Intermediate Corporate Finance
FIN 302
Dr. Kelly R. Brunarski
Fall Semester, 2009
Office: 3123 FSB
Office Phone: 529-1564
Office Hours: Tues. 10:30-11:45 (RM 3123) & Tues. 3:30-4:10 (RM 32);
& Thurs. 3:30-4:10 (RM 32)
Email:
Text: Principles of Corporate Finance by Brealey, Myers and Allen (9th ed.)
Webpage: www.sba.muohio.edu/brunarkr/302.htm
Objectives:
1) To discuss risk and how it is priced for both financial and real assets
2) To provide students with techniques to make decisions involving advanced capital budgeting scenarios including:
a. Recognition of appropriate cash flows to discount
b. Evaluation of project risk
c. Decisions regarding mutually exclusive projects with unequal lives
d. Sensitivity analysis and Monte-Carlo simulations of cash flows
e. Real Options
3) To discuss methods of effective corporate governance.
4) To discuss methods of executive compensation and the risk-taking incentives they can create
5) To understand reasons underlying the choice of debt versus equity in the firm’s capital structure.
6) To investigate the relationship between capital structure and the cost of capital
7) To examine the reasons that firms disburse cash to stockholders, different options for cash disbursements, and the implications of the payout decisions for the both the firm and investor
8) To discuss venture capital and how and why firms should issue various types of debt and equity instruments
9) The discuss reasons underlying mergers and acquisitions, as well as the methods firms or investors use to gain control of other firms.
Graded Materials and Final Grade Determination:
There will be three exams; two non-comprehensive midterms and a comprehensive final. The exams will be closed-book. Formula sheets will be provided for both midterms. You are permitted to bring one 8.5” x 11” sheet of notes – both sides - containing anything you want for the final exam only. Extra credit may be available through out the semester, and any extra credit points will be added to a designated exam score. Your final grade will be determined as follows:
Midterm I 25% or 35%* Tuesday, Sept 29th
Midterm II 25% or 35%* Tuesday, Nov 3rd
Final Exam 40% 2:15 section: Tues 12/15 3-5PM; 4:10 section: Thurs 12/17 3-5PM
*Your highest midterm score (including any extra credit) will be weighted 35%.
Attendance:
You must attend the section in which you are registered.
If you miss class, you are responsible for obtaining the missed notes from a fellow student. Missed exams may be made-up only if you provide documentation of one of the following:
1) Death in the family
2) Illness
3) Out-of-town interview
Other:
* Discussion questions / problems will be assigned periodically. Answers will either be provided in-class or on-line.
* Please turn off your cell phone ringtone during class. (This has been a particular problem with classes that meet later in the day!) Also, please do not text during class.
* Laptops may be used for note-taking purposes but may not be used to surf the web as this is distracting to students around or behind you in class.
* Make every effort to arrive on-time to class. Arriving late can be disruptive.
* Due to seating limitations, you must attend the 302 section in which you are registered.
* NO food is permitted in the classrooms. Only (plain) water is permitted as a beverage.
Chapters / Topics: (Order of topics may be subject to change)
1-5 (Review) Various topics (especially 2.3, 4.3,4.5)
8 Risk, return and the OCC
9 Risk and return, CML, SML (review)
10 Capital budgeting, risk and international projects
11 Capital budgeting sensitivity analysis & Monte-Carlo simulation
6 & 7 Evaluating projects with unequal lives / Capital budgeting and cash flows
23 Valuing projects with real options
13 Agency costs & corporate governance
17 Dividends & payout policy
18 &19 Debt policy / capital structure
16 How and why corporations issue equity securities
25 How and why firms issue various types of debt or hybrid securities
32 Mergers & Acquisitions
34 International corporate governance (if time allows)
Intermediate Corporate Finance
Fall Semester, 2009
Chapter 1-5 Review
Goal of the Manager of the Firm:
a) Maximize shareholder wealth
b) Minimize risk
c) Maximize profits (max dividends; max after-tax cash flows over time)
d) Maximize his or her salary
e) All of the above
f) All of the above, except d
Are these valid objectives?
Minimize Risk:
Maximize Profits:
What is S/H wealth and why does it weigh the risk/return trade-off?
Stock Price = PV of future expected dividends. Why not include stock price appreciation?
Summation formulas:
T
P0 = ∑[Dt/(1+r)t] + PT/(1+r)T (1)
t=1
P0 = D1 / (r –g) (2)
r =
g =
– Dividends reflect return (in dollar metric)
– Discount rate of divs, r, reflects risk of______.
Another formula for Stock Price:
P0 = EPS1 / r + PVGO (3)
EPS1/r = capitalized value of earnings with no-growth policy
PVGO = NPV of growth opportunities (per share)
Example:
Prior stock price = $50
1-million shares outstanding
Managers accept a project with an NPV of $10 million.
Stock price when S/H’s learn about the project?______
When will the stock price react, assuming that the s/h’s correctly value the project?
a) When rumors circulate about a positive NPV project available to the firm
b) When the S/H’s learn of mgmt’s decision to accept the project
c) When the project is “officially” accepted (done deal: contracts signed, etc)
d) When the cash inflows from the project occur
Recall that P0 = EPS1 / r + PVGO. Can stock price ever be less than EPS1/r?
Such firms can become takeover targets. Why?
What about the interests of other stakeholders of the firm. Other than stockholders, who has an interest in the firm’s continued success?
What is the best goal if maximizing shareholder wealth conflicts other stakeholder interests?
Percentage of firms in the given country that claim shareholder dividends come before job security of employees: (figure 2.3)
• France
• Germany
• UK
• USA / • 3% dividends
• 40% dividends
• 41% dividends
• 89% dividends
• 89% dividends
Why is it important for US firms to understand corporate objectives for firms located in other countries?
Chapter 8: Risk, Return & the Opportunity Cost of Capital (OCC)
Chapter 8: Practice Questions: 11, 12, & 22
Discount rates should reflect the project’s risk….but what kind of risk?
– Market risk?
– Business risk?
– Total risk?
How would you define the investor’s risk for a given investment?
____T-bills
____Government bonds (long-term)
____Common stocks
Which is riskier: Typical corporate bonds vs. long-term gov’t bonds?
Small firm stocks vs. avg firm stocks?
The Value of an Investment of $1 in 1900:
The Risk Premium (RP): Required rate in excess of the risk-free rate (to compensate for added risk).
Add to RF rate to get a discount rate for projects, or use market risk premium and project beta.
Historical average (1900-2000) for stocks:
Use arithmetic averages, not compound rates of return
Stock return = 11.7%; T-bill rate = 4.1%;
RISK PREMIUM for stocks = 11.7-4.1 = 7.6%
RP estimates differ; range: 5-8%
RP’s vary by country; from 4.3% in Denmark to 10.7% in Italy.
Do Risk Premiums vary over time?
• Why would they?
– Reduced risk from availability of international investments
– Access to mutual funds (pension funds)
• Why wouldn’t they?
– Investors do not diversify internationally as much as they should.
– No reason to expect stocks are getting riskier over time.
What effect do higher interest rates or expected inflation have on stock returns?
…On stock prices?
• CAPM: E[Ri] = Rf + i [E(Rm) – Rf]
• If risk premium is assumed constant, what effect will higher interest rates have on the expected return of stock i?
• What happens to stock prices, in general, when interest rates go up?
• How can returns on stocks increase if stock prices fall?
Definitions:
Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments.
Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk”, “unsystematic risk” and “business risk”
Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk” and “undiversifiable risk”.
Is there a limit to risk reduction that can be achieved through diversification? Can we reduce all risk (variability) by adding different types of investments to our portfolio?
Note: Greater risk reduction going from 1 to 2 securities, than from 5 to 6 securities.
Chapter 9: Risk and Return, The CAPM, The SML, Other Models
Recommended problems Chapter 9: 6, 7, 8, 15 (not part a); challenge question 1
When and why is diversification desirable?
Individual perspective:
Corporate perspective:
Question: An investor fails to diversify her portfolio. She earns returns on this undiversified investment based on:
a) Total Risk
b) Unique (business) risk only
c) Market risk only
What do YOU think?
An investor diversifies her portfolio nationally, but holds no foreign stocks. Her expected portfolio returns are based upon:
A. The amount of risk in her portfolio assuming she had diversified to the fullest extent, internationally
B. The amount of risk in her portfolio based on the amount of typical international diversification for investors within her country
C. The amount of risk based on market risk within her country only
Firms in countries whose investors fail to diversify internationally have a higher cost of capital (b/c their cost of equity is higher)
This can make firms less competitive …higher WACC means more available projects are negative NPV.
Stock Return Distributions
INVESTMENT A & B (respectively)
% return
INVESTMENT C
Assume A and B have equal expected returns. Which is preferable, A or B?
Which has a greater variance, A or B?
Which has a higher beta, A or B?
Which offers the higher expected return, B or C?______higher beta?______
Of A, B or C, which would be reasonable investments to recommend, assuming the investors will not diversify further?
If we assume the investor is fully diversified, which is preferable?
Return Distributions:
Ø Stocks: symmetric, normal distributions
Ø “flatness” of distribution indicates risk (std dev).
Ø Mean return can be used to infer market risk (beta); (higher E[ret], higher beta.)
Ø Non-symmetric distributions (skewed distributions):
Do Investors prefer (right / left) skewness?
What types of investments could have a skewed distribution?
Project, firm or stock correlation:
You combine a low risk stock with a high risk stock* (50% invested in each) The resulting risk of the portfolio will be______
a) Between that of the high and low risk stocks
b) The average of that of the high and low risk stock
c) Less than that of the low risk stock
d) Potentially a, b or c
Implications for project risk:
Query: You are considering a project that is riskier than your firm’s average project (i.e., higher variance of after tax cash flows). Will the addition of the new project increase the overall risk of your firm or decrease it? Is it possible to know with certainty from the above information?
Now assume that the risky project is negatively correlated with the other lines of business in our firm? Can we know whether the new project will increase or decrease the overall risk of our firm?
MUST the new project be negatively correlated to reduce the overall risk of our firm?
Will the addition of a new, higher-risk project increase our firm’s equity beta?
Portfolio return = weighted average return of all stocks in the portfolio =
x1 E[ret1] + x2 E[ret2]
Portfolio variance is the sum of the following boxes: (“x” is the % of the money invested in stocks 1 and 2.)
Example
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The expected return on your portfolio is:
Assume the same example above: The standard deviation of Exxon and Coca Cola’s annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.
• Lending or Borrowing at the risk free rate (rf) allows us to exist outside the efficient frontier.
Led to development of CAPM:
Best investment is some % in tangency portfolio (M), and rest in risk free asset or engage in riskless borrowing
Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market.
Beta - Sensitivity of a stock’s return to the return on the market portfolio.
What is done with the borrowed money (to obtain a point on the CML above M)?
Return exg:
RM = 20%; Rf = 5%,
$100 borrowed, $100 own
Ret = ($ ret on M – $ int) / own $
SML: Plot of the CAPM:
Diagram:
Intercept:
Y-axis:
X-axis:
Slope:
.
Stocks (investments) that plot above the SML are:
a) overvalued
b) Undervalued
c) neither
What can we learn from the SML?
• Overvalued / Undervalued investments (Can use with project betas as well as equity betas).
• Illustration of undiversifiable risk & beta
• Do returns plot, roughly around the actual SML? (If not, evidence against the CAPM)
– Purists would say that you can’t test a model that measures expected returns by plotting “actual returns.”
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