Fin 3717 - Test 1
repatriation tax
Additional corporate tax owed, based on the difference between the U.S. and foreign tax rates, if profits earned abroad are returned to the U.S.
Alpha
Alpha = R - Rf - beta (Rm-Rf)
Net Alpha
Alpha after deducting fees
Gross Alpha
Alpha before deducting fees
high-minus-low (HML) portfolio
An annually updated portfolio that is long stocks with high book-to-market ratios and short stocks with low book-to-market ratios.
Debt Covenants
conditions of making a loan in which creditors place restrictions on actions that a firm can take
Agency Costs
costs that arise when there are conflicts of interest between a firm's stakeholders
In order for sophisticated investors to profit from investor mistakes, two conditions must hold.
First, the mistakes must be sufficiently pervasive and persistent to affect stock prices. That is, investor behavior must push prices so that non-zero alpha trading opportunities become apparent. Second, there must be limited competition to exploit these non-zero alpha opportunities. If competition is too intense, these opportunities will be quickly eliminated before any trader can take advantage of them in a significant way.
Data Snooping Bias
Given enough characteristics, it will always be possible to find some characteristic that by pure chance happens to be correlated with the estimation error of average returns
Economic Distress
a significant decline in the value of a firm's assets, whether or not the firm experiences financial distress due to leverage
management entrenchment
a situation arising as a result of the separation of ownership and control, in which managers may make decisions that benefit themselves at investors' expense
Dilution
an increase in the total number of shares that will divide a fixed amount of earnings
Strong Form Efficiency
states that it should not be possible to consistently profit even by trading on private information.
Weak Form Efficiency
states that it should not be possible to profit by trading on information in past prices by
Familiarity Bias
that they favor investments in companies they are familiar with.
Tradeoff Theory
the firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress and agency costs the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs
Smart Beta Strategy
the idea that investors can tailor their risk exposures based on common risk factors
Size Effect
the observation that small stocks (or stocks with a high book-to-market ratio) have higher returns
Book-to-market ratio
the ratio of the book value of equity to the market value of equity
interest tax shield
the reduction in taxes paid due to the tax deductibility of interest payments
overconfidence bias
the tendency of individual investors to trade too much based on the mistaken belief that they can pick winners and losers better than investment professionals
Free Cash Flow Hypothesis
the view that wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed to make all positive-NPV investments and payments to debt holders
leverage increases the risk of equity even when there is no risk that the firm will default
true
Three key factors determine the present value of financial distress costs:
(1) the probability of financial distress, (2) the magnitude of the costs if the firm is in distress, and (3) the appropriate discount rate for the distress costs.
Market Value (Example 13.2)
1 / Cost of Capital
Chapter 11 Reorganization
A common form of bankruptcy for large corporations in which all pending collection attempts are automatically suspended, and the firm's existing management is given the opportunity to propose a reorganization plan. While developing the plan, management continues to operate the business as usual. The creditors must vote to accept the plan, and it must be approved by the bankruptcy court. If an acceptable plan is not put forth, the court may ultimately force a Chapter 7 liquidation of the firm.
single factor model
A model using an efficient portfolio, capturing all systemic risk alone.
Fama-French-Carhart (FFC) factor specification
A multi-factor model of risk and return in which the factor portfolios are the market, small-minus-big, high-minus-low, and prior 1-year momentum portfolios identified by Fama, French and Carhart.
Chapter 7 Liquidation
A provision of the U.S. bankruptcy code in which a trustee is appointed to oversee the liquidation of a firm's assets through an auction. The proceeds from the liquidation are used to pay the firm's creditors, and the firm ceases to exist.
underinvestment problem
A situation in which equity holders choose not to invest in a positive NPV project because the firm is in financial distress and the value of undertaking the investment opportunity will accrue to bondholders rather than themselves
market value balance sheet
Balance sheet showing market rather than book values of assets, liabilities, and stockholders' equity First, all assets and liabilities of the firm are included—even intangible assets such as reputation, brand name, or human capital that are missing from a standard accounting balance sheet. Second, all values are current market values rather than historical costs.
Beta meaning
Beta is a concept that measures the expected move in a stock relative to movements in the overall market. A beta greater than 1.0 suggests that the stock is more volatile than the broader market, and a beta less than 1.0 indicates a stock with lower volatility.
Momentum Strategy
Buying stocks that have had past high returns and (short) selling stocks that have had past low returns
interest tax shield formula
Corporate Tax Rate x Interest Payments
The market portfolio can be inefficient (so it is possible to beat the market) only if a significant number of investors either
Do not have rational expectations so that they misinterpret information and believe they are earning a positive alpha when they are actually earning a negative alpha, or Care about aspects of their portfolios other than expected return and volatility, and so are willing to hold inefficient portfolios of securities.
CAPM formula
ERi = Rf + beta*(Rm - Rf) ERi = capital asset expected return Rf = risk-free rate of interest Beta = sensitivity Rm = expected return of the market
Why are firms under-leveraged? Either firms are content to pay more taxes than necessary rather than maximize shareholder value, or there is more to the capital structure story than we have uncovered so far. While some firms may deliberately choose a suboptimal capital structure, it is hard to accept that most firms are acting suboptimally. The consensus of so many managers in choosing low levels of leverage suggests that debt financing has other costs that prevent firms from using the interest tax shield fully.
Increasing the level of debt increases the probability of bankruptcy. Aside from taxes, another important difference between debt and equity financing is that debt payments must be made to avoid bankruptcy, whereas firms have no similar obligation to pay dividends or realize capital gains. If bankruptcy is costly, these costs might offset the tax advantages of debt financing.
What are some indirect costs of financial distress?
Losing Customers, Suppliers, Employees, Receivables, Fire Sale of Assets, Inefficient Liquidation, and Costs to Creditors.
Finally, investors appear to put too much weight on their own experience rather than considering all the historical evidence. As a result, people who grew up and lived during a time of high stock returns are more likely to invest in stocks than people who experienced times when stocks performed poorly
TRUE
In order to profit by buying a positive-alpha stock, there must be someone willing to sell it
TRUE
debt-to-value ratio
Ratio of debt to debt plus equity, in terms of market values. It is also common to use net debt in place of debt (the debt-to-enterprise value ratio).
The difference between a stock's expected return and its required return according to the security market line is the
Stocks Alpha'
When a corporation becomes financially distressed, outside professionals, such as legal and accounting experts, consultants, appraisers, auctioneers, and others with experience selling distressed assets, are generally hired. Investment bankers may also assist with a potential financial restructurin
THIS IS VERY COSTLY
According to the CAPM, the market portfolio is efficient, so it should be impossible to consistently do better than the market without taking on additional risk
TRUE
According to the provisions of the 1978 Bankruptcy Reform Act, U.S. firms can file for two forms of bankruptcy protection: Chapter 7 or Chapter 11.
TRUE
Also, the higher the firm's beta, the more likely it will be in distress in an economic downturn, and thus the more negative the beta of its distress costs will be. the present value of distress costs will be higher for high beta firms.
TRUE
An implication of this overconfidence bias is that, assuming they have no true ability, investors who trade more will not earn higher returns. Instead, their performance will be worse once we take into account the costs of trading (due to both commissions and bid-ask spreads).
TRUE
Because of this fear that the firm will not honor its long-term commitments in bankruptcy, highly levered firms may need to pay higher wages to their employees, charge less for their products, and pay more to their suppliers than similar firms with less leverage. Because these costs are not limited by the cost of renegotiating to avoid bankruptcy, they may be substantially greater than other kinds of bankruptcy costs.
TRUE
But the more capital the manager has to invest, the harder it is to find profitable trading opportunities. Once these opportunities are exhausted, the manager can no longer produce better-than-average performance
TRUE
In that sense, diversification is a "free lunch" that all investors should take advantage of.
TRUE
In the case of Chapter 11 reorganization, creditors must often wait several years for a reorganization plan to be approved and to receive payment. To ensure that their rights and interests are respected, and to assist in valuing their claims in a proposed reorganization, creditors may seek separate legal representation and professional advice
TRUE
In the presence of corporate taxes, we must include the interest tax shield as one of the firm's assets.
TRUE
MM Proposition II: The cost of capital of levered equity increases with the firm's market value debt-equity ratio,
TRUE
Market Value of Equity = Market Value of Assets - Market Value of Debt and Other Liabilities
TRUE
Recall that equity financing does not carry this risk. While equity holders hope to receive dividends, the firm is not legally obligated to pay them.
TRUE
Studies show that individuals are more likely to buy stocks that have recently been in the news, engaged in advertising, experienced exceptionally high trading volume, or have had extreme (positive or negative) returns
TRUE
The U.S. bankruptcy code was created to organize this process so that creditors are treated fairly and the value of the assets is not needlessly destroyed.
TRUE
Thus, although debt holders bear these costs in the end, shareholders pay the present value of the costs of financial distress upfront.
TRUE
Whatever firm has the lower market value has the higher alpha
TRUE
When a firm faces financial distress, it may choose not to finance new, positive-NPV projects. In this case, when shareholders prefer not to invest in a positive-NPV project, we say there is a debt overhang or under-investment problem.2
TRUE
With perfect capital markets, the answer is no. As long as the value of the firm's assets exceeds its liabilities, Armin will be able to repay the loan. Even if it does not have the cash immediately available, it can raise the cash by obtaining a new loan or by issuing new shares.
TRUE
if a firm has access to capital markets and can issue new securities at a fair price, then it need not default as long as the market value of its assets exceeds its liabilities. That is, whether default occurs depends on the relative values of the firm's assets and liabilities, not on its cash flows. Many firms experience years of negative cash flows yet remain solvent.
TRUE
no corporate tax benefit arises from incurring interest payments that regularly exceed the income limit
TRUE
the Sharpe ratio of a portfolio will increase if we buy stocks whose expected return exceeds their required return—that is, if we buy stocks with positive alphas. Similarly, we can improve the performance of our portfolio by selling stocks with negative alphas.
TRUE
the optimal proportion of debt in the firm's capital structure will be lower, the higher the firm's growth rate.
TRUE -- if theres a 30% limit, you will want debt to be lower so that you can take the rest from tax savings and give it to your other shareholders so they make money as well from the tax shield
CAPM meaning
The capital asset pricing model (CAPM) is an idealized portrayal of how financial markets price securities and thereby determine expected returns on capital investments
Sensation Seeking
The increase in trading activity due to an individuals desires for novel or intense risk-taking experiences
Capital Structure
The relative proportions of debt, equity, and other securities that a firm has outstanding
Factor Betas
The sensitivity of the stock's excess return to the excess return of a factor portfolio, as computed in multifactor regression
Disposition Effect
The tendency of investors to hold on to stock that have lost value and sell stocks that have risen in value since the time of purchase
Herd Behavior
The tendency of investors to make similar trading errors by actively imitating other investors' actions.
MM Proposition I (no taxes)
The value of the levered firm is the same as the value of the unlevered firm
Thus, there is no disadvantage to debt financing, and a firm will have the same total value and will be able to raise the same amount initially from investors with either choice of capital structure.
TruE
Default
When a firm fails to make the required interest or principal payments on its debt, or violates a debt covenant
Leveraged recapitalization
When a firm uses borrowed funds to pay a large special dividend or repurchase a significant amount of outstanding shares
Homemade leverage
When investors use leverage in their own portfolios to adjust the leverage choice made by the firm
debt overhang
When shareholders choose not to invest in a positive-NPV project because some of the gains from investment will accrue to debtholders
Workout
a method for avoiding a declaration of bankruptcy in which a firm in financial distress negotiates directly with its creditors to reorganize
prepackaged bankruptcy
a method for avoiding many of the legal and other direct costs of bankruptcy in which a firm first develops a reorganization plan with the agreement of its main creditors, and then files Chapter 11 to implement the plan
Arbitrage pricing theory
a model that uses more than one portfolio to capture systematic risk. The portfolios themselves can be thought of as either the risk factor itself or a portfolio of stocks correlated with an unobservable risk factor.
multifactor model
a model that uses more than one risk factor to capture risk
small-minus-big (SMB) portfolio
a portfolio resulting from a trading strategy that each year buys a small market value portfolio and finances that position by selling short a large market value portfolio
Self Financing portfolio
a portfolio that costs nothing to construct
prior one-year momentum (PR1YR) portfolio
a self-financing portfolio that goes long on the top 30% of stocks with the highest prior year returns, and short on the 30% with the lowest prior year returns, each year
perfect capital markets
a set of conditions in which investors and firms can trade the same set of securities at competitive market prices; there are no frictions and the firm's financing decisions do not change the cash flows generated by its investments
Unlevered Equity
equity in a firm with no debt
levered equity
equity in a firm with outstanding debt
Lower market cap associates with
higher book to market ratio
mental accounting
how individuals evaluate gains and losses separately rather than aggregating them into a single bottom line
Relative Wealth Concerns
investors care most about the performance of their portfolio relative to that of their peers
Higher market cap associates with
lower book to market ratio
debtor-in-possession financing
new debt issued by a bankrupt firm; this debt is senior to all existing creditors, providing renewed access to financing to allow a firm that has filed for bankruptcy to keep operating
leverage ratchet effect
once existing debt is in place, shareholders may have an incentive to increase leverage even if it decreases the value of the firm, and shareholders may prefer not to decrease leverage by buying back debt even when it will increase the value of the firm
Factor Portfolios
portfolios that can be combined to form an efficient portfolio
Cost of Capital is the same as
required rate of return
Semi-Strong form efficiency
states that it should not be possible to consistently profit by trading on any public information, such as news announcements or analysts' recommendations
asset substitution problem
when a firm faces financial distress, shareholders can gain from decisions that increase the risk of the firm sufficiently, even if they have negative NPV
Rational Expectations
which means that all investors correctly interpret and use their own information, as well as information that can be inferred from market prices or the trades of others.4
Cumulative Abnormal Return
which measures the stock's return relative to that predicted based on its beta, at the time of the event
Informational Cascade Effect
which traders ignore their own information hoping to profit from the information of others
