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Investment Vehicle Model Investors provide financing to the firm in exchange for
financial securities (bonds and shares), and firm invests these funds in assets. The
income generated by the firm is distributed to the investors.
Balance Sheet Model (Accounting Model) Investment decisions are represented by
LHS/Assets and Financing decisions are represented by RHS/Liabilities & Equity on the
balance sheet.
Total Value of Assets = Total Firm Value to Investors
Corporation
Limited Liability
Market Values
Separation of ownership
& management
Separation of ownership
& management
Determined by GAAP
Unlimited Life
Ease of raising capital
Ease of transferring
ownership
The Primary Goal of Financial Management is to maximize shareholder wealth
(maximize stock price).
1.
Maximize the value of the firm
Treasurer
Sole Proprietorship
Partnership
Advantages
Disadvantages
Unlimited liability
Difficult to sell/transfer
2.
3.
4.
Maximize its contribution to the economy
Shareholder wealth is a cash-flow related concept, maximizing annual profits,
market share, sales and minimizing costs may not max wealth.
Concentrating on the long term.
Ability to generate cash flows for stockholders determines stock prices
Amount, timing, and riskiness of cash flows determine the intrinsic value of stocks.
Intrinsic Value estimate of stocks true value with accurate risk & return information
Market Price based on perceived information by the marginal investor
Reputation compilation of impressions held by all of the entitys stakeholders
Indirect Agency Costs: lost opportunities that would increase firm value
Operating net income and changes in most current accounts (AP, AR, Invent);
Investment changes in fixed assets; Financing changes in notes payable, LT debt,
equity accounts and dividends.
Cash = Retained Earnings (Net Income) + CL - CA other than cash -Net fixed
assets + Long Term Debt + Common Stock
Cash = Operating Activities: Net Income + depreciation + non-interest bearing
current liabilities - current assets other than cash. Investment activities: - (net fixed
assets + depreciation) Financing Activities: +interest bearing current liabilities longterm debt +common stock - dividends
Accounts Payables do not bear interest
M/B Ratio: Market Price per share/Book Value per share how much investors are Financial Markets allow companies, government and individuals to increase utility
"
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Expected Portfolio Return: Weighted average of E(R) on individual stocks
Liquidity Ratios: measure ability to pay liabilities in the short run (ability to convert
assets to cash quickly without a significant loss in value)
Interval Measure: Current Assets / Average daily operating costs - (how many days
of operations can the current assets fund)
Fixed Asset Turnover: Sales/Net Fixed Assets (for every $ of fixed asset, how
much sales can it generate)
Pure Discount Loans: Like zero-coupon bonds, pure discount bonds, principal (and all
interest) paid at maturity, no periodic interest payment, issued at discount
Interest Only Loans: Interest paid throughout loan period, principal at maturity
Loans with Fixed Principal Payments: Interest and fixed principal payments over life
Amortized Loan: Equal payments cover interest expense and reduce principal
Expected Portfolio : Find , treating portfolio as 1 stock (or below). CVp same
Portfolio Risk Premium based on market risk.
SD of a 2 stock portfolio:
Ordinary Annuity: Payments are made at the end of the period.
Annuity Due: Payments are made at the beginning of the period
2 +
2
2
Correlation
= w12Coefficient/Covariance:
1.0
Perpetuity: Infinite series of equal payments. PV = payment/interest rate.
(1 w1 ) 2 + 2w-1.0
p
1
1 (1 w1 ) 12 1 2
Growing Perpetuity: set of payments which grow at a constant rate each period and
If =-1.0, 2 stocks can form a riskless portfolio
Long Term Solvency Ratios (Financial Leverage): extent of relying on debt financing continue forever. PV = payment/(interest rate growth rate)
If =+1.0, there is no reduction of risk for the 2 stock portfolio
rather than equity. More debt means more likely to default
Long Term Debt Ratio = Long Term Debt/Long Term Debt + Total Equity
Effective Annual Rate (EAR): the actual rate paid (or received) after taking into
Times Interest Earned Ratio = EBIT / Interest (given what I earn, how much can it consideration any compounding that may occur during the year.
measures stocks market/systematic risk, shows volatility relative to market, indicating
cover my interests payable)
Annual Percentage Rate (APR): annual rate that is quoted by law. Period rate = APR / how risky a stock is if held in a well-diversified portfolio. Market is 1.
P/E Ratio: Price/Earnings how much investors are willing to pay for $1 of earnings
OR
Risk is the uncertainty associated with future possible outcomes.
Investment risk is the potential for investment return to fluctuate up and down
Standard deviation measures stand-alone risk of an investment
Using Historical Data: Ravg = Arithmetic mean (avg annual return) Rt = realized ROR
Coefficient of Variation CV better measure of risk
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Chapter 5 Risk and Return II
Risk-Return Trade-off for a portfolio is measured by portfolios expected return and
standard deviation (volatility of the portfolio)
Diversification involves investing in different asset classes and sectors. It reduces
variability of returns without equivalent reduction in expected returns.
Well Diversified Portfolios have very little unsystematic risk. Risk = systematic risk
Buying or Selling bonds before maturity can result in gains or losses outside coupon
Bonds of similar risk & maturity will be priced similarly regardless of coupon
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Price
Vs
YTM
Assets below SML are overpriced and assets above SML are underpriced
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Capital Asset Pricing Model: equation describing SML. Appropriate return for risk
Higher
Unsecured
Subordinated
No Sinking Fund
Callable
Lower
Secured
Senior
Sinking Fund
Non callable
TIE Ratio
Where market portfolios and risk free assets are determined by CML, security factors
Yield To Maturity rate earned if bond is held to maturity. Rate at which cash flows are Current Ratio
are determined by SML. CML is superior to SML in measuring risk factors.
discounted to the present value. Interest rate required on a bond in the market.
When YTM > Coupon Rate, bond sells below par value - Discount Bond
Interest Rate rises, YTM increase, Bond prices decrease
When YTM < Coupon Rate, bond sells above par value - Premium Bond
Effect of Time on Bond Prices
Interest rate falls, YTM decreases, Bond prices increase
Holding a bond till maturity ensures repayment of principal as long as no default
1.
2.
3.
4.
5.
6.
Pure Discount Bonds: 0-coupon bonds, sold at discount (YTM comes from difference
between PV and principal sum) cannot sell more than par value. T bills
Floating Rate Bonds: coupon rate float depending on index such as inflation. Less price
risk. Coupon floats and unlikely to differ from YTM. Collar controlling rate
Disaster bonds: issued by property and casualty companies. Pay interest and principal
as usual unless claims reach a certain threshold for a single disaster. At that point,
bondholders may lose all remaining payments Higher required return.
LECTURE 4: Risks & Returns I
Income bonds coupon payments depend on level of corporate income. If earnings are
not enough to cover the interest payment, it is not owed. Higher required return.
Convertible bonds bonds can be converted into shares of common stock at the
bondholders discretion Lower required return
Put bond bondholder can force the company to buy the bond back prior to maturity
Lower required return
Structure of Interest Rates: r/s of time to maturity and yields ceteris paribus
Does not include effects of default risk, different coupons
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Fischer Effect:
1+Nominal Rate = (1+real rate)(1+inflation)
Approximation:
Nominal Rate = Real Rate + Inflation