Test #2

WACC Method

- CFs = FCF - Discount Rate = WACC - Value = VL - D and E are market values

FTE (flow to equity) method

- CFs = FCFE - Discount Rate = RE - Value = E

APV method

- Discount rate = R0 - CF = FCF - Value of firm = PV (all equity firm) + PV (Tax Shield) - Value = VU

Bonds

- Fixed-income products issued by governments for corporations to raise funds. - Issuer pays back the face value, interest, and coupons

Loans

- Lump-sum amounts extended by financial institutions or companies for a set amount. - The borrower agrees to repay the full amount + fixed interest

Modigliani and Miller Proposition 1

- Perfect world - no taxes - VL = VU - the value of a levered firm is equal to the value of an unlevered firm

WACC No taxes

- RE * (E/V) + RD* (D/V) - WACC does not change with debt - as you add debt the cost of equity increases

Junior Debt

- Ranks after other debt during liquidation or bankruptcy. - can provide higher returns - more risky, higher interest rates

Tradeoff Theory of Debt

- VL = Vu + PV(Tax Shield) - PV (Distress Costs) - increased cost of financial distress reflected in R0 and rating - firms face trade off between too little debt and too much

Callable Debt

- borrower gets a call option - the option allows the borrower to buy back the bond from the bond holder - interest rate increase, bond price decrease

Buyer vs Seller

- buyer always has the option to exercise - seller simply do as they are told - buyers gain is the sellers loss - buyers loss is the sellers gains

Agency Costs

- conflict between shareholders and debtholders - risk of shifting incentives - incentive to underinvest -incentive to decrease asset value

MM Proposition #2 takeaways

- cost of equity increases with leverage - but, increases less than in a world without taxes

Financial Distress Indirect Costs

- customers anticipation of disruption or denial after sale - competitive disadvantages - quality decrease - suppliers stops supplying - reputation damages

Do shareholders want debt?

- debt can lead to a higher ROE - Shareholders want a higher ROE - they can take the money that they would have used to buy stock, and invest in another company

Secured Debt

- debt guaranteed by collateral - low risk - low interest rates

Terminal Value

- growing perpetuity - often accounts for most of firm value - TV = (CF * (1+g)) / r -g

Call Option dividends

- if the stock pays dividends, you can exercise early - if the stock does not pay dividends, you will never exercise early

MM Proposition #1: Takeaways

- in a world with taxes, the value of a levered firm is higher than an unlevered firm

Modigliani and Miller with taxes

- interest on debt is tax deductible - cash flows from the IRS are safe cash flows, so the firm is safer

Financial Distress Direct Costs

- legal and admin - 3% of firm value - bankruptcy costs - reorganization costs

Unsecured Debt

- no collateral is needed to secure the loan - borrowers are approved for the loan based on creditworthiness - Interest rates higher, bc no collateral

Senior Debt

- prioritized for repayment in the case of bankruptcy - Highest Priority - Lower risk, lower interest rate

Put Option vs. Selling Short

- put option worst outcome is 0 - Short Sell worst outcome is losing money - Short sell has no premium

ROE and Taxes

- the ROE of a levered firm is higher than that of an unlevered firm - The financial risk is higher for a levered firm - BUT, tax shield makes equity safer

Modigliani and Miller Proposition 2

- the risk of equity increases with debt - shareholders expected return is proportional to the risk of equity - a levered firms cost of equity will be higher than that of an unlevered firm - but the cost of equity is offset by the tax shield, so the WACC decreases when the firm takes on more debt

Time Horizion

- the time horizon can be cast into two broad period: 1) Explicit Forecast Period (exceptional growth) 2) Terminal Value (Remaining Stable Life)

Problems of DCF

- time horizon - what CFs to use - Appropriate discount rate

Explicit Forecast Period

- time until the firm reaches a steady state - better longer than shorter

Writing a Put Option

-bullish - think stock price will rise

Debt

-lenders = debtholders -something, typically money, that is owed or due

levered firm

A company that uses both debt and equity in its capital structure.

unlevered firm

A company that uses only equity in its capital structure.

Payoff Equation Risk

E(X) = (outcome 1 * probability) + (outcome 2 * probability)

American Option

Exercisable at any time; Will never have a smaller premium than a European option; More flexible

Zero Seller Liability

If S < K, at maturity, the buyer will not exercise the call and sellers liability will be zero

Risk Shifting Shareholders Perspective

If the expectancy value is the same, take the one with higher payoff. If the worse option in both scenarios is zero, then take the one with higher payoff because the worst that can happen is you get nothing

Increase Time

Increase Call Option Value, Increase Put Option Value

Increase Volatility

Increase Call Option Value, Increase Put option value.

Increase in Stock Price

Increases Call Option Value, Decrease Put Option Value

Interest Tax Shield

Interest * Tax Rate

Strike Price

K , pre-specified price

No Arbitrage Initial Investment Payoff

K will be the same in the upstate and downstate = call-put parity.

Call Option Payoff

Max{0, S-K}

Out of the money

Negative Payoff

Does leverage increase WACC?

No, WACC levered < WACC unlevered - cost of debt is usually cheaper than cost of equity

Firm Value DCF

PV(CF explicit value) + PV ( CF continuation period)

P

Put option price

After Tax Cost of Debt

Rd x (1-Tc)

Put Option Goal

S < K

Call Option Goal

S > K

Put Call Parity Equation

S+P-C = K / (1+r)^t

Profit Equation

S-K-C

Equity Securities

Securities issued by corporations as a form of ownership in the business.

No-arbitrage condition

Securities that offer an identical stream of cash flows will be priced the same in the financial markets. Any risk-less strategy= earn only the risk free rate.

Short Sell

Shorting, or short-selling, is when an investor borrows shares and immediately sells them, hoping he or she can scoop them up later at a lower price, return them to the lender and pocket the difference. But shorting is much riskier than buying stocks, or what's known as taking a long position

Debt Holders and Tax

Single taxation

Writing a Call transactions

Stage 1: - Buyer Gives call option price, C, to writer - Writer gives an option Stage 2: Only if K>S - Buyer gives strike price, K, to writer - Writer gives buyer shares (zero upside, zero sum game)

Risk Shifting Debt holders Perspective

Take the option that has a higher chance of paying off debt. Dont take the option where the probability of getting paid back is 0.

Option Writer

The party who sells the option to the buyer and has the obligation to go through with the option contract if called on by the buyer.

Milking the Property

This involves paying out extra dividends when the firm will likely go bankrupt. This leaves less for the bond holders.

Value of a Levered Firm

VL = VU + (D*TC)

WACC

Weighted average cost of capital. The average cost of financing a firm in percentage terms.

Covered Call

When the writer of a call also owns the stock he is obligated to sell; Used to increase income in a time when you do not expect the stock price to increase; Can be written out of the money to add insurance that the stock won't get called away; Trading away chance of stock appreciating in future for income now

Buying a put option

Writer has limited downside. do this if u think asset is going down in price. Believes price will drop below the exercise price before expiration.

At the money

Zero Payoff

Sunk Cost

a cost that has already been committed and cannot be recovered

Naked Call

a short call position not backed up by ownership of the shares the writer is obligated to deliver upon exercise. Can lose a lot of money. If S>K, buyer will definetly buy.

No Dividend Payment

does not force default

Dual class

firms have two classes of common shares outstanding, with different voting rights assigned to each class

Firm Distress

happens if the firm cant pay debts

Seller Gives Up Shares

if S > K, the buyer will exercise

After tax interest expense

interest expense x (1 - tax rate)

Writing a Call

is a bearish strategy, unlimited downside potential

Put option payoff

max{0, K-S}

open interest

number of contracts outstanding

In the money

positive payoff

ask price

price at which dealer will sell security, always buy at ask price

What do financial distress costs affect?

shareholder value

S

stock price

K

strike price

Dividend and tax

subject to double taxation

Loan Covenants

terms of a loan agreement that if broken, entitle the lender to renegotiate loan terms or force repayment - fixed percent dividend - no dividends cant trigger default

call option

the option to buy shares of stock at a specified time in the future

put option

the option to sell shares of stock at a specified time in the future

bid price

the price a dealer is willing to pay for a security, always sell at bid price

Arbitrage

the purchase of securities in one market for immediate resale in another to profit from a price discrepancy

t

time to maturity

preferred stock

A special type of stock whose owners, though not generally having a say in running the company, have a claim to profits before other stockholders do.

Put Call Parity

An equation expressing the equivalence (parity) of a portfolio of a call and a bond with a portfolio of a put and the underlying, which leads to the relationship between put and call prices.

Put Options and Portfolio Insurance

Buy stock and buy put option with a strike price. Irrespective of the current stock price, this portfolio is at least worth the strike price. Payoff stays at strike price, untile S> K. Unlimited upside

Strike Price (K) Increase

Call Price (C) decrease, Put Price (P) increase

Stock Price (S) Increase effects

Call Price (C) increase, Put Price (P) decrease

Time (T) Increase effects

Call Price (C) increase, Put Price (P) increase

C

Call option price or premium

DCF (discounted cash flow)

Compares the value of the future cash flows of the project to today's dollars.

PV (Tax Savings)

Debt * Tax Rate

Increase in Strike Price

Decrease Call Option Value, Increase Put Option Value

European option

can be exercised only at expiration

FCF

cash flows to all capital providers