Intermediate Corporate Finance Fall Semester, 2012 REVIEW

Goal of the Manager of the Firm: a) b) c) d) e) f) Maximize shareholder wealth Minimize risk Maximize profits (max dividends; max after-tax cash flows over time) Maximize his or her salary All of the above All of the above, except d

Are these valid objectives?

Minimize Risk: Low risk can result in much lower returns and as a result a low profit.

Maximize Profits: Higher risk taken on

Need a performance measure that weighs the risk/return trade-offs.

What is S/H wealth and why does it measure the risk/return trade-off? S-T: Can be measured by price x # shares L-T: Must consider dividends in addition to above How does stock price weigh the risk/return tradeoff? To answer this, we need to examine stock price formulas.

Stock Price = PV of future expected dividends. Why not include stock price appreciation when we value of stock price? (I.e., Wouldnt you be willing to pay more for a stock that is expected to appreciate, compared to one that is not?) Todays price appreciation=PV of tomorrows dividends

STOCK PRICE FORMULAS :

T

P0 = [Dt/(1+r)t] + PT/(1+r)T
t=1

(1)Dividends reflect return (2)

P0 = D1 / (r g) r =Risk g =growth rate of dividends

Dividends reflect return (in dollar metric) Discount rate of divs, r, reflects risk of___________stock_________.

P0 = EPS1 / r + PVGO

(3)

EPS1/r = capitalized value of future earnings per share, with a no-growth policy (i.e., assuming 0 NPV investment opportunities) PVGO = NPV of future growth opportunities (earnings not reflected in EPS) on a pershare basis Example: Prior stock price = $50 1-million shares outstanding Managers accept a project with an NPV of $10 million. Stock price when S/Hs (shareholders) learn about the project?_________________

When will the stock price reflect a projects value? a) When rumors circulate about a positive NPV project available to the firm b) When the S/Hs learn of managements announcement that they plan to accept the project c) When the project is officially accepted (done deal announced: contracts signed, etc) d) When the cash inflows from the project occur e) a, b, and c f) All of the above? What are your assumptions?

Recall that P0 = EPS1 / r + PVGO. Can stock price ever be less than EPS1/r? Such firms can become takeover targets. Why?

Are only poorly-performing firms subject to takeover?

Sometimes a project is negative NPV for one firm, but + NPV to another.

Investing in positive NPV projects is one way that managers maximize shareholder wealth.

Are positive NPV projects plentiful in the economy?

When we discuss topics in capital budgeting, we will explore some of the sources of positive NPV.

You plan to become an investment analyst. Why might the topic of capital budgeting be important to you?

STAKEHOLDERS VS. STOCKHOLDERS Should management care about the interests of non-stockholder stakeholders in the firm? (Who are the non-stockholder stakeholders)?

Does maximizing non-stockholder stakeholder wealth transfer wealth from stockholders to these stakeholders? Explain.

Is maximizing S/H wealth the only sustainable goal in the long-run? Explain.

Some academics suggest that managers should jointly maximize (bondholder + shareholder) wealth. Failure to do so could result in the acquisition both the firm's stock and bonds by an outside party. Why? When you maximize shareholder wealth, don't you necessarily maximize bondholder wealth also? Can you think of any examples whereby stockholders might benefit at the expense of bondholders?

Discussion: To what degree can firms choose NOT to max S/H wealth? This answer to this question related to the degree of the firm's financial slack (define), protectionism (define), regulation, takeover barriers (define), competition.

financial slack: protectionism: takeover barriers:

Percentage of firms in the countries below that claim shareholder dividends come before job security of employees: (figure 1.3)

3 40 41

97 60 59 89 89 50 100 150

11 11 0
Dividends Job Security

% of responses

Is it important for US firm managers to understand corporate objectives for international firms? Explain.

It is not surprising that corporate objectives differ across the world, since corporate control and ownership differ. Some examples follow. Germany: Two-tiered boards of directors, a supervisory board and management board. Half of the supervisory board is elected by employees. Germany has high firm

ownership by financial institutions. France: High board representation by financial institutions (FIs), whereby the FI has a business relationship with the firm. Europe & Asia: Common to have family-control of the firm. Families control (but dont necessarily own) a large proportion of many Asian economies (I.e., Hong Kong: 10 largest family groups control 32% of the assets; Indonesia: 10 largest family groups control 58% of the assets. (See table 33.1.)

Chapter 7 & 8 RISK AND RETURN

Assignment: Chapter 7: 4, 5, 12, 13, 19 & Page 184 (Real Time Data analysis) #1 (parts a c) Use Yahoo Finance for the data.) Also, from Yahoo finance, obtain monthly returns for the same three companies for 2005, through 2007 How does your standard deviation of returns for firms in 2005-2007 compare with the most recent three years of data for the same firms? Assignment Chapter 8: 7, 8, 12, Challenge question #22 (requires calculus) Discount rates should reflect the projects risk.but what kind of risk? Market risk? Business risk? Total risk?

The Risk Premium (RP): Required rate in excess of the risk-free rate (to compensate for added risk). Why is it important to use the correct risk premium: You can add the risk premium to the riskless rate to get a discount rate for projects or use it in the CAPM equation along with the beta. (Note: the CAPM risk premium = E[Rm Rf]) Ways to obtain the RP: - Use historical arithmetic average of RP (where RP = actual rate of return less risk free rate for the same period). Do not use compound rates of return or geometric averages. - The US stock RP estimate varies, ranging from 5% - 8% - RPs vary by country (see below)

11 10 9 8 7 6 5 4 3 2 1 0 Denmark Belgium Switzerland Ireland Spain Norway Canada U.K. Netherlands Average U.S. Sweden Australia South Africa Germany France Japan Italy
Do Risk Premiums vary over time? If so, we have to be careful when using historical averages - since we typically want the EXPECTED (i.e., future) RISK PREMIUM in our formulas to PREDICT return. Why might the RP change over time? Why might the RP be expected to remain constant over time? Suppose the RP had increased. How would this change affect stock returns? 7

Corporate investment?

Lets examine another part of the CAPM equation, the risk free rate (Rf) What effect do higher interest rates have on stock returns? On stock prices? CAPM: E[Ri] = Rf + i [E(Rm) Rf] If risk premium is assumed constant, how will higher interest rates affect the expected return for 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.

Portfolio standard deviation

0 5 10 15 Number of Securities

Portfolio standard deviation

Unique risk Market risk 0 5 10 15 Number of Securities

Theres a limit to diversification. Why? Because most stocks are affected by similar sources of risk - I.e., economy, oil prices, inflation, default (credit) risk. Non-CAPM pricing models (APT, Fama-French and others) may have a separate beta for EACH risk factor. The CAPM model assumes that all risks are incorporated in the single beta (measuring market risk).

Why is diversification generally desirable? Is it ever undesirable? Individual perspective:

Corporate perspective: Diversification by accepting different types of projects.

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Managers could diversify the firm and reduce risk. What kind of risk? Business risk, market risk or total risk? Investors could diversify on their own by investing in different types of stocks.

Pros and Cons of corporate diversification of the firm's assets: Pros:

Con:

International diversification of corporate assets may be desirable if investors do not fully diversify internationally on their own account. 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

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Graph: The addition of securities to a portfolio with international stocks, included.

Portfolio standard deviation 0 5 10 15 Number of Securities

Implication: Firms in countries whose investors fail to diversify internationally have a higher cost of capital (b/c their cost of equity is higher) Such firms less competitive, internationally. Why?

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Stock Return Distributions (Normally distributed) Return plots on x-axis & frequency (of observations of a particular return) plots on y-axis. Height of boxes represents the number of times the return was in the particular range of returns noted on the x-axis. INVESTMENT A & B (respectively)
20 18

16
14 12 10 8 6 4 2 0
-50 0 50

20

18
16 14 12 10 8 6 4 2 0
-50 0 50

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INVESTMENT C
20 18 16 14 12 10 8 6 4 2 0
-50 0 50

Assume A and B have equal mean returns. Which is preferable, A or B?

Which investment has the higher beta, A or B?

Which offers the higher expected return, B or C?________ higher beta?_________

In an efficient market, could stocks B & C co-exist? Explain why or why not.

Of A, B or C, which would be reasonable investment(s) to recommend, assuming investors will are undiversified, and will hold only this single investment?

If we assumed full diversification, which stock(s) are reasonable investments?

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Facts about normally distributed Returns: Stock returns have symmetric, normal distributions flatness of distribution indicates risk (std dev). Where the distribution peaks indicates mean (expected return) Mean return can be used to infer market risk (and hence, beta); o Higher E[ret] Higher beta.

FYI: Stock Market Return Distribution (1900-2008)

24
24 20 16 12 8 4 0

21 17 11 11 1 2
-50 to -40

13 3 2

4
-10 to 0
10 to 20 30 to 40 -30 to -20

50 to 60

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NONSYMMETRIC DISTRIBUTIONS Example:

20 18 16

14
12 10 8 6 4 2 0
-40 10 60

For a given expected return, do investors prefer an investment with right or left skewness?

Return skewness impacts risk-taking incentives. If an investment has a return distribution that is skewed right, it will make investors more or less risk (variance)-loving._____________ What if the investment's returns are skewed left? Examples of investments that have return distributions that are skewed:

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MARKOWITZ PORTFOLIO THEORY CORRELATION COEFFICIENTS Expected Returns and Standard Deviations vary given different weighted combinations of the stocks

Expected Return (%) Coca Cola

40% in Coca Cola

Exxon Mobil Standard Deviation

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 What tells us: = +1: Returns move in perfect proportion to each other, in same direction = -1: = 0:

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Example:

AB = __________ (note: would be the same if you added a constant to columns A

and B - not necessarily the same constant.) Project A 10% -5% 20% 4% 0% 20% Project B -5% 2.5% -10% -2% 0% -10%

How could you obtain a riskless investment by investing in A and B? Excel function for correlation: either pearson (column1, column2) or correl(column1, column2)

PROJECT RISK & CORRELATION COEFFICIENTS

You combine a low risk project with a high risk project, investing 50% in each. The resulting overall risk will be? a) Between that of the high and low risk projects b) The average of that of the high and low risk projects c) Less than that of the low risk project d) Either a, b or c

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Query: You are considering a project that is riskier than your firms 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 firms equity beta?

RETURN AND STANDARD DEVIATION CALCULATION 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.)

Stock1 Stock1 Stock 2

2 2 x1 1

Stock 2 x1x 2 12 x1x 2121 2 x 2 2 2 2

x1x 2 12 x1x 2121 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:

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Assume the same example above: The standard deviation of Exxon and Coca Colas annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

THE SECURITY MARKET LINE (SML) Diagram:

Intercept: Y-axis: X-axis: Slope:

Stock A is________________________ a) overvalued b) Undervalued c) neither A stock that plots above the line is:________________

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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) Some would say that you cant test a model that measures expected returns by plotting actual returns.

ADDITIONAL MODELS TO PREDICT RETURN (PRICE RISK)

1) Arbitrage Pricing Theory: Risk other than market risk is undiversifiable. Market risk does not capture all of the other sources of risk. Separate betas are computed for each firm for each risk factor. There is no consensus on how many risk factors there are. Market risk may be one of the factors.

Return a b1 (rfactor1 ) b2 (rfactor 2 ) b3 (rfactor 3 ) .... noise

Expected Risk Premium r rf b1 (rfactor1 rf ) b2 (rfactor 2 rf ) ...

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2)

Fama French Three Factor Model: Size, market, book to market equity ratio.

TABLE 8.3 Estimates of expected equity returns for selected industries using the Fama-French three-factor model and the CAPM. Three-Factor Model . bmarket Autos Banks Chemicals Computers Construction Food Oil and gas Pharmaceuticals Telecoms Utilities 1.51 1.16 1.02 1.43 1.40 .53 0.85 0.50 1.05 0.61 Factor Sensitivities bsize .07 -.25 -.07 .22 .46 -.15 -.13 -.32 -.29 -.01 . bbook-tomarket

CAPM Expected return* 15.7 11.1 10.2 6.5 16.6 5.8 8.5 1.9 5.7 8.4 Expected return** 7.9 6.2 5.5 12.8 7.6 2.7 4.3 4.3 7.3 2.4

0.91 .7 .61 -.87 .98 .47 0.54 -.13 -.16 .77

The expected return equals the risk-free interest rate plus the factor sensitivities multiplied by the factor risk premia, that is, rf + (bmarket x 7) + (bsize x 3.6) + (bbook-to-market x 5.2) ** Estimated as rf + (rm rf), that is rf + x 7.

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