Managerial Finance Ronald F. Singer

1
Managerial Finance Ronald F. Singer

• FINA 6335
• Review
• Lecture 10

2
Outline

• Capital Budgeting Decision
• NPV Rule
• Arbitrage and Risk
• Time Value of Money
• Financial Statement Analysis
• Complicated Decisions
• Investments
• Risk versus Return
• Optimal Portfolio Selection (CML)
• Equilibrium Prices (SML and CAPM)

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Capital Budgeting

• The Net Present Value Rule
• What is it?
• Why does it work?
• Why would all investors regardless of their
  personal preferences for current versus future
  consumption agree on the NPV Rule?
• Present Value and the No-Arbitrage Price
• Why securities should sell at a price that is
  equal to the PV of the Cash Flow to the holders.

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First Separation Principle

• The firm can make a capital budgeting decision
  independently of how the project will be
  financed.
• Eventually, the firm will have to worry about how
  to finance the project, but the simple question
  right now is
• Are the benefits from investing greater than the
  cost?
• i.e. is the NPV of the project positive?

5
Risk

• Securities are priced as if the market in general
  is risk averse. That is, the typical investor
  appears to prefer a less risky alternative to a
  more risky alternative.
• So in order to induce investors to hold risky
  investments, the investment must be priced so as
  to reward the investor for the risk he takes on.
• This reward is called the risk premium associated
  with the expected return of risky securities, and
  projects.

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Risk versus Return

• That is
• E(Return of a risky venture)
• The reward for waiting plus compensation
  for taking on risk.
• Risk free return plus a risk premium.

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Present value of what?

• We talk about the Value of something being
  equal to the present value of something.
• What is this something?

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CASH!!!

• So, when we consider the value of a security or
  of a project, or of a firm, or any investment
  activity, we want to know what the Cash Flow will
  be and how to discount it.

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Central Role of Cash Flow

• Capital Budgeting Must consider Incremental
  Cash Flow
• Bonds and Stock (Dividends, interest,
  repurchases, principle)
• Investments (Free Cash Flow)
• Firm Valuation (Free Cash Flow)

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Bond valuation

• What is the cash flow expected from a typical
  bond?
• You must be careful here to distinguish between
  the Coupon Rate and the Required Return.
• The coupon rate describes how the bond gets some
  of its cash flow out to the holders. It reflects
  the risk and interest rate of the Bond at the
  time the bond was originally issued, and may or
  may not be representative of the risk and level
  of interest rates today.

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Stock

• Again, we need to find the Present Value of the
  Dividend stream.
• Predicting the dividend stream is not easy.
• We generally rely on fundamental analysis of the
  value of the issuer.
• Then value the firm and subtract the non-equity
  securities issued by the firm to get the value of
  the Equity.

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Investments

• Here the real question is how does a rational
  investor choose a portfolio of securities?
• There are three things that needs to be
  considered
• The Efficient set of Risky Assets
• Diversification
• The Efficient Risky Portfolio (CML)
• the Relationship Between Risk and Expected
  Return for
• Portfolios
• Individual Securities

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Efficient Set of Risky Assets
return
minimum variance portfolio
Individual Assets
?P
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Efficient Risky Portfolio
return
CML
efficient frontier
M
rf
?P
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Relationship between Risk and Return

• Efficient Portfolios (Capital Market Line)
• Rp Rf Risk Premium
• Rf (Rm - Rf) sp
• sM

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Relationship between Risk and Return

• Individual Securities (Capital Asset Pricing
  Model)
• Ri Rf Risk Premium
• Rf (Rm - Rf) bi