How does a company grow money? 1) Debt 2) Equity 3) Retained Profits. Who finances?

1) Stockholders (get dividends) 2) creditors (get interests). Companies can raise cash to
T = number of years for
finance their investment activities by selling/issuing securities to financial markets: 1)
future expectations
bonds, if they’re debt 2) stocks, if they’re equity (2 ways of getting money from a stock:
(for past data, use T-1)
1) dividends - how much I will receive at the end of the year for the stock 2) appreciation –
increase price of stocks, then we can sell them and gain the difference).

Notes: 1) As the creditors are paid sooner, their risk is smaller. 2) If we Diversified Portfolio (contribution of each security to the expected return on risk of the
have too much debt, EBIT goes up (increase interests) and we’ll be working portfolio)
to pay our debts. 3) COGS – costs of goods sold; SGA – administrative costs; BETA – only about systematic risk! Everything that has to do with the market (e.g. new
Dep. – depreciation and amortization; Int. – interests on our debt; retained
drug patented or CEO leaving are under unsystematic risk)
earnings – profit that we reinvest in the company.

TIME VALUE OF MONEY 1) An euro is worth more today that it will

tomorrow (due to inflation and interest rates) 2) a higher risk needs a
higher interest 3) when we consider an investment we have to factor in our alternatives - covariance (how 2 assets move
(opportunity costs – our 2nd best alternative) 4) we have to perform all calculations at the together)
same point in time (in order to compare them)… so we have:
- correlation (standardized measure for covariance (-1 to 1) but with correlation we cannot
know which asset causes the change of the other 1) +1 both returns on stock A and B are
1) FUTURE VALUE (compounding)
higher/lower than each respective average at the same time, 2) -1 one has a higher than
- if the compound is semiannual, we divide the r by 2 - r=interest rate=opportunity
average return when the other has a lower than average return and vice-versa, 3) 0 the
cost
return on security A is completely unrelated to the return on security B.

2) PRESENT VALUE (discounting)

CAPM (Capital Asset Pricing Model)

Expected return = risk free + beta x (expected return on the market

– risk free)
if… - we’re only taking the systematic risk so this should be the minimum return we’d get
- if the volatility is high, the beta tends to be higher, so we will demand a higher return
(when the PV is calculated for a period later
than the preceding the one in which the 1st cash flow occurs) CAPITAL STRUCTURE Decisions about the CS of a firm involve the selection of the
sources of financing and the proportions of debt and equity
INFLATION 10% may seem like a good return, but we have to consider the effects of
inflation (if it is 20%... MODIGLIANI-MILLER
10% of AIR would be 1) Without taxes… the value of a company would depend only on the profitability of its
bad). assets
- Proposition I: VL = VU (levered, company with debt = unlevered, company without
Rr = real interest rate Rn = nominal interest rate i= debt)
inflation rate Leverages add no value to the investor
- Real cash flow must be discounted at real int. rate; nominal cash - Proposition II: RS = RO + B/S x (RO – RB) R 0 = cost of capital for an
flow at nominal int. rate; ALL-EQUITY firm (R0 = RWACC)
either approach will yield the same NPV RWACC = [ B/(B+S) x RB ] + [ S/(B+S) x RS ] RB = cost of debt
(bonds)
BONDS are a form of debt (it is a certificate showing that the borrower owes a specific RS = cost of equity (stock)
sum; if I lent money to a company, it will issue me a bond and will pay me a certain
interest, and at the end will give me back the money I lent). TYPES: 1) With taxes
1) pure discount bond (or zero d.b.) – pays no coupon rate, only a single payment at a fixed - Proposition I: VL = VU + TCB (T CB is the present value of all taxshiel) – stands for
future date (a treasury bill or T-bill is a pure d.b. of government that will mature in 1 year or a firm with perpetual debt
less and is risk-free)
- Proposition II: RS = RO + B/S x (1 – TC) x (RO – RB) (1 – TC) is the tax shield

2) level-coupon bond – offers regular cash payments, not just at maturity but also at
regular times in between (these regular payments = coupons)

3) consols (perpetuity) – have no final maturity date and never stop paying a coupon

Whenever the coupon rate = interest rate, then the bond’s present value = its face
value. (bond is traded at its face value):
1) when coupon rate = YTM, price =
face value
2) when coupon rate > YTM, price >
face value
3) when coupon rate < YTM, price <
face value

All else being equal… 1) a bond with longer maturity has a higher relative price change (%)
than one with a shorter maturity, when YTM changes – the cash flows will be more eroded
by time 2) a lower coupon bond has a higher relative price change (%) than a higher
coupon rate, when YTM changes.

VALUING STOCKS 1) an asset’s value is determined by the PV of its future cash

flows 2) a stock has 2 types of cash flows:
1) Dividends – the Dividend Growth Model

- Perpetuity zero growth

- Perpetuity constant growth
- Differential growth
(≠rates → g1,g2)
g = retention ratio x return on retained earnings (ROE – hi storical return on
equity)
retention ratio = retained earnings / net income

2) Capital gains – selling stocks

RISK & RETURNS

1) Total return = Dividend income (%) + Capital Gain (%)

2) Holding period returns (total return for any given

interval of time)  e.g. 3 years returns: 11%, -5%, 9%
HPR = 1€ x (1+r 1) x (1+r2) x
1+r3) =
= 1€ x (1,11) x (-1,05) x
(1,09)

1 Security (1 single asset)

- average/expected return – describes the past annual returns on the stock market over
a period of time

- variance/standard dev. – characterizes the distribution of returns relative to the

expected return and its risks
1security 2 securities Var(portfolio)