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Corporate Finance > Corporate Finance I > Flashcards

Corporate Finance I Flashcards

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1
Q

What are property rights

A
  • Rights to use an asset - Rights to alienate those use rights Well defined and enforced property rights result in efficient allocation and generate the right incentives
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2
Q

What are the assumptions behind the CAPM

A
  1. Investors have mean-variance preferences 2. Investors have the same belifes about the distribution from which returns are drawn 3. Investors have a common investment horizon 3. No costs of trading in financial markets; easy to go short, all investors can borrow and lend at the risk-free interest rate
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3
Q

What should be used to calculate the expected return

a) The required investment amount
b) Market value of the project

A

Market value of the project

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4
Q

What variation of the CAPM should be used to evaluate cash flows

A

Certainty equivalent CPM

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5
Q

How does the certainty CAPM work on a very high level?

A

Instead of changing the discount rate to account for risk, the CE-CAPM adjusts the expected cash flow

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6
Q

Derive the CE-CAPM

A
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7
Q

What is to be thought of when choosing a risk free rate

A

Default risk, investment risk, inflation risk are all relevant

There may be several risk free rates

Heuristic: use either 90 T-bill yields or 10-year-T-bon

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8
Q

How do get the market risk premium

A

Generally, use historic data to estimate the future

Have investors’ risk preferences really not changed

A very long interval is needed to get a low S.E. of estimate

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9
Q

Can cost of debt be priced with the CAPM in general

A

Yes, the CAPM applies to all capital asset classes, including debt

The cost of debt equals the expected return on debt \mu_{Debt}

The conventional approach uses promised yield to maturity (YTM) to proxy

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10
Q

What is the problem of using the promised return as the cost of debt to opt out the debt beta ?

A

The expected return of debt does not equal to promised return. There is a risk of default that is not considered in the promised return.

Investors care about default even if they do not care about variance or risk

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11
Q

How big is the error when using the promised rate of return instead the expected return on debt?

What method (approximation) is applied here

A

Quick and Dirty formula

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12
Q

Derive the quick and dirty formula

A
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13
Q

What are the assumptions for the quick and dirty formula?

A
  1. Debt is perpetual
  2. Probability of default is the same in each period.
  3. If default occurs, bondholders receive gamma fraction of the face value of the bond plus accrued interest
  4. Bond is sold at par, i.e. the bonds initial price equals its principal value
  5. If the bond does not default, the bondholder receives the promised coupon payment
  6. Discount rates are constant over time
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14
Q

What is the payback period?

A

The payback period is the smallest number of periods over which the accumulated free cash flows exceed the initial investment outlay

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15
Q

What is the interpolated payback

A

Sometime payback is computed by interpolating between periods

Example

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16
Q

What is the Internal rate of return (IRR)

A

The internal rate of return IRR an interest rate at which the NPV is zero

NPV is what remains of free cash flow after paying investors a fair return on their capital

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17
Q

What are problems of the IRR

A
  1. IRR assumes that cash thrown off from the project can be reinvested at the IRR rate
  2. It is very hard to comapre projects using IRR
  3. When project cash flow change signs many times, the project can have many IRRs
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18
Q

What is the modified IRR and what kind of rates do we need for that criteria?

A

A financing rate is applied to outflows to push them to date

A reinvestment rate is applied to inflows to push them to date T

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19
Q

What is the MIRR from that example

A
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20
Q

What are the pro and cons of the MIRR

A

The advantage of MIRR is that it does not have the multiple root problem of IRR

Whereas the IRR does not have to assume a discount rate, the MIRR one needs to assume two rates of return

In total we need three discount rates for that method

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21
Q

What are potential problems with multiples

A

First, it is to say that multiple valuation is easy which is a plus point, but

Multiple generates relative values, they will not identify sectoral mispricing

NPV is fundamental, multiples are sometimes harder to justidy

Problems with irregular cash flows

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22
Q

How to value terminal project valuations

A

The terminal value at this horizon date is usually estimated by either

EBITDA multiples

Gordon growth formula

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23
Q

How does the gordon growth formula look like?

A
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24
Q

What are problems with terminal value estimates

(Gordon Growth, Multiples)

A

If gordon growth formula is used:

Terminal valuations are very sensitive to g

There is no lower bound for g, but a stable g cannot exceed the growth rate of the economy

If multiples are used:

The projects’s long run cash-flow matches industry norms

Today’s multiples are the same as those which will obtain at the end of planning horizon

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25
Q

What is a ex post project evaluation

A

Economic Value Added (EVA)

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26
Q

How is economic and accounting depreciation calculated

A
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27
Q

How is EVA calcualted?

A
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28
Q

Why is EVA not optimal as project evaluation per se?

A

EVA is a period by period snapshot of the value of an investment project. A project selection criterion is a overall valuation of the project over its whole life

NOPAT is not free cash flow

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29
Q

EVA of a positive NPV project need not be positive in every year of the project’s life

EVA of a negative NPV project need not be negative in every year of the project’s life

The PV of the EVAL of a project equals the project’s realized NPV

Why?

A

NPV is a single number that reflects the total effect of a project on firm value

EVA is a consequence, one for each period

Trying to compare EVA with NPV is like trying to compare 6 with 1 7 -2

The present value of EVA equals the realized NPV from the project

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30
Q

Show that the present value of EVA equals NPV

Begin with the equation

A
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31
Q

What are arguments for and against the use of EVA

A

Pro:

If your manager is sure to stick around for the life of the project

Compensating your manager with rewards proportional to EVA will lead to her make value maximising project choices

Cons:

Assumptions are not realistic

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32
Q
A
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33
Q

State the gordon growth formula for share prices in terms of the dividend payout ratio

A
34
Q

What is the MM proposition I

A

Suppose that market are complete with perfect competition and no transaction costs that all agents have the same information that there are no costs of bankruptcy and no agency costs. Then in the absence of taxes, the value of a corporation is independent of its capital structure

Proofed by arbitrage

35
Q

What is MM proposition II

A

Since FCF is independent of capital structure, the corporate cost of capital is independent of the capital structure

36
Q

What does constant growth of cash flows ensure (thinking about discount rates)

A

We then will have constant rates of return

37
Q

What are implications of the constant rate of growth assumption

A

The unlevered firm’s discount rate is constant and equal to r_u

The value of the unlevered firm in every period is a constant multiple of its current cash flows - These multiples are known constants at date 0

38
Q

How is the tax shield valued at time t

A
39
Q

What discount rate should we use when having a constant debt ratio in the WACC model

A
40
Q

How do we value the tax shield when we have a constant debt level

A
41
Q

Would you allocate:

Miles Ezzell policy

WACC policy

MM policy

to either Constant ratio policy or constant level policy

A

Constant ratio policy:

Miles Ezzell policy

WACC policy

Constant level policy

MM Policy

42
Q

What are the two methods of the constant ratio policy and how are they used

A
43
Q

How does the levered company discount rate/ beta compare against its unlevered counterpart in a constant level policy setting and why

A
44
Q

What is the Capital Cash Flow approach

A

Applied when the company has a constant ratio policy. This approach values the tax shield separately using the cost of the unlevered company. The reason for that is that the tax shield has the same risk as the company’s cash flows

45
Q

Using this equation of the CCF approach and show that this is equivalent to the WACC approach

A
46
Q

How does the WACC look like if it is adjusted for taxes

A
47
Q

Describe the Miles Ezzell on a very high level

A

The Miles-Ezzel ME formula obtains a cost of capital for free cash flows based on the unlevered cost of capital, constant over time, and the current cost of debt capital

48
Q

What does the APV differently to the WACC valuation

A

The alternative to WACC valuation is to direclty value the tax shield, discount it at its own appropriate rate

49
Q

How are equity betas and unlevered betas related under the constant ratio and constant level policies

A
50
Q

Show how the relation between the unlevered beta and equity beta is arrived under the constant ratio assumption

A

Simply stating the weighted average beta of the company combined with the assumption that beta debt is equal to zero

51
Q

Show how the relation between the unlevered beta and the equity beta is arrived under the constant level assumption

A
52
Q

What is bankrupcty

A

It is the law that governs the way that the company’s assets are distributed in the wake of a failure to pay debt

53
Q

What are direct and indirect costs of bankruptcy

A

Direct costs are out-of-the pocket expenses associated with bankruptcy proceedings

54
Q

What are indirect costs of bankruptcy

A
  1. Industry performance
  2. Firm performance
  3. Short-term interest changes
  4. Firm leverage
55
Q

What is the trade off theory of the tax shield and bankruptcy

A

Firms trade off the value of the tax shield against the increasing expected costs of bankruptcy until the two effects are the same at the margin

56
Q

What is the Miller Equilibrium

A

The argument of Miller is that in equilibrium the marginal borrower derives no tax advantages from issuing debt rather than equity

57
Q

How do you compare the lease and purchase options

A

Discount lease cash flows using a discount rate appropriate to each cash flow

Disocunt buy cash flows at a discount rate appropriate to each cash flow

Choose the option that produces the highest discounted value

58
Q

What is a financial lease

A

A lease where essentially all of the economic value of the leased asset is transferred to the lessee

Lease term equals the economic life of the asset

Lease is non-callable

Lessee assumes all maintenance and upkeep costs associated with the asset

59
Q

What is rule of Myers, Dill and Bautista regarding lease vs. buy

A

Discount after tax lease excluding lost debt tax shields at the after tax cost of debt capital. If the resulting present value is less than the purchase price, lease; otherwise buy

60
Q

What are assumptions of MDB regarding the classic lease vs. buy formula

A

Lease obligations are identical to debt obligations with respect to risk

Lease obligations are perfect substitutes for debt in the firm’s capital structure

Firm follows a constant-debt-level policy

The firm can fully utilise all of its tax shields

Valuation of the firm is based on MM analysis with taxes

61
Q

For which kind of leases is the lease obligation assumption made by MDB realistic?

A

Only for financial leases

62
Q

Derive the classical lease formula given these parameters for the case when t < H and t >= H

A

If t >=H, future costs are 0, hence the cost of leasing is zero

The other case is described in the picture

63
Q

If the MDB assumptions for leases do not hold why can the follwoing be problematic

  1. Risk of lease contract is not the same as risk of debt
  2. Debt and lease contracts are not perfect substitutes
  3. Not all tax shields can be utilisied
A
  1. Options built into lease
  2. Differential treatment in insolvency bankruptcy
  3. Insufficient taxable income
64
Q

Explain every part of the formula and why it is there. Context: Financial leases

A

The first part of the equation is just the lease payment which is tax deductible and therefore we only count the part we actually pay

The second part is the tax benefit we lose because of not buying it and therefore also not depreciating the asset

The part afterwards is due to the fact that assuming we would have bought the asset with debt then we would have an increase in the tax shield

The last part is the future cost of lease. Here we have again the depreciation, the lease payment and the loss in the tax shield.

In the end we will iterate that process

65
Q

What are common approaches for real options

A

Simple shoehorning

Fancy shoehorning

Simulation

Analytical modelling

66
Q

What is simple shoehorning the context of real options

A

Fit the capital budgeting problem into the black scholes model for pricing european options

Try to find the current price of an underlying asset that drives the project’s payoff

67
Q

What is fancy shoehorning in the context of real options

A

Exchange option formula: Consider an option of exchange of two assets X and Y paying max(X-Y,0)

Compound option models: Options where exercising one option provides the holder with another option on the same asset

68
Q

Describe the simulation approach in the context of real options

A

Identify an underlying asset or use risk-adjusted discounting to value the project under the assumption that it undertaken

Use the black-scholes risk neutral valuation assumptions to generate random prize paths starting from the current value

Compute the payoff for each of these paths decision

Average the payoffs and discount back at the risk free rate

69
Q

What is the analytical approach in the context of real options

A

Develop your own continous time pricing model tailor to your project

Solve the model in closed form

Input the parameters into your solution

Value the asset

70
Q

When would the investor be indifferent between a tax-exempt municipial bond which offers a return r_0 and a corperate bond

A
71
Q

What is the sum of the cash flow to investors given these variable definitions

A
72
Q

Given these parameters, what is the Miller tax advantage?

A
73
Q

What is the alternative to value bonds if the beta is not known but the value of the company in different states in the world is known as well as the discount rate for the company as a whole

A

Risk neutral Probabilities are applicable.

First we calculate the RNP through the company, and then we apply these probabilities on the bond itself

74
Q

How do you calculate the nominal yield of a bond?

Why might that be incorrect as a measure of yield

What is the ‘correct’ way of calculating the required rate of return

A

Promised payment/ Price of the bond - 1

It does not price in the fact that default could occur

Expected Value of Cash flow / Price of the bond - 1

75
Q

How can it be possible that two companies have the same probability of default but the required rate of return is different?

A

The probability of default can be related to the state of the economy or not related to the sate of the economy.

Let us consider the first case: If it is related than this risk is not diversifiable and investors should be compensated for that risk

In the other case, if it is not related to the state of the economy that risk is company specific and hence can be diversified. Investors should not get compensated for that

76
Q

If the volatility of a project is 0.8, how do you calculate up and down probabilities?

Assuming the risk free rate is 5%

A
77
Q

Assuming you have the option to sell an asset at date t=1 for 24. You know that your asset can either have an up movement or a down movement. How do you value that real option in basic terms.

Hint (Risk neutral probabilities)

A
78
Q

Assume you have an option which entitles you to buy half of the company’s ownership for 2m. The company (which value at t=0 is denoted by V_0) can either have an up or a down movement which happen with the risk neutral probabilitiy q.

Furthermore, you can disregard the ‘down’ case as that would be negative

How would the valuation formula look like

A
79
Q

Assume that the volatility of return is 0.95

Calculate the up and down movement multiplier

A
80
Q
A

Corporate Finance (1 decks)

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