Finance Exam 3

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diversification effect and correlation

-As the correlation between two assets decreases, the diversification benefits increase -When it comes to diversified portfolios, correlation represents the degree of relationship between the price movements of different assets included in the portfolio. ... If two pairs of assets offer the same return at the same risk, choosing the pair that is less correlated decreases the overall risk of the portfolio

Bankruptcy Reorganization

-Chapter 11 of the Federal Bankruptcy Reform Act of 1978 -Restructure the corporation with a provision to repay creditors -prepackaged bankruptcies are relatively common (make plan, file, recover) -cram down when creditors are forced to accept bankruptcy plan -Bankruptcy abuse prevention and consumer protection act in 2005 allowing creditors to submit their own plans after 18 months -KERPs only if employee has offer form other company -Section 363 more like an auction and quicker than traditional

bankruptcy liquidation

-Chapter 7 of the Federal Bankruptcy Reform Act of 1978 1. petition filed in court (voluntary or involuntary) 2. Trustee takes over assets and sells them 3. distributes the proceeds according to the absolute priority rule (creditors, then shareholders if any left over) -higher claim, more likely to be paid -creditors are entitled to proceeds from the sale of security so are outside of ordering -if secured property insufficient, creditors split remaining liquidated value between secured and unsecured -APR usually not followed; subject to negotiation

the subjective approach

-Consider the project's risk relative to the firm overall -assume that all projects fall in to one of three risk classes or are mandatory (cost of capital irrelevant because has to be taken) -through time, the firm's WACC may change with economic conditions, and as will discount rates for the different types of projects -higher risk project = higher discount rate, lower risk project = lower discount rate -still might accept some bad projects and reject good ones, but better than not considering at all

capital structure weights

-E for market value of equity: number of shares outstanding * price per share -D for market value of firm's debt: long term-debt is market price of a single bond by bonds outstanding and if more than one repeat and add up. if no publicly traded debt, estimate using similar yields from publicly traded debt. short term debt (accounting), use book values as estimates -V (value of firm) = E + D -100% = E/V and D/V... these are capital structure weights -market values are better than book values -WACC = risk of an average project

Market Risk Premium (RPm)

-E(Rm-Rrf) -slope of SML -works out since the assets must all be on a line, it must have average systematic risk which is equal to 1, so no need for beta in denominator

Divisional Cost of Capital

-The cost of capital for a particular division of a company. This may be quite different from the Company WACC, depending on the risk of the division's cash flows. -therefore, a similar problem can arise as when a company analyzes projects with different risks at a divisional level -the riskier option would always look better since it has higher returns

Case 1: M&M Proposition II (no taxes or bankruptcy costs)

-The risk, thus the required return, of equity rises with leverage (the cost of equity increases as the firm increases its debt) - WACC = required return on firm's assets (RA) - Re = Ra + (Ra - Rd)(D/E) -cost of equity depends on: required return on firm's assets, firm's cost of debt, and the firm's debt to equity ratio -the WACC does not depend of the debt-equity ratio; again, the firm's overall cost of capital is unaffected by its capital structure.. the change in capital structure weights are offset by the change in the cost of equity + WACC stays same

CAPM (Capital Asset Pricing Model)

-Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium -shows that expected return for asset depends on three things

Divisional and Project Costs of Capital

-Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm's current operations -If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project -Divisions also often require separate discount rates

taxes and the WACC

-We are concerned with after-tax cash flows, so we also need to consider the effect of taxes on the various costs of capital -Interest expense reduces our tax liability -This reduction in taxes reduces our cost of debt -After-tax cost of debt = RD(1-TC) -Dividends are not tax deductible, so there is no tax impact on the cost of equity (ie, common stock and preferred stock)

financial leverage and capital structure policy

-a capital structure that maximizes the value of the firm will also maximize the value for the stockholder -this means the NPV rule applies to capital structure decisions, as the change in value of the overall firm is the NPV of a restructuring -restructuring = changing amount of leverage without changing assets

Security Market Line (SML)

-a positively sloped straight line displaying the relationship between expected return and beta -slope of the line is the reward to risk ratio, aka (expected return - risk free rate/beta) -ex: if slope was 7.5%, then the asset would have a risk premium of 7.5% per unit of systematic risk

standard deviation and number assets in porfolio

-as the number of securities in a portfolio increases, the standard deviation (total risk) declines

Optimal Capital Structure

-combination of debt and equity financing that minimizes the average cost of capital -firm borrows because interest tax shield is valuable -at low debt levels, probability of financial distress is low, so debt benefit outweighs cost -at high debt levels, the benefits from debt might be offset by financial distress costs -optimal structure is somewhere in between

Beta and standard deviation

-differ as risk measures in that beta measures systematic risk and standard deviation measures total risk -when determining which stock will have a greater expected return, betas must be compared, not standard deviation, as only systematic risk can be used to determine risk premium and expected return

systematic risk principle

-diversification leads to the fact that the expected return on a risky asset depends only on that asset's systematic risk -since unsystematic risk can essentially be eliminated through diversification at no cost, there is no reward for bearing it -however, systematic risk cannot be eliminated -no matter how much total risk an asset has, only the systematic portion is relevant for determining expected return and risk premium of the asset

the fundamental result of the SML

-ex of asset A and asset B could not last in a well-organized market because every investor would want asset A and not asset B.. asset A's price would rise -buying and selling would continue until the two assets were on the exact same line -the reward to risk ratio must be the same for all assets in the market -this means if one asset has 2x the systematic risk as another asset, the risk premium would be twice as large -if the price is too high given an asset's expected return and risk, the asset is said to be overvalued

Weighted Average Cost of Capital (WACC)

-expected rate of return on a portfolio of all the firm's securities, based on the market's perception of the risk of those assets and adjusted for tax savings due to interest payments (the weighted average of the cost of equity and the aftertax cost of debt)

Expected versus Unexpected Information and market efficiency

-expected return: the portion of the return that shareholders expect as a result of the information that have access to from the market -unexpected return: portion of the return that comes from unexpected information -total return = expected return + unexpected return -over time, the average value of the unexpected portion will be zero -announcement = expected + surprise -implicitly assume that markets are at least reasonably efficient + assume relevant info is in the expected return (exclude surprises) -efficient markets involve random price changes bc surprises cannot be predicted. -the easier It is to trade on surprises, the more efficient the market

bankruptcy liquidation and reorganization

-firms that cannot or choose not to make contractually required have two options: liquidate or reorganize -liquidation: termination of the firm as a going concern and selling assets -reorganization: option of keeping the firm a going concern; issuing new securites to replace old ones

The CAPM, the SML and Proposition II

-how does financial leverage affect systematic risk? -CAPM: RA = Rf +Ba(RM − Rf), where beta measures the systematic risk of the firm's assets -prop II: RE= Rf + Ba(1+D/E)(RM− Rf), replacing CAPM with Ra and assuming debt is risk less so that Rd = RF - Be = Ba(1+D/E), so that systematic risk of the stock depends on the systematic risk of the assets (business risk) and level of leverage (financial risk)

company valuation with the WACC

-in order to separate financing costs from cash flows, tax amount is what would have been paid if firm issues no debt -taxes = EBIT x Tc -CFA* = EBIT × (1 − TC) + Depreciation − Change in NWC − CapEx -if firm is growing steadily, value is = CFA*1 / (WACC − g) -if nonconstant: vt = cfa*t+1 = WACC -g -essentially, valuing a firm is the same as valuing an Investment

M&M propositions I and II with corporate taxes

-interest is tax deductible = potential benefit of debt financing -this deduction generates tax savings equal to the interest payment multiplied by the tax rate -this savings is called the interest tax shield -the debt is perpetual, so the same shield will be generate forever, and it becomes a perpetuity -PV of interest tax shield = corporate tax rate times debt or annual tax shield divided by cost of debt

Cost of Preferred Stock

-is equal to the dividend yield -preferred stock is a perpetuity, so use perpetuity formula (constant dividends paid forever) -D is a fixed dividend and Po is the current price per share of the preferred stock -cost can also be estimated by observing returns of similarly rated shares of preferred stock

WACC interpretation

-it is the overall return the firm must earn on existing assets to maintain the value of its stock - also the required return on any investments by the firm that have essentially the same risks -so, when evaluating projects, it is the discount rate we would use

Variance and Standard Deviation

-measure the volatility of asset returns -standard deviation is the square root of variance

Dividend Discount Model (DDM)

-method of estimating the value of a share of stock as the present value of all expected future dividend payments -since RE is the return that shareholder's require on the stock, it can be interpreted as the firm's cost of equity capital -D0 is dividend just paid and D1 is next period's projected dividend -D1 = D0 x (1+g) -D1/P0 is dividend yield and g is capital gains yield -price (P0) and dividend (D0) are both public; use historical data (average) to calculate growth

Observed Capital Structures

-most corporations have low debt-equity ratios -drug and computer companies: basically no debt -debt heavy: airline and cable -most industries rely more heavily on equity than debt -different industries have different operating characteristics (EBIT, asset types) there is a connection between these and capital structure

pecking order or static theory?

-no definite conclusion -static theory is more long run with financial distress costs and tax shield -pecking order more concerned with shorter-run issue of raising funds for investments

optimal capital structure and the cost of capital

-optimal capital structure maximizes value firm + minimizes cost of capital -initially, the WACC falls because of the tax advantage of debt -beyond D/E*, the optimal debt to equity ratio, the WACC begins to rise again because of financial distress costs -WACC initially declines bc the aftertax cost of debt is cheaper than equity, so initially cost of capital declines -however, as the cost of debt rises, the face that debt is cheaper than equity is offset. by financial distress costs and WACC will increase

Case 1: M&M Proposition I (no taxes or bankruptcy cost)

-proposition I is about firm value; to change the firm's value, change the cash flows and their risk -the pie model; the size of the pie doesn't rely on how it is sliced -it is completely irrelevant how a firm chooses to arrange its finances -WACC is the same no matter what mix of debt and equity -the value of the levered firm is the same as the value of the unlevered firm -as the firm adds debt, the increase in the cost of equity exactly offsets the larger proportion of the firm financed with lower-cost debt, so value of the firm and cost of capital are not changed

advantages and disadvantages to dividend discount model

-pros: easy to use and understand -cons: only applicable to companies paying dividends, not applicable unless growth rate is constant, very sensitive to g, and doesn't consider risk

advantages and disadvantages of using the SML approach

-pros: explicitly adjusts for systematic risk and is applicable to all companies as long as beta can be estimated -cons: have to estimate the expected market risk premium (varies over time), have to estimate beta (varies over time), and using the past to predict the future

capital structure question

-since firms can choose any capital structure they want, how should they choose its debt to equity ration? = MAXIMIZE firm value -this means to MINIMIZE wacc (discount rates and values move in opposite directions) -optimal capital structure = lowest possible WACC

the principle of diversification

-spreading an investment across a number of assets will eliminate some, but not all, of the risk -the portion of the risk that can be eliminated by diversification in the unsystematic risk -the portion of the risk that cannot be eliminated by diversification is the systematic portion -total risk = systematic + unsystematic risk -this means that for a well-diversified portfolio, the unsystematic risk is very small and essentially equal to systematic risk -standard deviation is a measure of total risk

the extended pie model: real world implications of M&M theory

-taxes are just another claim to the cash flows of the firm; as leverage is increased and taxes decrease, so does government's claim on the firm's cash flows -bankruptcy costs have claim on cash flows; value of claim increases with d/e ratio -the value of the firm depends on the total cash flow of the firm -the firm's capital structure cuts the cash flow in slices without altering the total

Beta

-the beta coefficient is used to measure systematic risk -measures the amount of systematic risk in an individual asset relative to the amount of risk in an average asset -1 = same, less than 1 = less than, more than one = more than

indirect bankruptcy costs

-the costs of avoiding a bankruptcy filing incurred by a financially distressed firm -larger than direct, but more difficult to measure/estimate -stockholders and bondholders often in different groups; stockholders wiped out if bankruptcy is filed so incentive to avoid bankruptcy filing and bondholders want to take control away from stockholders and protect assets -assets lose value over time as management tries to avoid bankruptcy -firm loses sales, employees, and operations are interrupted

financial policy and cost of capital

-the firm's capital structure (mix of debt and equity) are managerial decisions -when a firm has extra cash, it can pay it to investors or invest it in projects; the firm should follow the path of highest return for the investors -cost of capital reflects both cost of debt capital and cost of equity capital -assume D/E ratio is fixed

capital structure managerial recommendations: financial distress

-the greater the risk of financial distress, the less debt will be optimal for the firm. -so, firms with less risk of experiencing financial distress will borrow less than firms with a lower risk -cost of financial risk depends on transferability of the firm's assets (more tangible - easier to sell w/o loss in value + more incentive to borrow... less tangible assets = debt is less attractive) -varies by industry, so know cost for industry

the basics of financial leverage

-the impact of leverage is evident through looking at EPS and ROE -under more leverage, the variability in both EPS and ROE is much larger than without -financial leverage magnifies gains and losses to shareholders -really good year = more for stockholders -really bad year = less for stockholders -increasing debt financing increases fixed interest expense -break even point: (EBIT/shares outstanding) = (EBIT - interest/shares outstanding) -above break even point = leverage beneficial, below it is not

cost of capital

-the minimum required return on a new investment in order for the investment to be considered to be attractive -called cost of capital because required return is what the firm must earn on its capital investment to break even -effectively using the IRR to consider if investment is attractive, though now much better idea of what determines required return of an investment

the SML and the cost of capital

-the only way to benefit shareholders is to implement capital projects with expected returns that exceed the returns in the financial markets for investments of similar risk, as measured by beta; that is to implement projects with positive NPVs -"what is the appropriate discount rate" = use expected return offered in financial markets on investments with same systematic risk -basically compared investments with investments with the same betaa -SML is important because tells the "going rate" for bearing risk in the economy

required return versus cost of capital

-the return an investor in a security receives is the cost of that security to the company that issued it -the discount rate for evaluating a project should be the expected return on a financial asset of comparable risk -if required return is 10%, investment only has positive NPV if return exceeds 10% (and cost of capital is 10%) -as a result, the required rate of return on a capital project, and the appropriate discount rate for a capital project are essentially the same thing -the cost of capital for an investment depends on the risk of that investment; so, the cost of capital depends primarily on the use of funds, not the source of funds

the cost of debt

-the return that creditors require on the firm's debt -since the cost of debt is the interest the firm must pay on new borrowing, the interest rates can be observed directly -if firm has bonds outstanding, then YTM is the required rate -or, if bonds are AA rated, then used interest rate on AA bonds -NOT coupon rate; that tells cost of debt when issued, not today

Cost of Equity

-the return that equity investors require on their investment in the firm given the risk of the firm's cash flows -have to estimate since no way to directly observe -two approaches: dividend growth model and security market line approach

financial management and the bankruptcy process

-the right to go bankrupt is valuable -when firm files, immediate "stay" on creditors os that payments cease and gives firms options -some filings are strategic to improve firm's position -however, bankruptcy is long and expensive, so often agree to reschedule debt

Case 2: M&M Proposition II with taxes

-the risk, and therefore required return, of equity rises with leverage, but declines a bit with existence of taxes -with debt, the WACC is lower, and therefore the firm is better of with debt -general implications of prop II are the same with or without taxes

standard deviation

-the square root of the variance -measures the TOTAL risk (both systematic and unsystematic) of a stock -

the pecking order theory

-the static theory has dominated for a long time, but it has shortcomings; many sophisticated firm use little debt -firms prefer to use internal financing whenever possible, as selling securities can be expensive -don't want to issue stock when undervalued bc don't want to sell stock cheap, don't want to issue stock when overvalued bc investors will know and price will take a hit -order: internal, debt, equity

unexpected return

-the surprise portion of a return is the true risk of any investment -if an asset's return is perfectly predicted, it is risk free -risk comes from surprises -unexpected return = systematic risk + unsystematic risk

M&M Case 3: Static Theory of Capital Structure (bankruptcy costs and corporate taxes)

-the theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress -static bc assumes firm is fixed in assets and operations, only changing D/E ratio -yellow line = M&M prop I with no taxes shows that value of firm in not affected by capital structure -blue: M&M with taxes -pink: the value of the firm rises to a maximum value (VL*) is reached at (D* - optimal amount of borrowing), and declines from that point on -optimal firm is D*/VL* in debt and (1-D*/VL*) equity -dif between case 2 and 3 is loss from possible financial distress costs and dif between case 1 and 3 is gain from leverage net distress costs

pure play approach

-the use of a WACC that is unique to a particular project, based on companies in similar lines of business -steps: find companies that specialize in product or service considering, compute beta for each, take average, use beta and capm to find appropriate return for project with that risk -problem: can be difficult to find similar companies

Case 2: M&M Proposition I with taxes

-the value of the firm increases by the present value of the annual interest tax shield -therefore, the value of the levered firm is the value of the unlevered firm + pv of interest tax shield -VU = EBIT(1-t)/Ru (unlevered cost of capital) -VL = VU + (Tc x D) -value of equity = VL - D -the WACC decreases as the D/E increases bc of gov subsidy on interest payments -easy to draw the illogical conclusion that optimal capital structure is 100% debt

business and financial risk

-total systematic risk of equity has two components: business risk (assets and operations, Ra) and financial risk (firm's amount of debt in financial structure, Ra -Rd * D/E) -the greats the business risk, the great Ra is, and the great the firm's cost of equity -with more financial leverage, the financial risk increases and business risk remains the same

the SML approach

-used to estimate cost of equity -logical to use since has concluded that the expected return on an investment depends on the risk free rate, the market risk premium, and the systematic risk of the asset

marketed and unmarketed claimss

-value of the firm - marketed claims + nonmarketed claims -marketed claims: claims of stockholders and bondholders -nonmarketed claims: claims of government and other potential stakeholders -the overall value of the firm is unaffected by changes in capital structure -however, the division between marketed claims and nonmarketed claims may be impacted by capital structure decisions -any increase in Vm implies and increase in Vn -therefore, the optimal capital structure is the one that maximizes the value of marketed claims + minimizes the value of nonmarketed claims

the effect of financial leverage

-what is the impact of financial leverage (the extent to which firm relies on debt) on the payoffs to stockholders? -magnifies both gains and losses to shareholders -increase leverage: issue debt and repurchase outstanding shares -decrease leverage: issue new shares and retire outstanding debt

the SML and the WACC

-when evaluating investments with risks that are substantially different from those of the overall firm, using the WACC will potentially lead to poor decisions -for example, here, a project with a WACC great. than 15% would automatically be accepted, and a project with a WACC would automatically be rejected -however, a desirable investment is one that plots above the SML

homemade leverage

-when investors use leverage in their own portfolios to adjust the leverage choice made by a firm -though it may seem that capital structure is an important consideration to riskiness and expected return, because of homemade leverage, it is not -can use homemade leverage to undo or duplicate effects of corporate leverage (look to debt equity ratio) -create = borrow, undo = lend -based on assumptions: no tax, no transaction costs, and can borrow at same interest rate as the company

flotation costs approach

1. compute weighted average flotation costs 2. use target weights since firm will issues securities long term 3. total amount of capital required/(1-fa) = total raise required 4. the result is that for every $ of outside capital needed need to raise $ + fa -utilized for NPV analysis -internal equity has a flotation cost of 0

implications of the pecking order

1. no target capital structure: capital structure is determined by need for external financing 2. profitable firms use less debt: profitable firms have greater internal cash flows and therefore will have less debt 3. companies want financial slack: companies stockpile internally generated cash to avoid selling equity

3 things expected return depends on

1. pure time value of money (measured by the risk free rate; sole reward for waiting for your money w/o risk) 2. the reward for bearing systematic risk (measured by market risk premium; what market offers for bearing average amount of systematic risk) 3. the amount of systematic risk (measured by beta, the amount of systematic risk present in an asset or portfolio)

conclusions about financial leverage

1. the effect of financial leverage depends on company's EBIT; when EBIT is high, leverage is beneficial 2. leverage increases returns to shareholders (under scenario in textbook) shown by ROE and EPS 3. shareholders exposed to more risk under more leverage since there is more variability in ROE and EPS

Covariance

A measure of linear association between two variables. Positive values indicate a positive relationship; negative values indicate a negative relationship -measures relationship between two asset prices -helps investors to select stocks that complement each other in terms of price movement -helps reduce portfolio risk and increase potential return

Correlation

A measure of the extent to which two factors vary together, and thus of how well either factor predicts the other. -simply puts relationship of covariance in terms of a coefficient

Systematic Risk

A risk that influences a large number of assets. Also, market risk. - non-diversifiable risk -economic risk (GDP, inflation, interest rates, etc)

optimal capital structure summary

Case 1: no tax, no bankruptcy; top part shows that the value of the firm is no affected bu debt policy, so VL is constant. bottom part shows the same thing with WACC... overall cost of capital is not affected by debt policy and WACC is constant Case 2: taxes are introduced and can see in top part that firm's policy very much depends on debt policy... the more it is worth due to the present value of the interest tax shield. bottom part shows the WACC decline with more debt financing. increase in cost of equity offset by debt financing (optimal capital structure is almost 100% debt) Case 3: bankruptcy. value of firm not as much as thought because firm's value is reduced by PV of potential bankruptcy costs. these costs grow and eventually outweigh the tax advantage of debt financing. optimal a D* where tax savings = bankruptcy costs. bottom part shows that at D*/E*, the lowest possible WACC occurs

Volatility and Variance

Variance is a measure of the dispersion and is not bound by any time period. On the other hand, volatility captures the degree of variation of a time series over time. -In finance, volatility is a measure of the standard deviation over a certain time horizon (typically annual). -variance and standard deviation measure the volatility of returns

unsystematic risk

a risk that affects at most a small number of assets. Also, unique or asset-specific risk -labor strikes, past shortages, etc

total return

since total return = expected return + unexpected return AND unexpected return = systematic + unsystematic THEN total return = expected return + systematic risk (m) + unsystematic risk (e)

capital structure managerial recommendations: taxes

taxes: the tax benefit is only important if the firm has a large tax liability.. if benefits from elsewhere, such as depreciation, less incentive to borrow -therefore, the larger the tax liability, the more incentive to borrow -higher effective rate = greater incentive to borrow

bankruptcy costs

the costs a firm incurs when it files for protection from its creditors -Costs of financial distress (significant problems in meeting debt obligations, doesn't automatically mean file for bankruptcy) -bankrupt when value of assets = value of debt -the costs from bankruptcy may eventually offset tax gains from leverage -as D/E ratio rises, so does probability that firm can't pay off debts -increase in probability of bankruptcy = increase in expected bankruptcy costs -at some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost -here, the value of the firm will start to decrease, and the WACC will start to increase as more debt is added.

direct bankruptcy costs

the costs that are directly associated with bankruptcy -fraction of the firm's assets "disappear" in the process of going bankrupt -legal and administrative expenses -cause bondholders to incur losses -disincentive to debt financing

Equity Risk Premium

the difference between returns of the riskier stock investments and the less risky investments in government securities -calculated by subtracting risk-free rate from equity market return -shows extra return demanded by participants for increased risk - Rf + β×[E(RM)-RF)]

Bankruptcy Process

types of financial distress are business failure, legal bankruptcy, technical insolvency, and accounting insolvency 1. business failure: business has terminated with a loss to creditors 2. Legal bankruptcy: petition federal court for bankruptcy 3. technical insolvency: firm is unable to meet debt obligations 4. accounting insolvency: book value of equity is negative

flotation costs

-the total costs of issuing and selling a security -required return depends on risk, not how the money is raised, however, still don't want to ignore the costs of issuing new securities altogether


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