Conceptual Questions Finance 3320 Final
1. Define the three types of market efficiency. Also describe a trading strategy that yields abnormal returns for each type of market efficiency. Explain your reasoning.
There are three forms of market efficiency. Weak form efficiency is when all information about past stock prices is reflected in the current stock price. To earn abnormal returns in weak form efficient markets, one just needs to trade on other public information or private information, as this information would not be incorporated into the stock price. Semi-strong form efficiency is when all public information is reflected in the current stock price. This includes past stock prices and any publicly available information (such as financial statements, analyst reports, etc). To earn abnormal returns in semi-strong form efficient markets, one needs to trade private information, as this information would not be incorporated into the stock price. Strong form efficiency is when all information (both public and private) is reflected in the current stock price. To earn abnormal returns in strong form efficient markets... well, one cannot consistently earn abnormal returns in this case without luck, as there is no information that you can obtain that hasn't already be incorporated into the stock price.
a. Your high school buddy: "I think that I can look at the patterns of historical stock prices to determine where prices are going in the future. Since I know where prices are going in the future, I can earn higher returns than the market."
This person believes that markets are inefficient. Weak form efficiency states that current prices incorporate all information about past prices, but your buddy thinks that abnormal returns can be made just by analyzing past prices. Thus, this person does not believe that markets are efficient.
1. What are the three reasons why interest rates can vary depending on the maturity of the cash flows?
Three reasons: - Expectations of future interest rates: investors base long-term rates on their expectations of future rates relative to today's rates. - Term premium: investors require extra return to compensate them for the increased interest rate risk of longer-term investments. - Liquidity premium: investors need extra return to compensate them for decreased liquidity of longer-term investments.
In order to be certain that IRR will agree with NPV, what 2 conditions must hold? (3 pts)
To be certain that IRR will agree with NPV, the following two conditions must hold: - The CFs start negative and then switch to positive for the rest of the investment (only 1 sign change in the CF stream) - The investments are not mutually exclusive (or the decision for one investment does not affect the decision for another investment)
Explain how Microsoft's beta is measured. Be as specific as possible.
To calculate Microsoft's beta, we need to measure the past stock returns of Microsoft. Then we determine the relationship between the returns of Microsoft and the market portfolio (to get the systematic risk). For this, we do a regression analysis. We need to pick what will represent the market portfolio (usually, the S&P 500). The slope of the regression is the beta.
Total risk can be divided into two components. List and define each component. Which type of risk is compensated by the market, and why?
Total risk can be divided into systematic and non-systematic risk. Systematic risk is the risk that cannot be diversified away; it is risk one must bear if one wants to own assets. Non-systematic risk is the risk that can be diversified away. This is the risk that affects only a subset of all assets, and therefore can be eliminated by holding other assets. Because you can eliminate non-systematic risk on your own, the market does not compensate you for holding non-systematic risk. Only systematic risk is compensated by the market. Expected returns depend on the level of systematic risk of the investment.
1. Explain why traditional NPV analysis can potentially result in an under-representation of the value of an investment. You should also explain how the inclusion of real options fixes this situation.
Traditional NPV analysis assumes that, once an investment has been made, managers are passive and no changes are made to the investment over time. However, managers should and do make changes to an investment when such actions would improve the value of the investment. If we do not account for these potential improvements, our value for the investment (or NPV) will be understated relative to its true value. Real options are the identified opportunities for managers to make improvements to an investment in the future (some of these improvements include price changes, changes in production, and abandoning the investment). By including the value of these real options, we no longer assume that managers are passive once an investment has been made, and the NPV that we calculate reflects the true NPV of the investment.
1. True or false: if a real option has no cost, then it will ALWAYS increase the NPV of an investment. Explain your reasoning.
True! Real options are the ways that managers can make changes to investments AFTER they have been made. But managers will only step in and make changes to the investment if the changes will improve value. Thus, if there is no cost to having the real option, then real options will only lead to increases in the value of the investment... resulting in an increase in NPV.
1. Which combinations from above, if any, can you eliminate from consideration for your investment? Explain. (7 pts)
We can eliminate combinations (d) and (e) from consideration, as they have lower expected returns and higher risk than (c). We cannot eliminate any other combinations.
List and describe 4 roles of a financial manager at a firm
We discussed 5 roles: 1. Pick investments that the firm makes 2. Determine the mix of debt and equity at the firm 3. Decide how to return money to investors 4. Maintain short-term and long-term solvency 5. Caretaker of shareholder money (could be "maximize shareholder wealth")
In finance, we measure cash flows when determining the value of an investment. Interest expense is a cash flow, but we do not include it in our FCF analysis. Explain why interest expense is not included in our FCF analysis. Be complete in your answer.
We do not include interest expense because it is a financing CF, which means that it is a CF that goes to an investor. FCFs are the CFs available to pay all investors. So interest expense comes out of FCFs... thus, we do not include it in our calculations of FCF.
1. How do we adjust accounting data when performing financial analysis? Explain why. (3 pts)
We need to adjust accounting data by using market values instead of book values and free cash flows instead of earnings. We use market values because they represent the actual value of our assets to us (as opposed to historical values represented in book values). And we use free cash flows instead of earnings because investors care about cash flows, whereas earnings are not cash-based and can be manipulated.
For the typical firm, what should we use as the discount rate for the tax shields of debt, and why is this the correct discount rate? Be precise in your answer.
We should use the return on debt (rd) as the discount rate for the tax shields of a typical firm. The typical firm only receives the tax shield when they pay the interest expense... when they do not pay the interest expense, they do not receive the tax shield. So the CFs move together and thus have the same risk. And if they have the same risk, they should have the same rate of return.
a. Your stock broker: "I go through all of the financial statements, analyst reports and business news that pertain to public companies. Because of this, I can earn higher returns than the market."
Weak form efficiency: the broker believes that abnormal returns can be made by analyzing public information, so the broker does not believe that markets are semi-strong form efficient.
1. What assumption do we make when we use the time series approach to estimating expected returns for an investment? Be specific.
When using time-series statistics to estimate expected returns for an investment, we are using the average return over past periods to estimate future returns. In order to do this, we make the assumption that the distribution of past returns is essentially the same as the distribution of future returns. Note that we are NOT assuming the past returns will be the same as future returns... only that the distribution of returns will be the same.
1. When valuing companies using price multiples, why is it important that we use firms that are very similar to the one we are trying to value? Be specific in your answer. (10 pts)
When we use the price multiples method of equity valuation, we assume that the price multiple ratio for the comparable firm is EXACTLY the same as the price multiple for the firm we are trying to value. This is a big assumption, since most firms have unique price multiples. Thus, in order to justify this assumption, we must choose firms that are as similar to our firm of interest as possible.
Is it possible to combine two risky investments into a portfolio and have the resulting portfolio be risk-free? If so, explain how. If not, explain why not.
Yes, it is possible to combine two risky investments and have a portfolio that is risk-free. It requires two investments that are perfectly negatively correlated with each other. This means that the correlation between them is -1. When correlation is -1, the upward movements of one investment are completed offset by the downward movements of the other. The combination of these two investments results in no movement of the portfolio. The graph below shows this. As one goes up, the other falls... and the combined movement is zero.
1. Is it possible for one portfolio to have a beta of 1.25 and a standard deviation of 26% while another portfolio has a beta of 1.52 and a standard deviation of 21% (i.e.: can one portfolio have a higher standard deviation but lower beta than another portfolio)? Explain.
Yes, it is possible, but only when the portfolios are not well diversified. When a portfolio is well-diversified, then the unsystematic risk has been essentially eliminated... leaving only systematic risk. So the total risk of a well-diversified portfolio contains only systematic risk. In this case, the total risk should be proportional to the systematic risk, and the situation above should not be possible. But if at least one of the portfolios is not well-diversified, then the total risk of the portfolio should contain unsystematic risk. So while the portfolio might have low systematic risk, the unsystematic risk could cause the total risk of the portfolio to be large.
Give one example of each of the following for Oracle stock. (1 pt)
- systematic risk: Any event that would affect all stocks (such as interest rate shocks, recession, war, etc) - non-systematic risk: Any event that is specific to Oracle or its industry (building catches on fire, lawsuit filed against Oracle, growth of computer industry, etc)
List and describe the three methods to value the equity of a firm.
1) Dividends - dividends are the cash flows to shareholder. Therefore, the PV of these cash flows should be the price of the shares. 2) Residual CFs to equity - sometimes, a company doesn't pay a dividend. But the FCFs of the firm are the CFs available to pay all investors. Since it is relatively easy to forecast CFs to debt, and we can forecast the FCFs of the firm, we can solve for the PV of the CFs to shareholders: MV of equity = PV of FCFs - MV of debt 3) Price multiples - we can use similar firms to the firm of interest, and compute ratios that contain value and another measure that is correlated with value. We then apply this ratio to the firm we want to value.
If you are choosing between two investments that will be repeated indefinitely, but each investment has a different life span, describe the two methods to determine which investment is the better one.
1) Same common end-year: continue both investments until both investments end at the same end year, then compute and compare the values of the entire stream of cash flows for each investment. 2) Equivalent annual annuity (EAA): calculate the PV of each investment stream, then compute an equivalent annual annuity CF that has the same life span and same PV as the original investment stream. Then compare the two annual cash flows to determine which annual CF is better.
1. What is the difference between an index fund and an actively-managed mutual fund? Is there any reason to believe that one might be a better investment than the other? Explain, and be specific.
1. Casey, Chuck and Sarah are secret government spies on a stakeout. To pass the time, they talk about investing in stock markets. Sarah started to brag about how her stock investments have consistently beat the market, and how she is very skilled at picking winning stocks because she know what to look for in the financial statements of publicly-traded companies. Casey couldn't understand why Sarah went to all the trouble of reading the financial statements of firms, because he thought that picking winning stocks only required an analysis of past returns. Chuck, on the other hand, was skeptical of Sarah's skills at picking stocks. He said that, if she really had consistently beaten the market returns, she was either extremely lucky or she used insider information to make her high returns. Using the terminology that we used in class, state and explain how each person views the efficiency of financial markets. (6 pts each)
What is a Treasury strip, and how are they created?
A Treasury strip is a single CF to be received (or maturing) in the future. They are created by taking Treasury bonds (with a series of CFs in the future) and "stripping" the CFs from each bond, so that investors can buy a single Treasury CF instead of the entire series of CFs in a Treasury bond.
1. What is meant when a mutual fund has a "load" fee? Are there any advantages/disadvantages for investing in a mutual fund with a load fee (relative to a "no-load" mutual fund)? (10 pts)
A load fee is fee that is charged by a mutual fund in order to invest your money in that fund. The fee is a percentage of the funds invested in the fund. These fees can be charged at the beginning (front-end load; when you initially invest) or at the end (back-end load; when you withdraw your funds), but the effect of the fee is the same...you lose the percentage of the load fee from your investment money. The evidence is that mutual funds cannot consistently earn abnormal returns. The way to maximize your returns on your investments in mutual funds is to minimize the fees that you pay. Since the load-fee funds cannot do any better on average than no-load funds, there is no advantage to paying a load fee. However, it is a big disadvantage to pay the load fee, as it increases your fees. You're better off with a no-load mutual fund.
1. Explain the difference between a nominal rate of return and a real rate of return. (3 pts)
A nominal rate of return describes how much our investment actually earns (or how fast our money grows), while the real rate of return describes how fast our purchasing power is growing.
1. What is the difference between Rollover IRAs and traditional IRAs? Be specific. (16 pts)
A traditional IRA is an account in which individuals can contribute to a retirement fund that is tax-advantaged (money is not taxes upon entry and no taxes on returns while money remains in the fund). Whereas a rollover IRA is an account into which one can transfer 401-k or 403-b retirement account funds upon leaving a company. You can contribute up to $5,500 per year (at the moment) into a traditional IRA, whereas the maximum limit to contribute to a rollover IRA is the amount in your company's 401-k or 403-b fund.
How does capital structure affect the value of the firm in the real world, according to MM Theory?
According to MM Theory, capital structure has to affect the value of the firm through one of four channels: taxes, transaction or distress costs, investment policy, and imperfect information.
Explain and give an example of an "agency problem".
Agency problems are when manager and owner roles are separated, and thus managers might have incentives to make decisions that are not in the best interests of owners. Any type of decision that would benefit managers disproportionately would qualify has an agency problem (such as overinvesting in corporate jets, excessive spending on CEO offices, etc.)
1. What are agency problems, and what causes them? In your answer, give an example of an agency problem.
An agency problem is when the owner and manager roles of the firm are separated and managers have incentives to make decisions outside of the interests of the owners. They have incentives to make decisions in their own interests instead. An example of an agency problem would be an expensive remodeling of the CEO's office. This may add little to the value of the firm, but would be enjoyed by the CEO.
How is beta calculated? Be specific.
Beta is calculated by regression analysis using past returns of both the company's stock and the returns of the market portfolio. This regression analysis of the matched return data results in the characteristic line for the company, and the slope of this line is the beta.
Give three reasons (and explain each) why a cash flow occurring in the future might not be worth as much as the same cash flow occurring today.
CFs lose value due to interest rates. The three factors driving interest rates are: - Time value of consumption: you must be compensated (with interest) for having to delay consumption - Expected inflation: you must be compensated (with interest) for receiving cheaper dollars in the future from an investment. - Risk: you must be compensated (with interest) for taking on risk.
1. We have discussed why interest expense is not included in capital budgeting analysis. a. State the technical reason why this is the case. Be specific.
Capital budgeting is determining the value of the incremental FCFs of an investment. The FCFs are the CFs available to pay all investors. Interest expense is a CF to an investor. So interest expense comes OUT of FCFs... it doesn't go into the calculation of FCFs.
1. What are the two types of decisions that a financial manager makes? Name them, and briefly describe each.
Capital budgeting: deciding which investments to make and how much to invest Financing: deciding the mix of debt and equity used to finance the business
List the 4 ways in which capital structure affects the value of the firm.
Capital structure can affect the value of the firm through these 4 channels: • Taxes • Transaction and distress costs • Investment policy • Imperfect information
1. Casey, Chuck and Sarah are secret government spies on a stakeout. To pass the time, they talk about investing in stock markets. Sarah started to brag about how her stock investments have consistently beat the market, and how she is very skilled at picking winning stocks because she know what to look for in the financial statements of publicly-traded companies. Casey couldn't understand why Sarah went to all the trouble of reading the financial statements of firms, because he thought that picking winning stocks only required an analysis of past returns. Chuck, on the other hand, was skeptical of Sarah's skills at picking stocks. He said that, if she really had consistently beaten the market returns, she was either extremely lucky or she used insider information to make her high returns. Using the terminology that we used in class, state and explain how each person views the efficiency of financial markets. (6 pts each)
Casey: Casey believes that markets are inefficient. If he believes that knowing past prices and returns can lead to abnormal returns, then he believes that this information isn't incorporated into current prices. Thus, markets are not even weak-form efficient... they are inefficient. Chuck: Chuck believes that markets are semi-strong form efficient. If he believes that the only way to beat the market is to have inside information (or be lucky), then markets must be semi-strong form efficient, as prices do not include private information. Sarah: Sarah believes that markets are weak-form efficient. Since she believes that using public information is enough to earn abnormal returns, it means that public information is not included in currently prices. So markets must only be weak form efficient.
1. In this class, we have just been using straight-line depreciation in our capital budgeting analyses. But how should we depreciate capital expenditures in "real" capital budgeting? Explain how you would determine the depreciation schedule for a capitalized asset and why this is the appropriate method for depreciation. (16 pts)
Depreciation is not an actual CF... and we want changes to the firm's FCFs when determining whether or not to make an investment. So why include depreciation in our framework? Because of its effect on taxes! Depreciation reduces profitability, which reduces the taxes paid, and taxes are a CF. So if the only reason to include depreciation is to capture the effect on taxes, then we need to use the depreciation schedule that is used when doing taxes. And this is determined by the IRS. So we need to use the specific depreciation schedule allowed by the IRS when determining taxes when putting together our capital budgeting analysis.
1. At your next big family reunion, your uncle (who is a poet) comes to talk to you. He has heard that you just took a finance class, and wants to know what this whole "diversification" things is all about. He would like you to explain diversification to him in terms of what it is and why it is so beneficial. Explain the concept of diversification. In your answer, you should say what diversification is and how it benefits investors. (15 pts)
Diversification is the elimination of risk by combining investments together into a portfolio. Risk is eliminated through the offsetting movements of the investments within the portfolio. These offsetting movements occur due to the less-than-perfectly positively correlated investments within the portfolio, and lower correlation leads to more offsetting movements. These offsetting movements represent the unsystematic risk cancelling out. However, the systematic risk remains, as it is the risk that affects all investments in the portfolio. Investors do not like risk, so they can improve their portfolios through diversification, as it eliminates unwanted risk. Investors do like returns, and diversification does not affect the returns of the portfolio. So through diversification, investors keep what they like (returns) and eliminate what they don't like (risk).
1. What are the three ways to value a stock that we have discussed in class? Briefly describe each.
Dividend discount method: Forecast dividends, then value the dividends by computing the PV of the dividend stream. Residual CF to equity: Forecast the FCFs of the firm, and find the PV. Subtract the PV of the debt of the firm to determine the value of the equity. Price Multiples: compute ratios of value for comparable firms, then apply these valuation ratios to the firm that we are trying to value.
1. What is an event study and how are they used in testing market efficiency? And what has been learned from event studies in relation to market efficiency?
Event studies use the response of the market to the release of new information to test how efficiently markets utilize information. Because market efficiency is based on how much information is incorporated into prices, the speed at which markets react to new information can indicate the type and level of market efficiency. Event studies have shown that new information is incorporated extremely quickly into market prices. The time between the release of new information and the full incorporation of that information into prices is typically less than the time it takes to log onto a computer and place a trade. This indicates that markets are (most likely) semi-strong form efficient.
1. Define financial risk.
Financial risk is the probability and magnitude of obtaining outcomes below expected value. It is the volatility of possible outcomes.
1. Explain why "maximizing firm value" is the same as "maximizing shareholder wealth". Be specific. (12 pts)
Firm value is equal to the sum of the MV of debt and the MV of equity (which is shareholder wealth). When we increase firm value, we do nothing to the MV of debt (as the amount that we owe doesn't change depending on the outcome of how we invest the firm's money). Thus, any changes to the value of the firm results in an equal change in the value of shareholder wealth. Thus, the two are the same!
1. Briefly describe the two methods for converting a future nominal value to its real value. (3 pts)
First method: calculate a PV using the nominal rate, and then calculate a future value using the real rate. Second method: Calculate the real FV by discounting the nominal FV to a PV using the inflation rate as the discount rate.
1. What are the two conditions that must be met for the IRR rule to always result in the same investment decision as NPV?
For the IRR rule to always result in the same investment decision as NPV: 1) The cash flows of the investment must start negative and then switch to positive and stay positive (only one sign change in the CF stream) 2) The investment decision for that investment does not affect the investment decision for any other investments (no mutually exclusive investments).
What is the definition of free cash flow? And how is free cash flow related to the value of the firm? Be specific in your answer.
Free cash flow is the CF available to pay ALL investors (both debt and equity). We determine the value of the firm by calculating the PV of the FCFs of the firm.
1. You are in a meeting in which one of your peers is presenting his analysis of two mutually-exclusive investments. There are no other possible investments at the present time. The information for the investments is below. Investment Today Yr 1 Yr 2 Yr 3 IRR NPV A -$10 million $7 million $6 million $10 million 52% $4.792 million B - $8 million $6 million $9 million $4 million 63% $4.790 million He goes on to argue that, since the discount rate for these investments is 24%, the firm should take Investment B because it has the highest rate of return. You raise your hand and tell him that, since these two projects are mutually-exclusive, IRR should not be used to determine the investment. You argue that NPV should be used instead. His response is as follows: "The NPV of A is slightly higher than B. But this doesn't take into consideration the fact that A costs $2 million more than B. We can invest $8 million in B at a higher rate of return and invest the remaining $2 million at our opportunity cost of 24%. The combination of these two investments should surely exceed the NPV of A by itself." Evaluate his argument. If he is correct, explain why. If not, explain why not.
His argument is incorrect. By investing in projects that earn a rate of return equal to the cost of capital, one guarantees an NPV of zero. Think of the IRR rule when making investments... if the IRR equals the discount rate for the investment, then we are indifferent to making the investment. So, by investing the remaining $2 million at the discount rate, the NPV of investing in B doesn't change. Thus, A is still the best investment to make.
1. You are comparing two bonds, A and B. The bonds are identical in every way (risk, par value, coupon rate, payment frequency) with the exception of maturity: bond A matures one year after bond B. If the yield curve is downward sloping, can we determine which bond would have the higher YTM? If so, state the bond with the higher YTM and explain why. If not, explain why we cannot determine the bond with the higher YTM from the information given. (14 pts)
If the yield curve is downward sloping, that means that, the longer the time to receive a CF, the lower the interest rate used to discount that CF to a PV. So when looking at these two bonds, Bond A will receive CFs at lower interest rates that Bond B does not have. And more importantly, it is at this lower interest rate where Bond A would receive the par value, and thus where the most weight would go in determining the YTM. Thus, bond B will have a higher YTM than bond A.
If we are to use any investment decision tool other than NPV, what must be true about the alternative investment decision tool for us to be confident about the decision we make?
If we want to use anything other than NPV, the one thing that must be true for us to be confident about the decision we make is that the alternative to NPV must AGREE with NPV.
1. You are looking at an investment with the following cash flows: Today $100 million Yr 1 -$25 million Yr 2 -$35 million Yr 3 -$30 million Yr 4 -$10 million Yr 5 -$50 million
If you were given the benchmark rate of return for the IRR decision rule, would you be able to use IRR to determine if this investment is good or bad? If so, explain why. If not, explain why not. (14 pts) Yes. Because the CFs start positive and then switch to negative, we cannot use the IRR rule that states that when IRR > benchmark, we invest and when IRR < benchmark, we reject. But we can flip the decision rule in this case. Assuming that we're not choosing between mutually-exclusive investments, we can use the flipped rule that if IRR < benchmark, we accept and when IRR > benchmark, we reject.
What do we know about prices and earning abnormal returns in a weak-form efficient market? Be specific.
In a weak-form efficient market, prices reflect all available information contained in past prices and returns. In a weak-form efficient market, information about past prices and returns will not help us earn abnormal returns.
Southwest Airlines is looking to find a discount rate for an investment. What must be true about the investment in order for it to be appropriate for Southwest Airlines to use its own risk in determining the discount rate for the investment? Be specific.
In order for Southwest to use its own risk to determine the discount rate for an investment, the investment under consideration must be a scale-expansion of Southwest Airlines. We assume that the risk of Southwest Airlines is the same as the risk of the investment, and that is only a good assumption when the investment is a scale-expansion of Southwest Airlines.
1. When determining the FCFs of a firm, why do we use NOPAT (Net Operating Profit After Taxes) instead of Earnings (or Net Income)? In other words, why not just use accounting earnings or net income, which have already been determined by the accountants, instead of hand-calculating NOPAT? Explain. (10 pts)
In order to calculate Net Income, one needs to subtract interest expense. But interest expense is a financing CF. We do not include financing CFs when computing the FCF of the firm, as the FCFs represent the CF available to pay all investors (including debt investors). Thus, interest expense comes out of FCFs; it is not including in the calculation of FCF.
1. You are trying to value a share of XYZ Corporation. They sell home and office printers. XYZ is not publicly traded, but it has EBIT of $1.70 per share and CFs of $0.80 per share. You find information on HP (a manufacturer of printers) and PepsiCo (makers of Pepsi and other consumer drinks). You find that HP has a price-to-earnings ratio of 15, a price-to-EBIT ratio of 20, and a market-to-book ratio of 3. PepsiCo has a price-to-earnings ratio of 10, a price-to-EBIT ratio of 12, and a market-to-book ratio of 2. What is your estimate (or estimates) for the value of XYZ?
In order to use price multiples, we have to choose our comparable firm(s) carefully, as we are making a big assumption that the ratio for this/these firm(s) are exactly equal to our firm of interest. In that case, PepsiCo isn't a good comparable firm, and thus should be excluded from consideration. That leaves just HP. We also want to utilize these ratios exactly as they are calculated. We have the P/E, P/EBIT and M/B ratios for HP. And we have EBIT and CFs of XYZ. Thus, the only ratio that we can reproduce exactly as it was calculated for HP is the P/EBIT ratio.
1. What is the second (and most important) proposition of MM Theory? Be specific.
In proposition II, MM show that it is ONLY in a world with no taxes, no transaction or distress costs, fixed investment policy, and perfect information that firm value is independent of capital structure.
1. What is inflation, and how is it calculated in the United States?
Inflation is the loss of purchasing power of a currency (or the general increase in prices in an economy). It is calculated as the percent change in the Consumer Price Index (CPI), which is a basket of goods which are purchased by the average American household.
Explain why it is not enough to know the actual return on an investment in order to determine if its performance was good or poor.
Investors care about both return and risk. You need to know both the return and the risk undertaken (or the required rate of return, which takes into account the time value of consumption, expected inflation, and risk) in order to determine investment performance.
4. Acme Industries, Inc. looks at the following decision criteria when evaluating projects: 1. NPV must be greater than zero. 2. IRR must be greater than the cost of capital. 3. Payback period must be less than 6 years. 4. The value of the firm must increase by at least $500,000 as a result of the investment. In order to undertake an investment, at least three of the four criteria above must be met (in other words, one of the criteria may say "no", but if the other 3 say "yes", then the investment is undertaken). Critically evaluate the above policy (i.e. discuss its pros and cons). If the policy is a good one, explain why. If not, explain why not and suggest an alternative policy.
Let's look at each component of the policy: 1. NPV gives us the correct investment decision every time (assuming that the value of real options have been included and that we aren't looking at repeated investment choices with different life spans). But these assumptions would also need to be incorporated in the other criteria as well... so this really isn't a knock on NPV. 2. IRR also gives us the correct investment decision as long as the following conditions hold: i) the initial CFs of the investment are negative, then followed by positive CFs and ii) the investment choices are not mutually exclusive. 3. Payback period is not a good method for evaluating investment decisions. Future CFs are not discounted, distant CFs are ignored, and the benchmark period is arbitrary. 4. This is the same as saying that NPV must be at least $500,000. This means that the firm would ignore some investments that increase firm value by less than $500,000. Shareholders would not approve of foregoing investments that could increase their wealth! Of these choices, only NPV works all the time. Because there are essentially two NPV requirements, we would be certain that we would never take a negative NPV project (as this would fail two of the conditions). But we may pass on good investments. One could imagine a scenario that an investment had an NPV of "only" $450,000 and the payback period was not met... resulting in no investment. Or that NPV was $1 million, but the CFs were such that IRR was meaningless and the payback period was 9 years. Ultimately, because this policy will cause us to miss out on good investments, it is not a good policy. I suppose that there are several "correct" policies that you could suggest, but the best one (in my mind) is to just use NPV greater than zero. It will always identify good investments to make and we will avoid bad investments.
1. There have been some new developments in the world... Taxistan, one of the small, rarely heard-of states from the former Soviet Union, has decided to abolish all taxes in the country. The Taxistan government has also decreed that all managers must use and follow NPV at all times when making investment decisions. The government will subsidize all investment banking and bankruptcy costs for firms, and all information about any company must be freely available to all. a. What would MM say about the effect of capital structure on firm value in Taxistan with these policies? (12 pts)
MM says that if and only if there are no taxes, no transaction costs, perfect information, and fixed investment policy, then the capital structure will not affect firm value. In Taxistan, there are no taxes, no transaction costs, perfect information and fixed investment policy; thus, in this country, capital structure does not affect firm value.
What does MM theory tell us about how capital structure affects the value of the firm? Be specific.
MM theory says that, if capital structure affects firm value, it will do so through these four channels: taxes, transaction and distress costs, investment policy, and imperfect information.
1. At your next big family reunion, your uncle (who is a poet) comes to talk to you. He has heard that you just took a finance class, and wants to learn about picking winners in the stock market and "beating the market." Explain market efficiency to him, give him your opinion on the level of market efficiency in U.S. markets (and the evidence to back up your opinion), and your advice regarding how to earn abnormal returns. (15 pts)
Market efficiency is the degree to which prices in financial markets reflect available information. The more information that is incorporated into prices, the more efficient that market becomes. The evidence suggests that markets in the U.S. are both weak and semi-strong form efficient. In weak form efficient markets, prices incorporate information about past prices and returns, while in semi-strong form efficient markets, prices incorporate all publicly available information. Studies have shown that markets are very fast to incorporate new information into prices; often, the new information is incorporated within seconds of announcement. Other evidence includes the failure of fundamental and technical analysis (two methods which try to use publicly-available information to pick investments) to earn abnormal returns (a fancy way of saying that they do not beat the market). We also know that markets are not strong form efficient... prices do not include all public and private information. Studies have shown that insiders consistently earn abnormal returns on their trades. Thus, private information is not reflected in the prices we see in the markets. If you want to consistently earn abnormal returns in U.S. markets, you need to either be very lucky or use insider information. And since insider trading is illegal in the U.S., I don't recommend that approach!
1. Explain why we ignore sunk costs when performing NPV analysis.
NPV analysis looks at valuing the incremental FCFs that result from an investment... that is, how the FCFs of the firm change as a result of making an investment. Because sunk costs have already happened, they are not incremental. The FCFs of the firm do not change as a result of the investment, as the sunk costs are incurred regardless of the investment decision. Thus, sunk costs can be ignored.
Define net working capital. Be precise in your definition.
NWC is current assets minus non-interest bearing current liabilities.
1. You are presenting your capital budgeting analysis in a meeting, and your colleague objects to your analysis. He says that, when calculating CFs, you need to capture the effects of the project on the CFs of the firm. He points out that you've included depreciation in your analysis, but depreciation isn't actually a cash flow. He also says that interest expense is a cash flow, but it is missing from your analysis. Is he correct? Carefully explain why or why not. (14 pts)
No... he is not correct. His comments on depreciation are mistaken. Depreciation is not a CF, so while we subtract it when calculating EBIT, we add it back after computing NOPAT. So why include it at all? While depreciation is not a CF, depreciation affects our profitability, which in turn affects taxes. And taxes are a CF. So we must include the effects of depreciation on the incremental taxes of the firm. And interest expense is not included in capital budgeting. Interest expense is a financing CF, meaning that it is a CF to an investor. The definition of FCF is the CF available to pay all investors. So interest expense would come out of FCFs... and not factor into FCFs. Thus, while a CF, interest expense is irrelevant to the FCFs of the firm.
We have discussed in class that dividends are the CFs that result from an equity investment. Thus, the value of the stock (to a shareholder) is the PV of the future dividends to be received. However, many firms do not pay dividends and have no intention of paying a dividend in the foreseeable future... even though these firms may have the money available to pay dividends to shareholders. If a firm has the money to pay dividends, is it always in the best interests of shareholders to pay dividends? If yes, explain why. If no, explain under what conditions it is better for firms to retain the cash (instead of paying a dividend).
No... it is not always in the best interests of shareholders to pay dividends. If the company has positive NPV projects to invest in, then it is always better to keep the cash and reinvest in the firm. When managers invest in positive NPV investments, the value of the firm increases. When managers have only negative NPV investments to make, then it is better to pay the cash out as a dividend.
1. Your cousin works at a company in which the stated goal of all managers is to "maximize revenues." Is this a good policy? If so, explain why this is the right goal for managers. If not, explain what is wrong with this policy (use an example to demonstrate why it's not good), and state the policy that should be used.
No... this is not a good policy. While it may seem like a good goal for managers, it will not always lead to good financial decisions. An easy example would be selling $20 bills for $10 each. Revenues would go way up, but the company's investors would eventually lose their money. The right policy is to maximize shareholder wealth. They are the owners who have given the company money and are taking the risk of investing in the firm. If you maximize their wealth, you're making the right business decisions.
1. Your colleague (who went to Texas A&M) is talking to you about risk and return. You start talking to him about how, when investors receive extra return for holding risk, it is only the systematic risk that matters. You say that unsystematic risk does not result in extra return. Your colleague replies: "Yup... that's what you get for having Obama in the White House. He nominates a 'risk/return' guru who oversees all of the different markets and regulates what type of risk gets rewarded with return. When his presidential term is up... and assuming the country doesn't elect someone similar to replace him... soon we'll all be able to earn extra return for holding onto unsystematic risk." Is your friend correct? If so, explain why. If not, explain how it is that unsystematic risk does not get rewarded with extra return. (10 pts)
No... we cannot blame Obama for this one! There is no guru that ensures that only systematic risk is compensated with return. The reason that unsystematic risk is uncompensated by the market is because diversified investors set prices. When an investment is riskier for an investor, the investor values it less (as investors don't like risk)... and thus the price falls. So for any investment, the investor who sees the least risk with that investment will value it the most! Every investment has both systematic and unsystematic risk. Well-diversified investors have many investments in their portfolios; the unsystematic risk of any investment will be eliminated through the offsetting movements of other investments within the portfolio. These investors only "see" the systematic risk of each investment. On the other hand, undiversified investors do not have as many investments in their portfolio and thus cannot fully eliminate all of the unsystematic risk of each investment. These investors "see" both the systematic and unsystematic risk of an investment. In free markets, the highest price wins. And who will be setting the highest price? It will be the investor who sees the least risk and thus values the investment the most. This is the diversified investor who only needs to be compensated for the systematic risk. No guru needed!
1. You have just started your first job out of college, and you become aware that your boss uses discounted payback period to decide on investment proposals. You mention to her that payback period is not appropriate for making investment decisions, and she asks you to put together a short write-up to convince her that payback period doesn't work. Use the space below to convince her that, when making investment decisions, payback period is a poor method and NPV is best. Be succinct yet complete in your answer.
Payback period is a terrible way to make investment decisions. The boss uses discounted payback period, so it avoids the problem of not discounting future CFs. But it still ignores distant CFs, the benchmark period is arbitrary, and it does not provide any information about what is happening to the value of the firm as a result of making the investment. NPV is a better method. Since our objective as managers is to maximize the value of the firm, we want to undertake investments that increase the value of the firm. NPV measures how much the value of the firm is expected to change as a result of the investment by measuring the value of all of the incremental FCFs of the investment. This makes it an ideal measure for determining which investments to make.
What is payback period? In your answer, be sure to define the concept, describe how it is used, and detail the benefits and/or drawbacks of its use.
Payback period is the length of time that it takes for the cumulative cash flows of an investment to equal the initial investment... or the time it takes for an investment to pay back its initial investment. The decision rule for payback period is to accept any investment in which the payback period is shorter than a pre-specified benchmark period of time, and to reject any investment in which the payback period is longer than a pre-specified benchmark period of time. Payback period is not a good way to evaluate investments. Its drawbacks are: • It does not discount future CFs • It ignores distant CFs • The benchmark period is arbitrary • It does not reflect the change in the value of the firm that results from making the investment
1. We discussed alternatives to NPV when making investment decisions. Describe the payback period method, and give at least 2 reasons why payback period is an inappropriate measure for making an investment decision.
Payback period is the length of time until the sum of future CFs equals the initial investment. The decision rule is to accept any project with a payback period less than the benchmark payback period. Payback period has the following problems: a. Payback period does not correspond to a measure of the investment's effect on the value of the firm b. Payback does not discount future CFs c. Payback ignores distant CFs d. The benchmark period is arbitrary
1. What is the difference between real and nominal values? Explain.
Real value: this is the purchasing power of a future CF Nominal value: this is the amount of value you actually receive
a. Your friendly Starbucks barista: "I think that it's pretty hard to earn higher returns than the market, unless you have some inside information."
Semi-strong efficiency: the barista believes that all public information is already incorporated into the stock price. However, abnormal returns can be made with private information, so this does not describe strong form efficiency.
1. Compare and contrast 401-k plans and traditional IRAs. Be specific. (14 pts)
Similarities between 401-k plans and traditional IRAs include: • Both are investment vehicles that encourage saving for retirement • Both allow for investment in stocks, bonds, mutual funds, etc. • Both allow for investment of pre-tax dollars (i.e. investors avoid taxes today on what they save) • Both investments grow tax-free. • Both investments are taxed once money is removed from accounts during retirement • Investors of both would incur penalties if they try to withdraw these funds prior to retirement age (except for a very few circumstances) Differences include: • 401-k plans are through one's employer, while IRAs can be set up by individuals • Participation in 401-k is limited to those with that particular benefit from their employer, while anyone can open an IRA • Employers often match 401-k contributions, while IRA contributions are not matched by anyone • The annual maximum contribution is different for each
a. Your uncle: "I find it hard to believe that anyone could consistently beat the market, even if they had insider knowledge."
Strong form efficiency: all information (including insider or private information) is already incorporated into the stock price. Even if you had inside information, you could not earn an abnormal return with that information.
1. Systematic risk is the risk that cannot be diversified away. Why is it that we cannot eliminate systematic risk by combining investments into a portfolio? Be specific.
Systematic risk is the risk that affects all investments in the same direction, whereas diversification is the elimination of risk through offsetting movements of returns within the portfolio. If systematic risk moves all investments in the same direction, then it cannot cause offsetting movements and thus cannot be eliminated.
1. Compare and contrast technical analysis and fundamental analysis. And given what is known about market efficiency, which method of analysis works better? Explain as completely as you can. (14 pts)
Technical analysis is the use of past prices and returns to determine which stocks will do well (or poorly) in the future. Fundamental analysis is the use of publicly available financial information (financial statements, analyst reports, etc.) to determine which stocks will perform well/poorly in the future. Both are methods of trying to use information to pick winner/loser stocks and earn returns above the market returns. However, technical analysis depends on looking past prices for this information, while fundamental analysis depends on publicly available information. Given that markets are semi-strong form efficient, we know that all information about past prices AND publicly available information are already incorporated into the current stock price. In other words, having that information will not enable you to pick winners/losers in the stock market. Thus, neither method of analysis has been shown to work at all. Neither is better.
What is technical analysis, and what is evidence regarding its effectiveness? Be specific
Technical analysis is the use of past prices and returns to earn abnormal returns in the market. The evidence shows that technical analysis does not lead to abnormal returns; stock prices move in a random walk, and thus past prices and returns have no relationship to future prices and returns.
What are the 3 factors that determine the interest rate?
The 3 factors are: • Time value of consumption • Expected inflation • Risk of investment
In class, we discussed 3 methods to value common stocks. Describe/explain two of the methods.
The 3 methods were dividend discounting, CF to shareholders, and multiples. • Dividend discounting takes the PV of the future streams of dividends in order to find the value of the stock. • FCFs are the CFs available to pay all investors. So we can determine the value of the FCFs and then subtract the value that belongs to debtholders. The remainder must be the value to shareholders. • Multiples valuation assumes that financial ratios (such as P/E or market/book ratios) are identical for similar firms. You calculate the financial ratio for the similar company, then multiply the ratio to the financial data of the company you want to value.
Define the 95% confidence interval for an investment. Be specific.
The 95% confidence interval is the range of returns in which we are 95% confident that the next return will fall. The equation for the 95% confidence interval is the expected return plus and minus 2 standard deviations.
a. There have been some new developments in the world... Taxistan, one of the small, rarely heard-of states from the former Soviet Union, has decided to abolish all taxes in the country. The Taxistan government has also decreed that all managers must use and follow NPV at all times when making investment decisions. The government will subsidize all investment banking and bankruptcy costs for firms, and all information about any company must be freely available to all. What would happen to the market values of firms in Taxistan upon the announcement of these policies? And which types of firms would be more greatly affected... firms currently with high levels of debt or firms currently with low levels of debt? (12 pts)
The CFs of a firm have 3 claims... that of debt, equity, and the government (through taxes). So, if there are no taxes in Taxistan, then there is no government claim on the CFs of the firm, and the value of all firms will increase. We know that adding debt to the capital structure can reduce the taxes that companies pay; so (all other things being equal) firms that have lower debt end up paying more taxes. So, firms with lower debt will have the greatest increases in value once these policies are in effect.
Compare and contrast NPV and IRR as criteria for making investment decisions. Be sure to include similarities as well as differences in your answer.
The NPV of the investment is the change in the firm's value as a result of making the investment, while IRR is the single discount rate that implies an NPV of zero for an investment. The decision rule for NPV is to accept all projects with positive NPVs, while for IRR the decision rule is to accept all projects with an IRR greater than the discount rate for that project. NPV can be used all of the time; IRR can only be used when the following two conditions are met: the investment has negative CFs followed by all positive CFs (so only one sign change in the stream of CFs) and IRR is not used to choose between two investments.
What is the "Rule of 72" and how is it used? Use an example in your answer.
The Rule of 72 allows us to approximate the doubling time of an investment. Doubling time ≈ 72 divided by interest rate (in percent) For example, at 6%... it would take about (72/6 =) 12 years to double.
What is the Security Market Line? Explain briefly.
The Security Market Line is the graphical representation of the CAPM. It is a graph that shows the relationship between returns and beta.
Define yield to maturity (YTM), and explain how one would estimate it.
The YTM is the single discount rate that, when applied to a bond's CFs, results in the bond's price. We can estimate the YTM by calculating a weighted average of the interest rates used to price the bond, and weighted by how much CF occurs at each time period. Since most bonds have the vast majority of its CFs occur in the final period, the most weight falls on the interest rate for the final CF.
Define YTM
The YTM is the single discount rate that, when applied to the stream of CFs of a bond, gives the bond's price. It can be estimated by a weighted average of the interest rates used to value the bond, weighted by the amount of CFs as each interest rate.
What is the characteristic line for an investment
The characteristic line is the best fit line that results from a regression analysis between an investment's returns and the market portfolio returns. The slope of this line is beta, which is the measure of systematic risk for an investment.
What is the characteristic line for a firm? Be specific.
The characteristic line is the result of the regression analysis of an investment's returns on the market portfolio's returns. It is the best fit line for the return data used to run the regression. The slope of this line is beta, which is our measure of systematic risk.
1. Explain the decision rule for EPS as a determinant of a good or bad investment. Also, state whether EPS is a good way to make investment decisions, and explain why or why not.
The decision rule for EPS: accept an investment if it will increase EPS of the firm, and reject if it will decrease EPS of the firm. EPS is NOT a good way to make investment decisions: • EPS can be manipulated • An increase in EPS does not necessarily mean it's a good investment • It is unclear which year's EPS must increase • Earnings includes financing CFs • Increases in EPS do not measure the increase in the value of the firm as a result of the investment
1. Explain how we can be sure that the perpetual growth rate (g) will not be larger than the discount rate (r) when solving for the value of a growing perpetuity. (10 pts)
The growing perpetuity formula describes the value of a stream of CFs that grows at a constant rate each period and lasts forever. As you can see below, if r equals g, then the value is infinite, and if r <g, then the value is negative... neither of which results in useful valuations. So how is it that we can be sure that r > g? If the growth rate each year, into forever (!) is greater than the overall growth rate of the economy, then eventually the investment will become the ONLY investment in the economy (the investment will grow and takeover all other investments). This would be a foolish assumption to make... there will always be other investments for investors to choose from. Thus, the growth rate in the growing perpetuity formula will never be greater than the overall growth rate of the economy, which is lower than the discount rates we use to value streams of CFs.
What is the market portfolio? Be specific in your answer, including how we use the market portfolio in finance.
The market portfolio is a portfolio that has all risky assets in it... any and every investment that is risky. Because of this, the market portfolio has no unsystematic risk (it has all been diversified away). The market portfolio only has systematic risk. We use the market portfolio to determine the systematic risk of other investments by finding the relationship between an investment's returns and the market portfolio returns. Since the market portfolio has only systematic risk, a regression analysis will tell how much systematic risk of the investment.
Explain why NPV is the appropriate measure for determining if an investment should be made.
The objective of the manager is to maximize the value of the firm (or maximize shareholder wealth). They can accomplish this by undertaking investments that increase the value of the firm. In order to do this, they need to know how firm value changes as a result of an investment. NPV is the measure of how firm value changes as a result of the investment, so NPV gives managers a measure that corresponds directly with their overall objective.
1. Explain what is meant by "opportunity cost of existing assets" and why we must account for this when doing NPV analysis. (14 pts)
The opportunity cost of existing assets is to account for the cost of using existing assets in a new investment. The discount rate accounts for the opportunity cost of the money contributed to the investment, but we must account for the opportunity cost of any currently-owned asset that will also be contributed to the investment. This should be the value of the next best alternative use for the existing asset (which often is just the MV that could be obtained from selling it). This is a foregone value as a result of the investment, so we must account for it in our NPV analysis.
Explain what is meant by "opportunity cost of existing assets" and why we must account for this when doing NPV analysis.
The opportunity cost of existing assets is to account for the cost of using existing assets in a new investment. The discount rate accounts for the opportunity cost of the money contributed to the investment, but we must account for the opportunity cost of any currently-owned asset that will also be contributed to the investment. This should be the value of the next best alternative use for the existing asset (which often is just the MV that could be obtained from selling it). This is a foregone value as a result of the investment, so we must account for it in our NPV analysis.
What is the payback period? Explain how it is used, and give 3 reasons why it is not a good measure for making investment decisions.
The payback period is the amount of time until the sum of an investment's future CFs equals its initial investment. The payback period of an investment is compared to a benchmark payback period, and an investment is accepted if its payback period is less than the benchmark period; otherwise the investment is rejected. The payback period is not an appropriate investment measure for the following reasons: • It does not discount future CFs • It ignores distant CFs • The benchmark period is arbitrary • Payback period does not correspond to the investment's effect on firm value.
1. What is the primary objective of a financial manager, and why? Briefly explain your answer.
The primary objective is to maximize the wealth of the shareholders. I would also accept maximize firm value, maximize the PV of the firm's free cash flows, maximize the economic profits of the firm, or maximize the value of the financial claims on the firm. The reason is that the shareholders are the owners of the firm. They have put the money into the firm and have taken on the risk associated with the firm. Thus, managers should work to increase their wealth.
1. What is the security market line? Be specific. (10 pts)
The security market line is the graphical representation of the CAPM. It is a line that represents the returns of an investment given its systematic risk (or beta). It has a y-intercept of the risk-free rate, and a slope of , or the expected risk premium per unit of beta.
The expected return of a portfolio is a weighted average of the expected returns of each investment within the portfolio. Explain why the standard deviation of a portfolio is not the weighted average of the standard deviations of each investment in the portfolio.
The standard deviation of a portfolio is NOT the weighted average of the standard deviations of each investment within the portfolio because we also need to know how the investments in the portfolio are correlated with each other (how they move relative to one another).
1. Explain why an upward-sloping yield curve is considered the most typical yield curve. In other words, why is this more common a downward-sloping yield curve?
The term premium and liquidity premium both lead to long-term rates being higher than short-term rates. It would take really strong expectations of future rates being lower in order to offset the upward-sloping impact of the term premium and liquidity premium. Thus, upward-sloping yield curves are most common.
1. Explain why an upward-sloping yield curve is considered the most typical yield curve. In other words, why is this more common than a downward-sloping yield curve?
The term premium and liquidity premium both lead to long-term rates being higher than short-term rates. It would take really strong expectations of future rates being lower in order to offset the upward-sloping impact of the term premium and liquidity premium. Thus, upward-sloping yield curves are most common.
1. If standard deviation is measure of total risk while beta is a measure of systematic risk, then explain how a stock can have total risk of 0.22 but systematic risk of 1.2? (12 points)
The two measures of risk are different in the units that they measure. Standard deviation measures in units of percent... a standard deviation of 0.3 is the same as 30%. Beta is scaled by the market's standard deviation... thus, beta is measured relative to the market. It is not in units of percent.
What are the two characteristics or requirements of a "good" price multiple? Be specific in your answer.
The two requirements of a good price multiple: - The price multiple must have price or value as one of the components of the ratio - The other component of the ratio must be correlated with value So price-to-earnings is a good price multiple, as price is the numerator and earnings are correlated with value. Earnings-per-share would be a bad price multiple, as it doesn't include price as part of the ratio. And price-to-zip code would be bad as well, as zip code is not correlated with price.
1. We have discussed why interest expense is not included in capital budgeting analysis. a. State the intuitive reason why this is the case. Be specific. (8 pts)
The value of an investment should NOT depend on how we pay for it. So if we borrow to pay for the investment or pay for it with owner's (equity) money, it should not affect the value of the investment to us. Therefore, since interest expense is only an outcome of how we pay for an investment, we shouldn't include it when determining the value of the investment.
a. Explain the problems with using earnings per share as an investment criteria for investment decisions. Be specific.
There are several problems with using EPS as an investment criteria: • Earnings can be manipulated • An increase in EPS is not necessarily associated with a good investment • Unclear as to which year's EPS should increase • Earnings include financing CFs • EPS does not tell us how firm value changes as a result of the investment
1. Earl and Randy Hickey are brothers who won the lottery and have decided to go into business together. They are interested in oil prospecting, which is the business of looking for oil and drilling oil wells. Most oil prospectors find oil in only 1 out of every 5 wells that they drill, but Earl and Randy feel that their good karma will enable them to find oil in 1 out of every 2 wells that they drill. Regardless of their karma, they have signed contracts to sell any oil that they find to Exxon oil refineries at set prices. Thus, the only risk of their potential venture is whether they find oil and how much oil they find. They hire you to evaluate whether this venture is a good investment for them to make. Do you have enough information to calculate a discount rate for them? If so, explain why and calculate the discount rate. If not, explain why not. (10 pts)
Yes, there is enough information to calculate a discount rate. When determining a discount rate, we are concerned with the riskiness of the cash flows that result from the project. But we are not concerned with total risk... only systematic risk. Thus, to determine a discount rate, we need to know the amount of systematic risk, or beta, of the CFs from the investment. Once we have beta for the investment, we can plug the beta into the CAPM and get a discount rate. Now let's look at this investment. It is risky... there is a chance that no oil will be found, and who knows how much oil they would find if they are successful. However, because they have locked in a price for any oil that they find, the ONLY risk of the investment is whether they find oil and how much they find. Both of these risks are company or project-specific... market-wide economic shocks will not affect Earl's ability to find the oil or the amount that they eventually find. Therefore, there is no systematic risk in this investment... and beta is zero. Therefore, the correct discount rate for Earl and Randy to use is the risk-free rate, or 4%.
1. The management of a small, independent sporting shoe manufacturing company wants to calculate a discount rate for its various shoe manufacturing projects and has hired you as a consultant. Since they are a privately-held company, you suggest that they use Nike's equity beta and capital structure to determine the discount rate for their project. Their response is: "We are way too small to compare to a large firm like Nike. We think that the appropriate firm to use is Hammock Enterprises, Inc (they make hammocks). They are very similar in size to our firm, and their hammock factory is just down the street from ours. And we sell to many of the same sporting goods stores as Hammock Enterprises." Who is correct, and why? Explain. (10 pts)
You are correct. According to the market portfolio, size is a risk factor should be something that can be diversified away... the only risk is that risk which is related to the sensitivity of the firm to the overall market. You want to know how much systematic risk is in the business of producing and selling shoes, which is what Nike does. Hammocks, while sold in the same stores, are not the same products, and thus would probably not be the same risk (and certainly shouldn't be assumed to have the same risk) as manufacturing shoes.
You cannot determine from the information given how the portfolio risk will change. Look at the formula for portfolio risk. When we change from Verizon to Phillip Morris, two components of the equation change... the of Verizon to the of Phillip Morris, and the correlation between Nintendo and Verizon to the correlation between Nintendo and Phillip Morris. Since we don't know how the correlation is changing, we cannot be certain as to the change in the risk of the portfolio. While the increase in the risk of Phillip Morris would cause the risk of the portfolio to increase if everything else stayed the same, a decrease in the correlation could more than offset the increase in risk and cause the portfolio risk to be less than before.
You cannot determine from the information given how the portfolio risk will change. Look at the formula for portfolio risk. When we change from Verizon to Phillip Morris, two components of the equation change... the of Verizon to the of Phillip Morris, and the correlation between Nintendo and Verizon to the correlation between Nintendo and Phillip Morris. Since we don't know how the correlation is changing, we cannot be certain as to the change in the risk of the portfolio. While the increase in the risk of Phillip Morris would cause the risk of the portfolio to increase if everything else stayed the same, a decrease in the correlation could more than offset the increase in risk and cause the portfolio risk to be less than before.
1. At your first job, a colleague and you are discussing the financing decisions of your company. Your colleague says: "MM Theory tells us that having debt in the capital structure increases the value of the firm through the tax benefits of debt. Specifically, the firm lowers its profitability (and thus its taxes) by deducting interest expense from its pre-tax profits. Our goal, as managers of the firm, is to maximize the value of the firm. Thus, we should take on as much debt as possible... even if it means being 100% financed with debt." Is your colleague correct? Explain why or why not. (15 pts)
Your colleague is partially correct. It is correct that the MM Theory states taxes lead to increases in the value of the firm through the tax shields created by interest expense. Interest expense doesn't lower the FCFs of a company (because interest expense comes out of FCFs), but taxes are lowered as pre-tax profitability is reduced by the interest expense. The reduction in taxes is an increase in the FCFs of the firm, and thus increase the value of the firm. However, this does not mean that taking on as much debt as possible will maximize the value of the firm. MM Theory discusses 4 channels through which capital structure affects the value of the firm: taxes, transaction and distress costs, investment policy, and imperfect information. As debt goes up, the other channels may affect the value of the firm in a negative way. For example, we discussed how when debt goes up, the PV of distress costs goes up. At some high levels of debt, the loss of value due to distress costs is greater than the increase in value from tax shields. Therefore, it does not maximize the value of the firm to take on as much debt as possible.
