Corporate Finance and Portfolio Mgt. Flashcards
Dividend Discount Model
P = D(1) / Re - g
Sustainable Growth Rate for DDM
g = (1 - D/EPS) x ROE
Beta of Equity
Beta(Asset) x [ 1 + {(1-t)D/E}]
Beta of Asset
Bequity [ 1 / [1+{(1-t)D/E}]]
What is the beta of a company with no debt financing?
Basset = Bequity
What is leverage?
The use of fixed costs in a company’s cost structure
Difference between variable and fixed costs?
Variable costs fluctuate with the level of production and sales while fixed costs are expenses that are the same regardless of the production and sales of the company
What is sales risk?
uncertainty with respect to the price and quantity of goods and services
Degree of Operating leverage (DOL)
Percentage change in operating income over the percentage change in units sold (I.E. gross profit divided by operating income)
The greater the use of fixed relative to variable costs, the more sensitive operating income is to change in units sold (i.e. more higher operating leverage)
Contribution Margin
The difference between the price per unit and the variable cost per unit
If DOL is 2.0, a 1% change in units sold results in a 2% change in operating income
Degree of Financial Leverage (DFL)
Percentage change in net income / Percentage change in operating income
If two companies have identical unit sales volume and operating risk, they are most likely to have identical ?
Degree of Operating Leverage or the sensitivity of operating earnings to changes in the number of units produced and sold
Breakeven Point
(F + C) / (P - V) , divide the fixed cost by the per unit contribution
Percentage Change in Operating Income
DOL x Percentage Change in Units Sold
Dividend Reinvestment Plan
Three types
Open-market DRPs - company purchases shares in the open market to acquire the additional shares credited to plan participants
New-issue DRPs - company meets needs for additional shares by issuing them instead of purchasing them
Or Mix of Both
Stock Dividend
Stock dividends generally not taxable because it merely divides the pie into smaller pieces. Cost basis remains the same but the cost per share is reduced
Do this if stock price gets to high and they want to come back down to a more comfortable range ($20-$80) - lower stock price is more attractive
Retained earnings reduced but APIC increased
Stock Splits
Similar to stock dividends in that they have no economic effect on the company and the shareholders total cost basis does not change - treated as a transfer from retained earnings to contributed capital
This does not affect the P/E ratio
Dividend Payment Chronology
Declaration date, ex-dividend date, holder of record date, and then payment date
Declaration Date
The day that the corporation issues a statement declaring a specific dividend (1st day of the process)
Ex-Dividend Date
the ex-date is two business days before the holder-of-record date. The first day that a share trades without the dividend
Holder of Record Date
Typically two business days after the ex-dividend date. It is the date that a shareholder listed in the corporation’s records will be deemed to have ownership of the shares for purposes of receiving the upcoming dividend
Payment Date
The day the company actually mails out the dividend payment
Share Repurchase Methods
Buy in the open market, buy a fixed number of shares at a fix price, dutch auction (buy a number of shares across a range of prices),, repurchase by direct negotiation
Financial Statement Effects of Repurchases
Both assets and equity decline if repurchase financed with cash. As a result, leverage increases. Debt ratios will increase even more if the repurchase is financed with debt
Share repurchase effect on EPS
Effect depends on whether the repurchase is financed internally or externally. In the case of internal financing, a repurchase increases EPS only if the funds used for the repurchase would not earn their cost of capital if retained by the company
In the case of external financing, the effect on EPS is positive if the earnings yield exceeds the after tax cost of financing the repurchase
Share repurchase effect on BVPS
When the market price per share is greater than its book value per share, BVPS will decrease after share repurchases (destroying value in a sense). When the market price per share is less than BVPS, however, BVPS will increase after a share repurchase
Liquidity
The extent to which a company is able to meet its short term obligations
Quick Ratio
Cash + STInv. + Receivables / Current Liabilities
Accounts Receivable Turnover
Sales / Average Receivables
Inventory Turnover
COGS / Avg. Inventory
Days Receivable
(Accounts Receivable / Sales) x 365
Days of Inventory
(Inventory / COGS) x 365
Operating Cycle
DIO + DSO
Net Operating Cycle (Cash Conversion Cycle)
DIO + DSO - DPO
Discount Interest
the difference between the purchase price and the face value (t-bills and bankers acceptances are issued at a discount)
Nominal Interest
rate of interest baesd on the security’s face value
Yield
actual return on the investment if it is held to maturity
Money Market Yield
typically annualized using ratio of 360 to the number of days to maturity
(Face value - purchase price) / (purchase price) x (360 / days to maturity)
Bond Equivalent Yield
typically annualized using the ratio of 365 to the number of days to maturity
(Face value - purchase price) / (purchase price) x (365 / days to maturity)
Short Term Investment Strategies
Two types of active strategies. Matching and mismatching strategies. Mismatching is riskier and requires very accurate reliable forecasts
Laddering is another form, which entails scheduling maturities on a systematic basis within the investment portfolio such that investments are spread out equally over the term of the ladder
Captive Finance Subsidiary
A wholly owned subsidiary of the company that is established to provide financing of the sales of the parent company
Types of Customer Credit Accounts
Open book (most common)
Documentary (most for cross border transactions)
Installment
Revolving Credit
ACH and Giro System
Electronic payment network available to businesses individuals, and financial institutions in the US and Canada. GIRO is postal based systems in Europe and elsewhere
Lockbox System
coordinated with the banking institution in which customer payments are mailed to a post office box and the banking institution retrieves and deposits these payments several times a day, enabling the company to have use of the fund sooner than in a centralized system in which customer payments are sent to the company
Next best service after EFT
Good Performance Measure for Check Deposits
Float factor = Avg. daily float / (total amount of checks deposited / number of days)
Represents the amount of money that is in transit between payments made by customers and the funds that are usable by the company
Volatility is measured as…
standard deviation of returns
Diversification Ratio
The ratio of the standard deviation of the equally weighted portfolio to the standard deviation of the randomly selected security
Portfolios affect ____ more than ______
risk more than return
How do portfolios effectively reduce risk?
combine securities whose returns do not move together
Portfolio diversification during severe market turmoil?
Does not reduce risk during times of severe market turmoil as it does when economy and markets are operating normally. Diversification was ineffective in 2008
Modern Portfolio Theory
Main conclusion is that investors should not only hold portfolios but should also focus on how individual securities in the portfolios are related to one another
Defined Contribution Pension Plan
A DC plan is a pension plan in which contributions rather than benefits are specified, such as 401k plans in the US. The key is that the employee accepts the investment risk and is responsible for ensuring that there are enough funds in the plan to meet their needs upon retirement
Defined Benefit Plan
an employer has an obligation to pay a certain annual amount to its employees when they retire. Requires the sponsor to specify the terms of retirement income benefits
Cumulative Voting
Enhancing the likelihood that shareowners interests are represented on the Board
Good Corporate Governance
Board members act in best interest of shareowners
Company acts in lawful and ethical manner in its dealings with all stakeholders
all shareowners have a right to participate in the governance of the company and receive fair treatment from the board and management
Board structured to act independently from management and individuals that have control over management
Appropriate controls and procedures are in place covering management’s activities in running the day-to-day operations of the company
Companies governance, operating, and financial activities are reported to shareholders accurately, fair, timely, and reliable
Corporate Governance
System of internal controls and procedures by which individual companies are managed. It provides a framework that defines the rights, roles, and responsibilities of various groups - management, board, controlling shareowners, and minority or noncontrolling shareholders within an organization
Board Member
All members who sit on the board including executive board members, independent board members, and nonindependent board members
Four things board members need to act in best interest of the shareholders
Majority of independent board members, board members with appropriate experience and expertise, mechanisms to support the board (hire external auditor, consultants etc.), access to complete and accurate information about the financial position of the company
Steps in the Portfolio Management Process
The planning step, the execution step, and the feedback step
IPS
a written planning document that describes the clients investment objectives and the constraints that apply to the client’s portfolio
Mutual Fund
A comingled investment pool in which investors in the fund each have a pro-rata claim on the income and value of the fund. The value is referred to as the “net asset value”. Computed on a daily basis on the closing price of the securities in the portfolio
Open End Fund
A mutual fund that accepts new investment money and issues additional shares at a value equal to the net asset value of the fund at the time of investment
Closed End Fund
A mutual fund in which no new investment money is accepted. New investors invest by buying existing shares, and investors in the fund liquidate by selling their shares to other investors (these funds can sell at a premium or discount to net asset value)
ETFs
ETFs are created by fund sponsor s who determine which securities will be included in the basket securities. Main difference between mutual funds is that ETFs are are bought and sold from other investors, similar to shares. Investing in a mutual fund requires buying shares directly from the fund
Key difference between hedge funds and mutual funds?
Vast majority of hedge funds are exempt from many of the reporting requirements for the typical public investment company. Hedge funds cannot be offered for sale to the general public. Must be offered to accredited investors. Restricted liquidity
Separately Managed Account
Investment portfolio managed exclusively for the benefit of an individual or an institution
Institution with the greatest need for liquidity?
Bank
Institution with the longest time horizon?
University Endowement
Holding Period Return
the return earned from holding an asset for a single specified period of time
R = [(1+R1) x (1+R2) x (1+R3)] - 1
Arithmetic Mean Return
The average of the mean returns. Assumes the amount invested at the beginning of each period is the same, similar to the concept of calculating simple interest
Geometric Mean Return
Assumes that the amount invested is not reset at the beginning of each year and, in effect, accounts for the compounding of returns - basically reflects a buy and hold strategy
Money Weighted Return
Accounts for the money invested and provides the investor with the information on the return she earns on her actual investment. The money-weighted return and its calculation are similar to the internal rate of return and the yield to maturity. Difficulty is that it doesn’t allow for return comparison between different individuals or different investment opportunities. Two investors in the same fund may have different MWRs because they invested different amounts in different years
Portfolio Weighted Return
Rp = W1R1 + (1-W1)R2
Gross Return
Return earned by an asset manager prior to deductions for management expenses, custodial fees, taxes, or any other expenses not directly related to the generation of returns
Real Returns
(1 + real return) = ( 1 + return) / (1 + inflation)
Return aka Expected Return
( 1 + return) = (1 + RF Return) x (1 + inflation) x (1 + RP)
When calculating the after-tax real return
taxes are paid before adjusting for inflation
Variance
measure of the volatility or the dispersion of returns. Measured as the average squared deviation from the mean
Difference between historical return and expected return?
Expected return is the nominal return that would cause the marginal investor to invest in an asset based on the real risk free interest rate, expected inflation, and expected RP for the risk of the asset.
Risk Premium
Extra return investors can expect for assuming additional risk, after accounting for the nominal risk-free interest rate
Skewness
Refers to asymmetry of the return distribution, that is returns are not symmetric around the mean. Left skew equals left tail and right skew equals right tail
Kurtosis
Fat tails or higher than normal probabilities for extreme returns and has the effect of increasing an asset’s risk that is not captured in a mean-variance framework. Investors evaluate kurtosis by using such statistical techniques as value at risk (VAR)
Cost of Trading
brokerage comission, bid-ask spread, and price impact. Liquidity affects bid-ask spread and price impact
Utility Function - variable (A)
Measure of risk aversion. Higher for more risk-averse investors. Risk neutral investor would make this zero
Risk aversion
For a risk neutral investor, any changes in risk do not affect his/her utility. For a risk lover, additional risk contributes to an increase in utility . A risk free asset generates the same utility for all individuals
Indifference curve
plots the combinations of risk-return pairs that an investor would accept to maintain a given level of utility - the investor is indifferent about the combinations on any one curve because they provide the same level of overall utility. IC’s are defined in terms of a trade-off between expected rate of return and variance of the rate of return
Capital Allocation Line
Represents the portfolios available to an investor. The combination of risk free asset with zero risk and the portfolio of all risky assets that provides for the set of feasible investments.
When two assets are perfectly correlated…
portfolio risk is unaffected
Minimum variance portfolio
The portfolio with the minimum variance for each given level of expected return
Global Minimum Variance Portfolio
Portfolio on the minimum variance frontier with the smallest variance of return. An investor cannot hold a portfolio consisting of risky assets that has less risk than that of the global minimum variance portfolio
Markowitz Efficient Frontier
The graph set of portfolios offering the maximum expected return for their level of risk. Contains all the portfolios of risky assets that a rational, risk-averse investors will choose
Capital Allocation Line
Allowing for borrowing at the risk-free rate and investing in the portfolio of all risky assets provides for attainable portfolios that dominate risky assets below the CAL
As the number of assets in an equally weighted portfolio increases, the contribution of each individual asset’s variance to the volatility of the portfolio _____
Decreases
The Efficient Frontier
Is the set of all attainable risky assets with the highest expected return for a given level of risk and the lowest amount of risk for a given level of return
Compared to the efficient frontier of risky assets, the dominant capital allocation line has higher rates of return for levels of risk greater than the optimal risky portfolio because of the investor’s ability too
borrowing at the risk-free rate
With respect to the mean variance theory
the optimal portfolio is determined by each individual investors risk perference
Two fund separation theorem
the theory that all investors, regardless of taste, risk preferences, and initial wealth will hold a combination of two portfolios or funds - a risk free asset and an optimal portfolio of risky assets
Homogeneity of Expecations
all investors have the same economic expectations and thus the same expectations of prices, cash flows, and other investment characteristcs
Informationally Efficient Market
A market in which asset prices reflect new information quickly and rationally
Market
Includes all risky assets or anything that has value, which includes stocks, bonds, real estate, and even human capital
Capital Market Line
A special case of the capital allocation line where the risky portfolio is the market portfolio.
Systematic Risk
Risk that cannot be avoided and is inherent in the overall market. It is non-diversifiable, it includes risk factors that are innate within the market and affect the market as a whole
Nonsystematic risk
Risk that is local or limited to a particular asset or industry that need not affect assets outside of that asset class
Multi-factor model
allows more than one variable to be considered in estimating returns and can be built using different kinds of factors
Beta
a measure of sensitive an assets return is to the market as a whole and is calculated as the covariance of the return on i and the return on the market divided by the variance of the market return (i.e. the ratio of the asset’s standard deviation to the market’s)
Beta captures systematic risk
Beta flaws
Shorter period beta estimates are less accurate because they may be affected by special events in that short period
Longer period beta estimates are more accurate but are a poor representation of future expectations, especially if major changes in the asset have occurred
CAPM Assumptions
Investors are risk averse, utility maximizing, rational individuals
Markets are frictionless, including no transaction costs and no taxes
Investors plan for the same single holding period
Investors have homogeneous expectations or beliefs
All investments are infinitely divisible
Investors are price takers
Security Market Line
is a graphical representation of the CAPM with beta on the x-axis and expected return on the y axis
Sharpe Ratio
Portfolios risk premium divided by its risk. Also called the reward-to-variability ratio. This is simply the slope of the capital allocation line - the greater the slope, the better the asset. Ratio uses total risk, not systematic risk
Two limitations of the sharpe ratio
uses total risk instead of only systematic risk (only systematic risk is priced)
The ratio itself is not informative - it must be compared to another portfolio’s sharpe ratio
Treynor Ratio
A simple extension of the sharpe ratio and resolves the sharpe ratio’s first limitation by substituting beta risk for total risk. The numerators must be positive for the Treynor ratio to give meaningful results.
M-Squared Ratio
A measure of what a portfolio would have returned if it had taken on the same total risk as the market index. Based on total risk. By using M2, we are not only able to determine the rank of a portfolio, but also which, if any, of our portfolios beat the market on a risk-adjusted basis
Jensen’s Alpha
Based on systematic risk. Measures a portfolio’s systematic risk by estimating the market model. The coefficient on the market return is an estimate of the beta risk of the portfolio.
The difference between the actual portfolio return and the calculated risk-adjusted return is a measure of the portfolio’s performance relative to the market portfolio
If it is positive, then the portfolio has outperformed the market. If negative, then it has underperformed the market. Jensions alpha is also the maximum amount that you should be willing to pay the manager to manage your money
Limitations of the CAPM
Market portfolio - true market portfolio is unobsesrvable
Proxy for a market portfolio - proxies vary among analysts
Estimation of beta risk - periods used for beta may vary
CAPM is a poor predictor of returns - empirical support is weak
Homogenuity in investor expectations - assumes that homogeneity exists in investor expectations for the model to generate a single optimal risky portfolio and a single security market line
Five major constraints on portfolio selection
liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances
Strategic Asset Allocation
The set of exposures to IPS permissible asset classes that is expected to achieve the client’s long-term objectives given the clients investment constraints
Risk Budgeting
The process of deciding on the amount of risk to assume in a portfolio and subdividing that risk over the sources of investment return
Tactical Asset Allocation
The decision to deliberately deviate from the policy exposures to systematic risk factors with the intent to add value based on forecasts of the near-term returns of those asset classes
Components of an IPS
Introduction
Statement of Purpose
Statement of Duties and Responsibilities
Procedures
Investment Objectives
Investment Constraints
Investment Guidelines
Evaluation and Review
Appendices
Time Horizons
Greater than 10 years is long term. Medium term is 5-10, short term is 1-5 years
What is the purpose of an IPS?
Communicates a plan for achieving investment success
Return on asset classes are best described as being a function of _____
exposure to sets of systematic factors relevant to those asset classes
Pairwise correlations within asset classes should generally be ____
higher than correlations among asset classes (intra vs. inter argument)
Tactical asset allocation is best described as
the decision to deliberately deviate from the policy portfolio
Core Satellite Approach
Investing the majority of the portfolio on a passive or low active risk basis while a minority of the assets are managed aggressively in smaller portfolios
Slope of the security market line is best derived from
market risk premium
Portfolio with equal parts weighted in risk free asset and risky asset will most likely lie on the ….
Capital allocation line
