FINA 3770.007 April 2, 2014 Reference Sheet Exam 3 Five Principles of Finance 1) Cash flow is what matters 2) Money has a time value 3) Risk requires a reward 4) Market prices are generally right 5) Conflicts of interest cause agency problems Interest Rate Determinants • Nominal interest rate = Real risk free rate + Inflation risk premium + Default Risk premium + Maturity Premium + Liquidity Premium Time Value of Money Holding Period Return: Holding Period $ Gain = dividend + (Priceend of period – Pricebeginning of period) Holding Period Rate of Return (%) = dividend + (Priceend of period – Pricebeginning of period) Pricebeginning of period Expected Cash Flow: Expected Return Expected Return (%) = ΣPi*ri Where: Pi = probabilities of outcome i ri = expected % return in outcome I 1FINA 3770.007 April 2, 2014 Portfolio Risk • The risk of the portfolio may be less than the risk of its component assets. • Total risk of portfolio is due to two types of risk: • Systematic (or market risk) is risk that affects all firms (ex.: tax rate changes, war) Also know as Beta. • Unsystematic (or company-unique risk) is risk that affects only a specific firm (ex.: labor strikes, CEO change) Only unsystematic risk can be reduced or eliminated through effective diversification. Characteristic line is the “line of best fit” for all the stock returns relative to returns of S&P 500. • The slope of the characteristic line measures the average relationship between a stock’s returns and those of the S&P 500 Index Returns. • This slope (called beta) is a measure of the firm’s market risk Beta is the risk that remains for a company even after we have diversified our portfolio. • A stock with a Beta of 0 has no systematic risk • A stock with a Beta of 1 has systematic risk equal to the “typical” stock in the marketplace • Portfolio beta indicates the percentage change on average of the portfolio for every 1 percent change in the general market. 2FINA 3770.007 April 2, 2014 • βportfolio = Σ wj*βj o Where wj = % invested in stock j o βi = Beta of stock j Asset allocation refers to diversifying among different kinds of asset types (such as treasury bills, corporate bonds, common stocks). • Return = Σ Weightj * Return%j Capital asset pricing model--CAPM The required rate of return for a given security can be expressed as ( )Required rate risk-free rate beta market return risk-free rate= +× − Basic Valuation Process where: V = the intrinsic value, or present value, of an asset producing expected future cash flows, Ct, in years 1 through n C = Future expected cash flows in the form of interest and repayment of principal n = The time to maturity of the loan r = The investor’s required rate of return Bond Valuation • Yield to maturity o The yield to maturity is the rate of return the investor will earn if the bond is held to maturity, provided, of course, that the company issuing the bond does not default on the payments. o We compute the yield to maturity by finding the discount rate that gets the present value of the future interest payments and principal payment just equal to the bond's current market price. • Current yield o The current yield on a bond is the ratio of the annual interest payment of the bond’s current market price. o Current Yield = Annual Interest Payment Current Market Price of the Bond o The current yield is not an accurate measure of the bondholder’s expected rate of return from holding the bond to maturity. Bond Value: Three Important Relationships • First relationship o Bond prices moves inversely to yield. The change in value caused by changing interest rates is called interest rate risk. 3FINA 3770.007 April 2, 2014 • Second relationship 1. If the bondholder's required rate of return (current interest rate) equals the coupon interest rate, the bond will sell at par, or maturity value. 2. If the current interest rate exceeds the bond's coupon rate, the bond will sell below par value or at a "discount." 3. If the current interest rate is less than the bond's coupon rate, the bond will sell above par value or at a "premium." • Third relationship o A bondholder owning a long-term bond is exposed to greater interest rate risk than when owning a short-term bond. Preferred Stock • Preferred stock has priority over common stock with regard to claims on assets in the case of bankruptcy. • Most preferred stock carries a cumulative feature that requires all past unpaid preferred stock dividends to be paid before any common stock dividends are declared. • The value of a preferred stock equals the present value of all future dividends. • If the stock is nonmaturing, where dividends are expected in equal amount each year in perpetuity, the value may be calculated as follows: Valueps = annual dividend required rate of return = psDr Common Stock • As owners of the corporation, common shareholders have the right to the residual income and assets after bondholders and preferred stockholders have been paid. • Common stock shareholders are generally the only security holders with the right to elect the board of directors. • Common stock’s value is equal to the present value of all future cash flows expected to be received by the stockholder. Dividend Valuation Model • Company growth occurs either by: o The infusion of new capital. o The retention of earnings, which we call internal growth. The internal growth rate of a firm equals: o Return on equity × Percentage of earningsretained within the firm o g = ROE x pr o If we assume that the amount of dividend is increasing by a constant growth rate each year; that is, the dividend in year t, Dt, equals: o Dt = D0 (l + g)t o Where: g = the growth rate D0 = the most recent dividend payment o If the growth rate, g, is the same each year and is less than the required rate of return, rcs, the valuation equation for common stock can be reduced to 4FINA 3770.007 April 2, 2014 o Vcs = 1 csDrg− = 0 (1 ) csDgrg+− Expected Rate of Return of Stockholders • Preferred stockholder’s expected rate of return o Preferred stock expected rate of return = annual dividendmarket price of the stock or o psr = psDP •