Notesale: Turn your study into money

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Introduction to Finance Notes
Goals and Governance of the firm and Financial markets and institutions
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e
...

2) Financing decisions
 Raising finance to fund investments
 Issuing ‘financial assets’
 Debt Capital & Equity Capital
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2
Firms
Operations
(Real Assets)

1
Investors
(Financial
Assets)

Financial
Manager
3

4

At point 4, the financial manager must decide whether to reinvest the firm’s profits in more real
assets of pay a dividend to the shareholders
...

Definition: The Opportunity Cost of Capital is the minimum acceptable rate of return on new
investments, as it is the rate of return investors could generate for themselves
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 The natural financial objective that shareholders agree on is that they should
maximise the current market value of the firm
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This can lead to agency costs
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Introduction to Finance Notes
 Financial Markets and Institutions:
Flow of savings to investment for a closely held company
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 Financial Markets:
 Where securities (A traded financial asset such as a share or bond) are issued and
traded
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 Over the counter (OTC) market – where securities are traded directly between two
large parties
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Flow of savings to investment for Large PLC’s
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i
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mutual funds, hedge funds
and pension funds
 Financial Institution: an intermediary that also raise finance in special ways like accepting
deposits or selling insurance policies
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e
...


Introduction to Finance Notes

Financial Intermediaries:
Mutual and
Hedge
Funds

Large
Companies

Investors

(Top arrows are sold shares, bottom arrows are money flows)

 Mutual Funds: Investors invest small amounts, spread across a range of companies, Spreads
risk and they offer professional investment management
 Hedge Funds: Bigger scale mutual funds
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 Pension Funds: Set up by employers to provide for employee’s retirement
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This once again has the advantage of spreading
risk and offering professional investment management
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DON’T accept deposits or make loans to
companies
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Funding
is achieved through selling insurance policies to customers
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Functions of financial markets and intermediaries:





Transporting Cash across time: (allow saving and borrowing)
Risk transfer and diversification: (insurance policies and mutual funds)
Liquidity: (access to cash when needed)
Payment mechanism: (Bank accounts, credit cards etc
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Definitions:
 Future Value – the amount to which an investment will grow after earning interest
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 Compound Interest - interest is earned on the original investment and previous interest
earned
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 Annuity – A steam of equally spaced level cash flows occurring for a finite period, e
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a
mortgage or a bond
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Easiest way to compute: 𝑃𝑉 = 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤 ∗ ∑ 𝐷𝐹
Taking the sum of all discount factors (i
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0
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9070) and multiplying by the
cashflow
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AF = [ −

1
𝑟

1
]
𝑟(1+𝑟) 𝑡

o 𝑃𝑉 = 𝐶 ∗ 𝐴𝐹
o Annual cash flow that occurs one year from today
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o

𝑃𝑉 =

𝐶
𝑟

o C = Cash Flow, r = interest rate
o The perpetuity is an annual cash flow and the first flow occurs one year from today
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o Calculating the future value of an annuity
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)
𝐹𝑉

 Compound Interest Present Value: 𝑃𝑉(𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡) = (1+𝑟) 𝑡
1

Which means the Discount Factor is equal to: (1+𝑟) 𝑡 and therefore PV = FV*DF
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g
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8%
interest is earned on the money
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08)2 = 2,572
1

1

 Present Value of multiple cash flows: PV = [𝐶1 ∗ (1+𝑟)1 ] + [𝐶2 ∗ (1+𝑟)2 ] + … etc
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Interest Rates



APR – Annual percentage rate: An interest rate that is annualised using simple interest
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E
...
Given a monthly interest rate of 1%, what is the EAR and the APR?
Sol’n:


APR = 1% * 12 = 12%
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12 12
)
12

− 1 = 0
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68%

Definitons:




Inflation: rate at which prices in general increase
Nominal Interest Rate: the rate at which invested money grows
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

The real interest rate is calculated as follows: 1 + 𝑟𝑒𝑎𝑙𝑟𝑎𝑡𝑒 = 1+𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑟𝑎𝑡𝑒

1+𝑛𝑜𝑚𝑖𝑛𝑎𝑙𝑟𝑎𝑡𝑒

Introduction to Finance Notes

Net Present Value and Other Investment Criteria:
 NPV – Present Value of the cash flows minus initial investment
 Cost of Capital – required annual rate of return on an investment project (a
...
a discount
rate, hurdle rate, required rate of return)
 NPV decision Rule – if NPV is positive then accepting the project will increase the wealth of
the shareholders
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This is a normal
investment
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i
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cash flows occurring 1 year from the project are paid at T1
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NPV Cost of Capital:



Minimum accepted (annual) RoR on new investment projects and is used to discount future
cash flows back to their present value
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K
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 The higher the cost of capital, the less the future cash flow is worth
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NPV - The investment timing decision
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Look at NPV at year of purchase, multiply by DF and pick larger NPV Today
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EAA = PVCosts/annuityfactor
PV Costs = present value of initial purchased and annual operating costs
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Optimum Replacement Cycle:



Replace regularly – Assets are always relatively new/efficient but high purchase costs are
incurred frequently
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Introduction to Finance Notes
Payback Period: - Time until a projects cash inflows recover the initial investment in the project
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Internal Rate of Return:








Common to use IRR to appraise potential investments rather than calculate an NPV, because
it is easier to understand
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g
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House will be sold in 1 years time
for £500,000
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This
means it can be compared to the cost of capital
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If IRR < Cost of capital, then project should be rejected and will have a negative NPV
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IRR can be calculated in the long run using Linear Interpolation
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Use the percentages as whole
integers
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IRR Pitfalls:




In lending or borrowing projects,
In mutually exclusive projects
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Multiple IRR’s, i
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cash outflows and inflows all throughout the project
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There are two types
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o Hard Rationing – Due to an actual shortage of funds available for investment
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PI = NPV Project / initial investment
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Consistent with maximising value of firm and properly chooses amongst mutually exclusive
investments, but falls against capital rationing
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Falls against mutually exclusive projects
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IR - Accept the project if the payback period is less than some specified number of years
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Profitability index:
 Ratio of NPV to value of Initial investment
 IR - Accept if Profitability index is greater than zero, accept with capital rationing, where
projects combined give highest then they should be chosen
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Introduction to Finance Notes

Valuing stocks and Shares
 Definitions:
 Common Shares (stock) – Shares in PLC’s
 Primary Market – Market for new securities/
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 Primary Offering - General Term used when a company sells shares to investors
 Secondary Market – Market where previously issued securities are traded amongst
investors
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 Dividend per share(DPS) – Total dividend / Number of shares
 Dividend Yield – DPS/Share price *100%
 Earnings Per Share – Annual Earnings (Profits)/ Number of Shares
 Price – Earnings (PE) Ratio – Share Price/ EPS (Earnings per share)
 Book Value – Net value of the firm per the balance sheet
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The minimum acceptable takeover price when one firm
wants to take over another one
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Market Capitalisation
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 If you own a share in a PLC, you own a proportion of the company
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With Dividend streams, you buy a share and receive
annual dividends for the foreseeable future
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 Reasons Market Value > Book/Liquidation Value:




Extra earning power, businesses can utilise their assets to generate more than an adequate
rate of return
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Valuing Common Shares

Introduction to Finance Notes


Method 1 – Valuation by comparable:
Involves valuing shares based on comparison to similar firms and is often used
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Can use PE ratio, which measures how much an investor is willing
to pay share price for each $ of earnings
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

Method 2 – Price and intrinsic value:
Intrinsic value of a share = PV of future cash received
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Where the investor intends to hold onto the stock for more than one year:
𝑃0 =

𝐷𝐼𝑉1
𝐷𝐼𝑉2
+ (1+𝑟)2
1+𝑟

+ ⋯+

𝐷𝐼𝑉𝐻+𝑃𝐻
(1+𝑟) 𝐻

, where DIV1,2,etc = annual dividend, and H = Horizon

date(when share is sold)
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States that P0 is equal to the PV of all the expected future dividends
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If the same dividend is paid
into infinity, then the formula to calculate the PV of share would be

𝑃0 =

𝐷𝐼𝑉
,
𝑟

where

DIV is the annual dividend and r the discount rate
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e
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Therefore, the price at P0 would be P0 = DIV1/(r-g), this is referred to as Gordons growth
model
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Plowback Ratio - % of annual earnings reinvested within the business
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(annual profits/shareholders equity)
Plowback Ratio = 1 – Payout Ratio -> In case in exam
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o Achieved by spotting and exploiting patterns in share price movements, like buying
shares when prices are falling
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2) Fundamental Analysis
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Hard to beat the market because share prices react quickly
to news
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Fundamental Analysis would beat the market
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Strong-form efficient: share prices reflect all information about the company
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No investor can always beat the market
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For a short term loan they’ll go to the bank
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Definitions:











Bond – Security that obligates the insurer (PLC) to make payments to the bondholder
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Issue Price – initial price of bond in the primary market
Market Price – Current price of a bond (which fluctuates) in the secondary market
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£1000 in the exam always
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Always annual in exam
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Issued
at a discount
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Convertible bonds – provide the bond holder the option of converting the bond into shares
rather than receiving face value
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 Calculating PV of a bond in the long term:
o (Coupon * Annuity Factor) + (Face Value * Discount Factor) = Bond Price Today
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Increase in interest rates causes people to sell their
bonds, pushing the price down
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Current Yield, Yield to Maturity and Rate of Return
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Yield to maturity = discount rate for which the present value of the bonds payments, both
coupon and face value, equals the bond’s price
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Sometimes the yield demanded will change
due to interest rates or default risk
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This is known as the ‘default
premium’
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If bonds are issued at a discount, then the yield will be greater than the coupon rate, the
current yield will be less than the yield to maturity if prices don’t fall due to interest rate risk
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If bonds are issued at a premium then the yield will always be less than the coupon rate, the
current yield will be greater than the yield to maturity, and the rate of return will be equal to
the yield to maturity
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The formula is 𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 =





𝐷𝐼𝑉1
𝑃0

+ 𝑔

where g is growth, and P0 is price today
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To calculate the WACC a company needs to know the cost of equity and the after tax cost of
debt
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𝑊𝐴𝐶𝐶 =


𝐷
𝐸
∗ 𝑟 𝑑𝑒𝑏𝑡 (1 − 𝑇 𝑐 ) + ∗ 𝑟 𝑒𝑞𝑢𝑖𝑡𝑦
𝑉
𝑉

D = Debt, E = Equity, Tc = Tax Rate, rdebt = pre-tax cost of debt and requity = cost of equity
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WACC can only be used as the cost of capital if the capital structure of the firm is
expected to remain unchanged
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These represent the
required returns of investors now and in the future
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Shares are higher risk investment than bonds, due to:
o The coupon is guaranteed, dividends aren’t
o Bonds pay face value on maturity, shares have no equiv
o If companies go into financial difficulty, bondholders would be paid something
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Maturity Premium: Extra return versus treasury bills for bonds
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Risk Free rate of return: RoR on short term gov bonds, known as treasury bills
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Risk: As far as an investment is concerned risk is determined by the dispersion/spread of
possible outcomes
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Measure of volatility
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Expected Value = Σ 𝑝𝑥 where p is probabilities, x is outcomes
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Risk and Return
 Diversification
 Diversification:
Strategy designed to reduce the overall risk exposure by spreading an investment portfolio
over a range of investments
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This is
dependent on performance of other shares in that portfolio
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Arises due to
the factors that can affect a firms performance, i
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the introduction of new industry specific
regulations
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Caused by macroeconomic issues, such as Interest Rates or inflation
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 CAPM:


Beta (𝛽) Factor:
Represents how sensitive the returns on a share are to Market Risk
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Share or portfolio has an average level of risk
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Share or portfolio has an above average level of risk
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𝛽 = 0-1 Share or portfolio has a below average level of risk
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𝛽 is negative: Share (or portfolio) is counter cyclical
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Represents the ultimate level of
diversification possible
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The market portfolio considered to offer an average level of return and be
exposed to an average level of risk is said to have a beta factor of 1
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This can be referred to as the market
risk premium
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rf = risk free rate of return
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β = shares beta factor (Rm – Rf) = market risk
premium
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 Options:
o Options are valuable tools for risk management, for individual investors and for financial
managers
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o An investor can purchase an option on a share which gives them the right, but not the
obligation to buy or sell a share at a specific price (known as the strike price), up until
the option expiration date
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Example:
A call option on an Apple share is available at a strike price of $95 and with an expiration date in
one years’ time
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2) Why would an investor purchase the call option?
If looking to purchase a share an investor would be concerned about it rising in price prior to
purchase
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Should the actual share price be lower than $95 they can allow the option to
lapse and purchase the share for cheaper
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In this case the option would
be classed as IN THE MONEY
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In this scenario, the investor would choose to allow the call option to lapse (not exercise) as
buying the share on the stock market would be $5 cheaper
...

3c) What would happen if on the date the investor wanted to purchase the share, the share
price was $95?

Introduction to Finance Notes
In this scenario, it doesn’t matter if the investor exercises the call option or buys the share on
the stock market as either way it will cost $95
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 For a Call Option:
o In the money if the share price is greater than the strike price, then the option has
intrinsic value
...

o At the money or out of the money: if the share price is less than or equal to the strike
price as in 3b) or 3c) then the option has no intrinsic value
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o Option Premium: the price the investor
must pay to purchase an option
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o PROFIT ON AN OPTION = INTRINSIC VALUE
– PREMIUM

Put options: purchasing a put option gives the investor
the right (but not the obligation) to sell an asset at the
strike price up until the expiration date
...

1) If an investor purchases this put option, what does this mean?
This means that at any point over the next year the investor could exercise the option to sell the
share at the strike price of $45
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Should the actual share price be higher than $45 they can allow the option to lapse and sell
the share for a higher price
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The option would be classed as IN THE MONEY
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The option would be classed as OUT OF THE MONEY
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The option
would be classed as AT THE MONEY
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INTRINSIC VALUE PUT OPTION = STRIKE PRICE –
SHARE PRICE = $45 - $40 = $5
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An option can never
have negative intrinsic value

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