Fin 2004 - Market Equilibrium
Autor: ptlsisptls • July 6, 2018 • Course Note • 4,408 Words (18 Pages) • 447 Views
Callability: Issuer redeem bond before maturity (risky) Putability: Buyer redeem bond b4 maturity (During High IR environment) Seniority: Preference in lender position (opposite: Subordinate) Debenture: Unsecured. By general credit and repmt ability (No collateral) Basis Points: 0.12 = 12 basis points Convertibility: Bond → Stock Protective Covenants: Limits certain actions of company Sinking Fund: Set aside for bond payment at maturity overtime. ↓ CR risk Bond Indenture:Contract. Terms, amount, security, sinking fund, protective Bond Value = PV of coupons + PV of par = PV annuity + PV of lump sum [pic 1] Overall Rate of Return = (Annual Coupon + (Current Price – Beg Price of Bond))/ Beginning Bond Price Calculating PV of bond: FV = 1000, I/YR (Discount rate rD), PMT (Coupon) 1. Coupon Rate > Discount rate = Price > Par → Premium 2. CR < DR = Price < Par → Discount, 3. CR = DR, Price = Par YTM: Rate earned if held to maturity, discount rate of all future CF to current price, market rate for bond = required rate in market, yield in short. Calculating YTM: Use N, PV (opposite sign), PMT and FV must same sign. YTM Semi-annual coupons: Must divide PMT, multiply N and I/R (result) Current Yield: Annual interest paid by bond (Interest/Market price) % Why not look at CR to determine bond’s yield? Bond price can change as to market. Not always at par. Only at par, YTM = Coupon Rate. YTM and Bond Price Relationship: IR increase, bond’s PV decrease, VV. YTM increase, bond price decrease. 1. Coupon Rate < Current Yield < YTM → Discount Bond 2. Coupon Rate > Current Yield > YT → Premium Bond 3. Coupon Rate = Current Yield = YTM → Par Value Bond Pricing Theorems Bonds of similar risk and maturity will be priced to yield about the same return (YTM), regardless of coupon rate Factors affecting Default Risk & Bond Ratings: Financial Performance (Debt ratio, TIE, CR) and indenture (Security, senior, sinking fund, maturity) Government Bonds (Treasury Securities) 1. T-bills – pure discount bonds (0 coupon bonds) with original maturity <1Y 2. T-notes – coupon debt with original maturity between 1-10Y 3. T-bonds - coupon debt with original maturity >10Y Floating Rate Bonds: Coupon rate float on index value (LIBOR?) Taxable Bond: Coupon Rate (1-tax) Other Bonds: Disaster, income, convertible, put Term Structure of I/R: Relationship between time to maturity and yields Normal: Upward Sloping; LT yield > ST yield Inverted: Downward Sloping: LT yield < ST yield Factors affecting Bond Yields: Real rate of interest, expected future inflation, interest rate risk, default risk, taxability, lack of liquidity L7: Stock Valuation: Intrinsic value of an asset depends on: – Size and Timing of the expected future cash flows. – The individual’s required rate of return (depends on risk/return, preferences, returns on competing investments, inflation, tax rates) Price of a stock is the present value of all expected future dividends/CF [pic 2] 1. Constant Dividend (Zero-Growth Dividend) Perpetuity – Constant dividend forever. Perpetuity formula for P. Divide % for quarter 2. Constant Dividend Growth (Stable Growth) Growing Perpetuity – Constant % increase every period[pic 3] - Firms with LT stable G rate = LT nominal G % (GDP real G + INF) Price↓ Growth Rate ↓ RR ↑ (rE > G) →R/S General Dividend Discount Model (DDM) / Gordon Growth Model: Cannot use model unless rE > g and unless g expected to be constant forever. [pic 4] Price grows same rate as dividends. Eg: D2 = D1 (1+g) or D0 (1+g)2 3. Supernormal Growth (Non-constant Growth) – Not constant becomes constant - the PV of all expected future dividends For different RR rates: 1) Compute dividends at each level with each rE (e.g. Y1 – Y3 10%, Y4-Y6 12%, constant 5% after) 2) Find expected price at Y3 (D4/ (rE-g)) and Y6 (D7/ (rE-g)) rE use next’s 3) Discount back dividends and price Y6 to Y3 then Y3 to Y0 = PV For different growth %: Calc div yearly till growth lvls off & discount back |
In equilibrium, Required returns (CAPM) = Expected returns [pic 5] = [pic 6] rE: from estimating dividends and capital gains. rE implied by the asset’s expected future cash flows and current price. If expected return>required return, price is too low → BUY. (above SML) Changes in Stock Price due to: - rE change (inflation) or g Δ (macroeconomic/firm-specific situation) Corporate Value Model Value of the entire firm = PV of the firm’s free cash flows (future CFFA) 1) find PV of firm’s future CFFAs 2) Minus MV of firm’s debt & preferred stock to get MV of common stock. 3) Divide MV of common stock by no. of shares outstanding to get intrinsic price per share. [pic 7] Enterprise Value: MV of Equity + Debt – Excess Cash (Acquire co cost) L8: Capital Budgeting I Capital Expenditure: $ on FA used for production Capital Budgeting: Deciding how to allocate scarce capital resources to inv alternatives Over-riding Rule: Accept if cost Good Decision Rules: TMV, Adjust for Risk, Creating value for firm? NPV: No ranking problems like other CB techniques (IRR, PB, DPB, PI) 1. Estimate expected future CF - Amount and timing (Use time-line) 2. Estimate RR for projects of this risk level (may use CAPM) 3. Find the PV of the cash flows and subtract the initial investment (CF0) [pic 8]Rule: Accept proj if NPV>0 Intrinsic value = NPV – Cost. +ve NPV = Cash in > cash out = add value Payback period: No. of years to recover initial costs Step: Estimate CF and add future CF to initial cost till recovered Accept if the payback period is less than some preset limit ADV: Easy to calculate/understand, adjusts for uncertainty of later cash flows, biased towards liquidity DISADV: Ignore TMV, require arbitrary cutoff point, ignore CF past certain point, biased against long-term proj such as R&D/new projects. Discounted payback period: Compute PV of each cash flow and then determine how long it takes to payback on a discounted basis (At Y0) Accept if pay back on a discounted basis within specified time ADV: Include TMV, easy to understand, does not accept negative estimated NPV investments, biased towards liquidity DISADV: May reject positive NPV investments. Same as payback disadv Average Accounting Return: Average net income / average book value. Accept if the AAR > Required AAR (determined arbitrarily). ADV: Easy to calculate, needed info is easily available DISADV: Not true rate of return, ignore TMV, arbitrary benchmark cutoff rate, based on acc net income/book values not cash flows or intrinsic/market value Internal Rate of Return (IRR) Return making NPV=0. Enter all CF <2nd> Accept the project if the IRR is greater than the required return. ADV: Knowing return is intuitively appealing, simple way to communicate value of a project, If IRR is high enough, may not need to estimate RR NPV vs IRR: Same result unless mutually exclusive project (different time and initial investments) or non-conventional cash flow (positive and –ve CF) →IRR unreliable. NPV measures increase in value. NPV > IRR NPV profiles: Calculate NPV & keep changing i/r. Plot computed NPV. Slight curve. 2 projects’ NPV profiles cross due to: size & timing diff. Crossover point is the IRR of the differential cash flows. Step: - CF of every year of A from B. Use difference of CF find IRR (NPV=0) Reinvestment Rate Assumptions NPV assumes CFs reinvested at WACC (Opp Cost of Cap). IRR assumes CFs reinvested at IRR. NPV method more realistic, better for MUTUALLY EXCLUSIVE proj. Hybrid of IRR that uses WACC = MIRR MIRR (PV outflows = TV inflows/ (1+MIRR)n Discount rate that makes a project’s TV = the PV of its costs TV = compounding +ve project inflows at WACC to date of maturity. |
ADV: MIRR correctly assumes reinvt at OC (WACC) & no multiple IRR Profitability Index (Benefit/unit cost, based on TMV) PI 1.1, $0.1 for $1 inv [pic 9] = Benefits/costs. Decision rule: Accept if PI > 1 Useful during limited capital ADV: Closely related to NPV, easy to understand and communicate, useful when available investment funds are limited DISADV: May lead to incorrect decisions in comparing mutually exclusive investments (NPV bias to size) Tutorial: NPV of stock vs bond. NPV of stock = PV of Div/Future CF – initial cost. Efficient market (equilibrium), initial cost = PV, NPV = 0. NPV of bond = PV of principal + coupon payments – initial cost. EQUIL. cost = PV, NPV =0. L9: Capital Budgeting II Sunk costs, dividend and int exp irrelevant, never include in CF. [pic 10] Bottom up (no i/r): NI + Depreciation Top down (no i/r): Sales – costs – taxes Tax Shield: (Sales-costs) (1-T) + Depreciation (T) →↑cash (↓tax) Depreciation tax shield = D*T. Full Depreciation: Initial cost/ years. SV: (Initial – SV)/ years Net Salvage Value S > B (gain): S – T*(S – B) → Pay tax on gain B > S (loss): S – -T*|S – B| = S + T*|S-B| → Tax savings Mutually Exclusive Unequal Life Projects (Equivalent Annual Annuities (EAA)/ Equivalent Annual Cost (EAC)) 1) Calculate NPV of each project 2) Calculate EAA: Input NPV as PV, N, I/Y and 3) Select the higher EAA. For cost, select least negative EAA. *assume indefinite repeating proj: common life span. Ignores inflation, econ conditions, unreliability of future CF, tech affecting CF, diff in initial inv size OCF: calculated from NI and DEPN. Terminal NCF = NSV + Changes in NOWC (return/inflow) + OC Replacement project[pic 11] (only look at incremental CF). Pro-forma → Incremental cost savings, depreciation (new-old), Y0: Cost – NSV in (old) = NCS (out) Y5: NSV out (old) = opp cost (old) NSV (new) = inflow at Y5, last year Rental OC: Initial cost, minus this after-taxed OC 1-T) from NCF Impact of Inflation Expected annual inflation → may cause bias for NPV if inflation is not incorporated into the cash flow. Will create a downward bias on PV. Inflation will affect Revenues. Use Calculator to find inflated values L10: Financial Planning and Forecasting Investment, degree of fin lev, liquidity req, cash paid to SH (Div) Pro-forma Statements (I/S and B/S) Change in sales → B/S (Change FA, CA) → I/S (Change costs) Notes payable, LTD, Equity do not vary with sales (depends on mgmt) → Flexible, allow different items to grow at different rate. → Remember to add in retained earnings from new NI to equity! * TA > TL + E || External Financing Needed: →Borrow ST (Notes), LT Debt, sell common stock, decrease dividends AFN Equation (Additional Financing Needed Equation) Assume: Full capacity firm, Constant PM, Div Payout/ RR, Cap Structure [pic 12] Spontaneous ↑ in Assets – Spontaneous ↑ in Liabilities – ↑ in R.E. A*: Spon Assets, S0: Current sales, S1: Coming sales, ΔS: S1 – S0 L*: Spon Liabilities, M: PM (Original Net income/ O.Sales), RR: (1 – Div %) TA < TL + TE || Operating at Less than Full Capacity: 1) Full capacity sales? Current sales/current capacity % 2) Estimated sales: > (1): need additional FA. <(1): no need addition FA Repay ST, LT debt, buy stock, pay more dividends, increase cash acc IGR: Assuming L* = 0! (ROA x b)/ 1 – (ROA x b) How much firm can grow assets using RE as only source of financing where b = RR ((NI-Div)/NI) Sustainable Growth Rate: L* = 0! (ROE x b)/ 1 – (ROE x b) How much the firm can grow using internally generated funds and issuing debt to maintain a constant debt ratio. |
ROE = PM * TATO * EM TATO: 1/ (A/S) = Sales/Assets → asset-use efficiency EM: A/E = L/E or (D/E) + E/E (1) PM: operating efficiency How excess capacity affects AFN and ratios New AFN: Old AFN – projected increase in fixed assets Assets lower (better turnover), lesser new debt → lower interest → higher profits (EPS, ROE increase), Debt ratio and TIE improve Insufficient Capacity for Increased sales Target ratio = FA/Max capacity Sales Required FA = Target Ratio * New Excess Sales L11: Working Capital Management Gross working capital: Total CA. Net WC: CA - CL WC Policy: decide level of CA to hold & financing it ($, inv, receiv mgmt) Sources and Uses of Cash: E + LTL + CL – other CA - FA Source: ↑ LTL, E, CL. ↓ FA, other CA Use: ↓ LTL, E, CL. ↑ FA, other CA The Operating Cycle [pic 13]
Operating cycle: time between purchasing inventory and collecting the cash from selling the inventory. Inventory period – time required to purchase and sell the inventory. Accounts Payable Period: time between purchase of inventory and payment for the inventory Cash Conversion Cycle: Difference between when we receive cash from the sale and when we have to pay for the inventory. Time period for which we need to finance our inventory. CCC = OC – AP period = Inventory period + AR period – AP period Minimize the cash cycle → minimizes the amount of external financing the firm has to raise to fund current operations. Carrying vs Shortage Costs Carrying costs ↑– ↑CA, costs to store and finance it Shortage costs ↓ – ↑CA, the costs to replenish assets, trading or order costs, costs due to safety reserves (lost sales, cust and prod stoppages) Why hold cash? Transactions (cash to operate), Precaution (safety stock, reduced by line of credit and marketable securities. Compensating balances (for loans/ services provided. Speculation (take adv of bargain, discounts.) Minimizing Cash Holdings (Goal of Cash Manaagement) ↓ need for safety stock of cash by: Increasing forecast accuracy, holding marketable securities, negotiating a line of credit & Managing float Float [Available balance at bank – book balance] Collection float: Chq received ↑ book before bank (Daily Pmt * Days) Net float = Disbursement float + Collection float • Size of float depends on $ & collection delay (mailing time + processing delay + availability delay). Goal of float mgmt: ↓collection delay Average Daily Float: (delay)*(cheque)/30 Total Amount unavailable to earn interest: Delay * Avg Daily Receipts Managing Cash Disbursements: Slowing down payments, controlling disbursements (Zero-balance account, controlled disbursement acc (deposit $ on day of disbursement) Stretch out AP as much, negotiate terms with vendors, turn receivables ASAP, easier payment methods (lockboxes, pp envelope, discounts) Managing float: Lockbox, insist wire transfers, remote disbursement acc Cash Budget: To forecast cash inflows, outflows and ending cash balance used to plan loans needed/funds avail. to invest Howdy co has a beg cash balance of $200 on Jan 1. Sales of $600 in dec, projected sales of 1200 in jan, 800 in feb. COGS =7 0% of sales. Goods r purchased 1 mth prior to month of sale. AP period 30 days, AR period 10days. Additional monthly cash exp of 300. Whats the projected ending cash bal @ end of jan? Jan collections= 10/30 (600) + 20/30 (1200) = 1000, Jan disbursements for payables: 0.7 (1200) = $840, Jan ending cash balance: $200 + $1000 - $840 - $300 = $600 Accumulation of Receivables: Depends on volume of sales and length of collection. AR = Credit sales/day * Length of Collection period Aging schedules: Breakdown receiv by age (1-30 day, 31–60 day) Elements of CR Policy: CR period, disc, CR standards, collection policy Effects: Revenue (Delay, increase price, sales) Cost (bad debt, disc, cost of debt (receivables), cost of sale incurred when cash not received)
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