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
What is the difference between primary and secondary markets?
- Primary market is where securities are issued/traded in the first instance e.g. new co-share issues.
- Secondary market deals with subsequent trading of securities which have already been issued. Comprises bulk of trading in financial markets.
Outline 2 benefits of Primary market
- Direct Fund raising for companies
- Strict Corporate Governance procedures for initial listing
Outline 2 benefits of Secondary market
- A capital market for the trading of marketable securities
- Strict Corporate governance procedures for companies listed in a secondary market
Ad and disad of Debentures
+ Ads:
- Tax deduction of interest
- No dilution of ownership
+ Disad:
• Increases Financial risk
Ad and disad of Preference shares
+ Ads:
• Security over ordinary shares as defined dividend and usually preferential in liquidation
+ Disad:
• Can be no participation therefore no claim on profit above scheduled dividend
Ad and disad of Ordinary shares
+ Ads:
- Reduces Financial risk
- Dividends no legally required
+ Disads:
- Dilution of ownership
- No tax Shield
Risk Averse Investor ?
One who dislikes risk
Systematic Risk ?
market related or non- diversifiable risk
Dividend Yield ?
dividend per share divided by share price
Weak Form Efficient Market
the information contained in the past series of prices of a security is reflected in the security’s current market price
Equity Instrument
Funds provided by or an interest of owners of an entity
Debt Instrument
a financial contract in which the receiver of the initial cash promises a particular cash flow, usually calculated using an interest rate, to the provided of funds.
With corporate taxes, what is the optimal capital structure for a company?
Borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. Borrow up to the point where your weighted average cost of capital is minimised.
Fisher Separation Theorem provides a single decision rule for a firm’s investment decisions I. What is the decision rule?
The decision rule is that management’s role is to maximise the present value of the firm’s investments in productive assets.
Fisher Separation Theorem provides a single decision rule for a firm’s investment decisions II. What is the implication of the theorem?
The benefit of the theorem is that it is one decision rule that management can follow to aid in optimally allocating the firm’s resources among the competing interests of a multitude of shareholders.
Market Capitalisation ?
The total market value of all the shares of a company on issue. A direct measure of the total wealth of shareholders that is invested in the company
Financial Asset ?
A claim to a series of cash flows against some economic unit. For eg A bank account or a share in a company
What is an investment portfolio? How can investors reduce investment risk by constructing an investment portfolio?
An Investment Portfolio is the name for a group of single assets held by an investor .There are 2 types of risk unsystematic and systematic. The risk that can be reduced is unsystematic risk. This consists of business risk factors specific to the individual company such as a strike. However the portfolio does not eliminate systematic risk but you can construct a portfolio to follow the average risk as measured by movements in the all ordinaries index.
What is meant by the term ’Capital Structure’?
The amount of debt relative to equity used by a corporation
What is meant by the term ‘Optimal Capital Structure’?
Borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. Borrow up to the point where your weighted average cost of capital is minimised.
Total Risk ?
The total systematic risk of the firm’s equity - ie the total of business risk and financial risk
What does a beta coefficient measure?
Beta coefficient is the amount of systematic risk present in a particular risky asset relative to an average risky asset.
Why can’t systematic risk be diversified away?
It is a market risk that affects almost all assets to some degree Refer page 365 Ross text
Explain why the risk of a portfolio of two stocks can be less than the individual risk of each of those stocks individually
Portfolio Risk – Systematic Risk Individual Risk – Systematic and Unsystematic Diversify unsystematic or unique risk
If a company has a beta of 1.5 what does this mean?
Systematic risk is 1.5 times that of the market therefore compensation is 1.5 times market premium
Describe the risks for which shareholders would be compensated for under the assumptions of the capital asset pricing model.
Systematic risks or market risks such as changes in interest rates
What is the Security Market Line?
Graphical representation of CAPM
What is the CAPM and what does it tell us?
Model that prices share based on risk ie Rf + (Rm – Rf ) Beta
Beta coefficient (β)
measures the amount of systematic risk in a particular investment relative to an average risky investment in the market.
An investment with a beta of 0.50
An investment with a beta of 0.50 has half the systematic risk that an average risky investment has.
CAPM has three components
- Pure time value of money: as measured by the risk-free rate, which is the reward for merely waiting for your money without taking any risk
- The reward for bearing systematic risk, as measured by market risk premium [E(RM) – Rf], which is the amount of reward for bearing the systematic risk of an average risky asset in the market
- The amount of systematic risk, as measured by beta, which is the amount of systemacit risk present in the asset, relative to an average risky asset
Variance?
is the average squared deviation between the actual return and the average return
Standard deviation?
is the square root of the variance
The efficient market hypothesis (EMH)?
asserts that the price of a security accurately reflects all available information - Implies that all investments have a zero NPV - Implies also that all securities are fairly priced - If this is true then investors cannot earn ‘abnormal’ or ‘excess’ returns
Dollar returns made up of two components
- income (e.g. dividends, rent) … in the form of cash may be - capital gain (or loss)… because of change in the market value of the asset
What is an investment portfolio? How can investors reduce investment risk by constructing an investment portfolio?
An Investment Portfolio is the name for a group of single assets held by an investor .There are 2 types of risk unsystematic and systematic. The risk that can be reduced is unsystematic risk. This consists of business risk factors specific to the individual company such as a strike. However the portfolio does not eliminate systematic risk but you can construct a portfolio to follow the average risk as measured by movements in the all ordinaries index.
M&M proposition I & II
