exam prep - Flashcards
(10 cards)
- List the avenues a firm could take to offer managers equity stake in a firm
- Use examples to explain the key functions of financial institutions - SMPLR
- Between a long term bond and a short term bond, all else being equal which bond is more affected by a change in interest rates
- Explicitly granting shares
Awarding options on the firms stock
Allowing purchase of stocks at a subsidised price through employee stock ownership plans - Liquidity provision - Financial institutions ensure depositors can withdraw funds on demand whilst lending most of these deposits out. This liquidity underpins confidence in the financial system.
Risk management - Financial institutions help reduce information asymmetry by screening out and monitoring borrowers. They diversify across many loans and assets to reduce impact of any single borrower impact
Size transformation - Financial institutions pool smalls savings from many individuals to provide large loans to businesses and governments
Maturity transformation - Many savers want quick and short term access to their money while borrowers often need long term financing. Financial institutions reconcile this by offering savers liquid accounts and simultaneously extending long term loans to borrowers.
Payment services - Financial institutions provide a robust payment infrastructure allowing for efficient trade and commerse - All else equal long term bonds experience larger price changes when interest rates change as opposed to short term bonds. This is because a bond’s price is the present value of all of its cash flows thus the longer out cash flows extend the more suceptible the bond is to changes in price due to changes in the interest rate - this effect is known as duration risk or interest rate risk
What do call provisions allow bond issuers to do - why do bond issuers include these
What is the difference between common stock and preferred stock.
Explain the security market lines equation.
Identify and explain a common measure for the risk return relationship.
- Call provisions allow issuers to pay of bond debts early at a cost of the principle along side a call premium. Generally, bond issuers utilise these in cases where interest rates have substantially decvlined within an economy. Bond issuers call th existing bonds back and re issues them at a lower interest rate in order to lower the interest payments the bond issuer pays each year
- Common stock is a stock that represents partial company ownership. They come with voting rights within a company and their value and dividend payments are unfixed fluctuating based on the value of the companies underlying business and market performance. In cases of bankruptcy common stock owners hold less priority than preferred stock owners
Preffered stock is a type of stock that sits between bond and common stock when considering return. They pay constant dividends boasting greater income certainty and thus are tailored towards low risk income focused investors. Their prices fluctuate with market interest rates and behave like corporate bondprices. In cases of bankruptcy preferred stock owners hold precedence of common stock owners. - The SML is a key concept from the CAPM - capital asset pricing model - it shows the relationship between the expected return of an investment and the systematic risk associated
The line shows how much demand for taking on additional risk. Its a benchmark for pricing risky assets helping identify whether a stock or a portfolio offers adequate return for it’s risk level.
The risk-return relationship s commonly measured by the (CoV) coefficient of variation. The CoV is a standard deviation of investments returns divided by its average returns. The CoV represents the amount of risk taken for every 1% of returns earned, Thus a lower CoV indicates a more favourable risk return relationship
CoV = Sd/mean x 100
What are the two components of total risk and their respective sources
Why does optimal capital structure shift from debt doesnt matter to the more debt the better when corporate tax is being considered?
Explain the trade off between tax shields and cost of financial distress:
Total risk includes firm specific risk and market risk. Firm specific risk can be eliminated/ accounted for utilising diversification acheived through owning many different investments to a variety f different companies. The portion of total risk left after diversifying, market risk is the risk expected to be rewarded.
Firm specific risk stems from the uncertainity that arises from micro events that impact the firm or the industry. Market risk comes from macro events that affect all firms to some extent.
When interest on debt is tax deductible the government picks up part of the bill debt by foregoing tax. This makes debt cheaper thus firms maximise their use of tax in order to maximise the interest rate tax shield.
Interest rate tax shields and costs of financial distress interact to formulate a firmms optimal structure. This optimal debt to equity ratio is dependent on how quickly he costs of financial distress accumulate and the firm tax rate. When debt levels are low the advantages debt financing, being tax shields dominates, when debt gets larger however financial distress costs begin to substantially reduce company value.
Discuss and explain what it means for an organisation to have an objective of maximising shareholder wealth
intro - define objective
- define shareholder wealth maximisation objective
-describe how this determines levels of an organisation
- describe shortcomings of this objective
-describe an alternative perspective.
objective definition
An objective of a firm is a clearly defined target that guides its operations, strategies, and decision-making processes.
definition of shhareholder welath max
shareholders bear the most risk and are rewarded the most of a firms porfits accordingly.
Shareholder wealth is reflected in the stock price and Stock price depends on future cash flows, profitability and risk levels therefore Shareholder wealth maximisation is increasing long term company value focusing on these variables. this objective Forms the basis of corporate governance structures and decision making. - pricing and cost control decisions are made with the impact of shareholder value in mind. Companies who maximise shareholde3r wealth focus on increasing firm value
Profit maximisation focuses on short term earnings as opposed to long term company value. - but comes under profitaility therefore the objective must be applied in full and not narrowly.
How firms operationalise ths:
Profit and value maximisation permeate every level of the organisation
Influences management decisions/responsibilities
Human resource and hiring strategies - ) hour contract allow closely allinging labour supply with demand
Product and pricing decisions
Marketing and innovation - strong brand creates loyalty which creates repeat st=ales and stable cash flows.
limitations of this objective model
Principle agent relationship, managers may not act in shareholder best interests, managers may pursue personal goals, job security, prestige or convenience rather than making tough profitable decisions. Reduce effectiveness and introduce inefficiencies to the shareholder wealth model. - fims address by offering firm equity in 3 ways
Ethical concerns, exploitative or socially irresponsible behaviour, outsourced labour to countries with poor working conditions. Comprising worker welfare. Environmental harm, tax avoidance, customer manipulation all maximise shareholder wealth at the cost of broader social good
alternative perspectives:
Stakeholder theory - argues that firms should consider the intyerests of all of its stakeholders and not just share hoolders. E.g employees, the community, customers, the environment
Companies like unilever or patagonia have adopted stake holder theory models prioritising ethical sourcing, sustainability and social responsibility alongside profitabiility.
Ethical labor practices, environmental sustainability and customer trust can enhance firm reputation can improve company performance over time. Loyal consumers and brand preference means repeat sales constant cash flow and increasing cashflows.
Explain and discuss modiglani and miller theorem.
brief intro
prop 1
prop 2
prop 2 brief justification
re justify prop 2
conclusion - models practical use
We apply the MM (modagaini and miller) theorem under perfect capital market conditions. Perfect capital market conditions assume: No taxes, no chance of bankruptcy, no cost of capital, perfectly efficient markets and symmetrical information. Under these conditions the MM theory provides a framework to agree or disagree with the claims.
The modiglani and miller theorem was made by franco modiglani and merton miller in 1958 and later revised in 1963. It is built upon key propositions.
Proposition 1 : VL = VU.where VL = value of a leveraged firm and VU = value of an unleveraged firm. The value of a firm is independent of its capital structure. This proposition is saying thay a firms overall value does not change whether it is financed through through equity, debt or a combination of both.
Proposition 2: The cost of equity increases linearly with leverage, reflecting increased financial risk to equity holders. rE = rU + (rU-rD)(D/E) where rE = cost of equity, rU = cost of capital for unleveraged firm, rD = cost of debt, D/E = debt to equity ratio.
While debt is cheaper to equity, more debt increases risk borne by shareholders thus they require a larger return. Proposition 2 shows an increase in equity cot exactly offsets the benefits of using cheaper debt. The firms overal WACC - weighted average cost of capital - reemains unchanged.
The logic disagrees with the intuitive claim that you could offset costs by replacing expensive equity financing with debt reducing overall financing costs. However using MM theorems framework we can see that this isnt the case underneartch perfect market conditions. The risk return tradeoff ensures any return from lower cost debts is neutralised by rising equity costs making capital structure decisions irrelevant to firmm value.
Perfect market conditions do not exist. The assumption are unrealistic but can be used as a benchmark for understanding capital structure. It shows us how in a frictionless world firm value is independent of how it is financed. Any real world leverage must stem from factors like no taxes, bankruptcy or agency issues. Firms can evaluate the tradeoff between benefits of debt e.g tax shields and irs costs e.g financial distress. The model helps identify the drivers of value and clarify impacts of capital structure choices.
Re-explain modglani and miller’s theorem under the inclusion of corporate taxes.
brief intro para address the Q
explain impact of corporate taxes
state proposition 1
state equation and variables
1 para evaluate why theory is right
1 para evaluate why its wrong
1 para adressing the tradeoff
proposition 2 state and define
explain prop 2 impact on wacc
how does it affect agwncy principal relations
conclusion - should be a balance
When corporate snd financial distress are introduced the assumptions of modiglani and millers original 1958 theory do not hold. Under real-world conditions, capital structures become relevant to firm value. Leveraged and unleveraged firms differ in both cost of capital and overall value due to competing effects of tax shields and financial distress.
With corporate taxes, interest payments on debt are tax deductible, creating a tax shield. THis reduces a firms taxable income and its tax liability. The present value of tax shields increases the firms overall value.
The value of a leverage firm becomes: Proposition 1
vL = vU + tCD
Where vL = value of a leveraged firm
vU = value of an unleveraged firm
Tc = Corporate tax rate
D = amount of debt
This revised equation is from Modiglani and Millers 1963 theory which build on their old theory considering corporate tax, it shows how leveraged firms can increase value purely through the tax advantages of debt.
However high levels of debt also increase the probability of financial distress which induces the costs associated with financial distress. Including direct costs (legal and administrative), and indirect costs (lost customers, lower employee morale and disrupted operatrions).
There is now a trade off between the benefit derived from tax shields and the cost of financial distress. Giving rise to the trade off theory of capital structure. It suggests there is an optimal level of debt where the marginal benefit of the tax shield equals the marginal cost of financial distress. Therefore an unleveraged firm avoids financial distress risk but misses out on tax advantages meaning it isnt at optimal valuation.
Proposition 2: remains unrevised but ture
rE = rA + ( rA - rD )(d/e)
Where rE = cost of equity
rA = unleveraged firm cost of capital
rD = cost of debt
d/e = debt to equity ratio
Under proposition 2 the inclusion of taxes creates a tax shield. Interest payments are tax deductible and taxable income is reduced increasing firm value. The proposition holds however cost of equity still rises with increased leverage due to increased financial risk. The Weighted average cost of capital WACC declines as debt increases but this benefit is offset by indirect and direct costs associated with high risk of financial distress. Proposition 2 helps illustrate the tradeoff showing there is an optimal leverage level after which firm value will decline
Leveraged firms also have different management styles, diluted company ownership creates separation between ownership and control creating agency issues. Manager interests and shareholder interests conflict thus managers do not always act in shareholder interest. E.g spending on personal perks, poor investment decisions. Debt helps restrict this issue by limiting free cash flows (agency benefit of debt ) reducing wasteful spending of resources. However too much debt can create risk shifting incentives (agency costs). These effects adding another layer to the debt to debt comparison.
Comparing unleveraged to leveraged firms in a world with corporate taxes and financial distress costs, leveraged firms may enjoy a higher value due to tax savings but also face greater risk and potential loss from financial distress. Unlike MM’s original theory firm capital structure now matters and must be balanced with an amount of debt that is beneficial and not harmful.
IRR
intro
advantage 1
2
3
cons 1
2
3
conclusion
IRR - A capital budgeting metric used to asses the profitability of potential investments. IRR is internally calculated based on cashflows making it a straightforward profitability measure. A similar tool to NPV.
It represents the discount rate at which NPV = 0. It is essentially the rate of return a project is expected to generate.
One advantage of using IRR is that it considered the time value of money. It recognises money received sooner is more valuable than money received later. It gives these sooner received cash flows more weight thus making it more accurate and reliable than tools like payback period.
Another advantage is that it has a clear decision rule. IRR expresses a projects profitability as a single percentage, this makes it easy for managers and stakeholders to interpret and compare against the firms cost of capital or other investment return metrics
The clearness of the decision rule also allows for easier project comparability. Investors can rank projects based on their IRR - making it a more desirable tool when capital is constrained as it identifies the highers profits per pound invested.
If a project has alternating positive and negative cash flows it may produce multiple IRR’s making the decision rule ambiguous and a poor choice for projects with unconventional cash flows
IRR also fails to consider scale. THis is an issue because a smaller project with less returns may present a higher IRR than a larger project with more returns.
IRR is also sensitive to estimations errors, especially when considering long term projects. A small estimation error can drastically impact the IRR making it a less suitable tool the longer further a projects lifespan extends.
To conclude, the IRR is a widely used capital budgeting metric for evaluating investment projects. Its advantages include easy project comparison, a clear percentage return and a straightforward decision rule. However it comes with limitations also. It also flaunts difficulties with unconventional cash flows producing multiple IRR’s, and isnt useful for evaluating longer term projects due to estimation error significantly impacting our result. IRR should be used in confluence with other tools like NPV to ensure well informed investment decisions.
CAPM model crit eval
intro
pros 3
cons 4
conclusion
compare beta and standard deviation as risk measures.
CAPM - intro - The CAPM explains how expected return relates to systematic risk, it links expected return tio beta allowing investors to identify whether an asset offers adequate compensation for its risk. It assumes perfect capital markets meaning - no taxes….. - which is where the models real world applicabiloity comes into question. It is graphically represented by the SML, assets above the SML are undervalued and assets below the SML are overvalued.
Pros - provides simplicity and clarity, the CAPOM offers a straightforward way of quantifying risk and estimating expected returns based on market risk
Market based logic, the model incorporates systematic risk (beta), this being unavoidable risk that cannot be diversified away from, it makes the model crucial for investors with diversification based investment models.
Benchmark tool - a commonly used and accepted tool in investment analysis, portfolio management and cost of capital estimation.
Cons - unrealistic assumptions, the CAPM assumes perfect market conditions which rarely occurs in reality this taking away it individual usefulness requiring other models to provide context and more effective model application
Beta limitations - beta is calculated based on historical data which may not accurately predict future risk. It also assumes a linier market relationship which is unlikely to occur in real life.
Ignores other risk factors, the CAPM exclusively considers market risk, it ignores firm specific or macroeconomic risks like, momentum, size, competition and liquidity.
Empirical issues, Empirical research shows that actual returns often fial to match the CAPM predictions. The model is not independently sufficient in most cases.
Conclusion - The CAPM is useful for estimating required return or comparing risk, however its limitations mean it should be carefully applied considering other models or contextual and qualitative factors to makeup for the models shortcomings.
Beta as a risk measure:
- Beta measures sytematic risk, this is the volatility of a securities returns relative to market conditions
- It exclusively focuses on systematic risk, it indicates how much stock returns fluctuate in response to shifts in the broader market as opposed to firm specific risk(unsystematic)
- pros - it is effective for portfolio analysis and the CAPM. this is because beta focusess on non diversifiable risk
- cons - doesnt acount for total volatility. A stock with low beta has potential to be volatile if firm specific risk (unsystematic) is high
Standard deviation as a risk measure:
- measures a securities total risk, or the variability of its returns from its average return
- It effectively captures all types of risk, both systematic (market related) and unsystematic (firm specific) thus proportionately representing total risk/volatility
- pros - good for understanding overall investment return unporedictability, excels in standalone analysis of an asset.
- cons - not ideal for diversified portfolios. It is unable to distinguish between diversifiable and non diversifiable risk, this is an issue because in portfolios most unsystematic risk can be addressed and eliminated.
conclusion
- standard deviation captures total risk, both systematic and unsystematic, beta isolates firm specific risk making it useful for diversified protfolios and models like the CAPM. Investors whpp want to divertsify should use beta. Strandard deviation is valuable for assesinng standalon investment volatility and is often implemented by risk averse individual asset investors.
EMH - Q - Briefly discuss the theory and its forms, then discuss the empiriacal evidence for and agaiinst it.
intro
forms
evodence for 3 points
evidence against 3 points
critical discussion (assumptions)
conclusion
Intro - The efficient market hypothesis (EMH) suggests that markets are informationally efficient. This means asset prices reflect all available information, taking what is essentially a random path and implying that investors cannot constantly receive above average returns.
The theory was made by Eugene Fama in the 1970s and relies on a few key assumptions. All market participants have free and instant information acces, investors are rational and tend to passively invest, there are no transaction costs or tax costs limiting trade and prices adjust quickly and accurately to reflect new information.
Emh has had undeniable impact on asset pricing, regulatory policies and portfolio management however it remains a highly debated and contreversial topic in finance.
EMH forms
Weak form - states all past trading data is already incorporated into stock prices. This implies technical analysis cannot consistently produce above average returns
Semi strong form - builds further on weak form asserting all publicly available information.g economic news, financial statements etc are already reflected in market prices and thus fundamental analysis cannot consistently produce above average retruns.
Strong form efficiency - posits stock prices already hold all information. This include private or insider info and implies that even those with insider knowledge cannot consistently produce above average returns.
Empirical evidence for emh -
Index fund performance - empirical studies show actively managed funds on average do worse than index funds over long time periods. This supports semi strong market efficiency
Event studies - research shows stock prices rapidly adjust to newly available information, this suggests markets are at least semi strong efficient
High competition and liquidity - the vast number of market participants with access to the same data ensures prices adjust to reflect information
Empirical evidence against emh -
Market anomalies - patterns like the tendency of small cap stocks to outperform large cap stocks or momentum contradict the randomness expected by the emh
Behavioural biases - overconfidence and herd behavioura re patterns commonly seen in investors. This demonstrates that investors are not always rational
Buffet’s critique - Warren buffet alongside other big names have consistently outperformed the market, this chalklenges strong form emh.
Critical discussion - whilst emh provides a useful framework for understanding how information impacts stock prices, assumptions such as investors being rational, perfect information and zero transactions costs are, in most cases, unrealistic.
We know investors arenot always rational influyenced by herd behaviour and groupthinnk, we know that in reality information asymmetry exists, some investors have better or faster access to data and transactions costs can influence trading behaviour and market efficiency. These practical frictions challenge the idea that markets are always perfectly efficient. EMH provides a useful framework but is unable to fully capture the complexity of real world markets.
Conclusion - Investors and policy makers should be careful to balance emh prinicples and the insight derived from them, with real world complexities to implement real world decisions and rules.
emh empirical evidence
-weak form
classens, dagupta and glen 1965
higher autocorrelation of stock prices in emerging markets as opposed to developed markets. essentially saying that weak form efficiency holds best in developed markets and emerging markets are more likely to have expploitable patterns
-semi strong form
Peter and wolfson 1984
- their empirical evidence showed markets immediately reacting to earnings news after public release thus supporting the idea asset prics reflect publicly available information
-strong form
jensen 1968
- his empirical evidence showed actively managed funds do not outperfom the marekt after fees thus supporting the idea that all information is priced in and that the market cannot be consistently beaten
