Finance Final Conceptual

Explain the "time value of money" in your own words?

"A dollar today is worth more than a dollar tomorrow" "Receiving money sooner is more valuable than receiving money later" "There's an opportunity cost to receiving money later."

If a company's cost of capital is less than the required return on equity, then the firm: A. is financed with more than 50% debt B. is perceived to be safe C. has debt in its capital structure D. cannot be using any debt

C. has debt in its capital structure

Don enters the following into his calculator, and it returns an error message. What should he do to proceed? PMT =? FV = 100,000, PV = 110,000, IR = 6%

Make FV or PV negative!!

What is the primary advantage of IRR?

The calculation does not require the cost of capital.

Which stock is safest for an undiversified investor who puts all her funds in one of these stocks?

stock with the lowest volatility or sd

Describe the difference between "Total return" and "Yield to Maturity"

· YTM is forward-looking: what do you think your total return will be if you hold the bond until maturity? It's expected interest + expected interest on interest + expected capital gains · TR = backwards looking. It's coupons + interest on coupons + capital gains

If a stock is selling for $100, it just issued a dividend of $5, and it generates an expected return of 8%... what growth rate is the market expecting? Without calculation, if you were trying to check your work, what is an upper bound on the predicted growth rate?

$100 *(.08-g) = $5 -> 8 - 100g = 5 -> g = -3/-100 -> 3% A reasonable upper bound is 8%. If the growth rate were over .08, either the sale price or dividend would need to be negative, which doesn't make sense intuitively.

Which kind of stock is safest for a diversified investor?

A diversified investor will find the lowest-beta stock safest.

What is a "market portfolio"?

A perfectly diversified portfolio with zero exposure to unique risk

The variance of an investment's returns is a measure of the: A. volatility of the rates of return B. probability of a negative return C. historic return over long periods D. average value of the investment

A. volatility of the rates of return

What is the rule for accepting or rejecting a project using NPV? Using IRR?

Accept the project if it has a positive NPV or an IRR greater than or equal to the "hurdle rate."

Alpha Corp. and Beta Corp. both produce turbo encabulators. Both companies' assets and operations are growing at the same rate, and their annual capital expenditures are about the same. However, Alpha Corp. is the more efficient producer and is consistently more profitable. According to the pecking order theory, which company should have the higher debt ratio? Explain.

Alpha Corp is more profitable and is therefore able to rely to a greater extent on internal finance (retained earnings) as a source of capital. It will therefore have less dependence on debt, and the lower debt ratio.

attempt to create the lowest-possible duration bond and the highest-possible duration bond. What can you conclude?

Anything with lower coupon rates, a longer time to maturity, and/or lower yields will have a higher duration.

Do you want your bank to charge simple or compound interest on loans? Do you want them to pay you simple or compound interest on deposits?

Assuming you're a rational person who wants more money, you'd want your bank to charge you simple interest, and pay you compound interest.

the discount rate that makes the PC of a bond's pmt = to its price is called: A. rate of return B. YTM C. current yield D. cpn rate

B. YTM

The cpn rate of a bond equals: A. its YTM B. a % of its FV C. the maturity value D. a % of its price

B. a % of its FV

Common stock can be valued using the perpetuity valuation formula is the: A. discount rate is expected to remain constant B. dividends are not expected to grow C. growth rate in dividends is not constant D. investor does not intend to sell the stock

B. dividends are not expected to grow

When companies announce an issue of common stock, the share price typically falls. When they announce an issue of debt, there is typically only a negligible change in the stock price. Can you explain why?

Because debtholders share in success of the firm only to a minimal extent (i.e., to the extent that bankruptcy risk falls), an issue of debt is not usually taken as a signal that a firm's management has concluded that the market is overvaluing the firm. Thus, debt issues are not signals of the firm's future success and they therefore do not induce investors to reassess the value of the firm.

Which of these pieces of information won't help us solve for WACC? - YTM, CAPM, coupon rate, book value of debt, book value of equity

Book value of equity and coupon rate

Which of the following presents the correct relationship? As the CPN rate of a bond increases, the bonds: A. FV increases B. current price decreases C. interest pmts increases D. maturity date is extended

C. paymnets increases

Imagine purchase bond for half the par that you did before ($500 vs $1000). What happens to price?

Calculation for price will not change. The price of the bond today isn't influenced by how much you paid in the past. The PV of the bond's future CFs will still be the same.

A bond's par value can also be called its: A. cpn pmt B. PV C. default risk D> FV

D. FV

What two elements are represented in security returns? A. a premium for market risk and for unique risk B. a premium for unique risk and a premium for firm-specific risk C. a premium for diversification and a premium for portfolio risk D. a premium for the TVM and a premium for market risk

D. a premium ofr TVM and a premium for market risk

Which of the following is fixed for the life of a given bond? A. current price B. current yield C. YTM D. cpn rate

D. cpn rate

The curernt yield of a bond can be calculated by: A. multiplying the price by the cpn rate B. dividing the price by the annual cpn pmts C. dividing the price by the par value D. dividing the annual cpn pmts by the price

D. dividing annual cpn pmts by price

When reading the Wall Street Journal, you come across bad news: a company whose bonds you own lost a lot of money, and may not be able to repay their debt. Which kind of risk are you worried about?

Default risk

EAR is annualized using ___ interest and APR is annualized using ____ interest

EAR is annualized using compound interest and APR is annualized using simple interest

How can you "earn" money in the stock market? How can you "lose" money in the stock market?

Earn through: Dividends and capital gains. Dividends are when the firm distributes profits to all "owners." Capital gains occur when you purchase a stock for a given price, then the firm performs well and the price rises, and you sell your shares for that higher price. Lose through: Negative capital gains. These occur when you purchase stock, the price falls, and you sell for that lower price. There's no negative version of dividends.

T/F: Bond B will have a higher price than Bond D since it provides more cpn pmts

False

T/F: a project's payback period is the length of time necessary to generate an NPV of zero

False

T/F: junk bonds have more interest rate risk than Investment grade bonds, so they should have lower prices and higher yields

False

T/F: market risk can be eliminated in a stock portfolio through diversification

False

T/F: strong-form market efficiency implies that one could earn above-average returns by examining the history of a firm's stock price

False

T/F: sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend payout ratio

False

T/F: If you are a day trader in the stock market, you probably believe in the strong form efficient market hypothesis

False, if you believe in strong form efficient market hypothesis you invest in "safe" things (ex. bonds) and just leave them to grow

T/F: Bond A has more interest rate risk than Bond D since it has a shorter maturity

False, longer maturity = more IR risk

T/F: to value equity using a comps analysis, you need: comparable items and attribute relevant to value, but you do not need market prices

False, you DO need market prices along with comp items and attributes relevant to value to allow for direct comp (both items in same mkt)

T/F: If I hold a zero-cpn bond, I am more worried about reinvestment risk because only one cpn pmt at maturity, so greatly affected by IR risk

False, zero-cpn bonds have no reinvestment risk because only 1 cpn pmt @ maturity, so greatly affected by IR risk

T/F: If a stock's expected rate of return plots below the security market line, it is underpriced.

False. A stock plotting below the SML offers too low an expected return relative to the expected return indicated by the CAPM. The stock is overpriced.

T/F: An undiversified portfolio with a beta of 2.0 is twice as volatile as the market portfolio.

False. An undiversified portfolio has more than twice the volatility of the market. In addition to the fact that it has double the sensitivity to market risk, it also has volatility due to unique risk.

True or false: The investment timing rule is to choose the project with the highest-NPV at purchase.

False. Choose the highest NPV project today. See chart from page 27 of Ppt2.

T/F: The expected rate of return on an investment with a beta of 2.0 is twice as high as the expected rate of return of the market portfolio.

False. The stock's risk premium, not its expected rate of return, is twice as high as the risk premium of the market portfolio.

Explain how financial distress can lead to conflicts of interest between debt and equity investors. Then explain how these conflicts can lead to costs of financial distress.

Financial distress can lead to distorted investment incentives (high risk NPV-negative - bondholders bear risk, equity holders benefit - called "bet the bank's money") Or, a firm on the brink of insolvency unwilling to engage in a positive-NPV venture if it requires additional capital, reasoning that even if the project goes well, the firm's creditors will capture much of the returns. ("don't bet your own money") These conflicts of interest lead to costs of financial distress since the potential for poor decisions (which reduce firm value) is reflected in the stock price that investors see as reasonable for the firm.

Why do we use WACC for cost of capital (rather than, say, CAPM)?

Firms are usually financed through both debt and equity

Suzie tried to find the price of a semi-annual coupon bond, with a face value of $100, 3 years until maturity, a coupon rate of 10%, and a YTM of 4%. However, she made two errors. Examine her work below and identify the errors:

First, she calculated an annual coupon instead of a semi-annual coupon. It should be only $5. Second, when entering everything into her calculator, she made an error with cash flow timing. If there are 6 coupon payments followed by a face-value re-payment, she should have entered 5 coupon payments followed by 1 period of "coupon + face value" payment. This is a common mistake, because of the way we write out the bond pricing equation. The final coupon cash flow should come at the same time as face value repayment.

Three assets have betas of -.8, .6, and 5. In no order, you know that one of these is a bar of gold, one is stock in a startup, one is a share of a Berkshire Hathaway portfolio. Which is which?

Gold (negative beta), stock in a startup (high beta, 5), one is a share of a Berkshire Hathaway portfolio (less risky than the market, so under 1).

What is wrong with the following argument? A capital investment opportunity offering a 10% internal rate of return is an attractive project if it can be 100% debt-financed at an 8% interest rate.

If the opportunity were the firm's only asset, this would be a good deal. Stockholders would put up no money and would therefore have nothing to lose. The trouble is, rational lenders will not advance 100 percent of the asset's value for an 8 percent promised return unless other assets are put up as collateral. Sometimes firms find it convenient to borrow all the cash required for certain investments. But these investments don't support all of the additional debt; the lenders are protected by the firm's other assets too. In any case, if firm value is independent of leverage, then any asset's contribution to firm value must be independent of how it is financed. Therefore, the statement ignores the effect on the stockholders of an increase in financial leverage. The company should be using WACC to evaluate the project (assuming similar risk).

In 1990, the Dow Jones Industrial Average was at a level of about 2,600. In 2010, it was about 12,000. Would you expect the Dow in 2010 to be more or less likely to move up or down by more than 40 points in a day than in 1990? Does this mean the market was riskier in 2010 than it was in 1990?

In 2010, the Dow was nearly four times its 1990 level. Therefore, in 2010, a 40-point movement was far less significant in percentage terms than it was in 1990. We would expect to see more 40-point days in 2010 even if market risk as measured by percentage returns is no higher than it was in 1990.

Preferred Stock. Preferred stock of financially strong firms sometimes sells at lower yields than the bonds of those firms. For weaker firms, the preferred stock has a higher yield. What might explain this pattern?

In general, the fact that preferred stock has lower priority in the event of bankruptcy reduces the price of the preferred stock and increases its yield compared to bonds. On the other hand, the fact that 70 percent of the preferred stock dividend payments are free of taxes to corporate holders increases the price and reduces the yield of the preferred stock. For strong firms, the default premium is small and the tax effect dominates, so that the preferred stock has a lower yield than the bonds. For weaker firms, the default premium dominates.

What are the two broad types of valuation, and their main differences?

Intrinsic valuation prices an asset using its predicted future cash flows, while comparable valuation prices it by comparing it to similar assets' prices.

Explain the connection between PVGO and the two sources of income from owning stock.

Intrinsic valuation prices stock by discounting its future cash flows, which come from two sources: dividends and capital gains. Firms face a choice between reinvesting earnings ("plowback") to increase the growth rate or issuing them to shareholders ("payout") to increase dividends. We compare the stock prices under a 100% payout policy and under some set payout ratio, to determine whether the present value of growth opportunity is positive or negative.

1) Real vs. Financial Investments. Why do investments in financial markets almost always have zero NPVs, whereas firms can find many investments in their product markets with positive NPVs?

Investments in financial markets, such as stocks or bonds, are available to all participants in the marketplace. As a result, the prices of these investments are bid up to 'fair' levels, that is, prices which reflect the present value of expected cash flows. If the investment weren't zero-NPV, investors would buy or sell the asset and thereby put pressure on its price until the investment becomes a zero-NPV prospect. In contrast, investments in product markets are made by firms with various forms of protection from full competition. Such protection comes from specialized knowledge, name recognition and customer loyalty, and patent protection. In these cases, a project may be positive NPV for one firm with the know-how to make it work, but not positive NPV for other firms. Or a project may be positive NPV, but only available to one firm because it owns a name brand or patent. In these cases, competitors are kept out of the market, and the costs of the firm's investment opportunities are not bid to levels at which NPV is reduced to zero.

Maturity Premiums. Investments in long-term government bonds produced a negative average return during the period 1977-1981. How should we interpret this? Did bond investors in 1977 expect to earn a negative maturity premium? What do these 5 years' bond returns tell us about the normal future maturity premium?

Investors would not have invested in bonds if expected to earn (-) average returns. Unanticipated events (inflation and nominal interest rates increases) must have led to large capital losses on long-term bonds. The realized premium over short periods contains little info about expectations of future premiums.

Why might projects have different discount rates

Less-risky projects should have lower discount rates

What is wrong with the following argument? Moderate borrowing doesn't significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won't increase the expected rate of return demanded by stockholders.

Moderate borrowing does not significantly affect the probability of financial distress, but it does increase the variability (and the beta) borne by stockholders. This additional risk must be offset by a higher expected rate of return to stockholders.

Using your understanding of discounting, explain why profitability index gives more weight to distant cash flows?

Normally, all cash flows are discounted, which shrinks them. The more distant cash flows are discounted the most, which shrinks them the most. By ignoring time value of money, it allows all cash flows to stay the same size as they're pulled back through time, and the later ones benefit the most since they had the most to lose.

We discussed "Scale insensitivity" in IRR problems. Why might this cause a company to make sub-optimal decisions?

One project may have a slightly higher return on investment but generate less cash for the firm. The IRR alone would be misleading. You'd rather have 5% of $100 ($5) than 10% of 10 ($1) even though 10% > 5%.

What two factors do we take into account when determining a "discount" rate?

Opportunity cost and risk

Pros and Cons of IRR

PRO: (1) TVM, (2) simple to interpret and easy to visualize, (3) no requirement of finding hurdle rate, (4) managers make rough estimate of RR CONS: (1) ignores economies of scale, (2) impractical implicit assumption of reinvestment rate @IRR itself for remaining period of the project, (3) dependent/contingent projects ignored when calculating, (4) mutually exclusive projects ignored, (5) dif terms of project not considered

Pros and Cons of NPV

PRO: TVM and decision making CONS: (1) no set guidelines to calculate required rate of return, (2) cannot be used to compare projects of different sizes, (3) hidden costs

Pros and Cons of PI

PRO: TVM, allows for two investment comparison CONS: 2 projects with vastly dif investment/$ return can have same PI

What do we mean by the "present value?" The "future value?"

PV = This is how much money you would need to set aside today to have that amount 20 years from now. FV = The amount of money a current investment will grow to in 20 years.

Which capital budgeting method ignores the time value of money?

Payback period

Tech firm issues bonds and uses the cash to finance a daring new project. They believe project will generate 30% IRR, which would more than cover the 3% YTM they would owe bondholders. Why would anyone purchase their 3% bonds instead of investing directly in the project, with a higher potential return?

Risk aversion, investors purchase bonds because they dont want the uncertainty that comes with "owning" part of a company and its projects. In finance, lower-risk investments generate lower returns

In which of the following situations would you get the largest reductions in risk by spreading your portfolio across two stocks? The stock returns vary with each other. The stock returns are independent. The stock returns vary against each other.

Risk reduction is most pronounced when the stock returns vary against each other. When one firm does poorly, the other will tend to do well, thereby stabilizing the return of the overall portfolio.

Suzie says, "a perfectly diversified portfolio has a beta of 0." Is she correct? Why or why not?

She's incorrect. A perfectly diversified portfolio has a beta of 1. A beta of 0 would mean the market was uncorrelated with itself. Only treasury bills and cash have a beta of 0.

We've said stockholders are "owners" rather than "lenders." What do we mean by this? How is common stock ownership different than, say, founding/owning a small business outright?

Stockholders are paid like owners. They are entitled to a share of the firm's profits (if there are any profits after costs have been covered and debts have been repaid). These earnings are variable and may be zero. Unlike someone who owns a business outright, stockholders don't have direct "control" over the firm's decisions. They instead vote for directors, who make decisions. Stockholders are also never liable for a firm's losses, they worst that can happen is not making a profit. Depending on the legal structure of a small business, the owner may be liable for debts the firm cannot pay.

Affect on Bondholder vs Stockholder: Company pays a $10 cash dividend

Stockholders gain and bondholders lose. Bond value decreases because the value of assets securing the bond has decreased.

Stocks are perpetuities/annuities, while bonds are perpetuities/annuities. Why?

Stocks = perpetuities. Bonds = annuities. We assume the companies we own a piece of won't go out of business, so our return never ends. With bonds, our payments will end when the firm has repaid our debt + interest.

A financial analyst at Dawn Chemical notes that the firm's total interest payments this year were $10 million while total debt outstanding was $80 million, and he concludes that the cost of debt was 12.5 percent. What is wrong with this conclusion?

The 12.5% value calculated = current yield of the firm's outstanding debt: interest payments/bond value. It ignores that bonds not selling at par provide expected returns determined in part by expected price appreciation/depreciation. The analyst should be using YTM instead of current yield to calculate cost of debt, assuming value of debt provided is the market value.

Risk and Return. According to the CAPM, would the expected rate of return on a security with a beta less than zero be more or less than the risk-free interest rate? Why would investors be willing to invest in such a security?

The CAPM states that: r = rf + b(rm - rf ) If b < 0 then r < rf Investors would invest in a security with an expected return below the risk-free rate because of the hedging value such a security provides for the rest of the portfolio. Investors get their 'reward' in terms of risk reduction rather than in the form of high expected return.

University Products is evaluating a new venture into home computer systems. The internal rate of return on the new venture is estimated at 13.4 percent. WACCs of firms in the personal computer industry tend to average around 14 percent. Should the new investment be pursued? Will University Products make the correct decision if it discounts cash flows on the proposed venture at the firm's WACC?

The IRR on project < WACC of firms industry, so project should be rejected. However, the WACC of the firm (based on its existing mix of projects) is only 11.36%. If the firm uses this figure as the hurdle rate, it will incorrectly go ahead with the venture in home computers.

Who would view the stock of Leaning Tower of Pita (see Problem 14) as a risk-reducing investment—the owner of a gambling casino or a successful bankruptcy lawyer?

The bankruptcy lawyer does well when the rest of the economy is floundering, therefore, the Leaning Tower of Pita is a risk-reducing investment. When the economy does well and the lawyer's bankruptcy business suffers, the stock return is excellent, thereby stabilizing total income.

Affect on Bondholder vs Stockholder: Company encounters an investment opportunity requiring a $10 initial investment with NPV=$0. It borrows $10 to finance the project by issuing more bonds with the same security, seniority, and so on, as the existing bonds.

The bondholders lose and the stockholders gain. The firm adds assets worth $10 and debt worth $10. This increases the debt ratio, leaving the old bondholders more exposed. The old bondholders' loss is the stockholders' gain.

Suppose interest rates increase from 8 to 9 percent. Which bond will suffer the greater percentage decline in price: a 30-year bond paying annual coupons of 8 percent or a 30-year zero-coupon bond? Can you explain intuitively why the zero exhibits greater interest rate risk even though it has the same maturity as the coupon bond?

The coupon bond will fall from an initial price of $1,000 (when yield to maturity = 8%) to a new price of $897.26 when yield to maturity immediately rises to 9%. This is a 10.27% decline in the bond price.The initial price of the zero-coupon bond is: 1000/1.08^30 = $99.38The new price of the zero-coupon bond is: 1000/1,09^30 = $75.37 This is a price decline of 24.16%, far greater than that of the coupon bond.The price of the coupon bond is much less sensitive to the change in yield. It seems to act like a shorter maturity bond. This makes sense: there are many coupon payments for the 8% bond, most of which come years before the bond's maturity date. Each payment may be considered to have its own "maturity date" which suggests that the effective maturity of the bond should be measured as some sort of average of the maturities of all the cash flows paid out by the bond. The zero-coupon bond, by contrast, makes only one payment at the final maturity date.

Affect on Bondholder vs Stockholder: Company finances the investment opportunity in part c) by issuing more common stock.

The original stockholders lose and bondholders gain. There are now more assets backing the bondholders' claim. Bonds worth more -> market value of outstanding stock increased by less than the additional investment in the firm. This implies a loss to stockholders. However, because the new stockholders will invest only if they receive stock with value at least equal to their investment, the loss must be borne by the old shareholders.

Investment Performance. It seems that every month we read an article in the Wall Street Journal about a stockpicker with a marvelous track record. Do these examples mean that financial markets are not efficient?

There are several thousand mutual funds in the United States. With so many professional managers, it is no surprise that some managers will demonstrate brilliant performance over various periods of time. As an analogy, consider a contest in which 10,000 people flip a coin 20 times. It would not surprise you if someone managed to flip heads 18 out of 20 times. But it would be surprising if he could repeat that performance. Similarly, while many investors have shown excellent performance over relatively short time horizons, and have received favorable publicity for their work, far fewer have demonstrated consistency over long periods.

If cost of capital is high, will there be fewer positive NPV projects? Explain.

There will be fewer positive NPV projects. Most investments we work with start with a negative cash outflow, followed by several positive inflows discounted to the

What is the purpose of a "capital budgeting rule"?

They are methods to decide which projects to take, and which to reject

An analyst at Dawn Chemical notes that its cost of debt is far below that of equity. He concludes that it is important for the firm to maintain the ability to increase its borrowing, because if it cannot borrow, it will be forced to use more expensive equity to finance some projects. This might lead it to reject some projects that would have seemed attractive if evaluated at the lower cost of debt. Comment on this reasoning.

This reasoning is faulty in that it implicitly treats the discount rate for the project as the cost of debt if the project is debt financed, and as the cost of equity if the project is equity financed. In fact, if the project poses risk comparable to the risk of the firm's other projects, the proper discount rate is the firm's WACC

Which kinds of bonds are more susceptible to interest rate risk? How can you completely mitigate interest rate risk?

Those with lower coupon rates, and longer times to maturity. You can hold your bond until maturity, instead of selling it early.

When would we use the EAR formula?

To compare investments with different compounding periods

T/F: Capital structure in essence is a firm's mix of long-term financing

True

T/F: Compound interest pays interest for each time period on the original investment plus the accumulated interest

True

T/F: If Bond E has more reinvestment rate risk than Bond D, then its cpn rate (X) must be greater than 5%

True

T/F: a bond's payment at maturity is referred to as its FV

True

T/F: an annuity due must have a PV at least as large as an equivalent ordinary annuity

True

T/F: as the OCC decreases, the NPV of a project increares

True

T/F: bond ratings measure the bond's credit risk

True

T/F: if investors believe a company will have the opportunity to make very profitable investments in the future, they will pay more for the company's tock today

True

T/F: if the market is efficient, stock prices should be expected to react only to new info that is released

True

T/F: the DDM indicates that the value of a stock is the PV of the dividends it will pay over the investor's horizon plus the PV of the expected stock price at the end of that horizon

True

T/F: the security market line displays the relationship between expected return and beta

True

T/F: when choosing among mutually exclusive projects, the choice is easy using the NPV rule:L as long as at least one project has positive NPV, simply choose the project with the highest NPV

True

T/F: when you are considering whether to replace an aging machine with a new one every three years, you should compare the annual cost of opperating the old one with the equivalent annual annuity of the new one

True

T/F: yield curves plot a bond's maturity (x-axis) versus its rate of return (y-axis) and downward sloping curves imply deflation expectations and may signal a recession

True

T/F: zero-cpn bonds are issued at prices below FV, and the investor's return comes from the dif between the purchase price and the pmt of FV at maturity

True

T/F: we typically value bonds using modified annuity formulas and value stocks using perpetuity formulas

True, bond = annuity, stock = perpetuity

T/F: A diversified portfolio with a beta of 2.0 is twice as volatile as the market portfolio.

True. If the portfolio is diversified to such an extent that it has negligible unique risk, then the only source of volatility is its market exposure. A beta of 2 then implies twice the volatility of the market portfolio.

T/F: The contribution of a stock to the risk of a diversified portfolio depends on the market risk of the stock.

True. The stock's unique risk does not affect its contribution to portfolio risk.

What is wrong with the following argument? As the firm borrows more and debt becomes more risky, both stock- and bondholders demand higher rates of return. Thus by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off.

Under Proposition I, the cost of capital of the firm (rassets) is not affected by the choice of capital structure. The reason the stated argument seems to be true is that it does not account for the changing proportions of the firm financed by debt and equity. As the debt-equity ratio decreases, it is true that both the costs of equity and debt decrease; but a larger portion of the firm is financed by the more expensive equity. The overall effect is to leave the firm's cost of capital unchanged.

What are the two kinds of risk? Which of these can be eliminated, and how?

Unique risk (can be eliminated through diversification) and market risk

Hedge fund managers are more likely to make money trading the stock of a firm whose CEO graduated from their MBA program. Which level(s) of market efficiency does this suggest?

Weak or semi-strong form efficiency. This sounds like insider trading. Weak suggests that firms can make money using public or private information. Semi-strong form suggests that firms can make money using private information only.

Under what circumstances can IRR problems have multiple rates?

When the sign switches multiple times.

When would you use profitability index?

When you have a set amount of resources and various investment combinations

Would the "time value of money" still apply on investments which earn simple interest? Explain.

Yes! Recall from the notes that the definition of future value is "the amount to which an investment will grow after earning interest." The equations presented in this course refer to compound interest, and compound interest will grow your money faster, but TVM applies universally.

Can you have a situation where one portfolio has a higher standard deviation, yet a lower expected return? Which kind of risk must be contributing to the high standard deviation?

Yes! Standard deviation measures total risk, and investors are only compensated for market risk. Most of that high standard deviation must be unique risk.

What actually causes money to grow?

You deposit is an investment that earns interest. This can be in stocks, bonds, real estate, etc...

Your aunt says, "But I have a change jar in my room, and it hasn't magically accumulated more change...this means there isn't a time value of money." Why is she wrong?

You have to "put the money to work" by putting it somewhere where it will earn you interest - you could deposit in a bank account, invest in the stock or bond market, etc.

Mini-Case: The shareholder primacy model of corporate governance argues that shareholder interests should be the primary driver of a firm's decisions. An alternate model suggests that firms should consider bondholder interests equally alongside shareholder interests. You want to reduce risky-decision-making in the financial sector. Which model do you support and why?

You support the model that considers both shareholders and bondholders. This is because bondholders are more risk-averse than shareholders. Bond-holders gain nothing when a firm takes extra risks, because their best-case-scenario is receiving payment as promised. They don't do any better if the firm makes $1 or $1m profit beyond what they needed to re-pay their debt. Their voice would add some risk-aversion.

Voting for Directors. The shareholders of the Pickwick Paper Company need to elect five directors. There are 400,000 shares outstanding. How many shares do you need to own to ensure that you can elect at least one director if the company hasmajority voting?cumulative voting?

a. If the company has majority voting, each candidate is voted on in a separate election. To ensure that your candidate is elected, you need to own at least half the shares, or 200,000 shares (or 200,001 shares, in order to ensure a strict majority of the votes). b. If the company has cumulative voting, all candidates are voted on at once, and the number of votes cast is: 5 400,000 = 2,000,000 votes If your candidate receives one-fifth of the votes, that candidate will place at least fifth in the balloting and will be elected to the board. Therefore, you need to cast 400,000 votes for your candidate, which requires that you own 80,000 shares.

Define trade-off theory of capital structure

trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. management strikes a balance between the tax advantage of debt and the costs of possible financial distress. In the trade-off theory, exchange offers would be undertaken to move the firm's debt level toward the optimum.

T/F: the primary stock pricing methods are Comps and Intrinsic valuation

true

When will YTM and Total Return be equal? When will they be different? Describe when they will be different using the types of risk we covered in class.

· They will equal when you buy a bond and hold it to maturity, and interest rates stay constant. · Interest rate risk: They'll differ if interest rates move (and therefore bond prices move), then you sell early. This will give you an unexpected capital gain or loss. · Reinvestment rate risk: They'll differ if interest rates move and your coupon earnings have to be reinvested at a different rate than your YTM.

"The after-tax cost of debt is lower when the firm's tax rate is higher; therefore, the WACC falls when the tax rate rises. Thus, with a lower discount rate, the firm must be worth more if its tax rate is higher." Explain why this argument is wrong.

​​Even if the WACC were lower when the firm's tax rate is higher, this does not imply that the firm would be worth more. The after-tax CFs the firm would generate for its owners would also be lower. This would reduce the value of the firm even if CFs were discounted at a lower rate. If the tax authority is collecting more income from the firm, the value of the firm will fall.

You are considering the purchase of real estate that will provide perpetual income that should average $50,000 per year. How much will you pay for the property if you believe its market risk is the same as the market portfolio's? The T-bill rate is 5 percent, and the expected market return is 12.5 percent.

​​If the systematic risk were comparable to that of the market, the discount rate would be. 12.5%. The property would be worth: $50,000/0.125 = $400,000

Affect on Bondholder vs Stockholder: Company halts its operations, sells its fixed assets for $6, and converts net working capital into $20 cash. It invests its $26 in Treasury bills.

​​If we assume the cash is left in Treasury bills, then bondholders gain. The bondholders are sure to receive $26 plus interest. This is greater than the $25 market value of the debt. Stockholders lose; in fact stock value falls to one.

Sassafras Oil is staking all its remaining capital on wildcat exploration off the Cote d' Huile. There is a 10 percent chance of discovering a field with reserves of 50 million barrels. If it finds oil, it will immediately sell the reserves to Big Oil, at a price depending on the state of the economy. Thus the possible payoffs are as follows: Is Sassafras Oil a risky investment for a diversified investor in the stock market—compared, say, to the stock of Leaning Tower of Pita, described in Problem 7? Explain.

​​Sassafras is not a risky investment for a diversified investor since its return is better when the economy enters a recession, so the company risk offsets the risk of the rest of the portfolio (portfolio stabilizer despite 90% chance of loss. Similarly, Sassafras may be viewed as analogous to an insurance policy on the rest of your portfolio since it tends to yield higher returns when the rest of the economy fares poorly.

What is wrong with the following argument? The more debt the firm issues, the higher the interest rate it must pay. That is one important reason why firms should operate at conservative debt levels.

​​This is not an important reason for conservative debt levels. So long as MM's proposition holds, the company's overall cost of capital is unchanged despite increasing interest rates paid as the firm borrows more. (However, the increasing interest rates may signal an increasing probability of financial distress -- and that can be important.)