Chap 13 Flashcards
How do you calculate NPV of borrowing?
= amount borrowed - pv of interest payments - pv of load repayment
the initial amount borrowed will be a positive cash flow and the pv calculations will be negative.
What would the opportunity cost of capital be, in the NPV of borrowing calculation?
Think of it this way:
What interest rate would my firm need to pay to borrow money directly from the capital markets?
What are some differences between investment and financing decisions?
- The number of different securities and financing strategies is well into the hundreds.
- Financing decisions are easier to reverse
- More difficult to find positive NPV financing strategies than positive NPV investment decisions
True or False:
Prices of stocks and commodities seem to follow a “random walk”.
Explain
True.
- Each stock and commodity follows a random walk with a positive/negative drift.
- Price changes are independent of one another
Why do prices tend to take a “random walk”?
If past price changes could be used to predict future price changes, investors could make easy profits.
What is an efficient market?
A market in which stock prices fully reflect information
What are the three levels of market efficiency?
Weak Market Efficiency: prices reflect the information contained in the record of past prices (trend analysis)
Semi-strong market efficiency: prices reflect not just past prices but all other public information
Strong Market Efficiency: prices reflect all the information that can be acquired by painstaking analysis of the company and the economy
How do researchers test for semi-strong efficiency?
researchers have measured how rapidly security prices respond to different items of news, such as earnings or dividend announcements, news of a takeover, or macroeconomic information
What is the market model for expected stock return (in terms of alpha and beta)?
Expected stock return = α + β × return on market index
alpha: states how much on average the stock price changed when the market index was unchanged
beta: tells us how much extra the stock price moved for each 1% change in the market index
remember to choose an alpha and beta in a period where the stock behaved normally
How do you calculate the abnormal stock return?
= ̃r − ( α + β ̃r m )
Abnormal stock return = actual stock return − expected stock return
Why does trend analysis not work?
Because cycles disappear once they are found
Why do undervalued and overvalued firms exist?
Because more and more investors are simply “buying the index”, they are ignoring stocks that deserve capital
What is the small firm effect?
The superior performance of small firms.
Sometimes investors demand more return from small firms due to the increased risk factor, however this could also be a coincidence
The small-firm effect would be an important exception to the efficient-market theory.
What are some examples (anomalies) that have shown evidence against market efficiency?
- superior performance of small firms
- Initial Public Offerings that catch too much attention (end up having a loss by the time the stock is sold)
Quick fact that i found in the footnote: IPO’s are good for tax strategizing. Investors can sell the losers, deducting the losses against other capital gains, and hold the winners, thus deferring taxes.
What is an anomaly?
In an efficient market it is not possible to find expected returns greater (or less) than the risk-adjusted opportunity cost of capital.
If the price differs from the fundamental value, investors can earn more than the cost of capital, by selling when the price is too high and buying when it is too low.
When this happens it is an anomaly.
What are the two difficulties when valuing common stocks?
First, investors find it easier to price a common stock relative to yesterday’s price or relative to today’s price of comparable securities.
Second, most of the tests of market efficiency are concerned with relative prices and focus on whether there are easy profits to be made.
Which are the two biggest “bubbles” that the stock market has experienced?
The Japanese bubble and the dot.com bubble
What are bubbles?
Bubbles can result when prices rise rapidly, and more and more investors join the game on the assumption that prices will continue to rise. These bubbles can be self-sustaining for a while.
Why would prices differ from fundamental values?
Behavioural finance - when people are not 100% rational 100% of the time.
How does attitudes toward risk affect fundamental values?
It seems that investors do not focus solely on the current value of their holdings, but look back at whether their investments are showing a profit or a loss.
(Investors will be more comfortable buying a stock when they have received a gain in the recent past, and less willing to invest if they have incurred a loss)
How does beliefs about probabilities affect fundamental values?
Most investors do not have a PhD in probability theory and may make systematic errors in assessing the probability of uncertain events.
When judging possible future outcomes, individuals tend to look back at what happened in a few similar situations. As a result, they are led to place too much weight on a small number of recent events (and are also too conservative in the face of new evidence)
Which types of bias may occur when investors are calculating probabilities with stocks?
- overconfidence
They consistently overestimate the odds that the future will turn out as they say and underestimate the chances of unlikely events.
How does sentiment affect fundamental values?
Generally right before crashes, investors sentiment is very positive. Usually the actual reality of what happens in the market is the opposite of what investors predict.
Go to page 341 to see the graph for proof; bullish (good outlook) vs. bearish (negative outlook)
How do limits to arbitrage affect fundamental values?
In an efficient market, if prices get out of line, arbitrage forces them back.
- limits put on the ability of the rational investors to exploit market inefficiencies.
What is arbitrage?
- an investment strategy that guarantees superior returns without any risk (by exploiting market inefficiencies)
- an arbitrageur gains profit from buying low and selling high
Arbitrage trading is also known as..
convergence trading
What was the subprime crisis?
When US house prices had fallen by a third in 2006, banks were selling their Mortgage-backed securities (banks were approving almost anyone for a mortgage) in secondary markets to government backed companies - the mortgages defaulted and boom recession hit
How is “Markets have no memory” a lesson of market efficiency?
Past market performances do not affect future performances, it is really a random walk with a positive trend - no such thing as trend analysis
How is “Trust Market Prices” a lesson of market efficiency?
In efficient markets you can trust prices, there is no way for most investors to achieve consistently superior rates of return.
How is “Read the Entrails” a lesson of market efficiency?
If the market is efficient, prices impound all available information. Therefore, prices can tell us a lot about the future.
How is “The Do-It-Yourself Alternative” a lesson of market efficiency?
In an efficient market investors will not pay others for what they can do equally well themselves
- It doesn’t pay for individual companies to diversify their risk, better off focusing on your strengths and then taking on risk from there. It will be up to the shareholders to diversify the risk
- Don’t want the companies to diversify at the company level, you want the shareholders to do it
How is “Seen One Stock, Seen Them All” a lesson of market efficiency?
Stocks have very high elasticity of demand.
If its prospective return is too low relative to its risk, nobody will want to hold that stock. If the reverse is true, everybody will scramble to buy.
During acquisitions what happens to the target firms stock price?
Goes up substantially because acquiring firms usually have to pay a large “takeover premium”
Why are mutual funds compared to a “benchmark” portfolio of similar securities?
to control the differences depending on what sector of the market the mutual fund specializes in (such as low-beta stocks or large-firm stocks)
The funds earned a LOWER return than the benchmark portfolios AFTER expenses, and roughly matched the benchmarks before expenses
What if markets are NOT efficient, and Your Company’s Shares Are Mispriced?
If your stock is overpriced:
- never issue stock to invest in a project that offers a lower rate of return than you could earn elsewhere in the capital market
- such a project would have a negative NPV
- instead invest in common stock elsewhere (to yield an NPV of zero?)
What if markets are NOT efficient, and Your Firm Is Caught in a Bubble?
- easy to be tempted to cover up the bad news or manufacture the good
- but the “bubble” will burst eventually and there will be consequences for managers who have resorted to tricky accounting or misleading public statements in an attempt to sustain the inflated stock price
