Finance Exam 3
When is a new issue usually priced?
On the last day of the registration period
Dividend disc model pros and cons
Pros: -easy to use Cons: -only for companies with dividends -only for companies with STEADY dividend growth rates -doesn't consider risk
iCLICKER 13: The expected risk premium on a stock is equal to the expected return on a stock minus the
Risk Free Rate
iCLICKER 13: The principle of diversification tells us that
Spreading an investment across many diverse assets will eliminate some of the total risk. BC Systematic will always be there. you can change unsystematic and total risk=U+S
Two components of Unexpected Return
Systematic and Unsystematic RISK
Expected Return
The return that an investor expects to earn on a risky asset in the future
Green Shoe Provision
a contract provision giving the underwriter the option to purchase additional shares from the issuer at the offering price-- used to cover excess demand and oversubscriptions
Portfolio
a group of assets held by an investor -holding 100 shares of a single stock would not be considered a portfolio.
Red herring
a preliminary prospectus distributed to prospective investors in a new issue of securities
If a securities E(Ri) is equal to Rf and the market risk premium >0, what is B based on CAPM
a) equal to B b) 0. c)-1 d)1
iCLICKER 13: Which of the following is irrelevant to a well diversified portfolio?
a. systematic risk B. unsystematic risk c. market risk d non-diversifiable risk e. systemic portion or surprise.
The best way to include flotation costs is to __________
add them to the initial investment
Shelf Registration
allows firms to offer multiple issues of stock over a two-year period with only one registration statement "Dribble" method= shares sold occasionally via a stock exchange
In bankruptcy, assets are transferred from
bondholders to shareholders.
The systematic risk principle argues that the market does not reward risks that are
borne unnecessarily
dilution of ownership
can be avoided with a rights offering
MM I shows that
capital structure does not affect value of a firm
When calculating the free cash flows for a levered firm, you must consider
cash flows to both bond holders and stock holders
Leverage increases
cost of equity and also cost of debt(?)
MM II shows that
cost of equity rises with leverage
Are flotation costs the cost of issuing debt or equity?
debt
BV are often similar to MV for ______
debt
The increase in the number of stocks in a portfolio results in a(n) _____ in the average standard deviation of annual portfolio returns
decrease
crowd funding
done online
The return an investor in a security receives is ____ ______ the cost of the security to the company that issued it.
equal to
Dilition refers to a loss in _______ shareholder's value
existing
Total Return
expected return + unexpected return unexp ret= (systematic portion + unsystematic portion)
SML line
graphical depiction of the capital asset pricing model E(Rm) v. B
In the presence of corporate taxes, the tax shield effect of debt will_______ the value of the firm
increase
Standard Deviation of a portfolio
is always less than or equal to the weighted average of the standard deviations of the assets in the portfolio
a firm can use shelf registration if it
is rated investment grade, hasn't defaulted on debt in the past 3 yrs, the firms aggregate MV is more than 150 million
Competitive Offering
issuing firm offers its securities to highest bidder
Finding a firm's overall cost of equity is difficult because:
it cannot be observed directly
The WACC is the minimum return a company needs to earn to satisfy ________
its bond holders and stockholders
An investment will have a negative NPV when its expected return is ________ what the fin markets offer for the same risk
less than
Ideally, we should use __________ __________ in the WACC
market values
Slope on SML
market-risk-premium
There is _____ correlation between the unsystematic risk of two companies from two different industries
no
Does internal financing increase free cash flows?
not necessarily
Bankruptcy is very valuable because:
payments to creditors cease pending the outcome of the bankruptcy process and it can be used to strategically improve a firms competitive position
If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be:
positive
most debt is
privately issued
Lockup Period
prohibits insider shares from being sold immediately following an IPO
New common stock issues are __________
rare
The rate used to discount project CF is known as the _____.
required return, disc rate or cost of capital
It would be useful to understand how the _________ of the risk premium on a risky asset is determined
size
SML Approach
solves for the cost of equity (RE) using the market risk premium, the risk-free rate, and the beta coefficient
When an investor is diversified only ______ risk matters
systematic
When calculating flotation costs the _______________________ should be used
target debt to equity ratio should be used
Under US tax law, a corporations interest payments are _________ _________
tax deductible.
economic value added?
the amount by which company profits exceed the cost of capital in a given year "is being created or destroyed"
A company must file a reg stmt with the SEC unless
the issue <5 million
cost of capital
the minimum required return on a new investment when its risk is similar to that of projects the firm already owns
According to CAPM, what is the expected retuen on a stock if its beta is equal to zero
the risk free rate bc rf+0
Flotation Costs
the total costs of issuing and selling a security
firm commitment underwriting
the underwriter buys the entire issue, assuming full financial responsibility for any unsold shares
at some point debt becomes
too expensive
If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept _______________.
too many high risk projects
Dutch auction AKA
uniform price auction
The value of a firm is maximized when the:
weighted average cost of capital is minimized
examples of unsystematic risk
- Labor Strikes - Changes in mgmt
Whether a firm obtains capital by debt or equity financing depends on:
- the size of the firm - the firms growth prospects -the firms life-cycle stage
The risk of owning an asset comes from:
- unanticipated events - surprises
The growth rate of dividends can be found using
-Historical dividend growth rates -Security analysts' forecasts
Systematic risk examples
-Increase in Federal funds rate -Increase in corp tax rate
in the absence of taxes, the value of a firm is the same with debt asa it is with equity bc....
-MM1 demonstrated that debt financing is not better or worse than equity financing in ABSENCE OF TAXES - the asset to be financed is the same
Firms with high leverage
-airlines -cable television
_____ risk is reduced as more securities are added to the portfolio
-diversifiable -unique -unsystematic
A firms cost of debt can be __________________
-estimated easier than cost of equity -obtained by talking to inv bankers -obtained checking yields on publicly traded bonds - NOT calculated using DGM--> thats for equity
Advantages of using internal financing
-prevents bad reaction from market with an SEO -cheaper than debt /equity issues
effect of financial leverage and EBI
-rate of return on assets is unaffected by leverage -Financial leverage increases the slope of EPS line -below BEP, unlevered cap structure is better
Variance
-standard deviation squared -Variance is a measure of the squared deviations of a security's return from its expected return
When debt levels are extremely high
-the possibility of financial distress will become a chronic problem -The benefits of debt financing may be more than offset by the costs of financial distress
To estimate the growth rate of a stock we can
-use security analysts forecasts, -use the historical dividend growth rate
By definition, what is the B of the average asset equal to
1 - market B
Preferred source order of financing for firms according to pecking order theory
1. Retained Earnings 2. Debt 3. Common Stock
Steps in Calculating Variance
1. calculate expected return 2. calculate deviation of each return from the expected return 3. Square each deviation 4. Calculate the average squared deviation
ABC has a beta of 2.5 and XYZ has a beta of 1.5. The Risk-free rate is 4 percent and the market risk premium is 9 percent. What is the expected return on a portfolio that is equally invested in ABC and XYZ?
22% (solve) First find new B Then plug B into CAPM BE CAREFUL WITH MRP
A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV?
950,000
Risk Premium
Additional Conversation for taking risk over and above risk-free rate
How can a positive relationship between E(Ri) on a sec and its B be justified
Bc the diff b/n E(Rm) and rf is likely to be positive
Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Division's projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?
Division B explanation: Division A is riskier, so its cash flows should be discounted at a higher rate. Because they're not discounted differently, the projects in Division A will look better than those in B. Division B's cash flows will be discounted at a higher rate than should be used, so it'll appear less appealing and is more likely to be rejected.
T or F: SH and BH are the only claimants to the cash flows of the firm
F
T or F: projects should always be discounted at the firms overall cost of capital
F- the should reflect their particular level of risk.
WACC rises at higher levels of debt because of
Financial Distress Costs
Necessary assumption for MM 1 to hold
Individuals can borrow on their own int rate equal to that of the firm
Examples of info that may impact the risky return of a stock
Info that will be revealed in the near future-- not historical info - The Fed's Decision on interest rates at their meeting next week. - The outcome of an application currently pending with the Food and Drug Admin
In reality, most firms cover the equity portion of their capital spending with _________.
Internally generated cash flows
iCLICKER 13: Which of the following is an example of systematic risk?
Investors panic causing security prices around the globe to fall. remember- systematic risk will affect ALL the stocks in the stock market. Ignore firm/company/industry/city specific impacts. THINK BIG
What is an uncertain or risky return?
It is the portion of return that depends on information that is currently unknown.
Two components of the Expected Return on the Market
Market Risk Premium and Risk Free Rate - E(Rm)= rf+ (E(Rm)-rf)