FNCE 101: Final
Disadvantages of Dividend Growth Model
- only applicable to firms that pay dividends - estimated cost of equity is very sensitive to estimated growth rate - does not explicitly consider risk
Disadvantages of SML approach
- requires market risk premium and beta coefficient to be estimated and if those estimates are poor, the resulting cost of equity will be inaccurate - rely on the past to predict the future
underwriters services
1. Formulating the method used to issue the securities 2. Pricing the new securities 3. Selling the new securities
Advantages of SML approach
1. It explicitly adjusts for risk 2. It is applicable to other companies other than just those with steady dividend growth.
initial public offering (IPO)
A company's first equity issue made available to the public
seasoned equity offering (SEO)
A new equity issue of securities by a company that has previously issued securities to the public
flotation cost
Costs associated with obtaining new project (ex: new bonds and stocks)
european option
Option that may be exercised only at the expiration date
venture capital
Poindexter is funded by a group of wealthy investors for the sole purpose of providing funding for individuals and small firms that are trying to convert their new ideas into viable products. What is this type of funding called?
Small-company stocks
Portfolio composed of the stock corresponding to the smallest 20% of the companies listed on the NYSE
Large-company stocks
Portfolio is based on the S&P500 index, which contains 500 of the largest companies in the US
seasoned equity offering
Sale of newly issued equity shares by a publicly owned company
True
Some of the risk associated with individual assets can be diversified away and some cannot (T/F)
True
The cost of capital depends primarily on the use of the funds, not the source (T/F)
strike price
The fixed price in the option contract at which the holder can buy or sell the underlying asset
Return on your investment
The gain or loss you receive on your investment from buying an asset
True
The interest paid by a corporation is deductible for tax purposes, but payments to stockholders, such as dividends, are not (T/F)
call option
The right to buy an asset at a fixed price during a particular period
put option
The right to sell an asset at a fixed price during a particular period of time (opposite of a call option)
False
The terms required return, appropriate discount rate, and cost of capital don't mean the same thing (T/F)
True
Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk (T/F)
static theory of capital structure
a firm borrows up to the point where tax benefit from extra dollar in debt equals cost that comes from increased probability of financial distress
portfolio
a group of assets such as stocks and bonds held by an investor
syndicate
a group of underwriters formed to share the risk and to help sell an issue
preliminary prospectus
a legal document describing details of the issuing corporation and the proposed offering to potential investors
security market line (SML)
a positively sloped straight line displaying the relationship between expected return and beta
rights offer
a public issue of securities in which securities are first offered to existing shareholders
unsystematic risk (Unique or asset-specific risk)
a risk that affects at most a small number of assets
registration statement
a statement filed with the SEC that discloses all material information concerning the corporation making a public offering
Normal distribution
a symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation
weak 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
rights offering (offer/privileged subscription)
an issue of common stock offered to existing stockholders
general cash offer
an issue of securities offered for sale to the general public on a cash basis
Dilution of proportionate ownership
arises whenever a firm sells shares to the general public
strong form efficient
at a minimum, the current price of a stock reflects the stock's own past prices
US Treasury Bills
based on T-bills with a one-month maturity
Long-term US government bonds
based on US government bonds with 20 years to maturity
Long-term corporate bonds
based on high quality bonds with 20 years to maturity
Capital gain yield
change in price during the year/beginning price
option
contract that gives its owner the right to buy or sell some asset at a fixed price on or before a given date
direct bankruptcy costs
costs directly associated with bankruptcy, such as legal and administrative expenses
frequency distribution
counts the number of times the annual return falls within each 10% range
venture capital (VC)
financing for new, often high-risk ventures
principle of diversification
implies some of the riskiness with individual assets can be eliminated by forming portfolios
angels
individuals who invest their own money, but they tend to focus on smaller deals
Systematic Risk (Market Risk)
influences many assets (ex: GDP, interest rates, or inflation)
underwriters
investment firms that act as intermediaries between a company selling securities and the investing public
dilution
loss in existing shareholders' value in terms of ownership, market value, book value, or EPS
american option
option that may be exercised at any time until its expiration date
efficient capital market
security prices reflect available information
Advantages of Dividend Growth Model
simplicity
M&M Proposition II
states a firm's cost of equity capital is a positive linear function of the firm's capital structure
M&M Proposition I
states the value of the firm is independent of the firm's capital structure
True
stock options are a zero-sum game (T/F)
exercising the option
the act of buying or selling the underlying asset via the option contract
geometric average return
the average compound return earned per year over a multiyear period
Variance
the average squared difference between the actual return and the average return
unlevered cost of capital
the cost of capital for a firm that has no debt, (Ru)
indirect bankruptcy costs
the costs of avoiding a bankruptcy filing incurred by a financially distressed firm
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
systematic risk principle
the expected return on a risky asset depends only on that asset's systematic risk
financial leverage
the extent to which a firm relies on debt
the exercise price
the higher the exercise price (E) is, the less the call is worth
the risk-free rate
the higher the risk-free rate (Rf) is, the more the call is worth
the stock price
the higher the stock price (So) is, the more the call is worth
expiration date
the last day on which an option may be exercised
beta coefficient
the level of systematic risk
the time to expiration
the longer the time to expiration (t) is, the more the option is worth
upper bound
the most a call option can sell for
Weighted Average Cost of Capital (WACC)
the overall return the firm must earn on its existing assets to maintain the value of its stock (also the required return on any investment by the firm that have essentially the same risks as existing operations
portfolio weights
the percentage of a portfolio's total value that is invested in a particular asset
Standard deviation
the positive square root of the variance
arithmetic average return
the return earned in an average year over a multiyear period
expected return
the return on a risky asset expected in the future
Cost of equity
the return that equity investors require on their investment in the firm
cost of debt
the return that lenders require on the firm's debt
market risk premium
the slope of the SML - the difference between the expected return on a market portfolio and the risk-free rate
interest tax shield
the tax saving attained by a firm
Pure play approach
the use of a WACC that is unique to a particular project, based on companies in similar lines of business
private equity (PE)
used to label the rapidly growing area of equity financing for nonpublic companies
False
venture capital is not expensive (T/F)
intrinsic value
what the option would be worth if it were about to expire, lower bound