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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 1 Topics Covered What Is A Corporation? The Role of The Financial Manager Who Is The Financial Manager? Separation of Ownership and Management Financial Markets

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 2 Corporate Structure Sole Proprietorships Corporations Partnerships Unlimited Liability Personal tax on profits Limited Liability Corporate tax on profits + Personal tax on dividends

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 3 Role of The Financial Manager Financial manager Firm's operations Financial markets (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors (1)(2) (3) (4a) (4b)

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 4 Ownership vs. Management Difference in Information Stock prices and returns Issues of shares and other securities Dividends Financing Different Objectives Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 5 Valuation Rule Mean – Variance Valuation Rule

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 6 Valuing an Office Building Step 1: Forecast cash flows Cost of building = C 0 = 350 Sale price in Year 1 = C 1 = 400 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 7%, then Cost of capital = r = 7%

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 7 Valuing an Office Building Step 3: Discount future cash flows Step 4: Go ahead if PV of payoff exceeds investment

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 8 Risk and Present Value Higher risk projects require a higher rate of return. Higher required rates of return cause lower PVs.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 9 Risk and Present Value

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 10 General Rule For Valuation Of Any Risky Cash Stream 1.Expected cashflows 2.Required rate of return 3.Discounted value Mean – Variance Rule Other valuation rules

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 11 Net Present Value Rule Accept investments that have positive net present value Required rate of return = cost of capital

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 12 Net Present Value Rule Accept investments that have positive net present value. Example Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return?

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 13 Topics Covered Valuing Long-Lived Assets PV Calculation Short Cuts Compound Interest Interest Rates and Inflation Example: Present Values and Bonds

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 14 Present Values Discount Factor = DF = PV of $1 Discount Factors can be used to compute the present value of any cash flow.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 15 Present Values Example You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 16 Present Values PVs can be added together to evaluate multiple cash flows.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 17 Present Values Discount Factors can be used to compute the present value of any cash flow.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 18 Present Values Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 19 Short Cuts Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tolls allow us to cut through the calculations quickly.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 20 Short Cuts Perpetuity - Financial concept in which a cash flow is theoretically received forever.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 21 Short Cuts Annuity - An asset that pays a fixed sum each year for a specified number of years.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 22 Annuity Short Cut Example - continued You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 23 Valuing a Bond Example If today is October 2000, what is the value of the following bond? An IBM Bond pays $115 every Sept for 5 years. In Sept 2005 it pays an additional $1000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%). Cash Flows Sept 0102030405 1151151151151115

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 24 Valuing a Bond Example continued If today is October 2000, what is the value of the following bond? An IBM Bond pays $115 every Sept for 5 years. In Sept 2005 it pays an additional $1000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%).

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 25 Bond Prices and Yields Yield Price

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 26 Topics Covered How To Value Common Stock Capitalization Rates Stock Prices and EPS Cash Flows and the Value of a Business

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 27 Stocks & Stock Market Common Stock - Ownership shares in a publicly held corporation. Secondary Market - market in which already issued securities are traded by investors. Dividend - Periodic cash distribution from the firm to the shareholders. P/E Ratio - Price per share divided by earnings per share.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 28 MANAGERS SHOULD BE MAKING DECISIONS WHICH INCREASE SHARE PRICE NEED TO UNDERSTAND HOW SHARE PRICE IS DETERMINED CASES WHERE WE CANNOT DIRECTLY OBSERVE STOCK PRICE WE ARE TRYING TO VALUE A DIVISION OF A COMPANY PRIVATELY HELD FIRM FOR POSSIBLE SALE WHY IS IT IMPORTANT TO HAVE A THEORY OF THE VALUATION OF COMMON STOCKS?

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 29 HOW MUCH SHOULD I PAY FOR A STOCK TODAY (P0) IF I AM GOING TO RECEIVE A DIVIDEND AT THE END OF ONE YEAR (DIV1) AND THEN I’M GOING TO SELL IT (AT A PRICE P1)? LET’S CHANGE OUR ASSUMPTIONS

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 30 PRICE OF THE STOCK IS THE PRESENT VALUE OF THE CASH FLOWS RECEIVED BY THE INVESTOR TWO EQUIVALENT WAYS OF ANSWERING THE QUESTION

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 31 I CAN CALCULATE TODAY’S PRICE ONLY IF I KNOW THE PRICE AT THE END OF THE YEAR. I AM ASSUMING THAT I HOLD THE STOCK FOR ONE YEAR AND I SELL IT. WHAT HAPPENS IF MY HOLDING PERIOD IS NOT ONE YEAR? LET’S GET RID OF BOTH LIMITATIONS. HAVE I REALLY SAID ANYTHING USEFUL? WHAT ARE THE LIMITATIONS OF MY ANSWER?

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 32 HOW MUCH SHOULD THE PERSON WHO BUYS IT FROM ME PAY FOR THE STOCK IN A YEAR’S TIME (P1) IF SHE IS GOING TO RECEIVE A DIVIDEND AFTER ONE YEAR (DIV2) AND THEN SHE IS GOING TO SELL IT (AT A PRICE P2)? LET’S SEE HOW MUCH SOMEONE WILL PAY FOR THE STOCK IN A YEAR’S TIME

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 33

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 34 EXPECTED DIVIDENDS IN YEARS 1 AND 2, DIV1 AND DIV2 EXPECTED PRICE AT END OF YEAR 2, P2 WE CAN REPEAT THE PROCESS WE HAVE NOW SUCCEEDED IN RELATING TODAY’S PRICE TO:

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 35 HOW MUCH SHOULD THE PERSON PAY FOR THE STOCK IN TWO YEAR’S TIME (P2) IF SHE IS GOING TO RECEIVE A DIVIDEND AFTER ONE YEAR (DIV3) AND THEN SHE IS GOING TO SELL IT (AT A PRICE P3 )? LET’S SEE HOW MUCH SOMEONE WILL PAY FOR THE STOCK IN TWO YEAR’S TIME

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 36 P0P0

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 37 = NOW THE PRICE OF THE STOCK IS OBVIOUSLY INDEPENDENT OF THE TIME HORIZON, H. AS WE GO OUT FURTHER IN TIME, MORE OF THE PRICE IS ACCOUNTED FOR BY THE DIVIDEND TERMS, SO THAT THE PRESENT VALUE OF THE TERMINAL PRICE BECOMES LESS IMPORTANT.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 38 1. BY CONSIDERING HOW MUCH A BUYER WILL PAY FOR THE STOCK WHEN IT IS REPEATEDLY SOLD, WE FIND THAT THE STOCK PRICE IS THE PV OF ALL FUTURE DIVIDENDS. 2. WE OBTAIN THE SAME RESULT INDEPENDENTLY OF THE ASSUMPTIONS WE MAKE ABOUT THE LENGTH OF SUCCESSIVE HOLDING PERIODS. P 0 =

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 39 SPECIAL CASES WHERE WE CAN MAKE SOME SIMPLIFYING ASSUMPTIONS ABOUT THE GROWTH PATTERN OF FUTURE DIVIDENDS

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 40 GOOD APPROXIMATION FOR MANY UTILITY STOCKS SPECIAL CASES 1. NO GROWTH SIMILAR TO PREFERRED STOCK, WITH CONSTANT DIVIDENDS DIV1=DIV2=.......=DIV ORDINARY PERPETUITY WHERE WE CAN MAKE SOME SIMPLIFYING ASSUMPTIONS BOUT THE GROWTH PATTERN OF FUTURE DIVIDENDS

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 41 DIVIDENDS EXPECTED TO GROW AT CONSTANT RATE WE KNOW THIS WON’T HAPPEN EXACTLY REASONABLE APPROXIMATION WITHIN THE ACCURACY OF OUR ESTIMATE OFTEN STATED AS COMPANY GOAL GROWING PERPETUITY CONSTANT EXPECTED DIVIDEND GROWTH (GORDON MODEL)

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 42 IF DIVIDENDS ARE EXPECTED TO GROW AT A CONSTANT RATE (g < r), VALUE OF THE STOCK IS DIV1 DIV0(1+g) P0 = = r - g r - g FOR FLEDGLING ELECTRONICS, DIV1 = 5.00, g =.10, r =.15 DIV1 5 P0 = = = $100 r - g.15 -.10 CONSTANT EXPECTED DIVIDEND GROWTH (GORDON MODEL)

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 43 DIV 1 5 P 0 = = = $50 r - g.15 -.05 WHAT HAPPENS TO THE STOCK PRICE WHEN REQUIRED RATE OF RETURN INCREASES FROM 15% TO 20% WITH INCREASE IN GENERAL LEVEL OF INTEREST RATES? EXPECTED GROWTH RATE 10%.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 44 CHANGES IN EXPECTED GROWTH RATES CAN HAVE MAJOR IMPACT ON STOCK PRICES.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 45 WHAT HAPPENS TO THE STOCK PRICE WHEN REQUIRED RATE OF RETURN INCREASES FROM 15% TO 20% WITH INCREASE IN GENERAL LEVEL OF INTEREST RATES? EXPECTED GROWTH RATE 10%. DIV 1 5 P 0 = = = $50 r - g.20 -.10

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 46 CHANGES IN REQUIRED RATES OF RETURN ON STOCKS CAN HAVE MAJOR IMPACT ON STOCK PRICES.

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 47 If dividends are expected to grow at a constant rate, g DIV 1 P 0 = r - g DIV 1 so that r = + g P 0 MARKET CAPITALIZATION RATE =DIVIDEND YIELD, (D 1 /P 0 ) + EXPECTED RATE OF GROWTH IN DIVIDENDS, g ESTIMATING THE CAPITALIZATION RATE OR REQUIRED RATE OF RETURN

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 48 SUPERNORMAL GROWTH

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 49 INVESTORS OFTEN DISTINGUISH BETWEEN : GROWTH STOCKS –EXPECTATION OF CAPITAL GAINS, BASED ON FUTURE GROWTH IN EARNINGS INCOME STOCKS –CASH DIVIDENDS DOES THIS DISTINCTION MAKE SENSE? STOCK PRICE AND EARNINGS PER SHARE (EPS)

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 50 SIMILAR TO PREFERRED STOCK, WITH CONSTANT DIVIDENDS, DIV1=DIV2=...... ORDINARY PERPETUITY EXPECTED RETURN = DIVIDEND YIELD = EARNINGS PRICE RATIO NO GROWTH

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 51 WE CAN THINK OF STOCK PRICE AS THE CAPITALIZED VALUE OF EARNINGS UNDER A NO- GROWTH POLICY; PLUS PRESENT VALUE OF GROWTH OPPORTUNITIES GROWTH COMPANY

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 52 EARNINGS PRICE RATIO WILL UNDERESTIMATE MARKET CAPITALIZATION RATE, r, BECAUSE PVGO > 0 GROWTH COMPANY

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 53 A MAJOR PART OF THE VALUE OF A GROWTH STOCK IS THE NPV OF FUTURE INVESTMENTS MAY PAY NO CURRENT DIVIDENDS GROWTH COMPANY

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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 54 PVGO = PVGO P 0 EPS r P 0 - EPS/ r % of P 0 Income stocks AT&T 51.13 3.76.136 23.88 47 Conagra 32.882.16.139 17.38 53 Duke Power 38.253.10.097 6.16 16 Exxon 64.00 4.42.109 23.26 36 Intl Paper 72.758.51.143 13.06 18 Growth stocks Genzyme 39.00 2.09.244 30.45 72 Hewlett Packard 118.50 9.33.214 74.90 63 Merck 42.50 2.84.152 23.82 56 Microsoft 64.31 2.57.165 48.73 76 WalMart 24.38 1.54.153 10.05 59 Estimated PVGOs

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