Financial management: lecture 10 Corporate Financing and Market Efficiency Where to get money for...
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Transcript of Financial management: lecture 10 Corporate Financing and Market Efficiency Where to get money for...
Financial management: lecture 10
Corporate Financing and Market Efficiency
Where to get money for good projects
Financial management: lecture 10
Today’s plan
Review WACC Investment Decision vs. Financing Decision Equity and debt financing Does the stock price follow a random walk? Three forms of Market Efficiency
• Weak form efficiency
• Semi-strong form efficiency
• Strong form efficiency
Financial management: lecture 10
What have we learned in the last lecture ? Motivation for WACC
• How do we know that a project is worth taking?
• How do we find the cost of capital for a project ?
• What is the formula of WACC without tax?
• What is the formula of WACC with tax?
• Should we use the market value or book value of equity and debt in calculating WACC?
Financial management: lecture 10
What have we learned in the last lecture (1)?
WACC without tax
WACC with tax
de rVD
rVE
WACC
EDVwhere
eVE
dVD r +Tc)r-(1 =WACC
Financial management: lecture 10
What have we learned in the last lecture (2)?
The cost of bond• It is the YTM, the expected return required by
the investors.
• That is
• The expected return on a bond can also be calculated by using CAPM
tddd r
principalcpn
r
cpnr
cpn
111
P2bond
)( fmdfd rRrr
Financial management: lecture 10
What have we learned in the last lecture (2)?
The cost of equity is calculated by using • CAPM
• Dividend growth model
)r-(R+r=r fmfe e
gP
DIVr
gr
DIVP e
e
0
110
Financial management: lecture 10
What have we learned in the last lecture (2)?
Three steps in calculating WACC• First step: Calculate the market value of each
security and calculate its portfolio weight
• Second step: Determine the cost of capital on each security.
• Third step: Calculate a weighted average cost of capital on these securities.
Financial management: lecture 10
A summary example John Cox, a recent MBA student of SFSU, was asked by his
boss in Geothermal to decide whether the firm should take an expansion project: the cost of the project is $30 million, and the project is expected to generate a perpetual incremental cash flow of $4.5 million. Currently, Geothermal has 20 million shares of common stocks outstanding, with a market price of $22.65 per share. The Beta of the firm’s equity is 1.1. The risk free rate is 4% and the market risk premium is 5.6%. The firm also has long-term debt, with the YTM of 9%. John also got the following information from the firm’s balance sheet:• Debt (12 years maturity, 8% coupon): $200 million
• Common stocks:$110 million If the tax rate is 35%, should John suggest to his boss to take
the project or not?
Financial management: lecture 10
Solution
51.200891.0/5.430/5.430
%91.8)1(
68.18509.1
200)
09.1*09.0
1
09.0
1(*16
45365.22*20
%16.10%6.5*1.1%4
%9
1212
WACCNPV
rED
Ert
ED
DWACC
D
E
r
r
ed
e
d
Financial management: lecture 10
Investment vs. Financing
Investment decisions or capital budgeting is about how to take projects to maximize V.
Financing decisions are about how to raise capital (E or D) to finance the projects that are to be taken
Asset Liabilities and equity
VDebt: D
Equity: E
Types of Securities Equity
• Common stock• Preferred stock
Debt• Commercial paper• Debentures• Guaranteed notes• Remarketable debt• Euro notes• Sterling notes• New Zealand dollar notes• Bank loans
Common StockTreasury Stock
Stock that has been repurchased by the company and held in its treasury
Issued Shares
Shares that have been issued by the company.
Outstanding Shares
Shares that have been issued by the company and held by investors.
Common StockAuthorized Share Capital
Maximum number of shares that the company is permitted to issue, as specified in the firm’s
articles of incorporation.
Par Value
Value of security shown on certificate.
Retained Earnings
Earnings not paid out as dividends.
Addiotional Paid Up CapitalDifference between issue price and par
Common Stock
Book Value vs. Market Value Book value is a backward looking
measure. It tells us how much capital the firm has raised from shareholders in the past. It does not measure the value that shareholders place on those shares today. The market value of the firm is forward looking, it depends on the future dividends that shareholders expect to receive.
Common Stock
Example - H.J. Heinz Book Value vs. Market Value (5/2007)
Total Shares outstanding = 322 million
1,843Value)(Book equity common Net
219-Other
4,406-costat sharesTreasury
5,779earnings Retained
581capitalin paid Additional
108par) ($.25 SharesCommon
Common Stock
Example - H.J. Heinz Book Value vs. Market Value (5/2007)
Total Shares outstanding = 322 million
billion $14.812ValueMarket
322x shares of #
$46/sh= priceMarket 2007May
Common StockCorporate Equity Holdings
Mutual Funds28.3%
Pension Funds22.3%
Insurance Companies
8.0%
Rest of World12.6%
Households27.1%
Other1.4%
Banks & Savings0.3%
Preferred Stock
Preferred Stock - Stock that takes priority over common stock in regards to dividends.
Net Worth - Book value of common shareholder’s equity plus preferred stock.
Floating-Rate Preferred - Preferred stock paying dividends that vary with short term interest rates.
Corporate Debt
Debt has the unique feature of allowing the borrowers to walk away from their obligation to pay, in exchange for the assets of the company.
“Default Risk” is the term used to describe the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily.
“Bond Ratings”are issued on debt instruments to help investors assess the default risk of a firm.
Corporate Debt
Prime Rate - Benchmark interest rate charged by banks.
Funded Debt - Debt with more than 1 year remaining to maturity.
Sinking Fund - Fund established to retire debt before maturity.
Callable Bond - Bond that may be repurchased by firm before maturity at specified call price.
Corporate Debt
Subordinate Debt - Debt that may be repaid in bankruptcy only after senior debt is repaid.
Secured Debt - Debt that has first claim on specified collateral in the event of default.
Investment Grade - Bonds rated Baa or above by Moody’s or BBB or above by S&P.
Junk Bond - Bond with a rating below Baa or BBB.
Corporate Debt
Eurodollars - Dollars held on deposit in a bank outside the United States.
Eurobond - Bond that is marketed internationally.
Private Placement - Sale of securities to a limited number of investors without a public offering.
Protective Covenants - Restriction on a firm to protect bondholders.
Lease - Long-term rental agreement.
Convertible Securities
Warrant - Right to buy shares from a company at a stipulated price before a set date.
Convertible Bond - Bond that the holder may exchange for a specified amount of another security.
Convertibles are a combined security, consisting of both a bond and a call
option.
Patterns of Corporate Financing
Firms may raise funds from external sources or plowback profits rather than distribute them to shareholders.
Should a firm elect external financing, they may choose between debt or equity sources.
Patterns of Corporate Financing
-100
-50
0
50
100
150
200
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Year
Per
cen
t of
tot
al s
ourc
es
New Debt
New Equity
Internal Funds
Patterns of Corporate FinancingD
ebt R
atio
, %Debt to (Debt + Equity) Ratio for Non-Financial Firms
Financial management: lecture 10
Market Efficiency
Market efficiency is concerned about whether or nor capital markets have all relevant information about the cash flows and risk of projects to price securities accordingly.
Market Efficiency
Financial management: lecture 10
Efficient capital markets
Efficient Capital Markets – If capital markets are efficient, then security prices reflect all relevant information about asset values.
Financial management: lecture 10
Market efficiency and random walk
Market efficiency concepts are very abstract.
How can we use a simple way to check whether the stock market (one of the capital markets) is efficient or not?• If the stock price follows a random walk, then
the stock market is efficient.
Financial management: lecture 10
What is a random walk of stock prices?
The movement of stock prices from day to day DO NOT reflect any pattern.
Statistically speaking, the movement of stock prices is random.
Financial management: lecture 10
A Random Walk example
$101.00
$100.00
$102.09
$97.43
$97.50
$100.43
$95.06
Coin Toss Game
Heads
HeadsHeads
Tails
Tails
Tails
Financial management: lecture 10
Three forms of market efficiency
The random walk concept is still abstract Financial economists have used three
more specific forms to characterize or judge market efficiency.• Weak-form
• Semi-strong form
• Strong form
Financial management: lecture 10
Weak-form of market efficiency
Weak Form Efficiency - Market prices reflect all information contained in the history of past prices, or you cannot use past stock prices to predict future prices
Technical Analysts - Investors who attempt to identify over- or undervalued stocks by searching for patterns in past prices.
Financial management: lecture 10
Efficient Market Theory
Last Month
This Month
Next Month
$90
70
50
EI’s Stock Price
Cycles disappear
once identified
Financial management: lecture 10
Semi-strong form of market efficiency
Semi-Strong Form Efficiency - Market prices reflect all publicly available information such as earnings, price-to-earnings ratios,etc.
Fundamental Analysts - Analysts who attempt to fund under- or overvalued securities by analyzing fundamental information, such as earnings, asset values, and business prospects.
Financial management: lecture 10
Efficient Market Theory
-16
-11
-6
-14
9
14
19
24
2934
39
Days Relative to annoncement date
Cu
mu
lati
ve A
bn
orm
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rn
(%)
Announcement Date
Financial management: lecture 10
Market Efficiency
0
5
10
15
20
25
Av
era
ge
re
turn
, pe
rce
nt
Highest
Book-Market Ratio
Fama & FrenchReturn vs. Book-Market
Financial management: lecture 10
Strong form of market efficiency
Strong Form Efficiency - Market prices reflect all information that could in principle be used to determine true value.
Inside trading• Investors use private information to predict
future price movements
Financial management: lecture 10
Efficient Market Theory
-16
-11
-6
-14
9
14
19
24
2934
39
Days Relative to annoncement date
Cu
mu
lati
ve A
bn
orm
al R
etu
rn
(%)
Announcement Date
Financial management: lecture 10
Some exercises
1. If stock markets are efficient, what should the correlation between stock returns for two non-overlapping periods?
2. Which is the most likely to contradict the weak-form of efficiency
a. Over 25% of mutual funds outperform the market on average
b. Insiders can make abnormal profits
c. Every January, the stock market earns abnormal return