Download pdf - Finance Chapter 8 GSU

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