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CFA1 > Equity Investments > Flashcards

Equity Investments Flashcards

1
Q

sole proprietorship

A

unlimited liability;
taxed passthrough to owner;
small scale cuz only can expand within owner’s ability to secure financing;
1 person

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2
Q

general partnership

A

2+ people;
partnership agreement=partners responsibilities for business operations and shares of pnl;
unlimited liability;
taxed passthrough to owner

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3
Q

limited partnership

A

general partner=operate the business;

unlimited liability; taxed as personal income;

limited partner=NOT involved in appointing or removing general partners or day to day; only capital contributor; limited lia;

taxed passthrough to owner

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4
Q

corporation

A

seperate legal entity; maanged by BOD; limited; double taxation

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5
Q

limited liability partnership

A

general partner not allowed, only limited partner

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6
Q

double taxation

A

tax firms on earnings and tax dividends as personal income; impact more of firm paid out more div

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7
Q

free float

A

actively traded shares not owned by insiders, strategic investors or sponsors

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8
Q

investors in a private limited company have to wait until the company goes public or is sold to exit their investment

A

share value is not readily observable and transfer is difficult; few regulatory requirements; disclose less info than public; investors can take longer term view of businesses

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9
Q

private placements

A

private companies raise capital through private placement; restricted to accredit investors (high net worth, corp institutional investors)

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10
Q

private company go public

A

IPO, direct listing(no underwrite or lock-up period, available for public to buy more quickly), acquisition by SPV (special purpose acquition company=corp set up to acquire a private firm, raise capital through IPO and put fund into a trust to make acquisition where acquired comp doesnt have to be identified, SPAC aka blank check companies)

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11
Q

increase leverage, increases ROE if rate of return>=cost of debt but more risky leveraged if revenue decreases

A
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12
Q

debt holder more concerned with firms ability to pay debt and less with potential growth; equity holder wants firm to issue debt to obtain growth cuz wont dilute the shares. so debt holders have covenants state the maximum leverage or minimum interest coverage

A
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13
Q

shareholder theory

A

conflict of interest between the managers and its shareholders;
shareholder wants to max market value of firm

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14
Q

stakeholder theory

A

conflicts among several groups that have an interest in the firm

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15
Q

Shareholders

A

residual interest; voting right; control over firm and management; ongoing growth that will increase firm value

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16
Q

board of directors

A

responsible for protecting the interests of shareholders; hire and set compensation of firm’s managers; strategic firm direction;

inside directors=founders, conflict of interest with shareholders but not independent directors

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17
Q

Negative externalities

A

firm do not bear full cost of its actions (e.g. pollution)

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18
Q

ESG risks

A

Equity investors bear the brunt of the risk from adverse outcomes than debt investors unless loss is large enough to default;

not all debt holders are equally exposed to ESG risk; long term debt holders exposed if coal plant is in compliance now but may be obsolete in future

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19
Q

principal-agent conflict

A

Managers and directors may choose a lower level of business risk than shareholders would. cuz managers have their employment income tied to the firm solvency could cause by information asymmetry

managers paid stock option grant want more risk than cash comp managers;

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20
Q

dual-class structure

A

some shareholders with more voting power; CFA is against this because it furthers one groups interest at the expense of another

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21
Q

hostile takeover

A

not supported by the company’s management

22
Q

bond indenture

A

legal document specifies the rights of bondholders and the company’s obligations

23
Q

covenants

A

rules in bond indenture

23
Q

auditor committee

A

oversee financial reporting, oversee internal control and internal audit, propose remedies based on audit results

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supplier offers 2/10 net 30 terms
offer 2% discount if paid in 10 days, total 30 days;
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Primary liquidity sources
cash and marketable securities on hand, bank borrowings, and cash generated from the business
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secondary liquidity sources
retained earnings; delay capital investments; selling assets; issue equity
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drag on liquidity vs pull on liquidity
inflow lagged (inventory build up)vs outflow accelerated
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working capital mgmt
max profit with sufficient liquidity to meet firm obligations; conservative=high amt of short term asset; finance working capital with long term debt and equity; higher cost aggressive=low level of short term asset; finance wc with short term debt, lower financial cost; higher liquidity risk (refinance risk); higher financial risk (more volatile) moderate=permanent current asset funded with long term capital; seasonal current asset funded with short term sources (use both st and lt)
29
primary liquidity sources: borrowings from bank, cash flow from operations. cash and marketable securities
30
Self-dealing
put own interest first before acting in the best interests of the people they represent
31
entrenchment
management prioritizes their own job security or self-interest over maximizing shareholder value.
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types of capital investments
Going concern projects=maintain the busienss and dont need detail analysis (e.g. improve equipment efficiency using match funding approach match capital source with project life); regulatory/compliance projects=required by government to solve safety concerns, no revenue so need to evaluate different ways to carry out project; expansion projects=forecast future demand, need complex decision making and detailed analysis other projects=new line of business, decision with detailed analysis
33
capital allocation process
Idea generation; Analyzing project proposals=future cash flows; Create the firm-wide capital budget=prioritize profitable project; morning and post-audit
34
internal rate of return (IRR)
discount rate that makes the PV cash inflows = PV cash outflow; also discount rate where NPV of project=0; if IRR>required rate of return (I), accept the project; hurdle rate=minimum IRR above where a project will be accepted; shows profitability as %, return on each dollar invested and margin of safety (IRR-I) but it assume each project invested at IRR (unrealistic) where NPV assume at req return rate; if multiple sign changes, could have multiple IRR
35
Net present value (NPV
PV of expected cash flow if project happens using the discount rate (firm's cost of capital); positive NPV project should cause a proportionate increase in stock price.
36
return on invested capital (ROIC)=return on capital=net operating profit after tax (NOPAT)
net operating profit after tax/ average book value of total capital; (EBI)/debt and equity sources of capital; ROIC = (NOPAT/Average Invested Capital) = (NOPAT/Sales) × (Sales/Average Invested Capital); increase its ROIC by improving its operating margin or by increasing its capital turnover. If ROIC is greater than the required rate, the firm is adding value over time. based on accounting data so avaialble to outside investors who cant invest in firms inidivdual project but firm as a whole; not comparable across firms; backward-looking; mix good with bad projects
37
Cognitive Errors
Poor forecasting, Not considering the cost of internal funds (OC, use fund on poor projects rather pay div), incorrect accoutning for inflation
38
Real options
future actions that a firm can take, given that they invest in a project today like options
39
shareholder activism
goal to increase firm value; a way that shareholders can influence a corporation's behavior by exercising their rights as partial owners.
40
capital structure
MM proposition without tax: I: value of firm is unaffected by capital structure (Vunlevered=Vlevered); II: cost of equity increases with greater proportion of debt (because its more risky), just offset tax savings of using debt, so WACC is constant; MM proposition with tax: I: firm value is maximized at 100% debt, WACC is minimized; tax shield increases value of company; firm cant use 100% debt financing cuz financial distress and bankruptcy costs are very high, higher risk of distress; optimal structure=portion of debt at which increase in value of tax shield is exactly offset by increase in cost of financial distress
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CFA1 (11 decks)

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