finma ii ~ presentation 1

7/31/2019 FinMa II ~ Presentation 1

1/48


2/48

Return to NPV

Example

The government is lending you $100,000 for 10 years

at 3% and only requiring interest payments prior to

maturity. Since 3% is obviously below market, whatis the value of the below market rate loan?

repaymentloanofPV-

pmtsinterestofPV-borrowedamountNPV =


3/48

Return to NPV

Example

The government is lending you $100,000 for 10 years at 3% and only

requiring interest payments prior to maturity. Since 3% is obviously below

market, what is the value of the below market rate loan?

Assume the market return on equivalent risk projects is 10%.

012,43$

988,56000,100

)10.1(

000,100

)10.1(

000,3000,001NPV

10

10

1

=

=

=

=tt


4/48

Random Walk Theory

The movement of stock prices from day to day

DO NOT reflect any pattern.

Statistically speaking, the movement of stock

prices is random (skewed positive over the long term).


5/48

Random Walk Theory

$103.00

$100.00

$106.09

$100.43

$97.50

$100.43

$95.06

Coin Toss Game

Heads

Heads

Heads

Tails

Tails

Tails


6/48

Random Walk Theory

S&P 500 Five Year Trend?

or

5 yrs of the Coin Toss Game?

80

130

Month

Level


7/48

Random Walk Theory

S&P 500 Five Year Trend?

or

5 yrs of the Coin Toss Game?

80

130

180

230

Month

Level


8/48

Efficient Market Theory

Last

Month

This

Month

Next

Month

$90

70

50

MicrosoftStock Price

Cycles

disappear

once

identified

Actual price as soon as upswing is

recognized


9/48

Random Walk Theory


10/48

Random Walk Theory

R

eturninweekt+

1,

(%)

Return in week t, (%)

FTSE 100(correlation = -.08)


11/48

Random Walk Theory

R

eturninweekt+

1,

(%)


Nikkei 500(correlation = -.06)


12/48

Random Walk Theory

R

eturninweekt+

1,

(%)


DAX 30(correlation = -.03)


13/48

Random Walk Theory

R

eturninweekt+

1,

(%)


S&P Composite

(correlation = -.07)


14/48


Weak Form Efficiency

Market prices reflect all historical information

Semi-Strong Form Efficiency

Market prices reflect all publicly available

information

Strong Form Efficiency

Market prices reflect all information, both public

and private


15/48


Fundamental Analysts

Research the value of stocks using NPV and other

measurements of cash flow


16/48


Technical Analysts

Forecast stock prices based on the watching the

fluctuations in historical prices (thus wiggle

watchers)


17/48


-16

-11

-6

-1

4

9

14

19

24

29

34

39

Days Relative to annoncement date

Cum

ulativeAbnorm

alReturn

(%)

Announcement Date


18/48


-40

-30

-20

-10

0

10

20

30

40

1962

1977

1992

Return(%)

Funds

Market

Average Annual Return on 1493 Mutual Funds and theMarket Index


19/48


0

5

10

15

20

First Second Third Fourth Fifth

AverageReturn(%)

IPO

Matched Stocks

IPO Non-Excess Returns

Year After

Offering


20/48


2000 Dot.Com Boom

883,1208.092.

6.154

)( 2000March === gr

Div

indexPV

589,8074.092.

6.154)( 2002October =

=

=

gr

DivindexPV


21/48

Lessons of Market Efficiency

Markets have no memory

Trust market prices

Read the entrails

There are no financial illusions

The do it yourselfalternative

Seen one stock, seen them all


22/48

M&M (Debt Policy Doesnt Matter)

Modigliani & Miller

When there are no taxes and capital markets

function well, it makes no difference whether the

firm borrows or individual shareholders borrow.Therefore, the market value of a company does

not depend on its capital structure.


23/48

M&M (Debt Policy Doesnt Matter)Assumptions

By issuing 1 security rather than 2, companydiminishes investor choice. This does not reducevalue if:

Investors do not need choice, OR

There are sufficient alternative securities

Capital structure does not affect cash flows e.g...

No taxes

No bankruptcy costs

No effect on management incentives


24/48


Profits01.01V.

urnDollar RetInvestmentDollar

U

L

LL

L

L

01V.Profits01.)E01(D.Total

Interest)-Profits(01.01E.Equity

Interest.0101D.Debt


=

+


25/48


).01(V

interest)-Profits(01.01E.


LL

L

D=

Interest)-Profits(01.)D01(V.Total

Profits01.01V.Equity

Interest.01-01D.Borrowing


LU

U

L

+


26/48

Example - Macbeth Spot Removers - All Equity Financed

201510%5(%)sharesonReturn

2.001.501.00$.50shareperEarnings

2,0001,5001,000$500IncomeOperatingDCBA

Outcomes

10,000$SharesofValueMarket

$10shareperPrice

1,000sharesofNumber

Data


Expected

outcome


27/48

Examplecont.

50% debt


3020100%(%)sharesonReturn

321$0shareperEarnings

500,11,000500$0earningsEquity

500500500$500Interest

000,21,5001,000$500IncomeOperating

CBA

Outcomes

5,000$debtofueMarket val

5,000$SharesofValueMarket

$10shareperPrice

500sharesofNumber

Data

D


28/48

Example - Macbeths - All Equity Financed- Debt replicated by investors

3020100%(%)investment$10onReturn

3.002.001.000$investmentonearningsNet1.001.001.00$1.0010%@Interest:LESS

4.003.002.00$1.00sharestwoonEarnings

DCBAOutcomes



29/48

MM'S PROPOSITION I

If capital markets are doing their job,

firms cannot increase value by tinkering

with capital structure.

V is independent of the debt ratio.

AN EVERYDAY ANALOGY

It should cost no more to assemble a

chicken than to buy one whole.

No Magic in Financial Leverage


30/48

Proposition I and Macbeth

2015(%)shareperreturnExpected

1010($)shareperPrice

2.001.50($)shareperearningsExpectedEquityandDebtEqual

:StructureProposed

EquityAll

:StructureCuttent

Macbeth continued


31/48

Leverage and Returns

securitiesallofuemarket val

incomeoperatingexpectedrassetsonreturnExpected a ==

++

+=

ED

E

rED

D

rr EDA


32/48

M&M Proposition II

15.000,10

1500securitiesallofuemarket val

incomeoperatingexpectedrr AE

==

==

( )V

Drrrr DAAE +=

Macbeth continued


33/48

M&M Proposition II

15.000,10

1500

securitiesallofuemarket val

incomeoperatingexpectedrr AE

==

==

( )

20%or20.

5000

500010.15.15.

=

+=Er

Macbeth continued( )VDrrrr DAAE+=


34/48

Leverage and Risk

20%-020%sharesonReturn

$2.00-02($)shareperEarnings:debt%50

10%-5%15%sharesonReturn

$1.00-0.501.50($)shareperEarningsequityAll

Change

$500

Income

to$1,500

Operating

Macbeth continuedLeverage increases the risk of Macbeth shares


35/48


Asset Value 100 Debt (D) 40

Equity (E) 60

Asset Value 100 Firm Value (V) 100

rd = 7.5%

re = 15%

Market Value Balance Sheet example

%75.12100

6015.

100

40075. =

+

=

++

+=

A

EDA

r

ED

Er

ED

Drr


36/48


Asset Value 100 Debt (D) 40

Equity (E) 60

Asset Value 100 Firm Value (V) 100

rd = 7.5% changes to 7.875%

re = ??

Market Value Balance Sheet example continued

What happens to Re when debt costs rise?

%0.16

100

60

100

4007875.1275.

=

+

=

e

e

r

r


37/48


+

=

V

EB

V

DBB EDA

( )DAAE BBVD

BB +=


38/48

WACC

+

==

V

Er

V

DrrWACC EDA

WACC is the traditional view of capitalstructure, risk and return.


39/48

r

D

V

rD

rE

rE =WACC

WACC


40/48

r

D

E

rD

rE

M&M Proposition II

rA

Risk free debt Risky debt


41/48

r

D

V

rD

rE

WACC

WACC (traditional view)


42/48

r

D

V

rD

rE

WACC

WACC (M&M view)


43/48

After Tax WACC

The tax benefit from interest expense

deductibility must be included in the cost of

funds.

This tax benefit reduces the effective cost of

debt by a factor of the marginal tax rate.

+

=

V

ErV

DrWACC ED

OldFormula


44/48

After Tax WACC

+

= V

ErV

DTcrWACC ED )1(

Tax Adjusted Formula

Aft T WACC


45/48

After Tax WACC

Example - Union Pacific

The firm has a marginal tax rate of 35%.

The cost of equity is 10.0% and thepretax cost of debt is 5.5%. Given the

book and market value balance sheets,

what is the tax adjusted WACC?

Aft T WACC


46/48

After Tax WACC

Example - Union Pacific - continued

Balance Sheet (Market Value, billions)

Assets 22.6 7.6 Debt

15 Equity

Total assets 22.6 22.6 Total liabilities

MARKET VALUES

Aft T WACC


47/48

After Tax WACC


+

= V

E

rV

D

TcrWACC ED )1(

Debt ratio = (D/V) = 7.6/22.6= .34 or 34%

Equity ratio = (E/V) = 15/22.6 = .66 or 66%

Aft T WACC


48/48

After Tax WACC


+

=

V

Er

V

DTcrWACC ED )1(

( ) ( )

%8.7078.

66.10.34.)35.1(055.

==

+=WACC

finma ii ~ presentation 1

Documents