Corporate Finance mid-term – Flashcards
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What are the three types of financial management decisions and what questions are they designed to answer?
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Capital budgeting What long-term investments or projects should the business take on? Capital structure How should we pay for our assets? Should we use debt or equity? Working capital management How do we manage the day-to-day finances of the firm?
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What are the three major forms of business organization?
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Sole Proprietorship Partnership (General, Limited) Corporation (C-Corp, S-Corp, Limited Liability Company)
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What is the goal of financial management?
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Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company's stock?
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What are agency problems and why do they exist within a corporation?
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Agency relationship Principal hires an agent to represent his/her interests Stockholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between principal and agent Management goals and agency costs
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What is the difference between a primary market and a secondary market?
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Dealer vs. auction markets Listed vs. over-the-counter securities NYSE NASDAQ
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How do you find the value of a bond, and why do bond prices change?
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Bonds of similar risk (and maturity) will be priced to yield about the same return, regardless of the coupon rate If you know the price of one bond, you can estimate its YTM and use that to find the price of the second bond
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What is a bond indenture, and what are some of the important features?
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Contract between the company and the bondholders that includes: -The basic terms of the bonds -The total amount of bonds issued -A description of property used as security, if applicable -Sinking fund provisions -Call provisions -Details of protective covenants
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What are bond ratings, and why are they important?
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capacity to pay
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How does inflation affect interest rates?
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nominal rate= real rate+expected inflation rate
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What is the term structure of interest rates?
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the relationship b/w time to maturity and yields, all else equal. (normal or inverted: sloping and LT vs ST) yield=real rate+inflation premium+interest rate risk premium
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What factors determine the required return on bonds?
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coupon rate depends on risk (anything affects the risk of cash flows to the bondholders): default risk premium, taxability premuim(municiple), liquidity premium (frequent trading?)
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cash flows from stock, pricing of stocks
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1.dividends 2.sell the stock to market or company PV of expected cash flows
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What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%?
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The firm will pay a constant dividend forever This is like preferred stock The price is computed using the perpetuity formula
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What if the company starts increasing dividends by 3% per year, beginning with the next dividend? The required return stays at 15%.
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The firm will increase the dividend by a constant percent every period The price is computed using the growing perpetuity model Supernormal growth Dividend growth is not consistent initially, but settles down to constant growth eventually The price is computed using a multistage model zero growth present value of expected future dividends can be found using the perpetuity formula
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stock price sensitivity to R or g
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g rate up, P up R rate up, P down
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What are some of the major characteristics of common stock?
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-Voting Rights -Proxy voting -Classes of stock -Other Rights 1.Share proportionally in declared dividends 2.Share proportionally in remaining assets during liquidation 3.Preemptive right - first shot at new stock issue to maintain proportional ownership if desired
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What are some of the major characteristics of preferred stock?
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Dividends -Stated dividend that must be paid before dividends can be paid to common stockholders -Dividends are not a liability of the firm, and preferred dividends can be deferred indefinitely -Most preferred dividends are cumulative - any missed preferred dividends have to be paid before common dividends can be paid Preferred stock generally does not carry voting rights
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expected return and standard deviation for an individual asset? For a portfolio?
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An asset's risk and return are important in how they affect the risk and return of the portfolio The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets
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What is the difference between systematic and unsystematic risk?
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systematic: -Risk factors that affect a large number of assets -Also known as non-diversifiable risk or market risk -Includes such things as changes in GDP, inflation, interest rates, etc. Unsystematic: -Risk factors that affect a limited number of assets -Also known as unique risk and asset-specific risk -Includes such things as labor strikes, part shortages, etc.
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What type of risk is relevant for determining the expected return?
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There is a reward for bearing risk There is not a reward for bearing risk unnecessarily The expected return on a risky asset depends only on that asset's systematic risk since unsystematic risk can be diversified away
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What is the reward-to-risk ratio in equilibrium?
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risk premium/beta of asset asset RtoR=mkt RtoR at eq, it is at SML, slope is (E(RM)-Rf)/betaM<-always 1 so, slope of SML is market risk premium
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What are the two approaches for computing the cost of equity?
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Dividend Growth Model SML or CAPM
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How do you compute the cost of debt and the after-tax cost of debt?
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cost of debt is the YTM, but not coupon rate p.s. cost of preferred stock is a perpetuity
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How do you compute the capital structure weights required for the WACC?
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w=?/V (use mkt value or book value) WACC=weRe+wdRd(1-Tc) !!! cost of debt is tax deductable
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What is the WACC?
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-is a discount rate, diff risk diff rate -use the individual costs of capital that we have computed to get our "average" cost of capital for the firm. -This "average" is the required return on the firm's assets, based on the market's perception of the risk of those assets -The weights are determined by how much of each type of financing is used
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What happens if we use the WACC for the discount rate for all projects?
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...
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What are two methods that can be used to compute the appropriate discount rate when WACC isn't appropriate?
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pure play approach: use average beta in CAPM subjective approach: adjust WACC according to risk level
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How should we factor flotation costs into our analysis?
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1.compute the weighted average flotation cost 2.find NPV (including flotation cost is including the cost of issuing, may lead to negative NPV)
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Explain the effect of leverage on EPS and ROE
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-When we increase the amount of debt financing, we increase the fixed interest expense - good or bad years -Leverage amplifies the variation in both EPS and ROE
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What is the break-even EBIT, and how do we compute it?
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Find EBIT where EPS is the same under both the current and proposed capital structures -that is EBIT/shares value=(EBIT-bond value)/shares value
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How do we determine the optimal capital structure?
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to maximize the cash inflow, max stockholder wealth, or min the WACC because according to capital structure theory, firm value is determined by the change in risk of cash flow, and change in cash flows
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What is the optimal capital structure in the three cases that were discussed in this chapter?
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Case I - no taxes or bankruptcy costs No optimal capital structure Case II - corporate taxes but no bankruptcy costs -Optimal capital structure is almost 100% debt -Each additional dollar of debt increases the cash flow of the firm Case III - corporate taxes and bankruptcy costs -Optimal capital structure is part debt and part equity -Occurs where the benefit from an additional dollar of debt is just offset by the increase in exected bankruptcy costs
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What is the difference between liquidation and reorganization?
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Reasons: business failure, legal bankruptcy, technical insolvency, accounting insolvency Liquidation: Trustee takes over assets, sells them and distributes the proceeds according to the absolute priority rule Reorganization: Restructure the corporation with a provision to repay creditors
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What are the different types of dividends, and how is a dividend paid?
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regular, extra, special, liquidating declaration date, ex-dividend date, date of record, date of payment !!!dividend matter, but not dividend policy
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What is the clientele effect, and how does it affect dividend policy relevance?
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Asymmetric information - managers have more information about the health of the company than investors investors have preferences in dividend payouts
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What is the information content of dividend changes?
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Dividend increases -Management believes it can be sustained -Expectation of higher future dividends, increasing present value -Signal of a healthy, growing firm Dividend decreases -Management believes it can no longer sustain the current level of dividends -Expectation of lower dividends indefinitely; decreasing present value -Signal of a firm that is having financial difficulties
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What are stock dividends, and how do they differ from cash dividends?
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-Pay additional shares of stock instead of cash -Increases the number of outstanding shares
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How are share repurchases an alternative to dividends, and why might investors prefer them?
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-Company buys back its own shares of stock -Similar to a cash dividend in that it returns cash from the firm to the stockholders -Stock repurchases send a positive signal that management believes the current price is low -The stock price often increases when repurchases are announced
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expected vs unexpected
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Over time, the average of the unexpected component is zero Announcements and news contain both an expected component and a surprise component It is the surprise component that affects a stock's price and therefore its return
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efficient markets
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Efficient markets are a result of investors trading on the unexpected portion of announcements The easier it is to trade on surprises, the more efficient markets should be Efficient markets involve random price changes because we cannot predict surprises
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systematic risk measurement
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beta coefficient: asset systematic risk vs market systematic risk (greater >1 is bad) risk premium=expected return-risk-free rate beta up, risk premium up
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What is the expected return on the asset?
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pure time value of money: Rf reward for bearing sys risk: E(Rm)-Rf amount of sys risk: Beta
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CAPM
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defines the relationship between risk and return if we know Beta of asset(sys risk of asset), we ca use CAPM to determine its expected return
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cost of capital
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also the risk of the asset in investor's view required return=appropriate discount rate=risk of CF risk=buz risk+fin risk
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DGM A&D
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Advantage - easy to understand and use Disadvantages -Only applicable to companies currently paying dividends -Not applicable if dividends aren't growing at a reasonably constant rate -Extremely sensitive to the estimated growth rate - an increase in g of 1% increases the cost of equity by 1% -Does not explicitly consider risk
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SML or CAPM A
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Advantages -Explicitly adjusts for systematic risk -Applicable to all companies, as long as we can estimate beta Disadvantages -Have to estimate the expected market risk premium, which does vary over time -Have to estimate beta, which also varies over time -We are using the past to predict the future, which is not always reliable
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Value of the firm
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V=mkt claims(share & bond)+nonmkt claims(bankruptcy & tax) overall value of the firm X by captial structure division of value will (TAX,D/E ratio)
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pecking-order theory & Tradeoff theory
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POT: internal > debt > equity TOT: with target D/E ratio, profitable firm use debt
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Business and Financial Risk
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Re=Rf+Be(Rm-Rf) Be=Ba(1+D/E) where Ba is business risk (sys risk) D/E is financial risk (level of leverage)
