Management has one basic, overriding goal - to create value for stockholders

Management cant engage in illegal employment practices, create monopolies to exploit consumers, violate
anti-pollution laws, or engage in a host of other prohibited activities. So managements explicit goal, then,
should be to maximize value for shareholders, subject to government- imposed constraints.

stock ownership has become increasingly concentrated in the hands of institutional investors, and their
holdings are so large they would depress a stocks price if they simply dumped it.

stock price is based primarily on expected cash flows projected out into the distant future, and these
expectations are based on the information that is available in the market at that time

Stock price maximization requires that corporations be efficient, that is, be able to produce high-quality goods
and services at the lowest possible cost

If a company is indeed successful and does earn above-normal profits, those very profits will attract
competition, which will eventually drive prices down and thus benefit consumers.

studies show that newly privatized companies tend to grow and thus require more employees when they are
managed with the goal of stock price maximization

admiration for a company is highly correlated with both its ability to satisfy employees and its creation of value
for shareholders

strong stock prices stimulate the economy in two ways: (a) There is increased individual spending because of
the wealth effect, and (b) corporate investment increases because high stock prices make it more feasible to
raise equity capital.

Any financial asset, including a companys stock, is valuable only to the extent that it generates cash flows; (2)
the timing of cash flows matterscash received sooner is better; and (3) investors are averse to risk, so all else
equal, they will pay more for a stock whose cash flows are relatively certain than for one whose cash flows are
more risky.

Because of these three facts, managers can enhance their firms value by increasing the size of the expected
cash flows, by speeding up their receipt, and by reducing their risk.

The cash flows that matter are called free cash flows (FCFs), not because they are costless, but because they
are free in the sense that they are available for distribution to all of the companys investors, including
creditors and stockholders.

three primary determinants of free cash flows are (1) sales revenues, (2) operating costs and taxes, and (3)
required new investments in operations.

Managers can increase unit sales, hence cash flows, by truly understanding their customers and then providing
the goods and services that customers want.

Managers must constantly strive to create new products, services, and brand identities that cannot be easily
replicated by competitors, and thus extend the period of high growth and high prices for as long as possible.
One way to increase operating profit is to reduce direct expenses such as labor and materials. However, and
paradoxically, sometimes companies can create even higher profits by spending more on labor and materials.

It takes cash to create cash. But each dollar tied up in operations is a dollar that is unavailable for distribution
to investors. Therefore, reducing asset requirements increases cash flows, which increases the stock price. For
example, companies that successfully implement justin- time inventory systems generally increase their cash
flows because they have less cash tied up in inventory.

Financial managers also must decide how to finance the firm. In particular, what mix of debt and equity should
be used, and what specific types of debt and equity securities should be issued? Also, what percentage of
current earnings should be retained and reinvested rather than paid out as dividends?

the general level of interest rates in the economy, the risk of the firms operations, and stock market investors
overall attitude toward risk determine the rate of return that is required to satisfy the firms investors. This is a
return from the investors perspective, but it is a cost from the companys point of view, and it is called the
weighted average cost of capital (WACC).

A stock valuation based on expected free cash flows is called the intrinsic value.

Eeach investor calculates a potentially different intrinsic value for the stock, based on the information he or she
has available.

The stocks market price, which is the value quoted in the market, is based on the aggregate markets
expectation of cash flows, and it is set by the marginal investor. Thus, the market price is equal to the marginal
investors intrinsic value.

Investors at the margin are the ones who actually set stock prices

The market value can be manipulated over the short term if management releases false or misleading
information. Over time, however, the stocks market price will tend toward its true intrinsic value

We will also refer to this true intrinsic value as its fundamental value, or fundamental price. If the market price
is equal to this true intrinsic value, then the stock is said to be in equilibrium.

To combat the agency problem and help make managers focus on stock price, corporate boards began
awarding managers executive stock options which are worth more when stock price is high

The reality of the situation was a bit different from the theory. Since executives primarily cared about the stock
price on the day they exercised their options and then sold their stock, many took on projects that looked good
in the short run but not in the long run, and they avoided projects that penalized short-term profits even
though they were good in the long run

Fundamental value is the value the stock would have if all accurate, pertinent information were available to
the market. If fundamental value is not equal to market value , then it is managements job to maximize the
fundamental value, and also to work to reveal accurate information so that the market price does not deviate
too far from the fundamental value.


An agency relationship arises whenever someone, called a principal, hires someone else, called an agent, to
perform some service, and the principal delegates decision-making authority to the agent.

A potential agency problem arises whenever a manager owns less than 100 percent of the firms common
stock

Some managers try to maximize the size of their firms.5 By creating a larger firm, managers (1) increase their
job security, because a hostile takeover is less likely; (2) increase their personal power and status; and (3) since
compensation is positively correlated with size, justify a higher salary and bonuses

To reduce agency conflicts, stockholders must incur agency costs, which include all costs borne by shareholders
to encourage managers to maximize the firms long-term stock price rather than act in their own self-interests.
Because managers can manipulate the information that is available in the market, it is critical that good
incentive compensation plans be based on stock prices over the long term rather than the short term.

There are three major categories of agency costs: (1) expenditures to monitor managerial actions, such as
auditing costs; (2) expenditures to structure organizations in ways that will limit undesirable managerial
Behavior, such as appointing outside investors to the board of directors; and (3) opportunity costs that are
incurred when shareholder-imposed restrictions, such as requirements for stockholder votes on certain issues,
limit the ability of managers to take timely actions that would enhance shareholder wealth.

There are two extreme positions regarding how to deal with shareholder-manager agency conflicts. At one
extreme, if a firms managers are compensated solely on the basis of long-term stock prices, At the other
extreme, stockholders could monitor every managerial action, but this would be costly and inefficient

Some specific mechanisms used to motivate managers to act in shareholders best interests include (1)
managerial compensation plans, (2) direct intervention by shareholders, (3) the threat of firing,
and (4) the threat of takeovers.

Structure of the compensation package can and should be designed to meet two primary objectives: (a) to
attract and retain able managers and (b) to align managers actions as closely as possible with the interests of
stockholders, who are primarily interested in stock price maximization

A typical senior executives compensation is structured in three parts: (a) a specified annual salary, which is
necessary to meet living expenses; (b) a cash or stock bonus paid at the end of the year, which depends on the
companys profitability during the year; and (c) options to buy stock, or actual shares of stock, which reward
the executive for long-term performance.

More and more firms are using a relatively new metric, economic value added (EVA)

EVA is found by subtracting from after-tax operating profit the annual cost of all the capital a firm uses. The
higher its EVA, the more wealth the firm is creating for its shareholders.

Why are institutions now taking such an interest in the management of companies they own? The primary
reason is that they no longer have an easy exit from the market. Their portfolios are so big that if they decided
to dump a stock, its price would take a free-fall. Therefore, rather than throwing up their hands and selling the
stock, many institutional investors have decided to stay and work with management

Another fundamental change that institutional investors are lobbying for is a more independent board of
directorsinstitutional investors see a management-controlled board as the weak link in the chain of
managerial accountability to shareholders

Until recently, the probability that its stockholders would oust a large firms management was so remote that it
posed little threat

Hostile takeovers are most likely to occur when a firms stock is undervalued relative to its potential because of
poor management. In a hostile takeover, the managers of the acquired firm are generally fired, and any who
are allowed to stay on lose status and authority. Thus, managers have a strong incentive to take actions
designed to maximize stock prices.

Creditors have a
claim on the firms earnings stream, and they have a claim on its assets in the
event of bankruptcy. However, stockholders have control (through the managers)
of decisions that affect the firms riskiness.

Creditors lend funds at rates that are based on the firms perceived risk at the time the credit is extended,
which in turn is based on (1) the riskiness of the firms existing assets, (2) expectations concerning the riskiness
of future asset additions, (3) the existing capital structure, and (4) expectations concerning future capital
structure changes

If reliable, accurate information is available to all market participants, then we are said to have market
transparency


Sarbanes-Oxley Act, known in the industry now as SOX, consists of eleven chapters, or titles, which establish
wide-ranging new regulations for auditors, CEOs and CFOs, boards of directors, investment analysts, and
investment banks.

These regulations are designed to ensure that (a) companies that perform audits are sufficiently independent
of the companies that they audit, (b) a key executive in each company personally certifies that the financial
statements are complete and accurate, (c) the board of directors audit committee is relatively independent of
management, (d) financial analysts are relatively independent of the companies they analyze, and (e)
companies publicly and promptly release all important information about their financial condition.

In general, the quoted (or nominal) interest rate on a debt security, r, is composed of a real risk-free rate of
interest, r*, plus several premiums that reflect inflation, the riskiness of the security, and the securitys
marketability (or liquidity)

Quoted interest rate = r + r* + IP + DRP + LP + MRP

r = the quoted, or nominal, rate of interest on a given security. There are many different securities, hence many
different quoted interest rates.

r* = the real risk-free rate of interest, r* is pronounced r-star, and it is the rate that would exist on a riskless
security if zero inflation were expected.

IP = inflation premium. IP is equal to the average expected inflation rate over the life of the security. The
expected future inflation rate is not necessarily equal to the current inflation rate, so IP is not necessarily equal
to current inflation.

rRF = r* + IP, and it is the quoted risk-free rate of interest on a security such as a U.S. Treasury bill, which is very
liquid and also free of most risks. Note that rRF includes the premium for expected inflation because rRF=r*+IP.

DRP = default risk premium. This premium reflects the possibility that the issuer will not pay interest or
principal at the stated time and in the stated amount. DRP is zero for U.S. Treasury securities, but it rises as
the riskiness of issuers increases.

LP = liquidity, or marketability, premium. This is a premium charged by lenders to reflect the fact that some
securities cannot be converted to cash on short notice at a reasonable price. LP is very low for Treasury
securities and for securities issued by large, strong firms, but it is relatively high on securities issued by very
small firms.

MRP = maturity risk premium. As we will explain later, longer-term bonds, even Treasury bonds, are exposed to
a significant risk of price declines, and a maturity risk premium is charged by lenders to reflect this risk.

The real risk-free rate is not staticit changes over time depending on economic conditions, especially (1) the
rate of return corporations and other borrowers expect to earn on productive assets and (2) peoples time
preferences for current versus future consumption

Inflation has a major effect on interest rates because it erodes the purchasing power of the dollar and lowers
the real rate of return on investments.

It is important to note that the inflation rate built into interest rates is the inflation rate expected in the future,
not the rate experienced in the past

Note also that the inflation rate reflected in the quoted interest rate on any security is the average rate of
inflation expected over the securitys life.

The nominal, or quoted, risk-free rate, rRF, is the real risk-free rate plus a premium for expected inflation

If the term risk-free rate is used without either the modifier real or the modifier nominal, people
generally mean the quoted (nominal) rate

The risk that a borrower will default on a loan, which means not pay the interest or the principal, also affects
the market interest rate on the security: The greater the default risk, the higher the interest rate.

Default risk premium (DRP) is sometimes called the bond spread.

A liquid asset can be converted to cash quickly and at a fair market value. Financial assets are generally
more liquid than real assets. Because liquidity is important, investors include liquidity premiums (LPs) when
market rates of securities are established.

A maturity risk premium (MRP), which is higher the longer the years to maturity, must be included in the
required interest rate.

The effect of maturity risk premiums is to raise interest rates on long-term bonds relative to those on short-
term bonds.

We should mention that although long-term bonds are heavily exposed to interest rate risk, short-term bills are
heavily exposed to reinvestment rate risk

The concept of return provides investors with a convenient way to express the financial performance of an
investment
Although expressing returns in dollars is easy, two problems arise: (1) To make a meaningful judgment about
the return, you need to know the scale (size) of the investment and (2) You also need to know the timing of the
return

The rate of return calculation standardizes the return by considering the annual return per unit of
investment.

Risk is defined in Websters as a hazard; a peril; exposure to loss or injury. Thus, risk refers to the chance that
some unfavorable event will occur

An assets risk can be analyzed in two ways: (1) on a stand-alone basis, where the asset is considered in
isolation, and (2) on a portfolio basis, where the asset is held as one of a number of assets in a portfolio. Thus,
an assets stand-alone risk is the risk an investor would face if he or she held only this one asset.

No investment should be undertaken unless the expected rate of return is high enough to compensate the
investor for the perceived risk of the investment.

An events probability is defined as the chance that the event will occur
If all possible events, or outcomes, are listed, and if a probability is assigned to each event, the listing is called a
probability distribution.

If we multiply each possible outcome by its probability of occurrence and then sum these products, we have a
weighted average of outcomes.

The weights are the probabilities, and the weighted average is the expected rate of return, r, called r-hat. =
ri*pi

The tighter, or more peaked, the probability distribution, the more likely it is that the actual outcome will be
close to the expected value, and, consequently, the less likely it is that the actual return will end up far below
the expected return. Thus, the tighter the probability distribution, the lower the risk assigned to a stock.


The tighter the probability distribution of expected future returns, the smaller the risk of a given investment.

To be most useful, any measure of risk should have a definite valuewe need a measure of the tightness of the
probability distribution. One such measure is the standard deviation, the symbol for which is , pronounced
sigma. The smaller the standard deviation, the tighter the probability distribution, and, accordingly, the less
risky the stock

S^2 = ^2 = (ri-r"hat")^2*Pi - variance

The past realized rate of return in period t is denoted by r bar t and the average annual return over the last n
years is "r bar Avg"

^2=[(r bar t-r bar Avg)]^2/(n-1)

The historical is often used as an estimate of the future . Because past variability is likely to be repeated, S
may be a good estimate of future risk. However, it is usually incorrect to use "r bar Avg" for some past period
as an estimate of "r hat", the expected future return.

How do we choose between two investments if one has a higher expected return but the other a lower
standard deviation? To help answer this question, we often use another measure of risk, the coefficient of
variation (CV), which is the standard deviation divided by the expected return

CV = /r hat

The coefficient of variation shows the risk per unit of return, and it provides a more meaningful basis for
comparison when the expected returns on two alternatives are not the same.

Because the coefficient of variation captures the effects of both risk and return, it is a better measure than just
standard deviation for evaluating stand-alone risk in situations where two or more investments have
substantially different expected returns.

Other things held constant, the higher a securitys risk, the lower its price and the higher its required return

In a market dominated by risk-averse investors, riskier securities must have higher expected returns, as
estimated by the marginal investor, than less risky securities. If this situation does not exist, buying and selling
in the market will force it to occur

An asset held as part of a portfolio is less risky than the same asset held in isolation. Accordingly, most financial
assets are actually held as parts of portfolios.

Fact that a particular stock goes up or down is not very important; what is important is the return on his or her
portfolio, and the portfolios risk. Logically, then, the risk and return of an individual security should be
analyzed in terms of how that security affects the risk and return of the portfolio in which it is held

The expected return on a portfolio, "r hat p", is simply the weighted average of the expected returns on the
individual assets in the portfolio, with the weights being the fraction of the total portfolio invested in each
asset

p=wi*i
Sum of all wi's must be 1.
The portfolios risk will almost always be smaller than the weighted average of the assets s.

It is theoretically possible to combine stocks that are individually quite risky as measured by their standard
deviations to form a portfolio that is completely riskless, with p = 0.
The tendency of two variables to move together is called correlation, and the correlation coefficient measures
this tendency
Diversification does nothing to reduce risk if the portfolio consists of perfectly positively correlated stocks.

In reality, most stocks are positively correlated, but not perfectly so. On average, the correlation coefficient for
the returns on two randomly selected stocks would be about +0.6

Under such conditions (positive correlation), combining stocks into portfolios reduces risk but does not
eliminate it completely

As a rule, the risk of a portfolio will decline as the number of stocks in the portfolio increases.

The smaller the positive correlation coefficients, the lower the risk in a large portfolio.

A portfolio consisting of all the stocks is called the market portfolio

Almost half of the risk inherent in an average individual stock can be eliminated if the stock is held in a
reasonably well-diversified portfolio, which is one containing 40 or more stocks in a number of different
industries.

The part of a stocks risk that can be eliminated is called diversifiable risk, while the part that cannot be
eliminated is called market risk

Diversifiable risk is caused by such random events as lawsuits, strikes, successful and unsuccessful marketing
programs, the winning or losing of a major contract, and other events that are unique to a particular firm

Market risk, on the other hand, stems from factors that systematically affect most firms: war, inflation,
recessions, and high interest rates. Since most stocks are negatively affected by these factors, market risk
cannot be eliminated by diversification

The primary conclusion of the Capital Assesment Price Model is this: The relevant risk of an individual stock is
its contribution to the risk of a well-diversified portfolio. A stock might be quite risky if held by itself, but if half
of its risk can be eliminated by diversification, then its relevant risk, which is its contribution to the portfolios
risk, is much smaller than its stand-alone risk.

The risk that remains after diversifying is market risk, or the risk that is inherent in the market, and it can be
measured by the degree to which a given stock tends to move up or down with the market.

The benchmark for a well-diversified stock portfolio is the market portfolio

Therefore, the relevant risk of an individual stock, which is called its beta coefficient, is defined under the
CAPM as the amount of risk that the stock contributes to the market portfolio

bi=(i/m)im
A stock with a high standard deviation will tend to have a high beta

The tendency of a stock to move up and down with the market is reflected in its beta coefficient. An average
risk stock is defined as one with a beta equal to 1.0. Such a stocks returns tend to move up and down, on
average, by about the same amount as the general market, which is measured by some index such as the Dow
Jones Industrials, the S&P 500, or the New York Stock Exchange Index
Theoretically, it is possible for a stock to have a negative beta. In this case, the stocks returns would tend to
rise whenever the returns on other stocks fall. In practice, very few stocks have a negative beta.

The beta of a portfolio is a weighted average of its individual securities betas
bp=wi*bi
Compensation is required only for risk that cannot be eliminated by diversification

Since a stocks beta coefficient determines how the stock affects the risk of a diversified portfolio, beta is the
most relevant measure of any stocks risk.

The CAPM is an ex ante model, which means that all of the variables represent before-the-fact, expected
values. In particular, the beta coefficient used by investors should reflect the expected volatility of a given
stocks return versus the return on the market during some future period. However, people generally calculate
betas using data from some past period, and then assume that the stocks relative volatility will be the same in
the future as it was in the past.

The first step in a regression analysis is compiling the data.
The second step is to convert the stock prices into rates of return
It is usually unreasonable to think that the future expected return for a stock will equal its average historical
return over a relatively short period, such as four years. However, we might well expect past volatility to be a
reasonable estimate of future volatility, at least during the next couple of years.

The market risk premium, RPM, shows the premium investors require for bearing the risk of an average stock,
and it depends on the degree of risk aversion that investors on average have.

It follows that if one stock were twice as risky as another, its risk premium would be twice as high, while if its
risk were only half as much, its risk premium would be half as large.

Here the risk-free return includes a premium for expected inflation, and we assume that the assets under
consideration have similar maturities and liquidity. Under these conditions, the relationship between the
required return and risk is called the Security Market Line (SML)

Required rates of return are shown on the vertical axis, while risk as measured by beta is shown on the
horizontal axis.

Riskless securities have bi = 0
The slope of the SML reflects the degree of risk aversion in the economythe greater the average investors
aversion to risk, then (a) the steeper the slope of the line, (b) the greater the risk premium for all stocks, and (c)
the higher the required rate of return on all stocks.

Both the Security Market Line and a companys position on it change over time due to changes in interest rates,
investors aversion to risk, and individual companies betas.

As risk aversion increases, so does the risk premium, and this causes the slope of the SML to become steeper.

A companys beta can also change as a result of external factors such as increased competition in its industry,
the expiration of basic patents, and the like. When such changes occur, the required rate of return also
changes.

Fama and French found two variables that are consistently related to stock returns: (1) the firms size and (2) its
market/book ratio. After adjusting for other factors, they found that smaller firms have provided relatively high
returns, and that returns are relatively high on stocks with low market/book ratios. At the same time, and
contrary to the CAPM, they found no relationship between a stocks beta and its return.

As an alternative to the traditional CAPM, researchers and practitioners have begun to look to more general
multi-beta models that expand on the CAPM and address its shortcomings.

In the multi-beta model, market risk is measured relative to a set of risk factors that determine the behavior of
asset returns, whereas the CAPM gauges risk only relative to the market return.

It is important to note that the risk factors in the multi-beta model are all nondiversifiable sources of risk.