All Flashcards
What is the equation to find Enterprise value?
Market value of equity + debt - cash
What is the relationship between the term of a bond and interest rates?
The longer the term, the increased the sensitivity to interest rates
What are 2 reasons to IPO?
Raise capital
Increase valuation of the company as it increases its liquidity
Gain brand awareness
What are 4 reasons to not IPO?
Onerous and expensive reporting standards
Often increased focus on short term performance rather than long term for shareholders
Potentially worse scrutinising of management as everyone is relying on each other to do it
More liable to takeover, hostile or otherwise
What is the equation for net working capital?
NWC = current assets - current liabilities
What is the law of one price?
If an asset is abnormally profitable and undervalued, people will realise this and buy it until the price of the asset stabilises at a price where it is valued correctly
What is the efficient market hypothesis?
The efficient-market hypothesis is a hypothesis in finance that states that asset prices reflect all available information. A direct implication is that it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information.
What is the variance of a stock?
The volatility of its returns
What is an efficient portfolio?
A portfolio diversified such that it gains the highest returns for the amount of risk it has taken on
What is the equation for a levered beta?
BetaL = BetaU (1 + Debt/Equity)
What are the 2 main reasons a company might use debt financing rather than share financing?
Debt financing charges interest, which is tax deductible as a cost of doing business whereas dividends aren’t
(Cheaper)
Debt financing does not dilute the ownership of the company/bond holders have no say in decision making
Why is there an optimal D/E ratio? Why not always use debt financing if it has the tax shield?
Since bond holders always have to be paid their coupons, not diversifying the financing of the company from just bonds can increase risk dramatically since if the cashflows cease being negative, the company will have to sell things or lay people off to pay their debts.
The threat of this before it happens can cause employees to leave and suppliers to offer less credit if they think it will be defaulted on.
What are 3 reasons to manage risk?
Reduce underinvestment
Stabilise cashflows by allowing the sourcing of financing to be consistent if required
Keep cost of debt down
Reduce the tax bill with scheduled payments
In terms of valuation, when do companies issue new shares/when do they try to avoid issuing new shares?
Companies try to avoid issuing new shares when they are overvalued as investors think that the reason the company is issuing them is because they are overvalued which can mean that the price then drops
What does a beta of 1 mean? What about 0.5? Or -1?
1 is the same movements as the market portfolio up or down, 0.5 is half the movement so up by 1 would mean up by 0.5 for that asset, and -1 is exactly opposite to the market so up by 1 = down by 1 for that asset
What is the equation for the tax shield?
Tax Rate x (Debt/(Debt + Equity)) x Cost of Debt
What is the difference between a treasury note and treasury bond?
Notes are 1 - 10y maturity, bonds are 10y+
What effect does an increase of interest rate have on a bond’s price and therefore yield?
Price decreases as the face value is being discounted more heavily, which then means that the yield proportional to that price increases since the coupon is the same
What is the yield to maturity equation?
YTM = ((Face Value/Price)^1/n) - 1
Below which rating are bonds considered junk?
BBB-
What is a put option?
Buying the right to buy a stock at an agreed price
What is a call option?
Buying the right to sell a stock at an agreed price
What is the equation for the price of a future?
Futures Price = Spot price (1 + today’s interest rate)^TTM/360
What are 4 reasons why futures are used?
Can hedge against a lot of things
Longer trading hours than the stock exchange
Cheaper to trade stock futures than stocks themselves
Easier to short futures
Less counterparty risk since cash balance to close out at any time required
What is the equation for required return on equity?
Re = Risk free rate [Rf] + Beta(Return on market [Rmkt] - Rf)
Approximately how many stocks are often required in a portfolio for it to become efficient?
30, but this is a generalisation
What is idiosyncratic risk?
Risk that is individual to an asset, sometimes called diversifiable risk, a shareholder is not compensated for holding this extra risk
What is systematic/market risk?
Undiversifiable risk, this is the risk that a shareholder is paid extra to hold
What is the equation for the price of a bond?
P = ((CPN + FV) / (1 + YTM)^n) + Any other coupons discounted to present at YTM rate
What are options used for?
Hedging and speculating on stock market movements. Can also be part of a risk management strategy
What is the equation for the price of a stock using the price and dividend after y0?
P0 = P1/(1+Ke) + D1/(1+Ke)
What is the equation to find the terminal value of a dividend paying stock?
(Dprev + ((Dprev(1+g))/Re-g))/(1+Re)^n
What actually is the yield to maturity of a bond? What is the difference between it and the coupon rate?
The total expected return (interest rate) of a bond if it is held until maturity (inc. coupons) it changes with the current price of the bond, whereas the coupon rate is constant as a percentage of the face value
What is plotted on the yield curve?
The expected yield of a bond (Y axis) versus the maturity of the bond (aka time) (X axis)
What does the yield curve convey?
The expectation of the yield of a bond versus maturity, it can be used not only predict the yields, but, more importantly, as an indicator of consumer confidence in interest rates
What is the equation for a 3 stage DDM?
(D1/(1+Re)) + (D2/(1+Re)^2) + ((D3 + ((D3(1+g))/Re-g))/(1+Re)^n)
What is the equation for the price of a share (related to enterprise value) using PV, shares outstanding, debt and cash?
P0 = (PV of future cashflows + Cash0 - Debt0) / Shares outstanding
What tends to be a smaller discount rate, WACC or Re? Why?
WACC as it averages the cost of debt in the equation as well, which tends to be cheaper and therefore brings the overall rate down
What are the 3 types of transformations for investment? Explain them shortly
Risk (Diversification principle of high risk and low risk being bundled together to make an overall amount that is customisable)
Size (Lots of small investments collated together to make a large one)
Maturity (net out of ins and outs after initial to maintain overall, risk of credit crunch)
In layman’s terms, what is the worth of a right/how do you find the worth of a right?
You find the price of the shares before the new issuance and then find the average after the issuance and subtract the second from the first
What are the three versions of the yield curve?
Normal, flat and inverted. Normal would be expected in an ‘optimal/normal’ economy as you get paid a risk premium for holding the bonds for a longer time.
What does an inverted yield curve convey?
Inverted is common in recessions or the like and conveys an expectation that future interest rates will be lower than now (therefore lower yield).
What is the free cash flow equation?
FCF = EBIT * (1 - Tax) + Depreciation - Changes in NWC - Investment
What is the core idea of the Modigliani Miller theorem in a world without taxes? Why is this flawed in reality?
That the makeup of a company’s financing does not affect its valuation as it does not affect the cashflows. In reality, this is not the case as taxes and therefore the tax shield do exist, which means a company can increase its cashflow by paying less tax by increasing the proportion of its financing that is bonds/debt
The security market line depicts relationship between a security’s…
Expected return and market beta
