2007 David K. Linnan SECURITIES, STREAMS OF PAYMENT & VALUATION Prof David K. Linnan LAWS #600 August 21, 2007

2007 David K. Linnan CONCEPTS I BACKGROUND FOR TODAY Be conscious that we are talking on the side of securities, valuations and markets today, so we are talking in effect about “ownership” rather than “management,” any you are doing a budget b-school introduction

2007 David K. Linnan CONCEPTS II SIX CONCEPTS FOR TODAY 1.The what is a share of common stock (security) question, a.Piece of paper on course home page (or in corporations kit) b.The equity stuff described in Klein & Coffee as a vote & residual claim? c.Something under the corporations code 2.Financial asset concept (stream of payments & certainty) a.Bonds? b.Stock? c.Derivatives? 3.Discounted present value/terminal value calculations

2007 David K. Linnan CONCEPTS III SIX CONCEPTS FOR TODAY (CONT’D) 4.Expectation theory of interest rates/yield curve shows current rates, but they change daily 5.Market interest rate concept, treasury bills currently ?%, recently ?%, how much one year ago; assume fixed payment stream like bond, can calculate current value based on current conditions 6.Valuing streams of payments/financial assets on present discounted basis using risk-free rate plus (default) premium (can value comparatively as IRR to determine better or worse investments comparing IRRs)

2007 David K. Linnan PAYMENT STREAM I FINANCIAL ASSET AS STREAM OF PAYMENTS, TREATMENT OVER TIME 1.Assume bond, conceived of as income payment stream of fixed interest payments plus principal repaid at maturity 2.What happens when the market rate of interest changes?

2007 David K. Linnan PAYMENT STREAM II FINANCIAL ASSET AS STREAM OF PAYMENTS, TREATMENT OVER TIME (CONT’D) 1.Assume bond bears market interest rate at 10% for 10 years, principal repaid of U$ Means 10 payments of U$100 at end of each year, final additional payment of U$1000 at end of 10 years 3.What happens to the value of the bond if the market rate of interest rises to 20% per annum for 10 year bonds?

2007 David K. Linnan PAYMENT STREAM III FINANCIAL ASSET AS STREAM OF PAYMENTS, TREATMENT OVER TIME (CONT’D) 4.What happens to the value of the bond if the market rate of interest falls to 5% per annum for 10 year bonds? 5.What happens to the value of the bond if it was not issued with a fixed interest rate of 10% originally but instead with a floating market interest rate which just happened to be 10% upon issuance 6.What happens to the value of that bond if the market interest rate rises to 20% versus falls to 5%?

2007 David K. Linnan IRR CALCULATION I FINANCIAL ASSET AS STREAM OF PAYMENTS, TREATMENT OVER TIME & IRR 1.IRR is simply the methodology for comparing internal rates of return between two separate payment streams 2.IRR simply solves for the discount rate (IRR) at which the net present value of the investment is zero

2007 David K. Linnan IRR CALCULATION II FINANCIAL ASSET AS STREAM OF PAYMENTS, TREATMENT OVER TIME & IRR (CONT’D) 3.IRR calculates plus & minus of cash in-flows & outflows for comparison of positive net present value calculations compared to capital costs 4.Concept of reinvestment risk (e.g., rates can go down so less interest if buy Treasuries at ?% today than last year at ?

2007 David K. Linnan STREAM OF PAYMENTS VALUATION OF FINANCIAL ASSETS 1.Does the financial asset’s nature matter as payment stream? 2.Nature of stream of payments from different kinds of securities a.Bonds (contracts) b.Stocks (vote plus residual claim) c.Derivatives 3.Nature & timing of stream of payments, effect of taxes

2007 David K. Linnan PV & IRR PRESENT VALUE OF FUTURE PAYMENT STREAM OF $1 IN YEAR X vs IRR Present Value Formula, in year X, A is end amount, PV is Present Value, Interest Rate = r, for example 10% annual A X =PV(1 + r) x orPV=A X /(1 + r) X IRR formula same, only make it 0=A X /(1 +r) X A IS EFFECTIVELY CASH FLOW PROJECTIONS, SOLVE FOR R AS INTEREST RATE/IRR. HURDLE RATE (TRAD 30% FOR INDONESIA)?

2007 David K. Linnan EXPECTATION THEORY WHAT IS COMPOSITION OF INTEREST RATES? 1.Time Value of money.07 – 3.0% 2.Purchase Power Risk (inflation expectation) 3.Default Risk (0% for government, credit risk for corporate) 4.[Currency Risk Internationally (depends upon revaluation expectations] 5.[Liquidity Risk] WHY DOES THE YIELD CURVE CHANGE DAILY?

2007 David K. Linnan JG WENTWORTH? KNOWING WHAT YOU KNOW, VALUING A STRUCTURED SETTLEMENT (TVCOMMERCIAL)? 1.What is a structured settlement, like the Tobacco settlement promises to pay in the future (producing tobacco bonds, any different form an individual settlement & cashing out? 2.How do you value in present terms a future stream of income? What do you look to and what do you take into account? 3.Is the price paid as current value for a structured settlement going to be the same on any given day? How much can it vary?

2007 David K. Linnan TAXES EFFECT OF TAXES & CONCERNS? 1.What is the effect of taxes on the value of a stream of payments? 2.Should all goods/investments be taxed at the same rate, and what is the effect when they are not (e.g., taxing or not taxing interest vs capital gains in trading equities)? What about a preferential dividend rate? 3.How do you decide as a businessperson how much profit you would make from an investment, and how do you chose between investments if you have only limited funds?