AFIN353 Slide 1

AFIN353 Week 1 2012
This publisher provided but modified set of slides is intended to guide ones reading before lecture. Refer to the Unit-guide [Unit Schedule p.14] for the reading particulars. As one would expect, no attempt is made in the lecture to deal with each of the slides in the set. A sub-set of slides will be displayed and discussed. Therefore, access to the handout version of the set of slides, in either soft or hard copy, will assist with note taking during the lecture and study for assessment tasks.
Copyright 2011 Pearson Education. All rights reserved.
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Learning Objectives
1. 2. Assess the relative merits of two-period projects using net present value. Define the term competitive market, give examples of markets that are competitive and some that arent, and discuss the importance of a competitive market in determining the value of a good. Calculate the no-arbitrage price of an investment opportunity. Show how value additivity can be used to help managers maximize the value of the firm. Describe the Separation Principle.
3. 4. 5.
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Learning Objectives (contd)

6. Calculate the value of a risky asset, using the Law of One Price. 7. Describe the relationship between a securitys risk premium and its correlation with returns of other securities. 8. Describe the effect of transactions costs on arbitrage and the Law of One Price. 9. Describe the impact of efficient markets hypothesis on positive-NPV trades by individuals with no inside information.
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Learning Objectives (contd)

10. Discuss why investors who identify positive-NPV trades should be skeptical about their findings, unless they have inside information or a competitive advantage. As part of that, describe the return the average investor should expect to get. 11. Assess the impact of stock valuation on recommended managerial actions.
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Ch 3.1 Valuing Decisions Identify Costs and Benefits

May need help from other areas in identifying the relevant costs and benefits
Marketing Economics Organizational Behavior Strategy Operations
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Analyzing Costs and Benefits Suppose a jewelry manufacturer has the opportunity to trade 10 ounces of platinum and receive 20 ounces of gold today. To compare the costs and benefits, we first need to convert them to a common unit.
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Analyzing Costs and Benefits (cont'd) Suppose gold can be bought and sold for a current market price of $250 per ounce. Then the 20 ounces of gold we receive has a cash value of:
(20 ounces of gold) X ($250/ounce) = $5000 today
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Analyzing Costs and Benefits (cont'd) Similarly, if the current market price for platinum is $550 per ounce, then the 10 ounces of platinum we give up has a cash value of:
(10 ounces of platinum) X ($550/ounce) = $5500
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Analyzing Costs and Benefits (cont'd) Therefore, the jewelers opportunity has a benefit of $5000 today and a cost of $5500 today. In this case, the net value of the project today is:
$5000 $5500 = $500
Because it is negative, the costs exceed the benefits and the jeweler should reject the trade.
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Using Market Prices to Determine Cash Values Competitive Market

A market in which goods can be bought and sold at the same price.
In evaluating the jewelers decision, we used the current market price to convert from ounces of platinum or gold to dollars.
We did not concern ourselves with whether the jeweler thought that the price was fair or whether the jeweler would use the silver or gold.
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Textbook Example 3.1
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Textbook Example 3.1 (cont'd)
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Alternative Example 3.1 Problem

Your car recently broke down and it needs $2,000 in repairs. But today is your lucky day because you have just won a contest where the prize is either a new motorcycle, with a MSRP of $15,000, or $10,000 in cash. You do not have a motorcycle license, nor do you plan on getting one. You estimate you could sell the motorcycle for $12,000. Which prize should you choose?
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Alternative Example 3.1 (cont'd) Solution

Competitive markets, not your personal preferences (or the MSRP of the motorcycle), are relevant here: One Motorcycle with a market value of $12,000 or $10,000 cash. Instead of taking the cash, you should accept the motorcycle, sell it for $12,000, use $2,000 to pay for your car repairs, and still have $10,000 left over.
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You are offered the following investment opportunity: In exchange for $27,000 today, you will receive 2,500 shares of stock in the Ford Motor Company and 10,000 euros today. The current market price for Ford stock is $9 per share and the current exchange rate is $1.50 per .Should you take this opportunity? Would your decision change if you believed the value of the euro would rise over the next month?
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Alternative Example 3.2 (cont'd)

Solution
The costs and benefits must be converted to their cash values. Assuming competitive market prices: 2,500 shares $9/share = $22,500 10,000 $1.50/ = $15,000 The net value of the opportunity is $22,500 + $15,000 $40,000 = -$2,500, we should not take it. This value depends only on the current market prices for Ford and the euro. Our personal opinion about the future prospects of the euro and Ford does not alter the value the decision today.
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Ch 3.5 No-Arbitrage and Security Prices Valuing a Security with the Law of One Price
Assume a security promises a risk-free payment of $1000 in one year. If the risk-free interest rate is 5%, what can we conclude about the price of this bond in a normal market?
PV ($1000 in one year) ($1000 in one year) (1.05 $ in one year / $ today) $952.38 today
Price(Bond) = $952.38
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Identifying Arbitrage Opportunities with Securities

What if the price of the bond is not $952.38?
Assume the price is $940.
Table 3.3 Net Cash Flows from Buying the Bond and Borrowing
The opportunity for arbitrage will force the price of the bond to rise until it is equal to $952.38.
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Identifying Arbitrage Opportunities with Securities

What if the price of the bond is not $952.38?
Assume the price is $960.
Table 3.4 Net Cash Flows from Selling the Bond and Investing
The opportunity for arbitrage will force the price of the bond to fall until it is equal to $952.38.
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Determining the No-Arbitrage Price Unless the price of the security equals the present value of the securitys cash flows, an arbitrage opportunity will appear. No Arbitrage Price of a Security Price(Security) PV (All cash flows paid by the security)
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Determining the Interest Rate From Bond Prices If we know the price of a risk-free bond, we can use
Price(Security) PV (All cash flows paid by the security)
to determine what the risk-free interest rate must be if there are no arbitrage opportunities.
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Determining the Interest Rate From Bond Prices (cont'd) Suppose a risk-free bond that pays $1000 in one year is currently trading with a competitive market price of $929.80 today. The bonds price must equal the present value of the $1000 cash flow it will pay.
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Determining the Interest Rate From Bond Prices (cont'd)

$929.80 today ($1000 in one year) (1 rf $ in one year / $ today)
1 rf $1000 in one year 1.0755 $ in one year / $ today $929.80 today
The risk-free interest rate must be 7.55%.
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The NPV of Trading Securities and Firm Decision Making In a normal market, the NPV of buying or selling a security is zero.
NPV (Buy security) PV (All cash flows paid by the security) Price(Security) 0
NPV (Sell security) Price(Security) PV (All cash flows paid by the security) 0
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The NPV of Trading Securities and Firm Decision Making (contd) Separation Principle
We can evaluate the NPV of an investment decision separately from the decision the firm makes regarding how to finance the investment or any other security transactions the firm is considering.
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Valuing a Portfolio The Law of One Price also has implications for packages of securities.
Consider two securities, A and B. Suppose a third security, C, has the same cash flows as A and B combined. In this case, security C is equivalent to a portfolio, or combination, of the securities A and B.
Value Additivity
Price(C) Price(A B) Price(A) Price(B)

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Moon Holdings is a publicly traded company with only three assets:
It owns 50% of Due Beverage Co., 70% of Mountain Industries, and 100% of the Oxford Bears, a football team. The total market value of Moon Holdings is $200 million, the total market value of Due Beverage Co. is $75 million and the total market value of Mountain Industries is $100 million.
What is the market value of the Oxford Bears?

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Alternative Example 3.8 (cont'd)

Solution
Think of Moon as a portfolio consisting of a:
50% stake in Due Beverage
50% $75 million = $37.5 million
70% stake in Mountain Industries

70% $100 million = $70 million
100% stake in Oxford Bears
Under the Value Added Method, the sum of the value of the stakes in all three investments must equal the $200 million market value of Moon.
The Oxford Bears must be worth:
$200 million $37.5 million $70 million = $92.5 million
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Chapter Quiz 1. What is the Law of One Price? 2. What is Arbitrage? 3. If a firm makes an investment that has a negative NPV, how does the value of the firm change? 4. What is the Separation Principle?
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Ch 3 Appendix: The Price of Risk Risky Versus Risk-free Cash Flows

Table 3A.1 Cash Flows and Market Prices (in $) of a Risk-Free Bond and an Investment in the Market Portfolio
Assume there is an equal probability of either a weak economy or strong economy.

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Appendix: The Price of Risk (cont'd) Risky Versus Risk-free Cash Flows (contd)
Price(Risk-free Bond) PV(Cash Flows) ($1100 in one year) (1.04 $ in one year / $ today) $1058 today
Expected Cash Flow (Market Index)

($800) + ($1400) = $1100 Although both investments have the same expected value, the market index has a lower value since it has a greater amount of risk.
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Risk Aversion and the Risk Premium Risk Aversion

Investors prefer to have a safe income rather than a risky one of the same average amount.
Risk Premium
The additional return that investors expect to earn to compensate them for a securitys risk. When a cash flow is risky, to compute its present value we must discount the cash flow we expect on average at a rate that equals the risk-free interest rate plus an appropriate risk premium.
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Risk Aversion and the Risk Premium (contd)

Expected Gain at end of year Expected return of a risky investment Initial Cost
Market return if the economy is strong

(1400 1100) / 1100 = 40%
Market return if the economy is weak

(800 1000) / 1000 = 20%
Expected market return

(40%) + (20%) = 10%
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The No-Arbitrage Price of a Risky Security

Table 3A.2 Determining the Market Price of Security A (cash flows in $)
If we combine security A with a risk-free bond that pays $800 in one year, the cash flows of the portfolio in one year are identical to the cash flows of the market index. By the Law of One Price, the total market value of the bond and security A must equal $1000, the value of the market index.
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The No-Arbitrage Price of a Risky Security (cont'd)

Given a risk-free interest rate of 4%, the market price of the bond is:
($800 in one year) / (1.04 $ in one year/$ today) = $769 today Therefore, the initial market price of security A is $1000 $769 = $231.
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Risk Premiums Depend on Risk If an investment has much more variable returns, it must pay investors a higher risk premium.
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Risk Is Relative to the Overall Market

The risk of a security must be evaluated in relation to the fluctuations of other investments in the economy. A securitys risk premium will be higher the more its returns tend to vary with the overall economy and the market index. If the securitys returns vary in the opposite direction of the market index, it offers insurance and will have a negative risk premium.
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Risk Is Relative to the Overall Market (cont'd)

Table 3A.3 Risk and Risk Premiums for Different Securities
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Textbook Example 3.A.1
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Textbook Example 3A.1 (cont'd)
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Risk, Return, and Market Prices When cash flows are risky, we can use the Law of One Price to compute present values by constructing a portfolio that produces cash flows with identical risk.
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Figure 3.3 Converting Between Dollars Today and Dollars in One Year with Risk
Computing prices in this way is equivalent to converting between cash flows today and the expected cash flows received in the future using a discount rate rs that includes a risk premium appropriate for the investments risk:
rs rf ( risk premium for investment s )
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Textbook Example 3A.2
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Alternative Example 3A.2 Problem

Consider a risky stock with a cash flow of $1500 when the economy is strong and $800 when the economy is weak. Each state of the economy has an equal probability of occurring. Suppose an 8% risk premium is appropriate for this particular stock. If the risk-free interest rate is 2%, what is the price of the stock today?
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Alternative Example 3A.2 (contd) Solution

From Eq. 3A.2, the appropriate discount rate for the stock is: rs = rf + (Risk Premium for the Stock) = 2% + 8% = 10% The expected cash flow of the bond is ($1,500) + ($800) = $1,150 in one year. Thus, the price of the stock today is $1,150/1.10 = $1,045.45.
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Arbitrage with Transactions Costs What consequence do transaction costs have for no-arbitrage prices and the Law of One Price?
When there are transactions costs, arbitrage keeps prices of equivalent goods and securities close to each other. Prices can deviate, but not by more than the transactions cost of the arbitrage.
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Textbook Example 3A.3
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Ch 3 Appendix Quiz 1. Why does the expected return of a risky security generally differ from the risk-free interest rate? 2. Should the risk of a security be evaluated in isolation? 3. In the presence of transactions costs, why might different investors disagree about the value of an investment opportunity?
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Ch 9.5 Information, Competition, and Stock Prices Information in Stock Prices

Our valuation model links the firms future cash flows, its cost of capital, and its share price. Given accurate information about any two of these variables, a valuation model allows us to make inferences about the third variable.
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Figure 9.3 The Valuation Triad
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Information, Competition, and Stock Prices (cont'd) Information in Stock Prices

For a publicly traded firm, its current stock price should already provide very accurate information, aggregated from a multitude of investors, regarding the true value of its shares.
Based on its current stock price, a valuation model will tell us something about the firms future cash flows or cost of capital.
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Competition and Efficient Markets Efficient Markets Hypothesis

Implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors.
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Competition and Efficient Markets (cont'd) Public, Easily Interpretable Information

If the impact of information that is available to all investors (news reports, financials statements, etc.) on the firms future cash flows can be readily ascertained, then all investors can determine the effect of this information on the firms value.
In this situation, we expect the stock price to react nearly instantaneously to such news.
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Competition and Efficient Markets (cont'd) Private or Difficult-to-Interpret Information

Private information will be held by a relatively small number of investors. These investors may be able to profit by trading on their information.
In this case, the efficient markets hypothesis will not hold in the strict sense. However, as these informed traders begin to trade, they will tend to move prices, so over time prices will begin to reflect their information as well.
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Competition and Efficient Markets (cont'd) Private or Difficult-to-Interpret Information

If the profit opportunities from having private information are large, others will devote the resources needed to acquire it.
In the long run, we should expect that the degree of inefficiency in the market will be limited by the costs of obtaining the private information.
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Textbook Example 9.13 (contd) Figure 9.4 Possible Stock Price Paths
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Lessons for Investors and Corporate Managers Consequences for Investors

If stocks are fairly priced, then investors who buy stocks can expect to receive future cash flows that fairly compensate them for the risk of their investment.
In such cases the average investor can invest with confidence, even if he is not fully informed.
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Lessons for Investors and Corporate Managers (cont'd) Implications for Corporate Managers
Focus on NPV and free cash flow Avoid accounting illusions Use financial transactions to support investment
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The Efficient Markets Hypothesis Versus No Arbitrage The efficient markets hypothesis states that securities with equivalent risk should have the same expected return. An arbitrage opportunity is a situation in which two securities with identical cash flows have different prices.
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AFIN353 Week 1 2012

Copyright 2011 Pearson Education. All rights reserved.

Learning Objectives (contd)

Copyright 2011 Pearson Education. All rights reserved.

Learning Objectives (contd)

Copyright 2011 Pearson Education. All rights reserved.

Ch 3.1 Valuing Decisions Identify Costs and Benefits

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Using Market Prices to Determine Cash Values Competitive Market

Textbook Example 3.1

Copyright 2011 Pearson Education. All rights reserved.

Textbook Example 3.1 (cont'd)

Copyright 2011 Pearson Education. All rights reserved.

Alternative Example 3.1 Problem

Copyright 2011 Pearson Education. All rights reserved.

Alternative Example 3.1 (cont'd) Solution

Copyright 2011 Pearson Education. All rights reserved.

Textbook Example 3.2

Copyright 2011 Pearson Education. All rights reserved.

Textbook Example 3.2 (cont'd)

Copyright 2011 Pearson Education. All rights reserved.

Alternative Example 3.2 Problem

Alternative Example 3.2 (cont'd)

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Identifying Arbitrage Opportunities with Securities

Copyright 2011 Pearson Education. All rights reserved.

Identifying Arbitrage Opportunities with Securities

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Textbook Example 3.6

Copyright 2011 Pearson Education. All rights reserved.

Textbook Example 3.6 (cont'd)

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Determining the Interest Rate From Bond Prices (cont'd)

The risk-free interest rate must be 7.55%.

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Textbook Example 3.7

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Textbook Example 3.7 (cont'd)

Copyright 2011 Pearson Education. All rights reserved.

Price(C) Price(A B) Price(A) Price(B)

Textbook Example 3.8

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Textbook Example 3.8 (cont'd)

Copyright 2011 Pearson Education. All rights reserved.

Alternative Example 3.8 Problem

What is the market value of the Oxford Bears?

Alternative Example 3.8 (cont'd)

70% stake in Mountain Industries

100% stake in Oxford Bears

Copyright 2011 Pearson Education. All rights reserved.

Copyright 2011 Pearson Education. All rights reserved.

Ch 3 Appendix: The Price of Risk Risky Versus Risk-free Cash Flows

Assume there is an equal probability of either a weak economy or strong economy.

Copyright 2011 Pearson Education. All rights reserved.