GBUS 400 Final Exam
The Hamada Equation
- Because the increased use of debt causes both the costs of debt and equity to increase, we need to estimate the new cost of equity. - The Hamada equation attempts to quantify the increased cost of equity due to financial leverage. - Uses the firm's unleveraged beta, which represents the firm's business risk as if it had no debt.
Financial leverage/risk
- Financial leverage is the use of debt and preferred stock. - Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage. - Financial risk depends only on the types of securities issued. - More debt = more financial risk. - Concentrates business risk on stockholders. - As the debt the company has increases, the firm's bond rating decreases b/c of increased financial risk and the cost of debt increases
Payback Period
- How long it takes to recover project's costs - adds projects cash inflow to its cost until cumulative cash flow turns positive. - just simple math, but weakness is that it doesn't take the PV of the cash flows. - so, can use the discounted payback period, which uses the discounted cash flows rather than the raw CFs Strengths and weaknesses: strengths: - provides indication of project risk/liquidity - easy to calculate and understand Weakness: - ignores PV/time value of money (not in discounted model tho) - ignores CFs occurring after the payback period - no relationship b/w given payback and investor wealth maximization - so essentially just wouldn't use this as the sole deciding factor
Preferred Stock
- Hybrid security. - Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. - However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.Therefore, it is more risky than common stock - Sells for a yield as a bond does - Most buyers are corporations due to tax break - No participation in the upside potential
Risk associated with investing overseas
- exchange rate risk = if an investment is denominated in a currency other than USD, the investment's value will depend on what happens to exchange rates - country risk - arises from investing / doing business in a different country, contingent upon country's economic, political and social environment. (ex/im bank assesses this)
Types of mergers
- horizontal (banks and airlines) - vertical (comcast - NBC) - congeneric (Intel - McAfee - same industry, different products) - conglomerate - buy company but then essentailly let them operate independently Other items: - hostile vs. friendly - leveraged/management buyouts - but shareholders have to agree on both sides
Loan Amortization
- how to pay off loan with fixed amounts over time - amortization tables are widely used for home mortgages, auto loans, business loans, retirement plans, etc. step 1: find required annual payment. the FV will be 0 BECAUSE THE GOAL IS TO DEPLETE THE LOAN. step 2: find interest paid in year 1 based upon the interest rate - the borrower owes money based upon the initial balance at end of Y1 step 3: principle = total amount paid - interest paid step 4: find end balance = beginning balance - principle can present this in a table until you get an end balance of 0. the interest paid declines with each payment.
Expected return in the market
- made up of dividends and capital appreciation (stock value)
Beta
- measures a stock's market risk, and shows a stock's volatility RELATIVE TO THE MARKET - indicates how risky a stock is ASSUMING THE STOCK IS HELD IN A WELL-DIVERSIFIED PORTFOLIO - market has a beta of 1, so if a stock has 1.5 as beta, then the return is usually 50% higher than the market - beta of 0 or close to 0 = risk has zero correlation relative to the market
Types of bonds
- mortgage bonds - debentures - subordinated debentures - investment-grade bonds - junk bonds - state/local/gov issued + general obligation + revenue - international bonds (as in foreign currency - non-home country currency) e.g. a euro bond - issued in a currency other than the currency of the country, so like a $ bond sold in france - foreign bond: foreign company selling a bond in another country in the same currency, e.g. a US company selling a euro denominated bond in germany - callable bonds - require a higher yield for investors b/c they hurt the investor intrinsically if can be pulled back before all interest is earned - when u buy and sell bonds, you do it with accrued interest
Ordinary Annuity versus Annuity Due
- ordinary annuity = payments made at end of the period, but annuity due = payments made at beginning
Diversifiable risk
- portion of a security's stand-alone risk that can be eliminated through proper diversification e.g. company-specific: ceo goes to jail, etc.
Corporate Valuation Model (Free cash flow method)
- suggests entire value of a firm is equal to the present value of the firm's free cash flows, which are the operating income less the net capital investment FCF = [EBIT(1-T) + dep and amortization] - [capital expenditures + difference in NOWC] - usually preferred to the counted dividend model since not all firms pay dividends and the ones who do are hard to forecast. - similar to discounted dividend model in that it assumes some free cash flow iwill grow at a constant rate - horizon value (HVn) represents value of firm at the point that growth becomes constant
Rationale for mergers
- synergy - operating economics, financial economics, market power, better management - tax considerations - purchase assets below cost (oil, technology) - diversification but, US gov has to approve to make sure it doesn't skew competition too much - e.g. office max and office depot can't merge
Capital Asset Pricing Model (CAPM)
- model linking risk and required returns. CAPM suggests that there is a security market line (SML) that states that a stock's required return equals the risk-free return plus a risk premium that reflects the stock's risk after diversification. - primary conclusion: the relevant riskiness of a stock is its contribution to the riskiness of a well-diversified portfolio. required rate of return = risk free rate + (market risk - risk free rate)(beta of investment) **market premium is market risk - risk free rate if required > expected then sell or do not buy if required < expected then buy or do not sell if required = expected then stock is in eqbm - the CAPM has not been completely verified b/c statistical tests have problems that make verification almost impossible - some argue that there are additional risk factors, other than market premium, that must be considered - beta is internally flawed b/c built on past returns and may not be same as future risk and returns.
Portfolios
- more than one stock or bond - needed to decrease risk - weighted average of all investments in portfolio is portfolio's return - market risk is more important as portfolio becomes more diversified
Four factors affecting level of IR
- production opps - time preferences for consumption - risk - expected inflation
T-bills
- return what is promised reurn regardless of economy - not completely risk-free because still exposed to inflation, although it's unlikely that unexpected inflation would cause too much harm in a short amount of time - risky in terms of re-investment risk
Investment Bankers
- serve as brokers for buyers and sellers - establish fair value - arrange financing - defensive tactics - poison pill - change by laws - white knight to compete
Cash flow considerations
- shipping/handling/installation costs add to fixed asset costs - don't consider sunk costs - opportunity costs can offset additional cash flows - externalities - maybe cannibalization (reduction in market position of company's other products) - expansion projects should include all cash flows - replacement projects should include only additional cash flows
Interest Risk
- short term - reinvestment risk - long-term - maturity risk
3 types of project risk
- stand alone risk project's total risk, if operated independently - usually measured by standard deviation / coefficient of variation - ignores firms diversification among projects and investors diversification among firms - corporate risk - project's risk when considering other projects in the firm - function of projects NPV and standard deviation and its correlation w returns on other firm projects - market risk - project's risk to a well-diversified investor - usually measured by proejct's beta and considers both stockholder and corporate diversification - for capital projects, market risk is most relevant b/c management's primary goal is shareholder wealth maximization - but, since corporate risk also affects creditors, customers, suppliers and employees, it shouldn't be completely ignored.
Effective Rates of Return
- the actual rate of interest each year, considering compounding - must consider to compare investments effectively. - truth in savings = effective annual rate (EAR) - truth in lending = periods x i(APR)
Pure expectations theory
- the shape of the yield curve depends on investors' expectations about future interest rates - which is based on expected inflation
Solving for the PV
- this is called discounting (the reverse of compounding) - shows the value of cash flows in terms of today's purchasing power PV = FV based on years / (1+i)^N Table can give you the factor for this
Calculating Betas
- typical approach is to run a regression of the security's past returns against the past returns of the market - the slope of the regression line is defined as the beta coefficient for the security
Valuing a Company - 3 Methods
1. Market Multiples - compare to other publicly traded companies, recent acquisitions, etc. Essentially, just looking at what's been paid in the transactions for similar businesses. similar in terms of net income, revenue, ebitda, book value, etc. 2. discounted cash flow 3. liquidation value - if sold, what would it be worth
Leasing
3 types: - sale and leaseback - owner is lessor - renter is lessee - payments return full price and rate of return - provides cash to lessee - operating lease - provides financing and maintenance - doesn't cover full cost of item - life is < life of item - can be cancelled - computers, cars, copiers, etc. - usually around a 2 yr lease term - financial or capital lease - fully amortizes the cost - term is equivalent to life - no maintenance included - cannot be cancelled - frequently sold by manufacturer to user as a way to finance sale when buyer cannot get credit, provides expertise - must go on balance sheet -- look same as buying - ex/im and aircraft
Bond
A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond. - becomes short term in its last year Demand-issuers: - mortgages - corporations - governments: state, local and treasuries, - universities, water and sewer utilities supply - buyers - people saving and investing - life insurance companies - other insurance companies - corporate pensions and state/local government retirement plans - mutual funds and other investors bond markets - usually traded over the counter and among large financial institutions, so WSJ reports on key developments in bond markets
Constant Growth Formula - Gordon Model (CAPM / DCF)
A stock whose dividends are expected to grow forever at a constant rate, g Dt = D0(1 + g)^t - If g > rs, the constant growth formula leads to a negative stock price, which does not make sense. - The constant growth model can only be used if: - r > g. - g is expected to be constant forever.
Length of time of investment options
Bills = short term Notes = 5 years Bonds = long term
Firm specific risk vs. total risk
Business Risk + Financial Risk = Firm Specific Risk Firm Specific Risk + Market Risk = Total Risk
Business Risk
Business risk depends on business factors such as competition, product obsolescence, and operating leverage. Sources: - Competition -Uncertainty about demand (sales) -Uncertainty about output prices -Uncertainty about costs -Product obsolescence -Foreign risk exposure -Regulatory risk and legal exposure -Operating leverage (use of fixed costs rather than variable costs) so, if the fixed costs are high and can't be reduced if demand declines, then the firm has high operating leverage - calculate by looking at break even - higher break even = more risk
3 Ways To Determine the Cost of Common Equity
CAPM: rs = rRF + (rM - rRF)b DCF: rs = (D1/P0) + g Bond-Yield-Plus-Risk-Premium: rs = rd + RP **examples in chapter 10 lecture
Solving for FV
Compounding the interest rate over N number of years, or can get the factor from the table and multiply by number
Current Yield
Current Yield (CY) = Annual coupon payment / current price this is what the bond pays the investor
Capital that firms use
Debt - Notes Payable + long term debt Preferred Stock Common equity - retained earnings + new common stock
Will FV be larger or smaller if compounded more often?
Larger, because of more frequent compounding
Failure to diversify - should there be compensation for extra risk?
No - stand-alone risk is not important to well-diversified investors and there can be only one price for a given security.
Priority claims in liquidation
1. secured creditors from sales of secured assets 2. trustee's costs 3. wages, subject to limits 4. taxes 5. unfunded pension liabilities 6. unsecured creditors 7. preferred stock 8. common stock
Discount Rates *****
Bonds: required rate of return = risk free rate + premiums Stock: required rate of return = CAPM Projects: weighted average cost of capital adjusted for risk
Capital Gains/Loss Yield
CGY = Change in price / beginning price
Weighted Average Cost of Capital
WACC = wdrd(1 - T) + wprp + wcrs - represents the risk undertaken on an average project by the firm. used for typical project. must adjust risk value for different projects, and not just use composite WACC. - d is for debt values, p is for preferred stock and - calculation ignores flotation costs - rd is the marginal cost of debt capital. - The yield to maturity on outstanding L-T debt is often used as a measure of rd. - 1-T is b/c of adjusting rd to be post-tax value - rp = Dp / Pp - rs is marginal cost of common equity
Basis points
bp - 100 bp = 1%, essentially a penny - increase in IR from 5 to 5.7% is 70 bp increase from 6 to 7 is 100 bp, or 1 point
What is the opportunity cost of debt capital?
discount rate (r) is the opp cost of capital, and is the rate that could be earned on alternative investments of equal risk discount rate = r* + IP + MRP + DRP + LP MRP - maturity risk premium/duration DRP - default risk LP - liquidity premium
Normal vs. nonnormal CFs
normal - one change of sign: negative to start, then just positive nonnormal - two or more changes of signs - negative CF then positive, then negative to close project
Nominal vs. real intest rates
r = reps any nominal rate r* = represents real risk free rate of interest rRF = representst eh rate of interest on US treasury securities
Yield to Maturity
rate of return earned on a bond until maturity
Determinants of interest rates
required rate of return = real risk free rate of interest + inflation premium + default risk premium + liquidity premium + maturity risk premium - these are used to construct the yield curve macroeconomic factors - federal reserve policy - federal budget deficits/surpluses - international factors - level of business activity
Capital Budgeting
- analysis of potential additions to fixed assets - long term decisions for firm's future types of projects: - replacement (i.e. machines, etc.) - replacement- cost reduction - expansion of existing products or markets - expansion into new products or markets - safety and environmental - buildings, corporate jets - mergers steps required: 1. estimate cash flows 2. assess riskiness of cash flows 3. determine the appropriate cost of capital 4. find npv/irr 5. accept if npv > 0 or IRR > WACC independent projects - cash flows of one are unaffected by the acceptance of the other - i.e. differentiating products mutually exclusive projects - cash flows of one are adversely affected by another (i.e. building a bridge to an island vs. a ferry boat)
Firm multiples method
- analysts often use the following multiples to value stocks: - P/E - P/CF - P/Sales
Other types of bonds
- convertible bond - may be exchanged for common stock of the firm, at the holder's option - serial bond - bonds called in over time - warrant - long-term option to buy a stated number of shares of common stock at a specified price - putable bond - allows holder to sell the bond back to the company prior to maturity - income bond - pays interest only when interest is earned by the firm - indexed bond - interest rate paid is based upon the rate of inflation
Corporate vs. treasury yield curves
- corporate yields usually higher than treasury - spread widens as corporate bond rating decreases - since corporate yields include a default risk premium (DRP) and liquidity premium (LP) the corporate bond yield spread can be calculataed as subtracting DRP - LP - the difference here is really the default risk, because maturity and inflation are built in
Establishing Eqbm
- expected r > required r, more buyers than sellers, then price increases, r decreases & vv - prices adjust to establish eqbm where required = expected
Factors affecting default risk and bond ratings
- financial performance i.e. debt ratio, TIE ratio, current ratio - qualitative factors: bond contract terms, i.e. secured vs. unsecured debt, senior vs. subordinated debt, guarantee and sinking fund provisions, debt maturity - miscellaneous qualitative factors: earnings stability, regulatory environment, potential antitrust or product liabilities, pension liabilities, potential labor problems.
Chapter 11 Bankruptcy
- if a company can't meet its obligations then it files under chapter 11 to stop creditors from foreclosing, taking assets and closing the business and has 120 days to file a reorganization plan - management usually stays in control - company must demonstrate that with the reorganization plan makes company worth more alive than dead, otherwise judge will order chapter 7 liquidation **generally, unsecured creditors prefer reorganization b/c they wouldn't receive anything in liquidation - and a little bit is better than nothing - various groups of creditors vote on the reorganization plan, and if they agree with the judge, then the company 'emerges' from bankruptcy with lower debts, reduced interest charges and a chance for success
When does effective rate = nominal rate
- if annual compoudning is used, M=1 - if M>1, then EAR will always be greater than the nominal rate
Risk premium
the difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold riskier securities
Stand-alone risk
Market risk + diversifiable risk
Why is the cost of retained earnings cheaper than the cost of issuing new common stock?
- When a company issues new common stock they also have to pay flotation costs to the underwriter. - Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price.
Why is there a cost for retained earnings?
- Earnings can be reinvested or paid out as dividends. - Investors could buy other securities, earn a return. - If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk). - Investors could buy similar stocks and earn rs. - Firm could repurchase its own stock and earn rs.
Flotation Costs
- Flotation costs depend on the firm's risk and the type of capital raised. - Flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. - We will frequently ignore flotation costs when calculating the WACC. - But you could also include them in the DCF to account for it - usually increases it - they must earn more in order to give the customer the same return.
Bonds and Interest Rates**
- INVERSE RELATIONSHIP - when IR goes up, bond price goes down - when IR goes down, bond prices go up
Internal Rate of Return
- IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0: 0 = sum of CFt / (1+IRR)^t Rationale: - If IRR > WACC, the proejcts return > costs, so you accept the project - if they're independent, can accept more than one project if they're larger than the WACC - management decides acceptable IRR
Default Risk
- If an issuer defaults, investors receive less than the promised return. so, the expected return on corporate and municipal bonds is less than the promised return - influenced by the issuers financial strength and terms of the bond contract - moody's, s&p and fitch ratings assess this - bond ratings get graded at AAA, aa, a, etc. - bond ratings are meant to reflect the probability of a bond issue going into default
NPV vs. IRR
- NPV assumes cash flows are reinvested at the WACC, which is better, IRR assumes its own rate - this is especially useful when choosing between mutually exclusive projects - hybrid of IRR that assumes cost of capital reinvested would be useful, because the percentage it yields is preferrable to the dollar format of the NPV - IRR Is the same thing as a YTM - Managers prefer IRR to the NPV when they use the MIRR, which 1. assumes cash inflows are reinvested at the WACC - causes PV of the project's terminal value to equal PV of its costs 2. MIRR avoids multiple IRRs problem, and gives a % answer.
Capital Budgeting - 2 methods used by companies to evaluate projects
- Net Present Value (NPV) - Internal Rate of Return (IRR)
Intrinsic Value and Stock Price
- Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stock's intrinsic value (P0). - In equilibrium we assume that a stock's price equals its intrinsic value. - Outsiders estimate intrinsic value (based on true cash flows and true risk) to help determine which stocks are attractive to buy and/or sell. - Stocks with a price below its intrinsic value are undervalued & vv Approaches: - Discounted dividend model - corporate valuation model - P/E multiple approach Value of a stock = present value of the future dividends expected to be generated by a stock
Key features of a bond
- Par value: face amount of the bond, which is paid at maturity (e.g. 1k) - coupon interest rate: stated interest rate (generally fixed) paid by the issuer. multiply by par value to get dollar payment of interest. - maturity date: years until the bond must be repaid - issue date: when bond was issued - yield to maturity: rate of return earned on a bond held until maturity (also called the "promised yield") - at maturity, value of a bond must equal its par value - if rd (discount rate) remains constant, then the value of a premium bond would decrease over time until it reached 1k - the value of the discount bond would increase over time, until it reached 1k - value of a par bond stayed at 1k
Market risk
- Portion of a security's stand-alone risk that can't be eliminated through diversification. - measured by beta (systematic risk) - affected by political climate, wars, etc.
A Sinking Fund
- Provision to pay off a loan over its life rather than all at maturity - similar to amortization of a term loan - more credit worthy - reduces risk to investor and shortens average maturity - but not good for investors if rates decline after issuance
Common Stock
- Represents ownership - Ownership implies control - Stockholders elect directors - Directors elect management - Management's goal: Maximize the stock price
Periodic Rate (Iper)
Amount of interest charged each period, i.e. monthly or quarterly Iper = Inom/M, where M is the number of compounding periods per year. M = 4 for quarterly and 12 for monthly.
Perpetuity
Annuity that goes on indefinitely
Risk aversion
Assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities
Stock ownership risk and reward***
Risks 1. Business risk 2. Financial risk 3. Market risk Rewards 1. Dividends 2. Capital appreciation
Expected total return
Expected total return = YTM = Expected CY + CGY
Factors that influence WACC
Factors the firm cannot control: - Market conditions such as interest rates and tax rates. Factors the firm can control: - Firm's capital structure. - Firm's dividend policy. The firm's investment policy. Firms with riskier projects generally have a higher WACC.
Nominal Interest Rate (Inom)
Quoted or stated rate - annual rate which ignores compounding effects. It's stated in contracts for quarterly/daily interest
NPV
Sum of all the pvs of all cash inflows and outflows of a project NPV = sum of CFt / (1+r)^t **will need to calc this on final and payback period Rationale - if projects are independent, accept if NPV > 0 - if projects are mutually exclusive, then accept the one with higher NPV - shows net gain in wealth
Solving for i or N
Use the table to determine the info that would've given you the appropriate factor for the FV/PV values given over number of years. - do same thing with N, look for it based upon information given.
How do you assess the value of a financial asset?
The value of a financial asset is equal to the present value of its future cash flows. So, Value = CF/(1+r)^1 + CF/(1+r)^2+....CF/(1+r)^n last one is 1,000 or the actual amount due, so value of bond
Optimal Capital Structure
Use methods to either: 1. minimize WACC 2. maximize stock price - The capital structure (mix of debt, preferred, and common equity) at which P0 is maximized. - Trades off higher E(ROE) and EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debt's risk-related costs. - The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital. Signaling effects in capital structure: Assumptions: - Managers have better information about a firm's long-run value than outside investors. - Managers act in the best interests of current stockholders. What can managers be expected to do? - Issue stock if they think stock is overvalued. - Issue debt if they think stock is undervalued. As a result, investors view a stock offering negatively; managers think stock is overvalued; will keep unused debt capacity to avoid a stock sale - Need to make calculations as we did (hamada eqtn), but should also recognize inputs are "guesstimates." - As a result of imprecise numbers, capital structure decisions have a large judgmental content. - We end up with capital structures varying widely among firms, even similar ones in same industry.
