Corporate Finance Flashcards
Lessons from capital market history
There is a reward for bearing risk.
Greater the risk, Greater the reward.
It is called risk return trade-off
Total Dollar Return
Income from investment + Capital gain
Dividend Yield (PR)
Income / Beginning Price
Capital Gains Yield
(Ending p - Beginning p) - Beginning p
Total Percentage Returns
Dividend Yield - Capital Gains Yield
Importance of Financial Markets
Businesses have to go to financial markets and institutions for the financing they need to GROW.
5 Important Types of Financial Markets
Large Company Stocks, Small “, Long Term Corporate Bonds, Long Term US government bonds, US Treasury Bills
Best Guess About the size of the RETURN for a year selected Random
%11.8
Risk-free rate
the Rate of Return that can be earned with CERTAINTY.
Risk Premium
the excess return required from an investment in a risky asset over that required from a risk-free investment.
Variability Measured by Standard Deviation
It measure the uncertainty of asset returns, GREATER THE UNCERTAINTY, GREATER THE TOTAL RISK.
Standard Deviation
Square root of the VAR(R)
Variance
VAR(R)
Arithmetic Average
Return earned in an AVERAGE PERIOD over MULTIPLE PERIODS
Geometric Average
Average COMPOUND RETURN per period over MULTIPLE PERIODS
Arithemtic Average is
Overly optimistic for LONG HORIZONS
Geometric average is
Overly pessimisticfor SHORT HORIZONS
EFM (Efficent Market Hypothesis)
New info. is assimilated quickly & correctly into financial asset prices.
When Financial Markets are Efficent?
When new info becomes available, people buy and sell stocks and bonds try to incorporate new info into their estimates of the security.
According to EFM,
Stock prices are in equilibrium, Stocks are fairly priced informational efficiency.
What Makes Markets Efficent?
As new info comes to market it is being analyzed and trades are made based on this info. Prices should reflect all available public info. IF INVESTORS STOP researching stocks, then the market WONT be efficent.
Strong-Form Efficent Market
Info is Public or Private, INSIDE INFO IS BEING USED.
Semistrong-form Efficent Market
Info is publicly available. Fundamental ANALYSIS IS BEING USED.
Weak Form Efficent Market
Info is past prices and volume data. Technical ANALYSIS IS OF LITTLE USE.
Common Misconceptions about EMH
EM do not mean that you can’t make money, They do mean that: on average you will earn a return that is appropriate for the risk undertaken.
Market efficiency will not protect you from wrong choices if you do not diversify.
Portfolios
It is a collection of assets, An asset’s risk and return is how they effect the risk and return of a portfolio. The risk-return trade-off for a portfolio is measured by the portfolio expected return adn standard deviation, JUST AS WITH INDIVIDUAL ASSETS.
Expected Return on a Portfolio
Wealth-weighted average of the returns expected from the assets held in the portfolio.
Portfolio Variance
The combination of the WEALTH-WEIGHTED AVERAGE of the variances of the two assets and their covariance.
Systematic Risk
Component of total risk which is due to economy-wide factors.
Non-systematic Risk
Component of total risk which is unique to an asset or firm.
Diversification (Formula)
Total Risk = Systematic Risk + Nonsystematic Risk
Principle of Diversification
Spreading an investment across a number of assets will eliminate some, but not all of the risk.
Measuring Systematic Risk
We use the BETA Coefficent.
Security Market Line
Representation of Market Equilibrium
Capital Asset Pricing Model (CAPM)
A Model that RELATES the REQUIRED RATE of return on a security to its systematic risk as measured by BETA
Covariance and Correlation
Covarience term measures HOW returns change together
Risk of Portfolio
Represents the amount of risk that the organization is currently exposed to.
NPV
Net Present Value
What is NPV?
NPV is the PV of future cash flows - the cost of the investment. If the NPV is ABOVE ZERO then it’s a GOOD INVESTMENT.
Calculating NPV Steps
1- Estimate expected future cash flows
2- Estimate the required return
3- Find the present value of the cash flows
What is PP? (Payback Period)
Amount of time required for an investment to generate CASH FLOWS SUFFICENT to RECOVER ITS INITIAL COST.
Adv. Of PP
Easy to understand - Adjusts for uncertainty of later cash flows. Biased Towards Liquidity
Disadv. Of PP
Time value of money and risk is ignored - Ignores cash flows beyond the cut-off trade. Biased against LONG-TERM and NEW PROJECTS.
Disadv. Of PP
Time value of money and risk is ignored - Ignores cash flows beyond the cut-off trade. Biased against LONG-TERM and NEW PROJECTS.
What is CUT-OFF Trade?
The daily cut-off is the time that forex dealers set that distinguishes the end of one trading day from the beginning of the next
Discounted Payback Period
Takes into account as TIME VALUE OF MONEY. More difficult to Calculate - Length of time required for an investments discounted cash flows to EQUAL its INITIAL COST.
What is Initial Cost?
Initial cost is the average cost of purchasing or manufacturing your stock on hand.
Adv. of Discounted Payback
Includes time value of money.
Easy to understand.
Biased towards liquidity.
Disadv. of Discounted Payback.
May reject positive NPV investments.
Biased against long-term and new products.
Accounting Rate of Return
Measurement of an investments profitability.
Adv. of ARR (Accounting Rate of Return)
Easy to calculate and understand, ALMOST Always available.
Disadv.of ARR
Measure is not a true reflection of return. Time value is ignored
Internal Rate of Return (IRR)
DISCOUNT RATE that makes the NPV of an investment zerov
Adv. of IRR
Popular in practice, does not require a discount rate.
Disadv. of IRR
More than one negative cash flow. Project is not INDEPENDENT.
Present Value Index (PVI)
Expresses a projects benefits relative to its initial cost.
Adv. of PVI
Closely Related to NPV, generally leading to identical decisions.
Disadv. Of PVI
May lead to incorrect decisions in comparisons of mutually exclusive investment.
Disadv. Of PVI
May lead to incorrect decisions in comparisons of mutually exclusive investment.
Capital Budgeting in Practice (SUM OF THEM)
We should consider several investment criteria when making decisions: NPV and IRR are the most commonly used primary investment criteria. Payback is a commonly used secondary investment criteria.
Capital Budgeting in Practice (SUM OF THEM)
We should consider several investment criteria when making decisions: NPV and IRR are the most commonly used primary investment criteria. Payback is a commonly used secondary investment criteria.
Considerations in International Financial Management
Have to consider the effect of exchange rates when operating in more than one currency.
Have to consider the political risk associated with actions of foreign governments.
More financin opportunutiies when you consider the international capital markets and this may reduce the firm’s cost of capital.
International Finance Terminology
Cross-rate
Eurobond
Eurocurrency
Foreign Bonds
Gilts
London Interbank Offer Rate
Swaps
Global Capital Markets
Number of exchanges in foreign cuntries continues to increase, as does the liquidity on those exchanges.
Exchange Rates
Price of one country’s currency in terms of another. All currencies are in some way quotes to U.S. Dollars.
Exchange Rates
Price of one country’s currency in terms of another. All currencies are in some way quotes to U.S. Dollars.
Transaction Terminology
Spot trade (Exchange currency immediately) exchange rate for an immedite trade.
Forward trade (Agree today to exchange currency at some future date.) exchange rate specified in the forward contract.
Absolute Purchasing Power Parity
Transaction costs are zero.
No barriers to trade.
No difference in the commoditiy between locations.
Relative Purchasing Power Parity
Provides information about what causes changes in exchange rates.
Interest Rate Parity
There must be a forward rate that would prevent the arbitrage opportunity.
Short Run Exposure
Risk from day to day fluctuations in exchange rates.
Short Run Exposure
Risk from day to day fluctuations in exchange rates.
Long Run Exposure
Fluctuations come from UN-ANTICIPATED CHANGES in relative economic governments.
Translation Exposure
Income from foreign operations has to be translated back to domestic currency.
Political Risk
Changes in value due to political actions in the foreign country.
Overseas Production: Alternative Approaches
Home currency approach - foreign currency approach
Home Currency Approach
Estimate Cash flows in foreign currency, estimate future exchange rates using UIP (Uncovered interest rate parity)
Foreign Currency Approach.
Estimate cash flows in foreign currency. Use the IFE to convert domestic required return TO foreign required return.
