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AFM 273 > chapter 3 > Flashcards

chapter 3 Flashcards

1
Q

what are the decisions in other business functions?

A

Marketing: to determine the increase in revenues resulting from an advertising campaign

Economics: to determine the increase in demand from lowering the price of a product

Organizational Behaviour: to determine the productivity impact of a change in management structure

Strategy: to determine a competitor’s response to a price increase

Operations: to determine production costs after the modernization of a manufacturing plant

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2
Q

what’s the general principle in competitive market trading

A

that price determines the cash value of the good. As long as a competitive market exists, the value of the good will not depend on the views or preferences of the decision maker.

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3
Q

define a competitive market

A

by which we mean a market in which it can be bought and sold at the same price

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4
Q

define the valuation principle

A

The value of an asset to the firm or its investors is determined by its competitive market price. The benefits and costs of a decision should be evaluated using these market prices, and when the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm.

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5
Q

define the time value of money

A

the difference in value between money today and money in the future

observation that 2 cash flows at 2 different points in time have different values

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6
Q

how can we convert money today into money un the future with no risk?

A

deposit money in a savings account

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7
Q

what does borrowing money from the bank mean?

A

we can exchange money in the future for money today

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8
Q

what determines the rate at which we can exchange money today for money in the future

A

the current interest rate

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9
Q

how does the interest rate work as an exchange rate

A

It tells us the market price today of money in the future.

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10
Q

define the risk-free interest rate

A

the interest rate at which money can be borrowed or lent without risk over a given period

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11
Q

what does the risk-free interest rate depend on?

A

the supply + demand

supply of savings = demand for borrowing

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12
Q

what’s the discount rate

A

aka risk-free interest rate

rate used to discount a stream of cashflows; cost of capital of a stream of cash flows

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13
Q

how can we make a decision

A

comparing the costs + benefits at the same point in time

corps usually do it in the net present value

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14
Q

define net present value

A

the difference between the present value of its benefits and the present value of its costs of a project or investment

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15
Q

But what if you don’t have the $500 needed to cover the initial cost of the project? Does the project still have the same value? Because we computed the value using competitive market prices, it should not depend on your tastes or the amount of cash you have in the bank. If you don’t have the $500, suppose you borrow $509.26 from the bank at the 8% interest rate and then take the project. What are your cash flows in this case?

A

cashflow today: 509 loan - 500 = +9

cashflow in the future = $550 - (509 x 1.08) (loan balance) = $0

This transaction leaves you with exactly $9.26 extra cash in your pocket today and no future net obligations. So taking the project is like having an extra $9.26 in cash up front.

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16
Q

what’s a good characteristics of he NPV

A

Thus, the NPV expresses the value of an investment decision as an amount of cash received today. As long as the NPV is positive, the decision increases the value of the firm and is a good decision regardless of your current cash needs or preferences regarding when to spend the money.

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17
Q

what’s the NPV decision rule?

A

When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today.

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18
Q

what does the NPV decision rule imply?

A

Accept those projects with positive NPV because accepting them is equivalent to receiving their NPV in cash today

Reject those projects with negative NPV; accepting them would reduce the wealth of investors, whereas not doing them has no cost .

do the project with the higher NPV

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19
Q

what’s the first separation principle?

A

Separation of the Individual’s Consumption Preferences From the Optimal Investment Decision

Regardless of our consumption preferences that dictate whether we prefer cash today versus cash in the future, we should always maximize NPV first. We can then borrow or lend to shift cash flows through time so as to match our most preferred consumption spending pattern through time. In effect, our preferences regarding consumption spending through time are separate from our optimal investment decision.

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20
Q

define arbitrage

A

The practice of buying and selling equivalent goods in different markets to take advantage of a price difference

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21
Q

define arbitrage opportunity

A

situation in which it is possible to make a profit without taking any risk or making any investment

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22
Q

why does the abritrage opportunity evaporate

A

whenever an arbitrage opportunity appears in financial markets, investors will race to take advantage of it. Those investors who spot the opportunity first and who can trade quickly will have the ability to exploit it. Once they place their trades, prices will respond, causing the arbitrage opportunity to evaporate.

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23
Q

define a normal market

A

competitive market in which there are no arbitrage opportunities

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24
Q

define the law of 1 price

A

If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in all markets.

25
Q

what’s a useful consequence of the law of 1 price

A

when evaluating costs and benefits to compute a net present value, we can use any competitive price to determine a cash value, without checking the price in all possible markets.

26
Q

define financial security (aka security)

A

An investment opportunity that trades in a financial market

27
Q

define a bond

A

a security sold by governments and corporations to raise money from investors today in exchange for the promised future payment.

28
Q

how can we receive cash flow?

A

buy the security - borrow the money?

invest money at the risk free rate

29
Q

For example, suppose the bond traded for a price of $940. How could we profit in this situation?

when the equivalent price is 952.38

A

In this case, we can buy the bond for $940 and at the same time borrow $952.38 from the bank. Given the 5% interest rate, we will owe the bank in one year. Our overall cash flows from this pair of transactions are as shown in Table 3.3. Using this strategy, we can earn $12.38 in cash today for each bond that we buy, without taking any risk or paying any of our own money in the future. Of course, as we—and others who see the opportunity—start buying the bond, its price will quickly rise until it reaches $952.38 and the arbitrage opportunity disappears.

30
Q

For example, suppose the bond is trading for $960.

A

In that case, we should sell the bond and invest $952.38 at the bank. As shown in Table 3.4, we then earn $7.62 in cash today, yet keep our future cash flows unchanged by replacing the $1000 we would have received from the bond with the $1000 we will receive from the bank. Once again, as people begin selling the bond to exploit this opportunity, the price will fall until it reaches $952.38 and the arbitrage opportunity disappears.

pretty much shorting the bond - short sale

When the bond is overpriced, the arbitrage strategy involves selling the bond and investing some of the proceeds -

31
Q

define short sale

A

the person who intends to sell the security first borrows it from someone who already owns it. Later, that person must either return the security by buying it back or pay the owner the cash flows he or she would have received.

it is possible to exploit the arbitrage opportunity when the bond is overpriced even if you do not own it.

32
Q

define the no-arbitrage price

A

in the normal market, when the price of a security equals the present value of the cash flows paid by the security

33
Q

can we determine the no-arbitrage price of a risk free bond?

A

yes, with the given risk-free interest rate

34
Q

how do financial news services report current interest rates?

A

derived these rates based on the current prices of risk-free government bonds trading in the market

35
Q

what if there’s an arbitrage in the bond e.g bond offered a higher return or a lower return?

A

If the bond offered a higher return, then investors would earn a profit by borrowing at the risk-free interest rate and investing in the bond.

If the bond had a lower return, investors would sell the bond and invest the proceeds at the risk-free interest rate.

36
Q

what is no arbitrage equivalent to the idea of

A

No arbitrage is therefore equivalent to the idea that all risk-free investments should offer investors the same return.

37
Q

if there’s no arbitrage, the risk-free interest rate is equal to?

A

to the return from investing in a risk-free bond

38
Q

When securities trade at no-arbitrage prices, what can we conclude about the value of trading them?

A

the cost and benefit are equal in a normal market and so the NPV of buying a security is zero:

39
Q

Consider a security that pays its owner $100 today and $100 in one year, without any risk. Suppose the risk-free interest rate is 10%. What is the no-arbitrage price of the security today (before the first $100 is paid)? If the security is trading for $195, what arbitrage opportunity is available? At what interest rate would the arbitrage opportunity disappear?

A

We need to compute the present value of the security’s cash flows. In this case, there are two cash flows: $100 today, which is already in present value terms, and $100 in one year. The present value of the second cash flow is given below:

Therefore, the total present value of the cash flows is today, which is the no-arbitrage price of the security.

If the security is trading for $195, we can exploit its overpricing by selling it for $195. We can then use $100 of the sale proceeds to replace the $100 we would have received from the security today and invest $90.91 of the sale proceeds at 10% to replace the $100 we would have received in one year. The remaining is an arbitrage profit.

At a price of $195, we are effectively paying $95 to receive $100 in one year. So, an arbitrage opportunity exists unless the interest rate equals .

40
Q

if we sell a security, what’s the benefit and cost?

A

the price we receive is the benefit, and the cost is the cash flows we give up

41
Q

is security trading in a normal markets zero-NPV transaction? why?

A

yes

Trading securities in a normal market neither creates nor destroys value.

Instead, value is created by the real investment projects in which the firm engages, such as developing new products, opening new stores, or creating more efficient production methods.

Financial transactions are not sources of value but merely serve to adjust the timing and risk of the cash flows to best suit the needs of the firm or its investors.

42
Q

define the Separation of the Investment and Financing Decisions

A

Security transactions in a normal market neither create nor destroy value on their own. Therefore, we can evaluate the NPV of an investment decision separately from the decision the firm makes regarding how to finance the investment or any other security transactions the firm is considering.

43
Q

Your firm is considering a project that will require an upfront investment of $10 million today and will produce $12 million in cash flow for the firm in one year without risk. Rather than pay for the $10 million investment entirely using its own cash, the firm is considering raising additional funds by issuing a security that will pay investors $5.5 million in one year. Suppose the risk-free interest rate is 10%. Is pursuing this project a good decision without issuing the new security? Is it a good decision with the new security?

A

Without the new security, the cost of the project is $10 million today, and the benefit is $12 million in one year. Converting the benefit to a present value we see that the project has today.

Now suppose the firm issues the new security. In a normal market, the price of this security will be the present value of its future cash flow: Thus, after it raises $5 million by issuing the new security, the firm will only need to invest an additional $5 million to take the project. To compute the project’s NPV in this case, note that in one year the firm will receive the $12 million payout of the project, but owe $5.5 million to the investors in the new security, leaving $6.5 million for the firm. This amount has a present value of.

Thus, the project has today, as before. In either case, we get the same result for the NPV. The separation principle indicates that we will get the same result for any choice of financing for the firm that occurs in a normal market. We can therefore evaluate the project without explicitly considering the different financing possibilities the firm might choose.

44
Q

define protfolio

A

a collection of securities

45
Q

define value additivity

A

a relationship determined by the law of 1 price, in which the price of an asset that consists of other assets must equal the sum of the prices of the other asset

price C = price A + price B

implies that the value of a portfolio is equal to the sum of the values of its parts. That is, the “à la carte” price and the package price must coincide.

46
Q

why is value additivity have an important consequence for the value of an entire term?

A

The cash flows of the firm are equal to the total cash flows of all projects and investments within the firm. Therefore, by value additivity, the price or value of the entire firm is equal to the sum of the values of all projects and investments within it. In other words, our NPV decision rule coincides with maximizing the value of the entire firm: To maximize the value of the entire firm, managers should make decisions that maximize NPV. The NPV of the decision represents its contribution to the overall value of the firm.

47
Q

Horton Holdings is a publicly traded company with only two assets: It owns 60% of Tim’s Donuts chain and 100% of the Caribou hockey team. Suppose the market value of Horton Holdings is $160 million, and the market value of the entire Tim’s Donuts chain (which is also publicly traded) is $120 million. What is the market value of the Caribou hockey team?

A

We can think of Horton as a portfolio consisting of a 60% stake in Tim’s Donuts and 100% of the Caribou hockey team. By value additivity, the sum of the values of the stake in Tim’s Donuts and the Caribou hockey team must equal the $160 million market value of Horton. Because the 60% stake in Tim’s Donuts is worth , the Caribou hockey team has a value of .

48
Q

why do investors pay less to receive $1100 on average than to receive $1100 with certainty

A

bc they don’t like risk - the personal cost of losing a dollar in bad times is greater than the benefit of an extra dollar in good times.

49
Q

define risk aversion

A

notion that investors prefer to have a safe cash flow than a risky one of the same expected amount

50
Q

define expected return

A

compute the return of a security based on the payoff we expect to receive on average

51
Q

how can you calculate an expected return?

A

computing the expectation of these actual returns by multiplying the actual returns by their probabilities and then summing 1/2(40%) + 1/2(-20%) = 10%

52
Q

define the risk premium

A

the difference between the return of a risky security and riskless security

represents the additional return that investors expect to earn to compensate them for the security’s risk

53
Q

how to compute the presents value of a risky cashflow

A

we must discount the cash flow we expect on average at a rate that equals the risk-free interest rate plus an appropriate risk premium.

54
Q

can you use the risk premium of the market index to value other risky securities?

A

yes e.g. By the Law of One Price, the total market value of the bond and security A must equal $1000, the value of the market index

55
Q

why are risk premiums so different?

A

compare the actual returns for the two securities - Given its much more variable returns, the security must pay investors a higher risk premium

56
Q

why would investors be more willing to pay for a security (security B) that pays them when the market is poor but doesn’t pay when the market is good

A

security B is not really “risky” from an investor’s point of view; rather, security B is an insurance policy against an economic decline. By holding security B together with the market index, we can eliminate our risk from market fluctuations. Risk-averse investors are willing to pay for this insurance by accepting a return below the risk-free interest rate.

57
Q

how can the risk of a security be evaluated?

A

The risk of a security cannot be evaluated in isolation.

The risk of a security must be evaluated in relation to the fluctuations of other investments in the economy. A security’s risk premium will be higher the more its returns tend to vary with the overall economy and the market index. If the security’s returns vary in the opposite direction of the market index, it offers insurance and will have a negative risk premium.

58
Q

Consider a risky bond with a cash flow of $1100 when the economy is strong and $1000 when the economy is weak. Suppose a 1% risk premium is appropriate for this bond. If the risk-free interest rate is 4%, what is the price of the bond today?

A

The expected cash flow of the bond is 1050 in one year. Thus, the price of the bond today is as given below 1000 today

rs = rf + rp = risk free + risk premium

AFM 273 (12 decks)

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