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Economics 173A

Comprehensive (excluding MPT) Slide Deck

To help to finance Companies

Annual Working Capital increases = $ 150 Billion

Annual Capital Expenditures “CAPEX” = $ 900 Billion

= $ 1,050 Billion

Source of funds:

Annual Earnings = ($ 800 Billion)

GAP $ 250 Billion

2. Annual Debt issued ($ 300 Billion)

( $ 50 Billion)

Equity -this represents repurchases of Equity

Capital MarketsFixed Income

Bonds

Real Estate

Equity

Shares

Units

Derivatives

Options

Futures

The Process

Asset Allocation

Equity/Fixed

60/40

80/20

120/20 ?

Security Selection

Security Analysis

Assets & InvestingRisk Return Trade-off

Certificates of Deposit

U.S. Treasury Bills

Money Market Funds

Bond Market

U.S Treasury Notes, Bills, and Bonds

U.K. Gilts and Consols

Municipal Bonds

Corporate Bonds

Equity Market

Common Stock

Preferred Stock

Derivative Market

Options

Futures

Other

Swaps

Pass-throughs

Financial InstrumentsCommercial Banks

Investment Banks

Funds

Mutual

Hedge

Pension

Private Equity

Foreign Exchange

Commodity

Securitization

GNMA

CMOs, CDOs

Bundling (Un)

STRIPS

Engineering

Custom-tailored Risk/Return

Synthetics – derivative hedges – mimic something

Intermediation and InnovationCDs – bank time-deposits

Paper – unsecured, trade-able company debt

Acceptances – bank promises

Eurodollars - $ denominated foreign bonds

Repos, Reverse Repos – of treasury debt

Treasuries – bills, notes, bonds

Rates

Prime

Fed Funds

LIBOR

TED Spread : the 3-month Treasury less LIBOR

Fixed Securities & RatesOriginally calculated as the difference between interest rates on 3-month T-bills and 3-month Eurodollar contracts w/ identical expiration.

Acronym is derived from the “T” for “Treasuries" and the ticker symbol for Eurodollars, which is “ED”.Today, the TED spread is calculated as the difference between interest rates on 3-month T-bills and 3-month LIBOR (London Interbank Offered Rate).

Denominated in basis points (bps).

Historically 10 to 50 bps – average 30 bps

A rising TED spread indicates shrinking liquidity –an indicator of perceived credit risk:

T-bills are considered risk-free

LIBOR reflects the credit risk of lending banks.

Widening TED spread is a sign that lenders believe default risk on interbank (counterparty) loans is increasing.]

2007 Average 150 – 200 bps

September 2008 > 300 bps; and on October 8th 465 bps

Bonds

- Characteristics
- Pricing
- Yields
- Sensitivity to Time, i.e. maturity
- Sensitivity to interest rates

Economics 175

Bond Characteristics

- Debt Security – related to borrowing
- Also called a Fixed Income security
- Covenants or Indenture define the contract (this can be complex)
- 2 types of Payments: interest & principal
- Interest payments are the Coupon
- Principal payment is the Face

Bond Basics

- Fixed Income Securities: A security such as a bond that pays a specified cash flow over a specific period.

Fixed Income Securities vs. Common Stock

Fixed Claim

Residual Claim

High Priority on cash flows

Lowest Priority on cash flows

Tax Deductible

Not Tax Deductible

Fixed Maturity

Infinite life

No Management Control

Management Control

Bonds

Hybrids (Combinations

Common Stock

of debt and equity)

The bond indenture usually lists:

Amount of Issue, Date of Issue, Maturity

Denomination (Par value) Face

Annual Coupon, Dates of Coupon Payments

Security

Sinking Funds

Call Provisions

Covenants

Features that may change over time:

Rating

Yield-to-Maturity

Market price

Bond Basics- The indenture is a written agreement between the corporate debt issuer and the lender.

Types of Bonds (Fixed Income Instruments)

- Convertibles (into Equity)
- Callable Bond (buy-back by Issuer) – shorten the term
- Putable Bond (sell-back by Owner) – extend the term
- Floating-rate & Inverse Floaters
- Asset-backed (like CMOs)
- Zeros – no Coupons
- Strips – no Face
- Senior versus Subordinated

Economics 175

Treasury Bonds, Bills, & Notes

- Notes – up to 10 year term
- Bonds – to 30 years
- Face (denomination) of $1,000; quotes in $100’s
- Coupon (rate) paid semi-annually
- Prices quoted in points (of face) + 1/32
- No default / credit risk

Bond Pricing

As with all Financial Assets

The price is a Present Value of the expected cash flows discounted at the appropriate (relative to risk) discount (interest) rate.

Coupon Payments

- Relative to other types of securities, bonds produce cash flows that an analyst can predict with a high degree of precision.
- Fixed rate
- Variable rate
- Zero coupons
- Consols – consolidated annuities - perpetuities introduced in 1751.

The effective, or true, annual rate of return. The APY is the rate actually earned or paid in one year, taking into account the affect of compounding. The

APY is calculated by taking 1+r

… the periodic rate and raising it to the number of periods in a year.

For example, a 1% per month rate has an APY of 12.68% (1.01^12).

Bond Pricing

- DCF Technique

PB = Price of the bond

Ct = interest or coupon payments

T = number of periods to maturity

r = semi-annual discount rate or the semi-annual yield to maturity

S

40

1

=

+

P

1000

B

t

20

(1+.03)

(1+.03)

t

=1

Bond Pricing- Example (annual coupon paid SA). Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000 in a 6% risk-adjusted market.

Ct = 40 (SA), F = 1000, T = 20 periods, r = 3% (SA)

PB = $1,148.77

Three Bonds in a 10 percent world …

Insert Figure 4-6 here.

Bond Pricing

- Zero Coupon Bonds
- Consols – Zero Face Bonds

Bond Yields

- Yield to Maturity: The discount rate that makes the present value of a bond’s payments equal to its price.
- Internal rate of return from holding bond till maturity.
- Example3 year bond with interest payment of $100, principal of $1,000 and current price of $900
- Assume coupon proceeds are reinvested at the YTM.

S

40

1

=

+

P

1000

B

t

20

(1+.03)

(1+.03)

t

=1

Bond Pricing- Example (annual coupon paid SA) in a 6 percent world.Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000

Ct = 40 (SA), P = 1000, T = 20 periods, r = 3% (SA)

PB = $1,148.77

Approximate Yield to Maturity

Bond Yields

- Approximating YTM
Using the earlier example

Avg. Income = 80 + (1000-1149)/10 = 65.10

Avg. Price = (1000 + 1149)/2 = 1074.50

Approx. YTM = 65.10/1074.50 = 0.0606

Actual YTM = 6.00%

Bond Yields

- Prices and Yields (required rates of return) have an inverse relationship
- When yields get very high the value of the bond will be very low
- When yields approach zero, the value of the bond approaches the sum of the cash flows

Daily Treasury Yield Curve Rates

http://www.ustreas.gov/

Daily Treasury Yield Curve Rates

http://www.ustreas.gov/

Bond Yields

- Current or Annual Yield: Annual coupon divided by bond price.
- Different from YTM!

- Accrued Interest
- Interest is earned for each day that a bond is held, although interest payments are generally made twice a year only.
- A bond buyer must pay the accrued interest to the seller of the bond.
- dirty price = bond price + accrued interest
- clean price = bond price

- By convention, accrued interest is calculated using a 360-day year.

Bond Pricing: Accrued Interest

- Example
- Consider a bond that is paying a six percent annual coupon rate in semiannual payments with a yield to maturity of 10 percent and two years and ten months until its maturity.
- What is the quoted price or clean price?
- What is the dirty price?

- Consider a bond that is paying a six percent annual coupon rate in semiannual payments with a yield to maturity of 10 percent and two years and ten months until its maturity.

Bond Pricing: Accrued Interest

- What is the quoted price or clean price?
Step One: Calculate the present value of a bond that has 2.5 years until it matures and pays semiannual interest coupons.

Step Two: The $30 coupon is added to $913.39. The sum is $943.19.

Step Three: The value $943.19 is discounted back 4 months to the purchase date.

Bond Pricing: Accrued Interest

- What is the dirty price?
Calculate the accrued interest for two months. There are 180 days between semiannual coupon payments and 30 days in a month. Therefore 60/180 is the fraction of the coupon payment earned by the seller. In other words the accrued interest is $10 and the dirty price is $923.16.

Bond Risks

- Price Risks
- Default risk
- Interest rate risk

- Convenience Risks
- Call risk
- Reinvestment rate risk
- Marketability risk

Default Risk

- The income stream from bonds is not riskless unless the investor can be sure the issuer will not default on the obligation.
- Rating companies
- Moody’s Investor Service
- Standard & Poor’s
- Duff and Phelps
- Fitch

Default Risk

- Rating Categories
- Investment Grade Bonds
- Speculative Grade Bonds
S&P Moody’s

Very High Quality AAA, AA Aaa, Aa

High Quality A, BBB A, Baa

Speculative BB, B Ba, B

Very Poor CCC, CC, C, D Caa, Ca, C, D

Linear measure of the sensitivity of a bond's price to fluctuations in interest rates.

Measured in units of time; always less-than-equal to the bond’s maturity because the value of more distant cash flows is more sensitive to the interest rate.

“Duration" generally means Macaulay duration.

Bond DurationFor small interest rate changes, duration is the approximate percentage change in the value of the bond for a 1% increase in market interest rates.

The time-weighted average present value term to payment of the cash flows on a bond.

Macaulay DurationThe proportional change in a bond’s price is proportional to duration through the yield-to-maturity

Macaulay DurationA 10-year bond with a duration of 7 would fall approximately 7% in value if interests rates increased by 1%.

The higher the coupon rate of a bond, the shorter the duration.

Duration is always less than or equal to the overall life (to maturity) of the bond.

A zero coupon bond will have duration equal to the maturity.

Macaulay DurationDuration x Bond Price 7% in value if interests rates increased by 1%.: the change in price in dollars, not in percentage, and has units of Dollar-Years (Dollars times Years).

The dollar variation in a bond's price for small variations in the yield.

For small interest rate changes, duration is the approximate percentage change in the value of the bond for a 1% increase in market interest rates.

Dollar DurationModified Duration – 7% in value if interests rates increased by 1%.where n=cash flows per year.

Modified Durationand

Modified Duration 7% in value if interests rates increased by 1%.

What will happen to the price of a 30 year 8% bond priced to yield 9% (i.e. $897.27) with D* of 11.37 - if interest rates increase to 9.1%?

Duration Characteristics 7% in value if interests rates increased by 1%.

- Rule 1: the duration of a zero coupon bond is equal to its time-to-maturity.
- Rule 2: holding time-to-maturity and YTM constant, duration is higher when the coupon rate is lower.
- Rule 3: holding coupon constant, duration increases with time-to-maturity. Duration always increases with maturity for bonds selling at par or at a premium.
- Rule 4: cateris parabus, the duration of coupon bonds are higher when its YTM is lower.
- Rule 5: duration of a perpetuity is [(1+r)/r].

Bond Convexity 7% in value if interests rates increased by 1%.

- Bond prices do not change linearly, rather the relationship between bond prices and interest rates is convex.
- Convexity is a measure of the curvature of the price change w.r.t. interest rate changes, or the second derivative of the price function w.r.t. relevant interest rates.
- Convexity is also a measure of the spread of future cash flows.
- Duration gives the discounted mean term; convexity is used to calculate the discounted standard deviation of return.

Prices and Coupon Rates 7% in value if interests rates increased by 1%.

Duration versus Convexity

Price

Yield

Common Stocks 7% in value if interests rates increased by 1%.

- Residual Owners:
- Stockholders of a firm are entitled to dividend income derived from the firm’s earnings.
- Stocks may provide a steady stream of current income through dividends.
- Stocks may increase in value over time through capital gains.

Market Performance 7% in value if interests rates increased by 1%.

- Routine Decline: a drop of 5% or more in one of the major market indexes, like the Dow Jones Industrial Average (DJIA)
- Correction: a drop of 10% or more in one of the major market indexes
- Bear Market: a drop of 20% or more in one of the major market indexes

- Stock Returns 7% in value if interests rates increased by 1%.:
Both price changes, called capital gains, and dividend income:

- Over past 50 years, stock returns have ranged from +48.28% in 1954 to -21.45% in 1974
- Stock returns over past 50 years have averaged around 11%
- From 1998 through mid-’03, DJIA averaged 1.7%

- Provide opportunity for higher returns than 7% in value if interests rates increased by 1%.other investments
- Over past 50 years, stocks averaged 11% and high-grade corporate bonds averaged 6%
- Good inflation hedge since returns typically exceed the rate of inflation
- Easy to buy and sell stocks
- Price and market information is easy to find in financial media
- Unit cost per share of stock is low enough to encourage ownership

- Stocks are subject to many different kinds of risk: 7% in value if interests rates increased by 1%.
- Business risk
- Financial risk
- Market risk
- Event risk

- Hard to predict which stocks will go up in value due to wide swings in profits and general stock market performance
- Low current income compared to other investment alternatives

- Stock Split 7% in value if interests rates increased by 1%.: when a company increases the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share
- Usually done to lower the stock price to make it more attractive to investors
- Stockholders end up with more shares of stock that sells for a lower price
- Investor with 200 shares in a 2-for-1 stock split would have 400 shares after the stock split
- If the stock price was $100 before the split, the price would be near $50 after the split

- Treasury Stock 7% in value if interests rates increased by 1%.: shares of stock that were originally sold by the company and have been repurchased by the company. Share repurchases are often called “buybacks.”
- Reduces the number of shares outstanding to public
- Companies buyback when they believe stock is undervalued and a good buy
- Companies may try to raise undervalued stock price or prop up overvalued stock price
- May be used for employee stock option plans

- Classified Common Stock 7% in value if interests rates increased by 1%.: common stock issued in different classes, each of which offers different privileges and benefits to its holders
- Different shares may have different voting rights
- Often used to allow a relatively small group to control the voting of a publicly-trade company
- Ford family owns “B” shares and other investors own “A” shares; Ford family controls 40% of Ford Motor Company
- May have different dividend payout schedules

- Par Value 7% in value if interests rates increased by 1%.: the stated, or face, value of a stock
- Mainly an accounting term and not very useful to investors

- Book Value: the amount of stockholders’ equity
- The difference between the company’s assets minus the company’s liabilities and preferred stock

- Market Value: the current price of the stock in the stock market

- Market Capitalization 7% in value if interests rates increased by 1%.: the overall current value of the company in the stock market
- Total number of shares outstanding multiplied by the market value per share

- Investment Value: the amount that investors believe the stock should be trading for, or what they think it’s worth
- Probably the most important measure for a stockholder

- Earnings Per Share 7% in value if interests rates increased by 1%.: the amount of annual earnings available to common stockholders, stated on a per-share basis

Dividends 7% in value if interests rates increased by 1%.

- Dividend income is one of the two basic sources of return to investors.
- Dividend income is more predictable than capital gains, so preferred by investors seeking lower risk.
- Dividends are taxed at maximum 15% tax rate, same as capital gains.
- Dividends tend to increase over time as companies’ earnings grow; increases average 3-5% per year.
- Dividends represent the return of part of the profit of the company to the owners, the stockholders.

- Dividend Payout Ratio 7% in value if interests rates increased by 1%.: the portion of earnings per share (EPS) that a firm pays out as dividends
- Companies are not required to pay dividends
- Some companies have high EPS, but reinvest all money back into company

Key Dates for Dividends 7% in value if interests rates increased by 1%.

Dividends and Dividend Yield 7% in value if interests rates increased by 1%.

- Dividend Yield: a measure to relate dividends to share price on a percentage basis
- Indicates the rate of current income earned on the investment dollar
- Convenient method to compare income return to other investment alternatives

- Stock Dividend 7% in value if interests rates increased by 1%.: payment of a dividend in the form of additional shares of stock
- Dividend Reinvestment Plans (DRIPs): plans where cash dividends are automatically reinvested into additional shares of the firm’s common stock
- Over 1,000 companies offer DRIPs
- Usually have no brokerage fees
- Uses dollar-cost averaging

- Blue Chip Stocks 7% in value if interests rates increased by 1%.: financially strong, high-quality stocks with long and stable records of earnings and dividends
- Companies are leaders in their industries
- Relatively lower risk due to financial stability of company
- Popular with investing public looking for steady growth potential, perhaps dividend income
- Provide shelter during unsettled markets
- Examples: Wal-Mart, Proctor & Gamble, Microsoft, United Parcel Service, Pfizer and 3M Company

A Blue Chip Stock 7% in value if interests rates increased by 1%.

- Income Stocks 7% in value if interests rates increased by 1%.: stocks with long and sustained records of paying higher-than average dividends
- Dividends tend to increase over time (unlike interest payments on bonds)
- Examples: Verizon, Conagra Foods, Pitney Bowes.

- Growth Stocks 7% in value if interests rates increased by 1%.: stocks that experience high rates of growth in operations and earnings
- Investors expect higher price appreciation due to increasing earnings; pay little or no dividends
- Examples: Lowe’s, Harley-Davidson, Starbucks, Kohls

- Speculative Stocks 7% in value if interests rates increased by 1%.: stocks that offer potential for substantial price appreciation, usually due to some special situation such as a new product.
- Examples: Chipotle, P.F. Chang’s, Quicksilver.

- Tech Stocks 7% in value if interests rates increased by 1%.: stocks representing the technology sector of the market
- Small companies that have never shown a profit and blue chip stocks of large companies that are growth-oriented
- Difficult to put value on due to erratic or no earnings
- Examples: Microsoft, Cisco Systems, Dell.

- Cyclical Stocks 7% in value if interests rates increased by 1%.: stocks whose earnings and overall market performance are closely linked to the general state of the economy
- Best for investors willing to move in and out of market as economy changes
- Examples: Caterpillar, Maytag Corp.

- Defensive Stocks 7% in value if interests rates increased by 1%.: stocks that tend to hold their value, and even do well, when the economy starts to falter
- Stock price remains stable or increases when general economy is slowing
- Products are staples that people use in good times and bad times, such as electricity, beverages, foods and drugs; Gold stocks.
- Best for aggressive investors looking for “parking place” during slow economy
- Examples: Proctor & Gamble, WD-40

Market Capitalization 7% in value if interests rates increased by 1%.

- Small-Cap Stocks: under $1 billion
- Mid-Cap Stocks: $1 billion to $4 or $5 billion
- Large-Cap Stocks: more than $4 or $5 billion

- Small-Cap Stocks 7% in value if interests rates increased by 1%.: small companies with market capitalizations less than $1 billion
- Provide opportunity for above-average returns (or losses)
- Usually do not have a financial track record
- Earnings tend to grow in spurts and can have dramatic impact on stock price
- Usually not widely-traded; liquidity is issue
- Examples: Rubio’s, Hot Topic, Sonic Corp.

- Mid-Cap Stocks 7% in value if interests rates increased by 1%.: medium-sized companies with market capitalizations between $1 billion and $4 or $5 billion
- Provide opportunity for greater capital appreciation than Large-Cap stocks, but less price volatility than Small-Cap stocks
- Usually have long-term track records for profits and stock valuation
- “Baby Blues” offer same characteristics of Blue Chip stocks except size
- Examples: Wendy’s, Barnes & Noble, Petsmart, Cheesecake Factory

- Large-Cap Stocks 7% in value if interests rates increased by 1%.: large companies with market capitalizations over $4 or $5 billion
- Number of companies is smaller, but account for 80% to 90% of the total market value of all U.S. equities
- Bigger is not necessarily better
- Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility
- Examples: AT&T, General Motors, Microsoft

The Economy, The Market, The Business 7% in value if interests rates increased by 1%.

Forecast Earnings and Cash Flows

Growth rates

Dividend payout rate

Select Valuation Model

Select the Discount Rate

Exogenous or endogenous

Conclusion & Recommendation

Under or over Valued

Buy, Sell, Hold

The Valuation ProcessEconomy, Sector, Market, Company 7% in value if interests rates increased by 1%.

- Inherent sector and industry profitability
- Industry structure
- Company’s relative competitive position
- Market share
- Cost leadership
- Pricing power
- Product differentiation versus product focus

Forecasting 7% in value if interests rates increased by 1%.

- Top-down forecast
- Economy-Sector-Industry-Company
- Financial forecast
- Financial Statement Analysis: revenues & expenses
- From profits to cash flows, esp. Free Cash Flows
- Costs, prices, and the Product life cycle

Concepts of Value 7% in value if interests rates increased by 1%.

- Book Value
- Market value
- Liquidation Value
- Fair Market Value, Intrinsic Value
- Value given a thorough appreciation of the Company, its prospects, and the market
- Look for mispricing
- Alpha = E(HPR) less Market RRR

The Valuation Model 7% in value if interests rates increased by 1%.

- Approach
- Cost
- Income
- Market
- Method
- De Novo or M&A
- Revenues, Earnings, Cash flows
- Comparables

Models 7% in value if interests rates increased by 1%.

- Dividend Discount Model
- D.C.F.
- C.A.P.M.
- Guideline Company Approach

Discount Rates 7% in value if interests rates increased by 1%.

- Build-up Method
- Risk-free Rate +
- Equity risk premium +
- Company risk premium
- P/E implied
- C.A.P.M.
- Risk-free Rate +
- Non-systematic risk premium

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