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FIN 621 > Final Exam > Flashcards

Final Exam Flashcards

1
Q

Alternative Investments

A
  • Real Estate
  • Commodities
  • Private Equities
  • Hedge Funds
  • Currencies
  • Derivative Secerities
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2
Q

Derivative Securities

A

A security whose value derives from the value of some underlying asset.

Examples: futures, forwards, swaps, options

Underlying assets:
interest rate, foreign exchange rate, index value such as stock, commodity price, common stock

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3
Q

Uses of Derivatives

A
  • Hedge risk
  • speculate
  • Arbitrage profit lock-in
  • change nature of liability
  • Change nature of investment
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4
Q

Forward Contract

A

an agreement to buy or sell an asset at a certain time in the future for a certain price

At delivery (end of contract) ownership is transferred

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5
Q

Futures Contract

A

A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (futures price)

  • The party that is buying has a long position
  • The party that is selling has a short position
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6
Q

Forward vs Future

A

Forwards are: private, non standard, 1 specified delivery date, settled at maturity, delivery or final cash usually occurs

Futures are: exchange traded, standard, range of delivery dates, settled daily, usually closed out prior to maturity

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7
Q

Swaps

A

A financial contract between two counterparties who exchange future cash flows according to a prearranged formula.

Example: Interest rate swaps

Purpose is to hedge interest rate cash flows on balance sheets

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8
Q

LIBOR

A

London Interbank Offer Rate

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9
Q

Call option

A

A call option on an asset is an option to buy the asset at a fixed price.

Buyer is betting on price increasing
Seller is betting on price decreasing

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10
Q

Put Option

A

AN asset that is an option to sell the asset at a fixed price.

Buyer is betting on price decreasing
Seller is betting on price increasing

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11
Q

Options vs Forward/Futures

A

A forward/future contract gives the holder the obligation to buy/sell at a certain price.

A option gives the holder the right to buy/sell at a certain price.

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12
Q

A successful option

A

In the Money

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13
Q

Naked Call

A

Means you write a call without owning the underlying asset.

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14
Q

Cover call

A

Means you write a call while owning the underlying asset to hedge downside risk

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15
Q

Option Premium

A

Premium = intrinsic value (@ any point in time) + time value (is premium when intrinsic value is 0)

Always better to sell vs buy because you capture the time value.

Intrinsic value = value if about to expire

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16
Q

Factors affecting option premium

A

Risk: an option is insurance. The greater the risk, the more the option is worth.

Interest rates: Call options are worth more if the interest rate is higher. Put options are less.

Time to maturity: A greater time to maturity implies a higher investment factor and generally implies greater risk.

Current stock price
Future stock price=strike price

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17
Q

Long Put

A

Is a good way to hedge stock project against downside

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18
Q

Options in corporate securities

A
  • convertible debt and preferred stock
  • callable debt and preferred stock
  • callable convertible debt and preferred
  • warrants (call options)
  • put warrants
19
Q

NPV Rule

A

Net Present Value of all cash flows

All projects with NPV>0 should be accepted.

20
Q

IRR

A

Internal Rate of Return: the discount rate that makes the NPC of investment =0.

  • Break even discount rate
  • Measures annualized rate of return
  • In general, take project for which IRR > cost of capital
21
Q

IRR & YTM

A

The YTM on a bond is an example of an internal rate of return. They are equal

22
Q

IRR Rule

A

A project is standard if there are negative cash flows in one or more years at the beginning and positive cash flows in the later years.

For standard projects, NPV > 0 if and only if IRR >cost of capital

A standard project should only be taking if and only if its IRR is greater than the opportunity cost of capital.

For nonstandard projects, don’t use IRR not NPV.

23
Q

Mutually Exclusive Projects

A

You want the largest NPV, not necessarily the largest IRR.

-It is usually better to earn 30% on 10 million than investment than earn 100% on a $100 investment.

24
Q

Profitability Index (PI)

A

THe profitability index of a project expresses the present value as a proportion of the initial outlay.

Decision rule: accept a project if PI>1 and reject a project if PI<1.

For every $1 I put into a project, I make $x.

PI=Present value of all cash inflow/present value of all cash outflows

25
Q

Payback Period

A

If payback period < cutoff period internally.. invest

Rank in order of lowest to highest payback periods

26
Q

Working Capital

A
  • Cash that is tied up but not consumed. At end of project company gets paid.
  • Cash employed to run the day-to-day
27
Q

Net working capital

A
  • inventories and accounts receivable are working capital (current assets).
  • For most projects, inventories + accounts receivable - accounts payable

A growth in net working capital = negative cash flow

28
Q

Example of NWC

A

Net cash from equipment sale = Market value - (Market value -Book value (price of purchase - depreciation) times tax rate.

29
Q

Investing now or later?

A

These are mutually exclusive projects, so choose one with highest NPV

30
Q

Sunk Costs

A

Costs that have already been incurred and cannot be removed should be ignored

31
Q

Opportunity Costs

A

AN opportunity cost is the most attractive alternative that is given up if a particular investment is undertaken.

Typically at a minimum of current market resale value.

32
Q

Stand Alone Principle

A

A project should be evaluated on a stand alone basis

In effect, the cash flows from the project should be sufficient to meet the requirements of its security holders

33
Q

Incremental Cash Flows

A

Always consider increment cash flows from a project, not total cash flows. Example: company already makes 1M, with project makes 3M, Incremental value is 3-1=2M

34
Q

Incremental Costs

A
  • Forget sunk costs
  • Allocate only incremental overhead
  • Include opportunity costs
35
Q

Cost of capital

A

Is the hurdle rate

  • appropriate discount rate
  • risk adjusted discount
36
Q

Consequences of wrong discount rates

A

if discount rate is too high, NPV will be lower, so you are going to decline projects that could’ve been profitable

If discount rate is low, NPC will be higher, so you might take projects that you shouldn’t.

37
Q

Capital Components

A

Debt (bonds), Equity (stocks), preferred stock

Sources of funding that come from investors

38
Q

WACC (Weighted Avg Cost of Capital)

A

WACC is the average cost of funds from all sources

A firm’s WACC represents:

  • individual costs of capital and
  • financing mix
39
Q

WACC Formula

A

Weight of debtcost of debt(1-tax rate) + weight of preferred stock* cost of PS + Weight of stock * cost of stock

40
Q

Estimating Cost of Debt

A

Pre-tax cost of debt =yield to maturity on new bond issue

after tax cost = pretax cost * (1-tax rate)

Actual expected cost may be somewhat lower:

  • possibility of default lowes expected returns to investors relative to calculated YTM
  • Call provisions lower expected corp interest costs
41
Q

CAPM

A

Expected return on equity=risk free rate + Beta*Market risk premium

42
Q

Source of Risk

A

THe cost of capital for a project depends on the riskiness of the assets being financed, not on the source of financing.

43
Q

WACC

A

Is the hurdle rate on graph…. Shows that you should use different hurdle rates for different levels of risk on projects.

The lower the risk, the lower the hurdle. The higher the risk, the higher the hurdle.

FIN 621 (2 decks)

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