WK 4 The investment decision Four main aspects of management Investment decision (capital budgeting) o Invest in which assets Financing decision (capital structure) o How to fund the purchase of these assets Liquidity (working capital management) o How to best manage current assets and current liabilities Dividend policy decision o How to retain and/or distribute profits Left side of B/S: uses of funds Right side of B/S: sources of funds Two important measures to quantify the contribution of an investment NPV and IRR o NPV: difference between present value of cash flows associated with an investment and the cost of the investment o IRR: required rate of return so that NPV = 0 Accept investment if IRR>firm's required rate of return Financial asset: entitlement of future cash flows Price is PV of expected future cash flows Use CF DISCOUNTING FORMULA The financing decision Debt vs equity financing Risk: uncertainty or variability of expected cash flows derived from Business/idiosyncratic risk o Failure of computers o Bad management decisions Financial risk: Exposure to factors that impact value of A/L and cash flow Interest rate risk: Foreign exchange risk Liquidity risk o Insufficient cash in short run Credit risk o Risk of default by debtors Capital risk o Insufficient shareholder funds Country risk NO agreed appropriate debt to equity ratio, depends on: Industry norms Page 1 of 17
Transcript
WK 4
The investment decisionFour main aspects of management
Investment decision (capital budgeting)o Invest in which assets
Financing decision (capital structure)o How to fund the purchase of these assets
Liquidity (working capital management)o How to best manage current assets and current liabilities
Dividend policy decisiono How to retain and/or distribute profits
Left side of B/S: uses of fundsRight side of B/S: sources of funds Two important measures to quantify the contribution of an investment
NPV and IRRo NPV: difference between present value of cash flows associated with an investment and the cost of the
investmento IRR: required rate of return so that NPV = 0
Accept investment if IRR>firm's required rate of return Financial asset: entitlement of future cash flowsPrice is PV of expected future cash flows Use CF DISCOUNTING FORMULA
The financing decisionDebt vs equity financing Risk: uncertainty or variability of expected cash flows derived fromBusiness/idiosyncratic risk
o Failure of computerso Bad management decisions
Financial risk: Exposure to factors that impact value of A/L and cash flow Interest rate risk: Foreign exchange risk Liquidity risk
o Insufficient cash in short run Credit risk
o Risk of default by debtors Capital risk
o Insufficient shareholder funds Country risk
NO agreed appropriate debt to equity ratio, depends on:
Industry norms Historic level of firm's ratio Limit imposed by lenders through loan covenants (restrictions placed on a borrower in a loan contract) Management's assessment of the firm's capacity to service/repay debt
Gearing ratio: percentage of firm's total funding provided by debt
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IPOUnderwriters:
Ensure a company raises the full amount of the issue Assists with advice on structure, price, timing and marketing of the issue and allocation of securities
Prospectus lodged with ASIC Document prepared by a company stating terms of conditions of an issue
Out-clause Specific conditions precluding full enforcement of an underwriting agreement
Ordinary shares: limited liability companies
Major source of equity funding Shareholders have voting rights Shares are usually bought fully paid Shareholder liability is limited to price of fully paid shares Partly paid shareholders have a contractual agreement to repay the amount when it is called upon
Ordinary shares: no liability companies Used for highly speculative ventures Shares issued as partly paid Shareholders may decide not to meet future calls, and instead just forfeit ownership instead of paying
Listing business on stock exchangeCompany must abide with listing rules, which are additional to corporations' legislation obligations - a non-complying listed company can be delisted Listing rule principle embraces the interests of listed entities, maintain investor protection, and maintain reputation and integrity of the market Main principles of a stock exchange's listing rules include
Security issue must be fair to both new and existing shareholders Prescribed information must be disclosed Sufficient investor interest Minimum standards on quality, size, operations, and disclosure
Different forms available to established companies
Additional ordinary shareso Rights issue: offering of shares at special price to existing shareholders in proportion to their holding of
old shares Issued pro rata: eg 1:5 Factors influencing price
Company's cash flow requirements Projected earnings flow from new investment funded by rights issue Cost of alternative funding sources
Rights issued at discount to current share price Two types
Renounceable: shareholder may sell their rights Non-renounceable: vice versa
o Placements: sale of shares to small number of select investors Prospectus not required, but memorandum of information needed Minimum subscription $500,000 to not more than 20 people Price discount cannot be excessive Allows smaller discount and shorter time frame than rights issue Dilutes holding on non-participating shareholders
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o takeover issues Acquiring company issues additional ordinary shares to owners of target company in settlement of
the transaction Alleviates need for owners of acquiring company to inject cash for purchase of company
o dividend reinvestment schemes Shareholders have option of reinvesting dividends in additional shares Usually issued at discount between 0-5% No brokerage or stamp duty
Preference shareso Hybrid: characteristics of both debt and equityo Fixed dividend rates are set at issueo Ranks ahead of ordinary shareholders in payment of dividends and liquidationo Includes combo of
Cumulative or non Participating or non Issued with different rankings
o Adv Fixed interest borrowings but they are equity finance instrument Assist in maintaining DE ratio
Quasi-equityo Convertible notes: hybrid instrument issued for fixed term at stated rate of interest for term of the note
Holder has right to convert the note into ordinary shares at specified date and preset price Option to convert to equity has VALUE Notes usually issued at a price close to market price of shares at the time of issue and the rate of
interest offered on noes is usually lower than that offered on straight debt instruments Interest payments are tax deductible Notes are often issued for longer periods than is possible with straight debt borrowing
o Optionso warrants
Pricing of shares Share price determined by supply/demand of share, as well as information Price of a share with coupons: CF/1+r Price of share with constant dividend: CF/r Price of share with constant dividend growth: D(1+g)/(r-g)
Cum-dividend and ex-dividend
Dividends are payments made to shareholders expressed as cents per share Dividends are declared at one date and paid at a later date During the period between the two dates, the shares have the future dividend entitlement attached
o i.e. Cum dividend Once dividend is paid the shares are traded ex-dividend Theoretically, price will fall on ex-dividend date by size of the dividend
Bonus share issues Where company has accumulated reserves, it may distribute these to existing shareholders As with dividends, there will be downward adjustment in share price when shares go ex-bonus
As no new capital is raised, there is no change in the assets or expected earnings of the company
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o Example—If a bonus 1:4 issue is made:
Cum-bonus price $5.00
Market value of 4 cum-bonus shares $20.00
Theoretical value of 5 ex-bonus shares $20.00
Theoretical value of 1 ex-bonus share $4.00
Share splits
Involves division of the number of shares on issue Involves no change in structure or asset value of company Theoretically, share price will fall in proportion of split
o 5 for 1 split Pre-split price: $50 Ex-split price: $10
Pro-rata rights issue
Example - market price cum-rights $1, with 1:5 rights issue priced at $0.88o Cum rights share price $1o Market value of 5 cum rights shares $5o Plus new funds from 1:5 issue 0.88o Market value of 6 ex-rights shares 5.88o Theoretical ex-rights share price 5.88/6 = 0.98
A renounceable right is a right that can be sold before it is exercisedo Value of right = N(cum rights price - subscription price)/N+1
N = number of shares required to obtain the rights issue share, and subscription price is discounted price of additional share
WK 5
EthicsRestoring trust1st - embrace transparency
Clearly show investment success and missteps Disclose conflicts of interests, quickly address problems Fully disclose fees and impact
2nd - demonstrate integrity Resolving conflict of interest in favour of clients Structure fees to align with client's risk/return objectives
3rd - improve communication Communicate with clients early and often Avoid ambiguity in talks
CFA Code of ethics Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients,
prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets.
Place the integrity of the investment profession and the interests of clients above my own personal interests. Use reasonable care and exercise independent professional judgment when conducting investment analysis,
making investment recommendations, taking investment actions, and engaging in other professional activities.
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Practice and encourage others to practice in a professional and ethical manner that will reflect credit on ourselves and the profession.
Promote the integrity of, and uphold the rules governing, capital markets. Maintain and improve my professional competence and strive to maintain and improve the competence of
other investment professionals.
7 standards:1 - professionalism2 - integrity of capital markets3 - duties to clients4 - duties to employers5 - investment analysis, recommendations, and actions6 - conflicts of interest7 - responsibilities as a CFA member
1 - ProfessionalismA. Knowledge of the law Conduct determined by
o Government/regulatorso Licensing agencieso Professional associations
CFA members musto Understand and comply with lawo Comply with stricter of applicable law or code of standardso Not knowingly participate in violations
B. Independence and objectivity Avoid situations that cause a loss of independence or objectivity in investment recommendations Maintain professional integrity by being objective Ways objectivity may be compromised
o Giftso Invites to lavish eventso Ticketso Favourso Bribes
C. Misrepresentation Must not knowingly make any misrepresentations relating to investment analysis To avoid, consider:
o Be honest about professional credentials o Exercise care and diligence when relying on outside informationo Be upfront about risk of investmentso No plagiarism
D. Misconduct Avoid dishonest, fraudulent conduct Trust is crux of financial market
3 - Duties to clientsA. Loyalty, Prudence, and Care Loyalty: carry out investments for sole benefit of client. Client interests before employer/self Prudence: act with care, skill and diligence Care: act in judicious manner to avoid harming clients
B. Fair dealing
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Recommend policies that will help to ensure that investment recommendations are explained to clients fairly Recommend policies to ensure that all clients are treated in a fair and impartial manner when taking
investment actions Some actions for fair dealing compliance
o Limit number of people involvedo Shorten time frame between decision and disseminationo Publish guidelines for pre-dissemination behaviouro Maintain list of clients and their holdings
C. Sustainability Make reasonable inquiry of your client's situation to make suitable investment recommendations Document client's needs, circumstances, and objectives in INVESTMENT POLICY STATEMENT
o Client nameo Investor objectiveso Investor constraintso Performance measurement benchmarkso Review and update investment policy statement regularlyo Documents attempts to carry out a review if circumstances prevent ito Develop test procedures for choosing investments:
Analysis of impact on portfolio diversification Comparison of investment risks with client's assessed risk tolerance Fit of investment with required investment strategy
D. Performance Presentation Give a fair and complete presentation of performance information by
o Applying Global Investment Performance Standards GIPS, or without GIPS:o Considering knowledge and sophistication of the audienceo Presenting performance of the weighted composite of similar portfolios rather than using single
representative accounto Including terminated accounts as part of performance history with a clear indication of when accounts
were terminatedo Maintaining data and records used to calculate performance being presented
E. Preservation of confidentiality Maintain client confidentiality Disclose information when required by law or client permits disclosure
WK 6
Currency exchange Major currencies adopt floating exchange rate, determined by demand and supply Other types of exchange rate regimes:
o Managed float: held within defined band relative to other currency eg Chinao Crawling peg: allowed to appreciate in controlled steps over timeo Linked exchange rate: tied to value of another currency eg HKD
Demand for a currency: As price of base currency falls, demand by foreigners increases Supply of a currency: upward sloping supply curve occurs as quantity of AUD supplied increases as price of
Relative inflation rates (US>AUS) Relative national income growth rate(AUS>US)
Relative interest rate(AUD>USD)
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Expectation(Expect AUD to decrease)
Central bank also influences byo Direct policy altering relative to inflation rate, income growth, interest rateo Intervening in trade flowso Intervening in foreign investment flowso Directly intervening in FX market
Global FX MarketsFX Markets
Comprises all financial transactions denominated in foreign currency, over USD4t per day Facilitates exchange from one currency to another
FX market participants can be classified as FX dealers and brokers Central banks Firms conducting international trade transactions Foreign currency speculators Arbitrageurs: A type of investor who attempts to profit from price inefficiencies in the market by making
simultaneous trades that offset each other and capturing risk-free profits. An arbitrageur would, for example, Page 8 of 15
seek out price discrepancies between stocks listed on more than one exchange, and buy the undervalued shares on one exchange while short selling the same number of overvalued shares on another exchange
Types of FX transactionsFX market instruments are usually
Spot transactions (T+2)o Have maturity date 2 business days after FX contract is entered into
Forward transactionso Maturity more than 2 days
Also Today (T), Tomorrow (T+1)
Spot FX quotationsIndirect quote when non-USD is base. Direct quote is when USD is base EUR/AUD 1.3755-65 means bank buys 1 EUR for 1.3755AUD and sells for 1.3765 To get AUD/EUR, inverse it. 1/1.3765 - 1/1.3755. when inversing, swap buy and sell price Cross rates Crossing a direct and indirect FX quotationGBP/USD 1.6270-75USD/NZD 1.3292-97 -> GBP/NZD
Bid = 1.6270 x 1.3292 = 2.1626 2.1626 Offer = 1.6275 x 1.3297
Crossing 2 direct FX quotationsUSD/EUR 0.8340-50USD/JPY 86.75-85 EUR/JPY = EUR/USD x USD/JPY
Forward exchange rate Forward exchange rate is FX bid/offer rates applicable at a specified date beyond spot value date Forward exchange rate varies from sport rate due to interest rate parity
o Interest parity: exchange rates will adjust to reflect interest rate differentials between countries Forward exchange rates are quoted as forward points, below or above spot rate
o +ve forward points, means forward premium, interest rate of the base currency is lowero -ve forward points means forward discount, interest rate of base currency is higher
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WK 7
Interest rate determination RBA adjusts the CASH RATE: the rate at which banks loan funds to each other Increase in IR (tightening of monetary policy) will
o Increase long term IRo Slow consumer spendingo Reducing inflation and demand for imports as we spend lesso Decrease size of current accounto Attract foreign investment, causing domestic currency to appreciate
3 effects of changes in interest rates
Liquidity effecto Effect of RBA's market operations on money supply and system liquidityo RBA increases rates by selling CGS (commonwealth government securities)
Income effecto Flow on effect form liquidity effecto If rates rise, economic activity will slow
Inflation effecto As rate of growth in economic activity slows, demand for loans also slowso Results in easing of inflation
Economic indicators
Leading indicatorso Economic variables that change before a change in business cycle
Coincident indicatorso Economic variables that change at the same time as the business cycle changes
Lagging indicatorso Economic variables that change after business cycle changes
Difficulties exist with: Knowing the extent of timing of indicators Consistently performing indicators
o Eg: rates of growth in money measures were once lead indicators and are now lagging indicators
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Loanable funds approach to IR determinationLF are the funds available in financial system for lending
LF approach is preferred way of explaining and forecasting interest rates because it iso Preferred by financial market analystso A conceptually simplistic model
LF assumes downward sloping demand curve and upward supply curve Demand for loanable funds
Business Bo Short term working capitalo Long term capital investment
Government Go Finance budgets deficits and other infrastructure spending
DEMAND FOR LOANABLE FUNDS (B+G)
Supply of LF comprises of 3 sources
Household savings S Changes in money supply M Dishoarding D
o Dishoarding (currency holdings decrease) occurs as IR rise and more securities are purchased with currency
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Term structure of IR Yield is total return on investment, including interest received and capital gain/loss Differently shaped yield curves occur
o Normal or positive yield curve Longer term interest rates are higher than short term
o Inverse or negative yield curve Short term IR higher than long term
o Humped yield curve Shape of yield curve changes over time from normal to inverse
3 theories to explain shape of yield curve 1 - Expectation theory
Current short term IR and expectations about future short term IR are used to explain shape and changes in curve
Longer term rates will be equal to average of short term rates over the period Assumptions:
o Large number of investors with homogenous expectationso No transaction costso Investors aim to maximize returns and view bonds as perfect substitutes
Explanation of shape of yield curveso Inverse yield curve
Will result if market expects future short term IR to be lower than current short term rateso Normal yield curve
Results from expectations that future short-term rates will be higher than current short-term rateso Humped yield curve
Investors expect short term IR to rise in future but to fall in following periods 2 - Segmented markets theory
If central bank increases average maturity of bonds by purchasing short term bonds and selling long term bonds
Suggests short term yields decrease and long term yields increase Although financial system liquidity is unchanged, economic activity is affected because areas of expenditure
sensitive to:o Short term IR will expando Long term IR will contract
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o
Expectation vs segmented markets
Emphasis of segmented markets theory on risk management denies existence of investors seekingo Arbitrage opportunities: without them, extreme segmentation theory would facilitate discontinuities in
yield curveo Speculative profits: speculators' trading actions are dictate by expectations
3 - Liquidity premium theory
Investors want to be compensated as longer term securities are less liquid and bear more risk Liquidity premium can be included in expectations theory equation
o L = size of liquidity premium
Risk structure of interest rates Default risk is risk that borrower will fail to pay back Commonwealth government bonds are assumed to have 0 risk Some borrowers may have greater risk of default eg state government or private firms Investors will require compensation for bearing extra risk
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Summary Changes in monetary policy interest rate settings are likely to affect the state of the economy, which in turn
affects interest rates generally o This occurs through the liquidity effect, income effect and inflation effect
Leading, coincident and lagging economic indicators assist in assessing the direction of the economy, likely future monetary policy actions and the effect on interest rates
A more disciplined approach to forming a view on future interest rates is provided by the loanable funds theory
The term structure of interest rates is represented by a yield curve, which may be normal, inverse, humped or flat
The expectations, segmented markets and liquidity preference theories describe how a yield curve obtains its shape
The risk structure of interest rates reflects the level of credit risk, over time, of a particular debt issue
