Chapter 4 --Value-driven
Management -- Arbitrage
 Explain
how arbitrage works to ensure that the prices of
financial claims are equal to the present value of the
expected future cash flows.
 You have two investments of equal risk below:
 Investment A -- price $120 with a $10 return forever.
 Investment B -- price $80 with a $10 return forever.
 What should happen in the market?
 Answer
-- equal financial claims of equal risk sell for
equal prices in the market.
Arbitrage
 Explain
how arbitrage works to ensure that the prices of
financial claims are equal to the present value of the
expected future cash flows.
 Two
investments of equal risk below:
 Investment A -- price $100 with a $12 return forever.
 Investment B -- price $100 with a $8 return forever.
 What
should happen in the market?
 Answer -- financial claims of equal risk sell for equal rates
of return in the market.
Price Terminology

What is the difference between bid prices, the
highest bid price, asked prices, the lowest asked
price and market price?

What role does the existence of different
information sets play in determining the different
prices above?
Information Sets
Who probably has the better information set
pertaining to the future cash flows of Microsoft?
 Bill Gates -- the Chairman of the Board and
Chief Executive of Microsoft
 A typical stockholder of Microsoft
 When we refer to the intrinsic value of Microsoft,
to whose intrinsic value are we referring?
 What happens when the intrinsic value is different
than the market price of the stock?

Information Sets – Financing Decisions &
Capital Investment
 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.
 Managers may be more optimistic than the market about
the future cash flows of the company:
 What influence does this have on the financing of new
investment opportunities?
 The market may be more optimistic than management
about the future cash flows of the company:
 What influence does this have on the financing of new
investment opportunities?
Bonds
 Bonds
are one claim on the value of a firm
 Know how to find the present value of a
bond
 Know how to use the IRR function on the
calculator to find the market return or yield
to maturity
 Know how to use the IRR function on the
calculator to find the yield to call
Bond Terminology

Bond yield terminology
 Yield to maturity
 Yield to call
 Current yield
 Coupon rate
Preferred Stock
Preferred stock is another claim on the value of a
firm
 The value of preferred stock can be found using
the perpetual no-growth model in chapter 3
 Value today = Expected dividend / required rate of
return for preferred shareholders
 Market typically tells you the price and the
dividend in know – work backwards to get the
required return

Common Stock
Common stock is another claim on the value of a
firm:
 A short-cut method to value common stock is to
use the constant dividend growth model
 Value today = Expected dividend /(required return
for common shareholders - growth)
 Weaknesses of the model:
 constant growth
 companies that do not pay dividends

Asset View: Variables That Drive Stock
Value
 Looking
at value from the asset side instead of the
financing side, the firm value is driven by:
 Existing projects -- dividends or cash flows from existing
projects
 NPV of new investment opportunities expected to be taken
in the future -- with perfect information
 Competitive advantage --> Economic Profit --> taken to
present leads to net present value --> which measures the
increase in value of the stock (with perfect information)
Other Events
Factors that do not influence value -- smoke and
mirrors
Stock splits
Stock dividends
 Factors that influence value
 Earnings
 Investment announcements

Value of Currency
 Purchasing
power parity (PPP) theory states
that equilibrium exchange rates between
two countries will result in identical goods
selling at identical prices.
 Ex.
The price of Big Macs.
 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.
Interest Rate Parity Theory
 Rf
= (ERspot/ERforward)(1 + Rd) -1
 See
these examples in p.122
The Questions Are…
 Combine
thinking about purchasing power
and interest rate.
 And,
advanced thinking, expecting and
speculating, and expecting the expecting.