Finance 300 Exam 3 Concept Questions

How many times did large-company stocks return greater than 30%? Less than negative 20%?

20, 5

With normal distribution, what is the probability of ending up with more than one standard deviation below average?

5%

What is the second lesson from capital marketing history?

Bearing risk is rewarded, but in a given year, there is a significant chance of a dramatic change in value. The greater the potential reward the greater is the risk

What are some of the claims to a firm's cash flows?

Bondholder, stockholder, bankruptcy, tax

How can cost of preferred stock be calculated?

D/P0 (where D=fixed dividend)

In words, how do we calculate the variance of the expected return?

First, you find the deviation between the actual return and expected return. Second, you square the deviation. Third, you multiply the squared deviation by the probability of the state of economy and add the products together for the final variance.

What is the difference between a dollar return and percentage return? Why are percentage returns more convenient?

For each dollar invested you get an amount back in dividends. One is the percentage of a payment. It is easier to summarize information about returns in percentage terms because that way your return doesn't depend on how much you actually invest

Why are unrealized capital gains or losses included in the calculation of returns?

If you sold the stock at the end of the ear, the total amount of cash you would have would be your initial investment plus the total return

Why do we multiply cost of debt by (1-Tc) when we compute WACC?

Interest paid to bondholders is tax deductible. We multiply the cost of debt by (1-Tc) to factor in the portion of the interest that the government pays. This is the post-tax cost of debt.

What is the difference between a marketed claim and a nonmarketed claim?

Marketed claims can be bought and sold in financial markets, nonmarketed claims cannot

How often did the T-bill portfolio have a negative return?

Never!

Do U.S. corporations rely heavily on debt financing?

No

Is there a simple relationship between the standard deviation on a portfolio and the standard deviation of the assets in the portfolio?

No!

How do we calculate the expected return on a portfolio?

Sum of each individual portfolio weight multiplied by that assets expected return

What was nominal risk premium on corporate bonds? Real risk premium?

The nominal risk premium is the difference between real risk premium on corporate bond and the historical nominal rate. The real risk premium is the expected inflation rate on the corporate bonds over the life of the bond.

Smallest return over those 91 years for each investment? Approximately when did it occur?

The smallest return for large company stocks was below -40. For small company, it was below -50. The smallest return for bonds and bills is almost -10. For treasury bills it was close to 0.

What is the first lesson from capital market history?

There is reward for bearing risk!

Why do we adjust a firm's taxes when we do a firm's valuation?

To removed the effects of debt financing. Debt financing causes a reduction in taxes due to interest paid which is tax deductible

Why might we prefer to use a ratio when calculating terminal value when we do firm valuation?

Using a ratio allows for the comparison of different firm valuations

How is the WACC calculated?

WACC = (E/V) Re + (D/V) Rd (1-Tc) (If the firm is financed by preferred stock, then the product of the cost of preferred stock and its capital structure weight must be added to the equation)

What are the three determinants of a firm's cost of equity?

WACC, cost of debt, debt-equity ratio

What is the security market line? Why must all assets plot directly on the SML in well-functioning markets?

a positively sloped straight line displaying the relationship between expected return and beta in a well-functioning market, a market portfolio is made up of all these assets, so all the assets must plot on the SML

What regularities do we observe in capital structure?

a) U.S. firms don't rely heavily on debts. In fact, they pay a large amount in taxes. This reflects that there is some restriction in using debt financing (through which interest tax shield can be enjoyed) b) The use of debt financing is varied across different industries. Firms' assets and operations in one industry is different from other industry and accordingly, the use of debt financing is different.

If investment has a positive NPV, would it plot above or below the SML? Why?

above expected return exceeds what is offered in financial markets for the same risk

What is the APR?

absolute priority rule - the rule establishing priority of claims in liquidation

If we consider only the effect of taxes, what is the optimal capital structure?

all debt firm

What does beta coefficient measure?

amount of systematic risk present in a particular risky asset relative to that in an average asset (1 is average)

What stock market is going to do over next century --> geometric or arithmetic?

arithmetic

In words, how do we calculate a variance? A standard deviation?

average squared distance between actual and average return - Square all of the deviations, add up the squares, divide the returns by the number of returns less than 1.

The total systematic risk of a firm has two parts. What are they?

business risk and financial risk

How can cost of debt be calculated?

by observing the current interest rate the firm must pay on new borrowing or the interest rate on similarly rated bonds

What is CAPM? What does it tell us about the required return on a risky investment?

capital asset pricing model tells us the pure TVM (Rf), reward for bearing systematic risk (E[Rm]-Rf), and the amount of systematic risk (beta)

What are indirect bankruptcy costs?

costs of avoiding a bankruptcy filing incurred by a financially distressed firm

What are direct bankruptcy costs?

costs that are directly associated with bankruptcy, such as legal and administrative expense

What happens to the standard deviation of return of the portfolio if we increase the number of securities in the portfolio?

decreases

What are the two approaches to estimating cost of equity capital?

dividend growth model (Re= (D1/P0)+g) and SML approach (Re=Rf+beta(Rm-Rf))

What are the two parts of total return?

dividend yield and capital gains uield

What do we mean when we say a corporation's costs of equity capital is 16%?

equity investors require a 16% return on their investment

What is the relationship between required return and cost of capital associated with an investment?

essentially the same - the required return is what the firm must earn to compensate the investors for their use of capital required to finance the project

What is the real (not nominal) risk premium on common stock portfolio?

expected rate on the common stock portfolio over the life of the portfolio

What are the two basic parts of a return?

expected return and unexpected return

What is the systematic risk principle?

expected return on a risky asset depends only on that asset's systematic risk

What do we mean by "excessive return" and "risk premium?"

extra money required from an investment in a risky asset over that required from a risk-free asset (compensation for risk)

True or False: Expected return on a risky asset depends on the asset's total risk. Explain.

false - the expected return depends on that asset's systematic risk only

*What is the impact of financial leverage on stockholders?

financial leverage can dramatically alter the payoffs to shareholders in the firm

What stock market is going to do over next year --> geometric or arithmetic?

geometric

Under what conditions will a company's announcement have no effect on common stock prices?

if the effects of the announcement have been expected or predicted accurately

Why might firms prefer not to issue new equity?

if you try to raise money by selling equity, you run the risk of signaling to investors that the price is too high

Under the pecking-order theory, what is the order in which firms will obtain financing?

internal financing, issue debt, sell equity at last resort

Why is Trans Am's capital structure irrelevant?

investors can always increase financial leverage themselves to create a different pattern of payoffs. It makes no difference whether Trans Am chooses the proposed capital structure.

Why can't systematic risk be diversified away?

it affects almost every asset to some degree (GDP or interest rate change)

With 20/20 hindsight, what do you say was the best investment for the period from 1926 through 1935?

large company stocks, then small company stocks

What are the important factors in making capital structure decisions?

marginal costs (due to distress and bankruptcy) and marginal benefits (due to tax savings due to interest deductibility)

What is an efficient market?

market in which security prices reflect available information

Why is the coupon rate a bad estimate of a firm's cost of debt?

measures what the firm's initial cost of debt, not the current cost or yield

What is meant by the term "cost of capital?"

minimum required return on new investment (opportunity cost associated with firm's capital investment)

How do you calculate a portfolio beta?

multiply each asset's beta by portfolio weight

What are some differences in implications of the static and pecking-order theories?

pecking-order more concerned with shorter-run, tactical issue of raising external funds to finance investments (static theory is more long-run financial goals or strategies)

What is a portfolio's weight?

percentage of portfolio's total value that is invested in particular asset

Why should financial managers choose a capital structure that maximizes the value of a firm?

principal goal of finance

Why doesn't everyone just buy small stocks as investments?

risk!

What is the fundamental relationship between risk and reward in well-functioning markets?

risk-to-reward ratio must be the same for all assets in the market

What is the principle of diversification?

spreading an investment across a number of assets will eliminate some, but not all, of the risk

What are the forms of market efficiency?

strong (all info of every kind is reflected in stock prices), semi-strong (all public info reflected in stock prices), weak (at minimum, current price of stock reflects stock's own past prices)

How do we calculate the expected return on a security?

sum of possible returns multiplied by their probabilities

What are the two basic types of risk?

systematic (risk that influences a large number of assets, also called "market risk") & unsystematic (risk that affects at most a small number of assets, also called "unique" or "asset-specific" risk)

What is the distinction between the two types of risk?

systematic affects nearly all assets while unsystematic only affects a small number

What is an optimal capital structure?

the chief goal of any corporate finance department find the optimal capital structure that will result in the lowest WACC and the maximum value of the company

What is the difference between liquidation and reorganization?

the debtor keeps most of his property in reorganization

Why is some risk diversifiable? Why is some not?

the effects of events on certain assets have a cancelling out effect, meaning more diverse assets cancel out each other's risk systematic risk cannot be diversified and is the minimum level of risk (asymptote)

Under what conditions is it correct to use WACC to determine NPV?

the proposed investment is a replica of the firm's existing operations or if the investment is closely related to the firm's operations

What are flotation costs?

the transaction cost incurred when a firm issues new stocks or bonds to finance projects

What is the primary determinant of cost of capital for investment?

the use of funds (not the source)

What is homemade leverage?

the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed

What does M&M proposition I state?

the value of the firm is independent of the firm's capital structure

What are likely consequences if a firm uses WACC to evaluate all proposed investments?

they will have a tendency to both accept unprofitable investments and become increasingly risky

What does the extended pie model say about the value of all the claims to a firm's cash flows?

total value of all the claims to a firm's cash flows is unaltered by capital structure

Can you describe the trade-off that defines the static theory of capital structure?

tries to balance the costs of financial distress with the tax shield benefit from using debt

How are flotation costs included in NPV analysis?

true cost of funding the new plant [x/(1-fa)] is deducted from the project's PV of cash flows giving the true NPV of the project

What is the pure play approach? When might it be used?

use of a WACC unique to a particular project based on companies in similar lines of business useful when you can find a suitable company

What is the relationship between WACC and the value of a firm?

value of the firm is maximized when the WACC is minimized

What is the relationship between the value of an unlevered firm and the value of a levered firm once we consider the effect of corporate taxes?

value of the levered firm is equal to the value of the unlevered firm plus the present value of the interest tax shield