Test #2
WACC Method
- CFs = FCF - Discount Rate = WACC - Value = VL - D and E are market values
FTE (flow to equity) method
- CFs = FCFE - Discount Rate = RE - Value = E
APV method
- Discount rate = R0 - CF = FCF - Value of firm = PV (all equity firm) + PV (Tax Shield) - Value = VU
Bonds
- Fixed-income products issued by governments for corporations to raise funds. - Issuer pays back the face value, interest, and coupons
Loans
- Lump-sum amounts extended by financial institutions or companies for a set amount. - The borrower agrees to repay the full amount + fixed interest
Modigliani and Miller Proposition 1
- Perfect world - no taxes - VL = VU - the value of a levered firm is equal to the value of an unlevered firm
WACC No taxes
- RE * (E/V) + RD* (D/V) - WACC does not change with debt - as you add debt the cost of equity increases
Junior Debt
- Ranks after other debt during liquidation or bankruptcy. - can provide higher returns - more risky, higher interest rates
Tradeoff Theory of Debt
- VL = Vu + PV(Tax Shield) - PV (Distress Costs) - increased cost of financial distress reflected in R0 and rating - firms face trade off between too little debt and too much
Callable Debt
- borrower gets a call option - the option allows the borrower to buy back the bond from the bond holder - interest rate increase, bond price decrease
Buyer vs Seller
- buyer always has the option to exercise - seller simply do as they are told - buyers gain is the sellers loss - buyers loss is the sellers gains
Agency Costs
- conflict between shareholders and debtholders - risk of shifting incentives - incentive to underinvest -incentive to decrease asset value
MM Proposition #2 takeaways
- cost of equity increases with leverage - but, increases less than in a world without taxes
Financial Distress Indirect Costs
- customers anticipation of disruption or denial after sale - competitive disadvantages - quality decrease - suppliers stops supplying - reputation damages
Do shareholders want debt?
- debt can lead to a higher ROE - Shareholders want a higher ROE - they can take the money that they would have used to buy stock, and invest in another company
Secured Debt
- debt guaranteed by collateral - low risk - low interest rates
Terminal Value
- growing perpetuity - often accounts for most of firm value - TV = (CF * (1+g)) / r -g
Call Option dividends
- if the stock pays dividends, you can exercise early - if the stock does not pay dividends, you will never exercise early
MM Proposition #1: Takeaways
- in a world with taxes, the value of a levered firm is higher than an unlevered firm
Modigliani and Miller with taxes
- interest on debt is tax deductible - cash flows from the IRS are safe cash flows, so the firm is safer
Financial Distress Direct Costs
- legal and admin - 3% of firm value - bankruptcy costs - reorganization costs
Unsecured Debt
- no collateral is needed to secure the loan - borrowers are approved for the loan based on creditworthiness - Interest rates higher, bc no collateral
Senior Debt
- prioritized for repayment in the case of bankruptcy - Highest Priority - Lower risk, lower interest rate
Put Option vs. Selling Short
- put option worst outcome is 0 - Short Sell worst outcome is losing money - Short sell has no premium
ROE and Taxes
- the ROE of a levered firm is higher than that of an unlevered firm - The financial risk is higher for a levered firm - BUT, tax shield makes equity safer
Modigliani and Miller Proposition 2
- the risk of equity increases with debt - shareholders expected return is proportional to the risk of equity - a levered firms cost of equity will be higher than that of an unlevered firm - but the cost of equity is offset by the tax shield, so the WACC decreases when the firm takes on more debt
Time Horizion
- the time horizon can be cast into two broad period: 1) Explicit Forecast Period (exceptional growth) 2) Terminal Value (Remaining Stable Life)
Problems of DCF
- time horizon - what CFs to use - Appropriate discount rate
Explicit Forecast Period
- time until the firm reaches a steady state - better longer than shorter
Writing a Put Option
-bullish - think stock price will rise
Debt
-lenders = debtholders -something, typically money, that is owed or due
levered firm
A company that uses both debt and equity in its capital structure.
unlevered firm
A company that uses only equity in its capital structure.
Payoff Equation Risk
E(X) = (outcome 1 * probability) + (outcome 2 * probability)
American Option
Exercisable at any time; Will never have a smaller premium than a European option; More flexible
Zero Seller Liability
If S < K, at maturity, the buyer will not exercise the call and sellers liability will be zero
Risk Shifting Shareholders Perspective
If the expectancy value is the same, take the one with higher payoff. If the worse option in both scenarios is zero, then take the one with higher payoff because the worst that can happen is you get nothing
Increase Time
Increase Call Option Value, Increase Put Option Value
Increase Volatility
Increase Call Option Value, Increase Put option value.
Increase in Stock Price
Increases Call Option Value, Decrease Put Option Value
Interest Tax Shield
Interest * Tax Rate
Strike Price
K , pre-specified price
No Arbitrage Initial Investment Payoff
K will be the same in the upstate and downstate = call-put parity.
Call Option Payoff
Max{0, S-K}
Out of the money
Negative Payoff
Does leverage increase WACC?
No, WACC levered < WACC unlevered - cost of debt is usually cheaper than cost of equity
Firm Value DCF
PV(CF explicit value) + PV ( CF continuation period)
P
Put option price
After Tax Cost of Debt
Rd x (1-Tc)
Put Option Goal
S < K
Call Option Goal
S > K
Put Call Parity Equation
S+P-C = K / (1+r)^t
Profit Equation
S-K-C
Equity Securities
Securities issued by corporations as a form of ownership in the business.
No-arbitrage condition
Securities that offer an identical stream of cash flows will be priced the same in the financial markets. Any risk-less strategy= earn only the risk free rate.
Short Sell
Shorting, or short-selling, is when an investor borrows shares and immediately sells them, hoping he or she can scoop them up later at a lower price, return them to the lender and pocket the difference. But shorting is much riskier than buying stocks, or what's known as taking a long position
Debt Holders and Tax
Single taxation
Writing a Call transactions
Stage 1: - Buyer Gives call option price, C, to writer - Writer gives an option Stage 2: Only if K>S - Buyer gives strike price, K, to writer - Writer gives buyer shares (zero upside, zero sum game)
Risk Shifting Debt holders Perspective
Take the option that has a higher chance of paying off debt. Dont take the option where the probability of getting paid back is 0.
Option Writer
The party who sells the option to the buyer and has the obligation to go through with the option contract if called on by the buyer.
Milking the Property
This involves paying out extra dividends when the firm will likely go bankrupt. This leaves less for the bond holders.
Value of a Levered Firm
VL = VU + (D*TC)
WACC
Weighted average cost of capital. The average cost of financing a firm in percentage terms.
Covered Call
When the writer of a call also owns the stock he is obligated to sell; Used to increase income in a time when you do not expect the stock price to increase; Can be written out of the money to add insurance that the stock won't get called away; Trading away chance of stock appreciating in future for income now
Buying a put option
Writer has limited downside. do this if u think asset is going down in price. Believes price will drop below the exercise price before expiration.
At the money
Zero Payoff
Sunk Cost
a cost that has already been committed and cannot be recovered
Naked Call
a short call position not backed up by ownership of the shares the writer is obligated to deliver upon exercise. Can lose a lot of money. If S>K, buyer will definetly buy.
No Dividend Payment
does not force default
Dual class
firms have two classes of common shares outstanding, with different voting rights assigned to each class
Firm Distress
happens if the firm cant pay debts
Seller Gives Up Shares
if S > K, the buyer will exercise
After tax interest expense
interest expense x (1 - tax rate)
Writing a Call
is a bearish strategy, unlimited downside potential
Put option payoff
max{0, K-S}
open interest
number of contracts outstanding
In the money
positive payoff
ask price
price at which dealer will sell security, always buy at ask price
What do financial distress costs affect?
shareholder value
S
stock price
K
strike price
Dividend and tax
subject to double taxation
Loan Covenants
terms of a loan agreement that if broken, entitle the lender to renegotiate loan terms or force repayment - fixed percent dividend - no dividends cant trigger default
call option
the option to buy shares of stock at a specified time in the future
put option
the option to sell shares of stock at a specified time in the future
bid price
the price a dealer is willing to pay for a security, always sell at bid price
Arbitrage
the purchase of securities in one market for immediate resale in another to profit from a price discrepancy
t
time to maturity
preferred stock
A special type of stock whose owners, though not generally having a say in running the company, have a claim to profits before other stockholders do.
Put Call Parity
An equation expressing the equivalence (parity) of a portfolio of a call and a bond with a portfolio of a put and the underlying, which leads to the relationship between put and call prices.
Put Options and Portfolio Insurance
Buy stock and buy put option with a strike price. Irrespective of the current stock price, this portfolio is at least worth the strike price. Payoff stays at strike price, untile S> K. Unlimited upside
Strike Price (K) Increase
Call Price (C) decrease, Put Price (P) increase
Stock Price (S) Increase effects
Call Price (C) increase, Put Price (P) decrease
Time (T) Increase effects
Call Price (C) increase, Put Price (P) increase
C
Call option price or premium
DCF (discounted cash flow)
Compares the value of the future cash flows of the project to today's dollars.
PV (Tax Savings)
Debt * Tax Rate
Increase in Strike Price
Decrease Call Option Value, Increase Put Option Value
European option
can be exercised only at expiration
FCF
cash flows to all capital providers