International Finance, Schemi e mappe concettuali di Finanza

Scarica International Finance e più Schemi e mappe concettuali in PDF di Finanza solo su Docsity! FINANCE AND FINANCIAL MARKETS Finance has three sub-areas 7 | N CAPITAL MARKETS FINANCIAL MANAGEMENT INVESTMENTS (CORPORATE FINANCE) The field of capital markets Investment management deals studies the financial system. Financial management, also known as with the management of business or corporate finance, is the area (individual or institutional) funds The financial system of an of finance concerned with financial (asset allocation). economy is composed of: decision making within a business entity (i.e., a firm). Portfolio theory: - Markets — Intermediaries Financial managers are primarily Investment objectives —> © Regulators concerned with: Allocation of resources —> Performance evaluation © Investment decisions (using funds) © Financing decisions (raising funds) - Risk management (minimizing risk) The objective is to maximize the value of the firm. WHAT IS AN ASSET? An asset is any resource that we expect to provide future benefits and, hence, has economic value. = Tangible assets —> the value depends on physical properties (buildings, aircrafts, lands, machineries) - Intangible assets —> they represent a legal claim to some future economic benefit (patents, copyrights, trademarks) Not necessarily the value of the asset is the price of the asset. Financial assets are also intangible assets. A financial asset is a legal claim to a future (stream of) cash flow(s). Financial instruments are securities when they are traded in financial markets. Securities include: - Bonds - Shares of stock = Hybrids - Derivatives Examples of financial assets: * A loanby a commercial bank to you * A corporate bond issued by a firm * A government bond issued by the Italian Treasury * A common stock issued by a firm Why do we need financial assets? —> Financial assets serve two principal functions: 1. They allow the transference of funds from entities having surplus funds to entities needing funds 2. They allow to redistribute risk among those seeking and those providing the funds. Issuer —> Financial intermediary —> Holder We classify a financial instrument by the type of claim the investor has on the issuer: * Debt —> the issuer agrees to pay the investor interest, plus repay the amount borrowed. - The investor realizes no more than the contractual amount (fixed income instruments) * Equity —> the issuer pays the investor an amount based on earnings (if any), after the obligations toward creditors are paid. - Common stock is the ownership interest in a corporation. Distribution of a company's earnings is known as dividends. Dividends: remuneration of equity. The classification of debt and equity is important for two legal reasons: * Inthe case of a bankruptcy of the issuer, investors in debt instruments have a priority on the claim on the issuer’s assets over equity investors. * The tax treatment of the payments by the issuer differs depending on the type of class. Interest payments made on debt instruments are tax deductible to the issuer, whereas dividends are not. FINANCIAL MARKETS Financial markets connect people having an excess of available funds to people having a shortage of funds. They provide three major economic functions: * Price discovery : the interactions of buyers and sellers in a financial market determine the price of the traded asset; * Liquidity : the ability to convert financial assets into money at a short notice and at low cost, or a “fair” price; * Reduced transaction costs : costs of transacting when parties want to trade a financial instrument (search and information costs). PRIMARY MARKET (Initial Public Offering) —> new issues of a security are sold to initial buyers. First time shares are available. In the primary market there are some players which are important, like investment banks. SECONDARY MARKET — > financial instruments are resold among investors. We classify this market according to the way in which securities are traded: - market structure, i.e. order-driven (e.g. Borsa Italiana) vs. quote driven (e.g. NASDAQ) (or hybrids); - organized exchanges vs over-the-counter (OTC) markets. There are other ways in which financial markets can be classified: * The type of asset traded —> debt market vs equity market (but also derivatives market) * The maturity of the asset traded —> money markets (short-term debt instruments) vs capital markets (longer- term debt and equity instruments) * The time of settlement —> cash or spot market (immediate settlement) vs forward or futures market (settlement some time in the future) In the equity market stocks are traded; futures are traded in the derivatives market. Futures market —> ex: futures on oil —> | buy instruments today that allow me to buy oil in the future, there is a future settlement. PARTICIPANTS IN THE FINANCIAL MARKETS * Brokers and dealers (market makers) - Brokeris a financial intermediate (like a bank) that brings the order to the stock exchange; - Dealer —> | buy the stock directly with my dealer (the bank), not in the stock exchange. The bank has its own inventory of stock and | buy it from there. A dealer has its own position on the stock/asset | want to acquire. * Arbitrageurs, hedgers and speculators - Arbitrageurs exploit price differences and make riskless (guaranteed) profits; their actions drive the market price of a security toward its “theoretical” price until the arbitrage opportunity is eliminated. Arbitrageurs are very important players in the market, they are large players in the market (hedge funds, pension 2 DEPOSITORY FINANCIAL INSTITUTIONS accept deposits. O Deposits are /iabilities, and funds are used to make loans and investments, i.e. depository institutions’ assets. O Their profit is (mainly) the spread between the cost of funding and the return on their investment portfolios. O In conducting their business, they face risks. Banks are generally riskier than industrial companies. They face more risks: - funding (or interest-rate) risk + volatility of your interest margin - default risk + major risk for bank, risk | will not repay the loan you make to me. | took a loan and | am not able to repay it. My loan becomes a non-performing loan (NPL). - liquidity risk > liquidity shortage + many people want at the same time to withdraw money from the bank but the bank could not have money, because it made many loans. - regulatory risk A bank accepts deposits from the public and makes loans. Positive interest —> that the bank receives Negative interest —> the one the bank pays Spread is an interest rate differential, it's generally any difference between interest rates. Their profit is the difference between the interest a bank pays on deposit to me and what they get from funds which are lent to deficit agents. Banks make loans, which are assets from a bank view point, and liabilities to the entity taking the loan, like a company, which pays an interest, makes an interest payment on the loan which is a revenue to a bank. Today, the interest rate a bank has to pay on deposits is 0, and as a consequence competition between banks lowers the positive interest rate a bank gets from loans + it is very cheap nowadays to take up a loan, a mortgage. There is plenty of liquidity at low cost. The real estate market is low, it's a good time to buy a house. The conclusion is that interest margins shrank a lot for banks, banks get positive rates to them that are low, and they pay O. Very low interest margin which was the main source of profit to banks. Banks have changed in a way their business, from a profit which was centered on the interest margin, to a profit that now also includes, to a progressively larger extent, fees. Now banks are profiting not only from the interest margin, but also from fees, from the services they provide (like credit cards). It's the fee structure that is now the major source of revenues and profit to banks. Still, the core business of a bank is accepting deposits and making loans, so hopefully in the future the interest margin will rise again and become the main source of profit for banks. Online banks charge lower fees than physical banks, and have almost no operating labour cost. We live in a world of negative interest rates. COMMERCIAL BANKS Commercial banks accept deposits and lend for a profit. The principal services provided are: *. Individual banking — > consumer lending, residential mortgage lending, credit card financing, automobile financing, etc. *. Institutional banking —>loans to non-financial/financial businesses and government entities, commercial real estate financing, etc. * Global banking —> they compete with investment banks BANKS FUNDING Banks are highly leveraged financial institutions (alta leva finanziaria) —> most of their funds come from borrowing. REGULATION AND CAPITAL ADEQUACY Adequate capital is necessary to ensure that banks remain solvent. O A basic equity capital ratio is: —> ECR= minimum amount of equity a bank has to keep at all times ECR = ( Equity capital / Total Assets) x 100 In the example of below: ECR = (20/100)*100 = 20% (keep 20% at all times) © Central banks and national supervisory authorities of major countries (G10) met in Basel to create an international standard for banking regulation. - 1988 (Basel | accord) - 2004 (Basel Il accord) - 2010 (Basel III accord) They signed an agreement which is called Basel | (1998) + it concerned regulating credit risks in the bank industry (the ECR was 8%). It set a minimum amount of equity capital in order to face losses: if losses occur, banks have enough equity capital to absorb such losses and still survive. The agreement has been revised (2004 and 2010) and they suggested regulating not only credit risk but also other risks, like market risks (Ex: a bank can have its own portfolio) and operational risk. Balance sheet of a bank or a company + statement in which we find assets } Sana het A = assets D = debt + liability ® E = equity — the capital of the owners of the bank. It's divided into shares. Debt capital is a liability, equity capital is the capital of the owners of the bank, of the shareholders. E For a bank, in A there are loans, while for a company | loans are in D (are debit capital). The bank needs funding, through deposits + deposit is an asset to me and a liability (passività) to the bank. Banks are high leveraged institutions (HLI) + Leveraged is debt. Why? Usually what happens is that the debt is much larger than the equity (the opposite for an industrial company, which usually has more equity than debt - the normal situation for an industrial company is that the debt-equity ratio is moderately low, the opposite for a bank). Banks get founded through deposits and make loans, it's the core activity of banks being highly leveraged. PROBLEM + 10, 5, 6 are amounts of three different loans, which during the financial crisis default. The combined value of these loans is 21 + as this happens, the bank is dead. Why? Because the total amount of my assets is now 79 and the bank has to repay 80. Even if the bank liquidates everything, is not gonna be able to pay 80. The equity capital goes negative (-1) and that is default for the bank. Ifthe total amount of non-performing loans exceeds the amount of equity (which for a bank is relatively low) the bank goes bankrupt. The default of a bank it's important and needs to be avoided. A=E+D+ accounting identity The probabilistic tool to measure unexpected financial losses is the Value-at-Risk (VaR). REGULATORY CAPITAL CET 1- Common Equity Tier 1: purer form of equity capital —> equity capital is shares. CET 2 + Common Equity Tier 2: total amount of equity capital Not all assets are equally risky. 100% + very risky 20% + less risky 0% + cash, completely riskless Risky assets + attach a weight to the assets, a weight which is higher the higher is the risk. RWA — Risk weighted assets + total amount of assets once l’ve taken into account riskiness. Basel IIl > the total equity capital a bank got to keep in order to face the amount of risky assets must be 10.5% * RWAs. Basel IIl increased the requirement, from 8% under Basel Il. Basel Ill: leverage Basel III not only regulates credit risk, market risk and operating risk but also: leverage + in Basel Ill special attention was paid to the size of the bank's balance sheet: it can't become too large. Keep at least 3% of my total assets in the form of equity. lf a bank wants to raise its assets, it also needs to take additional capital, and since it is not easy to raise the capital, especially during a financial crisis, that limits the size of the assets. CET 1 39% Total assets Basel Ill: liquidity Basel IIl paid attention to the fact that a bank has to be able to survive after 30 days of particularly difficult market conditions (stress test) + bank's liquidity has to be large enough to survive at least 30 days of particularly difficult market conditions in which a number of people want at the same time withdraw funds from the bank. There has to be a balance between liquid loans and deposits. A bank has to have liquid assets in a quantity which is large enough to be able to survive after 30 days of particularly illiquid market conditions. Liquid assets > 100% Total outflow over next 30 days THEORY OF FINANCIAL VALUATION Money has a time value. 1€ today is worth more than 1€ at some future for the following reasons: 1. Inflation erodes the purchasing power of 1€ —> Nowadays Inflation is close to 0. Inflation reduces the purchasing power of 1 euro + if 2% is the medium to long term objective of the inflation rate ofthe ECB, that is, if there is 2% inflation rate expected from today to tomorrow, 100€ that you are going to receive in one year are worth 98€ today because there is 2% inflation rate. Or with a 100€ today, the purchasing power will be reduced by 2% in the future + 98€. 2. Even if there is no inflation, individuals prefer present consumption to future consumption 3. There may be uncertainty (= risk) associated with the cash flow in the future —> financial decisions often require combining cash flows or comparing values. Three rules govern this process, and they hold together. Three rules of time travel: 1. Only values at the same point in time can be compared or combined —> | can't accumulate 10€ today and 10€ in the future. 2. To move a cash flow forward in time you have to “compound” it 3. To move a cash flow backward in time you have to “discount” it — > Bring the money from tomorrow to today. Most of the time we need discounting. The discount rate/compound rate (they are interchangeable) is the rate at which present and future cash flows are traded off. It also represents: © The opportunity cost of the curent investment —> the return that we would have made by investing our money elsewhere. The discount rate is an opportunity cost of the capital. O The expected return on the current investment We must consider both the opportunity cost and the uncertainty related to getting the money back. * Translating a current value into its equivalent future value is compounding. * Translating a future cash flow or value into its equivalent value in a prior period is discounting. CALCULATING THE FUTURE VALUE Future Value = Present Value + Intetest ————<—ìRFRV =PVx(1+r)—>FV=PV+rxPV Compound factor (1+r) > 1 —> the compound factor is a number > 1, which allows me to transform 100 into 110. r>0 The period depends on how you define the interest rate; ifthe interest rate is per annum, you got to measure time in years, if it isin semester, you got to measure time in semesters, and so on. O Simple interest — if the €50 interest is withdrawn at the end ofthe period, the principal is left to earn interest at the 5% rate. © Compound interest —> if both the principal and the interest rate are left on deposit, the balance earns interest on the previously paid interest. FV = PV + 1st period interest + 2nd period interest €1,102.50 = €1,000 + €50 + (0.05 x €1,050) N = number of periods —> when N goes up, also the compound rate increases. Shorthand to represent the FV at the end of 2 periods: 10 FV=PVx(1+r)/2 More in general —> FV= PVx(1+r)AN The value of N is the number of compounding periods, where a compounding period is the unit of time after which interest is paid at the rate r. The term “(1+r) N ” is the compound factor, it represents the rate of exchange between present and future euros. The longer the time period, the more relevant is the interest on interest. Interest rates are not constant over time. CALCULATING THE PRESENT VALUE PV=FV/(1+r)AN The term “ 1/(1+r) AN ” is the discount factor, since it is used to translate a future value to its equivalent present value. Compound factor (CF) = (1+r)*N > 1 Discount factor (DF) = (1/14) 4N<1 Discounting reduces the value a lot as time goes by. As the number of discount periods goes up, the PV goes down —> exponential pattern. . The simple interest is linear . The compound interest is exponential > the difference between the two is the interest on interest . Discounting reduces a lot the value of money over time + exponential; the present value goes to 0 very quickly when T is large, goes to infinity. When some of the money is allocated far from today, like 100 years, today is worth almost 0. Moving this cashflow far from today, means reducing the PV today; when the cash flow is far from today, is worth almost 0. MULTIPLE CASH FLOW Applications in finance often require determining the present or future value of a series of cash flows, rather than simply a single cash flow. BTP = Bono del tesoro poliennale lm lending money to the government today and the government will return the money to me at time 60. You cannot combine flows unless they are located at the same point of time + they are (t=0). If | have many cash flows, it's easy to proceed: discount each and transform each cash flow into its present value (value at t=0, PV) and then I add them together. | can accumulate them because | transformed them into a common currency (currency not €, but € today). If we want to find the PV or the FV of a stream of cash flows, we add up the PV or FV of each. In other words, PV and FV obey the principle of value additivity; that is, the present (future) value of many cash flows combined is the sum of their individual present (future) values. HH Value additivity — value is additive once | have taken into account time; once | convert cash flows to a common unit of measures (€ at time t, common t) value is additive, flows can be combined. 11 VALUING A PERPETUITY There are circumstances where cash flows are expected to continue forever. A series of cash flows that occur at regular intervals, forever, is a perpetuity. * A perpetuity is a collection of cash flows which has no finite maturity + l’m keeping a given constant cash flow every year up to the infinity. Constant annual cash flow up to infinity. It's not very common to find a perpetuity in the real world. * Bonds issued by governments without stated maturity, they should not end, mature at a time t. Bonds which are perpetual are known as consols: consols are perpetual bonds. Stocks do not have a stated maturity. PV of the console = CF /r —> the annual interest is constant and equal to CF A special example of perpetuity is an asset that pays a constantly growing stream of cash flows. - If cash flows will grow at the rate g and CF is the cash flow expected at the end of the first period, then the present value of this perpetuity is(r>g). PV=CF/r-g —>this formula is valid only ifr>g CF is the first. ANNUITIES Some evaluation problems require to evaluate a series of cash flows received at regular intervals but for a finite time. A series of cash flows of equal amount that occur at regular intervals for a finite time is referred to as an annuity. A perpetuity is an annuity when the maturity is the infinity. Perpetuity is a particular case of an annuity. INTEREST RATES AND YIELDS A common problem in finance is comparing alternative financing or investment opportunities when the interest rates are specified in a way that makes it difficult to compare terms. Example: - Investment A pays 10% interest compounded semiannually - Investment B pays 10% interest compounded quarterly — > if they cost the same, which one do you prefer? - If l'm investing, | prefer B —> the effective annual rate is higher “ If l'"m borrowing, | prefer A You have to understand whether the rate you're employing is a nominal rate or an effective rate. So when | say 10% per annum semi annually compounded, 10% is nominal and you have to compute the equivalent effective keeping into account that you are going to receive 2 payments per year, or quarterly compounded, or monthly compounded, and so on and so forth. 12 DEFAULT RISK Default risk is the risk that the issuer of a debt obligation may be unable to make timely payment of interest or the principal amount when it is due. Most market participants gauge default risk in terms of the credit rating assigned by the major rating agencies: © Moody's Investor Service © Standard&Poor'îs Corporation © Fitch Ratings Default risk nn Default risk: Italy |_————_——24À<iE;KTT2221_É5.t21 S&P and Fitch _—Moody’s AAA Ana High AA An } Ual | nvestment A A grade Agency Rating Outlook FOO ea S&P BBB Stable a m Non-investment Fitch BBB- Stable grade (junk Moody's Baa3 Stable B B bonds) c c Source: http://countryeconomy.com/ratings/italy Credit spreads are time varying, changing over time. Default risk . ; Corporate Treasury Yield spread Maturiy Rating yicld(%) yield (%) bps) S-year AAA 245 217 28 S-year AA 2.86 2.17 69 10-year AAA 3.93 3.48 45 10-year AA 4.71 3.48 123 Yields reported on itp./inance.yah00.com 24.02.2011. The original source is ValuBond. LIQUIDITY Bonds trade with different degrees of liquidity. © Bonds with a short-term maturity or an active secondary market have greater liquidity © Bonds with greater expected liquidity will have lower yields that investors would require O Treasury bonds are the most liquid bonds in the world — > the /ower yield offered on Treasury securities relative to non-Treasury securities also reflects difference in liquidity The yield, the return, is a positive function of the risk + the riskier is the borrower, the larger the return you expect, the interest rate. Risk requires return. Liquidity is the fact that you can quickly and at no cost convert your piece of paper into cash, selling it. The easier to do so, the more liquid the market. It is a good property + the more liquid the market in which your assets are traded, the better. 15 Investors are concerned with after-tax income earned on securities. COVENANTS —> Arrangements which provide protection to bondholders. Covenants are clauses in the contract that aim to reduce the credit risk, they allow the borrower to pay less so they reduce the cost. O Covenants on financing activities © Covenants on investment activities O Covenants related to corporate payouts Negative covenants ( —> you will not): ©. pay dividends beyond specified amount - sell more senior debt (also, amount of new debt is limited) Positive covenants ( —> you will): - use proceeds from sale of assets for other assets - allow redemption (rimborso) in event of merger or spinoff Time Interest Earn (TIE): your profits over your interest expenses Yankee bonds are bonds issued in the US by companies which are located elsewhere. Social trust —> the larger the trust of the country the firm is located into, the lower the number of covenants. There are many yield curves, depending on who the borrower is and depending on the country the borrower is located. THE TERM STRUCTURE A factor that is important in determining the rate of interest to be charged is the duration of a loan. Interest rates for bonds vary by term to maturity. O The yield curve is a plot of the interest rate charged against different terms to maturity for a (Treasury) bond that is identical in all other respects. A yield curve is a structure, a collection of interest rates, and each rate holds for a given maturity. The yield curve is also known as the term structure, it is a collection of interest rates with different maturities when the issuer is the government. What | find in the term structure is yields of government bonds, for different maturities. Investors have typically constructed yield curves from observations of prices and yields in the Treasury market for two reasons: 1. Treasury securities are (generally) free of default risk. Therefore, these instruments are directly comparable. 2. As the largest and most active bond market, the Treasury market offers the fewest problems of illiquidity or infrequent trading. Why government bonds? 1. Theyare veryliquid + they show the highest possible level of liquidity 2. Theyare free of default + if the government default, everything else default Shape ofthe term structure: usually the term structure is rising. In normal times it is 16 The term structure There are three popular explanations of the term structure of interest rates (i.e. why the yield curve is shaped the way it ZA T__ is): © The expectations hypothesis © The liquidity preference hypothesis © The market segmentation (preferred habitats) hypothesis Rising Declining 1 There is some truth in each of these hypotheses, but the EXPECTATIONS HYPOTHESIS is the most accepted. Flat Humped The main proposition is that long-term interest rates are determined by market expectations about the path of future short-term rates. O A positively sloped yield curve indicates the market expects short-term interest rate to rise in the future O A negatively sloped yield curve indicates that market expects short-term interest rate to fall in the future According to this hypothesis, investors are completely indifferent whether to invest in a long term bond or a series of short term bonds. Expectations hypothesis Example. Consider the following term structure of interest rates. Year Rate 70% 75% 80% 85% 90% If the market does not allow arbitrage, an investor is indifferent between the two following strategies. — If I lend money to the government and the maturity of this loan is 1 year, the government pays 7% so | get 7% for an investment that lasts 1 year. According to the expectations theory, the forward rate | can compute today is the unbiased estimator of the future level of interest rate. LIQUIDITY PREFERENCE HYPOTHESIS The liquidity preference hypothesis contends that investors require a premium for the increased volatility of long- term investments. Thus, long-term rates should be higher than short-term rates. —> note that long-term rates contain a premium, even if they are lower than short-term rates. 17 if instead the market thinks that my credit worthiness improves, this yield goes down. It is a continuous perception that the market has on the fair return | should get. The more liquid the market, the more meaningful this number, because there is a continuous flow of money both on the demand and supply side, making the equilibrium price very meaningful. The more liquid the market, the better. The price of the bond is: -€1,023.40 is negative because it is you paying and 5 5 5 me receiving and all the others are positive because PV= (1+4.47%)! (1+447%)? (1+447%)3 + you are receiving and me paying. 5 105 + C4447%)* (14447%)8 — 102.34 This means that investing €1023.40 now yields: -€1,023.40 €50.00 €50.00 €50.00 €50.00 €1,050.00 0 1 2 3 4 Ss time) P_=PV= 102.34 [1 pro ] @| How we obtain €1023.40: the price | observe in the market (PV, PO) is 102.34 (% of 4100/ the par, the par is 100% of itself) + lo0 | <—7 { 1000 100% of the par corresponds to 1000€. 102.34 is a % of the par — 102.34% * 1000€ > 1.0234 * 402.34 f x £ 1.000 1000€ = €1023.40 41.023k x £ 1000 = £ 1023. A fundamental property of a bond is that its price changes in the opposite direction from the change in the required yield. The reason is that the price of the bond is the present value of the cash flows. The price-yield relationship has a bowed (convex) shape. It's not linear, it's convex. Decreasing and convex. Yield _ Bondprice 125 10% H94l 199 15% 1674 20% mala "IS 25% ILS NO 30% 109.16 I as 16m "95 4.0% 104.45 100 45% 1021995 50% 10000 go 55% 97.86 60% 9579 85 65% 97 80 SE % »% 4 6% 8 If the yield goes up, the price goes down, and vice versa. 20 Relationship between coupon rate, required yield and price of a bond: © When yields rise above the coupon rate, the price of the bond falls so that an investor buying the bond can realizes capital appreciation O The appreciation is a compensation to new investors, since they receive a coupon rate lower than the required yield - When a bond sells below its par value, it is said to be selling at a discount = Abond whose price is above its par value is said to be selling at a premium IF THEN WE REFER TO THIS BOND ASA Coupon rate < Required yield Price < Par Discount bond Coupon rate = Required yield Price = Par Par bond Coupon rate > Required yield Price > Par Premium bond When the required yield is equal to the coupon rate (5), the price is equal to the par, and we name this bond as a par bond. (Yield 5.0% , bond price 100.00) —> Vedi tabella sopra There is an inverse relationship between coupon and yield. When the two are equal the bond trades at the par (the coupon is 5%, | want 5%, no reason for overpay or pay less); when coupon > the yield, the price goes above the par. What is the point in setting the coupon rate at a level which is different from the yield? it is not what issuers normally do. But the point is that time goes by. l issue the bond at 100 (coupon = yield), but then the yield changes, goes up and down; but the coupon is constant during the life of the bond. When the yield goes up, the price readjusts and goes down, when the yield goes down, the price readjust and goes up, when yield = coupon the price is 100. Not only yields go up and down. Which bonds are riskier? Fixed-rates bonds or floating-rates bonds? Fixed-rates bonds are riskier, because risk is the fact that prices change, and they change less for a floating rate bond. Fixed-rate bonds are volatile, their price readjust to changes in the yield. Prices change less for floating-rate bonds. With zero-coupon bonds issuers do not make any periodic coupon payments. Instead, the investor realizes interest as the difference between the maturity value and the purchase price. —> bonds which pay no coupon. They trade at discount. They are usually discount bonds and short dated (less than 2 years usually). 21 The yield to maturity (YTM) is the average annual rate of return that a bondholder will earn under the following assumptions: © the bond is held to maturity “ the interest payments are reinvested at the YTM The YTM is the same as the bond's internal rate of return (IRR). YTM + it is the constant discount rate for all payments of the bond which, if employed in the discounted cash flow formula, the formula returns the market price of the bond. It is the constant yield return discount rate, which if | plug this return into the discounted cash flow formula, the formula returns the market price of the bond. I don't find the YTM in the yield curve + it is a complex average of the rates | find in the yield curve. The price of a bond can change for 3 reasons: 1) There is a change in the required yield owing to a change in the yield on comparable bonds (i.e. a change in the yield required by the market) 2) There is a change in the required yield owing to changes in the credit quality of the issuer The price of a bond changes because the yield changes. 8) There is a change in the price of the bond without any change in the required yield, simply because the bond is moving toward maturity —> structural reason: as time goes by, as the bond's life approaches 0 (its maturity), there is a convergence of the price of the bond to the par: the day before the bond expires, the price will be very close to the par plus the last coupon, this is what you will receive at the end of the life of the bond. The price of the bond does not change that much as the bond's price approaches maturity, there is not that much time for the bond's price to change. The magnitude of the price change is affected by the following variables: O Time to maturity —> the longer the term to maturity, the larger the change in price for a given change in yield © Coupon rate —> the lower the coupon, the larger the percentage change in price for a given change in yield © Direction of yield change —> price changes are greater when rates fall than when rates rise Let's compare two bonds: 1) onehas a 10% (pays a lot over time) coupon rate 2) the other one 1% c.r. —> they have the same time to maturity. Which one is more volatile, riskier? (one pays a very large coupon, the other very low coupon) Since the time to maturity is the same, if there is a change in the required yield, in the yield to maturity, this change affects both bonds in the same manner. However, there is a difference in par because there are different coupon rates. The bond which pays the larger coupon rate is less affected by a change in the yield, because lm starting getting my money back earlier. The one which pays a very large coupon is less risky because in present value terms, money goes back to my pockets earlier. For the other one | have to wait + the sooner | receive the money back the better. 22 A company defaults when the debt burden is excessive. When a company accumulates losses, the equity capital is eroded, and the debt ratio goes up. When the total amount of debts exceeds the total value of the firm, the total value of the firm is not even enough to repay the debts. “Portare i libri in tribunale” + “Filing for chapter 11” , in the US = starting a procedure for bankruptcy A company goes bankrupt when the equity goes negative: even liquidating everything you have is not enough for repaying the total amount of your debts. A company can try to top the equity up, requesting additional funds from the shareholders (very difficult, nobody would like to add equity capital to an already defaulted business). But still, shareholders did not lose more than the amount they invested (this is the so called limited liability principle): even if the equity capital goes negative, those who suffer the losses are debt holders, not the shareholders. Shareholders lost everything but don't have to add capital. This negative equity reduces the capital which should be given back to debt holders, which will receive less than the amount they lent to the company. 2) VOTING RIGHTS Common shareholders are entitled to: O elect the board of directors, which selects the management team that runs the company's operations —> Shareholders vote on many matters at the company level and one of the most important ones is to elect the board of directors. © approve any change in the corporate charter Standard voting right is typically one vote per share . However, this scheme can be altered by issuing: - non-voting stocks + you got shares but you don't vote, but there is a compensation © super voting rights, which provide the holders with multiple votes per share + more votes per share = If you have 10 shares, you have 10 votes. Voting rights Separation between ownership and control. © Example. Google. = Restricted voting class (Class A) = 1 vote per share (the oniy - NOSH = number of shares class traded at NASDAQ). ® Superior voting class (Class B) = 10 votes per share. Official reason (reported in SEC filing form 10-K): "mantain founders' control and focus on long term strategy" In 2011: superior voting class represents 21.5% of total If 100 is the n. of shares: equity and 73.3% of total voting power. © 21.5 shares have 10 votes per share (B) NOSH Votes p/share___N Votes Control 21,5% to 2.150 733% “ 78.5 shares have 1 vote per share (A). 78.5% 1 0.785 26.7% = How many votes in total? (21.5 * 10) + (78.5* 1) + What is the % of votes held by people retaining just 21.5 shares? 2.150 / (2.150 + 0.785) = 73.3 You contributed to the equity of the company in terms of % of it (20% only), but you control the company because your votes counts 10 times as much relative to the votes of class A shares. 25 PREFERRED STOCKS Preferred stock is a hybrid security, as it has characteristics of both stocks and bonds. Like common stocks, preferred stocks: O Have no fixed maturity date O Failure to pay dividends does not lead to bankruptcy O Dividends are not tax-deductible Like bonds: O Dividends are fixed O They have no voting right © They have priority on assets and income ITALIAN STOCKS © Ordinary shares (azioni ordinarie) : common stocks - they confer on their holders all rights in the company + 1 vote per share O Preferred shares (azioni privilegiate) - they confer a right of priority in the distribution of the company's net profits and net assets upon liquidation but limited voting rights (extraordinary meeting only). Preferred shares are not very widespread, you only vote in the so called extraordinary meetings (assemblea straordinaria) but not in ordinary meetings. © Saving shares (azioni di risparmio) - they do not give the right to attend and vote at any shareholders’ meetings, but they benefit from distribution of a company's profits and assets in case of liquidation + no vote, but compensation in another way in exchange (larger dividend) ITALIAN SHARES VS DEBT Ordinary shares Preferred and saving shares Voting rights: ordinary and Voting rights: Voting rights: none extraordinary shareholders - none (saving share); meetings - extraordinary meeting only (preferred shares) Dividends: after interests and Dividends: after interests Dividends: before interests preferred/saving share dividends Seniority: none Seniority: between debt and Seniority: yes ordinary shares 26 MULTIPLE VOTING SHARES IN ITALY 24th June 2014: “Competitiveness Decree” introduce multiple voting shares, waiving (revocando) the principle of “one share-one vote”. O Up to a 2 (8) votes per share for listed (private) companies © Only to “loyal” shareholders (L-shares): - shares continuously held for at least 2 years Pros: “ it exists in many developed markets “lt may guarantee a stable management Cons: - in Italy market distortions have been caused by the influence of controlling shareholders It was a major change. Multiple voting shares were not allowed, but now they are. LOYALTY SHARES Mi Loyalty shares have been adopted by 20% of Italian listed firms since 2014 Wi Family firms are more likely to opt for loyalty shares than non-family firms + the probability of introducing loyalty shares is very high when you are a family firm, smaller when you're not a family firm. mi Controlling shareholders use loyalty shares to reduce risk, but not to foster growth Mi Institutional investors oppose loyalty shares, yet they do not vote with their feet Mi Bolstering family control is the main effect of the introduction of loyalty shares This is a voting mechanism which is chosen and applied by a number of companies in Italy. VOTING PREMIUM . . The investment segment is the value of the dividends you Voting premium receive. I If | compute the difference between the ordinary and the saving share, what l’m doing is underestimating the value of Roe sto the vote, but this is commonly done. = value of an ordinary share — value of a saving The size of the vote segment is a proxy of private benefits. share + difference between investment If the value of the voting segment is large, is attributable to the Scene fact that eventually this stock can enter into the pool of the Ordinary share Saving share share employed for controlling the company. If | control the company, | can exploit and extract private benefits of control. The larger the private benefits of control, the larger the value of the vote segment. If the size of the private benefits is large, it matters a lot whether you control the company or not. In Italy the private benefits of control are non negligible (irrilevante, trascurabile), so any new legislation aimed at empowering the controlling shareholders should be kept into consideration; we know that is potential detrimental to the minority. 27 There are two sources of growth: B External growth > A company which is worth $100, | want to make an acquisition and | want to use mostly debt: this is an LBO (Leveraged Buy-Out) , which are acquisitions made with a very high level of debt (acquisizioni attraverso debito). LBOs are risky. So the company grows, makes an acquisition, because it takes up new capital; the company's value is $100, it takes a mortgage or it issues a bond $30 and makes an acquisition. So the total value is equal to $130. The debt is employed to make an acquisition. So there is a growth, from 100 to 130: a 30% growth rate and this comes from external capital. However, it's not an ordinary event, but an extraordinary event, because a company does not take up debt every year, does not issue equity capital every year; it does so only if it has to make some important investments. External capital is an important source of growth, but it's completely unpredictable and it will depend on the investment opportunities in the future, which are now unknown. Bi Internal growth + if a company has an ROE (return on equity capital) = 10%. ROE is a profiîtability indicator, ratio of a firm. It is the return on my equity capital: my 100, if invested at time 0, will yield a 10% return at time 1, that is over a 0-1 time period what | get from the invested equity capital is 10%: 100 at time 0, 10 at time 1 (10 is 10% of 100). The earnings (10) are fully distributable, they can be distributed to my shareholders, they can become dividends or they can completely be reinvested. What happens if | pay 100% of my earnings in the form of dividends? At time 1, the balance sheet of my firm is the same as before. | got 10, which are completely distributed to my shareholders, so my end of year equity is equal to my start of period equity. The growth rate is 0. What happens if l’m not distributing anything, but I'm reinvesting? My assets were 100, and my equity was 100, l'm adding 10, that means lm adding 10 (my equity capital) and I'm investing and acquiring a new machine, a new land, I'm investing in research and innovation, l'm doing something with my money here, so new assets also. The important thing is that the new E is now equal to 110, so there is a 10% growth (from 100 to 110). Plowback ratio (PR) is the % of my earnings which | do reinvest into myself._ Say that my PR is 100%, which means the payout is 0, l'm not paying any dividend, so the growth rate is 10%. If | want to fully pay dividends, the payout is 100% and 100%-100% = 0, the plowback is 0, l’m not growing. The internally generated growth rate is the product of two quantities: O one is the expected return on equity (ROE) which depends on who you are, depends on the industry, competition, market-wide conditions, on whether you are indebted or not (leverage ratio); © and the plowback which depends on the strategy of the firm, which decides whether to invest or not. There are firms which keep reinvesting 100% of their earnings, there are firms which never pay the dividends, so called 0 dividends firms (like Warren Buffet's firm, Berkshire.) So shareholders don't get dividends, but the company keeps investing, which means that the company grows, so shareholders don't get dividends but the value of their stocks goes up, so it's a tradeoff. Risk and return go hand in hand. Capital Asset Pricing Model (CAPM) + is an equilibrium model + R as a function of something. R is the required return that is needed for computing the dividend discount model. Beta is a parameter which means risk + if beta = 0 means no risk at all. 30 If you're not willing to take any risk, your return will be equal to the return of an investment which has no risk, so called risk-free rate of return. If you're willing to take risk, beta goes up, and your return also goes up, larger return. Beta = 1 is the market portfolio, so the average return of the market index. If the risk of your asset is 1, that means it is similar to the risk of the market portfolio, and the return is equal to the return of the market portfolio. * lfbeta<1 andbeta > 0, the return of your asset is smaller than that of the market portfolio but larger than that of the risk-free rate. * lfbeta=0, the return is exactly that of the risk-free rate. * Ifbeta>1,itwill be larger than the return of the market portfolio. If a firm chooses to pay a lower dividend, and reinvest its earnings, the stock price increases because future dividends may be higher. + Payout ratio: fraction of earnings paid out as dividends * Plowback ratio: fraction of earnings retained growth rate = return on equity x plowback ratio Stock valuation and growth: 9/1 1 Market efficiency: the price today impounds, embeds (incorpora, integra) all of the information the market possibly has on the future. So what the market expects from the future is impounded in Example. Fears led to downward revision of the growth rate for companies, and hence lower expected dividends. Increased uncertainty led to a larger required retumn on prices today. This is a concept of market efficiency: investment, R. if the market is efficient, from an informative view ® As predicted by the Gordon growth model, these two effects of _—point, that means that prices today discount, the 9/11 attacks were followed by a drop in stock prices. embed, incorporate all the available information the market has today. Date S&P500 10/09/2001 109254 1,092.54= O. After 9/11, the stock exchange did not operate for a 21/09/2001 965.80 i i while. It reopened on 21/09 with updated information. The market (market operators, the traders) discounted on the future, they changed their expectations in a downward manner, they were more pessimistic on the future growth and that was discounted in prices. S&P500 is the US market index which includes the first 500 largest companies in the US, by market capitalization. The price of the S&P500 went down to 965.60 index point: what matters is the difference + the first 500 stocks in the US, on average, went down in terms of prices, yielding a price drop in terms of the index. 14.2 was the average dividend converted in index point, which was distributed by these 500 companies. The current market price of a stock is an equilibrium market price, that is: O right side is what investors are willing to pay for the stock, given their current desires and beliefs; O if right side were greater than the market price, investors would increase their demand for the stock and thus bid up this market price (left side); O if right side were less than market price, investors would reduce their demand for the stock, thus causing this market price (left side) to fall. 31 FINANCIAL STATEMENT ANALYSIS AND RATIOS Financial statements are summaries of the operating, financing, and investment activities of a business. At the end of each year (fiscal year) a company has to let the market know everything regarding the performance of the firm. A financial statement is a snapshot, a picture today of the company. It is useful to internal stakeholders and to external stakeholders. A company should let the internal and external stakeholders know what the true and actual profitability and situation of the company is. - Internal stakeholders: employees, managers, board of directors - External stakeholders: investors, lenders, suppliers, customers, Governments, unions, media, competitors, market There can be frauds of financial statements + a company can alter its financial statement in order to make it look better than it is. At least once a year, all listed companies have to disclose their financial information. The financial statements contain assumptions that affect how we use and interpret the financial data: 1. Transactions are recorded at historical cost + A company has to register the cost of the purchased asset into the balance sheet. The historical cost is the price the firm did pay at the time when the firm purchased the asset. Obviously, the value of an asset changes over time: in the balance sheet of the firm | don't find the fluctuation of the value, because the value is registered at historical cost. 2. The statements are recorded for a predefined period of time + Financial statements are recorded for a given period of time (1 year usually). If I look at the income statement, the very last item in the income statement will be the earnings or the net income, if positive, or the net loss, if negative, over a predefined period of time (usually 1 year). So the item | will see in the income statement will be the earnings over the last year: net income (if positive), a loss (if negative). 3. Statements are compliant with accrual accounting/matching principle > What you will find in the financial statement, in particular in one of the components of the fin. stat., which is the income statement, are items which are compliant with this principle. In particular, items are not registered on the basis of a cash accounting, but rather accrual accounting (contabilità per competenza). - Example 1: a firm sells a product to you in November, and you will pay in 90-days time, so you will pay in the new fiscal year (February), so the firm is not registering this transaction in 3 months time, when you’Il make the payment and the firm will receive the money: this would be cash accounting, registering items when they are paid or received + this is not how the income statement works + The firm registers the revenue today (November), register the sale of the product to me today, and | will pay in 3 months time. Why does the firm register the revenue today? Because the sale belongs to the current fiscal year, not to the next one. So when the firm receives my payment, it will not register anything, in terms of revenues, because they belong to the previous fiscal year. This is the so-called accrual or matching principle > the firm has to match that the item is registered when it provides utility to the firm. - Example 2: a firm makes an investment today (long term investment that is going to last many years, it is going to provide utility to the firm also in the next years, not just today) and you will pay it today, so there would be a cash out flow today. But the firm is not going to register today the full amount of the investment, why? Because the firm is not preparing the income statement according to a cash principle, but according to a matching principle. So the firm is going to understand what is the length of this investment: say that this investment will provide utility to the firm for the next 10 years, then the firm splits the investment evenly in the next 10 years: the investment is 100, l’Il register just 10 today, in the income statement | will find 10 > 10 is the share, the portion of the investment which belongs to the current fiscal year according to the matching principle. And then the firm will register 10 the next year and so on up to the end of the period. 32 LIABILITIES Liability is debt + debt can be either a short-term debt (current), or a long-term debt (mortgage or a bond). A company can employ long-term debts —»> o Liabilities are presented in order of their due date. for funding investments and short-term debts to fund daily operations, so there can be financial debts even in the current liabilities section. / Current liabilities: are obligations due within one year or one operating cycle (whichever is longer). = (unpaid bills to suppliers) Mi Accrued expenses (expenses recorded but not paid) Wi Current portion of long- term debt Mi Short term borrowing/ bankloans Net working capital da Long-term liabilities: are obligations that are due beyond one year. i Bonds and long-term banks loans i Capital leases i Asset retirement liability i Deferred taxes Working is a synonym for operating + working capital it doesn't include financial items. ASSETS LIABILITIES AND EQUITY x Net working capital is the difference between current assets Accounts receivable Capita 18° ” vogn Cute Accounts payable and current liabilities, in particular operating liabilities + the Inventories Ia TeEST] most important one is the accounts receivable. Cash and equivalents Current assets and current liabilities have to exclude financial items. Non-cash working capital is defined as current assets (except for cash and equivalents) minus current operating liabilities. Example: . Accounts receivable, that is, amount which you will receive in less than 1 year = 10 ‘ Inventories = 20 . +10+20=30 . Accounts payable, an operating debt which is due in less than 1 year = 25 . That means the Net Working Capital = 5 + 10+20 - 25=5 . NWC is a measure of liquidity of the firm + since all of the items composing the working capital are expected not to stay with the company for more than 12 months, so you are expected to liquidate both currents assets and currents liabilities, if the NWC > 0 it means after you liquidate all of your current assets you are able to pay you current liabilities and something is left to you, so you are liquid. On the contrary, if current liabilities exceeds current assets you are expected to run into a shortage of cash in the next 12 months, so you have to pay attention to a negative working capital because that means that you are expected to need more cash or to fund this difference, this lack of liquidity in the next 12 months. So it's highly desirable for a firm to exhibit a positive working capital. 35 EQUITY is the owners of the firm’s capital + we can split it between common equity (ordinary or common stocks) and preferred equity (saving shares, azioni di risparmio) MI Stock value i Retained earnings Stock value and retained earnings + example: you are worth 100, 100 is the equity. 20x1 is tomorrow. You experience a profit, a net income, equal to +10. What can you do with this ‘amount? Pay dividends or reinvest. If the amount is reinvested, the total value of the firm at time 20x1 is 110 + the new equity is 110: 100 is the nominal value of the equity (as before), and 10 is the retained earnings. SHAREHOLDERS EQUITY is the book value of the ownership of a company. It is comprised of: ® Par value + nominal amount per share of stock value ® Additional paid-in capital > capital surplus, e.g. the amount paid for shares of stock by investors in excess of par value ® Retained earnings + accumulation of prior and current periods’ earnings and losses, less any prior or current periods’ dividends Balance sheet: example ASSETS 20xx1 — 20xx Change LIABILITIES AND EQUITY 20xx-1 20xx Change ci i doo si » 4 Ù Notes payable 71.60 76.20 4.60 ante (RS gie n Gemmipn str | 3500 3500 os Prepaid expenses 32.70 38.40 570 Aeg GOL AEEZZI E CR inventoey Ere Accrued expenses 58.50 60.70 220 TOTAL CURRENT'ASSETS 748.001 © 786901 © 389010 TOTAL CURRENT LIABILITIES 4650 460.15 13.65 LONG-TERM DEBT 62500 600.00 -25.00 (Gross fixed assets 129.50 135000 120.50 Accumulated depreciation 396.70 439.30. 42.60 Stock value 200.00 200.00 0.00 TOTAL (NET) FIXED ASSETS 832.80 910.70 77.90 Retained carnings 30930 437.45 128.15 EQUITY CAPITAL 309.30 63745 128.15 TOTAL ASSETS 1580,80 _1697.60 116.80 _ TOTAL LIABILITIES AND EQUITY ——1580.80_1697.60 116.80 THE INCOME STATEMENT The income statement is a summary of operating performance over a period of time. It contains flow quantities and it tells what happened in between time 0 and time 1. It tells the story regarding the profitability of the firm; it gives information on how the company is profitable. The balance sheet instead is a sort of a general situation of the total assets and liabilities of the firm. The most important item in the income statement is the net income (the profit). O The cost of sales, referred to as the cost of goods sold (COGS) is deducted from revenues, giving a gross profit. COGS = sales (total amount of revenues) - the cost of the goods sold + this difference is the gross margin/ profit. The cost of what you spent for purchasing raw materials is an important part of the cost of goods you are selling during this year. 36 O General operating expenses (SG&A) are related to the support of the general operations of the company, and include salaries, marketing costs, and R&D. SG&A are electricity costs, general labour costs, etc,. + Gross profit - SG&A is the EBITDA (earnings before interest, taxes and Depreciation8Amortization) + this is very important because it is really what you have after deducting all cash expenses, apart from interest costs. Example: revenues = 100 , costs of goods sold = 50, SG&A = 20 100 - 50 - 20= 30 + 30 is the EBITDA (Earnings before of - so gross of - Interest, Taxes, Depreciation and Amortization) Depreciation and amortization are costs + depreciation is part of the investment in fixed assets which | allocate to any given year subsequent to the year when | make the initial investment. D&A must be subtracted from the EBITDA. O Depreciation is the amortized cost of physical assets © From operating income, we deduct interest expense and add any interest income. Income statement Net income is positive + generating profits Sales (revenues) otherwise is - Costof goods sold (COGS) = purchases in year {final _ _ inventory in year f + initial inventory in year f a Net loss + negative profits = Gross profit — Selling, general, and administrative expenses (SG&A) = sales commission + advertising and promotion + overhead + payroll = EBITDA (eamings before interest, taxes and D&A) — Depreciation and amortization (D&A) = EBIT (eamings before interest and taxes) + Interest income — Interest expenses = EBT (earnings before taxes) — Taxes on EBT = Net income STATEMENT OF CASH FLOWS The statement of cash flows is the summary of a company's cash flows. It is composed of 3 sections: 1. Section whose last item (output) is the cash flow from the firm’s operations (OC F) + operating cash flows from day-to-day operations. It is basically net income adjusted for non cash expenditures, and changes in working capital accounts. 2. Section that deals with /ong-term investments + cash flow from investing (ICF) is the cash flows related to the acquisition of plant, equipment, and other assets, as well as the proceeds from the sale of assets. 8. Third section generates cash flow from financing activities (FCF) + cash flow from activities related to the sources of capital funds (e.g., buyback common stock, pay dividends, issue bonds). 37 If | want to understand whether the equity is profitable, | use the ROE. If | want to understand the extent to which the assets as a whole, regardless of whether | funded these assets using debt or equity, are profitable, l’ve got to compute the ratio between the net operating margin and the total assets. ROE is net of debt, ROA is gross of debt. If for a firm the ROE is very small and the ROA is large, how do you interpret this difference? lt means the company is highly leveraged + ROA 20%, ROE 0%, how is it possible that the company is not profitable at the equity level but is profitable at the level of the assets? The company is profitable, but the point is that you are completely eroding the margin because you pay a lot of interest to the bank + the company is profitable, potentially, but unfortunately is too leveraged, it is too indebted. So if you want to make the company profitable also at the equity level, you've got to reduce in a way your leveraged ratio. If the company is completely free of debt: ROE = ROA ROE goes up as the debt goes up. Companies which are in good shape, not in financial distress, and they are indebted, usually have a very large ROE. So shareholders should be happy. Problems are triggered when the debt to equity ratio gets too high. It's all related to risk. l’m adding debt, lm adding risk, so adding return. Up to a given point, risk becomes excessive. l’m leveraging on debt to increase return. Ml The profitability of the firm’s revenues (sales) is expressed by the return on sales (ROS), that is: ROS = operating profit / revenues ROS is the firm’s operating profit margin. It represents the profit produced per dollar of revenues. The larger the ROS, the more profitable will be the firm towards the end of the income statement. ROE, ROA and ROS are three profitability indicators which are very frequently employed when you look at the profitability of the firm. The combination ofthe three should be taken into account. 40 CAPITAL BUDGETING AND RISK Capital budgeting means assessing Capital budgeting whether potential investment projects which are available to a firm are profitable and * Every possible method for evaluating investment decisions impacts the understanding instead which ones are company's flow of cash as follows. not. The conclusion should be to undertake investment projects which are value Investment Investment creating. opportunities [mo] ‘Shareholder I opportunities . . si (real assets) (financial assets) Projects which maximize the wealth of the shareholders should be undertaken. Alternative: pay Shareholders invest Cash cycle within a company. dividend to for themselves shareholders If a company is not able to invest in profitable investment opportunities, the company should rather repay cash to the company shareholders. A company should invest in positive projects, in projects which add value; otherwise a company should return cash to the shareholders in the form of dividends or stock by banks, that are repurchasing stocks in the open market + both alternatives are aimed at returning cash to the shareholders. Either the firm invests itself, or if it is not able to create value it should return money to the shareholders which will invest by themselves in the capital market. Important link emphasized by this picture: real assets, which are the assets the company can invest into, financial assets which are the assets individual shareholders can invest into. When assessing the profitability of an investment project at the firm level, we will use firm level variables, the cash flows, and market level variables that l'm gathering looking at the financial market. Capital budgeting tools NPV = net present value * Survey data on CFO use of investment evaluation techniques. IRR = internal rate of return + employed in fixed income but also in capital budgeting E n.15. Payback is simply the amount of time required for the >AKKel@eEEe/] ws * © project to recover. REeE ee«=”e Book rate of return is the ROA + is a rate of return of a Bookrate of project based on accounting figures. MEIN 1: 20% Proftabil The profitability index is simply an indicator which is a index 12% function of the NPV > is the ratio between the NPV and the invested capital. 0% 20% 40% 60% 80% 100% ST The most important ones are the NPV and the IRR. PAYBACK PERIOD Mi Payback period: amount of time required for a project to generate cash flows that cover the initial investment outlay Ml Payback period rule: accept a project if the payback period is less than some pre-specified cutoff. 41 ADVANTAGES AND DISADVANTAGES of the payback period ] ] Itis a simple rule * It ignores time value of money It focuses on the liquidity of *. Itignores cash flows arriving after the payback period an investment project . . Lo. * The choice of cutoff is arbitrarily selected by managers It adjusts for the uncertainty LoL . . . of late-arriving cash flows *_ Itis biased against long-term projects, such as R&D investments The NPV of a project with cash flows over N periods is: NPV = CF1/(1+1) + CF2/(1+M)A2+.... + CFN/(1+)4N - initial investment Decision rule: Mi If NPV> 0 + accept project i I{NPV<0 + reject project The internal rate of return (IRR) on an investment is the required return that results in a zero NPV when used as the discount rate. * For example, in the case of a one-period project: rate of return = (payoff / investment) - 1 NPV = payoff / (1 + discount rate) - investment I#{NPV=0, then: discountrate = (payoff/investment) - 1 So, rate of return = discount rate , when NPV = 0. In the case of multi-period projects, we solve for IRR in the equation: NPV = CFo+ CFi / (1+IRR) + CF2/ (1+IRR)A2 + ..... +CFN/(1+IRR)AN=0 Decision rule: E If IRR > firm’s discount rate + accept project E If IRR < firm’s discount rate + reject project Investing in projects with IRR > discount rate creates value for the firm. The IRR of an investment project is the discount rate which makes the NPV of the project equal to 0. Cross countries studies show that countries in which the protection of the shareholders is high, value cash more. Firms which stockpile cash (accumulare denaro contante) and they are located into an environment which protects shareholders from expropriation are valued more. Firms which stockpile cash but they are located in an environment with a low protection of minorities, are tempted to expropriate minorities, are valued less in terms of cash + so the very same dollar of cash is worth different depending on who you are and where you are located, because the environment is different. And the basis of this is agency + agency's costs are larger when it is possible to leverage an agency. There are indexes which measure the level of shareholders protection in a given country or area. Usually common law countries are seen to exhibit higher levels of investment protection, of shareholders protection. Civil law countries, on average, lower levels. 42 The more the fixed costs impact the operating margin, the riskier the firm. Industries which require high investments in fixed assets, fixed costs, are riskier. Industries which don't require such a very large investment in infrastructures and fixed assets in general, are more flexible and less risky. Operating risk is larger for: * Cyclical companies * Companies with a large fixed to total costs ratio (operating leverage) Leverage is risk, it means increasing return at the expense of risk. Financial leverage has to do with the capital structure. Debt makes the equity riskier because it adds a fixed cost. Fixed cost is the interest | have to pay no matters what happens to the revenues. Financial leverage adds a fixed cost, interest expenses. Operating risk Growth vs Value firms + Beta-assets * Growth firms are firms for which most of their value comes from the future. Business risk Operating * Value firms are firms which most of their leverage . 9 value comes from the assets already in place. (a) Cyclical companies have higher betas (@) Firms with high infrastructure needs and than noneyelical ones; rigld cost structures should have higher (6) hay and high priced good firme have betas than firms with flexible cost sructures; higher betas than basic and low prices (©) smaller firms should have higher betas 900ds; han larger firms; (©) growth firms have higher betas than (e) young firms should have higher betas value firms. than older firms, 1isthe beta of the market + - larger than 1 very risky , technology companies have betas > 1 - lower than1, close to 0, not very risky Is the company a leader ofthe industry or a follower? If you are the largest company in the industry and you are the leader, your beta is lower, your risk is lower. 45 CORPORATE RISK MANAGEMENT Itis important for a firm to hedge risk, manage hedgeable risk. Not all risks are hedgeable, some are. Differentiation between market and credit risk —> market risk is hedgeable, credit risk usually is not, it is uninsurable (non assicurabile). Credit risk is pure risk. Risk is variability, but not credit risk, credit risk is pure risk: pure risk means that you only got one side of risk, the negative side, it is uninsurable. Market risk has instead also a positive side, market risk is the volatility, it goes up and down. Interest rate, exchange rate, commodities prices are the three underlying subjects to potential risk, which | probably want to hedge. Yield curve risk + | got a loan, | took up an adjusted . rate mortgage, what | pay over time depends on the Corporate risks behavior of interest rates. Fluctuation in interest rates. The risk depends on the yield curve, which goes up and down. Repricing risk + | take a loan, a fixed rate loan, 5% p.a. , if the interest rate goes up | still pay 5%, the same if it goes down. This is risky. Agents (shareholders, managers, stakeholders) are all Hedging and value risk averse, they don't like risk. This is an empirical fact. Hedging is reducing risk. ® Should a company hedge its future prospects? Ifhedging reduces risk, and l’m risk averse, hedging should be beneficial to the firm. Is it so? No. — in perfect markets hedging should be value neutral; in perfect markets | should be indifferent, at the firm level, on hedging or not, because regardless of Hedging is beneficial whether | hedge or not, the value of my firm is not affected. This is an important result in finance. ® But a fundamental proposition in finance is that financing and risk Hedging means altering the pattern of the cashflow management decisions do not add value in perfects markets. of the firm. What generates the cash flow? The assets. I may want to add something to my firm, making this cash flow less volatile. How? Purchasing some financial instruments, derivatives. Where are the financial instruments? Financing decisions. Hedging is similar to a financing decision in taking debt or not. This holds in perfect markets. In the real world markets are not perfect, hence if l'm getting rid of these assumptions of the model, hedging is value creating. And this explains the fact that almost all firms in the world do hedge to a different extent their Agents (shareholders, managers, stakeholders) are risk averse Hedging reduces risk * This is because investors can hedge their individual portfolios exposure. Why is it the case that in perfect markets hedging is not value creating? Where is value created at the firm level? The assets. Why should shareholders be indifferent between the firm hedging or not? Because the shareholders are infinitely diversified in the portfolio. The shareholders own a very small % of the equity of the firm, along with many other assets in their portfolio. 46 1. The assets create value at the firm level 2. The equity is composed of many shareholders 3. Shareholders are infinitely diversified, so their investment on the firm occupies just a very small part of their portfolio. So they are hedging themselves — you should be diversified. If you invest in many assets you are able to reduce risk, without losing return. The perfect markets assumption does not hold. What is the meaning of perfect markets? Symmetric information, no transaction costs, no frictions, assets which are infinitely divisible (you can buy a part of a share), agents are all price takers, no taxes. These are the perfect market assumptions under which this proposition holds in theory. But markets are not perfect and shareholders are not infinitely diversified: they are under diversified in most cases, so it matters a lot whether the firm manages risk or not. Shareholders are normally under diversified. A number of papers show that hedging is value creating, everywhere. The value created by hedging depends on many things (industry, who you are, on the presence of intangible assets in your balance sheet or not). But what is more or less certain is the fact that value is positive. The size of the benefits can be estimated, but the benefit is positive. 1. Hedging reduces the expected costs of financial distress * If realized profits are smaller than X, the company goes bankrupt and bears financial distress costs. Hedging does not alter the costs of financial distress, they are there. What changes is the probability the market attaches to the event you go to financial distress. What is financial distress? It occurs whenever the value of your cash flow goes below X. You have to repay your debts, if you don't generate enough cash, you will go bankrupt in a one period model. The model is estimating the probability the firm goes below X: if the firm hedges, it minimizes such probability, hence it minimizes financial distress costs. What the imperfect markets hypothesis says is that even if a company goes bankrupt, no costs | suffer as a shareholder. ® Direct bankruptcy costs —> costs that are directly linked to bankruptcy, they are easy to estimate *. Legal / administrative costs in bankruptcy and liquidation (court, lawyers, accountants) *. Direct bankruptcy costs are smaller than < 1% of overall market value of the firm 8 Indirect costs of bankruptcy *. Costs involved with the difficulties of running a business while it is going through bankruptcy * These costs are difficult to quantify, but substantial. Examples: - missed positive NPV investment opportunities - loss of customers that value post-sale services - loss of willing suppliers - difficulty retaining and recruiting employees - forces sales of assets at reduced prices 47 OTC = Over the Counter, not exchanged in an official exchange Speculators provide liquidity to the market. Forwards * A forward gives the owner the obligation to buy a specified asset on a specified date and price * The seller of the forward contract has the obligation to sell the asset on the date for the price - at the end of the forward contract (“delivery”) ownership of the good is transferred and payment is made from the purchaser to the seller - generally, no money changes hands on the origination date of the forward contract (symmetric position) What identifies a derivative is its payoff. The payoff is what you will pay or receive at the maturity of the contract, when the contract expires (at time T). F is the forward price, what you will pay or receive at time T. When the price is higher at the maturity of the contract than it is at the inception of the contract (F), the long ofthe contract gets a profit, the short suffers a loss. FUTURE VS FORWARDS Forward markets Futures markets Marketplace: No physical location Physical location (futures exchange) Contract size: Customized Standardized Delivery date: Customized Standardized Security deposit: None (but collateral) Margin Liquidation: Actual delivery Offset Clearing: Banks, brokers Clearinghouse (daily settlement) Regulation: Self-regulating Publicly regulated The main difference between the two is that the forward is OTC, between the bank and the company + isa contract between private parties. Forward is a tailor made contract, tailor to the needs of the firm. Future is the same but it is publicly exchanged. There is an active market for futures. It is an exchange traded contract. The forward is not liquid, the future is liquid. Forward allows the buyer to enter into a contract such that at time T (6 months) the buyer will buy an underlying asset (oil) and spend a price that is agreed today. Long position = you will buy forward Short position = you will sell forward Hedge funds sometimes collapse. Hedge funds do not hedge. They are very risky. Margin call. Hedging with futures/forwards involves taking a position in a futures market that is opposite the position already held in a cash market. * A short (or selling) hedge occurs when you hold a long cash position and sell futures/forward contracts for protection against downward price exposure * Along (or buying) hedge occurs when you hold a short cash position and buy futures/forwards contracts for protection against upward price exposure 50 Options An option grants the holder the right to either buy (call option) or sell (put option) an underlying asset at a specified price (exercise or strike price) on (European option) or before (American option) a specified date. Unlike a futures contract, the holder of an option can simply not do anything, letting the option expire. * The seller grants this right in exchange for a certain amount of money, the option price or premium. * This amount of money changes hands on the origination date of the option contract (asymmetric position) Options are asymmetric contracts which allow you to separate profits from losses. Mi Acall option is the equivalent of longing a forward, that is buying the asset at time T. You will buy the asset if buying the asset allows you to get a positive payoff, if not you will not do so. E Put option: if you sell. FORWARDS VS OPTIONS * Unlike forwards, which are risk-sharing instruments, options are insurance-type instruments - one party to an option contract is not obliged to transact (the option buyer), whilst the other party (option writer) does have the obligation to perform * The risk/reward characteristics of the two contracts are also different - futures are referred to as having a “linear payoff” - the most that the buyer of an option can lose is the option price, hence options have having a nonlinear payoff Swaps A swap is an OTC agreement whereby two parties agree to exchange periodic payments based on a predetermined dollar principal (notional). Generally, the only dollars exchanged between the parties are the agreed-upon payments, not the notional. The two main types of swaps are: *. Interest-rate swaps (IRS) —> swap when the underlying is an interest rate. It is an instrument allowing to hedge interest rate risk. * Currency swaps (CS) —> the underlying is an exchange rate. There also exist commodity swaps. Swaps are forward like products; swaps belong to the symmetric contracts. Swaps are nothing but portfolios of forward. Swap is a long lived contract. It is like a portfolio of smaller forward contracts. i In a interest rate swap (IRS), the counter-parties swap payments based on an interest rate = For example, one of the counter-parties can pay a fixed interest rate and the other party a floating interest rate i In a currency swap, two parties agree to swap payments based on different currencies. = Companies use currency swaps to raise funds outside of their home currency and then swap the payments into their home currency. = The currency swap is an exchange of payments based on two different currencies. 51