FIN 500 Class Web Page, Fall '17
Business Finance Online, an interactive learning tool for the Corporate Finance Student https://www.zenwealth.com/BusinessFinanceOnline/index.htm
Weekly SCHEDULE, LINKS, FILES and Questions
Coverage, HW, Supplements
Week 1, 2
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Capital Flow Chart (pdf)
Chapter 5 Time value of money 1
Concept of FV, PV, Rate, Nper
Calculation of FV, PV, Rate, Nper
Concept of interest rate, compounding rate, discount rate
Chapter 6 Time Value of Money 2
Concept of PMT, NPV
Calculation of FV, PV, Rate, Nper, PMT, NPV, NFV
Concept of EAR, APR
Calculation of EAR, APR
HOMEWORK of Chapters 5 and 6 (due on 11/28)
1. The Thailand Co. is considering the purchase of some new equipment. The quote consists of a quarterly payment of $4,740 for 10 years at 6.5 percent interest. What is the purchase price of the equipment? ($138,617.88)
condominium at the beach that you want to buy costs $249,500. You plan to
make a cash down payment of 20 percent and finance the balance over 10 years
at 6.75 percent. What will be the amount of your monthly mortgage
4. Shannon wants
to have $10,000 in an investment account three years from now. The account
will pay 0.4 percent interest per month. If Shannon saves money every month,
starting one month from now, how much will she have to save each month?
5. Trevor's Tires
is offering a set of 4 premium tires on sale for $450. The credit terms are
24 months at $20 per month. What is the interest rate on this
12. Fred was
persuaded to open a credit card account and now owes $5,150 on this card.
Fred is not charging any additional purchases because he wants to get this
debt paid in full. The card has an APR of 15.1 percent. How much longer will
it take Fred to pay off this balance if he makes monthly payments of $70
rather than $85? (93.04 months)
13. Bridget plans
to save $150 a month, starting today, for ten years. Jordan plans to save
$175 a month for ten years, starting one month from today. Both Bridget and
Jordan expect to earn an average return of 8 percent on their savings. At the
end of the ten years, Jordan will have approximately _____ more than
14. What is the
future value of weekly payments of $25 for six years at 10 percent? ($10,673.90)
15. At the end of this month, Bryan will start saving $80 a month for retirement through his company's retirement plan. His employer will contribute an additional $.25 for every $1.00 that Bryan saves. If he is employed by this firm for 25 more years and earns an average of 11 percent on his retirement savings, how much will Bryan have in his retirement account 25 years from now? ($157,613.33)
Investments offers an annuity due with semi-annual payments for 10 years at 7
percent interest. The annuity costs $90,000 today. What is the amount of each
annuity payment? ($6,118.35)
17. Mr. Jones just won a lottery prize that will pay him $5,000 a year for thirty years. He will receive the first payment today. If Mr. Jones can earn 5.5 percent on his money, what are his winnings worth to him today? ($76,665.51)
18. You want to save $75 a month for the next 15 years and hope to earn an average rate of return of 14 percent. How much more will you have at the end of the 15 years if you invest your money at the beginning of each month rather than the end of each month? ($530.06)
19. What is the
effective annual rate of 10.5 percent compounded semi-annually? (10.78%)
22. What is the effective annual rate of 12.75 percent compounded daily? (13.60 percent)
grandparents loaned you money at 0.5 percent interest per month. The APR on
this loan is _____ percent and the EAR is _____ percent. (6.00; 6.17)
FV = PV *(1+r)^n
PV = FV / ((1+r)^n)
N = ln(FV/PV) / ln(1+r)
Rate = (FV/PV)1/n -1
N = ln(FV/C*r+1)/(ln(1+r))
N = ln(1/(1-(PV/C)*r)))/ (ln(1+r))
EAR = (1+APR/m)^m-1
APR = (1+EAR)^(1/m)*m
To get FV, use FV function.
=abs(fv(rate, nper, pmt, pv))
To get PV, use PV function
= abs(pv(rate, nper, pmt, fv))
To get r, use rate function
= rate(nper, pmt, pv, -fv)
To get number of years, use nper function
= nper(rate, pmt, pv, -fv)
To get annuity payment, use PMT function
= pmt(rate, nper, pv, -fv)
To get Effective rate (EAR), use Effect function
= effect(nominal_rate, npery)
To get annual percentage rate (APR), use nominal function
= nominal(effective rate, npery)
Fall of Lehman Brother part i
Fall of Lehman Brother part ii
Fall of Lehman Brother part iii
Fall of Lehman Brother part iv
Fall of Lehman Brother part v
Fall of Lehman Brother part vi
Chapter 7 Bond Pricing
Simplified Balance Sheet of WalMart
· What is this “long term debt”?
· Who is the lender of this “long term debt”?
So this long term debt is called bond in the financial market. Where can you find the pricing information and other specifications of the bond issued by WMT?
How Bonds Work (video)
FINRA – Bond market information
WAL-MART STORES INC
For class discussion:
Fed has hiked interest rates. So, shall you invest in short term bond or long term bond?
1. Find bond sponsored by WMT
just go to www.finra.org, è Investor center è market data è bond è corporate bond
2. 2. Understand what is coupon, coupon rate, yield, yield to maturity, market price, par value, maturity, annual bond, semi-annual bond, current yield.
3. 3. Understand how to price bond
Bond price = abs(pv(yield, maturity, coupon, 1000)) ------- annual coupon
Bond price = abs(pv(yield/2, maturity*2, coupon/2, 1000)) ------- semi-annual coupon
Also change the yield and observe the price changes. Summarize the price change pattern and draw a graph to demonstrate your findings.
Again, when yield to maturity of this semi_annual coupon bond is 4%, how should this WMT bond sell for?
4. Understand how to calculate bond returns
Yield to maturity = rate(maturity, coupon, -market price, 1000) – annual coupon
Yield to maturity = rate(maturity*2, coupon/2, -market price, 1000)*2 – semi-annual coupon
For example, when the annual coupon bond is selling for $1,100, what is its return to investors?
For example, when the semi-annual coupon bond is selling for $1,100, what is its return to investors?
5. Current yield: For the above bond, calculate current yield.
6. Zero coupon bond: coupon=0 and treat it as semi-annual coupon bond.
Example: A ten year zero coupon bond is selling for $400. How much is its yield to maturity?
A ten year zero coupon bond’s yield to maturity is 10%. How much is its price?
7. Understand what is bond rating and how to read those ratings.
a. Who are Moody, S&P and Fitch?
b. What is WMT’s rating?
c. Is the rating for WMT the highest?
d. Who earned the highest rating?
HW due week 5 (Due on 11/28)
Refer to the above table and answer questions 1-4 . 5-8 are deleted.
1. How much is the coupon?
2. This WMT bond is callable. This means that when interest rate increases, Wal-Mart might call this bond back from bondholders. True _____ False _____
3. Moody’s rating of this bond is Aa2 for this bond. Assume that GE’s bond rating is A. JEA’s rating is B+. Treasury bond’s rating is AAA. Rank the risk of the four bonds from low to high.
4. Calculate the current yield based on the above table.
9. Firm AAA’s bonds price = $850. Coupon rate is 5% and par is $1,000. The bond has six years to maturity. Calculate for current yield? (5.88%)
10. For a zero coupon bond, use the following information to calculate its yield to maturity. (14.35%) Years left to maturity = 10 years. Price = $250.
11. For a zero coupon bond, use the following information to calculate its price. ($456.39) Years left to maturity = 10 years. Yield = 8%.
12. Imagine that an annual coupon bond’s coupon rate = 5%, 15 years left. Draw price-yield profile. (hint: Change interest rate, calculate new price and draw the graph).
13. IBM 5 year 2% annual coupon bond is selling for $950. How much this IBM bond’s YTM? 3.09%
14. IBM 10 year 4% semi-annual coupon bond is selling for $950. How much is this IBM bond’s YTM? 4.63%
15. IBM 10 year 5% annual coupon bond offers 8% of return. How much is the price of this bond? 798.7
16. IBM 5 year 5% semi-annual coupon bond offers 8% of return. How much is the price of this bond? $878.34
17. IBM 20 year zero coupon bond offers 8% return. How much is the price of this bond?
18. Collingwood Homes has a bond issue outstanding that pays an 8.5 percent coupon and matures in 18.5 years. The bonds have a par value of $1,000 and a market price of $964.20. Interest is paid semiannually. What is the yield to maturity? (8.90%)
19. Grand Adventure Properties offers a 9.5 percent coupon bond with annual payments. The yield to maturity is 11.2 percent and the maturity date is 11 years from today. What is the market price of this bond if the face value is $1,000?
20. The zero coupon bonds of D&L Movers have a market price of $319.24, a face value of $1,000, and a yield to maturity of 9.17 percent. How many years is it until these bonds mature? (12.73 years)
21. A zero coupon bond with a face value of $1,000 is issued with an initial price of $212.56. The bond matures in 25 years. What is yield to maturity? (6.29%)
22. The bonds issued by Stainless Tubs bear a 6 percent coupon, payable semiannually. The bonds mature in 11 years and have a $1,000 face value. Currently, the bonds sell for $989. What is the yield to maturity? (6.14%)
Bond Pricing Formula (FYI)
Bond Pricing Excel Formula
Summary of bond pricing excel functions
To calculate bond price (annual coupon bond):
Price=abs(pv(yield to maturity, years left to maturity, coupon rate*1000, 1000)
To calculate yield to maturity (annual coupon bond)::
Yield to maturity = rate(years left to maturity, coupon rate *1000, -price, 1000)
To calculate bond price (semi-annual coupon bond):
Price=abs(pv(yield to maturity/2, years left to maturity*2, coupon rate*1000/2, 1000)
To calculate yield to maturity (semi-annual coupon bond):
Yield to maturity = rate(years left to maturity*2, coupon rate *1000/2, -price, 1000)*2
To calculate number of years left(annual coupon bond)
Number of years =nper(yield to maturity, coupon rate*1000, -price, 1000)
To calculate number of years left(semi-annual coupon bond)
Number of years =nper(yield to maturity/2, coupon rate*1000/2, -price, 1000)/2
To calculate coupon (annual coupon bond)
Coupon = pmt(yield to maturity, number of years left, -price, 1000)
Coupon rate = coupon / 1000
To calculate coupon (semi-annual coupon bond)
Coupon = pmt(yield to maturity/2, number of years left*2, -price, 1000)*2
Coupon rate = coupon / 1000
Chapter 8 Stock Valuation
from google.com/finance for Wal-Mart (NYSE:WMT)
Stock screening tools
· Reuters stock screener to help select stocks
· WSJ stock screen
· Simply the Web's Best Financial Charts
You can find analyst rating from MSN money
Zacks average brokerage recommendation is Moderate Buy
How to pick stocks
Capital Asset Pricing Model (CAPM)Explained
Ranking stocks using PEG ratio
Summary of stock screening rules from class discussion
PE<15 (? FB’s PE>100?)
Analyst ranking: strong buy only
Zacks average =1 (from Ranking stocks using PEG ratio)
· Stockholders’ rights
· Risk and return – where to find how risky the stock is
2. Calculate stock prices
1) Given next dividends and price expected to be sold for
Po= + +
Po= + ++
2) Given all dividends – Dividend growth model
R = D1/Po+g = Do*(1+g)/Po+g
D1=Do*(1+g); D2= D1*(1+g)…
Where Po: current stock price; D1: next period dividend; r: stock return; g: dividend growth rate
Do: current dividend
1. Consider the valuation of a common stock that paid $1.00 dividend at the end of the last year and is expected to pay a cash dividend in the future. Dividends are expected to grow at 10% and the investors required rate of return is 17%. How much is the price?
2. The current market price of stock is $90 and the stock pays dividend of $3 with a growth rate of 5%. What is the return of this stock?
5. Avoid emotional investing
3) Mental accounting
5) Gambler’s fallacy
6. How to pick stocks – Does it work?
PEG ratio (peg ratio vs. PE ratio – video)
HOMEWORK (Due 11/28)
1. Northern Gas recently paid a $2.80 annual dividend on its common stock. This dividend increases at an average rate of 3.8 percent per year. The stock is currently selling for $26.91 a share. What is the market rate of return? (14.60 percent)
2. Douglass Gardens pays
an annual dividend that is expected to increase by 4.1 percent per year. The
stock commands a market rate of return of 12.6 percent and sells for $24.90 a
share. What is the expected amount of the next dividend? ($2.12)
4. The current market price of stock is $50 and the stock is expected to pay dividend of $2 with a growth rate of 6%. How much is the expected return to stockholders? (10%)
5. Investors of Creamy Custard common stock earns 15% of return. It just paid a dividend of $6.00 and dividends are expected to grow at a rate of 6% indefinitely. What is expected price of Creamy Custard's stock? ($70.67)
6. Read “2017 US Equity Outlook: Democracy in America and the Triumph of Hope over Fear”. On page 10, the authors say that “we recommend three strategies for US equity investors”. What are the three strategies? Paper is in blackboard under course documents /introduction
See the following for the summary of the paper above.
Summary of Goldman Sachs 2017 Market Outlook
2017 US Equity Outlook: Democracy in America and the Triumph of Hope over Fear
November 28, 2016
· US equity investors have focused “more on hope than fear” since Donald Trump’s election. Ironically, many commentators believe his campaign rhetoric focused “more on fear than hope.” In 2017, we expect the stock market will be animated by competing views of whether economic policies and actions of President Trump and a Republican Congress instill hope or fear.
· “Hope” will dominate through 1Q 2017 as S&P 500 climbs by 9% to 2400. The inauguration occurs on January 20 and our Washington economist expects much legislation will be proposed during the first 100 days. The prospect of lower corporate taxes, repatriation of overseas cash, reduced regulations, and fiscal stimulus has already led investors to expect positive EPS revisions. Instead of our baseline adjusted EPS growth of 5% to $123, growth could accelerate to 11% and reach $130, which would support a P/E multiple above 18x. Top “Hope” investment recommendations: (1) Cyclicals vs. Defensives; (2) Stocks with high US versus foreign sales exposure; and (3) High tax rate companies.
· “Fear” is likely to pervade during 2H and S&P 500 will end 2017 at 2300, roughly 5% above the current level. Our economists expect inflation will reach the Fed’s 2% target, labor costs will be accelerating at an even faster pace, and policy rates will be 100 bp higher than today. Rising inflation and bond yields typically lead to a falling P/E multiple. Congressional deficit hawks may constrain Mr. Trump’s tax reform plans and the EPS boost investors expect may not materialize. Potential tariffs and uncertainty around other policy positions may raise the equity risk premium and lead to lower stock valuations in 2H. The median stock trades at the 98th percentile of historical valuation based on an array of metrics. Top “Fear” investment recommendations: (1) Low vs. High labor cost companies; and (2) Strong vs. Weak Balance Sheet stocks.
· Money flow represents a potential upside to our baseline forecast. Equity mutual fund and ETF inflows may benefit as investors lose money owning bonds. After years of active management underperformance and outflows, higher return dispersion will increase the alpha opportunity for investors skilled enough to capture it. Economic policy uncertainty and the later stages of the economic cycle are typically associated with higher stock return dispersion.
DEMOCRACY IN AMERICA AND THE TRIUMPH OF HOPE OVER FEAR
More than 180 years after it was first published, Alexis de Tocqueville’s Democracy in America remains the most insightful analysis of US society and its political economy. Although written in 1835, his description of the presidential elections is timeless: “For a long while before the appointed time has come, the election becomes the important and, so to speak, the all-engrossing topic of discussion. Factional ardor is redoubled, and all the artificial passions which the imagination can create in a happy and peaceful land are agitated and brought to light. . . . As the election draws near, the activity of intrigue and the agitation of the populace increase; the citizens are divided into hostile camps, each of which assumes the name of its favorite candidate; the whole nation glows with feverish excitement; the election is the daily theme of the press, the subject of private conversation, the end of every thought and every action, the sole interest of the present. It is true that as soon as the choice is determined, this ardor is dispelled, calm returns, and the river, which had nearly broken its banks, sinks to its usual level; but who can refrain from astonishment that such a storm should have arisen.” (Alexis de Tocqueville, Democracy in America, originally published 1835).
The words above perfectly characterize the nature of the 2016 election and the unexpected victory of Donald Trump. Another observation of de Tocqueville has particular relevance to our 2017 US equity outlook: “One of the principal vices of the elective system is that it always introduces a certain degree of instability into the internal and external policy of the estate.”
Policy uncertainty introduces a degree of instability to our 2017 forecast that has been absent in recent years. Of course, last year any reference to “policy uncertainty” would have related to the Fed’s own projections that it would raise the funds rate four times during 2016, although as of this writing it has not tightened even one time (but a hike is widely expected on December 14).
Uncertainty always exists when forecasting, but our projections for next year have more elements of instability than usual. Tax reform is widely anticipated but details of any corporate tax cuts are unknown. Policies on the repatriation of foreign earnings are unknown. Specifics regarding any aspect of fiscal stimulus are unknown. President-elect Trump has promised to reduce regulations, but specific policies have not yet been identified.
We expect no policy details will be available until March 2017 at the earliest. Our Washington, DC-based economist Alec Phillips anticipates draft budget resolutions from the House and Senate Budget Committees will be released towards the end of 1Q. These resolutions will show the top-line revenue, spending, and deficit projections for the next 10 years and include reconciliation instructions for the tax-writing and other committees relating to tax reform, infrastructure, and other fiscal issues. (see US Daily: A Fiscal Boost in 2017: How Much, How Fast?, November 17, 2016)
In March or April, our economist expects President Trump will submit a FY 2018 spending bill with detail on tax reform and health care proposals. Between April and July the actual budget resolutions will be debated on the floor of the House and Senate, the tax-writing committees will begin work on detailed legislation, and both chambers will consider the actual tax reform legislation.
In September, the final House/Senate conference report will be enacted before the October 1 start of FY 2018. Note that many of the details of tax reform are likely to change until final agreement is reached. Put simply, enormous tax and fiscal policy uncertainty will exist for almost all of 2017.
Trade is another area of great policy uncertainty. Reflecting on the Great Convention of 1831 relating to the tariff, de Tocqueville wrote: “The question of a tariff or free trade has much agitated the minds of Americans. The tariff was not only the subject of debate as a matter of opinion, but it affected some great material interests of the states.” The issues de Tocqueville identified nearly 200 years ago remain contemporary. The revenue impact on individual companies from potential tariffs, trade barriers, or a border-adjusted tax system will remain unknown until details are released by the new administration.
We end our political discussion on a hopeful note after cautioning investors about the unusual uncertainty surrounding our 2017 forecast. As de Tocqueville observed: “The President is chosen for four years, and he may be re-elected, so that the chances of a future administration may inspire him with hopeful undertakings for the public good and give him the means of carrying them into execution.”
In some ways, the market response to the election of Donald Trump parallels the market’s heightened expectations following the December 2012 election of Shinzo Abe as the Prime Minister of Japan. After years of economic stagnation, Japan finally elected a politician committed to reflating the economy. Investors cheered and the TOPIX rallied by 6% during the ten days between the election and when he took office, and then surged by more than 50% within five months. We expect S&P 500 will rally during the next four months by a relatively modest 9%.
OUR 2017 US EQUITY FORECAST ASSUMES THE FOLLOWING:
1. Earnings. S&P 500 operating EPS will grow by 10% to $116 in 2017 and adjusted EPS will increase by 5% to $123.Investors are excited about a prospective cut in corporate taxes that could boost adjusted EPS to perhaps $130, representing growth of 11%. However, our economists are skeptical that all the anticipated tax cuts will take place given the federal budget deficit constraints. Some tax reform will take place and upside exists to our baseline EPS forecast but it will be less than many investors now expect.
2. Inflation and interest rates. In terms of inflation, core PCE will reach the Fed’s 2% objective by the end of next year. The Fed will hike interest rates next month and three additional times in 2017. Ten-year US Treasury yields will rise to 2.75%.
3. Valuation. S&P 500 currently trades at 19x our forward top-down operating EPS estimate, 18x our forward top-down adjusted EPS and 17x our upside adjusted EPS scenario. The market trades at 17x forward consensus bottom-up adjusted EPS. US equities are highly valued relative to history on most metrics and versus inflation and interest rates. We forecast static valuation during the next 12 months.
4. Path and target. We expect the S&P 500 index will rise to 2400 (+9%) by the end of 1Q as investors embrace the possibility that lower taxes will lead to positive EPS revisions. But less-than-expected tax cuts and higher inflation and interest rates will limit both upward EPS revisions and any P/E multiple expansion. S&P 500 will end next year at 2300, reflecting a price gain of 5% and a total return of 7% including dividends.
5. Buybacks and dividends. Buybacks will rise by 30% as companies repatriate cash held overseas. Dividends will rise by 6% in 2017, above the 4% growth rate currently implied by the dividend swap market.
6. “Hope” vs. “Fear” strategies: “Hope” will dominate during the first part of 2017 as Cyclicals beat Defensives. Firms with high domestic sales will outperform along with companies with high tax rates. “Fear” will dominate later in the year when investors focus on rising inflation and interest rates. Low labor cost and strong balance sheet firms will outperform.
This outlook was authored by GS Global Investment Research team.
Chapter 9 Capital Budgeting
1. NPV Excel syntax
Rate is the rate of discount over the length of one period.
Value1, value2, ... are 1 to 29 arguments representing the payments and income.
· Value1, value2, ... must be equally spaced in time and occur at the end of each period. NPV uses the order of value1, value2, ... to interpret the order of cash flows. Be sure to enter your payment and income values in the correct sequence.
2. IRR Excel syntax
Values is an array or a reference to cells that contain numbers for which you want to calculate the internal rate of return.
Guess is a number that you guess is close to the result of IRR.
3. MIRR( values, finance_rate, reinvest_rate )
Where the function arguments are as follows:
Chapter 9 Study Guide
Part I: Single project
Consider the following scenario.
You are reviewing a new project and have estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Your required return for assets of this risk level is 12%.
1) Using payback period method to make capital budgeting decision.
2) Using discounted payback period method to make capital budgeting decision.
3) Using net present value method (NPV) (answer: $12,627.41)
4) Using profitable index method (PI) (answer: 1.077)
5) Using the Internal Rate of Return method (answer: 16.13%)
6) Using modified IRR method (MIRR, using 12% for both investment rate and financing rate. Answer: 14.79%)
Part II: Multi-Projects
If the required rate of return is 10%. Which project shall you choose?
1) How much is the cross over rate? (answer: 11.8%)
2) How is your decision if the required rate of return is 13%? (answer: NPV of B>NPV of A)
· Rule for mutually exclusive projects: (answer: Choose B)
· What about the two projects are independent? (answer: Choose both)
More on IRR – (non-conventional cash flow)
Suppose an investment will cost $90,000 initially and will generate the following cash flows:
– Year 1: 132,000
– Year 2: 100,000
– Year 3: -150,000
The required return is 15%. Should we accept or reject the project?
1) How does the NPV profile look like? (Answer: Inverted)
2) IRR1= 10.11% -- answer
3) IRR2= 42.66% -- answer
An investment project has the following cash flows:
CF0 = -1,000,000; C01 – C08 = 200,000 each
If the required rate of return is 12%, what decision should be made using NPV?
How would the IRR decision rule be used for this project, and what decision would be reached?
How are the above two decisions related?
HOMEWORK(Due on 12/18)
Year Cash flows
1) How much is the payback period (approach one)? ---- 4 years
2) If the firm has a 10% required rate of return. How much is NPV (approach 2)?-- $2456.74
3) If the firm has a 10% required rate of return. How much is IRR (approach 3)? ---- 14.55%
4) If the firm has a 10% required rate of return. How much is PI (approach 4)? ---- 1.12
Question 2: Project with an initial cash outlay of $60,000 with following free cash flows for 5 years.
Initial outlay –60,000
The firm has a 15% required rate of return.
Calculate payback period, NPV, IRR and PI. Analyze your results.
Question 3: Mutually Exclusive Projects
1) Consider the following cash flows for one-year Project A and B, with required rates of return of 10%. You have limited capital and can invest in one but one project. Which one?
§ Initial Outlay: A = $200; B = $1,500
§ Inflow: A = $300; B = $1,900
2) Example: Consider two projects, A and B, with initial outlay of $1,000, cost of capital of 10%, and following cash flows in years 1, 2, and 3:
A: $100 $200 $2,000
B: $650 $650 $650
Which project should you choose if they are mutually exclusive? Independent? Crossover rate?
Chapter 14 Cost of Capital ppt
Discount rate to figure out the value of projects is called WACC (weighted average cost of capital)
WACC = weight of debt * cost of debt + weight of equity *( cost of equity)
Wd= total debt / Total capital = total borrowed / total capital
We= total equity/ Total capital
Cost of debt = rate(nper, coupon, -(price – flotation costs), 1000)*(1-tax rate)
Cost of Equity = D1/(Po – Flotation Cost) + g
D1: Next period dividend; Po: Current stock price; g: dividend growth rate
Note: flotation costs = flotation percentage * price
Or if beta is given, use CAPM model (refer to chapter 6)
Cost of equity = risk free rate + beta *(market return – risk free rate)
Cost of equity = risk free rate + beta * market risk premium
A firm borrows money from bond market. The price they paid is $950 for the bond with 5% coupon rate and 10 years to mature. Flotation cost is $40. For the new stocks, the expected dividend is $2 with a growth rate of 10% and price of $40. The flotation cost is $4. The company raises capital in equal proportions i.e. 50% debt and 50% equity (such as total $1m raised and half million is from debt market and the other half million is from stock market). Tax rate 34%. What is WACC (weighted average cost of capital, cost of capital)? (Answer: 9.84%)
1) Why does the firm raise capital from the financial market? Is there of any costs of doing so? What do you think?
2) What is cost of debt?
(Kd = rate(nper, coupon, -(price – flotation costs $)), 1000)*(1-tax rate))
3) Cost of equity? (Ke = (D1/(Price – flotation costs $)) +g, or Ke = Rrf + Beta*MRP))
Why no tax adjustment like cost of debt?
4) WACC=Cost of capital = Percentage of Debt * cost of debt + percentage of stock * cost of stock = Wd*Kd + We* Ke
Meaning: For a dollar raised in the capital market from debt holders and stockholders, the cost is WACC (or WACC * 1$ = several cents, and of course, the lower the better but many companies do not have good credits)
No homework for chapter 14
‘Simple Rules’ for Running a Business
From the 20-page cellphone contract to the five-pound employee handbook, even the simple things seem to be getting more complicated.
Companies have been complicating things for themselves, too—analyzing hundreds of factors when making decisions, or consulting reams of data to resolve every budget dilemma. But those requirements might be wasting time and muddling priorities.
So argues Donald Sull, a lecturer at the Sloan School of Management at the Massachusetts Institute of Technology who has also worked for McKinsey & Co. and Clayton, Dubilier & Rice LLC. In the book Simple Rules: How to Thrive in a Complex World, out this week from Houghton Mifflin Harcourt HMHC -1.36%, he and Kathleen Eisenhardt of Stanford University claim that straightforward guidelines lead to better results than complex formulas.
Mr. Sull recently spoke with At Work about what companies can do to simplify, and why five basic rules can beat a 50-item checklist. Edited excerpts:
WSJ: Where, in the business context, might “simple rules” help more than a complicated approach?
Donald Sull: Well, a common decision that people face in organizations is capital allocation. In many organizations, there will be thick procedure books or algorithms–one company I worked with had an algorithm that had almost 100 variables for every project. These are very cumbersome approaches to making decisions and can waste time. Basically, any decision about how to focus resources—either people or money or attention—can benefit from simple rules.
WSJ: Can you give an example of how that simplification works in a company?
Sull: There’s a German company called Weima GmBH that makes shredders. At one point, they were getting about 10,000 requests and could only fill about a thousand because of technical capabilities, so they had this massive problem of sorting out which of these proposals to pursue.
They had a very detailed checklist with 40 or 50 items. People had to gather data and if there were gray areas the proposal would go to management. But because the data was hard to obtain and there were so many different pieces, people didn’t always fill out the checklists completely. Then management had to discuss a lot of these proposals personally because there was incomplete data. So top management is spending a disproportionate amount of time discussing this low-level stuff.
Then Weima came up with guidelines that the frontline sales force and engineers could use to quickly decide whether a request fell in the “yes,” “no” or “maybe” category. They did it with five rules only, stuff like “Weima had to collect at least 70% of the price before the unit leaves the factory.”
After that, only the “maybes” were sent to management. This dramatically decreased the amount of time management spend evaluating these projects–that time was decreased by almost a factor of 10.
Or, take Frontier Dental Laboratories in Canada. They were working with a sales force of two covering the entire North American market. Limiting their sales guidelines to a few factors that made someone likely to be receptive to Frontier—stuff like “dentists who have their own practice” and “dentists with a website”—helped focus their efforts and increase sales 42% in a declining market.
WSJ: Weima used five factors—is that the optimal number? And how do you choose which rules to follow?
Sull: You should have four to six rules. Any more than that, you’ll spend too much time trying to follow everything perfectly. The entire reason simple rules help is because they force you to prioritize the goals that matter. They’re easy to remember, they don’t confuse or stress you, they save time.
They should be tailored to your specific goals, so you choose the rules based on what exactly you’re trying to achieve. And you should of course talk to others. Get information from different sources, and ask them for the top things that worked for them. But focus on whether what will work for you and your circumstances.
WSJ: Is there a business leader you can point to who has embraced the “simple rules” guideline?
Donald Sull: Let’s look at when Alex Behring took over America Latina Logistica SARUMO3.BR +1.59%, the Brazilian railway and logistics company. With a budget of $15 million, how do you choose among $200 million of investment requests, all of which are valid?
The textbook business-school answer to this is that you run the NPV (net present value) test on each project and rank-order them by NPV. Alex Behring knows this. He was at the top of the class at Harvard Business School.
Similarly, the global-health arm of the Gates Foundation gets many, many funding requests. But since they know that their goal is to have the most impact worldwide, they focus on projects in developing countries because that’s where the money will stretch farther.
FYI- The application of IRR in academic studies
Chapter 13 Return, Risk and Security Market Line
1. Pick three stocks. Has to be the leading firm in three different industries. (We chose Tesla, GE, and Wal-mart)
2. From finance.yahoo.com, collect stock prices of the above firms, in the past five years (Here is the excel solution, from November 2012 to November 2017)
Search for the company
Click on “Historical prices” in the left column on the tope
Change the starting date and ending date to “December 2nd, 2012” and “December 2nd, 2017”, respectively. (Download it to Excel
Delete all inputs, except “adj close” – this is the closing price adjusted for dividend.
3. Evaluate the performance of each stock: average return, and risk (standard deviation)
4. Let’s draw a normal distribution CURVE using the average return and the standard deviation of each firm
Normal distribution f(x)
Normal distribution F(x)
5. What is your conclusion?
6. Imagine you are rational and hold a highly diversified portfolio: return and risk of this portfolio?
Systematic risk vs. idiosyncratic risk;
Beta and its calculation
Use slope function to find beta in Excel beta = slope(return of each stock, market return)
7. SML(Security market line) and CAPM (Capital asset pricing model)
Stock return = risk free rate + beta *(market return – risk free rate) ---- CAPM
HOMEWORK (Due on 12/18):
1. An investor currently holds the following portfolio: He invested 30% of the fund in Apple with Beta equal 1.1. He also invested 40% in GE with Beta equal 1.6. The rest of his fund goes to Ford, with Beta equal 2.2. Use the above information to answer the following questions. The beta for the portfolio is? 1.63. The three month Treasury bill rate (this is risk free rate) is 2%. S&P500 index return is 10% (this is market return). Now calculate the portfolio’s return. 15.04%
2. The three month Treasury bill rate (this is risk free rate) is 2%. S&P500 index return is 10% (this is market return).
2. What is the value of A? 2%
3. What is the value of B? 10%
4. How much is the slope of the above security market line? 8%
5. Your uncle bought Apple in January, year 2000 for $30. The current price of Apple is $480 per share. Assume there are no dividend ever paid. Calculate your uncle’s holding period return. 15 times
6. Your current portfolio’s BETA is about 1.2. Your total investment is worth around $200,000. You uncle just gave you $100,000 to invest for him. With this $100,000 extra funds in hand, you plan to invest the whole $100,000 in additional stocks to increase your whole portfolio’s BETA to 1.5 (Your portfolio now worth $200,000 plus $100,000). What is the average BETA of the new stocks to achieve your goal? (hint: write down the equation of the portfolio’s Beta first) 2.10
Years Market r Stock A Stock B
1 3% 16% 5%
2 -5% 20% 5%
3 1% 18% 5%
4 -10% 25% 5%
5 6% 14% 5%
· Calculate the average returns of the market r and stock A and stock B. (Answer: -1%, 18.6%, 5%)
· Calculate the standard deviations of the market, stock A, & stock B (Answer: 6.44%, 4.21%; 0 )
· Calculate the correlation of stock market r and stock a. (Answer: -0.98)
· Assume you invest 50% in stock A and 50% in stock B. Calculate the average return and the standard deviation of the portfolio. (Answer: 11.8%; 2.11%)
Calculate beta of stock A and beta of stock B, respectively (Answer: -0.64, 0)
Final (Exam due on 12/18) – Check blackboard/course introduction for final exam questions