Finance Exam Flashcards
What is Finance
the study of how and under what term saving (money are allocated between lenders and borrows
consists of financial systems (public, private and government spaces, and the study of finance and financial instruments)
What is corporate finance
the area of finance that deals with the sources of funding and the capital structure of corporations, and the actions taken to increase the value of firm to shareholders
primary goal is to maximize/increase shareholder value
Corporate Finance decisions
Capital budeting
Capital structure
What is Capital Budgeting
the process of making and managing expenditures on long-lived assets (“what investments should the firm undertake?”)
What is Capital Structure
the mixture of debt and equity capital maintained by the firm and used to finance its investment activities (“how should the firm make this investment?”
Absence of Arbitrage Opportunities
arbitrage involves exploiting price differences to earn diskless profit
Time Value of Money
a dollar today is worth more than receiving a dollar in the future
Risk-Return trade off
expected return rises when an increase in risk
Financial Markets
Money Markets: markers for short term instruments
Capital Markets: markets for long term debt and equity securities
Primary Markets: when corp issues new securities (cash flows from investors to the firm
Seconday Markets: involve the purchase & sale of “used” securities from one investor to another
Financial Institutions (intermediaries)
facilitate flows of funds from savers to borrows (banks,, Pension funds, etc.). Most efficient manner (direct or indirect (intermediation) finance)
Two major categories of financial securities
Debt instruments: commercial paper, treasury bills and notes, mortgage loans, bonds
Equity instruments: common stick, preferred stock
Marketable securities
can trade between or among investors after their original issue in public markets and before they mature or expire (publicly-listed stocks, corporate bonds)
non-marketable securities
cannot be traded or amount investors (savings accounts, term deposits)
Separation of Ownership and Control
Agency Relationship
Agency Problem
Agency Costs
Agency relationship
principals hire agents to represent their interests (shareholders hire managers)
Agency Problem
when their are conflicts of interest between principle and agents. Agents incentives might be misaligned
Agency Costs
the costs of resolving conflicts of interest (agency problem)
Financial Markets Fisher Model:
motivates the existence of capital markets, individuals can borrow or lend fund in financial markets to alter their consumption and increase utility
motivates the “positive NVP rule”, accept projects > NPV
Consumption vs. Investment decisions (can be made independently of each other)
basic principle of investment decision making is: “investments must be at least as desirable as opportunities available in the finance markets
Key conceptual issues with fisher separation
- says that all investors will want to accept or reject the same investment project using NPV rule, regardless of personal consumption preferences
- shareholders will be united in their preference for the firm to undertake profit NPV decisions, regardless of their personal consumption prefrences
Shareholder Wealth Maximization
considered the most appropriate goal
genuine economic profit
reflects the value of these economic profits both now and into the future
Can only be one equilibrium interest rate (otherwise arbitrage opportunities would arise
Perfectly competitive & frictionless markets
trading is costless (no taxes)
info about borrowing and lending opportunities is available to all agents
there are many traders (all price takers, not setters).
The one period case
PV and FV (lump sum cash flows)
The multi-period case
PV (multiple cash flows)
APR
Annual Percentage Rate, or “quoted” rate
IGNORES COMPOUNDING effects
APR = EAR when there is annual compounding and payments are made annually
just “r” in formula
EAR
Effective annual rate
ACCOUNTS for compounding effects
gives the TRUE rate states in annualized terms
Simplifications to reduce calculations
Annuities and Perpetuities
“m” in EAR formula
compound periods
NPV
If the project’s NPV is positive, the project should be accepted
Cash flows/(1+r) - the initial Investment
- represents the expected change in firm value from undertaking the project. the positive NVP’s creative value, and negative destroy value
Strengths of NPV measure
uses cash flows rather than accounting numbers
analyzes all of the projects cash flows
correctly discounts these cash flows accounting for the TVM
is conceptually attractive and relatively easy to interpret
Payback Period
= PBP represents the time a project requires to recover the initial cost. A project is accepted if its payback period is less than a specified benchmark
accepted: PBP < specified benchmark
Weaknesses of PBP
- Cash flows occurring after PBP is achieved are ignored
- Cash flows are not discounted. PBP thus ignore the TMV
- the choice of policy benchmark is arbitrary
Strengths of PBP
- simple to compute & easy to understand making it useful for small day-to-day decisions
- may be useful for firms with limited access to capital due to its emphasis on speedy cash recovery
- may not be as limited in practice as its theory. significant cash flows beyond the cutoff may be ignored
IRR
discount rate applied to a projects cash flows such that the project has a net present value of zero (BREAK EVEN DISCOUNT RATE)
most important alternative approach to NPV
no algebraic formula that can be used when more than 2 non-zero cash flows (FINANCIAL CALC)
IRR decision rule
IRR > project’s discount rate —-> Accept project (NPV>O)
IRR < projects discount rate ——> REJECT project (NPV<0)
Issues with IRR approach
independent and mutually exclusive projects
independent projects
independent is its acceptance/reject has no impact on the acceptance of other projects
mutually exclusive projects
mutually exclusive when accepting one project dictates the rejection of all others (amount of land - open a nightclub, parking lot or shop?)
Multiple Rates of Return
Future cash flow is negative.
ex: open, profit, close and renovate
2 feasible MULTIPLE IRR’s (2 multiple signs
Issue’s facing mutually exclusive projects
Scale Problem:
- IRR is states as percentage that doesn’t account for the size of the iniacial investment
- could use the NPV approach instead
- Incremental IRR
Timing Problem:
- projects that have larger cash flows earlier will tend to have higher IRR’s
Scale problem : Incremental IRR
select larger project and forgo smaller one
Timing problem solve
- compare projects NPV’s
Profitablilty Index
A profitability index thats > 1 signifies that a project has a positive NPV
- indefendent projects
- mutually exclusive projects
- caption rationing
Profitabiliy index : Independent Projects
accept all projects with PI’s greater than 1 (positive NPV)
Profitabiliy index : Mutually exclusive projects
PI measure suffers from the scale problem as the IRR measure (doesn’t account for the size of mutually exclusivee projects )
Use NPV approach instead
Profitabiliy index : Capital rationing
may not have sufficient funds available to pursue all of its positive NPV projects - lead to incorrect decision based on NPV criterion
rank in order of PI (lowest to highest) - which provides most value per dollar invested
Capital budgeting problems using NPV rule steps
- identify incremental cash flows
- dress the tax implications
- TVM (discount back to PV)
Step 1. identify incremental cash flows
depreciation expense is NOT a cash flow
any cash flow must be incremental - (does rallying this cash flow depend directly on acceptance or rejection of project?
Opportunity costs (incremental)
Erosion (incremental cash flow) - cash flow you will loose from existing flow if you open another one
Synergy (opposite of erosion)
Note: SUNK costs are NOT INCREMENTAL
Step 2. Address the tax implications
Revenue (after tax). = revenue (pretax) x (1-tax rate)
Capital Cost Allowance Tax Sheild - PV CCATS
= the easiest way to determine the present value of these tax savings is to apply the formula
Step 3. Time Value of Money (discount all future cash flows to their time zero PV
ensure all after tax cash flows are discounted back to time zero - PV CATTS already does this (PV)
Inflation and Discount Rates
real cash flows - real discount rates
nominal cash flows - nominal discount rates
convert interest rates from real to nominal, we can use the famous Fisher Equation
Operate Cash flows
OCF is the cash flow thats started on after tax basis
Top Down approach (OCF)
OCF = Sales - costs - taxes
Tax shield Approach
on formula sheet
Bottom up approach (OCF )
OCF = Net income + depreciation
Investments with unequal lives
inadequate when different expected durations
longer = more time to generate positive cash flows
find the C in pV annuity formula
find NPV of each project under analysis and find the equivalent annual cash flow by computing annuity payment associated with NPV
Risk and Capital Budgeting
Sensitivity Analysis
focuses on evaluating how susceptible a projects NPV is to a change in one of the inputs. one input is varied while others are assumed to meet their expected values
Scenario Analysis
is a variation on sensitivity analysis where a number of differently likely scenarios are evaluated and each scenario involves multiple factors varying
ex :if management is ineffective, variable costs, FC’s and initial costs might all rise above their expected values
Break-even analysis
shows the level of sales that are needed to achieve a zero NPV. BEP determine the sales level such that PV inflows equals PV outflows
Bond Valuation
Bonds = debt securities (fancy IOU)
Zero-coupon bond (pure discount)
funds are borrowed at t=0 and FV is repaid upon maturity. PV lump sum formula
ex: Canadian Treasury Bills
Coupon bonds
funds are borrowed at t=0
make coupon payments to repay the FV at maturity
PV annuit and PV lump sum formula an adding the two results together
YTM
discount rate
Coupon bond = conceptually equivalent to capital budgeting project IRR
Coupon rates
not the same as the bonds YTM. refers to the bonds coupon payments
CR = Annual coupons / FV
Bonds concepts
when the discount rate increases, future cash flows willl have a lower PV today
Bond price > FV
Premium bonds
Bond Price = Face Value
PAR bonds
Bond Price < Face Value
Discount bonds
Coupon rate > YTM
premium bond
Coupon rate < YTM
Discount bond
Bonds with lower CR
are more sensitive to yield changes
Bonds with longer maturities
are more sensitive to yeild changes
Spot rates
actual price in the moment
forward spot rates
expectation of what the rate will be
Measuring historical return, two components to stock return
: dividend yield and capital gains yield
r1 = D1/P0 + (P1 - P0 / PO) = total return
Historical returns
“historical” - looking back
Higher risk asset classes have earned higher returns over the long run
expect common stock have a higher return than bonds, which have a higher reuturn than Treasury bills
Risk Premium
The return generated by risky assets over and above the risk =-free rate is called a risk-premium
standard deviation and historical returns
higher the risk, higher the standard deviation, higher the return
annual returns calculations
ex :
(2016 share price - 2015 share price) + dividends / 2015 share price
means, variance, standard deviation for historical data
interested in calculating forward-looking paparementers esitmates
1. identify possible future states of the world with known probabilities
Pairwise Assets
- Expected covariance
- Correlation
= measure how two random variables (future asset returns) move in relation to one another
if both asset returns tend to be positive/negative - their returns tend to move together and their corvariance/corellation will be positive
Leess than perfectly positive (pxy< 1) , DIVERSIFICATION BENEFITS
“the risk of the sum is less than the sum of the risks”
Portfolios of Assets
Expected return (formula given)
Standard deviation (2 asset portfolio formula given)
- formula expands as we add more assets to the portfolio. each pair of assets will have its own covariance/correlatoin which must be considered in the portfolio standard deviation calculationrisk
measured by standard deviation of portfolio return
increases with mean return
Correlation coefficient meanings
P =1 max St. dev P
P=0 reduced st. dev P
P = -1 min st. dev P
Diversification
can substantially reduce the variability of returns without an equivalent reduction in expected returns
risk reduction arises when
“worse than expected” returns are offset by “better than expected” returns from another asset in the portfolio
Unsystematic risk
aka: firm-specific risk, idiosyncratic risk, unique risk
can be diversified away
Systematic risk
aka: market risk, non-diversifiable risk
cannot be eliminated through simple diversification
pervasive events that affect nearly all assets to some degree
ex: interest rate exposure, foreign exchange rates, exposure to oil prices
Total risk
(variance of returns)
can be decomposed into systematic risk and unsystematic risk
refers to events that affect a single security or small group of securities
ex: labour unrest at a particular firm, inclement weather in particular region, unfortunate events like fires, thefts, etc.
Asset Pricing Formula (CML)
Slope of the line connecting the risk-less asset w Portfolio T is the steepest line that can feasibly be drawn. Combing the diskless asset with portfolio T and investor can realize the most efficient trade-off between risk and return
Price model assumptions
- investors only hold efficient portfolios
- markets are perfectly competitive
all investors are price takers
full information is simulatenosly available to all agents
There are no “market frictions (taxes, regulatory constraints, transaction costs)
Investors have Homogeneous beliefs regarding expected returns, variances & covariances of all tents
TANGENCY PORTFOLIO IS THE MARKET PORTFOLIO
———> all investors are holding the same portfolio of risky assets - sum of all investors portfolios is “the market”
Measuring Market risk
diversified portfolios don’t need to be concerned about the unique risk of a stock
Marginall contribution of portfolio risk
captured by the assets beta coefficient which measures
- security’s contribution to the market portfolio’s total risk
- securirties responsiveness to changes in the market portfolio
- securitys market risk or systematic risk
Security Market Line (SML)
relationship between an assets required return and its systematic risk
calculates the cost of common equity
key result of the capital asset pricing model (CAPM)
Slope term in SML
market risk premium (E(rm) - rf)
Implications of the CAPM
relationship between required return & beta is linear
all securities, if fairly priced, should lie on SML
investors rewarded only for exposure to systematic risk
WACC
tells us the average after-tax cost a firm faces when raising new funds to pursue expansion projects
use as the projects discount rate if the new project has the same risk as the company’s existing operations
Beta and Cyclicality
strong pro-cyclical stocks have higher beta’s
High debt = high risk = high beta
Beta = Cov/ Var
firms assets can be viewed as a portolfio of debt and equity A= D + A
Beta is just the weighted average of individual betas
Estimating Beta
industry beta provides a better estimate of a firms beta IF the firms operations are similar to those of other firms in the industry
Can also be estimated by regressing the returns of an individual stock agains the returns of a “market” portfolio
Efficient market
info is readily available to investors there forms of market efficiency - Weak form efficiency - semi-strong efficiency - strong form efficiency
hypothese conveys
- since info is immediately reflected in prices, investors should not expect to earn abnormal returns
- learning new info doesn’t help investors because prices adjust before investor can exploit info
- firms should expect to receive “fair value” for any securities they issue
weak form efficiency
all past stock price/return info is incorporated into current asset prices
- technical analysis cannot be used to generate abnormal returns
semi strong form efficiency
then all publicly available information is incorporated into current asset prices
- fundamental analysis cannot be used to generate abnormal returns
strong form efficiency
all pertinent information (public and private) is incorporated into current asset price
- insider trading cannot be used to general abnormal returns
Foundation of market efficiency
rationality
- when new info becomes available all investors adjust their estimates to asset prices
independent deviations from reality
- small # of individuals may act less then rationally
pessimistic group will be offset by a optimistic investors who estimates of assets new price is too high (cancel each other out)
arbitrage
- arbitrage opportunity involves the simultaneous purchase and sale of different but similar assets to earn a riskless profit due to the misplacing of some asset. assume that savvy investors would take steps to correct misplacing by engaging in arbitrage trading
Testing market efficiency
weak form efficiency:
- can be evaluated by testing the serial correlation of an assets returns
Semi-strong efficiency
- often tested using the Event Study Metholofy
- look for evidence under-reaction, over-reaction, early reaction or delayed reaction around the time of a significant event
Strong form efficiency
- tests vernally revolve around instances of insider trading (using non-public info to earn abnormal returns)
- illagilty of insider trading makes difficult
