FIN4424 Exam 2 Notes
If an investor buys a portion of both debt and equity of a levered firm, their payoff is
(X) * (profits)
For a two-stock portfolio, the maximum reduction in risk occurs when the correlation coefficient between the two stocks equals
-1
What range of values can correlation coefficients take?
-1 to 1
The beta of treasury bills is
0
The correlation coefficient between the efficient portfolio and the risk-free asset is
0
If a question does not show the weight of either portfolio, assume it is
0.5
The beta of the market portfolio is
1
One would expect a stock with a beta of 1.25 to increase in returns
25 percent more than the market in up markets
Convertible bond
A corporate bond that can be exchanged for a fixed number of shares of stock is a
Capital Structure Decision
A firm's financing choice. It addresses the mix of debt and equity financing. The decision boils down to determine the optimal leverage ratio
Proposition 3
A firm's return on asset is independent of its leverage
Proposition 2
A firm's return on equity and return on debt are positively correlated its leverage
Which of the following is not a sensible reason for a firm to rely on internal funds
A new bond issue may drive the firm's debt ratio too high. Equity issues are expensive. Financial Markets interpret the issuance of equity unfavorably
What is NOT a sensible reason for a firm to rely on internal funds
A new bond issue may drive the firms debt ratio too high. Equity issues are expensive. Financial markets interpret the issuance of equity unfavorably
Correlation Coefficient
A statistical measure of the degree to which securities' returns move together
Diversification
A strategy designed to reduce risk by spreading the portfolio across many investments
Debts in Disguise
Accounts payable, leases, and underfunded pensions
A stock having a covariance with the market that is higher than the variance of the market will
Always have a beta above 1
Costs of financial distress are costs arising from
Bankruptcy and distorted business decisions before bankrupty
With a well-diversified portfolio
Beta of an asset is the measure of risk
Debt Issuance
Better since the value of debt securities is more certain than equity, thus information asymmetry has less impact
In the case of Google, which has issued Class A and Class B shares
Both classes of shares have the same cash-flow rights and both classes of shares have different control rights
Capital Structure is irrelevant if
Capital markets are efficient, each investor can borrow/lend on the same terms as the firm. There are no tax benefits to debt
Trade-off Theory
Capital structure is based on trade-off between tax savings and costs of financial distress
How to reduce standard deviation
Combining assets into portfolios
Which portfolio has had the highest average risk premium during the period 1900 to 2014?
Common Stock
Market Risk
Economy-wide sources of risk that affect the overall capital market. Also called "systematic risk"
A portfolio with a beta of one offers an expected return equal to the market risk premium
FALSE
An investor who puts $10,000 in Treasury bills and $20,000 in the market portfolio will have a beta of 2
FALSE
Investors demand higher expected rates of return on stocks with more variable rates of return
FALSE
Low standard deviation stocks always have low betas.
FALSE
Stocks with high standard deviations will necessarily also have high betas.
FALSE
The CAPM predicts that a security with a beta of 0 will offer a zero expected return
FALSE
The average beta of all stocks in the market is zero
FALSE
Financial Markets and Intermediaries
Facilitate payment mechanism, borrowing and lending, pooling risk, and information exchange
Unique Risk is also called
Firm-specific risk
Pecking-Order Theory
Firms prefer to issue debt over equity if internal finances are insufficient
A portfolio of treasury bills
Has the least risk
What is NOT regarded as an investment fund
Insurance companies
Which of the following sources of funds has played the greatest role in the financing of U.S. nonfinancial firms
Internal funds
Recently, which of the following sources of funds has played the greatest role in the financing of U.S. nonfinancial firms
Internal funds have played the greatest role in the financing of U.S. nonfinancial firms
If one wants to borrow with limited liability, they should
Invest in the equity of a levered firm
If a bond is junior or subordinated
It must give preference to senior creditors in the event of default
Why does MM proposition 1 not hold in the presence of corporate taxes
Levered firms pay lower taxes when compared with identical unlevered firms
Information Asymmetry
Managers know more about their companies than investors, implying that the price of a firm's securities is not always equal to their value
The market value of equity =
Market Price * # of shares outstanding
Beta is a measure of
Market risk
For a portfolio of N-stocks, the formula for portfolio variance contains
N(N - 1)/2 different covariance term
When 2 asset returns' correlation coefficient equals 1
No diversification effect can be achieved
The distribution of returns, measured over a short interval of time, such as daily returns, is best approximated by the
Normal Distribution
Mean and Standard Deviation
Normal and lognormal distributions are completely specified by
Pairs of stocks tend to have both
Positive covariances and correlations
When securities are sold by a firm, it is termed a
Primary issue
The following functions, provided by financial intermediaries, enable the smooth functioning of the economy
Processing of payments, borrowing and lending, and pooling risks
A grant of authority allowing someone else to vote shares of stock that you own is
Proxy voting
Unique Risk
Risk factors affecting only that asset. Also called "diversifiable risk"
The trade-off theory of capital structure predicts that
Safe firms should borrow more than risky ones
The graphical representation of the CAPM (capital asset pricing model) is called the
Security market line
Preference in position among creditors when it comes to repayment is called
Seniority
Capital Structure Depends on
Size, Tangible assets, profitability, and market-to-book ratio
What signal is sent to the market when a firm decides to issue new stock to raise capital?
Stock price is too high
Market risk is also called
Systematic risk and undiversifiable risk
Investors demand higher expected rates of return from stocks with returns that are highly exposed to macroeconomic risks
TRUE
Investors demand higher expected rates of return from stocks with returns that are very sensitive to fluctuations in the stock market
TRUE
The beta of a well-diversified portfolio is equal to the value weighted average beta of the securities included in the portfolio
TRUE
The portfolio risk that cannot be eliminated by diversification is called market risk
TRUE
U.S. firms, in general, have been repurchasing shares and thus net equity issues have been negative
TRUE
The security market line (SML) is the graph of
expected rate of return on investment vs. beta
The following are characteristics of preferred stock except it
has voting rights
The main advantage of debt financing for a firm is that
interest expenses are tax deductible
According to the trade-off theory of capital structure
it is optimal when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress
If a firm is financed with both debt and equity, the firm's equity is known as
levered equity
Investments with greater risk are associated with
lower price and higher expected return
Modigliani and Miller Assumptions
no tax, no bankruptcy cost, no agency cost, and no information asymmetry.
Eurobonds are
not denominated in euros
One would expect a stock with a beta of zero to have a rate of return equal to
risk free rate
Investors are
risk-averse on average; they dislike risk and shall be compensated for taking more risk
The trade-off theory of capital structure predicts
that safe firms should borrow more than risky ones
MM proposition 2 states that
the expected return on equity is positively related to leverage, the required return on equity is a linear function of the firm's debt to equity ratio, and the risk to equity increases with leverage
The Higher the beta
the higher the risk
How can firms raise funds?
through internal financing (retained earnings) and external financing (debt and equity)
The total risk of an asset can be decomposed into
unique risk and market risk
A stock return's beta measures
The change in the stock's return for a given change in the market return
What makes diversification possible?
The correlation coefficients (co-movement) among asset returns
The change in a firm's retained earnings is
The difference between the net income earned and the dividends paid during a year
Normal Distribution
The distribution of returns, measured over a short interval of time, such as daily returns
Without sufficient slack
The firm might be caught at the bottom of the pecking order and be forced to issue undervalued stocks
The Capital Structure of the Firm
The firm's mix of different securities used to finance assets
Risk
The inaccuracy in predicting a future outcome
Proposition 1
The market value of a firm does not depend on the firm's leverage
PV (tax shield)
The sum of present value of all future tax savings due to interest payment
Managers of Corporations prefer internally generated cash to finance their capital expenditures because
They can avoid the discipline of financial markets, the costs of issuing new securities are high, and the announcement of a new equity issue is bad news for investors
A risk premium is the difference between a security's return and the
Treasury bill return
The type of risk that can be eliminated by diversification is called
Unique risk
As the number of stocks in a portfolio is increased
Unique risk decreases and approaches 0
When a firm has no debt, it is know as
Unlevered firm and an all-equity firm
Common Stocks
Which portfolio had the highest standard deviation during the period between 1900 and 2014
If a stock were overpriced, it would plot
below the security market line