Financial markets for corporate and retail clients, Dispense di Finanza Aziendale

Scarica Financial markets for corporate and retail clients e più Dispense in PDF di Finanza Aziendale solo su Docsity! FINANCIAL MARKETS FOR CORPORATE AND RETAIL CLIENTS Why are financial institutions special? In a system without /nancial ins2tu2ons Corpora&on can in&uence the amount of savings available in 3nancial system by issuing equity and debt claims in order to increase spending. Corpora;ons are usually governments. Households receive equity and debt claims and in exchange they give cash. Without 3nancial ins;tu;ons, there is a low level of funds &ow between corpora;ons and households; those funds are not enough to 3nance corpora;ons. If governments decide to increase spending by issuing debts, the amount of available funds goes down and the cost of funds goes up. Usually in a 3nancial system with only direct loans there a limited amount of funds and that’s why this happen. In addi;on, when leading money directly to corpora;ons, people are exposed to costs and risks:  Monitoring costs They are necessary costs for monitoring borrowers and their ability to repay (and if it is maintaining over the ;me). Financial ins;tu;ons are beJer at monitoring because since they are large, they can use economies of scale which means reducing costs. By merging and becoming larger they can enjoy more economies of scale. Financial ins;tu;ons are beJer in screening, when selec;ng the borrowers, and monitoring during the loan.  Liquidity costs They occurred because money are blocked for the dura;on of the loan even if you need your money back. For this reason, it is unlikely that people make direct loan to someone.  Substan&al price risk If people invest in bonds and stocks, the price of those is exposed to price risk because the value of the investment can go down and people suMer a loss. In a system with /nancial ins2tu2ons The role of 3nancial ins;tu;ons is to facilitate the &ow of funds from borrowers to savers. There two types of 3nancial ins;tu;ons:  Brokers They facilitate the matching, reducing the cost of searching the poten;al investments and to reduce transac;on costs.  Asset transformer (or real @s) They put between seller and borrowers their balance sheet (typical example are commercial banks: they collect deposit from households, and they make loans to corpora;ons and there is a balance sheet in the middle of the transac;on). 1 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 j mi Advantages 1. If you deposit money in bank you are not taking any big risk because in the near future if you want your money back, you can withdraw the same amount without any liquidity or price risks (the money you deposit is the exactly you withdraw, no change in the value) but you are 3nancing corpora;ons at the same ;me. In addi;on, it is the bank responsible for selec;ng, screening and monitoring the poten;al borrowers. 2. If banks behave in the right manner they play a social role because they facilitate the &ow of funds. To sum up, direct 3nance is without 3nancial ins;tu;ons in the middle of rela;onship, but they operate on 3nancial markets (buying stocks directly on the market). FINANCIAL POSITION of the main economic actors is the diMerence between savings and borrowings. It can be posi;ve or nega;ve. FUNCTION OF THE FINANCIAL SYSTEM The main role of 3nancial system is to allocate eVciently capital to the best projects/businesses and in this way suppor;ng the economy. That’s because they can screen out bad borrowers and 3nance good borrowers (with good projects and investments). They can also improve the well-being of consumers by allowing them to ;me their purchase beJer. By having access to 3nancial market, I can buy a home by having money from a bank or I consume now even if I do not have enough savings (access to 3nance). When the 3nancial system does not work properly, one of the consequences is the 3nancial crisis. Financial crisis  severe economic hardship  poli2cal instability 2 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 INDIRECT FINANCE In indirect 3nance system, 3nancial ins;tu;ons stand ready between lender-savers (ex. collec;ng deposits) and borrowers-spenders (ex. making loans/buying bonds). They facilitate the &ow of funds between them. This process of using 3nancial ins;tu;ons is called 3nancial intermedia;on. Financial ins;tu;ons are a far more important source of 3nancing for corpora;ons than security markets are. Financial ins;tu;ons are very important especially because of: - TRANSACTION COSTS Those are the ;me and money spend in carrying out 3nancial transac;ons. They are about costs involved in: 3nd the borrower, write up a contract, collect payments and recover overdue payments. Thanks to the exper;se of 3nancial intermediaries and economies of scale, they provide liquidity services (deposits can be used for making transfers/payments easily + I can redeem my money whenever I want, and my deposit can be used to make transfer and pay bills). Transac;on costs assess the ability of poten;al partner. For all these aspects, 3nancial intermediaries have very low transac;on costs. - RISK SHARING Low transac;ons costs allow 3nancial intermediaries to share risk at low cost. Through the ASSET TRANSFORMATION, risky assets are turned into safer assets for investors. Financial ins;tu;ons pool a collec;on of assets (ex. loans) into a new asset and then sell it to individuals (ex. depositors). The DIVERSIFICATION is when the overall risk is lower than for individual assets. The loans are spread into a lot of investors in order to reduce the risk. Since I reduce the level of risk it is possible to transform risky investments into safer ones because of the diversi3ca;on. For depositors is not always easy to dis;nguish between liquidity and solvency crisis: solvency crisis is when equity is not enough to cover losses. Since they are not able to dis;nguish, they might mistake, and the aim of deposit insurance is to avoid bankruptcy. - INFORMATION COSTS (asymmetric informa;on) Asymmetric informa;on is the lack of informa;on both before and a^er the transac;on. One party does not know enough about the other party to make accurate decisions. For this reason, listed companies are obliged to disclose informa;on about their performance. There are 2 types of asymmetric informa;on: 1. Adverse selec2on (HIDDEN CHARACTHERISTIC), it is a lack of informa;on about some characteris;cs about the person (before the transac;on occurs) It is not possible to dis;nguish between good and bad person. Since that, the consequences of this lack of informa;on lead to a lower amount of loans or not to give loans at all. If the informa;on is available, the person which is very risky it will be charged a higher price, or the loan would have been denied. Informality leads to a reduc;on in the loans. 2. Moral hazard (HIDDEN ACTION), when the person has the money, but they do not behave in a desirable way from the perspec;ve of the lender (aJer the transac;on occurs). It is the risk (hazard) that the borrower might engage in ac;vi;es that are undesirable (immoral) from the lender's point of view because they make it less likely that the loan will be paid back. 5 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 Similar to the case of adverse selec;on, the lender may decide that it would rather not make a loan if moral hazard is very likely. It happens everywhere especially in insurance contract. If most of the clients are bad, then lender are less likely to do loans especially because they cannot dis;nguish bad or good client. Then if no loans are given, the system breaks down. Adverse selec;on and moral hazard are signi3cant impediments to well-func;oning 3nancial markets and 3nancial intermediaries alleviate them: - Adverse selec;on  3nancial intermediaries are beJer equipped than individuals to screen out bad credit risks from good ones. - Moral hazard  3nancial intermediaries develop exper;se in monitoring the par;es they lend to. ECONOMIES OF SCOPE and CONFLICTS OF INTEREST Financial intermediaries provide mul;ple 3nancial services to their customers (loans, selling bonds for them, money transfers, payment services, insurance, etc.). By providing mul;ple services, 3nancial intermediaries can also achieve economies of scope: they can lower the cost of informa;on produc;on for each service by applying one informa;on resource to many diMerent services. However, the presence of economies of scope (by providing mul;ple services) can create poten;al costs in terms of con@icts of interest: Con&ict of interest  type of moral hazard problem that arises when a person or ins;tu;on has mul;ple objec;ves and, as a result, has con&icts between those objec;ves. They may lead an individual or ins;tu;on to conceal informa;on or disseminate misleading informa;on. Con&icts of interest reduce the quality of informa;on and make 3nancial markets and the economy less eVcient (funds are not channelled to the most produc;ve investment opportuni;es). It is about instead of ac;ng of client’s interest, they act in favour of banks, because they have an interest in proving a service instead of another. FUNCTIONS OF FLS 1. Brokerage, they are agent for savers.  Lowers transac;on and informa;on costs  Encourages higher rate of savings 2. Asset-transforma;on  AJrac;ve 3nancial claims to household savers which are less risky and more liquid. 3. Asymmetric informa;on problem (COST REDUCTION); investors exposed to agency costs.  Delegated monitoring (greater incen;ve to monitor, economies of scale in collec;on of informa;on)  Informa;on produc;on 4. Liquidity and price risk  Secondary claims have less price risk, deposits are more liquid and consequently more aJrac;ve to small investors, advantage in diversifying risks. 6 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 - They play a special role in the 3nancial and economic system - They provide credit to key sectors - They facilitate the money supplier mission of central banks to economic system because most of money is in deposit - They play an important role in credit alloca;on. - Reduced transac;ons costs - Maturity intermedia;on - Transmission of monetary policy - "Special" credit alloca;on - Intergenera;onal transfers or ;me intermedia;on - Payment services - Denomina;on intermedia;on REGULATIONS Financial intermediaries are subject to special regula;ons because:  Their failure can produce nega;ve externali;es  They provide special services  They provide key func;ons in the economic and 3nancial system - Money supply transmission (banks) - Credit alloca;on - Payment services, since most of the transac;on payments occur in the bank system Regula;ons are important for several reasons: 1. Protect savers (retail savers mostly) Savers deposit in bank and they trust banks; since there is a problem of asymmetric informa;on if something bad occurs in 3nancial system, depositors lose trust in banks and this cause bankrupt leading to a collapse of a bank or a group of those. The aim is to make sure banks do not fail and they are able to pay oM deposit. 2. Prevent unfair prac&ces To prevent misbehaviours of banks because they have several advantages that can be used against depositors instead of crea;ng value for them. 3. Ensure soundness of the Snancial system Banks are part of a network in the 3nancial system. The idea is to avoid the casque eMect due to the failure of a bank. Investors/depositor can think that since banks are related when a bank fails the all network system can be aMected by that. 7 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 F ENTERPRISE RISK MANAGEMENT: in management of banks it is necessary the management of risk. How can banks create value for shareholders? By recognizing the value in priori;zing and managing the impact of risks on an interrelated porqolio basis. It means that for banks is important to control risk in comprehensive manner crea;ng value for shareholders. Prior to the crisis the focus was on the process and systems to be more eVcient and reduce costs, to increase speed but not in terms of reducing risks. A^er the crisis they realized that the risk management was the best approach for crea;ng value for shareholders. Home prices started to plum in 2006 and 2007 and the mortgage bubble exploded. Investors in mortgage lost money; even if banks tend to sell mortgages to other banks through the securi;za;on process, they were s;ll obliged to provide liquidity facility to make up for those cases where mortgage holders were not able to make their payments. Risk managements is fundamental for the success of a bank. During the crisis, many banks bailed out and failed because of their incapacity to manage risk and to predict it. The central banks intervened with a rescue plan, and they infused a lot of money in addi;on to Troubled Asset Relief Program. How business get Snanced? Here the role of 3nancial ins;tu;ons in 3nancial markets by looking at how business raise funds in 3nancial markets. Businesses get 3nanced by: - Bank loans - Non-bank loans (hedge funds that invests in businesses) - Stocks - Bonds (market-based funds) they are debt instruments issued by businesses to collect 3nance and to raise funds. There are eight basic facts about business: 1. Stocks are not the most important source of external Snancing (11% of the total funds) 2. Marketable debt (bonds) and equity (stocks) is not the primary source of Snancing (32% + 11% = 43%)  57% private funds (loans) 3. Indirect Snance is many &mes more important than direct Snance. In the US, since 1970 less than 5% of marketable debt (corporate bonds and commercial paper) and less than one-third of marketable equity (stocks) have been sold directly to American households. - Indirect 3nance (intermediaries which facilitate the transfer of funds between net savers and net borrowers) - Direct 3nance (throw 3nancial markets where net savers and borrowers they transfer funds directly and net borrowers issue instruments to collect money from net savers). 4. Financial intermediaries, par&cularly banks, are the most important source of external funds (56% in the US, more than 70% in Germany, Japan and Canada). In non-US countries, bank loans are the largest category (more than 70% in Germany and Japan, and more than 50% in Canada). 5. The Snancial system is among the most heavily regulated sectors of the economy. Main mo;va;ons: to promote the provision of informa;on and to ensure the soundness (stability) of the 3nancial system. 6. Only large, well-established corpora&ons have easy access to securi&es markets to 3nance their ac;vi;es. 10 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 C e 7. Collateral is a prevalent feature of debt contracts for both households and businesses. (collateral is property pledged as guarantee; collateralized debt or secured debt). 8. Debt contracts typically are extremely complicated legal documents that place substan;al restric;ons on the behaviour of the borrower. Long legal documents with provisions (called restric;ve covenants). FACT 3: Indirect Snance is more important than direct Snance. TRANSACTION COSTS in&uence the 3nancial structure. Example: inves;ng $5,000 in stocks or bonds. If you invest in stocks, your net investment is $5,000 minus the brokerage commission. If you invest in bonds you have a minimum denomina;on of, for example, $10,000. Furthermore, since every transac;on implies some transac;on costs, you can make only a limited number of investments. It follows that: lower diversi3ca;on higher risk. Financial intermediaries reduce transac;on costs because they have: - Economies of scale, bundle the funds of many investors. Thanks to economies of scale the deposit is diversi3ed into many investors which made it much safer. They enjoy economies of scale because they are very large so they can reduce the impact of brokerage commissions and the impact of denomina;on on the ability to diversify. Economies of scale are also important in lowering the cost of things such as informa;on technology that 3nancial ins;tu;ons need to accomplish their tasks. Example: mutual fund, that is a 3nancial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. - Exper&se, develop exper;se to lower transac;on costs. They know how to avoid excessive cost. - Provision of liquidity services, services that make it easier for customers to conduct transac;ons. They make investments more liquid. When people invest in shares, they can use their shares to write checks, to make transfers so even if the money is invested in short term debt instrument, s;ll the investors are able to use money to make payments. Example: money market mutual funds allow shareholders to write checks for convenient bill paying. ASYMMETRIC INFORMATION (fact 3): it is a situa;on when one party’s insuVcient knowledge about the other party makes it impossible to make accurate decisions when conduc;ng a transac;on. Managers have beJer informa;on than shareholders and that can lead to the asymmetric informa;on problem with respect to shareholders  Principle agent model: there is a principle (shareholder ) and an agent (manager) and the agent can act in their interest instead of in the interest of the shareholder because there is an asymmetric informa;on. Asymmetric informa;on is a problem, but 3nancial ins;tu;ons are able to screen out bad credit and monitor borrowers.  Agency theory is applied to explain the form of 3nancial markets. 11 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 i ADVERSE SELECTION: poten;al bad credit risks are the ones who most ac;vely seek out loans. - Investment in (common) stocks: can you dis;nguish between good 3rms with high expected pro3ts and low risk and bad 3rms with low expected pro3ts and high risk? If there is an asymmetric informa;on you cannot dis;nguish them properly, the price will re&ect the average quality of the stock. Managers of good 3rms know that their securi;es are undervalued and will not sell them. Only the bad 3rms will sell. Result: few 3rms will sell securi;es. - Investment in corporate bonds: with adverse selec;on problems, similar to stocks, investors will buy only if the interest rate is enough to compensate for the average default risk (between good and bad 3rms). Owners of good 3rms will be unlikely to borrow. Only bad 3rms will. Result: few bonds are likely to sell in this market. Explains fact 2: why securi2es are not the primary source of /nancing. How to solve the problem? 1. By the private produc&on and sale of informa&on. If the company is public and listed (bonds and stocks traded in the market), there will be no advantage for investors to make an eMort to produce private informa;on on the company because if the company is listed and they collect informa;on to evaluate the riskiness of the company and based on that they make an investment, the other investors will bene3t from that because your informa;on which is implied in your decision to invest is exploited from other investors as well, and at the new price of bonds and stocks in the market it would lead to a 0 bene3t for the investor who decided to make an eMort to assess the riskiness of the company. Banks make private loans to corpora;ons and not traded in the market: if they would trade loans on the market other investors will bene3t from the ac;vity of the bank in screening out good borrowers and supervising clients and the advantage for banks would be lower. Banks by making private loans they can take advantage of the private informa;on that they collect because they keep the informa;on private. They do not disclose the informa;on that they collect. 2. Government regula&on also plays a role in suppor;ng the transparency of corpora;ons: government encourages corpora;ons to reveal honest informa;on about themselves. The listed corpora;ons are obliged to provide 3nancial informa;on periodically. However, disclosure by ins;tu;ons is not enough because corpora;ons can s;ll lie on the 3nancial informa;on that they provide, manipula;ng them). More in general, adverse selec2on helps explain why /nancial markets are heavily regulated (fact 5). 3. Financial intermedia&on they facilitate the market because they understand the value 3rms. As intermediaries they produce informa;on (they are experts) and they are able to take value out of that because they are experts in the evalua;on about 3rms. They can invest in 3rms and make to them loans because they can understand what the risk implies and by making private loans they avoid the free rider problem (when I produce a piece of informa;on and when it becomes public and available to everyone it means that the return from producing the informa;on is almost 0 because everybody is enjoying). Example: most used cars are not sold directly by one individual to another. Instead, they are sold by used- car dealers (intermediary). Used-car dealers produce informa;on in the market by becoming expert. 12 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 F Asymmetric Information Problem Adverse selection Moral hazard in equity contracts (principal-agent problem) Moral hazard in debt contracts Tools to Solve It Private production and sale of information Government regulation to increase information Financial intermediation Collateral and net worth Production of information: monitoring Government regulation to increase information Financial intermediation Debt contracts Collateral and net worth Monitoring and enforcement of restrictive covenants Financial intermediation Explains Fact Number 1,2 5 3,4,6 6,7 3,4 Credit Risk INDIVIDUAL LOAN Credit risk is part of 3nancial intermedia;on because it is important to evaluate informa;on available to measure credit risk and to control borrowers. In addi;on, it is part of credit alloca;on of 3nancial ins;tu;ons since they transform claims of household savers into loans. Financial ins;tu;ons are exposed to credit risk less than individual but s;ll and for this, they ask for a fair return. Financial ins;tu;ons collect savings and make loans and they are subject to some costs: - The 3nancial resources they collect are costly (cost of funding) - A cost for the poten;al loss involved in lending (credit risk). The credit risk can be view from 2 perspec;ve: single borrower (individual loan) or overall loan porqolio. It is important to measure credit risk: - To understand whether the price we ask for a loan is enough to cover credit risk - To value a bond correctly - To set appropriate limits on amount and loss exposure in order to avoid an excess of risk CREDIT RISK MANAGEMENT involves the determina;on of several features: 1. Interest rate 2. Maturity 3. Collateral (if the loans is secured or unsecured) 4. Other covenants It is important because major credit risk event were caused by a bad credit risk management. In addi;on, the credit quality problems emphasizes the importance credit risk analysis. DIFFERENT TYPES OF LOANS  Individual or consumer loans Consumer loans can be personal, auto, credit card. They can be: - Non revolving loans, because the amount given is 3xed Ex. Automobile, mobile home, personal loans - Revolving loans, because the loan can be increased Ex. Credit card debt, proprietary card. In this market the risks are mainly due to the compe;;ve condi;ons and usury ceiling (interest rate are usually in average higher than on RE and C&I loans). Risks can be aMected also by changes in laws such Bankruptcy Reform Act (2005) that made for individual much more diVcult to declare bankruptcy. The high default rates during 3nancial crisis highlight the importance of risk evalua;on prior to making a credit decision.  Real estate loans (mainly mortgage) There can be mortgage with: - Fixed rate over the mortgage - Adjustable-rate mortgages  They provide an ini;al interest rate which is 3xed for a period which it resets periodically becoming variable, according to an index. 16 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 __ Mortgages can be subject to default risk when the indicator loan-to-value rises, and houses prices fall below amount of loan outstanding. It is an indicator of how much a bank is exposed to risk is the loan (mortgage) to value (of house); the collateral is the house price.  Commercial & Industrial loans They can be divided into: - Secured (providing a collateral) - Unsecured (not collateral) In C%I loans most of the collateral consist of 3xed assets such as machineries. This kind of loans if they are of a very large size, they are provided by a SYNDACATE  It is a loan provided by a syndica;on of banks. It a group of banks which provide a loan to a client because the they want to share the risk. The loans size is so large that one single bank is not able to provide the loan alone. - Fixed rate (don’t change over ;me)  Pres;; a termine - Floa;ng rate (change according over ;me according to an index LIBOR/EURIBOR + a spread) - Spot loans (loans that are withdrawn immediately by the company and repaid at the end of the contract). - Loan commitment (can be withdrawn when the client want over the life span of the loan) or credit lines. In US it have been registered a decline in C&I because there was a growth in commercial banks and commercial paper market (cambiale 3nanziaria).  All others It includes farm loans, other banks, non-bank 3nancial ins;tu;ons (broker margin loans), state and local governments. Calcula&ng the Return on a Loan We need to consider: Interest rate, fees, credit risk premium, collateral, and other nonprice terms, such as compensa;ng balances (a share of the loan must be kept in the deposit) and reserve requirements. RETURN = in&ow/ouqlow 1+k = 1+(of + (BR + ø))/(1-[b(1-RR)]) Expected return 1 + E(r) = p(1+k) k contractually promised gross return on the loan of  origina;on fees (fees to cover other expenses) ø  premium asked to cover credit risk (extra interest rate) BR  base rate (benchmark) ex. Cost of funding BR + ø  loan interest rate (very low credit risk aJached) RR  reserve requirement (must be kept to the central banks = hidden cost for the bank) b  compensa;ng balance (borrowers asked to keep a share of their loan on the bank’s deposit = hidden cost for the borrower and hidden advantage for the bank) p  probability of complete repayment Note that realized and expected return may not be equal because the actual one depends on the repayment of the client (credit risk). 17 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 EXAMPLE  Suppose that the 3nancial ra;ons of a poten;al borrowing 3rm take the following values: X1 = 0.2 X2 = 0 X3 = -0.2 X4 = 0.1 X5 = 2.0 The ra;o X2 is zero and X3 is nega;ve, indica;ng that the 3rm has had nega;ve earnings or losses in recent periods. Also, X4 indicates that the borrower is highly leveraged. However, the working capital ra;o X1 and the X5 indicate that the 3rm is reasonably liquid and is maintaining its sales volume. The Z score provides on overall score or indicatore of the borrower’s credit risk. Z=1.2(0.2)+1.4(0)+3.3(-0.20)+0.6(0.10)+1.0(2.0)=1.64 With a Z score less than 1.81 the 3nancial ins;tu;on should not make a loan to this borrower unitl it improves its earnings. The problems associated with discriminant /linear analysis model: - Only considers two extreme cases (default/no default) - No reason to expect that the weights in a credit scoring model will be constant long-term; sensi;vity to variable weights (the weight used are es;mated on past data of other borrowers, there is not reason to believe that those weight are useful for future borrowers) - Ignores hard to quan;fy factors, including business cycle eMects and reputa;on (there are some qualita;ve factors that are hard to de3ne) - Database of defaulted loans is not available to benchmark the model (if banks are small they do not have enough data to create those database) NEWER MODELS OF CREDIT RISK MEASUREMENT AND PRICING They use 3nancial theory and more widely available 3nancial market data, in order to overcome some of the constraints of credit scoring and linear discriminant models: Present value formula: it is based on the no;on that a dollar of cash &ow paid to you in the future is less valuable to you than a dollar paid to you today. The decision between spending your money now or saving it for the future depends on the interest that you can earn on your savings. Example: principal (100$) and interest (10$), what is the interest rate? i=$10/$100=0.10=10% (simple interest rate). At the end of the year you receive $100x(1+0.10): - If you lend out the amount of $110 for another year, at the end of the second year you would receive $100x(1+0.10)=$121 - If you reinvest $100 for another year, you would receive $100x(1+0.10)x(1+0.10)=$100x(1+0.10)2=$121 Generalizing, $100(1+i)n Present Value = Future Cash Flow/(1+i) n  i = annual interest rate Increasing this, the PV goes down because it is more discounted.  n = number of years 20 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 e It can be used as a proxy for the market value of debt instrument. 1. TERM STRUCTURE DERIVATION OF CREDIT RISK APPROACH The idea is to look at the market data available. Consider two bonds: one risky, one risk free. If the return we get from a bond is greater than the return we get on a risk-free bond, it is called risk premium (extra return we get for inves;ng in a risky bond). If the risk premium is known, we can infer the probability of default (p). Risk premium can be computed using Treasury strips (are US government bonds with one payment) and zero-coupon corporate bonds (just one interest payment). They must be zero coupon bonds, otherwise there would be an extra risk which is known as reinvestment risk. p(1+k) = 1+i 1+i Total return at the end from the investment in a risk-free bond. P(1+k) Return I get inves;ng is a zero-coupon corporate bond; it is not risk free but there is a probability of default. They are equal because we are considering investors who are indiMerent in terms of risk (they know there is a probability of default p). Yield increases with the maturity; the diMerence between the two bonds is the RISK PREMIUM (extra yield because inves;ng in a risky bond). p: probability of repayment K: contractually promised return i: one-year treasury strip EXAMPLE: i = 2.05% k = 7.8% p = (1.0205)/(1.0780)=0.9467(probability of repayment) PD=1-p=0.0533=5.33% (probability of default, implied in the risk premium of the bond) ø =k-i=5.75% (risk premium) What if there is a par2al repayment? [(1-p) γ(1+k)]+p (1+ k) = 1+ i 1+k = return on the bond 1-p = probability of default p = probability of repayment γ = propor;on of repayment (share) ø = risk premium ø =k-i=[(1+i)/(γ+p+pγ)] -(1+i) in case of default, we s;ll can recover a por;on. EXAMPLE: I = 2.05% k = 7.8% p = (1.0205)/(1.0780)=0.9467 PD=1-p=0.0533=5.33% γ=0.9 (recovery) ø =k-i=0.55% (risk premium)  It is lower than the 3rst example because we are s;ll able to get a share 21 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 C f e Note: p and γ are perfect subs&tutes If the probability of repayment goes down and the probability of default goes up, we can make an eMort to increase the por;on of repayment in case of default for example asking more collateral. Considering a mul&period debt instrument (not just one payment but mul;ple payments) The default probability of the second payment is condi;onal on the fact that default has not occurred earlier. If the client defaults on the payment, the second payment is much riskier because the client probably will not make the second payment. In every year t there is a MARGINAL DEFAULT PROBABILITY = the probability that the client will make that speci3c payment. Cumula;ve default probability over 2 years: Cp=1-[(p1) (p2)] EXAMPLE: PD1 = 1-p1= 0.05 PD2 = 1-p2 = 0.07 Cp = 1 – [(0.95) (0.93)] = 0.1165 11.65% probability of default over 2 years. 0.95 = probability that the 3rst payment will be done (1-PD1) 0.95*0.93 = probability that everything will be paid. How to determine the marginal default probability in year t? 1+f1 = [(1+i2)^2] / (1+i1)  f1 is the forward interest rate  I1 and i2 are yields of treasury strips with maturi;es of 1 and 2 years, respec;vely FORWARD INTEREST RATE  It is an interest rate applied to future loan. If we have one-year risk free bond and a two-year risk-free bond (1+i2) we can extract from them the implied interest rate that is requested by investors for a future loan. In case of corporate bond: 1+c1 = [(1+k2)^2] / (1+k1)  c1 is the forward interest rate (corporate bond with maturity one year)  k1 and k2 are yields of zero-coupon corporate bonds with maturi;es of 1 and 2 years, respec;vely Then: p2=probability of repayment in the future for a one-year corporate bond 1+f1= return I get in the future from a one-year government bond E[PD2]= Expected probability of default p2(1+c1)= 1+f1 p2=(1+f1)/(1+c1) E[PD2]=1-p2 EXAMPLE: Government bond: i1 = 2.05%; i2 = 3% 1+f1 = (1.03)^2 / (1.0205) = 1.0396 f1 = 3.96% Corporate bond: k1 = 7.8%; k2 = 10% 1+c1=(1.10)^2 / (1.078) = 1.1224 Probability of repayment: p2 = 1.0396 / 1.1224 = 0.9262 Probability of default: 1-p2 = 1 – 0.9262 Cumula;ve probability: 1- [(0.9467) (0.9262)] = 12.32% 2. MORTALITY RATE APPROACH It is similar to the process employed by insurance companies to price policies; the probability of default is es;mated from past data on defaults of corpora;ons. There are two MARGINAL MORTALITY RATES: - MMR1 = Value Grade B default in year 1 / Value grade B outstanding yr.1 (total outstanding bonds in that period 0-1 with the same grade) - MMR2 = Value Grade B default in year 2 / Value grade B outstanding yr. 2 (between 1-2) 22 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 FATE a Then: RAROC = 0.003 /(0.04 x 0.8) = 9.375% 4. OPTION MODELS This model employs op;on pricing methods to evaluate the op;on to default. It is used by many of the largest banks to monitor credit risk. Financial op;ons are a type of 3nancial instruments. It provide to the holder the right to buy or sell some securi;es at the end of the contract. Call op&on = the holder has the opportunity at the end of the contract to buy some shares at the given price. Put op&on = the debt holder has the op;on at the end of the contract to sell some 3nancial instruments to seller of put op;on at a given price. IDEA: if a borrower’s investment projects fail so that it cannot repay the bondholder or the bank, it has the op;on of defaul;ng on its debt repayment and turning any remaining assets over to the debtholder. Borrower’s loss is limited on the downside by the amount of equity invested in the Srm. BORROWER’S PERSPECTIVE Borrower’s payoM from loans: - S = size of the ini;al equity investment - B = value fo outstanding bonds or loans - A = market value of assets If project fails and A becomes lower than B, the limited-liability stockholderowners will default: stockholder-owners’ payoM is «-S». The higher A is rela;ve to B, the beJer oM are the 3rm’s stakeholders. So, if A is greater than B, the payoM is «A-B-S». Equity is analogous to buying a call op&on on the assets of the 3rm (op;on to buy equity in the future at a 3xed price (excercise price) of B). In case the project fails, there is no incen;ve to con;nue the ac;vity, so it is beJer to default. But in case the value of share remains posi;ve, the best is to pay oM the debt (op;on to pay oM) and to keep the remaining value (A-B-S). (Assets = Debt + Equity If the project fails, the value of assets goes down Assets <= Debt, then Equity (shares in the market) = 0) DEBT HOLDER’S PERSPECTIVE Debt holder’s payoM from loans: S = size of the ini;al equity investment B = value of outstanding bonds or loans A = market value of assets The maximun amount the FI or bond holder can get back is B, the promised payment. However, borrower would repay if A > B (posi;ve payoM for the borrower), that is, if the market value of assets exceeds the value of value of promised debt payments. If A < B, the borrower would default and turn over any remaining assets to the debt holders. The debt holder will receive back only those assets remaining as collateral, thereby losing B – A. 25 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 F The payoM func;on to the debt holder is similar to wri;ng a put op&on (op;on to sell) on the value of the borrower’s assets with B, the face value of debt, as the exercise price. Credit Risk LOAN PORTFOLIO AND CONCENTRATION RISK The diMerence between individual and loan porqolio is that when considering the loan porqolio, we have to take into considera;on the diversi3ca;on bene3ts. MODEL OF LOAN CONCENTRATION: 1. MIGRATION ANALYSIS (changes in corpora;ons’ ra;ngs from one year to another one). This analysis tracks credit ra;ngs (measure of credit risk of a corpora;on) of similar 3rms in a par;cular sector or ra;ngs class for unusual declines. Loan migra&on matrix re&ects historic credit ra;ng experience of a pool of loans and serves as a measure of the probability of the loan being upgraded, downgraded, or defaul;ng over some speci3ed period Migra;on analysis is widely applied to commercial loans, credit card porqolios, and consumer loans. This is a loan migra;on matrix. Problem  informa;on may be too late because ra;ngs agencies usually downgrade issues only a^er the 3rm or industry has experienced a downgrade. 2. SET CREDIT LIMITS Management sets external limit on maximum amount of loans to be made to individual borrower or sector (i.e., concentra;on limits). CL = (max loss as percentage of capital) (1/loss rate) Equity should absorb losses; here the idea is to set a maximum level of loan based on the amount of capital. It is used by FIs to limit exposure between highly correlated industries and geographic locales. Concentra&on Limits for Loan Porsolio Example Management caps losses at 15% of FI’s capital to a par;cular sector and es;mates that amount loss per dollar of defaulted loans in the sector is 40 cents. Thus, the maximum loans to a single sector as a percent of capital, i.e., the concentra;on limit, is: CL = (max loss as % of capital)(1/loss rate) CL = (15%)(1/0.4) = 37.5% 3. MODERN PORTFOLIO THEORY (MPT) Using MPT allows FI to diversify sizeable amounts of credit risk exposure by taking advantage of its size. 26 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 a Returns of assets within the porqolio must be imperfectly correlated with regards to their default risk adjusted returns (if the returns of two loans are not perfectly correlated we can enjoy diversi3ca;on bene3ts and we can 3nd a combina;on of two loans that minimize the risk).  Minimum risk porsolio: combina;on of assets that reduces porqolio risk to lowest feasible level. To the extent that an FI, manager can hold widely traded loans and bonds as assets or, alterna;vely, can calculate loan or bond returns, porqolio diversi3ca;on models can be used. Porsolio DiversiSca&on The higher the dispersion the greater the risk, that the expected return will not be realized. B is the porqolio with the lowest risk. Given the same level of risk there is more than one porqolio but they have diMerent return: the idea is to minimize the risk with the higher return. The bene3ts of diversi3ca;on are maximised when the correla;on is nega;ve. MODERN PORTFOLIO THEORY - Expected return - Variance EXAMPLE: Porqolio of loans: - 70% loans to construc;on sector: E(r) = 10% std = 4% - 30% loans to industrial sector: E(r) = 15% std = 6% E(r) = 70% * 10% + 30% * 15% = EXAMPLE: Suppose that an FI holds two loans with the following characteris;cs: 27 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 T gg The return and risk of the porqolio are then: Rp = 0.6(6.25%) + 0.4(5.60%) = 5.99% !" 2 = 0.6^2 (0.04265)^2+ 0.4^2 (0.028)^2+2*(0.6) (0.4) (−0.25) (0.04265) (0.028) = 0.0006369 Thus, !" = sqr(0.0006369) = 0.0252 = 2.52% (lower that the other 2 enjoying diversi3ca;on bene3t). EXERCISES ON CREDIT RISK 1. ROA on a loan Suppose that a bank does the following: - Sets a loan rate on a prospec;ve loan at 8% (where BR=5% and O =3%) - Charges a 0,1% loan origina;on fee to the borrower - Imposes a 5% compensa;ng balance requirement to be held as noninterest bearing demand deposits - Hold reserve requirements of 10% imposed by the Federal Reverse on the bank’s demand deposits. CALCULATE THE BANK’S ROA CALCULATE THE EXPECTED ROA if the probability of repayment is 95%. It is lower than ROA because the 5% of the loans be lost. 2. Linear probability models Suppose there were two factors in&uencing the past default behaviour of borrowers: the leverage or debt assets ra;o and the pro3t margin ra;o (net income – sales). Based on past default experience, the linear probability model is es;mated as: PDi= 0.105(D/A) – 0.35 (PMi) Prospec;ve borrower A has a D/A = 0.65 and PM = 5% Prospec;ve borrower B has a D/A = 0.45 and a PM = 1%. CALCULATE THE PROSPECTIVE BORROWERS’ EXPECTED PROBABILITIES OF DEFAULT. Which borrower is the beJer loan candidate? Explain the answer. The beJer loan candidate is B. Despite having a lower pro3tability, B is less leveraged than B. 30 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 t e 3. Linear discriminant models Suppose that the 3nancial ra;os of a poten;al borrowing 3rm take the following values: - Working capital / Total assets ra;o (X1) = 0.75 - Retained earnings / Total assets ra;o (X2) = 0.10 - Earning before interest and taxes / Total assets ra;o (X3) =0.05 - Market value of equity / Book value of total liabili;es (X4) = 0.10 - Sales / Total assets ra;o (X5) = 0.65 CALCULATE THE ALTMAN’S Z SCORE FOR THE BORROWER. How is this number a sign of the borrower’s default risk? With a Z score greater than 1.81, the FI should make a loan to this borrower but strictly monitor the performance over ;me. 4. Term structure of credit risk If the rate on one-year treasury strips currently is 6%, what is the repayment probability for each of the following securi;es? Assume that if the loan is defaulted, no payments are expected. What is the market determined risk premium for the corresponding probability of default for each security? - One-year AA-rated zero-coupon bond yielding 9.5% - One-year BB-rated zero-coupon bond yielding 13.5% IMPLIED PROBABILITIES OF REPAYMENT AND CREDIT PREMIUMS - AA-rated bond - BB-rated bond 31 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 Tfr É 4. RAROC (with duraSon) An FI wants to evaluate the credit risk of a $5 million loan with a dura;on of 4.3 years to a AAA borrower. There are currently 500 publicly traded bonds in that class. The current average level of rates R on AAA bons is 8%. The largest increase in credit risk premiums on AAA loans, the 99% worst-scenario, over the last year was equal to 1.2%. The projected one-year spread on the loans is 0.3% and the FI charges 0.25% of the face value of the loan in fees. CALCULATE THE CAPITAL AT RISK AND THE RAROC ON THIS LOAN. (return adjusted to the risk) 5. PorTolio concentraSon limits A manager decides not to lend to any 3rm in sectors that generate losses in excess of 5% of capital. - If the average historical losses in the automobile sector total 8%, what is the maximum loan a manager can lend to 3rms in this sector as a percentage of total capital? - If the average historical losses in the mining sector total 15%, what is the maximum loan a manager can make to 3rms in this sector as a percentage of total capital? CONCENTRATION LIMITS (what size of the loan?) - CL = 5% / 8% = 62.5% of total capital (is the maximum percentage of loan as percentage of capital) - CL = 5% / 15% = 33.3% of total capital 32 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 z a 3. DERIVATIVE CONTRACT: agreement between two par;es to exchange a standard quan;ty of an asset at a predetermined price at a speci3ed date in the future. 4. WHEN-ISSUED TRADING: trading in securi;es prior to their actual issue (I commit to invest in them, but they are not issued). 5. LOAN SOLS: loans sold to other investors (3nancial ins;tu;on commits to sell some loans to investors). They are considered as OBS only if sold without recourse (loans cannot be returned to the 3nancial ins;tu;on if the credit quality of loans deteriorate). LOAN COMMITMENTS Loan commitment is a contractual commitment by an FI to lend to a 3rm a certain maximum amount at a given interest rate terms. The agreement also de3nes the length of ;me over which the borrower has the op;on to take down this loan. Sources of income for the FI: - Interest rate on the used balances - Upfront fee: percent of the commitment size (paid when the commitment is done) - Back-end fee: percent of unused balances (at the end of the contract on the loan not used) EXAMPLE: Calcula;on of the promised return on a loan commitment (1-td)= unused part of loan 35 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 The loan commitments risks are: - Interest rate risk If 3xed-rate or variable-rate commitment, the bank is exposed to interest rate risk If &oa;ng rate commitment, there is s;ll exposure to basis risk (i.e. loan rates and deposit rates are not perfectly correlated in the movements over ;me) - Takedown risk Uncertainty of ;ming of takedown on loan commitment: exposes the FI to a degree of future liquidity risk (= possibility not to have enough liquidity to make a loan when the client take down the loan commitment). Back-end fees (on unused por;on of the loan) are intended to reduce this risk because they are calculated on the part of the loan which is not used, so the client has incen;ve to use the loan. - Credit risk Credit worthiness of the borrower may deteriorate over life of the commitment (ex. Ra;ng migra;on from AAA to BBB): it is a con;ngent credit risk (the risk occurs only if the client takes down the loan). Financial ins;tu;on o^en adds a risk premium on current assessment of the client (but it might be not enough). In some loan commitment contracts, 3nancial ins;tu;ons provide an adverse material change in condi;ons clause (allow to cancel or reprice the loan commitment in case there is a change in the credit quality of the client). However, may put the client out of business and result in costly legal claims. - Aggregate funding risk During a credit crunch, bank may 3nd it diVcult to meet all of the commitments. This is usually compounded by externality eMect and rising interbank borrowing rates. In other words: borrowers’ aggregate demand to take down loan commitment is likely to be greatest (during a credit crunch/3nancial downturn) when the FI’s borrowing and funding condi;ons are most costly and diVcult (FIs are also aMected by the credit crunch/3nancial downturn). Commercial Leters of Credit (LCs) LCs are par;cularly important for foreign purchases, though are used frequently for domes;c trade. If creditworthiness of the importer is unknown to seller or lower than the bank’s, then gains available through using a LC. Standby Leters of Credit (SLCs) SLCs o^en used to ensure risks that are more severe, less predictable and/or not trade related. - Performance bond guarantees (whereby an FI may guarantee that a real estate development may be completed in some interval of ;me). 36 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 i - Commercial Paper insurers also prominent in selling SLCs (allow 3rms to borrow or borrow at a lower funding cost). DERIVATIVE CONTRACTS They are used by 3nancial ins;tu;ons for hedging (and other) purposes. Financial ins;tu;ons can also be dealers of deriva;ves.  Futures, forwards, swaps, and op2ons Forward (and swap) contracts involve substan;al counterparty risk (because they are most of the ;me over the counter); other deriva;ves create far less default risk. ORGANISED MARKET = Borsa italiana 37 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 F If the client is not using the money, we can use the money for another loan. 4. LETTER OF CREDIT A German bank issues a three-month leJer of credit on behalf of its German customer who is planning to import $100000 worth of goods from the USA. The banks charges an upfront fee of 100 basis points. - What upfront fee does the bank earn? Upfront fee = $100000 * 1% = $ 1000 - If the U.S. exporter decides to discount this leJer of credit a^er is has been accepted by the German bank, how much will the exporter receive, assuming that the interest rate currently is 5% and that 90 days remain before maturity? Present Value = $100000 * (1 – (5% (90 / 365))) = $ 98767 5. STANDBY LETTER OF CREDIT A corpora;on is planning to issue $1 million of 270-day commercial paper for an eMec;ve annual yield of 5%. The corpora;on expects to save 30 basis points on the interest rate by using a SLC as collateral of the issue. - What are the net savings to the corpora;on if a bank agrees to provide a 270-day SLC for an upfront fee of 20 basis points to back the commercial paper issue? Annualized upfront fee = 0.2% * (360/270) = 0.27% Net savings = 0.3% - 0.27% = 0.03% Financial statement analysis There four diMerent types of 3rms: 40 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 S  SOLE PROPRIETORSHIP  They are owned and run by just one person. The employee can be just the owner or few of them. Advantages: - Easy to create and manage Disadvantages: - There is no separa;on between the 3rm and the owner so there is an unlimited personal liability - Limited life (in US)  PARTNERSHIP  There is more than one owner (group of people). All partner are personally liable for all of the 3rm’s debts (unlimited personal liability). The partnership ends with the DEATH or the WITHDRAWAL of any single partner. Limited partnership has two types of owners: - General partners = they run the 3rm on a day-to-day basis. They have the same rights and liability as partners in a regular partnership. - Limited partners = limited liability They do not have any management authority and cannot legally be involved in the managerial decision making (cannot run the 3rm).  LIMITED LIABILITY COMPANY (LLC)  All owners have limited liability, but they can also run the business.  CORPORATION  It is a legal en;ty separate from its owners Since the corpora;on is a legal en;ty, it has legal powers such as the ability to: - Enter into contracts - Own assets - Borrow money The corpora;on is solely responsible for its own obliga;ons (= owners are not liable for any obliga;on). FORMATION It must be legally formed. 1. Files a charter with the state it wishes to incorporate in (which country). 2. The state then allows the corpora;on, formally giving its consent to the incorpora;on. Due to its aJrac;ve legal environment for corpora;ons, Delaware is a popular choice for incorpora;on. OWNERSHIP It is represented by shares of stock (when a stock is transferred, also the ownership is). The owner of stock is called shareholder, stockholder or equity holder. The owner is en;tled to dividend payments (depending on the value of the owned stock).  The sum of all ownership value (of all stocks of all shareholders) is called EQUITY. There are no limits to the number of shareholders and to the amount of funds. TAX IMPLICATIONS Since the company is a legal en;ty separated from the owners, it has to pay it owns taxes. There is a double taxa&on, because the corpora;on is taxed but also the shareholders (they are taxed when they receive dividends). 41 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 Tt 9  In “S” Corpora;ons, pro3ts are not subject to corporate income tax, but they allocated directly to the shareholders. EXAMPLE: Taxa&on of Corporate Earnings Problem The corpora;on earns $5 per share before taxes (for every share I own, I receive 5 dollars per share). The corporate tax rate is 40%. Personal tax rate on dividend income is 15%. How much of the earnings remains a^er all taxes are paid? Corporate taxes: 0.40 × $5 = $2 (remaining $3) Income taxes 0.15 × $3 = $0.45 Net per share: $2.55 Total ecec2ve tax rate: 2.45 / 5 = 49%. EXAMPLE: Taxa&on of Corporate Earnings Problem Income before taxes: $4 million. 1 million shares outstanding. Corporate tax rate: 34% Personal tax rate on dividend income: 20%. As a shareholder with 100 shares, how much will you receive a^er all taxes are paid? Corporate taxes: 34%×$4 million = $1.36 million ($2.64 million to distribute to shareholders) Shareholder taxes (all): 20%×$2.64 million = $528,000 $2.64 million − $528,000 = $2,112,000 a^er all taxes are paid $2.112 mln / 1 mln (shares outstanding) = $ 2.112 net income per share Net income of the owner of 100 shares: $211.20 EXAMPLE: Taxa&on of S Corporate Earnings Problem Rework Example 1.1 assuming the corpora;on in that example has elected subchapter S treatment and your tax rate on non-dividend income is 30%. OWNERSHIP VS CONTROL OF CORPORATIONS In a corpora;on, ownership and direct control are typically separate (managers and owners are not the same person). The board of Directors is elected by shareholders and they are the ul;mate decision-making authority. It nominates the Chief Execu;ve OVcer (CEO), who is delegates to day-to-day decision making. Financial Manager (chief 3nancial oVcer) is responsible for: - Investment Decisions - Financing Decisions - Cash Management  The main goal of the 3rm is to MAXIMIZE THE VALUE OF SHARES (make the price of shares to increase over ;me, and this can be done only by genera;ng the value). O^en, an increase in the value of the 3rm’s equity bene3ts society as a whole because the wealth of the society goes up. 42 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 Sta Stockholder’s Equity The book value of equity is given by the diMerence between the book value of the 3rm’s assets and book value of liabili;es (what’s le^ a^er paying oM liabili;es).  It could possibly be nega;ve in some cases (when the value of assets < value of liabili;es). One of the main piqalls of the book value of equity is that it is not the true representa;on of the value of the company: many of the 3rm’s valuable assets may not be captured on the balance sheet. That’s why the value of the company depends on keys strategic characteris;cs of the company. On the other hand, the market value of equity is valued by stockholders and it is given by: Market Price per Share × Number of Shares Outstanding  It cannot be nega;ve (the lowest value is zero). The market value of equity o^en diMers substan;ally from book value. MARKET TO BOOK RATIO = (market value of equity)/(book value of equity) - Value stocks, when stocks with low M/B ra;o without high growth perspec;ve (ex. companies opera;ng in mature sectors) - Growth stocks, when stocks with high M/B ra;os (ex. companies opera;ng in high-growth sectors) ENTERPRISE VALUE = market value of equity + debt – cash It is the price that an investor will be willing to pay to buy out the company. Cash is subtracted because it reduces the net price for a poten;al acquirer (cash is used to issue dividends or pay oM debt). EXERCISE If Global conglomerate (note: this is the company of Table 2.1) has 3.6 million shares outstanding, and these shares are trading for a price of $14 per share, what is Global’s market capitaliza;on compare to Global’s book value of equity in 2015?  Global’s market capitaliza;on is (3.6 million shares) x $14 (price per share) = $50.4 This market capitaliza;on is signi3cantly higher than Global’s book value of equity of $22.2 million.  Market-to-book ra;o = 50.4 / 22.2 = 2.27 Thus, investors are willing to pay 2.27 ;mes the amount Global’s shares are “worth” according to their book value. EXERCISE Rylan Enterprises has 5 million shares outstanding. The market price per share is $98. The 3rm’s book value of equity is $50 million. What is Rylan’s market capitaliza;on and Rylan’s Market-to-Book ra;o? Rylan’s market capitaliza;on is $490 million 5 million shares × $98 share = $490 million. The Market-to-Book ra;o is: $490 /$50 = 9.80 45 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 2. INCOME STATEMENT The main equa&on of the income statement is Total Sales / Revenues - Cost of sales = GROSS PROFIT - Gross Pro3t - Opera;ng Expenses* = OPERATING INCOME *Selling, General, and Administra;ve Expenses; R&D; Deprecia;on and Amor;za;on. - Opera;ng Income +/- Other Income/Other Expenses = EARNINGS BEFORE INTEREST AND TAXES (EBIT) - Earnings Before Interest and Taxes (EBIT) +/- Interest Income/Interest Expense = PRE-TAX INCOME - Pre-Tax Income - Taxes = NET INCOME - Earnings per Share (EPS) = net income / shares outstanding There can be a dilu;ve eMect of shares that could be issued by the company. If the company has emplaced stock op;ons or conver;ble bonds, these two increase the number of shares; then the real EPS goes down = diluted EPS (assumes that all shares that could be outstanding have been issued). 3. STATEMENT OF CASH FLOWS The net income typically does NOT equal the amount of cash the 3rm has earned. The diMerence between net income and cash &ow is due to: - Non-cash expenses (deprecia;on/amor;za;on) - Uses of cash not on the income statement (investment in property, plant and equipment) The statement of cash &ow has three sec;ons: Opera&ng Ac&vity It adjusts net income by all non-cash items related to opera;ng ac;vi;es and changes in net working capital. a. Deprecia;on – add the amount of deprecia;on (plus) b. Accounts Receivable – deduct the increases (minus) c. Accounts Payable – add the increases (plus) d. Inventories – deduct the increases (minus) Investment Ac&vity a. Capital Expenditures b. Buying or Selling Marketable Securi;es Financing Ac&vity a. Payment of Dividends Retained Earnings = Net Income – Dividends b. Changes in Borrowings 46 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 EXERCISE Suppose Global had an addi;onal $1 million deprecia;on expense in 2015. If Global’s tax rate on pre-tax income is 26%, what would be the impact of this expenses on Global’s earnings? How would it impact Global’s cash balance at the end of the year?  Deprecia;on is an opera;on expense, so Global’s opera;ng income, EBIT, and pre-tax income would fall by $1 million. This decrease in pre-tax income would reduce Global’s tax bill by 26% × $1 million = $0.26 million. Therefore, net income would fall by 1 − 0.26 = $0.74 million.  On the statement of cash &ows, net income would fall by $0.74 million, but we would add back the addi;onal deprecia;on of $1 million because it is not a cash expense. Thus, cash from opera;ng ac;vi;es would rise by − 0.74 + 1 = $0.26 million. Thus, global’s cash balance at the end of the year would increase by $0.26 million, the amount of the tax savings that resulted from the addi;onal deprecia;on expense. EXERCISE: Impact of deprecia;on In 2016, Rylan Enterprises net income increased by $1.5 million while its deprecia;on expense decreased by $750,000, accounts receivable increased by $5,000,000 and accounts payable increased by $3,000,000. Rylan’s total corporate tax rate is 40%. How did the decline in Rylan’s deprecia;on expense impact its end-of-year cash balance? The decrease in deprecia;on expense increases Rylan’s pre-tax income by $750,000. This increases Rylan’s tax obliga;on by: 40% × $750,000 = $300,000 Rylan must pay $300,000 more in taxes due to the decline in deprecia;on expense. Thus, its end-of-year cash balance is $300,000 lower as a direct result of the lower deprecia;on expense. 4. STATEMENT OF STOCKHOLDERS’ EQUITY Change in Stockholders’ Equity = Retained Earnings (not distributed to shareholders) + Net sales of stock (issue of stocks) = Net income – Dividends + Sales of stock – Repurchases of Stock Other 3nancial statement informa;on are:  Management discussion and analysis (oM-balance sheet transac;ons)  Notes to the 3nancial statements EXERCISE: Sales revenues In the Segment Results sec;on of its 3nancial statements, Hormel Foods Corp (HRL) reported the following sales revenues by reportable segment / product category ($ million). 47 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 s_ Quick Ra;o 2016: ($2,000,000 + $7,000,000 + $20,000,000)/$35,000,000 = 0.83 2015: ($4,000,000 + $6,000,000 + $15,000,000)/$27,000,000 = 0.93 Cash Ra;o 2016: $2,000,000/$35,000,000 = 0.06 2015: $4,000,000/$27,000,000 = 0.15 Using either measure, Rylan’s liquidity has deteriorated. WORKING CAPITAL RATIOS - Accounts receivables days Accounts receivable / Average daily sales The smaller, the beJer: it is a proxy of number of days needed to transform account receivables in cash. - Account payables days Accounts payable / Average daily cost of sales The longer, the beJer: it is a proxy of number of days needed to ex;nguish the debt (to pay). - Inventory days Inventory / Average daily cost of sales The smaller, the beJer: it is the number of days needed to transform the inventory in sales. - Accounts receivables turnover Annual sales / Accounts receivables The larger, the beJer. - Accounts payables turnover Annual costs of sales / Accounts payables The smaller, the beJer. - Inventory turnover Annual cost of sales / Inventory The larger, the beJer. INTEREST COVER RATIOS It is the ability of the company to meet its interest payments obliga;on over ;me. - Interest coverage ra&os EBIT / Interest (before the interest) EBITDA / Interest EBITDA = EBIT + deprecia;on and amor;za;on The larger, the beJer. EXERCISE: compu;ng interest coverage ra;os Assess Global’s ability to meet its interest obliga;ons by calcula;ng interest coverage ra;os using both EBIT and EBITDA. In 2014 and 2015, Global had the following interest coverage ra;os: 2015 EBIT / Interest = 10.4 / 7.7 =1.35 50 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 Cgt EBITDA / Interest = 10.4+1.2 / 7.7 = 1.51 2014 EBIT / Interest = 7.1 / 4.6 = 1.54 EBITDA / Interest = 7.1+1.1 / 4.6 = .178 In this case Global’s low-and declining-interest coverage could be a source of concern for its creditors. EXERCISE Assess Rylan’s ability to meet its interest obliga;ons by calcula;ng interest coverage ra;os using both EBIT and EBITDA. EBIT/Interest 2016 $100,000,000 / $10,000,000 =10.0 2015 $87,500,000 / $9,000,000 = 9.72 EBITDA/Interest 2016 $125,000,000 / $10,000,000 =12.5 2015 $110,000,000 / $9,000,000 =12.2 Using either measure, Rylan’s ability to meet it is very good and improving. LEVERAGE RATIOS - Debt-to-equity-ra&o Total debt / Total equity - Debt-to-capital ra&o Total debt / (Total equity + total debt) - Debt-to-enterprise value Net debt / (Market value of equity + Net debt) NET DEBT = Total debt – Excess cash and short-term investment - Equity mul&plier Total assets / Book value of equity ROA * Equity mul;plier = ROE VALUTATION RATIOS - Price to Earnings ra&o Market capitaliza;on / Net income = Share price / Earnings per share When it is high, it shows that investors are willing to pay more. In addi;on, it could be because this investment is less risky - Enterprise value to EBIT Market value of equity + Debt – Cash / EBIT (the higher, the beJer) - Enterprise value to Sales Market value of equity + Debt – Cash / Sales (the higher, the beJer) EXERCISE: compu;ng pro3tability and valua;on ra;os Consider the following data as of July 2015 for Walmart and Target Corpora;on (in $ billion). Compare Walmart’s and Target’s EBIT margins, net pro3t margins, P/E ra;os, and the ra;o of enterprise value to sales, EBIT, and EBITDA. 51 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 r Walmart had an EBIT Margin of 26.6 / 485.7 = 5.5%, a net pro3t margin of 16.2 / 485.7 = 3.3% and a P/E ra;o of 235.6 / 16.2 =14.5. Its enterprise value was 235.6 + 48.8 − 9.1 = 275.3 billion, which has a ra;o of 275.3 / 485.7 = 0.57 to sales, 275.3 / 26.6 =10.3 to EBIT, and 275.3 / (26.6+9.2) = 7.7 to EBITDA. Target had EBIT margin of 4.5/73.3 = 6.2%, a net pro3t margin of 2.5/73.1 = 3.4$ì%, and a P/E ra;o of 52.9 / 2.5 = 21.2. Its enterprise value was 52.9 + 12.8 – 2.2 = 63.5 billion, which has a ra;o of 63.4 / 73.1 = 0.87 to sales, 63.5/4.5 = 14.4 to EBIT, and 63.5 / (4.5+2.1) = 9.6 to EBITDA.  Note that despite the large diMerence in the size of the two 3rms, Target trades at higher, though comparable, mul;plies. EXERCISE: compu;ng pro3tability and valua;on ra;os Using the balance sheet and the income statement from previous examples (slides 52, 53 and 61), calculate Rylan Corpora;on’s opera;ng margin, net pro3t margin, P/E ra;o, and enterprise value for 2016. EBIT margin 100/500 =20% Net pro3t margin 54/500 =10.80% P/E ra;o 54/490 = 11.02 Recall, Ryan’s market capitaliza;on was previously calculated to be $490 million. Enterprise value 490 + 55 – 2 = 543 OPERATING RETURNS - Return on equity (ROE) Net income / Book value of equity The higher, the beJer - Return of assets (ROA) (net income + interest expenses) / Total assets - Return on invested capital EBIT (1-Tax rate) / Book value of equity + net debt EXERCISE: compu;ng opera;ng returns Assess how Global’s ability to use its assets eMec;vely has changed in the last year by compu;ng the change in its return on invested capital. 52 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 Therefore, the jeweller’s opportunity has a bene3t of $12,000 today and a cost of $13,000 today. In this case, the net value of the project today is $12,000 - $13,000 = - $1,000. Because it is nega;ve, the costs exceed the bene3ts, and the jeweller should reject the trade. It can also be used the market prices to determine cash values. In a COMPETITIVE MARKET everything has a value  a market in which goods can be bought and sold at the same price. Jeweller’s decision: we used the current market price to convert from ounces of pla;num or gold to dollars. There is no concern about whether the jeweller thought that the price was fair or whether the jeweller would use the silver or gold. EXERCISE: compe;;ve prices determine value You have just won four ;ckets for a concert: face value $40 each. You have no inten;on of going to the concert. Second choice: two ;ckets to your favourite band’s sold-out show (face value $45 each). On eBay, ;ckets to the concert are being bought and sold for $30 apiece and ;ckets to your favourite band’s show are being bought and sold at $50 each. Which prize should you choose?  Compe&&ve market prices are relevant here Four concert ;ckets at $30 apiece = $120 market value Two of your favourite band’s ;ckets at $ 50 apiece = $100 market value You should accept the concert ;ckets, sell them on eBay, and use the proceeds to buy two ;ckets to your favourite band’s show. You’ll even have $ 20 le^ over. EXERCISE: compe;;ve prices determine value Your car needs $2,000 in repairs. Today you have just won a contest where the prize is either: a new motorcycle, with a MSRP (Manufacturer's Suggested Retail Price) of $15,000, or $10,000 in cash. You es;mate you could sell the motorcycle for $12,000. Which prize should you choose?  Compe&&ve markets are relevant here: you should accept the motorcycle, sell it for $12,000, use $2,000 to pay for your car repairs and s;ll have $10,000 le^ over. EXERCISE: applying the valua;on principle You are the opera;ons manager at your 3rm. Due to a pre-exis;ng contract, you have the opportunity to acquire 200 barrels of oil and 3,000 pounds of copper for a total of $12,000. Current compe;;ve market prices: • For oil is $50 per barrel • for copper is $2 per pound. You are not sure you need all of the oil and copper and are concerned that the value of both commodi;es may fall in the future. Should you take this opportunity?  First, convert the costs and beneSts to their cash values using market prices: (200 barrels of oil)*($50/barrel of oil today) = $ 10000 today (3000 pounds of copper)*($2/pound of copper today) = $ 6000 today Net value of the opportunity= $10.000+$6.000 -$12.000 = $4.000 today 55 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 Net value > 0, you should take it. It depends only on the CURRENT MARKET PRICES for oil and copper. Even if you do not need all the oil or copper, or expect their values to fall, you can sell them at current market prices and obtain their values of $16,000. Thus the opportunity is a good one for the 3rm and will increase its value by $ 4,000. EXERCISE: applying the valua;on principle Investment opportunity: in exchange for $50,000 today, you will receive 2,500 shares of stock in the Ford Motor Company and 10,000 euros today. - Current market price for Ford stock = $14 per share - Current exchange rate = $1.12 per €. Should you take this opportunity? Would your decision change if you believed the value of the euro would rise over the next month?  The costs and beneSts must be converted to their cash values. Assuming compe;;ve market prices: €10000*($1.12/euros) = $11.200 2500 shares * ($14/share) = $35.000 Net value of the opportunity is $35000+$11200-$50000=-$3800 Net value < 0, we should not take it This value depends only on the current market prices for Ford and the euro. Our personal opinion about the future prospects of the euro and Ford does not alter the value of the decision today. TIME VALUE OF MONEY consider the value of costs and bene3ts over ;me Consider an investment opportunity with the following certain cash &ows: • Cost: $100,000 today • Bene3t: $105,000 in one year The diverence in value (105,000 – 100,000 = 5,000) between money today and money in the future is due to the &me value of money. THE INTEREST RATE Interest rate The rate at which we can exchange money today for money in the future is determined by the current interest rate. Suppose the current annual interest rate is 7%. By inves;ng or borrowing at this rate, we can exchange $1.07 in one year for each $1 today.  Risk–Free Interest Rate (Discount Rate), rf It is the interest rate at which money can be borrowed or lent without risk (it does not consider the credit risk). Interest rate factor = 1+ rf Discount factor = /(1+rf) EXERCISE: What is the value of investment in one year? If the interest rate is 7%, then we can express our costs as: Cost = ($100.000 today) * (1.07$ in one year/$ today) = $ 107.000 in our year 56 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 Both costs and bene3ts are now in terms of “dollars in one year,” so we can compare them and compute the investment’s net value: $105,000- $107,000= - $2000 in one year In other words, we could earn $2000 more in one year by pung our $100,000 in the bank rather than making this investment. We should reject the investment. EXERCISE: What is the value of investment today? Consider the bene3t of $105,000 in one year. What is the equivalent amount in terms of dollars today? Bene3t = ($105000 in one year) / (1.07$ in our year / $ today) = ($105000 in one year) * 1/1.07 = $98130.84 today This is the amount the bank would lend to us today if we promised to repay $ 105000 in one year. Now we are ready to compute the net value of the investment: $98,130.84 - $100,000= - $1869.16 today Once again, the nega;ve result indicates that we should reject the investment. This demonstrates that our decision is the same whether we express the value of the investment in terms of dollars in one year or dollars today. If we convert from dollars today to dollars in one year: (-$1869.16 today)*(1.07$ in one year / $ today) = $-2000 in one year. The two results are equivalent but expressed as values at diMerent points in ;me.  When we express the value in terms of dollars (or euros) today, we call it the PRESENT VALUE (PV) of the investment.  If we express it in terms of dollars (or euros) in the future, we call it the FUTURE VALUE of the investment. We can interpret 1/1+r = 1/1.07 = 0.93458 as the price today of $1 in one year. The amount is called the one- year discount factor. The risk-free rate is also referred to as the discount rate for a risk-free investment. EXERCISE: comparing costs at diMerent points in ;me The cost of rebuilding the San Francisco Bay Bridge to make it earthquake-safe was approximately $3 billion in 2004. At the ;me, engineers es;mated that if the project were delayed to 2005, the cost would rise by 10%. If the interest rate were 2%, what would be the cost of a delay in terms of dollars in 2004? If the project were delayed, it would cost: $3 billion × 1.10 = $3.3 billion in 2005. To compare this amount to the cost of $3 billion in 2004, we must convert it using the interest rate of 2%: $3.3 billion in 2005 / ($1.05 in 2005 / $ in 2004) = $3.235 billion in 2004 Therefore, the cost of a delay of one year was $3.235 billion - $3 billion = $235 million in 2004. That is, delaying the project for one year was equivalent to giving up $235 million in cash. EXERCISE: comparing costs at diMerent points in ;me 57 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 T __ 3. Hire someone to manage the business while you are in school for one more year and then sell the business (requiring you to spend $50000 on expensed now but genera;ng $100000 in pro3t at the end of the year) The best choice is the one with the highest NPV, which is hire a manager and sell in one year. Choosing this alterna;ve is equivalent to receiving $222727 today. TODAY IN ONE YEAR NPV Sell now $200000 0 $200000 Scale back opera;ons -$30000 $50000 -30000+(250000/1.10) =197273 Hire a manager -$50000 $100000 -50000+(300000/1.1) =222272 EXERCISE: choosing among alterna;ve investments You have $10000 to invest and are considering three one-year-risk-free investment op;ons: 1. Invest up to $10000 in a T-Bill paying 2% 2. Invest in a project that costs $6000 and returns $6100 in one year 3. Invest in a project that costs $4000 and returns $4100 in one year Since all of investment op;ons are for one year and risk free the appropriate discount rate is 2%. The PV of each investment at 2% is: 1. $10000*(1.02)/1.02-$10000=$0 2. NPV= $6100/1.02-$6000= - $19.61 3. NPV=$4100/1.02-$4000=$19.61 The op;mal strategy is to invest $4000 in number 3 and $6000 in the T-Bill. The NPV of this strategy is ($4100+$6000*1.02)/1.02-$10000=$19.61. even if the NPV of the T-Bill investment is $0 it is a beJer investment than not inves;ng those funds at all. NET PRESENT VALUE AND CASH NEEDS Regardless of our preferences for cash today vs cash in the future, we should always maximize NPV 3rst. We can then borrow of lend to shi^ cash &ows through ;me and 3nd our most preferred paJerns of cash &ows. Valuing projects requires to understand if the prices and rates are not subject to poten;al arbitrage opportunity. 60 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 i ARBITRAGE is the prac;ce of buying and selling equivalent goods in diMerent markets to take advantage of a price diMerence. An arbitrage opportunity occurs when it is possible to make a pro3t without taking any risk or making any investment. In a compe;;ve market there are no arbitrage opportuni;es.  If there no arbitrage opportuni;es and equivalent investment opportuni;es trade simultaneously in diMerent compe;;ve markets, then they must trade for the same price in both markets. EXERCISE: valuing a security with the low of one price Assume a security promises a risk-free payment of $10000 in one year. If the risk-free interest rate if 5%, what can we conclude about the price of this bond in a normal market? PV ($1000 in one year) = ($1000 in one year)/ (1.05$ in one year/$today) = $952.38 today Price (Bond) = $952.38 What if the price of the bond is $940? The opportunity for arbitrage will force the price of the bond to rise un;l it is equal to $952.38. What if the price of the bond is $960? The opportunity for arbitrage will force the price of the bond to fall un;l it is equal to $952.8.  Determining the no-arbitrage price Unless the price of the security equals the PV of the security’s cash &ows, an arbitrage opportunity will appear. No arbitrage price of a security Price(security) = PV (All cash @ows paid by the security) EXERCISE: compu;ng the no-arbitrage price Consider a security that pays its owner $100 today and $100 in one year without any risks. Suppose the risk-free interest rate is 10%. What is the no-arbitrage price of the security today (before the 3rst $100 is paid)? If the security is trading for $195, what arbitrage opportunity is available? We need to compute the PV of the security’s cash &ows. In this case there are two cash &ows: $100 today, which is already in PV terms and $100 in one year. The PV of the second cash &ows is: $100 in one year / (1.10$ in one year/$ year) = $90.91 today 61 Today $ In one year $ Buy the bond -940 +1000 Borrow from the bank +952.38 -1000 NET CASH FLOW +12.38 0 Today $ In one year $ Sell the bond +960 -1000 Invest at the bank -952.38 +1000 NET CASH FLOW +7.62 0 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 e The total PV of the cash &ows is $100+$90.91= $190.91 today, which is the no-arbitrage price of the security. If the security is trading for $195, we can exploit its overpricing by selling it of $195. We can then use $100 of the sale proceed to replace the $100 we would have received from the security today and invest $90.91 of the sale proceed at 10% to replace the $100 we would have received in one year. The remaining $195-$100 -$90.9=$4.09 is an arbitrage pro3t. EXERCISE: compu;ng the no-arbitrage price Consider a security that pays its owner $5000 in one year without any risk. Suppose the risk-free interest rate is 6%. What is the no-arbitrate price of the security today? If the security is trading for $4750, what arbitrage opportunity is available? We need to compute the PV of the security’s cash &ows: $5000/1.06 = $4716.98. If the security is trading for $4750 but only costs $4716.98, an investor can exploit its overpricing by buying the security at $4716.98 and then immediately selling it at $4750. The diMerence $4750-$4716.98 = $33.02 in arbitrage pro3ts. Another way to looking at it is that the investor can primes to pay $5000 in one year in exchange of $4750 today. The investor takes the $4750 and immediately invests it at the risk-free rate of 6%. In one year, the $4750 grows to: $7750 * 1.06 = $5035 In one year, the investor pays the $5000 back and keeps the $35 in arbitrage pro3ts. One a NPV basis, this is worth $35/1.06 = $33.02.  Determining the Interest Rate from Bond Prices If we know the price of a risk-free bond, we can use: Price (Security) = PV (All cash @ows paid by the security) to determine what the risk-free interest rate must be if there are no arbitrage opportuni;es. EXERCISE: Suppose a risk-free bond that pays $1,000 in one year is currently trading with a compe;;ve market price of $929.80 today. The bond’s price must equal the present value of the $1000 cash &ow it will pay. $929.80 today = ($1000 in one year) ÷ (1 + rf $ in one year / $ today) 1+rf = $1000 in one year /$929.80 today =1.0755 $ in one year / $ today The risk-free interest rate must be 7.55%. 62 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 IMPACT OF RISK ON VALUATION When cash &ows are risky, we must discount them at a rate equal to the risk-free interest rate plus an appropriate risk premium. The appropriate risk premium will be higher the more the project’s returns tend to vary with overall risk in the economy. Cash &ows and Market Prices (in $) of a RiskFree Bond and an Investment in the Market Porqolio Assume there is an equal probability of either a weak economy or strong economy. Risky Versus Risk-free Cash Flows  Price (Risk-free Bond) = Pv(Cash Flows)  ($1100 in one year) /(1.04 $ in one year / $ today)  $1058 today  Expected Cash Flow (Market Index) = ½*($800) + ½*($1400) = $1100 Although both investments have the same expected value, the market index has a lower value since it has a greater amount of risk. RISK AVERSION  Investors prefer to have a safe income rather than a risky one of the same average amounts. RISK PREMIUM  The addi;onal return that investors expect to earn to compensate them for a security’s risk. When a cash &ow is risky, to compute its present value we must discount the cash &ow we expect on average at a rate that equals the risk-free interest rate plus an appropriate risk premium. Expected return of a risky investment = Expected gain at end of year / Ini;al cost  Market return if the economy is strong (1400 - 1000) /1000  40%  Market return if the economy is weak (800 - 1000) /1000  - 20%  Expected market return 1/2*(40%) + 1/2*(-20%) = 10% Investment decision rules Consider a take-it-or-leave-it investment decision involving a single, stand-alone project for Fredrick’s Feed and Farm (FFF). EXERCISE: The project costs $250 million and is expected to generate cash &ows of $35 million per year, star;ng at the end of the 3rst year and las;ng forever. The NPV of the project is calculated as: NPV = -250+35/r  The NPV is dependent on the discount rate (the higher the discount rate us, the discount is high, NPV is low and can be nega;ve) 65 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 2 If FFF’s cost of capital is 10%, the NPV is $100 million, and they should undertake the investment. Some;mes alterna;ve investment rules may give the same answer as the NPV rule, but at other ;mes they may disagree. Anyway, NPV is the best one (it is the only one which is not in&uenced by any piqalls). When the rules congict, the NPV decision rule should be followed. INTERNAL RATE OF RETURN (IRR) INVESTMENT RULE According to this rule we should:  Take any investment where the IRR exceeds the cost of capital  Turn down any investment whose IRR is less than the cost of capital The IRR Investment Rule will give the same answer as the NPV rule in many, but not all, situa;ons. In general, the IRR rule works for a stand-alone project if all of the project’s nega2ve cash gows precede its posi2ve cash gows. In Figure on slide 3, whenever the cost of capital is below the IRR of 14%, the project has a posi;ve NPV, and you should undertake the investment. In other cases, the IRR rule may disagree with the NPV rule and thus be incorrect. Situa;ons where the IRR rule and NPV rule may be in con&ict (piqalls): 1. Delayed Investments Assume you have just re;red as the CEO of a successful company. A major publisher has oMered you a book deal. The publisher will pay you $1 million upfront if you agree to write a book about your experiences. You es;mate that it will take three years to write the book. The ;me you spend wri;ng will cause you to give up speaking engagements amoun;ng to $500,000 per year. You es;mate your opportunity cost to be 10%.  Should you accept the deal? The IRR is greater than the cost of capital. Thus, the IRR rule indicates you should accept the deal. NPV = 1000000-(500000/1.1)-(500000/1.1^2)- (500000/1.1^3)=$243.426 Since the NPV is nega;ve, the NPV rule indicates you should reject the deal. When the bene3ts of an investment occur before the costs, the NPV is an increasing func;on of the discount rate. 2. Non-existent IRR Suppose Star informs the publisher that it needs to sweeten the deal before he will accept it. The publisher oMers $550,000 advance and $1,000,000 in four years when the book is published.  Should he accept or reject the new oMer? 66 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 NPV= -550000-(500000/1+r)-(500000/(1+r)^2)-(500000/(1+r)^3)+(1000000(1+r)^4) By seng the NPV equal to zero and solving for r, we 3nd the IRR. In this case, there are two IRRs: 7.164% and 33.673%. Because there is more than one IRR, the IRR rule cannot be applied. Between 7.164% and 33.673%, the book deal has a nega;ve NPV. Since your opportunity cost of capital is 10%, you should reject the deal. 3. Mul&ple IRRs Finally, Star is able to get the publisher to increase his advance to $750,000, in addi;on to the $1 million when the book is published in four years. With these cash &ows, no IRR exists; there is no discount rate that makes NPV equal to zero. No IRR exists because the NPV is posi;ve for all values of the discount rate. Thus the IRR rule cannot be used While the IRR rule has shortcomings for making investment decisions, the IRR itself remains useful. IRR measures the average return of the investment and the sensiSvity of the NPV to any esSmaSon error in the cost of capital. EXERCISE: problem with the IRR rule  Which of these projects have an IRR close to 20%?  For which of these projects is the IRR rule valid? We can see that projects A, B, and C each have an IRR of approximately 20%, which project D has no IRR. Note also that projects B has another IRR of 5%. The IRR rule is valid only if the project has a posi;ve NPV for every discount rate below the IRR. Thus, the IRR rule is only valid for project A. This project is the only one for which all the nega;ve cash &ows precede the posi;ve ones. While the IRR Rule works for project A, it fails for each of the other projects. C(posi;ve before nega;ve), B(two IRR), D(non-existent). EXERCISE: problem with the IRR rule Es;mate each project’s IRR by graphing the NPV pro3le for each. 67 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 Tema 1ha 2. Timing of cash _ows Another problem with the IRR is that it can be aMected by changing the ;ming of the cash &ows, even when the scale is the same. IRR is a return, but the dollar value of earning a given return depends on how long the return is earned. Consider again the coMee shop and the music store investment from slide #33. Both have the same ini;al scale and the same horizon. The coMee shop has a lower IRR, but a higher NPV because of its higher growth rate. 3. Di^erences in risk An IRR that is aJrac;ve for a safe project need not be aJrac;ve for a riskier project. Consider the investment in the electronics store from slide #33. The IRR is higher than those of the other investment opportuni;es, yet the NPV is the lowest. The higher cost of capital means a higher IRR is necessary to make the project aJrac;ve. THE INCREMENTAL IRR RULE We can apply the IRR rule to the diMerence between the cash &ows of the two mutually exclusive alterna;ves (the increment to the cash &ows of one investment over the other). EXERCISE: using the incremental IRR to compare alterna;ves Your 3rm is considering overhauling its produc;on plant. The engineering team has come up with two proposals, one for a minor overhaul and one for a major overhaul. The two op;ons have the following cash &ows (in milions of dollars):  What is the IRR of each proposal?  What is the incremental IRR?  If the cost of capital for both of these projects is 12%, what should your 3rm do? We can compute the IRR of each proposal using the annuity calculator. For the minor overhaul, the IRR is 36.3%: 70 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 Tago Which project is best? Because the projects have diMerent scales, we cannot compare their IRRs directly. To compute the incremental IRR of switching from the minor overhaul to the major overhaul, we 3rst compute the incremental cash &ows: These cash &ows have an IRR of 20.0% Because the incremental IRR exceeds the 12% cost of capital, switching to the major overhaul looks aJrac;ve (i.e., its larger scale is suVcient to make up for its lower IRR). We can check this result using 3gure 7.6, which shows the NPV pro3les for each project. At the 12% cost of capital, the NPV of the major overhaul does indeed exceed that of the minor overhaul, despite its lower IRR. Note also that the incremental IRR determines the crossover point of the NPV pro3les, the discount rate for which the best project choice switches from the major overhaul to minor one. We can see that despite its lower IRR, the major overhaul has a higher NPV at the cost of capital of 12%. Note also that the incremental IRR of 20% determines the crossover point or discount rate at which the op;mal decision changes. EXERCISE: using the incremental IRR to compare alterna;ves Suppose your 3rm is considering two diMerent projects, one that lasts one year and another that lasts 3ve years. The cash &ows for the two projects look like this:  What is the IRR of each proposal?  What is the incremental IRR?  If your 3rm’s cost of capital is 10%, what should you do? We can compute the IRR of Project L using the annuity calculator: 71 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 __e We can compute the IRR of Project S using the annuity calculator: We can calculate the incremental IRR this way: Because the 12.47% incremental IRR is bigger than the cost of capital of 10%, the long-term project is beJer than the short-term project, even though the short-term project has a higher IRR.  Shortcomings (carenze) of the Incremental IRR Rule The incremental IRR may not exist because in some cases is not possible to take the diMerence. Mul;ple incremental IRRs could exist. The fact that the IRR exceeds the cost of capital for both projects does not imply that either project has a posi;ve NPV. When individual projects have diMerent costs of capital, it is not obvious which cost of capital the incremental IRR should be compared to. It is possible also to evaluate projects with diverent resource constraints. Consider three possible projects with a $100 million budget constraint: PROFITABILITY INDEX can be used to iden;fy the op;mal combina;on of projects to undertake because of resource constrains. Profitability index= Value created Resource consumed = NPV ResourceConsumed From Table on previous slide, we can see it is beJer to take projects II & III together and forgo project I. EXERCISE: pro3tability index with a human resource constraint Your division at NetIt, a larger networking company, has put together a project proposal to develop a new home networking router. 72 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 - Incremental Earnings The amount by which the 3rm’s earnings are expected to change as a result of the investment decision EXERCISE: revenue and cost es;mates Linksys has completed a $300,000 feasibility study to assess the aJrac;veness of a new product, HomeNet. The project has an es;mated life of four years. Revenue Es2mates Sales = 100,000 units/year Per Unit Price = $260 Cost Es2mates Up-Front R&D = $15,000,000 Up-Front New Equipment = $7,500,000 Annual Overhead = $2,800,000 Per Unit Cost = $110 Expected life of the new equipment is 3ve years. Housed in exis;ng lab - CAPITAL EXPENDITURES AND DEPRECIATION The $7.5 million in new equipment is a cash expense, but it is not directly listed as an expense when calcula;ng earnings. Instead, the 3rm deducts a frac;on of the cost of these items each year as deprecia;on. Straight Line Deprecia&on  the asset’s cost is divided equally over its life (annual deprecia;on) = $7.5/5 year = $1.5 million/year - INTEREST EXPENSE In capital budge;ng decisions, interest expense is typically not included, because it is irrelevant how we 3nance the project (equity or something else). The ra;onale is that the project should be judged on its own, not on how it will be 3nanced. Unlevered net income  it does not include the interest expenses - TAXES The marginal corporate tax rate is the tax rate on the marginal or incremental dollar of pre-tax income. A nega;ve tax is equal to a tax credit. Income tax = EBIT * Incremental tax rare Unlevered net income calcula;on: Unlevered net income = EBIT *(1-incremental tax rate) = (revenues – costs -deprecia;on) *(1-incremental tax rate). EXERCISE: Taxing Losses for Projects in Pro3table Companies 75 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 E Kellogg Company plans to launch a new line of high-3ber, gluten-free breakfast pastries. The heavy adver;sing expenses associated with the new product launch will generate opera;ng losses of $15 million next year for the product. Kellogg expects to earn pretax income of $460 million from opera;ons other than the new pastries next year.  If Kellogg pays a 40% tax rate on its pretax income, what will it owe in taxes next year without the new pastry product?  What will it owe with the new pastries? Without the new pastries, Kellogg will owe $460 million × 40% = $184 million in corporate taxes next year. With the new pastries, Kellogg’s pretax income next year will be only $460 million − $15 million = $445 million, and it will owe $445 million × 40% = $178 million in tax. Thus, launching the new product reduces Kellogg’s taxes next year by $184 million − $178 million = $6 million. EXERCISE: Taxes NRG, Inc. plans to launch a new line of energy drinks. The marke;ng expenses associated with launching the new product will generate opera;ng losses of $500 million next year for the product. NRG expects to earn pre-tax income of $7 billion from opera;ons other than the new energy drinks next year. NRG pays a 39% tax rate on its pre-tax income.  What will NRG owe in taxes next year without the new energy drinks?  What will it owe with the new energy drinks? Without the new energy drinks, NRG will owe corporate taxes next year in the amount of: $7 billion × 39% = $2.730 billion With the new energy drinks, NRG will owe corporate taxes next year in the amount of: $6.5 billion × 39% = $2.535 billion Pre-Tax Income = $7 billion − $500 million = $6.5 billion Launching the new product reduces NRG’s taxes next year by: $2.730 billion − $2.535 billion = $195 million Indirect evects on incremental earnings  Opportunity Cost: the value a resource could have provided in its best alterna;ve use. In the Home Net project example, space will be required for the investment. Even though the equipment will be housed in an exis;ng lab, the opportunity cost of not using the space in an alterna;ve way (e.g., ren;ng it out) must be considered. EXERCISE: The Opportunity Cost of Home Net’s Lab Space Suppose Home Net’s new lab will be housed in warehouse space that the company would have otherwise rented out for $200,000 per year during years 1–4.  How does this opportunity cost aMect Home Net’s incremental earnings? In this case, the opportunity cost of the warehouse space is the forgone rent. 76 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 E_ o This cost would reduce HomeNet’s incremental earnings during years 1–4 by $200,000 × (1 − 40%) = $120,000, the a^er-tax bene3t of ren;ng out the warehouse space. EXERCISE: The Opportunity Cost Suppose NRG’s new energy drink line will be housed in a factory that the company could have otherwise rented out for $900 million per year.  How would this opportunity cost aMect NRG’s incremental earnings next year? The opportunity cost of the factory is the forgone rent. The opportunity cost would reduce NRG’s incremental earnings next year by: $900 million × (1 − 0.39) = $549 million.  Project Externali&es: indirect eMects of the project that may aMect the pro3ts of other business ac;vi;es of the 3rm. Cannibaliza;on is when sales of a new product displaces sales of an exis;ng product. In the HomeNet project example, 25% of sales come from customers who would have purchased an exis;ng Linksys wireless router if Home Net were not available. Because this reduc;on in sales of the exis;ng wireless router is a consequence of the decision to develop Home Net, we must include it when calcula;ng Home Net’s incremental earnings. Spreadsheet HomeNet’s Incremental Earnings Forecast Including Cannibaliza;on and Lost Rent  Sunk costs: costs that have been or will be paid regardless of the decision whether or not the investment is undertaken. Sunk costs should not be included in the incremental earnings analysis. 1. Fixed Overhead Expenses: they are typically 3xed and not incremental 2. Past Research and Development Expenditures: money that has already been spent 3. Unavoidable Compe22ve Ecects: when developing a new product, 3rms may be concerned about the cannibaliza;on of exis;ng products. However, if sales are likely to decline in any case as a result of new products introduced by compe;tors, then these lost sales should be considered a sunk cost. The real-world complexi;es: sales will change from year to year the average selling price will vary over ;me the average cost per unit will change over ;me EXERCISE: Product Adop;on and Price Changes Suppose sales of Home Net were expected to be: 100,000 units in year 1; 125,000 units in years 2 and 3, and 50,000 units in year 4. Suppose also that Home Net’s sale price and manufacturing cost are expected to decline by 10% per year, as with other networking products. By contrast, selling, general, and administra;ve expenses are expected to rise with in&a;on by 4% per year. 77 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 F  Calcula&ng the NPV Home Net NPV (WACC = 12%) = -16.500+4554+5740+5125+4576+1532 = 5027 NPV is useful to choose among manufacturing alterna;ves: Launching the HomeNet project produces a posi;ve NPV, while not launching the project produces a 0 NPV. In the HomeNet example, assume the company could produce each unit in-house for $95 if it spends $5 million upfront to change the assembly facility (versus $110 per unit if outsourced). The in-house manufacturing method would also require an addi;onal investment in inventory equal to one month’s worth of produc;on. Outsource Cost per unit =$ 110 Investment in A/P = 15% of COGS Cogs= 100000 units * $100 = $11 million A/P = 15% *$11 million = $ 1.65 million ΔNWC = -$1.65 million in Year 1 and will increase by $1.65 million in year 5 NWC falls since this A/P is 3nanced by suppliers. In-House Cost per unit = $95 Up-front cost of $5,000,000 Investment in A/P = 15% of COGS Cogs= 100,000 units × $95 = $9.5 million A/P = 15% × $9.5 million = $1.425 million Investment in Inventory= $9.5 million/12= $0.792 million ΔNWC in Year 1 = $0.792 million – $1.425 million = –$0.633 million NWC will fall by $0.633 million in Year 1 and increase by $0.633 million in Year 5  Outsourcing is the less expensive alterna;ve Further adjustments to free cash &ow: these are some elements that we have to consider in order to adjust the FCF.  Other non-cash items = Amor;za;on  Timing of cash @ows = Cash &ows are o^en spread throughout the year  Accelerated deprecia&on = Modi3ed accelerated cost recovery system (MACRS) deprecia;on which is used for tax purposes in the U.S. It allows for faster deprecia;on in the 3rst years of an asset’s life and slows deprecia;on later on EXERCISE: compu;ng accelerated deprecia;on Assuming the equipment is put into use by the end of year 0 and designated to have a 3ve-year recovery period. What deprecia;on deduc;on would be allowed for Home net’s equipment using the MACRS method? 80 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 o_ Note that as long as the equipment is put into use by the end of year 0, the tax code allows us to take our 3rst deprecia;on expenses in the same year 0. Compared with straight-line deprecia;on, MACRS method allows for larger deprecia;on deduc;ons earlier in the asset’s life which increase the PV of the deprecia;on tax shield so will raise the project’s NPV. EXERCISE: MACRS method The machine will cost $50000 and falls into the MACRS 3-year asset class. What deprecia;on deduc;on would be allowed for the machine using the MACRS method assuming the equipment is put into use in year 0?  Liquida&on or salvage value Assets that we could have sold but that we do not sell, and we keep it for another project: there is an opportunity cost. CAPITAL GAIN = Sale price – Book value (plusvalenza) BOOK VALUE = Purchase price – Accumulated Deprecia;on A^er tax cash &ow from asset sale = Sale price – (*capital gain) EXERCISE: adding salvage value to free cash &ow Suppose that in addi;on to the $7.5 million in new equipment required for Home Net, some equipment will be transferred to the lab from another Cisco facility. This equipment has a resale value of $2 million and a book value of $1 million. If the equipment is kept rather than sold, its remaining book value can be depreciated next year. When the lab is shut down in year 5, the equipment will have a salvage value of $800000. What adjustments must we make to Home Net’s free cash &ow in this case? The exis;ng equipment could have been sold for $2 million. The a^er tax proceeds from this sale are an opportunity costs of using the equipment in the Home Net lab. Thus, we must reduce Home Net’s free cash &ows in year 0 by the sale price less any taxes that would have been owed has the sale occurred; $2 million – 40% ($2 million - $1 million) = $ 1.6 million In year 1, the remaining $1 million book value of the equipment can be depreciated crea;ng a deprecia;on tax shield of 40% *$1 million = $400000 In year 5, the 3rm will sell the equipment for a salvage value of $800000 will be taxable as a capital gain so the a^er tax cash &ow from the sale is $800000*(1-40%) = $ 480000 EXERCISE: adding salvage value to free cash &ow Plen;x is considering replacing its some old equipment that has a market value of $1 million but a book value of only $200000. If the equipment is not sold, the 3rm will depreciate the remaining book value in the coming year. 81 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 F The 3rm’s marginal tax rate is 34%. How would the 3rm’s free cash &ows be aMected if the 3rm keeps the equipment vs selling the old equipment? IF THE EQUIPMENT IS KEPT, the 3rm will have a $200000 of addi;onal deprecia;on which will reduce the 3rm’s taxable income by $200000. With a 34% marginal tax rate, this will reduce the 3rm’s taxes by $200000*34% = $68000 Because the 3rm will pay $68000 less in taxes, free cash &ow will increase by the same amount for the year. IF THE EQUIPMENT IS SOLD, the 3rm receives $1 million in cash but will have to pay taxes on the gain above the book value or $1 million - $200000 = $800000 The taxes due on the sale will be $800000*34% = $272000 The free cash &ow will increase by $1000000*$272000= $728000 for the year.  Terminal or con&nua&on value This amount represents the market value of the free cash &ow from the project at all future dates. Many projects have a in3ni;ve lives. EXERCISE Base hardware is considering openin a set of new retail stores. The free cash &ow projec;ons for the new stores are shown below. A^er year 4, the 3rm expects free cash &ow from the stores to increase at a rate of 5% per year. If the appropriate cost of capital for this investment is 10%, what con;nua;on value in year 4 caputes the value of future free cash &ows in year 5 and beyond? What is the NPV of the new stores? Because the future free cash &ows beyond year 4 is expected to grow at 5% per year, the con;nua;on value in year 4 if the free cash &ow in year 5 and beyond can be calculated as a constant growth perpetuity: We can compute the con;nua;on value as a mul;ple of the project’s 3nal free cash &ow. We can restate the free cash &ows of the investment as follow: The NPV of the investment in the new stores is NPV = -10500 - 5500/1.10+800/1.10^2+1200/1.10^3+28600/1.10^4 = $5567 EXERCISE Now assume Plen;x is considering a new project that costs $200 million and will generate free cash &ows in its 3rst three years of $10 million, $15 million and $20 million. A^er the third year the free cash &ows are expected to grow at an annual rate of 7%. 82 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 It is a 3nancial opera;on when a group of private investors purchase all the equity of a public corpora;on and 3nances the purchase primarily by issuing debt (for example bonds). The new issued debt will be part of the new company.  PUBLIC DEBT: the prospectus A public bond issue is similar to a stock issue. There is indenture which is included in a prospectus; it is a formal contract between a bond issuer and a trust company. The trust company represents the bondholders and makes sure that the terms of the indenture are enforced. In the case of default, the trust company represents the interests of the bond holders. Corporate bonds almost always pay coupons semi-annually, although a few corpora;ons have issued zero- coupon bonds. Most corporate bonds have maturi;es of 30 years or less. The face value or principal amount of a bond is denominated in standard increments, most o^en $1000. The face value does not always correspond to the actual money raised because of underwri;ng fees and/or if the bond is issued at a discount.  The original issue discount bond describes a bond that is issued at a discount. 1. BEARER BONDS (al portatore) is similar to currency in that whoever physically holds the bond cer;3cate owns the bond- To receive a coupon payment, the holder of a bearer bond must provide explicit proof of ownership by literally clipping a coupon oM the bond cer;3cate and reming it to the paying agent. 2. REGISTERED BONDS The issuer of this type of bond maintains a list of all holders of its bonds. Coupon and principal payments are made only to people on this list. Almost all bonds today are registered bonds. There are diMerent types of corporate debt: - Unsecured Debt A type of corporate debt that, in the event of bankruptcy, gives bondholders a claim to only the assets of the 3rm that are not already pledged as collateral on other debt. - Secured Debt A type of corporate debt in which speci3c assets are pledged as collateral. - Notes A type of unsecured corporate debt. Notes typically are coupon bonds with maturi;es shorter than 10 years. - Debentures A type of unsecured corporate debt. Debentures typically have longer maturi;es than notes. 85 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 T ara - Mortgage Bonds A type of secured corporate debt. Real property is pledged as collateral that bondholders have a direct claim to in the event of bankruptcy. All classes of securi;es are paid from the same cash &ow source. - Asset-Backed Bonds A type of secured corporate debt. Speci3c assets are pledged as collateral that bondholders have a direct claim to in the event of bankruptcy. Can be secured by any kind of asset. Bonds are usually issued in: Tranches  DiMerent classes of securi;es that comprise a single bond issue All classes of securi;es are paid from the same cash &ow source. Seniority  A bondholder’s priority in claiming assets not already securing other debt Most debenture issues contain clauses restric;ng the company from issuing new debt with equal or higher priority than exis;ng debt. Subordinated Debentures  Debt that, in the event of a default, has a lower priority claim to the 3rm’s assets than other outstanding debt. In public debt, the bond market includes: - Interna;onal Bonds - Domes;c Bonds (denominated in the local currency) Bonds issued by a local en;ty and traded in a local market but purchased by foreigners. - Foreign Bonds (denominated in the local currency) Bonds issued by a foreign company in a local market and intended for local investors. Ex. Yankee Bonds (USA), Samurai Bonds (JP), Bulldogs (UK) - Eurobonds Interna;onal bonds that are not denominated in the local currency of the country in which they are issued - Global Bonds Bonds that are oMered for sale in several diMerent markets simultaneously Global bonds can be oMered for sale in the same currency as the country of issuance (unlike Eurobonds).  PRIVATE DEBT Private debt is not publicly traded, and it has the advantage that it avoids the cost of registra;on but has the disadvantage of being illiquid. 1. Term Loan  a bank loan that lasts for a speci3c term 2. Syndicated Bank Loan  a single loan that is funded by a group of banks rather than just a single bank 3. Revolving Line of Credit  a credit commitment for a speci3c ;me period, typically two to three years, which a company can use as needed 4. Private Placement  a bond issue that is sold to a small group of investors rather than the general public. a. Because a private placement does not need to be registered, it is less costly to issue than public debt. b. Because this debt is tradable between 3nancial ins;tu;ons, it is only slightly less liquid than public debt. Bond covenants are restric;ve clauses in a bond contract that limit the issuers from undercung their ability to repay the bonds. 86 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 f For example, covenants may restrict the ability of management to pay dividends, restrict the level of further indebtedness or specify that the issuer must maintain a minimum amount of working capital. Repayment provisions A bond issuer typically repays its bonds by making coupon and principal payments as speci3ed in the bond contract. However, the issuer can:  Repurchase a frac;on of the outstanding bonds in the market  Make a tender oMer for the en;re issue  Exercise a call provision CALLABLE BONDS, contain a call provision that allows the issuer to repurchase the bonds at a predetermined price. A call feature allows the issuer of the bond the right (but not the obliga;on) to re;re all outstanding bonds on (or a^er) a speci3c date (the call date), for the call price. The call price is generally set at or above, and expressed as a percentage of, the bond’s face value. A 3rm may choose to call a bond issue if interest rates have fallen. The issuer can lower its borrowing costs by exercising the call on the callable bond and then immediately re3nancing the issue at a lower rate. If rates rise a^er a bond is originally issued, there is no need to re3nance. Holders of callable bonds understand that the issuer will exercise the call op;on only when the coupon rate of the bond exceeds the prevailing market rate.  If a bond is called, investors must reinvest the proceeds when market rates are lower than the coupon rate they are currently receiving. This makes callable bonds rela;vely less aJrac;ve to bondholders than iden;cal non-callable bonds. A callable bond will trade at a lower price (and therefore a higher yield) than an otherwise equivalent non- callable bond. Consider what happens to a bond that is callable at par on only one speci3c date. On the call date: 1. If the yield of the callable bond is less than the coupon, the callable bond will be called, so its price is its par value. 2. If this yield is greater than the coupon, then the callable bond will not be called, so it has the same price as the non-callable bond. The callable bond price is capped at par: the price can be low when yields are high but does not rise above the par value when the yield is low. Prior to the call date: when market yields are high rela;ve to the bond coupon, investors an;cipate that the likelihood of exercising the call is low and the bond price is similar to an otherwise iden;cal noncallable bond. When market yields are low rela;ve to the bond coupon, investors an;cipate that the bond will likely be called, so its price is close to the price of a non-callable bond that matures on the call date. Yield to Call (YTC): the yield of a callable bond calculated under the assump;on that the bond will be called on the earliest call date. EXERCISE: calcula;ng the YTC 87 Scaricato da Anna Brasi (annabrasi2000@gmail.com) lOMoARcPSD|7471623 TUA  Convertible bond value Warrant A call option written by the company itself on new stock • When a holder of a warrant exercises it and thereby purchases stock, the company delivers this stock by issuing new stock. 
 • Convertible debt carries a lower interest rate because it has an embedded warrant. 
 VALUING STOCKS THE DIVIDEND-DISCOUNT MODEL A One-Year Investor • Potential Cash Flows • Dividend • Sale of Stock • Timeline for One-Year Investor 
   Since the cash flows are risky, we must discount them at the equity cost of capital. A One-Year Investor • If the current stock price were less than this amount, expect investors to rush in and buy it, driving up the stock’s price.  
 • If the stock price exceeded this amount, selling it would cause the stock price to quickly fall.
 DIVIDEND YIELDS, CAPITAL GAINS, AND TOTAL RETURNS    Dividend Yield Capital Gain • Capital Gain Rate 
 Total Return • Dividend Yield + Capital Gain Rate • The expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk. 
 EXAMPLE: stock prices and returns Problem Suppose you except Walgreen Company (a drugstore chain) to pay dividends of $1.40 per share and trade for $80 per share at the end of the year. If investments with equivalent risk to Walgreen’s stock have an excepted return of 8.5%, what is the most you would pay today for Walgreen’s stock? What dividend yield and capital gain rate would you except at this price? Solution Using Equation 9.1, we have        At this price, Walgreen’s dividend yield is Div1 / P0 = 1.40/75.02 0 1.87% The expected capital gain is $80.00 − $75.02 = $4.98 per share, for a capital gain rate of  4.98 / 75.02 = 6.63% Therefore, at this price, Walgreen’s expected total return is 1.87% + 6.63% = 8.5%, which is equal to its equity cost of capital. Another example: Problem • 3M (MMM) just paid a dividend of $4.50 per share. 
 • You expect the stock price will $178.50 and the dividend to be 5% higher by the end of the year.  
 • Investments with equivalent risk have an expected return of 11%. 
 • Based on the Dividend-Discount Model, what would pay today for 3M stock? 
 Solution Dividend in one year • $4.50 × 1.05 = $4.725 
   A multi-year investor What is the price if we plan on holding the stock for two years?   The dividend-discount model equation What is the price if we plan on holding the stock for N years?   • This is known as the Dividend-Discount Model. 
 • Note that the above equation (9.4) holds for any 
 horizon N. Thus all investors (with the same beliefs) will attach the same value to the stock, independent of their investment horizons.  
 The price of any stock is equal to the present value of the expected future dividends it will pay. EXAMPLE: curring dividends for profitable growth Problem Crane sporting goods excepts to have earnings per share of $6 in the coming year. Rather than reinvest these earnings and grow, the firm plans to pay out all of its earnings as a dividend. With these exceptions of no growth, Crane’s current share price is $60. Suppose crane could cut its dividend payout rate to 75% for the foreseeable future and use the retained earnings to open new stores. The return on its investment in these stores is excepted to be 12%. Assuming its equity cost of capital is unchanged, what effect would this new policy have on Crane’s stock price? Solution First, let’s estimate Crane’s equity cost of capital. Currently, Crane plans to pay a dividend equal to its earnings of $6 per share. Given a share price of $60, Crane’s dividend yield is $6 / $ 60 = 10% with no expected growth (g = 0) we can use Equation 9.7 to estimate rE:    In other words, to justify Crane’s stock price under its current policy, the expected return of other stocks in the market with equivalent risk must be 10%.  Next, we consider the consequences of the new policy. If Crane reduces its dividend payout rate to 75%, then from Eq. 9.8 its dividend this coming year will fall to Div1 = EPS1 × 75% = $6 × 75% = $4.50. At the same time, because the firm will now retain 25% of its earnings to invest in new stores, from Eq. 9.12 its growth rate will increase to g = Retention Rate × Return on New Investment = 25% × 12% = 3% Assuming Crane can continue to grow at this rate, we can compute its share price under the new policy using the constant dividend growth model of Equation 9.6:   EXAMPLE: unprofitable growth Problem Suppose crane sporting goods decides to cut its dividend payout rate to 75% to invest in new stores, as in example 9.3 but now suppose that the return on these new investments is 8%, rather than 12%. Given its excepted earnings per share this year of $6 and its equity cost of capital of 10% ,what will happen to Crane’s current share price in this case? Solution Crane’s dividend will fall to $6 × 75% = $4.50. Its growth rate under the new policy, given the lower return on new investment, will now be g = 25% × 8% = 2%. The new share price is there fore Thus, even though Crane will grow under the new policy, the new investments have negative NPV. Crane’s share price will fall if it cuts its dividend to make new investments with a return of only 8% when its investors can earn 10% on other investments with comparable risk. Another example Problem • Dren Industries is considering expanding into a new product line.   
 • Earnings per share are expected to be $5 in the coming year and are expected to grow annually at 5% without the new product line but growth would increase to 7% if the new product line is introduced.   
 • To finance the expansion, Dren would need to cut its dividend payout ratio from 80% to 50%.   
 • If Dren’s equity cost of capital is 11%, what would be the impact on Dren’s stock price if they introduce the new product line? Assume the equity cost of capital will remain unchanged.
 Solution • First, calculate the current price for Dren if they do not introduce the new product. To calculate the price, D1 is needed. To find D1, EPS1 is required: 
 Thus, the current price without the new product should be $70 per share. Next, calculate the expected current price for Dren if they introduce the new product: Thus, the current price is expected to fall from $70 to $66.875 if the new product line is introduced.