BUSI4412

FINANCIAL SECURITY VALUATION

This course is aimed at providing you with the foundation of valuation in finance. The course will focus on finance theory, and my objective will be to cover much of the valuation concepts in finance. Unlike some other areas of business, finance has a core of theory which is fairly widely applied in the real world. The jump you will have to make from academics to application will, therefore, be somewhat smaller in the case of what you learn in your finance courses (though I admit that such a jump exists!). A recent article by two economics professors listed some of the contributions made by theoretical research in economics (economists consider finance to be part of economics) which are now widely adopted in practice. Of the ten contributions they listed, five were in finance. These were: (i) The use of Net Present Value for capital budgeting (ii) Portfolio selection rules (iii) The Beta co-efficient and the Capital Asset Pricing Model (iv) Duration Analysis (v) The Black-Scholes option pricing model. I promise you that we will study all of them in this course.

Chiefly, we will be concerned with valuation. We will study how investors value various financial assets (or securities or instruments: we will use these words interchangeably). These financial assets, like stocks, bonds, etc., are sold by firms in financial markets (like the stock market or bond market) to raise capital for investment in their "projects". Thus, financial assets are a way in which investors' wealth is transferred to firms, who invest it in productive assets.

Why do investors buy these financial assets? Because firms will give them cash flows in the future: dividends in the case of stocks, or interest or coupon in the case of bonds. We will study how investors should make their "portfolio decision" with respect to these assets: i.e., what fraction of their wealth to invest in each asset, etc. This decision is somewhat complicated by risk: the fact that investors do not know for sure the amount or timing of the cash flows they will get from each asset.

In the second part of the course, we will look at various decisions from the point of view of the corporation. First, given the way in which investors value various assets, how should corporate financial managers choose projects to invest in? This decision is often referred to as the "investment decision. Second, how should they make their "financing decision?" i.e., what is the mix or proportion of each type of financial security they should sell to raise the money to invest in their projects?

2. Forms of organization of a firm:

(1) Sole Proprietorship (2) Partnership (3) Corporation.

(1) A sole proprietorship is a business or firm owned by one individual. It is easily and inexpensively formed; the business pays no corporate income taxes, and business income is taxed at the tax rate of the individual who owns the business. The business is not subject to extensive government regulation. Against these advantages must be weighed the disadvantage that the liability of the owner is unlimited: the proprietor's personal assets may be held accountable for debts incurred for running the firm. Further, it may be difficult to raise large amounts of money under this organizational form.

(2) In a partnership, two or more persons associate to conduct a business. Many of the features of a partnership are similar to that of a proprietorship: unlimited liability and tax treatment, for instance. (However, there can be limited partnerships, quite common in the real estate business.)

(3) The corporation, however, is quite distinct from the other two forms of business organization. It is a legal entity separate from its owners and managers. This gives it some advantages: (a) It has an unlimited life (b) It permits easy transfer of ownership interest, simply by transferring shares of stock (c) it permits limited liability: i.e., shareholders' assets cannot be attached against the corporation's debt. Only the corporation goes bankrupt if it cannot pay its debt. However, corporations are subject to corporate income tax. Thus, assume that the corporation earns $1 in income. If the applicable corporate tax rate is 25%, the amount left to be divided among the shareholders is only $0.75! Corporations are of two types: private limited companies and public limited companies. In the case of the latter, its shares are freely traded in the stock market. These are also subject to additional government regulation (disclosure requirements, etc.)

In this course, we will assume that the corporations we are dealing with are ones whose shares are actively traded. We will also assume in general that all investors have free access to the capital market, and there are no "frictions" (for instance, transactions costs) preventing the free trading of securities.

3. The objective of the financial manager

Suppose you are the CEO of a car manufacturing company, which has the following three shareholders, each holding a third of its shares: an old lady, a little boy, and a pension fund manager. At a meeting of shareholders, you ask them: what should the firm manufacture? The old lady wants quick profits. She asks you to manufacture large cars, which is currently in demand. The little boy, who doesn't need much money now, asks you to spend a lot of money on R&D and come up with electric cars, which he says will be the wave of the future. The pension fund manager wants you to build small cars. What decision will you make?

The above question already exposes the problem with saying "maximize profits", since then the question arises: Profits in which period? Also, the question arises: how much risk should the management take in order to maximize profits? We can show that if all shareholders have free access to the capital markets (i.e., frictions are quite small) the answer to the above question is: manufacture that product that maximizes shareholder wealth (i.e., the share price of the firm). Will this solution please everybody? Yes, because even if the project chosen by this measure is a long-term project which is going to yield large profits to the firm only ten years from now, the old lady can borrow money against the shares in the company (or sell her shares) to generate wealth to consume today. We will see as we go along that the objective of maximizing shareholder value also takes into account automatically the different risk characteristics of different projects.

If share-price maximization is then the proper objective, how should projects be selected? We can show that if management picks that project which has the highest Net Present value (NPV), it is, in essence, maximizing shareholder value, since (given that investors have enough information about project cash flows and so on) the firm's share price will go up by the extent of the NPV of the project undertaken. In summary, if the company's stock is publicly traded, and all investors have free and cheap access to the capital markets, individual shareholders do not have to interfere in the day to day running of the company. They can leave these decisions to a manager, with instructions to maximize shareholder wealth, which, in turn, is equivalent to asking him/her to pick positive NPV projects (and, if he has to choose between projects, pick those with the highest NPV). (This result is often referred to as the Fisher Separation Theorem).

4. Net Present Value

Recall that the Net Present Value is the present value of the benefits from undertaking a project minus the present value of the investment amounts required to undertake the project. If this difference is positive, the project is yielding the firm more benefits than it costs, so that it increases firm value, and should be undertaken; if it is negative, the project will reduce firm value if undertaken, and should not be.