PAST PAPERS Flashcards
difference between regulatory capital and economic capital
regulatory capital is the capital that corporations are required to have to cover standard risks, expected losses and some unexpected losses.
economic capital is an internal measure that a company estimates to cover unexpected losses. It is used as a risk managemnt tool and is not regulated
what is g asset side in the WACC?
ROI*(Operating reinvestments/NOPAT)
where
Operating reinvestments: CAPEX + variations in NWC, they are the portion of a company’s cash flows reinvested to support ongoing operations and future growth
NOPAT (net operating profit after tax): operating income * (1-t)
note that operating income is EBIT
characteristics of the market portfolio in the CAPM model.
According to “modern portfolio theory,” investors care only about risk and return and, therefore, seek to maximize their utility by building efficient portfolios
that generate the highest rate of return for a given level of risk.
Through diversification (imperfect correlation between the returns of different assets) investors minimize the total risk of a portfolio for a given level of return.
The possible combinations of these risky assets are represented by the investment opportunity set. In an economy without risk free assets, ALL efficient investors in terms of mean variance ratio select only portfolios in the efficient frontier
Characteristics of CML:
Investors can make their
portfolio allocation decisions more complex and improve their risk/return profile by lending and borrowing at
the risk-free rate. In essence, investors no longer select a portfolio along the efficient frontier.
maximization of the ratio between risk premium and standard deviation of returns (sharpe ratio)
! note that:
- risky assets does not only mean “stocks”
- one of the disadvantages is not having opportunities below a certain risk (min. variance portfolio)
should a company with 7.5% WACC invest its EXCESS LIQUIDITY with a risk free return of 2.5%, given that the market risk free rate is 2%?
What if the company did not have any excess liquidity?
1) yes
the decision to invest excess liquidity in a risk free asset is independent of the WACC, which applies to the company’s operations and not its cash management
in this case the opportunity offers a return higher than the market rate, and thus creates value
2) no
the company’s WACC is 7.5%, which means that any investment the company makes should ideally have a return higher than its WACC to create value.
what is the definition of credit risk according to Moody’s?
the expected loss that a lender might face due to the default or downgrade of a borrower financial instrument.
where expected loss is given by:
probability of default*loss give default
what happens to a fixed coupon bond and to a fixed rate bank debt in case the borrower’s risk increases?
both hold the same interest rate but will adapt their market value (now lower)
formula of the PVGO
The value of growth opportunities can be calculated as the difference between the value of a company that
will grow by creating NPV and that of a company that will invest in the same way but with an NPV equal to
zero (whose value is equivalent to that of a company deciding to distribute all profits as dividends)
according to the theory of market timing
in some periods, prices are irrationally high/low
for this reason, depending on market timing it might be more convenient to raise money with equity and in some with debt
what is a corporation’s objective?
to maximize shareholder value
could be measured by Tobin’s Q = mkt value of assets / replacement cost of assets
when does APV lead to a different result from WACC method?
when ko /= WACC
when to use adjusted beta?
The adjusted beta is commonly used when the raw (historical) beta may not be a reliable estimate of future risk due to certain issues like illiquidity, extreme volatility, or lack of trading activity. An adjusted beta attempts to correct for the potential under- or overestimation of risk by blending the historical beta with an assumed average beta (often closer to 1) over time, which represents the market’s overall risk.
or
This type of adjustment is made especially in cases where the “raw” beta value is particularly low or high,
and is justified by the empirical observation of the fact that betas have a structural tendency over time to
“mean reversion” (towards a value equal to 1) and to correct excessively high or low values, but not when
the value is justified by industry characteristics or a particularly high financial leverage
the formula is:
2/3 beta corp + 1/3 beta market
considered an unlevered corporation with
ko = 8%
it issues bonds
kd = 5%
D/E becomes 1
what happens to ko?
ko stays the same, it is by definition applied to “unlevered” situation.
the WACC would change
DDM formula
P = Div/(Ke-g)
Beta equity formula
Beta equity = Cov(r_i , r_mkt) / [Std_mkt^2])
what does payout on NP depend on?
Even the choices regarding the optimal dividend policy are made on the basis of the principle of maximizing the value of equity (consequent to the dividend policy).
The payout ratio (the proportion of earnings paid out as dividends) depends heavily on the expected returns on future operating investments because:
If a company expects high returns from future investments, it may retain more earnings (i.e., a lower payout ratio) to reinvest in these profitable opportunities rather than distributing them as dividends.
Conversely, if future investment opportunities are less attractive or the company has fewer growth prospects, it might choose to distribute a larger portion of its earnings to shareholders in the form of dividends (i.e., a higher payout ratio).
how to comput ELR (expected loss rate)
ELR = PD*LGD
the trade off theory (modigliani, miller)
!! second model, not first
since interest payments on debt are tax deductible and generate a tax shield, the presence of debt creates value for the company.
At the same time, growing debt creates the conditions for a an implicit probabilistic negative component of the cost of debt, represented by bankruptcy costs.
this allows to identify an optimum point of the financial structure maximizing EV
Agency Theory
agency theory focuses on opportunistic behaviourr of agents and information asymmetry. According to these theory, there are two different effects that determine agency costs:
- equity agency costs: management objectives other than the maximization of equity capital. According to this theory the greater the equity owned by managers, the more aligned are their objectives with shareholders.
Another way to keep managers in check is trough Debt. It becomes a discipline tool because it binds management to the payment of future cash flows.
- debt agency costs: this is between shareholders and financiers. In limited liability corporations, the greater the debt, the more the shareholders (and
management on behalf of the shareholders) will have an incentive to undertake risky investment
projects: this is because the creditors will bear the negative risk (downside risk), while the ownership
will obtain the gain in the event that the project is successful (upside risk). That is, there is a
decomposition of financial risk.
Pecking order theory
this theory starts with the removal of perfect information, it is assumed that management has more precise information than the market regarding the investment prospects of the company.
The cost of financing increases with the degree of information asymmetry (what the company knows and what investors know).
Firms order the possible sources of financing in the following way:
- self financing: not subject to any form of information asymmetry (and reaction to information asymmetry)
- debt: first risk free, then risky, then “close to equity”. If a project has a high NPV, debt is more convenient because upside is mostly of the company.
- equity issues are seen as a last resort: when a company sells shares, it is sharing the risks of future projects and investors know this. Why would it share the profits if it is expecting great returns?
Market timing theory
starts with the hypothesis that the market can give, at certain moments, an incorrect evaluation of the value of the company’s shares (or bonds, if listed),
Issuance of debt/equity depends on market over/undervaluation. Sometimes one is more convenient than the other and vice-versa.
when in the DDM can you apply Net Profit instead of dividends, as relevant cashflow for valuing a company?
when Plowback = 0 (payout = 1)
in case plowback =1, the DDM does not apply!
in which case is the market value of equity equal to accounting value of equity, in a “steady state” condition?
when ROE = K_e
what is the bankruptcy condition?
EV < financial debt
what is the difference between financial risk and bankrupcty risk?
financial risk is a “symmetric” risk, both downside and upside. The premium determined by the market is can be assessed by the interaction of an objective element (volatility) and subjective element (degree of risk aversion)
bankrupcty risk is a “pure” risk (only downsides). Futhermore, the only element of risk is determind by PD and the extent of the loss. It is only objective.
when determining TV, in case firm’s expected inflation rate is lower than the system’s inflation rate what do you do?
we must use nominal cashflows and nominal rate
in which case would shareholders in a “unlimited liability company” would be required to invest personal net worth in the enterprise?
in case the company defaults and its liquidation value is lower tha outstanding debt
bankruptcy costs reduce what?
enterprise value and equity value
why the probabilistic distribution of enterprise value relevant?
because it is one of the determinants of default risk and consequently cost of debt
is management’s subscription of stock options a protective covenant?
no
stock options are actually an incentive/form of compensation
what is in the CF statement the item that indicates need (or not) of additional funding?
financial surplus/deficit
in which case does the steady state value of a company equal its book value?
when ROE = K_e
how do you compute beta equity?
beta equity = std_i / std_mkt * CORR(i,mkt)
or
beta equity =
what happens when you discount nominal cashflows with a real discount rate in case there is inflation?
you undervalue the asset
PVGO formula
NP_0 * [P_back(ROE-K_e)]/K_e[K_e-(ROE*P_back)]
what happens if you use real discount rate on nominal cash flow?
you overvalue the asset (in case there is inflation)
