Corp Finance Flashcards
Describe the point at which a firms optimal amount of capital expenditure is determined.
The intersection of a firm’s investment opportunity schedule with its marginal cost of capital curve indicates the optimal amount of capital expenditure, the amount of investment required to undertake all positive NPV projects.
Describe a firms investment opportunity schedule
An investment opportunity schedule shows the IRRs of (in decreasing order), and the initial investment amounts for, a firm’s potential projects.
How is cost of equity capital Kce calculated using CAPM
This is the required rate of return on a firms common stock
CAPM approach: kce = Rf + β[E(Rmkt) – Rf].
How is cost of equity capital Kce calculated using divided discount
Dividend discount model approach: kce = (D1/P0) + g.
How is cost of equity capital Kce calculated using bond Yield plus risk premium
Bond yield plus risk premium approach: add a risk premium of 3% to 5% to the market yield on the firm’s long-term debt.
Profitability Index
PI = PV of future cash flows / CFo
If PI > 1.0, accept the project.
If PI < 1.0, reject the project.
Degree of Operating Leverage
The degree of operating leverage (DOL) is defined as the percentage change in operating income (EBIT) that results from a given percentage change in sales:
DOL = % change in EBIT / % change in SALES
DOL = Q(Price-vari cost) / (price-vari cost)-fixed cost
DOL = Sales-TVC / S-TVC-fixed cost
Note: If DOL = 2.5, if Beta Company has a 10% increase in sales, its EBIT will increase by 2.50 × 10% = 25%
Degree of Financial Leverage
The degree of financial leverage (DFL) is interpreted as the ratio of the percentage change in net income (or EPS) to the percentage change in EBIT:
DFL= % change in EPS (or net income) / % change in EBIT (or operating income)
DFL = EBIT / EBIT-Interest
Note: if DFL is 1.43, If Atom’s EBIT increases by 10%, earnings per share will increase by 14.3%.
Degree of Total Leverage
The degree of total leverage (DTL) combines the degree of operating leverage and financial leverage. DTL measures the sensitivity of EPS to change in sales. DTL is computed as:
DOL x DFL
Breakeven Quantity of Sales
Breakeven Quantity - The level of sales that a firm must generate to cover all of its fixed and variable costs. The breakeven quantity of sales is the quantity of sales for which revenues equal total costs, so that net income is zero.
Break-even quantity = Fixed Costs / (Price - Variable cost)
The variance of returns for a portfolio of two risky assets is calculated
Var portfolio = (Weight port 1^2 * Variance port 1^2) + (Weight port 2^2 * Variance port 2^2) + 2*weight port 1 * weight port 2 * Cov port 1&2
Describe minimum-variance portfolios
Portfolios that have the lowest standard deviation of all portfolios with a given expected return are known as minimum-variance portfolios. For each level of expected portfolio return, we can vary the portfolio weights on the individual assets to determine the portfolio that has the least risk. Together they make up the minimum-variance frontier.
Calculate and interpret beta.
The sensitivity of an asset’s return to the return on the market index in the context of the market model is referred to as its beta.
Beta of asset = covariance of Asset i’s return with the market return / variance of the market return
Beta of asset = correlation between the returns on the asset with the returns on the market index * (standard deviation of the asset / standard deviation of the market)
Note: the Market piece is always in the denominator.
CAPM
E(Ri) = Rf + βi[E(Rmkt) – Rf]
The CAPM holds that, in equilibrium, the expected return on risky asset E(Ri) is the risk-free rate (Rf) plus a beta-adjusted market risk premium, βi[E(Rmkt) – Rf]. Beta measures systematic (market or covariance) risk. Beta measures the relation between a security’s excess returns and the excess returns to the market portfolio.
CAPM Assumptions
The assumptions of the CAPM are:
- Risk aversion. To accept a greater degree of risk, investors require a higher expected return.
- Utility maximizing investors. Investors choose the portfolio, based on their individual preferences,
Frictionless markets. There are no taxes, transaction costs, or other impediments to trading.
One-period horizon. All investors have the same one-period time horizon.
Homogeneous expectations. All investors have the same expectations for assets’ expected returns, etc
Divisible assets. All investments are infinitely divisible.
Competitive markets. Investors take the market price as given and no investor can influence prices with their trades.
Identifying mispriced securities - Forecasts vs. Required Returns
Forecast (by analyst) is based on HPR
HPY = (price - purchase price + divds) / purchase price
Required Return is based on CAPM
E(Ri) = Rf + βi[E(Rmkt) – Rf]
Think of CAPM as the return the market requires and the analyst forecast as the value of the stock based on research. So if CAPM is > than the researched value, its overvalued.
Overvalued - If required return, based on CAPM, is > analyst forecast the stock is overvalued. It is forcasted/expected to earn 12%, but based on its systematic risk, it should earn 15%. It plots below the SML. Sell short.
Undervalued - If required return, based on CAPM, is < analyst forecast the stock is undervalued. It is forecasted/expected to earn 17.5%, but based on its systematic risk, it should earn 13.4%. It plots above the SML. Buy stock.
Properly valued - If required return, based on CAPM, is = analyst forecast the stock is undervalued. It is forecasted/expected to earn 16.6%, and based on its systematic risk, it should earn 16.6%. It plots on the SML.. Buy, sell or hold.
SML
Remember, all stocks should plot on the SML; any stock not plotting on the SML is mispriced.
The slope of the SML is the market risk premium from CAPM. the slope represents the portion of expected return that reflects compensation for market or systematic risk.
The CAPM and the SML indicate what a security’s equilibrium required rate of return should be based on the security’s exposure to market risk. An analyst can compare his expected rate of return on a security to the required rate of return indicated by the SML to determine whether the security is overvalued, undervalued, or properly valued.
Operating Cycle
Operating cycle = days of inventory + days of receivables.
Operating and cash conversion cycles that are high relative to a company’s peers suggest the company has too much cash tied up in working capital.
Cash conversion cycle
Cash conversion cycle = days of inventory + days of receivables – days of payables.
Operating and cash conversion cycles that are high relative to a company’s peers suggest the company has too much cash tied up in working capital.
Under Accounts Payable Management, what does 2/10 net 60 mean
Typical terms on payables (trade credit) contain a discount available to those who pay quickly as well as a due date. Terms of “2/10 net 60” mean that if the invoice is paid within ten days, the company gets a 2% discount on the invoiced amount and that if the company does not take advantage of the discount, the net amount is due 60 days from the date of the invoice.
If you don’t pay within the 10 days it better to wait until 60. That $ is best invested elsewhere
Bid and Ask/Offer Price
The bid price is the price at which a dealer will buy a security. The ask or offer price is the price at which a dealer will sell a security. The difference between the bid and ask prices is referred to as the bid-ask spread and is the source of a dealer’s compensation.
If you need to work with bid and ask prices, just remember that the price you get will be the one that is worse for you.
Securities: If you are buying, you must pay the higher price. If you are selling, you only receive the lower price.
Currencies: The bid or ask price you get is the one that gives you less of the currency you are acquiring. This works regardless of which way the exchange rate is quoted.
Cost of Equity - dividend discount model approach.
If dividends are expected to grow at a constant rate, g, then the current value of the stock is given by the dividend growth model:
Kce = (Divd / Price) + growth rate.
Michael Potter’s 5 Factorts
Determine industry competition
1 Rivalry among competitors
2 threat of entry
3 threat of substitutes - The more differentiated the products are within an industry, the less price competition there will be.
4 Power of buyers. Buyers’ ability to bargain for lower prices or higher quality influences industry profitability.
5 power of suppliers
industry experience curve shows the cost per unit relative to:
output
Cost of debt
= YTM on outstanding bonds * (1-tax rate)
some questions will give you the coupon rate and you’ll need to calc ytm
When would you have multiple IRRs?
if a project has an unconventional cash flow pattern, that is, the sign of the cash flows changes more than once (from negative to positive to negative, or vice-versa)
MCC Break Points
amount of capital for which the component’s cost of capital changes (i.e. low # of breakpoint) / weight of capital component
A projects Beta using pure play
B asset = B equity * [1/ (1 + (1 - t) * D/E)]
B project = B asset * [(1 + (1 - t) * D/E)]
Remember to use the debt to equity ratio of the specific firm
Weak Form Market Efficiency
Market reflects all currently available info. Past price/volume data trends are already priced in. Cannot achieve positive risk adjusted returns on average using technical analysis.
Semi strong form market efficiency
Markets reflect all publiclly available info. Security prices include all past security market information and nonmarket information available to the public. Investor cannot achieve positive risk-adjusted returns on average by using fundamental analysis.
Strong-form market efficiency. The strong form of the EMH
Strong form market efficiency
Market reflects all public and non public info. This means that no group of investors has monopolistic access to information relevant to the formation of prices, and none should be able to consistently achieve positive abnormal returns.
3 Major Steps in Portfolio Management
Planning - Develop investment policy statement
Execution - Top down and bottom up analysis
Feedback - Things change (i.e. investors circumstances, risk return profile of securities, etc) Re balance in this stage.
CML
In the specific case where the risky asset is the market portfolio, the combinations of the risky asset and the risk-free asset form the capital market line (CML).
Business Cycles
1 Embryonic - slow growth, low demand high prices, high failure
2 Growth - high growth, rapidly increasing demand, improving profitability, falling prices, and relativity low competition
3 shakeout - growth slows, intense competition, declining profits
4 Mature - slow growth, consolidation, high barriers to entry, prices stable
5 decline - negative growth, consolidation, falling prices
Country Risk Premium
Under cost of capital
Risk free rate + beta * (Rm - Rf + CRP)
Note this is CAPM and the CRP is added to the market risk premium piece.
CRP = (standard deviation of Brazil equity / standard deviation Brazil bond) * Sovereign yield spread
Yield spread = Brazil yields- us yield
Describe the risk/liquidity requirements of institutional investors: Pensions, Insurance and Charitable Foundations
Pensions/defined benefits: have quite high risk tolerances and quite low liquidity needs.
Insurance; Insurance companies need to be relatively conservative and liquid, given the necessity of paying claims when due.
charities/endowments: endowments/foundations typically have high risk tolerances and quite low liquidity needs.
ESG Investing - negative/positive screening
Negative Screening - exclude companies or sectors based on ESG
Positive Screening - identify compaines with positive ESG — best-in-class approach find companies in each industry with best ESG practices
Defined Contribution
Retirement plan where firm contributes $. Firm makes NO promises on future value of account. Employee manages investments and assumes risk.
Defined Benefit
firm promises to make payments after retirement. The employer assumes the investment risk. employer makes contributions to the fund to provide future benefit.
Business Risk
Operating Risk - the greater proportion of fixed cost to variable, the greater the operating risk
and
Sales - uncertainty about future sales.
sell out rights
Sell-out rights protect minority shareholders in acquisition situations by forcing acquirers to buy out minority shareholders at a fair price, even if those shareholders initially voted against the acquirer’s offer.
Cross Over Rate
Discount rate at which the NPV profiles of 2 projects are equal
Risk Governance Components
Top-down approach and is charged with risk oversight for the entire organization.
operate on an enterprise-wise basis rather than viewing each unit in isolation.
determine the organization’s risk tolerance and provide a sense of the maximum loss the organization can absorb.
Externality
Frequently, an investment affects the cash flows of other parts of the company, and these externalities can be positive or negative. If possible, these should be part of the investment decision.
Cannibalization is one externality. Cannibalization occurs when an investment takes customers and sales away from another part of the company.
