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Mutual Investment Club of Cornell Week 2: Corporate Finance Sept. 15, 2010

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Mutual Investment Club of Cornell Schedule

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Mutual Investment Club of Cornell For today… Time Value of Money Asset Types Asset Classes Primary & Secondary Markets

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Mutual Investment Club of Cornell Why Have a Financial System? Financial systems exist essentially to connect savers and borrowers (investors). A business is really an engine for turning excess money into more money. Financial intermediaries profit by connecting borrowers and savers. Complexity exists to sort out different appetites for size, risk, liquidity, etc.

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Mutual Investment Club of Cornell Time Value of Money If I have $100 today and can invest it at 5% interest (compounded annually), how much will I have after 1 year? 2 years? 10 years? $100 * (1 +.05) = $105 (1 year) $105 * (1 +.05) = $ (2 years) $100 * (1 +.05) 10 = $ (10 years) n years? $100 * (1 +.05) n

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Mutual Investment Club of Cornell Future Value Problems Problems like this are known as future value problems. They answer the question “If I have PV dollars today, how much will I have if I invest at interest rate r for n periods. FV = PV * (1 + r) n

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Mutual Investment Club of Cornell Present Value Problems Present Value problems do the opposite: They answer the question “How much money do I need to put away today to have FV dollars in n periods if I can invest at rate r? PV = FV/(1+ r) n For a series of cash flows, the formula is: Σ(CF/(1+ r) t ) = CF 1 /(1 + r) + … + CF T /(1 + r) T

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Mutual Investment Club of Cornell What does this mean for us? Using our P = $100, r = 0.05, n = 1 example from earlier, the present value formula tells us that we should be indifferent between receiving $100 today and receiving $105 in one year. Consequently, the value of a financial asset is the present value of its expected cash flows.

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Mutual Investment Club of Cornell Example Suppose I offered you a slip of paper that entitles you to $100 in 1 year, $150 in 2 years, and $50 in 3 years. How much would you be willing to pay for this paper (the interest rate is 5%)? PV = CF 1 /(1 + r) + CF 2 /(1 + r) 2 + CF 3 /(1 +r) 3 = 100/(1.05) + 150/(1.05) /(1.05) 3 $274.48

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Mutual Investment Club of Cornell Primary Asset Types: Debt Debt typically has a payment schedule that looks like this: PeriodPayment 1$50 2 …… N-1$50 N$1050

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Mutual Investment Club of Cornell Things to Note about Debt Relatively predictable cash inflows (easier to value). Cash flows are legally guaranteed Debt-holders fare better in the event of bankruptcy (more on that later)

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Mutual Investment Club of Cornell Primary Asset Types: Equity Represents ownership in (and share of the profits in) a company Equity-holders are paid (relatively) irregularly and unpredictably Equity-holders are in a bad position in the event of bankruptcy (more later)

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Mutual Investment Club of Cornell The Capital Structure A company is in default if it has failed to pay its debt obligations on time. In the event of default and bankruptcy, a company’s assets are liquidated, and entities that have a claim on its assets are paid in this order: Government Debt-holders Equity-holders Note: within each class there are more layers (Senior debt, junior debt, etc.)

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Mutual Investment Club of Cornell Asset Classes: Equity Common Stock Common stock represents a claim on the profits of the company. Common stockholders get paid only if all other claimants are paid first. Common stockholders are paid in the form of dividends, payments made at the discretion of management. So the value of a share of common stock is the present value of its expected future dividends.

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Mutual Investment Club of Cornell Aside on Valuation The present value of a perpetual (never ending) cash flow is (CF)/r. The present value of a perpetual cash flow that grows at a rate g every year is (CF)/(r – g). To value a stock, we estimate its dividends for five years, then assume a constant growth rate thereafter. We pretend that we hold for five years, then sell it.

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Mutual Investment Club of Cornell Valuing Common Stock PV = D 1 /(1 + r) + D 2 /(1 + r) 2 + D 3 /(1 + r) 3 + D 4 /(1 + r) 4 + (D 5 + P 5 )/(1 + r) 5, where P 5 = D 5 /(r – g) YearCash FlowPresent Value 1D1 D 1 /(1 + r) 2D2 D 2 /(1 + r) 2 3D3 D 3 /(1 + r) 3 4D4 D 4 /(1 + r) 4 5D5 + P5 (D 5 + P 5 )/(1 + r) 5 Present Value Total of above

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Mutual Investment Club of Cornell Example We expect dividends to be $3, $5, $10, $12, and $13 in years 1 through 5, with 3% growth thereafter. The interest rate is 8%. After 5 years, we sell. Note: P 5 = 13/(.05) = 260 YearCash FlowPresent Value Total

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Mutual Investment Club of Cornell Preferred Stock A special type of equity Preferred stock carries a fixed interest rate, but the company can choose to not pay it. However, before common stockholders can receive dividends, preferred stockholders must receive all of their back-dividends. Preferred stockholders rank above common stockholders in the capital structure.

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Mutual Investment Club of Cornell Asset Classes: Bonds Bonds are a type of debt security. Bondholders receive (usually semi-annual) payments called coupons. At the bond’s maturity, bondholders receive the Par or Face Value of the debt.

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Mutual Investment Club of Cornell Valuation Example 5 year bond, $50 coupon, interest rate is 5% YearCash FlowPresent Value Total 1000

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Mutual Investment Club of Cornell Money Markets Commercial Paper: short-term unsecured debt issued by a corporation (unsecured means that the debt-holders do not have a specific asset to seize in the event of default. Treasury bills: short term debt issued by the U.S. government. Certificates of Deposit (CD’s): a deposit at a bank that is typically untouchable for a specified period of time. Money market securities can be valued with the cash flow method

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Mutual Investment Club of Cornell Real Estate Land, buildings etc. Real estate is a real asset, not a financial asset, so it is really difficult to value using discounted cash flow. If you’re interested in real estate, talk to Jai Reddy, our real estate analyst.

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Mutual Investment Club of Cornell Commodities Oil, wheat, gold, lithium, timber, etc etc etc. Commodity prices typically depend largely on macroeconomic fundamentals. Commodities, like real estate, are real assets, so they cannot be valued with discounted cash flow.

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Mutual Investment Club of Cornell Foreign Exchange Refers to trading among different currencies (US$, euros, yen, etc.) Valuation is largely correlated to: Macro data Government borrowing Central bank action

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Mutual Investment Club of Cornell Markets Exchange market: securities that trade on exchanges trade in a centralized place or network. Example: New York Stock Exchange Major stocks trade on exchanges Over-the-Counter (OTC) market: an informal network who negotiate between one another. Bonds typically trade OTC

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Mutual Investment Club of Cornell Primary & Secondary Markets The primary market refers to the issuance of new securities to the public. The secondary market refers to situations where already outstanding securities are traded. Retail investors (small scale) typically purchase securities in the secondary market. An Initial Public Offering (IPO) of a company refers to the first time that company’s shares are issued to the public for purchase.

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Mutual Investment Club of Cornell Next Week Overview of the financial system Major players Structure

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Mutual Investment Club of Cornell See you next week

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