FINANCIAL MANAGEMENT Basic Review

1
FINANCIAL MANAGEMENTBasic Review

• Three questions in Finance-1 goal
• Time value of money
• Bond valuation
• Bond yield
• Stock valuation
• CAPM

2
GOAL OF FINANCIAL MANAGEMENT

• Options
• Survive?
• Maximize sales?
• Maximize profits?

3
Why not maximize profits?

• There are timing questions
• What about risk Considerations
• Accounting profit does not account for the cost
  of funds provided by shareholders
• Because of all of these problems-profit
  maximization is too narrow a goal
• Does not account for complexities

4
GOAL, ctd.

• Broader goal which does not limit the company is
  needed
• MAXIMIZE THE VALUE OF THE FIRM
• If corp. maximize the stock price
• If privatemaximize the value equity

5
Maximize the Stock price

• Creating Value
• Consider GM and Merck
• Focus on stock price -it is the best measure of
  the value of the firm
• Good decisions higher price
• Poor decisions lower price
• Best evaluator/cant cheat

6
HOW DO YOU DO SO?

• It is all about cash flows
• 1. The expected level of CFs
• 2. The timing of the CFs
• 3. The riskiness of the CFs
• Good financial decisions are those that increase
  CFs, speed up CFs, lower the risk of the CFs

7
3 QUESTIONS IN FINANCE

• 1 What projects do we undertake (Capital
  Budgeting)
• 2. How do we finance those projects (Capital
  Structure)
• 3. How do we carry out our short term financial
  management (Working Capital)

8
The Foundations of Financial Management

• 1. The risk-return relationship
  -the key word here is expected
• 2. Time value of Money
  -meaningful evaluation of future benefits
  requires discounting
• 3. Cash is King
  -what can you do without cash?
  -accounting profits cash?
  

9
The Foundations of Financial Management

• 4. Decisions focus on incremental CFs -it
  is only what changes that counts
• 5. In a competitive economy, it is hard to make
  money!
• 6. Markets are typically very efficient
  -I.e. they are fast
• 7. Agency Problems
  -do managers work for the owners?

10
The Foundations of Financial Management

• 8. Ethical Behavior Matters
• -Do what is right
• -What is your framework?
• -Ethical choices are everywhere
• LETS REVIEW SOME PRINCIPLES NOW

11
TIME VALUE OF MONEY

• The timing of the cash flows
• The value of any asset (Firm) is given by the the
  PRESENT VALUE of the expected CFs
• given FVtPV(1K)t
• then PV FVt/(1K)t

12
EXAMPLES

• FV1,000 N2 yrs K 8 PV?
• 1. PV 1,000/(1.08)2 857.34
• 2. PV 1,000(PVIF 8,2) 857.34
• 3. 1,000-----FV 8-----I/YR
  2-----N Then hit PV 857.34
  
  

13
ANNUITIES

• Equal series of payments
• 1. PV PMT (PVIFA n, k)
• 2. Calculator ------PMT ------
  n ------I/YR then hit PV

14
PERPETUITY

• Never ending cash flow
• Ex A company is expected to generate 1,000,000
  cash flow per year indefinitely. What is the
  value of such company?
• PV per CF/k
• PV 1,000,000/.08

15
BOND VALUATION

• Bond is a claim on specific cash flows
• CFs interest payments (fixedsemi)
  Principal payment (1,000)
• Value of bond PV of its cash flows
• Pb PV interest pmts PV principal
• Pb Pmt(PVIFAn,k) FV(PVIF)

16
EXAMPLE

• Face 1,000 coupon 8 maturity 15yrs
  required yield12
• Pb 40(PVIFA 30,4) 1,000(PVIF 30,4)
• Calculator 1,000--------FV
  40--------PMT 30-------N
  6-------I/YR then hit PV

17
BOND YIELD

• Best measure is YIELD TO MATURITY
• Def the interest rate that forces the PV of all
  CFs to equal the price paid for the bond
• EX You paid 952.50 for an IBM bond. The coupon
  rate is 7.5 and maturity is 10 years. What
  return will you earn if you hold it until
  maturity?

18
Solution

• Calculator
• 952.50--------PV
• 37.50---------PMT
• 20-------------N
• 1,000---------FV
• then hit I/YR 4.10 x 2 8.20

19
STOCK VALUATION

• Value of stock is also PV of all expected CFs
• It can be shown that all CFs can be expressed as
  dividends
• So value of a stock is the PV of its expected
  dividends
• Assume that dividends constant growth

20
GORDON MODEL

• Assume constant dividend growth
• Ps Do(1g)/Ks - g
• Ps D1/Ks - g
• Where
• Do is the last dividend paid g is the growth
  rate Ks required return on the stock

21
Example

• ATT Do2.50 g 5 Ks 12. What is the
  theoretical value of this stock?
• Ps 2.50(1.05)/.09 - .05 65.62
• Model is also used to find the required rate of
  return or cost of equity.
• Q What type of return investors want?

22
DISCOUNTED CASH FLOW MODEL

• Solving for Ks from the Gordon model
• Ks (D1/Ps) g
• Ex Disney stock selling for 120 last dividend
  3.20 growth rate 8. What is the cost of
  equity capital ?
• Ks (3.45/120) .08 10.8

23
RISK AND RETURN RELATIONSHIPS

• Basic idea Higher risk higher return
• This is quantified by the Capital Asset Pricing
  Model (CAPM)
• CAPM state required return on a risky security
  at least the risk free rate premium for being
  in stocks premium for risk of this stock given
  mkt.

24
CAPM

• Ks Krf (Km - Krf) beta
• Krf risk free rate
• Km expected return of the market
• Beta stocks volatility with the market

25
Example

• Entergy
• Krf (t-bond) 6.5
• Km 12
• Beta .9
• Ks 6.5 (12-6.5).9 11.45

26
TWO STORIES Disney Worldcom

• 1st Disney- Why is everybody wanting a piece of
  the mouse?
• Timeline of events
• 1. It is 1984 and a corporate raider (Saul
  Steinberg)purchased 7 of Disney stock
• 2. A few weeks later his stake is up 12
• He pays around 63 per share for these

27
Disney

• 3. Disney management is concerned-sounds like a
  unfriendly takeover
• 4. Disney tries to take a poison pill-make
  itself unattractive (borrow heavily and try to
  buy Gibson Cards)
• 5. Steinberg tenders an offer for 50 of shares
  67 with Gibson/ 72 without it
• 6. Stock is trading at 50 right now

28
Disney

• 7. Disney is shocked-how dare someone bid for us!
• 8. Disney pays greenmail-pays Steinberg 77 per
  share (cool 56M profit for him)
• 9. Stock price drops 6 at announcement
• 10. Shareholders file suits vs. board
• 11. Stock is at 47 and another raider announces
  a hostile takeover

29
TWO STORIES-WorldCom

• WorldCom and the quest for value
• A timeline of events
• 1. A 20 stock price /a bright star/a bullish
  market
• 2. The little guy gobbles up the giant /
  42billion buys MCI and beats GTE and BT

30
WorldCom

• 3. The missing piece-wireless/ lets buy Skytel/
  Wireless One/ SPRINT!! (123 billion)
• 4. Regulators see too much power (MCI WCOM
  SPRINT) No way!
• 5. All of the sudden Stock market slows down/
  our product is priced like a commodity/ the
  returns are lowtrouble!

31
WorldCom

• 6. Lets restructure-A tracking stock will let
  people see who we are
• Tracking stocks
• 1 entity/ 1 set of assets/ 1 Board of Directors/
  1 CEO but two stocks!
• Split the cash flows

32
WorldCom

• A. WorldCom group (1 share 1 share)/ high
  growth (data, Internet, Commercial long
  distance)/ no dividends / undervalued
• B. MCI group (1 share .20 share) / eroding/ low
  growth (residential long distance, pagers)/ pay
  dividends -2.40

33
WorldCom

• Did it work?
• WorldCom is trading 14-16 range (nor so far)
• MCI group is trading 16-18 range and has a 15
  yield
• Conflict of interests? Will the dividend be
  maintained? No CFs but still risk?