Picasso - Finance Flashcards
(102 cards)
1
Q
Explain the time value of money.
A
Bird in the hand is worth two in the bush
Value of a dollar tomorrow is worth less than today.
- Opportunity cost of investing in treasuries, bonds, stocks, etc.
- Risk = measured by the discount rate
- Inflation
2
Q
Why is inflation important?
A
- Reduces the purchasing power of your dollar
- Real interest rates –> Bond investor: fixed-rate instruments are hurt not only by the real value of dollars received by the coupon, but the fed may raise interest rates to slow inflation and make your bond less attractive
- Expectations of rising interest rates
- Some inflation is good for the economy: incentivizes people to spend their money today rather than tomorrow
3
Q
Company A has assets of $100 million versus Company B which has $10 million. Both have the same dollar earnings. Which company is better?
A
Return on assets
Let’s assume $5 of earnings.
A: $5/100=5.0%
B: $5/10=50.0%
All else equal, Company B is more efficient at using its assets.
But is this levered return? May be burdened with debt
4
Q
What is the treasury stock method? Walk through the calculation.
A
Method of calculating of net dilution from the exercise of options, assuming that any cash proceeds the Company receives are used to repurchase shares in the market
Shares issued - (Proceeds/Share price)=net shares issued
5
Q
A product’s life cycle is now mature. What happens to the net working capital?
A
Decrease as business becomes more efficient.
Company may be able to demand tighter receivable terms from customers, optimize inventory holding periods, and stretch payables.
6
Q
Why is bank debt maturity shorter than subordinated debt maturity?
A
Temporal seniority
If a subordinated bond matured before a bank loan, it would be “effectively senior” as it would be paid off first before the bank loan assuming the co is a going concern
7
Q
What is LIBOR? How is it often used?
A
London Interbank Offered Rate
Rate at which prime financial institutions lend overnight to one another.
Reference / benchmark rate at which many financial institutions lend to one another and at which instruments are priced.
8
Q
What is a PIK?
A
Paid in kind interest
Interest accrued on the principal balance that is not paid in cash to the bond honlder.
9
Q
What is a PIPE?
A
Private Investment in Public Equity Dave & Busters during Covid Qualified investors When credit markets are tight. No unencumbered assets. Need to raise capital quickly. Fast moving investor willing to put money in equity at a discount to current share price No expensive roadshow
10
Q
If you put $100 in the bank and got back $2 every year for the next 19 years and then in the 20th year, received $102, what is your IRR?
A
Same as a bond. 2%
11
Q
What is a coverage ratio? What is a leverage ratio?
A
Coverage = EBITDA / Net interest
- How many times do your earnings cover EBITDA? Try to have it above 2x
Leverage = Debt / EBITDA
- At a constant EBITDA, how many years would it take to pay down debt
12
Q
How do you think about the credit metric: (EBITDA – Capex)/interest expense?
A
Great for capital intensive companies
Numerator is a more realistic metric of a company’s cash flow and ability to meet its contractual obligations
13
Q
You have a company with $100 million in sales. Which makes the biggest impact? A) Volume increases by 20 percent B) price increases by 20 percent C) expenses decrease by $15 million.
A
(B) Price increases by 20%
A) Volume increase would be accompanied by an increase in variable costs
B) Straight to pre-tax income (though may not be sustainable)
C) Sales up $20 while expenses down $15.
14
Q
If a company’s revenue grows by 10 percent, would its EBITDA grow by more than, less than or the same percent?
A
Depends on variable / fixed costs. Assuming it has some operating leverage, EBITDA will grow more than 10% because costs will be constant notwithstanding output
15
Q
Why should the fair market value of a company be the higher of its liquidation value and its going-concern value?
A
One would think rational managers will liquidate the company if its going-concern value is worth less than what it’d be if it closed doors today (and vice versa)
16
Q
How will a decrease in financial leverage affect a company’s cost of equity capital, if at all?
A
Draw optimum capital structure graph.
Cost of debt is cheaper than equity due to its tax shield and relative seniority in the capital structure. As you incur more debt, WACC goes down up into the point that the company starts feeling the debt burden (extra distress > value of tax shield).
17
Q
Let’s say that I have a bond with a 5 percent coupon. What happens to the market price when the prevailing interest rates rise to 8 percent? How are the coupons affected?
A
Price of the bond will go down
Coupon unaffected
18
Q
What’s the difference between IRR, NPV and payback?
A
IRR: annualized rate of return given a stream of cash flows from an investment that makes NPV = 0
NPV: whether or not a project can add value based on its additional costs; use to compare the size of investments at a given discount rate
Payback: amount of time it takes an investor to recoup costs (no time value of money)
19
Q
Why would a company repurchase its own stock? What signals (positive and negative) does this send to the market?
A
- Reduce the denominator of EPS
- Return on buyback > other projects in the market
- Return capital to shareholders at capital gains rate (taxed more favorably)
(+) Signals = mgmt believes in the company, believes stock is undervalued (they know the co. better than anyone else)
(-) Signals = not using cash well. If the share price is too high, can be lighting capital on fire
20
Q
If you were to advise a company to raise money for an upcoming project, what form would you raise it with (debt versus equity)?
A
Depends on the (i) cost of debt; (ii) covenants on debt; (iii) current capital structure; (iv) current stock price; (v) age of the company, etc etc
21
Q
Why would a company issue preferred over common stock?
A
- Should raise from the cheapest source available, but there are other considerations
- Investors want downside protection and annual payments.
- Not dilutive
- Sufficent cash flow to cover payments (can PIK it too)
- Share price low
22
Q
Why might a company issue debt over equity?
A
- Cheaper cost of capital
- Unemcumbered assets or stable cash flows
- Tax deductible interest**
- Investors want downside protection and annual payments.
- recapitalization
- Not diluting shareholders
23
Q
What are some reasons why a company might tap the high-yield market?
A
- Too risky for investment grade market.
- LBO / M&A
- Recap
- Already levered
24
Q
What is the relationship between a bond’s price and its yield?
A
Inversely related
25
What are the factors that affect option pricing?
Option: right but not obliation to purchase or sell an asset at or before a specified point in the future.
- Price of underlying security
- Time to exercise
- Standard deviation of price of underlying asset
- Risk free rate / dividends impact cost of carry
26
Explain put-call parity.
Demonstrates the relationship between a put and call with the same strike and expiration
- Shows that the implied volatility of calls and puts are identical
- short a put and long a call
27
Say you have a normal bond that you buy at par and you get the face amount at maturity. Is that most similar to buying a put, selling a put, buying a call or selling a call?
- Limited upside; 100% downside
| - Selling a put
28
You have a company with $500 million of senior debt and $500 million of junior debt. The senior debt has an interest rate of L+ 500 and, in default, would recover 70 percent; the junior debt would recover 30 percent in default. What should the interest rate be on the junior debt?
Loss on default * Probability of default = incremental interest that needs to be paid
70% loss on a 5% probability (assumption) = 3.5%
L + 850
29
What if this was an LBO scenario and you had a sponsor putting in 500 million of equity?
What's the new recovery to juinor holders?
70%*500=350. Senior holders would recover 150 of the first 500.
The remaining 350 would go to the junior guys, bringing their recovery to 350+(0.3*500)=500
No incremental interest needed
30
A company has $10 million of cash and $1 million of shares, nothing else. What’s its stock price?
What is cash valued at?
1.0x?
Stock price of $10
31
What if the company wins $10 million in the lotto?
Cash up $10.
Stock market expectations.
$20?
32
What if the company uses the lotto money to repurchase shares at $25/share? What’s the share price today if the repurchase is in one month?
$10mm/$25=0.4mm shares
0.6 shares OS
PF share price = 10/.6=16.66
Wtd average share price = 0.4*25 + 0.6*16.667 = $20
33
What kind of stocks would you issue for a startup?
Protect downside while limiting dilition.
- Preferred stock (liquidation preference, convertible into debt, accruing)
- Voting stock
- Convertible debt
34
When should a company buy back stock?
- ROI on stock buybacks is greater than other investments
- Price low enough (cyclical industry)
- Send signal to market
35
Is the dividend paid on common stock taxable to shareholders? Preferred stock? Is it tax deductible for the company?
Dividends: Yes - ordinary tax rate
- Not tax deductible at corporate level
Preferred Stock: Yes - "return of capital" tax rate - treatment found in prospectus
- Normally NOT tax deductible
36
When should a company issue stock rather than debt to fund its operations?
- Stock price (Tesla) / You're Hertz
- Interest rate on debt burdensome (credit risk, credit markets are closed, etc.)
- Credit support lacking (lumpy cash flows or no asset support)
37
Why would an investor buy preferred stock?
- Protect downside
- Can structure and negotiate with company (coupon, liquidation preference, conversion features)
- Tax rate favorable (qualified dividend?)
- Equity / Debt unattractve
38
Why would a company distribute its earnings through dividends to common stockholders?
- ROI on dividend versus other capital allocation pathways (M&A, capex, R&D, share buybacks)
- Send signal to market
- Some investors rely on the dividends
39
You are in the board of directors of a company and own a significant chunk of the company. The CEO, in his annual presentation states that the company's stock is doing as it has gone up 20% in the last 12 months. Is the company's stock doing well?
Depends.
- Beta --> what's the market done?
- Industry / comps?
- Robinhood traders?
40
When would you write a call option on Disney stock?
"Write" = sell
You may or may not own some Disney stock but don't think it doesn't have much room to run over X period. Collect premium and hope it doesn't rise above strike.
- Hedge?
- Speculation?
41
Explain how a swap works.
Exchange of future cash flows (i.e., interest rates, FX)
| -- fixed floating rate
42
If I gave you $100 for 10 years or $1000 today, which option would you choose?
Depends on the discount rate on the annuity
(C/r)*(1- 1/(1+r)^n))
$1,000 = $100 (annuity factor)
43
Say I hold a put option on Amazon.com stock with an exercise price of $250, the expiration date is today, and Amazon is trading at $220. About how much is my put worth, and why?
Put gives you the option to sell at a pre-determined price. Sell at $250 vs. current $220.
- Put is worth $30
- If expiration date was further out, then it would be worth more
44
All else being equal, which would be less valuable: a December put option on Amazon.com stock or a December put option on Bell Atlantic stock?
Which one is more volatile? Depends on the strike price relative to the current price.
Bell Atlantic. Less volatile.
45
All else being equal, which would be more valuable: a December call option for eBay or a January call option for eBay?
January option. Longer the period, the more the time the option will be in the money and the more it's worth
46
Why do interest rates matter when figuring the price of options?
Net present value
| Opportunity cost
47
If the strike price on a put option is below the current price, is the option holder at the money, in the money or out of the money?
Out
48
If the current price of a stock is above the strike price of a call option, is the option holder at the money, in the money, or out of the money?
In
49
When would you buy a put option on General Mills stock?
Think the price will fall below the strike.
Volatility
Long expiration date
50
What does it mean for a market to be efficient?
- Market incorporates all public information
immediately.
- Consequence: connot legally generate risk-adjusted over the return of the market
- Characteristics: Low transaction costs. Little information asymmetry. Not many technical sellers
Does not mean it is right
51
Are markets efficient?
Depends on the market.
- Blue chip stocks = yes. Liquidity. Low transaction costs. Little information asymmetry. Not many technical sellers
- Distressed credit = less so
52
If you worked in the finance division of a company, how would you decide whether or not to invest in a project?
Does the IRR exceed the cost of capital?
IRR = annualized rate of return
NPV = absolute dollar amount of
53
Why would a company distribute its earnings through dividends to common shareholders?
- Steady income for certain investors
- Dividend yield
- Relatively more frequent than buy backs
https://corporatefinanceinstitute.com/resources/knowledge/finance/dividend-vs-share-buyback-repurchase/
54
What are the primary market and secondary markets?
Primary markets = first time issuance
| Secondary markets = selling already issued shares to another market participant (NYSE, NASDAQ)
55
What is the difference between basic and fully diluted shares?
Basic EPS = shares OS today.
Diluted EPS: include the impact of diluted securities, such as convertible debt, preferred stock, options, etc.
(treasury stock method)
56
A company has had positive EBITDA for the past ten years, but it recently went bankrupt. How could this happen?
EBITDA is not cash flow. May have been overspending on capex / issuing dividends and didn't meet an interest payment
- interest
- maturity wall & credit markets closed
- litigation / off balance sheet liability
57
When should a company issue stock rather than debt to fund its operations?
- while Re can never be LESS than Rd, it can come close
- Interest deduction maxed (30% of EBITDA)
- Stock price
- Lumpy cash flows so avoid credit (i.e. startup)
- Change capital structure
58
Which is less expensive, debt or equity?
Debt
| - Security and tax deducitiblity of interest
59
If you were to advise a company to raise money for an upcoming project, in what form would you raise the money?
Depends.
- Cash flows of that project? Asset quality / value?
- Credit markets?
- Cost of equity / stock price?
- Current capital structure
With answers to these, I can make a preliminary recommendation
60
What is meant by the current ratio? Quick ratio?
Both are measures of a company's ability to pay short term obligations.
Current = current assets / current liabilities
Quick = cash / current liabilities
61
What is a proxy statement?
SEC doc (DEF 14A) filed annually when soliciting shareholder votes on officer compensation (amount and form) of management, Board composition, Board fees
62
Describe the IPO process?
1. Company wants to raise new capita (primary shares), acquisition currency, compensation, recognition
2. Pitch
3. Diligence and draft Draft an S-1 (prospectus)
2. Roadshow
3. Gather institutional investors
4. Open on exchange
63
What is arbitrage?
Risk-free and instantenous profit by buying an instrument in one place and selling an investment elsewhere. Temp price difference.
64
What is operating leverage?
Ratio of fixed costs to the entire cost structure
- high operating leverage is like financial leverage: reduced flexibility to cut costs but have upside with additional output
65
Describe a typical company’s capital structure.
Revovler
Bank debt
Bonds
Common stock
66
What is an IPO and what are its pros and cons?
```
Primary issuance of shares
Pros:
- Liquidity event for equity holders
- Raise capital (new shares)
- Non-cash compensation for employees
- acquisition currency
- Recognition
Cons
- SEC / filing requirements
- IPO expenses
- Quarterly earnings - meet numbers
- At the whim of Mr. Market
- time intensive
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67
What are the characteristics of a value stock?
Value today. Cheap.
| - margin of safety = intrinsic value > market price
68
What are the characteristics of a growth stock?
Value tomorrow. Fairly high price today. Great companies.
| - what price do you put on growth?
69
What could a company do with excess cash on its balance sheet?
Capital allocation tool-kit
- Do nothing - interest income or invest in some securities. Having cash on hand is good during Covid
- Reinvest in firm (Capex, R&D)
- Expand (M&A, Build a business from scratch)
- Return capital (Dividend, Share buyback)
- Buy back debt
70
What are the differences between a strategic and financial buyer?
Strategic = company that hopes to gain synergies.
- Holding period = forever
- Usually higher purchase price
Financial = buy company as an investment to exit within the next 5-7 years
- Primary focus is not synergies, but generating returns for LPs
- Determine purchase price from a set IRR
71
How are bonds priced?
Function of
| - Maturity date, settlement date, yield, market interest rates, coupon date, and par value
72
How would you value a perpetual bond that pays you $1,000 a year in coupons?
Annuity
| $1,000 / Discount Rate
73
When should a company issue debt instead of issuing equity?
- Stock price low
- Avoid dilution
- Credit support
- Cheaper cost of capital
If the expected return on equity is higher than the expected return on debt, a company will issue debt. For example, say a company believes that projects completed with the $1 million raised through either an equity or debt offering will increase its market value from $4 million to $10 million. It also knows that the same amount could be raised by issuing a $1 million bond that requires $300,000 in interest payments over its life. If the company issues equity, it will have to sell 20% of the company ($1 million / $4 million). This would then grow to 20% of $10 million, or $2 million. Thus, issuing the equity will cost the company $1 million ($2 million - $1 million). The debt, on the other hand, will only cost $300,000. The company will therefore choose to issue debt in this case, as the debt is "cheaper" than the equity.
74
What major factors affect the yield on a corporate bond?
- Credit risk of issuer
- Forced selling
Market, economy
- Extraneous event
- Market rates
- Inflation
75
If you believe interest rates will fall, which should you buy: a 10-year coupon bond or a 10-year zero coupon bond?
10 year zero because it has a high duration. Higher sensitivity to changes in interest rates
76
Which is riskier: a 30-year coupon bond or a 30-year zero coupon bond?
Zero. Not recouping dividends
77
What is The Long Bond trading at?
30 year bond. 1.4%
78
If the price of the 10-year Treasury note rises, does the note's yield rise, fall or stay the same?
Decreases
79
If you believe interest rates will fall, should you buy bonds or sell bonds?
Buy
80
Why can inflation hurt creditors?
Purchasing power of fixed coupons go down (real interest rates go down)
81
How would the following affect the interest rates? U.S. bombers attack Iraq (again). The President is impeached and convicted.
How would the fed respond?
Market conditions?
I'd say people would flock to bonds, pushing interest rates down
82
What does the government do when there is a fear of hyperinflation?
Monetary: Raise rates
Fiscal: use taxation and gov't spending to regulate economic activity
83
How would you value a perpetual zero coupon bond?
Guide says zero:
I say: Need to know more here.
Give me the maturity date or expected maturity
**If anything, what will someone else pay for it?
Does it pay anything off in default?
84
Let's say a report released today showed that inflation last month was very low. However, bond prices closed lower. Why might this happen?
Other factors at play
If rates decrease, bond prices will go up but will be higher risk of inflation
Unemployment?
Guide: "Bond prices are based on expectations of future inflation. In this case, you can assume that traders expect future inflation to be higher (regardless of the report on last month's inflation figures) and therefore they bid bond prices down today. (A report which showed that inflation last month was benign would benefit bond prices only to the extent that traders believed it was an indication of low future inflation as well.)"
85
If you have two high-yield bonds with identical coupons and maturities, one from a supermarket and one from a high tech company, which one would you buy and why?
Comes down to credit risk of the firm.
- Super market: tangible assets (though you are likely unsecured) and cash flows (more stable, we always need groceries)
- Tech firm: assets are intangible and cash flows are more lumpy
86
What does the yield curve look like? Why?
Term structure of interest rates
- Expectations theory: future expectations of interest rates
- Liquidity preference theory: demand liquidity premiums
- Market segmentation: different investors have different preferences so trades differently
87
How do you know if a firm might be a credit risk?
What are its triggers?
- Maturities
- Interest payments vs cash flows
- Saleable assets
- Other extraneous events
- Off balance sheet liabilities
88
What does the current shape of the yield curve imply about the market’s expectation for economic growth?
Future interest rates and inflation expectations
- Upward sloping, expectation is that rates will rise
Expectations theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today.
89
In picking a stock, what do you typically look at?
```
Industry
Company
Financials
Go forward business plan
Price
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90
Which would provide more incentive to an executive, stock options or straight stock? Why?
Stock options - need t oget the share price over X to realize the benefit
91
If our bank was to give you $50 million and you had one year to invest it, would you rather hold a one-year bond or a five-year bond? Why?
Depends on the interest rate and other investments in the marekt
92
If you and a friend start a company and have equal ownership, then take the company pubic and issue 20% equity, how much of the firm do you own?
.5*.8=.4
93
Would you rather have $100 today or $200 four years from now?
Depends on the rate
200=100*(1+r)^4
Just under 20% due to compounding
200 four years from now. Hard to find that return elsewhere
94
What is the difference between fundamental and technical analysis?
Stocks fundamentals vs chart following, looking for signals
95
What is convexity?
Captures the curvature in the sensitivity to interest raes
96
What is duration?
Linear represenation of price and yield movements to changes in rates
97
What is the method for valuation of a bond?
PV of cash flows
98
What is the difference between convertible and reverse convertible bonds?
Reverse convertible bonds give the issuer the right, but not the obligation, to convert the bond's principal into shares of equity, cash or another form of debt at a set date.
99
What is the duration of a 5-year zero coupon bond?
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100
Explain to me whether a discount or premium bond would be more affected by changes in interest rates
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101
Direct listings pros and cons
Pros
- liquidity for shareholders, acquisition currency, form of compensation
- quicker and less expensive than IPOs
- don’t have to worry about undervaluing shares
Cons
- still have some txn fees
- no new capital
- relatively new/uncertain path
- hard if your company isn’t well known
102
SPAC - pros and cons
Rifle shot approach of investing. IPO a shell company and use proceeds to acquire a company
Pros
- they are HOT today. Gaining more acceptance
- private company reaps benefits of being a public company
- cost and speed
- investors get their money back if money isn’t put to use
Cons
- blank check company, risky? Everyone is doing it so competition
