Quote from Siri

1
Quote from Siri

• I hate the way they teach Math in the school.
  All the teacher does is put lots of examples on
  the board for the students to memorize.
• He does not explain the theory so that we could
  apply the theory to ANY numbers rather than
  memorizing 10 problems without understanding.
• I much prefer learning why and how and working
  different problems hands on, like at my school at
  home, rather than memorizing specific problems
  that Ill never see after school
• 17-year old Exchange Student from Finland at
  Shullsburg High (home of the Miners),
  Shullsburg, WI

2
Business 173A Intermediate Financial Management

• Professor Introduction
• COB Policies Review/Professor Policies Review
• Schedule/Requirements Review/Key Dates
• Course Grading
• Roll call and Student Intros
• Finance Overview and Risk Return Tradeoff Review
• Reminder You MUST change your WebCT password

3
Professor Contact Information

• Anu Vuorikoski
• WebCT E-mail Response usually same day,
  guaranteed within 24hrs.
• Web page Go to Faculty home pages/V
• Office Business Tower (BT) 961
• Physical Office hours (e-mail works) As I live
  148 miles away, only on campus M/W1200a-120p
  and 420-520p in OfficeInformal time before
  1200 as traffic allows

4
Professor Background

• Teaching at SJSU since Spring 98-Undergraduate
  170, 173A, 173B, 177-MBA Intro and High Tech
  Financial Analysis
• Have continued teaching because of letters/e-mail
  I get long after
• Teaching in corporate settings prior to that
• Formerly CFO of venture firm, start-up etc, and
  big company corporate finance AND
  Logistics/supply chain re-engineering, AND
  project management assignments
• Consulting (Bain, McKinsey, Touche Ross) and for
  start-ups
• MBA - Harvard, BA - Williams College
• CMA, CPIM, CIRM, PMP (all inactive)
• 20 yrs global experience Finance, Business
  Development, Logistics, Consulting, etc.
• Always real world focus even when students want
  easier

5
COB Policies Review

• B. College of Business Policies and Procedures,
  which will be enforced.
•  
• To ensure that every student, current and future,
  who takes courses in the Boccardo Business Center
  has the opportunity to experience an environment
  that is safe, attractive, and otherwise conducive
  to learning, the College of Business at San José
  State has established the following policies
•  
• Eating
• Eating and drinking (except water) are prohibited
  in the Boccardo Business Center.  Students with
  food will be asked to leave the building. 
  Students who disrupt the course by eating and do
  not leave the building will be referred to the
  Judicial Affairs Officer of the University.
•  
• Cell Phones
• Students will turn their cell phones off or put
  them on vibrate mode while in class.  They will
  not answer their phones in class.  Students whose
  phones disrupt the course and do not stop when
  requested by the instructor will be referred to
  the Judicial Affairs Officer of the University.
•  
• Computer Use
• In the classroom, faculty will allow students to
  use computers only for class-related activities. 
  These include activities such as taking notes on
  the lecture underway, following the lecture on
  Web-based PowerPoint slides that the instructor
  has posted, and finding Web sites to which the
  instructor directs students at the time of the
  lecture.  Students who use their computers for
  other activities or who abuse the equipment in
  any way, at a minimum, will be asked to leave the
  class and will lose participation points for the
  day, and, at a maximum, will be referred to the
  Judicial Affairs Officer of the University for
  disrupting the course.  (Such referral can lead
  to suspension from the University.)  Students are
  urged to report to their instructors computer use
  that they regard as inappropriate (i.e., used for
  activities that are not class related).
•  
• Academic Honesty
• Faculty will make every reasonable effort to
  foster honest academic conduct in their courses. 
  They will secure examinations and their answers
  so that students cannot have prior access to them
  and proctor examinations to prevent students from
  copying or exchanging information.  They will be
  on the alert for plagiarism.  Faculty will
  provide additional information, ideally on the
  green sheet, about other unacceptable procedures
  in class work and examinations.  Students who are
  caught cheating will be reported to the Judicial
  Affairs Officer of the University, as prescribed
  by Academic Senate Policy S98-1. 

6
My Policies

• C. My Class Room Policies1. Due to assistance in
  adhering to COB policies and to the demonstrated
  by past classes learning/attendance benefits
  it affords, classes will be run as back to back
  sessions with the break at the end. Thus the
  classes will run as follows130 to 350/55
  (with break from 355 to 415)530 to 750/55
  (with break from 755 to 815)2. Class will
  go full time. If something runs shorter than
  anticipated, an unscheduled class exercise that
  will further enhance learning will be added 3.
  Short courteous bio breaks are allowed during
  the class EXCEPT during exams.4. Courtesy to
  your class mates and the professor requires
  on-time arrival and informing the professor of
  early departures or missing class ahead of time
  (due to in class group exercises)

7
Why I do things the way I do..

• From industry looking to teach something that
  will help you on the job and, hopefully, ensure
  it is not exported offshore.
• Six 6-hour exams at end of HS (at 18) on
  EVERYTHING ever learned Only tools pencil,
  eraser, slide rule. No M/C
• CMA exam (Four 4-hour exams no M/C), PLUS CPIM,
  CIRM and PMP exams

8
Primary GoalsChallenge to Grow

• Improve Analytical/Modeling SkillsPLUS
• Deepen/Expand Discipline Specific Knowledge
  SkillsPLUS
• Prepare for lifelong learningEQUALS
• Work and Career Preparation

9
Schedule/Key Dates

• Exam Dates1. Feb 21 (Ch 1-8)2. Mar 21 (Ch 9-14,
  25)3. Final Date, Wed May 23 (do NOT book
  flights earlier, no exceptions will be made)
• Jeopardy DateMay 2

10
Grading
11
What grades are possible

• All grades from A to F
• Grades are based on points at the end of the
  semester (break point system)

12
So, how do I get an A?

• A typical A student in this class has the
  following profile Thinks of themselves as a
  responsible adult and likes being treated as such
  Works hard AND smart (usually had high grades
  in previous classes for the same reasons) uses
  time management tools Submits work on time
  without excuses or whining Tries to solve
  problems that, on the surface, may seem like
  new because they are in an unfamiliar format or
  ask for new information Asks questions when
  does not understand Fully participates in in
  class team exercises, etc.

13
Can I fail this class?

• Of course.
• A student who fails this class typically Feels
  like school work interferes with other more
  important activities/feels entitled to a C or
  above regardless. Has a poor record (lots of
  C-/D/F/U/W) when I check Feels professors
  should focus on only what will be on exam, and
  spoon feed all answers and that cheat sheets
  should be allowed etc. Use lots of excuses for
  not doing work/missing class Does not
  contribute to the in class exercises choosing to
  talk about other matters during them

14
Why dont you show us exactly how to do the
analysis and forecast and give right answer and
test on the same numbers?

• Answer You are here to learn how to approach a
  problem when you have not done exactly that
  problem before but have learned the tools
  previously.
• Do you suppose your boss would pay you if he/she
  had to do the project first?
• In real life, there are no single right answers

15
TOOO Much Work? Ch 1-3Review from 170, mostly
16

• The basic goal of management to create
  stock-holder value (measured by stock price!!!)
• Agency relationships get in the way
• 1. Stockholders versus managers
• 2. Stockholders versus creditors

17
What is an agency relationship?

• An agency relationship arises whenever one or
  more individuals, call (1) hires another
  individual or organization, to perform some
  service (2) delegates decision-making authority
  to that agent.

18
There are TWO potential agency conflicts

• Conflicts between stockholders and managers.
• Conflicts between stockholders and creditors.

19
Would going public in an IPO increase or decrease
agency problems?
.
20
Why might you want to inflate your reported
earnings or use off balance sheet financing to
make your financial position look stronger?

• A manager might inflate a firm's reported
  earnings or make its debt appear to be lower if
  he or she wanted the firm to look good
  temporarily. For example just prior to
  exercising stock options or raising more debt.

21
What are the potential consequences of inflating
earnings or hiding debt?

• If the firm is publicly traded, the stock price
  will probably drop once it is revealed that fraud
  has taken place. If private, banks may be
  unwilling to lend to it, and investors may be
  unwilling to invest more money.

22
What kind of compensation program might you use
to minimize agency problems?

• Reasonable annual salary to meet living
  expenses
• Cash (or stock) bonus
• Options to buy stock or actual shares of stock to
  reward long-term performance
• Tie bonus/options to EVA

23
EVA????

• Economic Value Added
• Profit over and beyond paying for the cost of
  capital
• NOPAT - Cost of Capital
• NOPATEBIT-Taxes
• Cost of Capital Capital (NWCFA) WACC
• Capital CA-CLFALTDEquity (CAFACLDE)
• CofC cost of debt after tax, cost of equity,
  impact of risk
• How do you impact the components???

24
Why might someone interviewing for an entry level
job have a better shot at getting a good job if
he or she had a good grasp of financial
management?

• Managers want to hire people who can make
  decisions with the broader goal of corporate
  value maximization in mind because investors are
  forcing top managers to focus on value
  maximization.

25
What are investment returns?

• Investment returns measure the financial results
  of an investment.
• Returns may be historical or prospective
  (anticipated).
• Returns can be expressed in
• .
• .

26
What is the return on an investment that costs
1,000 and is soldafter 1 year for 1,100?

• Dollar return ?

• Percentage return ?

27
What is investment risk?Risk Return Tradeoff

• Investment returns are not known with certainty.
• Risk refers to the probability of earning a
  return different from that expected.
  Variability of outcome.
• The greater the chance of a return far below the
  expected return, the greater the risk. The
  corollary is that, typically, there is also
  probability of high return.

28
Probability distribution
Stock X
Stock Y
Rate of return ()
50
15
0
-20

• Which stock is riskier? Why?

29
What about these?
Economy Prob. T-Bill A B C D
Recession 0.10 8.0 -22.0 28.0 10.0 -13.0
Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0
Average 0.40 8.0 20.0 0.0 7.0 15.0
Above avg. 0.20 8.0 35.0 -10.0 45.0 29.0
Boom 0.10 8.0 50.0 -20.0 30.0 43.0
1.00
30
How to calculate the expected rate of return on
each alternative.

r expected rate of return.

rA 0.10(-22) 0.20(-2) 0.40(20)
0.20(35) 0.10(50) 17.4.
31
What is the standard deviationof returns for
each alternative?
32

• Standard deviation measures the stand-alone risk
  of an investment.
• The larger the standard deviation, the higher
  the probability that returns will be far below
  the expected return.
• Coefficient of variation is an alternative
  measure of stand-alone risk.

33
Coefficient of VariationCV Expected
return/standard deviation.
34
Portfolio Risk and Return
Assume a two-stock portfolio with 50,000 in each

Calculate rp and ?p.
35
Portfolio Return, rp


rp is a weighted average
n


rp ??wiri?
i 1
36
Two-Stock Portfolios

• Two stocks can be combined to form a riskless
  portfolio if r -1.0.
• Risk is not reduced at all if the two stocks have
  r 1.0.
• In general, stocks have r ? 0.65, so risk is
  lowered but not eliminated.
• Investors typically hold many stocks.
• What happens when r 0?

37
What would happen to the risk of an average
1-stock portfolio as more randomly selected
stocks were added?

• ?p would decrease because the added stocks would
  not be perfectly correlated, but rp would remain
  relatively constant.

38
Prob.
Large
2
1
0
15
Return
?1 ??35 ?Large ??20.
39
?p ()
Company Specific (Diversifiable) Risk
35
Stand-Alone Risk, ?p
20 0
Market Risk
10 20 30 40 2,000
Stocks in Portfolio
40
Risk Stand-alone, Market, Diversifiable
Market risk is that part of a securitys
stand-alone risk that cannot be eliminated by
diversification. Firm-specific, or diversifiable,
risk is that part of a securitys stand-alone
risk that can be eliminated by diversification.
41
Conclusions

• As more stocks are added, each new stock has a
  smaller risk-reducing impact on the portfolio.
• ?p falls very slowly after about 40 stocks are
  included. The lower limit for ?p is about 20
  ?M .
• By forming well-diversified portfolios, investors
  can eliminate about half the riskiness of owning
  a single stock.

42
Can an investor holding one stock earn a return
appropriate to its risk?

• No. Rational investors will minimize risk by
  holding portfolios.
• They bear only market risk, so prices and returns
  reflect this lower risk.
• The one-stock investor bears higher (stand-alone)
  risk, so the return is less than that required by
  the risk.

43
How is market risk measured for individual
securities?

• Market risk, which is relevant for stocks held in
  well-diversified portfolios, is defined as the
  contribution of a security to the overall
  riskiness of the portfolio.
• It is measured by a stocks beta coefficient.
• In addition to measuring a stocks contribution
  of risk to a portfolio, beta also measures the
  stocks volatility relative to the market.

44
What is the CAPM from 170?

• The CAPM is an equilibrium model that specifies
  the relationship between risk and required rate
  of return for assets held in well-diversified
  portfolios.
• It is based on the premise that only one factor
  affects risk.
• What is that factor?

45
What are the assumptions of the CAPM?

• Investors all think in terms ofa single holding
  period.
• All investors have identical expectations.
• Investors can borrow or lend unlimited amounts at
  the risk-free rate.

(More...)
46

• All assets are perfectly divisible.
• There are no taxes and no transactions costs.
• All investors are price takers, that is,
  investors buying and selling wont influence
  stock prices.
• Quantities of all assets are given and fixed.

47
How are betas calculated?

• Run a regression line of past returns on Stock i
  versus returns on the market.
• The regression line is called the characteristic
  line.
• The slope coefficient of the characteristic line
  is defined as the beta coefficient.

48
Regression to Estimate Beta

• 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.
• The slope of the regression line, which measures
  relative volatility, is defined as the stocks
  beta coefficient, or b.

49
Calculating Beta in Practice

• Many analysts use the SP 500 to find the market
  return.
• Analysts typically use four or five years of
  monthly returns to establish the regression line.
  
• Some analysts use 52 weeks of weekly returns.

50
How is beta interpreted?

• If b 1.0, stock has average risk.
• If b gt 1.0, stock is riskier than average.
• If b lt 1.0, stock is less risky than average.
• Most stocks have betas in the range of 0.5 to
  1.5.
• Can a stock have a negative beta?

51
Finding Beta Estimates on the Web

• Go to www.bloomberg.com.
• Enter the ticker symbol for a Stock Quote, such
  as IBM or Dell.
• When the quote comes up, look in the section on
  Fundamentals.

52
Expected Return versus Market Risk
Expected
Security return Risk, b
1 17.4 1.29
Market 15.0 1.00
2 13.8 0.68
T-bills 8.0 0.00
3 1.7 -0.86

• Which of the alternatives is best?

53
Use the SML to calculate eachalternatives
required return.

• The Security Market Line (SML) is part of the
  Capital Asset Pricing Model (CAPM).
  
• SML ri rRF (RPM)bi .
• Assume rRF 8 rM rM 15.
• RPM (rM - rRF) 15 - 8 7.

54
Required Rates of Return
r1 8.0 (7)(1.29) 8.0 9.0
17.0.
rM 8.0 (7)(1.00) 15.0. r2. 8.0
(7)(0.68) 12.8. rT-bill 8.0
(7)(0.00) 8.0. r3 8.0 (7)(-0.86)
2.0.
55
Expected versus Required Returns

r r
1 17.4 17.0 Undervalued
Market 15.0 15.0 Fairly valued
2 13.8 12.8 Undervalued
T-bills 8.0 8.0 Fairly valued
3 1.7 2.0 Overvalued
56
Impact of Inflation Change on SML
Required Rate of Return r ()
? I 3
New SML
SML2
SML1
18 15 11 8
Original situation
0 0.5 1.0 1.5 2.0
57
Impact of Risk Aversion Change
After increase in risk aversion
Required Rate of Return ()
SML2
rM 18 rM 15
SML1
18 15
? RPM 3
8
Original situation
Risk, bi
1.0
58
The SML Equation

• The measure of risk used in the SML is the beta
  coefficient of company i, bi.
• The SML equation
• ri rRF (RPM) bi

59
Illustration of beta calculation
.
20 15 10 5
.
Year rM ri 1 15 18 2 -5 -10
3 12 16
_
-5 0 5 10 15 20
rM
-5 -10


.
ri -2.59 1.44 kM
60
Method of Calculation

• Analysts use a computer with statistical or
  spreadsheet software to perform the regression.
• At least 3 years of monthly returns or 1 years
  of weekly returns are used.
• Many analysts use 5 years of monthly returns.

(More...)
61
Interpreting Regression Results

• The R2 measures the percent of a stocks variance
  that is explained by the market. The typical R2
  is
• 0.3 for an individual stock
• over 0.9 for a well diversified portfolio

62
Interpreting Regression Results (Continued)

• The 95 confidence interval shows the range in
  which we are 95 sure that the true value of beta
  lies. The typical range is
• from about 0.5 to 1.5 for an individual stock
• from about .92 to 1.08 for a well diversified
  portfolio

63

• Betas of individual securities are not good
  estimators of future risk.
• Betas of portfolios of 10 or more randomly
  selected stocks are reasonably stable.
• Past portfolio betas are good estimates of future
  portfolio volatility.

64

• CAPM/SML concepts are based on expectations, yet
  betas are calculated using historical data. A
  companys historical data may not reflect
  investors expectations about future riskiness.
• Other models are being developed that will one
  day replace the CAPM, but it still provides a
  good framework for thinking about risk and return.