laying a foundation fin 461: financial cases & modeling george w. gallinger associate professor...

Laying a FoundationFIN 461: Financial Cases & Modeling

George W. GallingerAssociate Professor of FinanceW. P. Carey School of Business

Arizona State University

W. P. Carey School of Business Slide 2

Let’s Get Started on Materials

Partially covered in your FIN 361 textbook Chapters 1, 29 & 14.


What is Finance? Finance is derived from the Latin word finis

During Roman times, finis meant the completion of a contract between parties with either a transfer of money or barter (exchange) or a credit agreement

Much the same meaning today Finance encompasses the analysis of, the

issuance of, the distribution of, and the purchase of financial contracts written against real assets (e.g., land, buildings, equipment, and inventories)

Implicit in these activities is the determination of value; deciding what something is worth.


Areas of Finance

Finance is a multifaceted discipline, international in scope, and bound together by contracts

It includes the areas of: Managerial finance Investments Financial markets.


Managerial Finance


Investments

Closest many people get to finance

Personal portfolios Try to “beat the

market” So much news about

investments Markets open 24 hours

per day.


Financial Markets

A brief discussion later Key to value creation.


Relationships Financial management, investments, and

financial markets are closely related: Accepted financial objective of a company: Maximization

of its market value maximization of shareholder value Management's actions influence the firm’s

market value Simultaneous interplay of supply and demand for

financial securities in financial markets determines market value

Through the mechanism of these financial markets, companies participate as suppliers of securities and investors participate as demanders for securities

Interactions of the demands of all investors determine market values.


Finance Principles Finance is an integrated

body of knowledge Built around guiding

principles: wealth maximization, time value of money, expected return versus risk, leverage, & diversification

Principles provide the foundation for integrating the areas of finance and provide guidance for the issues.


Maximization of Wealth

Pursue value-adding activities

Conduct business in an ethical manner.


Time Value of Money


Expected Return vs. Risk


Operating Leverage


Financial Leverage


Diversification


Common Elements Usedin Finance

See nextslide


Organizational Form


Finance & Other Disciplines

As you prepare to study finance, and managerial finance in particular, keep the following perspective in mind

Finance relies on: Economics Accounting Quantitative

methods Management.


How Ethics & Finance Relate


Transition to an Accounting Review

Finance is not accounting! Many firms call the accounting

function the finance department Focus different in finance.


Accounting Information Every company has a history—good, bad, or

neutral—that is important to managers and potential investors, bankers, or creditors

Firm's history track record of accomplishments

From a financial perspective, you measure a firm's history by the company's principal financial statements

Balance sheet, income statement, and statement of cash flows

These statements evolve from the accrual accounting process, following accepted principles, procedures, and standards of the accounting profession.


Manipulation of Earnings Survey


Funds vs. Profits Finance is more concerned about funds than

about income, or profit Funds represent financial resources the firm uses to buy

inputs (such as material, labor, and assets) and pay investors

Funds come from many sources Revenue from operations, monies received from lenders,

new investments by shareholders, or from the sale of assets

Money represents funds, but so does buying on credit Profit is the return on investment

The amount received, or benefit gained, by making the investment

Return of investment recapture of the initial investment as a result of generating cash flows to repay the initial cost.


EBITDA

Many people define cash flow as EBITDA What is its relevance? What is it missing? Does it do a reasonably good job?

Why not use the statement of cash flows?


W. T. Grant

Accounting profits versus cash operating profits

Cash flow frequently defined as:Net income + depreciation

Poor definition.

Look at W. T. Grant’s trend... And then at Salton…


What Happened to W. T. Grant?

-200

-150

-100

-50

0

50

100

'66 '67 '68 '69 '70 '71 '72 '73 '74 '75

NI + depr.

NICFFO


What Happened to Salton?

-60

-40

-20

0

20

40

60

80

'93 '94 '95 '96 '97 '98 '99

EBITDACFFO


Rules for Identifying Cash Flows

Assets increase Use

Assets decrease Source

Financing increases Source

Financing decreases Use

Balance Sheet

Revenues = SourceExpenses = Use


Sustainable Growth What differentiates firms that create value

from those that destroy value? Ability to manage growth!


What Does Value Mean?

A central theme of this course is that management’s decisions are directed toward increasing the value of the firm

Necessary to carefully define what value means

The logic of accounting is different from the logic of finance

Accounting often refers to book value of assets Has little meaning in finance

Finance uses economic value and market value.


Transition to Economic Foundations

Economics provide theoretical underpinnings.


Operate in an Economic System Each financial player or participant purses

its goals within the economic system Economic system allows for the

exchange of goods or services and money Consists of business, government, and

household sectors of the economy, all of which interact with each other

While all societies or countries have such sectors, they relate in very different ways in different countries

Government sector is much more predominant in determining outcomes of the economic system in China or Cuba than it is in the United States.


Fiscal & Monetary Policies

Implementation of fiscal policy and monetary policy are means the government sector uses to alter economic activity of households and businesses

Fiscal policy refers to policies or laws that affect the government budget

Monetary policy involves changes in the economy’s money supply Responsibility of the nation’s central bank.


Importance of Finance A simple model economy to clarify the forces

that shape finance Economy initially has just one person, you,

who lives on a deserted island Your wealth consists of 100 pounds of seed corn Must meet your needs both now and in the near

future No opportunity exists to produce or increase your

initial wealth position, nor can you exchange goods or services with anyone else

Decision: You must decide how to allocate your wealth

between consumption of corn this period and next period

You cannot save corn past the next period.


Neither Production NorMarkets Exist

You must make a decision: Consumption

this period vs. next period?


Neither Production NorMarkets Exist


Assume 1 lb. of planted seed corn reaps 1.25 lbs. of corn next period:

55 x 1.25 = 68.75 Availability

increases 13.75 pounds, or 25%, over the earlier situation of no production opportunities

Introduce Production


Introduce ExchangeBetween Participants

With the growth in the number of people, the single-sector economy divides into two sectors

Business sector and household sector

Business sector produces goods and services

Household sector purchases goods and services from the business sector and provides inputs to the business sector so that it can produce the goods and services

To facilitate exchanges of goods and services between sectors, all participants in the economy agree on a form of money.


Introduce a Financial System Function of the financial system

Accept excess money of savers and lend it to deficit units in need of funds

This function is made more important by the fact that methods of production often require a volume of money greater than can be generated by the producing firm itself in its early stages of production

E.g.: a firm needs to construct buildings and equipment to manufacture a product

How does the financial system meet the needs of firms by locating, securing, and channeling the money to them?


Financial Markets & Interest Rates Interest rate a reflection of the time value

of money Many factors, including inflation and the risk of

default by the borrower, influence the time value of money

Central to this discussion supply of money and its effect on interest rates

There are in fact several different interest rates: money rates, consumer savings rates, government treasury rates, government agency rates, and corporate rate, among others

Generally, interest rates move in the same direction in response to economic activity

Necessary to distinguish between nominal interest rates and real interest rates.


Interest Rates Play Key Role


Example of Resource Allocations


Example Continued…

and DeGrazia


Types of Financial Markets Money markets: Short-term maturities of less than one year

Capital markets: Long-term maturities exceeding one year Primary market: Initial issuance of newly created securities Secondary market: Transactions subsequent to inital issuance of securities


Primary Market

Initial sale of securities Investment bankers major players Functions:

Investigative Risk bearing Selling.


2003 Investment Banking Rankings


Investigative Function

Researches the firm wanting to issue new securities

Is link between the capital markets, the firm issuing the securities, and other investment bankers (i.e., the syndicate)

Draws the covenants and ensures compliance with the laws

Establishes the securities' issuing price.


Risk-Bearing Function

Basically two extremes: "Take it or leave it“ Taking it - the investment banker assumes

the risk and underwrites the security issue (called a firm-commitment offer)

Leaving it - risk is left with the issuer (called a best-efforts offer)

Investment banker compensated by the spread Market price minus price to company.


Selling Function

Securities sold through selling divisions of the underwriters and invited brokerage houses

Formal announcement by: Red Herring - preliminary and unofficial Prospectus - official SEC document Tombstone - an after-the-fact

advertisement.


Secondary Markets Consists of four

submarkets 3rd Market

Trading of exchange-listed stocks in the OTC market

4th Market Electronic

trading system without brokers.


Money Market Instruments T-Bills - These are issued by the federal government and are short-term (less than one

year). They are discounted and interest is exempt from state income tax. The word "discounted" means that the buyer pays less than the face amount of the securities and receives the face amount when the securities mature. The difference represents the implicit interest earned

Federal Funds - These are funds that commercial banks borrow from each other when their reserves are low. These funds are repaid with interest in 1 to 3 days (very short-term securities).

Federal Agency Notes - These are debt securities that various agencies issue to fund operations. They are both short-term and long-term securities and are usually discounted.

Commercial Paper - This is an unsecured note issued by large companies with high credit rating (e.g., General Motors). They are short-term and can be discounted or interest bearing.

Negotiable Certificates of Deposit - These are issued by commercial banks with a maturity of 14 days or more. They are interest bearing with interest paid at maturity.

Eurodollar - Non-US banks from Europe and Cayman Islands issue these. They can mature overnight, but maturity is no more than one year. They are interest bearing with interest paid at maturity.

Banker's Acceptance - These are issued by commercial banks with maturity up to 6 months and are discounted.

Repurchase Agreements - These are issued by U.S. government securities dealers with an agreement to repurchase. They can mature overnight or up to 180 days and interest is paid at maturity in the form of a higher repurchase price.

Money Market Mutual Funds - Investment companies issue these. There is no maturity for these instruments, and interest is earned daily.


Capital Market Instruments

Debt Preferred stock Common stock.


Different Forms of Debt


Bond Ratings


Corporate Bonds

IBM bond: coupon of 9%; matures in 2008 Closing price is $1027.50 (= 102.75 x 10) Current yield is 8.8% (= $90 / $1027.50) $151,000 worth traded Closing price is up $5 from the previous day


Federal Status of Agency Securities


Preferred Stock


Common Stock

Represents an “ownership” claim Perpetual life Dividends and capital gains/losses.


Stock Market Reporting

52WEEKS YLD VOL NETHI LO STOCKSYMDIV % PE 100s HI LOCLOSE CHG

52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75

Gap has been as high as $52.75 in the last year.

Gap has been as low as $19.06 in the last year.

Gap pays a dividend of 9 cents/share

Given the current price, the dividend yield is ½ % Given the

current price, the PE ratio is 15 times earnings

6,517,200 shares traded hands in the last day’s trading

Gap ended trading at $19.25, down $1.75 from yesterday’s close


5.9 Stock Market Reporting52WEEKS YLD VOL NET

HI LO STOCKSYMDIV % PE 100s HI LOCLOSE CHG52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75

Gap Incorporated is having a tough year, trading near their 52-week low. Imagine how you would feel if within the past year you had paid $52.75 for a share of Gap and now had a share worth $19.25! That 9-cent dividend wouldn’t go very far in making amends.

Yesterday, Gap had another rough day in a rough year. Gap “opened the day down” beginning trading at $20.50, which was down from the previous close of $21.00 = $19.25 + $1.75

Looks like cargo pants aren’t the only things on sale at Gap.


Why Use Debt Financing?


Bypass the Covenants Drexel Burnham Lambert, a former investment banking company and buyout

specialist, controlled more than 50% of the equity in a company called Rexene. The remaining 50% was owned by investors solicited by Drexel. About six months before announcing that Rexene had serious financial difficulties, Drexel had Rexene make a $7 per share payment to equityholders--Drexel and its solicited investors. This payment exceeded the original equity investment.

The buyout specialist firm Kohlberg Kravis Roberts (KKR) managed to return to the equity investors in the buyout of Beatrice Company all of their original investment. However, many debt investors found themselves holding securities of a financially distressed company called the E-II Corporation.

KKR refinanced a leveraged buyout of Storer Communications and paid itself and other equity investors $1 billion. The unfortunate debt investors of the new SCI Communications were left with debt securities selling for only a fraction of their par values.

May Department Stores and Houston Lighting & Power Company retired high-coupon debt before the first call date allowed by the indenture. The companies offered to pay premium prices to bondholders who voluntarily tendered, while simultaneously announcing that any bonds not tendered voluntarily would be "cash called" at a lower price. Even though the debt covenants forbade the companies from issuing lower-coupon debt to retire higher-coupon debt, the firms ignored this fact and claimed any recent new low-cost debt financing was not the source of funds to retire the called debt.


Return to Interest Rates


Structure of Interest Rates


Calculating the Real Reate


Factors Influencing Interest Rates


Federal Reserve Central banks great influence on nominal

interest rates In the USA, the central bank is the Federal

Reserve Bank—often simply called the "Fed" The Fed drives nominal interest rates up or down

through its attempts to control the nation's money supply

The Fed has the responsibility of providing a flow of money and credit for the nation, to foster orderly economic growth, and attempt to maintain stable prices

The Fed uses monetary policy to control inflation Monetary policy can be either tight or loose

Restrictive monetary policy interest rates higher in an effort to fight inflation

Monetary ease provides a boost to the economy.


Managing Monetary Policy Fed’s Federal Open Market Committee

(FOMC) sets monetary policy It conducts monetary policy through:

Setting reserve requirements for banks Changing the borrowing rate—or "discount

rate“ Rate the Fed charges banks to borrow from it

Buying and selling federal government securities Inject or reduce, respectively, liquidity in the money

system (carried out by the New York Fed).


Changing Reserve Requirements


Creation of Money


Changing the Discount Rate


Fed Open Market Operations


Introduce the Concept of Market Efficiency

Extremely important concept for pricing assets.


Competition at the Turnstiles


Degrees of Market Efficiency

If a security is strong-form efficient, it is also semi-strong and weak-form efficient

The reverse logic is not true.


Some Events Supporting Market Efficiency


Simulated & Real Price Movements: Which Is Which?

Simulated market levels for 52 weeks Actual DJIA closing prices for 52 weeks

Source: Harry V. Roberts, “Stock Market “Patterns” and Financial Analysis: MethodologicalSuggestions,” Journal of Finance 14 (March 1959), pp. 1-10.


Price Adjustment Patterns

Current price reflects all public knowledge about the company - including historical information

New information is immediately impounded in the price.


Potential Returns from an Overreaction Strategy


Can Security Analysts Beat the Market?Can Security Analysts Beat the Market?


Market Efficiency Anomalies


October 1987 Market Crash Troubling signs were evident before Black Monday's market crash. The

Dow hit a record in August and then proceeded to give back gains on fears of it being overvalued. Inflation fears led to a massive sell off on October 19,1987.


Let’s Summarize


Overview of Managerial Finance


Overview of Value


The End

laying a foundation fin 461: financial cases & modeling george w. gallinger associate professor...

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