FIN 357 Exam 3
System vs. Unsystematic examples
-short term interest rates increase unexpectedly: systematic (bc affects the whole market/all companies) -the interest rate a company pays on its short-term debt borrowing is increased by its bank: unsystematic (bc its specific to that company) -oil prices unexpectedly decline: it could be both, but most likely systematic risk (bc it affects the whole market/all companies) -an oil tanker ruptures, creating a large oil spill: unsystematic (bc it is kind of a scandal/not expected) -a manufacturer loses a multimillion-dollar product liability suit: unsystematic (scandalous/unexpected and company specific) -a Supreme Court decision substantially broadens producer liability: systematic risk (bc it affects all assets)
Events that may/may not affect stock prices changes:
-the government announces that inflation unexpectedly jumped by 2% last month: a change in systematic risk would occur bc the announcement affects all assets and companies; market prices in general would most likely fall -a company's quarterly earnings report was just issued and fell in line with analyst's expectations: no change in unsystematic risk, bc company specific wise it fell right where they expected; company prices would probably remain constant -the government reports that economic growth last year was at 3%, which generally agreed with most economists' forecasts: no change in systematic risk; market prices would probably stay constant -the directors of a corporation die in a plane crash: a change in unsystematic risk (unexpected/company specific) has occurred; company prices would most likely fall -Congress approves changes to the tax code that will increase the top marginal corporate tax rate and this legislation had been debated for the previous 6 months: no change in systematic risk; market prices would generally stay constant assuming the market believes the legislation would be passed and would incorporate this change in the price already.
Summary and Conclusions of Cost of Capital and Long-Term Financing Policy
-the ideal mixture of debt and equity for a firm (its optimal capital structure) is the one that maximizes the value of the firm and minimizes the overall cost of capital. -if we ignore taxes, financial distress costs, and any other imperfections, we find that there is no ideal mixture and under these circumstances the firm's capital structure is irrelevant. -but if we incorporate the effect of corporate taxes, we find that capital structure matters a great deal. this conclusion is based on the fact that interest is tax deductible and generates a valuable tax shields. Unfortunately, we also find that the optimal capital structure is 100% debt which is not something we observe in healthy firms. -when we introduce costs associated with bankruptcy and more generally financial distress, these costs reduce the attractiveness of debt financing. Therefore, the optimal capital structure exists when the net tax savings from an additional dollar in interest just equals the increase in expected financial distress costs.
Ex-dividend stock prices and taxes
-the stock price drop on the ex-dividend date should be lower (in regards to the changes in tax laws and how it affected the ex-dividend stock price) -with taxes, stock prices should drop by the amount of the dividend less the taxes investors must pay on the dividends -a lower tax rate lowers the investors' tax liability
Weighted portfolio calculations: standard deviation
= (Weight of A x stdevA)^2 + (Weight of B x stdevB)^2 + 2(WeightAxWeightBxstdevAxstdevB) ^remember that this gives us the variance! To get the standard deviation, take the square root of this.
In the aggregate, debt offerings are much more common than equity offerings and typically much larger as well. Why?
A company's internally generated cash flows provides a source of equity financing. For a profitable company, outside equity may never be needed. Debt issues are larger because large companies have the greatest access to public debt markets (small companies tend to borrow more from private lenders). Equity issuers are frequently small companies going public; such issues are often quite small.
What is the impact of a stock repurchase on a company's debt ratio? Does this suggest another use for excess cash?
A stock repurchase reduces equity while leaving debt unchanged, making the debt ratio rise. A firm could, if desired, use excess cash to reduce debt instead. This is a capital structure decision.
With homemade leverage:
All equity firms become riskier, and 1/2 debt 1/2 equity firms become less risky. All equity homemade leverage: Investor borrows 10$ to buy 2 shares. The returns are the same as 1/2 debt and 1/2 equity by borrowing 1/2 of what they invested. 1/2 debt 1/2 equity: Investor buys one share for 10$ and lends out 10$ more. Since we lent out, the returns end up being the as an all equity firm.
Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?
Because many relevant factors such as bankruptcy costs, tax asymmetric, and agency costs cannot easily be identified or quantified, it is practically impossible to determine the precise debt-equity ratio that maximized the value of the firm. However, if the firm's cost of new debt suddenly becomes much more expensive, it's probably true that the firm is too highly leveraged.
Beta
Beta is the sensitivity to systematic risk. the slope of a regression line is beta if the beta of an asset is: 0: the asset has no measurable systematic risk and is = to the risk-free rate >1: the systematic risk for the asset is greater than the average for assets in the market <1, the systematic risk for the asset is less than the average for assets in the market if the beta is exactly 1: beta is equal to the market risk premium (note that the market risk premium is the reward investors expect to earn for holding a portfolio with a beta of 1) Aggressive beta: when the market moves up, beta also moves up but even more (GE is an example of a company with aggressive risk) Defensive beta: does not change too much with the market changes happening (Walmart)
Explain what is meant by business risk and financial risk. Suppose firm A has more business risk than firm B Is it true that Firm A also has a higher cost of equity capital?
Business risk is the equity risk arising from the nature of the firm's operating activity and is directly related to the systematic risk of the firm's assets. Financial risk is the equity risk that is due entirely to the firm's chosen capital structure. As financial leverage, or the use of debt financing, increases, so does the financial risk and hence, the overall risk of equity. Thus Firm B could have a higher cost of equity if it uses greater leverage.
MM Propositions and Formulas
Case 1: No taxes Vl = Vu Re= Ra + (Ra-Rd) x (D/E) -more debt causes the cost of equity to rise. -effect on fin leverage: cost of equity rises causing it to offsets change in debt -RA= WACC in this case -usually ebit - tax on ebit / Re Case 2: Taxes, no Bankruptcy Costs Vl = . Vu + DTr Re= Ru +[Ru-Rd] x D/E x (1-Tc) (only thing added is the tax incorporation) -we save on taxes; we deduct interest expense from EBIT, therefore, having less $ taxed on and ultimately increasing NPV. -Says that firm value bc of the above, increase with debt -effect on fin leverage: debt increase, equity increases (although not quite as much as Case1), and the WACC (our required return gets smaller) decreases -so debt is good, but we definitely do not want a firm to 100% debt or have too much debt that it creates distress... Case 3: Taxes AND Bankruptcy Costs, ie Financial Distress Vl = Vu + DTr - Financial Distress Costs -if financial distress costs <<< Vu + DTr, we good! -if financial distress costs >>> Vu + DTr, we bad. -With WACC, the lowest the value of the firm is the highest but will rise once it passes the optimal D/E ratio -incredibly hard to calculate -occurs where the benefit from an additional dollar of debt is just offset by the increase in bankruptcy costs.
What is the most expensive source of capital for a firm? What is the least expensive source of capital for a firm?
Common stock - most expensive source of capital Debt - least expensive source of capital
Correlation
Correlation = p = Cov(a,b) / stdev a x stdev b Perfectly negatively correlated = -1, and tells us that the two always move oppositely. Perfectly positive correlated = 1, and tells us that the two always move together/in the same direction. Uncorrelated, meaning that one return is completely unrelated to another return, = 0.
How is it possible that dividends are so important, but at the same time, dividend policy is irrelevant?
Dividend policy deals with the timing of dividend payments, not the amounts ultimately paid. Dividend policy is irrelevant when the timing of the dividend payments does not affect the present value of all future dividends.
If there are no taxes or other imperfections within a company, how are dividends seen?
Dividend policy would be seen as irrelevant when there are no taxes or other imperfections because shareholders can effectively undo the firm's dividend strategy. Shareholders who receive dividends greater than desired can reinvest the excess. Conversely, shareholders who receive dividends smaller than desired can sell off extra shares of stock.
If the market values stocks based expectations of the future, why are numbers (in regards to company earnings) summarizing past performances, relevant?
Earnings contain information about recent sales and costs. This is useful for projecting future growth rates and cash flows. Therefore, unexpectedly low earning often lead market participants to reduce estimates of future growth rates and cash flows, resulting in a price drop. Unexpectedly high earnings will lead to increase estimates of future growth rates and cash flows, resulting in a price increase.
Why are the costs of selling equity so much larger than the costs of selling debt?
Economies of scale are a part of it; Beyond this, debt issues are easier and less risky to sell from an investment bank's perspective. The two main reasons are that very large amounts of debt securities can be sold to a relatively small number of buyers, particularly large institutional buyers such as pension funds and insurance companies, and that debt securities are much easier to price than equity securities are.
True of false: the most important characteristic in determining the expected return of a well diversified portfolio is the variance of the individual assets in the portfolio.
False! the variance of individual assets is a measure of the total risk... the variance on a well diversified portfolio is a function of systematic risk only, since well diversified portfolios are only composed of and use systematic risk.
Why would management undertake a reverse stock split?
Generally, a reverse stock split is undertaken to satisfy exchange requirements. Rather than falling below the NYSE or NASDAQ minimums, a reverse stock split will increase the share price to an amount above the required thresholds. In finance, a reverse stock split or reverse split is a process by which shares of corporate stock are effectively merged to form a smaller number of proportionally more valuable shares.
What is true about an investment that plots above the security market line?
If an investment is ABOVE the SML, then it is undervalued, since its value is literally higher in reality than what it is priced at in the market. Vice versa, if an investment were to be BELOW the SML, then it is overvalued, since its value is literally lower in reality than what it is priced at in the market.
For initial public offerings of common stock, 2017 was a slow year and few companies paid dividends. Why do you think they chose to not pay dividends?
If firms just went public, they probably did so because they were growing and needed the additional capital. Growth firms pay very small dividends, if they pay a dividend at all. This is because they have numerous projects available and they reinvest the earnings in the firm instead of paying cash dividends.
If the government were to announce that the growth rate in the economy is likely to be 2% in the coming year, as compared to 5% for the past year, will security prices increase, decrease, or stay the same following this announcement? Does it make any difference whether the 2% was anticipated by the market?
If the market expected the growth rate in the coming year to be 2%, then there would be no change in security prices if this expectation had been fully anticipated and priced (because it would already be reflected in the stock price). However, if the market had been expecting a growth rate other than 2% and the expectation was incorporated into security prices, then the government announcement would surely cause security prices in general o change; prices would drop if the anticipated growth rate had been more than 2% and they would rise if the anticipated growth rate had been less than 2%.
Why do we use an after tax figure for cost of debt, but not cost of equity?
Interest expense is tax deductible, which is within the cost of debt. The cost of equity contains no difference between pre-tax and after-tax equity costs.
What control implications do a firm's capital structure decisions have?
Issuing debt does not change the ownership and therefore control of the firm, unless it is so much debt as to cause financial distress and the shareholders lose control to creditors. Issuing more common stock could dilute existing shareholders' ownership if they do not purchase a proportionate amount of the new shares, thereby reducing their control.
Firms sometimes use the threat of a bankruptcy filing to force creditors to renegotiate terms. Critics argue that in such cases, the firm is using bankruptcy laws a sword rather than a shield. Is this an ethical tactic?
It could be argued that using bankruptcy laws as a sword may be the best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy, and the interest charged incorporates this possibility.
Why is the use of debt financing referred to as financial "leverage"?
It is called "leverage" because it magnifies gain or losses.
If a firm's WACC is 12%, what does this mean?
It means that 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.
If you had a portfolio of 50% Security L and 50% Security M, assuming they are not perfectly positively correlated, what will your standard deviation of the portfolio be?
It must be less than 22.5% Portfolio standard deviations =(50%x25%) +(50%x20%) = 22.5%, but since its not perfectly positively correlated, it must be less than this.
"Keep your alpha high and your beta low."
Keeping your beta low means that you have a low level of systematic risk, while a high alpha means that your return is high compared to the level of risk taken. alpha measures the return in excess of the return the asset should have earned based on the level of risk as measured by beta.
If you can borrow all the money you need for a project at 6%, doesn't it follow that 6% is your cost of capital for the project?
No - the cost of capital depends on the risk of the project, not the source of money.
If a portfolio has a positive investment in every asset, can the expected return on the portfolio be greater than that on every asset in the portfolio? Can it be less than that on every asset in the portfolio?
No and no. The portfolio expected return is a weighted average of the asset returns, so it must be less than the largest asset return and greater than the smallest asset return.
Some corporations pay dividends in kind (they offer their services to shareholders below market cost). Should mutual funds invest in stocks that pay these dividends in kind? (The fundholders do not receive these services).
No, because the money could be better invested in stocks that pay dividends in cash which benefit the fundholders directly.
Why do non-investment grade bonds have much higher direct costs than investment grade issues?
Non-investment grade bonds are riskier and harder to market from an investment bank's perspective.
Some firms have filed for bankruptcy because of actual or likely litigation-related losses. Is this a proper use of the bankruptcy policy?
One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts in shareholders' best interest by managing this asset in ways that maximize its value. To the extent that a bankruptcy filing prevents a "race to the courthouse steps" it would seem to be a reasonable use of this process.
Present Value of Debt:
PV = D x Tr the present value of debt is the debt x the tax rate
Calculating Difficult Returns and Variances:
Q: What is the expected return on an equally weighted portfolio of these three stocks? A: Take the average of the portfolio returns (add the portfolio returns for stock A, stock B, and stock C and divide by 3, aka the number of stocks) Then multiply it by the probability of the state of the economy. Repeat and add together if more than one state of economy is given. Q: What is the variance of a portfolio invested 24 percent each in A and B and 52 percent in C? Take the %portfolio given above *each respective stock return, and add them together. Then multiply the the probability of the state of the economy. Add them together for all states of economy and that is your new Expected Return. Take the new expected return-%portfolio*respective stock you just calculated, square it, and multiply by state of economy. Same process and add together to get total variance.
Cost of Equity (dividend growth model approach)
RE = D1/P + g note that it does have to be the dividend they will pay; if they gave us a dividend that was "just paid" or paid last year, we have to compute it to D1 advantages: easy to understand and use disadvantages: -only applicable to companies currently paying dividends -not applicable if dividends aren't growing at a reasonably constant rate; for this to work, we are assume a constant dividend growth rate, which is not common for startups and such -extremely sensitive to the estimated growth rate and does not explicitly consider risk
With stock dividends:
REMEMBER that you are increasing the value of shares, by issuing stock instead of cash. So if it said: RC has a 15% stock dividend: we take the current number of shares * 1.15 to get the new number of shares. the new stock p: would be the old number of shares * the original p / the new number of shares you just found.
Reasons for High Dividend Payout and Reasons for Low Dividend Payout
Reasons for high: -desire for current income (retirees, endowments and trusts) -uncertainty resolution (no guarantee of higher dividend in future) -taxes (dividend exclusion for corporation) Reasons for low payout: -individuals in upper income tax brackets might prefer low payout given immediate tax liability (don't want dividends to be taxed when making in the highest tax bracket) -flotation costs -dividend restrictions (due to protective covenants, debt indentures, contracts of debt) *note that paying dividends to attract new investors or reducing flotation costs are NOT a priority/ low in priority percentage compare to things of high priority like stability of future earnings and smooth dividends each year.* Dividends are concentrated among a SMALL number of LARGE MATURE FIRMS
Stock Split:
Reduces the stock price. This is to To return to a more desirable trading range. Increases the number of shares The increase in value is NOT due to the stock split
Continental Airlines filed for bankruptcy, at least in part, as a means of reducing labor costs. Whether this move was ethical or proper was hotly debated. What are both sides of the argument?
Side 1: Continental was going to go bankrupt bc its costs made it uncompetitive. The bankruptcy filing enabled them to restructure and keep flying. Side 2: Continental abused the bankruptcy code. Rather than negotiate labor agreements, Continental abrogated them to the detriment of its employees. it is important to keep in mind that the bankruptcy code is a creation of law, not economics, and a strong argument can always be made that making the best use of the bankruptcy code is no different from, for example, minimizing taxes by making the best use of the tax code. A strong case can be made that it is the financial manager's duty to do so.
For interest paid to be fully deductible by a company after the Tax Cuts and Jobs Act of 2017, what must be true about this ratio? Assume the company has no interest income.
Since the interest expense is limited to 30% of EBIT, the minimum times interest earned ratio that allows the full deductibility of interest is 1/3. At any value above this, interest will be fully deductible.
cost of issuing securities
Some major patterns include: -substantial economies of scale: a larger amount will cause a decrease in %age in costs, a smaller amount will increase a higher %age in costs. -costs of selling debt ARE LESS than the cost of issuing equity -IPO costs >>> than SEO costs -Debt of SEO > Debt of IPO (bc IPO is brand new! Not much debt yet.) -Investment Grade bonds are cheaper than Junk bonds (harder to sell junk bonds, higher cost of selling) average spread is about 7%, underpricing costs are about 19.2% Total direct costs of IPOs are somewhere around 10.4% but direct costs are very large for issues of less than $10 million (smaller issues of stock) could be as high as 25.22% in direct costs.
Why are some risks diversifiable? Why are some risks non-diversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio but not the level of systematic risk?
Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unique portion of the total risk can be eliminated at little cost. On the other hand, there are some risks that affect all investments (systematic). This portion of the total risk of an asset cannot be costlessly eliminated. In other words, systematic risk can be controlled, but only by a costly reduction in expected returns..
Relationship between stock prices and dividends
Stock prices often drop because of an expected drop in future dividends. Since the stock price is the present value of all future dividend payments, if the expected future dividend decreases, then the stock value will decline.
"A 10 for 1 stock split"
The after stock split = current stock split x the 1/10 ("10 for 1") because every 1 share becomes 10. The new price of stock would be the current price per share x the reciprocal of the stock split: ex. $826/share x 1/10 = $8.26 new share price. The stock split did not substantially change anything for the company or the investors. Simply means that there are 10x the number of shares outstanding, however, each one is only worth 1/10 of what a share was worth before the split. A company may split their stock to lower their stock P, hoping to make their stock more accessible/attractive to investors. This also sends a positive signal to investors about management's outlook for the future. **Note that a REVERSE stock split does the opposite, it makes the price of the stock go up.**
How do you determine the appropriate cost of debt for a company? Does it make a difference if the company's debt is privately placed as opposed to being publicly traded? How would you estimate debt that is privately placed?
The appropriate cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today, hence the YTM. If the debt is privately placed, the firm could still estimate its cost of debt by looking at the cost of debt for similar firms in similar risk classes, looking at the average debt cost for firms with the same credit rating, or consulting analysts and investment bankers. Even if the debt is publicly traded, an additional complication occurs when the firm has more than one issue outstanding; these issues rarely have the same yields because no two issues are ever completely homogenous.
If increase in dividends tend to be followed by immediate increases in share prices, how can it be said that dividend policy is irrelevant?
The change in price is due to the change in dividends, not due to the change in dividend policy itself. Dividend policy can still be irrelevant without a contradiction.
A company is planning to raise fresh equity capital by selling a large new issue of common stock. They are a publicly traded corporation and is trying to choose between an underwritten cash offer and a rights offering (not underwritten) to current shareholders. They are interested in minimizing the selling costs and has asked you for advice on the choice of issue methods. What is your recommendation and why?
The evidence suggests that a non-under written rights offering might be substantially cheaper than a cash offering. However, such offerings are rare, and there may be hidden costs or other factors not yet identified or well understood by researchers. A rights offering is a group of rights offered to existing shareholders to purchase additional stock shares in proportion to their existing holdings.
Weighted portfolio calculations: ER
The expected return of a portfolio is the weighted average of the expected returns of the investments within it. =Weight of A x ER A + Weight of B x ER B
What factors would be looked at for the higher respected return of a security?
The higher expected return would be signified by the higher beta, and the lower standard deviation.
What do we notice about the types of industries with respect to their average debt-equity ratios? Are certain types of industries more likely to be highly leveraged than others? What are some possible reasons for this observed segmentation? Do the operating results and tax history of the firms play a role? How about future earnings prospects?
The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use greater financial leverage. Also, industries with less predictable future earnings (such as computers or drugs) tend to use less financial leverage. Such industries also have a higher concentration of growth and startup firms. Overall, the general tendency is for firms with identifiable, tangible assets and relatively more predictable future earnings to use more debt financing. These are typically the firms with the greatest need for external financing and the greatest likelihood of benfitting from the interest tax shield.
What will be the price of a stock that will be initially publicly offered tomorrow, based on our knowledge of Finance so far?
The price will probably go up because IPOs are generally underpriced. This is especially true for smaller issues. If you could get a substantial amount of shares of this IPO happening tomorrow at the offering price (told to you by your stock broker), we would assume that they are probably having trouble moving the issue and it is likely that the issue is not substantially underpriced.
Why are traditional sources of funding not usually available for new or emerging businesses?
There are three reasons entrepreneurs often have little or no access to traditional funding: 1)The high degree of risk involved in starting a new business 2)Their primary assets are often intangibles 3)Lack of investor knowledge of highly specialized technologies or new business areas.
Easier Expected return calculation:
To calculate ER, multiply the prob of state of economy * the portfolio returns, and add them all up.
Total Returns and Total Risk
Total Return = expected return + systematic portion of unexpected return + unsystematic portion of unexpected return We care about measuring systematic risk using CAPM Total Risk = systematic risk + unsystematic risk Standard deviation is the measure we use for total risk. An efficient portfolio will only contain systematic risk. There is no way to reduce the volatility of a portfolio without lowering its expected return. For well-diversified portfolios, unsystematic risk is very small, basically does not exist
What factors would be looked at for the most total risk of a security?
Total risk looks at the standard deviation as the measurement. Usually two securities side by side will have one with higher st dev and lower beta = to the most total risk
Tradeoff (Static) Theory vs. Pecking Theory
Tradeoff or Static Theory: would predict that a company would raise additional funds by issuing more debt, and have less taxes from doing so. This works well as long as the incremental tax savings are larger than the financial distress costs. The increase in debt in the Tradeoff Theory if it meets that, would increase the value of the firm. Pecking Theory is counter to Tradeoff. They would suggest that internally generating funds should be used first and would be far cheaper than issuing debt. The firm should only seek to use debt for financing once they have used all of their internal funding first.
Expected Returns vs. Required Returns
Uses the CAPM (SML) to calculate each stock's required return Rr= Rf + B(Rm-Rf) if expected return > required return: stock is undervalued if expected return < required return: stock is overvalued if expected return = required return: stock is fairly valued or efficiently valued.
Cost of Equity (SML approach)
Uses the CAPM formula: RE = Rf + B(ERm-Rf) advantages: -explicitly adjusts for systematic risk - applicable to all companies, startups, etc, as long as we can estimate the beta -practical, easy to implement, and robust -imposes a disciplined approach to cost of capital estimation that is difficult to manipulate -requires managers to think about risk in the correct way -more widely accepted than the dividend discount model since SML does not make any assumptions about the firms' overall dividends disadvantages: -have to estimate the Expected market risk premium, which varies over time -have to estimate beta, which also varies over time -we are using the past to predict the future which is not always reliable
Vl means
Vl = Vu - debt we can use this to solve for equity! By subtracting debt from the total.
the WACC
WACC = We*Re+Wp*Rp+Wd*Rd(1-t) WACC is what it cost to raise a dollar of capital. The average is the required return on the firm's assets, based on the market's perception of the risk of those assets have to add all the market values of equity, preferred stock, and debt (bonds outstanding) together, and then put each as a fraction of the total to get the We Wp Wd if the interest rate goes up, all of the WACCs go up, and if the interest rate goes down, all the WACCs go down (this is because it is the required return as a percentage we need to cover our costs) Note that the WACC will only work if the risk of the company = the risk of the project. Using it as our discount rate is only appropriate for projects that have the same risk as to the firm's current operations. If we need different discount rates, we could use the pure play approach (finding companies in our same field of industry with the same risk, and using a required return similar to theirs); or we can use a subjective approach, which looks at the risk of the project relative to the overall value of the firm. If we are taking on a riskier project, we use the WACC + a certain value. If less risky, WACC - a certain value, etc. Additionally, separate divisions usually require separate discount rates/different WACCS (think of all the division in GE! So many different business units with diff risks and diff WACCs)
Cost of Debt
We are calculating the YTM for this and assuming long term debt (most companies use bonds) the cost of debt = the required return on our company's debt the cost of debt is NOT the coupon rate. It IS the YTM. we have to adjust for the tax deductibility of the % Solved by: periods per year FV PMT -PV N =I/Yr (note that this is before taxes) then I/Yr(1-t) to get the after tax cost of debt. Note: there is only tax advantages on debt - there is no tax advantage on equity
If a question says to find the "rate of return on common stock":
We are solving for RE. Re = Ra + (Ra-Rd) x D/E if there is tax: Re = Ra + (Ra-Rd) x D/E x (1-Tc) *Be careful, RE is not the WACC - the WACC would not just be common stock, it would be more than that/have other things to incorporate such as debt and Pref stock.*
If given beta and found the required return, and then asked: What is the required return on a portfolio consisting of 40% of the asset above and the rest in an asset with an average amount of systematic risk?
We would take .40* the beta given in the previous portion + .60(1) 1 is the average amount of systematic risk.
Why do stock repurchases offer management greater flexibility in distributing value than cash dividends?
When a company announces an open market ongoing stock repurchase plan it is perceived as less of a commitment than a regular cash dividend. If management needs to decrease their cash outflow, they can cut back or end the repurchase program at any time, and this will not cause the same negative reaction that announcing a reduction of regular cash dividends would.
Costs of debt and equity rising analysis
While it is true that the equity and debt costs are rising, the key thing to remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt, the WACC does not necessarily rise.
How do you think the tax law changes affected the relative attractiveness of stock repurchases compared to dividend payments?
With a high tax on dividends and a low tax on capital gains, investors, in general, will prefer capital gains. If the dividend tax rate declines, the attractiveness of dividends increases.
Is it possible that a risky asset could have a beta of 0? Based on the CAPM, what is the expected return on such an asset? Is it possible to have a risky asset with a negative beta?
Yes, it is possible that a portfolio could have a beta of 0 of risky assets - this would cause the return to be equal to the risk-free rate. It is also possible to have a negative beta, in which case the return would be less than the risk-free rate. Note that a negative beta would have a negative risk premium because of its value as a diversification instrument.
If a portfolio has a positive investment in every asset, can the standard deviation on the portfolio be less than that on every asset in the portfolio? What about the portfolio beta?
Yes, the standard deviation can be less than that of every asset in the portfolio. However the beta of the portfolio cannot be less than the smallest beta because the beta of the portfolio is a weighted average of the individual asset betas.
Why is underpricing not a great concern with bond offerings?
Yields on comparable bonds can usually be readily observed, so pricing a bond issue accurately is much less difficult.
Covariance
a measure of the degree to which returns on two risky assets move in tandem If the covariance is Negative, the two returns move in opposite directions. This tells us that they have a negative relationship, where one is usually above the average return when the other is below the average return. If the covariance is Positive, the two returns tend to move together.
Stock repurchase
a stock repurchase acts much like a cash dividend, but has a significant tax advantage. Stock repurchases, therefore, are a very useful part of overall dividend policy.
If it says the debt taken on was 50% of LEVERED Value
at unlevered, we would be given everything we need but LEVERED, we do not have VL so: VL = VU +VL (0.50) (Tax) example: VL = 215000 + VL(0.50)(0.24) Solve for VL
Cost of Preferred Stock
constant dividend payments; perpetuity! Found by: Rp = D/P
Systematic Risk
due to market-wide news, aka market risk, undiversifiable risk includes things like interest rate changes, tax changes, inflation, gas prices. measured by beta! Beta=the sensitivity to systematic risk systematic risk is the only one that matters because: -investors do not like risk and will not bear risk they can avoid by diversification (diversifying their portfolios) -well diversified portfolios only contain systematic risk -portfolios that are not well-diversified face systematic risk plus unsystematic risk, but no one compensates investors for bearing unsystematic risk and investors will not accept the risk that they are not paid to take.
Financial distress vs. default
financial distress: a firm is only having major difficulties meeting debt obligations, this happens before default Default: to actually and literally miss payments of interest owed. This violates a debt covenant. After the firm defaults, debt holders ar given certain rights to the assets of the firm and may even take legal ownership of the firm's assets through bankruptcy.
Advantages of a share repurchase:
flexibility for shareholders, keeps stock prices higher, is an investment of the firm, has tax benefits.
Divisional Cost of Capital
if the different operating divisions were in much different risk classes, then separate cost of capital figures should be used for the different divisions. The use of a single overall cost of capital would be inappropriate. If the single hurdle rate were used, riskier divisions would tend to receive more funds for investment projects since their return would exceed the hurdle rate despite the fact that they may actually plot below the SML and hence, be unprofitable projects on a risk adjusted basis. The typical problem encountered in estimating the cost of capital for a division that it rarely has its own securities traded on the market, so it is difficult to observe the market's valuation of the risk of the division. Two ways around this are to use a pure play proxy for the division or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division.
Stock dividends :
increase the number of shares outstanding if a company declares a % stock dividend, multiply the current number of shares outstanding * 1+%stock dividend to get the new, higher, shares outstanding.
RC has a five for three stock split:
new stock price would be: current P * 3/5 (because five for three means that every 3 shares becomes 5) new numbers of shares would be: current shares * 5/3 (becomes number of shares increases in stock splits)
If it says to find the company's cost of equity CAPITAL:
still finding Re, but using WACC formula! Use D/E to find the weights of each. WACC= We*Re + Wd*Rd*(1-t)
cost of debt or Rd is sometimes found by
taking bond1/ total value of both bonds * YTM bond 1 + bond2/total value of both bonds * YTM bond 2
What is the basic goal of financial management with regard to capital structure?
the basic goal is to minimize the value of non-marketed claims
CAPM uses what as an input to estimate a specific company's return on their stock?
the company's systematic risk
How do we calculate the market value of a debt for computing WACC?
the present value of all future coupon & par value at the current interest rate of similar risk bonds #of bonds outstanding x FV x PV%age
Variance:
the probability x (the stock return % - ER)^2 (square the stock return - ER first, then multiply by the probability)
Expected Return of a stock or bond (ER)
the probability x the stock return % Sometimes ask to do it for diff scenarios (recession, normal, boom) in which case you need to add them together to get the total ER
standard deviation
the square root of the variance measures TOTAL RISK, so if given a question on what stock has the most total risk, look at St. Dev. if it said systematic risk, we would look at the beta.
The risk that a company will have a recall of one of their major products is an example of:
unsystematic risk Because it is specific to the single firm, and is unexpected/uncalled for.
