finance notes

Finance Notes

CAPM - Right or Wrong?Description: Financial markets' evaluation of risk determines the way firms invest. What if the markets are wrong?Financial markets' evaluation of risk determines the way firms invest. What if the markets are wrong?

Investors are rarely praised for their good sense. But for the past two decades a growing number of firms have based their decisions on a model which assumes that people are perfectly rational. If they are irrational, are businesses making the wrong choices?

The model, known as the 'capital-asset pricing model', or CAPM, has come to dominate modern finance. Almost any manager who wants to defend a project-be it a brand, a factory or a corporate merger-must justify his decision partly based on the CAPM. The reason is that the model tells a firm how to calculate the return that its investors demand. If shareholders are to benefit, the returns from any project must clear this 'hurdle rate'.

Although the CAPM is complicated, it can be reduced to five simple ideas:1. Investors can eliminate some risks-such as the risk that workers will strike, or

that a firm's boss will quit-by diversifying across many regions and sectors.2. Some risks, such as that of a global recession, cannot be eliminated through

diversification. So even a basket of all of the stocks in a stock market will still be risky.

3. People must be rewarded for investing in such a risky basket by earning returns above those that they can get on safer assets, such as treasury bills.

4. The rewards on a specific investment depend only on the extent to which it affects the market basket's risk.

5. Conveniently, that contribution to the market basket's risk can be captured by a single measure-dubbed 'beta'-which expresses the relationship between the investment's risk and the market's.

Beta is what makes the CAPM so powerful. Although an investment may face many risks, diversified investors should care only about those that are related to the market basket. Beta not only tells managers how to measure those risks, but it also allows them to translate them directly into a hurdle rate. If the future profits from a project will not exceed that rate, it is not worth shareholders' money.

Safe investments, such as treasury bills, have a beta of zero. Riskier investments should earn a premium over the risk-free rate which increases with beta. Those whose risks roughly match the market's have a beta of one, by definition, and should earn the market return.

So suppose that a firm is considering two projects, A and B. Project A has a beta of 1/2: when the market rises or falls by 10%, its returns tend to rise or fall by 5%. So its risk premium is only half that of the market. Project B's risk premium is twice that of the market, so it must earn a higher return to justify the expenditure. Every week, around the world, factories are closed, people sacked and new products launched using this kind of reasoning.

Never knowingly underpricedBut there is one small problem with the CAPM: it doesn't work. Financial economists have found that beta is not much use for explaining changes in firms' share prices.

Worse, there appears to be another measure which explains these changes quite well.

That measure is the ratio of a firm's book value (the value of its assets at the time they entered the balance sheet) to its market value. Several studies have found that, on average, companies that have high book-to-market ratios tend to earn excess returns over long periods, even after adjusting for the risks that are associated with beta.

The discovery of this book-to-market effect has sparked a fierce debate among financial economists. All of them agree that some risks ought to carry greater rewards. But they are now deeply divided over how risk should be measured. Some argue that since investors are rational, the book-to-market effect must be capturing an extra risk factor. They conclude, therefore, that managers should incorporate the book-to-market effect into their hurdle rates. They have labeled this alternative hurdle rate the 'new estimator of expected return', or NEER.

Other financial economists, however, dispute this approach. Since there is no obvious extra risk associated with a high book-to-market ratio, they say, investors must be mistaken. Put simply, they are underpricing high book-to-market stocks, causing them to earn abnormally high returns. If managers of such firms try to exceed those inflated hurdle rates, they will forgo many profitable investments. With economists now at odds, what is a conscientious manager to do?

In a new paper[1], Jeremy Stein, an economist at the Massachusetts Institute of Technology's business school, offers a paradoxical answer. If investors are rational, then beta cannot be the only measure of risk, so managers should stop using it. Conversely, if investors are irrational, then beta is still the right measure in many cases. Mr Stein argues that if beta captures an asset's fundamental risk-that is, its contribution to the market basket's risk-then it will often make sense for managers to pay attention to it, even if investors are somehow failing to.

Often, but not always. At the heart of Mr Stein's argument lies a crucial distinction-that between (a) boosting a firm's long-term value and (b) trying to raise its share price. If investors are rational, these are the same thing: any decision that raises long-term value will instantly increase the share price as well. But if investors are making predictable mistakes, a manager must choose.

For instance, if he wants to increase today's share price-perhaps because he wants to sell his shares, or to fend off a takeover attempt-he must usually stick with the NEER approach, accommodating investors' misperceptions. But if he is interested in long-term value, he should usually continue to use beta. Showing a flair for marketing, Mr Stein labels this far-sighted alternative to NEER the 'fundamental asset risk'-or FAR-approach.

Mr Stein's conclusions will no doubt irritate many company bosses, who are fond of denouncing their investors' myopia. They have resented the way in which CAPM-with its assumption of investor infallibility-has come to play an important role in boardroom decision-making. But it now appears that if they are right, and their investors are wrong, then those same far-sighted managers ought to be the CAPM's biggest fans.

Read more: MBA Boost - CAPM - Right or Wrong? http://www.mbaboost.com/print/144/#ixzz1qOlk0iB0

Economic Value Added (EVA)Description: Detailed notes about EVA and its calculation. Part of the excellent Damodaran Online site.The Economic Value Added (EVA) is a measure of surplus value created on an investment.

EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project)

Define the return on capital (ROC) to be the "true" cash flow return on capital earned on an investment.

Define the cost of capital as the weighted average of the costs of the different financing instruments used to finance the investment.

Things to Note about EVA

EVA is a measure of dollar surplus value, not the percentage difference in returns.

It is closest in both theory and construct to the net present value of a project in capital budgeting, as opposed to the IRR.

The value of a firm, in DCF terms, can be written in terms of the EVA of projects in place and the present value of the EVA of future projects.

DCF Value and NPVValue of Firm = Value of Assets in Place + Value of Future Growth

= ( Investment in Existing Assets + NPVAssets in Place) + NPV of all future projects

= ( I + NPVAssets in Place) +

where there are expected to be N projects yielding surplus value (or excess returns) in the future and I is the capital invested in assets in place (which might or might not be equal to the book value of these assets).

The Basics of NPV

NPVj = : Life of the project is n years

Initial Investment = : Alternative Investment

NPVj =

=

NPV to EVA

Define ROC = EBIT (1-t) / Initial Investment: The earnings before interest and taxes are assumed to measure true earnings on the project and should not be contaminated by capital charges (such as leases) or expenditures whose benefits accrue to future projects (such as R & D).

Assume that : The present value of depreciation covers the present value of capital invested, i.e, it is a return of capital.

DCF Valuation, NPV and EVA

Value of Firm = ( I + NPVAssets in Place) +

=

=

=

In other words,

Firm Value = Capital Invested in Assets in Place + PV of EVA from Assets in Place + Sum of PV of EVA from new projects

A Simple IllustrationAssume that you have a firm with

IA = 100 In each year 1-5, assume that

ROCA = 15% D I = 10 (Investments are at beginning of each year)

WACCA = 10% ROCNew Projects = 15%

WACC = 10%

Assume that all of these projects will have infinite lives.

After year 5, assume that

Investments will grow at 5% a year forever ROC on projects will be equal to the cost of capital (10%)

Firm Value using EVA ApproachCapital Invested in Assets in Place = $100

EVA from Assets in Place = (.15 - .10) (100)/.10 = $50

+ PV of EVA from New Investments in Year 1 = [(.15 - .10)(10)/.10] = $5

+ PV of EVA from New Investments in Year 2 = [(.15 - .10)(10)/.10]/1.12 = $4.55




Value of Firm = $170.86

Firm Value using DCF Valuation Base Year 1 2 3 4 5 Terminal Year

EBIT(1-t) from Assets in Place 15 15 15 15 15 15

EBIT(1-t): yr 1 1.50 1.50 1.50 1.50 1.50

EBIT(1-t) in yr 2 1.50 1.50 1.50 1.50

EBIT(1-t) in yr 3 1.50 1.50 1.50

EBIT(1-t) in yr 4 1.50 1.50

EBIT(1-t) in yr 5 1.50

EBIT(1-t) 16.50 18.00 19.50 21.00 22.50 23.63

- Net Capital Expenditures 10.00 10.00 10.00 10.00 10.00 11.25 11.81

FCFF -10.00 6.50 8.00 9.50 11.00 11.25 11.81

PV of FCFF -10.00 $5.91 $6.61 $7.14 $7.51 $6.99

Terminal Value $236.25

PV of Terminal Value $146.69

Value of Firm $170.85

In Summary

Both EVA and Discounted Cash Flow Valuation should provide us with the same estimate for the value of a firm.

In their full forms, the information that is required for both approaches is exactly the same - expected cash flows over time and costs of capital over time.

A policy of maximizing the present value of economic value added over time should be the equivalent of a policy of maximizing firm value.

In Practice: Some Measurement Issues

How do you measure the capital invested in assets in place?o Many firms use the book value of capital invested as their measure of capital

invested. To the degree that book value reflects accounting choices made over time, this may not be true.

o In cases where firms alter their capital invested through their operating decisions (for example, by using operating leases), the capital and the after-tax operating income have to be adjusted to reflect true capital invested.

How do you measure return on capital?o Again, the accounting definition of return on capital may not reflect the economic

return on capital.o In particular, the operating income has to be cleansed of any expenses which are

really capital expenses (in the sense that they create future value). One example would be R& D.

o The operating income also has to be cleansed of any cosmetic or temporary effects.

How do you estimate cost of capital?o DCF valuation assumes that cost of capital is calculated using market values of

debt and equity.o If it assumed that both assets in place and future growth are financed using the

market value mix, the EVA should also be calculated using the market value.o If instead, the entire debt is assumed to be carried by assets in place, the book

value debt ratio will be used to calculate cost of capital. Implicit then is the assumption that as the firm grows, its debt ratio will approach its book value debt ratio.

Year-by-year EVA Changes

Firms are often evaluated based upon year-to-year changes in EVA rather than the present value of EVA over time.

The advantage of this comparison is that it is simple and does not require the making of forecasts about future earnings potential.

Another advantage is that it can be broken down by any unit - person, division etc., as long as one is willing to assign capital and allocate earnings across these same units.

While it is simpler than DCF valuation, using year-by-year EVA changes comes at a cost. In particular, it is entirely possible that a firm which focuses on increasing EVA on a year-to-year basis may end up being less valuable.

Year-to-Year EVA Changes 0 1 2 3 4 5 Term. Yr.

EBIT(1-t) $15.00 $16.50 $18.00 $19.50 $21.00 $22.50 $23.63

WACC(Capital) $10.00 $11.00 $12.00 $13.00 $14.00 $15.00 $16.13

EVA $5.00 $5.50 $6.00 $6.50 $7.00 $7.50 $7.50

PV of EVA $5.00 $4.96 $4.88 $4.78 $4.66

Terminal Value of EVA $75.00

Value: Assets in Place = $100.00

PV of EVA = $70.85


When Increasing EVA on year-to-year basis may result in lower Firm Value If the increase in EVA on a year-to-year basis has been accomplished at the expense of the EVA of future projects. In this case, the gain from the EVA in the current year may be more than offset by the present value of the loss of EVA from the future periods.

For example, in the example above assume that the return on capital on year 1 projects increases to 17%, while the cost of capital on these projects stays at 10%. If this increase in value does not affect the EVA on future projects, the value of the firm will increase.

If, however, this increase in EVA in year 1 is accomplished by reducing the return on capital on future projects to 14%, the firm value will actually decrease.

Firm Value and EVA Tradeoffs over Time 0 1 2 3 4 5 Term. Yr.

Return on Capital 15% 17% 14% 14% 14% 14% 10%

Cost of Capital 10% 10% 10% 10% 10% 10% 10%

EBIT(1-t) $15.00 $16.70 $18.10 $19.50 $20.90 $22.30 $23.42

WACC(Capital) $10.00 $11.00 $12.00 $13.00 $14.00 $15.00 $16.12

EVA $5.00 $5.70 $6.10 $6.50 $6.90 $7.30 $7.30

PV of EVA $5.18 $5.04 $4.88 $4.71 $4.53

Terminal Value of EVA $73.00

Value: Assets in Place = $100.00

PV of EVA = $69.68


EVA and RiskWhen the increase in EVA is accompanied by an increase in the cost of capital, either because of higher operational risk or changes in financial leverage, the firm value may decrease even as EVA increases. For instance, in the example above, assume that the spread stays at 5% on all future projects but the cost of capital increases to 11% for these projects. The value of the firm will drop.

EVA with Changing Cost of Capital 0 1 2 3 4 5 Term. Yr.

Return on Capital 15% 16% 16% 16% 16% 16% 11%

Cost of Capital 10% 11% 11% 11% 11% 11% 11%

EBIT(1-t) $15.00 $16.60 $18.20 $19.80 $21.40 $23.00 $24.15

WACC(Capital) $10.00 $11.10 $12.20 $13.30 $14.40 $15.50 $16.65

EVA $5.00 $5.50 $6.00 $6.50 $7.00 $7.50 $7.50

PV of EVA $4.95 $4.87 $4.75 $4.61 $4.45

Terminal Value $68.18

Value of Assets in Place = $100.00

PV of EVA = $64.10


Advantages of EVA 1. EVA is closely related to NPV. It is closest in spirit to corporate finance theory

that argues that the value of the firm will increase if you take positive NPV projects.

2. It avoids the problems associates with approaches that focus on percentage spreads - between ROE and Cost of Equity and ROC and Cost of Capital. These approaches may lead firms with high ROE and ROC to turn away good projects to avoid lowering their percentage spreads.

3. It makes top managers responsible for a measure that they have more control over - the return on capital and the cost of capital are affected by their decisions - rather than one that they feel they cannot control as well - the market price per share.

4. It is influenced by all of the decisions that managers have to make within a firm - the investment decisions and dividend decisions affect the return on capital (the dividend decisions affect it indirectly through the cash balance) and the financing decision affects the cost of capital.

EVA and Market Value Added

The relationship between EVA and Market Value Added is more complicated than the one between EVA and Firm Value.

The market value of a firm reflects not only the Expected EVA of Assets in Place but also the Expected EVA from Future Projects

To the extent that the actual economic value added is smaller than the expected EVA the market value can decrease even though the EVA is higher.

Implications of Findings

This does not imply that increasing EVA is bad from a corporate finance standpoint. In fact, given a choice between delivering a "below-expectation" EVA and no EVA at all, the firm should deliver the "below-expectation" EVA.

It does suggest that the correlation between increasing year-to-year EVA and market value will be weaker for firms with high anticipated growth (and excess returns) than for firms with low or no anticipated growth.

It does suggest also that "investment strategies"based upon EVA have to be carefully constructed, especially for firms where there is an expectation built into prices of "high" surplus returns.

When focusing on year-to-year EVA changes has least side effects1. Most or all of the assets of the firm are already in place; i.e, very little or none

of the value of the firm is expected to come from future growth.[This minimizes the risk that increases in current EVA come at the expense of future EVA]

2. The leverage is stable and the cost of capital cannot be altered easily by the investment decisions made by the firm.[This minimizes the risk that the higher EVA is accompanied by an increase in the cost of capital]

3. The firm is in a sector where investors anticipate little or not surplus returns; i.e., firms in this sector are expected to earn their cost of capital.[This minimizes the risk that the increase in EVA is less than what the market expected it to be, leading to a drop in the market price.]

When focusing on year-to-year EVA changes can be dangerous

1. High growth firms, where the bulk of the value can be attributed to future growth. 2. Firms where neither the leverage not the risk profile of the firm is stable, and can

be changed by actions taken by the firm. 3. Firms where the current market value has imputed in it expectations of significant

surplus value or excess return projects in the future. Note that all of these problems can be avoided if we restate the objective as

maximizing the present value of EVA over time. If we do so, however, some of the perceived advantages of EVA - its simplicity and observability - disappear.

Read more: MBA Boost - Economic Value Added (EVA) http://www.mbaboost.com/print/252/#ixzz1qOlp39K2

Finance Textbook Notes - Chapter 10: Adjusting For Uncertainty and Financing Effects In Capital BudgetingDescription: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. Sensitivity analysis aids managers because it enables them to conduct "what-if' scenarios for projects. This is important because expected cash flows are uncertain, and deviations in CFAT variables from their expected values can

have varying degrees of influence on a project's NPV. By looking at various potential outcomes, the manager is more informed about potential outcomes other than the expected outcome and can use the information to gain comfort about or otherwise reject a positive NPV project.

2. Sensitivity analysis is advantageous for the reasons mentioned above, and it is relatively easy to perform. Disadvantages include its vagueness regarding optimistic or pessimistic scenarios, ignorance of potentially interrelated variables, and the inability to examine several scenarios simultaneously.

3. Computer simulation is a computerized way of performing complicated sensitivity analysis. With the power of the computer, many more scenarios can be run (simultaneously if desired), providing a deeper analysis of the project.

4. Disadvantages of computer simulation are primarily its expense, both in monetary terms and in time. Many simulation models are also often difficult to build. May not be suitable for a small company and most cost-effective for large projects at large companies.

5. The logic underlying the WACC approach is that any project must return at least what it cost to obtain the funds to enter the project.

6. The primary difficulty in calculating the cost of debt is bankruptcy risk and determining the appropriate interest rate that takes into account expected default or other non-compliance. It is assumed for practical purposes that the interest rate on the debt has been properly "bid-up" by the market and therefore takes those things into account.

7. The WACC approach is considered company specific because it uses the company to determine the discount rate. This implicitly assumes that the cash flows for the project will be similar in nature to the company's own cash flows - and therefore the risk associated with the project is based on the risk of the company considering the project.

8. In its true form, the NPV calculation is based on the RRR, or opportunity cost, of the company, which may or may not be its WACC and certainly is not dependent on its cost of debt or equity. As such, WACC is often considered to be inconsistent with opportunity cost itself and as it relates to the NPV calculation.

9. It is appropriate to use WACC in "scale-enhancing" projects because only in such projects are the future cash flows reasonably similar in nature the company's current cash flows. It also might be acceptable in projects that were very similar to "scale-enhancing."

10. The Adjusted Present Value (APV) approach is designed to take into account the effects of subsidized financing of projects. In this three-step process, the equity-only NPV is calculated, and then to that the NPV of any flotation costs are added, along with the NPV of any subsidized debt financing.

11. The major problem with implementing the APV approach is determining the appropriate beta to use when calculating the un-leveled cost of equity to be used in the equity-only discounting of future cash flows. Because projects deal with asset values, for which limited historical information generally exists, it is often impossible to calculate betas for the project (assets) based on historical figures (like can be done with securities).

12. If historical information is available, project betas can be calculated in the same manner as company betas using regression analysis by comparing historical returns on assets vs. the market.

13. A pure-play method is used when historical information about a project (its assets) is not available, and the project is not scale-enhancing in nature.

14. The logic underlying the pure-play method is that companies or industries engaged full-time in the type of project under consideration have cash flows

similar in nature and risk to the expected cash flows on the project. Therefore the risk, expressed as beta, for that company should approximate the risk for its underlying cash flows and therefore the risk for such a project.

15. An adjustment is usually required to the pure-play's beta value to account for leverage. Pure-play's are usually not leveraged in the same manner as the company doing the capital budgeting. To get a true (all-equity) beta for the project, which is independent of the means of financing used for the project (or by the pure-play), the beta must be stripped of its financial risk components so that all that is left is the pure equity (market) risk.

Read more: MBA Boost - Finance Textbook Notes - Chapter 10: Adjusting For Uncertainty and Financing Effects In Capital Budgeting http://www.mbaboost.com/print/155/#ixzz1qOlrj3Ky

Finance Textbook Notes - Chapter 11: Managing Total Risk With Derivative SecuritiesDescription: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. Strategic risk is the cash flow variability produced by changes in the firm's economic environment. By reducing cash flow volatility, managers can also reduce associated costs like financial distress, taxes and agency costs.

2. Hedging is a means of reducing strategic risk, which in turn can reduce agency costs, taxes and the cost of financial distress, all of which can increase firm value.

3. Comparison of pairs of derivative concepts. Speculation is taking above average risk with the expectation of receiving

substantial returns. Speculators willingly assume large risk. Hedging is a tool for reducing strategic risk in hopes of improving the timing or consistency of cash flows and minimize downside exposure while creating large upside potential.

Primary assets are the primitive financial or physical assets that are exchanged in the marketplace like stock, bonds, and real estate. Derivatives are securities that derive their value from some underlying primitive security.

Long position - you are in it for appreciation. Hoping the value of the asset will rise so you can sell it in the future (or buy and sell in the case of an option). A short position is the exact opposite - hoping for the value of an asset to fall.

A spot price is the price today in the cash market. The futures price is some price in the future in the futures market.

A put option is an option to sell a security at a certain striking price. Put holders have a short position. If the price of a stock drops below the striking price, the option has value and the holder is in the money (because they can sell at a higher price). A call option is an option to buy a security at a certain striking price. Call holders have long positions, hoping that the price of a security will rise above its striking price, when the holder can buy below market value and be in the money.

European options can only be exercised on the maturity date. American options can be exercised at any time prior to maturity.

A futures contract is a contract to buy and sell an asset at a futures price on a certain delivery date. Futures can be closed out before their maturity and are traded on exchanges. Forward contracts are obligations to buy and sell an asset at a forward price on a delivery date. They are not traded on

exchanges, are used primarily in the foreign exchange markets and cannot be close out prior to maturity. Futures are privately negotiated and are therefore not liquid.

4. The profit on a futures vs. forward contract is not identical. Futures are marked to market each day and can be closed out prior to maturity. Their value, and therefore the potential profit or loss, varies from day to day. Forward profit/loss is determined only at maturity.

5. The cost of forwards and futures as hedges is not an explicit payment, but an opportunity cost. Parties can hedge downside losses but also limit upside potential if the value of the asset rises above the forward or future price. The forgone upside is an opportunity cost that is the implicit cost of hedging with these contracts.

6. Standardization in the futures market makes them liquid. By providing a standardized set of rules for trading futures contracts in an organized exchange that acts as a clearinghouse and honors the contracts, they can be bought and sold prior to maturity at the prevailing market price. This standardization facilitates the smooth operation of the secondary market. It also lowers transactions costs.

7. Options are rights to buy (call) or sell (put) shares of a primitive security on or before a specified date at a stated striking price. Unlike futures and forwards, options are not commitments. Options derive their value from the underlying primitive asset, but do not affect the value of the primitive asset.

8. A holder of a call option has a long position and is hoping for the value of the underlying asset to increase above the striking price. A holder of put option has a short position and is hoping for the value of the underlying asset to decrease below the striking price. The payoff to the holder of a call option at exercise is the difference between the prevailing price (higher) in the market and the strike price (lower) less the cost of the option. The payoff to the holder of a put option at exercise is the difference between the prevailing market price (lower) and the strike price (higher) less the cost of the option.

9. The manager would also need to know the prevailing market price of the primitive security (stock), as well as the standard deviation of its returns. The manager could then calculate the price of the call (with Black-Scholes) and use the call-put parity principle to infer the price of the put.

10. Because of a limited time frame, the value of a call option can never be worth more than the value of the underlying asset. The same holds true for the value of put option vs. the value of a short position in the underlying asset.

Read more: MBA Boost - Finance Textbook Notes - Chapter 11: Managing Total Risk With Derivative Securities http://www.mbaboost.com/print/156/#ixzz1qOlvhDJt

Finance Textbook Notes - Chapter 1: The Firm and Its EnvironmentDescription: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. Freedom of choice is the driving force behind a capitalistic society. This influences our production and distribution decisions because we will channel our resources (because we are free to do so) into activities that benefit us most. In turn, society generally benefits overall.

2. Competition in the capitalistic marketplace encourages parties to act in the best interest of society as a whole. That is, if a good is perceived as beneficial to society, it will we purchased by the public. However, when this becomes

opportunistic, society can actually be worse off. To address this, regulations, policies, standards, ethics, etc. discourage opportunistic behavior. In general, capitalism promotes the pursuit of self-interest and discourages opportunism.

3. See above. Opportunism can lead to deception, unfair business practices, exploitation, expropriation, lying, deceit, stealing, etc. Eventually, this behavior leads to a worsening of societal welfare and firms that pursue opportunism are worse off.

4. Society is held together with contracts. Firms exist when the costs of writing contracts and conducting operations through them are less than the cost of making individual market transactions.

5. Proprietorships are generally limited to the capital of the individual owner and the limited amount of funds that can be obtained given the creditworthiness of a single individual. Partnerships have greater access to capital, but only because there are more individuals in the firm. Corporations have virtually unlimited access to capital because of their nature as a separate legal entity, owned by many individuals who can freely and easily transfer their ownership in organized markets. A corporation has access to all the forms of capital that are available in the economy through organized public exchanges.

6. Financial markets provide a source of capital to corporations in that firms can access this capital through organized public exchanges and other sources within the financial market.

7. Firms are in fact very interested in secondary markets because (1) the wealth of their stockholders' is measured through the price of company stock as traded on the secondary markets, and (2) the secondary market determines, to a large extent, a firms cost of funds in the primary market.

8. Debt securities (bonds) create creditors of a corporation whereby the creditors have a claim to interest payments and principle (or collateralized assets) from the firm. No ownership is involved. Equity securities (stocks) create owners of a corporation who have a residual claim to the earnings (or losses) of the firm according to the percentage ownership.

9. Yes, because if a firm declares bankruptcy, bondholders may be residual claimants to assets or funds in the bankruptcy distribution. However, their claims are superior to that of equity holders.

10. The goal of financial management is to maximize the welfare of its residual claimants (stockholders). This can be at odds with a benefit to society as a whole in that the pursuit of this narrow goal may come at a detriment to employees, customers, etc. However, in general this goal is viewed as proper because, given a competitive environment, the maximization of stockholder welfare will generally lead to a benefit to society.

11. A Firm's management might take a "stakeholder" view whereby it attempts not only to maximize stockholder welfare, but also the welfare of customers, employees, suppliers, and the world communities in which the firm operates. The effect of the stakeholder view is difficult to analyze. If a firm chooses to maximize the wealth to society at the detriment of its own stockholders, the end result (bankruptcy for instance) may actually hamper the efficient allocation of resources and ultimately retard economic growth and increase unemployment.

12. Stockholders play the most important role in regulating the activities of a corporation because they, unlike other stakeholders, have much more power to influence the firm through their ownership and voting rights.

13. Stakeholders should expect to gain wealth, as measured by metrics other than stock value, such as improved standards of living, greater access to goods and services, etc.

14. Society, through its government representatives, makes decisions regarding the relative trade-offs between desirable social goals and reduced efficiency

from reallocating those scarce resources necessary to realize those goals. A certain amount of government regulation is necessary for the general good, and therefore constraints should be imposed on a firm's value-maximizing behavior. Otherwise, the pursuit of this goal in an of itself might become opportunistic. The firm should therefore be allowed to maximize the shareholders' wealth, subject to the mandatory constraints imposed by society on all firms.

15. The vast potential for added revenues and reduced costs motivates American firms to pursue lucrative overseas business. If a comparative advantage exists, firms will want to exploit that advantage. The same is true for imperfect markets (the Imperfect Market Theory), such as those where labor costs are low (Taiwan) Also, international business can circumvent certain domestic constraints like tariffs and taxes.

16. Firms competing internationally can be exposes to exchange rate risk when operating in countries with different currencies that fluctuate in value relative to the firm's reporting currency. Firms also face political risk internationally in that other countries may enforce or enact certain restrictions on foreign companies that only effect those companies.

Read more: MBA Boost - Finance Textbook Notes - Chapter 1: The Firm and Its Environment http://www.mbaboost.com/print/69/#ixzz1qOlyGRbX

Finance Textbook Notes - Chapter 2: Maximizing Stockholders' WelfareDescription: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. Assets have two values in that they have a book, or accounting value based on the historical cost of the asset and its carrying value given certain accounting conventions and assumptions, and a market value which is based on the amount by which the asset could be sold in an exchange. When looking at economic value, assets have an exchange value and an in-use value, the sum of which is an asset's total economic value.

2. The accounting balance sheet ignores, for the most part, market values. It depicts assets at their historical costs and liabilities and equities irrespective of any market appreciation. The economic balance sheet is market-value oriented and considers the exchange value of assets, plus any wealth created by the firm's use of those assets (value in exchange plus wealth = value in use). Liabilities and equities are stated at their fair value as determined by the marketplace.

3. Because it is often difficult (or impossible) to determine directly the wealth created by a firm's use of assets, the claims definition of firm value, which is based on the market value of claims against the firm's assets and readily determinable via the exchange, is most often used over the assets definition.

4. Stockholders are concerned with the value in-use of a firm's assets because that value equates to the market value of the firm in the marketplace and directly determines the firm's stock price. To the extent that value in-use increases (and the value of debt remains fairly constant), the increase accrues to the shareholders.

5. In general, non-cash expenses, like depreciation, that don't involve an actual cash outlay can cause accounting profits to differ from cash flows. Also, changes in certain accounts, like accounts receivable, inventories, etc., may not be reflected in accounting profits but are actually cash flows.

6. The managers of a company are primarily responsible to the stockholder, but are also agents of the company's stakeholders, which can be employees, suppliers or society as a whole.

7. Agency costs are (1) pecuniary (salary, retirement, benefits, etc.), or (2) non-pecuniary (increased prestige or lifestyle). Pecuniary benefits are derived from a manager's employment contract. Non-pecuniary benefits are derived from the manager's power to make decisions. Examples of agency "leaks" are as follows:

Excessive perquisites (perks) Informational asymmetry (inside information not available to principals) Short horizons (a manager's tenure may be limited - encouraged to

improve welfare in the short-term only) Human capital expropriation (jumping ship after a firm invests in training) Risk aversion (managers are less likely to make risky decisions - might

effect their own welfare) Excessive retention (securing job status by having excess retention as a

cushion for the future)8. Agents pay for agency costs because in the long run their own value will be

comprised by their self-serving behavior as the principles have some influence (through some managerial decisions and the option of selling stock) over the behaviors of agents. If the self-serving activities of an agent cause a detriment to the principals, eventually these parties will eliminate the agent in favor of another. However, if this activity results in a detriment to the principals (say, in terms of a loss on stock) then both the agent and the principals pay. However, in the long run, it is the agents that ultimately pay for agency costs. It is in both parties' best interest to write contracts that minimize agency costs and maximize firm value.

9. Monitoring costs are incurred to ensure that agents adhere to their employment contract and do not take excessive advantage of their perks. Bonding costs are different in that they are incurred by the agent to reassure stockholders that he/she will adhere to employment contracts. This would involve considerable time spent developing firm-specific skills that may not be in demand elsewhere. This reduces the value of the agent to other firms and encourages he/she to act in the best interest of the firm and its principals.

10. The corporation is the most dominant entity in business, despite agency costs, for the following reasons:

Capital accumulation (firms have far greater access to capital - owners have limited liability and free exchange)

Efficient risk reduction (investors can invest small amounts in a variety of different companies)

Specialization (managers that specialize in certain aspects of a business can be hired)

11. Internal and external devices to control agency costs are as follows: Internal - governance (formal rules), competition/monitoring of mgmt.,

separation of mgmt. and control External - takeover threat, managerial competition, institutional investors,

government regulations, and lawsuits12. The management function performs the day-to-day operation and running of

the firm. The control function consists of actions that ensure that the managers are functioning in the best interest of the stockholders. This separation can reduce agency costs because board (control function) is encouraged to act in the best interest of the stockholders. Members are elected and can be removed by the stockholders. Therefore, management must convince the board that certain decisions are in the best interest of the

stockholders. The board can reject proposals that are not in the stockholders' best interest.

13. The officers of a firm have a fiduciary responsibility to the stockholders. This responsibility involves an agreement to perform all duties they are assigned with due diligence and with the skill that they represented themselves as possessing when they secured that position. As a fiduciary, the agents must act solely in the best interest of the stockholders and not in their own self-interest or the interest of other parties. Agents agree to be obedient and accountable for their decisions. The board has a fiduciary responsibility as well, in that it is representing the shareholders. However, directors are permitted to withhold certain info that would hurt the firm's competitive position.

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Finance Textbook Notes - Chapter 3: The Structure and Interpretation of Accounting StatementsDescription: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. The balance sheet provides a summary of a firm's financial position (its assets and claims on those assets) as of a particular point in time. The income statement provides the results of the firms operations (its profit or loss) over a specified period of time. The statement of stockholders' equity provides a reconciliation of the changes in the book value of a firm's equity over a specified period of time.

2. The income statement is a "picture" of the changes in equity on the balance sheet (resulting from the firms operations) for a specific period of time. The balance sheet reflects how the firm has invested its earnings and the claims on those assets. The equity statement reconciles changes in book value of equity, inclusive of both operations and other equity activities.

3. Managers need a cash flow statement because the basic financial statements do not provide enough information about how cash flows have changed over time and how those cash flows have been used in the business.

4. A firm's net income is determined by deducting its accounting expenses from its accounting revenues. Many of these may or may not involve an actual cash outlay. Therefore net income is a good proxy for long run cash flow, but not necessarily related to current cash flows.

5. In general, a cash flow statement begins with net income and then adds/subtracts any non-cash expenses reflected in that figure to arrive at pure cash flows from operations. Cash provided by or used for investing and financing purposes is then derived directly and presented separately. This is usually accomplished by an analysis of the changes in balance sheet captions from one reporting period to the next.

6. Just because a firm pays no tax, its cash flows do not necessarily equal is net income. The difference between net income and cash flows is affected not by taxes, but by the nature of the companies expenses (cash vs. non-cash) and its investment and financing decisions.

7. Common size statements are constructed by calculating the percentage of each line item on the statements vs. a "base" (total assets for balance sheet, revenues for income statement).

8. CSF are useful in that they depict captions as percentages that can be compared over time or against other companies of any size or against industry norms. By creating CSF, financial statements can be compared to one another, and decisions made about corporate performance, regardless of the size of a company. Without them, such comparisons are often difficult and/or meaningless. Such comparisons can flag certain aspects of a company's financial statements that may be of concern (or praiseworthy) to investors or other interested parties.

9. Interest payments on debt are deductible, but dividends are not. This may influence firms to finance their operations through debt because the deductibility of the interest reduces the cost of capital to the firm.

10. The average tax rate is percentage of tax expense to net income. Marginal tax rate is the particular rate at which the firm's earnings place it in the graduated tax scales. This rate is the highest rate taxed and is on the "top end" or latest net income.

11. In general, you would include tax benefits for firms whose actions bring about the desired employment.

12. The lower capital gains tax rate encourages businesses to invest in long-lived capital assets that will ultimately lead to capital gains which are taxed at lower rates than ordinary income. This was though to encourage capital investment which would stimulate economic growth.

13. See above for capital gains tax rate. ITCs are designed to encourage activities that promote economic growth by offering a tax break on certain expenses. For example, an ITC might be available for certain expenses incurred i/c/w a new investment. They are powerful because they are dollar-for-dollar reductions in tax payable, as opposed to taxable income.

Read more: MBA Boost - Finance Textbook Notes - Chapter 3: The Structure and Interpretation of Accounting Statements http://www.mbaboost.com/print/148/#ixzz1qOm3YRF6

Finance Textbook Notes - Chapter 4: Value and Risk:Description: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. Higher interest rates indicate that people's time preference is increasing. That is, that people want money now instead of later because they believe they can earn a greater return on the money and are willing to accept less (discounted at a higher rate). This indicates that the productivity of capital is increasing - the rate of return on the use of that capital is expected to be greater in the future.

2. Compounding is the process of extrapolating a future value of a cash flow or series of cash flows at a given interest rate. It determines the future value of those cash flows. Discounting is the opposite, where the present value of future cash flows is determined as of today (or a earlier point in time).

3. Simple interest earns a rate of return on an investment at a fixed percentage over time but does not earn interest on the interest. Compound interest allows interest to earn interest by allowing the interest earned to accrue through reinvestment.

4. The future value of investment decreases when the interest rate decreases. The present value of an investment increases when the interest rate decreases.

5. An ordinary annuity includes cash flows that occur at the end of given time intervals. An annuity due's cash flows occur at the beginning of the time intervals. An insurance premium paid in advance is an annuity due while a house payment is an ordinary annuity. The timing is significant because of the time value of money. Annuity dues start earning interest earlier (by one period) than ordinary annuities.

6. An annuity is a schedule of cash flows that occur at fixed intervals through time until a certain date. A perpetuity is a series of cash flows that continue indefinitely.

7. A stock variable has no time dimension. It is simply a number at a particular point in time. A flow variable is a stream of cash flows over time. Examples:

The amount of cash in your wallet - stock variable Monthly social security payments made to senior citizens - flow variable The value of your car - stock variable The monthly payments on your car - flow variables The GNP in the US - stock variable Rent on an apartment - flow variable

8. Present value decreases when cash flow will occur further in the future. Because you will get the cash flow at a later date than expected (and no interest is accruing), it will be worth less to you when you get it. You have an implicit discount rate and opportunity cost equal to the amount you could have earned on the loan for the additional two months.

9. When intra-year compounding occurs, the effective interest rate on an investment is greater than the nominal, or stated interest rate because you will earn interest on your compounded interest. This is also known as the annual percentage rate, or APR. To calculate the effective interest rate, you use the formula (1 + i/m)^mn.

10. Capitalization is the process of expressing the stock value of a series of flow values in the future by discounting the cash flows to a present value at a given discount rate. The cash flows are the flow variables and the present value is the stock variable.

11. A switch from quarterly to monthly compounding would be in your best interest because it would increase the APR by allowing more interest to be earned on accrued interest.

12. NPV is the difference between the present value of the cash inflows and the present value of the cash outflows. In order to determine the present values, you must have a discount rate. The IRR is the discount rate that equates the NPV of cash flows to zero. As such, you don't need a discount rate because that is what you are trying to calculate. The UAS is a way of expressing a series of uneven cash flows as even cash flows at fixed periods.

13. IRR is "internal" because the only information needed to compute it is the magnitude and timing of the cash flows of the loan or asset. No other external information is required.

Read more: MBA Boost - Finance Textbook Notes - Chapter 4: Value and Risk: http://www.mbaboost.com/print/149/#ixzz1qOm6Rp2Q

Finance Textbook Notes - Chapter 5: Financial Risk: Theory and EstimationDescription: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. Book measures of returns use book value inputs from accounting-based financial statements. Market returns use cash flow inputs. The ex-ante return is the expected return of an investment. The ex-post facto return is the realized, or actual, return on an investment. The ex-ante return is calculated by: R = (forecasted dividend) + (forecasted change in price)/investment. The ex-post facto is calculated by: R = (actual dividend) + (actual change in stock price)/investment.

2. Ex-ante and ex-post returns differ because of uncertainty. To the extent that actual returns differ from expected returns, the ex-post return will not equal the ex-ante return.

3. A probability distribution is a graphical depiction of the expected returns on an investment and the probability of achieving those returns. Discreet distributions are created with bar charts because it is assumed that the returns can take only certain discreet values. Continuous distributions are plotted as curves because it is assumed that the returns can take on any value within a certain range.

4. The arithmetic mean of a distribution is the expected return of the investment. It is what on average the investment is expected to return. The variance and standard deviation of a distribution are measures of the "spread" of possible returns around the average return and are indicators of the riskiness of the investment.

5. Risk is defined in finance as the potential for variability of returns.6. The assumption of a normal distributions allows for the calculation of an

estimate of the likelihood that an ex post observation will be within a certain range of returns (+/- 1,2,3 standard deviations).

7. Investors are rewarded for risk, but risk does not guarantee higher returns. Higher risk guarantees a higher likelihood of a greater return, but it also guarantees a higher likelihood of a greater loss. The shorter the period a risky stock is held, the less the likelihood that the investor will be rewarded for taking the risk. This relates to the uncertainty resolution principle, whereby over time the ex-post and ex-ante returns merge.

8. Imperfect correlation means that two or more stocks in a portfolio are not directly correlated with one another. That is, when one stock does well, the other does not do as well or does poorly, and vice versa. This concept is important because building a portfolio of imperfectly correlated stocks reduces the overall risk of the portfolio.

9. The expected return of a portfolio is determined by summing the expected returns of each stock in the portfolio times their relative weights in the portfolio. The variance of a portfolio is determined by multiplying the weight of each asset in the portfolio (squared) by the variance of each asset in the portfolio and adding (N)(Wa*Wb*Va*Vb*Ccab).

10. Diversification reduces risk intuitively because in a portfolio with stocks of different risks (variability), a gain or loss in one security would be offset by a different gain or loss in another security, and the overall risk would be less. Mathematically, if a portfolio only contained a single stock, risk would be defined as the standard deviation of the expected returns. However, with multiple stock portfolios that are imperfectly correlated, the overall standard deviation is a function of the weighted average of each of the stocks' variances, plus a correlation coefficient.

11. Because the future is uncertain and because statistically trends over time generally continue through the long run, historical stock information is the best available for estimating the future performance of a particular stock.

Read more: MBA Boost - Finance Textbook Notes - Chapter 5: Financial Risk: Theory and Estimation http://www.mbaboost.com/print/150/#ixzz1qOm8o2Io

Finance Textbook Notes - Chapter 6: Assessing Expected Rates of Return: Theory and EvidenceDescription: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. As the size of a portfolio increases, the portfolio's variance is dependent more on the covariances among the securities in the portfolio than on the variances of the individual securities. This happens because as the portfolio size increases, the number of covariance terms increases exponentially while the number of variance terms increases linearly. Therefore the variance term in calculating the variance of a portfolio approaches zero.

2. The components of an asset's total risk are (1) undiversifiable risk (covariance risk) and (2) diversifiable risk (remaining risk in the portfolio). Diversifiable risks are unique to a particular asset (or company) and can be "washed out" by investing in a portfolio of assets with different types of unique risk characteristics. This is also known as non-systematic risk. Undiversifiable risk is also known as market risk or systematic risk and cannot be diversified away. It relates to economic and other factors that are outside the control of the asset (or company).

3. Market risk is systematic because it is systematically dependent on the vagaries of the US economy

4. The limit of diversification is reached when the risk of the portfolio can be reduced no further by additional diversification. This risk level is the average covariance risk of the portfolio, which indicates that the variance risk of the portfolio has been eliminated.

5. Relevant risk is the non-diversifiable portion of an asset's risk. This is sometimes called systematic, or market risk. It is relevant because investors can diversify away non-systematic risk, leaving only systematic risk "relevant." It is also relevant in that it is the systematic risk that determines the supply and demand for an asset and hence its equilibrium price.

6. The relevant risk would decline if you invest internationally because the international markets have economic factors that differ from the US market. These differing factors would serve to offset systematic risk (relevant risk) to a certain degree, in the same way that diversification offsets non-systematic risk domestically. However, this reduction in relevant risk has a floor as well.

7. Beta is a statistical measure that relates the sensitivity of a security's returns to changes in the returns on the market. It relates market risk to asset risk.

8. Beta is a leverage measure of market returns because an assets beta will indicate the expected return on an asset given a certain return on the market; levered up or down (i.e. above or below 1).

9. Beta is calculated using the characteristic line approach, mathematical formulas, or is published by investment houses.

10. Portfolio betas are the betas for an entire portfolio of assets and indicate the responsiveness of a portfolio's value to changes in the market. The are calculated as the weighted average sum of the betas of each security in the portfolio.

11. The second term in the CAPM model is the market risk premium term, and is a measure of the spread between the expected return on the market and the risk free rate of return. The first term is beta, and indicates the "number of risk premiums" associated with the asset. In other words, the second term is the

expected risk in the market, and the first term is that risk amplified by the assets relationship to the market.

12. The five testable implications of CAPM are: A security's return should increase with its relevant risk The relationship between return and risk should be linear Nonsystematic risk should not affect returns On average, the slope of the CAPM should equal the risk premium On average, the intercept should equal the risk-free rate Empirical evidence has shown that 1-3 are clearly accurate, and that the

slope of the CAPM is actually flatter than the above indicate. This merely states that the model is not perfect, but is a good estimate. Other research says that CAPM is bogus and that no relationship exists, but CAPM keeps cropping up again and again as a pretty good model.

13. CAPM's strengths are its intuitiveness and ease of use, while its weaknesses are its broad and general assumptions.

14. The APT is a pricing theory that assumes no arbitrage can exist in the market and that prices are affected by more than one factor. In other words, an asset can be affected my several betas, called factor betas, and have multiple relationships with multiple factors.

15. CAPM and APT are similar in that APT is an extension of the beta/ risk premium format of the CAPM model. APT however is based on much more simplified assumptions and is therefore often more appealing. CAPM implies a single beta with the market. APT implies multiple relationships with as many factors as are relevant. Both allow for the elimination of non-systematic, or idiosyncratic, risk through diversification.

Read more: MBA Boost - Finance Textbook Notes - Chapter 6: Assessing Expected Rates of Return: Theory and Evidence http://www.mbaboost.com/print/151/#ixzz1qOmI9h8U

Finance Textbook Notes - Chapter 7: Bringing Together Risk and Expected ReturnDescription: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. In finance, the value of an asset is the maximum that someone is willing to pay for it.

2. For an asset to have value, it must provide some economic benefit, and procuring the assets must come at a cost. Costs can be either tangible (salary and wages) or intangible (prestige).

3. The true cost of anything is the most valuable alternative given up or sacrificed. This cost is called and opportunity cost, and it is the relevant cost in financial decision making. This is not the same as the cost of an asset, which is a book value figure. The relevant costs in finance are opportunity costs and are calculated not by looking at historical costs and prices but by evaluating the available alternatives.

4. Because opportunity cost is stated as a RRR (the return on the asset sacrificed), the notion of discounting figures into the value of an asset. The higher the RRR, the greater the discount (in present value terms) and therefore the lower the value. Therefore, asset values have an inverse relationship with opportunity cost.

5. Accounting profit is defined as an increase in wealth, but not the creation of wealth. It occurs when income exceeds expense, or when the value of an

investment increases. Economic profit is the excess profit that is gained from an investment over and above the profit that could be obtained from the best alternative forgone. This implies the creation of wealth.

6. The personal valuation process is subjective and varies from person to person depending on their own personal views of the future and risk aversion. Personal value therefore lies in the eyes of the beholder, and RRR and risk premiums vary from investor to investor. The market valuation process is based on the workings of supply and demand in the market. It assumes that all investors estimate the risk of an asset and the risk premium in the same way, and that discount rates are determined by the marginal investor.

7. If NPV=0 then no economic profit exists. Economic profit exists when NPV > 0.

8. Shareholder wealth is created when economic profits arise. That is, when the value of in-use assets exceed their value in exchange. Financial managers try to engage in projects that yield a positive NPV (wealth created). By maximizing NPV, shareholder wealth is also maximized.

9. The expected return as provided by CAPM is the risk-free rate + risk premium. This is the same equation used to express the RRR, or opportunity cost. Therefore the two equations are equal and the expected return implied by CAPM = RRR.

10. An asset that plots above the SML is a positive NPV investment because it implies an economic profit.

11. All assets will eventually plot on the SML because when an asset is overvalued (it lies below the SML), investors will recognize they are better off investing in a portfolio that earns the SML return than the particular asset. In doing so, investors will sell the asset and prices will fall until the value of the asset equates to a return that lies on the SML. In the long-run, markets are efficient and the potential for arbitrage is eliminated and an asset's expected rate of return will equal the RRR.

12. For financial managers the CAPM provides a framework for estimating the appropriate opportunity cost for evaluating an asset. The CAPM provides the market valuation theory that is required for calculating market values. Market theory provides an "average discount rate" that managers can use in an objective way and need not worry about the potentially different discount rates that the firm's owners may have.

13. In terms of reducing risk, hedging is useless because the only relevant risk in a project is its systematic risk. If stock prices are only affected by systematic risk, which is market risk that cannot be hedged, hedging becomes a futile exercise. However, hedging is not useless from the standpoint of altering the magnitude of expected cash flows. By increasing expected cash flows, rates of return can be increased while leaving risk (beta) unchanged.

14. An efficient market is a capital market in which the market value of assets reflects all available information about the assets. In an efficient market, it is not possible to generate excessive returns consistently.

Market efficiency is either: Weak form efficient - stock prices reflect historical price performance - US at

least Semi-strong efficient - stock prices reflect all historical and publicly available

information - US definitely Strong form efficient - stock prices reflect both publicly available and private

information - US not15. If markets are efficient, that implies:

That stock prices cannot be accurately predicted There is no strategy that can be followed to consistently yield excess returns

All investments will in the long-run have an NPV=0 Managers must consistently pursue new positive NPV investments An increase in a firm's value does result in an increase in stock prices The effectiveness of management decisions can be judged by the value of

stock prices because US markets are semi-strong efficient16. It is not impossible to "make money" in an efficient market, but it is basically

impossible to make money over an extended period of time. There are certainly one-off cases that seem to dispel this theory, but they are more anomalies than anything else.

17. The theory of efficient markets has been tested extensively and the results generally support the theory. There is no strong evidence that over the long-run any individual or institution (other than corporate insiders) has been able to generate excess returns consistently.

18. Because of the existence of noise traders, who trade not on information but on advice, for sentimental reasons, or whatever, prices may deviate from their fundamental values. As a result, asset prices may reflect more than just information about expected cash flows. This tends to weaken traditional notions of asset pricing.

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Finance Textbook Notes - Chapter 8: The Basics of Capital BudgetingDescription: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. The capital budgeting process is comprised of six stages: Identifying long-term goals - evaluation of strategic investment proposals,

which change the very character of the firm. When doing so, international markets must be taken into consideration. Also, they cannot be completely evaluated in terms of only their immediate impact on cash flows and stock price. Strategic considerations also involve timing decisions and marketing-related decisions. Also here are the evaluation of tactical investment proposals, which involve investments that would affect the firm's cash flows an economic wealth, but not necessarily change the character of the firm.

Screening - This involves a qualitative evaluation of a proposal. Proposals can be cost-reduction, vertical revenue expansion or horizontal revenue expansion in nature.

Evaluation - this process involves using discounted cash flows to evaluate the economic profitability of the proposal. Proposals can exhibit a certain level of economic dependence, which is the extent to which two proposals are related to one-another. Complementary proposals are those where adoption of the proposals together exceeds the value of adoption of either one or the other. Substitute proposals are those where the adoption of one proposal reduces the cash flows of another proposal. Mutually Exclusive proposals are those which cannot co-exist. Independent proposals are those where the adoption of one proposal has no impact whatsoever on another proposal. Only proposals that are economically independent can be evaluated separately. All others must be evaluated collectively as a project.

Implementation - making the required arrangements to take on the new project(s). Usually involves the capital outlay.

Control - monitoring the progress of the project to obtain feedback and determine corrective action as necessary.

Project Audit - performed when the project is completed to carefully examine the reasons for its success or failure and learn from the experience to make more informed project decisions in the future.

2. Because it is so difficult to assign values to certain qualitative characteristics of a proposal or project, managers must examine the overall "fit" of the project with the corporate strategy and stated objectives. Managers must recognize that they have to make decisions based on incomplete information and must use their best judgment and all available information when making the qualitative assessment of a particular project.

3. Because proposals are usually not independent, if several proposals are under consideration, they must be grouped into a project because of their interdependence. They must be evaluated together because a decision made in one proposal could impact another proposal and therefore the entire project. The individual proposals cannot be analyzed in isolation because their effects are not isolated.

4. Proposals can be (1) complementary (2) substitutes (3) mutually exclusive or (4) independent.

5. "Incremental" in CFAT refers to the additional cash flow (positive or negative) caused by the adoption of a project. This would be increments to existing revenues, expenses and taxes.

6. The three classifications of cash flows are: Initial cash flows - expenditures used to acquire PP&E when a project

begins. Could include direct cash flows like capital expenditures and operating expenditures or indirect cash flows like asset sale proceeds and changes in working capital.

Operating cash flows - the net benefits (incremental cash flows after taxes) received over a project's economic life.

Terminal cash flows - the cash flows that occur at the time a project's useful life ends. Typically include salvage value of the asset(s) and recovery of net working capital.

7. Direct cash flows involve direct cash outlays for capital expenditures and operating expenses. Indirect cash flows occur indirectly as a result of the requirements of the project (salvage sales and gain/loss or changes in working capital).

8. When an asset is sold, in can generate either a tax loss or a tax gain (or no gain/loss) based on the value received and the depreciated value of the asset sold. This has tax implications because gains result in cash outflows for increased taxes paid and losses result in cash inflows for tax savings earned.

9. Capital expenditures are those where are expected to produce future benefits that extend beyond one year. These types of expenditures are capitalized as assets on the balance sheet. Operating expenditures are those that provide no benefits beyond those of the current period and are expensed through the P&L.

10. Depreciation matters in capital budgeting because it is a non-cash expense that affects cash flows from operations. When calculating annual incremental operating cash flows, changes in depreciation must be taken into consideration.

11. The payback period methodology does not consider opportunity cost (TVM) or cash flows beyond the payback period. Sometimes a "discounted payback period" is used, but this still ignores cash flows beyond the discounted payback period. In addition, the payback method completely ignores risk. The AROR methodology uses accounting figures (profits) and ignores the TVM and other market-driven considerations. AROI is somewhat better in that

it uses cash flows instead of accounting profits, but does not consider the TVM.

12. The implication of value additivity is that as long as a project carries a positive NPV, the value of that project will accrue to the company as a whole and the company will have created economic value.

13. NPV and PI lead to the same accept reject decision because if NPV is positive, its PV of inflows must be greater than its PV of outflows, meaning that when you divide the former by the latter the result must be greater than one. However, when choosing between one of two projects, the PV vs. NPV choice can have some interesting consequences, primarily because the PI is a relative measure which the NPV is an absolute measure.

14. Given a stream of CFATs and a RRR, deciding whether or not to accept or reject a project should be a simple matter of calculating its NPV. However, operating flexibility and investment flexibility considerations must also be considered and are definitely of value.

15. Market imperfections like financing arrangements and labor costs in foreign countries, government regulations and patents, and general inefficiencies in the market for physical goods and services can be exploited to maintain positive NPV projects.

16. Operating flexibility is of value because it allows for the unexpected. The more inflexible a project, the more difficult it is to recover when changes occur during its life or become necessary for whatever reason.

17. For the opportunity to defer an irreversible investment, you would pay up to the NPV of the project with flexibility.

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Finance Textbook Notes - Chapter 9: Special Issues In Capital Budgeting DecisionsDescription: Notes from various chapters in the core finance textbook, FINANCIAL MANAGEMENT, by Rao.

1. To create an NPV profile, one needs only the stream of cash flows that comprise the project. From this, different NPVs can be run at RRRs between 0 and the IRR and each NPV can be plotted into a profile.

2. The IRR is the point on the NPV profile where the NPV line crosses the X-axis (i.e. where the NPV = 0).

3. Conventional projects have a negative initial cash outflow and then a series of cash inflows through the life of the project (or vice-versa). A non-conventional project has cash flows that may vary (inflows, outflows) from period to period during the life of the project (i.e. multiple sign changes can occur). The significance of this is that conventional projects have only one IRR (one sign change), while non-conventional projects can have none or many IRRs (one per sign change). This make the analysis of a non-conventional cash flow somewhat more complicated than a conventional.

4. When a project has more than one IRR, they are all correct. Therefore you must look to the NPV criterion.

5. A project might have no IRR if there is a large initial cash inflow as opposed to a capital outlay.

6. An accept/reject decision is merely assessing whether or not to accept/reject a project based on its NPV and/or IRR (depending on criterion used). Several projects, if they all have positive NPVs, should all be "accepted" by

management (ignoring all other constraints). Ranking involves comparing two or more mutually exclusive projects that are both "acceptable" (i.e. both earn excess returns) to determine which investments are the most valuable. Whenever two or more projects must be ranked because they are mutually exclusive, the rankings based on their IRRs may differ from their rankings based on the NPVs. This difference is based on the RRR used in the calculation, and within certain ranges of RRR, the ranking may yield a different decision based on the relative slope of the NPV profile. The best answer is to always use the NPV criterion, which is always consistent with value maximization.

7. There are also ranking conflicts when using NPV vs. PI, even though they are based on the same inputs. This is because the PI is a relative measure and does not consider the size of the cash flows. Once again, the NPV is preferable.

8. When mutually exclusive projects with unequal lives are encountered, once must "standardize" the lives of both projects to make them comparable. Without doing so, the projects cannot be ranked correctly because they do not consider the same discount period.

9. The UAS method is a much simpler calculation than the replacement chain method, especially when the comparative years are unusual and the common life is excessive.

10. Some common reasons for capital rationing are (1) to constrain organizational unit growth, (2) to constrain a firm's overall growth, and (3) to constrain financing to internally generated funds (debt-averse).

11. When faced with multiple indivisible independent projects, a manager should choose that combination of projects that yields the largest aggregate NPV within the boundaries of the capital constraint.

12. The PI criterion is best suited for ranking divisible projects with capital constraints because the object with divisible projects is to maximize the increment in wealth per dollar invested (which will be up to the capital constraint). This is exactly what the PI measures.

13. One might want to dispose of an asset before the end of a project's life if doing so would generate a larger NPV than not doing so.

14. To determine the optimal time to replace an asset, one must make an assumption about the market value of the asset at the end of each year in its life and then calculate a UAS for each possible life. The year with the largest UAS is the optimal year to replace the asset.

15. The market value of the asset at the end of each year is difficult to know.16. Firms want to compete in a global market to capitalize on the competitive

advantages that exist in the global economy (that may or may not be available domestically).

17. Political risk generally takes the form of country-specific risks or firm-specific risks. Country-specific risks, like bribes, affect every competitor in the country (foreign or domestic). Firm-specific risks, like special taxes or regulations on foreign companies operating in the country, only impact foreign firms. This political risk can be managed by cleverly designing alliances between foreign companies operating within that country, or by hiring local employees and encouraging local investment. Firms can also purchase political risk insurance.

18. A spot exchange rate is the current exchange rate between two currencies. A forward exchange rate is an agreement to buy/sell currency at a certain exchange rate some date in the near future. It is nothing more than the strike price of a futures contract.

19. In general, one must be cautious when figuring incremental cash flows from an international source. This is because many times there are special

arrangements, like supervisory fees, royalties, and tie-in sales that arise for various reasons in international settings. This make the identification of incremental cash flows more complicated. Also, when determining a discount rate, the international markets are not the domestic markets. Care should be taken when establishing a discount rate and one should not simple adjust the rate upward to account for risk. Market inefficiency in a particular country may in fact result in a lower discount rate. The overriding point is that there are more issues and considerations when dealing with global companies and international cash flows and extra care should be taken when analyzing global projects.

Read more: MBA Boost - Finance Textbook Notes - Chapter 9: Special Issues In Capital Budgeting Decisions http://www.mbaboost.com/print/154/#ixzz1qOmPY3z0

Finance FormulaeDescription: A compiled listing of the most common and useful fiance formulas.

NPV = PVinflows – PVoutflows

IRR = i that makes NPV = 0UAS – annuity that = PV of irregular cash flow pattern

Ri = realized asset = expected return

ß=1 ⇒ average risk ß<1 ⇒ below average risk ß>1 ⇒ above average risk

CAPM relates a security's relevant risk (ß) to expected return.

NPV (loan) = Amount borrowed – PV (all after-tax payments)

APV (Adjusted PV) = All equity value – PV(FC) + NPV(loan)1. Calculate NPV for all-equity financing2. Adjust NPV for flotation costs3. Adjust NPV for tax shield + subsidization

WACC (weighted average cost of capital)

{D + E = V}

Pure Play Method1. Find publicly traded company with business similar

to proposed project.2. Determine equity beta (ße) for pre-play firm's stock.3. Calculate pure-play assets ßA

Loan $ = Gross Proceeds (1 – FC%)

When to Lease?If there is a tax differential or if the lease lowers transaction costs and/or reduces uncertainty

RRRD = Rf + ßD[Rm – Rf]RRRA = Rf + ßA[Rm – Rf]ROE = ROA + D/E[ROA – Rf]ROA = RRREu = Rf + ßA[Rm – Rf] - expected return on an un-levered firm's assetsRRREl = RRREu + D/E [RRREu – RRRD]ROA = [E/(D+E)](ROE) + [D/(D+E)](Rf)ßA = [D/(D+E)]( bD) + [E/(D+E)]( ßE)ßE = ßA + D/E(ßA – ßD)E(RE) = Rf + ßE [E(Rm) – Rf] - M&M CAPM (Equity)

Payout Ratio = % Earnings paid as dividendsRetention Ratio = 1 – Payout Ratiog = (Retention Ratio)(ROE)ROE = NI/Earnings = Earnings/Book Equity

PVGO = PV[PV(cash inflows at time t) – PV(cash outflows at time t)] – present value growth option

Valuefirm = Cost of Assets + PV(OCF)E = VF – D {D = amount borrowed/rD}

Pre-Offer Post-Offer # shares 600,000 750,000Value of Equity $60,000,000 $70,500,000Price/Share $100 $94 {$94 figure calculated based on offering price}

1 share offered for $70 + 4 rights {150,000 new shares offered ⇒ $10,500,000 add'l equity}⇒ 4 rights = $94 - $70 = $24⇒ 1 right = $6

M&M (Modigliani and Miller)Proposition 1: method of structuring D/E has no effect on firm valueProposition 2: cost of equity capital increases as amount of debt increases

Assumes:1. No taxes2. No transaction costs3. No changes in investment policy

Read more: MBA Boost - Finance Formulae http://www.mbaboost.com/print/67/#ixzz1qOmggCgS

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