Session 10&11&12 Flashcards

Question

NPV vs IRR

Answer 1

for projects with conventional cash flow patterns (one sign change) they're the same, but ...

Answer 2

weighted average cost of capital the proper rate at which to discount the cash flows associated with a capital budgeting project. it is the correct discount rate to use to discount the cash flows of projects with risk equal to the average risk of a firm's projects. =(Wd)[Kd(1-t)] + (Wps)(Kps) + (Wce)(Kce) * Wd: percentage of debt in the capital structure * Wps: percentage of preferred stock in the capital structure * Wcs: percentage of common stock in the capital structure ***weights are based on the firm's target capital structure, the weights that firm expects to achieve over time. if not available, an analyst can use the current capital structure to calculate WACC

Answer 3

* Kd: the rate at which the firm can issue new debt= YTM on existing debt --> interest paid on corporate debt is tax deductible so we use Kd(1-t) * Kps: the cost of preferred stock * Kce: the cost of common equity. it is the required rate of return on common stock and is generally difficult to estimate ***all of these are rates, percentages!!

Answer 4

marginal cost of capital: the cost of raising additional capital (WACC may increase as larger amounts of capital are raised) --> MCC is an upward sloping curve =WACC(??)

Answer 5

the more capital we have we can take on more projects but since we are choosing on the basis of highest IRRs the more we continue the newer added projects would have lower IRRs and decrease the portfolio IRR --> investment opportunity schedule is a downward sloping curve

Answer 6

the intersection of the investment opportunity schedule and MCC

Answer 7

YTM or matrix pricing

Answer 8

Dps/P Dps: dividends of preferred stock P: MARKET price of preferred.

Answer 9

1. the capital asset pricing approach: Kce= RFR+ Beta[E(Rmkt)-RFR] 2. the dividend discount model approach: Kce= (D1/P0) + g g= retention rate * ROE 3. bond yield plus risk premium approach: adding a risk premium to the YTM of the firm's long term debt. Kce= YTM+risk premium

Answer 10

a measure of project's systematic or market risk. *can be used to adjust for differences between a specific project's risk and the average risk of a firm's projects. Calculation: because a specific project is not represented by a publicly traded security we cannot estimate project's Beta directly 1. pure play method: Beta of a company or a group of companies that are purely engaged in a business similar to that of the project. 2. pure play beta should get unlettered and then levered again according to our company's capital structure --->> first: Beta(asset) = Beta(equity) [1/1+{(1-t)D/E}] and t and D/E are from comparable company second: Beta(project) = Beta(asset)[1+{(1-t)D/E}] and t and D/E are from the subject firm.

Answer 11

Country risk premium when using CAPM to calculate Kce, the calculated Beta does not adequately capture the market risk for developing countries--> a country premium risk is added to the market risk premium Kce=Rf+ Beta[E(Rmkt)-Rf+CRP]

Answer 12

floatation cost: fees charged by investment bankers when a company raises external equity capital ``` Incorrect treatment under growth model: using P(1-floatation cost) is incorrect because it changes our whole WACC while this cost is not ongoing through the projects life, it's a one time cost ``` correct treatment: doesn't affect cost of capital, just affects the initial cost of the project.

Answer 13

1. refers to the uncertainty about operating earnings (EBIT) and results from sales risk and operating risk (fixed cost) 2. refers to the additional variability of EPS compared t EBIT. financial risk increases with greater use of fixed cost financing (debt) in a company's capital structure.

Answer 14

Degree of operating leverage= percentage change in EBIT / percentage change in sales= Q(P-V) / Q(P-V)-F= S-TVC / S-TVC-F Q: quantity of sales P: price V: variable cost per unit F: fixed cost

Answer 15

Degree of financial leverage= percentage change in EPS or net income / percentage change in EBIT= EBIT / EBIT-I I: interest rate

Answer 16

Degree of total leverage= percentage change in EPS or net income / percentage change in sales= DOL*DFL

Answer 17

Q= (fixed operating costs + fixed financing costs) / (price - variable cost per unit)

Answer 18

Q= fixed operating costs / price-variable cost per unit

Answer 19

1. regular 2. special: sth happened and the company make a one time additional payment 3. liquidating: business has stopped and liquidated and equity owners' residual interest is paid. **other things equal, paying a cash dividend decreases liquidity ratios and increases leverage ratios.

Answer 20

every shareholder gets X% new shares. | decreases share value

Answer 21

divide each existing share into multiple shares. decreases share value. a 2 for 1 stock split is equal to a 100% stock dividend.

Answer 22

1. open market 2. tender offer 3. direct negotiation with a large shareholder **a share repurchase is economically equivalent to a cash dividend of an equal amount, assuming the tax treatment of the two alternatives is the same. **in repurchase and dividend cash exits the company! in split and stock dividend it doesn't

Answer 23

1. declaration date: board approves payment of the dividend 2. Ex-dividend date: the first day that the share trades without the dividend (2 business dates prior to holder of record date) 3. holder of record: shareholders of record are designated to receive the dividend 4. payment date

Answer 24

The tender offer is a public, open offer or invitation (usually announced in a newspaper advertisement) by a prospective acquirer to all stockholders of a publicly traded corporation (the target corporation) to tender their stock for sale at a specified price during a specified time

Answer 25

1. on EPS, using borrowed funds: * E/P equal to after tax cost of borrowing--> no effect on EPS * E/P higher than after tax cost of borrowing--> higher EPS * E/P lower than after tax cost of borrowing--> lower EPS 2. on book value per share: * increase if the share price is less than original BVPS * decrease if the share price is greater than original BVPS

Answer 26

* primary: sources of cash a company uses in its normal operations. cash from sales, from short term investments and sources of short term funding like trade credit from vendors and lines of credit from banks. * secondary: asset sales, debt renegotiation, bankruptcy reorganization.

Answer 27

* receivables/inventory/payables turnover * number of days of receivables/inventory/payables Effectiveness: Operating cycle: days of inventory + days of receivables. Cash conversion cycle: operating cycle - days of payables. **if these measures are too high comparing to peers, it means that company has too much cash tied up in working capital.

Answer 28

* used for short term money market instruments used in cash management. 1. discount basis yield: %discount from face value * (360/T) 2. money market yield: HPY * (360/T) 3. bond equivalent yield: HPY * (365/T) **returns on firm's short term security investments under a cash management program should be stated as bond equivalent yields.

Answer 29

factors that weaken a company's liquidity position. 1. drags on liquidity: factors that delay or reduce cash inflows or increase borrowing costs, like uncollected receivables and bad debt and ... 2. pulls on liquidity: accelerate cash outflows. like paying vendors sooner than is optimal.

Answer 30

uninvested cash balances a firm has available to make routine purchases and pay expenses as they come due --> should be managed to have sufficient cash on hand and also avoid keeping excess cash. to manage daily cash position the firm should analyze it's typical cash inflows and outflows and prepare forecasts. then the firm can identify the periods its cash position is going to be too high or too low.

Answer 31

during periods of excess cash firms invest their cash in short term high credit money market instruments. investment policy statement includes objectives of these actions and policies regarding these investments.

Answer 32

shows the status in each month by showing the dollar value of outstanding receivables in a certain age interval. March--> less than 31 days: 200-- 31 to60: 150, .... **can also be presented as percentages of total outstanding receivables in that month

Answer 33

indicates the average days outstanding per dollar of receivables. (days of receivables is measure of the delay until we get the money of a sale not a dollar, it's not weighted by the dollar amount of that sale) check the picture!

Answer 34

not too strict to lose sales and not too loose to insure high financing costs. measures like turnover, average days, aging schedule and weighted average collection period.

Answer 35

not too low to lose sales and not too high to tie up capital. measures like turnover, average days, ..

Answer 36

* should be managed because they're a source of working capital to the firm. * pay not too soon to lose interest and too late to harm relationship. measures like turnover, average days, trade credit cost, ...

Answer 37

Trade credit is the credit extended to you by suppliers who let you buy now and pay later

Answer 38

"2/10 net 60" it means if you pay until 10 days you receive 2% discount and if not, you should pay until 60 days. **so if we not pay until 10 days, we will be using our trade credit at the cost of losing 2% discount, so: Cost of trade credit= annualized cost of not taking the discount (1+[ %discount/1-%discount])^(365/days past discount) - 2

Answer 39

1. Lines of credit 2. banker's acceptance: used by firms that export goods, it'a guarantee from the buyer's bank that a payment will be made upon receipt of the goods. the firm can then sell this acceptance at a discount in order to generate immediate funds. 3. factoring: the actual sale of receivable's at a discount. the factor (the buyer) takes on the responsibility for collecting receivables and their credit risk.

Answer 40

smaller firms may use non bank financial companies for products like that of a bank but with higher interest. large, creditworthy companies can issue commercial papers that are usually cheaper for them than bank options.

Answer 41

1. umcommited line of credit: a bank extends an offer of credit for a certain amount but may refuse to lend if circumstances change. 2. committed (regular) line of credit:a bank extends an offer of credit that it commits to for some period of time. banks charge a fee for making such a commitment. 3. revolving line of credit: an even more reliable source of short term financing than a committed line of credit. these are typically for longer terms sometimes as long as years.

Answer 42

* a majority of board and committee members should be independent (not management), and the board should meet regularly without management present. * board should have the resources to act independently, like the ability to hire outside consultants without approval from management * members who serve on the board for a long time may become too closely aligned with management to be considered independent. * board members should not be from companies that have close business relations with the company, like a supplier or customer.

Answer 43

responsible for providing financial information to shareholders. they should: 1. follow proper accounting and auditing procedures 2. appoint an external auditor that is free from management influence 3. have no restrictions on it's communications with the firm's internal auditors. .....

Answer 44

sets the compensation for firm's executives.

Answer 45

responsible for recruiting new, qualified, independent board members. and also reviewing and assessing the performance of current members. **+ prepare an executive management succession plan.

Answer 46

are provisions that make a company less attractive to a hostile bidder or more difficult to acquire.

Answer 47

sets the standard for basic principles of integrity, trust and honesty. * can be a mitigating factor with regulators. * should comply with corporate governance standards of the country and stock exchange. * prohibit business with insiders

Answer 48

* ability to vote proxies is a fundamental right of share holders * should check if company lets proxy voting * should check if company limits the ability to vote by requiring attendance * is the voting confidential (by third party, records get destroyed, ... * does the firm let share owners to nominate someone as a board member? * does the firm let share owners to propose initiatives for consideration at the annual meeting? * are board and management actually required to implement any shareholder approved proposals? (advisory or binding proposals) * are there different classes of common equity? what are rights of each class? what about voting rights in different classes. * can a share owner seek legal or regulatory action to enforce shareholder rights? (based on home country jurisdiction or company code of ethics) * are there takeover defense strategies that can be done without shareholder's approval?

Answer 49

prevents shareholders from trading their shares over a period prior to the annual meeting and is considered a restriction on the ability of shareholders to express their opinions and act in their own interest.

Answer 50

can be bad because a minority powerful group like a founding family can serve it's own interests.

Answer 51

The staggered election keeps some continuity in the elected body. For example United States Senators have a 6-year term but they are not all elected at the same time. Rather, every two years elections are held for one third of US Senate seats. *not good in companies because it makes it hard for the investors to change the board of directors. annual elections of all members is the best practice.

Answer 52

1. planning: determine client needs and circumstances, return objectives, risk tolerance, preferences, .... . create and then review and update in investment policy statement (IPS) that spells out these needs and circumstances. 2. execution: construct the client portfolio by determining suitable allocations to various asset classes based on the IPS and on expectations about macroeconomic variables (top down analysis) and identify attractively priced securities within an asset class for client portfolios based on valuation estimates from security analysis (bottom up analysis) 3. feedback: monitor and rebalance the portfolio to adjust asset class allocations and securities holdings in response to market performance.

Answer 53

involve taking company private by buying all available shares, usually funded by issuing debt.

Answer 54

HPR, arithmetic mean return, geometric mean return, money weighted return, time weighted return Gross return: total return after deducting commissions on trades but before fees for management and administration. Net return: after management and administration fees Pretax nominal return: numerical return before tax, without adjusting for inflation After tax nominal return: just after tax Real return: the increase in an investor's purchasing power, roughly nominal return minus inflation Leveraged return: the gain or loss on an investment as a percentage of an investor's cash investment.

Answer 55

a straight line from the risk free asset through the optimal risky portfolio, so CAL can be between risk free asset and any portfolio on the efficient frontier. * between different CALs, the best one for an investor is the one who tangents the highest utility curve, so the one with the highest slope is the best * if all of the investors have the same estimation of return, risk and correlations for different assets, there would be a single optimal portfolio and CAL for everyone (homogenous expectations assumption) **Optimal CAL for all investors is named capital market line (CML) *Standard deviation on this line is equal to Wa(Sigma)a because the risk is exactly equal to the exposure to that of the risky portfolio

Answer 56

E(Rp)= Rf + [(E(Rm)-Rf)/(Sgma)m](Sgm)p * ba tavajoh be inke ruye yek khat tu fazaye risko returne bazdeh gharar daran rahat mohasebe mishe. * by looking at this, we see that investor can expect to get one unit of market risk premium in additional return (above the risk free rate) for every unit of market risk, (Sgma)m that the investor is willing to accept.

Answer 57

E(Rm) - Rf

Answer 58

=systematic risk + unsystematic risk systematic risk is usually addressed as a ratio to market risk (beta) *systematic risk is not something constant in all assets, market risk is constant but the systematic risk is the risk caused by the exposure to the market risk factors and is different for each asset

Answer 59

used to estimate the expected returns on risky assets based on specific factors *multifactor models: usually use macroeconomic factors and fundamental factors (earnings, firm size, ...), general form of a multi factor model with k factors: E(Ri)-Rf= Bi1*E(factor1)+ ...+Bik*E(factor k) * the first factor is often the expected excess return on the market, E(Rm-Rf) * Betas are factor sensitivities.

Answer 60

-a return generating model that uses three factors: 1. firm size 2. firm book value to market value ratio and 3. the return on the market portfolio minus the risk free rate **Carhart adds a 4th factor that measures price momentum using prior period returns.

Answer 61

simplest return generating models using only E(Rm) - Rf single index model: E(Ri)-Rf = Bi[E(Rm)-Rf) *Bi= Cov(i,m)/SgmaM^2 = Cor(i,m)* Sgma(i)/Sgma(m) B is a measure of how sensitive the return on asset i is to the return on the overall market portfolio.

Answer 62

it's the slope of regression line between excess return of the asset over RFR and the excess return of the market over RFR * ***In a single index model or market model we just assume that there's a linear relationship between excess return of the asset and the excess return of the market, then the parameters can be estimated using regression. but where did this assumption of linear relationship come from???? - ---> it's based on modern portfolio theory, every asset has returns only to the extent of it's systematic risk and there's a linear relationship between more exposure to systematic risk and more return, so if the excess return of market doubles, the excess return of the asset doubles as well.

Answer 63

Securities market line plot of E(Ri) and Beta(i)

Answer 64

CML: between E(R) and Sigma * only efficient portfolios are plotted on CML * E(Rp)= RFR+[E(Rm)-RFR]*[Sgma(p)/Sgma(m)] SML: between E(R) and Beta

Answer 65

CAPM estimates expected return but in equilibrium expected return is equal to required return, so we can use CAPM

Answer 66

sharpe ratios of all portfolios on the CML (or portfolios on a CAL) are the same. and it's the slope of the line

Answer 67

=(Rp-Rf)Sm/Sp - (Rm-Rf) **leverage the portfolio until it has a total risk equal to that of the market, then ... *gives the same orders as sharpe

Answer 68

1. Treynor measure: Rp_Rf / Beta(p) | 2. Jensen's alpha: Rp-[Rf+Beta(p)[Rm-Rf]]

Answer 69

1. absolute risk objectives: in absolute terms, not related anything external, like "no greater than 5%probability of returns below -5% 2. relative risk objectives: relate to a benchmark, like "returns will not be less than 12 month LIBOR"

Answer 70

the portfolio manager should find out investor's both ability (like long horizons) and willingness (personality factors) to take risk and chooses a risk level that matches the lowest.

Answer 71

important points of portfolio construction. Risk, Return, Time horizon, Tax situation, liquidity, Legal restrictions and the unique constraints of a specific investor.

Answer 72

after determining IPS, we should choose appropriate asset classes and their weights *correlation of assets within an asset class should be high and correlations between asset classes should be low.

Answer 73

1. Equities 2. Bonds 3. Cash 4. Alternative investments *each of these can be further divided by being domestic or foreign, large or small, traded in emerging or developed markets

Answer 74

varying from strategic asset allocation weights (passive investment- based on efficient frontier) in order to take advantage of perceived short term opportunities. *active strategy

Answer 75

deviations from index weights on individual securities within an asset class *active strategy

Answer 76

invests the portion of the portfolio in passively managed indexes and the rest in active strategies