FIN4424 Exam 2 Notes

If an investor buys a portion of both debt and equity of a levered firm, their payoff is

(X) * (profits)

For a two-stock portfolio, the maximum reduction in risk occurs when the correlation coefficient between the two stocks equals

-1

What range of values can correlation coefficients take?

-1 to 1

The beta of treasury bills is

0

The correlation coefficient between the efficient portfolio and the risk-free asset is

0

If a question does not show the weight of either portfolio, assume it is

0.5

The beta of the market portfolio is

1

One would expect a stock with a beta of 1.25 to increase in returns

25 percent more than the market in up markets

Convertible bond

A corporate bond that can be exchanged for a fixed number of shares of stock is a

Capital Structure Decision

A firm's financing choice. It addresses the mix of debt and equity financing. The decision boils down to determine the optimal leverage ratio

Proposition 3

A firm's return on asset is independent of its leverage

Proposition 2

A firm's return on equity and return on debt are positively correlated its leverage

Which of the following is not a sensible reason for a firm to rely on internal funds

A new bond issue may drive the firm's debt ratio too high. Equity issues are expensive. Financial Markets interpret the issuance of equity unfavorably

What is NOT a sensible reason for a firm to rely on internal funds

A new bond issue may drive the firms debt ratio too high. Equity issues are expensive. Financial markets interpret the issuance of equity unfavorably

Correlation Coefficient

A statistical measure of the degree to which securities' returns move together

Diversification

A strategy designed to reduce risk by spreading the portfolio across many investments

Debts in Disguise

Accounts payable, leases, and underfunded pensions

A stock having a covariance with the market that is higher than the variance of the market will

Always have a beta above 1

Costs of financial distress are costs arising from

Bankruptcy and distorted business decisions before bankrupty

With a well-diversified portfolio

Beta of an asset is the measure of risk

Debt Issuance

Better since the value of debt securities is more certain than equity, thus information asymmetry has less impact

In the case of Google, which has issued Class A and Class B shares

Both classes of shares have the same cash-flow rights and both classes of shares have different control rights

Capital Structure is irrelevant if

Capital markets are efficient, each investor can borrow/lend on the same terms as the firm. There are no tax benefits to debt

Trade-off Theory

Capital structure is based on trade-off between tax savings and costs of financial distress

How to reduce standard deviation

Combining assets into portfolios

Which portfolio has had the highest average risk premium during the period 1900 to 2014?

Common Stock

Market Risk

Economy-wide sources of risk that affect the overall capital market. Also called "systematic risk"

A portfolio with a beta of one offers an expected return equal to the market risk premium

FALSE

An investor who puts $10,000 in Treasury bills and $20,000 in the market portfolio will have a beta of 2

FALSE

Investors demand higher expected rates of return on stocks with more variable rates of return

FALSE

Low standard deviation stocks always have low betas.

FALSE

Stocks with high standard deviations will necessarily also have high betas.

FALSE

The CAPM predicts that a security with a beta of 0 will offer a zero expected return

FALSE

The average beta of all stocks in the market is zero

FALSE

Financial Markets and Intermediaries

Facilitate payment mechanism, borrowing and lending, pooling risk, and information exchange

Unique Risk is also called

Firm-specific risk

Pecking-Order Theory

Firms prefer to issue debt over equity if internal finances are insufficient

A portfolio of treasury bills

Has the least risk

What is NOT regarded as an investment fund

Insurance companies

Which of the following sources of funds has played the greatest role in the financing of U.S. nonfinancial firms

Internal funds

Recently, which of the following sources of funds has played the greatest role in the financing of U.S. nonfinancial firms

Internal funds have played the greatest role in the financing of U.S. nonfinancial firms

If one wants to borrow with limited liability, they should

Invest in the equity of a levered firm

If a bond is junior or subordinated

It must give preference to senior creditors in the event of default

Why does MM proposition 1 not hold in the presence of corporate taxes

Levered firms pay lower taxes when compared with identical unlevered firms

Information Asymmetry

Managers know more about their companies than investors, implying that the price of a firm's securities is not always equal to their value

The market value of equity =

Market Price * # of shares outstanding

Beta is a measure of

Market risk

For a portfolio of N-stocks, the formula for portfolio variance contains

N(N - 1)/2 different covariance term

When 2 asset returns' correlation coefficient equals 1

No diversification effect can be achieved

The distribution of returns, measured over a short interval of time, such as daily returns, is best approximated by the

Normal Distribution

Mean and Standard Deviation

Normal and lognormal distributions are completely specified by

Pairs of stocks tend to have both

Positive covariances and correlations

When securities are sold by a firm, it is termed a

Primary issue

The following functions, provided by financial intermediaries, enable the smooth functioning of the economy

Processing of payments, borrowing and lending, and pooling risks

A grant of authority allowing someone else to vote shares of stock that you own is

Proxy voting

Unique Risk

Risk factors affecting only that asset. Also called "diversifiable risk"

The trade-off theory of capital structure predicts that

Safe firms should borrow more than risky ones

The graphical representation of the CAPM (capital asset pricing model) is called the

Security market line

Preference in position among creditors when it comes to repayment is called

Seniority

Capital Structure Depends on

Size, Tangible assets, profitability, and market-to-book ratio

What signal is sent to the market when a firm decides to issue new stock to raise capital?

Stock price is too high

Market risk is also called

Systematic risk and undiversifiable risk

Investors demand higher expected rates of return from stocks with returns that are highly exposed to macroeconomic risks

TRUE

Investors demand higher expected rates of return from stocks with returns that are very sensitive to fluctuations in the stock market

TRUE

The beta of a well-diversified portfolio is equal to the value weighted average beta of the securities included in the portfolio

TRUE

The portfolio risk that cannot be eliminated by diversification is called market risk

TRUE

U.S. firms, in general, have been repurchasing shares and thus net equity issues have been negative

TRUE

The security market line (SML) is the graph of

expected rate of return on investment vs. beta

The following are characteristics of preferred stock except it

has voting rights

The main advantage of debt financing for a firm is that

interest expenses are tax deductible

According to the trade-off theory of capital structure

it is optimal when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress

If a firm is financed with both debt and equity, the firm's equity is known as

levered equity

Investments with greater risk are associated with

lower price and higher expected return

Modigliani and Miller Assumptions

no tax, no bankruptcy cost, no agency cost, and no information asymmetry.

Eurobonds are

not denominated in euros

One would expect a stock with a beta of zero to have a rate of return equal to

risk free rate

Investors are

risk-averse on average; they dislike risk and shall be compensated for taking more risk

The trade-off theory of capital structure predicts

that safe firms should borrow more than risky ones

MM proposition 2 states that

the expected return on equity is positively related to leverage, the required return on equity is a linear function of the firm's debt to equity ratio, and the risk to equity increases with leverage

The Higher the beta

the higher the risk

How can firms raise funds?

through internal financing (retained earnings) and external financing (debt and equity)

The total risk of an asset can be decomposed into

unique risk and market risk

A stock return's beta measures

The change in the stock's return for a given change in the market return

What makes diversification possible?

The correlation coefficients (co-movement) among asset returns

The change in a firm's retained earnings is

The difference between the net income earned and the dividends paid during a year

Normal Distribution

The distribution of returns, measured over a short interval of time, such as daily returns

Without sufficient slack

The firm might be caught at the bottom of the pecking order and be forced to issue undervalued stocks

The Capital Structure of the Firm

The firm's mix of different securities used to finance assets

Risk

The inaccuracy in predicting a future outcome

Proposition 1

The market value of a firm does not depend on the firm's leverage

PV (tax shield)

The sum of present value of all future tax savings due to interest payment

Managers of Corporations prefer internally generated cash to finance their capital expenditures because

They can avoid the discipline of financial markets, the costs of issuing new securities are high, and the announcement of a new equity issue is bad news for investors

A risk premium is the difference between a security's return and the

Treasury bill return

The type of risk that can be eliminated by diversification is called

Unique risk

As the number of stocks in a portfolio is increased

Unique risk decreases and approaches 0

When a firm has no debt, it is know as

Unlevered firm and an all-equity firm

Common Stocks

Which portfolio had the highest standard deviation during the period between 1900 and 2014

If a stock were overpriced, it would plot

below the security market line