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Flashcards in Managerial Finance 2 Deck (66):
1

Interest Rates

- return on short-term risk-free security (usually a treasury security)
- also can be yields (internal rates of return) on longer-term treasury securities
- also complex rates of return on all treasury securities

2

Determinants of Interest Rates

1. productivity of real assets (capital goods) in the economy
2. degree of uncertainty about the productivity of a capital good
3. time preferences of investors
4. risk aversion
5. expected inflation

3

Real Rate vs. Nominal Rate

nominal = Real + inflation

4

EAR vs. APR

annual percentage rate = simple rate without interest compounding
effective annual rate = takes interest into account

5

T-Bill vs. Treasury Bond vs. Treasury Note

T-bill = short term
Treasury note = medium term
Treasury Bonds = longer term

6

Treasure Bill/Bond/Note Terminology

- all pay out once (at maturity when the face value is paid) and nothing at any other time
- coupon rate = given rate
- yield-to-maturity = average rate of return for the buyer if they hold to maturity
- yield curve = shows yields-to-maturity (y-axis) of treasure bonds of different maturities (x-axis)...provides discount rates and to extract market estimates (shape of the curve correlates to state of the economy)

7

Bonds

borrowing arrangement where the borrower issues an IOU to the investor
- issuer is getting the $ upfront
- face value is paid at the end to the investor (coupon payments in-between)
- normally bonds pay semi-annual coupons (twice per year)

8

Bond Prices in Relation to Yields

- as the yield drops, the bond price rises (and vice versa)
- the greater the maturity of a bond, the greater the price sensitivity of changes in the underlying yield
- long-term bonds, however, change less than short term so they are more volatile but less than in proportion to their maturities

9

Holding Period (Bonds)

computed for the actual time the bond is held

10

Bond that Sells for More/Less/Same than FV

- more = premium bond
- less = discount bond
- same = par bond

11

Types of Bond Issuers

- treasury bonds/notes
- corporate bonds
- other issuers such as state and local govts and/or govt agencies

12

Credit Risk

- corporate bonds are subject to default
- must offer a default premium (difference between promised yield and expected yield to maturity)

13

Types of Investment Decisions (4)

1. NPV (accept if NPV > 0)
2. Payback Period (accept if period is less than some preset limit)
3. Average Accounting Return - AAR (accept if the AAR is greater than the present rate)
4. Internal Rate of Return - IRR (accept if IRR is greater than the required rate of return)

14

Investment Decisions - NPV

- NPV is the difference between the market value of the project and its cost
1. estimate expected future cash flows
2. estimate the required return for projects of this risk level
3. find the PV of the cash flows and subtract the initial investment
4. accept if NPV > 0
- advantages - satisfies all Decision Criteria

15

Decision Criteria

- does the decision adjust for the time value of money?
- does the decision rule adjust for risk?
- does the decision rule provide information on whether we care creating value for the firm?

16

Investment Decisions - Payback Period

- how long does it take to get the initial cost back in a nominal sense?
1. estimate cash flows
2. subtract the future cash flows from the initial cost until the initial investment has been recovered
3. accept if period is less than some preset limit
- advantages - easy and adjusts for uncertainty of later cash flows
- disadvantages - ignores time value of money, ignores cash flow beyond cut off point, biased against long-term projects

17

Investment Decisions - Average Accounting Return

1. average net income of all years/average book value
2. accept if the AAR is greater than the present rate (need to have a cutoff target rate)
- note that the book value depends on how the asset is depreciated
- advantages - easy, needed info usually available
- disadvantages - time value of money is ignored, based on accounting numbers not market rates and cash flows

18

Investment Decisions - IRR

- IRR is the discount rate that makes NPV = 0
1. trial and error to find
2. accept if IRR is greater than the required rate of return
- advantages - simple way to communicate the value of a project, if the IRR is high enough don't need to calculate RRR, based entirely on estimated cash flows
- if cash flows change more than once, there are two IRRs (if lending, choose the one that's on the downward sloping part of the curve. if borrowing, choose the one on the upward sloping part)

19

NPV vs. IRR (re: Investment decisions)

- IRR and NPV generally give us the same decision (unless there are unconventional cash flows or mutually exclusive projects)
- if conflict, always go with NPV

20

Mutually Exclusive Projects (re: IRR)

- if you choose one, you can't choose the other
- choose one and then decide if you should switch...if switch, choose the other, if not - stay with the first

21

Profitability Index

- measures benefit per unit cost, based on the time value of money
= NPV/Initial Investment
- if the amount of money is limited, this is a good tool because it shows the biggest bang for the buck
- advantages - closely related to NPV, easy to understand and communicate
- disadvantages - may lead to incorrect decisions in comparison of mutually exclusive events

22

Capital Budgeting

- capital budget = the projects/investments that a company plans to undertake during the coming year.
- capital budgeting = firms analyze alternative projects and decide which ones to accept
- process begins with forecasts of the project’s future consequences some will affect the firm’s revenues; others will affect its costs
- ultimate goal = determine the effect of the decision on the firm’s cash flows, and evaluate the NPV of these cash flows to assess the consequences of the decision for the firm’s value

23

Incremental Cash Flows

- NPV is the sum of all the "prices" of future marketable flows so we should focus on cash flows (not earnings necessarily)
- we need to look at the extent to which the project adds value to the firm i.e. incremental cash flows (derived from incremental earnings)

24

Opportunity Cost

- the value it could have provided in its best alternative use

25

Project Externalities and Cannibalization

- Project Externalities = indirect effects of the project that may increase or decrease the profits of other business activities of the firm
- Cannibalization = when sales of a new
product displace sales of an existing product

26

Sunk Cost

- any unrecoverable cost for which the firm is already liable
- should not be included in evaluating a project

27

Overhead Expenses

- associated with activities that are not directly attributable to a single business activity but instead affect many different areas of the corporation
- should not be included in evaluating a project

28

Stock Price Fundamentals

- stock value = sum of all future dividends
- dividends = earnings - net new investment (i.e. re-investing in the firm)
- hence, a firm's stock price cannot be the present value of discounted earnings (unless the firm needs no new investment to maintain its earnings)

29

Dividend Irrelevance

A theory that investors are not concerned with a company's dividend policy since they can sell a portion of their portfolio of equities if they want cash.

30

Determinants of Dividend Growth Rate

- depends on ROE (income/book value equity) as well as the retention ratio

31

Total Payout Model

- allows for dividend payments and future share repurchases (i.e. an alternate way of distributing earnings)
- uses ALL the firms equity rather than a single share

32

Dividend Discount Model

- the price of the stock is equal to the present value of the expected future dividends it
will pay
- shortcomings = investors can obtain returns not only from dividends but also from share repurchases AND it's difficult to predict future dividends

33

Discounted Free Cash Flow Model

- goes one step further and begins by determining
the total value of the firm to all investors—both equity and debt holders

34

Valuation Using Multiples

- like the law of one price but more direct
- compute the "price" of a dollar of some flow variable (e.g. EBITA or sales - most common is earnings or net income) using the market valuations of comparable firms based on the same flow variable
- then, multiply the forecasted value of the flow variable for out firm by it's "price"

35

Efficient Market Hypothesis (EMH)

- says that asset's current price reflects all available information
- competition among investors works to eliminate all positive-NPV trading opportunities (e.g. even if someone noticed something the other investors didn't, their acting on it would adjust the stock price so everyone would know)
- applies to public info; private info only when it becomes public
- Market Reaction to Information - in the long run, market "inefficiency" will be limited only by the costs of obtaining information or analyzing the information

36

Asset Return Volatility

- the variance of the return is the mean squared deviation from the expected return
- mean = weighted average values of the deviations
- standard deviation = measure of how extreme a return is (i.e. volatility), measured as a percent squared
- more extreme outcomes = higher volatility

37

Confidence Interval Calculation in terms of Return Volatility

- you can be 95% confident within two SD's of the expected return
- higher volatility doesn't necessarily mean higher return

38

Individual Assets versus Portfolios

- when you put single assets in a portfolio, the volatility of the portfolio diminishes (by increasing the number of assets)
- a single asset can not be diversified
- there is an "e" factor related to the market return that, spread among a large number of assets, is zero

39

Beta vs. SD

- a beta is simply a market mimicking factor in terms of a single asset (in terms of CAPM)
- a single asset will be a regression line (beta is the slope coefficient)

40

CAPM

Capital Asset Pricing Model - a single asset's beta is their average return in a market where asset are properly priced. relative volatility (that can not be diversified) is the beta times the volatility of the market
- plotted, betas of single assets against their average returns is a straight line

41

Idiosyncratic versus Systematic Risk

- Idiosyncratic = fluctuations of a stock’s return that are due to firm-specific news are independent risks. Like theft across homes, these risks are unrelated across stocks.
- Systematic - fluctuations of a stock’s return that are due to market-wide news represent common
risk. As with earthquakes, all stocks are affected simultaneously by the news.

42

Stock Beta

- measures the stocks sensitivity to market movements
- related to the nature of the product sold by a company, especially its price elasticity
- The beta of a security is the expected % change in its return given a 1% change in the return of the market portfolio

43

Cost of Capital

- Cost of Capital for a firm is the return that investors in that firm require for investing in its projects. This is usually computed as the weighted average of the required return for the different classes of securities issued by the firm.

44

Diversification

- Diversification is the averaging out of independent risks in a large portfolio

45

Portfolio

- A portfolio is a mix of or collection of investments held by an institution or a private individual. It is also represented by a set of portfolio weights, corresponding to each asset in a set of investments.

46

Normal distribution

- The normal Distribution is a probability distribution that plots all of its values in a symmetrical fashion and most of the results are situated around the probability’s mean. - Values are equally likely to plot either above or below the mean.
- Grouping takes place at values that are close to the mean and then tails off symmetrically away from the mean
- It is also known as “bell curve.”

47

Standard Deviation

The standard deviation is a measure of dispersion of data about a mean value.
- A low standard deviation indicates that the data is clustered around the mean, whereas a high standard deviation indicates that the data is widely spread with significantly higher/lower figures than the mean.

48

Real Options

- A real option is an option that a firm has to take a particular decision to commit or commit resources to a particular project
- Often, the conditions that would be favorable to a positive decision to commit resources can be tied to the price of a traded asset. To this extent, a real option can be valued using option pricing techniques.

49

Capital Rationing

- capital Rationing refers to restrictions on the amount of capital available within the firm for investment. In a world of capital rationing, it may not be possible to invest in all projects with positive NPV.
- Furthermore, if projects are not divisible, then it may be optimal to choose some smaller lower NPV projects over a higher NPV project that requires the use of a large amount of capital.

50

Rights Offering

- this is an issue of new stock, but one which is limited to existing shareholders of the company
- The existing shareholders can trade these rights.

51

Treasury Stock

- this refers to shares that the company has repurchased and is holding in its treasury

52

Warrant

- a security which gives the holder the right to buy a share of the stock, which the company will issue, at a specified price within a specified period of time.
- This is similar to an option, except that when an option is exercised, the number of shares outstanding do not go up, as in the case of a warrant

53

Venture Capital

- this is the money invested to finance a new firm

54

Firm Commitment

- an underwriting arrangement, where the underwriter buys the securities from the firm and then resells them to the public.
- The underwriter takes on the risk that it might not be able to sell the stocks at the agreed offering price.

55

What are agency costs? What are the agency costs of debt?

- Agency costs arise whenever you hire someone else to do something for you; your interests(as the principal) may deviate from those of the person you hired (as the agent). Hence the agent may take actions that are suboptimal and inefficient and may lead to opportunity costs. Furthermore, to prevent this, the principal will be obliged to spend resources to monitor the agent. These are also unproductive expenditures caused solely because of the agency problem. Agency costs are the sum of these opportunity costs plus the unproductive out-of-pocket costs.
- Agency costs of debt arise because stockholders acting on behalf of bondholders may take excessive risk and may also invest insufficiently in the business. Bondholders impose costs in the form of restrictions called covenants on the stockholders.

56

Consider the following set of industries and rank them in order of their market beta magnitudes. Explain:
i. Food Processing
ii. Semiconductors
iii. Auto and Truck Manufacturers
iv. Electric Utilities

- Electric Utilities will have the lowest beta because they are regulated monopolies with relative stable cashflows.
- Food Processing is probably the next lowest -- food is a staple and demand will not fluctuate that much.
- Autos are more of a luxury and the betas of auto and truck manufacturers will be higher.
- Betas of Semiconductor firms will be highest because demand for them is a derived demand -- when the economy turns up, the demand for intermediate goods such as semiconductors will shoot up.

57

Stock prices typically rise when the firm makes an announcement of a new product. Why should this be so, according to the Efficient Market Hypothesis?

- When a firm makes an announcement of a new product, it usually indicates that the firms profits will rise. Hence, according to the Efficient Markets Hypothesis, the market takes this into account and causes the price to rise.

58

Why can the IRR method not always be used when choosing between mutually exclusive projects?

- this is because the projects could differ in scale. A project that is smaller might end up with a lower NPV even if its IRR is higher. The projects could also differ in duration; again, a short duration project with a high IRR could end up having a low NPV.

59

When stocks go ex-dividend, the stock price drops. Why don't we see this happening with bonds when the coupon is paid?

- This is because the bond price is quoted net of coupon. The "dirty" price, which is inclusive of coupon will drop.

60

Interest payments are deductible for corporate tax purposes. Hence, one would think that debt should increase the value of a firm. However, your friend is convinced that if all taxes are taken into account, debt could actually decrease the value of a firm. How could this be?

- This is because there are other costs related to debt. For example, as the amount of debt increases, the probability of bankruptcy rises and the expected bankruptcy costs go up. Similarly agency costs of debt rise, as well.

61

What are the advantages of payback as a investment criterion?

- It is simple to calculate and doesn't require a precise estimate of the cost of capital.

62

How is beta different from standard deviation of returns as a measure of risk?

- Standard deviation measures total risk, whereas beta only measures non-diversifiable risk.

63

What are the determinants of the rate of growth of a firm's earnings?

- The two major determinants are the return on equity and the plowback rate.

64

The holding period return is always greater than the yield-to-maturity. True or False? Explain.

- This is false. It depends on what happens to interest rates in the interim.

65

"Issuance of new equity dilutes earnings. Hence it's bad." Is this true or false? Explain.

- Issuance of new equity need not dilute equity; it depends on whether the return on equity on the new funds is greater or less than the return on existing equity. In any case, whether the issuance of new equity is good or not depends on what is done with the funds raised -- if the return on the funds is greater than the required rate of return, then it will be beneficial to existing shareholders, assuming that the firm has not promised more than the required rate of return to the new equity holders.

66

What is the most important source of capital for firms? Can you explain why this might be so?

- The most important source of capital for firms is internally generated funds. This is so because there are no information asymmetry issues involved in using internal funds for projects. Information asymmetries would tend to raise the required return on externally generated funds and the baseline rate of return required on new projects.