Copyright ©2004 Ian H. Giddy Investment Decisions 1 Finance in the Corporation Chairman of the Board and Chief Executive Officer (CEO) Board of Directors President and Chief Operations Officer (COO) Vice President Marketing Vice President Finance (CFO) Vice President Production Treasurer Controller Cash Manager Credit Manager Tax Manager Cost Accounting Manager Capital Expenditures Financial Planning Financial Accounting Manager Data Processing Manager

Copyright ©2004 Ian H. Giddy Investment Decisions 3 Prof. Ian Giddy New York University Applied Corporate Finance IBM

Copyright ©2004 Ian H. Giddy Investment Decisions 4 The Firm Must Attract Investors The Economy The Economy Investors Financial Markets Financial Markets

Copyright ©2004 Ian H. Giddy Investment Decisions 5 Investors Have Choices  Money market instruments - Short-term debt instruments, like deposits and bills  Bonds - used by businesses and governments to raise money  Common Stock - Units of ownership, interest, or equity  Preferred Stock, Convertibles, other hybrids - A form of ownership with features of both debt and common stock

Copyright ©2004 Ian H. Giddy Investment Decisions 6 Investors Compare Possible Investments Against Market Benchmarks Source: Bloomberg.com

Copyright ©2004 Ian H. Giddy Investment Decisions 7 Total Yield is What Investors Seek  “Yield to maturity” combines coupons and capital gains - all cash flows.  The yield to maturity on any bond is the rate that will make the present value of the cash flows from the investment equal to the price of the investment.  Also known as the internal rate of return or IRR.

Copyright ©2004 Ian H. Giddy Investment Decisions 8 The US Treasury Yield Curve January 2003 Source: bondsonline.com

Copyright ©2004 Ian H. Giddy Investment Decisions 9 Risk and Return  A positive relationship exists between risk and nominal or expected return  The actual return earned on a security will affect the subsequent actions of investors  Investors must be compensated for accepting greater risk with the expectation of greater return Return Risk Risker Investments Have to Offer Higher Returns

Copyright ©2004 Ian H. Giddy Investment Decisions 10 Risker Investments Have to Offer Higher Returns: Example Source: bondsonline.com

Prof. Ian Giddy New York University Investment Decisions: Risk and Return IBM

Copyright ©2004 Ian H. Giddy Investment Decisions 12 Investment: Risk and Return  Equity risk and bond risk  Risk in a portfolio context  Risk and beta  The required return on investments

Copyright ©2004 Ian H. Giddy Investment Decisions 13 A $1 Investment in Different Types of Portfolios: Index ($) $4, $33.73 $13.54 $8.85 $1, Small Company Stocks Large Company Stocks Long-Term Government Bonds Treasury Bills Inflation Year-End

Copyright ©2004 Ian H. Giddy Investment Decisions 14 Risk Types  The risk (variance) on any individual investment can be broken down into two sources. Some of the risk is specific to the firm, and is called firm-specific, whereas the rest of the risk is market wide and affects all investments.  The risk faced by a firm can be fall into the following categories –  (1) Project-specific; an individual project may have higher or lower cash flows than expected.  (2) Competitive Risk, which is that the earnings and cash flows on a project can be affected by the actions of competitors.  (3) Industry-specific Risk, which covers factors that primarily impact the earnings and cash flows of a specific industry.  (4) International Risk, arising from having some cash flows in currencies other than the one in which the earnings are measured and stock is priced  (5) Market risk, which reflects the effect on earnings and cash flows of macro economic factors that essentially affect all companies

Copyright ©2004 Ian H. Giddy Investment Decisions 15 Equity versus Bond Risk Uncertain value of future cash flows Uncertain value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Contractual int. & principal No upside Senior claims Control via restrictions AssetsLiabilities Debt Residual payments Upside and downside Residual claims Voting control rights Residual payments Upside and downside Residual claims Voting control rights Equity

Copyright ©2004 Ian H. Giddy Investment Decisions 16 Corporate Bonds Legal Aspects Of Corporate Bonds  A Bond Indenture is a contract between the borrowing corporation and the bondholders, stating the conditions under which a bond has been issued  Common features of bond indentures include: o Sinking-Fund Requirements o Security Interest  A Trustee is a third party paid to protect the bondholders' interest

Copyright ©2004 Ian H. Giddy Investment Decisions 17 Bond Credit Ratings

Copyright ©2004 Ian H. Giddy Investment Decisions 18 Factors Used by Rating Companies  Coverage ratios  Leverage ratios  Liquidity ratios  Profitability ratios  Cash flow to debt

Copyright ©2004 Ian H. Giddy Investment Decisions 19 Frequency Distribution of Returns on Common Stocks, Number of Years Return (%)

Copyright ©2004 Ian H. Giddy Investment Decisions 20 Returns, Standard Deviations, and Frequency Distributions: Source: © Stocks, Bonds, Bills, and Inflation 1997 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved. – 90% + 90% 0% Average Standard Series Annual Return DeviationDistribution Large Company Stocks12.7%20.3% Small Company Stocks Long-Term Corporate Bonds Long-Term Government Bonds U.S. Treasury Bills Inflation3.24.5

Copyright ©2004 Ian H. Giddy Investment Decisions 21 Volatility Data: Normally Distributed? Autocorrelated? Stable Over Time?

Copyright ©2004 Ian H. Giddy Investment Decisions 22 Characteristics of the Data

Copyright ©2004 Ian H. Giddy Investment Decisions 23 Volatility Projections: Pitfalls

Copyright ©2004 Ian H. Giddy Investment Decisions 24 The Risk-Return Trade-Off CAPITAL ALLOCATION LINE E(R) SD SLOPE IS THE RISK-RETURN TRADE-OFF 12% 14% 20%24% 0% 5%

Copyright ©2004 Ian H. Giddy Investment Decisions 25 The Risk-Return Trade-Off E(R) SD 12% 14% 20%26% If this is my indifference curve then that’s the portfolio I would pick 0% 5%

Copyright ©2004 Ian H. Giddy Investment Decisions 26 Capital Allocation Possibilities: Treasuries or an Equity Fund? r f =7% E(r S ) =17%  S =27% 10% S Expected Return Risk 7% THE EQUITY FUND TREASURIES

Copyright ©2004 Ian H. Giddy Investment Decisions 27 Capital Allocation Possibilities: Treasuries or an Equity Fund? C.A.L. SLOPE=0.37 E(R) SD 17% 14% 18.9%27% ONE PORTFOLIO: 30% Bills, 70% Fund E(R)=.3X7+.7X17=14% SD=.7X27=18.9% r f =7%

Copyright ©2004 Ian H. Giddy Investment Decisions 28 If E(r S )=15%,  S =22%,r f =7% Allocate your money between a stock fund (y) and a Treasury bills (1-y). Then: r p = yr s + (1-y)r f E(r p )= r f + y[E(r s - r f ] = 7 + y[15 - 7] = 7 + y8  p = y  s = y22

Copyright ©2004 Ian H. Giddy Investment Decisions 29 r f =7% E(r S ) =15%  S =22% 8% S Expected Return Risk 7% We Can Buy Some T-bills and Some of the Risky Fund...

Copyright ©2004 Ian H. Giddy Investment Decisions 30...Or Buy Two Risky Assets A E(r) B

Copyright ©2004 Ian H. Giddy Investment Decisions 31 Measuring Portfolio Return... To compute the return of a portfolio: use the weighted average of the returns of all assets in the portfolio, with the weight given each asset calculated as (value of asset)/(value of portfolio). The portfolio return E(R p ) is: E(R p) = (w 1 k 1 )+(w 2 k 2 )+... (w n k n ) =   w j k j where w j = weight of asset j, k j = return on asset j

Copyright ©2004 Ian H. Giddy Investment Decisions 32 …and Portfolio Risk The variance of a 2-asset portfolio is: where w A and w B are the weights of A and B in the portfolio.

Copyright ©2004 Ian H. Giddy Investment Decisions 33 Case Study: A Portfolio

Copyright ©2004 Ian H. Giddy Investment Decisions 34 Portfolio Return Computation

Copyright ©2004 Ian H. Giddy Investment Decisions 35 Portfolio Risk Computation

Copyright ©2004 Ian H. Giddy Investment Decisions 36 Summary: Portfolio Diversification Benefits  Expected return is a weighted average  Risk is less, because of diversification  In general, the lower the correlation between asset returns, the greater the potential diversification of risk  Only in the case of perfect negative correlation can risk be reduced to zero  The amount of risk reduction achieved through diversification is also dependent upon the proportions in which the assets are combined

Copyright ©2004 Ian H. Giddy Investment Decisions 37 Measuring Your Portfolio’s Risk: riskgrades.com

Copyright ©2004 Ian H. Giddy Investment Decisions 38 Extending Concepts to All Securities  The optimal combinations result in lowest level of risk for a given return  The optimal trade-off is described as the “efficient frontier”  These portfolios are dominant

Copyright ©2004 Ian H. Giddy Investment Decisions 39 To Find the Risk-Return Possibilities, Vary the Proportions A E(r) B

Copyright ©2004 Ian H. Giddy Investment Decisions 40 The Minimum-Variance Frontier of Risky Assets “Efficient frontier” Individual assets Global minimum- variance portfolio E(r)

Copyright ©2004 Ian H. Giddy Investment Decisions 41 Given Return, Find Lowest-Risk Compositions

Copyright ©2004 Ian H. Giddy Investment Decisions 42 Plotting the Efficient Frontier

Copyright ©2004 Ian H. Giddy Investment Decisions 43 The Efficient Frontier of Risky Assets with the Optimal CAL Efficient frontier CAL(P) E(r)

Copyright ©2004 Ian H. Giddy Investment Decisions 44 Optimal Overall Portfolio Indifference curve Opportunity set CALE(r) P Optimal complete portfolio

Copyright ©2004 Ian H. Giddy Investment Decisions 45 Finding the Optimal Portfolio: Computations

Copyright ©2004 Ian H. Giddy Investment Decisions 46

Copyright ©2004 Ian H. Giddy Investment Decisions 47 Optimal Overall Portfolio Indifference curve Opportunity set CAL E(r) P Optimal complete portfolio (one example) OPTIMAL RISKY PORTFOLIO

Copyright ©2004 Ian H. Giddy Investment Decisions 48 The Capital Asset Pricing Model CAPM Says:  All investors will choose to hold the market portfolio, ie all assets, in proportion to their market values  This market portfolio is the optimal risky portfolio  The part of a stock’s risk that is diversifiable does not matter to investors. CAL(P) E(r)

Copyright ©2004 Ian H. Giddy Investment Decisions 49 The Capital Asset Pricing Model CAPM Says:  The total risk of a financial asset is made up of two components. A. Diversifiable (unsystematic) risk B. Nondiversifiable (systematic) risk  The only relevant risk is nondiversifiable risk. CAL(P) E(r)

Copyright ©2004 Ian H. Giddy Investment Decisions 50 The Equation for the CAPM r j = R F +  j (r m - R F ) where: r j = Required return on asset j; R F = Risk-free rate of return  j = Beta Coefficient for asset j; r m = Market return The term [  j (r m - R F )] is called the risk premium and (r m -R F ) is called the market risk premium

Copyright ©2004 Ian H. Giddy Investment Decisions 51 The Capital Asset Pricing Model  Uses variance as a measure of risk  Specifies that only that portion of variance that is not diversifiable is rewarded.  Measures the non-diversifiable risk with beta, which is standardized around one.  Translates beta into expected return: Expected Return = Riskfree rate + Beta * Risk Premium

Copyright ©2004 Ian H. Giddy Investment Decisions 52 Beta Coefficients for Selected Companies Exxon-Mobil 0.33 AT&T0.84 IBM1.47 Wal-Mart0.91 GM1.19 Microsoft1.75 Harley-Davidson1.33 AOL2.68 Source: biz.yahoo.com

Copyright ©2004 Ian H. Giddy Investment Decisions 53 biz.yahoo.com Enter symbol (IBM) Click on “profile”

Copyright ©2004 Ian H. Giddy Investment Decisions 54 Estimating Expected Returns  IBM’s Beta = 1.47  Riskfree Rate = 5.00% (Long term Government Bond rate)  Risk Premium = 5.50% (Approximate historical premium) Expected Return = 5.00%+1.47(5.50%) =13.01%

Copyright ©2004 Ian H. Giddy Investment Decisions 55 From Cost of Equity to Cost of Capital  The cost of capital is a composite cost to the firm of raising financing to fund its projects.  It is the discount rate that will be applied to capital budgeting projects within the firm

Copyright ©2004 Ian H. Giddy Investment Decisions 56 Cost of Debt, Based on Bond Yield and Tax Rate Source: bondsonline.com 29%

Copyright ©2004 Ian H. Giddy Investment Decisions 57 The Cost of Capital ChoiceCost 1. EquityCost of equity - Retained earnings- depends upon riskiness of the stock - New stock issues- will be affected by level of interest rates - Warrants Cost of equity = riskless rate + beta * risk premium 2. DebtCost of debt - Bank borrowing- depends upon default risk of the firm - Bond issues- will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Cost of capital = Weighted average of cost of equity and Capitalcost of debt; weights based upon market value. Cost of capital = k d [D/(D+E)] + k e [E/(D+E)]

Copyright ©2004 Ian H. Giddy Investment Decisions 58 Estimating Market Value Weights  Market Value of Equity should include the following  Market Value of Shares outstanding  Market Value of Warrants outstanding  Market Value of Conversion Option in Convertible Bonds  Market Value of Debt is more difficult to estimate because few firms have only publicly traded debt. There are two solutions:  Assume book value of debt is equal to market value  Estimate the market value of debt from the book value

Copyright ©2004 Ian H. Giddy Investment Decisions 59 Estimating Cost of Capital: IBM  Equity  Cost of Equity =13.01%  Market Value of Equity = $142 Billion  Equity/(Debt+Equity ) = 70%  Debt  After-tax Cost of debt =4.95% (1-.29) =3.51%  Market Value of Debt = $ 62 Billion  Debt/(Debt +Equity) = 30%  Cost of Capital = 13.01%(.70)+3.51%(.30) = 10.16%

Copyright ©2004 Ian H. Giddy Investment Decisions 60 Choosing a Hurdle Rate  Either the cost of equity or the cost of capital can be used as a hurdle rate, depending upon whether the returns measured are to equity investors or to all claimholders on the firm (capital)  If returns are measured to equity investors, the appropriate hurdle rate is the cost of equity.  If returns are measured to capital (or the firm), the appropriate hurdle rate is the cost of capital.

Copyright ©2004 Ian H. Giddy Investment Decisions 61 First Principles of Corporate Finance  Invest in projects that yield a return greater than the minimum acceptable hurdle rate.  The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)  Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.  Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.  If there are not enough investments that earn the hurdle rate, return the cash to stockholders.  The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.  Minimize unneeded financial risk.

Copyright ©2004 Ian H. Giddy Investment Decisions 62 Summary: Risk and Return  Equity risk and bond risk  Risk in a portfolio context  Risk and beta  The required return on investments

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Copyright ©2004 Ian H. Giddy Investment Decisions 67 Contact Prof. Ian Giddy NYU Stern School of Business 44 West 4 th Street New York, NY Tel ; Fax