Finance Lecture 5

Keating F&A 5-2 Spring 2008 Outline Lecture 5 The Allure of Leverage Present Value Calculations Bond Valuation Stock Valuation

Keating F&A 5-3 Spring 2008 Operational Leverage Means Replacing Variable Costs With Fixed Example: Automation replaces workers With more fixed costs, firm profits vary more with revenue  Revenue increases can be highly profitable  Revenue decreases are very damaging (since the firm has so many fixed costs) In a governmental context, even labor can sometimes be viewed as a fixed cost if you can’t easily lay people off

Keating F&A 5-4 Spring 2008 Comparably, Financial Leverage Means Taking On More Debt Debt is a fixed cost  Interest payments do not vary with sales volume The same investment, e.g., in new plant and equipment, provides much more upside and downside to stockholders when there is debt financing  A small revenue drop can sharply reduce stockholder equity  A revenue increase flows directly to a smaller number of stockholders

Keating F&A 5-5 Spring 2008 Trading Stock On Margin Is Another Example Of Financial Leverage Not content with simply buying stock the old-fashioned way, some investors buy yet more stock by borrowing funds from brokers “Margin call” – When the stock declines and the broker demands more money or stock sales to cover borrowing Margin traders are often blamed, fairly or unfairly, for stock market crashes and volatility Margin trading is not recommended for individual investors

Keating F&A 5-6 Spring 2008 Financial Leverage Works If Investment Return Exceeds Borrowing Costs In expected value terms, financial leverage is reasonable if expected return on new asset exceeds interest rate  Given interest payments are tax deductible, this criterion is often fairly straightforward to fulfill Indeed, one might wonder why more firms don’t make more use of leverage

Keating F&A 5-7 Spring 2008 There Can Be An Adverse Feedback Loop Between Leverage And Federal Deposit Insurance Suppose there is a savings and loan that is teetering on the edge of failure, e.g., a lot of questionable loans  If depositors are federally insured, they don’t much care  Stockholders are looking at little-to-nothing in bank liquidation if nothing is done This teetering S&L might be tempted to increase its leverage (i.e., pay higher interest to draw in more deposits) then make high-risk, high interest loans  If loans are paid back, S&L returns to profitability and stockholders make (potentially a lot of) money  If loans default, S&L fails and stockholders get nothing, but government pays off depositors  Moral Hazard of the “Walking Dead”

Keating F&A 5-8 Spring 2008 Outline Lecture 5 The Allure of Leverage Present Value Calculations Bond Valuation Stock Valuation

Keating F&A 5-9 Spring 2008 Interest Rates Impact Investment Desirability Year 0: Pay $100 Year 1: Receive $57 Year 2: Receive $57 Is this a good investment?

Keating F&A 5-10 Spring 2008 Present Value Puts Investment Flows In Today’s Dollars, Using Interest Rate Example: 5% interest Desirable, PV>0

Keating F&A 5-11 Spring 2008 Higher Interest Rates Make Given Investments Less Desirable Example: 10% interest Undesirable, PV<0

Keating F&A 5-12 Spring 2008 An Annuity Pays A Fixed Amount For A Fixed Number Of Years Year 1: $100 Year 2: $100 Year 3: $100 Year 4: $100 Year 5: $100 Year 6: $100 If interest rates are 7%,

Keating F&A 5-13 Spring 2008 Outline Lecture 5 The Allure of Leverage Present Value Calculations Bond Valuation Stock Valuation

Keating F&A 5-14 Spring 2008 Basic Bond Valuation Is Just A Present Value Calculation is today’s prevailing market rate of interest on debt of this sort

Keating F&A 5-15 Spring 2008 Basic Bond Valuation Is Just A Present Value Calculation Example: 5% annual coupon bond, maturing in 2017 with $1000 principal, current interest rate is 7% Note: Present Value determined by current interest rates, not interest rate when issued

Keating F&A 5-16 Spring 2008 Bond Values Can Fluctuate Changing market interest rates, Changing perception of default probability Call potential

Keating F&A 5-17 Spring 2008 Bond Values Fall If Market Interest Rates Rise Value of 5% coupon bond paying $1000 principal in 2017

Keating F&A 5-18 Spring 2008 Bonds Further From Maturity Have Greater Interest Rate Sensitivity Both bonds have 5% coupon; maturity varies

Keating F&A 5-19 Spring 2008 Outline Lecture 5 The Allure of Leverage Present Value Calculations Bond Valuation Stock Valuation

Keating F&A 5-20 Spring 2008 Preferred Stock Is Valued Basically Like A Perpetual Bond Holder gets fixed payment (if corporation chooses to make it), no possibility of increase Payments can be skipped without bankruptcy

Keating F&A 5-21 Spring 2008 Common Stock Valuation Is Less Straightforward Than Bond Valuation Dividends might increase Holder gets capital gain if stock later appreciates Even stocks not currently paying dividends might be expected to someday generate sizable dividends (e.g., Amazon)

Keating F&A 5-22 Spring 2008 Ultimately, Common Stockholders Have To Expect Dividends Value of Stock = PV of expected future dividends is today’s expected rate of return on equity of this sort

Keating F&A 5-23 Spring 2008 A Healthy Corporation Should Be Expected To Have Growing Dividends Value of Stock = PV of expected future dividends Note: One can also make expected growth rate vary year-to-year

Keating F&A 5-24 Spring 2008 Various Factors Can Change A Stock’s Price Current dividend level (+) Expected dividend growth rate (+) Required return ( ) given perception of stock’s riskiness (-)