investment exam

Chapter One

The Investment Environment

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Cash is valuable

Having more is better than having less

Having more today is better than having more in future

- Why? Inflation

The stronger promise, the more valuable the cash today

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The capacity of the asset to generate cash flows

The timing of those anticipated cash flows

The expected growth of those cash flows

The uncertainty of those cash flows

Valuation Drivers:

Valuation of asset: CF / 1+ discount rate

CF bigger, valuation bigger

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Single cash flow

Annuity : a stream of constant cash flows over a specific period of time

Growing annuity : a stream of cash flow over a specific period of time growing at a constant rate

Perpetuity: a stream of cash flow that are the same number forever

Growing perpetuity : a stream of cash flow forever growing at a constant rate

PV

A growing annuity is the same as annuity in that payments for both end at a certain period. However, payments of growing annuity increase at a constant rate while payments of annuity are fixed. Growing annuity is also similar to growing perpetuity; payments of both increase at a constant rate.

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Value of Asset = CF1/(1+r)^1…………CFn/(1+n)^N

r=discount rate (capture the inflation and the riskiness of this cash flow)

The cash flow is bigger, the value of asset is bigger

The discount rate is bigger, the value of asset is smaller

PV

Larger cash Flows = higher value.

The faster the receipt of cash flows = higher value.

The higher the growth of the cash flows = higher value.

The more certain the cash flows = the higher the value.

Asset Values

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“Real” versus financial assets

Risk-return trade-off and efficient pricing of financial assets

Financial crisis of 2008

Illustrated connections between financial system and “real” side of the economy

Lessons about systemic risk

Chapter Overview

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Real Assets(can be both tangible or intangible)

Used to produce goods and services

Examples: Land, buildings, machines, intellectual property

Financial Assets

Claims to the income generated by real assets or claims on income from the government

Do not directly contribute to the productive capacity of the economy

Examples: Stocks, bonds

Real Assets vs. Financial Assets

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Capital expenditure is the company’s purchase of tangible asset

Financial asset hold claim against real assets

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Fixed-income / Debt securities

Promises either a fixed stream of income or a stream of income determined by a specified formula (e.g., corporate bond)

Equity

Represents ownership share in a firm (e.g., common stock)

Derivative securities

Payoff depends on the value of other financial variables such as stock prices, interest rates, or exchange rates

Types of Financial Assets

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Currency

$2 trillion of currency traded each day in London alone

GBP USD:1.45

If you want to buy one pounds, you will need to spend 1.45 dollars

Commodities

E.g., corn, wheat, natural gas

Other Types of Financial Markets

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The Informational Role

Consumption Timing

Allocation of Risk

Separation of Ownership and Management

Agency problems

Financial Markets and the Economy

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The Informational Role

Capital flows to companies with best prospects

Consumption Timing

Use securities to store wealth and transfer consumption to the future

Allocation of Risk

Investors can select securities consistent with their tastes for risk

Separation of Ownership and Management

Agency problems arise when managers start pursuing their own interests instead of maximizing firm's value

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Mechanisms to mitigate potential agency problems

Compensation plans tie the income of managers to the success of the firm

Monitoring from the board of directors

Monitoring by large investors and security analysts

Threat of takeover for poor performers

Financial Markets and the Economy (Continued)

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Corporate Governance and Corporate Ethics

Accounting scandals

Enron, Rite Aid, HealthSouth

Auditing scandals

Arthur Andersen (Enron’s auditor)

Sarbanes-Oxley Act (aka “SOX”)

Passed in 2002 in response to ethics scandals

Focused on corporate governance

Financial Markets and the Economy (Concluded)

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Portfolio: Collection of investment assets

Asset allocation

Choice among broad asset classes (e.g., stocks, bonds, real estate, etc.)

Security selection

Choice of securities within each asset class

The Investment Process

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Security analysis involves the valuation of particular securities that might be included in the portfolio

“Top-down” approach

Asset allocation followed by determination of particular securities to be held in each asset class

“Bottom-up” approach

Investment based on attractively priced securities without as much concern for asset allocation

The Investment Process (Continued)

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Financial markets are highly competitive

There will almost always be risk associated with investments

Risk-return trade-off - Higher-risk assets are priced to offer higher expected returns than lower-risk assets

Markets Are Competitive

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You should rarely expect to find bargains in the security markets

See Ch. 11 for a discussion of the theory and evidence of the efficient market hypothesis

Efficient market hypothesis

The prices of securities fully reflect available information to investor

If this were true, there would exist neither underpriced nor overpriced securities

Markets Are Competitive (Continued)

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No free lunch

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Passive management

Highly diversified portfolio

No attempt to improve investment performance by identifying mispriced securities

Active management

Focus on improving performance by finding mispriced securities or by timing the performance of broad asset classes

Markets Are Competitive (Concluded)

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Firms

Net demanders of capital

Raise capital now to pay for investments in plant and equipment

Households

Typically net suppliers of capital

Purchase securities issued by firms that need to raise funds

Governments

Can function as borrowers or lenders, depending on the relationship between tax revenue and government expenditures

The Players (1 of 4)

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They need capital to expand

People of saving provide capital

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Financial intermediaries bring the suppliers of capital (investors) together with the demanders of capital (primarily corporations and the federal government)

Examples

Investment companies

Banks

Insurance companies

Credit unions

The Players (2 of 4)

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Investment bankers specialize in the sale of new securities to the public, typically by underwriting the issue

Advise the issuing corporation on appropriate price, interest rates, etc.

New issues of securities are offered to the public in the primary market

Investors trade previously issued securities amongst themselves in the secondary market

The Players (3 of 4)

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Venture capital (VC) refers to money invested to finance a new, not yet publicly traded firm

VC investors commonly take an active role in the management of a start-up firm

High risk, high reward

Private equity refers to investments in companies whose shares are not publicly traded in a stock market

The Players (4 of 4)

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Antecedents of the Crisis

Fed response to high-tech bubble of 2000-2002 was an aggressive reduction in interest rates

T-bill rates dropped drastically between 2001 and 2004

As a result, this recession was mild and brief, engendering a new term, the “Great Moderation”

Historic boom in housing market resulted from seemingly stable economy and dramatically reduced interest rates

Greater tolerance for risk, such as securitized mortgages

The Financial Crisis of 2008

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INVESTMENTS | BODIE, KANE, MARCUS