exam prep - no week4 yet Flashcards
(4 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
State and explain both of Modagani & Millers propositions.
Why does optimal capital structure shift from debt doesnt matter to the more debt the better when corporate tax is being considered?
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.
Developed by franco modaganni and merton miller in 1958, the theory posits that companies operating in a perfect world, which consists of no taxes, no chance of bankruptcy, perfectly efficient markets and symmetrical information for all participants, Will, in theory one, have their firm value remain unaffected by their capital structure and two Even though debt is typically cheaper than equity, adding more debt increases risk for equity holders, because they are paid last. So, shareholders will demand higher returns, which cancels out the cost savings from cheaper debt.
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.
Explain the trade off between tax shields and cost of financial distress:
Interest rate tax shields and cost of financial distress interact to formulate firm optimal structure. A firms optimal debt to equity ratyio depends on the firms tax rate and how quickly the costs of financial distress increase as a function of debt. At moderate debt levels the liklinness of financial distress is low thus the advantages of debt dominate. However as debt gets larger and larger the percentage of financial distress rises and the potential cost of distress begins to substantially erode company value.
