finance 300 final exam
standard deviation
- a measure of total risk (how much an asset moves for all types of surprises) - square root of the forward looking variance
capital asset pricing model
- a model that expresses an asset's expected return as a linear of the risk-free rate, the asset's beta, & the market risk premium - the risk-free rate compensates investors for inflation and waiting - the market risk premium is the average reward for bearing systematic risk in the economy
security market line
- a positively sloped straight line that displays the relationship between an asset's expected return and its beta - the riskless rate is the intercept and the market risk premium its slope
normal distribution
- a symmetric bell-shaped distribution commonly used to characterize the distribution of many variables - the mean & sd completely specify its shape & therefore associated probabilities
market portfolio
- a theoretical portfolio that exhausts all opportunities for further diversification by holding a little bit of every risky asset in the economy - THEORETICAL
diversifiable risk
- also called unsystematic risk - a risk that arises from an asset's uncorrelated price shocks, which an investor can cancel out by holding many assets that also have uncorrelated price changes - easily avoided risk
pure play
- an application of the law of one price where a firm with multiple divisions with differing risks uses the required return for a company solely devoted to a single line of business to evaluate projects in one of its divisions in the same industry
The static theory of capital structure advocates that the optimal capital structure for a firm. . .
- equates the tax savings from an additional dollar of debt to the increased financial distress costs related to that additional dollar of debt - will minimize the firm's weighted average cost of capital
systematic risk principle
- financial markets provide a reward for bearing risk, but not unnecessary risk - unsystematic risk is an unnecessary risk because an investor can avoid it easily & at a low cost through diversification - the result is that the expected return on a risky asset depends only on that asset's systematic risk bc that's the portion of the asset's total risk that is difficult for investors to avoid through diversification
homemade leverage
- in the absence of taxes & bankruptcy, the ability of investors to lever up or down their personal portfolios to achieve whatever return volatility they desire, regardless of the manager's capital structure choice - homemade leverage render's the manager's debt-to-equity selection irrelevant
nondiversifiable risk
- systematic risk - a risk that arises from an asset's correlated price shocks, which an investor cannot cancel out by holding many assets that also have correlated price changes
from the shareholders POV, which risks are impacted by a firm's capital structure policy?
- systematic risk - market risk - financial risk
financial risk
- the additional volatility that a manager imposes upon the shareholders by levering up. Increasing the D/E ratio takes the existing business risk and magnifies it from the perspective of the owners - this is because increasing leverage puts payments to the bondholders ahead of those to the residual claimants, the shareholders, in all states of the world, thus making their position riskier
expected return
- the average return investors expect to receive if they hold an asset for many periods in which there are uncertain events - it is the weighted average of an asset's state-contingent returns, where probabilities are the weight
portfolio weight
- the fraction of money invested in an asset that is part of a portfolio - sum to one to account for 100% of the invested money
subjective approach
- the last approach to estimate a project's required return when the project's risk profile does not look like the existing firm nor is a pure play available - the manager uses their experience & business wisdom to adjust the firm's WACC appropriately given a project's perceived risk - it is a crude attempt to apply the reward-to-risk tradeoffs of US capital market history to project evaluation when all else fails
probability
- the likelihood that a certain state of the world will be realized, expressed as the ratio of favorable outcomes to total outcomes - the result is a linear scale from zero (impossible) to one (certainty)
cost of preferred
- the minimum required rate of return by a preferred stockholder to provide capital to a firm - this OC can be estimated by calculating the current dividend yield on the preferred stock outstanding - preferred dividends are not tax deductible, so the cost of preferred & the after-tax cost of preferred are the same
cost of equity
- the minimum required rate of return by a shareholder to provide capital to a firm. This opportunity cost can be estimated by using the Capital Asset Pricing Model (CAPM). - dividends paid to shareholders are not tax deductible, so the cost of equity and the after-tax cost of equity are one and the same.
Weight Average Cost of Capital (WACC)
- the overall required ROR a firm must get from its assets - also known as the discount rate, the rr, the return on assets, the cost of capital - accounts for capital providers' opportunity costs on an after-tax basis & the fraction of the financing coming from each source of capital
return on assets
- the overall return that a set of assets must generate to compensate the capital providers for their opportunity costs, account for taxes, and account for the fraction of the funding coming from each of the capital providers - it is also known as the required return, discount rate, weighted average cost of capital, and WACC
capital structure weights
- the percentage of money raised from each source of capital, which in this class is stockholders & bondholders - the capital structure weights must sum to one in order to account for all the financing
diversification
- the process of spreading investments across more than a single asset - reduces unsystematic risk by investing in a variety of assets that do not move alike
arithmetic average return
- the sum of the returns divided by the number of observations - the mean of the distribution which implies the average deviation from the mean is zero
interest tax shield
- the tax savings due to the deductibility on interest expense. - the interest tax shield allows the manager to reduce the cash flow from the firm that goes to pay government taxes and use the savings to increase payments to the capital providers, the bondholders and stockholders
weak-form efficiency
a market in which a trader cannot generate an abnormal return using historical market information such as price and volume data
beta coefficient
a measure of an asset's sensitivity to systematic risk relative to the market as a whole - the marginal impact an asset will have on the systematic risk of a portfolio - risk-less asset has a beta coefficient of zero, while the market portfolio has a beta of 1
alpha
a measure of investment performance above & beyond the risks borne by the investor, indicating an abnormal return
financial distress
a situation where the firm is close to bankruptcy without entering it
momentum
a strategy that assumes recent stock market winners will remain winners in the near term & recent losers will continue to be losers
fundamental analysis
a trading strategy that uses public info to forecast a business's expected future cash flows, then applies discounted cash flow techniques to estimate the company's value
All else equal, the financial leverage of a firm will ______________ as the firm's retained earnings account grows.
decrease
levering down
decreasing the use of debt relative to equity to finance a firm's assets. This is achieved by issuing stock in the primary markets and using the proceeds to repurchase bonds in the secondary market. Though no assets change in the transaction, the firm's debt-to-equity ratio is reduced. In terms of a balance sheet, the assets on the left-hand side remain fixed while the claims on those asset represented by the right-hand side change.
total return
expected return + unexpected return
A fim's asset beta increases when the CFO levers up.
false
A firm's levered beta captures the variability of EBIT across different unsytematic states of the world.
false
A long strategy involves borrowing another market participant's shares. (t/f)
false
A portfolio's variance is a linear combination of the assets' variances that make up the portfolio.
false
A portfolio's variance is a weighted average of the assets' variances that make up the portfolio because asset's that don't move alike reduce the portfolio's overall volatility.
false
A portfolio's variance is a weighted average of the assets' variances that make up the portfolio.
false
A short strategy involves buying low then selling high. (t/f)
false
All else equal, the smaller the unlevered beta the bigger the financial risk premium. (t/f)
false
An asset's realized return is only a function of the price the investor receives when they sell the asset. (t/f)
false
An investor that beats the S&P500 for ten straight years is a clear violation of market efficiency. (t/f)
false
As the firm's debt-to-equity ratio decreases, its asset beta decreases as well.
false
As the firm's debt-to-equity ratio decreases, its stock beta increases as well.
false
As the firm's debt-to-equity ratio increases, its asset beta increases as well.
false
Compared to individual assets, when calculating the expected variance of a portfolio's return you begin by calculating the portfolio's expected return. This step requires you to use the portfolio weights.
false
From U.S. capital market history, Treasury bills did not provide investors with extra consumption bundles. (t/f)
false
If there is a delayed reaction to new positive information, a trader has an incentive to collect , process, and trade on the information by buying the asset before its price rises, thus pushing the price away from its fair market value. (t/f)
false
If there is a delayed reaction to new positive information, a trader has an incentive to collect , process, and trade on the information by going short in order to capture an abnormal return. (t/f)
false
In a world with no taxes and no bankruptcy, if the CFO levers down and the shareholder doesn't like it, they can use homemade leverage to increase the volatility of their portfolio by reducing their personal debt-to-equity ratio.
false
In a world with no taxes and no bankruptcy, if the CFO levers down and the shareholder doesn't like it, they can use homemade leverage to increase the volatility of their portfolio by using their own money to invest in company's stock and bonds.
false
In a world with no taxes and no bankruptcy, if the CFO levers up and the shareholder doesn't like it, they can use homemade leverage to reduce the volatility of their portfolio by increasing their personal debt-to-equity ratio.
false
In a world with uncertainty, there must be a finite number of states.
false
In a world with uncertainty, there must be an infinite number of states.
false
Levering up changes both the right and left hand sides of the balance sheet.
false
The expected return on a portfolio can be expressed as, E[rp] = p1E[r1] + p2E[r2] + ... + pmE[rm]
false
The expected return on a portfolio, E[rp] = w1E[r1] + w2E[r2] + ... + wmE[rm], uses portfolio weights but not probabilities.
false
The expected return on an asset is based on the probabilities of the m possible state-contingent outcomes.
false
The levered beta captures the systematic risk of the cash flows from assets due to the nature of the firm's business.
false
The realized return on an asset is based on the probabilities of the n possible states.
false
The required return rA ignores taxes because dividend payments to the common and preferred shareholders are not tax deductible.
false
The returns on fixed income assets are independent of the returns on equities.
false
The statement, 'The market is semi-strong-form efficient.' is not controversial. (t/f)
false
WACC is the overall required return on the firm's common stock, and depends on the market's perception of the riskiness the stock.
false
We can learn many important lessons from U.S. capital market history if asset prices are consistently above the assets' true value. (t/f)
false
When calculating the forward looking variance, you divide the sum of the squared deviations from the expected value by T-1.
false
When using the weighted average cost of capital as the discount rate for a project, the only assumption you need to make is that the project will use the same mix of funding as the existing firm.
false
You adopt a long strategy if you think asset is overpriced. (t/f)
false
levering up
increasing the use of debt relative to equity to finance a firm's assets. This is achieved by issuing debt, typically bonds, in the primary markets and using the proceeds to repurchase shares of stock in the secondary market. Though no assets change in the transaction, the firm's debt-to-equity ratio increases. In terms of a balance sheet, the assets on the left-hand side remain fixed while the claims on those asset represented by the right-hand side change.
bankruptcy costs
the costs a firm incurs when it files for protection from its creditors
flotation costs
the fees investment banks charge to issue securities in primary market transactions
unlevered beta
the firm's beta coefficient if it has no debt
capital structure weight of debt
the fraction of the financing that is raised from lenders to fund the firm's assets
capital structure weight of equity
the fraction of the financing that is raised from owners to fund the firm's assets
capital structure weight of preferred
the fraction of the financing that is raised from preferred stockholders to fund the firm's assets
Case III - Proposition I
the gain from the tax shield on debt is offset by financial distress costs. an optimal capital structure exists that just balances its additional gain from leverage against the added financial distress costs
efficient market hypothesis
the theory that markets are efficient when prices respond instantly & correctly to the revelation of new information
static theory of capital structure
the value of the firm is maximized when the marginal benefit from another dollar of debt due to the interest tax shield equals that dollar of debt's marginal cost due to expected financial distress
business risk
the volatility of cash flows generated by a firm's assets
A firm's levered beta captures the variability of EBIT across different sytematic states of the world.
true
A portfolio's variance is a linear combination of the assets' variances that make up the portfolio because asset's that don't move alike reduce the portfolio's overall volatility.
true
A portfolio's variance is not a linear combination of the assets' variances that make up the portfolio.
true
A portfolio's variance is not a weighted average of the assets' variances that make up the portfolio because asset's that don't move alike reduce the portfolio's overall volatility.
true
A portfolio's variance is not a weighted average of the assets' variances that make up the portfolio.
true
A short strategy involves borrowing another market participant's shares. (t/f)
true
Compared to individual assets, when calculating the expected variance of a portfolio's return you begin by calculating the portfolio's state-contingent returns. This step requires you to use the portfolio weights.
true
From U.S. capital market history, Treasury bills cover inflation and a little bit more to compensate the investor for waiting. (t/f)
true
From U.S. capital market history, Treasury bills provided investors with extra consumption bundles. (t/f)
true
From U.S. capital market history, the average return on a portfolio of large-company stocks, such as the S&P500, is about twelve percent. (t/f)
true
In a world with no taxes and no bankruptcy, if the CFO levers down and the shareholder doesn't like it, they can use homemade leverage to increase the volatility of their portfolio by using their own money and borrowed money to invest in company's stock.
true
Levering down changes the right hand side of the balance sheet but not the left.
true
variance
- a forward-looking measure of an asset's anticipated return volatility - uses probabilities to weight the squared deviations from the mean
Which risks determine the required return on assets?
- business - systematic
what is true of a return which plots below the security market line?
- negative NPV - overpriced
reward-to-risk ratio
= (premium)/(beta) - in equilibrium, all assets have the same reward-to-risk ratio due to the actions of traders
idiosyncratic risk
Another name for unsystematic risk.
case III assumptions
Corporate taxes, but no personal taxes Bankruptcy costs
nasdaq composite index
a capitalization-weighted portfolio of the thousands of stocks listed on the nasdaq stock exchange
portfolio
a collection of assets held as an investment
strong-form efficiency
a market in which a trader cannot generate an abnormal return using private nor public info
semi-strong form efficiency
a market in which a trader cannot generate an abnormal return using public info
variance
a measure of spread around the mean of a distribution
indirect bankruptcy costs
difficult to measure, such as lost sales, suppliers changing contract terms, difficulty retaining & attracting talented employees, managerial distraction
Compared to individual assets, when calculating the expected variance of a portfolio's return you begin by calculating the portfolio's expected return. This step requires you to use the probabilities of the states.
false
From U.S. capital market history, Treasury bills cover inflation but no more. (t/f)
false
The weighted average cost of capital is not the same as the return on assets.
false
There is volatility in a firm's EBIT across different states of the world due to financial risk.
false
WACC is our required return for capital budgeting projects, and the Payback rule depends on it.
false
cost of debt
the minimum required rate of return by a bondholder to provide capital to a firm. This opportunity cost can be estimated by calculating the yield-to-maturity of a firm's bonds that are currently trading in secondary markets
geometric average return
the single compound return that equates a pv to a fv
When a firm levers up the variability of ROE increases.
true
When applied to asset returns, the forward looking standard deviation is in percent.
true
case II assumptions
- Corporate taxes, but no personal taxes - No bankruptcy costs
bankruptcy
- a legal proceeding involving a business that is unable to fulfill its contractually required debt obligations - the process begins with a petition, either filed by the debtor or creditors - then the debtor's assets are evaluated & a court decides which assets, if any, will be liquidated, which debts will be forgiven & which parties will control the firm when the proceedings are concluded
technical analysis
- a trading strategy that uses historical market data to try & generate abnormal returns - often compares a long-run moving average to a short-run moving average
systematic risk
- also market risk - a risk that produces a large # of correlated asset price changes
case I assumptions
No corporate or personal taxes No bankruptcy costs
Case II - Proposition II
The WACC decreases as D/E increases because of the government subsidy on interest payments
Case I - Proposition II
The WACC of the firm is NOT affected by capital structure
Case I - Proposition I
The value of the firm is NOT affected by changes in the capital structure The cash flows of the firm do not change; therefore, value doesn't change
Case III - Proposition II
WACC falls initially because of the tax benefit from debt, beyond the point D/E it begins to rise because of financial distress costs
s&p 500
a capitalization weighted portfolio of the 500 largest US publicly traded corporations
unlevered
a firm that is financed with 100% equity and thereby no debt
state-contingent return
an asset's realized return in a given state of the world
if a firm uses its overall weighted average cost of capital as the discount rate for all of its proposed projects, then the firm will tend to. . .
become riskier over time
You adopt a short strategy if you think asset's price is going to rise. (t/f)
false
You can estimate the opportunity costs of the bondholders by looking at the coupon rate on similar bond issues.
false
You can estimate the opportunity costs of the bondholders by looking at the coupon rate on the firm's existing bonds.
false
direct bankruptcy costs
measurable legal, consulting, & admin expenditures
does the dividend growth model explicitly consider risk?
no
which form(s) of market efficiency supports the idea that market prices reflect all public, but not all private information?
semi-strong form
unexpected return
systematic portion + unsystematic portion
levered beta
the beta of a company's stock, which reflects the systematic risk of the business & any financial risk due to the management increasing the firm's debt-to-equity ratio
after-tax cost of debt
the cost of using debt financing net of the tax savings due to the deductibility of interest expense
risk premium
the excess return from an investment in a risky asset over that required from a risk-free investment
leverage
the extent to which debt is used to finance the assets of the firm
traded claims
the stock & bond securities that trade in secondary markets & represent slice of the value pie due to the capital providers
non-traded claims
the tax, financial distress & bankruptcy costs that are not traded in secondary markets & reduce the slice of the value pie available to the traded claims
Case II - Proposition I
the value of the firm increases by the PV of the annual interest tax shield
A firm's cost of capital is the after-tax cost of debt for the optimally financed company in Case II. (t/f)
true
Levering up changes the right hand side of the balance sheet but not the left.
true
M&M Case I Proposition II states that the cost of equity rises as the debt-equity ratio increases. (t/f)
true
The expected return on a portfolio, E[rp] = w1E[r1] + w2E[r2] + ... + wmE[rm], uses portfolio weights and probabilities.
true
The returns on fixed income assets are related to the returns on Treasury bills.
true
The returns on fixed income assets are related to the returns on equities.
true
The statement, 'The market is semi-strong-form efficient.' is controversial. (t/f)
true
WACC is our required return for capital budgeting projects, and the Discounted Payback rule depends on it.
true
WACC is the average return required to attract different types of capital providers.
true
WACC is the overall required return on the firm's assets, and depends on the market's perception of the riskiness of those assets.
true
WACC is the overall required return on the firm's common stock, and depends on the riskless rate.
true
When a firm levers down the variability of ROE decreases.
true
You can estimate the opportunity costs of the bondholders by looking at the yield-to-maturity on Treasurys with a similar time to maturity to the firm's existing bonds.
true
wP is the capital structure weight of equity, and is the percent of the firm financed with preferred stock.
true
financial distress costs
when the firm gets close to bankruptcy without entering it, it will suffer from lost sales, suppliers changing the terms of their contracts, difficulty in retaining and attracting talented employees, and managerial distraction