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Topics Covered

Topics Covered. What Is A Corporation? The Role of The Financial Manager Who Is The Financial Manager? Separation of Ownership and Management Financial Markets. Corporate Structure. Sole Proprietorships. Unlimited Liability Personal tax on profits. Partnerships. Limited Liability

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Topics Covered

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

  2. Corporate Structure Sole Proprietorships Unlimited Liability Personal tax on profits Partnerships Limited Liability Corporate tax on profits + Personal tax on dividends Corporations

  3. Role of The Financial Manager (2) (1) Financial Firm's Financial (4a) manager operations markets (4b) (3) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors

  4. Difference in Information Stock prices and returns Issues of shares and other securities Dividends Financing Different Objectives Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders Ownership vs. Management

  5. Valuation Rule • Mean – Variance Valuation Rule

  6. Valuing an Office Building Step 1: Forecast cash flows Cost of building = C0 = 350 Sale price in Year 1 = C1 = 400 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 7%, then Cost of capital = r = 7%

  7. Valuing an Office Building Step 3: Discount future cash flows Step 4: Go ahead if PV of payoff exceeds investment

  8. Risk and Present Value • Higher risk projects require a higher rate of return. • Higher required rates of return cause lower PVs.

  9. Risk and Present Value

  10. General Rule For Valuation Of Any Risky Cash Stream • Expected cashflows • Required rate of return • Discounted value • Mean – Variance Rule • Other valuation rules

  11. Net Present Value Rule • Accept investments that have positive net present value • Required rate of return = cost of capital

  12. Net Present Value Rule • Accept investments that have positive net present value. Example Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return?

  13. Topics Covered • Valuing Long-Lived Assets • PV Calculation Short Cuts • Compound Interest • Interest Rates and Inflation • Example: Present Values and Bonds

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

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

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

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

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

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

  20. Short Cuts Perpetuity - Financial concept in which a cash flow is theoretically received forever.

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

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

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

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

  25. Bond Prices and Yields Price Yield

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

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

  28. WHY IS IT IMPORTANT TO HAVE A THEORY OF THE VALUATION OF COMMON STOCKS? • MANAGERS SHOULD BE MAKING DECISIONS WHICH INCREASE SHARE PRICE • NEED TO UNDERSTAND HOW SHARE PRICE IS DETERMINED • CASES WHERE WE CANNOT DIRECTLY OBSERVE STOCK PRICE • WE ARE TRYING TO VALUE • A DIVISION OF A COMPANY • PRIVATELY HELD FIRM FOR POSSIBLE SALE

  29. LET’S CHANGE OUR ASSUMPTIONS HOW MUCH SHOULD I PAY FOR A STOCK TODAY(P0) IF I AM GOING TO RECEIVE A DIVIDEND AT THE END OF ONE YEAR (DIV1) AND THEN I’M GOING TO SELL IT (AT A PRICE P1)?

  30. TWO EQUIVALENT WAYS OF ANSWERING THE QUESTION • PRICE OF THE STOCK IS THE PRESENT VALUE OF THE CASH FLOWS RECEIVED BY THE INVESTOR

  31. HAVE I REALLY SAID ANYTHING USEFUL? WHAT ARE THE LIMITATIONS OF MY ANSWER? • I CAN CALCULATE TODAY’S PRICE ONLY IF I KNOW THE PRICE AT THE END OF THE YEAR. • I AM ASSUMING THAT I HOLD THE STOCK FOR ONE YEAR AND I SELL IT. • WHAT HAPPENS IF MY HOLDING PERIOD IS NOT ONE YEAR? • LET’S GET RID OF BOTH LIMITATIONS.

  32. LET’S SEE HOW MUCH SOMEONE WILL PAY FOR THE STOCK IN A YEAR’S TIME HOW MUCH SHOULD THE PERSON WHO BUYS IT FROM ME PAY FOR THE STOCK INA YEAR’S TIME(P1) IF SHE IS GOING TO RECEIVE A DIVIDEND AFTER ONE YEAR (DIV2) AND THEN SHE IS GOING TO SELL IT (AT A PRICE P2)?

  33. WE HAVE NOW SUCCEEDED IN RELATING TODAY’S PRICE TO: • EXPECTED DIVIDENDS IN YEARS 1 AND 2, DIV1 AND DIV2 • EXPECTED PRICE AT END OF YEAR 2, P2 • WE CAN REPEAT THE PROCESS

  34. LET’S SEE HOW MUCH SOMEONE WILL PAY FOR THE STOCK IN TWO YEAR’S TIME HOW MUCH SHOULD THE PERSON PAY FOR THE STOCK INTWO YEAR’S TIME(P2) IF SHE IS GOING TO RECEIVE A DIVIDEND AFTER ONE YEAR (DIV3) AND THEN SHE IS GOING TO SELL IT (AT A PRICE P3)?

  35. P0

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

  37. S P0 = 1. BY CONSIDERING HOW MUCH A BUYER WILL PAY FOR THE STOCK WHEN IT IS REPEATEDLY SOLD, WE FIND THAT THE STOCK PRICE IS THE PV OF ALL FUTURE DIVIDENDS. 2. WE OBTAIN THE SAME RESULT INDEPENDENTLY OF THE ASSUMPTIONS WE MAKE ABOUT THE LENGTH OF SUCCESSIVE HOLDING PERIODS.

  38. SPECIAL CASESWHERE WE CAN MAKE SOME SIMPLIFYING ASSUMPTIONS ABOUT THE GROWTH PATTERN OF FUTURE DIVIDENDS

  39. SPECIAL CASES WHERE WE CAN MAKE SOME SIMPLIFYING ASSUMPTIONS BOUT THE GROWTH PATTERN OF FUTURE DIVIDENDS 1. NO GROWTH SIMILAR TO PREFERRED STOCK, WITH CONSTANT DIVIDENDS DIV1=DIV2=.......=DIV ORDINARY PERPETUITY GOOD APPROXIMATION FOR MANY UTILITY STOCKS

  40. CONSTANT EXPECTED DIVIDEND GROWTH (GORDON MODEL) • DIVIDENDS EXPECTED TO GROW AT CONSTANT RATE • WE KNOW THIS WON’T HAPPEN EXACTLY • REASONABLE APPROXIMATION WITHIN THE ACCURACY OF OUR ESTIMATE • OFTEN STATED AS COMPANY GOAL • GROWING PERPETUITY

  41. CONSTANT EXPECTED DIVIDEND GROWTH (GORDON MODEL) • IF DIVIDENDS ARE EXPECTED TO GROW AT A CONSTANT RATE (g < r), VALUE OF THE STOCK IS DIV1 DIV0(1+g) P0 = = r - g r - g • FOR FLEDGLING ELECTRONICS, DIV1 = 5.00, g = .10, r = .15 DIV1 5 P0 = = = $100 r - g .15 - .10

  42. WHAT HAPPENS TO THE STOCK PRICE WHEN • REQUIRED RATE OF RETURN INCREASES • FROM 15% TO 20% • WITH INCREASE IN GENERAL LEVEL OF INTEREST RATES? • EXPECTED GROWTH RATE 10%. DIV1 5 P0 = = = $50 r - g .15 - .05

  43. CHANGES IN EXPECTED GROWTH RATES CAN HAVE MAJOR IMPACT ON STOCK PRICES.

  44. WHAT HAPPENS TO THE STOCK PRICE WHEN • REQUIRED RATE OF RETURN INCREASES • FROM 15% TO 20% • WITH INCREASE IN GENERAL LEVEL OF INTEREST RATES? • EXPECTED GROWTH RATE 10%. DIV1 5 P0 = = = $50 r - g .20 - .10

  45. CHANGES IN REQUIRED RATES OF RETURN ON STOCKS CAN HAVE MAJOR IMPACT ON STOCK PRICES.

  46. ESTIMATING THE CAPITALIZATION RATEOR REQUIRED RATE OF RETURN If dividends are expected to grow at a constant rate, g DIV1 P0 = r - g DIV1 so that r = + g P0 MARKET CAPITALIZATION RATE =DIVIDEND YIELD, (D1 /P0) + EXPECTED RATE OF GROWTH IN DIVIDENDS, g

  47. SUPERNORMAL GROWTH

  48. STOCK PRICE AND EARNINGS PER SHARE (EPS) • INVESTORS OFTEN DISTINGUISH BETWEEN : • GROWTH STOCKS • EXPECTATION OF CAPITAL GAINS, BASED ON FUTURE GROWTH IN EARNINGS • INCOME STOCKS • CASH DIVIDENDS • DOES THIS DISTINCTION MAKE SENSE?

  49. NO GROWTH • SIMILAR TO PREFERRED STOCK, WITH CONSTANT DIVIDENDS, DIV1=DIV2=...... ORDINARY PERPETUITY • EXPECTED RETURN • = DIVIDEND YIELD • = EARNINGS PRICE RATIO

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