Lec 1-6: Valuation Flashcards
How is beta defined
covar(r,m)/Var(m)
Is a high beta stock more likely to be a technology firm or a utility company?
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.
Define Residual Claimant
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
Why may shareholders not follow the NPV rule?
If investments change debt value (shareholders are not residual claimants) or if there is a financing gain
What is the annuity formula?
What are the axis of the Capital Market Line?
Return (not excess return) on the y-axis, standard deviation on the x-axis
What is a key requirement for using the CE-CAPM?
That you are willing to estimate covariance of cash flows and the market.
Derive the CE CAPM
State the CE CAPM
When is it a good idea to use real-risk free rates?
When inflation is very high
What are some solutions, if there is no risk-free rate available?
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
What are some commonly used risk-free rate estimates?
90-day t-bill and 10-year T-bond. These have high liquidity. Use the one that matches duration of assets the best
What is a key condition for risk-free rate estimate to matter?
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
When will YTM and cost of debt differ?
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
Derive the “Quick and Dirty” adjustment to YTM
State the quick and dirty adjustment to YTM
What are some problems with calculating debt betas from credit ratings
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.
What are the formulas for levering and unlevering debt?
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.
What is the Hamada Formula?
What is the Harris-Pringle formula?
Explain interpolated payback
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.
Explain MIRR
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
Discuss the relevance of the payback criterion
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
What are some problems with IRR?
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
Discuss the Profitability Index?
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
What is EVA?
Show why EVA based on market value and economic depreciation is a useless measure?
What is the relationship between EVA and NPV?
The present value of the EVA equals the realized NPV from the project. Not necessarily the ex ante NPV based on expectations.
What is the MM proposition I?
The value of a corporation is independent of its capital structure
What are the assumptions of the MM proposition?
Complete markets (firms cannot complete markets by issuing new securities)
Perfect competition
No transaction costs
Perfect information
No bankruptcy costs
No taxes
What does the MM Proposition II say?
The corporate cost of capital is independent of the capital structure, since the free cash flows is independent of capital structure
When should you use APV and when should you use WACC?
APV when the firm has a constant debt level, WACC when it has a constant debt ratio
What the the trade-off theory?
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
What are the problems with the trade-off theory?
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
What is APV?
To value cash flows and tax shield separately. Value tax-shield at cost-of-debt. Value firm at levered cost of capital.
What is the beta of cash?
It can safely be assumed to be zero
How to adjust beta for cash?
Betas are weighted averages of the different betas of a company. Assume beta of cash is 0. Solve for beta of operations
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?
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.
Describe the Miller Equilibrium
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.
How is demand decided in the “Miller model”?
Demand for securities is decided upon by their after tax returns. If a security offers higher after-tax returns, more investors will buy it
How is supply determined in the ‘Miller model’?
Corporates will supply more debt as long as the tax advantage is positive
What is the Miller tax advantage?
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))]
How is the Harris Pringle formula derived?
Asset beta is the weighted average of debt beta and equity beta
We can we set C = P*r_ytm in the ‘quick and dirty’ adjustment?
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)
