COMM 121 Chapter 1 1. Capital budgeting 2. Capital structure

COMM 121
Chapter 1
1.1 What is corporate finance?
1. Capital budgeting: the process of making and managing expenditures on long-lived assets
(capital expenditure) – left side of balance sheet
2. Capital structure: the proportions of the firm’s financing from current and long-term debt and
equity – right side of balance sheet
- V (value) = B (bonds) + S (shares)
3. Net working capital: (current assets – liabilities) the mismatching of cash inflows and outflows
- Financial managers: create value from firm’s capital budgeting, financing, and liquidity activities
- Timing of cash flows: one dollar received today is worth more than one dollar received next
year because today’s dollar can be invested to earn interest
1.3 The Corporate Firm
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Partnership & Sole Proprietors: advantage = cost of getting started, disadvantages = (1)
unlimited liability (2) limited life of the enterprise (3) difficulty of transferring ownership
Corporation: difficult to start- become their own citizen of its province of incorporation
o Shareholders (the owners)
o Directors
o Corporation officers (top management)
Income trusts: hold the debt and equity of an underlying business and distribute the income
generated to unitholders
1.4 Goals of the Corporate Firm
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Shareholders and managerial interest conflict – pricey to enforce agency costs
Managers: survival, independence, and self-sufficiency (corporate wealth)
Stakeholder concerns are attaining additional clout through the growth of interest in ethical or
socially responsible investing
1.5 Financial Institutions, Financial Markets, and the Corporation
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Financial institutions: intermediaries between investors and firms raising funds
Money markets: where short-term debt securities of many varieties are bought and sold
Capital markets: for long-term debt and shares of stock
Primary market: the corporation is the seller and raises money through the transaction
Secondary market: one owner or creditor selling to another (auction and dealer markets)
Foreign exchange market: where one country’s currency is traded for another’s
1.6 Trends in Financial Markets and Management
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Hedgefunds: collective term for different types of investment funds
Chapter 4
4.1 The Financial Market Economy
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Market clearing: the total amount one party wishes to lend equals the total amount that the
others would like to part
Equilibrium rate of interest: an interest rate that clears the market ç
4.3 The Competitive Market
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Assume Perfectly competitive financial markets: trading is costless, borrowing and lending is
readily available, the single trader can have a significant impact
4.6 Illustrating the Investment Decision
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Net present value rule: an investment is worth making if it has a positive NPV
Chapter 5
5.1 The One-Period Case
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Future value (compound value): the value of a sum after investing over one or more periods.
Present value (PV): C1/(1+r) where C1 is cash flow at date 1 and r is interest rate
Net Present Value of Investment = cost today (negative) + present value of next year’s sales
price
5.2 The Multiperiod Case
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Compounding: the process of leaving money in the capital market and lending it for another
year
Simple interest: rx is interest on interest
Compound interest: each interest payment is reinvested
Future Value of an Investment: FV = C0 x (1+r)T where T is the number of period over which the
cash is invested
Discounting: the process of calculating the present value of a future cash flow
Present Value Factor: the factor used to calculate the present value of future cash flow
PV= (C/(1+r)x)
5.3 Compounding Periods
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C0(1+r/m)m where r is the stated annual interest at m times a year
Effective annual interest rate: the annual rate of return
(1+r/m)m – 1
Future value with compounding: FV = C0(1+r/m)mT for T years
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Continuous compounding: to compound every infinitesimal instant
C0 x erT
5.4 Simplifications
- Perpetuity: a constant stream of cash flows without end
- Formula for present value of perpetuity: PV = C/r
- Growing perpetuity: assuming that the rise will continue indefinitely
- Formula for present value of growing perpetuity: PV = C/ (r-g) where g is growth per period
- Annuity: a level stream of regular payments that lasts for a fixed number of periods
- Formula for present value of annuity: PV = C [(1/r) – (1/(r(1+r)T))]
- Annuity factor: the term we use to compute the value of the stream of level payments, C, for T
years
- Mortgages: annuity with monthly payments
- Growing annuity: finite number of growing cash flows
- Formula for present value of growing annuity: PV = C [ (1/(r-g)) – (1/(r-g)) X ((1+g)/(1+r))T]
Chapter 6
6.1 Definition and Example
- Bond: a certificate showing that a borrower owes specified sum
6.2 How to Value Bonds
- Pure discount bond: promises a single payment at a fixed future date
- Maturity date: the date the issuer of the bond makes the last payment
- Face value: payment of bond at maturity
- Value of pure discount bond: PV = F/(1+r)T
- Coupons: cash issued at regular times before reaching maturity
- Value of a level-coupon bond: PV = C[(1/r) + (1/(r x (1+r)T))] + F/(1+r)T
Or PV = C X
+ F/(1+r)T
- Clean price: quoted price net of “accrued interest”
- Dirty price: price actually paid that includes accrued interest
- Consols: bonds that never stop paying a coupon
6.3 Bond Concepts
- Trade at a face value of $1000 if he coupon rate is equal to the marketwide interest rate
- Trade at discount if the coupon rate is below the marketwide interest rate
- Trade at a premium if he coupon rate is above the market wide interest rate
- Discount: to sell the bond at lesser value
- Premium: to sell the bond at greater value
- Yield to maturity: percent return
- Holding-period return = (ending price – beginning price)/ Beginning price
6A Appendix
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Spot rates: different rates of interest over different years
Term structure: describes the relationship of spot rates with different maturities
Forward rate: hypothetically return the second year of a spot rate
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Forward rate:
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Amount bond is expected to sell for
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Expectation hypothesis: f2 = spot rate expected over year 2 . . . .the forward rate over the
second year is set to the spot rate that people expect to prevail over the second year
Liquidity-preference hypothesis: f2 > Spot rate expected over year 2. . . investors hold he riskier
two-year bonds, the market sets the forward rate over the second year to be above the spot
rate expected
f2 < Spot rate expected over year 2. . . introduces risk aversion
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6.4 The Present Value of Common Stocks
->
(
)
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P0=
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The value of a firm’s common stock to the investor is equal to the present value of all of the
expected future dividends
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Constant growth
6.5 Estimates of Parameters in the Dividend Discount Model
- Earnings nxt yr = Earnings this yr + retained earnings this year x Rtrn on retained earnings
o Divide by earnings this yr
o 1+g = 1 + Retention ratio x Return on retained earnings
- Return on Equity (ROE): the return on the firm’s entire equity, which is the return on the
cumulation of all the firm’s past projects
- Firm’s growth rate: g = Retention ratio x Return on retained earnings
- The value of the firm is infinite when g=r
- Payout ratio: the ration of dividends/earnings . . .r = Div/P0 + g
6.6 Growth Opportunities
- Value of a share of stock when a firm acts as a cash cow EPS/r = Div/r
- EPS: earnings per share
- NPVGO : net present value of growth opportunity
- Stock price after firm commits to new project: EPS/r + NPVGO
- to increase value (1) earnings must be retained so that projects can be funded, (2) projects must
have positive net present value
6.7 The Dividend Growth Model and the NPVGO Model (Advanced)
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NPVGO model: (1) net present value of a single growth opportunity, (2) the net present value of
all growth opportunities, (3) the stock price if the firm acts as a cash cow. Sum 2 + 3
6.8 Price-Earnings Ratio
- Discount rate is positively linked to the stock’s risk or variability
- A company’s P/E ratio is likely to be high if (1) it has many growth opportunities, (2) it has low
risk, (3) its accounting is conservative
Chapter 10
10.1 Returns
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Total earnings = dividend income + Capital gain (or loss)
Total cash if stock is sold = initial investment + Total dollar earnings
Dividend yield = Dt+1 / Pt = %
Percentage return = (dividends paid at end of period + change in market value over period)/Beg
market value
Capital gains yield = (Pt+1 – Pt)/Pt
Total return on investment = Rt+1 = (Divt+1)/Pt + (Pt+1 – Pt)/ Pt = %
10.2 Holding-period returns
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Canadian common stocks: the common stock portfolio is based on a sample of the largest
companies (in terms of total market value of outstanding stock) in Canada
U.S. Common stocks: this portfolio consists of 500 of the largest U.S. companies. The full
historical series is given in U.S. dollars and in Canadian dollars, adjusting for shifts in exchange
rates
Small stocks: this portfolio, complied by BMO Nesbitt Burns, includes the bottom fifth of stocks
listed on the Toronto Stock Exchange (XTX). The ranking is by market value of equity
capitalization- the price of the stock multiplied by the number of shares outstanding
Long bonds: this portfolio includes high-quality, long-term corporate, provincial, and
Government of Canada bonds
Canada Treasury bills: this portfolio consists of the Treasury bills with a three month maturity
10.3 Return statistics
- Frequency distribution: plots the histogram of the yearly stock market returns- height giving
number of sample observations in the range on the horizontal access
10. 4 Average Stock Returns and Risk-Free Returns
- Yield on T-bills the risk-free return over a short time
- Risk premium: excess return on the market portfolio: additional return resulting from the
riskiness of common stocks
Chapter 11
11.1 Individual securities
- Expected return: the return that an individual expects a stock to earn over the next period
- Variance: a measure of the squared deviations of a security’s return from its expected return
- Standard deviation: the square root of variance- standardized version of variance
- Covariance and correlation: a statistic measuring he interrelationship between two securities
11.2 Expected Return, Variance, and Covariance
- Var (R)= Expected value of (R- ̅ )2 (actual-expected return)
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SD(R) = √
Cov(RA,RB) = Expected value of [(RA - ̅ A) X(RB - ̅ B)]
Corr(RA,RB) = (Cov(RA,RB))/ (
Positive correlation: positively correlated
Negative correlation: negatively correlated
Zero correlation: uncorrelated
11.3 The Risk and Return for Portfolios
- Portfolio: combination of securities to hold
- The expected return on a portfolio is simply a weighted average of the expected returns on the
individual securities
- Expected return on portfolio = XA ̅ A + XB ̅ B where X are the portions of total portfolio in A or B
- The variance of the portfolio =
+ 2XAXB A,B +
- As long as < 1, the standard deviation of a portfolio of two securities is less than the weighted
average of the standard deviations of the individual securities
11.4 The Efficient Set for Two Assets
- MV minimum variance
- Opportunity set (feasible set): the investor can achieve any point on the curve by selecting the
appropriate mix between the two securities
- Efficient set: the curve for MV to riskier value
11. 5 The Efficient Set of Many Securities
- He variance of the return on a portfolio with many securities is more dependent on the
covariances between the individual securities than on the variances of the individual securities
11.6 Diversification: An Example
- Total risk of individual security (var) = Portfolio risk (Cov) = Unsystematic or diversible risk (varcov)
- Portfolio risk (systematic or market risk): is the risk that one still bears after achieving full
diversifications, which is cov
- Diversifiable, unique, or unsystematic risk: is that risk that can be diversified away in a large
portfolio, which must be (var-cov) by definition
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Risk-averse: avoiding risk
Mutual funds: pool funds from individual investors, allowing them to own units in large,
diversified portfolios