Final Flashcards
. You work for a company that has many divisions. What kind of mistakes would you make if you
used the company’s WACC as your discount rate for all projects in the company?
You would be using the wrong discount rate for most of your investment decisions. In particular, you
would be using too low a discount rate in your riskier divisions and too high a discount rate in your
safer divisions. This would lead you to accept to many risky division projects and reject too many
safer division projects
Why does a lower correlation coefficient for two stocks lead to lower portfolio variance? [6]
A lower correlation coefficient means that the two stocks move together less, leading to a greater
diversification effect from holding them together in a portfolio. This greater diversification effect
leads to more of the total risk being diversified away, leaving a lower overall portfolio variance.
Why do we focus on beta?
We focus on beta because beta measures systematic risk. We care about systematic risk because this
is the risk that cannot be diversified away in a portfolio and is therefore the risk we must be
compensated to bear
- Assume that TER has two divisions and one of them is in the same line of business as FOS. TER
has total cash flows of $100 million, split equally between its two divisions.What is the correct
discount rate for projects in that division? Explain.
The cost of capital for the project should be the appropriate expected return for the risk of that
project. If TER’s division is just like FOS, then the risk of its projects should be the same as the asset
risk of FOS, meaning that the discount rate should be the expected return on assets for TER: 9.72%
What will happen to your pre‐tax WACC? Explain. [
Your pre-tax WACC won’t change—it will stay 12%. The change in capital structure won’t change
your underlying risk of assets, so your WACC shouldn’t change. As a technical point, your after-tax
WACC will decrease slightly because you are shifting toward the subsidized debt capital and away
from the unsubsidized equity capital.
Explain the concept of market efficiency in the context of U.S. stock markets. [
The basic idea is that prices incorporate all available (public) information and that they are, on
average, correct in the sense that you cannot identify mispricing ex ante. This does not mean
that prices are never wrong ex post. However, as we cannot predict the news, we will not
know which prices turned out to be too high or too low with hindsight.
Another way of saying this is that investments in US stocks are zero‐NPV investments because
they are priced to allow you to earn an expected return that exactly compensates you for the
risk you bear.
In class, you learned 3 Nobel Prize-winning concepts. Name them
- Portfolio theory / portfolio optimization / diversification (Markowitz)
- CAPM (Sharpe)
- M&M Theorem (Modigliani and Miller)
Your friend is looking at a finance websites and remarks, “Why would anyone buy a stock that costs 30
times earnings when other stocks only cost 10 times earnings?” Explain how you would answer. [6
Answer should indicate understanding that we’re talking about P/E ratios and that stocks can have
very different P/E ratios depending on the expected growth relative to current earnings.
Is it possible for Stock A to have a greater standard deviation than stock B, but have a lower beta than B?
Explain. [6]
Yes. Answer should indicate understanding that standard deviation measures total risk and that
beta measures systematic risk. Stock A could have high total risk, but if most of it is diversifiable,
then its systematic risk could be low. The answer may also mention that sigma and beta are not
“on the same scale,” which I used to explain how beta could be bigger than sigma and still only be
part of what sigma measures. However, just saying they aren’t on the same scale is not answering
the question.
Describe one of the investor biases (mistakes) we discussed in class.
We talked about overconfidence (excessive trading), hanging on to losers, inattention, and mood.
Overconfidence is when investors think they are better at identifying over/under priced stocks than
they are, leading them to trade a lot, which simply results in average performance with high
transaction costs, so the net performance is low.
Hanging on to losers is the phenomenon whereby you do not sell stocks that have performed very
badly because doing so would force you to realize the loss and admit that you were wrong.
Inattention refers to the fact that stocks that are in the news tend to get more attention and more
trading and sometimes get a short-lived positive bump that then reverses.
Mood: there is evidence that investors’ mood (caused by sunny days and World Cup soccer losses)
contributes to the overall market return in a given day.
Explain the intuition behind the Modigliani and Miller Theorem. [
Answer should indicate an understanding that the basic insight is that capital structure changes are just reshuffling the claims on the business without changing the business itself. There is no reason why that reshuffling should change the total value created by the business unless it changes what we do (investment policy), involves transaction costs, or changes the part of the value created by the business that is actually leftover for investors.
- If there were no covenants to restrict them, discuss two ways that equity holders might take actions that
leave bondholders worse-off. [6]
The 3 ways we discussed in class are:
1. Paying excessive (or even liquidating) dividends, that bleed down the cash
cushion in the firm that could otherwise be used to pay the bondholders in a
down year.
2. Asset substitution: switching from relatively safe to riskier assets after
issuing the bonds. This way, you get a loan at a low rate reflecting your safe
assets and then make a switch to a riskier business that would have required
a higher interest rate.
3. Issuing bonds of higher priority: After you sell bonds, you turn around and
sell new bonds with senior priority to those bonds, thus placing them in a
riskier position.
- Explain why we only care about systematic risk.
Unsystematic risk is diversified away in a portfolio. The only risk we end up bearing is the systematic
risk, which cannot be diversified away. Thus, we focus on systematic risk.
. Explain the relation between growth expectations and P/E ratios. [6]
Because P/E ratios compare the value of a company to its current earnings, higher P/E ratios
generally correspond to expectations of greater growth. The P in P/E is price, determined by
the PV of all future cash flows. When the PV of future cash flows is high relative to current
earnings, it must be that the market is expecting future cash flows to be considerably higher
than current ones, which means that it is expecting considerable growth. Conversely, when
the PV of future cash flows is lower relative to current ones, the market is impounding an
expectation of lower growth.
What are the major tradeoffs determining a firm’s capital structure? [
When adding debt to the capital structure, a firm trades-off the benefit of additional
debt (the tax deductibility of interest) against the cost (higher likelihood of
distress/bankruptcy).
