Topics Covered

1
Topics Covered

• What Is A Corporation?
• The Role of The Financial Manager
• Who Is The Financial Manager?
• Separation of Ownership and Management
• Financial Markets

2
Corporate Structure
Sole Proprietorships
Unlimited Liability Personal tax on profits
Partnerships
Limited Liability Corporate tax on profits
Personal tax on dividends
Corporations
3
Role of The Financial Manager
(1)
(2)
Financial
Firm's
Financial
(4a)
manager
operations
markets
(4b)
(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
4
Ownership vs. Management

• Difference in Information
• Stock prices and returns
• Issues of shares and other securities
• Dividends
• Financing

• Different Objectives
• Managers vs. stockholders
• Top mgmt vs. operating mgmt
• Stockholders vs. banks and lenders

5
Valuation Rule

• Mean Variance Valuation Rule

6
Valuing an Office Building

• Step 1 Forecast cash flows
• Cost of building C0 350
• Sale price in Year 1 C1 400
• Step 2 Estimate opportunity cost of capital
• If equally risky investments in the capital
  market
• offer a return of 7, then
• Cost of capital r 7

7
Valuing an Office Building

• Step 3 Discount future cash flows
• Step 4 Go ahead if PV of payoff exceeds
  investment

8
Risk and Present Value

• Higher risk projects require a higher rate of
  return.
• Higher required rates of return cause lower PVs.

9
Risk and Present Value
10
General Rule For Valuation Of Any Risky Cash
Stream

• Expected cashflows
• Required rate of return
• Discounted value
• Mean Variance Rule
• Other valuation rules

11
Net Present Value Rule

• Accept investments that have positive net present
  value
• Required rate of return cost of capital

12
Net Present Value Rule

• Accept investments that have positive net present
  value.

Example Suppose we can invest 50 today and
receive 60 in one year. Should we accept the
project given a 10 expected return?
13
Topics Covered

• Valuing Long-Lived Assets
• PV Calculation Short Cuts
• Compound Interest
• Interest Rates and Inflation
• Example Present Values and Bonds

14
Present Values

• Discount Factor DF PV of 1
• Discount Factors can be used to compute the
  present value of any cash flow.

15
Present Values
Example You just bought a new computer for
3,000. The payment terms are 2 years same as
cash. If you can earn 8 on your money, how much
money should you set aside today in order to make
the payment when due in two years?
16
Present Values

• PVs can be added together to evaluate multiple
  cash flows.

17
Present Values

• Discount Factors can be used to compute the
  present value of any cash flow.

18
Present Values

• Replacing 1 with t allows the formula to be
  used for cash flows that exist at any point in
  time.

19
Short Cuts

• Sometimes there are shortcuts that make it very
  easy to calculate the present value of an asset
  that pays off in different periods. These tolls
  allow us to cut through the calculations quickly.

20
Short Cuts

• Perpetuity - Financial concept in which a cash
  flow is theoretically received forever.

21
Short Cuts

• Annuity - An asset that pays a fixed sum each
  year for a specified number of years.

22
Annuity Short Cut
Example - continued You agree to lease a car for
4 years at 300 per month. You are not required
to pay any money up front or at the end of your
agreement. If your opportunity cost of capital
is 0.5 per month, what is the cost of the lease?
23
Valuing a Bond

• Example
• If today is October 2000, what is the value of
  the following bond?
• An IBM Bond pays 115 every Sept for 5 years. In
  Sept 2005 it pays an additional 1000 and retires
  the bond.
• The bond is rated AAA (WSJ AAA YTM is 7.5).
• Cash Flows
• Sept 01 02 03 04 05
• 115 115 115 115 1115

24
Valuing a Bond

• Example continued
• If today is October 2000, what is the value of
  the following bond?
• An IBM Bond pays 115 every Sept for 5 years. In
  Sept 2005 it pays an additional 1000 and retires
  the bond.
• The bond is rated AAA (WSJ AAA YTM is 7.5).

25
Bond Prices and Yields
Price
Yield
26
Topics Covered

• How To Value Common Stock
• Capitalization Rates
• Stock Prices and EPS
• Cash Flows and the Value of a Business

27
Stocks Stock Market

• Common Stock - Ownership shares in a publicly
  held corporation.
• Secondary Market - market in which already issued
  securities are traded by investors.
• Dividend - Periodic cash distribution from the
  firm to the shareholders.
• P/E Ratio - Price per share divided by earnings
  per share.

28
WHY IS IT IMPORTANT TO HAVE A THEORY OF THE
VALUATION OF COMMON STOCKS?

• MANAGERS SHOULD BE MAKING DECISIONS WHICH
  INCREASE SHARE PRICE
• NEED TO UNDERSTAND HOW SHARE PRICE IS DETERMINED
• CASES WHERE WE CANNOT DIRECTLY OBSERVE STOCK
  PRICE
• WE ARE TRYING TO VALUE
• A DIVISION OF A COMPANY
• PRIVATELY HELD FIRM FOR POSSIBLE SALE

29
LETS CHANGE OUR ASSUMPTIONS

• HOW MUCH SHOULD I PAY FOR A STOCK TODAY (P0)
  
• IF I AM GOING TO RECEIVE A DIVIDEND AT THE END OF
  ONE YEAR (DIV1)
• AND THEN IM GOING TO SELL IT (AT
  A PRICE P1)?

30
TWO EQUIVALENT WAYS OF ANSWERING THE QUESTION

• PRICE OF THE STOCK IS THE PRESENT VALUE OF THE
  CASH FLOWS RECEIVED BY THE INVESTOR

31
HAVE I REALLY SAID ANYTHING USEFUL? WHAT ARE
THE LIMITATIONS OF MY ANSWER?

• I CAN CALCULATE TODAYS PRICE ONLY IF I KNOW THE
  PRICE AT THE END OF THE YEAR.
• I AM ASSUMING THAT I HOLD THE STOCK FOR ONE YEAR
  AND I SELL IT.
• WHAT HAPPENS IF MY HOLDING PERIOD IS NOT ONE
  YEAR?
• LETS GET RID OF BOTH LIMITATIONS.

32
LETS SEE HOW MUCH SOMEONE WILL PAY FOR THE STOCK
IN A YEARS TIME

• HOW MUCH SHOULD THE PERSON WHO BUYS IT FROM ME
  PAY FOR THE STOCK IN A YEARS TIME (P1)
• IF SHE IS GOING TO RECEIVE A DIVIDEND AFTER ONE
  YEAR (DIV2)
• AND THEN SHE IS GOING TO SELL IT
• (AT A PRICE P2)?

33
(No Transcript)
34
WE HAVE NOW SUCCEEDED IN RELATING TODAYS PRICE
TO

• EXPECTED DIVIDENDS IN YEARS 1 AND 2, DIV1 AND
  DIV2
• EXPECTED PRICE AT END OF YEAR 2, P2
• WE CAN REPEAT THE PROCESS

35
LETS SEE HOW MUCH SOMEONE WILL PAY FOR THE STOCK
IN TWO YEARS TIME

• HOW MUCH SHOULD THE PERSON PAY FOR THE STOCK IN
  TWO YEARS TIME (P2)
• IF SHE IS GOING TO RECEIVE A DIVIDEND AFTER ONE
  YEAR (DIV3)
• AND THEN SHE IS GOING TO SELL IT
• (AT A PRICE P3)?

36
P0
37
S

• NOW THE PRICE OF THE STOCK IS OBVIOUSLY
• INDEPENDENT OF THE TIME HORIZON, H.
• AS WE GO OUT FURTHER IN TIME, MORE OF
• THE PRICE IS ACCOUNTED FOR BY THE
• DIVIDEND TERMS, SO THAT THE PRESENT
• VALUE OF THE TERMINAL PRICE BECOMES
• LESS IMPORTANT.

38
S
P0
1. BY CONSIDERING HOW MUCH A BUYER WILL PAY FOR
THE STOCK WHEN IT IS REPEATEDLY SOLD, WE FIND
THAT THE STOCK PRICE IS THE PV OF ALL FUTURE
DIVIDENDS. 2. WE OBTAIN THE SAME RESULT
INDEPENDENTLY OF THE ASSUMPTIONS WE MAKE ABOUT
THE LENGTH OF SUCCESSIVE HOLDING PERIODS.
39
SPECIAL CASESWHERE WE CAN MAKE SOME SIMPLIFYING
ASSUMPTIONS ABOUT THE GROWTH PATTERN OF FUTURE
DIVIDENDS
40
SPECIAL CASES
WHERE WE CAN MAKE SOME SIMPLIFYING ASSUMPTIONS
BOUT THE GROWTH PATTERN OF FUTURE DIVIDENDS
1. NO GROWTH SIMILAR TO PREFERRED STOCK, WITH
CONSTANT DIVIDENDS DIV1DIV2.......DIV ORDINARY
PERPETUITY
GOOD APPROXIMATION FOR MANY UTILITY STOCKS
41
CONSTANT EXPECTED DIVIDEND GROWTH (GORDON MODEL)

• DIVIDENDS EXPECTED TO GROW AT CONSTANT RATE
• WE KNOW THIS WONT HAPPEN EXACTLY
• REASONABLE APPROXIMATION WITHIN THE ACCURACY OF
  OUR ESTIMATE
• OFTEN STATED AS COMPANY GOAL
• GROWING PERPETUITY

42
CONSTANT EXPECTED DIVIDEND GROWTH (GORDON MODEL)

• IF DIVIDENDS ARE EXPECTED TO GROW AT A CONSTANT
  RATE (g lt r), VALUE OF
  THE STOCK IS
• DIV1
  DIV0(1g)
• P0
  
• r - g
  r - g
• FOR FLEDGLING ELECTRONICS,
• DIV1 5.00, g .10, r .15
• DIV1 5
• P0 100
• r - g .15 - .10

43

• WHAT HAPPENS TO THE STOCK PRICE WHEN
• REQUIRED RATE OF RETURN INCREASES
• FROM 15 TO 20
• WITH INCREASE IN GENERAL LEVEL OF INTEREST RATES?
  
• EXPECTED GROWTH RATE 10.

DIV1 5 P0
50 r - g .15 -
.05
44
CHANGES IN EXPECTED GROWTH RATES CAN HAVE MAJOR
IMPACT ON STOCK PRICES.
45

• WHAT HAPPENS TO THE STOCK PRICE WHEN
• REQUIRED RATE OF RETURN INCREASES
• FROM 15 TO 20
• WITH INCREASE IN GENERAL LEVEL OF INTEREST RATES?
  
• EXPECTED GROWTH RATE 10.

DIV1 5 P0
50 r - g .20 -
.10
46
CHANGES IN REQUIRED RATES OF RETURN ON
STOCKS CAN HAVE MAJOR IMPACT ON STOCK PRICES.
47
ESTIMATING THE CAPITALIZATION RATEOR REQUIRED
RATE OF RETURN
If dividends are expected to grow at a constant
rate, g DIV1
P0 r - g
DIV1 so that r
g P0
MARKET CAPITALIZATION RATE DIVIDEND YIELD,
(D1 /P0) EXPECTED RATE OF GROWTH IN
DIVIDENDS, g
48
SUPERNORMAL GROWTH
49
STOCK PRICE AND EARNINGS PER SHARE (EPS)

• INVESTORS OFTEN DISTINGUISH BETWEEN
• GROWTH STOCKS
• EXPECTATION OF CAPITAL GAINS, BASED ON FUTURE
  GROWTH IN EARNINGS
• INCOME STOCKS
• CASH DIVIDENDS
• DOES THIS DISTINCTION MAKE SENSE?

50
NO GROWTH

• SIMILAR TO PREFERRED STOCK, WITH CONSTANT
  DIVIDENDS, DIV1DIV2...... ORDINARY
  PERPETUITY

• EXPECTED RETURN
• DIVIDEND YIELD
• EARNINGS PRICE RATIO

51
GROWTH COMPANY

• WE CAN THINK OF STOCK PRICE AS
• THE CAPITALIZED VALUE OF EARNINGS UNDER A
  NO-GROWTH POLICY PLUS
• PRESENT VALUE OF GROWTH OPPORTUNITIES

52
GROWTH COMPANY
EARNINGS PRICE RATIO WILL UNDERESTIMATE
MARKET CAPITALIZATION RATE , r, BECAUSE PVGO gt 0
53
GROWTH COMPANY

• A MAJOR PART OF THE VALUE
  OF A GROWTH STOCK IS
  THE NPV OF
  FUTURE INVESTMENTS
• MAY PAY NO CURRENT DIVIDENDS

54
Estimated PVGOs
PVGO
PVGO P0 EPS
r P0 - EPS/r of P0 Income
stocks ATT 51.13 3.76
.136 23.88 47 Conagra
32.88 2.16 .139 17.38
53 Duke Power 38.25 3.10 .097
6.16 16 Exxon 64.00
4.42 .109 23.26
36 Intl Paper 72.75 8.51
.143 13.06 18 Growth
stocks Genzyme 39.00 2.09
.244 30.45 72 Hewlett
Packard 118.50 9.33 .214
74.90 63 Merck 42.50
2.84 .152 23.82
56 Microsoft 64.31
2.57 .165 48.73
76 WalMart 24.38 1.54
.153 10.05 59