Exam 2

Capital Gains Yield

(ending price - beginning price) / beginning price

Short Answer: Understand the relationship between inflation and the real rate of return

A real rate of return is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects.

Dividend Yield

dividends per share/market price per share

IPO Process

1. Select a bank - The first step in the IPO process is for the issuing company to choose an investment bank to advise the company on its IPO and to provide underwriting services. 2. Due diligence and filings - Underwriting is the process through which an investment bank (the underwriter) acts a broker between the issuing company and the investing public to help the issuing company sell its initial set of shares. 3. Pricing - After the IPO is approved by the SEC, the effective date is decided. On the day before the effective date, the issuing company and the underwriter decide the offer price (i.e. the price at which the shares will be sold by the issuing company) and the precise number of shares to be sold. Deciding the offer price is important because it is the price at which the issuing company raises capital for itself. 4. Stabilization - The underwriter carries out after-market stabilization in the event of order imbalances by purchasing shares at the offering price or below it. 5. Transition - The final stage of the IPO process, the transition to market competition, starts 25 days after the initial public offering, once the "quiet period" mandated by the SEC ends.

The IPO Process (8 Steps)

1. The firm's owners decide to go public. 2. If not already completed, an audit of the last three years financial statements is conducted. 3. An investment banker is selected to guide the IPO process. 4. An S-1 registration is drafted and filed with SEC. 5. Management responds to suggested comments by the SEC, and issues a Red Herring/Prospectus. 6. Firm goes "on the road" explaining its attributes to investors. 7. On the day before public offering, an offering price is decided upon. 8. Offering the stock to the public and seeing how it is received.

Dividend Policy

Changes in dividends convey information Dividend increases Management believes it can be sustained Expectation of higher future dividends, increasing present value Signal of a healthy, growing firm Dividend decreases Management believes it can no longer sustain the current level of dividends Expectation of lower dividends indefinitely; decreasing present value Signal of a firm that is having financial difficulties

An underwriter must draft the following documents:

Engagement Letter: A letter of engagement typically includes: Reimbursement clause: This clause mandates that the issuing company must cover the all out-of-the-pocket expenses incurred by the underwriter, even if the IPO is withdrawn during the due diligence stage, the registration stage, or the marketing stage. Gross spread/underwriting discount: Gross spread is arrived at by subtracting the price at which the underwriter purchases the issue from the price at which they sell the issue. Gross spread = Sale price of the issue sold by the underwriter - Purchase price of the issue bought by the underwriter Typically, the gross spread is fixed at 7% of the proceeds. The gross spread is used to pay a fee to the underwriter. If there is a syndicate of underwriters, the lead underwriter is paid 20% of the gross spread. 60% of the remaining spread, called "selling concession", is split between the syndicate underwriters in proportion to the number of issues sold by the underwriter. The remaining 20% of the gross spread is used for covering underwriting expenses (for instance, road show expenses, underwriting counsel, etc.). Letter of Intent: A letter of intent typically contains the following information: The underwriter's commitment to enter an underwriting agreement with the issuing company A commitment by the issuing company to provide the underwriter with all relevant information and thus, fully co-operate in all due diligence efforts. An agreement by the issuing company to provide the underwriter with a 15% over allotment option. The letter of intent does not mention the final offering price. Underwriting Agreement: The letter of intent remains in effect till the pricing of the securities, after which the Underwriting Agreement is executed. Thereafter, the underwriter is contractually bound to purchase the issue from the company at a specific price. Registration Statement: The registration statement consists of information regarding the IPO, the financial statements of the company, the background of the management, insider holdings, any legal problems faced by the company, and the ticker symbol to be used by the issuing company once listed on the stock exchange. The registration statement has two parts: The Prospectus - this is provided to every investor who buys the issued security Private filings - this comprises information which is provided to the SEC for inspection but is not necessarily made available to the public The registration statement ensures that investors have adequate and reliable information about the securities being important. The SEC then carries out due diligence to ensure that all the required details have been disclosed correctly. Red herring document: In the cooling off period, the underwriter creates an initial prospectus which consists of the details of the issuing company, save the effective date and offer price. Once the red herring document has been created, the issuing company and the underwriters market the shares to public investors. Often, underwriters go on road shows (called the dog and pony shows - lasting for 3 to 4 weeks) to market the shares to institutional investors and evaluate the demand for the shares.

Step 2 of the IPO Process: The following underwriting arrangements are available to the issuing company.

Firm Commitment: Under such an agreement, the underwriter purchases the whole offer and resells the shares to the investing public. The firm commitment is the most common underwriting arrangement because it guarantees the issuing company that a particular sum of money will be raised. Best Efforts Agreement: Under such an agreement, the underwriter does not guarantee the amount that they will raise for the issuing company. It only sells the securities on the behalf of the company. Syndicate of Underwriters: Public offerings can be managed by one underwriter (sole managed) or by multiple managers. When there are multiple managers, one investment bank is selected as the lead or book-running manager. Under such an agreement, the lead investment bank forms a syndicate of underwriters by forming strategic alliances with other banks, each of which then sells a part of the IPO. Such an agreement arises when the lead investment bank wants to diversify the risk of an IPO among multiple banks.

Be able to calculate the standard deviation and variance

Historical variance = sum of squared deviations from the mean / (number of observations - 1) Standard deviation = square root of the variance

Short Answer: The dividend policy of a company and what it means or signals about the company

On the whole, studies indicate that dividend signaling does occur. Increases in a company's dividend payout generally forecast positive future performance of the company's stock while, conversely, decreases in dividend payouts tend to accurately portend negative future performance by the company. Dividends matter - the value of the stock is based on the present value of expected future dividends Dividend policy may not matter Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future. Companies generally cut a dividend to raise cash when they've exhausted their ability to borrow, but don't want to issue new shares. New debt may make a company lose its investment-grade credit rating, and new share issuance means that shareholders holding a potentially bargain bin stock get diluted at a low price. This is a great sign that executives are being responsive to the desire of shareholders, but be sure to look behind the press release. Does the company have a history of increasing the dividend each year? If so, compare it to prior years. If it comes in low, it may just be a token increase for continuity. Has the company increased its dividend sporadically? If so, a big dividend increase may be an indication that management sees improving business going forward. Also, you may want to look at the historical dividend yield and payout ratio to ensure that the company can continue to pay the increased dividend. To do: see how the dividend policy increase will affect the company's cash flows. While management is usually conservative with dividend policies, you'll want to be sure the company can afford its dividends and interest payments on debt (if any) well into the future without any trouble. A new dividend from a company that has never before paid anything to shareholders can be a big sign. First, it shows that the company has no need to retain earnings for further investments. In a capital intensive business, this shows slowing earnings growth. In a business like technology, it's less indicative of forward earnings. Secondly, a new dividend indicates that management is open to ways to boost shareholder value.

What under/overpriced and over/under subscribed means

Oversubscribed is the term for when the demand for an IPO's shares is greater than the number of shares issued. The degree of oversubscription is shown as a multiple. Undersubscribed is a situation in which the demand for an initial public offering of securities is less than the number of shares issued. Undersubscribed offerings are often a matter of overpricing the securities for sale. Typically, the goal of a public offering is to sell at the exact price at which all the issued shares can be sold to investors, and there is neither a shortage nor a surplus of securities. If the demand is too low, the underwriter and issuer might lower the price to attract more subscribers. If there is more demand for a public offering than there is supply (shortage), it means a higher price could have been charged, and the issuer could have raised more capital. On the other hand, if the price is too high, not enough investors will subscribe to the issue, and the underwriting company will be left with shares it either cannot sell or must sell at a reduced price, incurring a loss

Short Answer: Understand dividends, stock splits and reserve stock splits. What impact does it have on price?

Stock dividends are similar to cash dividends; however, instead of cash, a company pays out stock. As a result, a company's shares outstanding will increase, and the company's stock price will decrease. Stock splits occur when a company perceives that its stock price may be too high. Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (a regular lot = 100 shares). Companies tend to want to keep their stock price within an optimal trading range. A company performs a reverse stock split to boost its stock price by decreasing the number of shares outstanding, which typically leads to an increase in the price per share. When a company does a reverse split, it cancels its current outstanding stock and distributes new shares to its shareholders in proportion to how many shares they owned before the reverse split.

What is the efficient market theory and be able to apply it

Stock prices are in equilibrium or are "fairly" priced If this is true, then you should not be able to earn "abnormal" or "excess" returns. What is abnormal? Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market First, the efficient market hypothesis assumes that all investors perceive all available information in precisely the same manner. The numerous methods for analyzing and valuing stocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another investor evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock's fair market value. Therefore, one argument against the EMH points out that, since investors value stocks differently, it is impossible to ascertain what a stock should be worth under an efficient market.

Calculate the Cost of Equity: Dividend Growth Model

Suppose that your company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity? P = D1 / (r - g) D0 (1 + G)

Short Answer: Understand systematic and unsystematic risk and how return relates to both of them

Systematic Risk: Unsystematic Risk: How return relates to both: Unsystematic risk, also known as "specific risk," "diversifiable risk" or "residual risk," is the type of uncertainty that comes with the company or industry you invest in. Unsystematic risk can be reduced through diversification of a number of stocks,. Systematic risk, also known as "market risk" or "un-diversifiable risk", is the uncertainty inherent to the entire market or entire market segment. Also referred to as volatility, systematic risk consists of the day-to-day fluctuations in a stock's price. volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction. Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Systematic risk can be mitigated only by being hedged.

Short Answer: Understand after and pretax cost of debt

The difference in the cost of debt before and after taxes lies in the fact that interest expenses are deductible. Businesses often look at the after-tax cost of debt capital to gauge its impact on the budget more accurately. Payments on debt interest are typically tax-deductible, so the acquisition of debt financing can actually lower a company's total tax burden. This will affect net income and give a better view of the company.

Be able to calculate the cost of debt using YTM

The required return is best estimated by computing the YTM on the existing debt.

Short Answer: Understand the components of the CAPM/SML line

The security market line (SML) is the representation of market equilibrium positively sloped straight line displaying the relationship between expected return and beta The security market line is an investment evaluation tool derived from the CAPM, a model that describes risk-return relationships for securities, and is based on the assumptions that investors have to be compensated for both the time value of money and the corresponding level of risk associated with any investment, referred to as the risk premium.

Total Dollar Return

income from investment + capital gain (loss) due to change in price