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Théorie Financière 2008-2009 1. Introduction

Théorie Financière 2008-2009 1. Introduction

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Théorie Financière 2008-2009 1. Introduction

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  1. Théorie Financière2008-20091. Introduction Professeur André Farber

  2. Organisation du cours • Ouvrages de référence: Brealey, R., Myers, S. and Allen, F. (BMA) Principle of Corporate Finance 9th ed., McGraw-Hill 2008 Farber,A. Laurent, M-P., Oosterlinck, K., Pirotte, H. (FLOP) Finance 2d ed. Pearson Education, 2008 • Site web: www.ulb.ac.be/cours/solvay/farber • Copie des transparents (PowerPoint) • Glossaire anglais - français • Notes pédagogiques, exercices, anciens examens • Liens vers d’autres sites • Examen(s) Tfin 2008 01 Introduction

  3. Exercices • Assistants: • Benoit Dewaele • Ritha Sukadi • 6 séances (Vendredi 10-12), 4 groupes • Groupe 1: A à F • Groupe 2: G à L • Groupe 3: M à P • Groupe 4: Q à Z Semaines 2, 4, 6, 9, 11, 13 Semaines 3, 5, 8, 10, 12, 14 Tfin 2008 01 Introduction

  4. Plan du cours • 1. Introduction - Fondements • 2. Valeur actuelle • 3. Cash flows, planning financier • 4. Evaluation d’entreprises • 5,6. Analyse de projets d’investissement • 7,8. Rentabilité attendue et risque • 9,10. Options • 11, 12. Evaluation et financement Tfin 2008 01 Introduction

  5. What is Corporate Finance? • INVESTMENT DECISIONS: Which REAL ASSETS to buy ? • Real assets: will generate future cash flows to the firm • Intangible assets : R&D, Marketing, .. • Tangible assets : Real estate, Equipments,.. • Current assets: Inventories, Account receivables,.. • FINANCING DECISIONS: Which FINANCIAL ASSET to sell ? • Financial assets: claims on future cash flows • Debt: promise to repay a fixed amount • Equity: residual claim • DIVIDEND DECISION: How much to return to stockholders? Tfin 2008 01 Introduction

  6. Balance sheet Income statement Sales Operating expenses = Earnings before interest and taxes (EBIT) Interest expenses Taxes = Net income (earnings after taxes) Retained earnings Dividend payments Accounting View of the Firm Net Working Capital Current liabilites Current assets Long-term debt Fixed assets Shareholders’ equity Tfin 2008 01 Introduction

  7. Cash Flows of the Firm Firm issue securities Firm invest Firm Financial markets Investors Cash flow from operations Dividend and debt payments Timing of cash flows + uncertainty Tfin 2008 01 Introduction

  8. Market Value of the Firm Book values Market values Market value of equity Total capital Book equity Market capitalization Fixed Assets + Net Working Capital Market value of debt Debt Tfin 2008 01 Introduction

  9. Value creation • Market value added (MVA) • = Market value of the firm’s capital – Total capital employed • VALUE CREATION : 2 strategies • Strategy 1 • Buy assets at a cost lower than the value of the future revenues • real assets • financial assets • Strategy 2 • Sell financial assets for a price higher than the value of future payments Stockholders’ equity + Financial debt Market value of equity + Market value of debt Tfin 2008 01 Introduction

  10. Examples (Sept 5, 2008) Tfin 2008 01 Introduction

  11. The Cost of Capital • The firm can always give cash back to the shareholders • Capital employed by the firm has an opportunity cost • The opportunity cost of capital is the expected rate of return offered by equivalent investments in the capital market • The weighted average cost of capital (WACC) is the (weighted) average of the cost of equity and of the cost of debt ? Stockholder Investment opportunities in capital markets Project Cash Tfin 2008 01 Introduction

  12. Stockholders’ problem Company Capital market ROEReturn on Equity rExpected return Tfin 2008 01 Introduction

  13. How to measure value creation ? • 1. Compare market value of equity to book value • Value creation if M/B > 1 • 2. Compare return on equity to the opportunity cost of equity • Value creation if ROE > Opportunity Cost of Equity Tfin 2008 01 Introduction

  14. Value creation: Example • Data: • Book value of equity = € 10 b • Net income = € 2 b / year • Cost of equity r = 10% • Return on equity ROE = 2 / 10 = 20% > 10% • Market value of equity = NI / r = 2 / 10% = € 20 b • Market value added: MVA = 20 – 10 = €10 b • Market to Book M/B = 20 / 10 = 2 Tfin 2008 01 Introduction

  15. M/B vs ROE • Simplifying assumptions: • ·       Expected net income income = constant • ·       Net income = dividend • Market value determination: • Net income = Expected return  Market value of equity • NI = r  MVeq • ROE (definition): • Return on equity = Net income / Book value of equity • ROE = NI / BVeq • = r  MVeq / Bveq • Conclusion: in this simplified setting, • M/B = MVeq/BVeq > 1 ROE> r Tfin 2008 01 Introduction

  16. Drivers of ROE • PROFITABILITY (du Pont system) • Three determinants : Profit Margin Asset Turnover Financial Leverage Tfin 2008 01 Introduction

  17. Example (Sept. 5, 2008) Tfin 2008 01 Introduction

  18. Foundations of Finance

  19. Theory of finance • A young science • Finance has been around for many centuries, of course… • Main problem: calculation!! • Imagine having to calculate the future value of 1 euro invested for 13 years when the annual interest rate is 4.35% (with annual compounding): Future value = (1.0435)13 • A nightmare….. • This problem disappeared after WWII with the development of computers. • Now we have calculators and spreadsheets…. • We also have large data bases Tfin 2008 01 Introduction

  20. Irving Fisher • Finance has its roots in economics • Irving Fisher laid the foundations of modern theory of finance. • Takes into account the time dimension of financial decisions • Main ideas: • Decisions should based on present value • Net Present Value (NPV): a measure of additional wealth • With perfect capital markets: independent of preferences Tfin 2008 01 Introduction

  21. Present value: 1 period, certainty • Perfect capital market • Risk-free interest rate: rf • Future cash flow C1 • Present value: • or: PV(C1) = v1 C1 with Interpretation: v1 = 1-year discount factor price of 1€ to be received in one year price of unit 1-year zero coupon Tfin 2008 01 Introduction

  22. Using present value: 1-year bond valuation Consider a risk-free zero coupon bond: Face value = 100 Maturity = 1 year Suppose 1-year risk-free interest rate = 5% How much would you be willing to pay for this bond? Tfin 2008 01 Introduction

  23. No arbitrage – 1st pass If P0≠ 95.24: arbitrage opportunity Suppose P0 = 95.50 NO FREE LUNCH There are no arbitrage opportunities in competitive markets t = 0 t = 1 Sell one bond + 95.50 - 100Invest - 95.24 + 100Total = 0.26 = 0 Suppose P0 = 95 t = 0 t = 1 Buy one bond - 95.00 + 100Borrow + 95.24 - 100Total = 0.24 = 0 Tfin 2008 01 Introduction

  24. Microeconomics: a review • Consumption over time: • 1 periods, certainty • Perfect capital markets => budget constraint • Slope = -(1+r) • Intercept = W0(1+r) • Optimum: • Marginal Rate of Substitution (MRS) = 1+r • Optimal consumption independent of timing of income Tfin 2008 01 Introduction

  25. Economic foundations of net present value Euros next year I. Fisher 1907, J. Hirshleifer 1958 165 Perfect capital markets Separate investment decisions from consumption decisions 157.5 Y1 105 Slope = - (1 + rf) = - (1 + 5%) 52.5 Euros now 150 50 100 200 Y0 Tfin 2008 01 Introduction

  26. Net Present Value Suppose the risk-free rate is rf = 5% Consider the following investment project: Initial cost: I (50) Future cash flow: C1 (60) NPV = -I + v1 C1 = -50 + 0.9524  60 = 7.14 Budget constraint with project: Tfin 2008 01 Introduction

  27. Fisher Separation Theorem Euros next year I. Fisher 1907, J. Hirshleifer 1958 Perfect capital markets Investment decision independent of:- initial allocation- preferences (utility functions) 165 105 Slope = - (1 + r) = - (1 + 5%) NPV -50 Euros now 50 100 200 207.14 Tfin 2008 01 Introduction

  28. Enterprise Valuation Suppose an all equity financed company is created for this project. Market Cap. Cash flows Step 1: Creation t = 0 t = 1-50 +60 NPV = Assets 0 Equity 0 Step 2: Equity offering + investment I+NPV = t = 0 t = 1 +60 Assets 50 Equity 50 Tfin 2008 01 Introduction

  29. Enterprise Valuation With Debt Suppose that the company borrows 40 to finance part of the project. Market Value Cash flows to equity Step 1: Creation t = 0 t = 1-10 +60 – 42 = 18 Equity = Assets 0 Equity 0 Step 2: Borrow + investment Equity = t = 0 t = 1 +18 +42 Assets 50 Equity 10Debt 40 Debt = Enterprise= 57.14 Tfin 2008 01 Introduction

  30. Entreprise Value Maximisation Numerical example Euros next year Investment opportunities Investment NPV 0 Euros today Market value of company Tfin 2008 01 Introduction

  31. Review: Certainty – 1 period Present value: Investment rules: Meaning of NPV: Variation of stockholder’s wealth Independent of time preferences (if perfect capital market) Enterprise value: Unlevered: Levered: Tfin 2008 01 Introduction

  32. Uncertainty: 1952 – 1973- the Golden Years • 1952: Harry Markowitz* • Portfolio selection in a mean –variance framework • 1953: Kenneth Arrow* • Complete markets and the law of one price • 1958: Franco Modigliani* and Merton Miller* • Value of company independant of financial structure • 1963: Paul Samuelson* and Eugene Fama • Efficient market hypothesis • 1964: Bill Sharpe* and John Lintner • Capital Asset Price Model • 1973: Myron Scholes*, Fisher Black and Robert Merton* • Option pricing model Tfin 2008 01 Introduction

  33. Uncertainty: 1 period - 2 states example You observe the following data: What is the value of the following asset? What are its expected returns? Tfin 2008 01 Introduction

  34. Introducing uncertainty Two possible approaches: Discount the expected cash flow using a risk-adjusted discount rate Later in course Discount the risk-adjusted expected cash flow using the risk-free interest rate Today Tfin 2008 01 Introduction

  35. Market statistics (details) Risk-free interest rate rf Stocks: expected cash flow Expected return on stocks Tfin 2008 01 Introduction

  36. Relative Pricing Relative pricing: Is it possible to reproduce the payoff of NewAsset by combining the bond and the stocks? To do this, solve the following system of equations: The solution is: nB = -1.00 nS = 2.50 The value of this portfolio is: V = (-1) × 95.24 + 2.50 × 100 = 154.76 Conclusion: the value of NewAsset is V = 154.76 Otherwise, ARBITRAGE Tfin 2008 01 Introduction

  37. States prices (= Digital options) A digital option is a contract that pays 1 in one state, 0 in other states (also known as Arrow-Debreu securities, contingent claims) 2 states→ 2 D-options Valuation nB = -0.020 nS = 0.025 nB = 0.030 nS = -0.025 vu = 0.595 vd = 0.357 Prices of digital options are known as state prices Tfin 2008 01 Introduction

  38. Valuation using state prices Once state prices are known, valuation is straightforward. The value of an asset with future payoffs C1u and C1dis: This formula can easily be generalized to S states: Tfin 2008 01 Introduction

  39. State prices and absence of arbitrage In equilibrium, the price that you pay to receive 1€ in a future state should be the same for all securities Otherwise, there would exist an arbitrage opportunity. • An arbitrage portfolio is defined as a portfolio: • with a non positive value (you don’t pay anything or, even better, you receive money to hold this portfolio) • a positive future value in at least one state, and zero in other states The absence of arbitrage is the most fundamental equilibrium condition. Tfin 2008 01 Introduction

  40. Fundamental Theorem of Finance In complete markets (number of assets = number of states), the no arbitrage condition (NA) is satisfied if and only if there exist unique strictly positive state prices such that: In our example: Expected return: Tfin 2008 01 Introduction

  41. State prices: formulas Tfin 2008 01 Introduction

  42. Risk-adjusted expected cash flow Define: Risk-adjusted expected cash flow Pricing equation Risk-free rate Properties: puand pd look like probabilities puand pd are risk-neutral probabilities such that the expected return, using these probabilities, is equal to the risk-free rate. Tfin 2008 01 Introduction

  43. Risk neutral probabilities: example In previous example, state prices are: The risk neutral probabilities are: Risk-adjusted expected cash flow: Present value calculation: Tfin 2008 01 Introduction

  44. Final remarks Had we known the risk-adjusted discount rate (that we calculated – see previous slide) r = 13.08%, then: Expected cash flow: Present value calculation: (True) Expected Cash Flow Risk-adjusted discount rate Tfin 2008 01 Introduction

  45. References • Corporate finance textbooks (MBA level) • Brealey, Richard, Steward Myers and Franklin Allen, Principles of Corporate Finance, 9th edition, McGraw-Hill 2006 • Ross, Stephen A., Randolph W. Westerfield and Jeffrey F. Jaffe, Corporate Finance, 6th edition, McGraw-Hill Irwin 2002 • Damoradan, Aswath, Corporate Finance: Theory and Practice, Wiley 1997 • Ouvrages de référence en français: • Bodie, Z. et Merton, R. Finance (édition française dirigée par C. Thibierge) Pearson education 2000 • Corporate finance texts for executives • Bertoneche, Marc and Rory Knight, Financial Performance, Butterworth Heinemann 2001 • Hawawini, Gabriel and Claude Viallet, Finance for Executives: Managing for Value Creation, South-Western College Publishing, 1999 Tfin 2008 01 Introduction