KAPLAN 5-9

Question 1

WACC

Answer 1

cost of debt and equity averaged based on market value of each source of finance
[Ve/Ve+Vd]Ke + [Vd/Vd+Ve]Kd(1-T)
Ke, Kd - return required by equity and debt holders

Question 2

Ke - CAPM

Answer 2

derives required return for investor by relaitng return to the level of systematic risk faced by investor (assumption that all investor are well diversified, so syst risk is only relevant)
Ke (CAPM) = Rf + Bi(E(Rm)-Rf)
Rf - risk free rate
E (Rm) - expected return on the market
(E(Rm) - Rf) is called equity risk premium
Bi - beta factor - systematic risk of the firm or project compared to market
B>1 - above average risk
B<1 relatively low risk

B = based on statistical analysis of returns from a particular share over a period compared to the overall market returns; if indiv returns are more volatile then B>1

Question 3

bETA

Answer 3

Beta values reflect:
business risk (resulting from operations) and finance risk (resulting from their level of gearing)
2 types of gearing:
1. asset or ungeared, Ba, - only systematic risk of business area
2. Be - equity or geared beta, reflects the systematic risk of business area and specific gearing position of the company in question

Question 4

de-gear and re-gear Beta

Answer 4

Ba = [Ve/(Ve+Vd(1-T)]Be

Question 5

Dividend Valuation Model

Answer 5

value of company is PV of expected future dividends discounted at shareholders required rate of return
P0 = D0(1+g)/(ke-g)
g - constant growth rate in dividends
D0 - currrent level of dividend
P0 - current share price
Ke = [D0(1+g)/P0]+g

Question 6

MM’s proposition 2

Answer 6

Ke = Kei +(1-T)(Kei-Kd)(Vd/Ve)
V - market value
Kd - pre-tax return required by debt holders
Kei - cost of equity in equivalent ungeared firm
Ke - cost of equity in geared firm

Question 7

cost of debt

Answer 7

the value of share = PV of future dividends at the shareholders required rate of return
The value of bond = PV of future receipts (interest + redemption amount) discounted at lender’s required rate of return
Irredeemable debt
Kd(1-T) = I (1-T)/MV
I - annual interest paid
T - corporate tax rate
MV - current bond price
Redeemable debt
Kd(1-T) = the Internal Rate of Return of :
- bond price
- interest (net of tax)
- redemption payment

Question 8

pre-tax cost of debt

Answer 8

also called yield to investor, yield to maturity, or gross redemption yield
for irredeemable debt, pre-tax Kd is I/MV - interest/cost of bond now
for redeemable debt = pre tax cost of debt is IRR of the bond price, the GROSS interest (i.e. pre-tax) and redemption payment

Question 9

credit spread (default risk premium)

Answer 9

Kd(1-T) = (Risk free rate + Credit spread)(1-T)
credit spread is a measure of the risk associated with the company. generally calculated by credit rating agency

Question 10

credit risk, rating agencies and spread

Answer 10

credit or default risk is the uncertainty surrounding a firm’s ability to service its debts and obligations
credit rating agencies provide infor on creditworthiness

Question 11

factor indicating likelihood that company will default on its obligations

Answer 11

• the magnitude and strength of company’s CF
• the size of debt relative to the asset value of the firm
• the volatility of the firm’s asset value
• the length of time the debt has to run
  AAA - BBB - Investment - from highest quality - zero risk, AA - HQ, little risk, A - strong, min risk
  BBB - medium grade - low but clear risk
  BB-C - junk
  BB grade - marginal risk
  B - significant risk exposure
  CCC - considerable risk exposure
  CC - highly speculative - v high risk
  C - in default - v high likelihood of failure
  Kaplan Urwitz model to calc credit rating

CREDIT SPREAD
to compensate lenders for uncertainty with low rank firms, firm pay SPREAD or PREMIUM over Risk free rate of interest, which is proportional to their default probability

Yield on corporate bond = Yield on equivalent treasury bond + credit spread

Question 12

Iterative process for determining spot yield curve by bootstraping coupon paying bonds

Answer 12

current trading price of the bond = 100+coupon rate (107)/(1+r1)
so 103=(107/(1+r1))
R1=107/103-1=3.88%
Bond B, redeemable in 2yrs, coupon rate of 6% and is trading at $102
Bond B; 102 = ($6/1.0388)+[106/(1+r2)^2]; r2 = 4.96%
Bond C: $98 = ($5/1.0388)+(5/1.0496)+[105/(1+r3)^3]
r3 = 5.8%
the annual spot yield curve:
year
1 = 3.88%
2 = 4.96
3 = 5.8

Question 13

Macalay duration for bond

Answer 13

1. calculate PV of each future receipt from bond, using pre-tax cost of debt as discount rate
2. calculate the sum of (time to maturity PV of receipt) (10.03+(28.15)+(37.36)… =404.
3. divide this by PV of receipts (i.e. the bond price) = 404.30/97.25=4.157 yrs
   Modified duration = Macalay duration/(1+discount rate) = 4.157/1.10743 = 3.754 - the size of modified duration = identified how much the value of the nond will change if there is a change in interest rates
   the value of the bond will change by 3.754 times the change in interest rates mulitplied by original value of the bond

Question 14

duration pros and cons

Answer 14

duration measures average time it takes for a bond to pay its coupons and principal and measures redemption period of a bond
1. allows comparison of binds with different maturities

main cons
assumes a linear relationship bn interest rates and bond price. the extent of deviation from linear relationship is known as convexity
themore convex, the more inaccurate duration is for measuring interest rate sensistivity

Question 16

Risk and WACC

Answer 16

Ba=Be*Ve/VD(1-T)
Kd= I(1-T)
- assumption: debt is perpetual, this overvalues tax shield where debt is finite
Ignores issue cost on equity

Question 17

ApV adj PV

Answer 17

APV=Base case NPV+ financing impact
Can be used if a new project has different financing risk (d/e ratio) from the company , i.e. overall capital structure of company changes
Value of geared project = Value of an all equity financed project + PV of financing side effects

Question 18

FRA ( forward rate agreement)

Answer 18

A way of placing bet on interest rates moving - make gain or loss to offset

Question 19

FRA ( forward rate agreement)

Answer 19

A way of placing bet on interest rates moving - make gain or loss to offset

Question 20

Interest rate cap

Answer 20

Maximum interest rate that we have to pay on our loan

Question 21

over the counter option

Answer 21

tailor made option - usually sold by a bank (normally EU options)
option can be used to avoid downside risk exposure w/o foregoing upside exposure

Question 22

intrinsic value of the option

Answer 22

exercise price vs price of underlying asset. Can’t be negative.
Share price 80
Exercise price 100
Int Value 0 (out of the money
Share price 120
Exercise price 100
Int Value 20 (in the money)
When same exercise and share price = at the money
the value of call option increases as share price increases

Question 23

call option

Answer 23

R, but not O to buy a particular good at an exercise price

Question 24

put option

Answer 24

R, but not O, to sell a particular good at an exercise price

Question 25

exercise price

Answer 25

fixed price at which the good maybe bought or sold

Question 26

premium

Answer 26

the cost of an option

Question 27

traded option

Answer 27

standardized option contracts sold on futures exchange (American option)
as period of expiry increases, chance of profit increases as well

Question 28

volatility of the share price

Answer 28

decrease in price is no problem for option buyer as there is downside limit
- option holder gains if price increases, There is no limit to the upside
greater the volatility, the better as it increases the Proba-ty of valuable increase in price
owning call option is more valuable when interest rates are high

Question 29

Increase in share price

Answer 29

value of a call Increases

Question 30

Increase in exercise price

Answer 30

value of a call decreases

Question 31

increase in time to expiry
Increase in volatility; interest rate

Answer 31

value of a call increases
value of a call increases

Question 32

Increase in share price on put option

Answer 32

put option value decreases

Question 33

increase in exercise price

Answer 33

put option value decreases

Question 34

increase in time to expiry; volatility; interest rate for put option

Answer 34

share price and exercise price - opposite of call option
time and volatility - same argument as for call option
interest rate increase - a higher interest rate reduces the PV of value of deferred receipts making the optionless valuable as an alternative to selling now

Question 35

volatility

Answer 35

SD of day to day price changes in security, expressed in annualised percentage. measures of volatility: historical and implied (taking current quoted options prices and working backwards)

Question 36

risk free rate in options

Answer 36

Rf is the minimum return required by investors from a risk-free investment
treasury bills or other short term