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

Mutual Investment Club of Cornell Schedule

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

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.

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

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

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

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.

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

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

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)

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)

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.)

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.

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.

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

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

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.

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.

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

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

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.

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.

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

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

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.

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

Mutual Investment Club of Cornell See you next week