Home > Preview
The flashcards below were created by user
jtpdogyo
on FreezingBlue Flashcards.

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.

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.

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.

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).

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.

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.

Effective annual rate (EAR)
If a rate is expressed annually, but compounded more frequently, then the effective rate is higher than the stated rate.

What is a firm worth?
A firm should be worth the present value of the firm's cash flows.

Financial Decision Making
 Investment Decision
 Financing Decision
 Payout Decision

Investment Decision
Invest in Assets that earn more than the minimum acceptable rate of return

Financing Decision
Find the right mix of equity and debt, and the right kind of debt to finance your operations

Payout Decision
If you cannot find investments that return the minimum acceptable rate, then return cash to the shareholders.

What kinds of securities are issued by corporations?
 Debtownership interest
 EquityShort or long term borrowing

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

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

Bond princing equation
annuity of coupon payment and PV of principal face value



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

Price risk
Changes in price due to changes in interest rate

Reinvestment rate risk
Uncertainty concerning rates at which cash flow can be reinvested

bond classifications
 Registered vs bearer forms (terms of a bond)
 security
 *collateralsecured by financial securities
 *mortgagesecured by real property, norm land or bldgs
 *debenturesunsecured
 *notesunsecured 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).

Some common bonds
 Gov bonds
 Zero coupon bonds (pure discount)no coupons, just payment @ end, cannot sell for more than face value
 Floating rate bondsmortgage, adjustable rate; coupon rate floats depnedign on some index value; coupons may have a collar, canot exceed ceiling or floor.

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)

Treasury securities
 Federal govt debt
 Tbill: pure discount bonds, maturity < 1 yr
 Tnote: coupon debt, maturity b/w 1 and 10 yrs
 Tbond: coupon debt, maturity > 10 yrs

Municipal securities
 Debt of state and local governments
 Varying degrees of default risk, rated similar to corp debt
 Interest received is taxexcept at the federal level

What is r?
current market rate of interest; risk received by marekt in investing in bonds of this nature

Real rate of interest
change in purchasing power

Nominal rate of interest
quoted rate of interest, change in purchasing power and inflation; had not been adjusted for inflation

term structure of interest rates
 relationship b/w time and matuirty and yields, all else equal
 yield curve is graphical representation of this

Stock ownership produces cash flows from:

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

Growth opportunities
 Growth opportunities are opportunities to invest in positive NPV projects.
 Value of a firm: sum of 100% of earnings as dividends + NPVGO

Prerequisities to growth
 It must not pay out all earnings as dividends
 It must invest in projects with a positive NPV

Priceearnings ratio
P/E ratio=price per share/EPS

Factors impacting the P/E ratio
 firm's growth opportunites
 firm's R
 conservative accounting principles

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 cumulativeany missed preferred div have to be paid before common dividends can be paid.
 preferred stock generally does not carry voting rights.

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)

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.

Average accounting return (dis)
Doesn't take into account time value of $$, accounting numbers not cashflows.

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)

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

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

What cashflows matter?
 Cash flows
 Incremental cash flows
 Taxes (aftertax)
 Inflation

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.

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).

Returns have two components
current income (e.g. interest or dividends) and capital gains or losses.

arith vs geo
 geo < arith unless all returns equal
 arith: overly optimistic for long horizons
 geo: overly pessimistic for short

Frequency distribution
 Small companies: higher avg return, wider array (variance of actual returns).
 Larger companies; lower avg return, narrow array of actual returns.

Average stock returns and riskfree 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.

Covariance
product of deviations x probability of state

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.

correlation
 if p=1, no risk reduction is possible
 if p=1, complete risk reduction is possible

optimal portfolio with a riskfree asset
with a risk free asset availabe and the efficient frontier identified, we choose the capital allocation line with the steepest slope.

systematic vs unsystematic risk
 systematic (market or nondiversifiable risk):
 risk factors that affect a large number of assets; this is what is reward ed in market
 unsystematic (unique or assetspecific risk):
 risk factors that affect a limited number of assets

Returns
 =exp and unexp return
 unexp=sys and unsys
 >>> total return=exp + sys + unsys

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

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.

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.

Beta
measures the responsiveness of a security to movements in the market portfolio.

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, riskaverse 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.

