Finance Midterm

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  1. Ch8 In the context of capital budgeting, what is an opportunity cost?
    an opportunity cost refers to the value of an asset or other input that will be used in a project. The relevant cost is what the asset or input is actually worth today, not, for example, what it cost to acquire.
  2. Ch8 Incremental Cash Flows
    • the reduction in the sales of the company's other products referred to as erosion. These lost sales are included because they are a cost (a revenue reduction) that the firm must bear if it chooses to produce the new product.
    • Operating costs, depreciation expense, resale value, personnel.
  3. Ch6 Why does the value of a share of stock depend on dividends?
    The value of any investment depends on the present value of its cash flows; i.e., what investors will actually receive. The cash flows from a share of stock are the dividends.
  4. Ch6 Investors are willing to buy shares for companies that don't pay dividends. Why?
    • Investors believe the company will eventually start paying dividends (or be sold to another
    • company).
  5. Ch6 Under what circumstances might a company choose not to pay dividends?
    companies that need the cash will often forgo dividends since dividends are a cash expense. Young, growing companies with profitable investment opportunities are one example; another example is a company in financial distress.
  6. Ch6 What assumptions can we use dividend growth model to determine the value of a share of stock? Reasonableness?
    The general method for valuing a share of stock is to find the present value of all expected future dividends. The dividend growth model presented in the text is only valid (i) if dividends are expected to occur forever; that is, the stock provides dividends in perpetuity, and (ii) if a constant growth rate of dividends occurs forever. A violation of the first assumption might be a company that is expected to cease operations and dissolve itself some finite number of years from now. The stock of such a company would be valued by applying the general method of valuation explained in this chapter. A violation of the second assumption might be a start- but is expected to eventually start making dividend payments some number of years from now.
  7. Effective annual rate (EAR)
    If a rate is expressed annually, but compounded more frequently, then the effective rate is higher than the stated rate.
  8. What is a firm worth?
    A firm should be worth the present value of the firm's cash flows.
  9. Financial Decision Making
    • Investment Decision
    • Financing Decision
    • Payout Decision
  10. Investment Decision
    Invest in Assets that earn more than the minimum acceptable rate of return
  11. Financing Decision
    Find the right mix of equity and debt, and the right kind of debt to finance your operations
  12. Payout Decision
    If you cannot find investments that return the minimum acceptable rate, then return cash to the shareholders.
  13. What kinds of securities are issued by corporations?
    • Debt--ownership interest
    • Equity--Short or long term borrowing
  14. Debt vs equity: debt
    • not an ownership interest
    • creditors do not have voting rights
    • interest is considered cost of doing business and is tax deductible
    • creditors have legal recourse if interest or principal payments are missed
  15. Debt vs equity: equity
    • ownership interest
    • common stockholders vote for the board of directors and other issues
    • dividends are not considered a cost of doing business and are not tax deductible
    • dividends are not the liability of the firm, and stockholders have no legal recourse if dividends are not paid
  16. Bond princing equation
    annuity of coupon payment and PV of principal face value
  17. Premium
    When YTM<coupon
  18. Discount
  19. Two types of interest rate risk; sensitivity depends on two things
    • Price Risk
    • Reinvestment rate risk

    2 things: coupon rate, time to maturity

    • higher coupons have lower interest rate risk
    • lower coupons have higher interest rate risk
    • higher maturity, greater interest rate risk
    • higher maturity, lower reinvestment risk
  20. Price risk
    Changes in price due to changes in interest rate
  21. Reinvestment rate risk
    Uncertainty concerning rates at which cash flow can be reinvested
  22. bond classifications
    • Registered vs bearer forms (terms of a bond)
    • security
    • *collateral--secured by financial securities
    • *mortgage-secured by real property, norm land or bldgs
    • *debentures-unsecured
    • *notes-unsecured debt with original maturity less than 10 years
    • Seniority (indicates preference in position over other lenders)
    • Sinking funds (lower rate returns, req by investors, $$ to set aside to pay for debt)
    • Call provisions (allows company to call)
    • Protective covenants (limits certain actions a company might otherwise take during term of loan).
  23. Some common bonds
    • Gov bonds
    • Zero coupon bonds (pure discount)--no coupons, just payment @ end, cannot sell for more than face value
    • Floating rate bonds--mortgage, adjustable rate; coupon rate floats depnedign on some index value; coupons may have a collar, canot exceed ceiling or floor.
  24. Other bond types
    • Income bonds (coupon payments dependent on company income)
    • Convertible bonds (can be swapped for fixed # of shares before maturity)
    • Put bonds (allows holder to force issuer to buy back)
  25. Treasury securities
    • Federal govt debt
    • T-bill: pure discount bonds, maturity < 1 yr
    • T-note: coupon debt, maturity b/w 1 and 10 yrs
    • T-bond: coupon debt, maturity > 10 yrs
  26. Municipal securities
    • Debt of state and local governments
    • Varying degrees of default risk, rated similar to corp debt
    • Interest received is tax-except at the federal level
  27. What is r?
    current market rate of interest; risk received by marekt in investing in bonds of this nature
  28. Real rate of interest
    change in purchasing power
  29. Nominal rate of interest
    quoted rate of interest, change in purchasing power and inflation; had not been adjusted for inflation
  30. term structure of interest rates
    • relationship b/w time and matuirty and yields, all else equal
    • yield curve is graphical representation of this
  31. Stock ownership produces cash flows from:
    • Dividends
    • Capital gains
  32. Ch6 stocks discount rate composed of
    dividend yield and capital gains

    great deal of estimation error: when stocks not paying dividends or stockts with g expected to equal or exceed R
  33. Growth opportunities
    • Growth opportunities are opportunities to invest in positive NPV projects.
    • Value of a firm: sum of 100% of earnings as dividends + NPVGO
  34. Prerequisities to growth
    • It must not pay out all earnings as dividends
    • It must invest in projects with a positive NPV
  35. Price-earnings ratio
    P/E ratio=price per share/EPS
  36. Factors impacting the P/E ratio
    • firm's growth opportunites
    • firm's R
    • conservative accounting principles
  37. A note of preferred stock
    • stated div must be paid before dividends can be paid to common stockholders.
    • div are not a liability of the firm, and preferred dividends can be deferred indefinitely.
    • most preferred div are cumulative--any missed preferred div have to be paid before common dividends can be paid.
    • preferred stock generally does not carry voting rights.
  38. Stock markets
    • Dealers (maintain inventory) vs brokers (bring buyers and sellers together)
    • NYSE: largest stock market in world, specialists (assigned dealer for set of securities)
    • NASDAQ: not a physical exchange, computer -based quotation system, multiple market makers (diff from specialists)
  39. Payback period method (dis and ad)
    • Dis:
    • cashflows beyond payback are ignored
    • ignoring time value of money
    • arbitrary cutoff date

    • Ad:
    • makes sense for smaller companeis & social enterprises. used when there is a limitation on capital. "limited budgets" use method to decide whether to invest.
  40. Average accounting return (dis)
    Doesn't take into account time value of $$, accounting numbers not cashflows.
  41. IRR (dis and ad)
    • Accept if IRR > required return
    • Dis:
    • Does not distinguish b/w investing and borrowing
    • IRR may not exist, or there may be multiple IRRs
    • May not work when comparing mutually exclusive investments whose cashflows differ in scale and timing

    • Ad:
    • Easy to understand and communicate
    • IRR will generall give the same answer as nPV (except for when problems above occur)
  42. NPV vs IRR
    • most time same decision
    • exception:
    • cash flows sign change more than once
    • mutually exclusive projects: initial investments are substantially different, timing of cash flows sub diff
  43. PI (dis and ad)
    • Accept if PI>1
    • Dis:
    • Problems with mutually exclusive investments
    • Can't compare projects of different scale

    • Ad:
    • May be useful when available investment funds are limited
    • Easy to understand and communicate
    • Correct decision when evaluating independent projects
  44. What cashflows matter?
    • Cash flows
    • Incremental cash flows
    • Taxes (after-tax)
    • Inflation
  45. What is the basis of capital budgeting decisions?
    Base capital budgeting analysis on cash flow, not income. Cash flows does not equal earnings/accounting income.

    Examples of reconciling items: depreciation, amortization, deferrals and accruals.
  46. Incremental cash flows
    • Sunk costs not relevant.
    • Opp costs matter.
    • Side effects matter: erosion and cannibalism - new product reduces sales; synergies + new product increases cash flows
    • Overhead allocations
    • Salvage value
    • Changes in net working capital (difference b/w current assets and current liabilities).
  47. Returns have two components
    current income (e.g. interest or dividends) and capital gains or losses.
  48. arith vs geo
    • geo < arith unless all returns equal
    • arith: overly optimistic for long horizons
    • geo: overly pessimistic for short
  49. Frequency distribution
    • Small companies: higher avg return, wider array (variance of actual returns).
    • Larger companies; lower avg return, narrow array of actual returns.
  50. Average stock returns and risk-free returns
    • US debt is considered risk free because the gov can raise taxes to repay it
    • Risk premium is the added return (over and above the risk free rate) resulting from bearing risk.
  51. Covariance
    product of deviations x probability of state
  52. Efficient set
    • a graphical representation of a set of possible portfolios that minimize risk at specific return levels; and maximize returns at specific risk levels.
    • section of the opportunity set above the min variance portfolio is the efficient frontier.
  53. correlation
    • if p=1, no risk reduction is possible
    • if p=-1, complete risk reduction is possible
  54. optimal portfolio with a risk-free asset
    with a risk free asset availabe and the efficient frontier identified, we choose the capital allocation line with the steepest slope.
  55. systematic vs unsystematic risk
    • systematic (market or non-diversifiable risk):
    • risk factors that affect a large number of assets; this is what is reward ed in market

    • unsystematic (unique or asset-specific risk):
    • risk factors that affect a limited number of assets
  56. Returns
    • =exp and unexp return
    • unexp=sys and unsys
    • >>> total return=exp + sys + unsys
  57. diversification and portfolio risk; what can diversification get rid of?
    diversification can substantially reduce the variability of returns without an equivaelnet reduction in exp returns.

    diversification can get rid of unsys only. not sys.

    variance terms are essentialy diversified away, but not covar
  58. diversifiable risk
    • risk that could be elim by combining assets into portfolio
    • if hold only one asset, exposing self to risk that could be diversified.
  59. CAPM popularity over alternative models
    • APT better than CAPM in explaining past returns, but not in predicting future expected returns
    • Other modles are more complicated and require more inputs
    • For most, expected returns generated by more sophisticated models are not sufficiently different to justify the trouble.
  60. Beta
    measures the responsiveness of a security to movements in the market portfolio.
  61. What sort of investor rationally views the variance of an individual security's return as the security's proper measure of risk? What sort of investor ratioanlly views the beta of a security as the securitys proper measure of risk?
    • A rational, risk-averse investor.
    • Above still applies, but, no longer interested in variance of each dinividaul security's return. Rather interested in contribution of an indiv security to variance of portfolio.
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Finance Midterm
Finance Midterm 1
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