topic a (ch 1, week1)

1.

Cores of Learning in This Chapter

The determinants of interest ratesTerm structurePure expectations hypothesis

2.

Overview of Financial Management

Definition of finance

Financial management functions

Goals of the corporation

Financial markets

Interest rates and yield curves

3.

Definition of finance

Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among individuals and organizations.

Definition of finance

4.

Relationships among investors, firms, and financial markets

FinancialInstitutions

FinancialMarkets

FirmsInvestors

Funds Funds

Funds Funds

Deposit certificates

Loan contracts

Securities Securities

5.

Forecasting and planning

Investment and financing decisions

Coordination and control

Transactions in the financial markets

Managing risk

Financial management functions

6.

The primary goal is shareholder wealth maximization, which translates to maximizing stock price.Should firms behave ethically? YES!Do firms have any responsibilities to

society at large? YES! Shareholders are also members of society.

Goals of the Corporation

7.

Is maximizing stock price good for society, employees, and customers?

Actions maximizing stock price also benefit society: managers that maximize stock price improve

the quality of lives of their owners, a lot of whom are ordinary citizens

stock price maximization requires efficient, low-cost operations that produce high quality products that benefit consumers

Companies that successfully increase stock price also grow and add more employees, thus benefiting employees

8.

Amount of cash flows expected by shareholders

Timing of the cash flow stream

Risk of the cash flows

Figure 1-1 (slide 12).

Factors that AffectCompany Value (Stock Price)

9.

Factors that Affect the Amountof Cash Flows

Sales Revenues (investment decisions)

Increase unit sales单位销售额 by providing what customers want

Develop new products for higher prices

Operating costs and taxes

Reduce operating costs by supply chain management and employee training, etc.

Investments in operations

Reduce asset requirements: e.g. JIT

10.

Factors that Affect the Riskof Cash Flows (WACC)

Financing decisions: wd, wce

Capital structureSpecific type of financing

Interest rate: rRF

Firm risk: betaBusiness characteristics

Market risk: rM - rRF

Stock market investors’ overall attitude toward risk

11.

Value of OperationsThe Influence of Timing onCompany Value

)WACC1(

FCF....

)WACC1(

FCF

)WACC1(

FCFValue

22

11

12.

Value of OperationsDeterminants of A Firm’s Value

Sales

Revenues

OperatingCosts and

Taxes

RequiredInvestments

in Operations

Financing

Decisions

Interest

Rates

Firm

Risk

Market

Risk

Free Cash Flows

(FCF)

Weighted AverageCost of Capital

(WACC)

Value of the Firm

)WACC1(

FCF....

)WACC1(

FCF

)WACC1(

FCFValue

22

11

Amount of cash flows Risk of cash flows

Timing of cash flows

13.

The Financial Environment

Financial marketsDeterminants of interest ratesYield curves 产出曲线

14.

Define these markets

A market is a method of exchanging one asset (usually cash) for another asset.

Markets for physical assets Markets for financial assets Money versus capital markets Primary versus secondary markets Spot versus futures markets

15.

What do we call the price, or cost, of debt capital?

The interest rate

What do we call the price, or cost, of equity capital?

Required Dividend Capital return yield gain= + .

16.

What four factors affect the costof money?

Production opportunities (r*)Time preferences for consumption

(r*)Risk (DRP, LP, MRP)Expected inflation (IP)

17.

Real versus Nominal Rates

r = Any nominal rate.

= Real risk-free rate. T-bond rate if no inflation; 1% to 4% (0.67% for an inflation-indexed treasury bond of 4-year maturity in Apr. 2003)= Rate on Treasury securities= r* + IP.

r *

rRF

18.

r = r* + IP + DRP + LP + MRP.

Here:

r = Required rate of return on a debt security.

r* = Real risk-free rate.

IP = Inflation premium.

DRP = Default risk premium (0.6-3.5%).

LP = Liquidity premium (2-5%).

MRP = Maturity risk premium (1-3%).

19.

Premiums Added to r* for Different Types of Debt

ST Treasury: only IP for ST inflationLT Treasury: IP for LT inflation, MRPST corporate: ST IP, DRP, LPLT corporate: LT IP, DRP, LP, MRP

(Besides MRP, DRP and LP are also larger for long-term bond. • There is a higher default risk in a longer maturity.• Due to low DRP and MRP of short-term bond, a buyer can buy it without doing much credit checking. higher liquidity)

20.

What is the “term structure of interest rates”? What is a “yield curve”?

Term structure: the relationship between interest rates (or yields) and maturities.

A graph of the term structure is called the yield curve.

21.

Data for yield curve construction

Inflation rate – 5% next year, 6% the following year, and 8% thereafter.

Maturity risk premium – 0 for securities that mature within 1 year, 0.1% for 2-year security, MRP increase by 0.1% point per year thereafter up to year 20, after which it is stable.

Real risk-free rate is 3%.

22.

Yield Curve Construction

Step 1: Find the average expected inflation rate over years 1 to n:

n

INFLt

t = 1

nIPn = .

23.

IP1 = 5%/1.0 = 5.00%.

IP10 = [5 + 6 + 8(8)]/10 = 7.5%.

IP20 = [5 + 6 + 8(18)]/20 = 7.75%.

Must earn these IPs to break even versus inflation; that is, these IPs would permit you to earn r* (before taxes).

24.

Step 2: Find MRP based on this equation:

MRPt = 0.1%(t - 1).

MRP1 = 0.1% x 0 = 0.0%.

MRP10 = 0.1% x 9 = 0.9%.

MRP20 = 0.1% x 19 = 1.9%.

25.

Step 3: Add the IPs and MRPs to r*:

rRFt = r* + IPt + MRPt .

rRF = Quoted market interestrate on treasury securities.

If r* = 3%:

rRF1 = 3% + 5% + 0.0% = 8.0%.rRF10 = 3% + 7.5% + 0.9% = 11.4%.rRF20 = 3% + 7.75% + 1.9% = 12.65%.

26.

Hypothetical Treasury Yield Curve

0

5

10

15

1 10 20

Years to Maturity

InterestRate (%) 1 yr 8.0%

10 yr 11.4%20 yr 12.65%

Real risk-free rate

Inflation premium

Maturity risk premium

27.

What factors can explain the shape of this yield curve?

This constructed yield curve is upward sloping.

This is due to increasing expected inflation and an increasing maturity risk premium.

A yield curve can be downward sloping if the expected inflation is lower in the long-term than in the short-term. (decreasing IP, increasing MRP)

28.

What kind of relationship exists between the Treasury yield curve and the yield curves for corporate issues?

Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not necessarily parallel to the Treasury curve (The spread widens in maturity since DRP and LP are larger in longer maturity only for corporate bonds).

The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases (DRP, LP).

29.

Hypothetical Treasury and Corporate Yield Curves

0

5

10

15

0 1 5 10 15 20

Years tomaturity

Interest Rate (%)

5.2%5.9%

6.0%Treasuryyield curve

BB-Rated

AAA-Rated

30.

The Pure Expectations Hypothesis (PEH)

As large bond traders buy and sell long-term bonds as frequently as short-term bonds to pick up short-term profit, they are not exposed to MRP. Thus MRP = 0. (for long-term bonds, they are exposed to more LP, exposed to the same DRP compared to short-term bonds)

Shape of the yield curve depends on the investors’ expectations about future interest rates. Interest rate is an average of current and expected future short-term interest rates.

)IPr(n

1r i

n

1i

*iRFn