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INTRODUCTIONTOFINANCIALENGINEERING?FredSongSeptember20011INTRODUCTIONTOFINANCIALENGIIntroductoryWhatisFinance?WhatisFinancialEngineering?What’stheroleofFinancialEngineeringinNewEconomy?
Neweconomy
Financialengineeringande-commerce2IntroductoryWhatisFinance?NWhatisFinance?Money&Banking—MonetaryEconomicsInternationalFinance—
InternationalEconomics3WhatisFinance?Money&BankinCorporateFinanceCapitalMarket(Investments)FinancialEconomicsMultinationalCorporateFinanceInternationalFinancialMarketFinancial
Engineering4CorporateFinanceCapitalMarkeWhatisFinancialEngineering?Generalizing:FinancialEngineeringinvolvesthedesign,thedevelopment,andtheimplementationofinnovativefinancialinstrumentsandprocesses,andtheformulationofcreativesolutionstoproblemsinfinance.Specializing:FinancialEngineeringisriskmanagementviacreativestructuraltools.5WhatisFinancialEngineering?FINANCEI.T.ENGINEERINGF.E.6FINANCEI.T.ENGINEERINGF.E.6CHAPTERONE:MMTheoryandNoArbitrageMMTheory
TwomeasurementsofvalueAccounting:bookvalue—historiccostFinance:marketvalue—netpresentvalue7CHAPTERONE:MMTheoryandNoAssets=Liabilities+EquityAccountingEquality:duelentitysystemBookvaluemeasurementFunduseFundsourceFinanceEquality:Funduse=FundsourceMarketvaluemeasurement8Assets=Liabilities+EquityA
CorporateFinanceAssetsLiabilitiesandEquity
Asset1
Asset2Liabilities
Asset3..Equity.
AssetnTotalAssetsTotalLiabilitiesandEquityAccounting:Yes!Finance:No!CapitalMarketRealEconomyNPVFirmValue+NPV9CorporateFinanceAccountiLiabilitiesValueEquityValueLiabilitiesValueAssetsValueCapitalStructureFinancialleverage:orHasachangeoffinancialleverageanyimpactonthefirmvalue?10LiabilitiesValueLiabilitiesVM&MTheoryM&Massumptions:FrictionlessassumptionsNoincometaxesNotransactioncostsNoinformationasymmetryNocosttoresolveinterestconflictsamongstakeholdersAllliabilitiesarerisk-free11M&MTheoryM&Massumptions:11Notes:Amini-caseTwocompaniesEBITCapitalstructureFirmvalue$10millionp.abonds:$40million,8%shares:600,000A’sshareprice:$100pershareexpectedreturn:10%1millionshares$100millionB?AB’sbond:risk-freethesharenumberissupposedshareexpectedreturn:?12Notes:Amini-caseTwocompan(Risk-free)NoPositionImmediateCashFlowCashFlowintheFutureReplicationofA’sStockUsingB’sStockandBondsB’sTotalPayments=B’sNetEarnings+InterestPayments=(EBIT-$3.2million)+$3.2million=EBITSupposepriceofB’sstock=$90pershareShortsell1%A’ssharesat$100pershareBuy1%B’ssharesat$90pershareBuy1%B’sbonds+$1,000,0001%ofEBIT$540,0001%(EBIT$3,200,000)$400,0001%$3,200,000NetCashFlow$60,0000ArbitragePriceofB’sstock=$100pershare13(Risk-free)NoPositionM&MProposition1Proposition1:UnderM&MAssumption,i.e.,inthefrictionlessenvironment,thetotalmarketvalueofafirmisindependentofitscapital
structure.Thinkofthefirmasagiganticpizza,dividedintoquarters.Ifnow,youcuteachquarterinhalfintoeights,theM&Mpropositionsaysthatyouwillhavemorepieces,butnotmore
pizza.
—MertonMiler14M&MProposition1PropositionProbabilityDistributionofEBITandEPSfortheTwoCompaniesStateoftheEconomyEBITCompanyACompanyBEPSNetEPS(1millionshares)Earnings(600,000shares)
Badbusiness$5million$5$1.8million$3.00Normalbusiness10106.811.33Goodbusiness151511.819.67Mean10106.811.33Standarddeviation46.81Beta1.01.01.67NOTE:Eachstateoftheeconomyisequallylikely.15ProbabilityDistributionofEBThecostofcapitaldependsonitsuseandnotonitssource.Proposition!16ThecostofcapitaldependsonWeightedAverageCostofCapitalCostofcapitalofthefirmwithoutliabilityRiskpremiumofWACCFinancialleverageM&MProposition2:ThecostofcapitalofafirmequalsthecostofcapitalofthefirmwithoutliabilityandtheriskpremiumofWACCmultipliedbyfinancialleverage.17WeightedAverageCostofCapitAlltransactionsinfinancialmarketsarezero–NPVtransactionactivities.Proposition!18AlltransactionsinfinancialImplicationofM&MTheoryFrictionlessenvironmentdoesnotexistintherealworld.TaxesTransactioncostsInformationasymmetryCostsresolvinginterestconflictLiabilitiesarerisk-bearing19ImplicationofM&MTheoryFrict—TaxShieldCompanyA:Taxrate:T=33%CompanyACompanyBClaimantCreditorsShareholdersGovernmentTaxAuthority
TotalFirmValuebeforeTaxation$100million$100million067million33millionCompanyB:(1–T)(EBIT–Interests)+Interests=(1-T)EBIT+TInterests40.0million40.2million19.8million$13.2million20—TaxShieldCompanyA:Taxrate—WACCwithTaxesOtherM&MassumptionsholdHasachangeoffinancialleverageanyimpactonthefirmvalue?Answer:Yes!Discountrateforcashflowofthefirm21—WACCwithTaxesOtherM&Mas—StockPriceShareNumberTotalEquitySharePriceCompanyA:1million67.0million$67CompanyB:600,00040.2million$67?IfCompanyAweretoannounceanissueof$40milliondebttobeusedtorepurchaseandretirecommonstockA’scapitalstructure=B’scapitalstructureMarketreaction:priceofA’ssharewouldgouptoreflectthe$13.2milliontaxshield:$(67.0+13.2)million/1million=$80.2pershare.Whereisthebenefitofthetaxshield?22—StockPriceShareNumberStatePricesu=1.07d=0.98Risk-freesecurityRisk-freeinterestrateBondABondB23StatePricesu=1.07d=0.98Ri—BasicSecuritiesBasicSecurity1BasicSecurity2=
?=
?Portfolio{BasicSecurity1,BasicSecurity2}replicatingBondA=NoArbitrage24—BasicSecuritiesBasicSecuriReplicatingrisk–freesecurityPortfolio{BasicSecurity1,BasicSecurity2}replicating=LetStatePrices25Replicatingrisk–freesecurReplicatingBondAandBondBNoArbitrageQuestions?Dothereexistsuchkindbasicsecuritiesintherealworld?Arethereenoughbasicsecuritiesthatcanbeusedtoreplicateallthepayoffofsecuritiesinthemarket?Answers:Findsomeequivalentinstrumentsinsteadofbasicsecurities.Itinvolvesinmarketcompleteness.26ReplicatingBondAandBondBReplicationviaequivalentinstrumentsPortfolio{BondA,marketvaluerisk-freesecurity}replicatingBondB27ReplicationviaequivalentinMarketCompletenessWheneverthenumberofdifferentinstrumentsusedtoreplicatesecuritiesequalsthenumberofstatessothatwecanattainanypayoffofsecuritiesinfuture,insuchacircumstance,themarketisacompleteone.Otherwise,themarketisincomplete.Completenessisacoreconceptoffinancetheories!28MarketCompletenessWhenevSummaryofChapterOneNoArbitrageEquilibriumReplicationMethodologyStatePricesTechnology29SummaryofChapterOneNoArbitCHAPTERTWO:TimeValueofMoneyandTermStructureofInterest
—DiscountedCashFlowFormulaYes!istheexpectedrateofreturn,i.e.,themeanofthediscountratesfordifferenttermsLetNo!isthediscountratethatcannotbeusedforsolongperiod?30CHAPTERTWO:TimeValueofMon
—DeterminationofInterest
Capitalproductionability——themorethecapital’sexpectedretu
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