Cameron School of Business UNIVERSITY OF NORTH CAROLINA WILMINGTON

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Cameron School of Business UNIVERSITY OF NORTH CAROLINA WILMINGTON. An Introduction to Finance. Edward Graham Professor of Finance Department of Economics and Finance. Continuing your Introduction to Finance. Recalling the Broad Introduction to Finance - PowerPoint PPT Presentation

Transcript of Cameron School of Business UNIVERSITY OF NORTH CAROLINA WILMINGTON

PowerPoint PresentationAn Introduction to Finance
Copyright© 2007
Recalling the Broad Introduction to Finance
I. The Three Primary Duties of the Financial Manager
II. The Concept of Risk and Return
III. Capital Structure Choice
What is finance?
Finance is the study of the art and the science of money
management; it is based on the Latin root finis,
meaning the end. In managing ours or our firm’s money,
we consider historical outcomes or “endings,”
and we propose future results as a function of decisions
made today. Those outcomes or results are
typically portrayed using financial statements.
Copyright© 2007
Financial Manager
Whether managing monies for the home, or for the firm, our
duties are met with decisions framed by the same general
principles. These principles instruct us in making three main
types of decisions as we perform those three primary duties:
The capital budgeting decision
The capital structure decision
The working capital decision
We are past the half-way point. Celebrate.
Now, back to work!
In Chapter 10, we examine the stock market, not towards learning how to beat it, as that is highly unlikely, but in merely seeking to better understand it.
So, what about the stock market and stock returns? What is a stock return?
Recalling the Dividend Growth Model or DGM, we remember that:
R = D1/Po + g, or our return is comprised of a dividend
yield and a capital gains yield. (p. 292-294)
Or, for a $20 share of Duke Energy expected to pay an
$.80 dividend and sell for $22 in a year, our expected return becomes:
R = .8/20 + .10 = .14
The Concept of Risk and Return
A fourteen percent return does not sound thundering, but recalling the rule of 72, that is a return that doubles our money every 5.2 years or so, that beats the stock market averages over the past 50 or so years, and that turns our $20,000 investment today into over $1,000,000 in less than 30 years. (Check it our with your BA II Plus buddies)
Historically, as with your text on page 295, and the table on page 296 (Table 10.4), we see typical stock and bond performances.
The first lesson on those pages is that with higher returns comes higher risk.
A game-playing example in the next slide illustrates.
Copyright© 2007
The Risk Return Relationship
Game A, you win $100,000
Game B, you win $10,000,000 two percent of the time, the rest of the time, you win nothing.
Which game do you play?
Expected value of Game A is $100,000
Expected value of Game B = P(winnning) Winnings + P(losing) Zero
Or .02(10 million) + .98 (0) or $200,000
And, 200,000 > 100,000
Copyright© 2007
The Concept of Risk and Return
Game B is far riskier, and that introduces our second lesson:
The variability of returns. From chapter 10, we can appreciate the importance of this topic as illustrated on pages 303-308 of your text.
To go for the higher return of Game B, as with a risky stock, we must accept far more risk as illustrated by the variability of Game B’s returns, versus the risk-free guarantee of Game A.
But, in life, there are few guarantees, so if you wish to “take a risk,” recall that the stock market is widely considered to be “efficient.”
There are three versions of an Efficient Market Hypothesis to describe this efficiency: the weak form, the semi-strong form, and the strong form. Each is illustrated by example. (pages 313-315)
Copyright© 2007
The Concept of Risk and Return
In Chapter 11, as introduced on pages 323-327, we underscore the ideas of risk and return.
For example, in our game-playing example, we could describe our games’ returns thusly:
Expected Return of Game A = Risk Free (Rf) portion + Risk Premium (RP)
Expected Return of Game B = Rf + Risk Premium, or
E(A) = Rf + RP = 100,000 + 0
E(B) = Rf + RP = 100,000 + 100,000
In effect, you are not compensated for risk with Game A, and you get a 100,000 bump in Game B for taking the risk. Further, to not play Game B, in exchange for the guarantee of Game A, you PAY $100,000 in insurance to assure a positive outcome, forgoing the “expectation” of $200,000 with Game B.
Copyright© 2007
The Concept of Risk and Return
We extend the tradeoff of being compensated for risk with an investment example:
Suppose we have a risky asset “A,” with expected returns of 100% one-half the time, and a loss of 50% half the time. This is contrasted with an available risk-less or risk-free asset yielding 5%.
E(A) = Rf + RP = .5(100%) + .5(-50%) = 25%.
As we “know” there is a risk-free asset available yielding 5%, our function is:
E(A) = Rf + RP = .05 + .20. We are compensated, or we demand, an additional return of 20% for taking the risk of asset A, for risking that half the time we will lose half our money!
And, to avoid this risk of a single asset, like asset A, we form portfolios.
Copyright© 2007
The Concept of Risk and Return
Suppose we have 1 million dollars to invest, in bonds, real estate and stocks. (This is covered in Section 11.2 on page 327 of your text)
We decide to invest $250,000 in bonds yielding 8%, $300,000 in real estate yielding 10%, and $450,000 in stock yielding 12%. These are expected yields, by the way, and not guarantees! We are just hedging our bets by not placing all our money in a single stock or even in a single economic sector!
Our Portfolio’s Expected Return is a weighted average:
E(Rp) = W(b)R(b) + W(re)R(re) + W(s)R(s)
= (250,000/1m)(.08) + (300,000/1m)(.10) + (.45)(.12) = .104
The Concept of Risk and Return
We achieve a reduction in our portfolio’s variance as in Table 11.7 on page 335 and Figure 11.1 on page 336 with this portfolio.
In an environment with a t-bill or other risk-free asset yielding 3%, our risk premium with this portfolio would be 7.4%.
We avoid, with this portfolio, most of the shock to any one sector or industry (called non-systematic or non-economy-wide risk), but with any risky investment or risky portfolio we still have systematic or economic risk. (As on page 333 of your text in Section 11.3).
With diversification, we get rid of most of the unsystematic or diversifiable risk, but we can only get rid of the economy-wide or non-diversifiable risk with t-bills or certificates of deposit.
Copyright© 2007
The Concept of Risk and Return
A model exists, Section 11.7 on pages 341-348 of your text, called the Capital Asset Pricing Model or CAPM that describes the nature of risky asset returns as a function of a risk-free guarantee, a risk-premium and the systematic risk of the asset in question.
We describe security expected returns or E(R)’s as the sum of a Risk-free return and a Risk Premium.
E(R) = Rf + Bi [ E(Rm) – Rf ], defining each term as in Table 11.9 on page 348. Bi is a measure of systematic or economy-wide risk – it is the measure of the exposure of McDonald’s stock to the whole economy, for example, and not just beef prices (that is an example of non-systematic risk). The portion “Bi[E(Rm) – Rf]” is the Risk Premium. Rm is the expected return on the market, like the S and P 500 stock index, for example.
The CAPM “story” is told with the Security Market Line or SML, as in your text on page 347. The SML is the central prediction of the CAPM.
Copyright© 2007
With the capital structure decision, the financial manager decides
from where best to acquire monies long-term. The purchase of that
new delivery truck with cash or with a loan from GMAC or Ford
Motor Credit is a capital structure decision; the use of long-term
borrowing to fund a franchise purchase is another.
Perhaps most importantly, the decision to fund a firm’s growth with
equity - such as with funds invested by the firm’s founders, angel
investors, venture capitalists or public stock offerings – or debt, is
a critical capital structure choice. Two features of this choice bear
mentioning:
The risk of the debt
The loss of control and reduced potential cash flows to the
founders with an equity or stock sale
We expand our review with a few capital structure decisions.
Copyright© 2007
The Capital Structure Decision
Recall that our overall objective as financial managers is to “borrow” money at one rate of interest (letting that borrowing cost be an assembly of our debt costs and our stockholders’ expected returns), invest that money at a higher rate of return, and “keep the difference. In this case, we keep the difference on behalf of our shareholders and towards elevating our stock price.
Table 12.1 on page 373 captures the spirit of the costs of capital material in Chapter 12. There, we see that our “borrowing cost” above becomes this curious weighted average cost of capital or:
WACC = (E/V)Re + (D/V)Rd(1-Tc) or our WACC is simply the market-valued weighted average of each of our debt and equity funding levels times the respective costs of each of those funding sources. The debt costs are reduced to the after-tax level of expense as interest is tax deductible, but dividends and capital gains earned by shareholders are not.
Copyright© 2007
E is the market value of outstanding equity
V is the market value of the firm, E + D
Re is the required return on equity using the DGM or CAPM
D is the market value of outstanding debt
Rd is the pre-tax cost of borrowing, typically the YTM on the firm’s bonds, or other published borrowing costs
Tc is the marginal tax rate of the firm
Copyright© 2007
WACC = (E/V)Re + (D/V)Rd(1-Tc), Tc, the tax rate, is 40%
Suppose a firm has 100 million shares of stock outstanding trading at $50, E is just 50 x 100m or $5 billion.
Assume also the firm has 3 million 8% bonds outstanding trading at $950. They have ten years to maturity, and pay an annual coupon. D is $950 x 3m or $2.85 billion.
V = D + E = $5 billion + $2.85 billion = $7.85 billion
YTM? 1,000 FV, 80 PMT, 10 N, -950 PV, CPT I/Y = 8.77%
Re? Suppose the firm uses the CAPM (the firm could just as easily use the DGM or some other method to estimate its costs of equity), its beta is 1.2, treasury bills are yielding 1%, and the expected market return is 8%.
Re = Rf + Bi(Rm–Rf) = .01 + 1.2(.08 - .01) = .01 + .084 = 9.4%
Copyright© 2007
D/V = the debt weight = (2.85/7.85) = 1 - .637 = .363
Rd = YTM = I/Y = 8.77% = .0877
Re = 9.4% (from the CAPM) = .094
Tc is still 40% or .4
WACC = (.637).094 + (.363).0877(.6) = .06 + .019 = 7.9%