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