Corporate Finance Flashcards
What is capital?
Which forms of capital can be differentiated?
Financial resources available to a company in the form of equity or debt.
Equity financing: financing from company’s own resources
Debt financing: Outside capital
What is a capital market?
Market in which investors (creditors or company shareholders) provide borrowers or investees with medium- or long-term financing in form of equity or capital.
Distinct from money market where money is lent to borrowers on a short-term basis.
Describe a perfect capital market.
When are they efficient/perfect?
A concept used in economic theory to enable financial problems to be analyzed as clearly as possible.
They are efficient (perfect) when:
- Frictionless
- Perfect competition exists
- Market participants operate with absolute rationality
- Information efficiency exists
Describe the characteristics of the perfect capital market.
Frictionless: Transactions do not incur costs or taxes; securities can be perfectly shared or traded (information efficiency); free of regulatory restrictions
Complete competition: Market participants are price takers = no effect on market price; raise or invest capital at a single interest rate
Rational market participants: seek to act logically in their best interest
Information efficiency: Information processing can cause market prices to change therefore any given time the market reflects all relevant and current information.
Describe information efficiency.
- Multiple information channels feeding info about a company (market sector analysis, economic and business reports, financial statements)
- Role of information procurement and distribution is significant.
- Processing of information itself can cause market prices to change
Efficiency: at any given time the market reflects all relevant and current information.
What is the problem with information efficiency in practise?
Every market participant wants to achieve a excess return (outperform the most efficient market player by obtaining and evaluation information).
Chances to outperform are not very high in a liquid market (buyers and sellers look for them)
Stock prices are said to be informationally efficient as they reflect a price to anyone at a given moment in time (everyone has equal access to the info)
- However: new info = direct price change
What distinctions can be made regarding information efficiency with stocks?
Distinction based on quantity of information.
- Weak-form: All past prices of a stock are reflected in the current market price.
- Semi-strong form: current market price reflects all public info and info on past prices. –> Analysis on financial statements to identify over- or undervalued stocks would not work due to new info changing the price immediately (most common form)
- Strong-form: current price also reflects private info (“insider info”) –> some market participants are better informed and can gain greater returns
What is the risk-return ratio?
The greater the risk an investor is prepared to take, the higher the potential returns on his/her investment and vice versa.
What is the goal of an investment portfolio?
How can it be achieved?
Goal is to minimize risk and maximize the potential level of return.
Diversification strategy of Markowitz:
- Investing in a variety of different financial instruments to spread risk
- bundling securities (portfolios) based on a strategy that optimizes risk/reward
- handling risk (unsystematic risk = diversifiable variance and risk and systematic risk/market risk = non-diversifiable variance
- Unsystematic risk can be reduced by adding an asset likely to fluctuate in its performance in ways that do NOT interfere with rest of portfolio –> Variance of return is minimized by the asset added to the portfolio
What are the questions the portfolio theory aims to answer?
- What should a single individual (investor) do to construct an optimized portfolio?
- Which criteria are relevant to this decision making process?
- How are investments assessed in relation to this process?
- What is the optimal capital-allocation strategy for any given expectations?
Describe the CAPM.
What are the underlying assumptions?
CAPM = Capital asset pricing model
- Not about rational, individual decision making: it is about the way decisions aggregate to create market equilibrium
- Overall risk cannot be eliminated through diversification
- Explains how to evaluate risky investment opportunities
- Uses concept of stock’s beta to assess the level of risk premium
Assumptions:
- Investors have a single period transactrion horizon
- market participants are risk-averse and look to maximize their utility
- Investors are price takers i.e. cannot influence prices via their individual decision making
- market participants have homogenous expectations regarding the returns on their securities
- Risk-free investment (i.e. risk-free returns can be generated)
- perfect capital market exists
What is Beta in the measure of risk?
What can be an issue regarding beta?
Important indicators to calculate within the CAPM.
Standardised measure of risk exposure of stocks or securities.
- Relative measure of risk
- Indicates the sensitivity of the return of an asset or security
Regression analysis to calculate beta.
Issue:
- CAPM is a single-period model referring to anticipated values but beta for the future is unknown
- Ex post values are used as basis for estimation of beta (monitoring period and level of precision have significant influence on beta)
- Beta is therefore not stable and can be subject to considerable fluctuations
What is the difference between loss and risk?
Risk and loss are not the same
An expected loss is not a risk
Risk is only unexpected potential loss.
Risks can be managed; loss should be avoided (e.g. by diversification)
What are price market risks?
Name five examples.
Price market risks are changes in the price of stocks, bonds and currencies due to market movements and/or changes in the yield curve and volatilities.
Currency risk: devaluation of foreign currency in which the investment is denominated. exchange rate of foreign currency into home country currency.
Inflation risk: devaluation of cash due to increase in price levels
Interest-rate risk: deviation from an expected rate of interest or adverse development of interest-rate (affects fixed- or floating-interest securities)
can be divided into:
- reinvestment risk and price risk: reinvestment = likelihood that an investor will need to reinvest at a higher rate than planned
- price risk: fixed-interest securities are subject to an price risk; if market-rate interest moves follow the purchase of fixed-interest rate securities = price of bond changes since the coupon payment amount is fixed
Equity price risk: possibility of negative movement in individual securities or assets as a result of reductions in price
Commodity risk: all losses as a result of unfavourable movement in the prices of commodities.
Next to the price market risks, which additional risks need to be assessed?
Country risk: can arise as a result of convertibility, transfer, freezing of payment on part of the country (hazard of political intervention in the financial market); foreign exchange restrictions
Liquidity risk: temporal structure of payment flows cannot be maintained at the level of quality sufficiently adequate to ensure liquidity.
Capital maintenance: possibility that the investor could lose some or all of the capital in the event of bankruptcy
Information risk: not all necessary information are available; particularly with involvement of intermediaries: asymmetries in information putting investors at a disadvantage
Settlement and management risk: misappropriation or disloyal management of capital places by the investor
Advocacy risk: representative exploits an investor’s interest to a disadvantage
Conditions risk: change of acquiring an investment at unfavourable terms.
Name all relevant risks that need to be managed.
Market price risks:
- currency risk
- inflation risk
- interest-rate risk (reinvestment and price risk)
- equity price risk
- commodity risk
Additional risks:
- country risk
- liquidity risk
Special investor risks:
- capital maintenance risk
- information risk
- settlement and management risk
- advocacy risk
- conditions risk
What can be done to minimise risk?
Name two measures.
Risk must be minimised within the scope of risk management.
Appropriate processes must be developed for identifying, measuring and managing financial risk.
Two measures:
- Sharpe ratio
- Treynor ratio
What is the purpose of the sharpe ratio?
How is it calculated?
Measure for risk management to identify, measure and manage financial risk
Provides measure of the excess return generated per added unit of absolute risk. Explicitly accounts for zero-risk interest.
“Reward-to-variability-ratio”
Calculated:
Quotient of its excess return and its total historical risk
SR = (portfolio return - risk-free rate of return) / standard deviation (volatility)
–> The higher the higher the performance; ranking possible
Every additional percent of risk is compensated with a risk premium of X (result)
What are advantages and disadvantages of the sharpe ratio?
+ intuitive interpretation of performance
+ simplicity of calculation
+ comparability
- lack of comparison with overall risk
- offers no insight into the composition of portfolio risk
What is the Treynor Ratio?
How is it calculated?
Risk management context:
Identifies the excess return generated per unit of added undiversifiable risk
“reward-to-volatility ratio”
Calculation:
Quotient of its excess return and its systematic or undiversifiable risk.
TR = (portfolio return - risk-free rate of return) / beta
–> Rating possible; absolute key ratio
What are pros and cons of the Treynor Ratio?
+ permits comparision with other portfolios and benchmarks
+ requires a determination of beta instead of the standard deviation
+ together with sharpe ratio can result into insights in portfolio structure
- disregards unsystematic risk
How is return calculated?
What types can differentiated?
Calculated:
Without subsequent outflows or inflows of funds.
Return = ((investment value at a later point in time / investment value now) -1) *100
–> Percentage change in the value of the initial investment
Return can be time-weighted and money-weighted.
What is a time-weighted return?
Is a return approach to measure historical performance, which compensates for external cash flows.
Net movements of value , which result from transfer into or out of the initial investment or portfolio.
Broken down into several periods
What is a money-weighted return?
Takes money value of cash flows into account
Starting value of the portfolio at the beginning of the year, end-of-year value and the cash flow attributed to the months involved.
Highly dependent on the timing of an investment or withdrawal (e.g. unfavourable time)
Money-weighted = internal rate of return
Indicates not only the timing of payment but also of what the market situation was like.
–> If money-weighted return is less than time-weighted return the investor’s timing of deposits and withdrawals was unfavourable.
What are the tasks of stock analysis?
What is the overall goal?
- Systematically compile and analyze all information pertaining to a company and its environment
- Come up with short- and long-term forecasts of trends in the price of a company’s stock
- Information collection and processing
- fundamental and market-based assessment
- outlook, forecast, scenarios
4 portfolio analysis
–> Goal: facilitate decision-making for selection, timing and asset allocation
Which methods for stock-price analysis can be applied?
Objective and subjective components
Objective =
- fundamental analysis
- technical analysis
- innovative methods
Subjective =
- surveys of experts
- intuitive methods
What is fundamental analysis?
To which type of stock-price-analysis does it belong?
- Each stock has an intrinsic value (fair value) based on internal and external data.
- A share can be over- or underrated based on its intrinsic value vs. the current market price.
- Factors to influence stock price: macro- and microeconomic data to be analyzed
Intrinsic value calculation with discounted clash flow method –> complex
Fundamental analysis = key ratio like
- price/earnings ratio (P/E) = price / earnings per share
- price/cash flow ratio (P/CF) = price / cash flow per share
Objective type of stock price analysis
What is the issue with P/E parameters?
How can this parameter be supported?
- Price per earning is a retrospective parameter
- Current price in relation to the companies last know annual earnings
- Market participants expectations (e.g. future earnings or lower risk) influence the price and are not factored in
- highly dependant on accounting standards in country (international comparability very questionable )
Supported by price/cash flow parameter P/CF to factor in cash flow as future oriented parameter.
What are pros/cons of P/CF parameters?
Defines the ratio of stock price to cash flow per share.
+ Cash flow considers a companies future flows of cash (future oriented) less malleable that the company’s profit.
+ Especially useful in international context (more meaningful statement for assessing a company (depreciation, amortisation and provision is taken into account; therefore disregard differences in accounting standards)
- bad investment = write-down but is not reflected in the P/CF
–> Should only be considered complementary
What can be influences on the share price of a company?
Actual share price is induced by a variety of influences:
- market participants’ expectation relative to economic trend
- sentiment indicators (i.e. positions of market participants)
- Future contracts (permit conclusions about market participants position)
- Forecasts of larger firms have impact on stock prices
- Speculative reasons as a result
What is the purpose of technical analysis?
What methods does it use?
What are the underlying hypothesis to apply technical analysis?
Technical analysis aims to forecast stock-prices.
Deals exclusively with price and trading volume trends of securities.
Forecasting methods are chart analysis as well as mathematical forecasting systems
Classic methods offer graphic presentation of stock price trends drawing on past price data to provide orientation for future price trends
Hypotheses for future development:
- price trends are the result of supply and demand
- numerous rational and irrational factors –> market constantly compensates
- prices tend to develop along lines of predictable phases and trends
- forecast changes in basic direction by changes in supply and demand
- past patterns by influencing factors repeat themselves because of human behaviour (under similar circumstances)
What is technical analysis?
Technical analysis aims to forecast stock-prices.
Deals exclusively with price and trading volume trends of securities.
Forecasting methods are chart analysis as well as mathematical forecasting systems
“chart technique”
Broken down into
- presentation analysis = follows trends in chart form
- formation analysis = examines geometric price trends (triangles; head-and-shoulder formations) to predict future price trends
- market analysis = trends and potential zones of support and resistance (make use of certain indicators)
What are innovative methods of analysis?
Chaos theory and neural networks
Chaos theory:
- assumes that movements in stock prices are not random but based on complex patterns
- assumes prices follow a nonlinear, dynamic process = effects are not just linear outcomes but causes influence on the cause (feedback) self-reinforcing effect
Neural networks:
- first artificial neural networks
- computer based to simulate models of learning (theory of learning)
- neural network processes are not yet widely utilized in practise
What is a capital structure?
Which distinctions can be made?
Refers to the composition of total funds (debt, equity and hybrid securities) that a company has at its disposal to finance its operations and growth.
- Equity capital provided by owners.
- Capital provided by creditors in form of debt capital.
What is an equity interest?
What is specific about it?
Grants specific rights to its owner including
- voting rights
- share of company profits
- share of company’s assets in the event of liquidation
Does not entitle to a compulsory return or any repayments.
What are debt securities?
- does not grant the right of influence
- credit is granted for limited duration
- legal entitlement to repayment
- creditors neither profit from gains made nor are affected by losses incurred
- receive a fixed income from debt security in form of interest payments
What does the term leverage effect refer to?
If ROI is constant then borrowing additional funds will result in increased income provided that the interest on borrowed capital remains lower than the overall income derived from the investment.
Starting point for capital structure optimization.
Focus on debt:equity relation in capital structure.
Basic theorem: The higher the debt the higher the return on equity.
Describe the characteristics of the net income approach of the traditional theorem of capital structure.
Extreme view of the optimal capital structure by Durand.
The capital structure decision is relevant for the valuation of a company based on the assumption:
- Cost of debt is lower than the cost of equity
- risk perception of investor does not change with the use of debt
- No personal or corporate income taxes exist
- -> Result: Ratio of debt to equity increases, the cost of capital will decline while the value of the company as well as the share price will increase.
- -> Debt financing to the maximum possible extent
Describe the characteristics of the net operating income approach of the traditional theorem of capital structure.
Extreme view of the optimal capital structure by Durand.
Capital structure is irrelevant and unrelated to the company’s value:
- cost of debt is lower than cost of equity
- risk perception of lenders of debt does not change with leverage (=consistent)
- market determines the value of a company as a whole (debt:equity split is irrelevant)
- no personal or corporate income taxes exist
- -> Because of risk perception of owners they will expect higher returns if the amount of debt increases –> Will offset any savings from lower costs for debt
- -> Capital structure does not affect the overall cost of capital = market value does not change
What is the traditional theorem?
Name three effects that can be observed.
Aims for a compromise between net income approach and net operating income approach.
Optional debt ratio (leverage) exists, when the average cost of capital is minimized.
Increases in a company’s debt proportion or leverage ratio increases the return for equity holders.
Observed Effects:
- Increasing the use of debt ensures that expensive equity is replaced by cheaper borrowed funds. WAAC will decrease as an result of increased level of debt.
- As indebtness increases, so does the risk related to owners’ tied-up equity; in turn increasing the return
- Level of debt is high = outside creditors view their shares as risky due to increased risk of insolvency; new creditors only when additional risk premiums are accepted - cost of indebtness increases
What is the Modigliani-Miller Theorem?
What are the underlying assumptions?
Asserts that under perfect market conditions, the market value of a company cannot be increased by altering the claims on its asset (i.e. changing debt-equity ratio)
Capital structure is irrelevant.
Assumptions:
- investment policy is taken as given
- investors demand a certain average gross return on their investment (same expectations)
- Companies can be divided into homogenous risk classes
- Allocating a company to a certain risk class permits a comparison with known market values of other companies in the same class
- perfect capital market exists (same risk class without debt = WACC is the same; price per share of profits is the same); no transaction cost, etc.
- equity investors have expectations in terms of their effective returns
- Borrowing costs are independent of debt-equity ratio
- interest rate on capital investments and borrowing is uniform
- Companies finance operations through risk-free debt capital or equal equity
- Cash flows are assumed to continue in perpetuity
What is the main difference between Modigliani-Miller Theorem and the traditional theorem?
Cost-of-equity rate does not remain constant even if there is a change in the amount of risk-free securities issued.
What are dividends?
Describe the dividend policy according to Modigliani-Miller.
Dividends are portions of a stock corporations’ profits distributed to stockholders.
M&M:
- irrelevance of company capital structure extends to dividend policy = self-financing by retaining earnings and profit distribution followed by issuing new shares
- dividend policy has no effect on the company’s value
What are drawbacks from the M&M model?
Highly simplified assumptions = unrealistic
No taxes or transaction costs are taking into account.
They can significantly influence the total value of a company
What are transaction costs and how do they occur?
Transaction costs must be evaluated when considering an optimal capital structure.
Arise through purchase of sales and securities.
Represent an outflow of funds with the result, that the free cash flow falls and accordingly the market value of a company.
Level of transaction costs is dependent on type of financing used –> typically lower when debt capital is used (profit participation of equity)
How is the capital structure influenced by taxes?
Taxes need to be taken into account when defining the value of a company.
Company value drops if taxes are brought to the equation (high taxes, lower cash flow, lower value)
Taxation is basically irrelevant to the relationship of debt-equity ratio and the company valuation because borrowing costs are usually tax deductible –> cheaper to use debt than equity capital (tax shield)
Value rises if debt increases
What are agency cost and what influence to a capital structure of a company do they have?
Usually neglected in the neo-classical models.
Arise as a result of separating ownership and management.
= monitoring cost (control expenditure and information acquisition)
= bonding cost (agent is trying to act credible to convey promises)
= residual loss (not economically viable to monitor all manager’s actions)
Agency cost lower the value of a company.
Describe the characteristics of the neo-institutional model.
Interests are intensifying when increased indebtedness of a company
neo-inst. models help to minimize the agency cost and reduce and optimize cost of capital.
Rising debt ratio is problematic with agency relationship
- new debt has negative impact on bonds already issued
- owners have strong interest to increase the value of their capital
–> Creditors are as a result more willing to expose themselves to risk = deterioration of capital structure
More unlikely to repay obligations (risk of bankruptcy)
Basic theory: market value keeps increasing until the marginal change in NPV of the tax savings is equal to the marginal change in capital value of the bankruptcy costs (optimal debt ratio) –> trade off theory
Describe “trade off theory”.
Increased indebtedness of company = decreasing likelihood to repay obligations = higher risk of bankruptcy
The market value keeps increasing until the marginal change in NPV of the tax savings is equal to the marginal change in capital value of the bankruptcy costs (optimal debt ratio) –> trade off theory
How do taxes change dividend policies?
Significant changes because taxes rates for retained and distributed profits exist.
Tax rate for distributed profit is lower than for retained profit it makes sense to distribute profits first and then appeal to the shareholders to reinvest. “pay out and plough back” policy.
Countries different tax systems must be considered when planning global policies.
How is the company value of levered company V(l) calculated?
Company value of all-equity firm V(u) - net present value of transaction cost \+ net present value of tax benefits from borrowed capital (tax shield) - net present value of insolvency cost - net present value agency cost
= company value of levered company V(1)
What are issues when trying to determine an optimal debt-to-equity ratio?
Large number of constraints involved
- Political aspects
- industry practices
very difficult to determine an optimum and not achievable in real-life
What are the four basic types of financing?
- External financing with debt = funds are provided for a certain time for a rate of interest (EXTERNAL + DEBT)
- Accrued liability reserves = from company’s own resources to finance current or future assets (INTERNAL + DEBT)
- External financing with equity = provided from outside by existing or new shareholders (important for startup or expanding) (EXTERNAL + EQUITY)
- Funds from retained earning = surplus of financial resources flowing into the company from business activities and out for goods or dividends (INTERNAL + EQUITY)
What is mezzanine financing?
Type of financing of both equity and debt.
Loan is provided that gives providers right to convert to equity if it is not paid in time and in full.
Treated as equity on balance sheet.
What is the fundamental difference between equity and debt financing?
Debt capital from creditors must be replayed in full at the agreed a timeframe.
Interest rates must be paid.
Contractual agreements as basis.
Greater security in case of bankruptcy
No right to control; no impact from losses or profits
Can lead to liquidity issues due to fixed amounts of payment of interest and principal
