Financial Management of the Firm (Final)

Capital Structure Decision

* a firm's financing decision *the mix of debt and equity *determining the optimal leverage ratio= D/D+E or D/V

Unique risk

*aka specific risk *risk factors only affecting that asset or firm- so different for each firm *"diversifiable risk" **can REMOVE with diversification (holding many assets in your portfolio) *importnat if you have a single stock!!

Trade off theory (bankruptcy costs and agency costs)

*capital structure is based on the trade off between tax savings and costs of financial distress *optimal leverage ratio--> marginal benefit of debt=marginal cost of debt **only thing we can use to calculate the leverage ratio or cap structure or CAPM *each firm has its own optimal leverage ratio under the trade off theory (its firm specific) *increase debt until the value from the PV tax shield is offset by increase of PV of FD **VL= Vu+ PV(tax shield)- PV Cost of FD

replacing an old machine

*cash flows are inflows *calculate NPV for old and new machine's future cash flows (***do not include old machine's initial investment amount in NPV calculation since that occurred in the past) separately * then apply EAA to both NPV of old and new **replace old machine until the EAA of the old machine is smaller than the EAA of the new machine

Investment timing decision????

*compare the PV of NPV of the new projected calculated at a different time point *for NPV calculated at t>0, discount it at r to t=0 and then make the comparison--solve by NPV in the future and discounting it back to time 0 and then make a comparison *some projects are more valuable if undertaken in the future

Cons of EVA

*does not measure P *rewards for quick paybacks *ignores time value of money

Market risk

*economy wide sources of risk that affect the overall capital market *"systematic risk" *CANNOT REMOVE ever *limit of diversification *measure of well diversified portfolio--only thing that matters!!

Profitability of the firm

*inconsistent with the trade off theory (it should increase leverage ratio bc a profitable firm should issue more debt but we see the opposite in reality) *consistent with pecking order

Pros of EVA

*mangers are motivated to invest in projects that earn more than cost *cost of capital is now visible to managers *leads to a decrease in assets employed

Beta

*measures the sensitivity of stock's returns to the return on market portfolio *measures the comovement of stock returns or asset with market return ** beta of market portfolio =1 **ß>1- stock is riskier than the market portfolio **ß<1- less risky

Internal Rate of Return

*the discount rate that makes NPV=0 **easier to communicate since it is a % *accept if IRR is less than the opportunity cost of capital *the larger the IRR the better *calcularte IRR for incremental CFs to use IRR

NPV

*the marginal improvement of the ability to generate future cash flows =PV- required investment =C0 + PV *use when you have UNLIMITED access to capital *take the project if NPV is positive *better than PBP because it takes uncertainty into account with discount factor

for 2 risky assets

--> correlation coefficition --> Rpand ∂p --> sharpe ratio

many risky assets- diversification

--> total risk- unique and market risk --> Beta --> CAPM: expected return of equity

Diversification

-a strategy designed to reduced risk by spreading the portfolio across many investments -can reduce ∂ below simple weighted average calculation *made possible due to the correlation coefficients (co movement) among asset returns *good since we are risk averse *reduces variability

why firms are not 100% debt financed

-bankruptcy costs -agency costs -information asymmetry -and personal tax??

stock repurchase

-flexible -tax advantaged (capital gain taxes are lower than dividend tax rates) -do not convey as much information -not a commitment to continue repurchases in later years -have increased in popularity recently due to the change in capital gain tax -buy shares on the market, tender offer, dutch auction or private negotiation (greenmail) -can be a sign that investors view shares as underpriced--its an optimistic thing -repurchase above market price shows a manager is confident in the future -> causes a rise in SP

balanced viewpoint

-good to return money to stock holders when you have excess wash and few good investment opportunities with a positive NPV -bad to return money to stockholders when you do not have excess cash and several investment opportunities that have a positive NPV

stock return

-has a normal distribution--bell shaped curve -2 parameters-> standard deviation and mean

Relative tax advantage formula (RAF) (personal and corporate taxes)

-incorporates corporate and personal taxes-- with equity income there is personal tax AND corporate tax involved -if RAF>1--> debt over equity--> does not solve problem -if RAF<1--> equity over debt--> solves problem

(1-TC)

-incorporates the benefit of tax shield -discount for bondholders -tax benefit

we discount bc of...

-inflation -impatience of consumption -uncertainty

D in (D/V)

-long term debt -can find on B/S

Capital expenses

-record capital expenditures when they occur -to determine cash flow from income add back depreciation and subtract capital expenditures

Agency cost games

-risk shifting- managers will take risky projects bc stockholder of levered firm gain when risk increases -refusing to contribute equity capital- acting out of own interest. a increase in MV is shared by bondholders and equity holders but bondholders have priority so may not get all of equity capital back as a result. -cash in and run- reluctant to put money in but happy to take money out in financial distress bc MV of firm decreases by dividend paid -playing for time-- slowing down tie to salvage what they can -bait and switch- start conservative and then suddenly switch and issue a lot more and debt now becomes risky so a capital loss on old bondholders = stockholders gain

how firms pay dividends

-set by a board of directors -declaration date--> ex dividend date (must own/sell stock before this date for dividend payment)--> record date (dividend will be paid to those registered on this date) --> payment date (checks are mailed out)

who monitors top management of public firms

-shareholders -board of directors -independent accounting firms that audit -lenders

extra info on payout policy

-some people prefer regular dividend amounts than selling small amounts of stock (especially retirees) -taxes on dividends have to be paid immediately but capital gain taxes can be deferred until shares are sold and gains are realized- the longer investors wait, the lower the PV of their tax liability -payout makes the firm's earnings more credible . -stock price will fall by the amount of the dividend on the ex-dividned date because buyers of stock on this date are not entitled to receive the dividend

Methods for making investment decisions

1) Book rate of return 2) Payback period 3) Internal Rate of Return 4) MIRR 5) NPV 6) Profitability Index (WAPI)

problems in financial management (6)

1) Capital Budgeting 2) Capital Structure 3) Return and Risk 4) Payout Policy 5) Information Asymmetry 6) Corporate Governance

using NPV rule to choose among projects (3 problems)

1) Investment timing decision 2) EAA- choice between long term and short term equip. and replacing an old machine 3) Real options

Recapitalization

1) Target leverage ratio- issue debt to retire stock --> increases firm value by increasing tax shield --> payout to shareholder 2) Issue stock to retire debt --> increase credit rating --> increase liquidity --> avoiding financial distress

Why is IRR the wrong methodology? (4 scenarios)

1) Unable to differ borrowing (inflow) from lending (outflow) 2) ?? Needs to solve quadratic or higher order equations which may have no or multiple solutions (multiple rates of return)-cash flows generate NPV=0 at 2 different discount rates- more than one change in the sign of CF?? 3) Ignores the magnitude of cash flows (mutually exclusive projects- "either or" decision) 4) Assumes all cash flows received during the life time of the project can be reinvested at the IRR, not the rate of return on asset (more than one opportunity cost of capital)

if only corporate tax is considered

1) Vl= Vu + TcD 2) optimal leverage ratio is 100% dec financed--> the more you borrow, the more tax shield you have 3) WACC= rd x (1-Tc) X (D/V) + Re x (E/V)

finding price after announcement (step 3)

1) Vu=(P x shares outstanding +Dl)- DlTc +Prob(FD) x Cost (FD) 2) Vl'= Vu= D'Tc-Prob'(FD) x Cost (FD) 3) El= Vl'-Dl' 4) Shares Outstading'= Shares outstanding + E issued/P issued 5) P'= El'/ shares outstanding'

Good reasons to pay diviends

1) clientele effect (rightists) 2) signaling theory 3) the wealth appropriation story

If there is no tax difference between dividends and capital gain

1) companies can issue stock at no cost to raise equity whenever needed (no information asymmetry) 2) there is no agency costs so dividends do not matter and the payout policy does not affect value -the price change will equal the dividend

2 ways to compare the performance of a division or plant

1) compare ROI with cost of capital *ROI= the ratio of after tax operating income to the net (depreciated) BV of assets 2)EVA- calculates the net dollar return to shareholders and is finding the earnings after deducting a charge for COC *EVA= NI after deducting the dollar return required by investors *EVA= residual income *can improve EVA by increasing earnings or decreasing capital employed

Corporate Governance Mechanisms- Monitoring

1) compensation- incentive and pay- target bonus (performance based), long therm incentive plans (stock and grant options) and base salary 2) shareholders 3) board of directors--> Sarbanes Oxley Act (67% of board must be independent) 4) Rival Companies--> take over market- can still be a mechanism even if this fails bc it serves as a wakeup call 5) Public Media--> repetitional capital (human capital) at stake-- affects your likelihood of becoming manager and your salary 6) Auditors- monitor a firms misconduct and ensures there is consistency with GAAP. *conflict of interest here* ?? 7) Lenders- bank tracks a company's assets, earnings and cash flows when companies takes out a loan--> monitoring the behavior and performance of corporate managers

payout policy facts

1) dividends are sticky and repurchases are flexible 2) the tax difference between dividend income and capital gain affects payout decisions 3) managers are reluctant to change the level of dividends and believe there is a cost of dividend cut > financing cut --> these facts go against the pecking order theory?

Bad reasons for paying dividends???

1) dividends now are more certain than capital gains later-- you need to compare appropriation price today and the dividend price. The stock price will decrease on the ex- dividend date. 2) the firm has excess cash on its hands this year, no investment projects and wants to give money back to shareholders--- the firm must consider future financing needs and cost of raising new financing in the future can be staggering

Finding the loss imposed to shareholders by the capital constraint (part of WAPI question)

1) find change in value without capital constraint- add up all investments 2) find change in value with constraint-?? 3) find the loss= change without constraint- change with constraint **the loss is the opportunity cost imposted by the constraint to shareholders

our investment decisions are driven by

1) greed--> non satiation of wants-- we always want more! 2) feer-->risk aversion- we pay more attention to the negative realization of the world

payout policy resolves 2 questions

1) how much cash should the corporation pay out to its shareholders? (**this decision should change over the life cycle of the firm) 2) how should this cash be distributed? by cash dividends or stock repurchases? ---> the goal is to maximize value

problems we face with investment decision

1) investment timing 2) long term vs short term 3) replacement decision 4) cost of excess capital

3 point of views

1) investors pay more for firms with generous and stable dividends (the rightists saying dividends increase value) 2) repurchases are better because it means higher stock price and less taxes 3) the choice between dividends and repurchases has no effect on value

the capital structure theory should

1) lead us to the optimal leverage ratio 2) by consistent with internal > debt > equity

themes of dividends and repurchases

1) managers are reluctant to make a dividend change that may have to be reversed. they would have to issue shares or motor to maintain a dividend if worried about rescinding a dividend increase 2) mangers "smooth" dividends- meaning they are promising to keep paying dividends. A change in transitionary earnings is not likely to affect dividends. Follow shifts in long run and sustainable earnings. 3) focus more on dividend changes than absolute dividend levels--> a change in dividends is an indicator of sustainability of earnings

power of stockholders at annual meetings is diluted by

1) most small stockholders do not go because the cost of going > their value in their holdings 2) Incumbent management has an advantage- proxies that are not opted become votes for incumbent management *If you do not vote, your vote goes to management (40% of shareholders do not vote) *need 41% of ownership to make a change in a firm 3) ?? large shareholders vote with their feet when confronted by managers that they do not like bc this is the lest resistant path?? * annual meetings are tightly scripted so it is difficult for outsiders and rebels to bring up issues that management does not like

Modigliani and Miller Assumptions (4)

1) no tax 2) no bankruptcy costs 3) no agency costs 4) no information asymmetry **assuming a perfect world/market-- so financing decisions do not matter**

NPV method (DCF analysis)

1) only cash flow is relevant- capital expenses ( tax shield from depreciation) & change of net working capital 2) think at the margin- all items (taxes, SV, incidental effects, opportunity costs) should reflect incremental cash flows that are caused by taking on the new project 3) Pay attention to opportunity costs 4) Ignore sunk costs and allocated overhead costs 5) treat inflation consistently- discount nominal cash flows using nominal discount rate and discount real cash flows using real discount rate

Roles of financial markets and intermediaries (4 roles)

1) payment mechanism- make and receive payments quickly over long distances (checking accounts, credit cards, electronic transactions) 2) borrowing & lending- channels savings towards those who can best use them (individuals) so company can focus and separate its time on firm and investors 3) Pooling risk- allowing individuals to share the risk (insurance companies) 4) information exchange- allows estimation of expected rates of return

2 factors to predict for assets

1) price movement 2) diversification

Agency problems (when managers are aware they are not acting in the best interest of shareholders)

1) reduced effort 2) perks or private benefits (entertainment, travel costs, etc) 3) empire building- want to increase the size because it is related to their compensation plans and want more power but larger size does not mean higher value. 4) excessive risk taking due to stock option- very risk. could be worth a lot if the stock price increases for a call option but worthless if the stock price decreases 5) gambling for redemption- when a manager's job is on the line- can take a lot of risk so if it goes well, they keep join and get returns but if it is bad, the consequences go to their successor

Quality of board of directions depends on...

1) size (should be small) 2) independent (should be mostly independent members) 3) CEO/Chairman duality (CEO should not be Chairman)

4 main factors of capital structure

1) size--> increases leverage ratio as it increases 2) tangible assets--> increases leverage ratio as it increases 3)**profitability of firm--> decreases leverage ratio as it increases 4) market to book ratio--> decreases leverage ratio as it increases

how to solve PI ???

1) solve PI 2) determine possible combination of projects for amount (gets you to amount or close to it but CANNOT EXCEED) 3) calculated the weighted average PI for each combo **WAPI= Project A invst/capital *PI for A + Project B invst/capital * PI for B 4) choose the best PI

surplus cash if....

1) the company is generating positive free cash flow after making all investments with positive NPV and CF is expected to continue 2) the firm's debt ratio is prudent (well advised) - there will be top priority to pay down debt of the ratio is too high 3) if the company's cash holdings are a sufficient cushion for set backs and unexpected opportunities

M&M Theory (3)

1) the market value of a firm does not depend on the firm's leverage or capital structure. (*leverage is independent of firm value) so there is NO OPTIMAL LEVERAGE RATIO --> VU=VL 2) a firm's return on equity and return on debt are positively correlated to its leverage (as leverage increases, risk increases so RE and RD increase) *RE increases just enough to keep up WACC constant *does not increase shareholder value 3) A firm's return on asset (COC) is independent of its leverage--> Ra is constant! *in a perfect world- Ra= D/Vrd + E/Vre **only impact leverage has on a firm is the risk!!!

Measures of volatility

1) variance (∂^2) 2) standard deviation (∂)

Value of a levered firm (for 100% debt financed and perfect world so corporate tax is involved)

= Vu + PV(tax shield) = Vu + TCd

dividend payout

= dividends/NI - measures the percent of earnings a company pays in dividends but cannot be computed if the NI is negative

Profitability Index (PI)

= how much you can invest for each dollar invested =NPV/investment *tool for selecting between project combinations and alternatives *set of limited resources and projects can yield various combinations *use when there is LIMITED access to capital *take the combination that yields the largest WAPI (hard rationing) *the optimal project is the one with the highest WAPI *weight is determined by the investment

increase borrowing...

= increased expected return

EVA

= residual income -the economic value added -attempts to overcome errors in accounting measurements of performance -emphasizes NPV over accounting standards -more long term -more closely tracks shareholder value -what managers compensation is based off of so its linked to performance

total risk of an asset

= unique risk + market risk

Economic Profit

=(ROI-r) x capital invested

beta of market portfolio

=1

book leverage ratio

=BV of debt/ BV of debt + BV of equity =debt/total assets

Security market line

=CAMP=Er= rf+ß(rm-rf) =opportunity cost of capital if opportunity cost >expected return then NPV is negative

Depreciation

=Capex/years *not a cash flow *just an accounting number that reduces taxes *the tax reduced (tax shield) by depreciation is a cash flow *first subtract depreciation from operating cash flows to calculate the tax payment, and then addd it back afterwards

Net Working Capital

=ST assets - liabilities =AR-AP+ Inventory *only CHANGE of NWC between 2 periods is cash flow relevant * reflects incremental investment (incremental cash outflows) in NWC *NWC is static bc its a B/S item

Clientele Effect ????

=a theory that explains how a company's stock price will move according to the demands and goals of investors in reaction to a tax, a dividend or another policy change --investors in your company like dividends so clients increase the price of stock through demand for dividend paying stock?? - investors in your company may form clients based on their tax brackets--> study found that senior investors and poorer investors both tended to hold high dividend stocks -investors have different perceptions of riskiness of dividends and retained earnings -investors are indifferent to returns from dividends and capital gains * age is positively correlated (older investors pay higher dividends) *income is negatively correlated *high Beta stock is correlated to lower dividends

financial intermediaries

=an organization that raises money from investors and provides financing -helps firm save or borrow money - banks, insurance companies and investment funds *important source of financing for corporations bc it channels savings to investments

Book rate of return

=average income/avg book value over project life =book income/book assets =accounting rate of return *reflects tax and accounting figures, not MV or cash flows *the larger the BRR, the better --> wrong method bc accountants make numbers tricky to avoid taxes

dividend yield

=dividends per share/ stock price -measures the return that an investor can make from dividends alone *becomes part of the expected return on the investment

Pecking order (info asymmetry)

=firms prefer to issue debt over equity if internal finances are insufficient *we are risk averse so we assume mangers are hiding something- info asymmetry *less information is available with debt so this is why we prefer internal financing>external financing *but if internal is insufficient, debt is better than equity because there are less discounts with debt and the value with debt is more certain--> info asymmetry has less of an impact as a result *issuing safest security first (debt)-> convertible bond --> equity *Financial slack is valuable bc without it companies could be at the bottom of the pecking order and be forced to issue overvalued stock *to show changes in capital market

Financial Slack

=having cash, marketable securities, readily stable real assets and readily access to debt markets or bank financing =Extra money that a company has available in case of a downturn in sales, revenue, or profit *need this so financing is quickly available for good investments *can make agency problems worse *most value comes from capital investments and operating decisions. Less from financing!!

standard deviation

=how concentrated numbers are around the mean =how spread out numbers are *low SD= more concentrated= less risk so less negative return *objective **can measure risk when we only have 1 asset ** dont change to decimal for variance calculation

ROI

=income/ net assets

Equivalent Annual Annuity (EAA)

=r*NPV/ 1-(1+r)^-n *used to annualize NPV *comparing 2 projects with different time frames *if CF are future cash inflows- choose larger EAA *if CF are future cash outflows (operating costs)- choose smaller EAA **steps- NPV, EAA, Choose *Using NPV allows us to compare with EAA

Rd

=return on debt =cost of debt? -long term borrowing rate -find from corporate ratings

Re

=return on equity =cost of equity -can find from CAPM

correlation coefficient

=the co movement of 2 asset prices =P12 *always between negative 1 and positive 1 *optimal amount= -1--> greatest power of diversification *we can only diversify if 2 numbers move up/down differently (<1) *if i= +1--> no diversification/ power of diversification because they are moving together now so no comovement *keep adding assets to portfolio as long as P12 <1 *=1 if they are wholly unrelated

WACC

=the expected rate of return on the MV of all firm's securities *captures the value of interest tax shields because it uses the after tax cost of debt *most appropriate discount rate to use in the future- for projects just like firm *based on a firm's current characteristics *used to discount future cash flows *more accurate when business risk and debt ratio are constant *want WACC low to max NPV*

Payback Period

=the number of years before cumulative cash flow equals initial outlaw *only accept projects that pay back within a desired time frame *ignores later cash flows and PV of future cash flows- ignoring timing of CF with period and later CF entirely *does not take opportunity cost into account *the sooner, the better

Info Asymmetry

=transactions where one party has more or better information than the other. This creates an imbalance of power in transactions, which can sometimes cause the transactions to go awry, a kind of market failure in the worst case *present whenever one party to an economic transaction possesses greater material knowledge than the other party *managers know more about their companies than investors, implying the price of securities is not always equal to the value of a firm

financial markets

=where financial assets are issued and traded -allows investors to trade among themselves *used to raise money through primary issues *helps firms manage risks

NPV formula

=£ FCFt/ (1+r)^t --> FCF are the resources --> t is the time --> r is the uncertainty/ discount rate

market leverage ratio

BV of debt/ BV of debt + MV of equity **better ratio bc it includes the MV of equity**

Opportunity Cost

Cash inflows forgone because of taking the new project

The signaling story

Dividends can be signals to the market that you believe that you have good cash flow prospects in the future and is a signal fortune. -the market uses dividend announcements as information of assessing the firm value (decrease= bad, increase= good) -only increase dividend if you are confident you can maintain this level

finding price at announcement (step 2)

E(=price*shares outstanding) + ∆V/ Shares outstanding

Beta measuring a contribution to the overall portfolio risk...

In the context of a well-diversified portfolio, the only risk characteristic of a single security that matters is the security's contribution to the overall portfolio risk. This contribution is measured by beta

How to determine if transaction of equity to debt exchange should go through

P issue > P' > P ann ((Prince ann > SP of equity for equity transaction to go through)))

CAPM

Rf + ß( rm-rf) ***discount rate if a firm is 100% equity financed

Agency problems when managers are not aware

There is an incentive to bypass problems -too many projects for top management to analyze -details are beyond the view of executives -small decisions add up -executives are subject to human error -overconfidence

dividend

a form of the payout policy. managers tend to smooth dividends, meaning they rarely increase or decrease dividends. -sticky -more stable than repurchases (fell less during crisis) -double taxed-- you should try and pay as lowest dividend as possible -a increase is a good sign because you should only increase a dividend if you are confident you can maintain this amount -focus on CHANGE in dividends!! --> cash dividend, regular cash dividend, special cash dividend or stock dividend

Corporation

a nexus of contracts between different parties -the value is derived from its ability to generate future cash flow

Why is BRR method wrong?

accountants make numbers tricky to avoid taxes -it is also calculated on accounting numbers which are no cash flow relevant- depreciation is not a cash flow but it can cause a big change in BRR

Modified Internal Rate of Return (MIRR)

assumes that positive cash flows are reinvested at the firm's cost of capital and the initial outlays are financed at the firm's financing cost *more accurately reflects the cost and profitability of a project *gives a more realistic evaluation of the project *the larger, the better *FV (+)--> inflows *PV (-)--> outflows *solves pitfall 1, 2, 4

greenmail

buying a voting stake in a company (buying a lot or shares) with the threat of a hostile takeover so the target company is forced to buyback the stake at a premium

market portfolio risk (rm)

can find on the stock market index (S&P 500) *cannot get rid of this **measure of risk for a well diversified portfolio

Costs of financial distress

costs arising from bankruptcy (legal and accounting fees) and distorted business decisions before bankruptcy (due to agency costs between equity and debt holders)

why debt > equity

debt does not get to participate in the upside of the business but interest payments are treated as a cost so they are deducted from taxable income and interest is paid from before tax income. --> return to bondholders escape taxation at corporate level so total income is higher

increase ROI by??

decreasing assets under management and increasing NI

if dividends are taxed higher than capital gains

dividends > price change - better to be 100% repurchases in this case

if dividends create a tax disadvantage for investors (relative to share repurchases)

dividends are bad and increasing dividends will decrease value -best payout policy is 0% dividends and 100% repurchases

if stockholders like dividends (clientele effect) or dividends operate as a sign of future prospects (signaling effort)

dividends are good and increasing dividends will increase value

The wealth appropriation story

dividends are one way of transferring wealth from lenders to equity investors -this is good for equity investors but and for lenders--> there is a conflict of interest for stockholders and bondholders!

relationship between leverage, risk and beta

high leverage= high risk= high beta

Relationship between risk and leverage

higher leverage= higher risk

M&M theory

in a perfect world (no tax, information asymmetry and agency costs) the choice between dividend and shares repurchase has no effect on firm value. --> payout policy and dividend income is independent of firm value so the payout policy does not matter

When optimal capital structure is 100% debt financing

in a world with no bankruptcy costs, agency costs, no information asymmetry but TAX (corporate) *cost of debt is lower than cost of equity after tax WACC bc no corporate tax on debt?

Why is Payback Period method wrong?

it does not focus on future cash flows so it is ignoring large cash flows far back in the future **ignores TVM

Direct bankruptcy costs

legal and administrative fees

low beta

less the risk

how to unlever Beta

levered beta/ 1 + (1-Tc x D/E)

Rf, Rm and other Rf in CAPM

long term treasury bond= Rf 1 historical S&P return= Rm historical government bond= Rf2 ß= the unlevered amount by taking average of peers

Real Options

managements ability to alter investments *gives you options to do something at a specific price at a specific price *has value so you should be able to create future cash flows - option to expand (R&D) -option to abandon (outsourcing) -timing option (purchasing land ahead of time) -flexible production facilities (temporary workers)

ß of 1

market risk

investors demand higher expected rates of return on stocks with....

more non diversifiable risk (not variable)

if financing at 50% margin

now having to invest 2x as much as before so risk is now twice as much--> multiply ∂ by 2

what do dividend amounts depend on

past dividends + current and forecasted earnings

Market portfolio

portfolio of all assets in the economy -usually uses a broad stock market index to represent value -finding a proxy of market portfolio

Indirect bankruptcy costs

possible delays in liquidation, poor investment or operating decisions, threat of bankruptcy

if dividends are taxed lower than capital gains

price change > dividends

when you sell an asset

price decreases and return increases

ß of 0

risk free rate

Agency costs

separation of ownership and management -will always have agency costs because of non satiation wants and risk aversion -less agency costs when managers (agents) have more stake in the company

high beta

stock is riskier than the market portfolio (riskier)

WAPI (if combination leaves a remanning amount)

sum of the (weighted investment for projects (investment of project/total investment) x PI and repeat for project 2 then +unused fund/total investment x 0)

Financial Management

the allocation of resources under uncertainty through time

Risk

the inaccuracy of predicting future outcome *investors are risk averse ad dislike risk and shall be compensated for taking more risk *higher risk= higher return = lower prices

Mean

the location of the most likely case

E (in E/V)

the market value of equity =price x shares outstanding

sharpe ratio

the ratio of risk premium to standard deviation *trade off between risk and reward *want this to be HIGH so you are compensated more =for 1 unit of risk, how much are we compensated for

risk premium

the return in excess of the risk free rate

PV (tax shield)

the sum of PV of all future tax savings due to interest payments -not specific to a company -same level of debt forever -the more you borrow, the more tax shield you have (more borrowing = lower taxes) -increases after tax value

How firms raise funds

through internal financing (RE) and external financing (debt + equity) ***internal financing > debt financing > equity financing***

why dividend ( under m&m?)

to assure stockholders will run a tight ship, paying out free cash flow to limit temptation for careless spending *this commitment to financial discipline can outweigh the tax costs of dividends

why shares repurchase ( under m&m?)

to retain flexibility to cut back payout if value investment opportunities rises.

V

total debt + total equity

Objective of financial managers

tp maximize the value of shareholder's wealth *with an efficient (well functioning) financial market, shareholders can modify their pattern of consumption through borrowing and lending and match their risk preferences

risk free rate (rf)

treasury bond

for 1 risky asset

use standard deviation and mean -confidence internal

fraction of money invested in each asset

x1 & x2 (for E(rp))

if a firm is well diversified the SD of a portfolio depends on

ß and ∂ of market porfolio

finding change in value (step 1)

∆V = Vl' - Vl --> [D'Tc-Prob'(FD)xCost(FD)]-[DTc-Prob(FD)xCost(FD)] **the ∆V is reflected at announcement-- market efficiency?