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71 Cards in this Set
- Front
- Back
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The behavior of bond prices over time
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The expected price of pure discount bonds rises exponentially to the face value w time and the actual price never exceeds par
Coupon bonds are more complex - value may exceed par, but when they reach maturity --> par. The longer-term bonds have more volatility than shorter-term bonds but as it nears maturity, it becomes much more sedate. ==lots more variance farther out when bonds have a long time to maturity. 30 yr bond is much riskier bc more sensitive to changes in -rate. |
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what about bond trajectories would explain why banks did not want to hold onto mortgages
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30 yrs - long-term more volatility
risk of paying off risk of refinancing if the i-rate goes down. |
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Discounted Dividend Model (also part of the Gordon Growth Model)
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DDM is any model that computes the value of a share of a stock as the PV of the expected future cash dividends.
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what is the risk-adjusted discount rate or market capitalization rate
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is the expected rate of return that investors require to be willing to invest in the stock, generally referred to as "k".
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E(r) - expected return formula for discounted dividend model
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= sum of cash dividends discounted at rate of k, which is the risk-adjusted rate of turn, over a period of time
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under the discounted dividend model, assume there is a constant growth rate and a perpetual stream of payments
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P = D1 / k-g
g=growth rate d1 = dividend payment at year 1 k = risk-adjusted rate |
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Discounted Cash Flow Approach to Valuing Stocks - for a company that does not pay dividends.
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assuming no taxes and no new shares --
PV == PV(Expected cash flows at k) - PV(investments) |
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Modigliani and Miller and Capital Structure principle
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where there are no costs of issuing new shares of stock nor costs of repurchasing existing shares or taxes, a firm's dividend policy can have no effect on the wealth of current shareholders
==If I’m not paying dividends going to make it up in the future, but this is not always true bc of taxes Co can buy back stock or pay dividends – as a shareholder you do not care bc are equivalent. == higher income taxes on dividends gives an incentive not to pay dividends and allow the money to ride and invest it. |
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The Real World: Share Repurchase Scenarios
Reality of M&M's capital structure does not matter theory |
A company had a good year, but is considering not declaring a dividend. It doesn't need the cash, but holding cash tax shelters the shareholders
– IRS rules provide huge penalties for this kind of activity Companies will finance projects using cheaper retained earnings rather than issuing more stock at a discount from its “true” market value Signaling -- if company has a bad year, company may still pay dividend even if less retained earnings to prevent sending a signal that there is a problem w co |
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Diversification
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Diversification reduces unsystematic risk bc increases the poss # of outcomes and decreases the volitity
Reduces risk - if one can diversify across diff't financial assets w diff't risk characteristics, one can reduce the tot amt of risk faced. |
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Systematic v. Unsystematic Risk
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You can diversify unsys risk, but not systematic risk.
Systematic risk is no matter how much you are diversified still some market, general economy risk. but what about diversifying w inter'l markets? now global economy - markets are related |
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What is Beta?
How do we get beta? |
Companies/Industries respond diff'tly to systematic risk of the market. The sensitivity of an individual stock to movements in the stock market is called beta.
Beta is = 1 then it tracks the market perfectly. If it moves up 1/2 as much - less exposure 2x as much - more exposure beta can be negative - it does better in worse economic times Beta is measured over time, by plotting movements in individual stocks at each point - beta is estimated w a linear regression compared to the risk free rate of US treasury securities and the S&P 500 Index. ==plot stock price relative to the market |
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Risk v expected returns
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if there is risk assoc w a portfolio - he will have to be compensated for the risk
higher risk, higher returns risk-return tradeoff Want higher return, must bear more risk. |
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what does Capital Asset Pricing Model (CAPM)
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it gives the appropriate expected rate of return (cost of capital) for ea project if you give it the project's relevant risk characteristics.
Rate of return that is required for someone to take on the investment. this is also k in the DDM. |
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what is equity or market risk premium?
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the difference btwn expected rate of return on the stock market and the risk free investment.
E(rM) - rF |
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What is the Security Market Line?
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n Modern Portfolio Theory, the Security Market Line (SML) is the graphical representation of the Capital Asset Pricing Model. It displays the expected rate of return for an overall market as a function of systematic (non-diversifiable) risk (beta).
The Y-Intercept (beta=0) of the SML is equal to the risk-free interest rate. The slope of the SML is equal to the Market Risk Premium and reflects investors' degree of risk aversion at a given time. When used in portfolio management, a single asset is plotted against the SML using its own beta and historical rate of return. If the plot of the asset falls above the SML it is considered to have a good rate of return relative to its risk, and vice versa if it falls below. So if Co A's price is greater than the market -- ppl are going to buy and price is going to come down Co B's price is low and so ppl want to sell - price goes up. So if |
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Debt (leverage) and risk
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increasing level of debt can have a large effect on beta
Increasing a firm's debt (raising debt and reducing equity) increases the risk of an equity investment. Debt is not risk free Now w default possible on debt holders bear some of the risk. |
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why might M&M's proposition that capital structure does not matte wrong?
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1. taxes -- M&M assumes the same amt of taxes for ea capital structure
2. using debt makes managers behave as investors want them too 3. debt affects the beta! |
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Why is the Net Income Perspective (world before M&M) wrong?
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Trad'l method of analysis suggested that if the rate of interest on borrowing is lower than the rate of return demanded by investors in a firm's stock, the firm should borrow to finance new projects taht are expected to return the rate = to the discount rate demanded by invetors.
Nutshell: Net income avail for shareholders of firms is the wrong measuring factor bc firms w debt and firms w no debt can have same net income w the same expected earnings. Hwr, CAPM rate will tell you that the rate you would have to give an investor to make it worth your while to risk would be diff't for a firm w debt than w/o regarless of net income bc -the expected earnigns for the shares of firm 2 more volatile than those of firm 1 bc of the fixed demands for creditors for there interest regardless of whether the firm is having a good year or not. -2 identical firms but one more leveraged would not have the same beta! More leveraged would have a higher beta Equity holder is going to bear more risk, not a higher variance. Leverage is not going to make firm value go up -- s.hs are not stupid and debt holders bear the risk of the debt. |
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M&M Assumptions
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1. no taxes
2. no difference in borrowing costs btwn corps and shareholders 3. low txn costst so invetors can readily shift btwn investments. 4. No differences of opinion on information. Managers value of risk v shareholders w limited information's valuation. leverage has no value, which underlies the first of the Modigliani & Miller propositions, is premised upon numerous assumptions which he did not establish, including that capital markets are perfectly efficient and individual investors can borrow at the same rate as financial institutions. |
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M&M Proposition re leverage and beta
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M&M Proposition II
• The expected rate of return on common stock of a leveraged firm increases in proportion the debt-equity ratio of the firm. • The expected return on equity required by investors increases with leverage because leverage increases the variance of returns. • As the D/E ratio increases creditors must be compensated for default risk and debt holders are bearing some of the risk. |
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Agency costs - managers and debt
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• Outside debt financing reduces agency cost because of the discipline imposed, and because the owner/manager still bears the agency cost imposed by residual claimants
• Agency costs of debt rise with increasing use of debt as owner/mangers take higher risks. |
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The Delaware Block Approach to Valuing Firms
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three elements of value were examined, which were market value, asset value, and earnings value. These values are then averaged in order to determine the fair value of the equity of the company. However, the problem with this approach is that each element is weighted, and this weight is arbitrarily determined.
Earnings value was determined from the last 5 years. Capitalizer is drawn from comparable companies in the same industry Dividends are ignored except in closely held firms Net asset value - assumption is the value of imminent liquidation |
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Importance of Weinberger v. UOP
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A cashout merger
"Fair Value" of Firm can be determined through forward-looking methods. merger…In determining such fair value, the Court shall take into account all relevant factors.” W rejected the DCF method. The speculative elements of value arising from the merger are excluded. But elements of future value may be considered. |
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Stock Price
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• If the company’s stock is publicly and actively traded, the ECMH says that the share value will reflect the current value of the company’s assets and investors’ views as to the competency of management.
• If the managers are managing the company to maximize shareholder value, the share price will be a good measure of the value of the company. Implicit Minority Discount affects the stock prices ability to reflect the actual value of the corp |
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Implicit minority discount
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• The IMD it posits that, no matter how liquid and informed the financial markets may be, all publicly traded shares persistently and continuously trade in the market at a substantial discount relative to their proportionate share of the value of the corporation.
• This discount arises because the stock prices represent “minority” positions, and minority positions trade at a discount to the value of the company’s equity. • IMD implies that estimates must be adjusted upward by adding a premium to offset the “implicit minority discount” asserted to exist in the comparable companies’ share prices. • The size of this upward adjustment has been routinely fixed at 30 percent concern” standard has had a largely happy and fruitful marriage with modern principles of finance. |
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EMH and publicly traded stock and fair value
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If co's stock is pub traded, EM says that the share value will reflect the current value of the co's assets and investor's views as to the competence of management
If management is operating to max sh value, the share price is a good measure of value. hwr, if managers are managing assets poorly, the market price would be lower than the "fair value" |
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3 Measures affecting fair value
-market value -third pty sale -going concern |
-market value: are we using the market value to determine price? if not, then there must be something wrong w the market value - either it doesn't exist or there is an inadequate protection for minority shs since the value may increase as a result of the merger
-thd pty sale - value of firm is not the thid pty sale. Acquirer will pay a premium to purchase control; merger price will usus be greater than the appraisal remedy so more likely to take merger price. But this gain in price for the control cannot be obtained w/o removal of minority shs, so should they rec'v these benefits? -going concern value - return on holder's shares would have been generated had merger not occurred. this is the DCF. |
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Value of the Firm
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value = discounted free cash flows for the year (minus investments per year), discounted by the weighted avg cost of capital, assumed to go to infinity.
1. Determine annual free cash flows over a horizon period, H 2. Determine the terminal value of the firm 3. determine co's cost of equity capital -- discount rate |
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Gordon Growth Model
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value of the firm = present value of all future cash flows over a period of time h, then multiplied by a future growth rate, g.
g will be litigated over. |
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Comparable Company Method
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Value = present value of yearly free cash flows for h period, then for h+1, multiply by a market multiplier
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Problem w IMD
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The implicit minority discount, or IMD, is a fairly new concept in Delaware appraisal law. A review of the case law discussing the concept, however, reveals that it has emerged haphazardly and has not been fully tested against principles that are generally accepted in the financial community. While control share blocks are valued at a premium because of the particular rights and opportunities associated with control, these are elements of value that cannot fairly be viewed as belonging either to the corporation or its shareholders. In corporations with widely dispersed share holdings, the firm is subject to agency costs that must be taken into consideration in determining going concern value. A control block-oriented valuation that fails to deduct such costs does not represent the going concern value of the firm. As a matter of generally accepted financial theory, on the other hand, share prices in liquid and informed markets do generally represent that going concern value, with attendant agency costs factored or priced in. There is no evidence that such prices systematically and continuously err on the low side, requiring upward adjustment based on an implicit minority discount.
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how to value minority sh value
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Gordon Growth Method and
Comparable Company Method |
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What is an abnormal return?
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The models, such as CAPM, produce a "predicted" return for stock i on a given day/week/mth. the stock's adnormal return is the amt by which the stock's actual return exceeds or falls short of this predicted value.
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Fraud on the Market and link to ECM for reliance element of fraud
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semi-strong theory says by definition if you trade on it you know it bc you think the price is going to appreciate -- there must be some good news causing it to go up - bc infor pub avial bests reflected in teh stock price, so the affect of info is generally avial even if the specific information (fraud) is not - can say he traded on raising price and that price rose bc of the fraud.
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Elements of Fraud on the Market
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1. Misrepresentation
2. Materiality 3. Scienter 4. Reliance 5. Txn Causation 6. Loss causation 7. Damages |
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Misrepresentation Element of Fraud
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Rules have been interpreted to incl a duty to refrain from making materially misleading public statements.
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Scienter -- element of fraud
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Statement must be made w the intent to deceive.
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Material statement - element for fraud
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false/misleading stmt is material if there is a substantial likelihood that a reasonable person would consider the stmt important in deciding to enter the txn.
Even studies used to analyze materiality questions in two ways: 1. Ex ante - Did a stock price experience abnormal returns (presumably upward) on the day that a false disclosure was made? in other words, did the stock begin to trade at an atifically inflated price when the false info was internalized by market traders? 2. Ex post - did the stock experience abnormal returns (presumably downward) when a corrective disclosure of fraud occurred? |
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Reliance - element of fraud
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Pla need not prove actual reliance on Def's misreps so long as they suffered harm trading in a market show to be "efficient"
Pla may be presumed to rely on the "integrity of the market price" in making their trading decisions, but those trading on inefficient market must show actual reliance on fraudulent info. FOM says that so long as there is a healthy trading market, market price itself can proxy for any actual reliance. Reflects the semi-strong form of ECM - if pub disclosures are quickly reflected in the market prices you are still injured. |
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Transactional Causation
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but for the fraud you would not have bought the stock and would be in a better position had the fraud not occurred.
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Loss Causation
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Fraud was the cause of Pla's financial loss.
Dura Pharm - not enough to have just purchased and sold during the period of material fraud. if you sold before the fraud was revealed, you did not suffer a loss caused by the fraud. |
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Significance of Dura
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Dura Pharm - not enough to have just purchased and sold during the period of material fraud. if you sold before the fraud was revealed, you did not suffer a loss caused by the fraud.
-narrow focus of an event study to ex post approach not enough to prove the original false disclosures likely induced positive abnormal returns either approach was acceptable before Dura. a failure to identify a fall in stock price "after the truth became known" is a lck of loss causation. |
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Damages - fraud element
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- use abnormal returns and determine the amt that the stock was overvalued. problem: may over-compensate if the fraud slowly aggregated over time. bad for those who bought early on; good for those who bought at the end of the class period. can be conflated w other disclosures.
2. use postivie abnormal retruns on dates of ea fraudulent disclosure to est the amt by which the stock was over-valued |
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More on Dura
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that plaintiffs seeking damages under section 10(b) and Rule 10b-5 cannot rely exclusively on the allegation that they purchased securities at a price artificially inflated by the defendant's false statement. Rather, the Court concluded, such plaintiffs must further plead (and, at trial, prove) that they suffered actual economic loss caused by the false statement. The Court strongly suggested that, in order to meet those requirements, plaintiffs must allege and prove that the price of the relevant security declined significantly in the wake of a corrective disclosure.
rejected the notion that an investor suffers compensable injury simply by virtue of having purchased a security at a price inflated by a misstatement or omission. The Court reasoned that in many instances - such as where an investor purchases securities at an artificially inflated price but sells before any corrective disclosure - a misstatement or omission may inflate the price of a security but cause no loss at all. Thus, the Court held that, in "fraud on the market" cases, "an inflated purchase price will not itself constitute or proximately cause the relevant economic loss." Rather, the Court ruled that, under section 10(b) and Rule 10b-5, plaintiffs must plead and prove a pecuniary loss caused by the alleged misstatement or omission. |
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When the truth becomes known - Dura principle.
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failure to identify a fall in stock price after the fraud becomes known is a lack of loss causation.
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Problem w Dura
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some think that it will induce strategic behavior - riding down prices by a series of soft corrective disclosures, bundling disclosure of bad news w good news.
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Definition of an option
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a K giving the holder the right to buy or sell an asset on or before a future date at a specific price
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Derivative
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derives value from another security
e.g. mortgage backed security, stream of pymts sold to third pty |
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call option
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a K right to buy an asset at or before a future date at a specified price
right to buy |
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put option
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a k right giving the holder the right to sell an asset at or before a future date at a specific date
==right to sell |
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american v european option
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A - k that allows the holder to buy or sell asset on or before expiration date
E - k that allows holder to buy or sell an asset only on the expiration date. |
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Uses for Options
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Uses for Options
• Reduce exposure to risk o Option that you’ll buy crops instead of a forward K But if you transfer risk, you implicitly increased their risk which they will charge you a fee • Compensation • Real estate – project cannot be undertaken w/o all parcels or zoning charges • Warrants and preferred stock |
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Put-Call Parity
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– The investor's position is the same whether the stock rises or falls.
– Since the investment is riskless we expect the investor to earn the risk free rate of return. – The law of one price means that the investor can earn no more than if they held risk-free bond. – The values of a put and a call with the same exercise date and the same expiration date are identical: put-call parity. – This assumes that the costs of purchasing a call option and selling a put option are sufficient to remove any gains in excess of the risk-free rate. – If not arbitrage would adjust prices until they are equivalent. |
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Importance of call-put parity in finance
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1. A riskless zero-coupon bond
2. A share of stock 3. A call option on the stock 4. a put option on the stock • Either can be bought (long) or sold (short) • The put-call parity theorem then states that with any three of these instruments, the fourth can be replicated. |
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Importance of call put parity in law
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the values assume no default risk, so if risk free then can use to circumvent any rule covering another asset through put-call.
– The basis for legal/regulatory arbitrage is the put-call parity theorem. – The put-call parity theorem’s legal significance arises when economically equivalent positions receive different legal treatments simply because they are constructed from different instruments. – The legal system is inconsistent: some cash flow patterns correspond to more than a single legal treatment and regulatory arbitrage is possible |
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BS valuing options underlying assumptions
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• The underlying stock does not pay dividends before expiration;
• Both the option and the stock can be continuously traded in a frictionless market at zero cost; • There are no restrictions on short selling of any asset (including borrowing and lending at the risk free rate); • The risk free rate of interest (rF ) is constant over time; • The underlying stock has returns that are “lognormally” distributed with a standard deviation (or “volatility”) parameter (σ) that is constant over time. o If this does not look like a bell curve, then the option of going up is not the same as the same as the down side. Means out of the money may mean its worth more o Equally likely for the stock to go up or down. This is not true for most stocks |
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what happens to the option price when the variables of black scholes change?
current stock price strike price - K interest rate to maturity volatility to maturity |
• Current stock price (S0): Positive: A call option is worth more when the stock price today is higher.
• Strike Price (K): Negative: A call option is worth more when the strike price is lower • Interest Rate to Maturity (rF): Positive: A call option is worth more when the interest rate is higher. o The intuition is that as the call option purchaser, you do not need to lay out the cash to cover the strike price immediately. o The higher the interest rate, the more value there is to you, the call owner, not to have topay the strike price upfront. • Volatility to Maturity (σ): Positive: A call option is worth more when there is more volatility. o When the underlying stock increases in volatility, the call option holder gets all the extra upside, but does not lose more from all the extra downside. o This increases the value of the option. o An option with a strike price of $100 on a stock that will be worth either $99 or $101 at expiration is worth less than an option on a stock that will be worth either $50 or $150 at expiration. |
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Reasons for employee stock option plans and problems assoc
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• Many firms have managerial and employee stock options plans (ESOP) in order to motivate their work force better.
• The Idea: Options are more sensitive to changes in the underlying value of the firm than stock, so employees will be especially motivated to work hard if they own options. o Make Managers sensitive to the stock price – incentive to increase value, agency costs. • There are many unusual details to these employee options making them very hard to value: o They tend to be very long-term (often as long as 10 years). No options traded are longer than 3 yrs o They often vest only after a few years (meaning that if the employee leaves the firm, he loses the option). o They are actually misnamed. If exercise triggers the creation of new underlying shares by the firm, the proper name for such a claim is warrant, not option. This is the case here: almost all employee stock options are dilutive. These are usu warrants, B-S assumes they are the hedging the options someone is betting under and someone is betting over But usu what happens the co creates them and dilutes the price of the company. o Because of tax rules, most of these options must have a strike price equal to the current underlying stock price. o They cannot be sold or bought, cannot be hedged by employees less valuable to employees than third ptys o The last feature means that employee stock options are very different from other financial options. o Employees should exercise their options as soon as they can in order to diversify their wealth away from being too linked to this one company. o Early exercise also robs the firm of the options’ incentive effects sooner, which was after all the whole point of granting these options in the first place. == “The Black-Scholes formula or put-call parity are definitely not applicable in this context.” |
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Who do managers represent and its impact on value.
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Who do Managers Represent?
• Investors (for e.g., the company’s equity holders and debt holders) • Customers and Suppliers • Employees Caps on CEO pay are NOT the handle the problem – ppl try to get around it and wastes money What factors influence managerial incentives? • Proportion of the co’s stock owned by managers also determines the extent to which managements interests deviate from those equity holders o If manager owns only 5% of firms share, ea dollor of unncesseary expenditures that benefit the manager personally costs him .05$ • Time spent on the job – more power Why shareholders cannot control managers? • Free-rider problem – it is not in the interest of diffuse shareholders to take actions to discipline managers • No one wants to be the one to monitor the CEO so no one does it • Proxy fight o Req’ organizing shareholders to oust the incumbent BOD by electing a new board Expensive and usu don’t win o CEO’s protect themselves from staggered elections |
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Why do management decisions deviated from those that maximize firm values
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1) Managers take advantage of their positions and engage in actions that allow them to benefit personally at the expense of shareholders
2) Managers view their positions as serving broader constituency than just shareholders -loyalty to employees |
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Why shareholders cannot control managers
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• Free-rider problem
– It is not in the interest of diffuse shareholders to take actions to discipline managers • Proxy fights – Require organizing shareholders to oust the incumbent board of directors by electing a new board – Very expensive – Usually don’t win |
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upside of separation of control and ownership
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• Firms with concentrated ownership are likely to be better monitored and thus better managed.
• Shareholders who take large equity stakes may be inadequately diversified. • All shareholders benefit from better management, however, the costs of having a less diversified portfolios are borne by the large shareholders. • Because of the costs of bearing firm-specific risk, ownership is likely to be less concentrated than it would be if management efficiency were the only consideration. |
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Management shareholdings and market value
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• Ownership of shares in many corporations is actually quite concentrated.
• The effect of management shareholdings on stock prices – Holding a large number of shares tells investors that the entrepreneur is confident about the firm’s prospects. • Entrepreneurs may obtain a better price for their shares if they commit to holding a larger fraction of the firm’s outstanding shares. |
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How management control distorts investment decisions
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The investment choices managers prefer
– Making investments that fit the manager’s expertise – Making investments in visible/fun industries – Making investments that pay off early – Making investments that minimize the manager’s risk and increase the scope of the firm – Trading off the benefits and costs of discretion • Managers may prefer investments that enhance their own human capital and minimize risk. • Managers may prefer larger, more diversified firms • Managers may prefer investments that pay off more quickly than those that would maximize the value of their shares. |
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Executive compensation and agency costs
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Executive compensation and agency costs
Executive compensation • Principal-agent relationship in which shareholders (principals) have conflicting interest with agents (management). • The agency problem – Two components of an agency problem – Measuring inputs versus measuring outputs – Designing optimal incentive contracts – Minimizing agency costs |
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Methods of compensation and their drawbacks
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2 ways to Monitor
1. Effort - hrs worked 2. Output – outcome |
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Is executive pay closely tied to performance?
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– Jensen and Murphy’s estimates suggest that
if an executive purchased an extra $10 million jet he would lose only about $30k • More recent evidence suggests this is an underestimate. Why it is important to consider the CEO future compensation 1) A CEO who was promised a bonus in each year equal to 30% of the amount earnings exceeded a certain level. 2) If the CEO took actions that doubled earnings in his first year the stock would increase and reflect not only this year’s earnings but also the higher earnings in the future. 3) This would produce a weak link between CEO earnings and stock returns. 4) Cross sectionally there would be a relationship over many years. |
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Is executive compensation tied to relative performance?
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Is executive compensation tied to relative performance?
• One way to eliminate extraneous risk is a relative performance contract. • Determines compensation according to how well the executive’s firms performs relative to some benchmark – The advantage is that the contracts eliminate the effect of some of the risks that are beyond the mangers control. – The disadvantage is that the contract may cause firms to compete too aggressively which would reduce industry profits. Competing for market share does not improve profits and hence lowers returns. |
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Stock-Based vs. Earning-Based
Performance Pay |
Stock-Based vs. Earning-Based
Performance Pay • Stock-based compensation has the advantage that it motivates managers to improve share prices. – Stock prices change for reasons outside of a manager’s control and only partially reflect the efforts of a manager who heads an individual business units in a diversified company. • A cash flow-based compensation plan that appropriately adjusts for capital costs may provide better motivation. – Very hard to measure. |
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Existing pay arrangements and arm-length transactions to negotiating salaries. What evidence shows not arm length txns? Why are they not arms length?
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Existing pay arrangements produce two types of incentive problems.
– Compensation arrangements provide weaker incentives than would be provided under arm’s-length contracting. – Prevailing practices create perverse incentives. 21 Evidence • Goodbye payments • Link to luck (windfalls) • Rewards for short-term spikes • Repricing & backdating of options 22 Why does Arm’s-Length View Fail? • Director behavior is also subject to an agency problem – Directors ownership positions are too small to give them much incentive to resisting executives. – The director slate proposed by management is the only one offered. – Developing a reputation as a director who blocks compensation arrangements (may) harm a director’s chances of being invited to join other boards |
