Transaction in the share market
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Transcript Transaction in the share market
Corporate Finance
Objectives of the Course
On successful completion of this course, you should be able to:
Identify the purpose and relevance of Corporate Finance;
Explain the use of a variety of advance capital budgeting techniques;
Discuss the importance of risk and return in Corporate Finance;
Discuss the process determining the capital structure and dividend
policy;
Apply financial derivatives in risk management; and
Discuss factors that affect shareholders’ wealth.
Topic 1: Value and Capital Budgeting
Net Present Value
How to Value Bonds and Stocks
Some Alternative Investment Rules
Net Present Value and Capital Budgeting
Risk Analysis, Options and Capital Budgeting
Topic 2: Risk and Return
Capital Market Theory: An Overview
Return & Risk: The Capital Asset Pricing Model
(CAPM)
An Alternate View of Risk and Return: The Arbitrage
Pricing Theory
Risk, Cost of Capital, and Capital Budgeting
Topic 3: Capital Structure and Dividend Policy
Corporate Financing Decisions and Efficient Capital
Markets
Long-Term Financing: An Introduction
Capital Structure: Basic Concepts
Capital Structure: Limits to the Use of Debt
Valuation and Capital Budgeting for the Levered
Firm
Dividend Policy: Why Does It Matter?
Topic 4&5: Long-Term Financing &
Derivatives
Issuing Securities to the Public
Long-Term Debt
Leasing
Topic 5: Options, Futures, and Corporate
Finance
Options and Corporate Finance: Basic Concepts Warrants and Convertibles , Derivatives and Hedging
Risk
Research!
Research is the art of seeing what everyone else has
seen, and doing what no-one else has done.
The Time Value of Money
Which would you rather have -- $1,000 today or
$1,000 in 5 years?
Obviously, $1,000 today.
Money received sooner rather than later allows one
to use the funds for investment or consumption
purposes. This concept is referred to as the TIME
VALUE OF MONEY!!
Why TIME?
NOT having the opportunity to earn interest on
money is called OPPORTUNITY COST
Remember, one CANNOT compare numbers in
different time periods without first adjusting them
using an interest rate.
Compound Interest
When interest is paid on not only the principal
amount invested, but also on any previous interest
earned, this is called compound interest.
FV = Principal + (Principal x Interest)
= 2000 + (2000 x .06)
Future Value
If you invested $2,000
today in an account that pays
6% interest, with interest compounded annually, how
much will be in the account at the end of two years if
there are no withdrawals?
FV1 = PV (1+i)n
= $2,000 (1.06)2
= $2,247.20
FV = future value, a value at some future point in time
PV = present value, a value today which is usually
designated as time 0
i = rate of interest per compounding period
n = number of compounding periods
Future Value Example
John wants to know how large his $5,000 deposit will
become at an annual compound interest rate of 8% at the
end of 5 years.
FVn = PV (1+i)n
FV5 = $5,000 (1+ 0.08)5
= $7,346.64
Present Value
Since FV = PV(1 + i)n.
PV = FV / (1+i)n.
Discounting is the process of translating a future
value or a set of future cash flows into a present
value.
Present Value Example
Joann needs to know how large of a deposit to make today
so that the money will grow to $2,500 in 5 years. Assume
today’s deposit will grow at a compound rate of 4%
annually.
Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0
= $2,500/(1.04)5 = $2,054.81
Finding “n” or “i” when one knows PV and FV
If one invests $2,000 today and has accumulated
$2,676.45 after exactly five years, what rate of
annual compound interest was earned?
Annuities
An
Annuity represents a series of equal payments
(or receipts) occurring over a specified number of
equidistant periods.
Examples of Annuities Include:
Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings
Dividend Policy
Learning Objectives
Important Terms
Mechanics of Dividend Payments
Cash Dividend Payments
M&M’s Dividend Irrelevance Theorem
The “Bird in the Hand” Argument
Dividend Policy in Practice
Relaxing the M&M Assumptions
Stock Dividends and Stock Splits
Share Repurchases
Summary and Conclusions
Dividend Policy
What is It?
Dividend Policy refers to the explicit or implicit
decision of the Board of Directors regarding the
amount of residual earnings (past or present) that
should be distributed to the shareholders of the
corporation.
This decision is considered a financing decision because the
profits of the corporation are an important source of financing
available to the firm.
Types of Dividends
Dividends are a permanent distribution of residual
earnings/property of the corporation to its owners.
Dividends can be in the form of:
Cash
Additional Shares of Stock (stock dividend)
Property
If a firm is dissolved, at the end of the process, a final dividend of
any residual amount is made to the shareholders – this is known
as a liquidating dividend.
Dividends a Financing Decision
In the absence of dividends, corporate earnings accrue to the benefit of
shareholders as retained earnings and are automatically reinvested in the
firm.
When a cash dividend is declared, those funds leave the firm permanently
and irreversibly.
Distribution of earnings as dividends may starve the company of funds
required for growth and expansion, and this may cause the firm to seek
additional external capital.
Retained Earnings
Corporate Profits After Tax
Dividends
Dividends versus Interest Obligations
Interest
Interest is a payment to lenders for the use of their funds for a
given period of time
Timely payment of the required amount of interest is a legal
obligation
Failure to pay interest (and fulfill other contractual
commitments under the bond indenture or loan contract) is an
act of bankruptcy and the lender has recourse through the courts
to seek remedies
Secured lenders (bondholders) have the first claim on the firm’s
assets in the case of dissolution or in the case of bankruptcy
Dividends
A dividend is a discretionary payment made to shareholders
The decision to distribute dividends is solely the responsibility of
the board of directors
Shareholders are residual claimants of the firm (they have the
last, and residual claim on assets on dissolution and on profits
after all other claims have been fully satisfied)
Dividend Payments
Cash Dividend - Payment of cash by the firm to its
shareholders.
Ex-Dividend Date - Date that determines whether a
stockholder is entitled to a dividend payment; anyone
holding stock before this date is entitled to a dividend.
Record Date - Person who owns stock on this date received
the dividend.
Mechanics of Cash Dividend Payments
Declaration Date
this is the date on which the Board of Directors meet and declare the dividend. In their resolution
the Board will set the date of record, the date of payment and the amount of the dividend for each
share class.
when CARRIED, this resolution makes the dividend a current liability for the firm.
Date of Record
is the date on which the shareholders register is closed after the trading day and all those who are
listed will receive the dividend.
Ex dividend Date
is the date that the value of the firm’s common shares will reflect the dividend payment (ie. fall in
value)
‘ex’ means without.
At the start of trading on the ex-dividend date, the share price will normally open for trading at the
previous days close, less the value of the dividend per share. This reflects the fact that purchasers
of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend.
Date of Payment
is the date the cheques for the dividend are mailed out to the shareholders.
Dividend Policy
Dividends, Shareholders and the Board of Directors
There is no legal obligation for firms to pay dividends to common
shareholders
Shareholders cannot force a Board of Directors to declare a
dividend, and courts will not interfere with the BOD’s right to
make the dividend decision because:
Board members are jointly and severally liable for any damages they
may cause
Board members are constrained by legal rules affecting dividends
including:
Not paying dividends out of capital
Not paying dividends when that decision could cause the firm to become
insolvent
Not paying dividends in contravention of contractual commitments (such
as debt covenant agreements)
Dividend Reinvestment Plans (DRIPs)
Involve shareholders deciding to use the cash dividend
proceeds to buy more shares of the firm
DRIPs will buy as many shares as the cash dividend allows with the
residual deposited as cash
Leads to shareholders owning odd lots (less than 100 shares)
Firms are able to raise additional common stock capital
continuously at no cost and fosters an on-going relationship
with shareholders.
Dividend Payments
Stock Dividends
Stock dividends simply amount to distribution of
additional shares to existing shareholders
They represent nothing more than recapitalization of
earnings of the company. (that is, the amount of the
stock dividend is transferred from the R/E account to
the common share account.
Because of the capital impairment rule stock
dividends reduce the firm’s ability to pay dividends in
the future.
Dividend Payments
Stock Dividends
Implications
reduction in the R/E account
reduced capacity to pay future dividends
proportionate share ownership remains unchanged
shareholder’s wealth (theoretically) is unaffected
Effect on the Company
conserves cash
serves to lower the market value of firm’s stock modestly
promotes wider distribution of shares to the extent that current owners divest themselves of
shares...because they have more
adjusts the capital accounts
dilutes EPS
Effect on Shareholders
proportion of ownership remains unchanged
total value of holdings remains unchanged
if former DPS is maintained, this really represents an increased dividend payout
Dividend Payments
Stock Dividends
ABC Company
Equity Accounts
as at February xx, 20x9
Common stock (215,000)
$5,000,000
Retained earnings
20,000,000
Net Worth
$25,000,000
The company, on March 1, 20x9 declares a 10 percent stock dividend
when the current market price for the stock is $40.00 per share.
This stock dividend will increase the number of shares outstanding by 10
percent. This will mean issuing 21,500 shares. The value of the shares
is:
$40.00 (21,500) = $860,000
This stock dividend will result in $860,000 being transferred from the
retained earnings account to the common stock account:
Dividend Payments
Stock Dividends
After the stock dividend:
ABC Company
Equity Accounts
as at March 1, 20x9
Common stock (236,500)
Retained earnings
Net worth
$5,860,000
19,140,000
$25,000,000
The market price of the stock will be affected by the stock dividend:
New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36
The individual shareholder’s wealth will remain unchanged.
Cash Dividend Payments
The Macro Perspective
Aggregate after-tax profits run at approximately 6% of GDP but are
highly variable
Aggregate dividends are relatively stable when compared to after-tax
profits.
They are sustained in the face of drops in profit during recessions
They are held reasonably constant in the face of peaks in aggregate
profits.
Aggregate Dividends and Profits
Cash Dividend Payments
The Macro Perspective - Question
Why are dividends smoothed and not matched to
profits?
The companies chosen here illustrate the dramatic differences
between companies:
Some pay no dividends
Some pay consistent cash dividends representing substantial
yields on current shares prices
The highest yields are found in the case of Income Trusts and
large stable ‘blue-chip’ financials and utilities
Cash Dividend Payments
Dividend Yields
Table 22-1 S&P/TSX 60 Index Dividend Yields
BCE
Celestica Inc.
CIBC
Cott Corporation
Kinross Gold Corporation
TransAlta Corporation
Yellow Pages Income Fund
1996
%
1997
%
1998
%
1999
%
2000
%
2001
%
2002
%
2003
%
2004
%
2005
%
Average
4.69
0
3.67
0.23
0
6.22
3.42
0
3.07
0.53
0
5.16
2.52
0
2.85
0.54
0
4.52
1.41
0
3.37
0
0
5.35
1.07
0
3.17
0
0
5.59
3.15
0
2.9
0
0
4.06
3.99
0
3.48
0
0
4.92
4.08
0
3.28
0
0
5.73
4.29
0
3.31
0
0
5.88
7.34
4.44
0
3.57
0
0
4.51
7.09
3.31
0.00
3.27
0.13
0.00
5.19
7.22
Modigliani and Miller’s Dividend Irrelevance Theorem
The value of M&M’s Dividend Irrelevance argument
is that in the end, it shows where value can be
created with dividend policy and why.
M&M’s Dividend Irrelevance Theorem
Assumptions
No Taxes
Perfect capital markets
large number of individual buyers and sellers
costless information
no transaction costs
All firms maximize value
There is no debt
M&M’s Dividend Irrelevance Theorem
Residual Theory of Dividends
The Residual Theory of Dividends suggests that
logically, each year, management should:
Identify free cash flow generated in the previous period
Identify investment projects that have positive NPVs
Invest in all positive NPV projects
If free cash flow is insufficient, then raise external capital – in this
case no dividend is paid
If free cash flow exceeds investment requirements, the residual
amount is distributed in the form of cash dividends.
M&M’s Dividend Irrelevance Theorem
Residual Theory of Dividends - Implication
The implication of the Residual Theory of Dividends are:
Investment decisions are independent of the firm’s dividend
policy
No firm would pass on a positive NPV project because of the lack of
funds, because, by definition the incremental cost of those funds is
less than the IRR of the project, so the value of the firm is maximized
only if the project is undertaken.
If the firm can’t make good use of free cash flow (ie. It has no projects
with IRRs > cost of capital) then those funds should be distributed
back to shareholders in the form of dividends for them to invest on
their own.
The firm should operate where Marginal Cost equals Marginal
Revenue as seen in Figure on the following slide:
M&M’s Dividend Irrelevance Theorem
Internal Funds, Investment, and Dividends
FIGURE
Rate of
Return
OPTIMAL INVESTMENT
MC=MR
WACC
Internal Funds Available
$11,976
Million
22 - 38
$177,607
Million
CHAPTER 22 – Dividend Policy
The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed
Risk is a real world factor.
Firm’s that reinvest free cash flow, put that money at
risk – there is no certainty of investment outcome –
those forfeit dividends that are reinvested…could be
lost!
Remember the two-stage DDM?
The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed
Myron Gordon suggests that dividends are more stable than
capital gains and are therefore more highly valued by investors.
This implies that investors perceive non-dividend paying firms to
be riskier and apply a higher discount rate to value them causing
the share price to fall.
The difference between the M&M and Gordon arguments are
illustrated in Figure 2 on the following slide:
M&M argue that dividends and capital gains are perfect substitutes
The “Bird-in-the-Hand” Argument
M&M versus Gordon’s Bird in the Hand Theory
FIGURE 2
OPTIMAL INVESTMENT
D1
P0
Gordon
M&M
22 - 41
P1 P0
P0
CHAPTER 22 – Dividend Policy
The “Bird-in-the-Hand” Argument
M&M versus Gordon’s Bird in the Hand Theory
Conclusions:
Firms cannot change underlying operational characteristics by
changing the dividend
The dividend should reflect the firm’s operations through the
residual value of dividends
Dividend Policy in Practice
Firms smooth their dividends
Firms tend to hold dividends constant, even in the face of
increasing after-tax profit
Firms are very reluctant to cut dividends
Relaxing the M&M Assumptions
Welcome to the Real World!
Dividends and Signalling
Under conditions of information asymmetry, shareholders and the
investing public watch for management signals (actions) about what
management knows.
Management is therefore very cautious about dividend changes…they
don’t want to create high expectations (this is the reason for extra or
special dividends) that will lead to disappointment, and they don’t
want to have investors over react to negative earnings surprises (the
sticky dividend phenomenon)
(The Signalling Model is explained in Figure 3 found on the next slide.)
Relaxing the M&M Assumptions
The Signalling Model
FIGURE 3
et
$
et*
dt*
dt
1
2
3
Time
Relaxing the M&M Assumptions
Welcome to the Real World!
Agency Theory
Investors are wary of senior management so they seek to put controls
in place.
There is a fear that managers may waste corporate resources by overinvesting in low or poor NPV projects.
Gordon Donaldson argued this is the reason for the pecking order
managements tend to use when raising capital
Shareholders would prefer to receive a dividend and then have
management file a prospectus, justifying investment in projects and the
need to raise the capital that was just distributed as a dividend.
Shareholders are prepared to pay those additional underwriting costs as
an agency cost incurred to monitor and assess management.
Relaxing the M&M Assumptions
Welcome to the Real World!
Taxes and the Clientele Effect
Table (on the following slide) illustrates that different classes of
investors face different tax brackets
Preference for dividends versus capital gains income depends on the
province of residence and taxable income level leading to tax
clienteles.
High income earners tend to prefer capital gains (there is an additional
tax incentive for such individuals in that they can choose the timing of the
sale of their investment…remember only ‘realized’ capital gains are
subject to tax
Low income earners tend to prefer dividends
Conclusion – firm’s should not change dividend policy drastically since
it upsets the existing ownership base.
Relaxing the M&M Assumptions
Taxes
Table 22-3 Individual Tax Rates (% ) on Dividends and Capital Gains
Income Level
British Columbia
Alberta
Ontario
Quebec
Nova Scotia
Dividends
Capital gains
Dividends
Capital gains
Dividends
Capital gains
Dividends
Capital gains
Dividends
Capital gains
$25,000
$50,000
$75,000
$100,000
2.52
12.45
3.63
12.63
0.00
10.65
5.95
14.37
0.00
12.02
6.19
15.58
8.03
16.00
8.24
15.58
15.42
19.19
8.75
18.48
15.69
18.85
13.83
18.00
20.74
21.71
26.06
22.86
17.05
21.34
20.04
20.35
13.83
18.00
20.74
21.71
26.06
22.86
19.06
22.63
Share Repurchases
Simply another form of payout policy.
An alternative to cash dividend where the objective is
to increase the price per share rather than paying a
dividend.
Since there are rules against improper accumulation
of funds, firms adopt a policy of large infrequent
share repurchase programs.
Share Repurchases
reasons for use:
Offsetting the exercise of executive stock options
Leveraged recapitalizations
Information or signalling effects
Repurchase dissident shares
Removing cash without generating expectations for future
distributions
Take the firm private.
Disadvantages of Share Repurchases
they are usually done on an irregular basis, so a
shareholder cannot depend on income from this
source.
if regular repurchases are made, there is a good
chance that Revenue Canada will rule that the
repurchases were simply a tax avoidance scheme
(to avoid tax on dividends) and will assess tax
there may be some agency problems - if managers
have inside information, they are purchasing from
shareholders at a price less than the intrinsic
value of the shares.
Methods of Share Repurchases
tender offer:
open market purchase:
this is a formal offer to purchase a given number of shares at a given
price over current market price.
the purchase of shares through an investment dealer like any other
investor
this is not designed for large block purchases.
private negotiation with major shareholders
In any repurchase program, the securities commission requires
disclosure of the event as well as all other material information
through a prospectus.
Repurchase Example
Current EPS
= [total earnings] / [# of shares] = $4.4 m / 1.1 m =
$4.00
Current P/E ratio
= $20 / $4 = 5X
EPS after repurchase of 100,000 shares
= $4.4 m / 1.0 = $4.40
Expected market price after repurchase:
= [p/e][EPSnew] = [5][$4.40] = $22.00 per share
Effects of A Share Repurchase
EPS should increase following the repurchase if
earnings after-tax remains the same
a higher market price per outstanding share of
common stock should result
stockholders not selling their shares back to the firm
will enjoy a capital gain if the repurchase increases
the stock price.
Advantages of Share Repurchases
signal positive information about the firm’s future
cash flows
used to effect a large-scale change in the firm’s capital
structure
increase investor’s return without creating an
expectation of higher future cash dividends
reduce future cash dividend requirements or increase
cash dividends per share on the remaining shares,
without creating a continuing incremental cash drain
capital gains treated more favourably than cash
dividends for tax purposes.
Disadvantages of Share Repurchases
signal negative information about the firm’s future
growth and investment opportunities
the provincial securities commission may raise
questions about the intention
share repurchase may not qualify the investor for a
capital gain
Borrowing to Pay Dividends
Is this legal? is it possible to do?
Yes
the firm must have the ability and capacity to borrow
the firm must have sufficient retained earnings to allow it to
pay the dividend
the firm must have sufficient cash on hand to pay the cash
dividend
the firm must NOT have agreed to any limitations on the
payment of dividends under the bond indenture.
Why?
A possible answer is to signal to the market that the board is
confident about the firm’s ability to sustain cash dividends into
the future.
Borrowing to Pay Dividends
An Example
Before Borrowing:
Assets:
Cash
Fixed Assets
Total Assets
0% Debt
Liabilities:
10
140
$150
Long-term Debt
0
Common Stock
50
Retained Earnings 100
Total Claims
$150
After Borrowing…before cash dividend:
Assets:
Cash
Fixed Assets
Total Assets
22 - 59
25% Debt
Liabilities:
60
140
$200
Long-term Debt
50
Common Stock
50
Retained Earnings 100
Total Claims
$200
CHAPTER 22 – Dividend Policy
Borrowing to Pay Dividends
An Example …
After Dividend Declaration…before date of payment.
Assets:
Cash
Fixed Assets
Total Assets
Liabilities:
60
140
$200
Current liabilities
Long-term Debt
Common Shares
Retained earnings
Total Claims
50
50
50
50
$200
After Cash Dividend payment of $50
Assets:
Cash
Fixed Assets
Total Assets
22 - 60
33% Debt
Liabilities:
10
140
$150
Long-term Debt
Common Stock
Retained earnings
Total Claims
50% Debt
50
50
50
$150
CHAPTER 22 – Dividend Policy
Borrowing to Pay Dividends
An Example
The foregoing example illustrates:
it is possible for a firm with ‘borrowing capacity’ to borrow funds
to pay cash dividends.
this is not possible if the lenders insist on restrictive covenants that
limit or prevent this from occurring.
the cash for the dividend must be present in the cash account.
payment of dividends reduces both the cash account on the asset
side of the balance sheet as well as the retained earnings account
on the ‘claims’ side of the balance sheet.
in the absence of restrictions, it is possible to transfer wealth from
the bondholders to the stockholders. (Bondholders in this example
may have thought their firm would have only a 25% debt ratio….after the
dividend the debt ratio rose to 33% and the equity cusion dropped from
75% to 66%.)
Summary and Conclusions
In this chapter you have learned:
About the different types of dividends including, regular and special
cash dividends, stock dividends, and share repurchases.
M&M’s dividend irrelevance argument and the real world factors
such as transactions costs, taxes, clientele effects and signalling tend
to favour real-world dividend relevance
Tax motives and other reasons explain why firms might want to
repurchase their shares.
Concept Review Questions
Define four important dates that arise with
respect to dividend payments.
Past year Qs
Leasing
Types of Leases
The Basics
– A lease is a contractual agreement between a lessee and
lessor.
– The agreement establishes that the lessee has the right to use
an asset and in return must make periodic payments to the
lessor.
– The lessor is either the asset’s manufacturer or an
independent leasing company.
Operating Leases
• Usually not fully amortized. This means that the
payments required under the terms of the lease are not
enough to recover the full cost of the asset for the
lessor.
• Usually require the lessor to maintain and insure the
asset.
• Lessee enjoys a cancellation option. This option gives
the lessee the right to cancel the lease contract before
the expiration date.
Financial Leases
The exact opposite of an operating lease.
1.
2.
3.
4.
Do not provide for maintenance or service by the lessor.
Financial leases are fully amortized.
The lessee usually has a right to renew the lease at expiry.
Generally, financial leases cannot be cancelled, i.e., the
lessee must make all payments or face the risk of
bankruptcy.
Sale and Lease-Back
• A particular type of financial lease.
• Occurs when a company sells an asset it already owns
to another firm and immediately leases it from them.
• Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease payments, thereby
retaining the use of the asset.
Leveraged Leases
• A leveraged lease is another type of financial lease.
• A three-sided arrangement between the lessee, the
lessor, and lenders.
– The lessor owns the asset and for a fee allows the lessee to
use the asset.
– The lessor borrows to partially finance the asset.
– The lenders typically use a nonrecourse loan. This means that
the lessor is not obligated to the lender in case of a default by
the lessee.
Accounting and Leasing
• In the old days, leases led to off-balance-sheet
financing.
• In 1979, the Canadian Institute of Chartered
Accountants implemented new rules for lease
accounting according to which financial leases must be
“capitalized.”
• Capital leases appear on the balance sheet—the present
value of the lease payments appears on both sides.
Accounting and Leasing
Balance Sheet
Truck is purchased with debt
Truck
$100,000
Land
$100,000
Total Assets
$200,000
Debt
Equity
$100,000
$100,000
Total Debt & Equity
$200,000
Operating Lease
Truck
Land
$100,000
Total Assets
$100,000
Debt
Equity
$100,000
Total Debt & Equity
$100,000
Capital Lease
Assets leased
Land
Total Assets
Obligations under capital lease
$100,000
Equity
$100,000
Total Debt & Equity
$200,000
$100,000
$100,000
$200,000
Capital Lease
• A lease must be capitalized if any one of the following is met:
– The present value of the lease payments is at least 90-percent
of the fair market value of the asset at the start of the lease.
– The lease transfers ownership of the property to the lessee by
the end of the term of the lease.
– The lease term is 75-percent or more of the estimated
economic life of the asset.
– The lessee can buy the asset at a bargain price at expiry.
Taxes and Leases
•
•
The principal benefit of long-term leasing is tax reduction.
Leasing allows the transfer of tax benefits from those who need
equipment but cannot take full advantage of the tax benefits of
ownership to a party who can.
• If the CCRA (Canada Customs and Revenue Agency) detects
one or more of the following, the lease will be disallowed.
1. The lessee automatically acquires title to the property after
payment of a specified amount in the form of rentals.
2. The lessee is required to buy the property from the lessor.
3. The lessee has the right during the lease to acquire the property
at a price less than fair market value.
The Cash Flows of Leasing
Consider a firm, ClumZee Movers, that wishes to acquire
a delivery truck.
The truck is expected to reduce costs by $4,500 per year.
The truck costs $25,000 and has a useful life of five years.
If the firm buys the truck, they will depreciate it straightline to zero.
They can lease it for five years from Tiger Leasing with
an annual lease payment of $6,250.
21-74
The Cash Flows of Leasing
• Cash Flows: Buy
Cost of truck
After-tax savings
Depreciation Tax Shield
Year 0
–$25,000
Years 1-5
4,500×(1-.34) =
5,000×(.34) =
–$25,000
$2,970
$1,700
$4,670
• Cash Flows: Lease
Year 0
Lease Payments
After-tax savings
Years 1-5
–6,250×(1-.34) =
4,500×(1-.34) =
–$4,125
$2,970
–$1,155
• Cash Flows: Leasing Instead of Buying
Year 0
$25,000
McGraw-Hill Ryerson
Years 1-5
–$1,155 – $4,670 = –$5,825
© 2003 McGraw–Hill Ryerson Limited
21-75
The Cash Flows of Leasing
• Cash Flows: Leasing Instead of Buying
Year 0
$25,000
Years 1-5
–$1,155 – $4,670 = –$5,825
• Cash Flows: Buying Instead of Leasing
Year 0
–$25,000
Years 1-5
$4,670 –$1,155 = $5,825
• However we wish to conceptualize this, we need to
have an interest rate at which to discount the future
cash flows.
• That rate is the after-tax rate on the firm’s secured
debt.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
NPV Analysis of the Lease-vs.-Buy Decision
•
A lease payment is like the debt service on a secured bond
issued by the lessee.
• In the real world, many companies discount both the
depreciation tax shields and the lease payments at the after-tax
interest rate on secured debt issued by the lessee.
• The various tax shields could be riskier than lease payments for
two reasons:
1. The value of the CCA tax benefits depends on the firm’s ability
to generate enough taxable income.
2. The corporate tax rate may change.
21-77
NPV Analysis of the Lease-vs.-Buy Decision
• There is a simple method for evaluating leases: discount
all cash flows at the after-tax interest rate on secured debt
issued by the lessee. Suppose that rate is 5-percent.
NPV Leasing Instead of Buying
Year 0
$25,000
Years 1-5
–$1,155 – $4,670 = -$5,825
5
NPV $25,000
t 1
$5,825
$219.20
t
(1.05)
NPV Buying Instead of Leasing
Year 0
Years 1-5
-$25,000
$4,670 – $1,155 = $5,825
5
$5,825
$219.20
t
t 1 (1.05)
NPV $25,000
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
Reasons for Leasing
• Good Reasons
– Taxes may be reduced by leasing.
– The lease contract may reduce certain types of uncertainty.
– Transactions costs can be higher for buying an asset and
financing it with debt or equity than for leasing the asset.
• Bad Reasons
– Leasing and accounting income
– 100% financing
Summary and Conclusions
• There are three ways to value a lease.
1. Use the real-world convention of discounting the
incremental after-tax cash flows at the lessor’s after-tax rate
on secured debt.
2. Calculate the increase in debt capacity by discounting the
difference between the cash flows of the purchase and the
cash flows of the lease by the after-tax interest rate. The
increase in debt capacity from a purchase is compared to the
extra outflow at year 0 from a purchase.
3. Use APV (presented in the appendix to this chapter).
• They all yield the same answer.
• The easiest way is the least intuitive.
Capital Structure
capital structure refers to the way a corporation finances its assets
through some combination of equity, debt, or hybrid securities.
A firm's capital structure is then the composition or 'structure' of its
liabilities.
In reality, capital structure may be highly complex and include
dozens of sources.
An optimal capital structure: maximizes the value of the firm.
The impact of capital structure on value depends upon the effect of
debt on:
WACC
FCF
Modigliani-Miller theorem,
The theorem states that, in a perfect market, how a
firm is financed is irrelevant to its value.
perfect capital market;
-no transaction or bankruptcy costs;
-perfect information
- firms and individuals can borrow at the same
interest rate;
-no taxes;
-and investment decisions are not affected by
financing decisions.
Capital structure in the real world
The theories below try to address some of these
imperfections, by relaxing assumptions made in the
M&M model.
1. Trade-off theory - bankruptcy cost Vs. Tax benefit but it
(doesn't explain differences within the same industry).
2. Pecking order theory -companies prioritize their sources
of financing (from internal financing to equity) / costs of
asymmetric information
3. Agency Costs - Underinvestment problem / Free cash
flow management issues
Capital structure Ratios
Capital structure ratios compare a company's debt and
its equity.
Debt and equity are the two methods companies acquire
capital. Debt refers to money borrowed, while equity
refers to money invested or earned.
Financial ratios that measure capital structure include
the debt-to-equity ratio
the ratio of fixed assets to long-term liabilities.
Gearing ratio
EPS and PE ratio
Capital gearing ratio = (Capital Bearing Risk) : (Capital
not bearing risk)
Factors to be considered
Debt ratios of other firms in the industry.
Pro forma coverage ratios at different capital
structures under different economic scenarios.
Lender and rating agency attitudes
(impact on bond ratings).
Reserve borrowing capacity.
Effects on control.
Type of assets: Are they tangible, and hence suitable
as collateral?
Tax rates.
why investors
should establish
portfolios
This is neatly captured
in the old saying ‘don’t
put all your eggs in one
basket’.
The logic
The logic is that an investor who puts all of their
funds into one investment risks everything on the
performance of that individual investment. A wiser
policy would be to spread the funds over several
investments (establish a portfolio) so that the
unexpected losses from one investment maybe offset
to some extent by the unexpected gains from
another.
EXPECTED RETURN
Investors receive their returns from shares in the
form of dividends and capital gains/ losses.
formula
The formula for calculating the annual return on a
share is:
Annual return = D 1 + (P1 - P 0)/P0
where:
D1 = dividend per share
P1 = share price at the end of a year
P0 = share price at the start of a year.
Example
Suppose that a dividend of 5p per share was paid
during the year on a share whose value was 100p at
the start of the year and 117p at the end of the year:
Annual return =
5 + (117 - 100)/100 × 100 = 22%
dividend yield and capital gain
The total return is made up of a 5% dividend yield and a
17% capital gain. We have just calculated a historical return,
on the basis that the dividend income and the price at the
end of year one is known .
The future expected return
Calculating the future expected return is a lot more
difficult because we will need to estimate both next
year ’s dividend and the share price in one year ’s
time. Analysts normally consider the different
possible returns in alternate market conditions and
try and assign a probability to each.
Example 1 shows the calculation of the
expected return for A plc.
The current share price of A plc is 100p and the
estimated returns for next year are shown .
The investment in A plc is risky.
Risk refers to the possibility of the actual return
varying from the expected return, ie the actual return
may be 30% or 10% as opposed to the expected
return of 20%.
Required return
The required return consists of two elements,
which are:
Required return = Risk-free return + Risk premium
Risk-free return
The risk-free return is the return required by
investors to compensate them for investing in a riskfree investment.
The risk-free return compensates investors for
inflation and consumption preference, ie the fact
that they are deprived from using their funds while
tied up in the investment.
The return on treasury bills is often used as a
surrogate for the risk-free rate.
Risk premium
Risk simply means that the future actual return may
vary from the expected return.
If an investor undertakes a risky investment he
needs to receive a return greater than the risk-free
rate in order to compensate him.
The more risky the investment the greater the
compensation required.
This is not surprising and it is what we would expect
from risk averse investors.
The Barclay Capital Equity Gilt Study 2003
The Barclay Capital Study calculated the average
return on treasury bills in the UK from 1900 to 2002
as approximately 6%.
It also calculated that the average return on the UK
stock market over this period was 11%.
Thus if an investor had invested in shares that had
the same level of risk as the market, he would have to
receive an extra 5% of return to compensate for the
market risk.
Thus 5% is the historical average risk in the UK.
The required return calculation
Suppose that Joe, the investor believes that the
shares in A plc are twice as risky as the market and
that the use of long-term averages are valid.
Calculate the required return
The required return may be calculated as follows:
Required return of A plc = Risk free + Risk premium
16% = 6% + (5% × 2)
Thus 16% is the return that Joe requires to
compensate for the perceived level of risk in A plc,
i.e. it is the discount rate that he will use to appraise
an investment in A plc.
THE NPV CALCULATION
Suppose that Joe is considering investing £100 in A
plc with the intention of selling the shares at the end
of the first year.
Assume that the expected return will be 20% at the
end of the first year.
Given that Joe requires a return of 16% should he
invest?
THE NPV CALCULATION
Cash flows year 0 (100), year end 120
Discount factor – 16%, year 0 = 1, year 1= 0.862
(100) 103
NPV=3
Decision criteria:
accept if the NPV is zero or positive.
The NPV is positive, thus Joe should invest.
A positive NPV opportunity is where the expected return
more than compensates the investor for the perceived
level of risk, i.e. the expected return of 20% is greater
than the required return of 16%.
An NPV calculation compares the expected and required
returns in absolute terms.
Calculation of the risk premium
Calculating the risk premium is the essential
component of the discount rate.
This in turn makes the NPV calculation possible.
To calculate the risk premium, we need to be able to
define and measure risk.
THE STUDY OF RISK
The definition of risk that is often used in finance
literature is based on the variability of the actual
return from the expected return.
Statistical measures of variability are the variance
and the standard deviation (the square root of the
variance).
The variance and standard deviation of the returns.
Example 1 - A plc,
Market conditions [Actual return Probability – expected return]2
Boom [30 - 20]2
Normal [20 - 20]2
Recession [10 - 20]2
0.1
0.8
0.1
Variance σ2
Standard deviation σ = 4.47
10
0
10
20
The variance
The variance of return is the weighted sum of
squared deviations from the expected return.
The reason for squaring the deviations is to ensure
that both positive and negative deviations contribute
equally to the measure of variability.
Thus the variance represents ‘rates of return
squared’.
The standard deviation
Standard deviation is the square root of the variance,
its units are in rates of return.
As it is easier to discuss risk as a percentage rate of
return, the standard deviation is more commonly
used to measure risk.
A choice of investing in either A plc or Z plc,
Shares in Z plc have the following returns and
associated probabilities:
Probability
0.1
0.8
0.1
Return %
35
20
5
A choice of investing in either A plc or Z plc,
Let us then assume that there is a choice of investing
in either A plc or Z plc, which one should we choose?
To compare A plc and Z plc, the expected return and
the standard deviation of the returns for Z plc will
have to be calculated.
Calculation
The expected return is: (0.1) (35%) + (0.8)(20%) +
(0.1) (5%) = 20%
The variance is: = σ2, z = (0.1) (35% - 20%)2 + (0.8)
(20% - 20%)2 + (0.1) (5% - 20%)2 = 45%
The standard deviation is: = σz = 6.71%
Summary table
Investment
A plc
Z plc
Expected return
20%
20%
Standard deviation
4.47%
6.71%
Given that the expected return is the same for both
companies, investors will opt for the one that has the
lowest risk, ie A plc.
The decision
The decision is equally clear where an investment gives
the highest expected return for a given level of risk.
However, these only relate to specific instances where the
investments being compared either have the same
expected return or the same standard deviation.
Where investments have increasing levels of return
accompanied by increasing levels of standard deviation,
then the choice between investments will be a subjective
decision based on the investor ’s attitude to risk.
RISK AND RETURN ON TWO-ASSET
PORTFOLIOS
So far we have confined our choice to a single
investment. Let us now assume investments…
The risk-return relationship will now be measured
in terms of the portfolio’s expected return and the
portfolio’s standard deviation.
Information about four investments: A plc, B plc, C
plc, and D plc.
Assumption
Assume that our investor, Joe has decided to
construct a two-asset portfolio and that he has
already decided to invest 50% of the funds in A plc.
He is currently trying to decide which one of the
other three investments into which he will invest the
remaining 50% of his funds.
The expected return of a two-asset portfolio
The expected return of a portfolio (Rport) is simply
a weighted average of the expected returns of
the individual investments.
Return on investments (%)
Market conditions
Probability
A plc
B plc
C plc
D plc
Boom
Normal
Recession
0.1
0.8
0.1
30
20
10
30
20
10
10
20
30
10
22.5
10
Expected return
20
20
20
20
Standard deviation
4.47 4.47 4.47 4.47
E.g. 3 - Return on investments (%)
Market Conditions
Boom
Normal
Recession
A plc
30
20
10
B plc
30
20
10
Portfolio A + B
30
20
10
Portfolio Expected Return calculation
Rpor t = x.RA + (1 - x).RB
x = the proportion of funds invested in A
(1 - x) = the proportion of funds invested in B
RA + B = 0.5 × 20 + 0.5 × 20 = 20
RA + C = 0.5 × 20 + 0.5 × 20 = 20
RA + D = 0.5 × 20 + 0.5 × 20 = 20
Portfolio Expected Return
Given that the expected return is the same for all the
portfolios, Joe will opt for the portfolio that has the
lowest risk as measured by the portfolio’s standard
deviation.
The standard deviation of a two-asset portfolio
We can see that the standard deviation of all the
individual investments is 4.47%.
Intuitively, we probably feel that it does not matter
which portfolio Joe chooses, as the standard
deviation of the portfolios should be the same
(because the standard deviations of the individual
investments are all the same).
The standard deviation of a two-asset portfolio
However, the above analysis is flawed, as the
standard deviation of a portfolio is not simply the
weighted average of the standard deviation of
returns of the individual investments but is generally
less than the weighted average.
So what causes this reduction of risk?
What is the missing factor?
The missing factor is how the returns of the two
investments co-relate or co-vary, i.e. move up or
down together. There are two ways to measure co
variability.
The first method is called the covariance and the second
method is called the correlation coefficient.
Before we perform these calculations let us review the
basic logic behind the idea that risk may be reduced
depending on how the returns on two investments covary.
Portfolio A+B – perfect positive correlation
The returns of A and B move in perfect lock step,
(when the return on A goes up to 30%, the return on
B also goes up to 30%, when the return on A goes
down to 10%, the return on B also goes down to
10%), ie they move in the same direction and by the
same degree.
Example 3.
This is the most basic possible example of perfect
positive correlation , where the forecast of the actual
returns are the same in all market conditions for
both investments and thus for the portfolio (as the
portfolio return is simply a weighted average).
Example 3.
Hence there is no reduction of risk. The portfolio’s
standard deviation under this theoretical extreme of
perfect positive correlation is a simple weighted
average of the standard deviations of the individual
investments:
σpor t (A,B) = 4.47 × 0.5 + 4.47 × 0.5
= 4.47
Portfolio A+C – perfect negative correlation
The returns of A and C move in equal but opposite
ways (when the return on A goes up to 30%, the
return on C goes down to 10%,
when the return on A goes down to 10%, the return
on C goes up to 30%). See Example 4.
EXAMPLE 4-Return on investments (%)
Market Conditions
A plc
C plc
Portfolio A + C
Boom
Normal
Recession
30
20
10
10
20
30
20
20
20
Portfolio A+C – perfect negative correlation
This is the utopian position, i.e. where the
unexpected returns cancel out against each other
resulting in the expected return. If the forecast actual
return is the same as the expected return under all
market conditions, then the risk of the portfolio has
been reduced to zero.
This is the only situation where the portfolio’s
standard deviation can be calculated as follows:
σport (A,C) = 4.47 × 0.5 - 4.47 × 0.5 = 0
EXAMPLE 5
Market Conditions
A plc D plc Portfolio A + D
Boom
Normal
Recession
30
20
10
10
20
22.5 21.25
10
10
Market conditions
The forecast actual return is the same as the
expected return under normal market conditions and
almost the same under boom market conditions (20
v 21.25).
Therefore, we can say that the forecast actual and
expected returns are almost the same in two out of
the three conditions.
Market conditions
This compares with only one condition when there is
perfect positive correlation (no reduction of risk) and
all three conditions when there is perfect negative
correlation (where risk may be eliminated).
Therefore, when there is no correlation between the
returns on investments this results in the partial
reduction of risk.
Measuring co-variability
Co-variability can be measured in absolute terms by
the covariance or in relative terms by the correlation
coefficient.
The covariance
A positive covariance indicates that the returns move
in the same directions as in A and B.
A negative covariance indicates that the returns
move in opposite directions as in A and C.
A zero covariance indicates that the returns are
independent of each other as in A and D.
The correlation coefficient
Using the covariance formula, we can easily
determine the formula for the correlation coefficient.
ρA,B = Cov a,b/σaσb
The correlation coefficient as a relative measure of
co-variability expresses the strength of the
relationship between the returns on two
investments.
It is strictly limited to a range from -1 to +1. See
Example 6.
Reality
In reality, the correlation coefficient between returns
on investments tends to lie between 0 and +1.
It is the norm in a two-asset portfolio to achieve a
partial reduction of risk (the standard deviation of a
two-asset portfolio is less than the weighted average
of the standard deviation of the individual
investments).
Reality
Therefore, we will need a new formula to calculate
the risk (standard deviation of returns) on a two asset portfolio. The formula will obviously take into
account the risk (standard deviation of returns) of
both investments but will also need to incorporate a
measure of co-variability as this influences the level
of risk reduction .
The formulae for the standard deviation of
returns of a two-asset portfolio
Version 1
Version 2
Summary table
Investment
Expected return (%)
Standard deviation (%)
Port A + B
20
20
20
4.47
0.00
3.16
Port A + C
Port A + D
Summary
A + C is the most efficient portfolio as it has the
lowest level of risk for a given level of return.
Perfect negative correlation does not occur between
the returns on two investments in the real world, ie
risk cannot be eliminated, although it is useful to
know the theoretical extremes.
However, as already stated, in reality the correlation
coefficients between returns on investments tend to
lie between 0 and +1.
Investments in different industries
Indeed, the returns on investments in the same
industry tend to have a high positive correlation of
approximately 0.9, while the returns on investments
in different industries tend to have a low positive
correlation of approximately 0.2.
Thus investors have a preference to invest in
different industries thus aiming to create well
diversified portfolio, ensuring that the maximum risk
reduction effect is obtained.
Initial understanding
Based on our initial understanding of the risk-return
relationship, if investors wish to reduce their risk
they will have to accept a reduced return. However,
portfolio theory shows us that it is possible to
reduce risk without having a consequential
reduction in return.
Initial understanding
This can be proved quite easily, as a portfolio’s
expected return is equal to the weighted average of
the expected returns on the individual investments,
whereas a portfolio’s risk is less than the weighted
average of the risk of the individual investments due
to the risk reduction effect of diversification caused
by the correlation coefficient being less than +1.
By investing in just two investments we
can reduce the risk
We can see from Portfolio A + D above where the
correlation coefficient was zero, that by investing in
just two investments we can reduce the risk from
4.47% to just 3.16% (a reduction of 1.31 percentage
points).
Imagine how much risk we could have diversified
away, had we created a large portfolio of say 500
different investments or indeed 5,000 different
investments.
10 KEY POINTS TO REMEMBER
1 The expected return on a share consists of a dividend
yield and a capital gain/loss in percentage terms.
2 The required return on a risky investment consists of
the risk-free rate (which includes inflation) and a
risk premium.
3 Total risk is normally measured by the standard
deviation of returns (σ).
KEY POINTS TO REMEMBER
4 Portfolio theory demonstrates that it is possible to
reduce risk without having a consequential reduction
in return, i.e. the portfolio’s expected return is equal
to the weighted average of the expected returns on
the individual investments, while the portfolio risk is
normally less than the weighted average of the risk of
the individual investments.
KEY POINTS TO REMEMBER
5 The extent of the risk reduction is influenced by the
way the returns on the investments co-vary. Covariability is normally measured in the exams by the
correlation coefficient.
6 In reality, the correlation coefficient between returns
on investments tend to lie between 0 and +1. Thus
total risk can only be partially reduced, not
eliminated.
KEY POINTS TO REMEMBER
7 A portfolio’s total risk consists of unsystematic and
systematic risk.
However, a well-diversified portfolio only suffers
from systematic risk, as the unsystematic risk has
been diversified away.
8 An investor who holds a well-diversified portfolio
will only require a return for systematic risk. Thus
their required return consists of the risk-free rate
plus a systematic risk premium.
KEY POINTS TO REMEMBER
9 Investors who have well-diversified portfolios
dominate the market.
Thus the market only gives a return for systematic
risk.
10 The preparation of a summary table and the
identification of the most efficient portfolio (if
possible) is an essential exam skill.
The Efficient Market Hypothesis
What is Efficient Market?
A market where there are large numbers of
rational profit maximizers actively competing, with
each trying to predict future market values of
individual securities, and where important current
information is almost freely available to all
participants.
The Efficient Market Hypothesis
Efficient Market Hypothesis
• Securities prices always fully reflect all available, relevant
information about the security.
Note the key words of the definition: “always,” “fully,” and
“information.”
• Two important questions – What is all available
information? – What does it mean to “Reflect all available
information?”
The Efficient Market Hypothesis
All available information
• Past Price : Weak Form
• All public information : Semi Strong Form –
Past price, news etc..
• All information including inside information
: Strong Form
Forms of the EMH
Weak Information Set
The relevant information is historical prices and other trading
data such as trading volume.
If the markets are weak form efficient, use of such information
provides no benefit “at the margin.”
Semi-strong Information set :
The relevant information is "all publicly available information,
including past price and volume data."
If the markets are semi-strong form efficient, then studying
past price and volume data & studying earnings and growth
forecasts provides no net benefit in predicting price changes at
the margin.
Forms of the EMH
• Strong information set:
– The relevant information is “all information” both public
and private or “inside” information.
– If the markets are strong form efficient, use of any
information (public or private) provides no benefit at the
margin.
• SEC Rule 10b-5 limits trading by corporate insiders,
(officers, directors and major shareholders). Inside
trading must be reported.
Forms of the EMH
Relationships between forms of the EMH
Revision –Investment analysis
Explain the usefulness of financial
derivatives to business organization?
What is the difference between money
market and capital market?
What is meant by market portfolio?
Define Security Market Line (SML)?
What is the advantage of using margin
facility in share trading to an investor?
Revision –Exam style questions
Which security is an example of a hybrid
security?
A. Ordinary share
B. Commercial paper
C. Bond
D. Convertible share
Revision –Investment analysis
The share of Medex Ltd. is currently trading at
$3.35. You expect the share price to go up to
$3.80 in the next few days.
What type of order would you give to your broker
to purchase the shares now?
A. Margin order
B. Market order
C. Stop-loss order
D. Limit order
Revision –Investment analysis
Which is the definition for an optimal
portfolio?
A. The portfolio that has the lowest risk.
B. The portfolio that gives the best set of
returns.
C. The portfolio that has the best set of
returns within its specific risk level.
D. The portfolio that comprises of assets that
are risk-free.
Revision –Investment analysis
Assuming a portfolio has 3 assets. How many
variances and co-variances need to be calculated
to compute the portfolio risk?
A. The number of variance is 3 and the number
of covariance is also 3.
B. The number of variance is 6 and the number
of covariance is 3.
C. The number of variance is 3 and the number of
covariance is 6.
D. The number of variance is 6 and the number
of covariance is also 6.
Revision –Investment analysis
A share has a beta of 1.1. The risk-free rate is 2.5%
and the return on the market is 12%. The estimated
return for the share is 14%.
Based on the Capital Asset Pricing Model (CAPM),
what should an investor do?
A. Sell the share because the required return is
9.95%.
B. Sell the share because the required return is
16.5%.
C. Buy the share because the required return is 11.5%.
D. Buy the share because the required return is
12.95%.
Revision –Investment analysis
On 13 October 2010, Mr. Aik bought 2,000
shares of Zee Ltd. (Zee) at $3 per share. He
receives a dividend of $0.06 per share on 15
December 2010 and later sold the shares for
$3.30 per share on 29 December 2010.
Based on this information, how much is the
dividend yield and capital gain of Zee’s
shares?
Revision –Investment analysis
You have a portfolio consisting of 30% of
Share Ae and the balance in Share Be. The
beta coefficient of Share Ae and Share Be are
0.7 and 1.5 respectively. The risk-free rate is
4% and the expected market return is 12%.
What is your portfolio’s expected return?
Revision –Investment analysis
Mr. Kasim, an investor wishes to construct a
portfolio consisting of 40% index share and
60% risk-free asset. The return on the riskfree asset is 2% and the expected return on
the index share is 10%. If the standard
deviation of returns on the index share is 8%,
what is the expected standard deviation of
the portfolio?
VALUATION PROCESS
There are two approaches to evaluate security. They
are:
(a) Top to Bottom Approach
(b) Bottom Up Approach
Two approaches
In the Top to Bottom Approach, we begin by
analysing the economy followed by the industry and
then proceed to the firms in the industry.
In the Bottom Up Approach, analysts will try to
identify firms that are undervalued. These firms were
chosen without taking into account the economic
situation and environment.
The basic valuation model
In the basic valuation model, we will look at:
(a) the Discounted Dividend Model
(b) the Constant Growth Model
(c) the Relationship between Share Price and Growth
(d) Multistage Growth
Discounted Dividend Model
In the Discounted Dividend Model, the share price is
calculated by finding the present value of the
predicted dividend and the predicted selling price of
the share.
Constant Growth Model
If there is a rise in the dividend, the Discounted
Dividend Model (formula 5.6) will have to be
adjusted. For example, let’s assume the dividend of
the company rise at a rate of 5% per year. So, if we
take 3 years ahead, the dividend will be:
D1 = 0.50(1.05) = 0.525
D2 = 0.525(1.05) = 0.55125 or 0.05(1.05)2
D3 = 0.55125 (1.05) = 0.579 or 0.05(1.05)3
Constant Growth Model
Generally, the situation above is the same as:
D1 = D0(1+g)
D2 = D1(1+g) or D0 (1+g)2
D3= D2(1+g) or D1(1+g)3
Note: g is the growth rate.
PRICE EARNING (PE) RATIO MODEL
This model is also known as the earnings multiplier
model. This is because the PE ratio is also known as
the earning multiplier
ECONOMIC ANALYSIS
The prospect and future of a firm depends on the
economic situation and business environment where
the firm operates. Sometimes, the environment plays
a great role on the performance of a firm.
In the evaluation of share prices, we have to evaluate
the following economic and industrial situations:
(a) World Environment
(b) Domestic Economy
(c) Government Policy
INDUSTRY ANALYSIS
A simple definition of industry would be where a
group of firms run the same business.
The purpose of industrial analysis is to understand
the characteristics and structure of an industry.
There is a relationship between the character and
structure of the industry with earnings that can be
generated by firms in the industry.
In addition, a good firm usually is in a healthy and
growing industry.
Sales Level and Industry Life Cycle
Competitive Structure in Industry
We can complete the industry analysis by examining
the competitive structure of an industry.
The competitive structure can give insight into the
earning of firms in the industry. The tighter the
competition, the harder it will be for firms to get or
maintain high profit.
Michael Porter, 5 forces model
COMPANY ANALYSIS
The objective of company analysis is to examine the
nature and characteristics of a company.
SWOT analysis
It also involves examining the financial affairs of that
company and determining the quality of its earnings.
Company analysis - 3 main financial statements
There are 3 main financial statements. They are:
(a) Balance Sheet which is a statement of the
company’s assets, liabilities and stockholders’ equity.
(b) Income Statement which provide a summary of
operating results.
(c) Statement of Cash Flows which provide a summary
of cash flow and events that caused the cash position
to change.
Financial statements
To increase earnings
There are two main strategies that a company can use
in order to increase earnings.
They are:
(a) Low Cost Strategy
(b) Differentiation Strategy
Low Cost Strategy
Through this strategy the company endeavors to
increase earnings by controlling costs.
This is only done when there is no opportunity to
increase the price of the product.
Differentiation Strategy
Through this strategy the company will maintain its
pricing policy, being confident that customers will
not stop buying its products as it is perceived to be
different and maybe of high quality.
Porters Generic Strategies
Fixed Income Security
A bond is a fixed income security which promises the
investor a fixed stream of income for a specific time
period.
CHARACTERISTICS OF BONDS
Maturity Period
Maturity Value
Coupon Rates
Floating Rate
Zero-coupon Bonds
Embedded Options
Floating Rate
A floating rate indicates that the coupon rate may
change according to the current interest rate. This
current interest rate is dependent on the state of the
economy.
Embedded Options
Embedded options are specific characteristics
stipulated in the bond indentures. These
characteristics may include the option to call the
bond at an earlier date before maturity.
Another type of option is when bonds can be
converted to equity.
The latter is known as convertible bonds.
RISKS ASSOCIATED WITH BONDS
Interest Rate Risks
Reinvestment Risks
Redemption Risks (or Risk of a Call)
Default Risks
Inflation Risks
Liquidity Risks
BOND PRICING
The price/value of a bond is the present value of the
expected cash flow from the bond.
The expected cash flows are the coupon payments
and the face value.
These cash flows are then discounted at the required
rate of return. This rate of return is normally called
the yield of the bond.
Yield
This yield will depend vastly on the present market
interest rate.
The present market interest rate will consider the
risk-free rate of return and compensate its investor
for the expected inflation.
Depending on the risk structure of the bond, the
investor will also be compensated for additional risks
faced throughout the life of the bond.
These risks may include liquidity, default or call risk
which are normally specific to the security and firms.
Example
For example, a three-year RM1,000 bond with 10%
coupon rate with a yield of 8% will have a value of:
Calculate…
Bond value = Present value of coupons + Present
value of face value
Yield to Maturity
The rate of return earned from investing in bonds
until the bond matures is termed as yield to
maturity. Yield to maturity is also viewed as the
promised rate of return accruing to investors.
However, investors can only expect the promised
return only if:
-the probability of the issuer defaulting in payment is
zero; and
-the bond cannot be called before maturity.
Current Yield and Holding period return
The current yield of a bond is just the coupon
payment divided by the price.
The holding period return equals income earned over
a period (including capital gains or losses) as a
percentage of the bond price at the start of the
period.
The return can be calculated for any holding period
based on the income generated over that period.
VOLATILITY IN BOND PRICES
The most important factor that influences the value
of the bond is the market interest rate, which directly
influences the yield that an investor is looking for.
Changes in this interest rate will affect the changes in
the prices of bonds referred to as the volatility of
bond prices.
Bond Prices Move Inversely with Interest
Rates
Generally, the price of bonds will move counter
cyclical to the movements in interest rates. In other
words, if the price of bonds has a tendency to fall,
then it may be due to the upward movements of
interest rates in the market.
Go through the exmple.
Volatility of Bond Prices for Longer Term
Maturity Bonds
Bonds with longer maturity periods, experience a
more volatile price movement.
Table 7.1 shows that the rate of change in price is
higher for a ten-year bond compared to a one-year
bond.
Observe also that the rate of change in price reduces
at a decreasing rate as the maturity period increases
given the same level of interest rate.
Modified Duration
Modified duration is used to estimate the sensitivity
of bond price as a result of a change in interest rates.
It is calculated as:
Use the formula…
Where D* is the Macaulay Duration, i is the yield and
n is the number of times the coupon rate is paid in a
year.
If a bond is sold at RM1,000, and has Macaulay Duration
of 5 years with a yield of 8% and pays the coupon twice in
a year.
Calculate the modified duration.
Macaulay duration, named for Frederick Macaulay who
introduced the concept, is the weighted average maturity
of a bond
Modified Duration = Macaulay Duration /( 1 + y/n),
where y = yield to maturity and n = number of
discounting periods in year ( 2 for semi - ann pay bonds )
BOND PORTFOLIO MANAGEMENT
Investors can put their money in more than one
bond to create a bond portfolio.
There are two types of management strategies
namely the passive and active.
a) Passive Strategy;
-Buy and Hold Strategy
-Index Strategy
b) Active Strategy
Active Strategy
There are 4 sources of active management strategies
namely:
i) Interest Rates Forecasting
ii) Choosing a Sector
iii) Movements Between Sector
iv) Choosing a ‘Wrongly’ Priced Bond
Active Bond Management
In an active bond portfolio management, there is
always a need to change the portfolio of bonds. A
bond manager may have to switch from one sector to
another, or from one bond to another. Sometimes
there is no need to actually buy and sell bonds.
Instead the manager can just enter a swap.
A swap is an exchange between one bond with
another.
Go through the examples of swap…
Liability Funding Strategy
Apart from maximising profits given a specific level
of risk, investments in bonds provide a buffer against
contingent claims.
An insurance company for example, receiving
premiums must be able to pay its customers’ claims
at the end of the life of the insurance. This does not
include any unexpected claims made by the clients.
Derivatives
This topic explains derivative securities: forward contracts,
futures, and both call and put options.
Among the most innovative and most rapidly growing
markets to be developed in recent years are the markets for
financial futures and options. This is known as Derivative
market.
Futures and options trading are designed to protect the
investor against interest rate risks, exchange rate risks and
price risks.
A derivative security is a financial contract written on an
underlying asset.
The underlying asset
The underlying asset may be a share, Treasury Bill,
foreign currency or even another derivative security.
Go through the examples…
Two types of derivative security, futures and options
are actively traded on organized exchanges.
These contracts are standardized with regard to
description of the underlying asset, the right of the
owner, and the maturity date.
Not standardized contracts
Forward contracts, on the other hand, are not
standardized; each contract is customized to its
owner, and they are traded in what is called the
inter-bank market.
Options can be found embedded in other securities,
convertible bonds and extendible bonds being two
such examples.
A convertible bond contains a provision that gives an
option to convert the security into common share. As
extendible bond contains a provision that gives an
option to extend the maturity of the bond.
A forward contract and A futures contract
A forward contract is an agreement to buy or sell a
specified quantity of asset at a specified price, with
delivery at a specified time and place.
A futures contract is an agreement to buy or sell a
specified quantity of an asset at a specified price, and
at a specified time and place.
This part of the definition of a futures contract is
identical to that of a forward contract. But futures
contracts differ from forward contracts in four
important ways.
The differences are
(a) Futures contracts allow participants to realise
gains or losses on a daily basis, while forward
contracts are cash settled only at delivery.
(b) Futures contracts are standardised with respect
to the quality and the quantity of the asset
underlying the contract, the delivery date or period,
and the delivery place if there is physical delivery. In
contrast, forward contracts are customised on all
these dimensions to meet the needs of the two
counterparties.
The differences are
Futures contracts are settled through a clearing
house. The clearing house acts as a middleman. This
minimises credit risk as the second party to a futures
contract is always the clearing house.
Futures markets are regulated, while forward
contracts are unregulated.
Now let’s look at an example of a futures contract.
Clearing House
This intervention of the clearing house means that
the futures market has no counterparty risk.
If A plans to buy futures and B plans to sell futures,
both parties will refer to the clearing house to fulfil
their intentions. The clearing house is thus the
counter party to every contract.
In this case, B is not the counter party to A.
Settlement Price
A futures contract is marked-to-market each day.
When each trading is closed, the exchange will
establish the closing price, which is the settlement
price.
This settlement price is used to compute the
investor’s position, whether a loss or a gain
compared to the initial settlement price agreed upon
at the inception of the contract.
Daily Margin
When a person enters into a futures contract, the
individual is required to deposit funds in an account with
the broker.
This account is called the margin account.
The exchange sets the minimum amount of margin
required, but brokers can increase the margin if they feel
that the risk of the investors’ default is increased.
This margin account may earn interest or may not earn
interest.
The economic role of the margin account is to act as
collateral to minimise the risk of default by either party
in the futures contract.
Basis
The difference between the futures price and the spot
price is known as the basis.
Basis t = F(t, T) -S(t).
Basis with respect to maturity
Using Futures for Hedging
Futures are usually used to hedge our investment or
lock the price of the underlying asset.
Thus with hedging, we can construct a portfolio
consisting of assets on both the spot and the
derivatives markets.
It is important to understand that in the spot market,
we are dealing with the price risk whereas in the
futures market, we are faced with the basis risk.
Hedging is easier to understand by using examples
An options contract
An options contract is a contract where the writer (or
seller) of the options gives the right to the buyer of
the options, but not an obligation, to buy (call
options) or sell (put options) to the writer
‘something’ (or the underlying) at a specified price,
during a specified period (or specific time).
Options Moneyness
Options moneyness refers to a situation of whether it
is profitable or not when we initiate the contract.
Moneyness is always viewed from the buyer or the
long position viewpoint and not from the seller’s
view point.
Further, moneyness is obtained by comparing the
exercise price with the spot value of the underlying
asset.
Difference between Options and Futures
Contracts
Only the sellers (not the buyer) are obliged to buy or
sell. The buyer of options need not buy or sell the
underlying. In the futures contract, the buyers and
sellers are obliged to buy or sell.
Thus, the main advantage of options is where the
holder or the buyer of options will benefit from an
upside benefit while limiting a downside loss.
Difference between Options and Futures
Contracts
The buyer of options must pay a fee or the price of
the options to the seller to get the right. In the
futures contract, there is no exchange of money
when the contract is initiated.
The buyer of the options will decide on the price of
the options to buy (for call options) or to sell (for put
options) but can take the opportunity if the price of
the options is low. In the futures contract, the price is
already fixed and the parties to the contract cannot
obtain profit or suffer losses from any price
movement.
The Binomial Pricing Model
In this model, we will use a riskless portfolio (S - C)
where we buy a unit of the underlying asset and sell a
call option on the asset.
We further assume that there are only two possible
states, market goes up or market goes down.
The assumptions used in this model
(a) There are no market frictions.
(b) Market participant entails no counterparty risk.
(c) Markets are competitive.
(d) Market participants prefer more wealth to less.
(e) There are no arbitrage opportunities.
The Black-Scholes Model
The Black-Scholes model for pricing put (p) and call (c) options is as follow:
Formula..
N(d1), N(d2), = the cumulative probability density. The value for N(.) is
obtained
from a normal distribution that is tabulated in most statistics textbooks.
c = European call option price p
P = European put option price
S0 = Share price today
ST = Share price at option maturity
K = Strike price
T = Life of option
R = Risk-free rate for maturity T with cont comp
σ = Volatility of stock price
Mutual Fund Investment and Performance
Measurement
TOPIC 9
INTRODUCTION
This topic discusses another alternative approach to
investment.
In this topic we will mainly discuss investment in
mutual funds.
These mutual funds are basically portfolios that are
managed by professional financial service organisations.
There are various kinds of funds available in the market.
To manage the portfolio, they will need to go through a
process.
Finally, we will discuss performance evaluation of
investments.
PROCESS OF PORTFOLIO MANAGEMENT
Asset Classification
Go through table 9.1 Asset Classification
INVESTORS’ OBJECTIVES
As we mentioned earlier, there are many investors
with different risk tolerance.
Therefore, each major group of investors will have
different portfolios that suit their needs.
The easiest way to determine an investors profile is
by their age.
Table 9.1: Investors Needs Categorised According to
Age
MUTUAL FUNDS: PROFESSIONALLY
MANAGED INVESTMENT PORTFOLIOS
A mutual fund is a financial service that collects
money from shareholders and invests those funds on
their behalf in a diversified portfolio of securities.
Characteristics of a Fund
An open-end fund is a type of fund where investors
can buy shares from the fund.
A close-end fund is a fund where the number of
shares is fixed. Investors can buy these shares
initially from the fund, but they cannot sell it back to
the fund.
Types of Funds
A growth fund’s specific objective is price
appreciation. They target securities that will have
long-term growth and capital gains and less on
securities that give dividends or income.
Because of this, growth fund is risky. This type of
fund is suitable for investors between the age group
of 25 to 40. Their objective is to accumulate capital.
Types of Funds
Income funds emphasise on current income. They
will invest in securities that provide stable income.
Shares that provide high dividends are normally the
favourite choice as well as established blue chip
companies.
They however do hold a few growth shares. Apart
from shares, these types of funds also invest in
bonds.
The investment is less risky than growth shares.
Types of Funds
Index fund is a portfolio that replicates the
combination of shares in an index.
For example the KLCI contain 100 shares, with
predetermine weight for each share.
A portfolio can be built to replicate that index and
use the same 100 shares and weights.
PERFORMANCE EVALUATION
Sharpe’s Measure
Sharpe’s Differential Return
Treynor’s Measure
Treynor’s Differential Return
Revision
1. Calculate the price of a bond with a per value of
$1000 to be paid in ten years, a coupon rate of 10%,
and a required yield of 12%. Assume that coupon
payments made annually to bond holders and that
the next coupon payment is expected in six months.
Calculate bond price…
2. Bond investors are exposed to interest rate risk and
redemption risk.
Explain these risks…
Revision
What do you understand by the term top
down security analysis?
What is the consequence of an increase in
interest rates?
What is the consequence of an increase in
inflation?
What type of stocks the constant growthmodel is best suited for?
Define an expansionary economic policy?
Revision
List some of the popular tools for technical
analysis?
What is the implication of random walk
hypothesis?
Describe the term “efficient market” ?
Briefly explain the main objectives of
technical analysis?
Write the difference between ‘bond at a
premium’ and ‘bond at a discount’?
Revision
What makes the bond prices to be most
volatile?
Explain zero coupon bond?
What do you understand by the term T-Bill?
Explain what is a passive bond portfolio
strategy with some examples?
Explain what is an active bond portfolio
strategy with some examples?
Revision
What is an immunization strategy?
What is forward contract?
What is the main difference between future
contract and forward contract?
How does a call option differ from a put
option?
What is growth fund?
Revision
1. If XYZ Ltd. has a price earnings (P/E) ratio of
10 and an earnings per share (EPS) of $0.90,
what is the current price of the share?
A. $11.11 per share.
B. $17.07 per share.
C. $09.00 per share.
D. $19.35 per share
Revision
2. A common stock is expected to pay a $0.85 annual
dividend next year. If the dividends are expected to
grow at 5% annually and the current stock price is
$8.50, what is the required rate of return of the
stock?
A. 15.00%
B. 8.91%
C. 10.73%
D. 11.38%
Revision
3. The constant-growth dividend valuation model
is best suited for what type of stocks?
A. Stocks of new or emerging companies.
B. Small-cap stocks within growing industries.
C. Stocks of mature, dividend-paying companies.
D. Stocks of cyclical companies.
Revision
4. Which one describes the point-and-figure approach in
technical analysis?
A. A point-and-figure chart depicts all of the closing
prices of a stock over a period of time.
B. A point-and-figure chart consists of columns of X’s and
O’s.
C. A typical bar chart uses vertical bars to show the
closing price as well as the change in price from the
previous day.
D. A sell signal occurs when prices break through a
resistance line on a chart pattern.
Revision
5. If the market is strong-form efficient, what types of
information will be reflected in the stock price?
A. Only historical information.
B. Only the information related to events that have
already occurred.
C. All publicly known information related to past
events and announced future events.
D. All information including both public and private.
Revision
6. Which one signals a strong market?
A. A greater number of advancing stocks than declining stocks
and a greater volume of declining stocks than advancing stocks
B. A greater number of advancing stocks than declining stocks
and a greater volume of rising stocks than declining stocks
C. A greater number of declining stocks than advancing stocks
and a greater volume of rising stocks than declining stocks
D. A greater number of declining stocks than advancing stocks
and a greater volume of declining stocks than advancing stocks
Revision
7. If investors can use past share prices to predict
the future prices of the share, what does this
indicate?
A. The security market is weak-form efficient
B. The security market is semi-strong efficient
C. The security market is strong-form efficient
D. The security market is inefficient
Revision
8. If you expect market interest rates to rise,
what type of bonds should you purchase?
A. Short term, low coupon bonds.
B. Short term, high coupon bonds.
C. Long term, low coupon bonds.
D. Long term, high coupon bonds.
Revision
9. What is the current price of a bond if its par
value is $1,000, coupon rate of 6% and pays
interest semi-annually, matures in 10 years and
has a yield-to-maturity of 7.1325%?
A.$567
B.$920
C.$1,030
D.$1,080
Revision
10. What does the duration of a bond measure?
A. The sensitivity of bond price against interest
rate.
B. The average return of a bond.
C. The relationship between bond price and
money supply.
D. The movement of bond price in response to
changes in foreign exchange rate.
Revision
11. A $1,000 par value, 6% annual coupon bond
matures in 3 years. The bond is currently priced
at $993.35 and has a yield to maturity of 6.25%.
What is the duration of this bond?
A.1 year
B.2.67 years
C.2.83 years
D.2.89 years
Revision
12.What is the expression for put-call parity?
A.Stock price + Call Price = Put Price + Risk Free
Bond Price
B.Stock price + Put Price = Call Price + Risk Free
Bond Price
C.Put price + Call Price = Stock Price + Risk Free
Bond Price
D.Stock price - Put Price = Call Price + Risk Free
Bond Price
Revision
13. A stock currently sells for $15 per share. Assume that a
call option on the stock with an exercise price $15.50
currently sells for $2.50.
What is the terminology used to describe this situation?
A.In-the-money
B.Out-of-the-money
C.At-the-money
D.Break-even point
Revision
14Ali owns a portfolio that has a standard deviation of
13%, a beta of 1.05, and a total return of 10.5%. The riskfree rate is 4% and the overall market return is 9.8%.
What is the value of Sharpe’s measure for Ali’s portfolio?
A.0.05
B.0.06
C.0.50
D.0.81
Revision
15.A portfolio has a total return of 10.5%, a beta of 0.72
and a standard deviation of 6.3%. Assume that the risk
free rate is 3.8% and the market return is 12.4%.
What is Jensen’s measure of this portfolio’s performance?
A. 4.3%.
B. 7.9%.
C. 9.3%.
D. 0.5%