Finance

Tuesday, September 07, 2010 2:01 PM

Finance: The process in which money is transferred among businesses, government and households The purpose of any firm - Is to increase the value of their stock - Stock reflects the value of its future financial profits Why should it be relevant to me as a student? - Career plans - Investing activity - It is important in personal life beyond activities as an investor

Spending income Borrowing saving

Using Saving

Life time Financial System Financial intermediaries: - Banks Commercial Investment - Insurance Companies Mutual funds - Financial Markets Coordination Lender savers Borrowers and spenders Federal Reserve Financial Managers Financial Markets Investors

All interact with one another

Financial Management Obtaining funds (financing) Investing Funds (investing) Maximize the value of the firm Pshare * Nshares Three ways to increase the price per share: 1) Higher cash inflows 2) Money received sooner 3) Lower the risk of shareholders - "Agency Costs" Things that management provides for itself from the firms resources for the financial teams benefit that doesnt benefit the firm directly itself Private planes, expensive offices, fancy cars Benefits the managers but not the stock itself - "Social Responsibilities" Being a good citizen by firms giving money to a service It is the firms responsibility to enhance its value in order to benefit the community for the firms service

Government decisions effect the populations outcome. Thus an informed population can benefit the community as a whole An informed decision is better than not. Financial success is at stake if one does not understand finance

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An informed decision is better than not. Financial success is at stake if one does not understand finance

Financial Managers: Nonprofit- fund the operations of the institution given the goals of the institution They dont have to be as creative. They just have to accomplish the mission by managing the given budget Mission first funding comes after - Issues involved in this There is no real limit to what you can do There is little incentive to grow Inefficient operation For Profits- maximize the value of the firm

Firm organization: [Prez]CEO VP HR VP Manuf VP Fin Vp Mktg VP Infor

Treas (Fin Mgt)

Controller (accounting)

Financial Managers effect the left side of the balance sheet [The Assets] Accounting Formula: A= L + OE OE= A-L Required Return Time Preference You have to offer a higher consumption that what one could consume now

R.R Rf 0 Risk

Funding: Two sources: 1) Debt finance Borrow money 2) Equity Finance Retained Earnings Selling equity securities (ownership shares) Common stocks Preferred stocks Financial managers optimize the sources of funding

Investors Types: 1) Individuals 2) Institutions Loans: Include principal and interest Debt securities : Issued at discount Resalable Mature Equity Securities No maturity date, resalable Return either dividends paid to holders and increase in price is a return

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No maturity date, resalable Return either dividends paid to holders and increase in price is a return All securities are risky Risk on debt securities is a risk of default Equity-the risk is the market price going down. Low dividends or no dividends at all Investors are risk averse- higher risk higher returns Risk-averse Risk-lovers Gamblers Financial markets assist thee flows of money Financial managers help real assets Investors decisions increase the value of the firm Ps Ps1 Ps0 Ds Ss

Ds 0 Q0 Q1 Q

Six Basic principals of Finance 1) Time Value of Money i. With repect to money present values exceed future values PV<FV 1) You buy a bond at $1000 at %5= $1050 in one year 2) Risk takers must be compensated (or they wont take the risk) 3) Risk can be reduced by diversification p.7 Return .5(0)+.5(2400)=$1200 Outcome Combined s investment 1 2 3 4 1000 1000 1000 1000 Possible returns 0+0 0+1,200 1200+0 1200+1200 Combined Returns 0 1200 1200 2400 Rf 0 Risk

Diversification is less risky when the probabilities are different 4) Financial markets are efficient in pricing i. Markets bring information together and consequently set the prices that represent the best information ii. The good info about a stock will spread through the market and the price per share will go up until return is brought down again ABC Corp. Expected earning per share (EPS) is $5 & Current Price = $50 Current Expected Return $5/$50=$0.1 %10 Expected EPS is now $6 Expected return is $6/$50=$0.12 %12 Expected Return is $6/$60=$0.1 %10 5) Managers objectives can be different from the owners 6) Reputation Matters Business ethics vs political ethics: Business ethics are higher than political ethics because of the market. Politicians also have a check on them you can remove them from office

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from office How do you influence the financial managers so that what they do is beneficial to the firm: Investor trading Shareholder activism Takeover (buy all the shares to put yourself in charge) [Calr Ichan] Financial Intermediaries They are in-between savers and investors Channel savings into loans or investments The Fed: National Debt Sept. 7 2010- $13,461,672,342,582.93 GDP: II Q 2010- $14.7 trillion Financial Institutions Commercial banks Depository institutions Mutual funds Pension funds Saveing and loans Before 1790: The banking system began in 1790 in the united states Before this most money that circulated was gold and silver from europe They were going out of the US because there was a trade deficit more goods were coming in than going out of the US 2.5 million people in the colonies 3 million in england 12 million dollars in circulation in US = $5 per person Payment was supplemented by bartering, tobacco, corn etc. 1618 the Virginia specified an official price for tobacco 1690 Massachusetts started printing bills of credit Parliament in England didnt like this so in 1690 England set up the bill act that prevented paper money from being printed 1779 congress had issued 1 million continental bills 1781 they chartered the bank of north America Bank of north america issued bank notes, and issued credit New york and boston soon built banks also which was the start of the bank industry Commercial loan theory of credit- banks should never make anything but short term liquid loans bc they are short term gains The money supply will only expand as the country expands The first bank of US was a federal bank which acted as a fiscal agent of the US It had a 20 year charter Hamilton started it He did two important things to get the government to a stable start - Payed off the debts gained over the revolution - Established the bank of US which acted as the fiscal bank for the government Made loans Issued currancy Collected costums 1810 90 banks charted by states This resulted in a ton of different bank notes 1816 250 banks and paper currency was being issued like crazy There were so many different kinds of currancy 2nd charter of the US bank 20 year charter The 2nd bank tried to discipline the banks by issuing gold & silver for their notes This lead to panic of 1819 -> many banks failed 1823 - Nicholas Biddle was appointed president of the second bank of the US

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1823 - Nicholas Biddle was appointed president of the second bank of the US He regulated the bank system As the gold and silver increased by banks the number of notes increased 1833 Jackson stopped the 2nd bank by refusing deposits to the bank Jackson told the treasury to distribute the surplus to the state banks in proportion to the senators in congress 1846 congress passed the independent treasury act - States changes their banking systems - Some states refused banks to open - Others let anyone open a bank Ney York the banking act that the legislation passed worked so well that the national banking system was modeled after it - It required all banks to maintain a certain percentage of reserves - The national banking act superseded anything at that time Banking before 1863 was a large mixture of differently run operations The idea of having a nationally charted bank was for the bank to sell federal securities to raise money for the government State banks saw the demand deposite system to work to avoid government charges and this started the creation of money and checking accounts The panic of 1907 It was severe short term panic, A bank in New york going bankrupt would then bankrupt the smaller state bank invested in them so the panics caused people to pull money out 1912 the establishment of a central bank that would regulate all banks The compromise was the federal reserve act- a decentralized central bank which set up 12 districts

Commercial Banks Depository They buy debt, issue loans etc Demand deposits: payable on demand Time Deposits: they remain their, so savings accounts etc CD- certificate of deposit Banks who make loans often give Term loans: loan for specific period of time Lines of credit: there is a specific amount of money available if company wants to draw on it How banks create money: Money: anything that performs a medium of exchange - Store of Value, you accumulate value in the form of exchange and you hang onto it through time to support later spending - Standard of value, its a measuring stick of the value of things and their prices - Standard of differed payments Federal Reserve knows the amount of money in the system M1 Into the second quarter= 1718.4 billion M2=M1+ 8,610.9 billion p.19 ^^ p.69: Table 3.2 www.Stlouisfed.org 5.9% is the current saving rate which is the highest in a few decades people are conserned for the future. How banks create money:

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Money supply doesnt really go up and down, the rate of increase rises and falls Commercial banks are regulated by: Federal insurance policies National banks are regulated by the comptroller of the currency State banks are regulated by the state banking board Federal Reserve Federal Reserve System: Established in 1913 as a lender of last resort The Fed is a Banker's Bank Any bank that is apart of the system has an account at then Fed, which is used to settle inner bank debts Banks can pull money from the fed when needed, especially during Christmas time 12 regional banks Each regional bank has a board of directors and each board has 9 people, 3 people elected by banks, 3 elected by the public, 3 elected by board of governors, pres of the board is elected by the board -Ben bernanke monatary economist Board of governors itself has 7 memebers, they are appointed by the prez with the consent of congress, each has 14 year term. Cannot be removed unless impeached or found guilty of a high crime

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a high crime They try to carry out monetary policy Making changes in the money supply and interest rates that are favorable to the economy Fractional Reserve System: Fed Reserve 3 responsibilities: 1) Government checking account 2) Banker's bank 3) Supervise and regulate local banks 4) Conducts monetary policy - Manage Money supply and interest rates ^Money supply leads to pushes down the interest rates which leads toincreased interest rates which increases employment which leads to causes malinvestment and a recession vMoney supply leads interest rates to go up which leads to lower interest rates which leads to decrease in employment Tools: 1) Reserve requirement - 3%-12% 2) Discount rate - Rate the fed charges member banks to borrow from it Federal funds rate: rate banks charge each other for overnight loans 3) *Open Market Operations Bond Prices and Interest rates move inversely Term structure on interest rates I L

Ms->

I-rates->

Ms->^irates->VIVL Commercial Banks Mutual Funds Securities Firms Brokerage Investment companies Investment Banks Insurance companies Pension funds Depository institutions

Relationship between Money supply and Economic activity: Manipulators Of the economy

Monetarists:
Money Supply x Velocity Money= Ro x PL MV=P*Q i Io i1 0 y

lm Lm1

Keynsians:
Ms -> i-rates -> expenditures -> GDP

Austrians:
Ms -> i-rates (nominal) -> structure of expenditures -> malinvestment -> Bust You can't do anything, you just have to wait and it will fix itself eventually If you try to mess around and fix it you just prolong the issue

International Finance S$ P$ [E] .777 .699 1.43 S$ PE SE

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S$ P$ [E] .777 .699 D$ 0 Q$ 0 1.43 1.287 DE QE DE S$ PE SE

The employment act of 1946 It was a responsibility of these to promote economic growth and full employment, price stability, and net exports= 0 Established the council of economic advisors Food P.P Curve ^ resources, improve technology, improve economic order (division of labor, improve knowledge of cause and effect), Mkt economy vs. Planned economy > Economic growth

0 GDP= C + I + G + (X-M) GDP= PCE + GPDI + GE + NE

Housing

Congress and President both engage in physical policy Physical policy= manipulation of government spending and taxes Government has a couple of responsibility: according to Smith Police and the court Bismarck brought the idea of the state being the molder of society >this leads to a departure from smiths idea G=T balanced budget G>T deficit and Borrow G<T surplus and redeem

p.63 2nd Q 2010 GDP= 13,191.5 PCE= 10,325.5 GDPI= 1,838.7 GE= 2,991 NE= -536 2008 14,441 ? 2,136 2,883 -696 10% 9 8 7 6 5 4 3 2007 2008 2009 Actual

W/o Plan Stimulus Plan

2010

Mankiw: Published the first intro econ textbook Foreign sources Government and private Sources of savings Government: Projects Most failed and were a financial failure Foreign Sources Industries China Brittain (cattle investment in tx) 3 sources for development in poor countries International organization (world bank etc) Government to government lending

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International organization (world bank etc) Government to government lending Non profit organization lending Government to Government Lending to repressive regimes dont really work Governments using their lending to achieve undermining goals Historically we dont have good results Private sources Most successful in history Globalization, capital transfers

Savings:
Personal = positive Business= deficit

Table 3.2 p. 69

What affect saving? 1) incomes 2) Expectations *** - Price levels - incomes 3) Business Cycle and Demographics 4) Life stages

Financial Markets: 1) Establish Prices i. trades 2) Provide Liquidity i. Dealers in financial markets (middle man) 3) Minimize transactions costs i. High volume of trade ii. Rules iii. Standardized contracts

Financial Markets Primary Markets Secondary Markets New york stock exchange Market for used assets 1366 seats (the right to trade) Organized markets for securities OTC (over the counter market) Nasdaq - Amex Dealers p ask p1 ^ po v Bid 0 Derivatives Mortgage Speculation on interest rate movements Foreign exchange rates speculations s

Leon Walra Approximating the right price surplus shortage d Q If there Is a surplus you drop the prices, if there is a deficit you raise the prices

Investors change their behavior so prices fluctuate Money Markets: Trade over many means of communication Banks use them to park funds until they find something to do with the money Borrowing people use money markets to make short term gains US treasury- sells: B-N-B Bills= < 1 year Notes= between 1 and 10 years Bonds = 10+ Treasury bills 13 10K 26 15k 360 50k, 100k ,1million Ex. Actual return= 10,000 -9,800 9,800 = 9,800 .0204=2.4% 2) 9900-9800 9800 = .0102=1.02% 1) 91 days 182 days No interest Only way to gain is to get the right price initially Yield= Sell price - buy price buy price = risk free rate of return

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Federal Funds Market Repurchase Agreements Negotiable Certificates of deposit Commercial paper Banker's Acceptances

9800 = .0102=1.02% 3) 9900-9800 365 9800 x 180 = .0207 or 2.07% 4) 10,000-9900 365 9,900 x 180 =.0205 or 2.05%

Capital Markets Government bonds and notes - Federal - State - Local/municipal - Corp bonds - Corp stock - Mortgages - Bonds Treasury 10-30 years Treasury notes 1-10 years Yield= sell price - buy price buy price + sum of 6 mo coupon payments Tax exempt from state and local taxes Agency bonds Municipal bonds General obligation bonds Revenue bonds $5,000 minimum Tax exempt from all levels Corporate bond $1,000 10-30 years in maturity Debenture- you get no return Mortgage Stocks Common Voting rights Everyone gets paid before you get paid Preferred Guaranteed they will be paid a dividend No voting rights

Rf= r = RR= 1P r=nominal RR= real rate + inflation rate RR=r- lP

Interest Rate Risk free: treasury bill, note, bond rate r=RR+IP Rf-P=r r=RR+IP+DRP+MRP+LP Any interest rate on a security is on the markets belief on what needs to be included Where do interest rates come from? They come from a market for loan able funds r SLF S'LF How do you change the rate of loanable funds? 1- Savers change their practices i. Saving more brings the interest rates down 2- The Feds to what they do i. Open markets ii. Discount rate iii. Legal reserve rate

ro* r1

S -> I S=D

DLF L

Supply and demand of loan-able funds:

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Supply:

W/P I1 Io*

S'LF SLF

Demand: r SLF

ro* DLF S=I* L S=I DLF L

SLF

Demand in business is driven by optimism or pessimism House holds Optimism, pessimism Government

ro*

DLF S=I If prices are higher then the supply will shift to the left, and the demand will also increase When people think inflation rates are going to be higher. Supply and demand goes up. Expected effects of fed supporting treasury borrowing The fed supports the treasury buy supporting the treasuries borrowing to hold down interest rates The treasury borrowing drives monetary policy They stopped this Who owns our national debt? p.91 text Jun 30 2010: fed owns 40% private investors 60% Foreign banks/investors 30% Term Structure of Interest Rates How an interest rate spreads out through time 3 theories : 1- Expectations theory 1) The yield curve a) Reflects investors expectations of future interest rates, and inflation i) Investors can think rates are going to be higher

Short term funds r SLF

Long term funds W/P SL

ro ro1 DLF 0 L* LF r r=RR+IP

W/p*

DL L* L

IP=inflation premium

LF

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ii) Anticipation of interest rates being lower Short term funds r r1 ro SLF Long term funds r SLF

ro r1 DLF DLF 0 L* LF

L*

LF

LF

2) Liquidity Preference Theory a. The risk on short term is lower than long term securities b. The yeild curve tends to slope up 3) Market segmentation theory a. The short term and long term markets are different i. The interest rates are set separately between the short term and long term

Fisher Equation (Irving Fisher) N=r+INF+r(INF) >i=r+^e

N=nominal interest rate r= real interest rate INF= inflation

Default risk: - Business risk (cash-flow) - Financial risk (debt load)

Maturity Risk: - The longer you have a security the more the price is effected by interest rates

Investment Grade

BBB BB

Baa Ba

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Investment Grade Junk Bond

Return %

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Speculative Common Stocks Prefferred Stock Medium Grade Bonds Investment Grade bonds Investment grade nots U.S. Treas 0 Risk Prime Com Paper

Increases in interest rates: Increase investment and promote economic growth Bonds become more attractive than stocks Push people to save more and consume less

Test Prep:
Two parts- true false, multiple choice One demand and supply curve Know finance And divisions Institutions Markets Six principles Mager componenets of financial system Money History in the US 1st and 2nd banks Fiat M1 Simple form of quantity theory of money (mv=PQ) ->increase in money supply increases price levels and visaversa Depository instituition Savings Banks creation of money Fractional reserve Monetary policy 3 tools Legal reserves Discount rate Open market operations Open market committee Money multiplier p.52 Employment act of 1946 GDP from expenditure point of view Balanced budget Surplus Where national debt comes from Business and gov are the biggest borrowers Major factors that effect saving Real assets vs --- assets Securities Bonds Stocks Money market vs capital market Money securities <1 Capital securities> 1 year Terms of market of nominal rate of interest = sum of inflation rate Premiums Treasury securities (hand out) Treasury bills= short run Treasury bonds= 10 yrs or more

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Time Value of Money Financial institutions Financial instruments Timing of money going in and out of the hands of the public or the firms hand Calculating future value- calculate the end value of the cash flow Compounding Future Value

-10,000 0. 1

3,000 5,000 3000 2000 2 3 4 5

Present Value Discounting These values are calculated by financial tables and/or calculators Interest is paid on principle Compounded by being added to the principle being made EX. Saving money and you want to know how much you saved after 4 years You had $1000 @ 10% a year Year 1: 1000+ 1000(.10)= $1100 Year 2: [1000+ 1000(.10)]* .10=110/1210 Year 3: {[1000+1000(.10)].10}.10= 121/1331 Year 4: [{[1000+1000(.10)].10}.10].10= 133.10/ $1464.10 Calc: MO=0.00 Dec=4 Periods per year: 2nd-> p/y = 1.0000 1000-> present value-> 10% FV=$1000(1+.10)^4=$1000(1.46)=$1460 General formula: FVn=Pvo(1+r)^n FV13= 100,000 (1.05)^13 = $188,600

2010 1 2

M1 3.83 1.75

MZM -4.24 -4.61

M2 .01 1.95 The fed is not increasing th money supply right now

Time Value of Money Future values: found by compounding

FVn=PVo(1+r)^n
Ex. 188,564.91=1000,000(1.05)^13 Semiannual:

FVn=PV(1+[r/m])^(nm)
100,000 semiannually at 4% Period 6mo 12mo 18mo Principal 100,000 102,000 104,040 FVIF 1.02 1.02 1.02 FV 102,000 104,040 106,120.80 108,160- annual 108,285.70- quarterly 108,314.30-monthly 108,325.38-weekly 108,328.23-daily 108,328.71-continuous

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24mo

106120.80 1.02

108,243.22

108,328.71-continuous

Compounding continuously: e^x f(n)=[1+(1/n)]^n = 2.71828=e f(1)=(1+1/1)^1=2 F(2)=(1+1/2)^2=2.25 f(3)=(1+1/3)^3= 2.37 f(4)=(1+1/4)^4=2.44

If a dollar can be shown to be "e" dollars continuously compounded at %100 given an interest rate of I then: e^x= e^i*n PV(e^i*n) Principal I $1 $1 $PV $PV 100% 100% 100% I Years 1 n n n Asset value and the end of the period e e^n PV(e^n) PV(e^i*n) or PV(e^x)

FVn(cont. compounding)= PV(e^i*n) Ex. n=2, r=4% =.04 So, e^i*n=e^.04*2 = e^.08 = 2.7183^.08=1.0833 FV=100,000(1.0833)= 108,330 Effective annual rate of interest: E.A.R - The frequency of compounding E.A.R=(1+r/m)^m-1

Accumulating a future Balance/Amount If FVn=Pvo(1+r)^n Then, Pvo=FVn/(1+r)^n =100,000/(1.05)^5= 100,000/1.276281562=$78,352.62 Inflation in mind: FV1=PV1(1+.03)^1= 40,000(1.03)=$41,200 Retiring: FV35= 40,000(1+.025)^35 = 40,000(2.3732)= $94,928.21

Annuities Streem of equal value payments over a specified time period. 2 kinds: 1- Ordinary - You receive payments after the end of the first year - Fvoa=PMT1+PMT2 (1+r) + PMT3(1+r)^2+ PMTn(1+r)^n-1) PMT{(1+r)^n-1/r)} 2- Annuity due - Higher future values

Ex. FV 4= $10,000(1.05)^4= 10,000(1.216)= $12,160.00 FV 3=$10,000(1.05)^3=10,000(1.158)= $11,580.00 FV 2= $10,000(1.05)^2=10,000(1.102)= $11,020.00 FV 1=10,000(1.05)^0= 10,000(1)= $10,000 5.526 55,260.00

Its in the table in the book

Suppose you want to save money for a business and you need $50,000 to open a franchise, and another $50,000 to open up the stand. Need to save $100,000 How much money do you need to deposit at 5% FVAn=PMT(FVIFAi,n)

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FVAn=PMT(FVIFAi,n) Then PMT= FVAn/FVIFAi,n = 100,000/5.526=18,096.2722 $18,096.72 Future Value of Annuity Due FVIFAi,n (1+r) 5.526(1.05)=5.802 So, Fva.d. =$10,000(5.802)= $58,020 Present values: Present value of a future value is the amount of money one would have to invest in in order to grow to the future amount i=8% PV+FV(8%)=$1,000 PV(1+8%)= $1000 PV(1.08)=$1000 PV= 1000/1.08 = 1/1.08(1,000)= (.9259)1000=$925.90

PV+ i-rates move inverse to one another i=6% When you were receiving 6% on your money and you wanted to know how much you need to have to receive 100000 at the end of the year $890

PV+PV(%6)+[PV+PV(6%)] 6%=6% $1000 PV + PV(.06)+[PV+PV(.06)].06=$1000 PV(1+0.6)+[PV(1+.06)].06=$1000 1) PV + irates move inverse to one another Pv(1.06)+[PV(1.06)].06=1000 2) PV + time move inverse to one another PV(1.06)[1+.06]=1000 PV(1.06)(1.06)=1000 PV(1.06^2)=1000 Pvo=FVn/(1+r)^n= 1/(1+r)^n FVn FV n=(1+r)^nPVo

Problems at the end of ch. 5: 2,4,6,8,19(a,e) p. 132 Problem 1 p.137

Present Value of ordinary annuity PV 5=$10,000 (1/1.05^5)=$10,000 (.784)=$7,840 PV 4=$10,000 (1/1.05^4)=$10,000(823)= $8,230 PV 3=$10,000 (1/1.05^3)=$10,000(.864)=$8,640 PV 2=$10,000 (1/1.05^2)=$10,000(.907)=$9,070 PV 1=$10,000 (1/1.05^1)=$10,000(.952)=$9520 $43,300 PVAs=$10,000(4.33)=$43,300 Value of a Perpetuity PVIFAr = 1/r = 1/.05 = 20.0 PVA5 = (20)$10,000= $200,000 Present value of a mixed stream of payments Discount each of the lumps in the stream of unequal payments Year 1 2 3 FV 50,000 60,000 70,000 PVIF .909 .826 .751 PV 45,450 49,560 52,570 =147,580 P.V. Calculator 45,454.55 49,586.78 52,592.04 =147,633.37

Calc instructions: CFO Enter V50,000 enter vv 60,000 enter vv 70,000 enter Npv 10 enter V cpt #147,633.36

Loan Amortization Calculate the stream of payments over the term of the loan If PVAn =PMT (PVIFAr,n) Then PMT= PVAn/ PVIFAr,n

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If PVAn =PMT (PVIFAr,n) Then PMT= PVAn/ PVIFAr,n =100,000/4.329= 23,100.02 End of Year Beginning Principal Payment 1 2 3 4 5 100,000 81,902.52 62,900.17 42,947.70 21,997.61 Interest Principal End principal

23,097.48 5,000

18,097.48 81,902.52

23,097.48 4,095.13 19,002.35 62,900.17 23,097.48 3,145.01 19,952.47 42,947.70 23,097.48 2,147.39 20,950.19 21,997.61 23,097.48 1,099.88 21,997.60 .01

Growth Rates Year 2009 2008 2007 2006 2005 PMT 25,000 23,000 21,000 19,000 18,000 18,000/25,000=0.72 ~9%

Calculate growth rate for a stream of payments from an initial amount Borrow $20,000 after 4 years pay 3,500 per year for ten years. What is your interest rate? PVAn=PMT(PVIFAi,n) PVIFAi,n= PVAn/PMT= 20,000/3500=5.7143 -take this number and look at ten years and look for a number closest to this number and fid out what percent =11.7255 p.33 problem 19 part e IRR CPT Annual interest rate - 2nd clwrk - 2nd reset enter - CF0= .00 - 75,000 enter - V - CO1- 35,000 enter vv - Co2- 30,000 enter vv - 5,000 enter vv - 0 enter - =10.0416 PV/ FV - Everything is easy accept for unequal payment.

Rate of Return Any time one makes an investment they do so after analyzing possible returns and losses. Rt=Ct+(PE-PE-1) Pt-1 Gypsy Cab Bought a cab 20,000 90,000 miles Now its worth 8,000 2nd year it generated a net income of 45,000 45,000+(8,000-20,000) 20,000 = 33,000 = 1.65 or 16.5% 20,000

Rt= n/t=1 Rt/n= 16.5% + 150% + 200% + 175%/ 4 = 690/4 = 172.5% Risk and return: Risk is that the rate of return may be different than you epected

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Risk is that the rate of return may be different than you epected Ways to measure risk: Variance G=nt=1 (Rt-R)/ n-1 Year 1 2 3 4 Return R 165 150 200 175 172.5 172.5 172.5 172.5 Re-R (deviation) (RE-R) -7.5 -22.5 27.5 2.5 56.25 506.25 756.25 6.25 =1,325 G=1,325/3= 441.67 G=G = 441.67= 21.02 1 standard deviations: 68% of obs 2 s.d.:98.5% 3 s.d.: 100% 172.5-21.02=151.48 172.5+21.02=193.52 172.5-2(21.02)=130.46 172.5+2(21.02)=214.54

151.48 172.5 193.53 Coefficient of Variation= C.V.= G/R = 21.02/172.5=0.1219 The smaller the coefficient of variation the tighter the distribution Sources of Risk: 3 areas1) Firm Specific Risk a. Business risk - Risk that a firm cannot cover operating cost b. Financail Risk - Firm cannot meet its financial obligations 2) Investor Specific Risk a. Interest rate risk b. Liquidity Risk - An investment becomes less liquid c. Market Risk - Something will happen in the market that will effect everyone 3) Firm and Investor Risk a. Event Risk b. Exchange rate risk c. Purchasing power risk d. Tax Risk Risk assessment for the future: Boom: R1=20% ; p=.1 Normal: R2=10% ; p=.2 Recession : R3=2% ; p=.7 - Three possible scenerios Estimate alternate returns Assign probabilities Plug into E (R )= ni-1 pi Ri = (.1)(20)+(.2)(10)+(.7)(2)= 5.4

Relationship Between Risk & Return Measuring Risk Future Estimate returns in every scenerio- recession, boom, same or different

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 Future Estimate returns in every scenerio- recession, boom, same or different Sensitivity Analysis Set up a range of possible returns (to measure the risk) Two investments: $100 thousand each - Car wash - Mexican restaurant Which will return 10% annually? Measure the most optimistic and pessimistic Wash Car wash Restaurant Initial I Annual R Pessimistic 5% Most likely 10% Optimistic 15% Range 10% 8% 10% 12% 4% $100,000 100,000 Prob .2 .6 .2 Prob. .7 .6 .5 .4 .2 .1 0 5 Prob. .7 .6 .5 .4 .2 .1 0 10 15 20 Return Wtd value Wtd value 1% 6 3 E( R)=10 1.6% 6 2.4 10 Car Wash: I 1 2 3 [Ri-E( R)]2 25 0 25 Ri 5 10 15 Pi .2 .6 .2 E ( R) 10 10 10 Ri- E( R) -5 0 5 Using Standard Deviation R=nEi=1/n E( R)=nEi=1 piRi G2=nEi=1Pi[Ri-E( R)] 2 Gi= G2 8 10 12 Return Restaurant

[Ri-E( R)]2* Pi 5 0 5 10

10=3.162 =G 10+ =G

Restaurant: I 1 2 3 Ri 8 10 12 E ( R) 10 10 10 Ri- E( R) -2 0 2 [Ri-E( R)]2 4 0 4 Pi .2 .6 .2 [Ri-E( R)]2* Pi .8 0 .8 1.6 1.6=1.265=G

Confidence intervals W-CV=3.1623/10= .3162 R- CV= 1.265/10=.1265

Portfolio Risk Efficient Portfolio: - Given any risk you maximize return - What return do I want -- minimize your risk Diversification: - Limits risk - Pick assets from different markets Total Risk= Diversification + Non diversifiable Unsystematic risk(firm specific, industry specific) Market risk (systematic risk) E(Rp)= W 1E(R1)+W 2E(R2)++W nE(Rn) % of the portfolio Expected return investment

1000*.085=85.0

Valuing Stocks:

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Po=Do(1+g) = D1 rs-g rs-g g<rs

= 1.00(1+.0574) .08-.0574

= 1.0574 .0226 =$46.79

Rs-g= D1/Po And r=D1/Po+g = 1.0574/46.79 + .0574=.0799=%8

Po=D1/r-g g=Po*r-Do Po+Do

If Po=D1/r-g, then r-g=D1/Po And -g=D1/Po-r Or g=r-D1/Po =.08-1.0574/46.79=.0574

p.214 Growth rate changes the value of the stock can still be calculated

If Po= Do(1+g) = D1 r-g r-g Capital Asset pricing model: r=Rf+[(Rm-Rf)] B tells how risky the firm is

What do you do to value a stock that doesnt pay dividends? Or a company with an erratic dividend history? Cerro gate: Price earnings ratio P E P/E*E=P Google: P/E=25.04 EPS=$24.62 P= 25.04*24.62=616.48 If price of stock is less then it is undervalued If price of stock is more then it is overvalued

Test Prep: Chapter 5,6,7,8 [9&10-> reading assignment] Ch6. 1,2,5,7 Ch7. 4,5,12 Ch8. 7,9,11,13

Dutch vs. American Auction: American- start low and go up at the highest bid Dutch- start high and sell parts Security exchange commission: They suck at everything

Ch10: Investment applications Capitol Asset Pricing Model Securities are subject to two types of risk Unsystematic risk- asset or company specific Minimize it by diversification Systematic risk-effected by whatever happens in the market Going international is one way to minimize the risk Attempt to measure how the systematic risk in a particular security or asset =slope

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Attempt to measure how the systematic risk in a particular security or asset =slope Capitol asset pricing Asset Return =1

Market return (%)

Your companies volatility of returns is more volatile than the market Your companies volatility of returns is less volatile than the market

Calculator: Month 1 2 3 4 5 6 7 b=2 J is twice as volatile as the market Portfolio Beta Bp=(w1*b1)+(w2*b2)++(wn*bn) Y: Return on J X:return of Market -10 -5 5 -2 10 12 0 -5 -2.5 2.5 -1 5 6 0

2nd- data 2nd clrwork Key in X value Enter v Key in Y value Enter v Key in next x enter v Key in next y enter v Enter last (dont press v) 2nd Stat 2nd clr work

Capitol asset pricing model: The efficient market Assumes that you have a market of many small investors with no restrictions on investors and all investors are rational Ri= Rf+bi(Rm-Rf) Google: Ri= 2.7%+ 1.13(8.41-2.7) =2.7+1.13(5.71)= 2.7+6.4523 =9.2 Expect a return of 9.2% Rf- if the risk free rate goes up then your expectations on the investment you need is expected to go up too i- if a companies beta goes up then expectation goes up too. B shows the systematic risk of the system Rm& Rf- the greater the distance between the market rate and risk free rate the better

Required Return 20 15 10 2.7 5 0 0 .5

SML (security market line)

Market risk premium

1.0 1.5 2.0 2.5 3.0

Ch.11 Balance sheet, income statements Operating plans are made to support the mission Business organizations: Proprietors (72%)- owned by a person, account for (5% total sales) Grows to the point where it cannot grow anymore

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Grows to the point where it cannot grow anymore Partnerships- the more people you have the more difficult it is to make decisions, this leads to limited partnerships where you have people with more say than others Corporations -(20% of all firms) (85% sales)- infinite in lifespan with limited liability. Firms are structured: Board of directors- manage the CPO- who manages everyone else CFO - Treasurer - Controller Generally accepted accounting practices (GAAP) Defined by the financial accounting standards board (FASB) Annual reports: Balance sheet, cash flow statement, income statement Finance manager- cash flow (development/decision driven) Accountants-balance sheet Stock holders Calculating the value of bonds Once a year Twice a year

Yield to Maturity of a bond

If Pb= nt=1 Cn/(1+rb)n + par/(1+rb)n Then solve for rb C=$70 Par=$1000 $1,206.42 n=28 2.47%

Summary on bonds:
1) The higher the coupon rate, the higher the market value of the bond, given the market rate . 2) The more frequent the coupon payment the higher the bond price (because the cash flows are received sooner) 3) The higher the market i-rate, the lower the price of the bond and the higher the YTM 4) More risky bonds have higher coupons + higher required yields or sell at lower prices

(1+.0247) 2-1=.05 =%5

Assume mkt rate is 6% The I'=(1+.06) 1/2-1=.0296 Pb=$1,101.82 vs. 1,206.42 YTM=(1+.0296) 2-1= .0601

Equity Capitol Equity is permanent, you can buy a stock and own it until the company doesnt exist any more Debt interest is tax deductible The most you can lose is the vale of the stock The par value of common stock is relatively meaningless, its only there for accounting purposes Preemptive right to purchase stock at lower than the market price Stock split: The epensive stock is split so that iit is more affordable So each stock owner gets another stock thus making a lot on money Treasury stock: Held by the company itself -some shares of stock get the option of super voting -stock without a vote Dividends are discretionary Consist of cash, additional stock, or commodities There are differences between one preferred stock to another Investment Banks may engage in underwriting, to guarantee the corp. that is selling debt the corp. will receive a certain amount of proceeds for the sold debt The investment bank can also say they will may their best effort and give the company a portion of what they sell # of ways companies can go public: - Securities and Exchange registration 20 days before approval S.E.C Registration The company can issue a prospectus telling corps what they plan to do

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 S.E.C Registration - The company can issue a prospectus telling corps what they plan to do "red herring" selling to potential buyers before the 20 days Costs: Flotation cost Under writing cost- spread of what they buy and sell it for Legal cost They can have an auction instead of going through the SEC Private placement -find a lender or group of leaders to buy it off

Preferred Stock: Po=Do/rs Ex. $1.25/.08=$15.62 Rs=Do/Po 1.25/15.63=0.08 =8%

Common Stock: 1. One-Period Valuation Po=D1/(1+rs) + P1/(1+rs) D1=D0(1+g) Ex. P0=1.25/1.08+20/1.08= $19.68 2. General Model Po= Do(1+g)/(1+rs) + D1(1+g)/(1+rs)2++D /(1+rs) or Po=t-1Dt/(1+rs) t a. No-Growth Po=D1/rs= $2.00/.08=$25.0 Ex. Dow Chemical D1=.60 Po=.6/.02= $30 Rs=D1/Po is "Dividend Yield" b. Constant Growth Model (Myron Gordon growth model) Po= Do(1+g)/(1+rs) + D1(1+g)/(1+rs) 2++D /(1+rs) or Po=t-1Dt/(1+rs)t -> as a future amount approaches zero we can collapse it to: Po= Do(1+g)/(rs-g) and g<rs Ex. Dividend history: 2009:1.00 2008:.95 2007:.90 2006:.85 2005:.80 1.00(1+0.0574)/.08-.0574= $46.79

Test-Next Thursday the 18th

p.214-215 Variable growth model Read it Write out the procedures for the different calculations

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Depreciation is for the purpose of saving money Companies are forced to use various depreciation by government that has nothing to do with old equipment. p.325-26 The full cost of the item is depreciated - Life of asset - Rate at which it will depreciate What you can depreciate is what can be subtracted from your income before being taxed Capitol Budgeting Evaluating and selecting long term investment projects

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Evaluating and selecting long term investment projects Projects that will last greater than 1 year Steps: 1) Proposal 2) Reviewed and analyzed 3) Decision 4) Implementation 5) Follow up Independent projects Mutually exclusive Decision making Accept or reject Rank process to do the projhects in a certain order Cash flow scenarios: Conventional- outflows followed by inflows Non-conventional: outflows and inflows period after period Different techniques: Goal of firm is to maximize the wealth of the owners/ the value of the firm In evaluating- identify all cash flows analyze- capitol budget techniques: Capital Budgeting Techniques: Payback period Net present value method Profitability index (NPV) Internal rate of return Modified IRR Interpret results Simple: Payback periodOnce you have estimate of inflows Calculate amount of time it will take the firm to cover initial investment Max acceptable limit for payback Expected cash flow= year 0 1 2 3 4 5 Saving -256,800 77,000 93000 80000 76000 75000 70,000+85000=155000+95000=250,000 Which one should we do? 77000+93000=170000+80000=250000 256800-250000=6800 76000/12=6333.3333 Jan

Computer system replacement^^^ System analysis year 0 1 2 3 4 5 Saving -250000 70000 85000 95000 110000 100000

Net Present Value Approach: Expected cash flow= year 0 1 2 Saving -256,800 77,000 93000 NPV=E1n CFE/(1+rs) t - CF Assume: rs=.10 Present value of cash inflows-initial investment=NPV

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3 4 5

80000 76000 75000 See Sheet: calculate NPV Whatever has the highest value is the most valuable

Computer system replacement^^^ System analysis VVV year 0 1 2 3 4 5 Saving -250000 70000 85000 95000 110000 100000

Discount Rates(X)% Computer system Systems Analysis D.f 0 5 10 15 20 25 144,200 91,283.95 48,642 13,820.68 -14,961.65 -39,014.40 210,000 144,678.63 92,482.81 50,216.35 15,573.56 -13,136 65800 53,394.6 43840.81 36,395.67 30.535.21 -25,876.40

1000's 250 200 Systems analysis 150 100 Computer System 50 0 5 10 15 20 25 30 %

Using NPV: Profitability Index PI=PV(cash inflows)/ PV(cash outflows) Or PV(cash inflows)/ initial investment

Accept the project if the PI>1 Computer system PI=305,442/256,800=1.19 System Analysis PI=342,453/250,000=1.37

IRR IRR=Ent=1 CFt/(1+IRR) t= CF0 Computer system Expected cash flow= year 0 1 2 3 4 5 Saving -256,800 77,000 93000 80000 76000 75000 256,800 NPV=0 IRR=17.2860%

System analysis VVV year 0 1 2 3 Saving -250000 70000 85000 95000 250,000 IRR=22.5986%

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3 4 5

95000 110000 100000

250,000 NPV=0

Modified IRR When all the cash flows are not all in 0 -10,000 8% PV outflows 10,000 1,714.68 $11,714.68 n=4 Capital Budgeting Techniques 1) Payback period 2) Net present Value 3) Profitability index 4) Internal rate of return 5) Modified IRR 1 5000 2 -2000 3 5000 4 5000

FV Inflows 6,298.56 5,400.00 5,000.00 16,698.56

2 $

3 $

4 $

5 $

Investment $

PV PI=pv/investment

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