Finance Review

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Finance Review

• Finance 488
• Jim Mahar

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What Is Finance?

• We all know Finance has to do with money but what
  else?The reason for businessYour most important
  classForward looking
• Your favorite class

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Three Main Areas of Finance

• Money and capital markets
• Investments
• Financial management (corporate finance)
• All are very interrelated

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Jobs in Finance

• Difficult to categorize due to interdependency
• Http//www.Cob.Ohio-state.Edu/dept/fin/osujobs.Htm
  
• Corporate (financial management)
• Project analyst, credit manager

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Jobs in Finance (Continued)

• Investments
• Brokers
• Mutual funds
• Financial planners
• Money and capital markets
• Banks-IB and CB
• Mutual funds

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Finance (and Accounting) Often Get Bad Name

• Fear of the unknown
• Scapegoat for many layoffs, firings, and
  restructuring
• More mathematical than other disciplines
• Lottery and get rich quick mentality of some in
  the field
• Short-term thinking myth, reality, or some of
  both?

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Finance and Social Responsibility

• What is the purpose of a firm?
• Do social responsibility and ethical behavior fit
  with good business?
• Short answer yes. Long answer probably.
• What if others in industry do not behave
  ethically? Information?
• Regulations might be necessary

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Trends in the 1990s

• Globalization
• Technology
• Deregulation

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Financial System

• Exists to lower transactions costs
• Money flows from investors to those who need the
  money and back
• Competitive
• See drawing of financial system

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Investments

• Concerned with where to invest
• Stocks, bonds, derivatives
• Diversification
• Retirement planning

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Corporate Finance

• For much of this course we will focus on
  Corporate Finance
• Two basic questions facing every CFO
• What to invest in (how much)?
• How to get the necessary cash?

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• Before we can investigate corporate or
  investments we must introduce the players in this
  game

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Nexus of contracts

• A firm is a nexus of contracts
• Key idea!
• Explains much of what we see in the financial
  world
• Implicit and explicit contracts between many
  parties

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Shareholders

• Residual claimants
• owners
• elect Board of Directors
• have preemptive rights, rights to equal dividend
  distributions

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Bondholder-Shareholder conflicts

• Equity as a call option
• SH like risk
• BH hate risk
• similar to SL crisis
• controlled by
• law, covenants, reputation, price protection,
  security design

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Bondholder-Shareholder conflicts

• Equity as a call option
• SH like risk
• BH hate risk
• similar to SL crisis
• controlled by
• law, covenants, reputation, price protection,
  security design

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Keeping score

• Markets allow us to judge winners and losers
• Goal maximize SH value
• Often conflicts of interest
• back to nexus of contracts

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Models of human behavior-see Notes from Web

• Altruistic
• Honest
• Evil
• Holy/Religious
• REMPS

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People are REMMS or REMPS

• Resourceful
• Evaluative
• Maximizing
• People
• Meaning people will do what they feel is in
  their best interest

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REMPS continued

• has broad implications
• be skeptical of what other say
• signaling plays a key role-security issuance,
  dividends
• executive pay
• regulations

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Manager-Shareholder conflicts

• Managers are people
• People do lie for many reasons
• feel important
• to not hurt others
• to save face, job, ego, etc
• make money
• Investors know all of the above

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Manger-Shareholder relations

• work for Shareholders
• Monitored by BoD and shareholders (discuss)
• principle-agent conflict (agency cost)
• managers will look out for themselves

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Agency Costs

• costly to monitor
• can be reduced by compensation plans (align
  incentives)
• problems reward for rising market?
• Too high of pay?
• What if too closely aligned with shareholders?

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Free-Cash flow

• cash that is left over after all positive NPV
  projects
• Jensen 1986
• example of agency costs

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Investors vs. Managers

• More than just agency costs
• Investors realize managers are out for themselves
• VERY skeptical
• price protection
• Actions speak louder than words

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Two theories to explain Investor-Manger actions

• Information Asymmetries
• Signaling
• dividends, issuance, buybacks

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Valuation and capital budgeting
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Valuation (Step back into 345)

• What is anything worth?
• Present value of its future cash flows

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Present value

• PV?(cf(t)/(1r)t for t0 to ?
• Note Cash flows not Accounting Income
• Note ALL cashflows
• very difficult to predict cash flows
• information asymmetries

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Discount rate

• cost of capital
• dependent on risk of project not average risk of
  existing projects
• changes over time
• Often found using CAPM or other pricing models,
  industry comparisons, historical returns

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Calculating Present value

• requires forecasts of future cash flows
• Draw time line
• Money now is worth more than money later

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Present value

• Depends on timing and size of cash flows as well
  as riskiness
• Higher risk leads to higher required return
• What is correct risk-return relationship?
  
• We dont know

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Present Value continued

• Basically everything is tied to PV (or more
  appropriately NPV)
• business decisions (credit policy, marketing,
  hiring practices)
• everyday decisions (driving decisions,
  relationships, etc)

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Capital Budgeting

• What to invest in
• Want to increase shareholder value
• invest in good projects
• what is good

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Capital Budgeting Methods

• NPV and the alternatives
• NPV is 1
• IRRdiscount rate that makes NPV0
• Payback, discounted payback
• Profitability Index
• Accounting Based Rules

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Capital Budgeting Methods Continued

• Net Present Value
• PV of Benefits - PV of costs
• Positive NPV value increasing
• Decision Rule positive, then do it!
• cost and benefits must be in PV terms
• The best decision rule
• all others are judged against this

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Capital Budgeting-Payback Period

• Payback period calculates how long until you get
  the money back
• ex. 1000 cost, get 400 back a year payback 2.5
  years
• Advantages
• Easy, fast, fast, easy, simple, not too hard

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Capital Budgeting-payback continued

• Disadvantages
• ignores time value of money
• arbitrary cutoff
• ignores future cash flows beyond payoff
• leads to short term thinking

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Capital Budgeting-Discounted Payback

• Better than Payback but still has problems
• Uses present value of cash flows
• Still uses an arbitrary cutoff
• still ignores cash flows after the payback

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Capital Budgeting Methods Internal Rate of Return

• Internal Rate of return
• Discount rate that makes NPV0
• PV of costs Summation (benefits/(1IRR)T)
• Decision Rule if greater than hurdle rate, do
  it!
• Advantages of IRR
• Well liked by managers
• number is in percentage terms which is similar to
  required return. Easy to understand.

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Capital Budgeting continuedIRR

• Problems
• For mutually exclusive projects timing and scale
  differences
• Multiple IRRs possible
• Reinvestment rate assumption

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Capital Budgeting-MIRR

• Modified Internal Rate of Return
• MIRRdiscount rate that equates PV of costs and
  PV of benefits
• Advantage over IRR reinvestment assumption
• Decision Rule if MIRR gt hurdle rate, do it!

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Capital Budgeting Methods Profitability Index

• Profitability Index
• Several methods
• Most common PINPV/Investment
• Often used for ranking projects especially if
  rationing is in place
• Investment should be in PV terms

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Capital Budgeting Accounting based measures

• Average return on assets, or equity, or
  investment
• ignores TVM
• many assumptions
• Not cash flows!
• often used for managerial pay
• EVA

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EVA Economic Value Added

• Red Hot
• Measures on a period basis (usually yearly)
• Most large firms now using it or something like
  it
• somewhat scorned by many in academia as common
  sense
• http//www.mediapool.com/offtherecord/eva.html

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EVA (continued)

• EVA (after tax operating profit) - (after tax
  cost of capital)
• main difference is that it accounts for cost of
  equity
• other differences in what is an expense and what
  is an investment (ex advertising)
• Depreciation assumed to equal economic
  depreciation

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http//www.mediapool.com/offtherecord/eva.html

• EVA operating profits minus the cost of all of
  the capital
• employed to produce those earnings.
• To pump up EVA, a company has to do one of three
  things
• 1. increase operating profits without tying up
  more capital.
• 2. invest new capital in projects that earn more
  than the cost of capital.
• 3. divert or liquidate capital from business
  activities that do not provide adequate returns.

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Discount rates

• What is the correct discount rate?
• Risk and Return
• Risk should be evaluated on a project by project
  basis, NOT WACC

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Problems with WACC

• WACC vs True cost of capital graph
• Using WACC will result in passing up safe
  positive NPV projects and accepting risky
  negative NPV projects

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Efficient Markets

• Driven by competition
• Informational efficiency vs. Transaction cost
  efficiency
• Information Efficiency generally what we mean
  when we say efficient markets

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Information Efficiency

• Weak form
• Semi-strong form
• Strong form
• The price represents our best guess as to the
  correct price

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Product market efficiency

• comparison of financial and product markets is
  good for understanding
• financial markets are more efficient
• where are markets less efficient?
• little competition, barriers to entry
• patents, trademarks, etc.
• higher transactions costs

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Porters keys to abnormal returns

• Michael Porter identifies keys to industry
  profitability. Three of the things he finds
• Barriers to entry
• Buyer Power
• Seller Power
• All are more prevalent in product markets

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Why financial markets are so tough to beat

• Buyer Powergt almost zero
• Seller Powergt almost zero
• Barriers to entrygtalmost zero

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Market Efficiency

• All of this means is that it is very difficult to
  beat the market
• What does it mean to beat the market? Often
  mistaken. Does Not mean you can not make money
  (even lots of money) in the market.

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Market Efficiency

• no Free-lunch
• beating the market means making ABNORMAL returns
  on a consistent basis, Abnormal is judged on a
  risk-adjusted basis
• In practice since we do not know how to measure
  risk we often simply compare it to SP500, but
  this overstates abnormality and is wrong. Even
  then the market is hard to beat

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Market Efficiency (rewording of previous slide)

• Beating what is predicted/expected/required
• Problem not sure what is expected. Should be
  risk adjusted, but often is not

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How to measure risk?

• Standard Deviation
• Variance
• Beta and CAPM
• APT
• Other?

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CAPM
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