7-10 slides Flashcards
What does the cost of capital indicate?
The cost of capital indicates the return risk premium we need to earn on our investments to compensate for the riskiness of the cash flows of the projects or firm
What is the ‘pure play’ evaluation approach?
plus one difficulty…
Find one or more companies that specialize in the product or service that we are considering.
Estimate the asset beta for each company.
Deleverage the asset beta to calculate unlevered beta and average these across comparison firms.
Adjust average unlevered beta for chosen Capital Structure of the project.
Use this beta along with the CAPM to find the appropriate required return for a project.
Often difficult to find pure play companies
Advantages of debt financing
Interest expenses are tax deductible (Tax shield)- Should imply higher tax rates leads to more use of debt financing.
Fixed liability(regular repayments)- Impose a discipline on management. The must maintain performance to meet these payments.
Debt can be accessed more quickly than equity and more cheaply, offering investment flexibility
Disadvantages of debt financing
Fixed liability(regular repayments)- Failure to meet these liabilities or covenants will lead to loss of control and maybe bankruptcy.
High levels of debt can make lenders less ready to offer more credit.
How does leveraging effect both the dividends and the returns?
It amplifies the variation in both of them
What are the 2 M&M propositions?
Proposition I
The value of the firm is NOT affected by changes in the capital structure
The cash flows of the firm do not change; therefore, value doesn’t change
Proposition II
The WACC of the firm is NOT affected by capital structure
What does the systematic risk depend on?
Therefore, the systematic risk of the stock depends on:
Systematic risk of the assets, U, (Business risk)
and the Level of leverage, D/F, (Financial risk)
Name 2 popular valuation methods and say when each is preferred.
The WACC method
The WACC method accounts for any benefits of debt by adjusting the discount rate.
Preferred method when constant level of leverage – D/E stays constant.
The Adjusted Present Value (APV) method
calculates the net present value (NPV) of the all-equity-financed project and adds the value of the tax (and any other) benefits of debt
Preferred method when constant value of debt
Name 3 direct costs of bankrupcy
Legal and administrative costs
Ultimately cause bondholders to incur additional losses
Disincentive to further debt financing
Name some indirect costs of bankruptcy
Larger than direct costs, but more difficult to measure and estimate
Stockholders want to avoid a formal bankruptcy filing
Bondholders want to keep existing assets intact
Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business
The firm may also lose sales, experience interrupted operations and lose valuable employees
How do we estimate optimum capital structure?
Very difficult to estimate accurately.
Need to estimate the indirect costs of financial distress (v. hard)
Need to estimate the WACC for different capital mixes (easier).
In practise we can get close using a lookup table:
Choose an acceptable default probability or debt credit rating.
Using the table, to find a target interest coverage ratio, (Interest Payments)/EBIT, consistent with this rating.
Estimate a target level of debt consistent with keeping the firm interest cover below this target.
What are margin payments in the futures market?
No payment is made when contract is entered.
However a deposit/collateral on the trade is required in a margin account – the first payment is known as the initial margin. The size of the margin is set by the exchange.
Every day the contract is ‘marked to market’. If the investor has lost money, and the value in the account falls below the maintenance margin level, then additional funds must be added to the margin account to restore it to the initial margin – this payment is termed the variation margin.
The clearing house/futures exchange acts as an intermediary between buyers and sellers (and keeps a record of all transactions)
Why is future selling so popular?
Short Selling + trading made simple-futures contracts are traded on exchanges and easy way of going short
Longer trading hours-Most futures markets trade out of hours, e.g. S&P future trades round the clock (though trading concentrated in opening hours)
No Credit Risk-Clearing House ensures you are not exposed to credit risk (your counter-party going bankrupt)
Characteristics of ‘forwards’
Private (non-marketable) contract between two parties
Delivery or cash settlement at expiry
Usually one delivery date
Negotiable choice of delivery dates, size of contract
No cash paid until expiry
Introduces credit risk with counterparty.
What is the specualtive value of an option?
The difference between the option premium and the intrinsic value of the option.
