Sec B - Corporate Finance Flashcards
Bond convexity
positive convexity =
duration rises as yield declines
(works in investor’s favor, price becomes less sensitive when yield rises)
negative convexity =
duration rises as yield increases
(less attractive to investors)
Uses of derivatives
a) Hedging — to reduce of eliminate unwanted risks
b) Speculation — to bet on price changes
c) Arbitrage — to take advantage of short-term price anomalies
Common types of derivatives include futures contracts, forward contracts, options, and swaps
Call Option
A call option is a type of option that gives the option holder…
- the right but not the application to buy a security
- at a predetermined price (or strike price)
- at a specified future date
The holder (buyer) of a call option can benefit when the underlying asset’s price increases.
The writer (seller) of a call option must comply with the buyer’s decision.
Put Option
A put option is a type of option that gives the option holder…
- the right but not the obligation to sell a security
- at a predetermined price
- at a specified future date
The holder (buyer) of a put option can benefit when the underlying asset’s price decreases.
The writer (seller) of a put option must comply with the buyer’s decision.
Exercise price
Strike price
Option premium and
Intrinsic value
Exercise price (strike price) is the price at which the underlying asset can be purchased (for call options) or sold (for put options).
Option premium is the price paid for the option. It is the price paid by the buyer to acquire the right to buy (call option) or the right to sell (put option) the underlying asset.
Intrinsic value is the amount the option buyer will receive if the option is exercised. The intrinsic value will only be realized if the option is “in the money.” Therefore there will be zero intrinsic value if the option is “at the money” or “out of the money” for both call and put options.
Stock Pricing
Stock Pricing:
P0 = Σ ( Dn )
—————
(1 + i)^n
The Intrinsic Value of a Call
Intrinsic value of a call =
C = Max[0, M - S]
Interest Rate Swap
An interest rate swap is…
- the exchange of future interest payments
- between two parties
- based on specified face value
A fixed-for-floating swap (plain vanilla swap) is essentially exchanging a loan at the floating rate (often based on LIBOR) with a fixed interest rate loan. Parties will only pay difference between floating interest rate and fixed interest rate at each payment period. Used to manage exposure to interest rate fluctuations.
Foreign Currency Swap
A foreign currency swap is the exchange of principal and interest denominator in one currency for principal and interest with a different currency.
Used to minimize exchange rate risks and trade internationally by borrowing the currency needed for the transaction.
Convertible Securities
Convertible securities are:
- considered a hybrid security because it possesses both debt and equity elements
- generally have a lower cost of capital or rate of return than non-convertible financial instruments due to its conversion feature
- most common types are convertible bonds and convertible preferred stock
- converted using the conversion ratio, ratio to one share of common stock
- include a conversion price or the price at which the convertible security can be converted into common stock
Warrants
Warrants…
- give a hold of the right (but not the obligation) to purchase from the issuer
- a certain number of units of a security
- at a specified price before the expiration of the warrant.
Characteristics:
- typically issued with lower interest rates than securities without similar securities “sweetners”?
- Most common types are detachable warrants and naked warrants. detached = issued with underlying security (bonds and preferred stock), naked = issued alone
- Ownership of a warrant does not represent automatic ownership of the underlying security as it is only a right, not an obligation.
- Offered by the issuing company rather than third parties, as in the case of options.
- Usually have longer-terms than options
- Can be either exercised on or before the expiration of the warrant (American) or only on the day of expiration (European)
Capital Assets Pricing Model (CAPM)
Capital Assets Pricing Model (CAPM) =
R = Rf + β(Rm - Rf)
R = Expected Return Rf = Risk-Free Rate β = Beta coefficient Rm = Market rate
Weighted Average Cost of Capital (WACC)
WACC =
Debt:
(Wd x Cd(1-t)) +
Preferred Equity:
(Wp x Cp) +
Common Equity:
(Wc + Cc)
Weighted Marginal Cost of Capital
STEP 1:
Compute breakpoint
(if Retained Earnings will be used)
Breakpoint =
Unappropriated Retained Earnings /
Target Weight of Common Stock in Capital Structure
STEP 2:
Compute the weighted marginal cost of capital until the breakpoint.
STEP 3:
Compute the weight of the marginal cost of capital after the breakpoint.
STEP 4:
compute the weighted marginal cost of capital of all new capital to be issued.
Target Marginal WMCC
Weight % Cost
————— ————- ———- Debt Preferred Stock Common Stock
Net Advantage to Leasing (NAL)
Net Advantage to Leasing (NAL) steps:
- Begin with the cost of the asset (use the depreciation base as the cost)
- Subtract the present value of after tax lease payments
- Subtract the present value of the depreciation text shield
- Add the present value of after-tax operating costs
- Subtract the present value of the after-tax salvage value of the asset
