul><ul><li>Independence </li></ul></ul><ul><li>Increased growth and size are not necessarily the same thing as increased shareholder wealth. </li></ul>
    16. 16. Do Shareholders Control Management ? <ul><li>Shareholders vote for the board of directors, who in turn hire the management team. </li></ul><ul><li>Compensation Schemes can be carefully constructed to be incentive compatible . </li></ul><ul><li>There is a market for managerial talent—this may provide market discipline to the managers—they can be replaced. </li></ul><ul><li>If the managers fail to maximize share price, they may be replaced in a hostile takeover. </li></ul>
    17. 17. Example: Moral Hazard in Financial Relations Increase the interest rate to 20% does not lead to a solution Moral Hazard can destroy business opportunities:
    18. 18. Expected Value Option A Expected Value Option B Solution of Moral Hazard Problems By Credit Limits A solution should provide no incentives to the management to follow the risky option B, i.e. the expected values of each option should at least equal =

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