04. Finance Flashcards
Explain the time value of money.
The “Time Value of Money” suggests that a dollar today is worth more than a dollar tomorrow because a dollar today can be invested at a risk-free interest rate. A dollar tomorrow is worth less because it has missed out on the interest you would have earned on that dollar had you invested it today. Additionally, inflation diminishes the buying power of future money
A discount rate is the rate that is chosen to discount the future value of your money; it is a measure of risk
Why is inflation important?
(1) Affects future purchasing power of money and affects real interests rates
(2) Creates uncertainty about the future in terms of purchasing power
Company A has assets of $100 million versus Company B which has $10 million. Both have the same dollar earnings. Which company is better?
Company B has a higher return on assets (“ROA”) given that both company had the same earnings but Company B was able to generate it with fewer assets and is, thus, more efficient. Something to think more about is if Company A was entirely debt financed whereas Company B was entirely equity financed. From a return on equity or investment (“ROE” & “ROI”) perspective, Company A might be a better company but it would be riskier from a bankruptcy perspective so the “better” company would be less black and white in this situation. The interviewer is probably looking for the simple answer, though; that Company B is better because it is more efficient with its assets.
What is the treasury stock method? Walk through the calculation.
The treasury stock method assumes that acquirers will use option proceeds to buy back exercised options at the offered share price. New shares = common shares + in the money options – (options x strike/offered price).
A product’s life cycle is now mature. What happens to the net working capital?
The net working capital needs should decrease as the business matures, which increases cash flows. As the business develops, it becomes more efficient; investment requirements are lower.
Why is bank debt maturity shorter than subordinated debt maturity?
Bank debt will usually be cheaper (lower interest rate) because of its seniority. This is because it’s less risky, since its needs to be paid back before debt tranches below it. To make it less risky to the lenders, a shorter maturity helps, usually less than 10 years. Secondly, bank deposits tend to have shorter maturities, so this aligns the cash flows of the bank business. You’ll often see bank debt as the line item “Term Loan A” or “Term Loan B.”
What is LIBOR? How is it often used?
The London Interbank Offered Rate tracks the daily interest rates at which banks borrow unsecured funds from banks in the London wholesale money market, and is roughly comparable to the Fed Funds rate. LIBOR is used as a reference rate for several financial instruments, such as interest rate swaps or forward rate agreements, and they provide the basis for some of the world’s most liquid and active interest rate markets.
What is a PIK?
As previously noted in the accounting chapter, PIK stands for “paid in kind,” another important non-cash item, which refers to interest or dividends is paid by issuing more of the security instead of cash. It can be “toggled on” at a particular time, often times at the option of the issuer. It became popular with PE firms, who could pay more aggressive prices by assuming more debt.
Flipping on PIK may be an indicator that the company is nearing default on interest payments due to lack of cash because of a deteriorating business. It is a dangerous crutch for companies; PIK can dramatically increase the debt burden on the company at a time when it is already showing signs of difficulty with the existing levels.
What is a PIPE?
With the cost of credit rising, private investments in public equity, (“PIPEs”), have become more popular. This is an alternative way for companies to raise capital; PIPEs are made by qualified investors (HF, PE, mutual funds, etc.) who purchase stock in a company at a discount to the current market value. The financing structure became prevalent due to the relative cheapness and efficiency in time versus a traditional secondary offering. There are less regulatory requirements as there is no need for an expensive roadshow. The most visible PIPE transaction of 2008: Bank of America’s $2 billion investment in convertible preferreds of mortgage lender Countrywide Financial.
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?
2 percent. The duration of the investment does not matter.
What is a coverage ratio? What is a leverage ratio?
Coverage ratios are used to determine how much cash a company has to pay its existing interest payments. This formula usually comes in the form of EBITDA/interest. Leverage ratios are used to determine the leverage of a firm, or the relation of its debt to its cash flow generation. There are many forms of this ratio. A standard leverage ratio would be debt/EBITDA or net debt/EBITDA. Debt/equity is another form of a leverage ratio; it measures the relation of debt to equity that a company is using to finance its operations
How do you think about the credit metric: (EBITDA – Capex)/interest expense?
It represents how many times a company can cover its interest burden while still being able to reinvest into the company.
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.
The answer is B) price by 20 percent. Think about how EBITDA is affected by all three scenarios. It’s not C because EBITDA will only increase by $15 million. Volume will increase the revenue to $120 million but variable costs will increase proportionally. By increasing price, you will capture the entire $20 million impact.
If a company’s revenue grows by 10 percent, would its EBITDA grow by more than, less than or the same percent?
Unless there are no fixed costs, EBITDA will grow more. This is because fixed costs will stay the same, so total costs will not increase as much as revenue. Note this is similar to the previous question, but now looking at it in terms of percentage.
Why should the fair market value of a company be the higher of its liquidation value and its going-concern value?
Liquidation value is the amount of money that a firm could quickly be sold for immediately, usually at a discount. The fair market value, the rightful value at which the assets should be sold, is higher. Basically a liquidation value implies the buyer of the assets has more negotiating power than the seller, while fair market value assumes a meeting of the minds. The going-concern value is the firm’s value as an operating business to a potential buyer, so the excess of goingconcern value over liquidation value is booked as goodwill in acquisition accounting. If positive goodwill exists, i.e., the company has intangible benefits that allow it to earn better profits than another company with the same assets; the going-concern value should be higher than the fair market value.
How will a decrease in financial leverage affect a company’s cost of equity capital, if at all?
A decrease in financial leverage lowers the beta which lowers the cost of equity capital. With less debt, the firm has a reduced risk of defaulting. This change causes equity investors to expect a lower premium for their investments and therefore reduce the cost of equity.
Which corporate bond would have a higher coupon, a AAA or a BBB? What are the annual payments received by the owner of a five year zero coupon bond?
The corporate bond with a rating of BBB will have a higher coupon because it is perceived to have a higher risk of defaulting. To compensate investors for this higher perceived risk, lower rated bonds offer higher yields. The owner of a fiveyear zero coupon bond receives no annual payments. Instead, the owner will pay a discount upfront and then receive the face value at the time of maturity.
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?
When the prevailing interest rates rise to 8 percent, the market price of the coupon bond decreases. This happens because the investor can obtain a higher interest rate on the market than what the bond is currently yielding. To make the bond appealing to potential investors, the market price decreases. This causes the bond’s return to increase at maturity as a means of compensating for the decreased value of coupon payments. The coupons themselves remain constant; the new market price instead balances the yield to keep it neutral with the current market.
What’s the difference between IRR, NPV and payback?
IRR measures the return per year on a given project and is the discount rate that makes NPV equal to zero. NPV measures whether or not a project can add additional or equal value to the firm based on its associated costs. Payback measures the amount of time it takes for a firm to recoup the initial costs of a project without taking into account the time value of money.
Why would a company repurchase its own stock? What signals (positive and negative) does this send to the market?
A company repurchases its own stock if it perceives the market is undervaluing its equity. Since the management has more information on the company than the general public, when the management perceives the company as undervalued, it sends a creditable signal to the rest of the market.
If you were to advise a company to raise money for an upcoming project, what form would you raise it with (debt versus equity)?
The right answer is “it depends.” First and foremost, companies should seek to raise money from the cheapest source possible. However, there might exist certain conditions, limitations or implications of raising money in one form or another. For example, although the cheapest form of debt is typically the most senior (corporate loans), the loan market might not have any demand. Or the company might not have the cash flow available to make interest payments on new debt. Or the equity markets might better receive a new offering from this company than the debt markets. Or the cost of raising an incremental portion of debt might exceed that of raising equity. All of this should be considered when answering this question. Be prepared to ask more clarifying questions—your interviewer will most likely be glad you did.
Why would a company issue preferred over common stock?
Preferred stock is effectively a hybrid between common stock and bonds.
(1) Receive fixed dividend payments similar to a bond. However, preferred dividends can be changed.
(2) Receive preferential status over common stock in a bankruptcy situation
(3) Viewed as cheaper than common stock as it has more advantages
(4) Can be set up to be viewed as equity for credit rating agencies and as debt for tax authorities
(5) Preferred shareholders usually have limited voting rights – but their approval must be received before changing anything that affects their claim
Why might a company issue debt over equity?
(1) Debt tax shield
(2) Low interest rates and/or depressed stock price
(3) Debt is “cheaper” than equity (rD < rE)
(4) Firm has stable cash flows and can handle the fixed cash expenditures required
(5) Firm wants to keep all the upside of the investment (i.e. what you use the funds for) for itself and not dilute ownership
(6) Company wants to change its capital structure in some way
However, some companies cannot float bonds b/c leverage ratio is too high or debt too costly. Companies usually can’t borrow more than 3 ½ times earnings
What are some reasons why a company might tap the high-yield market?
Companies with low credit ratings are unable to access investment grade investors and would have to borrow at higher rates in the high-yield markets. Other companies might have specific riskier investments that they must pay a higher cost of capital for.
What is the relationship between a bond’s price and its yield?
They are inversely related. That is, if a bond’s price rises, its yield falls and vice versa. Simply put, current yield = interest paid annually/market price * 100 percent.
What are the factors that affect option pricing?
An option conveys the right, but not obligation, to engage in a future transaction on some underlying security. There are several factors that influence an option’s premium, which is intrinsic value plus time value. A change in the price of the underlying security either increases or decreases the value of an option, and the price changes have an opposite effect on calls and puts. The strike price determines whether the option has intrinsic value, and it generally increases as the option becomes further in the money. Time influences option pricing because as expiration approaches, the time value of the option decreases. A security’s volatility impacts the time value of a premium, and higher volatility estimates generally result in higher option premiums for both puts and calls alike. Finally, dividends and the current risk-free interest rate have a small effect known as the “cost of carry” of shares in an underlying security.
Explain put-call parity.
It demonstrates the relationship between the price of a call option and a put option with an identical strike price and expiration date. The relationship is derived using arbitrage arguments, and shows that a portfolio of call options and x amount of cash equal to the PV of the option’s strike price has the same expiration value as a portfolio comprising the corresponding put option and the underlying option. The parity shows that the implied volatility of calls and puts are identical. Also, in a delta-neutral portfolio, a call and a put can be used interchangeably.
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?
You can liken it to selling a put because if the stock decreases in value, you lose money, like a bond defaulting. But if its neutral, you’re neutral in both cases.
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. So 70 percent loss * 5 percent probability (an assumption you have to make) = 350 basis points over the senior debt or L + 850.
What if this was an LBO scenario and you had a sponsor putting in 500 million of equity?
The company would be less risky because it has more liquidity now.
A company has $10 million of cash and $1 million of shares, nothing else. What’s its stock price?
What if the company wins $10 million in the lotto?
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?
Stock price is value/shares so $10 million/1 million, which is a stock at $10 per share.
The company doubled its cash and thus its value. Now it’s up to $20 per share.
The stock should be worth $20/share today. With $10 million buying $25/share, you can repurchase 0.4 million shares. You have 1 million - 0.4 million= 0.6 million shares left. The 0.4 shares are worth $25/share because that was what was paid for them. The remaining 0.6 shares are worth the remaining value/remaining shares, which is $10 million/0.6 million = $16.67/share. If you weight the two shares, $16.67 * 60% + $25 * 40%, then your total share price is $20.
What kind of stocks would you issue for a startup?
A startup typically has more risk than a well-established firm. The kind of stocks that one would issue for a startup would be those that protect the downside of equity holders while giving them upside. Hence the stock issued may be a combination of common stock, preferred stock and debt notes with warrants (options to buy stock).
When should a company buy back stock?
When it believes the stock is undervalued and believes it can make money by investing in itself. This can happen in a variety of situations. For example, if a company has suffered some decreased earnings because of an inherently cyclical industry (such as the semiconductor industry), and believes its stock price is unjustifiably low, it will buy back its own stock. On other occasions, a company will buy back its stock if investors are driving down the price precipitously. In this situation, the company is attempting to send a signal to the market that it is optimistic that its falling stock price is not justified. It’s saying: “We know more than anyone else about our company. We are buying our stock back. Do you really think our stock price should be this low?”
Is the dividend paid on common stock taxable to shareholders? Preferred stock? Is it tax deductible for the company?
The dividend paid on common stock is taxable on two levels in the U.S. First at the firm level, as a dividend comes out from the net income after taxes (i.e., the money has been taxed once already) and then at the shareholder level. The shareholders are taxed for the dividend as ordinary income (O.I.). Dividend for preferred stock is treated as an interest expense and is tax-free at the corporate level.
When should a company issue stock rather than debt to fund its operations?
There are several reasons for a company to issue stock rather than debt. The first is if it believes its stock price is inflated, and it can raise money (on very good terms) by issuing stock. The second is when the projects for which the money is being raised may not generate predictable cash flows in the immediate future. A simple example of this is a startup company. The owners of startups generally will issue stock rather than take on debt because their ventures will probably not generate predictable cash flows, which is needed to make regular debt payments, and also so that the risk of the venture is diffused among the company’s shareholders. A third reason for a company to raise money by selling equity is if it wants to change its debt-to-equity ratio. This ratio in part determines a company’s bond rating. If a company’s bond rating is poor because it is struggling with large debts, they may decide to issue equity to pay down the debt.
Why would an investor buy preferred stock?
(1.) An investor that wants the upside potential of equity but wants to minimize risk would buy preferred stock. The investor would receive steady interest-like payments (dividends) from the preferred stock that are more assured than the dividends from common stock. (2.) The preferred stock owner gets a superior right to the company’s assets should the company go bankrupt. (3.) A corporation would invest in preferred stock because the dividends on preferred stock are taxed at a lower rate than the interest rates on bonds.
Why would a company distribute its earnings through dividends to common stockholders?
Regular dividend payments are signals that a company is healthy and profitable. Also, issuing dividends can attract investors (shareholders). Finally, a company may distribute earnings to shareholders if it lacks profitable investment opportunities.
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?
Another “trick” stock question that you should not answer too quickly. First, ask what the Beta of the company is. (Remember, the Beta represents the volatility of the stock with respect to the market.) If the Beta is 1 and the market (i.e. the Dow Jones Industrial Average) has gone up 35%, the company actually has not done too well in the stock market.
Who is a more senior creditor, a bondholder or stockholder?
The bondholder is always more senior. Stockholders (including those who own preferred stock) must wait until bondholders are paid during a bankruptcy before claiming company assets.
When would you write a call option on Disney stock?
When you expect the price of Disney stock to fall (or stay the same). Because a call option on a stock is a bet that the value of the stock will increase, you would be willing to “write” (sell) a call option on Disney stock to an investor if you believed Disney stock would not rise. (In this case, the profit you would make would be equal to the option premium you received when you sold the option.)
Explain how a swap works.
A swap is an exchange of future cash flows. The most popular forms include foreign exchange swaps and interest rate swaps. They are used to hedge volatile rates, such as currency exchange rates or interest rates.
If I gave you $100 for 10 years or $1000 today, which option would you choose?
Annuity formula – (C/r)[1 – 1/(1+r)^n]
$1,000 today because $1,000 > $614
(100/0.1)[1 – 1 /(1 + 0.1)^10] = 1000(1 – 1/2.59) = $614
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?
Your put is worth about $30, because today, you can sell a share of stock for $250, and buy it for $220. (If the expiration date were in the future, the option would be more valuable, because the stock could conceivably drop more.)
When would a trader seeking profit from a long-term possession of a future be in the “long position”?
The trader in the long position is committed to buying a commodity on a delivery date. She would hold this position if she believes the commodity price will increase.
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?
The put option on Bell Atlantic should be less valuable. Amazon.com is a more volatile stock, and the more volatile the underlying asset, the more valuable the option.
All else being equal, which would be more valuable: a December call option for eBay or a January call option for eBay?
The January option: The later an option’s expiration date, the more valuable the option.
Why do interest rates matter when figuring the price of options?
Because of the ever-important concept of net present value, higher interest rates lower the value of options.
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?
Because a put option gives the holder the right to sell a security at a certain price, the fact that the strike (or exercise) price is below the current price would mean that the option holder would lose money. Translate that knowledge into option lingo, and you know that the option holder is “out of the money.”
