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Return to NPV
Example
The government is lending you $100,000 for 10 years
at 3% and only requiring interest payments prior to
maturity. Since 3% is obviously below market, whatis the value of the below market rate loan?
repaymentloanofPV-
pmtsinterestofPV-borrowedamountNPV =
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Return to NPV
Example
The government is lending you $100,000 for 10 years at 3% and only
requiring interest payments prior to maturity. Since 3% is obviously below
market, what is the value of the below market rate loan?
Assume the market return on equivalent risk projects is 10%.
012,43$
988,56000,100
)10.1(
000,100
)10.1(
000,3000,001NPV
10
10
1
=
=
=
=tt
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Random Walk Theory
The movement of stock prices from day to day
DO NOT reflect any pattern.
Statistically speaking, the movement of stock
prices is random (skewed positive over the long term).
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Random Walk Theory
$103.00
$100.00
$106.09
$100.43
$97.50
$100.43
$95.06
Coin Toss Game
Heads
Heads
Heads
Tails
Tails
Tails
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Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
80
130
Month
Level
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Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
80
130
180
230
Month
Level
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Efficient Market Theory
Last
Month
This
Month
Next
Month
$90
70
50
MicrosoftStock Price
Cycles
disappear
once
identified
Actual price as soon as upswing is
recognized
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Random Walk Theory
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Random Walk Theory
R
eturninweekt+
1,
(%)
Return in week t, (%)
FTSE 100(correlation = -.08)
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Random Walk Theory
R
eturninweekt+
1,
(%)
Return in week t, (%)
Nikkei 500(correlation = -.06)
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Random Walk Theory
R
eturninweekt+
1,
(%)
Return in week t, (%)
DAX 30(correlation = -.03)
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Random Walk Theory
R
eturninweekt+
1,
(%)
Return in week t, (%)
S&P Composite
(correlation = -.07)
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Efficient Market Theory
Weak Form Efficiency
Market prices reflect all historical information
Semi-Strong Form Efficiency
Market prices reflect all publicly available
information
Strong Form Efficiency
Market prices reflect all information, both public
and private
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Efficient Market Theory
Fundamental Analysts
Research the value of stocks using NPV and other
measurements of cash flow
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Efficient Market Theory
Technical Analysts
Forecast stock prices based on the watching the
fluctuations in historical prices (thus wiggle
watchers)
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Efficient Market Theory
-16
-11
-6
-1
4
9
14
19
24
29
34
39
Days Relative to annoncement date
Cum
ulativeAbnorm
alReturn
(%)
Announcement Date
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Efficient Market Theory
-40
-30
-20
-10
0
10
20
30
40
1962
1977
1992
Return(%)
Funds
Market
Average Annual Return on 1493 Mutual Funds and theMarket Index
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Efficient Market Theory
0
5
10
15
20
First Second Third Fourth Fifth
AverageReturn(%)
IPO
Matched Stocks
IPO Non-Excess Returns
Year After
Offering
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Efficient Market Theory
2000 Dot.Com Boom
883,1208.092.
6.154
)( 2000March === gr
Div
indexPV
589,8074.092.
6.154)( 2002October =
=
=
gr
DivindexPV
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Lessons of Market Efficiency
Markets have no memory
Trust market prices
Read the entrails
There are no financial illusions
The do it yourselfalternative
Seen one stock, seen them all
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M&M (Debt Policy Doesnt Matter)
Modigliani & Miller
When there are no taxes and capital markets
function well, it makes no difference whether the
firm borrows or individual shareholders borrow.Therefore, the market value of a company does
not depend on its capital structure.
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M&M (Debt Policy Doesnt Matter)Assumptions
By issuing 1 security rather than 2, companydiminishes investor choice. This does not reducevalue if:
Investors do not need choice, OR
There are sufficient alternative securities
Capital structure does not affect cash flows e.g...
No taxes
No bankruptcy costs
No effect on management incentives
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M&M (Debt Policy Doesnt Matter)
Profits01.01V.
urnDollar RetInvestmentDollar
U
L
LL
L
L
01V.Profits01.)E01(D.Total
Interest)-Profits(01.01E.Equity
Interest.0101D.Debt
urnDollar RetInvestmentDollar
=
+
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M&M (Debt Policy Doesnt Matter)
).01(V
interest)-Profits(01.01E.
urnDollar RetInvestmentDollar
LL
L
D=
Interest)-Profits(01.)D01(V.Total
Profits01.01V.Equity
Interest.01-01D.Borrowing
urnDollar RetInvestmentDollar
LU
U
L
+
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Example - Macbeth Spot Removers - All Equity Financed
201510%5(%)sharesonReturn
2.001.501.00$.50shareperEarnings
2,0001,5001,000$500IncomeOperatingDCBA
Outcomes
10,000$SharesofValueMarket
$10shareperPrice
1,000sharesofNumber
Data
M&M (Debt Policy Doesnt Matter)
Expected
outcome
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Examplecont.
50% debt
M&M (Debt Policy Doesnt Matter)
3020100%(%)sharesonReturn
321$0shareperEarnings
500,11,000500$0earningsEquity
500500500$500Interest
000,21,5001,000$500IncomeOperating
CBA
Outcomes
5,000$debtofueMarket val
5,000$SharesofValueMarket
$10shareperPrice
500sharesofNumber
Data
D
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Example - Macbeths - All Equity Financed- Debt replicated by investors
3020100%(%)investment$10onReturn
3.002.001.000$investmentonearningsNet1.001.001.00$1.0010%@Interest:LESS
4.003.002.00$1.00sharestwoonEarnings
DCBAOutcomes
M&M (Debt Policy Doesnt Matter)
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MM'S PROPOSITION I
If capital markets are doing their job,
firms cannot increase value by tinkering
with capital structure.
V is independent of the debt ratio.
AN EVERYDAY ANALOGY
It should cost no more to assemble a
chicken than to buy one whole.
No Magic in Financial Leverage
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Proposition I and Macbeth
2015(%)shareperreturnExpected
1010($)shareperPrice
2.001.50($)shareperearningsExpectedEquityandDebtEqual
:StructureProposed
EquityAll
:StructureCuttent
Macbeth continued
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Leverage and Returns
securitiesallofuemarket val
incomeoperatingexpectedrassetsonreturnExpected a ==
++
+=
ED
E
rED
D
rr EDA
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M&M Proposition II
15.000,10
1500securitiesallofuemarket val
incomeoperatingexpectedrr AE
==
==
( )V
Drrrr DAAE +=
Macbeth continued
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M&M Proposition II
15.000,10
1500
securitiesallofuemarket val
incomeoperatingexpectedrr AE
==
==
( )
20%or20.
5000
500010.15.15.
=
+=Er
Macbeth continued( )VDrrrr DAAE+=
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Leverage and Risk
20%-020%sharesonReturn
$2.00-02($)shareperEarnings:debt%50
10%-5%15%sharesonReturn
$1.00-0.501.50($)shareperEarningsequityAll
Change
$500
Income
to$1,500
Operating
Macbeth continuedLeverage increases the risk of Macbeth shares
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Leverage and Returns
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100
rd = 7.5%
re = 15%
Market Value Balance Sheet example
%75.12100
6015.
100
40075. =
+
=
++
+=
A
EDA
r
ED
Er
ED
Drr
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Leverage and Returns
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100
rd = 7.5% changes to 7.875%
re = ??
Market Value Balance Sheet example continued
What happens to Re when debt costs rise?
%0.16
100
60
100
4007875.1275.
=
+
=
e
e
r
r
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Leverage and Returns
+
=
V
EB
V
DBB EDA
( )DAAE BBVD
BB +=
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WACC
+
==
V
Er
V
DrrWACC EDA
WACC is the traditional view of capitalstructure, risk and return.
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r
D
V
rD
rE
rE =WACC
WACC
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r
D
E
rD
rE
M&M Proposition II
rA
Risk free debt Risky debt
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r
D
V
rD
rE
WACC
WACC (traditional view)
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r
D
V
rD
rE
WACC
WACC (M&M view)
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After Tax WACC
The tax benefit from interest expense
deductibility must be included in the cost of
funds.
This tax benefit reduces the effective cost of
debt by a factor of the marginal tax rate.
+
=
V
ErV
DrWACC ED
OldFormula
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After Tax WACC
+
= V
ErV
DTcrWACC ED )1(
Tax Adjusted Formula
Aft T WACC
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After Tax WACC
Example - Union Pacific
The firm has a marginal tax rate of 35%.
The cost of equity is 10.0% and thepretax cost of debt is 5.5%. Given the
book and market value balance sheets,
what is the tax adjusted WACC?
Aft T WACC
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After Tax WACC
Example - Union Pacific - continued
Balance Sheet (Market Value, billions)
Assets 22.6 7.6 Debt
15 Equity
Total assets 22.6 22.6 Total liabilities
MARKET VALUES
Aft T WACC
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After Tax WACC
Example - Union Pacific - continued
+
= V
E
rV
D
TcrWACC ED )1(
Debt ratio = (D/V) = 7.6/22.6= .34 or 34%
Equity ratio = (E/V) = 15/22.6 = .66 or 66%
Aft T WACC
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After Tax WACC
Example - Union Pacific - continued
+
=
V
Er
V
DTcrWACC ED )1(
( ) ( )
%8.7078.
66.10.34.)35.1(055.
==
+=WACC