FNCE 101: Final

Disadvantages of Dividend Growth Model

- only applicable to firms that pay dividends - estimated cost of equity is very sensitive to estimated growth rate - does not explicitly consider risk

Disadvantages of SML approach

- requires market risk premium and beta coefficient to be estimated and if those estimates are poor, the resulting cost of equity will be inaccurate - rely on the past to predict the future

underwriters services

1. Formulating the method used to issue the securities 2. Pricing the new securities 3. Selling the new securities

Advantages of SML approach

1. It explicitly adjusts for risk 2. It is applicable to other companies other than just those with steady dividend growth.

initial public offering (IPO)

A company's first equity issue made available to the public

seasoned equity offering (SEO)

A new equity issue of securities by a company that has previously issued securities to the public

flotation cost

Costs associated with obtaining new project (ex: new bonds and stocks)

european option

Option that may be exercised only at the expiration date

venture capital

Poindexter is funded by a group of wealthy investors for the sole purpose of providing funding for individuals and small firms that are trying to convert their new ideas into viable products. What is this type of funding called?

Small-company stocks

Portfolio composed of the stock corresponding to the smallest 20% of the companies listed on the NYSE

Large-company stocks

Portfolio is based on the S&P500 index, which contains 500 of the largest companies in the US

seasoned equity offering

Sale of newly issued equity shares by a publicly owned company

True

Some of the risk associated with individual assets can be diversified away and some cannot (T/F)

True

The cost of capital depends primarily on the use of the funds, not the source (T/F)

strike price

The fixed price in the option contract at which the holder can buy or sell the underlying asset

Return on your investment

The gain or loss you receive on your investment from buying an asset

True

The interest paid by a corporation is deductible for tax purposes, but payments to stockholders, such as dividends, are not (T/F)

call option

The right to buy an asset at a fixed price during a particular period

put option

The right to sell an asset at a fixed price during a particular period of time (opposite of a call option)

False

The terms required return, appropriate discount rate, and cost of capital don't mean the same thing (T/F)

True

Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk (T/F)

static theory of capital structure

a firm borrows up to the point where tax benefit from extra dollar in debt equals cost that comes from increased probability of financial distress

portfolio

a group of assets such as stocks and bonds held by an investor

syndicate

a group of underwriters formed to share the risk and to help sell an issue

preliminary prospectus

a legal document describing details of the issuing corporation and the proposed offering to potential investors

security market line (SML)

a positively sloped straight line displaying the relationship between expected return and beta

rights offer

a public issue of securities in which securities are first offered to existing shareholders

unsystematic risk (Unique or asset-specific risk)

a risk that affects at most a small number of assets

registration statement

a statement filed with the SEC that discloses all material information concerning the corporation making a public offering

Normal distribution

a symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation

weak form efficient

all information of every kind is reflected in stock prices; there is no such thing as inside information

semi-strong form efficient

all public information is reflected in the stock price

rights offering (offer/privileged subscription)

an issue of common stock offered to existing stockholders

general cash offer

an issue of securities offered for sale to the general public on a cash basis

Dilution of proportionate ownership

arises whenever a firm sells shares to the general public

strong form efficient

at a minimum, the current price of a stock reflects the stock's own past prices

US Treasury Bills

based on T-bills with a one-month maturity

Long-term US government bonds

based on US government bonds with 20 years to maturity

Long-term corporate bonds

based on high quality bonds with 20 years to maturity

Capital gain yield

change in price during the year/beginning price

option

contract that gives its owner the right to buy or sell some asset at a fixed price on or before a given date

direct bankruptcy costs

costs directly associated with bankruptcy, such as legal and administrative expenses

frequency distribution

counts the number of times the annual return falls within each 10% range

venture capital (VC)

financing for new, often high-risk ventures

principle of diversification

implies some of the riskiness with individual assets can be eliminated by forming portfolios

angels

individuals who invest their own money, but they tend to focus on smaller deals

Systematic Risk (Market Risk)

influences many assets (ex: GDP, interest rates, or inflation)

underwriters

investment firms that act as intermediaries between a company selling securities and the investing public

dilution

loss in existing shareholders' value in terms of ownership, market value, book value, or EPS

american option

option that may be exercised at any time until its expiration date

efficient capital market

security prices reflect available information

Advantages of Dividend Growth Model

simplicity

M&M Proposition II

states a firm's cost of equity capital is a positive linear function of the firm's capital structure

M&M Proposition I

states the value of the firm is independent of the firm's capital structure

True

stock options are a zero-sum game (T/F)

exercising the option

the act of buying or selling the underlying asset via the option contract

geometric average return

the average compound return earned per year over a multiyear period

Variance

the average squared difference between the actual return and the average return

unlevered cost of capital

the cost of capital for a firm that has no debt, (Ru)

indirect bankruptcy costs

the costs of avoiding a bankruptcy filing incurred by a financially distressed firm

financial distress costs

the direct and indirect costs associated with going bankrupt or experiencing financial distress

Capital Asset Pricing Model (CAPM)

the equation of the SML showing the relationship between expected return and beta

financial risk

the equity risk that comes from the financial policy (the capital structure of the firm)

business risk

the equity risk that comes from the nature of the firm's operating activities

Risk premium

the excess return required from an investment in a risky asset over that required from a risk-free investment

systematic risk principle

the expected return on a risky asset depends only on that asset's systematic risk

financial leverage

the extent to which a firm relies on debt

the exercise price

the higher the exercise price (E) is, the less the call is worth

the risk-free rate

the higher the risk-free rate (Rf) is, the more the call is worth

the stock price

the higher the stock price (So) is, the more the call is worth

expiration date

the last day on which an option may be exercised

beta coefficient

the level of systematic risk

the time to expiration

the longer the time to expiration (t) is, the more the option is worth

upper bound

the most a call option can sell for

Weighted Average Cost of Capital (WACC)

the overall return the firm must earn on its existing assets to maintain the value of its stock (also the required return on any investment by the firm that have essentially the same risks as existing operations

portfolio weights

the percentage of a portfolio's total value that is invested in a particular asset

Standard deviation

the positive square root of the variance

arithmetic average return

the return earned in an average year over a multiyear period

expected return

the return on a risky asset expected in the future

Cost of equity

the return that equity investors require on their investment in the firm

cost of debt

the return that lenders require on the firm's debt

market risk premium

the slope of the SML - the difference between the expected return on a market portfolio and the risk-free rate

interest tax shield

the tax saving attained by a firm

Pure play approach

the use of a WACC that is unique to a particular project, based on companies in similar lines of business

private equity (PE)

used to label the rapidly growing area of equity financing for nonpublic companies

False

venture capital is not expensive (T/F)

intrinsic value

what the option would be worth if it were about to expire, lower bound