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Week 2: Corporate Finance

Week 2: Corporate Finance. Sept. 15, 2010. Schedule. For today…. Time Value of Money Asset Types Asset Classes Primary & Secondary Markets. Why Have a Financial System?. Financial systems exist essentially to connect savers and borrowers (investors).

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Week 2: Corporate Finance

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  1. Week 2: Corporate Finance Sept. 15, 2010

  2. Schedule

  3. For today… • Time Value of Money • Asset Types • Asset Classes • Primary & Secondary Markets

  4. Why Have a Financial System? • Financial systems exist essentially to connect savers and borrowers (investors). • A business is really an engine for turning excess money into more money. • Financial intermediaries profit by connecting borrowers and savers. • Complexity exists to sort out different appetites for size, risk, liquidity, etc.

  5. Time Value of Money • If I have $100 today and can invest it at 5% interest (compounded annually), how much will I have after 1 year? 2 years? 10 years? • $100 * (1 + .05) = $105 (1 year) • $105 * (1 + .05) = $110.25 (2 years) • $100 * (1 + .05)10 = $162.89 (10 years) • n years? • $100 * (1 + .05) n

  6. Future Value Problems • Problems like this are known as future value problems. They answer the question “If I have PV dollars today, how much will I have if I invest at interest rate r for n periods. • FV = PV * (1 + r)n

  7. Present Value Problems • Present Value problems do the opposite: They answer the question “How much money do I need to put away today to have FV dollars in n periods if I can invest at rate r? • PV = FV/(1+ r)n • For a series of cash flows, the formula is: • Σ(CF/(1+ r)t) = CF1/(1 + r) + … + CFT/(1 + r)T

  8. What does this mean for us? • Using our P = $100, r = 0.05, n = 1 example from earlier, the present value formula tells us that we should be indifferent between receiving $100 today and receiving $105 in one year. • Consequently, the value of a financial asset is the present value of its expected cash flows.

  9. Example • Suppose I offered you a slip of paper that entitles you to $100 in 1 year, $150 in 2 years, and $50 in 3 years. How much would you be willing to pay for this paper (the interest rate is 5%)? • PV = CF1/(1 + r) + CF2/(1 + r)2 + CF3/(1 +r)3 • = 100/(1.05) + 150/(1.05)2 + 50/(1.05)3 • $274.48

  10. Primary Asset Types: Debt • Debt typically has a payment schedule that looks like this:

  11. Things to Note about Debt • Relatively predictable cash inflows (easier to value). • Cash flows are legally guaranteed • Debt-holders fare better in the event of bankruptcy (more on that later)

  12. Primary Asset Types: Equity • Represents ownership in (and share of the profits in) a company • Equity-holders are paid (relatively) irregularly and unpredictably • Equity-holders are in a bad position in the event of bankruptcy (more later)

  13. The Capital Structure • A company is in default if it has failed to pay its debt obligations on time. • In the event of default and bankruptcy, a company’s assets are liquidated, and entities that have a claim on its assets are paid in this order: • Government • Debt-holders • Equity-holders • Note: within each class there are more layers (Senior debt, junior debt, etc.)

  14. Asset Classes: Equity Common Stock • Common stock represents a claim on the profits of the company. • Common stockholders get paid only if all other claimants are paid first. • Common stockholders are paid in the form of dividends, payments made at the discretion of management. • So the value of a share of common stock is the present value of its expected future dividends.

  15. Aside on Valuation • The present value of a perpetual (never ending) cash flow is (CF)/r. • The present value of a perpetual cash flow that grows at a rate g every year is (CF)/(r – g). • To value a stock, we estimate its dividends for five years, then assume a constant growth rate thereafter. • We pretend that we hold for five years, then sell it.

  16. Valuing Common Stock • PV = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3 + D4/(1 + r)4 + (D5 + P5)/(1 + r)5, where P5 = D5/(r – g)

  17. Example • We expect dividends to be $3, $5, $10, $12, and $13 in years 1 through 5, with 3% growth thereafter. The interest rate is 8%. After 5 years, we sell. Note: P5 = 13/(.05) = 260

  18. Preferred Stock • A special type of equity • Preferred stock carries a fixed interest rate, but the company can choose to not pay it. • However, before common stockholders can receive dividends, preferred stockholders must receive all of their back-dividends. • Preferred stockholders rank above common stockholders in the capital structure.

  19. Asset Classes: Bonds • Bonds are a type of debt security. • Bondholders receive (usually semi-annual) payments called coupons. • At the bond’s maturity, bondholders receive the Par or Face Value of the debt.

  20. Valuation Example • 5 year bond, $50 coupon, interest rate is 5%

  21. Money Markets • Commercial Paper: short-term unsecured debt issued by a corporation (unsecured means that the debt-holders do not have a specific asset to seize in the event of default. • Treasury bills: short term debt issued by the U.S. government. • Certificates of Deposit (CD’s): a deposit at a bank that is typically untouchable for a specified period of time. • Money market securities can be valued with the cash flow method

  22. Real Estate • Land, buildings etc. • Real estate is a real asset, not a financial asset, so it is really difficult to value using discounted cash flow. • If you’re interested in real estate, talk to Jai Reddy, our real estate analyst.

  23. Commodities • Oil, wheat, gold, lithium, timber, etc etcetc. • Commodity prices typically depend largely on macroeconomic fundamentals. • Commodities, like real estate, are real assets, so they cannot be valued with discounted cash flow.

  24. Foreign Exchange • Refers to trading among different currencies (US$, euros, yen, etc.) • Valuation is largely correlated to: • Macro data • Government borrowing • Central bank action

  25. Markets • Exchange market: securities that trade on exchanges trade in a centralized place or network. • Example: New York Stock Exchange • Major stocks trade on exchanges • Over-the-Counter (OTC) market: an informal network who negotiate between one another. • Bonds typically trade OTC

  26. Primary & Secondary Markets • The primary market refers to the issuance of new securities to the public. • The secondary market refers to situations where already outstanding securities are traded. • Retail investors (small scale) typically purchase securities in the secondary market. • An Initial Public Offering (IPO) of a company refers to the first time that company’s shares are issued to the public for purchase.

  27. Next Week • Overview of the financial system • Major players • Structure

  28. See you next week

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