Chapter 4 --Value-driven Management -- Arbitrage Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value of the expected future cash flows. You have two investments of equal risk below: Investment A -- price $120 with a $10 return forever. Investment B -- price $80 with a $10 return forever. What should happen in the market? Answer -- equal financial claims of equal risk sell for equal prices in the market.

Arbitrage Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value of the expected future cash flows. Two investments of equal risk below: Investment A -- price $100 with a $12 return forever. Investment B -- price $100 with a $8 return forever. What should happen in the market? Answer -- financial claims of equal risk sell for equal rates of return in the market.

Price Terminology What is the difference between bid prices, the highest bid price, asked prices, the lowest asked price and market price? What role does the existence of different information sets play in determining the different prices above?

Information Sets Who probably has the better information set pertaining to the future cash flows of Microsoft? Bill Gates -- the Chairman of the Board and Chief Executive of Microsoft A typical stockholder of Microsoft When we refer to the intrinsic value of Microsoft, to whose intrinsic value are we referring? What happens when the intrinsic value is different than the market price of the stock?

Information Sets – Financing Decisions & Capital Investment When the information set of management does not match the information set of the stockholders, two situations may exist that have an impact on the financing decision. Managers may be more optimistic than the market about the future cash flows of the company: What influence does this have on the financing of new investment opportunities? The market may be more optimistic than management about the future cash flows of the company:

Bonds Bonds are one claim on the value of a firm Know how to find the present value of a bond Know how to use the IRR function on the calculator to find the market return or yield to maturity Know how to use the IRR function on the calculator to find the yield to call

Bond Terminology Bond yield terminology Yield to maturity Yield to call Current yield Coupon rate

Preferred Stock Preferred stock is another claim on the value of a firm The value of preferred stock can be found using the perpetual no-growth model in chapter 3 Value today = Expected dividend / required rate of return for preferred shareholders Market typically tells you the price and the dividend in know – work backwards to get the required return

Common Stock Common stock is another claim on the value of a firm: A short-cut method to value common stock is to use the constant dividend growth model Value today = Expected dividend /(required return for common shareholders - growth) Weaknesses of the model: constant growth companies that do not pay dividends

Asset View: Variables That Drive Stock Value Looking at value from the asset side instead of the financing side, the firm value is driven by: Existing projects -- dividends or cash flows from existing projects NPV of new investment opportunities expected to be taken in the future -- with perfect information Competitive advantage --> Economic Profit --> taken to present leads to net present value --> which measures the increase in value of the stock (with perfect information)

Other Events Factors that do not influence value -- smoke and mirrors Stock splits Stock dividends Factors that influence value Earnings Investment announcements

Value of Currency Purchasing power parity (PPP) theory states that equilibrium exchange rates between two countries will result in identical goods selling at identical prices. Ex. The price of Big Macs.

Ert = Ert-1(1 + INFd)/(1 + INFf) but the differences in Interest Rates and Perceived Safety between countries. Market forces are not enough. And, the difficulty of movement between two countries.

Interest Rate Parity Theory Rf = (ERspot/ERforward)(1 + Rd) -1 See these examples in p.122

The Questions Are… Combine thinking about purchasing power and interest rate. And, advanced thinking, expecting and speculating, and expecting the expecting.