Finance management

What are agency costs, and who bears them?

An agency, in general terms, is the relationship between two parties, where one is a principal and the other is an agent who represents the principal in transactions In finance, two important agency relationships are those between stockholders and managers, and stockholders and creditors. Agency costs occur when a company's management or "agent" places his own personal financial interests above those of the shareholder or "principal." In other words, it’s a potential conflict of interests between the agent and principal. Agency costs must bear by shareholders. In the absence of any effort whatever to affect managerial behavior, and hence with zero agency costs, there will almost certainly be some loss of shareholder wealth due to improper managerial actions. Conversely, agency costs would be very high if shareholders attempted to ensure that every single managerial action coincided exactly with shareholder interests. Thus, the optimal amount of agency costs to be borne by shareholders should be viewed like any other investment decision. Some mechanisms to motivate agents to act in stockholders’ interests include Managerial compensation (specified annual salary, a bonus), Direct intervention by principal, the threat of firing, the threat of takeovers

Identify some factors beyond a firm’s control that influence its stock price.

we can lay out three basic facts here. (1) Any financial asset, including a company’s stock, is valuable only to the extent that the asset generates cash flows. (2) The timing of the cash flows matters—cash received sooner is better, because it can be reinvested to produce additional income. (3) Investors are generally averse to risk, so all else equal, they will pay more for a stock whose cash flows are relatively certain than for one with relatively risky cash flows. Because of these three factors, managers can enhance their firms’ value (and the stock price) by increasing expected cash flows, speeding them up, and reducing their riskiness.

Define EBITDA and please define the reasons of calculating EBITDA.

EBITDA stands for Earnings Before Interest, Tax, Depreciation & Amortization and is one of the most commonly used indicators of the profitability of a firm.

4248152921000EBITDA can make a company look less expensive than it is

Using EBITDA we can find the net income available to stockholders.

EBITDA is a popular metric used for comparing companies.

EBITDA shows company’s profitability

All the same, one of the biggest reasons for EBITDA's popularity is that it shows more profit than just operating profits

Explain statement of cash flows and types of questions it answers.

Statement of cash flows is the financial statement reporting the impact of a firm’s operating, investing, and financing activities on cash flows over an accounting period.

The cash flow statement reports the cash generated and used during the time interval specified in its heading.

It answers the questions:

Where the money came (will come) from?

Where it went (will go)?

Is the firm generating enough cash to purchase the additional assets required for growth?

Is the firm generating any extra cash that can be used to repay debt or to invest in new product?

Will inadequate cash flows force the company to issue more stock?

Identify and briefly explain the 3 different categories of activities shown in the statement of cash flows.

- include net income, depreciation and change in current assets and current liabilities other than cash and short-term debts.

-include investments in or sales of fixed assets

Include cash raised during the year by issuing short-term debt, long-term debt, or stock

Define net operating working capital and total operating capital.

Net operating working capital is a financial metric used to measure operational liquidity of a business. Net operating working capital operating working capital less noninterest-bearing current liabilities.

Total operating capital is the sum of all net operating working capital and fixed assets.

NOWC= All current assets – All current liabilities that do not charge interest

(Cash and Marketable securities+Accounts receivable+Inventories)-(Accounts Payable+Accruals)

TOC= NOWC + Net fixed assets

Net fixed assets include net plant and equipment.

Determine NOPAT and explain why it might be a better performance measure than net income.

NOPAT is the profit a company would generate if it had no debt and held only operating assets. Net income is the profit available to common stockholders; thus, both interest and taxes have been deducted. NOPAT is a better measure of the performance of a company’s operations than net income because debt lowers income. In order to get a true reflection of a company’s operating performance, one would want to take out debt to get a clearer picture of the situation.

NOPAT= EBIT(1-tax rate)

Define free cash flow and explain why free cash flow the most important determinant of a firm’s value.

Free cash flow is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets, new products, and operating working capital necessary to sustain ongoing operations. It is defined as FCF=NOPAT-Net investment in operating capital or Operating cash flow-Gross investment in operating capital. It is the most important measure of cash flows because it shows the exact amount available to all investors (stockholders and debtholders). The value of a company’s operations depends on expected future free cash flows. Therefore, managers make their companies more valuable by increasing their free cash flow. Net income, on the other hand, reflects accounting profit but not cash flow. Therefore, investors ought to focus on cash flow rather than accounting profit.

Define the terms “Market Value Added”(MVA) and “Economic Value Added (EVA)”. Explain the differences between EVA and accounting profit.

Market Value Added-the difference between market value of a firm’s stock and equity capital supplied by investors.

MVA=Market value of stock – Equity capital supplied by investors.

<(Shares outstanding)(Stock price) – Total common equity> outstanding – кол-во акций

Economic Value Added – value added to shareholders by management during a given year.

EVA=Net operating profit after taxes,or NOPAT – after tax dollar cost of capital used to support operations

EVA=EBIT(1-tax rate)-(Total investor-supplied operating capital)(After tax percentage cost of capital)

EVA is an estimate of a business’s true economic profit for the year. The most important reason EVA differs from accounting profit is that the cost of equity capital is deducted when EVA is calculated. Other factors that could lead to differences include adjustments that might be made to depreciation, to research and development costs, to inventory valuations and so on.

Determine characteristics of liquid assets and identify the ratios that are used to analyze a firm’s liquidity position and write out their equations.

Liquid Asset -an asset that can be converted to cash quickly without having to reduce the asset’s price very much. A liquidity ratio is a ratio that shows the relationship of a firm’s cash and other current assets to its current liabilities. Two commonly used liquidity ratios are the current ratio and quick, or acid test, ratio.

The current ratio is found by dividing current assets by current liabilities. It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. Current ratio = Current assetsCurrent liabilities

The quick, or acid test, ratio is found by taking current assets less inventories and then dividing by current liabilities. Quick ratio= Current assets-InventoriesCurrent liabilities

Unit - times

Identify 4 ratios that are used to measure how effectively a firm is managing its assets, and write out their equations.

Asset management ratios are a set of ratios that measure how effectively a firm is managing its assets.

Inventory Turnover Ratio- use to evaluate inventories. ITR=SalesInventories

Days Sales Outstandingused to evaluate Receivables. DSO=ReceivablesAverage sales per day=ReceivablesAnnual sales/365

Fixed assets turnover – measures how effectively the firm uses its plant and equipment. FAT=SalesNet fixed assets

Total assets turnover- measures the turnover of all the firm’s assets. TAT=SalesTotal assets

Unit- times, except DSO - days

Explain the financial leverage and usage of financial leverage.

Financing leverage- the use of debt financing. The use of borrowed money to increase production volume, and thus sales and earnings. The greater the amount of debt, the greater the financial leverage. It is also a measure of a company's ability to repay its obligations. When examining the health of a company, it is critical to pay attention to the financing leverage. If the financing leverage is increasing, the company is being financed by creditors rather than from its own financial sources which may be a dangerous trend. Lenders and investors usually prefer low financing leverage because their interests are better protected in the event of a business decline. Thus, companies with high financing leverage may not be able to attract additional lending capital.

Identify and write out the equations for 4 ratios that show the combined effects of liquidity, asset management and debt management of profitability.

1. Profit margin on sales=Net income available to common stockholdersSales this ratio measures net income per dollar of sales

2. Basic Earning Power= EBITTotal assets this ratio indicates the ability of the firm’s assets to generate operating income.

3. (ROA)Return on total assets=Net income available to common stockholdersTotal assets

4. (ROE)Return on Common Equity=Net income available to common stockholdersCommon Equity measures the rate of return on common stockholders’ investment

Unit - %

Describe 3 ratios that relate a firm’s stock price to its earnings, cash flow, and book value per share, and write out their equations.

Price/Earnings ratio shows the dollar amount investors will pay for $1 of current earnings.

Price/Earnings ratio=Price per shareEarnings per share

Price/Cash flow ratio shows the dollar amount investors will pay for $1 of cash flow

Price/Cash flow ratio=Price per shareCash flow per share

Market/Book ratio a financial ratio used to compare a company’s current market price to its book value

Market/Book ratio=Market price per shareBook value per share

The market value of an asset reflects its earning power and expected cashflows.

Since the book value of an asset reflects its original cost, it might deviate significantly from market value if the earning power of the asset has increased or declined significantly since its acquisition.

Unit - Time

Explain the calculation of book value per share and explain how inflation and goodwill cause book values to deviate from market values.

Book value per share=Common equityShares outstanding

BVPS provides a snap shot of a firm's current situation, but considerations of the firm's future are not included.

Taking out intangibles is an important element of the price-to-book ratio. It means that the P/B ratio indicates what investors are paying for real-world tangible assets, not the harder-to-value intangibles. 

When inflation rises book value decreases.

The key to understanding the argument below is to recognize that as inflation increases, central banks increase interest rates to reduce the money supply and slow inflation down: When interest rates are high, people find it expensive to borrow, and therefore there is less money floating around. With interest rates are high, people require higher returns on stocks. Well, its not so easy to just increase earnings for a stock, so its price has to adjust downward.

Thanks to conservative accounting rules, book value completely ignores intangible assets like brand name, goodwill, patents and other intellectual property created by a company. Book value doesn't carry much meaning for service-based firms with few tangible assets. Think of software giant Microsoft, whose bulk asset value is determined by intellectual property rather than physical property; its shares have rarely sold for less than 10 times book value. In other words, Microsoft's share value bears little relation to its book value.

Define the usage of Du Pont system to analyze ways of improving the firm’s performance.

The DuPont System shows the interrelationship between key financial ratios(Return On investment, asset turnover, profit margin, and leverage). It can be presented as

ROA=Profit margin*Total assets turnover= Net incomeSales*SalesTotal assets= Net incomeTotal assets

ROE=Profit margin*Total assets turnover*Equity multipliyer= ROA*Equity multiplier

If the company were financed only with common equity and has no debt, the ROA and ROE would be the same bcs total assets would equal common equity.

By using the DuPont equation, an analyst can easily determine what processes the company does well and what processes can be improved. Furthermore, ROE represents the profitability of funds invested by the owners of the firm.

Define the standard deviation and coefficient of variation, and explain which one is a better measure for performance.

Standard deviation a statistical measure of the variability of a set of observations, the symbol for which is “σ(sigma)”.

Coefficient of variation standard measure of 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; calculated as standard deviation divided by the expected return. CV=σκ

The standard deviation can sometimes be misleading in comparing the risk. Because the coefficient of variation captures the effects of both risk and return, it is a better measure for evaluating risk in situations where investments have substantially different expected returns.

Explain the following statement: “most investors are risk averse”. Explain the relationship between risk aversion and rates of return.

First of all, we must understand what does risk aversion mean? Risk aversion – assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities. Risk averse- A description of an investor who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk. Consequently, he or she will demand a greater rate of return for a risky investment to compensate themselves for this risk element. Therefore, in summary, riskier investments will attract greater rate of returns.

Determine Security Market Line and construction of this line.

The security market line (SML) is the line that reflects an investment's risk versus its return. The measure of risk used for the security market line is beta. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed. The line begins with the risk-free rate (with zero risk) and moves upward and to the right. As the risk of an investment increases, it is expected that the return on an investment would increase. An investor with a low risk profile would choose an investment at the beginning of the security market line. An investor with a higher risk profile would thus choose an investment higher along the security market line.

SML: ki=kRF+(kM-kRF)b= Risk-free return+ (Market risk premium)(Stock I’s beta)

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Explain Market Risk Premium and calculation.

Market Risk Premium is additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. The size of premium depends on perceived risk of the stock market and investors’ degree of risk aversion. The market risk premium can be calculated as follows:

Market Risk Premium = Expected Return of the Market – Risk-Free Rate= kM-kRF

Market risk premium is equal to the slope of the security market line (SML), a capital asset pricing model. MRM shows the difference between the expected return on an investment and and the risk-free rate of return.

Explain the correlation between returns on a project and returns on the firm’s other assets affect the project’s risk.

Most projects’ risk are positively correlated with returns of the firm’s other assets.

Taking on a project with a high degree of either stand-alone or corporate riskwill not necessarily affect the firm’s beta. However, if the project has highly uncertain returns, and if those returns are highly correlated with returns on the firm’s other assets and with most other assets in the economy, the project will have a high degree of all types of risk. For example, suppose General Motors decides to undertake a major expansion to build commuter airplanes. GM is not sure how its technology will workon a mass production basis, so there are great risks in the venture—its stand-alone risk is high. Management also estimates that the project will do best if the economy is strong, for then people will have more money to spend on the new planes. This means that the project will tend to do well if GM’s other divisions do well and will tend to do badly if other divisions do badly. This being the case, the project will also have high corporate risk. Finally, since GM’s profits are highly correlated with those of most other firms, the project’s beta will also be high. Thus, this project will be risky under all three definitions of risk.

Define floating rate bonds and zero coupon bonds.

Floating rate bond a debt instrument with a variable interest rate. Also known as a “floater” or “FRN. Financial institutions and governments mainly issue floaters, and they typically have a two- to five-year term to maturity. They tend to become more popular when interest rates are expected to increase. Compared to fixed-rate debt instruments, floaters protect investors against a rise in interest rates. Because interest rates have an inverse relationship with bond prices, a fixed-rate note’s market price will drop if interest rates increase. FRNs, however, carry lower yields than fixed notes of the same maturity. They also have unpredictable coupon payments. FRNs may be issued with or without a call option

Zero Coupon Bond a bond that pays no annual interest but is sold at a discount below par, thus providing compensation to investors in the form of capital appreciation. Also known as an "accrual bond." A zero-coupon bond makes no periodic interest payments but instead is sold at a deep discount from its face value. Why buy a bond that pays no interest? The answer lies in the fact that the buyer of such a bond does receive a return. This return consists of the gradual increase (or appreciation) in the value of the security from its original, below-face-value purchase price until it is redeemed at face value on its maturity date.

Define convertible bonds, bonds with warrants, income bonds, and indexed bonds.

Convertible bond a bond that is exchangeable, at the option of the holder, for common stock of the issuing firm. Convertible have a lower coupon rate than nonconvertible debt.

Warrant a long term option to buy a stated number of shares of common stock at a specified price. Bond issued with warrants, similar to convertibles. They carry lower coupon rates than straight bonds and provide a capital gain if the price of the stock rises.

Income bond a bond that pays interest only if the interest is earned. This securities cannot bankrupt a company, but from an investor’s standpoint they are riskier than regular bonds.

Indexed bond a bond that has interest payments based on an inflation index so as to protect the holder from inflation. Also called “Purchasing power bond”. This bond first became popular in Israel and Brazil, and other countries with high inflation. The interest rate paid on this bond is based on an inflation index, so if inflation rises interest paid rises automatically, thus protecting bondholders against inflation.

Explain the reasons why bonds with warrants and convertible bonds have lower coupons than similarly rated bonds that do not have these features.

The reason for this is because convertibles and warrant bonds can be called in at any time. This means that the person holding the bond can demand cash from the entity that issued the bond. This poses a risk for the issuer because and increases liquidity for the holder. Thus you see lower rates.

Explain what happens to the price of a fixed-rate bond if (1) interest rates rise above the bond’s coupon rate or (2) interest rates fall below the bond’s coupon rate.

1. When interest rises above the coupon rate, a fixed-rate bond’s price will fall below its par value. Such bond called discount bond

2. When interest rate is less than stated coupon rate. A fixed-rate bond’s price will rise above its par value. Such bond is called a premium bond.

Explain why prices of fixed-rate bonds fall if expectations for inflation rise. Define discount bond and a premium bond.

Inflation is a bond's worst enemy. Inflation erodes the purchasing power of a bond's future cash flows. We know that an increase in interest rate will cause the prices of fixed-rate bonds to fall. Inflation has direct influence to interest rate. When inflation rises, the interest rate rises too.

Discount bond a bond that sells below its par value

Premium bond a bond sells above its par value.

Explain the yield to maturity and yield to call, and describe their differences.

Bond yields are the rate of return you receive after purchasing a bond and are the accounting measurements that allow you to compare one bond with another. Two yield calculations are generally evaluated when it comes to selecting callable bonds for a portfolio:

1. yield to maturity -the expected rate of return on a bond if bought at its current market price and held to maturity. A bond’s yield to maturity calculation provides you with the total return you would receive if the bond was held through its maturity date.Yield to maturity is based on the coupon rate, face value, purchase price and year until maturity, calculated as:

Yield to maturity = {Coupon rate + (Face value – Purchase price/years until maturity)} / {Face value + Purchase price/2}

OR

2. yield to call -the yield of a bond or note if you were to buy and hold the security until the call date. This yield is valid only if the security is called prior to maturity. The calculation of yield to call is based on the coupon rate, the length of time to the call date and the market price.

For most bond investors, it is important to also estimate the yield to call, or the total return that would be received if the bond purchased was held until its call date instead of full maturity. Because it is impossible to know when an issuer may call a bond, you can only estimate this calculation based on the bond’s coupon rate, the time until the first (or second) call date, and the market price.

Differentiate between interest rate risk and reinvestment rate risk.

interest rate risk the scenario in which interest rates rise after a bond is issued leads to interest rate risk. Since prices will decline if interest rates rise, the holder of a fixed-rate bond may experience a capital loss if the bond is sold before its maturity date. The longer the period until maturity, the more the bond is subject to interest rate risk. At maturity, the bond will refund the face amount, so bonds near maturity have little interest rate risk. 

reinvestment rate risk. What if interest rates go down instead? The price of a fixed-rate bond will rise and entice some holders to sell the bond for a profit. But others will hold onto the bond and will find that they cannot make as much interest income from reinvesting the periodic coupon payments they receive. This is reinvestment risk -- if interest rates go down, your interest on interest will decline. This lowers a bond’s yield to maturity, which is a function of the total income, including reinvested interest income, which will be provided by the bond

To which type of risk are holders of long-term bonds more exposed and short-term bondholders?

Long-term bondholders exposed to Interest rate risk. Interest rate risk is the risk from a varying interest rates on a bond. If rates fall, the price of a bond rises. As rates rise, the price of a bond will fall. The longer the period until maturity, the more the bond is subject to interest rate risk.

Short-term bondholders are subject to the reinvestment risk, as interest available upon maturity may be lower than those currently available.

Explain and define mortgage bonds, debentures, and junk bonds.

Mortgage bonds a bond backed by fixed assets. These bonds are typically backed by real property such as equipment. Mortgage bonds offer the investor a great deal of protection in that the principal is secured by a valuable asset that could theoretically be sold off to cover the debt. However, because of this inherent safety, the average mortgage bond tends to yield a lower rate of return than traditional corporate bonds that are backed only by the corporation's promise and ability to pay.

Debenture a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond in order to secure capital.

Junk bonds are risky investments, but have speculative appeal because they offer much higher yields than safer bonds. Companies that issue junk bonds typically have less-than-stellar credit ratings, and investors demand these higher yields as compensation for the risk of investing in them. A junk bond issued from a company that manages to turn its performance around for the better and has its credit rating upgraded will generally have a substantial price appreciation.

Explain reasons for the existence of the preemptive right

Preemptive right a provision in the corporate charter that gives common stockholders the right to purchase additional shares in the company.

The first reason is PR enables current stockholders to maintain control. If it were not for this safeguard, the management of a corporation could issue a large number of shares and purchase these shares itself. The second reason is that prevents the transfer of control to new stockholders. For instance, it blocks the ability for new buyers to buy stock at a falsely lower price, thereby instantly making profit and devaluing the price of the shares held by the current stockholders. Overall it prevents the rapid changing of stockholder control for a firm.

Explain the reasons why a company uses classified stocks.

The separation of company equity into more than one class of common shares, usually called "Class A" and "Class B”, and so forth, to meet special needs of the company. Voting privileges are the main reason companies create different classes, although liquidation and dividend rights may also be involved. The use of classified stock thus enabled the public to take a position in a conservatively financed growth company without sacrificing income. The use of a classified stock investment structure for a company can be a very attractive option that helps the corporation attract more than one type of investor. Sometimes considered acomplex capital structure, classified stock is really a relatively easy strategy to implement and manage.

Define and differentiate between a closely held corporation and a publicly owned corporation

Closely held corporation a corporation that is owned by a few individuals who are typically associated with the firm’s management.

Publicly owned corporation a corporation that is owned by a relatively large number of individuals who are not actively involved in its management.

The biggest difference between a closely held corporation and a publicly owned company is that a closely held corporation has a tight-knit group of shareholders that make up the ownership committee for the company, while a publicly held corporation is one that is owned by stockholders. In a publicly held company, the ownership shares of the corporation are traded publicly on the international stock market.

Define and differentiate between primary, secondary markets and IPO.

Primary Market – the market in which firms issue new securities to raise corporate capital. The important thing to understand about the primary market is that securities are purchased directly from an issuing company.

Secondary Market – the market in which “used” stocks are traded after corporations have issued them. A market where investors purchase securities or assets from other investors, rather than from issuing companies themselves. The company receives no new money when sales occur in this market.

IPO(initial Public offering) – the market for stocks of companies that are in the process of going public.

You can think of the primary market as being synonymous with an initial public offering. But the different is that an IPO occurs when private company sells stocks to the public for the first time.

Determine the capital gains yield and the dividend yield of a stock.

Capital gains yield – the capital gain during a given year divided by the beginning price.

The price appreciation component of a security's (such as a common stock) total return. For stock holdings, the capital gains yield will be the change in price divided by the original (purchase) price.

Calculated as:

Where:P0 = market price of the stock today

P1 = expected price of the stock at the end of each year

Dividend yield of a stock – the expected dividend divided by the current price of a share of stock. A financial ratio that shows how much a company pays out in dividends each year relative to its share price.

D1P0

Define the two parts of most stock’s expected total return.

Total return accounts for two categories of return: expected dividend yield and expected capital gain yield. Total return includes interest, capital gains, dividends and distributions realized over a given period of time. Calculated as:

ETR=EDY+ECGY ks= D1P0+P1- P0P0

Write out and explain the valuation formula for a constant growth stock.

Used to find the value of a constant growth stock. Growth stock – shares in a company whose earnings are expected to grow at an above-average rate relative to the market.

P0=D0(1+g)ks-g=D1ks-g

D0- dividend

g− growth rate

ks-required rate of return

D1- first dividend expected

ks>g this is a necessary condition for equation. If the required rate of return is not greater than growth rate, the results will be both wrong and meaningless.

Define the conditions that a company must hold if a stock to be evaluated using the constant growth model.

For a constant growth stock, the following conditions must hold:

1. The dividend is expected to grow forever at a constant rate, g.

2. The stock price is expected to grow at this time.

3. The expected dividend yield is a constant.

4. The expected capital gains yield is also a constant, and it equal to growth rate, g.

5. The expected total rate of return, ks, is equal to the expected dividend yield plus the expected growth rate: ks= dividend yield + g.

Explain how one would find the value of a supernormal growth stock.

supernormal growth or nonconstant growth the part of the firm’s cycle in which it grows rapidly than the economy as a whole.

Many firms enjoy periods of rapid growth. These periods may result from the introduction of a new product, a new technology, or an innovative marketing strategy. However, the period of rapid growth cannot continue indefinitely. Eventually, competitors will enter the market and catch up with the firm. This section presents a more general approach which allows for the dividends/growth rates during the period of rapid growth to be forecast. Then, it assumes that dividends will grow from that point on at a constant rate which reflects the long-term growth rate in the economy. Stocks, which are experiencing the above pattern of growth, are called nonconstant, supernormal, or erratic growth stocks. The value of a nonconstant growth stock can be determined using the following equation:

P0=n=1ND1(1+ks)N+DN+1ks-g(1+ks)N

P0- stock value

N – years of supernormal growth

D – dividend

ks- stockholder’s required rate of return

g- growth rate

How to find out stock’s value:

1. Find the PV of the dividends during the period of nonconstant growth.

2. Find the price of the stock at the end of the nonconstant growth period,

at which point it has become a constant growth stock, and discount this

price back to the present.

3. Add these two components to find the intrinsic value of the stock, P0.

Explain what is meant by terminal date and terminal value?

Terminal date (Horizon date)- N the date when the growth rate becomes constant. At this date it is no longer necessary to forecast the individual dividends.

Terminal value (Horizon value) the value at the horizon date of all dividends expected thereafter. Horizon value = PN= DN+1ks-g

Define the conditions for a stock to be in equilibrium.

Equilibrium the condition under which the expected return on a security is just equal to its required return, k=k. Also, P0= P0

In equilibrium two related conditions must hold:

1. A stock’s expected rate of return as seen by the marginal investor must equal its required rate of return: ki=ki

2. The actual market price of a stock must equal ints intrinsic value as estimated by the marginal investor: P0=P0

Efficient markets hypothesis.

The hypothesis that securities are typically in equilibrium – that they are fairly priced in the sense that the price reflects all publicly available information on each security.

An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

Define the difference among the three forms of efficient market hypothesis: (1) weak form, (2) semistrong form, and (3) strong form.

weak form – one of the different degrees of efficient market hypothesis (EMH) that claims all past prices of a stock are reflected in today's stock price. This hypothesis assumes that the rates of return on the market should be independent; past rates of return have no effect on future rates. Given this assumption, rules such as the ones traders use to buy or sell a stock, are invalid.

2. Semi-Strong EMH

The semi-strong form EMH implies that the market is efficient, reflecting all publicly available information. This hypothesis assumes that stocks adjust quickly to absorb new information. The semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that stock prices reflect all new available information and investors purchase stocks after this information is released, an investor cannot benefit over and above the market by trading on new information.

3. Strong-Form EMH

The strong-form EMH implies that the market is efficient: it reflects all information both public and private, building and incorporating the weak-form EMH and the semi-strong form EMH. Given the assumption that stock prices reflect all information (public as well as private) no investor would be able to profit above the average investor even if he was given new information.

Explain the following statement: “Preferred stock is a hybrid security”.

Preferred stock is a hybrid security having some characteristics of debt and some of equity. It is similar to bonds in some respects and to common stocks in others. Like bond, preferred stock has a par value and a fixed amount of dividends that must be paid before dividends can be paid on the common stock. However, if the preferred dividends is not earned, the directors can pass it without throwing the company into bankruptcy.

Identify the reasons of calculating the cost of capital used in capital budgeting to be calculated as a weighted average of the various types of funds the firm generally uses, not the cost of the specific financing used to fund a particular project.

The use of debt impacts the ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project. The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debtholders, so WACC tells us the return that both stakeholders - equity owners and lenders - can expect.

Identify the firms 3 major capital structure components, and give their respective component cost symbols.

There are three major capital components: debt, preferred stock, and common equity.

kp- component cost of preferred stock

ks- component cost of common equity

kd(1-T)= after-tax component cost of debt, where T is the firm’s marginal tax rate, kd- interest rate on the firm'snew debt

Explain the reasons of using after-tax cost of debt rather than the before-tax cost in calculating the weighted average cost of capital.

The reason for using the after-tax cost of debt in calculating the weighted average cost of capital is as follows. The value of the firm’s stock, which we want to maximize, depends on after-tax cash flows. Because interest is a deductible expense, it produces tax savings that reduce the net cost of debt, making the after-tax cost of debt less than the before-tax cost. We are concerned with after-tax cash flows, and since cash flows and rates of return should be placed on a comparable basis, we adjust the interest rate downward to take account of the preferential tax treatment of debt.Note that the cost of debt is the interest rate on new debt, not that on already outstanding debt; in other words, we are interested in the marginal cost of debt. Our primary concern with the cost of capital is to use it for capital budgeting decisions—for example, would a new machine earn a return greater than the cost of the capital needed to acquire the machine? The rate at which the firm has borrowed in the past is irrelevant—we need the cost of new capital.

Explain three approaches that are used to estimate the cost of common equity.

There are three methods one can use to derive the cost of retained earnings:a) Capital-asset-pricing-model (CAPM) approach

b) Bond-yield-plus-premium approach

c) Discounted cash flow approach

a) CAPM Approach

To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate of return on the market (rm).

The next step is to estimate the company's beta (bi), which is an estimate of the stock's risk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained earnings.

Formula 11.3 

ks=kRF+(km-kRF)bi

ks – CAPM

kRF – Risk-free rate

km - risk premium

Example: CAPM approach

For Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of retained earnings for Newco using the CAPM approach?

Answer:ks = rf + bi (rm - rf) = 4% + 1.1(15%-4%) = 16.1%

b) Bond-Yield-Plus-Premium Approach

This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firm's long-term debt and add a risk premium (typically three to five percentage points): 

Formula 11.4

ks= long-term bond yield + risk premium

Example: bond-yield-plus-premium approach

The interest rate on Newco's long-term debt is 7% and our risk premium is 4%. What is the cost of retained earnings for Newco using the bond-yield-plus-premium approach?

Answer: ks = 7% + 4% = 11%

c) Discounted Cash Flow Approach

Also known as the "dividend yield plus growth approach". Using the dividend-growth model, you can rearrange the terms as follows to determine ks.

Formula 11.5

P0 =  D1        ks-g

where:D1 = next year's dividendg = firm's constant growth rateP0  = price

Typically, you must also estimate g, which can be calculated as follows:Formula 11.6g = (retention rate)(ROE) = (1-payout rate)(ROE)

Example: discounted cash flow approach 

Assume Newco's stock is selling for $40; its expected return on equity (ROE) is 10%, next year's dividend is $2 and the company expects to pay out 30% of its earnings. What is the cost of retained earnings for Newco using the discounted cash flow approach?Answer: g must first be calculated: g = (1-0.3)(0.10) = 7.0%ks = 2/40 + 0.07 = 0.12 or 12%

Identify some problems with the CAPM approach.

The first problem, if a firm’s stockholders are not well diversified, they may be concerned with stand-alone risk rather than just market risk. In that case, the firm’s true investment risk would not be measured by its beta, and the CAPM procedure would understate the correct value of ks. Further, even if the CAPM method is valid, it is hard to obtain correct estimates of the inputs required to make it operational because (1) there is controversy about whether to use long-term or short-term Treasury yields for kRF, (2) it is hard to estimate the beta that investors expect the company to have in the future, and (3) it is difficult to estimate the market risk premium.

Explain the two approaches that can be used to adjust for flotation costs.

The first approach simply adds the estimated dollar amount of flotation costs for each project to the project’s up-front cost. The estimated flotation costs are found as the sum of the flotation costs for the debt, preferred, and common stock used to finance the project. Because of the now-higher investment cost, the project’s expected rate of return and NPV are decreased.

The second approach involves adjusting the cost of capital rather than increasing the project’s cost. If the firm plans to continue to use the capital in the future, as is generally true for equity, then this second approach is better. The adjustment process is based on the following logic. If there are flotation costs, the issuing company receives only a portion of the total capital raised from investors, with the remainder going to the underwriter. When calculating the cost of common equity, the DCF approach can be adapted to account for flotation costs. For a constant growth stock, the cost of new common stock, ke, can be expressed as:

Cost of equity from new stock issues = ke = D1P0(1 _ F)

Write out the equation for the weighted average cost of capital and explain.

WACC = wdkd1-T+wpkp+ wcks

WACC - weighted average of the component costs of debt, preferred stock, and common equity.

kd1-T – After-tax cost of debt; kd – before-tax cost of debt

kp – cost of preferred stock

ks – cost of common equity

wd, wp, wc – weights used for debt, preferred and common equity, respectively.

Explain the calculation of debt structure in the capital structure used to calculate WACC.

When calculating the firm’s target capital structure, total debt includes both long-term debt and bank debt. Investor-supplied capital doesn’t include other current liabilities such as accounts payable and accruals.

Define the two factors that affect the cost of capital that are generally beyond the firm’s control.

There are two factors beyond the firm’s control:

The level of interest rates If interest rates in the economy rise, the cost of debt increases because firms will have to pay bondholders more to obtain debt capital. The higher interest rates increase the costs of common and preferred equity capital.

Tax rates, which are largely beyond the control of an individual firm, have an important effect on the cost of capital. Tax rates are used in the calculation of the component cost of debt. In addition, tax policy affects the cost of capital in other less apparent ways. For example, lowering the capital gains tax rate relative to the rate on ordinary income makes stocks more attractive, and that reduces the cost of equity. That would lower the WACC, and, it would also lead to a change in a firm’s optimal capital structure (toward less debt and more equity).

Explain how a change in interest rates would affect each component of the weighted average cost of capital.

An increase in interest rate lead to increase the cost of debt, the cost of common and preferred equity capital. If interest rates in the economy rise, the cost of debt increase because firms will have to pay bondholders more to obtain debt capital. And conversely, decreases in interest rate reduce the cost of capital, encouraging additional investment.

Three types of project risk and show the level of relevance.

Stand-Alone Risk - the risk an asset would have if it were a firm’s only asset and if investors owned only one stock. It is measured by the variability of the asset’s expected returns. Stand-alone risk does not take into account how the risk of a single asset will affect the overall corporate risk.

Corporate, or Within-Firm, Risk risk not considering the effects of stockholders’ diversification; it is measured by a project’s effect on uncertainty about the firm’s future earnings.

Market, or Beta, Risk That part of a project’s risk that cannot be eliminated by diversification; it is measured by the project’s beta coefficient.

Of the three measures, market risk is theoretically the most relevant measure because it is the one reflected in stock prices. Then on the second place, corporate risk, and last is stand-alone risk

Describe the pure play and the accounting beta methods for estimating individual project’s betas.

pure play is a company that invests its resources in only one line of business. As such, this type of stock has a performance that correlates highly to the performance of the stock's particular industry. For example, many electronic retailers or "e-tailers" are pure plays. All they do is sell one particular type of product over the internet. Therefore, if internet buying declines even slightly, these companies are negatively affected.An accounting beta method – a method of estimating a project’s beta by running a regression of the company’s return on assets against the average return on assets for a large sample of firms. Accounting betas for a totally new project can be calculated only after the project has been accepted, placed in operation, and begun to generate output and accounting results—too late for the capital budgeting decision.

Identify some problem areas in cost of capital analysis. Explain how they invalidate the cost of capital procedures.

Depreciation-generated funds In brief, depreciation cash flows can either be reinvested or returned to investors (stockholders and creditors). The cost of depreciation-generated funds is approximately equal to the weighted average cost of capital from retained earnings and low-cost debt.

Privately owned firms there is a serious question about how one should measure the cost of equity for a firm whose stock is not traded. Tax issues are also especially important in these cases. As a general rule, the same principles of cost of capital estimation apply to both privately held and publicly owned firms, but the problems of obtaining input data are somewhat different for each.

Small business Small businesses are generally privately owned, making it difficult to estimate their cost of equity

Measurement problems One cannot overemphasize the practical difficulties encountered when estimating the cost of equity. It is very difficult to obtain good input data for the CAPM, for g in the formula ks =D1/P0+g, and for the risk premium in the formula ks = Bond yield + Risk premium. As a result, we can never be sure just how accurate our estimated cost of capital is.

Costs of capital for projects of differing riskiness It is difficult to measure projects’ risks, hence to assign risk-adjusted discount rates to capital budgeting projects of differing degrees of riskiness.

Capital structure weights the state of the art in cost of capital estimation is really not in bad shape. The procedures outlined in this chapter can be used to obtain cost of capital estimates that are sufficiently accurate for practical purposes, and the problems listed here merely indicate the desirability of refinements. The refinements are not unimportant, but the problems we have identified do not invalidate the usefulness of the procedures outlined in the chapter.

Define the determination of the capital structure weights that are used to calculate the WACC

The percentage of debt, preferred stock, and common equity that will maximize the firm’s stock price. The capital structure weights used in computing the weighted average cost of capital are based on the market value of the firm's debt and equity securities.

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