PAST EXAM Flashcards
The _____________ (NIR) is an annual rate without consideration of compounding
Nominal Interest Rate
The ____________ (EAR) isan annual rate that accounts for compounding
Effective Annual Interest Rate
Two examples of market risk
The Reserve Bank announces an unexpected increase in inflation A High Court decision substantially broadens producer liability for injuries suffered by product users
Two example of individual risk
The managing director announces an increase in expenses unexpectedly A manufacturer loses a multimillion-dollar customer
What risk is measured by beta? Explain your answer
Beta coefficient; amount of systematic risk present in a particular risky assest relative to an average risky asset
SML
The security market line is a line of individual company returns based on beta.
What are the main differences between corporate debt and equity?
- Debt is not an ownership interest in the firm. Creditors generally do not have voting power.
- The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax-deductible
- Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganisation, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possiblity of financial failure. This problem does not arise when equity is issued.
Primary market?
a market where securities are traded for the first time
Secondary market ?
a market where subsequent trading of securities occurs
Financial distress costs ?: the direct and indirect costs associated with going bankrupt or experiencing financial distress
Firms with a greater risk of experencing financial distress will borrow less than firms with a lower risk of financial distress. For example, all other things being equal, the greater the volatility in EBIT, the less a firm should borrow
The static theory of capital structure?
Firms borrow up to the point there the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress
Explain what is meant by a 6 percent, $2 par, non-cumulative, convertible, redeemable, non- paritcipating preference share?
- 6%: The dividend is 6% of the par value of the share (i.e. l2¢ = 6% × $2)
- $2 par: The par value of the share is the limit of the shareholders’ liability.
- Cumulative: Arrears of dividends (from previous years) do have to be paid before ordinary share dividends., non-cummulative: are paid in a particular year, they will not be carried forward and paid in the future.
- Non-convertible: The share cannot be converted to an ordinary share at some future time according to the terms of the issue.
- Redeemable: At the option of the company, the company may redeem (buy back) the share.
- Non-participating: Should profits increase, the dividend does not increase.
- Preference: Preference is given to these shareholders (over ordinary shareholders) in payment of dividends and in repayment if the company is wound up.
Should shareholdersbe compensated for bearing the total risk associated with the returns of the individual company?
No – principle of diversification
Australian Securitites Exchange (ASX)?
Austrailia’s central marketplace for companies raising funds
Rights Issue and Share Issue?
- Rights issue is an issue of shares to existing shareholders in proportion to their existing shareholding where they have the right to purchase these shares at a lower subscription price than the market price. This protects their proportionate interests in the company.
- Raising of funds from the issue of ordinary or preference shares directly to the public i.e. IPO or private placement, or rights issue or dividend reinvestment plan
IPO?
An initial public offering (IPO) is the first time that the stock of a private company is offered to the public.
Efficient market hypothesis (EMH)
- asserts that well-organised capital markets such as Australian Securities Exchange or New York Stock Exchange are efficient markets, at least as a practical matter.
- In other words, an advocate of the EMH might argue that while inefficiencies may exist, they are relatively small and not common.
- If a market is efficient, then there is a very important implication for market participants: All investments in an efficient market are zero NPV investment
What are the potential advantages and disadvantages to a company’s shareholders if the company increases the proportion of debt in its capital structure?
Advantages:
- Increase Earnings per share if return on assets exceeds cost of debt.
- Benefit tax deduction from debt ie M &M theory V (l) = V (U) + Tr x Debt
Disadvantages:
BUT Increase level of financial risk Legal obligation Financial Distress (Present value of the tax benefit from the future interest payments. Compared to Greater Financial Risk)
Business Risk ?
the risk of future net cash flows attributed to the nature of the company’s operations. It is the risk shareholders face if the company is financed only by equity
Financial Risk ?
– the additional risk borne by shareholders because of the use of debt as a source of finance
Default Risk ?
The chance that a borrower will fail to meet obligations to pay interest and principal as agreed
“The essential message of portfolio theory is that diversification reduces risk”
a. How does diversification reduce risk?
- The principle of diversification is that spreading an investment across a number of assets will eliminate some, but not all, of the risk.
- Forming portfolios can eliminate the diversifiable risk or unique risk associated with individual assets.
- There is a minimum level of risk that cannot be eliminated simply by diversifying. This minimum level is labelled ‘non- diversifiable risk’ or systematic risk
“The essential message of portfolio theory is that diversification reduces risk”
b. How do we measure the risk of an individual share? Give examples of such risk
A beta coefficient tells us how much systematic risk a particular asset has relative to an average asset.
Examples of Systematic risk are GNP, interest rates and inflation.
“The essential message of portfolio theory is that diversification reduces risk”
c) How do we measure the risk of a well-diversified portfolio? Give examples of such risk
The risk of a well-diversified portfolio is measured using a portfolio Beta. Multiple each asset’s beta by its portfolio weight and then add the results up to get the portfolio’s beta. . Examples of Systematic risk are GNP, interest rates and inflation.
“The essential message of portfolio theory is that diversification reduces risk”
d) What risk are investors compensated for? Why?
Systematic Risk as non systematic risk is essentially eliminated by diversification, so a relatively large portfolio has almost no non- systematic risk
“The essential message of portfolio theory is that diversification reduces risk”
e) Use the Security Market Line to illustrate the relationship between risk and return on an individual security and explain how this line may be used to derive the return required on an individual share.
SML Positively sloped straight line displaying the relationship between expected return and beta
M&M proposition I & II
