fin 300 final
Translation exposure
the impact of translation gains and losses will not be recognized explicitly in net income until the underlying assets and liabilities are sold or otherwise liquidated
Expected returns are based on the probabilities of
Possible outcomes
additional return we earn by moving from a relatively risk-free investment to a risky one
Risk Premium
E(R ) - Rf
Risk premium
he British pound trades at $1.5872 in London and $1.5769 in New York. How much profit could you earn on each trade with $10,000?
$10,000(£/$1.5769) = £6,341.56 in New York. Sell the £6,341.56 in London for £6,341.56($1.5872/£) = $10,065.32 Your profit is $10,065.32 - 10,000 = $65.32 for each $10,000 transaction
Consider an asset with a beta of 1.2, a risk-free rate of 5%, and a market return of 13%. What is the reward-to-risk ratio in equilibrium? What is the expected return on the asset?
.08x1.2=E(Ra)-Rf = .096+.05 = E(Ra) E(Ra)= 14.6% E(R) = 5% + (13% - 5%)* 1.2 = 14.6%
Top performers historically
1. Small company stock 2. Large company stocks 3. Long term corporate bonds 4. Long term govt bonds 5. intermediate govt bonds
If we only consider the effect of taxes, what is the optimum capital structure?
100% debt
Long term bond portfolios are generally
20 years
costs of avoiding a bankruptcy filing incurred by a financially distressed firm are called
Indirect bankruptcy costs
two parties exchange a floating-rate payment for a fixed-rate payment or vice versa
Interest rate swap
a security issued in the United States that represents shares of a foreign stock, allowing that stock to be traded in the United States
ADR
a commodity costs the same regardless of what currency is used to purchase it or where it is selling
Absolute purchasing power parity
You've observed the following returns on Barnett Corporation's stock over the past five years: −12 percent, 23 percent, 18 percent, 7 percent, and 13 percent... What is the arithmetic average return?
Arithmetic average return = (-.12 + .23 + .18 + .07 + .13) / 5 Arithmetic average return = .0980, or 9.80%
A stock has had returns of −23 percent, 9 percent, 37 percent, −8 percent, 28 percent, and 19 percent over the last six years. What are the arithmetic and geometric returns for the stock?
Arithmetic average return = (-.23 + .09 + .37 -.08 + .28 +.19) / 6 Arithmetic average return = .1033, or 10.33% Geometric average return = [(1 + R1) × (1 + R2) × ... × (1 + RT)]^1/T - 1 Geometric average return = [(1 - .23)(1 + .09)(1 + .37)(1 - .08)(1 + .28)(1 + .19)]^(1/6) - 1 Geometric average return = .0828, or 8.28%
in calculating WACC, if you had to use book values for debt or equity which would you choose?
Book values for debt are likely to be much closer to their market values than are book values for equity
risk inherent in a firm's operations is called
Business risk
return that the firm's creditors demand on new borrowing
Cost of debt
the required rate of return on the firm's assets, RA; the firm's cost of debt, RD; and the firm's debt-equity ratio, D/E
Cost of equity
the implicit exchange rate between two currencies (usually non-U.S.) when both are quoted in some third currency, usually the U.S. dollar
Cross rate
agreements to deliver one currency in exchange for another
Currency swaps
Value=
Debt+Equity
legal and administrative expenses associated with the bankruptcy proceeding
Direct bankruptcy cost
You purchased 250 shares of a particular stock at the beginning of the year at a price of $87.25. The stock paid a dividend of $1.15 per share, and the stock price at the end of the year was $94.86. What was your dollar return on this investment?
Dollar return = 250($94.86 - 87.25 + 1.15) Dollar return = $2,190
Stock Y has a beta of 1.20 and an expected return of 11.6 percent. Stock Z has a beta of .85 and an expected return of 10.3 percent. If the risk-free rate is 4.1 percent and the market risk premium is 7 percent, are these stocks correctly priced?
E(RY) = .041 + .07(1.20) E(RY) = .1250, or 12.50% E(RZ) = .041 + .07(.85) E(RZ) = .1005, or 10.05% Reward-to-risk ratio Y = (.116 - .041) / 1.20 Reward-to-risk ratio Y = .0625
Using CAPM. A stock has a beta of 1.23, the expected return on the market is 10.9 percent, and the riskfree rate is 3.6 percent. What must the expected return on this stock be?
E(Ri) = .036 + (.1090 - .036)(1.23) E(Ri) = .1258, or 12.58%
A stock has an expected return of 11.4 percent, the risk-free rate is 3.7 percent, and the market risk premium is 7.1 percent. What must the beta of this stock be?
E(Ri) = Rf + [E(RM) - Rf] × βi .114 = .037 + .071βi βi = 1.08
You have $250,000 to invest in a stock portfolio. Your choices are Stock H, with an expected return of 12.9 percent, and Stock L, with an expected return of 9.8 percent. If your goal is to create a portfolio with an expected return of 11.1 percent, how much money will you invest in Stock H? In Stock L?
E(Rp) = .111 = .129xH + .0980(1 - xH) xH = .4194 xL = 1 - xH xL = 1 - .4194 xL = .5806 Investment in H = .4194($250,000) Investment in H = $104,838.71 Investment in L = .5806($250,000) Investment in L = $145,161.29
Taxes*=
EBIT x Tc
a bond issued in multiple countries, but denominated in a single currency, usually the issuer's home currency. traded mostly from London
Eurobond
money deposited in a financial center outside of the country whose currency is involved
Euroccurency
Total Return = ?
Expected return + unexpected return R = E(R) + U
direct and indirect costs associated with going bankrupt and/or avoiding a bankruptcy filing
Financial distress cost
extra risk that arises from the use of debt financing is called
Financial risk
are issued in a single country and are usually denominated in that country's currency
Foreign bonds
an agreement to exchange currency at some time in the future. The exchange rate that will be used is agreed upon today and is called the forward exchange rate
Forward trade
firms try to match up foreign currency inflows and outflows
Hedging long run exposure
use of local financing, perhaps from the government of the foreign country in question, reduces the possible loss because the company can refuse to pay on the debt in the event of unfavorable political activities
Hedging political risk
enter into a forward exchange agreement to lock in an exchange rate
Hedging short run exposure
use of personal borrowing to alter the degree of financial leverage
Homemade leverage
Silverton Co. is comparing two different capital structures. Plan I would result in 11,500 shares of stock and $494,000 in debt. Plan II would result in 16,000 shares of stock and $260,000 in debt. The interest rate on the debt is 10 percent. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $68,000. The all-equity plan would result in 21,000 shares of stock outstanding. Which of the three plans has the highest EPS? The lowest?
I II All-equity EBIT $68,000 $68,000 $68,000 Interest 49,400 26,000 0 NI $18,600 $ 42,000 $68,000 EPS $1.62 $2.63 $3.24
Beta
If B = 1.0, stock has average risk If B > 1.0, stock is riskier than average If B < 1.0, stock is less risky than average Most stocks have betas in the range of 0.5 to 1.5 Beta of the market = 1.0 Beta of a T-Bill = 0
If a firms WACC is 12%, what does this mean?
It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this, value is created
According to purchasing power parity, if a Big Mac sells for $4.79 in the United States and krona 135.34 in Iceland, what is the krona/$ exchange rate?
Krona 135.34 / $4.79 = Krona 28.2547/$
the value of a foreign operation can fluctuate because of unanticipated changes in relative economic conditions
Long run exposure
Cash flows of the firm do not change; therefor value does not change value is not affected by changes in the capital structure
M&M Proposition I
WACC of firm is not affected by capital structure.
M&M prop II
Standard Deviation Beta Security C 20% 1.25 Security K 30% 0.95 Which security has more total risk? Which security has more systematic risk? Which security should have the higher expected return?
More risk= C
Explain why a characteristic of an efficient market is that investments in that market have zero NPVs
On average, the only return that is earned is the required return—investors buy assets with returns in excess of the required return (positive NPV), bidding up the price and thus causing the return to fall to the required return (zero NPV); investors sell assets with returns less than the required return (negative NPV), driving the price lower and thus the causing the return to rise to the required return (zero NPV)
You bought one of Rocky Mountain Manufacturing Co.'s 6.5 percent coupon bonds one year ago for $1,032.15. These bonds make annual payments and mature nine years from now. Suppose you decide to sell your bonds today, when the required return on the bonds is 5.2 percent. If the inflation rate was 3.5 percent over the past year, what would be your total real return on investment?
P1 = $65(PVIFA5.2%,9) + $1,000 / 1.052^9 P1 = $1,091.58 R = ($1,091.58 - 1,032.15 + 65) / $1,032.15 R = .1206, or 12.06% r = (1.1206 / 1.035) - 1 r = .0827, or 8.27%
Kyle Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 300,000 shares of stock outstanding. Under Plan II, there would be 210,000 shares of stock outstanding and $2,367,000 in debt outstanding. The interest rate on the debt is 10 percent, and there are no taxes. If EBIT is $600,000, which plan will result in the higher EPS? What is the break-even EBIT?
Plan 1 EPS = $600,000 / 300,000 shares EPS = $2.00 Plan 2 NI = $600,000 - .10($2,367,000) NI = $363,300 EPS = $363,300 / 210,000 shares EPS = $1.73 Break Even: EBIT / 300,000 = [EBIT - .10($2,367,000)] / 210,000 EBIT = $789,000
changes in value that arise as a consequence of political actions
Political risk
Weighted average of the Betas of the assets in the portfolio
Portfolio Beta
You bought a share of 5.5 percent preferred stock for $104.18 last year. The market price for your stock is now $102.67. What is your total return for last year?
R = ($102.67 - 104.18 + 5.50) / $104.18 R = .0383, or 3.83%
You bought a stock three months ago for $42.67 per share. The stock paid no dividends. The current share price is $45.38. What is the APR of your investment? The EAR?
R = ($45.38 - 42.67) / $42.67 R = .0635, or 6.35% APR = 4(6.35%) APR = 25.40% EAR = (1 + .0635)^4 - 1 EAR = .2793, or 27.93%
Rework Problem the previous problem assuming the ending share price is $62.
R = [($62 - 72) + 1.65] / $72 R = -.1160, or -11.60% Dividend yield = $1.65 / $72 Dividend yield = .0229, or 2.29% Capital gains yield = ($62 - 72) / $72 Capital gains yield = -.1389, or -13.89%
Suppose a stock had an initial price of $72 per share, paid a dividend of $1.65 per share during the year, and had an ending share price of $85. Compute the percentage total return. What was the dividend yield? The capital gains yield?
R = [($85 - 72) + 1.65] / $72 R = .2035, or 20.35% Dividend yield = $1.65 / $72 Dividend yield = .0229, or 2.29% Capital gains yield = ($85 - 72) / $72 Capital gains yield = .1806, or 18.06%
The Giuntoli Co. just issued a dividend of $2.55 per share on its common stock. The company is expected to maintain a constant 5 percent growth rate in its dividends indefinitely. If the stock sells for $43 a share, what is the company's cost of equity?
RE = [$2.55(1.05) / $43] + .05 RE = .1123, or 11.23%
he cost of preferred stock, RP, is
RP=D/Po D is the fixed dividend and Po is the current price per share of the preferred stock
tells what determines the change in the exchange rate over time
Relative purchasing power parity
You purchased a zero-coupon bond one year ago for $352.81. The market interest rate is now 5.4 percent. If the bond had 20 years to maturity when you originally purchased it, what was your total return for the past year?
Since one year has elapsed, the bond now has 19 years to maturity, so the price today is: P1 = $1,000 / 1.027^38 P1 = $363.35 Capital gains: R = ($363.35 - 352.81) / $352.81 R = .0299, or 2.99%
an agreement to exchange currency "on the spot," which actually means that the transaction will be completed, or settled, within two business days
Spot trade
firms borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress
Static theory of capital structure
There is a reward for bearing risk There is no reward for bearing risk unnecessarily The expected return (market required return) on an asset depends only on that asset's systematic or market risk
Systemic Principle
changes in GDP, inflation, interest rates, etc
Systemic risk
The exchange rate for the Australian dollar is currently A$1.40. This exchange rate is expected to rise by 10 percent over the next year. Is the Australian dollar expected to get stronger or weaker?
The Australian dollar is expected to weaken relative to the dollar, because it will take more A$ in the future to buy one dollar than it does today
Pounds per $1: .60 Swiss frank per $1: 2.00 What is cross rate for franks to pounds? Assume you have $100, you could...
The cross-rate should be SF 2.00/£.60 = SF 3.33 per pound you could... Exchange dollars for francs: $100 × 2 = SF 200. Exchange francs for pounds: SF 200/3 = £66.67. Exchange pounds for dollars: £66.67/.60 = $111.12
Suppose you have $1,000, how many Japanese yen can you get? Alternatively, if a Porsche costs €200,000 (€ is the symbol for the euro), how many dollars will you need to buy it? USD Equiv Currency Per USD Yen: .00843 118.62 Euro: 1.2452 .8031
The exchange rate in terms of yen per dollar is 118.62. Your $1,000 will thus get you: 118,620 yen ecause the exchange rate in terms of dollars per euro is 1.2452, you will need: $249,040
Suppose the rate of inflation in Russia will run about 3 percent higher than the U.S. inflation rate over the next several years. All other things being the same, what will happen to the ruble versus dollar exchange rate?
The exchange rate will increase, as it will take progressively more rubles to purchase a dollar as the higher inflation in Russia will devalue the ruble
A stock market analyst is able to identify mispriced stocks by comparing the average price for the last 10 days to the average price for the last 60 days. If this is true, what do you know about the market?
The market is not weak form efficient
What are the disadvantages of using the dividend growth model (DGM) for determining the cost of equity capital?
The method is disadvantaged in that (1) the model is applicable only to firms that actually pay dividends; many do not; (2) even if a firm does pay dividends, the DGM model requires a constant dividend growth rate forever
Cost of capital depends on...
The risk of the project
expected return on a risky investment depends on
The risk-free rate, Rf The market risk premium, E(RM) − Rf The systematic risk of the asset relative to that in an average risky asset, which we called its beta coefficient, β
You own a portfolio that has $2,750 invested in Stock A and $3,900 invested in Stock B. If the expected returns on these stocks are 9 percent and 14 percent, respectively, what is the expected return on the portfolio?
Total value = $2,750 + 3,900 Total value = $6,650 E(Rp) = ($2,750 / $6,650)(.09) + ($3,900 / $6,650)(.14) E(Rp) = .1193, or 11.93%
What are the portfolio weights for a portfolio that has 165 shares of stock A that sell for $69 per share and 125 shares of Stock B that sell for $44 per share?
Total value = 165($69) + 125($44) Total value = $16,885 Portfolio weight= xA = 165($69) / $16,885 xA = .6743 xB = 125($44) / $16,885 xB = .3257
For absolute PPP to hold absolutely, what must be true? (using apples)
Transaction costs must be zero, here must be no barriers to trading, Finally, an apple in New York must be identical to an apple in London
Systematic portion (m) + Unsystematic portion (ε)
Unexpected return
Risk that can be eliminated by combining assets into portfolios For good portfolios, this number is very small Ex: labor strike, part shortages
Unsystemic Risk
the overall return the firm must earn on its existing assets to maintain the value of its stock.
WACC
Crosby Industries has a debt-equity ratio of 1.5. Its WACC is 9.1 percent, and its cost of debt is 5.5 percent. There is no corporate tax. What is the company's cost of equity capital? What would the cost of equity be if the debt-equity ratio were 2.0?
WACC = .091 = (1/2.5)RE + (1.5/2.5)(.055) RE = .1450, or 14.50% 091 = (1/3)RE + (2/3)(.055) RE = .1630, or 16.30%
Tulloch Manufacturing has a target debt-equity ratio of .45. Its cost of equity is 10.3 percent, and its pretax cost of debt is 6.4 percent. If the tax rate is 35 percent, what is the company's WACC?
WACC = .103(1/1.45) + .064(.45/1.45)(1 - .35) WACC = .0839, or 8.39%
Suppose the exchange rate for the Swiss franc is quoted as SF 1.10 in the spot market and SF 1.13 in the 90-day forward market, Is the dollar selling at a premium or a discount relative to the franc? Does the financial market expect the franc to strengthen relative to the dollar? Explain. What do you suspect is true about relative economic conditions in the United States and Switzerland?
a. The dollar is selling at a premium, because it is more expensive in the forward market than in the spot market b. The franc is expected to depreciate relative to the dollar, because it will take more francs to buy one dollar in the future than it does today. c. Inflation in Switzerland is higher than in the United States, as are interest rates.
One issue paid $4.92 annually per share and sold for $97.00 per share. Another paid $4.52 per share annually and sold for $95.00 per share. What was Alabama Power's cost of preferred stock?
first issue: RP= 4.52/95 =4.76% Second issue: 4.25/95 =4.76%
The cost of capital depends primarily on the use of the
funds, not the source
Suppose Hornsby Ltd. just issued a dividend of $1.65 per share on its common stock. The company paid dividends of $1.24, $1.33, $1.44, and $1.53 per share in the last four years. If the stock currently sells for $55, what is your best estimate of the company's cost of equity capital using arithmetic and geometric growth rates?
g1 = ($1.33 - 1.24) / $1.24 g1 = .0726, or 7.26% g2 = ($1.44 - 1.33) / $1.33 g2 = .0827, or 8.27% g3 = ($1.53 - 1.44) / $1.44 g3 = .0625, or 6.25% g4 = ($1.65 - 1.53) / $1.53 g4 = .0784, or 7.84% g = (.0726 + .0827 + .0625 + .0784) / 4 g = .0741, or 7.41% RE = [$1.65(1.0741) / $55] + .0741 RE = .1063, or 10.63% $1.65 = $1.24(1 + g)^4 g = .0740, or 7.40% RE = [$1.65(1.0740) / $55] + .0740 RE = .1062, or 10.62%
Firms with substantial accumulated losses will get little value from the
interest tax shield
What is an optimal capital structure?
optimal capital structure is the lowest possible WACC
Expected return=?
pi*Ri Pi = the probability of state "i" occurring Ri = the expected return on an asset in state i
An asset's risk and return impact how the stock affects the?
risk and return of the portfolio
day-to-day fluctuations in exchange rates
short run exposure
Variance and standard deviation measure?
the volatility of returns
Stock J has a beta of 1.19 and an expected return of 12.95 percent, while stock K has a beta of .84 and an expected return of 10.40 percent. You want a portfolio with the same risk as the market. How much will you invest in each stock? What is the expected return of your portfolio?
ßp = 1 = xJ(1.19) + (1 - xJ)(.84) xJ = .4571 xK = 1 - .4571 xK = .5429 E(RP) = .4571(.1295) + .5429(.1040) E(RP) = .1157, or 11.57%
You own a stock portfolio invested 15 percent in Stock Q, 25 percent in stock R, 40 percent in Stock S, and 20 percent in Stock T. The betas for these four stocks are .75, .87, 1.26, and 1.76, respectively. What is the portfolio beta?
βp = .15(.75) + .25(.87) + .40(1.26) + .20(1.76) βp = 1.19
You own a portfolio equally invested in a risk-free asset and two stocks. If one of the stocks has a beta of 1.63 and the total portfolio is equally as risky as the market, what must the beta be for the other stock in your portfolio?
βp = 1.0 = 1/3(0) + 1/3(1.63) + 1/3(βX) Beta solving for X we get βX = 1.37