Finance Final Chapters 10-15

seasoned equity offering (SEO)

A new equity issue of securities by a company that has previously issued securities to the public

systematic risk

A risk that influences a large number of assets aka market risk because they have marketwide effects ex: uncertainties about general economic conditions, such as GDP, interest rates, or inflation

extra cash dividend

a dividend that indicates that this part may or may not be repeated in the future

portfolio

a group of assets such as stocks and bonds held by an investor combining assets into portfolios can substantially alter the risks faced by the investor

syndicate

a group of underwriters formed to share the risk and to help sell an issue

prospectus

a legal document describing details of the issuing corporation and the proposed offering to potential investors

bankruptcy

a legal proceeding for liquidating or reorganizing a business, the transfer of some or all of a firm's assets to its creditors

letter of comment

a letter the SEC sends if changes need to be made to the registration statement, 20 day waiting period restarts if this is sent back

one capital structure is better than another is it results in ________

a lower WACC

dividend

a payment made out of a firm's earnings to its owners, in the form of either cash or stock

discounted the announcement

an announcement isn't news to the market has less impact on the market because the market already knew much of it

dividend policy by itself ______ raise the dividend at one date while keeping it the same at all other dates

cannot dividend policy merely establishes the trade-off between dividends at one date and dividends at another date

if there are no imperfections _____ and _____ are essentially the same things

cash dividend, share repurchasing *yet another example of the irrelevance of dividend policy*

year-to-year percentage change in CPI (Consumer Price Index)

commonly used measure of inflation so that we can calculate real returns using this as the inflation rate

systematic risk and _________ are used interchangeably

nondiversifiable risk no matter how many assets you put into a portfolio the systematic risk does non go away

a cash dividend payment reduces corporate cash and retained earnings except in the case of ______

liquidating dividends

most corporation seem to have relatively ______ debt-equity ratios and much ______ debt financing than equity financing

low, less

we should use _____ is available but ______ for debt and equity would be better than nothing, but should be taken with a grain of salt

market values, accounting values

calculate a portfolios beta

multiply each assets beta by its portfolio weight and then add the results up

stock prices tend to decline following the announcement of __________, although they tend to not change much following a _______ announcement

new equity issue, debt

lockup agreement

the part of the underwriting contract that specifies how long insiders must wait after an IPO before they can sell stock once this expires there is the possibility that a large number of shares will hit the market on the same day and thereby depress values

capital structure

the particular mixture of debt and equity a firm chooses to employ a managerial variable

portfolio weight

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

capital structure weights

the percentages of the total capital represented by the debt and equity

standard deviation

the positive square root of the variance

aftertax interest rate equals

the pretax rate multiplied by 1 minus the tax rate

in an efficient market _____

the price of a stock adjusts immediately to the new information and no further changes in the price of the stock take place

overreaction and adjustment

the price over adjusts to the new information; it overshoots the new price and subsequently corrects

trading range

the price range between the highest and lowest prices at which a stock is typically traded when the security is priced above this level many investors do not have the funds to buy the common trading unit of 100 shares (called a round lot) thus firms will split the stock to keep the price within the range

book building

the process of soliciting information about the buyers and the prices an quantities they would demand

arithmetic average return

the return earned in an average year over a multiyear period answers the question what was your return in an average year over a particular period tells you what you earned in a typical year

cost of equity

the return that equity investors require on their investment in the firm there is no way of directly observing the return that the firm's equity investors require on their investment

cost of debt

the return that lenders require on the firm's debt can be observed directly or indirectly because it is simply the internet rate the firm must pay on new borrowing and interest rates can be observed in the financial market

the cost of capital for a risk free investment is ______

the risk free rate

the cost of capital associated with an investment depends on ________

the risk of that investment

interest tax shield

the tax saving attained by a firm from interest expense

accounting insolvency

Firms with negative net worth are insolvent on the books. This happens when the total book liabilities exceed the book value of the total assets

repurchase

Refers to a firm's purchase of its own stock; an alternative to a cash dividend. exploded in the past two decades during the recession firms stopped to conserve cash

shelf registration

Registration permitted by SEC Rule 415, which allows a company to register all issues it expects to sell within two years at one time, with subsequent sales at any time within those two years

market risk premium

Slope of the security market line; the difference between the expected return on a market portfolio and the risk-free rate.

innovation or surprise

The difference between the actual result and the forecast U is used as the symbol

dutch auction underwriting

The type of underwriting in which the offer price is set based on competitive bidding by investors. Also known as a uniform price auction. common in bond markets

Large company stocks

This common stock portfolio is based on the Standard & Poor's (S&P) 500 index, which contains 500 of the largest companies (in terms of total market value of outstanding stock) in the United States.

business failure

This term is usually used to refer to a situation in which a business has terminated with a loss to creditors; but even an all-equity firm can fail.

pure play approach

Use of a weighted average cost of capital that is unique to a particular project, based on companies in similar lines of business. the issue with this may be that we ,may not be able to find suitable companies

regular cash dividends

a cash payment made by a firm to its owners in the normal course of business, usually paid four times a year

pure play

a company that focuses on a single line of business

initial public offering (IPO)

a company's first equity issue made available to the public aka unseasoned new issue

green shoe provision

a contract provision giving the underwriter the option to purchase additional shares from the issuer at the offering price, aka over allotment option

efficient capital market

a market in which security prices reflect available information

stock dividend

a payment made by a firm to its owners in the form of stock, diluting the value of each share outstanding commonly expressed as a percentage ex: a 20% stock dividend means that a shareholder receives one new share for every 5 currently owned

small company stocks

a portfolio composed of stock of smaller companies, where small corresponds to the smallest 20% of the companies listed in the NYSE again measured by market value of outstanding stock aka small cap for small capitalization

strong form efficient

all information of every kind is reflected in stock prices, there is no such thing as inside information

semi strong form efficient

all public information is reflected in the stock price controversial because it implies that security analysts who try to identify misplaced stocks are wasting their time because that information is already reflected in the current price

tombstone

an advertisement announcing a public offering

if the portfolio is representative of all the assets in the market it must have _______

average systematic risk or beta of 1.0

US treasury bills

based on treasury bills or t-bills with one month maturity

no matter what pattern of dividend payout the form chooses the value of the stock will _____

be the same

_______ have strong incentive to seek bankruptcy to protect their interests and keep stockholders form further dissipating the assets of the firm

bondholders

fundamental relationship between risk and return

buying and selling would continue until the two assets plotted on exactly the same line, which means they would off the same reward for bearing the same risk

spread

compensation to the underwriter, determined by the difference between the underwriter's buying price and offering price sometimes will be non cash in the form of warrants and stock in addition to the spread

ex-dividend date

date 2 business days before the date of record, establishing those individuals entitled to a dividend

date of record

date by which holders must be on record to receive a dividend

the standard deviation _______ as the number of securities increases

declines

term loans

direct business loans of typically one to five years

unsystematic risk and __________ are used interchangeably

diversifiable risk

total dollar return equals

dividend income + capital gain/loss

percentage return equals

dividend yield + capital gains yield

cost of preferred stock equals

dividend yield on the preferred stock fixed dividend divided by current price per share

share repurchase causes _____ to increase

earnings per share this reasons is it reduces the shares available

unsystematic risk is essentially _______ by diversification

eliminated (a relatively large portfolio has essentially no unsystematic risk)

expected return on a security or other asset

equal to the sum of the possible returns multiplied by their probabilities

_________ of the issuing form are not helped by underpricing

existing shareholders

on average actual return equals ______

expected return

venture capital

financing for new, often high-risk ventures

the costs of financial distress depend primarily on the ________

firms assets

negotiated offer

firms negotiated directly with an underwriter usually do new issues of debt and equity on this basis

legal bankruptcy

firms or creditors bring petitions to a federal court for bankruptcy

dividend yield says

for each dollar we invest we get X in dividends

quiet period

from the time a company begins to seriously an IPO until 40 calendar days following an IPO all communications with the public must be limited to ordinary announcements and other purely factual matters SEC's logic is that all relevant information should be contains in the prospectus

if you are doing a very long forecast covering many decades then you should use _______

geometric average

assets with larger betas have ___________

greater systematic risks and will thus have greater expected returns

brackets

groups investment banks are divided into on the tombstone based on their participation in the issue and the names of the banks are listed alphabetically within each bracket the higher the bracket the greater is the underwriters prestige

financial distress costs will be determined by ________

how easily ownership of those assets can be transferred

investors can always ________ financial leverage themselves to create a different pattern of payoffs

increase

the value of a firm is _______ of its capital structure

independent

debt has 2 distinguishing features:

interest paid on debt is tax deductible failure to meet debt obligations can result in bankruptcy

_______ paid by a corporation is tax deductible while _______ are not

interest, dividends

underwriters

investment firms that act as intermediaries between a company selling securities and the investing public

as a result in an efficient market ______

investors get exactly what they pay for and firms receive exactly what their stocks and bonds are worth when they sell them

the coupon rate is ______ when it comes to cost of debt

irrelevant that just tells us what the firms cost of debt was back when the bonds were issued not what it is today

If you are forecasting a few decades (like retirement planning) in the future you should ______

just split the difference between the arithmetic and geometric average returns

firms with a greater risk of experiencing financial distress will borrow ______ than firms with a lower risk of financial distress

less

firms that have substantial tax shields from other sources such as depreciation will get less benefit from _______

leverage

second stage financing

might be a major investment needed to actually begin manufacturing, marketing, and distribution

first stage financing

might be enough to get a prototype built and a manufacturing plan completed

the value of a firm is maximized when the WACC is _______

minimized because values and discount rates move in opposite directions minimizing the WACC will maximize the value of the firm's cash flow

technical insolvency

occurs when a firm is unable to meet its financial obligations

distribution

payment made by a firm to its owners from sources other than current or accumulated retained earnings

capital gains yield says

per dollar invested we get X in capital gain/loss

long term US government bonds

portfolio of U.S. government bonds with 20 years to maturity

long term corporate bonds

portfolio of high-quality bonds with 20 years to maturity

under current tax law a _______ generally has a significant tax advantage

repurchase shareholder only pays taxes if the shareholder actually chooses to sell and the shareholder has capital gain on the sale (which even then has less tax implications)

if the dividend per share at a given date is raised, while the dividend per share at every other dates held constant, the stock price will _____

rise the reason is that the present value of the future dividends must go up if this occurs

slope of the line of a portfolio expected return and betas for an asset is the ___________

risk premium

Treasury bills

shortest time to maturity, this debt is virtually free of any default risk over its short life, called a risk-free return

special cash dividend

similar to extra dividend, but definitely won't be repeated

principle of diversification

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

_____ and ______ have the same effect

stock dividend and stock split

small stock dividends

stock dividends of less than 20-25%

reverse splits

stock split under which a firms number of shares outstanding is reduced

until the firm is legally bankrupt the ______ control it

stockholders this means they have strong incentive to avoid bankruptcy filing

in an inefficient market ____

stocks prices don't adjust immediately to the new information and it gradually adjusts to reflect the new information this would mean buying stock immediately following the release of new information then selling it several days later would be a positive NPV activity because the price is too low for several days after the announcement

beta coefficient

the amount of systematic risk present in a particular risky asset relative to that in an average risky asset

geometric average return

the average compound return earned per year over a multiyear period answers the question what was your average compound return per year over a particular period what you actually earned on average per year compounded annually

variance

the average squared difference between the actual return and the average return the bigger this number is the more the actual returns tend to differ from the average return

indirect bankruptcy costs

the costs of avoiding a bankruptcy filing incurred by a financially distressed firm ex: the assets of the firm lose value because management is busy trying to avoid bankruptcy, normal operations are disrupted, sales are lost, valuable employees leave, etc.

direct bankruptcy costs

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

projected risk premium

the difference between the expected return on a risky investment and the certain return on a risk free investment

excess return

the difference between the virtually risk-free return on t-bills and the very risky return on common stocks the additional return we earn from moving from a relatively risk-free investment to a risky one

financial distress costs

the direct and indirect costs associated with going bankrupt or experiencing financial distress

capital asset pricing model (CAPM)

the equation of the SML showing the relationship between expected return and beta

financial risk

the equity risk that comes from the financial policy (the capital structure) of the firm

business risk

the equity risk that comes from the nature of the firm's operating activities

risk premium

the excess return required from an investment in a risky asset over that required from a risk-free investment t-bill is 0

systematic risk principle

the expected return on a risky asset depends only on that assets systematic risk underlying rationale: because unsystematic risk can by eliminated by virtually no cost (by diversifying) there is no reward for bearing it [the market does not reward risks that are borne unnecessarily]

financial leverage

the extent to which a firm relies on debt the more debt financing a firm uses in it capital structure the more financial leverage it employs may not affect the overall cost of capital

the higher the tax rate ________

the greater incentive to borrow

cost of capital

the minimum required return on a new investment

cost of capital

the minimum required return on a new investment called this because the required rate of return is what the firm must earn on its capital investment in a project just to break even can be interpreted as the opportunity cost associated with the firms capital investment

homemade leverage

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

Weighted average cost of capital or WACC

the weighted average of the cost of equity and the aftertax cost of debt the overall return the firm must earn on its existing assets to maintain the value of a stock

expected return on a portfolio

the weighted average of the expected returns on the assets held in the portfolio

if you know the true arithmetic average then

this is what you should use for your forecast the problem is we usually only have estimates and estimates have errors

the cost of capital depends primarily on the ____ of funds not the _______

use, source

private equity

used to label the rapidly growing area of equity financing for nonpublic companies

liquidating dividend

usually means that some or all of the business has been liquidated that is sold off

we assume that relevant information known today is already reflected in the expected return thus ________

we are implying that marketing are at least reasonably efficient in the semi strong form sense

what is the appropriate discount rate

we should use the expected return offered in financial markets on investments with the same systematic risk

competitive offer

when a firm offers its securities to the highest bidding underwriter

return on investment

your gain or loss from an investment 2 components income component: direct cash received from an investment capital gain/loss: the change in value of an asset

all investments in an efficient market are ______

0 NPV investments if prices are neither too low nor too high then the difference between the market value of an (hence 0 NPV investments)

reasons for this:

1. Managerial information: if management has superior information about the market value fo the firm, it may know when the firm is overvalued. if it does it will attempt to issue new shares of stock when the market value exceeds the correct value. this will benefit existing shareholders 2. debt usage: a company's issuing new equity may reveal that the company has too much debt or too little liquidity 3. issue costs: there substantial costs associated with selling securities

straight liquidation procedures

1. a petition is filed in a federal court, a corporation may file a voluntary petition or involuntary petitions may be filed against the corporation by several of its creditors 2. a trustee-in-bankruptcy is elected by the creditors to take one the assets of the debtor corporation, the trustee will attempt to liquidate all the assets 3. when the assets are liquidated, after payment of the bankruptcy administration costs, the proceeds are distributed among the creditors 4. if any proceeds remain, after expenses and payments to creditors, they are distributed to the shareholders

bankruptcy reorganization process

1. a voluntary petition can be filed by the corporation or an involuntary petition can be filed by creditors 2. a federal judge either approves or denies the petition, if the petition is approved a time for filing proofs of claims is set 3. in most cases the corporation (the debtor in possession) continues to run the business 4. the corporation (and in certain cases the creditors) submits a reorganization plan 5. creditors and shareholders are divided into classes, a class of creditors accepts the plan if a majority of the class agrees to the plan 6. after its acceptance by creditors the plan is confirmed by the court 7. payments in cash, property, and securities are made to creditors and shared holders, the plan may provide for the issuance of new securities 8. form some fixed length of time the firm operates according to the provisions of the reorganization plan

share repurchases are typically accomplished in one of three ways:

1. companies may simply purchase their own stock just as anyone who would buy shares of a particular stock 2. firm could institute a tender offer: the firm announces to all of its stockholders that it is willing to buy a fixed number of shares at a specific price 3. firms may repurchase from a specific individual stockholder (targeted repurchase)

factors favoring a high payout of dividends

1. desire for current income: these people don't care about the taxes they just want the money 2. taxes and legal benefits: high-dividend low capital gain stocks are more appropriate for corporate investors to hold because of tax breaks, tax-exempt investors for things like pension funds, endowment funds, and trust funds

calculating the variance of returns

1. determine the squared deviations from the expected returns 2. multiply each possible squared deviation by its probability 3. add them up

key considerations in choosing a venture capitalist

1. financial strength: venture capitalist needs to have the resources and financial reserves for additional financing stages should they become necessary 2. style is important: how they manage 3. references are important: how have they been successful in the past 4. contacts are important: who do they know that can help your business 5 exit strategy is important: generally aren't long term investors so how and when will they cash out

why is the right to go bankrupt valuable?

1. from an operational standpoint when a firm files for bankruptcy there is an immediate "stay" on creditors usually meaning that payments to creditors will cease and creditors will have to wait the outcome of the bankruptcy payments to find out if and how much they will be paid 2. some bankruptcy filings are actually strategic actions intended to improve a firms competitive position and firms have filed for bankruptcy even though they are not insolvent at the time

what does capital market history say about market efficiency?

1. prices do appear to respond very rapidly to new information and the response is at least not grossly different from what we would expect in an efficient market 2. the future of market prices, particularly in the short run, is very difficult to predict based on public information 3. if misplaced stocks do exist then there is no obvious means of identifying them

reasons for a reverse split:

1. stock exchanges have a minimum price per share requirement and a reverse split may bring the stock price up to the minimum 2. companies sometimes perform reverse splits and at the same time buy out any stockholder who end up with less than a certain amount of shares (save on expenses related to shareholders) 3. the liquidity and marketability of a company's stock might be improved when its price is raised to the popular trading range 4. stocks selling below a certain point aren't considered respectable

calculating the geometric average

1. take the T annuals returns and 1 to each (after converting them to decimals) 2. multiply all the numbers from step 1 together 3. take the result from step 2 and raise it to the 1/T power 4. subtract 1 from the answer

factors favoring a lower payout of dividends

1. taxes: a firm that adopts a low-dividend payout will reinvest the money instead of paying it out, the reinvestment increased the value of the firm and of the equity, the net effect is capital gain portion of the return is higher which is taxed at a lower rate 2. floatation costs: if a firm has a higher payout it will periodically have to sell some stock to catch up which is expensive to do so most firms are more inclined to the low payout 3. dividend restrictions: there are restrictions on dividends that are too high

qualifications for Rule 415

1. the company must be rated investment grade 2. the form cannot have defaulted on its debt the past three years 3. the aggregate market value of the firms outstanding stock must be more than 150 million 4. the firm must not have had a violation of the securities act of 1934 in the past three years

The return on any stock traded in a financial market is composed of two parts

1. the normal or expected return from the stock is part of the return that shareholders in the market predict or expect 2. the uncertain or risky part, the portion that comes from unexpected information revealed within the year

The CAPM shows that the expected return for a particular asset depends on three things:

1. the pure time value of money: as measured by the risk free rare this is the reward for merely waiting for your money without taking any risk 2. the reward for bearing systematic risk: as measured by the market risk premium this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting 3. the amount of systematic risk: as measured by beta of an investment this is the amount of systematic risk in a particular asset relative to an average asset

to use the dividend growth model for estimating cost of equity we must come up with an estimate for the growth rate by one of two ways:

1. use of historical growth rates 2. use of analysts forecasts of future growth rates

clientele effect

Argument that stocks attract particular groups based on dividend yield and the resulting tax effects

weak form efficiency

At a minimum, the current price of a stock reflects its own past prices studying past prices in an attempt to identify misplaced securities is futile

private placements

Loans, usually long term in nature, provided directly by a limited number of investors.

red herring

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

rights offer

a public issue of securities in which securities are first offered to existing shareholders aka rights offering

unsystematic risk

a risk that affects at most a small number of assets aka unique or asset-specific risk because these risks are unique to individual companies or assets ex: an announcement of an oil strike by a company

registration statement

a statement filed with the SEC that discloses all material information concerning the corporation making a public offering

large stock dividend

a stock dividend greater than 20-25%

the normal distributions or bell curve

a symmetric bell shaped frequency distribution that is completely defined by its average and standard deviation

advantages and disadvantages of the SML approach to estimating cost of equity

advantages: it explicitly adjusts for risk, it is applicable to companies other than just those with steady dividend growth disadvantages: requires 2 things to be estimated (the market risk premium and the beta coefficient) and if our estimates are poor the resulting cost of equity will be inaccurate, we rely on the past to predict the future and economic conditions can change very quickly so the past is not a good guide for the future

advantages and disadvantages of using the dividend growth model to estimate cost of equity

advantages: its simplicity, it is both easy to understand and easy to use disadvantages: only applicable to companies that pay dividends (and the dividend grows at a constant rate), it is very sensitive to the estimated growth rate, does not explicitly consider risk

The dividend market is in equilibrium when:

all clienteles are satisfied further changes in dividend policy are pointless because all clienteles are satisfied thus making dividend policy for any individual firm irrelevant

stock split

an increase in the number of outstanding shares of a corporation without any change in owners equity each share is split up to create additional shares

general cash offer

an issue of securities offered for sale to the general public on a cash basis

the geometric average return is

approximately equal to the arithmetic average return minus half the variance (assuming all the numbers are expressed in decimals)

if you are using averages calculates over a long period of time (like 89 years) to forecast up to a decade or so into the future then you should use ______

arithmetic average

declaration date

date on which the board of directors passes a resolution to pay a dividend

date of payment

date that the dividend checks are mailed

the expected return on an asset depends only on ___________

that assets systematic risk

efficient market hypothesis

the hypothesis that actual capital markets, such as the NYSE, are efficient while inefficiencies may exist they are relatively small and not common

firms with substantial accumulated losses will get little value from _______

the interest tax shield

what does it mean when we say that the minimum required return is 10%?

the investment will have a positive NPV only if the return exceeds 10%

nondiversifiable risk

the minimum level of risk that cannot be eliminated simply by diversifying

static theory of capital structure

the theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress called this because it assumes that the firm is fixed in terms of its assets and operations and it only considers possible changes in the debt-equity ratio

firm commitment underwriting

the underwriter buys the entire issue, assuming full financial responsibility for any unsold shares risk is usually minimal because underwriters have already investigated

best efforts underwriting

the underwriter sells as much of the issue as possible but can return any unsold shares to the issuer without financial responsibility very uncommon

optimal capital structure

when a particular debt-equity ratio results on the lowest possible WACC aka target capital structure

partial adjustment phenomenon

when firms raise their IPO offer prices they only do so partially meaning that they don't move the price high enough