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8/10/2019 Finance Chapter 8 GSU
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Chapter 8
Financial Securities
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Learning Objectives
Define a financial security.
Discuss the principles of risk and return.
Capital Asset Pricing Model
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Overview
FI 3300: Corporate Finance
Accounting Review (2)
Statement of
Cash Flows (3)
Financial statement
Analysis (4)
Firms Financial Statements Valuation
Time Value of Money (6, 7)
Financial Securities &
Markets (8)
Valuation of
Bond & Stock (9)
Capital Budgeting
Basics (10)
Capital Budgeting
Advanced (11)
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What is a financial security?
It is a contractbetween the provider of funds and the userof funds which specifies:
Amount of money provided
Terms & conditions of repayment
Provider: the bank, venture capitalist, private investor etc.
User: entrepreneur or firm
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Example of a Financial Security
>You start your firm by borrowing 7.5 million dollars
from a bank at 8% interest p.a.
> In return, your contract with the bank stipulates thatyou will repay the bank in 10 equal yearly
installments. Each installment is approximately 1.118million dollars every year.
> The loan is a financial security
oUser of funds:
o Provider of funds:
oAmount of funds provided:
o Terms and conditions of repayment:
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Common Financial Securities
Debt security Equity security
Holder is a creditor of the firm.
No say in running of the firm.
Holder is an owner of the firm.
Have a say in running of the firm.
Fixedpayment. Payment is not fixed.
Receives payment before
anything is paid to equity holders.
Receives whats left over after all
debt holders are paid.
If firm cannot pay, debt holderswill take over ownership of firm
assets.
If firm cannot pay debt holders, losescontrol of firm to debt holders.
Limited liability. Limited liability.
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Example--Debt and Equity
Suppose ABC Co. has outstanding debt on which the obligatorypayment is $300,000 per year
Firm Cash
flow level
$500,000 $300,000 $100,000 $0
Cash flow
to debt
$300,000 $300,000 $100,000 $0
Cash flow
to equity
$200,000 $0 $0 $0
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The Principles of Risk and Return
Financial securities are risky.
There is a positive relationship between risk and return.
To take on more risk, you expect (demand) a higher rate of return.
How do you figure out the rate of return that you woulddemand from buying a risky financial security?
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The Principles of Risk and Return
Required rate of return = Risk-free rate + Risk Premium.
Risk premium: the additional rate of return, above the risk-free
rate, which you demand because of the riskiness of the financial
Security
The risk premium for a debt security is different from the risk
premium for an equity security.
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Risk and Return---Debt Security
Risk premium for debt security consists of two parts: Default risk premium (DP): compensation for the risk that
issuer may default on payments.
Maturity risk premium (MP): compensation for the maturity ofthe debt. The longer the maturity, the greater the risk that youwont get your money back.
Required rate of return for a debt security
= Risk-free rate + DP + MP
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Risk and Return---Equity Security
>Expected return for a stock is affected by:o Future dividends (residual cash flows)
o Future capital gains (potential losses)
>Uncertainty makes it difficult to define the riskpremium
>To measure therisk premium
for an equitysecurity, we apply the Capital Asset Pricing
Model (CAPM)
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CAPM
CAPM defines the risk premium of equity as
(rmrf)
: how the stock moves with the market; higher the beta,
higher the risk
rm: expected return on the market portfolio (e.g. S&P 500) rf: risk-free rate
Required rate of return for an equity security = rf+ (rmrf)
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Required Rate of Return
Required rate of return = Risk-free rate + Risk Premium
Debt
Required rate of return = rf+ DP + MP
Required rate of return / expected rate of return / appropriate discountrate / the bonds yield to maturity / cost of debt, all the terminology mean
the same thing
Equity
Required rate of return = rf+ (rmrf)
Required rate of return / expected rate of return / appropriate discount
rate / cost of equity, all the terminology mean the same thing
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What We have learnt
Define a financial security
Amount of money provided
Terms & conditions of repayment
Risk-return relationships for debt and equity securities Positive relation between risk and return
Required rate of return = Risk-free rate + Risk Premium
Required rate of return of debt= rf+ DP + MP Required rate of return of equity= rf+ (rmrf)
CAPM: risk premium of equity is (rmrf), higher , higher risk