Corp Finance

Question 1

Describe the point at which a firms optimal amount of capital expenditure is determined.

Answer 1

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.

Question 2

Describe a firms investment opportunity schedule

Answer 2

An investment opportunity schedule shows the IRRs of (in decreasing order), and the initial investment amounts for, a firm’s potential projects.

Question 3

How is cost of equity capital Kce calculated using CAPM

Answer 3

This is the required rate of return on a firms common stock

CAPM approach: kce = Rf + β[E(Rmkt) – Rf].

Question 4

How is cost of equity capital Kce calculated using divided discount

Answer 4

Dividend discount model approach: kce = (D1/P0) + g.

Question 5

How is cost of equity capital Kce calculated using bond Yield plus risk premium

Answer 5

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.

Question 6

Profitability Index

Answer 6

PI = PV of future cash flows / CFo

If PI > 1.0, accept the project.

If PI < 1.0, reject the project.

Question 7

Degree of Operating Leverage

Answer 7

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%

Question 8

Degree of Financial Leverage

Answer 8

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%.

Question 9

Degree of Total Leverage

Answer 9

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

Question 10

Breakeven Quantity of Sales

Answer 10

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)

Question 11

The variance of returns for a portfolio of two risky assets is calculated

Answer 11

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

Question 12

Describe minimum-variance portfolios

Answer 12

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.

Question 13

Calculate and interpret beta.

Answer 13

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.

Question 14

CAPM

Answer 14

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.

Question 15

CAPM Assumptions

Answer 15

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.

Question 16

Identifying mispriced securities - Forecasts vs. Required Returns

Answer 16

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.

Question 17

SML

Answer 17

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.

Question 18

Operating Cycle

Answer 18

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.

Question 19

Cash conversion cycle

Answer 19

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.

Question 20

Under Accounts Payable Management, what does 2/10 net 60 mean

Answer 20

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

Question 21

Bid and Ask/Offer Price

Answer 21

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.

Question 22

Cost of Equity - dividend discount model approach.

Answer 22

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.

Question 23

Michael Potter’s 5 Factorts

Answer 23

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

Question 24

industry experience curve shows the cost per unit relative to:

Answer 24

output

Question 25

Cost of debt

Answer 25

= YTM on outstanding bonds * (1-tax rate)

some questions will give you the coupon rate and you’ll need to calc ytm

Question 26

When would you have multiple IRRs?

Answer 26

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)

Question 27

MCC Break Points

Answer 27

amount of capital for which the component’s cost of capital changes (i.e. low # of breakpoint) / weight of capital component

Question 28

A projects Beta using pure play

Answer 28

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

Question 29

Weak Form Market Efficiency

Answer 29

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.

Question 30

Semi strong form market efficiency

Answer 30

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

Question 31

Strong form market efficiency

Answer 31

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.

Question 32

3 Major Steps in Portfolio Management

Answer 32

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.

Question 33

CML

Answer 33

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).

Question 34

Business Cycles

Answer 34

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

Question 35

Country Risk Premium

Under cost of capital

Answer 35

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

Question 36

Describe the risk/liquidity requirements of institutional investors: Pensions, Insurance and Charitable Foundations

Answer 36

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.

Question 37

ESG Investing - negative/positive screening

Answer 37

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

Question 38

Defined Contribution

Answer 38

Retirement plan where firm contributes $. Firm makes NO promises on future value of account. Employee manages investments and assumes risk.

Question 39

Defined Benefit

Answer 39

firm promises to make payments after retirement. The employer assumes the investment risk. employer makes contributions to the fund to provide future benefit.

Question 40

Business Risk

Answer 40

Operating Risk - the greater proportion of fixed cost to variable, the greater the operating risk

and

Sales - uncertainty about future sales.

Question 41

sell out rights

Answer 41

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.

Question 42

Cross Over Rate

Answer 42

Discount rate at which the NPV profiles of 2 projects are equal

Question 43

Risk Governance Components

Answer 43

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.

Question 44

Externality

Answer 44

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.