Lec 1-6: Valuation

Question 1

How is beta defined

Answer 1

covar(r,m)/Var(m)

Question 2

Is a high beta stock more likely to be a technology firm or a utility company?

Answer 2

High beta stocks react more violently to movements in the broad market than low beta stocks. On the basis of recent experience, this is more likely to apply to technology stocks than to utility stocks.

Question 3

Define Residual Claimant

Answer 3

Residual Claimants are the claimants (among a group of claimants) who would receive their claims after claims of all other claimants have been paid off

Question 4

Why may shareholders not follow the NPV rule?

Answer 4

If investments change debt value (shareholders are not residual claimants) or if there is a financing gain

Question 5

What is the annuity formula?

Answer 5

Question 6

What are the axis of the Capital Market Line?

Answer 6

Return (not excess return) on the y-axis, standard deviation on the x-axis

Question 7

What is a key requirement for using the CE-CAPM?

Answer 7

That you are willing to estimate covariance of cash flows and the market.

Question 8

Derive the CE CAPM

Answer 8

Question 9

State the CE CAPM

Answer 9

Question 10

When is it a good idea to use real-risk free rates?

Answer 10

When inflation is very high

Question 11

What are some solutions, if there is no risk-free rate available?

Answer 11

Use a large corporate bond (or basket) and reduce by AAA spread (about 1%)

Use other country. Use forward currency markets to impute a risk-free local currency rate

Use government bond rating to determine their spread over a rf

Question 12

What are some commonly used risk-free rate estimates?

Answer 12

90-day t-bill and 10-year T-bond. These have high liquidity. Use the one that matches duration of assets the best

Question 13

What is a key condition for risk-free rate estimate to matter?

Answer 13

That market beta is very different from 1. From beta is different from 1, risk-free rate impacts both intercept and slope on security market line

Question 14

When will YTM and cost of debt differ?

Answer 14

Whenever the expected payment is not equal to the promised payment. YTM can heavily exceed expected return on debt, if there is high default risk

Question 15

Derive the “Quick and Dirty” adjustment to YTM

Answer 15

Question 16

State the quick and dirty adjustment to YTM

Answer 16

Question 17

What are some problems with calculating debt betas from credit ratings

Answer 17

Credit rating do not only reflect systematic risk (also idiosyncratic default risk)

Companies may issue various bonds with different credit ratings. Not clear which one to use.

Question 18

What are the formulas for levering and unlevering debt?

Answer 18

1) The Hamada. Constant debt levels. Debt provides tax shield. Debt is risk-free
2) The Harris-Pringle. Constant debt ratio. Debt is not risk-free.

Question 19

What is the Hamada Formula?

Answer 19

Question 20

What is the Harris-Pringle formula?

Answer 20

Question 21

Explain interpolated payback

Answer 21

It is the normal payback plus a correction, such that if the project cash flows in p are greater than what it takes to break even, the payback will be adjusted downards.

Question 22

Explain MIRR

Answer 22

It is similar to IRR, but all outflows are discounted to period 0 at at a financing rate, and all inflows are pushed to period T (final period) with a reinvestment rate. The MIRR is than calculated as an IRR of a project with only two cash flows

Question 23

Discuss the relevance of the payback criterion

Answer 23

It is a measure that will often conflict with the NPV rule. There may be very high cash flows after the firm breaks even. It can work as heuristic rule in simple situations, e.g. if cash flows are even, a payback criterion of 1/r is consistent with the NPV rule

Question 24

What are some problems with IRR?

Answer 24

1) It assumes that investors like higher interest rates. With periodic negative cash flows, this may not hold true
2) IRR assumes cash flows can be reinvested at the IRR rate
3) Comparability is often rather low
4) When cash flows change sign many times, projects can have multiple IRRs

Question 25

Discuss the Profitability Index?

Answer 25

PV(inflows)/PV(outflows)

It is very similar to NPV. And a PI rule will accept and reject the same projects.

BUT, one should not try to maximize PI

Question 26

What is EVA?

Answer 26

Question 27

Show why EVA based on market value and economic depreciation is a useless measure?

Answer 27

Question 28

What is the relationship between EVA and NPV?

Answer 28

The present value of the EVA equals the realized NPV from the project. Not necessarily the ex ante NPV based on expectations.

Question 29

What is the MM proposition I?

Answer 29

The value of a corporation is independent of its capital structure

Question 30

What are the assumptions of the MM proposition?

Answer 30

Complete markets (firms cannot complete markets by issuing new securities)

Perfect competition

No transaction costs

Perfect information

No bankruptcy costs

No taxes

Question 31

What does the MM Proposition II say?

Answer 31

The corporate cost of capital is independent of the capital structure, since the free cash flows is independent of capital structure

Question 32

When should you use APV and when should you use WACC?

Answer 32

APV when the firm has a constant debt level, WACC when it has a constant debt ratio

Question 33

What the the trade-off theory?

Answer 33

A theory of firms’ capital structure: 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

Question 34

What are the problems with the trade-off theory?

Answer 34

Some very proftiable firms have little or no debt

Debt predates corporate taxation

Firms issue far less debt than the trade-off theory suggests they should

Question 35

What is APV?

Answer 35

To value cash flows and tax shield separately. Value tax-shield at cost-of-debt. Value firm at levered cost of capital.

Question 36

What is the beta of cash?

Answer 36

It can safely be assumed to be zero

Question 37

How to adjust beta for cash?

Answer 37

Betas are weighted averages of the different betas of a company. Assume beta of cash is 0. Solve for beta of operations

Question 38

How important are the probabilities that each of the possible states of the world in the proof of the MM result obtains? Does your answer change if there is a cost of bankruptcy?

Answer 38

Probabilities do not matter in the absence of bankruptcy costs. This is a hedging argument (like option pricing) and it does not only hold in expectation, it holds in every state of the world.

With bankruptcy costs, this changes. Value of firms with bankruptcy costs equals value of firms without them plus the expected value of these costs. And the latter depends on the probabilities. Bankruptcy costs cannot be hedged as MM is about hedging cash flow risk.

Question 39

Describe the Miller Equilibrium

Answer 39

In equilibrium, corporate will not have an incentive to issue more debt, else they would have done so. The marginal borrower derives no tax advantage from issuing debt rather than equity.

Question 40

How is demand decided in the “Miller model”?

Answer 40

Demand for securities is decided upon by their after tax returns. If a security offers higher after-tax returns, more investors will buy it

Question 41

How is supply determined in the ‘Miller model’?

Answer 41

Corporates will supply more debt as long as the tax advantage is positive

Question 42

What is the Miller tax advantage?

Answer 42

It is a coefficient that multiplied to debt level determines the PV of the tax shield. The coefficient is “[1 - ( (1-tax)(1-tax_equity)/(1-tax-debt))]

Question 43

How is the Harris Pringle formula derived?

Answer 43

Asset beta is the weighted average of debt beta and equity beta

Question 44

We can we set C = P*r_ytm in the ‘quick and dirty’ adjustment?

Answer 44

YTM is defined as the discount rate that makes the payments equal to the price. In the perpetuity formula, this is P = C/(r_ytm)