principle 4: market prices reflect informationprice changes reflect changes in expected future cash flows. good decisions will tend to increase the stock prices and vice versawhat happens without ethics and trust?nothing worksproprietorship-largest number -one person owns, holds title and is legally responsible advantages: easy to form disadvantages: unlimited legal responsibilitypartnership-all partners have unlimited liability -jointly responsible for liabilities of partnership advantages: easy to form disadvantages: unlimited legal responsibilitylimited partnerships-two types of partners: 1. general partners run the business and face unlimited liability for the firms debts, while the limited partner are only liable for the invested amount disadvantage: difficult to transfer the ownership of the general partnercorporation-business form existing separate and apart from its owners advantages: limited legal responsibility, easy and cheap to change ownership, change in ownership does not impact operations, easy in raising capital disadvantages: double taxation of dividends(corp earnings are taxed and dividends taxed at personal level) , time and money to incorporatelimited liability company (LLC)a cross between a partnership and a corporation -retains limited liability for its owners -runs and is taxed like a partnership -both states and IRS have rules for what qualifies, but the bottom line is it must not look to much like a corporation or else it will be taxed as one.a lower corporate tax rate means:-more cash will be avaliable to corporations for reinvesting in the business and/or paying dividends to shareholders -US corporations will be more competitive in world markets as they keep more of their earnings after paying income taxes -the lower tax rate will cause an increase in the after-tax cost of borrowing money. Under the old tax code, a firm will save $0.35 in taxes for every dollar of interest the firm deducts. But with the new tax rate of 24%, the tax savings from deducting $1 of interest is only $0.21limitation of interest deductionsinterest paid on debt is tax-deductible expense but with the new tax law there is a limit as to how much interest is tax deductible in the year it is paid. now the maximum amount of interest can be deducted from corporate taxable income is 3-% of earnings before interest, taxes, depreciation, and amortization (EBITDA)implications of taxes-the limitation on taking a tax deduction for interest expense makes borrowing money more expensive -the higher cost especially affects firms that typically use large amount of debt (and consequently incur high interest expense)allowable deductions from incomedepreciation -pre 2018, depreciation over assets depreciable life is classified by IRS -post 2018, business can immediately deduct 100% of the cost of eligible property in the year it is placed into service, through 2022. in 2023, and the 100% immediate deduction steadily declineswhy do financial markets existthe function of a financial markets, then, is to allocate savings in an economy to the ultimate demander (user) of the savingscapital market securities-long term greater than 1 year (as opposed to money market which is less than 1 year) -long term securities issued by corporations and governmentsequityrepresents the ownership position in a business enterprise (common stock)common stockholders..are the residual or ultimate owners of a corporationprice earnings ratiothis is the ratio of the stocks price to the stocks earnings, it indicates how highly valued a companies earnings are price/earnings P/E (ttm) means trailing 12 monthsstock market indexesmeasuring what is happening to stocks -dow jones industrial average -S&P 500 -NASDAQ -Russell 2000dow jones industrial average (DIJA or Dow)the average of 30 large companiesS&P 500average of 500 large companiesNASDAQover the counter (OTC) marketrussell 2000ranks stocks largest to smallestwhy would a P/E ratio go up?-if you expect future earnings to grow -less risk -less inflationmaking money on stocksbuy low, sell highshort selling:sell the stock first, the buy it back later (covering your position) - you hope the price fallsreading the wall street journalpreferred stockholders have prior claim on income and assets of a firm (relative to common stockholders) -halfway between stocks and bondsdividendsPreferred stock: fixed dividends Common stock: varry accounting to earningspreferencePreferred stock: has preference in terms of claim in bankruptcy and income before common stockgovernanceCommon shareholders elect the board preferred shareholders no votenotes and bondsnotes have maturities up to 10 years while bonds have maturities greater than 10 yearssecured debtbacked by collateraldebenturesunsecured bonds -CDOCDOcollaterized debt obligationpar valueamount you get at maturityinterest paid(coupon rate) x (par value)current yieldinterest paid/price of bondbasis point1/100 of 1%closing priceis listed as % of par ($1000)when you buy a bond you get:1. interest (generally paid semi annually) 2. at maturity - you get the par value back regardless of what you purchased it forderivative securitiessecurities whose value is based upon the value of another security or assetoptionan option gives the owner the right to buy (call option) or sell (put option) a specified asset at a specified price over a specified period of time with an option, you only exercise them if it is in your best interest, that is.. if the price goes the wrong way, you just let them expirecall option(to buy) you are betting that the price of the underlying asset will go upput option(to sell) you are betting that the price of the underlying asset will go down. that is because you put locks in selling pricepremiumwhat you pay for the optionoptions sell..sell in lots of contracts of 100exercise or striking pricethe price you can buy the stock for (if it is a call) or the price you can sell the stock for (if it is a put)VIXa measure of the markets EXPECTATION of stock market volatility over the next 30-day period. referred to as the fear index or the fear gauge - it is based on S&P 500 index options - if the vix is 15 this represents an annualized change of 15% over the next 30 days, it means investors expect the S&P 500 to move up or down 15% / root 12 = 4.33% over the next 30 day periodfutures contracta contract to buy or sell a stated commodity (such as soybeans or corn) or a financial claim (such as US treasury bonds) at a specified price at some future specified time - there are futures contracts on commodities (cotton, corn, pork bellies, orange juice) and on securities (index futures, t-bill futures) they are contracts, no matter what you must honor themhedgerreduce risk by locking in buying or selling pricespeculatorbetting on the future movement on the assets priceinterest rate determinants-the real rate of interest is approximately equal to the difference between the nominal rate and the anticipated rate of inflation -the notion of the "real rate of interest" can be thought of as the return you get after netting out anticipated inflation -equation: r (nominal) = r(real) + r(inflation) + (r(real) x r(inflation))real rate of interest equationr (nominal) = r (real) + r (inflation)nominal or quoted interest ratethe interest rate that is quoted does not adjust for inflationreal interest ratenominal interest after inflation has been taken outapproximate nominal rate equationapproximate nominal rate = real rate + anticipated inflationterm structure of interest raterelationship between interest rates and maturity with risk held constantunbiased expectations theorythe long term interest rate is an unbiased average of the current shot term rate and future short term rates expected to prevail over the life of the obligationliquidity preference theorylender would rather land for short periods of time, borrowers would rather borrow for long periods of time and a liquidity premium adjustment to the yield come curve is necessary to bring about equilibriumNnumber of periods (can be years, months, or whatever)I/Yinterest rate per periodPVpresent valuePMTannuity pointFVfuture valueratio analysis-compare with past ratios -compare with competitorsfinancial statements balance sheetassets: what you use to make money liabilities and equity: where you get the money to finance that stuff, borrowing (debt), $ from owners (equity)EBITDAa common measure of cash flow from operations EBITDA = EBIT + depreciation + amortizationequationsales - cost of goods sold = gross profit - operating expenses = operating income or EBIT - interest expense = earnings before taxes (EBT) - income taxes = earnings after taxes (EAT) or NI or PAT - preferred stock dividends = net income avaliable to common shareholders (to be reinvested for them to send out in the form of dividends)current ratiocurrent assets/current liabilitiesacid- test (or quick ratio)(Current Assets - Inventory) / Current Liabilitiesinventory turnoverCost of Goods Sold / Inventoryaccounts receivable turnoverannual credit sales/accounts receivablegross profit marginsales less cost of goods sold/salesnet profit marginNet Income/Salesreturn on investmentsNet Income / Total Investmentoperation profit marginNet Operating Income (EBIT) / Salestimes interest earnedNet Operating Income (EBIT) / Interest Expensesdebt ratiototal liabilities/total assetstotal asset turnoverSales/Total AssetsROInet income/ some measure of investment investment may be measured by: 1. (ROA) assets = debt + equity ROE > ROA net income/total assets 2. stockholders or common equity (ROE) net income / common equityanalysis- return on assets or ROAprofit margin x asset turnover (profit after taxes / sales) x (sales / assets) = ROAanalysis- return on equity or ROEyou make money 3 ways: 1. profitability 2. efficiency (turnover) 3. leverage ROE = (profit after taxes / sales) x (sales / assets) x (assets/ equity) profitability x turnover x equity multiplierwhere do profitable project come from? how to we find projects that provide a greater return that what is indicated by principle 2?1. in competitive markets profitable projects do not last for long - business law: promote competition (low prices, keep employment high) 2. barriers to entry create excess profits - patents -quality -service -product differentiation: coolness, uniqueness -cost averages -control of raw materialstime value of moneyall else equal: 1. investors prefer more money to less money 2. investors prefer their money earlier rather than later 3. investors prefer safe to riskyif one had a choice between a dollar today or a dollar one year from now, most would choose a dollar today. why?interest and opportunity cost of passing up the earning potential of a dollarcompounding(compound interest): single payment -suppose you place $100 in a savings account that pays 6% interest, compounded annuallyannuitiesa series of fixed payments for a specified number of years. the cash payments or receipts are constant or level assumption: cash flows occur at the end of each period compound sum: suppose you deposit $100 at the end of each year in a 6% savings account * see formulaordinary annuitiesthe cash flows occur at the end of each time periodannuities duethe cash flows occur at the beginning of each time period. in effect, each cash flow has been moved forward by one period FVn (annuity due) = FVn (ordinary annuity) x (1 + i) PV(annuity due) = PV (ordinary annuity) x (1 + i)perpetuitiesan annuity that goes on forever PV = PP / i *pp = the equal dollar amount received fevernon-annual compoundingFV = PV (1 + r/m)^(nxm) m= # of times compound occurs per yearAPR or annual percentage rate (AKA nominal or quoted rate)the stated nominal annual rate before compoundingAPY or EARannual percentage yield or equivalent annual rate: the actual annual interest rate earned or paidtaking an APRthis is the nominal or quoted rate, it is generally the number that is given- to annual percentage yield (also sometimes called EAR) - press ICONV -NOM = x -press the up arrow and C/Y appears.. this is asking for m - enter this number -press up arrow, EFF=# appears, press CPT to find the APY

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The given problem (10.16) projected financial statements for Walmart for Years +1 through +5. The following data for Walmart include the actual amounts for 2012 and the projected amounts for Years +1 through +5 for comprehensive income and common shareholders’ equity, assuming it will use implied dividends as the financial flexible account to balance the balance sheet (amounts in millions).

	Actual	Projected
	2012	Year +1	Year +2	Year +3	Year +4	Year +5
Comprehensive income	$18,579	$17,666	$18,416	$19,195	$20,007	$20,851
Common shareholders’ equity:
Paid-in Capital	$ 3,952	$ 4,163	$ 4,282	$ 4,392	$ 4,491	$ 4,581
Retained Earnings	72,978	75,625	77,023	77,934	78,213	77,859
Accumulated Other Comprehensive Income	(587)	(587)	(587)	(587)	(587)	(587)
Total Common Equity	$76,343	$79,201	$80,719	$81,738	$82,117	$81,853

Assume that the market equity beta for Walmart at the end of 2012 was 1.00. Assume that the risk-free interest rate was 3.0% and the market risk premium was 6.0%. Also assume that Walmart had 3,314 million shares outstanding at the end of 2012, and share price was $69.09.

Required:

a. Use the CAPM to compute the required rate of return on common equity capital for Walmart.
b. Compute the weighted-average cost of capital for Walmart as of the start of Year +1. At the end of 2012, Walmart had$48,222 million in outstanding interest-bearing debt on the balance sheet and no preferred stock. Assume that the balance sheet value of Walmart’s debt is approximately equal to the market value of the debt. Assume that at the start of Year +1, it will incur interest expense of 4.2% on debt capital and that its average tax rate will be 32.0%. Walmart also had $5,395 million in equity capital from noncontrolling interests. Assume that this equity capital carries a 15.0% required rate of return. (For our forecasts, we assume noncontrolling interests are similar to preferred shares and receive dividends equal to the required rate of return each year.)
c. Use the clean surplus accounting approach to derive the projected dividends for common shareholders for Years +1 through +5 based on the projected comprehensive income and shareholders’ equity amounts. (Throughout this problem, you can ignore dividends to noncontrolling interests.)
d. Use the clean surplus accounting approach to project the continuing dividend to common shareholders in Year +6. Assume that the steady-state long-run growth rate will be 3% in Years +6 and beyond.
e. Using the required rate of return on common equity from Requirement a as a discount rate, compute the sum of the present value of dividends to common shareholders for Walmart for Years +1 through +5.
f. Using the required rate of return on common equity from Requirement a as a discount rate and the long-run growth rate from Requirement d, compute the continuing value of Walmart as of the beginning of Year +6 based on its continuing dividends in Years +6 and beyond. After computing continuing value, bring continuing value back to present value at the start of Year +1.
g. Compute the value of a share of Walmart common stock, as follows:

Compute the sum of the present value of dividends including the present value of continuing value.
Adjust the sum of the present value using the midyear discounting adjustment factor.
Compute the per-share value estimate.

h. Using the same set of forecast assumptions as before, recompute the value of Walmart shares under two alternative scenarios. To quantify the sensitivity of your share value estimate for Walmart to these variations in growth and discount rates, compare (in percentage terms) your value estimates under these two scenarios with your value estimate from Requirement g.

Scenario 1: Assume that Walmart’s long-run growth will be 2%, not 3% as before, and assume that its required rate of return on equity is 1 percentage point higher than the rate you computed using the CAPM in Requirement a.
Scenario 2: Assume that Walmart’s long-run growth will be 4%, not 3% as before, and assume that its required rate of return on equity is 1 percentage point lower than the rate you computed using the CAPM in Requirement a.

i. What reasonable range of share values would you expect for Walmart common stock? Where is the current price for Walmart shares relative to this range? What do you recommend?

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