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MBA 515

MBA 515. Financial Management. Today’s class. Introductions and house keeping Review of 507 concepts. My Background. NAME : Ken Shah PhD : University of Oregon INDUSTRY EXPERIENCE : 4 yrs Floor Trader / Stock Broker - Bombay Stock Exchange

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MBA 515

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  1. MBA 515 Financial Management

  2. Today’s class... • Introductions and house keeping • Review of 507 concepts

  3. My Background • NAME: Ken Shah • PhD: University of Oregon • INDUSTRY EXPERIENCE: • 4 yrs Floor Trader / Stock Broker - Bombay Stock Exchange • 3 yrs Quantitative Portfolio Management Research, Portland, Oregon

  4. Academic Experience • Taught at • University of Oregon • University of Auckland • Southern Methodist University • Courses in capital budgeting, corporate finance, investments, and money and banking

  5. Recent Research • Analyst Forecasts • Bond Returns • Capital Structure • Initial Public Offerings

  6. Please Introduce yourself... • Please fill out the student information sheet • Drop by my office! • Information sheet with photo next class

  7. Information Sheet • Attach a photo/photocopy of a photo • Tell me about yourself, if you like – present career, goals, etc. • Tell me about any anticipated absences • Any other special concerns/considerations

  8. Course Objectives • Build on MBA 507 concepts • How investment and financing decisions affect firm value • Valuation, Sources of financing, and Capital structure

  9. Course Prerequisites • Understanding of: • Financial statements • Discounting of cash flows • Spreadsheets • Rudimentary statistics • Pre-requisites: MBA 500-512

  10. Texts • Required: • Class packet at CopyMart • Lecture notes on the class web page • Optional: • Brealey & Myers, Principles of Corporate Finance • Damodaran, Investment Valuation (Advanced reading)

  11. Evaluation • Final Exam 300 • Homeworks 600 • Class Participation 100 • TOTAL 1000

  12. Grading Policy • If you attend all classes and diligently complete all required work, you would be assured of a B- grade • In order to get an A/A-, you must show work of superior quality and make a meaningful contribution to the class discussions • roughly 15% of the class

  13. Class Attendance • Mandatory • Please inform me of anticipated absences • First absence will not affect your grade • Each subsequent absence will adversely affect your grade by half grade point for each absence

  14. HW Assignments • A group of 3 students turns in one solution • Group work is required • Each member should make copies of assignment prior to turning in to facilitate discussion

  15. Review • Discounted Cash Flow/Time Value of Money • Bond Valuation • Stock Valuation • NPV • CAPM • Capital Budgeting

  16. DCF/TVM • PV and FV of a lump sum • PV and FV of Annuities • PV and FV combined • Perpetuities

  17. PV and FV of a lump sum • ‘r’ and ‘t’ must match • If t is # of months, r must be a monthly rate

  18. TVM example • How many years does it take to double your $100,000 inheritance if you can invest the money earning 11% compounded annually?Answer: 6.64 years

  19. PV of Annuity • Again: ‘r’ and ‘t’ must match • If t is # of months, r must be a monthly rate, and C is the payment per month

  20. PV of Annuity: Mortgage payments • House cost $250,000 • Mortgage Rate = 7.5% annually • Term of loan = 30 years • Payments made monthly • What are your payments? • Answer: $1748.04

  21. FV of Annuity • Again: ‘r’ and ‘t’ must match • If t is # of months, r must be a monthly rate, and C is the payment per month

  22. FV of Annuity Example • You will contribute $400 per month for the next 35 years into a retirement savings plan. If your money earns 12% interest per year, how much will you have accumulated at retirement? • Answer: $2,572,383

  23. How much must you contribute in an IRA per month to have an amount in 20 years that will provide an annual income of $200,000 per year for 10 years? Interest rate is 8% per year. • Answer: $2,278.28

  24. Perpetuity • Note: C and r measured over same interval

  25. Perpetuity Example • Preferred stock pays $1.00 dividend per quarter. The required return, r, is 10% per year. • What is the stock value? • Answer: $40.00

  26. Review: Bond Valuation • Fixed periodic coupon payments • Typically semi-annual • Principal payment at maturity • Yield to maturity (YTM) is that discount rate which makes the PV of all cash flows equal to the price

  27. Bond Price

  28. Example • $1000 par bond maturing 15 years from today has an annual coupon rate of 53/4 % paid semiannually. Required return on bond (r) is 7.5% per year compounded semiannually. • What is the value today? • Answer: $843.99 • If price is 104% of par, what is its YTM? • Answer: 5.36%

  29. Coupon Rate • Coupon Rate = Annual Coupon Payment Face Value • Coupon rate is always quoted annually • Example: 4 3/4% ATT 09 • 4 3/4% is the coupon rate

  30. Yield to Maturity (YTM) • It is the yield ‘r’ calculated when market price of bond is known • If • bond is held to maturity, AND • bond does not default, AND • bond is not called • then, • YTM is the return an investor earns on the bond • YTM is the ‘best guess’ of an investor’s expected return

  31. Current Yield • An approximation of YTMCurr. Yld. = Annual Coupon Payment Market Price • Reported for Corporate bonds in the WSJ

  32. Important to... • Distinguish between: • Yield To Maturity • Coupon Rate • Current Yield • They are not all the same!!

  33. Bond Rates and Yields • Suppose a bond currently sells for $932.90. It pays a semi-annual coupon of $35, and it matures in 10 years. It has a face value of $1000. What are its coupon rate, current yield, and yield to maturity (YTM)? 1. The coupon rate (or just “coupon”) is the annual dollar coupon expressed as a percentage of the face value: Coupon rate = $____ /$_____ = 7.00% 2. The current yield is the annual coupon divided by the current market price of the bond: Current yield = $___ _/_____ = 7.50% 3. The yield to maturity is = 7.99%

  34. Review Stock Valuation • Residual ownership • Uncertain dividends • Dividends must be estimated • Voting rights • CAPM gives us a way to estimate the required return on a stock

  35. Dividend Discount Model (DDM) • r = required rate of return on stock • ALL future dividends must be estimated • “ from here to eternity!!!” • Of little practical importance

  36. Note • Stock value is the PV of all future expected dividends • Stock value is NOT the PV of all future expected earnings or EPS • Unless a company pays out all earnings as dividends • Which implies that there is no growth

  37. Constant Growth DDM • Notice it is much simpler to estimate: • You need only THREE inputs: D1, r, g

  38. Caution • Constant growth model is simple but inappropriate model to use for many or most companies that have abnormal growth phases • Constant growth model is appropriate only for stable, mature companies like utilities • Constant growth model is often used to estimate the steady-state terminal values in a multi-stage growth model of valuing stocks

  39. Example • Kinesis Keyboard: D0 = $0.50Super growth in years 1 to 5: 55%Thereafter, constant growth of 11%r = 18%What is the current stock price? • Answer: ________

  40. Calculate dividends and terminal value 2 0 1 3 4 5 6 • Now you have all the numbers needed • Fill in the boxes • Show all the dividends and P5 on the time line +

  41. Using your calculator (HP 10B/12B) CFj CFj • Enter CF0 as: $0.0000Enter CF1 as: $0.7750 • Enter CF2 as: $1.2013 • Enter CF3 as: $1.8619 • Enter CF4 as: $2.8860 • Enter CF5 as D5 + P5: $75.4071 • Enter interest rate 11 • Hit • Answer: $ 49.68 CFj CFj CFj CFj I/YR Shift NPV

  42. Review of NPV • NPV is the dollar value added to the enterprise • it’s the amount by which the enterprise is richer! • For public companies, NPV is the increase in total market value of equity • Managers should not take negative NPV projects since it reduces the firm value

  43. NPV Formula • ‘r’ has many names: • ‘r’ is called the discount rate or • ‘r’ is called the required return or • ‘r’ is called the cost of capital

  44. Computing NPV on calculator • Use the CFj key • First entry is at time 0 • Subsequent entries are time 1, 2, 3, ... and so on • make sure the cash flows have the proper signs • Enter ‘r’ as the I/YR • Use the keys NPV

  45. Discounting Cash Flows • ALWAYS USE A DISCOUNT RATE THAT REFLECTS THE RISK OF THE CASH FLOWS THAT YOU ARE DISCOUNTING • ‘r’ in the denominator should reflect the risk of the CFt in the numerator • ‘r’ reflects the risk of the investment, not the risk of the investor!

  46. CAPM • The main contribution of CAPM is to derive an exact relation between risk and return • The main message of CAPM is that • Investors hold fully diversified (market) portfolio • Diversified portfolios have no unsystematic risk • Therefore, for individual securities, risk is measured by the contribution that security makes to the risk of the (market) portfolio, i.e., systematic risk or beta

  47. Portfolio Diversification Average annualstandard deviation (%) 49.2 Diversifiable risk 23.9 19.2 Non-diversifiable Risk Number of stocksin portfolio 1 10 20 30 40 1000

  48. CAPM Equation • [E(Rm) – Rf] = Market Risk Premium (MRP) • Rf = Risk Free rate • βi = stock beta

  49. The Security Market Line (SML) Asset expectedreturn E (Ri) = E (RM ) – Rf E (RM) Rf Assetbeta 0 M= 1.0

  50. Review of Compounding • To compound or not to compound - that is the question!! • Compounding means reinvesting the proceeds • SEC requires funds and investment managers to report returns that account for compounding

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