Corporate Finance

Question 1

Calculate rates of return

Answer 1

Rate of return = Income / Average Investment Amount

It is the rate at which an asset or capital generates income and is calculated on an annual basis.

It is the ratio of income or the return to the average investment amount.

Question 2

Identify and explain systematic (market) risk and unsystematic (company risk)

Answer 2

Systematic risk ( market risk) is the risk attributed to the market as a whole. It’s considered undiversifiable. Risks include, interest rate, inflation, war & recessions.

AKA : Market, nondiversifiable, unavoidable.

Unsystematic (company risk) is the risk attributed to a specific company. There is no correlation between these risks and other market factors. Risk can be reduced by diversification.

AKA: company, unique, diversifiable, avoidable.

Question 3

Identify and explain Credit risk

Answer 3

The risk of loss due to the inability to repay a loan or failure to adhere to debt agreements

Question 4

Identify and explain Foreign Exchange Risk

Answer 4

The risk that a particular currency loses its value relative to another currency.

Question 5

Identify and explain Interest Rate Risk

Answer 5

The risk that a change in market interest rates can significantly reduce the value of an investment

Question 6

Identify and explain market risk

Answer 6

The risk that the value of an investment will change because of the overall market performance. A systematic risk that can’t be reduced or eliminated.

Question 7

Identify and explain industry risk

Answer 7

The risk that the industry’s performance may negatively affect the investment of a company or the company itself.

Question 8

Identify and explain political risk

Answer 8

The risk that political actions and government rules and regulators will affect the performance of an entity and its investments.

Question 9

Explain the relationship between risk and return

Answer 9

They have a direct relationship.

The higher the risk the lower the return and vice versa

Question 10

Distinguish between individual security risk and portfolio risk

Answer 10

Individual risk is for a single security which carries a great risk the a diversified portfolio.

Portfolio risk is the risk that it will not be able to maximize return or reduce risk low enough.

Portfolio risk can be measured by calculating the covariance ( the variance between two variables)

Question 11

Explain diversification

Answer 11

investing in a portfolio to mitigate risks, only unsystematic risks.

Differing investments can neutralize the negative effects of a loss on a particular assets from gains on other assets.

Question 12

Define beta and explain how a change in beta impacts a securities price.

Answer 12

Beta is the relationship between the performance of an investment/portfolio and the entire market.

Beta is the measure of systematic risk and is used in the Capital asset Pricing Model (CAPM)

Beta > 1 = higher risk (1.5 means increase/decrease is 1.5 times the market)

Beta < 1 = low risk (.75 mean increase/decrease is .75 times the market)

Beta = 1 = there is no correlation with the market

Beta is negative = inverse relationship to the market

Question 13

Explain Capital Asset Pricing Model (CAPM) and calculate the expected risk adjustment returns using CAPM

Answer 13

CAPM is a financial model used in calculating the expected risk-adjustment returns.

It’s based on the concept of the time value of money and risk represented by the risk free rate & the beta multiplied by the market risk premium.

R = Rf + b(RM-RF)
(Return = Risk free rate + beta x (Market rate - risk free rate)

Question 14

Explain the difference between debt financing and equity financing

Answer 14

Debt financing is when a company raises money for working capital or capital expenditures by selling bones or notes. The investors become creditors with and receive a promise to repay the principal + interest

Equity financing is the method of raising capital by selling company stock. SH receive ownership.

Question 15

Describe the term structure of interest rates & explain why it changes over time.

Answer 15

Structure of interest rates (aka yield curve) refers to the relationship between interest rates & maturity.

Upsloping (normal) yield curve indicates an expectation for higher yields for fixed income w/ LT maturities as comparted to ST income.
As interest rate increases, the price of securities declines and yields increase.

Downsloping yield curve anticipates the interest rate to drop in the future. Interest rates decrease, market price increases and yields drop

Flat yield curve indicates yields to be constant over time.

Question 16

Describe the 3 main theories that support term structure of interest rates changes over time

Answer 16

Pure Expectation Theory: Assumes yield curve is purely based on expectations of market ST interest rates.

Liquidity Preference Theory: Assumes changes in rates over time were based on belief the LT bonds tend to be less liquid and therefore, have a higher risk of loss comparted to ST investments, which can be easily converted to cash w/o significant loss.

Market Segmentation Theory: Assumes supply & demand for LT & ST securities in segmented markets determine the structure of rates in a particular market.

Question 17

Define and identify the characteristics of common stock

Answer 17

Common stock is a type of equity where investors are considered residual owners.

Pre-emptive rights: CSH are given preference to buy shares for new issues
Voting Power - entitled to it
Capital Appreciation - stocks appreciate in value
Dividend distribution - not received at regular intervals
Share in net assets - Paid first in liquidation

Question 18

Define and identify the characteristics of preferred stock

Answer 18

Preferred stock is a type of equity where investors receive preferential rights to dividends

Pre-emptive rights: Don’t apply
Voting Power - No voting power
Capital Appreciation - stocks don’t appreciate in value
Dividend distribution - Fixed & prioritized over CS
Share in net assets - Preferred over CS in liquidation.

Question 19

Identify and describe the basic features of a bond

Answer 19

A bond is a contractual debt agreement between the issuer (the debtor) and the bondholder (the creditor), where the issuer will be obliged to pay principal and interest during a specified period.

A form of debt financing and less risky

Maturity: Specified date when principal will be fully paid
Par Value: Face/maturity value
Fixed coupon rate: Fixed rate
Floating coupon rate: variable and tied to a benchmark
Zero-Coupon rate: no interest rate (sold less than par and redeemed at full price)

Question 20

Identify commonly issued bonds

Answer 20

Government: issued by US government
Municipal: Local/State gov’t to fund capital projects
Corp: to fund growth and other strategies
Agency: Fannie Mae/Freddie Mac
Foreign: Issued in domestic market by foreign entity to raise capital

Question 21

Identify the options granted to the issuer or bondholder

Answer 21

Call provision: the right to redeem the bond on a specified date before maturity

Refunding: to replace the bond w/ lower coupon rate

Sinking Fund: An amount set aside by issuer to retire bond at maturity.

Conversion: gives owner the option to convert bonds into common stock

Covenants/Restrictions: Embedded in bond indenture. set boundaries on bondholders

Indentures: legal doc that serves as proof of contractual agreement and may include sinking fund terms.

Question 22

Identify & evaluate debt issuance or refinancing strategies

Answer 22

Debt issuance:

1) Partnering w/ underwriters who assume responsibility of selling all debt issuances
2) Inclusion of debt covenants, a benefit to all to restrict actions to avoid non-payment

Refinancing: To replace existing debt or substitute with updated terms & conditions. Also to restructure or replace existing debt by lowering rates and extending maturity time.

Question 23

Value bonds, common and preferred stock using discounted cash flow methods

Answer 23

Selling price of bond = PV of principal + PV of interest

(PVFp x P) + (PVFi x1)

Market interest rate is the prevailing intrest rate or current interest rate and can be used in either factor

Stated interest (coupon) rate is stated on bond is is used in the PVFi

Question 24

Value Common and preferred stock valuation using discounted cash flows

Answer 24

Po = sum of Dn/ (1+i)n

Value of stock = sum of expected dividends per share at the end of a period divided by 1 + investors required return (discount rate) raised to the period

Question 25

Describe duration as a measure of bond interest rate sensitivity

Answer 25

Is the weighted average number of years the investor must hold a bond until the present value of the bond equals the amount paid for the bond (principal and interest).

Influenced by coupon rate, yield and remaining time to maturity.

Higher the duration the higher the interest rate risk and vice versa.

Question 26

Define and explain derivatives and their uses

Answer 26

Financial instruments the derive (depend) their value from underlying assets. The price of the underlying assets will determine the price of the instruments.

Traded on standardized exchange or OTC

Uses include:
Hedging - Reduce/eliminate unwanted risk (match length of financing to term)

Speculation - Bet on price changes

Arbitrage - Taking advantage of ST price anomalies

Types of derivatives include, Futures/Forwards/Options/Swaps

Question 27

Identify & describe the basic features of futures & forwards

Answer 27

Futures: Contractual agreement to trade specific instruments/commodity @ a specified price in the future

• Update market positions EOD (Marked to Market)
• Traced on exchange & settled via clearinghouse
• Regulated by gov’t & exchanges

Forwards: customized (OTC) agreement to trade a specific instrument/commodity @ specified price on a specific future date.

• Customized to meet specific user’s needs
• OTC
• May not be regulated

Question 28

Distinguish a long position from a short position

Answer 28

Long position taken by entity that decided to ACQUIRE underlying asset due to expectation the price would increase in the future.

Short position taken by entity that decided to SELL asset due to expectation that price would decrease in the future.

Long buys - gains increase asset $
Short sells - gains decrease asset $

Question 29

Define options and distinguish between a call & put

Answer 29

An Option is the right, but not the obligation to buy/sell @ a predetermined price @ a specified future date.

To acquire, the buyer (holder) pays an option premium

Call = buy [Price increases Long gains & short losses]

Put = sell [Price decreases Long gains & short losses]

Question 30

Define exercise price, strike price, option premium, intrinsic value & moneyness

Answer 30

Exercise price: known as strike price, at which the asset can be purchased

Option Premiums: Price paid for the option by the buyer to acquire the right to call or put the asset

Intrinsic value: Amt the option buyer receives if option is exercised. (“In the money”, “at the money”, “out of the money”

Moneyness: Relates to the relationship between exercise price & market price, and how it is interrupted.

Question 31

Describe the interrelationship of the variable for moneyness

Answer 31

Call:
In the money: exercise price < market price
Out of the money: exercise price > market price
At the money: exercise price = market price

Put:
In the money: exercise price > market price
Out of the money: exercise price < market price
At the money: exercise price = market price

Intrinsic value: Call = max of 0 or Market-Strike price)
C=Max[0,M-S]

Question 32

Define swaps for interest rates and foreign currency

Answer 32

An interest rate swap is the exchange of future interest pymts between 2 parties based on a specified face value. A fixed-for-floating- swap (plain vanilla) is exchanging a loan at a floating rate with a fixed rate loan

A foreign currency swap is the exchange of principal and interest denominated in one currency for the same in a different currency.

Question 33

Define other long-term sources of financing (Leases, convertible securities and warrants)

Answer 33

Leases: Operating or Financial

Convertible securities: Bonds/PS that can be converted to common stock

• Considered a hybrid due to debt/equity elements
• Lower cost of capital or rate of return
• Converted using conversion ratio (1:2) includes price

Warrants: Give holders the right, but not the obligation, to purchase from the issuer a certain number of units at a specified price before the expiration of warrant.

• Issued with lower interest rate
• Detachable issued w/security or Naked issued w/o security
• not automatic ownership, right not obligation
• Offered only by issuing company * have longer terms
• Can be exercised on or before exp date (American) or only on day of exp dat (European)

Question 34

Define cost of capital and how it applies in capital structure decisions

Answer 34

The cost of financing business using debt or equity

If more debt then WACC is lower and more finance then WACC is higher as financing is more expensive.

Question 35

Calculate the cost of capital & Marginal cost of capital (assume RE is exhausted)

Answer 35

WACC = (Wd x Cd(1-t) + (Wp x Cp) + (Wc x Cc)

WMCC +(TWd x Cc(1-t) + (TWp x Cp) + (TWC x Cc)

Always use market value

Question 36

Calculate the breakpoint

Answer 36

Breakpoint is where the marginal cost of capital increases

BP= Unappropriated R.E / TW of CS in capital structure

Calculate WACC, but break out C.S portion

Question 37

Calculate the constant growth dividend discount model and explain the two-stage dividend discount model

Answer 37

Constant growth assumes rate is constant

Po= D1 / (r-g)

Gordan Model
Cre = (D1/Po) + g

Zero Growth
Po= d/r

Two-stage assume two stages of dividend growth, applicable when expected when companies undergo rapid expansion.

Question 38

Define Business, Finance and Marginal risk

Answer 38

Both financial risk and interest rate risk deal with the concept of financial leverage and the cost of debt, and since the firm only utilizes equity financing, these risk types do not apply.

Marginal risk is the risk that is assumed by the issuer of a foreign exchange contract or debt (forward contract) in the event that the investor goes bankrupt. It is related to the risk of the last dollar of a transaction defaulting.

Business risk is the uncertainty associated with the ability to forecast EBIT (earnings before interest and taxes) due to such factors as sales variability and operating leverage. This risk is inherent in equity financing.