Chapter 4 --Value-driven Management -- Arbitrage

1. Chapter 4 --Value-driven Management -- Arbitrage • Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value of the expected future cash flows. • You have two investments of equal risk below: • Investment A -- price $120 with a $10 return forever. • Investment B -- price $80 with a $10 return forever. • What should happen in the market? • Answer -- equal financial claims of equal risk sell for equal prices in the market.

2. Arbitrage • Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value of the expected future cash flows. • Two investments of equal risk below: • Investment A -- price $100 with a $12 return forever. • Investment B -- price $100 with a $8 return forever. • What should happen in the market? • Answer -- financial claims of equal risk sell for equal rates of return in the market.

3. Price Terminology • What is the difference between bid prices, the highest bid price, asked prices, the lowest asked price and market price? • What role does the existence of different information sets play in determining the different prices above?

4. Information Sets • Who probably has the better information set pertaining to the future cash flows of Microsoft? • Bill Gates -- the Chairman of the Board and Chief Executive of Microsoft • A typical stockholder of Microsoft • When we refer to the intrinsic value of Microsoft, to whose intrinsic value are we referring? • What happens when the intrinsic value is different than the market price of the stock?

5. Information Sets – Financing Decisions & Capital Investment • When the information set of management does not match the information set of the stockholders, two situations may exist that have an impact on the financing decision. • Managers may be more optimistic than the market about the future cash flows of the company: • What influence does this have on the financing of new investment opportunities? • The market may be more optimistic than management about the future cash flows of the company: • What influence does this have on the financing of new investment opportunities?

6. Bonds • Bonds are one claim on the value of a firm • Know how to find the present value of a bond • Know how to use the IRR function on the calculator to find the market return or yield to maturity • Know how to use the IRR function on the calculator to find the yield to call

7. Bond Terminology • Bond yield terminology • Yield to maturity • Yield to call • Current yield • Coupon rate

8. Preferred Stock • Preferred stock is another claim on the value of a firm • The value of preferred stock can be found using the perpetual no-growth model in chapter 3 • Value today = Expected dividend / required rate of return for preferred shareholders • Market typically tells you the price and the dividend in know – work backwards to get the required return

9. Common Stock • Common stock is another claim on the value of a firm: • A short-cut method to value common stock is to use the constant dividend growth model • Value today = Expected dividend /(required return for common shareholders - growth) • Weaknesses of the model: • constant growth • companies that do not pay dividends

10. Asset View: Variables That Drive Stock Value • Looking at value from the asset side instead of the financing side, the firm value is driven by: • Existing projects -- dividends or cash flows from existing projects • NPV of new investment opportunities expected to be taken in the future -- with perfect information • Competitive advantage --> Economic Profit --> taken to present leads to net present value --> which measures the increase in value of the stock (with perfect information)

11. Other Events • Factors that do not influence value -- smoke and mirrors • Stock splits • Stock dividends • Factors that influence value • Earnings • Investment announcements