Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value of the expected future cash flows. u You have two investments of equal risk below: u Investment A -- price $120 with a $10 return forever. u Investment B -- price $80 with a $10 return forever. u What should happen in the market? u Answer -- equal financial claims of equal risk sell for equal prices in the market. 1

Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value of the expected future cash flows. u Two investments of equal risk below: u Investment A -- price $100 with a $12 return forever. u Investment B -- price $100 with a $8 return forever. u What should happen in the market? u Answer -- financial claims of equal risk sell for equal rates of return in the market. 2

Price Terminology u What is the difference between bid prices, the highest bid price, asked prices, the lowest asked price and market price? u What role does the existence of different information sets play in determining the different prices above? 3

Information Sets u Who probably has the better information set pertaining to the future cash flows of Microsoft? u Bill Gates -- the Chairman of the Board and Chief Executive of Microsoft u A typical stockholder of Microsoft u When we refer to the intrinsic value of Microsoft, to whose intrinsic value are we referring? u What happens when the intrinsic value is different than the market price of the stock? 4

Information Sets – Financing Decisions & Capital Investment u 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. u Managers may be more optimistic than the market about the future cash flows of the company: u What influence does this have on the financing of new investment opportunities? u The market may be more optimistic than management about the future cash flows of the company: u What influence does this have on the financing of new investment opportunities? 5

Bonds u Bonds are one claim on the value of a firm u Know how to find the present value of a bond u Know how to use the IRR function on the calculator to find the market return or yield to maturity u Know how to use the IRR function on the calculator to find the yield to call 6

Bond Terminology u Bond yield terminology u Yield to maturity u Yield to call u Current yield u Coupon rate 7

Preferred Stock u Preferred stock is another claim on the value of a firm u The value of preferred stock can be found using the perpetual no-growth model in chapter 3 u Value today = Expected dividend / required rate of return for preferred shareholders u Market typically tells you the price and the dividend in know – work backwards to get the required return 8

Common Stock u Common stock is another claim on the value of a firm: u A short-cut method to value common stock is to use the constant dividend growth model u Value today = Expected dividend /(required return for common shareholders - growth) u Weaknesses of the model: u constant growth u companies that do not pay dividends 9

Asset View: Variables That Drive Stock Value u Looking at value from the asset side instead of the financing side, the firm value is driven by: u Existing projects -- dividends or cash flows from existing projects u NPV of new investment opportunities expected to be taken in the future -- with perfect information u Competitive advantage --> Economic Profit --> taken to present leads to net present value --> which measures the increase in value of the stock (with perfect information) 10

Other Events u Factors that do not influence value -- smoke and mirrors u Stock splits u Stock dividends u Factors that influence value u Earnings u Investment announcements 11

Value of Currency u Purchasing power parity (PPP) theory states that equilibrium exchange rates between two countries will result in identical goods selling at identical prices. u Ex. The price of Big Macs. 12

u 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. 13

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

The Questions Are… u Combine thinking about purchasing power and interest rate. u And, advanced thinking, expecting and speculating, and expecting the expecting. 15