Finance Exam 3

When is a new issue usually priced?

On the last day of the registration period

Dividend disc model pros and cons

Pros: -easy to use Cons: -only for companies with dividends -only for companies with STEADY dividend growth rates -doesn't consider risk

iCLICKER 13: The expected risk premium on a stock is equal to the expected return on a stock minus the

Risk Free Rate

iCLICKER 13: The principle of diversification tells us that

Spreading an investment across many diverse assets will eliminate some of the total risk. BC Systematic will always be there. you can change unsystematic and total risk=U+S

Two components of Unexpected Return

Systematic and Unsystematic RISK

Expected Return

The return that an investor expects to earn on a risky asset in the future

Green Shoe Provision

a contract provision giving the underwriter the option to purchase additional shares from the issuer at the offering price-- used to cover excess demand and oversubscriptions

Portfolio

a group of assets held by an investor -holding 100 shares of a single stock would not be considered a portfolio.

Red herring

a preliminary prospectus distributed to prospective investors in a new issue of securities

If a securities E(Ri) is equal to Rf and the market risk premium >0, what is B based on CAPM

a) equal to B b) 0. c)-1 d)1

iCLICKER 13: Which of the following is irrelevant to a well diversified portfolio?

a. systematic risk B. unsystematic risk c. market risk d non-diversifiable risk e. systemic portion or surprise.

The best way to include flotation costs is to __________

add them to the initial investment

Shelf Registration

allows firms to offer multiple issues of stock over a two-year period with only one registration statement "Dribble" method= shares sold occasionally via a stock exchange

In bankruptcy, assets are transferred from

bondholders to shareholders.

The systematic risk principle argues that the market does not reward risks that are

borne unnecessarily

dilution of ownership

can be avoided with a rights offering

MM I shows that

capital structure does not affect value of a firm

When calculating the free cash flows for a levered firm, you must consider

cash flows to both bond holders and stock holders

Leverage increases

cost of equity and also cost of debt(?)

MM II shows that

cost of equity rises with leverage

Are flotation costs the cost of issuing debt or equity?

debt

BV are often similar to MV for ______

debt

The increase in the number of stocks in a portfolio results in a(n) _____ in the average standard deviation of annual portfolio returns

decrease

crowd funding

done online

The return an investor in a security receives is ____ ______ the cost of the security to the company that issued it.

equal to

Dilition refers to a loss in _______ shareholder's value

existing

Total Return

expected return + unexpected return unexp ret= (systematic portion + unsystematic portion)

SML line

graphical depiction of the capital asset pricing model E(Rm) v. B

In the presence of corporate taxes, the tax shield effect of debt will_______ the value of the firm

increase

Standard Deviation of a portfolio

is always less than or equal to the weighted average of the standard deviations of the assets in the portfolio

a firm can use shelf registration if it

is rated investment grade, hasn't defaulted on debt in the past 3 yrs, the firms aggregate MV is more than 150 million

Competitive Offering

issuing firm offers its securities to highest bidder

Finding a firm's overall cost of equity is difficult because:

it cannot be observed directly

The WACC is the minimum return a company needs to earn to satisfy ________

its bond holders and stockholders

An investment will have a negative NPV when its expected return is ________ what the fin markets offer for the same risk

less than

Ideally, we should use __________ __________ in the WACC

market values

Slope on SML

market-risk-premium

There is _____ correlation between the unsystematic risk of two companies from two different industries

no

Does internal financing increase free cash flows?

not necessarily

Bankruptcy is very valuable because:

payments to creditors cease pending the outcome of the bankruptcy process and it can be used to strategically improve a firms competitive position

If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be:

positive

most debt is

privately issued

Lockup Period

prohibits insider shares from being sold immediately following an IPO

New common stock issues are __________

rare

The rate used to discount project CF is known as the _____.

required return, disc rate or cost of capital

It would be useful to understand how the _________ of the risk premium on a risky asset is determined

size

SML Approach

solves for the cost of equity (RE) using the market risk premium, the risk-free rate, and the beta coefficient

When an investor is diversified only ______ risk matters

systematic

When calculating flotation costs the _______________________ should be used

target debt to equity ratio should be used

Under US tax law, a corporations interest payments are _________ _________

tax deductible.

economic value added?

the amount by which company profits exceed the cost of capital in a given year "is being created or destroyed"

A company must file a reg stmt with the SEC unless

the issue <5 million

cost of capital

the minimum required return on a new investment when its risk is similar to that of projects the firm already owns

According to CAPM, what is the expected retuen on a stock if its beta is equal to zero

the risk free rate bc rf+0

Flotation Costs

the total costs of issuing and selling a security

firm commitment underwriting

the underwriter buys the entire issue, assuming full financial responsibility for any unsold shares

at some point debt becomes

too expensive

If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept _______________.

too many high risk projects

Dutch auction AKA

uniform price auction

The value of a firm is maximized when the:

weighted average cost of capital is minimized

examples of unsystematic risk

- Labor Strikes - Changes in mgmt

Whether a firm obtains capital by debt or equity financing depends on:

- the size of the firm - the firms growth prospects -the firms life-cycle stage

The risk of owning an asset comes from:

- unanticipated events - surprises

The growth rate of dividends can be found using

-Historical dividend growth rates -Security analysts' forecasts

Systematic risk examples

-Increase in Federal funds rate -Increase in corp tax rate

in the absence of taxes, the value of a firm is the same with debt asa it is with equity bc....

-MM1 demonstrated that debt financing is not better or worse than equity financing in ABSENCE OF TAXES - the asset to be financed is the same

Firms with high leverage

-airlines -cable television

_____ risk is reduced as more securities are added to the portfolio

-diversifiable -unique -unsystematic

A firms cost of debt can be __________________

-estimated easier than cost of equity -obtained by talking to inv bankers -obtained checking yields on publicly traded bonds - NOT calculated using DGM--> thats for equity

Advantages of using internal financing

-prevents bad reaction from market with an SEO -cheaper than debt /equity issues

effect of financial leverage and EBI

-rate of return on assets is unaffected by leverage -Financial leverage increases the slope of EPS line -below BEP, unlevered cap structure is better

Variance

-standard deviation squared -Variance is a measure of the squared deviations of a security's return from its expected return

When debt levels are extremely high

-the possibility of financial distress will become a chronic problem -The benefits of debt financing may be more than offset by the costs of financial distress

To estimate the growth rate of a stock we can

-use security analysts forecasts, -use the historical dividend growth rate

By definition, what is the B of the average asset equal to

1 - market B

Preferred source order of financing for firms according to pecking order theory

1. Retained Earnings 2. Debt 3. Common Stock

Steps in Calculating Variance

1. calculate expected return 2. calculate deviation of each return from the expected return 3. Square each deviation 4. Calculate the average squared deviation

ABC has a beta of 2.5 and XYZ has a beta of 1.5. The Risk-free rate is 4 percent and the market risk premium is 9 percent. What is the expected return on a portfolio that is equally invested in ABC and XYZ?

22% (solve) First find new B Then plug B into CAPM BE CAREFUL WITH MRP

A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV?

950,000

Risk Premium

Additional Conversation for taking risk over and above risk-free rate

How can a positive relationship between E(Ri) on a sec and its B be justified

Bc the diff b/n E(Rm) and rf is likely to be positive

Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Division's projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?

Division B explanation: Division A is riskier, so its cash flows should be discounted at a higher rate. Because they're not discounted differently, the projects in Division A will look better than those in B. Division B's cash flows will be discounted at a higher rate than should be used, so it'll appear less appealing and is more likely to be rejected.

T or F: SH and BH are the only claimants to the cash flows of the firm

F

T or F: projects should always be discounted at the firms overall cost of capital

F- the should reflect their particular level of risk.

WACC rises at higher levels of debt because of

Financial Distress Costs

Necessary assumption for MM 1 to hold

Individuals can borrow on their own int rate equal to that of the firm

Examples of info that may impact the risky return of a stock

Info that will be revealed in the near future-- not historical info - The Fed's Decision on interest rates at their meeting next week. - The outcome of an application currently pending with the Food and Drug Admin

In reality, most firms cover the equity portion of their capital spending with _________.

Internally generated cash flows

iCLICKER 13: Which of the following is an example of systematic risk?

Investors panic causing security prices around the globe to fall. remember- systematic risk will affect ALL the stocks in the stock market. Ignore firm/company/industry/city specific impacts. THINK BIG

What is an uncertain or risky return?

It is the portion of return that depends on information that is currently unknown.

Two components of the Expected Return on the Market

Market Risk Premium and Risk Free Rate - E(Rm)= rf+ (E(Rm)-rf)