CF Short Answers
57. List the three forms of market efficiency and explain the basis for it.
• Weak-form efficiency •Semi-strong form efficiency •Strong form efficiency These distinctions are based on the level of information reflected in the security prices. Weak-form efficiency deals with historical prices. Semi-strong form deals with publicly available information that also includes historical information. Lastly, strong-form which includes all information.
73. What are some of the additional factors that have to be considered while estimating cash flows in other countries and currencies?
•Currency of the cash flow should be relevant to the project•Use an appropriate inflation rate for the project• Use the relevant tax rate and depreciation method for the project• Use the appropriate discount rate for the project
74. Discuss the importance of "beta" as a measure of risk.
"Beta" is a measure of market risk. It is also called relative measure of risk as it measures risk relative to the market risk. Beta is useful as a measure of risk in the context of well-diversified portfolios. It measures the risk contribution of a single security to the portfolio risk.
72. Briefly explain how "beta" of a stock is estimated.
"Beta" of a stock can be estimated graphically by plotting the market returns on the x-axis and the corresponding stock returns on the y-axis. The slope of the resulting linear graph is the "beta" estimate for the stock.
68. Briefly explain the term "hard rationing."
A firm faces hard rationing when it cannot raise more money in the capital markets. It is also be indicative of market imperfections. Market imperfections do not invalidate the NPV rule as long as the shareholders of the firm have access to well-functioning capital markets so that their portfolio choice is not restricted. The NPV rule is undermined when imperfections restrict shareholders' portfolio choice. Generally, hard rationing is rare for corporations in the U.S.A.
73. Briefly explain the trade-off theory of capital structure.
A firm's debt-equity decision can be thought of as a trade-off between interest tax shields and the costs of financial distress. These two interact to provide an optimal capital structure for a firm. This is called the trade-off theory.
60. What is the relationship between spot and forward rates?
A forward rate is the internal rate of return derived from the future value of bonds given spot rates from two different maturity bonds.
73. A retiree believes that investing in a non-dividend paying growth firm, that requires the periodic sale of stock for income, will eventually lead to a loss of all shares. Explain the flaw in this logic.
A growth firm, by definition, we have an increasing share price. Over time the firm will either have stock splits to maintain a stock price within a certain trading range or the price will go up substantially over time. In the case of stock splits, the retiree will get an ever increasing number of shares. In the case of an increasing share price, the retiree will need to liquidate an ver decreasing quantity of shares. In either case, the share will not disappear any faster than they would through dividend payments
97. Define the term "perpetuity."
A perpetuity is defined as the same cash flow occurring each year forever.
83. Explain why the cost of equity and the cost of debt are concave upward at high levels of debt.
As firm's take on higher levels of debt, the risk of default increases. Default risk requires a risk premium for investors. Since the risk of both debt and equity not getting paid increases, the premium also increases. Thus, both issues require an ever increasing risk premium.
100. Briefly explain, "continuous compounding."
As frequency of compounding increases, the effective rate on an investment also increases. In case of continuous compounding the frequency of compounding is infinity. In this case, the nature of the function also changes. The effective interest rate is given by (er - 1), where the value of e = 2.718. e is the base for natural logarithms
63. Briefly describe the factors that determine asset betas.
Asset betas are determined by the cyclical nature of the cash flows. Generally, cyclical firms have higher betas. Operating leverage also affects the asset beta of a firm. Firms with high fixed costs tend to have higher asset betas.
62. Briefly discuss some of the important findings of behavioral finance studies.
Behavioral finance studies have focused on three important areas: (1) limits to arbitrage, (2) attitudes toward risk, and (3) beliefs about probabilities. Arbitrage is defined as a strategy that exploits market inefficiency and generates superior returns if and when the prices return to efficient market prices or equilibrium prices. If arbitrage is not powerful enough to drive all prices to equilibrium levels, it will result in mispricing. This is caused by investors' attitude towards risk and the way the investors assess probabilities. This has led to the development of "prospect theory." Most investors are either too conservative or overconfident. In other words, investors are not 100% rational 100% of the time. Thus behavioral finance provides new interpretations of some long-standing puzzles and anomalies.
80. Explain why international stock may have high standard deviation but low betas.
Beta is traditionally measured relative to the S&P 500 index. As such, there may be very little statistical relationship between the S&P 500 and an international stock. If these two assets are independent of one another there is little chance they will have a statistically significant covariance. With a low covariance, by definition, the stock will have a low beta. This could occur even if the standard deviation of the beta is very high.
50. Briefly explain the cash flows associated with a bond to the investor.
Bonds provide two types of cash flows: interest payments and the principal payment. Interest payments occur each period, usually annually or semi-annually. Periodic interest payments are also called coupon payments. Thus this forms an annuity. Principal payment occurs at the time of maturity of the bond and is a lump sum payment.
80. Under what circumstances would MM's proposition is violated?
Briefly discuss. MM's proposition I is violated when the firm, by imaginative design of its capital structure, is able to offer some financial service that meets the needs of a particular clientele. Either the service must be new and unique or the firm must find a way to provide some existing service more cheaply than other firms or financial intermediaries is able to provide. Therefore, smart financial managers look for an unsatisfied clientele, investors who need a particular type of financial instrument but because of market imperfections are unable to get it or get it cheaply.
84. What are some of the additional factors that have to be considered when analyzing an international project?
Briefly explain. Sometimes international projects have additional features, like special contracts with suppliers, customers, or governments, that provide guarantees. These guarantees are valuable for the firm and should be added to the APV. Sometimes governments impose special restrictions. These restrictions generally decrease the value of the project to the firm. The value of the restrictions are subtracted from the APV.
59. What are TIPs?
Briefly explain. TIPs(Treasury Inflation-Protected Securities) are issued by the U.S. Treasury. The U.S. Treasury began issuing TIPs in 1997. These are also known as Inflation-indexed bonds. The real cash flows on TIPs are fixed, but the nominal cash flows, which includes interest and principal, are increased as the Consumer Price Index (CPI) increases. Thus the buying power of the lender in protected.
68. Define the term cash flow for a project.
Cash flow for a project is the net income plus depreciation. Cash flows are always estimated on an after-tax basis.
81. Discuss a successful example of corporations trying to add value through innovative financing.
Citicorp was the first to issue floating rate notes whose interest payments changed with changes in short term interest rates. The success of the issue suggests that Citicorp was able to add value through financing, by meeting an unmet need of the investors.
56. What are the primary reasons for a company to use debt in its capital structure?
Companies use debt for two main reasons: (a) debt is less expensive due to the tax-deductibility of interest charges, and (b) the use of debt does not dilute shareholders' equity position.
91. Briefly explain the term "discount rate."
Discount rate is the rate of return used for discounting future cash flows to obtain the present value. The discount rate can be obtained by looking at the rate of return, an equivalent investment opportunity in the capital market.
53. Discuss the concept of duration.
Duration can be thought of as the weighted average time of a bond's cash flow. The weights are determined by the present value factors. Duration is expressed in units of time. Duration is an important concept for two reasons. First, the volatility of a bond is directly related to its duration. Second, one way to hedge interest rate risk is through a strategy of duration matching.
69. What are some of the important points to remember while estimating the cash flows of a project?
Estimate after-tax cash flows on an incremental basis.• Include all incidental effects.• Include working capital requirements.• Include opportunity costs.• Do not include sunk costs.•Take inflation into consideration in a consistent manner.
70. How does Modigliani-Miller's proposition I is modified when taxes and financial distress costs are considered?
Financial distress occurs when bondholder contracts are broken or fulfilled with great difficulty. Financial distress could lead to bankruptcy. Financial distress is costly. This is reflected in the market value of the levered firm. Value of a levered firm = Value of an equivalent unlevered firm + PV(tax shield) - PV(cost of financial distress)
58. Why is liquidity relevant?
Firms have a need to convert assets into cash quickly. This is necessary to meet short term obligations. Without liquidity, even the most short term loans could force a company into bankruptcy.
73. Briefly explain what "beta" of a stock means.
For each additional 1% change in the market return, the return on the stock on the average changes by "beta" times 1%. For example the beta of IBM is 1.59, then for additional 1% change in the market return is expected change the returns on the IBM stock by 1.59%.
97. What are LYONs?
LYONs (Liquid yield option notes) are an innovation in bond design. They are puttable, callable, convertible and carry zero-coupon interest rate.
60. Discuss why one might use an industry beta to estimate a company's cost of capital.
Generally, an industry beta can be estimated more precisely than a company's beta. This is similar to the estimate of the beta of a portfolio is more precise than the estimate of the beta of a single stock. The estimated industry cost of capital must be suitably adjusted before using for company's cost of capital. For example, differences in the capital structure of the firm and the industry.
51. Briefly explain the relationship between accounting standards and the legal traditions.
Generally, companies from countries with English or Scandinavian legal traditions provide more accounting information and have higher accounting standards than companies from countries with French or German legal traditions.
83. What method would you use for evaluating international projects?
Generally, international projects have numerous and important side effects like special contracts with governments, suppliers, and customers. They also have special project financing packages. All these effects can be explicitly considered by using the APV method.
55. State the important differences between investment decisions and financing decisions
Generally, investment decisions have positive NPVs, while financing decisions have zero NPV. Mostly, investment decisions are irreversible while financing decisions are reversible. Investment decisions are made in factor markets while financing decisions are made in financial markets
62. Briefly explain what value should be used for the risk-free interest rate.
Generally, the value used for the risk-free rate is the short-term Treasury bill rate.
96. Discuss why a dollar tomorrow cannot be worth less than a dollar the day after tomorrow.
If a dollar tomorrow is worth less than a dollar a day after tomorrow, it would be possible to earn a very large amount of money through "money machine" effect. This is only possible, if someone else is losing a very large amount of money. These conditions can only exist for a short period of time, and cannot exist in equilibrium as the source of money is quickly exhausted. Thus a dollar tomorrow cannot be worth less than a dollar the day after tomorrow.
58. Briefly explain the difference between company and project cost of capital.
If a firm is considering projects that have the same risk as the firm, then the company cost of capital is the same as the project cost of capital. But if the firm is considering projects which have risks different from the company then the project cost of capital becomes relevant.
79. Briefly explain the concept of value additivity.
If the capital market establishes a value PV(A) for asset A and PV(B) for asset B the market value of the firm that holds both these assets is: PV(AB) = PV(A) + PV(B). This logic can be extended for any number of assets. Value additivity is also applicable to cash flows. We can add the present values of two cash flows and get the present value of the combined cash flows. It can be stated as follows: PV(A + B) = PV(A) + PV(B) and PV(A + B + C) = PV(A) + PV(B) + PV(C) This idea can be extended for any number of cash flows.
92. Briefly explain what is meant by "force conversion?"
If the conversion value is greater than the call price and bond is called, then the call is said to force conversion. Obviously, bondholders would convert the bonds to realize the higher conversion value.
66. Briefly describe the leftists' point of view on dividends and taxes.
If the dividends are taxed at a higher rate than capital gains, firms should pay the lowest cash dividends. By shifting their distribution policy, corporations can transform dividends into capital gains. Leftists generally favor low dividend payout.
59. Briefly explain how the use of single company cost of capital to evaluate projects might lead to erroneous decisions.
If the firm is considering projects with differing risk characteristics, the firm will reject low-risk projects and accept high-risk projects. In reality low - risk projects should be discounted at a lower rate and high-risk projects at a higher discount rate to account for differing risks.
94. Briefly explain the concept of risk.
If the future cash flows from an investment are not certain then we call it a risky cash flow. That means there is an uncertainty about the future cash flows or future cash flows could be different from expected cash flows. The degree of uncertainty varies from investment to investment. Generally, uncertain cash flows are discounted using a higher discount rate than certain cash flows. This is only one method of dealing with risk. There are many ways to take risk into consideration while making financial decisions.
92. Intuitively explain the concept of the present value.
If you have $100 today, you can invest it and start earning interest on it. On the other hand, if you have to make a payment of $100 one year from today, you do not need to invest $100 today but a lesser amount. The lesser amount invested today plus the interest earned on it should add up to $100. The present value of $100 one year from today at an interest rate of 10% is $90.91. [PV = 100/1.1 = 90.91]
72. Briefly discuss how taxes are taken into consideration in countries like Japan.
In Japan and all of the European Community countries, it is not possible to separate tax accounts reported to the government and those reported to shareholders. They must be same. In some countries it is not possible to use the accelerated depreciation.
56. Briefly explain why, in a competitive securities market,successive price changes are random.
In a competitive market, prices reflect all available information. The only reason prices change is because of new information. By definition new information arrives randomly. Therefore security prices change randomly.In a competitive market, prices reflect all available information. The only reason prices change is because of new information. By definition new information arrives randomly. Therefore security prices change randomly.
64. Briefly discuss the certainty equivalent approach to estimating the NPV of a project.
In the certainty equivalent approach, certainty equivalent cash flows are discounted at the risk-free rate to calculate the NPV of a project. First risky cash flows have to be converted to certainty equivalent cash flows by using individual risk factors. One advantage of this method is that the risk adjustment is separated from the time value of money. Conceptually this is a more sensible method than the risk adjusted discount rate method. But estimating certainty equivalent cash flows could be cumbersome.
70. Briefly describe the "imputation tax system."
In the imputation tax system, shareholders are taxed on dividends, but they receive a tax deduction, which is equal to their share of the corporate tax that the company has paid. This is followed in Australia.
77. Briefly explain how individuals can adjust their preferences for current and future consumption.
Individuals can adjust their preferences for consumption by borrowing or lending in the financial market. The appropriate balance between present and future consumption that each individual will choose depends on personal preferences. But individuals with different preferences can adjust their preferences using financial market
52. What is the relationship between interest rates and bond prices?
Interest rates and bond prices are inversely related. High interest rates cause bond prices to fall and vice-versa. For a given change in interest rates, prices of long-term bonds fluctuate more than for short-term bonds. Similarly, for a given change in interest rates low coupon bond prices fluctuate more than for high coupon bonds.
95. State the "rate of return rule."
Invest as long as the rate of return on the investment exceeds the rate of return on equivalent investments in the capital market.
93. State the "net present value rule."
Invest in projects with positive net present values. Net present value is the difference between the present value of future cash flows from the project and the initial investment.
85. "Urban renewal can be accomplished by the provision of government tax and loan incentives to business, despite the existence of negative NPV projects." Explain why this is true.
Investments may have a negative NPV in the absence of other incentives. When the government provides a financial incentive, in the form of subsidies, tax breaks, or low interest loans, the APV of the project may increase. If the increase is enough, the NPV may become positive and the firm might make the investment. This could cause economic development in areas that would not otherwise receive investments. The risk, however, is that the eventual elimination of the incentives may cause urban blight to return.
63. List the six lessons of market efficiency.
List the six lessons of market efficiency. • Markets have no memory • Trust market prices • Read the entrails • There are no financial illusions • The Do-it yourself alternative • Seen one stock, seen them all.
71. Briefly explain the acronym MACRS.
MACRS is short for Modified Accelerated Cost Recovery System. This is the result of the Tax Reform Act of 1986. It is based on a combination of double declining method and straight line depreciation methods. In this system, assets are classified into several classes like 3-year class, 5-year class etc. Tax depreciation allowed under each asset class is provided in a Table format. It uses mid-year convention and hence an asset under 3-year class has depreciation for four years, and etc. The alternative is to use the straight-line depreciation method.
95. Discuss the differences between publicly issued bonds and private placements.
Mainly, there are three differences. First, publicly issued bonds must be registered with the SEC, while private placements need not. Second, publicly issued bonds are highly standardized, while private placements are tailor-made for the firms involved. Third, the restrictions placed on the issuer are much more stringent with private placements.
67. Briefly explain the term "soft rationing".
Management uses soft rationing to get better financial control over investment decisions. Soft rationing is imposed by the management on a temporary basis and not by capital markets.
76. Briefly explain how the cost of excess capacity is taken into consideration.
Many managers assume that the marginal cost of excess capacity is zero and encourage employees to use up the excess capacity. This may not be a very sound way to utilize excess capacity. If we use the equivalent annual cost (EAC) approach cost of excess capacity can be estimated easily. Indiscriminate use of excess capacity may result in replacing the existing machine with a new machine sooner. This is the cost of excess capacity and must be taken into consideration.
72. Explain the term market risk.
Market risk is that part of the risk that is associated with market-wide variations. Investors cannot eliminate market risk. All the risk in a well-diversified portfolio is market risk. Beta is a measure of market risk.
68. Briefly describe the middle-of-the-roaders' position.
Middle-of-the-roaders hold that a firm's value is not affected by its dividend policy.
69. State how the present value of tax shield is changed when personal taxes are included.
Miller developed a modified form of proposition I by including personal taxes on equity income and interest income. These could be different from corporate taxes. VL= VU+ [(1 - (1 - TC)(1 - TPE)/(1 - TP)](D) Where: TC = Corporate tax rate, TPE= personal tax rate on income from equity and TP = personal tax rate on interest income.
82. State the generalized version of Modigliani-Miller proposition I.
Modigliani-Miller proposition I states that changes in capital structure does not affect the value of a firm. MM's proposition I is an extremely general result. Any change in the capital structure of the firm can be duplicated or "undone" by the investors at no cost. The investors need not pay extra for borrowing indirectly (by holding shares in a levered firm) when they can borrow just as easily and cheaply on their own account. It applies equally to trade-offs of any choice of financial instruments. For example, the choice between long-term debt and short-term debt would also not affect the value of the firm. Generally, the choice between issuing preferred stock, common stock, or some combination of the two should not have any effect on the overall value of the firm. It also applies to the mix of debt securities issued by the firm. The choices of long-term versus short-term, secured versus unsecured, senior versus subordinated, and convertible and nonconvertible debt all should not have any effect on the overall value of the firm.
78. How can individual investors diversify?
One of the simplest ways for individual investor to diversify is to buy shares in a mutual fund that holds a diversified portfolio.
96. Briefly explain project financing.
Project financing refers to debt financing that is largely a claim against the cash flow from a particular project rather than against the firm as a whole. Project financing is used for power, communication and transportation projects. This is also used extensively in developing countries.
74. How do you compare projects with different lives?
Projects with different lives are compared assuming that the projects are repeated to infinity, called replacement chains. The replacement chains are analyzed using equivalent annual costs (EAC) or adjusted NPVs (adjusted for differences in project lives).
61. What are puzzles and anomalies?
Puzzles and anomalies are abnormal behavior of stocks that apparently contradict the efficient market hypothesis. There are quite a few of them. For example, stocks of small firms have provided abnormally high returns compared to stocks of large firms.
64. How does the random walk theory explain market crashes?
Random walk theory relies upon the concept of a normal or lognormal distribution pattern for stocks. This requires that the stock price gains and losses reflect a normal distribution. For this to occur, there must, on rare occasion, be large movements in stock prices in either direction. Thus, a large drop in stock prices must occur for the movement to truly be random
58. Define the term, "real interest rate."
Real interest rate is the inflation adjusted nominal interest rate. We do not observe it directly. The relationship between the two is given by: 1 + r nominal = (1 + real rate)(1 + inflation rate). (An approximate formula that works for low values is: r nominal = r real rate + Inflation rate)
98. What are reverse floaters?
Reverse floaters are floating-rate bonds that pay a higher rate of interest when other rates of interests fall and a lower rate when other rates rise.
73. Briefly explain the term "security market line."
Security market line (SML) is the straight-line plot of "beta" on the x-axis and expected return on investment on y-axis. This straight line joins two benchmark investments: Risk-free rate on the y-axis and the market portfolio, which has a beta of one. It provides the risk-return tradeoff for any security. In equilibrium all securities should plot on SML. It is used for comparing investments with different risk characteristics.
60. State the semi-strong form of market efficiency and its implications.
Security prices reflect all publicly available information. If markets are efficient in this sense, then prices will adjust immediately to public announcements.
58. State the strong form of market efficiency.
Security prices reflect all the information that is available to the investors.
59. State the weak form of market efficiency and its implications.
Security prices reflect the information contained in the record of past prices. This implies that prices will follow a random walk. It is impossible to make consistently superior profits by studying past returns. Type: Medium
69. Briefly explain how shareholders' returns are taxed twice in the United States?
Shareholders' returns are taxed at the corporate level as corporate tax, and at the shareholders level as either income tax or capital gains tax.
93. Explain why firms issue convertible debt.
Smaller and more risky firms generally issue convertibles. Convertibles are useful when investors have difficulty in assessing the risk of a company's debt. They also diminish the possible conflicts of interest between bondholder and stockholder.
53. How are "uses and sources" of funds are calculated?
Sources and uses of funds are calculated as follows: Total uses of funds = Investment in net working capital + investment in fixed assets + dividends paid to shareholders Total sources of funds = operating cash flow + new issues of long-term debt + new issues of equity
67. Briefly explain how current tax laws favor capital gains?
Tax rate on capital gains tax rate is 20%, while for taxable income it is much higher. Tax laws favor capital gains in another way. Taxes on dividends have to be paid immediately. But, taxes on capital gains can be deferred until the shares are sold and capital gains realized. The longer the shareholders wait, less the present value of capital gains liability.
82. What discount rate should be used for calculating the present value of safe, nominal cash flows?
The discount rate used for finding the present value of safe, nominal cash flows is the after-tax cost of debt. This present value is also the value of an equivalent loan that can be paid off using the cash flows.
80. Under what circumstances would it be better to use the Adjusted Present Value approach?
The APV approach is better if there are many side effects to financing. For example, if a firm is getting a subsidized loan for a project then the APV method should be used. It is used when the amount of debt is known.
57. Discuss the DuPont system.
The DuPont system is a quick way of looking at the performance of a firm or a division. ROA and ROE can be thought of as comprising of several ratios and hence provide some useful information about the interaction of these ratios.
69. When calculating a weighted average profitability index should you apply an index of 0 to left over money?
The NPV of money that is not invested is zero. If the NPV is zero the profitability index is zero. Thus, the math leads to a PI of zero for left over money. Additionally, money not invested cannot be assumed to have created value.
77. What is the beta of a portfolio with a large number of randomly selected stocks?
The beta of a portfolio with a large number of randomly selected stocks is equal to one. The standard deviation of such a portfolio is equal to the standard deviation of the market.
75. Explain the impact of government loan guarantees on corporate financing.
The capital markets naturally punish firms for excess use of debt via default and bankruptcy. Firms naturally will turn away from debt financing and back towards equity financing. Intervention in the capital markets by the government to provide loan guarantees to firms on the brink of failure works in the opposite direction by encouraging further leveraging.
75. Briefly explain how the decision to replace an existing machine is made?
The decision to replace an existing machine is done for economic or technological reasons or for both. For this equivalent annuity approach is used. As long as the benefits exceed equivalent annual costs replacing old machine with a new one, the decision will be a sound one.
78. Briefly explain how the beta of equity of a firm changes with changes in debt-equity ratio when taxes are considered.
The equity beta of a firm increases linearly with changes in debt-equity ratio. This is modified by the tax factor. The exact relationship is obtained by combining capital asset pricing model and Modigliani-Miller proposition II with taxes. The relationship is given by: bE = bA + (1 - TC)(bA- bD)(D/E)
57. What is the relationship between real and nominal rates of interest?
The exact relationship is given by: (1 + nominal rate ) = (1 + real rate) * (1 + expected Inflation rate). It can also be written as: nominal rate = real rate + Inflation rate + (real rate) * (Inflation rate)
77. State and explain MM's Proposition II.
The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio, stated in market values. rE = rA + (D/E) * (rA - rD). As the debt-equity ratio increases the cost of equity increases; the cost of debt and the weighted average cost of capital remain constant. This also implies that the beta of the firm's equity also increases in the same manner.
61. Briefly explain how a firm's cost of equity is estimated using the capital asset pricing model (CAPM).
The first step is to estimate the beta of the firm's common stock by regressing the returns on the stock on the market returns using historical data. Expected stock return is estimated using CAPM [E(R) = rf + (beta)( rm- rf )]. Expected return is the estimate of the firm's cost of equity.
78. Explain why growth mutual funds are worse investments than taking out a second mortgage on a home and investing in the market index.
The growth mutual fund is usually riskier than the market portfolio. It is well below the security market line and is not producing an efficient risk return trade off. While difficult to accept, a second mortgage permits the investor to create a leveraged investment in the tangency portfolio. This generates a return that is on the security market line and has a higher return given the same level of risk as the growth fund. As such, the investor can earn a better risk return trade off than with the growth fund. True, this is a very risky investment, but it is better than the growth fund. Investors often fail to realize the risk of the growth fund.
94. Explain the differences between warrants and convertibles.
The main differences are: warrants are usually issued as a part of a private placement; warrants can be detached and sold separately; warrants may be issued on their own; warrants are exercised for cash; warrants and convertibles are subject to different tax rules.
76. Briefly explain how EPS-Operating Income analysis helps determine the capital structure of a firm?
The plot of EPS - operating income at a specified amount of debt will provide the break-even income. If the firm's income is above the break-even point debt financing is preferred and below that equity financing is preferred. In this method expected level of operating income will determine whether debt financing should be used or equity financing be used.
98. Describe how you would go about finding the present value of any annuity given the formula for the present value of a perpetuity.
The present value of any annuity can be thought of as the difference between two perpetuities one payment stating in year-1 (immediate) and one starting in year (n + 1) (delayed). By calculating difference between the present values of these two perpetuities today we can find the present value of an annuity.
62. Briefly explain the term "market capitalization rate."
The rate of return expected by the investors in common stocks is called the market capitalization rate. It is also called the cost of equity capital. For a constant growth stock it is the dividend yield plus the growth rate in dividends.
79. Briefly explain how the rate of return on equity of a firm changes with changes in debt-equity ratio when taxes are considered.
The rate of return on equity of a firm increases linearly with changes in debt-equity ratio. This is modified by the tax factor. The exact relationship is obtained by combining capital asset pricing model and Modigliani-Miller proposition II with taxes. The relationship is given by: rE = rA + (1 - TC)(rA - rD)(D/E)
54. What are the common ratios used to measure liquidity of a firm?
The ratios commonly used to measure liquidity are the current ratio, quick ratio, and cash ratio.
74. Briefly explain the "capital asset pricing model."
The relationship, that in a competitive market, the expected risk premium on a security varies in direct proportion to beta is called the capital asset pricing model (CAPM). It is expressed as:
68. What is the relative tax advantage of debt when corporate and personal taxes are considered?
The relative tax advantage of debt can be stated as: (1 - TP)/[(1 - TC)(1 - TPE)] Suppose all equity income is in the form of dividends then TPE= TP, the relative tax advantage of debt is: 1/(1 - TC) In case (1 - TP) = (1 - TC)(1 - TPE), the relative tax advantage is zero.
65. Briefly discuss the risk adjusted discount rate approach to estimating the NPV of a project.
The risk adjusted discount rate approach uses the discount rate to adjust for both risk and the time value of money. The main advantage of this approach is simplicity. Risky project cash flows are discounted using risk adjusted discount rates (higher rates) to calculate the NPV of a project.
76. Briefly explain how individual securities affect portfolio risk.
The risk of a well-diversified portfolio depends on the market risk of the securities included in the portfolio. Portfolio beta is the weighted average of individual security betas included in the portfolio.
77. Briefly explain the difference between an equivalent annual cost and an equivalent annual annuity.
The technique of equivalent annual cash flows can be employed for evaluating cost saving projects or projects that generate positive NPVs. When used to evaluate cost savings projects the term equivalent annual cost is used and we seek to minimize this number. When looking at positive NP
55. Briefly explain what is meant by "the term structure of interest rates."
The term structure of interest rates is the plot of interest rates on the y-axis and the maturity on the x-axis. It is also called the yield curve. It shows how interest rates and maturity are related. Economists have developed several theories to explain the shape of the yield curve.
52. What are the three basic financial statements?
The three basic financial statements are the balance sheet, the income statement, and the sources and uses of funds.
77. Briefly discuss how you would use Fama-French three-factor model to estimate the cost of equity for a firm.
The three factors considered are: (1) market factor, (2) size factor, and (3) book-to-market value factor.•Estimate the risk premiums for each factor.•Estimate the factor sensitivities. Use the following model to estimate the expected equity returns on the stock.
76. Briefly explain the Fama-French Three-Factor Model.
The three-factor model was developed by Fama and French and is an empirical model. They have identified three factors that explain the security risk premium better. The three factors are: Market factor, Size factor, and Book-to-market factor.
79. Briefly describe the traditional position on capital structure.
The traditional view of the debt policy states that moderate amounts of debt increase the expected return on equity, but when the firm borrows too much the expected return on equity declines. The weighted average cost of capital declines initially at low levels of debt and later increases at higher levels of debt. Hence, there is an optimal capital structure for a firm.
81. Briefly explain how APV can be used for valuing a business.
The value of a business can be estimated by calculating the present value of free cash flows (FCF) generated by a firm using opportunity cost of capital as the discounts rate for the life of the firm. This gives the base-case NPV. Business debt levels, interest, and interest tax shields are calculated. If the debt levels are fixed, then the interest tax shields are discounted at the borrowing rate to get the present value of interest tax shields. The value of the firm is the base-case NPV plus the present value of interest tax shields.
63. Discuss the general principle in the valuation of a common stock.
The value of a common stock is the present value of all the dividends received by owning the stock discounted at the market capitalization rate or the cost of equity. This is called the discounted cash flow (DCF) method.
91. What are the three elements of convertible bond value?
The value of a convertible bond is determined by straight bond value, conversion value and the option value. Value of a convertible bond = Higher of [Straight bond value, conversion value] + Option value. The straight bond value and the conversion values provide the floor for the convertible bond value.
51. Briefly explain the term "yield to maturity."
The yield to maturity is the single discount rate that is used to calculate the present value of cash flows received from buying a bond. It is used for calculating the bond value. Conceptually it is the same as the internal rate of return (IRR). It is also stock-in-trade of any bond dealer.
71. Briefly explain bankruptcy costs.
There are direct and indirect costs to bankruptcy. Direct costs include legal and administrative costs of liquidation or reorganization. Indirect costs of financial distress include impaired ability to conduct business and increased agency costs. Agency costs associated with managerial actions under the threat of bankruptcy are: risk shifting, under-investment or refusal to invest more equity, and milking the property.
55. Briefly explain the different categories of financial ratios.
There are five categories of financial ratios. They are: leverage ratios, liquidity ratios, efficiency ratios, profitability ratios, and market value ratios.
64. Briefly explain the assumptions associated with the constant dividend growth formula.
There are two important assumptions that are necessary for the formula to work correctly. First assumption is that the growth rate in dividends is constant. The second assumption is that the discount rate is greater than the growth rate in dividends.
66. Briefly discuss capital rationing.
There are two types of capital rationing; soft rationing imposed by the company and hard rationing imposed by the capital markets. Capital rationing results in the firm foregoing some positive NPV projects thereby reducing a firm's value.
61. Briefly explain the major types of exchanges prevalent in the USA.
There are two types of exchanges that are prevalent in the USA. They are auction markets and dealer markets. The New York Stock Exchange is an example of an auction market. Here specialists act as auctioneers and match up would-be buyers and sellers. The Nasdaq is an example of a dealer market. In the case of a dealer market all trades take place between a group of dealers and the investors. Dealer markets are also active in trading many other types of financial instruments such as bonds.
70. Briefly explain how inflation is treated consistently while estimation the project NPV.
There are two ways to treat inflation consistently in the estimation of NPV of a project. If the discount rate is stated in nominal terms, then consistency requires that project cash flows also be estimated in nominal terms. This might involve using different inflation rates for different components of cash flow. If the discount rate is stated in real terms then real cash flows are estimated for the project. The consistency rule is: discount nominal cash flows at a nominal discount rate and discount real cash flows at a real discount rate.
78. Briefly explain how changes in debt-equity ratio impacts on the beta of the firm's equity?
There is a linear relationship between the equity beta of a firm and its debt-equity ratio. It is obtained by combining Modigliani-Miller proposition II with the capital asset pricing model (CAPM). The relationship is given by: bE= bA + (D/E)(bA- bD). Many times bD(beta of debt) is zero. Then the relationship is written as: bE= [1 + (D/E)](bA).
66. Why do firms with large cash flow betas also have high asset betas?
There is a strong correlation between the risk of the assets of a firm and the risk of the firm's earnings. As such high asset betas lead to high cash flow betas.
100. Explain why the following phrase is true or false. "Government loan guarantees are costless methods for the government to help troubled firms."
This phrase is false for many reasons. While the issuance of a guarantee does not involve an upfront cost, it does transfer value and risk. A loan guarantee adds value to the recipients. By providing a guarantee the firm will assume more risk than the capital markets would otherwise allow it to take. The transfer of risk to the government and the subsequent reduced risk aversion of the firm, may increase the chance of a payout by the government. The intervention of the government prevents capital markets from assigning proper risk adjusted prices to firm assets.
74. Explain the pecking order theory of capital structure.
This theory is based on the observation that, in general, managers know more about the firm's prospects, risks, and values than do outsiders. This asymmetric information affects the choice between internal and external financing and between new issues of debt and equity. The implication is that firms prefer internal financing to external financing. When firms are propelled to go for external financing it prefers debt to equity.
56. Briefly explain the expectations theory.
This theory postulates that the current forward rates are the expected value of the corresponding future spot rates.
75. Where would under priced and overpriced securities plot on the SML (security market line)?
Under priced securities would plot above the SML and overpriced securities would plot below the SML. These conditions do not last long in a competitive market. As investors start buying the under priced securities, their prices will increase and would be forced to move towards the SML. Investors would sell the overpriced securities thereby forcing their prices down and again these securities would move towards the SML. In equilibrium all securities will plot on the SML.
75. Briefly explain the difference between beta as a measure of risk and variance as a measure of risk.
Variance measures the total risk of a security and is a measure of stand-alone risk. Total risk has both unique risk and market risk. In a well-diversified portfolio, unique risks tend to cancel each other out and only the market risk is remaining. Beta is a measure of market risk and is useful in the context of a well-diversified portfolio. Beta measures the sensitivity of the security returns to changes in market returns. Market portfolio has a beta of one and is considered the average risk.
54. Briefly discuss the concept of volatility.
Volatility is calculated as Duration/ (1 + yield). Bonds with longer duration also have greater volatility. Bond's volatility is directly related to duration. Volatility is also the slope of the curve relating the bond price to the interest rate.
72. Discuss some examples of the conflicts of interest that may arise between bondholders and stockholders when a firm is in financial distress.
When a firm is in distress, the shareholders are interested in protecting the value of their securities and hence take actions that might decrease the value of the firm and hence reduce the debtholders' wealth. Some examples of such actions are risk shifting, refusing to contribute equity capital, milking the assets, playing for time and bait and switch.
60. Explain the term "secondary market."
When already issued stocks are traded in the market, it is called a secondary market transaction. Most transactions in the stock market are secondary market transactions.
99. What is the difference between simple interest and compound interest?
When money is invested at compound interest, each interest payment is reinvested to earn more interest in subsequent periods. In the simple interest case, the interest is paid only on the initial investment.
59. Explain the term "primary market.
When new shares of common stocks are sold in the market to raise capital, it is called a primary market transaction. A good example of a primary market transaction is the IPO (Initial Public Offering)