Class 23 Flashcards
Perfect markets elements
- info is freely available and its all we need (assumer rationality)
- large # of sellers
- large # of buyers
- homogenous goods
firm value =
present value of expected cash flows:
E(Net Cash Flow)/ (1+r)^t
how is firm value determined?
- expected cash flows (earnings)
- required rate of return
cash flows =
earnings
required rate of return =
expected return could earn on the next best investment (Affected by time and risk)
time effect
- preference for cash (to make investments) today rather than in the future
- the longer the duration until payment, the lower the value today
risk
individual preference for less risk rather than more risk; all else equal (what source of risk)
speculative risk
can gain or lose
pure risk
can only have a loss
low frequency, high severity =
more risky
assume that corporations (publicly traded firms) operate in…
perfect markets
what is the objective for publicly traded firms?
to maximize shareholder wealth (i.e. maximize firm value)
components of a firm’s total risk
- diversifiable (also called idiosyncratic or nonsystematic risk)
- non-diversifiable (also called market or systematic risk)
diversifiable =
nonsystematic (or idiosyncratic); relatively independent observations
non-diversifiable =
systematic; relatively positively correlated observations
which type of risk is pooling effective for?
diversifiable risk (investors can pool it away in exactly the same way that insurers take advantage of pooling)
RM for firms owned by well diversified investors can only increase firm value by…
increasing net cash flow because the risk in firm value calculation is only systematic risk, which is not diversifiable
why do we observe corps. buying insurance and spending resources on RM?
they do not buy insurance for benefit of pooling (in a perfect market)
ways to increase expected cash flows
- insurer sometimes offers desired services more efficiently, lowering costs
- costs associated with financial distress might be reduced
- raising new funds (capital) may be less costly
- tax payments may be delayed (and insurers can deduct reserves even though insureds cannot)
raising new funds (Capital) may be less costly
- obtaining new funds thru issuing bonds, stocks, or getting a loan has costs
- using existing (internal) fund takes resources from productive investments (and has signaling effect)
costs of issuing debt
- signaling costs
- sell shares costs
- having bank help
- cost of divulging share value
- to invest internal funds (not putting in some other use_
30/70 Reinsurance agreement
Primary: pays 30%
Re: pays 70%
what is the only risk that matters?
systematic risk
