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Chapter 8

Financial Securities

Learning Objectives

Define a financial security.

Discuss the principles of risk and return.

Capital Asset Pricing Model

Overview
FI 3300: Corporate Finance
Firms Financial Statements

Valuation

Accounting Review (2)

Statement of
Cash Flows (3)

Time Value of Money (6, 7)

Financial Securities &


Markets (8)

Capital Budgeting
Basics (10)

Valuation of
Bond & Stock (9)

Capital Budgeting
Advanced (11)

Financial statement
Analysis (4)

What is a financial security?

It is a contract between the provider of funds and the user


of funds which specifies:

Amount of money provided

Provider: the bank, venture capitalist, private investor etc.

Terms & conditions of repayment

User: entrepreneur or firm

Example of a Financial Security

> You start your firm by borrowing 7.5 million dollars


from a bank at 8% interest p.a.

> In return, your contract with the bank stipulates that


you will repay the bank in 10 equal yearly
installments. Each installment is approximately 1.118
million dollars every year.

> The loan is a financial security


o User of funds:
o Provider of funds:
o Amount of funds provided:
o Terms and conditions of repayment:

Common Financial Securities


Debt security

Equity security

Holder is a creditor of the firm.


No say in running of the firm.

Holder is an owner of the firm.


Have a say in running of the firm.

Fixed payment.

Payment is not fixed.

Receives payment before


anything is paid to equity holders.

Receives whats left over after all


debt holders are paid.

If firm cannot pay, debt holders


will take over ownership of firm
assets.

If firm cannot pay debt holders, loses


control of firm to debt holders.

Limited liability.

Limited liability.

Example--Debt and Equity


Suppose ABC Co. has outstanding debt on which the obligatory
payment is $300,000 per year
Firm Cash $500,000
flow level

$300,000

$100,000

$0

Cash flow
to debt

$300,000

$300,000

$100,000

$0

Cash flow
to equity

$200,000

$0

$0

$0

The Principles of Risk and Return

Financial securities are risky.

There is a positive relationship between risk and return.

To take on more risk, you expect (demand) a higher rate of return.

How do you figure out the rate of return that you would
demand from buying a risky financial security?

The Principles of Risk and Return


Required rate of return = Risk-free rate + Risk Premium.
Risk premium: the additional rate of return, above the risk-free
rate, which you demand because of the riskiness of the financial
Security
The risk premium for a debt security is different from the risk
premium for an equity security.

Risk and Return---Debt Security

Risk premium for debt security consists of two parts:

Default risk premium (DP): compensation for the risk that


issuer may default on payments.

Maturity risk premium (MP): compensation for the maturity of


the debt. The longer the maturity, the greater the risk that you
wont get your money back.

Required rate of return for a debt security


= Risk-free rate + DP + MP

Risk and Return---Equity Security

> Expected return for a stock is affected by:


o Future dividends (residual cash flows)
o Future capital gains (potential losses)

> Uncertainty makes it difficult to define the risk


premium

> To measure the risk premium for an equity


security, we apply the Capital Asset Pricing
Model (CAPM)

CAPM
CAPM defines the risk premium of equity as

(rm rf)
: how the stock moves with the market; higher the beta,
higher the risk
rm: expected return on the market portfolio (e.g. S&P 500)
rf: risk-free rate

Required rate of return for an equity security = rf + (rm rf)

Required Rate of Return


Required rate of return = Risk-free rate + Risk Premium

Debt
Required rate of return = rf + DP + MP
Required rate of return / expected rate of return / appropriate discount
rate / the bonds yield to maturity / cost of debt, all the terminology mean
the same thing

Equity
Required rate of return = rf + (rm rf)
Required rate of return / expected rate of return / appropriate discount
rate / cost of equity, all the terminology mean the same thing

What We have learnt

Define a financial security

Risk-return relationships for debt and equity securities

CAPM: risk premium of equity is (rm rf), higher , higher risk

Amount of money provided


Terms & conditions of repayment

Positive relation between risk and return


Required rate of return = Risk-free rate + Risk Premium
Required rate of return of debt= rf + DP + MP
Required rate of return of equity= rf + (rm rf)