Review Corrections Flashcards
(23 cards)
What is underpricing in an IPO? Why should a financial manager of a firm be concerned about
underpricing?
Underpricing is when the share price on the first day of trading is greater than the IPO offer
price.
The financial manager should be concerned because the firm could have raised additional money
(or sold a smaller percentage of the firm) if it had increased the offer price.
List and briefly discuss four characteristics of IPOs that are puzzling.
- On average IPOs appear to be underpriced. The price at the end of trading on the first day is
often substantially higher than the IPO price. - The number of issues is highly cyclical. When times are good, there are many new issues; when
times are bad, there are fewer new issues. - The costs of an IPO are very high, and it is unclear why firms are willing to incur such high
costs. - The long-run performance of a newly public company is poor. On average, a three- to five-year
buy-and-hold strategy appears to be a bad investment.
Discuss two potential difficulties in making the investment decision, in the above example, using
the Internal Rate of Return method. Write your answer below with no more than three dot points.
Mutually exclusive projects with differences in scale may produce an IRR decision that is
inconsistent with NPV.
* For projects involving both positive and negative future cash flows, multiple internal rates
of return can exist.
Rank the following financial assets from the lowest to the highest level of risk:
What does the dividend-discount model say about valuing shares?
The dividend-discount model states that the value of a share should equal the present value of
all future payments to be received from the share. It is a direct application of the Valuation
Principle.
Briefly explain the meaning of the yield to maturity on a bond.
The yield to maturity is the discount rate that equates the present value of the bond’s cash flows
with its price.
What are three key differences between preference and ordinary shares? Write your answer
below with no more than three dot points
- Preference shares have preference over ordinary shares in the payment of dividends.
- Preference shares have preference over ordinary shares in liquidation/bankruptcy of the
company. - Ordinary shares carry the right to vote for the board of directors and in other important
matters, while preference shares do not.
What are the main differences between a firm commitment IPO and an auction IPO?
A firm commitment IPO results in the firm selling all of its shares to the underwriter
for a set price slightly below the offer price, with the underwriter then selling the shares
at the offer price on the IPO day. An auction IPO results in the market setting the offer
price of the shares given the number of shares that the issuing firm is selling.
Why do IRR and NPV rank the two projects differently?
The IRR and NPV rank differently due to the difference in the initial investment.
Project A earns a higher rate of return on a smaller investment. Project B increases
the value of the firm by a greater amount because of the larger investment. You
should therefore invest in project B.
What is the intuition behind the payback rule? What are some of its drawbacks?
The payback period is the amount of time in years it takes for a project to pay back the
initial investment. The drawbacks of the payback period are:
* It does not adjust cash flows for the time value of money.
* It ignores all cash flows beyond the payback period.
* The choice of the payback period is not grounded in economic theory
What is the intuition behind the internal rate of return (IRR) rule? What are some of
its drawbacks?
The IRR decision rule is to accept a project when the IRR is greater than the cost of
capital. This gives the same decision as the NPV rule most of the time, but does not
necessarily work under the following conditions:
* You are deciding between mutually exclusive investments.
* The investment has an initial inflow of cash, followed by cash outflows.
* The direction of the cash flows (from positive to negative or vice versa) changes
more than once over the life of the project.
How does the Valuation Principle help a financial manager make decisions?
The Valuation Principle helps financial managers make decisions by providing a very
specific criterion for the decision process: If the present value of the benefits outweighs
the present value of the costs, then the investment should be made.
Can we directly compare dollar amounts received at different points in time?
We can directly compare dollar amounts received at different points in time bydiscounting all future cash flows back to a present value. Once the future amounts are valued in dollars today, i.e., a present value, we can compare them.
Why is a cash flow in the future worth less than the same amount today?
A cash flow in the future is worth less than the same cash flow today because of the time value of money; i.e., you can invest money today and have it grow over time.
What is compound interest?
Compound interest is the ability to earn interest on previous interest payments. For example, $100 invested at 10% per year will become $110 in one year. If left to earn
interest for another year, both the $100 initial investment and the $10 interest payment will earn 10%, resulting in $121 after the second year.
A financial asset
is a claim to a series of future cash flows against an economic unit.
Examples are bonds, and shares. Financial assets are issued by firms to raise the finance needed to purchase real assets.
A real asset
are assets that can be put to productive use to generate cash flows. Examples are computers, vehicles, property and equipment. The cash flows generated
by the real assets of a firm belong to the providers of capital – the owners of the financial assets issued by the firm.
Consumption and savings decisions
How much of their current wealth should they spend on consumption, and how much of their current income should they save
for the future?
Investment decisions:
How should they invest the money they have saved?
Financing Decisions
How and when should individuals use other people’s moneyto implement their consumption and investment plans?
How does the financial system allow individuals to trade-off between present and future consumption?
The financial system enables individuals to adjust their income and consumption patterns to suit their needs. Those who need to spend more now and less later can
borrow the money they need (for example, through a housing loan for their house) and use future income to repay the loan. Those with high future consumption needs can
invest their excess current income at the market rate of interest and have more consumption later. However, while the financial system enables individuals to tradeoff between consumption now and consumption later, the amount one can consume is
limited by income. The level of consumption in all periods can be increased if we can
earn more.
Investment Decisions (Firm)
Decisions about which real assets the firm should purchase
Financing Decisions (Firm)
Decisions about how the firm should finance the real assets
purchased.
