t

Law 635 Outline

I.

Basic Finance Equations

a. PV =

Ct 1 r

, where r is discount factor and C = dollars in year t

b. NPV =
T

C0
t 1

Ct 1 r

c. DCF =

Ct

(For different cash flows Ct at each t) C r

(1 r)

d. PV of perpetuity =

e. PV of annuity =

1 1 r r 1 r

(t-year annuity factor) for fixed sum for specified period

f. Annuity due: first payment made immediately; multiply PV of ordinary annuity by (1 + r)

1 r 1 g. FV of annuity = r
t

h. PV of growing perpetuity = i. PV of T-period growing annuity = j.

C1 , where g is the growth rate rg 1 rg

1 g r g 1 r
t

t
r

Continuous compounding annuity: the new r is such that e = 1+[old rate] i.

1 1 1 PV C * rt r r e
m n

k. Compound Interest: FVn P * , where m is number of compounds per year 1 m

i.

Limit as m gives you FVn = Pe

rt

II. Bonds
a. Definitions i. Bond: 1. Entitled to fixed set of cash payoffs; regular interest payments (coupon) 2. At maturity, you get final interest payment + face value

(par value) of the bond ii. Ask Price: Amount needed to buy note Bid price: Amount needed from dealer iii.

to sell note to dealer

iv.

Spread: Difference between bid and ask

v. Duration / Macaulay duration = weighted average of times when bonds cash payments are received vi. viii. ix. Term structure of interest rates = relationship b/w shortSpot rate rn = n-year rate of interest Stripped bond / strips = bonds that make one cash payment Arbitrage = money Ratings and long-term rates vii.

machine x.

(Moodys / S&P 1. High = AAA; AA 2. Medium = A; BBB 3. Low = BB; CCC; CC 4. Very Low (Junk) = C, D b. PV of bond = (coupon * annuity factor) + (final payment * discount factor) i. =

1 1 C* r r 1 r

ParValue 1 r t

ii. Example: 4-year bond with $8.5 coupon; 3% discount rate; $100 face value

iii.

PV 8.5 *

1 1 0.0 0.03 4 3 *1.03

100 (1.03)
4

c. YTM = rate of return on the bond (IRR), backed out from PV calculation as a function of price, coupon, and par value d. Duration =

t 1

PV

t * PV (Ct )

, where final maturity date is at T

i. A weighted average time to each payment; shorter than the maturity date

e. Modified duration = volatility =

duratio n , a measure of interest-rate risk 1 yield

i. A measure of how much the bond price changes given a 1% change in YTM ii. Cash Flows Bond prices and interest rates move in opposite directions f. Inflation, Nominal Cash Flows, Real

Ct

i. Real cash flow at date t = ii. Real rate of return = iii. iv. v.

(1 CPI ) 1i 1 CPI

t,

where C = nominal cash flow

1 , where i is nominal interest rate

Real interest rate i CPI Average US inflation is about 3% Fishers theory: Change in expected inflation rate causes same proportionate change in nominal interest rate; no effect on required real interest rate

1. 1 + i = (1 + r)(1 + CPIexpected) g. Types of corporate bonds i. ii. i. ii. iii. i. Floating rate bonds (e.g. coupon payments tied to treasury rate + 2%) Convertible bonds (may exchange bond for shares of common stock) Real rate of interest (theoretically, this is flat) Expected future inflation (can be upward or downward sloping) Interest rate risk premium (increases with time)

h. How bond yields vary with maturity depends on

Expectations theory of term structure: bonds priced so that investor who holds succession of short bonds can expect same return as investor who holds long-term bond i. But it leaves out risk Effect on Bond Price Lower Lower Lower Higher Lower Higher

j.

Some comparative statics Factor (as this goes higher) Default probability Inflation risk Taxability of coupon payments Liquidity Yield to maturity / IRR Coupon rate

III. Stocks
a. Definitions i. ii. iii. iv. Primary market = Sales of shares to raise new capital Secondary market = stock exchanges like NYSE / NASDAQ Market order = to buy / sell stock at best available price Limit order = Price at which person is willing to Auction markets: NYSE; TSE; LSE;

buy/sell stock v. Deutsche Borse vi.

Non-auction market: NASDAQ

vii. Exchange-traded funds (ETFs): portfolios of stocks to buy/sell in a single trade viii. i. Growth stocks bought primarily for capital gains; income stocks Valuation Techniques / Stock price determinants PV(stock) = PV(dividends), Comparables: Look at market-to-book value ratio; primarily for dividends b.

price-earnings ratio ii. theoretically

1. Gains come from dividends and capital gains; that is,

DIV1

 (P1 P0 ) P0

?1

2. Rearranging gives you Equation (1): P0

DIV1 P1 1r

3. r = market capitalization rate or cost of equity capital, which is the rate of return of stocks in the same risk class (assumed to all have same return) 4. We know from (1) that into (1) 1 5. Or, we can generalize to P0
H

DIV P 2 P 1r

; we could plug this

DIVH PH DIV1 DIV2 2 ... 1 r H 1 r 1r PH

, where H is the horizon.

6. Rearranged,

P0

DIVt

t 1

1 r

1 r

Theoretically, though, the terminal price should approach zero as H approaches infinity, giving us

P0

DIVt
t

t 1

iii.

Dividend theory: growth companies (e.g. CSCO) that never pay dividends now are just investing for later when there are fewer profitable opportunities; those later dates will have higher dividends (which accounts for the high valuation today)

c. Cost of Equity Capital i. If we forecast a growth rate g for the companys expected dividends, we get:

P0
ii.

DIV1 , so long as r > g rg r P0 DIV1 g DIV1 is the dividend yield P0

Rearranging, we get

, where

iii. Example: Company has stock price of $42.45; dividend payments of $1.68 / share; annual growth of 6.1% 1. r = (1.68 / 42.45) + (0.061) = 0.101 = 10.1% iv. Since long-run growth rate is hard to come by, can also use payout ratio (Div / EPS) 1. Plowback ratio = 1 payout

DIV

ratio =

EPS
2. EPS / book equity per share = return on equity = ROE 3. Dividend growth rate = g = plowback * ROE d. DCF Valuation with Varying Growing Rates i. Plowback ratio is based on old numbers; may represent Instead, get the realistic growth unsustainable growth ii.

number gt at time t, and back out r from it

P 0

DIV
1

DI V (12 r)

1r

DIV ... * t (1 rg r)t t 1 4

iii.

You can use multiple-stage DCF models to do ramp-up years and steady growth years using the model above

e. Price and EPS i. Expected return of company that plows back nothing and only produces dividends = like a perpetual bond; expected return is therefore dividend yield = EPS 1 / P0 1. Therefore, P0 = EPS1 / r ii. If earnings are reinvested (a stock thats purely a growth stock rather than an income stock), and reinvestment has same risk as present business, then share price should be unaffected 1. Reduction in value by 0 dividend should be offset by increase in value in dividends in later years, so same formula for P 0 2. This is only true if the NPV of the new project is 0. 3. More generally,

P0

EPS1 r

PVGO , where PVGO is the net

present value

of growth opportunities a. Example: Stock with market capitalization rate of 15%; $5 dividend in Y1 and 10% growth thereafter; ROE = 0.25. i. Then,

P0

DIV1 rg

$5 $100 0.15 0.1

b. Assume earnings per share is $8.33 i. Payout ratio is then

DIV
1

EPS
1

$5 0.6 , which $8.3 means 3

that the plowback ratio is 40%. ii. The equation balances g = (plowback * ROE) = (0.4 * 0.25) = 0.1 c. If there were no growth opportunities, we should find

EPS1 r

instead, P 0

$8.33

$55.56 , but = $100.

0

0.15

d. Since ROE = 0.25, the plowback NPV can be represented as

NPV1 (0.4) * ($8.33) $2.22

[(0.4) * ($8.33)]* 0.25 0.1 5

e. In Year 2, the plowback has a 10% growth rate, giving us about $2.44:

NPV2 (0.4) * (8.33) * (1.1) (1.1)]* 0.25

[(0.4) * (8.33) * 0.15

f.

That is, NPVt = (1.1)(NPVt - 1), which gives us

PVGO

NPV1 rg

$2.2 $44.44 , which completes 2 the 0.15 0.1

equation:

P0
f. Valuation through DCF i. ii.

EPS1 PVGO $55.56 $44.44 $100 r

Free cash flow = amount of cash a firm can pay to investors after paying for all investments necessary for growth Valuation: discount the free cash flows to horizon, and add the discounted present value at time H 1. Estimating horizon value a. Constant-growth DCF formula i. Example: discount rate of 10%; long-run growth rate of 6%; free cash flow of 1.59 at year 7 ii.

PV H

1 (1 r)
H

FCF 1 H [CHECK THIS et seq.

for

rg

off-by-one error] b. P/E ratios i. Example: Take an assumed P/E ratio, and plug it in ii.

PV
H

1 (1H r)

(ratio * earnings

H 1

c. Market-Book ratios i. Example: Take an assumed Market-Book ratio, and plug it ii.

PV
H

1 (1H r)

(MarketToBookRatio * AssetValue H )

d. Growth Opportunities i. Assume that, at some point H, PVGO is zero

R ii. g. Price/Earnings

earnin gs PVH

H 1

r
i. Growth stocks: low current earnings, Income stocks: high current Rough guide to high PVGO ii. PVGE 1. 0-10 = stock undervalued, or earnings expected to decline 2. 10-17 = P/E is at fair value

earnings, low PVGO iii.

3. 17-25 = overvalued or earnings fell relative to last report 4. 25 = very promising future or speculative bubble

IV. Alternatives to the NPV

a. Three things to remember about NPV i. ii. Dollar today worth more than a dollar tomorrow NPV depends on cash flow and opportunity cost of capital 1. Investors who look at book rate of return only dont get the whole picture (depends whats treated as a capital investment); companies may worry how book return is affected by an investment iii. NPV(A + B) = NPV(A) + NPV(B) The 1. Definition a. Payback period found by counting t it takes before cumulative cash flow equals the initial investment b. Payback rule = if payback period is less than some t, then the project should be accepted. 2. Three Examples Proje ct A B C C0 (2,00 0) (2,00 0) (2,00 0) C1 50 0 50 0 1,80 0 C2 50 0 1,80 0 50 0 C3 5,00 0 0 0 Payback Pd 3 2 2 NPV at 10% 2,62 4 (58 ) 50 b. Competitors to the NPV Rule i. Payback Rule

a. If the cutoff above is 2 years, then only B and C get investments even though B has a negative NPV 3. Problems with payback rule a. Ignores cash flows after cutoff date b. Equal weight to all cash flows before the cutoff date 4. Advantages with payback rule a. Easy to communicate / justify b. Short paybacks = quick profits = quick promotions c. Limited access to capital favors rapid payback even w/some NPV hit 5. Discounted Payback a. Definition: How long does it last in order for NPV to be positive? b. In example above, DPP(A) = 3; DPP(B) = DNE; DPP(C) = 2

c. Allows manager to reject non-NPV-positive projects that make sense from a payback-only perspective ii. Book Rate of Return / Accounting Rate of Return 1. Definition a. Average income divided by average book value over project life b. Book Rate of Return = 2. Problems a. Not a good measure of true profitability; depends on whats capex and whats opex b. Average across all of the firms activities; thats not usually the right hurdle for new investments i. E.g. if opportunity cost of capital is 12% but historic book return is 24%, implication is reject a 20% rate of return investment iii. IRR (Internal Rate of Return) / DCF (Discounted Cash Flow) 1. Definition in single period is easy a.

BookIncome BookAssets

IRR

Payoff 1 Investment 0 , which can be rewritten as r C2 (1 IRR) 2 CT (1 T IRR) C1 C

0

b.

C NPV 1 1 C0 r

2. Calculating the IRR a.

NPV C0

C1 1 IRR

...

0,

which is solved through trial and error. 3. The Rule a. IRR rule = accept a project if the opportunity cost of capital is less than the internal rate of return 4. Problems a. Lending or Borrowing? i. Project A has C0 of (1,000), C1 of 1,500, IRR = 50% ii. Project B has C0 of 1,000, C1 of (1,500), IRR = 50% iii. These arent equally attractive; one is borrowing (which we

want to do at a low IRR) and one is lending (want high) b. Multiple Rates of Return

i.

Sometimes, you can solve for two different r that satisfy the IRR equation. (There can be infinitely many; depends on how many sign changes there are in the cash flows). There are also cases where no IRR exists.

c. Mutually Exclusive Projects i. A project may have higher IRR but lower NPV; if theyre mutually exclusive (e.g. capital constraints), you actually want the one with better NPV. ii. IRR also doesnt have the value additivity property (cf. NPV) c. Capital Rationing d. Multiple Opportunity Costs of Capital i. Cost of capital varies over time ii. Inappropriate when short- and long-term rates diverge i. Basic Equation 1. Profitability Index =

NPV Investm ent

2. Pursue the projects that have the highest profitability index, but there are capital constraints; with a limited number of projects, its easy, but with more, use linear programming models ii. Soft Rationing capital constraints are soft and are provisional limits adopted by management iii. i. Hard Rationing implies market imperfections; examples are Three rules 1. Only cash flow is relevant 2. Always estimate cash flows on an incremental basis 3. Be consistent in your treatment of inflation ii. Rule 1 (cash flow is king) 1. Always estimate cash flow on an after-tax basis 2. Make sure cash flows recorded only when they occur iii. basis) 1. Dont confuse average and incremental payoffs a. Incremental NPV from investing in a loser may be positive (chasing losses is OK); similarly, dont chase Rule 2 (cash flows on an incremental shareholder vetoes, etc. d. How to apply NPV

good money after good (a 20-year old race horse is not a good investment) 2. Include all incidental effects

a. E.g. investing in a new regional air route may be NPV in isolation, but +NPV when adding new business b. E.g. New product may cannibalize own business, but competitor products will eat away market share anyway; invest and hope for good. 3. Forecast sales today and recognize after-sales cash flows to come later 4. Dont forget working capital requirements

V. Risk
a. Definitions i.

Diversifiable risk risk that can be reduced Nondiversifiable cannot be

or eliminated ii. eliminated

b. Order of risk (in descending order) i. cap iv. Small cap Large iii. stocks stocks ii. Junk bonds Investment-grade Municipal corporate bonds v. bonds vi. bonds c. risk i. Variance / Standard Deviation
2 x1 x 2 1 2 2 2 2

US T-bills / Measuring

ii. Portfolio variance for two assets: iii.

2(x1 x2 12 1 2 )

Portfolio risk = systematic risk + unsystematic risk 1. Beta = sensitivity of stocks return to return on market portfolio (cannot be eliminated through diversification)

a.

i
im 2 m

, with numerator = covariance with market

2. Portfolio Beta = weighted average of each stocks portfolio 3. Systematic risk is the market standard deviation multiplied by beta d. Efficient Frontier / Market Porfolio borrowing and lending at risk-free rate

rm r f

i. ii.

Slope of capital market line is the Sharpe Ratio, which is

Bottom line points: 1. Only invest in efficient portfolios that maximize return per unit of risk 2. Capital market line depicts tradeoff b/w risk and return for diversified portfolios 3. Separation theorem: Its efficient just to invest in the market portfolio, and borrow / lend at the risk-free rate

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VI. CAPM
a. Expected return on an asset = r f b. Challenges to the model: i. iii. iv. i. iii. Can only test model against actual results, so not Estimating beta is difficult Can only use a proxy for the complete market portfolio, since not all assets are publicly traded Testing CAPM is a joint test of both the validity of CAPM and efficiency Assumptions underlying CAPM: No transactions No taxes Passive Homogenous expectations / of asset pricing c. costs ii. testable ex ante ii.

a (rm r f )

valuations iv. investment v.

Ability to freely borrow / lend at Risk-free security

risk-free rate vi. exists vii.

Investors only concerned about Market efficiency

systematic risk viii. i.

d. Arbitrage Pricing Theory Identify a reasonably short list of macroeconomic factors expected to Estimate risk premium on each of these factors; affect stock returns ii. these factors

multiply by sensitivity of stock to each of

VII. Cost of Capital and WACC

a. Cost of capital = expected return on assets = rdebt * (debt / total firm value) + requity * (eq / total firm value) b. WACC = (1 Tc) * rD * (D / V) + rE * (E / V), where Tc is the marginal rate of corporate tax VIII. Efficient Markets Hypothesis a. Three Forms: i. Weak (price reflects historical price / trading information) (random walk hypothesis) ii. Semi-strong: Market prices reflect all publicly Strong: Market prices reflect all available information iii.

information, both public and private 1. Implication: even corporate insiders cannot earn

abnormal returns b. Testing these hypotheses i. Weak form: technical analysis doesnt provide greater returns than buy & hold, given trading costs

11

ii.

Semi-strong: Observe stock price response to events like stock splits / dividends announcements, etc. prices react within 5-10 minutes for earnings and dividend changes (Patell & Wolfson)

iii. Strong: Whether mutual funds / pension funds consistently outperform the market; 1. Jeng et al. corporate insiders buys have abnormal returns > 6%/year 2. Ziobrowski Senators portfolios outperform market by 12% c. Mechanisms (Gilson and Kraakman): i. ii. Universally informed trading Professionally informed Derivatively

trading iii.

informed trading 1. Made permissible by direct / indirect info leakages 2. Trade decoding 3. Price decoding iv. Uninformed trading 1. Soft information like forecasts / predictions d. i. Information Costs Acquisition costs ii. Processing Costs iii. Verification Costs e. Anomalies i. January effect: Returns tend to be higher in January than other months (particularly small-cap stocks); seems to have disappeared lately ii. iii. Returns tend to be lower on Monday Investors tend to underreact to surprise earnings Stock market overreaction (e.g. New-issue puzzle:

announcements iv.

JPN stock market in the 1980s) v. IPOs tended to underperform vi.

S&P Effect: When added to S&P 500, price rises between 2-3%

vii. Stock market crash (1987): 23% devaluation of American corporate sector 1. But can be explained using Div / (r g) with big dropoff in g or big increase in r viii. Internet Bubble: Companies excess valued, but even savvy Behavioral Finance Theory (Shleifer & Summers) analysts pushing f.

i.

Two types of traders: arbitrageurs; Noise traders =

noise traders ii. Investor biases:

responsive to pseudo-signals iii. 1. Overconfidence 2. Over / underreaction to recent events 3. Trend chasing

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4. Excessive trading 5. Underdiversification iv. Arbitrageurs are risk-averse and cant totally eliminate noise traders noise 1. Arbitrage has high transaction costs 2. Short-selling prevents convergence trading 3. Budget constraints 4. Risky to adopt contrarian position v. Heterogeneous Expectations Asset Pricing Model (HEAPM) 1. CAPM assumes investors have homogenous expectations value converges to best estimate 2. HEAPM assumes investors disagree on future risks / returns, PLUS limits to arbitrage, making stock prices not fundamentally efficient vi. Critiques 1. Anomalies shouldnt account for much money relative to size of market 2. Many anomalies tend to be short-lived and disappear when discovered 3. Anomalies not easily translatable into profitable trading strategies b/c of transactions costs 4. Unpredictable

IX. Corporate Finance

a. Term s Tunneling = transfer of assets / profits out of firms for benefit of i. controlling sh/hs ii. Preferred stock takes priority over common stock in regards to dividends iii. Floating-Rate Preferred Stock Pays dividends that vary with short term interest rates iv. Subordinate debt = repaid in bankruptcy only after senior debt Secured debt = first claim on specific collateral in event of default Protective covenants = Restrictions on firm to protect bondholders

v. vi.

vii. Eurodollars = dollars held on deposit in bank outside the US viii. Eurobond = Bond marketed internationally; may be denominated in any currency ix. Private placement = sale of securities to limited number of qualified investors without a x. public offering Convertible bond = bond that holder can exchange for some other security (smth like bond + call option)

xi. Warrant: Right to buy shares from company at stipulated price before set date essentially an option xii. Book Value: backward looking; cf. Market value

b. Relationship v. Arms Length Finance i. Relationship finance: Financier has power over the firm being financed

13

1. Physical asset-intensive businesses; older industries; lower market-to-book ratios ii. Arms length finance: Financier protected by explicit Ks / transparency 1. High-tech; intangible assets like IP; R&D; high market-to-book iii. Length Finance) iv. Venture capital = hybrid (financing for start-ups; usually high tech) 1. Exit mechanisms: a. Sale to another company b. Start-up buys itself back c. Block sale of VCs stake to another block investor d. IPO c. IPO terminology i. Underwriter: Firm that buys an issue of securities; resells to public 1. Asymmetric info b/c of new issuer; underwriter reduces verification costs ii. iii. Prospectus: Formal summary, provides info like risk factors / line of business Underpricing: Issue securities at offering price set below true Rights Issue: Issue of securities offered only value of security iv. Various pros and cons (search Arms

to current stockholders

d. Dividends
i. Term s Cash Dividend = payment of cash by firm to sh/hs 1. 2. Ex-dividend date: Determines date when stockholder is entitled to dividend payment 3. Record date: Person who owns stock on this date receives dividend, unless acquired after ex-dividend date ii. Type s 1. Regular Cash Dividend 2. Special Cash Dividend 3. Stock Dividend 4. Stock Repurchase a. Buy shares on open market b. Tender offer to shareholders c. Private negotiation d. Dutch auction iii. Dividend Policy

1. Lintners Sylized Facts (from interviews with corporate managers) a. Long-term target payout ratios

14

b. Managers reluctant to make changes (esp. increases) that might have to reverse c. Transitory earnings changes unlikely to affect dividend payouts d. Repurchase, rather than issue dividends with large amount of unwanted cash 2. Information effect: Investors react positively to dividend increases; negatively to decreases a. Signaling effect b. Firm value change? Three theories i. Dividend policy irrelevant (Miller1. Assumptions: a. No taxes, transaction costs, market imps b. budgeting plan c. Fixed borrowing d. Efficient capital markets e. Financial deficit funded by retained earnings; all extra cash paid out as dividends 2. Investors dont need dividends to convert shares to cash Modigliani Fixed capital

Modigliani)

X.

Capital Structure a. Miller-

a. Wont pay higher prices for firms with more divide nd payou ts b. Divid i. iii. ii.

end policy = irrelevant; no impact on firm value! Dividends increase firm value 1. Some investors prefer high dividends to support current income 2. Managers that dont have high present value growth opportunities have incentives to spend cash wastefully (Goodyear) 3. Easterbrook: Mitigate monitoring costs with Easterbrook Dividends reduce firm value 1. Dividends were taxed more heavily than capital gains 2. No longer true after Bushs 2003 dividend tax cut

Proposition I capital structure doesnt matter

15

1. Doesnt matter whether firm borrows or individual borrows 2. Claim: levered firm and unlevered firm have same value 3. Assumptions: a. Perfect capital markets i. Perfect competition in Firms / capital market ii.

investors borrow at same rate 1. Brealey-Myers: This isnt realistic iii. iv. no taxes b. costs c. Capital structure doesnt affect investment / operating policies / management incentives d. WACC is fixed (rA = Operating Income / Value of securities) ii. Proposition II : Leverage raises required return on equity 1. Return on equity increases in proportion to the debt-equity ratio; rate of increase depends on spread between expected return on assets and on debt: 2. Equal access to all relevant information No transaction costs; No bankruptcy

rE rA

D (r r ) E A D D ( A E

3. Similarly, leverage increases beta of firms shares 4.

5. Critique (Brealey Myers) a. At moderate levels of debt, shareholders dont increase their required rate of return in exact proportion to increase in leverage b. Imperfections in the capital market give corporate debt an advantage over personal debt; shareholders thus pay premium for levered shares b. Tax-Adjusted WACC:

TC ) *

WACC rD * (1

D V

rE *

E V

c. Why Debt Policy DOES Matter i. Tax Advantage interest expenses deductible from corporate income

1. All else equal, levered firm pays less in taxes than all-equity firm 2. PV(tax shield) = TC * D, assuming permanent borrowing a. This is equal to corporate tax rate * interest payment / expected return on debt b. For more, search PV of Tax Shield or Space Babies 3. Firm value = Value of All-Equity Firm + PV (Tax Shield) 4. M-M I with corporate taxes suggests: Optimal = 100% debt

16

a. BUT company needs to have income to shield b. Alternative means to shield income from taxes c. Need to consider offsetting costs of debt 5. New M-M I: VL = VU + TCD+ Costs of Financial Distress ii. Costs of Financial Distress 1. Direct costs 2. Indirect Costs 3. Agency Costs a. When firm is levered, conflict b/w interests of stockholder and bondholder arise b. Temptation to cash in and run, play for time, bait and switch c. Undertake negative NPV investments corporate waste) 4. Adjusted Present Value = Base Case NPV + PV Impact iii. Trade-Off Theory 1. Capital structure is a tradeoff between tax savings and distress costs of debt 2. Companies with intangible assets have higher costs of distress; should have lower D/E ratios. Safe tangible asset companies should have high D/E ratios 3. Consistent with industry differences in structure 4. BUT some highly profitable companies like MSFT/PFE have minimal debt iv. Pecking-Order Theory 1. Premise = asymmetric information 2. Issuing equity signals managers belief that firm is overvalued the firms stock price will fall, so issue debt if possible 3. Issue debt next; choose safest debt first 4. Conflicts with Trade-off Theory (Look up Tensions b/w Theories)

XI. Options
a. Payoff Diagrams (x-axis is stock price; y-axis is payoff) b. Buying a call:

c. Selling a call:

17

d. Buying a put:

e. Selling a put

f.

Protective Put (buy stock;

buy put) Downside protection, w upside potential

g. Straddle (buy call, buy put) Profit from volatility

h. Downside Protection (buy call and have bank deposit paying the strike price same payoff diagram as the protective put i. j. Put-Call Parity: Value of call + PV of exercise price = Value of put + Share price Option value determinants: Factor (as this goes higher) Stock price (intrinsic value) Exercise price (intrinsic) Interest rate (speculative) Volatility (speculative) Effect on Call Price + + + + Effect on Put Price +

Expiration date + + (speculative) k. Intrinsic value = difference between exercise price and spot price of underlying asset l. Speculative value = difference between option price and intrinsic value of option

XII. Executive Compensation

a. Goal = reduce Principal-Agent problem b. Options

compensation incentivizes, but:

18

i. ii. iii. i.

Too many options might make managers reckless Need to get the right mix of stocks / options / other forms of compensation to get incentives correct Option compensation might run risk of Lower the strike price so options dont fall out FASB said no, but firms found

self-dealing c. Options Repricing of the money ii. backdoor means d. Options Backdating i. Manager designates grant date earlier than date board made Estimated cost = $500mm per sample decision to grant options ii. firm e. Options Forward Dating i. i. If stock price has been falling, manager designates Option Reloading Exercise price of new options set to Receive a new option for each received when you later grant date f.

exercise options ii. new stock price

g. Bullet Dodging delay options grant until just after bad news h. i. Spring loading time an options grant to precede good news Checks: SEC disclosure rules; substantive restrictions

XIII. Yields
a. An example: Bond has par of $1K, 5% coupon, 20% chance of bankruptcy (will only pay $500) i. Expected CF = (1050 * 0.8) + (500 * 0.2) = $940 1. Value = $940 / 1.05 = $895 2. YTM = (1050 / 895) 1 = 17.3% b. Default Option: i. Bond value = bond value assuming no default, less value of put option on assets

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