Corporate Finance Flashcards

Question 1

Q

Week 1 Risk Return - What has the highest return if invested $1 in 1900 and valued in 2007?

Portfolio of Treasury Bills
Portfolio of U.S government Bonds
Portfolio of U.S common stock

Answer

A

Portfolio of Treasury Bills: $71

Portfolio of U.S government Bonds: $242

Portfolio of U.S common stock: $14,276

Question 2

Q

Week 1 Risk Return - Given the following portfolios:

Portfolio of Treasury Bills
Portfolio of U.S government Bonds
Portfolio of U.S common stock

What is can be said about the attributes of each?

Answer

A

Treasury Bills: No default risk and relatively stable prices.

U.S government Bonds: Prices fluctuate with interest rates to remain competitive (bond price down when interest rate up). Newly realeased bonds may have different coupon payments so the existing bonds adjust to remain competitive.

Portfolio of U.S common stock: Risk subject to interest rate changes and the volatile of the stocks.

The higher the risk, the higher the expected return required by investors.

Question 3

Q

Week 1 Risk Return - r|p|?

Answer

A

The Expected Return from a portfolio of N securities, being the weighted average of expect returns from the single securities in the portfolio.

Question 4

Q

Week 1 Risk Return - r|p| equation?

Answer

A

w|1| r|1| + w|2| r|2| + … + w|N| r|N|
= Σ w|i| r|i|

where w|i| is the weight of the security in the portfolio and will be the percentage (in decimal terms)

equally be 0.XX, where xx is the expected return.

Question 5

Q

Week 1 Risk Return - What is the rate of return of a stock? (formula) - CHECK THIS

Answer

A

r = [ { p(t) - p(t - 1) } / p(t-1)] * 100

Question 6

Q

Week 1 Risk Return - Aside from expected return, what are two possibly equivalent measures of risk?

Answer

A

Variance and Standard Deviation.

Question 7

Q

Week 1 Risk Return - Variance Formula and interpretation?

Answer

A

σ² = 1/N [Σ (x|i| - μ)²]

The mean of the squared deviations from the mean.

It is a measure of volatility.

If 0, the portfolio is riskless.

Question 8

Q

Week 1 Risk Return - When talking about the risk of a portfolio, what are we really talking about?

Answer

A

Idiosyncratic Risk (Stock specific or unsystematic): The risk associated with each individual security.

Systematic Risk (Macro Risk): The degree to which the securities covary, being the covariance between securities.

Question 9

Q

Week 1 Risk Return - Covariance In terms of the standard deviation and correlation coefficient of two stocks?

Answer

A

σ|12| = ρ|12| σ|1| σ|2|

σ|12|: the Covariance of the two securities.

σ|i|: the variance of security i.

ρ|12|: The correlation coefficient between security 1 and 2.

Question 10

Q

Week 1 Risk Return - Given the covariance definition “ σ|12| = ρ|12| σ|1| σ|2| “, write the formula for risk (variance) of a portfolio.

Answer

A

σ|p|² =
Σ|i=1| Σ|j=1| w|i| w|j| σ|ij|

= Σ|i=1| Σ|j=1| w|i| w|j| ρ|ij| σ|i| σ|j|

σ|ij|: the Covariance of the two securities.

σ|i|: the variance of security i.

ρ|12|: The correlation coefficient between security 1 and 2.

Question 11

Q

Week 1 Risk Return -What will the portfolio volatility of a two stock portfolio be?

Answer

A

BA 1.

σ|p|² =
Σ|i=1| Σ|j=1| w|i| w|j| σ|ij|

σ|p|² = w|1|²σ|1|² + w|2|²σ|2|² + 2w|1| w|2| σ|12|

where σ|12| = ρ|12| σ|1| σ|2|

The following equation is therefore equivalent:

σ|p|² = w|1|²σ|1|² + w|2|²σ|2|² + 2w|1| w|2| ρ|12| σ|1| σ|2|

Question 12

Q

Week 1 Risk Return - Given the two security portfolio variance equation:

σ|p|² = w|1|²σ|1|² + w|2|²σ|2|² + 2w|1| w|2| σ|12|,

What is the interpretation of each part?

Answer

A

w|1|²σ|1|²: Component due variance (idiosyncratic risk) of security 1.

w|2|²σ|2|²: Component due variance (idiosyncratic risk) of security 2.

2w|1| w|2| σ|12|: Component due to the covariance between security 1 and security 2 (systematic risk).

Each security contributes w|1| w|2| σ|12| worth of systematic risk.

Question 13

Q

Week 2 Risk Return - Consider a portfolio of securities with expected return r|p| = 20% and standard deviation σ|p| = 50%. Suppose the composition of the portfolio is changed, such that the standard deviation reduces. What is this an example of?

Answer

A

Diversification.

Question 14

Q

Week 2 Risk Return - What iii diversification with a portfolio?

Answer

A

To get at least the same return with lower risk, or lower risk and a lower return.

It is not diversification if the expected return falls though and the risk remains the same.

We need the expected return to stay the same (or improve) AND the portfolio risk to fall (So the standard deviation to fall.

Question 15

Q

Week 2 Risk Return - Given the portfolio risk equation for two stocks:

σ|p|² = w|1|²σ|1|² + w|2|²σ|2|² + 2w|1| w|2| σ|12|,

What additions would be made if there were three stocks.

Answer

A

We would add

w|3|²σ|3|² + 2w|1| w|3| σ|23| + 2w|2| w|3| σ|23|

So the idiosyncratic risk associated with the additional stock and the systematic risk due to the covariance with the third stock with the other two stocks.

Question 16

Q

Week 2 Risk Return - If you have calculated the portfolio variance of two stocks and want to calculate the standard deviation when adding a further stock, what would the process be?

Answer

A

You could start from scratch and calculate using the equation, or, given the knowledge of the first portfolio variance, use this to get the standard deviation and use the equation counting the portfolio as a solitary security.

Question 17

Q

Week 2 Risk Return - When N securities are uncorrelated, what is the portfolio S.D?

Answer

A

σ|p| = [w|1|²σ|1|² + w|2|²σ|2|² + … + w|N|²σ|N|²]^1/2

SO the second part of the equation is removed (the systematic risk) leaving only the stock specific idiosyncratic risk.

Question 18

Q

Week 2 Risk Return - How do we get to the risk pooling result in which variance is equal to 0 when N approaches infinity and what other axioms are required?

Answer

A

We assume stocks are uncorrelated (strong and unrealistic assumption) so
σ|p| = [w|1|²σ|1|² + w|2|²σ|2|² + … + w|N|²σ|N|²]^1/2

We then assume each share has the same variance and weighting, so w|I| become 1/N

The whole equation simplifies to:

(N * 1/N² σ²) ^1/2 =
(1/N σ²) ^1/2

As N approaches infinity, σ|p| approaches 0 (as this is what we were using the equation to find).

As more and more uncorrelated risks are pooled together, total risk is reduced.

Question 19

Q

Week 2 Risk Return - Market Risk?

Graph?

Answer

A

The risk that cannot be eliminated through optimal diversifying the investment portfolio.

It is the risk driven by the economy as a whole.

See BA 2 for graph.

Question 20

Q

Week 2 Risk Return - Total Risk?

Answer

A

Total Risk = Diversifiable risk + market risk.

It is the contribution of an individual security to the risk of a portfolio.

Diversifiable risk contributed to unique risk and can be eliminated through diversification.

Only market risk contributes towards risk of a well diversified portfolio.

Question 21

Q

Week 2 Risk Return - What does risk pooling show?

Answer

A

That there is one type of risk that cannot be diversified away from, being market risk,

Question 22

Q

Week 2 Risk Return - Beta (β)?

Answer

A

A measure of sensitivity of the stock, being how much the stock fluctuates given a change in the market (Purely Theoretical)

The market is made up of all stocks, so has a β=1 (this is an assumption)

Securities that move in the same direction but tend to amplify the movement of the market have β > 1.

Those that move in the same direction as the market but tend to reduce the movement have 0 < β < 1.

They will move up or down with the market.

Stocks that move opposite the market are very rare.

Question 23

Q

Week 2 Risk Return - Beta (β)?

Answer

A

The systematic risk part.

The covariance of the asset with the market portfolio return divided by the variance of the market portfolio

A measure of sensitivity of the stock, being how much the stock fluctuates given a change in the market (Purely Theoretical)

The market is made up of all stocks, so has a β=1 (this is an assumption)

Securities that move in the same direction but tend to amplify the movement of the market have β > 1.

Those that move in the same direction as the market but tend to reduce the movement have 0 < β < 1.

They will move up or down with the market.

Stocks that move opposite the market are very rare.

Question 24

Q

Week 2 Risk Return - How do we calculate β?

Answer

A

r|i| = α + β|i| r|m| + error|i|

r|m| : Return of market portfolio.

r|i| : Return on security

We use linear regression to calculate the slope of the line.

β|i| = σ|im| / σ|m|²

The beta is the covariance between stock and the market scaled by the variance of the market.

Question 25

Q

Week 2 Risk Return - What is a well diversified portfolio?

Answer

A

A portfolio that has low unique risk and mainly consists of market risk.

Question 26

Q

Week 2 Risk Return - Markowitz Portfolio Risk - Efficient Portfolios?

Answer

A

The combination of securities that create the OPTIMAL combination of expected returns and standard deviations.

Optimal means diversifying away specific risk.

On a graph showing risk and returns, these will be the points to the far left of the possible combination and then all the way to the greatest standard deviation in attainable.

The point will be dependent on the risk averseness/ love of the investor, but an point should be selected along the efficient frontier.

Question 27

Q

Week 2 Risk Return - See BA 3. What is this function representative of and when should it be used?

Answer

A

See BA 3.

Question 28

Q

Week 2 Risk Return - If the daily returns are distributed approximately by the normal distribution, what does this lead us to say?

Answer

A

The expected value and variance (or standard deviation) of a portfolio are the only measures an investor needs to consider.

This is because the normal distribution can be calculated using only these two, as shown in BA 3.

Question 29

Q

Week 2 Risk Return - When evaluating a two security portfolio, how would the variance and expected return vary with different weighting?

Answer

A

Only the idiosyncratic risk will be altered, being the first two additions in the equation.

The portfolio SD and r are functions of the amount invested in each company, when there is no perfect correlation (+ or -)

Question 30

Q

Function of meaning?

Answer

A

Something (such as a quality or measurement) that is related to and changes with (something else) Height is a function of age in children. It increases as their age increases.

So part of the equation that make sure the y.

Question 31

Q

Week 2 Risk Return - Explain the graph in BA 4.

Answer

A

A graph showing the resulting portfolio r and σ given different combination of w in a two stock portfolio.

The blue line represents that risk reward payoff.

Question 32

Q

Week 2 Risk Return - Efficient Portfolios?

Answer

A

Lie on the efficient frontier and offer the highest expected return for a given level of risk, or the lowest level of risk for a given expected return.

Question 33

Q

Week 2 Risk Return - r|f|?

Answer

A

The investors can borrow at the risk free rate, r|f|.

Question 34

Q

Week 2 Risk Return - With the introduction of lending money, how would this effect the S.D and expected returns ?

Answer

A

The expected returns would just the proportion of money in each tool multiplied by the expected return.

When lending, the S.D is 0. Therefore, the S.D of a combination of a portfolio and lending would just be the weighting of S that is in the portfolio multiplied by the S.D of the portfolio.

Question 35

Q

Week 2 Risk Return - With the introduction of borrowing money, how would this effect the S.D and expected returns ?

Answer

A

Expected returns: The amount of wealth compared to initial wealth due to borrowing * expected return of S minus the amount of wealth borrowed * interest rate

S.D: The amount of wealth compared to initial wealth due to borrowing * Standard deviation of S minus the amount of wealth borrowed * interest rate

Question 36

Q

Week 2 Risk Return - Looking at BA 5, Explain the graph.

Question 37

Q

Week 2 Risk Return - If you have a graph of efficient portfolios, and know the risk free rate r|f|, how would you add the borrowing and lending line?

Answer

A

Start at r|f| and draw the steepest line that touches the efficient frontier.

Question 38

Q

Week 2 Risk Return - Sharpe Ratio?

Answer

A

The ratio of risk premium to standard deviation:

Sharpe Ratio =
Risk Premium/ S.D =
(r - r|f|) / σ

Question 39

Q

Week 2 Risk Return - What are the shortcomings of the Markowitz Approach?

Answer

A

Zero taxes and transaction costs false.

Fractional securities are not available.

Credit limits constrain investors

Investors seem to have an influence on the market (large institutional investors)

Correlations between assets are never stable and fixed.

Past performance is not a good indicator of future performance.

Question 40

Q

Week 3 Asset Pricing - Why do Treasury Bills have a Beta value of 0?

Answer

A

Return is flex, so they are unaffected by the market, giving them a Beta value of 0.

Question 41

Q

Week 3 Asset Pricing - How do we get from Markowitz to the CAPM model?

Answer

A

Previously we looked at a market portfolio with Beta = 1 and treasury bills beta = 0/

What about when the Beta of the portfolio is not 1?

Question 42

Q

Week 3 Asset Pricing - What underpinning of the CAPM model?

Answer

A

In a Competitive Market, the expected risk premium varies in direct proportion to beta.

The risk premium is r|p| - r|f|, as at the risk free rate, the risk is 0.

This leads all investments to lie on the SECURITY MARKET LINE, being the line that is drawn from the r|f| on the y axis to the market portfolio r|m| and associated beta = 1.

e.g. the expected risk premium of an investment with beta of .4, will have .4 * the expected market risk premium.

Question 43

Q

Week 3 Asset Pricing - How do we get from Markowitz to the CAPM model?

Answer

A

Previously we looked at a market portfolio with Beta = 1 and treasury bills beta = 0.

What about when the Beta of the portfolio is not 1?

Question 44

Q

Week 3 Asset Pricing - What underpinning of the CAPM model?

Answer

A

In a Competitive Market, the expected risk premium varies in direct proportion to beta.

The risk premium is r|p| - r|f|, as at the risk free rate, the risk is 0.

This leads all investments to lie on the SECURITY MARKET LINE, being the line that is drawn from the r|f| on the y axis to the market portfolio r|m| and associated beta = 1.

e.g. the expected risk premium of an investment with beta of .4, will have .4 * the expected market risk premium.

CAPM assumed that investors are only concerned about the expected return and the risk of an investment strategy.

Question 45

Q

Week 3 Asset Pricing - CAPM - Expected risk premium on stock formula?

Answer

A

Expected risk premium on stock =
beta x expected risk premium on market

r - r|f| = β(r|m| - r|f|)

Question 46

Q

Week 3 Asset Pricing - What are the 5 basic principle of the CAPM model?

Answer

A

Investors like high expected return and low standard deviation. Common stock
portfolios that offer the highest expected return for a given standard deviation are
known as efficient portfolios.
If the investor can lend or borrow at the risk-free rate of interest, one efficient
portfolio is better than all the others: the portfolio that offers the highest ratio of risk
premium to standard deviation.

A risk-averse investor will put part of his money in this efficient portfolio and part in the risk-free asset.

A risk-tolerant investor may put all her money in this portfolio or she may borrow
and put in even more.

The composition of this best efficient portfolio depends on the investor’s assessments of expected returns, standard deviations, and correlations. But suppose everybody has the same information and the same assessments. If there is no superior information, each investor should hold the same portfolio as everybody else; in other words,
everyone should hold the market portfolio.

Now let us go back to the risk of individual stocks:

Do not look at the risk of a stock in isolation but at its contribution to portfolio risk.
This contribution depends on the stock’s sensitivity to changes in the value of the
portfolio.
A stock’s sensitivity to changes in the value of the market portfolio is known as beta.

Beta, therefore, measures the marginal contribution of a stock to the risk of the market
portfolio.

Now if everyone holds the market portfolio, and if beta measures each security’s contribution to the market portfolio risk, then it is no surprise that the risk

Question 47

Q

Week 3 Asset Pricing - CAPM - What if a stock does not lie on the security market line.

Answer

A

If a stock is below the line, the investor can attain higher return for that level of risk.

The price of A will have to fall until the expected return matches what you could get elsewhere.

Nobody will hold a stock with a lower return than β(r|m| - r|f|)

As no stocks can lie below the line, it must equally be the case that none lie above the line, as the market line is the average of all the securities in the market portfolio.

Question 48

Q

Week 3 Asset Pricing - What would the expected return be of a portfolio made up of a risk free asset and the market portfolio?

Show how we get the final equation using the expected return.

Answer

A

= w|m| r|m| + (1- w|f|) r|f|

Rearranging:

w|m| = (r|p| - r|f|) /
(r|m| - r|f|)

So the weight dedicated the market portfolio is the premium of the selected portfolio divided by the market premium.

Question 49

Q

Week 3 Asset Pricing - CAPM meaning?

Answer

A

Capital Asset Pricing Model.

An approach to establishing the reward for baring the systematic risk of a portfolio.

Question 50

Q

Week 3 Asset Pricing - Week 3 Asset Pricing - What would the S.D be of a portfolio made up of a risk free asset and the market portfolio?

What can this be simplified to?

Answer

A

σ|p| = √(w|m| x σ|m|)²
= w|m| x σ|m|

As the risk free asset has no standard deviation.

We then attain

w|m| = σ|p| / σ|m|

To find the proportion of investment in the market portfolio.

Question 51

Q

Week 3 Asset Pricing - Derive the Capital Market Line Equation.

Answer

A

From the standard deviation equation we found attained:

w|m| = σ|p| / σ|m|

From the expected return equation we attained:

w|m| = (r|p| - r|f|) /
(r|m| - r|f|)

We now make the above to equal and write in terms of r|p|:

σ|p| / σ|m| = (r|p| - r|f|) /
(r|m| - r|f|)

r|p| = r|f|) +σ|p| / σ|m| (r|m| - r|f|)

See BA 6 for a clearer representation.

Question 52

Q

Week 3 Asset Pricing - Explain the Capital Market Line Equation:

r|p| = r|f| +[(r|m| - r|f|)/ σ|m|] σ|p|

What will the graph be?

Answer

A

The slope of the line [(r|m| - r|f|)/ σ|m|] shows the rate at which risk σ|p| and return r|p| can be traded against each other on a portfolio as a combination fo the market portfolio and the risk free asset.

It shows how the return of a portfolio increases above the risk free amount and the assorted risk to attain the extra return.

See BA 7 for the graph.

Question 53

Q

Week 3 Asset Pricing - Given that portfolios on the capital market line are efficient, what can be said about the combinations and the correlation?

Answer

A

Portfolios on the capital market line are efficient portfolios.

This is because they are obtained as a combination of the market portfolio and the risk free asset: therefore, they are perfectly positively correlated with the market portfolio.

Formally, this means
that the correlation coefficient between a portfolio on the capital market line and the market portfolio is equal to ρ|pm| = 1.

Question 54

Q

Week 3 Asset Pricing - How do we derive the equation for a security market line, given that the capital market line is
r|p| = r|f| +[(r|m| - r|f|)/ σ|m|] σ|p|

Answer

A

We know that ρ|pm| = 1 for the capital market line and the portfolio as the portfolio is made up of a proportion of the market portfolio.

In general, it can be shown that:
r|p| = r|f| +[(r|m| - r|f|)/ σ|m|] σ|p|ρ|pm|

since σ|pm| = ρ|pm| σ|p|σ|m|,

we rewrite the CAPM line to be:

r|p| = r|f| +[(r|m| - r|f|)/ σ|m|] [σ|pm|/
σ|m|]

By analogy, a security:

r|i| = r|f| +[(r|m| - r|f|)/ σ|m|] [σ|im|/
σ|m|]

The β for security I is:

β|i| = σ|im|/
σ|m|²

{from OLS regression]

The Security Market Line is therefore:

r|i| = r|f| + β|i|(r|m| - r|f|)

Question 55

Q

Week 3 Asset Pricing - How does the graph for CAPM change when we swap from the capital market line to the security market line?

Answer

A

See BA 8.

Question 56

Q

Week 3 Asset Pricing - Interpret the security market line equation:

r|i| = r|f| + β|i|(r|m| - r|f|)

Answer

A

r|i| = r|f| + β|i|(r|m| - r|f|)

The expected risk premium (r|I| - r|f|) varies in direct proportion to the security beta β|i|. β|i| measures how sensitive security I is to market movements.

Therefore, the market only rewards market risk, because unique risk can be diversified away.

Question 57

Q

Week 3 Asset Pricing - ABT?

Answer

A

The arbitrage pricing theory.

Question 58

Q

Week 3 Asset Pricing - What does CAPM attempt to answer?

Answer

A

How returns on assets are determined.

You are required for bearing the systematic risk of the asset.

Question 59

Q

Week 3 Asset Pricing - What does the APT assume?

Answer

A

Each stock’s return depends on two components: some macroeconomic composes “factors”, and a “noise” component.

Return = a + b|1|(r|factor1|) + b|2|(r|factor2|) + …+ ε

Where:
r|factor1| is the return on the first factor, etc. b1, b2 etc measure the securities sensitivity to each factor.
ε: the noise.

The APT does not say what the factors are

Question 60

Q

Week 3 Asset Pricing - APT - What could some examples of the factors and what are they?

Answer

A

Market portfolios

Market capitalisation

GDP

Interest Rates

(anything macro economic)

The factors must be common factors across all securities, so they move the entire market, not just idiosyncratic (so they are only looking at systematic sources of risk).

Question 61

Q

Week 3 Asset Pricing - Why could unique risk be ignored when buying a stock?

Answer

A

Because the risk can be diversified away.

Question 62

Q

Week 3 Asset Pricing - What is a key difference between CAPM and the APT?

Answer

A

CAPM and the use of Betas of a security or portfolio simply shows how much the portfolio or stock moves relative to the market.

APT sheds some light on what these factors could be.

Question 63

Q

Week 3 Asset Pricing - APT - According to the APT, what does the risk premium (r - r|f|) depend on?

Answer

A

The expected risk premium associated with each factor (r|factor1| - r|f|), (r|factor2| - r|f|) etc.
The security’s sensticitiy to each factor b1, b2 etc.

Question 64

Q

Week 3 Asset Pricing - APT - What is the formula for the expected risk premium on a security?

Answer

A

r - r|f| = b|1|(r|factor1| - r|f|) + b|2|(r|factor2| - r|f|) + …

Answer 64

A

If b1 = b2 = 0, the risk premium (r -r|f|) = 0. This implies that a diversified portfolio contracted to have zero sensitivity to each macroeconomic factor is risk free and is priced to offer zero risk premium. If this were the case but r - r|f| > 0, a risk free arbitrage profit could be made by borrowing at rate r:f: to buy the asset that offer a rate r. If r - r|f| < 0, you could sell the asset offering rate r and make a risk free profit by lending at rate r|f|.
A portfolio constructed to be exposed to only factor (factor 2, 3 … =0) offers a risk premium that varies proportionally with the portfolio’s sensitivity to that factor (b1). i.e. if you have portfolios A and B, with portfolio A being twice as sensitive to factor 1, then must portfolio A must offer twice the risk premium of portfolio B.

Answer 65

A

Both stress that expected returns only depend upon economy wide market risk and should not be influenced by unique risk.

CAPM relies on the notion of market portfolio, and it may not always be possible to measure this. APT does not require this.

CAPM condenses all macroeconomic factors into one factor (the expected returns on the market portfolio). APT does not tell us the underlying factors.

Answer 66

A

Their impact on asset prices manifests in their unexpected movements
They should represent un-diversifiable influences (these are, clearly, more likely to be macroeconomic rather than firm-specific in nature)
Timely and accurate information on these variables is required
The relationship should be theoretically justifiable on economic
grounds

Answer 67

A

As with the CAPM, the factor specific betas are found via a linear regression of historical security returns on the factor in question.

Answer 68

A

Surprises in inflation;
Surprises in GNP as indicated by an industrial production index;
Surprises in investor confidence due to changes in default premium in
corporate bonds;
Surprise shifts in the yield curve.

Note : surpise = (expectation - realisation)

Answer 69

A

The price at time t of a stock reflects all the available information.

We factor in surprises (when the outcome goes against the consensus).

Say we have a consensus that the interest rate will increase by .5%. If in fact it increases by 0.75%, the model will need to be updated to reflect of difference, being 0.25%, which is the news.

The difference is the noise and the aim of a model is to minimise the noise and maximise what is explained by a model≥

Answer 70

A

We can use indices, spot or futures market prices as a reflection of the underlying factor. Multiple different variables can be attributed to one macro economic factor.

Answer 71

A

Short-term interest rates;
The difference in long-term and short-term interest rates;
A diversified stock index such as the SP 500 or NYSE Composite;
Oil prices
Gold or other precious metal prices
Currency exchange rates

Answer 72

A

A company’s mix of debt and equity financing. Refers to the decision about how to raise funds to conduct the business, specifically the decision between debt (borrowing) and equity (bringing in new partners).

Retained earnings are a first choice to raise funds and do not tend to be included.

Answer 73

A

Keep the profits in the firm rather than paying back to the owners. (AKA Plowback or retained earning)
Borrow the cash.
Bring in new partners (sources of cash)

Answer 74

A

Debt = Principal + accrued interest.

Debts are a cost to the firm, not the owners, and the company has a legal obligation to pay the debts. Failure to do so enables to the lender to seize assets of the company or force the company into liquidation.

Lenders do not own the company

Answer 75

A

The main two ways are:
1. loans from a bank/ private investor.

Issuing bonds, being a debt security that is (generally) traded on the market.

Answer 76

A

The issue of bonds by a firm is known as a primary issue, and they are sold on the primary market.

The initial creditor can sell on the bond to someone else without the company’s approval: these are known as secondary transactions, and take place in the secondary market.

Answer 77

A

A company can purchase its shares back from the secondary market. The shares do not raise money but instead just distribute money back to the owners.

Answer 78

A

Debt is a legally enforceable promise to pay the providers of capital. Lenders are not owners of the company. Payments generally consist of periodic interests followed by the repayment of the principal.

Equity promises only part ownership of the company, no specific cash claims are legally enforceable. Payments to shareholders generally consist of periodic dividends (although the company is not legally required to pay dividends) and any liquidation value of the company if it ceases to operate.

Answer 79

A

Value = Debt + Equity

V = D + E

V: The firms market value
D: The market value of the firm’s outstanding debt.
E:The market value of the

Answer 80

A

FE = Debt / Equity

It is the proportion of debt relative to the equity of the company. The higher this number, the more risky a firm is.

Answer 81

A

The difference between cash that a company needs and the cash that the company generates (though plowback)

Answer 82

A

The decision by a firm as to how much of the profits should be retained and how much should be payed to the shareholders.

Answer 83

A

In most countries, the tax system creates distortions in the capital structure decision, being the allocation of debt and equity. The capital structure thus depends on the tax system, not just the private-sector fundamentals.

Answer 84

A

Equity: Income tax is levied on corporate and personal income. Income is taxed at the company level and to the shareholders when they receive income as dividends.

So dividends get taxed twice.

Debt: No double taxation generally exists, only the lender gets taxed, being the interest.

Answer 85

A

A firm decided how much is will return to shareholders or plowback, which related to payout policy.

Plowback does not generally cover cash needs for a firm. The difference between what cash the firm needs and what the firm raises internally is the financial deficit.

The firm must decide what proportion of the financial deficit to fund though borrowing and though issuing equity. the mixture of these issues called the capital structure.

Answer 86

A

Modigliani and Miller.

Answer 87

A

A firms value is determined by its real assets, not by its capital structure.

Answer 88

A

Company value is dictated by the company’s assets. The capital structure simply alters the risk.In a world with perfect capital markets, no risk of default and no informational issues, capital structure does not matter, so the market value of a firm is independent of its capital structure and is determined by real assets when the firm’s investment decisions are taken as a given.

Specifically, a firm cannot change the total value of its securities just by splitting its cash flows into different streams (debt or equity streams). Whether all financing is attained through equity, or just 50%, the cost of financing will be exactly the same.

Thus, we are able to completely separate the investment and financing decisions.

Although in practice capital structure does matter, we must understand understand under what conditions the the MM theory holds to fully understand what capital structure is better than another given specific market imperfections.

It relies upon the assumption that by maximising the Total value of the firm, financial managers maximise the wealth of the shareholders.

Answer 89

A

When equity of a company is leveraged though debt, increasing its value.

It is also known as gearing.

Answer 90

A

See BA 9.

In general, a policy that maximises the market value of a firm also maximises the wealth of shareholders:

Max(W) = Mac(V)

THIS RELIES ON the assumptions that:

Firms can ignore payout policy (i.e. dividend policy)
The value of the existing debt stock is not affected.

Answer 91

A

See BA 10.

Answer 92

A

If we have two streams of cash flow, A and B, then the present value of A + B is equal to the present value of A plus the present value of B.

We are not combining assets but splitting them up.

With perfect capital markets, combining or splitting will not affect values as long as they do not affect an investor’s choice.

Answer 93

A

The value of an asset is preserved regardless of the nature of the claims against it.

This can be used to show how the value of a leveraged firm and unleveraged firm are equal given the MM assumption (perfect capital markets).

Answer 94

A

With perfect capital markets where companies and individuals can borrow and lend at the same risk free rate, individuals can undo the effect of any changes in the firm’s capital structure.

Answer 95

A

See BA 1.

First invest in a leveraged company, paying the interest.

Then an unleveraged, and borrowing an amount to account for the interest payment.

Answer 96

A

No Personal or Corporate Taxes (or at least not distortions, so a tax system that taxes debt and equity equally)

Perfect Capital Market: People can borrow and lend at the same rate that companies do.

No Informational issues: So individuals do not infer anything about a firms capital structure.

No costs of financial distress: So no costs when a company is in poor health.

No Effects On Management: No issues such as leverage affecting values of executive stock options, which in turn would affect executive incentives. (or if a company is doing bad, effort going down etc)

Answer 97

A

As a firm takes on more debt, the equity becomes riskier and must be priced to earn a higher return. This is balanced out exactly by the fact that more of the capital structure is (cheaper) debt.

The expected return on equity r|E| of a levered firm increases in proportion to the debt-equity ratio D /E , and the rate of increase depends on (rA − rD).

Remember that D / E will increase at an increases rate with rises in D (or equally, falls in equity)

Answer 98

A

r|A| = expected operating income / market value of all securities.

So it is the yearly expected income that will be generated by the assets divided by the value of all securities.

This is constant according to MM proposition 1, as the MARKET VALUE OF ALL SECURITIES IS CONSTANT.

Answer 99

A

r|A| = (r|D| * D / D+E ) + (r|E| * E / D+E )

Expected return on assets = proportion in debt x expected return on debt + the proportion of equity x expected return on equity.

w|D| = D / (D + E)
w|E| = E / (D + E)
This is the expected return on a portfolio of all the firms securities.

We can change this to be in terms of the return on equity:

r|E| = r|A| + D/E(r|A| - r|D|)

Answer 100

A

D\E is the leverage.

When there is no debt, r|E| = r|A|

Then the firm is leverered, they require a premium of D/E(r|A| - r|D|) to compensate them for the extra risk.

MM 2 states that as a firm takes on more debt, the
equity becomes riskier and so must be priced to earn a higher return. But this is balanced out exactly by the fact that more of the capital
structure is (cheaper) debt.

More capital structure is composed of cheaper debt.

If the overall r|A| is determined by the weighted average of the return on debt and return on equity. r|E| increases with risk (which will lead to r|D| increasing), this is offset by he fact that the weight the debt is increasing (which has a lower return), which moves in the opposite direction, keeping r|A| constant.

r|E| increases, and w|E| falls, given that w|D| rises.

Answer 101

A

Any increase in expected

return is exactly offset by an increase in risk and therefore in shareholders’ required rate of return.

Answer 102

A

MM proposition 1: financial leverage has no effect on shareholders’ expected wealth (since it does not change the market value of the
firm).

MM proposition 2: the rate of return on equity rE increases as the firm’s leverage increases.

An increase in rE is exactly offset by an increase in risk, and therefore in shareholders’ required rate of return. Leverage can then be seen as a way to move outward the risk-return trade-off. In this
sense, MM is very similar to the CAPM.

Answer 103

A

r|a| is consistent under MM and will equal r|e| when w|e| = 100.

Answer 104

A

Beta’s measure the return of a company (dependent on its risk).

The beta of a firm’s asset is equal to the beta of a portfolio of the firm’s debt and its equity.

The beta of this hypothetical portfolio is the weighted average of the debt and equity ratios (the weight of each)

Answer 105

A

β|portfolio| = β|A|
= β|D|D/(D + E) + β|E|E/(D + E)

β|E| = β|A| + D/E(β|A| - β|D|)

Where β|E| is the r|E|

Answer 106

A

Yes. As lenders are not the owners of the firm, interest rates are considered a cost and are therefore tax-deductible.

This means debt financing is tax deductible as the cost can be taken away from corporation tax.

This is known as the tax shield for debt.

Answer 107

A

Relies on the fact that debt financing (interest) is tax deductible.

It is the amount saved due to debt financing.

Tax Shield: Interest x Corporate Tax Rate
: r|D| x D x T|c|

Answer 108

A

Assumption 1 (D constant): The company’s debt D is fixed and permanent (that
is, the company commits to refinance its present obligations when
they mature, and to keep rolling over its debt obligations indefinitely).

Assumption 2 (T|c| constant): The corporate tax rate T|c| is (reasonably) stable over time: therefore, T|c| can be treated as constant.

Assumption 3 (r|D| = interest rate payment amount): The risk on the tax shields is the same as the risk of the interest payments that generate them. This assumption is equivalent to saying that capital markets are perfect. The interest rate that is paid on the debt is the same as the interest rate used to discount.

Answer 109

A

PV(tax shield): tax shield/ discount rate = tax shield/ expected return
= [(r|D| x D) x T|c|] /r|D|
= D x T|c|

So the PV(tax shield) is independent of expected return on debt r|D|

Answer 110

A

Dividends from profits.
Retained earnings increasing firm value.
Share buybacks increases the value of the remaining shares on the market.

Answer 111

A

Maximising the wealth of investors is the same as maximising the value of the company.

If investors are taxed more, they receive less from a firm and therefore the risk to reward payoff if altered, leading to the company being less valued than if investors were only being taxed once.

The firms new aim is to minimise all taxes, meaning those of the firm, bondholders and shareholders, thereby maximising after-tax income.

Answer 112

A

T|p|: personal tax rate on interest (debt income)

T|pE|: The effective tax rate on equity income (dividends and capital gains).

T|c|: Corporate tax rate.

Answer 113

A

Statutory Rates (rates fixed by law) applicable to equity income may be lower.
Capital gains are not taxed until the shares are sold, so there is a tax deferral advantage, lowering the present value of the tax.

Answer 114

A

Debt investor:
£(1-T|p|)
Remember, these interest payments are tax deductible from corporation tax, so that tax is not included.
Equity investor:
£(1-T|c|)(1-T|pE|)

Answer 115

A

RA= (1-T|p|) / [(1-T|c|)(1-T|pE|)]

So this is the post tax income of debt investors compared to the income of equity investors as a ratio.

When RA goes up, the more of an advantage there is to debt financing rather than equity financing.

RA = 1 when there is no advantage.

Answer 116

A

See BA 13.

Answer 117

A

Question: Is there an economy-wide debt-equity ratio (macro)?

People de factor have different tax rates.

Answer 118

A

T|pE| = 0
All companies have the same marginal T|c|
Different investors have different T|p|, ranging on both sides of T|p|:

T|pL| < T|c| < T|pH|

With L and H being Low and High respectively.

Answer 119

A

T|pE| = 0
All companies have the same marginal T|c|
Different investors have different T|p|, ranging on both sides of T|p|:

When T|p| < T|c|, It is cheaper to sell debt.

When T|c| < T|p|, it is cheaper to sell equity.

The Relative Advantage is simplified to
(1-T|p|) / (1-T|c|)

The economy wide capital structure is then equal to the relative wealth of the two types of investors. There is no optimal debt-equity ratio for a single firm as it depends on the specific investors each firm has to deal with, it is only for the economy as a whole.

Answer 120

A

Value of Firm = Value if all-equity financed + PV(tax shield) - PV (costs of financial distress)

The last two are due to the tradeoff that the more a firm is leveraged, the more problems are exacerbated should it enter financial distress.

Answer 121

A

A theoretical optimum reached when the present value of tax savings due to further borrowing is just offset by increases in the present value of costs of distress.

Remember that V = Value if all equity financed + PV(Tax Shield) - PV (Costs of financial distress)

The costs of financial distress are not necessarily going to happen, but it is an expectation.

Costs of distress increase at an increasing rate value of a firm increases at a decreasing rate. We find when the marginal unit of each is equal.

Answer 122

A

The optimal debt ratio will be different for different companies.a

Companies will have a different change of incurring financial distress.

For instance, a start-up may have a higher probability of financial distress, so the less debt can be taken on.

Companies with a large number of tangible assets (higher liquidity) and plenty of taxable income to shield should aim at relatively high debt rations.

The chance of financial distress will fall as businesses get less risky.

Answer 123

A

Asymmetric information.

Manager taking the decision have superior information about the firm’s health condition and might reveal this information through their debt-equity choice.

A firm that believes their stock is under valued will favour debts. Issuing shares at the current price would be to financially beneficial to investors, not to the company that is showing it is valued at this level or lower.

If a firm that believes the stock is overvalued issues shares at the current price, the market instantly assumes that the shares are overvalued, so investors will stop investing. So the firm may in fact issue bonds to avoid the market responding negatively.

Answer 124

A

Asymmetric Information favours debt over equity. If managers are better informed than investors, then any company that can borrow will do so rather than issuing new equity.

Remark 1: It does not rule out issuing equity, as there are other forces outside of capital structure.

Remark 2: Asymetric information and costs of financial distress imply that issue of new debt may affect the price of outstanding shares.

Answer 125

A

A theory on how firms raise funds.

Firms prefer internal finance (retained earnings)

Target levels of dividends are selected and firm stick to this as much as possible. They have STICKY POLICIES.

Answer 126

A

Natural fluctuations in year to year cash flow can lead to deficits of cash. One solution would be to change the debt to equity amount and take on more of either.

Firms prefer to finance internally though so selling assets to cover a shortfall is preferable.

Intangible assets are harder to liquidate, which provides more of an incentive to take on debt.

Answer 127

A

Looking at SME in Brazil and studies the sources of capital ( D/E greater and less than 50%.

Answer 128

A

Companies prefer retained earnings over external sources of financing and that the preferences do not change with D/E ratios.

They conclude that pecking order theory holds.

1) Retained Earnings
2) Debt
3) Equity

Debt is still preferred over equity even with high D/E ratios.

They prefer to keep control of the company, and debt owners do not attain control of a company.

Answer 129

A

Propensity Score Matching algorithm (PSM)

Their conjecture was that firms with low D/E ratio should leverage more and those with high D/E should deleverage.

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