TIME VALUE OF MONEY THERE IS A RISK-RETURN TRADE-OFF RISK PRICING. Key Idea. Key Idea KEY CONCEPTS IN FINANCE. Risk-Return Tradeoff.

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1 KEY CONCEPTS IN FINANCE TIME VALUE OF MONEY What you should have learned by now Copyright 2003, Alan Marshall 1 Copyright 2003, Alan Marshall 2 THERE IS A RISK-RETURN TRADE-OFF Risk-Return Tradeoff Return is desirable Risk is undesirable You cannot expect to increase returns without accepting more risk Great book: Peter L. Bernstien, Against the Gods: The Remarkable Story of Risk. New York: John Wiley & Sons, Copyright 2003, Alan Marshall 3 Copyright 2003, Alan Marshall 4 RISK PRICING Risk Pricing Discount rates are determined by adding Risk Premia to the Risk Free Rate Government bonds: r B = r f + Term Premium Corporate Bonds: r D = r f + Term Premium + Default Risk Premium + Other Risk Premia Copyright 2003, Alan Marshall 5 Copyright 2003, Alan Marshall 6 1

2 Risk Pricing Equities: CAPM: E(r j ) = r f + β j [MRP] MRP: The Market Price of Risk, the premium investors demand for assuming the risk level of the market DIVERSIFICATION REDUCES RISK APT: E(r j ) = r f + Σb jk F k F k : One of k risk factors Copyright 2003, Alan Marshall 7 Copyright 2003, Alan Marshall 8 Diversification There will always be some potential to reduce risk through additional diversification However, the cost may not be justified by the benefit FINANCIAL MARKETS ARE EFFICIENT Copyright 2003, Alan Marshall 9 Copyright 2003, Alan Marshall 10 Efficient Markets Market participants do not ignore available information When new information arrives, it immediately affects prices Therefore, prices reflect the consensus valuation in the market place. Trust Market Prices Efficient Markets - Caveat Markets are not perfectly efficient and there may be opportunities to make abnormal profits Copyright 2003, Alan Marshall 11 Copyright 2003, Alan Marshall 12 2

3 THE GOAL OF THE FIRM IS TO MAXIMIZE ITS MARKET VALUE Maximizing Firm Value When the firm is healthy, maximizing firm value is consistent with maximizing shareholder value and the interests of all stakeholders Copyright 2003, Alan Marshall 13 Copyright 2003, Alan Marshall 14 Maximizing Firm Value - Caveat When the firm faces financial distress, there can be a significant divergence between what shareholders would want and what is best for the firm as a whole, which includes bondholders and other stakeholders INDIVIDUALS ACT IN THEIR OWN SELF-INTEREST Copyright 2003, Alan Marshall 15 Copyright 2003, Alan Marshall 16 Individuals rationally act in there own selfinterest Individuals will pay as little as possible and sell for the highest price possible This leads us to efficient, competitive pricing Individuals rationally act in there own selfinterest Individuals will pay as little as possible and sell for the highest price possible This leads us to efficient, competitive pricing GREED IS GOOD - Gordon Gecko, in Wall Street Copyright 2003, Alan Marshall 17 Copyright 2003, Alan Marshall 18 3

4 With a proprietorship or single person corporation, there is no divergence of interests Bondholders expect Shareholders to manage the firm for everyone s benefit Shareholders elect Directors to manage the firm Directors appoint Managers to run the firm ALL MAY HAVE DIFFERENT INTERESTS Copyright 2003, Alan Marshall 19 Bondholders: Liquidity, Safety Shareholders: Growth Directors: Honour of the position vs. the responsibility of the position. Manager s: Under-diversified, survivaloriented Copyright 2003, Alan Marshall 20 Consider the firm that is almost insolvent Do all the creditors have the same interests? Who gets paid first? FOCUS ON CASH FLOWS AND INCREMENTAL EFFECTS Copyright 2003, Alan Marshall 21 Copyright 2003, Alan Marshall 22 Cash flow is real Cash Flow Profit is whatever you want it to be, within limits Incremental Effects When evaluating a proposal, you must be sure that you are only evaluating the incremental cash flows Watch for synergies, both positive and negative Copyright 2003, Alan Marshall 23 Copyright 2003, Alan Marshall 24 4

5 OPTIONS ARE VALUABLE MODIGLIANI & MILLER ARE RELEVANT Copyright 2003, Alan Marshall 25 Copyright 2003, Alan Marshall 26 Modigliani & Miller In perfect capital markets w/o taxes, firm value is independent of capital structure Since equity holders risk increases with the debt-equity ratio, the benefits of using cheaper debt are offset by the increasing cost of equity Modigliani & Miller In perfect capital markets with taxes, firm value increases with the amount of debt used. Relaxing the assumptions of prefect capital markets, the costs of financial distress and agency problems will determine debt capacity Copyright 2003, Alan Marshall 27 Copyright 2003, Alan Marshall 28 FINANCIAL SLACK IS VALUABLE Financial Slack Firms will often choose to use less than the optimal amount of debt to have some financial slack Copyright 2003, Alan Marshall 29 Copyright 2003, Alan Marshall 30 5

6 LIQUIDITY IS VALUABLE Liquidity The more liquid the instrument, the lower the return Liquidity implies an implicit option Copyright 2003, Alan Marshall 31 Copyright 2003, Alan Marshall 32 6