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Pierpont
Morgan
1837-1913
J.P. Morgan & Co
23 Wall Street
-Financed
railroads, canals,
steel mills,
shipping lines
--
H.E. Thompson
Intermediary
between users
and suppliers of
capital
H.E. Thompson
H.E. Thompson
From Keowon, Scott, Martin, Petty, Basic Financial Management , 7th Ed., 1996
Maxim1
The Risk-Return Tradeoff
Investment alternatives have different
risks and expected returns
The more risk in an investment the more
and investor will demand in expected
return
The expected return on a junk bond is
greater than on a treasury because the risk
is greater
H.E. Thompson
Small Firm
Common Stocks
Common Stocks
Long U.S.
Short U.S.
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
Inflation
Annual Return
H.E. Thompson
0%
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Small Firm
Common
Stock
Common
Stocks
Long Corp.
Debt
Long U.S.
Short U.S.
Inflation
Standard Deviation
of Rate of Return
30%
25%
20%
15%
10%
5%
Maxim 2
The Time Value of Money
A Dollar today is worth more than a dollar
in the future
Opportunity cost of earning interest
Current wealth is the present value of
future cash
An investment decision compares the
value of wealth in different forms (cash
today or an asset that provides cash
tomorrow)
H.E. Thompson
Maxim 3
Cash is King
Wealth depends on cash flows not profits
Profits and cash flows are different
Cash flows are the actual revenue or
expenditure rates at a particular time
Profits depend on allocated revenues and
costs.
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x
Unit Price
Revenues
Market
Share
_
Variable
Costs
+
Fixed
Costs
Capital
Expenditures
H.E. Thompson
Before
Tax Profit
Total
Operating
Expenses
Total
Expenses
Depreciation
10
Before
Tax Profit
_
Loss Carry
Forwards
Income
Taxes
Rates
After
Tax Profits
Annual
Cash Flow
Depreciation
_
Required
Capital
Expenditures
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11
Maxim 4
Incremental Cash Flows
Business decisions are based on
changes
To value a project consider the difference
between cash flows with the project and
without it
To value Saturn, General Motors must look
at not only the cash flows from Saturn but
also the impact Saturn has on sales of
Chevrolet, Buick, Pontiac
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12
Maxim 5
The Curse of Competitive Markets
It is hard to find profitable projects
High profits in product markets attract
competitors
Competitors put downward pressure on
prices and profits
Profits can be maintained through
economies of scale
F proprietary technology
F monopolistic control of product or raw materials
markets
F
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13
Maxim 6
Efficient Capital Markets
Market prices fully reflect all public
information about a security
Capital markets react very quickly to
information
The value of a firm in the market is the best
measure of true value
Investors cannot profit from publicly
available information
Maximize shareholder wealth implies
maximize the share price
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14
15
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16
17
Maxim 7
The Agency Problem
Managers are agents of the stockholders
But managers primary interest is in their
own wealth
So managers incentives must be aligned
to maximize wealth of shareholders
Mechanisms for aligning incentives
Stock options, profit sharing
F Bond covenants
F
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18
Aligning Incentives
Creation and maintenance of wealth
An Example
Disney- Michael Eisner CEO
Disney Market Value 1984 $2.2 Billion
Disney Market Value 1994 $22 Billion
A shareholder who invested $100 in 1984
has value of $1460 in 1994
Eisners Reward: $203 Million
Mostly Incentive Related
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19
Maxim 8
Taxes Bias Business Decisions
Taxes have a significant impact on
decisions
Income taxes affect cash flows
Government sometimes provides
incentives for investment that are tax
related
accelerated depreciation
F investment tax credits
F
20
Maxim 9
All Risk is Not Equal
Credit risk and market risk
Credit risk - risk of missing or being late on
a payment
Market risk - risk of change in market value
21
Maxim 10
Ethical Dilemmas are Everywhere in
Finance
Ethical behavior and value maximization
Opportunities for unethical behavior exist
Ethical behavior leads to trust
Trust is necessary for business efficiency
Ethical behavior is enforced
Through markets
F Through regulations
F Through courts
F
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24
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25
Cash
Flow
$M
$40
$20
$0
($20)
($40)
($60)
($80)
($100)
Years
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PV
60
50
40
($M)30
20
10
0
-10
-20
-30
-40
-50
0.00%
22.5%
Return
Small Firm
Common
Stocks
Common
Stocks
7.50%
15.00%
22.50%
Rate of Return
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28
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29
Financing Issues
How are projects financed?
How big are the financial markets?
How are the costs of financing related to
the risks?
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30
Financing Projects
Retained Earnings
Internal
Depreciation
New Equity Issues
New Bond Issues
External
Bank Loans
Governments
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31
32
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34
Outstanding Debt
U.S. Bond Market, Year-End 1993 ($Billions)
U.S. Treasury Securities
U.S. Agency Securities
Domestic Corporate Bonds
Municipal Securities
Yankee Bonds
Mortgage-Backed Securities
Total U.S. Bond Market
$2,275
549
1,455
988
126
1,600
$6,993
32.5%
7.9%
20.8%
14.1%
1.8%
22.9%
100.0%
Source: F. Fabozzi, Bond Markets, Analysis and Strategies, 2nd ed. 1996, p.2
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Bond Ratings
Moodys Ratings for Corporate
Bonds
Aaa
Aa
A
Baa
Ba
B
Caa
Ca
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Investment Grade
Prime, Maximum Safety
Very High Grade
Upper medium Grade
Lower Medium Grade
Junk
Speculative
Highly Speculative
Substantial Risk of Default
May be in Default
37
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Aa
A
Baa
Bond Rating
Ba
38
Recent Yields
March 1, 1996
Security
Treasury 10+ Yrs
Corporates(Aaa-Aa)
Corporates(A-Baa)
Junk(Ba-C)
Nextel Commun(Caa)
Yield
Spread
6.63%
7.28%
7.61%
9.57%
13.29%
.65%
.98%
2.94%
6.66%
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39
References
Keown, Scott, Martin, Petty, Basic Financial Management, 7th ed. Prentice-Hall 1996
Bodie, Kane, Marcus, Investments, 3rd ed. Irwin, 1996
Greenberg, Hertzfeld, Space Economics, Vol 144, Progress in Astronautics and Aeronautics, American
Institute of Aeronautics and Astonautics, 1992
Thompson, "Cost of 3He from the Moon," Second Wisconsin Symposium on Helium-3 and Fusion
Power, Wisconsin Center for Space Automation and Robotics, July 1993, p.159-172