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Universidad Complutense de Madrid Facultad de CC EE y Empresariales Grado en Economía

FINANCE
SALVADOR ROJÍ FERRARI

srojifer@ccee.ucm.es
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CONTENTS 1. Overview of Corporate Finance 1.1 What is Corporate Finance? 1.2 Forms of Business Organization 1.3 The Agency Problem

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2. Financial Statements & Long-Term Financial Planning 2.1 Review of Financial Statements & taxes 2.2 Cash Flow 2.3 Financial Planning Models 2.4 External Financing and Growth
3. Introduction to Valuation: 3.1 Future & Present Value 3.2 Discounted Cash Flow Valuation 3.3 Effective Annual Rate 4. Interest Rates and Bond Valuation 4.1 Bond valuation, Features, types, and markets 4.2 Inflation and Interest Rates 4.3 Determinants of Bond Yields

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5. Stock Valuation 5.1 Common Stock Valuation 5.2 Some Features of Common and Preferred Stock 5.3 The Stock Market 6. Net Present Value and other Investment Criteria 6.1 Net Present Value & Profitability Index 6.2 The (Discounted) Payback Rule 6.3 The Internal Rate of Return 7. Making Capital Investment Decisions 7.1 Project Cash Flow (CF): A First Look 7.2 Pro Forma Financial Statements and Project Cash Flows 7.3 Alternative Definitions of Operating CFs 7.4 Special Cases of Discounted CF Analysis 8. Project Analysis and Evaluation 8.1 Evaluating NPV Estimates 8.2 Scenario and Other What-if Analysis 8.3 Break-Even Analysis 8.4 Operating Leverage 9. Some Lessons from Capital Market History 9.1 Returns 9.2 The Variability of Returns 9.3 Capital Market Efficiency

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1 Capital Structure & the Cost of Equity Capital 13.1 The Financing Life Cycle 12.2 Underwriters. Raising Capital 12.3 Rights & Dilution 12.5 The Security Market Line 11.4 Other Models 4 . Capital Structure 13.• • • • • • • • • • • • • • • 10.4 Systematic Risk and Beta 10. and the Security Market Line 10.1 Expected Returns and Variances 10. IPOs & New Equity Sales 12. Return.3 The Weighted Average Cost of Capital 12.1 Cost of Equity 11. Surprices.3 Optimal Capital Structure 13. & Expected Returns 10. Risk.2 Announcements.3 Diversification & Portfolio Risk 10.2 M&M Propositions 13. Cost of Capital 11.2 Cost of Debt & Prefered Stock 11.4 Debt & Shelf Registration • • • • • 13.

3 Credit & Inventory Management • • • • Ross. 9th edition 5 .• • • • • • • • • 14. & Stock Splits 15. Jordan McGraw Hill Corporate Finance Fundamentals.1 Short-Term Finance 15. Westerfield.3 Establishing a Dividend Policy 14.2 Cash Management 15.1 Cash Dividend 14. 8th edition Fundamentals of Corporate Finance.2 Does Dividend Policy Matter? 14. Dividend Policy 14. Other Topics 15.4 Stock Repurchase & Stock Dividends.

october 29. I expect to see the stock market much higher than today” Irving Fisher • (14 days before Wall Street crashed on Black Tuesday. 1929) • “A severe depression such as 1920-21 is outside the range of probability.• “In a few months. We are not facing a protracted liquidation” The Harvard Economic Society (analysis offered days after the crash) 6 .

eBay. Studebaker. • • • • • Group C.4% of the Fortune 500 companies in 1955 were still on the list 56 years later in 2011…. Group B. Deere. Maytag and National Sugar Refining. McDonald's. but not 1955. All the companies in Group A were in the Fortune 500 in 1955. but not in 2011. American Motors. Campbell Soup. • Only 13. Cisco. Microsoft and Yahoo. Boeing. IBM and Whirlpool. All the companies in Group B were in the Fortune 500 in both 1955 and 2011. Detroit Steel.• What do the companies in these three groups have in common? • Group A. 7 . All the companies in Group C were in the Fortune 500 in 2011.

and it's probably safe to say that many of today's Fortune 500 companies will be replaced by new companies in new industries over the next 56 years. only 13. That's a lot of churning and creative destruction. In other words.Comparing the Fortune 500 companies in 1955 and 2011. or still exist but have fallen from the top Fortune 500 companies (ranked by gross revenue). merged. gone private. Most of the companies on the list in 1955 are unrecognizable. forgotten companies today. and almost 87% of the companies have either gone bankrupt.4% of the Fortune 500 companies in 1955 were still on the list 56 years later in 2011. 8 . there are only 67 companies that appear in both lists.

1 What is corporate finance? • It is the study of ways to answer by the Chief Financial Officer the 3 questions: 1) What long term investments should the firm take on? What (and where) real assets should the firm invest in? It is an investment or capital budget decision. The CFO tries to: • • • Find the right mix Debt & Equity Find the least expensive sources of funds How & Where to raise the money 9 . Overview of Corporate Finance 1. timing & risk of future CFs 2) Where will you take the long term financing? How should the cash for the investment be raised? It is a financial or capital structure decision.1. The CFO tries to: • identify business opportunities • Evaluate size.

financial planning • Controller (ensures that the money is used efficiently).What should be our short-term financing? • Treasurer (obtain & manage the firm´s capital) – cash management.3) How will you manage the everyday financial activities? It is a working capital decision that ensures that the firm has sufficient resources to continue its operations . raising capital. accounting. – Preparation of financial statements.Should we sell on credit? .How much cash & inventory to keep on hand? . tax obligations 10 .

– Unlimited liability. – No distinction between personal & business income (for taxation) – Limited equity to raise difficulty in raising cash – Its life span = owner´s difficulty in transfering ownership • Partnership.• 1. Two or more owners-partners – General Partnership: all share gains & losses (partnership agreement) – Unlimited liability – Limited Partnership: • One or more general partners run the business & unlimited liability.2 Forms of Business Organization • Sole Propietorship: Own by one person. • The limited partners dont run the business & limited liability: Common in real estate – Both types have similar limitations than Sole Propietorship 11 .

# shares. purpose.) – Bylaws or rules describing how the Co regulates its existence Stockholders elect the board of directors who then select the managers The separation of ownership and management has clear advantages. sue and be sued... be a general or limited partner. it easier to raise cash 12 .• Corporation (Co) • • It is a legal entity separate & distinct from its owners Can borrow money. own property. – Articles of incorporation (name. enter into contracts. own stock in another Co. It allows share ownwership to change without interfering with operations It allows the firm to hire professional managers Its life is unlimited The Co borrows money in its own name stockholders with limited liability Due to these factors.

business-ethics. • The IRS considers it a Co unless it meets certain specific criteria • Large accounting & law firms • objectives might differ  agency costs • -----------------------------------------------------------------------• www.com 13 .• Some disadvantages of the C corporation: • Double taxation: corporate and personal level – an S Co: 100 or less shareholders is taxed as a partnership – Limited Liability Company LLC: • a hybrid of partnership and Co.

• Profit maximization?  Risk v profit? Short v long term? Accounting profit? Value creation? • To maximize the current value per share of the existing stock or to maximize the market value of the existing owners´equity (not traded) • Shareholder returns can’t give purpose to corporate life in the lengh of time a stock is held  • GE 3.The Goal of Financial Management is..5 years. Microsoft 3. The Agency Problem. Yahoo! 3.5 months.5 days! • Sarbanes-Oxley or Sarbox Act (2002) (for listed firms) • To protect investors from corporate abuses  • makes Co´s management responsible for the accuracy of the Co´s financial statements better internal controls • Some Co delist or go dark  higher cost of capital or join the AIM 14 ..3.• 1.

Related to the way managers are compensated (Stock options / markets for managers) Can managers be replaced if they do not pursue stockholder goals? .• • The Agency Problem Exists whenever someone (the principal) hires another (the agent) to represent his or her interests •  possibility of conflict of interest between the stockholder & management • The cost of conflict: – Indirect or lost opportunities (risky investments aren´t favor by agents) – Direct: 1) Unneeded expenditures & 2) monitor management actions How closely are management goals aligned with stockholder goals? .Related to the control of the firm (proxy fights & takeovers) 15 .

. huge • Some changes in accounting rules affect the book value of assets.but not its market value • Many valuable assets (reputation.. and cash flow • Balance Sheet BS • Assets: current / fixed . Financial Statements. for fixed. taxes. small difference.. talent.) don´t appear on the BS • The equity figure and the true value of the stock need not be related 16 .• Chapter 2. A review.. sometimes.tangible / intangible • Liabilities: current / long term – Three things to keep in mind when examining a BS: • liquidity / debt v equity / Market value versus book value • Financial statements in the USA  generally shows assets at historical cost • For current assets.

forces • • • There are six corporate tax brackets or marginal rates Average (tax bill / taxable income) versus marginal tax rate (of the extra tax if you earn an extra $) 17 . not economic. both fixed & variable The tax code is the result of political.• The income statement IS • • Revenue when it accrues (GAAP rules)  recognized at the time of sale (not collection) Expenses are based on the matching principle (match revenues with the costs associated with producing them)  • • • the cash outflow may have occured at some different time  the IS figures are not representatives of the actual cash in-out flows A primary reason the IS contains noncash items. but accountants classify costs as product (COGS) & period (SG&AE). depreciation Firms can vary output level by varying exp(fixed and variable). ie.

beginning NWC • • CF to creditors (bondholders) = interest paid less net new borrowing CF to stockholders = dividends paid less net new equity raised 18 .• 2.2. Cash Flow CF • • CF identity:CF from assets (Free CF) = CF to creditors + CF to stockholders It is the cash that the firm is FREE to distribute to creditors & stockholders because is not needed for WC or CAPEX • FCF : OCF – net CAPEX – change in NWC Operating CF = EBIT + Depreciation D – Taxes T Accounting OCF = NI – D (avoid confusion¡¡¡¡ it considers interest) we need to know how much of the OCF was reinvested: Capital spending CAPEX : ending net fixed assets NFA – beguining NFA + depreciation Change in net working capital NWC = ending .

or liquidity measures: – The ability to pay its bills over the short run.S-T solvency. – Focus on current assets & liabilities – Book values & market values are likely to be similar • Current ratio: current assets / current liabilities (in $ or times) • It can be affected by some transactions: • ∆ L-T borrowing  ∆ current assets  ∆ ratio 19 . • Grouped into • 1.. Avoid confusion • Mostly accounting figures.• Ratio Analysis • Different people compute these ratios differently.

• The quick or acid test ratio • Current assets CA – Inventory) / Current liabilities CL – Inventory is the least liquid current asset – Book and market values are not always similar – Large inventories are a sign of overproduction  tied up in slow-moving • Cash ratio = Cash / Current liabilities • NWC to Total Assets • Interval measure = CA / average daily operating costs • • Or how long the Co can operate withour another round of financing For newly founded firms 20 .

.• 2. Total Debt Ratio = (Total assets (TA) – total equity (TE)) / TA Debt – equity Ratio = Total debt (TD) / Total equity (sometimes only L-T D / Total equity ) Equity multiplier = Total Assets / total equity Perhaps accounts payable reflects trade practice more than debt policy  L-T debt Ratio = L-T D / (L-T D + Total equity) (aka total capitalization) Times interest Earned or interest coverage ratio = EBIT / interest Cash coverage ratio = (EBIT + depreciation = EBITDA) / interest 21 .L-T solvency measures or leverage ratios – The ability to pay its bills over the long run.

• 3. or turnover measures • Measures how efficiently a firm uses its assets to generate sales • We could use average or ending figures – Inventory turnover IT = Cost of goods sold / inventory (how fast we can sell products) – Day´s sales in inventory = 365 / IT – Receivables turnover = Sales / Accounts receivable (how fast we collect on those sales) – Average collection period = 365 / receivables turnover 22 ..Asset Management.

..Market value measures – EPS = Net income / shares outstanding – PEratio = price per share / earnings per share – PEG = PE / expected future growth rate (if too high –> PE is too high 23 .Profitability measures (remember there are accounting figures¡¡¡) • How efficiently a firm uses its assets & manages its operations – Profit margin = Net income (NI) / sales – ROA= NI / TA or EBIT / TA – ROE= Net income / Total equity • 5.• 4.

.Multiply by TA & sales ROE = Sales / sales x NI / TA x TA /TE = ROE = NI / sales x sales / TA x TA / TE ROE = profit margin x Total asset turnover x EM = ROA x EM (EM could be considered financial leverage) 24 .Multiply by TA ROE = NI / TE = NI / TE x TA / TA = NI / TA x TA / TE  ROE = ROA x Equity multiplier (EM) o ROA x (1+D/E ratio) ROA = profit margen x total asset turnover 2.Tobin´s Q Ratio = Market value of firm´s assets / replacement cost The Du Pont Identity 1.- Price / sales Ratio (for star ups) ..Market to book Ratio (focus on historical cost) .

measured by total asset turnover – Financial leverage.M&A 25 . Perfomance evaluation benchmark:Time trend & peer group analysis . S-T & L-T analysis by creditors & potencial investors . The custormer to evaluate if the firm will be around in the future . Credit-rating agencies to evaluate creditworthiness .• ROE is affected by – Operating efficiency. Competitors . measured by profit margin – Asset efficiency. Planning for the future (projections) . The firm to evaluate suppliers and these to evaluate us to extend credit . measured by equity multiplier Financial statement information is used for .

liquidation a normal case a best case new products & expansion (detail the financing needed) 26 .3 Long-term financial planning process (FPP) • • The six Ps= Proper Prior Planning Prevents Poor Performance FP formulates the way in which financial GOALS are achieved: • • Is Growth the ultimate goal? Dimensions of financial planning: – Planning horizon: 2-5 years – Aggregation: all projects are combined to determine needed investment The FPP might require each division to prepare 3 alternative plans: a worse case cost cutting. divestiture.• 2.

exploring investment & financing options for different scenarios . goals & objectives) .ensure feasibility and consistency (coherence plans.make managers to think about goals & priorities 27 .make explicit the linkages between investments & financing choices .The FPP should accomplish .develop contingency plans to avoid surprises .

The Plug to bring the BS into balance external financing is needed Some Caveats: – Rely on accounting relationships and not financial the 3 basics ingredients of firm value get left out: CF size.Financial Requirements: dividend & stock & debt policies 5.Pro Forma Statements : Forecast BS.Asset Requirements: changes in fixed assets & NWC 4. statement of CFs 3. IS.. timing – It is an iterative process – It is negociated between all the different parties. risk.Sales Forecast is the driver factor  projections The goal: to examine the interplay between investment & financing at different possible sales levels • • • • • 2..• FP model: the ingredients • • • 1... not the assessment of the future 28 ..

and Equity ∆ 50  190 goes as – Cash dividends (plug) or. • If NI = $240.• Computerfield Co... Financial Statement • (to see the interactions between sales growth & financial policy) • IS BS Sales $1000 Assets $500 Debt $250 Costs 800 Equity 250 • ------------------------------------------------------------• NI 200 Total A 500 Total 500 • Assuming all items grow at the same rate as sales by 20% • Then.. NI = $240. – Retained earnings  250 + 240 = 490  debt must be retired to keep 29 TA=$600debt must be 600-490= 110  250-110= $ 140 retired (plug) . TA & TL+Equity = $600 • We must reconcile these two pro formas...

b= plowback or retention rate the maximun growth rate achieved without any external financing The sustainable growth rate: the maximun growth rate achieved without external equity financing & keeping D/E constant ROE * b / (1-ROE*b) If total equity is taken from an ending balance If from the beginning. the g= ROE * b. another formula 30 .4 External financing & growth (book 4. if the average. the greater the need for external financing whether a firm runs a cash surplus or deficit depends on growth Determinants of growth: profit margin.2.4 both editions). total asset turnover The internal growth rate: ROA * b / (1-ROA*b). financial policy. Both are related the higher the rate of growth in sales or assets. dividend policy.

2% monthly  the APR is 1.4%.39% Continuous compounding EAR= e^q -1 if APR (q) = 5. PV factor = 1/(1+r)^t Annuity future value = C * [FVfactor-1] / r Perpetuities  PV = C/r 3. Quoted (q) or Stated interest rate The interest rate expressed in terms of the interest payment made each period Ie.3 Effective Annual Rate EAR (annual percentage yield) The interest rate expressed as if it were compounded once per year v. Introduction to valuation 3.1. 2 Discounted CF Valuation Annuity present value = C * [1-PV factor] / r. a rate compounded 10% semiannually  it pays 5% every 6 months  $1 * 1.25% EAR The quote rate is also called the Annual percentage Rate APR (q) Ie.1025 -1= or 10.3.05^2= $1. 9th edition) 3.1 Future & Present Value (chapter 5 RWJ.39% 31 .2 * 12 = 14. EAR = 15.1025  1.25% EAR= 5.

pay the interest each period + some fixed amount (principal) .loan types & amortization Pure discount loan (T-bills) Interest-only loans (T-bonds) Amortized loans: (see chapter 6) The borrower repays parts of the loan amount over time .make a fixed payment each period  the interest decline every period the most common way of amortizing loans & mortages 1) find out the payment C by using the annuity present value 2) Calculate the interest 3) Subtract it from the total payment C to calculate the principal portion 32 .

then 6% twice a year EAR= (1+. The risk depends on the price sensitivity to IR changes: – – – – The longer the time to maturity.36% • • • Current Yield. Interest rates & Bond Valuation. The specified date on which the principal amount is paid Yield to Maturity YTM. The principal amount that is repaid at the end Coupon Rate. The annual coupon / face value Maturity. if YTM= 12%.• 4. 4.06)^2-1= 12. Quoted as APRs Ie.1 Bonds and Bond Valuation • • • • • • Coupon. the greater the IR risk The lower the coupon rate. The stated interest payment made on a bond Face (Par) Value. A bond´s annual coupon divided by its price Discount (premium) bond sold for less (more) than face value Interest rate risk IRR. The rate required in the market. the greater the IR risk The IRR increases at a decreasing rate Asymmetry 33 .

notes < 5 / 10 years. and make sure the terms are obeyed 34 .• Creditor or lender v. represents the bondholders in default. L-T Debt > 5 / 10 (Bonds) indenture or deed of trust: • The written legal agreement between the corporation and its creditors • • A trustee is appointed by the Co to represent the bondholders Manage the sinking fund. Debtor or borrower Debt: Promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance (Interest is payable semiannually) Hybrid securities: – bond + option – preferred= perpetual bond that pays only if money is earned  tax benefit of bonds + bankrupcy benefits of stock • S-T: < 18 months.

they are secured In the UK. Secured by a mortgage on the real property of the borrower (real estate).mortgage securities. less common) 2. Classified according to . Terms of a bond.Collateral. blanket (all the real property) or specific A debenture is an unsecured bond (no pledged) in the UK. Co Bonds usually have a face value of $1000 The par value (initial accounting value) is almost always = face value In registered or bearer form (ownership is not recorded. Any asset (usually bonds / stocks) pledged on a debt .Provisions of the bond indenture or deed of trust: 1. debenturesindustrial & financial 35 . Security. bonds are called treasure stock or gilds Secured  utility & railroad bonds.

Repayment At maturity or before through a sinking fund (early redemption) The Co makes annual payments to the trustee who retire a portion of the debt after a specified period of time (10 or more years) Two ways: buying in the market calling in a fraction of the outstanding bond 36 .• 3. Seniority preference in position over other lenders • Some debt is subordinated In the event of default. they are paid off only after the specified creditors have been compensated  senior / junior 4.

For some period  deferred call provision (protected) • Make-whole call  bondholders receive what the bond is worth: Yield to maturity of a T-bond + premium 6.• 5. Protective covenants – Part of the indenture to limit actions a Co might wish to take • limitations to dividends • limits pledging any assets to other lenders • Limits M&A • Limits sales or leases of any asset • maintain WC & collateral • furnish periodically audited financial statements 37 . Call provision Allows the Co to repurchase or call part or all of the bond issue at stated prices over a specific period The stated call price is above the par value call premium (becames smaller over time).

and Fitch Best quality: S&P AAA.how likely the firm is to default and. B. Bond ratings An assessment of the creditworthiness of the corporate issuer or. Moody´s  Aaa Speculative: S&P  BB.. . B They don´t always agree. Moody´s  Ba.6. A bond´s credit rating can change 38 .... Moody´s.the protection creditors have Bond-rating firms: Standard & Poor´s (S&P).. .

but not federal¡¡¡ • Municipal notes & bonds – – – – Have vaying degrees of default risk “Munis” are callable Exempt from federal income taxes.• Types of bonds • Government Bonds – Most are ordinary. noncallable – No default risk – Exempt from state income taxes. because of the tax break • Zero coupon bonds – For tax purposes. not necessarily state taxes¡¡¡ The yield is lower. the issuer deducts (implicit) interest & the owner pays 39 taxes on interest accrued (even though no interest is received) – Some are a mix of ordinary and zero .

• Floating-rate bonds (floaters) – Adjustments tied to an IR index with a lag to some base rate – Its value depends on how the coupon adjustments are defined – Some have provisions: • a floor & ceiling or collar • redeemable at par after some specified amount of time (put provision) • Inflation-linked bonds TIPS / Treasure Inflation Protecion Securities or linkers (principal / coupons) Other bonds: Catastrophe or cat bonds Warrants: The buyer receives the right to purchase stock at a fixed price Convertible bonds: swapped for a fixed number of shares Income bonds: coupons are paid only if the fim´s income is sufficient Put bonds: force the issuer to buy back the bond at a stated price if an specific event happens (the reverse of the call provision) 40 .

906% face value or $1. but improving: corporate bond dealers are now required to report trade info through TRACE • Small liquidity • Bid-ask spread the price a dealer is willing to pay & take • Quoted in 32nds  1/32 or tick. • If quoted 136:29 136 29/32136.• Bond Markets • Most are traded OTC through networks of dealers • No transparency  privately negociated.15625% face value • The convention is to quote prices net of accrued interest (clean price) but the price actually paid includes it (dirty or invoice price) • you pay more than the quoted price • Inflation  nominal v real rates 41 .06 • If changed(previous day):+ 5 5/32 of 1%or 0.369.

• 4.2 Inflation & interest rates • Nominal rate on an investment: % ∆ in the # $ • Real rate: % ∆ in the buying power • Fisher effect: • 1+nominal rate = (1+real rate) * (1+Inflation) • Financial rates are almost always quoted in nominal terms • To calculate PV: • either discount nominal CFs at a nominal rate or discount real CFs at a real rate  be consistent • Read the articule by Altman about Junk bonds 42 .

• 4. pure discount bonds (single lump sum) of all maturities or the time value of money • Basic components: 1) Real rate or compensation for forgoing the use of money 2) the inflation premium or compensation for expected inflation 3) The IR-risk premium due to the potencial risk of loss resulting from changes in IR (IRP ∆ at a decreasing rate) The three interact producing upward / downward sloping 43 .3 Determinants of Bond Yields – The Term Structure of Interest Rates (TSIR) • Shows the relationship ST – LT • It tells us what nominal IR are on default-free.

IR risk) and 3 premiums for 3 extra features: – default – taxability – liquidity 44 . inflation.– Bond Yields & Yield Curve or the Treasure YC • The Yield curve or plot of the yields on T-notes & bonds relative to maturity (based on coupon bond yields) • (the TSIR are based on pure discount bonds) • Components real rate + IR & inflation premiums The non-Treasury bonds represent the combined effect of 3 components (real rate.

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• The directors are elected one at a time. It permits minority participation • Some states have mandatory cummulative voting • Its impact is minimized by staggered elections – Straight voting.2 Features of Common & Preferred Stock Shareholders elect directors who hire managers who hire workers…. • The directors are elected all at once • If there are N directors for election. then 1/(N+1)% of the stock + one share garantees a seat.1 Common Stock Valuation  the Gordon model The required return= dividend yield + capital gains yieldk= D/P + g 5.• • • • • 5. Shareholder rights – Cumulative voting. • The shareholder may cast all votes for each member of the board 46 – Proxy voting: grant of authority to someone else to vote his shares .

they are carried forward. convertible. it is a form of equity. etc. dividends. without interest & be granted voting rights) or noncumulative (not very common) The board can defer dividends indefinitely (common also forgo…) not debt they have many debt features: sinking funds. B… – Rights: to vote for directors. liquidation. mergers.Classes of stock – Dual or multiple classes for control: A. usually.. credit ratings. callable Some firms issue securities that look like preferred but treated as debt for taxes 47 . $100 dividends payable are cumulative (if not paid. preemptive right (to maintain proportion in any new stock sold) Preferred stock features holders receive dividends & assets (liquidation) before ordinary stockholders non voting privileges for tax and legal purposes. but NOT for CFs debt have a stated liquidating value.

• 5. Chi-X. AIM.. Bats. Alternext. NASDAQ. and buys & sells at any time. Turquoise. Entry Standard – Secondary market. – Dealer / market maker / specialist maintains an inventory.3 The Stock Markets consists of the – primary market. LSE. in which new securities are originally sold to investors • Traditional stock exchanges:NYSE-Euronext. It pays the bid price and sells the ask price  spread – Broker: – brings buyers & sellers together 48 . BME (Spain) • Alternative markets: MAB. internet. in which previously issued securities are traded • The traditional & alternative markets • Other platforms: ECNs..

are dealers in charge of a small set of securities .Organization of the NYSE or the Big Board . Paris. Its 200 years old & It became a publicly owned corporation in 2006. Brussels. Lisbon. maintain a fair market (inventoryliquidity) for their securities . merged with Euronext (Amsterdam.366 members who own trading licenses . The NYSE Co. Execute customer orders & find the best price for the orders 2) Specialists (or market makers) . The largest in the world: It has 1. Less important because of the electronic order system SuperDOT 49 4) Floor traders independently trade for their own accounts on trading . is listed in the NYSE¡¡¡ 1) Commission brokers (members of brokerage houses)  . LIFFE) & Arca (Archipelago Xch) . buy/sell when there are quantity disparities 3) Floor brokers help commission brokers to execute orders .

Sometimes well over a billion shares change hands in a day • The process of order flow • NASDAQ – – – – Is a computer network Has a multiple market maker system rather than a specialist system It is almost an OTC market Made up of the • Global Select Market (1200) for larger and more actively traded • Global Market (1450) for large firms • Capital Market (550) for small firms • ECN – A website that allows investors to trade directly with each other – Orders are transmitted to the NASDAQ: dealers & individual investors enter orders  increase liquidity & competition 50 .

6. NPV & Investment criteria 51 .

2 The payback rule (to break even in an accounting sense) – Shortcomings: ignores time value & CFs beyond the cutoff.1 NPV or DCF The Profitability Index= PV CFs / Initial investment – It may lead to incorrect decisions in comparisons of mutually exclusive investments • 6. shortermism – Advantages: many small decisions do not need detailed scrutiny bias toward liquidity free up cash for other uses quickly • The discounted payback (to break even in an economic sense) 52 .• 6 NPV & Investment criteria • • An investment is worth undertaking if it creates value for its owners Capital budgeting or capital asset allocation (see slide 6) – It is a search for investments for positive NPVs – It becomes easier when we can compare the market price with roughly comparable investments • • 6.

230. then.3 The IRR (it doesn´t need a discount rate) • Flaws: multiples rates of return Mutually exclusive investments (NPV profile) Investing or financing? • • assumes a reinvestment rate similar to the IRR (optimistic) CFs -100. 1 generates a superior IRR  it ignores scaling Solution: to calculate the incremental IRR: 10-1= 9. mutually exclusive investments 1) You give me 1 € and I give you 1. -132  TIR: 10% & 20%.• 6. 11-1. the largest project should be carry out.5 € tomorrow 2) You give me 10 € and I give you 11 € tomorrow 2 generates a superior NPV. A solution: the Modified IRR (MIRR): many approaches 53 .5  Compare this IRR to the discount rate. If it is superior.5= 9.

49/129.44 + 155/(1+r) = 0  r= 284. 155. Add them to the initial cost • 3. Discount all negative CFs back to the present at the required return RR • 2. • -60 – 100/1.74% 54 .44 = 19.• The Modified IRR (MIRR): The discounting approach • 1.2^2 = -129. -100  two IRRs: 25% & 33.3% • If RR= 20% then.44 • -129. Calculate de IRR • CFs= -60.

Negative: Erosion or canibalism • The CFs of a new project that come at the expense of a firm´s existing project • ( A positive spillover effect: An ∆ in consumables due to a reduction in prices) 55 .• 7. then. Making Capital Investement Decisions • .1 Which CFs are relevant? • The incremental CFs  take the project as a kind of “minifirm” » we. can compare it to the cost of acquiring it Some pitfalls: – Sunk costs: already been incurred and can not be removed – Opportunity cost: the most valuable alternative that is given up – Side effects.

principal) • we are interested only in the CFs generated by the assets Other issues. not accrued – After-tax We start a project evaluation with a Pro Forma or projected financial statements Afterwords.• • Net Working Capital NWC: The firm supplies it at the beguinning & recovers it toward the end Current Assets – Current Liabilities Financing costs – we do not include financing costs (interests. dividends. We are interested in – CFs that actually occurs. we use the techniques described in chapter 9 56 .

7. and the book value is 690.2) Depreciation has CF consequences because it influences the tax bill – Follows the modified accelerated cost recovery system or MARCS • Every asset is assigned to a particular class with a specific tax life • The annual depreciation: cost of the asset times a fixed % • The market value can differ substantially from the book value  – if the market value is $3000. and we get a tax saving 57 . then we must pay taxes on the difference – If the book value exceeds market value. the difference is treated as a loss.2. then. Pro Forma financial statement or projected CFs Financial statements projecting future years´ operations We need (quality) estimates of many quantities (see book case & 2.

7,3 Alternative definitions of Operating CFs  No covered

• 7.4 Special cases of DCF analysis
– Evaluating cost-cutting proposals buy new piece of machinery?

– Machinery cost: 80,000, 5 year-live straight-line depreciation, market value= 20,000, savings: 22,000 / year, tax =34%, discount rate= 10%
– The operating income increases by 22,000, and a depreciation of 80,000 / 5 = 16,000 / year  EBIT= 22,000 – 16,000 = 6,000 – Operating CF: – EBIT– taxes + depreciation = 6,000 – 2040 + 16,000 = 19,960 – capital spending (year 0) = - 80,000 – (year 5) = 20000 *(1-0,34)= + 13,200 – CFs= -80,000 19,969 19,969 19,969 19,969 9,969 33160

– NPV= 3,860

58

mutually exclusive projects with different lives & similar benefits

A firm must choose between two machines. The CFs are (real costs) are:
Machine A costs 500 € and 120 / year to operate. Replaced every 2 years Machine B: costs 600 € and 100 / year to operate. Replaced every 3 years

WE must evaluate them with similar lives The discount rate= 10%VA(A): 798, VA(B): 917  ¿is A better? Equivalent Annual Cost (EAC) or annuity We work out a cost per year for these two alternatives: What annual amount has the same PV of costs? PV= EAC * present value interest value factor or [1-(1/(1+R)^t)] / R  we get EAC PV annuity= VA (A)=798= annual payment x1.7355  798/1.7355 = annual payment = 459.81 € PV annuity= VA (B)=917= annual payment x (annuity factor (3 years): 2.4869)  917/2.4869 = annual payment = 368.73 € We should purchase B because is cheaper
59

• 8.1 Project Analysis and Evaluation

• A positive NPV just means we must take a closer look...
• Projected future CFs  forecasting or estimation risk  assess economic “reasonableness” of the estimates. Avoid GIGO • Potencial sources of value
– A basic principle of economics+ NPV investments are rare in highly competitive environments….
• Is our product better than that of our competition? • Can we manufacture at lower cost?

• Can we distribute it more effectively?
• Can we identify underdeveloped market niches? • Can we gain control of the market?
60

• What about potential competition?

investigate the impact of assumptions about the future • Put upper and lower bounds on the components of the project • No simple decision rules. a initial set of projections or base case • 2nd. Stick to reasonable cases Scenario all variables change a few values .Worst / best cases will tell us the min / max NPV of the project by assigning the most / least favorable value to each item Sensitivity one variable takes many values: To freeze all the variables except one to pinpoint which ones deserve the most attention 61 .• 8.2 What-if Analysis • 1st.

4 Operating leverage / DOL 62 .Simulation – A combination of scenario & sensitivity – Repeat the sequence many times  computer assistance – many NPVs  average value & spread – All values are equaly likely to occur no realistic: values closer to the base scenario are more likely. sales. and profitability Methods: 1) accounting  net income is zero 2) cash  operating CF is zero 3) financial  NPV is zero 4) general  EBIT is zero 8. New software has solved this problem 8.3 Break-even Analysis Studies the relationship between the most important variable.

.1% 2.1 RP: 8.? 63 .5 RP: 2. Some Lessons from Capital Market History about risk & return 9..1 The historical record of returns.3 RP:13.3 SD: 20.6% 2.3 SD: 8.2 SD: 34.7 SD: 8. 2 components: 1) Income or cash received while you own the investment 2) Capital gain / lost Finance is the most readily quantifiable branch of economics • • T-Bills T-Bonds Corporate Bonds: Stocks SP 500 Small Cap 0.3 Year-to-year historical rates of return after inflation (before taxes¡¡¡) in the USA mid 20s-90s $ returns: dividend income + capital gains % returns: dividend yield D1/ Po + capital gains yield= (P1-Po)/ Po Risk premiums RP: The excess return from an investment in a risky asset over a risk-free investment.9% RP: 0 RP: 1.9.9% 13.3 SD: 3.7% 8. or T-Bill What determines the relative sizes of the RPs for the different assets.

402 (nominal) y $ 659.. if you could each month know in advance which of the two options.5 • 64 6.7 Small cap S&P 500 corporate bonds T-bonds T-bills • BUT. then. offer a higher return.T-bills or S&P 500 Index between 1926 y 1996.. • • • • A) $ 9. and act accordingly..6 • 49 5 • 16.710 C) $ 2.349 B) $ 18.300 mill D) $ 58.6 (real) • 2.• $1 invested in the USA in 1926 + investing dividends & interests it would have accumulated in year 2000 (before taxes): • $6..6 1.586 266.098 64 . the final nominal return before taxes would be.

2 The variability of returns 1) We draw a frequency distribution for the returns= to count up the # of times the annual return on the portfolio falls within a each range. next year rises back to $100 Average return on investment? Arithmetic average return: (-50% + 100%) /2 = 25% ¿? Geometric average return: [(1+R1)*(1+R2).. it falls to $50. is rewarded Buy a stock for $100. earn a RP Lesson 2: Bearing risk.9. after a year.(1+Rt)]^(1/t) -1= (50%*200%) -1= 0 It is compounded over a multiyear period.. lets say. It is smaller than the arithmetic Geometric: what you actually earned per year on average compounded annually Arithmetic: what you earned in a typical year 65 . 10% each 2) Measure the spread of returns how volatile the return is Variance how much the actual return deviates from the average in a typical year (standard deviation SD is the square root of the variance) Lesson 1: Risky assets.. on average. on average..

3 +/.20%) is 68%.3% (12..7 to 52.2*20%) The historical average stock RP over a 106-year period is 7. if historically.• Returns are at least roughly normally distributed  described by the average and the standard deviation (sd) Ie.8% (1802-2007) • • • • • • • • 66 . and the average return is 12. then: For one sd: The probability that the return in a given year is in the range of -7. you should be outside this range in one year out of every three For two sd: There is a 5% chance that you should be outside the range -27.. the sd of returns on the large-company stocks is 20%.1%. or roughly. There is a stability of long-run real equity returns the compound annual geometric real return on US stocks averaged 6. Nowdays is much smaller.7 to 32.2% (12.3 +/.3%..

• Coefficient of Variation: • to standardize the sd or risk per unit of return: sd / expected value • The probability distributions of returns pd are based on • ex ante or ex post data • For ex ante probabilidades. historical / (n-1) • In financial analysis. ie. we face two sources of risk: – 1) the risk associated with uncertain outcomes – 2) the additional risk that results from using an incorrect pd 67 . variance * Prob • For ex post.

the market becomes increasingly efficient The investors study expectations about the firm (debt. international) They are zero NPV investments No arbitrage opportunities In the Long run intrinsic value = market value 68 . managers…) + the environment (industry.3 Capital Market Efficiency • In an efficient capital market.• 9. Three possibilities: – Overreaction & correction – Delayed reaction – Efficient market reaction Well-organized capital markets are efficient  very small & uncommon Inefficiencies Other markets are less efficient real estate / real asset markets Due to competition among investors. macro. clients. current market prices fully reflect available information.

All public information is reflected in the stock price • Weak form – The price reflects the stock´s own past prices History tells us that prices respond rapidly to new information the future of prices & mispricing are difficult to predict EMH or “no free lunch”  costless trading policies do not generate excess returns 69 . private and public. is reflected in stock prices • Semistrong .• • • • Efficiency = a “fair” price  it reflects the value of that stock given the information available Forms of market efficiency Strong form. – All information.

a) 10 m.b) 10 m euros expected according to the following conditions: Economic state boom stagnant recession probability 1/3 1/3 1/3 return 20 m 10 m 0m 20*1/3 + 10*1/3 + 0*1/3 = 10 m ¿which of the two options would you pick up? 70 .. and the security market line • 10.1 Expected return & variance (versus historical.) – Select between the returns a or b: . euros .• 10 Return.. risk.

The expected value is thus – 71 . The pot starts at 1$ and is doubled every time a head appears. In short. with probability 1/8 you win 4 dollars etc. ending the game. Petersburg Paradox / Nicolas y Daniel Bernoulli Consider the following game of chance: you pay a fixed fee to enter and then a fair coin is tossed repeatedly until a tail appears. What would be a fair price to pay for entering the game? • • • Consider what would be the average payout: With probability 1/2. you win 1 dollar. with probability 1/4 you win 2 dollars.• • • • • • St. you win 2k−1 dollars if the coin is tossed k times until the first tail appears.

a variance & covariance matrix is developed 72 .To do so.The expected rate of return on a portfolio is simply a weighted average of the expected returns of the individual securities in the portfolio . and each stock´s contribution to the portfolio sd is not xσ .An optimal portfolio: the Markowitz model .Portfolio risk is measured by the weighted sum of all covariances between all the assets in the portfolio .However the sd of a portfolio is not a weighted average of the sd of the individual securities.

5 and 0. the coefficient woulb be +1 The actual average correlation is between +0.7 73 ...08% 0% Given the same return..we present data on realized rates of return for stocks W & M for a portfolio invested 50% in each Year Stock W stock M portfolio WM --------------------------------------------------------------------------1 10% 2% 6% 2 2 10 6 3 9 3 6 4 3 9 6 --------------------------------------------------------------------return 6% 6% 6% sd 4.the risk has been eliminated¡ The returns have a correlation coefficient of -1 If the returns were similar.08% 4.

in our case.year stock W stock M portfolio WM --------------------------------------------------------------------1 8% 2% 5% 2 4 10 7 3 10 -4 3 4 2 16 9 --------------------------------------------------------------------return 6% 6% 6% sd 3. if they move in opposite directions. then. we standarize them by dividing them by the product of their sd: correlation coefficient. it will be negative If they move independently from each other. then. then. the covariance is zero.58% If the returns tend to move together.6 74 . Our portfolio has a covariance of -24 To compare cov.79% 2.65% 8. the covariance is positive. -0.

5% • σ²(p)= .25*20% = 13.25*15% + .05-.085)² = 0.75% • bust/E(R) = 5% • E(Rp)= 8.085)² + .0018375 • σ(p) = 5. B&C= 25% • Boom/ E(R) = .4% 75 .• • • • State of Economy Probability Return A Return B Return C --------------------------------------------------------------------------------------Boom 40% 10% 15% 20% Bust 60% 8% 4% 0% • Weights: A= 50%.1375-.4*(.5*10% + .6*(.

15% 8 10% 100% A returns 100% B 16% M B A 100% A risks Efficient frontier 100% B 8 16 risk-return trade-offs Expected portfolio return Feasible or attainable set Portfolio risk 76 .

• 10.2 Announcements, Surprises & Expected Returns

• Lets look at why there is a difference between the actual return on an asset or portfolio and the expected return
• The return on a stock in the coming year is composed of:
– Expected return. It depends on the information shareholders have that bears on the stock
– Unexpected return. Based on the uncertainty & unexpected information actual return= expected + unexpected return (+ or -, on average= zero) actual return= expected An announcement = expected part + surprise The relevant inf is already reflected or discounted in the expected return  markets are reasonably efficient in the semistrong form News represent the surprise part of an announcement, not discounted by the market

77

• 10.3 Diversification & Portfolio Risk (return & variance)

• The return on any stock traded in a financial market is composed of
– The normal or expected return by the sockholders based on information – The uncertainty or risk due to unexpected information

Inditex increased in earnings= 19% …whereas H&M´s just 14%, Inditex stock fell 4% ¿why?
The unanticipated part of the return is the true risk. Two types:

systematic or market risk: influences a large number of assets unsystematic or specific risk: affects a small number of assets
Total return R = E(R) + (unexpected return= market m + specific ε)
78

• Diversification and Portfolio risk

• As the number of securities is increased, the portfolio´s standard deviation declines (from an average 49% to about 20%)
• Some of the stocks will go up in value because of positive companyspecific events and some will go down because of negative events • The net effect on the overall value is small cancel each other out

• The unsystematic risk is eliminated by diversification
• σ
Diversifiable risk

Nondiversifiable risk 30 # stocks
79

the market will compensate investors. not for bearing the total risk of a stock.As the unsystematic risk is eliminated by diversification. but for bearing the nondiversifiable risk or portfolio risk 80 .

To determine the optimal portfolio for a particular investor. we must know the investor´s attitude toward risk as reflected in his risk/return trade-off function or indifference curve A Expected return Risk premium B Risk 81 .

there is a higher expected return The optimal portfolio for each investor is found at the tangency point between the efficient set of portfolios and one of the investor´s indifference curves. • This tangency point marks the highest level of satisfaction the investor can attain 82 .• A requires a higher expected return to compensate for a given amount of risk • A higher risk aversion causes A to require a higher risk premium • The higher curves denote a greater level of satisfaction or utility  • For any level of risk.

Expected portfolio return Km ∆ utility A Krf Optimal portfolio p Portfolio risk 83 .

To estimate all the parameters = N*(N+3) /2 or 8000 for the 125 stocks in the IGBM. To calculate the weights of each stock requires a procedure cuadratic programming to maximize the return. given a specific return 84 .If we assume that the return distribution of individual stocks follows a normal distribution. given a specific risk. then. the portfolio risk could be derived based on the portfolio covariances we build a covariance matrix whose diagonal is made out of the portfolio´s variances. or minimize the risk.

4*0.6*1.50 • Which has greater total risk? • Systematic? Unsystematic? • Higher risk premium? • The beta of the portfolio? A weight= 40%0.30.50 • Security B  SD= 20%. beta= 0.64. Yahoo! = 2.52. ·3M = .• 10.5+0.1 85 . Google = 2. beta= 1.4 Systematic risk and beta • There is a reward for bearing risk called risk premium • It is based on the systematic or market risk • The expected return on an asset depends only on that asset´s systematic risk • It is measured by Beta or β coefficient (how much systematic risk relative to an average asset) • The average asset has a beta of 1 • Coca cola = 0.5= 1.60 • Security A  SD= 40%.

• Consider a portfolio made up of an asset A and the risk-free asset (by definition. it has no systematic or unsystematic risks = beta 0) • We can vary the proportions between both securities.5 The security market line (how risk is rewarded) • Applied to active. and the riskfree can be borrowed or lent • Plot portfolio expected returns against the portfolios betas • The slope of the line is just the risk premium RP on asset / beta • The slope: a reward-to-risk ratio or RP per unit of systematic risk • If we consider a second asset B. competitive. we can compare slopes 86 . well-functioning (financial) markets...• 10.

slope= 6. and vice versa The buying and selling would continue until the two assets plotted on the same line  same reward per unit of risk • • • • All assets must plot on the same line¡ It must have average systematic risk  Beta of 1 The slope = (E(Rm) – Rf) / 1 or market risk premium E(Rp) Asset A.5% Asset B. A. will attract investors away from the lower B A´s price would rise A´s expected return would decline.67% • Bp 87 . slope= 7.• The higher slope.

• Also. then. • E(Rm) E(Ri) = Rf + [E(Rm) – Rf] βi E(Rm) -Rf The slope = market risk premium Bm = 1 88 ..• The Capital Asset Pricing Model CAPM • If we let E(Ri) and βi stand for the expected return and beta on any asset. we know that asset must plot on the SML... rearrange this.. a market portfolio made up of all the assets with systematic risk or Bm= 1 slope = E(Rm) -Rf / 1 or market risk primium • Therefore (E(Ri) –Rf) / Bi = E(Rm) – Rf.

• The SML and the cost of capital • Any new investment must offer an expected return that is no worse than what the financial markets offer for the same risk • It must have a + NPV • What is the appropiate discount rate? • The expected return offered in financial markets on investments with the same systematic risk • We compare expected return on investment to what the financial markets offer on an investment with the same beta • This return is the minimum an investment must offer to be attractive • It is called the cost of capital associated with the investment • It is an opportunity cost 89 .

it needs the market RP and Beta 90 . not the source (how & where) • The cost of equity (Re) o return equity investors require • two approaches (based on the past): – The dividend growth model approach. It is simple..• Chapter 11... cost of capital • The return an investor receives is the cost of that security to the company that issued it • Required rate of return = appropiate discount rate = cost of capital • The cost of capital of an investment depends on its risk • It depends on the use of the funds.. & no dividends needed – But.but it needs dividends Re is too sensitive to the growth rate g no explicit risk is considered – The SML approach: it uses implicit risk.

91 . • Cost of preferred stock (Rp) It is a perpetuity Rp = Div / price • • 11. then – the yield to maturity is the market-required rate on the firm´s debt – If we know the rating.2 The costs of debt (Rd).• 11... we can find the IR on newly issued bonds..3 The Weight Average Cost of Capital WACC The overall return the firm must earn on its existing assets to maintain the value of its stock • • E= market value of Equity. Tc = corporate tax rate WACC = (E/V) Re + (D/V) Rd(1-Tc). # shares outstanding x price per share D= market value of Debt. • • Is the return the firm´s creditors demand & firm must pay on new borrowing If the firm already has bonds outstanding.

.and flotation costs.• • • • • The interest paid by a corporation is deductible for tax purposes we could add (P/V)Rp or cost of preferred stock... we have to .the NPV is compared with this amount to see if the project is feasible 92 . If we assume the firm uses a target capital structure. – Use a WACC based on companies in similar lines of business – Use a subjective adjustment Flotation costs.factor in the flotation costs for each of the amounts of D & E raised . Do not use WACC as a cutoff for investments  sometimes different projects / divisions have different betas..

. • GE= 3.5 months • Yahoo!= 3..• Chapter 12 Raising Capital • A basic reason shareholder returns can´t give purpose to corporate life is the length of time a stock is held.5 days¡ • Can such “customer” serve as the proper focus for the • corporate strategy? 93 .5 years • Microsoft= 3.

.good referrences & contacts with suppliers.• 12..mezzanine-level (step 2: manufacturing. Exit strategy is key. distribution) They participate in running the start-up firm due to their general business expertise: . etc.involved in operations & decision making. .financial strength & resources .ground floor or seed money (step 1: to get a prototype) . marketing.1 The Financing Life Cycle: Early-Stage Financing & Venture Capital VC The term Private Equity labels equity financing for nonpublic firms VC firms specialize in pooling funds from various sources provide financing in stages contingent on specified goals being met: . also VC is very expensive 94 . customers.specialization.

2 IPOs .• 12.Selling securities to the Public • Steps: – Approval from the board of directors – Registration statement about financial information and file it with the SEC except • loans that mature within 9 months • less than $ 5 million (regulation A. along with a final prospectus – Tombstone ads are used by underwriters (investment banks) during & after the waiting period 95 . with less requirements) • A private issue (fewer than 35 investors) – Preliminary Prospectus (red herring) given to potential investors – The Registration is effective on the 20th day after its filing – That day  a price is determined & selling effort gets under way.

pricing the new securities .formulating the method used to issue the securities . (uncommon in the US) General Cash Offer: offered to the general public Inicial public offering IPO  The first public equity issue Seasoned equity offering SEO a new issue for a company with securities that have been previously issued Underwriters (investment firms) buy the securities for less that the offering price (the gross spread). They form a Syndicate. They performe the following services: .selling 96 .• Two types of public issues: • Rights Offer: securities are initially offered only to existing owners.

Dutch (or Uniform Price) Auction Underwriting. The Quiet Period. usually. who then attempt to resell it. Very common in bond markets The Aftermarket: the period after a new issue is initially sold Green Shoe Options. the underwriter does not guarantee any particular amount. The most common. The issuer sells the entire issue to the underwriters. The underwriter conducts an auction in which investors bid for shares. The SEC requires a quiet period (40 days) = all communications are limited to ordinary announcements (no extra infor) logic: all relevant information is contained in the prospectus 97 • • • • • • . Uncommon. Beyond this.• Types of Underwriting • Firm Commitment. Gives the underwriters the rights to buy additional shares at the offering price to cover overallotments (15% of the new shares) Lockup Agreements: How long insiders must wait after an IPO before they can sell their stock. 180 days. Best Efforts.

highly speculative issues Why does it exist? The average investor don´t get shares in a successful offering….2% the degree of underpricing & # IPOs is highly variable through time  cycles Atributable to small. To attract the average investor & avoid to be sued  underprice new issues 98 .IPOs and Underpricing If the price is too high  unsuccessful & withdrawn If the price is too low the existing shareholders experience an opportunity loss & the new ones earn a higher return The 1999-2000 experience  a lot of underpricing  The 1975-2007  average 17..

Debt usage: it may reveal too much debt or too little liquidity 3. why should the firm let new shareholders in on it?. Bad signal: if the project is good…. On announcement of a seasoned issues. better issue debt 4. the existing stock drops on average 3% Why? 1.. Issue cost 99 . Managerial information: to issue stock when overvalued 2..• New Equity Sales Abnormal returns..

IPO´s lower price • Green Shoe Options.• The cost of issuing securities • Gross spread. Filing & legal fees. Existing stock drops on average 3% • Underpricing. Management time • Abnormal returns. Direct fees paid to the underwriter or spread (7% average) between the price the issuer receives and the offer price • Other direct expenses. Gives the underwriters the rights to buy additional shares at the offering price to cover overallotments • There are economies of scale & Debt issues are less expensive 100 . taxes • Indirect expenses.

3 Rights If a preemptive right is in the corporation  the firm must offer any new issue to existing shareholders Each shareholder is issued rights to by a specified number of new shares at a specified price & time • • • • • The rights are traded in securities exchanges or OTC.• • • 12. the new owner will receive the rights It goes ex-rights two trading days before the record date or last day • • Shareholders can exercise their rights or sell them: he will not lose or win because of the rights offering The new market price of the stock will be lower than before the offeringit is like a stock split & the subscription price is arbitrary 101 . Rare in the USA Cheaper than cash offers No underwriter needed If the stock is sold before the ex-rights date – the rights on-.

4 Debt Issuing Public L-T Debt.dont require SEC registration . Avoided by using a Rights Offering – Market value MV & book value BV • If MV< BV and ∆ # shares  EPS go down  • Three dilutions: Accounting.• Dilution • Loss in existing shareholders´value in terms of dilution of: – Ownership. market.more restrictive covenants .life insurance companies & pension funds dominate the segment 102 . Similar procedures: Direct Private L-T Debt Financing (term loans & private placements) . ownership • Market dilution ONLY occurs if the project´s NPV is negative (and MV>AV) 12.

seasoned issuers – The firm can fulfill all registration-related procedures beforehand and go to market quickly when conditions become favorable. Direct business loans: 1-5 years Private placements. – Allows a Co to register all issues it expects to sell within two years – It uses a dribs & drabs or step by step method – Rated investment grade & MV > $150 m 103 .• Direct Private L-T Debt Financing. Two types: Term loans. The maturity is longer • Shelf Registration (for Equity & Debt) – A relaxed registration process that applies to well-known.

is capital structure a key consideration? • It depends on homemade leverage: • the use of personal borrowing or lending to change the overall amount of leverage so. 511) • Under leverage. 1 CAPITAL STRUCTURE POLICY (no taxes¡) • Capital restructuring decisions in isolation from its investment decisions • Management should try to find the capital structure (the target) that maximizes the firm or minimizes WACC • The effect of Financial leverage depends on the company´s EBIT • Under leverage. the higher ROE & EPS (p.• 13.5 104 .see page 514 & table 16... the higher the EBIT. shareholders are more exposed to risk because ROE & EPS are more sensitive to changes in EBIT • Because of those factors. the answer is NOT..

000 40.000 110.000 22% = 15 + (15-8) 15% ROE = ROI + (ROI-Kd) D/E If the net income is different & % D changes ROE is also different: (try D=75%36%) If EBIT= 0 & 100% Equity  ROE= 0.000 & 100% Equity ROE=20%. next slide) You can observe a greater variability with ROE than with ROI (no leverage)  ∆ Debt  Explicit cost in terms of a larger Kd (not under MM) • Implicit cost in terms of a larger Ke 105 . 50% Equity 32% (see financial leverage.000 ROE 15% ROI 15% attractive va 50% 150. Kd= 8% Investment Equity 100% EBIT 150. 50% Equity. Ke= 12%.000 Interest 0 Net Income 150.• • • • • • • • • • • • • • If Kd < ke  it does NOT mean it is always €1 mill. ROE  -8% If EBIT= 200.

000 150.000 Plan B low levered 50.000 200.000 • Degree of financial leverage or DFL? 106 .000 200.25 • • Debt (8% ) • Equity • Total assets Plan A high levered 150.000 • Stock price: $ 6.000 • Two settings  EBIT: 12.• Total assets: $ 200.000 50.000 & 36.

• 13.2 M&M Proposition I: The Pie Model • If the assets and operations are the same: 40% E – 60% D or 60% E – 40% D  • The size of the pie (the value of the firm) doesn´t depend on how it is sliced • M&M Proposition II • WACC= Ra= E/V * Re + D/V * Rd Rel= Reu + (Reu-Rd) * D/E Cost of capital Re Ra Rd D/E 107 .

• Its risk is the business risk • (Ra-Rd) *D/E is determined by the financial structure. • Its risk is the financial risk debt financing ∆ the risks borne by the stockholders  the required rate of return rises • Both risks together  the systematic risk • M&M I & II with taxes & bankruptcy • Interest paid is tax deductible • Failure to meet debt obligations can result in bankruptcy 108 .• Proposition II: Ra is the required return on the firm´s assets & it depends on the operating activities.

Rd)* (D/E) * (1-Tc) Value of the firm Vl= Vu + Tc*D Cost of capital Re Ru Vu WACC Rd(1-Tc) D D/E 109 .• Interest tax shield. u= unlevered) • WACC: Proposition II: Rel = Reu + (Reu. The tax saving from interest expense • PV = Tc (tipo impositivo) * D * Rd /Rd (assuming a perpetual debt) • Proposition I: Vl = Vu + Tc * D (l= levered.

6 + (14m/24m)* 13.71% • WACC ka = (D/V)*kd(1-T) + (E/V)Kl • WACC ka = (10m/24m)*8%*0. T: 40%. Ku= 12% • Vu= ebit (1-T) / ku = 4 mill / 0.• MM with corporate taxes • Ebit: $ 4 mill (no-growth situation). • alsoKa= ebit(1-T) / V = 4 mill * 0.8%)*10m/14m*0.12 = $20 mill • With $10m debt Vl = Vu + Tc *D= 24m • Equity E = V –D = 14m • kl= ku + (ku-kd) * (D/E) * (1-Tc) • kl= 12% + (12% .6= 13. Kd= 8%. constant.71%= 10%.6 / 24 = 10 mill 110 . the firm pays out all its income as dividends.

...Turning over the assets to the bondholders is a legal process... but.• Bankruptcy & Financial Distress Costs • In principle. a firm becomes bankrupt when the value of its assets equals the value of its debt  • the value of equity is zero D = Assets  economically bankrupt.. – direct bankrupcy costs: legal & administrative – indirect bankrupcy costs: cost of avoiding a bankruptcy filing normal operations are disrupted – The possibility of loss that limits the amount of debt used 111 . not an economic one. • ...

or with other tax shield sources.3 Optimal Capital Structure CS • The static trade off theory of capital structure no changes – Firms borrow up to the point where the tax benefit from an extra $ = the cost in terms of probability of financial distress – But. depreciation.. get none or little shield – Also. ie..firms with losses. firms with greater volatility in EBIT or intangible assets get debt at Re higher cost V Vl= Vu+Tc*D Financial distress cost of capital Ru WACC Rd Vu D D/E 112 .• 13.

also.• • • What is irrelevant. trade-off) (1) The Extended Pie Model – Taxes & bankruptcy costs represent claims on the CFs – The value of the government claims (taxes) decreases with leverage – The value of bankruptcy claims rises with leverage We can add slices to the pie.4 Other models (besides MM. their sizes change The essence of the MM intuition  the value of the firm depends on the total CF But. M&M or the capital structure? 13. the capital structure just cuts the CF up into slices without altering the total The claims by share & bondholders are marketed claims The ones by the government and litigants are nonmarketed 113 .

the structure that better fits that rate 114 . – Second.The total value = marketed + nonmarketed claims (unaltered by capital structure) The value of the marketed claims may be affected by changes in the structure ∆ in marketed claims implies an identical .∆ in the nonmarketed  The optimal structure:  the one that max the value of marketed claims & min the nonmaketed • Financial institutions are strongly levered due to: – – – – Benefits are less volatile Watched by the central bank No fiscal shields Deposit insurance that reduces risks Many CFOs select: – First. a specific credit rating.

tactical issue of raising funds (versus the trading off model. applied to long-run target capital goals) Wide variation across industries: drugs & computers v.• (2) The Pecking-Order Theory • Firms prefer to use internal financing first – If the stock is undervalued (a new project) dont sell it too cheaply – If the stock is overvalued send a signal to investors  the price falls – There are extra expenses to raise capital externally – No target capital structure – Profitable firms (generally) use less debt – Firms want financial slack or cash reserve – It is applied to short-run. airlines & cable TV 115 .

Payment to preferred stockholders 8. Wages. Consumer claims 5. Administrative & legal expenses associated with the bankrupty 2. salaries 3.• A Quick Look at the Bankrupty Process • Financial distress can be defined as: – Business failure a terminated firm with a loss to creditors – Legal bankruptcy  a legal proceeding for liquidating (chapter 7) or reorganizing (chapter 11) – Technical insolvency unable to meet its financial obligations – Accounting insolvency negative net worth book liabilities > book assets The absolute priority rule for the proceeds of the liquidation: 1. Contributions to employee benefit plans 4. Governments tax claims 6. Payment to stockholders 116 . Payment to unsecured creditors 7.

• 14. then. special.1 Dividends & dividend policy • Should the firm pay out money to its shareholders. extra. then you´ll get the Dividend When the stock goes ex-dividend. we expect the value of the stock 117 will go down by about (because of taxes) the dividend amount . & liquidating • Expressed in terms of 1) $. or should the firm invest it for its shareholders? • It is a payment made out of a firm´s earnings to its owners • It can be regular. 3) % of net income • A chronology: – – – – Declaration date: the board of directors passes a resolution Ex-dividend date: two business days before the date of record Date of record: date of recorded shareholders (designated to receive it) Date of payment If you buy the stock two days before date of record. 2) % of market price.

. Since 2002. 5%.• 14. The PV of the dividend stream is unchanged (in theory) – Homemade dividend policy. 39.).6%¡¡¡) Capital gains are deferred until the stock is sold Flotation costs (equity & debt) Bond indentures with covenants prohibiting ∆ dividends The reinvestment by the firm increases the value of the equity If the firm has excess cash The correct dividend policy will depend on the individual & corporate tax rates 118 . debt. 2 Does dividend policy matter? • • Dividend policy is the pattern of dividend payout 1) The irrelevance of dividend policy – Any increase in dividend is offset by a decrease somewhere else (CFs. sell new stock.. Some corporations offer automatic dividend reinvestment plans (ADRs or DRIPs) 2) Factors favoring a low payout Taxes (see article # 1). (from january 1st. 2011.

sell stock. but there are brokeage fees and transaction costs • Investors with substancial current consumption needs will prefer high current dividends • A high payout resolves uncertainty  Gordon´s bird-in-hand • Many investors don´t receive an unfavorable tax treatment: – Corporate investors are granted a 70% dividend exclusion. but not capital gains or interest on bonds – Pension. endowment. stock prices react to unanticipated changes in dividends . & trust funds are in the zero tax brackets 119 BUT.• 3) Factors favoring a high payout • The desire for current income through the homemade dividend argument  – if low payout.

. An ∆ signals to the market that the firm is expected to do well (not because of a ∆ payout policy) & vice versa The clientele effect Different investors desire different levels of dividends It is a supply / demand argument until a dividend market is in equilibrium If many investors like high dividends..Information content effect Based on expectations... can a firm boost its share price by rising the dividend payout ratio? 120 .

sell equity Maintain a target D/E & dividend payout ratios To avoid instability.. dividend cuts. 121 . create two types of dividends: regular & extra.3 Establishing a dividend policy The residual dividend approach: After meeting its investment needs while maintaining a desired D/E ratio it can become an unstable`policy A compromise dividend stability: Avoid cutting +NPV projects.14...

the investor pays taxes only if sells & on the capital gain on the sale. targeted purchase (specific stockholders) • It is an alternative to cash dividends both are essentially the same thing. EPS doesn´t change • If repurchase: EPS goes up. whereas a dividend pays as ordinary income • The IRS does not allow a repurchase to avoid paying taxes • Corporations smooth dividends  avoid uncertainty 122 . PE is similar to dividend´s • Net equity sales in the US have been negative in some years • Under current tax law.• 14. tender offer (existing stockholders). a repurchase has a significant tax advantage: – A dividend is fully taxed as ordinary income – In a repurchase. But if there are taxes & other imperfections.4 Stock Repurchase • 3 ways: open market... • If dividends paid: stock price & PE fall.

• Stock dividend & stock split
– They ∆ # shares outstanding....diluting its value accordingly – The stock dividend is expressed as a percentage

– The stock split is expressed as a ratio: three for two one extra for two
– The accounting treatment is different:
• a stock split affects the par value & # shares outstanding • A stock dividend affects # shares outstanding & retain earnings • for small dividends (less than 25%), it affects capital in excess of par value In theory, stock dividends & splits should leave the value of the firm unaffected  liquidity? Trading range (to buy a round lot)? For every share of Microsoft in 1986 you would own 288 shares today Reverse splits: one for four  four old shares for one new  respectability? Some exchanges delist companies under $1 price share
123

• 15.1 Short-term Finance STF

• Net working capital NWC = CA – CL
• The primary concern in STF is the firm´s short-run operations and financing activities that create patterns of cash inflows & outflows

• The typical operating cycle.
– The period it takes to acquire inventory, sell it (inventory period), and collect for it (accounts receivable period)

– It describes how a product moves through the current asset accounts
The account payable period:

The time between receipt of inventory and payment
The cash cycle: The time between cash disbursement and collection it depends124 on the inventory, receivables, and payables periods

Calculating the operating & cash cycles  already studied in accounting? Cash flow time line
Some firms have negative cash cycles.(Amazon, 50 days, Boeing, 77 )....

Inventory purchased

Inventory sold

Inventory period
Accounts payable period

Accounts receivable period

Cash cycle

Cash paid for inventory

Cash received

Operating cycle
125

• The longer the cash cycle. but future CFs are expected to be higher ie. liberal financing • A restrictive policy would maintain – a low ratio of current assets to sales – more S-T debt and less L-T debt 126 . the more financing is required • The gap between S-T inflows & outflows can be filled either by borrowing or by holding a liquidity reserve (marketable securities) • The S-T financial policy that a firm adopts will be reflected in at least two ways: • A flexible policy would maintain: – a high ratio of current assets to sales – less S-T debt and more L-T debt – a higher level of liquidity / NWC It is costly.

• Managing current assets • Involves a trade-off between costs that increases or decreases with ∆ current assets – carrying –opportunity. lost customer goodwill • brokerage costs $ Carrying costs Shortage costs Current assets 127 . stockout.costs – shortage costs • cashout.

Marketable securities Short-term financing (borrowing) Flexible policy $ seasonal variation Compromise policy Restrictive policy Growth in fixed Assets & permanent Current assets time 128 ...• A compromise financing policy • The firm borrows in the short term to cover peak financing needs. but maintains a cash reserve during slow periods..

Similar for lower periods • Committed lines of credit are more formal legal arrangements • Compensating balances. The bank issuing the letter promises to make a loan if certain conditions are met (the international goods arrive as promised) 129 .• The Cash Budget • A forecast of cash receipts and disbursements for the next planning period (see exercise) • Short-term borrowing – Unsecured loans • A line of credit. The firm is authorized to borrow up to a specific amount • A revolver. Money kept by the fitrm with a bank in low-interest bearing accounts as part of a loan agreement (2-5% of the amount borrowed • Letters of credit.

Backed by a special line of credit • Trade credit. To increase the account payable period. highly rated firms. Expensive 130 .• Secured loans • Accounts receivable financing involves – Assigment: the lender has the receivables as security. but the borrower is still responsable – Factoring. Issued by large. The receivable is discounted and sold to the lender – Credit card receivable funding: A portion of each credit card sale is routed to the factor until the loan is paid off • Inventory loans (to purchase inventory) • Commercial paper.

representing the net effect of checks in the process of clearing • Two types: A firm´s payment generate a disbursement float.• 15.2 Cash Management • A cash balance must be maintained to provide the liquidity necessary for transaction needs: paying bills • Holding cash + marketable securities (cash equivalents) has an opportunity cost • Cash managementoptimizing mechanisms for collecting and disbursing cash • Float: • The difference between book cash and bank cash. and its collection activities generate collection float • The net effect or the sum of both is the net float • Electronic data interchange has reduced float to the limit 131 .

credit analysis. but there are costs: • Carrying the receivables (trade & consumer) & not been paid • Components: terms of sale.3 Credit and Inventory Management • Credit • Offering credit is a way of stimulating sales. low variable operating costs. repeat customers extend credit more liberally 132 . collecting policy • The optimal amount of credit is determined by the point the ∆ CFs form ∆ sales are equal to the ∆ costs of carrying the ∆ in investment in accounts receivables • Firms with excess capacity.• 15.

obsolescence. Derived-Demand Inventories 133 . Economic Order Quantity Model. opportunity cost of capital – Shortage costs: restocking costs & costs related to safety reserves There is a trade-off between both Inventory Management Techniques: ABC.• Inventory Management • It has become an increasingly important specialty in its own right • A firm´s operating cycle is made up of its inventory period and receivables period • Inventory costs: – Carrying costs: storage & tracking costs. theft.

• Economic Order Quantity Model EOQM • To determine what order size the firm should use when it restocks • Assume that the inventory is sold off at a steady rate until it hits zero & restock back to some optimal level • Total carrying costs= average inventory * carrying costs / unit • • (Q/2) * CC • Total restocking costs= fixed costs per order * nº orders • • F * (T/Q). • T= total unit sales Q Average inventory time 134 .

• Solving for Q*= [(2T * F) / CC]½ • But.• The cost-mnimizing quantity occurs where carrying & restocking costs are the same or the two lines cross • (Q/2) * CC = F * (T/Q). the firm orders in advance of anticipated needs and keeps a safety stock of inventory Delivery time Costs of holding inventory Carrying costs Restocking costs Q* Optimal size Safety stock Reorder point 135 .

• Derived-Demand Inventories • Materials Requirements Planning MRP – A computer-based system for ordering /scheduling production – The ability to schedule backwards from finished goods to work-inprocess to raw materials inventories • Just-inTime Inventory JIT – It minimizes inventory holdings – It maximizes turnover – It requires a lot of cooperation between suppliers – Also called kanban (signal) systems 136 .